Investment Analysis FINAL UPDATED
Exam Questions and CORRECT Answers
Efficient market hypothesis - Correct Answer- there's full info in the market and everybody
knows everything. Hence, all stocks in terms of their valuation and prices reflect the full info.
weak form efficiency - Correct Answer- prices reflect all past market information such as
price and volume
You take a look at past history of stock price movements and by looking at that you'll be able
to predict the future. So you look at historical and make a prediction about the future.
semi-strong form efficiency - Correct Answer- Market prices reflect all publicly available
information
strong form efficiency - Correct Answer- prices reflect all information, including public and
private
Using private information is the strong form test. However, nobody has that information
aside. That basically is the criticism on efficient markets hypothesis. You cannot do a strong
form test.
uniform series compound amount factor - Correct Answer- used to determine future worth of
a series of equal payments or receipts
sinking fund payment factor - Correct Answer- the amount you have to deposit each period to
have a certain amount at the end?
capital recovery - Correct Answer- the annualized equivalent value of the initial investment
cost of a capital asset
uniform series present worth - Correct Answer- present value of an annuity
,forward rate - Correct Answer- the inferred short-term rate of interest for a future period that
makes the expected total return of a long-term bond equal to that of rolling over short-term
bonds
interest rate from year X to year Y is R1
interest rate from year Y to year Z is R2
yield curve - Correct Answer- a graph showing the relationship between yields (returns) and
maturities
A yield curve is composed of different segments and each one of those segments is composed
of a different rate for that segment
Typically, longer investment means higher yield/int rate (and shorter investment means low
yield/int rate)
liquidity premium theory - Correct Answer- Investors prefer short-term liquid securities but
will be willing to invest in long-term securities if compensated with a premium for lower
liquidity
Short-term investors will be willing to accept lower rates of return because their investment is
liquid. Meaning, they can get out of their investment very quickly. Therefore, the curve keeps
on moving upwards usually over time and the more time you have to tie up your money, the
more return you won't get paid because you're tying up your money. Simple assumption: if
you want liquidity then you're going to accept a lower rate of return
expectation theory - Correct Answer- suggests that the shape of the yield curve reflects the
market's expectations about future changes in interest rates. According to this theory, the
yield curve slopes upwards when long-term interest rates are expected to rise in the future,
and slopes downwards when long-term interest rates are expected to fall in the future.
In other words, the expectation theory suggests that the yield curve reflects the market's
expectations about the direction and magnitude of future changes in interest rates. This theory
is based on the idea that investors demand a higher yield on longer-term bonds to compensate
for the greater uncertainty and risk associated with holding those bonds over a longer period
of time.
, preferred habitat theory - Correct Answer- A theory that holds that the interest rate on a long-
term bond is equal to an average of the short-term interest rates expected to occur over the
life of the long-term bond, plus a positive term premium. Closely related to the liquidity
premium theory.
Preferred Habitat theorists look at the yield curve in terms of segments. So you build sort of a
set of categories: short-term segment, medium-term segment and long-term segment. They
argue that those that are interested in the short-term segment, have no interest in the medium-
term or long-term and vice versa. There's a supply and demand schedule for each one
segment and that's why there are times when you look at the yield curve and it's disjointed.
bootstrap method - Correct Answer- supposing you have two bonds. One is for the first half
year and the other is for the full year. You can figure out from bond number one what the rate
is for the first half year; you can then take the initial price of the bond and compound it for a
half year based on the first unit being 4.81% and for the second half year (r2). Then you solve
for r2 which is called using the bootstrap method because you're assuming both bonds are
discount factor - Correct Answer- the amount that you're going to multiply each cash flow in
order to bring it back to time period 0 (present value of a $1 future payment)
d1 = 1/(1+r0,1) = 1/(1+S1)
d2 = 1/((1+r0,1)(1+r1,2)) = 1/(1+S2)^2
d3 = 1/((1+r0,1)(1+r1,2)(1+r2,3)) = 1/(1+S3)^3
how to find the PV (price) of a bond using annual discount factors - Correct Answer- P0 =
(CF1)(d1) + (CF2)(d2) + (CF3)(d3) + ... etc
spot rate - Correct Answer- the average rate of return from time zero to the end of the time
period
Ex) If there are 5 periods, it's the average of the forward rates of each of the periods.
Therefore, if we're told that the spot rate is S2 then S2 is the rate of return on average for the
first two periods (from 0 to 1, and 1 to 2 per period). Therefore: (1+r01)(1+r12) = (1+S2)^2
Exam Questions and CORRECT Answers
Efficient market hypothesis - Correct Answer- there's full info in the market and everybody
knows everything. Hence, all stocks in terms of their valuation and prices reflect the full info.
weak form efficiency - Correct Answer- prices reflect all past market information such as
price and volume
You take a look at past history of stock price movements and by looking at that you'll be able
to predict the future. So you look at historical and make a prediction about the future.
semi-strong form efficiency - Correct Answer- Market prices reflect all publicly available
information
strong form efficiency - Correct Answer- prices reflect all information, including public and
private
Using private information is the strong form test. However, nobody has that information
aside. That basically is the criticism on efficient markets hypothesis. You cannot do a strong
form test.
uniform series compound amount factor - Correct Answer- used to determine future worth of
a series of equal payments or receipts
sinking fund payment factor - Correct Answer- the amount you have to deposit each period to
have a certain amount at the end?
capital recovery - Correct Answer- the annualized equivalent value of the initial investment
cost of a capital asset
uniform series present worth - Correct Answer- present value of an annuity
,forward rate - Correct Answer- the inferred short-term rate of interest for a future period that
makes the expected total return of a long-term bond equal to that of rolling over short-term
bonds
interest rate from year X to year Y is R1
interest rate from year Y to year Z is R2
yield curve - Correct Answer- a graph showing the relationship between yields (returns) and
maturities
A yield curve is composed of different segments and each one of those segments is composed
of a different rate for that segment
Typically, longer investment means higher yield/int rate (and shorter investment means low
yield/int rate)
liquidity premium theory - Correct Answer- Investors prefer short-term liquid securities but
will be willing to invest in long-term securities if compensated with a premium for lower
liquidity
Short-term investors will be willing to accept lower rates of return because their investment is
liquid. Meaning, they can get out of their investment very quickly. Therefore, the curve keeps
on moving upwards usually over time and the more time you have to tie up your money, the
more return you won't get paid because you're tying up your money. Simple assumption: if
you want liquidity then you're going to accept a lower rate of return
expectation theory - Correct Answer- suggests that the shape of the yield curve reflects the
market's expectations about future changes in interest rates. According to this theory, the
yield curve slopes upwards when long-term interest rates are expected to rise in the future,
and slopes downwards when long-term interest rates are expected to fall in the future.
In other words, the expectation theory suggests that the yield curve reflects the market's
expectations about the direction and magnitude of future changes in interest rates. This theory
is based on the idea that investors demand a higher yield on longer-term bonds to compensate
for the greater uncertainty and risk associated with holding those bonds over a longer period
of time.
, preferred habitat theory - Correct Answer- A theory that holds that the interest rate on a long-
term bond is equal to an average of the short-term interest rates expected to occur over the
life of the long-term bond, plus a positive term premium. Closely related to the liquidity
premium theory.
Preferred Habitat theorists look at the yield curve in terms of segments. So you build sort of a
set of categories: short-term segment, medium-term segment and long-term segment. They
argue that those that are interested in the short-term segment, have no interest in the medium-
term or long-term and vice versa. There's a supply and demand schedule for each one
segment and that's why there are times when you look at the yield curve and it's disjointed.
bootstrap method - Correct Answer- supposing you have two bonds. One is for the first half
year and the other is for the full year. You can figure out from bond number one what the rate
is for the first half year; you can then take the initial price of the bond and compound it for a
half year based on the first unit being 4.81% and for the second half year (r2). Then you solve
for r2 which is called using the bootstrap method because you're assuming both bonds are
discount factor - Correct Answer- the amount that you're going to multiply each cash flow in
order to bring it back to time period 0 (present value of a $1 future payment)
d1 = 1/(1+r0,1) = 1/(1+S1)
d2 = 1/((1+r0,1)(1+r1,2)) = 1/(1+S2)^2
d3 = 1/((1+r0,1)(1+r1,2)(1+r2,3)) = 1/(1+S3)^3
how to find the PV (price) of a bond using annual discount factors - Correct Answer- P0 =
(CF1)(d1) + (CF2)(d2) + (CF3)(d3) + ... etc
spot rate - Correct Answer- the average rate of return from time zero to the end of the time
period
Ex) If there are 5 periods, it's the average of the forward rates of each of the periods.
Therefore, if we're told that the spot rate is S2 then S2 is the rate of return on average for the
first two periods (from 0 to 1, and 1 to 2 per period). Therefore: (1+r01)(1+r12) = (1+S2)^2
