Chapter 10

Answers to critical thinking and concepts review questions

1. They all wish they had! Since they didnt, it must have been the case that the stellar performance
was not foreseeable, at least not by most.

2. As in the previous question, its easy to see after the fact that the investment was terrible, but it
probably wasnt so easy ahead of time.

3. No, shares are riskier. Some investors are highly risk averse, and the extra possible return doesnt
attract them relative to the extra risk.

4. On average, the only return that is earned is the required returninvestors buy assets with
returns in excess of the required return (positive NPV), bidding up the price and thus causing the
return to fall to the required return (zero NPV); investors sell assets with returns less than the
required return (negative NPV), driving the price lower and thus the causing the return to rise to
the required return (zero NPV).

5. The market is not weak-form efficient.

6. Yes, historical information is also public information; weak form efficiency is a subset of semi-
strong form efficiency.

7. Ignoring trading costs, on average, such investors merely earn what the market offers; the trades
all have zero NPV. If trading costs exist, then these investors lose by the amount of the costs.

8. Unlike gambling, the shares market is a positive sum game; everybody can win. Also,
speculators provide liquidity to markets and thus help to promote efficiency.

9. The EMH only says, that within the bounds of increasingly strong assumptions about the
information processing of investors, that assets are fairly priced. An implication of this is that, on
average, the typical market participant cannot earn excessive profits from a particular trading
strategy. However, that does not mean that a few particular investors cannot outperform the
market over a particular investment horizon. Certain investors who do well for a period of time
get a lot of attention from the financial press, but the scores of investors who do not do well over
the same period of time generally get considerably less attention.

10. a. If the market is not weak-form efficient, then this information could be acted on and a profit
earned from following the price trend. Under (2), (3), and (4), this information is fully
impounded in the current price and no abnormal profit opportunity exists.

b. Under (2), if the market is not semistrong-form efficient, then this information could be
used to buy the shares cheap before the rest of the market discovers the financial
statement anomaly.

Since (2) is stronger than (1), both imply that a profit opportunity exists; under (3) and (4),
this information is fully impounded in the current price and no profit opportunity exists.
c. Under (3), if the market is not strong form efficient, then this information could be used as a
profitable trading strategy, by noting the buying activity of the insiders as a signal that the
shares is underpriced or that good news is imminent. Since (1) and (2) are weaker than (3),
all three imply that a profit opportunity exists. Note that this assumes the individual who
sees the insider trading is the only one who sees the trading. If the information about the
trades made by company management is public information, under (3) it will be discounted
 in the shares price and no profit opportunity exists. Under (4), this information does not
signal any profit opportunity for traders; any pertinent information the manager-insiders
may have is fully reflected in the current share price.

Solutions to questions and problems

NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require
multiple steps. Due to space and readability constraints, when these intermediate steps are included
in this solutions manual, rounding may appear to have occurred. However, the final answer for each
problem is found without rounding during any step in the problem.

Basic questions (118)

1. The return of any asset is the increase in price, plus any dividends or cash flows, all divided by
the initial price. The return of these shares is:

R = [($69 61) + 1.40] / $61

R = 0.1541, or 15.41%

The dividend yield is the dividend divided by price at the initial period price, so:

Dividend yield = $1.40 / $61

Dividend yield = 0.0230, or 2.30%

And the capital gains yield is the increase in price divided by the initial price, so:

Capital gains yield = ($69 61) / $61

Capital gains yield = 0.1311, or 13.11%

2. Using the equation for total return, we find:

R = [($54 61) + 1.40] / $61

R = 0.0918, or 9.18%

And the dividend yield and capital gains yield are:

Dividend yield = $1.40 / $61

Dividend yield = 0.0230, or 2.30%

Capital gains yield = ($54 61) / $61

Capital gains yield = 0.1148, or 11.48%

Heres a question for you: Can the dividend yield ever be negative? No, that would mean you
were paying the company for the privilege of owning the shares, however, it has happened on
bonds.

3. To calculate the dollar return, we multiply the number of shares owned by the change in price
per share and the dividend per share received. The total dollar return is:

Dollar return = 250($76.45 68.12 + 0.85)

Dollar return = $2295

4. a. The total dollar return is the change in price plus the coupon payment, so:

Total dollar return = $949 941 + 75

 Total dollar return = $83

b. The nominal percentage return of the bond is:

R = [($949 941) + 75] / $941

R = 0.0882, or 8.82%

Notice here that we could have simply used the total dollar return of $83 in the numerator of
this equation.

c. Using the Fisher Effect equation, the real rate of return was:

(1 + R) = (1 + r)(1 + h)

r = (1.0882 / 1.04) 1
r = 0.0464, or 4.64%

7. The average return is the sum of the returns, divided by the number of returns. The average return for
each stock was:

N .14 .21 .17 .09 .23 .0840, or 8.40%

X xi N
i 1 5

N .32 .05 .17 .12 .45 .1540, or 15.40%

Y yi N
i 1 5

Remembering back to sadistics, we calculate the variance of each stock as:

N

X 2 x i x 2 N 1
i 1
X2
1
5 1

.14 .0842 .21 .0842 .17 .0842 .09 .0842 .23 .0842 .029580

Y 2
1
5 1

.32 .1542 .05 .1542 .17 .1542 .12 .1542 .45 .1542 .058030

The standard deviation is the square root of the variance, so the standard deviation of each stock is:

X = (0.02958)1/2
X = 0.1720, or 17.20%

Y = (0.058030)1/2
Y = 0.2409, or 24.09%

9. a. To find the average return, we sum all the returns and divide by the number of returns, so:

Arithmetic average return = (0.12 +0.21 + 0.27 + 0.06 + 0.17)/5

Arithmetic average return = 0.1180, or 11.80%

b. Using the equation to calculate variance, we find:

 Variance = 1/4[(0.12 0.118)2 + (0.21 0.118)2 + (0.27 0.118)2 + (0.06 0.118)2 +
(0.17 0.118)2]
Variance = 0.02357

So, the standard deviation is:

Standard deviation = (0.02357)1/2

Standard deviation = 0.1535, or 15.35%

21. To calculate the arithmetic and geometric average returns, we must first calculate the return for
each year. The return for each year is:

R1 = ($107.11 99.15 + 1.60) / $99.15 = 0.0964, or 9.64%

R2 = ($91.65 107.11 + 2.00) / $107.11 = 0.1257, or 12.57%
R3 = ($127.16 91.65 + 2.20) / $91.65 = 0.4115, or 41.15%
R4 = ($162.15 127.16 + 2.60) / $127.16 = 0.2956, or 29.56%
R5 = ($192.60 162.15 + 3.00) / $162.15 = 0.2063, or 20.63%

The arithmetic average return was:

RA = (0.0964 0.1257 + 0.4115 + 0.2956 + 0.2063)/5

RA = 0.1768, or 17.68%

And the geometric average return was:

RG = [(1 + 0.0964)(1 0.1257)(1 + 0.4115)(1 + 0.2956)(1 + 0.2063)]1/5 1

RG = 0.1616, or 16.16%

22. To find the real return, we need to use the Fisher Effect equation. Re-writing the Fisher Effect
equation to solve for the real return, we get:

r = [(1 + R)/(1 + h)] 1

So, the real return each year was:

Bank Real
CPI
Quarter Bills return
Mar-88 2.70% 1.70% 0.98%
Jun-88 2.82% 1.90% 0.90%
Sep-88 3.27% 1.80% 1.44%
Dec-88 3.51% 2.00% 1.48%
Mar-89 3.77% 1.00% 2.74%
Jun-89 4.34% 2.50% 1.80%
Sep-89 4.51% 2.30% 2.16%
Dec-89 4.66% 1.80% 2.81%
Total 29.58% 15.00% 14.32%

a. The average return for bank bills over this period was:

Average return = 0.0.2958 / 8

 Average return = 0.0370 or 3.70%

And the average inflation rate was:

Average inflation = 0.1500 / 8

Average inflation = 0.0188 or 1.88%

b. Using the equation for variance, we find the variance for bank
bills over this period was:

Variance = 1/7[(0.027 0.0370)2 + (0.0282 0.0370)2 + (0.0327 0.0370)2 + (0.0351

0.0370)2 + (0.0377 0.0370)2 + (0.0434 0.0370)2 + (0.0451 0.0370)2 + (0.0466 0.0370)2]
Variance = 0.000057

And the standard deviation for T-bills was:

Standard deviation = (0.000057)1/2

Standard deviation = 0.0075 or 0.75%

The variance of inflation over this period was:

Variance = 1/7[(0.017 0.0188)2 + (0.019 0.0188)2 + (0.018 0.0188)2 + (0.02 0.0188)2

+ (0.01 0.0188)2 + (0.025 0.0188)2 + (0.023 0.0188)2 + (0.018 0.0188)2
Variance = 0.000020

And the standard deviation of inflation was:

Standard deviation = (0.000020)1/2

Standard deviation = 0.0045 or 0.45%

c. The average observed real return over this period was:

Average observed real return = 0.1432 / 8

Average observed real return = 0.0179 or 1.79%

d. The statement that bank bills have no risk refers to the fact that there is only an extremely
small chance of the banks defaulting, so there is little default risk. Since bank bills are short
term, there is also very limited interest rate risk. However, as this example shows, there is
inflation risk, i.e. the purchasing power of the investment can actually decline over time
even if the investor is earning a positive nominal return.

23. To find the return on the coupon bond, we first need to find the price of the bond today, so:

P1 = $80(PVIFA7.2%,9) + $1000/1.0729
P1 = $1051.68

You received the coupon payments on the bond, so the nominal return was:

R = ($1 051.68 1032.15 + 80) / $1032.15

R = 0.0964, or 9.64%

And using the Fisher Effect equation to find the real return, we get:

r = (1.0964 / 1.035) 1
r = 0.0594, or 5.94%
24. Looking at the government bond return history in Figure 10.10, we see that the mean return was
9.3%, with a standard deviation of 5.4%. In the normal probability distribution, approximately
of the observations are within one standard deviation of the mean. This means that of the
observations are outside one standard deviation away from the mean. Or:

Pr(R< 3.7 or R>14.7) 1/3

But we are only interested in one tail here, that is, returns less than 3.7 %, so:

Pr(R< 3.7) 1/6

You can use the z-statistic and the cumulative normal distribution table to find the answer as
well. Doing so, we find:

z = (X )/

z = (3.7% 9.3%)/5.4% = P(z< 2.407)

Looking at the z-table, this gives a probability of 0.80%

The range of returns you would expect to see 95 percent of the time is the mean + or 2 standard
deviations, or:

95% level: R 2 = 9.3% 2(5.4%) = 1.50% to 20.10%

The range of returns you would expect to see 99% of the time is the mean + or 3 standard
deviations, or:

99% level: R 3 = 9.3% 3(5.4%) = 6.9% to 25.5%

25. The mean return for shares was 12.36%, with a standard deviation of 17.5%. Doubling your
money is a 100% return, so if the return distribution is normal, we can use the z-statistic. So:

z = (X )/

z = (100% 12.36)/17.5% = 5.008 standard deviations above the mean

This corresponds to a probability of 0.00003%. Tripling your money would be:

z = (200% 12.36)/17.5% = 10.722 standard deviations above the mean.

This corresponds to a probability of almost zero.

26. It is impossible to lose more than 100% of your investment. Therefore, return distributions are
truncated on the lower tail at 100%, and cannot truly follow a normal distribution.

Challenge questions (2728)

27. Using NORM.DIST

=NORM.DIST(0,0.1236,0.1750,1)
= 0.24
Using the z-statistic, we find:

z = (X )/

z = (0% 12.36%)/17.5% = 0.7063

P(x< 12.36) = P(z< (0 12.36)/17.5) = P(z< 0.7063) = 24.00%