PFS Investment Planning 2 — Questions and Answers
Question 1: A client holds a portfolio with a beta of 1.4 and the market returns 8% while the risk-free rate is 2%. What is the expected return according to CAPM?
- 10.4% (Correct answer)
- 11.2%
- 9.6%
- 13.2%
Correct answer: 10.4%
CAPM: Expected return = Rf + β(Rm - Rf) = 2% + 1.4(8% - 2%) = 2% + 8.4% = 10.4%.
Question 2: Which bond characteristic causes its price to be more sensitive to interest rate changes?
- Higher coupon rate
- Shorter maturity
- Lower coupon rate (Correct answer)
- Higher credit rating
Correct answer: Lower coupon rate
Lower coupon bonds have higher duration, meaning their prices are more sensitive to interest rate movements.
Question 3: A client wants inflation protection with liquidity. Which investment is MOST appropriate?
- 30-year TIPS
- Series I Savings Bonds
- Treasury Bills (Correct answer)
- Commodities futures
Correct answer: Treasury Bills
Treasury Bills provide liquidity and implicitly track short-term rates that often adjust with inflation, though TIPS are superior for direct inflation protection; among these options T-Bills best combine both needs.
Question 4: What does the Sharpe ratio measure?
- Total return relative to benchmark
- Excess return per unit of total risk (Correct answer)
- Return relative to market risk only
- Portfolio alpha minus beta
Correct answer: Excess return per unit of total risk
The Sharpe ratio equals (portfolio return - risk-free rate) divided by the portfolio's standard deviation, measuring reward per unit of total risk.
Question 5: An investor in the 37% federal tax bracket compares a 4.5% municipal bond to a taxable bond. What taxable equivalent yield makes them equal?
- 5.89%
- 7.14% (Correct answer)
- 6.43%
- 4.86%
Correct answer: 7.14%
Taxable equivalent yield = 4.5% / (1 - 0.37) = 4.5% / 0.63 ≈ 7.14%.
Question 6: Which diversification strategy best reduces unsystematic risk?
- Increasing bond allocation
- Adding more uncorrelated securities (Correct answer)
- Shortening portfolio duration
- Buying put options on the index
Correct answer: Adding more uncorrelated securities
Unsystematic (company-specific) risk is reduced by holding a larger number of securities with low correlations to each other.
Question 7: A dollar-cost averaging strategy is MOST beneficial when:
- Markets trend consistently upward
- A lump sum is invested at a market peak
- Regular fixed-dollar investments are made in a volatile market (Correct answer)
- An investor needs to minimize transaction costs
Correct answer: Regular fixed-dollar investments are made in a volatile market
Dollar-cost averaging lowers average cost per share when prices fluctuate because more shares are purchased when prices are low.
PFS Investment Planning 2
A client holds a portfolio with a beta of 1.4 and the market returns 8% while the risk-free rate is 2%.
What is the expected return according to CAPM?