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MODERN PORTFOLIO THEORY AND INVESTMENT ANALYSIS
9TH EDITION
ELTON, GRUBER, BROWN, & GOETZMANN
The following exam questions are organized according to the text's sections. Within each
section, questions follow the order of the text's chapters and are organized by multiple
choice, true-false with discussion, problems, and essays. The correct answers and the
corresponding chapter(s) are indicated below each question.
PART 4: SECURITY ANALYSIS AND PORTFOLIO THEORY
Multiple Choice
1. The fact that superior returns can not be made by selling stocks that cut dividends
is evidence of:
a. weak-form efficiency.
b. semi-strong-form efficiency.
c. strong-form efficiency.
Answer: b
Chapter: 17
1
Test Bank Modern Portfolio Theory and Investment Analysis, 9th
Edition
2. Tests of market efficiency tend to

a. look for statistical dependencies that exist in price changes over time.
b. measure the nature of the impact of new information on security prices as
that new information becomes available.
c. search for trading systems that might be able to generate supernormal
profits.
d. all of the above
Answer: d
Chapter: 17
3. Which of the following is an implication of market efficiency?

a. Resources are allocated among firms that put them to the best use.
b. No investor will do better than the S&P 500 in any time period.
c. No investor will do better than the S&P 500 consistently after adjusting for
risk.
d. No investor will do better than the S&P 500 consistently after adjusting for
risk and transactions costs.
Answer: d
Chapter: 17
4. Which of the following statements is (or are) true of the efficient markets
hypothesis?
a. It implies perfect forecasting ability.
b. It implies that prices reflect all available information.
c. It results from keen competition among investors.
d. It implies that market is irrational.
e. It implies that prices do not fluctuate.
Answer: b and c
Chapter: 17
5. Studies of firms classified on the basis of P/E ratios come to the conclusion that low-
P/E-ratio stocks earn much higher returns, after adjusting for risk, than high-P/E-ratio
stocks. This is because
a. low-P/E-ratio stocks are riskier than high-P/E-ratio stocks.
b. investors like low-P/E-ratio stocks.
c. low-P/E-ratio stocks are more likely to be undervalued.
Answer: c
Chapter: 18
6. Which of the following investment strategies is inconsistent with a "contrarian"

philosophy?
a. buying low, selling high
b. buying when odd-lot buying is lower than normal
c. buying when mutual fund cash positions are low
2 Copyright © 2014 John Wiley & Sons, Inc.

Modern Portfolio Theory and Investment Analysis, 9th Edition Test Bank
d. buying when most investment advisory services are bearish

e. selling after a market crash or decline
Answer: e
Chapter: 20
7. Which of the following is not a general conclusion of studies of stock prices?

a. The serial correlation in daily returns in U.S. stocks is positive.
b. The serial correlation in longer period returns (monthly, annual) in U.S. stocks
is negative.
c. Filter rules greater than 1% generally do not make money.
d. Stocks that have done well in the past are also likely to do well in the future.
e. There are more runs in daily stock prices than we would expect to find
under a random walk.
Answer: d
Chapter: 19
8. A common stock is expected to generate an end-of-period dividend of $5 and an

end-of-period price of $62. If this security has a beta coefficient of 1.3, the risk-free interest
rate is 10%, and the expected return on the market portfolio is 19%, then what is the value
of this security today?
a. $55.50
b. $59.98
c. $55.05
d. $56.30
Answer: c
Chapter: 18
9. If expectation theory holds then:

a. a flat yield curve is an indication that long-run rates are expected to
increase.
b. investors must be offered a higher expected return to hold a bond longer
c. the yield curve cannot be downward sloping
d. then an upward sloping yield curve is an indication that short-term rates are
expected to increase.
Answer: d
Chapter: 21
10. Which of the following statement is correct with regard to bond valuation?
a. All else equal, the longer the time to maturity, the smaller the interest rate risk.
b. All else equal, the higher the coupon rate, the greater the interest rate risk
c. Spot interest rates are yields to maturity on loan or bonds that pay multiple cash
flows to the investor.
d. Bond price will fall as the market interest rate rise, as the present value of the
bond’s future cash flows is obtained by discounting at a higher interest rate.
Copyright © 2014 John Wiley & Sons, Inc. 3

Edition
Answer: d
Chapter: 21
11. Which of the following statements is true?

a. An increase in coupons increases the duration of the bond.
b. The longer the maturity of a bond, the greater will be its duration.
c. An increase in the interest rate decreases the duration of the bond.
d. Duration is a measure of the sensitivity of the equities.
Answer: c
Chapter: 22
12. All other things equal, which of the following bond price is more sensitive to
interest rate changes?
a. a 10 year bond with a 10% coupon
b. a 20 year bond with a 7% coupon
c. a 20 year bond with a 10% coupon
d. a 30 year bond with 7% coupon
Answer: d
Chapter 22
13. Which of the following statements is true of warrants?

a. A warrant is almost identical to a put option.
b. When warrants are exercised the number of warrants still outstanding
increases.
c. A warrant is a combination of call and put options.
d. A warrant is issued by the corporation rather than another investor.
Answer: d
Chapter: 23
14. Which of the following is an attribute of futures contract?

a. There are no limits on the size of the position that any investor can take in
financial futures markets.
b. Futures contracts are marked to the market on a daily basis
c. Margins for futures are more relative to other types of markets.
d. Almost all futures positions are settled by delivery.
Answer: b
Chapter: 24
True-False
1. A high positive serial correlation in prices would imply market inefficiency.

a. true
b. false
Answer: a
Chapter: 17
2. Studies of stock splits indicate that one could make excess returns by investing in
stocks after splits occur.
a. true
b. false
Answer: b
Chapter: 17
3. In a strongly efficient market, the price of a firm's stock should not change if no
new information comes out about the firm.
a. true
b. false
Answer: b
Chapter: 17
4. In a strongly efficient market, no mutual fund manager will beat the market in any
period.
a. true
b. false
Answer: b
Chapter: 17
5. Studies show that stocks with high dividend yields and low P/E ratios earn excess
returns.
a. true
b. false
Answer: b
Chapter: 17
6. A significant portion of the small-firm premium is earned in the first two weeks of
the calendar year.
a. true
b. false
Answer: a
Chapter: 17
7. Stocks that have high P/E ratios are much more likely to be found to be
undervalued using the dividend-discount model.

Edition
a. true
b. false
Answer: a
Chapter: 18
8. The Fed announces a tightening of monetary policy, leading to an increase in

interest rates. Other things remaining equal, P/E ratios for stocks will decrease.
a. true
b. false
Answer: a
Chapter: 18
9. Spot interest rates are yields to maturity on loans or bonds that pay only one cash
flow to the investor.
a. true
b. false
Answer: a
Chapter: 21
10. Everything else remaining equal, the duration of a coupon bond increases with
maturity.
a. true
b. false
Answer: a
Chapter: 22
11. The duration of a bond decreases as the coupon rate on the bond increases.
a. true
b. false
Answer: a
Chapter: 22
12. The duration of a perpetual bond is infinite.

a. true
b. false
Answer: b
Chapter: 22
13. The duration of a five year maturity 10% coupon bond will be higher than the
duration of a five year maturity zero coupon bond.
a. true
b. false
Answer: b
Chapter 22

True-False With Discussion
1. Discuss whether the following statement is true or false:

If semi-strong efficiency holds, then weak-form efficiency must hold.
Answer: True
Semi-strong form tests of the efficient market hypothesis are tests of whether publicly
available information is fully reflected in current stock prices. On the other hand, Weak-
form tests are tests of whether all information contained in historical prices is fully reflected
in current prices. Thus, weak-form efficiency is a subset of semi-strong efficiency which
means weak-form efficiency must hold if semi-strong efficiency holds.
Chapter: 17

The random walk model implies that the best estimate of tomorrow's price is today's
price.
Answer: False
The random walk model assumes that successive returns are independent and that the
returns are identically distributed over time. In other words, the random walk theory says
that the historical prices cannot predict the future prices of the stock and that the prices
of stock are independent of each other.
Chapter: 17

If markets are semi-strong-form efficient, one should not observe excess returns after the
announcement of a dividend increase.
Answer: True
The semi-strong form of the efficient market hypothesis states that investors reassess the
value of the security on the availability of any new information. This the reassessment
leads to an immediate adjustment in price. Hence, an investor buying a security based
on any new information would be paying on an average the actual worth of the security.
Thus if the semi-strong form of efficiency holds, investors should not be able to observe
excess returns after the announcement of an increase in dividend.
Chapter: 17

A certain retailing firm has a strong seasonal pattern to its sales. Therefore, we would
expect to find a seasonal pattern to its stock price as well.
Answer: False
In an efficient market we should not observe a seasonal pattern in stock prices. If investors
observe high returns in a particular month they will start purchasing the stock just before
the month when sales are expected to rise to take advantage of the extra return. This
adjustment of the pattern of investor purchases should cause the pattern to disappear.
Hence, the stock prices of the firm will not follow the same pattern as sales in an efficient
market.

Edition
Chapter: 17
5. Your friend claims that, since the market went up seven days in a row recently,
there is no way that the market could follow a random walk. Discuss whether your friend's
claim is true or false.
Answer: False
The random walk model assumes that successive returns are independent and that the
returns are identically distributed over time. A trend in a stock or a market’s price does
not necessarily mean a deviation from random walk model. It can, and is very natural, for
am market to react to change in the underlying fundamentals. Semi-strong form of
market efficiency states that the prices adjust to reflect any new information so that
excess returns cannot be observed. A seven day uptrend may reflect the increasing risk-
return functions of the market. Stock prices essentially follow a random and an
unpredictable path.
Chapter: 17

The use of a dividend-discount model to value common stocks is inconsistent with strong-
form efficiency but is consistent with weak-form efficiency.
Answer: False
The dividend-discount model calculates the value of a stock by discounting the future
expected dividends to their present value. Strong form of market efficiency all the
possible information whether public or private is reflected in the stock price. Future
dividends are no exception. Therefore, dividend discount model is consistent with the
strong form of efficiency of the market. Weak form of efficiency states that all historical
information is reflected in the prices. Since dividend discount model assumes future
dividends as inputs, it is inconsistent with weak form of efficiency.
Chapter: 17

The existence of a downward-sloping yield curve is inconsistent with the liquidity
preference theory.
Answer: True
The liquidity preference theory suggests that the premium required by the investors for the
cash invested by them is directly proportional to the term of investment. This means, the
longer the maturity, the higher the premium that would be demanded by the investor.
This will result in an upward-sloping yield curve. Under expectations theory, a downward
sloping yield curve indicates that short-term rates are expected to decline.
Chapter: 21

An investor is considering purchasing either a zero-coupon bond with 5 years to maturity
or a 10% coupon bond with 5 years to maturity, but if both bonds have identical yields to
maturity and the investor expects to hold the bond for the full 5 years, then it does not
matter which bond is purchased.
Answer: False

Yield to maturity implicitly assumes that any intermediate income received from a bond is
reinvested at the same rate. If the interest rates in the market move, the coupons
received on a bond will need to be re-invested at the new rates, consequently affecting
the realized yields. This is commonly known as re-investment risk. However, for a zero-
coupon bond, the yield to maturity will always be equal to the realized yield.
Chapter: 21

A GNMA (mortgage pool) security with a 20-year maturity should sell at a lower yield to
maturity than a 20-year corporate bond, because the interest and principal of the GNMA
security are government insured.
Answer: True
Yields on corporate bonds are typically higher than those on GNMA security to
compensate for the credit risk. A corporate may or may not honor its obligation to pay
interest and principal, whereas, a GNMA security has the complete backing by the
government of United States. Additionally, the interest payments on corporate bonds are
taxed at the state level whereas interest payments on government bonds are not.
Chapter: 21

The promised yield on corporate bonds will in general be higher than the expected yield.
Answer: True
The promised yield on a corporate bond is higher than its expected yield because of
default premium. Default premium is the amount of return that the investor requires to
bear the risk of default of the corporate bond. Unlike government bonds, for corporate
bonds there is a risk that the coupon or principal payments will not be met. Therefore,
there is a difference between the promised yield of a corporate bond and the expected
yield on the same bond. A corporate bond may promise a yield of 10% but is there is a
risk of default associated with the bond its expected return could be 8%. This difference in
promised and expected return is referred to as default premium.
Chapter: 21

Two portfolios with matching cash flows are always immunized.
Answer: True
Generally, the portfolios with matching cash flows are immunized to interest rates
sensitivities except for two circumstances. First, if the cash-flows are matched using a
callable bond and interest rates rise, there is always a risk of the bonds being called
upon. Second, if the surplus cash flow matching technique is used there is a re-investment
risk. If interest rates fall, the cash flows may not materialize to the extent required to
service the liabilities.
Chapter: 22

Edition
Buying a call option on a portfolio of common stocks is the same as buying a futures
contract on the same portfolio.
Answer: False
Payoff on a long call option position is different from that of a long position in a futures
contract. Call option gives a buyer the right but not an obligation to purchase a security
at a pre-determined price. The buyer pays a premium to purchase this right and exercises
the option only if the spot prices rise above the strike price. If the price for the underlying
falls, the buyer can simply chose not to exercise the contract. The maximum loss in this
case is the premium amount paid. The payoff in case of futures contract is directly
proportional to the change in the underlying asset’s prices. If the spot price falls, futures
price will also fall simultaneously and the buyer of the futures contract will suffer losses to
the extent of the fall. Upside potential, however, in both the contracts remain same
theoretically
Chapter: 23
Problems
1. You have just completed a study of small and large stocks and have obtained the
following results:
small stocks large stocks

excess returns 5% 0%
transactions costs 10% 2%
Given the difference in transactions costs, how long would your investment horizon have
to be for small stocks to be a better investment than large stocks?
Answer:
Horizon at which returns on small stocks will at least equal returns on large stocks
Difference in transaction costs  (10 − 2 ) 
=   = 1.6 years
Excess returns on small stocks  5 
Therefore, any investment horizon greater than 1.6 years will generate greater returns on
small stocks.
Chapter: 17
2. ABC Corp. has just paid an annual dividend of $0.50 per share. Dividends are
expected to grow at 15% for each of the next 8 years, at 10% for the 2 years after that,
and at 3% thereafter. If the appropriate discount rate is 10%, what is the intrinsic value of
the stock?
Answer:
The timeline for the dividends looks like this (split to fit on the page):
0 1 2 3 4 5 6 7
| | | | | | | |

| | | | | | | |
0.5(1.15 0.5(1.15) 0.5(1.15) 0.5(1.15) 0.5(1.15) 0.5(1.15) 0.5(1.15)
) 2 3 4 5 6 7
8 9 10 11 12
| | | | |
| | | | |
0.5(1.15) 0.5(1.15)8(1. 0.5(1.15)8(1.1 0.5(1.15)8(1.1)2(1.0 0.5(1.15) (1.1)2(1.03)2
8
8 1) )2 3) ...
Starting with D11, we have a stream of cashflows that continue forever and grow at
a constant growth rate. Hence, we can find the price (at t=10) of D11 and all
subsequent dividends by using the growing perpetuity formula.
P10 = D11/(k – g) = 0.5(1.15)8(1.1)2(1.03) / (0.1-0.03) = $27.2319
Note also that D1 through D8 are an eight-year annuity growing at a constant rate of
15%. Thus, we can find the PV of D1 through D8 using the growing annuity formula.
D1   1 + g  T  0.5(1.15)   1 + 0.15  8 
P0 (D1 through D8) = 1 −   = 1 −    = $4.91
k−g   1 + k   0.1 − 0.15   1 + 0.1  
The two formulas above found the PV(at t=0) of D1-D8 and the PV(at t=10) of D11 and
onward. Accounting for the PV of D9 and D10 and discounting the $27.2319 back to
time 0, we arrive at a stock price of:
0.5  1.158  1.1 0.5  1.158  1.12 27.2319

P0 = 4.91 + + + = $16.84
1.19 1.110 1.110
Chapter: 18
3. You are trying to value Godzilla, Inc. You are provided with the following data for
the company: the current earnings per share is $2.50; the expected return on assets is
15%; the current dividend payout ratio is 40%, and this rate is expected to stay constant
over the next five years, during which time the firm expects high growth; the firm has a
debt-equity ratio of 0.5; the firm pays an interest rate of 10% on its debt; after the fifth
year, the firm is expected to grow at a constant rate of 8%, and the return on assets will
remain unchanged at 15%; the firm's beta is 0.8; the riskless rate is 7%; the expected return
on the market is 15%.
a. Value the firm.
b. Mr. Poone Bickens is attempting to take over Godzilla, Inc. He claims that
the managers are not managing the firm optimally. In particular, he feels
that the firm should prune some of its losing assets and should borrow more
money, so that the return on assets will be 20% and the debt-equity ratio will
be 1.5. He agrees with the constant growth estimate for the stable phase
(after the fifth year and on). Assuming Mr. Bickens is right, how much will he

Edition
be willing to pay for the firm?

Answer:
a.
 D 
g1= (1-Payout )  ROA+ (ROA-i ) 
 E 
g1= 10.50%
Ke = Rf + ( Rm − Rf ) 
Ke = 13.40%
  1+ g1 
N

1−  1+ k   =$4.63
Value of the share for first 5 years = D1    
 k − g1 
 
 
 g
Payout ratio after 5 years = 1−   = .54
r
Dividend in the 6th year = $2.42
 D  1 
Pn =  n+1   n
 k − g2  (1+ k) 
 2.4155+1   1 
Pn =    5
 0.134 − 0.08  (1+ 0.134) 
Pn = $23.845
Therefore,
P0 = $23.845 + $4.63
P0 = $28.475
b.
With the changes in estimates, the new g1 would be 21% which is calculated as [(1−40%)
× (20%+1.5 × (20% − 10%)]
  1+ g1  
N
 1−  1+ k  
P0 = D1     = $6.099
 k − g1 
 
 
( )
Dividend in the 6th year; $2.5  1.215  1.08  0.77 = $3.80
 5.40  1 
Terminal value of the stock can be calculated using  0.134 − 0.08   (1 + 0.134)5  = 53.35
 
Value of the stock = $6.099 + $53.35 = $59.44
Chapter: 18
4. Silicon Valley Electronics (SVE) is expected to pay out 40% of its earnings and to
earn an average return of 15% per year forever on its reinvested earnings. Stocks with

similar characteristics are priced to return 12% to investors. By what percentage can SVE's
earnings per share be expected to grow each year? What is the appropriate P/E ratio for
the stock? What portion of SVE's total yield is likely to come from capital gains? What
portion will come from dividend yield?
Answer:
g=b×r
g = 9%
To calculate the P/E ratio of Silicon Valley, we will relate the P/E ratio to DVM and arrive
at an equation for the price earnings ratio in terms of dividend payout, required rate of
return, and growth:
P 1− b
P/E Ratio = 0 =
E1 k − br
0.40
P/E Ratio =
0.12 − 0.09
To calculate the capital and the dividend yield, consider the DVM formula
D1
P0 =
k−g
D
Or, k = 1 + g
P0
This means that the required rate of return is an addition of dividend yield (D1/P0) and the
growth rate (capital yield)
Hence, the yield from capital gains of SVE is 9%.
The dividend yield will be 3% (r – g).
Chapter: 18
5. You have been hired as an analyst by a noted security analysis firm and asked to
value two stocks. You have been given the following data on the two firms:
firm 1 firm 2
required return 20% 12%
dividend payout ratio 20% 60%
current EPS $1 $1
return on investment 25% 15%
stage of growth high stable
You estimate that firm 1 will become a stable firm after five years have passed, after
which it will have a constant growth rate of 6%, and that firm 1's return on investment will
remain unchanged. Value each firm.
Answer:
Firm 1
Growth rate for the first 5 years = b × r = 20%
Expected dividend = $0.24

Edition
  1+ g  N 
1−  1

Value for the first 5 years =   1+ k  
P0 = D1 = $1
 k − g1 
 
 
 g
Payout ratio after 5 years = 1−   = .76
r
 D  1 
Pn =  n+1   n
= $5.75
 k − g2  (1+ k) 
Value of stock = $6.75
Firm 2
Growth rate = b × r = 6%
D1
P0 =
k−g
P0 = $10.60
Chapter: 18
6. On January 1, 1991, you are considering buying stock in Genetic Biology Systems
(GBS), which has just announced a new type of corn that will provide nitrogen to the soil
and thus eliminate the need for additional fertilizer. GBS had an EPS of $1.20 in 1990. The
firm's expected annual growth rate is 50% for 1991 and 1992, 25% for the following two
years, and 10% thereafter. Its dividend payout ratio is expected to be zero in 1990 and
1991, to rise to 20% for the following two years, and then to stabilize at 50% thereafter. The
risk-free rate is 15%, and GBS has a beta of 1.2. The market rate of return is 16%.
a. What is the value of GBS stock?
b. Now assume that you are in the 40% tax bracket but that capital gains are
taxed at 16%. Assume that you can buy GBS stock for $22.26. You can also
buy the stock of ISD, Inc., which is of equal risk to GBS and sells for $42.86.
ISD has just paid a dividend of $6, and has an expected constant growth
rate of 2%. If you plan to hold either investment for four years and then sell
it, which stock is a better investment for you?
Answer:
a.
Cost of equity = Rf + ( Rm − Rf )  = 
Following table shows the expected dividends in the next five years –
Year 1990 1991 1992 1993 1994 1995+
Growth rate 50% 50% 25% 25% 10%
EPS 1.2 1.8 2.7 3.4 4.2 4.6
P/O ratio 0 0 0.2 0.2 0.5 0.5
DPS 0.00 0.00 0.54 0.68 2.11 2.32

Value for the first four years = present value of the dividends for the first four years
discounted at the cost of equity; $1.988
 D  1 
Pn =  n+1   n
 k − g2  (1+ k) 
 2.32   1 
=   4
 0.162 − 0.1 (1.162) 
= $20.52
b.
Marginal tax rate = 40%
Capital gains tax rate = 16%
Investment in GBS stock –
The following table shows the present value of post tax dividends for the investor –
Year 1990 1991 1992 1993 1994
Growth rate 0.50 0.50 0.25 0.25
DPS 0.00 0.54 0.68 2.11
Post tax dividend 0.00 0.32 0.41 1.27
PV of dividends 0.00 0.24 0.26 0.69
Total present value of post tax dividend income = $1.19
D1 $2.32
Expected stock price at the end of year 4 = P0 = = = $37.42
Ke − g 0.162 − 0.1
Post tax capital gains = ( $37.42 − $22.26 )(1− 0.16 ) = $12.74
$12.74
Present value of capital gains = = $6.99
(1.162 )
4
 ( $6.99 + $1.19) 
Return on Investment for the investor =   100 = 36.74%
 $22.26 
Investment in ISD stock –
Current stock price = $42.86

Constant growth rate = 2%
The following table shows the present value of post tax dividends for the investor –
Year 1990 1991 1992 1993 1994 1995+
DPS 6.00 6.12 6.24 6.37 6.49 6.62
Post tax dividend 0.00 3.67 3.75 3.82 3.90

Edition
Total present value of post tax dividend income = $15.13

$6.624
Expected stock price at the end of 4 year = = $46.65
0.162 − 0.02
Post tax capital gains = ( $46.65 − $42.86 )(1− 0.16 ) = $3.18
$3.18
Present value of capital gains = = $1.75
(1.162 )
4
 ( $15.13 + $1.75) 
Return on Investment for the investor =   100 = 39.39%
 ( $42.86) 
ISD stock is a better investment opportunity since its ROI is higher.
Chapter: 18
7. Firm A has a stock price of $10 per share, an expected dividend for next year of $1
per share, an expected constant growth rate of 8% per year, and a beta of 0.8 on its
stock. Firm B has a stock price of $50 per share, an expected dividend for next year of
$5.50 per share, a retention rate of 40%, a historical rate of return on investment of 20%,
and a beta of 1.3 on its stock. If the riskless rate is 10% and the expected return on the
market portfolio is 18%, is either of these stocks underpriced or overpriced? What is your
buy/sell recommendation for each stock?
Answer:
FIRM A
k = 10% + 0.8(18%-10%) = 16.40%
D1
P0 =
k−g
P0 = $11.90
Therefore, the stock of Firm A is underpriced.
FIRM B
g = 8% (40%  20%)
k = 10% + 1.3(18% − 10%) = 20.40%
D1
P0 =
k−g
P0 = $44.35
Therefore, the stock of Firm B is overpriced.
Chapter: 18
8. You have been given the following historical data on XYZ Corporation:

year XYZ return market return

1986 20% 30%
1987 -15% -10%
1988 25% 10%
1989 -20% -10%
1990 40% 20%
a. Estimate the beta for XYZ.

b. The price of XYZ stock was $50 a year ago, and today it is $55. The
dividends paid by XYZ over the last twelve months amount to $3. The T-bill
rate a year ago was 6%, and the NYSE index has risen 10% over the past
year. Assume that the average dividend yield on all stocks is 3% and
evaluate the performance of XYZ stock over the past year.
c. If the T-bill rate today is 5.5%, what would you project the price of XYZ stock
to be a year from today? (Assume that XYZ will continue to pay an annual
dividend of $1.)
Answer:
a.
Covariance = 0.032
Variance (σ2m) = 0.0256
Beta = 0.032 ÷ 0.0256 = 1.25
b.
The required rate of return (k) of XYZ’s stock is 11% (6% + 1.25 (10% − 6%)) and the actual
return on stock of XYZ is 16% (($55 − $50 + $3) ÷ $50). The stock has outperformed the
market and delivered returns in excess of expected returns as per CAPM pricing model.
c.
Expected return on the stock = = 5.5+ (10-5.5)×1.25 = 11.125%
Expected annual dividend = $1
Expected stock price should yield 11.125%
Therefore, Expected price = ((11.125%×55)-1) +55 =$ 60.12
Chapter: 18
9. You are a financial analyst for General Motors and have been asked to evaluate
the effect on risk of taking over RandomTech, an electronics firm. You have collected the
following data for both firms:
GM RandomTech
share price $60 $20
number of shares 13.25 million 10 million
beta 1.0 2.0
standard deviation 20% 80%
You estimate the correlation of returns between GM and RandomTech to be 0.3.

Edition
a. How will taking over RandomTech affect GM's beta?

b. What will the variance of the combined firm be if the takeover is carried
through?
Answer:
a.
Market value of GM = $60 × 13.25 million = $795 million
Market value of RandomTech = $20 × 10 million = $200 million
795 200
Beta of GM after take over = 1+  2 = 1.20
995 995
b.
Variance of the new firm = w2a2a + w2a2b + 2wawb cov(a, b)
Variance of the new firm = 6.68%
Chapter: 18
10. You are a research analyst for a major investment bank and have been asked to
evaluate three candidates for a takeover and recommend one. You estimate the risk-
free rate to be 5% and the market risk premium to be 8%. You also have the following
data:
MTT Corp. NOR Corp. TECH Corp.

current price $20 $25 $200
number shares 100,000 80,000 10,000
current EPS $4 $2.50 $5
payout ratio 50% 20% 10%
(first 5 yrs)
beta 1.0 1.25 1.5
growth rate:
first 5 yrs. 5% 20% 50%
beyond 5 yrs. 5% 10% 10%
D/E ratio 0 0 0
ROA:
first 5 yrs. 10% 25% 55.56%
beyond 5 yrs. 10% 20% 25%
Which firm is the best candidate for a takeover?

Answer:
MIT Corp.
Expected dividend = $4×1.05×0.5 = $2.1
Expected Return = Rf + ( Rm − Rf )  = 13%
Since the firm is in stable growth phase,
D1
Stock value can be computed using the formula
ke − g
Intrinsic value = $26.25

NOR Corp.
Expected return = Rf + ( Rm − Rf )  = 
For first stage-
Expected dividend = $2.5×1.2×0.2 = $0.6
  1+ g N 
1−  1
 
  1+ k   = $2.84
Value for the first five years = D1
 k−g 
1
 
 
For second stage –
Payout ratio = 1-(g/b) = 1-(0.1/0.20) = 0.5
(E  (1+ g )N  (1+ g )) (p / o)   1 
Terminal value -  
0 1 2 2
N
= $34.02
 k − g2  (1+ k) 
 
Intrinsic value = $2.84+$34.02 = $36.87
TECH Corp.
( )
Expected return = R f + Rm − R f  = 5+(8)×1.5 = 17%
For first stage-
Expected dividend = $5×1.5×0.1 = $0.75
  1+ g N 
1−  1
 
  1+ k   = $5.59
Value for the first five years = D1
 k−g 
1
 
 
For second stage –
New payout ratio = g/b = 1-(0.1/0.25) = 0.6
 ( E0  (1 + g1 ) N  (1 + g 2 ))  ( p / o) 2   1 
Terminal Value =   N 
= $163.28
 k − g2   (1 + k ) 
Intrinsic value = $5.59+$163.28 = $168.83
Undervaluation/Overvaluation
MIT Corp. = ($20/$26.25)-1 = −23.81%
Nor Corp. = ($25/$36.87)-1 = −32.2%
Tech Corp. = ($200/$168.82)-1 = 18.43%
Since Nor Corp is the most undervalued stock, it is the best buy.
Chapter: 18
11. You have been asked to evaluate the performance of a firm over the last year
and to make some predictions for performance over the next year. The following data
are provided to you:

Edition
one year ago today

6-month T-bill rate 5% 6%
firm's estimated beta 1.25 1.5
NYSE index level 130 137.8
firm's stock price 50 52.50
firm's exp. dividend yield 4% 4%
market's exp. divided yield 3% 3%
a. Evaluate the firm's performance over the last year. (Estimate the excess
returns, either positive or negative, made by this firm.)
b. What would you expect the stock price to be one year from today?
c. You estimate that the standard deviation of this stock next year will be 50%
and the standard deviation of the market will be 20%. What proportion of
the firm's total risk is non-diversifiable?
Answer:
a.
For the firm –
Price appreciation = ($52.5−$50) = $2.5
Dividends = 4%×$50 = $2
Total return = ((2.5+2) ÷ 50) = 9%
For the market –
Price appreciation = 137.8−130 = 7.8
Dividends = 3%×130 = $3.9
Total return = (7.8+3.9) ÷ 130 = 9%
Thus, the firm’s returns are equivalent to market returns.
b.
Market return = (137.8/130)-1 = 6%
Expected return on the stock = Rf + ( Rm − Rf )  = 
Expected dividend = 4%×52.5 = $2.1
Expected stock price = ($52.5×1.105) − $2.1 = $55.92
c.
Total variance for the firm = σ 2 = (0.50) 2 = 25%
Systematic risk = β2σ 2m = 1.52  .202 = 9%
Therefore,
Unsystematic risk = Total risk − Systematic risk = 25% − 9% = 16%
Chapter: 18
12. Last year, ABC Corp. earned $10 per share and its retention rate was 40%. You
require a 12% rate of return on the stock and believe that ABC can realize a rate of return
of 15% on its retained earnings.
a. If ABC has just paid its annual dividend, and you are planning to buy and

hold forever, what is a share of ABC worth to you now?

b. Assuming that your expectations and the market's expectations are the
same, and that these expectations are met over the next thirty years, what
will the market price of a share of ABC stock be at the end of thirty years
from now?
Answer:
a.
The growth rate of ABC is 6% (40% × 15%)
D1 = $6.36
D1
P0 =
k−g
P0 = $106
b.
The market price of ABC’s share, with a constant growth of 6%, at the end of thirty years
would be $608.81 ($106 × (1+.06)30)
Chapter: 18
13. You are trying to value a stable firm that has the following characteristics: current
EPS = $5.00; dividend payout ratio = 60%; ROA = 16%; debt/equity ratio = 0.8; interest rate
on debt = 11%; required rate of return = 15%; number of shares outstanding = 100,000.
What is your best estimate of the firm's value?
Answer:
Growth rate (g) = 8%
Required rate of return = 15%
D1 = $3.24
D1
Using the formula,
ke − g
P0 = $46.28
Value of Firm = $46.28 × 100,000 shares = $4,628,571
Chapter: 18
14. You are an analyst looking at the risk-return characteristics of XYZ Corporation. You
decide to use the CAPM as your model for estimating risk. Using a regression of stock
returns on market returns, you come up with the following regression equation: Rjt = 0.02 +
1.2 Rmt.
a. If the current riskless rate is 7% and the stock is currently selling for $50, what
is your best estimate of the stock price a year from today? (Assume that the
expected dividend per share next year is $2 and the market of return is
15%.)
b. The stock was selling for $54 a year ago. You have been asked to judge the
performance of the stock over the last year. (Assume that the NYSE index

Edition
declined from 150 to 145.5 over the same period, that the T-bill rate was 7%
a year ago, and that the dividend per share last year was also $2.)
c. XYZ Corp. is considering the acquisition of ABC Co. for $25 million. You have
estimated the beta for ABC Co. to be 2.0, and the correlation between XYZ
and ABC stock returns to be 0.4. If XYZ goes through with the acquisition,
what will its beta be afterwards? (There are one million shares of
outstanding XYZ stock.)
Answer:
a.
Given the regression equation, the expected return on the stock will be
R jt = 0.02 + 1.2Rmt
R jt =0.02+1.2(0.15) = 20%
Therefore, expected stock price = ( $50  1.2 ) − $2  =$58
b.
 145.5  
Return on the market =   − 1 = −3%
 150  
 ( 50 − 54 ) + 2 
Return on XYZ stock =   = −3.7%
 54 
XYZ stock has underperformed the market in the last one year.
c.
Beta for the new company will be the weighted average of the acquirer and the target
company.
Market capitalization of XYZ = (1 $50 ) = $50m
Value of ABC = $25m
 50    25  
 =    1.2  +    2  = 1.467
 ( 50 + 25 )    ( 50 + 25 )  
Chapter: 18
15. You have been given the following information on AD Corporation, and you
expect this information to hold for the next five years: ROA = 20%; debt/equity ratio = 0.5;
interest rate on debt = 10%; dividend payout ratio = 20%. After five years have passed,
you expect AD's growth rate to be 10%. The annualized six-month T-bill rate is 7%, current
EPS is $4.00, and the stock's beta is 1.25. Assume a market rate of return of 15%.
a. Using the dividend-discount model, estimate the intrinsic value of the stock.
b. The company's CFO is considering increasing his payout ratio to 40% for the
first five years. Advise him by estimating the value of the stock with the new
payout ratio.
c. The CFO is also considering increasing the debt/equity ratio to one.

Estimate the value of the stock with the new ratio.
Answer:
a. g1 = (1-Payout) (ROA+ D/E (ROA-i)) = 20%
d1 = ($4 × 20%) × (1+20%) = 0.96
ke = Rf + ( Rm − Rf )  = 
Expected dividend = ( $4  1.2  0.2 ) =$0.96
  1+ g N 
1−  1
 
  1+ k   = $4.32
Value for the first 5 years = D1
 k−g 
1
 
 
After 5 years –
 g 
Payout ratio changes to 1−   = 60%
 ROE 
Dividend in the 6th year - $4  (1.2 )  1.1 0.6 = $6.57
5
(E  (1+ g )N  (1+ g )) (p / o)   1 

Terminal value -  0 1 2 2
 N
 k − g2  (1+ k) 
 
= $42.80
Value of the stock of AD Corp. = $4.32 + $42.80
= $47.12
b.
If the Payout ratio in the first five years changes to 40%
Growth rate for the first five years = ( retention ratio  ROE) = 15%
  1+ g N 
1−  1

  1+ k  
Value for the first 5 years = D1 = $7.59
 k−g 
1
 
 
After 5 years –
5
(E  (1+ g )N  (1+ g )) (p / o)   1 

Terminal value -  
0 1 2 2
N
 k − g2  (1+ k) 
 
= $34.59
Value of the stock of AD Corp. = $7.59 + $34.59

Edition
=$42.19
c.
If the Debt-Equity ratio is increased to 1-
D
ROE = ROA+
E
(ROA − i ) = 30%
Growth rate for the first five years = (Retention ratio × ROE) = 24%
  1+ g N 
1−  1

  1+ k  
Value for the first 5 years - D1 = $4.78
 k−g 
1
 
 
After 5 years –
 g 
Payout ratio changes to 1−   = 66.67%
 ROE 
5
(E  (1+ g )N  (1+ g )) (p / o)   1 

Terminal value -  0 1 2 2
 N
= $56.03
 k − g  (1+ k) 
 2

Value of the stock of AD Corp. = $4.78 + $56.03 = $60.81
Chapter: 18
16. Assume that you have been asked to evaluate the P/E ratios of five prospective
acquisition candidates. You have the following information:
company P/E ratio beta growth rate payout ratio

A 10 1.0 5% 0.9
B 8 1.25 8% 0.8
C 9 1.25 10% 0.6
D 6 1.5 11% 0.4
E 5 2.0 12% 0.45
a. If the riskless rate is 7% and the above statistics will hold through infinity,
which of the companies are overvalued and which are undervalued?
b. Now assume that you are using a regression methodology to estimate the
relationship between P/E ratios and these variables. Using a cross-sectional
sample, you obtain the following equation: P/E = 2 + 0.3 x growth rate + 5 x
payout ratio - 1 x beta. Using this equation, which of the companies are
overvalued and which are undervalued?
Answer:
a.

Cost of equity can be calculated for each stock using - Rf + ( Rm − Rf ) 

P0 1− b
=
E k − br
P/E ratio based on fundamentals can be calculated using - 1
P/E based on
Company P/E ratio Cost of equity fundamentals Valuation
A 10 15% 9.00 overvalued
B 8 17% 8.89 undervalued
C 9 17% 8.57 overvalued
D 6 19% 5.00 overvalued
E 5 23% 4.09 overvalued
b.
Using the regression equation for P/E of each stock - P/E = 2 + (0.3 x Growth rate) + (5 x
Payout ratio) - (1 x beta)
Given P/E P/E based on

Company ratio fundamentals Valuation
A 10 7 overvalued
B 8 7.15 overvalued
C 9 6.75 overvalued
D 6 5.8 overvalued
E 5 5.85 overvalued
Chapter: 18
17. UV Company has just been formed with $100 million in equity capital to invest in
five projects, all with infinite lives, with the following characteristics:
project return on equity investment needs

A 14% $20 million
B 17% $15 million
C 11% $25 million
D 19% $20 million
E 10% $20 million
If all five projects have a beta of 1 and the riskless rate is 7%, what is the estimated price-
to-book-value ratio of this firm assuming that all five projects are taken? (Assume market
rate of return of 15% and the growth rate for the company is 20%)
Answer:
Cost of capital for the company = 7 + (15 − 7 )  1 = 15%

Edition
 ROE − g 
Price-to-book value for each project can be calculated as  
 k−g 
Project P/BV
A 1.2
B 0.6
C 1.8
D 0.2
E 2
Therefore, the price-to-book value for the company will be the weighted average of the
price-to-book value for each project, the weights being investment in each project.
 20   20   20   20   20 
P / BV0 = 1.2   +  0.6   +  1.8   +  0.2   +  2  = 1.22
 100   100   100   100   100 
Chapter: 18
18. You are responsible for valuing QXR Corporation, given the following data: current
EPS = $4.00; current payout ratio = 40%, ROA = 20%; beta = 1.2; debt/equity ratio = 0.75;
interest rate on debt = 12%; annualized 6-month T-bill rate = 8%; number of shares
outstanding = 100,000. You expect the firm to grow at 8% after the first five years, with the
ROA declining to 15%. You also know that QXR has substantial real estate holdings that
are currently unutilized and can be sold for $1,000,000. What is your estimate of QXR's
intrinsic value? Assume a market rate of return of 15%.
Answer:
Cost of equity = Rf + ( Rm − Rf )  = 16.4%
D
ROE for first 5 years = ROA +
E
( ROA − i ) = 26%
Growth rate for first 5 years = g = b  r = 15.60%
D1 = E0 (1+ g1 )  Payout ratio = $1.85
  1+ g N 
1−  1

  1+ k  
Value for the first five years = D1 = $7.84
 k−g 
1
 
 
After 5 years –
D
ROE = ROA +
E
( ROA − i ) = 17.25%

g
Payout ratio = 1 − = 0.536
r
D6 = (E0  (1+ g1 )  (1+ g2 )) (p / o)2 = $4.78
N
 D6   1 
Terminal value =    = $24.64 ;
2  (1+ k ) 
N
 k − g 
 
Intrinsic value of the firm = Market value of stock + Real estate value
= ( $34.48  100,000 ) + $1,000,000
= $4,448,000
Chapter: 18
19. You are attempting to value MNC Inc., a conglomerate firm with three divisions.
Each division is in a different industry, and you are provided with the following
information:
MNC data industry averages

division earnings payout ratio beta P/E ratio
A $2.0 million 0.40 1.25 8
B $5.0 million 0.25 1.50 10
C $4.0 million 0.75 1.00 6
The corporate tax rate is 40% and all the industries are in their stable growth phases. MNC
Inc. pays out 50% of its earnings as dividends and has no debt. The current annualized 6-
month T-bill rate is 8%. What is your best estimate of earnings growth for MNC? Assume a
market rate of return of 15%.
Answer:
Based on the industry data, cost of equity for each division in the company can be
(
calculated using CAPM R f + Rm − R f 
.
)
The ROE for each division can be calculated using the price-to-earnings relationship
P0 1− b
=
E1 k − br
Division Cost of equity ROE

A 16.75% 19.58%
B 18.50% 21.33%
C 15.00% 10.00%
ROE of the firm is the weighted average of ROE’s for different divisions of the firm, with
earnings being the weights.

Edition
2  5  4 
ROE of the firm =  ×19.58%  +  ×21.33%  ×10%  = 16.89%
 11   11  11 
Given the retention ratio of 0.5
The growth rate of the firm can be calculated using (Retention ratio× ROE) = 0.5 ×
16.89% = 8.45%
Chapter: 18
20. You are considering investing your money with Value Max, a professional money
management firm. Value Max's portfolio maintains constant percentages in computer
stocks (40%), bio-technology stocks (20%), and health service stocks (40%). Value Max has
sent you the following information on past performance and investment details: Value
Max returns = 40% per annum over the last 5 years; returns on NYSE index = 20% per
annum over last 5 years; average annualized 6-month T-bill rate = 7% over last 5 years.
Your research indicates that the average betas for the three sectors Value Max invests in
are 1.2 for computer stocks, 1.5 for bio-technology stocks, and 0.8 for health service
stocks.
a. What is the appropriate beta to use to evaluate Value Max's portfolio?
b. Evaluate Value Max's performance over the last five years.
Answer:
a.
N
βP =  Xiβi
i=1
βP = 1.1
b.
Using the beta of portfolio, we will calculate the required rate of return as:
N
RP =  Xi Ri
i =1
RP = 21.30%
The average return of the Value max portfolio (40%) exceeds its expected rate of return.
Chapter: 18
21. The government has just issued two bonds. The first bond pays $1,000 at the end of
year 1 and is now selling for $909.29. The second bond pays $100 at the end of year 1
and $1,100 at the end of year 2 and is now selling for $976.15.
a. What are the spot and forward rates for 1-year and 2-year bonds?
b. Using the spot rates determined in part a, what is the duration of each of
these bonds?
c. If a new bond is offered that pays $60 at the end of year 1 and $60 at the
end of year 2, what must it sell for now?
Answer:
a.

Spot Rate:
First bond
1000
P=
(1 + S 01 )
S 01 = 9.98%
Second Bond
c 1000 + c
P= +
(1 + S01 ) (1 + S 02 ) 2
S 01 = 11.47%
Forward Rate:
Forward rates for one year after one year ( f (1,2) )
 (1 + S )2  
=   − 1 = 12.9747%
02
f (1,2)
 (1 + S01 )  

b.
As the first bond is a pure discount bond its duration (D) will be equal to its maturity that is
1 year.
For the second Bond the duration would be calculated as:
D = 1.90 years
c.
60 60
Value of the bond = + = $102.91
(1+ S01) (1+ S02 )2
Chapter: 21
22. Bond A pays $10 at the end of year 1 and $110 at the end of year 2, bond B pays
$5 at the end of year 1 and $105 at the end of year 2, and bond C pays $20 at the end
of year 1 and $120 at the end of year 2. If bond A is selling for $100, bond B for $95, and
bond C for $105, does the law of one price hold? If not, describe the arbitrage that
would restore the law of one price.
Answer:
The yield to maturity for each bond can be calculated as solving for I in the following
equations –
 10 110 
Bond A = 100 =  + 2
; i = 10%
 (1 + i ) (1 + i ) 
 5 105 
Bond B = 95 =  + 2
; i = 8%
 (1 + i ) (1 + i ) 

Edition
 20 120 
Bond C =105 =  + 2
; i = 17%
 (1 + i ) (1 + i ) 
The law of one price states that two identical items should sell at the same price. In the
above scenario, Bond C is trading relatively cheap to both bonds A and B. The investors
can short-sell a portfolio of Bonds A & B and buy Bond C. This process will continue in the
market until the yields on all three bonds are in equilibrium.
Chapter: 21
23. Consider the following data for bonds A, B, and C:
price cash flows

t=0 t=1 t=2 t=3
A $900 $1,000 0 0
B $1,000 $100 $1,100 0
C $900 $50 $50 $1,050
a. Calculate the forward and spot rates for each period.

b. What is the value of the discount function for the first period?
c. What is the yield to maturity for bond C assuming annual payment periods?
Answer:
a.
 1000 1/2 
One year spot rates ( S 02 ) =   − 1 *2 = 10.8185%
 900  
Two year spot rates ( S 04 ) –
  
1/4

   
   100   1110   
1000 =  − 1 * 2 ; S 04 =9.7094%
   S 2    S 4  
   1 + 02    1 + 04    
    2    2    
 
Three year spot rate - S 06 -
     
     
 50   50   1050 
900 = + + ; S = 8.6843%
  S02     S04     S    06
2 4 6
 1 +    1 +    1 +  06   
  2     2      2   

 4 1/2
 

  1 + S  
 
04
  2   
f (1,2) =  − 1 * 2 ; f (1,2) = 8.60%
  S 2 
 1 + 02   
  2   
 6 1/4
 
 S
 1 + 06   
  2   
f(1,3) =  − 1 * 2 ; f(1,3) = 7.625%
 2

 1 + S02   
  2   
 6 1/2
 
 S
 1 + 06   
  2   
f (2,3) =  − 1 * 2 ; f (2,3) = 6.65%
 4

 1 + S04   
  2   
b.
 S02 2 
Value of discount function = 1 +   =1.11
 2  
c.
50 50 1050
900 = + + = YTM = 9%
1 + i (1 + i ) (1 + i )3
2
Chapter: 21
24. Consider the following data for bonds A and B:
price annual cash flows

t=0 t=1 t=2 t=3
A $990 $100 $1,100 0
B $900 $50 $50 $1,050
a. Assuming a flat yield curve of 10%, the expectations theory of the term
structure, and semi-annual compounding, which bond is a superior
investment?
b. If you kept everything the same in part a, except for replacing the
assumption of the expectations theory with the assumption of a liquidity
premium theory, would your answer to part a be affected and, if so, how?
Answer:
a.
Given a flat yield curve of 10% and expectations theory holds,

Edition
 100   1100 
Price of Bond A =  + 2 
= $1000
 1.1   1.1 
 50   50   1050 
Price of Bond B =  + 2 + 3 
= $875.65
 1.1   1.1   1.1 
Bond A is trading below its fair value while Bond B is trading is priced rich. Therefore,
Bond A is a superior investment.
b.
Liquidity premium theory states that yields on longer term securities should be higher
than short term securities.
One year spot rate = 10%
Two-year and Three-year spot rates can be calculated using Boot-strapping.
  
1/2
  
1100
Two-year spot rate=    − 1 = 10.61%
  100   
 990 −  1.1   
   
  
1/3
  
 1050
Three-year spot rate=    − 1 = 8.871%
  50   50   
 900 −  1.1  −  1.10612   
     
Assuming a liquidity premium of –
20 basis points for two-year spot rates and 40 basis points for 3 year spot rates –
New two-year spot rates = 10.61% + 0.2% = 10.81%
New three-year spot rates = 8.871% + 0.4% = 9.271%
 100   1100 
Price of Bond A =  + 2 
= $986.76
 1.1   1.1081 
 50   50   1050 
Price of Bond B =  + 2 
+ 3 
= $890.95
 1.1   1.1081   1.09271 
If there is a premium of 20 basis points on two-year spot rates and 40 basis points for
three-year spot rates, and the liquidity premium hypothesis holds, both the bonds are
trading cheap.
Chapter: 21
25. Assume that the annual interest rate on 2-period loans is 10% and the annual
interest rate on 3-period loans is 12%.
a. What is the forward rate on loans made in period 2 and repaid in period 3?
b. What is the present value of a security with a cash flow of $300 at the end
of period 1 and a cash flow of $400 at the end of period 3?
c. What is the future value (at the end of period 3) of the security in part b?
Answer:

Six month spot rates for period 1 - (1.1)  − 1 = 4.881%

1/2
 
Six month spot rates for period 2 - (1.1)  − 1 = 4.881%
1/2
 
Six month spot rates for period 3 - (1.12 )  − 1 = 5.8301%
1/2
 
a.
Forward rate on loans made in period 2 and repaid in period 3
 (1.05831)3 
 2
− 1 ; 7.754%
 (1.04881) 
b.
300 400
Present value of the security; + = $685.96
1.04881 (1.058301)3
c.
Forward rate for deposits made at the end of period 1 till the end of period 3 –
 (1.05831)3 
  − 1 =13.014%
 (1.04881) 
Future value of the security = 300 (1.13014 ) + 400 = $739.04
Chapter: 21
26. Consider the following interest rates: r01 = 10%, r12 = 11%, r03 = 12%, r34 = 13%, and r05
= 14%, where r0t is the annual spot rate for period t and rt t+1 is the annual forward rate
from period t to t + 1. What is the price of a $1,000 par bond with 5 years to maturity that
has an annual coupon rate of 10% and annual coupon payments?
Answer:
(1 + S01 )
(1 + f12 ) =
(1 + S02 ) 2
Solving for S02,
(1 + S02 )2 = (1 + S01 )(1 + f12 )
S02 = 10.50%
Similarly,
(1 + S04 )
4
(1 + f34 ) =
(1 + S03 )3
S04 = 12.25%
100 100 100 100 1100
P= + + + +
(1 + 0.10) (1 + 0.105) (1 + 0.12) (1 + 0.1225) (1 + 0.14)5
2 3 4
P = $878.28

Edition
Chapter: 21
27. Consider the following two bonds: a discount bond paying 100 in one year, selling
at 93; a coupon bond paying 10 in one year, 110 in two years, selling at 95.
a. What is the one-year spot rate? What is the forward rate for the second
year?
b. Suppose there is a liquidity premium of 50 basis points on two-year lending.
What is the market's expectation of what the one-year spot rate will be in
the second year? What does the market expect the second bond's price
to be at the beginning of the second year?
c. Suppose you are in the 40% effective marginal tax bracket. What is the total
amount you expect to have after taxes at the end of year 2 if you buy the
second bond? (Don't forget to reinvest the first-year coupon.)
d. Suppose you buy the second bond and then the market's expectation of
the spot rate in the second year changes to 10%. What would be the
immediate price change on the bond? If you sold the bond right away,
what would be your after-tax profit or loss?
Answer:
a.
100
P1 = $93 =
(1 + S01 )
S01 = 7.53%
10 110
P2 = $95 = +
(1 + S01 ) (1 + S02 ) 2
S02 = 13.29%
(1 + S02 ) 2
(1 + f12 ) =
(1 + S01 )
f12 = 19.37%
b.
(1 + S02 )2 = (1 + S01 )(1 + S 12 + P)
S 12 = 18.87%
110
P2 =
(1 + S 12 ) 2
P2 = $77.85
c.
After-tax cash flows-
Coupons = $10
Maturity value = [100 – (5× 40%)] = $98
Total Cash flow from second bond = 6(1+19.37%) + 6 + 98 = $111.16
d.
If the expected rate is 10% for the second period,

 10   110 
New price of the bond =   2
= $100.20
 (1 + 0.0753)   (1 + 1.10 ) 
If the bond is sold immediately; post tax gain on the transaction = (100.20 − 95)×(1-0.4) =
$3.125
Chapter: 21
28. Consider the following securities: a fully taxable coupon bond paying 12 in one
year, 112 in two years, selling at 103; a fully taxable coupon bond paying 5 in one year,
105 in two years, selling at 92; a municipal bond paying 8 in one year, 108 in two years,
selling at 98; a bank account paying 10%.
a. Which of the above securities is most attractive to an investor in the 40%
effective tax bracket? (Ignore capital gains tax)
b. Which one is most attractive to a tax-exempt investor?
Answer:
a.
Cash flows for the investor can be tabulated as -
Pre tax returns Post tax return
Price Year 1 Year 2 Year 1 Year 2
Bond A (taxable) 103 12 112 7.2 107.2
Bond B (taxable) 92 5 105 3 103
Municipal bond 98 8 108 8 108
Bank account 100 10 110 6 106
Yield on the four securities can be calculated using –
CF1 CF2
P0 = +
(1 + i ) (1 + i )
1 2
YTM for bond A = 5.58%

YTM for bond B = 7.45%
YTM for Municipal bond = 9.14%
Yield on Bank savings = 6%
Therefore, an investor who is falling in the tax bracket of 40% should invest in the
municipal bonds.
b.
Cash flows for the tax exempt investor are -
Price Year 1 Year 2
Bond A 103 12 112
Bond B 92 5 105

Edition
Municipal bond 98 8 108

Bank account 100 10 110
Yield on the four securities can be calculated using –
CF1 CF2
P0 = +
(1 + i ) (1 + i )
1 2
YTM for bond A = 10.265%

YTM for bond B = 9.584%
YTM for Municipal bond = 9.14%
Yield on Bank savings = 10%
The investor should invest in Bond A.
Chapter: 21
29. At the end of years 1 through10, an investor deposits $450 per year in a bank
account paying 9% per year. At the end of years 11 through 20, she withdraws $450 per
year. At the end of years 21 through 30, she deposits $450 per year. What is the account
balance at the end of year 30?
Answer:
Annuity amount = $450
Interest rate = 9%
For years 0 to10 the value of deposits would be calculated as:
 (1 + i )n − 1 
$450   = $6,836.82
 i 
Value at the end of 30 years = 6,836.82 (1.09 )
30
= $38,316.34
For years 10 to 20 the value of withdrawals would be calculated as:
 (1+ i )n − 1
−$450   = −$6,836.82
 i 
 
Value at the end of 30 years = −6,836.82 (1.09 )
30
= −$16185.2
For years 20 to 30 the value of the deposits would be calculated as
 (1+ i )n − 1
$450   = $6,836.82
 i 
 
Value of the portfolio at the end of 30 years = $6,836.82 + −$16,185.2 + $6,836.82
= $28,967.92
Chapter: 22

30. You have the opportunity to invest at the following rates. Rank them from best to
worst.
a. 10% compounded continuously
b. 10.3% compounded monthly
c. 10.7% simple interest (compounded annually)
Answer:
10% compounded continuously –
Effective annual yield: e0.1 − 1 = 10.517 %
10.3% compounded monthly –
 0.103 
12

Effective annual yield: 1+ − 1 = 10.8 %
 12  
10.7% simple interest (compounded annually) – will yield 10.7% effectively.
Rate structure Effective annual yield Rank

10% compounded continuously 10.52% 3
10.3% compounded monthly 10.80% 1
10.7% simple interest
(compounded annually) 10.70% 2
Chapter: 21
31. An annual-coupon corporate bond has a 20-year maturity, an 11.5% coupon rate,
and a par value of $1,000. The yield to maturity on the bond is 11%. An investor plans to
buy the bond today and hold it to maturity, reinvesting the coupon payments at a 9%
reinvestment rate.
a. What is the purchase price of the bond?
b. How much will the investor have at maturity?
Answer:
a.
Price of the bond is the present value of the cash flows from a bond.
It can be calculated using
115 115 115 115 1115

+ + .... + = $1039.82
(1.11) (1.11) (1.11) (1.11) (1.11)
1 2 3 19 20
b.
If the coupon is reinvested at 9%, at the end of 20 years it grows to
115 (1.09) + 115 (1.09 ) + 115 (1.09 ) + ... + 115 (1.09 ) + 115 (1.09 ) = $5,768.414
19 18 17 2 1
At the end of 20 years, the investor will have $1115 + $5,768.414 = $6,883.41
Chapter: 21
32. Consider the following spot rates: i01 = 6%, i02 = 7%, i03 = 7.5%, i04 = 8%, i05 = 9%.

Edition
a. Based on the pure expectations theory, what does the market expect the
one-year spot rate to be at the end of year 3?
b. Based on the liquidity premium hypothesis, would you expect the actual
one-year spot rate at the end of year 3 to be below the number you
computed in part a? Why or why not?
c. Based on the pure expectations hypothesis, what does the market expect
the two-year (annualized) spot rate to be at the end of year 3?
d. Can we say whether the yield to maturity on a four-year coupon bond will
be above or below 8%? Explain.
Answer:
a.
As per pure expectations theory one year spot rates after 3 years –
 8 1/2
   8

1/2

 S
 1 + 08    
  1 + 0.08  
 
  2      2   
f3,4 = − 1 * 2 ;  − 1 * 2 = 9.50724%
 6
 6

 1 + S06     1 + 0.075   
  2      2   
b.
The forward rate under liquidity premium theory would be higher because the liquidity
premium theory says that the one period forward rate equals the estimate of the one-
period future spot rate plus a liquidity premium for the same period.
c.
As per pure expectations theory – two year annualized spot rates after 3 years –
 10 1/4
   10 1/4
 

  1 + S   
  1 + 0.09  
   
10
  2      2   
f3,5 = − 1 * 2 ;  − 1 * 2 = 11.27%
  S 6  6

 1 + 06     1 + 0.075   
  2      2   
d.
The yield curve in this example is upward sloping. The maximum rate at which the cash-
flows would be discounted for a 4 year coupon bond is 8 percent (terminal value),
However the coupons are discounted at rates below 8 percent. This would mean that the
YTM of the bond is below the 4th year spot rate of 8 percent.
Chapter: 21
33. It is now time 0. You are a bond portfolio manager using a barbell strategy to
immunize. Your portfolio will consist of two bonds: bond A, which is a $100 par zero
coupon bond maturing in five years; bond B, which is a $100 par zero-coupon bond
maturing in ten years. You are trying to immunize a $1 million liability that is due in six
years. The yield curve is flat at 10%, so you need a present value of $1 million/(1.10)6 =
$564,474.

a. Of the $564,474, how much will you put in bond A and how much will you
put in bond B? How many of the A and B bonds will you buy?
b. One minute after you set up the portfolio, the yield curve shifts up to 15%
(staying flat). How much is your portfolio worth?
c. After the shift in part b, is your liability immunized? If not, what should you do
to immunize it? Be specific, and give numbers if you can.
d. Now assume that the shift in part b never happened. You leave the firm
and nobody bothers to look at the portfolio again until the end of year 4.
Interest rates are still at 10%; there have been no further changes. At the
end of year 4, a new bond portfolio manager takes over, goes through the
files, and finds the records of the portfolio. What, if anything, will she have to
do to keep the liability immunized? Be specific, and give numbers if you
can.
Answer:
a.
Barbell strategy matches the duration of assets to duration of liabilities to immunize a
portfolio.
Duration of liabilities = 6 years.
The portfolio constructed using Bond A and Bond B in such a manner so as to have
duration of 6 years.
If x is the proportion of bond A in the portfolio then 5x + (1− x)10 = 6 years
Solving for x , we get the proportion of Bond A in the portfolio as 0.8.
Therefore, proportion of Bond B in the portfolio = (1− 0.8) = 0.2
100
Price of Bond A = = $62.09
(1.1)5
100
Price of Bond B = = $38.55
(1.1)10
Investment in Bond A = 0.8  $564,474 = $451,479.2
Investment in Bond A = 0.2  $564,474 = $112,894.8
$451,479.2
Number of Bond A required to be purchased = = 7272.72  7273 bonds
$62.09
$112,894.8
Number of Bond B required to be purchased = = 2928.2  2928 bonds
$38.55
b.
100
Price of Bond A after the shift = = $49.72
(1.15)5
100
Price of Bond B after the shift = = $24.72
(1.15)10
Value of the portfolio = ( $49.72  7273 ) + ( $24.72  2928 ) = $433,964
c.

Edition
After the shift in the yield curve, the duration of assets and liabilities change, and hence
the portfolio is not immunized. To immunize the portfolio, a certain number of bonds A
and B should be swapped in order to match the duration of assets the duration of
liabilities.
After the shift in yield curve:
Proportion of Bond A in the portfolio =

( $49.72  7273 ) = 0.833
$433,964
Proportion of Bond B in the portfolio =

( $24.72  2928 ) = 0.167
$433.964
Therefore duration of the portfolio becomes ( 0.833  5) + ( 0.167  10 ) = 5.84 years
As computed in part(a), the duration of the portfolio should be 6 years.
New proportion required; Bond A = 0.8 and Bond B = 0.2

$1,000,000
Present value of liability = = $432,327.6
(1.15 )
6
Investment required in Bond A = ( 0.8  $432,327.6) = $345,862.1

Investment required in Bond B = ( 0.2  $432,327.6) = $86,465.52
$345,862.1
Number of Bonds A required = = 6956.52  6957 bonds
$49.72
$86,465.52
Number of Bonds B required = = 3498.01  3498 bonds
$24.72
Number of Bonds A to be sold = 7273−6957 = 316
Number of Bonds B to be bought = 3498−2928 = 570
d.
After four years –
Price of Bond A = $62.09  (1.1) = $90.90
4
Price of Bond B = $38.55  (1.1) = $56.45

4
Value of investment in Bond A = $90.90  7273 = $661,157.10

Value of investment in Bond A = $56.45×2928 = $165,289.28
Value of the portfolio = ( $90.90  7273 ) + ( $56.45  2928 ) = $826,446.38
 $661,157.1   $165,289.28 
Duration of the portfolio =  ( 5 − 4 ) +  $826,446.38 (10 − 4 ) = 2 years
 $826,446.38   
Duration of liabilities = (6-4) = 2 years.
Since the duration of assets matched the duration of liabilities, the investor is immunized
from price risk arising due to interest changes.
Chapter: 22

34. A $1,000 par bond has an annual coupon rate of 12% with semi-annual coupon
payments and has a 5-year maturity. Assuming a flat yield curve of 10%, what is the
bond's duration?
Answer:
Effective semi-annual rate = (1+ 0.1)0.5 − 1 = 4.881%
P0 of the bond is the present value of all the cash-flows of the bond.
 1 
1− N −1 
P0 = A 
(1+ i )  + PV of Terminal value
 i 
 
 
 1 
1− 9 
= 60 
(1.04881)  +  (1000 + 60  = $1086.92
 
 0.04881   (1.04881)10 
   
 
T
tC(t) 60 60 1060

(1+ i ) (1.4881) (1.04881) (1.04881)
t 1 2 10
t =1
D= = + + ...... + = 3.95 Years
P0 1086.92 1086.92 1086.92
Chapter: 22
35. You have been asked to estimate the duration of a ten-year, 8% coupon bond
with a yield to maturity of 10%. It has a sinking fund provision where 10% of the
outstanding bonds will be retired each year. What is the duration of this bond?
Answer:
To calculate the duration of the bond let us assume that the bond is a $100 par, with
coupons being paid annually.
Annual cash-flow for the investor would be coupon payment of $8 plus 10% of
outstanding value.
The following table shows the computations of cash flows and their present values to the
investor.
Years 1 2 3 4 5 6 7 8 9 10
Coupon 8 8 8 8 8 8 8 8 8 8
Outstanding value 100.00 90.00 81.00 72.90 65.61 59.05 53.14 47.83 43.05 52.65
Sinking fund payout 10.00 9.00 8.10 7.29 6.56 5.90 5.31 4.78 4.30 52.65
Total cash-flows 18.00 17.00 16.10 15.29 14.56 13.90 13.31 12.78 12.30 60.65
PV of cash-flows 16.36 14.05 12.10 10.44 9.04 7.85 6.83 5.96 5.22 23.38

Edition
P0 of the bond is the present value of all the cash-flows of the bond = $111.24
The duration of a coupon paying bond can be calculated using
T
tC(t)

(1+ i )
t
t =1
D=
P0
18 14.04 60.65
(1.1) (1.1) (1.1)
1 2 10
+ + ...... + = 5.314 years

111.23 111.23 111.23
Chapter: 22
36. You are evaluating the riskiness of a government bond with a coupon rate of 8%
and a maturity of 5 years. If the current yield to maturity is 10%, what is the duration of this
bond?
Answer:
We assume a $100 par, semi-annual coupon paying bond.
Effective semi-annual rate = (1 + 0.1)0.5 − 1 = 4.881%
Price of the bond is the present value of the cash flows from a bond.
It can be calculated using
4 4 4 104
+ + ..... + = $93.15
(1.04881) (1.04881) (1.04881) (1.04881)
1 2 9 10
T
tC(t)

(1+ i )
t
t =1
Duration of the above bond can be calculated using D =
P0
(1)4 (2)4 (10)104
(1.104881) (1.104881) (1.104881)
1 2 10
= + + ..... + = 4.184 Years

93.15 93.15 93.15
Chapter: 22
37. You are the CFO of a small corporation and you anticipate that you will have a
significant liability of $10 million coming due in five years. You are considering investing
enough money in one or both of the following two bonds to protect yourself against
interest rate risk: a five-year bond with a coupon rate of 16%, and a ten-year bond with a
coupon rate of 12%. Each bond has a yield to maturity of 12%. Assuming duration is a
perfect measure of interest rate risk, what combination of the two bonds would provide
you with complete protection against interest rate risk?

Answer:
To immunize the liability using the duration approach, the duration of liabilities should
be equal to duration of assets (portfolio of bonds)
T
tC (t )
 (1 + i )
t =1
t
Using - D =
P0
Duration for Bond A = 3.88 years
Duration of Bond B = 6.33 years
If x be the weight of investment in Bond A = ( 3.88 x ) + (1− x ) 6.33  = 5
Solving for x, the proportion of investment required in Bond A = 54.287%
Therefore, proportion of investment required in Bond B = 45.713%
Investment required in Bond A = $5,674,269  0.54287 = $3,080,390
Investment required in Bond B = $5,674,269  0.457143 = $2,593,878
c (t )
P0 = 
t (1 + y )
t
Using -
Price of Bond A = $114.42
Price of Bond B = $100
Number of Bond A required to be purchased = $3,080,390/$114.42 = 26,922

Number of Bond B required to be purchased = $2,593,878/$100 = 25,939
Chapter: 22
38. Assume that the yield curve is currently flat at 12.5% and that you are considering
the following four investments, all of which are currently selling for $100, for a holding
period of four years: a series of one-year securities with coupon rate = yield to maturity; a
four-year zero-coupon bond; a five-year bond that pays coupons of $12.50 per year; a
perpetuity.
a. What is the duration of each investment?
b. Which investment would you choose for complete immunization?
c. Calculate the rate of return on each investment if interest rates go up to
20%; do the same if interest rates go down to 5%. How does this relate to
the duration measure in part a?
Answer:
A series of one-year securities with coupon rate = yield to maturity – If $100 is invested
today, the amount received will need to be re-invested at the beginning of the second,
third and fourth years. Receipt of cash flow will only be at the end of fourth year. The
duration of this investment will be, therefore, 4 years.

Edition
A four-year zero-coupon bond – Duration of a zero-coupon bond is always equal to its

maturity. Therefore the duration of this bond will be 4 years.
A five-year bond that pays coupons of $12.50 per year – Duration of a bond with coupon
T
tC (t )
 (1 + i )
t =1
t
of $12.5 and a YTM of 12.5% can be calculated using D =

P0 ; 4 years.
 (1 + i ) 
Perpetuity – Duration of a perpetuity can be calculated using -  ;
 i 
 (1.125 ) 
  = 9 years.
 0.125 
b.
The duration of the series of one year securities and the coupon bond will change with
the change in the interest rates. However, it will remain constant for the zero-coupon
bond. Therefore, the zero-coupon bond is the best investment for complete
immunization.
c.
If Interest rates change to 20% -
A series of one-year securities - An investment of $100 with a return of 12.5% in the first
year and 20% for the next three years will grow to;
100 1.125  (1.2 )3  = $194.4.
 
 194.4 1/4 
There rate of return on investment =   − 1 = 18.08%
 100  
Since, the cash inflow is only at the end of four years, the duration of the investment still
remains 4 years.
A four-year zero-coupon bond – A subsequent change in interest rates will not change
the return on the investment if the bond is held to maturity. Therefore, the rate of return
remains at 12.5% while the duration will be 4 years.
A five-year coupon paying bond – At 5% Coupon payments of $12.5 grows

= 12.5  (1.2 ) + 12.5  (1.2 ) 12.5  (1.2 ) 12.5 = $67.1
3 2 1
 
 112.5  
Price of the bond at the end of 4 years =    = $93.75
 1.2  
Total cash flow at the end of 4 years = $67.1 + $93.75 = $160.85

 160.85 1/4 
Rate of return;   − 1 =12.617 %
 100  
Duration of a bond with coupon of $12.5 and a YTM of 20% can be calculated using
T
tC (t )
 (1 + i )
t =1
t
D= =3.86 years
P0
 A   12.5 
Perpetuity – Price of the perpetuity at YTM of 12.5% =   ;  = $100
 i   0.125 
 A  12.5 
Price of the perpetuity at YTM of 20%=   ;  = $62.5
 i   0.2 
At 20% Coupon payments of $12.5 grows
= 12.5  (1.2 ) + 12.5  (1.2 ) 12.5  (1.2 ) 12.5 = $67.1
3 2 1
 
 129.6 1/4 
Rate of return;   − 1 = 6.7%
 100  
 (1.2 ) 
Duration of the perpetuity =   = 6 years.
 0.2 
If Interest rates change to 5% -
A series of one-year securities - An investment of $100 with a return of 12.5% in the first
year and 5% for the next three years will grow to;
100 1.125  (1.05 )3  = $130.23
 
 130.23 1/4 
There rate of return on investment =   − 1 = 6.83%
 100  
Since, the cash inflow is only at the end of four years, the duration of the investment still
remains 4 years.
A four-year zero-coupon bond – A subsequent change in interest rates will not change
the return on the investment if the bond is held to maturity. Therefore, the rate of return
remains at 12.5% while the duration will be 4 years.
A five-year coupon paying bond – At 5% Coupon payments of $12.5 grows

= 12.5  (1.05 ) + 12.5  (1.05 ) 12.5  (1.05 ) 12.5  = $53.87
3 2 1
 
 112.5  
Price of the bond at the end of 4 years =    = $107.14
 1.05  

Edition
 161.02 1/4 
Rate of return;   − 1 =12.65 %
 100  
Duration of a bond with coupon of $12.5 and a YTM of 5% can be calculated using
T
tC (t )
 (1 + i )
t =1
t
D= = 4.14 years
P0
 A   12.5 
Perpetuity – Price of the perpetuity at YTM of 12.5%=   ;  = $100
 i   0.125 
 A  12.5 
Price of the perpetuity at YTM of 20%=   =  = $250
 i   0.05 
At 5% Coupon payments of $12.5 grows
= 12.5  (1.05 ) + 12.5  (1.05 ) 12.5  (1.05 ) 12.5  = $53.87
3 2 1
 
Total cash flow at the end of 4 years = $53.87 + $250 = $303.88
 303.88 1/4 
Rate of return =   − 1 = 32.03%
 100  
 (1.05 ) 
Duration of the perpetuity =   = 21 years.
 0.05 
Chapter: 22
39. Assume bond returns are given by a single-index model where the index is the
percentage change in 1 plus the interest rate.
a. What is the appropriate measure of how bond returns are affected by the
index?
b. If the above model is used as a return-generating process, what is the
corresponding APT model?
Answer:
a.
Returns on bonds are comprised of interest income and price changes. Price changes in
a bond occur due to shifts in the term structure. However, the sensitivity of changes in the
price due to interest rates movements is different for each bond. This measure of
sensitivity is known as duration.
A single index model defines the returns on a bond as –
Ru =  + (− D )i
Where,
Ru
= return on a bond
 = return on a bond considering yield curve remains unchanged
D = duration

 d (1 + i ) 
 
i = proportional change in the interest rate  1 + i 
The rate of change in the interest rate can be captured by

(1 + i ) . However, the
denominator in the i equation of

(1 + i )
is used to reflect the change of duration to
modified duration.
Minus duration time the proportional change in one plus interest rate is the sensitivity of
the returns on the bond due to unanticipated price movements as a result of changes in
the interest rates.
The duration of a bond depends on how early cash flows occur in the life of a
bond. Therefore a zero coupon bond will always have a duration equal to its maturity
while duration will less than the maturity for a coupon paying bond.
b.
The Arbitrage pricing theory is a return-generating process that relates the returns on a
security to movement of more than one common and correlated factor.
While a bond’s sensitivity to interest rates can be measured by duration, it is a good
approximation in the local neighbourhood only. Duration is a linear measure of sensitivity
while the relationship between a bond price and interest rates is non-linear. An impact of
larger interest rate shock can be measured using convexity.
An APT model describing the returns of a bond can be represented as –

Ri = 0 + 1bi1 + 2bi 2 + i
Where,
Ri = Expected return on bond
0 = Expected return on bond assuming interest rates remain constant
1 = change in interest rates
bi1
= duration
2 = change in interest rates
bi 2
= convexity
i = error term with expected mean of zero.
According to this model,

0 is the yield to maturity of the bond at the time of purchase of

the bond. i1 is the increase in expected return for a one-unit increase in 1 . i is the error
b
term in the model and represents the random variations in the returns. It has an expected
mean of zero. Although, both duration and convexity are approximations, sensitivity of
bond prices to interest rates can be fairly accurately predicted using both the
parameters.
Chapter: 22

Edition
40. Assume you want to get a 5-year mortgage on your house and that the yield
curve is flat at 10%.
a. If you want to pay back the mortgage in 5 equal annual installments of
$1,000, how much can you borrow?
b. What would be the duration of the above mortgage?
Answer:
a.
Amount that can be borrowed for five equal instalments of $1000 can be
     
 1−  1     1−  1   
   (1+ i )n       (1.1)5   
     = 1000    
calculated using = A  = $3790.78
 i   0.1 
   
   
   
T
tC(t)

(1+ i )
t
t =1
Duration of the above mortgage can be calculated using D =
P0
1000 1000 1000 1000 1000
(1.1) (1.1) (1.1) (1.1) (1.1)
1 2 3 4 5
+ + + + = 2.81Years
3790.78 3790.78 3790.78 3790.78 3790.78
Chapter: 22
41. Assume that the yield curve is flat at 10% and that the expectations theory of the
term structure holds. For a bond with 5 years to maturity, an annual coupon rate of 20%,
and semi-annual coupon payments occurring at the middle and end of each year, what
is the duration as of the beginning of year 3 just after a coupon payment?
Answer:
Since the yield curve is flat and the expectations theory holds, the 6 months spot rate will
be = (1 + 0.1)0.5 − 1 = 4.881%
Price of Bond at the end of 3 years is the present value of the cash flows for the next two
years at the beginning of the fourth year.
c (t )
P0 = 
(1+ y )
t
Using - t
10 10 10 110
P0 = + + + = $118.21
(1.04881) (1.04881) (1.04881) (1.04881)
1 2 3 4

T
tC(t)

(1+ i )
t
t =1
D=
Duration of the bond at the end of 3 years will be P0
10 10 10 110
(1.0488 ) (1.10488 ) (1.10488 ) (1.10488 )
1 2 3 4
D= + + + = 1.765 Years
118.21 118.21 118.21 118.21
Chapter: 22
42. Consider the following data for a stock and a call option on that stock: S0 = $50, S1
= $75 or $100, E = $50, and r = 1.10. Derive the hedge ratio (α) and the price of the call
option.
Answer:
If the stock rises to $100, the intrinsic value of the call is $50 and if it rises to $75, the intrinsic
value of the call is $25
S u = 100
S d = 75
Cu = 50
Cd = 25
Su − S d 100 − 75
Hedge ratio = ; =1
Cu − Cd 50 − 25
50
Minimum amount required to be borrowed to set up a hedge = = $45.45
1.1
Price of the call = HR ( Stock price – Amount borrowed) = 1 ( 50 − 45.45 ) = $4.545
Chapter: 23
43. Consider the purchase of a put option with an exercise price of $40 and a cost of
$5 and the purchase of a call option with the same expiration date and on the same
stock with an exercise price of $45 and a cost of $6. Graph the profit of this combination.

Edition
Be sure to label all points.
Answer:
a.
Stock price Payoff from call Payoff from put Net pay-off
10 0 30 19
15 0 25 14
20 0 20 9
25 0 15 4
30 0 10 -1
35 0 5 -6
40 0 0 -11
43 0 0 -11
45 0 0 -11
47 2 0 -9
50 5 0 -6
55 10 0 -1
60 15 0 4
65 20 0 9
70 25 0 14
75 30 0 19
25
20
15
10
5 Series1
0
10 15 20 25 30 35 40 43 45 47 50 55 60 65 70 75
-5
-10
-15
Chapter: 23
44. Consider a portfolio consisting of long positions in both 6-month Treasury bills and
call options. What is the payoff pattern (potential cash flows) and what is this portfolio
equivalent to? (Hint: Use put-call parity.)
Answer:
A portfolio consisting of long positions in call and an amount equal to present value of
the strike price invested in bonds, will always generate a payoff equivalent to a portfolio

consisting of a stock and a put (on the same stock, for the same strike price and same
maturity).
Let us consider two portfolios –

Portfolio 1 - consisting of a long position call and a long position in a bond with payoff at
maturity equal to strike price.
Portfolio 2 - consisting of a long position in put and a long position in stock.
Where,
S 0 = Stock price
E = Exercise price
E
= Long position in bond
(1 + r )
C = Call price
P = Put price
S1 = Stock price at maturity
The following table shows the payoffs for both the portfolios considering two scenarios;
call ends in-the-money and call ends out-of-the money.
If S1 > E
Portfolio 1 Payoff Portfolio 2 Payoff
Bond E Long put 0
Call S1 - E Stock S1
Payoff E + S1 - E Payoff 0+ S1
Net Payoff S1 Net Payoff S1
If S1 < E
Bond E Long put E - S1

Call 0 Stock S1
Payoff E +0 Payoff E
Net Payoff E Net Payoff E
Similarly, the payoffs for the portfolio can also be checked using the put option ending in-
the-money and out-of-the money.
Chapter: 23
45. Consider the following table of partial cash flows:
t=0 t=1
S1 = $50 S1 = $70
put ? $10 0
stock $60 $50 $70

Edition
Assume that the risk-free rate over the period is 10% and price the put option.
Answer:
Given the stock can go up to $70 and go or down to $50
 70 
u =   = 1.167
 60 
 60 
d =   = 0.833
 50 
a = ert
Assuming the time period between T1 and T0 is 1 year r = 1.1
a−d 1.1− 0.833

Risk neutral probability; p = = = 0.8
u − d 1.167 − 0.833
(1 − p) = (1-.8) = 0.2
At the end of one year, if the stock ends at $70, the option is out-of-money and the value
of the option is zero. If the stock ends at $50, the intrinsic value of the put is $50.
Therefore, price of the put option today = ( 0.8155  0 + 0.1845  10 ) e
−(0.1*1)
= $1.669
Chapter: 23
46. You are convinced that the next three months are going to be boom or bust
months for IBM. Foreseeing a major increase or decrease in the stock price, you set up a
position in options where you buy July 120 calls at $8.75 and you buy July 120 puts at
$8.25. IBM is currently selling for $119.
a. Draw the payoff diagram of cash flows on this position.
b. What are the break-even points on the upside and downside of this
position?
c. Now assume that IBM has a variance of 0.08. Using the Black-Scholes
model to value these two options, do you still think that you should take the
above position? Why or why not? (Today is December 21, 2002; the options
expire on July 18, 2003; the annualized riskless rate is 6%; ignore dividends.)
d. What is the implied variance in the July 120 call?
Answer:
a.
Total premium cost = $8.75 + $ 8.25 = $ 17

Pay-off table –
Stock price Pay-off from call Pay-off from put Net pay-off
90 −8.75 21.75 13
95 −8.75 16.75 8
100 −8.75 11.75 3
105 −8.75 6.75 −2
110 −8.75 1.75 −7
115 −8.75 −3.25 −12
120 −8.75 −8.25 −17
125 −3.75 −8.25 −12
130 1.25 −8.25 −7
140 11.25 −8.25 3
145 16.25 −8.25 8
150 21.25 −8.25 13
160 31.25 −8.25 23
b.
Break-even point – Upside = Current stock price + Premium cost
= $120 + $17 = $137
Break-even point – Downside = Current stock price - Premium cost
= $120 − $17 = $103
c.
S = $119; E = $120; Variance = 8%; Risk-free rate = 6%; Expiration date = 07-18-2003
Annualized time to expiry = 209/365 days = 0.5726 years
 1 
ln ( S0 / E ) +  r +  2  t
 2 
d1 = = 0.228437
 t
N(d1) = 0.5910

Edition
 1 
ln ( S0 / E ) +  r −  2  t
 2 
d2 = = 0.014408
 t
N(d2 ) = 0.508
E
C = S0 N ( d1 ) − N ( d2 ) = $11.428
ert
N(−d1) = 0.409
N(−d2 ) = 0.492
E
P= N ( −d2 ) − S0 N ( −d1 ) = $8.375
ert
Since both the call and put are trading below their intrinsic value - both the option can
be purchased.
d.
Using trial and error in the Black-Scholes model, an implied volatility of 20.01% gives the
market price of $8.75.
Chapter: 23
47. The following is a listing of option prices on Perdida Enterprises on December 12,
2002:
calls puts
strike price Dec. Jan. Feb. Dec. Jan. Feb.
40 6.00 6.82 7.50 0.125 0.50 0.75
45 1.125 2 2.875 0.375 1.125 1.50
50 0.0625 0.43 0.875 4.50 5.00 5.25
The current stock price is 45.75, and the riskless rate is 7%.
a. Consider the following position: sell one January 40 call; buy two January 45
calls; sell one January 50 call. Evaluate the net cash flows on this position at
expiration for different stock prices, and draw a payoff diagram.
b. Are the three January put options correctly priced relative to the
corresponding call options? (Assume that there are 42 days on the January
option.)
Answer:
a.
Net premium form the positions would be 6.82 − ($2  2) + $0.43 = $3.25
The payoff at different closing prices would be:
Closing Payoff on Payoff on Payoff on Net payoff

stock price E=40 E=45 E=50
36 0 0 0 3.25
38 0 0 0 3.25

40 0 0 0 3.25
42 -2 0 0 1.25
44 -4 0 0 -0.75
45 -5 0 0 -1.75
46 -6 1 0 -1.75
48 -8 3 0 -1.75
50 -10 5 0 -1.75
52 -12 7 -2 -3.75
54 -14 9 -4 -5.75
56 -16 11 -6 -7.75
58 -18 13 -8 -9.75
60 -20 15 -10 -11.75
b.
According to the put call parity relationship, the prices of the puts can be calculated
E
by = P = C − S0 +
(1+ r )
t
Prices of puts under

Strike Price Price of call parity Market prices
40 6.82 0.750382671 0.5 Underpriced
45 2 0.890430505 1.125 Overpriced
50 0.43 4.280478339 5 Overpriced
Chapter: 23
48. An investment bank has come up with a new product on the S&P 500 index. It
offers an appreciation share, the owner of which is entitled to all price appreciation over
10% in the first two years and over 20% in the next three years after that. If the current
index value is 250, the riskless rate is 8%, the dividend yield on the index is 3%, and the
annualized standard deviation of the index is 20%, what is the value of this share? (Hint:
There might be more than one option in this share.)
Answer:

Edition
The value of option at each node is calculated using the probability of the option being
in the money considering all possible paths as shown below.
Present value of the option at the end of year 1 –
( 0.5775×30.35+0.4225×0 ) = $16.23
(1+0.08)1
Present value of the option at the end of year 2 –
( 0.5775 ×37.07+0.4225×.5775×24.85) = $15.79

2
(1+0.08)2
Similarly, the PV of option can be calculated for each year.
Therefore the value of the option = $39.82
Chapter: 23
49. Suppose you are holding the following portfolio: 100 shares of XYZ stock plus a call
option contract for 100 shares of XYZ with exercise price of 50 and a June expiration date
plus a put option contract for 100 shares of XYZ with exercise price of 40 and a June
expiration date.
a. What will this portfolio be worth on expiration date if XYZ is at 35? At 45? At
55?
b. Can this portfolio ever be worth less than $3500? Can it be worth more than

$10,000? Explain.
c. Answer the questions in part a and part b if your portfolio involves a short
position in the call option contract instead of a long position. (I.e., you are
long 100 shares of stock and the put contract, and short the call option
contract.)
Answer:
a.
The portfolio will have the following payoff:
Pay off from - Stock Call Put Portfolio Value

Stock price
$35 $3500 $0 $500 $3500
$45 $4500 $0 $0 $4500
$55 $5500 $500 $0 $6000
b.
The floor value of the portfolio would be $4,000, as any fall in the price of the stock below
$40 would be offset by a gain on the put option. Upside potential on the portfolio is
theoretically unlimited. A rise in the stock price would result in profits on the stock as well
as call option.
c.
Having a short call position instead of long call will have the following pay-off
Pay off from - Stock Call Put Portfolio Value

Stock price
$35 $3500 $0 $500 $4000
$45 $4500 $0 $0 $4500
$55 $5500 $−500 $0 $5000
The maximum that this portfolio can gain is $5000 as gains beyond $50 would be capped
by a loss on short position on the call. The maximum loss on this portfolio will be $4000 as
any loss below $40 would be offset by a gain on long position in put option.
Chapter: 23
50. You have just learned through the grapevine that Pfizer (currently at $50.625 per
share) may be a takeover candidate at $65 per share. You would like to speculate on
the rumor, but you are worried that the stock will drop significantly if the rumor is false.
Therefore, you have decided to use options to exploit this information. You are given the
following option data for today, May 15th:
calls puts
strike price May June Sept. May June Sept.
45 s 5.825 7.375 s r 1.125
50 1.25 2.50 4.50 0.75 1.8125 3.00
55 0.1875 0.8125 2.25 4.875 5.00 5.625

Edition
60 0.0625 0.375 1.125 9.75 9.875 r

65 r 0.125 0.75 r 15.00 15.00
a. Set up an option position that will best exploit the information you have,
assuming that the takeover will happen by September 16 (the expiration
day of the September options).
b. Assume now that the annualized standard deviation of Pfizer's stock price is
0.40 and that the six-month T-bill rate is 6%. Furthermore, assume that Pfizer
pays a quarterly dividend of 50 cents and that the dividends are paid in
April, July, October and January. What would your Black-Scholes estimates
be for the options in the position that you have described in part a?
c. If the beta of Pfizer stock is 1.0, what is the beta of the position that you
have set up in part a?
d. What are the deltas of the options that you have chosen for your position?
Answer:
a.
The investor wants to participate on the up-move but is worried about the protection if
the rumour is false. Since the take-over price is $65 and the news is correct the stock is
likely to trade at around $65. Setting up a strategy for a target price of $65 and
protecting the downside would be an ideal strategy. Also a further upside to $65 cannot
be ruled out. Under the given scenario, a short position in September $65 put, a long
position in September $50 put and a long position in September $65 call would be an
optimal strategy. It ensures immediate cash inflow of $11.25 and would be the net profit if
the stock price ends up at $65. If it falls below $65, the put is likely to be exercised. A long
put position on the $50 strike would ensure that the downside is limited while a long
position on the $65 call would ensure participation in any upside beyond $65.
Premium inflow on short $65 put = $15

Premium outflow on long $50 put = $3
Premium outflow on long $65 call = $0.75
Net premium inflow = $11.25
The following is the payoff table for the investor under various possible closing stock price.
Payoff from -
Stock price Short Sep $65 put Long Sep $50 put Long Sep $65 call Net payoff
25 -40 25 0 -3.75
30 -35 20 0 -3.75
35 -30 15 0 -3.75
40 -25 10 0 -3.75
43 -22 7 0 -3.75
45 -20 5 0 -3.75
47 -18 3 0 -3.75
50 -15 0 0 -3.75
52 -13 0 0 -1.75
55 -10 0 0 1.25

54 -11 0 0 0.25
55 -10 0 0 1.25
56 -9 0 0 2.25
58 -7 0 0 4.25
60 -5 0 0 6.25
62 -3 0 0 8.25
64 -1 0 0 10.25
65 0 0 0 11.25
66 0 0 1 12.25
68 0 0 3 14.25
70 0 0 5 16.25
75 0 0 10 21.25
80 0 0 15 26.25
85 0 0 20 31.25
b.
Dividend payment of $0.40 during the life of the September option occurs only once (in
July)
Time to expiry = 4 months = 4/12 years
 2
−  
 12 
Assuming dividend is paid on July 15th - Present value of the dividend = 0.5e =
$0.495
Stock price to be considered = S 0 − I = $50.625 – 0.495 = $50.13
For $65 put option –
 1   50.13   1  4 
ln ( S0 / E ) +  r +  2  t ln   +  0.06 +  0.42  
d1 =  2 
; 
65   2  12  = -0.8802
 t  4
0.4  
 12 
 1   50.13   1  4 
ln ( S0 / E ) +  r −  2  t ln   +  0.06 −  0.42  
d2 =  2 
; 
65   2  12  = -1.111
 t  4
0.4  
 12 
N(-d1) = 0.8106
N(-d2) = 0.8667
65
Value of the put ; (0.06 4/12)
 0.8667 − 50.13   = $14.58
e
For $50 put option –

Edition
 1   50.13   1  4 
ln ( S0 / E ) +  r +  2  t ln   +  0.06 +  0.42  
d1 =  2 
; 
50   2  12  = 0.2558
 t  4
0.4  
 12 
 1   50.13   1  4 
ln ( S0 / E ) +  r −  2  t ln   +  0.06 −  0.42  
d2 =  2 
; 
50   2  12  = 0.0249
 t  4
0.4  
 12 
N(-d1) = 0.3990
N(-d2) = 0.4900
50
Value of the put ; (0.06 4/12)
 0.4900 − 50.13   = $3.817
e
For $65 call option –
 1   50.13   1  4 
ln ( S0 / E ) +  r +  2  t ln   +  0.06 +  0.42  
d1 =  2 
; 
65   2  12  = -0.8802
 t  4
0.4  
 12 
 1   50.13   1  4 
ln ( S0 / E ) +  r −  2  t ln   +  0.06 −  0.42  
d2 =  2 
; 
65   2  12  = -1.111
 t  4
0.4  
 12 
N(d1) = 0.1893
N(d2) = 0.1332
E
Value of the call option; C = S0 N ( d1 ) − N ( d2 )
ert
65
C = 50.13×0.1893 − (0.06*4/12)
×0.1332= $1.09
e
c.
Beta of an option portfolio would be weighted average of the delta of the options in
the portfolio –
Total exposure in three options = $65 + $50 + $65
= $180
 65   50   65 
  −0.8106  +   −0.3990  +   −0.1893 
Beta of the portfolio =  180   180   180  = -0.3351
d.
Delta of $65 strike put = N(d1)-1 = -0.8106
Delta of $50 strike put = N (d1)-1 = 0.3990

Delta of $65 strike call = N (d1) = 0.1893
Chapter: 23
51. The trade deficit numbers are expected out on February 19, and you think that
market will move a lot, either up or down. You want to take advantage of this using
options. You are given the following stock-index option data for today, January 14 (the
current level of the index is 236.99, and the annualized T-bill rate is 6%):
calls puts
strike price Jan. Feb. March Jan. Feb. March
230 8.625 14.25 17.625 1.625 9 10.625

235 5 11.5 17.75 3.125 10.75 13.25
240 2.25 8.75 12.75 5.5 12.75 14.5
245 0.875 6.5 10 9.5 14 18
250 0.3125 4.5 8.25 13.5 17.75 19.5
255 0.125 3.125 7.5 17.75 20.5 20
a. Find at least two options in the above listing that violate arbitrage
conditions.
b. How would you set up a position using February options to take advantage
of the volatility from the trade deficit numbers? (The February options expire
on the evening of February 19.)
c. What are the breakeven points for the position in part b? (You can draw a
payoff diagram if you want to.)
d. Assume no dividends are paid and that the variance in the stock index is
0.09, and use the Black-Scholes model to value the February 235 call and
the February 235 put.
Answer:
 35 
Time to expiration for the February contract is 35 days;  = 0.0956 years.
 365 
According to the put-call parity relationship –
C + Xert = P + S0 ;
For February $235 strike, price of the put should be - P = C + Xert − S0 ;
P = 11.5 + 235e(0.06) − 236.99 = $8.16
For February $240 strike, price of the put should be - P = C + Xert − S0 ;
P = 8.75 + 240e(0.06) − 236.99 = $10.38
Assuming the calls are correctly price according to the black-scholes model, both the
puts violate arbitrage conditions.
b.

Edition
If a trader expects huge volatility in the market, but is unsure of the direction, a long
straddle is an ideal strategy. Buying near-the-money (strike price of $235 or $240) one call
and one put option would set up a position to gain from a move on the either side.
c.
Assuming a long straddle at strike $240 –
Premium cost on call = $8.75
Premium cost on Put = $8.75
Total cost = $21.5
Breakeven price on the upside = $240 + $21.5 = $261.5
Breakeven price on the upside = $240 - $21.5 = $218.5
The following is the payoff table for the trader at various closing index levels –
d.
For February $235 call –
 1 
ln ( S0 / E ) +  r +  2  t
d1 =  2 
 t
 236.99   1 
ln   +  0.06 +  0.09  0.096
d1 = 
235   2  = 0.19915
0.3 0.096
 1 
ln ( S0 / E ) +  r −  2  t
d2 =  2 
 t
 236.99   1 
ln   +  0.06 −  0.09  0.096
d2 = 
235   2  = 0.10625
0.3 0.096
N(d1) = 0.5789
N(d2) = 0.5423
N(-d1) = 0.4210

N(-d2) = 0.4576
Value of the call option

E
C = S0 N ( d1 ) − N ( d2 )
ert
235
C = S236.99×0.5789- (0.06×0.0956)
×0.5423 = $10.4885
e
Value of the Put option

E
P= N ( −d 2 ) − S0 N ( −d1 )
ert
235
P = (0.06×0.096) ×0.4576-236.99×0.4210=$7.15
e
Chapter:
52. Leland, O'Brien and Rubinstein (who invented portfolio insurance) came up with a
product called "supershares." The product works as follows. It starts with two conventional
funds: an index fund owning stocks in the S&P 500 and a money-market fund.
The index fund is divided into two securities. One of those securities is called a "dividend
share" and gives the holder the right to all dividends paid during three years and all price
appreciation up to 25% during those three years. The other security is called an
"appreciation share" and gives the holder the right to all price appreciation above 25%
during those three years.
The money-market fund is also divided into two securities. One of those securities is called
a "money market income supershare" and the other security is called a "protection
supershare". The money market supershare gives the holder the right to all interest income
during three years. At the end of those three years, the holder may also get back some or
all of the principal value, depending on how well the stock market performs. For every 1%
that the S&P 500 has fallen below its current level, the principal value payable to the
holder of a money market supershare is reduced by 1% and is instead paid to the holder
of a protection supershare (which also has a three-year lifetime).
Assume that the current level of the S&P 500 index is 277, that the standard deviation of
the index is 25%, and that the average dividend yield on the index is 4%. Also assume that
the current six-month T-bill rate is 8% (which is also the rate on the money-market
account) and that money-market fund securities are in units of $100.
(Hints: Remember that the value of the dividend share plus the appreciation share equals
the current level of the S&P 500 index and that the value of the money market income
supershare plus the protection supershare equals the value of the money market fund.
Also, you can adjust for dividends in the Black-Scholes formula by subtracting the
dividend yield from the riskless rate and then using this adjusted rate instead of the riskless

Edition
rate in the formula.)

a. Estimate the value of the appreciation share.
b. Estimate the value of the dividend share.
c. Estimate the value of the protection supershare.
d. Estimate the value of the money market income supershare.
Answer:
a.
The value of an appreciation share can be treated like the value of a call option, since
the investor receives benefits only if the underlying asset moves above a certain price.
Since the investor will receive the benefits of the price appreciation only above 25%, the
strike of the call option to the investor becomes ( 277  1.25 ) = $346.25
 1   277   1 
ln ( S0 / E ) +  r − q +  2  t ln   +  0.08 − 0.04 + 0.252  3
d1 =  2   346.25   2 
 t 0.25 3
= − 0.0217
 1   277   1 
ln ( S0 / E ) +  r − q −  2  t ln   +  0.08 − 0.04 − 0.252  3
 2   346.25   2 
d2 =
 t 0.25 3
= 0.4547
N(d1) = 0.4913
N(d2) = 0.3246
E  346.25 
Value of the call; C = S0 N ( d1 ) − rt
N ( d2 ) ( 277  0.4913 ) −  (0.08*3)  0.3246 
e = e 
= $47.65
b.
Given that the value of the dividend share plus the appreciation share equals the current
level of the S&P 500 index;
Value of dividend share = $277 − $47.65 = $329.325
c.
Protection supershare gains its value only if the underlying falls in value from the current
levels. It can therefore, be valued as a put option with a strike price of $277
 1   277   1 
ln ( S0 / E ) +  r − q +  2  t ln   +  0.08 − 0.04 +  0.252  3
 2  =  277   2 
d1 =
 t 0.25 3
= 0.4936
 1   277   1 
ln ( S0 / E ) +  r − q −  2  t ln   +  0.08 − 0.04 −  0.252  3
 2   277   2 
d2 =
 t 0.25 3

= 0.0606
N (-d1) = 0.3107
N (-d2) = 0.4758
E
Value of the protection share = P = N ( −d2 ) − S0 N ( −d1 )
e(r )t
 277 
=  (0.08*3) ×0.3107 - ( 277×0.4758 )
e 
= $17.595
d.
Value of money market supershare can be taken as a long position in a bond and a
short position in the put (value of the protection share).
Therefore, value of the share will be $100 - $17.595 = $82.405
Chapter: 23
53. You are interested in putting together an option position on Flaming Yon, Inc. The
current stock price is 58.25, and The Wall Street Journal of December 11, 2002, reports the
following prices for the various listed options on the stock:
calls puts
strike price Dec. Jan. Feb. Dec. Jan. Feb.
50 8.25 9.25 r 0.125 0.75 1.125
55 4 5.5 r 0.68 1.82 2.00
60 0.625 1.625 2.06 2.25 2.75 3.5
a. Assume that you buy a January 50 call and a January 60 put. Draw the
payoff diagram for this position at maturity.
b. What are the upside and downside breakeven points for this position?
Answer:
a.
Cost of Jan 50 call 9.25
Cost of Jan 50 put 0.75
Total premium cost 10
The payoff from long positions on both the options can be shown as –
Stock price at expiration Payoff from call Payoff from put Net pay-off
30 0 20 10
32 0 18 8
34 0 16 6
36 0 14 4
38 0 12 2
40 0 10 0
42 0 8 -2

Edition
44 0 6 -4
46 0 4 -6
48 0 2 -8
50 0 0 -10
52 2 0 -8
54 4 0 -6
56 6 0 -4
58 8 0 -2
60 10 0 0
62 12 0 2
64 14 0 4
66 16 0 6
68 18 0 8
70 20 0 10
Payoff table
15
10
5
Payoff
0
30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 62 64 66 68 70
-5
-10
-15
Prices
b.
Breakeven point – upside = Strike price + total premium cost
= $50 + $10 = $60
Breakeven point – downside = Strike price - total premium cost
= $50 − $10 = $40
Chapter: 23
54. By example, diagram, and/or verbal description, demonstrate how put options
can be used to construct a "floor" under the return on a portfolio of common stocks.
Answer:
Put options gives the buyer a right but not an obligation to sell an asset at a pre-
determined price on or before a pre-specified time. It can hence be used to construct

a floor on a portfolio by synthetically gaining from the downside while the portfolio loses
its value. In the following example, the portfolio manager has used the put options on
Index to limit the downside potential on his portfolio.
Terry is a fund manager who manages a portfolio replicating the S&P index. He is of the
view that the market may witness a downturn in the short term and wants to buy put
options to protect the value of his portfolio. The value of the S&P index is $250 and the
puts on the strike price of $250 are trading at $2. The payoff table for Terry based on the
market movements can be prepared as:
Index level Pay off on put Payoff on portfolio

225 23 -25
230 18 -20
235 13 -15
240 8 -10
245 3 -5
250 0 0
255 0 5
260 0 10
265 0 15
270 0 20
275 0 25
The payoff table shows that if the index falls below $250, the loss on the portfolio is offset
by the gain on the put options position. The difference of $2 in the payoff comes from
the premium paid by Terry for buying the insurance on his portfolio.
Chapter: 23
55. Consider a futures contract on Japanese yen. Derive the relationship between the
spot $/yen exchange rate and the futures contract price. (Hint: Consider an investment in
the riskless asset of each country.)
Answer:
The price of any futures contract is defined by the spot price plus its cost of carry till
expiration. In case of futures contract on currencies the cost of carry is the interest cost
to borrow spot currencies. However, currencies carry an additional benefit of monetary
value that it holds. It can be re-invested in the country of foreign currency.
Let S be the number of yen that can be purchased with one U.S. dollar. Typically
rates for yen-dollar futures are quoted in yen/$ terms. Therefore, the rate used to
convert yen to dollars would be 1/S. Let F be the futures price on yen and the riskless
rate in the foreign currency (dollar) be rd . The dollar bought with one yen (1/S) can be
 1 + rd 
invested at rd . The value of debt at the maturity would be   . This can be
 S 
 1 + rd 
converted back to yen using   F . If the law of one price holds, the return for an
 S 

Edition
investor investing in yen should be equal to the returns that can be generated by
investing in dollars. If the domestic rate on yen is ry -
 1 + rd  
ry =   F  −1
 S  
 1 + ry  
Therefore, the futures price on yen/$ should be ry = F =  S .
  1 + rd  
Chapter: 24
56. Tribbles are soft, furry creatures that reproduce themselves by dividing (like
amoebas do) into two tribbles every 60 days. If a tribble now costs $1, what should be the
price of a forward contract that expires in 60 days (immediately after the reproduction
takes place) for one tribble?
Answer:
Assuming 30 days a month, if one tribble doubles in to two every 60 days – An investor
with one tribble will have 32 tribbles at the end of the year.
 32 
Annual return on continuous compounding will be - ln   ; 346.57%
1
Price of a forward contract can be determined using F0 = (S0 − I )ert
Where S 0 = Spot price
I = Present value of dividends
= Annualized rate of interest
r
t = Time period of the forward contract
Considering the extra tribble received at the end of two months as dividends –
Present value of the dividend = 1 e− ( rt ) = 1 e− (3.462/12) = 0.5612
Price of the forward contract = (1 − 0.5612)e(3.46572/12) = $0.7818
Chapter: 23
57. Assume that one can purchase gold bars or 6-month futures on gold bars.
a. Using the law of one price, derive the relationship between the spot price
of gold and the futures contract price.
b. Assume that the futures are underpriced relative to the contract price just
derived. What action should an investor take?
Answer:
a.
The law of one price states that two assets with same cash-flows should sell at the same
price.

 PV (C ) 
The relationship can be formed as – F0 = P0 (1 + R ) + (1 + R )
 P0 
Where, F0 = Futures contract price
P0 = Spot price
R = Risk free rate of interest
PV (C ) = Present value of cost of carry
b.
If the futures price are underpriced relative to the theoretical price –
At T = 0 At T = 1
1. Buy the gold futures 1. Accept the delivery of gold
2. Sell the spot gold 2. Reverse the short trade in the spot market
3. Invest the proceeds from the sale 3. Collect the proceeds invested in risk-free
of assets
spot gold in risk-free assets
Chapter: 24
58. You are a portfolio manager who has just discovered the possibilities of stock-index
futures. Assume that today is January 12.
a. Assume that you have the resources to buy and hold the stocks in the S&P
500. The current level of S&P 500 index is 258.90, the June S&P 500 futures
contract is selling for 260.15, the annualized rate on the T-bill expiring on the
expiration date of the futures contract is 6%, and the annualized dividend
yield on S&P 500 stocks is 3%. Assume that dividends are paid out
continuously over the year. Is there a potential for arbitrage, and, if so, how
would you go about setting up the arbitrage?
b. Assume now that you are known for your stock selection skills. You have
10,000 shares of Texacola (now selling for 38) in your portfolio, and you are
worried about the direction of the market until June. You would like to
protect yourself against market risk by using the December S&P 500 futures
contract (which is currently at 260.15). If Texacola's beta is 0.8, how would
you go about creating this protection?
Answer:
Assuming the June future has exactly six months to expiration,
Intrinsic value of the S&P futures can be calculated using -

(1 + R ) 
PV ( D)
F = P (1 + R ) −
 P 

Edition
   
  0.03  258.9    
   
  1 +  0.06   
 0.06     
 2     0.06   
F = 258.9 1 +  − 1 +  2    = 262.7835
 2  258.9    
 
 
 
 
Since the futures is trading at 260.15 which is below its fair value, a reverse cash and
carry arbitrage can be set up by short-selling S&P spot index, investing the proceeds in
the riskless assets, and buying the futures.
On the expiration date –

Accept delivery to reverse short position 260.15
Reverse short at 258.9
Interest earned 7.767
Dividend paid to lender of the index 3.8835
Arbitrage gain 2.6335
Chapter: 24
59. Assume that you are a mutual fund manager with a total portfolio value of $100
million. You estimate the beta of the fund to be 1.25. You would like to hedge against
market movements by using stock index futures. You observe that the S&P 500 June
futures are selling for 260.15 and that the index is at 256.90.
a. How many stock index futures would you have to sell to protect yourself
against market risk?
b. If the riskless rate is 6% and the market risk premium is 8%, what return would
you expect to make on the mutual fund (assuming you don't hedge)?
c. How much would you expect to make if you hedge away all market risk?
Answer:
a.
Number of contracts required to hedge away market risk =
 PV 
N = ( P )  
 fp  cs 
100, 000, 000 
N = (1.25 )  = 961.54
 260.15  250 
b.
The portfolio manager needs to sell approximately 962 contracts.
( )
Required rate of return = R f + Rm − R f  = 16%
c.
If the market risk is hedged away, since the beta is zero, the required return = 6%

Chapter: 24
60. Assume that it is now December 2002. You are given the following information:
December 2003 gold futures contract price = 515.60/troy oz.;
spot gold price = 481.40/ troy oz.;
annualized interest rate = 6%;
annualized carrying cost of gold = 2%.
a. The above information presents an arbitrage opportunity. Describe what
you would have to do now to set up the arbitrage.
b. What would you have to do in December to unwind the position in part a?
What is the arbitrage profit?
Answer:
a.
Intrinsic value of the futures contract will be spot price plus the cost of carry –
F0 = S0 1+ ( r + c)  = 481.4 1+ ( 0.06 + 0.02 )  = $519.912
Since the futures price is less than its fair value, a trader can enter in to reverse cash-
and-carry arbitrage. This would mean he will need to sell spot gold and buy the futures.
The proceeds from the short-sale needs to be invested in the riskless securities.
b.
In December 2003, the following steps would ensure an arbitrage profit –
Steps in December 2003 Inflow/(Outflow)

Pay for the gold futures and accept delivery ($515.6)
Reverse short position --
Interest earned $28.884
Savings in storage costs $9.628
Arbitrage gain $4.32
Chapter: 24
61. You have been asked to determine the theoretical bounds on a futures contract
on gold. You are supplied with the following information: spot price of gold = $400/troy
oz.; time to expiration on futures contract = 6 months; riskless rate = 10%; borrowing rate
for marginal investor = 12%; lending rate for marginal investor = 8%; storage costs for gold
= $20/troy oz. per year. Short sellers can hope to recover only half of the storage costs
that they save by short selling.
a. What is the upper bound on the theoretical futures price?
b. What is the lower bound on the theoretical futures price?
c. Assume that investors are required to put up a 10% margin on all futures
transactions and that only cash (no T-bills) can be used to meet margin

Edition
requirements. Evaluate the effect this would have on the upper and lower
bounds you estimated in part a and part b. (Recalculate the new bounds.)
Answer:
a.
 20 
 
PV of storage costs =  2  = $9.52
  0.1 
 1+ 2  
 
 RB 
Upper No-Arbitrage Bound; F0  ( S0 + I ) 1+
 2 
Where, S 0 = Spot price
I = Present value of storage costs
RB = Borrowing costs
0.12 
Therefore, F0  ( 400 + 9.52 ) 1+ 2 
or F0  $434.095

b.
 20  
 2  0.5 
 
PV of the recoverable storage cost =   = $4.76
 0.1
1+ 2 
 
 RL 
Lower No-Arbitrage Bound; F0  ( S0 + I ) 1+
 2 
Where, S 0 = Spot price
I = Present value of storage costs
RL = Lending rate
0.08 
Therefore, F0  ( 400 + 4.76) 1+ 2 
= F0  $420.95

c.
Taking the 0.5% haircut charged by CME on T-bills;
 100  
New effective borrowing rate =   1.12  − 1 = 12.563%
 99.5  
 99.5  
New effective lending rate =   1.08  − 1 = 7.46%
 100  
 RB 
Upper No-Arbitrage Bound; F0  ( S0 + I ) 1+
 2 

0.12563 
Therefore, F0  ( 400 + 9.52 ) 1+ 2  = F0  $435.24
 
 RL 
Lower No-Arbitrage Bound; F0  ( S0 + I ) 1+
 2 
 0.746 
Therefore, F0  ( 400 + 4.76 ) 1+ = F0  $419.86
 2 
Chapter: 24
62. You are examining the pricing of futures on the S&P 500. The spot level of the S&P
500 index is 250, and the riskless rate is 5%. It is January 1, 2003, and the futures contract
expires March 31, 2003. The dividend yield by month of year is as follows:
month: Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
yield: 0.1% 0.1% 0.5% 0.1% 0.1% 0.5% 0.1% 0.1% 0.5% 0.1% 0.1% 0.5%
a. What is the theoretical price of this futures contract?

b. Will this contract ever sell for less than the spot level of the index? If so, what
is the earliest time at which this will happen? (Assume that the riskless rate
and the dividend yield do not change between January 1, 2003, and
March 31, 2003.)
c. Assume now that this contract is correctly priced (= theoretical price) and
that you have a portfolio of $50 million that you would like insured against
market movements until March. If the portfolio has a beta of 1.25, how
would you protect yourself against market risk?
d. Assuming you protect yourself against market movements, what would your
expected return be on the protected portfolio through March 1990?
Answer:
a.
PV of dividends in Jan =
( 250  0.001) = 0.2489
  1 
1+  0.05  12  
  
PV of dividends in Feb =
( 250  0.001) = 0.2479
  2 
1+  0.05  12  
  
PV of dividends in Mar =
( 250  0.005 ) = 1.234
  3 
1+  0.05  12  
  
PV of total dividends during the life of the contract = $1.7314

Edition
 PV(D) 
Using, F0 =P (1+R)- (1+R)
 P 
  3   1.7314   3  
F0 = 250 1+  0.05    − 1+  0.05     = $251.3718
  12   250   12   
b.
Yes, at the end of Feb (with one month to expiration), the futures contract is likely to
trade at discount, because of the negative cost of carry. The monthly risk free rate is
approximately 0.4167%, while the dividend yield is 0.5%
c.
Futures price 251.3719
Spot price 250.0000
Portfolio value 50,000,000
Beta 1.2500
Market risk can be hedged by selling appropriate number of futures contracts on the
 PV 
index. Number of contracts to be sold can be calculated using – N = (βP )  
 fp  cs 
 50,000,000 
or, N = (1.25 )   = 994.54  995 contracts
 251.37 × 250 
d. Since the hedged portfolio has a beta of zero, there will be no gain/loss in the
portfolio due to market movements.
Chapter: 24
63. The only significant cost of storing gold is the interest on the money you have tied
up in it. Suppose you can borrow money at 10% to buy gold and that today's price of
gold is $460 per troy ounce. Gold futures contracts are available now. The future for
delivery in six months is at $480, and the future for delivery in twelve months is at $506.
Devise two ways you might exploit this situation to make an excess profit. Are there risks
involved?
Answer:
 0.1 
Fair value of six month gold contract = 460  1 +  = $483
 2 
Fair value of twelve month gold contract = 460  (1.01) = $506
Option 1-
Since the six month futures are trading below its fair value, we should sell spot gold and
buy the futures. The proceeds from the short sale should be invested in the riskless assets.

After six months –

Close the short position in spot market by accepting delivery from futures contract this
will result in a cash outflow of $480.
 0.1 
Receive proceeds from the investment 460  1 +  = $483
 2 
Arbitrage gain = $483 − $480 = $3
Option 2-
We buy a six month future at $480 today and hold the future contract for the next six
months and simultaneously, we sell a twelve month contract for $506.
Assuming a flat yield curve, Interest rates for six months from now should be 5 percent.
After six months –
Accept delivery of gold 480
Interest cost for Six months
($480*1.05) 24
Total cost after 12 months 504
Inflow from sale of gold after 12
months 506
Profit $2
Option 1 is a riskless arbitrage strategy. In Option 2, the investor assumes Basis risk. It is
the risk that arises from loss due to change in the spread between the six month and
twelve month contracts. If there is any news in the market regarding long term supply
constraints, the prices longer term futures contract will rise more than the six month
contract, widening the basis. Being short on 12 month contract will lose more than the
gain on 6 month contract.
Chapter: 24
64. You want to invest $1 million in the S&P 500 index for one year. There are two ways
to go about it. You could actually buy all the stocks in the index according to their index
investment weights, or you could buy an S&P index futures contract (and put the $1
million in a risk-free investment for one year). The S&P index is now at 350, and an S&P
index future with a one-year maturity is selling at 355. The riskless rate is 8%, and the
dividend yield on the S&P index is 6%. Assume that the S&P contract size is equal to the
index, and that all cash flows to the future occur at maturity (i.e., there is no daily
resettlement).
a. What should you do and why?
b. Under your strategy for part a, how much money will you have at the end
of the year if the S&P index closes at 380?
Answer:
a.
The dividend yield on the S&P is 6% while the risk free rates are 8%. Capital appreciation
and erosion would be approximately equal under both strategies. Since the investment in

Edition
the risk free assets yields two percent extra, one should look to buy futures and invest the
money in riskless assets.
b.
The contract size of S&P futures is equal to the index
 380 
Value of futures position =    $1,000,000 = $1,070,422.5
 355 
Interest earned on riskless assets = $1,000,000 ×(1.08) = $80,000
Total portfolio value = $1,150,422.5
Chapter: 24
Essays
1. Consider a forecast of the next period's earnings. How much information is in past
earnings?
Answer:
There are two types of studies that try to explain the forecast of earnings based on the
behavior of past earnings. One deals with the concept of growth stocks and how much
the past growth influences future earnings. Another school of thought explores the
concept of normal earnings.
A growth stock is one which has had a history of stable and sustained growth in
the past. This leads many to believe that such performance would continue in the future
and future earnings would reflect the past growth. However, a number of studies have
found evidence to the contrary. Lintner and Glauber (1969) studied the correlations
between the growths of a number of companies between different buckets of time
period. The study showed that less than ten percent of variations in future growth rate
was explained by past growth. Brealey (1969) studied the patterns of high-growth stocks
and low-growth stocks on a year-on-year basis. In order for past growth to be an
indicator of future earnings, a stock needs to exhibit sustained periods of growth, high or
low. However, his study concluded that the switch from a high-growth period to low
growth-period and vice-versa was too frequent to base any forecast on the past
earnings. These two studies along with a number of other studies conclude that in a
competitive economy where a number of influences that affect the earnings year-over-
year are beyond management’s control. Thus, past growth may not necessarily be
reflected in future earnings.
The concept of normal earnings assumes two scenarios. First, earnings tend to
revert to their mean over a long-term period and second, forecast earnings are based on
past earnings scaled by growth expectations. In the former, the starting point for forecast
is the mean growth and the latter assumes the starting point of forecast as the previous
earnings. A number of studies by different scholars have concluded contrarian results.
While forecast for some companies were more accurate using mean earnings as a
starting point, forecasts for a number of companies were a lot more accurate when prior

period earnings was used as a starting point.

Results of studies on the time series of earnings and their patterns to forecast future
earnings seem to less than conclusive for any judgment on the impact of past earnings
on the forecasted earnings.
Chapter: 17
2. You are attempting to allocate your time and effort efficiently. Rank the following
markets in terms of likelihood of finding market efficiency, and elucidate the likely
source(s) of inefficiency.
a. The New York Stock Exchange
b. The Over The Counter market
c. Real estate
d. Fine art
e. Baseball cards
f. Government bonds
g. Corporate bonds
h. Foreign stock markets
Answer:
A market is inefficient to the degree that little is known about the future of traded assets
and risk positions. Different classes of assets have different degrees of inefficiencies.
Following classes of assets are ranked in order of most efficient to least efficient.
a. The New York Stock Exchange – Stock trading in the United States are some of the
most tracked securities in the world. A number of professional individuals and institutions
follow and actively research to “dig out” any possible information to exploit economic
value. As such, New York Stock Exchange is considered a highly efficient market. Only
likely source of inefficiency is the marginal cost of acquiring new information that is not
reflected in the price of a security.
b. Foreign stock markets – In a global economic environment where fund managers
in the developed economies are diversifying their portfolios to include stocks listed under
foreign market, the information asymmetry has reduced considerably. A high correlation
in the stock markets around the world testifies the fact. However, there are inefficiencies
with information flow to investors on small stocks. Also, transaction costs and tax structures
are potential sources of inefficiencies.
c. Government bond market in any country is also a well tracked and participated
market. Typically these securities tend to set the benchmark riskless rates of borrowing
and lending in the country. Although it is also considered a near efficient market, one like
source of inefficiency stems from the fact the information from government quarters is
limited to only as much as the policy makers chose to reveal. Moreover, the timing of
announcements is also, at time, unpredictable.
d. Corporate bonds – Corporate bond market in the United States, particularly for
bonds issued by large corporations, is a liquid and well participated market. The risk in
corporate bond is primarily credit risk, and since the equities of these corporations is
widely tracked; the information regarding the financial health of the company is truly
incorporated in the prices. However, the risks of interventions of government policies on
corporate borrowing and tax structures remain a likely source of inefficiency. Also the
transaction costs on these bonds are higher than government bonds.

Edition
e. Over-The-Counter market – A significant portion of derivatives trading around the

world is done in over-the-counter market. The very nature of this market (direct trading
between two parties and the fact that the products are highly customized structured
products to suit individual needs) lead to information asymmetry. Lack of understanding
of the product and complex payoff structures often result in cases where a party to a
trade discovers the risks associated much after the trades have been entered into.
Therefore, the prices of these securities very seldom reflect all the available information.
Also, since the trades are done through a market maker and not on exchanges, the
transaction costs are higher. The marginal costs of acquiring the information on such
trades are also very high. Lack of regulation in the OTC trades also result in lack of
transparency in the market.
f. Real estate –Vested in interests in immovable assets, typically characterized by
land and buildings are known as real estate investments. The biggest source of
inefficiency in such market is lack of liquidity. The fact that trades in the real estate market
are done as much by retail individuals as by institutions and the value in each transaction
being high, results in a high bid-ask spreads in the market. The transaction costs,
therefore, associated with each transaction is very high. High prices of assets also cause
entry-exit barriers in the industry. High costs of obtaining information and differentiation of
products, volatility in government regulations, interest rates, and tax laws in the industry
also causes the inefficiencies in pricing of assets.
g. Fine art – Investments in fine arts typically involve acquiring assets related to
paintings, sculptures, and architectures. The most striking feature of the assets in
consideration is that these are developed more for aesthetics than practical application
purposes. The very nature of these investments is that they may be held in high esteem for
one individual while being worthless for another. This causes information asymmetry in the
pricing of an asset. An investment in fine arts requires the same amount of due diligence
as a stock, or probably more, but the cost of information to make any judgment on the
pricing is very limited and costly. Also, this form of an investment is still considered niche
rather than mainstream, resulting in very limited participants and low liquidity.
h. Baseball cards – Baseball cards are trading cards with a picture, name and other
statistics of baseball players. In terms of investment, it derives its value if it is really old and
contains information about vintage players. The value is presumably more if it contains an
autograph of the player. This is probably one of the most, illiquid forms of investment. Its
value of such investments can be more in the countries where baseball is popular, with
people who would be willing to pay for such cards. The pricing of such assets is difficult to
determine due to lack of information and pricing methodologies.
Chapter: 17
3. Tests of market efficiency are often referred to as joint tests of two hypotheses: that
the market is efficient and that an expected returns model holds. Explain. Is it ever
possible to test market efficiency alone (i.e., without also testing some type of asset-
pricing model)?
Answer:
An efficient market always fully reflects all the available information, but to determine

how the markets should reflect such information, it is essential to determine an investor’s
risk-return preferences. Therefore, any test of efficient market hypotheses is always done
in conjunction with expected returns of investors.
Any test of efficiency assumes a normal rate of return on the market based on a
model that defines equilibrium returns. A rejection of market efficiency will mean that
either the market is actually inefficient or the equilibrium model is flawed. This is
commonly known as joint hypotheses problem and means that effectively, tests on
market efficiencies cannot be rejected.
For an asset pricing model to be consistent markets need to be efficient but it is
not necessarily true the other way round. In fact, “Efficient market hypotheses are not a
well-defined and empirically refutable hypothesis”, says Lo in Lo and Mackinlay (1999). In
order to make it operational one needs to specify additional structures like information
pattern, investor preferences, business environment, etc, he adds. However, to tests
efficiency in such cases would also mean testing joint hypotheses of several auxiliary
factors and a rejection of joint hypotheses would provide little information on the aspects
of the tests that are inconsistent.
Therefore, any test of efficient market hypotheses is also jointly a test of the
efficiency model that defines equilibrium returns.
Chapter: 17
4. What is the phenomenon of the size effect in stock performance? How does it
relate to the "turn-of-the-year" ("year-end") effect? Can you suggest any good reason
why the returns of small stocks, after adjusting for beta, still do better than those for large
stocks? What strategy would you follow to exploit this anomaly? What factors do you
have to keep in mind?
Answer:
The ‘size effect’ hypothesis states that stocks with smaller market capitalization tend to
provide excess returns as compared to large-cap stocks. Also, the excess return on a
stock is inverse function to its market capitalization. The smaller is the size of the firm, the
larger will be the returns. A number of studies show that a significant portion of the excess
returns for smaller size firms are generated in the month of January. In fact, a paper by
Keim (1983) shows, that about half of the excess returns for small stocks for the entire year
are realized in January.
Small firms typically have low production efficiencies and are therefore riskier in
the sense that they have a lower probability of surviving in the market during stress, as
pointed out by Chan and Chen (1991). So size serves as a proxy for fundamental risks in a
small company and thus investors demand a higher return for assuming such risks.
Another reason why the expected returns on the stocks are higher is due to higher
transaction costs as a result of illiquidity.
A multi-index model which incorporates the possible factors that affect the
required rate of return on a small stock can be used to select mispriced security and
generate excess profits. The biggest risk in investing in small stocks based on multi-index
model is omission of relevant factors in the model. This increases the error term or portion
of returns unexplained by the model. In addition to some of the risks like lower liquidity
and higher transaction costs cited above, there are several risks inherent risks in an
investment in a small stock. Poor quality of management, high variability in returns,

Edition
greater vulnerability to economic shocks, lack of reliable data, risks of a hostile take-over,
high financial and operating leverage, and insider trading are some of the factors that
must be considered before investing in a small size company.
Chapter: 17
5. One explanation of the "year-end" ("turn-of-the-year" or "January") effect has to do

with sales and purchases related to the tax year.
a. Present the "tax-effect" hypothesis.
b. Studies have shown that the January effect occurs internationally, even in
countries where the tax year does not start in January. Speculate on a
good reason for this.
Answer:
a. The "tax-effect" hypothesis is one of the possible explanations on the excess returns
exhibited in a lot of markets around the world. The hypothesis states that investors tend to
sell the securities on which they have incurred loss in late December, only to buy it back
in January. If the losses are substantial, it will create a tax loss for the investor in excess of
transaction costs, resulting in net gain. This phenomenon depresses the prices in
December and pushes the prices up in January, thereby, generating excess returns for
the securities in the month of January.
b. One of the possible reasons of the January effect is ‘Window-dressing’. Many fund
managers have a mandate to invest in only certain class of securities with low-risk low-
return characteristics. Also, there would be other managers who have the mandate to
invest in risky securities, and have actually incurred losses in such securities. Regulations in
most countries make it mandatory for fund managers to report the portfolio and
performances periodically to exchanges as well as to investors. Both types of managers
discussed above, therefore, tend to sell in late December to ‘clean up’ the portfolio for
reporting purposes. They usually buy back the securities early January. This also partly
explains the fact that excess returns in January is typically exhibited by smaller-cap stocks.
Chapter: 17
6. What is the Efficient Markets Hypothesis? How efficient are the U.S. financial
markets? Is it a sign of probable inefficiency if:
a. the price of a security does not follow a random walk? (What is a random
walk?)
b. capital gains on American Stock Exchange stocks are regularly larger than
those on New York Stock Exchange stocks with the same beta?
c. stocks with high P/E ratios earn lower returns than stocks with low P/E ratios
after adjusting for risk?
d. the stock price for companies that sell ice cream goes up in the summer
and down in the winter every year?
e. stock market prices follow a 2.3-year intermediate cycle superimposed on
a 22-year major cycle?
f. a company announces earnings are down 37% from last year and its stock
goes up in price?

g. a company announces it has been awarded a lucrative government

contract and its stock rises for the next four days after the announcement?
h. a stock rises in price when the company announces it is going to split 2 for
1?
Answer:
Markets in which the security prices fully reflect all the available information are
considered as efficient. Efficient market hypotheses are, thus, various forms of tests
conducted to test the efficiency of a market. Securities market in the United States is one
of the most widely tracked markets in the world. A large number of people follow a
significant number of securities professionally. This results in instant dissemination of any
new information, which is quickly incorporated in the price of a security. Markets in the
U.S are, therefore, considered as efficient.
a. Random walk theory states that the successive returns on a security are
independent and identically distributes. However, efficient market hypotheses allow
deviations in the random walk if the fundamentals on which the returns depend are
changing. A market may be considered inefficient if a security does not follow random
walk even if there are no changes in the underlying fundamentals.
b. A stock with same risks generating different returns on different exchanges is a sign
of market inefficiency. It implies that the information is not fully reflected in the price of
the stock in at least one exchange.
c. The P/E multiple of a stock is closely related to the growth prospects of a

company. A stock of a corporation commands higher multiple if the market perceives
that the growth prospects of the organization is high and vice-versa. If, however, the
returns generated on the stocks does not correspond to the P/E multiple, it is likely that
the market is not correctly pricing the prospects and is inefficient.
d. It is very obvious that companies that sell ice-cream would do a better business
during summer as opposed to winter. An efficient market would quickly incorporate the
cyclical nature of the business into the stock price. Thus, a market where the stock price
of ice-cream selling companies go up in summer and down in winter, is a sign of
inefficiency.
e. A 22 year period would tend to have many smaller economic cycles intermittently.
Periods of high-growth and low-growths in the economy tend to vary. However, it would
be a reasonable assumption that a 2-3 year period will witness different economic
environment. Therefore, a stock market intermediate cycle of 2-3 years may not
necessarily be a sign of market inefficiency.
f. Announcement of a 37 percent drop in earnings, assuming there is no other news

which indicates a value-creation for shareholders, should adjust the stock price
downwards. On the contrary, if the stock price moves up, it is a sign of probable
inefficiency in the market.
g. If semi-strong form of market hypothesis holds, any new information is quickly

incorporated in a stock’s price. Any investor would not be able to earn excess returns

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based on any announcements. Therefore, if the stock of a company rises for the next four
days after the announcement of receiving a lucrative contract, it is a sign of probable
inefficiency.
h. A stock split in itself does not add any financial value to a stock. However, a
reduction in face value increases the affordability for a lot of investors and thus, increases
the liquidity in the stock. This phenomenon could fundamentally drive up the demand for
the stock. A rise in the stock price therefore, is reflective of efficiency of the market.
Chapter: 17
7. You are testing the effect of merger announcements on stock prices. (This type of
testing is called an "event study.") Your procedure is as follows:
Step 1: You select the twenty biggest mergers of the year.
Step 2: You isolate the date the merger becomes effective as the key date around which
you will examine the data.
Step 3: You look at the returns for the five days after the effective merger date.
After looking at the returns in step 3 (you found an average of 0.13%), you conclude that
you could not have made money on merger announcements. Are there any flaws that
you can detect in this test? How could you correct for them? Can you devise a stronger
test?
Answer:
The event study conducted above has a fundamental flaw in selection of dates for the
study. The key date (or day zero) after which the returns are being studied is the effective
date of merger. Typically mergers and acquisitions take considerable time to take effect
after the announcement. An efficient market would have reacted to the information in
the few days leading up to and a few days after the date of announcement. A better
selection of key date is therefore announcement date of the merger and not effective
merger date. Another flaw with the model is that only the days after the event are being
considered. Often, the news of new information going to be announced at a certain
point in time is known and the price starts reflecting in anticipation. In specific cases like
splits, the announcement is made after enormous price rise. There is also a possibility of
information leakage. So period before zero date must be considered.
A stronger test would revolve around the same idea except the key date is
changed and period of study also includes period prior to announcement. Additionally,
abnormal returns over expected returns in the study period should be calculated for
each day. An average of excess results can be then cumulated see the effect of the
merger announcement on the price. The study can be concluded by analyzing potential
returns for investors purchasing the security after the announcement.
Chapter: 17
8. Is it possible for:
a. a stock to have a standard deviation of return lower than the market
portfolio if the stock's beta is greater than 1.0?
b. all of the stockholders of XYZ Corporation to believe XYZ is undervalued?
c. everyone to expect the stock market to go down in the next month?

d. someone who sells stock short to make money even if the stock goes up?
e. everyone to expect the Treasury 14s of 2011 to go down in price over the
next month?
Answer:
cov ( s,m)
a. Beta of a stock is calculated as . At a beta of one, covariance equals the
 s m
product of the standard deviations of the stock and the market. For the stock to have a
beta of greater than one, the denominator (the product of standard deviations) has to
decrease. Given the conditions, only if the standard deviation of the stock increases does
the beta of the stock remain greater than one. Therefore, a stock with beta greater than
one will never have a standard deviation lower than that of the market.
b. Tests of efficient market hypotheses state that the price of a security fully reflects all
the available information and no excess returns can be generated. In an efficient
market such a situation cannot occur. In an inefficient market also, a situation where all
the shareholders believe that the stock is undervalued is not likely as in this case, the stock
will witness aggressive buying and the price would quickly adjust upwards.
c. Everyone expecting the stock markets to go down next month implies the
presence of some information which will affect the market returns negatively. Semi-strong
hypothesis of efficient market says that the any new information is incorporated in the
prices quickly enough for any investor to take advantage of such news to generate
excess gains. If this holds, by the time everyone is aware of the information, the market
would have corrected to reflect such information. In inefficient markets also when
everyone is having pessimistic view, the markets would adjust downward immediately.
d. For someone who has sold a stock short, the payoff is positive if the stock falls and
is negative if the stock rises. In such a situation, unless the person has long positions in
derivatives, the investor will only lose money if the stock rises.
e. It is quite normal for a term structure of interest rates to be upward sloping. It

means that investors expect the interest rates to rise in the future. Since the bond prices
are inverse functions of interest rates, the prices are expected to fall. However, the price
of a bond at any point in time is the present value of its cash flows discounted using the
term structure. If the interest rates are expected to rise further, and semi-strong form of
efficient market hypothesis holds, the prices will adjust instantly.
Chapter: 17
9. What is an "event study"? Discuss a specific example to explain the objectives,

methodology, and results of an event study.
Answer: An “event study” studies the relationship between a piece of information coming
in public domain and its impact on the price of a security. Earlier, the objectives of an
event study were to test the efficiency of a market and the speed with which any new
information was incorporated in the price of a security. However, many studies have
concluded that the process of price reflecting any new information is fairly quick, and

Edition
therefore, more recent studies tend to focus on determination of the extent of

information that is already reflected in the price. It may also happen at times that the
impact of the news is unclear, and a study is done to assess the quality and nature of the
news for the price of a security.
Let us consider the effect of the announcement of positive earnings surprises in a
result season. The study would entail the following steps-
1. We first need to collect the sample of firms that announced positive earnings
surprise in a particular quarter.
2. Designate the day of announcement as day ‘zero’.
3. Define the study period; we will assume a period of 15 days from day zero.
4. We now compute the abnormal return for each security in the sample for the
study period. Abnormal can be defined as actual returns reduced by expected returns.
Expected returns can be calculated using any model; albeit it should be consistent for
the entire sample.
5. The next step is to calculate the average abnormal return for all the firms in the
sample.
6. Cumulate the abnormal returns from the -15th day (beginning of the study period)
to the 15th day (end of the study period). This is done in order to see the lead and lag
effects of the announcement on the price.
When the results in the last step are graphed, it will show the effects of the
announcement on the prices. The study can be used to test whether an investor can
earn abnormal returns over a long term if he decided to purchase a security based on
the positive announcement. Event studies can therefore be used for the semi-strong
forms of tests of efficient market hypothesis.
Chapter: 17
10. Merle Linch, an up-and-coming security analyst has found an exciting investment
strategy based on a correlation between the television programs a firm sponsors and the
market performance of its stock. Over the period 1970-1982, he finds that those
companies that sponsored football and hockey games did significantly better than the
rest of the market, yielding 9.4% a year on average versus 8.4% for the Dow Jones
Industrials and 8.5% for the S&P 500 index. He writes up his findings in a market letter for
general distribution to his firm's clients. His research is also noticed and publicized by the
companies whose stock Linch is recommending on the basis of his "contact sports"
theory.
a. How else might you explain what Linch has observed?
b. Precisely how should one test such a theory statistically?
c. What would you expect to find if you did test Linch's theory rigorously?
Explain.
d. Suppose the "contact sports" theory is verified. What will happen in markets
now that everyone is aware of it? How long should people be able to earn
excess profits by buying these stocks?
Answer:
a. Linch has observed an anomaly in the market which can be used to generate
greater returns.

Although the returns cited by the analyst are greater than the market in absolute
terms, based on correlation, it is incorrect to conclude that the entire returns generated
by the stocks under the study are due to the sponsorship of football and hockey games.
Correlation in itself does not explain the deviations in returns. Square of correlation
coefficient is rather the correct measure that explains the variations in returns generated
due to a particular factor. Therefore, Linch’s observation overstates the returns explained
by sponsorship of the games.
b. A single-factor regression model can be used to compute the expected return on

the companies.
Ri =  + bS + i
Where,
Ri = Expected return on the stocks
 = Expected return if factor is zero
b = sensitivity of the return to the factor S
S = sponsorship expenses of various games
i = Error term of the regression model (with expected value of zero)
We can run a regression of the returns on a stock over its sponsorship expenses to
compute the sensitivity of the stock’s return to the expenses incurred by the companies.
The explained sum of squares (commonly referred to as ESS or R 2 ) of the regression model
will show the portion of the increased return which is explained by the increase in
sponsorship of games. The square root of this number is the correlation coefficient
between the stocks return and sponsorship expenses.
c. If the analyst’s theory is tested, except for the situation where there is a perfect
positive correlation between the return and sponsorship expenses (r=1), the explained
variation the return of the stock will be lower than considered in the model. This is
because the square of correlation coefficient (which lies between 1) will be lower than
correlation coefficient itself.
d. If the ‘contact sport’ theory is verified in the market, effectively implying new
positive information for the stocks, the stock prices would adjust upwards immediately.
Semi-strong form of efficient market hypothesis states that any new information is quickly
reflected in the stock price. Thus any investor purchasing the stocks based on this new
information would on an average be paying the new worth of the stock and will not be
able to earn any excess return.
Chapter: 17
11. Returns on Mondays are generally much more negative than returns on other
days of the week. How would you best explain this? (Give only one reason, and specify
whether it is consistent with notions of market efficiency.)
Answer: Returns on Mondays are much lower than on other days of the week on the New
York Stock Exchange. The reason for this can be attributed to Friday announcements. In

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general, companies tend to hold the bad news to be announced by the weekend
which leads to a decline in stock prices on Monday.
This is an anomaly to the market efficiency theory. In an efficient market the stock price
should reflect all the information privately or publicly available. Lower returns on Monday
indicate that market is inefficient.
Chapter: 17
12. Suppose the U.S. Treasury issues $50 billion of 10-year notes over the next month to
finance the budget deficit. Describe what should happen to the term structure of interest
rates according to each of the following theories:
a. segmented markets
b. pure expectations
c. preferred habitat
d. liquidity preference
What do you think would actually happen?
Answer:
a. Segmented markets theory states that interest rate for any maturity depends solely
on the demand and supply of paper for that particular maturity. An issue of 10-year notes
would affect the yield on 10-year securities. All the other yields on the term structure
would remain unaffected.
b. According to pure expectations theory, an investor is indifferent between cash

flows from two different maturity bonds. A large issue of 10-year notes will push the yields
up for 10-year securities. For the indifference in the yield to persist, the longer term
forward rates will have to come down. The term structure in this case is likely to flatten out
or at least become less steep than it was before the issue.
c. The preferred habitat theory states that investors tend to prefer assets with
maturities matching the maturities of their liabilities. Any deviation from this preference is
only due to premium on yields for other maturities. The premium generated on the issue
of 10-year securities with respect to yields on other maturities is not clear and therefore, it
will be difficult to conclude the shift in the term structure.
d. According to Liquidity premium hypothesis, yields on longer term securities needs

to be at a premium to shorter term securities to compensate an investor for the
additional risks undertaken. A large issue in the 10-year market will tend to push up the
yields for 10 year securities. If the liquidity premium hypothesis holds, premiums will also
adjust on longer dated securities. Given the scenario, the term structure will become
steeper than it was prior to the issue.
10-year U.S. treasuries market is the most liquid fixed-income market in the world.
Being the benchmark for long-term riskless rate in the market, there is a huge trading
interest in the segment. Empirical evidences suggest that huge issues in the segment go
through in the market without any impact on the yields. Even if there is a ‘lesser demand’
and considering the size of the issue, it is likely to be absorbed in the market with a rise in
the yields of less than 5 bps.

Chapter: 17
13. In November 1978, the Fed announced a stringent new program to combat
inflation, which had gotten out of hand. The response in the financial markets was the
Treasury bill yields increased while long-term yields dropped. Can you explain why?
Answer:
In 1978, the U.S dollar was under severe market pressure, falling nearly 34 percent against
a basket of major currencies, amidst high oil prices, high inflation, and adverse balance
of payments. Additionally, all the measures of money supply in the economy were well
above the Fed’s comfort level. The FOMC took a series of steps to stem the fall of dollar
and curb inflation, including increasing the discount rate to an unprecedented level of
9.5 percent.
A steep hike in the discount rate immediately translated into surge in the T-bills yields since
banks in the U.S. typically use the Federal Reserve’s discount window to finance their short
term borrowing requirements. However, higher borrowing costs for the banks meant they
would be less inclined to lend and this will reduce money supply in the economy. Bond
markets perceived the tightening monetary policies as a potential tool that would curb
inflation, leading to an eventual decline in the interest rates. This led to a fall in the long
term yields.
Chapter: 18
14. a. Would a 10-year, 15% U.S. Treasury note be priced in the market to yield
more, less, or the same as a 10-year, 8% Treasury note? Explain.
b. How would you expect the yields on the following two bonds to compare
with each other? Both are rated A.
ABC Corp. 18s of 2011, callable in 2007
PDQ Corp. 18s of 2009, non-callable
c. How would the yields on the bonds in part b compare if their coupons were
8 instead of 18?
Answer:
a. The yield on a coupon paying bond, all else being equal, is a decreasing function
of coupon rate. A bond with a higher coupon will always have a lower duration than that
of a lower coupon paying bond. This translates into lower risk for the investor and
therefore, a bond with higher coupon will always command a lower yield, all the other
factors remaining constant. A 10-year, 15% U.S. Treasury note, therefore, will be priced in
the market to yield less than a 10-year, 8% Treasury note.
b. Yield on a callable bond is always higher than a straight bond since the investor
carries an additional risk of the bond being called in the event of fall in interest rates. At a
significantly high coupon rate of 18 percent, there is strong likelihood that interest rates
may fall below the coupon rate. ABC Corp. has a good chance of being called upon
and thus would command a premium on the yield as compared to PDQ Corp
c. If coupons were 8, instead of 18, the likelihood of interest rates falling below the
coupon rates is much lower. Thus, ABC corp. is less likely to call back the issued bonds. In
such a scenario the yields on both the bonds are likely to be in close proximity.
Chapter: 21

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15. Herbert Avocado has just come up with an idea for a new type of financial
intermediary, which is designed to take advantage of the opportunity presented by an
inverted yield cure, such as the one that existed in 1981 when one-year bonds were
yielding 16% and 30-year bonds were at 14%. When the yield curve becomes inverted,
Avocado's firm will issue long-term bonds and use the proceeds to buy one-year
instruments that have higher yields and are less risky. Avocado is now just waiting for the
yield curve to become downward sloping again so that he can get his firm off the
ground and make his fortune. What do you think of his plan?
Answer:
Herbert Avocado’s plan is pure play on the term structure of interest rates; with
long position in short term bonds and a short position in long term bonds. There are two
possibilities once the trade is entered into.
First, the yield curve flattens out or further still becomes upward sloping. Short-term
interest rates will fall pushing up prices of shorter term securities resulting in capital gains
on the bonds purchased. Longer-term interest rates will rise and the prices of securities
issued would fall. This would also result in capital gain on the short position. Herbert can
reverse both the trades and make handsome gains.
Second, the yield curve inverts further. This is the risk in the trade. Rise in short-term
rates and further fall in long-term rates, will result in loss on both the positions.
Inverted yields are a result of bursts in short-term inflation levels. Empirical data and mean
reversion theories suggest that the term structure eventually reverts to upward sloping
shape. Liquidity premium theory also states that longer term investors need to be
compensated with a premium on yield for the additional risk undertaken by the investor.
Chapter: 21
16. a. Define the duration of a bond. Why is duration often thought of as a

measure of risk for a bond?
b. What is the duration of a two-year zero-coupon bond? How about a two
year 10% coupon bond (one coupon per year)?
c. How does a given bond's duration change when interest rates in the
market rise?
d. Explain how duration is used in setting up an immunization strategy.
Answer:
a. Duration is defined as a measure of sensitivity of a bond’s price to the changes in
the interest rates. It is often considered as a measure of risk because it can be used to
determine the requirements to hedge a bond or a portfolio.
b. The duration of a zero-coupon bond is always equal to its maturity. Therefore, for a
two-year zero-coupon bond, the duration will be two years. Duration is a decreasing
function of present values cash flows in a bond. A two year coupon paying bond will be
slightly lower than two years.
c. The duration of a bond is inversely related to the interest rates and would therefore
fall when the interest rates rise.
d. Immunization involves selection of assets in a manner that completely offsets the
gain/loss in the value of liabilities in the event of changes in the interest rates in the
market. This is done by matching the duration of assets with that of liabilities. Since,
duration measures the sensitivity of changes in the interest rates, the impact on the assets

and liabilities would be approximately same when the interest rates change. This ensures
the net value of the assets and liabilities remains same.
Chapter: 22
17. You work for a large insurance company and have been assigned to explain to a
customer (a large pension fund) how strategies of 1) exact matching and 2) duration
matching will help in meeting a projected set of pension fund liabilities. Explain what
each technique entails and how it works. Examples would be useful. Be sure to conclude
your report with a discussion of the advantages and disadvantages of each technique.
Answer:
Exact matching and duration matching are two different methods of hedging
interest rate risks in a portfolio. Let us consider that the insurance company has the
following liabilities –
Year 1 2 3
Liability $1,000 $1,500 $10,000
Exact matching involves creating the lowest cost portfolio that produces sufficient
outflows at the maturity to service all the liabilities. It is a passive management technique
and involves no changes in the interim. In the above scenario, the portfolio manager
can buy bonds that exactly produce cash-flows matching the liabilities. Any subsequent
change in the interest rates would not alter the cash flows and the liabilities can be easily
serviced.
Another variant of this technique is the fund manager carry-forward cash flows
method, where one can buy bonds such that the cash-flow received at the end of year
one is more than $1000, say $1,180. The excess $180 is then re-invested to produce
sufficient cash flows to meet the liabilities of $1,500 at the end of year two. If the yield
curve is upward sloping and the manager is able to receive a better rate of return in year
two, the cost of investment reduces for the firm.
Duration matching, also known as immunization, is a technique of hedging the
risks of shift in the term structure by matching the duration of assets and liabilities. Since
duration is the sensitivity of a bond to the change in the interest rates, matching the
duration would ensure that the change in the value of assets equals liabilities. Suppose
the duration of the liabilities in our example is 2.8 years. The fund manager will need to
select a portfolio of bonds having weighted average duration of 2.8 years. A focused
immunization strategy would entail choosing bonds with maturities close to 3 years while
a Barbell strategy will entail choosing bonds with far away maturities but the duration of
the portfolio matches the duration of liabilities.
An advantage of exact matching is complete immunization and the portfolio manager is
not required to make any changes in the portfolio. The only risk in this method is default
risk. If the carry-forward of cash flow method is used, the manager can further reduce the
cost of portfolio by earning a superior return. A major risk in this method is re-investment
risk. If interest rates fall, the cash flows will not be sufficient to service the liabilities. The risk
in immunization is that if the yield curve shifts, the duration changes and the portfolio will
need to be re-constituted. This can be a costly affair. Also, duration is a linear
approximation of price changes and is ineffective in correctly predicting price

Edition
movements in large shifts of term structure. Also, this method assumes a parallel shift in the
term structure, which is not always the case in the markets. The degree of change in the
rates in the long-term and short-term is non-linear.
Chapter: 21
18. For each of the following assets, discuss all of the essential aspects of return, risk,
and other factors, such as marketability, that investors should consider before the asset:
a. three-month T-bills
b. a 20-year, 8% coupon corporate bond selling for 65 (don't calculate the
yield to maturity)
c. municipal bonds
d. a house in the suburbs
e. a 20-year, 15% mortgage on a house in the suburbs (i.e, you would be the
lender)
f. U.S. Treasury 10 5/8s of 2015
Answer:
a. T-bills are short term securities issued by the U.S. treasury, usually for a maturity of
less than a year. These are backed by the government and are considered risk free.
These are extremely liquid securities and set a benchmark for short term interest rates in
the economy. Unless in exceptional circumstances like inverted yield curve, T-bills yields
are very low and are considered as cash parking vehicles for investment managers. Most
of the exchanges also accept T-bills as margin in lieu of cash for derivative trades.
b. A significant discount to the par value implies that the yield on the bond is well
above the coupon rate. Though, this may not necessarily be due to the interest rates in
the economy. Corporate bonds usually trade at a premium yield to government bonds
due to credit risk. Also since the maturity of the bond is twenty years, the duration of the
bond will be high and the price will be prone to significant interest rate risks. Longer term
coupon paying bonds also have an additional risk of re-investment of coupons. Except
for highly rated securities, corporate bond market is also less liquid and therefore
commands a liquidity premium.
c. Municipal bonds are issued by the government entities below the state level to
finance infrastructural needs. A striking feature of these bonds is that income from such
securities is exempt from federal taxes as well as state taxes in the state where the bonds
are issued. Due to low probability of default and income tax exemptions, investors often
accept low yields on these bonds. Also it translates in lower borrowing costs to the issuer.
Municipal bonds have an active secondary market and can be easily purchased and
sold through exchanges. Until recently, these were considered riskless assets. However
after the recent financial crisis and housing market collapse, some of the local
governments have had issues with servicing of debts. This implies that the credit risk on the
bonds is a function of credit quality of the authorities issuing the bonds.
d. The payoff structure of a real estate investment is very different compared to any
other form of investment. The risk-return characteristic of a typical house is more
dependent on the state of the housing market in general than its own features. Therefore,
purely from an investment standpoint, it is based on more of a play on the sector rather

than the characteristics of the property itself. Real estate investments are also relatively
illiquid compared to any other forms of investment which can be traded on exchanges.
e. As discussed in the previous section, real estate, and particularly housing is a

market dependent sector. Typically, these investments are financed by banks and
mortgage finance companies and is highly capital intensive with long gestation periods.
Since a twenty year period is likely to see more than one economic and interest rate
cycle, the lender faces focused credit risk. At 15%, the likely-hood of a borrower having a
negative home equity in the event of further interest rate hikes becomes very high.
Coupled with the illiquid nature of the industry, the risk-return trade-off in the investment is
highly skewed.
f. The United States treasury department often issues long term zero-coupon bonds
in the form of T-bonds and T-notes to finance government debt. These are extremely
liquid securities and are a proxy for the long-term riskless rates in the market. Since the
securities are auctioned during the issue, they usually yield the prevailing risk free rate in
the market, irrespective of the coupon rate. However, these securities can be
restructured and the interest and principal components can be separated on request.
The decomposed securities are called “STRIPS”. The duration of longer term securities
being higher than short term, the interest rate sensitivity for these securities is higher. Since
U.S. treasuries are considered the safest assets in the world, during times of “flight to
safety”, these bonds tend to exhibit excessive demand and result in suppressed yields.
Also, regulatory requirements make it mandatory for a lot of banks and financial
institutions to hold treasuries creating artificial demand and reduced yields.
Chapter: 21
19. a. Explain why futures trading is a zero-sum game. Are options also a zero-sum
game? What about buying warrants?
b. Suppose you are long 100 shares of XYZ stock at 50 and you have written a
December 50 call option against your long position. Do you want the stock
price to go up or down tomorrow? Explain.
c. Answer part b if you have written a December 50 put option instead of the
call option.
Answer:
a. Futures trading is essentially a zero sum game for the simple reason that for every
part that gains on a contract, there is a counterparty who loses. The trades are matched
at a price at which a buyer and seller are willing to enter into a trade. The clearing house,
thereafter, splits each trade to become the counterparty to each trade to offset credit
risk in futures trading. The mark to market profit/loss calculated each day is credited or
debited to both the parties. The party whose account is debited is required to bring in
further margin to continue is position, failing which the money is debited to the margins
deposited by the respective exchange members. This entire process ensures that a
futures trade is a zero-sum game.
Options trades are conducted in the same manner as futures trades and are also
zero-sum games. Except for the different risk-reward payoffs for the buyers and sellers, the
characteristics of an option trade remain same.

Edition
Warrants are financial instruments much like a call option for a buyer are which
gives the right to convert the debt into equity of a corporation at a pre-specified strike
price. Therefore, the gain to an investor is a loss to an issuer and thus it is a zero sum
game. For all practical purposes though, a corporation almost always, hedges this risk by
buying options in the OTC markets to offset the risk.
b. Owning a stock and writing a call is a covered call strategy and is a hedged
position. If the stock goes up more than the premium collected on the option, call will be
exercised and the investor faces an opportunity loss. The investor would ideally, therefore,
want the stock to trade below $50 till the month of December to gain from the option
premium and then hope to gain from the rise in the stock price.
c. Writing a put is essentially a selling protection in a stock. The put option will be
exercised if the stock price falls and the investor will lose on the option. The loss is
compounded by the loss on the stock. So since both the positions are long, the investor
would want the stock to rise.
Chapter: 23
20. Describe:
a. the transactions a grain elevator operator would make in using March corn
futures to hedge a silo full of corn from October through February.
b. how the price on a futures contract is related to the price for the underlying
commodity.
c. how futures prices are expected to move over time.
Answer:
a. In the United States, corn is planted in April and May and it is harvested during
October and November. The price of corn typically falls as it is being harvested and then
steadily rises over the next twelve months to reflect storage costs. A grain elevator
operator is likely to store the corn in a silo till the next plantation. To hedge away any
price risk, the operator should sell the March futures and lock-in the selling price.
b. Commodity futures are priced in much the same way as financial futures. Futures
price is a function of spot price and carrying cost. Commodities can be primarily
classified into investment assets and consumption assets. Pricing of both the types of
commodities is slightly different. For investment commodities, like precious metals, the
( r + D)t
price of a futures contract is F0 = S0 e , where,
F0 = Current futures price

S 0 = Spot price
r = riskless rate of interest
D = storage costs
t = time to expiration of the contract

For consumption assets like oil, wheat, etc., the owner of a business which uses the
commodity as an input, owning physical commodity rather than futures creates value.
This is called a convenience yield. In such case the price of a futures contract is scaled
down by the benefit. Thus, the price of a futures contract on a consumption asset
( r + D)t
becomes F0 = S0 e ; where c is the convenience yield.
c. To prevent any arbitrage, a futures price at the end of the contract becomes
equal to the then spot price in the market. During the life of the contract, how a futures
price moves relative to the spot price depends on the variables determining the carrying
cost. If the futures price prevailing in the market is more than the spot rates, the market is
said to be in a contango with an upward sloping curve. If the futures prices are below
spot prices, it is known as backwardation and has a downward sloping curve. Since the
spot price and futures price converge on expiration, a futures market in contango will
experience a downward trajectory during the life of the contract. On the contrary, a
market in backwardation will see an upward bias during its life. However, the prices of
both spot and futures price move approximately linearly and react to demand-supply
factors in the market.
Chapter: 24
21. Your company, Solid State Gizmo, Inc. (SSG) has just been spun off by its parent
firm, Octopus Industries, into a separate firm. SSG's pension fund, currently amounting to
$250 million of assets, has also been spun off. SSG's board of directors has asked you to
study proposals from a number of investment management firms, each offering to
manage the pension fund. You are to give the board a report discussing the different
styles of management that are available and making recommendations about which
firms should be seriously considered and how SSG should instruct them to manage the
pension fund if they are hired. Carefully describe the following:
a. What is "passive" investment management? What kinds of things does a
passive manager do?
b. What factors would you look at to judge if one passive manager is better
than another?
c. If passive management is chosen, what instructions might you want to give
the fund manager to tailor the optimal passive strategy for SSG's pension
fund?
d. What is "active" investment management? What kinds of things does an
active manager do?
e. How would you judge if one active manager is better than another?
f. If active management is chosen, what instructions might you want to give
the fund manager?
Answer:
a. Passive management is a form of investment management wherein a fund mimics
the risk and return of an index or another portfolio. A passive manager would typically be
responsible to replicate and churn the composition of his portfolio so that the returns
generated are as close as possible to the benchmark’s return.
b. A passive manager’s efficiency can be judged by the percentage of tracking

Edition
error of the fund. Tracking error is the difference of returns generated for a passive fund as
compared to its benchmark. These usually result due to transaction costs, management
fees, different composition due to rounding off percentages in each securities, etc. The
lower the tracking error, the better is a fund manager’s performance.
c. Since the fund in question is a pension fund, the passive manager should be asked
to select a benchmark such as a broad diversified index which provides a stable return in
the long run possibly closer to the long-term average of equity returns.
d. An active management is a form of fund management with an objective of

generating excess returns as compared to that of its benchmark. A manager of an
active fund chases ‘Alpha’ by selecting securities that generate excess returns and
outperforms the market.
e. The performance of two active fund managers can be easily compared by the
kind of excess returns generated by the funds over their respective benchmarks. However
a better way of judging would be to check for every unit of risk undertaken to generate
the each unit of alpha.
f. Since active management involves the art of securities selection to generate

returns, there is an inherent risk embedded in the nature of the fund. The fund in question
being a pension fund, the fund manager would be well advised to create an optimal mix
of fixed income in the portfolio.
Chapter: 22
22. Discuss (in list form) the risks associated with the following investment strategies.
a. exact matching
b. immunization
c. portfolio insurance
d. timing
e. sector selection
f. selecting mispriced options using the Black-Scholes formula
Answer:
a. Exact matching involves creating a portfolio that produces sufficient outflows at
the maturity to service all the liabilities. The major risk in such a strategy is that the cash-
flows may not materialize as expected if the bonds are callable. In the event of interest
rates rise, these bonds would almost certainly be called upon. The strategy also involves
credit risk such that the bond issuer may default on the payments. If the strategy involves
cash and carry forward, there is also a re-investment risk. A downward shift in the interest
rates will mean insufficient cash-flows at maturity.
b. Immunization involves matching the duration of assets with duration of liabilities to

hedge against the interest rate movements. However, selection of wrong duration based
on different assumptions of cash flows is the major risk involved in this strategy. A shift in
the yield curve different from the assumption would change the duration and expose the
portfolio to sensitivities to interest rate movements. Another risk to immunization is the

change in the duration of assets in the event of shift in the yield curve or passage of time.
This requires constant portfolio rebalancing which is a costly process. If a manager ignores
small deviations in durations of assets and liabilities, the portfolio is exposed to large shifts
in the yield curve.
c. Portfolio insurance is used to hedge the market risk of a portfolio during uncertain
and volatile periods. A position with reverse payoff to cash/spot market position is
created using futures, options or other derivatives to protect the degradation of a
portfolio. However, there still remains what is known as basis risk in a portfolio hedged
using derivatives. Basis is the spread between the price of the asset which is hedged and
price of the instrument used to hedge the risk. It can arise under two circumstances –
Difference in assets – There may be times when hedging instruments may not be
available for a particular class of asset. An asset with similar payoffs and risk is then used
as a hedging tool. For example, airline companies regularly use heating oil contracts to
hedge their risks because there are no futures available on Jet fuel. However, when the
prices of jet fuel and heating oil diverge, hedging may not work out as expected.
Difference in maturity selection – Using a different time horizon to hedge the risk of an
asset that is expected to be volatile in a different period may result in basis risk. A bond
portfolio manager who expects a drop in the value of his portfolio due to rise in short-term
interest rates may use long-term maturity futures to hedge his risk. However, the term
structure may not shift parallelly when the rates do actually rise. This will mean that the
hedge may not generate the payoffs as expected.
d. Timing is rebalancing the duration of an immunized portfolio in anticipation of

interest rates movement. The risk, however, is that interest rates may not move in
anticipated direction. Moreover, the quantum of the change may be different from what
was anticipated. This leaves the portfolio unimmunized and exposed to price level
changes due to further shifts in the yield curve.
e. Portfolio managers involved in sector selection typically engage in selecting bonds

with lower rating for higher yields. This strategy increases credit risk in the portfolio and the
uncertainty of cash flows in case of default by an issuer.
f. Often managers select bonds based on the mispricing between the market price
and the theoretical price. Theoretical price is often determined by discounting future
cash flows and adjusting the price of any option value. Option values calculated using
the Black-Scholes model assumes a certain riskless rate and considers historical volatility
as parameters. Both of these are subject to change. A change in the interest rate can
result as a policy initiative while volatility can change as a result of change in the market
dynamics. A change in either will result in the change in the theoretical as well as market
price of the bond, leaving the portfolio exposed to price volatility.
Chapter: 23
23. You can form a portfolio from the following assets: T-bill futures, T-bond futures,
stock index futures, and IBM stock. Given the following predictions, indicate which of
these assets you would hold and whether you'd be long or short in the asset, so that you

Edition
will profit if your prediction is correct. (You don't have to give numbers.)
a. While the total sales of computers will depend on the overall state of the
economy and the stock market (about which you have no strong beliefs),
you firmly believe that IBM is going to lose market share.
b. The yield curve is currently upward sloping. You don't have any idea where
interest rates on average are headed, but at the end of this year, you firmly
believe that the yield curve will be downward sloping.
c. You believe that the stock market is driven by corporate profits and
(inversely) by interest rates. You think that corporate profits are due for a big
surge next year, but you aren't sure about interest rates.
d. You believe that stocks are going to go up next year, unless there is a
spectacular short crash like the one that occurred in October 1987. If there
is a crash, you believe that there will be a "flight to safety", i.e., that investors
will dump stocks and buy government bonds.
Answer:
a. In a scenario where IBM is believed to be certain to lose market share, the firm’s
sales and profitability is going to fall and the stock is most likely to fall. An appropriate
strategy in this case would be to short the IBM stock.
b. T-Bonds futures can be used to take advantage of a shift in the yield curve. Since
T-Bonds futures are priced inversely to the interest rates, an investor can benefit from
going long futures and gain from a drop in the interest rates.
c. If the corporate profits surge, the stock index is most likely to rise. To gain from such
a movement, an investor should go long on Stock index futures. The uncertainty of
interest rates rise can be hedged by going short on the T-Bonds futures.
d. A long exposure to stock index futures would help investor gain from the up-move
in the market. If however there is a crash resulting in “flight to safety”, the prices of bonds
would rise, resulting in a decline in the interest rates. A long position in the T-Bonds futures
would gain in such a scenario.
Chapter: 23
24. Steve is a Los-Angeles based software developer for one of the leading firms in the
United States. His entire portfolio of equity investments consists of stocks in the companies
based in California. Explain this kind of investor behavior.
Answer:
Behavior of investing in local companies is one of the several biases that investors tend to
make while making investment decisions and has been a subject of study for many
scholars. Local investing can be limited to investing in one’s own region, state, or even a
country. Empirical evidences suggest that this is a common tendency among many
investors.
Potentially the biggest argument in favor of such behavior is that investors have superior
knowledge of companies operating in their region. However, Ning Zhu (2005) studied a
large number of individuals investing in Iocal stocks and concluded that these trades do

not produce superior returns. Another school of thought is that this behavior is more a
result of greater investor confidence in local stocks than superior knowledge. This
behavior is not limited to individuals only. Even institutional investors like mutual funds tend
to invest in stocks closer to home. Studies say there is some evidence of these investors
generating superior returns. Grinblatt and Keloharju (2001) suggest that the choice of
investors’ stock selection is influenced by specific geographies rather than closer to
home.
Critics of such an investor behavior strongly argue that lack of diversification in such
strategies results in lower returns in the portfolio. However, the proponents of the theory
state that excess returns based on superior information should offset the lack of benefits
of diversification.
How much of the investor behavior to invest in local stocks is driven by informational
advantage though still remains a subject of study.
Chapter: 20

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Modern Portfolio Theory and

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ELTON, GRUBER, BROWN, & GOETZMANN

PART 4: SECURITY ANALYSIS AND PORTFOLIO THEORY

2. Tests of market efficiency tend to

3. Which of the following is an implication of market efficiency?

6. Which of the following investment strategies is inconsistent with a "contrarian"

2 Copyright © 2014 John Wiley & Sons, Inc.

d. buying when most investment advisory services are bearish

7. Which of the following is not a general conclusion of studies of stock prices?

8. A common stock is expected to generate an end-of-period dividend of $5 and an

9. If expectation theory holds then:

Copyright © 2014 John Wiley & Sons, Inc. 3

11. Which of the following statements is true?

13. Which of the following statements is true of warrants?

14. Which of the following is an attribute of futures contract?

1. A high positive serial correlation in prices would imply market inefficiency.

4 Copyright © 2014 John Wiley & Sons, Inc.

Copyright © 2014 John Wiley & Sons, Inc. 5

8. The Fed announces a tightening of monetary policy, leading to an increase in

12. The duration of a perpetual bond is infinite.

6 Copyright © 2014 John Wiley & Sons, Inc.

True-False With Discussion

1. Discuss whether the following statement is true or false:

2. Discuss whether the following statement is true or false:

3. Discuss whether the following statement is true or false:

4. Discuss whether the following statement is true or false:

Copyright © 2014 John Wiley & Sons, Inc. 7

6. Discuss whether the following statement is true or false:

7. Discuss whether the following statement is true or false:

8. Discuss whether the following statement is true or false:

8 Copyright © 2014 John Wiley & Sons, Inc.

9. Discuss whether the following statement is true or false:

10. Discuss whether the following statement is true or false:

11. Discuss whether the following statement is true or false:

12. Discuss whether the following statement is true or false:

Copyright © 2014 John Wiley & Sons, Inc. 9

small stocks large stocks

10 Copyright © 2014 John Wiley & Sons, Inc.

0.5  1.158  1.1 0.5  1.158  1.12 27.2319

Copyright © 2014 John Wiley & Sons, Inc. 11

be willing to pay for the firm?

12 Copyright © 2014 John Wiley & Sons, Inc.

Copyright © 2014 John Wiley & Sons, Inc. 13

14 Copyright © 2014 John Wiley & Sons, Inc.

Investment in GBS stock –

Total present value of post tax dividend income = $1.19

Investment in ISD stock –

Current stock price = $42.86

Copyright © 2014 John Wiley & Sons, Inc. 15

Total present value of post tax dividend income = $15.13

16 Copyright © 2014 John Wiley & Sons, Inc.

year XYZ return market return

a. Estimate the beta for XYZ.

You estimate the correlation of returns between GM and RandomTech to be 0.3.

Copyright © 2014 John Wiley & Sons, Inc. 17

a. How will taking over RandomTech affect GM's beta?

MTT Corp. NOR Corp. TECH Corp.

Which firm is the best candidate for a takeover?

18 Copyright © 2014 John Wiley & Sons, Inc.

Copyright © 2014 John Wiley & Sons, Inc. 19