Question 1 Investment Policy Statement (IPS). Several of the components of the

Question 1

Investment Policy Statement (IPS). Several of the components of the IPS include the statement

of investment goals, objectives, and constraints; performance measures and benchmarks;

considerations in developing strategic asset allocation; and investment strategies and investment

styles.

True

False

Question 2

Basis Risk and Convergence: While the futures price and the spot price must converge at

maturity, the basis defines the difference between the futures price and the spot price. Basis risk

is assumed over the life of the contract, except at maturity where convergence occurs.

True

False

Question 3

Operating & Financial Leverage: Operating leverage and financial leverage increase sensitivity

to the business cycle. By definition, operating leverage links to fixed costs as a percentage of

total costs while financial leverage links to the percentage of debt to total capital.

True

False

Question 4

Tracking Error (TE). TE is estimated from the time series of differences between the returns of

the risky portfolio and the risk free returns. Over the past 30+ years, TEs have tended to

decline, suggesting that risky portfolios have become more index-like.

True

False

Question 5

Internal Rate of Return: Dollar weighted rates of return is another term for Internal Rate of

Return (IRR). Because of the nuances of the (oftentimes) highly irregular cash flows both into

and out of the limited liability partnership (LLP), IRR is used in the performance measurement of

alternative assets.

True

False

Question 6

Equity Style Analysis: Equity style analysis was introduced by William Sharpe and finds its

visualization in the Morningstar Boxes. Regressing fund returns on style benchmarks would

enable the analyst to measure the fund’s implicit allocation to that style.

True

False

Question 7

Binomial and Black Scholes Option Pricing Model: The multi period approach to option pricing

is labeled the binomial model and with the use of continuously compounded mathematics, the

Black Scholes pricing formula can be derived. The Black Scholes model assumes a constant

volatility over the life of the option.

True

False

Question 8

Venture Capital Business Model: The successful venture capital portfolio model hinges on the

ability to find a “home run,” thereby generating a return that offsets the losses and the breakeven

positions. Roughly half of the portfolio positions are assumed to eventually fail.

True

False

Question 9

Long or Short Futures: The trader taking the long position commits to buying the commodity on

the delivery date while the trader taking the short position commits to selling.

True

False

Question 10

Futures Hedge Ratio: In general, the hedge ratio is the number of futures contracts one would

need to offset the risk of a particular unprotected position. Futures contracts could be used to

hedge interest rates, stock market indices, currency or commodity risk.

True

False

Question 11

Earning Quality (EQ): One of the best indicators of EQ is a high percentage of the earnings,

accrual accounting defined, covered (or reflected) by working capital.

True

False

Question 12

Option Basics: A put option is the right to sell an asset at an agreed upon exercise price. A call

option is the right to buy an asset at a given strike price. The difference between the asset price

and the exercise price is used to determine whether the option is in the money, at the money, or

out of the money.

True

False

Question 13

Protective Put and Covered Call: A protective put is a form of insurance whereby a stock is

overlaid with a put option that is purchased. A covered call is the purchase of a share of stock

with a simultaneous sale of a call option on that stock. A protective put is an

example of the use of options in risk management.

True

False

Question 14

Price Metrics: The P/E ratio is a useful measure of the market’s assessment of the firm’s growth

opportunities. Many analysts form their estimates of a stock’s value by multiplying their forecast

of next year’s earnings per share by a predicted P/E multiple. The P/B ratio is a useful measure

of the market’s assessment of the firm’s return on equity (ROE) opportunities. The P/S ratio is a

useful measure of the market’s assessment of the firm’s net margins and the expectations thereof.

True

False

Question 15

FCFF: The Free Cash Flow to the Firm (FCFF) is oftentimes employed by private equity firms to

measure available pretax cash flows from operations minus necessary working capital and

essential capital spending needs. It is discounted via WACC. For equity valuation, the FCFF is

discounted by the WACC to arrive at a present value (PV), from which debt is subtracted to

arrive at an equity value.

True

False

Question 16

Swaps: Swaps in essence, call for the exchange of a series of cash flows. For example, an interest

rate swap may call for the exchange of a series of fixed cash flows for a series of floating rate

cash flows.

True

False

Question 17

Implied Volatility: The implied volatility of an option is the standard deviation of stock returns

consistent with an option’s market price or stated differently, the volatility level for the stock that

is embedded in its price. The measure of volatility of the S&P500 is known commonly as the

open interest. High levels of open interest correspond to perceived risky markets while low levels of open interest

correspond to less risk markets.

True

False

Question 18

Real Assets: Real assets (as an alternative asset class) include timberland, farmland, REITs, direct

real estate investment, and infrastructure. Its particularly important characteristic is its inflation

sensitivity or more specifically, its ability to act as an inflation hedge.

True

False

Question 19

Home Country Bias (HCB). HCB refers to the common tendency for investors to overweight

foreign equities in their portfolio of risky assets.

True

False

Question 20

Attribution: Common attribution procedures partition performance improvements to asset

allocation, sector selection, and security selection. Performance is assessed by calculating

departure of portfolio composition from a benchmark portfolio.

True

False

Question 21

Futures Markets: “Backwardation” futures markets are those in which spot prices are higher than

futures prices while “Contango” futures markets are those in which spot prices are lower than

futures prices

True

False

Question 22

Life Cycle Approach to Investing (LCAI). The LCAI views the individual as passing through a

series of stages, becoming more risk seeking in later years, the rationale being that one ages, an

individual uses up his/her human capital and have less time remaining to recoup possible

portfolio losses through increased labor supply.

True

False

Question 23

Strategic Asset Allocation (SAA) and Tactical Asset Allocation (TAA). TAA represents a

dynamic investment strategy that actively adjusts the portfolio’s asset allocation, shifting it

towards undervalued assets and away from overvalued assets for time periods generally spanning

one to several years. Conversely, SAA is long term.

True

False

Question 24

Futures Profitability and Zero Sum Game: The profit to a long futures contract is the spot price at

maturity minus the original futures price. The profit to a short futures contract is the original

futures price minus the spot price at maturity. When summed, the profits to the long and the short

suggest that futures contracts are a zero-sum arrangement.

True

False

Question 25

Valuation Model Consistency: Valuation model consistency refers to the proper linking of the

numerator and denominator’s components. For example, the discounting factors for FCFE and

FCFF are the CAPM required return and the WACC, respectively.

True

False

Question 26

FCFE. The Free Cash Flow to Equity equals FCFF minus after tax interest expenditures plus

increase in net debt. FCFE is discounted by the CAPM.

True

False

Question 27

Alternative Asset Attributes: Diversification, illiquidity, and inefficiency define a number of the

distinguishing characteristics of the alternative assets space. Alternative assets are termed alpha

investments (representing manager skill to generate a positive risk adjusted return).

True

False

Question 28

Forwards & Futures: A futures contract is similar to a forward contract, differing more

importantly in the aspects of standardization and daily marking to market, which is the process by

which gains and losses on futures contract positions are settled daily. Futures contracts can be

used for hedging or speculating.

True

False

Question 29

Two Classes of LLP Partners. The two classes of LLP partners are Equity Partners and Debt

Partners. Debt partners, while limited in their authority, are nonetheless responsible for

providing the majority of the capital investment.

True

False

Question 30

M^2 Measure of Performance. To compute the M^2 measure-of-performance, a managed

portfolio is adjusted such that the adjusted portfolio matches the volatility of the benchmark

portfolio. Because the adjusted portfolio and the benchmark have the same standard deviation, an

analyst can compare their performance simply by comparing returns.

True

False

Question 31

Option Hedge Ratio: Hedge ratios (or deltas) are one for deep out-of-the-money call options and

zero for deep in-the-money calls.

True

False

Question 33

Portfolio Constraints (PC) in Investment Policy Statements. PC can include liquidity, investment

horizon, regulations, tax considerations, and unique needs.

True

False

Question 34

Option Valuation: Option values may be viewed as the sum of intrinsic value plus time value.

The value of a call option increases if the stock price increases, the exercise price (or strike price)

decreases, the volatility increases, the time to expiration increases, the risk free interest rate

increases, and the dividend payment decreases.

True

False

Question 35

Sector Rotation (SR): One means analysts think about the relationship between industry analysis

and the business cycle is the notion of SR. The idea is to shift the portfolio more heavily into

industry or sector groups that are expected to outperform based on one’s assessment of the state

of the business cycle. For instance, if one were anticipating an economic expansion, one would

focus attention on the consumer discretionary, materials, industrials, and energy sectors.

True

False

Question 36

Defined Contribution (DC) vs. Defined Benefit (DB). The two types of pension plans are DC and

DB, the later where the contributions made on behalf of the employees by the firm specifies the

retirement benefits to which the employee is entitled. The benefit formula typically takes into

account years of service for the employer and level of wages. In DC plans, the investment risk is

transferred to the employee.

True

False

Question 37

J Curves. J curves are generally associated with venture capital investments and indicate the

anticipated negative return (or cash flows) early on in its life cycle.

True

False

Question 38

Value Proposition: The consulting model value proposition suggests that a stock price will be

higher the larger the expected dividend per share (or free cash flow), the higher the market

capitalization rate (or risk), and the higher the expected growth rate of dividends (or free cash

flow).

True

False

Question 39

Credit Default Swaps (CDS). CDS are in effect, an insurance product that pays off in the event of

a trigger event (some sort of technical or real default). The protection seller receives a premium

from the protection buyer.

True

False

Question 40

European Australasia, Far East (EAFE) Index. EAFE is one of the most used indexes of non-US

stocks.

True

False

Question 41

Tobin’s Q. Tobin’s Q is the ratio of market price to book value.

True

False

Question 42

Industry Life Cycle: When conducting an analysis, the company’s positioning on the industry life

cycle may oftentimes yield important valuation information. For example, as one travels from

start-up to consolidation to maturity to relative decline, one

will usually witness an increase in the price / earnings ratio.

True

False

Question 43

Constant Growth DDM (CG): The CG is best suited for firms that are expected to exhibit stable

growth rates over the foreseeable future. It is oftentimes used as a normalized measure of

terminal value in intrinsic value calculations after shorter horizon DCFs (i.e., 3-5 years, for

example) are modeled.

True

False

Question 44

Risk Adjusted Performance: Because portfolio or position risk must be considered in assessing

performance, risk adjusted performance measures have been developed. Sharpe’s Ratio,

Treynor’s Measure, Jensen’s Alpha, and the Information Ratio each measure risk adjusted

performance that can be compared to a peer universe or benchmark.

True

False

Question 45

Straddle. A long straddle is established by buying both a call and a put on the stock, each with the same exercise price and the same expiration date. A straddle is an example of how options can be combined to capture an anticipated outcome.

True

False

Question 46

Dollar vs. Time Weighted Returns: Time weighted rates of return are fundamentally the internal

rate of return (IRR) while the dollar weighted returns are the geometric average rate of return.

True

False

Question 47

Commodity Cost of Carry: The commodity cost of carry is similar to the financial cost of carry

except that storage costs are added in the place of dividends: F = S (1 + RF + C)^T, where the

latter term in parenthesis is the cost of carry.

True

False

Question 48

Economic Value Added: EVA is the spread between ROC and the COC and measures the return

in excess of the opportunity cost. Stern Stewart, the human resources consulting firm, uses the

term residual income to describe EVA and in the HR function, it can be used as a hurdle rate for

bonuses.

True

False

Question 49

International Risk: Exchange rate risk imparts an extra source of uncertainty to investments

dominated in foreign currencies. To this end, political risk in international markets is generally a

risk factor as well. International equities are generally subdivided into developed and emerging

markets

True

False

Question 49

International Risk: Exchange rate risk imparts an extra source of uncertainty to investments

dominated in foreign currencies. To this end, political risk in international markets is generally a

risk factor as well. International equities are generally subdivided into developed and emerging

markets

True

False

Question 50

DCF: Discounted cash flow models give estimates of the intrinsic value (V) of a stock that in

turn, can be compared to market prices (P) for purchase (buy when V > P) or sale (sell when V <

P) decision making. The discounted cash flows, in general, are the free cash flows that can be

returned to the capital providers

True

False

Question 51

Good Companies as Good Investments. Good companies are not necessarily good investments.

Stock market prices of successful firms may be bid up to levels that reflect that success, or

perhaps more. These firms are often labeled glamour firms and have high, embedded growth and

/ or profitability expectations.

True

False

Question 52

Out of the Money Call Option. An out-of-the-money call option would be where the stock price

is greater than the exercise price.

True

False

Question 53

Cyclical vs. Defensive Industries. Cyclical industries have an above average sensitivity to the

business cycle while defensive industries have below average sensitivity.

True

False

Question 54

European vs. American style options. European style options can be exercised early (i.e., at any

time over the life of the contract) while American style can be exercised on at the maturity date of

the contract.

True

False

Question 55

Financial Cost of Carry: The financial cost of carry is determined by the relative costs of buying a

stock with deferred delivery in the futures market versus buying it in the spot market with

immediate delivery and carrying it in inventory. The financial cost of carry is depicted as F = S

(1 + RF – D)^T where the latter term in parenthesis is the cost of carry.

True

False

Question 56

Market Value Added: MVA and EVA are usually inversely related. In general, when EVA rises,

MVA falls. Conceptually, a positive MVA is a byproduct of a high – or positive – EVA (or

series of EVAs).

True

False

Question 57

Hedge Fund Philosophies: Hedge fund philosophies can oftentimes be characterized as macro &

managed futures, relative value, equity biased, and event driven. Hedge funds have a long / short construction.

True

False

Question 58

Capitalized Earnings Valuation: For firms with no growth opportunities (i.e., no PVGO), the P/E

ratio is simply the reciprocal of the capitalization rate (i.e. the required rate of return).

True

False

Question 59

Structured Assets. Structuring is the process of reengineering cash flows from existing asset

exposures (i.e. portfolios of mortgages, credit card debt, etc.). Financial structuring (or

engineering) enables different investors to hold claims with different risk exposures (labeled as

tranches) from the same underlying assets.

True

False

Question 60

ROE Determinants: A firm’s current ROE is a key determinant of the (potential) growth rate of

its earnings.

True

False

Question 61

Emerging Markets Risk: Emerging markets average returns are riskier (and generally higher)

than developed market returns.

True

False

Question 62

International Benefits: The benefits (employing the Markowitz efficient frontier) from

international diversification are oftentimes enhanced in bear markets because correlations

tend to ratchet downward (towards zero).

True

False

Question 64

In the Money Put Option. An in-the-money put option would be where the exercise price is

greater than the stock price.

True

False

Question 65

Implied Volatility: If the anticipated volatility forecast by the analyst is greater than the implied

volatility (the standard deviation of stock returns consistent with the options price), the call option

is considered a buy. If the anticipated volatility is less, the analyst should consider selling or

writing the call option.

True

False

Question 66

DuPont Analysis: It is often useful to decompose a firm’s ROE or ROA or ROIC into the

product of several accounting ratios and to analyze their separate behaviors over time (i.e., trends)

and across companies (i.e., cross sectional) within an industry.

True

False

Question 67

Growth Theory: The expected growth rate of earnings is related both to the firm’s expected

profitability (ROE) and to its dividend policy, more specifically the retention rate.

True

False

Question 69

Fiscal & Monetary Policy: The traditional tools of macro-policy are government spending and

tax collection, which constitute fiscal policy, and manipulation of the money supply, which

constitute monetary policy, primarily through the use of the fed funds rate, discount rate, open

market operations, and quantitative easing.

True

False

Question 70

Private Equity Business Model: The four-step process of a private equities manager is to

recapitalize the acquired public company, cut costs, maximize free cash flows, and finally, return

the company to the public market, usually via an IPO or sale to a strategic buyer.

True

False

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