1. Financial engineering has been disparaged as nothing more than paper shuffling.

Critics argue
that resources used for rearranging wealth (that is, bundling and unbundling financial assets)
might be better spent on creating wealth (that is, creating real assets). Evaluate this criticism.
Are any benefits realized by creating an array of derivative securities from various primary
securities?
2. Why are money market securities sometimes referred to as cash equivalents?
3. How do margin trades magnify both the upside potential and the downside risk of an investment
position?
4. Balanced funds, life-cycle funds, and asset allocation funds all invest in both the stock and bond
markets. What are the differences among these types of funds?
5. Use Figure 5.1 in the text to analyze the effect of the following on the level of real interest rates:
a. Businesses become more pessimistic about future demand for their products and decide to
reduce their capital spending.
b. Households are induced to save more because of increased uncertainty about their future
Social Security benefits.
c. The Federal Reserve Board undertakes open-market purchases of U.S. Treasury securities in
order to increase the supply of money.
6. Draw the indifference curve in the expected returnstandard deviation plane corresponding
to a utility level of .05 for an investor with a risk aversion coefficient of 3. ( Hint: Choose
several possible standard deviations, ranging from 0 to .25, and find the expected rates of return
providing a utility level of .05. Then plot the expected returnstandard deviation points so
derived.)
7. Solve numerically for the proportions of each asset and for the expected return and standard
deviation of the optimal risky portfolio.
8. Consider the two (excess return) index model regression results for A and B:
R A 5 1% 1 1.2 R M
R -square 5 .576
Residual standard deviation 5 10.3%
R B 5 2 2% 1 .8 R M
R -square 5 .436
Residual standard deviation 5 9.1%sit us at www.mhhe.com/bkm
a. Which stock has more firm-specific risk?
b. Which has greater market risk?
c. For which stock does market movement explain a greater fraction of return variability?
d. If r f were constant at 6% and the regression had been run using total rather than excess
returns, what would have been the regression intercept for stock A ?
Use the following data for Problems 9 through 14. Suppose that the index model for
stocks A and B is estimated from excess returns with the following results:
RA 5 3% 1 .7RM 1 eA
RB 5 22% 1 1.2RM 1 eB
sM 5 20%; R-squareA 5 .20; R-squareB 5 .12
9. Consider the following table, which gives a security analysts expected return on two stocks for
two particular market returns:
Market Return Aggressive Stock Defensive Stock
5% 22% 6%
25 38 12

a. What are the betas of the two stocks?

b. What is the expected rate of return on each stock if the market return is equally likely to be
5% or 25%?
c. If the T-bill rate is 6% and the market return is equally likely to be 5% or 25%, draw the
SML for this economy.
d. Plot the two securities on the SML graph. What are the alphas of each?
e. What hurdle rate should be used by the management of the aggressive firm for a project with

the risk characteristics of the defensive firms stock?