Professional Documents
Culture Documents
1. Financial engineering has been disparaged as nothing more than paper shuffling.
Critics argue that resources used for rearranging wealth (i.e. bundling and unbundling
financial assets) might be better spent on creating wealth. Evaluate this criticism. Are any
benefits realized by creating an array of derivative securities from various primary
securities?
While it is ultimately true that real assets determine the material well-being of an
economy, financial innovation in the form of bundling and unbundling securities creates
opportunities for investors to form more efficient portfolios. Both institutional and individual
investors can benefit when financial engineering creates new products that allow them to manage
their portfolios of financial assets more efficiently. Bundling and unbundling create financial
products with new properties and sensitivities to various sources of risk that allows investors to
reduce volatility by hedging sources of risk more efficiently.
2. Why would you expect securitization to take place only in highly developed capital
markets?
Securitization requires access to a large number of potential investors. To attract these
investors, the capital market needs:
a safe system of business laws and low probability of confiscatory taxation/regulation.
a well-developed investment banking industry.
a well-developed system of brokerage and financial transactions.
well-developed media, particularly financial reporting.
These characteristics are found in (indeed make for) a well-developed financial market.
4. Although we stated that real assets comprise the true productive capacity of an
economy, it is hard to conceive of a modern economy without well-developed financial
markets and security types. How would the productive capacity of the U.S. economy be
affected if there were no markets in which one could trade financial assets?
The existence of efficient capital markets and the liquid trading of financial assets make it
easy for large firms to raise the capital needed to finance their investments in real assets.
If BHP, for example, could not issue stocks or bonds to the general public, it would have
a far more difficult time raising capital.
Contraction of the supply of financial assets would make financing more difficult,
thereby increasing the cost of capital.
A higher cost of capital results in less investment and lower real growth.
5. Firms raise capital from investors by issuing shares in the primary markets. Does
this imply that corporate financial managers can ignore trading of previously issued shares
in the secondary market?
Even if the firm does not need to issue stock in any particular year, the stock market is
still important to the financial manager. The stock price provides important information about
how the market values the firm's investment projects. For example, if the stock price rises
considerably, managers might conclude that the market believes the firm's future prospects are
bright. This might be a useful signal to the firm to proceed with an investment such as an
expansion of the firm's business.
In addition, shares that can be traded in the secondary market are more attractive to initial
investors since they know that they will be able to sell their shares. This in turn makes investors
more willing to buy shares in a primary offering and thus improves the terms on which firms can
raise money in the equity market.
Remember that stock exchanges like those in New York, London, and Paris are the heart of
capitalism, in which firms can raise capital quickly in primary markets because investors know
there are liquid secondary markets.
b. Prepare the balance sheet after Lanni spends the $70,000 to develop its software
product. What is the ratio of real assets to total assets?
c. Prepare the balance sheet after Lanni accepts the payment of shares from
Microsoft. What is the ratio of real assets to total assets?
((Conclusion: When the firm starts up and raises working capital, it will be characterised
by a low ratio of real to total assets. When it is in full production, it will have a high ratio of real
assets. When the project "shuts down" and the firm sells it, the percentage of real assets to total
assets goes down again because the product is again exchanged into financial assets))
9. Examine the balance sheet of commercial banks in Table 1.3. What is the ratio of
real assets to total assets?
The ratio of real assets = Total real assets/ Total assets
= $107.5 billion / $10,410.9 billion = 0.0103
11. Discuss the advantages and disadvantages of the fol- lowing forms of managerial
compensation in terms of mitigating agency problems, that is, potential conflicts of
interest between managers and shareholders.
a. A fixed salary.
A fixed salary means that compensation is (at least in the short run) independent
of the firm's success. This salary structure does not tie the manager's immediate
compensation to the success of the firm, so a manager might not feel too
compelled to work hard to maximize firm value. However, the manager might
view this as the safest compensation structure and therefore value it more highly.
13. Give an example of three financial intermediaries and explain how they act as a
bridge between small investors and large capital markets or corporations.
Banks accept deposits from customers and loan those funds to businesses or use the funds
to buy securities of large corporations.
Pension funds accept funds and then invest, on behalf of current and future retirees,
thereby channeling funds from one sector of the economy to another.
Commercial banks mobilize capital mainly in the form of: payment deposits, savings
deposits, and time deposits. Funds raised are used for lending: commercial loans,
consumer loans, real estate loans and to buy government securities, local government
bonds.
Mutual funds accept funds from small investors and invest, on behalf of these investors,
in the national and international securities markets.
14. The average rate of return on investments in large stocks has outpaced that on
investments in Treasury bills by about 8% since 1926. Why, then, does anyone invest in
Treasury bills?
Although the return on stock has been higher than T-bills since 1926, some investors
choose to invest into these bills because they have a low risk (can be said to be risk-free)
tolerance and want a stable return. U.S. treasury bills are the safest investment in the world
which is attractive to some people.
15. What are some advantages and disadvantages of top- down versus bottom-up
investing styles?
Advantage:
A “top-down” investing style focus on asset allocation of the entire portfolio.
Top-down investing strategy pays more attention to overall economic and political
conditions of a country which can affect the performance of a particular industry.
Disadvantage:
Top-down investing strategy may ignore undervalued securities. Undervalued securities
are a good bet for investment. Undervalued stock means that it is selling for a price below
its true intrinsic value. Undervalued stocks are estimated by analyzing company's
financial statements its fundamentals, such as price/earnings ratio, return on assets and
profit retention. But top-down investment strategy tends to overlook such securities
which can give potential returns to investors.
16. You see an advertisement for a book that claims to show how you can make $1
million with no risk and with no money down. Will you buy the book?
This is a false advertisement. I have learned, when investing must accept risk (the greater
the risk, the higher the return). All investments involve taking on risk. Before any proceeds are
made, an entrepreneur must bear the costs associated with the business. The financial market is
very competitive, to make 1 million dollars is not easy, to earn higher returns, one has to take
more risks. Therefore, it is possible to make a lot of money without risk, unless the activities are
illegal.
17. Below is an excerpt from the investor education Web site of the SEC.
a. How does the excerpt define the difference between saving and investing?
Saving is usually put into the safest places, or products, that allow you access to your
money at any time. Savings products include savings accounts, checking accounts, and
certificates of deposit. But there’s a tradeoff for security and ready availability. Your
money is paid a low wage as it works for you. Most smart investors put enough money in
a savings product to cover an emergency, like sudden unemployment. Some make sure
they have up to six months of their income in savings so that they know it will absolutely
be there for them when they need it.
When you “invest,” you have a greater chance of losing your money than when you
“save.” The money you invest in securities, mutual funds, and other similar investments
typically is not federally insured. You could lose your “principal”—the amount you’ve
invested. But you also have the opportunity to earn more money.
b. In what ways does this differ from the economist’s definition given in this chapter?
Any type always comes with risks. The best way to limit risk is always to diversify tools
and portfolios and at the same time take a long-term view when planning investment
strategies.
“Don’t put all your eggs in one basket.” It is often said that the greater the risk, the
greater the potential reward of an investment, but taking unnecessary risks can often be
avoided. Investors are best protected against risk by spreading their money between different
investments, in the hope that if one investment loses, the other investments will more than
make up. cover those losses.
Once you've saved money to invest, carefully weigh all your options and think about which
diversification strategy is right for you (stocks and mutual funds, public bonds, etc.).
companies and municipalities, bond mutual funds, certificates of deposit, money market
funds, and USTreasury securities).
Diversification cannot guarantee that your investments will not be affected if the market
drops. But it can improve your chances of not losing money, or if you do, it won't be as much
as if you weren't diversifying.
2. What purpose does the SuperDot system serve on the New York Stock Exchange?
The SuperDot system expedites the flow of orders from exchange members to the specialists. It
allows members to send computerized orders directly to the floor of the exchange, which allows
the nearly simultaneous sale of each stock in a large portfolio. This capability is necessary for
program trading.
3. Who sets the bid and asked price for a stock traded over the counter? Would you
expect the spread to be higher on actively or inactively traded stocks?
The dealer sets the bid and asked price. Spreads should be higher on inactively traded stocks and
lower on actively traded stocks.
4. Suppose you short sell 100 shares of IBM, now selling at $120 per share.
a. What is your maximum possible loss?
b. What happens to the maximum loss if you simultaneously place a stop-buy order at
$128?
a. In principle, potential losses are unbounded, growing directly with increases in the price of
IBM.
b. If the stop-buy order can be filled at $128, the maximum possible loss = (120-
128)*100=$800=$8 per share. If the price of IBM shares goes above $128, then the stop-buy
order would be executed, limiting the losses from the short sale.
5. Dée Trader opens a brokerage account and purchases 300 shares of Internet
Dreams at $40 per share. She borrows $4,000 from her broker to help pay for the
purchase. The interest rate on the loan is 8%.
a. What is the margin in Dée’s account when she first purchases the stock?
b. If the share price falls to $30 per share by the end of the year, what is the
remaining margin in her account? If the maintenance margin requirement is 30%,
will she receive a margin call?
c. What is the rate of return on her investment?
a. The stock is purchased for $40 x 300 shares = $12,000. Given that the amount borrowed from
the broker is $4,000, Dee's margin is the initial purchase price net borrowing: $12,000 - $4,000 =
$8,000.
b. If the share price falls to $30, then the value of the stock falls to $9,000. By the end of the
year, the amount of the loan owed to the broker grows to: Principal x (1 + Interest rate) = $4,000
x (1 + 0.08) = $4,320. The value of the stock falls to: $30 x 300 shares = $9,000.
The remaining margin in the investor's account is: Margin on long position = Equity in account /
Value of stock = $9,000 - $4,320 / $9,000 = 0.52 = 52% Therefore, the investor will not receive
a margin call.
c. Rate of return = Ending equity in account - Initial equity in account / Initial equity in account
= $4,680 - $8,000 / $8,000 = - 0.4150 = - 41.50%
6. Old Economy Traders opened an account to short sell 1,000 shares of Internet Dreams
from the previous problem. The initial margin requirement was 50%. (The margin
account pays no interest.) A year later, the price of Internet Dreams has risen from $40
to $50, and the stock has paid a dividend of $2 per share.
a. What is the remaining margin in the account?
b. If the maintenance margin requirement is 30%, will Old Economy receive a margin
call?
c. What is the rate of return on the investment?
a. The stock is purchased for $40 x 300 shares = $12,000.
Given that the amount borrowed from the broker is $4,000, Dee's margin is the initial purchase
price net borrowing: $12,000 - $4,000 = $8,000.
If the share price falls to $30, then the value of the stock falls to $9,000. By the end of the year,
the amount of the loan owed to the broker grows to:
Principal x (1 + Interest rate) = $4,000 x (1 + 0.08) = $4,320. The value of the stock falls to: $30
x 300 shares = $9,000.
The remaining margin in the investor's account is: Margin on long position = Equity in account /
Value of stock = $9,000 - $4,320 / $9,000 = 0.52 = 52% Therefore, the investor will not receive
a margin call.
c. Rate of return = Ending equity in account - Initial equity in account / Initial equity in account
= $4,680 - $8,000 / $8,000 = - 0.4150 = - 41.50%
8. Consider the following limit-order book of a specialist. The last trade in the stock
occurred at a price of $50.
Limit Buy Orders Limit Sell Orders
Price Shares Price Shares
$49.75 500 $50.25 100
49.50 800 51.50 100
49.25 500 54.75 300
49.00 200 58.25 100
48.50 600
a. If a market buy order for 100 shares comes in, at what price will it be filled?
b. At what price would the next market buy order be filled?
c. If you were the specialist, would you want to increase or decrease your inventory of
this stock?
a. The market-buy order will be filled at $50.25, the best price of limit-sell orders in the book.
b. The next market-buy order will be filled at $51.50, the next-best limit-sell order price.
c. As a security dealer, you would want to increase your inventory. There is considerable buying
demand at prices just below $50, indicating that downside risk is limited. In contrast, limit-sell
orders are sparse, indicating that a moderate buy order could result in a substantial price increase.
9. You are bullish on Telecom stock. The current market price is $50 per share, and you
have $5,000 of your own to invest. You borrow an additional $5,000 from your broker
at an interest rate of 8% per year and invest $10,000 in the stock.
a. What will be your rate of return if the price of Telecom stock goes up by 10% during
the next year? (Ignore the expected dividend.)
b. How far does the price of Telecom stock have to fall for you to get a margin call if
the maintenance margin is 30%? Assume the price fall happens immediately
Price per share $50
Equity invested $5,000
Borrowed funds $5,000
Interest rate 8.00%
Total investment $10,000
Price change 10.00%
Margin required 30.00%
Your initial investment is the sum of $5,000 in equity and $5,000 from borrowing, which enables
you to buy 200 shares of Telecom stock:
Initial investment / Stock price = $10,000 / $50 = 200 shares
The shares increase in value by 10%: $10,000 * 0.10 = $1,000.
You pay interest of = $5,000 * 0.08 = $400.
The rate of return will be:
$1,000 - $400 / $5,000 = 0.12 = 12%
The value of the 200 shares is 200P. Equity is (200P - $5,000), and the required margin is 30%.
Solving 200P -$5,000 / 200P = 0.30, we get P = $35.71.
You will receive a margin call when the stock price falls below $35.71.
10. You are bearish on Telecom and decide to sell short 100 shares at the current market
price of $50 per share.
a. How much in cash or securities must you put into your brokerage account if the
broker’s initial margin requirement is 50% of the value of the short position?
b. How high can the price of the stock go before you get a margin call if the
maintenance margin is 30% of the value of the short position?
Initial margin is 50% of $5,000, which is $2,500.
Total assets are $7,500 ($5,000 from the sale of the stock and $2,500 put up for margin).
Liabilities are 100P. Therefore, net worth is ($7,500 - 100P).
Solving $7,500-100P / 100P = 0.30, we get P = $57.69.
A margin call will be issued when the stock price reaches $57.69 or higher.
11. Suppose that Intel currently is selling at $40 per share. You buy 500 shares using
$15,000 of your own money, borrowing the remainder of the purchase price from your
broker. The rate on the margin loan is 8%.
a. What is the percentage increase in the net worth of your brokerage account if the
price of Intel immediately changes to: (i) $44; (ii) $40; (iii) $36? What is the
relationship between your percentage return and the percentage change in the price of
Intel?
b. If the maintenance margin is 25%, how low can Intel’s price fall before you get a
margin call?
c. How would your answer to ( b ) change if you had financed the initial purchase with
only $10,000 of your own money?
d. What is the rate of return on your margined position (assuming again that you
invest $15,000 of your own money) if Intel is selling after 1 year at: (i) $44; (ii) $40;
(iii) $36? What is the relationship between your percentage return and the percentage
change in the price of Intel? Assume that Intel pays no dividends.
e. Continue to assume that a year has passed. How low can Intel’s price fall before you
get a margin call?
a. Equity increases to: ($44 * 500) - $5,000 = $17,000
Percentage gain = $2,000/$15,000 = 0.1333 = 13.33%
(ii) With price unchanged, equity is unchanged.
Percentage gain = 0
(iii) Equity falls to ($36 * 500) - $5,000 = $13,000
Percentage gain = (-$2,000/$15,000) = -0.1333 = -13.33%
b. The value of the 500 shares is 500P. Equity is (500P - $5,000). You will receive a margin call
when:
(500P-$5000)/500P
= 0.25 --> when P = $13.33 or lower
c. The value of the 500 shares is 500P. But now you have borrowed $10,000 instead of $5,000.
Therefore, equity is (500P - $10,000). You will receive a margin call when:
(500P-$10,000)/500P
= 0.25 --> when P = $26.67 or lower
With less equity in the account, you are far more vulnerable to a margin call
d. By the end of the year, the amount of the loan owed to the broker grows to:
$5,000 * 1.06 = $5,300
The equity in your account is (500P - $5,400). Initial equity was $15,000. Therefore, your rate of
return after one year is as follows:
12. Suppose that you sell short 500 shares of Intel, currently selling for $40 per share, and
give your broker $15,000 to establish your margin account.
a. If you earn no interest on the funds in your margin account, what will be your rate
of return after 1 year if Intel stock is selling at: (i) $44; (ii) $40; (iii) $36? Assume that
Intel pays no dividends.
b. If the maintenance margin is 25%, how high can Intel’s price rise before you get a
margin call? c. Redo parts ( a ) and ( b ), but now assume that Intel also has paid a
year-end dividend of $1 per share. The prices in part ( a ) should be interpreted as ex-
dividend, that is, prices after the dividend has been paid.
a. general --
share value (cash in) = 20,000
margin account (another asset/insurance) = 15,000
current debt = 20,000
current equity = 15,000
14. Here is some price information on Fincorp stock. Suppose first that Fincorp trades in
a dealert market.
Bid Asked
55.25 55.50
a. Suppose you have submitted an order to your broker to buy at market. At what price
will your trade be executed?
b. Suppose you have submitted an order to sell at market. At what price will your trade
be executed?
c. Suppose you have submitted a limit order to sell at $55.62. What will happen?
d. Suppose you have submitted a limit order to buy at $55.37. What will happen?
a. The trade will be executed at $55.50.
b. The trade will be executed at $55.25.
c. The trade will not be executed because the bid price is lower than the price specified in the
limit-sell order.
d. The trade will not be executed because the asked price is higher than the price specified in the
limit-buy order.
15. Now reconsider Problem 14 assuming that Fincorp sells in an exchange market like
the NYSE.
a. Is there any chance for price improvement in the market orders considered in parts
(a) and ( b )?
b. Is there any chance of an immediate trade at $55.37 for the limit-buy order in part
(d)?
a) Price improvement:
The Asked Price is $55.50
The Limit order to sell is $55.50
The Limit order to buy is $55.37
Yes, there are chances of price improvement, which can be beneficial for both the buyer and the
seller.
As asked price is $55.50, it means that the price of Fincorp cannot go above $55.50. If trade is
executed at $55.37, then the customer will benefit by$0.13, as the limit order to sell is $55.62.
This means that prices may go up to $55.62 if the asked price is not an option.
In this way, customer benefits by:
Benefit = $55.37 - $55.50
= $0.13
The benefit is because customer needs to pay $0.13 less.
The seller will benefit by:
Benefit = $55.62 -$55.50
= $0.12
The seller will benefit by $0.12.
b. No, there is no immediate trade opportunity at $55.37 for a limit buy order in part (d) because
the price offered is higher than the price specified in the buy limit order
16. You’ve borrowed $20,000 on margin to buy shares in Disney, which is now selling at
$40 per share. Your account starts at the initial margin requirement of 50%. The
maintenance margin is 35%. Two days later, the stock price falls to $35 per share.
a. Will you receive a margin call?
b. How low can the price of Disney shares fall before you receive a margin call?
a. You will not receive a margin call. You borrowed $20,000 and with another $20,000 of your
own equity you bought 1,000 shares of Disney at $40 per share. At $35 per share, the market
value of the stock is $35,000, your equity is $15,000, and the percentage margin is:
$15,000/$35,000 = 42.9%
Your percentage margin exceeds the required maintenance margin.
17. On January 1, you sold short one round lot (that is, 100 shares) of Zenith stock at $14
per share. On March 1, a dividend of $2 per share was paid. On April 1, you covered
the short sale by buying the stock at a price of $9 per share. You paid 50 cents per
share in commissions for each transaction. What is the value of your account on April
1?
The proceeds from the short sale (net of commission) were: ($14 x 100) - $50 = $1,350
A dividend payment of $200 was withdrawn from the account. Covering the short sale at $9 per
share cost you (including commission): $900 + $50 = $950
Therefore, 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). Your net proceeds per
share was:
$14 selling price of stock
-$9 repurchase price of stock
-$2 dividend per share
-$1 2 trades x $0.50 commission ea.
$2
CHAPER V:
1. The Fisher equation tells us that the real interest rate approximately equals the
nominal rate minus the inflation rate. Suppose the inflation rate increases from 3% to 5%.
Does the Fisher equation imply that this increase will result in a fall in the real rate of
interest? Explain.
The Fisher equation relates nominal rates required by investors to real rates required by investors
and inflation. You can think about this from two perspectives:
i. Ex-ante (before) required Nominal Return as a function of required Real Return and
the Expected Inflation: (1 + rNominal) = (1 + rReal)(1 + E(i))
ii. Ex-post (afterward) realized Real Return as a function of Nominal Return and the
Realized Inflation: (1 + rReal) = (1 + rNominal)/(1 + i)
Assume the question asks this instead:
Suppose the expected inflation rate increases from 3% to 5%. Does the Fisher equation imply
that this increase will result in a fall in the real rate of interest?
The theory is the ex-ante required real return is not a function of inflation. If expected inflation
increase, required real return will remain unchanged and the required nominal return will
increase (the security will have to pay more).
Now assume the question asks this:
Suppose realized inflation is 5% instead of the 3% expected inflation. Does the Fisher equation
imply that this increase will result in a fall in the real rate of interest?
Since the nominal return was set when the asset was purchased, a realized inflation greater than
expected inflation will decrease the realized real return.
2. You've just stumbled on a new dataset that enables you to compute historical rates
of return on U.S. stocks all the way back to 1880. What are the advantages and
disadvantages in using these data to help estimate the expected rate of return on U.S. stocks
over the coming year?
If we assume that the distribution of returns remains reasonably stable (same expectation,
standard deviation, skew, kurtosis,…) over the entire history, then a longer sample period
increases the precision of the sample statistic’s estimate of the actual expected return. The
standard error of the estimate decreases as the sample size increases. (If you use the sample mean
as an estimate of the “true” population mean, the standard error is the sample standard deviation
divided by the square root of the sample size.)
However, if we believe the expected return of stocks is different now than it was in the late in the
late 1800’s (changes in the structure of the economy or the financial system are possible reasons
for the difference), using data from that time period may not be appropriate for estimate modern
stock price changes and therefore only more recent data should be employed.
3. You are considering two alternative 2-year investments: You can invest in a risky
asset with a positive risk premium and returns in each of the 2 years that will be identically
distributed and uncorrelated, or you can invest in the risky asset for only 1 year and then
invest the proceeds in a risk-free asset. Which of the following statements about the first
investment alternative (compared with the second) are true?
There are two investment opportunities available. The first option is to invest in a risky
asset with a positive risk premium and return for 2 years. The second option is to invest in risky
asset for first year and then the proceeds in a risk-free asset.
a. Its 2-year risk premium is the same as the second alternative.
The risk premium for a risky asset for year 1 year and year 2 is different. This is because;
the risk premium is affected by the internal and external investment factors. The standard
deviation measures the deviation of an observation from the mean. The standard deviation for
risky asset tends to change over the period of time due to changes in observations and mean.
Moreover, the standard deviation for first option is greater than the standard deviation of second
option. Sharpe ratio shows the excess return an investor earns for holding a risky asset. In this
situation, Sharpe ratio can be used to compare only the first year of the investment. This is
because; the second year of the investment proceeds is done in risk-free asset. Hence, it is not the
correct measure of comparison of the two investment options.
b. The standard deviation of its 2-year return is the same.
Therefore, the options (a), (b) and (d) are incorrect.
c. Its annualized standard deviation is lower.
The annual standard deviation for first alternative is lower which can be explained as
follows: Suppose, Hence, the annualized standard deviation for the first investment alternative is
equal to: From the above equation, the standard deviation of the first alternative is less than the
standard deviation of the risk investment.
d. Its Sharpe ratio is higher.
Investors who have lower degree of risk aversion tend to opt for risky assets. The first
option is riskier than the second option. The first option has investment for 2 years in risky assets
while in second option; the investment in risky asset is only for 1 year and for the other 1 year,
the proceeds are invested in risk-free asset. The time factor does not diversify the risk under the
first option and the risk for first option does not reduce.
e. It is more attractive to investors with lower degrees of risk aversion
Therefore, the correct answers are options (c) and (e).
4. You have $5,000 to invest for the next year and are considering three alternatives:
Forecasting interest rate plays a vital role in deciding the investment plans. It is the only
way through which we can expect some extra amount of return by making comparison.
You have three options of investment plans which offer different interest rates. Selection
of best investment plan requires a forecast of interest rates.
a. A money market fund with an average maturity of 30 days offering a current yield of 6%
per year.
A money market fund is of a very short duration (30 days), it offers the minimum interest
rate risk as the return will not be affected by interest rate changes. So, for an investor, who
forecasts a rise in interest rates that $5,000 can be invested in money market fund now and after
a rate increase, the funds can be re-invested in assets offering higher interest rates.
b. A I-year savings deposit at a bank offering an interest rate of 7.5%.
One year saving deposit will make sense when an investor is relatively neutral on interest
rates i.e. he is not expecting much changes in interest rates. Investing in saving deposit as an
alternative fall somewhere in middle in terms of risk and return trade off. It offers higher return
that money market fund but far less degree of interest rate risk than 20 year U.S. treasury bond
because of the lower maturity.
c. A 20-year U.S. Treasury bond offering a yield to maturity of 9% per year. What role
does your forecast of future interest rates play in your decisions?
In terms of risk, 20 year U.S. treasury bond offers the highest interest rate risk among the
three alternatives because of the highest maturity. So, if an investor forecasts a fall in interest
rates in long run, then $5,000 can be invested in 20 year U.S. Treasury bond.
The 20-year Treasury bond also offers higher rate of interest than saving deposits. So, if
it is assumed that the yield will rise in future, then the value of the bond will diminish. This may
lead to the loss in terms of capital. So, if the returns on bond remain constant, then only it is good
to invest, otherwise the money market fund is the best option.
5. Use Figure 5.1 in the text to analyze the effect of the following on the level of real
interest rates:
a. Businesses become more pessimistic about future demand for their products and
decide to reduce their capital spending.
If businesses reduce their capital spending, then they are likely to decrease their de-mand
for funds. This will shift the demand curve in Figure 5.1 to the left and reducethe equilibrium
real rate of interest
b. Households are induced to save more because of increased uncertainty about their
future social security benefits.
Increased household saving will shift the supply of funds curve to the right and causereal
interest rates to fall.
c. The Federal Reserve Board undertakes open-market purchases of U.S. Treasury
securities in order to increase the supply of money.
Open market purchases of U.S. Treasury securities by the Federal Reserve Board
areequivalent to an increase in the supply of funds (a shift of the supply curve to theright). The
FED buys treasuries with cash from its own account or it issues certifi-cates which trade like
cash. As a result, there is an increase in the money supply, andthe equilibrium real rate of interest
will fall.
6. You are considering the choice between investing $50,000 in a conventional 1-year
bank CD offering an interest rate of 5% and a 1-year “Inflation-Plus” CD offering 1.5%
per year plus the
rate of inflation.
a. Which is the safer investment?
The “Inflation-Plus” CD is the safer investment because it guarantees the purchasing power
of the investment. Using the approximation that the real rate equals the nominal rate minus the
inflation rate, the CD provides a real rate of 1.5% regardless of the inflation rate.
b. Which offers the higher expected return?
The expected return depends on the expected rate of inflation over the next year. If the
expected rate of inflation is less than 3.5% then the conventional CD offers a higher real return
than the inflation-plus CD; if the expected rate of inflation is greater than 3.5%, then the opposite
is true.
c. If you expect the rate of inflation to be 3% over the next year, which is the better
investment? Why?
If you expect the rate of inflation to be 3% over the next year, then the conventional CD
offers you an expected real rate of return of 2%, which is 0.5% higher than the real rate on the
inflation-protected CD. But unless you know that inflation will be 3% with certainty, the
conventional CD is also riskier. The question of which is the better investment then depends on
your attitude towards risk versus return. You might choose to diversify and invest part of your
funds in each.
d. If we observe a risk-free nominal interest rate of 5% per year and a risk-free real rate of
1.5%
on inflation-indexed bonds, can we infer that the market’s expected rate of inflation is 3.5%
per year?
No. We cannot assume that the entire difference between the risk-free nominal rate (on
conventional CDs) of 5% and the real risk-free rate (on inflation-protected CDs) of 1.5% is the
expected rate of inflation. Part of the difference is probably a risk premium associated with the
uncertainty surrounding the real rate of return on the conventional CDs. This implies that the
expected rate of inflation is less than 3.5% per year.
7. Look at Spreadsheet 5.1 in the text. Suppose you now revise your expectations
regarding the
Use Equations 5.11 and 5.12 to compute the mean and standard deviation of the HPR on stocks.
Compare your revised parameters with the ones in the spreadsheet.
8. Derive the probability distribution of the I-year HPR on a 30-year U.S. Treasury
bond with an 8% coupon if it is currently selling at par and the probability distribution of
its yield to maturity a year from now is as follows:
State of the Economy Probability YTM
Boom 0.20 11.0%
Normal growth 0.50 8.0
Recession 0.30 7.0
For simplicity, assume the entire 8% coupon is paid at the end of the year rather than
every 6 months.
Formula used:
For calculating HPR
endingpriceofashare−beginningprice+ cashdividend
HPR=
beginningprice
0 .25
1 .25
2 .50
Step-by-step explanation:
q: 0 1 2
Formula:
Variance =
Empirical rule defines the relation between the range of mean and movement of actual
variables expected and standard deviation.
The following are the difference range of actual variable movements under various
Confidence levels:
If the actual variable movement range is (68% - 95%), then the confidence level is [Mean
± Standard deviation].
If the actual variable movement range is (95% - 99.7%), then the confidence level is [Mean ± ( 2
x Standard deviation)].
If the actual variable movement range is (Above99.7%), then the confidence level is
[Mean ± ( 3 x Standard deviation)].
Stock mean is 20% and standard deviation is 30%. With 95.44% confidence find the
expected actual return in any particular year.
11. Using historical risk premiums over the 1926–1995 period as your guide, what
would be your estimate of the expected annual HPR on the S&P 500 stock portfolio if the
current risk-freeinterest rate is 6%?
Information provided from the question,
Historical risk premiums over the 1926-1995 period should be used as guide.
The current risk-free interest rate = 6 percent
To estimate the expected annual holding period return (HPR) on the Big/Value portfolio,
we solve; Since, the average risk premium for the period 1926-2016 = 11.67% per year. 11.67%
would be added to the 6% risk-free interest rate, Therefore, the expected annual HPR for the
Big/Value portfolio = 6% + 11.67% = 17.67%.
12. You can find annual holding-period returns for several asset classes at our Web site
(www.mhhe.com/bkm); look for links to Chapter 5. Compute the means, standard
deviations, skewness, and kurtosis of the annual HPR of large stocks and long-term
Treasury bonds using only the 30 years of data between 1976–2005. How do these statistics
compare with those computed from the data for the period 1926–1941? Which do you
think are the most relevant statistics to use for projecting into the future?
13. During a period of severe inflation, a bond offered a nominal HPR of 80 percent per
year. The inflation rate was 70 percent per year.
a. What was the real HPR on the bond over the year?
Answer: Let r denote the nominal return on the bond and let i denote the inflation rate. Then
the real HPR is given by 1 + r 1 + i − 1 = 1.80 1.70 − 1 = 5.88% .
Clearly, R = r − i is not a good approximation for large values of r and i. Use Table 1 to
answer problems 9 through 11.
Bear Market Normal Market Bull Market
Working Note 2:
Calculate the Holding Period Returns (HPR).
Working Note 3:
The ending values of $89.75 and $46 is taken from spreadsheet 5.1.
Working Note 4:
b. What is the probability distribution of the HPR on a portfolio consisting of one share of
the index fund and a put option?
Calculate the probability distribution of the HPR on a portfolio.
Take both the cost of index fund and the cost of put option also. Cost of one share of the
index fund plus a put option is $112.
The probability distribution of the HPR on the portfolio is as follows:
c. In what sense does buying the put option constitute a purchase of insurance in this case?
Buying the put option would guarantee the investor with a minimum HPR of 0.0%
irrespective of the fluctuations in the stock's price.
Hence, it offers an insurance against decline in prices.
17. Take as given the conditions described in the previous problem, and suppose the
risk-free interestrate is 6% per year. You are contemplating investing $107.55 in a 1-year
CD and simultaneously buying a call option on the stock market index fund with an
exercise price of $110 and expiration of 1 year. What is the probability distribution of your
dollar return at the end of the year?
Holding period return (HPR): It is the return obtained from a security in a period if it is
hold for that certain period. It comprises of return from increase in price of the security and
dividends or interest payments from the security.
Expected rate of return is the probability weighted average of the returns in different
scenarios.
Call option gives the buyer the right but not the obligation to buy the underlying at a pre-
determined price in the future.
Determine the probability distribution of return
When the price of the stock index is less than the exercise price, then the call will expire
worthless. When stock index price is higher than the exercise price of the call, then call will be
exercised. Substitute, price of CD as 107.55, risk free rate as 6% and exercise price of call as
$110 to get the probability distribution of return as follows:
State of the Probability Ending Price Ending value Ending value Combined
economy of stock of CD ($) of call ($) value
index ($)
Excellent 0.25 126.5 114.003 16.5 130.503
Good 0.45 110 114.003 0 114.003
Poor 0.25 89.75 114.003 0 114.003
Crash 0.05 46 114.003 0 114.003
Only when economy is excellent will the call be exercised as exercise price is lower than
the ending price.