A Few Practice Problems for Midterm - Answers

Use the following information for problems 1-3. You have been asked to create a
small index of North Carolina Stocks using Cree Research (CREE), Duke Energy
(DUK), Bank of America (BAC ), and Goodrich (GR). Your manager asks you to
prepare a price-weighted and a market-weighted index for comparison purposes.

1. Calculate the percentage change in value from yesterday (t=0) to today

(t=1) using a Price-Weighted Index.
2. Calculate the percentage change in value from yesterday (t=0) to today
(t=1) using a Market-Weighted Index.
3. Suppose that after the market closes on t=1, GR does a 2-for-1 (2:1) stock
split. Using the Price-Weighted Index approach, calculate the new divisor.
Answers to 1-3
Stock
CREE
DUK
BAC
GR
sum
divide

Price, t=0
$30.73
$14.10
$11.41
$52.18
$108.42
$27.11

Price, t=1
$30.21
$14.08
$13.25
$48.25
$105.79
$26.45

Price-weighted index

Shares
(million)
89
1287
8357
124

-2.43%

26.45/27.11 -1
Market-weighted index
t=0
CREE
$2,734.97
DUK
$18,146.70
BAC
$95,353.37
GR
$6,470.32

12.08%
t=1
$2,688.69
$18,120.96
$110,730.25
$5,983.00

sum
set to
100

$122,705.36

$137,522.90

100

112.075707

Stock
CREE
DUK
BAC
GR
sum
divide

Price, t=0
$30.73
$14.10
$11.41
$52.18
$108.42
$27.11

Price, t=1
$30.21
$14.08
$13.25
$24.13
$81.67
$26.45
81.67/26.45

New divisor

Shares
(million)
89
1287
8357
124

3.087523629

4. Suppose you are in the 15% tax bracket. Would you prefer to earn a 4%
taxable return or a 3% tax-free yield? What is the equivalent taxable yield
of the 3% tax-free yield? Answer both questions
Bond A = 4% taxable
Bond B = 3% tax-free
Calculate taxable yield: Bond A = 4% taxable, Bond B = 3%/(1-.15) = 3.53%
Calculate tax-free yield: Bond B = 4%(1-.15) = 3.4%, Bond B = 3%
In the 15% tax bracket, select Bond A.

5. Suppose the risk premium on the market portfolio is estimated at 7.1%

with a standard deviation of 28%. What is the risk premium on a portfolio
invested in 40% Google with a beta of 1.8 and 60% in Duke with a beta of
0.9? {E(rp) rf = p[E(rm) rf]}
Portfolio beta = .4(1.8) + .6(0.9) = 0.72 + 0.54 = 1.26
Risk premium = 1.26(7.1) = 8.95
6. Stock XYZ has an expected return of 14% and risk of = 1.2. Stock ABC
is expected to return 18% with a beta of 1.6. The markets expected
return is 12% and rf = 3%. = E(r) - {rf + [E(rm) rf]}
a. According to the CAPM, which stock is a better buy?
b. What is the alpha for each stock?
c. Plot the SML and the two stocks and show the alphas of each on
the graph.

CAPM = kxyz = 3 + 1.2 (12-3) = 13.80; kabc = 3 + 1.6(12-3) = 17.40

xyz = 14-{3+1.2[12-3]} = 0.2; abc = 18-{3+1.6[12-3]} = 0.6
ABC is a better buy
7. Assume that you manage a risky portfolio with an expected rate of return
of 15% and a standard deviation of 22%. The current T-bill rate is 5%.
Your client chooses to invest 62% of a portfolio in your fund and the
remaining 38% in a T-bill money market fund. Suppose your risky portfolio
includes the following investments in the given proportions:
Stock A
Stock B
Stock C

30%
32%
38%

What is the reward-to-variability ratio (S) of your risky portfolio and your
clients overall portfolio?
S = [(15-5) / 22] = 0.45; or Rc = .62(15) + .38(5) = 9.3 + 1.9 = 11.2,
c = .62(22) = 13.64, S = [(11.2-5)/13.64] = 0.45
8. You open a brokerage account and purchase 500 shares of IBM at $77.62
by borrowing half of the required funds (you pay for 250 shares and
borrow enough to buy another 250 shares). You pay 7% annual interest
on the borrowed money. At the end of one year, what price would trigger a
margin call if the maintenance margin were set at 30% by the brokerage
firm?
You invest 250 shares at $77.62 = $19,405
You borrow 250 shares at $77.62 = $19,405; you pay 7% interest or $1,358.35
Total amount invested 500 at $77.62 = $38,810
[(500P - $19,405 - $1,358.35)/500P] = 0.30 and solve for P
P = $59.32
Use the following information for problems 9-12:

Time
1
2
3
4
5

A (%)

B (%)

C (%)

D%

Market (%)

12
4
-10
8
12

7
3
4
12
5

22
-13
4
22
0

3
6
-12
34
9

8
21
11
-2
12

9. Calculate the geometric return for security B.

10. Calculate the covariance of securities A and C.
11. Calculate the beta of security D with the market.
12. Calculate the portfolio variance if you put of your money in B and the
other in the market.