Module 2: Investment Vehicle Characteristics

• Topic 01

  Cash and Cash Equivalents

  178 questions
• Topic 02

  Fixed Income Securities

  127 questions
• Topic 03

  Equity Securities

  89 questions
• Topic 04

  Pooled Investments

  127 questions
• Topic 05

  Derivative Securities

  98 questions
• Topic 06

  Alternative Investments

  135 questions
• Topic 07

  Insurance-Based Products

  96 questions

A few questions from this unit, with the answer and a full explanation. The complete bank is available when you start practising.

1. What is a unit investment trust (UIT)?

   • A
     A trust that holds a single security (typically a government bond) until it matures
   • B
     An investment club structure where members vote on portfolio changes quarterly
   • C
     A type of closed-end fund that issues a fixed number of units traded on an exchange
   • D
     An investment company with a fixed portfolio of securities and a fixed termination date; the portfolio is assembled once and generally not actively managed or traded thereafter
     Correct answer
   Explanation

   A unit investment trust (UIT) is a type of investment company registered under the Investment Company Act of 1940. It has three defining characteristics: (1) a fixed, defined portfolio of securities selected at inception; (2) a fixed termination date at which the trust dissolves and distributes proceeds; and (3) no active management—the portfolio is not actively traded after assembly (there is a trustee but no portfolio manager making ongoing investment decisions). Investors purchase 'units' representing proportional ownership of the fixed portfolio.

2. What does a high P/E ratio reflect about investor growth expectations?

   • A
     A high P/E means the company is a low-risk, defensive investment with stable earnings
   • B
     A high P/E generally indicates the stock is overvalued and should be sold immediately
   • C
     Investors expect the company to grow earnings rapidly in the future and are willing to pay a premium today for anticipated higher future earnings
     Correct answer
   • D
     A high P/E indicates the company has very high current earnings relative to its price
   Explanation

   A high P/E reflects market optimism about future earnings growth. If investors believe earnings will grow significantly, they are willing to pay a high multiple of current earnings today. Technology and growth companies often trade at high P/Es because of expected rapid earnings growth. A high P/E may also reflect a temporary earnings dip (low E) rather than high growth expectations — context is critical.

3. A stock pays an annual dividend of $2.00. Dividends are expected to grow at 5% per year indefinitely. An investor requires a 10% return. What is the intrinsic value of the stock using the Gordon Growth Model?

   • A
     P₀ = $2.00 / (0.10 − 0.05) = $2.00 / 0.05 = $40.
   • B
     P₀ = $2.00 × 0.10 / 0.05 = $4.00.
   • C
     P₀ = $2.00 / (0.10 + 0.05) = $2.00 / 0.15 = $13.33.
   • D
     P₀ = D₁ / (k − g) = ($2.00 × 1.05) / (0.10 − 0.05) = $2.10 / 0.05 = $42.
     Correct answer
   Explanation

   Step 1: Calculate D₁ (next year's dividend) = D₀ × (1+g) = $2.00 × 1.05 = $2.10. Step 2: Apply Gordon Growth Model: P_0 = D_1 / (k - g) = \2.10 / (0.10 - 0.05) = $2.10 / 0.05 = $42. The most common error is using D₀ (\2.00) instead of D₁ ($2.10) in the numerator — this gives $40. The model uses the next period's dividend (D₁), not the current dividend (D₀). If the stock is trading at $42, it is fairly valued; below $42 is undervalued; above $42 is overvalued according to the model. The formula's sensitivity to small changes in k or g is a well-known limitation.