FN 350 Chapter Problem Sets

19. Give an example of three financial intermediaries, and explain how they act as a bridge between small investors and large capital markets of corporations.

1. (answers will vary) Mutual funds accept funds from small investors and invest, on behalf of these investors, in the national and international securities markets. Pension funds accept funds and then invest, on behalf of current and future retirees, thereby channeling funds from one sector of the economy to another. Venture capital firms pool the funds of private investors and invest in start-up firms. Banks accept deposits from customers and loan those funds to businesses or use the funds to buy securities of large corporations.

9. How does buying on margin magnify both the upside potential and downside risk of an investment portfolio?

Margin is a type of leverage that allows investors to post only a portion of the value of the security they purchase. As such, when the price of the security rises or falls, the gain or loss represents a much higher percentage, relative to the actual money invested.

12. What are money market securities often called cash equivalents?

Money market securities are referred to as "cash equivalents" because of their great liquidity. The prices of money market securities are very stable, and they can be converted to cash (i.e., sold) on very short notice and with very low transaction costs.

3. What features of money market securities distinguish them from other fixed-income securities?

1. Money market securities are short-term, relatively low risk, and highly liquid. Also, their unit value almost never changes.

16. Wall Street firms have traditionally compensated their traders with a share of the trading profits that they generated. How might this practice have affected traders' willingness to assume risk? What is the agency problem this practice engendered?

1. Since the traders benefited from profits but did not get penalized by losses, they were encouraged to take extraordinary risks. Since traders sell to other traders, there also existed a moral hazard since other traders might facilitate the misdeed. In the end, this represents an agency problem.

21. The average rate of return on investments in large stocks has outpaced that on investments in Treasury bills by 8% since 1926. Why, then, does anyone invest in Treasury bills?

1. Treasury bills serve a purpose for investors who prefer a low-risk investment. The lower average rate of return compared to stocks is the price investors pay for predictability of investment performance and portfolio value.

22. You see an advertisement for a book that claims to show how you can make $1 million with no risk with no money down. Will you buy the book?

1. You should be skeptical. If the author actually knows how to achieve such returns, one must question why the author would then be so ready to sell the secret to others. Financial markets are very competitive; one of the implications of this fact is that riches do not come easily. High expected returns require bearing some risk, and obvious bargains are few and far between. Odds are that the only one getting rich from this book is its author.

1. What is the difference between an IPO and an SEP (seasoned equity offering)?

An IPO is the first time a formerly privately-owned company sells stock to the general public. A seasoned equity offering (or seasoned issuance) is the issuance of stock by a company that has already undergone an IPO.

6. What are the differences between a limit order and a market order?

An order that specifies price at which an investor is willing to buy or sell a security is a limit order, while a market order directs the broker to buy or sell at whatever price is available in the market.

Chapter 1

Chapter 1

Chapter 2

Chapter 2

1. What are the key differences between common stock, preferred stock, and corporate bonds?

Common stock is an ownership share in a publicly held corporation. Common shareholders have voting rights and may receive dividends (but are not contractually obligated to do so). Preferred stock represents nonvoting shares in a corporation, usually paying a fixed stream of dividends (but are not contractually obligated to do so). While corporate bonds are long-term debt issued by corporations, the bonds typically pay semi-annual coupons (and are contractually obligated to pay them) and return the face value of the bond at maturity.

9. Why are corporations more apt to hold preferred stock than other potential investors?

Corporations may exclude 50% of dividends received from domestic corporations in the computation of their taxable income.

For Problems 12-16, assume that you manage a risky portfolio with an expected rate of return of 17% and a standard deviation of 27%. The T-bill rate is 7%.

For Problems 12-16, assume that you manage a risky portfolio with an expected rate of return of 17% and a standard deviation of 27%. The T-bill rate is 7%.

3. What do we mean by fundamental risk, and why may such risk allow behavioral biases to persist for long periods of time?

Fundamental risk means that even if a security is mispriced, it still can be risky to attempt to exploit the mispricing because the correction to price could happen after the trader's investing horizon. This limits the actions of arbitrageurs who take positions in mispriced securities. Thus, the bias may persist since no one takes advantage of it.

13. The composition of the Fingroup Fund portfolio is as follows: Stock Shares Price A 200,000 $35 B 300,000 40 C 400,000 20 D 600,000 25 The fund has not borrowed any funds, but its accrued management fee with the portfolio manager currently totals $30,000. There are 4 million shares outstanding. What is the net asset value of the fund?

Given that net asset value equals assets minus liabilities expressed on a per-share basis, we first add up the value of the shares (e.g., Value of A =2000,000*$35=7,000,000 ) to get the market value of the portfolio: Stock Value Held by fund A $7,000,000 B 12,000,000 C 8,000,000 D 15,000,000 Total $42,000,000 Knowing that the accrued management fee, which adjusts the value of the portfolio, totals $30,000, and the number of the shares outstanding is 4,000,000, we can use the NAV equation: Net asset value=(Market value of assets-Market value of liabilities)/Shares outstanding = ($42,000,000-$30,000)/4,000,000 = $10.49

16. Corporate Fund started the year with a net asset value of $12.50. By year-end, its NAV equaled $12.10. The fund paid year-end distributions of income and capital gains of $1.50. What was the rate of return to an investor in the fund?

Given the NAV at the beginning and the end of the period, and the distributions during the period, we can use the equation below to solve for the rate of return of the Corporate Fund: Rate of return=((NAV EOY-BOY)+Distributions)/Start of year NAV =($12.10-$12.50+$1.50)/$12.50 = 0.0880=8.80%

13. (ER) Beta A 20% 1.4 B 25% 1.2 If the simple CAPM is valid, which of the situations in Problems 13-19 below are possible? Explain. Consider each situation independently.

Not possible. Portfolio A has a higher beta than Portfolio B, but the expected return for Portfolio A is lower.

10. The market price of a security is $40. Its expected rate of return is 13%. The risk-free rate is 7%, and the market risk premium is 8%. What will the market price of the security be if its beta doubles (and all other variables remain unchanged)? Assume the stock is expected to pay a constant dividend in perpetuity.

If the beta of the security doubles, then so will its risk premium. The current risk premium for the stock is: (13% — 7%) = 6%, so the new risk premium would be 12%, and the new discount rate for the security would be: 12% + 7% = 19% If the stock pays a constant dividend in perpetuity, then we know from the original data that the dividend (D) must satisfy the equation for a perpetuity: Price = Dividend/Discount rate 40 = D/0.13 > D= 40 x 0.13 = $5.20 At the new discount rate of 19%, the stock would be worth: $5.20/0.19 = $27.37 The increase in stock risk has lowered the value of the stock by 31.58%.

9. "Constantly fluctuating stock prices suggest that the market does not know how to price stocks." Respond.

Incorrect. In the short term, markets reflect a random pattern. Information is constantly flowing in the economy and investors each have different expectations that vary constantly. A fluctuating market accurately reflects this logic. Furthermore, while increased variability may be the result of an increase in unknown variables, this merely increases risk and the price is adjusted downward as a result.

10. What is meant by limited liability?

Limited liability means that the most shareholders can lose in event of the failure of the corporation is their original investment (which differs from owners of unincorporated businesses).

16. ER Stdev Risk free) 10% 0% Market) 18 24 A) 20 22

Not possible. Portfolio A clearly dominates the market portfolio. It has a lower standard deviation with a higher expected return.

15. ER Stdev Risk Free) 10% 0% Market) 18 24 A) 16 12

Not possible. The reward-to-variability ratio for Portfolio A is better than that of the market, which is not possible according to the CAPM, since the CAPM predicts that the market portfolio is the most efficient portfolio. Using the numbers supplied: Sa=(16-10)/12 = 0.05 Sm = (18-10)/24=0.33 These figures imply that Portfolio A provides a better risk-reward tradeoff than the market portfolio.

10. Open-end equity mutual funds commonly keep a small fraction of total investments in very liquid money market assets. Closed-end funds do not have to maintain such a position in "cash-equivalent" securities. What difference between open-end and closed-end funds might account for their differing policies?

Open-end funds must honor redemptions and receive deposits from investors. This flow of money necessitates retaining cash. Close-end funds no longer take and receive money from investors. As such, they can be fully invested at all times.

3. If prices are as likely to increase as decrease, why do investors earn positive returns from the market on average?

Over the long haul, there is an expected upward drift in stock prices based on their fair expected rates of return. The fair expected return over any single day is very small (e.g., 12% per year is only about 0.033% per day), so that on any day the price is virtually equally likely to rise or fall. However, over longer periods, the small expected daily returns accumulate, and upward moves are indeed more likely than downward ones.

14.ER Stdev A 30% 35% B 40 25

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.

2. After reading about three successful investors in The Wall Street Journal you decide that active investing will also provide you with superior trading results. What sort of behavioral tendency are you exhibiting?

Representativeness bias. The sample size is not considered when making future decisions. Three successful investors are not a large enough sample to base a fundamental shift in your investment patterns. If you are willing to begin active investing after reviewing such a small sample size, you will likely also display overconfidence, tending to overestimate your abilities.

19. What is the reward-to-volatility (Sharpe) ratio for the equity fund in the previous problem?

Reward to volatility ratio = Port Risk Premium/Stdev of Port Excess Return 10%/14% = 0.7143

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.

5. Characterize each company in the previous problem as underpriced, overpriced, or properly priced.

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.

1. In forming 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 a 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.

10. What is the Sharpe ratio of the best feasible CAL?

The Sharpe ratio of the optimal CAL is: (E(rp)-Risk free rate)/Stdev=(12.88%-5.50%)/23.34%=0.3162

15. An investor is in a 30% combined federal plus state tax bracket. If corporate bonds offer 9% yields, what yield must municipals offer for the investor to prefer them to corporate bonds?

The after-tax yield on the corporate bonds is: 0.09 x (1 - 0.30) = 0.063 or 6.3%. Therefore, the municipals must offer at least 6.3% yields.

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.

6. Why are high-tax-bracket investors more inclined to invest in municipal bonds than are low-bracket investors?

The coupons paid by municipal bonds are exempt from federal income tax and from state tax in many states. Therefore, the higher the tax bracket that the investor is in, the more valuable the tax-exempt feature to the investor.

3. What are some different components of the effective costs of buying or selling shares of stock?

The effective price paid or received for a stock includes items such as bid-ask spread, brokerage fees, commissions, and taxes (when applicable). These reduce the amount received by a seller and increase the cost incurred by a buyer.

4. An investor ponders various allocations to the optimal risky portfolio and risk-free T-bills to construct his complete portfolio. How would the Sharpe ratio of the complete portfolio be affected by this choice?

The expected return of the portfolio will be impacted if the asset allocation is changed. Since the expected return of the portfolio is the first item in the numerator of the Sharpe ratio, the ratio will be changed.

22. Good News, Inc., just announced an increase in its annual earnings, yet its stock price fell. Is there a rational explanation for this phenomenon?

The market may have anticipated even greater earnings. Compared to prior expectations, the announcement was a disappointment.

5. Suppose your expectations regarding the stock market are as follows: State of the Economy Probability HPR Boom 0.3 44% Normal Growth 0.4 14 Recession 0.3 -16 Use equations 5.10-5.12 to compute the mean and the standard deviation of the HPR on stocks.

Using Equation 5.10, calculate the mean of the HPR (holding period return) as: E(t) = Suminzation p(s) r(s) = (0.3 x 0.44) + (0.4 x 0.14) + [0.3 x (-0.16)] = 0.14 or 14% Using Equation 5.11, calculate the variance: s Var(r) = Stdev^2 = Sumin p(s)[r(s)-E(r)]^2 = [0.3 x (0.44 —0.14)^2] + [0.4 x (0.14 — 0.14)^2] + [0.3 x (-0.16 — 0.14)^2] = 0.054 Using Equation 5.12, derive standard deviation from variance: SD(r) = Stdev = SQRT Var(r) = SQRT 0.054 = 0.2324 or 23.24% [Standard Deviation]

23. A stock has an expected return of 6%. What is its beta? Assume the risk-free rate is 8% and the expected rate of return on the market is 18%. |

Using the SML: 6% = 8% + B x (18% — 8%) => B=-2/10 =-0.2

6. The stock of Business Adventures sells for $40 a share. Its likely dividend payout and end of year price depend on the state of the economy by the end of the year as follows: State of the Economy Dividend Stock Price Boom $2.00 $50 Normal Growth 1.00 43 Recession 0.50 34 a. Calculate the expected holding period return and standard and standard deviation of the holding period return. All three scenarios are equally likely. b. Calculate the expected return and standard deviation of a portfolio ivested half in Business Adventures and half in Treasury bills. The return on bills is 4%.

We use the below equation to calculate the holding period return of each scenario: HPR= (Ending Price — Beginning Price + Cash Dividend)/ Beginning Price a. The holding period returns for the three scenarios are: Boom: (50 — 40 + 2)/40 = 0.30 = 30% Normal: (43 —40 + 1)/40 =0.10 = 10% Recession: (34 — 40 + 0.50)/40 =-0.1375 =—13.75% E(HPR) = Sumin p(s) r(s) = [(1/3) x 0.30] + [(1/3) x 0.10] + [(1/3) x (-0.1375)] = 0.0875 or 8.75% Var(HPR) = Sumin p(s) [r(s)-E(r)^2 = [(1/3) x (0.30 — 0.0875)^2] + [(1/3) x (0.10 — 0.0875)^2] + [(1/3) (0.1375 — 0.0875)^2] = 0.031979 SD(r) = Stdev = SQRT Var(r) = SQRT 319.79 = 0.1788 or 17.88% b. E(r) = (0.5 x 8.75%) + (0.5 x 4%) = 6.375% Stdev =0.5 x 17.88% = 8.94%

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. 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.

19. City Street Fund has a portfolio of $450 million and liabilities of $10 million. a. If there are 44 million shares outstanding, what is the net asset value? b. If a large investor redeems | million shares, what happens to the portfolio value, to shares outstanding, and to NAV?

a. (NAV Market value of assets-Market value of liabilities)/Shares outstanding =($450,000,000-$10,000,000)/44,000,000 = $10 b. Because 1,000,000 shares are redeemed at NAV = $10, the value of the portfolio decreases to: Portfolio value = $450,000,000 — ($10 x 1,000,000) = $440,000,000 The number of shares outstanding will be the current shares outstanding minus the number of shares redeemed: 44,000,000 — 1,000,000 = 43,000,000. Thus, net asset value after the redemption will be: (NAV Market value of assets-Market value of liabilities)/Shares outstanding =($440,000,000-$10,000,000)/43,000,000 = $10

12. Are the following statements true or false? If false, correct them. a. An investor who wishes to sell shares immediately should ask their broker to enter a limit order b. The ask price is less than the bid price c. An issue of additional shares of stock to the public buy Microsoft would be called an IPO d. An ECN (electronic communications network) is a computer link used by security dealers primarily to advertise prices at which they are willing to buy or sell shares

a. False; An investor who wishes to sell shares immediately should ask his or her broker to enter a market order. b. False; The ask price is greater than the bid price. c. False; An issue of additional shares of stock to the public by Microsoft would be called an SEO (Seasoned Equity Offering). d. False; An ECN (Electronic Communications Network) is a computer link used by all participants to advertise prices at which they are willing to buy or sell shares.

9. Draw a tangent from the risk-free rate to the opportunity set. What does your graph show for the expected return and standard deviation of the optimal risky portfolio?

see answer sheet

5. What are the differences between real and financial assets?

1. Real assets have productive capacity; they are assets used to produce goods and services. Real assets can be tangible (e.g., machinery) or intangible (e.g., a patent). Financial assets are claims on real assets or the income generated by them.

4. What are agency problems? What are some approaches to solving them?

1. Agency problems are conflicts of interest between managers and stockholders. They can be addressed through corporate governance mechanisms, such as the design of executive compensation, oversight by the Board, and monitoring from the institutional investors.

3. What is the difference between asset allocation and security selection?

1. Asset allocation is the allocation of an investment portfolio across broad asset classes. Security selection is the choice of specific securities within each asset class.

15. Oversight by large institutional investors or creditors is one mechanism to reduce agency problems. Why don't individual investors in the firm have the same incentive to keep an eye on management?

1. Even if an individual investor has the expertise and capability to monitor and improve the managers' performance, the payoffs would not be worth the effort, since his ownership in a large corporation is so small compared to that of institutional investors. For example, if the individual investor owns $10,000 of IBM stock and can increase the value of the firm by 5%, a very ambitious goal, the benefit would only be: $10,000 x 5% = $500. In contrast, a bank that has a multimillion-dollar loan outstanding to the firm has a big stake in making sure the firm can repay the loan. It is clearly worthwhile for the bank to spend considerable resources to monitor the firm.

6. How does investment banking differ from commercial banking?

1. Investment bankers are firms specializing in the sale of new securities to the public, typically by underwriting the issue. Commercial banks accept deposits and lend the money to other borrowers. After the Glass-Steagall Act was repealed in 1999, some commercial banks started transforming to "universal banks" which provide the services of both commercial banks and investment banks. With the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, Glass-Steagall was partially restored via the Volcker Rule (which generally prohibits commercial banks from conducting certain investment activities with their own accounts and investing in hedge funds and private equity funds). In 2018, Congress passed The Economic Growth, Regulatory Relief, and Consumer Protection Act established a threshold ($10 billion) for banks to be exempt from the Volcker Rule.

13. Why do financial assets show up as a component of household wealth, but not of national wealth? Why do financial assets still matter for the material well-being of an economy?

1. National wealth is a measurement of the real assets used to produce GDP in the economy. Financial assets are claims on those assets held by individuals. Financial assets owned by households represent their claimson the real assets of the issuers, and thus show up as wealth to households. Their interests in the issuers, on the other hand, are obligations to the issuers. At the national level, the financial interests and the obligations cancel each other out, so only the real assets are measured as the wealth of the economy. The financial assets are important since they drive the efficient use of real assets and help us allocate resources, specifically in terms of risk return trade-offs.

1. Match each example to one of the following behavioral characteristics. a. Investors are slow to update their beliefs when given new evidence. b. Investors are reluctant to bear losses due to their unconventional decisions. c. Investors exhibit less risk tolerance in their retirement accounts versus their other stock accounts. d. Investors are reluctant to sell stocks with "paper" losses. e. Investors disregard sample size when forming views about the future from the past. i. Disposition effect ii. Representativeness bias iii. Regret avoidance iv. Conservatism bias v. Mental accounting

1. Note the following matches: a. Investors are slow to update their beliefs when given new evidence - Conservatism bias b. Investors are reluctant to bear losses due to their unconventional decisions - Regret avoidance c. Investors exhibit less risk tolerance in their retirement accounts versus their other stock accounts - Mental accounting d. Investors are reluctant to sell stocks with "paper" losses - Disposition effect e. Investors disregard sample size when forming views about the future from the past - Representation bias

13. A municipal bond carries a rate of 2.25% and is trading at par. What would be the equivalent taxable yield of this bond to a taxpayer in a 35% combined tax bracket?

Equivalent taxable yield = Rate on municipal bond/(1-Tax rate) = 0.0225/(1-0.35) = 0.0346 or 3.46%

14. Problem 14. Suppose that s short-term municipal bonds currently offer yields of 4%, while comparable taxable bonds pay 5%. Which gives you the higher after-tax yield if your combined tax bracket is: a. Zero b. 10% c. 20% d. 30%

After-tax yield = Rate on the taxable bond x (1 － Tax rate) The taxable bond. With a zero tax bracket, the after-tax yield for the taxable bond is the same as the before-tax yield (5%), which is greater than the 4% yield on the municipal bond. The taxable bond. The after-tax yield for the taxable bond is: 0.05 x (1 - 0.10) = 0.045 or 4.50%. Neither. The after-tax yield for the taxable bond is: 0.05 x (1 - 0.20) = 0.04 or 4%. The after-tax yield of taxable bond is the same as that of the municipal bond. The municipal bond. The after-tax yield for the taxable bond is: 0.05 x (1 - 0.30) = 0.035 or 3.5%. The municipal bond offers the higher after-tax yield for investors in tax brackets above 20%.

9. What must be the beta of a portfolio with E(rp) (Expected Return) = 20%, if rf (Risk free rate)= 5% and E(rm,) = 15%?

E(rp)=rf+beta[E(rm)-rf) Given r5% and E(rm)=15%, we can calculate beta: 20%=5%+beta*(15%-5%) > B=1.5

18. You manage an equity fund with an expected risk premium of 10% and a standard deviation of 14%. The rate on Treasury bills is 6%. Your client chooses to invest $60,000 of her portfolio in your equity fund and $40,000 in a T-bill money market fund. What are the expected return and standard deviation of your client's portfolio?

Expected return for your fund = T-bill rate + risk premium = 6% + 10% = 16% Expected return of client's overall portfolio = (0.6 x 16%) + (0.4 x 6%) = 12% Standard deviation of client's overall portfolio = 0.6 x 14% = 8.4%

1. What are the benefits to small investors of investing via mutual funds? What are the disadvantages?

Mutual funds offer many benefits: the ability to invest with small amounts of money, diversification, professional management, low transaction costs, tax benefits, and the ability to reduce administrative functions. The disadvantages associated with investing in mutual funds are generally operating expenses, marketing expenses, distribution charges, and loads. Loads are fees paid when investors purchase or sell the shares.

14. . Steady Growth Industries has never missed a dividend payment in its 94-year history. Does this make it more attractive to you as a possible purchase for your stock portfolio?

No, it is not more attractive as a possible purchase. Any value associated with dividend predictability is already reflected in the stock price.

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.

5. At a cocktail party, your co-worker tells you that he has beaten the market for each of the last three years. Suppose you believe him. Does this shake your belief in efficient markets?

No. The notion of random walk naturally expects there to be some people who beat the market and some people who do not. The information provided, however, fails to consider the risk of the investment. Higher risk investments should have higher returns. As presented, it is possible to believe him without violating the EMH.

17. Port ER Beta Risk free 10% 0% Market 18 1.0 A 16 1.5

Not possible. Given these data, the SML is: E(r) = 10% + B(18% — 10%) A portfolio with beta of 1.5 should have an expected return of: E(r) = 10% + 1.5 x (18% — 10%) = 22% The expected return for Portfolio A is 16% so that Portfolio A plots below the SML (i.e., has an alpha of -6%), and hence is an overpriced portfolio. This is inconsistent with the CAPM.

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.

4. How do security dealers earn their profits?

The primary source of income for a securities dealer is the bid-ask spread. This is the difference between the price at which the dealer is willing to purchase a security and the price at which they are willing to sell the same security.

14. Reconsider the Fingroup Fund in the previous problem. If during the year the portfolio manager sells all of the holdings of stock D and replaces it with 200,000 shares of stock E at $50 per share and 200,000 shares of stock F at $25 per share, what is the portfolio turnover rate?

The value of the stocks sold=$15,000,000 = 200,000 X $50 + 200,000 X $25 Turnover rate value of stocks sold of replaced/Value of assets =$15,000,000/$42,000,000 = 0.3571=35.71%

10. What has been the historical average real rate of return on stocks, Treasury bonds, and Treasury bills? T-bills: 3.38% T-bonds: 5.83% Stocks: 11.72% Inflation 3.01%

To answer this question with the data provided in the textbook, we look up the historical average for Treasury Bills, Treasury Bonds and stocks for 1927-2018 from Table 5.3 Arithmetic Average, Nominal Returns T-bills: 3.38% T-bonds: 5.83% Stocks: 11.72% To estimate the real rate of return, use historical inflation rate 3.01% from Table 5.2: The relationship between real rates and nominal rates/inflation is: 1+ r =1+R/1+i = T-bills: r=(1+R/1+i)-1 = (1+0.338)/(1+0.0301) -1 = .0036 = 0.36% T-bonds: r=(1+R/1+i)-1 =(1+0.058)/(1+0.0301)-1 = 0.0274=2.74% Stocks: r=(1+R/1+i)-1 = (1+0.1172)/(1+0.0302)-1 = 0.0846=8.46%

21. 'You know that firm XYZ is very poorly run. On a scale of | (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.

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 500 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.

12. Your client chooses to invest 70% of a portfolio in your fund and 30% in a T-bill money market fund. a. What are the expected return and standard deviation of you clients portfolio? b. Suppose your risky portfolio includes the following investments in the given proportions: Stock A 27% Stock B 33 Stock C 40 What are the investment proportions of each stock in your clients overall portfolio, including the position in T-bills? c. What is the Sharpe ratio (s) of your risky portfolio and your clients overall portfolio? d. Draw the CAL of your portfolio on an expected return/standard deviation diagram. What is the slope of the CAL? Shoe the position of your client on your funds CAL.

a. ER = 14%; Stdev = 18.9% b. T-Bills = 30% A=18.9% B = 23.1 C = 28% c1. = 0.3704 c2 = 0.3704

14. DRK, Inc., has just sold 100,000 shares in an initial public offering. The underwriter's explicit fees were $60,000. The offering price for the shares was $40, but immediately upon issue, the share price jumped to $44. a. What is the total cost to DRK of the equity issue? b. Is the entire cost of the underwriting a source of profit to the underwriters?

a. In addition to the explicit fees of $60,000, we should also take into account the implicit cost incurred to DRK from the underpricing in the IPO. The underpricing is $4 per share, or a total of $400,000, implying total costs of $460,000. b. No. The underwriters do not capture the part of the costs corresponding to the underpricing. However, the underpricing may be a rational marketing strategy to attract and retain long-term relationships with their investors. Without it, the underwriters would need to spend more resources in order to place the issue with the public. The underwriters would then need to charge higher explicit fees to the issuing firm. The issuing firm may be just as well off paying the implicit issuance cost represented by the underpricing.

13. Which of the following observations would provide evidence against the semistrong form of the efficient market theory? Explain. a. Mutual fund managers do not on average make superior returns. b. You cannot make superior profits by buying (or selling) stocks after the announcement of an abnormal rise in dividends. c. Low P/E stocks tend to have positive abnormal returns. d. In any year approximately 50% of mutual funds outperform the market.

c. The P/E ratio is public information so this observation would provide evidence against the semi-strong form of the efficient market theory.

T-bill is 15%; correlation is 0.15 ER Stdev Fund (S) 15% 32% Fund (B) 9 23 8. Tabulate and draw the investment opportunity set of the two risky funds. Use investment proportions for the stock fund of 0% to 100% in increments of 20%. What expected return and standard deviation does your graph show for the minimum-variance portfolio?

see answer sheet

14. Discuss the advantage and disadvantages of the following forms of managerial compensation in terms of mitigating agency problems, that is, potential conflicts of interest between managers and shareholders. a. A fixed Salary b. Stock in the firm that must be held for five years. c. A salary linked to the firm's profits

1. Compensation and Agency Problems a. A fixed salary means compensation is (at least in the short run) independent of the firm's success. This salary structure does not tie the manager's immediate compensation to the success of the firm, and thus allows the manager to envision and seek the sustainable operation of the company. However, since the compensation is secured and not tied to the performance of the firm, the manager might not be motivated to take any risk to maximize the value of the company. b. A salary paid in the form of stock in the firm means the manager earns the most when shareholder wealth is maximized. When the stock must be held for five years, the manager has less of an incentive to manipulate the stock price. This structure is most likely to align the interests of managers with the interests of the shareholders. If stock compensation is used too much, the manager might view it as overly risky since the manager's career is already linked to the firm. This undiversified exposure would be exacerbated with a large stock position in the firm. c. When executive salaries are linked to firm profits, the firm creates incentives for managers to contribute to the firm's success. However, this may also lead to earnings manipulation or accounting fraud, such as divestment of its subsidiaries or unreasonable revenue recognition. That is what audits and external analysts will look out for.

20. Firms raise capital from investors by issuing shares in the primary markets. Does this imply that corporate financial managers can ignore trading of previously issued shares in the secondary market?

1. Even if the firm does not need to issue stock in any particular year, the stock market is still important to the financial manager. The stock price provides important information about how the market values the firm's investment projects. If the stock price rises considerably, managers might conclude that the market believes the firm's future prospects are bright (and generally supports the actions of management). This might be a useful signal to the firm to proceed with an investment such as an expansion of the firm's business. Since shares can be easily traded in the secondary market it makes them more attractive to investors since investors know that they will be able to sell their shares quickly. This makes investors more willing to buy shares in a primary offering, and thus improves the terms on which firms can raise money in the equity market.

7. For each transaction, identify the real and/or financial assets that trade hands. Are any financial assets created or destroyed in the transaction? a. Toyota takes out a bank loan to finance the construction of a new factory b. Toyota pays off its loan c. Toyota uses $10 million of cash on hand to purchase additional inventory of spare parts

1. Financial and Real Assets a. Toyota creates a real asset—the factory. The loan is a financial asset that is created in the transaction. b. When the loan is repaid, the financial asset is destroyed but the real asset continues to exist. c. The cash is a financial asset that is traded in exchange for a real asset, inventory.

8. Suppose that in a wave of pessimism, housing prices fall by 10% across the entire economy. a. Has the stock of real assets of the economy changed? b. Are individuals less wealthy? c. Can you reconcile your answers to a and b?

1. Real Estate as a Real Asset a. No. The real estate in existence has not changed, only the perception of its value has. b. Yes. The financial asset value of the claims on the real estate has changed, and thus the balance sheet of individual investors has been reduced. c. The difference between these two answers reflects the difference between real and financial asset values. Real assets still exist, yet the value of the claims on those assets or the cash flows they generate do change. Thus, there is the difference.

11. Which of the following would most appear to contradict the proposition that the stock market is weak/y 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.

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.

Chapter 3

Chapter 3

Chapter 5

Chapter 5

Chapter 6

Chapter 6

Chapter 7

Chapter 7

Chapter 8

Chapter 8

Chapter 9

Chapter 9

Chapter 4

Chapter4

4. Here are data on two companies. The T-boll rate is 4% and the market risk premium is 6% Company $1 Discount Store Everything $5 Forecast return 12% 11% Stdev of return 8% 10% Beta 1.5 1.0 What should be the expected rate of return for each company, according to the capital asset pricing model (CAPM)?

E(r) = Risk free rate+Beta[E(rm)-Risk free rate]=0.04+beta*0.06 E(r $1 Discount)=0.04+1.5*0.06=0.13=13% E(r Everything $5) = 0.04+1.0*0.06=0.11=10%

20. a. Impressive Fund had excellent investment performance last year, with portfolio returns that placed it in the top 10% of all funds with the same investment policy. Do you expect it to be a top performer next year? Why or why not? a. Suppose instead that the fund was among the poorest performers in its comparison group. Would you be more or less likely to believe its relative performance will persist into the following year? Why?

Empirical research indicates that past performance of mutual funds is not highly predictive of future performance, especially for better-performing funds. While there may be some tendency for the fund to be an above average performer next year, it is unlikely to once again be a top 10% performer.

1. What are the differences between equity and fixed income securities?

Equity is a lower-priority claim on earnings (expressed as dividends) that represents an ownership share in a corporation. Fixed-income (debt) security is a higher-priority claim that legally obligates the issuer to pay the holder of the debt, but does not have an ownership interest. Fixed-income securities typically pay a specified cash flow at pre-contracted time intervals until the last payment on the maturity date. Shares of equity have an indefinite life.

5. What are the advantages and disadvantages of exchange-traded funds versus mutual funds?

Exchange-traded funds can be traded during the day, just as the stocks they represent. They are most tax-effective in that they do not have as many distributions. They have much lower transaction costs. They also do not require load charges, management fees, and minimum investment amounts. The disadvantages are that ETFs must be purchased from brokers for a fee, and investors may incur a bid-ask spread when purchasing an ETF.

6. What is the expected rate of return for a stock that has a beta of | if the expected return on the market is 15%? a. 15%. b. More than 15%. c. Cannot be determined without the risk-free rate.

a. 15%. Its expected return is the same as the market return when beta is 1.0 E(r) = Risk free rate+Beta[E(rm)-Risk free rate] = risk free rate+1*[E(rm)-risk free]=E(rm)

19. You are bearish on Telecom and decide to sell short 100 shares at the current market price of $50 per share. a. How much in cash or securities must you put into your brokerage account if the broker's initial margin requirement is 50% of the value of the short position? b. How high can the price of the stock go before you get a margin call if the maintenance margin is 30% of the value of the short position?

a. Initial margin is 50% of $5,000, which is $2,500. b. Total assets are $7,500 ($5,000 from the sale of the stock and $2,500 put up for margin). Liabilities are 100P. Therefore, net worth is ($7,500 - 100P). Solving (7,500-100P)/100P= 0.30, we get P = $57.69. A margin call will be issued when the stock price reaches $57.69 or higher.

25. Suppose the yield on short-term government securities (perceived to be risk-free) is about 4%. Suppose also that the expected return required by the market for a portfolio with a beta of | is 12%. According to the capital asset pricing model: a. What is the expected return on the market portfolio? b. What would be the expected return on a zero-beta stock? c. Suppose you consider buying a share of stock at a price of $40. The stock is expected to pay a dividend of $3 next year and to sell then for $41. The stock risk has been evaluated at B = -.5. Is the stock overpriced or underpriced?

a. Since the market portfolio, by definition, has a beta of 1.0, its expected rate of return is 12%. b. B=0 means the stock has no systematic risk. Hence, the portfolio's expected rate of return is the risk-free rate, 4%. c. Using the SML, the fair rate of return for a stock with B = —0.5 is: E(r) = 4% + (-0.5) x (12% — 4%) = 0.0% The expected rate of return, using the expected price and dividend for next year: E(r) = ($41 + $3)/$40 — 1 = 0.10 = 10% Because the expected return exceeds the fair return, the stock must be under priced.

18. Turn to Figure 2.8 and look at the listing for Home Depot. Close = 224.15; Div = 5.44 a. What was the firm's closing price yesterday? b. How many shares can you buy for $5,000? c. What would be your annual dividend income from those shares? d. What must be Home Depot's earnings per share?

a. The closing price today is $224.15, which is $1.44 above yesterday's price. Therefore, yesterday's closing price was: $224.15 － $1.44 = $222.71. b. You would buy 22 shares: $5,000/$224.15 = 22.31 (round down for 22 shares) c. Your annual dividend income on 22 shares would be 22 x $5.44 = $119.68. d. Earnings per share can be derived from the price-earnings (PE) ratio: Given price/Earnings = 22.36 and Price = $224.15, we know that Earnings per Share = $224.13/22.36 = $10.02

11. Consider a risky portfolio. The end of year cash flow derived from the portfolio will be either $50,000 or $150,000, with equal probabilities of 0.5. The alternative riskless investment in T-bills pays 5%. a. If you require a risk premium of 10%, how much will you be willing to pay for the portfolio? b. Suppose the portfolio can be purchased for the amount you found in (a). What will the expected rate of return on the portfolio be? c. Now suppose you require a risk premium of 15%. What is the price you will be willing to pay now? d. Comparing your answers to (a) and (c), what do you conclude about the relationship between the required risk premium on a portfolio and the price at which the portfolio will sell?

a. The expected cash flow is: (0.5 x $50,000) + (0.5 x $150,000) = $100,000 With a risk premium of 10%, the required rate of return is 15%. Therefore, if the value of the portfolio is X, then, in order to earn a 15% expected return: Solving X x (1 + 0.15) = $100,000, we get X = $86,957 b. If the portfolio is purchased at $86,957, and the expected payoff is $100,000, then the expected rate of return, E(r), is: $100,000 — $86,957/ $86,957 = 0.15 = 15% The portfolio price is set to equate the expected return with the required rate of return. c. If the risk premium over T-bills is now 15%, then the required return is: 5% + 15% = 20% The value of the portfolio (X) must satisfy: X * (1 + 0.20) = $100, 000 > X = $83,333 d. For a given expected cash flow, portfolios that command greater risk premiums must sell at lower prices. The extra discount in the purchase price from the expected value is to compensate the investor for bearing additional risk.

16. Old Economy Traders opened an account to short-sell 1,000 shares of Internet Dreams at $40 per share. The initial margin requirement was 50%. (The margin account pays no interest.) A year later, the price of Internet Dreams has risen from $40 to $50, and the stock has paid a dividend of $2 per share. a. What is the remaining margin in the account? b-1. What is the margin on the short position? b-2. If the maintenance margin requirement is 30%, will Old Economy receive a margin call? c. What is the rate of return on the investment? (Negative value should be indicated by a minus sign.)

a. The initial margin was: $40 x 1,000 ´ 0.50 = $20,000. As a result of the $10 increase in the stock price, Old Economy Traders loses: $10 ´ 1,000 shares = $10,000. Moreover, Old Economy Traders must pay the dividend of $2 per share to the lender of the shares: $2 ´ 1,000 shares = $2,000. The remaining margin in the investor's account therefore decreases to: $20,000 - $10,000 - $2,000 = $8,000. b. Margin on short position = Equity/Value =$8,000/(50*1,000 shares) = 0.16 = 16% Because the percentage margin falls below the maintenance level of 30%, there will be a margin call. c. The rate of return = (Ending Equity-Initial Equity (margin))/Initial Equity (margin) = ($8,000-$20,000)/$20,000= - 0.60 = - 60%

15. Dee Trader opens a brokerage account and purchases 300 shares of Internet Dreams at $40 per share. She borrows $4,000 from her broker to help pay for the purchase. The interest rate on the loan is 8%. a. What is the margin in Dee's account when she first purchases the stock? b. If the share price falls to $30 per share by the end of the year, what is the remaining margin in her account? c. If the maintenance margin requirement is 30%, will she receive a margin call? What is the rate of return on her investment? d. What is the rate of return on her investment?

a. The stock is purchased for $40 ´ 300 shares = $12,000. Given that the amount borrowed from the broker is $4,000, Dee's margin is the initial purchase price net borrowing: $12,000 - $4,000 = $8,000. b. If the share price falls to $30, then the value of the stock falls to $9,000. By the end of the year, the amount of the loan owed to the broker grows to: Principal ´ (1 + Interest rate) = $4,000 ´ (1 + 0.08) = $4,320. The value of the stock falls to: $30 ´ 300 shares = $9,000. The remaining margin in the investor's account is: $9.000 —$4.320 = $4.680 c. Margin on long position = Equity in account/Value of stock = $9,000-$4,320/$9,000= 0.52 = 52% Therefore, the investor will not receive a margin call. d. Rate of return =(Ending equity in account-Initial equity in account)/Initial equity in account = ($4,680-$8,000)/$8,000= - 0.4150 = - 41.50%

21. Here is some price information on Fincorp stock. Suppose first that Fincorp trades in a dealer market. Bid Asked 55.25 55.50 a. Suppose you have submitted an order to your broker to buy at market. At what price will your trade be executed? b. Suppose you have submitted an order to sell at market. At what price will your trade be executed? (Round your answer to 2 decimal places.) c. What will happen suppose you have submitted a limit order to sell at $55.62. d. What will happen suppose you have submitted a limit order to buy at $55.37.

a. The trade will be executed at $55.50. b. The trade will be executed at $55.25. c. The trade will not be executed because the bid price is lower than the price specified in the limit-sell order. d. The trade will not be executed because the asked price is higher than the price specified in the limit-buy order.

22. You've borrowed $20,000 on margin to buy shares in Ixnay, which is now selling at $40 per share. Your account starts at the initial margin requirement of 50%. The maintenance margin is 35%. Two days later, the stock price falls to $35 per share. a) Will you receive a margin call? b) How low can the price of Ixnay shares fall before you receive a margin call?

a. You will not receive a margin call. You invest in 1,000 shares of Ixnay at $40 per share with $20,000 in equity and $20,000 from borrowing. At $35 per share, the value of the stock becomes $35,000. Therefore, the equity decreases to $15,000: Equity = Value of stock - Debt = $35,000 - $20,000 = $15,000 Percentage margin = Equity in account/Value of stock= $15,000/$35,000 = 0.4286 or 42.86% The percentage margin still exceeds the required maintenance margin. b. Solving (1,000P-$20,000)/1,000P= 0.35 or 35%, we get P = $30.77 You will receive a margin call when the stock price falls to $30.77 or lower.

18. You are bullish on Telecom stock. The current market price is $50 per share, and you have $5,000 of your own to invest. You borrow an additional $5,000 from your broker at an interest rate of 8% per year and invest $10,000 in the stock. a. What will be your rate of return if the price of Telecom stock goes up by 10% during the next year? (Ignore the expected dividend.) b. How far does the price of Telecom stock have to fall for you to get a margin call if the maintenance margin is 30%? Assume the price fall happens immediately.

a. Your initial investment is the sum of $5,000 in equity and $5,000 from borrowing, which enables you to buy 200 shares of Telecom stock: Initial investment/stock price= $10,000/$50= 200 shares The shares increase in value by 10%: $10,000 ´ 0.10 = $1,000. You pay interest of = $5,000 * 0.08 = $400. The rate of return will be: ($1,000-$400)/$5,000= 0.12 = 12% b. The value of the 200 shares is 200P. Equity is (200P - $5,000), and the required margin is 30%. Solving (200P-$5,000)/200P= 0.30, we get P = $35.71. You will receive a margin call when the stock price falls below $35.71.

15. You estimate that a passive portfolio invested to mimic the S&P 500 index provides an expected rate of return of 13% with a standard deviation of 25%. a. Draw the CML and your funds CAL on an expected return/standard deviation diagram b. What is the slope of the CML? c. Characterize in one short paragraph the advantage of your fund over the index fund.

b. 0.24 c. Your fund allows an investor to achieve a higher expected rate of return for any given standard deviation than would a passive strategy. i.e., a higher expected return for any given level of risk.

6. Which of the following statements are trve if the efficient market hypothesis holds? 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.