Chapter 1 - test bank
Fundamentals of Investing, 13e (Smart)
Chapter 1 The Investment Environment
1.1 Learning Goal 1
1) A non-interest bearing checking account is still considered an
investment. Answer: FALSE
Is cash placed in a simple (no-interest) checking account an investment? No, because it fails both
tests of the definition: It does not provide added income and its value does not increase. In fact,
over time inflation erodes the purchasing power of money left in a non-interest-bearing checking
account. (P32)
2) Land and buildings are examples of real property
investments. Answer: TRUE
Property, on the other hand, consists of investments in real property or tangible personal property.
Real property refers to land, buildings, and that which is perma- nently affixed to the land. (P33)
3) Since 1900, the average return on stocks has exceeded the average return on
savings accounts by more than 6 percentage points.
Answer: TRUE
In the United States since 1900, the average annual return on a savings account has been a little
more than 3%. The average annual return on common stock has been about 9.6%. (P32)
4) A United States Savings Bond is an example of an investment as defined in the
text. Answer: TRUE
5) Most sources of investment information are in print format, expensive, and difficult
to access.
Answer: FALSE
Investments of every type are available, from virtually zero-risk savings accounts at banks, which
in recent years offered returns hovering barely above 0%, to shares of common stock in high-risk
companies that might triple in value in a short time. The investments you choose will depend on
your resources, your goals, and your willingness to take risk. (P32)
1.2 Learning Goal 2
1) Institutional investors manage money for businesses and nonprofit organizations, but not
for individuals.
Answer: FALSE
Individuals who lack the time or expertise to make investment decisions often employ
institutional investors—investment professionals who earn their living by man- aging other
people’s money. These professionals trade large volumes of securities for individuals, as well as
for businesses and governments.(P36)
2) Institutional investors are individuals who invest indirectly through financial
institutions. Answer: FALSE
Individuals who lack the time or expertise to make investment decisions often employ
institutional investors—investment professionals who earn their living by man- aging other
people’s money. These professionals trade large volumes of securities for individuals, as well as
for businesses and governments.(P36)
3) Banks and insurance companies are examples of institutional
investors. Answer: TRUE
Institutional investors include banks, life insurance companies, mutual funds, pension funds, and
hedge funds. For example, a life insurance company invests the premiums it receives from
policyholders to earn returns that will cover death benefits paid to beneficiaries.(P36)
4) In the financial markets, individuals are net demanders of funds. Answer: FALSE
In financial markets, individuals (households) are typically net suppliers of funds, not net
demanders. This is because individuals often save money by depositing it in banks, investing
in stocks or bonds, or contributing to retirement accounts. These savings are then channeled to
borrowers (such as businesses or governments) that need funds for investment or spending.
Net demanders of funds are usually businesses and governments, which borrow to finance
projects, expand operations, or cover deficits. While some individuals do borrow (e.g., for
mortgages or personal loans), on aggregate, households supply more funds to the financial
system than they demand.
1.3 Learning Goal 3
1) Bond investors lend their money for a fixed period of time and receive
interest. Answer: TRUE
Bond is one of the most common fixed-income securities. Fixed-income
securities are investments that offer a periodic cash payment that may be fixed in
dollar terms or may vary according to a predetermined formula. (P39)
2) A collection of securities designed to meet an investment goal is called a
portfolio. Answer: TRUE
An investment is simply any asset into which funds can be placed with the expectation that it will
generate positive income and/ or increase its value, and a collection of different investments is
called a portfolio. (P32)
3) If the value of a common stock increases the value of an option to buy that stock should
also increase.
Answer: TRUE
If the stock price rises above the strike price, the call option gains intrinsic value (Stock Price –
Strike Price).
Even if the stock price is below the strike price, a rising stock price increases the probability that
the option will eventually become profitable (increasing its time value).
4) An option to purchase common stock is a type of derivative
security. Answer: TRUE
Derivative securities are securities that are neither debt nor equity but are structured to exhibit the
characteristics of the under- lying assets from which they derive their value. (P38)
Options are securities that give the investor an opportunity to sell or buy another security at a
specified price over a given period of time. Investors purchase options to take advantage of an
anticipated change in the price of common stock. (P42)
5) Bonds represent a lower level of risk than do stocks in the same
company. Answer: TRUE
Bonds are less risky than stocks in the same company because:
1. Priority in Bankruptcy: Bondholders get paid before stockholders if the company fails.
2. Fixed Returns: Bonds provide steady interest payments, while stocks depend on
unpredictable market performance.
3. Lower Volatility: Bond prices fluctuate less than stock prices.
4. Legal Protections: Bond contracts often include safeguards against default risk, unlike
stocks.
Stocks only profit if the company grows, while bonds offer more stability, making them safer.
6) Exchange traded funds are similar to mutual funds, but are traded like
stocks. Answer: TRUE
A mutual fund is a portfolio of stocks, bonds, or other assets that were purchased with a pool of
funds contributed by many different investors and that are managed by an investment company
on behalf of its clients. (P40)
Like mutual funds, exchange-traded funds (ETFs) hold portfolios of securities, and investors
buy shares in the ETF. ETFs are very similar to mutual funds. They allow investors to form well-
diversified portfolios with low initial investments, and the fees charged by ETFs are generally
quite low. (P41)
7) Mutual funds invest in diversified portfolios of securities. Answer: TRUE
Investors in a mutual fund own an interest in the fund’s collection of securities. Mutual funds
allow investors to construct well-diversified portfo- lios without having to invest a large sum of
money. (P41)
8) Bond prices rise as interest rates decline. Answer: TRUE
For example, If you purchased a $1,000 bond paying 9% interest in semiannual installments, you
would receive an interest payment equal to $1,000 * 9% * 1⁄2 year = $45 every six months. The
interest rate declines at 7% in semiannual installments, so the interest payment equal to $1,000 *
7% * 1⁄2 year = $35 every six months. (P39)
9) Bond interest and stock dividends are different ways of distributing a corporation's
earnings to its owners.
Answer: FALSE
Bond interest is not a distribution of earnings to owners—it’s a contractual debt payment to
creditors. Bondholders are lenders, not owners, and interest is a fixed expense the company must
pay regardless of profitability. Stock dividends, however, are earnings distributed to shareholders,
but only if the company chooses to pay them. Unlike bond interest, dividends are discretionary
and come from after-tax profits, not obligations.
1.4 Learning Goal 4
1) Earning a high rate of return with little or no risk is a realistic investment
goal. Answer: FALSE
It is unrealistic to expect high returns without taking on significant risk. There is a fundamental
tradeoff between risk and return — generally, investments offering the potential for high returns
also come with higher risk. Safer investments, like government bonds, tend to offer lower
returns, while riskier assets like stocks or commodities may yield higher returns but with much
greater uncertainty.
2) Under current tax laws, most taxpayers will pay a lower tax rate on capital gains than
on dividends.
Answer: FALSE
Under current tax laws, qualified dividends and long-term capital gains are usually taxed at the
same preferential rates for most taxpayers. Therefore, dividends and capital gains are not treated
significantly differently in terms of taxation, and many individuals pay similar rates on both.
3) Under current tax laws, most taxpayers will pay a lower tax rate on capital gains than
on income from wages.
Answer: TRUE
Long-term capital gains are often taxed at reduced rates (0%, 15%, or 20%) depending on the
taxpayer’s income level, while wages are taxed at ordinary income tax rates, which can be much
higher, especially for higher earners. (P48)
4) Investors can postpone or avoid income taxes by investing through Individual
Retirement Accounts.
Answer: TRUE
Investing through Individual Retirement Accounts (IRAs) allows investors to defer paying taxes
on contributions and earnings until withdrawal. This tax deferral can lead to significant
compounding benefits over time and is a key advantage of retirement savings accounts. (P49)
5) Short-term capital gains are taxed at the taxpayer's marginal tax
rate. Answer: TRUE
Short-term capital gains, which are gains from the sale of assets held for one year or less, are
taxed as ordinary income at the taxpayer's marginal tax rate. This makes them more expensive
from a tax standpoint compared to long-term capital gains.
6) To qualify for long-term capital gains rates, a stock must be held for at least 12
months. Answer: TRUE
Under U.S. tax law, assets must be held for more than 12 months to benefit from the lower long-
term capital gains tax rates. If sold earlier, gains are treated as short-term and taxed at higher
ordinary income rates.
7) Retirement plans, such as a 401(k), allow employees to defer taxes on the plan
contributions until such time as the funds are withdrawn from the retirement plan.
Answer: TRUE
401(k) plans allow workers to contribute pre-tax income, meaning they do not pay taxes on the
money now. Taxes are deferred and paid when the funds are withdrawn, typically during
retirement when individuals may be in a lower tax bracket. (P49)
8) You should spend money on housing, clothing and basic insurance before
investing. Answer: TRUE
It is essential to cover basic living expenses and insurance needs before committing funds to
investments. Having a secure financial foundation ensures that investments are made from a
position of strength, reducing the need to liquidate investments prematurely during emergencies.
9) Discuss the relationship between stock prices and investors' beliefs about the
business cycle.
Answer: Stock prices tend to anticipate the economic conditions that investors expect in the
future. When they believe that economic conditions will deteriorate and profits will decline,
stock prices fall. When they expect an improving economy and higher corporate profits, stock
prices rise.
10) What are some of the important prerequisites to investing?
Answer: Before entering risky investments, individuals need to provide for the necessities of
life such as housing, transportation, and taxes. They should have liquid assets available to meet
unforeseen emergencies such as job loss, auto repairs or dental treatments. They should also
have insurance for catastrophic events involving health or property.
11) Discuss the general investment philosophy and the types of investments preferred
by investors in each phase of the life cycle.
Answer:
1.5 Learning Goal 5
1) U.S. Treasury Bills mature in 1 year or less.
Answer: TRUE
U.S. Treasury Bills (T-bills) are short-term government securities that mature in one year or less.
They are sold at a discount to face value and do not pay periodic interest, but investors receive
the full face value at maturity, making them a very safe and liquid investment.
2) Liquidity is the ability to convert an investment into cash quickly with little or no loss
of value.
Answer: TRUE
Liquidity refers to how easily an investment can be sold for cash without significantly affecting
its price. Highly liquid assets, like Treasury Bills or money market instruments, can be quickly
and easily converted into cash with minimal risk of losing value. (P52)
3) Short-term investments generally provide liquidity, safety, and a high rate of
return. Answer: FALSE
Suppose you invest $10,000 in a money market fund or a three-month Treasury Bill, both
considered short-term investments. These investments are highly liquid — meaning you can
easily sell them for cash — and very safe because they have little default risk. However, the
rate of return you earn will be very low, often just around 2–4% per year (or even less,
depending on interest rates). In contrast, investing $10,000 in stocks could potentially earn you
8–10% or more annually, but stocks are much riskier and less liquid in volatile markets.
Therefore, short-term investments do not provide a high rate of return — they sacrifice return
in exchange for liquidity and safety.
4) Money market accounts, certificates of deposit, bonds and commercial paper are all forms
of short-term investment vehicles.
Answer: FALSE
While money market accounts, certificates of deposit (with short maturities), and commercial
paper are short-term investment vehicles, bonds typically refer to longer-term debt instruments
with maturities exceeding one year. (Table in P54)
1.6 Learning Goal 6
1) Certified Financial Planners typically manage institutional portfolios. Answer: FALSE
Certified Financial Planners (CFPs) primarily focus on serving individual clients by helping
them with personal financial planning, including retirement, estate planning, and investment
management, rather than managing large institutional portfolios.
2) A major goal of corporate financial management is to increase the value of the firm
to investors.
Answer: TRUE
Corporate financial management seeks to maximize the value of the firm, which benefits
shareholders and investors. Increasing firm value often involves strategies like increasing
profitability, managing risk, and optimizing capital structure.
3) Stringent regulations and vigorous enforcement have all but eliminated unethical
behavior by financial professionals in recent years.
Answer: FALSE
Despite stronger regulations and enforcement following events like the 2008 financial crisis,
unethical behavior still exists among financial professionals. High-profile cases of fraud and
misconduct continue to occur, showing that no system can completely eliminate unethical
practices.
4) Insurance companies invest the premiums and fees collected from customers in order
to neutralize the risks assumed from their clients.
Answer: TRUE
Insurance companies collect premiums and invest those funds to generate returns that help cover
potential claims. These investments help them manage and neutralize the financial risks they
assume from policyholders.
5) Chartered Financial Analyst (CFA) is a degree offered by several prestigious
business schools.
Answer: FALSE
The Chartered Financial Analyst (CFA) designation is not a university degree but a professional
credential awarded by the CFA Institute after passing a series of rigorous exams and meeting
professional experience requirements.
6) Briefly describe three different career paths that require a strong background in investments.
Answer: Students may discuss any of the following career paths. Answers will vary.
Responsibilities of commercial bankers may include portfolio management, managing short- term
securities, and advising individuals as personal bankers.
Corporate financial managers must raise external fuds through the debt and equity markets,
manage short-term investments, and understand investor expectations for their business.
Financial planners assist individuals in choosing the investments that will help them meet their
short and long term goals.
The insurance industry employs professionals to invest and manage the large sums collected from
premiums.
Within the investment management industry, professionals may work as securities analysts, fund
managers, or retail brokers.
