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# CS 7646 Midterm Finance Questions Prep CS7646

Georgia Tech

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This 87 page Study Guide was uploaded by Dominique Notetaker on Wednesday January 27, 2016. The Study Guide belongs to CS7646 at Georgia Institute of Technology taught by Balch, Tucker R in Winter 2016. Since its upload, it has received 63 views. For similar materials see Mach Learn For Trading in Computer Science and Engineering at Georgia Institute of Technology.

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Date Created: 01/27/16

Below are possible questions and answer to help you ready for the Midterm Question relates to Chapter 7 Which of the following is true for a beta-balanced portfolio? a) The beta values of all stocks in the portfolio are equal. b) The beta values of all stocks in the portfolio sum to zero. c) All stocks in the portfolio have equal weight. d) The weighted beta values of all stocks in the portfolio sum to zero. Correct answer is d) as described in Chapter 7 of the text: "Most hedge funds seek beta-balanced portfolios so that they are precisely protected against market-wide moves. That means, essentially Sum(beta_i*w_i) = 0, and Sum(|w_i|)=1.0" Question relates to Chapter 7 You are the manager of an ETF that tracks the performance of the S&P 500 (i.e your ETF is just like SPY). What are the alpha and beta numbers for your ETF? A) alpha = 0, beta = 0 B) alpha = 0, beta = 1 C) alpha = 1, beta = 0 D) alpha = 1, beta = 1 Answer B. Explanation : Your ETF / SPY tracks the overall market performance. Therefore its alpha = 0 and beta = 1, because its performance is equivalent to that of the markets Question relates to Chapter 7 Given the following Symbols and their associated Betas what would be a beta balanced portolio? ABC .75 DEF .25 GHI 1 a) [ABC: -.5, DEF: -.1, GHI: .4] b) [ABC: .5, DEF: .1, GHI: .4] c) [ABC: .5, DEF: .25, GHI: .25] d) [ABC: -.5, DEF: .25, GHI: .25] Correct Answer: a Reason: It is the only one that satisfies both properties of a beta-balanced portfolio (page 54) >>>(.75 * -.5) + (.25 * -.1) + (1 * .4) 0.0 And 0.0 >>> .5 + .1 + .4 1.0 Question relates to Chapter 7 In the Capital Asset Pricing Model, on average what is alpha assumed to be, and why? a) 0 - because it is a coefficient that ranges from -1 to +1, and 0 is the median b) 0 - because it is the difference in performance of a stock above the market, and taken collectively all stocks cannot beat the market c) 1 - because it represents the weightings of assets in a portfolio, which must sum to 1 d) 1 - because it is a stock's price volatility relative to the overall market, which by definition is 1 Correct answer is b. (From Ch. 7) Collectively all stocks cannot beat the market because together they are the market... any stocks with positive alphas are counterbalanced by other stocks with negative alphas. Question relates to Chapter 7 The stocks of company A and B have a correlation coefficient of -0.7, what could prossibly be, company A and B? A) A cell phone manufacturing company and a medicine manufacturing company B) Two luxury goods manufacuring company C) A automobile manufacturing company and a petroleum company D) An airline company and a confectionary company(which makes candies) Answer: c) A) Cell phone and medicine are unrelated sectors, so their correlation would be around 0 B) Two luxury goods company are same sectors, they might be positivly correlated C) If the oil price goes up, that might result in the decrese of the sales of cars, so they are negativly correlated D) Airline companies have nothing to do with candys, so their correlation might be around 0 Question relates to Chapter 7 Consider the following stock prices: Date (dd/mm/yyyy) Stock A Price Stock B Price 1. 01/03/2015 $50.00 $32.21 2. 04/03/2015 $51.00 $31.98 3. 07/03/2015 $50.04 $32.73 4. 12/03/2015 $52.19 $30.74 5. 20/03/2015 $52.24 $30.50 Based solely on the foregoing prices, how would you best describe the relationship between Stock A and Stock B? a) Positively correlated b) Negatively correlated c) Insufficient data to determine correlation d) No correlation Correct answer is b) Negatively correlated Explanation: The stocks can best be described as negatively correlated because as the price of one stock increases, the price of the other stock decreases (and vice versa). Question relates to Chapter 7 find stocks that systematically outperform the market the market is known as a)seeking alpha b)buying alpha c)buying beta d)seeking beta Correct answer is b) because Alpha is the systematic difference in performance(return) of a stock over and above the market. Question relates to Chapter 7 Which of the following statement is NOT corrected about CAPM (return = beta * spy + alpha) : a) Alpha is the systematic difference in performance of a stock over and above the market. b) Beta represents the stock's price volatility relative to the overall market. c) If you are seeking alpha, you should buy ETF, such as SPY. d) If you are seeking alpha, you should try to improve your investment skills and bet on individual stocks. correct answer is c) because for buying ETF, such as SPY, return is primarily based on the upward of general market to get return, which is called buying beta. Question relates to Chapter 7 If we can ignore or disprove the Efficient Market Hypothesis, based on the CAPM model, which combination of variables will give us the optimal portfolio performance when the S&P500 is in a bear market? (Assuming we can predict that S&P500 will go down indefinitely and our portfolio uses S&P500 as a benchmark for the market) a) high beta, high alpha b) high beta, low alpha c) low beta, high alpha d) low beta, low alpha Answer: c) CAPM equation is r(p) = beta(p)*r(m) + alpha(p); if we can predict market returns will be negative, we would want to choose a low or even negative beta to maximize this equation. Alpha does not depend on market returns so we will always want a high alpha. Question relates to Chapter 7 On a given day, the return of stock XYZ's is -3% and its beta is 2; the general overall market return is -2% on that same day. According to the Capital Assets Pricing Model (CAPM), what is the alpha of stock XYZ on that given day? Select one answer: a) 0 b) 1 c) -1 d) -7 Correct answer: b) Explanation CAPM equation is: Return(XYZ) = beta * return(general overall market) + alpha => -3% = (2 * -2%) + alhpa => alpha = -3% + 4% => alpha = 1 Question relates to Chapter 7 APPL weight: 22%; APPL return: 10% GOOG weight: 48%; GOOG return: -5% SPY weight: 20%; SPY return: 3% XOM weight: 10%; XOM return: 5% What would be the portfolio's overall return? a) 5.75% b) 0.9% c) 13.0% d) 5.7% Correct answer is b) because 22% * 10% + 48% * -5% + 20% * 3% + 10% * 5% = 2.2% + (-2.4%) + 0.6% + 0.5% = 0.9% Question relates to Chapter 7 What correlation coefficient best represents that two financial instruments prices are changing independently of each other? a) -0.8 b) -0.1 c) 0.4 d) 0.9 Correct answer is b) because it is the answer choice closest to 0. The correlation coefficients quantify the extent at which the price change of one instrument moves with or against the other instrument. A correlation of 1 is a perfect positive correlation. -1 is a perfect negative correlation. 0 is no correlation between the two financial instruments. Moving independently means that there is not a strong correlation between the two. Question relates to Chapter 7 Consider two stocks with tick codes BAD and DET. BAD and DET have market capitilsations of $400,000,000 and $100,000,000 respectively. What is the return on a cap weighted portfolio if BAD achieved a return of 1% and DET a return of -2% ? Select one answer: a) 1.2% b) -1.4% c) 0.4% d) 0.8% Correct answer: c) Solution: Since the portfolio is cap weighted then asset BAD will represent 80% of the portfolio and DET 20% of the portfolio. Then the portfolio return is given by: ret = 0.8 x 0.01 + 0.2 x -0.02 = 0.4% Question relates to Chapter 7 Suppose the market is guaranteed to increase in value over a time period. If purchasing a stock with a positive Alpha Which of the below Beta values would be most desirable during that time period? a) Beta = 0.0 b) Beta = 2.0 c) Beta = 1.0 d) Beta = -2.0 Answer: b - A positive Alpha means that the stock will have a return suprior to the market. Becasuse we know the market is increasing in value we want to purchase the stock that is going to have the greatest fluctuation from the market in the same direction as the market. Positive Beta designates that the stock is moving in the same direction as the market so we want the largest movement in that direction. answer choice b is the highest positive Beta. Negative Beta designates that the stock is moving inversely to the market which makes answer choice d the worst performing. Question relates to Chapter 7 A portfolio is defined by a weighted collection of stocks, S_i, where sum(|W_i|) = 1.0. Given that each stock has an associated beta, B_i, a "Beta Balanced" portfolio means that: A) The sum of all beta is 1.0: sum(B_i) = 1 B) All B_i are approximately equal: B_0 ~= B_1 ~= B_2 ~= ... C) The sum of all beta is 0.0: sum(B_i) = 0 D) The sum of beta times the weight is 0.0: sum(W_i * B_i) = 0 Correct answer is D) as this formula is directly in the text. Also, intuitively, Beta represents a stock's volatility with respect to the market. Multiplying the volatility times the weight of a stock, gives the weighted volatility of the portfolio (with respect to the market). A portfolio with zero volatility is in theory "protected from market-wide moves". Question relates to Chapter 7 An investor forecasted that stock A will experience positive development and rise 2 % over the overall market. So, he buys a long position of 100$ . At the same time he expects stock B to go down 1% below the market so goes 50$ short with it. Assuming that the beta for the stock A is 2.0 and beta for stock B is 1.0. What would be the net return on the investment if the market stayed flat. a)2 Dollars b)1.5 Dollars c)2.5 Dollars d)3 Dollars Answer: 2.5 Dollars Solution. Use CAPM equation return(A) =beta(A)*return(market) + alpha(A) = 0 + 2% = 2% return(A) in dollars = 2% of $100 = $2 return(B) = beta(B)*return(market) + alpha(B) = 0 + (-1%) = -1% return(B) in dollars = -1% of -($50) = $0.5 net return = return(A) + return(B) = $2 + $0.5 = $2.5 [the beta component of both the equations became 0 as the market remained flat so the value of return(market) =0 since the investor went short position on stock B, return in dollars for stock B would be positive.] Question relates to Chapter 9 Fund A has outperformed SPY by 2% over the last year. The standard deviation of the difference between Fund A and SPY has been 8%. What is the information ratio for this fund over the last year. What is the information ratio (IR) of the fund? Also, assuming the fund can maintain it’s performance over more stocks or trades what change to its trading could fund make to triple its information ratio? a) IR = 4; Fund A needs to double trades to triple IR b) IR = .25; Fund A cannot triple its information ratio c) IR = .25; Fund A needs to take 9x as many trading opportunities d) IR = .5; Fund needs to diversify into 3x as many stocks Correct answer is c) IR = Excess Return per Period / StDev of Excess Return (IR = . 02/.08 = .25) and IR = skill * sqrt(breadth)so assuming that skill remains the same to triple return needs 9x breadth. Question relates to Chapter 9 Barren Wuffett's portfolio has returned 20% over the past year, while making 10 trades. Rebirth Technology's portfolio has returned 20% over the past year, while making 10,000 trades. Assume both portfolios carry the same levels of risk. According to the fundamental law of active portfolio management, which manager has the most skill as measured by information coefficient? a) Barren Wuffett. b) Rebirth Technology. c) The two have equal skill, because their total returns are the same. d) It depends on the return of the SP500. Answer: a) IR_wuffett == IR_rebtec, and because IR = IC * sqrt(breadth): IC_w * sqrt(BR_w) == IC_rt * sqrt(BR_rt) IC_w * sqrt(10) == IC_rt * sqrt(10000) IC_w * 3.16 == IC_rt * 100 IC_w > IC_rt Question relates to Chapter 9 According to Grinold's simplified Fundamental Law of Active Portfolio Management, a four-times increase in breadth (number of trades) should result in what change in performance? a) Zero change. b) A four-times decrease. c) A four-times increase. d) A two-times increase. Correct answer is d) because the law states that performance = skill * sqrt(breadth). Question relates to Chapter 9 In Grinold's Fundamental Law of Active Portfolio Management, which of the following represents a perfectly correct predictor for the managers Information Coefficient or IC. a. -1.0 b. 1.5 c. 1.0 d. 0.0 answer is = c. 1.0 Question relates to Chapter 9 Modern portfolio theory distinguishes between two broad categories of risk. Which type of risk is reduced by diversifying your portfolio, and why? a) Systematic Risk is reduced because diversification reduces volatility of a portfolio. b) Specific Risk is reduced because diversification increases your information coefficient. c) Specific Risk is reduced because diversification reduces volatility of a portfolio. d) Systematic Risk is reduced because diversification increases your information coefficient. Correct answer is c) because research has shown that the volatility of a portfolio of stocks declines as more individual stocks are included in a portfolio. Question relates to Chapter 9 You have the following situation: - You have a fair coin (50% heads, 50% tails), and can make bets based on the outcome of coin-tossing: - In alternative 1 you can make 1000 bets for $1 each (if you toss heads you gain $1, if you toss tails, you lose $1) - In alternative 2 you can make one bet on $1000 (if you toss heads you gain $1000, if you toss tails, you lose $1000) Which tools would help you choose between alternatives? a) Sharpe ratio b) The standard deviation of returns c) Return to risk ratio (unadjusted for risk free return) d) All of the above. Correct answer is b) since the expected return of both alternatives is the same ($0), the best choice would be to choose the alternative with the lowest risk. Question relates to Chapter 9 What is the difference between the Sharpe Ratio and the Information Ratio? a) Unlike the Sharpe Ratio, the Information Ratio measures excess return and risk relative to a specific benchmark index. The Sharpe ratio is similar but is relative to a risk free rate instead of a benchmark index. b) Unlike the Information Ratio, the Sharpe Ratio measures excess return and risk relative to a specific benchmark index. The Information ratio is similar but is relative to a risk free rate instead of a benchmark index. c) Unlike the Sharpe Ratio, the Information Ratio separates market return from stock-specific return. d) Unlike the Sharpe Ratio, the Information Ratio is the number of trading opportunities over time. Correct answer is a) because the Information Ratio measures excess return and risk relative to a specific benchmark index. The Sharpe ratio measures excess return and risk relative to a risk free rate. Question relates to Chapter 9 Assume you enter into a bet with Jim Simons to see who is the better investor(achieve a higher information ratio). You know that the breadth of his portfolio exceeds your own by 400x. How much higher does your Information Coefficient(skill) need to be to level the playing field? a) 10 b) 20 c) 15 d) 5 Answer: b) 20 Grinold's Fundamental Law of portfolio management can be specified as: IR=IC*sqrt(breadth) setting the IR values equal and substituting Jim Simon's breadth given in the question IC1*sqrt(b1)=IC2*sqrt(b2) IC1*sqrt(b1)=IC2*sqrt(400b1) IC1=20*IC2 so given a breadth increase of 400x you must have a 20x improvement in your IC(IC1) to compensate Question relates to Chapter 9 Fund manager Alice specializes in energy stocks while fund manger Bob specializes in technology stocks. Both of them exclusively build portfolios from their respective sectors. They decide to join forces and create a combined portfolio. Which of the following are true statements: A. Their information ratio (IR) is higher as their information coefficients (ICs) add up B. Their IR is higher due to the increase in breadth a) Only A b) Only B c) Both A and B d) None Correct answer is b) because their skills will get averaged out, but the breadth of the portfolio will increase. Question relates to Chapter 9 A rubber shortage causing the stock price of a tire company to drop is an example of what type of risk? a) Company-specific risk b) Industry risk c) Supplier risk d) Systematic risk Correct Answer: b In this case, the rubber shortage which would affect the en-”tire” industry. That same rubber shortage is unlikely to affect the stock price of a movie production company illustrating how the risk is isolated to one industry. Question relates to Chapter 9 What is the range for Information Coefficient? a) -1 to 1 b) 1 to 100 c) 0 to 1 d) 0% to 100% Correct answer is “a”. Information Coefficient is similar to correlation and it ranges from -1 to 1 inclusive. IR and IC can be negative. Question relates to Chapter 9 According to the Fundamental Law of Active Portfolio Management, to exactly double Information Ratio while the Information Coefficient stays the same, what do we have to do? A.) A manager must find four times as many trading opportunities. B.) A manager must find eight times as many trading opportunities. C.) A manager must evaluate stocks based on systematic risk. D.) A manager must reduce the standard deviation by 4. Correct answer A.) because IR = IC*sqrt(breadth). And breadth is the total number of trading opportunities presented over time. Question relates to Chapter 9 Diversification of a portfolio has shown to mitigate which type of risk? a. Systematic risk b. Specific risk c. Market risk d. Investor-specific risk Correct answer: b. Research has shown that the volatility, or standard deviation of returns, of a portfolio of stocks declines as more individual stocks are included in the portfolio. Question relates to Chapter 9 Which of the following can give your portfolio more breadth? Choose the best answer. 1 Diversification of Assets 2 Trading More Frequently 3 Including more people in the decision on where to invest A) 1 B) 2 C) 1,2 D) 1,2,3 Answer: C Justification: Breadth is "the number of trading opportunities presented over time" (p65). In a conventionally managed portfolio, having more assets presents more trading opportunities over time because trade decisions aren't cornered by the performance of one asset. Making more frequent trades with portfolio equities is a way of creating more trading opportunities in a more active management strategies (p61). Question relates to Chapter 9 Why is it that an increment in the information coefficient (IC) has a greater reflection on the information ratio (IR) than an equal increment in the portfolio breadth? a) portfolio breadth is inversely proportional to the IR. b) portfolio breadth affects IR as square root, whereas IC affects IR proportionally. c) portfolio breadth cannot be increased at a later point. d) IR is directly proportional to the exponential of IC. Correct answer is b) because IR (Information Ratio) = IC * sqrt(breadth) Question relates to Chapter 9 Which of the following components reflects the price movement that cannot be attributed to the market overall, and is sometimes attributed to the skill of the investor? a. Sharpe Ratio b. beta c. Information Ratio d. alpha Correct answer is (d) because beta is a measure of the volatility of the stock, while alpha is the residual, or what is seen due to the skill of the investor or the quality of information used in selecting a stock. Question relates to Chapter 4 You are a Hedge Fund Manager meeting with a prospective client. The client requires that you double his money in 10 years. What is the Compound Annual Growth Rate (CAGR) of the fund portfolio needed to meet the client demands? a)7.2 % b)10 % c)14.4 % d)20 % The correct answer is a) Using the Rule of 72 we can determine the required CAGR. CAGR= 72/10 years Question relates to chapter 4 John has $20,000 saved. He's optimistic, but not unreasonably so, and thinks he might be able to average an 8% annual return each year. Approximately how long will it take for his savings to exceed $1,000,000? Select the choice that is closest to the exact answer. (a) 55 years (b) 52 years (c) 45 years (d) Nobody lives that long Correct Answer: (b) 52 years (a) 55 years: is closest to what the Rule of 72 would say, but too long. (72 / 8) = 9 years per doubling, 6 doublings required -> 54 years. (b) 52 years: is correct and closest to the actual answer, since Rule of 72 says 54 years, but 6 doublings yields roughly $1,280,000. We needed to aim for less time, not more. (c) 45 years: is for people who made a mistake in the number of doublings needed. (d) Nobody lives that long: is for people that don't know the rule of 72 or the awesome power of compounding interest. Question relates to Chapter 4 Which of the following is true about the market spread? a) A smaller market spread means the market is not very liquid b) The market spread is unrelated to the liquidity of the market c) Brokers can earn money from the market spread when clients have overlapping buy and sell orders d) High trading volume markets have large market spreads Correct answer is c) because brokers with overlapping buy and sell orders can act like a middle man and profit on the difference between the buy and sell price (i.e., the market spread). The other answers are incorrect because the market spread is inversely correlated with liquidity and the trading volume of the market. Question relates to Chapter 4 For the following order book, what is the average price per share a buyer would pay on a market order of 1200 shares? Bid Size Price Ask Size $220.00 1000 $210.00 500 $200.00 500 500 $190.00 500 $180.00 500 $170.00 a) $205.83 b) $207.50 c) $184.16 d) $182.50 CORRECT ANSWER: b) $207.50 ANSWER VALIDATON: (quantity available at each price up to 1200 shares) / number of shares ((500 * $200) + (500 * $210) + (200 * $220)) / 1200 = $207.50 Question relates to Chapter 4 Brokers can legally make money in all the below trades except: a) Trading in dark pools between brokerage firms from a portion of the market makers spread. b) Trading among their own brokerage firm clients on the market makers spread. c) Trading in advance of their own clients via front running. d) Trading in advance of any other broker's clients. Answer c) is correct according to the end of chapter 4 on the mechanisms of clearing trade orders. According to the book, "Front Running" is trading in advance of clients, knowing what the price movements will likely be. The ethics of this are dubious when it is trading against its own clients. Question relates to chapter 4 Which of the following is TRUE of mutual funds but not hedge funds? a) Mutual funds rely on funds from individual investors b) Mutual funds must report their holdings regularly c) Mutual fund investors must be accredited d) Mutual funds are not allowed to advertise Correct answer is b) since all other answers are true of hedge funds or not true of mutual funds. Question relates to Chapter 4 Which of the following best describes the Fundamental Law with respect to risk- adjusted returns? a) Increasing breath will have greater positive impact then increasing information coefficient by the same amount. b) Increasing the information ratio is equivalent to increasing the information coefficient c) Increasing the information coefficient is proportional to increasing the information ratio, whereas increasing the breath affects the information ratio only as a square root d) Decreasing the breath while holding the information coefficient constant will increase the information ratio. Answer: (c) The Information Ratio is defined as IR = IC * sqrt(breath) Question relates to Chapter 4 A given portfolio has 3 percent CAGR. Approximately how many years will be required for this portfolio to double in size? a) 72 years b) 2 years c) 48 years d) 24 years Correct answer is d) because according to the Rule of 72, a portfolio growing at 3 percent CAGR will require 24 years to double (3x24=72) Question relates to Chapter 4 Which order is accepted by exchanges? a) trailing stop b) sell limit c) sell short d) stop loss b) is correct because exchanges only accept buy/sell market/limit orders. Other orders are handled by brokers. Question relates to Chapter 4 How do hedge fund fees typically differ from the fees of mutual funds? a) Hedge funds fees are based only on a percentage of assets under management (expense ratio) b) Hedge funds are lightly regulated and secretive therefore they do not disclose their fees c) Hedge funds are compensated in a hybrid structure incorporating both the traditional expense ratio and a portion of the funds returns d) Hedge fund fees are based solely on the funds ability to outperform a particular stock index. Correct answer is c) a hybrid structure using both a percentage of assets under management and a portion of the funds returns. The expense ratio for a hedge fund is typically 2% (double that of the typical mutual fund’s 1%). Also hedge funds customarily charge 20% of the funds returns. As a result, this fee arrangement is often referred to as “2 and 20”. However these values are not the universal standard as hedge funds may choose their specific fee arrangement. Question relates to Chapter 4 Consider the following entries appears on the Order Book for IBM stock: Bid/Ask Price size Ask 105.05 1000 Ask 105.00 200 Ask 104.99 500 Bid 104.50 400 Bid 104.25 800 Now, the following 2 buy orders are placed as it appears below: Buy, 400, Limit, 105.06 Buy, 250, Limit, 105.05 What should be the price of the stock after execution of those 2 orders? a. 105.06 b. 104.99 c. 105.00 d. 105.05 Answer is c. The first buy order will execute at 104.99 and still have 100 share left at that price. For the 2nd buy order will first get 100 share at 104.99 and rest 150 at a price 105.00. Making the last transacted price as 105.00. Question relates to Chapter 4 Q. A broker purchased 100 shares of a stock at the price of $10 per share, together with a trailing stop order placed with 10% trailing threshold for the stock holding. If the stock went up to its highest $12 per share, and dropped to $8 per share. What would be the outcome? a) The trailing stop order triggered a market order as soon as the price dropped to $9 dollars to sell all 100 shares but with a loss of $100. b) The trailing stop order triggered a market order as soon as the price reached to $11 dollars to buy another 100 shares and paid $1100. c) The trailing stop order triggered a market order after the stock dropped to $10.8 from $12 to sell the 100 shares and received a profit of $80. d) The trailing stop order triggered a market order as soon as the price reached to $12 to sell 10% of the 100 shares (10 shares) and received a profit of $20. Correct answer is c) The trailing stop order acts similar to a normal stop order but unlike a stop order referring its threshold to the purchase price, it refers to the most recent high price to preserve most of the gains for an asset whose price has risen since original purchase. Since the recent high for the stock is $12, and if the price continues to drop until 10% below the high, which is $12 - $12 * 10% = $10.8, it immediately triggers a market order to sell. Question relates to Chapter 4 According to the Bollinger?s Bands with technical analyses, you should sell your shares when the price of the stock is 2 standard deviations __________ band and buy when the price of the stock is 2 standard deviations __________ the band. a) above, on the lower b) above, below c) on the upper, below d) below, above Correct answer is b). Bollinger Bands suggest selling your shares when the price of the share is two standard deviations above or buying when the price is two standard deviations below. If it?s exactly on either bands, the stock is expected to follow a stable (i.e., low volatility) simple moving average. Question relates to Chapter 4 Which of the following is not a valid argument for why short selling is generally more risky than going long. a) The long term trend in stock prices is generally upward b) The maximum loss for a short is unlimited c) Shorts require exceptionally deep research to be successful d) Shorting involves two separate transactions Correct answer is d) because a trade being two seperate transactions doesn't necessarily make it more risky. The reasoning for d being the answer is weak at best compared to the other three answers. a, b, and c are objective facts that make shorting riskier than going long. Question relates to Chapter 4 How does the liquidity of a market affect volumes and market spreads? a) High liquid markets tend to have low volume and high market spreads b) Low liquid markets tend of have high volume and low market spreads c) High liquid markets tend to have high volume and low market spreads d) Liquidity does not affect volumes or market spreads Correct answer is c): High liquid markets tend to have the smallest spread and high volumes Question relates to Chapter 2 Suppose your portfolio is worth $200 this year (2016) after you started with “$X” in 2006. If your compound annual growth rate (CAGR) is 10%, what is the value of X i.e. the principal of portfolio? a. 100 b. 85 c. 110 d. 77 correct answer is d. Solution: Compound Amount (CA)= $200 years (n) = 10 Compound Annual Growth Rate(CAGR) = 10 Principal(P)= X formula CA = PA * (1 + CAGR)^n 200 = X * (1 + 10%)^10 X = 200 / (1 + 10/100)^10 = 200 /(1.1)^10 = 200/2.594 = ~ $77 Question relates to Chapter 4 Joe purchased 1000 shares of a XYZ stock at the price of $15 per share.Joe set a trailing stop at 5%. If XYZ stock went up to its highest $20 per share, and dropped to $10 per share. Which of the following statements are true? a)Joe is at loss 750$ b)Joe is at profit 750$ c)Joe is at profit 4000$ d)Joe is at loss 5000$ Answer: C Explanation: Trailing stop is set at 5%. When the price is 15$, stop loss is set to 14.25. Since price of XYZ stock increased to 20$ stop loss will automatically change to 19$. So when price reduce to 19$ stop loss will be triggered. Gain per share is 4$, for 1000 shares profit is 4000$ Question relates to Chapter 4 Given the below order book for stock XYZ what is the market spread? Bid Size| Price| Ask Size | $20.05| 100 | $19.95| 100 | $19.90| 200 400| $19.80| 100| $19.70| 100| $19.50| a) $.55 b) $.10 c) $.30 d) $.15 Answer: b) $.10 The market spread is the difference between the lowest ask price and hightest bid price. $19.90 - $19.80 = $.10 Question relates to Chapter 2 Using the Rule of 72, approximately how long would it take a portfolio growing at 3 percent to double? a) 100 years b) 24 years c) 33.3 years d) 72 years Answer: b, 24 years The Rule of 72 is a shortcut method that allows quick computation of compound interest and exponential growth. By dividing the annual interest or growth rate of a porfolio into 72, one can get a quick but inexact number of years required to double the value of the portfolio. In this case, 72 / 3 = 24. The precise value is 23.450 years. Question relates to Chapter Question relates to chapter 10 What is NOT true for an optimal portfolio? a) Returns on an optimal portfolio are cyclic in that when an asset becomes popular, its future returns are reduced b) If a global event affects two apparently unrelated assets in an optimal portfolio, uncorrelated assets can suddenly become highly correlated c) It always includes all stocks with a very high positive correlation d) Weakly correlated asset choices can be part of an optimized portfolio Correct Answer: c Explanation: because portfolio optimization depends on portfolio diversification to keep risk in an acceptable range while aiming for higher returns. Question relates to chapter 10 Which best explains why the Sharpe ratio of a portfolio may be higher than the Sharpe ratio of any of its individual components? a.) Portfolios can be optimized to maximize returns while individual assets cannot. b.) Positive asset correlations maximize the returns of the portfolio in an up market. c.) Returns of a portfolio are always higher than the returns of its individual components. d.) Negatively correlated assets in the portfolio reduce overall portfolio volatility. Correct answer is d) because negatively correlated assets in a portfolio reduce the oscillations (volatility) in returns of the portfolio, thus increasing its Sharpe ratio. Question relates to chapter 10 Why is low correlation valued so highly? a) It reduces diversification b) If one asset does poorly, it is given that the other asset will help overcome losses since they are uncorrelated c) It dampens the oscillations that occur in return, thereby reducing volatility d) It's difficult to find highly correlated values in the first place Answer: (c) Justification: Combining negatively or low correlated assets helps to reduce the effects on return from the oscillations that occur in the individual assets. Question relates to chapter 10 When comparing investments with different Sharpe Ratios, consider the Sharpe Ratio and its slope to find the proper risk and return that produces a better optimized investment. Which answer is correct? a) A steeper slope will produce more risk and a higher return. b) A steeper slope will produce less risk and a higher return. c) A more level slope will produce less risk and a higher return than a steeper slope. d) A more level slope will produce more risk and a higher return than a steeper slope. Correct answer is b) because the steeper the slope, the higher the Sharpe Ratio will be. An investment with a higher the Sharpe Ratio will perform better overall because it is less risky and also produces a higher return based on risk. Question relates to chapter 10 Which one is not the common componet for portfolio optimization? a. Decision variables b. Objective function c. Constraints d. Sharp ratio correct answer: c). the common components of portfolio optimization includes decision variables, objective function, constraints and search procedure. Sharp ratio is not included. Question relates to chapter 10 Which of the following statements is NOT true? (A) Based on the modern finance fundamental assumption, if the investor wants to get higher return, he usually has to accept higher risk. (B) In the real market, it's hard to find out negatively correlated assets, but we can use low positive correlated assets combination instead. (C) The portfolio optimization can help us to find out a set of stock weights, which achieves a target return with the lowest risk. (D) No matter how the market changed, uncorrelated assets can't become correlated. The correct answer is (D) Explanation: (A) Chapter10, page 71, last paragraph: "This risk and return trade-off is one of the fundamental assumptions in modern finance". (B) Chapter10, page 75, first paragraph: "In practice, few assets are negatively correlated, so we will have to settle for low positive correlations." (C) Chapter10, page 76-77 : "For each level of target return, there is a set of weights that provides the lowest-risk portfolio for that return" (D) Chapter10, page 77, last paragraph: "Correlations can change: If a global event affects two apparently unrelated assets, uncorrelated assets can suddenly become highly correlated" Question relates to chapter 10 Which of the following statement is false? a) A good strategy while building a portfolio is to look for anticorrelation in long term and positive corrrelation in short term between the individual stocks in the portfolio. b) Global event can affect two apparently uncorrelated assets and they can suddenly become highly correlated. c) It is possible to provide lower-risk portfolios than individual assets with similar returns. d) With efficient frontier, we cannot get a higher return in a portfolio than the individual stock with the highest return in the portfolio. Correct answer is a) because overall we look to maximize our returns and for this, we need to look for anticorrelation in short term and positive correlation in longer term (Lecture 2-10, module - Mean Variance Optimization) b is from the "Dynamic Process" section of chapter 10 of the book "What hedge funds really do" The efficient frontier indicates c and d are true. Question relates to chapter 10 Both stock A and stock B have a risk of 10%. And the covariance between the daily returns of stock A and stock B is -0.9. For a portfolio with 50% stock A and 50% stock B, what the risk of this portfolio would be? a) lower than 10% b) higher than 10% c) equal to 10% d) cannot be determined Correct answer is a) because the covariance is -0.9, which means stock A and stock B are highly anti-correlated. The combination of stock A and stock B would have a lower risk than 10%. Question relates to chapter 10 What is tail risk and why is it dangerous? a) The risk that two assets are closely correlated; this will cause their value to move up or down together. b) The risk that an extreme negative event will occur that is too rare for your data series to detect and account for. c) The risk that the performance of an asset will trail behind other assets in your portfolio, underperforming expectations. d) The unaccounted for risk that an asset's performance will move sideways, neither up no down, underperforming expectations. The correct answer is b). See Chapter 10, under the "No Panacea" heading near the end (I have the Kindle version of the book, which doesn't include page numbers). This describes tail risk and the effects it can have on a portfolio (up to and including destruction of a firm). Question relates to chapter 10 Assume you have plotted the efficient frontier for a portfolio. Which of the following must be true? a) The ray (line segment from the origin to a specific point on the frontier) with the steepest slope represents the maximum Sharpe ratio b) The ray (line segment from the origin to a specific point on the frontier) with with the longest length represents the maximum Sharpe ratio c) The ray (line segment from the origin to a specific point on the frontier) with the shortest length represents the maximum Sharpe ratio d) The ray (line segment from the origin to a specific point on the frontier) with the flattest slope represents the maximum Sharpe ratio Correct answer is a) because the ray with the steepest slope represents the maximum expected return with the lowest possible risk (standard deviation) Question relates to chapter 10 Which one of the following statements about Harry Markowitz's Efficient Frontier is false: a) There is always an optimal portfolio for each specified return. b) Straying away from the efficient frontier line will result in a sub-optimal portfolio. c) Reduced rewards always correlates to reduce risk. d) Maximum Sharpe ratio is the slope of the line that connects the risk-free rate lying on the y-axis. Correct answer is c) because reduced risk at some point doesn't correlate to reduced risk and might end-up increasing risk. Question relates to chapter 10 The optimized risky portfolio can be found in the efficient frontier by getting the point of _____________. a) the maximum return point on the efficient frontier b) the minimum variance point on the efficient frontier c) the tangency point of the capital market line and the efficient frontier d) None of the above choice Correct answer is c) because according to CAPM theory,at this point, shape ratio is maximized.The portfolio with maximum Sharpe ratio is the point where a line through the risk free return that tangent to the efficient frontier, in mean-standard deviation space, because this point has the property that is has the highest possible mean-standard deviation ratio. tangency portfolio is optimized risky portfolio. Question relates to chapter 10 Regarding efficient frontier, which one of the following statements is NOT correct: a) Portfolio on efficient frontier will provide the lowest standard deviation for a given return b) Portfolio on efficient frontier will provide the same sharp ratio c) Portfolio on efficient frontier will provide the highest return for a given standard deviation d) Portfolio within efficient frontier is not optimal Answer is b), because sharp ratio of portfolio on efficient frontier is different, and tangency portfolio provides the highest sharp ratio Question relates to chapter 10 Two portfolios A and B both are a combination of US stocks. On risk return scatter plot, we observe that the slope of a ray from the origin outward that passes through portfolio A's and B's location is 1 and 1.2 respectively. Which portfolio has higher Sharpe ratio? a) Sharpe ratio A < Sharpe ratio B b) Sharpe ratio A = Sharpe ratio B c) Sharpe ratio A > Sharpe ratio B d) Not enough data is given to calculate Sharpe ratio Correct answer is a) because the slope represents a portfolio's Sharpe ratio and portfolio B has larger slope. Question relates to chapter 10 In a two asset portfolio, if we reduce the correlation between these two assets, to which direction the efficient frontier will be moved? a) The efficient frontier extends to the left, or northwest quadrant. It represents a reduction in risk while maintaining or enhancing portfolio returns; b) The efficient frontier is stable unless return expectations change. If they do, the efficient frontier will extend to the upper right with little or no change in risk; c) The frontier moves to down and the left. It represents increased risk from negative correlation; d) The frontier is stable unless the assets expected volatility changes. This depends on each assets Standard Deviation; ------------------------------------------ Correct answer is a) Because: - Reducing correlation between the two assets results in the efficient frontier expanding to the left and possibly slightly upward. This reflects the influence of correlation on reducing portfolio risk. b) is wrong, because a move to upper right would indicate, higher returns for higher risk. c) is the wrong choice, because if EF moves left your risk is decreased not increased. d) is not the right one. In Modern Portfolio Theory, Optimization reduces some of the guesswork of portfolio construction. What limitations does its apparent rigor and scientific basis suffers from? A) Outputs are only as good as inputs B) Standard deviation of return is not the only measure of risk C) Tail Risks D) All of the above Answer: D - All of the above Explanation: A: Outputs are only as good as inputs. Asset allocations depend on forecast returns, and forecasts can be noisy and erroneous. B: Standard deviation of return is not the only measure of risk.Other metrics that focus mainly or exclusively on downside deviations in asset returns, such as the Sortino ratio or downside capture, may better reflect what risk means to you. C: Beware tail risk. Many hedge fund blowups, occurred because managers underestimated the likelihood of extreme negative events. Question relates to chapter 10 You are deciding how to allocate your portfolio between three assets. Asset A has 10% return and 5% risk. Asset B has 10% return and 5% risk. Asset C has 10% return and 5% risk. When you look more closely at the individual price movements of each asset, you find that the price of A and B are positively covariant, and the price of A and C, as well as B and C, are negatively covariant. How should you allocate your portfolio to meet a target return of 10% with minimum risk? A) I should split my portfolio allocation 50%-50% between assets A and B. Positive covariation between these two assets means that investing in just these assets will make it more likely to meet my target return. B) I should split my portfolio allocation 25% for asset A, 25% for asset B, and 50% for asset C. The risk from the combined allocation into assets A and B is offset by the risk of asset C, which results in the minimum level of risk for my portfolio. C) I should split my portfolio allocation 33%-33%-33% across all three assets. All of these assets bear some risk, so I should hedge my risk by allocating evenly across each asset. D) I should allocate 100% of my entire portfolio into either one of these assets. The return/risk level is the same across each asset, so I am just as likely to meet my target return by investing in either of them. Answer: B The student should understand the concept of covariance, and how it applies to portfolio optimization. Covariance in asset price movements refers to how changes in price between assets move together/away from one another over time. Prices that move together are positively covariant (and therefore exhibit the same or similar risk pattern), and prices that move apart are negatively covariant (and therefore exhibit a different or dissimilar risk pattern). To optimize our portfolio for a target return with minimum risk, we should allocate our portfolio to balance covariance. In this case, assets A & B are positively covariant, and asset C is negatively covariant. A 50% allocation evenly split for A and B, and 50% allocation for C, balances our covariance to minimize our overall risk while meeting our target return. Question relates to chapter 10 Which of the following are TRUE regarding points on the Efficient Frontier? I. They represent a portfolio's change in Sharpe Ratio over time. II. They represent the lowest risk portfolio for each level of target return. III. They represent lower risk portfolios than individual assets with the same or similar returns. a) I and II b) I and III c) II and III d) I, II and III Answer: c) Explanation: "The lowest risk portfolios for each level of return lie along a line called the efficient frontier... Note that the efficient frontier provides lower-risk portfolios than individual assets with similar returns." What Hedge Funds Really Do pg.77 The efficient frontier does not have a time element. Question relates to chapter 10 A very risk-averse client is asking you how to allocate two stocks that have the following data in order to ensure that their risk is minimized, no matter what the market does. Squigglies stock: Seems to follow the market exactly Anticipated to be 4% worse than the market in a week. Snugglies stock Seems to follow the market fluctuations, but does so with 3x the volatility Anticipated to be 2 % better than the market in a week. What allocations would you recommend between the two stocks?? a. 25% allocated to Snugglies, 75% shorted on Squigglies b. 25% shorted on Snuggles, 75% shorted on Squigglies c. 33% allocated to Snugglies, 66% shorted on Squigglies d. 33% allocated to Snugglies, 66% allocated on Squigglies Answer a) some proof: Wsq (-1) + Wsn (3) = 0 Wsq = 3 Wsn abs(-3Wsn) + abs (Wsn) = 1 4Wsn = 1 Wsn = .25 Wsq = -0.75 Question relates to chapter 10 How many times can you optimize a portfolio? a) once b) twice c) size of porfolio d) infinite Correct answer is a) Once you have optimized a portfolio you must use the orginial numbers to perform a new optimization. This means it can be optimized only 1 time. Question relates to chapter 10 The Modern Portfolio Theory assumes that investors are generally a) risk averse b) risk neutral c) risk seekers d) risk moderate Correct answer: a) Modern Portfolio Theory assumes that investors are risk averse, meaning that given two portfolios that offer the same expected return, investors will prefer the less risky one. Thus, an investor will take on increased risk only if compensated by higher expected returns. Conversely, an investor who wants higher expected returns must accept more risk. Question relates to chapter 10 Which of the following is NOT true about optimization problem components? a) An example of a possible objective function is to maximize total portfolio return. b) An example of a possible constraint is that the sum of all weights is greater than 100 percent in a long-only portfolio. c) For a search procedure, when considering any function for which there is a calculable derivative there will be an immediately identifiable optimum. d) Decision variables are the proportion of the portfolio devoted to each asset. Correct answer is b) because there exists a definitional constraint such that the sum of all weights in a long-only portfolio cannot exceed 100 percent. Furthermore, the other three answer choices are all true. Chapter 5: Introduction to Company Valuation How is the book value of a company calculated? a) The total value of the assets minus intangible assets and liabilities. b) By multiplying the number of shares outstanding by the stock price. c) The sum of all the future discounted dividends over the life of the company. d) The average value on the books at all of the major stock exchanges. Correct answer is a) because this is the definition of a company’s book value. Chapter 5: Introduction to Company Valuation When talking to your friend, he claims that certain company's stock is really valuable given the amount of dividends that it will be paying. What kind of value is your friend talking about? == 4 possible answers labeled a) through d) == a) Book value b) Intrinsic value c) Dividend value d) Share value == Short, complete, explanation == The intrinsic value of any assert is the present value of all future returns. In this case, the value discussed regarding the stock is related to all the returns through dividends, thus, its intrinsic value. Chapter 5: Introduction to Company Valuation Market cap per book value is one way to measure how "expensive" a stock is. Choose the stock that has the lowest market cap per book value (B = Billion). Stock = AAPL Book value = $100B Outstanding shares = 5B Stock price = $100/share Stock = IBM Stock price = $130/share Book value per share = $13/share Stock = GOOG Market Cap = $500B Patent value = $100B Book Value = $125B Stock = TSLA Market Cap = $20B Book Value = $1B a) AAPL b) IBM c) GOOG d) TSLA Correct answer is c) because market cap per book value results as follows AAPL = 5; IBM = 10; GOOG = 4; TSLA = 20. Chapter 5: Introduction to Company Valuation Which of the following answer choices are true: a) a company that pays a dividend of 1$/year and a discount rate of 3% has an intrinsic value of $33.3333 b) a company that has tangible assets valued at $100 million, intellectual property assets valued at $10 million and liabilities that are equal to $50 million has a book value of $60 million dollars c) a company with 100,000 shares where each share has a price of $90 has a market capitilization of $900,000 d) choices a) and b) are both correct Correct answer is a) becasue for answer choice 'a' the given information is relevent to intrinsic value which is equal to pv = fv/dr; therefore pv = 1/0.03 -> pv = 33.3333 Answer b is incorrect becuase the correct book value is $50 million. Similarly, answer c) is also wrong because the correct market cap is $9,000,000. Finally, answer d) cannot be correct since the only correct answer is a) Chapter 5: Introduction to Company Valuation Consider you own a 100 share in Microsoft, Which pays you 20 dollars in dividends every quarter. Another investment opportunity is offered to you with a 8 Percent return a year on your money. Which of the following represent the total stream of dividends for the next 2 years: a) 40.00 b) 35.6652 c) 142.6611 d) 160.00 The Correct answer is C Correct answer explanation is: We used the dividend discount model to evaluate the dividend stream for two years compared to the other investment opportunity return which is 8 percent in our example. Dividends stream is worth less over time because the value evaluated in the future there for 80 dollars in yearly dividends will be worth 68.5871 in the second year in the future. 1st year = 74.0740 2nd year = 68.5871 Total dividend stream after 2 years is: 142.6611 Chapter 5: Introduction to Company Valuation The data for two companies 'ABC' and 'XYZ' is provided below. Which company has higher 'price to book ratio'? Choose one of the four options provided at the end. Company 'ABC' Total Assets : $140 million Intellectual Property : $40 million Liabilities : $20 million Market Capitalization : $240 million Company 'XYZ' Fixed Assets : $100 million Intellectual Property : $30 million Liabilities : $20 million Market Capitalization : $160 million a) ABC b) XYZ c) Both have equal ratio d) Data is insufficient Correct Answer: a Explaination: price to book ratio = market cap/book value For ABC : 240/(140 -40 -20) = 3 For XYZ : 160/(100 -20) = 2 The person who has not understood the concept will simply ignore the intellectual propery for both the companies and will go for option c. Chapter 5: Introduction to Company Valuation Assume you are a conservative value-style investor who only invests when you can buy a share for less than what you estimate the companies shares would be worth if the company closed its doors tomorrow. Which method should you use for estimating the company's value? a) Sharpe Ratio b) Intrinsic Value c) Book Value d) Projected Earnings Growth, discounted for the potential 1-day holding period Correct answer is c) because Book Value is the difference between the company's assets and liabilities and is the best available approximation of what owners would be left with after selling off assets and paying off obligations. Chapter 5: Introduction to Company Valuation For which of the following options is it best to valuate a company based on its book value (asset-based valuation)? a) A startup that just went past its first round of funding. b) A stable profitable company with no growth for the past 10 years. c) A company about to be liquidated. d) A company with a consistent 5% growth for each of the past 10 years. Correct answer is c) because a company about to be liquidated is only as valuable as its current assets, future expected growth and dividends are minimal. Chapter 5: Introduction to Company Valuation Company A is worth 100Mil in books. After a detailed fundamental analysis, you figure this company has an intrinsic value of 400Mil. You also find that this company has never failed dividend payout in the last 10 years. As an "Intelligent investor" who believes in value investing you want to look for the market capitalisation before going long on this stock. Assuming 1 million outstanding shares, which of the following prices will pique your interest in going long with this stock a) 500$ b) 650$ c) 400$ d) 200$ Ans: d. Market capitalisation is #of outstanding shares * price. Here MC is 200Mill which is a 50% discount on your Intrinsic valuation Chapter 5: Introduction to Company Valuation If you were to pay $500,000,000 for a company, which of the following companies is certain to maximize your profit if you purchase it? a)One that pays $31,000,000 per year in dividends at a discount rate of 5%. b)One that has 10,000,000 outstanding shares at $61 stock price. c)One that owns 64 factories at $10,000,000 each, but also has $20,000,000 in liabilities. d)One that employs world-class talent in the field of business development. The correct answer is c). The book value of the company is $620,000,000, which yields immediate profit of $120,000,000 if it is bought and then sold for pieces. Answer d) is meaningless, a) provides an intrinsic value of $620,000,000, but that is the expected return over the years and there are no guarantees. b) gives a market cap of $610,000,000. Chapter 5: Introduction to Company Valuation Alice has an impatient friend, Jan, who wants to buy a new sail boat today for $200,000, but the banks won't lend her any money. She is currently receiving an annual check for $50,000 as part of a settlement she won three years ago. She has 5 more annual payments that she is guaranteed to receive and offers to sell them to Alice today, for a lump sum of $200,000. Assuming a 10% discount rate, is buying Jan's remaining annual payments for a lump sum of $200,000 a good investment? a) Yes, the present value is $250,000.00 b) Yes, the present value is $500,000.00 c) No, the present value is only between $180,000 and $190,000 d) No, the present value is less than $180,000 Correct answer: c Proof: Using the formula PV = FV/(1 + DR)^I pv1 = 50000/1.1^1 = 45454.545454545454545454545454545 pv2 = 50000/1.1^2 = 41322.314049586776859504132231405 pv3 = 50000/1.1^3 = 37565.740045078888054094665664914 pv4 = 50000/1.1^4 = 34150.672768253534594631514240831 pv5 = 50000/1.1^5 = 31046.066152957758722392285673482 pv1 + pv2 + pv3 + pv4 + pv5 = 189539.33847042241277607714326518 Chapter 5: Introduction to Company Valuation Your friend Alice has been running a micro-brewery out of her garage for five years now. Her annual profits from the micro-brewery are $10,000 per year. Alice has been approached by a large beer company that wants to purchase her company. Alice knows that you have been taking Machine Learning for Trading, so she asks your opinion on what her little micro-brewery is worth. What is her company's intrinsic value based on the $10,000/year profits? Assume a discount rate of 5%. a) $10,000 b) $50,000 c) $200,000 d) $2,000,000 Correct answer is c) because using a cashflow-based valuation, PV (microbrewery) = Annual profit / discount rate = $10,000 / 0.05 or $200,000. Chapter 5: Introduction to Company Valuation A friend of yours is moving in exactly a year, and he offers to sell you his car today. The catch is that he would remain the owner of the car for the whole year until he moves, at which point you will officially own the car. Assume you know with 100% certainty that the car will be worth exactly $5,000 in one year. Also assume that the best alternative to buying your friend's car would be to invest your money in a bond that guarantees exactly a %2 annual return. Rounded to the nearest dollar, what is the maximum amount you should pay for the car? a) $4,902 b) $4,904 c) $4,906 d) $4,908 The correct answer is a) Present value = Future value / (1 + Discount Rate) ^ (number of years until payment) Present value = 5000 / (1 + 0.02) ^ 1 Present value = 4901.96 (rounded to 4902) Chapter 5: Introduction to Company Valuation Which of these companies would not give an immediate positive return if it were bought and its assets sold? a) Book Value: 50 million Share Price: $100 Available Shares: 0.4 million b) Book Value: 100 million Share Price: $3.75 Available Shares: 25 million c) Book Value: 70 million Share Price: $3.50 Available Shares: 25 million d) Book Value: 300 million Share Price: $100 Available Shares: 2.8 million Correct answer is c because Immediate Return = Book Value - (Share Price * Available Shares). C is the only one that would result in a negative value. Chapter 5: Introduction to Company Valuation The following are the assets & liabilities for TuringCo: (2) Data Centers: $25 million each PCB factory: $80 million Patent on the solution to the halting problem: $15 million Raw materials contract (debt): $20 million TuringCo stock data: Shares of stock: 2,000,000 Current stock price: $50 John values companies based on book value, and uses a 25% margin of safety when considering a long position. Which of the following would make John willing to buy stock in TuringCo? a) John is already willing to buy the stock. b) A stock price increase of $10 per share. c) A stock price decrease of $2.50 per share d) TuringCo paying off their raw material contract in full. Answer Explanation: the correct answer is d) With the only liability paid off, the book value becomes: 25 + 25 + 80 = $130 million 130/100 = 1.30 = 30% safety margin, which is greater than 25% Original values from the question description: TuringCo book value = 25 + 25 + 80 - 20 = $110 million TuringCo market capitalization = 2 million * $50 = $100 million margin of safety = 110 / 100 = 1.10 = 10% margin of safety (too low) a) The margin of safety is not high enough yet. (only 10%) b) This would decrease the margin of safety. c) $2.50 decrease in stock price would decrease market capitalization by $5 million to a total of $95 million 110 / 95 = 1.158 = 15.8% margin of safety (too low ) Chapter 5: Introduction to Company Valuation In the latest Berkshire Hathaway Shareholder's letter, Warren Buffett writes: "... we would be delighted to repurchase our shares should they sell as low as 120% of book value." This suggests that even at 120% of book value, Buffett believes his company is undervalued. What is one reason that book value can diverge from market value? a) Since accounting rules are conservative, appreciation in asset values are not included on balance sheets. b) Book values are post-tax and market values are pre-tax. c) When the value of any asset is discounted it becomes more than 120% its current value. d) Within a year dividend payments make up the difference between book and market value. Correct answer: a) from Chapter 5: "First, accounting rules are biased to be conservative, so even if an asset has risen in value since the firm originally purchased itâ€” say, a piece of real estate in a growing cityâ€” it will be carried on the balance sheet at its original price, less accumulated depreciation." b) is incorrect since tax is not a concern when comparing book and market values by themselves. c) is incorrect because assets aren't typically discounted, cashflows are. d) is incorrect because dividend payments are usually discounted for far longer than one year in the future. And even with discounting it would be much greater than the difference between book and market value. Chapter 5: Introduction to Company Valuation What is the book value for company XYZ given the following information? * Manufacturing equipment worth $10M * Liabilities of $1M * Real estate holdings worth $5M * Technology patents worth $1M * Cash in bank accounts of $2M a) $14M b) $15M c) $16M d) $19M Correct answer is c Book Value = Total Tangible Assets minus Total Liabilities Total Tangible Assets = $10M (Manufacturing) + $5M (Real Estate) + $2M (Cash) = $17M Total Liabilities = $1M Therefore: $17M - $1M = $16M Chapter 5: Introduction to Company Valuation If certain investment gives a guaranteed return of 100 dollars every year, what is the total or accumulated present value of the investment until the 20th year with a discount rate of 10%? (a) 90.91 (b) 851.36 (c) 1000.00 (d) 18181.81 Answer: (b) Explanation: At first glance it seems that the only way to get this answer right is to sum all the present values up to the 20th year. But is all about establishing boundaries. The two equations that governs the present value are: Present Value for Year I: ------------------------ PV = FV / (1 + DR) ^ I Present Value for ALL years (sum) up to Infinity (payments in perpetuity): -------------------------------------------------------------------------- PV = FV / DR That gives up that the present value of all the rewards up to infinity is: PV = 100 / 0.1 = $1000 That gives an upper limit for the rewards, eliminating (c) and (d). The answer (a) is trivial. It is the present value for the reward of the first year. The only answer left is (b) that is less that the computed payments in perpetuity, and must be the correct answer. Chapter 12: Overcoming Data Quirks to Design Trading Strategies The following scenarios consist of two parts: (1) the market incident and (2) the responsive action to account for said incident within a data-series. From the given s

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