Finc Exam 2
6. What is the expected rate of return for a stock that has a beta of 1 if the expected return on the market is 15% 15% More than 15% Cannot be determined without the risk-free rate
15%
15. If you believe the U.S. dollar is about to depreciate more dramatically than do other investors, what will be your stance on investments in U.S. auto producers?
A depreciating dollar makes imported cars more expensive and American cars cheaper to foreign consumers. This should benefit the U.S. auto industry.
1. Which of the following statements about the security market line (SML) are true? The SML provides a benchmark for evaluating expected investment performance. The SML leads all investors to invest in the same portfolio of risky assets. The SML is a graphic representation of the relationship between expected return and beta. Properly valued assets plot exactly on the SML.
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.
2. Karen Kay, a portfolio manager at Collins Asset Management, is using the capital asset pricing model for making recommendations to her clients. Her research department has developed the information shown in the following exhibit. Shape Forecasted Returns, Standard Deviations, and Betas Forecasted Return Standard Deviation Beta StockX 14.0% 36% 0.8 StockY 17.0 25 1.5 Market index 14.0 15 1.0 Risk-free rate 5.0 Calculate the equilibrium expected return according to the CAPM and the alpha for each stock. Identify and justify which stock would be more appropriate for an investor who wants to: Add this stock to a well-diversified equity portfolio. Hold this stock as a single-stock portfolio.
Answer: QUESTION: How to calculate alpha Alpha = R - Rf - beta (Rm-Rf) R represents the portfolio return. Rf represents the risk-free rate of return. Beta represents the systematic risk of a portfolio. Rm represents the market return, per a benchmark. a. StockX E(r) = 5% + 0.8 x (14% - 5%) = 12.2% StockX Alpha = 14% - 12.2% = 1.8% .14 - 5 - 0.8(5-.14) StockY E(r) = 5% + 1.5 x (14% - 5%) = 18.5% Stock Y alpha = 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. 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.
1. The semistrong form of the efficient market hypothesis asserts that stock prices: a. Fully reflect all historical price information. b. Fully reflect all publicly available information. c. Fully reflect all relevant information including insider information. d. May be predictable.
Answer: b. Public information constitutes semi-string efficiency, while the addition of private information leads to strong form efficiency.
3. A "random walk" occurs when: a. Stock price changes are random but predictable. b. Stock prices respond slowly to both new and old information. c. Future price changes are uncorrelated with past price changes. d. Past information is useful in predicting future prices.
Answer: c. A random walk reflects no other information and is thus random.
4. A market anomaly refers to: a. An exogenous shock to the market that is sharp but not persistent. b. A price or volume event that is inconsistent with historical price or volume trends. c. A trading or pricing structure that interferes with efficient buying and selling of securities. d. Price behavior that differs from the behavior predicted by the efficient market hypothesis.
Answer: d. Unexpected results are by definition an anomaly
2. What is the option embedded in a callable bond? A puttable bond?
Callable bonds give the issuer the option to repurchase the bond at a specified call price (typically par value + one coupon payment) at or after the call date (and hence before the maturity date). This allows firms to buy back bonds and refinance at lower interest rates when markets rates fall. Puttable bond (also known as extendable bond) gives the option to the bondholder to extend (for a given number of years) or retire the bond at or after the put date. If the bond's coupon rate exceeds current market yields the bondholder will choose to extend the bond's life.
10. What is typically true of corporate dividend payout rates in the early stages of an industry life cycle? Why does this make sense
Companies tend to pay very low, if any, dividends early in their business life cycle since these firms need to reinvest as much capital as possible in order to grow.
9. A bond with an annual coupon rate of 4.8% sells for $970. What is the bond's current yield?
Current Yield = Annual coupon/bond price = (1000x0.048)/970=4.95%
1. A three-asset portfolio has the following characteristics: Asset Expected Return SD Weight X 15% 22% 0.50 Y 10% 8% 0.40 Z 6% 3% 0.10 What is the expected return of this three-asset portfolio?
E(r) = ( .5 x 15) + ( .4 x 10) + ( .10 x 6) = 12.1%
4. Here are data on two companies. The T-Bill rate is 4% and the market risk premium isa 6t% Company X Y Forecast return 12% 11% SD of Returns 8% 10% Beta 1.5 1.0 What should be the expected rate of return for each company, according to CAPM 5. Characterize each company in the previous problem as underpriced, overpriced, or properly priced.
E(r) = Expected return on a security Rf = Risk-free rate B = Beta of the security Rm = Expected return of the market/market forcast return E(rm)-rf = risk premium already given E(r) = rf + B x (E(rm)-rf) = .04 + B x 0.06 Company 1 .04 + 1.5x0.06 = 13% Company 2 0.04 + 1.0 x 0.06 = 10% 5. Since the forecasted return (12%) is less than the CAPM predicted return (13%), $1 Discount Store stock is overpriced. Since the forecasted return (11%) is greater than the CAPM predicted return (10%), Everything $5 stock is underpriced
14. What monetary and fiscal policies might be prescribed for an economy in a deep recession?
Expansionary monetary policy to lower interest rates would help to stimulate investment and expenditures on consumer durables. Expansionary fiscal policy (i.e., lower taxes, higher government spending, increased welfare transfers) would directly stimulate aggregate demand.
19. A project has a 0.7 chance of doubling your investment in a year and a 0.3 chance of halving your investment in a year. What is the standard deviation of the rate of return on this investment?
Expected return = (.7 x 1) + .3 x (- .5) = 0.55 or 55% Variance = [ .7 x (1 - 0.55)^2] + [ .3 x (-.50 - 0.55)^2] = 0.4725 Standard Deviation = Square Root 0.4725 = 0.6874 or 68.74%
12. ATech has fixed costs of $7 million and profits of $4 million. Its competitor, ZTech, is roughly the same size and this year earned the same profits, $4 million. But it operates with higher fixed costs of $8 million and lower variable costs. a. Which firm would you expect to have profits that are more sensitive to the state of the economy? b. Which firm would you expect to have the higher stock market beta?
First calculate the Degree of Operating Leverage (DOL): ATech's operating leverage = 1 +(Fixed Costs/Profits) = 1 + (7/4) = 2.75 ZTech's operating leverage = 1 + (Fixed Costs/Profits) = 1 + (8/4) = 3.00 Using DOL, ZTech has the higher level of operating leverage, therefore small swings in business conditions have a large impact on profitability for firms with high operating leverage, ZTech's higher operating leverage will yield higher profits. Since Ztech's profits are more impacted by small swings in business conditions, all other things being equal, it is likely to have a higher stock market beta.
FUND Characteristics Fund Return SD Correlation Returns A 15% 25% +0.80 B 11% 22% +0.60 C 16% 25% +0.90 D 14% 22% +0.65 State which fund Coppa should recommend to Stephenson. Justify your choice by describing how your chosen fund best meets both of Stephenson's criteria. No Calculations are required.
Fund D represents the single best addition to complement Stephenson's current portfolio, given his selection criteria. First, Fund D's expected return (14.0 percent) has the potential to increase the portfolio's return somewhat. Second, Fund D's relatively low correlation with his current portfolio (+ .65) indicates that Fund D will provide greater diversification benefits than any of the other alternatives except Fund B. The result of adding Fund D should be a portfolio with approximately the same expected return and somewhat lower volatility compared to the original portfolio. The other three funds have shortcomings in terms of either expected return enhancement or volatility reduction through diversification benefits. Fund A offers the potential for increasing the portfolio's return, but is too highly correlated to provide substantial volatility reduction benefits through diversification. Fund B provides substantial volatility reduction through diversification benefits, but is expected to generate a return well below the current portfolio's return. Fund C has the greatest potential to increase the portfolio's return, but is too highly correlated to provide substantial volatility reduction benefits through diversification.
What are the two paths to a positive risk premium for your stock/portfolio? Hint: What does alpha mean? How about beta?
Have a positive alpha or a higher beta, but this will give you more market risk
37. The yield curve is upward-sloping. Can you conclude that investors expect short-term interest rates to rise? Why or why not?
If the yield curve is upward sloping, we cannot conclude that investors expect short-term interest rates to rise because the rising slope could be due to either expectations of future increases in rates or the demand of investors for a risk premium on long-term bonds. In fact the yield curve can be upward sloping even in the absence of expectations of future increases in rates.
18. What is the relationship of the portfolio standard deviation to the weighted average of the standard deviations of the component assets?
In the special case that all assets are perfectly positively correlated, the portfolio standard deviation is equal to the weighted average of the component-asset standard deviations. Otherwise, as the formula for portfolio variance shows, the portfolio standard deviation is less than the weighted average of the component-asset standard deviations. The portfolio variance is a weighted sum of the elements in the covariance matrix, with the products of the portfolio proportions as weights. Return = weighted average simple average SD = 3 terms, weighted average with a 3rd term that is related to the correlation. If the correlation is 0, then the simple weighted average will be the SD. If the correlation is positive, your portfolio sd will be higher, if negative portfolio sd will be lower.
What are the two categories of assumptions behind the CAPM model?
Individual investors are all the same and rational Market conditions/no transaction costs
o According to the CAPM model, what is the only risk that is priced/rewarded?
Market
4. A successful firm like Microsoft has consistently generated large profits for years. Is this a violation of the EMH?
No, this is not a violation of the EMH. Microsoft's continuing large profits do not imply that stock market investors who purchased Microsoft shares after its success already was evident would have earned a high return on their investments. And those investors who purchased the shares prior did not know success was certain; risk was present. For example, many firms did not survive the bursting of the dot-com bubble.
What is the difference between the "risk premium" and "raw return" of an individual asset? Hint: think about risk-free rate.
Raw return-risk free rate = Risk premium
• Below is the Capital Asset Pricing Model (CAPM). You should understand the meaning of each term in this model. o 𝑅𝑖 =𝛼𝑖 +𝛽𝑖𝑅𝑀 +𝑒𝑖
Ri = required return A = excess return
4. A coupon bond paying semiannual interest is reported as having an ask price of 117% of its $1000 par value. If the last interest payment was made one month ago and the coupon rate is 6%, what is the invoice price of the bond?
Semi-annual coupon = $1,000 x 6% x 0.5 = $30. Accrued Interest = (annual coupon payment/2) x (days since last coupon payment/days separating coupon payment) =30x(30/182) = 4.945 At a price of 117, the invoice price is: $1,170 + $4.945 = $1,174.95
3. A portfolio's expected return is 12%, its Standard deviation is 20%, and the risk-free rate is 4%. Which of the following would make for the greatest increase in the portfolio's Sharpe Ratio?
Sharpe Ratio: Sp=(.12-.04)/.2 = .4 a. An increase of 1% in expected return. (.13-.04)/.2=.45 b. A decrease of 1& in the risk-free rate. (.12-.03)/20=.45 c. A decrease of 1% in its standard deviation (.12-.03)/19=.42 A and B will have the same impact of increasing the Sharpe Ratio
In performing a portfolio of two risky assets, what must be true of the correlation coefficient between their returns if there are to be gains from diversification? Explain.
So long as the correlation coefficient is below 1.0, the portfolio will benefit from diversification because returns on component securities will not move in perfect lockstep. The portfolio standard deviation will be less than the weighted average of the standard deviations of the component securities. The smaller the correlation, the bigger the gains from diversification. The upper limit of these gains occurs when the correlation coefficient hits its lower bound of -1.0. The correlation coefficient is dented by the Greek letter rho, ρ Correlation varies from 1 to -1. A correlation of -1 means that an asset's turns vary perfectly inversely with another asset. If it is 1, then there would be a perfect positive correlation. If it is 0, then there is no correlation between the 2 assets. If it is less than 1 it will benefit from divarication because returns on component securities will not move in perfect lockstep. If it is below 0 it will benefit even more.
7. Kaskin, Inc, stock has a beta of 1.2 and Quinn Inc has a beta of 0.06 which of the following statements are most accurate a. the equilibrium expected rate of return is higher for kaskin than for quinn b. the stock of kaskin has higher volatility than quinn c. the stock of quinn has more systematic risk than that of kaskin
Statement a is most accurate. The flaw in statement b is that beta represents only the systematic (Market) risk. If the firm-specific risk is low enough, the stock of Kaskin, Inc. could still have less total risk than that of Quinn, Inc. Statement c is incorrect. Lower beta means the stock carries less systematic risk.
2. George Stephenson's current portfolio of $2 million is invested as follows: Value | Percentage | Expected Return | Annual SD Short Term Bonds : $200,000 | 10% | 4.6% | 1.6% Domestic Large-Cap: $600,000 | 30% | 12.4% | 19.5% Equities Domestic Small-Cap: 1,200,000 | 60% | 16% | 29.9% Equities: Total Portfolio: $2,000,000 | 100% | 13.8% | 23.1%
Stephenson soon expects to receive an additional $2 million and plans to invest the entire amount in an exchange-traded fund that best complements the current portfolio. Stephanie Coppa, CFA, is evaluating the four funds shown in the following table for their ability to produce a portfolio that will meet two criteria relative to the current portfolio: (1) maintain or enhance expected return and (2) maintain or reduce volatility. Each fund is invested in an asset class that is not substantially represented in the current portfolio.
14. Suppose that many stock are traded in the market and that it is possible to borrow at the risk-free rate, rf. The characteristics of two of the stocks are as follows:
Stock Expected Return SD A 8% 40% B 13% 60% Correlation = -1 Could the equilibrium rf be greater than 10%? (hint: can a particular stock portfolio be formed to create a synthetic risk free asset?) Since Stock A and Stock B are perfectly negatively correlated, a risk-free portfolio can be created and the rate of return for this portfolio in equilibrium will always be the risk-free rate. To find the proportions of this portfolio, set the standard deviation equal to zero. With perfect negative correlation, the portfolio standard deviation reduces to: The expected rate of return on this risk-free portfolio is: E(r) = (.60 x .08) + (.40 x .13) = 10.0% Therefore, the risk-free rate must also be 10.0%.
8. Which version of the efficient market hypothesis (weak, semistrong, or strong-form) focuses on the most inclusive set of information?
Strong-form efficiency includes all information: historical, public, and private.
7. Two bonds have identical times to maturity and coupon rates. One is a callable at 105, the other at 110. Which should have a higher yield to maturity? Why?
The bond callable at 105 should sell at a lower price because the call provision is more valuable to the firm. Therefore, its yield to maturity should be higher.
1. If markets are efficient, what should be the correlation coefficient between stock returns for two nonoverlapping time periods?
The correlation coefficient should be zero. If it were not zero, then returns from one period to predict returns in later periods and therefore earn abnormal profits.
2. When adding a risky asset to a portfolio of many risky assets, which property of the asset has a greater influence on risk: its standard deviation or its covariance with the other assets? Explain.
The covariance with the other assets is more important. Diversification is accomplished via correlation with other assets and covariance is a function of correlation. Note that covariance is based on the assets' standard deviations as well as correlation, but the contribution to decreased risk comes from the correlation component, not the standard deviations.
20. Investors expect the market rate of return this year to be 10%. The expected rate of return on a stock with a beta of 1. 2is currently 12%. If the market return this year turns out to be 8%, how would you revise your expectation of the rate of return on the stock?
The expected rate of return on the stock will change by beta times the unanticipated change in the market return: 1.2 x (.08 - .10) = -2.4% Therefore, the expected rate of return on the stock should be revised to: .120 - .024 = .096 = 9.6%
25. General Weedkillers dominates the chemical weed control market with its patented product Weed-ex. The patent is about to expire, however. What are your forecasts for changes in the industry? Specifically, what will happen to industry prices, sales, the profit prospects of General Weedkillers, and the profit prospects of its competitors? What stage of the industry life cycle do you think is relevant for the analysis of this market?
The expiration of the patent means that General Weedkillers will soon face considerably greater competition from its competitors. We would expect prices and profit margins to fall, and total industry sales to increase somewhat as prices decline. The industry will probably enter the consolidation stage in which producers are forced to compete more extensively on the basis of price.
20. We know that the market should respond positively to good news and that good-news events such as the coming end of a recession can be predicted with at least some accuracy. Why, then, can we not predict that the market will go up as the economy recovers?
The market responds positively to new good news. If the eventual recovery is anticipated, then the recovery is already reflected in stock prices. Only a better-than-expected recovery (or a worse-than-expected recovery) should affect stock prices.
2. Why does it make intuitive sense that the slope of the yield curve is considered a leading economic indicator?
The yield curve, by definition, incorporates future interest rates. As such, it reflects future expectations and is a leading indicator.
41. The yield to maturity on one-year zero-coupon bonds is 8%. The yield to maturity on two-year zero-coupon bonds is 9%. a. What is the forward rate of interest for the second year? b. If you believe in the expectations hypothesis, what is your best guess as to the expected value of the short-term interest rate next year? c. If you believe in the liquidity preference theory, is your best guess as to next year's short-term interest rate higher or lower than in (b)?
The yield to maturity on the zero-coupon bonds assumes annual compounding. a. The forward rate (f2) is the rate that makes the return from rolling over one-year bonds the same as the return from investing in the two-year maturity bond and holding to maturity:(1 + 8%) x (1 + f2) = (1 + 9%)2 x f2 = 0.1001 = 10.01% b. According to the expectations hypothesis, the forward rate equals the expected value of the short-term interest rate next year, so the best guess would be 10.01%. c. According to the liquidity preference hypothesis, the forward rate exceeds the expected short-term interest rate next year, so the best guess would be less than 10.01%.
36. Under the expectations hypothesis, if the yield curve is upward-sloping, the market must expect an increase in short-term interest rates. True/false/uncertain? Why?
True. Under the expectations hypothesis, there are no risk premia built into bond prices. The only reason for long-term yields to exceed short-term yields is an expectation of higher short-term rates in the future.
5. A zero-coupon bond with face value of $1,000 and maturity of five years sells for $746.22, a. What is its yield to maturity B. what will happen to its yield to maturity if its price falls immediately to $730?
Using a financial calculator, PV = -746.22, FV = 1,000, n = 5, PMT = 0. The YTM is 6.0295%. (this assumes annual compounding) Using a financial calculator, PV = -730.00, FV = 1,000, n = 5, PMT = 0. The YTM is 6.4965%. (this assumes annual compounding)
24. Two investment advisors are comapring performance. One averaged a 19% return and the other a 16% return. However, the beta of the first advisor was 1.5, while that of the second was 1. Can you tell which adviser was a better selector of individual stocks If the t bill rate were 6% and the market return during the period were 14%, which adviser would appear to be the superior stock selector? What if the t bill rate were 3% and the market return 15%?
We denote the first investment advisor 1, who has r = 19% and Beta = 1.5, and the second investment advisor 2, as r = 16% and Beta = 1.0. In order to determine which investor was a better selector of individual stocks, we look at the abnormal return, which is the ex-post alpha; that is, the abnormal return is the difference between the actual return and that predicted by the SML. a. Without information about the parameters of this equation (i.e., the risk-free rate and the market rate of return), we cannot determine which investment adviser is the better selector of individual stocks. b. If rf = 6% and rM = 14%, then (using alpha for the abnormal return): α1 = 19% - [6% + 1.5 x (14% - 6%)] = 19% - 18% = 1% α2 = 16% - [6% + 1.0 x (14% - 6%)] = 16% - 14% = 2% Here, the second investment adviser has the larger abnormal return and thus appears to be the better selector of individual stocks. By making better predictions, the second adviser appears to have tilted his portfolio toward underpriced stocks.
21. You know that firm XYZ is very poorly run. On a scale of 1 (worst) to 10 (best), you would give it a score of 3. The market consensus evaluation is that the management score is only 2. Should you buy or sell the stock?
You should buy the stock. The firm's management is not as bad as everyone else believes it to be, therefore, the firm is undervalued by the market. You are less pessimistic about the firm's prospects than the beliefs built into the stock price.
13. The stated yield to maturity and realized compound yield to maturity of a (default-free) zero-coupon bond are always equal. Why?
Zero coupon bonds provide no coupons to be reinvested. Therefore, the final value of the investor's proceeds comes entirely from the principal of the bond and is independent of the rate at which coupons could be reinvested (if they were paid). There is no reinvestment rate uncertainty with zeros
5. Bonds of Zello Corporation with a par value of $1,000 sell for $960, mature in five years, and have a 7% annual coupon rate paid semiannually. a. Calculate the: (1) Current yield. (2) Yield to maturity. (3) Horizon yield (also called realized compound return) for an investor with a three-year holding period and a reinvestment rate of 6% over the period. At the end of three years, the 7% coupon bonds with two years remaining will sell to yield 7%. b. Cite one major shortcoming for each of the following fixed-income yield measures: (1) Current yield. (2) Yield to maturity. (3) Horizon yield (also called realized compound return).
a. (1) Current yield = Coupon/Price = $70/$960 = 0.0729 = 7.29% (2) YTM = 3.993% semiannually or 7.986% annual bond equivalent yield [n = 10; PV = -960; FV = 1000; PMT = 35] Then compute the interest rate. (3) Realized compound yield is 4.166% (semiannually), or 8.332% annual bond equivalent yield. To obtain this value, first calculate the future value of reinvested coupons. There will be six payments of $35 each, reinvested semiannually at a per period rate of 3%:[PV = 0; PMT = $35; n = 6; I/Y = 3] Compute FV = $226.39 The bond will be selling at par value of $1,000 in three years, since coupon is forecast to equal yield to maturity. Therefore, total proceeds in three years will be $1,226.39. To find realized compound yield on a semiannual basis (i.e., for six half-year periods), we solve: $960 x (1 + realized)^6 = $1,226.39 realized = 4.166% (semiannual) b. Shortcomings of each measure: (1) Current yield does not account for capital gains or losses on bonds bought at prices other than par value. It also does not account for reinvestment income on coupon payments. (2) Yield to maturity assumes that the bond is held to maturity and that all coupon income can be reinvested at a rate equal to the yield to maturity. (3) Realized compound yield (horizon yield) is affected by the forecast of reinvestment rates, holding period, and yield of the bond at the end of the investor's holding period.
a. A bond with a call feature: (1) Is attractive because the immediate receipt of principal plus premium produces a high return. (2) Is more apt to be called when interest rates are high because the interest saving will be greater. (3) Will usually have a higher yield to maturity than a similar noncallable bond. (4) None of the above. b. In which one of the following cases is the bond selling at a discount? (1) Coupon rate is greater than current yield, which is greater than yield to maturity. (2) Coupon rate, current yield, and yield to maturity are all the same. (3) Coupon rate is less than current yield, which is less than yield to maturity. (4) Coupon rate is less than current yield, which is greater than yield to maturity. c. Consider a five-year bond with a 10% coupon selling at a yield to maturity of 8%. If interest rates remain constant, one year from now the price of this bond will be: (1) Higher. (2) Lower. (3) The same. (4) Par.
a. (3) The yield on the callable bond must compensate the investor for the risk of call. Choice (1) is wrong because, although the owner of a callable bond receives principal plus a premium in the event of a call, the interest rate at which he can subsequently reinvest will be low. The low interest rate that makes it profitable for the issuer to call the bond makes it a bad deal for the bond's holder. Choice (2) is wrong because a bond is more apt to be called when interest rates are low. There will be an interest saving for the issuer only if rates are low. b. (3) c. (2)
24. You have $5,000 to invest for the next year and are considering three alternatives: a. A money market fund with an average maturity of 3o days offering a current annualized yield of 3% b. A two-year CD at a bank offering an interest rate of 4.5%. c. A 20-year U.S. Treasury bond offering a yield to maturity of 6% per year. What role does your forecast of future interest rates play in your decision?
a. Because of the very short average maturity (30 days), the rate of return on the money market fund will be affected only slightly by changes in interest rates. The fund might be a good place to "park" cash if you forecast an increase in interest rates, especially given the high liquidity of money market funds. The $5,000 can be reinvested in longer-term assets after rates increase. b. If you are relatively neutral on rates, the one-year CD might be a reasonable "middle-ground" choice. The CD provides a higher return than the money market fund, unless rates rise considerably. On the other hand, the CD has far less interest rate risk (that is, a much lower duration) than the 20-year bond, and therefore less exposure to interest rate increases. c. The long-term bond is the best choice for an investor who wants to speculate on a decrease in rates.
1. What are all of the different types of bonds?
a. Catastrophe bond: Typically issued by an insurance company. They are similar to an insurance policy in that the investor receives coupons and par value, but takes a loss in part or all of the principal if a major insurance claim is filed against the issuer. This is provided in exchange for higher than normal coupons. b. Eurobond: They are bonds issued in the currency of one country but sold in other national markets. c. Zero-coupon bond: Zero-coupon bonds are bonds that pay no coupons but do pay a par value at maturity. d. Samurai bond: Yen-denominated bonds sold in Japan by non-Japanese issuers are called Samurai bonds. e. Junk bond: Those rated BBB or above (S&P, Fitch) or Baa and above (Moody's) are considered investment grade bonds, while lower-rated bonds are classified as speculative grade or junk bonds. f. Convertible bond: Convertible bonds may be exchanged, at the bondholder's discretion, for a specified number of shares of stock. Convertible bondholders "pay" for this option by accepting a lower coupon rate on the security. g. Serial bond: A serial bond is an issue in which the firm sells bonds with staggered maturity dates. As bonds mature sequentially, the principal repayment burden for the firm is spread over time just as it is with a sinking fund. Serial bonds do not include call provisions. h. Equipment obligation bond: A bond that is issued with specific equipment pledged as collateral against the bond. i. Original issue discount bonds: Original issue discount bonds are less common than coupon bonds issued at par. These are bonds that are issued intentionally with low coupon rates that cause the bond to sell at a discount from par value. j. Indexed bond: Indexed bonds make payments that are tied to a general price index or the price of a particular commodity.
17. Which of the following phenomena would be either consistent with or a violation of the efficient market hypothesis? Explain briefly. a. Nearly half of all professionally managed mutual funds are able to outperform the S&P 5oo in a typical year. b. Money managers who outperform the market (on a risk-adjusted basis) in one year are likely to outperform in the following year. c. Stock prices tend to be predictably more volatile in January than in other months. d. Stock prices of companies that announce increased earnings in January tend to outperform the market in February e. Stocks that perform well in one week perform poorly in the following week.
a. Consistent. Half of all managers should outperform the market based on pure luck in any year. b. Violation. This would be the basis for an "easy money" rule: Simply invest with last year's best managers. c. Consistent. Predictable volatility does not convey a means to earn abnormal returns. d. Violation. The abnormal performance ought to occur in January, when the increased earnings are announced. e. Violation. Reversals offer a means to earn easy money: Simply buy last week's losers.
3. Are the following true or false? Explain. a. Stocks with a beta of zero offer an expected rate of return of zero b. The CAPM implies that investors require a higher return to hold highly volatile securities. c. You can construct a portfolio with a beta of 0.75 by investing 0.75 of the investment budget in T-Bills and the remainder in the market portfolio.
a. False. According to CAPM, when beta is zero, the excess return should be zero. Investors are still compensated at the risk-free rate. b. False. CAPM implies that the investor will only require risk premium for systematic risk (market risk) and not idiosyncratic risk (firm-specific risk). Investors are not rewarded for bearing higher risk if the volatility results from the firm-specific risk since that risk is easily diversified away. CAPM implies that an investor will only require risk premium for market risk. c. False. We can construct a portfolio with the beta of .75 by investing 75% of the investment budget in the market portfolio and the remaining 25% in T-bills.
5. How do each of the following affect the sensitivity of profits to the business cycle? a. Financial leverage. b. Operating leverage.
a. Financial leverage increases the sensitivity of profits in the business cycle since the interest payments have to be made regardless of the business cycle. Companies would thus become more sensitive to the business cycle while increasing their financial leverage. b. Firms with high fixed costs are said to have high operating leverage. As small swings in business conditions can have large impacts on profitability, they are more sensitive to the business
21. In which stage of the industry life cycle would you place the following industries? (Note: There is considerable room for disagreement concerning the "correct" answers to this question.) a. Oil well equipment. b. Computer hardware. c Computer software. d. Genetic engineering. e. Railroads.
a. Oil well equipment Decline (environmental pressures, decline in easily-developed oil fields) b. Computer hardware Consolidation stage c. Computer software Consolidation stage d. Genetic engineering Start-up stage e. Railroads Relative decline
9. Your investment client asks for information concerning the benefits of active portfolio management. She is particularly interested in the question of whether active managers can be expected to consistently exploit inefficiencies in the capital markets to produce above-average returns without assuming higher risk. The semistrong form of the efficient market hypothesis asserts that all publicly available information is rapidly and correctly reflected in securities prices. This implies that investors cannot expect to derive above-average profits from purchases made after information has become public because security prices already reflect the information's full effects. a. Identify and explain two examples of empirical evidence that tend to support the EMH implication stated above. b. Identify and explain two examples of empirical evidence that tend to refute the EMH implication stated above. c. Discuss reasons why an investor might choose not to index even if the markets were, in fact, semistrong-form efficient.
a. Some empirical evidence that supports the EMH is: (i) professional money managers do not typically earn higher returns than comparable risk, passive index strategies; (ii) event studies typically show that stocks respond immediately to the public release of relevant news; (iii) most tests of technical analysis find that it is difficult to identify price trends that can be exploited to earn superior risk-adjusted investment returns. b. Some evidence that is difficult to reconcile with the EMH concerns simple portfolio strategies that apparently would have provided high risk-adjusted returns in the past. Some examples of portfolios with attractive historical returns: (i) low P/E stocks; (ii) high book-to-market ratio stocks; (iii) small firms in January; (iv) firms with very poor stock price performance in the last few months. Other evidence concerns post-earnings-announcement stock price drift and intermediate-term price momentum. c. An investor might choose not to index even if markets are efficient because he may want to tailor a portfolio to specific tax considerations or to specific risk management issues, for example, the need to hedge (or at least not add to) exposure to a particular source of risk (e.g., industry exposure).
7. a. Briefly explain the concept of the efficient market hypothesis (EMH) and each of its three forms--weak, semi strong, and strong-and briefly discuss the degree to which existing empirical evidence supports each of the three forms of the EMH. b. Briefly discuss the implications of the efficient market hypothesis for investment policy as it applies to: i. Technical analysis in the form of charting. ii. Fundamental analysis. c. Briefly explain the roles or responsibilities of portfolio managers in an efficient market environment.
a. The efficient market hypothesis (EMH) states that a market is efficient if security prices immediately and fully reflect all available relevant information. If the market fully reflects information, the knowledge of that information would not allow an investor to profit from the information because stock prices already incorporate the information. The weak form of the EMH asserts that stock prices reflect all the information that can be derived by examining market trading data such as the history of past prices and trading volume. A strong body of evidence supports weak-form efficiency in the major U.S. securities markets. For example, test results suggest that technical trading rules do not produce superior returns after adjusting for transaction costs and taxes. The semistrong form states that a firm's stock price reflects all publicly available information about a firm's prospects. Examples of publicly available information are company annual reports and investment advisory data. Evidence strongly supports the notion of semistrong efficiency, but occasional studies (e.g., those identifying market anomalies such as the small-firm-in-January or book-to-market effects) and events (such as the stock market crash of October 19, 1987) are inconsistent with this form of market efficiency. However, there is a question concerning the extent to which these "anomalies" result from data mining. The strong form of the EMH holds that current market prices reflect all information (whether publicly available or privately held) that can be relevant to the valuation of the firm. Empirical evidence suggests that strong-form efficiency does not hold. If this form were correct, prices would fully reflect all information. Therefore even insiders could not earn excess returns. But the evidence is that corporate officers do have access to pertinent information long enough before public release to enable them to profit from trading on this information. b. (i) Technical analysis involves the search for recurrent and predictable patterns in stock prices in order to enhance returns. The EMH implies that technical analysis is without value. If past prices contain no useful information for predicting future prices, there is no point in following any technical trading rule. (ii) Fundamental analysis uses earnings and dividend prospects of the firm, expectations of future interest rates, and risk evaluation of the firm to determine proper stock prices. The EMH predicts that most fundamental analysis is doomed to failure. According to semistrong-form efficiency, no investor can earn excess returns from trading rules based on publicly available information. Only analysts with unique insight achieve superior returns.In summary, the EMH holds that the market appears to adjust so quickly to information about both individual stocks and the economy as a whole that no technique of selecting a portfolio using either technical or fundamental analysis can consistently outperform a strategy of simply buying and holding a diversified portfolio of securities, such as those comprising the popular market indexes. c. Portfolio managers have several roles and responsibilities even in perfectly efficient markets. The most important responsibility is to identify the risk/return objectives for a portfolio given the investor's constraints. In an efficient market, portfolio managers are responsible for tailoring the portfolio to meet the investor's needs, rather than to beat the market, which requires identifying the client's return requirements and risk tolerance. Rational portfolio management also requires examining the investor's constraints, including liquidity, time horizon, laws and regulations, taxes, and unique preferences and circumstances such as age and employment.
17. Consider two firms producing smartphones. 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. a. Which firm will have higher profits in a recession? b. In a boom? c. Which firm's stock will have a higher beta?
a. The human workers process will have higher profits in a recession. b. The robotics process firm will perform better in a boom due to higher fixed costs and lower variable (labor) costs For example, costs will rise less rapidly than revenue when sales volume expands during a boom. C. Because its profits are more sensitive to the business cycle, the robotics firm will have the higher beta.
10. An investor believes that a bond may temporarily increase in credit risk. Which of the following would be the most liquid method of exploiting this? a. The purchase of a credit default swap. b. The sale of a credit default swap. c. The short sale of the bond.
a. The purchase of a credit default swap. The investor believes the bond may increase in credit risk, which raises the prices of the credit default swaps because of the widened swap spread.
32. A 30-year maturity, 6% coupon bond paying coupons semiannually is callable in five years at a call price of $1,100. The bond currently sells at a yield to maturity of 5% (2.5% per half-year).(#LO10-4) a. What is the yield to call? b. What is the yield to call if the call price is only $1,050? c. What is the yield to call if the call price is $1, 100 but the bond can be called in two years instead of five years?
a. Using your calculator: n = 60; I/Y = 2.5; FV = 1,000; PMT = 30 PV = $1,154.5433 based on the 2.5% yield to maturity Using your calculator: n = 10; PV = -1,154.54; FV = 1,100; PMT = 30 Therefore, yield to call is 2.1703% semiannually, 4.3407% annually. b. Using your calculator: n = 10; PV = -1,154.54; FV = 1,050; PMT = 30 Therefore, yield to call is 1.7625% semiannually, 3.5249% annually. c. Using your calculator: n = 4; PV = -1,154.54; FV = 1,100; PMT = 30 Therefore, yield to call is 1.4426% semiannually, 2.8852% annually.
6. Which of the following statements are true if the efficient market hypothesis holds? (LO8-1) a. It implies that future events can be forecast with perfect accuracy. b. It implies that prices reflect all available information. c. It implies that security prices change for no discernible reason. d. It implies that prices do not fluctuate.
b. This is the definition of an efficient market.
3. Which one of the following firms would be described as having below-average sensitivity to the state of the economy? a. An asset play firm. b. A cyclical firm. c. A defensive firm. d. A stalwart firm.
c. A defensive firm. Defensive firms and industries have below-average sensitivity to the state of the economy
8. Which of the following is consistent with a steeply upwardly sloping yield curve? a. Monetary policy will be expansive and fiscal policy will be expansive. b. Monetary policy will be expansive while fiscal policy will be restrictive. c. Monetary policy will be restrictive and fiscal policy will be restrictive.
c. Monetary policy will be restrictive and fiscal policy will be restrictive. This is consistent with a steeply upward-sloping yield curve because, while the expansionary policies stimulate the economy and decrease the short-term rate, high inflation in the future is expected which forces up the yield in longer maturity.
11. Which of the following would most appear to contradiet the proposition that the stock market is weakly efficient? Explain. a. Over 25% of mutual funds outperform the market on average. b. Insiders earn abnormal trading profits. c. Every January, the stock market earns abnormal returns.
c. This is a predictable pattern of returns, which should not occur if the stock market is weakly efficient.
In Contrast to the capital asset pricing model, arbitrage pricing theory: Requires that markets be in equilibrium. Uses risk premiums based on micro variables. Specifies the number and identifies specific factors that determine expected retums. Does not require the restrictive assumptions concerning the market portfolio.
d. APT does not require the restrictive assumptions concerning the market portfolio. It takes merely the actions of few arbitrageurs to enforce the fair market price.
7. In an efficient market, professional portfolio management can offer all of the following benefits except which of the following? a. Low-cost diversification. b. A targeted risk level. c. Low-cost record keeping. d. A superior risk-return trade-off
d. It is not possible to offer a higher risk-return trade off if markets are efficient.
