FIN 401 Final

(Q1) What is the coupon rate for a bond with three years until maturity, an annual coupon payment, a price of $1,053.46, and a yield to maturity of 6%?

$1,053.46 = Present value of payments and par value = present value of 3 payments + present value of par = PMT [16.667 - 13.994] + 839.60 $80.00 = PMT 8% coupon rate

What is the PV of a $1 perpetuity? Time 0 1 2 3 4 .... Payment0 $1$1$1$1 ....

$1/r

You are considering the purchase of a 3-year, 10% coupon bond. The bond pays coupons annually. The discount rate for similar bonds is 8%. What price are you willing to pay for the bond?

$1051.54

A firm purchases goods on credit worth $150. The same firm pays off $100 in old credit purchases. An investment is made via the purchase of a new facility, and equity is issued in the amount of $300 to pay for the purchase. What is the change in net cash provided by operations?

$50 increase

What is the PV of $100 to be received every year for 10 years starting in 1 year, discounted at 10%?

$614.46

(1)Nominal dollars refer to the amount of purchasing power. (2)The CPI index price level has generally remained at the 1984 level over the last 30 years. (3)Inflation is measured using simple year-to-year differences in the CPI. All price changes are inflation.

(1)False (2)False (3)False - Inflation is measured as a percent change in the CPI not a simple difference (4)False - prices can change due to other reasons (e.g., changes in quality)

If investors are to earn a 3% real interest rate, what nominal interest rate must they earn if the inflation rate is... a. 0%? b. 4%? c. 6%?

(1+nominal rate) = (1+real rate) ´ (1+inflation rate) a. 1.03 ´ 1.0 = 1.03 Þ nominal rate = 3.00% b. 1.03 ´ 1.04 = 1.0712 Þ nominal rate = 7.12% c. 1.03´ 1.06 = 1.0918 Þ nominal rate = 9.18%

Assume you have an 8% annual coupon 30 year bond with a YTM of 9%. It's price is $897.26. What is this bond's duration?

(1+y)/y-((1+y)+n(c-y))/(c[(1+y)^n-1]+y) = 1.09/.09-((1.09)+30(.08-.09))/(.08[(1.09)^30-1]+.09) = 11.37 years = Duration(settlement, maturity, coupon, yield, frequency) = DURATION(DATE(2011,3,21),DATE(2041,3,21),0.08,0.09,1)

Calculate the bond price change if the yield to maturity went from 9% to 9.5%. Use the previous example's bond information.

(∆Bond Price)/(Bond Price)=-D/(1+y) (∆y) +(.5)[1/(Price(1+y)^2 ) ∑_(t=1)^n▒〖 〖CF〗_t/(1+y)^t 〗 (t^2+t)]〖(∆y)〗^2 ∆Bond Price= {-D/(1+y) (∆y) +(.5)[Convexity] (∆y)^2 }Bond Price ={-11.37/1.09 (.005) +(.5)[1615.46] (.005)^2 }897.26 = -28.68 Using duration and convexity the price falls by $28.68 For the convexity calculation see next slide Convexity= 1/(Price(1+y)^2 ) ∑_(t=1)^n▒〖 〖CF〗_t/(1+y)^t 〗 (t^2+t)=1/(897.26(1.09)^2 ) {[∑_(t=1)^30▒〖 80/(1.09)^t 〗 (t^2+t)]+ 1000/(1.09)^30 (30^2+30)} l Convexity = 1615.46 (see convexity tab of immunization file on Canvas website.)

What will happen to the bond price if the bond's yield to maturity increases to 9.5%? Use the duration and other bond information from previous example.

(∆Bond Price)/(Bond Price)=-D^∗ (∆y)= - D/(1+y) (∆y) ∆Bond Price = - D/(1+y) (∆y) Bond Price ∆Bond Price = - 11.37/1.09 (.005) (897.26) = -46.79 à The price will fall by $46.79

1.How are regression coefficients related to a scatter plot? 2.OLS solves for the trend line using what approach? 3.Describe what the R-square value tells you. 4.What does 1 minus R-square tell you in a CAPM-based regression?

1. X - Explanatory varibale y- Dependent variable OLS Trend line - Trend line that minimizes sum of squared residuals 2. Minimization of the sum of squared residuals 3. Variation in y explained by the model 4. Firm specific events

CAPM Assumptions

1.We are all "price takers". 2.We are all rational mean-variance optimizers. 3.We all have the same set of assets to choose from when making a portfolio and we utilize the same information and approaches to forming our expectations about future returns as well as risk.

Assume the risk free rate is 8% and the expected rate of return on the market is 18%. A share of stock is now selling for $100. It will pay a dividend of $9 per share at the end of the year. Its beta is 1. What do investors expect the stock to sell for at the end of the year?

21 Since the stock's beta is equal to 1.0, its expected rate of return should be equal to that of the market, that is, 18%. E(r) = (D+P1 - P0)/P0 0.18 =(9+P1-100)/100 è P1= $109 ---------------

Suppose another portfolio E is well diversified with a beta of 2/3 and an expected return of 9%. Would an arbitrage opportunity exist? If so, what would the arbitrage strategy be?

27 Since the beta for Portfolio F is zero, the expected return for Portfolio F equals the risk-free rate. For Portfolio A, the ratio of risk premium to beta is: (10 - 4)/1 = 6 The ratio for Portfolio E is higher: (9 - 4)/(2/3) = 7.5 This implies that an arbitrage opportunity exists. For instance, by taking a long position in Portfolio E and a short position in Portfolio F (that is, borrowing at the risk-free rate and investing the proceeds in Portfolio E), we can create another portfolio which has the same beta (1.0) but higher expected return than Portfolio A. For the beta of the new portfolio to equal 1.0, the proportion (w) of funds invested in E must be: 3/2 = 1.5. See table shown on slide #30 As summarized above, taking a short position in portfolio A and a long position in the new portfolio, we produce an arbitrage portfolio with zero investment (all proceeds from the short sale of Portfolio A are invested in the new portfolio), zero risk (because b = 0 and the portfolios are well diversified), and a positive return of 1.5%.

Suggested review of chapter 7 material lCFA end-of-chapter problems 1-2,4-9

34 The first two factors (the return on a broad-based index and the level of interest rates) are most promising with respect to the likely impact on Jennifer's firm's cost of capital. These are both macro factors (as opposed to firm-specific factors) that cannot be diversified away; consequently, we would expect that there is a risk premium associated with these factors. On the other hand, the risk of changes in the price of hogs, while important to some firms and industries, is likely to be diversifiable, and therefore is not a promising factor in terms of its impact on the firm's cost of capital. ----------------- CFA 1 Answer: a, c, and d are true; b is incorrect because the SML doesn't require all investors to invest in the market portfolio but provides a benchmark to evaluate investment performance for both portfolios and individual assets. ----------------- CFA 2 (Note that the "forecasted returns" are forecasted using a non-CAPM-based approach. Answer: (a) E(rX) = 5% + 0.8 ´ (14% - 5%) = 12.2% αX = 14% - 12.2% = 1.8% E(rY) = 5% + 1.5 ´ (14% - 5%) = 18.5% αY = 17% - 18.5% = -1.5% (b i) For an investor who wants to add this stock to a well-diversified equity portfolio, Kay should recommend Stock X because of its positive alpha, while Stock Y has a negative alpha. In graphical terms, Stock X's expected return/risk profile plots above the SML, while Stock Y's profile plots below the SML. Also, depending on the individual risk preferences of Kay's clients, Stock X's lower beta may have a beneficial impact on overall portfolio risk. (b ii) For an investor who wants to hold this stock as a single-stock portfolio, Kay should recommend Stock Y, because it has higher forecasted return and lower standard deviation than Stock X. Stock Y's Sharpe ratio is: (0.17 - 0.05)/0.25 = 0.48 Stock X's Sharpe ratio is only: (0.14 - 0.05)/0.36 = 0.25 The market index has an even more attractive Sharpe ratio: (0.14 - 0.05)/0.15 = 0.60 However, given the choice between Stock X and Y, Y is superior. When a stock is held in isolation, standard deviation is the relevant risk measure. For assets held in isolation, beta as a measure of risk is irrelevant. Although holding a single asset in isolation is not typically a recommended investment strategy, some investors may hold what is essentially a single-asset portfolio (e.g., the stock of their employer company). For such investors, the relevance of standard deviation versus beta is an important issue. ----------------- CFA 3 Answer: (a) McKay should borrow funds and invest those funds proportionally in Murray's existing portfolio (i.e., buy more risky assets on margin). In addition to increased expected return, the alternative portfolio on the capital market line (CML) will also have increased variability (risk), which is caused by the higher proportion of risky assets in the total portfolio. (b) McKay should substitute low beta stocks for high beta stocks in order to reduce the overall beta of York's portfolio. By reducing the overall portfolio beta, McKay will reduce the systematic risk of the portfolio and therefore the portfolio's volatility relative to the market. The security market line (SML) suggests such action (moving down the SML), even though reducing beta may result in a slight loss of portfolio efficiency unless full diversification is maintained. York's primary objective, however, is not to maintain efficiency but to reduce risk exposure; reducing portfolio beta meets that objective. Because York does not permit borrowing or lending, McKay cannot reduce risk by selling equities and using the proceeds to buy risk free assets (i.e., by lending part of the portfolio). ----------------- CFA 4 Answer: (a) "Both the CAPM and APT require a mean-variance efficient market portfolio." This statement is incorrect. The CAPM requires the mean-variance efficient portfolio, but APT does not. (b) "The CAPM assumes that one specific factor explains security returns but APT does not." This statement is correct. ----------------- CFA 5 Answer: a. A security's expected return as a function of its systematic risk (beta). ----------------- CFA 6 Answer: d. The expect return on the market, rM: E(r) = rf + b[E(rM) -rf ] = rf + 1.0 ´ [E(rM) -rf ] = E(rM) ----------------- CFA 7 Answer: d. Insufficient data given. We need to know the risk-free rate. ----------------- CFA 8 Answer: d. Insufficient data given. We need to know the risk-free rate. ----------------- CFA 9 Answer: Under the CAPM, the only risk that investors are compensated for bearing is the risk that cannot be diversified away (i.e., systematic risk). Because systematic risk (measured by beta) is equal to 1.0 for each of the two portfolios, an investor would expect the same rate of return from each portfolio. Moreover, since both portfolios are well diversified, it does not matter whether the specific risk of the individual securities is high or low. The firm-specific risk has been diversified away from both portfolios.

1.The duration of a zero coupon bond is the time to maturity. ● 2.With time to maturity and YTM held constant, a bond's duration is higher when the coupon rate is lower. (coupon) ● 3.With coupon rate held constant, a bond's duration increases with time to maturity. (term) ● 4.With other factors held constant, the duration of a coupon bond are higher when the bond's YTM is lower. (YTM)

5.The duration for a level perpetuity is (1+y)/y ● 6.The duration for a level annuity is (1+y)/y-n/(〖(1+y)〗^n-1) where n is the number of payment periods, and y is the yield per payment period. ● 7.The duration for a coupon bond equals (1+y)/y-((1+y)+n(c-y))/(c[(1+y)^n-1]+y) where c is the coupon rate per payment period.

Assume that Julie just graduated from Miami University. Assume inflation will be 3% per year going forward and that she plans to take a big vacation in 5 years. The type of vacation she wants to take would cost $10,000 in today's dollars. What will be the cost of the vacation in year 5?

Answer to (a) : The cost of the vacations will be as follows. Note that the formula shown below simply accounts for the inflation. 10,000*(1.03)^5 = $11,592.741

Estimating Expected Returns

Assume •Boeing's Beta = 0.96 •Risk-free Rate = 5.00% (Long term government bond rate) •Risk Premium = 5.50% (Approximate historical premium) Then according to the CAPM: Expected Return = 5.00% + 0.96 (5.50%) = 10.31%

Let's compare two options: (option 1) 30 equal payments (an annuity) that totals $425 million (option 2) a single payment (PV) of $242 million What is the present value of the 30 payments at a 5% discount rate? What discount rate would make these two options equal?

Assume annual compounding: PV of annuity=CF[1/r-1/((r) (1+r)^n )] =425/30 [1/.05-1/((.05) (1+.05)^30 )]= $217.77 A discount rate of ~4.1% makes the 2 options equal.

(Q3) You buy an 8% coupon, 10-year maturity bond for $980. A year later, the bond price is $1,100. •What is the new YTM on the bond? •What is the rate of return over the year?

At a price of $1,100 and remaining maturity of 9 years, find the bond's yield to maturity by solving for r in the following equation: 1,100=80[1/r-1/(r(1+r)^9 )]+ 1000/((1+r)^9 ) Þ r = 6.50% = YTM Using a financial calculator, enter: n = 9; PV = (-)1100; FV = 1000; PMT = 80, and then compute i = 6.50% Rate of return = (80+1100-980)/980 = 20.41%

Bonds rated ______ or better by Standard & Poor's are considered investment grade.

BBB

As a potential investor in Boeing, what does this expected return of 10.31% tell you? a.This is the return that I can expect to make in the long term on Boeing, if the stock is correctly priced and the CAPM is the right model for risk, b.This is the return that I need to make on Boeing in the long term to earn a fair return on my investment in the stock c.Both

Both. If the stock is correctly priced, the beta is correctly estimated and the CAPM is the right model, this is what you would expect to make on Boeing in the long term. As an investor, this is what you would need to make to break even on the investment.

You find a 5-year AA Xerox bond priced to yield 6%. You find a similar-risk 5-year Canon bond priced to yield 6.5%. If you expect interest rates to rise, what should you do?

Buy the Canon bond, and short the Xerox bond.

Assume now that you are an active investor and that your research suggests that an investment in Boeing will yield 25% a year for the next 5 years. Based upon the CAPM expected return of 10.31%, you would a.Buy the stock b.Sell the stock

Buy the stock, since you think you can make more than the hurdle rate (10.31%)

(Q2) A 6-year Circular File bond pays interest of $80 annually and sells for $950. What is the coupon rate, current yield, and yield to maturity?

Coupon rate = $80/$1,000 = 0.080 = 8.0% Current yield = $80/$950 = 0.0842 = 8.42% To compute the yield to maturity, use the following equation: 950=80[1/r-1/(r(1+r)^6 )]+ 1000/((1+r)^6 )Þ r = 9.119% = YTM Using a financial calculator, compute the yield to maturity by entering: n = 6; PV = (-)950; FV = 1000; PMT = 80, compute i = 9.119%

Operating ROA is calculated as __________.

EBIT/ total assets

Which one of the following ratios is used to calculate the times-interest-earned ratio?

EBIT/interest expense

Consider two firms producing smart phones. One uses a highly automated robotics process, while the other uses human workers on an assembly line and pays overtime when there is heavy production demand. Which firm will have higher profits in a recession?

Firm using human workers

Consider two firms producing smart phones. One uses a highly automated robotics process, while the other uses human workers on an assembly line and pays overtime when there is heavy production demand. Which firm will have higher profits in a boom?

Firm using robotics

Consider two firms producing smart phones. One uses a highly automated robotics process, while the other uses human workers on an assembly line and pays overtime when there is heavy production demand. Which firm's stock will have a higher beta?

Firm using robotics

Why would we all hold the market portfolio as part of our overall portfolio?

Given the assumption that we are homogenous in our optimization techniques, the available securities to invest in, and information, we will all trace out the same efficient frontier and find the same tangency portfolio that maximizes the slope of the CAL. In the end we will all realize that the market portfolio is the portfolio with the highest Sharpe ratio.

Sinking funds are commonly viewed as protecting the ______ of the bond.

Holder

Which of the following is a true statement? I. the actual value of a call option is greater than its intrinsic value prior to expiration II. the intrinsic value of a call option is always greater than its time value prior to expiration III. the intrinsic value of a call option is always positive prior to expiration IV. the intrinsic value of a call option is greater than its actual value prior to expiration.

I

The duration of a bond normally increases with an increase in: I. term to maturity II. yield to maturity III. Coupon rate

I only

The yield to maturity on a bond is: I. Above the coupon rate when the bond sells at a discount and below the coupon rate when the bond sells at a premium. II. The discount rate that will set the present value of the payments equal to the bond price. III. Equal to the true compound return on investment only if all interest payments received are reinvested at the YTM.

I, II, and III

To earn a high rating from the bond rating agencies, a company would want to have: I. A low times-interest-earned ratio II. A low debt-to-equity ratio III. A high quick ratio

II and III only

A 1% decline in yield will have the least effect on the price of a bond with a ______________. I. 10-year maturity, selling at 80 II. 10-year maturity, selling at 100 III. 20-year maturity, selling at 80 IV. 20-year maturity, selling at 100

II. 10-year maturity, selling at 100

Which of the following bonds would most likely sell at the lowest yield? I. a callable debenture II. a puttable mortgage bond III. a callable mortgage bond IV. a puttable debenture

II. a puttable mortgage bond

Which of the following is NOT an example of fiscal policy? I. Social Security spending II. Medicare spending III. Fed purchases of Treasury securities IV. changes in tax rate

III

Which of the following statements is false? I. Bond prices and yields are inversely related II. An increase in a bond's YTM results in a smaller price change than a decrease in yield of equal magnitude III. Prices of short-term bonds tend to be more sensitive to interest rate changes than prices of long-term bonds. IV. Interest rate risk is inversely related to bond's coupon rate.

III

Which one of the following statements about market and book value is correct? I. All firms sell at a market-to-book ratio above 1 II. all firms sell at market-to-book ratio greater than or equal to 1 III. all firms sell at market-to-book ratio below 1 IV. most firms have a market-to-book ratio above 1, but not all

IV

lJensen wanted to (1) create a systematic way to think about mutual fund performance, and (2) to analyze whether the average existing mutual funds "beat the market".

If the CAPM is right, then (r_M-r_f) should explain (r_J-r_f) and the intercept should be zero.

According to the ____________________________, the forward rate exceeds the expected short-term interest rate next year.

Liquidity preference hypothesis

What is consistent with a steeply upwardly sloping yield curve?

Monetary policy is expansive and fiscal policy is expansive

Speculative view

Only buy and sell options to make a profit. — Q: if you buy a call, do you hope the price will increase or decrease? A: increase, Holder has infinite upside.

(Q4) Fill in the table below for the following zero-coupon bonds. The face value of each bond is $1,000.

Price Maturity (Years) Yield to Maturity $300.00 30.00 4.095% $300.00 15.64 8.000% $385.54 10.00 10.000%

Exercise price (X) :

Price you'll pay if the call option is exercised (typically stock is never purchased). - People typically sell the option contract instead of exercising it.

_________ are examples of synthetically created zero-coupon bonds.

STRIPS

If the simple CAPM is valid, which of the situations in questions 13 and 14 are possible? Consider each question separately.

Solutions: 13 Not possible. Portfolio A has a higher beta than Portfolio B, but the expected return for Portfolio A is lower. -------------- 14 Possible. If the CAPM is valid, the expected rate of return compensates only for systematic (market) risk as measured by beta, rather than the standard deviation, which includes nonsystematic risk. Thus, Portfolio A's lower expected rate of return can be paired with a higher standard deviation, as long as Portfolio A's beta is lower than that of Portfolio B.

Calculating the index level using a price-weighted index

Stock, Initial Price (P1), Next period's price (P2), Shares outstanding, MCAP1 1, 10, 12, 8, 80 2, 5, 4, 4, 20 3, 2, 3, 50, 100 Price-Weighted Index (assuming an initial divisor of 3) Level1 = 1/3(10+5+2) = 5.67 Level2 = 1/3(12+4+3) = 6.33 Percent Change = (6.33/5.67)-1 = 11.64%

If the expected risk premium for asset i is βi{E[rM]-rf}, then why does the CAPM suggest that only market risk is rewarded? What about firm-specific risk?

The CAPM assumptions have everyone holding the market portfolio. This means they are holding a diversified position and hence firm-specific risk has been diversified away. In equilibrium, only market risk is rewarded.

Suppose you will receive $10,000 in one year and $20,000 in three years. Your discount rate is 6%. What is the present value of this stream of two cash flows?

The PV of the 2 payments is equal to the present value of the first payment plus the present value of the second payment.

Option premium :

The dollar price to buy the option. - Reflects where the stock price is vs. the exercise price

Duration measures what?

The effective maturity of a bond, the weighted average of the time until each payment is received, with weights proportional to the present value of the payment, and the average maturity of the bond's promised cash flows

Cash flows of 8-yr bond with 9% annual coupon and 10% YTM

The height of each bar is the total coupon payment each year ($90) for years 1-7. In year 8 it represents the principal plus the last coupon payment. The colored bar represents the present value of each cash flow each year. The Macaulay duration is 5.97 years

Given the following zero-coupon yields, compare the yield to maturity for a three-year zero-coupon bond and a three-year coupon bond with 4% annual coupons. Assume all of these bonds are default free.

The price of the 4% bond can be written using either the rates for each period or using a single rate. l lFirst, solve for the price using the rates: P= 40/1.035+40/〖1.040〗^2 +(40+1000)/〖1.045〗^3 =$986.98 l lThen use this price to solve for the YTM on the coupon bond. $986.98= 40/(1+y)+40/〖(1+y)〗^2 +(40+1000)/〖(1+y)〗^3 RATE(NPER,PMT,PV,FV) = RATE(3,40,−986.98,1000)

Why would we all expect the same risk premium per unit of market risk? I.e., why is the risk premium related to E[rM]-rf?

The slope of the CAL to the market portfolio (M) describes the highest feasible reward-to-risk relation: {E[rM]-rf}/ σM. Hence all rational investors would want and expect {E[rM]-rf} per σM units of risk. When we think about the expected risk premium for individual asset i we will expect βi{E[rM]-rf} of risk premium where βi measures the amount of market risk (σM ) from adding asset i to our portfolio.

Assume you have a $15,000 liability in 5 years. To prepare for this obligation you want to buy a coupon bond. How do you pick the right bond to immunize the assets and liabilities? (See Immunization spreadsheet on course website)

To do this we would select bonds with remaining term (n), coupon rate, face value, and yield to satisfy these two equations (assume r=7%): (1) (Coupon PMT)(1/r-1/(r(1+r)^n ))+ (face value)/〖(1+r)〗^n =15000/〖(1+r)〗^5 l (2) (1+y)/y-((1+y)+n(coupon rate-y))/(coupon rate[(1+y)^n-1]+y) = 5

lDuration (without convexity correction) gives only an approximation of the price change for a given interest rate change. lThe duration-based formula indicates that the percentage price change is proportional to the change in the bond's yield lThe linear duration price change formula underestimates the increase in bond prices when yield falls lThe linear duration price change formula overestimates the decline in price when the yield rises

True True True True

A top-down analysis of a firm's prospects starts with an analysis of the _________.

US economy or even the global economy

Value-weighted index calculation (continued)

Using the same stock information from before... The total market cap initially (at time 1) is: (80 + 20 + 100 ) = $200 Weights are given by w1 = 40%, w2 = 10%, w3= 50%, Value-weighted portfolio return calculations: •r1 = 20%, r2 = -20%, r3 = 50% •value-weighted return = .4(0.2) + 0.1(-0.2) + 0.5(0.5) = 31% The index level next period is 100(1.31)=131 From before Stock 1: P0=10, P1=12, shares outstanding=8 Stock 2: P0=5, P1=4, shares outstanding=4 Stock 3: P0=2, P1=3, shares outstanding=50 So w1 = 80/200 = 40%, w2 = 20/200 = 10%, and w3 = 100/200 = 50% And r1 = (12-10)/10 = 20%, r2 = (4-5)/5 = -20%, and r3 = (3-2)/2 = 50%

(Q2) Assume your uncle recorded his salary history during a 40-year career and found that it had increased ten-fold. If inflation averaged 5% annually during the period, how would you describe his purchasing power, on average? A)His purchasing power remained on par with inflation. B)He "beat" inflation by nearly 1% annually. C)He "beat" inflation by slightly over 2% annually. D)He "beat" inflation by 5% annually.

We know inflation averaged 5% a year. What growth rate is necessary in his salary to end up with 10 times larger salary. After solving for the growth rate we can compare it to 5%. 10 = 1(1 + i)40, i = 5.925% à answer is B

Assume the price is observed to be $1,046.87 on a 3 year 10% coupon bond.

We know the cash flows and the price (PV) of the bond. Now solve for the YTM. PV=〖CF〗_1/(1+YTM)^1 +〖CF〗_2/(1+YTM)^2 +〖CF〗_3/(1+YTM)^3 $1,046.87=$100/(1+YTM)^1 +$100/(1+YTM)^2 +$1,100/(1+YTM)^3 The YTM must equal 8.176% in order for the above expression to be true.

Implications of CAPM assumptions:

We will all seek the portfolio on the efficient frontier with the highest Sharpe ratio. Hence we will all end up holding a combination of the tangency market portfolio (M) and the risk-free asset. The market portfolio's return and risk can be written as: rM and σM. 2. The best possible reward (for everyone) for holding additional risk will be described by the slope of the CAL linking the risk- free return to the market portfolio: {E[rM]-rf}/ σM.

Price-weighted index calculations with stock splits(from #1)

What if stock 1 split in the second period? With split: price = 6, shares outstanding=16 With no split: price = 12, shares outstanding = 8 6.33=(6+4+3)/D D=2.0537

Assume you are paid $10,000 this year for part time work. You expect your part-time salary to increase by 10% a year. What is the present value in nominal and real terms for your salary over the next 3 years if inflation is 5% per year and the nominal discount rate is 8% per year?

Year, Nominal income (growth = 10%), Real income 0, $10,000, $10,000 1, $11,000, $10,476 2, $12,100, $10, 975

Does the CAPM describe real-world risk-return behavior?

Yes but poorly -- and not as much in recent time periods. There are other factors known to explain returns not captured by the classical CAPM.

Which of the following set of conditions will result in a bond with the greatest price volatility?

a low coupon and a long maturity

Moving to higher-yield bonds, usually with longer maturities, is called ____________.

a pure yield pickup swap

A bond swap made in response to forecasts of interest rate changes is called ___________.

a rate anticipation

A portfolio manager believes interest rates will drop and decides to sell short-duration bonds and buy long duration bonds. This is an example of __________ swap.

a rate anticipation

Assuming all other factors remain unchanged, _____________ would increase a firm's price-earnings ratio.

a reduction in investor risk aversion

The exchange of one bond for a bond that has similar attributes but is more attractively priced is called __________________.

a substitution swap

The writer of a put option ___________.

agrees to buy shares at a set price if the option holder desires

Because of convexity, when interest rates change, the actual bond price will _______________ the bond price predicted by duration.

always be higher than

What would result in an increase in cash to the firm?

an increase in accounts payable

A one-dollar increase in a stock's price would result in _____________ in the call option's value of ___________ than one dollar.

an increase; less

A portfolio manager sells Treasury bonds and buys corporate bonds because the spread between corporate- and Treasury-bond yields is higher than its historical average. This is an example of ____________ swap.

an intermarket spread

What ratio will definitely increase when a firm increases its annual sales with no corresponding increase in assets?

asset turnover

The delta of a put option on a stock is always ____________

between 0 and -1

Hedge ratios for long calls are always ________________.

between 0 and 1

Consider two bonds, A and B. Both bonds presently are selling at their par value of $1,000. Each pays interest of $120 annually. Bond A will mature in 5 years, while bond B will mature in 6 years. If the yields to maturity on the two bonds change from 12% to 14%, ____________________.

both bonds will decrease in value but bond B will decrease more than bond A

Which one of the following describes the amount by which government spending exceeds government revenues? I. Balance of trade II. budget deficit III. gross domestic product IV. output gap

budget deficit

Everything else equal, if you expect a larger interest rate increase than other market participants, you should ______________.

buy short-term bonds

A bond portfolio manager notices a hump in the yield curve at the 5-year point. How might a bond manager take advantage of this event?

buy the 5-year bonds, and short the surrounding maturity bonds

The historical yield spread between the AA bond and the AAA bond has been 25 basis points. Currently the spread is only 9 basis points. If you believe the spread will soon return to its historical levels, you should ________________.

buy the AAA and short the AA

According to the put-call parity theorem, the payoffs associated with ownership of a call option can be replicated by _______________________________.

buying the underlying stock, borrowing the present value of the exercise price, and buying a put on the same underlying stock and with the same exercise price.

The maximum loss a buyer of stock call option can suffer is the __________.

call premium

A _____________ bond gives the issuer an option to retire the bond before maturity at a specific price after a specific date.

callable

If you are holding a discount bond, you must expect a ___________ each year until maturity. (assume YTM remains stable over time)

capital gain

If you are holding a premium bond, you must expect a _______________ each year until maturity. (assume YTM remains stable over time)

capital loss

When assessing the sustainability of a firm's cash flows, analysts will prefer to see cash growth generated from which of the following sources?

cash flow from operating activites

In an era of particularly low interest rates, which of the following bonds is most likely to be called?

coupon bonds selling at a premium

Floating rate bonds have a _______________ that is adjusted with current market interest rates.

coupon rate

You invest in the stock of Rayleigh Corp. and write a call option on Rayleigh Corp. This strategy is called a ___________.

covered call

Generally speaking, as a firm progresses through the industry life cycle, you would expect the PVGO to __________ as a percentage of share price.

decrease

If interest rates increases, business investment expenditures are likely to ______________ and consumer durable expenditures are likely to _____________.

decrease; decrease

When YTM increases, the duration _____________.

decreases

The value of a call option increases with all of the following except _____________.

dividend yield

In the context of a bond portfolio, price risk and reinvestment rate risk exactly cancel out at a time horizon equal to the __________.

duration of the portfolio

According to the ___________________________, the forward rate equals the expected value of the short-term interest rate next year.

expectations hypothesis

Earnings yields tend to _______ when treasury yields fall.

fall

The analysis of the determinants of firm value is called ______________.

fundamental analysis

Call Option

gives holder (buyer) the right (not obligated) to buy stock at a stated price (ie. the strike/exercise price) during a specified time period. -if convinced stock price will rise, you use the exercise price.

An underpriced stock provides an expected return that is __________ the required return based on the capital asset pricing model (CAPM).

greater than

As a result of bond convexity, an increase in a bond's price when yield to maturity falls is ___________ the price decrease resulting from an increase in yield of equal magnitude.

greater than

The constant growth dividend discount model (DDM) can be used only when the _____________.

growth rate is less than the required return

If you believe the economy is about to go into a recession, you might change your asset allocation by selling ___________ and buying __________.

growth stocks; long-term bonds

Consider a 7-year bond with a 9% coupon and a yield to maturity of 12%. If interest rates remain constant, 1 year from now the price of this bond will be __________.

higher

Firms with higher expected growth rates tend to have P/E ratios that are ____________ the P/E ratios of firms with lower expected growth rates.

higher than

All else equal, call option values are _________ if the _________ is lower.

higher; exercise price

If the Black-Scholes formula is solved to find the standard deviation consistent with the current market call premium, that standard deviation would be called the ____________.

implied volatility

A call option on Brocklehurst Corp. has an exercise price of $30. The current stock price of Brocklehurst Corp. is $32. The call option is ___________.

in the money

A put option on Dr. Pepper Snapple Group, Inc., has an exercise price of $45. The current stock price is $41. The put option is ___________.

in the money

What transaction would result in a decrease in cash flow from operations?

increase in accounts receivable

TIPS offer investors inflation protection by ____________________ by the inflation rate each year.

increasing both the par value and the coupon payment

The _________ is the document that defines the contract between the bond issuer and the bondholder.

indenture

The fed funds rate is the ________________.

interest rate banks charge each other for overnight loans of deposits on reserve at the Fed

The discount rate is the ______________________.

interest rate the Fed charges commercial banks on short-term loans

A bank has an average duration of its liabilities equal to 2 years. The bank's average duration of its assets is 3.5 years. The bank's market value of equity is at risk if _________________.

interest rates rise

A high price-to-book ratio may indicate which one of the following?

investors may believe that this firm has opportunities for earning a rate of return in excess of the market capitalization rate

The intrinsic value of an out-of-the-money call option ______________.

is zero

lSuppose we wondered what a daughter's expected height would be if her mother's height were 63 inches (5 ft., 3 inches). We would plug this X value into the equation and solve.

lE[Dheight] = 29.91 + 0.54*63 = 63.93 inches

The yield curve spread between the 10-year T-bond yield and the federal funds rate is a ________ economic indicator.

leading

Everything else equal, the _________ the maturity of a bond and the ____________ the coupon, the greater sensitivity of the bond's price to interest rate changes.

longer; lower

An increase in the value of of the yen against the US dollar can cause the Japanese automaker Toyota to either _________________ on its US sales.

lose market share or reduce its profit margin

All else equal, bond price volatility is greater for _____________.

lower coupon rates

Banks and other financial institutions can best manage interest rate risk by ______________.

matching the durations of their assets and liabilities

At contract maturity the value of a call option is ______________, where X equals the option's strike price and S(t) is the stock price at contract expiration.

max (0, S(t)-X)

At contract maturity the value of a put option is ___________, where X equals the option's strike price and S(t) is the stock price at contract expiration.

max (0, X-S(t))

If the economy is going into a recession, a good industry to invest in would be the _________ industry.

medical services

Bond prices are ________ sensitive to changes in yield when the bond is selling at _________ initial yield to maturity.

more; lower

ROE is calculated as ___________.

net profit/ equity

You calculate the Black-Scholes value of a call option at $3.50 for a stock that does not pay dividends, but the actual call price is $3.75. The most likely explanation for the discrepancy is that either the option is ______________ or the volatility you input into the model is too _____________.

overvalued and should be written; low

The delta of a call option on a stock is always __________.

positive but less than 1

Bond portfolio immunization techniques balance _____________ and ____________ risk.

price; reinvestment

What strategy could be considered insurance for an investment in a portfolio of stocks?

protective put

You invest in the stock of Valleyview Corp. and purchase a put option on Valleyview Corp. This strategy is called a _____________.

protective put

Operating ROA can be found as the product of ____________.

return on sales * ATO

An American put option gives its holder the right to ______________.

sell the underlying asset at the exercise price on or before the expiration date

In regard to bonds, convexity relates to the _____________.

shape of the bond price curve with respect to interest rates.

If you combine a long stock position with selling an at-the-money call option, the resulting net payoff profile will resemble the payoff profile of a ___________.

short put

An increase in a bond's yield to maturity results in a price decline that is __________ the price increase resulting from a decrease in yield of equal magnitude.

smaller than

The price-to-sales ratio is probably most useful for firms in which phase of the industry life cycle?

start-up phase

If the currency of your country is depreciating, this should ____________ exports and ____________ imports.

stimulate; discourage

The value of a put option increases with all of the following except ____________.

stock price

Market economists all predict a rise in interest rates. An astute bond manager wishing to maximize her capital gain might employ which strategy?

switch from high-duration to low-duration bonds

Yields on municipal bonds are generally lower than yields on similar corporate bonds because of differences in _________.

taxation

If a firm increases its plowback ratio, this will probably result in _____________ P/E ratio.

the answer cannot be determined from the information given

The delta of an option is ____________.

the change in the dollar value of an option for a dollar change in the price of the underlying asset

Given its time to maturity, the duration of a zero-coupon bond is ____________.

the same regardless of the discount rate

If a stock is correctly priced, then you know that ________________.

the sum of the stock's expected capital gain and dividend yield is equl to the stock's required rate of return

The _____________ is the difference between the actual call price and the intrinsic value.

time value

The potential loss for a writer of a naked call option on a stock is _____________.

unlimited

A debenture is _________.

unsecured

Of the variables in the Black-Scholes OPM, the _____________ is not directly observable.

variance of the underlying asset return

You want to earn a return of 10% on each of two stocks, A and B. Each of the stocks is expected to pay a dividend of $4 in the upcoming year. The expected growth rate of dividends is 6% for stock A and 5% for stock B. Using the constant-growth DDM, the intrinsic value of stock A __________.

will be higher than the intrinsic value of stock B

A stock has an intrinsic value of $15 and an actual stock price of $13.50. You know that this stock __________.

will generate a positive alpha

An investor who expects declining interest rates would maximize her capital gain by purchasing a bond that has a ___________ coupon and a __________ term to maturity.

zero; long