Investments Levy and Post PDF

Instructor’s Problem
Set
Investments
Haim Levy
Thierry Post
ISBN 0 273 68511 2
1
© Pearson Education Limited 2005
Chapter 1 Introduction
MULTIPLE CHOICE QUESTIONS
1. Which of the following is not a basic component of the investment process?

A. investor characteristics
B. investment vehicles
C. strategy development
D. strategy monitoring
E. All of the above are basic components of the investment process.
2
MULTIPLE CHOICE QUESTIONS: ANSWERS
1. E
3
OPEN QUESTIONS
1. “Following the investment process allows investors to identify an optimal portfolio and stick
with it indefinitely.”
Do you agree with this statement? Why or why not?
Answer:
The statement is false. The investment process is dynamic and never-ending. Investor
characteristics change as time passes. For example, older investors tend to be more risk-averse
than younger investors. Even if one can identify an optimal portfolio at a given point in time,
the portfolio’s characteristics may change over time. Suppose an investor determines that his
or her optimal asset allocation is 30% cash, 50% bonds, and 20% stocks. If stocks
subsequently perform very well, their values will increase, causing stocks to represent more
than 20% of the investor’s wealth. As investor characteristics, economic factors, and market
factors change, it will be necessary for investors to adjust their investment strategies. The
processes of strategy development, implementation, and monitoring go on continuously.
4
Chapter 2 Bonds, Stocks and Other Securities
1. Which type of risk is faced by holders of corporate bonds that can be considered non-existent by
holders of government bonds?
A. foreign exchange rate risk
B. inflation rate risk
C. market risk
D. default risk
5
1. D
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OPEN QUESTIONS
1. Explain what is meant by the following statement:
“The ownership of the firm is residual in nature."
Answer:
This statement refers to the fact that common shareholders receive what is left over after all other
claims on the firm have been provided.
2. Describe the differences between financial assets and physical assets for each of the following
characteristics.
a. Divisibility
b. Marketability
c. Holding period
Answer:
a. An asset is divisible if you can buy and sell small portions of it. Financial assets are easily
divisible, while most physical assets (such as factories) are not.
b. An asset is marketable (or liquid) if it can quickly and easily be sold for cash without
affecting its value. Most physical assets (such as houses) are illiquid. Financial assets
typically are more marketable than physical assets, even though some financial assets (such
as stocks) are much more liquid than others (such as stamps).
c. Those who purchase physical assets usually intend to hold them for a long time, because
such assets are not expected to provide cash flows until some time has passed. In contrast,
investors who buy financial assets often plan to hold them for only a very short time.
7
Chapter 3 Security Markets
MULTIPLE CHOICE
1. You purchase shares with a market price of $60 when the initial margin requirement is 80%. The
maintenance margin is 30%. What is the highest price that will trigger a margin call?
A. $8
B. $ 12
C. $ 17
D. $ 24
E. $ 48
2. Which type of underwriting arrangement requires the underwriter to buy the entire new issue from
the issuing corporation at a predetermined price, and absorb all unsold shares for his own account
at this price?
A. firm commitment
B. best effort
C. standby commitment
D. contractual offering
E. rights issue
8
1. C
2. A
9
OPEN QUESTIONS
1. What is margin trading, and why is it considered risky?
Answer:
Trading on margin refers to an investor buying securities by first borrowing a portion of the
funds needed from his or her broker. By borrowing, the investor can take a larger position than
otherwise would be possible. This “leverage” magnifies the possible positive, and negative,
returns the investor faces.
2. Suppose you purchase 500 shares of ABC Company common stock at $75 per share by
borrowing funds from your broker. Your initial margin is 65%, the maintenance margin 55%.
a. How much of your own money will you have to provide?
b. What is the price at which you would begin to receive a margin call?
Answer:
a. Based on the information given and the notation from the chapter, N = 500, P = $75, IM =
0.65, and MM = 0.55. You buy 500 ∙ $75 = $37,500 worth of common stocks and the 65%
margin means you have to provide 0.65 ∙ 37,500 = $24,375.
You can also use Equation 3.1 to arrive at this number:
From Equation 3.1 we observe
IM ∙ (N ∙ P) = N ∙ P – B
Thus, the amount initially provided equals IM ∙ (N ∙ P) = 0.65 ∙ (500 ∙ $75) = $24,375.
b. The margin call price is based on Equation 3.2, which is
B 500  $75 − $24,375 $13,125

P = = = = $58.33
N (1 − MM ) 500(1 − 0.55) 225
3. The price (P’), below which you will be called for the maintenance margin can be expressed
without the amount borrowed (B). Develop and explain this formula.
Answer:
From equation 3.2’ we have
B
P =
N (1 − MM )
10
However, Equation 3.1 is
NP−B
IM =
NP
And solving for the loan balance we have
B = N ∙ P – IM ∙ (N ∙ P) = N ∙ P ∙ (1 – IM)
Substituting B for our result here, we have
N  P(1 − IM )
P’ =
N (1 − MM )
Dividing all terms by N, we have
P(1 − IM )
P’ =
(1 − MM )
11
Chapter 4 Institutional Investors
1. Which type of fund is most likely to invest in high-grade commercial paper?

A. equity fund
B. bond fund
C. balanced fund
D. money market mutual fund
E. index fund
2. A mutual fund owns securities with a market value of $9,000,000, has 500,000 shares outstanding,
owes its employees $200,000, and has a 3% load charge. The net asset value per share is:
A. $18.00
B. $18.90
C. $16.85
D. $17.60
E. $18.48
3. The current market value of all securities held by a fund less any liabilities, divided by the number
of shares outstanding is the:
A. book value
B. net asset value
C. market value
D. net profit
E. share price
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2. D
2. D
3. B
OPEN QUESTIONS
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1. The ABC Fund, a closed-end fund, consists of three securities – 1,000 shares of Security A,
which is currently trading for $35; 2,000 shares of Security B, which is trading for $45; and
3,000 shares of Security C, which is trading for $55. What is its NAV if the fund has $87,000
in net liabilities and 10,000 shares outstanding?
Answer:
NAV = [1,000($35) + 2,000($45) + 3,000($55) – $87,000]/10,000
= [$35,000 + $90,000 + $165,000 – $87,000]/10,000
= $203,000/10,000 = $20.30
2. Why must open-end funds keep more cash on hand than closed-end funds?
Answer:
Open-end funds must be ready at all times to repurchase shares from the public, so the funds
must keep some cash on hand at all times. If they did not, they would be forced to sell assets
every time investors redeemed their shares and would incur significant transaction costs.
Closed-end funds do not have to be concerned with day-to-day liquidity needs because such
funds do not allow investors to redeem shares.
3. Can mutual funds be sold at a discount? At a premium? Explain.
Answer:
Mutual fund shares are priced at net asset value and may be sold at an offer price that includes
a load. Mutual funds do not trade at a premium or discount from NAV, as do closed-end funds.
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Chapter 5 Security Regulation and Investment Ethics
1. Which of the following created the Securities and Exchange Commission?

A. Securities Act of 1933
B. Glass-Steagall Banking Act of 1933
C. Securities Exchange Act of 1934
D. Securities Acts Amendments of 1975
E. Employee Retirement Income Security Act of 1974
2. Which of the following statements about corporate governance is wrong?

A. Corporate governance is important because it is the framework through which shareholders
can be assured of legal compliance.
B. Corporate governance is a method of controlling the corporation.
C. Corporate governance establishes the appropriate ethical conduct of the corporation.
D. Corporate control usually rests with the CEO, who is elected by the common shareholders.
E. With the increasing concentration of shares held by large institutional investors, the role of
active corporate governance on the part of the shareholders will increase.
3. Which of the following statements about churning is wrong?

A. Churning is buying and selling excessive amounts for a client.
B. It is difficult to prove in most cases whether churning has occurred or whether the broker is
pursuing some sort of investment strategy.
C. Churning is illegal under SEC rules as well as the rules of all major exchanges.
D. The courts have used the ratio of commissions to invested equity to determine whether
excessive trading exists.
E. Churning is unethical but not unlawful.
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1. C
2. D
3. E
OPEN QUESTIONS
16
1. A broker recommends several changes to your portfolio. You make several changes a month
based on your broker’s recommendations. At the end of six months your portfolio returns are
exceeded by your commission costs. Has your broker acted illegally?
Answer:
The broker may be guilty of churning, which is illegal under SEC Rule 10b-5. To prove
churning, the courts have used three tests to determine whether excess trading existed:
1. Annualized turnover ratio (how frequently securities are traded).
2. Ratio of commissions to invested equity.
3. The proportion of commissions derived by the broker from the account in question
compared with all other accounts handled by that broker
2. What are the differences between regulations and ethics?
Answer:
Regulations are rules established by governments for the purpose of identifying unacceptable
behavior. Ethics embodies the ideals we should strive for and how we should behave. A
behavior that is unacceptable based on ethical standards may be found acceptable by existing
regulations.
3. Describe a situation in which a corporate manager’s behavior is unethical but not unlawful.
Answer:
An example would be a CEO nominating people who are dependent on him or her to the board
of directors, which determines his or her compensation. This action is clearly unethical but not
unlawful.
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Chapter 6 Rates of Return
1. Which of the following should be used when estimating the average performance across different
securities for one period of time?
A. geometric average
B. arithmetic average
C. compound average
D. complex average
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1. B
OPEN QUESTIONS
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1. The table below provides a history of stock prices and dividends for Bismal Company stock.
Compute the after-tax return to an investor who buys 100 shares of Bismal stock on January 1
and sells the stock on December 31. Assume the tax rate on ordinary income is 20% and the tax
rate on capital gains income is 28%.
Market Price When

Date Dividend Dividend Is Received
January 1 $36
January 15 $0.85 $42
April 15 0.85 $42
July 15 0.85 $44
October 15 0.85 $40
December 31 $40
Answer:
Using the linking method:
Date Market Dividend Interim After- After-tax

Price Period tax
When Interim Time-
Dividend Rate of Weighted
Is Return Rate of
Received Return
1-Jan $36
15-Jan $42 $0.85 1 18.37% 18.37%
15-Apr $42 0.85 2 1.4571 20.0914
15-Jul $44 0.85 3 6.219 27.56
15-Oct $40 0.85 4 –7.7000 17.7379
31-Dec $40 5 –2.0000 15.3831
The return for interim periods 1 through 4 is:
R1 = [42 – 36 + 0.85(1 – 0.28)]/36 = 18.3667%.
R2 = [42 – 42 + 0.85(1 – 0.28)]/42 = 1.4571%.
20
R3 = [44 – 42 + 0.85(1 – 0.28)]/42 = 6.2190%.
R4 = [40 – 44 + 0.85(1 – 0.28)]/44 = –7.7000%.
The after-tax rate of return for interim period 5 is:
R5 = [40 – 40 – (40 – 36)(0.20) + (0)(1 – 0.28)]/40 = –2.0000%.
The after-tax return for the year is
(1.183667)(1.014571)(1.062190)(0.923000)(0.980000) – 1 = 15.3830%.
2. Describe three different ways indexes can be constructed.
Answer:
Indexes can be constructed using the price-weighted, value-weighted, or equally-weighted

methods. The price-weighted index weights its component securities by their market price,
whereas the value-weighted index weights its component securities on their equity value. The
equally-weighted index weights each security equally.
3. The following tab1e shows the NYSE composite index over a recent 15-year period:
End of NYSE
Year Composite
1988 156.26
1989 195.01
1990 180.49
1991 229.44
1992 240.21
1993 259.08
1994 250.94
1995 329.51
1996 392.30
1997 511.19
1998 595.81
1999 650.30
2000 656.87
2001 589.80
2002 472.87
2003 646.40
A. Ignoring dividends, calculate the simple annual rates of return.
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B. Calculate the arithmetic average of the annual rates of return.

C. Calculate the geometric average of the annual rates of return.
D. Compare your answers in Parts b and c. How do you account for the difference between
these averages?
Answer:
A. The interim rates of return are based on Equation 6.1 and are given in the following table:
End of NYSE Interim

Rate of
Year Composite
Return
1988 156.26
1989 195.01 0.2480
1990 180.49 -0.0746
1991 229.44 0.271
1992 240.21 0.047
1993 259.08 0.078
1994 250.94 -0.0314
1995 329.51 0.31
1996 392.30 0.1905
1997 511.19 0.303
1998 595.81 0.166
1999 650.30 0.091
2000 656.87 0.010
2001 589.80 -0.102
2002 472.87 -.198
2003 646.40 0.367
B. The arithmetic average of these 15 rates of return is:
RA = (0.2480 - 0.0746 + 0.271 + 0.047 + 0.078 - 0.0314 + 0.31 + 0.1905 + 0.303 + 0.166
+ 0.091 + 0.010 – 0.102 – 0.198 + 0.367)/15 = 1.6755/15 = 0.1117 or 11.17%
C. The geometric average of these 15 rates of return is:
22
1/15
 646.40 
RG =   − 1 = 9.93%
 156.26 
D. The difference in the averages is due to the variability of rates of return. When there is no
variability, the averages are identical.
23
Chapter 7 Fundamentals of Portfolio Analysis
1. Which of the following statements about risk is correct?

A. If all investors were risk averse, there would be no positive risk premium.
B. The variance of return is a measure of the dispersion around the mean and is used as a
measure of risk.
C. Risk-neutral investors are willing to pay a higher price for an asset whose variance increases.
D. Investors are risk averse when they ignore an asset’s variance and only consider the asset’s
expected return.
E. Most investors are risk neutral.
2. An analyst developed the following probability distribution of potential rates of return for Stock
Z under three scenarios and later revised the expected rate of return for each scenario:
Original Expected Revised Expected

Scenario Probability Rate of Return Rate of Return
1 0.20 0.20 0.210
2 0.50 0.30 0.310
3 0.30 0.50 0.525
If the original variance of the expected rate of return was 0.0124, Stock Z’s revised standard
deviation of expected return will be:
A. 0.1050.
B. 0.1114.
C. 0.1141.
D. 0.1169.
24
1. B
2. D
25
OPEN QUESTIONS
1. Given the following information, calculate the E(R), variance, and standard deviation.
State of economy Probability Mutual fund Common stock Certificate of deposit

Weak growth 33% 8% 6% 7%
Moderate growth 33% 10% 12% 7%
Strong growth 33% 12% 15% 7%
Expected return ____ ____ ____

Standard deviation ____ ____ ____
Answer:
Mutual fund
Probability HPR P(HPR) [HPR-E(R)]2 P[HPR-E(R)]2

33% 8% 2.64% (8 – 9.9) 2
1.1913
33% 10% 3.30% (10 – 9.9) 2
0.0033
33% 12% 3.96% (12 – 9.9) 2
1.4553
E(R) = 9.90
Variance 2 = 2.6499
Standard deviation  = 1.6279
Common stock
33% 6% 1.98% (6 – 10.89)2 7.8910

33% 12% 3.96% (12 – 10.89)2 0.4066
33% 15% 4.95% (15 – 10.89)2 5.5744
E(R) = 10.89%
Variance 2 = 13.5060
Standard deviation  = 3.6751
Certificate of deposit
33% 7% 2.31% (7 – 7)2 0

33% 7% 2.31% (7 –7)2 0
33% 7% 2.31% (7 -7)2 0
E(R) = 6.93% , Round to 7%
Variance  = 0
2
Standard deviation  = 0
Note that the certificate of deposit has 0 variance and standard deviation, meaning no risk.
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2. Next year a security will yield $90 with a probability of ½ and $110 with a probability of ½. An
investor is willing to pay $80 for this asset today. The risk-free interest rate is 15%.
a. Is this investor a risk seeker or a risk averter?
b. What is the risk premium?
Answer:
a. The rates of return are ($901$80) - 1 = 0.125 and ($110/$80) - 1 = 0.375. The expected rate
of return is
E(R) = ½ * (12.5%) + 1/2 * (37.5%) = 25%
and because this expected return exceeds the riskless interest rate, we know that this investor
is a risk averter.
b. The risk premium is equal to the expected return less the riskless rate or 25% - 15% = 10%.
3. Answer Question 24 assuming that the investor is ready to pay $95 for this asset.
Answer:
a. In this case, the rates of return are ($90/$95) - 1 = -0.053 and ($110/$95) - 1 = 0.1579. The
expected rate of return is
E(R) = ½ * (-5.3%) + ½ * (15.79%) = 5.245%
and because this expected return does not exceed the riskless interest rate, we know that this
investor is a risk seeker.
b. The risk premium is equal to the expected return less the riskless rate or 5.25% - 15.0% = -
9.75%.
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Chapter 8 Mean-Variance Analysis
1. Which of the following is not a variable in the calculation of the variance of a portfolio?
A. the correlations between assets
B. the variance of each asset
C. the expected return of each asset
D. the proportion invested in each asset
E. the covariances between assets
2. The correlation between Compaq and Pfizer is:

A. 0.19
B. 0.46
C. 0.51
D. 0.64
E. 0.38
3. The variance of the portfolio, composed of 25% invested in Compaq and 75% invested in
Pfizer, is:
A. 12.33
B. 13.94
C. 152
D. 144
E. 176
28
1. C
2. C
3. C
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OPEN QUESTIONS
1. Describe an asset's risk when held with other assets in a portfolio.
Answer:
The variance of the returns on the asset is the measure of risk of that asset when an investor
holds only one asset. However, when the investor holds more than one risky asset, the risk of
an individual asset is a function not only of its own variance but also of its degree of
dependency on the other assets in the portfolio.
2. Calculate the correlation of Stock C with Stock D.
State of
Economy Probability Stock C Stock D
Excellent 0.4 20% 0%
Wonderful 0.6 0% 10%
Answer:
We must first calculate C,D, C, and D. These calculations, in turn, require us to compute
E(RC) and E(RD).
E(RC) = 0.4(20%) + 0.6(0%) = 8%.
E(RD) = 0.4(0%) + 0.6(10%) = 6%.
2C = 0.4(0.20 – 0.08)2 + 0.6(0 – 0.08)2 = 0.0096.
2D = 0.4(0 – 0.06)2 + 0.6(0.10 – 0.06)2 = 0.0024.
C,D = 0.4(0.20 - 0.08)(0 - 0.06) + 0.6(0 - 0.08)(0.10 - 0.06) = -0.0048.
C,D = –0.0048/(0.0096)1/2(0.0024)1/2 = –1. The assets are perfectly negatively correlated.
3. The probability distributions of returns for Stock A and Stock B are given below:
State of
Economy Probability Stock A Stock B
Bad 0.2 –5% 0%

OK 0.3 0% 15%
Good 0.5 10% 30%
a. Calculate the expected returns for Stock A and Stock B.

b. Calculate the correlation of Stock A with Stock B.
c. Portfolio Q is formed by investing 80% in Stock A and 20% in Stock B. Calculate the
expected return and standard deviation of Portfolio Q.
Answer:
a. E(RA) = 0.2(–5%) + 0.3(0%) + 0.5(10%) = 4%.
30
(RB) = 0.2(0%) + 0.3(15%) + 0.5(30%) = 19.5%.

b. A,B = 0.2(–0.05 – 0.04)(0 – 0.195) + 0.3(0 – 0.04)(0.15 – 0.195) + 0.5(0.10 – 0.04)
(0.30 – 0.195) = 0.0072.
Calculate variances:
2A = 0.2(–0.05 – 0.04)2 + 0.3(0 – 0.04)2 + 0.5(0.10 – 0.04)2 = 0.0039.
2B = 0.2(0 – 0.195)2 + 0.3(0.15 – 0.195)2 + 0.5(0.30 – 0.195)2 = 0.013725.
Calculate correlation:
A,B = 0.0072/(0.0039)1/2(0.013725)1/2 = 0.984.
c. E(RQ) = 0.8(4%) + 0.2(19.5%) = 7.1%.
2Q = 0.22(0.0039) + 0.82(0.013725) + 2(0.2)(0.8)(0.0072) = 0.011244.
31
Chapter 9 Portfolio Diversification
1. Total risk decrease as the:

A. number of stocks in the portfolio decreases
B. correlation between the returns of the securities in the portfolio decreases
C. correlation between the returns of the securities in the portfolio increases
D. number of different industries in the portfolio decreases
E. number of stocks in the same industry increases
2. Diversification is most effective when security returns are:

A. negatively correlated
B. positively correlated
C. low
D. high
E. uncorrelated
32
1. B
2. A
33
OPEN QUESTIONS
1. Explain the statement: “A little diversification goes a long way.”
Answer:
In general, the greater the number of securities in a portfolio, the lower the portfolio’s variance.
However, as the number of securities increases, the incremental contribution to the reduction in
the portfolio’s variance becomes smaller and smaller. Therefore, the greatest gain is achieved by
diversifying in a relatively few securities
2. Why do most mutual funds hold hundreds of stocks, while it can be shown that about 90% of
the maximum potential benefit from diversification (when considering typical U.S. stocks) is
achieved with a portfolio composed of twelve to eighteen securities?
Answer:
First of all, although the benefit from including more stocks in the portfolio diminishes, the
benefit is still positive. An individual investor who faces large information and transaction costs
cannot study/trade hundreds of stocks. For a large mutual fund, however, the information and
transaction costs per $1 invested is so small that it is still worthwhile to increase the number of
assets in the portfolio and enjoy the little ensuing benefit from risk reduction.
Second, large funds cannot concentrate on a limited number of stocks without their buying and
selling greatly affecting the price of those securities.
3. “Investors with less than $100,000 should stick with mutual funds because of diversification
benefits.” Evaluate this statement.
Answer:
While it is true that mutual funds will provide the benefits of diversification, these benefits are
not free. The cost of diversification through mutual funds can be anything between 1% and 3%
per annum. The extra diversification benefits a mutual fund can provide to small investors must
outweigh these costs in order to be worthwhile.
34
Chapter 10 The Capital Asset-Pricing Model
1. An investor invests 40% of her wealth in a risky asset with an expected rate of return of 15% and
a standard deviation of 20%. The rest of her wealth is invested in the risk-free asset, which yields
6%. What are the expected return and standard deviation of her portfolio?
A. E(R) = 8.0%,  = 12%

B. E(R) = 9.6%,  = 8%
C. E(R) = 9.6%,  = 12%
D. E(R) = 11.4%,  = 12%
2. No matter how large the number of stocks in the portfolio is, the risk that cannot be diversified
away is the:
A. company-specific risk
B. unsystematic risk
C. systematic risk
D. unique risk
E. both a and b
35
1. B
2. C
36
OPEN QUESTIONS
1. Suppose investors can borrow and lend at the risk-free rate of 7%. Joyce Zoot wants the expected
return of her total portfolio to be 15%. Her financial planner has told her that this will require her
to invest some of her money in the risk-free asset and the rest in a risky asset (asset A) that has
an expected return of 30%. With this investment plan, the risk of Joyce’s complete portfolio will
be 20%. What is the standard deviation of Portfolio P?
Answer:
Use Equation 10.2. The expected return of Joyce’s portfolio will be 15% if
15% = wr(7%) + (1 – wr)(30%).
Solving,
wr = 0.652 and (1 – wr) = 0.348.
Now use Equation 10.3 to solve for the standard deviation of asset A:
0.20 = (1 – wr)A = 0.348A. Solving, A = 57.5%.
2. Regressing returns for Stock A against returns for the market portfolio yielded the following
results: Stock A’s alpha is 2%, Stock A’s beta is 2, and the standard deviation of Stock A’s
returns is 40%. The standard deviation of the market’s returns is 10%.
A. Where does Stock A’s characteristic line intercept the vertical axis?
B. What is the slope of Stock A’s characteristic line?
C. What is the systematic risk of Stock A?
D. What is the unique risk of Stock A?
Answer:
A. Alpha is the intercept for the characteristic line ( = 0.02).
B. Beta is the slope of the characteristic line ( = 2).
C. Using Equation 10.8, the systematic risk is  2i2m = 22(0.10)2 = 0.04.
E. Using Equation 10.8, the unique risk is 2i -  2i2m = 0.402 – 22(0.10)2 = 0.16 – 0.04 = 0.12.
37
3. A portfolio that is invested 5/9 in Stock A and 4/9 in Stock B has an expected return of 20%.
Stock A Stock B
Expected Not available 28%
Return
Variance 0.0484 0.0324
Beta 0.6 1.5
What are the risk-free rate and the expected return on the market?
Answer:
The beta of the portfolio is the weighted average of the betas of Stock A and Stock B:
p = (5/9)(0.6) + (4/9)(1.5) = 1.
Since the beta of the portfolio is the same as the market’s beta, the portfolio’s expected return
(20%) must be equal to the market’s expected return.
Additionally, the capital asset pricing model must hold for all assets in equilibrium. For Stock B,
we have
28% = r + 1.5(20% – r). Solving, r = 4%.
To check these results we can use CAPM to solve for Stock A’s expected return:
E(RA) = 4% + 0.6(20% – 4%) = 13.6%,
and calculate the portfolio’s expected return as the weighted average of the expected returns of
Stock A and Stock B:
E(Rp) = (5/9)(13.6%) + (4/9)(28%) = 20%.
38
Chapter 11 Arbitrage Pricing Theory
1. Which of the following statements about the single index model (SIM) is correct?
A. The SIM requires more computations to solve for the mean-variance efficient set.
B. The SIM can decompose risk into its systematic component and unsystematic component.
C. The SIM claims that both the systematic and unsystematic risks can be diversified away.
D. The SIM assumes that a firm's specific news is dependent on another firm's specific news.
E. Statements a and d are both correct.
2. Which of the following statements is false?

A. The single index model was developed to reduce the computational problems in calculating
the efficient frontier.
B. The APT was developed as an alternative to the CAPM.
C. With the single index model, risk can be broken down into systematic and unsystematic
components.
D. With large portfolios, systematic risk can be virtually eliminated.
E. The single index model assumes that returns are generated by a single factor and firm-specific
factors.
39
1. B
2. D
40
OPEN QUESTIONS
1. Why does the single index model (SIM) reduce the amount of computations?
Answer:
The SIM assumes that a firm's specific news is independent of another firm's specific news. In
statistical terms, this assumption implies that Cov. (ei, ej) = 0, where ei is the firm i's specific news.
Also, the deviation from the line for ei is assumed to be independent of the common factor. With
these assumptions, the covariance of these two stocks is reduced to:
Cov. (Ri, Rj) =  ijI2
Thus, the investor only needs to estimate the betas for each stock rather than all possible
covariances.
2.
a. According to the APT, if  i = 0, this implies that the ith stock has no unsystematic risk.
Evaluate this assertion.
b. According to the APT, if  i = 0, this implies that the rate of return on the ith stock must be
equal to the risk-free rate. Evaluate this assertion.
Answer:
a. This assertion is false  i = 0 implies that the stock has no systematic risk. Recall with APT
Ri = E ( Ri ) +  i I − E (I ) + ei
and when  i = 0, we have Ri = E ( Ri ) + ei , and so only unsystemic risk remains.

b. This assertion is also false. If  i = 0, this implies that the expected rate of return is zero.
However, for large portfolios when  wi ei = 0 , this assertion is true, but not for individual
assets. Again, by APT, returns are generated by
Ri = E ( Ri ) +  i I − E (I ) + ei
and when  i = 0, we have

Ri = E ( Ri ) + ei
and the possibility of different outcomes due to ei being a random variable.
3. There are three stocks with the following parameters:
41
Stock A Stock B Stock C
Mean return 10% ? 20%
Beta 1 4 2
a. What should be the mean return on Stock B to avoid arbitrage?

b. Find the value of a0 and a1 in the linear equation E(Ri) = a0 + a1 i.
Answer:
a. We need to find the mean rate of return that will make the slope of the SML the same regardless
of which securities are used. The slope of the line based on stock A and C is
(20% − 10%) = 10%
(2 − 1)
We need to find the mean rate of return such that the slope will be 10% when using stock B.
Thus, we need to solve for
(? % − 20%) = 10%
(4 − 2)
Solving for ?, we find 40%. Thus, the mean of stock B must be 40% or we are not in
equilibrium. The intercept must be zero in order to maintain a slope of 10%.
b. From above we have a 0 = 0.0, and a1 = 10% .
42
Chapter 12 Efficient Markets: Theory and Evidence
1. Which of the following statements is true?

I. In a strong form efficient market, it is possible for fundamental analysts to earn
abnormal returns consistently.
II. In a strong form efficient market, it is possible for technical analysts to earn
abnormal returns consistently.
III. In a strong form efficient market, asset allocation is useless.
A. I only
B. I and II only
C. III only
D. I, II, and III
E. neither I, nor II, nor III
2. If the market is perfectly efficient, which of the following statements is false?

A. Prices will fluctuate randomly around their true value.
B. Security prices reflect all publicly available information.
C. Smaller firms tend to outperform larger firms on a risk-adjusted basis.
D. An average mutual fund does not outperform the market as a whole.
E. Both technical analysis and fundamental analysis are economically worthless.
3. A random walk occurs when:

A. stock prices respond slowly to new information
B. the stock price level is random
C. past information is useful in predicting future prices
D. stock price changes are random but predictable
E. future price changes are uncorrelated with past price changes
43
1. E
2. C
3. E
44
OPEN QUESTIONS
1. Describe three forms of the efficient market theory (EMT).
Answer:
There are three forms of the efficient market theory: weak, semi strong, and strong EMT.
According to the weak form of the EMT, today’s stock prices reflect all information about the
historical prices of the stock. The semi strong form of the EMT states that prices reflect all
relevant publicly available information. The strong form states that current prices reflect all
publicly and privately available information.
2. Define anomaly and describe four common types of anomalies.
Answer:
A market anomaly is any event that can be exploited to produce abnormal profits. There are four
categories of anomalies: seasonal, event, firm, and accounting anomalies. Firm anomalies are
anomalies that result from firm-specific characteristics, such as the size effect. Seasonal
anomalies are anomalies that depend solely on time, such as the January effect. Event anomalies
are price changes that occur after some easily identified event, such as a listing announcement.
Accounting anomalies are changes in stock prices that occur after the release of accounting
information, such as an earnings announcement.
3. Noodles McSpirkle is a crackpot who has developed an asset pricing model. Like generally
accepted pricing models, Noodles’ model predicts a relationship between risk and expected
return. However, Noodles’ model uses something called Zarumba (represented by the variable Z
in Noodles’ writings) as a risk measure. No one but Noodles understands how to calculate
Zarumba, but Noodles claims to have proven that, for any stock, E(R) = 3Z. The following table
provides data for five stocks, including actual return, Zarumba, and beta.
Stock Zarumba Beta Actual

Return
A 0.08 2.00 32.0%
B 0.24 1.75 32.0
C 0.07 1.20 24.0
D 0.04 0.50 12.0
E 0.03 0.25 8.5
a. For each stock, calculate the expected return according to Noodles’ model and the CAPM.
The expected return on the market is 20%, and the risk-free rate is 4%.
b. For each stock, use both pricing models to determine whether or not the stock earned an
abnormal return.
c. What does this problem reveal about the real-world difficulties of determining whether or not
the market is efficient?
45
Answer:
a. Noodles’ model predicts that E(R) = 3Z. The expected return for Stock A is simply 3(8%) =
24%. Calculations for the rest of the stocks follow the same pattern.
The CAPM predicts that E(R) = r + [E(RM – r]. The expected return for Stock A is 4% +
2(20% – 4%) = 36%. Calculations for the rest of the stocks follow the same pattern. The
following table contains expected returns for each stock as predicted by each model.
Expected Return
Stock Noodles’ Model CAPM
A 24% 36.0%
B 72 32.0
C 21 23.2
D 12 12
E 9 8
b. An abnormal return is equal to actual return minus expected return. Whether or not a stock
earned an abnormal return depends on the expected return, which depends on the pricing
model used.
The following table compares actual returns with expected returns and indicates whether
abnormal return is positive, negative, or zero.
Expected Return A
B
N
O
R
M
A
L
R
E
T
U
R
N
Noodles Actual Noodles’
Stock ’ Model CAP Return Model CAPM
M
A 24% 36.0% 32.0% Positive Negative
B 72 32.0 32.0 Negative Zero
C 21 23.2 24.0 Positive Positive
D 12 12 12.0 Zero Zero
46
E 9 8 8.5 Negative Positive
c. In principle, we can test whether or not the market is efficient by comparing actual returns
with expected returns. If the market is efficient, actual returns should exceed expected
returns exactly as often as actual returns fall short of expected returns.
This problem demonstrates that such a test of market efficiency actually tests two
propositions at once because it presupposes that the researcher has accurately measured
expected return. If the test shows that abnormal returns tend to be positive, we cannot be
sure if the finding results because the expected return was incorrect or because the market is
not efficient. For Stock B, using CAPM to calculate expected return suggests that the market
is efficient, while Noodles’ model suggests that it is not.
47
Chapter 13 Interest Rates and Bond Valuation
1. Which of the following statements is true?

A. According to the unbiased expectations hypothesis, the yield curve will be flat if
expected future short-term rates exceed current short-term rates.
B. According to the unbiased expectations hypothesis, long-term rates are equal to
expected future short-term rates.
C. According to the liquidity preference hypothesis, the term structure is usually
downward sloping.
D. According to the market segmentations hypothesis, interest rates for long-
maturity bonds are independent from interest rates for short-maturity bonds.
2. Which of the following is the best measure of a discount bond’s total expected return?
A. current yield
B. yield to call
C. capital gains yield
D. yield to maturity
E. coupon yield
48
1. D
2. D
OPEN QUESTIONS
49
1. If interest rates rise, will individuals save more or less? Explain your answer.
Answer:
The relationship between the amount people save and interest rates is not immediately
apparent. First, an increase in interest rates may cause people to save more because
this will afford greater consumption. This effect is known as the substitution effect.
Second, an increase in interest rates may actually imply a decrease in savings because
you have to save less now in order to achieve a fixed level of consumption in the
future. This is known as the income effect. Finally, there is a wealth effect, which
asserts that an increase in interest rates implies an increase in current wealth level (for
a example, if you held a bond portfolio and the interest rates goes up from 8% to 10
%, the value of your portfolio goes down and your wealth is going down). The final
results depend on the strength of these conflicting forces.
2. “If the yield to maturity is zero, no matter what the maturity is, the par value of the
bond must be equal to its market value.” Evaluate this statement. Is there a specific type
of bond for which this is true?
Answer:
This statement is not true for any bond with annual coupons larger than zero (C>0).
Suppose we have a bond with one year to maturity, with a par value of $1000 and an
annual coupon of C=$100. If y=0, then by Equation (), we have
$100 $1000
P= + = $1,100
1.0 1.0
which is greater than Par = $1000. This statement is true only if the annual coupon is
zero because then the sum of the future coupons is zero, and the price will equal the par
value (because there is no discounting).
3. “If the yield curve is flat, then all forward rates must be equal to zero.” Evaluate this
statement. Demonstrate your answer with a numerical example.
Answer:
This statement is not true. If the yield curve is flat, all the forward rates are equal to
the spot rate. If the spot rate is 8% and the yield curve is flat. The expected rate for
next year will also be 8%. By the formula for the relationship between forward rates
and spot rates we see
(1.08) 2 = (1.08)(1 + f n )
(1.08) = (1 + f n )
f n = 0.08 or 8%
50
Chapter 14 Bonds—Analysis and Management
1. What is the duration of a 5-year zero-coupon bond?

A. 4.5
B. 5.0
C. 5.5
D. The answer cannot be determined without more information.
2. Which of the following is an income immunization strategy that selects only bonds
whose coupon and principal payments occur exactly when cash is required?
A. cash matching strategy
B. duration matching strategy
C. horizon matching strategy
D. contingent immunization strategy
51
1. B
2. A
52
OPEN QUESTIONS
1. Several immunization strategies were discussed in this chapter. Rank cash matching,
duration matching, and horizon matching from the least flexible to the most flexible.
Explain your rankings.
Answer:
The least flexible is cash matching, which requires each year’s cash flow to be matched
exactly. The most flexible is duration matching, where the duration of the assets is
matched with the duration of the liabilities. In between these two strategies is horizon
matching, which requires cash matching for the first several years and duration
matching thereafter.
2. Suppose you owned four different bonds with the following characteristics. What is
the duration of the bond portfolio?
Bond Market Value of Duration

Holdings
A $14,327 1.27 years
B $56,490 8.74 years
C $19,467 5.66 years
D $37,592 6.72 years
Answer:
From Equation 14.5, the duration of a portfolio is a weighted average of the durations
of the individual bonds where the weights are determined by the market value of the
bonds. In this case, the total market value of the holdings is
MV 14,327 56,490 19,467 37,592 127,876
The weights for each bond are
14,327
Bond A: = 0.1120
127.876
56,490
Bond B: = 0.4418
127.876
19,467
Bond C: = 0.1522
127.876
37,592
Bond D: = 0.2940
127.876
Thus, the duration of the bond portfolio is
D 0.1120(1.27) 0.4418(8.74) 0.1522(5.66) 0.2940(6.72) 6.84 years
3. There are five bonds, each of which has a duration of 4 years. Your holding period is 2
years. ‘By diversifying between these four bonds, you can reduce the portfolio duration
53
to 2 years.’ Assuming you cannot short sell, do you agree with this statement? Defend
your answer.
Answer:
This statement is not true. Recall from Equation 14.5 that
n
D =  wi Di
i =1
where wi = MVi / MV
MVi is the market value of the portfolio holdings of bond i

MV is the market value of the total bond portfolio
Di is the duration of bond i.
So long as wi is positive (thus, assuming you cannot short sell), the only possible value
of D is four years. That is,
n n
D =  wi 4 =  wi = 4(1) = 4
i =1 i =1
54
Chapter 15 Stocks—Valuation and Selection
1. Which of the following is not a problem encountered when implementing DDMs?

A. Using DDMs to identify undervalued stocks is useful only if the mispricing of
stocks is corrected in the market.
B. DDMs assume that the discount rate is constant over time.
C. Theoretical DDMs relate future cash flows to price, but future cash flows are
unknown today.
D. DDMs have little practical value because they value stocks assuming infinite cash
flows and investors’ investment horizons are always finite.
55
1. D
56
OPEN QUESTIONS
1. Using the constant-growth DDM, prove that the dividend growth rate, g, is equal to
the stock’s expected capital gains yield.
Answer:
Begin by expressing P1 as a function of d2:
P1 = d2/(k – g) = d1(1 + g)/(k – g).
But d1/(k – g) = P0, so P1 = P0(1 + g).
If we isolate g, we see that
1 + g = P1/P0
g = P1/P0 – 1 = (P1 – P0)/P0, which is the expected capital gains yield.
2. Cyclops Company’s stock is expected to pay a $0.25 dividend 1 year from today.
Analysts believe that thereafter dividends will grow at a constant rate of 1% per year.
The return on the market is forecast to be 12%, and the risk-free rate is 4%. The beta
of Cyclops’s stock is 0.2. What is the value of Cyclops’s stock?
Answer:
The required return is given by the CAPM: k = 4% + 0.2(12% – 4%) = 5.6%.
Cyclops is a constant-growth company, so
P0 = $0.25/(0.056 – 0.01) = $5.43.
3. “If a dividend discount model indicates that a stock is undervalued, investors should
buy the stock.” Is this statement always true, only sometimes true, or never true?
Carefully justify your answer.
Answer:
The statement is only sometimes true and reflects the reality that investors must be
very careful when interpreting the results of an analysis based on a DDM. If the DDM
indicates that the stock is undervalued, it does not guarantee that it will soon be
correctly valued. In fact, the stock could become more undervalued before turning
around, creating losses for investors unwilling or unable to wait for the mispricing to
be corrected.
Also, investors must be confident of the inputs used to draw the conclusion that the
stock is mispriced. The problems for this chapter have demonstrated how sensitive
the model’s value estimate is to the magnitude of its parameters. It is possible that
the market price of the stock is correct and that the analyst’s estimate of true value is
incorrect.
57
Chapter 16 Financial Statement Analysis
1. Sometimes when a company purchases a new asset, the full cost of the asset is not
recorded on the company’s income statement as an expense; instead, the asset is
depreciated, and the cost of the asset is spread out over several years. Which basic
accounting concept requires this treatment?
A. matching
B. historical cost
C. conservatism
D. consistency
2. Which of the following best matches costs with revenues during an inflationary period?
A. LIFO
B. FIFO
C. average cost method
D. all three methods match revenues with costs equally well
58
1. A
2. A
59
OPEN QUESTIONS
1. An investment analyst has identified the following information about J.L.

Manufacturing:
Total Costs ($)

Inventory on January 1 10,000 units @ $25 250,000
Purchases in January 5,000 units @ $29 145,000
Purchases in April 5,000 units @ $35 175,000
Purchases in November 4,000 units @ $40 160,000
Total available for sale 24,000 units 730,000
Inventory on December 31 4,000 units
What are the value of the ending inventory and the cost of goods (COGS) sold by the
FIFO, LIFO, and average cost method? Which method is preferred for tax purposes?
Answer:
FIFO method, the ending inventory is
4.000 * 40 = $160.000
COGS is 730.000 – 160.000 = $570.000
LIFO method, the ending inventory is

4.000 * 25 = $100.000
COGS is 730.000 – 100.000 = $630.000
Average cost method, the average cost is

730.000/24.000 = $30,42
The ending inventory is
4.000 * 30,42 = $121.680
COGS is 730.000 – 121.680 = $608.320
The LIFO method gives the highest COGS. Hence, it will produce the lowest taxable
profits, so it is preferred for tax reasons.
2. Suppose you are given the following information regarding Galactoca, Inc.:
Net Income $100 million
Depreciation $20 million
Stock Repurchases $10 million
Investments on New Project $30 million
Based solely on these figures, what is the net cash flow for this period?
Answer:
The statement of cash flow is given in the following table:
Millions
60
Operating Activities
Net Income $100
Depreciation $20
Net Cash $120
Investing Activities
Investments -$30
Net Cash -$30
Financing Activities
Stock Repurchases -$10
Net Cash -$10
Net Change in Cash $80
3. A firm’s current liabilities were $50 million, and its current assets were $60 million.
The firm has $40 million of inventory.
a. What is the current ratio?
b. What is the quick ratio?
Answer:
a. The current ratio is current assets divided by current liabilities or $60/$50 = 1.2.
b. The quick ratio is cash and near equivalents divided by current liabilities or ($60 -
$40)/50 = 0.4
61
Chapter 17 Macroeconomic Analysis
1. Gross domestic product consists of all of the following except

A. consumption.
B. investment.
C. budget deficit.
D. net trade.
2. All of the following are goals of fiscal policy except

A. maximizing GDP growth.
B. maximizing employment.
C. maintaining stable prices.
D. controlling the money supply.
3. Which of the following is not a variable in the calculation of the equation of the
international Fisher relationship?
A. domestic nominal rate of interest
B. foreign inflation rate
C. foreign exchange rate
D. domestic real rate of interest
E. domestic inflation rate
62
1. C
2 D
3. C
63
OPEN QUESTIONS
1. The government of Smallvia recently reported that its GDP for the year was $8 billion.
Consumption during the period was $1,5 billion, investment was $2 billion, and
government spending was $3 billion. What was Smallvia’s net trade for the period?
Answer:
Using Equation 17.1,
GDP = C + I + G + (X – M)
where (X – M) is net trade. Gives
8 = 1,5 + 2 + 3 + (X – M)
for Smallvia (in billions of dollars). Solving,
(X – M) = $1,5 billion.
2. Can an investor use macroeconomic data to predict stock returns?
Answer:
Yes. For example, Lettau and Ludvigson (2001a) show that the consumption-to-wealth
ratio is a powerful leading indicator for excess returns on aggregate stock market
indexes. Note that predicting excess returns does not mean we can earn systematic
abnormal risk-adjusted returns. That is, it does not yield abnormal risk-adjusted returns
if the predicted price change reflects only a change in risk or risk premiums.
3. What is the purchasing power parity?
Answer:
The purchasing power parity is the relationship between two countries'
inflation rates and their foreign exchange rates. This parity is used to estimate
exchange rates based on expected inflation rates. If a country has a high
inflation rate, its currency is expected to depreciate.
64
Chapter 18 Technical Analysis
1. Which of the following statements about the candlestick chart is false?

A. If the opening price is above the closing price, then the real body is shaded dark.
B. There are two parts of the candlestick line: the real body and the shadows.
C. The candlestick chart was developed in the United States, and became popular in
Japan and other countries.
D. The candlestick chart is based on a day’s opening, high, low, and closing prices.
E. The candlestick chart is similar in many ways to the bar chart in that it maps the
price movement over time.
2. Which of the following statements about technical analysis is false?

a. Technical analysts believe that financial prices reflect investors’ attitudes,
which at times may not be entirely rational.
b. Technical analysis assumes that security prices react quickly to new
information.
c. Technical analysis contradicts the weak form of the EMT.
d. Technical analysts believe that by studying historical market data, clues
will be found regarding the future direction of security prices.
e. Technical analysts believe that their analysis enables them to beat the
market consistently.
3. Which of the following statements is false?

a. Odd-lot trading is typically done by small investors who, technical
analysts believe, are usually wrong.
b. One basic tenet of the Dow Theory is that no additional information is
needed for the stock market outside of data on stock indexes.
c. Point-and-figure charts attempt to identify reversals in the direction of
stock prices without consideration of time.
d. The real body of the candlestick line is the broad part consisting of the
difference between the highest price and lowest price.
e. The Dow Theory claims that a bear market is established when both the
Dow Jones Industrial Average and the Dow Jones Transportation Average
are moving down.
65
1. C
2. B
3. D
OPEN QUESTIONS
66
Questions 1 through 3 use the following data for Acme Company:
Day Close High Low Open

1 $51.06 $52.63 $51.00 $51.38
2 51.63 52.94 51.00 51.00
3 50.69 50.88 50.00 51.00
4 51.88 53.19 51.38 51.81
5 52.13 54.25 52.00 52.75
6 53.56 54.25 52.44 54.19
7 54.25 54.25 51.00 53.88
8 53.69 57.44 53.69 57.25
9 56.75 57.00 55.38 56.44
10 56.94 61.44 56.50 60.25
11 61.00 61.00 57.81 57.88
12 57.63 58.88 57.25 58.63
13 59.31 60.25 57.81 58.75
14 59.06 59.06 56.06 57.44
15 57.63 58.69 57.00 57.00
1. Create a bar chart for Acme Company.
Answer:
The bar chart for Acme Company is:
Bar Chart For Acme Company
$63
$61
$59
$57
Price
$55
$53
$51
$49
$47
$45
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Day
2. Create a candlestick chart for Acme Company.
Answer:
67
The candlestick chart for Acme Company is:
Candlestick Chart for Acme Company
$65
$63
$61
$59
$57
Price
$55
$53
$51
$49
$47
$45
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Day
3.
a. Calculate the 3-day moving average closing stock price for Acme Company.
b. Graph the moving average and daily closing prices on the same chart. Use a
bar chart to represent closing prices and a line to represent the moving average.
c. Suppose a technical analyst bought the stock the first time the closing price
exceeded the 3-day moving average and sold the stock the first time the closing
price fell below the 3-day moving average, repeating this strategy as often as
possible. Calculate the profit or loss for this strategy for the 15-day period.
Answer:
a. The moving average is calculated as in Exhibit 18-11.
Three-Day Three-Day Simple
D Close Total (A) Moving Average
A (A/3)
Y
1 $51.06
2 51.63
3 50.69 $153.38 $51.13
4 51.88 154.20 51.40
5 52.13 154.70 51.57
6 53.56 157.57 52.52
68
7 54.25 159.94 53.31

8 53.69 161.50 53.83
9 56.75 164.69 54.90
10 56.94 167.38 55.79
11 61.00 174.69 58.23
12 57.63 175.57 58.52
13 59.31 177.94 59.31
14 59.06 176.00 58.67
15 57.63 176.00 58.67
b. The moving average chart for Acme Company is:

Closing Prices and Moving Average Prices for Acme
Company
$70
$60
$50
Closing Price
$40
Price
$30 3-day Moving

Average
$20
$10
$0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Day
c. The strategy leads to the following transactions.
Day Transaction Profit

4 Buy at $51.88
8 Sell at $53.69 $1.81
9 Buy at $56.75
69
12 Sell at $57.63 $0.88

14 Buy at $59.06
15 Sell at $57.63 –$1.43
Total Profit $1.26
Over the 15-day period, the investor would earn a profit of $1.26 per share (ignoring
transaction costs).
70
Chapter 19 Futures, Options and Other Derivatives
1. Which of the following actions will close a short position in a put option?
A. buying a call with the same strike price, expiration, and underlying asset
B. selling a call with the same strike price, expiration, and underlying asset
C. buying a put with the same strike price, expiration, and underlying asset
D. selling a put with the same strike price, expiration, and underlying asset
2. A plain vanilla swap is also known as a

A. standard swap.
B. conventional swap.
C. fixed for floating swap.
D. contractual swap.
71
1. C
2. C
72
OPEN QUESTIONS
1. What is the difference between European-style options and American-style options?
Answer: The distinction between American and European style options involves the
date when the contract can be exercised, and has nothing to do with geographic
location. European-style options can be exercised only on specific dates. American-
style options, in contrast, can be exercised any time on or before the expiration date
of the contract. The holder of an American option has the freedom to decide when, if
ever, the option contract will be exercised, as long as it is before the expiration date.
2. Straddles and strangles are related strategies involving 2 options, refer to section 19.6
for details.
a. Draw a pay-off diagram for a straddle.
b. Do the same for a strangle. Explain why this strategy is ‘a bet on volatility’, and
even more so than a straddle.
Answer:
a. Payoff diagram for a long straddle. A long straddle requires buying both a single
put and call on the same asset, with the same exercise price and expiration date.
$ Profit or loss Long call with the strike price X and

long put with the strike price X
Stock price at
expiration
b. Payoff diagram for a long strangle. The investor buys a call and a put, but the call
has a higher exercise price (XH). This results in an area where the movement of
the stock price between XL and XH doesn’t change the profit or loss, allowing for
higher price volatility. With strangle the downside risk is less, then with a straddle.
$ Profit or loss
XL XH
Stock price at
expiration
73
The payoff diagrams for short straddles and strangles and constructed in a similar
way, using short positions in options.
3. Use the following data for parts a through e.
Option Strike Price Option Price/Share

Call A $25 $2
Put A 30 13
Call B 20 4
Put B 15 2
Call C 10 13
Put C 20 3
a. If the underlying stock is priced at $20, which of the options is in-the-money? Out-
of-the-money? At-the-money?
b. Calculate the intrinsic value of each option.
c. Calculate the time value of each option.
d. If an investor bought all six options and the stock price was $30 at the options
expiration date, what would be the investor’s gain/loss on each option share?
e. Do part d for each option contract.
Answer:
a. In-the-money: Put A and Call C
Out-of-the-money: Call A and Put B
At-the-money: Call B and Put C
b. Intrinsic values:
Call A = $0
Put A = 30 – 20 = $10
Call B = 20 –20 = $0
Put B = $0
Call C = 20 – 10 = $10
Put C = 20 – 20 = $0
c. Time value = price – intrinsic value
Call A = 2 – 0 = $2
Put A = 13 – 10 = $3
Call B = 4 – 0 = $4
Put B = 2 – 0 = $2
Call C = 13 – 10 = $3
Put C = 3 – 0 = $3
d. Gain/loss per share
Call A = 30 – 25 – 2 = $3
Put A = 0 – 13 = – $13
Call B = 30 – 20 – 4 = $6
Put B = 0 – 2 = – $2
Call C = 30 – 10 – 13 = $7
74
Put C = 0 – 3 = – $3
e. Gain/loss per contract
Call A = 3 (100) = $300
Put A = – 13 (100) = – $1,300
Call B = 6 (100) = $600
Put B = – 2 (100) = – $200
Call C = 7 (100) = $700
Put C = – 3 (100) = – $300
75
Chapter 20 Derivatives Valuation
1. According to put-call parity, which one of the following is true?

a. Buying a call and selling a put is equivalent to buying stock and borrowing
PV(X).
b. Buying a call and selling a put is equivalent to selling stock and lending
PV(X).
c. Selling a call and buying a put is equivalent to selling stock and borrowing
PV(X).
d. Selling a call and buying a put is equivalent to buying stock and lending
PV(X).
2. Which of the following is inversely related to the value of a call option?

a. the value of the underlying asset
b. the strike price of the call option
c. the risk-free rate of interest
d. the call option’s time to expiration
e. the volatility of the underlying asset’s price
3. Which of the following is not a necessary assumption for the Black-Scholes option
pricing model?
a. The market is frictionless.
b. Investors are price takers.
c. Short selling is allowed, with full use of the proceeds.
d. Borrowing and lending both occur at the continuously compounded risk-
free rate.
e. All investors have the same expectation of St.
76
1. A
2. B
3. E
77
OPEN QUESTIONS
1. Suppose the standard deviation is  = 30%, S0 = $100, X = $100, r = 5%, q = 3%

and t = 1/2. Calculate the Black-Scholes call and put option prices.
Answer:
d1=
(
ln 100
100
)+ 0.02 + (0.3 2 )* 0.5 =
2
0.0325
= 0.1532
0.3 0.5 0.21213
d2= 0.1532 – (0.3 0.5 ) = -0.0589
so that N(d1) = 0.56089 and N(d2) = 0.47652
Call = 100e-(0.03*0.5) * 0.56089 – 100e-(0.05*0.5) * 0.47652

= 55.2539– 46.4755 = 8.78
Put = 100e-(0.05*0.5) * [1- 0.47652] – 100e-(0.03*0.5) * [1- 0.56089]
= 51.0555 – 43.2573 = 7.80
2. Explain intuitively why the upper boundary for the price of a European put option is
p0  X / (1 + r)t.
Answer:
A put option gives its holder the right to sell the underlying asset for $X.
Therefore, the put is most valuable when the underlying asset is worthless. In other
words, the maximum possible payoff for a put option is $X, but the payoff will not
be received until the option expires. The put can never be worth more than the
present value of its maximum payoff.
3. Use put-call parity to prove that an at-the-money call option on a given stock must
cost more than an at-the-money put option on the same stock. Assume the options
have the same maturity and strike price.
Answer:
Put-call parity gives the relationship among a call and a put with the same expiration
date and strike price, the strike price, and the price of the underlying asset (Equation
20.8):
X X
c0 = S 0 − + p 0 . Rearranging, c 0 − p 0 = S − .
(1 + r ) t
(1 + r ) t
If the call and the put are both at the money, then S = X and
X X
S− =X−  0 , so c0 − p0 > 0.
(1 + r ) t
(1 + r ) t
78
Chapter 21 Risk Management
OPEN QUESTIONS
1. Consider a portfolio consisting of $10 million invested in the S&P 500 and $5
million invested in US Treasury bonds. The S&P 500 has an expected return of 14
percent and a standard deviation of 16 percent. The Treasury bonds have an
expected return of 9 percent and a standard deviation of 4 percent. The correlation
between the S&P 500 and the US Treasury bonds is 0.2 percent. All figures are
stated on an annual basis.
a. Find the 99% VaR for one day.
b. Suppose the correlation rises to 0.4 percent. Find the VaR for one day, and explain
the difference with section a of this question.
Answer:
a.  p = w A 2 A 2 + wB 2 B 2 + 2w A wB A ,B
 p = ( 2 3 ) 2  16 2 + ( 13 ) 2  4 2 + 2  2 3  13  16  4  0.2
 p = 121.244
 p  11.011
VaR( , T ) = z −1 ( )   p  T  P
VaR(0.99,1) = 2.326  0.11011  1  15 = 0.24297

250
The 99% VaR is $ 242,972.84
b.  p = w A 2 A 2 + wB 2 B 2 + 2w A wB A ,B
 p = ( 2 3 ) 2  16 2 + ( 13 ) 2  4 2 + 2  2 3  13  16  4  0.4
 p = 126.933
 p  11.267
VaR( , T ) = z −1 ( )   p  T  P
VaR(0.99,1) = 2.326  0.11267  1  15 = 0.24862

250
The 99% VaR is $ 248,621.83 which is higher than the VaR calculated with section a. This
comes from the fact that the standard deviation of the portfolio rises through the
increase of the correlation between the S&P 500 and the US Treasury bonds.
2. An investor has a bond with a value of $100 and this bond’s initial credit rating is
BBB, in the table below the value of the bond is given depending on the credit rating
the bond has on a certain moment (these figures are made up).
Credit Rating Bond Value ($) Transition Probability (%)
AAA 111.76 0.02

AA 109.75 0.33
79
A 105.53 5.95
BBB 103.40 86.93
BB 100.96 5.30
B 93.84 1.17
CCC 84.98 0.12
Default 56.43 0.18
a. Calculate the best possible outcome and the worst possible outcome.
b. What is the recovery rate?
Answers:
a. The best possible outcome is an upgrade to AAA, in this case the value of the bond
rises from $103.40 to $111.76, and this is a gain of $8.36. The worst possible
outcome is of course default. This would result in a loss of $46.97 ($103.40 –
$56.43).
b. The recovery rate is a substantial amount of the principal that may still be recovered
in case of default. As you can see in the table in the second column, the recovery
rate is 56.43 %.
3. Briefly explain main similarities and differences between stress-testing approach

and Extreme Value Theory.
Answer:
Both stress testing and EVT are meant to supplement the VaR analysis. Stress-
testing involves VaR estimations at significant fluctuations of key variables. EVT
describes the behavior of the left-tail of the return distribution. In case of stress-
testing the VaR model is extended, but its assumptions are not changed. EVT
models a fat tail anew and does not necessarily follow the same model assumptions
that were used to compute VaR.
80
Chapter 22 Performance Evaluation
OPEN QUESTIONS
1. What is the problem caused by survivorship bias within data sets on mutual fund
performance?
Answer:
Most of the data sets employed for mutual fund performance evaluation include the past
records of all mutual funds currently in existence. Hence, when a fund merges or gets
liquidated (ceases to exist), its past performance is deleted from the database. This
because today’s investors are not interested in the records of funds that no longer exists.
Thus, if mutual funds with bad performance are taken of the market, their bad records are
deleted from the data set as well. Therefore, the average performance of the surviving
funds will overstate the success of the mutual fund industry as a whole (including the
liquidated funds).
2. What basic problems should one take into account when using performance analysis?
Answer:
The four basic problems when using performance evaluation are: the fact that
performance evaluation is a historical exercise by its very nature, and the link between
past performance and future performance may be weak; the fact that theory provides little
guidance in the selection of the appropriate set of risk factors to be used to correct for
risk; difficulties in estimating the risk and return characteristics of individual securities;
and difficulties in estimating the return distribution for portfolios due to changes in the
composition of a portfolio, and the lack of timely information on this composition.
3. Use Equations 22.3 and 22.4 to prove that Jensen’s performance index will indicate that
a portfolio beat the market if, and only if, Treynor’s performance index indicates that the
portfolio beat the market.
Answer:
We want to show that any portfolio that beats the market according to Jensen’s
performance index must have 1) a positive value for Jensen’s index and 2) a value for
Treynor’s index that exceeds the value of Treynor’s index for the market. Equation 22.4
shows that Jensen’s index is positive if, and only if,
Ri − [r + ˆ i  ( Rm − r )]  0
Thus,
Ri − r  ˆ i  ( Rm − r )
( Ri − r )  ̂ i  Rm − r
81
The left side of this inequality is Treynor’s index for the portfolio (Equation 22.3). The
right side of this inequality is Treynor’s index for the market (remember that the market’s
beta is 1). We see that Jensen’s index is greater than zero if and only if Treynor’s index
for the portfolio is greater than Treynor’s index for the market.
82

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Instructor’s Problem

ISBN 0 273 68511 2

MULTIPLE CHOICE QUESTIONS

1. Which of the following is not a basic component of the investment process?

MULTIPLE CHOICE QUESTIONS: ANSWERS

Do you agree with this statement? Why or why not?

MULTIPLE CHOICE QUESTIONS

MULTIPLE CHOICE QUESTIONS: ANSWERS

1. Explain what is meant by the following statement:

“The ownership of the firm is residual in nature."

MULTIPLE CHOICE QUESTIONS: ANSWERS

1. What is margin trading, and why is it considered risky?

You can also use Equation 3.1 to arrive at this number:

From Equation 3.1 we observe

b. The margin call price is based on Equation 3.2, which is

B 500  $75 − $24,375 $13,125

However, Equation 3.1 is

And solving for the loan balance we have

Substituting B for our result here, we have

Dividing all terms by N, we have

MULTIPLE CHOICE QUESTIONS

1. Which type of fund is most likely to invest in high-grade commercial paper?

MULTIPLE CHOICE QUESTIONS: ANSWERS

3. Can mutual funds be sold at a discount? At a premium? Explain.

MULTIPLE CHOICE QUESTIONS

1. Which of the following created the Securities and Exchange Commission?

2. Which of the following statements about corporate governance is wrong?

3. Which of the following statements about churning is wrong?

MULTIPLE CHOICE QUESTIONS: ANSWERS

2. What are the differences between regulations and ethics?

MULTIPLE CHOICE QUESTIONS

MULTIPLE CHOICE QUESTIONS: ANSWERS

Market Price When

Using the linking method:

Date Market Dividend Interim After- After-tax

The return for interim periods 1 through 4 is:

R1 = [42 – 36 + 0.85(1 – 0.28)]/36 = 18.3667%.

R2 = [42 – 42 + 0.85(1 – 0.28)]/42 = 1.4571%.

R3 = [44 – 42 + 0.85(1 – 0.28)]/42 = 6.2190%.

R4 = [40 – 44 + 0.85(1 – 0.28)]/44 = –7.7000%.

The after-tax rate of return for interim period 5 is:

R5 = [40 – 40 – (40 – 36)(0.20) + (0)(1 – 0.28)]/40 = –2.0000%.

The after-tax return for the year is

2. Describe three different ways indexes can be constructed.

Indexes can be constructed using the price-weighted, value-weighted, or equally-weighted

A. Ignoring dividends, calculate the simple annual rates of return.

B. Calculate the arithmetic average of the annual rates of return.

End of NYSE Interim

B. The arithmetic average of these 15 rates of return is:

C. The geometric average of these 15 rates of return is:

MULTIPLE CHOICE QUESTIONS

1. Which of the following statements about risk is correct?

Original Expected Revised Expected

MULTIPLE CHOICE QUESTIONS: ANSWERS

State of economy Probability Mutual fund Common stock Certificate of deposit

Expected return ____ ____ ____

Probability HPR P(HPR) [HPR-E(R)]2 P[HPR-E(R)]2

33% 6% 1.98% (6 – 10.89)2 7.8910

33% 7% 2.31% (7 – 7)2 0

MULTIPLE CHOICE QUESTIONS

2. The correlation between Compaq and Pfizer is:

MULTIPLE CHOICE QUESTIONS: ANSWERS

1. Describe an asset's risk when held with other assets in a portfolio.

Expected return