Instructor's Problem Set: Investments

Instructors Problem
Set
Investments
Haim Levy
Thierry Post
ISBN 0 273 68511 2
Pearson Education Limited 2005
1
Chapter 1 Introduction
MULTIPLE CHOICE QUESTIONS
1. Which o the o!!o"in# is not a $asic component o the investment process%
&. investor characteristics
'. investment vehic!es
C. strate#y deve!opment
(. strate#y monitorin#
E. &!! o the a$ove are $asic components o the investment process.
2
MULTIPLE CHOICE QUESTIONS: ANSWERS
1. E
)
OPEN QUESTIONS
1. *+o!!o"in# the investment process a!!o"s investors to identiy an optima! porto!io and stic,
"ith it indeinite!y.-
(o you a#ree "ith this statement% Why or "hy not%
Answer:
The statement is a!se. The investment process is dynamic and never.endin#. Investor
characteristics chan#e as time passes. +or e/amp!e0 o!der investors tend to $e more ris,.averse
than youn#er investors. Even i one can identiy an optima! porto!io at a #iven point in time0
the porto!io1s characteristics may chan#e over time. 2uppose an investor determines that his or
her optima! asset a!!ocation is )03 cash0 503 $onds0 and 203 stoc,s. I stoc,s su$se4uent!y
perorm very "e!!0 their va!ues "i!! increase0 causin# stoc,s to represent more than 203 o the
investor1s "ea!th. &s investor characteristics0 economic actors0 and mar,et actors chan#e0 it
"i!! $e necessary or investors to ad5ust their investment strate#ies. The processes o strate#y
deve!opment0 imp!ementation0 and monitorin# #o on continuous!y.
6
Chapter 2 'onds0 2toc,s and 7ther 2ecurities
1. Which type o ris, is aced $y ho!ders o corporate $onds that can $e considered non.e/istent $y
ho!ders o #overnment $onds%
&. orei#n e/chan#e rate ris,
'. in!ation rate ris,
C. mar,et ris,
(. deau!t ris,
5
1. (
8
OPEN QUESTIONS
1. E/p!ain "hat is meant $y the o!!o"in# statement9
*The o"nership o the irm is residua! in nature.:
Answer:
This statement reers to the act that common shareho!ders receive "hat is !et over ater a!! other
c!aims on the irm have $een provided.
2. (escri$e the dierences $et"een inancia! assets and physica! assets or each o the o!!o"in#
characteristics.
a. (ivisi$i!ity
b. ;ar,eta$i!ity
c. Ho!din# period
Answer:
a. &n asset is divisi$!e i you can $uy and se!! sma!! portions o it. +inancia! assets are easi!y
divisi$!e0 "hi!e most physica! assets <such as actories= are not.
b. &n asset is mar,eta$!e <or !i4uid= i it can 4uic,!y and easi!y $e so!d or cash "ithout aectin#
its va!ue. ;ost physica! assets <such as houses= are i!!i4uid. +inancia! assets typica!!y are more
mar,eta$!e than physica! assets0 even thou#h some inancia! assets <such as stoc,s= are much
more !i4uid than others <such as stamps=.
c. Those "ho purchase physica! assets usua!!y intend to ho!d them or a !on# time0 $ecause such
assets are not e/pected to provide cash !o"s unti! some time has passed. In contrast0
investors "ho $uy inancia! assets oten p!an to ho!d them or on!y a very short time.
>
Chapter ) 2ecurity ;ar,ets
MULTIPLE CHOICE
1. ?ou purchase shares "ith a mar,et price o @80 "hen the initia! mar#in re4uirement is A03. The
maintenance mar#in is )03. What is the hi#hest price that "i!! tri##er a mar#in ca!!%
&. @A
'. @ 12
C. @ 1>
(. @ 26
E. @ 6A
2. Which type o under"ritin# arran#ement re4uires the under"riter to $uy the entire ne" issue
rom the issuin# corporation at a predetermined price0 and a$sor$ a!! unso!d shares or his o"n
account at this price%
&. irm commitment
'. $est eort
C. stand$y commitment
(. contractua! oerin#
E. ri#hts issue

A
1. C
. A
B
OPEN QUESTIONS
1. What is mar#in tradin#0 and "hy is it considered ris,y%
Answer:
Tradin# on mar#in reers to an investor $uyin# securities $y irst $orro"in# a portion o the
unds needed rom his or her $ro,er. 'y $orro"in#0 the investor can ta,e a !ar#er position
than other"ise "ou!d $e possi$!e. This *!evera#e- ma#niies the possi$!e positive0 and
ne#ative0 returns the investor aces.
2. 2uppose you purchase 500 shares o &'C Company common stoc, at @>5 per share $y
$orro"in# unds rom your $ro,er. ?our initia! mar#in is 8530 the maintenance mar#in 553.
a. Ho" much o your o"n money "i!! you have to provide%
b. What is the price at "hich you "ou!d $e#in to receive a mar#in ca!!%
Answer:
a. 'ased on the inormation #iven and the notation rom the chapter0 N C 5000 P C @>50 IM C
0.850 and MM C 0.55. ?ou $uy 500 D @>5 C @)>0500 "orth o common stoc,s and the 853
mar#in means you have to provide 0.85 D )>0500 C @260)>5.
?ou can a!so use E4uation ).1 to arrive at this num$er9
+rom E4uation ).1 "e o$serve
IM D <N D P= C N D P E B
Thus0 the amount initia!!y provided e4ua!s IM D <N D P= C 0.85 D <500 D @>5= C @260)>5.
b. The mar#in ca!! price is $ased on E4uation ).20 "hich is
)) . 5A @
225
125 0 1) @
= 55 . 0 1 < 500
)>5 0 26 @ >5 @ 500
= 1 <
= =
=
MM N
B
P
). The price <P1=0 $e!o" "hich you "i!! $e ca!!ed or the maintenance mar#in can $e e/pressed
"ithout the amount $orro"ed <B=. (eve!op and e/p!ain this ormu!a.
Answer:
+rom e4uation ).21 "e have
= 1 < MM N
B
= P
10
Ho"ever0 E4uation ).1 is
P N
B P N
IM

=
&nd so!vin# or the !oan $a!ance "e have
B C N D P E IM D <N D P= C N D P D <1 E IM=
2u$stitutin# B or our resu!t here0 "e have
P1 C
= 1 <
= 1 <
MM N
IM P N

(ividin# a!! terms $y N0 "e have
P1 C
= 1 <
= 1 <
MM
IM P

11
Chapter 6 Institutiona! Investors
1. Which type o und is most !i,e!y to invest in hi#h.#rade commercia! paper%
&. e4uity und
'. $ond und
C. $a!anced und
(. money mar,et mutua! und
E. inde/ und
2. & mutua! und o"ns securities "ith a mar,et va!ue o @B000000000 has 5000000 shares
outstandin#0 o"es its emp!oyees @20000000 and has a )3 !oad char#e. The net asset va!ue per
share is9
&. @1A.00
'. @1A.B0
C. @18.A5
(. @1>.80
E. @1A.6A
). The current mar,et va!ue o a!! securities he!d $y a und !ess any !ia$i!ities0 divided $y the num$er
o shares outstandin# is the9
&. $oo, va!ue
'. net asset va!ue
C. mar,et va!ue
(. net proit
E. share price
12
. !
2. !
". #
OPEN QUESTIONS
1)
1. The &'C +und0 a c!osed.end und0 consists o three securities E 10000 shares o 2ecurity &0
"hich is current!y tradin# or @)5F 20000 shares o 2ecurity '0 "hich is tradin# or @65F and
)0000 shares o 2ecurity C0 "hich is tradin# or @55. What is its G&H i the und has @A>0000
in net !ia$i!ities and 100000 shares outstandin#%
Answer:
G&H C I10000<@)5= J 20000<@65= J )0000<@55= E @A>0000KL100000
C I@)50000 J @B00000 J @1850000 E @A>0000KL100000
C @20)0000L100000 C @20.)0
2. Why must open.end unds ,eep more cash on hand than c!osed.end unds%
Answer:
7pen.end unds must $e ready at a!! times to repurchase shares rom the pu$!ic0 so the unds
must ,eep some cash on hand at a!! times. I they did not0 they "ou!d $e orced to se!! assets
every time investors redeemed their shares and "ou!d incur si#niicant transaction costs.
C!osed.end unds do not have to $e concerned "ith day.to.day !i4uidity needs $ecause such
unds do not a!!o" investors to redeem shares.
). Can mutua! unds $e so!d at a discount% &t a premium% E/p!ain.
Answer:
;utua! und shares are priced at net asset va!ue and may $e so!d at an oer price that inc!udes
a !oad. ;utua! unds do not trade at a premium or discount rom G&H0 as do c!osed.end
unds.
16
Chapter 5 2ecurity Me#u!ation and Investment Ethics
1. Which o the o!!o"in# created the 2ecurities and E/chan#e Commission%
&. 2ecurities &ct o 1B))
'. N!ass.2tea#a!! 'an,in# &ct o 1B))
C. 2ecurities E/chan#e &ct o 1B)6
(. 2ecurities &cts &mendments o 1B>5
E. Emp!oyee Metirement Income 2ecurity &ct o 1B>6
2. Which o the o!!o"in# statements a$out corporate #overnance is "ron#%
&. Corporate #overnance is important $ecause it is the rame"or, throu#h "hich shareho!ders
can $e assured o !e#a! comp!iance.
'. Corporate #overnance is a method o contro!!in# the corporation.
C. Corporate #overnance esta$!ishes the appropriate ethica! conduct o the corporation.
(. Corporate contro! usua!!y rests "ith the CE70 "ho is e!ected $y the common shareho!ders.
E. With the increasin# concentration o shares he!d $y !ar#e institutiona! investors0 the ro!e o
active corporate #overnance on the part o the shareho!ders "i!! increase.
). Which o the o!!o"in# statements a$out churnin# is "ron#%
&. Churnin# is $uyin# and se!!in# e/cessive amounts or a c!ient.
'. It is diicu!t to prove in most cases "hether churnin# has occurred or "hether the $ro,er is
pursuin# some sort o investment strate#y.
C. Churnin# is i!!e#a! under 2EC ru!es as "e!! as the ru!es o a!! ma5or e/chan#es.
(. The courts have used the ratio o commissions to invested e4uity to determine "hether
e/cessive tradin# e/ists.
E. Churnin# is unethica! $ut not un!a"u!.
15
1. C
. !
". E
OPEN QUESTIONS
18
1. & $ro,er recommends severa! chan#es to your porto!io. ?ou ma,e severa! chan#es a month
$ased on your $ro,er1s recommendations. &t the end o si/ months your porto!io returns are
e/ceeded $y your commission costs. Has your $ro,er acted i!!e#a!!y%
Answer:
The $ro,er may $e #ui!ty o churnin#0 "hich is i!!e#a! under 2EC Mu!e 10$.5. To prove
churnin#0 the courts have used three tests to determine "hether e/cess tradin# e/isted9
1. &nnua!iOed turnover ratio <ho" re4uent!y securities are traded=.
2. Matio o commissions to invested e4uity.
). The proportion o commissions derived $y the $ro,er rom the account in 4uestion
compared "ith a!! other accounts hand!ed $y that $ro,er
2. What are the dierences $et"een re#u!ations and ethics%
Answer:
Me#u!ations are ru!es esta$!ished $y #overnments or the purpose o identiyin# unaccepta$!e
$ehavior. Ethics em$odies the idea!s "e shou!d strive or and ho" "e shou!d $ehave. &
$ehavior that is unaccepta$!e $ased on ethica! standards may $e ound accepta$!e $y e/istin#
re#u!ations.
). (escri$e a situation in "hich a corporate mana#er1s $ehavior is unethica! $ut not un!a"u!.
Answer:
&n e/amp!e "ou!d $e a CE7 nominatin# peop!e "ho are dependent on him or her to the
$oard o directors0 "hich determines his or her compensation. This action is c!ear!y unethica!
$ut not un!a"u!.

1>
Chapter 8 Mates o Meturn
1. Which o the o!!o"in# shou!d $e used "hen estimatin# the avera#e perormance across
dierent securities or one period o time%
&. #eometric avera#e
'. arithmetic avera#e
C. compound avera#e
(. comp!e/ avera#e
1A
1. #
OPEN QUESTIONS
1B
1. The ta$!e $e!o" provides a history o stoc, prices and dividends or 'isma! Company stoc,.
Compute the ater.ta/ return to an investor "ho $uys 100 shares o 'isma! stoc, on Panuary 1
and se!!s the stoc, on (ecem$er )1. &ssume the ta/ rate on ordinary income is 203 and the ta/
rate on capita! #ains income is 2A3.
!ate !$v$%en%
Mar&et Pr$ce W'en
!$v$%en% Is Rece$ve%
Panuary 1 @)8
Panuary 15 @0.A5 @62
&pri! 15 0.A5 @62
Pu!y 15 0.A5 @66
7cto$er 15 0.A5 @60
(ecem$er )1 @60
Answer:
Qsin# the !in,in# method9
!ate Mar&et
Pr$ce
W'en
!$v$%en%
Is
Rece$ve%
!$v$%en% Inter$m
Per$(%
A)ter*
ta+
A)ter*ta+
Inter$m
Rate ()
Ret,rn
T$me*
We$-'te%
Rate ()
Ret,rn
1.Pan @)8
15.Pan @62 @0.A5 1 1A.)>3 1A.)>3
15.&pr @62 0.A5 2 1.65>1 20.0B16
15.Pu! @66 0.A5 ) 8.21B 2>.58
15.7ct @60 0.A5 6 E>.>000 1>.>)>B
)1.(ec @60 5 E2.0000 15.)A)1
The return or interim periods 1 throu#h 6 is9
R1 C I62 E )8 J 0.A5<1 E 0.2A=KL)8 C 1A.)88>3.
R2 C I62 E 62 J 0.A5<1 E 0.2A=KL62 C 1.65>13.
R) C I66 E 62 J 0.A5<1 E 0.2A=KL62 C 8.21B03.
R6 C I60 E 66 J 0.A5<1 E 0.2A=KL66 C E>.>0003.
20
The ater.ta/ rate o return or interim period 5 is9
R5 C I60 E 60 E <60 E )8=<0.20= J <0=<1 E 0.2A=KL60 C E2.00003.
The ater.ta/ return or the year is
<1.1A)88>=<1.0165>1=<1.0821B0=<0.B2)000=<0.BA0000= E 1 C 15.)A)03.
2. (escri$e three dierent "ays inde/es can $e constructed.
Answer:
Inde/es can $e constructed usin# the price."ei#hted0 va!ue."ei#hted0 or e4ua!!y."ei#hted
methods. The price."ei#hted inde/ "ei#hts its component securities $y their mar,et price0
"hereas the va!ue."ei#hted inde/ "ei#hts its component securities on their e4uity va!ue. The
e4ua!!y."ei#hted inde/ "ei#hts each security e4ua!!y.
). The o!!o"in# ta$1e sho"s the G?2E composite inde/ over a recent 15.year period9
En% () N.SE
.ear C(m/(s$te
1BAA 158.28
1BAB 1B5.01
1BB0 1A0.6B
1BB1 22B.66
1BB2 260.21
1BB) 25B.0A
1BB6 250.B6
1BB5 )2B.51
1BB8 )B2.)0
1BB> 511.1B
1BBA 5B5.A1
1BBB 850.)0
2000 858.A>
2001 5AB.A0
2002 6>2.A>
200) 868.60
&. I#norin# dividends0 ca!cu!ate the simp!e annua! rates o return.
'. Ca!cu!ate the arithmetic avera#e o the annua! rates o return.
C. Ca!cu!ate the #eometric avera#e o the annua! rates o return.
21
(. Compare your ans"ers in Parts $ and c. Ho" do you account or the dierence $et"een
these avera#es%
Answer:
&. The interim rates o return are $ased on E4uation 8.1 and are #iven in the o!!o"in# ta$!e9
En% () N.SE Inter$m
.ear C(m/(s$te
Rate ()
Ret,rn
1BAA 158.28
1BAB 1B5.01 0.26A0
1BB0 1A0.6B .0.0>68
1BB1 22B.66 0.2>1
1BB2 260.21 0.06>
1BB) 25B.0A 0.0>A
1BB6 250.B6 .0.0)16
1BB5 )2B.51 0.)1
1BB8 )B2.)0 0.1B05
1BB> 511.1B 0.)0)
1BBA 5B5.A1 0.188
1BBB 850.)0 0.0B1
2000 858.A> 0.010
2001 5AB.A0 .0.102
2002 6>2.A> ..1BA
200) 868.60 0.)8>
'. The arithmetic avera#e o these 15 rates o return is9
A R
C <0.26A0 . 0.0>68 J 0.2>1 J 0.06> J 0.0>A . 0.0)16 J 0.)1 J 0.1B05 J 0.)0) J 0.188
J 0.0B1 J 0.010 E 0.102 E 0.1BA J 0.)8>=L15 C 1.8>55L15 C 0.111> or 11.1>3
C. The #eometric avera#e o these 15 rates o return is9
1L15
868.60
1 B.B)3
158.28
G
R

= =

(. The dierence in the avera#es is due to the varia$i!ity o rates o return. When there is no
varia$i!ity0 the avera#es are identica!.
22
2)
Chapter > +undamenta!s o Porto!io &na!ysis
1. Which o the o!!o"in# statements a$out ris, is correct%
&. I a!! investors "ere ris, averse0 there "ou!d $e no positive ris, premium.
'. The variance o return is a measure o the dispersion around the mean and is used as a
measure o ris,.
C. Mis,.neutra! investors are "i!!in# to pay a hi#her price or an asset "hose variance increases.
(. Investors are ris, averse "hen they i#nore an asset1s variance and on!y consider the asset1s
e/pected return.
E. ;ost investors are ris, neutra!.
2. &n ana!yst deve!oped the o!!o"in# pro$a$i!ity distri$ution o potentia! rates o return or 2toc, R
under three scenarios and !ater revised the e/pected rate o return or each scenario9
Or$-$na0 E+/ecte% Rev$se% E+/ecte%
Scenar$( Pr(bab$0$t1 Rate () Ret,rn Rate () Ret,rn
1 0.20 0.20 0.210
2 0.50 0.)0 0.)10
) 0.)0 0.50 0.525
I the ori#ina! variance o the e/pected rate o return "as 0.01260 2toc, R1s revised standard
deviation o e/pected return "i!! $e9
&. 0.1050.
'. 0.1116.
C. 0.1161.
(. 0.118B.
26
1. #
2. !
25
OPEN QUESTIONS
1. Niven the o!!o"in# inormation0 ca!cu!ate the E<M=0 variance0 and standard deviation.
2tate o economy Pro$a$i!ity ;utua! und Common stoc, Certiicate o deposit
Wea, #ro"th ))3 A3 83 >3
;oderate #ro"th ))3 103 123 >3
2tron# #ro"th ))3 123 153 >3
E/pected return SSSS SSSS SSSS
2tandard deviation SSSS SSSS SSSS
Answer:
;utua! und
Pr(bab$0$t1 HPR P2HPR3 4HPR*E2R35
P4HPR*E2R35
))3 A3 2.863 <A E B.B=

2
1.1B1)
))3 103 ).)03 <10 E B.B=
2
0.00))
))3 123 ).B83 <12 E B.B=
2
1.655)
E<M= C B.B0
Hariance
2
C 2.86BB
2tandard deviation C 1.82>B
Common stoc,
))3 83 1.BA3 <8 E 10.AB=
2
>.AB10
))3 123 ).B83 <12 E 10.AB=
2
0.6088
))3 153 6.B53 <15 E 10.AB=
2
5.5>66
E<M= C 10.AB3
Hariance
2
C 1).5080
2tandard deviation C ).8>51
Certiicate o deposit
))3 >3 2.)13 <> E >=
2
0
))3 >3 2.)13 <> E>=
2
0
))3 >3 2.)13 <> .>=
2
0
E<M= C 8.B)3 0 Mound to >3
Hariance
2
C 0
2tandard deviation C 0

Gote that the certiicate o deposit has 0 variance and standard deviation0 meanin# no ris,.
28
2. Ge/t year a security "i!! yie!d @B0 "ith a pro$a$i!ity o T and @110 "ith a pro$a$i!ity o T. &n
investor is "i!!in# to pay @A0 or this asset today. The ris,.ree interest rate is 153.
a. Is this investor a ris, see,er or a ris, averter%
b. What is the ris, premium%
Answer:
a. The rates o return are <@B01@A0= . 1 C 0.125 and <@110L@A0= . 1 C 0.)>5. The e/pected rate
o return is
E<M= C T U <12.53= J 1L2 U <)>.53= C 253
and $ecause this e/pected return e/ceeds the ris,!ess interest rate0 "e ,no" that this investor
is a ris, averter.
b. The ris, premium is e4ua! to the e/pected return !ess the ris,!ess rate or 253 . 153 C 103.
). &ns"er Vuestion 26 assumin# that the investor is ready to pay @B5 or this asset.
Answer:
a. In this case0 the rates o return are <@B0L@B5= . 1 C .0.05) and <@110L@B5= . 1 C 0.15>B. The
e/pected rate o return is
E<M= C T U <.5.)3= J T U <15.>B3= C 5.2653
and $ecause this e/pected return does not e/ceed the ris,!ess interest rate0 "e ,no" that this
investor is a ris, see,er.
b. The ris, premium is e4ua! to the e/pected return !ess the ris,!ess rate or 5.253 . 15.03 C
.B.>53.
2>
Chapter A ;ean.Hariance &na!ysis
1. Which o the o!!o"in# is not a varia$!e in the ca!cu!ation o the variance o a porto!io%
&. the corre!ations $et"een assets
'. the variance o each asset
C. the e/pected return o each asset
(. the proportion invested in each asset
E. the covariances $et"een assets
2. The corre!ation $et"een Compa4 and PiOer is9
&. 0.1B
'. 0.68
C. 0.51
(. 0.86
E. 0.)A
). The variance o the porto!io0 composed o 253 invested in Compa4 and >53 invested in
PiOer0 is9
&. 12.))
'. 1).B6
C. 152
(. 166
E. 1>8
2A
1. C
2. C
). C
2B
OPEN QUESTIONS
1. (escri$e an assetWs ris, "hen he!d "ith other assets in a porto!io.
Answer:
The variance o the returns on the asset is the measure o ris, o that asset "hen an investor
ho!ds on!y one asset. Ho"ever0 "hen the investor ho!ds more than one ris,y asset0 the ris, o
an individua! asset is a unction not on!y o its o"n variance $ut a!so o its de#ree o
dependency on the other assets in the porto!io.
2. Ca!cu!ate the corre!ation o 2toc, C "ith 2toc, (.
State ()
Ec(n(m1 Pr(bab$0$t1 St(c& C St(c& !
E/ce!!ent 0.6 203 03
Wonderu! 0.8 03 103
Answer:
We must irst ca!cu!ate C,D0 C0 and D. These ca!cu!ations0 in turn0 re4uire us to compute
E<RC= and E<RD=.
E<RC= C 0.6<203= J 0.8<03= C A3.
E<RD= C 0.6<03= J 0.8<103= C 83.
2
C C 0.6<0.20 E 0.0A=
2
J 0.8<0 E 0.0A=
2
C 0.00B8.
2
D C 0.6<0 E 0.08=
2
J 0.8<0.10 E 0.08=
2
C 0.0026.
C,D C 0.6<0.20 . 0.0A=<0 . 0.08= J 0.8<0 . 0.0A=<0.10 . 0.08= C .0.006A.
C,D C E0.006AL<0.00B8=
1L2
<0.0026=
1L2
C E1. The assets are perect!y ne#ative!y corre!ated.
). The pro$a$i!ity distri$utions o returns or 2toc, & and 2toc, ' are #iven $e!o"9
State ()
Ec(n(m1 Pr(bab$0$t1 St(c& A St(c& #
'ad 0.2 E53 03
7X 0.) 03 153
Nood 0.5 103 )03
a. Ca!cu!ate the e/pected returns or 2toc, & and 2toc, '.
b. Ca!cu!ate the corre!ation o 2toc, & "ith 2toc, '.
c. Porto!io V is ormed $y investin# A03 in 2toc, & and 203 in 2toc, '. Ca!cu!ate the
e/pected return and standard deviation o Porto!io V.
Answer:
a. E<RA= C 0.2<E53= J 0.)<03= J 0.5<103= C 63.
)0
<RB= C 0.2<03= J 0.)<153= J 0.5<)03= C 1B.53.
b. A,B C 0.2<E0.05 E 0.06=<0 E 0.1B5= J 0.)<0 E 0.06=<0.15 E 0.1B5= J 0.5<0.10 E 0.06=
<0.)0 E 0.1B5= C 0.00>2.
Ca!cu!ate variances9

2
A C 0.2<E0.05 E 0.06=
2
J 0.)<0 E 0.06=
2
J 0.5<0.10 E 0.06=
2
C 0.00)B.

2
B C 0.2<0 E 0.1B5=
2
J 0.)<0.15 E 0.1B5=
2
J 0.5<0.)0 E 0.1B5=
2
C 0.01)>25.
Ca!cu!ate corre!ation9
A,B C 0.00>2L<0.00)B=
1L2
<0.01)>25=
1L2
C 0.BA6.
c. E(RQ) = 0.8(4%) + 0.2(19.5%) = 7.1%.

2
Q C 0.2
2
<0.00)B= J 0.A
2
<0.01)>25= J 2<0.2=<0.A=<0.00>2= C 0.011266.
)1
Chapter B Porto!io (iversiication
1. Tota! ris, decrease as the9
&. num$er o stoc,s in the porto!io decreases
'. corre!ation $et"een the returns o the securities in the porto!io decreases
C. corre!ation $et"een the returns o the securities in the porto!io increases
(. num$er o dierent industries in the porto!io decreases
E. num$er o stoc,s in the same industry increases
2. (iversiication is most eective "hen security returns are9
&. ne#ative!y corre!ated
'. positive!y corre!ated
C. !o"
(. hi#h
E. uncorre!ated
)2
1. #
2. A
))
OPEN QUESTIONS
1. E/p!ain the statement9 *& !itt!e diversiication #oes a !on# "ay.-
&ns"er9
In #enera!0 the #reater the num$er o securities in a porto!io0 the !o"er the porto!io1s variance.
Ho"ever0 as the num$er o securities increases0 the incrementa! contri$ution to the reduction in
the porto!io1s variance $ecomes sma!!er and sma!!er. Thereore0 the #reatest #ain is achieved $y
diversiyin# in a re!ative!y e" securities
2. Why do most mutua! unds ho!d hundreds o stoc,s0 "hi!e it can $e sho"n that a$out B03 o
the ma/imum potentia! $eneit rom diversiication <"hen considerin# typica! Q.2. stoc,s= is
achieved "ith a porto!io composed o t"e!ve to ei#hteen securities%
&ns"er9
+irst o a!!0 a!thou#h the $eneit rom inc!udin# more stoc,s in the porto!io diminishes0 the
$eneit is sti!! positive. &n individua! investor "ho aces !ar#e inormation and transaction costs
cannot studyLtrade hundreds o stoc,s. +or a !ar#e mutua! und0 ho"ever0 the inormation and
transaction costs per @1 invested is so sma!! that it is sti!! "orth"hi!e to increase the num$er o
assets in the porto!io and en5oy the !itt!e ensuin# $eneit rom ris, reduction.
2econd0 !ar#e unds cannot concentrate on a !imited num$er o stoc,s "ithout their $uyin# and
se!!in# #reat!y aectin# the price o those securities.
). *Investors "ith !ess than @1000000 shou!d stic, "ith mutua! unds $ecause o diversiication
$eneits.- Eva!uate this statement.
&ns"er9
Whi!e it is true that mutua! unds "i!! provide the $eneits o diversiication0 these $eneits are
not ree. The cost o diversiication throu#h mutua! unds can $e anythin# $et"een 13 and )3
per annum. The e/tra diversiication $eneits a mutua! und can provide to sma!! investors must
out"ei#h these costs in order to $e "orth"hi!e.
)6
Chapter 10 The Capita! &sset.Pricin# ;ode!
1. &n investor invests 603 o her "ea!th in a ris,y asset "ith an e/pected rate o return o 153 and
a standard deviation o 203. The rest o her "ea!th is invested in the ris,.ree asset0 "hich
yie!ds 83. What are the e/pected return and standard deviation o her porto!io%
&. E<R= C A.030 C 123
'. E<R= C B.830 C A3
C. E<R= C B.830 C 123
(. E<R= C 11.630 C 123
2. Go matter ho" !ar#e the num$er o stoc,s in the porto!io is0 the ris, that cannot $e diversiied
a"ay is the9
&. company.speciic ris,
'. unsystematic ris,
C. systematic ris,
(. uni4ue ris,
E. $oth a and $
)5
1. #
2. C
)8
OPEN QUESTIONS
1. 2uppose investors can $orro" and !end at the ris,.ree rate o >3. Poyce Root "ants the
e/pected return o her tota! porto!io to $e 153. Her inancia! p!anner has to!d her that this "i!!
re4uire her to invest some o her money in the ris,.ree asset and the rest in a ris,y asset <asset
&= that has an e/pected return o )03. With this investment p!an0 the ris, o Poyce1s comp!ete
porto!io "i!! $e 203. What is the standard deviation o Porto!io P%
Answer:
Qse E4uation 10.2. The e/pected return o Poyce1s porto!io "i!! $e 153 i
153 C !<>3= J <1 E !=<)03=.
2o!vin#0
! C 0.852 and <1 E != C 0.)6A.
Go" use E4uation 10.) to so!ve or the standard deviation o asset &9
0.20 C <1 E !=A C 0.)6AA. 2o!vin#0 A C 5>.53.
2. Me#ressin# returns or 2toc, & a#ainst returns or the mar,et porto!io yie!ded the o!!o"in#
resu!ts9 2toc, &1s a!pha is 230 2toc, &1s $eta is 20 and the standard deviation o 2toc, &1s
returns is 603. The standard deviation o the mar,et1s returns is 103.
&. Where does 2toc, &1s characteristic !ine intercept the vertica! a/is%
'. What is the s!ope o 2toc, &1s characteristic !ine%
C. What is the systematic ris, o 2toc, &%
(. What is the uni4ue ris, o 2toc, &%
Answer:
&. &!pha is the intercept or the characteristic !ine < C 0.02=.
'. 'eta is the s!ope o the characteristic !ine < C 2=.
C. Qsin# E4uation 10.A0 the systematic ris, is
2
"
2
# C 2
2
<0.10=
2
C 0.06.
E. Qsin# E4uation 10.A0 the uni4ue ris, is
2
" .
2
"
2
# C 0.60
2
E 2
2
<0.10=
2
C 0.18 E 0.06 C 0.12.
)>
). & porto!io that is invested 5LB in 2toc, & and 6LB in 2toc, ' has an e/pected return o 203.
St(c& A St(c& #
E+/ecte%
Ret,rn
Got avai!a$!e 2A3
6ar$ance 0.06A6 0.0)26
#eta 0.8 1.5
What are the ris,.ree rate and the e/pected return on the mar,et%
Answer:
The $eta o the porto!io is the "ei#hted avera#e o the $etas o 2toc, & and 2toc, '9
$ C <5LB=<0.8= J <6LB=<1.5= C 1.
2ince the $eta o the porto!io is the same as the mar,et1s $eta0 the porto!io1s e/pected return
<203= must $e e4ua! to the mar,et1s e/pected return.
&dditiona!!y0 the capita! asset pricin# mode! must ho!d or a!! assets in e4ui!i$rium. +or 2toc, '0
"e have
2A3 C ! J 1.5<203 E !=. 2o!vin#0 ! C 63.
To chec, these resu!ts "e can use C&P; to so!ve or 2toc, &1s e/pected return9
E<RA= C 63 J 0.8<203 E 63= C 1).830
and ca!cu!ate the porto!io1s e/pected return as the "ei#hted avera#e o the e/pected returns o
2toc, & and 2toc, '9
E<R$= C <5LB=<1).83= J <6LB=<2A3= C 203.
)A
Chapter 11 &r$itra#e Pricin# Theory
1. Which o the o!!o"in# statements a$out the sin#!e inde/ mode! <2I;= is correct%
&. The 2I; re4uires more computations to so!ve or the mean.variance eicient set.
'. The 2I; can decompose ris, into its systematic component and unsystematic component.
C. The 2I; c!aims that $oth the systematic and unsystematic ris,s can $e diversiied a"ay.
(. The 2I; assumes that a irmWs speciic ne"s is dependent on another irmWs speciic ne"s.
E. 2tatements a and d are $oth correct.
2. Which o the o!!o"in# statements is a!se%
&. The sin#!e inde/ mode! "as deve!oped to reduce the computationa! pro$!ems in ca!cu!atin#
the eicient rontier.
'. The &PT "as deve!oped as an a!ternative to the C&P;.
C. With the sin#!e inde/ mode!0 ris, can $e $ro,en do"n into systematic and unsystematic
components.
(. With !ar#e porto!ios0 systematic ris, can $e virtua!!y e!iminated.
E. The sin#!e inde/ mode! assumes that returns are #enerated $y a sin#!e actor and irm.
speciic actors.
)B
1. #
. !
60
OPEN QUESTIONS
1. Why does the sin#!e inde/ mode! <2I;= reduce the amount o computations%
Answer:
The 2I; assumes that a irmWs speciic ne"s is independent o another irmWs speciic ne"s. In
statistica! terms0 this assumption imp!ies that Cov. <ei0 e5= C 00 "here ei is the irm iWs speciic ne"s.
&!so0 the deviation rom the !ine or ei is assumed to $e independent o the common actor. With
these assumptions0 the covariance o these t"o stoc,s is reduced to9
Cov. <Mi0 M5= C i5I
2
Thus0 the investor on!y needs to estimate the $etas or each stoc, rather than a!! possi$!e
covariances.
2.
a. &ccordin# to the &PT0 i " = 00 this imp!ies that the "th stoc, has no unsystematic ris,.
Eva!uate this assertion.
b. &ccordin# to the &PT0 i " = 00 this imp!ies that the rate o return on the "th stoc, must $e
e4ua! to the ris,.ree rate. Eva!uate this assertion.
Answer:
a. This assertion is a!se " = 0 imp!ies that the stoc, has no %&%t'#(t") !"%*. Meca!! "ith &PT
( ) [ ]
" " " "
' I E I R E R + + = = <
and "hen
i
= 0, "e have
" " "
' R E R + = = <
0 and so on!y +n%&%t'#") !"%* remains.
b. This assertion is a!so a!se. I " = 00 this imp!ies that the e/pected rate o return is Oero.
Ho"ever0 or !ar#e porto!ios "hen
= 0
" "
'
0 this assertion is true0 $ut not or individua!
assets. &#ain0 $y &PT0 returns are #enerated $y
( ) [ ]
" " " "
' I E I R E R + + = = <
and "hen
i
= 00 "e have
" " "
' R E R + = = <
and the possi$i!ity o dierent outcomes due to
"
'
$ein# a random varia$!e.
). There are three stoc,s "ith the o!!o"in# parameters9
61
St(c& A St(c& # St(c& C
;ean return 103 % 203
'eta 1 6 2
a. What should be the mean return on Stock B to avoid arbitrage?
b. Find the value of a
0
and a
1
in the linear equation E(R
i
) = a
0
+ a
1
i
.
Answer:
a. We need to ind the mean rate o return that "i!! ma,e the s!ope o the 2;L the same
re#ard!ess o "hich securities are used. The s!ope o the !ine $ased on stoc, & and C is
( )
( )
3 10
1 2
3 10 3 20
=
We need to ind the mean rate o return such that the s!ope "i!! $e 103 "hen usin# stoc, '.
Thus0 "e need to so!ve or
( )
( )
3 10
2 6
3 20 3 %
=
2o!vin# or %0 "e ind 603. Thus0 the mean o stoc, ' must $e 603 or "e are not in
e4ui!i$rium. The intercept must $e Oero in order to maintain a s!ope o 103.
b. +rom a$ove "e have
0 0 . 0
0
= (
and 3 10
1
= ( .
62
Chapter 12 Eicient ;ar,ets9 Theory and Evidence
1. Which o the o!!o"in# statements is true%
I. In a stron# orm eicient mar,et0 it is possi$!e or undamenta! ana!ysts to earn
a$norma! returns consistent!y.
II. In a stron# orm eicient mar,et0 it is possi$!e or technica! ana!ysts to earn
a$norma! returns consistent!y.
III. In a stron# orm eicient mar,et0 asset a!!ocation is use!ess.
&. I on!y
'. I and II on!y
C. III on!y
(. I0 II0 and III
E. neither I0 nor II0 nor III
2. I the mar,et is perect!y eicient0 "hich o the o!!o"in# statements is a!se%
&. Prices "i!! !uctuate random!y around their true va!ue.
'. 2ecurity prices re!ect a!! pu$!ic!y avai!a$!e inormation.
C. 2ma!!er irms tend to outperorm !ar#er irms on a ris,.ad5usted $asis.
(. &n avera#e mutua! und does not outperorm the mar,et as a "ho!e.
E. 'oth technica! ana!ysis and undamenta! ana!ysis are economica!!y "orth!ess.
). & random "a!, occurs "hen9
&. stoc, prices respond s!o"!y to ne" inormation
'. the stoc, price !eve! is random
C. past inormation is useu! in predictin# uture prices
(. stoc, price chan#es are random $ut predicta$!e
E. uture price chan#es are uncorre!ated "ith past price chan#es
6)
1. E
2. C
). E
66
OPEN QUESTIONS
1. (escri$e three orms o the eicient mar,et theory <E;T=.
Answer:
There are three orms o the eicient mar,et theory9 "ea,0 semi stron#0 and stron# E;T.
&ccordin# to the "ea, orm o the E;T0 today1s stoc, prices re!ect a!! inormation a$out the
historica! prices o the stoc,. The semi stron# orm o the E;T states that prices re!ect a!!
re!evant pu$!ic!y avai!a$!e inormation. The stron# orm states that current prices re!ect a!!
pu$!ic!y and private!y avai!a$!e inormation.
2. (eine anoma!y and descri$e our common types o anoma!ies.
Answer:
& mar,et anoma!y is any event that can $e e/p!oited to produce a$norma! proits. There are our
cate#ories o anoma!ies9 seasona!0 event0 irm0 and accountin# anoma!ies. +irm anoma!ies are
anoma!ies that resu!t rom irm.speciic characteristics0 such as the siOe eect. 2easona! anoma!ies
are anoma!ies that depend so!e!y on time0 such as the Panuary eect. Event anoma!ies are price
chan#es that occur ater some easi!y identiied event0 such as a !istin# announcement. &ccountin#
anoma!ies are chan#es in stoc, prices that occur ater the re!ease o accountin# inormation0 such
as an earnin#s announcement.
). Good!es ;c2pir,!e is a crac,pot "ho has deve!oped an asset pricin# mode!. Li,e #enera!!y
accepted pricin# mode!s0 Good!es1 mode! predicts a re!ationship $et"een ris, and e/pected
return. Ho"ever0 Good!es1 mode! uses somethin# ca!!ed Rarum$a <represented $y the varia$!e ,
in Good!es1 "ritin#s= as a ris, measure. Go one $ut Good!es understands ho" to ca!cu!ate
Rarum$a0 $ut Good!es c!aims to have proven that0 or any stoc,0 E<R= C ),. The o!!o"in# ta$!e
provides data or ive stoc,s0 inc!udin# actua! return0 Rarum$a0 and $eta.
St(c& 7ar,mba #eta Act,a0
Ret,rn
& 0.0A 2.00 32.0%
' 0.26 1.>5 )2.0
C 0.0> 1.20 26.0
( 0.06 0.50 12.0
E 0.0) 0.25 A.5
a. +or each stoc,0 ca!cu!ate the e/pected return accordin# to Good!es1 mode! and the C&P;.
The e/pected return on the mar,et is 2030 and the ris,.ree rate is 63.
b. +or each stoc,0 use $oth pricin# mode!s to determine "hether or not the stoc, earned an
a$norma! return.
c. What does this pro$!em revea! a$out the rea!."or!d diicu!ties o determinin# "hether or not
the mar,et is eicient%
65
Answer:
a. Good!es1 mode! predicts that E<R= C ),. The e/pected return or 2toc, & is simp!y )<A3= C
263. Ca!cu!ations or the rest o the stoc,s o!!o" the same pattern.
The C&P; predicts that E<R= C ! J IE<RM E !K. The e/pected return or 2toc, & is 63 J
2<203 E 63= C )83. Ca!cu!ations or the rest o the stoc,s o!!o" the same pattern. The
o!!o"in# ta$!e contains e/pected returns or each stoc, as predicted $y each mode!.
E+/ecte% Ret,rn
St(c& N((%0es8 M(%e0 CAPM
& 263 36.0%
' >2 )2.0
C 21 2).2
( 12 12
E B A
b. &n a$norma! return is e4ua! to actua! return minus e/pected return. Whether or not a stoc,
earned an a$norma! return depends on the e/pected return0 "hich depends on the pricin#
mode! used.
The o!!o"in# ta$!e compares actua! returns "ith e/pected returns and indicates "hether
a$norma! return is positive0 ne#ative0 or Oero.
E+/ecte% Ret,rn
A
#
N
O
R
M
A
L

R
E
T
U
R
N
St(c&
N((%0es
8 M(%e0 CAP
M
Act,a0
Ret,rn
N((%0es8
M(%e0 CAPM
& 24% 36.0% 32.0% Positive Ge#ative
' >2 )2.0 )2.0 Ge#ative Rero
C 21 2).2 26.0 Positive Positive
( 12 12 12.0 Rero Rero
E B A A.5 Ge#ative Positive
68
c. In princip!e0 "e can test "hether or not the mar,et is eicient $y comparin# actua! returns
"ith e/pected returns. I the mar,et is eicient0 actua! returns shou!d e/ceed e/pected returns
e/act!y as oten as actua! returns a!! short o e/pected returns.
This pro$!em demonstrates that such a test o mar,et eiciency actua!!y tests t"o propositions
at once $ecause it presupposes that the researcher has accurate!y measured e/pected return.
I the test sho"s that a$norma! returns tend to $e positive0 "e cannot $e sure i the indin#
resu!ts $ecause the e/pected return "as incorrect or $ecause the mar,et is not eicient. +or
2toc, '0 usin# C&P; to ca!cu!ate e/pected return su##ests that the mar,et is eicient0 "hi!e
Good!es1 mode! su##ests that it is not.
6>
Chapter 1) Interest Mates and 'ond Ha!uation
1. Which o the o!!o"in# statements is true%
&. &ccordin# to the un$iased e/pectations hypothesis0 the yie!d curve "i!! $e !at i
e/pected uture short.term rates e/ceed current short.term rates.
'. &ccordin# to the un$iased e/pectations hypothesis0 !on#.term rates are e4ua! to
e/pected uture short.term rates.
C. &ccordin# to the !i4uidity preerence hypothesis0 the term structure is usua!!y
do"n"ard s!opin#.
(. &ccordin# to the mar,et se#mentations hypothesis0 interest rates or !on#.
maturity $onds are independent rom interest rates or short.maturity $onds.
2. Which o the o!!o"in# is the $est measure o a discount $ond1s tota! e/pected return%
&. current yie!d
'. yie!d to ca!!
C. capita! #ains yie!d
(. yie!d to maturity
E. coupon yie!d
1. !
6A
. !
OPEN QUESTIONS
1. If interest rates rise, will individuals save more or less? Explain your answer.
6B
Answer:
The re!ationship $et"een the amount peop!e save and interest rates is not immediate!y
apparent. +irst0 an increase in interest rates may cause peop!e to save more $ecause
this "i!! aord #reater consumption. This eect is ,no"n as the su$stitution eect.
2econd0 an increase in interest rates may actua!!y imp!y a decrease in savin#s $ecause
you have to save !ess no" in order to achieve a i/ed !eve! o consumption in the
uture. This is ,no"n as the income eect. +ina!!y0 there is a "ea!th eect0 "hich
asserts that an increase in interest rates imp!ies an increase in current "ea!th !eve! <or
a e/amp!e0 i you he!d a $ond porto!io and the interest rates #oes up rom A3 to 10
30 the va!ue o your porto!io #oes do"n and your "ea!th is #oin# do"n=. The ina!
resu!ts depend on the stren#th o these con!ictin# orces.
2. If the yield to maturity is zero, no matter what the maturity is, the par value of the
bond must be equal to its market value. Evaluate this statement. Is there a specific
type of bond for which this is true?
Answer:
This statement is not true for any bond with annual coupons larger than zero (C>0).
Suppose we have a bond with one year to maturity, with a par value of $1000 and an
annual coupon of C=$100. If y=0, then by Equation (), we have
100 0 1 @
0 . 1
1000 @
0 . 1
100 @
= + = P
which is greater than Par = $1000. This statement is true only if the annual coupon is
zero because then the sum of the future coupons is zero, and the price will equal the
par value (because there is no discounting).
3. If the yield curve is flat, then all forward rates must be equal to zero. Evaluate this
statement. Demonstrate your answer with a numerical example.
Answer:
This statement is not true. I the yie!d curve is !at0 a!! the or"ard rates are e4ua! to the
spot rate. I the spot rate is A3 and the yie!d curve is !at. The e/pected rate or ne/t
year "i!! a!so $e A3. 'y the ormu!a or the re!ationship $et"een or"ard rates and
spot rates "e see
= 1 < = 0A . 1 <
= 1 =< 0A . 1 < = 0A . 1 <
2
n
n
-
-
+ =
+ =
0A . 0 =
n
-
or A3
50
Chapter 16 'ondsY&na!ysis and ;ana#ement
1. What is the duration o a 5.year Oero.coupon $ond%
&. 6.5
'. 5.0
C. 5.5
(. The ans"er cannot $e determined "ithout more inormation.
2. Which o the o!!o"in# is an income immuniOation strate#y that se!ects on!y $onds
"hose coupon and principa! payments occur e/act!y "hen cash is re4uired%
&. cash matchin# strate#y
'. duration matchin# strate#y
C. horiOon matchin# strate#y
(. contin#ent immuniOation strate#y
51
1. #
. A
52
OPEN QUESTIONS
1. 2evera! immuniOation strate#ies "ere discussed in this chapter. Man, cash matchin#0
duration matchin#0 and horiOon matchin# rom the !east !e/i$!e to the most !e/i$!e.
E/p!ain your ran,in#s.
Answer:
The !east !e/i$!e is cash matchin#0 "hich re4uires each year1s cash !o" to $e matched
e/act!y. The most !e/i$!e is duration matchin#0 "here the duration o the assets is
matched "ith the duration o the !ia$i!ities. In $et"een these t"o strate#ies is horiOon
matchin#0 "hich re4uires cash matchin# or the irst severa! years and duration
matchin# thereater.
2. 2uppose you o"ned our dierent $onds "ith the o!!o"in# characteristics. What is
the duration o the $ond porto!io%
#(n% Mar&et 6a0,e ()
H(0%$n-s
!,rat$(n
& @160)2> 1.2> years
' @5806B0 A.>6 years
C @1B068> 5.88 years
( @)>05B2 8.>2 years
Answer:
+rom E4uation 16.50 the duration o a porto!io is a "ei#hted avera#e o the durations
o the individua! $onds "here the "ei#hts are determined $y the mar,et va!ue o the
$onds. In this case0 the tota! mar,et va!ue o the ho!din#s is
M. 160)2> Z 5806B0 Z 1B068> Z )>05B2 12>0A>8
The "ei#hts or each $ond are
'ond &9

1120 . 0
A>8 . 12>
)2> 0 16
=
'ond '9

661A . 0
A>8 . 12>
6B0 0 58
=
'ond C9 1522 . 0
A>8 . 12>
68> 0 1B
=
'ond (9

2B60 . 0
A>8 . 12>
5B2 0 )>
=
Thus0 the duration o the $ond porto!io is
D 0.1120<1.2>= Z 0.661A<A.>6= Z 0.1522<5.88= Z 0.2B60<8.>2= 8.A6 years
). There are ive $onds0 each o "hich has a duration o 6 years. ?our ho!din# period is 2
years. ['y diversiyin# $et"een these our $onds0 you can reduce the porto!io
5)
duration to 2 years.1 &ssumin# you cannot short se!!0 do you a#ree "ith this statement%
(eend your ans"er.
Answer:
This statement is not true. Meca!! rom E4uation 16.5 that
=
=
n
"
" "
D D
1
"here " C M." L M.
M." is the mar,et va!ue o the porto!io ho!din#s o $ond "
M. is the mar,et va!ue o the tota! $ond porto!io
D" is the duration o $ond ".
2o !on# as " is positive <thus0 assumin# you cannot short se!!=0 the on!y possi$!e va!ue
o D is our years. That is0
( ) 6 1 6 6
1 1
= = = =

= =
n
"
"
n
"
"
D
56
Chapter 15 2toc,sYHa!uation and 2e!ection
1. Which o the o!!o"in# is not a pro$!em encountered "hen imp!ementin# ((;s%
&. Qsin# ((;s to identiy underva!ued stoc,s is useu! on!y i the mispricin# o
stoc,s is corrected in the mar,et.
'. ((;s assume that the discount rate is constant over time.
C. Theoretica! ((;s re!ate uture cash !o"s to price0 $ut uture cash !o"s are
un,no"n today.
(. ((;s have !itt!e practica! va!ue $ecause they va!ue stoc,s assumin# ininite cash
!o"s and investors1 investment horiOons are a!"ays inite.
55
1. !
58
OPEN QUESTIONS
1. Qsin# the constant.#ro"th ((;0 prove that the dividend #ro"th rate0 #0 is e4ua! to
the stoc,1s e/pected capita! #ains yie!d.
Answer:
'e#in $y e/pressin# P1 as a unction o /29
P1 C /2L<* E 0= C /1<1 J 0=L<* E 0=.
'ut /1L<* E 0= C P00 so P1 C P0<1 J 0=.
I "e iso!ate 00 "e see that
1 J 0 C P1LP0
0 C P1LP0 E 1 C <P1 E P0=LP00 "hich is the e/pected capita! #ains yie!d.
2. Cyc!ops Company1s stoc, is e/pected to pay a @0.25 dividend 1 year rom today.
&na!ysts $e!ieve that thereater dividends "i!! #ro" at a constant rate o 13 per year.
The return on the mar,et is orecast to $e 1230 and the ris,.ree rate is 63. The $eta
o Cyc!ops1s stoc, is 0.2. What is the va!ue o Cyc!ops1s stoc,%
Answer:
The re4uired return is #iven $y the C&P;9 * C 63 J 0.2<123 E 63= C 5.83.
Cyc!ops is a constant.#ro"th company0 so
P0 C @0.25L<0.058 E 0.01= C @5.6).
). *I a dividend discount mode! indicates that a stoc, is underva!ued0 investors shou!d
$uy the stoc,.- Is this statement a!"ays true0 on!y sometimes true0 or never true%
Careu!!y 5ustiy your ans"er.
Answer:
The statement is on!y sometimes true and re!ects the rea!ity that investors must $e
very careu! "hen interpretin# the resu!ts o an ana!ysis $ased on a ((;. I the ((;
indicates that the stoc, is underva!ued0 it does not #uarantee that it "i!! soon $e
correct!y va!ued. In act0 the stoc, cou!d $ecome more underva!ued $eore turnin#
around0 creatin# !osses or investors un"i!!in# or una$!e to "ait or the mispricin# to
$e corrected.
&!so0 investors must $e conident o the inputs used to dra" the conc!usion that the
stoc, is mispriced. The pro$!ems or this chapter have demonstrated ho" sensitive the
mode!1s va!ue estimate is to the ma#nitude o its parameters. It is possi$!e that the
mar,et price o the stoc, is correct and that the ana!yst1s estimate o true va!ue is
incorrect.
5>
Chapter 18 +inancia! 2tatement &na!ysis
1. 2ometimes "hen a company purchases a ne" asset0 the u!! cost o the asset is not
recorded on the company1s income statement as an e/penseF instead0 the asset is
depreciated0 and the cost o the asset is spread out over severa! years. Which $asic
accountin# concept re4uires this treatment%
&. matchin#
'. historica! cost
C. conservatism
(. consistency
2. Which o the o!!o"in# $est matches costs "ith revenues durin# an in!ationary period%
&. LI+7
'. +I+7
C. avera#e cost method
(. a!! three methods match revenues "ith costs e4ua!!y "e!!

5A
1. A
. A
5B
OPEN QUESTIONS
1. An investment analyst has identified the following information about J.L.
Manufacturing:
T(ta0 C(sts 293
Inventory on Panuary 1 100000 units \ @25 2500000
Purchases in Panuary 50000 units \ @2B 1650000
Purchases in &pri! 50000 units \ @)5 1>50000
Purchases in Govem$er 60000 units \ @60 1800000
Tota! avai!a$!e or sa!e 260000 units >)00000
Inventory on (ecem$er )1 60000 units
What are the va!ue o the endin# inventory and the cost o #oods <C7N2= so!d $y the
+I+70 LI+70 and avera#e cost method% Which method is preerred or ta/ purposes%
Answer:
+I+7 method0 the endin# inventory is
6.000 U 60 C @180.000
C7N2 is >)0.000 E 180.000 C @5>0.000
LI+7 method0 the endin# inventory is
6.000 U 25 C @100.000
C7N2 is >)0.000 E 100.000 C @8)0.000
&vera#e cost method0 the avera#e cost is
>)0.000L26.000 C @)0062
The endin# inventory is
6.000 U )0062 C @121.8A0
C7N2 is >)0.000 E 121.8A0 C @80A.)20
The LI+7 method #ives the hi#hest C7N2. Hence0 it "i!! produce the !o"est ta/a$!e
proits0 so it is preerred or ta/ reasons.
2. 2uppose you are #iven the o!!o"in# inormation re#ardin# Na!actoca0 Inc.9
Get Income @100 mi!!ion
(epreciation @20 mi!!ion
2toc, Mepurchases @10 mi!!ion
Investments on Ge" Pro5ect @)0 mi!!ion
Based solely on these figures, what is the net cash flow for this period?
Answer:
The statement of cash flow is given in the following table:
80
M$00$(ns
1$'!(t"n0 A)t"2"t"'%
Get Income @100
(epreciation @20
Get Cash @120
In2'%t"n0 A)t"2"t"'%
Investments .@)0
Get Cash .@)0
3"n(n)"n0 A)t"2"t"'%
2toc, Mepurchases .@10
Get Cash .@10
Net C'an-e $n Cas' 9:;
3. A firms current liabilities were $50 million, and its current assets were $60 million.
The firm has $40 million of inventory.
a. What is the current ratio%
b. What is the 4uic, ratio%
Answer:
a. The current ratio is current assets divided $y current !ia$i!ities or @80L@50 C
1.2.
$. The 4uic, ratio is cash and near e4uiva!ents divided $y current !ia$i!ities or <@80 .
@60=L50 C 0.6
81
Chapter 1> ;acroeconomic &na!ysis
1. Nross domestic product consists o a!! o the o!!o"in# e/cept
&. consumption.
'. investment.
C. $ud#et deicit.
(. net trade.
2. &!! o the o!!o"in# are #oa!s o isca! po!icy e/cept
&. ma/imiOin# N(P #ro"th.
'. ma/imiOin# emp!oyment.
C. maintainin# sta$!e prices.
(. contro!!in# the money supp!y.
). Which o the o!!o"in# is not a varia$!e in the ca!cu!ation o the e4uation o the
internationa! +isher re!ationship%
&. domestic nomina! rate o interest
'. orei#n in!ation rate
C. orei#n e/chan#e rate
(. domestic rea! rate o interest
E. domestic in!ation rate
82
1. C
2 !
). C
8)
OPEN QUESTIONS
1. The #overnment o 2ma!!via recent!y reported that its N(P or the year "as @A $i!!ion.
Consumption durin# the period "as @105 $i!!ion0 investment "as @2 $i!!ion0 and
#overnment spendin# "as @) $i!!ion. What "as 2ma!!via1s net trade or the period%
Answer:
Qsin# E4uation 1>.10
N(P C C J I J G J <4 E M=
"here <4 E M= is net trade. Nives
A C 105 J 2 J ) J <4 E M=
or 2ma!!via <in $i!!ions o do!!ars=. 2o!vin#0
<4 E M= C @105 $i!!ion.
2. Can an investor use macroeconomic data to predict stoc, returns%
Answer:
?es. +or e/amp!e0 Lettau and Ludvi#son <2001a= sho" that the consumption.to.
"ea!th ratio is a po"eru! !eadin# indicator or e/cess returns on a##re#ate stoc,
mar,et inde/es. Gote that predicting excess returns does not mean we can earn
systematic abnormal risk-adjusted returns. That is, it does not yield abnormal risk-
adjusted returns if the predicted price change reflects only a change in risk or risk
premiums.
). What is the purchasin# po"er parity%
Answer:
The purchasin# po"er parity is the re!ationship $et"een t"o countriesW
in!ation rates and their orei#n e/chan#e rates. This parity is used to estimate
e/chan#e rates $ased on e/pected in!ation rates. I a country has a hi#h
in!ation rate0 its currency is e/pected to depreciate.
86
Chapter 1A Technica! &na!ysis
1. Which o the o!!o"in# statements a$out the cand!estic, chart is a!se%
a. I the openin# price is a$ove the c!osin# price0 then the rea! $ody is shaded dar,.
$. There are t"o parts o the cand!estic, !ine9 the rea! $ody and the shado"s.
c. The cand!estic, chart "as deve!oped in the Qnited 2tates0 and $ecame popu!ar in
Papan and other countries.
d. The cand!estic, chart is $ased on a day1s openin#0 hi#h0 !o"0 and c!osin# prices.
e. The cand!estic, chart is simi!ar in many "ays to the $ar chart in that it maps the
price movement over time.
2. Which o the o!!o"in# statements a$out technica! ana!ysis is a!se%
a. Technica! ana!ysts $e!ieve that inancia! prices re!ect investors1 attitudes0
"hich at times may not $e entire!y rationa!.
$. Technica! ana!ysis assumes that security prices react 4uic,!y to ne"
inormation.
c. Technica! ana!ysis contradicts the "ea, orm o the E;T.
d. Technica! ana!ysts $e!ieve that $y studyin# historica! mar,et data0 c!ues
"i!! $e ound re#ardin# the uture direction o security prices.
e. Technica! ana!ysts $e!ieve that their ana!ysis ena$!es them to $eat the
mar,et consistent!y.
). Which o the o!!o"in# statements is a!se%
a. 7dd.!ot tradin# is typica!!y done $y sma!! investors "ho0 technica!
ana!ysts $e!ieve0 are usua!!y "ron#.
$. 7ne $asic tenet o the (o" Theory is that no additiona! inormation is
needed or the stoc, mar,et outside o data on stoc, inde/es.
c. Point.and.i#ure charts attempt to identiy reversa!s in the direction o
stoc, prices "ithout consideration o time.
d. The rea! $ody o the cand!estic, !ine is the $road part consistin# o the
dierence $et"een the hi#hest price and !o"est price.
e. The (o" Theory c!aims that a $ear mar,et is esta$!ished "hen $oth the
(o" Pones Industria! &vera#e and the (o" Pones Transportation &vera#e
are movin# do"n.
Pearson Education Limited 200)
85
1. C
. #
". !
OPEN QUESTIONS
88
Vuestions 1 throu#h ) use the o!!o"in# data or &cme Company9
!a1 C0(se H$-' L(w O/en
1 @51.08 @52.8) @51.00 @51.)A
2 51.8) 52.B6 51.00 51.00
) 50.8B 50.AA 50.00 51.00
6 51.AA 5).1B 51.)A 51.A1
5 52.1) 56.25 52.00 52.>5
8 5).58 56.25 52.66 56.1B
> 56.25 56.25 51.00 5).AA
A 5).8B 5>.66 5).8B 5>.25
B 58.>5 5>.00 55.)A 58.66
10 58.B6 81.66 58.50 80.25
11 81.00 81.00 5>.A1 5>.AA
12 5>.8) 5A.AA 5>.25 5A.8)
1) 5B.)1 80.25 5>.A1 5A.>5
16 5B.08 5B.08 58.08 5>.66
15 5>.8) 5A.8B 5>.00 5>.00
1. Create a $ar chart or &cme Company.
Answer:
The $ar chart or &cme Company is9
#ar C'art <(r Acme C(m/an1
@65
@6>
@6B
@51
@5)
@55
@5>
@5B
@81
@8)
1 2 ) 6 5 8 > A B 10 11 12 1) 16 15
!a1
P
r
$
c
e
2. Create a cand!estic, chart or &cme Company.
Answer:
The cand!estic, chart or &cme Company is9
8>
Can%0est$c& C'art )(r Acme C(m/an1
@65
@6>
@6B
@51
@5)
@55
@5>
@5B
@81
@8)
@85
1 2 ) 6 5 8 > A B 10 11 12 1) 16 15
!a1
P
r
$
c
e
).
a. Ca!cu!ate the ).day movin# avera#e c!osin# stoc, price or &cme Company.
b. Nraph the movin# avera#e and dai!y c!osin# prices on the same chart. Qse a $ar
chart to represent c!osin# prices and a !ine to represent the movin# avera#e.
c. 2uppose a technica! ana!yst $ou#ht the stoc, the irst time the c!osin# price
e/ceeded the ).day movin# avera#e and so!d the stoc, the irst time the c!osin#
price e!! $e!o" the ).day movin# avera#e0 repeatin# this strate#y as oten as
possi$!e. Ca!cu!ate the proit or !oss or this strate#y or the 15.day period.
Answer:
a. The movin# avera#e is ca!cu!ated as in E/hi$it 1A.11.
!
A
.
C0(se
T'ree*!a1
T(ta0 2A3
T'ree*!a1 S$m/0e
M(v$n- Avera-e
2A="3
1 @51.08
2 51.8)
) 50.8B @15).)A @51.1)
6 51.AA 156.20 51.60
5 52.1) 156.>0 51.5>
8 5).58 15>.5> 52.52
> 56.25 15B.B6 5).)1
A 5).8B 181.50 5).A)
B 58.>5 186.8B 56.B0
10 58.B6 18>.)A 55.>B
11 81.00 1>6.8B 5A.2)
12 5>.8) 1>5.5> 5A.52
1) 5B.)1 1>>.B6 5B.)1
16 5B.08 1>8.00 5A.8>
15 5>.8) 1>8.00 5A.8>
8A
b. The movin# avera#e chart or &cme Company is9
C0(s$n- Pr$ces an% M(v$n- Avera-e Pr$ces )(r Acme
C(m/an1
@0
@10
@20
@)0
@60
@50
@80
@>0
1 2 ) 6 5 8 > A B 10 11 12 1) 16 15
!a1
P
r
$
c
e
C!osin# Price
).day ;ovin#
&vera#e
c. The strate#y !eads to the o!!o"in# transactions.
!a1 Transact$(n Pr()$t
6 'uy at @51.AA
A 2e!! at @5).8B @1.A1
B 'uy at @58.>5
12 2e!! at @5>.8) @0.AA
16 'uy at @5B.08
15 2e!! at @5>.8) E@1.6)
T(ta0 Pr()$t @1.28
7ver the 15.day period0 the investor "ou!d earn a proit o @1.28 per share <i#norin#
transaction costs=.
8B
>0
Chapter 1B +utures0 7ptions and 7ther (erivatives
1. Which o the o!!o"in# actions "i!! c!ose a short position in a put option%
&. $uyin# a ca!! "ith the same stri,e price0 e/piration0 and under!yin# asset
'. se!!in# a ca!! "ith the same stri,e price0 e/piration0 and under!yin# asset
C. $uyin# a put "ith the same stri,e price0 e/piration0 and under!yin# asset
(. se!!in# a put "ith the same stri,e price0 e/piration0 and under!yin# asset
2. & p!ain vani!!a s"ap is a!so ,no"n as a
&. standard s"ap.
'. conventiona! s"ap.
C. i/ed or !oatin# s"ap.
(. contractua! s"ap.
>1
1. C
. C
>2
OPEN QUESTIONS
1. What is the dierence $et"een European.sty!e options and &merican.sty!e options%
Answer: The distinction $et"een &merican and European sty!e options invo!ves the
date "hen the contract can $e e/ercised0 and has nothin# to do "ith #eo#raphic
!ocation. European.sty!e options can $e e/ercised on!y on speciic dates. &merican.
sty!e options0 in contrast0 can $e e/ercised any time on or $eore the e/piration date
o the contract. The ho!der o an &merican option has the reedom to decide "hen0 i
ever0 the option contract "i!! $e e/ercised0 as !on# as it is $eore the e/piration date.
2. 2tradd!es and stran#!es are re!ated strate#ies invo!vin# 2 options0 reer to section
1B.8 or detai!s.
a. (ra" a pay.o dia#ram or a stradd!e.
b. (o the same or a stran#!e. E/p!ain "hy this strate#y is [a $et on vo!ati!ity10 and
even more so than a stradd!e.
Answer:
a. Payo dia#ram or a !on# stradd!e. & !on# stradd!e re4uires $uyin# $oth a sin#!e
put and ca!! on the same asset0 "ith the same e/ercise price and e/piration date.

@ Proit or !oss
2toc, price at
e/piration
]
Lon# ca!! "ith the stri,e price 4 and
!on# put "ith the stri,e price 4
b. Payo dia#ram or a !on# stran#!e. The investor $uys a ca!! and a put0 $ut the ca!!
has a hi#her e/ercise price <]H=. This resu!ts in an area "here the movement o
the stoc, price $et"een ]L and ]H doesn1t chan#e the proit or !oss0 a!!o"in# or
hi#her price vo!ati!ity. With stran#!e the do"nside ris, is !ess0 then "ith a stradd!e.

@ Proit or !oss
2toc, price at
e/piration
]
H
]
L

>)
The payo dia#rams or short stradd!es and stran#!es and constructed in a simi!ar
"ay0 usin# short positions in options.
). Qse the o!!o"in# data or parts a throu#h e.
O/t$(n Str$&e Pr$ce O/t$(n Pr$ce=S'are
Ca00 A @25 @2
P,t A )0 1)
Ca00 # 20 6
P,t # 15 2
Ca00 C 10 1)
P,t C 20 )
a. I the under!yin# stoc, is priced at @200 "hich o the options is in.the.money%
7ut.o.the.money% &t.the.money%
b. Ca!cu!ate the intrinsic va!ue o each option.
c. Ca!cu!ate the time va!ue o each option.
%. I an investor $ou#ht a!! si/ options and the stoc, price "as @)0 at the options
e/piration date0 "hat "ou!d $e the investor1s #ainL!oss on each option share%
e. (o part d or each option contract.
Answer:
a. In.the.money9 Put & and Ca!! C
7ut.o.the.money9 Ca!! & and Put '
&t.the.money9 Ca!! ' and Put C
b. Intrinsic va!ues9
Ca!! & C @0
Put & C )0 E 20 C @10
Ca!! ' C 20 E20 C @0
Put ' C @0
Ca!! C C 20 E 10 C @10
Put C C 20 E 20 C @0
c. Time va!ue C price E intrinsic va!ue
Ca!! & C 2 E 0 C @2
Put & C 1) E 10 C @)
Ca!! ' C 6 E 0 C @6
Put ' C 2 E 0 C @2
Ca!! C C 1) E 10 C @)
Put C C ) E 0 C @)
%. NainL!oss per share
Ca!! & C )0 E 25 E 2 C @)
Put & C 0 E 1) C E @1)
Ca!! ' C )0 E 20 E 6 C @8
Put ' C 0 E 2 C E @2
Ca!! C C )0 E 10 E 1) C @>
Put C C 0 E ) C E @)
>6
e. NainL!oss per contract
Ca!! & C ) <100= C @)00
Put & C E 1) <100= C E @10)00
Ca!! ' C 8 <100= C @800
Put ' C E 2 <100= C E @200
Ca!! C C > <100= C @>00
Put C C E ) <100= C E @)00
>5
Chapter 20 (erivatives Ha!uation
1. &ccordin# to put.ca!! parity0 "hich one o the o!!o"in# is true%
a. 'uyin# a ca!! and se!!in# a put is e4uiva!ent to $uyin# stoc, and
$orro"in# P.<4=.
$. 'uyin# a ca!! and se!!in# a put is e4uiva!ent to se!!in# stoc, and !endin#
P.<4=.
c. 2e!!in# a ca!! and $uyin# a put is e4uiva!ent to se!!in# stoc, and $orro"in#
P.<4=.
d. 2e!!in# a ca!! and $uyin# a put is e4uiva!ent to $uyin# stoc, and !endin#
P.<4=.
2. Which o the o!!o"in# is inverse!y re!ated to the va!ue o a ca!! option%
a. the va!ue o the under!yin# asset
$. the stri,e price o the ca!! option
c. the ris,.ree rate o interest
d. the ca!! option1s time to e/piration
e. the vo!ati!ity o the under!yin# asset1s price
). Which o the o!!o"in# is not a necessary assumption or the '!ac,.2cho!es option
pricin# mode!%
a. The mar,et is riction!ess.
$. Investors are price ta,ers.
c. 2hort se!!in# is a!!o"ed0 "ith u!! use o the proceeds.
d. 'orro"in# and !endin# $oth occur at the continuous!y compounded ris,.
ree rate.
e. &!! investors have the same e/pectation o 5
t
.
>8
1. A
. #
". E
>>
OPEN QUESTIONS
1. 2uppose the standard deviation is = )030 5
0
= @1000 4 = @1000 ! = 530 6 C )3
and t =
1
L2. Ca!cu!ate the '!ac,.2cho!es ca!! and put option prices.
Answer:
d1C
( ) ( ) [ ]
5 . 0 ) . 0
5 . 0 U
2
) . 0
02 . 0
100
100
!n
2
+ +
C
2121) . 0
0)25 . 0
C 0.15)2
d2C 0.15)2 E <0.) 5 . 0 = C .0.05AB
so that G<d1= C 0.580AB and G<d2= C 0.6>852
Ca!! C 100e
.<0.0)U0.5=
U 0.580AB E 100e
.<0.05U0.5=
U 0.6>852
C 55.25)BE 68.6>55 C A.>A
Put C 100e
.<0.05U0.5=
U I1. 0.6>852K E 100e
.<0.0)U0.5=
U I1. 0.580ABK
C 51.0555 E 6).25>) C >.A0
2. E/p!ain intuitive!y "hy the upper $oundary or the price o a European put option is
$
0
4 L <1 J !=
t
.
Answer:
& put option #ives its ho!der the ri#ht to se!! the under!yin# asset or @4. Thereore0
the put is most va!ua$!e "hen the under!yin# asset is "orth!ess. In other "ords0 the
ma/imum possi$!e payo or a put option is @40 $ut the payo "i!! not $e received
unti! the option e/pires. The put can never $e "orth more than the present va!ue o
its ma/imum payo.
). Qse put.ca!! parity to prove that an at.the.money ca!! option on a #iven stoc, must
cost more than an at.the.money put option on the same stoc,. &ssume the options
have the same maturity and stri,e price.

Answer:
Put.ca!! parity #ives the re!ationship amon# a ca!! and a put "ith the same e/piration
date and stri,e price0 the stri,e price0 and the price o the under!yin# asset <E4uation
20.A=9
0 0 0
= 1 <
$
!
4
5 )
t
+
+
=
. Mearran#in#0
t
!
4
5 $ )
= 1 <
0 0
+
=
.
I the ca!! and the put are $oth at the money0 then 5 C 4 and
0
= 1 < = 1 <
>
+
=
+
t t
!
4
4
!
4
5
0 so )
0
$
0
^ 0.
>A
Chapter 21 Mis, ;ana#ement
OPEN QUESTIONS
1. Consider a porto!io consistin# o @10 mi!!ion invested in the 2_P 500 and @5
mi!!ion invested in Q2 Treasury $onds. The 2_P 500 has an e/pected return o 16
percent and a standard deviation o 18 percent. The Treasury $onds have an
e/pected return o B percent and a standard deviation o 6 percent. The corre!ation
$et"een the 2_P 500 and the Q2 Treasury $onds is 0.2 percent. &!! i#ures are
stated on an annua! $asis.
a. +ind the BB3 HaM or one day.
b. 2uppose the corre!ation rises to 0.6 percent. +ind the HaM or one day0 and e/p!ain
the dierence "ith section ( o this 4uestion.
Answer:
a.
B A B A B B A A $

0
2 2 2 2
2 + + =
2 . 0 6 18 2 6 = < 18 = <
)
1
)
2
2 2
)
1
2 2
)
2
+ + =
$
266 . 121 =
$
011 . 11
$
P 7 8 7 .(R
$
=

= < = 0 <
1
262B> . 0 15
250
1
11011 . 0 )28 . 2 = 1 0 BB . 0 < = = .(R
The BB3 HaM is @ 2620B>2.A6
b.
B A B A B B A A $

0
2 2 2 2
2 + + =
6 . 0 6 18 2 6 = < 18 = <
)
1
)
2
2 2
)
1
2 2
)
2
+ + =
$
B)) . 128 =
$
28> . 11
$
P 7 8 7 .(R
$
=

= < = 0 <
1
26A82 . 0 15
250
1
1128> . 0 )28 . 2 = 1 0 BB . 0 < = = .(R
The BB3 HaM is @ 26A0821.A) "hich is hi#her than the HaM ca!cu!ated "ith section a. This
comes rom the act that the standard deviation o the porto!io rises throu#h the
increase o the corre!ation $et"een the 2_P 500 and the Q2 Treasury $onds.
2. &n investor has a $ond "ith a va!ue o @100 and this $ond1s initia! credit ratin# is
'''0 in the ta$!e $e!o" the va!ue o the $ond is #iven dependin# on the credit
ratin# the $ond has on a certain moment <these i#ures are made up=.
Cre%$t Rat$n- #(n% 6a0,e 293 Trans$t$(n Pr(bab$0$t1 2>3
AAA 111.79 0.02
&& 10B.>5 0.))
>B
& 105.5) 5.B5
''' 10).60 A8.B)
'' 100.B8 5.)0
' B).A6 1.1>
CCC A6.BA 0.12
(eau!t 58.6) 0.1A
a. Ca!cu!ate the $est possi$!e outcome and the "orst possi$!e outcome.
b. What is the recovery rate%
Answers:
a. The $est possi$!e outcome is an up#rade to &&&0 in this case the va!ue o the $ond
rises rom @10).60 to @111.>80 and this is a #ain o @A.)8. The "orst possi$!e
outcome is o course deau!t. This "ou!d resu!t in a !oss o @68.B> <@10).60 E
@58.6)=.
b. The recovery rate is a su$stantia! amount o the principa! that may sti!! $e
recovered in case o deau!t. &s you can see in the ta$!e in the second co!umn0 the
recovery rate is 58.6) 3.
). 'rie!y e/p!ain main simi!arities and dierences $et"een stress.testin# approach
and E/treme Ha!ue Theory.
Answer:
'oth stress testin# and EHT are meant to supp!ement the HaM ana!ysis. 2tress.
testin# invo!ves HaM estimations at si#niicant !uctuations o ,ey varia$!es. EHT
descri$es the $ehavior o the !et.tai! o the return distri$ution. In case o stress.
testin# the HaM mode! is e/tended0 $ut its assumptions are not chan#ed. EHT
mode!s a at tai! ane" and does not necessari!y o!!o" the same mode! assumptions
that "ere used to compute HaM.
A0
Chapter 22 Perormance Eva!uation
OPEN QUESTIONS
1. What is the pro$!em caused $y survivorship $ias "ithin data sets on mutua! und
perormance%
&ns"er9
;ost o the data sets emp!oyed or mutua! und perormance eva!uation inc!ude the past
records o a!! mutua! unds current!y in e/istence. Hence0 "hen a und mer#es or #ets
!i4uidated <ceases to e/ist=0 its past perormance is de!eted rom the data$ase. This
$ecause today1s investors are not interested in the records o unds that no !on#er e/ists.
Thus0 i mutua! unds "ith $ad perormance are ta,en o the mar,et0 their $ad records
are de!eted rom the data set as "e!!. Thereore0 the avera#e perormance o the
survivin# unds "i!! overstate the success o the mutua! und industry as a "ho!e
<inc!udin# the !i4uidated unds=.
2. What $asic pro$!ems shou!d one ta,e into account "hen usin# perormance ana!ysis%
Answer:
The our $asic pro$!ems "hen usin# perormance eva!uation are9 the act that
perormance eva!uation is a historica! e/ercise $y its very nature0 and the !in, $et"een
past perormance and uture perormance may $e "ea,F the act that theory provides
!itt!e #uidance in the se!ection o the appropriate set o ris, actors to $e used to correct
or ris,F diicu!ties in estimatin# the ris, and return characteristics o individua!
securitiesF and diicu!ties in estimatin# the return distri$ution or porto!ios due to
chan#es in the composition o a porto!io0 and the !ac, o time!y inormation on this
composition.
). Qse E4uations 22.) and 22.6 to prove that Pensen1s perormance inde/ "i!! indicate that a
porto!io $eat the mar,et i0 and on!y i0 Treynor1s perormance inde/ indicates that the
porto!io $eat the mar,et.
Answer:
We "ant to sho" that any porto!io that $eats the mar,et accordin# to Pensen1s
perormance inde/ must have 1= a positive va!ue or Pensen1s inde/ and 2= a va!ue or
Treynor1s inde/ that e/ceeds the va!ue o Treynor1s inde/ or the mar,et. E4uation 22.6
sho"s that Pensen1s inde/ is positive i0 and on!y i0
=K <
`
I ! R ! R
# " "
+ > 0
Thus0
! R
"

> = <
`
! R
# "

(
! R
"

) /
"
`
>
! R
#

A1
The !et side o this ine4ua!ity is Treynor1s inde/ or the porto!io <E4uation 22.)=. The
ri#ht side o this ine4ua!ity is Treynor1s inde/ or the mar,et <remem$er that the mar,et1s
$eta is 1=. We see that Pensen1s inde/ is #reater than Oero i and on!y i Treynor1s inde/
or the porto!io is #reater than Treynor1s inde/ or the mar,et.
A2

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