Alexander - Gordon - Sharpe - Solutions

Fundamentals of Investments, Third Edition
1. Issuers receive the net proceeds of securities sales when

their securities are initially sold in the primary market.
These securities represent claims on the issuing entities.
For publicly-traded securities, these claims can be
transferred through sales of the securities. This trading
among investors takes place in the secondary markets, where
the issuers have no direct involvement. When an investor
sells his or her shares of a particular security in the
secondary market, the issuer has no means or right to receive
any additional funds as a result of the trade.
2. The return on an investment, as shown in Equation (1.1) in the

text, is given by:
Ending Wealth Beginning Wealth

ROR =
Beginning Wealth
In the case of Colfax stock:
ROR = ($36 + $3 - $33)/($33)
= .182 = 18.2%
3. Using the formula for the return on an investment shown above,

in the case of Ray's portfolio:
a. ($25,000 - $20,000 + $1,000)/($20,000) = .300 = 30.0%
b. ($23,000 - $30,000 + $3,000)/($30,000) = -.133 = -13.3%
c. ($48,000 - $50,000 + $4,000)/($50,000) = .040 = 4.0%
4. Because the U.S. Treasury guarantees the payment of interest

and principal on Treasury bills, an investor can be certain of
the return that he or she will earn on a Treasury bill
investment. The government has the unlimited authority to tax
and print money to repay its debts. Therefore its ability to
make these promised payments is unquestioned.
This certain Treasury bill return, however, does not account

for the effects of inflation. Although the short maturity of
Treasury bills makes this issue relatively unimportant, if
inflation rose sharply and unexpectedly during the time that
an investor held Treasury bills, he or she would not be
compensated for the resulting lost purchasing power.
5. The average annual return on small stocks during 1976-1995 was

21.24%. The standard deviation of small stock returns during
Chapter 1 Page 1
this period was 19.94%.
The average annual return on common stocks during 1976-1995

was 15.35%. The standard deviation of common stock returns
during this period was 13.63%.
6. If one assumes that investors dislike risk (a reasonable

assumption and one that is discussed later in the text), then
higher-risk securities should exhibit higher returns over long
periods of time. If this relationship did not exist, and
higher-risk securities offered the same returns as lower-risk
securities, then investors could not be induced to hold these
riskier securities. They could avoid additional risk and
receive the same return by holding the lower-risk securities.
Such a situation could not be an equilibrium. Prices of
higher-risk securities would have to adjust to provide
investors with higher returns and therefore increase
investors' willingness to hold these securities.
7. Examples of non-financial market risk-return trade-offs

include: asking the boss for a raise, underreporting income to
the IRS, and self-insuring against damage to your home.
8. The statement in the text citing a positive relationship

between risk and return is made in the expectational sense.
That is, higher-risk securities are expected to produce
returns greater than lower-risk securities. On the other
hand, the data contained in Table 1.1 illustrates historical,
single period results. Various factors may have intervened to
cause lower-risk securities to outperform the higher-risk
securities in any given year.
9. The worst single year for common stock investors was 1931,
when they experienced a total return of -43.44%. In the
1970s, the worst year for common stock investors was 1974,
when they experienced a total return of -26.36%. However,
accounting for inflation, the real return (nominal return less
the inflation rate) on common stocks in 1974 was -38.70%,
while the real return on common stocks in 1931 was 34.12%.
In fact, inflation rates were negative for several years
during the Great Depression, while they were relatively high
during the mid-1970s. As a result, in terms of total real
returns, the market decline of the 1973-74 was as (or more)
severe than the market decline of the Great Depression
10. Foreign security returns do not necessarily move in the same

direction as returns on U.S. securities. For that reason,
including them in a portfolio will tend to dampen the ups and
downs of the portfolios total returns. This effect is known
Page 2 Chapter 1
as diversification and can significantly improve the risk

performance of a portfolio. In addition, some investors
contend that returns on foreign securities are generally
higher than those on comparable U.S. securities. While this
contention is controversial, an investor who believes it could
increase both the expected risk and return performance of his
or her portfolio by including foreign securities.
11. Life insurance companies receive cash from individuals in the

form of premiums. In exchange, the insurance companies write
policies promising to make payments in the event of the death
of the insured individual. The proceeds from the policy sales
are primarily invested in stocks, bonds, money market
instruments, and real estate.
Mutual funds receive cash from investors and, in exchange,

issue shares in the respective funds. The proceeds from the
funds' sales are invested in a wide variety of financial
assets, with the specific assets depending on the funds'
particular investment objectives.
Pension funds receive employer (and sometimes employee)

contributions and issue promises to pay retirement benefits in
exchange. The contributions are primarily invested in stocks,
bonds, and money market instruments.
12. The five steps to the investment process are:
1. Investment policy
2. Security analysis
3. Portfolio construction
4. Portfolio revision
5. Portfolio performance evaluation
Setting investment policy is important because it provides the

general framework around which the investment process is
conducted. It identifies the investors risk tolerance and
investment objectives. Security analysis is at the center of
the investment process. It involves specifically identifying
financial assets to be purchased for and sold from the
investors portfolio. Portfolio construction moves from
identifying the specific assets in the security analysis step
to combining those assets into a portfolio consistent with the
investors investment objectives. Portfolio revision is
necessary because investing is a dynamic process that responds
to changes in investment opportunities and the investors
financial circumstances. Finally, portfolio performance
evaluation is a feedback and control procedure intended to
help the investor examine whether his or her investment
Chapter 1 Page 3
program is meeting targeted objectives.
13. Because returns on financial assets are directly related to

risk, establishing an investment objective of "making a lot of
money," or equivalently, maximizing returns, might entail
inordinate levels of risk. More appropriate would be an
investment objective that jointly establishes desired levels
of return and risk.
14. It is probably not advisable for an elderly person to hold a

portfolio that includes no commons stocks. Common stocks have
by far outperformed other asset classes historically.
Moreover, compared to returns on bonds and money market
investments, common stocks are the only asset class to
historically produce a large premium over inflation. An
elderly person must be concerned about maintaining the
purchasing power of his or her investments. Given their
historical performance, common stocks seem to be well-suited
to helping maintain that purchasing power. Just what
proportion of the portfolio should be held in common stocks is
another matter.
15. Many factors could influence an investor's investment policy.

Some obvious factors would include the investor's financial
objectives (for example, saving for retirement or building a
child's college fund), the investor's willingness to bear
risk, the investor's current financial circumstances, and the
investor's investment time horizon (partly a function of age
and career status).
Page 4 Chapter 1
1. a. A market order instructs the broker to buy or sell

immediately at the best available price. The investor is
virtually assured that the order will be filled. However,
the actual trade price could differ from the price
existing when the order was placed.
b. A limit order instructs the broker to buy or sell at a

specified price (or better). The investor is assured
that, if the trade takes place, then it will be done at a
price at least as good as his or her limit price.
However, the investor cannot be certain when, or even if,
the order will eventually be filled.
c. A stop order instructs the broker to buy or sell at the

best available price once a stop price is reached. The
investor can be fairly certain that his or her order will
be filled if the stop price is reached. However, the
actual trade price could differ from the stop price.
2. Lollypop's balance sheet at the time of the margin purchase

would appear as follows:
Assets Liabilities & Net Worth

Securities Liabilties
$75/shr 200 shrs = $15,000 Margin Loan
(1-.55) $75/shr 200 shrs = $6,750
Net Worth
$15,000 - $6,750 = $8,250
3. An investors actual collateral is simply the market value of

the investors assets in the margin account. Thus for Buck:
a. 200 shrs $40/shr = $8,000
b. 200 shrs $60/shr = $12,000
c. 200 shrs $35/shr = $7,000
4. The minimum collateral required to avoid a margin call in the

case of a margin purchase is given by:
Minimum collateral = Loan/(1 maintenance margin requirement)
In Snooker's case:
Chapter 2 Page 5
Min collateral = [(1,000 shrs $60/shr) (1 - .50)]/(1 .70)
= $42,857.14
With the decline in price to $50/share, Snookers actual

collateral is now:
Collateral = 1,000 shrs $50/shr = $50,000
Snookers actual collateral is therefore above the minimum

level necessary to avoid a margin call. No margin call will
occur.
5. The maximum amount that Lizzie can purchase is found by

solving:
Initial Equity = Initial Margin Requirement Purchase Amount
or
Max Purchase Amount = Initial Equity/Initial Margin Requirement
= $15,000/.50 = $30,000
6. The maintenance margin requirement ensures that an investor

maintains sufficient equity in his or her account to protect
the broker against sudden shifts in the value of the
investor's securities purchased on margin. Margin in the
investors account represents the excess of asset values over
the value of the investors loan. Therefore the greater the
maintenance margin requirement, the greater is the broker's
"cushion" against declines in the value of the investor's
portfolio.
7. Penny's initial investment in South Beloit is $17,500 ($35

500) of which Penny put down $7,875 (.45 $17,500). Over the
course of the year Penny must pay interest of $1,155 (.12
$9,625). At year-end Penny's investment is worth $20,000 ($40
500). Thus Penny's return on investment for the year is:
ROR = [($20,000 - $17,500) - $1,155]/$7,875
= .171 = 17.1%
8. Note that the return on an investor's margin purchase can be

expressed on a total dollar basis or on a per share basis. In
the latter case:
Page 6 Chapter 2
Pt +1 Pt + Dt [r (1 im) Pt ]
ROR =
(im Pt )
In Ed Delahanty's case:
a. ROR = {($40 - $30 + $1) - [.13 (1 - .55) $30]}
/(.55 $30)
= ($11 - $1.755)/$16.50 = .560 = 56.0%
b. ROR = {($20 - $30 + $1) - [.13 (1 - .55) $30]}
/(.55 $30)
= ($-9 - $1.755)/$16.50 = -.652 = -65.2%
c. ROR = ($40 - $30 + $1)/$30
= $11/$30 = .367 = 36.7%
ROR = ($20 - $30 + $1)/$30
= $-9/$30 = -.300 = -30.0%
9. Beauty's balance sheet at the time of the short sale would

appear as follows:
Assets Liabilities & Net Worth

Cash Proceeds of Sale Liabilities
$25/shr 500 shrs = $12,500 Market Value of Short Sold Stock
Initial Margin $25/shr 500 shrs = $12,500
.50 $12,500 = $6,250
Total Assets Net Worth
$12,500 + $6,250 = $18,750 $18,750 - $12,500 = $6,250
10. The equity (or net worth) in an investors account who engages
in short selling is given by:
Equity = (short sale proceeds + initial margin) - loan
Thus for Candy:
a. [(200 shrs $50/shr) (1 + .45)] (200 shrs $58/shr)
Chapter 2 Page 7
= $14,500 - $11,600 = $2,900
b. [(200 shrs $50/shr) (1 + .45)] (200 shrs $42/shr)
= $14,500 - $8,400 = $6,100
11. The minimum collateral required to avoid a margin call in the

case of a short sale is given by:
Minimum collateral = Loan (1 + maintenance margin requirement)
In Dintys case, the minimum collateral is:
Min collateral = (500 shrs $50/shr) (1 + .35)
= $33,750
Dintys actual collateral equals the short sale proceeds plus

the initial margin or:
(500 shrs $45/shr) (1 + .55) = $34,875
Because the actual collateral exceeds the minimum collateral,

Dinty will not receive a margin call at this time.
12. The first statement is true. The upside potential of any

common stock is unbounded. Therefore, because a short seller's
losses increase as the price of the short sold stock rises,
the short seller's potential losses are infinite.
The second statement is false. It is true that if the initial

margin requirement on short sales was 100%, then the maximum
return that a short seller could earn would be 100%. (This
would occur if the shorted stock's price went to zero.)
However, given an initial margin requirement less than 100%,
the leveraged position of a short sale potentially can produce
returns in excess of 100%.
13. Calculated on a total dollar basis, Deerfoot's initial

investment in the short sale of DeForest stock is $35,000 (.50
$70 1,000). At year-end, Deerfoot had to reimburse the
owner of the DeForest stock with $2,000 ($2 1,000) for
dividends paid on the stock. Further, at year-end, if
Deerfoot purchased the stock and repaid the owner, then the
excess proceeds over the amount which Deerfoot originally
received when the stock was sold short would equal -$5,000
($70 - $75 1000). Thus Deerfoot's return on investment
during the year was:
Page 8 Chapter 2
ROR = [($70,000 - $75,000) - $2,000]/$35,000
= -.200 = -20.0%
14. Expressing the return on a short sold security on a per share

basis (including interest on the initial margin deposit)
given:
Pt Pt +1 Dt + (im Pt r )
ROR =
(im Pt )
a. If the Madison stock, which was originally sold short at

$50 per share, rises to $58 then:
ROR = [($50 - $58 - $0) + (.45 $50 .08)]/(.45 $50)
= -.276 = -27.6%
b. If the Madison stock, which was originally sold short at

$50 per share, falls to $42 then:
ROR = [($50 - $42 - $0)] + (.45 $50 .08)]/(.45 50)

= .436 = 43.6
15. When an investor receives a margin call, then the collateral

in his or her margin account has fallen below the minimum
amount specified by the maintenance margin requirement. The
investor's broker will request that the investor deposit
additional cash and/or sell securities to bring the collateral
up to or above the required level.
An investor's margin account is restricted if his or her

collateral falls below the amount specified by the initial
margin requirement. In this case the investor will not be
requested to increase his or her margin, but he or she may not
withdraw funds from the account such that the collateral would
be further reduced.
Chapter 2 Page 9
1. Continuous markets permit investors to trade at any time while

the markets are in operation. Conversely, in a call market,
investors must wait until the periodic call sessions occur to
complete their trades. Many investors do not really require
the immediate access to liquidity offered by continuous
markets. Nevertheless, this aspect of continuous markets has
proven to be very popular and is something for which investors
appear willing to pay a premium to support the intermediaries
(that is, specialists and dealers) who help these markets
function smoothly.
2. A specialist is charged by the NYSE with maintaining a "fair

and orderly" market in his or her assigned stocks. To carry
out this responsibility, the NYSE designates the specialist as
the sole market maker in those stocks. A specialist carries
out his or her responsibilities, and earns a profit, by
playing two roles. First, he or she acts as a broker,
facilitating trades by keeping a limit order book on his or
her assigned stocks. Second, he or she acts as a dealer,
buying and selling shares for his or her own account when
there exists a temporary imbalance in supply and demand for
his or her assigned stocks.
A dealer in the OTC market is not assigned by a central

organization to make a market in particular stocks. Rather,
the dealer chooses those stocks in which he or she will make a
market and this choice can be changed at any time. Further,
beyond certain disclosure and anti-fraud regulations, the
dealer is under no obligation to maintain a "fair and orderly"
market in his or her chosen stocks. The dealer earns a profit
by charging for the service (via the bid-ask spread) of
meeting the transactional demands of customers and by adroitly
buying and selling for his or her own account.
3. Commission brokers carry out the trading orders of the public

that have been placed with the brokers' respective brokerage
firms. Commission brokers are compensated by the commissions
paid by the firm's customers.
Floor brokers are not directly employed by particular

brokerage firms. Rather, they are independent exchange
members who assist commission brokers in executing their
orders, especially during periods of heavy trading. Floor
brokers are compensated by sharing in the commissions paid to
the commission brokers.
Floor traders are independent exchange members who trade only

for themselves, not for the public. They earn a profit by
recognizing mispriced stocks and appropriately buying and
Page 10 Chapter 3
selling those stocks.
4. a. The specialist will sell Eppa's commission broker 100

shares of Pigeon Falls at 35 5/8.
b. The specialist will record the limit order of Eppa's

broker in his or her limit order book.
c. Eppa's broker will execute the trade with the other broker
at 35 1/2. The specialist will not participate.
5. Assuming that Bosco or a broker from the crowd does not

participate:
a. Bosco will fill the sell market order from the limit order
book by executing the limit orders to buy 100 shares at
$29.75 and 100 shares at $29.
b. Bosco will also fill the second sell market order from the
limit order book by executing the limit order to buy 100
shares at $28.50.
c. Bosco would likely prefer to reduce the inventory of Eola

shares given the relatively large book of sell limit
orders just above the most recent trade price of $30.
6. The specialist in a particular stock is the only exchange

member with access to that stock's limit order book. This
access provides him or her with valuable information regarding
the stock's price support and resistance levels. Knowledge of
this information permits the specialist to adjust his or her
inventory at appropriate times so as to profit from price
movements near these sensitive price points. Earnings from
this activity more than compensates for occasionally having to
"fight the tape" by buying and selling against the market.
7. Nasdaq (National Association of Securities Dealers Automated

Quotations) permits brokers interested in trading an OTC stock
to quickly canvass the prices offered by dealers making a
market in that stock. Prior to the introduction of Nasdaq,
this canvassing process was very time-consuming. The existence
of Nasdaq encourages investors to trade in Nasdaq-listed OTC
stocks because of the immediate access to current prices
offered by competing dealers.
8. All other things remaining the same, reducing the size of

pricing unit increments should increase the opportunity for
price improvement. For example, prices expressed in
increments of one-eighth equate to a decimal unit of $.125.
Chapter 3 Page 11
Thus in that situation the bid-ask spread can be no narrower

than $.125. Moving to increments of $.01 would offer the
opportunity to narrow that spread to $.01. If a dealer
maintained a spread of $.125 even though prices could move in
$.01 increments, investors could potentially achieve price
improvement through trading inside the dealers quotes.
9. The most direct way a dealer has to discern whether a trade is

information-motivated is to know the identity of the trader.
For instance, if the dealer knew that the trader were
representing George Soros, the dealer would be inclined to
assume that the trade was based on knowledge about the traded
stock. Less directly, a trader may make assumptions about the
information behind the trade by examining the pattern of
trading. If the trader seems anxious to trade, seemingly at
any price, the dealer will tend to assume that the trader is
information-motivated.
10. The Securities Acts Amendments of 1975 directed the SEC to

move as rapidly as possible toward creating a competitive
nationwide security market.
On May 1, 1975, the NYSE completely eliminated fixed

commission rates.
In 1975, the Consolidated Tape began to report trades on the

NYSE, ASE, regional exchanges, and OTC Nasdaq-quoted
securities.
In 1978, the SEC instructed the stock exchanges to make their

quotations available to the Consolidated Quotations System.
In 1978, the Intermarket Trading System was created. The ITS

links the NYSE, ASE, several regional exchanges, and certain
OTC dealers. Orders can be routed through the ITS to the
market makers offering the best prices.
11. Proponents of alternatives to the NYSE's central trading

system claim that such alternatives enhance competition among
market makers thereby leading to lower transaction costs for
the investing public.
Opponents of alternative trading systems contend that the

economies of scale offered by the NYSE lower transaction
costs. Further they claim that the NYSE permits closer
scrutiny of market makers' activities, thereby reducing the
chances for unethical trading practices to occur.
12. On May 1, 1975 (May Day) the NYSE, as a result of pressure by
Page 12 Chapter 3
the Securities and Exchange Commission, completely ended its

system of fixed commission rates. From that time forward
member firms have been permitted to negotiate any desired
commission rate with any customer. The initial result of May
Day was to increase competition among brokerage firms,
especially competition for the business of large institutional
clients. May Day was one of the early significant steps
toward more competitive security markets.
13. SIPC insurance is designed to protect customers against the

possibility of a brokerage firm failing to meet its
obligations. SIPC insurance is likely to be most effective in
situations when an individual brokerage firm fails, for
example, due to fraud or mismanagement. In such a case the
system's financial resources are not likely to be overly-
strained.
SIPC insurance is likely to be ineffective in situations

affecting a large number of brokerage firms, such as a
devastating market crash. In such a case the insurance funds
might not be sufficient to protect customers against losses.
While the SIPC has access to a line of credit with the
Treasury in the event that its funds are exhausted, the
ensuing financial dislocations would likely be considerable.
14. The economies of scale present in large trades allowed brokers

to offer large traders considerably lower commissions after
May Day. On the other hand, small traders, who had been
subsidized by the artificially high commissions charged to
large traders, were now required to pay the full cost of
having their trades executed.
More recently, technological advances (particularly, computers

and the Internet) have reduced the costs of maintaining
accounts for small investors and executing their trades.
Factor in the elimination of the account representative and
one can understand why on-line brokerage firms can offer
commissions far below the rates charged by full-service
brokers after May Day.
15. The price of a security is determined by the supply and demand

for the security. In the short run, additional supply of a
security can only be obtained by increasing the offered price
for the security. Thus a trader wishing to buy a large amount
of the security will have to increase his or her bid price
more than a trader wishing to buy a smaller amount of the
security. The result is price impact. (Similar logic applies
to a trader desiring to sell a security.) In addition, the
larger the size of the order, the more a dealer is likely to
Chapter 3 Page 13
view the trade as information-motivated and, therefore, the

more he or she is likely to increase the bid-ask spread to
protect from the possibility that he or she will be picked
off by the trade.
Page 14 Chapter 3
1. a. The aggregate demand-to-buy schedule for Fairchild stock

will shift up and to the right. The aggregate supply-to-
sell schedule will shift up and to the left.Fairchild's
stock price will rise.
b. The aggregate supply-to-sell schedule will shift down and

to the right. Fairchild's stock price will fall and the
quantity traded will increase.
c. The demand-to-buy schedule will become flatter (or more

elastic). However, the equilibrium price will not change
and no additional transactions will take place.
2. If security prices were unrelated to investment values one

might expect that they would behave in a random fashion. Yet
such price behavior is precisely what one would observe in an
efficient market in which investment value information is
quickly impounded in security prices. As new information
arrives randomly, security prices would likewise move in a
random fashion.
3. The market price for any security represents a consensus view

of all investors. Each investor, given his or her own
expectations about those relevant factors affecting the value
of a particular security, will adjust his or her holdings so
that the marginal value of a unit of the security equals the
market price. It is the seemingly chaotic interaction of all
investors that determines the market price for the security.
4. Weak-form market efficiency implies that past price

information is immediately and fully reflected in security
prices. Thus this information cannot be employed to earn
abnormal profits.
Semistrong-form market efficiency implies that all relevant

publicly available information is immediately and fully
incorporated into security prices. Thus this information is
useless to investors seeking abnormal profits.
Strong-form market efficiency implies that all relevant

information, public or private, is immediately and fully
reflected in security prices. Thus this information cannot be
used to earn abnormal profits.
5. Weak-form efficiency does not imply strong-form efficiency.

However, strong-form efficiency does imply weak-form
efficiency. That is, a market cannot be strong-form efficient
without all available information, including past security
price information, being incorporated into security prices.
Chapter 4 Page 15
Conversely, a market can be weak-form efficient without non-

public information being incorporated into security prices.
6. a. Semistrong
b. Weak
c. Strong (assuming that these deliberations are private)
d. Strong
e. Semistrong
f. Weak
7. The process of fundamental security analysis should make

security markets more efficient. Investors engaging in
fundamental security analysis attempt to assess the various
determinants of security values and use that knowledge to
identify mispriced securities. By buying securities selling
for less than their fair values and selling securities priced
above their fair values, these investors drive security prices
toward the securities' fair values, thereby enhancing the
efficiency of security markets.
8. NYSE specialists should be able to earn abnormal profits even

in a semi-strong efficient market. A specialist has access to
a particular form of inside information - the limit order book
for his or her assigned security. This information gives the
specialist knowledge regarding price levels at which sizable
buy or sell orders may be activated. By buying or selling
ahead of those orders, a resourceful specialist should be able
to generate abnormal profits.
9. Investors transacting in a perfectly efficient market would be

able to consistently earn profits commensurate with the risk
assumed. However, they would not be able to consistently earn
abnormal profits (that is, profits greater than those
justified by the amount of risk that they incur).
10. The investment world is populated by numerous aggressive,

well-educated, and hardworking individuals. Their objective
is to identify mispriced securities and profit by
appropriately buying and selling such securities. It seems
improbable that these investors would frequently permit
abnormal profit opportunities to go unexploited for very long.
Ironically, it is the combined actions of these investors that
makes the attainment of their goal so difficult.
11. The earnings information could be considered a pleasant

surprise by some investors (perhaps former pessimists
regarding the stock's prospects) and an unpleasant surprise by
other investors (perhaps former optimists regarding the
stock's prospects). The formerly pessimistic investors will
Page 16 Chapter 4
want to increase their holdings of the stock. Conversely, the

formerly optimistic investors will want to decrease their
holdings. The net effect of these changes in opinion will be
to generate trades in the stock, yet have little impact on the
stock's price.
12. a. Successful insider trading, which involves earning

abnormal profits through the use of non-public
information, is consistent with weak-form and semistrong-
form market efficiency. It is not consistent with strong-
form market efficiency.
b. One could argue that insider trading makes the security

markets more efficient. By their actions traders using
inside information make that information public. Insider
trading causes securities to more quickly reflect all
information relevant to their true investment values.
13. Testing for market efficiency through the use of event studies
involves determining whether a set of returns is abnormal.
The definition of normal return requires the use of an
equilibrium-based asset pricing model. However, it is not a
given that the asset pricing model being used is valid. A
finding of abnormal returns might be due to the markets being
inefficient or it might be due to the asset pricing model
being incorrect, or it might be due to both reasons. It is
impossible to disentangle the two issues. Thus a test for
market efficiency using event studies tests both the
efficiency of the market and the validity of the asset pricing
model.
14. In a perfectly efficient market with transaction costs, it is

expensive to collect and process information. Moreover,
investors must pay to alter their portfolios in response to
new information. As a result, some securities will be priced
to yield abnormal returns because it is not cost effective for
market participants to search out and acquire (or sell) these
securities to drive their prices to fair value levels.
Investors will incur research and trading costs to search for
and acquire (or sell) mispriced securities up to the point
where these costs equal the abnormal returns that they earn
from investing in the mispriced securities.
15. In a perfectly efficient market, there should be no investors

who consistently earn abnormal returns. Superior performance
by an investor in a past period should be completely unrelated
to how well that same investor will perform in a future
period. An investor displaying positive historical abnormal
returns was simply lucky, while an investor displaying
Chapter 4 Page 17
negative abnormal returns was unlucky. But luck is random and

has no bearing on future performance.
Page 18 Chapter 4
1. Choosing between alternative investment opportunities involves

changes in income on the margin. The average tax rate has no
impact on the amount of the investor's additional income that
he or she will be able to retain. Rather, it is the marginal
tax rate that determines how much better off the investor will
be after choosing a particular investment.
2. Corporate shareholders are taxed the first time when the

company they own pays taxes on its income. These taxes reduce
earnings that could be paid to shareholders or reinvested in
the company to generate future earnings growth. Corporate
shareholders are taxed a second time when they pay taxes on
dividends distributed to them out of the companys earnings.
3.
25
M a rg inal T ax R ate
20
17.2
15
Tax Rate (%)
15.6
12.7 A verage T ax R ate

10 11.5
10.0
0
0 10 20 30 40 50 60
Income (in $Thous and)
4. The annual return on Minneapolis Pipelines preferred stock

(assuming no change in the price of the preferred stock)
before taxes is:
RORMP = $0.80/$12
= .067 = 6.7%
Assume that Maplewood Chemicals can exclude 80% of the

dividend income it earns when calculating its tax liability.
Thus given a corporate income tax rate of 34%, Maplewood's
effective tax rate on dividend income is (1 - .80) .34 =
.068 = 6.8%. The after-tax return on an investment in the
preferred stock therefore is:
RORMP = (1 - .068) 6.7% = 6.2%
Chapter 5 Page 19
Conversely, the return on the bond investment is taxed at the

full corporate tax rate. Thus the 9.8% yield translates into
an after-tax return of:
RORBond = (1 - .34) 9.8% = 6.5%
Therefore the bond investment would be slightly more

attractive than the preferred stock investment on an after-tax
return basis.
5. Progressive income tax rates are based on the presumption that

individuals with higher incomes are better able to pay a
larger percentage of their income in taxes than are persons
with lower incomes. Further, it is argued that it is more
equitable to require higher-income individuals to pay higher
tax rates. Both arguments have an implied goal of
redistribution of income from rich to poor.
Opponents of progressive income tax rates often argue that

such a tax structure discourages productive activity that
benefits society as a whole. That is, it is argued that high
income individuals, who presumably produce goods and services
highly valued by society, reduce their output under a
progressive tax structure relative to what they would produce
under a non-progressive tax structure.
6. For incomes in the $0 - $25,350 range, single taxpayers pay a

15% marginal tax rate. For incomes between $25,350 to
$61,400, the marginal tax rate is 28%. For incomes between
$61,400 to $128,100, the marginal tax rate is 31%. Thus
Footsie's tax bill is:
Tax = ($25,350 .15) + [($61,400 - $25,350) .28]
+ [($65,000 - $61,400) .31]
= $3,802.50 + $10,094.00 + $1,116.00
= $15,012.50
7. As Heine must pay 35% of the pay increase to the government in

taxes, only 6.2% [= (1 -.35) 9.5%] is left as increased
spendable income. With the price level expected to rise by
7%, Heine's after-tax real income will not increase by enough
to offset the purchasing power loss due to inflation.
8. The corporate bond offers capital gains income of $50 (=
Page 20 Chapter 5
$1,000 - $950) plus interest income of $50, for total income

of $100. Thus the before-tax return on the corporate bond
investment is:
RORCorp Bond = $100/$950 = 10.5%
With a marginal tax rate of 50%, the after-tax return on the

corporate bond would be:
RORCorp Bond = [$100 (1 - .50)]/$950 = 5.3%
If the bond had been a tax-exempt municipal bond, then the

investor would not have to pay taxes on the interest income.
Note, however, that the investor would have to pay taxes on
the capital gains. This taxation issue is not discussed until
Chapter 19, so the students should be allowed to answer the
question assuming either that the capital gains are taxed or
untaxed. In the former case:
RORMuni Bond = [$50 + $50 (1 - .50)]/$950 = 7.9%
In the latter case:
RORMuni Bond = $100/$950 = 10.5%
9. In general, the taxable equivalent yield of a tax-exempt

security is given by:
Tax equiv yield = (Tax-exempt yield)/(1 - tax rate)
Thus at the three tax rates, a taxable bond would have to

offer the following before-tax interest rates to be considered
equivalent in value to the 6% municipal bond.
a. 6%/(1 - .10) = 6.7%
b. 6%/(1 - .28) = 8.3%
c. 6%/(1 - .33) = 9.0%
10. Given that the taxable equivalent yield on a tax-exempt

security is (tax-exempt yield)/(1 - tax rate), then the tax-
free municipal security's taxable equivalent yield is:
5%/(1 - .30) = 7.1%
Since the taxable bond yields 7.5%, Spot should prefer it over
the municipal bond, all other factors remaining the same.
Chapter 5 Page 21
11. Ignoring capital gains, the Higgins' income of $120,000 would

put them in the 31% marginal tax bracket. With long-term
capital gains of $20,000 taxed at a 20% maximum rate, the
question is how to minimize their tax bill.
Using Table 5-2, with ordinary income of $100,000, the first

$42,350 is taxed at a 15% rate. The next $57,650 is taxed at a
28% rate.
In the case where the $20,000 of capital gains is treated as

short-term, it is taxed as ordinary income. Specifically, the
the first $2,300 is taxed a 28% rate (to bring the Higgins up
to the top end of the 28% tax bracket) and the remaining
$17,700 is taxed at a 31% rate:
Ordinary income: $42,350.00 .15 = $ 6,352.50

+ Ordinary income: $57,650.00 .28 = $16,142.00
+ S-T capital gains: $ 2,300.00 .28 = $ 644.00
+ S-T capital gains: $17,700.00 .31 = $ 5,487.00
Or in total, $28,625.50.
In the case where the $20,000 in capital gains is obtained

from assets held for 13 months, the preferential long-term
capital gains tax rate of a maximum 20% applies. Therefore,
the tax bill is:
Ordinary income: $42,350.00 .15 = $ 6,352.50

+ Ordinary income: $57,650.00 .28 = $16,142.00
+ L-T capital gains: $20,000.00 .20 = $ 4,000.00
Or in total, $26,494.50.
Thus the effect of the lower capital gains tax treatment of

long-term capital gains results in a lower tax bill for the
Higgins of $2,131.
12. A wash sale is the sale of a security and the subsequent

purchase within 30 days of the same or substantially identical
security. The IRS views these sales as possessing no validity
from an investment standpoint and perceives them to be
intended solely to avoid taxes.
13. The combined state and federal personal income tax rate is not
the sum of the two tax rates. Because taxpayers are permitted
to deduct state income taxes from their federal taxable
income, the combined state and federal tax rate is lower than
Page 22 Chapter 5
the sum of the two separate tax rates.
14. a. With cross-deductibility, the effective state marginal tax

rate is:
ts = [s - (s f)]/[1 - (s f)]
= [.08 - (.08 .25)]/[1 - (.08 .25)]
= .061 = 6.1%
b. With cross-deductibility, the effective federal marginal

tax rate is:
tf = [f - (s f)]/[1 - (s f)]
= [.25 - (.08 .25)]/[1 - (.08 .25)]
= .235 = 23.5%
c. With cross-deductibility, the effective combined marginal

tax rate is given by:
tc = [s + f - (2 s f)]/[1 - (s f)]
= [.08 + .25 - (2 .08 .25)]/[1 - (.08 .25)]
= .296 = 29.6%
15. Tax shelters are generally not economically attractive to

lower-income persons. The costs of the investments are
usually priced based on the marginal tax rates of the higher-
income investors. As a result they offer lower after-tax
returns to lower-income investors than to higher-income
investors. In fact, it is often the case that lower-income
investors are better off investing in taxable investments than
tax-free investments.
Chapter 5 Page 23
1. The inflation rate equals the percentage change in the price

index. In this case:
Inflation rate = (370/340) 1 = .088 = 8.8%
2. Over t years, the compound annual inflation rate is given by:
g = [(ce/cb)1/t] - 1
a. [(120/100)1/1] - 1 = .200 = 20.0%
b. [(175/120)1/3] - 1 = .134 = 13.4%
c. [(150/175)1/2] - 1 = -.074 = -7.4%
3. The nominal return measures changes in an investors wealth,

without adjustment for the purchasing power effect of
inflation. The real return measures changes in an investors
wealth, taking into account the purchasing power effect of
inflation. Essentially, the real return measures the change in
the goods and services that the investors wealth can
purchase. The nominal return measures simply the change in the
amount of dollars available for the investor to spend from his
or her wealth.
4. The arithmetic average inflation rate for the various time

periods is:
1899 - 1915 2.3%

1916 1919 16.4%
1920 - 1934 -2.2%
1935 1951 4.2%
1952 - 1965 1.3%
1966 - 1981 7.1%
1982 - 1998 3.3%
The arithmetic mean return calculated from any price or index

series is always greater than or equal to the geometric mean
return calculated from the same series. The greater the
variability of the series, the larger will be the difference
between the arithmetic and geometric mean returns.
5. The quantity one plus the inflation rate measures the cost of
a market basket of goods and services in a future period
relative to the cost of the same market basket in a base
period. Therefore the inverse of the quantity one plus the
inflation rate measures the purchasing power (that is, the
portion of the market basket) that $1 will be able to buy in
the future period. Thus the purchasing power of one dollar t
Page 24 Chapter 6
years from today expressed in today's dollars is given by:
Purchasing Powert years = 1/(1 + inflation rate)t years
a. 1/(1 + .05)5 = .78 = $0.78
b. 1/(1 + .10)5 = .62 = $0.62
c. 1/(1 + .15)5 = .50 = $0.50
6. If Bingo's portfolio grew at an 8% compound annual rate, then

over the eight year period the value of the portfolio would
have grown to:
$15,000 (1 + .08)8 = $27,763.95
The purchasing power of that portfolio in beginning-of-period

dollars is given by:
Purchasing Power 8 years = (Port value)/(1 + inf rate)8 years
or in Bingo's case:
Purchasing Power8 years = $27,763.95/(1 + .04)8 = $20,286.85
7. Using the formula:
Rr = [(1 + Rn)/(1 + I)] - 1
Kirby's nominal return over the two-year period was:
Rn = ($16,000/$11,500) - 1
= 1.391 - 1 = .391 = 39.1%
The inflation rate over the same time was:
I = (250/210) - 1
= 1.190 - 1 = .190 = 19.0%
Thus Kirby's real return over the two-year period was:
Rr = [(1 + .391)/(1 + .190)] - 1
= (1.391/1.190) - 1 = .169 = 16.9%
or on as an annualized figure:
Chapter 6 Page 25
Rr = (1.169).5 = .081 = 8.1%
8. Economywide inflation rates are calculated using a market

basket presumed to be purchased by the economy's "typical"
consumer. Of course, different consumers may purchase
different market baskets. They may buy some goods not in the
basket and fail to buy others included in the basket. Or they
may buy goods in the basket in proportions different than
those that the "typical" consumer is assumed to purchase.
These differences may be particularly prevalent between
regions of the country or between demographic groups. As a
result, consumers will be affected differently by reported
inflation rates.
9. For a portfolio growing at a given rate to triple in value,

the number of years required to achieve this value is found by
solving the following equation for the number of years:
$3 = $1 (1 + r)t
In this case the nominal growth rate is 9%. Thus:
$3 = $1 (1 + .09)t
ln 3 = t ln(1.09)
1.0986/.0862 = t
t = 12.7 years
If the inflation rate is 5%, the real growth rate in the

portfolio is:
(1 + .09)/(1 + .05) = 1.038 = 3.8%
Again solving for the number of years required for the

portfolio to triple in (real) value:
$3 = $1 (1 + .038)t
ln 3 = t ln(1.038)
1.0986/.0373 = t
t = 29.5 years
10. Investments represent deferred consumption on the part of
Page 26 Chapter 6
investors. If investors were not to incorporate an expected

inflation premium into their required investment returns, they
would voluntarily (and irrationally) be accepting a relative
reduction in their future consumption due to the expected rise
in prices.
11. As inflation rates rose sharply in the late 1970s and early
1980s, investors' inflation expectations and required bond
returns also rose, but with a considerable lag. As a result,
bond prices declined, producing negative nominal returns and
even lower real returns. Bondholders were actually witnessing
their real wealth diminishing, or being confiscated, to the
advantage of bond issuers.
12. In periods of rapid inflation, depreciation charges

(particularly straight line) are inadequate to reflect the
true replacement costs of an asset. Similarly, cost-of-goods-
sold expenses, as calculated under the FIFO inventory
valuation method, understate the true replacement costs of
inventories used. Because these two significant expenses were
unrealistically low during this period of high inflation,
reported earnings were unrealistically high, or of "poor
quality." Beyond misrepresenting the true results of company
operations, these "poor quality" and unrealistically high
earnings caused tax payments to be unnecessarily large.
13. Particularly in periods of high inflation, much of the

interest payments made to holders of inflation-indexed bonds
will be only to compensate for inflation. The government,
however, will tax these interest payments, thereby reducing
the after-tax return to bondholders.
14. Bonds (non-indexed) are fixed-income securities. They offer a

stream of nominal interest and principal payments, invariant
with respect to the inflation rate. Unexpected inflation
causes inflation expectations to rise, thereby causing
required returns to increase as well. To provide these higher
returns, bond prices must fall, producing principal losses for
current bondholders.
15. Some companies are better able to pass through price increases
to their customers than are others. Thus their earnings are
more inflation-sensitive and their stocks' returns are less
correlated with inflation. For example, electric utilities
may be constrained in their abilities to pass on cost
increases due to the regulated aspects of their business.
Conversely, defense contractors are often able to incorporate
cost increases into the prices of their products.
Chapter 6 Page 27
1.
25
3 0 u tils
20
2 0 u tils
Expected Return (%)
15
1 0 u tils
10
0
0 10 20 30
S ta nda rd D e via tio n (% )
2. The indifference curves of "typical" investor are assumed to

slope upward to the right because the investor is assumed to
be risk averse. As the standard deviation of portfolio
returns increases, a risk averse investor requires higher
expected returns if his or her level of satisfaction is to be
maintained.
3. Diminishing marginal utility of wealth means that an investor

derives less additional satisfaction from each extra dollar of
wealth. That is, when an investors wealth changes by $10,000
based on the result of a gamble, the extra dollar in
additional wealth is less satisfying than the extra dollar in
additional wealth when the investors wealth changes by only
$100 based on the results of a gamble.
As a result of diminishing marginal utility of income, a risk-

averse investor will find the dissatisfaction associated with
losing $1 in a gamble is greater than the pleasure of winning
$1 in the gamble. Therefore, the risk-averse investor will
refuse to accept a "fair bet."
4. a. Hack is less risk averse because Hack's indifference

curves are less steeply sloped than are Kiki's.
b. Hack is indifferent between investments A and B because

they lie on the same indifference curve. Kiki, however,
prefers investment A to investment B because it lies on a
higher indifference curve.
c. Both investors prefer investment D to investment C because

it lies on higher indifference curve for both of them.
Page 28 Chapter 7
5. Stock C is preferred to stock B because it has both a higher

expected return and lower risk. For the same reasons, stock D
is preferred to stock A.
6. The initial value of Corns's portfolio is:
W0 = ($50 100) + ($35 200) + ($25 50) + ($100 100)
= $23,250
The proportion that each security constitutes of Corns's

initial portfolio is:
XA = ($50 100)/($23,250)
= .215
XB = ($35 200)/($23,250)
= .301
XC = ($25 50)/($23,250)
= .054
XD = ($100 100)/($23,250)
= .430
The expected returns on the portfolio securities are:
r A = ($60 - $50)/$50 = 20.0%
r B = ($40 - $35)/$35 = 14.3%
r C = ($50 - $25)/$25 = 100.0%
r D = ($110 - $100)/$100 = 10.0%
The expected return on a portfolio is given by:

n
r p = ( X i ri )
i =1
In the case of Corns's portfolio:
Chapter 7 Page 29
r p = (.215 20.0%) + (.301 14.3%) + (.054 100.0%)
+ (.430 10.0%)
= 18.3%
7.
Proportion of
Expected Portfolios Initial
Stock Return Market Value
A ($700-$500)/$500 = 40.0% 19.2%
B ($300-$200)/$200 = 50.0% 7.7%
C ($1000-$1000)/$1000 = 0.0% 38.5%
D ($1500-$900)/$900 = 66.7% 34.6%
The portfolio's expected return is given by:

4
rp = ( X
i =1
i ri )
r p = (.192 40.0%) + (.077 50.0%) + (.385 0.0%)
+ (.346 66.7%)
= 34.6%
8. The correlation coefficient is related to the covariance

through the following mathematical expression:
ij = ij/(ij)
The correlation coefficient is a more convenient measure of

the extent to which two random variables move together because
it is a standardized measure of the covariance. The
correlation coefficient produces a standardized covariance
measure by dividing the covariance by the product of the
standard deviations of the two random variables. As a result,
the correlation coefficient is unit free and bounded by the
values -1 and +1. The standardization of the covariance
facilitates comparisons of the statistical interdependence
among pairs of random variables.
9. In the three-variable case the standard deviation of a

portfolio is given by:
p = [X1X111 + X1X212 + X1X313 + X2X121 + X2X222
Page 30 Chapter 7
+ X2X323 + X3X131 + X3X232 + X3X333]
Thus for this portfolio:
p = [(.5)(.5)(459) + (.5)(.3)(-211) + (.5)(.2)(112)
+ (.3)(.5)(-211) + (.3)(.3)(312) + (.3)(.2)(215)
+ (.2)(.5)(112) + (.2)(.3)(215) + (.2)(.2)(179)]
= [114.8 + (-31.7) + 11.2 + (-31.7) + 28.1 + 12.9 + 11.2
+ 12.9 + 7.2]
= [134.9] = 11.6%
10. A portfolio's risk is not equal to the weighted average of the

component securities' standard deviations because, in addition
to the standard deviations of the component securities, the
covariances between the securities will also affect the
portfolio's risk. (However, in the unlikely case when the
correlations between securities are all +1, portfolio risk is
a weighted average of the component securities' standard
deviations.) The general expression for portfolio standard
deviation illustrates this situation:
1/ 2
n n
P = X i X j ij
i =1 j =1
The term ij reflects not only each security's variance, but

the covariance between securities.
11. A two-security portfolio's standard deviation is given by:
P = [ X A2 A2 + X B2 B2 + 2 X A X B A B ]
1/ 2
a. p = [(.5)(30) + (.5)(40) + (2)(.5)(.9)(30)(40)]1/2
= [225 + 400 + 540]1/2
= [1165]1/2 = 34.1%
b. p = [(.5)(30) + (.5)(40) + (2)(.5)(0)(30)(40)]1/2
= [225 + 400 + 0]1/2
Chapter 7 Page 31
= [625]1/2 = 25.0%
c. p = [(.5)(30)+ (.5)(40) + (2)(.5)(-.9)(30)(40)]1/2
= [225 + 400 - 540]1/2
= [85]1/2 = 9.2%
12. A portfolio's standard deviation is given by:

1/ 2
n n
p = X i X j ij
i =1 j =1
1/ 2
n n
= X i X j i j ij
i =1 j =1
a. p = [X1X111 + X1X212 + X2X121 + X2X222]
= [(.2)(.2)(12)(12) + (.2)(.8)(12)(10)(.20)
+ (.8)(.2)(10)(12)(.20) + (.8)(.8)(10)(10)]
= [5.8 + 3.8 + 3.8 + 64.0]
= [77.4] = 8.8%
b. p = [X1X111 + X1X212 + X1X313 + X2X121 + X2X222
+ X2X323 + X3X131 + X3X232 + X3X333]
= [(.4)(.4)(12)(12) + (.4)(.2)(12)(15)(-1.00)
+ (.4)(.4)(12)(10)(.20) + (.2)(.4)(15)(12)(-1.00)
+ (.2)(.2)(15)(15) + (.2)(.4)(15)(10)(-.20)
+ (.4)(.4)(10)(12)(.20) + (.4)(.2)(10)(15)(-.20)
+ (.4)(.4)(10)(10)]
= [23.0 + (-14.4) + 3.8 + (-14.4) + 9.0 + (-2.4) + 3.8
+ (-2.4) + 16.0]
= [22.0] = 4.7%
Page 32 Chapter 7
13. The expected return of security i is given by:

n
ri = ( pj Rj )
j =1
where pj is the probability of return Rj occurring. For

Oakdale stock:
r i = (.10 -10%) + (.25 0%) + (.40 10%) + (.20 20%)
+ (.05 30%)
= 8.5%
The standard deviation of security i is given by:

1/ 2
n
I = p j ( R j r j ) 2
j =1
For Oakdale stock:
i = {[.10 (-10% - 8.5%)] + [.25 (0% - 8.5%)]
+ [.40 (10% - 8.5%)] + [.20 (20% - 8.5%)]
+ [.05 (30% - 8.5%)]}
= [34.2%2 + 18.1%2 + 0.9%2 + 26.5%2 + 23.1%2]
= 10.1%
14. The covariance between two securities is given by:
[ p ]
N
XY = i ( R Xi r X ) ( RYi r Y )
i =1
In the case of Lakeland and Afton stocks, their expected

returns are:
r L = (.15 -10%) + (.20 5%) + (.30 10%) + (.35 20%)
= 9.5%
r A = (.15 15%) + (.20 10%) + (.30 5%) + (.35 0%)
Chapter 7 Page 33
= 5.8%
Therefore:
LA = [.15 (-10% - 9.5%) * (15% - 5.8%)]
+ [.20 (5% - 9.5%) (10% - 5.8%)]
+ [.30 (10% - 9.5%) (5% - 5.8%)]
+ [.35 (20% - 9.5%) (0% - 5.8%)]
= (-26.9) + (-3.8) + (-0.1) + (-21.3)
= -52.1
The correlation coefficient between two securities is:
XY = XY/(X Y)
In the case of Lakeland and Afton stocks, their standard

deviations are:
L = {[.15 (-10% - 9.5%)] + [.20 (5% - 9.5%)]
+ [.30 (10% - 9.5%)] + [.35 (20% - 9.5%)]}
= [57.0 + 4.1 + 0.1 + 38.6]
= 10.0%
A = {[.15 (15% - 5.8%)] + [.20 (10% - 5.8%)]
+ [.30 (5% - 5.8%)] + [.35 (0% - 5.8%)]}
= [12.7 + 3.5 + 0.2 + 11.8]
= 5.3%
Therefore:
LA = -52.1/(10.0 5.3)
= -.98
Page 34 Chapter 7
15. The expected returns on securities A and B are:
r A = (10)(.10) + (12)(.25) + (8)(.35) + (14)(.20) + (19)(.10)
= 11.5%
r B = (20)(.10) + (25)(.25) + (33)(.35) + (27)(.20) + (22)(.10)
= 27.4%
The sum of the corresponding deviations from the expected

returns times the probabilities of the associated outcomes
gives the covariance between securities A and B:
AB = (.10)(10 - 11.5)(20 - 27.4) + (.25)(12 - 11.5)(25 - 27.4)
+(.35)(8 - 11.5)(33 - 27.4) + (.20)(14 - 11.5)(27 - 27.4)
+(.10)(19 - 11.5)(22 - 27.4)
= -10.3
Chapter 7 Page 35
1. Because very few securities will exhibit perfectly positive

correlation, diversification will tend to reduce portfolio
risk. Thus, for any given level of expected return, one would
expect that portfolios will exhibit lower risk (lie further to
the west in the feasible set) than individual portfolios
(which will therefore lie to the east in the feasible set).
2. Diversified portfolios are more efficient than individual

securities. That is, diversified portfolios provide the
investor with higher expected returns for given levels of risk
and/or lower risk for given levels of expected return when
compared with individual securities.
Diagrammatically, individual securities will lie in the

eastern portion of the feasible set. Hence they are dominated
by diversified portfolios, which lie in the northwestern
portion of the feasible set, including those on the efficient
set.
3. The macroeconomic forces that impact the U.S. economy tend to

have a strong effect on the earnings (and, hence, stock
prices) of all domestic corporations, although the magnitude
of this effect will vary among industries and specific firms.
For example, a recession causes most companies to experience a
downturn in earnings. While some companies may be more
severely affected than others, nevertheless, the broad
influence of a recession on general economic activity likely
results in most companies' stocks performing poorly.
Companies whose stocks would be expected to have a high

positive covariance are auto and steel companies. When auto
sales are strong (weak), the demand for steel generally rises
(falls). The earnings of companies in both industries would
rise and fall at roughly the same time and this movement would
likely be anticipated by the earlier rise and fall of their
stocks' prices.
Companies whose stocks would be expected to have a low

covariance are banks and gold mining firms. Rising interest
rates and poor business conditions generally produce declining
bank earnings. At the same time, a pessimistic economic
outlook often causes investors to increase their demand for
gold, which increases the price of gold and, therefore, the
earnings of gold mining firms. The result is that the stock
prices of banks and gold mining firms will not likely move in
the same direction.
4. It is the fact that all stocks do not have high positive

covariances that causes diversification to benefit the
Page 36 Chapter 8
investor. That is, by diversifying, investors can reduce

portfolio risk and thereby create more efficient portfolios.
If stocks did have high positive covariances, then holding a
well-diversified portfolio would not result in meaningful
reductions in risk relative to holding individual securities.
5. If the security in question had significant negative

correlation with the rest of the securities in the portfolio,
Mule might consider purchasing it even though it had a
negative expected return. The diversifying nature of the
security might reduce the risk of the portfolio sufficiently
to make it attractive despite its inferior return potential.
6. Given the expected returns and variance-covariance estimates

for all securities, an investor can construct the efficient
set. This information, combined with the unique risk-return
preferences of the investor, allows the investor to determine
his or her optimal portfolio. Diagrammatically, this optimal
portfolio lies at the point of tangency between the investor's
indifference curves and the efficient set.
7. The standard deviation of a two-security portfolio is given

by:
p = [ X A A2 + X B B2 + 2 X A X B AB A B ]
1/ 2
In Dode's case:
p = [(.35)(20) + (.65)(25) + 2(.35)(.65)(20)(25)12]
= [49 + 264 + 22812]
The portfolio's standard deviation will be at a minimum when

the correlation between securities A and B is -1.0. That is:
p = [49 + 264 - 228]
= 9.2%
The portfolio's standard deviation will be at a maximum when

the correlation between securities A and B is +1.0. That is:
p = [49 + 264 + 228]
= 23.3%
8. With a 12% expected return on the market index, the market
Chapter 8 Page 37
model would imply that the expected return on Leslie's

portfolio would be:
r P = 1.5% + .90 12.0%
= 12.3%
9. Beta, as derived from the market model, is the slope of the

regression line relating the return on a security (or
portfolio) to the return on a market index.
High beta stocks are termed "aggressive" because they will

tend to produce more volatile returns than the market index.
When the market produces a positive return the high beta
security will produce an even higher positive return. When
the market generates a negative return the high beta security
will produce an even lower negative return.
Conversely, low beta securities are termed "defensive" because

they tend to be relatively less sensitive to market moves.
When the market produces a positive return, the low beta
security's return will be less positive. When the market
produces a negative return the low beta security will produce
a less negative return.
10.
Estimating the slope of the characteristic line from the graph
gives a beta value of roughly 0.5 for Glenwood City
Properties.
Glenwood City Return
10
Market index
0 Return
-10 -5 0 5 10 15
-5
11. The most important "complexity" potentially undermining the

predictive power of the market model is that other factors
Page 38 Chapter 8
besides the return on the market index may be closely

associated with a security's return. For example, the return
on General Motors stock may be associated with economic
factors that affect primarily the auto industry. Ignoring
those factors decreases the ability to effectively "explain"
the return on General Motors stock through the market model.
Further, the market model is based solely on the historical

relationship between a security's return and the return on the
market index. To the extent that relationship changes over
time, the market model estimated over a past period may not
predict the future well.
In addition, the statistical technique used to generate the

market model for a specific security provides only an estimate
of the relationship between the security's return and that of
the market index. The estimation process is subject to
sampling error.
12. The market model defines a stock's return as:
ri = i + i rI + i
In the case of Lyndon stock over the five years, the random
error term can be calculated as follows (assuming a 0%
intercept term):
1 = 17.2 - [(1.2) (14.0)] = 0.4
2 = -3.1 - [(1.2) (-3.0)] = 0.5
3 = 13.3 - [(1.2) (10.0)] = 1.3
4 = 28.5 - [(1.2) (25.0)] = -1.5
5 = 9.8 - [(1.2) ( 8.0)] = 0.2
The average random error term is:
Average = (0.4 + 0.5 + 1.3 - 1.5 + 0.2)/5
= 0.2
The standard deviation of the random error term is therefore:
= {[(0.4 - 0.2) + (0.5 - 0.2) + (1.3 - 0.2)
+ (-1.5 - 0.2) + (0.2 - 0.2)]/(5-1)}
Chapter 8 Page 39
= {(.04 + .09 + 1.21 + 2.89 + 0)/4}
= 1.03%
13. The market risk of a portfolio depends on events that

influence all securities to some degree. That is, these
events are systematic. Because all securities are affected by
these systematic events, diversifying a portfolio will not
reduce exposure to them. Only if the securities added to a
portfolio had lower sensitivities to systematic events would
diversification reduce market risk. But there is no reason to
assume that randomly selected securities will have such lower
sensitivities.
The unique risk of a portfolio depends on events specific to

individual securities comprising the portfolio. These events
are unsystematic in the sense that an event that impacts one
security (in either a good or bad sense) is not expected to
impact other securities. As a result forming a diversified
portfolio tends to cause the net impact of these unsystematic
events to cancel each other out. The more diversified is the
portfolio, the greater will be this canceling effect, and the
lower is the portfolio's unique risk.
Mathematically:
1/ 2
n 2 n 2 2
2
p = X i i I + X i i
i =1 i =1
Looking at the market risk term:

2
n 2
X i i I
i =1
Clearly, I2 is unaffected by diversification. Further, the

term Xii is merely the average beta of the securities in the
portfolio. Again, it is not affected by diversification.
Thus market risk cannot be reduced by diversification.
Looking at the unique risk term:

n
X
i =1
i
2
2i
As the number of securities increases, X i2 becomes small very
Page 40 Chapter 8
quickly, while 2i remains roughly constant. Thus the unique

risk term approaches zero as diversification increases.
14. The beta of a portfolio is defined as the weighted average of

the component securities' betas. In the case of Siggy's
portfolio:
3
P = X i i
i =1
= (.30 1.20) + (.50 1.05) + (.20 0.90)
= 1.07
Further, the standard deviation of a portfolio can be

expressed as:
( )
1/ 2
p = P2 I2 + 2p
= [(1.07)(18) + (.30)(5.0) +(.50)(8.0)+ (.20)(2.0)]
= [370.9 + 2.3 + 16.0 + 0.2]
= [389.4] = 19.7%
15. The total risk of a portfolio can be expressed as:
p = p2 I2 + 2p
Further, the unique risk ( 2p ) is the weighted average of the

unique risks of the portfolio's individual securities.
In the case of the first portfolio with four equal-weighted

securities:
4
2p = (30.0) (.25)
2 2
i =1
= 56.25 4 = 225.0
Therefore the total risk of the first portfolio is:
12 = (1.00) 2 (20) 2 + 225.0
= 625.0
Chapter 8 Page 41
1 = 25.0%
In the case of the second portfolio with ten equal-weighted

securities:
10
2p = (30.0) (.10)
2 2
i =1
= 9.0 10 = 90.0
Therefore the total risk of the second portfolio is:
22 = (100
. ) 2 (20) 2 + 90.0
= 490.0
2 = 22.1%
Page 42 Chapter 8
1. Any security, even a pure-discount U.S. government security,

presents its owner with an uncertain return if the owner's
holding period does not coincide with the maturity of the
security.
If the security's life is less than the owner's holding

period, then the owner faces the uncertainty associated with
not knowing at what interest rate the security's proceeds can
be reinvested when the security reaches maturity. If the
security's life is greater than the owner's holding period,
then the owner faces the uncertainty associated with not
knowing at what price the security can be sold at the end of
the holding period.
2. The expected return of a portfolio invested in both a risky

portfolio and a riskfree asset is given by:
r p = X1 r 1 + X2rf
Further, because (X1 + X2) must equal 1.0, then X2 = (1 - X1).
a. r p = (1.20 15%) + (-.20 5%)
= 17.0%
b. r p = (.90 15%) + (.10 5%)
= 14.0%
c. r p = (.75 15%) + (.25 5%)
= 12.5%
3. The expected return of a portfolio invested in both a risky

r p = X1 r 1 + X2rf
In this case, the expected return of the total portfolio as

well as the risky portfolio and riskfree asset are known. The
question is what two weights, X1 and X2 will solve the
equation. That is:
24% = (X1 18%) + (X2 5%)
As (X1 + X2) must equal 1.0, then X2 = (1 - X1), so:
Chapter 9 Page 43
24% = (X1 18%) + [(1 - X1) 5%]
Solving for X1 yields a value of 1.46, meaning that a

weighting of 1.46 for the risky portfolio (thus involving
leverage) and a weighting of -.46 for the riskfree asset will
produce an expected return of 24%.
4. The standard deviation of a portfolio composed of a risky

p = X1 1
where X1 is the weight of the risky portfolio and 1 is the

standard deviation of the risky portfolio. As X1 = (1
weight of the riskfree asset), then:
a. X1 = 1 (.30) = 1.30, thus:
p = 1.30 20%
= 26.0%
b. X1 = 1 .10 = .90, thus:
p = .90 20%
= 18.0%
c. X1 = 1 .30 = .70, thus:
p = .70 20%
= 14.0%
5. The standard deviation of a portfolio invested in a risky

p = X1 1
As the standard deviation of Oyster's total portfolio is 20%,

solving for the proportion invested in the risky portfolio
(X1) gives:
20% = X1 25%
X1 = .80
Page 44 Chapter 9
The expected return of a portfolio invested in both a risky

portfolio (with proportion X1) and a riskfree asset with
proportion X2 or (1 - X1) is:
r p = (.80 12%) + [(1 - .80) 7%]
= 11.0%
6. Both Hick and Patsy are correct. Borrowing at the riskfree

rate to invest more than one's initial wealth in a risky
portfolio is equivalent to purchasing the risky portfolio on
margin. Further, borrowing at the riskfree rate is equivalent
to taking a short position in the riskfree asset and investing
the proceeds of the short sale in the risky portfolio.
7. The efficient set becomes all the portfolios that can be

constructed through a combination of a single risky portfolio
and lending or borrowing at the riskfree rate. The efficient
set will therefore consist of all portfolios along a ray
emanating from the riskfree asset, tangent to the curved
Markowitz efficient set (that is, the efficient set without
riskfree borrowing or lending), and continuing on out into
risk-return space. The tangency point represents the optimal
combination of risky assets for the investor.
8. Riskfree borrowing and lending permits the investor to create

any combination of portfolios allocated between a risky
portfolio (contained in the feasible set of risky portfolios)
and the riskfree asset. These combinations lie on rays
emanating from the riskfree asset. The more a ray is tilted
to the northwest, the more desirable is the associated set of
portfolios to the investor.
Because the feasible set of risky portfolios is concave, the

ray combining the riskfree asset and a risky portfolio, tilted
as far as possible to the northwest, must be tangent to the
feasible set of risky portfolios at only one point. This ray
is the efficient set under riskfree borrowing and lending.
All other portfolios in the feasible set of risky portfolios

(including the "old" efficient set) will lie to the south
and/or east of this "new" efficient set and, therefore, are
dominated by the portfolios of the new efficient set. That
is, these other portfolios offer less expected return and/or
more risk than the portfolios lying on the efficient set
generated under riskfree borrowing and lending.
Chapter 9 Page 45
9. The feasible set now becomes the area between two rays, each
emanating from the riskfree asset. The ray to the northwest
is the efficient set. The ray to the southeast will connect
the riskfree asset and generally the lowest expected return
asset. Any combination of risk and return between these two
rays can be created by appropriately combining a risky
portfolio with riskfree borrowing or lending.
10. The efficient set will be the same for both investors because
it represents investment opportunities, not preferences. (Of
course, the two investors may have different expectations
regarding available expected returns and risks.)
The more risk-averse investor's indifference curves will be

more steeply sloped than the indifference curves of the less
risk-averse investor.
The optimal portfolio of the more risk-averse investor will

lie to the southwest of the less risk-averse investor's
optimal portfolio. Both optimal portfolios, of course, will
lie on the efficient set. The more risk-averse investor's
optimal portfolio likely will lie to the southwest of the
tangency portfolio, implying lending at the riskfree rate.
Conversely, the less risk-averse investor's optimal portfolio
likely will lie to the northeast of the tangency portfolio,
implying borrowing at the riskfree rate.
11. a. The riskfree asset has a zero variance and has zero
covariance with other assets. Thus, examining the
variance-covariance matrix, the third security must be the
riskfree asset.
b. r p = (X1 r 1 ) + (X2 r 2 )
= (.50 10.1%) + (.50 7.8%)
= 9.0%
1/ 2
n n
p = X i X jij
i =1 j =1
= (X1X111 +X2X222 + 2X1X212)
= {[(.50) 210] + [(.50) 90]
+ (2) (.50) (.50) (60)}
Page 46 Chapter 9
= [52.5 + 22.5 + 30] = [105] = 10.2%
c. r tp = (.75 r p ) + (.25 r3)
= (.75 9.0%) + (.25 5.0%)
= 8.0%
tp = .75 p
= .75 10.2%
= 7.7%
12. The efficient set would be composed of the southwest portion

of the curved Markowitz efficient set (that is, the efficient
set without riskfree borrowing or lending) up to the tangency
portfolio (when both riskfree borrowing and lending are
permitted), where it would then become a ray emanating from
the tangency portfolio and extending out into risk-return
space. If this ray were extended to the southwest, it would
intersect the return axis at the riskfree rate.
13. The effect is to increase both expected return and risk.
The investor is leveraging his or her invested position.

Since the optimal risky portfolio has a higher expected return
than the riskfree asset, the expected return on the leveraged
risky portfolio is higher than that of the unleveraged
portfolio.
However, because the risky portfolio's return is variable, the

leveraged risky portfolio's return is more variable and hence
more risky than the return on the unleveraged risky portfolio.
14. Your optimal risky portfolio would not change (assuming the
feasible investment opportunities did not change). It would
remain the only risky portfolio lying on the efficient set.
However, your allocations to the riskfree asset and the risky
portfolio would change as your risk preferences changed. As
you became less risk averse, you would decrease (increase)
your riskfree lending (borrowing) and move to the northeast
along the efficient set.
15. The efficient set becomes divided into three segments. The
first segment is a straight line between the lending rate on
the return axis and tangent to the curved Markowitz efficient
set (that is, the efficient set without riskfree borrowing or
Chapter 9 Page 47
lending). The second segment lies to the northeast of the

first. It is a straight line tangent to the curved Markowitz
efficient set, extending northeast into risk-return space.
While this line does not extend to the return axis, if it did
it would intersect the axis at the borrowing rate. The third
segment lies between the first two. It is the portion of the
curved Markowitz efficient set that lies between the two
tangency portfolios.
Page 48 Chapter 9
1. There are ten key assumptions underlying the CAPM:
1. Investors evaluate portfolios by analyzing expected

returns and standard deviations over a one-period time
horizon.
2. Everything else equal, investors prefer portfolios with

greater expected returns.
3. Everything else equal, investors prefer portfolios with

lower standard deviations.
4. Assets are infinitely divisible.
5. Investors may borrow or lend at a single riskfree interest

rate.
6. Taxes and transaction costs are immaterial.
7. All investors have the same one-period time horizon.
8. All investors borrow and lend at the same riskfree rate.
9. All investors have immediate and costless access to all

relevant information.
10. Investors possess homogeneous expectations regarding the

expected returns and risks of securities.
2. The separation theorem states that an investor's optimal risky

portfolio can be determined without reference to the
investor's risk-return preferences.
Assuming that every investor has the same expectations

regarding expected returns and risks for available securities,
and assuming that everyone faces the same riskfree rate, then
the efficient set must be the same for all investors. This
implies that every investor will hold the same risky
portfolio. (That risky portfolio is represented by the point
of tangency between a ray emanating from the riskfree asset
and extending into risk-return space and tangent to the curved
Markowitz efficient set.) The only difference in portfolios
held by investors will be with respect to the amount of
riskfree lending or borrowing undertaken, which will depend on
the investors' individual risk-return preferences.
3. If investors wish to hold more units of a security than are

available, then they will bid up the price of the security,
thereby reducing its expected return. The lower expected
Chapter 10 Page 49
return will cause investors to reduce their desired holdings

of the security.
Conversely, if investors wish to hold fewer units of a

security than are available, then they will bid down the
security's price, thereby increasing its expected return. The
higher expected return will cause investors to wish to hold
more units of the security.
This process will drive the price of the security toward its
equilibrium value at which point the number of units investors
wish to hold will equal the number of units outstanding. This
equilibrating process will produce market clearing prices for
all securities. Further, the riskfree rate will move to a
level where the total amount of money borrowed will equal the
supply of money available for lending.
4. Just because IBM stock doubles in price relative to other

securities in the market portfolio does not require any
adjustments by an investor in the market portfolio. Every
security in the market portfolio is represented in proportion
to its market value relative to the market value of all
securities. The market value of a security is the units of
the security outstanding times the market price of the
security. Thus as relative prices of securities change, their
relative market values and therefore their proportions of the
market portfolio change concomitantly. No adjustment is
required on the part of the investor.
5. The equation of the Capital Market Line (CML) is:
r p = rf + [( r M - rf)/M]p
In this case, the market portfolio is composed of two

securities, A and B. Thus the expected return of the market
portfolio is:
r M = (XA r A ) + (XB r B )
= (.40 10%) + (.60 15%)
= 13.0%
The standard deviation of the market portfolio is:
M = [X A2 A2 + X B2 B2 + 2 X A X B AB A B ]
1/ 2
Page 50 Chapter 10
= {[(.40) (20)] + [(.60) (28)]
+ [2 (.40) (.60) (.30) (20) (28)]}
= [64 + 282.2 + 80.6] = 20.7%
Therefore the equation for the CML is:
r p = 5.0% + [(13.0% - 5.0%)/20.7%] p
= 5.0% + .39p
6. The standard deviation of the market portfolio can be shown to

equal the square root of the weighted average of the
covariances of all its component securities with it. In the
case of the this four security portfolio:
M = [.20 242 + .30 360 + .20 155 + .30 210]
= (250.4) = 15.8%
7. According to the CAPM, all investors will hold the market

portfolio combined with riskfree borrowing or lending.
Therefore all investors will be concerned with the risk (or
standard deviation) of the market portfolio. The standard
deviation of the market portfolio can be shown to be a
function of the covariances with it of each of the securities
that make up the market portfolio. Therefore the contribution
that each security makes to the market portfolio's risk will
be directly related to its covariance with the market
portfolio. Risk averse investors will demand higher returns
from securities exhibiting higher covariances with the market
portfolio.
8. With respect to risk, the investor ultimately is concerned

with the standard deviation of his or her portfolio.
Therefore, in evaluating a well-diversified portfolio, the
relevant measure of risk is standard deviation. However, the
contribution of an individual security to a portfolio's
standard deviation is not the standard deviation of the
security. That is, a portfolio's standard deviation is not
simply the weighted average of the standard deviations of the
component securities. The appropriate measure of a security's
risk is the contribution that it makes to the standard
deviation of a well-diversified portfolio. That contribution
is reflected in the security's covariance with the portfolio.
9. Oil is incorrect. The CAPM implies that it is possible for a
Chapter 10 Page 51
security to have a positive standard deviation and an expected

return less than the riskfree rate. The CAPM relationship
specifies that:
r p = rf + ( r M - rf)iM
Thus a security with a negative covariance with the market

portfolio would have an expected return less than the riskfree
rate. In practice, however, few, if any, securities have a
negative covariances with surrogates for the market portfolio.
10. The beta of a security is calculated as:
iM
i =
M2
Therefore:
292
A = = 130
.
152
180
B = = 0.80
152
225
C = = 100
.
152
11. The beta of a portfolio is given by:

n
p = X i i
i =1
In Kitty's case:
p = (.30 .90) + (.10 1.30) + (.60 1.05)
= 1.03
Page 52 Chapter 10
12. a.
24
Expected Return (%)
18
12 B
M
A
Rf = 6
0
0 .0 0 0 .5 0 1 .0 0 1 .5 0 2 .0 0
B eta
b. r i = rf + ( r M - rf)i
= 6% + (10% - 6%)i
= 6% + (4%)i
c. r A = 6% + (4%)(.85)
= 9.4%
r B = 6% + (4%)(1.20)
= 10.8%
13. A security that plots above the SML would be considered an

attractive investment. The expected return offered by such a
security is greater than that required given its risk.
Investors should wish to add such a security to their
portfolios.
14. Market (or systematic) risk is the portion of a security's

total risk that is related to movements in the market
portfolio and hence to the beta of the security. By
definition, because the market portfolio is perfectly
diversified, market risk in a portfolio cannot be reduced
through diversification.
Nonmarket (or unique or unsystematic) risk is the portion of a
Chapter 10 Page 53
security's total risk that is not related to moves in the

market portfolio. Rather, it is related to events specific to
the security. As a result, unique risk in a portfolio can be
reduced through diversification.
15. Two relationships are necessary to identify the missing data

in the table:
(1) r i = rf + ( r M - rf)i
( )
(2) i2 = p2 M2 + 2i
Using these equations, consider security D first:
7.0 = rf + ( r M - rf) 0
rf = 7.0%
Next consider security B:
19.0 = 7.0 + ( r M - 7.0) 1.5
r M = 15.0%
Next consider security C:
15.0 = 7.0 + (15.0 - 7.0) C
C = 1.0
Further:
(12) = (1.0) M2 + 0
M = 12%
Next consider security A:
r A = 7.0 + (15.0 - 7.0)(.8)
r A = 13.4%
Further:
A = [(.8) (12) + 81]
Page 54 Chapter 10
= 13.2%
Returning to security B:
A = [(1.5) (12) + 36]
= 19.0%
Finally, consider security E:
16.6 = 7.0 + (15.0 - 7.0) E
E = 1.2
Further:
(15) = (1.2) (12) + 2i
2i = 17.6
Chapter 10 Page 55
1. The auto industry's earnings are highly cyclical. Therefore

auto company stocks possess a high sensitivity (in a positive
direction) to the trend in economic activity.
Savings and loan companies (whose primary business is home

loans) generally have large portfolios of fixed-rate loans.
When interest rates rise (fall), their cost of funds rises
(falls), while revenues remain relatively stable. As a
result, their earnings fall (rise). Thus the stocks of these
companies are often responsive (in a negative direction) to
movements in real interest rates.
Electric utilities operate in regulatory environments. They

may have trouble passing on cost increases to consumers,
especially in the short run. Thus their stocks are sensitive
(in a negative direction) to unexpected inflation.
Crude oil producers and their stocks are sensitive (in a

positive direction) to the level of oil prices.
2. In order to derive the curved Markowitz efficient set, the

investor needs to estimate the expected returns, variances,
and covariances for all assets. One can show that without a
factor model, the investor must estimate (N + 3N)/2
parameters to derive the efficient set.
On the other hand, based on the assumptions underlying a

factor model, the common responsiveness of securities to the
factor(s) eliminates the need to estimate directly the
covariances between securities. These covariances are
captured by the securities' sensitivities to the factor(s) and
the factor'(s) variance(s). As a result the number of
parameters that must be estimated to derive the efficient set
with a factor model is significantly reduced.
3. Factor model relationships are based on two critical

assumptions. The first is that the random error term and the
factor are uncorrelated, meaning that the outcome of the
factor has no bearing on the outcome of the random error term.
The second assumption is that the random error terms of any

two securities are uncorrelated, meaning that the outcome of
the random error term of one security has no bearing on the
outcome of the random error term of any other security.
As a violation of the first assumption, consider a one-factor

model where the factor is growth in GDP. If it were the case
that a security had a positive random error term value every
time GDP was higher than expected, then the factor model has
Page 56 Chapter 11
been misspecified and should be adjusted to take into account

this unexplained sensitivity.
As a violation of the second assumption, suppose that whenever

security A had a positive random error term value, security B
also had a positive random error term value, then the factor
model has been misspecified. In this case there must be some
source of common responsiveness between the two securities
that has not been captured by the factor model.
4. By the term "similar stocks" Cupid presumably means that they

display similar sensitivities to various economic and
financial factors. If a factor model is correctly specified,
then two stocks with similar sensitivities to the model's
factors should generate returns that are roughly the same over
time. In the short run their returns may differ by the
differences in the values of their respective random error
terms. Given that the expected value of the random error term
is zero, over the long-run one would expect the random error
term to equal zero and thus the average return on the two
securities to be the same.
5. a. In a one-factor model, a portfolio's factor risk is

expressed as bp2 F2 . Since the sensitivity of the portfolio
to the factor is the weighted average of the component
securities' sensitivities (with their proportions serving
as weights), then:
Factor risk = (.40 .20 + .60 3.50)2 225
= 1,069.3
b. Non-factor risk (expressed as ep2 is the weighted average

of the component securities' random error term variances
(with the square of the securities' proportions serving as
weights), then:
Non-factor risk = .40 49 + .60 100
= 43.8
c. The standard deviation of the portfolio is given by:
p = (bp2 F2 + ep2 )1/ 2
= (1,069.3 + 43.8)
Chapter 11 Page 57
= 33.4%
6. The covariance between two securities in a one-factor world is

given by:
ij = bibj F2
In this case, the equation should be solved for F. That is:
F = [ij/bibj]
= [(-312.50)/(-0.50 1.25)]
= 22.4%
7. In a one-factor model world, the standard deviation of a

security is given by:
i = (bi2 F2 + ei2 )1/2
For security A:
A = [(.8) (18) + (25)]
= 28.9%
For security B:
B = [(1.2) (18) + (15)]
= 26.3%
8. The nonfactor risk of a portfolio is given by:

n
ep = X i2 ei2
i =1
Assuming that the securities in the portfolio are equal-

weighted, the portfolio's nonfactor risk is the average
nonfactor risk of the securities divided by the number of
portfolio securities. Thus the nonfactor risks of the various
portfolios are:
10-security portfolio: 225/10 = 22.5
100-security portfolio: 225/100 = 2.25
Page 58 Chapter 11
1,000-security portfolio: 225/1,000 = 0.225
9. In order to calculate the expected return and standard

deviation of a thirty-stock portfolio based on a five-factor
model (with uncorrelated factors), the following parameters
must be estimated:
Zero-factor for each security 30
Sensitivity of each security to each factor (5 30) 150
Variance of the random error term for each security 30
Variance of each factor 5
Expected value of each factor 5
Total 220
If the factors are correlated, then there will be (N - N)

factor covariances to estimate in addition to the parameters
listed above. In this case, the number of additional
parameters would be (5 - 5) = 20.
10. Factors thought to pervasively affect security returns are

usually viewed as "macroeconomic" or "microeconomic" in
nature. The text discussed several possible macroeconomic
factors. Other such factors might include money supply
growth, the size of the budget deficit (or surplus), the size
of the trade deficit (or surplus), or the level of consumer
confidence.
Microeconomic factors (or at least proxies for those factors)

that might pervasively influence security returns include
dividend yield, earnings growth rate, earnings growth momentum
(that is, the rate of change in earnings growth), book value -
to-price ratio, market capitalization, and financial leverage.
11. A portfolio's sensitivity to a factor is the weighted average

of the component securities' factor sensitivities. Therefore
in this case:
bp1 = (.60 -.20) + (.20 .50) + (.20 1.50)
= 0.28
bp2 = (.60 3.60) + (.20 10.00) + (.20 2.20)
= 4.60
bp3 = (.60 0.05) + (.20 .75) + (.20 0.30)
= 0.24
Chapter 11 Page 59
12. In the context of a factor model, the expected return on

securities is a function of the values expected to be attained
by the factor (or factors). Surprises in the actual outcomes
for the factor values will determine the actual returns earned
on the securities, with the exact nature of those actual
returns depending on the structure of the factor model.
Mathematically, the expected return on security based on a

single-factor model can be expressed as:
r i = ai + bi F
where r i and F are the expected return for security i and the
expected value of the factor, respectively.
Further, realized returns on a security can be expressed as:
ri = ai + biF + ei
Substituting ( r i - bi F ) for a in the preceding equation gives:
ri = r i + bi(F - F ) + ei
That is, the actual return on the security is a function of

its expected return and the surprise (or unexpected change) in
the value of the factor. The underlying correlations among
securities is represented by the sensitivities of the
securities to surprises in the factor value, combined with the
volatility of the factor value.
13. Based on a two-factor model, the variance of a security is:
i2 = bi21 F2 + bi22 F2 + 2bi1bi 2 COV ( F1 , F2 ) + ei2

1 2
Therefore for the two securities in this problem:
A2 = [(1.5) (20)] + [(2.6) (15)]
+ (2 1.5 2.6 225) + 25
= 4,201
A = (4,201) = 64.8%
B2 = [(0.7) (20)] + [(1.2) (15)]
Page 60 Chapter 11
+ (2 0.7 1.2 225) + 16
= 914
B = (914) = 30.2%
The covariance between two securities in a two-factor world

is:
ij = bi1b j1 F2 + bi 2b j 2 F2 + (bi1b j 2 + bi 2b j1 )COV ( F1 , F2 )

1 2
In this case:
AB = [(1.5 0.7) (20)] + [(2.6 1.2) (15)]
+ {[(1.5 1.2) + (2.6 0.7)] 225}
= 1,936.5
14. The time-series approach to factor model estimation begins

with the assumption that the factors are known in advance.
Typically, the identification of the factors proceeds from an
analysis of the economics of the firms involved. With the
factors specified, historical information concerning the
values of the factors and security returns are collected from
period to period. These data are used to estimate securities'
sensitivities to the factors, the securities' zero factors and
unique returns, and the standard deviations of factors and
their correlations.
The cross-sectional approach to factor model estimation begins

with estimates of the securities sensitivities to certain
factors. Then, in a particular time period, the values of the
factors are estimated based on the securities' returns and
their sensitivities to the factors. By repeating the process
over multiple time periods, statistically significant
estimates of the factors' standard deviations and correlations
can be computed.
The factor analysis approach to factor model estimation begins

simply with a set of securities and their corresponding
returns. A statistical procedure known as factor analysis is
used to identify the number of significant factors and the
securities' sensitivities to those factors as well as the
standard deviations of the factors and the correlations among
the factors.
15. Security prices represent investors consensus expectations
Chapter 11 Page 61
about the future prospects for the firms that issue the
securities. Past factor values will already be incorporated
into security prices. Thus past factor values will have no
effect on security price changes and, therefore, security
returns. Instead it is what investors expect will be the value
of factors in the future that should be related to security
price changes and, therefore, security returns.
Page 62 Chapter 11
1. In general, APT is a much less restrictive equilibrium asset

pricing theory than is the CAPM. The CAPM utilizes certain
strong assumptions about investor preferences, while APT
merely assumes that investors prefer more wealth to less.
Another important difference between the two pricing theories

is that APT, unlike the CAPM, assumes that security returns
are generated by a factor model. The CAPM, on the other hand,
states that security returns must be proportional to the
covariance of those returns to the market portfolio, with no
reference to an underlying return-generating process.
2. Arbitrage portfolios involve opportunities for an investor to

increase the expected return on his or her current portfolio
without increasing the portfolios risk. By definition, this
type of investment should be attractive to all risk-averse and
risk-neutral investors. Further, arbitrage portfolios are
self-financing; the investor is not required to put up any
additional funds. This feature permits the investor to avoid
the costs of financing the arbitrage portfolio investment.
3. An arbitrage portfolio is defined by three conditions:
1. It is self-financing. It does not require any additional

funds from the investor.
2. It is riskless. That is, it has no sensitivity to any

factor. Further, it has zero variance and hence zero
covariance with other portfolios. It also has negligible
nonfactor risk.
3. It has a positive expected return.
4. The weights of securities in any portfolio must add up to

100%, therefore if security 1s proportion is increased by .2,
then the proportions of the other securities must adjust so
that
X1 + X2 + X3 = 0
where the Xis are the changes in the proportions of the

respective securities in the total portfolio. Further, if the
factor sensitivity of the portfolio is to remain constant then
it must be true that:
.90X1 + 3.00X2 + 1.80X3 = 0
From the first equation, if X1 = +.2, then:
Chapter 12 Page 63
X2 = (-.2 - X3)
Substituting this expression for X2 into the second equation

gives:
.18 + 3.00 (-.2 - X3) + 1.80X3 = 0
-.42 - 1.2X3 = 0
X3 = -.35
Thus:
X2 = -.2 - (-.35) = .15
5. Given the expected value for the factor of 8% and the stated
factor model relationship, then the expected return on the
three portfolios should be:
r A = 4% + .8 8% = 10.4%
r B = 4% + 1.0 8% = 12.0%
r C = 4% + 1.2 8% = 13.6%
Thus portfolio B's expected return is "out-of-line" with (in

this case greater than) the factor model relationship.
As portfolio B's factor sensitivity is 1.0, then the issue is

what combination of portfolios A and C will yield a factor
sensitivity of 1.0. That is:
XA .8 + XC 1.2 = 1.0
It must be that XA + XC = 0 or XC = 1 - XA. Thus:
XA .8 + (1 - XA) 1.2 = 1.0
.8XA + 1.2 - 1.2XA = 1.0
-.4XA = -.2
XA = .50 and XC = .50
A portfolio formed of 50% portfolio A and 50% portfolio C has

an expected return of:
Page 64 Chapter 12
rp = .5 10.4% + .5 13.6%
= 12.0%
Investors can be expected to create arbitrage portfolios by

short selling portfolio B and buying a portfolio composed of
50% portfolio A and 50% portfolio C.
6. a. From the conditions required of an arbitrage portfolio, in

a three-asset case:
XA + XB + XC = 0
and
bAXA + bBXB + bCXC = 0
In this case it is required that:
.20 + XB + XC = 0
and
(2.0 .20) + (3.5 XB) + (0.5 XC) = 0
Since:
XC = -XB - .20
then:
.40 + (3.5 XB) + [.5 (-XB - .20)] = 0
.40 + (3.5 XB) - (.5 XB) - .10 = 0
.30 + (3.0 XB) = 0
XB = -.10
XC = -.10
b. The expected return on Socks's arbitrage portfolio equals:
(.20 20%) + (-.10 10%) + (-.10 5%) = +2.5%
c. The market's action of buying security A and selling

securities B and C will drive up the price of security A
Chapter 12 Page 65
(reducing its expected return) and drive down the prices

of securities B and C (increasing their expected returns).
7. Given the relatively high expected return and low factor

sensitivity of security B, one likely arbitrage portfolio is
to increase the holdings of that security. Assume that
security B holdings are increased by .10. In the three-asset
arbitrage portfolio, it is required that:
XA + XB + XC = 0
and
bAXA + bBXB + bCXC = 0
In this case:
.10 + XA + XC = 0
and
(.60 XA) + (.30 .10) + (1.20 XC) = 0
Since:
XC = -XA - .10
then:
(.60 XA) + .03 + [1.20 (-XA - .10)] = 0
(.60 XA) + .03 - [(1.20 XA) + .12] = 0
(-.60 XA) - .09 = 0
XA = -.15
XC = .05
Therefore, all of the conditions of an arbitrage portfolio are

satisfied:
1. -.15 + .10 + .05 = 0
2. (.60 -.15) + (.30 .10) + (1.20 .05) = 0
3. (-.15 12%) + (.10 15%) + (.05 8%) = +0.10%
Page 66 Chapter 12
8. It is the actions of investors forming arbitrage portfolios

that forces securities' expected returns to be proportional to
their factor sensitivities. Investors seek arbitrage
portfolios to risklessly enhance their expected portfolio
returns. In creating these arbitrage portfolios, investors
buy securities offering expected returns exceeding the amount
necessary to compensate for their associated factor risks.
Conversely, investors sell securities with expected returns
insufficient to compensate for their associated factor risks.
Once all arbitrage possibilities have been eliminated, there
will exist a linear relationship between security expected
returns and security factor sensitivities.
9. According to APT, given a one-factor model, the equilibrium

return on a security is given by:
r i = rf + bi
In this case:
r i = 5% + (7.0% 3.0)
= 26.0%
10. The process of investors buying and selling securities through

arbitrage portfolios will result in linear relationships
between securities' factor sensitivities and securities'
equilibrium expected returns. Securities with expected
returns greater than that justified by these relationships
will be purchased by investors, with combinations of other
securities sold short to finance the purchases. These actions
will drive up the prices of the excessively-high expected
return securities and push down the prices of the securities
sold short, which presumably display expected returns below
those justified by the linear APT relationship. Only when all
securities' expected returns are linearly related to their
factor sensitivities will all arbitrage opportunities have
been eliminated.
11. According to APT, for a one-factor model, the equilibrium

expected return on a portfolio is given by:
r p = rf + bp
In this case, with two portfolios:
r A = 9.8% = rf + 0.8
Chapter 12 Page 67
r B = 11.0% = rf + 1.0
There are two equations with two unknowns (rf and ). Solving
for both unknowns simultaneously gives:
rf = 5.0%
= 6.0%
12. A pure factor portfolio possesses a unit (1.0) sensitivity to

the particular factor and zero sensitivity to any other
factor. Further, it has zero non-factor risk.
A pure factor portfolio can be formed by buying and short

selling a large number of securities in appropriate
proportions to produce the characteristics cited above.
13. Based on a one-factor model, APT defines the equilibrium

expected return on a portfolio to be:
r p = rf + bp
The factor sensitivity of the portfolio is given by the

weighted average of the component securities' factor
sensitivities, where the weights are the securities'
proportions of the portfolio.
In this case:
bp = (.30 4.0) + (.70 2.6)
= 3.02
The factor risk premium is the expected return over the

riskfree rate offered by a portfolio with unit sensitivity to
the factor. In this case, the unit sensitivity portfolio has
an expected excess return of 2.5% (= 8.5% - 6.0%). Therefore
the equilibrium expected return is equal to:
r p = 6.0% + (2.5% 3.02)
= 13.6%
14. It is true that the CAPM and APT are untestable in the literal
sense that controlled experiments cannot be conducted that
verify the conclusions of the underlying theories or, for that
matter in the case of APT, identify the factors.
Page 68 Chapter 12
Nevertheless, both theories are still quite valuable in that

they describe how investors analyze the tradeoff between risk
and return. As a result, asset pricing models provide a
framework around which to develop explanations of how the
capital markets operate and therefore how to go about
efficiently applying various long-run investment strategies
and policies.
15. In speculating about the appropriate APT factors, researchers

and practitioners typically turn to economic theory. They
focus on broad economic variables that can logically be
expected to affect the performance of all securities to some
degree. For example, both the level of economic activity and
inflation affect corporate earnings and dividends. Further,
the term structure of interest rates (as measured by the
location and shape of the yield curve) affects the discounted
value of future earnings and dividends. Consequently, one can
state with some confidence that investors' expectations
concerning these types of economic variables will
systematically affect security returns.
Chapter 12 Page 69
1. The great advantage of the corporate form of organization is

the limited liability of corporate owners. Common
stockholders may lose their initial investment and no more.
That is, if the corporation fails to meet its obligations, the
stockholders cannot be forced to give the corporation the
funds needed to pay off the obligations.
Without limited liability, investors would be less willing to

enter into risky investments. If those investments failed,
and the investors faced unlimited liability, then their other
assets would be at risk. A reluctance to enter into risky
investments would hinder the economic growth of a capitalist
economy.
2. a. Under a majority voting system, a majority of the shares

outstanding is required to ensure election of one or all
of the directors of the board. In the case of Fall Creek
Company, 750,001 shares (that is, 50% plus one of the
outstanding shares) are needed.
b. Under a cumulative voting system, an investor can combine

his or her shares times the number of directors being
elected and vote that total for one director. In the case
where a minority investor is trying to elect one director
and where 1,500,000 shares are outstanding and five
directors are to be elected, the investor will need at
least 250,001 shares. That is, if a majority investor held
the remaining shares, the majority investor would have to
distribute those shares among all five candidates to try
to control all director positions. Combined with the
attempt by the minority investor to control one position,
there are effectively six positions to be voted on.
Dividing 1,500,000 by six yields 250,000. Therefore if the
minority investor holds 250,001 shares, the most the
majority investor could hold is 1,249,999 shares. That
amount, divided by the five director positions, is not
enough to vote more than 250,000 for every position.
3. Despite the fact that shareholders are the legal owners of a

corporation, their ability to ensure that their agents (the
corporate management) act in their best interests is limited.
Through control of proxy statements, management usually is
able to implement its own policies, regardless of shareholder
desires.
While management policies usually are consistent with the

interests of most shareholders, there may be certain issues on
which shareholders and management interests diverge. For
example, shareholders may endorse a takeover of the
Page 70 Chapter 13
corporation by outside interests as a way of maximizing the

return on their investments. Management, conversely, may view
such a takeover as a legitimate threat to its livelihood and
therefore oppose the takeover.
It is difficult to fully align the interests of shareholders

and management on every important corporate issue. However,
encouraging management to participate in the ownership of the
firm (for example, through stock option plans) is one direct
means to give management an incentive to maximize shareholder
wealth.
4. Different classes of common stock may be issued by

corporations for a variety of reasons. Frequently, different
classes of stock will have different voting rights. For
example, a privately-held firm may wish to raise capital
through a public stock offering. But the original owners may
not wish to relinquish voting control of the company. To
achieve this objective, the newly issued stock might receive
regular dividends, but possess no voting rights. The original
stock, on the other hand, might receive little or no
dividends, but retain all voting power.
Further, some corporations have issued "super voting rights"

stock as an anti-takeover measure. Under this arrangement,
current owners of a corporation's stock possess a multiple of
votes relative to any stock purchased by a hostile acquirer.
5. Many corporate managers argue that their shareholders perceive

stock dividends and splits as increases in wealth, despite the
arguments to the contrary. Therefore, the managers believe
that they are merely satisfying the desires of their
shareholders. Further, many managers and investors believe
that stocks trade more readily if the price per share is not
"too high." A more liquid stock may command a price premium
from the market.
Stock dividends and splits definitely generate administrative

costs which are indirectly borne by the shareholders.
Further, since commission costs and bid-ask spreads do not
decline proportionately as a stock's price is reduced through
a stock distribution, the additional shares produced by stock
dividends and splits eventually result in higher trading costs
to shareholders.
6. a. The effect of a 15% stock dividend on the number of

Menomonie shares is to increase that number by 15 for
every 100 currently outstanding. Thus with 1,200,000
shares currently outstanding, the number of shares
Chapter 13 Page 71
outstanding after the stock dividend is:
1.15 1,200,000 = 1,380,000
At the same time the price of Menomonie's stock should be

reduced by a factor of 1/1.15 due to the stock dividend.
That is,
$40/1.15 = $34.78 (or $34.75 rounded to the nearest 1/16

of a dollar)
b. With a 4-3 stock split, for every 3 shares of Menomonie

stock outstanding, shareholders will receive an additional
share. Thus, after the 4-3 split, the number of shares
outstanding will be:
(4/3) 1,200,000 = 1,600,000
Similarly, the price of Menomonie stock will be reduced by

a factor of 1/(4/3) = 1/1.333 due to the stock split.
That is,
$40/1.333 = $30.00
c. With a 3-1 reverse split, for every three shares of

Menomonie stock currently outstanding only 1 share will
exist after the split. That is,
(1/3) 1,200,000 = 400,000
The price of Menomonie stock will rise by a factor of

(3/1) due to the reverse split. That is,
$40/(1/3) = $120.00
7. The quarterly returns on Tomah's stock and the market index

are found by taking the percentage change in the respective
prices each quarter. That is,
Page 72 Chapter 13
Tomah Market
Quarter Return Return
1 4.17 5.00
2 3.00 4.25
3 -6.99 -10.00
4 -5.01 -8.00
5 8.13 10.00
6 8.13 14.00
7 4.89 8.00
8 -1.97 2.00
From this data, the following calculations are made:
Y = 14.35
X = 25.25
XY = 373.88
Y = 260.34
X = 571.06
T = 8
Beta = [(T XY) - (Y X)]/[(T X) - (X)]
= [(8 373.88) - (14.35 25.25)]/[8 571.06 -(25.25)]
= 2628.70/3930.92
= 0.67
8. From the data from problem 5 in Chapter 1 and Table 1.1, the
following calculations were made:
Y = 424.78
X = 306.91
XY = 9,481.85
Y = 16,574.08
X = 8,239.92
T = 20
Beta = [(T XY) - (Y X)]/[(T X) - (X)]
= [(20 9,481.85) - (424.78 306.91)]/[20 8,239.92
- (306.91)]
= 59,267.77/70,604.65
Chapter 13 Page 73
= 0.84
9. From the data given in the problem, the following calculations

are made:
Y = 34.90
X = 30.00
XY = 248.58
Y = 308.47
X = 212.34
T = 10
Beta = [(T XY) - (Y X)]/[(T X) - (X)]
= [(10 248.58) - (34.90 30.00)]/[(10 212.34)
- (30.0)]
= (2485.80 - 1047.00)/(2123.40 - 900.00)
= 1438.80/1223.40 = 1.18
Alpha = [(Y)/T] - [Beta (X)/T]
= (34.90/10) - [1.18 (30.00/10)]
= 3.49 - (1.18 3.00)
= -0.05
Std Error = {[Y - (Alpha Y) - (Beta XY)]/(T - 2)}
= {[308.47 - (-0.05 34.90) - (1.18 248.58)]
/(10 - 2)}
= {[308.47 - (-1.75) - 293.32]/8}
= [2.11] = 1.45
Page 74 Chapter 13
Corr Coeff = (T XY) - (Y X)
{[(T Y) - (Y)] [(T X) - (X)]}
= (10 248.58) - (34.90 30.00)
{[(10 308.47) - 1218.01] [(10 212.34) - 900.00]}
= (2485.8 - 1047)/[(3048.7 - 1218.01) (2123.4 - 900.00)]
= 1438.80/(1866.69 1223.40)
= 1438.80/1511.19 = .952
Since the coefficient of determination is merely the square of

the correlation coefficient, then:
Coefficient of Determination = (0.952)
= .906
Note: If these calculations are carried out using a computer

spread sheet, then small differences between these answers and
the spreadsheets calculations may occur due to rounding.
10. Investors in initial security offerings must be confident that

they can ultimately resell the securities in the secondary
market quickly and without significant price concessions. If
this were not the case, initial security offerings would
essentially be of a private placement form. Investor interest
would be greatly reduced. Financing costs, therefore, would
be considerably higher.
11. The underwriting syndicate agrees to sell an issuing

corporation's security offering to the public. In typical
underwriting agreements, the issuing company receives the
public offering price less a stated percentage spread. The
underwriters, in turn, sell the securities at the public
offering price. Once the price and the underwriting spread
have been determined, the underwriting syndicate bears all
risk that the demand for the newly issued security may be
inadequate at the public offering price.
12. The prospectus is meant to provide disclosure of information

relevant to the security's price. It ensures that investors
have available to them sufficient information to make an
informed judgment regarding the issuing company's business
prospects and any other material information regarding the
Chapter 13 Page 75
security itself.
The SEC's acceptance of the prospectus implies only that the

SEC believes that the adequate disclosure of relevant
information has been made. The SEC makes no judgments about a
security's appropriate value.
13. It appears that underwriters often set a security's offering

price below the security's fair value, thereby generating an
immediate abnormal return to initial investors as the
security's price moves to its fair value.
These abnormal returns are not a "sure" thing. While many new
issues appear underpriced, there is nothing requiring an
underwriter to underprice a security. Further, if negative
news concerning the issuing company appears at the time of
issuance, the price of the security could drop below the
issuing price.
The frequent occurrence of abnormal returns implies that

issuers are not receiving maximum funds from security
underwritings, thereby increasing the issuers' costs of equity
capital. If the securities were priced nearer their fair
values, issuers would receive more funds and returns to IPO
investors would be lower.
14. The empirical regularities studies discussed in the chapter

could imply either that the CAPM is somehow misspecified, or
that securities markets are not highly efficient, or both.
The abnormal returns produced by the size, January, and day-

of-the week effects could be a result of the CAPM being an
inaccurate representation of security returns. Or it may be
that these empirical regularities are simply due to market
inefficiencies that have not been fully exploited by
investors, contrary to efficient markets arguments. Finally,
it is possible that both explanations are correct.
15. Boileryard means that tests for empirical regularities

generally rely on an asset pricing model, such as the CAPM or
the APT, to adjust returns for security risk. As a result, in
testing for the existence of empirical regularities, one
implicitly assumes that the asset pricing model correctly
specifies the relationship between risk and return. If it
does not, then the conclusions drawn from such studies may be
erroneous.
Page 76 Chapter 13
1. Even in a highly efficient market, financial analysts still

serve several important functions. First, they identify the
relevant characteristics of individual securities or groups of
securities (for example, betas, unique risks, sensitivities to
various pervasive factors). Knowledge of these
characteristics is important in the construction of efficient
portfolios.
Second, financial analysts attempt to identify mispriced

securities. While in a highly efficient market these
opportunities may be limited in number, situations will still
arise for skillful analysts to find profitable (that is, net
of all costs) mispricings.
Third, financial analysts can develop an understanding of

their clients' risk-return preferences. This enables them to
design portfolios that suit the investment objectives of their
clients.
2. Being able to accurately forecast a companys next years

earnings does not necessarily imply an ability to discern the
performance of the companys stock. If other analysts also can
accurately forecast the companys earnings, then the consensus
forecast will likely be already imbedded in the stocks price.
The analysts accuracy will only be valuable when he or she
has identified a situation where his or her forecasts are
materially different from the consensus forecast. In that
case, the analyst should expect a strong relative risk-
adjusted return on the stock if his or her earnings forecast
is above the consensus and expect a weak relative risk-
adjusted return on the stock if his or her earnings forecast
is below the consensus.
3. The simplest answer would be that technical analysis can add

value. It may be that the tests used by efficient markets
proponents are too unsophisticated to capture the subtle
aspects of technical analysis employed by some investors.
Most tests debunking technical analysis focus on simple
technical patterns. In fact, in recent years, numerous
empirical studies have offered credence to various forms of
technical analysis (for example, studies indicating that
investors overreact to good or bad news).
Another answer could be that users of technical analysis are

simply fooling themselves into believing that it has merit.
Technical analysis proponents can be very convincing in
hindsight and their arguments may have persuaded many
investors to apply the techniques, notwithstanding the strong
body of evidence indicating that technical analysis cannot
Chapter 14 Page 77
produce superior returns.
4. Investors must overreact to certain types of information if

momentum and contrarian strategies are to be successful. For
example, momentum strategies rely on investors reacting too
favorably to good news or too unfavorably to bad news, driving
security prices away from equilibrium in the direction of the
news. However, implicit in the concept of momentum strategies
is that investors will continue to react in the same direction
for a period of time sufficient to allow the momentum investor
to profit from long positions in good news securities or
short positions in bad news securities. Contrarian
strategies similarly rely on overreaction by investors.
However, it is assumed that investors must ultimately reverse
course and that prices of securities for which good news has
been reported will eventually decline toward equilibrium.
Conversely, prices of securities for which bad news has been
reported will eventually increase toward equilibrium.
5. The two companies must differ in terms of the amount of

leverage they employ. Because:
(Earnings/Assets) (Assets/Equity) = ROE
and because the two firms have the same earnings and assets,
the amount of equity they have must differ. For companies
with positive ROA, their ROE is enhanced by maintaining higher
debt-equity ratios. Baldwin must have a higher debt-equity
ratio than Hudson.
6. We know that:
ROA = (Net income/EBIT) (EBIT/Sales) (Sales/Assets)
and
ROE = ROA (Assets/Equity)
In the case of Afton:
ROA = 0.65 0.10 2.10
= .137 = 13.7%
ROE = .137 3.0
= .411 = 41.1%
Page 78 Chapter 14
7. a. The price-earnings ratio is:
P/E = Price/Earnings/Average shares outstanding
For Augusta:
P/E = $30/$200,000/100,000
= 15.0
b. Book value per share is:
BV = Stockholders equity/Average shares outstanding
For Augusta:
BV = $600,000/100,000
= $6.00
c. The price-book ratio is:
P/B = Price/Book value per share
For Augusta:
P/B = $30/$6
= 5.0
d. The dividend yield is:
D/P = Dividends per share/Price
For Augusta:
D/P = $0.50/$30
= .017 = 1.7%
e. The payout ratio is:
P/O = Dividends per share/Earnings per share
For Augusta:
P/O = $0.50/$2
= .250 = 25.0%
Chapter 14 Page 79
8. It is not true that reported earnings numbers are always (or

even often) directly comparable across corporations.
Generally accepted accounting principles permit considerable
latitude in reporting on various corporate activities.
Examples include depreciation and inventory valuation. As a
result it is possible for companies in the same line of
business with the same revenues and costs to report radically
different earnings. The problem is even more acute when
comparing firms in different industries.
9. Unique student answer. Students should apply the relationship

illustrated in Figure 14.1.
10. Company As earnings should not be assumed to grow faster than

Company Bs despite the former companys higher ROE. High ROE
is not a guarantee of rapid earnings growth. If a company with
a high ROE also paid out a large proportion of its earnings,
then the companys earnings might not grow faster than a
company with a lower ROE but also a lower payout ratio. Thus,
if Company A reinvests its earnings in itself to a lesser
extent than does Company B, then it might grow at a slower
pace.
11. Ratio analysis is often more useful than simply examining

absolute financial statement numbers because those numbers
display more meaning when they are considered relative to one
another. For example, a growing firm will generally increase
the amount of its debt outstanding. Such increases are
expected and appropriate. However, when that debt relative to
total assets or stockholders equity increases significantly,
a red flag is raised for analysts. They will want to know the
reasons for, and ramifications of, such an increase in
leverage.
12. Comparisons of one companys ratios with those of its

competitors can be fraught with problems. In many industries,
competitors lines of business do not precisely match up. For
example, in the general retail merchandise industry, Sears
might be compared to J.C. Penney or Federated Department
Stores. However, Sears has a very large credit card operation
compared to its competitors. This business has a significant
effect on Sears balance sheet and income statement and makes
comparisons of those financial statements with its competitors
problematic. Further, even very similar companies may use
different accounting procedures. The result is often an apples
and oranges situation that diminishes the value of peer
comparisons.
13. The insider trading data reported in the Official Summary is
Page 80 Chapter 14
publicly available. If this information were truly valuable,

then in a highly efficient market investors should be expected
to incorporate it in the price of the affected stocks as soon
as it becomes available. Yet certain studies indicate that
abnormal profits can be earned by trading on this insider
trading data for an extended period of time after the
information is initially available to the public. This
finding is inconsistent with the semistrong-form view of
efficient markets.
14.
24
23
22
Fort McCoy Stock Price ($)
21
20
19
18
17
0 1 2 3 4 5 6 7 8 9 10
D ay
15. Rel strength = [Fort McCoy price/S&P 500 price] 100
Day 1 2 3 4 5 6 7 8 9 10
Rel
Strgh 6.7 6.7 6.9 6.8 6.6 6.9 6.7 6.2 5.9 5.5
Chapter 14 Page 81
1. The present value of the stream of cash flows is given by:
$5 $6 $7 $8 $9
PV = 1 + 2 + 3 + 4 +
(110
. ) (110
. ) (110
. ) (110
. ) . )5
(110
= $4.55 + $4.96 + $5.26 + $5.46 + $5.59
= $25.82
2. The NPV of any investment equals:
NPV = Sum of discounted cash flows - Cost
In the case of Alta Cohen:
NPV = $3,000 PVAF5 years,8% - $10,000
where:
PVAF5 years,8% is the present value of an annuity factor for 5

years at 8%.
NPV = $3,000 3.9927 - $10,000.00
= $11,978.10 - $10,000.00
= $1,978.10
3. The IRR of an investment is the interest rate, R, that equates

the cost of the investment to the discounted cash flows
generated by the investment. The IRR must be solved for
iteratively. In the case of Hub Collins:
$100 $200 $300

$513.04 = 1 + 2 +
(1 + R) (1 + R) (1 + R) 3
A 7.0% discount rate will equate the investment's cost to the

discounted cash flows.
4. a. A dividend growing at a constant rate g will be worth the

following in t years:
Dt = D0 (1 + g)t
In the case of Afton Products:
D10 = $4.00 (1 + .05)10
Page 82 Chapter 15
= $4.00 1.629
= $6.52
b. Solving Dt = D0 (1 + g)t for g gives:
g = (Dt/D0)1/t - 1
In the case of Afton Products:
g = ($5.87/$4.00)1/5 - 1
= (1.47)1/5 - 1
= 1.08 - 1 = .08 = 8.0%
5. The intrinsic value of a perpetual constant income stream,

discounted at a rate k, is given by:
V = D/k
In the case of Hammond Pipes, the intrinsic value of the

preferred stock is:
V = $12/.15
= $80.00
6. For a stock with constant dividend growth, its intrinsic value

is given by:
V = [D0 (1 + g)]/(k - g)
In the case of Milton Information Services:
V = [$4.00 (1 + .04)]/(.12 - .04)
= $4.16/.08 = $52.00
7. Assuming that a stock is fairly valued, if its dividend is

growing at a constant rate, the internal rate of return can be
found by solving the intrinsic value equation for k. That is:
V = D1/(k - g)
k = (D1/V) + g
Chapter 15 Page 83
In the case of Spring Valley:
k = ($3.00 1.06)/$53 + .06
= .06 + .06 = .120 = 12.0%
8. The multiple growth DDM expresses a stock's intrinsic value

as:
V = VN- + VN+
N Dt DN (1 + g )
= t + N
t =1 (1 + k ) ( k g ) (1 + k )
In the case of Monona Air Cleaners:
V = [$6.00/(1.10)1 + $6.00/(1.10)2 + $7.00/(1.10)3]
+ {$7.00 (1.04)/[(.10 - .04) (1.10)3]}
= [$5.45 +$4.96 + $5.26] + {$7.28/[(.06) (1.331)]}
= $15.67 + $91.16
= $106.83
9. a. For the analysts using a constant growth in dividends

assumption, the intrinsic value of Chief Medical stock is
given by:
D0 (1 + g )
V =
k g
So:
V = [$3.00 1.05]/(.14 - .05)
= $3.15/.09 = $35.00
b. For analysts predicting multiple growth in Chief Medical

dividends, the intrinsic value of the stock is given by:
V = VN- + VN+
N Dt DN (1 + g )
= t + N
t =1 (1 + k ) ( k g ) (1 + k )
Page 84 Chapter 15
So:
V = [$3.60/(1 + .14)1 + $4.32/(1 + .14)2 + $5.18
/(1 + .14)3] + {$5.18 (1.04)/[(.14 - .04) (1.14)3]}
= [$3.16 + $3.32 + $3.50] + {$5.39/[(.10) (1.482)]}
= $9.98 + $36.37 = $46.35
c. The constant growth intrinsic value equation can be solved

for the implied dividend growth rate, given the current
price for the stock. That is:
D0 (1 + g )
P=
kg
can be manipulated algebraically to give:
( P k ) D0
g=
P + D0
In the case of Chief Medical, the implied dividend growth

rate is:
g = [($39.75 .14) - $3.00]/($39.75 + $3.00)
= .06 = 6.0%
The normal price-earnings ratio (using next year's

earnings) based on the assumption of constant growth in
dividends is given by:
V/E1 = p [1/(k - g)]
In the case of Chief Medical, the implied normal P/E is:
V/E1 = .25 [1/(.14 - .06)]
= .25 12.50 = 3.13
10. When valuing a stock over a finite holding period, the

intrinsic value equals:
D1 D2 D3 PN
V = 1 + 2 + 3 + L +
(1 + k ) (1 + k ) (1 + k ) (1 + k ) N
Chapter 15 Page 85
The value of the stock N periods from now, assuming constant

dividend growth, equals:
PN = DN+1/(k - g)
In the case of Elk Mound:
V = [$3.00 (1.06)1/(1.10)1] + [$3.00 (1.06)2/(1.10)2]
+ [$3.00 (1.06)3/(1.10)3] + [$3.00 (1.06)4/(.10 - .06)
(1.10)4]
= $2.89 + $2.79 + $2.68 + $64.67
= $73.03
11. An increase in the perceived riskiness of a stock's future

cash flows will decrease the stock's price-earnings ratio.
The reason for the decrease is that risk averse investors will
insist on paying less for a more uncertain revenue stream,
thereby decreasing the numerator of the price-earnings ratio.
Mathematically, if the price-earnings ratio can be expressed

as:
V/Eo = p (1 + g)/(k - g)
then an increase in the uncertainty of the stock's future cash

flows will cause investors to apply a higher discount rate k
to those cash flows. This increase will cause the denominator
of the right-hand side of the equation to increase, thereby
causing the price-earnings ratio to fall.
12. If Roberts will earn 20% on its equity and pay out 50% of its
earnings indefinitely, then its growth rate is:
g = r (1 - p)
= .20 (1 - .50)
= .100 = 10.0%
In the case of a constant growth:
(1 p) E0 (1 + g )
V =
kg
Page 86 Chapter 15
Thus for Roberts:
V = [(1 - .50) $4 (1 + .10)]/(.15 - .10)
= $2.20/.05 = $44.00
13. Assuming constant dividend growth, the "normal" price-earnings

ratio for a stock is:
V/Eo = p (1 + g)/(k - g)
In the case of Osseo, the company is paying out 50% of its

earnings. Thus:
V/Eo = .50 (1 + .06)/(.11 - .06)
= 10.60
14. The "fair value" price-earnings ratio for a stock (assuming

constant growth) is given by:
V/Eo = p (1 + g)/(k - g)
In the case of Reedsburg:
50 = ($0.40/$4) [(1 + g)/(.15 - g)]
500 = (1 + g)/(.15 - g)
g = .1477 = 14.77%
Further:
g = r (1 - p)
.1477 = r (1 - .10)
r = .1641 = 16.41%
15. Fay's statement is incorrect. The DDM provides an implied

return on the stock over a long-term (actually infinite)
holding period. Even if other investors never come to
recognize that the stock is truly undervalued, the investor in
the stock will still earn a positive alpha. By buying the
stock at the current market price, receiving its dividends,
and eventually selling it at a value based on the other
Chapter 15 Page 87
investors' erroneous dividend or discount rate assumptions,

the investor will earn a return higher than that justified by
the risk of the stock.
Page 88 Chapter 15
1. Earnings represent a source of equity, while dividends

represent a use of equity. Therefore, if E < D + I, then the
firm can only avoid changing the debt-equity ratio by issuing
new stock. If it issued new debt or used retained earnings to
finance the cash shortfall, then the debt-equity ratio would
be altered. Issuing new stock brings in additional equity to
the firm that "offsets" the equity paid out as dividends.
On the other hand, if E > D + I, then the firm can only avoid
changing the debt-equity ratio by repurchasing existing stock.
If it retired debt or added to retained earnings to absorb the
cash inflow, then the debt-equity ratio would be altered.
Repurchasing existing stock expends equity that "offsets" the
equity not paid out as dividends.
2. In the case of Merrillan Motors E = $8 million and I = $5

million.
a. With dividends of $5 million,
E < D + I
or
$8 million < $5 million + $5 million
In order to maintain its current debt-equity ratio,

Merrillan must issue equity of $2 million. If Pat wishes
to maintain a constant proportional ownership in the firm,
Pat must purchase $400,000 (20% $2,000,000) of the
newly-issued equity.
b. With dividends of $1 million,
E > D + I
or
$8 million > $5 million + $1 million
In order to maintain its current debt-equity ratio,

Merrillan must repurchase $2 million of equity. If Pat
wishes to maintain a constant proportional ownership in
the firm, Pat must sell to Merrillan $400,000 of equity
(20% $2,000,000).
c. With dividends of $3 million,
Chapter 16 Page 89
E = D + I
or
$8 million = $5 million + $3 million
The firm will neither issue nor repurchase equity. Thus

Pat will not have to take any action to maintain a
constant proportional ownership.
3. Regardless of the firm's dividend policy, if the firm

maintains a constant debt-equity ratio and the stockholder
maintains a constant proportional ownership in the firm, then
the stockholder will be no better off financially under one
dividend policy as opposed to another. That is, he or she
still will be able to maintain the same level of consumption.
The amount that he or she will be able to spend is his or her
proportional share of E - I. If dividends are higher (lower),
then he or she will receive more (less) in dividend income,
but will either receive equivalently a smaller (larger) income
from repurchased shares (if E > D + I) or will have to spend
more (less) dollars to buy additional shares (if E < D + I).
4. The value of a firm can still be expressed as the discounted

value of expected dividends, despite the irrelevance of the
dividend decision. The point of the irrelevancy argument is
that shareholders should be indifferent between receiving an
additional $1 of dividends or having the firm retain the $1 of
earnings, assuming that the firm maintains a constant debt-
equity ratio. If the firm pays out the $1 in earnings as a
dividend, then the increased current dividend will be offset
by lower future dividends, as the firm will have to issue
additional equity and the future dividends will be divided
among an increased number of shares. If the firm retains the
$1 of earnings, then the firm will repurchase equity and the
future dividends will be increased as there will be fewer
shares among which to the divide future dividends. Thus a
firm's intrinsic value will still be the present value of all
dividends expected to be paid by the firm, whether the firm
pays those dividends now or later.
5. Given that most corporations' earnings are variable, a

constant payout ratio policy would produce variable dividends,
an outcome with which many investors would be uncomfortable.
Instead, most firms pursue a policy of paying out a constant
proportion of long-run earnings, thereby smoothing the long-
run pattern of dividends paid to shareholders.
6. Using the Linter model, dividends in year t can be expressed
Page 90 Chapter 16
as:
Dt = ap*Et + (1 - a)Dt-1
With dividends paid last year of $10 million, a desired payout

ratio of 50%, and a speed of adjustment factor of .60,
Hixton's dividends over the five years will be:
Year 1: D1 = .60 .50 $30 million + (1-.60) $10 million
= $13.0 million
Year 2: D2 = .60 .50 $35 million + (1-.60) $13 million
= $15.7 million
Year 3: D3 = .60 .50 $30 million + (1-.60) $15.7 million
= $15.3 million
= $13.6 million
= $14.4 million
7. Modifying Equation 16.12 slightly, the actual change in

dividends (Dt - Dt-1) serves as the dependent variable and the
preferred change in dividends (p*Et - Dt-1) serves as the
independent variable. That is:
Dt - Dt-1 = a(p*Et - Dt-1)
Solving for the coefficient a using the simple regression

formula from Table 13.1 gives:
XY = .163
Y = -.200
X = -.330
X2 = .275
T = 13
Thus:
a = [(13 .163) - (-.200 -.330)]/[(13 .275) - (-.330)]
Chapter 16 Page 91
= .59
8. It appears that a corporation's management changes dividends

in part to convey information to stockholders and other
interested parties about the future prospects of the firm.
Increases in dividends indicate that management is forecasting
increased future earnings, while dividend decreases indicate
that management is expecting decreased future earnings.
If dividend changes are used as signaling devices by corporate

managements, then one would expect that dividend changes would
be directly related to stock price changes. Empirical studies
suggest that this relationship does indeed exist.
9. If an investor purchased Dells Deli stocks at its book value

and still holds the stock, and if no dividends have been paid,
then one may conclude that such a person has "lost money" in
the past. However, current owners of the stock may have
purchased it at prices below the current market price and
hence have "made money" in the stock, despite its now selling
below book value.
As to the future, the current market price should reflect the

publicly known future prospects for Dells Deli, so that the
relationship of price to book value should contain little
information about future stock returns. Further, even if
previous capital investments had fared poorly for Dells Deli,
the firm may now have additional profitable investment
opportunities that should not be avoided simply because the
firm's stock sells for less than book value.
10. Corporate economic earnings are subject to variability from

year to year. Clearly, some corporations' business
environments are more stable than others. Nevertheless, to
expect any corporation's economic earnings to follow a steady
trend is unrealistic. Yet GAAP gives management considerable
flexibility in calculating reported earnings. It is possible
for management to manipulate reported earnings so that a
steady trend in reported earnings growth is achieved.
However, this growth pattern is unlikely to be reflective of
the trend of economic earnings.
11. If it is true that reported earnings are simply a source of

information about the value of the firm, and that investors
process this information when estimating a firm's market
value, then there is no single "correct" manner in which the
firm's activities should be reported. Many different
reporting procedures may permit investors to arrive at an
Page 92 Chapter 16
accurate estimate of the firm's value.
The proper way to evaluate different methods of calculating

reported earnings is to observe the impact of "surprises" on
the values produced by the different methods on the market
values of similar firms (or the same firm over time). To the
extent that these surprises have no relationship with the
firm's market value, then the inference is that the additional
information provided by that method is not of value to
investors.
12. Harlond's statement is not supported by empirical evidence.

The stocks of companies that the consensus expects to report
the largest positive earnings changes do not necessarily
perform well. Rather, it is the stocks of those companies
that experience the largest positive earnings surprises
relative to consensus expectations that invariably demonstrate
superior performance.
13. The quarterly earnings relationship expressed as an

autoregressive model of order one is:
QEt = QEt-4 + a(QEt-1 - QEt-5) + b + et
QEt - QEt-4 = a(QEt-1 - QEt-5) + b + et
Solving for the coefficients a and b using the simple

regression formula from Table 13.1 gives:
XY = .358
Y = 2.220
X = 2.370
X2 = .399
T = 15
Thus:
a = [(15 .358) - (2.220 2.370)]/[(15 .399) - 5.617]
= .295
b = 2.220/15 - [.295 (2.370/15)]
= .10
Using these calculations, the forecast of earnings in Quarter

21 is:
Chapter 16 Page 93
QE21 = $4.73 + [.295 ($4.78 - $4.63) + $.10]
= $4.87
14. Unexpected earnings are calculated by subtracting forecast

earnings from actual earnings. With forecast earnings given
by:
QEt = QEt-4 + .75(QEt-1 - QEt-5)
then forecast and unexpected earnings for Oakdale are:
Quarter Actual Forecast Unexpected
1 $2.00 - -
2 1.95 - -
3 2.05 - -
4 2.10 - -
5 2.40 - -
6 2.24 $2.25 -$0.01
7 2.67 2.27 +$0.40
8 2.84 2.57 +$0.27
9 2.64 2.96 -$0.32
The standardized unexpected earnings (SUE) are found by

dividing the unexpected earnings by the standard deviation of
unexpected earnings ($0.35). Thus the SUEs in quarters 6-9
are:
Quarter SUE
6 -0.03
7 +1.14
8 +0.77
9 -0.91
15. The most likely explanation for the "slow" reaction of stock
prices to earnings surprises is that information costs money
and that information transmission takes time. Thus not all
investors receive information regarding earnings surprises at
the same time. The delay in the full dissemination of
information might cause a delay in the stock price reaction to
the earnings announcement.
Page 94 Chapter 16
1. The traditional investment organization funnels information

through various levels to arrive at a portfolio composition
decision. In brief, various economic and financial market
data are received by the firm's security analysts. This
information is used to assess the relative attractiveness of
groups of securities. These security rankings are transmitted
to an investment committee which creates an approved list of
stocks eligible for purchase by the firm's portfolio managers.
The portfolio managers weigh information from their own
sources as well as from the firm's security analysts to select
the most attractive securities from the approved list. The
portfolio managers combine these securities into portfolios
subject to various constraints such as maximum security
weights, maximum economic sector weights, portfolio risk
characteristics, client preferences, and so on.
The decision-making process in the traditional investment

organization could be made more "quantitative" by employing
such techniques as dividend discount models to identify
expected security returns. Further, various optimization
techniques could be used in the portfolio construction process
to ensure that the firm's portfolios most efficiently
incorporate the security analysts' risk and return forecasts.
2. The traditional approach to investment management follows a

very deliberate and time-consuming process of analyzing
information relevant to security selection. For example,
there is the collection and analysis of company financial data
by the investment organization's security analysts, the
analysts' use of "second-hand" information obtained from
"street" analysts (that is, analysts working for brokerage
firms), the reporting of the analysts' conclusions to the
organization's investment committee, the consideration of this
information by the committee, and the committee's ultimate
decision whether to buy or sell the securities. These
procedures, as well as other factors, can hinder the rapid
processing of the large volume of information required to
effectively and quickly identify mispriced securities in a
highly efficient market.
3. Unique student answer. Ideally, students should discuss such

factors as the likely range of outcomes for various asset
mixes and how they feel about experiencing the extremes of
those ranges, particularly on the downside.
4. As the proportion of the portfolio invested in common stocks

rises, so will the portfolio's expected return and standard
deviation. The three primary factors that determine the shape
of a stock-Treasury bill (or riskfree asset) portfolio's
Chapter 17 Page 95
distribution of potential returns are the expected returns on

stocks and Treasury bills, the standard deviations of stocks
and Treasury bills (on an ex ante basis, by definition, is
zero for Treasury bills), and the covariance between stocks
and Treasury bills (by definition, zero).
5. The slope of an investor's indifference curve represents the

amount of additional return that the investor requires in
exchange for accepting an incremental increase in risk, if the
investor's level of satisfaction (that is, utility) is to
remain constant.
The "typical" risk-averse investor has indifference curves

that slope upward to the right (with expected return on the
vertical axis and risk on the horizontal axis) and are convex.
For such an investor, the amount of additional expected return
required for the same incremental increase in risk rises as
the total risk borne by the investor increases.
6. As indicated by Equation (17.2), for a selected combination of

a risky portfolio and the riskfree asset, an investor's risk
tolerance can be estimated as:
=
[ ]
2 ( r C r f ) S2
(r S r f ) 2
In this problem:
r C = .70 12% + .30 5%
= 9.9%
Thus:
= 2 [(9.9 - 5.0) (18)]/(12 - 5)
= 64.8
The risk tolerance figure of 64.8 implies that the investor is

willing to accept up to 64.8 units of variance (8.0% in
standard deviation terms) for each additional percentage point
of expected return.
7. An overpriced stock generally should be held in a smaller

amount than one would choose were it correctly priced. If the
stock were considerably overpriced, the optimal position might
involve a zero (or even negative) weighting. However, if it
Page 96 Chapter 17
were only slightly overpriced, the optimal position might well

be positive, particularly if the investor faced practical
constraints, such as limits on the number of securities owned,
or transaction costs. The investor must take into account
both the security's covariances with other securities in the
portfolio as well as the security's expected return in
determining an optimal position for that security in the
portfolio. Risk considerations may cause an investor to hold
a positive position in an overpriced security.
8. This is a very complex question faced by many investors. It

raises additional questions concerning how risk should be
defined over long periods of time. For example, one could
argue that stocks, while having a relatively high standard
deviation of returns compared to bonds on a year-to-year
basis, have considerably reduced relative volatility when
examined over ten-year holding periods. Further, one could
argue that over long periods of time the chances of stocks
underperforming bonds are almost zero. For an investor with a
long time horizon, and the desire to achieve a high level of
consumption, stocks might be viewed as less risky than bonds.
Nevertheless, an investor with a proclaimed distant investment

horizon might desire to place bonds in his or her portfolio
because his or her effective time horizon is actually much
shorter. That is, the investor may not be able to "stomach"
the high variability of an all-stock portfolio in the short-
run. Or the investor may be protecting against an unlikely,
but still possible, catastrophic financial event (for example,
a severe and prolonged economic slump) which could cause the
value of stocks to drop sharply relative to bonds.
9. Using equation (17.2) in the text to calculate Dee's risk

tolerance:
= 2{[(.60 15 + .40 6) - 6] 400}/(15 - 6)
= 53.3
The certainty equivalent return is given by:
u = rp - (1/) 2p
In Dee's case:
u = (.60 15 + .40 6) - [(1 / 53.3) (.60 20)]
= 8.7%
Chapter 17 Page 97
10. Much of the growth in passively-managed investments can be

attributed to increased investor awareness regarding the
highly efficient nature of the U.S. stock market. Investors
have come to understand that very few professional investors
can be expected to consistently beat the market on a risk-
adjusted basis. Because of the negative impact of active
management fees and transaction costs on active manager
performance, many investors have come to view passive
management as a cost-effective means of investing in financial
assets.
11. This statement is false. It is based on the mistaken notion

that the average active manager will generate results similar
to that of the market. If that were the case, then passively
investing in the market would result in returns similar to
that of the average manager - something one could conceivably
call "mediocrity." However, due to the costs of active
management, primarily management fees and transaction costs,
the average active manager must by definition produce results
below those of the market. Thus passive management implies
settling for above-average performance.
12. The one-stage approach to security selection processes

information regarding expected returns, standard deviations,
and covariances among all available securities simultaneously
in order to arrive at an optimal portfolio. The two-stage
approach, on the other hand, first processes information
concerning expected returns, standard deviations, and
covariances among available securities within each asset class
to arrive at desired portfolios for these asset classes.
Funds are then allocated across these asset classes.
The one-stage approach is superior to the two-stage approach

in the sense that it uses all available information relevant
to the construction of an optimal portfolio. In particular,
it considers the covariances of securities across asset
classes. The two-stage approach is sub-optimal in the sense
that it ignores potentially valuable information.
However, the two-stage approach is preferred by most

investment managers because it is simpler and cheaper to
implement. Investment managers frequently prefer to
specialize in one particular asset class. They believe that
they can bring superior skills to bear on the investment
process in one asset class as opposed to spreading their
knowledge across a number of asset classes. Once these
managers have determined a desired portfolio within their
specific asset class, a decision regarding the allocation of
Page 98 Chapter 17
funds across asset classes is considered simpler to make.
13. Under the terms of the swap, Smiley must deliver to Dude the
returns on the Trout Index. Using a $50 million notional
principal, Smiley will owe Dude the following amounts:
Quarter Amount
1 +.05 $50,000,000 = +$2,500,000
2 .01 $50,000,000 = $500,000
3 +.02 $50,000,000 = +$1,000,000
4 +.01 $50,000,000 = +$500,000
Similarly, Dude must deliver to Smiley the returns on LIBOR,

which, on the $50,000,000 notional principal, equate to the
following amounts:
Quarter Amount
1 +.015 $50,000,000 = +$750,000
2 +.014 $50,000,000 = +$700,000
3 +.013 $50,000,000 = +$650,000
4 +.016 $50,000,000 = +$800,000
Netting the cash flows results in the following cash movements

between the two counterparties:
Quarter Amount
1 +$1,750,000 (Smiley pays to Dude)
2 +$1,200,000 (Dude pays to Smiley)
3 +$350,000 (Smiley pays to Dude)
4 +$300,000 (Dude pays to Smiley)
14. The simple reason that money managers tend to invest the
portfolios of all their clients in a similar manner is that
this is the easiest way to run their business. Spending time
with clients to understand their individual investment
objectives is a time-consuming and difficult process.
To the extent that clients do not demand that their money

managers pay close attention to their investment objectives,
then the managers are unlikely to do so on their own
initiative. If the clients are to receive individual
attention, then they will have to be assertive in their
dealings with their managers and perhaps seek out those
managers who will provide such attention. Further, they will
have to be prepared to clearly specify their investment
objectives and thus require them to have a clear understanding
of their preferences as regards the tradeoff between risk and
Chapter 17 Page 99
expected return. Clients will also have to develop monitoring

procedures to evaluate their managers investment activities
relative to predefined goals and constraints.
15. Diversification of judgment refers to splitting funds among

managers to avoid being seriously harmed by the investment
decisions of one or two managers. The assumption is that not
all of the managers will make similar errors in judgment
simultaneously. Diversification of style refers to splitting
funds among managers who pursue different security selection
"styles." The investor attempts to avoid being excessively
exposed to the possible poor performance of a particular
investment style. The assumption is that not all investment
styles will perform poorly simultaneously.
Page 100 Chapter 17

1. The value of Crungy's portfolio at the end of Year 1 was:
Value = (100 $10) + (300 $5) + (250 $12)
= $5,500
The value of Crungy's portfolio at the end of Year 2 was:
Value = (100 $15) + (300 $4) + (250 $14)
= $6,200
The rate of return on a portfolio with no cash flows is:
ROR = (Ending Value - Beginning Value)/Beginning Value
In Crungy's case:
ROR = ($6,200 - $5,500)/$5,500
= .127 = 12.7%
2. For a portfolio that receives a contribution at the beginning

of the measurement period, the rate of return is:
ROR = (End Value - Beg Value - Cont)/(Beg Value + Cont)
In New Lisbon's case:
ROR = ($38 mil - $30 mil - $2 mil)/($30 mil + $2 mil)
= .188 = 18.8%
3. Calculating the time-weighted return for a portfolio involves

valuing the portfolio whenever a cash flow occurs,
calculating the rate of return in that subperiod, and then
linking the subperiod returns together. In Con's case:
Sub-Period Rate of Return
1 ($9,800 - $9,000 - $500)/$9,000 = .033 = 3.3%
2 ($10,800 - $9,800 - $500)/$9,800 = .051 = 5.1%
3 ($11,200 - $10,800 - $500)/$10,800 = -.009 = -0.9%
4 ($12,000 - $11,200 - $500)/$11,200 = .027 = 2.7%
Chapter 18 Page 101

For the year, Con's time-weighted return was:
[(1.033 1.051 .991 1.027) - 1] = .105 = 10.5%
4. The dollar-weighted rate of return is the interest rate that

equates the beginning value of a portfolio to the discounted
value of the cash flows and ending value of the portfolio. In
Dell's case:
$12,000 = -$800/(1 + rD)10 + ($13,977.71)/(1 + rD)30
(Note that a minus sign is attached to the $800 because it is

a contribution)
The dollar-weighted rate of return must be solved for

iteratively. A value of .30% for rD gives:
$12,000 = -$800/(1.003)10 + $13,977.71/(1.003)30
= -$776.39 + $12,776.39
= $12,000
This .30% figure is a daily dollar-weighted return. It can be

converted to a monthly return as follows:
rDM = (1.003)30 - 1 = .094 = 9.4%
5. The time-weighted rate of return measures the performance of

each dollar invested in the portfolio regardless of the size
or timing of the cash flow. The dollar-weighted rate of
return, on the other hand, measures the growth rate of all
funds invested in portfolio. As such, it is sensitive to the
size and timing of cash flows.
The dollar-weighted rate of return might be a desirable

performance measure in situations where the portfolio manager
has full discretion over contributions and withdrawals to and
from the portfolio. In this case the dollar-weighted rate of
return's sensitivity to the size and timing of cash flows will
reflect not only the manager's skill at investing each dollar
in the portfolio, but also the manager's ability to add or
subtract funds from the portfolio at appropriate times.
6. Calculating the time-weighted return for a portfolio involves

valuing the portfolio whenever a cash flow occurs, calculating
the rate of return in the subperiod, and then linking the
subperiod returns together. In Buttercup's case:
Page 102 Chapter 18

Subperiod 1: ($7,300 - $5,000 - $2,000)/$5,000 = .060 = 6.0%
Subperiod 2: ($9,690.18 - $7,300)/$7,300 = .327 = 32.7%
For the month, Buttercup's time-weighted return is:
(1.060 1.327) - 1 = .407 = 40.7%
The dollar-weighted rate of return is the interest rate that

equates the beginning value of a portfolio to the discounted
value of the cash flows and ending value of the portfolio. In
Buttercup's case:
$5,000 = -$2,000/(1 + rD)10 + $9,690.18/(1 + rD)30
The dollar-weighted rate of return must be solved for

iteratively. A value of 1.2% for rD gives:
$5,000 = -$2,000/(1.012)10 + $9,690.18/(1.012)30
= -$1,775.11 + $6,775.11
= $5,000
This 1.2% figure is a daily dollar-weighted return. It can be

converted to a monthly return as follows:
rDM = (1 + .012)30 - 1 = .430 = 43.0%
The two returns differ by 2.3% because the contribution to

Buttercup's portfolio was made prior to a period of relatively
high returns for the portfolio. Because the dollar-weighted
rate of return is sensitive to the size and timing of cash
flows, it shows a higher return than does the time-weighted
rate of return.
7. It is quite possible that the other common stock portfolios

are inappropriate benchmarks. They may not satisfy the
criteria of being relevant and feasible. That is, they may not
represent investment alternatives for the portfolio manager
being evaluated. The manager may have no practical
opportunity to invest in any of the sample portfolios,
particularly because they are not identified in advance.
Further, there is no reason to expect that the portfolios
comprising the sample have risk similar to that of the
portfolio being evaluated. While they might, usually there is
no way to verify that fact. The performance measurement
services typically do not supply detailed risk information on
the individual portfolios comprising their samples.
Chapter 18 Page 103

8. a. A 5% stock dividend should reduce the price of stock A by

a factor of 1.05. Thus after the stock dividend the price
of stock A should be:
$16/1.05 = $15.250 (rounded to nearest sixteenth)
Because the value of the price-weighted index before the

stock dividend was:
Index = (16 + 30)/2 = 23
After the stock dividend the divisor will adjust to

maintain the same index value. Thus:
23 = (15.250 + 30)/Divisor
Divisor = 1.967
b. After its 3-1 stock split, the price of stock B should be

reduced by a factor of 3. Thus it should be worth $10 per
share. Again, the value of the divisor must adjust to
keep the index's value constant after the split. Thus:
23 = (16 + 10)/Divisor
Divisor = 1.130
c. After its 4-1 split, the price of stock A should be

reduced by a factor of 4. Thus it should be worth $4 per
share. Again, adjusting the value of the divisor to
maintain a constant index value gives:
23 = (4 + 30)/Divisor
Divisor = 1.478
9. a. On Date 1, the price-weighted index's value is given by:
Ipw = (PX + PY + PZ)/3
= (16 + 5 + 24)/3 = 15.0
b. On Date 2:
Ipw = (22 + 4 + 30)/3 = 18.7
c. The 4-for-1 split of stock X causes its price to fall to

$5.50. But the split should not be permitted to change
Page 104 Chapter 18

the index's value. Therefore the divisor of the price-

weighted index must be adjusted to maintain an index value
of 18.7.
Ipw = (5.5 + 4 + 30)/D = 18.7
Solving for the divisor D gives:
D = (5.5 + 4 + 30)/18.7 = 2.11
d. The aggregate market value of the value-weighted index on

Date 1 is:
$16/shr 100 shrs + $5/shr 200 shrs + $24/shr 100

shrs
= $5,000
The aggregate market value of the value-weighted index on

Date 2 is:
$22/shr 100 shrs (pre-split) + $4/shr 200 shrs +
$30/shr 100 shrs
= $6,000
The ratio of the Date 2 index market value to the Date 1

index market value is:
$6,000/$5,000 = 1.20
Multiplying by 100 to scale the Date 2 value-weighted

index value to the initial value of 100 on Date 1 gives:
Ivw = 1.20 100 = 120.00
(Note: the split of stock X has no impact on the value of

the value-weighted index. Either the pre-split or post-
split price and shares of stock X can be used.)
10. Stock market indices composed of a small number of stocks

relative to the entire market are not designed simply to
measure the performance of the component securities. Rather,
the indices are designed to measure the performance of the
entire market.
For example, the performance of the thirty stocks comprising
Chapter 18 Page 105

the DJIA is not of great importance in and of itself.

Instead, it is the fact that changes in the value of those
thirty stocks are reasonably good indicators of changes in the
aggregate value of the many thousands of stocks not included
in the DJIA that makes the DJIA a useful representation of
market performance.
11. a. The return on the three securities from Date 1 to Date 2

is:
Security Return
A $55/$50 = 1.100 = 10.0%
B $28/$30 = 0.933 = -6.7%
C $75/$70 = 1.071 = 7.1%
The equal-weighted index will assign each of the three

security returns an equal weight. Summing the three
securities' returns and dividing by 3 gives a return of
3.5% [(10.0 - 6.7 + 7.1)/3].
b. Similarly, from Date 2 to Date 3, the securities' returns

are:
Security Return
A $60/$55 = 1.091 = 9.1%
B $30/$28 = 1.071 = 7.1%
C $73/$75 = .973 = -2.7%
Thus, the equal-weighted index return is:
[(9.1 + 7.1 - 2.7)/3] = 4.5%
12. Based on the ex post SML, the risk-adjusted return for a

portfolio is:
p = arp - [arf + (arm - arf)p]
In Pickles' case:
p = 16.8% - [7.4% + (15.2% - 7.4%) 1.10]
= 16.8% - 16.0%
= 0.8%
13. Applying the three measures of risk-adjusted performance to

the Venus Fund:
Page 106 Chapter 18

Ex post alpha = (arp - arf) - (arm - arf)p
For the Venus Fund:
Ex post alpha = 0.60 - (0.50 1.10) = +0.05
Reward-to-volatility = (arp - arf)/p
For the Venus Fund:
Reward-to-volatility = 0.60/1.10 = +0.55
For the S&P 500:
Reward-to-volatility = 0.50/1.00 = +0.50
Sharpe ratio = (arp - arf)/p
For the Venus Fund:
Sharpe ratio = 0.60/9.90 = +0.06
For the S&P 500:
Sharpe ratio = 0.50/6.60 = +0.08
Two of the performance measures (ex post alpha and reward-to-

volatility ratio) show that the Venus Fund outperformed the
market index on a risk-adjusted basis. Conversely, the Sharpe
ratio indicates that the Venus Fund underperformed the market
index. As a result, using only historical performance data,
the answer regarding which fund you should recommend to Dazzy
is indeterminate. However, if the portfolio happened to
represent all of Dazzy's wealth, you should place more
emphasis on the results of the Sharpe ratio and recommend that
Dazzy invest in the index fund.
14. If the portfolio represents the entire wealth of its owner,

then the total risk of the portfolio is the relevant risk
measure for performance evaluation purposes. The variability
of the portfolio's return is likely to be of more concern to
the investor than is beta, which measures only the market-
related portion of the portfolio's total risk.
15. The three risk-adjusted performance measures are calculated as

follows:
Chapter 18 Page 107

Ex post alpha = (arp - arf) - (arm - arf)p
Reward-to-volatility = (arp - arf)/p
Sharpe ratio = (arp - arf)/p
A portfolio's beta is defined as:
Beta = [(T XY) - (Y X)]/[(T X) - (X)]
Using the Minifund's returns as reported in the question, as

well as the returns on the market and the riskfree return as
given in Table 1-1 in the text:
p = (20 9700.13)-(321.05 249.21)/(20 8593.73)-(249.21)
= 1.038
Thus for Minifund:
Ex post alpha = (16.05% - 7.87%) - (12.46% - 7.87%) 1.038
= 3.42
Reward-to-volatility = (16.05% - 7.87%)/1.038
= 7.88
Sharpe ratio = (16.05% - 7.87%)/24.79
= 0.33
In contrast, the same performance measures for the market

index are:
Ex post alpha = 0.00 (by definition)
Reward-to-volatility = (12.46% - 7.87%)/1.00
= 4.59
Sharpe ratio = (12.46% - 7.87%)/17.00
= 0.27
By all three measures, the Minifund has produced superior

returns over the twenty-year period.
Page 108 Chapter 18

Note however that the benchmark used for performance

evaluation purposes is inappropriate. The large
capitalization nature of the stocks that make up the market
index is not relevant to the investment strategy of the
Minifund, which is to invest in only very small companies. In
fact none of the holdings of the Minifund would ever be found
in this market index.
Chapter 18 Page 109

1. a. For the thirteen-week period the discount, expressed as a

percent of the Treasury bill's face value, is given by:
($10,000 - $9,675)/$10,000 = .0325 = 3.25%
Converting this quarterly discount to an annual percentage

requires multiplying by the inverse of the proportion of
the year that the Treasury bill's remaining life
represents. That is:
.0325 (360/90) = .130 = 13.0%
b. The equivalent yield of the Treasury bill is given by

first calculating the discount in dollars expressed as a
percentage of the purchase price. This percentage is then
annualized. In this problem:
[($10,000 - $9,675)/$9,675] (360/90) = .0336 4.0
= .134 = 13.4%
2. The equivalent yield of the three-month Treasury bill is:
(100 - 98)/98 = .020 = 2.0%
The equivalent yield of the six-month Treasury bill is:
(100 - 96)/96 = .042 = 4.2%
Thus the equivalent yield of the 6-month Treasury bill is more

than twice that of the 3-month Treasury bill even though its
discount is twice that of the 3-month Treasury bill. The
reason is the effect of compounding the discount of the first
3-month period over the second 3-month period.
3. All the money market instruments are of roughly equal default

risk. The students should merely provide an intelligent
discussion of the reasons for their rankings.
As to latest money market interest rates, The Wall Street

Journal provides a daily summary in its Money Rates table
contained in the Credit Markets section.
4. Interest payments are made by bond issuers on specified dates.

If a bond is purchased after one of those interest payment
dates, then the new owner will receive the entire subsequent
interest payment. However, the previous owner had held the
bond for a period of time following the preceding interest
Page 110 Chapter 19

payment. Standard practice presumes that the previous owner

should receive a pro rata share of that interest payment, with
the proportion based on the percentage of the time between
payments that the previous owner held the bond. The bond's
purchase price is adjusted to include the amount of this
accrued interest.
5. Bond issuers who include a call provision wish to retain the

option to refinance high cost debt if interest rates should
decline significantly. They do not wish to be bound by past
financing decisions if the interest rate environment should
shift in their favor. By calling in their high cost bonds,
they can reduce their interest expenses with a commensurate
positive long-run impact on earnings.
Bond investors naturally dislike granting this refinancing

option to bond issuers. They will pay a lower price for a
bond that differs from another bond only in terms of the call
provision. This lower price translates into a higher yield on
the callable bond.
6. The ten-year zero coupon bond has a price of $300 and

ultimately returns $1,000. Therefore its rate of return over
the ten-year period is:
ROR = $1,000/$300 1 = 3.333 1 = 233.3%
On an annualized basis, the return is:
RORAnnual = (3.333)1/10 1 = 1.128 1= 12.8%
7. A bond's price is the discounted value of the cash flows that

it produces. These cash flows generally come in the form of
periodic interest payments and payment of the bond's face
value at maturity. If the bond offers a coupon rate that is
lower than prevailing market interest rates, then it will sell
at a discount (that is, its market price will be less than its
face value). This discount represents "compensation" for the
below-market coupon rate. The discount will eventually be
paid to the bond's owner when at maturity the bond's principal
is returned. The bond's discount from face value and the
bond's interest payments are viewed as financially equivalent
forms of return to the bond investor. Therefore, the IRS
treats them equivalently from a tax standpoint.
8. A mortgage participation certificate represents pro rata

ownership of a pool of mortgages. The owner of the
certificate receives a proportional share of all interest and
Chapter 19 Page 111

principal payments (less an administrative fee) made by the

homeowners whose mortgages are held in the pool.
The primary risk facing a participation certificate owner is

the risk that homeowners may pay off their mortgages early.
If interest rates should drop significantly relative to the
level of interest rates on the mortgages in the pool, then
homeowners have an incentive to prepay these mortgages.
Especially if the participation certificate represents a high
coupon mortgage pool, this prepayment risk creates uncertainty
regarding the expected life of the participation certificate.
It presents the possibility that the participation
certificate's owner may find a substantial portion of his or
her investment called away at a financially inopportune time.
9. Cozy is clearly mistaking the government backing of the GNMA

pass-through security's interest and principal payments with
the government guaranteeing the total return to a holder of
the security. As market interest rates fluctuate, the value
of the GNMA pass-through security will move in an inverse
direction like any other bond, the government's guarantee of
interest and principal payments notwithstanding.
10. Pigeon Falls could pledge some of its assets as collateral for
the bond issue. In particular, assuming that its airplanes
are in reasonably good condition, they could serve as the
collateral. Large mobile fixed assets, such as airplanes, can
be quickly sold by creditors to satisfy outstanding debts, if
necessary.
Pigeon Falls might also consider a convertible bond offering.

The issued bonds would be convertible into common stock at a
price above the company's current stock price. If the company
recovers and its stock performs well, the conversion option
will be valuable to the bondholders. This option could
enhance the attractiveness of any bonds that Pigeon Falls'
might issue, thereby reducing its borrowing costs.
11. A callable bond incorporates the right of the issuer to pay

off the bond prior to maturity at a predetermined price. This
right represents an option available to the issuer, which may
or may not be used depending on whether it is to the financial
benefit of the issuer to do so. From this perspective the
issuer sells a noncallable bond and simultaneously buys an
option contract (whose value is based on the value of the
noncallable bond) from the bondholders.
The net price of the bond can be viewed as the difference

between the value of the bond without a call provision and the
Page 112 Chapter 19

value of the option contract. Because the option contract has

a nonnegative value, the price of the callable bond will
always be less than or equal to that of the equivalent non-
callable bond.
12. For a bond with a 9% return and a 30% tax rate, Muddy's after-
tax return on the corporate bond is expected to be:
RORCB = 9% (1 - .30) = 6.3%
As the return on the municipal bond is free from tax, Muddy

will expect to receive its entire promised return of 6%. Thus
Muddy should select the corporate bond over the municipal
bond.
13. Most corporations that default on their debts are not

liquidated. That a firm is in default simply means that it
has violated a provision of its bond indenture. Often these
violations are corrected without any material legal action on
the part of bondholders.
Even if a firm should enter bankruptcy (either voluntarily or

involuntarily), this action does not necessarily lead to
liquidation of the firm. The on-going value of the firm may
not justify its liquidation. Often a firm that has entered
bankruptcy will be reorganized, with its creditors compensated
in a "fair and equitable" manner as determined by the
bankruptcy court.
14. Preferred stock has characteristics of both bonds and common

stocks; hence the term "hybrid" security. That is, similar to
a bond, preferred stock typically makes a fixed periodic
payment whose amount is unchanged if the firm performs well.
On the other hand, preferred stock dividend payments are not
legal obligations of the issuer. If the firm performs poorly,
they can be omitted as with common stock dividends. Further,
like common stocks, preferred stocks usually have no maturity
date.
15. The return on the preferred stock before taxes is:
ROR = $8/$50 = .160 = 16.0%
a. A corporation can generally exclude 80% of the dividends

received from the stock of other corporations, including
the dividends of preferred stocks. Thus the after-tax
return to the corporation is:
Chapter 19 Page 113

ROR = [$8 - (.2 $8 .35)]/$50 = .149 = 14.9%
b. The individual must pay taxes on all of his or her

preferred stock dividends. Thus the after-tax return to
the individual is:
ROR = [$8 - (.35 $8)]/$50 = .104 = 10.4%
Page 114 Chapter 19

1. The yield-to-maturity of a bond is that interest rate that

equates the price of the bond to the discounted value of the
bond's cash flows.
The general form of the bond valuation equation is:
I1 I2 IN M
Pb = 1 + 2 +L+ N +
(1 + Y ) (1 + Y ) (1 + Y ) (1 + Y ) N
a. In the case of the first bond, the yield-to-maturity is

found by solving the following equation for Y:
$816.30 = $1,000.00/(1+Y)3
(1 + Y)3 = $1,000.00/816.30
(1 + Y) = (1.225)1/3
Y = 1.07 - 1 = .070 = 7.0%
b. In the case of the second bond, the yield-to-maturity is

found by solving the following equation for Y:
$70 $70 $70 $1,000

$949.37 = 1 + 2 + 3 +
(1 + Y ) (1 + Y ) (1 + Y ) (1 + Y ) 3
Y must be solved for iteratively. Trying 9.0% gives:
$949.37 = $64.22 + $58.92 + $54.05 + $772.18
= $949.37
Thus the yield-to-maturity on the second bond is 9.0%.
2. The value of a bond is the sum of the discounted value of its

cash flows. In the case of the Camp Douglas bond, with a 12%
discount rate:
$100 $100 $100 $1,100

Pb = 1 + 2 + 3 +
(1 + .12) (1 + .12) (1 + .12) (1 + .12) 4
= $89.29 + $79.72 + $71.18 + $699.07
= $939.26
With an 8% discount rate:
Chapter 20 Page 115

$100 $100 $100 $1,100

Pb = 1 + 2 + 3 +
(1 + .08) (1 + .08) (1 + .08) (1 + .08) 4
=$92.59 + $85.73 + $79.38 + $808.53
= $1,066.23
3. The yield-to-maturity of a bond is that interest rate that

equates the price of the bond to the discounted value of the
bond's cash flows. In the case of Patsy's bond, the yield-to-
maturity is found by solving the following equation for Y:
$90 $90 $90 $1,000

$975.13 = 1 + 2 + 3 +
(1 + Y ) (1 + Y ) (1 + Y ) (1 + Y ) 3
Y must be solved for iteratively. Trying 10.0% gives:
$975.13 = $81.82 + $74.38 + $67.62 + $751.31
= $975.13
Thus the yield-to-maturity on Patsy's bond is 10.0%.
4. The N-period spot rate is the interest rate on a pure discount

bond whose life extends from today through N future periods.
Thus for pure-discount bonds with maturities of one, two, and
three years, spot rates for one, two, and three years can be
determined.
The one-year spot rate can be determined from the price of the
one-year pure discount bond.
$930.23 = $1,000/(1 + Y)1
(1 + Y)1 = $1,000/$930.23
(1 + Y)1 = 1.075
Y = .075 = 7.5%
The two-year spot rate can be determined from the price of the
two-year pure discount bond.
$923.79 = $1,000/(1 + Y)
(1 + Y) = $1,000/$923.79
(1 + Y) = 1.082
Page 116 Chapter 20

Y = .040 = 4.0%
The three-year spot rate can be determined from the price of

the three-year pure discount bond.
$919.54 = $1,000/(1 + Y)3
(1 + Y)3 = $1,000/$919.54
(1 + Y)3 = 1.088
Y = .028 = 2.8%
5. The discount factor for period t is given by:
dt = 1/(1 + st)t
In the case of the three-year pure discount bond, the three-

year spot rate is found by solving for Y:
$810.60 = $1,000/(1 + Y)3
(1 + Y)3 = $1,000/$810.60
(1 + Y)3 = 1.234
Y = .073 = 7.3%
Thus the three-year discount factor is:
d3 = 1/(1 + .073)3
= 1/1.234
= .810
In the case of the four-year pure discount bond, the four-year

spot rate is found by solving for Y:
$730.96 = $1,000/(1 + Y)4
(1 + Y)4 = $1,000/$730.96
(1 + Y)4 = 1.368
Y = .082 = 8.2%
Chapter 20 Page 117

Thus the four-year discount factor is:
d4 = 1/(1 + .082)4
= 1/1.368
= .731
In the case of the five-year pure discount bond, the five-year

spot rate is found by solving for Y:
$649.93 = $1,000/(1 + Y)5
(1 + Y)5 = $1,000/$649.93
(1 + Y)5 = 1.539
Y = .090 = 9.0%
Thus the five-year discount factor is:
d5 = 1/(1 + .090)5
= 1/1.539
= .650
6. The forward rate between periods t-1 and t is given by:
(1 + ft-1,t) = (1 + st)t/(1 + st-1)t-1
Thus in this problem:
(1 + f1,2) = (1 + .055)2/(1 + .050)1
= 1.060
f1,2 = .060 = 6.0%
(1 + f2,3) = (1.065)3/(1 + .055)2
= 1.085
f2,3 = .085 = 8.5%
(1 + f3,4) = (1.070)4/(1 + .065)3
= 1.085
Page 118 Chapter 20

f3,4 = .085 = 8.5%
7. The spot rate for t periods is given by:
(1 + st)t = (1 + ft-1,t) (1 + st-1)t-1
Thus in this problem:
(1 + s1)1 = (1 + .10) (1 + s0)0
= 1.100
s1 = .100 = 10.0%
(1 + s2)2 = (1 + .095) (1 + .10)1
= 1.205
s2 = (1.205)1/2 - 1
= .098 = 9.8%
(1 + s3)3 = (1 + .090) (1 + .098)2
= 1.314
s3 = (1.314)1/3 - 1
= .095 = 9.5%
(1 + s4)4 = (1 + .085) (1.095)3
= 1.425
s4 = (1.425)1/4 - 1
= .092 = 9.2%
8. a. The discount factors on the three bonds can be determined

sequentially. In the case of the first bond, the one-year
discount factor equates the price of the bond to the
discounted cash flow of the bond. That is:
$909.09 = $1,000.00 d1
d1 = $909.09/$1,000.00 = .909
Chapter 20 Page 119

In the case of the second bond, the one-year discount

factor is applied to the first year cash flow and the two-
year discount factor is that discount factor that, when
applied to the second year cash flow, equates the price of
the bond to the discounted cash flows of the bond. That
is:
$991.81 = ($100.00 d1) + ($1,100.00 d2)
= ($100.00 .909) + ($1,100.00 d2)
$991.81 - $90.90 = $1,100.00 d2
d2 = $900.91/$1,100.00 = .819
The three-year discount factor is found in a similar

manner:
$997.18 = ($100.00 .909) + ($100.00 .819)
+ ($1100.00 d3)
$997.18 - $90.90 - $81.90 = $1,100.00 d3
d3 = $824.38/$1,100.00 = .749
b. Given the discount factors from part (a), the forward

rates can be derived. In general:
(1 + ft-1,t) = (1 + st)t/(1 + st-1)t-1
= (1/dt)/(1/dt-1)
The forward rate from today to year one (which is simply

the one-year spot rate) is given by:
(1 + f0,1) = (1/d1)/(1/d0)
= (1/.909)/(1/1) = 1.100/1 = 1.100
f0,1 = 10.0%
The forward rate from year one to year two is given by:
(1 + f1,2) = (1/d2)/(1/d1)
= (1/.819)/(1/.909)
Page 120 Chapter 20

= 1.221/1.100 = 1.110
f1,2 = 11.0%
The forward rate from year two to year three is given by:
(1 + f2,3) = (1/d3)/(1/d2)
= (1/.749)/(1/.819)
= 1.335/1.221 = 1.094
f2,3 = 9.4%
c. The amount of the loan should be equal to the discounted

value of the cash payments. The one, two, and three-year
discount factors should be applied to these cash payments
in order to calculate their present value.
PV = (.909 $500) + (.819 $600) + (.749 $700)
= $454.50 + $491.40 + $524.30 = $1,470.20
You should be willing to "pay" $1,470.20 for the "bond"

that Honus is offering to sell you. In other words, the
loan should be for $1,470.20.
9. The effective annual interest rate of re (given a stated

annual interest rate of r), compounded over n periods per
year, is given by:
(1 + re) = (1 + r/n)n
In the case of Mercury National with its 6.0% passbook savings

account:
a. For semiannual compounding:
(1 + re) = (1 + .060/2)
= (1.03) = 1.061
re = 6.1%
b. For daily compounding:
(1 + re) = (1 + .060/365)365
Chapter 20 Page 121

= (1.0001644)365 = 1.062
re = 6.2%
10. Under terms of the loan, you actually receive only $6,500 and
must repay $8,000 at the end of two years.
The interest rate on the loan as calculated by the bank

discount method is:
BDR = [1 + ($1,500/$8,000)]1/2
= 1.09 = 9.0%
The true interest rate is given by BDR/(1 BDR) or .09/(1

.09) = 9.9%
11. Unique student answer.
12. A downward-sloping yield curve is not inconsistent with the

liquidity preference theory of the term structure of interest
rates. If expected future spot rates are substantially lower
than current one-year spot rates, it is possible that the
yield curve may be downward sloping even though investors
demand a liquidity premium for holding longer-term securities.
In such a situation, investors expect that interest rates will
decline significantly from current levels in the future,
perhaps due to an anticipated decline in the inflation rate.
13. According to the unbiased expectations theory, the expected

future spot rate equals the forward rate. That is:
est,t+1 = ft,t+1
Further:
(1 + f1,2) = (1 + s2)/(1 + s1)
= 1.188/1.080
f1,2 = .100 = 10.0%
(1 + f2,3) = (1 + s3)3/(1 + s2)
= 1.331/1.188
f2,3 = .120 = 12.0%
With es1,2 = 10.0% and es2,3 = 12.0%, then:
Page 122 Chapter 20

es1,3 = (1.10 1.12)1/2 = 1.11 = 11.0%
Therefore the expected yields on one-year and two-year pure

discount bonds one year from today are 10% and 11%.
14. According to the liquidity preference theory:
f1,2 = es1,2 + L1,2
f1,2 es1,2 = L1,2
As f1,2 = [(1 + s2)2/(1 + s1) 1], then:
f1,2 = [(1.07)2/(1.09) 1] = .0504. Thus:
L1,2 = 5.04% 4.50% = .54%
15. In problem 9, if continuous compounding is applied to the

savings account with a 6.0% stated annual interest rate, then
the effective annual interest rate is:
(1 + re) = er
= e.060 = 1.062
re = .062 = 6.2%
Chapter 20 Page 123

1. Calculating the fair value of a zero-coupon bond involves

simply finding the present value of the face value to be paid
at the stated date in the future. In Grapefruits case, the
bonds fair value is given by:
$10,000
Pb =
(1.06)10
= $5,583.95
2. The intrinsic value of a bond equals the discounted value of

its promised cash flows. In this case:
$75 $75 $1,075

V = 1 + 2 +
(110
. ) (110
. ) . )3
(110
= $68.18 + $61.98 + $807.66
= $937.82
Because the bond is currently selling for $975.48, it is

overpriced and Bones should consider selling it.
3. a. The intrinsic value of a bond is equal to the discounted

value of its cash flows. In this particular problem:
$800 $800 $800 $10,800

V = 1 + 2 + +
(110
. ) (110
. ) . ) 3 (110
(110 . )4
= $727.27 + $661.16 + $601.05 + $7,376.55
= $9,366.03
Because the bond is actually selling for $8,785.07, the

bond is underpriced and Patsy should purchase it.
b. The yield-to-maturity is the interest rate that equates

the price of the bond to the discounted value of the
bond's promised cash flows. In this particular problem:
$800 $800 $800 $10,800

$8,785.07 = + + +
(1 + Y )1 (1 + Y ) 2 (1 + Y ) 3 (1 + Y ) 4
The yield-to-maturity must be solved for iteratively.

Using a value of 12.0% solves the equation. Because the
yield-to-maturity is greater than the appropriate discount
rate for this bond of 10%, Patsy should purchase it.
Page 124 Chapter 21

4. Prior to the increase in the discount rate, the market value

of both bonds was $1,000, as the discount rate equaled the
coupon rate of both bonds. After the discount rate increase,
the five-year bond is worth:
V5 = $80 PVAF5 years, 10% + $1,000 PVF5 years, 10%
= $80 3.7908 + $1,000 .6209
= $924.16
The ten-year bond is worth:
V10 = $80 PVAF10 years, 10% + $1,000 PVF10 years, 10%
= $80 6.1446 + $1,000 .3855
= $877.07
Therefore the decline in the five-year bond's price is:
Decline5 = ($924.16 - $1,000)/$1,000 = -7.6%
Comparatively, the decline in the ten-year bond's price is:
Decline10 = ($877.07 - $1,000)/$1,000 = -12.3%
[Here PVAF denotes present value annuity factor and PVF

denotes present value interest factor (or discount factor).]
5. Treasury securities represent default-free securities. As a

result, they offer a convenient baseline instrument for
analyzing the underlying factors determining the yields on
fixed-income securities. The yields-to-maturity on default-
free securities are often viewed as forming the yield
structure. Risk premiums related to such factors as call and
put provisions, tax status, marketability, and the likelihood
of default are then incorporated to obtain the relevant
yields-to-maturity for other bonds.
6. In basis points, bond A's yield is expressed as 980 basis

points while bond B's yield is expressed as 873 basis points.
Therefore the difference between the two bonds' yields in
basis points equals:
980 - 873 = 107 basis points
7. a. A bond's yield-to-maturity is that interest rate that
Chapter 21 Page 125

equates the bond's current price to the discounted value

of its promised cash flows. In this case:
$100 $100 $100 $1,100

$1,032.40 = 1 + 2 + 3 +
(1 + Y ) (1 + Y ) (1 + Y ) (1 + Y ) 4
The yield-to-maturity must be solved for iteratively.

Using a value of 9% solves the equation. Thus 9.0% is the
current yield-to-maturity of Bibb's bond.
b. If the bond can be called in two years for $1,100, its

yield-to-call is found by solving for the yield-to-
maturity assuming the receipt of only two coupon payments
and a call price of $1,100. That is:
$100 $1,200
$1,032.40 = 1 +
(1 + Y ) (1 + Y ) 2
Solving iteratively for the yield-to-call produces a value

of (to the nearest tenth) 12.8%.
8. The actual yield-to-maturity is the interest rate that equates

the initial price of the bond to the discounted value of all
the cash flows generated by the bond. Thus:
$100 $1,300 $1,000 $70 $70 $1070

$1,000.00 = + + + +
(1 + Y )1 (1 + Y ) 2 (1 + Y ) 2 (1 + Y ) 3 (1 + Y ) 4 (1 + Y ) 5
The yield-to-maturity must be solved for iteratively. To the

nearest tenth, a value of 12.9% solves the equation.
9. Nellie receives four $90 coupon payments from the bond.

Assuming that they are reinvested at 15%, those coupon
payments plus the principal repayment will, after four years,
have grown to an accumulated value of:
Acc Value = $90 (1.15)3 + $90 (1.15)2 + $90 (1.15)1
+ $1,090 (1.15)0
= $136.88 + $119.03 + $103.50 + $1,090.00
= $1,449.41
As the bond had a purchase price of $1,000, Nellie's actual

yield-to-maturity over the four years is:
Actual yield = ($1,449.41/$1,000)1/4 = 1.097 = 9.7%
Page 126 Chapter 21

If the coupon payments were spent immediately upon receipt,

then the effective reinvestment rate is 0%. Thus the
accumulated value of the cash flows is:
Acc Value = $90 (1.0)3 + $90 (1.0)2 + $90 (1.0)1
+ $1,090 (1.0)0
= $1,360.00
Therefore, Nellie's actual yield-to-maturity over the four

years is:
Actual yield = ($1,360/$1,000)1/4 = 1.080 = 8.0%
10. Bond ratings are designed to indicate the creditworthiness of

particular bonds. That is, they indicate the relative
likelihood that the bond issuer will make full and timely
interest and principal payments on the bond.
Valuation of common stock is a much more complex process than

examining the likelihood of default on a bond issue. A single
quality rating is unlikely to provide useful information to an
investor attempting to understand the many interrelated
factors that affect a company's long-term earnings growth
prospects.
11. Agency ratings indicate whether a bond issuer is more or less

likely to default relative to other bond issuers, irrespective
of the prevailing economic climate. Bonds usually are not
reclassified as economic conditions change. As a result, the
probability of default of various bond rating classes changes
as economic conditions change. One would expect, therefore,
that yield spreads between classes would adjust
commensurately. In fact, such spread changes are observed.
Conversely, if bond ratings indicated absolute levels of risk,

then as economic conditions changed, bonds would be
reclassified to take into account their likelihood of default
under the prevailing economic conditions. One would expect to
see essentially constant yield spreads. As these constant
yield spreads are not observed, then by implication agency
ratings do not indicate absolute levels of risk.
12. The relationship between a bonds promised yield-to-maturity

and the bonds expected yield-to-maturity, its probability of
default, and the likely financial loss in the event of default
Chapter 21 Page 127

is given by Equation (21.4) in the text:
y + p d
y=
1 pd
In this case, calculating the promised yield-to-maturity

gives:
y = [.085 + (.60 .10)]/( 1 - .10)
= .161
Equation 21.5(b) shows that the default premium equals:
d = pd (y + )
which in this case results in:
d = .10 (.161 + .60) = .076 = 7.6%
13. If it were true that corporate defaults were the result of

totally unrelated causes, then default risk would be
diversifiable. However, this is generally not the case.
Defaults tend to be related to the level of economic activity,
a form of market risk. Default incidence tends to peak during
periods of economic distress. When the economy is weak, most
firms are affected.
Because defaults are strongly related to a systematic source

of risk, it is not possible to meaningfully diversify the risk
of default away. Hence the market requires a risk premium in
the form of a promised yield that is greater than the default-
free yield incorporated into Treasury bond prices.
14. Earnings variability should be positively associated with a

bond's yield spread. The more variable an issuer's earnings,
the greater the probability that those earnings will
experience a large negative shock, thereby impairing the
issuer's ability to meet scheduled interest and principal
payments.
The time without default should be negatively related to a

bond's yield spread. The longer the time without default, the
more stable the issuer's financial situation has been in the
past and presumably that stability will persist in the future.
The equity/debt ratio should be negatively related to a bond's

yield spread. The equity/debt ratio indicates the issuer's
Page 128 Chapter 21

equity resources relative to its debt burden. The larger that

relative burden (and the smaller the ratio), the more likely
the issuer will be unable to meet its obligations if its
earnings and cash flow should turn down.
The level of total debt is a measure of the marketability of

the issuer's bonds. As investors prefer more liquid assets to
less liquid assets, this factor should be directly related to
a bond's yield spread.
15. A widening of the yield spread likely indicates an increase in

the difference in the default premiums of two bond classes.
This change could be due to an increased level of market risk
aversion; more likely it is due to a change in investors'
assessments of the relative risks of the two classes of bonds.
Possibly the economic climate has turned unfavorable and
investors are now much more concerned about the possibility of
default on the part of lower quality bond issuers.
Chapter 21 Page 129

1. A bond's intrinsic value equals the discounted value of its

promised cash flows. In this case the bond's intrinsic value
equals the present value of a ten-year $80 annuity plus the
present value of $10,000 to be paid ten years from today.
Currently with an 8% yield-to-maturity:
V = $800 PVAF10 years, 8% + $10,000 PVF10 years, 8%
= $800 6.7101 + $10,000 .4632
= $10,000.00
With a 10% yield-to-maturity:
V = $800 PVAF10 years,10% + $10,000 PVF10 years,10%
= $800 6.1446 + $10,000 .3855
= $8,770.68
With a 5% yield-to-maturity:
= $800 7.7217 + $10,000 .6139
= $12,316.36
[Here PVAF denotes present value annuity factor and PVF

denotes present value interest factor (or discount factor).]
2. A bond's intrinsic value equals the discounted value of its

promised cash flows. In the case of bond A:
VA = $1,000 PVAF20 years,9% + $10,000 PVF20 years,9%
= $1,000 9.1285 + $10,000 .1784
= $10,912.50
In the case of bond B:
VB = $1,000 PVAF5 years,9% + $10,000 PVF5 years,9%
= $1,000 3.8897 + $10,000 .6499
Page 130 Chapter 22

= $10,388.70
Both bonds have coupon rates greater than their yields,

therefore both bonds sell at a premium above par. Bond A
sells at greater premium (higher price) than bond B because
its longer life means that it is offering this relatively high
coupon rate for a longer period of time than is bond B.
3. The bond has a 10% coupon rate, thus it initially sells at its
par value of $1,000. Discounting the bond's cash flows at 12%
gives the following intrinsic value:
= $100 3.6048 + $1,000 .5674
= $927.88
Given that the bond was originally selling at par ($1,000),

the percentage change in its intrinsic value is:
$927.88 - $1,000.00/$1,000.00 = -.072 = -7.2%
Discounting the bond's cash flows at 8% gives the following

intrinsic value:
= $100 3.9927 + $1,000 .6806
= $1,079.87
The percentage change in the bond's price from its original

par value is:
$1,079.87 - $1,000.00/$1,000.00 = .080 = 8.0%
4. Discounting the five-year bond's cash flows at 6% gives the

following intrinsic value:
= $80 4.2124 + $1,000 .7473
= $336.99 + $747.30
= $1,084.29
Chapter 22 Page 131

Thus the five-year bond increases by $84.29 ($1,084.29 -

$1,000.00) as its yield-to-maturity declines to 6%.
Prior to the decline in yield, the bond's intrinsic value was

calculated as:
= $80 3.9927 + $1,000 .6806
= $319.42 + $680.60
= $1,000.02 (effectively, $1,000)
Thus of the $84.29 increase in the five-year bond's price

79.1% [($747.30 - $680.60)/$84.29] came from the change in the
present value of the bond's principal and 20.9% [($336.99 -
$319.42)/$84.29] came from the change in the present value of
the bond's interest payments.
Discounting the twenty-year bond's cash flows at 6% gives the

following intrinsic value:
= $80 11.4699 + $1,000 .3118
= $917.59 + $311.80
= $1,229.39
Thus the twenty-year bond increases by $229.39 ($1,229.39 -

$1,000.00) as its yield-to-maturity declines to 6%.
Prior to the decline in yield, the bond's intrinsic value was

calculated as:
= $80 9.8181 + $1,000 .2145
= $785.45 + $214.50
= $999.95 (effectively, $1,000)
Thus of the $229.39 increase in the twenty-year bond's price

42.4% [($311.80 - $214.50)/$229.39] came from the change in
the present value of the bond's principal and 57.6% [($917.59
Page 132 Chapter 22

- $785.45)/$229.39] came from the change in the present value

of the bond's interest payments.
5. Discounting bond A's cash flows at 6% gives the following

intrinsic value:
= $1,000 7.3601 + $10,000 .5584
= $12,944.10
Before the change in yield, bond A's intrinsic value was:
= $1,000 6.7101 + $10,000 .4632
= $11,342.10
Thus the percentage change in bond A's price due to the yield
change is:
($12,944.10 - $11,342.10)/$11,342.10 = .141 = 14.1%
Discounting bond B's cash flows at 6% gives the following

intrinsic value:
VB = $800 PVAF10 years,6% + $10,000 PVF10 years,6%
= $800 7.3601 + $10,000 .5584
= $11,472.08
Given that bond B was originally selling at par, its

percentage change in price due to the yield change is:
($11,472.08 - $10,000.00)/$10,000.00 = .147 = 14.7%
6. The duration of a bond is given by:

N
Ct
(1 + Y )
t =1
t
D=
Pb
Because the bond in this problem is selling at par, its yield-

to-maturity is equal to its coupon rate of 7%. Thus:
Chapter 22 Page 133

$70 $70 $1,070

1 1 + 2 2 + 3
(1.07 ) (1.07 ) (1.07 ) 3
D=
$1,000
= [($65.42 1) + ($61.14 2) + ($873.44 3)]/$1,000
= $2,808.02/$1,000 = 2.8 years
7. A bonds modified duration is defined as:
D
Dm =
(1 + y )
From problem 6, we know that the bonds duration is 2.8 years,

thus its modified duration is:
2.8 years
Dm =
(1 + .07)
= 2.6 years
8. The duration of a bond portfolio is a weighted average of the

durations of the component securities. For Liz's portfolio:
D = (.20 4.5) + (.25 3.0) + (.25 3.5) + (.30 2.8)
= 3.4 years
9. The shortest duration bond must be bond #4. While all of the
other bonds have thirty years to maturity, bond #4 has only
five years to maturity. Because there are no other factors to
significantly lengthen its duration relative to the other
three bonds, it can be presumed that it has the shortest
duration.
The longest duration bond is bond #2, the zero coupon bond.
Because it makes no coupon interest payments, its duration
equals its term-to-maturity, or thirty years.
The remaining two bonds fall between bond #4 and bond #2 in

terms of duration. Of these two bonds, bond #3 can be
expected to have a shorter duration than bond #1. Because it
yields 7%, bond #3 is selling at a premium, while bond #1 is
selling at par. Selling at a premium, more of bond #3's
present value is recovered earlier compared to bond #1. Hence
bond #3's duration must be less than that of bond #1.
Page 134 Chapter 22

10. The relationship between a bond's duration, a given change in

yield, and the percentage change in the bond's price is:
Percentage price change = -D percentage change in (one plus yield)
In this problem:
Percentage price change = -3.5 [(1.083 - 1.080)/1.080)]
= -3.5 .0028
= -3.5 .28% = -.98%
11. As interest rates decline, the risk that homeowners will

prepay their mortgages increases. Thus as interest rates
decline, the call risk of mortgage pass-through securities
rises. This tends to dampen the positive effects of the
interest rate decline on these bonds' prices, particularly
those selling at a premium. Hence the negatively convex
price-yield relationship.
12. Immunization involves selecting a fixed-income portfolio whose

duration matches the duration of a given liability (or
liabilities). By "immunizing" the liability (or liabilities),
the investor can be confident (given certain assumptions) that
the realized return on the bond portfolio will be equal to the
promised yield. Thus the investor can determine the necessary
amount to invest in order to meet the future liability.
Immunization is effective because the two forms of risk

associated with a change in interest rates, namely
reinvestment rate risk and interest rate risk, have opposite
effects on the bond investor's wealth. Reinvestment rate risk
produces wealth effects in the same direction as the change in
interest rates, while interest rate risk has an inverse wealth
effect relative to the direction of the change in interest
rates. When a bond investment is immunized, the wealth
effects of reinvestment rate risk and interest rate risk
precisely offset one another.
13. The bullet strategy is less susceptible to "stochastic

process" risk than is the barbell strategy. That is, the
value of the bullet strategy bond portfolio is more likely to
move in tandem with the liability's value under various term
structure shifts than is the barbell strategy bond portfolio.
This is because, in terms of the timing of its cash flows, the
bullet strategy bond portfolio is more closely aligned to the
single-payment liability than is the barbell strategy bond
Chapter 22 Page 135

portfolio.
The disadvantage of the bullet strategy portfolio versus the

barbell strategy is that it is a less flexible and potentially
more expensive approach. There may be no bonds available with
the appropriate durations to implement the bullet strategy.
By comparison, the barbell strategy can select from a much
wider range of bonds to achieve the desired duration, so the
chances that the appropriate bonds are not available is much
smaller.
14. The intrinsic value of the bond with ten years to maturity at
a 10% yield-to-maturity is:
= $80 6.1446 + $1,000 .3855
= $877.07
Four years later the bond will have six years to maturity and
is projected to have a 9% yield-to-maturity. At that point
its intrinsic value would be:
= $80 4.4859 + $1,000 .5963
= $955.17
Thus the bond's projected total price change over this four
year period is:
Price change = $955.17 - $877.07 = $78.10
If the bond's yield-to-maturity was not projected to change,

then its price after four years would be:
V = $80 PVAF6 years,10% = + $1,000 PVF6 years,10%
= $80 4.3553 + $1,000 .5645
= $912.92
Thus the time change effect is:
Time change effect = $912.92 - $877.07 = $35.85
Page 136 Chapter 22

The yield change effect equals:
Yield change effect = Price change - Time change effect
= $78.10 - $35.85
= $42.25
The bond makes four $80 annual coupon payments over the four
years so that coupon income totals $320 (4 $80).
Finally, the interest on the coupon payments is found by

calculating the compound value of four $80 payments invested
at 9.5% and subtracting away the value of the coupon payments.
That is:
Interest on coupons = $80 CVAF4 years,9.5% - $320
= $80 4.6071 - $320
= $48.57
The overall dollar return on the bond is given by:
Overall dollar return = Time change effect + yield change effect
+ coupons + interest on coupons
= $35.85 + $42.25 + $320.00 + $48.57
= $446.67
Dividing the dollar return and its components by the bond's

original price gives the bond's projected overall rate of
return:
Overall return = ($35.85/$877.07) + ($42.25/$877.07)
+ ($320.00/$877.07) + ($48.57/$877.07)
= .041 + .048 + .365 + .055
= .509 = 50.9%
15. Contingent immunization is quite similar to a stop order. If

the contingently-immunized bond portfolio fails to achieve a
target return, active management is discontinued (stopped out)
and the portfolio is placed in appropriately structured bonds
Chapter 22 Page 137

so that at the end of the investor's time horizon, the

portfolio will be certain of attaining a prespecified value.
By comparison, a stop sell order discontinues investment in a

particular security if a prespecified decline in the
security's value occurs. The proceeds of the liquidation can
be placed in a riskfree asset, thereby assuring a particular
value at the end of the investor's time horizon.
Page 138 Chapter 22

1. The market value of Neptune's portfolio equals the combined

value of its investment holdings:
MVA = ($50,000 $10) + (20,000 $7) + (35,000 $30)
+ (10,000 100)
= $2,690,000
The net asset value of an investment company equals:
NAV = (MVA - LIAB)/NSO
In this case:
NAV = ($2,690,000 - $50,000)/150,000
= $17.60
3. It is true that the monthly rate of return on a mutual fund

can be computed by calculating the percentage change in the
net asset value from the beginning to the end of the month.
Assuming no distributions, the percentage change in the NAV
represents the change over the month of one dollar invested in
the fund at the beginning of the month. Note, however, that
an investor who makes contributions to or withdrawals from his
or her mutual fund during a given month will likely earn a
different rate of return than that reported by the mutual fund
for the month.
4. a. The NAV of a closed-end investment company is calculated

in the same manner as the NAV for an open-end investment
company. That is:
NAV = (MVA - LIAB)/NSO
In the case of the X fund:
NAV = ($500,000,000 - $2,000,000)/40,000,000
= $12.45
b. If the NAV is $12.45, then an 8% discount implies that the

fund's market price is:
Market price = (1 - .08) $12.45
Chapter 23 Page 139

= $11.45
5. Due to the 8.5% load charge you would only be able to actually
invest $915 in the mutual fund out of the initial $1,000 that
you had available to invest. Given the 1.10% annual operating
expenses, to find the annual return that the fund must earn to
match the accumulated dollars from a five-year investment in a
5% savings account, one must solve the following equation for
X:
$915.00 (1 + X - .011)5 = $1,000 (1.05)5
$915.00 (.989 + X)5 = $1,276.28
(.989 + X)5 = 1.3948
X = .080 = 8.0%
6. Probably the most important factor to consider in selecting an

investment company is its investment policy. Specifically,
what are the company's investment objectives and how much risk
is it willing to take to achieve those objectives? This
investment policy should be consistent with the role that the
investor expects the investment company to play in his or her
total portfolio.
Another important consideration is the amount of load charges

(if any) levied by the investment company. Mutual funds can
assess up to 8.5% of the amount invested as a front-end load
charge, considerably reducing the amount of funds available
for investment.
A potential investor should also evaluate the on-going

expenses incurred by the investment company, primarily
management fees and administrative charges. Management fees
can range from .25% of assets under management to over 1%.
Administrative charges average around .50% of assets under
management. These costs are not trivial and, because they
vary from fund to fund, they should be considered by a
potential investor.
Another expense that should be taken into account are

transaction costs. These costs will largely depend upon the
amount of turnover in an investment company's portfolio and
the liquidity of the securities traded. Transaction costs are
difficult to measure, but estimates in the 1% - 5% range are
not unusual for smaller capitalization common stocks. Many
Page 140 Chapter 23

investment companies' portfolios experience turnover of well

over 50% annually. Thus transaction costs can be material.
Past performance is another factor that is often considered in

selecting an investment company. However, as discussed in the
text, the correlation between past successful performance and
future successful performance appears to be quite low.
7. The return on a mutual fund paying a year-end distribution is

given by
rt = [(NAVt - NAVt-1) + Dt]/NAVt-1
In the case of the Saturn fund:
rt = [($16.90 - $18.50) + $1.25]/$18.50
= -0.019 = -1.9%
8. The return on a mutual fund paying year-end distributions of

income and realized capital gains is given by:
rt = [(NAVt - NAVt-1) + It + Gt]/NAVt-1
In the case of the Pluto Fund:
r1 = [($14.40 - $13.89) + $0.29 + $0.12]/$13.89
= .066 = 6.6%
r2 = [($15.95 - $14.40) + $0.33 + $0.25]/$14.40
= .148 = 14.8%
r3 = [($15.20 - $15.95) + $0.36 + $0.05]/$15.95
= -0.021 = -2.1%
9. The evidence indicates that past performance is of little help

in selecting a superior mutual fund. There is little
statistical support for the notion that many mutual fund
managers are capable of consistently outperforming the market
on a risk-adjusted basis. Clearly, some managers will
outperform the market in any given year. However, this
superior performance appears to be more often coincidental,
rather than a matter of skill. As a result, it should not be
expected that a mutual fund manager who performed well last
year will also perform well this year.
Chapter 23 Page 141

10. Rule 12b-1 was designed to permit mutual funds to levy a fee
on existing shareholders to offset various marketing expenses.
The logic was that the existing shareholders would benefit
from a larger fund due to increased economies of scale.
There has been little evidence to indicate that the fees

accomplish this objective. The 12b-1 fees appear to be simply
a means for certain mutual funds to increase their sponsor's
revenues at the expense of existing shareholders.
11. Mutual fund load charges are paid before the investor's assets
are invested. As the investor has fewer dollars to invest
after paying the load charges, the load charges therefore are
a higher percentage of this actual invested amount than of the
amount that the investor originally had available for
investment.
12. Even if investment company managers are unable to beat the

market on a risk-adjusted basis, investment companies still
offer significant advantages for most individual investors.
Specifically, investment companies offer the advantages of
economies of scale and professional management.
Economies of scale has several dimensions. First, by pooling

the resources of many investors, an investment company is able
to spread the fixed costs of investing across a larger asset
base than any one investor could accumulate. Second,
diversification is made more economical, again by the fact
that a larger asset base makes accumulating sufficiently large
positions in a diverse group of securities cheaper. Finally,
a large asset pool permits an investment company to negotiate
lower commissions from brokers.
Professional management refers to the expertise that managers

of investment companies bring to the investment process.
Professional management does not necessarily mean an ability
to consistently identify mispriced securities. It includes
maintaining an appropriate risk level in the portfolio,
handling the investment of funds in the portfolio, and keeping
accurate records for participants in the fund.
13. Unique student answer. Generally students will discuss that

the young professional with a long time horizon is able to
take on more risk and will invest more aggressively in common
stocks than the widow who has relatively short investment time
horizon and will likely prefer higher percentage conservative
fixed-income investments.
14. If investment company income was not free from federal
Page 142 Chapter 23

taxation, shareholders would be subject to a form of double

taxation. That is, shareholders must pay taxes on realized
gains on their investment company shares and on any income or
capital gains distributions made by the investment company.
Thus if investment company income were also taxed,
shareholders in effect would be taxed twice. Furthermore,
investors in common stock investment companies in effect would
be taxed a third time since the corporations, whose shares the
investment companies hold, also pay corporate income taxes to
the federal government.
15. Closed-end investment company shares frequently sell at

premiums or discounts to their net asset values. Discounts,
sometimes significant, are more common than premiums. Because
the NAV of an investment company represents the per share
market value of the assets held by the investment company, it
does not make sense that in an efficient market investors
would pay more or less than the "fair" value of the investment
companies' shares. No widely accepted explanation for the
premiums or discounts has been developed.
Chapter 23 Page 143

1. As in the case of any organized exchange dealing in financial

assets, option exchanges facilitate trading by providing a
mechanism through which buyers and sellers can meet. These
exchanges offer standardized contracts and trading procedures
that make it convenient for option buyers and sellers to
transact. For example, the exchanges establish specific
exercise prices and expiration dates for option contracts that
buyers and sellers can trade. This concentrates the trading
in a limited number of contracts. Furthermore, the Options
Clearing Corporation, jointly owned by the exchanges, acts as
a buyer to all sellers and a seller to all buyers. Thus the
risk of an option writer not being able to deliver is not a
matter of concern to market participants.
3. a.
70
60
50
40
Profit ($)
30
20
10
0
0 10 20 30 40 50 60 70 80 90 100
-1 0
P r ic e o f S t o c k a t E x p ir a t io n ($ )
Page 144 Chapter 24

b.
20
15
10
5
Profit ($)
0
0 10 20 30 40 50 60
-5
-1 0
-1 5
-2 0
c.
20
15
10
5
Profit ($)
0
0 10 20 30 40 50 60 70 80 90 100
-5
-1 0
-1 5
4. The time value of an option is the difference between the

option's premium and the option's intrinsic value. It
represents the amount that an investor is willing to pay over
the option's intrinsic value for the opportunity to benefit
from possible future changes in the underlying stock's price.
The time value of an option decreases as the option approaches

expiration because the probability of a favorable stock price
change decreases as the time to expiration decreases.
Chapter 24 Page 145

5. The possible paths of Shorewood stock's price and the value of

an investment in the riskfree asset are shown below:
$58.09
$50
$43.04
$50 $52.56
Thus in the up state the call option is worth $8.09 and in the
down state it is worthless. Applying the binomial option
pricing model, Ns and Nb must be found that simultaneously
satisfy:
$58.09 Ns + $52.56 Nb = $8.09
$43.04 Ns + $52.56 Nb = $0.00
Equivalently:
$15.05 Ns + 0 Nb = $8.09
Ns = .5375
Further:
$58.09 (.5375) + $52.56 Nb = $8.09
Nb = .4401
Therefore:
Pc = $50 .5375 + $50 -.4401
= $4.87
6. The possible paths of Hopkins stock's price and the value of

an investment in the riskfree asset are shown below:
Page 146 Chapter 24

$48.86
$44.21
(A)
$40.00
$40
(C)
$40.00
$36.19
(B)
$32.75
$40 $41.22 $42.48
Applying the binomial option pricing model, at node A:
If Ps = $44.21, then:
h = ($8.86 - $0)/($48.86 - $40) = 1.0
B = (h Psd - Pod)/eRT
= (1.0 $40 - $0)/1.0305
= $38.82
Vo = h Ps - B
= 1.0 $44.21 - $38.83
= $5.38
At node B, Vo = 0.0 by inspection.
Thus at node C:
h = ($5.38 - $0)/($44.21 - $36.19) = .6708
B = (.6708 $36.19 - $0)/1.0305
= $23.56
Vo = .6708 $40 - $23.56
Chapter 24 Page 147

= $3.27
7. The components of the Black-Scholes model, given the data in

this problem, are calculated as follows:
R T = (.05) (.25) = .0125
e(RT) = e.0125 = 1.0126
d1 = [ln(47/45) + (.05 + .08) .25]/[.4 .5]
= .380
d2 = [ln(47/45) + (.05 - .08) .25]/[.4 .5]
= .180
N(d1) = .648
N(d2) = .571
Thus:
Vc = [47 .648] - [(45/1.0126) .571]
= $5.08
8. A decline in a call option's premium does not necessarily mean

that it is now more attractively valued. A call option's
premium is a function of a number of factors that can change
over time without any effect on the relative attractiveness of
the call option. For example, if the stock's price declined,
then the call option's premium would also fall without
necessarily causing the call option to become underpriced.
9. The value of a call option is determined by five variables:
1) Market price of the common stock

2) Exercise price of the option
3) Length of time until expiration date
4) Riskfree rate of interest
5) Volatility of the common stock
The effect of changes in each of the variables (with all other

variables remaining the same) is:
1) The higher the price of the stock, the higher the value of
Page 148 Chapter 24

the call option.
2) The higher the exercise price, the lower the value of the
call option.
3) The longer the time to expiration date, the higher the

value of the call option.
4) The higher the riskfree rate of interest, the higher the

value of the call option.
5) The greater the volatility of the underlying stock, the

higher the value of the call option.
10. According to the Black-Scholes option pricing model, the value

of a non-dividend paying European call option is given by:
Vc = N(d1) Ps - E/eRT N(d2)
or
Vc = N{[ln(Ps/E) + (R + .5) T]/T.5} Ps - E/eRT
N{[ln(Ps/E) + (R - .5) T]/T.5}
Given the current value of the option is $8.54 and all other
variables of the valuation equation are known, the standard
deviation of the stock's price (implicit volatility) can be
found by solving the equation iteratively trying various
values of the standard deviation. Ultimately .40 will be
shown to be the appropriate value. (Obviously, these
iterations are best done in a spreadsheet or other computer-
based algorithm.)
11. The hedge ratio measures the expected change in an option's

price relative to a one dollar change in the underlying
stock's price. A $1 change in Merrimac's stock price would
equate to a $20,000 move in the value of Blondy's portfolio.
With a hedge ratio of .37, Blondy would have to buy put option
contracts worth $54,054 (= $20,000/.37) to achieve an
equivalent movement in the put options' value. This equates
to roughly 216 contracts (= $54,054/(100 $2.50)).
12. Using the Black-Scholes model, the value of a put equals:
Pp = (E/eRT)N(-d2) - PsN(-d1)
The components of the Black-Scholes model, given the data in
Chapter 24 Page 149

this problem, are calculated as follows:
R T = (.06) (.25) = .015
eRT = 1.015
d1 = [ln(32/45) + (.060 + .061) .25]/(.35 .5)
= -1.775
d2 = [ln(32/45) + (.060 - .061) .25]/(.35 .5)
= -1.950
N(-d1) = .962
N(-d2) = .974
Thus:
Vp = [(45/1.015) .974] - (32 .962)
= 43.18 - 30.78
= $12.40
13. All call options, unless they are very deep in or out of the
money, sell with a positive time value. A call option's
premium P can be expressed as:
P = IV + TV
where:
IV = option's intrinsic value
TV = option's time value
Given the option's exercise price (E) and the underlying

stock's current price (Ps), then:
P = (Ps - E) + TV
For the investor who exercises his option, the cost of

purchasing the stock is E. In comparison, the investor who
buys the stock in the open market and simultaneously sells the
option has a net cost of:
Page 150 Chapter 24

Net cost = Ps - P
= Ps - [(Ps - E) + TV]
= Ps - Ps + E - TV
= E - TV
Because the TV > 0, the call option holder who wishes to

acquire the underlying stock prior to expiration is always
financially better off (or at least no worse off) by buying
stock and selling the option.
14. a. The time to the option's expiration is approximately 8

months (2/3 of a year). If the Treasury bill with a
similar maturity as the option yields 12.6%, then we must
convert that yield to an 8-month return. That is:
(1 + r8 months) = 1.1262/3 = 1.0823
Thus the 8-month Treasury bill yield is 8.23%. With that

information, the present value of the option's exercise
price is:
$55/1.0823 = $50.81
The fair value of the put is then:
Pp = Pc + E/eRT - Ps
= $4.375 + $50.81 - $53
= $2.19
b. The fact that dividends are going to be paid generally

makes the put option more valuable. The discrepancy in
price could well be explained by the present value of the
two dividends expected to be paid prior to the option's
expiration.
15. The stock index option is affected by the diversification

between the securities underlying the index. This
diversification reduces the variability of the index return
relative to a simple weighted average of the variability of
the underlying stocks. With less variability of the
underlying "asset," the stock index option is worth less than
a portfolio of options on the stocks constituting the index.
Chapter 24 Page 151

1. Speculators transact in futures for the sole purpose of making

a profit by buying low and then selling high, or selling high
and then buying low.
Hedgers do not seek to profit directly from their transactions

in futures. Rather, they transact in futures to offset risk
that arises in the ordinary course of their business.
An example of a long hedger is a cereal producer who purchases

wheat for the purpose of processing it into cereal. The
cereal producer buys wheat futures contracts to offset the
risk that wheat prices might rise before the wheat is
delivered and paid for.
An example of a short hedger is a farmer who grows wheat. The

farmer sells wheat futures contracts short to offset the risk
that wheat prices might decline before the wheat is harvested
and delivered to buyers.
2. Each futures exchange has an associated clearinghouse that

becomes the "seller's buyer" and the "buyer's seller" as soon
as a trade is concluded. That is, after each trade, the
clearinghouse steps in to break the trade apart, thereby
acting as the "other side" for both the buyer and seller. In
this way both the buyer and seller can be confident that the
obligations of the other party will be fulfilled.
By acting as an intermediary between buyers and sellers, the

clearinghouse exposes itself to risk if either the buyer or
seller should fail to meet his or her obligations. The
clearing house protects itself from this risk by (1) imposing
initial margin requirements, (2) daily marking buyers' and
sellers' accounts to market, (3) imposing daily maintenance
margin requirements.
3. a. At $1.75 per bushel, the 5,000 bushels that make up each

corn futures contract are worth $8,750. Thus, four
contracts are worth $35,000. With an initial margin
requirement of 3%, Zack must put up initial margin of:
.03 $35,000 = $1,050.
b. The $0.10 increase in September corn prices translates

into an increase in equity of:
4 5,000 bushels $0.10/bushel = $2,000.
Because Zack had initial equity of $1,050, the increase in
Page 152 Chapter 25

September corn prices results in total equity of:
$1,050 + $2,000 = $3,050.
c. The $0.05 decrease in September corn prices translates

into a decrease in equity of:
4 5,000 bushels $0.05/bushel = $1,000.
Because Zack had initial equity of $1,050, the decline in

September corn prices results in total equity of:
$1,050 - $1,000 = $50.
This represents only $50/$1,050 = 4.8% of Zack's initial

margin. Thus Zack has violated the maintenance margin
requirement and will receive a margin call.
4. Forward contracts are very similar to futures contracts. Both

involve the promise to deliver a commodity at a specified
future date for a predetermined price that is payable on
delivery. Essentially, futures contracts are standardized,
exchange-traded forward contracts.
However, unlike forward contracts, futures contracts are

marked to market daily. Furthermore, futures contracts have
standard terms, while forward contracts are negotiated
individually between the two transacting parties.
Additionally, clearinghouses stand between buyers and sellers
of futures contracts. On the other hand, in the case of
forward contracts, the transacting parties basically deal
directly with one another.
5. Price limits do not protect a futures trader from losses.

Instead, they may make it difficult for the trader to realize
such losses if, and when, they occur. If the "true" market
value of a futures position falls below an amount allowed by
the limit move, the holder of the position still has incurred
the loss, but he or she is precluded from realizing it on the
exchange at that time.
6. The futures price should be related to the spot price as

follows:
Pf = Ps + I - B + C
In the case of the mangoes futures contract:
Chapter 25 Page 153

Ps = $2 2,000 = $4,000
I = .02 $4,000 = $80
B = $0
C = $0.10 2,000 = $200 (assuming this payment is made at the

end of the three months so that there are no associated
interest costs)
Thus the price of the futures contract on mangoes should be:
Pf = $4,000 + $80 + $200 = $4,280
7. Futures prices and current spot prices are described by the

following relationship:
Pf = Ps + I - B + C
In Byrd's case:
Ps = $5,000,000
I = .05 5,000,000 = $250,000
B = $300,000/1.05 (discounted value of the loan proceeds)
C = $200,000
Therefore:
Pf = $5,000,000 + $250,000 - $285,714 + $200,000
= $5,164,286
8. Assume that 1.50 DM trade for $1. In that case Tuck's

purchase of the BMW would cost
DM 80,000/1.50 = $53,333.33 at the current exchange rate.
Assume that Tuck can buy an 80,000 German mark futures

contract with delivery six months from today at an exchange
rate of DM 1.43 per dollar. That equates to a dollar
investment of:
DM 80,000/1.43 = $55,944.06
9. If Estel expects the spread in interest rates to narrow, this

implies an expectation of rising long-term bond prices
relative to short-term bond prices. To profit from a
(hopefully) superior forecasting ability, Estel would want to
Page 154 Chapter 25

take a long position in long-term bonds and a short position

in short-term bonds. This could be done by simultaneously
going long a Treasury bond futures contract and short a
Treasury bill futures contract, with both contracts having the
same delivery date.
10. Futures investments do act in a highly leveraged way. For a

relatively small initial investment (that is, the performance
margin), one can control a large futures position.
11. The multiplier on the S&P 500 futures contracts is 250. Thus
the five S&P 500 December futures contracts originally
represent $775,000 in market exposure (310 $250 10). If
the index rises to 318 (an increase of 8) that is a dollar
profit of $20,000 (8 $250 10) on the five contracts.
12. If the common stock portfolio is similar to the underlying

stock index of the futures contract, then movements in both
their values will be highly correlated, facilitating the
hedging process. If the investor has sold short the stock
index futures contract and holds an equivalent dollar amount
in the stock portfolio, then as the futures contract increases
in value the stock portfolio will decline in value by roughly
an equal amount (and the opposite change if the futures
contract decreases in value).
13. a. The theoretical value of a stock index futures contract

is:
Pf = Pc + (i - y) Pc
= 200 + (.06 - .04) 200
= 204.
b. The problems associated with applying this theoretical

value are:
1) Transaction costs hinder the ability of arbitraguers to

drive the futures contract price to its theoretical
value.
2) The timing and amount of dividends paid on stocks in

the index over the period prior to settlement cannot be
precisely known.
3) Short-term interest rates are not fixed over the period

prior to settlement. Because futures positions are
Chapter 25 Page 155

marked to market daily, borrowing/lending to meet

variation margin may be done at different interest
rates.
14. a. Hippo should purchase stock index futures now, thereby

investing the bonus in the market at current prices. When
the bonus check finally arrives, Hippo should liquidate
the futures position and use the proceeds to purchase
individual stocks. In the interim, Hippo is exposed to
market moves just as if Hippo had been able to immediately
use the bonus check to purchase stocks.
b. Hippo should sell short stock index futures now. This

will lock in the current value of the portfolio. Hippo
can then gradually unwind the futures as stocks are sold
from the portfolio. Meanwhile, changes in the market will
not affect Hippo's wealth. Increases (decreases) in the
market's value will decrease (increase) the value of the
short futures position, but at the same time will increase
(decrease) the value of the stock holdings.
c. Hippo should sell short stock index futures now for

delivery next year. Consequently, as described in part
(b), market fluctuations will not affect the portfolio's
value over the intervening period. Next year Hippo can
close out the short futures position and simultaneously
sell the portfolio, realizing the gain in the next tax
year.
15. The fair value of a stock index futures contract is

independent of investors expectations about the future value
of the underlying stock index. Instead the fair value will
depend only upon the current spot price of the index, the
riskfree rate, and the dividend yield on the stocks
constituting the index. If this relationship did not hold,
arbitrageurs would find profit opportunities and eventually
drive prices in line with their fair values.
Page 156 Chapter 25

1. Foreign investors must be concerned about the possibility that

private property is regulated, controlled, or expropriated by
the government to the detriment of corporations in that
country, and hence to investors in those businesses. Foreign
investors must also be concerned about the possibility that
the government might restrict or completely preclude the
payment of dividends and/or interest to foreign investors or
at least the ability to repatriate such earnings. The
domestic investor need be concerned only about the former type
of political risk.
Presumably, security prices take into account political risks

that affect both domestic and foreign investors. However,
prices may not fully reflect political risks that affect only
foreign investors. Rather, prices of stocks in a particular
country may adjust until the optimal portfolio for a domestic
investor includes relatively larger holdings of such stocks
than does the optimal portfolio for a foreign investor.
2. Assume that the exchange rate between U.S. dollars and U.K.
pounds is $1.90 per pound and that the exchange rate between
U.K. pounds and German marks is 0.35 pounds per mark. In this
case 30 translates into $57 (1.90 30) and DM 85.71 (1/.35
30).
3. An investor typically wishes to hedge currency risk to reduce

uncertainty concerning the exchange rate at which his or her
foreign security holdings (or the income from those holdings)
can be converted into the investor's domestic currency.
The primary factors to consider in determining whether to

hedge currency risk are:
- correlations between currencies

- correlations between domestic returns and currency returns
- cost of hedging
- proportion of total portfolio invested in foreign securities
- variability of foreign security returns
- variability of currency returns
4. Smead faces a yen-dollar exchange rate of:
Yen
= 130
Dollar
and a mark-dollar exchange rate of:
Chapter 26 Page 157

Mark
= 190
.
Dollar
Dividing one equation by the other gives the yen-mark exchange

rate of:
Yen
= 68.42
Mark
5. If a U.S. resident expects to be a net buyer (seller) of goods

or services in a foreign country, a futures contract in that
country's currency can be purchased (sold) so that the
exchange rate at which the purchase (sale) of goods or
services will be made is known in advance.
The risk reduction obtained by using currency futures to hedge

future transactions is only effective to the extent that
future cash flows are known. If future cash flows are
uncertain, exchange rate risk cannot be totally eliminated by
buying or selling currency futures.
6. The foreign return on a portfolio of foreign securities is

given by:
rF = rd + rc + rdrc
In Wickey's case:
rF = .08 + .20 + (.08 .20)
= .296 = 29.6%.
7. The return on an investment in this Japanese stock to a

Japanese investor is simply the percentage change in the yen
value of the stock (given the no-dividend assumption). That
is:
rd = (P1 - P0)/P0
= (350 - 280)/280
= .250 = 25.0%
In Tris' case, one must also account for changes in the

exchange rate between yen and dollars over the performance
measurement period. Tris' return is given by:
rF = [(X1 P1) - (X0 P0)]/(X0 P0)
Page 158 Chapter 26

= [($.010/ 350) - ($.008/ 280)]/($.008/ 280)
= .563 = 56.3%
8. The purpose of diversification is to lower the standard

deviation of portfolio returns without necessarily lowering
the portfolio's expected return. We know that, on average,
there is less correlation among returns on securities from
different countries than among returns on securities within a
country. As a result, the standard deviation of portfolio
returns can be reduced even on a well-diversified domestic
portfolio by including an investment in foreign securities.
9. The Canadian economy is tightly intertwined with the U.S.

economy. As a result, the returns offered by the two
countries' stock markets are highly correlated. This high
correlation significantly reduces the diversification benefits
to a U.S. investor buying Canadian stocks.
10. The foreign variance on a portfolio of foreign securities is

given by:
F2 = d2 + c2 + 2 dcd c
In Peek-A-Boo's case:
F2 = (.24) + (.07) + (2)(0.20)(.24)(.07)
= .069
Thus the foreign standard deviation is 26.3% [(.069) = .263].
11. If markets are reasonably efficient and investments are

relatively unimpeded across borders, then investors will act
to arbitrage away significant expected return differences
between investments of similar risk across countries. The only
differences that will remain will be based on interest rate
differentials between countries, which in turn are effectively
a function of expected inflation rate differences. High
inflation countries will have high interest rates and
depreciating currencies relative to low inflation, low
interest rate countries. The depreciation in a currencys
value suffered by foreign investors will offset the domestic
return advantages that those investors expect to earn, making
them no better off than if they held securities of similar
risk in their home countries.
Chapter 26 Page 159

12. Expected foreign and domestic returns are related by the

expression:
rF = rD + rC + rD rC
Interest rate parity implies that the expected return on the

U.S. and U.K. one-year riskfree rates must be equal after
taking into account the effects of expected currency returns.
Thus in the case of U.S. investors:
.06 = r D + .03 + .03 r D
Solving for r D gives:
r D = .029 = 2.9%.
Thus the implied U.K. one-year riskfree rate is 2.9%.
13. The expected foreign return on Lin's Zanistan portfolio is:
rF = rD + rC + rD rC
= .30 + 0 + (.30 0)
= .30 = 30.0%
The foreign variance of Lin's Zanistan portfolio is:
F2 = (.30) + (.10) + (2)(.15)(.30)(.10)
= .109
Thus the foreign standard deviation of Lin's Zanistan

portfolio is .330 [(.109)] or 33.0%.
Given that the U.S. and Zanistan markets are uncorrelated and
are both uncorrelated with the U.S.-Zanistan currency exchange
rate, the problem can be reduced to simply a two-asset
portfolio: an investment in the U.S. market and a foreign
investment in the Zanistan market. Therefore the expected
return is:
r p = (.60 20%) + (.40 30%)
= 24%
Page 160 Chapter 26

The variance is:
p2 = (.60)(.18) + (.40)(.33) + (2)(0)(.18)(.33)
= .029
Therefore:
p = (.029) = .170 = 17.0%
14. For the same reasons that mutual funds that invest in domestic
securities are attractive to a small investor (that is,
economies of scale and professional management), mutual funds
and WEBS investing in foreign securities are similarly
attractive. In addition, there are certain administrative
aspects of foreign investing, particularly repatriation of
foreign income and security sale proceeds as well as custody
of securities, that are not relevant or of major consequence
when investing domestically. These issues are most
efficiently and cost-effectively dealt with by professional
institutional investors, such as mutual funds and WEBS.
15. Low correlation of returns does not necessarily mean that one
should diversify. This is as true when considering investment
among two countries' market indices as it is when considering
investments in two domestic securities. To determine an
appropriate portfolio, one needs to take into account the
expected returns of the two markets and their risks (including
exchange and political risk), as well as the correlation of
returns between the two markets. However, it is true that,
all other things remaining the same, the lower the correlation
of returns between two country's security markets, the more
attractive will be a strategy involving securities from both
countries.
Chapter 26 Page 161

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Fundamentals of Investments, Third Edition

1. Issuers receive the net proceeds of securities sales when

2. The return on an investment, as shown in Equation (1.1) in the

Ending Wealth Beginning Wealth

In the case of Colfax stock:

ROR = ($36 + $3 - $33)/($33)

3. Using the formula for the return on an investment shown above,

a. ($25,000 - $20,000 + $1,000)/($20,000) = .300 = 30.0%

b. ($23,000 - $30,000 + $3,000)/($30,000) = -.133 = -13.3%

c. ($48,000 - $50,000 + $4,000)/($50,000) = .040 = 4.0%

4. Because the U.S. Treasury guarantees the payment of interest

This certain Treasury bill return, however, does not account

5. The average annual return on small stocks during 1976-1995 was

this period was 19.94%.

The average annual return on common stocks during 1976-1995

6. If one assumes that investors dislike risk (a reasonable

7. Examples of non-financial market risk-return trade-offs

8. The statement in the text citing a positive relationship

10. Foreign security returns do not necessarily move in the same

as diversification and can significantly improve the risk

11. Life insurance companies receive cash from individuals in the

Mutual funds receive cash from investors and, in exchange,

Pension funds receive employer (and sometimes employee)

12. The five steps to the investment process are:

Setting investment policy is important because it provides the

program is meeting targeted objectives.

13. Because returns on financial assets are directly related to

14. It is probably not advisable for an elderly person to hold a

15. Many factors could influence an investor's investment policy.

1. a. A market order instructs the broker to buy or sell

b. A limit order instructs the broker to buy or sell at a

c. A stop order instructs the broker to buy or sell at the

2. Lollypop's balance sheet at the time of the margin purchase

Assets Liabilities & Net Worth

3. An investors actual collateral is simply the market value of

a. 200 shrs $40/shr = $8,000

b. 200 shrs $60/shr = $12,000

c. 200 shrs $35/shr = $7,000

4. The minimum collateral required to avoid a margin call in the

Minimum collateral = Loan/(1 maintenance margin requirement)

Min collateral = [(1,000 shrs $60/shr) (1 - .50)]/(1 .70)

With the decline in price to $50/share, Snookers actual

Collateral = 1,000 shrs $50/shr = $50,000

Snookers actual collateral is therefore above the minimum

5. The maximum amount that Lizzie can purchase is found by

Initial Equity = Initial Margin Requirement Purchase Amount

Max Purchase Amount = Initial Equity/Initial Margin Requirement

6. The maintenance margin requirement ensures that an investor

7. Penny's initial investment in South Beloit is $17,500 ($35

ROR = [($20,000 - $17,500) - $1,155]/$7,875

8. Note that the return on an investor's margin purchase can be

a. ROR = {($40 - $30 + $1) - [.13 (1 - .55) $30]}

= ($11 - $1.755)/$16.50 = .560 = 56.0%

b. ROR = {($20 - $30 + $1) - [.13 (1 - .55) $30]}

= ($-9 - $1.755)/$16.50 = -.652 = -65.2%

c. ROR = ($40 - $30 + $1)/$30

= $11/$30 = .367 = 36.7%

ROR = ($20 - $30 + $1)/$30

= $-9/$30 = -.300 = -30.0%

9. Beauty's balance sheet at the time of the short sale would

Assets Liabilities & Net Worth

Equity = (short sale proceeds + initial margin) - loan

Thus for Candy:

a. [(200 shrs $50/shr) (1 + .45)] (200 shrs $58/shr)