CHAPTER 2 Financial Markets and Instruments 59

5. Preferred stock usually pays fixed dividends for the index, the NYSE and AMEX indices, the Nasdaq in-
life of the firm; it is a perpetuity. A firm’s failure to dex, and the Wilshire 5000 index.
pay the dividend due on preferred stock, however,
7. A call option is a right to purchase an asset at a stip-
does not precipitate corporate bankruptcy. Instead,
ulated exercise price on or before a maturity date. A
unpaid dividends simply cumulate. New varieties of
put option is the right to sell an asset at some exer-
preferred stock include convertible and variable-
cise price. Calls increase in value while puts de-
rate issues.
crease in value as the value of the underlying asset
6. Many stock market indices measure the performance increases.
of the overall market in Canada and the United States.
8. A futures contract is an obligation to buy or sell an
The Dow Jones Averages, the oldest and best-known
asset at a stipulated futures price on a maturity date.
indicators, are U.S. price-weighted indices. Today,
The long position, which commits to purchasing,
many broad-based market value-weighted indices are
gains if the asset value increases, while the short
computed daily. These include the main Canadian in-
position, which commits to delivering the asset,
dex, S&P/TSX Composite stock index, as well as the
loses.
S&P/TSX 60, the U.S. Standard & Poor’s 500 stock

K E Y E Q UAT IO N S
1,000 2 P 365
(2.1) rBEY 5 3 (2.2) P 5 1,000y[1 1 rBEY 3 (ny365)]
P n

P RO B LE MS

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1. Why are money market securities sometimes referred to as “cash equivalents”?

2. The investment manager of a corporate pension fund has purchased a Treasury bill with 182 days
to maturity at a price of $9,600 per $10,000 face value. The manager has computed the bank dis-
count yield at 8 percent.
a. Calculate the bond equivalent yield for the Treasury bill. Show your calculations.
b. Briefly state two reasons why a Treasury bill’s bond equivalent yield is always different from
the discount yield.
3. A T-bill has a bank discount yield of 6.81 percent based on the ask price, and 6.90 percent based
on the bid price. The maturity of the bill (already accounting for skip-day settlement) is 61 days.
Find the bid and ask prices of the bill.
4. Reconsider the T-bill of problem 3. Calculate its bond equivalent yield and effective annual yield
on the basis of the ask price. Confirm that these yields exceed the discount yield.
5. The bond equivalent yield of a 91-day T-bill is 5 percent. What is the price of the bill for a
$10,000 face value?
6. a. Which security offers a higher effective annual yield?
i. A three-month bill selling at $9,764
ii. A six-month bill selling at $9,539
b. Calculate the bank discount yield on each bill.
98 PART ONE Introduction

S U M M A RY
1. Firms issue securities to raise the capital necessary to
finance their investments. Investment bankers market
these securities to the public on the primary market.
Investment bankers generally act as underwriters who
purchase the securities from the firm and resell them
to the public at a markup. Before the securities may be
sold to the public, the firm must publish a securities
commission-approved prospectus that provides infor-
mation on the firm’s prospects.
2. Issued securities are traded on organized stock ex-
changes, on the over-the-counter market, and, for
large traders, through direct negotiation. Only
members of exchanges may trade on the exchange.
Brokerage firms holding seats on the exchange sell
their services to individuals, charging commissions
for executing trades on their behalf. The TSX
has  fairly strict listing requirements; the TSX
Venture Exchange is much less restrictive, being
designed for firms who do not meet the require-
ments of the TSX.
3. Trading may take place in dealer markets, via elec-
tronic communication networks, or in specialist
markets. In dealer markets, security dealers post bid
and ask prices at which they are willing to trade.
Brokers for individuals execute trades at the best
available prices. In electronic markets, the existing
book of limit orders provides the terms at which
trades can be executed. Mutually agreeable offers to
buy or sell securities are automatically crossed by
the computer system operating the market. In spe-
cialist markets, the registered trader or market-
maker acts to maintain an orderly market with price
continuity. Registered traders maintain a limit order
book, but also sell from or buy for their own inven-
tories of stock. Thus, liquidity in specialist markets
comes from both the limit order book and the regis-
tered trader’s inventory.
4. Block transactions are a fast-growing segment of the
securities market, which currently accounts for about
one-half of trading volume. These trades often are too
large to be handled readily by regular market-makers,
and thus block houses have developed that specialize
in these transactions, identifying potential trading
partners for their clients.
5. Total trading costs consist of commissions, the dealer’s
bid–asked spread, and price concessions. These costs
can represent as much as 30 percent of the value of the
securities traded.
6. Buying on margin means borrowing money from a
broker in order to buy more securities. By buying se-
curities on margin, an investor magnifies both the
upside potential and the downside risk. If the equity
in a margin account falls below the required mainte-
nance level, the investor will get a margin call from
the broker.
7. Short selling is the practice of selling securities that
the seller does not own. The short-seller borrows
the securities sold through a broker and may be re-
quired to cover the short position at any time on de-
mand. The cash proceeds of a short sale are always
kept in escrow by the broker, and the broker usually
requires that the short-seller deposit additional cash
or securities to serve as margin (collateral) for the
short sale.
8. Securities trading is regulated by the provincial
securities commissions and by self-regulation of
the exchanges and the dealer associations. Many of
the important regulations have to do with full dis-
closure of relevant information concerning the
securities in question. Insider trading rules also
prohibit traders from attempting to profit from
inside information.

K E Y E Q UAT IONS
Equity value Market value of assets 2 Loan
(3.1) Margin ratio 5 5
Market value of assets Market value of assets
Market value of assets
(3.2) Margin ratio 5
Value of stock owed
 CHAPTER 4 Return and Risk: Analyzing the Historical Record 141

S U MMA RY
1. The economy’s equilibrium level of real interest rates
depends on the willingness of households to save, as
reflected in the supply curve of funds, and on the ex-
pected profitability of business investment in plant,
equipment, and inventories, as reflected in the demand
curve for funds. It depends also on government fiscal
and monetary policy.
2. The nominal rate of interest is the equilibrium real
rate plus the expected rate of inflation. In general, we
can directly observe only nominal interest rates; from
them, we must infer expected real rates, using infla-
tion forecasts.
3. The equilibrium expected rate of return on any secu-
rity is the sum of the equilibrium real rate of interest,
the expected rate of inflation, and a security-specific
risk premium.
4. Investors face a tradeoff between risk and expected
return. Historical data confirm our intuition that assets
with low degrees of risk provide lower returns on
average than do those of higher risk.
5. Assets with guaranteed nominal interest rates are
risky in real terms because the future inflation rate is
uncertain.
6. Historical rates of return over the twentieth century in
developed capital markets suggest the Canadian his-
tory of stock returns is not an outlier compared to
other countries.
7. Historical returns on stocks exhibit more frequent large
negative deviations from the mean than would be pre-
dicted from a normal distribution. The lower partial
standard deviation (LPSD), the skew and kurtosis of the
actual distribution quantify the deviation from normal-
ity. The LPSD, instead of the standard deviation, is
sometimes used by practitioners as a measure of risk.
8. Widely used measures of risk are value at risk (VaR) and
conditional tail expectations or, equivalently, expected
shortfall (ES). VaR measures the loss that will be ex-
ceeded with a specified probability such as 5 percent.
The VaR does not add new information when returns are
normally distributed. When negative deviations from the
average are larger and more frequent than the normal dis-
tribution, the 5 percent VaR will be more than 1.65 stan-
dard deviations below the average return. Expected
shortfall (ES) measure the expected rate of return condi-
tional on the portfolio falling below a certain value. Thus,
1 percent ES is the expected return of all possible out-
comes in the bottom 1 percent of the distribution.

KE Y E Q UAT IO N S
(4.1) r < R 2 i Ending price Beginning Cash
2 1
of a share price dividend
11R (4.10) HPR 5
(4.2) 1 1 r 5 Beginning price
11i
(4.11) E(r) 5 a p(s)r(s)
R2i s
(4.3) r 5
11i
(4.12) σ 5 a p(s)[r(s) 2 E(r)] 2
2

(4.4) R 5 r 1 E(i) s
n 1 n
(4.5) R(1 2 t) 2 i 5 (r 1 i)(1 2 t) 2 i (4.13) E(r) 5 a p(s)r(s) 5 a r(s)
 

s51 n s51
5 r(1 2 t) 2 it
(4.14) Terminal value 5 (1 1 r1) 3 (1 1 r2) 3 ? ? ?
100 3 (1 1 r5)
(4.6) rf (T) 5 21
P(T)
(4.15) Geometric average 5 Arithmetic average 2 ½σ2
(4.7) 1 1 EAR 5 [1 1 rf (T)] 1/ T
1 n
n 1/T
(4.16) σ2 5 a [r(s) 2 r]
2
(4.8) 1 1 EAR 5 [1 1 rf (T )] 5 [1 1 rf (T)] n s51
5 [1 1 T 3 APR] 1/T
(4.9) 1 1 EAR 5 exp(rcc ) 5 ercc
 n 1 n E[r(s) 2 E(r)] 3
(4.17) σ2 5 a b 3 a [r(s) 2 r] 2 (4.19) Skew 5
n21 n j51 σ3
n
1 2 E[r(s) 2 E(r)] 4
5 a [r(s) 2 r]
n 2 1 j51 (4.20) Kurtosis 5 23
σ4
Risk premium
(4.18) Sharpe ratio (for portfolios) 5
SD of excess return
178 PART TWO Portfolio Theory
S U M M A RY
1. Speculation is the undertaking of a risky investment
for its risk premium. The risk premium has to be large
enough to compensate a risk-averse investor for the
risk of the investment.
2. A fair game is a risky prospect that has a zero risk
premium. It will not be undertaken by a risk-averse
investor.
3. Investors’ preferences toward the expected return and
volatility of a portfolio may be expressed by a utility
function that is higher for higher expected returns and
lower for higher portfolio variances. More risk-averse
investors will apply greater penalties for risk. We can
describe these preferences graphically using indiffer-
ence curves.
4. The desirability of a risky portfolio to a risk-averse
investor may be summarized by the certainty equiva-
lent value of the portfolio. The certainty equivalent
rate of return is a value that, if it is received with
certainty, would yield the same utility as the risky
portfolio.
5. Shifting funds from the risky portfolio to the risk-free
asset is the simplest way to reduce risk. Other meth-
ods involve diversification of the risky portfolio and
hedging. We take up these methods in later chapters.
6. T-bills provide a perfectly risk-free asset in nominal
terms only. Nevertheless, the standard deviation of
real rates on short-term T-bills is small compared to
that of other assets such as long-term bonds and com-
mon stocks, so for purposes of our analysis we con-
sider T-bills to be the risk-free asset. Money market
funds hold, in addition to T-bills, short-term relatively
safe obligations such as CP and CDs. These entail
some default risk, but again, the additional risk is small
K E Y E Q UAT IO N S
1 E(rP ) 2 rf
(5.1) U 5 E(r) 2 Aσ2
2 σP
(5.2) rC 5 yrP 1 (1 2 y)rf
(5.3) E(rC ) 5 yE(rP ) 1 (1 2 y)rf
(5.4) σC 5 yσP
(5.5) E[rC (y)] 5 rf 1 y[E(rP ) 2 rf ]
relative to most other risky assets. For convenience, we
often refer to money market funds as risk-free assets.
7. An investor’s risky portfolio (the risky asset) can
be characterized by its reward-to-variability ratio,
S 5 [E(rP) 2 rf]/σP. This ratio is also the slope of the
CAL, the line that, when graphed, goes from the risk-
free asset through the risky asset. All combinations of
the risky asset and the risk-free asset lie on this line.
Other things equal, an investor would prefer a steeper-
sloping CAL, because that means higher expected
return for any level of risk. If the borrowing rate is
greater than the lending rate, the CAL will be “kinked”
at the point of the risky asset.
8. The investor’s degree of risk aversion is characterized
by the slope of his or her indifference curve. Indiffer-
ence curves show, at any level of expected return and
risk, the required risk premium for taking on one
additional percentage point of standard deviation.
More risk-averse investors have steeper indifference
curves; that is, they require a greater risk premium for
taking on more risk.
9. The optimal position, y*, in the risky asset, is propor-
tional to the risk premium and inversely proportional
to the variance and degree of risk aversion:
E(rP ) 2 rf
y* 5
Aσ2P
Graphically, this portfolio represents the point at
which the indifference curve is tangent to the CAL.
10. A passive investment strategy disregards security
analysis, targeting instead the risk-free asset and a
broad portfolio of risky assets such as the S&P/TSX
Composite stock portfolio.
(5.6) S5
E(rP ) 2 rf
(5.7) y* 5
Aσ2P
1
(5.8) Required E(r) 5 .05 1 3 Aσ2
2
 CHAPTER 6 Optimal Risky Portfolios 219

K E Y E QUATIONS
(6.1) rP 5 wDrD 1 wErE
(6.2) E(rP ) 5 wD E(rD ) 1 wE E(rE )
(6.3) σ2P 5 w2Dσ2D 1 w2E σ2E 1 2wDwE Cov(rD,rE )
(6.4) Cov(rD,rD ) 5 a Pr(scenario)[rD 2 E(rD )][rD 2 E(rD )]
scenarios
(6.5) σ2P 5 wDwDCov(rD,rD ) 1 wEwE Cov(rE,rE ) 1 2wDwE Cov(rD,rE )
(6.6) Cov(rD,rE ) 5 ρDEσDσE
(6.7) σ2P 5 w2Dσ2D 1 w2E σ2E 1 2wDwE σDσE σDE
(6.8) σP 5 wDσD 1 wE σE
(6.9) σ2P 5 (wDσD 2 wE σE ) 2
(6.10) σP 5 Absolute value(wDσD 2 wE σE )  

σD
(6.11) wE 5 5 1 2 wD
σD 1 σE
σ2E 2 Cov(rD,rE )
(6.12) wmin (D) 5
σ D 1 σ2E 2 2 Cov(rD,rE )
2

[E(rD ) 2 rf ]σ2E 2 [E(rE ) 2 rf ]Cov(rD,rE )

(6.13) wD 5
[E(rD ) 2 rf ]σ2E 1 [E(rE ) 2 rf ]σ2D 2 [E(rD ) 2 rf 1 E(rE ) 2 rf ]Cov(rD,rE )
E(rP ) 2 rf
(6.14) y5
Aσ2P
n
(6.15) E(rP ) 5 a wi E(ri )
i51
n n n
(6.16) σ2P 5 a w2i σ2i 1 a a wiwj Cov(ri,rj )
i51
i51 i?j j51
n n n
1 1 2 1
(6.17) σ2P 5 an σ i 1 a a Cov(ri,rf )
n i51 n2
 

i51
i ? j j51

1 2 n21
(6.18) σ2P 5 σ 1 Cov
n n
   

P RO B LE MS

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1. Which of the following factors reflect pure market risk for a given corporation?
a. Increased short-term interest rates
b. Fire in the corporate warehouse
c. Increased insurance costs
d. Death of the CEO
e. Increased labour costs
 CHAPTER 7 The Capital Asset Pricing Model 257

9. The consumption-based capital asset pricing model 10. The security market line of the CAPM must be modi-
(CCAPM) is a single-factor model in which the mar- fied to account for labour income and other significant
ket portfolio excess return is replaced by that of a nontraded assets.
consumption-tracking portfolio. By appealing
11. Liquidity costs and liquidity risk can be incorporated
directly to consumption, the model naturally incorpo-
into the CAPM relationship. Investors demand com-
rates consumption-hedging considerations and
pensation for both expected costs of illiquidity as well
changing investment opportunities within a single-
as the risk surrounding those costs.
factor framework.

KE Y E Q UAT IO N S
E(rM ) 2 rf (7.8) E(rB ) 5 rf 1 βB [E(rM ) 2 rf ]
(7.1) y5
Aσ2M
(7.9) E(ri ) 2 E(rQ )
(7.2) E(rM ) 2 rf 5 Aσ2M Cov(ri,rP ) 2 Cov(rP,rQ )
5 [E(rP ) 2 E(rQ )]
(7.3) wB [w1Cov(r1,rB ) 1 w2Cov(r2,rB ) 1 p σ2P 2 Cov(rP,rQ )
1 wBCov(rB,rB ) 1 p 1 wnCov(rn,rB )]
Cov(ri,rM )
n n (7.10) E(ri ) 2 E(rz ) 5 [E(RM ) 2 E(RZ )]
σ2M
(7.4) a wi Cov(Ri,RB ) 5 a Cov(wiRi,RB )
i51 i51
n
5 βi [E(rM ) 2 E(rz )]
5 Cov a a wiRi, RB b PH
i51 Cov(Ri,RM ) 1 Cov(Ri,RM )
PM
Market risk premium E(rM ) 2 rf E(RM ) (7.11) E(Ri ) 5 E(RM )
(7.5) 5 5 PH
Market variance σ2M σ2M σ2M 1 Cov(RM,RH )
PM
E(rB ) 2 rf E(rM ) 2 rf E(RB ) K
(7.6) 5 , or (7.12) E(Ri ) 5 βiME(RM ) 1 a βik E(Rk )
Cov(rB,rM ) σ2M Cov(RB,rM ) t51
E(RM )
5 (7.13) E(Ri ) 5 βiCRPC
σ2M
(7.14) RPC 5 E(RC ) 5 E(rC ) 2 rf
Cov(rB,rM )
(7.7) E(rB ) 2 rf 5 [E(rM ) 2 rf ] or E(RB ) (7.15) E(RM ) 5 αM 1 βMCE(RC ) 1 εM
σ2M
Cov(RB,rM ) (7.16) Ri,t 5 λ0 1 λ1βi 1 λ2σ2ei 1 ηi,t
5 E(RM )
σ2M

P RO B LE MS

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1. What is the beta of a portfolio with E(rp) 5 18 percent, if rf 5 6 percent and E(rM) 5 14 percent?
2. The market price of a security is $50. Its expected rate of return is 14 percent. The risk-free rate
is 6 percent and the market risk premium is 8.5 percent. What will be the market price of the
security if its covariance with the market portfolio doubles (and all other variables remain
unchanged)?
 CHAPTER 8 Index Models and the Arbitrage Pricing Theory 305

9. Once we allow for multiple risk factors, we conclude
that the security market line also ought to be multidi-
mensional, with exposure to each risk factor contrib-
uting to the total risk premium of the security.
10. A risk-free arbitrage opportunity arises when two or more
security prices enable investors to construct a zero net in-
vestment portfolio that will yield a sure profit. Rational
investors will want to take infinitely large positions in ar-
bitrage portfolios regardless of their degree of risk aver-
sion. This will create pressure on security prices that will
continue until prices reach levels that preclude arbitrage.
11. When securities are priced so that there are no risk-
free arbitrage opportunities, we say that they satisfy
the no-arbitrage condition. Price relationships that sat-
isfy the no-arbitrage condition are important, because
we expect them to hold in real-world markets.
12. Portfolios are called well diversified if they include a
large number of securities and the investment propor-
tion in each is sufficiently small. The proportion of a
security in a well-diversified portfolio is small enough
so that, for all practical purposes, a reasonable change
in that security’s rate of return will have a negligible
effect on the portfolio rate of return.
13. In a single-factor security market, all well-diversified port-
folios have to satisfy the expected return–beta relationship
of the security market line in order to satisfy the no-
arbitrage condition. If all well-diversified portfolios
satisfy the expected return–beta relationship, then all but
a small number of securities also satisfy this relationship.
14. The APT does not require the restrictive assumptions
of the CAPM and its (unobservable) market portfolio.
The price of this generality is that the APT does not
guarantee this relationship for all securities at all times.
15. A multifactor APT generalizes the single-factor model
to accommodate several sources of systematic risk.
The multidimensional security market line predicts
that exposure to each risk factor contributes to the se-
curity’s total risk premium by an amount equal to the
factor beta times the risk premium of the factor port-
folio that tracks that source of risk.
16. A multifactor extension of the single-factor CAPM, the
ICAPM, is a model of the risk–return tradeoff that pre-
dicts the same multidimensional security market line as
the APT. The ICAPM suggests that priced risk factors
will be those sources of risk that lead to significant
hedging demand by a substantial fraction of investors.

K E Y E Q UAT IO N S
(8.1) ri 5 E(ri ) 1 mi 1 ei (8.15) RP 5 .04 1 1.4RS&PyTSX 1 eP
(8.2) ri 5 E(ri ) 1 βimi 1 ei (8.16) RC 5 RP 2 Rr 5 (.04 1 1.4RS&PyTSX 1 eP )
2 1.4RS&PyTSX 5 .04 1 eP
(8.3) σ 2i 5 β2iσ2m 1 σ2 (ei )
(8.17) Rt 5 α 1 βGDPGDPt 1 βIRIRt 1 et
(8.4) Cov(ri, rj ) 5 Cov(βim 1 ei, βjm 1 ej )
5 βiβjσ2m (8.18) E(r) 5 rf 1 β[E(rM ) 2 rf ]
(8.5) Ri (t) 5 αi 1 βiRM (t) 1 ei (t) (8.19) E(r) 5 rf 1 βRPM
(8.6) E(Ri ) 5 αi 1 βiE(RM ) (8.20) E(r) 5 rf 1 βGDPRPGDP 1 βIRRPIR
(8.7) Cov(Ri, Rj ) 5 Cov(βiRM, βjRM ) 5 βiβjσ2M (8.21) RP 5 E(RP ) 1 βPF 1 eP
(8.8) RP 5 αP 1 βPRM 1 eP (8.22) RP 5 αp 1 βpRM
1 n 1 n 1 n (8.23) E(RP ) 5 αp 1 βpE(RM )
(8.9) 5 a αi 1 a a βi b RM 1 a ei
n i51 n i51 n i51
(8.24) βZ 5 wpβp 1 (1 2 wp )βM 5 0
2 2 2 2
(8.10) σ P 5 β pσ M 1 σ (eP ) βM 5 1
(8.11) r 5 a 1 brM 1 e 1 βp
wp 5 ; wM 5 1 2 wp 5
1 2 βp 1 2 βp
(8.12) r 2 rf 5 α 1 β(rM 2 rf ) 1 e
(8.25) αZ 5 wpαp 1 (1 2 wp )αm 5 wpαp
(8.13) r 5 rf 1 α 1 βrM 2 βrf 1 e
5 α 1 rf (1 2 β) 1 βrM 1 e 1
(8.26) E(RZ ) 5 wPαP 5 α
1 2 βP P
σ2 (e)
(8.14) R-squared 5 1 2
σ2
306 PART THR EE Equilibrium in Capital Markets

(8.27) E(RP ) 5 βPE(RM ) (8.30) E(rQ ) 5βP1E(r1 ) 1βP2E(r2 ) 1 (12βP1 2βP2 )rf
5 rf 1 βP1 [E(r1 ) 2 rf ] 1 βP2 [E(r2 ) 2 rf ]
E(rU ) 2 rf E(rV ) 2 rf
(8.28) 5 (8.31) rit 5 αi 1 βiIPIPt 1 βiEIEIt 1 βiUIUIt
βU βV
1 βiCGCGt 1 βiGBGBt 1 eit
(8.29) Ri 5 E(Ri ) 1 βi1F1 1 βi2F2 1 ei
(8.32) rit 5 αi 1 βiMRMt 1 βiSMBSMBt
1 βiHMLHMLt 1 eit

P RO B LE MS

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1. A portfolio management organization analyzes 60 stocks and constructs a mean-variance efficient

portfolio that is constrained to these 60 stocks.
a. How many estimates of expected returns, variances, and covariances are needed to optimize
this portfolio?
b. If one could safely assume that stock market returns closely resemble a single-index structure,
how many estimates would be needed?
2. The following are estimates for two of the stocks in problem 1.

Expected Firm-Specific
Stock Return Beta Standard Deviation
A .13 .8 .30
B .18 1.2 .40

The market index has a standard deviation of .22 and the risk-free rate is .08.
a. What is the standard deviation of stocks A and B?
b. Suppose that we were to construct a portfolio with the following proportions:
Stock A .30
Stock B .45
T-bills .25

Compute the expected return, standard deviation, beta, and nonsystematic standard deviation of
the portfolio.
3. Consider the following two regression curves for stocks A and B.

rA – rf rB – rf

rM – rf rM – rf
 CHAPTER 9 Market Efficiency 345

S U MMA RY
1. Statistical research has shown that stock prices seem neither on market research nor on the frequent pur-
to follow a random walk with no discernible predict- chase and sale of stocks. Passive strategies may be tai-
able patterns that investors can exploit. Such findings lored to meet individual investor requirements.
are now taken to be evidence of market efficiency, that
5. Event studies are used to evaluate the economic im-
is, of evidence that market prices reflect all currently
pact of events of interest, using abnormal stock re-
available information. Only new information will
turns. Such studies usually show that there is some
move stock prices, and this information is equally
leakage of inside information to some market partici-
likely to be good news or bad news.
pants before the public announcement date. Therefore
2. Market participants distinguish among three forms of insiders do seem to be able to exploit their access to
the efficient market hypothesis. The weak form asserts information to at least a limited extent.
that all information to be derived from past stock
6. Empirical studies of technical analysis do not support
prices already is reflected in stock prices. The semis-
the hypothesis that such analysis can generate supe-
trong form claims that all publicly available informa-
rior trading profits. One notable exception to this con-
tion is already reflected. The strong form, usually
clusion over intermediate-term horizons is the
taken only as a straw man, asserts that all information,
apparent success of momentum-based strategies over
including insider information, is reflected in prices.
intermediate-term horizons.
3. Technical analysis focuses on stock price patterns and
7. Several anomalies regarding fundamental analysis have
on proxies for buy or sell pressure in the market. Fun-
been uncovered. These include the P/E effect, the small-
damental analysis focuses on the determinants of the
firm-in-January effect, the neglected-firm effect, post-
underlying value of the firm, such as current profitabil-
earnings-announcement price drift, the book-to-market
ity and growth prospects. Since both types of analysis
effect, and the insider trading effect in Canada. Whether
are based on public information, neither should gener-
these anomalies represent market inefficiency or poorly
ate excess profits if markets are operating efficiently.
understood risk premiums is still a matter of debate.
4. Proponents of the efficient market hypothesis often ad-
8. By and large, the performance record of profession-
vocate passive as opposed to active investment strate-
ally managed funds lends little credence to claims that
gies. The policy of passive investors is to buy and hold
most professionals can consistently beat the market.
a broad-based market index. They expend resources

K E Y E Q UAT IO N S
(9.1) rt 5 a 1 brMt 1 et (9.2) et 5 rt 2 (a 1 brMt )

P RO B LE MS

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1. If markets are efficient, what should be the correlation coefficient between stock returns for two
nonoverlapping time periods?
2. Which of the following most appears to contradict the proposition that the stock market is weakly
efficient? Explain.
a. Over 25 percent of mutual funds outperform the market on average.
b. Insiders earn abnormal trading profits.
c. Every January, the stock market earns above-normal returns.
414 PART THR EE Equilibrium in Capital Markets

S U M M A RY
1. Although the single-factor expected return–beta rela-
tionship has not yet been confirmed by scientific stan-
dards, its use is already commonplace in economic life.
2. Early tests of the single-factor CAPM rejected the
SML, finding that nonsystematic risk did explain
average security returns.
3. Later tests controlling for the measurement error in
beta found that nonsystematic risk does not explain
portfolio returns but also that the estimated SML is
too flat compared with what the CAPM would predict.
4. Roll’s critique implied that the usual CAPM test is a
test only of the mean-variance efficiency of a prespec-
ified market proxy and therefore that tests of the lin-
earity of the expected return–beta relationship do not
bear on the validity of the model.
5. Tests of the mean-variance efficiency of profession-
ally managed portfolios against the benchmark of a
prespecified market index conform with Roll’s cri-
tique in that they provide evidence of the efficiency of
the prespecified market index.
6. Empirical evidence suggests that most professionally
managed portfolios are outperformed by market
indices, which lends weight to acceptance of the
efficiency of those indices and hence the CAPM.
7. Work with economic factors suggests that factors
such as unanticipated inflation do play a role in
the expected return–beta relationship of security
returns.
8. Tests of the single-index model, accounting for human
capital and cyclical variations in asset betas, are far
more consistent with the single-index CAPM and APT.
These tests suggest that macroeconomic variables are
not necessary to explain expected returns. Moreover,
anomalies such as effects of size and book-to-market
ratios disappear once these variables are accounted for.
9. The equity premium puzzle originates from the obser-
vation that equity returns exceeded the risk-free rate to
an extent that is inconsistent with reasonable levels of
risk aversion—at least when average rates of return
are taken to represent expectations. Fama and French
show that the puzzle emerges from excess returns over
the last 50 years. Alternative estimates of expected re-
turns using the dividend growth model instead of av-
erage returns suggest that excess returns on stocks
were high because of unexpected large capital gains.
The study implies that future excess returns will be
lower than realized in recent decades.
10. Early research on consumption-based capital asset
pricing models was disappointing, but more recent
work is far more encouraging. In some studies, con-
sumption betas explain average portfolio returns as
well as the Fama-French three-factor model. These re-
sults support Fama and French’s conjecture that their
factors proxy for more fundamental sources of risk.

K E Y E Q UAT IONS
(11.1) E(ri ) 5 rf 1 βi [E(rM ) 2 rf ]; rit 2 rft 5 ai 1 bi (rMt 2 rft ) 1 eit
(11.2) ri 2 rf 5 γ0 1 γ1bi  i 5 1, p ,100; γ0 5 0  γ1 5 rM 2 rf
(11.3) ri 2 rf 5 γ0 1 γ1bi 1 γ2σ 2 (ei ); γ0 5 0  γ1 5 rM 2 rf  γ2 5 0
(11.4) E(ri ) 2 E(rZ ) 5 βi [E(rE ) 2 E(rZ )]; ri 2 rZ 5 γ0 1 γ1 3 Estimated βi
(11.5) ri 5 γ0 1 γ1βi 1 γ1β2i 1 γ3σ(ei )
(11.6) E(Ri ) 5 c0 1 csize log(ME) 1 cvwβvw 1 cprem βprem 1 clabourβlabour
(11.7a) r 5 a 1 βMrM 1 βIPIP 1 βEIEI 1 βUIUI 1 βCGCG 1 βGBGB 1 e
(11.7b) r 5 γ0 1 γMβM 1 γIPβIP 1 γEI βEI 1 γUIβUI 1 γCGβCG 1 γGBβCG 1 e
(11.8) E(ri ) 2 rf 5 ai 1 bi [E(rM ) 2 rf ] 1 siE[SMB] 1 hiE[HML]
 C H A P T E R 11 Empirical Evidence on Security Returns 415

(11.9) E(rM ) 2 rf 5 ACov(rM,rC )

D1
(11.10) E(r) 5 1g
P0

P RO B LE MS

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1. Suppose you find, as research indicates, that in the cross-section regression of the CCAPM, the
coefficients of factor loadings on the Fama-French model are significant predictors of average
return factors (in addition to consumption beta). How would you explain this phenomenon?
2. Search the Internet for a recent graph of market volatility. What does this history suggest about
the history of consumption growth?
The following annual excess rates of return (%) were obtained for nine individual stocks and a market
index:

Stocks
Year Market Index A B C D E F G H I
1 29.65 33.88 225.20 36.48 42.89 239.89 39.67 74.57 40.22 90.19
2 211.91 249.87 24.70 225.11 254.39 44.92 254.33 279.76 271.58 226.64
3 14.73 65.14 225.04 18.91 239.86 23.91 25.69 26.73 14.49 18.14
4 27.68 14.46 238.64 223.31 2.72 23.21 92.39 23.82 13.74 .09
5 5.18 15.67 61.93 63.95 232.82 44.26 242.96 101.67 24.24 8.98
6 25.97 232.17 44.94 219.56 69.42 90.43 76.72 1.72 77.22 72.38
7 10.64 231.55 274.65 50.18 74.52 15.38 21.95 243.95 213.40 28.95
8 1.02 223.79 47.02 242.28 28.61 217.64 28.83 98.01 28.12 39.41
9 18.82 24.59 28.69 2.54 2.32 42.36 18.93 22.45 37.65 94.67
10 23.92 28.03 48.61 23.65 26.26 23.65 23.31 15.36 80.59 52.51
11 241.61 78.22 285.02 2.79 268.70 285.71 245.64 2.27 272.47 280.26
12 26.64 4.75 42.95 248.60 26.27 13.24 234.34 254.47 21.50 224.46

3. Perform the first-pass regressions and tabulate the summary statistics.

4. Specify the hypotheses for a test of the second-pass regression for the SML.
5. Perform the second-pass SML regression by regressing the average excess return of each portfolio
on its beta.
6. Summarize your test results and compare them to the reported results in the text.
7. Group the nine stocks into three portfolios, maximizing the dispersion of the betas of the three
resultant portfolios. Repeat the test and explain any changes in the results.
8. Explain Roll’s critique as it applies to the tests performed in problems 3 to 7.
9. Plot the capital market line (CML), the nine stocks, and the three portfolios on a graph of average
returns versus standard deviation. Compare the mean-variance efficiency of the three portfolios
and the market index. Does the comparison support the CAPM?
452 PART F OUR Fixed-Income Securities

3. Callable bonds should offer higher promised yields to interest rate. CRA treats this price appreciation as im-
maturity to compensate investors for the fact that they puted taxable interest income to the investor.
will not realize full capital gains should the interest
10. When bonds are subject to default, the stated yield
rate fall and the bonds be called away from them at
to maturity is the maximum possible yield to matu-
the stipulated call price. Bonds often are issued with a
rity that can be realized by the bondholder. In the
period of call protection. In addition, discount bonds
event of default, however, that promised yield will
selling significantly below their call price offer im-
not be realized. To compensate bond investors for
plicit call protection.
default risk, bonds must offer default premiums,
4. Retractable and extendible bonds give the bondholder that is, promised yields in excess of those offered
rather than the issuer the option to terminate or extend by default-free government securities. If the firm
the life of the bond. remains healthy, its bonds will provide higher re-
turns than government bonds. Otherwise the returns
5. Convertible bonds may be exchanged, at the bond-
may be lower.
holder’s discretion, for a specified number of shares of
stock. Convertible bondholders “pay” for this option 11. Bond safety is often measured using financial ratio
by accepting a lower coupon rate on the security. analysis. Bond indentures are another safeguard to
protect the claims of bondholders. Common inden-
6. Floating-rate bonds pay a fixed premium over a refer-
tures specify sinking fund requirements, collateraliza-
ence short-term interest rate. Risk is limited because
tion of the loan, dividend restrictions, and subordination
the rate paid is tied to current market conditions.
of future debt.
7. The yield to maturity is the single interest rate that
12. Credit default swaps provide insurance against the
equates the present value of a security’s cash flows to
default of a bond or loan. The swap buyer pays an
its price. Bond prices and yields are inversely related.
annual premium to the swap seller, but collects a
For premium bonds, the coupon rate is greater than
payment equal to lost value if the loan later goes
the current yield, which is greater than the yield to
into default.
maturity. The order of these inequalities is reversed
for discount bonds. 13. Collateralized debt obligations are used to reallocate
the credit risk of a pool of loans. The pool is sliced
8. The yield to maturity often is interpreted as an esti-
into tranches, with each tranche assigned a different
mate of the average rate of return to an investor who
level of seniority in terms of its claims on the cash
purchases a bond and holds it until maturity. This in-
flows from the underlying loans. High-seniority
terpretation is subject to error, however. Related mea-
tranches are usually quite safe, with credit risk con-
sures are yield to call, realized compound yield, and
centrated on the lower level tranches. Each tranche
expected (versus promised) yield to maturity.
can be sold as a stand-alone security.
9. Prices of zero-coupon bonds rise exponentially over
time, providing a rate of appreciation equal to the

K E Y E Q UAT IONS
T Coupon
Par value
(12.1) Bond value 5 a t
1
t51 (1 1 r) (1 1 r) T

1 1 1
(12.2) Price 5 Coupon 3 a1 2 T
b 1 Par value 3
r (1 1 r) (1 1 r) T
5 Coupon 3 Annuity factor(r, T) 1 Par value 3 PV factor(r, T)
60
$40 $1,000
(12.3) Price 5 a t
1
t51 (1.04) (1.04) 60
 CHAPTER 13 The Term Structure of Interest Rates 479

3. The forward rate of interest is the breakeven future
interest rate that would equate the total return from a
rollover strategy to that of a longer-term zero-coupon
bond. It is defined by the equation
(1 1 yn ) n (1 1 fn11 ) 5 (1 1 yn11 ) n11
where n is a given number of periods from today. This
equation can be used to show that yields to maturity
and forward rates are related by the equation
(1 1 yn ) n 5 (1 1 r1 )(1 1 f2 )(1 1 f3 ) p (1 1 fn )
4. A common version of the expectations hypothesis
holds that forward interest rates are unbiased esti-
mates of expected future interest rates. However, there
are good reasons to believe that forward rates differ
from expected short rates by a risk premium known as
a liquidity premium. A positive liquidity premium can
cause the yield curve to slope upward even if no
increase in short rates is anticipated.
5. The existence of liquidity premiums makes it extremely
difficult to infer expected future interest rates from the
yield curve. Such an inference would be made easier if we
could assume the liquidity premium remained reasonably
stable over time. However, both empirical and theoretical
insights cast doubt on the constancy of that premium.
6. Forward rates are market interest rates in the impor-
tant sense that commitments to forward (i.e., deferred)
borrowing or lending arrangements can be made at
these rates.

K E Y E Q UAT IO N S
(13.1) 1 1 y2 5 [(1 1 r1 ) 3 (1 1 r2 )] 1y2 (13.5) (1 1 yn ) n 5 (1 1 yn21 ) n21 (1 1 fn )
(13.2) (1 1 yn ) n 5 (1 1 yn21 ) n21 3 (1 1 rn ) (13.6) (1 1 r1 )(1 1 r2 ) 5 (1 1 y2 ) 2
(1 1 yn ) n (13.7) 1 1 yn 5 [(1 1 r1 )(1 1 f2 )(1 1 f3 ) p (1 1 fn )] 1yn
(13.3) (1 1 rn ) 5
(1 1 yn21 ) n21 (13.8) fn 5 E(rn ) 1 Liquidity premium
n
(1 1 yn )
(13.4) (1 1 fn ) 5
(1 1 yn21 ) n21

E-INVESTMENTS Go to www.bank-banque-canada.ca/en/rates/yield_curve.html. Look at Figure 13.6 during the 2007–2008

The Yield recession, when the term spread was zero or negative. Select a few dates around that time and plot in Excel
Curves and the yield curves, as in Figure 13.1. Can you observe the inversion of the yield curve? Then select later dates
Economic and again plot the yield curves. What happened to them? What does this say about the economy? Which
Conditions varies more: short-term or long-term rates? Can you explain why?

P RO B LE MS

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1. What is the relationship between forward rates and the market’s expectation of future short
rates? Explain in the context of both the expectations and liquidity preference theories of the
term structure of interest rates.
2. “Under the expectations hypothesis, if the yield curve is upward-sloping, the market must expect
an increase in short-term interest rates.” Is this statement true, false, or uncertain? Why?
3. “Under the liquidity preference theory, if inflation is expected to be falling over the next few
years, long-term interest rates will be higher than short-term rates.” Is this statement true, false, or
uncertain? Why?
 CHAPTER 14 Managing Bond Portfolios 517

4. Immunization strategies are characteristic of passive in cash flow with projected liabilities, rebalancing will
fixed-income portfolio management. Such strategies be unnecessary.
attempt to render the individual or firm immune from
7. Active bond management consists of interest rate
movements in interest rates. This may take the form
forecasting techniques and intermarket spread anal-
of immunizing net worth or, instead, immunizing the
ysis. One popular taxonomy classifies active strate-
future accumulated value of a fixed-income portfolio.
gies as substitution swaps, intermarket spread
5. Immunization of a fully funded plan is accomplished swaps, rate anticipation swaps, and pure yield
by matching the durations of assets and liabilities. To pickup swaps.
maintain an immunized position as time passes and
8. Horizon analysis is a type of interest rate forecasting.
interest rates change, the portfolio must be periodi-
In this procedure the analyst forecasts the position of
cally rebalanced. Classic immunization also depends
the yield curve at the end of some holding period, and
on parallel shifts in a flat yield curve. Given that this
from that yield curve predicts corresponding bond
assumption is unrealistic, immunization generally will
prices. Bonds then can be ranked according to ex-
be less than complete. To mitigate the problem, multi-
pected total returns (coupon plus capital gain) over the
factor duration models can be used to allow for varia-
holding period.
tion in the shape of the yield curve.
9. Financial engineering has created many new fixed-
6. A more direct form of immunization is dedication, or
income derivative assets with novel risk characteristics.
cash flow matching. If a portfolio is perfectly matched

K E Y E Q UAT IO N S
T 11y (1 1 y) 1 T(c 2 y)
(14.1) D 5 a t 3 wt (14.5) 2
t51 y c[(1 1 y) T 2 1] 1 y

¢P ¢(1 1 y) 11y 1
(14.2) 5 2D 3 c d (14.6) c1 2 d
P 11y y (1 1 y) T

¢P ¢P 1
(14.3) 5 2D*¢y (14.7) 5 2D*¢y 1 3 Convexity 3 (¢y) 2
P P 2

11y T
(14.4) 2
y (1 1 y) T 2 1

P RO B LE MS

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1. A nine-year bond has a yield of 10 percent and a duration of 7.194 years. If the market yield
changes by 50 basis points, what is the percentage change in the bond’s price?
2. Find the duration of a 6 percent coupon bond making annual coupon payments if it has three
years until maturity and has a yield to maturity of 6 percent. What is the duration if the yield to
maturity is 10 percent?
3. Find the duration of the bond in problem 2 if the coupons are paid semiannually.
 CHAPTER 16 Equity Evaluation Models 597

models allow for an initial period of rapid growth, a
final period of steady dividend growth, and a middle,
or transition, period in which the dividend growth rate
declines from its initial high rate to the lower sustain-
able rate.
5. Stock market analysts devote considerable attention to
a company’s price-earnings ratio. The P/E ratio is a
useful measure of the market’s assessment of the
firm’s growth opportunities. Firms with no growth
opportunities should have a P/E ratio that is just the
reciprocal of the capitalization rate, k. As growth
opportunities become a progressively more important
component of the total value of the firm, the P/E ratio
will increase.
6. The expected growth rate of earnings is related both to
the firm’s expected profitability and to its dividend
policy. The relationship can be expressed as
g 5 (ROE on new investment) 3
(1 2 Dividend payout ratio)
7. You can relate any DDM to a simple capitalized earn-
ings model by comparing the expected ROE on future
investments to the market capitalization rate, k. If the
two rates are equal, then the stock’s intrinsic value re-
duces to expected earnings per share (EPS) divided by k.
8. Many analysts form their estimate of a stock’s value
by multiplying their forecast of next year’s EPS by a
P/E multiple. Some analysts mix the P/E approach
with the dividend discount model. They use an earn-
ings multiplier to forecast the terminal value of shares
at a future date, and add the present value of that ter-
minal value with the present value of all interim divi-
dend payments.
9. The free cash flow approach is the one used most often
in corporate finance. The analyst first estimates the
value of the entire firm as the present value of expected
future free cash flows to the entire firm and then sub-
tracts the value of all claims other than equity. Alterna-
tively, the free cash flows to equity can be discounted
at a discount rate appropriate to the risk of the stock.

K E Y E Q UAT IO N S
D1 D2 D3 D1 1 P1
(16.1) V0 5 1 2
1 3
1p5
11k (1 1 k) (1 1 k) 11k
D1
(16.2) V0 5
k2g
D1
(16.3) E(r) 5 k 5 1g
P0
E1
(16.4) P0 5 1 PVGO
k
P0 1 PVGO
(16.5) 5 a1 1 b
E1 k E/k
P0 12b
(16.6) 5
E1 k 2 ROE 3 b
(16.7) FCFF 5 EBIT(1 2 tc ) 1 Depreciation 2 Capital expenditures 2 Increase in NWC
(16.8) FCFE 5 FCFF 2 Interest expense 3 (1 2 tc ) 1 Increases in net debt
T FCFFt PT FCFFT11
(16.9) Firm value 5 a t
1 T
 where PT 5
t51 (1 1 WACC) (1 1 WACC) WACC 2g
T FCFEt PT FCFET11
(16.10) Market value of equity 5 a t
1 T
 where PT 5
t51 (1 1 kE ) (1 1 kE ) kE 2 g
 C H A P T E R 17 Financial Statement Analysis 645

value in many instances is difficult, and critics
contend that financial statements are therefore un-
duly volatile. Advocates argue that financial state-
ments should reflect the best estimate of current
asset values.
10. International financial reporting standards have
become progressively accepted throughout the world,
including the United States. They differ from
traditional U.S. GAAP procedures in that they are
“principles-based” rather than rules-based.

K E Y E Q UAT IO N S
Debt
(17.1) ROE 5 (1 2 Tax rate) c ROA 1 (ROA 2 Interest rate) d
Equity

Net profit Net profits Pretax profits EBIT Sales Assets

(17.2) 5 3 3 3 3
Equity Pretax profits EBIT Sales Assets Equity

(1) 3 (2) 3 (3) 3 (4) 3 (5)

(17.3) ROA 5 Margin 3 Turnover

P RO B LE MS

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1. What financial ratios would a credit rating agency such as Moody’s or Standard & Poor’s be most
interested in? Which ratios would be of most interest to a stock market analyst deciding whether
to buy a stock for a diversified portfolio?
2. If markets are truly efficient, does it matter whether firms engage in earnings management? On
the other hand, if firms manage earnings, what does that say about management’s view on effi-
cient markets?
3. What is the major difference in approach of international financial reporting standards and U.S. GAAP
accounting? What are the advantages and disadvantages of each?
4. The Crusty Pie Co., which specializes in apple turnovers, has a return on sales higher than the
industry average, yet its ROA is the same as the industry average. How can you explain this?
5. The ABC Corporation has a profit margin on sales below the industry average, yet its ROA is
above the industry average. What does this imply about its asset turnover?
6. Firm A and firm B have the same ROA, yet firm A’s ROE is higher. How can you explain this?
7. Use the Du Pont system of financial analysis and the following data to find return on equity:
• Leverage ratio (assets/equity) 2.2
• Total asset turnover 2.0
• Net profit margin 5.5%
• Dividend payout ratio 31.8%
8. Recently, Galaxy Corporation lowered its allowance for doubtful accounts by reducing bad debt
expense from 2 percent of sales to 1 percent of sales. Ignoring taxes, what are the immediate effects on
a. Operating income?
b. Operating cash flow?
 C H A P T E R 18 Options and Other Derivatives Markets: Introduction 693

S U MMA RY
1. A call option is the right to buy an asset at an agreed-
upon exercise price. A put option is the right to sell an
asset at a given exercise price.
2. American options allow exercise on or before the ex-
piration date. European options allow exercise only on
the expiration date. Most traded options are American
in nature.
3. Options are traded on stocks, stock indices, foreign
currencies, fixed-income securities, and several fu-
tures contracts.
4. Options can be used either to increase an investor’s
exposure to an asset price or to provide insurance
against volatility of asset prices. Popular option strate-
gies include covered calls, protective puts, straddles,
spreads, and collars.
5. The put–call parity theorem relates the prices of put
and call options. If the relationship is violated, arbitrage
opportunities result. Specifically, the relationship that
must be satisfied is that
P 5 C 2 S0 1 PV(X) 1 PV(dividends)
where X is the exercise price of both the call and the
put options; PV(X) is the present value of a claim to X
dollars to be paid at the expiration date of the options;
and PV(dividends) is the present value of dividends to
be paid before option expiration.
6. Many commonly traded securities embody option
characteristics. Examples include callable bonds, con-
vertible bonds and warrants. Other arrangements, such
as collateralized loans and limited-liability borrowing
can be analyzed as conveying implicit options to one
or more parties.
7. Trading in so-called exotic options now takes place in
an active over-the-counter market.

K E Y E Q UAT IO N S
(18.1) C 2 P 5 S0 2 X/(1 1 rf ) T
(18.2) P 5 C 2 S0 1 PV(X) 1 PV(dividends)
(18.3) S0 2 C 5 L/(1 1 rf ) T 2 P

P RO B LE MS

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1. Turn back to Figure 18.1, which lists prices of various RIM Ltd. options. Use the data in the figure
to calculate the payoff and the profits for investments in each of the following September maturity
options, assuming that the stock price on the maturity date is $14.
a. Call option, X 5 $11
b. Put option, X 5 $11
c. Call option, X 5 $14
d. Put option, X 5 $14
e. Call option, X 5 $17
f. Put option, X 5 $17
2. Suppose you think ABC stock is going to appreciate substantially in value in the next six months.
Also suppose that the stock’s current price, S0, is $100, and the call option expiring in six months
has an exercise price, X, of $100 and is selling at a price, C, of $10. With $10,000 to invest, you
are considering three alternatives.
742 PART SIX Derivative Assets

7. European put values can be derived from the call
value and the put–call parity relationship. This tech-
nique cannot be applied to American puts for which
early exercise is a possibility.
8. The implied volatility of an option is the standard
deviation of stock returns consistent with an option’s
market price. It can be backed out of an option pricing
model by finding the stock volatility that equates the
option model value to the observed market price.
9. The hedge ratio refers to the number of shares of stock
required to hedge the price risk involved in writing
one option. Hedge ratios are near zero for deep out-of-
the-money call options, and approach 1 for deep in-
the-money calls.
10. Although hedge ratios are less than 1, call options
have elasticities greater than 1. The rate of return on a
call (as opposed to the dollar return) responds more
than one-for-one with stock price movements.
11. Portfolio insurance can be obtained by purchasing a
protective put option on an equity position. When the
appropriate put is not traded, portfolio insurance en-
tails a dynamic hedge strategy in which a fraction of
the equity portfolio equal to the desired put option’s
delta is sold and placed in risk-free securities.
12. The option delta is used to determine the hedge ratio
options positions. Delta-neutral portfolios are inde-
pendent of price changes in the underlying asset. Even
delta-neutral option portfolios are subject to volatility
risk, however.
13. The simple two-state pricing model is the only model
where an exact option price can be derived from the
stock and the rate of interest. If there are more than two
possible stock prices, then only an upper and a lower
bound on admissible option values can be defined.
However, both bounds become, at the limit, equal to
the Black-Scholes formula, as the holding period is
subdivided into progressively finer subintervals.
14. Empirically, implied volatilities derived from the Black-
Scholes model for a given option maturity exhibit sys-
tematic patterns with respect to the exercise price. These
patterns differ between index and equity options, and
may indicate index option mispricings sufficient to cre-
ate trading profits. These empirical findings are incon-
sistent with the Black-Scholes assumptions.

K E Y E Q UAT IONS
L 0 if V $ L
(19.1) C0 5 S0N(d1 ) 2 Xe2rTN(d2 ) (19.4) Payoff 5 e 5L2 e    T
VT L 2 VT if VT , L
(19.2) P 5 C 1 PV(X) 2 S0
(19.5) v1 1 v2 1 v3 5 1/1.08
5 C 1 Xe2rT 2 S0
(19.3) P 5 Xe2rT [1 2 N(d2 )] 2 S0 [1 2 N(d1 )]

P RO B LE MS

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1. We showed in the text that the value of a call option increases with the volatility of the stock. Is
this also true of put option values? Use the put–call parity theorem as well as a numerical example
to prove your answer.
2. In each of the following questions, you are asked to compare two options with parameters as
given. The risk-free interest rate for all cases should be assumed to be 6 percent. Assume the
stocks on which these options are written pay no dividends.
a.
Put T X σ Price of Option
A .5 50 .20 $10
B .5 50 .25 $10
 CHAPTER 20 Futures, Forwards, and Swap Markets 795

14. Interest rate futures allow for hedging against interest
rate fluctuations in several different markets. Several
such contracts are currently actively traded in Canada.
15. Swaps, which call for the exchange of a series of cash
flows, may be viewed as portfolios of forward con-
tracts. Each transaction may be viewed as a separate
forward agreement. However, instead of pricing each
exchange independently, the swap sets one “forward
price” that applies to all of the transactions. There-
fore, the swap price will be an average of the futures
prices that would prevail if each exchange were
priced separately.

K E Y E Q UAT IO N S
(20.1) F0 5 S0 (1 1 rf ) 2 D 5 S0 (1 1 rf 2 d) 1 1 rCAN T
(20.6) F0 5 E0 a b
(20.2) F0 5 S0 (1 1 rf 2 d) T 1 1 rUK

(20.3) F(T2 )/F(T1 ) 5 (1 1 rf 2 d ) (T2 2T1) 1 1 rCAN

(20.7) F0 5 E
1 1 rUK 0
(20.4) F0 5 P0 (1 1 rf 1 c)
1 1 rf T
(20.5) F0 5 E(PT )a b
11k

P RO B LE MS

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1. Why is there no futures market in cement?

2. Why might an investor choose to purchase futures contracts rather than the underlying asset?
3. What is the difference in cash flow between short selling an asset and entering a short futures
position?
4. In each of the following cases discuss how you, as a portfolio manager, would use financial
futures to protect the portfolio.
a. You own a large position in a relatively illiquid bond that you want to sell.
b. You have a large gain on one of your long Treasuries and want to sell it, but you would like to
defer the gain until the next accounting period, which begins in four weeks.
c. You will receive a large contribution next month that you hope to invest in long-term corporate
bonds on a yield basis as favourable as is now available.
5. Consider this arbitrage strategy to derive the parity relationship for spreads: (1) enter a long
futures position with maturity date T1 and futures price F(T1); (2) enter a short position with
maturity T2 and futures price F(T2); and (3) at T1, when the first contract expires, buy the asset and
borrow F(T1) dollars at rate rf and pay back the loan with interest at time T2.
a. What are the total cash flows to this strategy at times 0, T1, and T2?
b. Why must profits at time T2 be zero if no arbitrage opportunities are present?
c. What must be the relationship between F(T1) and F(T2) for the profits at T2 to be equal to zero?
This relationship is the parity relationship for spreads.
6. Consider a stock that pays no dividends on which a futures contract, a call option, and a put option
trade. The maturity date for all three contracts is T, the exercise price of the put and the call are
both X, and the futures price is F. Show that if X 5 F, then the call price equals the put price. Use
parity conditions to guide your demonstration.
842 PART SEVEN Active Portfolio Management

K E Y E Q UAT IONS
E(rM ) 2 rf (21.4) e(t) 5 R(t) 2 [α 2 β1R1 (t) 2 β2R2 (t) 2 β3R3 (t)]
(21.1) y5
Aσ M2 (21.5) P 3 C 5 (P1 1 P2 2 1)[2N(σM 1T) 2 1]
n n n
(21.2) MP2 5 rP* 2 rM
(21.6) rP 2 rB 5 a wPirPi 2 a wBirBi 5 a (wPirPi 2 wBirBi )
i51 i51 i51
α̂ α̂1N
(21.3) t(α̂) 5 5
σ̂ (α) σ̂ (e)

P RO B LE MS

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1. A household (HH) saving-account spreadsheet shows the following entries:

Date Additions Withdrawals Value

1/1/10 148,000
1/3/10 2,500
3/20/10 4,000
7/5/10 1,500
12/2/10 13,460
3/10/11 23,000
4/7/11 3,000
5/3/11 198,000

Calculate the dollar-weighted average return on the HH saving account between the first and
final dates.
2. Is it possible that a positive alpha will be associated with inferior performance? Explain.
3. We know that the geometric average (time-weighted return) on a risky investment is always lower
than the corresponding arithmetic average. Can the IRR (the dollar-weighted return) similarly be
ranked relative to these other two averages?
4. We have seen that market timing has tremendous potential value. Would it therefore be wise to
shift resources to timing at the expense of security selection?
5. Consider the rate of return of stocks ABC and XYZ.

Year rABC rXYZ

1 .20 .30
2 .12 .12
3 .14 .18
4 .03 .00
5 .01 2.10

a. Calculate the arithmetic average return on these stocks over the sample period.
b. Which stock has greater dispersion around the mean?
c. Calculate the geometric average returns of each stock. What do you conclude?
888 PART SEVEN Active Portfolio Management

K E Y E Q UAT IONS
(22.1) E(Ri ) 5 αi 1 βiE(RM )
(22.2) Cov(ri, rj ) 5 βiβjσM2
n1
(22.3) αP 5 a wi αi ; for the index αn11 5 αM 5 0
i1
n1
βP 5 a wi βi ; for the index βn11 5 βM 5 1
i51
n1
σ2 (eP ) 5 a w2i σ2 (ei ); for the index σ2 (en11 ) 5 σ2 (eM ) 5 0
i51
n1 n1
(22.4) E(RP ) 5 αP 1 E(RM )βP 5 a wi αi 1 E(RM ) a wi βi
i51 i51

σP 5 [β2PσM2 1 σ 2 (eP ) 1/2 ] 5 c σM2 a a wi βi b 1 a w2i σ 2 (ei ) d

n11 2 n11 1/2

i51 i51
E(RP )
SP 5
σP
αA
2
σ (eA )
(22.5) w0A 5 ≥ ¥
E(RM )
α M2
w0A
(22.6) w*A 5
1 1 (1 2 βA )w0A

SP2 5 SM2 1 c d
αA 2
(22.7)
σ(eA )
αi
2
σ (ei )
(22.8) w0A 5 n
αi
a σ 2 (e )
i51 i

c d 5 a c d
αA 2 n αi 2
(22.9)
σ(eA ) i51 σ(ei )

(22.10) E(RM ) 5 A 3 Var(RM )

(22.11) f 5 (S2P 2 S2M )/2A

c d
1 n αi 2
(22.12) f 5 a
2A i51 σ(ei )
 CHAPTER 23 Managed Funds 941

the consistency of fund performance is mixed. In
some sample periods, the better-performing funds
continue to perform well in the following periods; in
other sample periods they do not.
12. Performance evaluation of hedge funds is complicated
by survivorship bias, by the potential instability of
risk attributes, by the existence of liquidity premiums,
and by unreliable market valuations of infrequently
traded assets. Performance evaluation is particularly
difficult when the fund engages in option positions.
Tail events make it hard to assess the true performance
of positions involving options without extremely long
histories of returns.
13. Exchange-traded funds (ETFs) are index securities
trading on the exchanges that provide low-cost alter-
natives to mutual funds.

K E Y E Q UAT IO N S
(23.1) rportfolio 5 rf 1 β(rM 2 rf ) 1 e 1 α

P RO B LE MS

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1. Would you expect a typical open-end fixed-income mutual fund to have higher or lower operating
expenses than a fixed-income unit investment trust? Why?
2. An open-end fund has a net asset value of $10.70 per share. It is sold with a front-end load of
6 percent. What is the offering price?
3. If the offering price of an open-end fund is $12.30 per share and the fund is sold with a front-end
load of 5 percent, what is its net asset value?
4. The composition of the Fingroup Fund portfolio is as follows:

Stock Shares Price ($)

A 200,000 35
B 300,000 40
C 400,000 20
D 600,000 25

The fund has not borrowed any funds, but its accrued management fee with the portfolio man-
ager currently totals $30,000. There are 4 million shares outstanding. What is the net asset value
of the fund?
5. Reconsider the Fingroup Fund in the previous problem. If during the year the portfolio manager
sells all of the holdings of stock D and replaced it with 200,000 shares of stock E at $50 per share
and 200,000 shares of stock F at $25 per share, what is the portfolio turnover rate?
6. The Closed Fund is a closed-end investment company with a portfolio currently worth $200 mil-
lion. It has liabilities of $3 million and 5 million shares outstanding.
a. What is the NAV of the fund?
b. If the fund sells for $36 per share, what is the percentage premium or discount that will appear
in the listings in the financial pages?
7. Corporate Fund started the year with a net asset value of $12.50. By year-end, its NAV equalled
$12.10. The fund paid year-end distributions of income and capital gains of $1.50. What was the
rate of return to an investor in the fund?
1002 PART SEVEN Active Portfolio Management

S U M M A RY
1. Canadian assets make up only a small fraction of the forward markets, but unless the foreign currency rate of
world wealth portfolio. International capital markets return is known, a perfect hedge is not feasible.
offer important opportunities for portfolio diversifica-
5. Financial markets in different countries may be inte-
tion with enhanced risk-return characteristics.
grated or segmented, depending on whether factors
2. Investors can diversify internationally by buying multi- that influence security prices are universal or specific
national firms on Canadian or U.S. markets or by buy- to the countries.
ing closed- or open-ended mutual funds that invest in
6. The benefits and risks of international diversification
specific countries, regions, or internationally in general.
require careful examination to eliminate fictitious
3. International investing entails country-specific risk claims; changes to the efficient frontier and correlation
from political and other factors; assessments of that between markets over time are particularly important.
risk are available.
7. Several world market indices can form a basis for passive
4. Exchange rate risk imparts an extra source of uncertainty international investing. Active international management
to investments denominated in foreign currencies. Much can be partitioned into currency selection, country selec-
of that risk can be hedged in foreign exchange futures or tion, stock selection, and cash/bond selection.

K E Y E Q UAT IONS
(24.1) 1 1 r(C) 5 [1 1 rf (UK)]E1yE0 (24.3) 1 1 r(C) 5 [1 1 r(foreign)]E1yE0
(24.2) F0yE0 5 [1 1 rf (C)]y[1 1 rf (UK)]

P RO B LE MS

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1. Much of this subject is based on the perspective of a U.S. investor, but we have illustrated many issues
from a Canadian perspective. Suppose you are advising an investor living in a small country (choose
one to be concrete). How might the lessons of this chapter need to be modified for such an investor?
2. In Figure 25.2, we provide stock market returns in both local and dollar-denominated terms.
Which of these is more relevant? What does this have to do with whether the foreign exchange
risk of an investment has been hedged?
3. Suppose a Canadian investor wishes to invest in a British firm currently selling for £40 per share.
The investor has $10,000 to invest, and the current exchange rate is $2/£.
a. How many shares can the investor purchase?
b. Fill in the table below for rates of return after one year in each of the nine scenarios (three pos-
sible prices per share in pounds times three possible exchange rates).

Pound- Dollar-Denominated Return for

Price per Denominated Year-End Exchange Rate
Share (£) Return (%) $1.80/£ $2/£ $2.20/£
£35 ___ ___ ___ ___
£40 ___ ___ ___ ___
£45 ___ ___ ___ ___

c. When is the dollar-denominated return equal to the pound-denominated return?