Investment Analysis

Accrued Interest A bond has a flat price of $1,030.10 and an annual coupon of $56.00. 60 days have passed since the last coupon payment and there are 179 days separating the coupon payments. What is the bond's invoice price?

$1,039.49 Explanation The invoice price = flat price + accrued interest. The accrued interest is found as: Accrued interest =Annual Coupons$/2×Days since last coupon payment/Days between coupon payments Accrued interest = ($56.00/2) x (60/179) = $9.39. The bond's invoice price is thus $1,030.10 + $9.39 = $1,039.49.

What is the ending price of a stock if its beginning price was $20, its cash dividend was $2, and the holding period return on a stock was 10%?

$20 0.1=(2+P1-20)/20 P1=20

What is the risk premium of a stock that has an expected return of 20%, assuming the rate of return on Treasury bills is 3%?

17%

The holding period return on a stock was 30%. Its ending price was $26 and its cash dividend was $1.50. Its beginning price must have been __________.

$21.15 P= (26+1.5)/1+.30=21.15

What must be the beta of a portfolio with E(rP) = 15.40%, if rf = 4% and E(rM) = 10%?

Beta of portfolio= 1.90 E(rP) = rf + β[E(rM) - rf] Given rf = 4% and E(rM) = 10%, we can calculate β: 15.40% = 4% + β(10% - 4%) ⇒⇒ β = 1.90

You buy a $10,000 par 90 day T-bill that has a bank discount quote of 3.8%. This bill's cost would be _____. a. $9,925 b. $9,915 c. $9,905 d. $9,935

$9,905 Explanation The T-bill price = Par × (1 - ((bank discount × days)/360)) = $10,000 × (1 - ((0.038 × 90)/360)) = $9,905

The risk-free asset is proxied by the _______________.

Treasury bills

The geometric average return of 10%, -20%, -10%, and 20% is _______________.

[(1+0.1)(1-0.2)(1-0.1)(1+0.2)]^(1/4) -1 = -1.26%

The primary risk to an investor from holding a standard Treasury bond is Multiple Choice a. default risk b. tax risk c. inflation risk d. liquidity risk

c. inflation risk Explanation Inflation risk is the primary risk because of the fixed income nature of the Treasury bond.

fixed-income (debt) securities

pay a specified cash flow over a specific period they promise either a fixed stream of income or a stream of income that is determined according to a specific formula.

The price of a stock is $55 at the beginning of the year and $53 at the end of the year. If the stock paid a $3 dividend what is the holding period return for the year?

1.82% HPR = (53 - 55 +3) / 55 = .0182

Assume that of your $10,000 portfolio, you invest $9000 in stock X and $1000 in stock Y. What is the expected return on your portfolio?

19% E(r) = (0.9 x 20%) + (0.1 x 10%) = 19%

Suppose you pay $9,950 for a Treasury bill with a $10,000 face value that matures in one month. What is the effective rate of return for this investment?

6.20% Return for 1 month = (10,000-9950)/9950 = 0.05025% EAR = (1+0.0005025)^12 - 1 =6.20%

SEC Rule 415 allows which of the following?

Allows a security issue to be preregistered and offered at any time within two years. Explanation SEC Rule 415 allows a security issue to be preregistered and offered at any time within two years.

Bond Prices A $1,000 par bond that pays interest semiannually has a quoted coupon rate of 5%, a promised yield to maturity of 5.7% and exactly 6 years to maturity. What is the bond's current value? Multiple Choice A. $1,001.04 B. $964.85 C. $945.92 D. $929.36

B. $964.85 Explanation The bond's value is found as follows: P = $964.85 With semiannual compounding you halve the ytm and coupon and double the number of periods. P={ΣT=1 ,12 $25/(1.0285)^T}+$1,000/(1+0.0285)^12 P = $964.85 With semiannual compounding you halve the ytm and coupon and double the number of periods.

A contract where the seller of the contract collects an annual premium (and sometimes an upfront fee) from the buyer and in exchange the seller of the contract pays the drop in value from par to the buyer if a security defaults is called a ___________________. A. putable bond B. credit default swap C. inverse floater D. CDO

B. credit default swap Explanation A credit default swap provides the swap buyer with insurance that covers the par value of the security in the event the security defaults.

TIPS A TIPS bond with a $1,000 par value was issued three years ago with a coupon rate of 5%. In the first year inflation was 2.5%, in the second year 3% and in the third year 3.5%. The coupon payment at the end of the third year would be ______. Multiple Choice A. $54.75 B. $54.55 C. $54.64 D. $50.00

C. $54.64 Explanation With a Treasury Inflation Protected Security or TIP the coupon rate stays the same but the par or principal grows each year with inflation as measured by the CPI. The coupon payment at the end of the third year = $1,000 (1.025)(1.03)(1.035)(0.05) = $54.64.

Xerox, which has been a public company for a long time, hires Morgan Stanley to help Xerox market additional new stock for sale to the general public. Morgan Stanley purchases the shares from Xerox and resells the shares to the public. This is an example of a/an _____________________. a. best efforts seasoned offering b. underwritten general cash initial public offering c. standby right offering d. underwritten general cash seasoned offeringCorrect

D. underwritten general cash seasoned offering This is an example of an underwritten general cash seasoned offering. In an underwritten offering the investment banker (Morgan Stanley) purchases the issue from the issuing firm and resells it to the public. Since Xerox had been a public company for a long time this could not be the initial public offering, rather it is a seasoned offering.

Match the following descriptions to the type of market: I. Buyers and sellers locate one another on their own II. A third party acts as an intermediate buyer/seller III. A third party assists a participant in locating a buyer or seller.

Direct search, dealer market, brokered market I is a direct search market, II is a dealer market and III is a brokered market.

BearM NormM BullM Prob 0.2 0.5 0.3 Stock X -20% 18% 50% Stock Y -15% 20% 10% What are the expected returns for X and Y

E(rX) = [0.2 x (-20%)] + [0.5 x 18%] + [0.3 x 50%)] = 20% E(rY) = [0.2 x (-15%)] + [0.5 x 20%] + [0.3 x 10%)] = 10%

A municipal bond carries a coupon rate of 7.50% and is trading at par. What would be the equivalent taxable yield of this bond to a taxpayer in a 40% combined tax bracket? (Round your answer to 2 decimal places.)

Equivalent taxable yield 12.50% Explanation Equivalent taxable yield =Rate on municipal bond/1 - Tax rate =rm/(1-t) = 0.0750/(1-0.40) = 01250 or 12.50%

If an investor believes that markets are efficient then which of the following investment strategies fit that belief?I. Buying and holding a diversified portfolioII. Attempting to identify mispriced securitiesIII. Adjusting your portfolio in accordance with forecasts of broad market trends Multiple Choice I only I and II only II only II and III only

I only Explanation If an investor believes that markets are efficient then they must believe that attempting to identify mispriced securities or adjusting your portfolio allocations with market forecasts are unprofitable activities.

The EMH maintains that prices reflect all relevant information. Weak, semi-strong and strong form efficiency are different versions that vary the relevant information set. Which versions of efficiency would imply that a trading strategy based on trends in historical price and trading volume would not be beneficial? I. Weak form II. Semi-strong form III. Strong form

I, II and III Explanation Trading on historical price and volume data is called technical analysis and is invalidated by weak form efficiency. In fact all three forms of market efficiency invalidate the strategy because semi-strong efficiency implies weak form efficiency and strong form efficiency implies all three.

Questions arise about the efficiency of markets because I. Investors have unequal access to information. II. Structural market problems that prevent arbitrage such as short sale restrictions. III. Prevalence of psychological factors among investors. IV. Stock prices are a random walk.

I, II and III only Explanation I, II and III are true and give rise to doubts about market efficiency. If IV is true then markets are efficient.

Portfolio A has an expected return of 35% and a standard deviation of 44% when the risk free rate is 6%. The market portfolio has an expected return of 32% and a standard deviation of 41%. Based on this data, which of the following conclusions are correct? I. This situation is inconsistent with the CAPMII. The Sharpe ratio for Portfolio A = 0.6591III. The Sharpe ratio for the market portfolio = 0.6341IV. This situation is consistent with the CAPM

I, II, III The Sharpe ratio for Portfolio A = (35% - 6%) / 44% = 0.6591. The Sharpe ratio for the market portfolio = (32% - 6%) / 41% = 0.6341. The CAPM requires the market portfolio to be the portfolio with the highest Sharpe ratio so this is inconsistent with CAPM.

CAPM assumptions include all but which one of the following? No individual's buy/sell decisions affect a stock's price. Information is costless and equally available to all investors Investors have heterogeneous expectations about security returns There are no taxes or transaction costs

Investors have heterogeneous expectations about security returns The CAPM assumes all investors have homogeneous (same) expectations about security returns.

An investor is in a 40% combined federal plus state tax bracket. If corporate bonds offer 8.00% yields, what yield must municipals offer for the investor to prefer them to corporate bonds? (Round your answer to 2 decimal places.)

Minimum municipals offer 4.80% Explanation The after-tax yield on the corporate bonds is: 0.0800 × (1 − 0.40) = 0.0480 or 4.80%Therefore, the municipals must offer at least 4.80% yields.

Look at the futures listings for corn in Figure 2.11.Suppose you buy one contract for May 2017 delivery at the closing price. If the contract closes in May at a price of $3.68 per bushel, what will be your profit or loss? (Each contract calls for delivery of 5,000 bushels.) (Round your answer to 2 decimal places.)

Profit 337.50 Explanation The May maturity futures price is $3.6125 per bushel. If the contract closes at $3.68 per bushel in May, your profit/loss on each contract (for delivery of 5,000 bushels of corn) will be: ($3.68 - $3.6125) × 5,000 = $337.50 gain.

Which of the following are discount instruments? a. Certificates of Deposit b. Eurodollars c/ Treasury bills d. Federal funds

Treasury bills Explanation Treasury bills are discount instruments; the others are not.

The Campbell and Shiller test of market efficiency study finds that

aggregate returns tend to be higher for firms with higher earnings yields Explanation The Campbell and Shiller results find that aggregate returns tend to be higher for firms with higher earnings yields.

You have $500,000 available to invest. The risk-free rate as well as your borrowing rate is 8%. The return on the risky portfolio is 16%. If you wish to earn a 22% return, you should __________.

borrow $375,000 y=(.22-.08)/(.16-.08)=1.75 Borrowing= 500,000(1.75-1) = 375,000

A security that pays a specified cash flow over a specified period

debt security Explanation Debt securities are fixed incomes that pay a specified amount.

A security that provides a payoff that depends on the values of other assets

derivative security Explanation Derivatives have values that are 'derived' from some underlying asset condition or payoff.

If markets are ________ efficient, use of any information, public or private, provides no benefit at the margin.

strong form Explanation Strong form efficiency implies that all information is already incorporated into stock prices so that no information, public or private, is of any value.

derivative securities

such as options and futures contracts provide payoffs that are determined by the prices of other assets such as bond or stock prices. Derivative securities are so named because their valus derive from the prices of other assets.

Which of the following describes the call feature of a bond? A. The issuing company may choose to call the bond and require the bondholder to turn in the bond in exchange for receiving the bond's call price. B. The bondholder may call and request a higher coupon payment in exchange for a deferral of the principal payment date. C. The bondholder has the right to sell the bond back to the issuing company at coupon payment dates. D. The issuing company may require the bondholder to exchange their bond for preferred stock.

A. The issuing company may choose to call the bond and require the bondholder to turn in the bond in exchange for receiving the bond's call price. Explanation A callable bond gives the issuing company the right to call in the bond by paying the bondholder the call price.

Chapter 12 of the text discusses a top down approach to fundamental analysis. In a top down approach, fundamental analysis attempts to identify good stock investments by first analyzing the ______, then analyzing the ______ and then analyzing the ______. a. economy; industry; firm b. firm; industry; economy c. industry; firm; economy d. economy, firm, industry

A. economy; industry; firm Explanation The top down approach starts with the economy, then tries to find an industry that will do well given the economy wide forecast, and then tries to find an attractively price firm within an industry that will have good performance.

Which of the following represents asset allocation? a. Julia decides she wants to reduce her investment in stocks from 60% of her portfolio to 30% of her portfolio. b. Cynthia chooses to put her inheritance money in First Interstate Bank CDs. c, Bill decides to invest in Microsoft stock because he believes Windows 7 is a real money maker. d. George decides that he no longer wants to hold Ford bonds and swaps them for Toyota debt.

A. is the correct answer Explanation Asset allocation is choosing the percentage of funds you put in different asset classes such as stocks and bonds; it is not choosing a specific security.

A listed call option contract for IBM with an exercise price of $150 has a price quote of $6.60. If you buy this option and hold it to expiration, the contract will generate a positive profit for you if the stock's price is ____________ at expiration. Multiple Choice

Above $156.60 Explanation If you purchase a call option you may choose to exercise it if the stock's price is above $150 but you won't earn a positive profit unless the stock's price rises above the exercise price plus the option cost = $150 + $6.60 = $156.60.

Here are data on two companies. The T-bill rate is 4.0% and the market risk premium is 8.0%. Company $1 DS Everything $5 FR 15% 14% SD of R 19% 21% Beta 1.7 1 What would be the fair return for each company, according to the capital asset pricing model (CAPM)?

$1 Discount Store Expected Return: 17.60% Everything $5 Expected Return: 12% Explanation E(r) = rf + β [E(rM) − rf] , rf = 4.0%, E(rM) − rf = 8.0% $1 Discount Store: E(r) = 4.0% + 1.7 × 8.0% = 17.60% Everything $5: E(r) = 4.0% + 1 × 8.0% = 12.00%

Bond Prices: A $1,000 par bond that pays interest semiannually has a quoted coupon rate of 6%, a promised yield to maturity of 5.9% and exactly 5 years to maturity. What is the bond's current value?

$1004.28 Explanation The bond's value is found as follows: P = $1004.28 With semiannual compounding you halve the ytm and coupon and double the number of periods. P={10 Σ T=1 $30/(1.0295)^T}+$1,000/(1+0.0295)^10 P = $1004.28 With semiannual compounding you halve the ytm and coupon and double the number of periods.

You buy 510 shares of stock that are priced at $48 a share using the full amount of margin available. The maintenance margin requirement or MMR is 35%. At what stock price do you get a margin call?

$36.92 The full amount of margin available is set at 50% by regulation. So you borrow the other 50% of the purchase price of 510 * $48 = $24,480, or $12,240. You receive a margin call at a stock price = Borrow/(1 - MMR)/ # shares = $12,240/(1 - 0.35)/510 = $36.92.

A stock has been trading at $38.00 per share for some time. It would make sense for an investor to enter a limit buy order at ______ per share or a limit sell order at ______ per share.

$37.75; $38.25 A limit order is an order to buy or sell at a specified price or better. Hence a limit buy would only make sense if it were lower than the current share price. Likewise a limit sell would only make sense if it were higher than the current share price.

You sell 450 shares of stock short that are priced at $52.15 a share. You post the 50% margin required. If the maintenance margin requirement (MMR) is 30% at what stock price do you get a margin call?

$60.17 You must post 50% of the sale price in your margin account = 50% × ($52.15 * 450) = $11,733.75. You must also pledge the sale proceeds to the margin account = $52.15 * 450 = $23,468. Your total margin account = $11,733.75 + $23,468 = $35,201.25. You get a margin call at a stock price = [Total margin account / (1 + MMR) / # shares] = ($35,201.25 / 1.30) / 450 = $60.17.

Zero Coupon Bonds A 8 year maturity zero coupon corporate bond has an 6% promised yield. The bond's price should equal ________.

$627.41 Explanation A corporate bond has a $1,000 par value so the zero coupon bond's price = $1,000 / (1.06)8 = $627.41.

The risk free rate is 2.35% and the market price of risk is 12%. A stock with a beta of 1.65 has an expected dividend yield of 7% and an expected capital gain of 14%. This stock's alpha is equal to ______ and the stock is ________.

-1.15, overpriced Explanation The expected return = 7% + 14% = 21%. The stock's required rate of return = rf + βi[E(rM) - rf] = 2.35% + 1.65(12%) = 22.15%. The stock's alpha = expected return - required return = 21% - 22.15% = -1.15%. With a negative alpha the stock is overpriced.

You buy 185 shares of stock that are priced at $42 a share using the full amount of margin available. The broker charges you a 3% interest rate on the margin loan. If you sell the stock in one year for $40 a share what was your rate of return?

-12.52% The full amount of margin available is set at 50% by regulation. So your initial equity = 50% of the purchase price of 185 * $42 = $7,770, or $3,885, and the other $3,885 is the amount borrowed. At the sale price of $40 the ending position equity = ($40 * 185) - [$3,885 *(1.03)] = $3,398.45. The rate of return = (End equity / Begin equity) -1 = $3,398.45 / $3,885 - 1 = -12.52%.

An investor places $5,000 in Stock A, $4,000 in Stock B and $10,000 in Stock C. Stock A has a beta of 0.9, Stock B has a beta of 1.05 and Stock C has a beta of 1.25. What is the resulting portfolio beta?

1.12 Portfolio beta = ΣWi βi = (5/19)0.9 + (4/19)1.05 + (10/19)1.25 = 1.12

On January 1 you buy a stock priced at $84 per share. At the end of the year you sell the stock for $75.95. You also collected a $1.00 dividend. For the year your dividend yield was ____, your capital gain yield was ____ and your total pre-tax return was ____.

1.19%; -9.583%; -8.393% Explanation The dividend yield = $1.00/$84 = 1.19%; the capital gain yield = ($75.95 - $84)/$84 = -9.583%, the total pre-tax return is the sum of the two = 1.19% + -9.583% = -8.393%

What is the expected rate of return for a stock that has a beta of 1 if the expected return on the market is 12%?

12% Explanation Its expected return is exactly the same as the market return when beta is 1.0.

You believe that a stock is fairly priced according to the CAPM. The stock has a beta of 2.7 when the market risk premium is 5.0% and the risk free rate is 2.4%. If the stock's dividend yield is 3.8% what is the stock's expected capital gain yield?

12.10% Explanation The stock's required rate of return = rf + βi[E(rM) - rf] = 2.4% + 2.7(5.0%) = 15.90%. The stock must give a 15.90% expected rate of return. If the dividend yield is 3.8% then the capital gain yield must be expected to be the rest or 12.10%.

Suppose you pay $9,800 for a Treasury bill maturing in two months. What is the annual percentage rate of return for this investment?

12.2% [(10000-9800)/9800]*6 = 12.2%

A stock has a beta of 1.2 when the risk free rate is 2% and the expected return on the market is 11.5%. The stock's required rate of return is equal to ______.

13.40% The stock's required rate of return = rf + βi[E(rM) - rf] = 2% + 1.2[11.5%-2%] = 13.40%

An investor invests 80% of her portfolio in a risky asset with an expected rate of return of 18% and a standard deviation of 25%. The investor invests the remaining 20% of her portfolio in a Treasury bill with a 4% rate of return. Her portfolio's expected rate of return and standard deviation are ____________ and ____________, respectively.

15.2%; 20.0% E(rc) = (0.8 x 18%) + (0.2 x 4%) = 15.2% per year σc = 0.8 x 25% = 20% per year σ=st. deviation

The sample standard deviation of returns of 18%, -15%, -10% and 30% is _______________.

21.7% r=(18-15-10+30)/4=5.75 St. deviation σ= take Sq root of 1/3[(18-5.75)^2 +(-15-5.75)^2 +(-10-5.75)^2 + (30-5.75)^2]= 21.7

A $1,000 par bond that pays interest semiannually has a quoted coupon rate of 4%, a promised yield to maturity of 3.3% and exactly 9 years to maturity. The present value of the coupon stream represents ______ of the total bond's value.

29.3% Explanation The bond's value is found as follows: P={18 Σ T-1 $20/(1.0165)^T}+$1,000/(1+0.0165)^18=$1,054.12P={ΣT−118⁢$20(1.0165)T}+$1,000(1+0.0165)18=$1,054.12 The present value of the coupon stream is the term in brackets and = $309.28. This represents $309.28 / $1,054.12 = 29.3% of the total present value of the bond. When this percentage is higher the bond's price will be less sensitive to an interest rate change everything else equal.

Find the yield to call for a 4% coupon, $1,000 par 15 year bond selling at $980.15 if the bond is callable in 10 years at a call price of $1,040. The bond makes semiannual coupon payments. Multiple Choice 3.43% 3.58% 4.57% 3.83%

4.57% Explanation The yield to call is found as the solution to the following: $980.15 ={ΣT−1,10 $20/(1+1/2r)^T}+ $ 1,040/(1+1/2r)^10 ;1/2r = 2.28% × 2 = 4.57%

Bond Prices A $1,000 par bond that pays interest semiannually has a quoted coupon rate of 7%, a promised yield to maturity of 7.6% and exactly 8 years to maturity. The present value of the coupon stream represents ______ of the total bond's value. Multiple Choice 45.3% 44.0% 42.9% 41.8%

42.9% Explanation The bond's value is found as follows: P={ΣT−1,16 $35/(1.038)^T}+$1,000/(1+0.038)^16=$964.52 The present value of the coupon stream is the term in brackets and = $413.91. This represents $413.91 / $964.52 = 42.9% of the total present value of the bond. When this percentage is higher the bond's price will be less sensitive to an interest rate change everything else equal.

A municipal bond has a promised yield to maturity of 3.69%. For an investor in a 30% tax bracket this municipal bond has the same effective yield as an equivalent corporate bond with a _____ promised yield to maturity.

5.271 % Explanation The equivalent corporate bond yield is found as 3.69% / (1 - 0.3) = 5.271%

Bond Yields Find the promised yield to maturity for a 6% coupon, $1,000 par 15 year bond selling at $1015.80. The bond makes semiannual coupon payments. Multiple Choice 5.36% 5.84% 6.06% 5.91%

5.84% Explanation The promised yield is found as the solution to the following: $1015.80={ΣT=1,30 $30/(1+1/2r)^T}+$1,000/(1+1/2r)^30;1/2r=2.92% × 2 =5.84%

A stock with a beta of 0.91 has an expected return of 15% and an alpha of 1.5% when the market expected return is 14.25% . What must be the risk free rate that satisfies these conditions? Multiple Choice

5.92% Explanation The stock's alpha = expected return - required return or -1% = 15% - required return. Thus the required return = 13.5%. Next use the CAPM to solve for the risk free rate: 13.5% = rf + 0.91(14.25%-rf). rf = 5.92%

An investment has a 10% probability of earning a 20% rate of return, a 60% probability of earning a 10% rate of return and a 30% probability of losing 5%. What is the expected rate of return for this investment?

6.5% E(R) = [0.1 x ( 20%)] + [0.6 x 10%] + [0.3 x (-5%)]= 6.5%

A complete portfolio is composed of a risky portfolio with an expected rate of return of 14% and a standard deviation of 20%, and Treasury bills with a rate of return of 5%. The complete portfolio has a standard deviation of 12%. What proportion of the complete portfolio is invested in the risky portfolio?

60% σc = y*σp therefore y = σc /σp =0.12/0.2= 0.6 Therefore, 60% of the fund is invested in the risky portfolio σ=standard deviation

Yield to Call Find the yield to call for a 8% coupon, $1,000 par 15 year bond selling at $1045.50 if the bond is callable in 10 years at a call price of $1,080. The bond makes semiannual coupon payments. Multiple Choice

7.87% Explanation The yield to call is found as the solution to the following: $1045.50 ={ΣT−110 $40(1+1/2r)T}+ $ 1,080(1+1/2r)10 ;{ΣT−110⁢ $40(1+1/2r)T}+ $⁢ 1,080(1+1/2r)10⁢ ;1/2r = 3.94% × 2 = 7.87%

A TIPS bond with a $1,000 par value was issued three years ago with a coupon rate of 7%. In the first year inflation was 2.3%, in the second year 2.8% and in the third year 3.3%. The coupon payment at the end of the third year would be ______.

76.04 Explanation With a Treasury Inflation Protected Security or TIP the coupon rate stays the same but the par or principal grows each year with inflation as measured by the CPI. The coupon payment at the end of the third year = $1,000 (1.023)(1.028)(1.033)(0.07) = $76.04.

Find the after-tax return to a corporation that buys a share of preferred stock at $47, sells it at year-end at $47, and receives a $5 year-end dividend. The firm is in the 30% tax bracket. (Round your answer to 2 decimal places.)

Answer 9.04% Explanation The total before-tax income is $5. The corporations may exclude 50% of dividends received from domestic corporations in the computation of their taxable income; the taxable income is therefore: $5 × 50% = $2.5.Income tax in the 30% tax bracket: $2.5 × 30% = $0.75After-tax income = $5 - $0.75 = $4.25After-tax rate of return = $4.25/$47 = 0.0904 or 9.04%

You buy a 5,000 par 180 day T-bill for 4, 920 bond equivalent yield would be ______ a. 3.30% b. 3.20% c. 3.32% d. 2.00%

Answer A The bond equivalent yield = (Par - Price)/Price x (365/n)= (5,000-4920)/4920 x (365/90) = 0.033 or 3.30%

You buy a $5,000 par 90 day T-bill for $4,965. This bill's bank discount rate quote would be _____. a. 2.89% b. 4.00% c. 2.80% d. 2.86%

Answer is C Bank discount rate = (Par-Price)/Par x (360/n) = (5,000-4965)/5,000 x (360/90)= 0.0280 or 2.80%

The _____________________ return ignores the compounding effect

Arithmetic average

The holding period return on a stock is equal to __________.

B) the capital gain yield over the period plus the dividend yield

The Players Fill in the following blanks: ________ are net borrowers. ________ are net savers. ________ can be either borrowers or savers. a. Households, Businesses, Government b. Businesses, Households, Governments c. Governments, Businesses, Households d. Households, Governments, Businesses

Businesses, Households, Governments Explanation Businesses are net borrowers, households are typically net savers and governments can be either.

Which one of the following statements about government deficits is not true? A. Larger government budget deficits can lead to higher interest rates. B. Even if crowding out does not occur, large budget deficits may result in reliance on foreign sources of funds to finance the deficit. C. Government budget deficits tend to increase during expansions and decrease during recessions. D. Larger government budget deficits may crowd out private investment that might have led to more growth than public investment.

C. Government budget deficits tend to increase during expansions and decrease during recessions. Explanation Government budget deficits tend to increase during recessions and decrease during expansions. Government tax receipts are higher during expansions and transfer payments such as unemployment insurance are lower then.

Which one of the following is not a true statement about the relationship between inflation and interest rates? A. The Federal Reserve may act to increase interest rates before inflation actually occurs. B. Funds demanders will be willing to pay a higher interest rate when inflation is expected. C. Government monetary policy may affect inflation but government fiscal policy does not. D. Suppliers of funds will require a higher interest rate to offset inflation.

C. Government monetary policy may affect inflation but government fiscal policy does not. Explanation Both government monetary policy and fiscal policy can affect inflation. If fiscal policy (spending) is too high it may cause prices to increase as demand for goods and services outstrips supply. For example, if the government gives taxpayers a tax rebate and the economy is near capacity and can't produce more the result would likely be inflation.

Which of the following result from the expectations theory of the yield curve? I. The observed long-term rate includes a risk premium II. Long term rates are a function of expected future short term rates III. An upward slope means that the market is expecting higher future short term rates IV. The observed yield curve is above the pure expectations yield curve. Multiple Choice A. I only B. I and II only C. II and III only D. II, III and IV only

C. II and III only Explanation I and IV come from the liquidity preference theory. II and III are conclusions from the expectations theory.

A bond has a par value of $1,000, a time to maturity of 20 years, and a coupon rate of 7.00% with interest paid annually. If the current market price is $700, what will be the approximate capital gain of this bond over the next year if its yield to maturity remains unchanged? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Capital gain $4.84 Explanation Using a financial calculator, input PV = -700, FV = 1,000, n = 20, PMT = 70. The YTM is 10.69%. Using a financial calculator, FV = 1,000, n = 19, PMT = 70, i = 10.69.The new price will be 704.84. Thus, the capital gain is $4.84.

Which of the following is a money market instrument? a. Common stock b. Commercial paper c. Preferred stock d. 5 year maturity Treasury note

Commercial paper Explanation Money market instruments have an original issue maturity of one year or less. Commercial paper has a maximum maturity at issue of 270 days.

The EMH implies which one of the following? Investors have unequal access to information. Stock prices conform to mathematical models. Competition among investors results in stock prices that fully reflect publicly available information very quickly. Stock prices exhibit long term trend reversals.

Competition among investors results in stock prices that fully reflect publicly available information very quickly.

Treasury bonds paying an 10.00% coupon rate with semiannual payments currently sell at par value. What coupon rate would they have to pay in order to sell at par if they paid their coupons annually? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Coupon rate 10.25% Explanation The effective annual yield on the semiannual coupon bonds is (1.05000)^2 − 1 = 10.25%. If the annual coupon bonds are to sell at par they must offer the same yield, which requires an annual coupon of 10.25%.

A bond with an annual coupon rate of 4.0% sells for $955. What is the bond's current yield? (Round your answer to 2 decimal places.)

Current Yield 4.19% Explanation Current yield= Annual coupon / bond price 1,000x4%/955=4.19%

Default Protections All but which one of the following will tend to reduce the required yield on a corporate bond? A. A sinking fund where the issuer may repurchase a given fraction of the outstanding bonds each year. B. A sinking fund where the issuer sets aside money each year to ensure the bond principal can be repaid when due C. A requirement that all future debt issues must be subordinated to the current debt. D. A call provision with a five year deferred call.

D. A call provision with a five year deferred call. Explanation The call feature will increase the required return on the bond. Firms call in bonds when interest rates have declined, forcing investors to reinvest at lower rates. Investors lose even though they receive the call price, which will be above par. The market value of the bond above the call price is lost and firms won't call the bond unless the market value is above the call price.

Functions of financial markets include a. allocating capital resources to productive uses b. allow investors to shift consumption through time c. allow investors to choose how much risk to bear in their investments d. All of the above

D. all of the above Explanation All of the above are functions of markets

Even if the market is efficient portfolio management still has many useful purposes, including all but which one of the following?

Earning positive abnormal returns Explanation If the market is efficient then one cannot consistently earn positive abnormal returns.

Assume that you manage a risky portfolio with an expected rate of return of 18.6% and a standard deviation of 28.2%. The T-bill rate is 6%. Your client chooses to invest 65% of a portfolio in your fund and 35% in a T-bill money market fund. What is the expected return and standard deviation of your client's portfolio?

Expected return 14.2% per year Standard deviation 18.3% per year E(rp) = (0.35 × 6%) + (0.65 × 18.6%) = 14.2% per year σP = 0.65 × 28.2% = 18.3% per year

A share of stock is now selling for $85. It will pay a dividend of $7 per share at the end of the year. Its beta is 1. What do investors expect the stock to sell for at the end of the year? Assume the risk-free rate is 7% and the expected rate of return on the market is 17%.

Expected selling price $92.45 Explanation Since the stock's beta is equal to 1, its expected rate of return should be equal to that of the market, that is, 17%. E(r) =(D + P1 - P0)/P0 0.17 = (7 + P1 - 85)/85 ⇒⇒ P1 = $92.45

Refer to the stock options on Microsoft in the Figure 2.10. Suppose you buy a September expiration call option on 100 shares with the excise price of $135. a-1.If the stock price in September is $139, will you exercise your call? a-2 What is the net profit/loss on your position a-3. What is the rate of return on your position? b-1. Would you exercise the call if you had bought the September call with the exercise price $130? b-2. What is the net profit/loss on your position? b-3. What is the rate of return on your position? c-1. What if you had bought an September put with exercise price $135 instead? Would you exercise the put at a stock price of $135? c-2. What is the rate of return on your position?

Explanation a. Yes. As long as the stock price at expiration exceeds the exercise price, it makes sense to exercise the call. Gross profit is: ($139 − $135) × 100 shares = $400 Net profit = ($4 − $4.82) × 100 shares = $82 Loss Rate of return = $0.82/$4.82 = 0.1701 or 17.01% Loss b. Yes, exercise. Gross profit is: ($139 − $130) × 100 shares = $900 Net profit = ($9 − $8.65) × 100 shares = $35 gain Rate of return = $0.35/$8.65 = 0.0405 or 4.05 % gain c. A put with an exercise price of $135 would expire worthless for any stock price equal to or greater than $135 (in this case $139). An investment in such a put would have a rate of return over the holding period of −100%.

Which of the following is inconsistent with efficiency? Finding that money managers tend to buy high growth stocks near the end of the quarter that have performed well. About half of the analysts' recommendations outperform the S&P500. A stocks' price runs up prior to an earnings announcement. Finding that money manager who underperformed the S&P500 in the prior month routinely outperform the S&P500 in the following month.

Finding that money manager who underperformed the S&P500 in the prior month routinely outperform the S&P500 in the following month. Explanation Finding that money manager who underperformed the S&P500 in the prior month routinely outperform the S&P500 in the following month would provide a profitable trading strategy that should lead to consistent abnormal returns. This would be a violation of efficiency.

4. You purchased 100 shares of ABC stock for $20 per share. One year later you received $1 cash dividend and sold the shares for $22 each. Your holding-period return was _______________.

HPR = (1 + 22 - 20)/20 = 15%

You buy a five-year bond that has a 3.75% current yield and a 3.75% coupon (paid annually). In one year, promised yields to maturity have risen to 4.75%. What is your holding-period return? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Holding-period return 0.18% Explanation The current yield and the annual coupon rate of 3.75% imply that the bond price was at par a year ago. Using a financial calculator, FV = 1,000, n = 4, PMT = 37.50, and i = 4.75 gives us a selling price of $964.33 this year. Holding period return = (-1,000 + 964.33 + 37.50)/1,000 =0.0018=0.18%

Which of the following statements about the CAPM are valid? I. As a theory the CAPM is not testable II. The practicality of the CAPM is testable III. CAPM betas are not as useful at predicting returns as the Fama-French factors IV. Even if the CAPM is false, markets can still be efficient

I, II, III, IV

Work by Eugene Fama and Kenneth French indicates that stock returns are a function of three factors. Which of the following are the factors they propose? I. The market index excess returnII. The ratio of the book value of equity to the market value of equityIII. The difference in returns between small and large firmsIV. Volume of tradingV. The number of institutions holding the stock

I, II, and III Explanation The Fama-French model proposes the first three as factors that determine stock returns.

The CAPM implies thatI. all investors who invest in risky assets will hold the same portfolio of risky assets.II. the risk premium of an individual security is a function of the security's contribution to the risk of the market portfolio.III. there is one unique market wide price of risk.IV. all investors hold equal proportions of the risky and the riskless asset in their complete portfolio.

I, II, and III only The CAPM implies the first three, but different individuals will hold different proportions of the risky and riskless assets that suit their own risk tolerance.

Rank the following from least risky to most risky I. Six month certificate of deposit II. Preferred stock III. Common Stock IV. Long term bonds

I, IV, II, III Explanation Six month certificates of deposit are a short term money market instrument and is the safest one on the list followed by bonds then preferred stock and finally common stock.

Which of the following are considered active strategies? I. Purchasing index fundsII. Engaging in security analysis to choose which stocks to hold this quarterIII. Following the advice of investment newslettersIV. Buying and holding a well diversified portfolio

II and III only Explanation Engaging in security analysis to choose which stocks to hold this quarter and following the advice of investment newsletters are both strategies that involve active trading.

Stock A has an expected return of 25% and a beta of 2. Stock B has an expected return of 25% and a beta of 1.6 when the risk free rate is 4%. Which of the following statements are correct? I. Stock A is underpriced relative to Stock BII. Stock B is underpriced relative to Stock AIII. This situation is inconsistent with the CAPMIV. This situation is consistent with the CAPM

II and III only Explanation The return per unit of risk for Stock A = (25% - 4%) / 2 = 10.5. The return per unit of risk for Stock B = (25% - 4%) / 1.6 = 13.12. Stock B provides a higher return per unit of risk than Stock A. Hence Stock B is underpriced relative to Stock A because Bâs return is too high. Under the CAPM these two ratios must be identical so this is inconsistent with the CAPM.

A bond with a coupon rate of 6% makes semiannual coupon payments on January 15 and July 15 of each year. The Wall Street Journal reports the ask price for the bond on January 30 at 100.2500. What is the invoice price of the bond? The coupon period has 182 days.

Invoice Price $1,004.97 Explanation The reported bond price is $1,002.500015 days have passed since the last semiannual coupon was paid, so there is an accrued interest, which can be calculated as: Accrued interest= Annual coupon payment/2 x Days since last coupon payment /Days separating coupon payment =$30 x (15/182)=$2.4725 The invoice price is the reported price plus accrued interest: $1,002.5000+$2,4725=$1,004.97

A coupon bond paying semiannual interest is reported as having an ask price of 120% of its $1,000 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? Assume that the month has 30 days. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Invoice Price $1,205 Explanation Semi-annual coupon=$1,000x6%x0.5=30 Accrued interest= (Annual coupon payment/2) x (Days since last coupon payment / Days separating coupon payment) =$30 x (30/182)= $4,945 At a price of 120, the invoice price is: $1,200 + $4,945 = $1,204.95

Which of the following is most correct concerning the standard deviation of a stock's returns?

It should be zero if the stock has the same return every year

Apparent anomalies that contradict market efficiency include all but which one of the following?

Mutual fund alphas Explanation Mutual fund alphas are on average consistent with market efficiency.

Assume that you manage a risky portfolio with an expected rate of return of 14% and a standard deviation of 22%. The T-bill rate is 5.7%. Your risky portfolio includes the following investments in the given proportions: Stock A 29% Stock B 37% Stock C 34% Suppose a client decides to invest in your risky portfolio a proportion (y) of his total investment budget with the remainder in a T-bill money market fund so that his overall portfolio will have an expected rate of return of 13.17%. a. What is the proportion y? b. What are your client's investment proportions in your three stocks and the T-bill fund? c. What is the standard deviation of the rate of return on your client's portfolio?

Proportion 0.9 Mean of portfolio = (1 - y)rf + y rP = rf + (rP - rf)y = 5.7 + 8.3 y If the expected rate of return for xthe portfolio is 13.17%, then, solving for y: 13.17 = 5.7 + 8.3 y ⇒ y = (13.17 - 5.7)/8.3 = 0.9 Therefore, in order to achieve an expected rate of return of 13%, the client must invest 90% of total funds in the risky portfolio and 10% in T-bills. b. Security Investment Proportion T-Bill 10% Stock A 26.1% Stock B 33.3% Stock C 30.6% Explanation: stock a (0.9x29%) stock b (0.9x37%) stock c (0.9x34%) σP = 0.9 × 22% = 19.8% per year

Assume that you manage a risky portfolio with an expected rate of return of 18.6% and a standard deviation of 28.2%. The T-bill rate is 6%. Suppose your risky portfolio includes the following investments in the given proportions Stock A 29% Stock B 39% Stock C 32% What are the investment proportions of your client's overall portfolio, including the position in T-bills?

Security Investment Proportions T-Bills 35% Stock A 18.8% Stock B 25.4% Stock C 20.8% Explanation: Security Inv. Prop T-Bills 35% S-A (0.65*29%)=18.8 S-B (0.65x39%)=25.4 S-C (0.65x32%)=20.8

Which of the following is typically the most liquid? a. Euro dollar deposits b. Commercial paper c. Treasury bills d. Banker's acceptances

Treasury bills Explanation Treasury bills are very actively traded and would typically be the most liquid.

A portfolio of nondividend-paying stocks earned geometric mean return of 5 percent between January 1, 2003 and December 31, 2009. The arithmetic mean return for the same period was 6 percent. If the market value of the portfolio at the beginning of 2003 was $100,000, what was the market value of the portfolio at the end of 2009?

Value(12/31/2009) = Value(1/1/2003) x (1 + g)^7 = $100,000 x (1.05)^7 = $140,710.04

Assume that you manage a risky portfolio with an expected rate of return of 18.6% and a standard deviation of 28.2%. The T-bill rate is 6%. What is the reward-to-variability ratio of your risky portfolio and your client's overall complete portfolio.

Your Reward-to-variability ratio 0.4468 Client's Reward-to-variability ratio 0.4468 Your Reward-to-variability ratio = S = (18.6 - 6)/28.2 = 0.4468 Client's Reward-to-variability ratio = (14.19-6)/18.33=0.4468

Consider the following information: Portfolio Expected Standard Return Deviation Risk-Free 5.0% 0% Market 11.2 26 A 9.2 15 a. Calculate the Sharpe ratios for the market portfolio and portfolio A. b. If the simple CAPM is valid, is the above situation possible?

a. Market Portfolio- 0.24 Portfolio A - 0.28 b. No Explanation 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 =(9.2 - 5)/15 = 0.28 SM =(11.2 - 5)/26 = 0.24 These figures imply that Portfolio A provides a better risk-reward tradeoff than the market portfolio.

The Arizona Stock Exchange lists a bid price of 1.21 and an ask price of 1.40 for Kicking Bird Energy Corporation. a. At what price can you buy the stock? (Round your answer to 2 decimal places.) Ask price $_____? b. What is the dealer's bid-ask spread? (Round your answer to 2 decimal places.) Bid-ask spread $______?

a. $1.40 You can buy the stock at the ask price of $1.40. $0.19 The dealer's bid-ask spread is $1.40 - 1.21 = $0.19.

Consider the three stocks in the following table. Pt represents price at time t, and Qt represents shares outstanding at time t. Stock C splits two-for-one in the last period. P0 Q0 P1 Q1 P2 Q2 A 81 100 86 100 86 100 B 41 200 36 200 36 200 C 82 200 92 200 46 400 Calculate the first-period rates of return on the following indexes of the three stocks: (Do not round intermediate calculations. Round your answers to 2 decimal places.) a. A market value-weighted index b. An equally weighted index

a. 4.59% b. 2.06% Explanation a. Total market value at t = 0 is: ($81 × 100) + ($41 × 200) + ($82 × 200) = $32,700Total market value at t = 1 is: ($86 × 100) + ($36 × 200) + ($92 × 200) = $34,200 Rate of return = V1/V0 - 1 = (34,200/32,700 - 1 = 0.0459 or 4.59% b. The return on each stock is as follows: b. RA 86/81 - 1 =6.17% RB 36/41 - 1 = -12.20% Rc 92/82 - 1 = 12.20% The equally-weighted average is: [6.17% + (-12.20%) + 12.20%]/3 = 2.06%

Consider a bond paying a coupon rate of 11.50% per year semiannually when the market interest rate is only 4.6% per half-year. The bond has four years until maturity. a. Find the bond's price today and six months from now after the next coupon is paid. b. What is the total rate of return on the bond?

a. Current price $1,075.54 Price after six months $1,067.52 b. Total rate of return 4.60% per six months Explanation a. The bond pays $57.50 every six months. Current price: [$57.50 × Annuity factor(4.6%, 8)] + [$1,000 × PV factor(4.6%, 8)] = $1,075.54 Assuming the market interest rate remains 4.6% per half year, price six months from now: [$57.50 × Annuity factor(4.6%, 7)] + [$1,000 × PV factor(4.6%, 7)] = $1,067.52

Problem 7-18 Consider the following information: Portfolio Expected SDeviation Risk-free 5% 0 Market 10.6 1.0 A 8.6 0.9 a. Calculate the expected return of portfolio A with a beta of 0.9. b. What is the alpha of portfolio A. c. If the simple CAPM is valid, is the above situation possible?

a. Expected return 10.04% b. Alpha = -1.44% c. No Explanation Not possible. Here, the required expected return for Portfolio A is: 5% + (0.9 × 5.6%) = 10.04% This is still higher than 8.6%. Portfolio A is overpriced, with alpha equal to: -1.44%

The yield to maturity on one-year zero-coupon bonds is 7.8%. The yield to maturity on two-year zero-coupon bonds is 8.8%. a. What is the forward rate of interest for the second year? (Do not round intermediate calculations. Round your answer to 2 decimal places.) 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? (Do not round intermediate calculations. Round your answer to 2 decimal places.) 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)?

a. Forward rate of interest 9.80% b. Short-term interest rate 9.80% c. Lower Explanation 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 + 7.8%) ×(1 + f2) = (1 + 8.8%)^2 ⇒⇒ f2 = 0.0981 = 9.81% 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 9.81%. 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 9.81%.

Which of the following is not an issuer of federal agency debt? a. Municipalities b. FHLMC c. GNMA d. FNMA

a. Municipalities Explanation State and local municipalities issue municipal bonds, not federal agency debt.

A T-bill with face value $10,000 and 83 days to maturity is selling at a bank discount ask yield of 3.0%. a. What is the price of the bill? (Use 360 days a year. Do not round intermediate calculations. Round your answer to 2 decimal places.) b. What is its bond equivalent yield? (Use 365 days a year. Do not round intermediate calculations. Round your answer to 2 decimal places.)

a. Price of the bill 9,930.83 b. Bond equivalent yield 3.06% Explanation a. Bank discount of 83 days: 0.030 ×83 days / 360 = 0.006917360 days Price: $10,000 × (1 - 0.006917) = $9,930.83b. b. Bond equivalent yield =Face value - Purchase price/Purchase price × T = $10,000 - $9,930.83 = 0.0306 or 3.06% $9,930.83 ×83 days/365 days

A 30-year maturity, 8.9% coupon bond paying coupons semiannually is callable in five years at a call price of $1,145. The bond currently sells at a yield to maturity of 7.9% (3.95% per half-year). a. What is the yield to call? (Do not round intermediate calculations. Round your answer to 2 decimal places.) b. What is the yield to call if the call price is only $1,095? (Do not round intermediate calculations. Round your answer to 2 decimal places.) c. What is the yield to call if the call price is $1,145 but the bond can be called in two years instead of five years? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

a. Yield to call 8.44% Explanation a. The bond sells for $1,114.20 based on the 3.95% yield to maturity:[n = 60; i = 3.95; FV = 1,000; PMT = 44.50] Therefore, yield to call is 4.2218% semiannually, 8.44% annually: [n = 10; PV = −1,114.20; FV = 1,145; PMT = 44.50] b. Yield to call 7.70% Explanation: If the call price were $1,095, we would set FV = 1,095 and redo part (a) to find that yield to call is 3.84940% semi-annually, 7.70% annually. With a lower call price, the yield to call is lower. c. Yield to call 9.28 % Explanation: Yield to call is 4.6388% semiannually, 9.28% annually:[n = 4; PV = −1,114.20 ; FV = 1,145; PMT = 44.50]

A zero-coupon bond with face value $1,000 and maturity of six years sells for $736.22. a. What is its yield to maturity? (Round your answer to 2 decimal places.) b. What will the yield to maturity be if the price falls to $720? (Round your answer to 2 decimal places.)

a. Yield to maturity 5.24% b. Yield to maturity 5.63% Explanation a. Using a financial calculator, PV = - 736.22, FV = 1,000, n = 6, PMT = 0. The YTM is 5.2363%. b. Using a financial calculator, PV = - 720.00, FV = 1,000, n = 6, PMT = 0. The YTM is 5.6277%.

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 1 is 7.0%. 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? Suppose you consider buying a share of stock at a price of $50. The stock is expected to pay a dividend of $5 next year and to sell then for $52. The stock risk has been evaluated at β = -0.5. c-1. Using the SML, calculate the fair rate of return for a stock with a β = -0.5. c-2. Calculate the expected rate of return, using the expected price and dividend for next year. c-3. Is the stock overpriced or underpriced?

a. expected rate of return = 7.0% b. expected rate of return = 4% c-1. fair rate of return= 2.5% c-2. 14% c-3. Because the expected return exceeds the fair return, the stock must be under-priced. Explanation a. Since the market portfolio, by definition, has a beta of 1, its expected rate of return is 7.0%. b. β = 0 means the stock has no systematic risk. Hence, the portfolio's expected rate of return is the risk-free rate, 4%. c-1. Using the SML, the fair rate of return for a stock with β = -0.5 is: E(r) = 4% + (-0.5) × (7.0% - 4%) = 2.5% c-2. The expected rate of return, using the expected price and dividend for next year: E(r) = ($52 + $5)/$50 - 1 = 0.1400 = 14.00% c-3. Because the expected return exceeds the fair return, the stock must be under-priced.

Consider the three stocks in the following table. Pt represents price at time t, and Qt represents shares outstanding at time t. Stock C splits two-for-one in the last period. P0 Q0 P1 Q1 P2 Q2 A 81 100 86 100 86 100 B 41 200 36 200 36 200 C 82 200 92 200 46 400 a. Calculate the rate of return on a price-weighted index of the three stocks for the first period (t = 0 to t = 1). (Do not round intermediate calculations. Round your answer to 2 decimal places.) b. What will be the divisor for the price-weighted index in year 2? (Do not round intermediate calculations. Round your answer to 2 decimal places.) c. Calculate the rate of return of the price-weighted index for the second period (t = 1 to t = 2).

a. rate of return 4.90% b. Divisor 2.36 c. Rate of return 0% Explanation At t = 0, the value of the index is: ($81 + $41 + $82)/3 = 68.00At t = 1, the value of the index is: ($86 + $36 + $92)/3 = 71.33 The rate of return is: V1/V0 - 1 = (71.33/68.00 - 1 = 0.0490 or 4.90% b. In the absence of a split, stock C would sell for $92, and the value of the index would be the average price of the individual stocks included in the index: ($86 + $36 + $92)/3 = $71.33. After the split, stock C sells at $46; however, the value of the index should not be affected by the split. We need to set the divisor (d) such that:71.33 = ($86 + $36 + $46)/dd = 2.36 c. The rate of return is zero. The value of the index remains unchanged since the return on each stock separately equals zero.

Consider the following information: Portfolio Expected Return Beta Risk-free 7% 0 Market 12.2 1.0 A 11.0 1.6 a. Calculate the the return predicted by CAPM for a portfolio with a beta of 1.6 b. What is the alpha of portfolio A. c. If the simple CAPM is valid, is the situation above possible?

a. return - 15.32% b. -4.32% c. No Explanation Not possible. Given these data, the SML is: E(r) = 7% + β(12.2% - 7%) A portfolio with beta of 1.6 should have an expected return of: E(r) = 7% + 1.6 × (12.2% - 7%) = 15.32% The expected return for Portfolio A is 11.0% so that Portfolio A plots below the SML (i.e., has an alpha of -4.32%), and hence is an overpriced portfolio. This is inconsistent with the CAPM.

Suppose you short-sell 100 shares of IBX, now selling at $152 per share. a. What is your maximum possible loss? The maximum possible loss is ____ b. What happens to the maximum loss if you simultaneously place a stop-buy order at $162.60? (Do not round intermediate calculations. Input the amount as a positive value.) The maximum possible loss is now $ 1,060

a. unlimited In principle, potential losses are unbounded, growing directly with increases in the price of IBX. b. $1,060 As the market value of the stock exceeds the price at which the short sale was executed, losses begin to incur, one-for-one per every dollar increase. The stop-buy order can limit these losses by buying shares of the stock when it rises above a predetermined stop-buy price. In this case, the stop-buy price is $162.60, and the loss is limited to -$162.60 + $152 = -$10.60 per share, for a total loss of $10.60 x 100 shares = $1,060.

equity

an ownership share in a corporation also known as common stock in a firm represents as ownership share in the corporation. Equity holders are not promised any particular payment. They receive any dividends the firm may pay and have prorated ownership in the real assets of the firm. They are dependent on how successful the firm is.

An investor begins to build her investment portfolio by choosing individual securities. She is engaging in what is called __________ or __________.

bottom up; security selection Explanation Building a portfolio by choosing individual securities that appear to be attractively priced is called security selection or taking a bottom up approach.

. The Term Structure The current five year interest rate is 4.60% and the current four year interest rate is 4.30%. The implied forward rate from year four to year five is ______. Multiple Choice a. 4.80% b. 4.45% c. 5.81% d. 5.60%

c. 5.81% Explanation The forward rate (f) can be calculated from the long term rates (y) using the following relationship: (1+y5)^5 = (1+y4)^4(1+4f5)^1 or 4^f5 = (1.046^5 / 1.043^4) - 1 = 5.81%

TIPS are a. issues of federal government agencies b. bonds issued in a currency other than the currency of the country in which it is issued. c. Treasury bonds whose principal is adjusted according to increases in the CPI d. Treasury bonds whose coupon is adjusted for inflation

c. Treasury bonds whose principal is adjusted according to increases in the CPI Explanation TIPS provide investors with some inflation protection as their principal is adjusted by changes in the CPI. Note that the CPI may understate actual inflation however.

The Rendleman, Jones and Latane study found a short term momentum effect around ________________that is counter to market efficiency.

earnings announcements Explanation Firms that had superior earnings tended to have positive abnormal stock returns after the earnings were announced. This violates efficiency.

A market where newly issued securities are offered to the public is called a/an a. OTC market b. derivatives market c. primary market d. secondary market

primary market The term primary market is applied to the market where new securities are created and sold to the public.

A share of Microsoft stock is bought and sold among individual investors. This is an example of a _______. Microsoft ______ from the transaction.

secondary market transaction; receives no funds. The purchase or sale of a pre-existing security is a secondary market transaction. Secondary market transactions do not provide any funds to the company that issued the shares.

Of the alternatives available, __________ typically have the highest standard deviation of returns.

stocks

An investor shorted stock that is currently trading at $52.75 a share. She is now worried about taking losses from an unfavorable price move, although she is not yet ready to close out the position. It may make sense for the investor to enter a ______________ order at ______ per share.

stop buy; $54.25 Since she shorted the stock she has an obligation to buy the stock back and she is at risk from rising stock prices. A stop buy order becomes a market buy order when the trigger price is encountered so a stop buy at $54.25 will limit her losses to approximately $1.50 per share if the market rises to $54.25.

An analyst identifies a head and shoulders price trend for a stock and buys the security. This is a form of __________.

technical analysis Explanation Technical analysis is using price and volume information to predict future price changes.

Money Market Instruments All else equal which one of the following will usually have the lowest yield? Commercial Paper Banker's Acceptance Certificate of Deposit Treasury Bill

treasury bill Explanation Treasury bills have the lowest default risk and are the most liquid. Both features lead to lower yields.

Historically, which security had the lowest standard deviation?

U.S. Treasury bills

In the following Venn diagram of forms of market efficiency the I. is the ____________, II. is the ____________, and the III. is the ____________. (((III)))) ((II)) (I)

weak form; semi-strong form; strong form Explanation The strong form includes the weak and semi-strong forms. The semi-strong form includes the weak form.

A complete portfolio holds _______________.

risky and risk-free assets

A Treasury bill pays a 6% rate of return. A risk averse investor __________ invest in a risky portfolio that pays 12% with a probability of 40% or 2% with a probability of 60% because __________.

would not; because she is not rewarded any risk premium T-bill give 6% return with 100% certainty (no risk), the other risky portfolio also gives E(R) = 6%, but with uncertainty (with risk), therefore, risk-averse investors will not choose the risky portfolio because she is not rewarded any risk premium

BearM NormM BullM Prob 0.2 0.5 0.3 Stock X -20% 18% 50% Stock Y -15% 20% 10%

σX2 = [0.2 x (-20 - 20)^2 ] + [0.5 x (18 - 20)^2 ] + [0.3 x (50 - 20)^2 ] = 592 σX = 24.33% σY = [0.2 x (-15 - 10)^2 ] + [0.5 x (20 - 10)^2 ] + [0.3 x (10 - 10)^2 ] = 175 σY = 13.23% σ= standard deviation