Chapter 3

26
a. Given the $15,000 invested funds and assuming the gain or loss on the short
position is (500 P), we can calculate the rate of return using the following
formula:
Rate of return = (500 P)/15,000
Thus, the rate of return in each of the three scenarios is:
(i)
Rate of return = (500 $)/$15,000 = 0.1333 = 13.33%
(ii)
Rate of return = (500 $)/$15,000 = 0%
(iii)
Rate of return = [500 ($4)]/$15,000 = 0.1333 = 13.33%
Total assets on margin are the sum of the initial margin and the proceeds from
the sale of the stock:
$20,000 + $15,000 = $35,000. Liabilities are 500P. A margin call will be
issued when:
$35,000 500 P
500 P

= 0.25 or 25% when P = $56 or higher.

b. With a $1 dividend, the short position must now pay on the borrowed shares:
($1/share 500 shares) = $500. Rate of return is now:
[(500 P) 500]/15,000
(i) Rate of return =[(500 $4) $500]/$15,000 = 0.1667 = 16.67%
(ii) Rate of return = [(500 $0) $500]/$15,000 = 0.0333 = 3.33%
(iii) Rate of return = [(500) ($4) $500]/$15,000 = 0.1000 = 10.00%
Total assets are $35,000, and liabilities are (500P + 500). A margin call will
be issued when:
$35,000 500 P 500
500 P

= 0.25 or 25% when P = $55.20 or higher.

Global Questions
a. Capital gains: 4,000 (24 x 1000-20 x1000)
Interest payments: 600 (10,000 x 6%)
So total profits = 3,400 (capital gains interest payments)
Rate of return on own capital = 3,400/10,000 =34%.
b. Logic same as above. Rate of return on own capital: 48%
Feedback: Because of higher leverage, in spite of higher interest rate costs
c. We must have capital gains = interest payments = 600. So, approximately 20.60

Chapter 4
13. Given that net asset value equals assets minus liabilities expressed on a per-share
basis, we first add up the value of the shares to get the market value of the portfolio:
Stock

Value Held by Fund

A
B
C
D
Total

$ 6,300,000
10,850,000
4,100,000
9,150,000
$30,400,000

Knowing that the accrued management fee, which adjusts the value of the portfolio,
totals $20,000, and the number of the shares outstanding is 3,000,000, we can use the
NAV equation:
Market v alue of assets Market value of liabilities
Net asset value = S h ares outstanding
$30, 400,000 $20,000
3, 000, 000

= $10.13

14. The value of stocks sold and replaced = $91,500,000.

Value of stocks sold or replaced
Turnover rate = Value of assets
$91,500, 000
$30, 400, 000

= 0.301 = 30.10%

Chapter 5
12.
a. Allocating 80% of the capital in the risky portfolio P, and 20% in risk-free
asset, the client has an expected return on the complete portfolio calculated by
adding up the expected return of the risky proportion (y) and the expected
return of the proportion (1 - y) of the risk-free investment:
E(rC) = y E(rP) + (1 y) rf
= (0.8 0.12) + (0.2 0.04) = 0.1040 or 10.40% per year
The standard deviation of the portfolio equals the standard deviation of the

risky fund times the fraction of the complete portfolio invested in the risky
fund:

= y P = 0.8 0.28 = 0.2240 or 22.40% per year

b. The investment proportions of the clients overall portfolio can be calculated

by the proportion of risky portfolio in the complete portfolio times the
proportion allocated in each stock.
Security
T-Bills
Stock A
Stock B
Stock C

0.8 20% =
0.8 30% =
0.8 50% =

Investment
Proportions
20.0%
16.0%
24.0%
40.0%

c. We calculate the reward-to-variability ratio (Sharpe ratio) using Equation 5.14.

For the risky portfolio:
Portfolio Risk Premium
S = S tandard Deviation of Portfolio Excess Return

E( r P) r f
P

0. 12 0.0 4
= 0. 28
= 0.2857

For the clients overall portfolio:

S=

d.

E( r C ) r f
C

0. 1040 0.0 4
= 0. 224 0

= 0.2857

E(r)

17

CAL(slope=.3704)

14

client
7

27

18.9

13.
d.

E(rC) = y E(rP) + (1 y) rf
= y 0.12 + (1 y) 0.04 = 0.11 or 11% per year
0. 11 0.04
Solving for y, we get y = 0. 10

= 0.875

Therefore, in order to achieve an expected rate of return of 11%, the client

must invest 87.5% of total funds in the risky portfolio and 12.5% in T-bills.
e. The investment proportions of the clients overall portfolio can be calculated
by the proportion of risky asset in the whole portfolio times the proportion
allocated in each stock.
Security
T-Bills
Stock A
Stock B
Stock C

0.875 20% =
0.875 30% =
0.875 50% =

Investment
Proportions
12.5%
17.50%
26.25%
43.75%

f. The standard deviation of the complete portfolio is the standard deviation of

the risky portfolio times the fraction of the portfolio invested in the risky asset:

= y P = 0.875 0.28 = 0.2450 or 24.5% per year

Chapter 6
CFA 2
Answer:
Fund D represents the single best addition to complement Stephenson's current
portfolio, given his selection criteria. First, Fund Ds expected return (14.0 percent)
has the potential to increase the portfolios return somewhat. Second, Fund Ds
relatively low correlation with his current portfolio (+ .65) indicates that Fund D will
provide greater diversification benefits than any of the other alternatives except Fund
B. The result of adding Fund D should be a portfolio with approximately the same
expected return and somewhat lower volatility compared to the original portfolio.
The other three funds have shortcomings in terms of either expected return
enhancement or volatility reduction through diversification benefits. Fund A offers the
potential for increasing the portfolios return, but is too highly correlated to provide
substantial volatility reduction benefits through diversification. Fund B provides
substantial volatility reduction through diversification benefits, but is expected to
generate a return well below the current portfolios return. Fund C has the greatest
potential to increase the portfolios return, but is too highly correlated to provide
substantial volatility reduction benefits through diversification.

CFA 3
Answer:
a. Subscript OP refers to the original portfolio, ABC to the new stock,
and NP to the new portfolio.
i. E(rNP) = wOP E(rOP ) + wABC E(rABC ) = ( .9 .67) + ( .1 1.25) = .7280%
ii. CovOP , ABC = CorrOP , ABC OP ABC = .40 2.37 2.95 = 2.7966
iii.

NP

= [wOP 2 OP 2 + wABC 2 ABC 2 + 2 wOP wABC (CovOP , ABC)]1/2

= [( .92 2.372) + ( .12 2.952) + (2 .9 .1 2.7966)]1/2
= 2.2672%

b. Subscript OP refers to the original portfolio, GS to government securities, and

NP to the new portfolio.
i. E(rNP) = wOP E(rOP ) + wGS E(rGS ) = ( .9 .67) + ( .1 .42) = .6450%
ii. CovOP , GS = CorrOP , GS OP GS = 0 2.37 0 = 0
iii.

NP

= [wOP 2 OP 2 + wGS 2 GS 2 + 2 wOP wGS (CovOP , GS)]1/2

= [( .92 2.372) + ( .12 0) + (2 .9 .1 0)]1/2
= 2.1330%

c. Adding the risk-free government securities would result in a lower beta for
the new portfolio. The new portfolio beta will be a weighted average of the
individual security betas in the portfolio; the presence of the risk-free
securities would lower that weighted average.
d. The comment is not correct. Although the respective standard deviations and
expected returns for the two securities under consideration are identical, the
correlation coefficients between each security and the original portfolio are
unknown, making it impossible to draw the conclusion stated. For instance,
if the correlation between the original portfolio and XYZ stock is smaller
than that between the original portfolio and ABC stock, replacing ABC
stocks with XYZ stocks would result in a lower standard deviation for the
portfolio as a whole. In such a case, XYZ socks would be the preferred
investment, assuming all other factors are equal.
e. Grace clearly expressed the sentiment that the risk of loss was more
important to her than the opportunity for return. Using variance (or standard
deviation) as a measure of risk in her case has a serious limitation because
standard deviation does not distinguish between positive and negative price
movements.

Chapter 7
25.
a. Since the market portfolio, by definition, has a beta of 1.0, its expected rate
of return is 14%.
b. = 0 means the stock has no systematic risk. Hence, the portfolio's expected
rate of return is the risk-free rate, 4%.
c. Using the SML, the fair rate of return for a stock with = 0.5 is:
E(r) = 4% + (0.5) (14% 4%) = 1.0%
The expected rate of return, using the expected price and dividend for next
year:
E(r) = ($31 + $4)/$30 1 = 0.1667 = 16.67%
Because the expected return exceeds the fair return, the stock must be underpriced.
26. The data can be summarized as follows:

a. UsingtheSML,theexpectedrateofreturnforanyportfolioPis:
E(rP) = rf + [E(rM) rf ]
SubstitutingforportfoliosAandB:
E(rA) = 6% + 0.8 (12% 6%) = 10.8% < 11%
E(rB) = 6% + 1.5 (12% 6%) = 15.0% > 14%
Hence,PortfolioAisdesirableandPortfolioBisnot.
b. TheslopeoftheCALsupportedbyaportfolioPisgivenby:
S=

E( r P) r f
P

Computingthisslopeforeachofthethreealternativeportfolios,wehave:
S (S&P 500) = (12% 6%)/20% = 6/20
S (A) = (11% 5/10 > S(S&P 500)
S (B) = (14% 8/31 < S(S&P 500)
Hence, portfolio A would be a good substitute for the S&P 500.
CFA 2
Answer:
a. E(rX) = 5% + 0.8 (14% 5%) = 12.2%

= 14% 12.2% = 1.8%

E(rY) = 5% + 1.5 (14% 5%) = 18.5%

= 17% 18.5% = 1.5%

b.
i.

For an investor who wants to add this stock to a well-diversified

equity portfolio, Kay should recommend Stock X because of its positive
alpha, while Stock Y has a negative alpha. In graphical terms, Stock Xs
expected return/risk profile plots above the SML, while Stock Ys profile
plots below the SML. Also, depending on the individual risk preferences
of Kays clients, Stock Xs lower beta may have a beneficial impact on
overall portfolio risk.

ii.

For an investor who wants to hold this stock as a single-stock

portfolio, Kay should recommend Stock Y, because it has higher
forecasted return and lower standard deviation than Stock X. Stock Ys
Sharpe ratio is:
(0.17 0.05)/0.25 = 0.48
Stock Xs Sharpe ratio is only:
(0.14 0.05)/0.36 = 0.25
The market index has an even more attractive Sharpe ratio:
(0.14 0.05)/0.15 = 0.60
However, given the choice between Stock X and Y, Y is superior. When a
stock is held in isolation, standard deviation is the relevant risk measure.
For assets held in isolation, beta as a measure of risk is irrelevant.
Although holding a single asset in isolation is not typically a
recommended investment strategy, some investors may hold what is
essentially a single-asset portfolio (e.g., the stock of their employer
company). For such investors, the relevance of standard deviation versus
beta is an important issue.
Chapter 8

25.
a. If a shift were actually predictable, it would be a violation of EMH. Such shifts
would be expected to occur as a result of a recession, but the recession is not
predictable; thus it is not actually a violation of EMH. That being said, such a shift
is consistent with EMH since the shift occurs after a recession or recovery occurs.
As the news hits the market, the risk premiums are adjusted.

b. The reason this is perceived as an overreaction is because there are two events
occurring. First, recessions lead to reduced profits, impacting the numerator in a
fundamental analysis. This reduced cash flow represses stock prices.
Simultaneously, the recession causes risk premiums to rise, thus increasing the
denominator in the fundamental analysis calculation. An increase in the
denominator further reduces the price. The result is the appearance of an
overreaction.
CFA 11
a. Some empirical evidence that supports the EMH is:
(i) professional money managers do not typically earn higher returns than
comparable risk, passive index strategies;
(ii) event studies typically show that stocks respond immediately to the public
release of relevant news;
(iii) most tests of technical analysis find that it is difficult to identify price
trends that can be exploited to earn superior risk-adjusted investment returns.
b. Some evidence that is difficult to reconcile with the EMH concerns simple
portfolio strategies that apparently would have provided high risk-adjusted returns
in the past. Some examples of portfolios with attractive historical returns:
(i) low P/E stocks;
(ii) high book-to-market ratio stocks;
(iii) small firms in January;
(iv)firms with very poor stock price performance in the last few months.
Other evidence concerns post-earnings-announcement stock price drift and
intermediate-term price momentum.
c. An investor might choose not to index even if markets are efficient because he or
she may want to tailor a portfolio to specific tax considerations or to specific risk
management issues, for example, the need to hedge (or at least not add to)
exposure to a particular source of risk (e.g., industry exposure).
Chapter 9
CFA 1
Answer:
i.

Mental accounting is best illustrated by Statement #3. Sampsons requirement

that his income needs be met via interest income and stock dividends is an
example of mental accounting. Mental accounting holds that investors
segregate funds into mental accounts (e.g., dividends and capital gains),
maintain a set of separate mental accounts, and do not combine outcomes; a
loss in one account is treated separately from a loss in another account.
Mental accounting leads to an investor preference for dividends over capital
gains and to an inability or failure to consider total return.

ii.

Overconfidence (illusion of control) is best illustrated by Statement #6.

Sampsons desire to select investments that are inconsistent with his overall
strategy indicates overconfidence. Overconfident individuals often exhibit
risk-seeking behavior. People are also more confident in the validity of their
conclusions than is justified by their success rate. Causes of overconfidence
include the illusion of control, self-enhancement tendencies, insensitivity to
predictive accuracy, and misconceptions of chance processes.
iii.Reference dependence is best illustrated by Statement #5. Sampsons desire to
retain poor performing investments and to take quick profits on successful
investments suggests reference dependence. Reference dependence holds that
investment decisions are critically dependent on the decision-makers
reference point. In this case, the reference point is the original purchase price.
Alternatives are evaluated not in terms of final outcomes but rather in terms of
gains and losses relative to this reference point. Thus, preferences are
susceptible to manipulation simply by changing the reference point.

CFA 5
Answer:
i.
Overconfidence (Biased Expectations and Illusion of Control): Pierce is basing her
investment strategy for supporting her parents on her confidence in the economic
forecasts. This is a cognitive error reflecting overconfidence in the form of both
biased expectations and an illusion of control. Pierce is likely more confident in the
validity of those forecasts than is justified by the accuracy of prior forecasts.
Analysts consensus forecasts have proven routinely and widely inaccurate. Pierce
also appears to be overly confident that the recent performance of the Pogo Island
economy is a good indicator of future performance. Behavioral investors often
conclude that a short track record is ample evidence to suggest future performance.
Standard finance investors understand that individuals typically have greater
confidence in the validity of their conclusions than is justified by their success
rate. The calibration paradigm, which compares confidence to predictive ability,
suggests that there is significantly lower probability of success than the confidence
levels reported by individuals. In addition, standard finance investors know that
recent performance provides little information about future performance and are
not deceived by this law of small numbers.
ii.

Loss Aversion (Risk Seeking): Pierce is exhibiting risk aversion in deciding to sell the
Core Bond Fund despite its gains and favorable prospects. She prefers a certain gain
over a possibly larger gain coupled with a smaller chance of a loss. Pierce is
exhibiting loss aversion (risk seeking) by holding the High Yield Bond Fund despite
its uncertain prospects. She prefers the modest possibility of recovery coupled with
the chance of a larger loss over a certain loss. People tend to exhibit risk seeking,
rather than risk aversion, behavior when the probability of loss is large. There is
considerable evidence indicating that risk aversion holds for gains and risk seeking
behavior holds for losses, and that attitudes toward risk vary depending on particular
goals and circumstances.
Standard finance investors are consistently risk averse, and systematically prefer a
certain outcome over a gamble with the same expected value. Such investors also
take a symmetrical view of gains and losses of the same magnitude, and their

sensitivity (aversion) to changes in value is not a function of a specified value

reference point.
iii.

Reference Dependence: Pierces inclination to sell her Small Company Fund

once it returns to her original cost is an example of reference dependence. Her
sell decision is predicated on the current value as related to original cost, her
reference point. Her decision does not consider any analysis of expected
terminal value or the impact of this sale on her total portfolio. This reference
point of original cost has become a critical but inappropriate factor in Pierces
decision.
In standard finance, alternatives are evaluated in terms of terminal wealth values
or final outcomes, not in terms of gains and losses relative to a reference point
such as original cost. Standard finance investors also consider the risk and return
profile of the entire portfolio rather than anticipated gains or losses on any
particular investment or asset class.
Global Questions

1.

C.
Feedback: The father commits mental accounting by segregating his decisions
in saving for his son and pays back the mortgage. He receives lower rate for
saving while paying out higher rates for a mortgage at the same time. Although
the equity premium is high, the fathers investment horizon is limited for 5 or
6 years. Therefore, it is justifiable to opt for a savings account with a lower
return. The floating rate depository account is not necessarily a better option
than a fixed rate depository account given no further information.