11.

(0.77)

Notes and debentures are unsecured debts.

Mortgage bonds and asset-backed bonds are secured debts. Thus, in case of bankruptcy, bondholders
can claim specific assets which have been designated as collateral. Mortgage bonds are secured with
real property, while asset-backed bonds are secured with any kind of asset.

Notes and debentures have lower seniority than mortgage bonds and asset-backed bonds.

Secured debt has a higher seniority than unsecured debt. Since mortgage bonds and asset-backed bonds
are secured while notes and debentures are unsecured, it follows that mortgage bonds and asset-
backed bonds have higher seniority than notes and debentures.

In order to protect themselves, debenture holders usually issue clauses that restrict companies from
issuing new debt with a higher seniority. The new debt that has lower seniority than existing debenture
issues is called a subordinated debenture.

Notes typically have shorter maturities (less than 10 years) than debentures.

9.2

(1.99)

Excessive trading reduces returns because of increased trading costs. Nevertheless, evidence shows that
individual investors tend to trade very actively.

One explanation for this behavior is that investors suffer from overconfidence bias. They often
overestimate their knowledge or expertise and believe they can do a better job in picking winners and
losers when, in fact, they cannot. This overconfidence leads to frequent trading. Studies have shown
that men tend to be more overconfident than women, and thus tend to trade more frequently than
women.

One study has also shown that trading activity increases with the number of speeding tickets an
individual receives. Researchers interpret the number of speeding tickets as a measure of sensation
seeking, or the individual’s desire for intense risk-taking experiences.

Note that familiarity bias is an explanation for investor's under-diversification but not for excessive
trading.

Here's a summary:
10.1

(4.4)

The downside standard deviation is the square root of the semi-variance.

Semi-variance must be non-negative. Even though all of the terms in min(0,R−E[R])min(0,R−E[R]) are
non-positive, the terms are then squared, resulting in a value that is non-negative.

X is defined as a random variable that represents the investment gain in a security over one period.
Since the Value-at-Risk of X at α=5% is 1%, we have:

Pr[X≤1%] = 0.05 or equivalently Pr[X>1%] = 0.95

This means that:

 There is a 5% probability that the investment gain over one period will be less than or equal to
1% (i.e., will be no more than 1%).

 There is a 95% probability that the investment gain over one period will be more than 1%.

Tail-Value-at-Risk is more conservative than Value-at-Risk as it provides a greater buffer against adverse
outcomes.

To illustrate this point, consider the following diagram:

Observe that the VaR is the point that separates the tail from the rest of the distribution while TVaR is
the expected value of the tail.

So, TVaR will always provide a more conservative number than VaR. TVaR measures how bad the bad
can be.

7.4

(2.58)

The capital market line passes through the risk-free asset and the market portfolio, not the origin. It will
pass through the origin if and only if the risk-free rate is 0.

The capital market line is upward slopping. As the risk increases, the reward increases. If the line is
downward sloping, then investors would only hold the risk-free asset. In that case, there would be no
demand for risky assets, and thus the market for risky asset would cease to exist.

The capital market line is the tangent line connecting the risk-free asset and the market portfolio on the
efficient market frontier of risky assets.

The slope of the capital market line is the Sharpe ratio. All portfolios on the capital market line have the
same slope, and thus the same Sharpe ratio.

The tangent portfolio (in this case it is the market portfolio) is the optimal risky portfolio that will be
selected by a rational investor regardless of risk preference. The only decision that the investor would
have to make is how to allocate investments between the risk-free asset and the tangent portfolio.

You have one choice of optimal risky portfolio, which is the tangent portfolio at the point of tangency
between the tangent line and the efficient frontier of risky assets. So, the tangent portfolio represents
the best choice for risky investment that all rational investors should choose. However, investors can
also combine this choice of risky investment with a risk-free investment. The combination of both form
portfolios that fall on the tangent line. See the diagram below.
Notice the tangent line is always above the efficient frontier of risky assets (except at the point of
tangency). So, the portfolios on the tangent line will have a higher expected return for each level of
volatility than any other attainable portfolio. Thus, all portfolios on the tangent line (i.e., all portfolios
that are combinations of the risk-free asset and the tangent portfolio) are efficient portfolios.

By incorporating the risk-free asset, we have narrowed down the risky portfolio that an investor would
choose to a single optimal portfolio, i.e., the tangent portfolio. The tangent portfolio is the optimal risky
portfolio that will be selected by a rational investor regardless of risk preference. The only decision that
the investor would have to make is how to allocate investments between the risk-free asset and the
tangent portfolio.

 For a conservative investor, a higher proportion will be invested in the risk-free asset, and thus
the optimal portfolio would lie closer to the vertical axis.

 For an aggressive investor, a higher proportion will be invested in the tangent portfolio, and
thus the optimal portfolio would lie farther away from the vertical axis.

 A more aggressive investor may even borrow money at the risk-free rate to invest in the tangent
portfolio, moving the optimal portfolio to the right of the tangent portfolio on the tangent line.
10.2

(1.02)

When break-even analysis is used, we calculate the value of each parameter so that the project has
an NPV of zero.

 Sensitivity analysis involves changing the input variables one at a time to see how sensitive NPV
is to each variable.

 Scenario analysis explores how NPV changes when various desired subsets of the complete set
of model variables are changed simultaneously

In a Monte Carlo simulation, input variables can be dependent with each other, in which case the joint
probability distribution for the set of variables would be needed.

The IRR is the rate at which NPV is zero.

2.3

(2.94)

A purchased collar is the purchase of a put option and sale of a call option with a higher strike price.
From put-call parity, the collar is a zero-cost collar if F0,T=K
C(S,K)−P(S,K) =FP0,T(S)−Ke−rT
=FP0,T(S)−F0,Te−rT
=FP0,T(S)−FP0,T(S)
=0
Because there is no difference the strike prices between the put and call, the collar is also zero-width
collar.

A purchased collar resembles a short forward contract since both gain from decreases in the underlying
asset but lose from increases in the underlying asset.

Comparing payoff diagrams:

1.3

(1.77)

Futures contracts are essentially exchange-traded forward contracts. As with forwards, futures contracts
represent a commitment to buy or sell an underlying asset at some future date. Because futures are
exchange-traded, they are standardized and have specified delivery dates, locations, and procedures.

Whereas forward contracts are settled at expiration, futures contracts are settled daily. The
determination of who owes what to whom is called marking-to-market. Frequent marking-to-market
and settlement of a futures contract can lead to pricing differences between a futures contract and an
otherwise identical forward.

As a result of daily settlement, futures contracts are liquid—it is possible to offset an obligation on a
given date by entering into the opposite position. For example, if you are long the September S&P 500
futures contract, you can cancel your obligation to buy by entering into an offsetting obligation to sell
the September S&P 500 contract. If you use the same broker to buy and to sell, your obligation is
officially cancelled.

Over-the-counter forward contracts can be customized to suit the buyer or seller, whereas futures
contracts are standardized. For example, available futures contracts may permit delivery of 250 units of
a particular index in only March or June. A forward contract, by contrast, could specify April delivery of
300 units of the index.

Because of daily settlement, the nature of credit risk is different with the futures contract. In fact,
futures contracts are structured so as to minimize the effects of credit risk.

9.2

(1.59)
Investors actively try to follow each other's behavior. This phenomenon is known as herd behavior.
Herding behavior has been used to explain under-reaction and over-reaction in financial markets.

There are three explanations for this behavior:

1. Investors may believe others have superior information. Thus, they copy trades, hoping to profit
from information others may have. This is also known as the information cascade effect.

2. Due to relative wealth concerns, investors may choose to follow others to avoid the risk of
underperforming compared to their peers.

3. Investment managers may risk damaging their reputations if their actions are far different from
those of their peers.

11.4

(2.36)

Direct costs include fees to outside professionals like legal and accounting experts, consultants,
appraisers, auctioneers, and investment bankers.

Indirect costs are difficult to measure and are often much larger than direct costs. Indirect costs include:

1. Loss of customers. Customers may be unwilling to buy products from firms in financial distress.

2. Loss of suppliers. Suppliers may be unwilling to provide a distressed firm with inventory if they
fear that they will not be paid.

3. Loss of employees. Distressed firms may have difficulty hiring new employees. Existing
employees may quit. Retaining key employees can be costly, especially for firms whose value is
derived largely from their human resources.

4. Loss of receivables. Distressed firms may have difficulty collecting money that is owed to them.
Knowing that the firm might go out of business reduces the incentive of customers to repay
what they owe to the firm.

5. Fire sale of assets. Distressed firms may attempt to sell assets quickly to raise cash. They may
accept a lower price than would be optimal if it were financially healthy.

6. Inefficient liquidation. Management may use bankruptcy protection to delay the liquidation of a
firm that should be shut down. If negative-NPV decisions are made while in bankruptcy, the firm
may lose a significant amount of value.

7. Costs to creditors. Creditors may also incur their own (indirect) costs of financial distress. The
loss to creditors on their investment in the firm may push them into financial distress.

5.3

(1.99)

 A guaranteed minimum death benefit guarantees a minimum amount will be paid to a

beneficiary when the policyholder dies.
  A guaranteed minimum accumulation benefit guarantees a minimum value for the underlying
account after some period of time, even if the account value is less. If the accumulated amount
is less than what the insurer has guaranteed, then the insurer will deposit the difference into the
policyholder's account.

 A guaranteed minimum withdrawal benefit guarantees that upon the policyholder reaching a
certain age, a minimum withdrawal amount over a specified period will be provided.

 An earnings-enhanced death benefit pays the beneficiary an amount based on the increase in
the account value over the original amount invested. This benefit is paid at the time of the
policyholder's death, and only if the account value at that time is greater than the original
amount. The amount received from this benefit may be used to offset taxable gains from the
variable annuity.

 A guaranteed minimum income benefit guarantees the purchase price of a traditional annuity at
a future time. Thus, a policyholder can guarantee the minimum amount of income he or she will
receive.

 A guaranteed minimum death benefit with a return of premium guarantee is similar to a

European put option with expiration contingent on the death of the policyholder or annuitant.

4.1

(9.08)

The forward price of a stock is given by F0,T(S)=S(0)e(r−δ)T. The expected stock price
is E[S(T)]=S(0)e(α−δ)T. By comparing the two, notice the only difference between them
is one uses r and the other uses α.

Another way to express this relationship is that the forward price is the expected future
stock price, discounted by the stock's risk premium:

F0,T(S)=E[S(T)]/e(α−r)T=S(0)e(α−δ)T/e(α−r)T=S(0)e(r−δ)T

The risk premium is the additional return in excess of the risk-free rate that an investor
would demand for the risk of the stock, α−r.

Assuming investors are risk-averse (i.e., investors don't like risk), they demand higher
returns for taking on more risk. Thus, for investors to invest in a risky asset such as a
stock, they demand a higher return on the stock than on the risk-free rate. For this reason,
the return on a stock must be higher than the risk-free return, i.e., α>r. As a
result, E[S(T)]>F0,T(S).

Because a forward predicts too low of a stock price, it is said to be a biased predictor of
future stock prices. For a forward price to provide an unbiased estimate of a future stock
price, the expected return on the stock must be the risk-free rate, α=r, which, as stated
above, is not a realistic assumption.

1.1

(2.67)

A stop-loss order specifies that the stock is sold if the price decreases to the specified amount.

Here is a quick review of the three kinds of order for stocks:

 A market order pays the market price (the ask price) to buy the stock immediately, or sells at the
market price (the bid price) immediately. As long as there are willing sellers and buyers, market
orders are executed. Market orders are used when certainty of execution is a priority over price
of execution.

 A limit order specifies the maximum buying price or the minimum selling price. This gives the
trader control over the price at which the trade is executed; however, the order may never be
executed. Limit orders are used when the trader wishes to control price rather than certainty of
execution.

 A stop-loss order specifies that the stock is sold if the price decreases to the specified amount.
As with all limit orders, a stop–limit order doesn't get filled if the security's price never reaches
the specified limit price. Since the stock is sold at the market price, the actual sales price may be
less than the cutoff point.

9.2

(3.37)

Which of the following behaviors may cause the market portfolio to be inefficient?

I. Investors invest in stocks of companies that are in the same industry or are geographically close.

II. Investors tend to hold on to investments that have lost value and sell investments that have
increased in value

III. Investors tend to buy stocks that have recently been in the news.

Systematic trading biases motivate investors to deviate from the market portfolio, causing the market
portfolio to be inefficient.

Systematic trading biases that are covered in the syllabus include:

 Holding on to losers and the disposition effect

 Investor attention, mood, and experience

 Herd behavior
Behavior II falls under the category of "holding on to losers and the disposition effect". Behavior III falls
under the category of "investor attention, mood, and experience".

Behavior I describes under-diversification. It is idiosyncratic (i.e., it is not followed in tandem by large

groups of investors) and does not cause the market portfolio to be inefficient.

8.2

(5.28)

Two key characteristics of the efficient portfolio are:

 Any efficient portfolio will be well-diversified.

 We can construct an efficient portfolio from other well-diversified portfolios.

This latter observation implies that it is not actually necessary to identify the efficient portfolio itself. As
long as we can identify a collection of well-diversified portfolios from which an efficient portfolio can be
constructed, we can use the collection itself to measure risk.

Assume that we have identified portfolios that we can combine to form an efficient portfolio; we call
these portfolios factor portfolios.

When we use an efficient portfolio, it alone will capture all systematic risk. However, since an efficient
portfolio is well-diversified but a well-diversified portfolio is not necessarily efficient, a well-diversified
portfolio alone may not capture all systematic risk.

The multifactor model does not require at least one of the factor portfolios to be efficient; the model
only requires a collection of well-diversified portfolios from which an efficient portfolio can be
constructed.

7.4

(4.37)

The portfolios that have the greatest expected return for each level of volatility (those that fall on the
red curve) make up the efficient frontier. The efficient frontier contains all the possible portfolios that
rational, risk-averse investors will consider investing in. Only Portfolio II falls on the efficient frontier.
Note that:

 Portfolio I is located below and to the right of the portfolio with minimum variance (represented
by the big black dot). All portfolios below that big black dot are inefficient. It is possible to find
another portfolio that produces a higher expected return for a given level of volatility. Thus,
Portfolio I is inefficient.

 Portfolio III is above the efficient frontier. Since it does not fall on the efficient frontier, this
portfolio is not attainable.

 Portfolio IV is below the efficient frontier. Thus, Portfolio IV is inefficient.

10.1

(4.64)

Note that because X is a random variable that represents returns, we are concerned with the adverse
scenario in the left tail of the probability distribution, and consequently we find the expected value of
the adverse outcome in the left tail, E[X∣X<π0.05].

On the exam, you should be able to figure out whether upside or downside risk is present based on
what is being analyzed. For example, if X is defined as a loss random variable, then we are concerned
with the adverse scenario in the right tail of the probability distribution, and consequently we find the
expected value of the adverse outcome in the right tail.

A general rule of thumb is:

 If α≤0.5, then presumably the risk is downside.

  If α>0.5, then presumably the risk is upside.

10.2

(2.74)

With break-even analysis, we determine the level of each model variable that makes the NPV = 0,
keeping all other variables at their base level. Since the NPV accounts for the time value of money, it
follows that break-even analysis accounts for the time value of money as well.

Sensitivity analysis (not scenario analysis) is useful tool for estimating the impact on a project’s NPV of
changing the value of one capital budgeting input variable at a time.

Scenario analysis (not sensitivity analysis) accounts for the fact that variables are interrelated. A scenario
analysis is particularly useful when the underlying variables are interconnected. In reality, the underlying
variables may fluctuate simultaneously due to market-wide economic factors or business reasons.

Sensitivity analysis (not scenario analysis) is designed to identify the variables that are most influential
on the success or failure of a project.

Sensitivity analysis involves changing the input variables one at a time to see how sensitive NPV is to
each variable. Using this analysis, we can identify the most significant variables by their effect on the
NPV.

Monte Carlo simulation allows for combining the risk of various sources of uncertainty. It is the most
thorough method for project analysis because allows us to consider all possible combinations of model
variables in an aggregate framework.

The more complex an insurance product, or an investment portfolio, the more beneficial simulation
methods will be. For example, if the insurance product’s cash flows depend either on interest rates or
the stock market, or if the investment portfolio contains a combination of stocks, bonds, and options.

7.3

(2.97)

It is possible for the covariance of returns between two stocks to be negative.

Covariance measures the extent to which two variables fluctuate or move together:

 If the covariance is positive, then the two variables tend to move together. In other words, if
one variable increases (or decreases), so does the other variable.

 If the covariance is negative, then the two variables tend to move in opposite directions. In
other words, if one variable increases, the other variable decreases.

 If the covariance is 0, then there is no linear relationship between the two variables.

Stocks in the same industry tend to have more highly correlated returns than stocks in different
industries.
The returns for the stocks in the same industry tend to go up and down together than stocks in different
industries.

Almost all pairs of randomly selected stocks have positive correlations, due to the tendency of stocks to
be affected similarly by economic events.

The lower the correlation coefficients among pairs of stocks in a portfolio, the lower the variability of
the portfolio.

For example, the variance of a two-stock portfolio is:

σ2P=x21σ21+x22σ22+2x1x2Cov[R1,R2] =x21σ21+x22σ22+2x1x2ρ1,2σ1σ2
From the expression above, note that as ρ1,2 decreases, σ2P decreases.

The diversification benefit is:

 least valuable when adding a second stock to a one-stock portfolio when the correlation
coefficient is 1.

 most valuable when adding a second stock to a one-stock portfolio when the correlation
coefficient is −1.

For example, for the variance of a two-stock portfolio, note that:

 σ2PσP2 is maximized when ρ1,2=1.

 σ2PσP2 is minimized when ρ1,2=−1.

9.1

(5.11)

According to the semi-strong form of the EMH, prices will adjust immediately upon the release of any
public announcements. Thus, if the semi-strong form of the EMH holds, then the stock price should
adjust instantaneously at the time of the announcement, and there should be no adjustments after the
announcement.

If the stock price does not move at the announcement date and an adjustment occurs after the
announcement, then this means that investors underreacted to the earnings announcement. As a result
of these slow price adjustments, companies that display the largest positive earnings surprises
subsequently display superior stock return performance, whereas poor subsequent performance is
displayed by companies with low or negative earnings surprises. This is called the earnings
announcement puzzle.

3.1

(8.22)

The price of a European option can be obtained by discounting the risk-neutral expected payoff of the
option at the risk-free interest rate.

V0=e−rh⋅E∗[Payoff]=e−rh[p∗Vu+(1−p∗)Vd]
For a one-period binomial tree, where the two possible values have probabilities p∗ and 1−p∗, the initial
stock price is the risk-neutral expected stock's payoff discounted at the risk-free rate:

S0=e−rh⋅E∗[Payoff]=e−rh[p∗⋅Payoff in up state+(1−p∗)⋅Payoff in down

state]=e−rh[p∗(S0u)eδh+(1−p∗)(S0d)eδh]
Note that we can rewrite the result above as:

S0e(r−δ)h=F0,h(S)=[p∗(S0u)+(1−p∗)(S0d)]=E∗[Sh]
where E∗ represents the expected value under the risk-neutral measure.

That formula

1/(1+eσh√)
is only true if we have a standard binomial tree in which u and d values are calculated as:

ud=e(r−δ)h+σh√=e(r−δ)h−σh√
If we don't have a standard binomial tree, then we can't use the formula above.

On the exam, a standard binomial tree may also be referred to as:

 "A tree based on forward prices."

 "The usual method in McDonald."

 "The standard method."

Interpret any of the above phrases as a standard binomial tree.

1.1

(6.11)

A company uses derivatives to manage its financial risk.

Determine in which of the following scenarios the company is MOST LIKELY to use a derivative security.

A: To comply with generally accepted accounting principles.

(A) is an unlikely reason, as accounting standards do not specify that derivatives must be used for
compliance.

B: To minimize its tax deductions.

(B) is an unlikely reason, as one use of derivatives is to maximize tax savings, not minimize.

C: To hedge against the increase of an asset the company already owns.

(C) is an unlikely reason, since if the company already owns the asset, then there is no need to insure
against its price increase.

D: To guarantee that an asset it will be purchasing can be bought at higher price.

(D) is an unlikely reason, because if the company wishes to purchase an asset, then it would prefer to do
so at a cheaper price.

E: To adequately fund a guarantee it has sold to its customers.

(E) is a likely reason, and is especially common among insurers who sell wealth savings products with
guarantees.

Thus, the correct answer is (E).

2.2

(5.93)

Naked writing is the practice of selling options and not taking an offsetting position in the underlying
asset.

A covered put involves writing a put while taking a short position in the underlying asset.

The time to expiration of an American-style put option is not bound by the time to expiration of an
otherwise equivalent European put option.

A long position in an in-the-money call or put option at expiration may have a negative profit at
expiration if the accumulated value of the premium is greater than the payoff of the option.

An out-of-the-money call or put option has a payoff of zero. Call and put option writers receive
premiums at time 0 for writing these options; as a result, the accumulated value of the premium plus
the option payoff of 0 will be positive.

8.1

(4.97)

Beta is defined as the expected percent change in an asset's return given a 1% change in the market
return.

9.2

(2.24)

Many individual investors have limited time and attention to spend on investment decisions. They tend
to be influenced by attention-grabbing news or events. Evidence shows that individual investors tend to
buy stocks that have recently been in the news.

Investors who follow the herd do not consistently outperform those who take more contrarian views.
Note that herd behavior is a systematic trading bias that can be used to explain underreaction and
overreaction in financial markets.

One of the explanations for herd behavior is that investors may believe others have superior
information. Thus, they copy trades, hoping to profit from information others may have. This is known
as the information cascade effect.
One of the explanations for herd behavior is that investment managers may risk damaging their
reputations if their actions are far different from those of their peers. This means that if they feel they
are going to fail, then they would rather fail with most of their peers than fail while most succeed.

Studies have shown that, compared to women, men tend to be more overconfident, trade more
frequently, and have lower average returns.

8.1

(5.59)

Beta measures market risk whereas volatility measures total risk, which includes both market and firm-
specific risks.

Diversification reduces a portfolio's total risk by averaging out non-systematic fluctuations. Non-
systematic risks (also known as firm-specific, independent, idiosyncratic, unique, or diversifiable risks)
can be reduced through diversification, whereas systematic risks (also known as common, market, or
undiversifiable risks) cannot be avoided through diversification.

Thus, when we combine many firms’ stocks into a portfolio, only non-systematic risks (firm-specific
risks) will be removed. The portfolio volatility will decline until only the systematic risk (market risk)
remains. As a result, in a well-diversified portfolio, market risk accounts for a considerably greater
proportion of total risk than firm-specific risk.

A portfolio's beta is the weighted average of all the betas for the individual stocks in the portfolio.

A stock's beta is the ratio of the covariance between the stock returns and the market returns to
the variance of market returns.

The average beta of a stock in the market is about 1.

7.4

(0.44)

A portfolio is inefficient if it is possible to find another portfolio that produces:

 a higher expected return for a given level of volatility, or

 a lower volatility for a given level of expected return

5.1

(5.19)

The Sharpe ratio for an asset is the ratio of its risk premium to its volatility.

The Sharpe ratio of a call option is equal to the Sharpe ratio of its underlying stock.

The Sharpe ratio of the put option is the negative of the Sharpe ratio of the call option on the same
underlying stock.

7.3
(3.73)

Here are two important principles regarding diversification:

1. Investors can eliminate nonsystematic (i.e., diversifiable) risk “for free” by diversifying their
portfolios. Because of this, investors will not require a reward or a risk premium for holding
nonsystematic risk. Thus, the risk premium for nonsystematic risk is zero. Investors will not be
compensated for holding nonsystematic risk.

2. Diversification does not reduce systematic risk. An investor who holds a large portfolio will still
be exposed to systematic risk. Since investors cannot eliminate systematic risk “for free” by
diversifying their portfolios, they will demand a risk premium for holding systematic risk. As a
result, the risk premium of a security is determined by its systematic risk and does not depend
on its nonsystematic risk.

4.3

(5.1)

If the dividend yield increases, then the present value of stock (i.e., Se−δt) decreases. Based on the
Black-Scholes formula, all else being equal, decreasing Se−δt will decrease the value of a call option but
increase the value of a put option.

5.3

(5.42)

A guaranteed minimum death benefit provides a guarantee on the amount that the beneficiary of the
contract receives when the policyholder dies.

A guaranteed minimum death benefit with a return of premium guarantee is similar to a

European put option. The only difference is that the time the guarantee/option comes due depends on
when the policyholder dies, which is uncertain.

An earnings-enhanced death benefit is an optional benefit available with some variable annuity
products that pays the beneficiary an additional amount when the policyholder/annuitant dies based on
the increase in the account value over the original amount invested. The earnings-enhanced death
benefit has characteristics similar to a European call option.

A guaranteed minimum accumulation benefit with a return of premium guarantee has characteristics
similar to a European put option. However, in this case, payment is contingent on the
policyholder surviving to the guarantee/option expiration date and the policy still being in force at that
time.

A guaranteed minimum accumulation benefit provides a guarantee on the value of the underlying
account after a specified period of time has elapsed provided that the policyholder is still alive and the
contract still in force at that time. Note that it is sometimes referred to as a guaranteed minimum
maturity benefit.
11.3

(6.2)

Since the question does not provide any indication that market imperfections (e.g., taxes, cost of
financial distress, agency costs) exist, we can assume a perfect capital market. Thus, we can use the
following equation:

rE=rU+D/E⋅(rU−rD)
Also, note that:

 The terms equity cost of capital, cost of equity, and required return on equity are used
interchangeably in this course. They mean the same thing: the rate of return that equity holders
require in order for them to contribute their capital to the firm.
  The terms debt cost of capital, cost of debt, and required return on debt are used
interchangeably in this course. They mean the same thing: the rate of return that debt holders
require in order for them to contribute their capital to the firm.

 Some exam questions may also use "required return" and "expected return" interchangeably.
Assume they are the same unless the question provides information that suggests otherwise.

2.1

(3.58)

If you have a long position in the underlying stock, you benefit from a price increase in the underlying
stock.

 If you own a stock outright, you want the price of the stock to increase (so that you can resell it
later at a higher price). Thus, owning a stock outright is long with respect to the underlying
stock.

 If you purchase a call option on the stock, the option payoff is max[0,S(T)−K], and so the option
payoff increases as the stock price increases. Thus, a purchased call option benefits from a price
increase in the underlying stock, and so it is long with respect to the underlying stock.

 If you write a put option on the stock, the option payoff is −max[0,K−S(T)], and so the option
payoff increases as the stock price increases. Thus, a written put option benefits from a price
increase in the underlying stock, and so it is long with respect to the underlying stock.

 If you short a forward on the stock, the payoff is F0,T−S(T), and so the payoff increases as the
stock price decreases. Thus, a short forward benefits from a price decrease in the underlying
stock, and so it is short with respect to the underlying stock.

7.2

(5.77)

2.4

(6.05)
An American option with expiry T and strike price K must be worth at least as much as one with expiry t
and strike price K, since you always have the option of exercising the longer-duration option at time t.

Recall that the premium of a European call option must be at least as great as the premium implied by
put-call parity to a put worth 0, i.e.:

CEur≥FP0,T(S)−Ke−rT
In particular, when the stock is a nondividend-paying stock, the expression above becomes:

CEur≥S0−Ke−rT
Since S0, K,and r are fixed, when T increases, Ke−rT decreases, and hence the value of the option
increases. So, the option with longer time to expiry must cost at least as much as one with shorter time
to expiry.

For a European call option on a dividend-paying stock, there may be a large dividend in the future. So,
the shorter-duration option, one that expires before the large dividend is paid, would likely to be worth
more than a longer-duration option, one that expires after the large dividend is paid.

1.1

(9.26)

There are four primary reasons to use derivatives:

 Risk management (hedging, reduce likelihood of bankruptcy, form of insurance)

 Speculation

 Reduced transaction costs

 Regulatory arbitrage

Derivatives are used to circumvent regulatory, tax, and accounting restraints.

9.1

(5.94)

If you are not given alpha or it says the CAPM holds, then the required return will equal the expected
return of the asset.

αi=E[Ri]−ri
5.1

(5.93)

Rho is the Greek that pertains to risk-free interest rate. In general, the rho of an option is defined as:

ρOption = Increase in the value of the option/Increase in the risk-free rate

6.3
(5.64)

Compound options with strike x and expiry t1 are options on options:

CallOnCall - PutOnCall = C – xe^-rt1

CallOnPut - PutOnPut = P – xe^-rt1 ;

where C and P are the prices of the strike assets (standard call and puts).

6.4

(6.32)

Increasing the trigger price above the strike price will eliminate some of the positive payoffs that would
otherwise happen if the final stock price is between the strike price and the trigger price. Because some
of positive payoffs are reduced, the option premium is reduced accordingly.

Increasing the strike for a gap call results in lower payoffs. As a result, the option premium decreases.

Below are the payoff diagrams of a gap call option as a function of the stock price at expiration.

From the diagram, note that if the trigger price, K2, exceeds the strike price, K1, it is not possible to
have negative payoffs.

For both gap call and gap put, if the strike price is the same as the trigger price (i.e., K1=K2), then the
gap option is an ordinary European option.

The option premium is positive if the trigger price is equal to the strike (because the premium for an
ordinary European option must be positive). Then, the trigger price can be increased until the premium
reduces to zero.

4.1

(5.92)

Letting the stock's expected return be continuously compounded, we can conclude that α−δ<0, as the
expected stock price is lower than the current spot price of 100. Note this means that the continuously
compounded dividend rate is greater than the expected return on the stock, i.e., α<δ.
Because these investors are risk-averse, they would simply invest in a risk-free asset if the expected
return on a risky asset was less than or equal to the risk-free rate. Thus, the investors require an
expected rate of return greater than the risk-free rate. In other words, α>r.

8.2

(5.24)

Trading strategies based on market capitalization, book-to-market ratios, and momentum appear to
have positive alphas. The portfolios that implement these strategies capture risk that is not captured by
the market portfolio. Thus, these portfolios are good candidates as other factor portfolios in a
multifactor model.

The portfolio that implements this strategy is known as the small-minus-big (SMB) portfolio. This self-
financing portfolio is constructed by longing a portfolio with small stocks and shorting a portfolio with
big stocks.

A trading strategy that each year buys a portfolio with high book-to-market stocks and finances this
position by short selling a portfolio with low book-to-market stocks has produced positive risk-adjusted
returns historically.

The portfolio that implements this strategy is known as the high-minus-low (HML) portfolio. This self-
financing portfolio is constructed by longing a portfolio with high book-to-market stocks (i.e., value
stocks) and shorting a portfolio with low book-to-market stocks (i.e., growth stocks).

Each year stocks are ranked by their return for the previous year. A portfolio is then constructed by
longing the top 30% of stocks and shorting the bottom 30%. This trading strategy requires holding the
portfolio for a year, and then forming a new self-financing portfolio and holding it for another year. This
process is then repeated annually. The resulting self-financing portfolio is known as the prior one-year
momentum (PR1YR) portfolio.

All four factor portfolios in the FFC model are indeed self-financing.

7.4

(2.61)

Mean-variance analysis is a fundamental implementation of modern portfolio theory. It asserts that

investors can evaluate the risk-return characteristics of investment opportunities based on the expected
returns, variances, and correlations of the assets.

Here are the underlying assumptions of mean-variance analysis:

1. All investors are risk-averse. This means investors prefer less risk to more risk for the same level
of expected return, and more return to less return for the same level of risk. While investors
may have different degrees of risk aversion, all investors are risk-averse to some extent.

2. The expected returns, variances, and covariances of all assets are known.

3. To determine optimal portfolios, investors only need to know the expected returns, variances,
and covariances of returns.
 4. There are no transactions costs or taxes.

10.1

(5.43)

There are 4 desirable characteristics for a risk measure. A risk measure is called coherent if all four
characteristics are present.

Let X and Y be two random variables with risk measures g(X) and g(Y). The 4 characteristics of coherent
risk measures are:

1. Translation Invariance: g(X+c)=g(X)+c,for c>0

Adding a positive amount to a risk adds an equivalent amount to the risk measure.

2. Positive Homogeneity: g(cX)=cg(X),for c>0

Multiplying a positive amount to a risk will adjust the risk measure in a proportional manner.

3. Subadditivity: g(X+Y)≤g(X)+g(Y)
It is not possible to reduce the capital required to manage a risk by splitting it into separate
parts. There are diversification benefits from combining risks as long as the two risks are not
perfectly correlated.

4. Monotonicity: If X≤Y, then g(X)≤g(Y)

If one risk always exceeds another, the corresponding risk measures must be similarly ordered.

Most of the time, the VaR is not coherent since it does not satisfy the subadditivity characteristic. This
leads to the increased use of TVaR as TVaR is coherent. However, many still prefer VaR as it is easy to
calculate and understand. In addition, if the loss distributions are assumed to be normal, the VaR can be
shown to be coherent.

5.3

(6.54)

A guaranteed minimum accumulation benefit (GMAB) guarantees a minimum value for the underlying
account after some period of time, even if the account value is less. If the accumulated amount is less
than what the insurer has guaranteed, then the insurer will deposit the difference into the policyholder's
account.

Thus, a GMAB exposes the insurer to downside risk. To hedge the risk, the insurer should purchase an
option that will pay when the market goes down. Among the choices, buying a put option on the
index is the most appropriate choice.

11.5

(6.63)

Note that the goal is to find the firm's value when the firm has zero debt. Thus, what we want to
calculate is the value of the unlevered firm, VU.

For a permanent debt, the present value of the interest tax shield is:
PV(Interest tax shield)=τC⋅D=0.35⋅D
The value of the levered firm is:

VL=VU+PV(Interest tax shield)−PV(Financial distress costs)−PV(Agency costs of

debt)+PV(Agency benefits of debt)VU+0.35D−0.00001D2+2000−0.10D
9.2

(4.73)

Overconfidence bias is a non-systematic trading bias, meaning it does not impact market efficiency.

Investors with alternative risk preferences cause the market portfolio to be inefficient, as investors will
not hold the market portfolio in aggregate. They care about about aspects of their portfolio other than
expected return and volatility (thus they are willing to hold portfolios that are mean-variance
inefficient).

The market portfolio can be inefficient (and thus it is possible to beat the market) if a significant number
of investors do not have rational expectations (thus information is misinterpreted).

3.1

(5.12)

S0e(r−δ)h=(p∗)Su+(1−p∗)Sd
11.1

(4.76)

Venture capitalists typically hold convertible preferred stock, which differs from common stock due to:

 Liquidity preference. In the event of a liquidation, sale, or merger of the company, a minimum
amount must be paid to preferred stockholders before any payments are made to common
stockholders. The liquidation preference is calculated as:

Liquidation preference=Multiplier×Initial investment

 Seniority. Investors in later rounds might demand higher seniority than investors in earlier
rounds; when instead those investors are given equal priority, they are deemed pari passu,
which is Latin for "on equal footing."

 Participation rights. This allows preferred stockholders to get both liquidity preference and any
payments to common shareholders as if the stocks have been converted.

 Anti-dilution protection. A "down round" is said to have occurred when a company raises funds
at a lower price than in the previous funding round. Anti-dilution protection allows the
preferred stockholder to convert their shares to a common stock at a cheaper price. This helps
to increase their ownership percentage in a down round.
  Board membership. An investor may attempt to arrange the appointment of one or more of the
firm's board of directors.

Guarantee on initial investment is not a typical feature of convertible preferred stock.

7.1

(4.83)

Here is a summary of the effective annual return (EAR) earned over an 89-year period for each asset
class.

 Small-cap Stocks (market cap in bottom 20% of NYSE): 12.83%

 Large-cap Stocks (S&P 500 Index): 9.99%

 World Portfolio (international stocks): 8.83%

 Corporate Bonds (AAA-rated, avg. 20-year term): 3.45%

 Treasury Bills (one-month term): 2.93%

Several things to note:

1. All five investment classes grew faster than inflation, as measured by the CPI.

2. While the stock portfolios rank best over the long run, they also have the greatest risk of sizable
losses during economic downturns.

3. The relative advantage of stock portfolios will increase over time. If looking at short time periods
only, the ranking shown above will not necessarily hold, especially if the time period being
considered contains a bear market (i.e., markets are falling).

4. T-Bills enjoyed steady, but modest gains, across almost every year between 1926-2014.

2.2

(2.64)

A ratio spread made up of calls is constructed by buying m calls at one strike and selling n calls at a
different strike, with all options having the same time to maturity and same underlying asset.

Thus, by definition, one way to create a 3:1 ratio spread is to buy 1 call and sell 3 calls at a different
strike price, with the same 1-year maturity.

In general, a ratio spread is created by buying m options at one strike price and then selling n options
with a different strike price, where m≠n. Thus, note that a ratio spread can also be created using all puts.

8.1

(5.66)

The CML uses total risk (i.e., volatility) on the horizontal axis. Only efficient portfolios consisting of
combinations of the risk-free asset and the market portfolio will plot on the CML.
Under the CAPM, the market portfolio is the efficient portfolio, so no individual security would plot on
the CML. Individual securities will plot below the CML.

The security market line (SML) is a graphical representation of the CAPM. The SML uses systematic risk
(i.e., beta) on the horizontal axis. This is because systematic risk is all that matters under the CAPM.
Nonsystematic risk is irrelevant. The SML relationship holds for any security or combination of securities,
not just efficient portfolios.

According to the CAPM:

E[Ri]−rf=βi(E[RMkt]−rf)
Risk Premiumi= βi⋅Market Risk Premium
Note that the risk premium of a traded security is equal to its beta times the market risk premium, with
beta as a measure of systematic risk.

2.1

(6.83)

The payoff of the stock at expiration is −Seδt, as the lender of the stock will require more than one share
of stock, due to dividend reinvestment.

A floor consists of a long position on an asset and a put. Thus, this is an example of a written floor (i.e., a
covered put).

6.5

(7.89)

Deferred rebate options are barrier options, and barrier options are path-dependent since their payoff
depends on whether the barrier is reached.

9.1

(5.81)

Stock returns have been observed to be higher in January and lower in December than in other months.
Stock returns have been observed to be lower on Monday and higher on Friday than in other days.
Stock returns have been observed to be more volatile at times close to market open and to market
close.

7.3

(5.89)

If the stocks are perfectly positively correlated, then the volatility of the portfolio is exactly equal to the
weighted average volatility of the individual stocks. In this case, there is no diversification benefit.

In general, as long as the stocks are not perfectly positively correlated, diversification would work, and
the resulting portfolio volatility is always less than the weighted average volatility of the individual
stocks.
Diversification over a large number of assets only eliminates diversifiable (a.k.a. non-systematic, firm-
specific, unique, independent) risk. Diversification cannot remove nondiversifiable (a.k.a. systematic,
market) risk.

For a portfolio with arbitrary weights, the portfolio risk is:

σP=∑i=1nxi⋅σi⋅ρi,P
Each security contributes to the portfolio volatility according to its volatility scaled by its correlation
with the portfolio, which adjusts for the fraction of the total risk that is common to the portfolio. The
lower the correlation between the security and the portfolio, the lower the portfolio risk.

To determine a stock's contribution to the portfolio risk, we need to know the correlation between the
stock and the portfolio. A stock with a low volatility but a high correlation with the portfolio could have
a higher contribution to the portfolio risk than a stock with a high volatility but a low correlation with
the portfolio.

For a well-diversified portfolio, all diversifiable (a.k.a. non-systematic, firm-specific, unique,

independent) risks are eliminated. As a result, the only risk that matters for a well-diversified portfolio is
nondiversifiable (a.k.a. systematic, market) risk.

4.1

(6.96)

Products of lognormal random variables are lognormally distributed, if the logs of the random variables
are jointly normal. The sums of lognormal random variables are not lognormally distributed.
It is skewed to the right.

Negative outcomes are impossible.

Its single hump occurs to the left of the mean.

In the binomial model, the stock price distribution approaches lognormality as the number of steps
becomes large.

10.1

(5.94)

The TVaR with α=40% is just the average of the returns that are less than or equal to the corresponding
VaR. In other words, it is the average of the two lowest returns.