305

CHAPTER 1

THE INVESTMENT SETTING


TRUE/FALSE QUESTIONS

(t) 1 The rate of exchange between certain future dollars and certain current
dollars is known as the pure rate of interest.

(t) 2 An investment is the current commitment of dollars over time to derive
future payments to compensate the investor for the time funds are
committed, the expected rate of inflation and the uncertainty of future
payments.

(f) 3 A dollar received to day is worth less than the same dollar received in the
future.

(f) 4 Expected Return = (1 + nominal risk-free rate)(1 + inflation rate)(1 + risk
premium) - 1

(f) 5 The three components of the required rate of return are the nominal interest
rate, an inflation premium, and a risk premium.

(t) 6 Risk is the uncertainty that an investment will earn its expected rate of
return.

(f) 7 A manager with a passive asset allocation strategy will try to increase
allocation of assets that he believes will outperform other classes in the next
period.

(t) 8 People invest with one or more of the following three basic needs in mind:
income, capital preservation, capital appreciation.

(t) 9 As the level of risk increases an investor will require an expected return that
will compensate for this additional risk.

(f) 10 An internally efficient market is one where stocks trade at low prices.

(t) 11 The required rate of return is the minimum rate of return that will induce an
investor to invest.

(t) 12 Participants in primary capital markets that gather funds and channel them
to borrowers are called financial intermediaries.

(t) 13 A manager with an active security selection philosophy will try to identify
securities that will do well over the coming period.



306

MULTIPLE CHOICE QUESTIONS

(d) 1 An investment is the current commitment of resources for a period of time
in the expectation that an investor will receive in the future a compensation
for

a) the time for which the resources are committed
b) the expected rate of inflation
c) the time for which the resources are committed and the expected rate of
inflation
d) the expected rate of inflation, the time for which the resources are
committed, and the uncertainty of future payments.
e) a) and b)

(b) 2 The following is not a reason for investing

a) to provide for retirement.
b) to fund higher levels of current consumption.
c) to fund higher levels of future consumption.
d) to fund children’s education needs.
e) to save up for a down payment on a house.


(a) 3 The statement – ‘risk drives expected returns’ refers to the notion that

a) an investor will require a higher rate of return the higher the perceived
riskiness of an asset.
b) an investor will require a lower rate of return the higher the perceived
riskiness of an asset.
c) markets over-react to news.
d) markets under-react to news.
e) none of the above.


(a) 4 The basic trade-offs in the investment process are

a) between the anticipated rate of return for a given investment
instrumentand its degree of risk.
b) between understanding the nature of a particular investment and
havingthe opportunity to purchase it.
c) between high returns available on single instruments and the
d) diversification of instruments into a portfolio.
e) between the desired level of investment and possessing the resources
necessary to carry it out.


(e) 5 The expected return is a function of

a) The real risk-free rate plus the investment's variance.
b) The prime rate and the rate of inflation.
307
c) The risk premium plus the inflation rate.
d) The nominal risk free rate minus the rate of inflation.
e) The nominal risk-free rate and the risk premium.

(c) 6 An externally efficient market is one where

a) Transaction costs of trading are low.
b) Stocks of highly efficient companies trade.
c) New information is quickly reflected into assets prices.
d) There is no overreaction to news.
e) None of the above.

(d) 7 An investor should diversify investment holdings across

a) Different asset classes.
b) Different industries.
c) Different countries.
d) All of the above.
e) None of the above.

(a) 8 An internally efficient market is one where

a) Transaction costs of trading are low.
b) Stocks of highly efficient companies trade.
c) New information is quickly reflected into assets prices.
d) There is no overreaction to news.
e) Stock prices are low.


(d) 9 An investor can invest in financial assets by investing:

a) In cash, stocks and bonds
b) Indirectly, in real assets and financial assets.
c) In options, futures and through derivatives.
d) Directly, indirectly and through derivatives.
e) In stocks, directly and through derivatives.

(a) 10 A direct investment occurs when an investor

a) Buys shares of stocks or bonds.
b) Buys shares of stocks or options and futures.
c) Buys shares of stocks, bonds or mutual funds
d) Deposits funds in a bank or buys mutual funds
e) Deposits funds in a bank or buys derivatives.

(d) 11 An indirect investment occurs when an investor

a) Buys shares of stocks or bonds.
b) Buys shares of stocks or options and futures.
c) Buys shares of stocks, bonds or mutual funds
d) Deposits funds in a bank or buys mutual funds
308
e) Deposits funds in a bank or buys derivatives.

(c) 12 A portfolio manager with an active asset allocation decision philosophy will
manage a portfolio by

a) Tracking a well known market index
b) Stock picking using a top-down or bottom-up approach
c) Using market timing
d) Maintaining predetermined allocation with periodic rebalancing
e) None of the above

(b) 13 A portfolio manager with an active security selection decision philosophy
will manage a portfolio by

a) Tracking a well known market index
b) Stock picking using a top-down or bottom-up approach
c) Using market timing
d) Maintaining predetermined allocation with periodic rebalancing
e) None of the above

(d) 14 A portfolio manager with a passive asset allocation decision philosophy will
manage a portfolio by

a) Tracking a well known market index
b) Stock picking using a top-down or bottom-up approach
c) Using market timing
d) Maintaining predetermined allocation with periodic rebalancing
e) None of the above

(a) 15 A portfolio manager with a passive security selection decision philosophy
will manage a portfolio by

a) Tracking a well known market index
b) Stock picking using a top-down or bottom-up approach
c) Using market timing
d) Maintaining predetermined allocation with periodic rebalancing
e) None of the above


309
MULTIPLE CHOICE PROBLEMS


(d) 1 If the nominal risk rate is 5% per year, the risk premium is 6% per year and
the expected rate of inflation over the next year is 3%, an investment of
$1000 today worth_____ one year from today.

a) $1000
b) $1081.50
c) $1091.80
d) $1113
e) $1146.39


(c) 2 If the nominal risk free rate is 8%, the expected rate of inflation is 2.5%,
and the risk premium is 5%, the required rate of return is

a) 10.5%
b) 7.5%
c) 13.4%
d) 16.24%
e) 10.7%


(a) 3 Assume that nominal risk free interest rate is 6%, the expected rate of
inflation is 2%, the risk premium is 3% and the required rate of return is
9.18%. What would be the value at the end of 25 years of $100 invested
today at the required rate of return?

a) $898.62
b) $343.51
c) $1474.28
d) $704.13
e) $918

USE THE FOLLOWING INFORMATION FOR THE NEXT THREE PROBLEMS

Consider the following information. The average annual return on a tax-deferred
account over a 10-year period is 9%. The average annual return on a taxable account
over the same 10-year period is 13%. The tax rate is 35%, and the amount invested at
the beginning of the 10-year period is $2500.

(b) 4 The before tax value of the tax deferred investment, assuming all savings
are removed at the end of 10 years is

a) $4414.17
b) $5918.41
c) $2943.42
d) $8663.71
e) $4987.26

310

(c) 5 The after tax value of the tax deferred investment, assuming all savings are
removed at the end of 10 years is

a) $4987.26
b) $5918.41
c) $3846.97
d) $2943.42
e) None of the above


(e) 6 The value of the taxable investment, assuming all savings are removed at
the end of 10 years is

a) $8663.71
b) $6943.42
c) $3846.97
d) $5918.41
e) $5626.46


(c) 7 Consider an investment portfolio consisting of three asset classes. The
allocations and returns for each asset class are as follows

Asset Class Allocation Percentage Annual Return
1 10% -10%
2 35% 35%
3 55% -5%

The annual portfolio return is

a) 15.5%
b) -10.0%
c) 8.5%
d) -7.75%
e) 7.75%


(d) 8 Consider an investment portfolio consisting of four asset classes. The
allocations and returns for each asset class are as follows

Asset Class Allocation Percentage Annual Return
1 10% -10%
2 25% 15%
3 35% 10%
4 30% 5%

The annual portfolio return is

a) 15.5%
b) 10.0%
311
c) 5.0%
d) 7.75%
e) None of the above


CHAPTER 1

ANSWERS TO PROBLEMS


1 1000(1.05)(1.06) = 1113

2 (1.08)(1.05) – 1 = 11.34%

3 1.0918
25
(100) = 898.62

4 1.09
10
(2500) = 5918.41

5 5918.41(1 – 0.35) = 3846.97

6 0.13(1 – 0.35) = 0.0845
1.0845
10
(2500) = 5626.46

7 (0.1)(-0.1) + (0.35)(0.35) + (0.55)(-0.05)] = 0.085

8 [(0.1)(-0.1) + (0.25)(0.15) + (0.35)(0.10) + (0.30)(0.05)] = 0.0775

























312
CHAPTER 2

RETURN AND RISK BASICS


TRUE/FALSE QUESTIONS

(f) 1 An investor should expect to receive higher returns from taking on lower
risks

(f) 2 The sources of investment returns are dividends and interest.

(f) 3 The holding period return (HPR) is equal to the return relative stated as a
percentage.

(t) 4 The geometric mean is the nth root of the product of the annual holding
period returns for N years minus one.

(f) 5 The geometric mean of a series of returns is always larger than the
arithmetic mean and the difference increases with the volatility of the series.

(t) 6 When rates of return are the same for all years,
the geometric mean and the arithmetic mean will be the same.

(f) 7 The coefficient of variation is the expected return divided by the standard
deviation of the return.

(f) 8 Historically return relatives are used to measure the risk for a series of
historical rates of return.

(t) 9 Widening interest rate spreads indicate a flight to quality.

(f) 10 The risk premium is a function of sales volatility, financial leverage, and
inflation.


MULTIPLE CHOICE QUESTIONS

(b) 1 The return relative is calculated as

a) (1 – HPR)
b) (1 + HPR)
c) (1 – HPR)
n

d) (1 + HPR)
n

e) (1 – (Income + Price Change))


(b) 2 When rates of return on a security have a high standard deviation then

a) Arithmetic mean will equal geometric mean
313
b) The difference between arithmetic mean and geometric mean will be
large.
c) The difference between arithmetic mean and geometric mean will be
small.
d) Geometric mean will exceed arithmetic mean.
e) None of the above.


(d) 3 The coefficient of variation is a measure of

a) Central tendency.
b) Absolute variability.
c) Absolute dispersion.
d) Relative variability.
e) Relative return.


(c) 4 The real risk free rate is influenced by the following factors:

a) Inflationary expectations and capital market conditions.
b) Business risk and financial risk.
c) Investment opportunities and time preference for consumption.
d) All of the above.
e) None of the above.



(c) 5 If a significant change is noted in the yield of a T-bill, the change is most
likely attributable to:

a) A downturn in the economy.
b) A static economy.
c) A change in the expected rate of inflation.
d) A change in the real rate of interest.
e) A change in risk aversion.


(a) 6 The nominal risk free rate is influenced by the following factors:

a) Inflationary expectations and capital market conditions.
b) Business risk and financial risk.
c) Investment opportunities and time preference for consumption.
d) All of the above.
e) None of the above.



(a) 7 The following would be an example of systematic risk:

a) Changes in interest rates.
b) Management decisions.
314
c) Stability of sales.
d) The amount of debt financing.
e) Liquidity.


(b) 8 If U.S. firms increase their debt/total capital ratios, it will very likely cause
required returns to

a) Increase and change the slope of the capital market line (CML).
b) Increase and cause a movement up along the capital market line (CML).
c) Remain unchanged and cause a parallel shift of the capital market line
(CML).
d) Decrease and change the slope of the capital market line (CML).
e) Decrease and cause a movement down along the capital market line
(CML).


(d) 9 An increase in the slope of the Capital Market Line (CML) is caused by

a) Changes in business risk.
b) Changes in financial risk.
c) Changes in liquidity risk.
d) Changes in systematic risk.
e) Changes in unsystematic risk.


(d) 10 A parallel shift in the capital market line (CML) is caused by changes in the
following factors:

a) Expected real growth in the economy.
b) Capital market conditions.
c) Expected rate of inflation.
d) All of the above.
e) None of the above.


MULTIPLE CHOICE PROBLEMS

(a) 1 The HPR on a security is 6.5%. If the holding period is 1 month, the
annualized HPR is

a) 113%
b) 78%
c) 65%
d) 6.5%
e) 1.129%


(c) 2 The HPR on a security is 3%. If the holding period is 4 weeks month, the
annualized HPR is

315
a) 39.15%
b) 78.87%
c) 46.87%
d) 158.25%
e) 52.25%


(d) 3 At the beginning of the year an investor purchased 100 shares of common
stock from ABC Corporation at $10 per share. During the year, the firm
paid dividends of $1 per share. At the end of the year, the investor sold the
100 shares at $11 per share. What is the HPR?

a) 1.20%
b) 5.50%
c) 12.00%
d) 20.00%
e) 30.00%


(d) 4 Assume that you invest $1000 for 15 years in an account that pays an
interest rate of 7% per year with annual compounding. Calculate the
proportion of the total value of the account that can be attributed to interest-
on-interest, at the end of 15 years.

a) 100%
b) 38.06%
c) 36.24%
d) 25.70%
e) 0%


(b) 5 Given the following returns and return relatives over the past four years,
compute the arithmetic mean (AM) and geometric mean (GM) rates of
return.


Period Returns Return Relative
t
1
0.05 1.05
t
2
-0.10 0.90
t
3
0.11 1.11
t
4
-0.02 0.98

a) AM = 4.000%, GM = 1.010%
b) AM = 1.000%, GM = 0.692%
c) AM = 0.692%, GM = 4.000%
d) AM = 1.000%, GM = 1.0692%
e) AM = 4.000%, GM = 0.0692%




316
USE THE FOLLOWING INFORMATION FOR THE NEXT THREE PROBLEMS

Assume that you invest $5000 for 30 years in an account that pays an interest rate of
8.5% per year with annual compounding.


(c) 6 The total value of your investment at the end of 30 years is?

a) $67,750
b) $52,791
c) $57,791
d) $40,041
e) $60,000


(b) 7 The amount of simple interest earned is?

a) $67,750
b) $52,791
c) $57,791
d) $40,041
e) $60,000


(d) 8 The amount of interest-on-interest earned is?

a) $67,750
b) $52,791
c) $57,791
d) $40,041
e) $60,000


(e) 9 Consider a stock that has an expected return of 10% and standard deviation
of 14%. Assuming that future returns will resemble past returns, an investor
can expect 95% of actual future returns to lie between

a) -10% and 24%
b) 10% and 14%
c) -32% and 52%
d) -4% and 24%
e) -18% and 38%


317
CHAPTER 2

ANSWERS TO PROBLEMS


1 (1 + 0.065)
1/(1/12)
= 2.129. The HPR = 2.129 – 1 = 1.129
or 113%

2 (1 + 0.03)
1/(4/52)
= 1.4687. The HPR = 1.4687 – 1 = 0.4687
or 46.87%


3 HPR = 20 . 0
1000
200
1000
100 100
= =
+
or 20%


4 1000(1.07)
15
= 2759.03

Original principal = 1000
Cumulative simple interest = 1050
Cumulative interest-on-interest = 709.03

709.03/2759.03 = 0.257 or 25.7%

5 AM = [(.05) + (-.10) + (.11) + (-.02)]/4 =.04/4 = .01 = 1%

GM = [(1.05)(.90)(1.11)(.98)]
1/4
- 1 = 1.00692 - 1 = .00692
= 0.692%


6 Value of account at the end of 30 years = 5000(1.085)
30
= $57,791.26


7 Original principal = 5000
Cumulative simple interest = 30 x 0.085 x 5000 = $12,750.00
Total interest = 57,791.26 – 5000 = $52,791.26
Cumulative interest-on-interest = 52,791.26 – 12,750 = $40,041.26


8 Total interest = 57,791.26 – 5000 = $52,791.26
Cumulative interest-on-interest = 52,791.26 – 12,750 = $40,041.26


9 95% of returns will lie between 10% +/- 2 x 14.
That is between –18% and 38%




318
CHAPTER 3

SELECTING INVESTMENTS IN A GLOBAL MARKET


TRUE/FALSE QUESTIONS

(f) 1 The U.S. equity and bond markets have grown in terms of their relative size
of the world equity and bond market.

(t) 2 Diversification with foreign securities can help reduce portfolio risk.

(f) 3 The total domestic return on German bonds is the return that would be
experienced by a U.S. investor who owned German bonds.

(t) 4 If the exchange rate effect for Japanese bonds is negative, it means that the
domestic rate of return will be greater than the U.S. dollar return.

(t) 5 Investors who limit themselves to the U.S. equity market experienced rates
of return below those in many other countries.

(f) 6 It is very important when diversifying that the correlation between rates of
return for various countries be high and very stable over time.

(t) 7 Municipal bonds are tax-exempt.

(f) 8 A Eurobond is an international bond denominated in a currency other than
that of the United States.

(f) 9 Yields on money market funds are often lower than yields available to
individuals investing in CD's because of the fees involved.

(f) 10 Income bonds are considered as safe as debentures because they pay higher
rates of interest.

(t) 11 Warrants are options issued in connection with the sale of fixed income
securities.

(f) 12 A call option is issued by a firm in conjunction with a convertible bond.

(f) 13 For a U.K. based investor with stock investments in the U.S. a weakening
dollar will enhance returns in terms of pounds.

(t) 14 For a U.S. based investor with stock investments in the U.K. a weakening
dollar will enhance returns in dollar terms.






319
MULTIPLE CHOICE QUESTIONS


(d) 1 If you are considering investing in German stocks as a means to reduce the
risk of your portfolio, the initial factor that you should examine is:

a) The average rate of return of the portfolio when you combine U.S.
and German stocks.
b) The standard deviation of the German stocks.
c) The standard deviation of the German stocks compared to the
standard deviation of U.S. stocks.
d) The correlation between the rates of return for German stocks and
U.S. stocks.
e) The coefficient of variation (CV) of rates of return for German stocks
versus the CV of rates of return for U.S. stocks.


(c) 2 Correlations of returns between U.S. bonds and those of foreign countries
differ because of differences in

a) Culture.
b) Political systems.
c) International trade patterns.
d) Language.
e) None of the above.


(c) 3 The legal document setting forth the obligations of a bond's issuer is called

a) A debenture.
b) A warrant.
c) An indenture.
d) A rights certificate.
e) A trustee deed.


(b) 4 The correlation between U.S. equities and U.S. government bonds has been

a) Strongly positive.
b) Weakly positive.
c) Strong negative.
d) Weakly negative.
e) Indeterminate.

(c) 5 U.S. investors should consider constructing global investment portfolios
because

a) Overseas markets usually outperform U.S. markets.
b) Overseas markets are less risky.
c) Overseas markets offer risk reduction via diversification.
d) Investors will benefit from a stronger dollar
320
e) None of the above.


(d) 6 In order to diversify risk an investor must have investments that that have
correlations with other investments in the portfolio that are

a) low positive
b) zero
c) negative
d) any of the above
e) none of the above


(a) 7 Correlations between stock markets in different countries have been rising
over time because

a) Countries are developing closer trade and
economic links.
b) Countries are becoming more segmented.
c) There are fewer barriers to travel.
d) U.S. investors are purchasing more foreign securities.
e) Correlations between bond markets of different countries have been
rising.

(c) 8 Global portfolio managers can diversify more risk by

a) diversifying across countries.
b) diversifying across industries.
c) diversifying across industries and countries.
d) diversifying across U.S. industries.
e) diversifying across U.S. asset classes.

(a) 9 Collateralized mortgage obligations (CMOs) offset some of the problems
associated with traditional mortgage pass-throughs because

a) They are overcolleralized.
b) They have variable rates.
c) Collateralized by auto-loans.
d) They are deep discount instruments.
e) Collateralized by credit card debt.


321
MULTIPLE CHOICE PROBLEMS


USE THE FOLLOWING INFORMATION FOR THE NEXT FIVE PROBLEMS

Security Annual Percentage Return
U.S. government T-bills 2.04%
Long-term government bonds 4.75%
Long-term corporate bonds 5.8%
Common Stock 12.50%
Small capitalization common stocks 14.60%


(c) 1 What is the maturity premium?

a) 3.76%
b) 1.05%
c) 2.71%
d) 3.25%
e) 4.70%


(b) 2 What is the default premium?

a) 3.76%
b) 1.05%
c) 2.71%
d) 3.25%
e) 4.71%


(e) 3 What is the common stock risk premium?

a) 1.66%
b) 12.56%
c) 4.92%
d) 8.80%
e) 10.46%


(b) 4 What is the small firm stock risk premium?

a) 1.32%
b) 2.10%
c) 2.50%
d) 3.50%
e) 4.90%


(c) 5 If the annual rate of inflation during the period was 4 percent, what was the
real rate of return on long-term corporate bonds?
322

a) 1.16%
b) 1.85%
c) 1.73%
d) 3.50%
e) 4.90%


(d) 6 You are trying to decide between a par value corporate bond carrying a
coupon rate of 6.25% per year and a par value municipal bond that pays an
annual coupon rate of 4.75%. Assuming all other factors are the same and
you are in the 28% tax bracket, which bond should you choose and why?

a) Corporate bond because the after tax yield is 6.25%.
b) Corporate bond because the after tax yield is 4.5%.
c) Municipal bond because the equivalent taxable yield is 6.3%.
d) Municipal bond because the equivalent taxable yield is 6.6%.
e) You will be indifferent between the two because the after tax yields are
the same.

USE THE FOLLOWING INFORMATION TO ANSWER THE NEXT FIVE PROBLEMS

Company Ticker Coupon Maturity
Last
Price
Last
Yield
EST
Spread UST
Est $
Vol
(000's)
Gen Elec GE 4.75
9/15/201
4 99.544 4.808 62 10 158736


(b) 7 What annual dollar coupon amount will investors receive?

a) $4.75
b) $47.50
c) $4.808
d) $48.08
e) $62


(e) 8 What price would you pay in dollars to purchase this bond?

a) $62
b) $9.954
c) $48.08
d) $99.544
e) $995.44


(a) 9 What is the estimated yield on Treasury securities?

a) 4.188%
b) 5.428%
323
c) 5.371%
d) 4.132%
e) 4.753%


(c) 10 What is the current yield for this bond?

a) 4.18%
b) 5.88%
c) 4.77%
d) 8.125%
e) 4.063%


(c) 11 What is the capital gains/loss yield on this bond?

a) -0.038%
b) 0.456%
c) 0.038%
d) -0.456%
e) None of the above


(d) 12 Consider a U.S. based investor who purchases German stocks on January 1,
2002. One year later, on January 1, 2003 he sells the German stocks. The
total return in local currency is 10%. The exchange rate on January 1, 2002
is $1.05/euro. The exchange rate on January 1, 2003 is $0.90/euro.
Calculate the return in dollar terms.

a) 10.83%
b) -28.33%
c) 5.71%
d) -5.71%
e) 10.0%


(a) 13 Consider a Germany based investor who purchases U.S. stocks on January
1, 2002. One year later, on January 1, 2003 he sells the German stocks. The
total return in local currency is -5%. The exchange rate on January 1, 2002
is $1.05/euro. The exchange rate on January 1, 2003 is $0.90/euro.
Calculate the return in euro terms.

a) 10.83%
b) -28.33%
c) 5.71%
d) -5.71%
e) 5.0%


(b) 14 An investor based in the U.S. has security investments in the U.K. The
324
exchange over a one year period has gone from $1.85 per pound to $2 per
pound. During this same period the investor’s return in dollar terms is
calculated to be 10%. Calculate the local currency returns for the U.K.
securities ( i.e. in pound terms).

a) 8.11%
b) 1.75%
c) -1.35%
d) -7.5%
e) 10.81%


(c) 15 Assume the exchange rate is $1.85 per pound at the beginning of the year
and $2 per pound at the end of the year. For an investor based in the U.K.
with security investments in the U.S. the exchange rate change is

a) 8.11%
b) 15%
c) -7.5%
d) -8.11%
e) -15%

THE FOLLOWING INFORMATION APPLIES TO THE NEXT TWO PROBLEMS

Treasury Bills
Maturity Days to Mat Bid Asked Chg Ask Yld
May 12 05 181 2.25 2.24 - ?


(c) 16 Use the information provided above to calculate the ask price for this
Treasury bill.

a) $9997.75
b) $9997.76
c) $9887.37
d) $10002.25
e) $10002.24


(a) 17 Use the information provided to calculate the ask yield (also known as the
investment rate or the bond equivalent rate.

a) 2.30%
b) 2.25%
c) 2.24%
d) 3.75%
e) 4.49%
325
CHAPTER 3

ANSWERS TO PROBLEMS


1 Maturity premium = 4.75 – 2.04 = 2.71%

2 Default premium = 5.8 – 4.75 = 1.05%

3 Common stock premium = 12.50 – 2.04 = 10.46%.

4 Small firm premium = 14.60 - 12.50 = 2.10%.

5 Real L-T corporate bond return = (1 + 0.058)/(1 + 0.04) – 1 = 0.0173 or 1.73%.

6 The municipal bond has an equivalent taxable yield of 0.475/(1 – 0.28)= 0.066. This is
higher than the bond yield of 0.0625.

7 Annual dollar coupon amount = (1000)(0.0475) = $47.50.

8 Price = $995.44. Or 99.544% of face value of $1000.

9 Estimated yield on 10 year Treasury = 4.808% - 0.62% = 4.188%.

10 Current yield = 47.50/995.44 = 0.0477 or 4.77%.

11 Capital gains yield = 4.808% - 4.77% = 0.038%.

12 Dollar returns = (1 + 0.10)(0.90/1.05) – 1 = -0.0571 or -5.71%

13 Euro returns = (1 - 0.05)(1.1111/0.9524) – 1 = 0.1083 or 10.83%%.

14 Exchange rate change = (2/1.85) -1 = 0.08108 or 8.11%

Local currency return = (1 + 0.10)/(1 + 0.08108) – 1 = 0.0175 or 1.75%

15 First restate exchange rates as 1/1.85 = pounds 0.5405 per $ and 1/2.0 = pounds 0.50
per dollar.
Exchange rate change = (0.50/0.5405) – 1 = -0.075 or -7.5%

16 Ask price = 10,000 – (0.0224 x 10,000 x 181)/360 = $9887.37

17 Ask yield = ((10000 – 9887.37)/9887.37) x (365/181) = 0.02296 or 2.3%


326
CHAPTER 5

THE ASSET ALLOCATION DECISION

TRUE/FALSE QUESTIONS

(t) 1 Experts suggest life insurance coverage should be seven to ten times an
individual's annual salary.

(t) 2 The gifting phase is similar to, and may be concurrent with, the spending phase.

(t) 3 Long-term, high-priority goals include some form of financial independence.

(f) 4 The investment performance of a portfolio manager of a small Capitalization
equity fund should be compared to the performance of the S&P 500 stock index.

(f) 5 Risk tolerance is exclusively a function of an individual's psychological makeup.

(f) 6 An appropriate investment objective for a typical 25-year-old investor is a low-
risk strategy, such as capital preservation or current income.

(f) 7 Marginal tax rate is defined as a person's total tax payment divided by their total
income.

(t) 8 Investment returns of an IRA investment, including any income, are deferred
until
the funds are withdrawn from the account.

(f) 9 Liquidity needs, time horizon, tax concerns and risk tolerance are all investment
constraints.

(t) 10 Average tax rate is defined as a person's total tax payment divided by their total
income.





MULTIPLE CHOICE QUESTIONS

(a) 1 Asset allocation is defined as the process of deciding how to allocate an investor’s
wealth among

a) Asset classes, sectors, and countries.
b) Asset classes, sectors and real estate.
c) Asset classes, sectors and derivatives.
d) Asset classes.
e) Sectors.

327

(a) 2 Which of the following is not a life cycle phase?

a) Discovery phase
b) Accumulation phase
c) Consolidation phase
d) Spending phase
e) Gifting phase


(e) 3 Which of the following is not a step in the portfolio management process?

a) Develop a policy statement
b) Study current financial and economic conditions
c) Construct the portfolio
d) Monitor investor's needs and market conditions
e) Sell all assets and reinvest the proceeds at least once a year


(e) 4 An example of a risk management strategy that involves ‘risk transfer’ is

a) Maintaining large cash reserves.
b) Purchasing commodities.
c) Investing largely in bonds.
d) Investing largely in stocks.
e) Purchasing derivative securities.


(c) 5 An individual in the consolidation phase of the investment life cycle would

a) Have retired and would seek to preserve the real value of their investments.
b) Have enough income to cover expenses and excess assets would be used to
benefit charities and family.
c) Be past the midpoint of their careers and have excess earnings that can be
invested in moderately risky investments.
d) Be in the early to middle stage of their career, have a small net worth and long
investment time horizon.
e) None of the above.


(d) 6 Which of the following statements is true?

a) Stocks are inappropriate investments in a tax deferred account.
b) The only way to maintain purchasing power over time is to invest in bonds.
c) After adjusting for taxes, long-term bonds consistently outperform stocks.
d) Investment in common stocks enables an investor to maintain real value over
time.
e) None of the above
328

(c) 7 In the U.K. equity allocation in pension fund portfolios stands around 78%. This
high level of allocation to equities can be explained by

a) The generous state pensions.
b) The high average age of the population.
c) The historically high inflation.
d) An illiquid stock market.
e) Government regulations.


(e) 8 Research has shown that the asset allocation decision explains % of the
variation in fund returns across all funds, and % of the variation in returns for a
particular fund over time.

a) 90 and 100.
b) 100 and 40.
c) 90 and 40.
d) 40 and 100.
e) 40 and 90.


(a) 9 In an investment policy statement the objectives of an investor are expressed in
terms of

a) risk and return
b) risk
c) return
d) time horizon
e) liquidity needs


(d) 10 Investors can manage risk confronting their wealth using the following

a) risk avoidance
b) risk anticipation
c) risk transfer
d) all of the above
e) none of the above


(d) 11 An individual in the accumulation phase of the investment life cycle would

a) Have retired and would seek to preserve the real value of their investments.
b) Have enough income to cover expenses and excess assets would be used to
benefit charities and family.
c) Be past the midpoint of their careers and have excess earnings that can be
invested in moderately risky investments.
d) Be in the early to middle stage of their career, have a small net worth and long
investment time horizon.
329
e) None of the above.
330
MULTIPLE CHOICE PROBLEMS


(d) 1 The nominal rate of return for a security is 12.5% per year. If the relevant tax rate
is 35% and the rate of inflation is 3.75% per year, calculate the after tax real rate
of return for the security.

a) 8.75%
b) 5.69%
c) 8.43%
d) 3.06%
e) 2.95%


USE THE FOLLOWING INFORMATION FOR THE NEXT 4 PROBLEMS

As part of a retirement planning exercise, you are comparing a regular IRA with a
Roth IRA. The regular IRA contribution is tax deductible. In both cases the
contribution amount is $2000. Your time horizon is 25 years and you expect to
earn 9.5% percent per year on both types of IRA accounts. Your current tax rate
is
20% but you expect you tax rate at retirement to be 15%.


(b) 2 Calculate the tax savings generated by the regular IRA at the time of investment.

a) $300
b) $400
c) $700
d) $100
e) $200


(c) 3 Calculate the future value, at the end of 25 years, of the tax savings.

a) $2,900.51
b) $3,867.35
c) $2,496.70
d) $1,248.35
e) $4,369.23


(c) 4 Calculate the total after tax future value, at the end of 25 years, of the regular IRA
contribution and the tax savings.

a) $19,336.73
b) $21,833.43
c) $18,932.92
d) $16,840.03
e) $16,436.23
331


(a) 5 Calculate the total after tax future value, at the end of 25 years, of the Roth IRA
contribution.

a) $19,336.73
b) $21,833.43
c) $18,932.92
d) $16,840.03
e) $16,436.23


(e) 6 Your portfolio currently has an asset allocation that is 15% cash, 35% bonds, and
50% stocks. The returns over the past years for cash was 3.5%, bonds
5.75%, and stocks –8.5%. The return on your portfolio for the past year was

a) -5.04%
b) 5.47%
c) 0.25%
d) 5.91%
e) -1.71%


(a) 7 The future value of $25,000 invested today, at the end of 20 years assuming an
interest rate of 11.5% per year, with semiannual compounding, is

a) $233,976
b) $220,515
c) $250,515
d) $500,673
e) $213,321


(b) 8 Assume that you invest $1000 at the end of each quarter for the next 15 years in a
mutual fund. The annual rate of interest that you expect to earn in
the this account is 8.75%. The amount in the account at the end of 15 years

a) $28,790
b) $121,749
c) $60,000
d) $315,000
e) $115,637


(d) 9 Assuming the investor's marginal tax rate is 28% and he is considering
investing in a municipal bond yielding 7%. What is the equivalent taxable
yield?

a) 5.04%
b) 5.47%
c) 8.96%
332
d) 9.72%
e) 9.80%


USE THE FOLLOWING INFORMATION FOR THE NEXT TWO PROBLEMS

Assume that you have just retired with $1,000,000 in savings in an investment
account. You expect to earn 10% per year on your investments. You plan to
withdraw 25% annually at the beginning of each year with interest credited on the
remaining balance at the end of the year.


(d) 10 Calculate the amount withdrawn at the beginning of the second year.

a) $148,739
b) $250,000
c) $170,156
d) $206,250
e) $186,320


(d) 11 Calculate the balance in the investment account at the end of the second year
(prior to any withdrawals)

a) $750,000
b) $618,750
c) $825,000
d) $680,625
e) $510,468


(b) 12 Someone in the 15 percent tax bracket can earn 8% on his investments in a tax-
exempt IRA account. What will be the value of a $10,000 investment after 5
years (assuming annual compounding)?

a) $ 6,805
b) $14,693
c) $15,528
d) $20,114
e) $50,000


(c) 13 Suppose you invest money in a taxable account earning 8% per year. What will be
the after-tax value of a $10,000 investment after 5 years if you are in the 15% tax
bracket (assuming annual compounding)?

a) $10,680
b) $11,765
333
c) $13,895
d) $14,693
e) $15,528


CHAPTER 5

ANSWERS TO MULTIPLE CHOICE PROBLEMS


1. After tax real rate = ([(1 + 0.125)/(1 + 0.0375)]-1)(1-.35)
= 0.0548 or 5.48%

2. Tax savings on regular IRA = (2000)(0.2) = 400.

3. FV of tax savings = 400(1 + 0.076)
25
= $2496.70

0.095(1 – 0.2) = 0.076

4. Pre tax FV of regular IRA contribution = 2000(1 + 0.095)
25
= $19,336.73

After tax FV of regular IRA = $19,336.73(1 – 0.15) = $16,436.22

FV of tax savings = 400(1 + 0.076)
25
= $2496.70

Total after tax = $18,932.92

5. After tax FV of Roth IRA contribution = 2000(1 + 0.095)
25
= $19,336.73


6. Portfolio return = (.15)(.035)+(.35)(.0575)+(.5)(-.085)

= -0.0171 or –1.71%

7. FV = 25,000(1 + .0575
40
) = $233,976

8. FV =
|
|
.
|

\
| ÷ +
021875 .
1 ) 021875 . 1 (
1000
60
=$121,749

9. Equivalent taxable yield = .07/(1 - .28) = .07/.72 = 9.72%




334
10.
Interest rate 10%
Withdrawal rate 25%
Year Principal outflow Balance
0

$1,000,000.00

$250,000.00

$750,000.00
1 $ 825,000.00

$206,250.00

$618,750.00
2 $ 680,625.00

$170,156.25

$510,468.75
The initial withdrawal is $1,000,000(0.25) = $250,000
The remaining balance of $750,000 earns interest of 10%.
At the end of the year it is worth 750,000(1.1) = $825,000
The withdrawal at the beginning of the second year is = 825,000(0.25) = $206,250


11. The remaining balance at the end of the first year = 825,000 – 206,250 = $618,750
This earns interest of 10% and at the end of year 2 is worth = 618,750(1.1) = $680,625


12. $10,000(1 + 0.08)
5
= $14,693


13. After-tax yield = Before-tax yield (1 - Tax rate) = 0.08(1 - 0.15) = 0.068 or 6.8%

$10,000(1 + 0.068)
5
= $13,895
335
CHAPTER 5 APPENDIX

MULTIPLE CHOICE QUESTIONS

(a) 1 Many endowments are tax-exempt.

a) True
b) False


(b) 2 Cash flows for nonlife insurance companies, such as property and casualty, are
similar to cash flows of life insurance companies.

a) True
b) False


(b) 3 The portfolio mixes of institutional investors around the world are approximately
the same.

a) True
b) False


(e) 4 In a defined contribution pension plan,

a) the plan does not promise to pay the retiree a specific income stream after
retirement.
b) the plan does promise to pay the retiree a specific income stream after
retirement.
c) the employee's retirement income is not an obligation of the firm.
d) the company carries the risk of paying future pension benefits to retirees.
e) Choices a and c


(d) 5 Banks typically have short-term investment horizons because

a) they have a strong need for liquidity.
b) they offer short-term deposit accounts.
c) they are required to by federal and state laws.
d) Choices a and b
e) All of the above






336
CHAPTER 6

ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS


TRUE/FALSE QUESTIONS


(t) 1 A continuous market that has price continuity requires depth of buyers and
sellers.

(f) 2 A market where prices adjust rapidly to new information is considered to be
internally efficient.

(f) 3 Informational efficiency is where the cost of acquiring information is very
cheap.

(f) 4 The primary market is where existing issues are traded between current and
potential owners.

(t) 5 A general obligation (GO) bond is backed by the full taxing power of the
municipality.

(t) 6 Negotiated, competitive bids, and best efforts are three forms of
underwriting arrangements.

(t) 7 Secondary markets are important because they provide liquidity to
individuals who have purchased issues in the primary market.

(f) 8 In a call market, trades occur at any time while the market is open.

(t) 9 The U.S. over-the-counter market is the largest segment of the U.S.
secondary market in terms of number of issues traded.

(f) 10 The third market describes direct trading of securities between parties with
no broker intermediary.

(f) 11 The fourth market is mainly used by individual investors because it is much
cheaper than using a broker.

(t) 12 A short seller can only trade on an uptick (or zero uptick) and must pay any
dividends to the lender of the stock.

(t) 13 The increase in institutional development has caused an increase in the
number and size of block trades.

(t) 14 Super DOT is an electronic order-routing system through which member
firms can transmit market and limit orders directly to the posts where the
securities are traded.

(t) 15 In the United States commons stocks are quoted in decimals not fractions.
337

(f) 16 Decimalization has increased spread size and caused an increase in
transaction costs.


MULTIPLE CHOICE QUESTIONS



(b) 1 A central limit order book (CLOB) refers to a system where

a) All limit orders are electronically matched.
b) All limit orders are visible to the specialist only.
c) All limit orders are visible to markets makers and specialists.
d) Orders are routed through Super Dot.
e) None of the above.


(b) 2 In a call market, trading for individual stocks

a) Occurs anytime the market is open.
b) Takes place at specific times.
c) Takes place at the open and close of the trading day.
d) All of the above.
e) None of the above.


(e) 3 A pure auction market is one in which

a) Dealers provide liquidity by buying and selling shares of stock for
themselves.
b) Dealers compete against each other to provide the highest bid and
lowest asking prices.
c) Buyers submit bid prices to sellers.
d) Sellers submit ask prices to buyers.
e) Buyers and sellers submit bid and ask prices to a central location to be
matched.


(a) 4 In a negotiated bid, the underwriter carries out the following service(s)

a) Origination, risk-bearing, and distribution.
b) Origination and risk-bearing.
c) Risk-bearing and distribution.
d) Origination and distribution.
e) Risk-bearing and distribution.


(d) 5 Municipal bonds are sold using the following method or methods

a) Competitive bid
338
b) Negotiated sale
c) Private placement
d) All of the above
e) None of the above



(d) 6 When a market externally efficient, it means that

a) Timely and accurate information is available
b) The market is liquid
c) Transaction costs are low
d) Prices adjust rapidly to new information
e) The number of buyers and sellers are the same


(b) 7 When a market is internally efficient, it means that

a) The market has price continuity.
b) The market has minimal transactions costs
c) The market has good depth
d) The market has more buyers than sellers
e) The market has more sellers than buyers


(b) 8 The impact of changing the system for quoting share prices from fractions
to decimals has been to

a) Increase spread size, increase transaction costs, and increase the number
of transactions.
b) Decrease spread size, decrease transaction costs, and increase the
number of transactions.
c) Decrease spread size, decrease transaction costs, and decrease the
number of transactions.
d) Decrease spread size, increase transaction costs, and increase the
number of transactions.
e) Decrease spread size, decrease transaction costs and decrease the
number of transactions..


(d) 9 Which of the following is not a characteristic of a "good" market?

a) Marketability
b) Price continuity
c) Low transaction costs
d) Few buyers and sellers
e) Informational efficiency


(b) 10 A "good" market is one

339
a) In which there is a strong likelihood of insider trading.
b) Where prices reflect new information regarding supply and demand
factors.
c) Where accurate information on cost and volume for past transactions is
difficult to obtain.
d) Which is illiquid and has high transaction costs.
e) All of the above.


(e) 11 Which of the following is(are) an underwriting function?

a) Origination.
b) Risk-bearing and origination.
c) Distribution and origination.
d) Risk bearing and distribution.
e) Origination, risk bearing and distribution.


(d) 12 With a best-efforts offering, the investment banker performs all of the
following roles:

a) Designs and plans the security issue.
b) Acquires the total issue through a competitive bid.
c) Accepts the responsibility for reselling the issue.
d) Acts as a broker to sell as many securities it can at a stipulated price.
e) All of the above are true.


(c) 13 The basic distinction between a primary and a secondary market is

a) Proceeds from sales in the primary market go to the current owner of a
security; proceeds in secondary market go to the original owner.
b) Primary markets involve direct dealings within regional exchanges.
c) Only new securities are sold in the primary market; only outstanding
securities are brought and sold in the secondary market.
d) Primary markets deal exclusively in bonds; secondary markets deal
primarily in common stock.
e) There is no difference between a primary and secondary market


(a) 14 The underwriting function of ‘origination’ involves

a) The design and planning of the security issue.
b) Acquiring the total issue through a competitive bid.
c) Accepting the responsibility for reselling the issue.
d) Acting as a broker to sell as many securities it can at a stipulated price.
e) All of the above are true.


(c) 15 The underwriting function of ‘risk-bearing’ involves
340

a) The design and planning of the security issue.
b) Selling the security issue through a selling syndicate.
c) Accepting the responsibility for reselling the issue.
d) Acting as a broker to sell as many securities it can at a stipulated
price.
e) All of the above are true.

(a) 16 A dealer market is one in which

a) Dealers compete and provide liquidity by buying and selling shares of a
security for themselves.
b) One dealer sets bid and ask prices at which securities will trade.
c) Buyers submit bid prices to sellers.
d) Sellers submit ask prices to buyers.
e) Buyers and sellers submit bid and ask prices to a central location to be
matched.


(e) 17 The term ‘third market’ describes the market where dealers and brokers:

a) Trade in stocks listed on regional stock exchanges.
b) Trade in stocks through electronic communication networks.
c) Trade in stocks listed on the London Stock Exchange.
d) Trade in stocks through electronic crossing systems.
e) Trade in exchange listed stocks away from the exchanges.


(e) 18 The vast majority of trading on regional stock exchanges is in

a) Stocks listed on the NYSE.
b) Stocks listed on the Nasdaq.
c) Dual listed stocks.
d) Stocks with unlisted trading privileges (UTP).
e) Dual listed and UTP stocks.


(e) 19 The member of the New York Stock Exchange who acts as a dealer on
assigned stocks is known as a

a) Registered trader.
b) Commission broker.
c) Registered dealer.
d) Floor dealer.
e) Specialist.


(c) 20 Floor brokers on the NYSE

a) Use their membership to buy and sell for their own account.
341
b) Are employees of a member firm and buy and sell for customers of the
firm.
c) Act as brokers for other members.
d) Handle limit and other special orders placed by other brokers on the
floor.
e) Maintain a fair and orderly market.


(a) 21 An order placed specifying the buy or sell price is a

a) Limit order.
b) Short sale.
c) Market order.
d) Priced order.
e) Stop loss.


(c) 22 When an investor borrows part of the investment cost it is known as

a) A short sale.
b) A fill or kill order.
c) A margin transaction.
d) A limit order.
e) A credit order.


(e) 23 Which of the following is not a function of the specialist?

a) Acting as a broker who handles the limit orders or special orders placed
with member brokers
b) Buying and selling securities in order to stabilize the market
c) Acting as a dealer in assigned stocks to maintain a fair and orderly
market
d) Maintain a minimum of $1 million or the value of 15,000 shares of each
stock assigned, whichever is greater
e) Speculating only for themselves, they do not execute traders for the
public nor for other brokers


(c) 24 If your broker required a maintenance margin of 25%, it means that

a) You may borrow up to 25% of a stock purchase.
b) You may borrow up to 75% of a stock purchase.
c) The ratio of your equity value to the total value of the position may not
fall below 25%.
d) The ratio of your equity value to the total value of the position may not
fall below 75%.
e) None of the above.


342


343
MULTIPLE CHOICE PROBLEMS


USE THE FOLLOWING INFORMATION FOR THE NEXT THREE PROBLEMS

Assume you deposit $100,000 in a margin account. The margin requirement is 50 percent and
commissions are ignored. Shares in Sisco Corp currently sell for $80 per share:

(b) 1 What is the value of stock that you can acquire?

a) $100,000
b) $200,000
c) $175,000
d) $150,000
e) $300,000


(c) 2 What is your profit if the price of Sisco Corp rises to $90?

a) $50,000
b) $12,500
c) $25,000
d) $100,000
e) $120,000


(c) 3 If the maintenance margin is 25 percent, to what price can Sisco Corp fall
before you receive a margin call?

a) $51.25
b) $43.25
c) $53.33
d) $45.33
e) $83.33


(d) 4 Calculate your percentage rate of return if the shares of Sisco Corp falls to
$65.

a) -15.00%
b) -25.00%
c) -23.07%
d) -37.50%
e) -30.50%


(b) 5 Suppose you buy a round lot of a stock on 55 percent margin when it is
selling at $35 a share. The broker charges a 10 percent annual interest rate
and commissions are 3 percent of the total stock value on both the purchase
and the sale. If at year end you receive a $0.90 per share dividend and sell
the stock for 32, what is your rate of return on the investment?
344

a) -29.38%
b) -28.00%
c) -26.23%
d) -25.00%
e) -35.00%



USE THE FOLLOWING INFORMATION FOR THE NEXT TWO PROBLEMS

You decide to sell 100 shares of a stock short when it is selling at its yearly high of $22.25.
Your broker tells you that your margin requirement is 55% and that the commission on the sale
is $55. While you are short, the stock, Tuna Boat pays a $0.75 per share dividend. At the end of
one year you buy shares of the stock to cover your short sale at $18.38 and are charged a
commission of $45 and a 9% interest rate on the funds you borrowed.


(a) 6 What is your dollar return on the investment?

a) $121.89
b) $315.05
c) $425.50
d) $637.73
e) $950.45


(d) 7 What is your rate of return on the investment?

a) 0.87%
b) 3.87%
c) 5.08%
d) 9.53%
e) 11.87%


USE THE FOLLOWING INFORMATION FOR THE NEXT FIVE PROBLEMS

You decide to sell short 200 shares of XCorp stock at a price of $75. Your margin deposit is
65%. Commission on the sale is 1.25%. During the year the stock pays a $1.75 per share
dividend. Interest on margin debt is 5.25% per year.

(d) 8 Calculate your initial investment

a) $15,000
b) $5,250.75
c) $9,750.25
d) $9,937.50
e) $15,187.50

345
(a) 9 At the end of one year you close out your short position by purchasing
shares of XCorp at $45 per share. The commission is 1.25%. Calculate your
dollar profit.

a) $5,074.38
b) -$4,038.13
c) $5250.00
d) -$5074.38
e) $4,038.13


(c) 10 If at the end of one year you close out your short position by purchasing
share of XCorp at $45 per share with commission of 1.25%, what is your
rate of return on the investment?

a) -55.92%
b) 10.31%
c) 51.06%
d) 23.1%
e) -33.05%


(b) 11 Suppose at the end of one year XCorp is selling at $90 per share and you
cover your short position at this price. What is your dollar profit on the
investment? (Assume a 1.25% commission on the purchase)

a) $5,074.38
b) -$4,038.13
c) $5250.00
d) -$5074.38
e) $4,038.13

(a) 12 If you cover your short position at $90 per share. What is your rate of return
on the investment? (Assume a 1.25% commission on the purchase)

a) -40.64%
b) -25.53%
c) 5.21%
d) 72.7%
e) –71.2%


USE THE FOLLOWING INFORMATION FOR THE NEXT FIVE PROBLEMS

Shares of RossCorp stock are selling for $45 per share. Brokerage commissions are 2% for
purchases and 2% for sales. The interest rate on margin debt is 6.25% per year. The
maintenance margin is 30%.

(e) 13 At the end of one year shares of RossCorp stock are selling for $55 per
share and the company paid dividends of $0.85 per share. Assuming that
346
you paid the full cost of the purchase, what is your rate of return if you sell
RossCorp stock?

a) 18.08%
b) 23.51%
c) 22.32%
d) 14.96%
e) 19.28%


(b) 14 At the end of one year shares of RossCorp stock are selling for $35 per
share and the company paid dividends of $0.85 per share. Assuming that
you paid the full cost of the purchase, what is your rate of return if you sell
RossCorp stock?

a) -33.05%
b) -23.42%
c) 23.42%
d) 33.05%
e) –25.35%


(c) 15 At the end of one year shares of RossCorp stock are selling for $55 per
share and the company paid dividends of $0.85 per share. Assuming that
you borrowed 25% of cost of the purchase, what is your rate of return?

a) -23.51%
b) 29.35%
c) 23.51%
d) 5.21%
e) 10.06%


(b) 16 At the end of one year shares of RossCorp stock are selling for $35 per
share and the company paid dividends of $0.85 per share. Assuming that
you borrowed 25% of cost of the purchase, what is your rate of return?

a) 33.05%
b) -33.05%
c) -23.51%
d) -25.35%
e) –40.64%


(d) 17 Assume that you purchase 150 shares of RossCorp stock by making a
margin deposit of 75%. At what price would you receive a margin call?

a) $29.39
b) $26.48
c) $50.39
d) $16.07
347
e) $50.10

CHAPTER 6

ANSWERS TO MULTIPLE CHOICE PROBLEMS


1. If X is the total investment your share will represent 50 percent.

Thus .50x = $100,000 and X = $100,000/.50 = $200,000.

Since the shares are $80 each, you can purchase

($200,000)/$80 = 2500 shares


2. Profit = (90 - 80)(2500) = $25,000


3. Margin = (Market Value - Debit Balance)/ Market Value

where Market Value = Price x Number of Shares = Price x 2500

Debit Balance = Initial Loan Value = (0.5)($80)(2500) = $100,000

0.25 = ((Price x 2500) - $100,000)/(Price x 2500)

Price = $53.33

4. Return = (65 – 80)/(0.5 x 80) = -0.375 or -37.5%

5. Initial investment= (.55 x $3,500) + (.03 x $3500) = $2030

Beginning Value of Stock = $3500

Profit = Ending Wealth - Beginning Value of Stock - Transaction Costs - Interest

Ending Wealth = Ending Market Value + Dividend= $3200 + $90 = $3290

Transaction Costs = .03 x 3500 + .03 x 3200 = $105.00 + 96 = $201

Interest = .10 x (.45 x $3500) = $157.50

Profit = $3290 - $3500.00 - $201 - $157.50 = - $568.50

Rate of Return = Profit/Initial Investment
= -$568.50/$2030
= -28%



348
For problems 6 and 7

Initial investment = (.55 x $2225) + 55 = $1278.75

Cost = $18.38 x 100 = $1838 (without transaction costs)

Profit = Total Return - Cost - Transaction Costs - Interest

Total Return = Beginning Market Value - Dividend = $2225 - $75 = $2150

Transaction Costs = $55 + $45 = $100.00

Interest = .09 x (.45 x $2225) = $90.11


6. Profit = $2150 - $1838 - $100 - $90.11 = $121.89

7. Rate of Return = $121.89/$1278.75 = 9.53%

8. Initial investment = (0.65)(200)(75) + (0.0125)(200)(75) = $9937.50

9. Dollar profit = 200(75 – 45 – 1.75) – (200)(75)(0.0125) –
(200)(45)(0.0125) – (200)(75)(0.35)(0.0525) = $5074.38

10. Rate of return = 5074.38/9937.50 = 0.5106 or 51.06%

11. Dollar profit = 200(75 – 90 – 1.75) – (200)(75)(0.0125) – (200)(90)(0.0125) –
(200)(0.35)(75)(0.0525) = -$4038.13

12. Rate of return = -4038.13/9937.50 = -0.4063 or -40.63%

13. Rate of return = [55- 45 + 0.85 - 1.10 - 0.90]/[45 + 0.90] = 19.28%

14. Rate of return = [35 – 45 + 0.85 -0.70 -0.90]/[45 + 0.90] = -23.42%

349
15. Rate of return = [55-45 + 0.85 -1.10-0.90-(1-.75)(45)(.0625)]/[(0.75)(45) + 0.90]
= 23.51%

16. Rate of return = [35-45+0.85-0.70-0.90- (1-.75)(45)(.0625)]/[(0.75)(45)+0.90]
= -33.05%

17. 0.30 = [(150)(P) – (0.25)(150)(45)]/[(150)(P)]

P = $16.07































CHAPTER 7
350

SECURITY-MARKET INDICATOR SERIES


TRUE/FALSE QUESTIONS

(t) 1 An aggregate market index can be used as a benchmark to judge the
performance of professional money managers.

(f) 2 A price-weighted index is the geometric average of the current prices of the
sampled securities.

(f) 3 The Dow-Jones Industrial Average (DJIA) is a value- weighted average.

(f) 4 The DJIA has been criticized because when a stock in the index splits there
are more shares outstanding and the importance of the stock in the
index increases.

(t) 5 Security market indexes have been used to create index funds and exchange
traded funds.

(f) 6 In a value-weighted index the highest priced stock carries the greatest
weight.

(t) 7 A value-weighted index contains an automatic adjustment for stock splits.

(f) 8 The S&P 500 stock index is an example of an equally-weighted index.

(t) 9 An index constructed using small-cap growth stocks would be referred to as
a style index .

(t) 10 The low correlations between the U.S. and the U.K., and the U.S. and
Japan, confirm the benefit of global diversification.

(t) 11 The correlations among the U.S. investment-grade-bond series were very
high because all rates of return for investment-grade bonds over time are
impacted by common macroeconomic variables.

351

MULTIPLE CHOICE QUESTIONS

(c) 1 Which of the following is not a use of security market indicator series?

a) To use as a benchmark of individual portfolio performance
b) To develop an index portfolio
c) To determine unsystematic risk
d) To determine factors influencing aggregate security price movements
e) To determine systematic risk


(c) 2 A properly selected sample for use in constructing a market indicator series
will consider the sample's source, size and

a) Value.
b) Average beta.
c) Breadth.
d) Variability.
e) Dividend record.


(a) 3 What effect does a stock substitution or stock split have on a price-weighted
series, such as DJIA?

a) Divisor will increase/decrease, index remains the same.
b) Index will increase/decrease, divisor remains the same.
c) Index and divisor will remain the same.
d) Index and divisor will both reflect the changes (immediately).
e) Not enough information provided.


(d) 4 An example of a value-weighted stock market indicator series is the

a) Dow Jones Industrial Average.
b) Nikkei-Dow Jones Average.
c) Value Line Index.
d) American Stock Exchange Index.
e) Lehman Brothers Index.


(d) 5 Which of the following indexes includes the most comprehensive list of
stocks?

a) New York Stock Exchange Composite Index
b) Standard and Poor's 500 Composite Index
c) American Stock Exchange Market Value Index
d) Nasdaq Composite
e) Dow Jones Industrial Average


352
(c) 6 The Value Line Composite Average is based on percent price changes
which has been computed using

a) An arithmetic mean.
b) A harmonic average.
c) A geometric mean.
d) An expected average.
e) A logarithmic average.


(e) 7 Which of the following are factors that make it difficult to create and
maintain a bond index?

a) The universe of bonds is broader than stocks.
b) The universe of bonds is constantly changing due to new issues, bond
maturities, calls, and bond sinking funds.
c) There can be difficulties in correctly pricing bond issues.
d) Choices a and c.
e) Choices a, b and c.


(a) 8 Low correlations between the S&P 500 stock index and the MSCI EAFE
suggest

a) That investors should diversify investment portfolios.
b) That investors should invest only in U.S. stocks.
c) That investors should invest only in Europe.
d) That investors should invest only is Asia.
e) Nothing.


(d) 9 Correlations between U.S. investment grade bonds are

a) Low because of the equity characteristics of high yield bonds.
b) Low because yields on investment grade bonds are determined by
systematic interest rate variables.
c) High because of the equity characteristics of high yield bonds.
d) High because yields on investment grade bonds are determined by
systematic interest rate variables.
e) None of the above.


(a) 10 Correlations between U.S. investment grade bonds and high yield bonds are

a) Low because of the equity characteristics of high yield bonds.
b) Low because yields on investment grade bonds are determined by
systematic interest rate variables.
c) High because of the equity characteristics of high yield bonds.
d) High because yields on investment grade bonds are determined by
systematic interest rate variables.
e) None of the above.
353
MULTIPLE CHOICE PROBLEMS

USE THE FOLLOWING INFORMATION FOR THE NEXT 12 PROBLEMS


31-Dec-03 31-Dec-0331-Dec-0431-Dec-04
Stock Price Shares Price Shares
W $ 75.00 10000 $ 50.00 30000
X $ 150.00 5000 $ 65.00 15000
Y $ 25.00 20000 $ 35.00 20000
Z $ 40.00 25000 $ 50.00 25000

Stocks W and X had 3 for 1 splits on December 31, 2003 at the end of trading.

(c) 1 Calculate the price weighted series for Dec 31, 2003, prior to the splits.

a) 103.57
b) 100.0
c) 72.5
d) 121.25
e) 119.25


(a) 2 Calculate the price weighted series for December 31, 2003 after the splits.

a) 72.5
b) 100.0
c) 119.25
d) 121.25
e) 103.57


(e) 3 Calculate the price weighted series for Dec 31, 2004.

a) 121.25
b) 119.25
c) 100.0
d) 72.5
e) 103.57


(a) 4 Calculate the percentage return in the price weighted series for the period
Dec 31, 2003 to Dec 31, 2004.

a) 42.86%
b) 20.00%
c) 21.76%
d) 33.33%
e) 40.00%
354


(d) 5 Calculate the value weighted index for Dec 31, 2003, prior to the splits.
Assume a base index value of 100. The base year is Dec 31, 2003.

a) 147.5
b) 81.69
c) 72.5
d) 100.0
e) 121.25


(c) 6 Calculate the value weighted index for Dec 31, 2003, after the splits.
Assume a base index value of 100. The base year is Dec 31, 2003.

a) 72.5
b) 81.69
c) 100.0
d) 147.5
e) 121.25


(e) 7 Calculate the value weighted index for Dec 31, 2004. Assume a base index
value of 100. The base year is Dec 31, 2003.

a) 121.25
b) 100.0
c) 81.69
d) 72.5
e) 147.5


(b) 8 Calculate the percentage return in the value weighted index for the period
Dec 31, 2003 to Dec 31, 2004.

a) 12.68%
b) 47.50%
c) 21.76%
d) 33.33%
e) 40.00%


(a) 9 Calculate the unweighted index for Dec 31, 2003, prior to the splits.
Assume a base index value of 100. The base year is Dec 31, 2003.

a) 100.0
b) 200.0
c) 150.0
d) 120.0
e) 175.0

355

(c) 10 Calculate the unweighted index for Dec 31, 2003, after the splits. Assume a
base index value of 100. The base year is Dec 31, 2003.

a) 110.0
b) 200.0
c) 100.0
d) 120.0
e) 150.0


(a) 11 Calculate the unweighted index (geometric mean) for Dec 31, 2004.
Assume a base index value of 100. The base year is Dec 31, 2003.

a) 146.05
b) 121.25
c) 151.25
d) 148.75
e) 100.25


(a) 12 Calculate the percentage return in the unweighted index (geometric mean)
for the period Dec 31, 2003 to Dec 31, 2004. Assume a base index value of
100. The base year is Dec 31, 2003.

a) 46.05%
b) 21.25%
c) 51.25%
d) 48.75%
e) 100.25%



USE THE FOLLOWING INFORMATION FOR THE NEXT THREE PROBLEMS


You are given the following information regarding prices
for a sample of stocks:



Stock Number of Shares Price
T
Price
T+1
A 1,000,000 50 60
B 10,000,000 30 35
C 25,000,000 20 25


(b) 13 Using a price-weighted series approach, what is the percentage change in
the series for the period from T to T + 1.

a) 1.20%
356
b) 20.00%
c) 21.76%
d) 33.33%
e) 40.00%


(d) 14 Using a value-weighted series approach, what is the percentage change in
the series for the period from T to T + 1.

a) 1.22%
b) 20.00%
c) 20.55%
d) 21.76%
e) 33.33%


(c) 15 Construct an unweighted series (arithmetic mean) assuming $1,000 is
invested in each stock. What is the percentage change in wealth for this
portfolio?

a) 1.21%
b) 20.00%
c) 20.56%
d) 21.76%
e) 33.33%


USE THE FOLLOWING INFORMATION FOR THE NEXT THREE PROBLEMS

Price Shares

COMPANY A B C A B C
Day 1 12 23 52 500 350 250
Day 2 10 22 55 500* 350 250
Day 3 8 26 51 1000 350 250**
Day 4 9 25 19 1000 350 750

*Split at Close of Day 2 **Split at Close of Day 3

(c) 16 Calculate a Dow Jones Industrial Index for Day 1.

a) 13.000
b) 19.000
c) 29.000
d) 87.000
e) 100.000


(c) 17 Calculate a Dow Jones Industrial Index for Day 4.

a) 11.2389
357
b) 21.3343
c) 31.2389
d) 41.6890
e) None of the above


(e) 18 Calculate a Standard & Poor's Index for Day 3 if the base period is Day 1
with an initial index value is 100.

a) 90.351
b) 91.035
c) 95.234
d) 101.628
e) 110.351



CHAPTER 7

ANSWERS TO MULTIPLE CHOICE PROBLEMS


1 PRICE WEIGHTED SERIES DEC 2003 = (75 + 150 + 25 + 40)/4 = 72.5

2 POST SPLIT SERIES = 72.5 = (25 + 50 + 25 + 40)/X

The new divisor, X = 1.931

3 PRICE WEIGHTED SERIES DEC 2004 = (50 + 65 + 35 + 50)/1.931 = 103.57

4 Return on series = (103.57 – 72.5)/72.5 = 42.86%

5 Value weighted series Dec 2003 =

100 100
1000000 500000 750000 750000
1000000 500000 750000 750000
= |
.
|

\
|
+ + +
+ + +
x

6 Value weighted post split = 100. Not affected by splits.

7 Value weighted series Dec 2004 =

5 . 147 100
1000000 500000 750000 750000
1250000 700000 975000 1500000
= |
.
|

\
|
+ + +
+ + +
x

8 SINCE THE BASE VALUE IS 100 AND THE CURRENT INDEX VALUE IS
147.5, the percentage return is 47.5%.

9 The index value Dec 2003 is 100
358

10 Post split the index value is 100

11 Index Dec 2004 = (2 + 1.3 + 1.40 + 1.25)
1/4
(100) = 146.05

12 The return on the index is 46.05%

13 Given a three security series and a price change from period T to T+1, the percentage
change in the price weighted series would be

Period T Period T+1
A $50 $60
B 30 35
C 20 25
Sum $100 $120
Divisor 3 3
Average 33.33 40.00

Percentage change = (40.00 - 33.33)/33.33 = 20.00%


14 Period T
Stock Price/Share # of Shares Market Value
A $50 1,000,000 $50,000,000
B 30 10,000,000 300,000,000
C 20 25,000,000 500,000,000
Total $850,000,000

Period T+1
Stock Price/Share # of Shares Market Value
A $60 1,000,000 $60,000,000
B 35 10,000,000 350,000,000
C 25 25,000,000 625,000,000
Total $1,035,000,000


Percentage change = (1,035 – 850)/850 = 21.76%


15 Period T
Stock Price/Share # of Shares Market Value
A $50 20.00 $1,000.00
B 30 33.33 1,000.00
C 20 50.00 1,000.00
Total $3,000.00

Period T+1
Stock Price/Share # of Shares Market Value
A $ 60 20.00 $1,200.00
B 35 33.33 1,166.55
C 25 50.00 1,250.00
359
Total $3,616.55

Percentage change = (3,616.55 - 3,000)/3,000 = 20.56%



16 Day 1 Index = (12 + 23 + 52)/3.0000 = 29.000


17 Day 2 Index = (10 + 22 + 55)/3.0000 = 29.000
Adjusted Day 2 Index = (5 + 22 + 55)/X = 29.000
X = 2.8276 (new divisor)

Day 3 Index = (8 + 26 + 51)/2.8276 = 30.0608
Adjusted Day 3 Index = (8 + 26 + 17)/Y = 30.0608
Y = 1.6966 (new divisor)

Day 4 Index = (9 + 25 + 19)/1.6966 = 31.2389


18 Base = ($12 x 500) + ($23 x 350) + ($52 x 250) = $27,050

Day 3 ($8 x 1000) + ($26 x 350) + ($51 x 250) = $29,850

Index = ($29,850/$27,050) x 100 = 110.351





















CHAPTER 8

360
AN INTRODUCTION TO PORTFOLIO MANAGEMENT


TRUE/FALSE QUESTIONS

(t) 1 Risk is defined as the uncertainty of future outcomes.

(t) 2 A basic assumption of the Markowitz model is that investors base decisions solely
on expected return and risk.

(t) 3 The yield spread between yields on AAA bonds and BAA bonds is evidence that
investors are risk averse.

(t) 4 Standardizing the covariance by the individual standard deviation yields the
correlation coefficient.

(t) 5 The covariance is a measure of the degree to which two variables (e.g., rates of
return) move together over time relative to their means.

(f) 6 For a two stock portfolio containing Stocks i and j, the correlation coefficient of
returns (r
i,j
) is equal to the square root of the covariance (cov
i,j
).

(f) 7 To reduce the standard deviation of a portfolio it is necessary to increase the
relative weight of assets with low volatility (small standard
deviation of returns).

(t) 8 Increasing the correlation among assets in a portfolio results in an increase in the
standard deviation of the portfolio.

(f) 9 A basic assumption of portfolio theory is that an investor would want to maximize
risk subject to a given level of return.

(t) 10 Most investors hold a diversified portfolio in order to reduce portfolio risk.

(f) 11 Most assets of the same type have negative covariances of returns with each
other.

361
MULTIPLE CHOICE QUESTIONS



(a) 1 The optimal portfolio is identified at the point of tangency between the
efficient frontier and the

a) highest possible utility curve.
b) lowest possible utility curve.
c) middle range utility curve.
d) steepest utility curve.
e) flattest utility curve.


(d) 2 An individual investor’s utility curves specify the tradeoffs he or she is willing to
make between

a) high risk and low risk assets.
b) high return and low return assets.
c) covariance and correlation.
d) return and risk.
e) efficient portfolios.


(c) 3 As the correlation coefficient between two assets decreases, the shape of the
efficient frontier

a) approaches a horizontal straight line.
b) bends out.
c) bends in.
d) approaches a vertical straight line.
e) none of the above.


(d) 4 A portfolio manager is considering adding another security to his portfolio. The
correlations of the 5 alternatives available are listed below. Which security
would enable the highest level of risk diversification

a) 0.0
b) 0.25
c) -0.25
d) -0.75
e) 1.0


(b) 5 A positive covariance between two variables indicates that

a) the two variables move in different directions.
b) the two variables move in the same direction.
c) the two variables are low risk.
d) the two variables are high risk.
362
e) the two variables are risk free.


(c) 6 A positive relationship between expected return and expected risk is consistent
with

a) investors being risk seekers.
b) investors being risk avoiders.
c) investors being risk averse.
d) all of the above.
e) none of the above.


(d) 7 What information must you input to a computer program in order to derive the
portfolios that make up the efficient frontier

a) Expected returns, covariances and correlations.
b) Standard deviations, variances and covariances.
c) Expected returns, standard deviations and variances.
d) Expected returns, variances and correlations.
e) Covariances, correlations and variances.


(d) 8 The Markowitz model is based on several assumptions regarding investor
behavior. Which of the following is an assumption of the Markowitz model?

a) Investors consider investment alternative as being represented by a joint
probability distribution of expected returns over some holding period.
b) Investors minimize one-period expected utility.
c) Investors estimate the risk of the portfolio on the basis of their utility
functions.
d) Investors base decisions solely on expected return and risk.
e) None of the above.


(a) 9 As the correlation coefficient between two assets increases, the shape of the
efficient frontier

a) approaches a horizontal straight line.
b) bends out.
c) bends in.
d) approaches a vertical straight line.
e) none of the above.


(d) 10 The probability of an adverse outcome is the definition of:

a) Statistics.
b) Variance.
c) Random.
d) Risk.
363
e) Semivariance.


(c) 11 Which of the following is a measure of risk?

a) Range of standard deviations
b) Expected return
c) Standard deviation
d) Covariance
e) Correlation


(b) 12 Semivariance, when applied to portfolio theory, is concerned with the

a) Square root of deviations from the mean.
b) Deviations below the mean.
c) Deviations above the mean.
d) All deviations (above and below the mean).
e) Summation of the squared deviations from the mean.


(a) 13 With low, zero or negative correlations it is possible to derive portfolios that have

a) Lower risk than the individual securities in the portfolio.
b) Lower risk than the highest risk individual security in the portfolio.
c) Higher risk than the individual securities that make up the portfolio.
d) Higher risk than the highest risk individual security in the portfolio.
e) None of the above.


(d) 14 Which of the following statements are correlation coefficient is false?

a) The values range between -1 to +1.
b) A value of +1 implies that the returns for the two stocks move together in a
completely linear manner.
c) A value of -1 implies that the returns move in a completely opposite direction.
d) A value of zero means that the returns are zero.
e) None of the above (that is, all statements are true)


(a) 15 In a two stock portfolio, if the correlation coefficient between two stocks were to
decrease over time everything else remaining constant the portfolio's risk would

a) Decrease.
b) Remain constant.
c) Increase.
d) Fluctuate positively and negatively.
e) Be a negative value.


364
(d) 16 Given the following correlations between pairs of stocks, a portfolio constructed
from which pair will have the lowest standard deviation?

Correl(A,B) = 0, Correl(C,D) = 1, Correl(E,F) = 0.75, Correl(G,H) = -0.75,
Correl(I,J) = -0.50.

a) Pair A,B
b) Pair C,D
c) Pair E,F
d) Pair G,H
e) Pair I,J


(c) 17 Given a portfolio of stocks the envelope curve containing the set of best possible
combinations is known as the

a) Efficient portfolio.
b) Utility curve.
c) Efficient frontier.
d) Last frontier.
e) Capital asset pricing model.


(d) 18 Estimation error refers to potential errors that arise from estimating

a) Expected security returns.
b) Standard deviations of expected returns.
c) Correlations of expected returns.
d) All of the above.
e) None of the above.


(a) 19 A portfolio is considered to be efficient if:

a) No other portfolio offers higher expected returns with the same risk.
b) No other portfolio offers lower risk with lower expected return.
c) There is no portfolio with a higher return.
d) There is no portfolio with lower risk.
e) None of the above




365
MULTIPLE CHOICE PROBLEMS


(d) 1 Consider two securities, A and B. Security A and B have a correlation coefficient of 0.65. Security A has standard deviation
of 12, and security B has standard deviation of 25. Calculate the covariance between these two securities.

a) 300
b) 461.54
c) 261.54
d) 195
e) 200


(a) 2 Calculate the expected return for a three asset portfolio with the following

Asset Exp. Ret. Std. Dev Weight
A 0.0675 0.12 0.25
B 0.1235 0.1675 0.35
C 0.1425 0.1835 0.40

a) 11.71%
b) 11.12%
c) 15.70%
d) 14.25%
e) 6.75%.


(c) 3 Given the following weights and expected security returns, calculate the expected
return for the portfolio.

Weight Expected Return
.20 .06
.25 .08
.30 .10
.25 .12

a) .085
b) .090
c) .092
d) .097
e) None of the above


(d) 4 the standard deviation for stock A is 0.15 and for stock B, it is 0.20. The
covariance between returns for these stocks is 0.01. The correlation coefficient
between these two stocks is:

a) -0.125
b) 0.195
c) -0.285
366
d) 0.333
e) 0.405


USE THE FOLLOWING INFORMATION FOR THE NEXT TWO PROBLEMS

Given: E(R
1
) = .10 E(R
2
) = .15
E(SD
1
) = .03 E(SD
2
) = .05
W
1
= .30 W
2
= .70

(d) 5 Calculate the expected return of the two stock portfolio.

a) .105
b) .115
c) .125
d) .135
e) None of the above


(c) 6 Calculate the expected standard deviation of the two stock portfolio when the
correlation is 0.40.

a) .0016
b) .0160
c) .0395
d) .1558
e) .3950


USE THE FOLLOWING INFORMATION FOR THE NEXT FOUR PROBLEMS

Given the following information about two stocks:
E(R
1
) = 0.12 E(R
2
) = 0.16
E(SD
1
) = 0.08 E(SD
2
) = 0.15

(a) 7 Calculate the expected return a two stock portfolio when w
1
= 0.75.
a) 0.13
b) 0.136
c) 0.14
d) 0.125
e) 0.16

(d) 8 Calculate the expected standard deviation of a two stock portfolio when w
1
=
0.75
and the covariance between stock 1 and stock 2 is -0.009.
367

a) 0.1025
b) 0.0705
c) 0.0906
d) 0.0404
e) 0.0623


(b) 9 Calculate the expected return a two stock portfolio when w
1
= 0.60.
a) 0.13
b) 0.136
c) 0.14
d) 0.125
e) 0.16


(c) 10 Calculate the expected standard deviation of a two stock portfolio when w
1
=
0.60
and the covariance between stock 1 and stock 2 is 0.8.

a) 0.1025
b) 0.0705
c) 0.0906
d) 0.0404
e) 0.0623

CHAPTER 8

ANSWERS TO MULTIPLE CHOICE PROBLEMS


1. Cov(A, B) = (0.65)(12)(25) = 195

2. E(R) = (0.25)(0.0675) + (0.35)(0.1235) + (0.40)(0.1425) = 0.1171 or 11.71%
3. E(R) = (0.20)(0.06) + (0.25)(0.08) + (0.30)(0.10) + (0.25)(0.12) = 0.092 or 9.2%

4. Correlation = (0.01)(0.15 x 0.20) = 0.3333

5. E(R) = (.3 x .10) + (.7 x .15) = .135

6. SD= [(.3)
2
(.03)
2
+ (.7)
2
(.05)
2
+ 2(.3)(.7)(.03)(.05)(.4)]
1/2
= 0.03947

7. E(R) = (.75 x .12) + (.25 x .16) = 0.13
8. SD = [(.75)
2
(.04)
2
+ (.25)
2
(.06)
2
+ 2(.75)(.25)(-.0009)]
1/2
= 0.0404
9. E(R) = (.60 x .12) + (.40 x .16) = 0.136
10. SD= [(.6)
2
(.04)
2
+ (.4)
2
(.06)
2
+ 2(.6)(.4)(.8)]
1/2
= 0.0906
368


CHAPTER 9

AN INTRODUCTION TO ASSET PRICING MODELS


TRUE/FALSE QUESTIONS

(t) 1 One of the assumptions of Capital Market Theory is that investors can borrow or
lend at the risk-free rate.

(f) 2 An assumption of Capital Market Theory is that buying or selling of assets entails
no taxes, but entails significant transaction costs.

(t) 3 A risky asset is an asset with uncertain future returns, and uncertainty (or risk) is
measured by the variance or standard deviation of returns.

(t) 4 The standard deviation of a portfolio that combines the risk-free asset with risky
assets is the linear proportion of the standard deviation of the risky asset portfolio.

(t) 5 The Capital Market Line (CML) is the line from the intercept point that represents
the risk-free rate tangent to the original efficient frontier.

(t) 6 The market portfolio consists of all risky assets.

(f) 7 All portfolios on the CML are perfectly negatively correlated, which means that
all portfolios on the CML are perfectly negatively correlated with the
completely diversified market portfolio since it lies on the CML.

(t) 8 Diversification reduces the unsystematic risk in a portfolio.

(f) 9 The Capital Asset Pricing Model (CAPM) is a technique for determining the
expected risk on an asset.

(t) 10 Beta is a standardized measure of systematic risk.

(t) 11 Multifactor models of risk and return can be broadly grouped into models that use
macroeconomic factors and models that use microeconomic factors.

(f) 12 Arbitrage Pricing Theory (APT) specifies the exact number of risk factors and
their identity
369

MULTIPLE CHOICE QUESTIONS


(d) 1 Which of the following is not an assumption of the Capital Market Theory?

a) All investors are Markowitz efficient investors.
b) All investors have homogeneous expectations.
c) There are no taxes or transaction costs in buying or selling assets.
d) There are no risk-free assets.
e) All investors have the same one period time horizon.


(e) 2 The market portfolio consists of all

a) New York Stock Exchange stocks.
b) International stocks and bonds.
c) Stocks and bonds.
d) U.S. and non-U.S. stocks and bonds.
e) Risky assets.


(c) 3 The separation theorems divides decisions on from decisions on .

a) Lending, borrowing
b) Risk, return
c) Investing, financing
d) Risky assets, risk free assets
e) Buying stocks, buying bonds


(d) 4 When identifying undervalued and overvalued assets, which of the following
statements is false?

a) An asset is properly valued if its estimated rate of return is equal to its
required rate of return.
b) An asset is considered overvalued if its estimated rate of return is below its
required rate of return.
c) An asset is considered undervalued if its estimated rate of return is above its
required rate of return.
d) An asset is considered overvalued if its required rate of return is below its
estimated rate of return.
e) None of the above (that is, all are true statements)


(b) 5 Utilizing the security market line an investor owning a stock with a beta of (-2)
would expect the stock's return to in a market that
was expected to decline 10 percent.

a) Rise or fall an indeterminate amount
b) Rise by 20.0%
370
c) Fall by 20.0%
d) Rise by 10.2%
e) Fall by 10.2%


(d) 6 The Capital Market Line (CML) refers to the efficient formed by creating
portfolios that

a) Invest solely in the market portfolio M.
b) Lend at the risk free asset and invest in the market portfolio.
c) Borrow at the risk free asset and invest in the market portfolio.
d) Lend and borrow at the risk free rate and invest in the market portfolio.
e) Short sell the market portfolio.


(e) 7 As the number of stocks in a portfolio increases

a) The expected return of the portfolio increases because systematic risk
decreases.
b) The expected return of the portfolio increases because unsystematic risk
decreases.
c) The standard deviation of the portfolio increases because systematic risk
increases.
d) The standard deviation of the portfolio decreases because systematic risk
increases.
e) The standard deviation of the portfolio decreases because unsystematic risk
decreases.


(a) 8 The Security Market Line (SML) represents the relation between

a) Risk and required return on an asset.
b) Systematic risk and required return on an asset.
c) Risk and return on a diversified portfolio of assets.
d) Unsystematic risk and required return on an asset
e) Systematic risk and required return on a diversified portfolio of assets.


(a) 9 In a macro-economic based risk factor model the following factor would be one
of many appropriate factors

a) Confidence risk.
b) Maturity risk.
c) Expected inflation risk.
d) Call risk.
e) Return difference between small capitalization and large capitalization stocks.


(d) 10 In a multifactor model, confidence risk represents

a) Unanticipated changes in the level of overall business activity.
371
b) Unanticipated changes in investors’ desired time to receive payouts.
c) Unanticipated changes in short term and long term inflation rates.
d) Unanticipated changes in the willingness of investors to take on investment
risk.
e) None of the above.


(b) 11 In a multifactor model, time horizon risk represents

a) Unanticipated changes in the level of overall business activity.
b) Unanticipated changes in investors’ desired time to receive payouts.
c) Unanticipated changes in short term and long term inflation rates.
d) Unanticipated changes in the willingness of investors to take on investment
risk.
e) None of the above.


(e) 12 In a micro-economic based risk factor model the following factor would be one
of many appropriate factors

a) Confidence risk.
b) Maturity risk.
c) Expected inflation risk.
d) Call risk.
e) Return difference between small capitalization and large capitalization stocks.


MULTIPLE CHOICE PROBLEMS



(b) 1 Consider an asset that has a beta of 1.5. The return on the risk-free asset is 6.5%
and the expected return on the stock index is 15%. The estimated return on the
asset is 20%. Calculate the alpha for the asset.

a) 19.25%
b) 0.75%
c) –0.75%
d) 9.75%
e) 9.0%



(b) 2 The table below provides factor risk sensitivities and factor risk premia for
a three factor model for a particular asset where factor 1 is MP the growth
rate in U.S. industrial production, factor 2 is UI the difference between
actual and expected inflation, and factor 3 is UPR the unanticipated change
in bond credit spread.

Risk Factor
Factor
Sensitivity(β)
Risk
Premium(λ)
372
MP 1.76 0.0259
UI -0.8 -0.0432
UPR 0.87 0.0149


Calculate the expected excess return for the asset.

a) 12.32%
b) 9.32%
c) 4.56%
d) 6.32%
e) 8.02%


(a) 3 The variance of returns for a risky asset is 25%. The variance of the error
term, Var(e) is 8%. What portion of the total risk of the asset, as measured
by variance, is unsystematic?

a) 32%
b) 8%
c) 68%
d) 25%
e) 75%


(c) 4 An investor wishes to construct a portfolio consisting of a 40% allocation to
a stock index and a 60% allocation to a risk free asset. The return on the
risk-free asset is 2% and the expected return on the stock index is 10%. The
standard deviation of returns on the stock index 8%. Calculate the expected
standard deviation of the portfolio.

a) 5.2%
b) 8.0%
c) 3.2%
d) 4.0%
e) 1.2%


(b) 5 An investor wishes to construct a portfolio by borrowing 35% of his
original wealth and investing all the money in a stock index. The return on
the risk-free asset is 4.0% and the expected return on the stock index is
15%. Calculate the expected return on the portfolio.

a) 18.25%
b) 18.85%
c) 9.50%
d) 15.00%
e) 11.15%


373
(d) 6 An investor wishes to construct a portfolio consisting of a 70% allocation to
a stock index and a 30% allocation to a risk free asset. The return on the
risk-free asset is 4.5% and the expected return on the stock index is 12%.
Calculate the expected return on the portfolio.

a) 8.25%
b) 16.50%
c) 17.50%
d) 9.75%
e) 14.38%


(d) 7 A stock has a beta of the stock is 1.1. The risk free rate is 2.5% and the return on
the market is 12%. The estimated return for the stock is 14%. According to the
CAPM you should

a) Sell because required return is 9.95%.
b) Sell because required return is 16.5%.
c) Buy because required return 11.5%.
d) Buy because required return is 12.95%.
e) Short because it is undervalued.


(b) 8 Consider a risky asset that has a standard deviation of returns of 15.
Calculate the correlation between the risky asset and a risk free asset.

a) 1.0
b) 0.0
c) -1.0
d) 0.5
e) -0.5


(a) 9 The expected return for a stock, calculated using the CAPM, is 10.5%. The
market return is 9.5% and the beta of the stock is 1.50. Calculate the
implied risk-free rate.

a) 7.50%
b) 13.91%
c) 17.50%
d) 21.88%
e) 14.38%


(d) 10 The expected return for a stock, calculated using the CAPM, is 25%. The
risk free rate is 7.5% and the beta of the stock is 0.80. Calculate the implied
return on the market.

a) 7.50%
b) 13.91%
c) 17.50%
374
d) 21.88%
e) 14.38%


(c) 11 The expected return for Zbrite stock calculated using the CAPM is 15.5%.
The risk free rate is 3.5% and the beta of the stock is 1.2. Calculate the
implied market risk premium.

a) 5.5%
b) 6.5%
c) 10.0%
d) 15.5%
e) 12.0%


(d) 12 Calculate the expected return for Express Inc. which has a beta of .69 when
the risk free rate is.09 and you expect the market return to be .14.

a) 0.05%
b) 13.91%
c) 10.92%
d) 12.45%
e) 14.25%


USE THE FOLLOWING INFORMATION FOR THE NEXT THREE PROBLEMS

You expect the risk-free rate (RFR) to be 5 percent and the market return to be 9 percent. You
also have the following information about three stocks.


CURRENT EXPECTED EXPECTED
STOCK BETA PRICE PRICE DIVIDEND
X 1.50 $ 22 $ 23 $ 0.75
Y 0.50 $ 40 $ 43 $ 1.50
Z 2.00 $ 45 $ 49 $ 1.00

(b) 13 What are the expected (required) rates of return for the three stocks (in the order
X, Y, Z)?

a) 16.50%, 5.50%, 22.00%
b) 11.00%, 7.00%, 13.00%
c) 7.95%, 11.25%, 11.11%
d) 6.20%, 2.20%, 8.20%
e) 15.00%, 3.50%, 7.30%


(a) 14 What are the estimated rates of return for the three stocks (in the order X, Y, Z)?

375
a) 7.95%, 11.25%, 11.11%
b) 6.20%, 2.20%, 8.20%
c) 16.50%, 5.50%, 22.00%
d) 11.00%, 7.00%, 13.00%
e) 15.00%, 3.50%, 7.30%


(e) 15 What is your investment strategy concerning the three stocks?

a) Buy stock Y, it is undervalued.
b) Buy stock X and Z, they are undervalued.
c) Sell stocks X and Z, they are overvalued.
d) Sell stock Y, it is overvalued.
e) Choices a and c


USE THE FOLLOWING INFORMATION FOR THE NEXT FOUR PROBLEMS

Year
Return for
GBC
Return for
Market
1 25 12
2 10 13
3 5 17
4 -13 -15
5 11 -8
6 -20 9


(a) 16 Compute the beta for GBC Company using the historic returns presented above.

a) 0.4255
b) 0.5929
c) 5.6825
d) 9.4163
e) 0.3333


(e) 17 Compute the correlation coefficient between GBC and the Market Index.

a) 0.4255
b) 0.5929
c) 5.6825
d) 9.4163
e) 0.3333


(b) 18 Compute the intercept of the characteristic line

376
a) 0.4255
b) 1.013
c) 1.4385
d) 0.5875
e) 0.5219


(d) 19 The equation of the characteristic line is

a) R
GBC
+ 1.013 = 0.4255(R
Market
)
b) R
GBC
= 1.013 - 0.4255(R
Market
)
c) R
Market
= 1.013 + 0.4255(R
GBC
)
d) R
GBC
= 1.013 + 0.4255(R
Market
)
e) R
Market
= 1.013 - 0.4255(R
Market
)


CHAPTER 9

ANSWERS TO PROBLEMS


1 6.5 + 1.5(15 – 6.5) = 19.25%

alpha = 20 –19.25 = 0.75%

2 The table below shows the relevant calculations

Risk
Factor
Factor
Sensitivity(β)
Risk
Premium(λ) (β)x(λ)
MP 1.76 0.0259 0.0456
UI -0.8 -0.0432 0.0346
UPR 0.87 0.0149 0.013
Expected return 0.1232


3 8%/25% = 0.32. = 32% unsystematic.

4 0.4(0.08) = 0.032 or 3.2%

5 -0.35(4) + 1.35(15) = 18.85%

6 E(R)= 0.3(4.5) + 0.7(12) = 9.75%

7 E(R)= 2.5 + 1.1(12 – 2.5) = 12.95%. Buy the stock is undervalued.

8 The correlation between a risky asset and a risk-free
asset is always zero.

9 10.5 = X + 1.5(9.5 – X). X = 7.5%.
377

10 25 = 7.5 + 0.8(X). X = 14.38%. Return on market = 14.38 + 7.5 = 21.88%

11 15.5 = 3.5 + 1.2(X). X = 10%.

12 k = .09 + .69 (.14 - .09) = .1245 = 12.45%

For problems 13 - 15

STOCK REQUIRED ESTIMATED EVALUATION

X .05 + 1.50(.09 - .05) = 11% (23 - 22 + 0.75)/22 = 7.95% Overvalued

Y .05 + 0.50(.09 -.05) = 7% (43 - 40 + 1.50)/40 = 11.25% Undervalued

Z .05 + 2.00(.09 - .05) = 13% (49 - 45 + 1.00)/45 = 11.11% Overvalued


For problems 16 – 19

The table below shows the relevant calculations.

(1) (2) (3) (4) (5) (6) (7) (8)
GBC Market GBC Market (6) x (7)
Year GBC Market (R-E(R ))
2
(R-E(R ))
2
R-E(R ) R-E(R )
1 25 12 484.00 53.73 22.00 7.33 161.26
2 10 13 49.00 69.39 7.00 8.33 58.31
3 5 17 4.00 152.03 2.00 12.33 24.66
4 -13 -15 256.00 386.91 -16.00 -19.67 314.72
5 11 -8 64.00 160.53 8.00 -12.67 -101.36
6 -20 9 529.00 18.75 -23.00 4.33 -99.59
Total 18 28 1386.00 841.33 358.00
Average 3.0000 4.67
Variance 277.20 168.27
Std. Dev. 16.65 12.97
Covariance 71.60
Correlation 0.33
Beta 0.4255


16 Beta for GBC Computer is computed as follows:

Beta = Cov(GBC, Market)/ Variance
Market


Beta = 18.40/82 = 0.2244



17 The correlation coefficient can be computed as follows:

378
Correlation = Cov(GBC, Market)/(SD
GBC
x SD
Market
)

= 71.6/(16.65 x 12.97) = 0.33

Where:
SD
GBC
= [1386/5]
1/2
= 16.65
SD
Market
= [841.33/5]
1/2
= 12.97

Cov(GBC, Market) = 358/5 = 71.60


18 The alpha or intercept of the characteristic line is computed as follows:

alpha = 3.0 - [(0.4255)(4.67)] = 1.013%


19 R
GBC
= 1.013 + 0.4255(R
Market
)

MULTIPLE CHOICE QUESTIONS (d) 1 An investment is the current commitment of resources for a period of time in the expectation that an investor will receive in the future a compensation for a) the time for which the resources are committed b) the expected rate of inflation c) the time for which the resources are committed and the expected rate of inflation d) the expected rate of inflation, the time for which the resources are committed, and the uncertainty of future payments. e) a) and b) (b) 2 The following is not a reason for investing a) b) c) d) e) (a) 3 to provide for retirement. to fund higher levels of current consumption. to fund higher levels of future consumption. to fund children’s education needs. to save up for a down payment on a house.

The statement – ‘risk drives expected returns’ refers to the notion that a) an investor will require a higher rate of return the higher the perceived riskiness of an asset. b) an investor will require a lower rate of return the higher the perceived riskiness of an asset. c) markets over-react to news. d) markets under-react to news. e) none of the above.

(a)

4

The basic trade-offs in the investment process are a) between the anticipated rate of return for a given investment instrumentand its degree of risk. b) between understanding the nature of a particular investment and havingthe opportunity to purchase it. c) between high returns available on single instruments and the d) diversification of instruments into a portfolio. e) between the desired level of investment and possessing the resources necessary to carry it out.

(e)

5

The expected return is a function of a) The real risk-free rate plus the investment's variance. b) The prime rate and the rate of inflation.

306

c) The risk premium plus the inflation rate. d) The nominal risk free rate minus the rate of inflation. e) The nominal risk-free rate and the risk premium. (c) 6 An externally efficient market is one where a) b) c) d) e) (d) 7 Transaction costs of trading are low. Stocks of highly efficient companies trade. New information is quickly reflected into assets prices. There is no overreaction to news. None of the above.

An investor should diversify investment holdings across a) b) c) d) e) Different asset classes. Different industries. Different countries. All of the above. None of the above.

(a)

8

An internally efficient market is one where a) b) c) d) e) Transaction costs of trading are low. Stocks of highly efficient companies trade. New information is quickly reflected into assets prices. There is no overreaction to news. Stock prices are low.

(d)

9

An investor can invest in financial assets by investing: a) b) c) d) e) In cash, stocks and bonds Indirectly, in real assets and financial assets. In options, futures and through derivatives. Directly, indirectly and through derivatives. In stocks, directly and through derivatives.

(a)

10

A direct investment occurs when an investor a) b) c) d) e) Buys shares of stocks or bonds. Buys shares of stocks or options and futures. Buys shares of stocks, bonds or mutual funds Deposits funds in a bank or buys mutual funds Deposits funds in a bank or buys derivatives.

(d)

11

An indirect investment occurs when an investor a) b) c) d) Buys shares of stocks or bonds. Buys shares of stocks or options and futures. Buys shares of stocks, bonds or mutual funds Deposits funds in a bank or buys mutual funds
307

e) Deposits funds in a bank or buys derivatives. (c) 12 A portfolio manager with an active asset allocation decision philosophy will manage a portfolio by a) b) c) d) e) (b) 13 Tracking a well known market index Stock picking using a top-down or bottom-up approach Using market timing Maintaining predetermined allocation with periodic rebalancing None of the above A portfolio manager with an active security selection decision philosophy will manage a portfolio by a) b) c) d) e) Tracking a well known market index Stock picking using a top-down or bottom-up approach Using market timing Maintaining predetermined allocation with periodic rebalancing None of the above (d) 14 A portfolio manager with a passive asset allocation decision philosophy will manage a portfolio by a) b) c) d) e) Tracking a well known market index Stock picking using a top-down or bottom-up approach Using market timing Maintaining predetermined allocation with periodic rebalancing None of the above (a) 15 A portfolio manager with a passive security selection decision philosophy will manage a portfolio by a) b) c) d) e) Tracking a well known market index Stock picking using a top-down or bottom-up approach Using market timing Maintaining predetermined allocation with periodic rebalancing None of the above 308 .

62 $343. assuming all savings are removed at the end of 10 years is a) b) c) d) e) $4414. The tax rate is 35%. the expected rate of inflation is 2%. and the risk premium is 5%.50 $1091.4% 16.26 309 .5% 7. (b) 4 The before tax value of the tax deferred investment. the expected rate of inflation is 2. the risk premium is 6% per year and the expected rate of inflation over the next year is 3%. an investment of $1000 today worth_____ one year from today. The average annual return on a tax-deferred account over a 10-year period is 9%.13 $918 USE THE FOLLOWING INFORMATION FOR THE NEXT THREE PROBLEMS Consider the following information.51 $1474.18%.42 $8663.71 $4987.39 If the nominal risk free rate is 8%.41 $2943. the risk premium is 3% and the required rate of return is 9.24% 10.28 $704.80 $1113 $1146. What would be the value at the end of 25 years of $100 invested today at the required rate of return? a) b) c) d) e) $898. The average annual return on a taxable account over the same 10-year period is 13%.5%. and the amount invested at the beginning of the 10-year period is $2500.MULTIPLE CHOICE PROBLEMS (d) 1 If the nominal risk rate is 5% per year. the required rate of return is a) b) c) d) e) 10. a) b) c) d) e) (c) 2 $1000 $1081.7% (a) 3 Assume that nominal risk free interest rate is 6%.5% 13.17 $5918.

assuming all savings are removed at the end of 10 years is a) b) c) d) e) $4987.75% Consider an investment portfolio consisting of four asset classes. The allocations and returns for each asset class are as follows Asset Class 1 2 3 Allocation Percentage Annual Return 10% -10% 35% 35% 55% -5% The annual portfolio return is a) b) c) d) e) (d) 8 15.0% 8.42 $3846. The allocations and returns for each asset class are as follows Asset Class 1 2 3 4 Allocation Percentage Annual Return 10% -10% 25% 15% 35% 10% 30% 5% The annual portfolio return is a) 15.75% 7.42 None of the above (e) 6 The value of the taxable investment.97 $5918. assuming all savings are removed at the end of 10 years is a) b) c) d) e) $8663.41 $5626.(c) 5 The after tax value of the tax deferred investment.0% 310 .46 (c) 7 Consider an investment portfolio consisting of three asset classes.97 $2943.5% -10.71 $6943.41 $3846.5% -7.5% b) 10.26 $5918.

06) = 1113 (1.10) + (0.091825(100) = 898.0775 311 .1)(-0.35)(0.55)(-0.08)(1.35) = 0.085 [(0.13(1 – 0.05)(1.05)] = 0.35)(0.1) + (0.34% 1.0845 1.05) – 1 = 11.15) + (0.1)(-0.c) 5.46 (0.35) + (0.084510(2500) = 5626.62 1.41 5918.0% d) 7.75% e) None of the above CHAPTER 1 ANSWERS TO PROBLEMS 1 2 3 4 5 6 7 8 1000(1.0910(2500) = 5918.1) + (0.30)(0.25)(0.05)] = 0.97 0.41(1 – 0.35) = 3846.

CHAPTER 2 RETURN AND RISK BASICS TRUE/FALSE QUESTIONS (f) (f) (f) (t) (f) (t) (f) (f) (t) (f) 1 2 3 4 5 6 7 8 9 10 An investor should expect to receive higher returns from taking on lower risks The sources of investment returns are dividends and interest. Historically return relatives are used to measure the risk for a series of historical rates of return. the geometric mean and the arithmetic mean will be the same. Widening interest rate spreads indicate a flight to quality. The geometric mean is the nth root of the product of the annual holding period returns for N years minus one. The holding period return (HPR) is equal to the return relative stated as a percentage. MULTIPLE CHOICE QUESTIONS (b) 1 The return relative is calculated as a) b) c) d) e) (b) 2 (1 – HPR) (1 + HPR) (1 – HPR)n (1 + HPR)n (1 – (Income + Price Change)) When rates of return on a security have a high standard deviation then a) Arithmetic mean will equal geometric mean 312 . When rates of return are the same for all years. The geometric mean of a series of returns is always larger than the arithmetic mean and the difference increases with the volatility of the series. The risk premium is a function of sales volatility. The coefficient of variation is the expected return divided by the standard deviation of the return. financial leverage. and inflation.

None of the above. (d) 3 The coefficient of variation is a measure of a) b) c) d) e) (c) 4 Central tendency. Business risk and financial risk. Relative return. e) None of the above. (a) 7 The following would be an example of systematic risk: a) Changes in interest rates. Absolute dispersion. Absolute variability. 313 . The real risk free rate is influenced by the following factors: a) b) c) d) e) Inflationary expectations and capital market conditions.b) The difference between arithmetic mean and geometric mean will be large. All of the above. A change in the expected rate of inflation. (a) 6 The nominal risk free rate is influenced by the following factors: a) b) c) d) e) Inflationary expectations and capital market conditions. All of the above. (c) 5 If a significant change is noted in the yield of a T-bill. Investment opportunities and time preference for consumption. A change in the real rate of interest. b) Management decisions. None of the above. A change in risk aversion. Investment opportunities and time preference for consumption. the change is most likely attributable to: a) b) c) d) e) A downturn in the economy. A static economy. c) The difference between arithmetic mean and geometric mean will be small. d) Geometric mean will exceed arithmetic mean. Relative variability. Business risk and financial risk.

the annualized HPR is a) b) c) d) e) 113% 78% 65% 6. Changes in systematic risk. (b) 8 If U. the annualized HPR is 314 . MULTIPLE CHOICE PROBLEMS (a) 1 The HPR on a security is 6. Changes in unsystematic risk. it will very likely cause required returns to a) Increase and change the slope of the capital market line (CML). Changes in liquidity risk. firms increase their debt/total capital ratios. None of the above.129% (c) 2 The HPR on a security is 3%.5% 1. Changes in financial risk. c) Remain unchanged and cause a parallel shift of the capital market line (CML). b) Increase and cause a movement up along the capital market line (CML). If the holding period is 4 weeks month. If the holding period is 1 month. A parallel shift in the capital market line (CML) is caused by changes in the following factors: a) b) c) d) e) Expected real growth in the economy. (d) 9 An increase in the slope of the Capital Market Line (CML) is caused by a) b) c) d) e) (d) 10 Changes in business risk. d) Decrease and change the slope of the capital market line (CML).c) Stability of sales. Capital market conditions. d) The amount of debt financing. Expected rate of inflation. e) Liquidity. All of the above.S. e) Decrease and cause a movement down along the capital market line (CML).5%.

a) b) c) d) e) (d) 3 39.000% AM = 1. GM = 1. Period t1 t2 t3 t4 a) b) c) d) e) Returns 0.50% 12.00% 20.000%. at the end of 15 years.0692% 315 . a) b) c) d) e) 100% 38. GM = 0.02 Return Relative 1.98 AM = 4. the investor sold the 100 shares at $11 per share.15% 78.20% 5. What is the HPR? a) b) c) d) e) 1.11 0.000%. GM = 4. During the year.11 -0. Calculate the proportion of the total value of the account that can be attributed to intereston-interest.000%.24% 25. GM = 1. At the end of the year.0692% AM = 4.70% 0% (b) 5 Given the following returns and return relatives over the past four years. the firm paid dividends of $1 per share.25% At the beginning of the year an investor purchased 100 shares of common stock from ABC Corporation at $10 per share. GM = 0.25% 52. compute the arithmetic mean (AM) and geometric mean (GM) rates of return.05 0.10 0.87% 158.90 1.000%.06% 36.05 -0.692% AM = 0.00% (d) 4 Assume that you invest $1000 for 15 years in an account that pays an interest rate of 7% per year with annual compounding.010% AM = 1.87% 46.692%.00% 30.

000 (e) 9 Consider a stock that has an expected return of 10% and standard deviation of 14%.791 $57.791 $57. (c) 6 The total value of your investment at the end of 30 years is? a) b) c) d) e) (b) 7 $67.000 The amount of simple interest earned is? a) b) c) d) e) $67.750 $52.791 $40. an investor can expect 95% of actual future returns to lie between a) b) c) d) e) -10% and 24% 10% and 14% -32% and 52% -4% and 24% -18% and 38% 316 .791 $40.791 $57.USE THE FOLLOWING INFORMATION FOR THE NEXT THREE PROBLEMS Assume that you invest $5000 for 30 years in an account that pays an interest rate of 8.000 (d) 8 The amount of interest-on-interest earned is? a) b) c) d) e) $67.791 $40.750 $52.750 $52.5% per year with annual compounding.041 $60. Assuming that future returns will resemble past returns.041 $60.041 $60.

26 – 5000 = $52.4687.129 – 1 = 1.87% 3 HPR = 100  100 200   0.041.2 x 14.03)1/(4/52) = 1.791.692% 6 7 Value of account at the end of 30 years = 5000(1.03 5 AM = [(.00692 .03 = 0.085)30 = $57.085 x 5000 = $12.10) + (.26 Original principal Cumulative simple interest Total interest Cumulative interest-on-interest Total interest Cumulative interest-on-interest = 5000 = 30 x 0.98)]1/4 .02)]/4 =.26 – 12.03 Original principal Cumulative simple interest Cumulative interest-on-interest 709.20 or 20% 1000 1000 4 1000(1.791.750 = $40.750.791.90)(1.00692 = 0.26 8 9 95% of returns will lie between 10% +/.791. The HPR = 1.04/4 = .129 or 113% (1 + 0.1 = 1. The HPR = 2.07)15 = 2759.257 or 25.7% = 1000 = 1050 = 709.11)(.26 = 52.791.4687 – 1 = 0.1 = .05)(. That is between –18% and 38% 317 .26 = 57.26 = 52.041.05) + (-.791.750 = $40.065)1/(1/12) = 2.26 – 12.01 = 1% GM = [(1.129.26 – 5000 = $52.791.4687 or 46.03/2759.11) + (-.00 = 57.CHAPTER 2 ANSWERS TO PROBLEMS 1 2 (1 + 0.

For a U. 318 .CHAPTER 3 SELECTING INVESTMENTS IN A GLOBAL MARKET TRUE/FALSE QUESTIONS (f) (t) (f) (t) (t) (f) (t) (f) (f) (f) (t) (f) (f) (t) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 The U.S. based investor with stock investments in the U. dollar return. It is very important when diversifying that the correlation between rates of return for various countries be high and very stable over time. equity market experienced rates of return below those in many other countries. For a U. Yields on money market funds are often lower than yields available to individuals investing in CD's because of the fees involved. If the exchange rate effect for Japanese bonds is negative. Diversification with foreign securities can help reduce portfolio risk. based investor with stock investments in the U.K. Investors who limit themselves to the U. A call option is issued by a firm in conjunction with a convertible bond. a weakening dollar will enhance returns in terms of pounds. it means that the domestic rate of return will be greater than the U.S. A Eurobond is an international bond denominated in a currency other than that of the United States.S. Income bonds are considered as safe as debentures because they pay higher rates of interest. The total domestic return on German bonds is the return that would be experienced by a U. Municipal bonds are tax-exempt. Warrants are options issued in connection with the sale of fixed income securities. investor who owned German bonds.S.S. a weakening dollar will enhance returns in dollar terms. equity and bond markets have grown in terms of their relative size of the world equity and bond market.K.S.

The standard deviation of the German stocks.S. (c) 2 Correlations of returns between U. the initial factor that you should examine is: a) b) c) d) e) The average rate of return of the portfolio when you combine U. Weakly negative. stocks. equities and U. Overseas markets offer risk reduction via diversification. Indeterminate. Weakly positive. None of the above. A rights certificate. bonds and those of foreign countries differ because of differences in a) b) c) d) e) Culture. stocks. and German stocks. markets. (b) 4 The correlation between U. (c) 3 The legal document setting forth the obligations of a bond's issuer is called a) b) c) d) e) A debenture. An indenture. Overseas markets are less risky. government bonds has been a) b) c) d) e) Strongly positive. Investors will benefit from a stronger dollar 319 .S. Political systems. The coefficient of variation (CV) of rates of return for German stocks versus the CV of rates of return for U.S. Language. stocks. International trade patterns. A trustee deed. The correlation between the rates of return for German stocks and U.S.S.S. (c) 5 U. investors should consider constructing global investment portfolios because a) b) c) d) Overseas markets usually outperform U.S. The standard deviation of the German stocks compared to the standard deviation of U.S. A warrant.MULTIPLE CHOICE QUESTIONS (d) 1 If you are considering investing in German stocks as a means to reduce the risk of your portfolio. Strong negative.S.

Countries are becoming more segmented. diversifying across U. asset classes. (c) 8 Global portfolio managers can diversify more risk by a) b) c) d) e) diversifying across countries. (a) 9 Collateralized mortgage obligations (CMOs) offset some of the problems associated with traditional mortgage pass-throughs because a) b) c) d) e) They are overcolleralized. diversifying across industries and countries. They are deep discount instruments. U. diversifying across industries. 320 . They have variable rates. There are fewer barriers to travel.S. Collateralized by auto-loans. In order to diversify risk an investor must have investments that that have correlations with other investments in the portfolio that are a) b) c) d) e) low positive zero negative any of the above none of the above (a) 7 Correlations between stock markets in different countries have been rising over time because a) b) c) d) e) Countries are developing closer trade and economic links. Correlations between bond markets of different countries have been rising.e) (d) 6 None of the above.S. investors are purchasing more foreign securities. diversifying across U. industries. Collateralized by credit card debt.S.

S.90% (c) 5 If the annual rate of inflation during the period was 4 percent. government T-bills Long-term government bonds Long-term corporate bonds Common Stock Small capitalization common stocks (c) 1 What is the maturity premium? a) b) c) d) e) (b) 2 3.8% 12.05% 2.66% 12.25% 4.MULTIPLE CHOICE PROBLEMS USE THE FOLLOWING INFORMATION FOR THE NEXT FIVE PROBLEMS Security U.70% Annual Percentage Return 2.25% 4.80% 10.71% 3.92% 8.50% 14.46% (b) 4 What is the small firm stock risk premium? a) b) c) d) e) 1.75% 5.32% 2.50% 3.60% What is the default premium? a) b) c) d) e) 3.71% 3.56% 4. what was the real rate of return on long-term corporate bonds? 321 .50% 4.76% 1.71% (e) 3 What is the common stock risk premium? a) b) c) d) e) 1.10% 2.76% 1.04% 4.05% 2.

75 Maturity 9/15/201 4 UST 10 (b) 7 What annual dollar coupon amount will investors receive? a) b) c) d) e) $4.73% 3.544 $995.808 $48.5%. Municipal bond because the equivalent taxable yield is 6.75%.50 $4. Corporate bond because the after tax yield is 4.75 $47.44 (a) 9 What is the estimated yield on Treasury securities? a) 4.85% 1.25%.954 $48. Assuming all other factors are the same and you are in the 28% tax bracket.3%.08 $62 (e) 8 What price would you pay in dollars to purchase this bond? a) b) c) d) e) $62 $9.544 Last Yield 4. Municipal bond because the equivalent taxable yield is 6.08 $99.188% b) 5. USE THE FOLLOWING INFORMATION TO ANSWER THE NEXT FIVE PROBLEMS Last Price 99. which bond should you choose and why? a) b) c) d) e) Corporate bond because the after tax yield is 6.428% 322 .a) b) c) d) e) (d) 6 1.90% You are trying to decide between a par value corporate bond carrying a coupon rate of 6.16% 1.6%.808 EST Spread 62 Est $ Vol (000's) 158736 Company Gen Elec Ticker GE Coupon 4. You will be indifferent between the two because the after tax yields are the same.25% per year and a par value municipal bond that pays an annual coupon rate of 4.50% 4.

71% -5.90/euro.063% What is the capital gains/loss yield on this bond? a) b) c) d) e) -0.456% None of the above (d) 12 Consider a U. stocks on January 1.S. on January 1. has security investments in the U.c) 5.132% e) 4.83% -28. 2002.S. 2002 is $1. The 323 . a) b) c) d) e) 10.71% 10.90/euro.77% 8. on January 1. 2003 is $0.88% 4. 2002. The exchange rate on January 1.038% -0.K. The exchange rate on January 1.71% 5. One year later.05/euro. a) b) c) d) e) 10. One year later.S.753% (c) 10 What is the current yield for this bond? a) b) c) d) e) (c) 11 4. Calculate the return in dollar terms. The exchange rate on January 1.0% (b) 14 An investor based in the U.038% 0.456% 0.33% 5.18% 5. 2003 he sells the German stocks.71% -5. The total return in local currency is -5%. 2002 is $1. Calculate the return in euro terms. The exchange rate on January 1.05/euro.83% -28. 2003 is $0.371% d) 4. The total return in local currency is 10%.33% 5. 2003 he sells the German stocks.125% 4. based investor who purchases German stocks on January 1.0% (a) 13 Consider a Germany based investor who purchases U.

37 $10002.25 $10002. For an investor based in the U.5% -8.K. the exchange rate change is a) b) c) d) e) 8.49% 324 .75% 4. Calculate the local currency returns for the U.S.35% -7. a) b) c) d) e) $9997. During this same period the investor’s return in dollar terms is calculated to be 10%.24 Chg Ask Yld ? (c) 16 Use the information provided above to calculate the ask price for this Treasury bill.81% Assume the exchange rate is $1. in pound terms).25 Asked 2.11% 15% -7.24% 3.11% -15% THE FOLLOWING INFORMATION APPLIES TO THE NEXT TWO PROBLEMS Treasury Bills Maturity Days to Mat May 12 05 181 Bid 2. securities ( i.11% 1.30% 2.24 (a) 17 Use the information provided to calculate the ask yield (also known as the investment rate or the bond equivalent rate.25% 2.e.75 $9997.85 per pound at the beginning of the year and $2 per pound at the end of the year. a) b) c) d) e) (c) 15 8.5% 10.75% -1. with security investments in the U. a) b) c) d) e) 2.K.76 $9887.exchange over a one year period has gone from $1.85 per pound to $2 per pound.

28)= 0.9524) – 1 = 0.60 .0475) = $47. Exchange rate change = (2/1.0571 or -5.0625.44 = 0.90/1.85) -1 = 0.37 Ask yield = ((10000 – 9887.0175 or 1. Capital gains yield = 4.000 – (0.62% = 4. The municipal bond has an equivalent taxable yield of 0. Current yield = 47.4. Dollar returns = (1 + 0.02296 or 2.50/995.50 – 2.37)/9887. Exchange rate change = (0.5405) – 1 = -0.50 = 2.808% .05) – 1 = -0.75 – 2.3% 16 17 325 .50.04 = 2.77% = 0.77%.73%.188%.5405 per $ and 1/2.10)(0. Estimated yield on 10 year Treasury = 4.50 per dollar. Or 99.0224 x 10.0 = pounds 0.CHAPTER 3 ANSWERS TO PROBLEMS 1 2 3 4 5 6 Maturity premium = 4.808% .000 x 181)/360 = $9887.544% of face value of $1000.1083 or 10.08108) – 1 = 0.11% Local currency return = (1 + 0.71% Euro returns = (1 . Price = $995. This is higher than the bond yield of 0.0.0477 or 4. Small firm premium = 14.075 or -7.10%.5% Ask price = 10.10)/(1 + 0.71% Default premium = 5.83%%.038%.475/(1 – 0.8 – 4.37) x (365/181) = 0.058)/(1 + 0.04) – 1 = 0.08108 or 8. Annual dollar coupon amount = (1000)(0.75% 7 8 9 10 11 12 13 14 15 First restate exchange rates as 1/1.12.1111/0. Real L-T corporate bond return = (1 + 0.05% Common stock premium = 12.85 = pounds 0.46%.05)(1.066.04 = 10.50/0.75 = 1.0173 or 1.0.44.

sectors and real estate. such as capital preservation or current income. Asset classes. The gifting phase is similar to. Sectors. 326 . and may be concurrent with. high-priority goals include some form of financial independence. the spending phase. An appropriate investment objective for a typical 25-year-old investor is a lowrisk strategy. Risk tolerance is exclusively a function of an individual's psychological makeup. are deferred until the funds are withdrawn from the account. Average tax rate is defined as a person's total tax payment divided by their total income. time horizon. The investment performance of a portfolio manager of a small Capitalization equity fund should be compared to the performance of the S&P 500 stock index. Investment returns of an IRA investment. and countries. Marginal tax rate is defined as a person's total tax payment divided by their total income. (f) (t) 9 10 MULTIPLE CHOICE QUESTIONS (a) 1 Asset allocation is defined as the process of deciding how to allocate an investor’s wealth among a) b) c) d) e) Asset classes. tax concerns and risk tolerance are all investment constraints. Long-term. sectors. Asset classes. including any income. sectors and derivatives. Liquidity needs. Asset classes.CHAPTER 5 THE ASSET ALLOCATION DECISION TRUE/FALSE QUESTIONS (t) (t) (t) (f) (f) (f) (f) (t) 1 2 3 4 5 6 7 8 Experts suggest life insurance coverage should be seven to ten times an individual's annual salary.

b) Have enough income to cover expenses and excess assets would be used to benefit charities and family. e) None of the above. Investment in common stocks enables an investor to maintain real value over time. The only way to maintain purchasing power over time is to invest in bonds. Purchasing commodities. (d) 6 Which of the following statements is true? a) b) c) d) Stocks are inappropriate investments in a tax deferred account. e) None of the above 327 . (c) 5 An individual in the consolidation phase of the investment life cycle would a) Have retired and would seek to preserve the real value of their investments. d) Be in the early to middle stage of their career. have a small net worth and long investment time horizon. Purchasing derivative securities. After adjusting for taxes. c) Be past the midpoint of their careers and have excess earnings that can be invested in moderately risky investments.(a) 2 Which of the following is not a life cycle phase? a) b) c) d) e) Discovery phase Accumulation phase Consolidation phase Spending phase Gifting phase (e) 3 Which of the following is not a step in the portfolio management process? a) b) c) d) e) Develop a policy statement Study current financial and economic conditions Construct the portfolio Monitor investor's needs and market conditions Sell all assets and reinvest the proceeds at least once a year (e) 4 An example of a risk management strategy that involves ‘risk transfer’ is a) b) c) d) e) Maintaining large cash reserves. Investing largely in stocks. long-term bonds consistently outperform stocks. Investing largely in bonds.

decision explains % of the % of the variation in returns for a (e) 8 Research has shown that the asset allocation variation in fund returns across all funds.K. 100 and 40. 328 . c) Be past the midpoint of their careers and have excess earnings that can be invested in moderately risky investments. d) Be in the early to middle stage of their career. 40 and 90. and particular fund over time.(c) 7 In the U. 90 and 40. Government regulations. a) b) c) d) e) 90 and 100. equity allocation in pension fund portfolios stands around 78%. The historically high inflation. have a small net worth and long investment time horizon. The high average age of the population. b) Have enough income to cover expenses and excess assets would be used to benefit charities and family. An illiquid stock market. (a) 9 In an investment policy statement the objectives of an investor are expressed in terms of a) b) c) d) e) risk and return risk return time horizon liquidity needs (d) 10 Investors can manage risk confronting their wealth using the following a) b) c) d) e) risk avoidance risk anticipation risk transfer all of the above none of the above (d) 11 An individual in the accumulation phase of the investment life cycle would a) Have retired and would seek to preserve the real value of their investments. This high level of allocation to equities can be explained by a) b) c) d) e) The generous state pensions. 40 and 100.

329 .e) None of the above.

92 $16. Your current tax rate is 20% but you expect you tax rate at retirement to be 15%.248.95% USE THE FOLLOWING INFORMATION FOR THE NEXT 4 PROBLEMS As part of a retirement planning exercise. a) b) c) d) e) 8. a) b) c) d) e) $2. a) b) c) d) e) (c) 3 $300 $400 $700 $100 $200 Calculate the future value.75% 5. Your time horizon is 25 years and you expect to earn 9.5% per year.51 $3.69% 8. at the end of 25 years.867. at the end of 25 years. of the regular IRA contribution and the tax savings.70 $1.840.23 (c) 4 Calculate the total after tax future value.436.833.35 $2. If the relevant tax rate is 35% and the rate of inflation is 3. The regular IRA contribution is tax deductible.03 $16.35 $4. (b) 2 Calculate the tax savings generated by the regular IRA at the time of investment.75% per year.496. a) b) c) d) e) $19. In both cases the contribution amount is $2000.06% 2. you are comparing a regular IRA with a Roth IRA.900. of the tax savings.43 $18.336. calculate the after tax real rate of return for the security.23 330 .932.43% 3.MULTIPLE CHOICE PROBLEMS (d) 1 The nominal rate of return for a security is 12.73 $21.369.5% percent per year on both types of IRA accounts.

43 $18.932.833.321 (b) 8 Assume that you invest $1000 at the end of each quarter for the next 15 years in a mutual fund. with semiannual compounding.73 $21. and 50% stocks.25% 5. The return on your portfolio for the past year was a) b) c) d) e) -5.000 $315.(a) 5 Calculate the total after tax future value.840.5%.03 $16. What is the equivalent taxable yield? a) 5.000 $115.637 (d) 9 Assuming the investor's marginal tax rate is 28% and he is considering investing in a municipal bond yielding 7%.5%.92 $16.749 $60. and stocks –8.790 $121.75%.04% b) 5.5% per year. The amount in the account at the end of 15 years a) b) c) d) e) $28. bonds 5. at the end of 20 years assuming an interest rate of 11.47% c) 8. The annual rate of interest that you expect to earn in the this account is 8. at the end of 25 years.75%. a) b) c) d) e) $19.71% (a) 7 The future value of $25.976 $220.000 invested today.515 $500. is a) b) c) d) e) $233.04% 5.515 $250. 35% bonds.91% -1.23 (e) 6 Your portfolio currently has an asset allocation that is 15% cash. of the Roth IRA contribution. The returns over the past years for cash was 3.673 $213.96% 331 .436.47% 0.336.

528 $20.72% e) 9.739 $250.765 332 .320 (d) 11 Calculate the balance in the investment account at the end of the second year (prior to any withdrawals) a) b) c) d) e) $750.000 $618.000 investment after 5 years if you are in the 15% tax bracket (assuming annual compounding)? a) $10.468 (b) 12 Someone in the 15 percent tax bracket can earn 8% on his investments in a taxexempt IRA account.750 $825.000 $680.680 b) $11. You plan to withdraw 25% annually at the beginning of each year with interest credited on the remaining balance at the end of the year.000 $170.625 $510.80% USE THE FOLLOWING INFORMATION FOR THE NEXT TWO PROBLEMS Assume that you have just retired with $1.693 $15.114 $50.156 $206. a) b) c) d) e) $148.250 $186.000 investment after 5 years (assuming annual compounding)? a) b) c) d) e) $ 6.d) 9. (d) 10 Calculate the amount withdrawn at the beginning of the second year. What will be the after-tax value of a $10.805 $14. What will be the value of a $10.000 (c) 13 Suppose you invest money in a taxable account earning 8% per year. You expect to earn 10% per year on your investments.000.000 in savings in an investment account.

693 e) $15.35)(.336.436.73(1 – 0.095)25 = $19.895 d) $14.35) = 0. After tax FV of Roth IRA contribution = 2000(1 + 0.021875   Equivalent taxable yield = .749 FV = 1000   .73 6.095)25 = $19. 8.336.71% 7.0171 or –1. 3.085) = -0.5)(-.976  (1  ..92 5.22 FV of tax savings = 400(1 + 0.73 After tax FV of regular IRA = $19.28) = .528 CHAPTER 5 ANSWERS TO MULTIPLE CHOICE PROBLEMS 1. FV of tax savings = 400(1 + 0.0575)+(. 9.125)/(1 + 0. FV = 25.076)25 = $2496.2) = 0.0548 or 5.c) $13.095(1 – 0.057540) = $233.15) = $16.0375)]-1)(1-.000(1 + .70 0.70 Total after tax = $18.076)25 = $2496.72 = 9.035)+(. Portfolio return = (.336. After tax real rate = ([(1 + 0.021875 60 )  1   =$121.076 4.15)(.48% Tax savings on regular IRA = (2000)(0.72% 333 . Pre tax FV of regular IRA contribution = 2000(1 + 0.932.07/(1 .2) = 400.07/. 2.

000.250 = $618.25) = $250.250 11. At the end of the year it is worth 750.00 $ 825.8% $10.00 $618.468.068)5 = $13.000(1 + 0.75 The initial withdrawal is $1.08(1 .250.625.00 $170.000(0.10.000.000 The remaining balance of $750.25 Balance $750.000.000 – 206.000(0.156.000.750(1. 13.00 10% 25% outflow $250.000.625 $10.000.693 12. The remaining balance at the end of the first year = 825.1) = $680.Tax rate) = 0.000 earns interest of 10%.068 or 6.08)5 = $14.895 334 .25) = $206.00 $ 680.750 This earns interest of 10% and at the end of year 2 is worth = 618.000 The withdrawal at the beginning of the second year is = 825.1) = $825.00 $206.0. After-tax yield = Before-tax yield (1 .15) = 0.00 $510.000(1.750. Interest rate Withdrawal rate Year 0 1 2 Principal $1.000(1 + 0.

a) True b) False (b) 2 Cash flows for nonlife insurance companies. such as property and casualty. d) the company carries the risk of paying future pension benefits to retirees. a) True b) False (e) 4 In a defined contribution pension plan. they offer short-term deposit accounts. Choices a and b All of the above 335 .CHAPTER 5 APPENDIX MULTIPLE CHOICE QUESTIONS (a) 1 Many endowments are tax-exempt. they are required to by federal and state laws. e) Choices a and c (d) 5 a) b) c) d) e) Banks typically have short-term investment horizons because they have a strong need for liquidity. a) the plan does not promise to pay the retiree a specific income stream after retirement. a) True b) False (b) 3 The portfolio mixes of institutional investors around the world are approximately the same. b) the plan does promise to pay the retiree a specific income stream after retirement. c) the employee's retirement income is not an obligation of the firm. are similar to cash flows of life insurance companies.

In the United States commons stocks are quoted in decimals not fractions. The increase in institutional development has caused an increase in the number and size of block trades. The primary market is where existing issues are traded between current and potential owners. Negotiated. trades occur at any time while the market is open.CHAPTER 6 ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS TRUE/FALSE QUESTIONS (t) (f) (f) (f) (t) (t) (t) (f) (t) (f) (f) (t) (t) (t) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 A continuous market that has price continuity requires depth of buyers and sellers. The U.S. The third market describes direct trading of securities between parties with no broker intermediary. over-the-counter market is the largest segment of the U. A market where prices adjust rapidly to new information is considered to be internally efficient.S. In a call market. and best efforts are three forms of underwriting arrangements. competitive bids. Informational efficiency is where the cost of acquiring information is very cheap. Super DOT is an electronic order-routing system through which member firms can transmit market and limit orders directly to the posts where the securities are traded. The fourth market is mainly used by individual investors because it is much cheaper than using a broker. (t) 336 15 . Secondary markets are important because they provide liquidity to individuals who have purchased issues in the primary market. secondary market in terms of number of issues traded. A general obligation (GO) bond is backed by the full taxing power of the municipality. A short seller can only trade on an uptick (or zero uptick) and must pay any dividends to the lender of the stock.

(a) 4 In a negotiated bid. d) Sellers submit ask prices to buyers. risk-bearing. None of the above. c) Buyers submit bid prices to sellers. Origination and distribution. Takes place at specific times. Takes place at the open and close of the trading day. b) Dealers compete against each other to provide the highest bid and lowest asking prices. Origination and risk-bearing. e) Buyers and sellers submit bid and ask prices to a central location to be matched. Risk-bearing and distribution. and distribution. (d) 5 Municipal bonds are sold using the following method or methods a) Competitive bid 337 . None of the above. Risk-bearing and distribution.(f) 16 Decimalization has increased spread size and caused an increase in transaction costs. All limit orders are visible to the specialist only. MULTIPLE CHOICE QUESTIONS (b) 1 A central limit order book (CLOB) refers to a system where a) b) c) d) e) All limit orders are electronically matched. (e) 3 A pure auction market is one in which a) Dealers provide liquidity by buying and selling shares of stock for themselves. (b) 2 In a call market. All of the above. trading for individual stocks a) b) c) d) e) Occurs anytime the market is open. All limit orders are visible to markets makers and specialists. Orders are routed through Super Dot. the underwriter carries out the following service(s) a) b) c) d) e) Origination.

b) c) d) e)

Negotiated sale Private placement All of the above None of the above

(d)

6

When a market externally efficient, it means that a) b) c) d) e) Timely and accurate information is available The market is liquid Transaction costs are low Prices adjust rapidly to new information The number of buyers and sellers are the same

(b)

7

When a market is internally efficient, it means that a) b) c) d) e) The market has price continuity. The market has minimal transactions costs The market has good depth The market has more buyers than sellers The market has more sellers than buyers

(b)

8

The impact of changing the system for quoting share prices from fractions to decimals has been to a) Increase spread size, increase transaction costs, and increase the number of transactions. b) Decrease spread size, decrease transaction costs, and increase the number of transactions. c) Decrease spread size, decrease transaction costs, and decrease the number of transactions. d) Decrease spread size, increase transaction costs, and increase the number of transactions. e) Decrease spread size, decrease transaction costs and decrease the number of transactions..

(d)

9

Which of the following is not a characteristic of a "good" market? a) b) c) d) e) Marketability Price continuity Low transaction costs Few buyers and sellers Informational efficiency

(b)

10

A "good" market is one

338

a) In which there is a strong likelihood of insider trading. b) Where prices reflect new information regarding supply and demand factors. c) Where accurate information on cost and volume for past transactions is difficult to obtain. d) Which is illiquid and has high transaction costs. e) All of the above. (e) 11 Which of the following is(are) an underwriting function? a) b) c) d) e) (d) 12 Origination. Risk-bearing and origination. Distribution and origination. Risk bearing and distribution. Origination, risk bearing and distribution.

With a best-efforts offering, the investment banker performs all of the following roles: a) b) c) d) e) Designs and plans the security issue. Acquires the total issue through a competitive bid. Accepts the responsibility for reselling the issue. Acts as a broker to sell as many securities it can at a stipulated price. All of the above are true.

(c)

13

The basic distinction between a primary and a secondary market is a) Proceeds from sales in the primary market go to the current owner of a security; proceeds in secondary market go to the original owner. b) Primary markets involve direct dealings within regional exchanges. c) Only new securities are sold in the primary market; only outstanding securities are brought and sold in the secondary market. d) Primary markets deal exclusively in bonds; secondary markets deal primarily in common stock. e) There is no difference between a primary and secondary market

(a)

14

The underwriting function of ‘origination’ involves a) b) c) d) e) The design and planning of the security issue. Acquiring the total issue through a competitive bid. Accepting the responsibility for reselling the issue. Acting as a broker to sell as many securities it can at a stipulated price. All of the above are true.

(c)

15

The underwriting function of ‘risk-bearing’ involves
339

a) b) c) d) e) (a) 16

The design and planning of the security issue. Selling the security issue through a selling syndicate. Accepting the responsibility for reselling the issue. Acting as a broker to sell as many securities it can at a stipulated price. All of the above are true.

A dealer market is one in which a) Dealers compete and provide liquidity by buying and selling shares of a security for themselves. b) One dealer sets bid and ask prices at which securities will trade. c) Buyers submit bid prices to sellers. d) Sellers submit ask prices to buyers. e) Buyers and sellers submit bid and ask prices to a central location to be matched.

(e)

17

The term ‘third market’ describes the market where dealers and brokers: a) b) c) d) e) Trade in stocks listed on regional stock exchanges. Trade in stocks through electronic communication networks. Trade in stocks listed on the London Stock Exchange. Trade in stocks through electronic crossing systems. Trade in exchange listed stocks away from the exchanges.

(e)

18

The vast majority of trading on regional stock exchanges is in a) b) c) d) e) Stocks listed on the NYSE. Stocks listed on the Nasdaq. Dual listed stocks. Stocks with unlisted trading privileges (UTP). Dual listed and UTP stocks.

(e)

19

The member of the New York Stock Exchange who acts as a dealer on assigned stocks is known as a a) b) c) d) e) Registered trader. Commission broker. Registered dealer. Floor dealer. Specialist.

(c)

20

Floor brokers on the NYSE a) Use their membership to buy and sell for their own account.

340

d) Handle limit and other special orders placed by other brokers on the floor.b) Are employees of a member firm and buy and sell for customers of the firm. Short sale. it means that a) You may borrow up to 25% of a stock purchase. d) The ratio of your equity value to the total value of the position may not fall below 75%. When an investor borrows part of the investment cost it is known as a) b) c) d) e) A short sale. (e) 23 Which of the following is not a function of the specialist? a) Acting as a broker who handles the limit orders or special orders placed with member brokers b) Buying and selling securities in order to stabilize the market c) Acting as a dealer in assigned stocks to maintain a fair and orderly market d) Maintain a minimum of $1 million or the value of 15. A limit order. Market order. (a) 21 An order placed specifying the buy or sell price is a a) b) c) d) e) (c) 22 Limit order. b) You may borrow up to 75% of a stock purchase. 341 . e) None of the above. whichever is greater e) Speculating only for themselves. A fill or kill order. e) Maintain a fair and orderly market. A credit order. they do not execute traders for the public nor for other brokers (c) 24 If your broker required a maintenance margin of 25%. A margin transaction. c) Act as brokers for other members. Priced order. c) The ratio of your equity value to the total value of the position may not fall below 25%.000 shares of each stock assigned. Stop loss.

342 .

000 $150.000 $120.00% -25.50% -30.25 $53.07% -37.25 $43.000 $200.000 in a margin account. what is your rate of return on the investment? 343 . The margin requirement is 50 percent and commissions are ignored.33 $83.000 $100.000 $300. Shares in Sisco Corp currently sell for $80 per share: (b) 1 What is the value of stock that you can acquire? a) b) c) d) e) (c) 2 $100.000 What is your profit if the price of Sisco Corp rises to $90? a) b) c) d) e) $50. The broker charges a 10 percent annual interest rate and commissions are 3 percent of the total stock value on both the purchase and the sale.00% -23. If at year end you receive a $0.50% (b) 5 Suppose you buy a round lot of a stock on 55 percent margin when it is selling at $35 a share.000 $12.000 $175.MULTIPLE CHOICE PROBLEMS USE THE FOLLOWING INFORMATION FOR THE NEXT THREE PROBLEMS Assume you deposit $100.33 (d) 4 Calculate your percentage rate of return if the shares of Sisco Corp falls to $65.000 (c) 3 If the maintenance margin is 25 percent.500 $25. a) b) c) d) e) -15.33 $45. to what price can Sisco Corp fall before you receive a margin call? a) b) c) d) e) $51.90 per share dividend and sell the stock for 32.

87% 5.73 $950.25%. Commission on the sale is 1.75 $9. the stock.a) b) c) d) e) -29.87% USE THE FOLLOWING INFORMATION FOR THE NEXT FIVE PROBLEMS You decide to sell short 200 shares of XCorp stock at a price of $75.00% -26.187.25.08% 9.00% USE THE FOLLOWING INFORMATION FOR THE NEXT TWO PROBLEMS You decide to sell 100 shares of a stock short when it is selling at its yearly high of $22. Your broker tells you that your margin requirement is 55% and that the commission on the sale is $55.250. Interest on margin debt is 5.05 $425.89 $315.45 What is your rate of return on the investment? a) b) c) d) e) 0. (d) 8 Calculate your initial investment a) b) c) d) e) $15.25% per year. Your margin deposit is 65%.000 $5.50 $637.25 $9.50 $15.50 344 .38 and are charged a commission of $45 and a 9% interest rate on the funds you borrowed.937.75 per share dividend. (a) 6 What is your dollar return on the investment? a) b) c) d) e) (d) 7 $121. During the year the stock pays a $1.75 per share dividend. While you are short. Tuna Boat pays a $0.87% 3. At the end of one year you buy shares of the stock to cover your short sale at $18.00% -35.750.38% -28.23% -25.53% 11.

(a) 9 At the end of one year you close out your short position by purchasing shares of XCorp at $45 per share. What is your dollar profit on the investment? (Assume a 1.25% commission on the purchase) a) b) c) d) e) -40.038. what is your rate of return on the investment? a) b) c) d) e) -55.64% -25.38 -$4.00 -$5074. The maintenance margin is 30%.25%.13 (c) 10 If at the end of one year you close out your short position by purchasing share of XCorp at $45 per share with commission of 1.038. Brokerage commissions are 2% for purchases and 2% for sales.06% 23.25%. a) b) c) d) e) $5.85 per share.074.92% 10.38 -$4. The interest rate on margin debt is 6. The commission is 1. (e) 13 At the end of one year shares of RossCorp stock are selling for $55 per share and the company paid dividends of $0.38 $4.1% -33.038.038.074.2% USE THE FOLLOWING INFORMATION FOR THE NEXT FIVE PROBLEMS Shares of RossCorp stock are selling for $45 per share.13 (a) 12 If you cover your short position at $90 per share.00 -$5074.25% per year.53% 5.25% commission on the purchase) a) b) c) d) e) $5.13 $5250. Assuming that 345 .38 $4.13 $5250. Calculate your dollar profit.31% 51.7% –71.05% (b) 11 Suppose at the end of one year XCorp is selling at $90 per share and you cover your short position at this price. What is your rate of return on the investment? (Assume a 1.21% 72.

39 $26. what is your rate of return if you sell RossCorp stock? a) b) c) d) e) -33.05% –25.85 per share.85 per share.96% 19.42% 33.05% -33. At what price would you receive a margin call? a) b) c) d) $29.85 per share.51% 29. what is your rate of return? a) b) c) d) e) -23. Assuming that you paid the full cost of the purchase.21% 10.51% 5.08% 23.07 346 . Assuming that you borrowed 25% of cost of the purchase.51% -25.35% –40. Assuming that you borrowed 25% of cost of the purchase.32% 14.39 $16. what is your rate of return if you sell RossCorp stock? a) b) c) d) e) (b) 14 18.42% 23.05% -23.51% 22.48 $50.64% (d) 17 Assume that you purchase 150 shares of RossCorp stock by making a margin deposit of 75%.35% (c) 15 At the end of one year shares of RossCorp stock are selling for $55 per share and the company paid dividends of $0.you paid the full cost of the purchase.28% At the end of one year shares of RossCorp stock are selling for $35 per share and the company paid dividends of $0. what is your rate of return? a) b) c) d) e) 33.35% 23.05% -23.06% (b) 16 At the end of one year shares of RossCorp stock are selling for $35 per share and the company paid dividends of $0.

e) $50.50 = $200.375 or -37.33 4.000 0.$157.03 x 3200 = $105.00 .000 and X = $100.$568. Since the shares are $80 each. Profit = (90 .03 x $3500) = $2030 Beginning Value of Stock = $3500 Profit = Ending Wealth .$100.50 Rate of Return = Profit/Initial Investment = -$568.Debit Balance)/ Market Value where Market Value = Price x Number of Shares = Price x 2500 Debit Balance = Initial Loan Value = (0.000)/(Price x 2500) Price = $53.50/$2030 = -28% 347 .55 x $3.000 Margin = (Market Value .Transaction Costs .50 = .10 x (. If X is the total investment your share will represent 50 percent.50 Profit = $3290 . Return = (65 – 80)/(0.5 x 80) = -0.25 = ((Price x 2500) .50x = $100.45 x $3500) = $157.80)(2500) = $25.500) + (.Beginning Value of Stock . Thus .5% Initial investment= (.000.000/. 5.10 CHAPTER 6 ANSWERS TO MULTIPLE CHOICE PROBLEMS 1.000)/$80 = 2500 shares 2. you can purchase ($200.03 x 3500 + .$201 .Interest Ending Wealth = Ending Market Value + Dividend= $3200 + $90 = $3290 Transaction Costs = .00 + 96 = $201 Interest = .$3500. 3.5)($80)(2500) = $100.

0125) – (200)(45)(0.09 x (.85 .1.85 -0.70 -0.65)(200)(75) + (0.75) – (200)(75)(0. Rate of return = [55.35)(0.75) – (200)(75)(0.35)(75)(0.90] = -23.11 = $121.0.38/9937. 11.90] = 19.89 7.90]/[45 + 0. Rate of return = 5074.50 Dollar profit = 200(75 – 45 – 1.75 Cost = $18.45 + 0.53% Initial investment = (0.38 10.50 = -0.0125) – (200)(90)(0.42% 348 .0525) = $5074.75 = 9.$90.Interest Total Return = Beginning Market Value .11 6.28% 14.4063 or -40.55 x $2225) + 55 = $1278.06% Dollar profit = 200(75 – 90 – 1.$100 .89/$1278. 8.00 Interest = .13 12.0125)(200)(75) = $9937.0125) – (200)(75)(0.Transaction Costs .0125) – (200)(0.90]/[45 + 0. Rate of Return = $121.10 .For problems 6 and 7 Initial investment = (.$75 = $2150 Transaction Costs = $55 + $45 = $100. Rate of return = [35 – 45 + 0.45 x $2225) = $90.50 = 0.Cost .0525) = -$4038.$1838 .13/9937.Dividend = $2225 .5106 or 51. 9.38 x 100 = $1838 (without transaction costs) Profit = Total Return . Rate of return = -4038.63% 13. Profit = $2150 .

75)(45)(.(1-.05% 17.51% 16.90-(1-.30 = [(150)(P) – (0.90] = -33.85 -1.75)(45) + 0.0625)]/[(0.25)(150)(45)]/[(150)(P)] P = $16.90.15.10-0.70-0.0625)]/[(0.75)(45)(.90] = 23. Rate of return = [55-45 + 0.85-0.75)(45)+0. Rate of return = [35-45+0. 0.07 CHAPTER 7 349 .

S. The DJIA has been criticized because when a stock in the index splits there are more shares outstanding and the importance of the stock in the index increases. The Dow-Jones Industrial Average (DJIA) is a value. A price-weighted index is the geometric average of the current prices of the sampled securities. A value-weighted index contains an automatic adjustment for stock splits.K.S.weighted average.. investment-grade-bond series were very high because all rates of return for investment-grade bonds over time are impacted by common macroeconomic variables. The low correlations between the U. In a value-weighted index the highest priced stock carries the greatest weight. The correlations among the U. and the U.SECURITY-MARKET INDICATOR SERIES TRUE/FALSE QUESTIONS (t) (f) (f) (f) 1 2 3 4 An aggregate market index can be used as a benchmark to judge the performance of professional money managers. Security market indexes have been used to create index funds and exchange traded funds. and Japan. and the U. (t) (f) (t) (f) (t) (t) (t) 5 6 7 8 9 10 11 350 . The S&P 500 stock index is an example of an equally-weighted index. confirm the benefit of global diversification. An index constructed using small-cap growth stocks would be referred to as a style index .S.

Dividend record.MULTIPLE CHOICE QUESTIONS (c) 1 Which of the following is not a use of security market indicator series? a) b) c) d) e) To use as a benchmark of individual portfolio performance To develop an index portfolio To determine unsystematic risk To determine factors influencing aggregate security price movements To determine systematic risk (c) 2 A properly selected sample for use in constructing a market indicator series will consider the sample's source. Index will increase/decrease. such as DJIA? a) b) c) d) e) Divisor will increase/decrease. Breadth. Nikkei-Dow Jones Average. Variability. index remains the same. American Stock Exchange Index. Not enough information provided. size and a) b) c) d) e) Value. (d) 4 An example of a value-weighted stock market indicator series is the a) b) c) d) e) Dow Jones Industrial Average. divisor remains the same. (a) 3 What effect does a stock substitution or stock split have on a price-weighted series. Average beta. Lehman Brothers Index. (d) 5 Which of the following indexes includes the most comprehensive list of stocks? a) b) c) d) e) New York Stock Exchange Composite Index Standard and Poor's 500 Composite Index American Stock Exchange Market Value Index Nasdaq Composite Dow Jones Industrial Average 351 . Index and divisor will both reflect the changes (immediately). Index and divisor will remain the same. Value Line Index.

c) High because of the equity characteristics of high yield bonds. c) There can be difficulties in correctly pricing bond issues. (a) 10 Correlations between U. A harmonic average. investment grade bonds and high yield bonds are a) Low because of the equity characteristics of high yield bonds. That investors should invest only in U.S. calls. e) Choices a. d) High because yields on investment grade bonds are determined by systematic interest rate variables. (e) 7 Which of the following are factors that make it difficult to create and maintain a bond index? a) The universe of bonds is broader than stocks. b) Low because yields on investment grade bonds are determined by systematic interest rate variables. stocks. b and c.S.S. d) High because yields on investment grade bonds are determined by systematic interest rate variables. (a) 8 Low correlations between the S&P 500 stock index and the MSCI EAFE suggest a) b) c) d) e) That investors should diversify investment portfolios. b) The universe of bonds is constantly changing due to new issues. c) High because of the equity characteristics of high yield bonds. d) Choices a and c. A geometric mean. A logarithmic average. bond maturities. Nothing. That investors should invest only in Europe. e) None of the above. An expected average. That investors should invest only is Asia. investment grade bonds are a) Low because of the equity characteristics of high yield bonds. b) Low because yields on investment grade bonds are determined by systematic interest rate variables. 352 . e) None of the above. and bond sinking funds. (d) 9 Correlations between U.(c) 6 The Value Line Composite Average is based on percent price changes which has been computed using a) b) c) d) e) An arithmetic mean.

00% 353 .25 Calculate the price weighted series for December 31.33% 40.00 10000 $ 50. 2003 after the splits.25 119.5 103. a) b) c) d) e) 72. a) b) c) d) e) (a) 2 103.57 (a) 4 Calculate the percentage return in the price weighted series for the period Dec 31. prior to the splits.25 103. (c) 1 Calculate the price weighted series for Dec 31.25 119.25 121.00 30000 $ 150.0 72.0 119. 2004.76% 33.00 20000 $ 40.00% 21. 2003 to Dec 31.00 20000 $ 35.5 121. a) b) c) d) e) 42.57 100.00 5000 $ 65. 2004.00 25000 Stock W X Y Z Stocks W and X had 3 for 1 splits on December 31.0 72.86% 20.5 100.00 25000 $ 50.MULTIPLE CHOICE PROBLEMS USE THE FOLLOWING INFORMATION FOR THE NEXT 12 PROBLEMS 31-Dec-03 31-Dec-0331-Dec-0431-Dec-04 Price Shares Price Shares $ 75. a) b) c) d) e) 121.00 15000 $ 25. 2003 at the end of trading.57 (e) 3 Calculate the price weighted series for Dec 31. 2003.25 100.

The base year is Dec 31.0 150. a) b) c) d) e) 12.5 81.5 100.68% 47. 2003. prior to the splits. 2003 to Dec 31. The base year is Dec 31. Assume a base index value of 100. a) b) c) d) e) 100. 2003.25 100.0 120. 2003.76% 33.5 81.0 147. The base year is Dec 31.00% (a) 9 Calculate the unweighted index for Dec 31.5 121.0 200. Assume a base index value of 100. a) b) c) d) e) 72.69 72. 2003. 2004. after the splits.0 121. Assume a base index value of 100. The base year is Dec 31.0 81. a) b) c) d) e) 121.5 (b) 8 Calculate the percentage return in the value weighted index for the period Dec 31. 2003. 2004. 2003.25 (e) 7 Calculate the value weighted index for Dec 31.25 (c) 6 Calculate the value weighted index for Dec 31.69 100. 2003. prior to the splits. Assume a base index value of 100.0 175.50% 21.(d) 5 Calculate the value weighted index for Dec 31.0 354 .33% 40.69 72. a) b) c) d) e) 147.5 147.

75 100.05% 21.75% 100.25 (a) 12 Calculate the percentage return in the unweighted index (geometric mean) for the period Dec 31.(c) 10 Calculate the unweighted index for Dec 31. Assume a base index value of 100.25 148.20% 355 . after the splits. a) b) c) d) e) 146.000 10.0 100. The base year is Dec 31.25% USE THE FOLLOWING INFORMATION FOR THE NEXT THREE PROBLEMS You are given the following information regarding prices for a sample of stocks: Stock A B C (b) 13 Number of Shares 1.000. 2004. Assume a base index value of 100.000.0 120. 2003 to Dec 31. The base year is Dec 31. 2003.0 (a) 11 Calculate the unweighted index (geometric mean) for Dec 31. Assume a base index value of 100. The base year is Dec 31.0 200. a) b) c) d) e) 46.0 150.05 121.25 151. what is the percentage change in the series for the period from T to T + 1. 2003. 2003.000 PriceT 50 30 20 PriceT+1 60 35 25 Using a price-weighted series approach.000. a) b) c) d) e) 110.25% 51.25% 48. a) 1. 2004.000 25. 2003.

33% 40. what is the percentage change in the series for the period from T to T + 1.000 19.000 100.000 (c) 17 Calculate a Dow Jones Industrial Index for Day 4.2389 356 .b) c) d) e) (d) 14 20.00% 20.22% 20.000 is invested in each stock.76% 33.55% 21.76% 33.56% 21. a) b) c) d) e) 1.000 29.00% 20. a) b) c) d) e) 13.00% Using a value-weighted series approach.33% USE THE FOLLOWING INFORMATION FOR THE NEXT THREE PROBLEMS Price COMPANY Day 1 Day 2 Day 3 Day 4 A 12 10 8 9 B 23 22 26 25 Shares C 52 55 51 19 A 500 500* 1000 1000 B 350 350 350 350 C 250 250 250** 750 *Split at Close of Day 2 (c) 16 **Split at Close of Day 3 Calculate a Dow Jones Industrial Index for Day 1.21% 20.00% 21.000 87.76% 33.33% (c) 15 Construct an unweighted series (arithmetic mean) assuming $1. a) 11. What is the percentage change in wealth for this portfolio? a) b) c) d) e) 1.

b) c) d) e) (e) 18 21. a) b) c) d) e) 90.2389 41.5.234 101.351 CHAPTER 7 ANSWERS TO MULTIPLE CHOICE PROBLEMS 1 PRICE WEIGHTED SERIES DEC 2003 = (75 + 150 + 25 + 40)/4 = 72.5%. Value weighted series Dec 2004 =  1500000  975000  700000  1250000    x100  147.5 = 42.5  750000  750000  500000  1000000  8 9 SINCE THE BASE VALUE IS 100 AND THE CURRENT INDEX VALUE IS 147.5)/72.57 Return on series = (103.5 = (25 + 50 + 25 + 40)/X The new divisor. Not affected by splits.351 91.3343 31.86% Value weighted series Dec 2003 =  750000  750000  500000  1000000    x100  100  750000  750000  500000  1000000  6 7 Value weighted post split = 100.57 – 72.931 = 103. X = 1. The index value Dec 2003 is 100 357 .6890 None of the above Calculate a Standard & Poor's Index for Day 3 if the base period is Day 1 with an initial index value is 100.5 2 POST SPLIT SERIES = 72.035 95. the percentage return is 47.931 3 4 5 PRICE WEIGHTED SERIES DEC 2004 = (50 + 65 + 35 + 50)/1.628 110.

000.00% 14 Period T Stock Price/Share A $50 B 30 C 20 Total Period T+1 Stock Price/Share A $60 B 35 C 25 Total # of Shares 1.00 Percentage change = (40.000.00 1.000 625.00 50.000.200.000.05 The return on the index is 46.33 50.10 11 12 13 Post split the index value is 100 Index Dec 2004 = (2 + 1.00 .33 = 20.00 1.000 # of Shares 1.000.000 25.000 500.000 300.166.000.05% Given a three security series and a price change from period T to T+1.250.25)1/4 (100) = 146.000.000.000 25.55 1.76% 15 Period T Stock Price/Share A $50 B 30 C 20 Total Period T+1 Stock Price/Share A $ 60 B 35 C 25 358 # of Shares Market Value 20. the percentage change in the price weighted series would be A B C Sum Divisor Average Period T $50 30 20 $100 3 33.000.000.00 $1.000.035 – 850)/850 = 21.33 1.00 # of Shares 20.33.000 Percentage change = (1.000.00 33.000 10.000.000 10.000.40 + 1.000 $850.000 $1.3 + 1.33)/33.000 350.00 33.00 Market Value $1.000.00 $3.000 Market Value $50.000.00 .035.33 Period T+1 $60 35 25 $120 3 40.000.000.000 Market Value $60.

616.6966 = 31.850 Index = ($29.56% 16 17 Day 1 Index = (12 + 23 + 52)/3.351 CHAPTER 8 359 .0000 = 29.0000 = 29.0608 Adjusted Day 3 Index = (8 + 26 + 17)/Y = 30.55 Percentage change = (3.000 = 20.2389 18 Base = ($12 x 500) + ($23 x 350) + ($52 x 250) = $27.Total $3.0608 Y = 1.6966 (new divisor) Day 4 Index = (9 + 25 + 19)/1.8276 = 30.616.55 .050 Day 3 ($8 x 1000) + ($26 x 350) + ($51 x 250) = $29.3.8276 (new divisor) Day 3 Index = (8 + 26 + 51)/2.850/$27.000 X = 2.000)/3.050) x 100 = 110.000 Day 2 Index = (10 + 22 + 55)/3.000 Adjusted Day 2 Index = (5 + 22 + 55)/X = 29.

j) is equal to the square root of the covariance (covi.j).g. A basic assumption of portfolio theory is that an investor would want to maximize risk subject to a given level of return. Standardizing the covariance by the individual standard deviation yields the correlation coefficient. The covariance is a measure of the degree to which two variables (e. Most investors hold a diversified portfolio in order to reduce portfolio risk. the correlation coefficient of returns (ri. A basic assumption of the Markowitz model is that investors base decisions solely on expected return and risk. To reduce the standard deviation of a portfolio it is necessary to increase the relative weight of assets with low volatility (small standard deviation of returns). The yield spread between yields on AAA bonds and BAA bonds is evidence that investors are risk averse. rates of return) move together over time relative to their means. 360 .AN INTRODUCTION TO PORTFOLIO MANAGEMENT TRUE/FALSE QUESTIONS (t) (t) (t) (t) (t) (f) (f) 1 2 3 4 5 6 7 Risk is defined as the uncertainty of future outcomes. For a two stock portfolio containing Stocks i and j.. Most assets of the same type have negative covariances of returns with each (t) (f) (t) 8 9 10 (f) 11 other. Increasing the correlation among assets in a portfolio results in an increase in the standard deviation of the portfolio.

steepest utility curve. (d) 4 A portfolio manager is considering adding another security to his portfolio. bends in. the two variables are low risk.0 A positive covariance between two variables indicates that a) b) c) d) the two variables move in different directions. the two variables move in the same direction. 361 (b) 5 . covariance and correlation.25 -0. the shape of the efficient frontier a) b) c) d) e) approaches a horizontal straight line.75 1. middle range utility curve. Which security would enable the highest level of risk diversification a) b) c) d) e) 0. efficient portfolios. none of the above. high return and low return assets.MULTIPLE CHOICE QUESTIONS (a) 1 The optimal portfolio is identified at the point of tangency between the efficient frontier and the a) b) c) d) e) highest possible utility curve.25 -0. approaches a vertical straight line. return and risk. The correlations of the 5 alternatives available are listed below. the two variables are high risk. lowest possible utility curve. (c) 3 As the correlation coefficient between two assets decreases. flattest utility curve. bends out. (d) 2 An individual investor’s utility curves specify the tradeoffs he or she is willing to make between a) b) c) d) e) high risk and low risk assets.0 0.

e) the two variables are risk free. Covariances. c) Investors estimate the risk of the portfolio on the basis of their utility functions. correlations and variances. standard deviations and variances. What information must you input to a computer program in order to derive the portfolios that make up the efficient frontier a) b) c) d) e) Expected returns. investors being risk avoiders. bends out. (d) 8 The Markowitz model is based on several assumptions regarding investor behavior. investors being risk averse. covariances and correlations. definition of: (d) 10 The probability of an adverse outcome is the a) b) c) d) Statistics. all of the above. Which of the following is an assumption of the Markowitz model? a) Investors consider investment alternative as being represented by a joint probability distribution of expected returns over some holding period. e) None of the above. Expected returns. bends in. Expected returns. the shape of the efficient frontier a) b) c) d) e) approaches a horizontal straight line. d) Investors base decisions solely on expected return and risk. none of the above. (c) 6 A positive relationship between expected return and expected risk is consistent with a) b) c) d) e) (d) 7 investors being risk seekers. (a) 9 As the correlation coefficient between two assets increases. Variance. Standard deviations. Random. variances and covariances. variances and correlations. approaches a vertical straight line. none of the above. b) Investors minimize one-period expected utility. Risk. 362 .

Higher risk than the highest risk individual security in the portfolio. d) A value of zero means that the returns are zero. all statements are true) (a) 15 In a two stock portfolio. when applied to portfolio theory.e) Semivariance. is concerned with the a) b) c) d) e) Square root of deviations from the mean. Lower risk than the highest risk individual security in the portfolio. c) A value of -1 implies that the returns move in a completely opposite direction. Summation of the squared deviations from the mean. if the correlation coefficient between two stocks were to decrease over time everything else remaining constant the portfolio's risk would a) b) c) d) e) Decrease. e) None of the above (that is. Be a negative value. (d) 14 Which of the following statements are correlation coefficient is false? a) The values range between -1 to +1. Deviations below the mean. (a) 13 With low. Increase. Higher risk than the individual securities that make up the portfolio. 363 . Deviations above the mean. b) A value of +1 implies that the returns for the two stocks move together in a completely linear manner. (c) 11 Which of the following is a measure of risk? a) b) c) d) e) (b) 12 Range of standard deviations Expected return Standard deviation Covariance Correlation Semivariance. Remain constant. All deviations (above and below the mean). None of the above. zero or negative correlations it is possible to derive portfolios that have a) b) c) d) e) Lower risk than the individual securities in the portfolio. Fluctuate positively and negatively.

Correl(C. Correl(E.75. Capital asset pricing model.75.H) = -0. Correlations of expected returns. There is no portfolio with a higher return. All of the above.J (c) 17 Given a portfolio of stocks the envelope curve containing the set of best possible combinations is known as the a) b) c) d) e) Efficient portfolio. (d) 18 Estimation error refers to potential errors that arise from estimating a) b) c) d) e) Expected security returns.F Pair G.H Pair I.D Pair E.B Pair C. Correl(I. No other portfolio offers lower risk with lower expected return. Efficient frontier.J) = -0.50. None of the above 364 . Standard deviations of expected returns.(d) 16 Given the following correlations between pairs of stocks. (a) 19 A portfolio is considered to be efficient if: a) b) c) d) e) No other portfolio offers higher expected returns with the same risk.B) = 0. Correl(G.F) = 0.D) = 1. Last frontier. There is no portfolio with lower risk. a) b) c) d) e) Pair A. None of the above. a portfolio constructed from which pair will have the lowest standard deviation? Correl(A. Utility curve.

75%.71% 11.1835 Weight 0.15 and for stock B.25 a) b) c) d) e) . Security A and B have a correlation coefficient of 0.25 .25% 6.25 0.20.1235 0.125 b) 0. A and B.65. Exp.090 .70% 14. The correlation coefficient between these two stocks is: a) -0.092 . and security B has standard deviation of 25. The covariance between returns for these stocks is 0.285 365 .MULTIPLE CHOICE PROBLEMS (d) 1 Consider two securities.1425 Std.08 .12 0. Security A has standard deviation of 12.12% 15. calculate the expected return for the portfolio.40 Given the following weights and expected security returns. Calculate the covariance between these two securities.085 .06 .1675 0.097 None of the above Expected Return .54 195 200 Calculate the expected return for a three asset portfolio with the following Asset A B C a) b) c) d) e) (c) 3 11.195 c) -0. Weight . 0.35 0. it is 0.10 . Ret.01.12 (d) 4 the standard deviation for stock A is 0.20 .30 . Dev 0. a) b) c) d) e) (a) 2 300 461.0675 0.54 261.

a) b) c) d) e) .03 W1 = .15 Calculate the expected return a two stock portfolio when w1 = 0.0395 .05 W2 = .009.16 (d) 8 Calculate the expected standard deviation of a two stock portfolio when w1 = 0.125 0. a) b) c) d) e) .1558 .125 .14 0.d) 0.115 .12 E(SD1) = 0.136 0.333 e) 0.75 and the covariance between stock 1 and stock 2 is -0.3950 USE THE FOLLOWING INFORMATION FOR THE NEXT FOUR PROBLEMS Given the following information about two stocks: E(R1) = 0.105 . 366 .16 E(SD2) = 0.40.135 None of the above (c) 6 Calculate the expected standard deviation of the two stock portfolio when the correlation is 0.0016 .15 E(SD2) = .405 USE THE FOLLOWING INFORMATION FOR THE NEXT TWO PROBLEMS Given: E(R1) = .75.30 (d) 5 E(R2) = .10 E(SD1) = . a) b) c) d) e) 0.08 (a) 7 E(R2) = 0.0160 .13 0.70 Calculate the expected return of the two stock portfolio.

0623 CHAPTER 8 ANSWERS TO MULTIPLE CHOICE PROBLEMS 1.4)2(.60 and the covariance between stock 1 and stock 2 is 0.03)2+ (.25)(-.25)(0.03)(.092 or 9.135 SD= [(.a) b) c) d) e) (b) 9 0. 10.04)2+ (. 2.1025 0.03947 E(R) = (.60.16) = 0.4)(.7 x .1171 or 11.2% Correlation = (0.0404 0.0705 0.3333 E(R) = (. Cov(A.136 SD= [(.0906 367 .12) + (.0906 0. 9.75)2(.6)2(.40)(0.0623 Calculate the expected return a two stock portfolio when w1 = 0.20)(0.14 0.35)(0.10) + (.71% 3.8)]1/2 = 0.8.16 (c) 10 Calculate the expected standard deviation of a two stock portfolio when w1 = 0. a) b) c) d) e) 0.3)(.136 0.3)2(.13 SD = [(. 4. 8.3 x .6)(. 7.10) + (0. a) b) c) d) e) 0.25)(0.25)2(.65)(12)(25) = 195 E(R) = (0. 6.01)(0.1425) = 0.05)(.0404 0.13 0. B) = (0.16) = 0.06)2+ 2(. E(R) = (0.12) = 0.06)2+ 2(.0675) + (0.04)2+ (.08) + (0.20) = 0.125 0.4)]1/2 = 0.30)(0.05)2+ 2(.25)(0.25 x . 5.12) + (.7)(.0705 0.0009)]1/2 = 0.75 x .1235) + (0.7)2(.60 x .40 x .15) = .06) + (0.0906 0.0404 E(R) = (.75)(.1025 0.15 x 0.

CHAPTER 9 AN INTRODUCTION TO ASSET PRICING MODELS TRUE/FALSE QUESTIONS (t) (f) (t) (t) (t) (t) (f) 1 2 3 4 5 6 7 One of the assumptions of Capital Market Theory is that investors can borrow or lend at the risk-free rate. The Capital Market Line (CML) is the line from the intercept point that represents the risk-free rate tangent to the original efficient frontier. Diversification reduces the unsystematic risk in a portfolio. Multifactor models of risk and return can be broadly grouped into models that use macroeconomic factors and models that use microeconomic factors. Beta is a standardized measure of systematic risk. which means that all portfolios on the CML are perfectly negatively correlated with the completely diversified market portfolio since it lies on the CML. but entails significant transaction costs. The Capital Asset Pricing Model (CAPM) is a technique for determining the expected risk on an asset. An assumption of Capital Market Theory is that buying or selling of assets entails no taxes. Arbitrage Pricing Theory (APT) specifies the exact number of risk factors and their identity (t) (f) (t) (t) (f) 8 9 10 11 12 368 . All portfolios on the CML are perfectly negatively correlated. The market portfolio consists of all risky assets. A risky asset is an asset with uncertain future returns. and uncertainty (or risk) is measured by the variance or standard deviation of returns. The standard deviation of a portfolio that combines the risk-free asset with risky assets is the linear proportion of the standard deviation of the risky asset portfolio.

buying bonds (d) 4 When identifying undervalued and overvalued assets.0% 369 . All investors have homogeneous expectations. borrowing Risk. d) An asset is considered overvalued if its required rate of return is below estimated rate of return. All investors have the same one period time horizon. risk free assets Buying stocks. Stocks and bonds. There are no risk-free assets. (c) 3 The separation theorems divides decisions on a) b) c) d) e) Lending. c) An asset is considered undervalued if its estimated rate of return is above required rate of return. all are true statements) its its its its (b) 5 Utilizing the security market line an investor owning a stock with a beta of (-2) would expect the stock's return to in a market that was expected to decline 10 percent. Risky assets. financing Risky assets.MULTIPLE CHOICE QUESTIONS (d) 1 Which of the following is not an assumption of the Capital Market Theory? a) b) c) d) e) All investors are Markowitz efficient investors. U. which of the following statements is false? a) An asset is properly valued if its estimated rate of return is equal to required rate of return. return Investing. stocks and bonds. International stocks and bonds.S. b) An asset is considered overvalued if its estimated rate of return is below required rate of return. a) Rise or fall an indeterminate amount b) Rise by 20. and non-U. There are no taxes or transaction costs in buying or selling assets. (e) 2 The market portfolio consists of all a) b) c) d) e) New York Stock Exchange stocks.S. e) None of the above (that is. from decisions on .

2% e) Fall by 10. Lend and borrow at the risk free rate and invest in the market portfolio.2% (d) 6 a) b) c) d) e) (e) 7 The Capital Market Line (CML) refers to the efficient formed by creating portfolios that Invest solely in the market portfolio M. c) The standard deviation of the portfolio increases because systematic increases. Return difference between small capitalization and large capitalization stocks. Unsystematic risk and required return on an asset Systematic risk and required return on a diversified portfolio of assets. confidence risk represents a) Unanticipated changes in the level of overall business activity. e) The standard deviation of the portfolio decreases because unsystematic decreases. risk risk risk risk risk (a) 8 The Security Market Line (SML) represents the relation between a) b) c) d) e) Risk and required return on an asset.0% d) Rise by 10. Lend at the risk free asset and invest in the market portfolio. b) The expected return of the portfolio increases because unsystematic decreases. (d) 10 In a multifactor model. Borrow at the risk free asset and invest in the market portfolio. Systematic risk and required return on an asset. d) The standard deviation of the portfolio decreases because systematic increases. Expected inflation risk. Short sell the market portfolio. Call risk.c) Fall by 20. As the number of stocks in a portfolio increases a) The expected return of the portfolio increases because systematic decreases. 370 . Maturity risk. (a) 9 In a macro-economic based risk factor model the following factor would be one of many appropriate factors a) b) c) d) e) Confidence risk. Risk and return on a diversified portfolio of assets.

factor 2 is UI the difference between actual and expected inflation. Unanticipated changes in short term and long term inflation rates.25% 0. and factor 3 is UPR the unanticipated change in bond credit spread. MULTIPLE CHOICE PROBLEMS (b) 1 Consider an asset that has a beta of 1. Call risk.5% and the expected return on the stock index is 15%.75% –0. Maturity risk. e) None of the above.5. Expected inflation risk. The return on the risk-free asset is 6.75% 9. Risk Factor Factor Sensitivity(β) Risk Premium(λ) 371 . Unanticipated changes in investors’ desired time to receive payouts. c) Unanticipated changes in short term and long term inflation rates.0% (b) 2 The table below provides factor risk sensitivities and factor risk premia for a three factor model for a particular asset where factor 1 is MP the growth rate in U. time horizon risk represents a) b) c) d) Unanticipated changes in the level of overall business activity. e) None of the above. Return difference between small capitalization and large capitalization stocks. Calculate the alpha for the asset.S. The estimated return on the asset is 20%. (b) 11 In a multifactor model. a) b) c) d) e) 19. Unanticipated changes in the willingness of investors to take on investment risk. (e) 12 In a micro-economic based risk factor model the following factor would be one of many appropriate factors a) b) c) d) e) Confidence risk.75% 9. d) Unanticipated changes in the willingness of investors to take on investment risk.b) Unanticipated changes in investors’ desired time to receive payouts. industrial production.

2% An investor wishes to construct a portfolio by borrowing 35% of his original wealth and investing all the money in a stock index. The return on the risk-free asset is 2% and the expected return on the stock index is 10%. The standard deviation of returns on the stock index 8%.25% 18. What portion of the total risk of the asset.02% The variance of returns for a risky asset is 25%.0432 0.76 -0.00% 11.0% 1.56% 6.0% and the expected return on the stock index is 15%.15% 372 . Calculate the expected standard deviation of the portfolio. a) b) c) d) e) (a) 3 12. Calculate the expected return on the portfolio.0% 3.0259 -0.2% 8. is unsystematic? a) b) c) d) e) (c) 4 32% 8% 68% 25% 75% An investor wishes to construct a portfolio consisting of a 40% allocation to a stock index and a 60% allocation to a risk free asset.87 0. a) b) c) d) e) 18. a) b) c) d) e) (b) 5 5.32% 4.2% 4. Var(e) is 8%. The variance of the error term.32% 8.32% 9.85% 9.0149 Calculate the expected excess return for the asset. as measured by variance. The return on the risk-free asset is 4.50% 15.8 0.MP UI UPR 1.

Calculate the implied return on the market. a) b) c) d) e) 8.88% 14.50% 17.95%. The risk free rate is 2.0 0.95%.0 0. Consider a risky asset that has a standard deviation of returns of 15.75% 14.50.0 -1.5 -0.5% and the beta of the stock is 0.5%.91% c) 17. Calculate the expected return on the portfolio.50% 21.50% 373 (b) 8 (a) 9 (d) 10 .38% (d) 7 A stock has a beta of the stock is 1.50% 13.5% and the expected return on the stock index is 12%. a) b) c) d) e) 7. Buy because required return 11.5 The expected return for a stock. Short because it is undervalued. a) 7. Sell because required return is 16.50% b) 13. According to the CAPM you should a) b) c) d) e) Sell because required return is 9. Buy because required return is 12.5%.(d) 6 An investor wishes to construct a portfolio consisting of a 70% allocation to a stock index and a 30% allocation to a risk free asset. Calculate the implied risk-free rate. The estimated return for the stock is 14%. is 10.50% 9. The market return is 9. is 25%.38% The expected return for a stock.91% 17. The risk free rate is 7.25% 16.1. calculated using the CAPM.5% and the beta of the stock is 1. a) b) c) d) e) 1.5%.5% and the return on the market is 12%.80. calculated using the CAPM. Calculate the correlation between the risky asset and a risk free asset. The return on the risk-free asset is 4.

25% USE THE FOLLOWING INFORMATION FOR THE NEXT THREE PROBLEMS You expect the risk-free rate (RFR) to be 5 percent and the market return to be 9 percent. 22.5% 6.95%.5% 10. 11. 7.00 What are the expected (required) rates of return for the three stocks (in the order X.5% 12. 0.00 STOCK X Y Z (b) 13 BETA 1.50%.00%. 8. 13.09 and you expect the market return to be . Y. 11. a) b) c) d) e) (d) 12 a) b) c) d) e) 5.69 when the risk free rate is.00% 11. 2. 7.00%.00%.75 $ 1.50%.14.5%.45% 14. 5.0% 15.50 $ 1.92% 12.20% 15.91% 10. Z)? a) b) c) d) e) (a) 14 16. Y.05% 13. CURRENT PRICE $ 22 $ 40 $ 45 EXPECTED PRICE $ 23 $ 43 $ 49 EXPECTED DIVIDEND $ 0.5% and the beta of the stock is 1.25%.00% 7.88% e) 14.38% (c) 11 The expected return for Zbrite stock calculated using the CAPM is 15. The risk free rate is 3.0% Calculate the expected return for Express Inc. Z)? 374 .20%. 3.30% What are the estimated rates of return for the three stocks (in the order X.20%. Calculate the implied market risk premium.50 0.11% 6.50%. which has a beta of .d) 21.2. You also have the following information about three stocks.50 2.

20%.3333 (e) 17 (b) 18 Compute the intercept of the characteristic line 375 .5929 5.a) b) c) d) e) 7. Buy stock X and Z. a) b) c) d) e) 0. a) b) c) d) e) 0. it is undervalued.6825 9.4255 0.00%.25%.50%.00%. 3. 7. 2.3333 Compute the correlation coefficient between GBC and the Market Index. Choices a and c USE THE FOLLOWING INFORMATION FOR THE NEXT FOUR PROBLEMS Year 1 2 3 4 5 6 Return for GBC 25 10 5 -13 11 -20 Return for Market 12 13 17 -15 -8 9 (a) 16 Compute the beta for GBC Company using the historic returns presented above. they are overvalued. Sell stocks X and Z.50%.4255 0.4163 0.6825 9. 8. 11.30% (e) 15 What is your investment strategy concerning the three stocks? a) b) c) d) e) Buy stock Y. it is overvalued. 13. Sell stock Y. 7.00% 15.4163 0.5929 5.95%.20% 16. 11. they are undervalued.11% 6.50%.20%. 5.00%.00% 11. 22.

5%.76 UI -0.013 = 0. 0.1232 3 4 5 6 7 8 9 376 8%/25% = 0.0149 (β)x(λ) 0. .5 + 1.5 – X).2% -0.35(15) = 18.5) = 19.013 1.1(12 – 2.4255(RMarket) CHAPTER 9 ANSWERS TO PROBLEMS 1 6.a) b) c) d) e) (d) 19 0.013 .0456 0. Buy the stock is undervalued.08) = 0. = 32% unsystematic.5 = X + 1. 10.4255(RMarket) RGBC = 1.4255(RMarket) RMarket = 1.35(4) + 1.013 .75% 2 The table below shows the relevant calculations Risk Factor Factor Sensitivity(β) MP 1.32.5875 0.013 + 0.0.4255(RMarket) RMarket = 1.7(12) = 9.0346 0.0259 -0.4385 0.5(9.95%. X = 7.4255 1.013 + 0.5) + 0.3(4.85% E(R)= 0. The correlation between a risky asset and a risk-free asset is always zero.0432 0.5) = 12.5(15 – 6.4255(RGBC) RGBC = 1.0.013 0.4(0.5219 The equation of the characteristic line is a) b) c) d) e) RGBC + 1.8 UPR 0.75% E(R)= 2.25 = 0.25% alpha = 20 –19.032 or 3.5 + 1.87 Expected return Risk Premium(λ) 0.

1245 = 12.09) = .00 277.5 = 21.45% For problems 13 .4255 (6) GBC R-E(R ) 22. X = 14.31 24.00 7.05 + 0.00 -16.45 + 1.10 11 12 25 = 7. Covariance Correlation Beta (2) GBC 25 10 5 -13 11 -20 18 3.40/82 = 0. Return on market = 14.20 16.33 12.65 (5) Market (R-E(R ))2 53.5 = 3.38 + 7..33 (8) (6) x (7) 161.67 4.14 .00)/45 = 11. X = 10%.09 + .88% 15.50)/40 = 11.33 -19.59 358.00 529.22 + 0.72 -101. Market)/ VarianceMarket Beta = 18.00(.75 841. Dev.69 (.66 314.09 .2(X).39 152.05 + 2.33 0.00 2..50(.00 8.75)/22 = 7.2244 17 The correlation coefficient can be computed as follows: 377 .67 (4) GBC (R-E(R ))2 484.33 168.27 12.0000 (3) Market 12 13 17 -15 -8 9 28 4.05) = 13% ESTIMATED (23 .00 256.67 -12.5 + 0.11% EVALUATION Overvalued Undervalued Overvalued For problems 16 – 19 The table below shows the relevant calculations.09 .03 386.33 8.91 160.60 0.00 4.00 (7) Market R-E(R ) 7.05) = 11% .36 -99.09 -.38%.25% (49 .5 + 1.00 16 Beta for GBC Computer is computed as follows: Beta = Cov(GBC. (1) Year 1 2 3 4 5 6 Total Average Variance Std.05) = 7% .00 1386.40 + 1..50(.95% (43 .15 STOCK X Y Z REQUIRED .00 -23.53 18.73 69.97 71.26 58.8(X).00 64.05 + 1. k = .00 49.

97) = 0.0 .67)] = 1.4255)(4.Correlation = Cov(GBC.97 Cov(GBC.33 Where: SDGBC = [1386/5]1/2 = 16.013% 19 RGBC = 1.[(0.013 + 0.6/(16. Market) = 358/5 = 71.65 x 12.4255(RMarket) 378 .33/5]1/2 = 12. Market)/(SDGBC x SDMarket) = 71.65 SDMarket = [841.60 18 The alpha or intercept of the characteristic line is computed as follows: alpha = 3.