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- Finance Beta - India
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)

Answers to Suggested Problems – Lecture 1

Chapter 2:

8.

a. At t = 0, the value of the index is: (90 + 50 + 100)/3 = 80

At t = 1, the value of the index is: (95 + 45 + 110)/3 = 83.3333

The rate of return is: (83.3333/80) – 1 = 4.167%

b. In the absence of a split, stock C would sell for 110, and the value of the index

would be: (95 + 45 + 110)/3 = 83.3333

After the split, stock C sells at 55. Therefore, we need to set the divisor (D) such

that:

83.3333 = (95 + 45 + 55)/D

or

D = 2.340

c. The rate of return is zero. The index remains unchanged, as it should, since the

return on each stock equals zero.

9.

a. Total market value at t = 0 is: (9,000 + 10,000 + 20,000) = 39,000

Total market value at t = 1 is: (9,500 + 9,000 + 22,000) = 40,500

The return on the value-weighted index equals:

(40,500/39,000) – 1 = 3.85%

b. The return on each stock is as follows:

Ra = (95/90) – 1 = 0.0556

Rb = (45/50) – 1 = –0.10

Rc = (110/100) – 1 = 0.10

The return on the equally-weighted index equals:

[0.0556 + (-0.10) + 0.10]/3 = 0.0185 = 1.85%

10.

**The after-tax yield on the corporate bonds is: [0.09 x (1 – 0.30)] = 0.0630 = 6.30%
**

Therefore, municipal bonds must offer a yield of at least 6.30%.

12.

**The equivalent taxable yield (r) is: r = rm/(1 – t)
**

a.

4.00%

b.

4.44%

c.

5.00%

d.

5.71%

Chapter 3:

1.

a. The underwriter charges a gross spread of 7% (and there are no other fees listed).

The total fees are therefore 1,000,000 x $50 x 7% = $3.5 million.

b. The firm raised $50 per share less the gross spread, or:

1,000,000 x $50 x (1-0.07) = $46.5 million.

c. The underpricing is $3 per share, or (53-50)/50 = 6.0%.

d. The firm paid $3.5 million in explicit fees to the underwriter. The implicit cost

associated with underpricing was $3 per share. The total explicit and implicit costs

were therefore $3.5 million + (1,000,000 x $3) = $6.5 million.

7.

a. You buy 200 shares of Telecom ($10,000/$50 per share). These shares increase in

value by 10%, or $1,000. You pay interest of: 0.08 x 5,000 = $400

The rate of return will be:

$1,000 − $400

= 0.12 = 12%

$5,000

b. The value of the 200 shares is 200P. The equity in the account is (200P – $5,000).

You will receive a margin call when:

200P − $5,000

= 0.30 when P = $35.71 or lower

200P

c. The value of the 200 shares is 200P. After one year, the equity in the account is

(200P – $5,000(1.08)). You will receive a margin call when:

200 P − $5,000(1.08)

= 0.30 when P = $38.57 or lower

200 P

8.

a. Initial margin is 50% of $30,000 or $15,000.

b. Total assets are $45,000 ($30,000 from the sale of the stock and $15,000 put up for

margin). Liabilities are 500P because you must pay back the borrowed shares. The

equity in the account is ($45,000 – 500P). A margin call will be issued when:

$45,000 − 500 P

= 0.30 when P = $69.23 or higher

500 P

your stop loss order would trigger a market sell order as soon as a transaction occurs at or below $55. your broker will sell your shares at the best available market price. but could be slightly above or below this price. the dividend payment of $200 is withdrawn from your account. The proceeds from the short sale (net of commission) were: ($14 x 100) – ($0.08 × (1 – 0.50 x 100) = $950 Therefore. If the stock never traded at or below $55. selling price of stock repurchase price of stock dividend per share 2 trades x $0. Your net proceeds per share were: $14 –$ 9 –$ 2 –$ 1 $ 2 19.384 Rate of return = $21.384 − $20 + $0.01) = $21.20 End of year NAV is based on the 8% price gain. the value of your account is equal to the net profit on the transaction: $1350 – $200 – $950 = $200 Note that your profit ($200) equals (100 shares x profit per share of $2). In this case. Start of year NAV = $20 Dividends per share = $0.350 You must repay the dividend to the original owner of the borrowed shares. After this transaction occurs.92% $20 .50 x 100) = $1. less the 1% 12b-1 fee: End of year NAV = $20 × 1. This price should be close to $55.20 = 0. Covering the short sale at $9 per share cost you (including commission): ($9 x 100) + ($0. As a result.18.50 commission per share d.0792 = 7. your stop loss order would never be executed. Chapter 4: 13.

4% × 0. each dollar invested in a fund with a 4% load and a portfolio return equal to r will grow to: $0.005)6 > 1.06 In this case. then the portfolio return. c.005)6 > (1.96 × (1 + r – 0..0672 1 + r > 1.50 = 0.96 × (1 + r – 0.0722 r > 7.06)2 If the mutual fund is to be the better investment.4185 (1 + r – 0.005 – 0.005)2 > 1.19.005) > 1. 20. on average.69% b.005)2 > 1. 50% of the portfolio is sold and replaced with other securities each year. must satisfy: 0. With a 12b-1 fee instead of a front-end load.1704 (1 + r – 0.005)2 > (1. Trading costs on the sell orders are 0. If you invest for six years.06)6 = 1. After two years.0075) > 1. the one-time front-end load) is spread out over a greater number of years.005 > 1.06)2 0.0869 = 8.25% regardless of the investment horizon. This means that.005)2 Each dollar invested in the bank CD will grow to: $1 × (1. the portfolio must earn a rate of return (r) that satisfies: (1 + r – 0.96 × (1 + r – 0. r.0869 Therefore. then the portfolio return must satisfy: 0. and the buy orders to replace those securities entail another 0.1236 (1 + r – 0. r > 0.4% . The turnover rate is 50%.22% The cutoff rate of return is lower for the six year investment because the "fixed cost" (i.4%. a.e.4% in trading costs.0819 1 + r > 1. r must exceed 7. Total trading costs will reduce portfolio returns by: 2 × 0.4776 1 + r – 0.96 × (1 + r – 0.

10)2] + [0.5($50.20 – .52 b) HPR = (100. E(RX) = [0.5 × 18%] + [0.) Answers to Suggested Problems – Lecture 2 Chapter 5: 6.3500 0.10)2] = . Investment 1 2 3 4 E(r) 0.33% σY = [0.12 0.5 × (. a) Expected cash flow: 0.5 × (.20)2 = 0.16 0.2 × (–. 7.23% 15. with 24%.52 = 15% .2 × (–.20)2] = .5 c. 9.15 0.000) + 0.000 .10 – . #4 When an investor is risk neutral. which results in a decline in risk premiums.20)2 ⇒ A = 0.1588 0.000) = $100. A = 0.Essentials of Investments (BKM 7th Ed.0592 σX = 24.000 .0% b.20 – . σX2 = [0.0175 σY = 13.0600 -0.956.09 = ½AσP2 = ½ × A × (0.10)2] + [0. a.09/( ½ × 0.P0)/P0 0. 0.30 0.5($150.50 0.20)2] + [0. #3 For each portfolio: Utility = E(r) – (½ × 4 × σ2 ).1518 The portfolio with the highest utility value is #3.21 U -0.24 σ 0.21 0.20)2] + [0. 18.15 – .18 – . E(RP) – Rf = ½AσP2 = ½ × 4 × (0.04) = 4.3 × 10%)] = 10% 10.08 = 8.2 × (–20%)] + [0.5 × 20%] + [0.15 = (100. This is investment #4.P0)/P0 P0 = $86. so that the portfolio with the highest utility is the portfolio with the highest expected return.3 × 50%)] = 20% E(RY) = [0. Increased risk tolerance means decreased risk aversion (A).3 × (.52)/86956.3 × (.50 – .2 × (–15%)] + [0.000 HPR = (P1 .86956.

00% 0.9% a) E(RP) = 0.RF)/σP = (17% .7(40%) = 28.00 d) There is an inverse relationship: price decreases as the risk premium increases.7(33%) = 23. you must be able to buy the security at a lower price.3(7%) + 0. In order to earn a higher risk-premium (assuming the cash flows stay the same).00% Expected Return 19.00% 2.1% Stock C = 0.00% Risk-Free 4. σP = 0.00% 5.7(27%) = 18.0% Stock A = 0. and 40% C) c) Your Reward-to-variability = (RP .7(27%) = 18.3704 d) The slope of the capital allocation line equals the reward-to-variability ratio (0.333.00% Standard Deviation 20.3704).7%)/18.00% 15. 18. 0.9% Stock B = 0.00% 25.9% = 0.P0)/P0 P0 = $83.c) A risk-premium of 15%.00% 14.7 12.00% 10.00% .0% Total Portfolio = 100% (The total weight in the portfolio is 70%. The investor requiring the 15% risk premium (20% HPR) is requiring a larger discount as compensation for risk.00% Risky Portfolio 16. and the portfolio consists of 27% A.00% 6. leads to an expected return of 15%+5%=20%. Note that this is the same at any point you choose on the CAL.00% 30.00% 10.7(17%) = 14% b) T-Bills = 30.00% 8.7%)/27% = 0.000 . 33% B. w=0.00% 0.20 = (100.3704 Client’s Reward-to-variability = (14% .

8*33%) (0.7407 = 74. then y = 20/27 = . My fund has a higher reward-to-variability (or a steeper CAL).80(0.0% = 21.27) = 0. If the client wants a standard deviation of 20%.216 = 21.07) b. Rule 2: σC = 0. a.20. 20 18 16 14 12 10 8 6 4 2 0 CAL (slope=.24 The diagram is shown below. Portfolio standard deviation = y × 27%.8*40%) c.407 = 14.07% in the risky portfolio. a. . Rule 1: E(RC) = RF + y(RP-RF) 0.24) 0 10 20 30 σ (%) b.15 = 0. In other words.07 + y(0. Slope of the CML = 13 – 7 25 = . This allows an investor in my fund to achieve a higher expected return for any given standard deviation than they would earn on the passive S&P fund.8*27%) (0.7407 × 10 = 7 + 7.6% = 26.0% y = 0.407% a. T-Bills Stock A Stock B Stock C = 20.80 (0.4% = 32. my fund provides a higher return at any given level of risk. 22.6% 21. Rule 2: E(R) = 7 + 10y = 7 + .0.17 . b.3704) CML (slope=.

00% 0. you can calculate the return and standard deviation on each of the six portfolio combinations (in 20% increments): Weight S 100% 80 70.89 10. RB) = ρσSσB = .25 12. 68.00% 35.25% Bonds) 14.Chapter 6: 6.8% 13.8% 12.0% Std.68 24.50 20. E(RB) = 9%.00% 20.42% Stocks.75 60 40 31.2% 9. ρ = 0.00 16.00% Optimal Risky Portfolio (70.37 23.5% This gives Cov(RS. The parameters of the opportunity set are: E(RS) = 15%.00% 5.00% 15.6% 12.58 80 100 E(R) 15.00% .00% 26.58% Bonds) 10.25 40 60 68.0% 13.15.18 19. Rf = 5.94 20.4% Minimum Variance Portfolio (31.00% 11. 29. 32.00% 25.00% 9.00% 30.0% 13.42 20 0 Weight B 0% 20 29.6% 11.Dev.00% 0.00% CAL 6.57 22. σS = 32%.00% 15.00% 2. σB = 23%.00% 10.75% Stocks.00% 4.01104 Using Rule 1* and Rule 2*.4% 10.2% 10.0% CAL 8.

you can solve for the exact weights in the optimal portfolio using the formula in footnote 3 on page 185 of the text: the weights are 70.5%.57%.3156 22.0529 − 0.25% and a standard deviation of 24. The portfolio with 70% stocks and 30% bonds is close to the optimal risky portfolio.42% in stocks and 68. This portfolio has an expected return of 13.6%.6 − 5.75% stock and 29. The reward-to-variability ratio of the optimal CAL (using the 60/40 portfolio) is: E (r p ) − r f σp 9. 7. rB ) 0.01104 = = 0.0529 − (2 × 0.5 The equation for the CAL (using the 60/40 portfolio) is: E (rC ) = r f + E (r p ) − r f σp σ C = 5. . This portfolio has an expected return of 13.1024 + 0. the minimum variance portfolio is the combination with 40% in stocks and 60% in bonds.3142 = 0.Of these six possible portfolios. If you consider only the six portfolios you created at 20% increments.01104) w Min (B) = 1 – 0. This portfolio has an expected return of 12.58% in bonds. The minimum-variance portfolio proportions are: w Min (S) = σ 2B − Cov(rS .25% bonds. You can use this portfolio to answer questions 8 through 10. (Note: The true optimal risky portfolio (P) is somewhere between the 60% stock and 80% stock choices. Although I will not require you to do this calculation.3142 2 2 σ S + σ B − 2Cov(rS .the exact minimum variance portfolio has a weight of 31. Note: The true minimum variance portfolio is actually between the 40% stock and 20% stock choices .5% + 0.3156σ C Setting E(rC) equal to 12% yields a standard deviation of 20.6858 Plugging these weights into Rule 1* and Rule 2* gives the expected return and standard deviation shown in the table above.5 = 0. The result can be found by minimizing the variance formula.) 8. Rule 2*. as we discussed in class. a) = 12.2% and a standard deviation of approximately 24.41%. the optimal risky portfolio is the portfolio that includes 60% stocks and 40% bonds. rB ) 0.6% and a standard deviation of 22.

If ρ = -1. a portfolio with wA = 0.08) + 0. The mean of the complete portfolio as a function of the proportion invested in the risky portfolio (y) is: E(rC) = (l − y)rf + yE(rP) = rf + y[E(rP) − rf] = 5.13) = 10% Since this portfolio is riskless. In other words.b. then the optimal risky portfolio may depend on the risk-aversion level of the individual).50 × 110. (Note: This answer assumes that there is a risk-free security in the economy and investors can borrow and lend at this risk-free rate.55% in the risky portfolio) 1 − y = 0. If there is no risk-free security.502 × 1024) + (0.46%).06% The efficient portfolio with a mean of 12% has a standard deviation of only 20.502 × 529) + (2 × 0. 14.6/(0.9155 × 0. This gives the minimum variance portfolio when ρ = -1.40 = 0.4(0. .6(.9155 (91.9155 × 0. However. investors will adjust portfolios to obtain the appropriate levels of risk by combining the risky portfolio with a risk-free asset such as TBills.60 and wB = 0.4)] 1/2 = 21.6 − 5.5) Setting E(rC) = 12% ⇒ y = 0.4+0.50 × 0.5 + y(12. the weight in stock A that gives a perfect hedge (zero risk) equals σB/(σA+σB)=0.6) = 60%.5 Investing 50% in stocks and 50% in bonds yields a mean of 12% and standard deviation of: σP = [(0.4507 10.6%. 12. We discussed the solution to this equation in class.40 would have σ = 0. This portfolio has a return of: E(R) = 0. All investors will have the same optimal risky portfolio.60 = 0. Using only the stock and bond funds to achieve a mean of 12% we solve: 12 = 15wS + 9(1 − wS ) = 9 + 6wS ⇒ wS = 0. Using the CAL reduces the SD by 46 basis points (0.0845 (8. since the optimal risky portfolio is independent of investor preferences. Here. the risk-free rate must be exactly equal to the expected return on this portfolio or 10%.5493 Proportion of bonds in complete portfolio = 0. a zero-risk portfolio can be created: To find the answer. substitute ρ = -1 into Rule 2* and then set the equation equal to zero.45% in T-bills) From the composition of the optimal risky portfolio: Proportion of stocks in complete portfolio = 0.

(Even if the correlation between A and B were exactly +1.0. the portfolio standard deviation will be less than the weighted average of the standard deviations of the component assets. The two measures are equal if ρ=+1.0 and +1.0.) 16. With a correlation between –1.15. In other words. Otherwise. for any ρ<1. . the graph should be a smooth curve passing through points A and B and bowing toward the Yaxis. It isn’t possible to get such a diagram. No. you can reduce the portfolio variance by diversifying. the frontier would be a straight line connecting A and B.

the slope of the CAL for A is 0. which is the slope of the security characteristic line (SCL). Chapter 6: 19.15 .6% of the variance of the excess return of ABC is explained by the market (systematic risk).5 6. b. Portfolio A clearly dominates the market portfolio with a lower standard deviation and a higher expected return. Security A is below the SML and is therefore overpriced. Not possible. the square of the correlation coefficient is 0. Security A has an expected return of 22% based on CAPM and an actual return of 16%. Portfolio A has a higher beta than B. a.) Answers to Selected Problems – Lecture 3 Note: The solutions to Example 6. The slope of the SCL. Part of A’s risk may be nonsystematic. the CML must be better than the CAL for any other security. Chapter 7: 3. 12. Here. Thus. E(Rp) = Rf + βp[E(RM) . If the CAPM is valid. 11.20 = 0. not zero.Rf] 0. Only the systematic portion of total risk is compensated. Not possible. The CML must be better than the CAL for security A. This indicates that 29. and hence the systematic risk. and hence Stock B's systematic risk is greater. The risk of the diversified portfolio consists primarily of systematic risk. Beta measures systematic risk. In other words.75 * 1) + (0. βp=(0. c) False: 75% of the portfolio should be in the market and 25% in T-bills.25 * 0) = 0. Not possible. a) False: β=0 implies E(R)=Rf. The undiversified investor is exposed to both systematic and firm-specific risk. of Stock A is lower. If the CAPM is valid.10 = 1.0.15/0. stock B is the riskiest. Stock B's SCL is steeper.4 and the concept checks are provided in the text. Stock A is therefore riskiest to this investor.33. for this investor. but a lower expected return. Stock A has higher total risk because the total variation of the observations around the SCL is larger for Stock A than for Stock B. 10.Essentials of Investments (BKM 7th Ed.5 while the slope of the CML is 0. b) False: Investors of a diversified portfolio require a risk premium for systematic risk. the market portfolio is the most efficient and a higher rewardto-variability ratio than any other security. In the regression of the excess return of Stock ABC on the market.75 8. The two figures depict the stocks' SCLs. Not possible. 9.296 (this is the R2 of the regression). rather than for nonsystematic risk. the expected rate of return compensates only for market risk (beta). Possible.05 + β(0.05) β = 0. It is also clear that security A has a . 25.

The expected return on the market. Portfolio A’s ratio of risk premium to beta is: (10-4)/1 = 6.88.5)γ2 Solving these two equations simultaneously gives γ1 = 4. 14.47βP1 + 11. The APT factors must correlate with major sources of uncertainty in the economy. E(RP) = rf + βP1[E(R1) . Portfolio E’s ratio of risk premium to beta is: (9-4)/(2/3) = 7. A revised estimate of the rate of return on this stock would be the old estimate plus the sum of the expected changes in the factors multiplied by the sensitivity coefficients to each factor: revised Ri = 14% + 1. This gives the following expected return beta relationship for the economy: E(RP) = 0. if you created a new portfolio by investing 1/3 in the risk-free security and 2/3 in security A. then the alpha of security R is 2. You need to know the risk-free rate.5%. the rate of inflation. d. 18. Security A has an expected return of 17. Since this new portfolio has the same beta as security E (2/3) but a lower expected return (8% vs. Portfolio A has a lower expected return and lower standard deviation than the market and thus plots below the CML. there is an arbitrage opportunity here. Possible.Rf] + βP2[E(R2) .1γ2 Portfolio B: 10% = 7% + 2. These factors would correlate with unexpected changes in consumption and investment opportunities.2 23. 13. You can think of this as the slope of the pricing line for Security A. 9%) there is clearly an arbitrage opportunity. The expected return of portfolio F equals the risk-free rate since its beta equals 0. then the alpha of security R is zero and it lies on the SML. d. but a lower return which is not consistent with CAPM.4% 29.0%.higher beta than the market. Not possible. suggesting that Portfolio E is not on the same pricing line as security A.8γ1 + 2.4(1%) = 15. and interest rates are candidates for factors that can be expected to determine risk premia. Using the SML: 6 = 8 + β(18 – 8) β = –2/10 = –. Industrial production varies with the business cycle. DNP. Security A is below the SML and is therefore overpriced. if we assume a risk-free rate of 4%. If we assume a risk-free rate of 8%.88βP2 33.Rf] Use each security’s sensitivity to the factors to solve for the risk premia on the factors: Portfolio A: 40% = 7% + 1. and thus is a candidate for a factor that is correlated with uncertainties related to investment opportunities in the economy.0% and it lies above the SML.47 and γ2 = 11.2% and an actual return of 16%.0γ1 + (-0. 34. 27. . 28. For example.07 + 4. For example. you would have a portfolio with a beta of 2/3 and an expected return equal to (1/3)*4% + (2/3)*10% = 8%. In other words.0(1%) + 0.

Dividends on five shares plus sale of one share at price of $90 each. Purchase of two shares at $110 less dividend income on three shares held. We need to distinguish between timing and selection abilities. If the manager tends to have a positive excess return even when the market’s performance is merely ‘neutral’ (i. Lines that become steeper as you move to the right of the graph show good timing ability.001661 = −0. A downward curvature would indicate poor market timing skill. then we conclude that the manager has on average made good stock picks – stock selection must be the source of the positive excess returns. has zero excess return). An upward curved relationship indicates that the portfolio was more sensitive to market moves when the market was doing well and less sensitive to market moves when the market was doing poorly -. set the present value of the outflows equal to the present value of the inflows (or the net present value to zero): 300 + 208 110 396 = + ⇒ R = −0. 1/1/97 | | -208 +110 | | 1/1/98 +396 | | 1/1/99 The Dollar-weighted return can be determined by doing an internal rate of return (IRR) calculation. Dividends on four shares plus sale of four shares at price of $95 each. Timing ability is indicated by curvature in the plotted line. In other words.Essentials of Investments (BKM 7th Ed.. The intercept of the scatter diagram is a measure of stock selection ability.e. .) Answers to Selected Problems – Lecture 4 Note: The solution to the concept check is provided in the text. Chapter 5: 14b. Time 0 1 2 3 Date: Cash flow –300 –208 110 396 1/1/96 | | -300 Explanation Purchase of three shares at $100 each.this indicates good market timing skill.1661% 1 2 (1 + R ) (1 + R) (1 + R) 3 Chapter 18: 5.

c. If both have the same risk-adjusted return.[6 + 0.0(21-12)] = 3. In that case. . Selection Ability Bad Good Good Bad Timing Ability Good Good Bad Bad The manager’s alpha is: 10 .5% T(A) = (24 . both A and B are candidates because they both have positive alphas. (iii) The funds may have significantly different levels of diversification.5(14-6)] = 0 10.5(21-12)] = 4. (ii) One year’s worth of data is too small a sample to make clear conclusions. the fund with the less diversified portfolio has a higher exposure to risk because of its higher firm-specific risk. a) α(A) = 24 .[12 + 1. Since the above measure adjusts only for systematic risk.5 = 12 As an addition to a passive diversified portfolio. 9. d.0% α(B) = 30 . b.12)/1 = 12 T(B) = (30-12)/1. it does not tell the entire story.[12 + 1.We can therefore classify performance ability for the four managers as follows: a. b) (i) The funds may have been trying to time the market. the SCL of the funds may be non-linear (curved).

) Answers to Selected Problems – Lecture 5 Chapter 8: 1. c. one could use returns from one period to predict returns in later periods and make abnormal profits. as the portfolio is less diversified.Essentials of Investments (BKM 7th Ed. the stocks that happen to have performed the best will pay higher dividends. “The January Effect” implies that one can predict January prices based on past January prices. This empirical tendency does not provide investors with a tool that will enable them to earn abnormal returns. After the fact. 13. 2 . Predictable volatility does not convey a means to earn abnormal returns. 3. Consistent. Zero. This is a predictable pattern in returns which should not occur if weak-form EMH is valid. b) 1 . b. c. This is a classic filter rule which should not be profitable in an efficient market. Microsoft’s continuing large profits do not imply that stock market investors who purchased Microsoft shares after its success already was evident would have earned a high return on their investments. The phenomenon instead reflects the fact that dividends occur as a response to good performance. 14. 17. Half of managers should beat the market based on pure luck in any year. . If not. investors may bid up the prices of these securities to reflect the now-known opportunity. 15. a) The grandson is referring to the small-firm effect (which can also be described as the January effect). An investor could not use this phenomenon to choose undervalued stocks today.Building a portfolio of only small firms results in increased risk. a. The P/E ratio is public information and should not predict abnormal security returns.After the results of these studies became publicly known. c. it does not suggest that investors are failing to use all available information. in other words. 5. This would be the basis of an "easy money" rule: simply invest with last year's best managers. 2. 3 . c. but this does not imply that you can identify the best performers early enough to earn abnormal returns. Consistent. No. this is not a violation of the EMH. this is not a violation of the EMH. No.Because the anomaly has existed in the past is not a predictor that the anomaly will exist in the future. Inconsistent.

Reversals offer a means to earn easy money: just buy last week's losers. You are less pessimistic about the firm’s prospects than the beliefs built into the stock price. Therefore.d. 26. the announcement was a disappointment. e. The market may have anticipated even greater earnings. you view the firm as undervalued by the market. Compared to prior expectations. The abnormal performance ought to occur in January when earnings are announced. Inconsistent. You should buy the stock. . the firm’s management is not as bad as everyone else believes it to be. In your view. Inconsistent. 24.

If the yield curve is upward sloping.1001 or 10. 9. The only reason for an upward sloping yield curve is the expectation of increased shortterm rates in the future. The bond callable at 105 should sell at a lower price because the call provision is more valuable to the firm when the call price is lower. the forward rate exceeds the expected short-term rate for next year (by the amount of the liquidity premium).1052. In fact. Interest rates have fallen since the bond was issued. a) The forward rate.01%. resulting in a lower price.42 Assuming that market interest rates remain at 4% per half year: the price 6 months from now = $1044.42 = . Lower. investors will require a higher yield to maturity. 35.01%. 5. so the best guess would be less than 10. so the best guess would be 10.08)(1 + f) = (1. Because the yield has not changed. the forward rate equals the expected short rate next year. c) According to the liquidity preference (liquidity premium) hypothesis.09)2 which implies that f = 0. the yield curve can be upward sloping even if future short-term rates are expected to remain flat or even decrease.42 + 50]/1052. Thus. True. Under the Expectations Hypothesis. 4.04 or 4% per 6 months.52 b) Rate of return = [1044. Because the call feature is more valuable to the firm (and more costly to investors).01% b) According to the expectations hypothesis. with a liquidity premium. a. you cannot conclude that investors expect short-term interest rates to rise because the rising slope could either be due to expectations of future increases in rates or due to a liquidity premium. 8. We obtain forward rates from the following table: 1 . the bond is selling at a premium and the price will decrease (toward par value) as the bond approaches maturity. a) The bond pays $50 every 6 months Current price = $1052. is the rate that makes rolling over one-year bonds equally attractive as investing in the two-year maturity bond and holding until maturity: (1.) Answers to Suggested Problems – Lecture 6 Chapter 10: 3. there are no risk premia built into bond prices.Essentials of Investments (BKM 7th Ed. the bond prices adjust such that the bond earns exactly the YTM.52 . 37. f.

27% If YTM=6%.62 three-year bond: $782. c.0% Forward rate 12. the two-year zero will be a one-year zero.824 years 2 .0% 12.112) $711. ΔB B = −D ⋅ Δy 1+ y -7.194 * (.00% $811. Duration=2.10) $811.93 [ = 1000/1.0327 or a decline of 3.1000 = 10. and it will sell for: $782. a shift upward in next year’s curve.01% [(1. Next year.005/1. We obtain next year’s prices and yields by discounting each zero’s face value at the forward rates derived in part (a): Maturity (years) 1 2 Price $892. and it will therefore sell at: $1000/1.112) – 1] Price (for part c) $909.62 ($1000/1.10) – 1] 14.01% 13.03% [(1.78 Chapter 11: Solutions to the concept checks are provided at the end of the chapter. the current three-year zero will be a two-year zero. 1.02% Note that this year’s upward sloping yield curve implies.1000 = 10.123) b.123/1.1201 x 1.1201] [ = 1000/(1.78 $782.09 ($1000/1.00% $711. 2.0% 11. Duration=2.93 Expected total rate of return: two-year bond: $892.1403)] YTM 12.833 years If YTM=10%.Maturity (years) 1 2 3 YTM 10.10) = -.112/1.78 Similarly.93 − 1 = 0. according to the expectations hypothesis.78 ($1000/1.1201 = $892.78 − 1 = 0.

the face value of the bond position must be: $17.08)2) = $17.985.000/((1.09 + 10.4808) = $18.92 The tuition obligation would be: 10.99 The tuition obligation would be: 10. has a higher coupon.591.08) + 10.07) + 10.09)2) = $17. a) Bond B has a higher yield since it is selling at a discount (perhaps because it has lower credit quality).09)1. b) Bond B is callable.65 Duration = (9259.4808 years to maturity (duration=1.11 or a net position change of only $0. 9. the duration of bond B is therefore lower (it is less sensitive to interest rate changes).4808) = $17. the value of the bond would be: $19.26/17832.65.19.080. Thus. If interest rates decrease to 7%.4808 years b) A zero-coupon bond with 1.079.832.08)1. the duration of bond B is lower (it is less sensitive to interest rate changes).07)2) = $18.985.26 If interest rates increase to 9%.832. 3 .4808) would immunize the obligation against interest rate risk.832.19. c) We need a bond position with a present value of $17. Thus.65)*2 = 1.6.39/17832.65*(1.07)1.590.000((1.000/((1. **The slight differences result from the fact that duration is only a linear approximation of the true convex relationship between fixed-income values and interest rates. the value of the bond would be: $19.985. a) PV = 10.26/((1.000/1. Thus.4808 = $19.65)*1 + (8573.26/((1. and has a higher yield (both because it is callable and because Y=C when the bond is selling for par value).18 or a net position change of $0.000/(1.000/(1.

thus.11. therefore. leading to a lower yield and. we again solve for w: w × 4 + (1 – w) × 21 = 9 21 – 17w = 9 w = 12/17 or .7059 So the proportion invested in the zero has to increase to 12/17 and the proportion in the perpetuity has to fall to 5/17. the longer duration. a) The Aaa-rated bond will have the lower yield to maturity and.05 = 21 years. 24. a longer duration).05/. Then we find w by solving: w × 5 + (1 – w) × 21 = 10 21 – 16w = 10 w = 11/16 or . Let w be the weight of the zerocoupon bond. Choose the longer-duration bond to benefit from a rate decrease. your portfolio would be 11/16 invested in the zero and 5/16 in the perpetuity. b) The zero-coupon bond now will have a duration of 4 years while the perpetuity will still have a 21-year duration. a) b) c) d) 4 4 4 2 29. b) The lower-coupon bond will have the longer duration ( it also has more de facto call protection.6875 Therefore. which is now the duration of the obligation. c) The lower-coupon bond will have a longer duration. 4 . a) The duration of the perpetuity is 1. To get a portfolio duration of 9 years.

a) Long Call option. Assume the stock price on Google at the maturity date is $590. a) II) The payoffs and profits on each of these positions is shown in the course notes. where $54. X=600 This option would be exercised. calculate the payoff and profit for investments in each of the following June maturity options. Supplemental Problems: I) The following options would be more valuable: Call option with X=90 . See the associated page numbers below: a) b) c) d) e) Page 7-3 Page 7-6 Page 7-9 Page 7-11 Page 7-12 III) Using the Google option prices provided in your notes. where $69. X=600 This option would not be exercised.70 or a loss of $13. c) Call option with 6 months to expiration .80 (loss). X=500 This option would be exercised. The payoff is zero and the profit is 0-13.40. the cost of the option.80 is the cost of the option. b) Put option – the Put option is currently in the money. d) Long Put option. 1 .70. the probability of being in the money and expected value of S-X are greater.78=$35.80=-59. since S<X.) Answers to Suggested Problems – Lecture 7 Handout: Answers to the options handout are provided at the back of the handout. b) Long Put option. c) Long Call option.40 or a loss of $10. The payoff is 590-500=$90 and the profit is 90-54. the cost of the option. while the Call is not.78 is the cost of the option. The payoff is 600-590=$10 and the profit is 10-69.Essentials of Investments (BKM 7th Ed.22. the probability of being in the money and expected value of S-X are greater. since S>X.with lower exercise price. d) Call option on Intel . since S>X.with longer maturity. The payoff is zero and the profit is 0-10. the probability of being in the money and expected value of S-X are greater.with higher volatility. X=500 This option would not be exercised. since S<X.

a comparison with the results from (d) show that options are a zerosum game. this option would not be exercised. since S<X. where $10.40=$10.40. Since the straddle cost $17. The profit would be -10+69.80 is the price of the option paid to the writer. Again. It is actually more appropriate to think of these statements as the “payoffs” to the various option positions. This is the description of the payoff to a put. since S<X. C is false. f) Short Put option. not a call. This reflects the fact that options are a zero-sum game. X=600 As noted above. this option would be exercised. Butterfly Spread S < X1 Position X 1 < S < X2 X 2 < S < X3 X3 < S Long call (X1) 0 S – X1 S – X1 S – X1 Short 2 calls (X2) 0 0 –2(S – X2) –2(S – X2) Long call (X3) 0 0 0 S – X3 Total 0 S – X1 2X2 – X1 – S (X2–X1 ) – (X3–X2) = 0 Payoff X2 – X1 ST X1 X2 2 X3 . The payoff is zero and the profit is 0+10.) 6.80. or 590-600=-10. The payoff would be the negative of that in (d). this is the amount by which the stock would have to move in either direction for the profit on either the call or put to cover the investment cost (not including time value of money considerations). Notice that the profit is exactly the opposite of that in (c). (Note the book uses the term “value”.e. a.e) Short Call option. both a put and a call on the stock. b. Purchase a straddle. The total cost of the straddle would be $10 + $7 = $17.40 is the price of the option which is paid to the writer. a.. where $69. Chapter 15: 1. X=600 As noted above. 9.80=$59. i.

Vertical combination Position ––––––––––– Long call (X2) S < X1 –––––– 0 X 1 < S < X2 –––––––––– 0 S >X2 –––––– S – X2 Long put (X1) X1 – S 0 0 Total X1 – S 0 S – X2 Payoff X1 ST X1 X2 3 .b.

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