Investments BKM - 9e Solutions

Chapter 2 - Asset Classes and Financial Instruments
CHAPTER 2: ASSET CLASSES AND FINANCIAL

INSTRUMENTS
PROBLEM SETS
1. Preferred stock is like long-term debt in that it typically promises a fixed payment
each year. In this ay! it is a perpetuity. Preferred stock is also like long-term
debt in that it does not gi"e the holder "oting rights in the firm.
Preferred stock is like e#uity in that the firm is under no contractual obligation to
make the preferred stock di"idend payments. Failure to make payments does not set
off corporate bankruptcy. $ith respect to the priority of claims to the assets of the
firm in the e"ent of corporate bankruptcy! preferred stock has a higher priority than
common e#uity but a loer priority than bonds.
2. %oney market securities are called &cash e#ui"alents' because of their great
li#uidity. (he prices of money market securities are "ery stable! and they can be
con"erted to cash )i.e.! sold* on "ery short notice and ith "ery lo transaction
costs.
+. )a* A repurchase agreement is an agreement hereby the seller of a security
agrees to &repurchase' it from the buyer on an agreed upon date at an agreed
upon price. ,epos are typically used by securities dealers as a means for
obtaining funds to purchase securities.
-. (he spread ill iden. .eterioration of the economy increases credit risk! that
is! the likelihood of default. In"estors ill demand a greater premium on debt
securities sub/ect to default risk.
0.
Corp. 1onds Preferred 2tock Common 2tock
3oting ,ights )(ypically* 4es
Contractual 5bligation 4es
Perpetual Payments 4es 4es
Accumulated .i"idends 4es
Fixed Payments )(ypically* 4es 4es
Payment Preference First 2econd (hird
6. %unicipal 1ond interest is tax-exempt. $hen facing higher marginal tax rates! a
high-income in"estor ould be more inclined to pick tax-exempt securities.
2-1
7. a. 4ou ould ha"e to pay the asked price of8
9681- : 96.-+70;< of par : =96-.+70
b. (he coupon rate is +.0< implying coupon payments of =+0.;; annually or!
more precisely! =17.0; semiannually.
c. Current yield : Annual coupon income>price
: =+0.;;>=96-.+70 : ;.;-;0 : -.;0<
9. P : =1;!;;;>1.;2 : =?!9;+.?2
?. (he total before-tax income is =-. After the 7;< exclusion for preferred stock
di"idends! the taxable income is8 ;.+; =- : =1.2;
(herefore! taxes are8 ;.+; =1.2; : =;.+6
After-tax income is8 =-.;; @ =;.+6 : =+.6-
,ate of return is8 =+.6->=-;.;; : ?.1;<
1;. a. 4ou could buy8 =0!;;;>=67.+2 : 7-.27 shares
b. 4our annual di"idend income ould be8 7-.27 =1.02 : =112.9?
c. (he price-to-earnings ratio is 11 and the price is =67.+2. (herefore8
=67.+2>Aarnings per share : 11 Aarnings per share : =6.12
d. Beneral .ynamics closed today at =67.+2! hich as =;.-7 higher than
yesterdayCs price. 4esterdayCs closing price as8 =66.90
11. a. At t : ;! the "alue of the index is8 )?; D 0; D 1;;*>+ : 9;
At t : 1! the "alue of the index is8 )?0 D -0 D 11;*>+ : 9+.+++
(he rate of return is8 )9+.+++>9;* 1 : -.17<
b. In the absence of a split! 2tock C ould sell for 11;! so the "alue of the
index ould be8 20;>+ : 9+.+++
After the split! 2tock C sells for 00. (herefore! e need to find the
di"isor )d* such that8 9+.+++ : )?0 D -0 D 00*>d d : 2.+-;
2-2
c. (he return is Eero. (he index remains unchanged because the return for
each stock separately e#uals Eero.
12. a. (otal market "alue at t : ; is8 )=?!;;; D =1;!;;; D =2;!;;;* : =+?!;;;
(otal market "alue at t : 1 is8 )=?!0;; D =?!;;; D =22!;;;* : =-;!0;;
,ate of return : )=-;!0;;>=+?!;;;* @ 1 : +.90<
b. (he return on each stock is as follos8
r
A
: )?0>?;* @ 1 : ;.;006
r
1
: )-0>0;* @ 1 : @;.1;
r
C
: )11;>1;;* @ 1 : ;.1;
(he e#ually-eighted a"erage is8
F;.;006 D )-;.1;* D ;.1;G>+ : ;.;190 : 1.90<
1+. (he after-tax yield on the corporate bonds is8 ;.;? )1 @ ;.+;* : ;.;6+; : 6.+;<
(herefore! municipals must offer at least 6.+;< yields.
1-. A#uation )2.2* shos that the e#ui"alent taxable yield is8 r : r
m
>)1 @ t*
a. -.;;<
b. -.--<
c. 0.;;<
d. 0.71<
10. In an e#ually-eighted index fund! each stock is gi"en e#ual eight regardless of its
market capitaliEation. 2maller cap stocks ill ha"e the same eight as larger cap
stocks. (he challenges are as follos8
Bi"en e#ual eights placed to smaller cap and larger cap! e#ual-
eighted indices )A$I* ill tend to be more "olatile than their market-
capitaliEation counterpartsH
It follos that A$Is are not good reflectors of the broad market hich
they representH A$Is underplay the economic importance of larger
companiesH
(urno"er rates ill tend to be higher! as an A$I must be rebalanced
back to its original target. 1y design! many of the transactions ould be
among the smaller! less-li#uid stocks.
2-+
16. a. (he higher coupon bond.
b. (he call ith the loer exercise price.
c. (he put on the loer priced stock.
17. a. 4ou bought the contract hen the futures price as =+.9+0 )see Figure
2.1;*. (he contract closes at a price of =+.970! hich is =;.;- more than the
original futures price. (he contract multiplier is 0;;;. (herefore! the gain ill
be8 =;.;- 0;;; : =2;;.;;
b. 5pen interest is 177!061 contracts.
19. a. 2ince the stock price exceeds the exercise price! you exercise the call.
(he payoff on the option ill be8 =21.70 =21 : =;.70
(he cost as originally =;.6-! so the profit is8 =;.70 =;.6- : =;.11
b. If the call has an exercise price of =22! you ould not exercise for any stock
price of =22 or less. (he loss on the call ould be the initial cost8 =;.+;
c. 2ince the stock price is less than the exercise price! you ill exercise the put.
(he payoff on the option ill be8 =22 =21.70 : =;.20
(he option originally cost =1.6+ so the profit is8 =;.20 I =1.6+ : I=1.+9
1?. (here is alays a possibility that the option ill be in-the-money at some time prior to
expiration. In"estors ill pay something for this possibility of a positi"e payoff.
2;.
3alue of call at expiration Initial Cost Profit
; - --
; - --
; - --
0 - 1
1; - 6
3alue of put at expiration Initial Cost Profit
1; 6 -
0 6 -1
; 6 -6
; 6 -6
; 6 -6
2--
21. A put option con"eys the right to sell the underlying asset at the exercise price. A
short position in a futures contract carries an obligation to sell the underlying asset
at the futures price.
22. A call option con"eys the right to buy the underlying asset at the exercise price.
A long position in a futures contract carries an obligation to buy the underlying
asset at the futures price.
CFA PROBLEMS
1. )d*
2. (he e#ui"alent taxable yield is8 6.70<>)1 ;.+-* : 1;.2+<
+. )a* $riting a call entails unlimited potential losses as the stock price rises.
-. a. (he taxable bond. $ith a Eero tax bracket! the after-tax yield for the
taxable bond is the same as the before-tax yield )0<*! hich is greater than
the yield on the municipal bond.
b. (he taxable bond. (he after-tax yield for the taxable bond is8
;.0 )1 @ ;.1;* : -.0<
c. 4ou are indifferent. (he after-tax yield for the taxable bond is8
;.;0 )1 @ ;.2;* : -.;<
(he after-tax yield is the same as that of the municipal bond.
d. (he municipal bond offers the higher after-tax yield for in"estors in tax
brackets abo"e 2;<.
0. If the after-tax yields are e#ual! then8 ;.;06 : ;.;9 J )1 @ t*
(his implies that t : ;.+; :+;<.
CHAPTER 3: HOW SECURITIES ARE TRADED
PROBLEM SETS
2-0
1. Ansers to this problem ill "ary.
2. (he dealer sets the bid and asked price. 2preads should be higher on inacti"ely traded
stocks and loer on acti"ely traded stocks.
+. a. In principle! potential losses are unbounded! groing directly ith increases
in the price of I1%.
b. If the stop-buy order can be filled at =129! the maximum possible loss per
share is =9! or =9;; total. If the price of I1% shares goes abo"e =129! then
the stop-buy order ould be executed! limiting the losses from the short sale.
-. )a* A market order is an order to execute the trade immediately at the best
possible price. (he emphasis in a market order is the speed of execution )the
reduction of execution uncertainty*. (he disad"antage of a market order is that
the price it ill be executed at is not knon ahead of timeH it thus has price
uncertainty.
0. )a* (he ad"antage of an Alectronic Crossing Ketork )ACK* is that it can execute
large block orders ithout affecting the public #uote. 2ince this security is
illi#uid! large block orders are less likely to occur and thus it ould not likely
trade through an ACK.
Alectronic Limit-5rder %arkets )AL5%* transact securities ith high trading
"olume. (his illi#uid security is unlikely to be traded on an AL5%.
6. a. (he stock is purchased for8 +;; =-; : =12!;;;
(he amount borroed is =-!;;;. (herefore! the in"estor put up e#uity! or
margin! of =9!;;;.
b. If the share price falls to =+;! then the "alue of the stock falls to =?!;;;. 1y the
end of the year! the amount of the loan oed to the broker gros to8
=-!;;; 1.;9 : =-!+2;
(herefore! the remaining margin in the in"estorCs account is8
=?!;;; =-!+2; : =-!69;
(he percentage margin is no8 =-!69;>=?!;;; : ;.02 : 02<
(herefore! the in"estor ill not recei"e a margin call.
c. (he rate of return on the in"estment o"er the year is8
2-6
)Anding e#uity in the account Initial e#uity*>Initial e#uity
: )=-!69; =9!;;;*>=9!;;; : ;.-10 : -1.0<
7. a. (he initial margin as8 ;.0; 1!;;; =-; : =2;!;;;
As a result of the increase in the stock price 5ld Aconomy (raders loses8
=1; 1!;;; : =1;!;;;
(herefore! margin decreases by =1;!;;;. %oreo"er! 5ld Aconomy (raders
must pay the di"idend of =2 per share to the lender of the shares! so that the
margin in the account decreases by an additional =2!;;;. (herefore! the
remaining margin is8
=2;!;;; @ =1;!;;; @ =2!;;; : =9!;;;
b. (he percentage margin is8 =9!;;;>=0;!;;; : ;.16 : 16<
2o there ill be a margin call.
c. (he e#uity in the account decreased from =2;!;;; to =9!;;; in one year! for a
rate of return of8 )=12!;;;>=2;!;;;* : ;.6; : 6;<
9. a. (he buy order ill be filled at the best limit-sell order price8 =0;.20
b. (he next market buy order ill be filled at the next-best limit-sell
order price8 =01.0;
c. 4ou ould ant to increase your in"entory. (here is considerable buying
demand at prices /ust belo =0;! indicating that donside risk is limited. In
contrast! limit sell orders are sparse! indicating that a moderate buy order could
result in a substantial price increase.
?. a. 4ou buy 2;; shares of (elecom for =1;!;;;. (hese shares increase in "alue by
1;<! or =1!;;;. 4ou pay interest of8 ;.;9 =0!;;; : =-;;
(he rate of return ill be8

=1! ;;; =-;;
;.12 12<
=0! ;;;

b. (he "alue of the 2;; shares is 2;;P. A#uity is )2;;P @ =0!;;;*. 4ou ill
recei"e a margin call hen8
P 2;;
;;; ! 0 = P 2;;
: ;.+; hen P : =+0.71 or loer
2-7
1;. a. Initial margin is 0;< of =0!;;; or =2!0;;.
b. (otal assets are =7!0;; )=0!;;; from the sale of the stock and =2!0;; put up for
margin*. Liabilities are 1;;P. (herefore! e#uity is )=7!0;; @ 1;;P*. A margin
call ill be issued hen8
P 1;;
P 1;; 0;; ! 7 =
: ;.+; hen P : =07.6? or higher
11. (he total cost of the purchase is8 =-; 0;; : =2;!;;;
4ou borro =0!;;; from your broker! and in"est =10!;;; of your on funds.
4our margin account starts out ith e#uity of =10!;;;.
a. )i* A#uity increases to8 )=-- 0;;* @ =0!;;; : =17!;;;
Percentage gain : =2!;;;>=10!;;; : ;.1+++ : 1+.++<
)ii* $ith price unchanged! e#uity is unchanged.
Percentage gain : Eero
)iii* A#uity falls to )=+6 0;;* @ =0!;;; : =1+!;;;
Percentage gain : )@=2!;;;>=10!;;;* : @;.1+++ : @1+.++<
(he relationship beteen the percentage return and the percentage change in
the price of the stock is gi"en by8
< return : < change in price
e#uity initial s In"estorM
in"estment (otal
: < change in price 1.+++
For example! hen the stock price rises from =-; to =--! the percentage change in
price is 1;<! hile the percentage gain for the in"estor is8
< return : 1;<
;;; ! 10 =
;;; ! 2; =
: 1+.++<
b. (he "alue of the 0;; shares is 0;;P. A#uity is )0;;P @ =0!;;;*. 4ou ill
P 0;;
;;; ! 0 = P 0;;
: ;.20 hen P : =1+.++ or loer
c. (he "alue of the 0;; shares is 0;;P. 1ut no you ha"e borroed =1;!;;;
instead of =0!;;;. (herefore! e#uity is )0;;P @ =1;!;;;*. 4ou ill recei"e a
margin call hen8
2-9
P 0;;
;;; ! 1; = P 0;;
: ;.20 hen P : =26.67 or loer
$ith less e#uity in the account! you are far more "ulnerable to a margin call.
d. 1y the end of the year! the amount of the loan oed to the broker gros to8
=0!;;; 1.;9 : =0!-;;
(he e#uity in your account is )0;;P @ =0!-;;*. Initial e#uity as =10!;;;.
(herefore! your rate of return after one year is as follos8
)i*
;;; ! 10 =
;;; ! 10 = -;; ! 0 = * -- = 0;; )
: ;.1;67 : 1;.67<
)ii*
;;; ! 10 =
;;; ! 10 = -;; ! 0 = * -; = 0;; )
: @;.;267 : @2.67<
)iii*
;;; ! 10 =
;;; ! 10 = -;; ! 0 = * +6 = 0;; )
: @;.16;; : @16.;;<
(he relationship beteen the percentage return and the percentage change in
the price of Intel is gi"en by8
< return :
,
_

in"estment (otal
price in change <

,
_

borroed Funds
< 9
For example! hen the stock price rises from =-; to =--! the percentage
change in price is 1;<! hile the percentage gain for the in"estor is8
,
_
;;; ! 10 =
;;; ! 2; =
< 1;
,
_

;;; ! 10 =
;;; ! 0 =
< 9
:1;.67<
e. (he "alue of the 0;; shares is 0;;P. A#uity is )0;;P @ =0!-;;*. 4ou ill
P 0;;
-;; ! 0 = P 0;;
: ;.20 hen P : =1-.-; or loer
12. a. (he gain or loss on the short position is8 )@0;; NP*
In"ested funds : =10!;;;
(herefore8 rate of return : )@0;; NP*>10!;;;
(he rate of return in each of the three scenarios is8
)i* rate of return : )@0;; =-*>=10!;;; : @;.1+++ : @1+.++<
)ii* rate of return : )@0;; =;*>=10!;;; : ;<
)iii* rate of return : F@0;; )@=-*G>=10!;;; : D;.1+++ : D1+.++<
b. (otal assets in the margin account e#ual8
2-?
=2;!;;; )from the sale of the stock* D =10!;;; )the initial margin* : =+0!;;;
Liabilities are 0;;P. 4ou ill recei"e a margin call hen8
P 0;;
P 0;; ;;; ! +0 =
: ;.20 hen P : =06 or higher
c. $ith a =1 di"idend! the short position must no pay on the borroed shares8
)=1>share 0;; shares* : =0;;. ,ate of return is no8
F)@0;; NP* @ 0;;G>10!;;;
)i* rate of return : F)@0;; =-* @ =0;;G>=10!;;; : @;.1667 : @16.67<
)ii* rate of return : F)@0;; =;* @ =0;;G>=10!;;; : @;.;+++ : @+.++<
)iii* rate of return : F)@0;;* )@=-* @ =0;;G>=10!;;; : D;.1;;; : D1;.;;<
(otal assets are =+0!;;;! and liabilities are )0;;P D 0;;*. A margin call ill be
issued hen8
P 0;;
0;; P 0;; ;;; ! +0
: ;.20 hen P : =00.2; or higher
1+. (he broker is instructed to attempt to sell your %arriott stock as soon as the
%arriott stock trades at a bid price of =2; or less. Oere! the broker ill attempt to
execute! but may not be able to sell at =2;! since the bid price is no =1?.?0. (he
price at hich you sell may be more or less than =2; because the stop-loss becomes
a market order to sell at current market prices.
1-. a. =00.0;
b. =00.20
c. (he trade ill not be executed because the bid price is loer than the price
specified in the limit sell order.
d. (he trade ill not be executed because the asked price is greater than the price
specified in the limit buy order.
10. a. In an exchange market! there can be price impro"ement in the to market orders.
1rokers for each of the market orders )i.e.! the buy order and the sell order* can
agree to execute a trade inside the #uoted spread. For example! they can trade at
=00.+7! thus impro"ing the price for both customers by =;.12 or =;.1+ relati"e to
the #uoted bid and asked prices. (he buyer gets the stock for =;.1+ less than the
#uoted asked price! and the seller recei"es =;.12 more for the stock than the
#uoted bid price.
2-1;
b. $hereas the limit order to buy at =00.+7 ould not be executed in a dealer
market )since the asked price is =00.0;*! it could be executed in an exchange
market. A broker for another customer ith an order to sell at market ould
"ie the limit buy order as the best bid priceH the to brokers could agree to the
trade and bring it to the specialist! ho ould then execute the trade.
16. a. 4ou ill not recei"e a margin call. 4ou borroed =2;!;;; and ith another
=2;!;;; of your on e#uity you bought 1!;;; shares of .isney at =-; per
share. At =+0 per share! the market "alue of the stock is =+0!;;;! your e#uity
is =10!;;;! and the percentage margin is8 =10!;;;>=+0!;;; : -2.?<
4our percentage margin exceeds the re#uired maintenance margin.
b. 4ou ill recei"e a margin call hen8
P ;;; ! 1
;;; ! 2; = P ;;; ! 1
: ;.+0 hen P : =+;.77 or loer
17. (he proceeds from the short sale )net of commission* ere8 )=21 1;;* @ =0; :
=2!;0;
A di"idend payment of =2;; as ithdran from the account.
Co"ering the short sale at =10 per share costs )ith commission*8 =1!0;; D =0; :
=1!00;
(herefore! the "alue of your account is e#ual to the net profit on the transaction8
=2!;0; @ =2;; @ =1!00; : =+;;
Kote that your profit )=+;;* e#uals )1;; shares profit per share of =+*. 4our net
proceeds per share as8
=21 selling price of stock
@=10 repurchase price of stock
@= 2 di"idend per share
@= 1 2 trades =;.0; commission per share
= +
CFA PROBLEMS
1. a. In addition to the explicit fees of =7;!;;;! F1K appears to ha"e paid an
implicit price in underpricing of the IP5. (he underpricing is =+ per share! or
a total of =+;;!;;;! implying total costs of =+7;!;;;.
b. Ko. (he underriters do not capture the part of the costs corresponding
to the underpricing. (he underpricing may be a rational marketing
2-11
strategy. $ithout it! the underriters ould need to spend more
resources in order to place the issue ith the public. (he underriters
ould then need to charge higher explicit fees to the issuing firm. (he
issuing firm may be /ust as ell off paying the implicit issuance cost
represented by the underpricing.
2. )d* (he broker ill sell! at current market price! after the first transaction at
=00 or less.
+. )d*
CHAPTER 4: MUTUAL FUNDS AND
OTHER INVESTMENT COMPANIES
PROBLEM SETS
1. (he unit in"estment trust should ha"e loer operating expenses. 1ecause the
in"estment trust portfolio is fixed once the trust is established! it does not ha"e to
pay portfolio managers to constantly monitor and rebalance the portfolio as
percei"ed needs or opportunities change. 1ecause the portfolio is fixed! the unit
in"estment trust also incurs "irtually no trading costs.
2. a. Unit investment trusts8 di"ersification from large-scale in"esting! loer
transaction costs associated ith large-scale trading! lo management fees!
predictable portfolio composition! guaranteed lo portfolio turno"er rate.
b. Open-end mutual funds8 di"ersification from large-scale in"esting! loer
transaction costs associated ith large-scale trading! professional management
that may be able to take ad"antage of buy or sell opportunities as they arise!
record keeping.
c. Individual stocks and bonds8 Ko management fee! realiEation of capital gains
or losses can be coordinated ith in"estorsC personal tax situations! portfolio
can be designed to in"estorCs specific risk profile.
+. 5pen-end funds are obligated to redeem in"estorMs shares at net asset "alue! and
thus must keep cash or cash-e#ui"alent securities on hand in order to meet potential
redemptions. Closed-end funds do not need the cash reser"es because there are no
redemptions for closed-end funds. In"estors in closed-end funds sell their shares
hen they ish to cash out.
2-12
-. 1alanced funds keep relati"ely stable proportions of funds in"ested in each asset
class. (hey are meant as con"enient instruments to pro"ide participation in a range
of asset classes. Life-cycle funds are balanced funds hose asset mix generally
depends on the age of the in"estor. Aggressi"e life-cycle funds! ith larger
in"estments in e#uities! are marketed to younger in"estors! hile conser"ati"e life-
cycle funds! ith larger in"estments in fixed-income securities! are designed for
older in"estors. Asset allocation funds! in contrast! may "ary the proportions
in"ested in each asset class by large amounts as predictions of relati"e performance
across classes "ary. Asset allocation funds therefore engage in more aggressi"e
market timing.
0. Pnlike an open-end fund! in hich underlying shares are redeemed hen the fund
is redeemed! a closed-end fund trades as a security in the market. (hus! their prices
may differ from the KA3.
6. Ad"antages of an A(F o"er a mutual fund8
A(Fs are continuously traded and can be sold or purchased on margin
(here are no Capital Bains (ax triggers hen an A(F is sold )shares are
/ust sold from one in"estor to another*
In"estors buy from 1rokers! thus eliminating the cost of direct marketing
to indi"idual small in"estors. (his implies loer management fees
.isad"antages of an A(F o"er a mutual fund8
Prices can depart from KA3 )unlike an open-end fund*
(here is a 1roker fee hen buying and selling )unlike a no-load fund*
7. (he offering price includes a 6< front-end load! or sales commission! meaning that
e"ery dollar paid results in only =;.?- going toard purchase of shares. (herefore8
5ffering price :
;6 . ; 1
7; . 1; =
load 1
KA3
: =11.+9
9. KA3 : offering price )1 @ load* : =12.+; .?0 : =11.6?
?. 2tock 3alue held by fund
A = 7!;;;!;;;
1 12!;;;!;;;
2-1+
C 9!;;;!;;;
. 10!;;;!;;;
(otal =-2!;;;!;;;
Ket asset "alue :
;;; ! ;;; ! -
;;; ! +; = ;;; ! ;;; ! -2 =
: =1;.-?
1;. 3alue of stocks sold and replaced : =10!;;;!;;;
(urno"er rate :
;;; ! ;;; ! -2 =
;;; ! ;;; ! 10 =
: ;.+07 : +0.7<
11. a.
-; . +? =
;;; ! ;;; ! 0
;;; ! ;;; ! + = ;;; ! ;;; ! 2;; =
KA3
b. Premium )or discount* :

KA3
KA3 ice Pr
:
-; . +? =
-; . +? = +6 =
: @;.;96 : -9.6<
(he fund sells at an 9.6< discount from KA3.
12.
1 ;
;
.istributions =12.1; =12.0; =1.0;
;.;99 9.9<
=12.0;
NAV NAV
NAV
+ +

1+. a. 2tart-of-year price8 P
;
: =12.;; J 1.;2 : =12.2-
And-of-year price8 P
1
: =12.1; J ;.?+ : =11.20
Although KA3 increased by =;.1;! the price of the fund decreased by8 =;.??
,ate of return :
1 ;
;
.istributions =11.20 =12.2- =1.0;
;.;-2 -.2<
=12.2-
P P
P
+ +

b. An in"estor holding the same securities as the fund manager ould ha"e
earned a rate of return based on the increase in the KA3 of the portfolio8
1 ;
;
.istributions =12.1; =12.;; =1.0;
;.1++ 1+.+<
=12.;;
NAV NAV
NAV
+ +

1-. a. Ampirical research indicates that past performance of mutual funds is not
highly predicti"e of future performance! especially for better-performing
funds. $hile there may be some tendency for the fund to be an abo"e a"erage
performer next year! it is unlikely to once again be a top 1;< performer.
2-1-
b. 5n the other hand! the e"idence is more suggesti"e of a tendency for poor
performance to persist. (his tendency is probably related to fund costs and
turno"er rates. (hus if the fund is among the poorest performers! in"estors
ould be concerned that the poor performance ill persist.
10. KA3
;
: =2;;!;;;!;;;>1;!;;;!;;; : =2;
.i"idends per share : =2!;;;!;;;>1;!;;;!;;; : =;.2;
KA3
1
is based on the 9< price gain! less the 1< 12b-1 fee8
KA3
1
: =2; 1.;9 )1 @ ;.;1* : =21.+9-
,ate of return :
2; =
2; . ; = 2; = +9- . 21 = +
: ;.;7?2 : 7.?2<
16. (he excess of purchases o"er sales must be due to ne inflos into the fund.
(herefore! =-;; million of stock pre"iously held by the fund as replaced by ne
holdings. 2o turno"er is8 =-;;>=2!2;; : ;.192 : 19.2<
17. Fees paid to in"estment managers ere8 ;.;;7 =2.2 billion : =10.- million
2ince the total expense ratio as 1.1< and the management fee as ;.7<! e
conclude that ;.-< must be for other expenses. (herefore! other administrati"e
expenses ere8 ;.;;- =2.2 billion : =9.9 million
18. As an initial approximation! your return e#uals the return on the shares minus the
total of the expense ratio and purchase costs8 12< 1.2< -< : 6.9<
1ut the precise return is less than this because the -< load is paid up front! not at
the end of the year.
(o purchase the shares! you ould ha"e had to in"est8 =2;!;;;>)1 ;.;-* : =2;!9++
(he shares increase in "alue from =2;!;;; to8 =2;!;;; )1.12 ;.;12* : =22!16;
(he rate of return is8 )=22!16; =2;!9++*>=2;!9++ : 6.+7<
1?.
Assume $1000 ines!men! Loaded-Pp Fund Aconomy Fund
"e#$%& '$()!* )1 .;1 .;;70* r + ).?9* )1 .;;20* r +
1 "e#$ +, -./ =1!;-2.0; =1!;+6.+0
0 "e#$s +, -./ =1!1++.;; =1!109.?6
10 "e#$s +, -./ =1!016.21 =1!71-.;9
2-10
2;. a.
=-0;! ;;;! ;;; =1;! ;;;;;;
=1;
--! ;;;! ;;;
b. (he redemption of 1 million shares ill most likely trigger capital gains taxes
hich ill loer the remaining portfolio by an amount greater than =1;!;;;!;;;
)implying a remaining total "alue less than =--;!;;;!;;;*. (he outstanding
shares fall to -+ million and the KA3 drops to belo =1;.
21. 2uppose you ha"e =1!;;; to in"est. (he initial in"estment in Class A shares is
=?-; net of the front-end load. After four years! your portfolio ill be orth8
=?-; )1.1;*
-
: =1!+76.20
Class 1 shares allo you to in"est the full =1!;;;! but your in"estment
performance net of 12b-1 fees ill be only ?.0<! and you ill pay a 1< back-
end load fee if you sell after four years. 4our portfolio "alue after four years
ill be8
=1!;;; )1.;?0*
-
: =1!-+7.66
After paying the back-end load fee! your portfolio "alue ill be8
=1!-+7.66 .?? : =1!-2+.29
Class 1 shares are the better choice if your horiEon is four years.
$ith a fifteen-year horiEon! the Class A shares ill be orth8
=?-; )1.1;*
10
: =+!?26.61
For the Class 1 shares! there is no back-end load in this case since the horiEon is
greater than fi"e years. (herefore! the "alue of the Class 1 shares ill be8
=1!;;; )1.;?0*
10
: =+!?;1.+2
At this longer horiEon! Class 1 shares are no longer the better choice. (he effect of
Class 1Ms ;.0< 12b-1 fees accumulates o"er time and finally o"erhelms the 6<
load charged to Class A in"estors.
22. a. After to years! each dollar in"ested in a fund ith a -< load and a portfolio
return e#ual to r ill gro to8 =;.?6 )1 D r @ ;.;;0*
2
Aach dollar in"ested in the bank C. ill gro to8 =1 1.;6
2
If the mutual fund is to be the better in"estment! then the portfolio return )r*
must satisfy8
;.?6 )1 D r @ ;.;;0*
2
Q 1.;6
2
;.?6 )1 D r @ ;.;;0*
2
Q 1.12+6
)1 D r @ ;.;;0*
2
Q 1.17;-
1 D r @ ;.;;0 Q 1.;91?
1 D r Q 1.;96?
(herefore8 r Q ;.;96? : 9.6?<
2-16
b. If you in"est for six years! then the portfolio return must satisfy8
;.?6 )1 D r @ ;.;;0*
6
Q 1.;6
6
: 1.-190
)1 D r @ ;.;;0*
6
Q 1.-776
1 D r @ ;.;;0 Q 1.;672
r Q 7.22<
(he cutoff rate of return is loer for the six-year in"estment because the
&fixed cost' )the one-time front-end load* is spread o"er a greater number of
years.
c. $ith a 12b-1 fee instead of a front-end load! the portfolio must earn a rate of
return )r* that satisfies8
1 D r @ ;.;;0 @ ;.;;70 Q 1.;6
In this case! r must exceed 7.20< regardless of the in"estment horiEon.
2+. (he turno"er rate is 0;<. (his means that! on a"erage! 0;< of the portfolio is sold
and replaced ith other securities each year. (rading costs on the sell orders are
;.-< and the buy orders to replace those securities entail another ;.-< in trading
costs. (otal trading costs ill reduce portfolio returns by8 2 ;.-< ;.0; : ;.-<
2-. For the bond fund! the fraction of portfolio income gi"en up to fees is8
< ; . -
< 6 . ;
: ;.10; : 10.;<
For the e#uity fund! the fraction of in"estment earnings gi"en up to fees is8
< ; . 12
< 6 . ;
: ;.;0; : 0.;<
Fees are a much higher fraction of expected earnings for the bond fund! and
therefore may be a more important factor in selecting the bond fund.
(his may help to explain hy unmanaged unit in"estment trusts are concentrated in
the fixed income market. (he ad"antages of unit in"estment trusts are lo
turno"er! lo trading costs and lo management fees. (his is a more important
concern to bond-market in"estors.
20. 2uppose that finishing in the top half of all portfolio managers is purely luck! and
that the probability of doing so in any year is exactly R. (hen the probability that
any particular manager ould finish in the top half of the sample fi"e years in a ro
is )R*
0
: 1>+2. $e ould then expect to find that F+0; )1>+2*G : 11 managers
2-17
finish in the top half for each of the fi"e consecuti"e years. (his is precisely hat
e found. (hus! e should not conclude that the consistent performance after fi"e
years is proof of skill. $e ould expect to find ele"en managers exhibiting
precisely this le"el of SconsistencyS e"en if performance is due solely to luck.
CHAPTER 1: INTRODUCTION TO RIS23 RETURN3 AND
THE HISTORICAL RECORD
PROBLEM SETS
1. (he Fisher e#uation predicts that the nominal rate ill e#ual the e#uilibrium real
rate plus the expected inflation rate. Oence! if the inflation rate increases from +<
to 0< hile there is no change in the real rate! then the nominal rate ill increase
by 2<. 5n the other hand! it is possible that an increase in the expected inflation
rate ould be accompanied by a change in the real rate of interest. $hile it is
concei"able that the nominal interest rate could remain constant as the inflation rate
increased! implying that the real rate decreased as inflation increased! this is not a
likely scenario.
2. If e assume that the distribution of returns remains reasonably stable o"er the
entire history! then a longer sample period )i.e.! a larger sample* increases the
precision of the estimate of the expected rate of returnH this is a conse#uence of the
fact that the standard error decreases as the sample siEe increases. Ooe"er! if e
assume that the mean of the distribution of returns is changing o"er time but e are
not in a position to determine the nature of this change! then the expected return
must be estimated from a more recent part of the historical period. In this scenario!
e must determine ho far back! historically! to go in selecting the rele"ant sample.
Oere! it is likely to be disad"antageous to use the entire dataset back to 199;.
+. (he true statements are )c* and )e*. (he explanations follo.
2tatement )c*8 Let
: the annual standard de"iation of the risky in"estments and

1
: the standard de"iation of the first in"estment alternati"e o"er the to-year
period. (hen8
2
1
(herefore! the annualiEed standard de"iation for the first in"estment alternati"e is
e#ual to8

<
2
2
1
2-19
2tatement )e*8 (he first in"estment alternati"e is more attracti"e to in"estors ith
loer degrees of risk a"ersion. (he first alternati"e )entailing a se#uence of to
identically distributed and uncorrelated risky in"estments* is riskier than the second
alternati"e )the risky in"estment folloed by a risk-free in"estment*. (herefore! the
first alternati"e is more attracti"e to in"estors ith loer degrees of risk a"ersion.
Kotice! hoe"er! that if you mistakenly belie"ed that Ttime di"ersificationC can
reduce the total risk of a se#uence of risky in"estments! you ould ha"e been
tempted to conclude that the first alternati"e is less risky and therefore more
attracti"e to more risk-a"erse in"estors. (his is clearly not the caseH the to-year
standard de"iation of the first alternati"e is greater than the to-year standard
de"iation of the second alternati"e.
-. For the money market fund! your holding period return for the next year depends on
the le"el of +;-day interest rates each month hen the fund rolls o"er maturing
securities. (he one-year sa"ings deposit offers a 7.0< holding period return for the
year. If you forecast that the rate on money market instruments ill increase
significantly abo"e the current 6< yield! then the money market fund might result
in a higher OP, than the sa"ings deposit. (he 2;-year (reasury bond offers a yield
to maturity of ?< per year! hich is 10; basis points higher than the rate on the
one-year sa"ings depositH hoe"er! you could earn a one-year OP, much less than
7.0< on the bond if long-term interest rates increase during the year. If (reasury
bond yields rise abo"e ?<! then the price of the bond ill fall! and the resulting
capital loss ill ipe out some or all of the ?< return you ould ha"e earned if
bond yields had remained unchanged o"er the course of the year.
0. a. If businesses reduce their capital spending! then they are likely
to decrease their demand for funds. (his ill shift the demand cur"e in
Figure 0.1 to the left and reduce the e#uilibrium real rate of interest.
b. Increased household sa"ing ill shift the supply of funds cur"e to the right and
cause real interest rates to fall.
c. 5pen market purchases of P.2. (reasury securities by the Federal ,eser"e
1oard are e#ui"alent to an increase in the supply of funds )a shift of the
supply cur"e to the right*. (he e#uilibrium real rate of interest ill fall.
6. a. (he &Inflation-Plus' C. is the safer in"estment because it guarantees the
purchasing poer of the in"estment. Psing the approximation that the real rate
e#uals the nominal rate minus the inflation rate! the C. pro"ides a real rate of
1.0< regardless of the inflation rate.
b. (he expected return depends on the expected rate of inflation o"er the next year. If
the expected rate of inflation is less than +.0< then the con"entional C. offers a
higher real return than the Inflation-Plus C.H if the expected rate of inflation is
greater than +.0<! then the opposite is true.
2-1?
c. If you expect the rate of inflation to be +< o"er the next year! then the
con"entional C. offers you an expected real rate of return of 2<! hich is ;.0<
higher than the real rate on the inflation-protected C.. 1ut unless you kno that
inflation ill be +< ith certainty! the con"entional C. is also riskier. (he
#uestion of hich is the better in"estment then depends on your attitude toards
risk "ersus return. 4ou might choose to di"ersify and in"est part of your funds in
each.
d. Ko. $e cannot assume that the entire difference beteen the risk-free nominal
rate )on con"entional C.s* of 0< and the real risk-free rate )on inflation-protected
C.s* of 1.0< is the expected rate of inflation. Part of the difference is probably a
risk premium associated ith the uncertainty surrounding the real rate of return on
the con"entional C.s. (his implies that the expected rate of inflation is less than
+.0< per year.
7. A)r* : F;.+0 J --.0<G D F;.+; J 1-.;<G D F;.+0 J )@16.0<*G : 1-<
2
: F;.+0 J )--.0 @ 1-*
2
G D F;.+; J )1- @ 1-*
2
G D F;.+0 J )@16.0 @ 1-*
2
G : 601.170
: 20.02<
(he mean is unchanged! but the standard de"iation has increased! as the
probabilities of the high and lo returns ha"e increased.
9. Probability distribution of price and one-year holding period return for a +;-year
P.2. (reasury bond )hich ill ha"e 2? years to maturity at yearCs end*8
Aconomy Probability 4(% Price Capital Bain
Coupon
Interest
OP,
1oom ;.2; 11.;< = 7-.;0 =20.?0 =9.;; 17.?0<
Kormal Broth ;.0; 9.;< =1;;.;; = ;.;; =9.;; 9.;;<
,ecession ;.+; 7.;< =112.29 =12.29 =9.;; 2;.29<
?. A)#* : ); J ;.20* D )1 J ;.20* D )2 J ;.0;* : 1.20
U
#
: F;.20 J ); @ 1.20*
2
D ;.20 J )1 @ 1.20*
2
D ;.0; J )2 @ 1.20*
2
G
1>2
: ;.92?2
1;. )a* $ith probability ;.?0--! the "alue of a normally distributed "ariable
ill fall ithin to standard de"iations of the meanH that is! beteen @-;<
and 9;<.
11. From (able 0.+ and Figure 0.6! the a"erage risk premium for the period 1?26-2;;?
as8 )11.6+< +.71<* : 7.?2< per year
Adding 7.?2< to the +< risk-free interest rate! the expected annual OP, for the
2VP 0;; stock portfolio is8 +.;;< D 7.?2< : 1;.?2<
2-2;
12. (he a"erage rates of return and standard de"iations are #uite different in the sub
periods8
2(5CW2
%
e
a
n
2
ta
n
d
a
r
d
.
e
"
ia
ti
o
n
2
k
e
n
e
s
s
W
u
rt
o
si
s
1?2
6 @
2;;
0
1
2
.
1
0
<
2
;
.
2
6
<
-
;
.
+
6
;
0
-
;
.
;
6
7
+
1?7
6 @
2;;
0
1
+
.
9
0
<
1
0
.
6
9
<
-
;
.
-
0
7
0
-
;
.
6
-
9
?
1?2
6 @
1?-
1
6
.
+
?
<
+
;
.
+
+
<
-
;
.
;
;
2
2
-
1
.
;
7
1
6
15K.2
%
e
a
2
ta
n
2
k
e
W
u
rt
2-21
n
d
a
r
d
.
e
"
ia
ti
o
n
n
e
s
s
o
si
s
1?2
6 @
2;;
0
0
.
6
9
<
9
.
;
?
<
;
.
?
?
;
+
1
.
6
+
1
-
1?7
6 @
2;;
0
?
.
0
7
<
1
;
.
+
2
<
;
.
+
7
7
2
-
;
.
;
+
2
?
1?2
6 @
1?-
1
-
.
-
2
<
-
.
+
2
<
-
;
.
0
;
+
6
;
.
0
;
+
-
(he most rele"ant statistics to use for pro/ecting into the future ould seem to be
the statistics estimated o"er the period 1?76-2;;0! because this later period seems
to ha"e been a different economic regime. After 1?00! the P.2. economy entered
the Weynesian era! hen the Federal go"ernment acti"ely attempted to stabiliEe the
economy and to pre"ent extremes in boom and bust cycles. Kote that the standard
de"iation of stock returns has decreased substantially in the later period hile the
standard de"iation of bond returns has increased.
1+. a
< 99 . 0 ;099 . ;
7; . 1
7; . ; 9; . ;
i 1
i ,
1
i 1
, 1
r

+
+
b. r , i : 9;< 7;< : 1;<

2-22
Clearly! the approximation gi"es a real OP, that is too high.
2-2+
1-. From (able 0.2! the a"erage real rate on (-bills has been8 ;.7;<
a. (-bills8 ;.72< real rate D +< inflation : +.7;<
b. Axpected return on large stocks8
+.7;< (-bill rate D 9.-;< historical risk premium : 12.1;<
c. (he risk premium on stocks remains unchanged. A premium! the difference
beteen to rates! is a real "alue! unaffected by inflation.
10. ,eal interest rates are expected to rise. (he in"estment acti"ity ill shift the
demand for funds cur"e )in Figure 0.1* to the right. (herefore the e#uilibrium
real interest rate ill increase.
16. a. Probability .istribution of the OP, on the 2tock %arket and Put8
2(5CW PP(
2tate of the
Aconomy
Probability
Anding Price
D .i"idend
OP,
Anding
3alue
OP,
Axcellent ;.20 = 1+1.;; +1.;;< = ;.;; 1;;<
Bood ;.-0 = 11-.;; 1-.;;< = ;.;; 1;;<
Poor ;.20 = ?+.20 I6.70< = 2;.20 69.70<
Crash ;.;0 = -9.;; 02.;;< = 6-.;; -++.++<
,emember that the cost of the index fund is =1;; per share! and the cost of the
put option is =12.
b. (he cost of one share of the index fund plus a put option is =112. (he
probability distribution of the OP, on the portfolio is8
2tate of the
Aconomy
Probability
Anding Price
D Put D
.i"idend
OP,
Axcellent ;.20 = 1+1.;; 17.;< : )1+1 112*>112
Bood ;.-0 = 11-.;; 1.9< : )11- 112*>112
Poor ;.20 = 11+.0; 1.+< : )11+.0; 112*>112
Crash ;.;0 = 112.;; ;.;< : )112 112*>112
c. 1uying the put option guarantees the in"estor a minimum OP, of ;.;<
regardless of hat happens to the stockMs price. (hus! it offers insurance
against a price decline.
2-2-
17. (he probability distribution of the dollar return on C. plus call option is8
2tate of the
Aconomy
Probability
Anding 3alue
of C.
Anding 3alue
of Call
Combined
3alue
Axcellent ;.20 = 11-.;; =16.0; =1+;.0;
Bood ;.-0 = 11-.;; = ;.;; =11-.;;
Poor ;.20 = 11-.;; = ;.;; =11-.;;
Crash ;.;0 = 11-.;; = ;.;; =11-.;;
CFA PROBLEMS
1. (he expected dollar return on the in"estment in e#uities is =19!;;; compared to the =0!;;;
expected return for (-bills. (herefore! the expected risk premium is =1+!;;;.
2. A)r* : F;.2 J )I20<*G D F;.+ J 1;<G D F;.0 J 2-<G :1;<
+. A)rX* : F;.2 J )I2;<*G D F;.0 J 19<G D F;.+ J 0;<G :2;<
A)r4* : F;.2 J )I10<*G D F;.0 J 2;<G D F;.+ J 1;<G :1;<
-. X
2
: F;.2 J )@ 2; @ 2;*
2
G D F;.0 J )19 @ 2;*
2
G D F;.+ J )0; @ 2;*
2
G : 0?2
X : 2-.++<
4
2
: F;.2 J )@ 10 @ 1;*
2
G D F;.0 J )2; @ 1;*
2
G D F;.+ J )1; @ 1;*
2
G : 170
4 : 1+.2+<
0. A)r* : );.? J 2;<* D );.1 J 1;<* :1?< =1!?;; in returns
6. (he probability that the economy ill be neutral is ;.0;! or 0;<. Given a neutral
economy! the stock ill experience poor performance +;< of the time. (he
probability of both poor stock performance and a neutral economy is therefore8
;.+; J ;.0; : ;.10 : 10<
7. A)r* : );.1 J 10<* D );.6 J 1+<* D );.+ J 7<* : 11.-<
CHAPTER -: RIS2 AVERSION AND
CAPITAL ALLOCATION TO RIS2" ASSETS
2-20
PROBLEM SETS
1. )e*
2. )b* A higher borroing rate is a conse#uence of the risk of the borroersC default.
In perfect markets ith no additional cost of default! this increment ould e#ual the
"alue of the borroerCs option to default! and the 2harpe measure! ith appropriate
treatment of the default option! ould be the same. Ooe"er! in reality there are
costs to default so that this part of the increment loers the 2harpe ratio. Also!
notice that anser )c* is not correct because doubling the expected return ith a
fixed risk-free rate ill more than double the risk premium and the 2harpe ratio.
+. Assuming no change in risk tolerance! that is! an unchanged risk a"ersion
coefficient )A*! then higher percei"ed "olatility increases the denominator of the
e#uation for the optimal in"estment in the risky portfolio )A#uation 6.7*. (he
proportion in"ested in the risky portfolio ill therefore decrease.
-. a. (he expected cash flo is8 );.0 J =7;!;;;* D );.0 J 2;;!;;;* : =1+0!;;;
$ith a risk premium of 9< o"er the risk-free rate of 6<! the re#uired rate of
return is 1-<. (herefore! the present "alue of the portfolio is8
=1+0!;;;>1.1- : =119!-21
b. If the portfolio is purchased for =119!-21! and pro"ides an expected cash inflo
of =1+0!;;;! then the expected rate of return FA)r*G is as follos8
=119!-21 J F1 D A)r*G : =1+0!;;;
(herefore! A)r* : 1-<. (he portfolio price is set to e#uate the expected rate
of return ith the re#uired rate of return.
c. If the risk premium o"er (-bills is no 12<! then the re#uired return is8
6< D 12< : 19<
(he present "alue of the portfolio is no8
=1+0!;;;>1.19 : =11-!-;7
d. For a gi"en expected cash flo! portfolios that command greater risk premia
must sell at loer prices. (he extra discount from expected "alue is a
penalty for risk.
0. $hen e specify utility by P : A)r* @ ;.0AU
Y2
! the utility le"el for (-bills is8 ;.;7
(he utility le"el for the risky portfolio is8
2-26
P : ;.12 @ ;.0 J A J );.19*
2
: ;.12 @ ;.;162 J A
In order for the risky portfolio to be preferred to bills! the folloing must hold8
;.12 @ ;.;162A Q ;.;7 A Z ;.;0>;.;162 : +.;?
A must be less than +.;? for the risky portfolio to be preferred to bills.
6. Points on the cur"e are deri"ed by sol"ing for A)r* in the folloing e#uation8
P : ;.;0 : A)r* @ ;.0AU
Y2
: A)r* @ 1.0U
Y2
Y
(he "alues of A)r*! gi"en the "alues of U
Y2
! are therefore8

2
A)r*
;.;; ;.;;;; ;.;0;;;
;.;0 ;.;;20 ;.;0+70
;.1; ;.;1;; ;.;60;;
;.10 ;.;220 ;.;9+70
;.2; ;.;-;; ;.11;;;
;.20 ;.;620 ;.1-+70
(he bold line in the graph on the next page )labeled [6! for [uestion 6* depicts the
indifference cur"e.
7. ,epeating the analysis in Problem 6! utility is no8
P : A)r* @ ;.0AU
Y2
: A)r* @ 2.;U
Y2
: ;.;0
(he e#ual-utility combinations of expected return and standard de"iation are
presented in the table belo. (he indifference cur"e is the upard sloping line in
the graph on the next page! labeled [7 )for [uestion 7*.

2
A)r*
;.;; ;.;;;; ;.;0;;
;.;0 ;.;;20 ;.;00;
;.1; ;.;1;; ;.;7;;
;.10 ;.;220 ;.;?0;
;.2; ;.;-;; ;.1+;;
;.20 ;.;620 ;.170;
(he indifference cur"e in Problem 7 differs from that in Problem 6 in slope.
$hen A increases from + to -! the increased risk a"ersion results in a greater
slope for the indifference cur"e since more expected return is needed in order to
compensate for additional U.
2-27

E(r)
5
U(Q6,A=3)
U(Q7,A=4)
U(Q8,A=0)
U(Q9,A<0)
9. (he coefficient of risk a"ersion for a risk neutral in"estor is Eero. (herefore! the
corresponding utility is e#ual to the portfolioCs expected return. (he corresponding
indifference cur"e in the expected return-standard de"iation plane is a horiEontal
line! labeled [9 in the graph abo"e )see Problem 6*.
?. A risk lo"er! rather than penaliEing portfolio utility to account for risk! deri"es
greater utility as "ariance increases. (his amounts to a negati"e coefficient of risk
a"ersion. (he corresponding indifference cur"e is donard sloping in the graph
abo"e )see Problem 6*! and is labeled [?.
1;. (he portfolio expected return and "ariance are computed as follos8
)1*
$
1ills
)2*
r
1ills
)+*
$
Index
)-*
r
Index
r
Portfolio
)1*J)2*D)+*J)-*

Portfolio
)+* J 2;<

2
Portfolio
;.; 0< 1.; 1+.;< 1+.;< : ;.1+; 2;< : ;.2; ;.;-;;
;.2 0< ;.9 1+.;< 11.-< : ;.11- 16< : ;.16 ;.;206
;.- 0< ;.6 1+.;< ?.9< : ;.;?9 12< : ;.12 ;.;1--
;.6 0< ;.- 1+.;< 9.2< : ;.;92 9< : ;.;9 ;.;;6-
;.9 0< ;.2 1+.;< 6.6< : ;.;66 -< : ;.;- ;.;;16
1.; 0< ;.; 1+.;< 0.;< : ;.;0; ;< : ;.;; ;.;;;;
2-29
11. Computing utility from P : A)r* @ ;.0 J AU
Y2
: A)r* @ U
Y2
! e arri"e at the "alues in
the column labeled P)A : 2* in the folloing table8
$
1ills
$
Index
r
Portfolio
Portfolio

2
Portfolio
P)A : 2* P)A : +*
;.; 1.; ;.1+; ;.2; ;.;-;; ;.;?;; .;7;;
;.2 ;.9 ;.11- ;.16 ;.;206 ;.;99- .;706
;.- ;.6 ;.;?9 ;.12 ;.;1-- ;.;9+6 .;76-
;.6 ;.- ;.;92 ;.;9 ;.;;6- ;.;706 .;72-
;.9 ;.2 ;.;66 ;.;- ;.;;16 ;.;6-- .;6+6
1.; ;.; ;.;0; ;.;; ;.;;;; ;.;0;; .;0;;
(he column labeled P)A : 2* implies that in"estors ith A : 2 prefer a portfolio
that is in"ested 1;;< in the market index to any of the other portfolios in the table.
12. (he column labeled P)A : +* in the table abo"e is computed from8
P : A)r* @ ;.0AU
Y2
: A)r* @ 1.0U
Y2
(he more risk a"erse in"estors prefer the portfolio that is in"ested -;< in the
market! rather than the 1;;< market eight preferred by in"estors ith A : 2.
1+. Axpected return : );.7 J 19<* D );.+ J 9<* : 10<
2tandard de"iation : ;.7 J 29< : 1?.6<
1-. In"estment proportions8 +;.;< in (-bills
;.7 J 20< : 17.0< in 2tock A
;.7 J +2< : 22.-< in 2tock 1
;.7 J -+< : +;.1< in 2tock C
10. 4our reard-to-"olatility ratio8
.19 .;9
;.+071
.29

ClientMs reard-to-"olatility ratio8
.10 .;9
;.+071
.1?6

16.
2-2?

Client
P
0
5
10
15
20
25
30
0 10 20 30 40
(%)
E(r)
%
CAL (Sloe = 0!3571)
17. a. A)r
C
* : r
f
D y J FA)r
P
* @ r
f
G : 9 D y J )19 9*
If the expected return for the portfolio is 16<! then8
16< : 9< D 1;< J y
.16 .;9
;.9
.1;
y

(herefore! in order to ha"e a portfolio ith expected rate of return e#ual to
16<! the client must in"est 9;< of total funds in the risky portfolio and 2;<
in (-bills.
b.
ClientCs in"estment proportions8 2;.;< in (-bills
;.9 J 20< : 2;.;< in 2tock A
;.9 J +2< : 20.6< in 2tock 1
;.9 J -+< : +-.-< in 2tock C
c. U
C
: ;.9 J U
P
: ;.9 J 29< : 22.-<
19. a. U
C
: y J 29<
If your client prefers a standard de"iation of at most 19<! then8
y : 19>29 : ;.6-2? : 6-.2?< in"ested in the risky portfolio
b.
) * .;9 .1 .;9 );.6-2? .1* 1-.-2?<
!
" r y + +
2-+;
1?. a. y\
;.+6--
;.27--
;.1;
;.29 +.0
;.;9 ;.19
AU
r * A)r
2 2
P
f P

(herefore! the clientCs optimal proportions are8 +6.--< in"ested in the risky
portfolio and 6+.06< in"ested in (-bills.
b. A)r
C
* : 9 D 1; J y\ : 9 D );.+6-- J 1;* : 11.6--<
C
: ;.+6-- J 29 : 1;.2;+<
2;. a. If the period 1?26 - 2;;? is assumed to be representati"e of future expected
performance! then e use the folloing data to compute the fraction allocated
to e#uity8 A : -! A)r
%
* I r
f
: 7.?+<! U
%
: 2;.91< )e use the standard
de"iation of the risk premium from (able 6.7*. (hen y
\
is gi"en by8
% f
2 2
%
A)r * r ;.;7?+
y\ ;.-079
AU - ;.2;91
(hat is! -0.79< of the portfolio should be allocated to e#uity and 0-.22<
should be allocated to (-bills.
b. If the period 1?69 - 1?99 is assumed to be representati"e of future expected
performance! then e use the folloing data to compute the fraction allocated
to e#uity8 A : -! A)r
%
* I r
f
: +.--<! U
%
: 16.71< and y\ is gi"en by8
% f
2 2
%
A)r * r ;.;+--
y\ ;.+;9;
AU - ;.1671
(herefore! +;.9;< of the complete portfolio should be allocated to e#uity and

6?.2;< should be allocated to (-bills.
c. In part )b*! the market risk premium is expected to be loer than in part )a*
and market risk is higher. (herefore! the reard-to-"olatility ratio is
expected to be loer in part )b*! hich explains the greater proportion
in"ested in (-bills.
21. a. A)r
C
* : 9< : 0< D y J )11< @ 0<*
.;9 .;0
;.0
.11 .;0
y

b. U
C
: y J U
P
: ;.0; J 10< : 7.0<
c. (he first client is more risk a"erse! alloing a smaller standard de"iation.
2-+1
22. ]ohnson re#uests the portfolio standard de"iation to e#ual one half the market
portfolio standard de"iation. (he market portfolio
2;<
#

hich implies
1;<
P

. (he intercept of the C%L e#uals
;.;0
f
r
and the slope of the C%L
e#uals the 2harpe ratio for the market portfolio )+0<*. (herefore using the C%L8
) *
) * ;.;0 ;.+0 ;.1; ;.;90 9.0<
# f
P f P
#
" r r
" r r
+ +
2+. .ata8 r
f
: 0<! A)r
%
* : 1+<! U
%
: 20<! and
1
f
r : ?<
(he C%L and indifference cur"es are as follos8

2-. For y to be less than 1.; )that the in"estor is a lender*! risk a"ersion )A* must be
large enough such that8
1
AU
r * A)r
y
2
%
f %
<
1.29
;.20
;.;0 ;.1+
A
2

>
For y to be greater than 1 )the in"estor is a borroer*! A must be small enough8
1
AU
r * A)r
y
2
%
f %
>
;.6-
;.20
;.;? ;.1+
A
2

<
For "alues of risk a"ersion ithin this range! the client ill neither borro nor
lend! but ill hold a portfolio comprised only of the optimal risky portfolio8
y : 1 for ;.6- ^ A ^ 1.29
20. a. (he graph for Problem 2+ has to be redran here! ith8
A)r
P
* : 11< and U
P
: 10<

b. For a lending position8 2.67
;.10
;.;0 ;.11
A
2

>
For a borroing position8 ;.9?
;.10
;.;? ;.11
A
2

<
(herefore! y : 1 for ;.9? ^ A ^ 2.67
2-+2
26. (he maximum feasible fee! denoted f! depends on the reard-to-"ariability ratio.
For y Z 1! the lending rate! 0<! is "ieed as the rele"ant risk-free rate! and e sol"e
for f as follos8
.11 .;0 .1+ .;0
.10 .20
f

.10 .;9
.;6 .;12 1.2<
.20
f

For y Q 1! the borroing rate! ?<! is the rele"ant risk-free rate. (hen e notice
that! e"en ithout a fee! the acti"e fund is inferior to the passi"e fund because8
_
%ore risk tolerant in"estors )ho are more inclined to borro* ill not be clients of
the fund. $e find that f is negati"e8 that is! you ould need to pay in"estors to
choose your acti"e fund. (hese in"estors desire higher risk-higher return complete
portfolios and thus are in the borroing range of the rele"ant CAL. In this range!
the reard-to-"ariability ratio of the index )the passi"e fund* is better than that of
the managed fund.
27. a. 2lope of the C%L
.1+ .;9
;.2;
.20

(he diagram follos.

CML and CAL
0
2
4
6
8
10
12
14
16
18
0 10 20 30
Standard Deviation
E
x
p
e
c
t
e
d

R
e
t
r
u
n

CAL" Sloe = 0!3571
C#L" Sloe = 0!20
b. %y fund allos an in"estor to achie"e a higher mean for any gi"en standard de"iation than
ould a passi"e strategy! i.e.! a higher expected return for any gi"en le"el of risk.
29. a. $ith 7;< of his money in"ested in my fundCs portfolio! the clientCs expected
return is 10< per year and standard de"iation is 1?.6< per year. If he shifts
that money to the passi"e portfolio )hich has an expected return of 1+< and
standard de"iation of 20<*! his o"erall expected return becomes8
A)r
C
* : r
f
D ;.7 J FA)r
%
* I r
f
G : .;9 D F;.7 J ).1+ @ .;9*G : .110 : 11.0<
2-++
(he standard de"iation of the complete portfolio using the passi"e portfolio
ould be8
U
C
: ;.7 J U
%
: ;.7 J 20< : 17.0<
(herefore! the shift entails a decrease in mean from 10< to 11.0< and a
decrease in standard de"iation from 1?.6< to 17.0<. 2ince both mean return
and standard de"iation decrease! it is not yet clear hether the mo"e is
2-+-
beneficial. (he disad"antage of the shift is that! if the client is illing to
accept a mean return on his total portfolio of 11.0<! he can achie"e it ith a
loer standard de"iation using my fund rather than the passi"e portfolio.
(o achie"e a target mean of 11.0<! e first rite the mean of the complete
portfolio as a function of the proportion in"ested in my fund )y*8
A)r
C
* : .;9 D y J ).19 I .;9* : .;9 D .1; J y
5ur target is8 A)r
C
* : 11.0<. (herefore! the proportion that must be in"ested
in my fund is determined as follos8
.110 : .;9 D .1; J y
.110 .;9
;.+0
.1;
y

(he standard de"iation of this portfolio ould be8
U
C
: y J 29< : ;.+0 J 29< : ?.9<
(hus! by using my portfolio! the same 11.0< expected return can be achie"ed
ith a standard de"iation of only ?.9< as opposed to the standard de"iation of
17.0< using the passi"e portfolio.
b. (he fee ould reduce the reard-to-"olatility ratio! i.e.! the slope of the CAL.
(he client ill be indifferent beteen my fund and the passi"e portfolio if the
slope of the after-fee CAL and the C%L are e#ual. Let f denote the fee8
2lope of CAL ith fee
.19 .;9 .1;
.29 .29
f f

2lope of C%L )hich re#uires no fee*
.1+ .;9
;.2;
.20

2etting these slopes e#ual e ha"e8
.1;
;.2; ;.;-- -.-<
.29
f
f
per year
2?. a. (he formula for the optimal proportion to in"est in the passi"e portfolio is8
2
%
f %
AU
r * A)r
y\

2ubstitute the folloing8 A)r

%
* : 1+<H r
f

: 9<H U
%
: 20<H A : +.08
2
;.1+ ;.;9
y\ ;.2296 : 22.96< in the passi"e portfolio
+.0 ;.20
2-+0
b. (he anser here is the same as the anser to Problem 29)b*. (he fee that you
can charge a client is the same regardless of the asset allocation mix of the
clientCs portfolio. 4ou can charge a fee that ill e#uate the reard-to-
"olatility ratio of your portfolio to that of your competition.
CFA PROBLEMS
1. Ptility for each in"estment : A)r* @ ;.0 J - J U
2
$e choose the in"estment ith the highest utility "alue! In"estment +.
In"estment
Axpected
return
A)r*
2tandard
de"iation
Ptility
P
1 ;.12 ;.+; -;.;6;;
2 ;.10 ;.0; -;.+0;;
+ ;.21 ;.16 ;.1099
- ;.2- ;.21 ;.1019
2. $hen in"estors are risk neutral! then A : ;H the in"estment ith the highest utility
is In"estment - because it has the highest expected return.
+. )b*
-. Indifference cur"e 2
0. Point A
6. );.6 J =0;!;;;* D F;.- J )=+;!;;;*G =0!;;; : =1+!;;;
7. )b*
9. Axpected return for e#uity fund : (-bill rate D risk premium : 6< D 1;< : 16<
Axpected rate of return of the clientCs portfolio : );.6 J 16<* D );.- J 6<* : 12<
Axpected return of the clientCs portfolio : ;.12 J =1;;!;;; : =12!;;;
)hich implies expected total ealth at the end of the period : =112!;;;*
2tandard de"iation of clientCs o"erall portfolio : ;.6 J 1-< : 9.-<
?. ,eard-to-"olatility ratio :
.1;
;.71
.1-

2-+6
CHAPTER -: APPENDI4
1. 1y year end! the =0;!;;; in"estment ill gro to8 =0;!;;; J 1.;6 : =0+!;;;
$ithout insurance! the probability distribution of end-of-year ealth is8
Probability $ealth
Ko fire ;.??? =20+!;;;
Fire ;.;;1 = 0+!;;;
For this distribution! expected utility is computed as follos8
AFP)$*G : F;.??? J ln)20+!;;;*G D F;.;;1 J ln)0+!;;;*G : 12.-+?092
(he certainty e#ui"alent is8
$
CA
: e
12.-+?092
: =202!6;-.90
$ith fire insurance! at a cost of =P! the in"estment in the risk-free asset is8
=)0;!;;; @ P*
4ear-end ealth ill be certain )since you are fully insured* and e#ual to8
F=)0;!;;; @ P* J 1.;6G D =2;;!;;;
2ol"e for P in the folloing e#uation8
F=)0;!;;; @ P* J 1.;6G D =2;;!;;; : =202!6;-.90 P : =+72.79
(his is the most you are illing to pay for insurance. Kote that the expected loss is
&only' =2;;! so you are illing to pay a substantial risk premium o"er the
expected "alue of losses. (he primary reason is that the "alue of the house is a
large proportion of your ealth.
2. a. $ith insurance co"erage for one-half the "alue of the house! the premium
is =1;;! and the in"estment in the safe asset is =-?!?;;. 1y year end! the
in"estment of =-?!?;; ill gro to8 =-?!?;; J 1.;6 : =02!9?-
If there is a fire! your insurance proceeds ill be =1;;!;;;! and the
probability distribution of end-of-year ealth is8
Probability $ealth
Ko fire ;.??? =202!9?-
Fire ;.;;1 =102!9?-
AFP)$*G : F;.??? J ln)202!9?-*G D F;.;;1 J ln)102!9?-*G : 12.--;2220
$
CA
: e
12.--;2220
: =202!766.77
b. $ith insurance co"erage for the full "alue of the house! costing =2;;! end-of-
2-+7
year ealth is certain! and e#ual to8
F)=0;!;;; @ =2;;* J 1.;6G D =2;;!;;; : =202!799
2ince ealth is certain! this is also the certainty e#ui"alent ealth of the fully
insured position.
c. $ith insurance co"erage for 1R times the "alue of the house! the premium
is =+;;! and the insurance pays off =+;;!;;; in the e"ent of a fire. (he
in"estment in the safe asset is =-?!7;;. 1y year end! the in"estment of
=-?!7;; ill gro to8 =-?!7;; J 1.;6 : =02!692
(he probability distribution of end-of-year ealth is8
Probability $ealth
Ko fire ;.??? =202!692
Fire ;.;;1 =+02!692
AFP)$*G : F;.??? J ln)202!692*G D F;.;;1 J ln)+02!692*G : 12.--;22;0
$
CA
: e
12.--;222
: =202!766.27
(herefore! full insurance dominates both o"er- and under-insurance. 5"er-
insuring creates a gamble )you actually gain hen the house burns don*.
,isk is minimiEed hen you insure exactly the "alue of the house.
CHAPTER 5: OPTIMAL RIS2" PORTFOLIOS
PROBLEM SETS
1. )a* and )e*.
2. )a* and )c*. After real estate is added to the portfolio! there are four asset classes in
the portfolio8 stocks! bonds! cash and real estate. Portfolio "ariance no includes a
"ariance term for real estate returns and a co"ariance term for real estate returns
ith returns for each of the other three asset classes. (herefore! portfolio risk is
affected by the "ariance )or standard de"iation* of real estate returns and the
correlation beteen real estate returns and returns for each of the other asset
classes. )Kote that the correlation beteen real estate returns and returns for cash is
most likely Eero.*
+. )a* Anser )a* is "alid because it pro"ides the definition of the minimum "ariance
portfolio.
-. (he parameters of the opportunity set are8
2-+9
A)r
2
* : 2;<! A)r
1
* : 12<! U
2
: +;<! U
1
: 10<! ` : ;.1;
From the standard de"iations and the correlation coefficient e generate the
co"ariance matrix Fnote that
) ! *
% %
!ov r r
G8
1onds 2tocks
1onds 220 -0
2tocks -0 ?;;
(he minimum-"ariance portfolio is computed as follos8
%in
)2* :
17+? . ;
* -0 2 ) 220 ?;;
-0 220
* r ! r ) Co" 2
* r ! r ) Co"
1 2
2
1
2
2
1 2
2
1
%in
)1* : 1 ;.17+? : ;.9261
(he minimum "ariance portfolio mean and standard de"iation are8
A)r
%in
* : );.17+? J .2;* D );.9261 J .12* : .1++? : 1+.+?<
U
%in
:
2 > 1
1 2 1 2
2
1
2
1
2
2
2
2
*G r ! r ) Co" 2 F + +
: F);.17+?
2
?;;* D );.9261
2
220* D )2 ;.17+? ;.9261 -0*G
1>2

: 1+.?2<
0.
Proportion
in stock fund
Proportion
in bond fund
Axpected
return
2tandard
.e"iation
;.;;< 1;;.;;< 12.;;< 10.;;<
17.+?< 92.61< 1+.+?< 1+.?2< minimum "ariance
2;.;;< 9;.;;< 1+.6;< 1+.?-<
-;.;;< 6;.;;< 10.2;< 10.7;<
-0.16< 0-.9-< 10.61< 16.0-< tangency portfolio
6;.;;< -;.;;< 16.9;< 1?.0+<
9;.;;< 2;.;;< 19.-;< 2-.-9<
1;;.;;< ;.;;< 2;.;;< +;.;;<
Braph shon belo.
2-+?

0!00
5!00
10!00
15!00
20!00
25!00
0!00 5!00 10!00 15!00 20!00 25!00 30!00
$%n&en'(
Port)olio
#ini*+*
,%ri%n'e
Port)olio
Efficient frontier
of risky assets
CML
I!ES"ME" #$$#R"%I"& SE"
r
f
: 9.;;
6. (he abo"e graph indicates that the optimal portfolio is the tangency portfolio ith
expected return approximately 10.6< and standard de"iation approximately 16.0<.
7. (he proportion of the optimal risky portfolio in"ested in the stock fund is gi"en by8
2
2 2
F ) * G F ) * G ) ! *
F ) * G F ) * G F ) * ) * G ) ! *
f % % f %
f % % f f % f %
" r r " r r !ov r r
&
" r r " r r " r r " r r !ov r r
+ +

F).2; .;9* 220G F).12 .;9* -0G
;.-016
F).2; .;9* 220G F).12 .;9* ?;;G F).2; .;9 .12 .;9* -0G

+ +
1 ;.-016 ;.0-9-
%
&
(he mean and standard de"iation of the optimal risky portfolio are8
A)r
P
* : );.-016 J .2;* D );.0-9- J .12* : .1061
: 10.61<
U
p
: F);.-016
2
?;;* D );.0-9-
2
220* D )2 ;.-016 ;.0-9- J -0*G
1>2

: 16.0-<
9. (he reard-to-"olatility ratio of the optimal CAL is8
) *
.1061 .;9
;.-6;1
.160-
p f
p
" r r

.-6;1 should be .-6;+ )rounding*
2--;
?. a. If you re#uire that your portfolio yield an expected return of 1-<! then you
can find the corresponding standard de"iation from the optimal CAL. (he
e#uation for this CAL is8
) *
) * .;9 ;.-6;1
p f
! f ! !
P
" r r
" r r
+ +
.-6;1 should be .-6;+ )rounding*
If A)r
C
* is e#ual to 1-<! then the standard de"iation of the portfolio is 1+.;+<.
b. (o find the proportion in"ested in the (-bill fund! remember that the mean of
the complete portfolio )i.e.! 1-<* is an a"erage of the (-bill rate and the
optimal combination of stocks and bonds )P*. Let y be the proportion in"ested
in the portfolio P. (he mean of any portfolio along the optimal CAL is8
) * )1 * ) * F ) * G .;9 ).1061 .;9*
! f P f P f
" r y r y " r r y " r r y + + +
2etting A)r
C
* : 1-< e find8 y : ;.7991 and )1 I y* : ;.211? )the proportion
in"ested in the (-bill fund*.
(o find the proportions in"ested in each of the funds! multiply ;.799- times
the respecti"e proportions of stocks and bonds in the optimal risky portfolio8
Proportion of stocks in complete portfolio : ;.7991 ;.-016 : ;.+00?
Proportion of bonds in complete portfolio : ;.7991 ;.0-9- : ;.-+22
1;. Psing only the stock and bond funds to achie"e a portfolio expected return of 1-<!
e must find the appropriate proportion in the stock fund )
2
* and the appropriate
proportion in the bond fund )
1
: 1 I
2
* as follos8
.1- : .2; J
2
D .12 J )1 I
2
* : .12 D .;9 J
2

2
: ;.20
2o the proportions are 20< in"ested in the stock fund and 70< in the bond
fund. (he standard de"iation of this portfolio ill be8
U
P
: F);.20
2
?;;* D );.70
2
220* D )2 ;.20 ;.70 -0*G
1>2
: 1-.1+<
(his is considerably greater than the standard de"iation of 1+.;-< achie"ed
using (-bills and the optimal portfolio.
11. a.
2--1
Standard Deviation(%)
0!00
5!00
10!00
15!00
20!00
25!00
0 10 20 30 40
-ol .
Sto'/0
1ti *%l CAL
P
A"en though it seems that gold is dominated by stocks! gold might still be an
attracti"e asset to hold as a part of a portfolio. If the correlation beteen gold
and stocks is sufficiently lo! gold ill be held as a component in a portfolio!
specifically! the optimal tangency portfolio.
b. If the correlation beteen gold and stocks e#uals D1! then no one ould hold
gold. (he optimal CAL ould be comprised of bills and stocks only. 2ince the
set of risk>return combinations of stocks and gold ould plot as a straight line
ith a negati"e slope )see the folloing graph*! these combinations ould be
dominated by the stock portfolio. 5f course! this situation could not persist. If
no one desired gold! its price ould fall and its expected rate of return ould
increase until it became sufficiently attracti"e to include in a portfolio.
2--2
Standard Deviation(%)
0
5
10
15
20
25
0!00 10!00 20!00 30!00 40!00
-ol.
Sto'/0
r
)
18
12. 2ince 2tock A and 2tock 1 are perfectly negati"ely correlated! a risk-free portfolio
can be created and the rate of return for this portfolio! in e#uilibrium! ill be the
risk-free rate. (o find the proportions of this portfolio Fith the proportion
A

in"ested in 2tock A and
1
: )1 @
A
* in"ested in 2tock 1G! set the standard
de"iation e#ual to Eero. $ith perfect negati"e correlation! the portfolio standard
de"iation is8
U
P
: Absolute "alue F
A
U
A

1
U
1
G
; : 0 J
A
I F1; )1 @
A
*G
A
: ;.6667
(he expected rate of return for this risk-free portfolio is8
A)r* : );.6667 J 1;* D );.++++ J 10* : 11.667<
(herefore! the risk-free rate is8 11.667<
1+. False. If the borroing and lending rates are not identical! then! depending on the
tastes of the indi"iduals )that is! the shape of their indifference cur"es*! borroers
and lenders could ha"e different optimal risky portfolios.
1-. False. (he portfolio standard de"iation e#uals the eighted a"erage of the
component-asset standard de"iations only in the special case that all assets are
perfectly positi"ely correlated. 5therise! as the formula for portfolio standard
de"iation shos! the portfolio standard de"iation is less than the eighted a"erage
of the component-asset standard de"iations. (he portfolio variance is a eighted
sum of the elements in the co"ariance matrix! ith the products of the portfolio
2--+
proportions as eights.
10. (he probability distribution is8
Probability ,ate of ,eturn
;.7 1;;<
;.+ I0;<
%ean : F;.7 J 1;;<G D F;.+ J )-0;<*G : 00<
3ariance : F;.7 J )1;; I 00*
2
G D F;.+ J )-0; I 00*
2
G : -720
2tandard de"iation : -720
1>2
: 69.7-<
16. U
P
: +; : y J U : -; J y y : ;.70
A)r
P
* : 12 D ;.70)+; I 12* : 20.0<
17. (he correct choice is c. Intuiti"ely! e note that since all stocks ha"e the same
expected rate of return and standard de"iation! e choose the stock that ill result
in loest risk. (his is the stock that has the loest correlation ith 2tock A.
%ore formally! e note that hen all stocks ha"e the same expected rate of
return! the optimal portfolio for any risk-a"erse in"estor is the global minimum
"ariance portfolio )B*. $hen the portfolio is restricted to 2tock A and one
additional stock! the ob/ecti"e is to find B for any pair that includes 2tock A!
and then select the combination ith the loest "ariance. $ith to stocks! I
and ]! the formula for the eights in B is8
* I ) 1 * ] )
* r ! r ) Co" 2
* r ! r ) Co"
* I )
%in %in
] I
2
]
2
I
] I
2
]
%in

+

2ince all standard de"iations are e#ual to 2;<8

) ! * -;; and ) * ) * ;.0
I ' I ' #in #in
!ov r r & I & '
(his intuiti"e result is an implication of a property of any efficient frontier!
namely! that the co"ariances of the global minimum "ariance portfolio ith all
other assets on the frontier are identical and e#ual to its on "ariance.
)5therise! additional di"ersification ould further reduce the "ariance.* In
this case! the standard de"iation of B)I! ]* reduces to8
1> 2
) * F2;; )1 *G
#in I'
G +
(his leads to the intuiti"e result that the desired addition ould be the stock
ith the loest correlation ith 2tock A! hich is 2tock .. (he optimal
2---
portfolio is e#ually in"ested in 2tock A and 2tock .! and the standard de"iation
is 17.;+<.
19. Ko! the anser to Problem 17 ould not change! at least as long as in"estors are not
risk lo"ers. ,isk neutral in"estors ould not care hich portfolio they held since
all portfolios ha"e an expected return of 9<.
1?. 4es! the ansers to Problems 17 and 19 ould change. (he efficient frontier of
risky assets is horiEontal at 9<! so the optimal CAL runs from the risk-free rate
through B. (his implies risk-a"erse in"estors ill /ust hold (reasury 1ills.
2;. ,earranging the table )con"erting ros to columns*! and computing serial
correlation results in the folloing table8
Kominal ,ates
2mall
company
stocks
Large
company
stocks
Long-term
go"ernment
bonds
Intermed-term
go"ernment
bonds
(reasury
bills
Inflation
1?2;s -+.72 19.+6 +.?9 +.77 +.06 -1.;;
1?+;s 7.29 -1.20 -.6; +.?1 ;.+; -2.;-
1?-;s 2;.6+ ?.11 +.0? 1.7; ;.+7 0.+6
1?0;s 1?.;1 1?.-1 ;.20 1.11 1.97 2.22
1?6;s 1+.72 7.9- 1.1- +.-1 +.9? 2.02
1?7;s 9.70 0.?; 6.6+ 6.11 6.2? 7.+6
1?9;s 12.-6 17.6; 11.0; 12.;1 ?.;; 0.1;
1??;s 1+.9- 19.2; 9.6; 7.7- 0.;2 2.?+
2erial Correlation ;.-6 -;.22 ;.6; ;.0? ;.6+ ;.2+
For example8 to compute serial correlation in decade nominal returns for large-
company stocks! e set up the folloing to columns in an Axcel spreadsheet.
(hen! use the Axcel function &C5,,AL' to calculate the correlation for the data.
.ecade Pre"ious
1?+;s -1.20< 19.+6<
1?-;s ?.11< -1.20<
1?0;s 1?.-1< ?.11<
1?6;s 7.9-< 1?.-1<
1?7;s 0.?;< 7.9-<
1?9;s 17.6;< 0.?;<
1??;s 19.2;< 17.6;<
Kote that each correlation is based on only se"en obser"ations! so e cannot arri"e
at any statistically significant conclusions. Looking at the results! hoe"er! it
appears that! ith the exception of large-company stocks! there is persistent serial
correlation. )(his conclusion changes hen e turn to real rates in the next
problem.*
2--0
21. (he table for real rates )using the approximation of subtracting a decadeCs a"erage
inflation from the decadeCs a"erage nominal return* is8
,eal ,ates
2mall
company
stocks
Large
company
stocks
Long-term
go"ernment
bonds
Intermed-term
go"ernment
bonds
(reasury
bills
1?2;s -2.72 1?.+6 -.?9 -.77 -.06
1?+;s ?.+2 ;.7? 6.6- 0.?0 2.+-
1?-;s 10.27 +.70 -1.77 -+.66 --.??
1?0;s 16.7? 17.1? -1.?7 -1.11 -;.+0
1?6;s 11.2; 0.+2 -1.+9 ;.9? 1.+7
1?7;s 1.+? -1.-6 -;.7+ -1.20 -1.;7
1?9;s 7.+6 12.0; 6.-; 6.?1 +.?;
1??;s 1;.?1 10.27 0.67 -.91 2.;?
2erial Correlation ;.2? -;.27 ;.+9 ;.11 ;.;;
$hile the serial correlation in decade nominal returns seems to be positi"e! it
appears that real rates are serially uncorrelated. (he decade time series )although
again too short for any definiti"e conclusions* suggest that real rates of return are
independent from decade to decade.
CFA PROBLEMS
1. a. ,estricting the portfolio to 2; stocks! rather than -; to 0; stocks! ill increase
the risk of the portfolio! but it is possible that the increase in risk ill be
minimal. 2uppose that! for instance! the 0; stocks in a uni"erse ha"e the same
standard de"iation )* and the correlations beteen each pair are identical! ith
correlation coefficient `. (hen! the co"ariance beteen each pair of stocks
ould be `U
2
! and the "ariance of an e#ually eighted portfolio ould be8
2 2 2
P
n
1 n
n
1
+
(he effect of the reduction in n on the second term on the right-hand side
ould be relati"ely small )since -?>0; is close to 1?>2; and `U
2
is smaller
than U
2
*! but the denominator of the first term ould be 2; instead of 0;. For
example! if U : -0< and ` : ;.2! then the standard de"iation ith 0; stocks
ould be 2;.?1<! and ould rise to 22.;0< hen only 2; stocks are held.
2uch an increase might be acceptable if the expected return is increased
sufficiently.
2--6
b. Oennessy could contain the increase in risk by making sure that he maintains
reasonable di"ersification among the 2; stocks that remain in his portfolio.
(his entails maintaining a lo correlation among the remaining stocks. For
example! in part )a*! ith ` : ;.2! the increase in portfolio risk as minimal.
As a practical matter! this means that Oennessy ould ha"e to spread his
portfolio among many industriesH concentrating on /ust a fe industries ould
result in higher correlations among the included stocks.
2. ,isk reduction benefits from di"ersification are not a linear function of the number
of issues in the portfolio. ,ather! the incremental benefits from additional
di"ersification are most important hen you are least di"ersified. ,estricting
Oennessy to 1; instead of 2; issues ould increase the risk of his portfolio by a
greater amount than ould a reduction in the siEe of the portfolio from +; to 2;
stocks. In our example! restricting the number of stocks to 1; ill increase the
standard de"iation to 2+.91<. (he 1.76< increase in standard de"iation resulting
from gi"ing up 1; of 2; stocks is greater than the 1.1-< increase that results from
gi"ing up +; of 0; stocks.
+. (he point is ell taken because the committee should be concerned ith the
"olatility of the entire portfolio. 2ince OennessyCs portfolio is only one of six ell-
di"ersified portfolios and is smaller than the a"erage! the concentration in feer
issues might ha"e a minimal effect on the di"ersification of the total fund. Oence!
unleashing Oennessy to do stock picking may be ad"antageous.
-. d. Portfolio 4 cannot be efficient because it is dominated by another portfolio.
For example! Portfolio X has both higher expected return and loer standard
de"iation.
0. c.
6. d.
7. b.
9. a.
?. c.
2--7
1;. 2ince e do not ha"e any information about expected returns! e focus exclusi"ely
on reducing "ariability. 2tocks A and C ha"e e#ual standard de"iations! but the
correlation of 2tock 1 ith 2tock C );.1;* is less than that of 2tock A ith 2tock 1
);.?;*. (herefore! a portfolio comprised of 2tocks 1 and C ill ha"e loer total
risk than a portfolio comprised of 2tocks A and 1.
11. Fund . represents the single best addition to complement 2tephensonMs current
portfolio! gi"en his selection criteria. Fund .Cs expected return )1-.; percent* has
the potential to increase the portfolioCs return somehat. Fund .Cs relati"ely lo
correlation ith his current portfolio )D;.60* indicates that Fund . ill pro"ide
greater di"ersification benefits than any of the other alternati"es except Fund 1. (he
result of adding Fund . should be a portfolio ith approximately the same expected
return and somehat loer "olatility compared to the original portfolio.
(he other three funds ha"e shortcomings in terms of expected return enhancement
or "olatility reduction through di"ersification. Fund A offers the potential for
increasing the portfolioCs return! but is too highly correlated to pro"ide substantial
"olatility reduction benefits through di"ersification. Fund 1 pro"ides substantial
"olatility reduction through di"ersification benefits! but is expected to generate a
return ell belo the current portfolioCs return. Fund C has the greatest potential to
increase the portfolioCs return! but is too highly correlated ith the current portfolio
to pro"ide substantial "olatility reduction benefits through di"ersification.
12. a. 2ubscript 5P refers to the original portfolio! A1C to the ne stock! and KP
to the ne portfolio.
i. A)r
KP
* :
5P
A)r
5P
* D
A1C
A)r
A1C
* : );.? ;.67* D );.1 1.20* : ;.729<
ii. Co" : `
5P

A1C
: ;.-; 2.+7 2.?0 : 2.7?66 2.9;
iii.
KP
: F
5P
2

5P
2
D
A1C
2

A1C
2
D 2
5P

A1C
)Co"
5P ! A1C
*G
1>2

: F);.?
2
2.+7
2
* D );.1
2
2.?0
2
* D )2 ;.? ;.1 2.9;*G
1>2

: 2.267+< 2.27<
b. 2ubscript 5P refers to the original portfolio! B2 to go"ernment securities! and
KP to the ne portfolio.
i. A)r
KP
* :
5P
A)r
5P
* D
B2
A)r
B2
* : );.? ;.67* D );.1 ;.-2* : ;.6-0<
ii. Co" : `
5P

B2
: ; 2.+7 ; : ;
iii.
KP
: F
5P
2

5P
2
D
B2
2

B2
2
D 2
5P

B2
)Co"
5P ! B2
*G
1>2

: F);.?
2
2.+7
2
* D );.1
2
;* D )2 ;.? ;.1 ;*G
1>2

: 2.1++< 2.1+<
2--9
c. Adding the risk-free go"ernment securities ould result in a loer beta for the
ne portfolio. (he ne portfolio beta ill be a eighted a"erage of the
indi"idual security betas in the portfolioH the presence of the risk-free securities
ould loer that eighted a"erage.
d. (he comment is not correct. Although the respecti"e standard de"iations and
expected returns for the to securities under consideration are e#ual! the
co"ariances beteen each security and the original portfolio are unknon! making
it impossible to dra the conclusion stated. For instance! if the co"ariances are
different! selecting one security o"er the other may result in a loer standard
de"iation for the portfolio as a hole. In such a case! that security ould be the
preferred in"estment! assuming all other factors are e#ual.
e. i. Brace clearly expressed the sentiment that the risk of loss as more important
to her than the opportunity for return. Psing "ariance )or standard de"iation* as
a measure of risk in her case has a serious limitation because standard de"iation
does not distinguish beteen positi"e and negati"e price mo"ements.
ii. (o alternati"e risk measures that could be used instead of "ariance are8
,ange of returns( hich considers the highest and loest expected returns in
the future period! ith a larger range being a sign of greater "ariability and
therefore of greater risk.
2emi"ariance can be used to measure expected de"iations of returns belo the
mean! or some other benchmark! such as Eero.
Aither of these measures ould potentially be superior to "ariance for Brace.
,ange of returns ould help to highlight the full spectrum of risk she is
assuming! especially the donside portion of the range about hich she is so
concerned. 2emi"ariance ould also be effecti"e! because it implicitly
assumes that the in"estor ants to minimiEe the likelihood of returns falling
belo some target rateH in BraceCs case! the target rate ould be set at Eero )to
protect against negati"e returns*.
1+. a. 2ystematic risk refers to fluctuations in asset prices caused by macroeconomic
factors that are common to all risky assetsH hence systematic risk is often
referred to as market risk. Axamples of systematic risk factors include the
business cycle! inflation! monetary policy and technological changes.
Firm-specific risk refers to fluctuations in asset prices caused by factors that
are independent of the market! such as industry characteristics or firm
characteristics. Axamples of firm-specific risk factors include litigation!
patents! management! and financial le"erage.
2--?
b. (rudy should explain to the client that picking only the top fi"e best ideas
ould most likely result in the client holding a much more risky portfolio.
(he total risk of a portfolio! or portfolio "ariance! is the combination of
systematic risk and firm-specific risk.
(he systematic component depends on the sensiti"ity of the indi"idual assets
to market mo"ements as measured by beta. Assuming the portfolio is ell
di"ersified! the number of assets ill not affect the systematic risk component
of portfolio "ariance. (he portfolio beta depends on the indi"idual security
betas and the portfolio eights of those securities.
5n the other hand! the components of firm-specific risk )sometimes called
nonsystematic risk* are not perfectly positi"ely correlated ith each other and!
as more assets are added to the portfolio! those additional assets tend to reduce
portfolio risk. Oence! increasing the number of securities in a portfolio
reduces firm-specific risk. For example! a patent expiration for one company
ould not affect the other securities in the portfolio. An increase in oil prices
might hurt an airline stock but aid an energy stock. As the number of
randomly selected securities increases! the total risk )"ariance* of the portfolio
approaches its systematic "ariance.
CHAPTER 6: INDE4 MODELS
PROBLEM SETS
1. (he ad"antage of the index model! compared to the %arkoitE procedure! is the
"astly reduced number of estimates re#uired. In addition! the large number of
estimates re#uired for the %arkoitE procedure can result in large aggregate
estimation errors hen implementing the procedure. (he disad"antage of the index
model arises from the modelCs assumption that return residuals are uncorrelated.
(his assumption ill be incorrect if the index used omits a significant risk factor.
2. (he trade-off entailed in departing from pure indexing in fa"or of an acti"ely
managed portfolio is beteen the probability )or the possibility* of superior
performance against the certainty of additional management fees.
+. (he anser to this #uestion can be seen from the formulas for

;
)e#uation 9.2;*
and \ )e#uation 9.21*. 5ther things held e#ual!

;
is smaller the greater the
residual "ariance of a candidate asset for inclusion in the portfolio. Further! e see
that regardless of beta! hen

;
decreases! so does \. (herefore! other things
e#ual! the greater the residual "ariance of an asset! the smaller its position in the
optimal risky portfolio. (hat is! increased firm-specific risk reduces the extent to
hich an acti"e in"estor ill be illing to depart from an indexed portfolio.
2-0;
-. (he total risk premium e#uals8 D ) J market risk premium*. $e call alpha a
&nonmarket' return premium because it is the portion of the return premium that is
independent of market performance.
(he 2harpe ratio indicates that a higher alpha makes a security more desirable.
Alpha! the numerator of the 2harpe ratio! is a fixed number that is not affected by
the standard de"iation of returns! the denominator of the 2harpe ratio. Oence! an
increase in alpha increases the 2harpe ratio. 2ince the portfolio alpha is the
portfolio-eighted a"erage of the securitiesC alphas! then! holding all other
parameters fixed! an increase in a securityCs alpha results in an increase in the
portfolio 2harpe ratio.
0. a. (o optimiEe this portfolio one ould need8
n : 6; estimates of means
n : 6; estimates of "ariances
77; ! 1
2
n n
2
estimates of co"ariances
(herefore! in total8 9?; ! 1
2
n + n
2
+
estimates
b. In a single index model8 r
i
r
f
: a
i
D b
i
)r
%
@ r
f
* D e
i

A#ui"alently! using excess returns8 ,
i
: a
i
D b
i
,
%
D e
i

(he "ariance of the rate of return can be decomposed into the components8
)l* (he "ariance due to the common market factor8
2
%
2
i

)2* (he "ariance due to firm specific unanticipated e"ents8 * e )
i
2
In this model8

/ i / i
* r ! r ) Co"
(he number of parameter estimates is8
n : 6; estimates of the mean A)r
i
*
n : 6; estimates of the sensiti"ity coefficient b
i

n : 6; estimates of the firm-specific "ariance U
2
)e
i
*
1 estimate of the market mean A)r
%
*
1 estimate of the market "ariance
2
%
(herefore! in total! 192 estimates.

(he single index model reduces the total number of re#uired estimates from
1!9?; to 192. In general! the number of parameter estimates is reduced from8
2-01
* 2 n + ) to
2
n + n
2
+
,
_
+
6. a. (he standard de"iation of each indi"idual stock is gi"en by8
2 > 1
i
2 2
%
2
i i
*G e ) F +
2ince b
A
: ;.9! b
1
: 1.2! U)e
A
* : +;<! U)e
1
* : -;<! and U
%
: 22<! e get8
U
A
: );.9
2
J 22
2
D +;
2
*
1>2
: +-.79<
U
1
: )1.2
2
J 22
2
D -;
2
*
1>2
: -7.?+<
b. (he expected rate of return on a portfolio is the eighted a"erage of the
expected returns of the indi"idual securities8
A)r
P
* :
A
J A)r
A
* D
1
J A)r
1
* D
f
J

r
f

A)r
P
* : );.+; J 1+<* D );.-0 J 19<* D );.20 J 9<* : 1-<
(he beta of a portfolio is similarly a eighted a"erage of the betas of the indi"idual
securities8
b
P
:
A
J b
A
D
1
J b
1
D
f
J b
f
b
P
: );.+; J ;.9* D );.-0 J 1.2* D );.20 J ;.;* : ;.79
(he "ariance of this portfolio is8
* e )
P
2 2
%
2
P
2
P
+
here
2
%
2
P
Yis the systematic component and * e )
P
2
is the nonsystematic
component. 2ince the residuals )e
i
* are uncorrelated! the non-systematic
"ariance is8
2 2 2 2 2 2 2
) * ) * ) * ) *
P A A % % f f
e & e & e & e + +
: );.+;
2
J +;
2
* D );.-0
2
J -;
2
* D );.20
2
J ;* : -;0
here U
2
)e
A
* and U
2
)e
1
* are the firm-specific )nonsystematic* "ariances of
2tocks A and 1! and U
2
)e
f
*! the nonsystematic "ariance of (-bills! is Eero.
(he residual standard de"iation of the portfolio is thus8
U)e
P
* : )-;0*
1>2
: 2;.12<
(he total "ariance of the portfolio is then8
-7 . 6?? -;0 * 22 79 . ; )
2 2 2
P
+ change 6??.-7 to 6?7.+
(he total standard de"iation is 26.-1<.
7. a. (he to figures depict the stocksC security characteristic lines )2CL*. 2tock A
has higher firm-specific risk because the de"iations of the obser"ations from
the 2CL are larger for 2tock A than for 2tock 1. .e"iations are measured by
2-02
the "ertical distance of each obser"ation from the 2CL.
b. 1eta is the slope of the 2CL! hich is the measure of systematic risk. (he
2CL for 2tock 1 is steeperH hence 2tock 1Cs systematic risk is greater.
c. (he ,
2
)or s#uared correlation coefficient* of the 2CL is the ratio of the
explained "ariance of the stockCs return to total "ariance! and the total
"ariance is the sum of the explained "ariance plus the unexplained "ariance
)the stockCs residual "ariance*8
* )e U U b
U b
,
i
2 2
%
2
i
2
%
2
i 2
+
2ince the explained "ariance for 2tock 1 is greater than for 2tock A )the
explained "ariance is
2
%
2
1
! hich is greater since its beta is higher*! and its
residual "ariance
2
) *
%
e is smaller! its ,
2
is higher than 2tock ACs.
d. Alpha is the intercept of the 2CL ith the expected return axis. 2tock A has a small
positi"e alpha hereas 2tock 1 has a negati"e alphaH hence! 2tock ACs alpha is
larger.
e. (he correlation coefficient is simply the s#uare root of ,
2
! so 2tock 1Cs
correlation ith the market is higher.
9. a.Firm-specific risk is measured by the residual standard de"iation. (hus! stock A
has more firm-specific risk8 1;.+< Q ?.1<
b. %arket risk is measured by beta! the slope coefficient of the regression. A has
a larger beta coefficient8 1.2 Q ;.9
c. ,
2
measures the fraction of total "ariance of return explained by the market
return. ACs ,
2
is larger than 1Cs8 ;.076 Q ;.-+6
d. ,eriting the 2CL e#uation in terms of total return )r* rather than excess
return ),*8
) *
)1 *
A f # f
A f #
r r r r
r r r

+
+ +

(he intercept is no e#ual to8
)1 * 1< )1 1.2*
f f
r r + +
2ince r
f
: 6<! the intercept ould be8
1< 6<)1 1.2* 1< 1.2< ;.2< +
2-0+
?. (he standard de"iation of each stock can be deri"ed from the folloing
e#uation for ,
2
8
2
i
2
%
2
i 2
i
,
(herefore8
< +; . +1
?9;
2; . ;
2; 7 . ;
,
A
2 2
2
A
2
%
2
A 2
A

For stock 18
< 29 . 6?
9;; ! -
12 . ;
2; 2 . 1
1
2 2
2
1

1;. (he systematic risk for A is8
2 2 2 2
;.7; 2; 1?6
A #

(he firm-specific risk of A )the residual "ariance* is the difference beteen
ACs total risk and its systematic risk8
?9; @ 1?6 : 79-
(he systematic risk for 1 is8
2 2 2 2
1.2; 2; 076
% #

1Cs firm-specific risk )residual "ariance* is8
-9;; @ 076 : -22-
11. (he co"ariance beteen the returns of A and 1 is )since the residuals are assumed
to be uncorrelated*8
++6 -;; 2; . 1 7; . ; * r ! r ) Co"
2
% 1 A 1 A

(he correlation coefficient beteen the returns of A and 1 is8
100 . ;
29 . 6? +; . +1
++6 * r ! r ) Co"
1 A
1 A
A1

2-0-
12. Kote that the correlation is the s#uare root of ,
2
8
2
,
1> 2
!
1> 2
!
) * ;.2; +1.+; 2; 29;
) * ;.12 6?.29 2; -9;
A # A #
% # % #
!ov r r
!ov r r

1+. For portfolio P e can compute8
U
P
: F);.6
2
J ?9;* D );.-
2
J -9;;* D )2 J ;.- J ;.6 J ++6*G
1>2
: F1292.;9G
1>2
: +0.91<
b
P
: );.6 J ;.7* D );.- J 1.2* : ;.?;
?09.;9 -;;* );.?; 1292.;9 U b U * )e U
2 2
%
2
P
2
P P
2

Co")r
P
!r
%
* : b
P
2
%
U :;.?; J -;;:+6;
(his same result can also be attained using the co"ariances of the indi"idual stocks
ith the market8
Co")r
P
!r
%
* : Co");.6r
A
D ;.-r
1
! r
%
* : ;.6 J Co")r
A
! r
%
* D ;.- J Co")r
1
!r
%
*
: );.6 J 29;* D );.- J -9;* : +6;
1-. Kote that the "ariance of (-bills is Eero! and the co"ariance of (-bills ith any asset
is Eero. (herefore! for portfolio [8
[ ]
[ ] < 00 . 21 * +6; + . ; 0 . ; 2 ) * -;; + . ; ) * ;9 . 292 ! 1 0 . ; )
* r ! r ) Co" 2
2 > 1
2 2
2 > 1
% P % P
2
%
2
%
2
P
2
P [
+ +
+ +
);.0 ;.?;* );.+ 1* );.2; ;* ;.70
) P P # #
& & + + +
02 . 2+? * -;; 70 . ; ) 02 . -6- * e )
2 2
%
2
[
2
[ [
2

+;; -;; 70 . ; * r ! r ) Co"
2
% [ % [

10. a.1eta 1ooks ad/usts beta by taking the sample estimate of beta and a"eraging it
ith 1.;! using the eights of 2>+ and 1>+! as follos8
ad/usted beta : F)2>+* J 1.2-G D F)1>+* J 1.;G : 1.16
b. If you use your current estimate of beta to be b
t@1
: 1.2-! then
b
t
: ;.+ D );.7 J 1.2-* : 1.169
2-00
16. For 2tock A8
F ) *G .11 F.;6 ;.9 ).12 .;6*G ;.2<
A A f A # f
r r r r + +
For stock 18
F ) *G .1- F.;6 1.0 ).12 .;6*G 1<
% % f % # f
r r r r + +
2tock A ould be a good addition to a ell-di"ersified portfolio. A short position
in 2tock 1 may be desirable.
17. a.
Alpha )a* Axpected excess return
a
Y
i
: r
i
@ Fr
f
D b
i
J )r
%
@ r
f
* G
A)r
i
* @ r
f

a
A
: 2;< @ F9< D 1.+ J )16< @ 9<*G : 1.6< 2;< @ 9< : 12<
a
1
: 19< @ F9< D 1.9 J )16< @ 9<*G : @ -.-< 19< @ 9< : 1;<
a
C
: 17< @ F9< D ;.7 J )16< @ 9<*G : +.-< 17< @ 9< : ?<
a
.
: 12< @ F9< D 1.; J )16< @ 9<*G : @ -.;< 12< @ 9< : -<
2tocks A and C ha"e positi"e alphas! hereas stocks 1 and . ha"e negati"e alphas.
(he residual "ariances are8
2
)e
A
* : 09
2
: +!+6-
2
)e
1
* : 71
2
: 0!;-1
2
)e
C
* : 6;
2
: +!6;;
2
)e
.
* : 00
2
: +!;20
b. (o construct the optimal risky portfolio! e first determine the optimal acti"e
portfolio. Psing the (reynor-1lack techni#ue! e construct the acti"e portfolio8
A ;.;;;-76 @;.61-2
1 @;.;;;97+ 1.1260
C ;.;;;?-- @1.2191
. @;.;;1+22 1.7;09
(otal @;.;;;770 1.;;;;
1e unconcerned ith the negati"e eights of the positi"e a stockscthe entire acti"e
position ill be negati"e! returning e"erything to good order.
$ith these eights! the forecast for the acti"e portfolio is8
a : F@;.61-2 J 1.6G D F1.1260 J )@ -.-*G @ F1.2191 J +.-G D F1.7;09 J )@ -.;*G
: @16.?;<
b : F@;.61-2 J 1.+G D F1.1260 J 1.9G @ F1.2191 J ;.7;G D F1.7;09 J 1G : 2.;9
2-06
(he high beta )higher than any indi"idual beta* results from the short positions
in the relati"ely lo beta stocks and the long positions in the relati"ely high
beta stocks.

2
)e* : F)@;.61-2*
2
J++6-G D F1.1260
2
J0;-1G D F)@1.2191*
2
J+6;;G D F1.7;09
2
J+;20G
: 21!9;?.6
)e* : 1-7.69<
(he le"ered position in 1 Fith high
2
)e*G o"ercomes the di"ersification
effect! and results in a high residual standard de"iation. (he optimal risky
portfolio has a proportion
\
in the acti"e portfolio! computed as follos8
2
;
2 2
> ) * .16?; > 21!9;?.6
;.;012-
F ) * G > .;9 > 2+
# f #
e
&
" r r

(he negati"e position is /ustified for the reason stated earlier.

(he ad/ustment for beta is8
;-96 . ;
* ;012- . ; *) ;9 . 2 1 ) 1
;012- . ;
* 1 ) 1
\
;
;

+
2ince \ is negati"e! the result is a positi"e position in stocks ith positi"e

alphas and a negati"e position in stocks ith negati"e alphas. (he position in
the index portfolio is8
1 @ )@;.;-96* : 1.;-96
c. (o calculate 2harpeCs measure for the optimal risky portfolio! e compute the
information ratio for the acti"e portfolio and 2harpeCs measure for the market
portfolio. (he information ratio for the acti"e portfolio is computed as follos8
A :
) * e
: @16.?;>1-7.69 : @;.11--
A
2
: ;.;1+1
Oence! the s#uare of 2harpeCs measure )2* of the optimiEed risky portfolio is8
1+-1 . ; ;1+1 . ;
2+
9
A 2 2
2
2 2
%
2
+
,
_
+
2 : ;.+662
Compare this to the marketCs 2harpe measure8
2
%
: 9>2+ : ;.+-79 A difference of8 ;.;19-
(he only-moderate impro"ement in performance results from only a small
position taken in the acti"e portfolio A because of its large residual "ariance.
d. (o calculate the makeup of the complete portfolio! first compute the beta! the
mean excess return and the "ariance of the optimal risky portfolio8
b
P
:
%
D )
A
J b
A
* : 1.;-96 D F)@;.;-96* 2.;9G : ;.?0
2-07
A),
P
* : a
P
D b
P
A),
%
* : F)@;.;-96* )@16.?;<*G D );.?0 J 9<* : 9.-2<
( ) ?- . 029 6 . 9;? ! 21 * ;-96 . ; ) * 2+ ?0 . ; ) * e )
2 2
P
2 2
%
2
P
2
P
+ +
< ;; . 2+
P

2ince A : 2.9! the optimal position in this portfolio is8
0690 . ;
?- . 029 9 . 2 ;1 . ;
-2 . 9
y

In contrast! ith a passi"e strategy8

0-;1 . ;
2+ 9 . 2 ;1 . ;
9
y
2

A difference of8 ;.;29-
(he final positions are )% may include some of stocks A through .*8
1ills 1 @ ;.0690 : -+.10<
% ;.0690 l.;-96 : 0?.61<
A ;.0690 )@;.;-96* )@;.61-2* : 1.7;<
1 ;.0690 )@;.;-96* 1.1260 : @ +.11<
C ;.0690 )@;.;-96* )@1.2191* : +.+7<
. ;.0690 )@;.;-96* 1.7;09 : @ -.71<
)sub/ect to rounding error* 1;;.;;
<
18. a. If a manager is not allowed to sell short he will not include stocks with negative
alphas in his portfolio, so he will consider only A and C:
d
2
)e*
A 1.6 +!+6- ;.;;;-76 ;.++02
C +.- +!6;; ;.;;;?-- ;.66-9
;.;;1-2; 1.;;;;
(he forecast for the acti"e portfolio is8
a : );.++02 J 1.6* D );.66-9 J +.-* : 2.9;<
b : );.++02 J 1.+* D );.66-9 J ;.7* : ;.?;
2
)e* : );.++02
2
J +!+6-* D );.66-9
2
J +!6;;* : 1!?6?.;+
U)e* : --.+7<
(he eight in the acti"e portfolio is8
;?-; . ;
2+ > 9
;+ . ?6? ! 1 > 9; . 2
> * , ) A
* e ) >
2 2
% %
2
;

Ad/usting for beta8

2-09
;?+1 . ;
G ;?- . ; * ?; . ; 1 F) 1
;?- . ;
* 1 ) 1
\
;
;
(he information ratio of the acti"e portfolio is8

2.9;
;.;6+1
) * --.+7
A
e

Oence! the s#uare of 2harpeCs measure is8
2
2 2
9
;.;6+1 ;.120;
2+
_
+

,
(herefore8 2 : ;.+0+0
(he marketCs 2harpe measure is8 2
%
: ;.+-79
$hen short sales are alloed )Problem 17*! the managerCs 2harpe measure is higher
);.+662*. (he reduction in the 2harpe measure is the cost of the short sale
restriction.
(he characteristics of the optimal risky portfolio are8
2 2 2 2 2 2
)1 ;.;?+1* );.;?+1 ;.?* ;.??
) * ) * );.;?+1 2.9<* );.?? 9<* 9.19<
) * );.?? 2+* );.;?+1 1?6?.;+* 0+0.0-
2+.1-<
P # A A
P P P #
P P # P
P
& &
" * " *
e

+ +
+ +
+ +
$ith A : 2.9! the optimal position in this portfolio is8

0-00 . ;
0- . 0+0 9 . 2 ;1 . ;
19 . 9
y

(he final positions in each asset are8

1ills 1 @ ;.0-00 : -0.-0<
% ;.0-00 )1 ;.;?+1* : -?.-7<
A ;.0-00 ;.;?+1 ;.++02 : 1.7;<
C ;.0-00 ;.;?+1 ;.66-9 : +.+9<
1;;.;;
<
b. (he mean and "ariance of the optimiEed complete portfolios in the
unconstrained and short-sales constrained cases! and for the passi"e strategy
are8
A),
C
*
2
C
Pnconstrained ;.0690 J 9.-2< : -.7? ;.0690

2
J 029.?- : 17;.?0
Constrained ;.0-00 J 9.19< : -.-6 ;.0-00
2
J 0+0.0- : 10?.+6
Passi"e ;.0-;1 J 9.;;< : -.+2 ;.0-;1
2
J 02?.;; : 10-.+1
2-0?
(he utility le"els belo are computed using the formula8
2
C C
A ;;0 . ; * r ) A
Pnconstrained 9< D -.7?< @ );.;;0 J 2.9 J 17;.?0* : 1;.-;<
Constrained 9< D -.-6< @ );.;;0 J 2.9 J 10?.+6* : 1;.2+<
Passi"e 9< D -.+2< @ );.;;0 J 2.9 J 10-.+1* : 1;.16<
1?. All alphas are reduced to ;.+ times their "alues in the original case. (herefore! the
relati"e eights of each security in the acti"e portfolio are unchanged! but the alpha
of the acti"e portfolio is only ;.+ times its pre"ious "alue8 ;.+ J 16.?;< : 0.;7<
(he in"estor ill take a smaller position in the acti"e portfolio. (he optimal risky
portfolio has a proportion
\
in the acti"e portfolio as follos8
2
;
2 2
> ) * ;.;0;7 > 21!9;?.6
;.;10+7
) * > ;.;9 > 2+
# f #
e
&
" r r

(he negati"e position is /ustified for the reason gi"en earlier.

(he ad/ustment for beta is8
;101 . ;
*G ;10+7 . ; ) * ;9 . 2 1 F) 1
;10+7 . ;
* 1 ) 1
\
;
;

+
2ince \ is negati"e! the result is a positi"e position in stocks ith positi"e alphas
and a negati"e position in stocks ith negati"e alphas. (he position in the index
portfolio is8 1 @ )@;.;101* : 1.;101
(o calculate 2harpeCs measure for the optimal risky portfolio e compute the
information ratio for the acti"e portfolio and 2harpeCs measure for the market portfolio.
(he information ratio of the active portfolio is ;.+ times its pre"ious "alue8
A :
0.;7
) * 1-7.69 e
: @;.;+-+ and A
2
:;.;;119
Oence! the s#uare of 2harpeCs measure of the optimi+ed risky portfolio is8
2
2
: 2
2
%
D A
2
: )9<>2+<*
2
D ;.;;119 : ;.1222
2 : ;.+-?0
Compare this to the marketCs 2harpe measure8 2
%
:
9<
2+<
: ;.+-79
(he difference is8 ;.;;17
Kote that the reduction of the forecast alphas by a factor of ;.+ reduced the s#uared
information ratio and the impro"ement in the s#uared 2harpe ratio by a factor of8
;.+
2
: ;.;?
2;. If each of the alpha forecasts is doubled! then the alpha of the acti"e portfolio ill
also double. 5ther things e#ual! the information ratio )I,* of the acti"e portfolio
also doubles. (he s#uare of the 2harpe ratio for the optimiEed portfolio )2-s#uare*
e#uals the s#uare of the 2harpe ratio for the market index )2%-s#uare* plus the
2-6;
s#uare of the information ratio. 2ince the information ratio has doubled! its s#uare
#uadruples. (herefore8 2-s#uare : 2%-s#uare D )- J I,*
Compared to the pre"ious 2-s#uare! the difference is8 +I,
Ko you can embark on the calculations to "erify this result.
CFA PROBLEMS
1. (he regression results pro"ide #uantitati"e measures of return and risk based on
monthly returns o"er the fi"e-year period.
b for A1C as ;.6;! considerably less than the a"erage stockCs b of 1.;. (his
indicates that! hen the 2VP 0;; rose or fell by 1 percentage point! A1CCs return
on a"erage rose or fell by only ;.6; percentage point. (herefore! A1CCs systematic
risk )or market risk* as lo relati"e to the typical "alue for stocks. A1CCs alpha
)the intercept of the regression* as @+.2<! indicating that hen the market return
as ;<! the a"erage return on A1C as @+.2<. A1CCs unsystematic risk )or
residual risk*! as measured by U)e*! as 1+.;2<. For A1C! ,
2
as ;.+0! indicating
closeness of fit to the linear regression greater than the "alue for a typical stock.
b for X4e as somehat higher! at ;.?7! indicating X4eCs return pattern as "ery
similar to the b for the market index. (herefore! X4e stock had a"erage systematic
risk for the period examined. Alpha for X4e as positi"e and #uite large!
indicating a return of 7.+<! on a"erage! for X4e independent of market return.
,esidual risk as 21.-0<! half again as much as A1CCs! indicating a ider scatter
of obser"ations around the regression line for X4e. Correspondingly! the fit of the
regression model as considerably less than that of A1C! consistent ith an ,
2
of
only ;.17.
(he effects of including one or the other of these stocks in a di"ersified portfolio
may be #uite different. If it can be assumed that both stocksC betas ill remain
stable o"er time! then there is a large difference in systematic risk le"el. (he betas
obtained from the to brokerage houses may help the analyst dra inferences for
the future. (he three estimates of A1CCs b are similar! regardless of the sample
period of the underlying data. (he range of these estimates is ;.6; to ;.71! ell
belo the market a"erage b of 1.;. (he three estimates of X4eCs b "ary
significantly among the three sources! ranging as high as 1.-0 for the eekly data
o"er the most recent to years. 5ne could infer that X4eCs b for the future might
be ell abo"e 1.;! meaning it might ha"e somehat greater systematic risk than
as implied by the monthly regression for the fi"e-year period.
(hese stocks appear to ha"e significantly different systematic risk characteristics. If
these stocks are added to a di"ersified portfolio! X4e ill add more to total "olatility.
2-61
2. (he ,
2
of the regression is8 ;.7;
2
: ;.-?
(herefore! 01< of total "ariance is unexplained by the marketH this is
nonsystematic risk.
+. ? : + D )11 +* : ;.70
-. d.
0. b.
CHAPTER 7: THE CAPITAL ASSET PRICIN' MODEL
PROBLEM SETS
1.
2. If the securityCs correlation coefficient ith the market portfolio doubles
)ith all other "ariables such as "ariances unchanged*! then beta! and therefore
the risk premium! ill also double. (he current risk premium is8 1-< @ 6< :
9<
(he ne risk premium ould be 16<! and the ne discount rate for the security
ould be8 16< D 6< : 22<
If the stock pays a constant perpetual di"idend! then e kno from the original data that
the di"idend ).* must satisfy the e#uation for the present "alue of a perpetuity8
Price : .i"idend>.iscount rate
0; : .>;.1- . : 0; ;.1- : =7.;;
At the ne discount rate of 22<! the stock ould be orth8 =7>;.22 : =+1.92
(he increase in stock risk has loered its "alue by +6.+6<.
+. a. False. b : ; implies A)r* : r
f
! not Eero.
b. False. In"estors re#uire a risk premium only for bearing systematic
)undi"ersifiable or market* risk. (otal "olatility includes di"ersifiable risk.
c. False. 4our portfolio should be in"ested 70< in the market portfolio and
20< in (-bills. (hen8
);.70 1* );.20 ;* ;.70
P
+
2-62
) * F ) * G
.12
.19 .;6 F.1- .;6G 1.0
.;9
P f P # f
P P
" r r " r r

+
+
-. (he expected return is the return predicted by the CAP% for a gi"en le"el of
systematic risk.
=1
=0
) * F ) * G
) * .;- 1.0 ).1; .;-* .1+ 1+<
) * .;- 1.; ).1; .;-* .1; 1;<
i f i # f
,iscount
"verything
" r r " r r
" r
" r
+
+
+
0. According to the CAP%! =1 .iscount 2tores re#uires a return of 1+< based on its
systematic risk le"el of b : 1.0. Ooe"er! the forecasted return is only 12<.
(herefore! the security is currently o"er"alued.
A"erything =0 re#uires a return of 1;< based on its systematic risk le"el of b : 1.;.
Ooe"er! the forecasted return is 11<. (herefore! the security is currently
under"alued.
6. (he expected return of a stock ith a b : 1.; must! on a"erage! be the same as the
expected return of the market hich also has a b : 1.;.
7. 1eta is a measure of systematic risk. 2ince only systematic risk is rearded! it is
safe to conclude that the expected return ill be higher for WaskinCs stock than for
[uinnCs stock.
9. (he appropriate discount rate for the pro/ect is8
r
f
D b J FA)r
%
* @ r
f
G : .;9 D F1.9 ).16 @ .;9*G : .22- : 22.-<
Psing this discount rate8
+ +

10 F= -; =
22- . 1
10 =
-; = KP3
1;
1 t
t
Annuity factor )22.-<! 1; years*G :
=19.;?
(he internal rate of return )I,,* for the pro/ect is +0.7+<. ,ecall from your
introductory finance class that KP3 is positi"e if I,, Q discount rate )or!
e#ui"alently! hurdle rate*. (he highest "alue that beta can take before the hurdle
rate exceeds the I,, is determined by8
.+07+ : .;9 D b J ).16 @ .;9* b : .277+>.;9 : +.-7
?. a. Call the aggressi"e stock A and the defensi"e stock .. 1eta is the sensiti"ity
2-6+
of the stockCs return to the market return! i.e.! the change in the stock return
per unit change in the market return. (herefore! e compute each stockCs beta
by calculating the difference in its return across the to scenarios di"ided by
the difference in the market return8
.;2 .+9 .;6 .12
2.;; ;.+;
.;0 .20 .;0 .20
A ,

b. $ith the to scenarios e#ually likely! the expected return is an a"erage of the
to possible outcomes8
A)r
A
* : ;.0 )@.;2 D .+9* : .19 : 19<
A)r
.
* : ;.0 ).;6 D .12* : .;? : ?<
c. (he 2%L is determined by the market expected return of F;.0 J ).20 D .;0*G :
10<! ith b
%
: 1! and r
f
: 6< )hich has b
f
:

;*. 2ee the folloing graph8

Expected Return ' (eta Re)ations*ip
0
5
10
15
20
25
30
35
40
0 0!5 1 1!5 2 2!5 3
(eta
E
x
p
e
c
t
e
d

R
e
t
u
r
n

SML
D M
A
A
(he e#uation for the security market line is8
A)r* : .;6 D b J ).10 @ .;6*
d. 1ased on its risk! the aggressi"e stock has a re#uired expected return of8
A)r
A
* : .;6 D 2.; J ).10 @ .;6* : .2- : 2-<
(he analystCs forecast of expected return is only 19<. (hus the stockCs alpha is8
a
A
: actually expected return @ re#uired return )gi"en risk*
2-6-
: 19< @ 2-< : @6<
2imilarly! the re#uired return for the defensi"e stock is8
A)r
.
* : .;6 D ;.+ J ).10 @ .;6* : 9.7<
(he analystCs forecast of expected return for . is ?<! and hence! the stock has
a positi"e alpha8
a
.
: actually expected return @ re#uired return )gi"en risk*
: .;? @ .;97 : D;.;;+ : D;.+<
(he points for each stock plot on the graph as indicated abo"e.
e. (he hurdle rate is determined by the pro/ect beta );.+*! not the firmCs beta.
(he correct discount rate is 9.7<! the fair rate of return for stock ..
1;. Kot possible. Portfolio A has a higher beta than Portfolio 1! but the expected return
for Portfolio A is loer than the expected return for Portfolio 1. (hus! these to
portfolios cannot exist in e#uilibrium.
11. Possible. If the CAP% is "alid! the expected rate of return compensates
only for systematic )market* risk! represented by beta! rather than for the
standard de"iation! hich includes nonsystematic risk. (hus! Portfolio ACs
loer rate of return can be paired ith a higher standard de"iation! as long as
ACs beta is less than 1Cs.
12. Kot possible. (he reard-to-"ariability ratio for Portfolio A is better than that of
the market. (his scenario is impossible according to the CAP% because the CAP%
predicts that the market is the most efficient portfolio. Psing the numbers supplied8
.16 .1; .19 .1;
;.0 ;.++
.12 .2-
A #

Portfolio A pro"ides a better risk-reard tradeoff than the market portfolio.
1+. Kot possible. Portfolio A clearly dominates the market portfolio. Portfolio A has
both a loer standard de"iation and a higher expected return.
1-. Kot possible. (he 2%L for this scenario is8 A)r* : 1; D b J )19 @ 1;*
Portfolios ith beta e#ual to 1.0 ha"e an expected return e#ual to8
A)r* : 1; D F1.0 J )19 @ 1;*G : 22<
(he expected return for Portfolio A is 16<H that is! Portfolio A plots belo the
2-60
2%L )
A
: @6<*! and hence! is an o"erpriced portfolio. (his is inconsistent
ith the CAP%.
10. Kot possible. (he 2%L is the same as in Problem 1-. Oere! Portfolio ACs re#uired
return is8 .1; D );.? J .;9* : 17.2<
(his is greater than 16<. Portfolio A is o"erpriced ith a negati"e alpha8
A
: @1.2<
16. Possible. (he C%L is the same as in Problem 12. Portfolio A plots belo the
C%L! as any asset is expected to. (his scenario is not inconsistent ith the CAP%.
17. 2ince the stockCs beta is e#ual to 1.2! its expected rate of return is8
.;6 D F1.2 ).16 @ .;6*G : 19<
1 1 ; 1
1
;
=0; =6
) * ;.19 =0+
=0;
, P P P
" r P
P
+ +

19. (he series of =1!;;; payments is a perpetuity. If beta is ;.0! the cash flo should
be discounted at the rate8
.;6 D F;.0 J ).16 @ .;6*G : .11 : 11<
P3 : =1!;;;>;.11 : =?!;?;.?1
If! hoe"er! beta is e#ual to 1! then the in"estment should yield 16<! and the price
paid for the firm should be8
P3 : =1!;;;>;.16 : =6!20;
(he difference! =2!9-;.?1! is the amount you ill o"erpay if you erroneously
assume that beta is ;.0 rather than 1.
1?. Psing the 2%L8 .;- : .;6 D b J ).16 @ .;6* b : @.;2>.1; : @;.2
2;. r
1
: 1?<H r
2
: 16<H b
1
: 1.0H b
2
: 1
a. (o determine hich in"estor as a better selector of indi"idual stocks e look
at abnormal return! hich is the ex-post alphaH that is! the abnormal return is
the difference beteen the actual return and that predicted by the 2%L.
$ithout information about the parameters of this e#uation )risk-free rate and
market rate of return* e cannot determine hich in"estor as more accurate.
b. If r
f
: 6< and r
%
: 1-<! then )using the notation alpha for the abnormal
2-66
return*8
a
1
: .1? @ F.;6 D 1.0 J ).1- @ .;6*G : .1? @ .19 : 1<
a
2
: .16 @ F.;6 D 1 J ).1- @ .;6*G : .16 @ .1- : 2<
Oere! the second in"estor has the larger abnormal return and thus appears to
be the superior stock selector. 1y making better predictions! the second
in"estor appears to ha"e tilted his portfolio toard underpriced stocks.
c. If r
f
: +< and r
%
: 10<! then8
a
1
: .1? @ F.;+ D 1.0 J ).10 @ .;+*G : .1? @ .21 : @2<
a
2
: .16 @ F.;+D 1 J ).10 @ .;+*G : .16 @ .10 : 1<
Oere! not only does the second in"estor appear to be the superior stock
selector! but the first in"estorCs predictions appear "alueless )or orse*.
21. a. 2ince the market portfolio! by definition! has a beta of 1! its expected rate of
return is 12<.
b. b : ; means no systematic risk. Oence! the stockCs expected rate of
return in market e#uilibrium is the risk-free rate! 0<.
c. Psing the 2%L! the fair expected rate of return for a stock ith b : @;.0 is8
) * ;.;0 F) ;.0* );.12 ;.;0*G 1.0< " r +

(he actually expected rate of return! using the expected price and di"idend for
next year is8
=-1 =+
) * 1 ;.1; 1;<
=-;
" r
+

1ecause the actually expected return exceeds the fair return! the stock is
underpriced.
22. In the Eero-beta CAP% the Eero-beta portfolio replaces the risk-free rate! and thus8
A)r* : 9 D ;.6)17 @ 9* : 1+.-<
2+. a. A)r
P* : r
f
D b
P
J FA)r
%
* @ r
f
G : 0< D ;.9 )10< I 0<* : 1+<
: 1-< 1+< : 1<
4ou should in"est in this fund because alpha is positi"e.
b. (he passi"e portfolio ith the same beta as the fund should be in"ested 9;<
in the market-index portfolio and 2;< in the money market account. For this
portfolio8
A)r
P* : );.9 J 10<* D );.2 J 0<* : 1+<
2-67
1-< I 1+< : 1< :
2-. a. $e ould incorporate li#uidity into the CCAP% in a manner analogous to the
ay in hich li#uidity is incorporated into the con"entional CAP%. In the
latter case! in addition to the market risk premium! expected return is also
dependent on the expected cost of illi#uidity and three li#uidity-related betas
hich measure the sensiti"ity of8 )1* the securityCs illi#uidity to market
illi#uidityH )2* the securityCs return to market illi#uidityH and! )+* the securityCs
illi#uidity to the market return. A similar approach can be used for the
CCAP%! except that the li#uidity betas ould be measured relati"e to
consumption groth rather than the usual market index.
b. As in part )a*! non-traded assets ould be incorporated into the CCAP% in a
fashion similar to part )a*. ,eplace the market portfolio ith consumption
groth. (he issue of li#uidity is more acute ith non traded-assets such as
pri"ately-held businesses and labor income.
$hile onership of a pri"ately-held business is analogous to onership of an
illi#uid stock! expect a greater degree of illi#uidity for the typical pri"ate
business. If the oner of a pri"ately-held business is satisfied ith the
di"idends paid out from the business! then the lack of li#uidity is not an issue.
If the oner seeks to realiEe income greater than the business can pay out!
then selling onership! in full or part! typically entails a substantial li#uidity
discount. (he illi#uidity correction should be treated as suggested in part )a*.
(he same general considerations apply to labor income! although it is
probable that the lack of li#uidity for labor income has an e"en greater impact
on security market e#uilibrium "alues. Labor income has a ma/or impact on
portfolio decisions. $hile it is possible to borro against labor income to
some degree! and some of the risk associated ith labor income can be
ameliorated ith insurance! it is plausible that the li#uidity betas of
consumption streams are #uite significant! as the need to borro against labor
income is likely cyclical.
CFA PROBLEMS
1. a. AgreeH ,eganCs conclusion is correct. 1y definition! the market portfolio lies on
the capital market line )C%L*. Pnder the assumptions of capital market theory!
all portfolios on the C%L dominate! in a risk-return sense! portfolios that lie on
the %arkoitE efficient frontier because! gi"en that le"erage is alloed! the C%L
creates a portfolio possibility line that is higher than all points on the efficient
frontier except for the market portfolio! hich is ,ainboCs portfolio. 1ecause
AagleCs portfolio lies on the %arkoitE efficient frontier at a point other than the
2-69
market portfolio! ,ainboCs portfolio dominates AagleCs portfolio.
2-6?
b. Konsystematic risk is the uni#ue risk of indi"idual stocks in a portfolio that is
di"ersified aay by holding a ell-di"ersified portfolio. (otal risk is composed
of systematic )market* risk and nonsystematic )firm-specific* risk.
.isagreeH $ilsonCs remark is incorrect. 1ecause both portfolios lie on the
%arkoitE efficient frontier! neither Aagle nor ,ainbo has any nonsystematic
risk. (herefore! nonsystematic risk does not explain the different expected
returns. (he determining factor is that ,ainbo lies on the )straight* line )the
C%L* connecting the risk-free asset and the market portfolio ),ainbo*! at the
point of tangency to the %arkoitE efficient frontier ha"ing the highest return per
unit of risk. $ilsonCs remark is also countered by the fact that! since
nonsystematic risk can be eliminated by di"ersification! the expected return for
bearing nonsystematic is Eero. (his is a result of the fact that ell-di"ersified
in"estors bid up the price of e"ery asset to the point here only systematic risk
earns a positi"e return )nonsystematic risk earns no return*.
2. A)r* : r
f
D b J FA)r
% * I r
f
G
Furhman Labs8 A)r* : .;0 D 1.0 J F.110 I .;0G : 1-.70<
Barten (esting8 A)r* : .;0 D ;.9 J F.110 I .;0G : 1;.2;<
If the forecast rate of return is less than )greater than* the re#uired rate of return!
then the security is o"er"alued )under"alued*.
Furhman Labs8 Forecast return @ ,e#uired return : 1+.20< I 1-.70< : I1.0;<
Barten (esting8 Forecast return @ ,e#uired return : 11.20< I 1;.2;< : 1.;0<
(herefore! Furhman Labs is o"er"alued and Barten (esting is under"alued.
+. a.
-. d. From CAP%! the fair expected return : 9 D 1.20 J )10 9* : 16.70<
Actually expected return : 17<
: 17 16.70 : ;.20<
0. d.
6. c.
7. d.
9. d. F4ou need to kno the risk-free rateG
2-7;
?. d. F4ou need to kno the risk-free rateG
1;. Pnder the CAP%! the only risk that in"estors are compensated for bearing is the
risk that cannot be di"ersified aay )systematic risk*. 1ecause systematic risk
)measured by beta* is e#ual to 1.; for both portfolios! an in"estor ould expect the
same rate of return from both portfolios A and 1. %oreo"er! since both portfolios
are ell di"ersified! it doesnCt matter if the specific risk of the indi"idual securities
is high or lo. (he firm-specific risk has been di"ersified aay for both portfolios.
11. a. %cWay should borro funds and in"est those funds proportionately in
%urrayCs existing portfolio )i.e.! buy more risky assets on margin*. In
addition to increased expected return! the alternati"e portfolio on the capital
market line ill also ha"e increased risk! hich is caused by the higher
proportion of risky assets in the total portfolio.
b. %cWay should substitute lo beta stocks for high beta stocks in order to
reduce the o"erall beta of 4orkCs portfolio. 1y reducing the o"erall portfolio
beta! %cWay ill reduce the systematic risk of the portfolio! and therefore
reduce its "olatility relati"e to the market. (he security market line )2%L*
suggests such action )i.e.! mo"ing don the 2%L*! e"en though reducing beta
may result in a slight loss of portfolio efficiency unless full di"ersification is
maintained. 4orkCs primary ob/ecti"e! hoe"er! is not to maintain efficiency!
but to reduce risk exposureH reducing portfolio beta meets that ob/ecti"e.
1ecause 4ork does not ant to engage in borroing or lending! %cWay
cannot reduce risk by selling e#uities and using the proceeds to buy risk-free
assets )i.e.! lending part of the portfolio*.
12. a.
Axpected ,eturn Alpha
2tock X 0< D ;.9 J )1-< 0<* : 12.2< 1-.;< 12.2< : 1.9<
2tock 4 0< D 1.0 J )1-< 0<* : 19.0< 17.;< 19.0< : 1.0<
b. i. Way should recommend 2tock X because of its positi"e alpha! compared to
2tock 4! hich has a negati"e alpha. In graphical terms! the expected
return>risk profile for 2tock X plots abo"e the security market line )2%L*!
hile the profile for 2tock 4 plots belo the 2%L. Also! depending on the
indi"idual risk preferences of WayCs clients! the loer beta for 2tock X may
ha"e a beneficial effect on o"erall portfolio risk.
ii. Way should recommend 2tock 4 because it has higher forecasted return and
loer standard de"iation than 2tock X. (he respecti"e 2harpe ratios for
2tocks X and 4 and the market index are8
2-71
2tock X8 )1-< 0<*>+6< : ;.20
2tock 48 )17< 0<*>20< : ;.-9
%arket index8 )1-< 0<*>10< : ;.6;
(he market index has an e"en more attracti"e 2harpe ratio than either of the
indi"idual stocks! but! gi"en the choice beteen 2tock X and 2tock 4! 2tock
4 is the superior alternati"e.
$hen a stock is held as a single stock portfolio! standard de"iation is the
rele"ant risk measure. For such a portfolio! beta as a risk measure is
irrele"ant.
Although holding a single asset is not a typically recommended in"estment
strategy! some in"estors may hold hat is essentially a single-asset portfolio
hen they hold the stock of their employer company. For such in"estors! the
rele"ance of standard de"iation "ersus beta is an important issue.
COAP(A, 1;8 A,1I(,ABA P,ICIKB (OA5,4 AK. %PL(IFAC(5, %5.AL2 5F
,I2W AK. ,A(P,K
PROBLEM SETS
1. (he re"ised estimate of the expected rate of return on the stock ould be the old
estimate plus the sum of the products of the unexpected change in each factor times
the respecti"e sensiti"ity coefficient8
re"ised estimate : 12< D F)1 J 2<* D );.0 J +<*G : 10.0<
2. (he AP( factors must correlate ith ma/or sources of uncertainty! i.e.! sources of
uncertainty that are of concern to many in"estors. ,esearchers should in"estigate
factors that correlate ith uncertainty in consumption and in"estment opportunities.
B.P! the inflation rate! and interest rates are among the factors that can be expected
to determine risk premiums. In particular! industrial production )IP* is a good
indicator of changes in the business cycle. (hus! IP is a candidate for a factor that
is highly correlated ith uncertainties that ha"e to do ith in"estment and
consumption opportunities in the economy.
+. Any pattern of returns can be &explained' if e are free to choose an indefinitely
large number of explanatory factors. If a theory of asset pricing is to ha"e "alue! it
must explain returns using a reasonably limited number of explanatory "ariables
)i.e.! systematic factors*.
-. A#uation 1;.? applies here8
A)r
p
* : r
f
D b
P1
FA)r
1
* r
f
G D b
P2
FA)r
2
* @ r
f
G
2-72
$e need to find the risk premium ),P* for each of the to factors8
,P
1
: FA)r
1
* r
f
G and ,P
2
: FA)r
2
* r
f
G
In order to do so! e sol"e the folloing system of to e#uations ith to unknons8
.+1 : .;6 D )1.0 J ,P
1
* D )2.; J ,P
2
*
.27 : .;6 D )2.2 J ,P
1
* D F)@;.2* J ,P
2
G
(he solution to this set of e#uations is8
,P
1
: 1;< and ,P
2
: 0<
(hus! the expected return-beta relationship is8
A)r
P
* : 6< D )b
P1
J 1;<* D )b
P2
J 0<*
0. (he expected return for Portfolio F e#uals the risk-free rate since its beta e#uals ;.
For Portfolio A! the ratio of risk premium to beta is8 )12 I 6*>1.2 : 0
For Portfolio A! the ratio is loer at8 )9 @ 6*>;.6 : +.++
(his implies that an arbitrage opportunity exists. For instance! you can create a
Portfolio B ith beta e#ual to ;.6 )the same as ACs* by combining Portfolio A and
Portfolio F in e#ual eights. (he expected return and beta for Portfolio B are then8
A)r
B
* : );.0 J 12<* D );.0 J 6<* : ?<
b
B
: );.0 J 1.2* D );.0 J ;<* : ;.6
Comparing Portfolio B to Portfolio A! B has the same beta and higher return.
(herefore! an arbitrage opportunity exists by buying Portfolio B and selling an
e#ual amount of Portfolio A. (he profit for this arbitrage ill be8
r
B
@ r
A
:F?< D );.6 J F*G F9< D );.6 J F*G : 1<
(hat is! 1< of the funds )long or short* in each portfolio.
6. 2ubstituting the portfolio returns and betas in the expected return-beta relationship!
e obtain to e#uations ith to unknons! the risk-free rate )r
f
* and the factor
risk premium ),P*8
12< : r
f
D )1.2 J ,P*
?< : r
f
D );.9 J ,P*
2ol"ing these e#uations! e obtain8
r
f
: +< and ,P : 7.0<
7. a. 2horting an e#ually-eighted portfolio of the ten negati"e-alpha stocks and
in"esting the proceeds in an e#ually-eighted portfolio of the ten positi"e-
alpha stocks eliminates the market exposure and creates a Eero-in"estment
portfolio. .enoting the systematic market factor as ,
%
! the expected dollar
return is )noting that the expectation of non-systematic risk! e! is Eero*8
2-7+
=1!;;;!;;; J F;.;2 D )1.; J ,
%
*G =1!;;;!;;; J F)@;.;2* D )1.; J ,
%
*GY
: =1!;;;!;;; J ;.;- : =-;!;;;
(he sensiti"ity of the payoff of this portfolio to the market factor is Eero
because the exposures of the positi"e alpha and negati"e alpha stocks cancel
out. )Kotice that the terms in"ol"ing ,
%
sum to Eero.* (hus! the systematic
component of total risk is also Eero. (he "ariance of the analystCs profit is not
Eero! hoe"er! since this portfolio is not ell di"ersified.
For n : 2; stocks )i.e.! long 1; stocks and short 1; stocks* the in"estor ill ha"e a
=1;;!;;; position )either long or short* in each stock. Ket market exposure is Eero! but
firm-specific risk has not been fully di"ersified. (he "ariance of dollar returns from the
positions in the 2; stocks is8
2; J F)1;;!;;; J ;.+;*
2
G : 19!;;;!;;;!;;;
(he standard de"iation of dollar returns is =1+-!16-.
b. If n : 0; stocks )20 stocks long and 20 stocks short*! the in"estor ill ha"e a
=-;!;;; position in each stock! and the "ariance of dollar returns is8
0; J F)-;!;;; J ;.+;*
2
G : 7!2;;!;;;!;;;
(he standard de"iation of dollar returns is =9-!90+.
2imilarly! if n : 1;; stocks )0; stocks long and 0; stocks short*! the in"estor
ill ha"e a =2;!;;; position in each stock! and the "ariance of dollar returns is8
1;; J F)2;!;;; J ;.+;*
2
G : +!6;;!;;;!;;;
(he standard de"iation of dollar returns is =6;!;;;.
Kotice that! hen the number of stocks increases by a factor of 0 )i.e.! from 2;
to 1;;*! standard de"iation decreases by a factor of 0 : 2.2+6;7 )from
=1+-!16- to =6;!;;;*.
9. a. * e )
2 2
%
2 2
+
991 20 * 2; 9 . ; )
2 2 2 2
A
+
0;; 1; * 2; ; . 1 )
2 2 2 2
1
+
?76 2; * 2; 2 . 1 )
2 2 2 2
C
+
b. If there are an infinite number of assets ith identical characteristics! then a
ell-di"ersified portfolio of each type ill ha"e only systematic risk since the
non-systematic risk ill approach Eero ith large n8
2-7-
2
2
2
$ell-.i"ersified 206
$ell-.i"ersified -;;
$ell-.i"ersified 076
A
%
!
;
;
;
(he mean ill e#ual that of the indi"idual )identical* stocks.
c. (here is no arbitrage opportunity because the ell-di"ersified portfolios all
plot on the security market line )2%L*. 1ecause they are fairly priced! there
is no arbitrage.
?. a. A long position in a portfolio )P* comprised of Portfolios A and 1 ill offer
an expected return-beta tradeoff lying on a straight line beteen points A and
1. (herefore! e can choose eights such that b
P
: b
C
but ith expected
return higher than that of Portfolio C. Oence! combining P ith a short
position in C ill create an arbitrage portfolio ith Eero in"estment! Eero beta!
and positi"e rate of return.
b. (he argument in part )a* leads to the proposition that the coefficient of b
2
must
be Eero in order to preclude arbitrage opportunities.
1;. a. A)r* : 6< D )1.2 J 6<* D );.0 J 9<* D );.+ J +<* : 19.1<
b. 2urprises in the macroeconomic factors ill result in surprises in the return of
the stock8
Pnexpected return from macro factors :
F1.2 J )-< @ 0<*G D F;.0 J )6< @ +<*G D F;.+ J );< @ 2<*G : @;.+<
A )r* :19.1< I ;.+< : 17.9<
11. (he AP( re-uired )i.e.! e#uilibrium* rate of return on the stock based on r
f
and the
factor betas is8
re#uired A)r* : 6< D )1 J 6<* D );.0 J 2<* D );.70 J -<* : 16<
According to the e#uation for the return on the stock! the actually expected return
on the stock is 10< )because the e.pected surprises on all factors are Eero by
definition*. 1ecause the actually expected return based on risk is less than the
e#uilibrium return! e conclude that the stock is o"erpriced.
12. (he first to factors seem promising ith respect to the likely impact on the firmCs
cost of capital. 1oth are macro factors that ould elicit hedging demands across
broad sectors of in"estors. (he third factor! hile important to Pork Products! is a
poor choice for a multifactor 2%L because the price of hogs is of minor importance
to most in"estors and is therefore highly unlikely to be a priced risk factor. 1etter
choices ould focus on "ariables that in"estors in aggregate might find more
2-70
important to their elfare. Axamples include8 inflation uncertainty! short-term
interest-rate risk! energy price risk! or exchange rate risk. (he important point here
is that! in specifying a multifactor 2%L! e not confuse risk factors that are
important to
2-76
a particular in"estor ith factors that are important to in"estors in generalH only the
latter are likely to command a risk premium in the capital markets.
1+. (he formula is8
) * ;.;- 1.20 ;.;9 1.0 ;.;2 .17 17< " r + +
1-. If
-<
f
r
and based on the sensiti"ities to real B.P );.70* and inflation )1.20*!
%cCracken ould calculate the expected return for the 5rb Large Cap Fund to be8
) * ;.;- ;.70 ;.;9 1.20 ;.;2 .;- ;.;90 9.0< abo"e the risk free rate " r + + +
(herefore! WonCs fundamental analysis estimate is congruent ith %cCrackenCs
AP( estimate. If e assume that both Won and %cCrackenCs estimates on the
return of 5rbCs Large Cap Fund are accurate! then no arbitrage profit is possible.
10. In order to eliminate inflation! the folloing three e#uations must be sol"ed
simultaneously! here the B.P sensiti"ity ill e#ual 1 in the first e#uation!
inflation sensiti"ity ill e#ual ; in the second e#uation and the sum of the eights
must e#ual 1 in the third e#uation.
1. 1.20 ;.70 1.; 1
2. 1.0 1.20 2.; ;
+. 1
&. &y &+
&+ &y &+
&. &y &+
+ +
+ +
+ +
Oere! &x' represents 5rbCs &Oigh Broth Fund'! &y' represents &Large Cap Fund'
and &E' represents &Ptility Fund.' Psing algebraic manipulation ill yield x :
y : 1.6 and E : -2.2.
16. 2ince retirees li"ing off a steady income ould be hurt by inflation! this portfolio
ould not be appropriate for them. ,etirees ould ant a portfolio ith a return
positi"ely correlated ith inflation to preser"e "alue! and less correlated ith the
"ariable groth of B.P. (hus! 2tiles is rong. %cCracken is correct in that
supply side macroeconomic policies are generally designed to increase output at a
minimum of inflationary pressure. Increased output ould mean higher B.P!
hich in turn ould increase returns of a fund positi"ely correlated ith B.P.
17. (he maximum residual "ariance is tied to the number of securities )n* in the
portfolio because! as e increase the number of securities! e are more likely to
encounter securities ith larger residual "ariances. (he starting point is to
determine the practical limit on the portfolio residual standard de"iation! )e
P
*! that
still #ualifies as a Tell-di"ersified portfolio.C A reasonable approach is to compare
2-77
2
)e
P
* to the market "ariance! or e#ui"alently! to compare )e
P
* to the market
standard de"iation. 2uppose e do not allo )e
P
* to exceed p
#
! here p is a
small decimal fraction! for example! ;.;0H then! the smaller the "alue e choose for
p! the more stringent our criterion for defining ho di"ersified a Tell-di"ersifiedC
portfolio must be.
Ko construct a portfolio of n securities ith eights &
1
! &
2
!f!&
n
! so that &
i
:1.
(he portfolio residual "ariance is8
2
)e
P
* : &
1
2
2
)e
i
*
(o meet our practical definition of sufficiently di"ersified! e re#uire this residual
"ariance to be less than )p
#
*
2
. A sure and simple ay to proceed is to assume the
orst! that is! assume that the residual "ariance of each security is the highest
possible "alue alloed under the assumptions of the problem8
2
)e
i
* : n
2
#
In that case8
2
)e
P
* : &
i
2
n
#
2
Ko apply the constraint8 &
i
2
n
#
2
^ )p
#
*
2
(his re#uires that8 n&
i
2
^ p
2
5r! e#ui"alently! that8 &
i
2
^ p
2
>n
A relati"ely easy ay to generate a set of ell-di"ersified portfolios is to use portfolio
eights that follo a geometric progression! since the computations then become
relati"ely straightforard. Choose &
1
and a common factor - for the geometric
progression such that - Z 1. (herefore! the eight on each stock is a fraction - of the
eight on the pre"ious stock in the series. (hen the sum of n terms is8
&
i

: &
1
)1@ -
n
*>)1@ -* : 1
or8 &
1
: )1@ -*>)1@ -
n
*
(he sum of the n s-uared eights is similarly obtained from &
1
2
and a common
geometric progression factor of -
2
. (herefore8
&
i
2
: &
1
2
)1@ -
2n
*>)1@ -
2
*
2ubstituting for &
1
from abo"e! e obtain8
&
i
2
: F)1@ -*
2
>)1@ -
n
*
2
G J F)1@ -
2n
*>)1@ -
2
*G
For sufficient di"ersification! e choose - so that8 &
i
2
^ p
2
>n
For example! continue to assume that p : ;.;0 and n : 1!;;;. If e choose
- : ;.??7+! then e ill satisfy the re#uired condition. At this "alue for -8
&
1
: ;.;;2? and &
n
: ;.;;2? J ;.??7+
1!;;;
In this case! &
1
is about 10 times &
n
. .espite this significant departure from e#ual
eighting! this portfolio is ne"ertheless ell di"ersified. Any "alue of - beteen
;.??7+ and 1.; results in a ell-di"ersified portfolio. As - gets closer to 1! the
portfolio approaches e#ual eighting.
2-79
19. a. Assume a single-factor economy! ith a factor risk premium A
%
and a )large*
set of ell-di"ersified portfolios ith beta
P
. 2uppose e create a portfolio e
by allocating the portion to portfolio P and )1 @ * to the market portfolio
%. (he rate of return on portfolio e is8
,
e
: ) J ,
P
* D F)1 @ * J ,
%
G
Portfolio e is riskless if e choose so that
e
: ;. (his re#uires that8
e
: ) J
P
* D F)1 @ * J 1G : ; : 1>)1 @
P
* and )1 @ * : @
P
>)1 @
P
*
2ubstitute this "alue for in the expression for ,
e
8
,
e
: gF1>)1 @
P
*G J ,
P
h @ gF
P
>)1 @
P
*G J ,
%
h
2ince
e
: ;! then! in order to a"oid arbitrage! ,
e
must be Eero.
(his implies that8 ,
P
:
P
J ,
%
(aking expectations e ha"e8
A
P
:
P
J A
%
(his is the 2%L for ell-di"ersified portfolios.
b. (he same argument can be used to sho that! in a three-factor model ith
factor risk premiums A
%
! A
1
and A
2
! in order to a"oid arbitrage! e must ha"e8
A
P
: )
P%
J A
%
* D )
P1
J A
1
* D )
P2
J A
2
*
(his is the 2%L for a three-factor economy.
1?. a. (he Fama-French )FF* three-factor model holds that one of the factors dri"ing
returns is firm siEe. An index ith returns highly correlated ith firm siEe
)i.e.! firm capitaliEation* that captures this factor is 2%1 )2mall %inus 1ig*!
the return for a portfolio of small stocks in excess of the return for a portfolio
of large stocks. (he returns for a small firm ill be positi"ely correlated ith
2%1. %oreo"er! the smaller the firm! the greater its residual from the other
to factors! the market portfolio and the O%L portfolio! hich is the return
for a portfolio of high book-to-market stocks in excess of the return for a
portfolio of lo book-to-market stocks. Oence! the ratio of the "ariance of
this residual to the "ariance of the return on 2%1 ill be larger and! together
ith the higher correlation! results in a high beta on the 2%1 factor.
b. (his #uestion appears to point to a fla in the FF model. (he model predicts
that firm siEe affects a"erage returns! so that! if to firms merge into a larger
firm! then the FF model predicts loer a"erage returns for the merged firm.
Ooe"er! there seems to be no reason for the merged firm to underperform
the returns of the component companies! assuming that the component firms
ere unrelated and that they ill no be operated independently. $e might
therefore expect that the performance of the merged firm ould be the same
as the performance of a portfolio of the originally independent firms! but the
2-7?
FF model predicts that the increased firm siEe ill result in loer a"erage
returns. (herefore! the #uestion re"ol"es around the beha"ior of returns for a
portfolio of small firms! compared to the return for larger firms that result
from merging those small firms into larger ones. Oad past mergers of small
firms into larger firms resulted! on a"erage! in no change in the resultant
larger firmsC stock return characteristics )compared to the portfolio of stocks
of the merged firms*! the siEe factor in the FF model ould ha"e failed.
Perhaps the reason the siEe factor seems to help explain stock returns is that!
hen small firms become large! the characteristics of their fortunes )and
hence their stock returns* change in a significant ay. Put differently! stocks
of large firms that result from a merger of smaller firms appear empirically to
beha"e differently from portfolios of the smaller component firms.
2pecifically! the FF model predicts that the large firm ill ha"e a smaller risk
premium. Kotice that this de"elopment is not necessarily a bad thing for the
stockholders of the smaller firms that merge. (he loer risk premium may be
due! in part! to the increase in "alue of the larger firm relati"e to the merged
firms.
CFA PROBLEMS
1. a. (his statement is incorrect. (he CAP% re#uires a mean-"ariance efficient
market portfolio! but AP( does not.
b. (his statement is incorrect. (he CAP% assumes normally distributed security
returns! but AP( does not.
c. (his statement is correct.
2. b. 2ince Portfolio X has : 1.;! then X is the market portfolio and A),
%
* :16<.
Psing A),
%
* : 16< and r
f
: 9<! the expected return for portfolio 4 is not
consistent.
+. d.
-. c.
0. d.
6. c. In"estors ill take on as large a position as possible only if the
mispricing opportunity is an arbitrage. 5therise! considerations of risk and
di"ersification ill limit the position they attempt to take in the mispriced security.
2-9;
7. d.
9. d.
CHAPTER 11: THE EFFICIENT MAR2ET H"POTHESIS
PROBLEM SETS
1. (he correlation coefficient beteen stock returns for to non-o"erlapping periods
should be Eero. If not! one could use returns from one period to predict returns
in later periods and make abnormal profits.
2. Ko. %icrosoftCs continuing profitability does not imply that stock market in"estors
ho purchased %icrosoft shares after its success as already e"ident ould
ha"e earned an exceptionally high return on their in"estments.
+. Axpected rates of return differ because of differential risk premiums.
-. Ko. (he "alue of di"idend predictability ould be already reflected in the
stock price.
0. Ko! markets can be efficient e"en if some in"estors earn returns abo"e the market
a"erage. Consider the Lucky A"ent issue8 Ignoring transaction costs! about 0;< of
professional in"estors! by definition! ill &beat' the market in any gi"en year. (he
probability of beating it three years in a ro! though small! is not insignificant.
1eating the market in the past does not predict future success as three years of
returns make up too small a sample on hich to base correlation let alone causation.
6. 3olatile stock prices could reflect "olatile underlying economic conditions as large
amounts of information being incorporated into the price ill cause "ariability in
stock price. (he Afficient %arket Oypothesis suggests that in"estors cannot earn
excess risk-ad/usted reards. (he "ariability of the stock price is thus reflected in
the expected returns as returns and risk are positi"ely correlated.
7. (he folloing effects seem to suggest predictability ithin e#uity markets and thus
dispro"e the Afficient %arket Oypothesis. Ooe"er! consider the folloing8
2-91
a. %ultiple studies suggest that &"alue' stocks )measured often by lo P>A
multiples* earn higher returns o"er time than &groth' stocks )high P>A multiples*.
(his could suggest a strategy for earning higher returns o"er time. Ooe"er!
another rational argument may be that traditional forms of CAP% )such as 2harpeCs
model* do not fully account for all risk factors hich affect a firmCs price le"el. A
firm "ieed as riskier may ha"e a loer price and thus P>A multiple.
b. (he book-to-market effect suggests that an in"estor can earn excess returns by
in"esting in companies ith high book "alue )the "alue of a firmCs assets minus its
liabilities di"ided by the number of shares outstanding* to market "alue. A study by
Fama and French
1
suggests that book-to-market "alue reflects a risk factor that is
not accounted for by traditional one "ariable CAP%. For example! companies
experiencing financial distress see the ratio of book to market "alue increase. (hus
a more complex CAP% hich includes book-to-market "alue as an explanatory
"ariable should be used to test market anomalies.
c. 2tock price momentum can be positi"ely correlated ith past performance )short
to intermediate horiEon* or negati"ely correlated )long horiEon*. Oistorical data
seem to imply statistical significance to these patterns. Axplanations for this
include a bandagon effect or the beha"ioralistsC )see Chapter 12* explanation that
there is a tendency for in"estors to underreact to ne information! thus producing a
positi"e serial correlation. Ooe"er! statistical significance does not imply
economic significance. 2e"eral studies hich included transaction costs in the
momentum models disco"ered that momentum traders tended to not outperform the
Afficient %arket Oypothesis strategy of buy and hold.
d. (he small-firm effect states that smaller firms produce better returns than larger
firms. 2ince 1?26 returns from small firms outpace large firm stock returns by
about 1< per year. .o small cap in"estors earn excess risk-ad/usted returnsi
(he measure of systematic risk according to 2harpeCs CAP% is the stockCs beta )or
sensiti"ity of returns of the stock to market returns*. If the stockCs beta is the best
explanation of risk! then the small-firm effect does indicate an inefficient market.
.i"iding the market into deciles based on their betas shos an increasing
relationship beteen betas and returns. Fama and French
2
sho that the empirical
relationship beteen beta and stock returns is flat o"er a fairly long horiEon )1?6+-
1??;*. 1reaking the market into deciles based on siEes and then examining the
relationship beteen beta and stock returns ithin each siEe decile exhibits this flat
relationship. (his implies that firm siEe may be a better measure of risk than beta
and the siEe-effect should not be "ieed as an indicator that markets are inefficient.
Oeuristically this makes sense! as smaller firms are generally "ieed as risky
compared to larger firms and percei"ed risk and return are positi"ely correlated.
1
Fama, Eugene and Kenneth French, Common Risk Factors in the Returns on Stocks and Bonds,
Journal of Finance 33:1, pp. 3-56.
2
ibid
2-92
In addition this effect seems to be endpoint and data sensiti"e. For example! smaller
stocks did not outperform larger stocks from the mid 1?9;s through the 1??;s. In
addition! databases contain stock returns from companies that ha"e sur"i"ed and do
not include returns of those that ent bankrupt. (hus small-firm data may exhibit
sur"i"orship bias.
9. 5"er the long haul! there is an expected upard drift in stock prices based on their
fair expected rates of return. (he fair expected return o"er any single day is "ery
small )e.g.! 12< per year is only about ;.;+< per day*! so that on any day the price
is "irtually e#ually likely to rise or fall. 5"er longer periods! the small expected
daily returns accumulate! and upard mo"es are more likely than donard ones.
?. c. (his is a predictable pattern in returns hich should not occur if
the eak-form A%O is "alid.
1;. a. Acute market inefficiencies are temporary in nature and are more
easily exploited than chronic inefficiencies. A temporary drop in a stock price
due to a large sale ould be more easily exploited than the chronic
inefficiencies mentioned in the other responses.
11. c. (his is a classic filter rule hich should not produce superior
returns in an efficient market.
12. b. (his is the definition of an efficient market.
1+. a. (hough stock prices follo a random alk and intraday price
changes do appear to be a random alk! o"er the long run there is compensation
for bearing market risk and for the time "alue of money. In"esting differs from
a casino in that in the long-run! an in"estor is compensated for these risks! hile
a player at a casino faces less than fair-game odds.
b. In an efficient market! any predictable future prospects of a
company ha"e already been priced into the current "alue of the stock. (hus! a
stock share price can still follo a random alk.
c. $hile the random nature of dart board selection seems to follo
naturally from efficient markets! the role of rational portfolio management still
exists. It exists to ensure a ell-di"ersified portfolio! to assess the risk-
tolerance of the in"estor and to take into account tax code issues.
2-9+
1-. d. In a semistrong-form efficient market! it is not possible to earn abnormally
high profits by trading on publicly a"ailable information. Information about
P>A ratios and recent price changes is publicly knon. 5n the other hand! an
in"estor ho has ad"ance knoledge of management impro"ements could
earn abnormally high trading profits )unless the market is also strong-form
efficient*.
10. %arket efficiency implies in"estors cannot earn excess risk-ad/usted profits. If the
stock price run-up occurs hen only insiders kno of the coming di"idend
increase! then it is a "iolation of strong-form efficiency. If the public also
knos of the increase! then this "iolates semistrong-form efficiency.
16. $hile positi"e beta stocks respond ell to fa"orable ne information about the
economyCs progress through the business cycle! they should not sho abnormal
returns around already anticipated e"ents. If a reco"ery! for example! is already
anticipated! the actual reco"ery is not nes. (he stock price should already
reflect the coming reco"ery.
17. a. Consistent. 1ased on pure luck! half of all managers should beat the market
in any year.
b. Inconsistent. (his ould be the basis of an &easy money' rule8 simply in"est
ith last yearMs best managers.
c. Consistent. In contrast to predictable returns! predictable volatility does not
con"ey a means to earn abnormal returns.
d. Inconsistent. (he abnormal performance ought to occur in ]anuary hen
earnings are announced.
e. Inconsistent. ,e"ersals offer a means to earn easy money8 /ust buy last
eekCs losers.
19. (he return on the market is 9<. (herefore! the forecast monthly return for Ford is8
;.1;< D )1.1 J 9<* : 9.?<
FordCs actual return as 7<! so the abnormal return as @1.?<.
1?. a. 1ased on broad market trends! the CAP% indicates that
AmbChaser stock should ha"e increased by8 1.;< D 2.; J )1.0< @ 1.;<* :
2.;<
2-9-
Its firm-specific )nonsystematic* return due to the lasuit is =1 million per =1;;
million initial e#uity! or 1<. (herefore! the total return should be +<. )It is
assumed here that the outcome of the lasuit had a Eero expected "alue.*
b. If the settlement as expected to be =2 million! then the actual settlement as a
&=1 million disappointment!' and so the firm-specific return ould be @1<! for
a total return of 2< @ 1< : 1<.
2;. Bi"en market performance! predicted returns on the to stocks ould be8
Apex8 ;.2< D )1.- J +<* : -.-<
1pex8 @;.1< D );.6 J +<* : 1.7<
Apex underperformed this predictionH 1pex outperformed the prediction. $e
conclude that 1pex on the lasuit.
21. a. A)r
%
* : 12<! r
f
: -< and b : ;.0
(herefore! the expected rate of return is8
-< D ;.0 J )12< @ -<* : 9<
If the stock is fairly priced! then A)r* : 9<.
b. If r
%
falls short of your expectation by 2< )that is! 1;< @ 12<* then you
ould expect the return for Changing Fortunes Industries to fall short of your
original expectation by8 b J 2< : 1<
(herefore! you ould forecast a &re"ised' expectation for Changing Fortunes of8 9< @ 1< :
7<
c. Bi"en a market return of 1;<! you ould forecast a return for Changing
Fortunes of 7<. (he actual return is 1;<. (herefore! the surprise due to firm-
specific factors is 1;< @ 7< : +< hich e attribute to the settlement.
1ecause the firm is initially orth =1;; million! the surprise amount of the
settlement is +< of =1;; million! or =+ million! implying that the prior
expectation for the settlement as only =2 million.
22. Implicit in the dollar-cost a"eraging strategy is the notion that stock prices
fluctuate around a &normal' le"el. 5therise! there is no meaning to statements
such as8 &hen the price is high.' Oo do e kno! for example! hether a price
of =20 today ill turn out to be "ieed as high or lo compared to the stock price
six months from noi
2+. (he market responds positi"ely to ne& nes. If the e"entual reco"ery is
anticipated! then the reco"ery is already reflected in stock prices. 5nly a better-
than-expected reco"ery should affect stock prices.
2-90
2-. 1uy. In your "ie! the firm is not as bad as e"eryone else belie"es it to be.
(herefore! you "ie the firm as under"alued by the market. 4ou are less
pessimistic about the firmCs prospects than the beliefs built into the stock price.
20. Oere e need a to-factor model relating FordCs return to those of both the broad
market and the auto industry. If e call r
I
the industry return! then e ould first
estimate parameters
!
# IN,
,
in the folloing regression8
/O*, # # IN, IN,
r r r + + +
Bi"en these estimates e ould calculate FordCs firm-specific return as8
F G
/O*, # # IN, IN,
r r r + + +
(his estimate of firm-specific nes ould measure the marketCs assessment of
the potential profitability of FordCs ne model.
26. (he market may ha"e anticipated e"en greater earnings. !ompared to prior
e.pectations( the announcement as a disappointment.
27. (hinly traded stocks ill not ha"e a considerable amount of market research
performed on the companies they represent. (his neglected-firm effect implies a
greater degree of uncertainty ith respect to smaller companies. (hus positi"e
CAP% alphas among thinly traded stocks do not necessarily "iolate the efficient
market hypothesis since these higher alphas are actually risk premia! not market
inefficiencies.
29. (he negati"e abnormal returns )donard drift in CA,* /ust prior to stock
purchases suggest that insiders deferred their purchases until after bad nes as
released to the public. (his is e"idence of "aluable inside information. (he
positi"e abnormal returns after purchase suggest insider purchases in anticipation of
good nes. (he analysis is symmetric for insider sales.
2?. a. (he market risk premium mo"es countercyclical to the economy! peaking in
recessions. A "iolation of the Afficient %arket Oypothesis ould imply that
in"estors could take ad"antage of this predictability and earn excess risk ad/usted
returns. Ooe"er! se"eral studies! including 2iegel
+
! sho that successfully timing
the changes ha"e eluded professional in"estors thus far. %oreo"er a changing risk
premium implies changing re#uired rates of return for stocks rather than an
inefficiency ith the market.
+
2iegel! ]eremy! tocks for the 0ong *un1 2he ,efinitive Guide to /inancial #arket *eturns
and 0ong-2erm Investment trategies! 2;;2! Ke 4ork8 %cBra-Oill.
2-96
b. As the market risk premium increases during a recession! stocks prices tend to fall.
As the economy reco"ers! the market risk premium falls! and stock prices tend to
rise. (hese changes could gi"e in"estors the impression that markets o"erreact!
especially if the underlying changes in the market risk premium are small but cumulati"e.
For example! the 5ctober Crash of 1?97 is commonly "ieed as an example of
market o"erreaction. Ooe"er! in the eeks running up to mid-5ctober! se"eral
underlying changes to the market risk premium occurred )in addition to changes in
the yields on long-term (reasury 1onds*. Congress threatened in"estors ith a
&merger tax' that ould ha"e truncated the booming merger industry and loosened
the discipline that the threat of mergers pro"ides to a firmCs management. In
addition! the 2ecretary of (reasury threatened further depreciation in the "alue of
the dollar! frightening foreign in"estors. (hese e"ents may ha"e increased the
market risk premium and loered stock prices in a seeming &o"erreaction.'
CFA PROBLEMS
1. b. 2emi-strong form efficiency implies that market prices reflect all publicly
available information concerning past trading history as ell as fundamental
aspects of the firm.
2. a. (he full price ad/ustment should occur /ust as the nes about the
di"idend becomes publicly a"ailable.
+. d. If lo P>A stocks tend to ha"e positi"e abnormal returns! this ould represent
an unexploited profit opportunity that ould pro"ide e"idence that in"estors
are not using all a"ailable information to make profitable in"estments.
-. c. In an efficient market! no securities are consistently o"erpriced or
underpriced. $hile some securities ill turn out after any in"estment period
to ha"e pro"ided positi"e alphas )i.e.! risk-ad/usted abnormal returns* and
some negati"e alphas! these past returns are not predicti"e of future returns.
0. c. A random alk implies that stock price changes are unpredictable!
using past price changes or any other data.
6. d. A gradual ad/ustment to fundamental "alues ould allo for the use of
strategies based on past price mo"ements in order to generate abnormal profits.
7. a.
2-97
9. a. 2ome empirical e"idence that supports the A%O8
)i* professional money managers do not typically earn higher returns than
comparable risk! passi"e index strategiesH
)ii* e"ent studies typically sho that stocks respond immediately to the
public release of rele"ant nesH
)iii* most tests of technical analysis find that it is difficult to identify price
trends that can be exploited to earn superior risk-ad/usted in"estment
returns.
b. 2ome e"idence that is difficult to reconcile ith the A%O concerns simple
portfolio strategies that apparently ould ha"e pro"ided high risk-ad/usted
returns in the past. 2ome examples of portfolios ith attracti"e historical
returns8
)i* lo P>A stocksH
)ii* high book-to-market ratio stocksH
)iii* small firms in ]anuaryH
)i"* firms ith "ery poor stock price performance in the last fe months.
5ther e"idence concerns post-earnings-announcement stock price drift and
intermediate-term price momentum.
c. An in"estor might choose not to index e"en if markets are efficient because he
or she may ant to tailor a portfolio to specific tax considerations or to specific
risk management issues! for example! the need to hedge )or at least not add to*
exposure to a particular source of risk )e.g.! industry exposure*.
?. a. (he efficient market hypothesis )A%O* states that a market is efficient if
security prices immediately and fully reflect all a"ailable rele"ant information.
If the market fully reflects information! the knoledge of that information
ould not allo an in"estor to profit from the information because stock
prices already incorporate the information.
i. (he &eak form of the A%O asserts that stock prices reflect all the information
that can be deri"ed by examining market trading data such as the history of past
prices and trading "olume.
A strong body of e"idence supports eak-form efficiency in the ma/or P.2.
securities markets. For example! test results suggest that technical trading rules
do not produce superior returns after ad/usting for transaction costs and taxes.
)continued on next page*
ii. (he semistrong form states that a firmCs stock price reflects all publicly
a"ailable information about a firmCs prospects. Axamples of publicly a"ailable
information are company annual reports and in"estment ad"isory data.
A"idence strongly supports the notion of semistrong efficiency! but occasional
studies )e.g.! identifying market anomalies such as the small-firm-in-]anuary or
2-99
book-to-market effects* and e"ents )e.g. stock market crash of 5ctober 1?!
1?97* are inconsistent ith this form of market efficiency. (here is a #uestion
concerning the extent to hich these &anomalies' result from data mining.
iii. (he strong form of the A%O holds that current market prices reflect all
information )hether publicly a"ailable or pri"ately held* that can be rele"ant
to the "aluation of the firm.
Ampirical e"idence suggests that strong-form efficiency does not hold. If this
form ere correct! prices ould fully reflect all information. (herefore e"en
insiders could not earn excess returns. 1ut the e"idence is that corporate
officers do ha"e access to pertinent information long enough before public
release to enable them to profit from trading on this information.
b. i. 2echnical analysis in"ol"es the search for recurrent and predictable patterns in
stock prices in order to enhance returns. (he A%O implies that technical analysis
is ithout "alue. If past prices contain no useful information for predicting future
prices! there is no point in folloing any technical trading rule.
ii. /undamental analysis uses earnings and di"idend prospects of the firm!
expectations of future interest rates! and risk e"aluation of the firm to determine
proper stock prices. (he A%O predicts that most fundamental analysis is doomed
to failure. According to semistrong-form efficiency! no in"estor can earn excess
returns from trading rules based on publicly a"ailable information. 5nly analysts
ith uni#ue insight achie"e superior returns.
In summary! the A%O holds that the market appears to ad/ust so #uickly to
information about both indi"idual stocks and the economy as a hole that no
techni#ue of selecting a portfolio using either technical or fundamental analysis
can consistently outperform a strategy of simply buying and holding a di"ersified
portfolio of securities! such as those comprising the popular market indexes.
c. Portfolio managers ha"e se"eral roles and responsibilities e"en in perfectly
efficient markets. (he most important responsibility is to identify the risk>return
ob/ecti"es for a portfolio gi"en the in"estorCs constraints. In an efficient market!
portfolio managers are responsible for tailoring the portfolio to meet the in"estorCs
needs! rather than to beat the market! hich re#uires identifying the clientCs return
re#uirements and risk tolerance. ,ational portfolio management also re#uires
examining the in"estorCs constraints! including li#uidity! time horiEon! las and
regulations! taxes! and uni#ue preferences and circumstances such as age and
employment.
1;. a. (he earnings )and di"idend* groth rate of groth stocks may be consistently
o"erestimated by in"estors. In"estors may extrapolate recent groth too far into
the future and thereby donplay the ine"itable slodon. At any gi"en time!
groth stocks are likely to re"ert to )loer* mean returns and "alue stocks are
2-9?
likely to re"ert to )higher* mean returns! often o"er an extended future time
horiEon.
b. In efficient markets! the current prices of stocks already reflect all knon rele"ant
information. In this situation! groth stocks and "alue stocks pro"ide the same
risk-ad/usted expected return.
CHAPTER 12: BEHAVIORAL FINANCE
AND TECHNICAL ANAL"SIS
PROBLEM SETS
1. (echnical analysis can generally be "ieed as a search for trends or patterns in
market prices. (echnical analysts tend to "ie these trends as momentum! or
gradual ad/ustments to TcorrectC prices! or! alternati"ely! re"ersals of trends. A
number of the beha"ioral biases discussed in the chapter might contribute to such
trends and patterns. For example! a conser"atism bias might contribute to a trend
in prices as in"estors gradually take ne information into account! resulting in
gradual ad/ustment of prices toards their fundamental "alues. Another example
deri"es from the concept of representati"eness! hich leads in"estors to
inappropriately conclude! on the basis of a small sample of data! that a pattern has
been established that ill continue ell into the future. $hen in"estors
subse#uently become aare of the fact that prices ha"e o"erreacted! corrections
re"erse the initial erroneous trend.
2. A"en if many in"estors exhibit beha"ioral biases! security prices might still be set
efficiently if the actions of arbitrageurs mo"e prices to their intrinsic "alues.
Arbitrageurs ho obser"e mispricing in the securities markets ould buy
underpriced securities )or possibly sell short o"erpriced securities* in order to profit
from the anticipated subse#uent changes as prices mo"e to their intrinsic "alues.
Conse#uently! securities prices ould still exhibit the characteristics of an efficient
market.
+. 5ne of the ma/or factors limiting the ability of rational in"estors to take ad"antage
of any Tpricing errorsC that result from the actions of beha"ioral in"estors is the fact
that a mispricing can get orse o"er time. An example of this fundamental risk is
the apparent ongoing o"erpricing of the KA2.A[ index in the late 1??;s. A
related factor is the inherent costs and limits related to short selling! hich restrict
the extent to hich arbitrage can force o"erpriced securities )or indexes* to mo"e
toards their fair "alues. ,ational in"estors must also be aare of the risk that an
2-?;
apparent mispricing is! in fact! a conse#uence of model riskH that is! the percei"ed
mispricing may not be real because the in"estor has used a faulty model to "alue the
security.
-. (here are to reasons hy beha"ioral biases might not affect e#uilibrium asset
prices8 first! beha"ioral biases might contribute to the success of technical trading rules
as prices gradually ad/ust toards their intrinsic "alues! and second! the actions of
arbitrageurs might mo"e security prices toards their intrinsic "alues. It might be
important for in"estors to be aare of these biases because either of these scenarios might
create the potential for excess profits e"en if beha"ioral biases do not affect e#uilibrium
prices.
In addition! an in"estor should be aare of his personal beha"ioral biases! e"en if
those biases do not affect e#uilibrium prices! to help a"oid some of these
information processing errors )e.g. o"erconfidence or representati"eness*.
0. Afficient market ad"ocates belie"e that publicly a"ailable information )and! for
ad"ocates of strong-form efficiency! e"en insider information* is! at any point in
time! reflected in securities prices! and that price ad/ustments to ne information
occur "ery #uickly. Conse#uently! prices are at fair le"els so that acti"e
management is "ery unlikely to impro"e performance abo"e that of a broadly
di"ersified index portfolio. In contrast! ad"ocates of beha"ioral finance identify a
number of in"estor errors in information processing and decision making that could
result in mispricing of securities. Ooe"er! the beha"ioral finance literature
generally does not pro"ide guidance as to ho these in"estor errors can be exploited
to generate excess profits. (herefore! in the absence of any profitable alternati"es!
e"en if securities markets are not efficient! the optimal strategy might still be a
passi"e indexing strategy.
6. a. .a"is uses loss a"ersion as the basis for her decision making. 2he holds on to
stocks that are don from the purchase price in the hopes that they ill reco"er.
2he is reluctant to accept a loss.
7. a. 2hrum refuses to follo a stock after she sells it because she does not ant to
experience the regret of seeing it rise. (he beha"ioral characteristic used for the
basis for her decision making is the fear of regret.
9. a. In"estors attempt to a"oid regret by holding on to losers hoping the stocks ill
rebound. If the stock rebounds to its original purchase price! the stock can be sold
ith no regret. In"estors also may try to a"oid regret by distancing themsel"es
from their decisions by hiring a full-ser"ice broker.
2-?1
?. a. @ i"
b. @ iii
c. @ "
d. @ i
e. @ ii
1;. Pnderlying risks still exist e"en during a mispricing e"ent. (he market mispricing
could get orse before it gets better. 5ther ad"erse effects could occur before the
price corrects itself )e.g. loss of clients ith no understanding or appetite for
mispricing opportunities*.
11. .ata mining is the process by hich patterns are pulled from data. (echnical
analysts must be careful not to engage in data mining as great is the human capacity
to discern patterns here no patterns exist. (echnical analysts must a"oid mining
data to su88($! a theory! rather than using data to !es! a theory.
12. A"en if prices follo a random alk! the existence of irrational in"estors combined
ith the limits to arbitrage by arbitrageurs may allo persistent mispricings to be
present. (his implies that capital ill not be allocated efficientlyccapital does not
immediately flo from relati"ely unproducti"e firms to relati"ely producti"e firms.
1+. (rin :
ad"ancing Kumber > ad"ancing 3olume
declining Kumber > declining 3olume 691! 29;! -?? > 1! -+-
;.?09
7?0! 097! 22; > 1! 6;-

(his trin ratio! hich is belo 1.;! ould be taken as a bullish signal.
1-. 1readth8
1readth is positi"ecbullish
signal )no one ould actually use
a one-day measure*.
10. (his exercise is left to the studentH ansers ill "ary.
16. (he confidence index increases from )0<>6<* : ;.9++ to )6<>7<* : ;.907.
(his indicates slightly higher confidence hich ould be interpreted by
technicians as a bullish signal. 1ut the real reason for the increase in the
index is the expectation of higher inflation! not higher confidence about the
economy.
2-?2
Ad"ances .eclines Ket Ad"ances
1!6;- 1!-+- 17;
17. At the beginning of the period! the price of Computers! Inc. di"ided by the industry
index as ;.+?H by the end of the period! the ratio had increased to ;.0;. As the
ratio increased o"er the period! it appears that Computers! Inc. outperformed other
firms in its industry. (he o"erall trend! therefore! indicates relati"e strength!
although some fluctuation existed during the period! ith the ratio falling to a lo
point of ;.++ on day 1?.
19. Fi"e day mo"ing a"erages8
.ays 1 @ 08 )1?.6+ D 2; D 2;.0 D 22 D 21.1+* > 0 : 2;.60
.ays 2 @ 6 : 21.1+
.ays + @ 7 : 21.0;
.ays - @ 9 : 21.?;
.ays 0 @ ? : 22.1+
.ays 6 @ 1; : 22.69
.ays 7 @ 11 : 2+.19
D#&s 6 9 12 : 20;41 2ell signal )day 12 price Z mo"ing a"erage*
.ays ? @ 1+ : 2+.+9
.ays 1; @ 1- : 2+.10
.ays 11 @ 10 : 22.0;
.ays 12 @ 16 : 21.60
.ays 1+ @ 17 : 2;.?0
.ays 1- @ 19 : 2;.29
.ays 10 @ 1? : 1?.+9
.ays 16 @ 2; : 1?.;0
D#&s 15 9 21 : 16;70 1uy signal )day 21 price Q mo"ing a"erage*
.ays 19 @ 22 : 1?.29
.ays 1? @ 2+ : 1?.?+
.ays 2; @ 2- : 21.;0
.ays 21 @ 20 : 22.;0
.ays 22 @ 26 : 2+.19
.ays 2+ @ 27 : 2-.1+
.ays 2- @ 29 : 20.1+
.ays 20 @ 2? : 26.;;
.ays 26 @ +; : 26.9;
.ays 27 @ +1 : 27.-0
.ays 29 @ +2 : 27.9;
D#&s 27 9 00 : 25;70 2ell signal )day ++ price Z mo"ing a"erage*
.ays +; @ +- : 29.2;
.ays +1 @ +0 : 29.-0
.ays +2 @ +6 : 29.60
.ays ++ @ +7 : 2?.;0
.ays +- @ +9 : 2?.20
.ays +0 @ +? : 2?.;;
.ays +6 @ -; : 29.70
2-?+
1?. (his pattern shos a lack of breadth. A"en though the index is up! more stocks
declined than ad"anced! hich indicates a &lack of broad-based support' for the rise
in the index.
2;.
.ay Ad"ances .eclines Ket Ad"ances
Cumulati"e
1readth
1 ?;6 7;- 2;2 2;2
2 60+ ?96 -+++ -1+1
+ 721 79? - 69 -1??
- 0;+ ?69 --60 -66-
0 -?7 1!;?0 -0?9 -1!262
6 ?7; 7;2 269 -??-
7 1!;;2 6;? +?+ -6;1
9 ?;+ 722 191 --2;
? 90; 7-9 1;2 -+19
1; 766 766 ; -+19
(he signal is bearish as cumulati"e breadth is negati"eH hoe"er! the negati"e
number is declining in magnitude! indicati"e of impro"ement. Perhaps the orst
of the bear market has passed.
21. (rin :
?+6 . ;
?;6 > million ++;
7;- > million 2-;
ad"ancing Kumber > ad"ancing 3olume
declining Kumber > declining 3olume

(his is a slightly bullish indicator! ith a"erage "olume in ad"ancing issues a bit
greater than a"erage "olume in declining issues.
22. Confidence Index :
bonds corporate grade - te intermedia on 4ield
bonds corporate rated - on top 4ield
(his year8 Confidence Index : )9<>1;.0<* : ;.762
Last year8 Confidence Index : )9.0<>1;<* : ;.90;
(hus! the confidence index is decreasing.
2-?-
2+. Kote8 In order to create the 26-eek mo"ing a"erage for the 2VP 0;;! e
con"erted the eekly returns to eekly index "alues! ith a base of 1;; for the
eek prior to the first eek of the data set. (he folloing graph shos the 2VP 0;;
"alues and the 26-eek mo"ing a"erage! beginning ith the 26
th
eek of the data
set.
a. (he graph summariEes the data for the 26-eek mo"ing a"erage. (he graph
also shos the "alues of the 2VP 0;; index.
b. (he 2VP 0;; crosses through its mo"ing a"erage from belo fourteen times!
as indicated in the table belo. (he index increases se"en times in eeks
folloing a cross-through and decreases se"en times.
.ate of
cross-through
.irection of 2VP 0;;
in subse#uent eek
;0>19>;1 .ecrease
;6>;9>;1 .ecrease
12>;7>;1 .ecrease
12>21>;1 Increase
;+>;1>;2 Increase
11>22>;2 Increase
;1>;+>;+ Increase
;+>21>;+ .ecrease
;->17>;+ Increase
;6>1;>;- .ecrease
;?>;+>;- Increase
1;>;1>;- .ecrease
1;>2?>;- Increase
2-?0
;->;9>;0 .ecrease
c. (he 2VP 0;; crosses through its mo"ing a"erage from abo"e fourteen times!
as indicated in the table belo. (he index increases nine times in eeks
folloing a cross-through and decreases fi"e times.
.ate of
cross-through
.irection of 2VP
0;; in subse#uent
eek
.ate of
cross-through
.irection of 2VP
0;; in subse#uent
eek
;6>;1>;1 Increase ;+>29>;+ Increase
;6>10>;1 Increase ;->+;>;- .ecrease
12>1->;1 Increase ;7>;2>;- .ecrease
;2>;9>;2 Increase ;?>2->;- Increase
;->;0>;2 .ecrease 1;>10>;- .ecrease
12>1+>;2 Increase ;+>2->;0 Increase
;1>2->;+ .ecrease ;->10>;0 Increase
d. $hen the index crosses through its mo"ing a"erage from belo! as in part
)b*! this is regarded as a bullish signal. In our sample! the index is as likely
to increase as it is to decrease folloing such a signal. $hen the index
crosses through its mo"ing a"erage from abo"e! as in part )c*! this is regarded
as a bearish signal. In our sample! contrary to the bearish signal! the index is
actually more likely to increase than it is to decrease folloing such a signal.
2-. In order to create the relati"e strength measure! e con"erted the eekly returns for
the Fidelity 1anking Fund and for the 2VP 0;; to eekly index "alues! using a
base of 1;; for the eek prior to the first eek of the data set. (he first graph
shos the resulting "alues! along ith the ,elati"e 2trength measure )J 1;;*. (he
second graph shos the < change in the ,elati"e 2trength measure o"er 0-eek
inter"als.
a. (he folloing graph summariEes the relati"e strength data Fund.
2-?6
b. 5"er fi"e-eek inter"als! relati"e strength increased by more than 0< tenty-
nine times! as indicated in the table and graph belo. (he Fidelity 1anking
Fund underperformed the 2VP 0;; index eighteen times and outperformed
the 2VP 0;; index ele"en times in eeks folloing an increase of more than
0<.
.ate of
Increase
Performance of
1anking Fund in
subse#uent eek
.ate of
Increase
Performance of
1anking Fund in
subse#uent eek
;7>21>;; 5utperformed ;+>;?>;1 5utperformed
;9>;->;; 5utperformed ;+>16>;1 Pnderperformed
;9>11>;; Pnderperformed ;+>+;>;1 Pnderperformed
;9>19>;; 5utperformed ;6>22>;1 Pnderperformed
;?>22>;; 5utperformed ;9>17>;1 Pnderperformed
;?>2?>;; Pnderperformed ;+>10>;2 5utperformed
1;>;6>;; Pnderperformed ;+>22>;2 Pnderperformed
12>;1>;; Pnderperformed ;+>29>;2 5utperformed
12>22>;; Pnderperformed ;->;0>;2 5utperformed
12>2?>;; 5utperformed ;->12>;2 Pnderperformed
;1>;0>;1 Pnderperformed ;->26>;2 5utperformed
;1>12>;1 Pnderperformed ;0>;+>;2 Pnderperformed
;2>16>;1 Pnderperformed ;0>1;>;2 Pnderperformed
;2>2+>;1 5utperformed ;6>29>;2 Pnderperformed
;+>;2>;1 Pnderperformed
2-?7
c. 5"er fi"e-eek inter"als! relati"e strength decreases by more than 0< fifteen
times! as indicated in the graph abo"e and table belo. (he Fidelity 1anking
Fund underperformed the 2VP 0;; index six times and outperformed the 2VP
0;; index nine times in eeks folloing a decrease of more than 0<.
.ate of
.ecrease
Performance of
1anking Fund in
subse#uent eek
.ate of
.ecrease
Performance of
1anking Fund in
subse#uent eek
;7>;7>;; Pnderperformed ;->16>;- Pnderperformed
;7>1->;; 5utperformed ;->2+>;- 5utperformed
;0>;->;1 Pnderperformed 12>;+>;- 5utperformed
;0>11>;1 5utperformed 12>1;>;- Pnderperformed
1;>12>;1 5utperformed 12>17>;- 5utperformed
11>;2>;1 5utperformed 12>2+>;- Pnderperformed
1;>;->;2 5utperformed 12>+1>;- Pnderperformed
1;>11>;2 5utperformed
d. An increase in relati"e strength! as in part )b* abo"e! is regarded as a bullish
signal. Ooe"er! in our sample! the Fidelity 1anking Fund is more likely to
under perform the 2VP 0;; index than it is to outperform the index folloing
such a signal. A decrease in relati"e strength! as in part )c*! is regarded as a
bearish signal. In our sample! contrary to the bearish signal! the Fidelity
1anking Fund is actually more likely to outperform the index increase than it is
to under perform folloing such a signal.
2-?9
20. It has been shon that discrepancies of price from net asset "alue in closed-end funds
tend to be higher in funds that are more difficult to arbitrage such as less-di"ersified
funds.

CFA PROBLEMS
1. i. %ental accounting is best illustrated by 2tatement j+. 2ampsonCs re#uirement
that his income needs be met "ia interest income and stock di"idends is an
example of mental accounting. %ental accounting holds that in"estors
segregate funds into mental accounts )e.g.! di"idends and capital gains*!
maintain a set of separate mental accounts! and do not combine outcomesH a
loss in one account is treated separately from a loss in another account.
%ental accounting leads to an in"estor preference for di"idends o"er capital
gains and to an inability or failure to consider total return.
ii. 5"erconfidence )illusion of control* is best illustrated by 2tatement j6.
2ampsonCs desire to select in"estments that are inconsistent ith his o"erall
strategy indicates o"erconfidence. 5"erconfident indi"iduals often exhibit
risk-seeking beha"ior. People are also more confident in the "alidity of their
conclusions than is /ustified by their success rate. Causes of o"erconfidence
include the illusion of control! self-enhancement tendencies! insensiti"ity to
predicti"e accuracy! and misconceptions of chance processes.
iii. ,eference dependence is best illustrated by 2tatement j0. 2ampsonCs desire
to retain poor performing in"estments and to take #uick profits on successful
in"estments suggests reference dependence. ,eference dependence holds that
in"estment decisions are critically dependent on the decision-makerCs
reference point. In this case! the reference point is the original purchase price.
Alternati"es are e"aluated not in terms of final outcomes but rather in terms of
gains and losses relati"e to this reference point. (hus! preferences are
susceptible to manipulation simply by changing the reference point.
2. a. FrostMs statement is an example of reference dependence. Ois inclination to sell
the international in"estments once prices return to the original cost depends not
only on the terminal ealth "alue! but also on here he is no! that is! his
reference point. (his reference point! hich is belo the original cost! has
become a critical factor in FrostCs decision.
In standard finance! alternati"es are e"aluated in terms of terminal ealth "alues or
final outcomes! not in terms of gains and losses relati"e to some reference point
such as original cost.
b. FrostCs statement is an example of susceptibility to cogniti"e error! in at least
to ays. First! he is displaying the beha"ioral fla of o"erconfidence. Oe
likely is more confident about the "alidity of his conclusion than is /ustified
by his rate of success. Oe is "ery confident that the past performance of
Country X4e indicates future performance. 1eha"ioral in"estors could! and
often do! conclude that a fi"e-year record is ample e"idence to suggest future
2-??
performance. 2econd! by choosing to in"est in the securities of only Country
X4e! Frost is also exemplifying the beha"ioral finance phenomenon of asset
segregation. (hat is! he is e"aluating Country X4e in"estment in terms of its
anticipated gains or losses "ieed in isolation.
Indi"iduals are typically more confident about the "alidity of their conclusions
than is /ustified by their success rate or by the principles of standard finance!
especially ith regard to rele"ant time horiEons. In standard finance!
in"estors kno that fi"e years of returns on Country X4e securities relati"e to
all other markets pro"ide little information about future performance. A
standard finance in"estor ould not be fooled by this &la of small numbers.'
In standard finance! in"estors e"aluate performance in portfolio terms! in this
case defined by combining the Country X4e holding ith all other securities
held. In"estments in Country X4e! like all other potential in"estments!
should be e"aluated in terms of the anticipated contribution to the risk- reard
profile of the entire portfolio.
c. FrostCs statement is an example of mental accounting. %ental accounting holds
that in"estors segregate money into mental accounts )e.g.! safe "ersus
speculati"e*! maintain a set of separate mental accounts! and do not combine
outcomesH a loss in one account is treated separately from a loss in another
account. 5ne manifestation of mental accounting! in hich Frost is engaging!
is building a portfolio as a pyramid of assets! layer by layer! ith the
retirement account representing a layer separate from the &speculati"e' fund.
Aach layer is associated ith different goals and attitudes toard risk. Oe is
more risk a"erse ith respect to the retirement account than he is ith respect
to the &speculati"e' fund account. (he money in the retirement account is a
donside protection layer! designed to a"oid future po"erty. (he money in
the &speculati"e' fund account is the upside potential layer! designed for a
chance at being rich.
In standard finance! decisions consider the risk and return profile of the entire
portfolio rather than anticipated gains or losses on any particular account!
in"estment! or class of in"estments. Alternati"es should be considered in
terms of final outcomes in a total portfolio context rather than in terms of
contributions to a &safe' or a &speculati"e' account. 2tandard finance
in"estors seek to maximiEe the mean-"ariance structure of the portfolio as a
hole and consider co"ariances beteen assets as they construct their
portfolios. 2tandard finance in"estors ha"e consistent attitudes toard risk
across their entire portfolio.
+. a. Illusion of kno&ledge8 %aclin belie"es he is an expert on! and can make
accurate forecasts about! the real estate market solely because he has studied
housing market data on the Internet. Oe may ha"e access to a large amount of
real estate-related information! but he may not understand ho to analyEe the
information nor ha"e the ability to apply it to a proposed in"estment.
Overconfidence8 5"erconfidence causes us to misinterpret the accuracy of our
information and our skill in analyEing it. %aclin has assumed that the information
2-1;;
he collected on the Internet is accurate ithout attempting to "erify it or consult
other sources. Oe also assumes he has skill in e"aluating and analyEing the real
estate-related information he has collected! although there is no information in the
#uestion that suggests he possesses such ability.
b. *eference point8 %aclinCs reference point for his bond position is the purchase
price! as e"idenced by the fact that he ill not sell a position for less than he
paid for it. (his fixation on a reference point! and the subse#uent aiting for
the price of the security to mo"e abo"e that reference point before selling the
security! pre"ents %aclin from undertaking a risk>return-based analysis of his
portfolio position.
c. /amiliarity8 %aclin is e"aluating his holding of company stock based on his
familiarity ith the company rather than on sound in"estment and portfolio
principles. Company employees! because of this familiarity! may ha"e a
distorted perception of their on company! assuming a &good company' ill
also be a good in"estment. Irrational in"estors belie"e an in"estment in a
company ith hich they are familiar ill produce higher returns and ha"e less
risk than non-familiar in"estments.
*epresentativeness8 %aclin is confusing his company )hich may ell be a good
company* ith the companyCs stock )hich may or may not be an appropriate
holding for his portfolio and>or a good in"estment* and its future performance.
(his can result in employeesC o"ereighting their company stock! thereby holding
an under-di"ersified portfolio.
-. a. (he beha"ioral finance principle of biased expectations>o"erconfidence is most
consistent ith the in"estorCs first statement. Petrie stock pro"ides a le"el of
confidence and comfort for the in"estor because of the circumstances in hich she
ac#uired the stock and her recent history ith the returns and income from the
stock. Ooe"er! the in"estor exhibits o"erconfidence in the stock gi"en the needs
of her portfolio )she is retired* and the bre"ity of the recent performance history.
b. (he beha"ioral finance principle of mental accounting is most consistent ith
the in"estorCs second statement. (he in"estor has segregated the monies
distributed from her portfolio into to &accounts'8 the returns her portfolio
recei"es from the Petrie stock! and the returns of the rest of her portfolio. 2he
is maintaining a separate set of mental accounts ith regard to the total funds
distributed. (he in"estorCs &specific uses' should be "ieed in the o"erall
context of her spending needs and she should consider the risk and return
profile of the entire portfolio.
2-1;1
0. i. Overconfidence 3%iased ".pectations and Illusion of !ontrol48 Pierce is basing
her in"estment strategy for supporting her parents on her confidence in the
economic forecasts. (his is a cogniti"e error reflecting o"erconfidence in the
form of both biased expectations and an illusion of control. Pierce is likely more
confident in the "alidity of those forecasts than is /ustified by the accuracy of
prior forecasts. AnalystsC consensus forecasts ha"e pro"en routinely and idely
inaccurate. Pierce also appears to be o"erly confident that the recent performance
of the Pogo Island economy is a good indicator of future performance.
1eha"ioral in"estors often conclude that a short track record is ample e"idence to
suggest future performance.
2tandard finance in"estors understand that indi"iduals typically ha"e greater
confidence in the "alidity of their conclusions than is /ustified by their success
rate. (he calibration paradigm! hich compares confidence to predicti"e ability!
suggests that there is significantly loer probability of success than the
confidence le"els reported by indi"iduals. In addition! standard finance in"estors
kno that recent performance pro"ides little information about future
performance and are not decei"ed by this &la of small numbers.'
ii. 0oss Aversion 3*isk eeking48 Pierce is exhibiting risk aversion in deciding to sell
the Core 1ond Fund despite its gains and fa"orable prospects. 2he prefers a certain
gain o"er a possibly larger gain coupled ith a smaller chance of a loss. Pierce is
exhibiting loss aversion )risk seeking* by holding the Oigh 4ield 1ond Fund
despite its uncertain prospects. 2he prefers the modest possibility of reco"ery
coupled ith the chance of a larger loss o"er a certain loss. People tend to exhibit
risk seeking! rather than risk a"ersion! beha"ior hen the probability of loss is
large. (here is considerable e"idence indicating that risk a"ersion holds for gains
and risk seeking beha"ior holds for losses! and that attitudes toard risk "ary
depending on particular goals and circumstances.
2tandard finance in"estors are consistently risk a"erse! and systematically prefer a
certain outcome o"er a gamble ith the same expected "alue. 2uch in"estors also
take a symmetrical "ie of gains and losses of the same magnitude! and their
sensiti"ity )a"ersion* to changes in "alue is not a function of a specified "alue
reference point.
iii. *eference ,ependence1 PierceCs inclination to sell her 2mall Company Fund
once it returns to her original cost is an example of reference dependence.
(his is predicated on the current "alue as related to original cost! her reference
point. Oer decision ignores any analysis of expected terminal "alue or the
impact of this sale on her total portfolio. (his reference point of original cost
has become a critical but inappropriate factor in PierceCs decision.
In standard finance! alternati"es are e"aluated in terms of terminal ealth "alues
or final outcomes! not in terms of gains and losses relati"e to a reference point
such as original cost. 2tandard finance in"estors also consider the risk and return
profile of the entire portfolio rather than anticipated gains or losses on any
particular in"estment or asset class.
2-1;2
CHAPTER 10: EMPIRICAL EVIDENCE ON SECURIT"
RETURNS
PROBLEM SETS
1. A"en if the single-factor CCAP% )ith a consumption-tracking portfolio used as
the index* performs better than the CAP%! it is still #uite possible that the
consumption portfolio does not capture the siEe and groth characteristics captured
by the 2%1 )i.e.! small minus big capitaliEation* and O%L )i.e.! high minus lo
book-to-market ratio* factors of the Fama-French three-factor model. (herefore! it
is expected that the Fama-French model ith consumption pro"ides a better
explanation of returns than does the model ith consumption alone.
2. $ealth and consumption should be positi"ely correlated and! therefore! market
"olatility and consumption "olatility should also be positi"ely correlated. Periods
of high market "olatility might coincide ith periods of high consumption
"olatility. (he Tcon"entionalC CAP% focuses on the co"ariance of security returns
ith returns for the market portfolio )hich in turn tracks aggregate ealth* hile
the consumption-based CAP% focuses on the co"ariance of security returns ith
returns for a portfolio that tracks consumption groth. Ooe"er! to the extent that
ealth and consumption are correlated! both "ersions of the CAP% might represent
patterns in actual returns reasonably ell.
(o see this formally! suppose that the CAP% and the consumption-based model are
approximately true. According to the con"entional CAP%! the market price of risk
e#uals expected excess market return di"ided by the "ariance of that excess return.
According to the consumption-beta model! the price of risk e#uals expected excess
market return di"ided by the co"ariance of ,
%
ith g! here g is the rate of
consumption groth. (his co"ariance e#uals the correlation of ,
%
ith g times the
product of the standard de"iations of the "ariables. Combining the to models! the
correlation beteen ,
%
and g e#uals the standard de"iation of ,
%
di"ided by the
standard de"iation of g. Accordingly! if the correlation beteen ,
%
and g is
relati"ely stable! then an increase in market "olatility ill be accompanied by an
increase in the "olatility of consumption groth.
2-1;+
Kote8 For the folloing problems! the focus is on the estimation procedure. (o
keep the exercise feasible! the sample as limited to returns on nine stocks plus a
market index and a second factor o"er a period of 12 years. (he data ere
generated to conform to a to-factor CAP% so that actual rates of return e#ual
CAP% expectations plus random noise! and the true intercept of the 2CL is Eero for
all stocks. (he exercise ill pro"ide a feel for the pitfalls of "erifying social-
science models. Ooe"er! due to the small siEe of the sample! results are not
alays consistent ith the findings of other studies as reported in the chapter.
+. Psing the regression feature of Axcel ith the data presented in the text! the first-
pass )2CL* estimation results are8
2tock8
A
1
C ,
A
/
B O I
, 2#uare ;.;6 ;.;6 ;.;6 ;.+7 ;.17 ;.0? ;.;6 ;.67 ;.7;
5bser"ations 12 12 12 12 12 12 12 12 12
Alpha ?.;; -;.6+ -;.6- -0.;0 ;.7+ --.0+ 0.?- -2.-1 0.?2
1eta -;.-7 ;.0? ;.-2 1.+9 ;.?; 1.79 ;.66 1.?1 2.;9
t-Alpha ;.7+ -;.;- -;.;6 -;.-1 ;.;0 -;.-0 ;.++ -;.27 ;.6-
t-1eta -;.91 ;.79 ;.79 2.-2 1.-2 +.9+ ;.79 -.01 -.91
-. (he hypotheses for the second-pass regression for the 2%L are8
(he intercept is EeroH and!
(he slope is e#ual to the a"erage return on the index portfolio.
0. (he second-pass data from first-pass )2CL* estimates are8
Average
E
x
c
e
s
s

R
e
t
u
r
n
Beta
A 0.19 -;.-7
1 -.1? ;.0?
C 2.70 ;.-2
2-1;-
. 6.10 1.+9
A 9.;0 ;.?;
F ?.?; 1.79
B 11.+2 ;.66
O 1+.11 1.?1
I 22.9+ 2.;9
% 9.12
2-1;0
2
(he second-pass regression yields8
*egression tatistics
%ultiple , ;.7;7-
, 2#uare ;.0;;-
Ad/usted , 2#uare ;.-2?1
2tandard Arror -.62+-
5bser"ations ?
!oefficients
tandard
"rror
t tatistic
for 567
t tatistic
for 5689:;
Intercept +.?2 2.0- 1.0-
2lope 0.21 1.?7 2.60 -1.-9
6. As e sa in the chapter! the intercept is too high )+.?2< per year instead of ;* and
the slope is too flat )0.21< instead of a predicted "alue e#ual to the sample-a"erage
risk premium8 r
%
r
f
: 9.12<*. (he intercept is not significantly greater than Eero
)the t-statistic is less than 2* and the slope is not significantly different from its
theoretical "alue )the t-statistic for this hypothesis is 1.-9*. (his lack of statistical
significance is probably due to the small siEe of the sample.
7. Arranging the securities in three portfolios based on betas from the 2CL estimates!
the first pass input data are8
"e#$ ABC .AB FHI
1 10.;0 20.96 06.6?
2 -16.76 -2?.7- -0;.90
+ 1?.67 -0.69 9.?9
- -10.9+ -2.09 +0.-1
0 -7.19 +7.7; -+.20
6 -2.26 0+.96 70.--
7 -19.67 10.+2 12.0;
9 -6.+0 +6.++ +2.12
? 7.90 1-.;9 0;.-2
1; 21.-1 12.66 02.1-
11 -2.0+ -0;.71 -66.12
12 -;.+; --.?? -2;.1;
A"erage -.;- 9.01 10.29
2td. .e". 1?.+; 2?.-7 -+.?6
2-1;6
(he first-pass )2CL* estimates are8
A1C .AB FOI
, 2#uare ;.;- ;.-9 ;.92
5bser"ations 12 12 12
Alpha 2.09 ;.0- -;.+-
1eta ;.19 ;.?9 1.?2
t-Alpha ;.-2 ;.;9 -;.;6
t-1eta ;.62 +.;2 6.9+
Brouping into portfolios has impro"ed the 2CL estimates as is e"ident from the higher ,-
s#uare for Portfolio .AB and Portfolio FOI. (his means that the beta )slope* is
measured ith greater precision! reducing the error-in-measurement problem at the
expense of lea"ing feer obser"ations for the second pass.
(he inputs for the second pass regression are8
A"erage
Axcess
,eturn
1eta
A1C -.;- ;.19
.AO 9.01 ;.?9
FBI 10.29 1.?2
% 9.12
(he second-pass estimates are8
%ultiple , ;.??70
, 2#uare ;.??-?
Ad/usted ,
2#uare
;.?9??
2tandard Arror ;.06?+
5bser"ations +
!oefficients
tandard
"rror
t tatistic
for 5 67
t tatistic
for 5 689:;
Intercept 2.62 ;.09 -.00
2lope 6.-7 ;.-6 1-.;+ -+.09
.espite the decrease in the intercept and the increase in slope! the intercept is no
significantly positi"e! and the slope is significantly less than the hypothesiEed "alue
by more than three times the standard error.
2-1;7
9. ,ollCs criti#ue suggests that the problem begins ith the market index! hich is
not the theoretical portfolio against hich the second pass regression should hold.
Oence! e"en if the relationship is "alid ith respect to the true )unknon* index!
e may not find it. As a result! the second pass relationship may be meaningless.
?.
Axcept for 2tock I! hich realiEed an extremely positi"e surprise! the C%L shos
that the index dominates all other securities! and the three portfolios dominate all
indi"idual stocks. (he poer of di"ersification is e"ident despite the "ery small
sample siEe.
1;. (he first-pass )2CL* regression results are summariEed belo8
A 1 C . A F B O I
,-2#uare ;.;7 ;.+6 ;.11 ;.-- ;.2- ;.9- ;.12 ;.69 ;.71
5bser"ations 12 12 12 12 12 12 12 12 12
Intercept ?.1? -1.9? -1.;; --.-9 ;.17 -+.-7 0.+2 -2.6- 0.66
1eta % -;.-7 ;.09 ;.-1 1.+? ;.9? 1.7? ;.60 1.?1 2.;9
1eta F -;.+0 2.++ ;.67 -1.;0 1.;+ -1.?0 1.10 ;.-+ ;.-9
t- Intercept ;.71 -;.1+ -;.;9 -;.+7 ;.;1 -;.02 ;.2? -;.29 ;.0?
t-1eta % -;.77 ;.97 ;.70 2.-6 1.-; 0.9; ;.70 -.+0 -.60
t-1eta F -;.+- 2.;6 ;.71 -1.;9 ;.?- -+.6? ;.77 ;.07 ;.6+
2-1;9
CA$I"AL MAR+E" LIE ,R#M SAM$LE DA"A
A2C
#%r/et
3E-
C
2
A
3
E
4
-
5
456
6
0
5
10
15
20
25
0 10 20 30 40 50 60 70
Standard Deviation
A
v
e
r
a
-
e

R
e
t
u
r
n
CML
11. (he hypotheses for the second-pass regression for the to-factor 2%L are8
(he intercept is EeroH
(he market-index slope coefficient e#uals the market-index a"erage returnH and!
(he factor slope coefficient e#uals the a"erage return on the factor.
)Kote that the first to hypotheses are the same as those for the single factor
model.*
12. (he inputs for the second pass regression are8
A"erage
Axcess
,eturn
1eta % 1eta F
A 0.19 -;.-7 -;.+0
1 -.1? ;.09 2.++
C 2.70 ;.-1 ;.67
. 6.10 1.+? -1.;0
A 9.;0 ;.9? 1.;+
F ?.?; 1.7? -1.?0
B 11.+2 ;.60 1.10
O 1+.11 1.?1 ;.-+
I 22.9+ 2.;9 ;.-9
% 9.12
F ;.6;
%ultiple , ;.72+-
, 2#uare ;.02++
Ad/usted , 2#uare ;.+6--
2tandard Arror -.9796
5bser"ations ?
C(e<<i=ien
!s
tandard
"rror
t tatistic
for 5 67
t tatistic
for 5 689:;
t tatistic
for 5 679<
Intercept +.+0 2.99 1.16
1eta % 0.0+ 2.16 2.06 -1.2;
1eta F ;.9; 1.-2 ;.06 ;.1-
(hese results are slightly better than those for the single factor testH that is! the
intercept is smaller and the slope on % is slightly greater. $e cannot expect a great
impro"ement since the factor e added does not appear to carry a large risk
premium )a"erage excess return is less than 1<*! and its effect on mean returns is
therefore small. (he data do not re/ect the second factor because the slope is close
to the a"erage excess return and the difference is less than one standard error.
Ooe"er! ith this sample siEe! the poer of this test is extremely lo.
2-1;?
1+. $hen e use the actual factor! e implicitly assume that in"estors can perfectly
replicate it! that is! they can in"est in a portfolio that is perfectly correlated ith the
factor. $hen this is not possible! one cannot expect the CAP% e#uation )the
second pass regression* to hold. In"estors can use a replicating portfolio )a proxy
for the factor* that maximiEes the correlation ith the factor. (he CAP% e#uation
is then expected to hold ith respect to the proxy portfolio.
Psing the bordered co"ariance matrix of the nine stocks and the Axcel 2ol"er e produce
a proxy portfolio for factor F! denoted PF. (o preser"e the scale! e include
constraints that re#uire the nine eights to be in the range of F-1!1G and that the
mean e#ual the factor mean of ;.6;<. (he resultant eights for the proxy and
period returns are8
Proxy Portfolio for Factor F )PF*
$eights on
Pni"erse
2tocks
Year
PF Oolding
Period
,eturns
A -;.1- 1 -++.01
1 1.;; 2 62.79
C ;.?0 + ?.97
. -;.+0 - -10+.06
A ;.16 0 2;;.76
F -1.;; 6 -+6.62
B ;.1+ 7 -7-.+-
O ;.1? 9 -1;.9-
I ;.;6 ? 29.11
1; 0?.01
11 -0?.10
12 1-.22
A"erage ;.6;
(his proxy )PF* has an ,-s#uare ith the actual factor of ;.9;.
$e next perform the first pass regressions for the to factor model using PF instead of
P8
A 1 C . A F B O I
,-s#uare ;.;9 ;.00 ;.2; ;.-+ ;.++ ;.99 ;.16 ;.71 ;.72
5bser"ations 12 12 12 12 12 12 12 12 12
Intercept ?.29 -2.0+ -1.+0 --.-0 -;.2+ -+.2; -.?? -2.?2 0.0-
1eta % -;.0; ;.9; ;.-? 1.+2 1.;; 1.6- ;.76 1.?7 2.12
1eta PF -;.;6 ;.-2 ;.16 -;.1+ ;.21 -;.2? ;.21 ;.11 ;.;9
t- Intercept ;.72 -;.21 -;.12 -;.+6 -;.;2 -;.00 ;.27 -;.++ ;.09
t-1eta % -;.9+ 1.-+ ;.?- 2.2? 1.66 6.;; ;.?; -.67 -.77
t-1eta PF -;.-- +.16 1.20 -;.?7 1.-7 --.02 1.;+ 1.1+ ;.79
Kote that the betas of the nine stocks on % and the proxy )PF* are different from those in
the first pass hen e use the actual proxy.
2-11;
(he first-pass regression for the to-factor model ith the proxy yields8
A"erage
Axcess
,eturn
1eta % 1eta PF
A 0.19 -;.0; -;.;6
1 -.1? ;.9; ;.-2
C 2.70 ;.-? ;.16
. 6.10 1.+2 -;.1+
A 9.;0 1.;; ;.21
F ?.?; 1.6- -;.2?
B 11.+2 ;.76 ;.21
O 1+.11 1.?7 ;.11
I 22.9+ 2.12 ;.;9
% 9.12
PF ;.6
%ultiple , ;.71
, 2#uare ;.01
Ad/usted , 2#uare ;.+0
2tandard Arror -.?0
5bser"ations ?
!oefficients
tandard
"rror
t tatistic
for 5 67
t tatistic
for 5 689:;
t tatistic
for 5 679<
Intercept +.0; 2.?? 1.17
1eta % 0.+? 2.19 2.-9 -1.20
1eta PF ;.26 9.+6 ;.;+ -;.;-
$e can see that the results are similar to! but slightly inferior to! those ith the actual
factor! since the intercept is larger and the slope coefficient smaller. Kote also
that e use here an in-sample test rather than tests ith future returns! hich is
more forgi"ing than an out-of-sample test.
1-. $e assume that the "alue of your labor is incorporated in the calculation of the rate
of return for your business. It ould likely make sense to commission a "aluation
of your business at least once each year. (he resultant se#uence of figures for
percentage change in the "alue of the business )including net cash ithdraals from
the business in the calculations* ill allo you to deri"e a reasonable estimate of
the correlation beteen the rate of return for your business and returns for other
assets. 4ou ould then search for industries ha"ing the loest correlations ith
your portfolio! and identify exchange traded funds )A(Fs* for these industries.
4our asset allocation ould then be comprised of your business! a market portfolio
A(F! and the lo-correlation )hedge* industry A(Fs. Assess the standard de"iation
of such a portfolio ith reasonable proportions of the portfolio in"ested in the
2-111
market and in the hedge industries. Ko determine here you ant to be on the
resultant CAL. If you ish to hold a less risky o"erall portfolio and to mix it ith
the risk-free asset! reduce the portfolio eights for the market and for the hedge
industries in an efficient ay.
CFA PROBLEMS
1. )i* 1etas are estimated ith respect to market indexes that are proxies for the true
market portfolio! hich is inherently unobser"able.
)ii* Ampirical tests of the CAP% sho that a"erage returns are not related to beta
in the manner predicted by the theory. (he empirical 2%L is flatter than the
theoretical one.
)iii* %ulti-factor models of security returns sho that beta! hich is a one-
dimensional measure of risk! may not capture the true risk of the stock of portfolio.
2. a. (he basic procedure in portfolio e"aluation is to compare the returns on a
managed portfolio to the return expected on an unmanaged portfolio ha"ing
the same risk! using the 2%L. (hat is! expected return is calculated from8
A)r
P
* : r
f
D b
P
FA)r
%
* @ r
f
G
here r
f
is the risk-free rate! A)r
%
* is the expected return for the unmanaged
portfolio )or the market portfolio*! and b
P
is the beta coefficient )or systematic
risk* of the managed portfolio. (he performance benchmark then is the
unmanaged portfolio. (he typical proxy for this unmanaged portfolio is an
aggregate stock market index such as the 2VP 0;;.
b. (he benchmark error might occur hen the unmanaged portfolio used in the
e"aluation process is not &optimiEed.' (hat is! market indices! such as the
2VP 0;;! chosen as benchmarks are not on the managerCs e. ante
mean>"ariance efficient frontier.
c. 4our graph should sho an efficient frontier obtained from actual returns! and
a different one that represents )unobser"ed* ex-ante expectations. (he C%L
and 2%L generated from actual returns do not conform to the CAP%
predictions! hile the hypothesiEed lines do conform to the CAP%.
d. (he anser to this #uestion depends on oneCs prior beliefs. Bi"en a consistent
track record! an agnostic obser"er might conclude that the data support the
claim of superiority. 5ther obser"ers might start ith a strong prior that!
since so many managers are attempting to beat a passi"e portfolio! a small
number are bound to produce seemingly con"incing track records.
e. (he #uestion is really hether the CAP% is at all testable. (he problem is
that e"en a slight inefficiency in the benchmark portfolio may completely
in"alidate any test of the expected return-beta relationship. It appears from
2-112
,ollCs argument that the best guide to the #uestion of the "alidity of the
CAP% is the difficulty of beating a passi"e strategy.
+. (he effect of an incorrectly specified market proxy is that the beta of
1lackCs portfolio is likely to be underestimated )i.e.! too lo* relati"e to the beta
calculated based on the &true' market portfolio. (his is because the .o ]ones
Industrial A"erage ).]IA* and other market proxies are likely to ha"e less
di"ersification and therefore a higher "ariance of returns than the &true' market
portfolio as specified by the capital asset pricing model. Conse#uently! beta
computed using an o"erstated "ariance ill be underestimated. (his result is
clear from the folloing formula8
2
Proxy %arket
Proxy %arket Portfolio
Portfolio
* r ! r ) Co"

An incorrectly specified market proxy is likely to produce a slope for the
security market line )i.e.! the market risk premium* that is underestimated
relati"e to the &true' market portfolio. (his results from the fact that the &true'
market portfolio is likely to be more efficient )plotting on a higher return point
for the same risk* than the .]IA and similarly misspecified market proxies.
Conse#uently! the proxy-based 2%L ould offer less expected return per unit
of risk.
CHAPTER 14: BOND PRICES AND "IELDS
PROBLEM SETS
1. a* Catastrophe bond @ A bond that allos the issuer to transfer &catastrophe risk'
from the firm to the capital markets. In"estors in these bonds recei"e a
compensation for taking on the risk in the form of higher coupon rates. In the
e"ent of a catastrophe! the bondholders ill gi"e up all or part of their
in"estments. &.isaster' can be defined by total insured losses or by criteria such
as ind speed in a hurricane or ,ichter le"el in an earth#uake.
b* Aurobond @ A bond that is denominated in one currency! usually that of the
issuer! but sold in other national markets.
c* eero-coupon bond @ A bond that makes no coupon payments. In"estors
recei"e par "alue at the maturity date but recei"e no interest payments until then.
(hese bonds are issued at prices belo par "alue! and the in"estorCs return comes
from the difference beteen issue price and the payment of par "alue at maturity.
d* 2amurai bond @ 4en-dominated bonds sold in ]apan by non-]apanese issuers.
2-11+
e* ]unk bond @ A bond ith a lo credit rating due to its high default risk. (hey
are also knon as high-yield bonds.
f* Con"ertible bond @ A bond that gi"es the bondholders an option to exchange
the bond for a specified number of shares of common stock of the firm.
g* 2erial bonds @ 1onds issued ith staggered maturity dates. As bonds mature
se#uentially! the principal repayment burden for the firm is spread o"er time.
h* A#uipment obligation bond @ A collateraliEed bond in hich the collateral is
e#uipment oned by the firm. If the firm defaults on the bond! the bondholders
ould recei"e the e#uipment.
i* 5riginal issue discount bond @ A bond issued at a discount to the face "alue.
/* Indexed bond @ A bond that makes payments that are tied to a general price
index or the price of a particular commodity.
k* Callable bond @ A bond hich allos the issuer to repurchase the bond at a
specified call price before the maturity date.
l* Puttable bond @ A bond hich allos the bondholder to sell back the bond at a
specified put price before the maturity date.
2. (he bond callable at 1;0 should sell at a loer price because the call pro"ision is
more "aluable to the firm. (herefore! its yield to maturity should be higher.
+. eero coupon bonds pro"ide no coupons to be rein"ested. (herefore! the in"estorMs
proceeds from the bond are independent of the rate at hich coupons could be
rein"ested )if they ere paid*. (here is no rein"estment rate uncertainty ith Eeros.
-. A bondCs coupon interest payments and principal repayment are not affected by
changes in market rates. Conse#uently! if market rates increase! bond in"estors in
the secondary markets are not illing to pay as much for a claim on a gi"en
bondCs fixed interest and principal payments as they ould if market rates ere
loer. (his relationship is apparent from the in"erse relationship beteen interest
rates and present "alue. An increase in the discount rate )i.e.! the market rate*
decreases the present "alue of the future cash flos.
0. Annual Coupon ,ate8 -.9;< =-9 Coupon Payments
Current 4ield8
=-9
-.?0<
=?7;
_

,
2-11-
6. a. Affecti"e annual rate for +-month (-bill8
< ; . 1; 1;; . ; 1 ;2-12 . 1 1
6-0 ! ?7
;;; ! 1;;
-
-

,
_
b. Affecti"e annual interest rate for coupon bond paying 0< semiannually8
)1.;0*
2
@ 1 : ;.1;20 or 1;.20<
(herefore the coupon bond has the higher effecti"e annual interest rate.
7. (he effecti"e annual yield on the semiannual coupon bonds is 9.16<. If the
annual coupon bonds are to sell at par they must offer the same yield! hich
re#uires an annual coupon rate of 9.16<.
9. (he bond price ill be loer. As time passes! the bond price! hich is no abo"e
par "alue! ill approach par.
?. 4ield to maturity8 Psing a financial calculator! enter the folloing8
n : +H P3 : ?0+.1;H F3 : 1;;;H P%( : 9;H C5%P i
(his results in8 4(% : ?.99<
,ealiEed compound yield8 First! find the future "alue )F3* of rein"ested coupons
and principal8
F3 : )=9; \ 1.1; \1.12* D )=9; \ 1.12* D =1!;9; : =1!269.16
(hen find the rate )y
realiEed
* that makes the F3 of the purchase price e#ual to =1!269.168
=?0+.1; )1 D y
realiEed
*
+
: =1!269.16 y
realiEed
: ?.??< or approximately 1;<
1;.
a. eero coupon9< coupon 1;< coupon
Current prices =-6+.1? =1!;;;.;; =1!1+-.2;
b. Price 1 year from no =0;;.20 =1!;;;.;; =1!12-.?-
Price increase = +7.;6 = ;.;; I = ?.26
Coupon income = ;.;; = 9;.;; =1;;.;;
Pre-tax income = +7.;6 = 9;.;; = ?;.7-
Pre-tax rate of return 9.;;< 9.;;< 9.;;<
(axes\ = 11.12 = 2-.;; = 29.10
After-tax income = 20.?- = 06.;; = 62.0?
After-tax rate of return 0.6;< 0.6;< 0.02<
2-110
c. Price 1 year from no =0-+.?+ =1!;60.10 =1!1?0.-6
Price increase = 9;.7- = 60.10 = 61.26
Coupon income = ;.;; = 9;.;; =1;;.;;
Pre-tax income = 9;.7- =1-0.10 =161.26
Pre-tax rate of return 17.-+< 1-.02< 1-.22<
(axes\\ = 1?.96 = +7.;+ = -2.20
After-tax income = 6;.99 =1;9.12 =11?.;1
After-tax rate of return 1+.1-< 1;.91< 1;.-?<
\ In computing taxes! e assume that the 1;< coupon bond as issued at par and
that the decrease in price hen the bond is sold at year end is treated as a capital
loss and therefore is not treated as an offset to ordinary income.
\\ In computing taxes for the Eero coupon bond! =+7.;6 is taxed as ordinary
income )see part )b**H the remainder of the price increase is taxed as a capital gain.
11. a. 5n a financial calculator! enter the folloing8
n : -;H F3 : 1;;;H P3 : @?0;H P%( : -;
4ou ill find that the yield to maturity on a semi-annual basis is -.26<. (his
implies a bond e#ui"alent yield to maturity e#ual to8 -.26< \ 2 : 9.02<
Affecti"e annual yield to maturity : )1.;-26*
2
@ 1 : ;.;97; : 9.7;<
b. 2ince the bond is selling at par! the yield to maturity on a semi-annual basis is
the same as the semi-annual coupon rate! i.e.! -<. (he bond e#ui"alent yield to
maturity is 9<.
Affecti"e annual yield to maturity : )1.;-*
2
@ 1 : ;.;916 : 9.16<
c. Weeping other inputs unchanged but setting P3 : @1;0;! e find a bond
e#ui"alent yield to maturity of 7.02<! or +.76< on a semi-annual basis.
Affecti"e annual yield to maturity : )1.;+76*
2
@ 1 : ;.;766 : 7.66<
12. 2ince the bond payments are no made annually instead of semi-annually! the
bond e#ui"alent yield to maturity is the same as the effecti"e annual yield to
maturity. F5n a financial calculator! n : 2;H F3 : 1;;;H P3 : @price! P%( : 9;G
(he resulting yields for the three bonds are8
1ond Price
1ond e#ui"alent yield :
Affecti"e annual yield
=?0; 9.0+<
=1!;;; 9.;;<
=1!;0; 7.01<
(he yields computed in this case are loer than the yields calculated ith semi-
annual payments. All else e#ual! bonds ith annual payments are less attracti"e
to in"estors because more time elapses before payments are recei"ed. If the bond
price is the same ith annual payments! then the bondMs yield to maturity is loer.
2-116
1+.
Price
%aturity
)years*
1ond e#ui"alent
4(%
=-;;.;; 2;.;; -.699<
=0;;.;; 2;.;; +.026<
=0;;.;; 1;.;; 7.177<
=+90.0- 1;.;; 1;.;;;<
=-6+.1? 1;.;; 9.;;;<
=-;;.;; 11.?1 9.;;;<
1-. a. (he bond pays =0; e"ery 6 months. (he current price is8
F=0; J Annuity factor )-<! 6*G D F=1!;;; J P3 factor )-<! 6*G : =1!;02.-2
If the market interest rate remains -< per half year! price six months from no is8
F=0; J Annuity factor )-<! 0*G D F=1!;;; J P3 factor )-<! 0*G : =1!;--.02
b. ,ate of return
=0; )=1! ;--.02 =1! ;02.-2* =0; =7.?;
-.;<
=1! ;02.-2 =1! ;02.-2
+

10. (he reported bond price is8 1;; 2>+2 percent of par : =1!;;;.620
Ooe"er! 10 days ha"e passed since the last semiannual coupon as paid! so8
accrued interest : =+0 \ )10>192* : =2.990
(he in"oice price is the reported price plus accrued interest8 =1!;;+.01
16. If the yield to maturity is greater than the current yield! then the bond offers the
prospect of price appreciation as it approaches its maturity date. (herefore! the
bond must be selling belo par "alue.
17. (he coupon rate is less than ?<. If coupon di"ided by price e#uals ?<! and
price is less than par! then price di"ided by par is less than ?<.
19.
(ime
Inflation
in year /ust
ended
Par "alue
Coupon
Payment
Principal
,epayment
; =1!;;;.;;
1 2< =1!;2;.;; =-;.9; = ;.;;
2 +< =1!;0;.6; =-2.;2 = ;.;;
+ 1< =1!;61.11 =-2.-- =1!;61.11
2-117
(he nominal rate of return and real rate of return on the bond in each year are
computed as follos8
Kominal rate of return :
,eal rate of return :
2econd year (hird year
Kominal return
;711?6 . ;
;2; ! 1 =
6; . +; = ;2 . -2 =
+
;0;-;; . ;
6; . ;0; ! 1 =
01 . 1; = -- . -2 =
+
,eal return
< ; . - ;-; . ; 1
;+ . 1
;711?6 . 1
< ; . - ;-; . ; 1
;1 . 1
;0;-;; . 1

(he real rate of return in each year is precisely the -< real yield on the bond.
1?. (he price schedule is as follos8
4ear
,emaining
%aturity )(*
Constant yield "alue
=1!;;;>)1.;9*
(
Imputed interest
)Increase in constant
yield "alue*
; )no* 2; years =21-.00
1 1? =2+1.71 =17.16
2 19 =20;.20 =19.0-
1? 1 =?20.?+
2; ; =1!;;;.;; =7-.;7
2;. (he bond is issued at a price of =9;;. (herefore! its yield to maturity is8 6.92-0<
(herefore! using the constant yield method! e find that the price in one year )hen
maturity falls to ? years* ill be )at an unchanged yield* =91-.6;! representing an
increase of =1-.6;. (otal taxable income is8 =-;.;; D =1-.6; : =0-.6;
21. a. (he bond sells for =1!12-.72 based on the +.0< yield to maturity.
Fn : 6;H i : +.0H F3 : 1;;;H P%( : -;G
(herefore! yield to call is +.+69< semiannually! 6.7+6< annually.
Fn : 1; semiannual periodsH P3 : @112-.72H F3 : 11;;H P%( : -;G
b. If the call price ere =1!;0;! e ould set F3 : 1!;0; and redo part )a*
to find that yield to call is 2.?76< semiannually! 0.?02< annually. $ith a loer
call price! the yield to call is loer.
c. 4ield to call is +.;+1< semiannually! 6.;62< annually.
Fn : -H P3 : I112-.72H F3 : 11;;H P%( : -;G
22. (he stated yield to maturity! based on promised payments! e#uals 16.;70<.
Fn : 1;H P3 : @?;;H F3 : 1;;;H P%( : 1-;G
2-119
1ased on e.pected coupon payments of =7; annually! the expected yield to
maturity is 9.026<.
2+. (he bond is selling at par "alue. Its yield to maturity e#uals the coupon rate! 1;<.
If the first-year coupon is rein"ested at an interest rate of r percent! then total
proceeds at the end of the second year ill be8 F=1;; \ )1 D r*G D =1!1;;
(herefore! realiEed compound yield to maturity is a function of r! as shon in the
folloing table8
r (otal proceeds ,ealiEed 4(% : @ 1
9< =1!2;9
@ 1 : ;.;??1 : ?.?1<
1;< =1!21;
@ 1 : ;.1;;; : 1;.;;<
12< =1!212
@ 1 : ;.1;;? : 1;.;?<
2-. April 10 is miday through the semiannual coupon period. (herefore! the in"oice
price ill be higher than the stated ask price by an amount e#ual to one-half of the
semiannual coupon. (he ask price is 1;1.120 percent of par! so the in"oice price
is8
=1!;11.20 D )R \=0;* : =1!;+6.20
20. Factors that might make the A1C debt more attracti"e to in"estors! therefore
/ustifying a loer coupon rate and yield to maturity! are8
i. (he A1C debt is a larger issue and therefore may sell ith greater li#uidity.
ii. An option to extend the term from 1; years to 2; years is fa"orable if interest
rates ten years from no are loer than todayCs interest rates. In contrast! if
interest rates increase! the in"estor can present the bond for payment and rein"est
the money for a higher return.
iii. In the e"ent of trouble! the A1C debt is a more senior claim. It has more
underlying security in the form of a first claim against real property.
i". (he call feature on the X4e bonds makes the A1C bonds relati"ely more
attracti"e since A1C bonds cannot be called from the in"estor.
". (he X4e bond has a sinking fund re#uiring X4e to retire part of the issue each
year. 2ince most sinking funds gi"e the firm the option to retire this amount at
the loer of par or market "alue! the sinking fund can be detrimental for
bondholders.
26. A. If an in"estor belie"es the firmCs credit prospects are poor in the near term and
ishes to capitaliEe on this! the in"estor should buy a credit default sap.
Although a short sale of a bond could accomplish the same ob/ecti"e! li#uidity is
often greater in the sap market than it is in the underlying cash market. (he
2-11?
in"estor could pick a sap ith a maturity similar to the expected time horiEon of
the credit risk. 1y buying the sap! the in"estor ould recei"e compensation if
the bond experiences an increase in credit risk.
27. A. $hen credit risk increases! credit default saps increase in "alue because the
protection they pro"ide is more "aluable. Credit default saps do not pro"ide
protection against interest rate risk hoe"er.
29. a. An increase in the firmCs times interest-earned ratio decreases the default risk
of the firmincreases the bondCs price decreases the 4(%.
b. An increase in the issuing firmCs debt-e#uity ratio increases the default risk of
the firm decreases the bondCs price increases 4(%.
c. An increase in the issuing firmCs #uick ratio increases short-run li#uidity!
implying a decrease in default risk of the firm increases the bondCs price
decreases 4(%.
2?. a. (he floating rate note pays a coupon that ad/usts to market le"els. (herefore!
it ill not experience dramatic price changes as market yields fluctuate. (he
fixed rate note ill therefore ha"e a greater price range.
b. Floating rate notes may not sell at par for any of se"eral reasons8
)i* (he yield spread beteen one-year (reasury bills and other money
market instruments of comparable maturity could be ider )or narroer*
than hen the bond as issued.
)ii* (he credit standing of the firm may ha"e eroded )or impro"ed* relati"e
to (reasury securities! hich ha"e no credit risk. (herefore! the 2<
premium ould become insufficient to sustain the issue at par.
)iii* (he coupon increases are implemented ith a lag! i.e.! once e"ery
year. .uring a period of changing interest rates! e"en this brief lag ill be
reflected in the price of the security.
c. (he risk of call is lo. 1ecause the bond ill almost surely not sell for much
abo"e par "alue )gi"en its ad/ustable coupon rate*! it is unlikely that the bond ill
e"er be called.
d. (he fixed-rate note currently sells at only 99< of the call price! so that yield to
maturity is greater than the coupon rate. Call risk is currently lo! since yields
ould need to fall substantially for the firm to use its option to call the bond.
2-12;
e. (he ?< coupon notes currently ha"e a remaining maturity of fifteen years and
sell at a yield to maturity of ?.?<. (his is the coupon rate that ould be needed
for a nely-issued fifteen-year maturity bond to sell at par.
f. 1ecause the floating rate note pays a variable stream of interest payments to
maturity! the effecti"e maturity for comparati"e purposes ith other debt
securities is closer to the next coupon reset date than the final maturity date.
(herefore! yield-to-maturity is an indeterminable calculation for a floating rate
note! ith &yield-to-recoupon date' a more meaningful measure of return.
+;. a. (he yield to maturity on the par bond e#uals its coupon rate! 9.70<. All else
e#ual! the -< coupon bond ould be more attracti"e because its coupon rate is far
belo current market yields! and its price is far belo the call price. (herefore! if
yields fall! capital gains on the bond ill not be limited by the call price. In
contrast! the 9k< coupon bond can increase in "alue to at most =1!;0;! offering a
maximum possible gain of only ;.0<. (he disad"antage of the 9k< coupon
bond! in terms of "ulnerability to being called! shos up in its higher promised yield to
maturity.
b. If an in"estor expects yields to fall substantially! the -< bond offers a greater
expected return.
c. Implicit call protection is offered in the sense that any likely fall in yields
ould not be nearly enough to make the firm consider calling the bond. In
this sense! the call feature is almost irrele"ant.
+1. a. Initial price P
;
: =7;0.-6 Fn : 2;H P%( : 0;H F3 : 1;;;H i : 9G
Kext yearMs price P
1
: =7?+.2? Fn : 1?H P%( : 0;H F3 : 1;;;H i : 7G
OP,
< 0- . 1? 1?0- . ;
-6 . 7;0 =
* -6 . 7;0 = 2? . 7?+ )= 0; =

+
b. Psing 5I. tax rules! the cost basis and imputed interest under the constant
yield method are obtained by discounting bond payments at the original 9< yield!
and simply reducing maturity by one year at a time8
Constant yield prices )compare these to actual prices to compute capital gains*8
P
;
: =7;0.-6
P
1
: =711.9? implicit interest o"er first year : =6.-+
P
2
: =719.9- implicit interest o"er second year : =6.?0
(ax on explicit interest plus implicit interest in first year :
;.-;\Y)=0; D =6.-+* : =22.07
Capital gain in first year : Actual price at 7< 4(% @ constant yield price :
2-121
=7?+.2? @ =711.9? : =91.-;
(ax on capital gain : ;.+;\Y=91.-; : =2-.-2
(otal taxes : =22.07 D =2-.-2 : =-6.??
c. After tax OP, :
< 99 . 12 1299 . ;
-6 . 7;0 =
?? . -6 = * -6 . 7;0 = 2? . 7?+ )= 0; =

+
d. 3alue of bond after to years : =7?9.92 Fusing n : 19H i : 7<G
,ein"ested income from the coupon interest payments : =0;\Y1.;+ D =0; : =1;1.0;
(otal funds after to years : =7?9.92 D =1;1.0; : =?;;.+2
(herefore! the in"estment of =7;0.-6 gros to =?;;.+2 in to years8
=7;0.-6 )1 D r*
2
: =?;;.+2 r : ;.12?7 : 12.?7<
e. Coupon interest recei"ed in first year8 =0;.;;
Less8 tax on coupon interest l -;<8 @ 2;.;;
Less8 tax on imputed interest );.-;\Y=6.-+*8 @ 2.07
Ket cash flo in first year8 =27.-+
(he year-1 cash flo can be in"ested at an after-tax rate of8
+< \Y)1 @ ;.-;* : 1.9<
1y year 2! this in"estment ill gro to8 =27.-+ J 1.;19 : =27.?2
In to years! sell the bond for8 =7?9.92 Fn : 19H i : 7<G
Less8 tax on imputed interest in second year8 @ 2.79 F;.-; J =6.?0G
Add8 after-tax coupon interest recei"ed
in second year8 D +;.;; F=0; J )1 @ ;.-;*G
Less8 Capital gains tax on
)sales price @ constant yield "alue*8 @ 2+.?? F;.+; J )7?9.92 @ 719.9-*G
Add8 CF from first yearMs coupon )rein"ested*8 D 27.?2 Ffrom abo"eG
(otal =92?.?7
=7;0.-6 )1 D r*
2
: =92?.?7 r : ;.;9-7 : 9.-7<
CFA PROBLEMS
1. a. A sinking fund pro"ision re#uires the early redemption of a bond issue. (he
pro"ision may be for a specific number of bonds or a percentage of the bond issue
o"er a specified time period. (he sinking fund can retire all or a portion of an
issue o"er the life of the issue.
2-122
b. )i* Compared to a bond ithout a sinking fund! the sinking fund reduces the
a"erage life of the o"erall issue because some of the bonds are retired prior to
the stated maturity.
)ii* (he company ill make the same total principal payments o"er the life of
the issue! although the timing of these payments ill be affected. (he total
interest payments associated ith the issue ill be reduced gi"en the early
redemption of principal.
c. From the in"estorCs point of "ie! the key reason for demanding a sinking fund
is to reduce credit risk. .efault risk is reduced by the orderly retirement of the
issue.
2. a. )i* Current yield : Coupon>Price : =7;>=?6; : ;.;72? : 7.2?<
)ii* 4(% : +.??+< semiannually or 7.?96< annual bond e#ui"alent yield.
5n a financial calculator! enter8 n : 1;H P3 : @?6;H F3 : 1;;;H P%( : +0
Compute the interest rate.
)iii* ,ealiEed compound yield is -.166< )semiannually*! or 9.++2< annual bond
e#ui"alent yield. (o obtain this "alue! first find the future "alue )F3* of
rein"ested coupons and principal. (here ill be six payments of =+0 each!
rein"ested semiannually at +< per period. 5n a financial calculator! enter8
P3 : ;H P%( : +0H n : 6H i : +<. Compute8 F3 : 226.+?
(hree years from no! the bond ill be selling at the par "alue of =1!;;; because the
yield to maturity is forecast to e#ual the coupon rate. (herefore! total proceeds in
three years ill be8 =226.+? D =1!;;; :=1!226.+?
(hen find the rate )y
realiEed
* that makes the F3 of the purchase price e#ual to
=1!226.+?8
=?6; J )1 D y
realiEed
*
6
: =1!226.+? y
realiEed
: -.166< )semiannual*
b. 2hortcomings of each measure8
)i* Current yield does not account for capital gains or losses on bonds bought at
prices other than par "alue. It also does not account for rein"estment income
on coupon payments.
)ii* 4ield to maturity assumes the bond is held until maturity and that all coupon
income can be rein"ested at a rate e#ual to the yield to maturity.
)iii* ,ealiEed compound yield is affected by the forecast of rein"estment rates!
holding period! and yield of the bond at the end of the in"estorMs holding
period.
2-12+
+. a. (he maturity of each bond is ten years! and e assume that coupons are paid
semiannually. 2ince both bonds are selling at par "alue! the current yield for each
bond is e#ual to its coupon rate.
If the yield declines by 1< to 0< )2.0< semiannual yield*! the 2entinal bond ill
increase in "alue to =1;7.7? Fn:2;H i : 2.0<H F3 : 1;;H P%( : +G.
(he price of the Colina bond ill increase! but only to the call price of 1;2. (he
present "alue of scheduled payments is greater than 1;2! but the call price puts a
ceiling on the actual bond price.
b. If rates are expected to fall! the 2entinal bond is more attracti"e8 since it is not
sub/ect to call! its potential capital gains are greater.
If rates are expected to rise! Colina is a relati"ely better in"estment. Its higher
coupon )hich presumably is compensation to in"estors for the call feature of the
bond* ill pro"ide a higher rate of return than the 2entinal bond.
c. An increase in the "olatility of rates ill increase the "alue of the firmCs option
to call back the Colina bond. If rates go don! the firm can call the bond! hich
puts a cap on possible capital gains. 2o! greater "olatility makes the option to call
back the bond more "aluable to the issuer. (his makes the bond less attracti"e to
the in"estor.
-. %arket con"ersion "alue : "alue if con"erted into stock : 2;.9+ J =29 : =09+.2-
Con"ersion premium : 1ond price @ market con"ersion "alue
: =770.;; @ =09+.2- : =1?1.76
0. a. (he call feature re#uires the firm to offer a higher coupon )or higher promised
yield to maturity* on the bond in order to compensate the in"estor for the firmMs
option to call back the bond at a specified price if interest rate falls sufficiently.
In"estors are illing to grant this "aluable option to the issuer! but only for a
price that reflects the possibility that the bond ill be called. (hat price is the
higher promised yield at hich they are illing to buy the bond.
b. (he call feature reduces the expected life of the bond. If interest rates fall
substantially so that the likelihood of a call increases! in"estors ill treat the
bond as if it ill SmatureS and be paid off at the call date! not at the stated
maturity date. 5n the other hand if rates rise! the bond must be paid off at the
maturity date! not later. (his asymmetry means that the expected life of the
bond is less than the stated maturity.
c. (he ad"antage of a callable bond is the higher coupon )and higher promised
yield to maturity* hen the bond is issued. If the bond is ne"er called! then an
in"estor earns a higher realiEed compound yield on a callable bond issued at par
than a non-callable bond issued at par on the same date. (he disad"antage of the
callable bond is the risk of call. If rates fall and the bond is called! then the
in"estor recei"es the call price and then has to rein"est the proceeds at interest
2-12-
rates that are loer than the yield to maturity at hich the bond originally as
issued. In this e"ent! the firmMs sa"ings in interest payments is the in"estorMs loss.
6. a. )iii*
b. )iii* (he yield to maturity on the callable bond must compensate the
in"estor for the risk of call.
Choice )i* is rong because! although the oner of a callable bond
recei"es a premium plus the principal in the e"ent of a call! the interest
rate at hich he can rein"est ill be lo. (he lo interest rate that makes
it profitable for the issuer to call the bond also makes it a bad deal for the
bondCs holder.
Choice )ii* is rong because a bond is more apt to be called hen interest
rates are lo. 5nly if rates are lo ill there be an interest sa"ing for the
issuer.
c. )iii*
d. )ii*
CHAPTER 11: THE TERM STRUCTURE OF INTEREST RATES
PROBLEM SETS;
1. In general! the forard rate can be "ieed as the sum of the marketCs expectation of
the future short rate plus a potential risk )or Tli#uidityC* premium. According to the
expectations theory of the term structure of interest rates! the li#uidity premium is
Eero so that the forard rate is e#ual to the marketCs expectation of the future short
rate. (herefore! the marketCs expectation of future short rates )i.e.! forard rates*
can be deri"ed from the yield cur"e! and there is no risk premium for longer
maturities.
(he li#uidity preference theory! on the other hand! specifies that the li#uidity
premium is positi"e so that the forard rate is greater than the marketCs expectation
of the future short rate. (his could result in an upard sloping term structure e"en
if the market does not anticipate an increase in interest rates. (he li#uidity
preference theory is based on the assumption that the financial markets are
dominated by short-term in"estors ho demand a premium in order to be induced to
in"est in long maturity securities.
2-120
2. (rue. Pnder the expectations hypothesis! there are no risk premia built into bond
prices. (he only reason for long-term yields to exceed short-term yields is an
expectation of higher short-term rates in the future.
+. Pncertain. Axpectations of loer inflation ill usually lead to loer nominal
interest rates. Ke"ertheless! if the li#uidity premium is sufficiently great! long-term
yields may exceed short-term yields despite expectations of falling short rates.
-. (he li#uidity theory holds that in"estors demand a premium to compensate them for
interest rate exposure and the premium increases ith maturity. Add this premium
to a flat cur"e and the result is an upard sloping yield cur"e.
0. (he pure expectations theory! also referred to as the unbiased expectations theory!
purports that forard rates are solely a function of expected future spot rates.
Pnder the pure expectations theory! a yield cur"e that is upard )donard*
sloping! means that short-term rates are expected to rise )fall*. A flat yield cur"e
implies that the market expects short-term rates to remain constant.
6. (he yield cur"e slopes upard because short-term rates are loer than long-term
rates. 2ince market rates are determined by supply and demand! it follos that
in"estors )demand side* expect rates to be higher in the future than in the near-term.
7. %aturity Price 4(% Forard ,ate
1 =?-+.-; 6.;;<
2 =9?9.-7 0.0;< )1.;00
2
>1.;6* @ 1 : 0.;<
+ =9-7.62 0.67< )1.;067
+
>1.;00
2
* @ 1 : 6.;<
- =7?2.16 6.;;< )1.;6
-
>1.;067
+
* @ 1 : 7.;<
9. (he expected price path of the --year Eero coupon bond is shon belo. )Kote that
e discount the face "alue by the appropriate se#uence of forard rates implied by
this yearCs yield cur"e.*
1eginning
of 4ear
Axpected Price Axpected ,ate of ,eturn
1 =7?2.16 )=9+?.6?>=7?2.16* @ 1 : 6.;;<
2
6? . 9+? =
;7 . 1 ;6 . 1 ;0 . 1
;;; ! 1 =

)=991.69>=9+?.6?* @ 1 : 0.;;<
+
69 . 991 =
;7 . 1 ;6 . 1
;;; ! 1 =
)=?+-.09>=991.69* @ 1 : 6.;;<
2-126
-
09 . ?+- =
;7 . 1
;;; ! 1 =
)=1!;;;.;;>=?+-.09* @ 1 : 7.;;<
?. If expectations theory holds! then the forard rate e#uals the short rate! and the one year
interest rate three years from no ould be

-
+
)1.;7*
1 .;901 9.01<
)1.;60*

1;. a. A +-year Eero coupon bond ith face "alue =1;; ill sell today at a yield of 6<
and a price of8
=1;;>1.;6
+
:=9+.?6
Kext year! the bond ill ha"e a to-year maturity! and therefore a yield of 6<
)from next yearCs forecasted yield cur"e*. (he price ill be =9?.;;! resulting
in a holding period return of 6<.
b. (he forard rates based on todayCs yield cur"e are as follos8
4ear Forard ,ate
2 )1.;0
2
>1.;-* @ 1 : 6.;1<
+ )1.;6
+
>1.;0
2
* @ 1 : 9.;+<
Psing the forard rates! the forecast for the yield cur"e ne.t year is8
%aturity 4(%
1 6.;1<
2 )1.;6;1 J 1.;9;+*
1>2
@ 1 : 7.;2<
(he market forecast is for a higher 4(% on 2@year bonds than your forecast.
(hus! the market predicts a loer price and higher rate of return.
11. a. 96 . 1;1 =
;9 . 1
1;? =
;7 . 1
? =
P
2
+
b. (he yield to maturity is the solution for y in the folloing e#uation8
96 . 1;1 =
* y 1 )
1;? =
y 1
? =
2

+
+
+
FPsing a financial calculator! enter n : 2H F3 : 1;;H P%( : ?H P3 : @1;1.96H
Compute iG 4(% : 7.?09<
2-127
c. (he forard rate for next year! deri"ed from the Eero-coupon yield cur"e! is
the solution for f
2
in the folloing e#uation8
;?;1 . 1
;7 . 1
* ;9 . 1 )
f 1
2
2
+ f
2
: ;.;?;1 : ?.;1<.
(herefore! using an expected rate for next year of r
2
: ?.;1<! e find that the
forecast bond price is8
?? . ?? =
;?;1 . 1
1;? =
P
d. If the li#uidity premium is 1< then the forecast interest rate is8
A)r
2
* : f
2
@ li#uidity premium : ?.;1< @ 1.;;< : 9.;1<
(he forecast of the bond price is8
?2 . 1;; =
;9;1 . 1
1;? =
12. a. (he current bond price is8

)=90 J ;.?-+-;* D )=90 J ;.97+02* D )=1!;90 J ;.916+7* : =1!;-;.2;
(his price implies a yield to maturity of 6.?7<! as shon by the folloing8
F=90 J Annuity factor )6.?7<! +*G D F=1!;;; J P3 factor )6.?7<! +*G : =1!;-;.17
b. If one year from no y : 9<! then the bond price ill be8
F=90 J Annuity factor )9<! 2*G D F=1!;;; J P3 factor )9<! 2*G : =1!;;9.?2
(he holding period rate of return is8
F=90 D )=1!;;9.?2 @ =1!;-;.2;*G>=1!;-;.2; : ;.;016 : 0.16<
1+.
4ear
Forard
,ate
P3 of =1 recei"ed at period end
1 0< =1>1.;0 : =;.?02-
2 7< =1>)1.;01.;7* : =;.9?;1
+ 9< =1>)1.;01.;71.;9* : =;.92-1
a. Price : )=6; J ;.?02-* D )=6; J ;.9?;1* D )=1!;6; J ;.92-1* : =?9-.1-
b. (o find the yield to maturity! sol"e for y in the folloing e#uation8
=?9-.1; : F=6; J Annuity factor )y! +*G D F=1!;;; J P3 factor )y! +*G
(his can be sol"ed using a financial calculator to sho that y : 6.6;<
2-129
c.
Period
Payment recei"ed
at end of period8
$ill gro by
a factor of8
(o a future
"alue of8
1 =6;.;; 1.;7 1.;9 =6?.+-
2 =6;.;; 1.;9 =6-.9;
+ =1!;6;.;; 1.;; =1!;6; .;;
=1!1?-.1-
=?9-.1; )1 D y
realiEed
*
+
: =1!1?-.1-
1 D y
realiEed
: ;666 . 1
1; . ?9- =
1- . 1?- ! 1 =
+ > 1

,
_
y
realiEed
: 6.66<
d. Kext year! the price of the bond ill be8
F=6; J Annuity factor )7<! 2*G D F=1!;;; J P3 factor )7<! 2*G : =?91.?2
(herefore! there ill be a capital loss e#ual to8 =?9-.1; @ =?91.?2 : =2.19
(he holding period return is8
< 99 . 0 ;099 . ;
1; . ?9- =
* 19 . 2 = ) 6; =

+
1-. a. (he return on the one-year Eero-coupon bond ill be 6.1<.
(he price of the --year Eero today is8
=1!;;;>1.;6-
-
: =79;.20
Kext year! if the yield cur"e is unchanged! todayCs --year Eero coupon bond ill
ha"e a +-year maturity! a 4(% of 6.+<! and therefore the price ill be8
=1!;;;>1.;6+
+
: =9+2.0+
(he resulting one-year rate of return ill be8 6.7;<
(herefore! in this case! the longer-term bond is expected to pro"ide the higher
return because its 4(% is expected to decline during the holding period.
b. If you belie"e in the expectations hypothesis! you ould not expect that the
yield cur"e next year ill be the same as todayCs cur"e. (he upard slope in
todayMs cur"e ould be e"idence that expected short rates are rising and that
the yield cur"e ill shift upard! reducing the holding period return on the
four-year bond. Pnder the expectations hypothesis! all bonds ha"e e#ual
expected holding period returns. (herefore! you ould predict that the OP,
for the --year bond ould be 6.1<! the same as for the 1-year bond.
10. (he price of the coupon bond! based on its yield to maturity! is8
F=12; J Annuity factor )0.9<! 2*G D F=1!;;; J P3 factor )0.9<! 2*G : =1!11+.??
If the coupons ere stripped and sold separately as Eeros! then! based on the yield to
maturity of Eeros ith maturities of one and to years! respecti"ely! the coupon
payments could be sold separately for8
2-12?
;9 . 111 ! 1 =
;6 . 1
12; ! 1 =
;0 . 1
12; =
2
+
(he arbitrage strategy is to buy Eeros ith face "alues of =12; and =1!12;! and
respecti"e maturities of one year and to years! and simultaneously sell the coupon
bond. (he profit e#uals =2.?1 on each bond.
16. a. (he one-year Eero-coupon bond has a yield to maturity of 6<! as shon belo8
1
y 1
1;; =
+- . ?- =
+
Yy
1
: ;.;6;;; : 6.;;;<
(he yield on the to-year Eero is 9.-72<! as shon belo8
2
2
* y 1 )
1;; =
?? . 9- =
+
Yy
2
: ;.;9-72 : 9.-72<
(he price of the coupon bond is8
01 . 1;6 =
* ;9-72 . 1 )
112 =
;6 . 1
12 =
2
+
(herefore8 yield to maturity for the coupon bond : 9.+++<
F5n a financial calculator! enter8 n : 2H P3 : @1;6.01H F3 : 1;;H P%( : 12G
b.
< ;; . 11 11;; . ; 1
;6 . 1
* ;9-72 . 1 )
1
y 1
* y 1 )
f
2
1
2
2
2

+
+
c. Axpected price
?; . 1;; =
11 . 1
112 =

)Kote that next year! the coupon bond ill ha"e one payment left.*
Axpected holding period return :
< ;; . 6 ;6;; . ;
01 . 1;6 =
* 01 . 1;6 = ?; . 1;; )= 12 =

+
(his holding period return is the same as the return on the one-year Eero.
d. If there is a li#uidity premium! then8 A)r
2
* Z f
2
A)Price* :
?; . 1;; =
* r ) A 1
112 =
2
>
+
A)OP,* Q 6<
17. a. $e obtain forard rates from the folloing table8
%aturity 4(% Forard ,ate Price )for parts c! d*
1 year 1;< =1!;;;>1.1; : =?;?.;?
2 years 11< )1.11
2
>1.1;* @ 1 : 12.;1< =1!;;;>1.11
2
: =911.62
+ years 12< )1.12
+
>1.11
2
* @ 1 : 1-.;+< =1!;;;>1.12
+
: =711.79
2-1+;
b. $e obtain next yearCs prices and yields by discounting each EeroCs face "alue
at the forard rates for next year that e deri"ed in part )a*8
%aturity Price 4(%
1 year =1!;;;>1.12;1 : =9?2.79 12.;1
< 2 years =1!;;;>)1.12;1 J 1.1-;+* : =792.?+ 1+.;2
<
Kote that this yearCs upard sloping yield cur"e implies! according to the
expectations hypothesis! a shift upard in next yearCs cur"e.
c. Kext year! the 2-year Eero ill be a 1-year Eero! and ill therefore sell at a price
of8 =1!;;;>1.12;1 : =9?2.79
2imilarly! the current +-year Eero ill be a 2-year Eero and ill sell for8 =792.?+
Axpected total rate of return8
2-year bond8
< ;; . 1; 1 1;;; . 1 1
62 . 911 =
79 . 9?2 =

+-year bond8
< ;; . 1; 1 1;;; . 1 1
79 . 711 =
?+ . 792 =

d. (he current price of the bond should e#ual the "alue of each payment times
the present "alue of =1 to be recei"ed at the &maturity' of that payment. (he
present "alue schedule can be taken directly from the prices of Eero-coupon
bonds calculated abo"e.
Current price : )=12; J ;.?;?;?* D )=12; J ;.91162* D )=1!12; J ;.71179*
: =1;?.;?;9 D =?7.+?-- D =7?7.1?+6 : =1!;;+.69
2imilarly! the expected prices of Eeros one year from no can be used to
calculate the expected bond "alue at that time8
Axpected price 1 year from no : )=12; J ;.9?279* D )=1!12; J ;.792?+*
: =1;7.1++6 D =976.9916 : =?9-.;2
(otal expected rate of return :
< ;; . 1; 1;;; . ;
69 . ;;+ ! 1 =
* 69 . ;;+ ! 1 = ;2 . ?9- )= 12; =

+
19. a.
%aturity
)years*
Price 4(%
Forard
rate
1 =?20.?+ 9.;;<
2 =90+.+? 9.20< 9.0;<
+ =792.?2 9.0;< ?.;;<
- =710.;; 9.70< ?.0;<
2-1+1
0 =60;.;; ?.;;< 1;.;;<
b. For each +-year Eero issued today! use the proceeds to buy8
=792.?2>=710.;; : 1.;?0 four-year Eeros
4our cash flos are thus as follos8
(ime Cash Flo
; = ;
+ -=1!;;; (he +-year Eero issued at time ; maturesH
the issuer pays out =1!;;; face "alue
- D=1!;?0 (he --year Eeros purchased at time ; matureH
recei"e face "alue
(his is a synthetic one-year loan originating at time +. (he rate on the
synthetic loan is ;.;?0 : ?.0<! precisely the forard rate for year -.
c. For each --year Eero issued today! use the proceeds to buy8
=710.;;>=60;.;; : 1.1;; fi"e-year Eeros
4our cash flos are thus as follos8
(ime Cash Flo
; = ;
- -=1!;;; (he --year Eero issued at time ; maturesH
the issuer pays out =1!;;; face "alue
0 D=1!1;; (he 0-year Eeros purchased at time ; matureH
recei"e face "alue
(his is a synthetic one-year loan originating at time -. (he rate on the
synthetic loan is ;.1;; : 1;.;<! precisely the forard rate for year 0.
1?. a. For each three-year Eero you buy today! issue8
=792.?2>=60;.;; : 1.2;-0 fi"e-year Eeros
(he time-; cash flo e#uals Eero.
b. 4our cash flos are thus as follos8
(ime Cash Flo
; = ;
+ D=1!;;;.;; (he +-year Eero purchased at time ; maturesH
recei"e =1!;;; face "alue
0 -=1!2;-.0; (he 0-year Eeros issued at time ; matureH
issuer pays face "alue
(his is a synthetic to-year loan originating at time +.
c. (he effecti"e to-year interest rate on the forard loan is8
2-1+2
=1!2;-.0;>=1!;;; 1 : ;.2;-0 : 2;.-0<
d. (he one-year forard rates for years - and 0 are ?.0< and 1;<! respecti"ely.
Kotice that8
1.;?0 J 1.1; : 1.2;-0 :
1 D )to-year forard rate on the +-year ahead forard loan*
(he 0-year 4(% is ?.;<. (he +-year 4(% is 9.0<. (herefore! another ay
to deri"e the 2-year forard rate for a loan starting at time + is8
< -6 . 2; 2;-6 . ; 1
;90 . 1
;? . 1
1
* y 1 )
* y 1 )
* 2 ) f
+
0
+
+
0
0
+

+
+
FKote8 slight discrepancies here from rounding errors in 4(% calculationsG

CFA PROBLEMS
1. Axpectations hypothesis8 (he yields on long-term bonds are geometric a"erages of
present and expected future short rates. An upard sloping cur"e is explained by
expected future short rates being higher than the current short rate. A donard-
sloping yield cur"e implies expected future short rates are loer than the current
short rate. (hus bonds of different maturities ha"e different yields if expectations
of future short rates are different from the current short rate.
Li#uidity preference hypothesis8 4ields on long-term bonds are greater than the
expected return from rolling-o"er short-term bonds in order to compensate in"estors
in long-term bonds for bearing interest rate risk. (hus bonds of different maturities
can ha"e different yields e"en if expected future short rates are all e#ual to the
current short rate. An upard sloping yield cur"e can be consistent e"en ith
expectations of falling short rates if li#uidity premiums are high enough. If!
hoe"er! the yield cur"e is donard sloping and li#uidity premiums are assumed
to be positi"e! then e can conclude that future short rates are expected to be loer
than the current short rate.
2. d.
+. a. )1Dy
-
*
-
: )1D y
+
*
+
)1 D f
-
*
)1.;00*
-
: )1.;0*
+
)1 D f
-
*
1.2+99 : 1.1076 )1 D f
-
* f
-
: ;.;7;1 : 7.;1<
b. (he conditions ould be those that underlie the expectations theory of the
term structure8 risk neutral market participants ho are illing to substitute
2-1++
among maturities solely on the basis of yield differentials. (his beha"ior
ould rule out li#uidity or term premia relating to risk.
2-1+-
c. Pnder the expectations hypothesis! loer implied forard rates ould
indicate loer expected future spot rates for the corresponding period. 2ince
the loer expected future rates embodied in the term structure are nominal
rates! either loer expected future real rates or loer expected future inflation
rates ould be consistent ith the specified change in the obser"ed )implied*
forard rate.
-. (he gi"en rates are annual rates! but each period is a half-year. (herefore! the per
period spot rates are 2.0< on one-year bonds and 2< on six-month bonds. (he
semiannual forard rate is obtained by sol"ing for f in the folloing e#uation8
;+; . 1
;2 . 1
;20 . 1
f 1
2
+
(his means that the forard rate is ;.;+; : +.;< semiannually! or 6.;< annually.
0. (he present "alue of each bondCs payments can be deri"ed by discounting each cash
flo by the appropriate rate from the spot interest rate )i.e.! the pure yield* cur"e8
1ond A8 0+ . ?9 =
11 . 1
11; =
;9 . 1
1; =
;0 . 1
1; =
P3
+ 2
+ +
1ond 18 +6 . 99 =
11 . 1
1;6 =
;9 . 1
6 =
;0 . 1
6 =
P3
+ 2
+ +
1ond A sells for =;.1+ )i.e.! ;.1+< of par "alue* less than the present "alue of its
stripped payments. 1ond 1 sells for =;.;2 less than the present "alue of its stripped
payments. 1ond A is more attracti"ely priced.
6. a. 1ased on the pure expectations theory! 3anOusenCs conclusion is incorrect.
According to this theory! the expected return o"er any time horiEon ould be
the same! regardless of the maturity strategy employed.
2-1+0
b. According to the li#uidity preference theory! the shape of the yield cur"e
implies that short-term interest rates are expected to rise in the future. (his
theory asserts that forard rates reflect expectations about future interest rates
plus a li#uidity premium that increases ith maturity. Bi"en the shape of the
yield cur"e and the li#uidity premium data pro"ided! the yield cur"e ould still
be positi"ely sloped )at least through maturity of eight years* after subtracting
the respecti"e li#uidity premiums8
2.?;< @ ;.00< : 2.+0<
+.0;< @ ;.00< : 2.?0<
+.9;< @ ;.60< : +.10<
-.;;< @ ;.70< : +.20<
-.10< @ ;.?;< : +.20<
-.+;< @ 1.1;< : +.2;<
-.-0< @ 1.2;< : +.20<
-.6;< @ 1.0;< : +.1;<
-.7;< @ 1.6;< : +.1;<
7. (he coupon bonds can be "ieed as portfolios of stripped Eeros8 each coupon can
stand alone as an independent Eero-coupon bond. (herefore! yields on coupon
bonds reflect yields on payments ith dates corresponding to each coupon. $hen
the yield cur"e is upard sloping! coupon bonds ha"e loer yields than Eeros
ith the same maturity because the yields to maturity on coupon bonds reflect the
yields on the earlier interim coupon payments.
9. (he folloing table shos the expected short-term interest rate based on the
pro/ections of Federal ,eser"e rate cuts! the term premium )hich increases at a
rate of ;.1;< per 12 months*! the forard rate )hich is the sum of the expected
rate and term premium*! and the 4(%! hich is the geometric a"erage of the
forard rates.
(ime
Axpected
short rate
(erm
premium
Forard
rate )annual*
Forard rate
)semi-annual*
4(%
)semi-annual*
; 0.;;< ;.;;< 0.;;< 2.0;;< 2.0;;<
6 months -.0; ;.;0 -.00 2.270 2.+97
12 months -.;; ;.1; -.1; 2.;0; 2.270
19 months -.;; ;.10 -.10 2.;70 2.220
2- months -.;; ;.2; -.2; 2.1;; 2.2;;
+; months 0.;; ;.20 0.20 2.620 2.271
+6 months 0.;; ;.+; 0.+; 2.60; 2.++-
(his analysis is predicated on the li#uidity preference theory of the term structure!
hich asserts that the forard rate in any period is the sum of the expected short
rate plus the li#uidity premium.
2-1+6
?. a. Fi"e-year 2pot ,ate8
0
0
-
-
+
+
2
2
1
1
* y 1 )
;7; ! 1 =
* y 1 )
7; =
* y 1 )
7; =
* y 1 )
7; =
* y 1 )
7; =
;;; ! 1 =
+
+
+
+
+
+
+
+
+
0
0
- + 2
* y 1 )
;7; ! 1 =
* ;716 . 1 )
7; =
* ;6;0 . 1 )
7; =
* ;021 . 1 )
7; =
* ;0 . 1 )
7; =
;;; ! 1 =
+
+ + + +
0
0
* y 1 )
;7; ! 1 =
;9 . 0+ = 6? . 09 = 2- . 6+ = 67 . 66 = ;;; ! 1 =
+
+ + + +
0
0
* y 1 )
;7; ! 1 =
+2 . 709 =
+
+2 . 709 =
;7; ! 1 =
* y 1 )
0
0
+
< 1+ . 7 1 -11 . 1 y
0
0

Fi"e-year Forard ,ate8
< ;1 . 7 1 ;7;1 . 1 1
* ;716 . 1 )
* ;71+ . 1 )
-
0

b. (he yield to maturity is the single discount rate that e#uates the present "alue
of a series of cash flos to a current price. It is the internal rate of return.
(he short rate for a gi"en inter"al is the interest rate for that inter"al a"ailable at
different points in time.
(he spot rate for a gi"en period is the yield to maturity on a Eero-coupon bond
that matures at the end of the period. A spot rate is the discount rate for each
period. 2pot rates are used to discount each cash flo of a coupon bond in
order to calculate a current price. 2pot rates are the rates appropriate for
discounting future cash flos of different maturities.
A forard rate is the implicit rate that links any to spot rates. Forard rates
are directly related to spot rates! and therefore to yield to maturity. 2ome
ould argue )as in the expectations hypothesis* that forard rates are the
market expectations of future interest rates. A forard rate represents a
break-e"en rate that links to spot rates. It is important to note that forard
rates link spot rates! not yields to maturity.
4ield to maturity is not uni#ue for any particular maturity. In other ords!
to bonds ith the same maturity but different coupon rates may ha"e
different yields to maturity. In contrast! spot rates and forard rates for each
date are uni#ue.
2-1+7
c. (he --year spot rate is 7.16<. (herefore! 7.16< is the theoretical yield to
maturity for the Eero-coupon P.2. (reasury note. (he price of the Eero-
coupon note discounted at 7.16< is the present "alue of =1!;;; to be recei"ed
in - years. Psing annual compounding8
+0 . 709 =
* ;716 . 1 )
;;; ! 1 =
P3
-

1;. a. (he to-year implied annually compounded forard rate for a deferred loan
beginning in + years is calculated as follos8
< ;7 . 6 ;6;7 . ; 1
11 . 1
;? . 1
1
* y 1 )
* y 1 )
* 2 ) f
2 > 1
+
0
2 > 1
+
+
0
0
+

1
]
1

1
]
1
+
+
b. Assuming a par "alue of =1!;;;! the bond price is calculated as follos8

1; . ?97 =
* ;? . 1 )
;?; ! 1 =
* 1; . 1 )
?; =
* 11 . 1 )
?; =
* 12 . 1 )
?; =
* 1+ . 1 )
?; =
* y 1 )
;?; ! 1 =
* y 1 )
?; =
* y 1 )
?; =
* y 1 )
?; =
* y 1 )
?; =
P
0 - + 2 1
0
0
-
-
+
+
2
2
1
1
+ + + +
+
+
+
+
+
+
+
+
+
CHAPTER 1-: MANA'IN' BOND PORTFOLIOS

PROBLEM SETS
1. $hile it is true that short-term rates are more "olatile than long-term rates! the
longer duration of the longer-term bonds makes their prices and their rates of return
more "olatile. (he higher duration magnifies the sensiti"ity to interest-rate
changes.
2. .uration can be thought of as a eighted a"erage of the TmaturitiesC of the cash
flos paid to holders of the perpetuity! here the eight for each cash flo is e#ual
to the present "alue of that cash flo di"ided by the total present "alue of all cash
flos. For cash flos in the distant future! present "alue approaches Eero )i.e.! the
eight becomes "ery small* so that these distant cash flos ha"e little impact! and
e"entually! "irtually no impact on the eighted a"erage.
+. (he percentage change in the bondCs price is8
2-1+9
< 27 . + ;+27 . ; ;;0 . ;
1; . 1
1?- . 7
y
y 1
.uration

+
or a +.27< decline
-. a. 4(% : 6<
)1* )2* )+* )-* )0*
(ime until
Payment
)years*
Cash Flo
P3 of CF
).iscount
rate : 6<*
$eight
Column )1*
Column )-*
1 =6;.;; =06.6; ;.;066 ;.;066
2 =6;.;; =0+.-; ;.;0+- ;.1;69
+ =1!;6;.;; =9?;.;; ;.9?;; 2.67;;
Column 2ums =1!;;;.;; 1.;;;; 2.9++-
.uration : 2.9++ years
2-1+?
b. 4(% : 1;<
)1* )2* )+* )-* )0*
(ime until
Payment
)years*
Cash Flo
P3 of CF
).iscount
rate : 1;<*
$eight
Column )1*
Column )-*
1 =6;.;; =0-.00 ;.;6;6 ;.;6;6
2 =6;.;; =-?.0? ;.;001 ;.11;2
+ =1!;6;.;; =7?6.+? ;.99-- 2.60+2
Column 2ums =?;;.0+ 1.;;;; 2.92-;
.uration : 2.92- years! hich is less than the duration at the 4(% of 6<.
0. For a semiannual 6< coupon bond selling at par! e use the folloing parameters8
coupon : +< per half-year period! y : +<! ( : 6 semiannual periods.
)1* )2* )+* )-* )0*
(ime until
Payment
)years*
Cash Flo
P3 of CF
).iscount
rate : +<*
$eight
Column )1*
Column )-*
1 =+.;; =2.?1+ ;.;2?1+ ;.;2?1+
2 =+.;; =2.929 ;.;2929 ;.;0606
+ =+.;; =2.7-0 ;.;27-0 ;.;92+6
- =+.;; =2.660 ;.;2660 ;.1;662
0 =+.;; =2.099 ;.;2099 ;.12?+?
6 =1;+.;; =96.261 ;.96261 0.17060
Column 2ums =1;;.;;; 1.;;;;; 0.07?71
. : 0.07?7 half-year periods : 2.79?? years
If the bondCs yield is 1;<! use a semiannual yield of 0<! and semiannual coupon of
+<8
)1* )2* )+* )-* )0*
(ime until
Payment
)years*
Cash Flo
P3 of CF
).iscount
rate : 0<*
$eight
Column )1*
Column )-*
1 =+.;; =2.907 ;.;+19; ;.;+19;
2 =+.;; =2.721 ;.;+;2? ;.;6;07
+ =+.;; =2.0?2 ;.;299- ;.;960+
- =+.;; =2.-69 ;.;27-7 ;.1;?99
0 =+.;; =2.+01 ;.;2616 ;.1+;91
6 =1;+.;; =76.96; ;.900-- 0.1+260
Column 2ums =9?.9-? 1.;;;;; 0.0022+
. : 0.0022 half-year periods : 2.7761 years
2-1-;
6. If the current yield spread beteen AAA bonds and (reasury bonds is too ide
compared to historical yield spreads and is expected to narro! you should shift
from (reasury bonds into AAA bonds. As the spread narros! the AAA bonds ill
outperform the (reasury bonds. (his is an example of an intermarket spread sap.
7. .
9. a. 1ond 1 has a higher yield to maturity than bond A since its coupon payments
and maturity are e#ual to those of A! hile its price is loer. )Perhaps the
yield is higher because of differences in credit risk.* (herefore! the duration
of 1ond 1 must be shorter.
b. 1ond A has a loer yield and a loer coupon! both of hich cause 1ond A to
ha"e a longer duration than 1ond 1. %oreo"er! A cannot be called! so that its
maturity is at least as long as that of 1! hich generally increases duration.
?. a.
)1* )2* )+* )-* )0*
(ime until
Payment
)years*
Cash Flo
P3 of CF
).iscount rate :
1;<*
$eight
Column )1*
Column )-*
1 =1; million =?.;? million ;.7907 ;.7907
0 =- million =2.-9 million ;.21-+ 1.;710
Column 2ums =11.07 million 1.;;;; 1.9072
. : 1.9072 years : re#uired maturity of Eero coupon bond.
b. (he market "alue of the Eero must be =11.07 million! the same as the market
"alue of the obligations. (herefore! the face "alue must be8
=11.07 million )1.1;*
1.9072
: =1+.91 million
1; In each case! choose the longer-duration bond in order to benefit from a rate
decrease.
a. ii. (he Aaa-rated bond has the loer yield to maturity and therefore the longer
duration.
b. i. (he loer-coupon bond has the longer duration and greater de facto
call protection.
c. i. (he loer coupon bond has the longer duration.
2-1-1
11. (he table belo shos the holding period returns for each of the three bonds8
%aturity 1 year 2 years + years
4(% at beginning of year 7.;;< 9.;;< ?.;;<
1eginning of year prices =1!;;?.+0 =1!;;;.;; =?7-.6?
Prices at year end )at ?< 4(%* =1!;;;.;; =??;.9+ =?92.-1
Capital gain @=?.+0 @=?.17 =7.72
Coupon =9;.;; =9;.;; =9;.;;
1-year total = return =7;.60 =7;.9+ =97.72
1-year total rate of return 7.;;< 7.;9< ?.;;<
4ou should buy the +-year bond because it pro"ides a ?< holding-period return
o"er the next year! hich is greater than the return on either of the other bonds.
12. a. P3 of the obligation : =1;!;;; Annuity factor )9<! 2* : =17!9+2.60
)1* )2* )+* )-* )0*
(ime until
Payment
)years*
Cash Flo
P3 of CF
).iscount
rate : 9<*
$eight
Column )1*
Column )-*
1 =1;!;;;.;; =?!20?.20? ;.01?2+ ;.01?2+
2 =1;!;;;.;; =9!07+ .+99 ;.-9;77 ;.?610-
Column 2ums =17!9+2.6-7 1.;;;;; 1.-9;77
.uration : 1.-9;9 years
b. A Eero-coupon bond maturing in 1.-9;9 years ould immuniEe the obligation.
2ince the present "alue of the Eero-coupon bond must be =17!9+2.60! the face
"alue )i.e.! the future redemption "alue* must be8
=17!9+2.60 J 1.;9
1.-9;9
: =1?!?90.26
c. If the interest rate increases to ?<! the Eero-coupon bond ould decrease in
"alue to8
?2 . 0?; ! 17 =
;? . 1
26 . ?90 ! 1? =
-9;9 . 1

(he present "alue of the tuition obligation ould decrease to8 =17!0?1.11
(he net position decreases in "alue by8 =;.1?
If the interest rate decreases to 7<! the Eero-coupon bond ould increase in
"alue to8
?? . ;7? ! 19 =
;7 . 1
26 . ?90 ! 1? =
-9;9 . 1

(he present "alue of the tuition obligation ould increase to8 =19!;9;.19
(he net position decreases in "alue by8 =;.1?
(he reason the net position changes at all is that! as the interest rate changes!
so does the duration of the stream of tuition payments.
2-1-2
1+. a. P3 of obligation : =2 million>;.16 : =12.0 million
.uration of obligation : 1.16>;.16 : 7.20 years
Call the eight on the 0-year maturity bond )hich has duration of - years*.
(hen8
) J -* D F)1 @ * J 11G : 7.20 : ;.0+07
(herefore8 ;.0+07 J =12.0 : =6.7 million in the 0-year bond and
;.-6-+ J =12.0 : =0.9 million in the 2;-year bond.
b. (he price of the 2;-year bond is8
F=6; J Annuity factor )16<! 2;*G D F=1!;;; J P3 factor )16<! 2;*G : =-;7.12
(herefore! the bond sells for ;.-;71 times its par "alue! and8
%arket "alue : Par "alue J ;.-;71
=0.9 million : Par "alue J ;.-;71 Par "alue : =1-.20 million
Another ay to see this is to note that each bond ith par "alue =1!;;;
sells for =-;7.12. If total market "alue is =0.9 million! then you need to
buy approximately 1-!20; bonds! resulting in total par "alue of =1-.20
million.
1-. a. (he duration of the perpetuity is8 1.;0>;.;0 : 21 years
Call the eight of the Eero-coupon bond. (hen8
) J 0* D F)1 @ * J 21G : 1; : 11>16 : ;.6970
(herefore! the portfolio eights ould be as follos8 11>16 in"ested in the
Eero and 0>16 in the perpetuity.
b. Kext year! the Eero-coupon bond ill ha"e a duration of - years and the
perpetuity ill still ha"e a 21-year duration. (o obtain the target duration of
nine years! hich is no the duration of the obligation! e again sol"e for 8
) J -* D F)1 @ * J 21G : ? : 12>17 : ;.7;0?
2o! the proportion of the portfolio in"ested in the Eero increases to 12>17 and
the proportion in"ested in the perpetuity falls to 0>17.
2-1-+
10. a. (he duration of the annuity if it ere to start in 1 year ould be8
)1* )2* )+* )-* )0*
(ime until
Payment
)years*
Cash Flo
P3 of CF
).iscount
rate : 1;<*
$eight
Column )1* J
Column )-*
1 =1;!;;; =?!;?;.?;? ;.1-7?0 ;.1-7?0
2 =1;!;;; =9!26-.-6+ ;.1+-0; ;.26?;;
+ =1;!;;; =7!01+.1-9 ;.12227 ;.+6692
- =1;!;;; =6!9+;.1+0 ;.11116 ;.---6+
0 =1;!;;; =6!2;?.21+ ;.1;1;0 ;.0;026
6 =1;!;;; =0!6--.7+? ;.;?197 ;.0011?
7 =1;!;;; =0!1+1.091 ;.;9+01 ;.09-6;
9 =1;!;;; =-!660.;7- ;.;70?2 ;.6;7+9
? =1;!;;; =-!2-;.?76 ;.;6?;2 ;.62119
1; =1;!;;; =+!900 .-++ ;.;6270 ;.627-0
Column 2ums =61!--0.671 1.;;;;; -.720-6
. : -.7200 years
1ecause the payment stream starts in fi"e years! instead of one year! e add
four years to the duration! so the duration is 9.7200 years.
b. (he present "alue of the deferred annuity is8
?69 ! -1 =
1; . 1
* 1; <! 1; ) factor Annuity ;;; ! 1;
-

Call the eight of the portfolio in"ested in the 0-year Eero. (hen8
) J 0* D F)1 @ * J 2;G : 9.7200 : ;.7016
(he in"estment in the 0-year Eero is e#ual to8
;.7016 J =-1!?69 : =+1!0-+
(he in"estment in the 2;-year Eeros is e#ual to8
;.2-9- J =-1!?69 : =1;!-2+
(hese are the present or market "alues of each in"estment. (he face "alues
are e#ual to the respecti"e future "alues of the in"estments. (he face "alue
of the 0-year Eeros is8
=+1!0-+ J )1.1;*
0
: =0;!9;1
(herefore! beteen 0; and 01 Eero-coupon bonds! each of par "alue =1!;;;! ould
be purchased. 2imilarly! the face "alue of the 2;-year Eeros is8
=1;!-20 J )1.1;*
2;
: =7;!12+
2-1--
16. Psing a financial calculator! e find that the actual price of the bond as a function
of yield to maturity is8
4ield to maturity Price
7< =1!62;.-0
9< =1!-0;.+1
?< =1!+;9.21
Psing the .uration ,ule! assuming yield to maturity falls to 7<8
Predicted price change ;
P y
y 1
.uration

,
_
+

11.0-
) ;.;1* =1! -0;.+1 =100.;6
1.;9
_

,
(herefore8 predicted ne price : =1!-0;.+1 D =100.;6 : =1!6;0.+7
(he actual price at a 7< yield to maturity is =1!62;.-0. (herefore8
< error
=1! 6;0.+7 =1! 62;.-0
;.;;?+ ;.?+<
=1! 62;.-0

)approximation is too lo*
Psing the .uration ,ule! assuming yield to maturity increases to ?<8
Predicted price change ;
P y
y 1
.uration

,
_
+

11.0-
;.;1 =1! -0;.+1 =100.;6
1.;9
_

,
(herefore8 predicted ne price : =1!-0;.+1 @ =100.;6: =1!2?0.20
(he actual price at a ?< yield to maturity is =1!+;9.21. (herefore8
< error
=1! 2?0.20 =1! +;9.21
;.;;?? ;.??<
=1! +;9.21

Psing .uration-ith-Con"exity ,ule! assuming yield to maturity falls to 7<
Predicted price change
[ ]
;
2
P * y ) Con"exity 0 . ; y
y 1
.uration
'
+
1
]
1
,
_
+

2
11.0-
) ;.;1* ;.0 1?2.- ) ;.;1* =1! -0;.+1 =169.??
1.;9
1 _
1 +
' ;
1 ]
, ]
(herefore8 predicted ne price : =1!-0;.+1 D =169.?? : =1!61?.+;
(he actual price at a 7< yield to maturity is =1!62;.-0. (herefore8
< error
=1! 61?.+; =1! 62;.-0
;.;;;7 ;.;7<
=1! 62;.-0

2-1-0
Psing .uration-ith-Con"exity ,ule! assuming yield to maturity rises to ?<8
Predicted price change
[ ]
;
2
P * y ) Con"exity 0 . ; y
y 1
.uration
'
+
1
]
1
,
_
+

2
11.0-
;.;1 ;.0 1?2.- );.;1* =1! -0;.+1 =1-1.11
1.;9
1 _
1 +
' ;
1 ]
, ]
(herefore8 predicted ne price : =1!-0;.+1 @ =1-1.11 : =1!+;?.2;
(he actual price at a ?< yield to maturity is =1!+;9.21. (herefore8
< error
=1! +;?.2; =1! +;9.21
;.;;;9 ;.;9<
=1! +;9.21

)approximation is too high*
Conclusion8 (he duration-ith-con"exity rule pro"ides more accurate
approximations to the true change in price. In this example! the percentage error
using con"exity ith duration is less than one-tenth the error using only duration to
estimate the price change.
17. 2hortening his portfolio duration makes the "alue of the portfolio less sensiti"e
relati"e to interest rate changes. 2o if interest rates increase the "alue of the
portfolio ill decrease less.
19. Predicted price change8
;
) =+.0901* .;1 1;; =+.0?
1
,uration
y P
y
_

+
,
decrease
1?. (he maturity of the +;-year bond ill fall to 20 years! and its yield is forecast to be
9<. (herefore! the price forecast for the bond is8 =9?+.20
FPsing a financial calculator! enter the folloing8 n : 20H i : 9H F3 : 1;;;H P%( : 7;G
At a 6< interest rate! the fi"e coupon payments ill accumulate to =+?-.6; after fi"e
years. (herefore! total proceeds ill be8 =+?-.6; D =9?+.20 : =1!297.90
(herefore! the 0-year return is8 )=1!297.90>=967.-2* @ 1 : ;.-9-7
(his is a -9.-7< 0-year return! or 9.22< annually.
2-1-6
(he maturity of the 2;-year bond ill fall to 10 years! and its yield is forecast to be
7.0<. (herefore! the price forecast for the bond is8 =?11.7+
FPsing a financial calculator! enter the folloing8 n : 10H i : 7.0H F3 : 1;;;H P%( : 60G
At a 6< interest rate! the fi"e coupon payments ill accumulate to =+66.-1 after fi"e
years. (herefore! total proceeds ill be8 =+66.-1 D =?11.7+ : =1!279.1-
(herefore! the 0-year return is8 )=1!279.1->=97?.0;* @ 1 : ;.-0++
(his is a -0.++< 0-year return! or 7.76< annually. (he +;-year bond offers the higher
expected return.
2;.
a.
Period
(ime
until
Payment
)4ears*
Cash
Flo
P3 of CF
.iscount rate :
6< per period
$eight
4ears J
$eight
A. 9< coupon bond 1 ;.0 =-; =+7.7+6 ;.;-;0 ;.;2;+
2 1.; -; +0.6;; ;.;+9+ ;.;+9+
+ 1.0 -; ++.090 ;.;+61 ;.;0-1
- 2.; 1!;-; 92+ .777 ;.9901 1.77;2
2um8 =?+;.6?9 1.;;;; 1.992?
1. eero-coupon 1 ;.0 =; =;.;;; ;.;;;; ;.;;;;
2 1.; ; ;.;;; ;.;;;; ;.;;;;
+ 1.0 ; ;.;;; ;.;;;; ;.;;;;
- 2.; 1!;;; 7?2 .;?- 1.;;;; 2.;;;;
2um8 =7?2.;?- 1.;;;; 2.;;;;
For the coupon bond! the eight on the last payment in the table abo"e is less than it is in
2preadsheet 16.1 because the discount rate is higherH the eights for the first three
payments are larger than those in 2preadsheet 16.1. Conse#uently! the duration of the
bond falls. (he Eero coupon bond! by contrast! has a fixed eight of 1.; for the single
payment at maturity.
b.
Period
(ime
until
Payment
)4ears*
Cash
Flo
P3 of CF
.iscount rate :
0< per period
$eight
4ears J
$eight
A. 9< coupon bond 1 ;.0 =6; =07.1-+ ;.;002 ;.;276
2 1.; 6; 0-.-22 ;.;026 ;.;026
+ 1.0 6; 01.9+; ;.;0;1 ;.;701
- 2.; 1!;6; 972 .;60 ;.9-22 1.69--
2um8 =1!;+0.-6; 1.;;;; 1.9+?6
2ince the coupon payments are larger in the abo"e table! the eights on the earlier
payments are higher than in 2preadsheet 16.1! so duration decreases.
2-1-7
21.
a. (ime
)t*
Cash
Flo
P3)CF*
t D t
2
)t D t
2
* J P3)CF*
Coupon : =9; 1 =9; =72.727 2 1-0.-00
4(% : ;.1; 2 9; 66.116 6 +?6.6?-
%aturity : 0 + 9; 6;.1;0 12 721.262
Price : =?2-.19- - 9; 0-.6-1 2; 1!;?2.922
0 1!;9; 67; .0?0 +; 2;!117 .901
Price8 =?2-.19-
2um8 22!-7-.;9+
Con"exity :
2um>FPrice J )1Dy*
2
G : 2;.;?7
b. (ime
)t*
Cash
Flo
P3)CF*
t
2
D t )t
2
D t* J P3)CF*
Coupon : =; 1 =; =;.;;; 2 ;.;;;
4(% : ;.1; 2 ; ;.;;; 6 ;.;;;
%aturity : 0 + ; ;.;;; 12 ;.;;;
Price : =62;.?21 - ; ;.;;; 2; ;.;;;
0 1!;;; 62; .?21 +; 19!627 .6-;
Price8 =62;.?21
2um8 19!627.6-;
Con"exity :
2um>FPrice J )1Dy*
2
G : 2-.7?+
22. a. (he price of the Eero coupon bond )=1!;;; face "alue* selling at a yield to
maturity of 9< is =+7-.9- and the price of the coupon bond is =77-.9-
At a 4(% of ?< the actual price of the Eero coupon bond is =+++.29 and the
actual price of the coupon bond is =6?1.7?
eero coupon bond8
Actual < loss
< ;? . 11 11;? . ;
9- . +7- =
9- . +7- = 29 . +++ =

loss
(he percentage loss predicted by the duration-ith-con"exity rule is8
Predicted < loss [ ] [ ] < ;6 . 11 11;6 . ; ;1 . ; + . 10; 0 . ; ;1 . ; * 91 . 11 )
2
+ loss
Coupon bond8
Actual < loss
< 72 . 1; 1;72 . ;
9- . 77- =
9- . 77- = 7? . 6?1 =

loss
(he percentage loss predicted by the duration-ith-con"exity rule is8
Predicted < loss [ ] [ ] < 6+ . 1; 1;6+ . ; ;1 . ; 2 . 2+1 0 . ; ;1 . ; * 7? . 11 )
2
+ loss
2-1-9
b. Ko assume yield to maturity falls to 7<. (he price of the Eero increases to
=-22.;-! and the price of the coupon bond increases to =970.?1
eero coupon bond8
Actual < gain
< 0? . 12 120? . ;
9- . +7- =
9- . +7- = ;- . -22 =

gain
(he percentage gain predicted by the duration-ith-con"exity rule is8
Predicted < gain [ ] [ ] < 06 . 12 1206 . ; ;1 . ; + . 10; 0 . ; * ;1 . ; ) * 91 . 11 )
2
+ gain
Coupon bond
Actual < gain
< ;- . 1+ 1+;- . ;
9- . 77- =
9- . 77- = ?1 . 970 =

gain
(he percentage gain predicted by the duration-ith-con"exity rule is8
Predicted < gain [ ] [ ] < ?0 . 12 12?0 . ; ;1 . ; 2 . 2+1 0 . ; * ;1 . ; ) * 7? . 11 )
2
+ gain
c. (he 6< coupon bond! hich has higher con"exity! outperforms the Eero
regardless of hether rates rise or fall. (his can be seen to be a general
property using the duration-ith-con"exity formula8 the duration effects on
the to bonds due to any change in rates are e#ual )since the respecti"e
durations are "irtually e#ual*! but the con"exity effect! hich is alays
positi"e! alays fa"ors the higher con"exity bond. (hus! if the yields on the
bonds change by e#ual amounts! as e assumed in this example! the higher
con"exity bond outperforms a loer con"exity bond ith the same duration
and initial yield to maturity.
d. (his situation cannot persist. Ko one ould be illing to buy the loer
con"exity bond if it alays underperforms the other bond. (he price of the
loer con"exity bond ill fall and its yield to maturity ill rise. (hus! the
loer con"exity bond ill sell at a higher initial yield to maturity. (hat
higher yield is compensation for loer con"exity. If rates change only
slightly! the higher yield-loer con"exity bond ill perform betterH if rates
change by a substantial amount! the loer yield-higher con"exity bond ill
perform better.
2+. a. (he folloing spreadsheet shos that the con"exity of the bond is 6-.?++.
(he present "alue of each cash flo is obtained by discounting at 7<. )2ince
the bond has a 7< coupon and sells at par! its 4(% is 7<.*
Con"exity e#uals8 the sum of the last column )7!-+-.170* di"ided by8
FP J )1 D y*
2
G : 1;; J )1.;7*
2
: 11-.-?
(ime
)t*
Cash flo
)CF*
P3)CF* t
2
D t )t
2
D t* J P3)CF*
1 7 6.0-2 2 1+.;9-
2 7 6.11- 6 +6.69-
+ 7 0.71- 12 69.06?
2-1-?
- 7 0.+-; 2; 1;6.9;0
0 7 -.??1 +; 1-?.727
6 7 -.66- -2 1?0.?;0
7 7 -.+0? 06 2--.119
9 7 -.;7- 72 2?+.+++
? 7 +.9;9 ?; +-2.679
1; 1;7 0- .+?+ 11; 0!?9+ .271
2um8 1;;.;;; 7!-+-.170
Con"exity8 6-.?++
(he duration of the bond is8
)1* )2* )+* )-* )0*
(ime until
Payment
)years*
Cash Flo
P3 of CF
).iscount
rate : 7<*
$eight
Column )1* J
Column )-*
1 =7 =6.0-2 ;.;60-2 ;.;60-2
2 =7 =6.11- ;.;611- ;.12229
+ =7 =0.71- ;.;071- ;.171-2
- =7 =0.+-; ;.;0+-; ;.21+61
0 =7 =-.??1 ;.;-??1 ;.2-?00
6 =7 =-.66- ;.;-66- ;.27?96
7 =7 =-.+0? ;.;-+0? ;.+;010
9 =7 =-.;7- ;.;-;7- ;.+20?+
? =7 =+.9;9 ;.;+9;9 ;.+-269
1; =1;7 =0- .+?+ ;.0-+?+ 0.-+?+-
Column 2ums =1;;.;;; 1.;;;;; 7.0102+
. : 7.010 years
b. If the yield to maturity increases to 9<! the bond price ill fall to ?+.2?< of
par "alue! a percentage decrease of 6.71<.
2-10;
c. (he duration rule predicts a percentage price change of8
< ;2 . 7 ;7;2 . ; ;1 . ;
;7 . 1
010 . 7
;1 . ;
;7 . 1
.

,
_

,
_
(his o"erstates the actual percentage decrease in price by ;.+1<.

(he price predicted by the duration rule is 7.;2< less than face "alue! or
?2.?9< of face "alue.
d. (he duration-ith-con"exity rule predicts a percentage price change of8
[ ] < 7; . 6 ;67; . ; ;1 . ; ?++ . 6- 0 . ; ;1 . ;
;7 . 1
010 . 7
2
+
1
]
1

,
_
(he percentage error is ;.;1<! hich is substantially less than the error using
the duration rule.
(he price predicted by the duration ith con"exity rule is 6.7;< less than face
"alue! or ?+.+;< of face "alue.
CFA PROBLEMS
1. a. (he call feature pro"ides a "aluable option to the issuer! since it can buy back
the bond at a specified call price e"en if the present "alue of the scheduled
remaining payments is greater than the call price. (he in"estor ill demand!
and the issuer ill be illing to pay! a higher yield on the issue as
compensation for this feature.
b. (he call feature reduces both the duration )interest rate sensiti"ity* and the
con"exity of the bond. If interest rates fall! the increase in the price of the
callable bond ill not be as large as it ould be if the bond ere noncallable.
%oreo"er! the usual cur"ature that characteriEes price changes for a straight
bond is reduced by a call feature. (he price-yield cur"e )see Figure 16.6*
flattens out as the interest rate falls and the option to call the bond becomes
more attracti"e. In fact! at "ery lo interest rates! the bond exhibits negati"e
con"exity.
2. a. 1ond price decreases by =9;.;;! calculated as follos8
1; J ;.;1 J 9;; : 9;.;;
b. R J 12; J );.;10*
2
: ;.;1+0 : 1.+0<
c. ?>1.1; : 9.19
d. )i*
2-101
e. )i*
f. )iii*
+. a. %odified duration
26 . ?
;9 . 1
1;
4(% 1
duration %acaulay

+
years
b. For option-free coupon bonds! modified duration is a better measure of the
bondCs sensiti"ity to changes in interest rates. %aturity considers only the
final cash flo! hile modified duration includes other factors! such as the
siEe and timing of coupon payments! and the le"el of interest rates )yield to
maturity*. %odified duration indicates the approximate percentage change in
the bond price for a gi"en change in yield to maturity.
c. i. %odified duration increases as the coupon decreases.
ii. %odified duration decreases as maturity decreases.
d. Con"exity measures the cur"ature of the bondCs price-yield cur"e. 2uch
cur"ature means that the duration rule for bond price change )hich is based
only on the slope of the cur"e at the original yield* is only an approximation.
Adding a term to account for the con"exity of the bond increases the accuracy
of the approximation. (hat con"exity ad/ustment is the last term in the
folloing e#uation8
\ 2
1
) * Con"exity ) y*
2
P
, y
P
1
+
1
]
-. a. )i* Current yield : Coupon>Price : =7;>=?6; : ;.;72? : 7.2?<
)ii* 4(% : +.??+< semiannually or 7.?96< annual bond e#ui"alent yield.
FFinancial calculator8 n : 1;H P3 : @?6;H F3 : 1;;;H P%( : +0 Compute the
interest rate.G
)iii* OoriEon yield or realiEed compound yield is -.166< )semiannually*! or
9.++2< annual bond e#ui"alent yield. (o obtain this "alue! first find the
future "alue )F3* of rein"ested coupons and principal. (here ill be six
payments of =+0 each! rein"ested semiannually at +< per period. 5n a
financial calculator! enter8
P3 : ;H P%( : =+0H n : 6H i : +<. Compute8 F3 : =226.+?
(hree years from no! the bond ill be selling at the par "alue of =1!;;;
because the yield to maturity is forecast to e#ual the coupon rate. (herefore!
total proceeds in three years ill be =1!226.+?.
Find the rate )y
realiEed
* that makes the F3 of the purchase price : =1!226.+?8
=?6; J )1 D y
realiEed
*
6
: =1!226.+? y
realiEed
: -.166< )semiannual*
2-102
b. 2hortcomings of each measure8
)i* Current yield does not account for capital gains or losses on bonds bought at
prices other than par "alue. It also does not account for rein"estment income on
coupon payments.
)ii* 4ield to maturity assumes the bond is held until maturity and that all coupon
income can be rein"ested at a rate e#ual to the yield to maturity.
)iii* OoriEon yield or realiEed compound yield is affected by the forecast of
rein"estment rates! holding period! and yield of the bond at the end of the
in"estorMs holding period.
Kote8 (his criticism of horiEon yield is a bit unfair8 hile 4(% can be calculated
ithout e.plicit assumptions regarding future 4(% and rein"estment rates! you
implicitly assume that these "alues e#ual the current 4(% if you use 4(% as a
measure of expected return.
0. a. )i* (he effecti"e duration of the -.70< (reasury security is8
2070 . 10
;2 . ;
1;; > * +72 . 96 997 . 116 )
r
P>P
)ii* (he duration of the portfolio is the eighted a"erage of the durations of
the indi"idual bonds in the portfolio8
Portfolio .uration :
1
.
1
D
2
.
2
D
+
.
+
D f D
k
.
k

here
i
: market "alue of bond i>market "alue of the portfolio
.
i
: duration of bond i
k : number of bonds in the portfolio
(he effecti"e duration of the bond portfolio is calculated as follos8
F)=-9!667!69;>=?9!667!69;* J 2.10G D F)=0;!;;;!;;;>=?9!667!69;* J 10.26G : 9.7?
b. 3anOusenCs remarks ould be correct if there ere a small! parallel shift in
yields. .uration is a first )linear* approximation only for small changes in
yield. For larger changes in yield! the con"exity measure is needed in order to
approximate the change in price that is not explained by duration.
Additionally! portfolio duration assumes that all yields change by the same
number of basis points )parallel shift*! so any non-parallel shift in yields
ould result in a difference in the price sensiti"ity of the portfolio compared
to the price sensiti"ity of a single security ha"ing the same duration.
2-10+
6. a. (he Aa bond initially has a higher 4(% )yield spread of -; b.p. "ersus +1 b.p.*!
but it is expected to ha"e a idening spread relati"e to (reasuries. (his ill
reduce the rate of return. (he Aaa spread is expected to be stable. Calculate
comparati"e returns as follos8
Incremental return o"er (reasuries :
Incremental yield spread )Change in spread J duration*
Aaa bond8 +1 bp ); J +.1 years* : +1 bp
Aa bond8 -; bp )1; bp J +.1 years* : ? bp
(herefore! choose the Aaa bond.
b. 5ther "ariables to be considered8
Potential changes in issue-specific credit #uality8 If the credit #uality of
the bonds changes! spreads relati"e to (reasuries ill also change.
Changes in relati"e yield spreads for a gi"en bond rating8 If #uality
spreads in the general bond market change because of changes in
re#uired risk premiums! the yield spreads of the bonds ill change e"en
if there is no change in the assessment of the credit #uality of these
particular bonds.
%aturity effect8 As bonds near their maturity! the effect of credit #uality
on spreads can also change. (his can affect bonds of different initial
credit #uality differently.
7. a. < price change : )Affecti"e duration* J Change in 4(% )<*
CIC8 )7.+0* J );.0;<* : +.670<
P(,8 )0.-;* J );.0;<* : 2.7;;<
b. 2ince e are asked to calculate horiEon return o"er a period of only one coupon
period! there is no rein"estment income.
OoriEon return :
CIC8
=26.20 =1! ;00.0; =1! ;17.0;
;.;6+1- 6.+1-<
=1! ;17.0;
+

P(,8
=+1.70 =1! ;-1.0; =1! ;17.0;
;.;0-7? 0.-7?<
=1! ;17.0;
+

c. Kotice that CIC is non-callable but P(, is callable. (herefore! CIC has
positi"e con"exity! hile P(, has negati"e con"exity. (hus! the con"exity
correction to the duration approximation ill be positi"e for CIC and negati"e
for P(,.
2-10-
9. (he economic climate is one of impending interest rate increases. Oence! e ill
seek to shorten portfolio duration.
a. Choose the short maturity )2;1-* bond.
b. (he AriEona bond likely has loer duration. (he AriEona coupons are slightly
loer! but the AriEona yield is higher.
c. Choose the ? +>9 < coupon bond. (he maturities are approximately e#ual!
but the ? +>9 < coupon is much higher! resulting in a loer duration.
d. (he duration of the 2hell bond is loer if the effect of the earlier start of
sinking fund redemption dominates its slightly loer coupon rate.
e. (he floating rate note has a duration that approximates the ad/ustment period!
hich is only 6 months! thus choose the floating rate note.
?. a. A manager ho belie"es that the le"el of interest rates ill change should
engage in a rate anticipation sap! lengthening duration if rates are expected
to fall! and shortening duration if rates are expected to rise.
b. A change in yield spreads across sectors ould call for an intermarket spread
sap! in hich the manager buys bonds in the sector for hich yields are
expected to fall relati"e to other bonds and sells bonds in the sector for hich
yields are expected to rise relati"e to other bonds.
c. A belief that the yield spread on a particular instrument ill change calls for a
substitution sap in hich that security is sold if its yield is expected to rise
relati"e to the yield of other similar bonds! or is bought if its yield is expected
to fall relati"e to the yield of other similar bonds.
1;. a. (he ad"antages of a bond indexing strategy are8
Oistorically! the ma/ority of acti"e managers underperform benchmark
indexes in most periodsH indexing reduces the possibility of underperformance
at a gi"en le"el of risk.
Indexed portfolios do not depend on ad"isor expectations and so ha"e less risk
of underperforming the market.
%anagement ad"isory fees for indexed portfolios are dramatically less than
fees for acti"ely managed portfolios. Fees charged by acti"e managers
generally range from 10 to 0; basis points! hile fees for indexed portfolios
range from 1 to 2; basis points )ith the highest of those representing
enhanced indexing*. 5ther non-ad"isory fees )i.e.! custodial fees* are also
less for indexed portfolios.
Plan sponsors ha"e greater control o"er indexed portfolios because indi"idual
managers do not ha"e as much freedom to "ary from the parameters of the
benchmark index. 2ome plan sponsors e"en decide to manage index
2-100
portfolios ith in-house in"estment staff.
Indexing is essentially &buying the market.' If markets are efficient! an
indexing strategy should reduce unsystematic di"ersifiable risk! and should
generate maximum return for a gi"en le"el of risk.
(he disad"antages of a bond indexing strategy are8
Indexed portfolio returns may match the bond index! but do not
necessarily reflect optimal performance. In some time periods! many
acti"e managers may outperform an indexing strategy at the same le"el of
risk.
(he chosen bond index and portfolio returns may not meet the client
ob/ecti"es or the liability stream.
1ond indexing may restrict the fund from participating in sectors or
other opportunities that could increase returns.
b. (he stratified sampling! or cellular! method di"ides the index into cells! ith
each cell representing a different characteristic of the index. Common cells
used in the cellular method combine )but are not limited to* duration! coupon!
maturity! market sectors! credit rating! and call and sinking fund features. (he
index manager then selects one or more bond issues to represent the entire
cell. (he total market eight of issues held for each cell is based on the target
indexCs composition of that characteristic.
c. (racking error is defined as the discrepancy beteen the performance of an
indexed portfolio and the benchmark index. $hen the amount in"ested is
relati"ely small and the number of cells to be replicated is large! a significant
source of tracking error ith the cellular method occurs because of the need to
buy odd lots of issues in order to accurately represent the re#uired cells. 5dd
lots generally must be purchased at higher prices than round lots. 5n the
other hand! reducing the number of cells to limit the re#uired number of odd
lots ould potentially increase tracking error because of the mismatch ith
the target.
11. a. For an option-free bond! the effecti"e duration and modified duration are
approximately the same. Psing the data pro"ided! the duration is calculated as
follos8
1;; . 7
;;2 . ;
1;; > * 2? . ?? 71 . 1;; )
r
P>P
b. (he total percentage price change for the bond is estimated as follos8
Percentage price change using duration : @7.?; J @;.;2 J 1;; : 10.9;<
Con"exity ad/ustment : 1.66<
2-106
(otal estimated percentage price change : 10.9;< D 1.66< : 17.-6<
c. (he assistantCs argument is incorrect. 1ecause modified con"exity does not
recogniEe the fact that cash flos for bonds ith an embedded option can change
as yields change! modified con"exity remains positi"e as yields mo"e belo the
callable bondCs stated coupon rate! /ust as it ould for an option-free bond.
Affecti"e con"exity! hoe"er! takes into account the fact that cash flos for a
security ith an embedded option can change as interest rates change. $hen
yields mo"e significantly belo the stated coupon rate! the likelihood that the
bond ill be called by the issuer increases and the effecti"e con"exity turns
negati"e.
12. mP>P : I.\ my
For 2trategy I8
0-year maturity8 mP>P : I-.9+ J )I;.70<* : +.6220<
20-year maturity8 mP>P : I2+.91 J ;.0;< : I11.?;0;<
2trategy I8 mP>P : );.0 J +.6220<* D F;.0 J )I11.?;0;<*G : I-.1-1+<
For 2trategy II8
10-year maturity8 mP>P : I1-.+0 J ;.20< : I+.0970<
2-107
1+. a. i. 2trong economic reco"ery ith rising inflation expectations. Interest rates
and bond yields ill most likely rise! and the prices of both bonds ill fall. (he
probability that the callable bond ill be called ould decrease! and the callable
bond ill beha"e more like the non-callable bond. )Kote that they ha"e similar
durations hen priced to maturity*. (he slightly loer duration of the callable
bond ill result in somehat better performance in the high interest rate
scenario.
ii. Aconomic recession ith reduced inflation expectations. Interest rates and
bond yields ill most likely fall. (he callable bond is likely to be called. (he
rele"ant duration calculation for the callable bond is no modified duration to
call. Price appreciation is limited as indicated by the loer duration. (he non-
callable bond! on the other hand! continues to ha"e the same modified duration
and hence has greater price appreciation.
b. Pro/ected price change : )modified duration* J )change in 4(%*
: )@6.9;* J )@;.70<* : 0.1<
(herefore! the price ill increase to approximately =1;0.1; from its current
le"el of =1;;.
c. For 1ond A! the callable bond! bond life and therefore bond cash flos are
uncertain. If one ignores the call feature and analyEes the bond on a &to maturity'
basis! all calculations for yield and duration are distorted. .urations are too long
and yields are too high. 5n the other hand! if one treats the premium bond selling
abo"e the call price on a &to call' basis! the duration is unrealistically short and
yields too lo. (he most effecti"e approach is to use an option "aluation
approach. (he callable bond can be decomposed into to separate securities8 a
non-callable bond and an option8
Price of callable bond : Price of non-callable bond @ price of option
2ince the call option alays has some positi"e "alue! the price of the callable bond
is alays less than the price of the non-callable security.
CHAPTER 15: MACROECONOMIC AND INDUSTR" ANAL"SIS
PROBLEM SETS
1. Axpansionary )looser* monetary policy to loer interest rates ould
stimulate both in"estment and expenditures on consumer durables.
Axpansionary fiscal policy )i.e.! loer taxes! increased go"ernment
spending! increased elfare transfers* ould stimulate aggregate
demand directly.
2-109
2. A depreciating dollar makes imported cars more expensi"e and
American cars less expensi"e to foreign consumers. (his should
benefit the P.2. auto industry.
+. (his exercise is left to the studentH ansers ill "ary.
-. A top-don approach to security "aluation begins ith an analysis of
the global and domestic economy. Analysts ho follo a top-don
approach then narro their attention to an industry or sector likely to
perform ell! gi"en the expected performance of the broader economy.
Finally! the analysis focuses on specific companies ithin an industry
or sector that has been identified as likely to perform ell. A bottom-
up approach typically emphasiEes fundamental analysis of indi"idual
company stocks! and is largely based on the belief that under"alued
stocks ill perform ell regardless of the prospects for the industry or
the broader economy. (he ma/or ad"antage of the top-don approach
is that it pro"ides a structured approach to incorporating the impact of
economic and financial "ariables! at e"ery le"el! into analysis of a
companyCs stock. 5ne ould expect! for example! that prospects for a
particular industry are highly dependent on broader economic "ariables.
2imilarly! the performance of an indi"idual companyCs stock is likely to
be greatly affected by the prospects for the industry in hich the
company operates.
0. Firms ith greater sensiti"ity to business cycles are in industries that
produce durable consumer goods or capital goods. Consumers of
durable goods )e.g.! automobiles! ma/or appliances* are more likely to
purchase these products during an economic expansion! but can often
postpone purchases during a recession. 1usiness purchases of capital
goods )e.g.! purchases of manufacturing e#uipment by firms that
produce their on products* decline during a recession because demand
for the firmsC end products declines during a recession.
6. a. Bold %ining. Bold traditionally is "ieed as a hedge against
inflation. Axpansionary monetary policy may lead to increased
inflation! and thus could enhance the "alue of gold mining stocks.
2-10?
b. Construction. Axpansionary monetary policy ill lead to loer
interest rates hich ought to stimulate housing demand. (he
construction industry should benefit.
7. 2upply-side economists belie"e that a reduction in income tax rates ill
make orkers more illing to ork at current or e"en slightly loer
)gross-of-tax* ages. 2uch an effect ought to mitigate cost pressures on
the inflation rate.
9. A. $hen both fiscal and monetary policies are expansi"e! the yield
cur"e is sharply upard sloping )i.e. short-term rates are loer
than long-term rates* and the economy is likely to expand in the
future.
?. A $hen ealth is redistributed through the go"ernmentCs tax policy!
economic inefficiency is created. (ax policies should promote
economic groth as much as possible.
1;. a. (he robotics process entails higher fixed costs and loer "ariable
)labor* costs. (herefore! this firm ill perform better in a boom
and orse in a recession. For example! costs ill rise less rapidly
than re"enue hen sales "olume expands during a boom.
2-16;
b. 1ecause its profits are more sensiti"e to the business cycle! the
robotics firm ill ha"e the higher beta.
11. a. Oousing construction )cyclical but interest-rate sensiti"e*8 )iii*
Oealthy expansion
b. Oealth care )a non-cyclical industry*8 )i* .eep recession
c. Bold mining )counter-cyclical*8 )i"* 2tagflation
d. 2teel production )cyclical industry*8 )ii* 2uperheated economy
12. a. 5il ell e#uipment8 ,elati"e decline )An"ironmental pressures!
decline in easily-de"eloped ne oil fields*
b. Computer hardare8 Consolidation
c. Computer softare8 Consolidation
d. Benetic engineering8 2tart-up
e. ,ailroads8 ,elati"e decline
1+. a. Beneral Autos. Pharmaceuticals are less of a discretionary
purchase than automobiles.
b. Friendly Airlines. (ra"el expenditure is more sensiti"e to the
business cycle than mo"ie consumption.
1-. (he index of consumer expectations is a useful leading economic
indicator because! if consumers are optimistic about the future! they
ill be more illing to spend money! especially on consumer durables!
hich ill increase aggregate demand and stimulate the economy.
2-161
10. Labor cost per unit is a useful lagging indicator because ages typically
start rising only ell into an economic expansion. At the beginning of
an expansion! there is considerable slack in the economy and output can
expand ithout employers bidding up the price of inputs or the ages
of employees. 1y the time ages start increasing due to high demand
for labor! the boom period has already progressed considerably.
16. (he expiration of the patent means that Beneral $eedkillers ill soon
face considerably greater competition from its competitors. $e ould
expect prices and profit margins to fall! and total industry sales to
increase somehat as prices decline. (he industry ill probably enter
the consolidation stage in hich producers are forced to compete more
extensi"ely on the basis of price.
17. a. Axpected profit : ,e"enues @ Fixed costs @ 3ariable costs
: =12;!;;; @ =+;!;;; @ F)1>+* =12;!;;;G : =0;!;;;
b.
6; . 1
;;; ! 0; =
;;; ! +; =
1
profits
ts cos fixed
1 .5L + +
c. If sales are only =1;9!;;;! profit ill fall to8
=1;9!;;; @ =+;!;;; @ F)1>+* =1;9!;;;G : =-2!;;;
(his is a 16< decline from the forecasted "alue.
d. (he decrease in profit is 16< : .5L J 1;< drop in sales.
e. Profit must drop more than 1;;< to turn negati"e. For profit to
fall 1;;<! re"enue must fall by8
< 0 . 62
6; . 1
< 1;;
.5L
< 1;;

(herefore! re"enue ould be only +7.0< of the original forecast.
At this le"el! re"enue ill be8 ;.+70 =12;!;;; : =-0!;;;
f. If re"enue is =-0!;;;! profit ill be8
=-0!;;; @ =+;!;;; @ )1>+* =-0!;;; : =;
2-162
19. A#uity prices are positi"ely correlated ith /ob creation or longer ork
eeks! as each ne dollar earned means more ill be spent. Oigh
confidence presages ell for spending and stock prices.
1?. a. 2tock prices are one of the leading indicators. 5ne possible
explanation is that stock prices anticipate future interest rates! corporate
earnings and di"idends. Another possible explanation is that stock
prices react to changes in the other leading economic indicators! such as
changes in the money supply or the spread beteen long-term and
short-term interest rates.
2;. a. Industrial production is a coincident indicatorH the others are leading.
21. b. If historical returns are used! the arithmetic and geometric means of
returns are a"ailable. (he geometric mean is preferred for multi-period
horiEons to look at long-term trends. An alternati"e to the e#uity risk
premium is to use a mo"ing a"erage of recent historical market returns.
(his ill re"eal a lo expected e#uity risk premium hen times ha"e
been bad! hich is contrary to in"estor expectations. $hen using
historical data! there is a tradeoff beteen long and short time spans.
2hort time spans are helpful to reduce the impact of regime changes.
Long time spans pro"ide better statistical data that are less sensiti"e.
22. a. Foreign exchange rates can significantly affect the competiti"eness
and profitability for a gi"en industry. For industries that deri"e a
significant proportion of sales "ia exports! an appreciating currency is
usually bad nes because it makes the industry less competiti"e
o"erseas. Oere! the appreciating French currency makes French imports
more expensi"e in Angland.
2+. .eterminants of buyer poer include buyer concentration! buyer
"olume! buyer information! a"ailable substitutes! sitching costs! brand
identity and product
2-16+
differences. Point 1 addresses a"ailable substitutes! Point 2 addresses
buyer information and Point - addresses buyer "olume and buyer
concentration. Point +! hich addresses the number of competitors in
the industry and Point 0! ne entrants! may be factual statements but do
not support the conclusion that consumers ha"e strong bargaining
poer.
2-. a. Product differentiation can be based on the product itself! the method
of deli"ery or the marketing approach.
20. A firm ith a strategic planning process not guided by their generic
competiti"e strategy usually makes one or more of the folloing
mistakes8
1. (he strategic plan is a list of unrelated action items that does
not lead to a sustainable competiti"e ad"antage.
2. Price and cost forecasts are based on current market
conditions and fail to take into account ho industry
structure ill influence future long-term industry
profitability.
+. 1usiness units are placed into categories such as build! hold
and har"estH ith businesses failing to realiEe that these are
not business strategies! but rather the means to achie"e the
strategy.
-. (he firm focuses on market share as a measure of
competiti"e position! failing to realiEe that market share is
the result and not the cause of a sustainable competiti"e
position.
2mithCs obser"ations 2 and + describe to of these mistakes and
therefore do not support the conclusion that the Korth $ineryCs
strategic planning process is guided and informed by their generic
competiti"e strategy.
2-16-
CFA PROBLEMS
1. a. Loering reser"e re#uirements ould allo banks to lend out a
higher fraction of deposits and thus increase the money supply.
b. (he Fed ould buy (reasury securities! thereby increasing the
money supply.
c. (he discount rate ould be reduced! alloing banks to borro
additional funds at a loer rate.
2. a. Axpansionary monetary policy is likely to increase the inflation
rate! either because it may o"er stimulate the economy! or
ultimately because the end result of more money in the economy is
higher prices.
b. ,eal output and employment should increase in response to the
expansionary policy! at least in the short run.
c. (he real interest rate should fall! at least in the short-run! as the
supply of funds to the economy has increased.
d. (he nominal interest rate could either increase or decrease. 5n the
one hand! the real rate might fall Fsee part )c*G! but the inflation
premium might rise Fsee part )a*G. (he nominal rate is the sum of
these to components.
+. a. (he concept of an industrial life cycle refers to the tendency of
most industries to go through "arious stages of groth. (he rate of
groth! the competiti"e en"ironment! profit margins and pricing
strategies tend to shift as an industry mo"es from one stage to the
next! although it is generally difficult to identify precisely hen one
stage has ended and the next begun.
2-160
(he start-up stage is characteriEed by perceptions of a large
potential market and by a high le"el of optimism for potential
profits. Ooe"er! this stage usually demonstrates a high rate of
failure. In the second stage! often called stable groth or
consolidation! groth is high and accelerating! the markets are
broadening! unit costs are declining and #uality is impro"ing. In
this stage! industry leaders begin to emerge. (he third stage!
usually called sloing groth or maturity! is characteriEed by
decelerating groth caused by factors such as maturing markets
and>or competiti"e inroads by other products. Finally! an industry
reaches a stage of relati"e decline in hich sales slo or e"en
decline.
Product pricing! profitability and industry competiti"e structure
often "ary by stage. (hus! for example! the first stage usually
encompasses high product prices! high costs ),V.! marketing! etc.*
and a )temporary* monopolistic industry structure. In stage to
)stable groth*! ne entrants begin to appear and costs fall rapidly
due to the learning cur"e. Prices generally do not fall as rapidly!
hoe"er! alloing profit margins to increase. In stage three
)sloing groth*! groth begins to slo as the product or ser"ice
begins to saturate the market! and margins are eroded by significant
price reductions. In the final stage! industry cumulati"e production
is so high that production costs ha"e stopped declining! profit
margins are thin )assuming competition exists*! and the fate of the
industry depends on replacement demand and the existence of
substitute products>ser"ices.
b. (he passenger car business in the Pnited 2tates has probably
entered the final stage in the industrial life cycle because
normaliEed groth is #uite lo. (he information processing
business! on the other hand! is undoubtedly earlier in the cycle.
.epending on hether or not groth is still accelerating! it is either
in the second or third stage.
c. Cars8 In the final stages of the life cycle! demand tends to be price
sensiti"e. (hus! Pni"ersal cannot raise prices ithout losing "olume.
%oreo"er! gi"en the industryCs maturity! cost structures are likely to
be similar across all competitors! and any price cuts can be matched
2-166
immediately. (hus! Pni"ersalCs car business is boxed in8 Product
pricing is determined by the market! and the company is a &price-
taker.'
2-167
Idata8 Idata should ha"e much more pricing flexibility gi"en its
earlier stage in the industrial life cycle. .emand is groing faster
than supply! and! depending on the presence and>or actions of an
industry leader! Idata may set prices high to maximiEe current profits
and generate cash for product de"elopment! or set prices lo in an
effort to gain market share.
-. a. A basic premise of the business cycle approach to in"estment
timing is that stock prices anticipate fluctuations in the business
cycle. For example! there is e"idence that stock prices tend to
mo"e about six months ahead of the economy. In fact! stock prices
are a leading indicator for the economy.
5"er the course of a business cycle! this approach to in"esting
ould ork roughly as follos. As the in"estor percei"es that the
top of a business cycle is approaching! stocks purchased should not
be "ulnerable to a recession. $hen the in"estor percei"es that a
donturn is at hand! stock holdings should be lightened ith
proceeds in"ested in fixed-income securities. 5nce the recession
has matured to some extent! and interest rates fall! bond prices ill
rise. As the in"estor percei"es that the recession is about to end!
profits should be taken in the bonds and rein"ested in stocks!
particularly those in cyclical industries ith a high beta.
Benerally! abnormal returns can be earned only if these asset
allocation sitches are timed better than those of other in"estors.
2itches made after the turning points may not lead to excess
returns.
b. 1ased on the business cycle approach to in"estment timing! the
ideal time to in"est in a cyclical stock such as a passenger car
company ould be /ust before the end of a recession. If the
reco"ery is already underay! AdamCs recommendation ould be
too late. (he e#uities market generally anticipates the changes in
the economic cycle. (herefore! since the &reco"ery is underay!'
the price of Pni"ersal Auto should already reflect the anticipated
impro"ements in the economy.
2-169
0. a. (he industry-ide ,5A is le"eling off! indicating that the
industry may be approaching a later stage of the life cycle.
A"erage P>A ratios are declining! suggesting that in"estors are
becoming less optimistic about groth prospects.
.i"idend payout is increasing! suggesting that the firm sees less
reason to rein"est earnings in the firm. (here may be feer
groth opportunities in the industry.
Industry di"idend yield is also increasing! e"en though market
di"idend yield is decreasing.
b. Industry groth rate is still forecast at 1;< to 10<! higher than
ould be true of a mature industry.
Kon-P.2. markets are still untapped! and some firms are no
entering these markets.
%ail order sale segment is groing at -;< a year.
Kiche markets are continuing to de"elop.
Ke manufacturers continue to enter the market.
6. a. ,ele"ant data from the table supporting the conclusion that the
retail auto parts industry as a hole is in the maturity stage of the
industry life cycle are8
(he population of 19-2? year olds! a ma/or customer base for the
industry! is gradually declining.
(he number of households ith income less than =+0!;;;! another
important consumer base! is not expanding.
(he number of cars fi"e to fifteen years old! an important end
market! has experienced lo annual groth )or actual decline in
some years*! so the number of units that potentially need parts is
not groing.
Automoti"e aftermarket industry retail sales ha"e been groing
sloly for se"eral years.
Consumer expenditures on automoti"e parts and accessories ha"e
gron sloly for se"eral years.
A"erage operating margins of all retail autoparts companies ha"e
steadily declined.
2-16?
b. )i* ,ele"ant data from the table supporting the conclusion that
$igam Autoparts Oea"en! Inc. )$AO* and its principal
competitors are in the consolidation stage of their life cycle are8
2ales groth of retail autoparts companies ith 1;; or more stores
ha"e been groing rapidly and at an increasing rate.
%arket share of retail autoparts stores ith 1;; or more stores has been
increasing but is still less than 2; percent! lea"ing room for much more
groth.
A"erage operating margins for retail autoparts companies ith 1;;
or more stores are high and rising.
)ii* 1ecause of industry fragmentation )i.e.! most of the market share
is distributed among many companies ith only a fe stores*! the
retail autoparts industry apparently is undergoing marketing
inno"ation and consolidation. (he industry is mo"ing toard the
&category killer' format! in hich a fe ma/or companies control
large market shares through proliferation of outlets. (he e"idence
suggests that a ne &industry ithin an industry' is emerging in the
form of the &category killer' large chain-store company. (his
industry subgroup is in its consolidation stage )i.e.! rapid groth ith
high operating profit margins and emerging market leaders* despite
the fact that the industry is in the maturity stage of its life cycle.
7. a. )iii*
b. )iii*
c. All of the abo"e
d. )iii*
CHAPTER 16: E>UIT" VALUATION MODELS
PROBLEM SETS
1. (heoretically! di"idend discount models can be used to "alue the stock of rapidly
groing companies that do not currently pay di"idendsH in this scenario! e ould
be "aluing expected di"idends in the relati"ely more distant future. Ooe"er! as a
2-17;
practical matter! such estimates of payments to be made in the more distant future
are notoriously inaccurate! rendering di"idend discount models problematic for
"aluation of such companiesH free cash flo models are more likely to be
appropriate. At the other extreme! one ould be more likely to choose a di"idend
discount model to "alue a mature firm paying a relati"ely stable di"idend.
2. It is most important to use multi-stage di"idend discount models hen "aluing
companies ith temporarily high groth rates. (hese companies tend to be
companies in the early phases of their life cycles! hen they ha"e numerous
opportunities for rein"estment! resulting in relati"ely rapid groth and relati"ely
lo di"idends )or! in many cases! no di"idends at all*. As these firms mature!
attracti"e in"estment opportunities are less numerous so that groth rates slo.
+. (he intrinsic "alue of a share of stock is the indi"idual in"estorCs assessment of the
true orth of the stock. (he market capitaliEation rate is the market consensus for
the re#uired rate of return for the stock. If the intrinsic "alue of the stock is e#ual to
its price! then the market capitaliEation rate is e#ual to the expected rate of return.
5n the other hand! if the indi"idual in"estor belie"es the stock is underpriced )i.e.!
intrinsic "alue Q price*! then that in"estorCs expected rate of return is greater than
the market capitaliEation rate.
-. First estimate the amount of each of the next to di"idends and the terminal "alue.
(he current "alue is the sum of the present "alue of these cash flos! discounted at
9.0<.
0. (he re#uired return is ?<.
=1.22 )1.;0*
;.;0 .;? ?<
=+2.;+
k

+

6. (he Bordon ..% uses the di"idend for period )tD1* hich ould be 1.;0.
=1.;0
=+0 .;9 9<
) .;0*
r
k

2-171
7. (he P3B5 is =;.068
=+.6-
=-1 =;.06
;.;?
PVGO
9. a.
b.
1
;
=2
=19.19
;.16 ;.;0
,
P
k g

(he price falls in response to the more pessimistic di"idend forecast. (he
forecast for current year earnings! hoe"er! is unchanged. (herefore! the
P>A ratio falls. (he loer P>A ratio is e"idence of the diminished optimism
concerning the firmMs groth prospects.
?. a. g : ,5A b : 16< ;.0 : 9<
.
1
: =2 )1 @ b* : =2 )1 @ ;.0* : =1
1
;
=1
=20.;;
;.12 ;.;9
,
P
k g

b. P
+
: P
;
)1 D g*
+
: =20)1.;9*
+
: =+1.-?
1;. a.
b. Leading P
;
>A
1
: =1;.6;>=+.19 : +.++
(railing P
;
>A
;
: =1;.6;>=+.;; : +.0+
c. 270 . ? =
16 . ;
19 . + =
6; . 1; =
k
A
P P3B5
1
;

(he lo P>A ratios and negati"e P3B5 are due to a poor ,5A )?<* that is
less than the market capitaliEation rate )16<*.
2-172
1
;
=2
;.16 ;.12 12<
=0;
,
k g
P
g g
+
+
1 ;
1
;
F ) * G 6< 1.20 )1-< 6<* 16<
2
?< 6<
+
1
)1 * )1 * =+ )1.;6* =1.;6
+
=1.;6
=1;.6;
;.16 ;.;6
f m f
k r " r r
g
, " g b
,
P
k g
+ +

+

d. Ko! you re"ise b to 1>+! g to 1>+ ?< : +<! and .
1
to8
A
;
1.;+ )2>+* : =2.;6
(hus8
3
;
: =2.;6>);.16 @ ;.;+* : =10.90
3
;
increases because the firm pays out more earnings instead of rein"esting a
poor ,5A. (his information is not yet knon to the rest of the market.
11. a.
16; =
;0 . ; 1; . ;
9 =
g k
.
P
1
;

b. (he di"idend payout ratio is 9>12 : 2>+! so the ploback ratio is b : 1>+. (he
implied "alue of ,5A on future in"estments is found by sol"ing8
g : b ,5A ith g : 0< and b : 1>+ ,5A : 10<
c. Assuming ,5A : k! price is e#ual to8
12; =
1; . ;
12 =
k
A
P
1
;

(herefore! the market is paying =-; per share )=16; @ =12;* for groth
opportunities.
12. a. k : .
1
>P
;
D g
.
1
: ;.0 =2 : =1
g : b ,5A : ;.0 ;.2; : ;.1;
(herefore8 k : )=1>=1;* D ;.1; : ;.2; : 2;<
b. 2ince k : ,5A! the KP3 of future in"estment opportunities is Eero8
; 1; = 1; =
k
A
P P3B5
1
;

c. 2ince k : ,5A! the stock price ould be unaffected by cutting the di"idend and
in"esting the additional earnings.
1+. a. k : r
f
DYb FA)r
%
* @ r
f
G : 9< D 1.2)10< @ 9<* : 16.-<
g : b ,5A : ;.6 2;< : 12<
92 . 1;1 =
12 . ; 16- . ;
12 . 1 - =
g k
* g 1 ) .
3
;
;

2-17+
b. P
1
: 3
1
: 3
;
)1 D g* : =1;1.92 1.12 : =11-.;-
< 02 . 19 1902 . ;
1;; =
1;; = ;- . 11- = -9 . - =
P
P P .
* r ) A
;
; 1 1

+

1-. (ime8 ; 1 0 6
A
t
=1;.;;; =12.;;; =2-.99+ =27.12+
.
t
= ;.;;; = ;.;;; = ;.;;; =1;.9-?
b 1.;; 1.;; 1.;; ;.6;
g 2;.;< 2;.;< 2;.;< ?.;<
a.
6
0
=1;.90
=19;.92
;.10 ;.;?
,
V
k g

0
;
0 0
=19;.92
=9?.?;
)1 * 1.10
V
V
k

+
b. (he price should rise by 10< per year until year 68 because there is no di"idend!
the entire return must be in capital gains.
c. (he payout ratio ould ha"e no effect on intrinsic "alue because ,5A : k.
10. a. (he solution is shon in the Axcel spreadsheet belo8
In8u!s 4ear .i"idend .i" groth (erm "alue In"estor CF
beta
.?;
2;;9 ;.77 ;.77
mktnprem ;.;9 2;;? ;.99 ;.99
rf ;.;-0 2;1; ;.?? ;.??
kne#uity ;.117 2;11 1.1; 1.1;
ploback ;.7- 2;12 1.2- ;.1262 1.2-
roe ;.1+ 2;1+ 1.+? ;.12+2 1.+?
termngth ;.;?62 2;1- 1.06 ;.12;2 1.06
2;10 1.7- ;.1172 1.7-
2;16 1.?- ;.11-2 1.?-
2;17 2.16 ;.1112 2.16
3alue line 2;19 2.+? ;.1;92 2.+?
forecasts of 2;1? 2.6- ;.1;02 2.6-
annual di"idends 2;2; 2.?1 ;.1;22 2.?1
2;21 +.2; ;.;??2 +.2;
2;22 +.01 ;.;?62 +.01
(ransitional period 2;2+ +.90
;.;?62
2;2.60 2;6.0;
ith sloing di"idend
groth
-0.71
: P3 of CF
1eginning of constant A17 \ )1D F17*>)10 - F17*
groth period KP3)10!O28O17*
b.! c. Psing the Axcel spreadsheet! e find that the intrinsic "alues are =2?.71 and
=17.+?! respecti"ely.
2-17-
16. (he solutions deri"ed from 2preadsheet 19.2 are as follos8
Intrinsic "alue8
FCFF
Intrinsic "alue8
FCFA
Intrinsic "alue
per share8 FCFF
Intrinsic "alue
per share8 FCFA
a. 91!171 69!-7; +6.;1 +7.9+
b. 0?!?61 -?!190 2-.2? 27.17
c. 6?!91+ 07!?1+ 2?.7+ +2.;;
17.
(ime8 ; 1 2 +
.
t
=1.;;;; =1.20;; =1.0620 =1.?0+
g 20.;< 20.;< 20.;< 0.;<
a. (he di"idend to be paid at the end of year + is the first installment of a di"idend
stream that ill increase indefinitely at the constant groth rate of 0<.
(herefore! e can use the constant groth model as of the end of year 2 in order
to calculate intrinsic "alue by adding the present "alue of the first to di"idends
plus the present "alue of the price of the stock at the end of year 2.
(he expected price 2 years from no is8
P
2
: .
+
>)k @ g* : =1.?0+120>);.2; @ ;.;0* : =1+.;2
(he P3 of this expected price is8 =1+.;2>1.2;
2
: =?.;-
(he P3 of expected di"idends in years 1 and 2 is8
1+ . 2 =
2; . 1
0620 . 1 =
2; . 1
20 . 1 =
2
+
(hus the current price should be8 =?.;- D =2.1+ : =11.17
b. Axpected di"idend yield : .
1
>P
;
: =1.20>=11.17 : ;.112 : 11.2<
c. (he expected price one year from no is the P3 at that time of P
2
and .
2
8
P
1
: ).
2
D P
2
*>1.2; : )=1.0620 D =1+.;2*>1.2; : =12.10
(he implied capital gain is8
)P
1
@ P
;
*>P
;
: )=12.10 @ =11.17*>=11.17 : ;.;99 : 9.9<
(he sum of the implied capital gains yield and the expected di"idend yield is e#ual
to the market capitaliEation rate. (his is consistent ith the ..%.
2-170
19.
(ime8 ; 1 - 0
A
t
=0.;;; =6.;;; =1;.+69 =1;.+69
.
t
=;.;;; =;.;;; =;.;;; =1;.+69
.i"idends : ; for the next four years! so b : 1.; )1;;< ploback ratio*.
a.
0
-
=1;.+69
=6?.12
;.10
,
P
k

)2ince k:,5A! knoing the ploback rate is unnecessary*
-
;
- -
=6?.12
=+?.02
)1 * 1.10
P
V
k

+
b. Price should increase at a rate of 10< o"er the next year! so that the OP, ill
e#ual k.
1?. 1efore-tax cash flo from operations =2!1;;!;;;
.epreciation 21;!;;;
(axable Income 1!9?;!;;;
(axes )l +0<* 661!0;;
After-tax unle"eraged income 1!229!0;;
After-tax cash flo from operations
)After-tax unle"eraged income D depreciation* 1!-+9!0;;
Ke in"estment )2;< of cash flo from operations* -2;!;;;
Free cash flo
)After-tax cash flo from operations @ ne in"estment* =1!;19!0;;
(he "alue of the firm )i.e.! debt plus e#uity* is8
;;; ! 00; ! 1- =
;0 . ; 12 . ;
0;; ! ;19 ! 1 =
1
;

g k
!
V
2ince the "alue of the debt is =- million! the "alue of the e#uity is =1;!00;!;;;.
2;. a. g : ,5A b : 2;< ;.0 : 1;<
11 =
1; . ; 10 . ;
1; . 1 0; . ; =
g k
* g 1 ) .
g k
.
P
; 1
;

2-176
b. (ime AP2 .i"idend Comment
; =1.;;;; =;.0;;;
1 =1.1;;; =;.00;; g : 1;<! ploback : ;.0;
2 =1.21;; =;.726; AP2 has gron by 1;< based on last
yearCs earnings ploback and ,5AH this
yearCs earnings ploback ratio no falls
to ;.-; and payout ratio : ;.6;
+ =1.2926 =;.76?6 AP2 gros by );.-* )10<* : 6< and
payout ratio : ;.6;
At time 28
001 . 9 =
;6 . ; 10 . ;
76?6 . ; =
g k
.
P
+
2

At time ;8
-?+ . 7 =
* 10 . 1 )
001 . 9 = 726 . ; =
10 . 1
00 . ; =
3
2
;

+
+
c. P
;
: =11 and P
1
: P
;
)1 D g* : =12.1;
)1ecause the market is unaare of the changed competiti"e situation! it belie"es the stock price
should gro at 1;< per year.*
P
2
: =9.001 after the market becomes aare of the changed competiti"e situation.
P
+
: =9.001 1.;6 : =?.;6- )(he ne groth rate is 6<.*
4ear ,eturn
1
< ; . 10 10; . ;
11 =
00 . ; = * 11 = 1; . 12 )=

+
2
< + . 2+ 2++ . ;
1; . 12 =
726 . ; = * 1; . 12 = 001 . 9 )=

+
+
< ; . 10 10; . ;
001 . 9 =
76?6 . ; = * 001 . 9 = ;6- . ? )=

+
%oral8 In Snormal periodsS hen there is no special information!
the stock return : k : 10<. $hen special information arri"es! all the
abnormal return accrues in that period! as one ould expect in an efficient
market.
2-177
CFA PROBLEMS
1. a. (his director is confused. In the context of the constant groth model
Fi.e.! P
;
: .
1
>)k @ g*G! it is true that price is higher hen di"idends are higher
holding everything else including dividend gro&th constant. 1ut e"erything
else ill not be constant. If the firm increases the di"idend payout rate! the
groth rate g ill fall! and stock price ill not necessarily rise. In fact! if ,5A
Q k! price ill fall.
b. )i* An increase in di"idend payout ill reduce the sustainable groth rate as
less funds are rein"ested in the firm. (he sustainable groth rate
)i.e. ,5A ploback* ill fall as ploback ratio falls.
)ii* (he increased di"idend payout rate ill reduce the groth rate of book
"alue for the same reason -- less funds are rein"ested in the firm.
2. Psing a to-stage di"idend discount model! the current "alue of a share of
2undanci is calculated as follos.
2
+
2
2
1
1
;
* k 1 )
* g k )
.
* k 1 )
.
* k 1 )
.
3
+
+
+
+
+
?9 . -+ =
1- . 1
* 1+ . ; 1- . ; )
062+ . ; =
1- . 1
-?76 . ; =
1- . 1
+77; . ; =
2 2 1

+ +
here8
A
;
: =;.?02
.
;
: =;.296
A
1
: A
;
)1.+2*
1
: =;.?02 1.+2 : =1.2066
.
1
: A
1
;.+; : =1.2066 ;.+; : =;.+77;
A
2
: A
;
)1.+2*
2
: =;.?02 )1.+2*
2
: =1.6099
.
2
: A
2
;.+; : =1.6099 ;.+; : =;.-?76
A
+
: A
;
)1.+2*
2
1.1+ : =;.?02 )1.+2*
+
1.1+ : =1.97--
.
+
: A
+
;.+; : =1.97-+ ;.+; : =;.062+
2-179
+. a. Free cash flo to e#uity )FCFA* is defined as the cash flo remaining
after meeting all financial obligations )including debt payment* and after co"ering
capital expenditure and orking capital needs. (he FCFA is a measure of ho
much the firm can afford to pay out as di"idends! but in a gi"en year may be more
or less than the amount actually paid out.
2undanciMs FCFA for the year 2;;9 is computed as follos8
FCFA : Aarnings D .epreciation Capital expenditures Increase in K$C
: =9; million D =2+ million =+9 million =-1 million : =2- million
FCFA per share :
=2- million
=;.296
j of shares outstanding 9- million shares
/!/"

At this payout ratio! 2undanciMs FCFA per share e#uals di"idends per share.
b. (he FCFA model re#uires forecasts of FCFA for the high groth years )2;;? and
2;1;* plus a forecast for the first year of stable groth )2;11* in order to allo for
an estimate of the terminal "alue in 2;1; based on perpetual groth. 1ecause all of
the components of FCFA are expected to gro at the same rate! the "alues can be
obtained by pro/ecting the FCFA at the common rate. )Alternati"ely! the
components of FCFA can be pro/ected and aggregated for each year.*
(his table shos the process for estimating the current per share "alue8
FCFE B#se Assum8!i(ns
2hares outstanding8 9- million! k : 1-<
Actual
2;;9
Pro/ected
2;;?
Pro/ected
2;1;
Pro/ected
2;11
Broth rate )g* 27< 27< 1+<
(otal Per share
Aarnings after tax =9; =;.?02 =1.2;?; =1.0+00 =1.7+01
Plus8 .epreciation expense =2+ =;.27- =;.+-9; =;.--1? =;.-??-
Less8 Capital expenditures =+9 =;.-02 =;.07-; =;.72?; =;.92+9
Less8 Increase in net orking capital =-1 =;.-99 =;.61?9 =;.7971 =;.99?-
A#uals8 FCFA =2- =;.296 =;.+6+2 =;.-61+ =;.021+
(erminal "alue =02.1+;;\
(otal cash flos to e#uity =;.+6+2 =02.0?1+\\
.iscounted "alue =;.+196\\\ =-;.-67+\\\
Current "alue per share =-;.790?\\\\
\Pro/ected 2;1; (erminal "alue : )Pro/ected 2;11 FCFA*>)r g*
\\Pro/ected 2;1; (otal cash flos to e#uity :
Pro/ected 2;1; FCFA D Pro/ected 2;1; (erminal "alue
\\\.iscounted "alues obtained usingk: 1-<
\\\\Current "alue per share:2um of .iscounted Pro/ected 2;;? and 2;1; (otal FCFA
2-17?
c. i. (he ..% uses a strict definition of cash flos to e#uity! i.e. the expected
di"idends on the common stock. In fact! taken to its extreme! the ..% cannot be
used to estimate the "alue of a stock that pays no di"idends. (he FCFA model
expands the definition of cash flos to include the balance of residual cash flos
after all financial obligations and in"estment needs ha"e been met. (hus the FCFA
model explicitly recogniEes the firmCs in"estment and financing policies as ell as
its di"idend policy. In instances of a change of corporate control! and therefore the
possibility of changing di"idend policy! the FCFA model pro"ides a better estimate
of "alue. (he ..% is biased toard finding lo P>A ratio stocks ith high
di"idend yields to be under"alued and con"ersely! high P>A ratio stocks ith lo
di"idend yields to be o"er"alued. It is considered a conser"ati"e model in that it
tends to identify feer under"alued firms as market prices rise relati"e to
fundamentals. (he ..% does not allo for the potential tax disad"antage of high
di"idends relati"e to the capital gains achie"able from retention of earnings.
ii. 1oth to-stage "aluation models allo for to distinct phases of groth! an
initial finite period here the groth rate is abnormal! folloed by a stable groth
period that is expected to last indefinitely. (hese to-stage models share the same
limitations ith respect to the groth assumptions. First! there is the difficulty of
defining the duration of the extraordinary groth period. For example! a longer
period of high groth ill lead to a higher "aluation! and there is the temptation to
assume an unrealistically long period of extraordinary groth. 2econd! the
assumption of a sudden shift from high groth to loer! stable groth is
unrealistic. (he transformation is more likely to occur gradually! o"er a period of
time. Bi"en that the assumed total horiEon does not shift )i.e.! is infinite*! the
timing of the shift from high to stable groth is a critical determinant of the
"aluation estimate. (hird! because the "alue is #uite sensiti"e to the steady-state
groth assumption! o"er- or under-estimating this rate can lead to large errors in
"alue. (he to models share other limitations as ell! notably difficulties in
accurately forecasting re#uired rates of return! in dealing ith the distortions that
result from substantial and>or "olatile debt ratios! and in accurately "aluing assets
that do not generate any cash flos.
-. a. (he formula for calculating a price earnings ratio )P>A* for a stable
groth firm is the di"idend payout ratio di"ided by the difference beteen the
re#uired rate of return and the groth rate of di"idends. If the P>A is calculated
based on trailing earnings )year ;*! the payout ratio is increased by the groth rate.
If the P>A is calculated based on next yearCs earnings )year 1*! the numerator is the
payout ratio.
P>A on trailing earnings8
P>A : Fpayout ratio )1 D g*G>)k g* : F;.+; 1.1+G>);.1- ;.1+* : ++.?
P>A on next yearMs earnings8
P>A : payout ratio>)k g* : ;.+;>);.1- ;.1+* : +;.;
2-19;
b. (he P>A ratio is a decreasing function of riskinessH as risk increases! the P>A ratio
decreases. Increases in the riskiness of 2undanci stock ould be expected to
loer the P>A ratio.
(he P>A ratio is an increasing function of the groth rate of the firmH the higher the
expected groth! the higher the P>A ratio. 2undanci ould command a higher P>A if
analysts increase the expected groth rate.
(he P>A ratio is a decreasing function of the market risk premium. An increased
market risk premium increases the re#uired rate of return! loering the price of a stock
relati"e to its earnings. A higher market risk premium ould be expected to loer
2undanciMs P>A ratio.
0. a. (he sustainable groth rate is e#ual to8
ploback ratio J return on e#uity : b J ,5A
Ket Income - ).i"idends per share shares outstanding*
here
Ket Income
b

,5A : Ket Income>1eginning of year e#uity

In 2;;78
b : F2;9 @ );.9; J 1;;*G>2;9 : ;.610-
,5A : 2;9>1+9; : ;.10;7
2ustainable groth rate : ;.610- J ;.10;7 : ?.+<
In 2;1;8
b : F270 @ );.9; J 1;;*G>270 : ;.7;?1
,5A : 270>19+6 : ;.1-?9
2ustainable groth rate : ;.7;?1 J ;.1-?9 : 1;.6<
b. i. (he increased retention ratio increased the sustainable groth rate.
,etention ratio :
FKet Income - ).i"idend per share 2hares 5ustanding*G
Ket Income

,etention ratio increased from ;.610- in 2;;7 to ;.7;?1 in 2;1;.
(his increase in the retention ratio directly increased the sustainable groth
rate because the retention ratio is one of the to factors determining the
sustainable groth rate.
ii. (he decrease in le"erage reduced the sustainable groth rate.
Financial le"erage : )(otal Assets>1eginning of year e#uity*
Financial le"erage decreased from 2.+- ): +2+;>1+9;* at the beginning of 2;;7 to
2.1; at the beginning of 2;1; ): +906>19+6*
(his decrease in le"erage directly decreased ,5A )and thus the sustainable groth
rate* because financial le"erage is one of the factors determining ,5A )and ,5A is
one of the to factors determining the sustainable groth rate*.
6. a. (he formula for the Bordon model is8
2-191
;
;
)1 * , g
V
k g
+
here8
.
;
: di"idend paid at time of "aluation
g : annual groth rate of di"idends
k : re#uired rate of return for e#uity
In the abo"e formula! P
;
! the market price of the common stock! substitutes
for 3
;
and g becomes the di"idend groth rate implied by the market8
P
;
: F.
;
J )1 D g*G>)k @ g*
2ubstituting! e ha"e8
09.-? : F;.9; J )1 D g*G>);.;9 @ g* g : 6.0-<
b. Pse of the Bordon groth model ould be inappropriate to "alue .ynamicCs
common stock! for the folloing reasons8
i. (he Bordon groth model assumes a set of relationships about the groth
rate for di"idends! earnings! and stock "alues. 2pecifically! the model assumes
that di"idends! earnings! and stock "alues ill gro at the same constant rate.
In "aluing .ynamicCs common stock! the Bordon groth model is inappropriate
because managementCs di"idend policy has held di"idends constant in dollar
amount although earnings ha"e gron! thus reducing the payout ratio. (his
policy is inconsistent ith the Bordon model assumption that the payout ratio is
constant.
ii. It could also be argued that use of the Bordon model! gi"en .ynamicCs current
di"idend policy! "iolates one of the general conditions for suitability of the model!
namely that the companyCs di"idend policy bears an understandable and
consistent relationship ith the companyCs profitability.
7. a. (he industryCs estimated P>A can be computed using the folloing model8
;
1
Payout ,atio P
" k g
Ooe"er! sincekand g are not explicitly gi"en! they must be computed using the
folloing formulas8
g
ind
: ,5A retention rate : ;.20 ;.-; : ;.1;
k
ind
: go"ernment bond yield D ) industry beta e#uity risk premium*
: ;.;6 D )1.2 ;.;0* : ;.12
(herefore8
;
1
;.6;
+;.;
;.12 ;.1;
P
"

2-192
b. i. Forecast groth in real B.P ould cause P>A ratios to be generally higher
for Country A. Oigher expected groth in B.P implies higher earnings
groth and a higher P>A.
ii. Bo"ernment bond yield ould cause P>A ratios to be generally higher for
Country 1. A loer go"ernment bond yield implies a loer risk-free rate and
therefore a higher P>A.
iii. A#uity risk premium ould cause P>A ratios to be generally higher for
Country 1. A loer e#uity risk premium implies a loer re#uired return and
a higher P>A.
9. a. k : r
f
D b )k
%
@ r
f
* : -.0< D 1.10)1-.0< -.0<* : 16<
b. 4ear .i"idend
2;;? =1.72
2;1; =1.72 1.12 : =1.?+
2;11 =1.72 1.12
2
: =2.16
2;12 =1.72 1.12
+
: =2.-2
2;1+ =1.72 1.12
+
1.;? : =2.6+
Present "alue of di"idends paid in 2;1; @ 2;128
4ear P3 of .i"idend
2;1; =1.?+>1.16
1
: =1.66
2;11 =2.16>1.16
2
: =1.61
2;12 =2.-2>1.16
+
: =1.00
(otal : =-.92
Price at year-end 2;12
07 . +7 =
;? . ; 16 . ;
6+ . 2 = 2;1+
g k
,
P3 in 2;;? of this stock price ;7 . 2- =
16 . 1
07 . +7 =
+

Intrinsic "alue of stock : =-.92 D =2-.;7 : =29.9?
c. (he data in the problem indicate that [uick 1rush is selling at a price substantially
belo its intrinsic "alue! hile the calculations abo"e demonstrate that 2mile$hite
is selling at a price somehat abo"e the estimate of its intrinsic "alue. 1ased on
this analysis! [uick 1rush offers the potential for considerable abnormal returns!
hile 2mile$hite offers slightly belo-market risk-ad/usted returns.
2-19+
d. 2trengths of to-stage "ersus constant groth ..%8
(o-stage model allos for separate "aluation of to distinct periods in a
companyCs future. (his can accommodate life cycle effects. It also can
a"oid the difficulties posed by initial groth that is higher than the discount
rate.
(o-stage model allos for initial period of abo"e-sustainable groth. It
allos the analyst to make use of her expectations regarding hen groth
might shift from off-trend to a more sustainable le"el.
A eakness of all ..%s is that they are "ery sensiti"e to input "alues. 2mall
changes in k or g can imply large changes in estimated intrinsic "alue. (hese
inputs are difficult to measure.
?. a. (he "alue of a share of ,io Kational e#uity using the Bordon groth model
and the capital asset pricing model is =22.-;! as shon belo.
Calculate the re#uired rate of return using the capital asset pricing model8
k : r
f
D b J )k
%
@ r
f
* : -< D 1.9 J )?< @ -<* : 1+<
Calculate the share "alue using the Bordon groth model8
-; . 22 =
12 . ; 1+ . ;
* 12 . ; 1 ) 2; . ; =
g k
g* )1 .
P
o
;

b. (he sustainable groth rate of ,io Kational is ?.?7<! calculated as follos8

g : b J ,5A : Aarnings ,etention ,ate J ,5A : )1 @ Payout ,atio* J ,5A :
< ?7 . ? ;??7 . ;
+0 . 27; =
16 . +; =
16 . +; =
2; . + =
1
A#uity 1eginning
Income Ket
Income Ket
i"idends .
1
,
_

,
_
1;. a. (o obtain free cash flo to e#uity )FCFA*! the to ad/ustments that 2haar
should make to cash flo from operations )CF5* are8
1. 2ubtract in"estment in fixed capital8 CF5 does not take into account the
in"esting acti"ities in long-term assets! particularly plant and e#uipment.
(he cash flos corresponding to those necessary expenditures are not
a"ailable to e#uity holders and therefore should be subtracted from CF5 to
obtain FCFA.
2. Add net borroing8 CF5 does not take into account the amount of capital
supplied to the firm by lenders )e.g.! bondholders*. (he ne borroings!
net of debt repayment! are cash flos a"ailable to e#uity holders and
should be added to CF5 to obtain FCFA.
2-19-
b. Note :8 ,io Kational had =70 million in capital expenditures during the year.
Ad=ustment8 negati"e =70 million
(he cash flos re#uired for those capital expenditures )@=70 million* are no
longer a"ailable to the e#uity holders and should be subtracted from net
income to obtain FCFA.
Note ;8 A piece of e#uipment that as originally purchased for =1; million as
sold for =7 million at year-end! hen it had a net book "alue of =+ million.
A#uipment sales are unusual for ,io Kational.
Ad=ustment8 positi"e =+ million
In calculating FCFA! only cash flo in"estments in fixed capital should be
considered. (he =7 million sale price of e#uipment is a cash inflo no
a"ailable to e#uity holders and should be added to net income. Ooe"er! the
gain o"er book "alue that as realiEed hen selling the e#uipment )=- million*
is already included in net income. 1ecause the total sale is cash! not /ust the
gain! the =+ million net book "alue must be added to net income. (herefore! the
ad/ustment calculation is8
=7 million in cash recei"ed @ =- million of gain recorded in net income :
=+ million additional cash recei"ed added to net income to obtain FCFA.
Note >8 (he decrease in long-term debt represents an unscheduled principal
repaymentH there as no ne borroing during the year.
Ad=ustment8 negati"e =0 million
(he unscheduled debt repayment cash flo )@=0 million* is an amount no
longer a"ailable to e#uity holders and should be subtracted from net income to
determine FCFA.
Note ?8 5n ]anuary 1! 2;;9! the company recei"ed cash from issuing
-;;!;;; shares of common e#uity at a price of =20.;; per share.
No ad=ustment
(ransactions beteen the firm and its shareholders do not affect FCFA. (o
calculate FCFA! therefore! no ad/ustment to net income is re#uired ith
respect to the issuance of ne shares.
Note @8 A ne appraisal during the year increased the estimated market "alue
of land held for in"estment by =2 million! hich as not recogniEed in 2;;9
income.
No ad=ustment
(he increased market "alue of the land did not generate any cash flo and as
not reflected in net income. (o calculate FCFA! therefore! no ad/ustment to net
income is re#uired.
2-190
c. Free cash flo to e#uity )FCFA* is calculated as follos8
FCFA : KI D KCC @ FCIK3 @ $CIK3 D Ket 1orroing
here KCC : non-cash charges
FCIK3 : in"estment in fixed capital
$CIK3 : in"estment in orking capital
%illion = Axplanation
KI : =+;.16 From (able 19B
KCC : D=67.17 =71.17 )depreciation and amortiEation from (able 19B*
@ =-.;;\ )gain on sale from Kote 2*
FCIK3 : @=69.;; =70.;; )capital expenditures from Kote 1*
@ =7.;;\ )cash on sale from Kote 2*
$CIK3 : @=2-.;; @=+.;; )increase in accounts recei"able from (able 19F* D
@=2;.;; )increase in in"entory from (able 19F* D
@=1.;; )decrease in accounts payable from (able 19F*
Ket 1orroing : D)@=0.;;* @=0.;; )decrease in long-term debt from (able 19F*
FCFA : =;.++
\2upplemental Kote 2 in (able 19O affects both KCC and FCIK3.
11. ,io KationalCs e#uity is relati"ely under"alued compared to the industry on a P>A-to-
groth )PAB* basis. ,io KationalCs PAB ratio of 1.++ is belo the industry PAB ratio
of 1.66. (he loer PAB ratio is attracti"e because it implies that the groth rate at ,io
Kational is a"ailable at a relati"ely loer price than is the case for the industry. (he
PAB ratios for ,io Kational and the industry are calculated belo8
,io Kational
Current Price : =20.;;
KormaliEed Aarnings per 2hare : =1.71
Price-to-Aarnings ,atio : =20>=1.71 : 1-.62
Broth ,ate )as a percentage* : 11
PAB ,atio : 1-.62>11 : 1.++
Industry
Price-to-Aarnings ,atio : 1?.?;
Broth ,ate )as a percentage* : 12
PAB ,atio : 1?.?;>12 : 1.66
CHAPTER 17: FINANCIAL STATEMENT ANAL"SIS
PROBLEM SETS
2-196
1. (he ma/or difference in approach of international financial reporting standards and
P.2. BAAP accounting stems from the difference beteen TprinciplesC and Trules.C
P.2. BAAP accounting is rules-based! ith extensi"e detailed rules to be folloed
in the preparation of financial statementsH many international standards! Auropean
Pnion adapted IF,2! allo much greater flexibility! as long as conformity ith
general principles is demonstrated. A"en though P.2. BAAP is generally more
detailed and specific! issues of comparability still arise among P.2. companies.
Comparability problems are still greater among companies in foreign countries.
2. Aarnings management should not matter in a truly efficient market! here all
publicly a"ailable information is reflected in the price of a share of stock. In"estors
can see through attempts to manage earnings so that they can determine a
companyCs true profitability and! hence! the intrinsic "alue of a share of stock.
Ooe"er! if firms do engage in earnings management! then the clear implication is
that managers do not "ie financial markets as efficient.
+. 1oth credit rating agencies and stock market analysts are likely to be more or less
interested in all of the ratios discussed in this chapter )as ell as many other ratios
and forms of analysis*. 2ince the %oodyCs and 2tandard and PoorCs ratings assess
bond default risk! these agencies are most interested in le"erage ratios. A stock
market analyst ould be most interested in profitability and market price ratios.
-. ,5A : ,52 A(5
(he only ay that Crusty Pie can ha"e an ,52 higher than the industry a"erage and an
,5A e#ual to the industry a"erage is for its A(5 to be loer than the industry
a"erage.
0. A1CCs Asset turno"er must be abo"e the industry a"erage.
6.
)1 *F ) * G
,ebt
*O" 2a. *ate *OA *OA Interest *ate
"-uity
+
,5A
A
Q ,5A
1
Firms A and 1 ha"e the same ,5A. Assuming the same tax rate and assuming
that ,5A Q interest rate! then Firm A must ha"e either a loer interest rate or a
higher debt ratio.
2-197
7.
Net Income Net Income ales Assets
*O"
"-uity ales Assets "-uity

: Ket profit margin Asset turno"er Le"erage ratio
: 0.0< 2.; 2.2 : 2-.2<
9. a. Loer bad debt expense ill result in higher operating income.
b. Loer bad debt expense ill ha"e no effect on operating cash flo until
Balaxy actually collects recei"ables.
?. A. Certain BAAP rules can be exploited by companies in order to achie"e
specific goals! hile still remaining ithin the letter of the la. Aggressi"e
assumptions! such as lengthening the depreciable life of an asset )hich are
utiliEed to boost earnings* result in a loer #uality of earnings.
1;. A. 5ff balance-sheet financing through the use of operating leases is acceptable
hen used appropriately. Ooe"er! companies can use them too aggressi"ely in
order to reduce their percei"ed le"erage. A comparison among industry peers and
their practices may indicate improper use of accounting methods.
11. A. A arning sign of accounting manipulation is abnormal in"entory groth as
compared to sales groth. 1y o"erstating in"entory! the cost of goods sold is
loer! leading to higher profitability.
12.
1+
2-199
)1 * F ) * G
;.;+ );.60* F ) ;.;6* ;.0G
;.;+ ;.?70 ;.;1?0
;.?70 ;.;-?0
;.;0;9 0.;9<
,ebt
*O" t *OA *OA Interest *ate
"-uity
*OA *OA
*OA
*OA
*OA
+
+

;.70 ;.6 ;.1 2.-; 1.20 .1+0 1+.0<
Net Income Net Income 2a.able Income "%I2 ales Assets
*O"
"-uity 2a.able Income "%I2 ales Assets "-uity
*O"

1-
.
a. Cash Flos from In"esting Acti"ities
2ale of 5ld A#uipment =72!;;;
Purchase of 1us )++!;;; *
Ket Cash Psed in In"esting Acti"ities +?!;;;
b. Cash Flos from Financing Acti"ities
,epurchase of 2tock =)00!;;;*
Cash .i"idend )9;!;;; *
Ket Cash Psed in Financing Acti"ities )1+0!;;;*
c. Cash Flos from 5perating Acti"ities
Cash Collections from Customers =+;;!;;;
Cash Payments to 2uppliers )?0!;;;*
Cash Payments for Interest )20!;;; *
Ket Cash Pro"ided by 5perating Acti"ities =19;!;;;
Ket Increase in Cash =9-!;;;
CFA PROBLEMS
1. 2mile$hite has higher #uality of earnings for the folloing reasons8
2mile$hite amortiEes its goodill o"er a shorter period than does
[uick1rush. 2mile$hite therefore presents more conser"ati"e earnings
because it has greater goodill amortiEation expense.
2mile$hite depreciates its property! plant and e#uipment using an accelerated
depreciation method. (his results in recognition of depreciation expense
sooner and also implies that its income is more conser"ati"ely stated.
2mile$hiteCs bad debt alloance is greater as a percent of recei"ables.
2mile$hite is recogniEing greater bad-debt expense than [uick1rush. If
actual collection experience ill be comparable! then 2mile$hite has the
more conser"ati"e recognition policy.
2. a.
A#uity
Assets
Assets
2ales
2ales
profits Ket
A#uity
profits Ket
,5A
2-19?
: Ket profit margin (otal asset turno"er Assets>e#uity
2-1?;
b.
-70 -! 70; 2! ?0;
1;< 1.61 1.-; .2262 22.62<
-! 70; 2! ?0; 2!1;;
*O"
c. g : ,5A ploback
1.7? ;.00
22.62< 10.67<
1.7?

+. a. CF from operating acti"ities : =26; @ =90 @ =12 @ =+0 : =129
b. CF from in"esting acti"ities : @=9 D =+; @ =-; : @=19
c. CF from financing acti"ities : @=+2 @ =+7 : @=6?
-. a. [uick1rush has had higher sales and earnings groth )per share* than
2mile$hite. %argins are also higher. 1ut this does not mean that [uick1rush
is necessarily a better in"estment. 2mile$hite has a higher ,5A! hich has
been stable! hile [uick1rushCs ,5A has been declining. $e can see the
source of the difference in ,5A using .uPont analysis8
Component .efinition [uick1rush 2mile$hite
(ax burden )1 @ t* Ket profits>pretax profits 67.-< 66.;<
Interest burden Pretax profits>A1I( 1.;;; ;.?00
Profit margin A1I(>2ales 9.0< 6.0<
Asset turno"er 2ales>Assets 1.-2 +.00
Le"erage Assets>A#uity 1.-7 1.-9
,5A Ket profits>A#uity 12.;< 21.-<
$hile tax burden! interest burden! and le"erage are similar! profit margin and
asset turno"er differ. Although 2mile$hite has a loer profit margin! it has a
far higher asset turno"er.
2ustainable groth : ,5A ploback ratio
,5A
Ploback
ratio
2ustainable
groth rate
LudloCs
estimate of
groth rate
[uick1rush 12.;< 1.;; 12.;< +;<
2mile$hite 21.-< ;.+- 7.+< 1;<
Ludlo has o"erestimated the sustainable groth rate for both companies.
[uick1rush has little ability to increase its sustainable groth @ ploback
2-1?1
Ket profits -70
;.1;; 1;<
2ales -70;

2ales -! 70;
1.61
Assets 2! ?0;

Assets 2! ?0;
1.-;
A#uity 2!1;;

already e#uals 1;;<. 2mile$hite could increase its sustainable groth by
increasing its ploback ratio.
b. [uick1rushCs recent AP2 groth has been achie"ed by increasing book "alue
per share! not by achie"ing greater profits per dollar of e#uity. A firm can
increase AP2 e"en if ,5A is declining as is true of [uick1rush. [uick1rushCs
book "alue per share has more than doubled in the last to years.
1ook "alue per share can increase either by retaining earnings or by issuing ne
stock at a market price greater than book "alue. [uick1rush has been retaining
all earnings! but the increase in the number of outstanding shares indicates that
it has also issued a substantial amount of stock.
0. a. ,5A : operating margin interest burden asset turno"er le"erage tax burden
,5A for Aasto"er )A5* and for 2outhampton )2OC* in 2;1; are found as follos8
profit margin :
2ales
A1I(
2OC8
A58
1-0>1!7?+ :
7?0>7!-;6 :
9.1<
1;.7<
interest burden :
A1I(
profits Pretax
2OC8
A58
1+7>1-0 :
6;;>7?0 :
;.?-
;.70
asset turno"er :
Assets
2ales
2OC8
A58
1!7?+>2!1;- :
7!-;6>9!260 :
;.90
;.?;
le"erage :
A#uity
Assets
2OC8
A58
2!1;->1!167 :
9!260>+!96- :
1.9;
2.1-
tax burden :
profits Pretax
profits Ket
2OC8
A58
?1>1+7 :
+?->6;; :
;.66
;.66
,5A
2OC8
A58
7.9<
1;.2<
b. (he differences in the components of ,5A for Aasto"er and 2outhampton are8
Profit margin A5 has a higher margin
Interest burden A5 has a higher interest burden because its pretax profits are
a loer percentage of A1I(
Asset turno"er A5 is more efficient at turning o"er its assets
Le"erage A5 has higher financial le"erage
(ax 1urden Ko ma/or difference here beteen the to companies
2-1?2
,5A A5 has a higher ,5A than 2OC! but this is only in part due
to higher margins and a better asset turno"er -- greater
financial le"erage also plays a part.
c. (he sustainable groth rate can be calculated as8 ,5A times ploback ratio.
(he sustainable groth rates for Aasto"er and 2outhampton are as follos8
,5A
Ploback
ratio\
2ustainable
groth rate
Aasto"er 1;.2< ;.+6 +.7<
2outhampton 7.9< ;.09 -.0<
\Ploback : )1 @ payout ratio*
A58 Ploback : )1 @ ;.6-* : ;.+6
2OC8 Ploback : )1 @ ;.-2* : ;.09
(he sustainable groth rates deri"ed in this manner are not likely to be
representati"e of future groth because 2;1; as probably not a &normal'
year. For Aasto"er! earnings had not yet reco"ered to 2;;7-2;;9 le"elsH
earnings retention of only ;.+6 seems lo for a company in a capital intensi"e
industry. 2outhamptonCs earnings fell by o"er 0; percent in 2;1; and its
earnings retention ill probably be higher than ;.09 in the future. (here is a
danger! therefore! in basing a pro/ection on one yearCs results! especially for
companies in a cyclical industry such as forest products.
6. a. (he formula for the constant groth discounted di"idend model is8
g k
* g 1 ) .
P
;
;
For Aasto"er8
2; . -+ =
;9 . ; 11 . ;
;9 . 1 2; . 1 =
P
;

(his compares ith the current stock price of =29. 5n this basis! it appears
that Aasto"er is under"alued.
b. (he formula for the to-stage discounted di"idend model is8
+
+
+
+
2
2
1
1
;
* k 1 )
P
* k 1 )
.
* k 1 )
.
* k 1 )
.
P
+
+
+
+
+
+
+
For Aasto"er8 g
1
: ;.12 and g
2
: ;.;9
2-1?+
.
;
: 1.2;
.
1
: .
;
)1.12*
1
: =1.+-
.
2
: .
;
)1.12*
2
: =1.01
.
+
: .
;
)1.12*
+
: =1.6?
.
-
: .
;
)1.12*
+
)1.;9* : =1.92
67 . 6; =
;9 . ; 11 . ;
92 . 1 =
g k
.
P
2
-
+

;+ . -9 =
* 11 . 1 )
67 . 6; =
* 11 . 1 )
6? . 1 =
* 11 . 1 )
01 . 1 =
* 11 . 1 )
+- . 1 =
P
+ + 2 1
;
+ + +
(his approach makes Aasto"er appear e"en more under"alued than as the
case using the constant groth approach.
c. Ad"antages of the constant groth model include8 )1* logical! theoretical
basisH )2* simple to computeH )+* inputs can be estimated.
.isad"antages include8 )1* "ery sensiti"e to estimates of grothH )2* g and k
difficult to estimate accuratelyH )+* only "alid for g Z kH )-* constant groth is an
unrealistic assumptionH )0* assumes groth ill ne"er slo donH )6* di"idend
payout must remain constantH )7* not applicable for firms not paying di"idends.
Impro"ements offered by the to-stage model include8
)1* (he to-stage model is more realistic. It accounts for lo! high! or Eero groth
in the first stage! folloed by constant long-term groth in the second stage.
)2* (he model can be used to determine stock "alue hen the groth rate in the
first stage exceeds the re#uired rate of return.
7. a. In order to determine hether a stock is under"alued or o"er"alued! analysts
often compute price-earnings ratios )P>As* and price-book ratios )P>1s*H then!
these ratios are compared to benchmarks for the market! such as the 2VP 0;;
index. (he formulas for these calculations are8
,elati"e P>A :
,elati"e P>1 :
(o e"aluate A5 and 2OC using a relati"e P>A model! %ulroney can calculate the
fi"e-year a"erage P>A for each stock! and di"ide that number by the 0-year a"erage
P>A for the 2VP 0;; )shon in the last column of (able 1?A*. (his gi"es the
historical a"erage relati"e P>A. %ulroney can then compare the a"erage historical
relati"e P>A to the current relati"e P>A )i.e.! the current P>A on each stock! using
2-1?-
the estimate of this yearCs earnings per share in (able 1?F! di"ided by the current
P>A of the market*.
For the price>book model! %ulroney should make similar calculations! i.e.!
di"ide the fi"e-year a"erage price-book ratio for a stock by the fi"e year
a"erage price>book for the 2VP 0;;! and compare the result to the current
relati"e price>book )using current book "alue*. (he results are as follos8
P>A model A5 2OC 2VP0;;
0-year a"erage P>A 16.06 11.?- 10.2;
,elati"e 0-year P>A 1.;? ;.7?
Current P>A 17.0; 16.;; 2;.2;
Current relati"e P>A ;.97 ;.7?
Price>1ook model A5 2OC 2VP0;;
0-year a"erage price>book 1.02 1.1; 2.1;
,elati"e 0-year price>book ;.72 ;.02
Current price>book 1.62 1.-? 2.6;
Current relati"e price>book ;.62 ;.07
From this analysis! it is e"ident that A5 is trading at a discount to its historical 0-
year relati"e P>A ratio! hereas 2outhampton is trading right at its historical 0-year
relati"e P>A. $ith respect to price>book! Aasto"er is trading at a discount to its
historical relati"e price>book ratio! hereas 2OC is trading modestly abo"e its 0-year
relati"e price>book ratio. As noted in the preamble to the problem )see CFA
Problem 0*! Aasto"erCs book "alue is understated due to the "ery lo historical cost
basis for its timberlands. (he fact that Aasto"er is trading belo its 0-year a"erage
relati"e price to book ratio! e"en though its book "alue is understated! makes
Aasto"er seem especially attracti"e on a price>book basis.
b. .isad"antages of the relati"e P>A model include8 )1* the relati"e P>A measures
only relati"e! rather than absolute! "alueH )2* the accounting earnings estimate
for the next year may not e#ual sustainable earningsH )+* accounting practices
may not be standardiEedH )-* changing accounting standards may make
historical comparisons difficult.
.isad"antages of the relati"e P>1 model include8 )1* book "alue may be
understated or o"erstated! particularly for a company like Aasto"er! hich has
"aluable assets on its books carried at lo historical costH )2* book "alue may
not be representati"e of earning poer or future groth potentialH )+* changing
accounting standards make historical comparisons difficult.
9. (he folloing table summariEes the "aluation and ,5A for Aasto"er and 2outhampton8
Aasto"er 2outhampton
2tock Price =29.;; =-9.;;
Constant-groth model =-+.2; =2?.;;
2-stage groth model =-9.;+ =+0.0;
Current P>A 17.0; 16.;;
2-1?0
Current relati"e P>A ;.97 ;.7?
0-year a"erage P>A 16.06 11.?-
,elati"e 0 year P>A 1.;? ;.7?
Current P>1 1.62 1.-?
Current relati"e P>1 ;.62 ;.07
0-year a"erage P>1 1.02 1.1;
,elati"e 0 year P>1 ;.72 ;.02
Current ,5A 1;.2< 7.9<
2ustainable groth rate +.7< -.0<
Aasto"er seems to be under"alued according to each of the discounted di"idend
models. Aasto"er also appears to be cheap on both a relati"e P>A and a relati"e P>1
basis. 2outhampton! on the other hand! looks o"er"alued according to each of the
discounted di"idend models and is slightly o"er"alued using the relati"e price>book
model. 5n a relati"e P>A basis! 2OC appears to be fairly "alued. 2outhampton
does ha"e a slightly higher sustainable groth rate! but not appreciably so! and its
,5A is less than Aasto"erCs.
(he current P>A for Aasto"er is based on relati"ely depressed current earnings! yet
the stock is still attracti"e on this basis. In addition! the price>book ratio for
Aasto"er is o"erstated due to the lo historical cost basis used for the timberland
assets. (his makes Aasto"er seem all the more attracti"e on a price>book basis.
1ased on this analysis! %ulroney should select Aasto"er o"er 2outhampton.
?. a. Ket income can increase e"en hile cash flo from operations decreases.
(his can occur if there is a buildup in net orking capital -- for example!
increases in accounts recei"able or in"entories! or reductions in accounts
payable. Loer depreciation expense ill also increase net income but can
reduce cash flo through the impact on taxes oed.
b. Cash flo from operations might be a good indicator of a firmMs #uality of
earnings because it shos hether the firm is actually generating the cash
necessary to pay bills and di"idends ithout resorting to ne financing. Cash
flo is less susceptible to arbitrary accounting rules than net income is.
1;. =1!2;;
Cash flo from operations : sales @ cash expenses @ increase in A>,
Ignore depreciation because it is a non-cash item and its impact on taxes is already
accounted for.
11. 1oth current assets and current liabilities ill decrease by e#ual amounts. 1ut this
is a larger percentage decrease for current liabilities because the initial current ratio
is abo"e 1.;. 2o the current ratio increases. (otal assets are loer! so turno"er
increases.
2-1?6
12. Considering the components of after-tax ,5A! there are se"eral possible explanations
for a stable after-tax ,5A despite declining operating income8
1. .eclining operating income could ha"e been offset by an increase in non-operating
income )i.e.! from discontinued operations! extraordinary gains! gains from changes in
accounting policies* because both are components of profit margin )net income>sales*.
2. Another offset to declining operating income could ha"e been declining interest rates
on any interest rate obligations! hich ould ha"e decreased interest expense hile
alloing pre-tax margins to remain stable.
+. Le"erage could ha"e increased as a result of a decline in e#uity from8 )a* riting
don an e#uity in"estment! )b* stock repurchases! )c* lossesH or! )d* selling ne debt.
(he effect of the increased le"erage could ha"e offset a decline in operating income.
-. An increase in asset turno"er could also offset a decline in operating income. Asset
turno"er could increase as a result of a sales groth rate that exceeds the asset groth
rate! or from the sale or rite-off of assets.
0. If the effecti"e tax rate declined! the resulting increase in earnings after tax could
offset a decline in operating income. (he decline in effecti"e tax rates could result
from increased tax credits! the use of tax loss carry-forards! or a decline in the
statutory tax rate.
1+. a.
2;;7 2;11
)1* 5perating margin :
5perating Income - .epreciation
2ales
< 0 . 6
0-2
+ +9
< 9 . 6
?7?
? 76
)2* Asset turno"er :

2ales
(otal Assets
21 . 2
2-0
0-2
+6 . +
2?1
?7?
)+* Interest 1urden :

?1- . ;
+ +9
+ + +9

1.;
)-* Financial Le"erage :
(otal Assets
2hareholdersM A#uity
0- . 1
10?
2-0
+2 . 1
22;
2?1
)0* Income tax rate :

Income (axes
Pretax Income
< 6+ . -;
+2
1+
< 22 . 00
67
+7
Psing the .u Pont formula8

,5A : F1.; @ )0*G )+* )1* )2* )-*
,5A)2;;7* : ;.0?+7 ;.?1- ;.;60 2.21 1.0- : ;.12; : 12.;<
,5A)2;11* : ;.--79 1.; ;.;69 +.+6 1.+2 : ;.1+0 : 1+.0<
2-1?7
)1ecause of rounding error! these results differ slightly from those obtained by
directly calculating ,5A as net income>e#uity.*
b. Asset turno"er measures the ability of a company to minimiEe the le"el of assets
)current or fixed* to support its le"el of sales. (he asset turno"er increased
substantially o"er the period! thus contributing to an increase in the ,5A.
Financial le"erage measures the amount of financing other than e#uity! including
short and long-term debt. Financial le"erage declined o"er the period! thus
ad"ersely affecting the ,5A. 2ince asset turno"er rose substantially more than
financial le"erage declined! the net effect as an increase in ,5A.
CHAPTER 20: OPTIONS MAR2ETS: INTRODUCTION
PROBLEM SETS
1. 5ptions pro"ide numerous opportunities to modify the risk profile of a portfolio.
(he simplest example of an option strategy that increases risk is in"esting in an Tall
optionsC portfolio of at the money options )as illustrated in the text*. (he le"erage
pro"ided by options makes this strategy "ery risky! and potentially "ery profitable.
An example of a risk-reducing options strategy is a protecti"e put strategy. Oere!
the in"estor buys a put on an existing stock or portfolio! ith exercise price of the
put near or somehat less than the market "alue of the underlying asset. (his
strategy protects the "alue of the portfolio because the minimum "alue of the stock-
plus-put strategy is the exercise price of the put.
2. 1uying a put option on an existing portfolio pro"ides portfolio insurance( hich is
protection against a decline in the "alue of the portfolio. In the e"ent of a decline in
"alue! the minimum "alue of the put-plus-stock strategy is the exercise price of the
put. As ith any insurance purchased to protect the "alue of an asset! the tradeoff
an in"estor faces is the cost of the put "ersus the protection against a decline in
"alue. (he cost of the protection is the cost of ac#uiring the protecti"e put! hich
reduces the profit that results should the portfolio increase in "alue.
+. An in"estor ho rites a call on an existing portfolio takes a covered call position.
If! at expiration! the "alue of the portfolio exceeds the exercise price of the call! the
riter of the co"ered call can expect the call to be exercised! so that the riter of
the call must sell the portfolio at the exercise price. Alternati"ely! if the "alue of
the portfolio is less than the exercise price! the riter of the call keeps both the
portfolio and the premium paid by the buyer of the call. (he tradeoff for the riter
of the co"ered call is the premium income recei"ed "ersus forfeit of any possible
capital appreciation abo"e the exercise price of the call.
2-1?9
-. An option is out of the money hen exercise of the option ould be unprofitable.
A call option is out of the money hen the market price of the underlying stock is
less than the exercise price of the option. If the stock price is substantially less than
the exercise price! then the likelihood that the option ill be exercised is lo! and
fluctuations in the market price of the stock ha"e relati"ely little impact on the
"alue of the option. (his sensiti"ity of the option price to changes in the price of
the stock is called the optionCs delta! hich is discussed in detail in Chapter 21. For
options that are far out of the money! delta is close to Eero. Conse#uently! there is
generally little to be gained or lost by buying or riting a call that is far out of the
money. )A similar result applies to a put option that is far out of the money! ith
stock price substantially greater than exercise price.*
A call is in the money hen the market price of the stock is greater than the
exercise price of the option. If stock price is substantially greater than exercise
price! then the price of the option approaches the order of magnitude of the price of
the stock. Also! since such an option is "ery likely to be exercised! the sensiti"ity of
the option price to changes in stock price approaches one! indicating that a =1
increase in the price of the stock results in a =1 increase in the price of the option.
Pnder these circumstances! the buyer of an option loses the benefit of the le"erage
pro"ided by options that are near the money. Conse#uently! there is little interest in
options that are far in the money.
0.
Cost Payoff Profit
a. Call option! X : =12;.;; =9.6+ =0.;; -=+.6+
b. Put option! X : =12;.;; =1.19 =;.;; -=1.19
c. Call option! X : =120.;; =-.70 =;.;; -=-.70
d. Put option! X : =120.;; =2.-- =;.;; -=2.--
e. Call option! X : =1+;.;; =2.19 =;.;; -=2.19
f. Put option! X : =1+;.;; =-.7? =0.;; =;.21
6. In terms of dollar returns! based on a =1;!;;; in"estment8
Price of 2tock 6 %onths from Ko
2tock Price =9; =1;; =11; =12;
All stocks )1;; shares* =9!;;; =1;!;;; =11!;;; =12!;;;
All options )1!;;; options* =; =; =1;!;;; =2;!;;;
1ills D 1;; options =?!+6; =?!+6; =1;!+6; =11!+6;
In terms of rate of return! based on a =1;!;;; in"estment8
Price of 2tock 6 %onths from Ko
2tock Price =9; =1;; =11; =12;
All stocks )1;; shares* -2;< ;< 1;< 2;<
All options )1!;;; options* -1;;< -1;;< ;< 1;;<
1ills D 1;; options -6.-< -6.-< +.6< 1+.6<
2-1??
Al l opti ons
Al l stocks
Bi l l s pl us opti ons
S
T
100
100
0
6.4
Rate of return (%)
100
110
7. a. From put-call parity8
;
.20
1;;
1; 1;; =7.60
)1 * 1.1;
2
f
A
P !
r
+ +
+
b. Purchase a straddle! i.e.! both a put and a call on the stock. (he total cost of the
straddle is8 =1; D =7.60 : =17.60
9. a. From put-call parity8
;
.20
0;
- 0; =0.19
)1 * 1.1;
2
f
A
! P
r
+ +
+

b. 2ell a straddle! i.e.! sell a call and a put to realiEe premium income of8
=0.19 D =- : =?.19
If the stock ends up at =0;! both of the options ill be orthless and your
profit ill be =?.19. (his is your maximum possible profit since! at any
other stock price! you ill ha"e to pay off on either the call or the put. (he
stock price can mo"e by =?.19 in either direction before your profits become
negati"e.
c. 1uy the call! sell )rite* the put! lend8 =0;>)1.1;*
1>-
(he payoff is as follos8
Position Immediate CF CF in + months
2
(
^ X 2
(
Q X
2-2;;
Call )long* C : 0.19 ; 2
(
@ 0;
Put )short* @P : -.;; @ )0; @ 2
(
* ;
Lending position 92 . -9
1; . 1
0;
- > 1
0; 0;
(otal
C @ P D
;; . 0;
1; . 1
0;
- > 1

2
(
2
(
1y the put-call parity theorem! the initial outlay e#uals the stock price8
2
;
: =0;
In either scenario! you end up ith the same payoff as you ould if you
bought the stock itself.
?. a. i. A long straddle produces gains if prices mo"e up or don! and limited
losses if prices do not mo"e. A short straddle produces significant losses if prices
mo"e significantly up or don. A bullish spread produces limited gains if prices
mo"e up.
b. i. Long put positions gain hen stock prices fall and produce "ery limited
losses if prices instead rise. 2hort calls also gain hen stock prices fall but create
losses if prices instead rise. (he other to positions ill not protect the portfolio
should prices fall.
1;. Kote that the price of the put e#uals the re"enue from riting the call! net initial
cash outlays : =+9.;;
Position 2
Z +0 +0
2
-;
X
2
X
2
XX
2
-; Z
2
1uy 2tock 2
$rite call )=-;* ; ;

-; -
2
1uy put )=+0*

+0-
2
; ;
(otal =+0 2
=-;

=+0

Profit
=2
-=+
=-;
2-2;1
11. Ansers may "ary. For =0!;;; initial outlay! buy 0!;;; puts! rite 0!;;; calls8
2-2;2
Position 2
: =+;
2
: =-;
X
2
X
2
XX
2
2
:=0;
2tock Portfolio =10;!;;; =2;;!;;; =20;!;;;
$rite call)X:=-0* ; ; -=20!;;;
1uy put )X:=+0* =20!;;; ; ;
Initial 5utlay -=0!;;; -=0!;;; -=0!;;;
Portfolio 3alue =17;!;;; =1?0!;;; =22;!;;;
Compare this to /ust holding the portfolio8
Position 2
: =+;
2
: =-;
X
2
X
2
XX
2
2
:=0;
2tock Portfolio =10;!;;; =2;;!;;; =20;!;;;
Portfolio 3alue =10;!;;; =2;;!;;; =20;!;;;
12. a.
5utcome 2
(
^ X 2
(
Q X
2tock 2
(
D . 2
(
D .
Put X @ 2
(
;
(otal X D . 2
(
D .
b.
5utcome 2
(
^ X 2
(
Q X
Call ; 2
(
@ X
eeros X D . X D .
(otal X D . 2
(
D .
(he total payoffs for the to strategies are e#ual regardless of hether 2
(

exceeds X.
c. (he cost of establishing the stock-plus-put portfolio is8 2
;
D P
(he cost of establishing the call-plus-Eero portfolio is8 C D P3)X D .*
(herefore8
2
;
D P : C D P3)X D .*
(his result is identical to e#uation 2;.2.
2-2;+
1+. a.
Position 2
(
Z X
1
X
1
2
(
X
2
X
2
Z 2
(
X
+ X
+
Z 2
(

Long call )X
1
*
; 2
(
@ X
1
2
(
@ X
1
2
(
@ X
1
2hort 2 calls )X
2
*
; ; @2)2
(
@ X
2
* @2)2
(
@ X
2
*
Long call )X
+
*
; ; ; 2
(
@ X
+
(otal ; 2
(
@ X
1
2X
2
@ X
1
@ 2
(
)X
2
@X
1
* @ )X
+
@X
2
* : ;
X
2
X
1
S
T
X
1
X
2
Payoff
X
3
b.
Position 2
(
Z X
1
X
1
2
(
X
2
X
2
X
2
XX
2
X
2
Z 2
(
1uy call )X
2
* ; ; 2
(
@ X
2
1uy put )X
1
* X
1
@ 2
(
; ;
(otal X
1
@ 2
(
; 2
(
@ X
2
2-2;-
X
1
S
T
X
1
X
2
Payoff
1-.
Position 2
(
Z X
1
X
1
2
(
X
2
XX
2
X
2
Z 2
(
1uy call )X
2
* ; ; 2
(
@ X
2
2ell call )X
1
* ; @)2
(
@ X
1
* @)2
(
@ X
1
*
(otal ; X
1
@ 2
(
X
1
@ X
2
Payoff
0
S
T
X1 X
2
Payoff
(X2X1
)
10. a. 1y riting co"ered call options! ]ones recei"es premium income of =+;!;;;.
If! in ]anuary! the price of the stock is less than or e#ual to =-0! then ]ones
ill ha"e his stock plus the premium income. 1ut the most he can ha"e at that
time is )=-0;!;;; D =+;!;;;* because the stock ill be called aay from him
if the stock price exceeds =-0. )$e are ignoring here any interest earned o"er
this short period of time on the premium income recei"ed from riting the
option.* (he payoff structure is8
2tock price Portfolio "alue
less than =-0 1;!;;; times stock price D =+;!;;;
greater than =-0 =-0;!;;; D =+;!;;; : =-9;!;;;
(his strategy offers some extra premium income but lea"es ]ones sub/ect to
substantial donside risk. At an extreme! if the stock price fell to Eero! ]ones
ould be left ith only =+;!;;;. (his strategy also puts a cap on the final
"alue at =-9;!;;;! but this is more than sufficient to purchase the house.
2-2;0
b. 1y buying put options ith a =+0 strike price! ]ones ill be paying =+;!;;; in
premiums in order to insure a minimum le"el for the final "alue of his
position. (hat minimum "alue is8 )=+0 J 1;!;;;* @ =+;!;;; : =+2;!;;;
(his strategy allos for upside gain! but exposes ]ones to the possibility of a
moderate loss e#ual to the cost of the puts. (he payoff structure is8
less than =+0 =+0;!;;; @ =+;!;;; : =+2;!;;;
greater than =+0 1;!;;; times stock price @ =+;!;;;
c. (he net cost of the collar is Eero. (he "alue of the portfolio ill be as follos8
less than =+0 =+0;!;;;
beteen =+0 and =-0 1;!;;; times stock price
greater than =-0 =-0;!;;;
If the stock price is less than or e#ual to =+0! then the collar preser"es the
=+0;!;;; principal. If the price exceeds =-0! then ]ones gains up to a cap
of =-0;!;;;. In beteen =+0 and =-0! his proceeds e#ual 1;!;;; times the
stock price.
(he best strategy in this case ould be )c* since it satisfies the to
re#uirements of preser"ing the =+0;!;;; in principal hile offering a chance
of getting =-0;!;;;. 2trategy )a* should be ruled out since it lea"es ]ones
exposed to the risk of substantial loss of principal.
5ur ranking ould be8 )1* strategy cH )2* strategy bH )+* strategy a.
2-2;6
16. Psing Axcel! ith Profit .iagram on next page.
S!(=? P$i=es
1eginning %arket
Price 116.0
P$i=e P$(<i!
Anding %arket Price 1+; En@inA S!$#@@%e
Bu&inA O8!i(ns: 0; -2.9;
C#%% O8!i(ns S!$i?e P$i=e P#&(<< P$(<i! Re!u$n . 6; +2.9;
11; 22.9; 2;.;; -2.9; -12.29< 7; 22.9;
12; 16.9; 1;.;; -6.9; --;.-9< 9; 12.9;
1+; 1+.6; ;.;; -1+.6; -1;;.;;< ?; 2.9;
1-; 1;.+; ;.;; -1;.+; -1;;.;;< 1;; -7.2;
11; -17.2;
Pu! O8!i(ns S!$i?e P$i=e P#&(<< P$(<i! Re!u$n . 12; -27.2;
11; 12.6; ;.;; -12.6; -1;;.;;< 1+; -+7.2;
12; 17.2; ;.;; -17.2; -1;;.;;< 1-; -27.2;
1+; 2+.6; ;.;; -2+.6; -1;;.;;< 10; -17.2;
1-; +;.0; 1;.;; -2;.0; -67.21< 16; -7.2;
17; 2.9;
S!$#@@%e P$i=e P#&(<< P$(<i! Re!u$n . 19; 12.9;
11; +0.-; 2;.;; -10.-; --+.0;< 1?; 22.9;
12; +-.;; 1;.;; -2-.;; -7;.0?< 2;; +2.9;
1+; +7.2; ;.;; -+7.2; -1;;.;;< 21; -2.9;
1-; -;.9; 1;.;; -+;.9; -70.-?<
Se%%inA O8!i(ns:
En@inA Bu%%is*
C#%% O8!i(ns S!$i?e P$i=e P#&(<< P$(<i! Re!u$n . S!(=?
P$i=e S8$e#@
11; 22.9; -2; 2.9; 12.29< 0; -+.2
12; 16.9; -1; 6.9; -;.-9< 6; -+.2
1+; 1+.6; ; 1+.6; 1;;.;;< 7; -+.2
1-; 1;.+; ; 1;.+; 1;;.;;< 9; -+.2
?; -+.2
Pu! O8!i(ns S!$i?e P$i=e P#&(<< P$(<i! Re!u$n . 1;; -+.2
11; 12.6; ; 12.6; 1;;.;;< 11; -+.2
12; 17.2; ; 17.2; 1;;.;;< 12; -+.2
1+; 2+.6; ; 2+.6; 1;;.;;< 1+; 6.9
1-; +;.0; 1; -;.0; 1+2.7?< 1-; 6.9
10; 6.9
M(ne& S8$e#@ P$i=e P#&(<< P$(<i! 16; 6.9
Bu%%is* S8$e#@ 17; 6.9
Purchase 12; Call 16.9; 1;.;; -6.9; 19; 6.9
2ell 1+; Call 1+.6; ; 1+.6; 1?; 6.9
Combined Profit 1;.;; 6.9; 2;; 6.9
21; 6.9
2-2;7
Profit diagram for problem 168
17. (he farmer has the option to sell the crop to the go"ernment for a guaranteed
minimum price if the market price is too lo. If the support price is denoted P
2
and
the market price P
m
then the farmer has a put option to sell the crop )the asset* at an
exercise price of P
2
e"en if the price of the underlying asset )P
m
* is less than P
2
.
19. (he bondholders ha"e! in effect! made a loan hich re#uires repayment of 1
dollars! here 1 is the face "alue of bonds. If! hoe"er! the "alue of the firm )3* is
less than 1! the loan is satisfied by the bondholders taking o"er the firm. In this
ay! the bondholders are forced to &pay' 1 )in the sense that the loan is cancelled*
in return for an asset orth only 3. It is as though the bondholders rote a put on
an asset orth 3 ith exercise price 1. Alternati"ely! one might "ie the
bondholders as gi"ing the right to the e#uity holders to reclaim the firm by paying
off the 1 dollar debt. (he bondholders ha"e issued a call to the e#uity holders.
2-2;9
1?. (he manager recei"es a bonus if the stock price exceeds a certain "alue and
recei"es nothing otherise. (his is the same as the payoff to a call option.
2;. a.
Position 2
(
Z 120 120 2
(
1+; 2
(
Q 1+;
$rite call! X : =1+; ; ; @)2
(
@ 1+;*
$rite put! X : =120 @)120 @ 2
(
* ; ;
(otal 2
(
@ 120 ; 1+; @ 2
(

S
T
125 130

Payoff
Write call Write put
b. Proceeds from riting options8
Call8 =2.19
Put8 =2.--
(otal8 =-.62
If I1% sells at =129 on the option expiration date! both options expire out of the
money! and profit : =-.62. If I1% sells at =1+0 on the option expiration date!
the call ritten results in a cash outflo of =0 at expiration! and an o"erall profit
of8 =-.62@ =0.;; : -=;.+9
c. 4ou break e"en hen either the put or the call results in a cash outflo of
=-.62. For the put! this re#uires that8
=-.62 : =120.;; @ 2
(
2
(
: =12;.+9
For the call! this re#uires that8
=-.62 : 2
(
@ =1+;.;; 2
(
: =1+-.62
d. (he in"estor is betting that I1% stock price ill ha"e lo "olatility. (his
position is similar to a straddle.
21. (he put ith the higher exercise price must cost more. (herefore! the net outlay to
establish the portfolio is positi"e.
Position 2
(
Z ?; ?; 2
(
?0 2
(
Q ?0
2-2;?
$rite put! X : =?; @)?; @ 2
(
* ; ;
1uy put! X : =?0 ?0 @ 2
(
?0 @ 2
(
;
(otal 0 ?0 @ 2
(
;
(he payoff and profit diagram is8

0
S
T
Payoff
5
90 95
Profit
Ket outlay to establish
position
22. 1uy the X : 62 put )hich should cost more but does not* and rite the X : 6; put.
2ince the options ha"e the same price! your net outlay is Eero. 4our proceeds at
expiration may be positi"e! but cannot be negati"e.
Position 2
(
Z 6; 6; 2
(
62 2
(
Q 62
1uy put! X : =62 62 @ 2
(
62 @ 2
(
;
$rite put! X : =6; @)6; @ 2
(
* ; ;
(otal 2 62 @ 2
(
;
0
S
T
2
60 62
Payoff = Profit (because net investment = 0)
2+. Put-call parity states that8
;
) * ).i"idends* P ! PV A PV + +
2ol"ing for the price of the call option8
;
) * ).i"idends* ! PV A PV P +
2-21;

=1;; =2
=1;; =7
)1.;0* )1.;0*
=?.96
! +
2-. (he folloing payoff table shos that the portfolio is riskless ith time-( "alue
e#ual to =1;8
Position 2
(
^ 1; 2
(
Q 1;
1uy stock 2
(
2
(
$rite call! X : =1; ; @)2
(
@ 1;*
1uy put! X : =1; 1; @ 2
(
;
(otal 1; 1;
(herefore! the risk-free rate is8 )=1;>=?.0;* @ 1 : ;.;026 : 0.26<
20. a.! b.
Position 2
(
Z 1;; 1;; 2
(
11; 2
(
Q 11;
1uy put! X : =11; 11; @ 2
(
11; @ 2
(
;
$rite put! X : =1;; @)1;; @ 2
(
* ; ;
(otal 1; 11; @ 2
(
;
(he net outlay to establish this position is positi"e. (he put you buy has a
higher exercise price than the put you rite! and therefore must cost more than
the put that you rite. (herefore! net profits ill be less than the payoff at
time (.
0
S
T
110
100
10
Payoff
Profit
c. (he "alue of this portfolio generally decreases ith the stock price.
(herefore! its beta is negati"e.
26. a. ]oeCs strategy
Position Cost Payoff
2-211
2
(
-;; 2
(
Q -;;
2tock index -;; 2
(
2
(
Put option! X : =-;; 2; -;; @ 2
(
;
2-212
(otal -2; -;; 2
(
Profit : payoff @ =-2; @2; 2
(
@ -2;
2allyCs strategy
Position Cost Payoff
2
(
+?; 2
(
Q +?;
2tock index -;; 2
(
2
(
Put option! X : =+?; 10 +?; @ 2
(
;
(otal -10 +?; 2
(
Profit : payoff @ =-10 @20 2
(
@ -10
Profit
Joe
Sally
-20
-25
390 400
S
T
b. 2ally does better hen the stock price is high! but orse hen the stock price
is lo. (he break-e"en point occurs at 2
(
: =+?0! hen both positions
pro"ide losses of =2;.
c. 2allyCs strategy has greater systematic risk. Profits are more sensiti"e to the
"alue of the stock index.
27. a.! b. )2ee graph belo*
(his strategy is a bear spread. Initial proceeds : =? @ =+ : =6
(he payoff is either negati"e or Eero8
Position 2
(
Z 0; 0; 2
(
6; 2
(
Q 6;
1uy call! X : =6; ; ; 2
(
@ 6;
$rite call! X : =0; ; @)2
(
@ 0;* @)2
(
@ 0;*
(otal ; @)2
(
@ 0;* @1;
2-21+
c. 1reake"en occurs hen the payoff offsets the initial proceeds of =6! hich
occurs at stock price 2
(
: =06. (he in"estor must be bearish8 the position
does orse hen the stock price increases.
0
S
T
50
60
6
-10
- 4
Profit
Payoff
29. 1uy a share of stock! rite a call ith X : =0;! rite a call ith X : =6;! and buy a
call ith X : =11;.
Position 2
(
Z 0; 0; 2
(
6; 6; Z 2
(
11; 2
(
Q 11;
1uy stock 2
(
2
(
2
(
2
(
$rite call! X : =0; ; @)2
(
@ 0;* @)2
(
@ 0;* @)2
(
@ 0;*
$rite call! X : =6; ; ; @)2
(
@ 6;* @)2
(
@ 6;*
1uy call! X : =11; ; ; ; 2
(
@ 11;
(otal 2
(
0; 11; @ 2
(
;
(he in"estor is making a "olatility bet. Profits ill be highest hen "olatility is lo
and the stock price 2
(
is beteen =0; and =6;.
2?. a.
Position 2
(
^ 79; 2
(
Q 79;
1uy stock 2
(
2
(
1uy put 79; @ 2
(
;
(otal 79; 2
(
Position 2
(
^ 9-; 2
(
Q 9-;
1uy call ; 2
(
@ 9-;
1uy (-bills 9-; 9-;
(otal 9-; 2
(
2-21-
Payoff
S
T
840
780
780 840
Bills plus calls
Protective put strategy
b. (he bills plus call strategy has a greater payoff for some "alues of 2
(
and
ne"er a loer payoff. 2ince its payoffs are alays at least as attracti"e and
sometimes greater! it must be more costly to purchase.
c. (he initial cost of the stock plus put position is8 =?;; D =6 : =?;6
(he initial cost of the bills plus call position is8 =91; D =12; : =?+;
2
(
: 7;; 2
(
: 9-; 2
(
: ?;; 2
(
: ?6;
2tock 7;; 9-; ?;; ?6;
D Put 9; ; ; ;
Payoff 79; 9-; ?;; ?6;
Profit @126 @66 @6 0-
1ill 9-; 9-; 9-; 9-;
D Call ; ; 6; 12;
Payoff 9-; 9-; ?;; ?6;
Profit @?; @?; @+; D+;
2-210

Profit
Bills plus calls
Protective put
-90
-126
780 840
S
T
d. (he stock and put strategy is riskier. (his strategy performs orse hen the
market is don and better hen the market is up. (herefore! its beta is higher.
e. Parity is not "iolated because these options ha"e different exercise prices.
Parity applies only to puts and calls ith the same exercise price and
expiration date.
+;. According to put-call parity )assuming no di"idends*! the present "alue of a
payment of =120 can be calculated using the options ith ]anuary expiration and
exercise price of =120.
P3)X* : 2
;
D P @ C
P3)=120* : =127.21 D =2.-- @ =-.70 :=12-.?;
+1. From put-call parity8
C @ P : 2
;
@ X>)l D r
f
*
(

If the options are at the money! then 2
;
: X and8
C @ P : X @ X>)l D r
f
*
(
(he right-hand side of the e#uation is positi"e! and e conclude that C Q P.
CFA PROBLEMS
1. a. .onie should choose the long strangle strategy. A long strangle option
strategy consists of buying a put and a call ith the same expiration date and
the same underlying asset! but different exercise prices. In a strangle strategy!
the call has an exercise price abo"e the stock price and the put has an exercise
price belo the stock price. An in"estor ho buys )goes long* a strangle
expects that the price of the underlying asset )(,( %aterials in this case* ill
either mo"e substantially belo the exercise price on the put or abo"e the
exercise price on the call. $ith respect to (,(! the long strangle in"estor
buys both the put option and the call option for a total cost of =?.;;! and ill
experience a profit if the stock price mo"es more than =?.;; abo"e the call
2-216
exercise price or more than =?.;; belo the put exercise price. (his strategy ould
enable .onieMs client to profit from a large mo"e in the stock price! either up
or don! in reaction to the expected court decision.
b. i. (he maximum possible loss per share is =?.;;! hich is the total cost of the
to options )=0.;; D =-.;;*.
ii. (he maximum possible gain is unlimited if the stock price mo"es outside
the breake"en range of prices.
iii. (he breake"en prices are =-6.;; and =6?.;;. (he put ill /ust co"er costs
if the stock price finishes =?.;; belo the put exercise price
)i.e.! =00 I =? : =-6*! and the call ill /ust co"er costs if the stock price
finishes =?.;; abo"e the call exercise price )i.e.! =6; D =? : =6?*.
2. i. A#uity index-linked note8 Pnlike traditional debt securities that pay a
scheduled rate of coupon interest on a periodic basis and the par amount of
principal at maturity! the e#uity index-linked note typically pays little or no
coupon interestH at maturity! hoe"er! a unit holder recei"es the original issue
price plus a supplemental redemption amount! the "alue of hich depends on
here the e#uity index settled relati"e to a predetermined initial le"el.
ii. Commodity-linked bear bond8 Pnlike traditional debt securities that pay a
scheduled rate of coupon interest on a periodic basis and the par amount of
principal at maturity! the commodity-linked bear bond allos an in"estor to
participate in a decline in a commodityCs price. In exchange for a loer than
market coupon! buyers of a bear tranche recei"e a redemption "alue that
exceeds the purchase price if the commodity price has declined by the
maturity date.
+. i. Con"ersion "alue of a con"ertible bond is the "alue of the security if it is
con"erted immediately. (hat is8
Con"ersion "alue : market price of the common stock J con"ersion ratio :
=-; J 22 : =99;
ii. %arket con"ersion price is the price that an in"estor effecti"ely pays for the
common stock if the con"ertible bond is purchased8
%arket con"ersion price : market price of the con"ertible bond>con"ersion ratio :
=1!;0;>22 : =-7.7+
-. a. i. (he current market con"ersion price is computed as follos8
%arket con"ersion price : market price of the con"ertible bond>con"ersion ratio :
=?9;>20 : =+?.2;
2-217
ii. (he expected one-year return for the 4tel con"ertible bond is8
Axpected return : F)end of year price D coupon*>current priceG @ 1
: F)=1!120 D =-;*>=?9;G @ 1 : ;.1999 : 19.99<
iii. (he expected one-year return for the 4tel common e#uity is8
Axpected return : F)end of year price D di"idend*>current priceG @ 1
: )=-0>=+0* @ 1 : ;.2907 : 29.07<
b. (he to components of a con"ertible bondCs "alue are8
the straight bond "alue! hich is the con"ertible bondCs "alue as a bond! andH
the option "alue! hich is the "alue from a potential con"ersion to e#uity.
)i.* In response to the increase in 4telCs common e#uity price! the straight
bond "alue should stay the same and the option "alue should increase.
(he increase in e#uity price does not affect the straight bond "alue component
of the 4tel con"ertible. (he increase in e#uity price increases the option "alue
component significantly! because the call option becomes deep &in the money'
hen the =01 per share e#uity price is compared to the con"ertibleCs con"ersion
price of8 =1!;;;>20 : =-; per share.
)ii.* In response to the increase in interest rates! the straight bond "alue should
decrease and the option "alue should increase.
(he increase in interest rates decreases the straight bond "alue component )bond
"alues decline as interest rates increase* of the con"ertible bond and increases
the "alue of the e#uity call option component )call option "alues increase as
interest rates increase*. (his increase may be small or e"en unnoticeable hen
compared to the change in the option "alue resulting from the increase in the
e#uity price.
0. a. )ii* FProfit : =-; @ =20 D =2.0; @ =-.;;G
b. )i*
COAP(A, 218 5P(I5K 3ALPA(I5K
PROBLEM SETS
1. (he "alue of a put option also increases ith the "olatility of the stock. $e see this
from the put-call parity theorem as follos8
P : C @ 2
;
D P3)X* D P3).i"idends*
Bi"en a "alue for 2 and a risk-free interest rate! then! if C increases because of an
increase in "olatility! P must also increase in order to maintain the e#uality of the
parity relationship.
2-219
2. A =1 increase in a call optionCs exercise price ould lead to a decrease in the
optionCs "alue of less than =1. (he change in the call price ould e#ual =1 only if8
)i* there ere a 1;;< probability that the call ould be exercised! and )ii* the
interest rate ere Eero.
+. Oolding firm-specific risk constant! higher beta implies higher total stock "olatility.
(herefore! the "alue of the put option increases as beta increases.
-. Oolding beta constant! the stock ith a lot of firm-specific risk has higher total
"olatility. (he option on the stock ith higher firm-specific risk is orth more.
0. A call option ith a high exercise price has a loer hedge ratio. (his call option is
less in the money. 1oth d
1
and K)d
1
* are loer hen X is higher.
6. a. Put A must be ritten on the stock ith the loer price. 5therise! gi"en the
loer "olatility of 2tock A! Put A ould sell for less than Put 1.
b. Put 1 must be ritten on the stock ith the loer price. (his ould explain
its higher price.
c. Call 1 must ha"e the loer time to expiration. .espite the higher price of
2tock 1! Call 1 is cheaper than Call A. (his can be explained by a loer
time to expiration.
d. Call 1 must be ritten on the stock ith higher "olatility. (his ould explain
its higher price.
e. Call A must be ritten on the stock ith higher "olatility. (his ould explain
its higher price.
2-21?
7.
Axercise
Price
Oedge
,atio
12; ;>+; : ;.;;;
11; 1;>+; : ;.+++
1;; 2;>+; : ;.667
?; +;>+; : 1.;;;
As the option becomes more in the money! the hedge ratio increases to a
maximum of 1.;.
9.
2 d
1
K)d
1
*
-0 -;.2769 ;.+?1;
0; ;.20;; ;.0?97
00 ;.7266 ;.7662
?. a. u2
;
: 1+; P
u
: ;
d2
;
: 9; P
d
: +;
(he hedge ratio is8
0
+
9; 1+;
+; ;
d2 u2
P P
O
; ;
d u

b.
,iskless
Portfolio
2
(
: 9; 2
(
: 1+;
1uy + shares 2-; +?;
1uy 0 puts 10; ;
(otal +?; +?;
Present "alue : =+?;>1.1; : =+0-.0-0
c. (he portfolio cost is8 +2 D 0P : +;; D 0P
(he "alue of the portfolio is8 =+0-.0-0
(herefore8 +;; D 0P : =+0-.0-0 P : =0-.0-0>0 : =1;.?1
2-22;
1;. (he hedge ratio for the call is8
0
2
9; 1+;
; 2;
d2 u2
C C
O
; ;
d u
,iskless
Portfolio
2 : 9; 2 : 1+;
1uy 2 shares 16; 26;
$rite 0 calls ; -1;;
(otal 16; 16;
Present "alue : =16;>1.1; : =1-0.-00
(he portfolio cost is8 22 @ 0C : =2;; @ 0C
(he "alue of the portfolio is8 =1-0.-00
(herefore8 C : =0-.0-0>0 : =1;.?1
.oes P : C D P3)X* @ 2i
1;.?1 : 1;.?1 D 11;>1.1; @ 1;; : 1;.?1
11. d
1
: ;.21?2 K)d
1
* : ;.0969
d
2
: @;.1+-- K)d
2
* : ;.--60
Xe
r (
: -?.2006
C : =0; J ;.0969 @ -?.2006 J ;.--60 : =7.+-
12. P : =6.6;
(his "alue is deri"ed from our 1lack-2choles spreadsheet! but note that e could
ha"e deri"ed the "alue from put-call parity8
P : C D P3)X* @ 2
;
: =7.+- D =-?.26 =0; : =6.6;
1+. a. C falls to =0.1--+
b. C falls to =+.99;1
c. C falls to =0.-;-+
d. C rises to =1;.0+06
e. C rises to =7.06+6
2-221
1-. According to the 1lack-2choles model! the call option should be priced at8
F=00 J K)d
1
*G @ F0; J K)d
2
*G : )=00 J ;.6* @ )=0; J ;.0* : =9
2ince the option actually sells for more than =9! implied "olatility is greater than ;.+;.
10. A straddle is a call and a put. (he 1lack-2choles "alue ould be8
C D P : 2
;
J

K)d
1
* Xe
@r(
J K)d
2
* D Xe
@r(
J F1 K)d
2
*G 2
;
F1 K)d
1
*G
: 2
;
J

F2K)d
1
* 1G D Xe
@r(
J F1 2K)d
2
*G
5n the Axcel spreadsheet )2preadsheet 21.1*! the "aluation formula ould be8
:10\)2\A- 1* D 16\AXP)1-\1+*\)1 2\A0*
16. A. A delta-neutral portfolio is perfectly hedged against small price changes in the
underlying asset. (his is true both for price increases and decreases. (hat is! the
portfolio "alue ill not change significantly if the asset price changes by a small
amount. Ooe"er! large changes in the underlying asset ill cause the hedge to
become imperfect. (his means that o"erall portfolio "alue can change by a significant
amount if the price change in the underlying asset is large.
17. A. .elta is the change in the option price for a gi"en instantaneous change in the stock
price. (he change is e#ual to the slope of the option price diagram.
19. (he best estimate for the change in price of the option is8
Change in asset price J delta : I=6 J )-;.60* : =+.?;
1?. (he number of call options necessary to delta hedge is
01! 70;
70! ;;;
;.6?
options or 70;
options contracts! each co"ering 1;; shares. 2ince these are call options! the options
should be sold short.
2;. (he number of calls needed to create a delta-neutral hedge is in"ersely proportional to
the delta. (he delta decreases hen stock price decreases. (herefore the number of
calls necessary ould increase if the stock price falls.
21. A delta-neutral portfolio can be created ith any of the folloing combinations8 long
stock and short calls! long stock and long puts! short stock and long calls! and short
stock and short puts.
2-222
22. (he rate of return of a call option on a long-term (reasury bond should be more
sensiti"e to changes in interest rates than is the rate of return of the underlying bond.
(he option elasticity exceeds 1.;. In other ords! the option is effecti"ely a le"ered
in"estment and the rate of return on the option is more sensiti"e to interest rate sings.
2+. Implied "olatility has increased. If not! the call price ould ha"e fallen as a result
of the decrease in stock price.
2-. Implied "olatility has increased. If not! the put price ould ha"e fallen as a result
of the decreased time to expiration.
20. (he hedge ratio approaches one. As 2 increases! the probability of exercise
approaches 1.;. K)d
1
* approaches 1.;.
26. (he hedge ratio approaches ;. As X decreases! the probability of exercise
approaches ;. FK)d
1
* @1G approaches ; as K)d
1
* approaches 1.
27. A straddle is a call and a put. (he hedge ratio of the straddle is the sum of the
hedge ratios of the indi"idual options8 ;.- D )@;.6* : @;.2
29. a. (he spreadsheet appears as follos8
INPUTS OUTPUTS
2tandard de"iation )annual* ;.+21+ d1 ;.;;9?
Axpiration )in years* ;.0 d2 -;.219+
,isk-free rate )annual* ;.;0 K)d1* ;.0;+6
2tock Price 1;; K)d2* ;.-1+6
Axercise price 1;0 1>2 call "alue 9.;;;;
.i"idend yield )annual* ; 1>2 put "alue 1;.-;76
(he standard de"iation is8 ;.+21+
b. (he spreadsheet belo shos the standard de"iation has increased to8 ;.+069
INPUTS OUTPUTS
2tandard de"iation )annual* ;.+069 d1 ;.;+19
Axpiration )in years* ;.0 d2 -;.22;-
,isk-free rate )annual* ;.;0 K)d1* ;.0127
2tock Price 1;; K)d2* ;.-129
Axercise price 1;0 1>2 call "alue ?.;;;;
.i"idend yield )annual* ; 1>2 put "alue 11.-;70
Implied "olatility has increased because the "alue of an option increases ith
greater "olatility.
2-22+
c. Implied "olatility increases to ;.-;97 hen expiration decreases to four
months. (he shorter expiration decreases the "alue of the optionH therefore! in
order for the option price to remain unchanged at =9! implied "olatility must
increase.
INPUTS OUTPUTS
2tandard de"iation )annual* ;.-;97 d1 -;.;192
Axpiration )in years* ;.+++++ d2 -;.20-1
,isk-free rate )annual* ;.;0 K)d1* ;.-?29
2tock Price 1;; K)d2* ;.+??7
Axercise price 1;0 1>2 call "alue 9.;;;1
.i"idend yield )annual* ; 1>2 put "alue 11.26-6
d. Implied "olatility decreases to ;.2-;6 hen exercise price decreases to =1;;.
(he decrease in exercise price increases the "alue of the call! so that! in order
for the option price to remain at =9! implied "olatility decreases.
INPUTS OUTPUTS
2tandard de"iation )annual* ;.2-;6 d1 ;.2+2;
Axpiration )in years* ;.0 d2 ;.;61?
,isk-free rate )annual* ;.;0 K)d1* ;.0?17
2tock Price 1;; K)d2* ;.02-7
Axercise price 1;; 1>2 call "alue 9.;;1;
.i"idend yield )annual* ; 1>2 put "alue 0.0+2;
e. (he decrease in stock price decreases the "alue of the call. In order for the
option price to remain at =9! implied "olatility increases.
INPUTS OUTPUTS
2tandard de"iation )annual* ;.+066 d1 -;.;-9-
Axpiration )in years* ;.0 d2 -;.+;;6
,isk-free rate )annual* ;.;0 K)d1* ;.-9;7
2tock Price ?9 K)d2* ;.+91?
Axercise price 1;0 1>2 call "alue 9.;;;;
.i"idend yield )annual* ; 1>2 put "alue 12.-;70
2?. a. (he delta of the collar is calculated as follos8
Position .elta
1uy stock 1.;
1uy put! X : =-0 K)d
1
* @ 1 : @;.-;
$rite call! X : =00 @K)d
1
* : @;.+0
(otal ;.20
If the stock price increases by =1! then the "alue of the collar increases by
=;.20. (he stock ill be orth =1 more! the loss on the purchased put ill be
=;.-;! and the call ritten represents a liability that increases by =;.+0.
2-22-
b. If 2 becomes "ery large! then the delta of the collar approaches Eero. 1oth
K)d
1
* terms approach 1. Intuiti"ely! for "ery large stock prices! the "alue of
the portfolio is simply the )present "alue of the* exercise price of the call! and
is unaffected by small changes in the stock price.
As 2 approaches Eero! the delta also approaches Eero8 both K)d
1
* terms
approach ;. For "ery small stock prices! the "alue of the portfolio is simply
the )present "alue of the* exercise price of the put! and is unaffected by small
changes in the stock price.
+;. Put X .elta
A 1; ;.1
1 2; ;.0
C +; ;.?
+1. a. Choice A8 Calls ha"e higher elasticity than shares. For e#ual dollar in"estments!
a callCs capital gain potential is greater than that of the underlying stock.
b. Choice 18 Calls ha"e hedge ratios less than 1.;! so the shares ha"e higher
profit potential. For an e#ual number of shares controlled! the dollar exposure
of the shares is greater than that of the calls! and the profit potential is
therefore greater.
+2. a. u2
;
: 11; P
u
: ;
d2
;
: ?; P
d
: 1;
(he hedge ratio is8
2
1
?; 11;
1; ;
d2 u2
P P
O
; ;
d u

A portfolio comprised of one share and to puts pro"ides a guaranteed payoff

of =11;! ith present "alue8 =11;>1.;0 : =1;-.76
(herefore8
2 D 2P : =1;-.76
=1;; D 2P : =1;-.76 P : =2.+9
b. Cost of protecti"e put portfolio ith a =1;; guaranteed payoff8
: =1;; D =2.+9 : =1;2.+9
2-220
c. 5ur goal is a portfolio ith the same exposure to the stock as the hypothetical
protecti"e put portfolio. 2ince the putCs hedge ratio is @;.0! the portfolio
consists of )1 @ ;.0* : ;.0 shares of stock! hich costs =0;! and the remaining
funds )=02.+9* in"ested in (-bills! earning 0< interest.
Portfolio 2 : ?; 2 : 11;
1uy ;.0 shares -0 00
In"est in (-bills 00 00
(otal 1;; 11;
(his payoff is identical to that of the protecti"e put portfolio. (hus! the stock
plus bills strategy replicates both the cost and payoff of the protecti"e put.
++. (he put "alues in the second period are8
P
uu
: ;
P
ud
: P
du
: 11; I 1;-.0; : 0.0;
P
dd
: 11; I ?;.20 : 1?.70
(o compute P
u
! first compute the hedge ratio8
+
1
0; . 1;- 121
0; . 0 ;
ud2 uu2
P P
O
; ;
ud uu

Form a riskless portfolio by buying one share of stock and buying three puts.
(he cost of the portfolio is8 2 D +P
u
: =11; D +P
u

(he payoff for the riskless portfolio e#uals =1218
,iskless
Portfolio
2 : 1;-.0; 2 : 121
1uy 1 share 1;-.0; 121.;;
1uy + puts 16.0; ;.;;
(otal 121.;; 121.;;
(herefore! find the "alue of the put by sol"ing8
=11; D +P
u
: =121>1.;0 P
u
: =1.7-6
(o compute P
d
! compute the hedge ratio8
; . 1
20 . ?; 0; . 1;-
70 . 1? 0; . 0
dd2 du2
P P
O
; ;
dd du

Form a riskless portfolio by buying one share and buying one put.
(he cost of the portfolio is8 2 D P
d
: =?0 D P
d

2-226
(he payoff for the riskless portfolio e#uals =11;8
,iskless
Portfolio
2 : ?;.20 2 : 1;-.0;
1uy 1 share ?;.20 1;-.0;
1uy 1 put 1?.70 0.0;
(otal 11;.;; 11;.;;
=?0 D P
d
: =11;>1.;0 P
d
: =?.762
(o compute P! compute the hedge ratio8
0+-- . ;
?0 11;
762 . ? 7-6 . 1
d2 u2
P P
O
; ;
d u

Form a riskless portfolio by buying ;.0+-- of a share and buying one put.
(he cost of the portfolio is8 ;.0+--2 D P : =0+.-- D P
(he payoff for the riskless portfolio e#uals =6;.0+8
,iskless Portfolio 2 : ?0 2 : 11;
1uy ;.0+-- share 0;.769 09.79-
1uy 1 put ?.762 1.7-6
(otal 6;.0+; 6;.0+;
=0+.-- D P : =6;.0+>1.;0 P : =-.2;9
Finally! e "erify this result using put-call parity. ,ecall from Axample 21.1 that8
C : =-.-+-
Put-call parity re#uires that8
P : C D P3)X* @ 2
=-.2;9 : =-.-+- D )=11;>1.;0
2
* =1;;
Axcept for minor rounding error! put-call parity is satisfied.
+-. If r : ;! then one should ne"er exercise a put early. (here is no &time "alue cost' to
aiting to exercise! but there is a &"olatility benefit' from aiting. (o sho this
more rigorously! consider the folloing portfolio8 lend =X and short one share of
stock. (he cost to establish the portfolio is )X @ 2 ;*. (he payoff at time ( )ith
Eero interest earnings on the loan* is )X @ 2 (*. In contrast! a put option has a
payoff at time ( of )X @ 2 (* if that "alue is positi"e! and Eero otherise. (he putCs
payoff is at least as large as the portfolioCs! and therefore! the put must cost at least
as much as the portfolio to purchase. Oence! P o )X @ 2 ;*! and the put can be sold
2-227
for more than the proceeds from immediate exercise. $e conclude that it doesnCt
pay to exercise early.
2-229
+0. a. Xe
r(
b. X
c. ;
d. ;
e. It is optimal to exercise immediately a put on a stock hose price has fallen to
Eero. (he "alue of the American put e#uals the exercise price. Any delay in
exercise loers "alue by the time "alue of money.
+6. 2tep 18 Calculate the option "alues at expiration. (he to possible stock prices and
the corresponding call "alues are8
u2
;
: 12; C
u
: 2;
d2
;
: 9; C
d
: ;
2tep 28 Calculate the hedge ratio.
2
1
9; 12;
; 2;
d2 u2
C C
O
; ;
d u
(herefore! form a riskless portfolio by buying one share of stock and riting to
calls. (he cost of the portfolio is8 2 @ 2C : 1;; @ 2C
2tep +8 2ho that the payoff for the riskless portfolio e#uals =9;8
,iskless
Portfolio
2 : 9; 2 : 12;
1uy 1 share 9; 12;
$rite 2 calls ; --;
(otal 9; 9;
(herefore! find the "alue of the call by sol"ing8
=1;; @ 2C : =9;>1.1; C : =1+.6+6
Kotice that e did not use the probabilities of a stock price increase or decrease.
(hese are not needed to "alue the call option.
2-22?
+7. (he to possible stock prices and the corresponding call "alues are8
u2
;
: 1+; C
u
: +;
d2
;
: 7; C
d
: ;
(he hedge ratio is8
2
1
7; 1+;
; +;
d2 u2
C C
O
; ;
d u
Form a riskless portfolio by buying one share of stock and riting to calls. (he
cost of the portfolio is8 2 @ 2C : 1;; @ 2C
,iskless
Portfolio
2 : 7; 2 : 1+;
1uy 1 share 7; 1+;
$rite 2 calls ; -6;
(otal 7; 7;
=1;; @ 2C : =7;>1.1; C : =19.192
Oere! the "alue of the call is greater than the "alue in the loer-"olatility scenario.
+9. (he to possible stock prices and the corresponding put "alues are8
u2
;
: 12; P
u
: ;
d2
;
: 9; P
d
: 2;
(he hedge ratio is8
2
1
9; 12;
2; ;
d2 u2
P P
O
; ;
d u

Form a riskless portfolio by buying one share of stock and buying to puts. (he
cost of the portfolio is8 2 D 2P : 1;; D 2P
,iskless
Portfolio
2 : 9; 2 : 12;
1uy 1 share 9; 12;
1uy 2 puts -; ;
(otal 12; 12;
=1;; D 2P : =12;>1.1; P : =-.0-0
According to put-call parity8 P D 2 : C D P3)X*
5ur estimates of option "alue satisfy this relationship8
=-.0-0 D =1;; : =1+.6+6 D =1;;>1.1; : =1;-.0-0
2-2+;
+?. If e assume that the only possible exercise date is /ust prior to the ex-di"idend
date! then the rele"ant parameters for the 1lack-2choles formula are8
2
;
: 6;
r : ;.0< per month
X : 00
U : 7<
( : 2 months
In this case8 C : =6.;-
If instead! one commits to foregoing early exercise! then e reduce the stock price
by the present "alue of the di"idends. (herefore! e use the folloing parameters8
2
;
: 6; @ 2e
I);.;;0 J 2*
: 09.;2
r : ;.0< per month
X : 00
U : 7<
( : + months
In this case! C : =0.;0
(he pseudo-American option "alue is the higher of these to "alues8 =6.;-
-;. (rue. (he call option has an elasticity greater than 1.;. (herefore! the callCs
percentage rate of return is greater than that of the underlying stock. Oence the B%
call responds more than proportionately hen the B% stock price changes in
response to broad market mo"ements. (herefore! the beta of the B% call is greater
than the beta of B% stock.
-1. False. (he elasticity of a call option is higher the more out of the money is the
option. )A"en though the delta of the call is loer! the "alue of the call is also
loer. (he proportional response of the call price to the stock price increases. 4ou
can confirm this ith numerical examples.* (herefore! the rate of return of the call
ith the higher exercise price responds more sensiti"ely to changes in the market
index! and therefore it has the higher beta.
-2. As the stock price increases! con"ersion becomes increasingly more assured. (he
hedge ratio approaches 1.;. (he price of the con"ertible bond ill mo"e one-for-
one ith changes in the price of the underlying stock.
2-2+1
-+. Boldman 2achs belie"es that the market assessment of "olatility is too high. It
should sell options because the analysis suggests the options are o"erpriced ith
respect to true "olatility. (he delta of the call is ;.6! hile the put is ;.6 @ 1 : @;.-.
(herefore! Boldman should sell puts and calls in the ratio of ;.6 to ;.-. For
example! if Boldman sells 2 calls and + puts! the position ill be delta neutral8
.elta : )2 J ;.6* D F+ J )@;.-*G : ;
--. If the stock market index increases 1<! the 1 million shares of stock on hich the
options are ritten ould be expected to increase by8
;.70< J =0 J 1 million : =+7!0;;
(he options ould increase by8
delta J =+7!0;; : ;.9 J =+7!0;; : =+;!;;;
In order to hedge your market exposure! you must sell =+!;;;!;;; of the market
index portfolio so that a 1< change in the index ould result in a =+;!;;; change
in the "alue of the portfolio.
-0. 2 : 1;;H current "alue of portfolio
X : 1;;H floor promised to clients );< return*
U : ;.20H "olatility
r : ;.;0H risk-free rate
( : - yearsH horiEon of program
a. Psing the 1lack-2choles formula! e find that8
d
1
: ;.60! K)d
1
* : ;.7-22! d
2
: ;.10! K)d
2
* : ;.00?6
Put "alue : =1;.27
(herefore! total funds to be managed e#uals =11;.27 million8 =1;; million
portfolio "alue plus the =1;.27 million fee for the insurance program.
(he put delta is8 K)d
1
* @ 1 : ;.7-22 @ 1 : @;.2079
(herefore! sell off 20.79< of the e#uity portfolio! placing the remaining funds in
(-bills. (he amount of the portfolio in e#uity is therefore =7-.22 million! hile
the amount in (-bills is8 =11;.27 million @ =7-.22 million : =+6.;6 million
b. At the ne portfolio "alue of ?78
(he put delta is8 K)d
1
* @ 1 : ;.7221 @ 1 : @;.277?
(his means that you must reduce the delta of the portfolio by8
;.277? @ ;.2079 : ;.;2;1
4ou should sell an additional 2.;1< of the e#uity position and use the
proceeds to buy (-bills. 2ince the stock price is no at only ?7< of its
original "alue! you need to sell8
2-2+2
=?7 million J ;.;2;1 : =1.?-6 million of stock
-6. Psing the true "olatility )+2<* and time to expiration ( : ;.20 years! the hedge
ratio for Axxon is K)d
1
* : ;.0067. 1ecause you belie"e the calls are under-priced
)selling at an implied "olatility that is too lo*! you ill buy calls and short ;.0067
shares for each call you buy.
-7. (he calls are cheap )implied U : ;.+;* and the puts are expensi"e )implied
U : ;.+-*. (herefore! buy calls and sell puts. Psing the &true' "olatility of
U : ;.+2! the call delta is ;.0067 and the put delta is8 ;.0067 @ 1.; : @;.--++
(herefore! for each call purchased! buy8 ;.0067>;.--++ : 1.206 puts
-9. a. (o calculate the hedge ratio! suppose that the market index increases by 1<.
(hen the stock portfolio ould be expected to increase by8
1< J 1.0 : 1.0< or ;.;10 J =1!20;!;;; : =19!70;
Bi"en the option delta of ;.9! the option portfolio ould increase by8
=19!70; J ;.9 : =10!;;;
]P %organ ChaseCs liability from riting these options ould increase by
the same amount. (he market index portfolio ould increase in "alue by
1<. (herefore! ]P %organ should purchase =1!0;;!;;; of the market
index portfolio in order to hedge its position so that a 1< change in the
index ould result in a =10!;;; change in the "alue of the portfolio.
b. (he delta of a put option is8
;.9 @ 1 : @;.2
(herefore! for e"ery 1< the market increases! the index ill rise by 1; points
and the "alue of the put option contract ill change by8
delta J 1; J contract multiplier : @;.2 J 1; J 1;; : @=2;;
(herefore! ]P %organ should rite8 =10!;;;>=2;; : 70 put contracts
2-2++
CFA PROBLEMS
1. 2tatement a8 (he hedge ratio )determining the number of futures contracts to sell*
ought to be ad/usted by the beta of the e#uity portfolio! hich is 1.2;. (he correct
hedge ratio ould be8
=1;; million
b -! ;;; b -! ;;; 1.2 -!9;;
=1;; 0;;

2tatement b8 (he portfolio ill be hedged! and should therefore earn the risk-free
rate! not Eero! as the consultant claims. Bi"en a futures price of 1;; and an e#uity
price of ??! the rate of return o"er the +-month period is8
)1;; ??*>?? : 1.;1< : approximately -.1< annualiEed
2. a. (he "alue of the call option decreases if underlying stock price "olatility
decreases. (he less "olatile the underlying stock price! the less the chance of
extreme price mo"ementscthe loer the probability that the option expires in
the money. (his makes the participation feature on the upside less "aluable.
(he "alue of the call option is expected to increase if the time to expiration of
the option increases. (he longer the time to expiration! the greater the chance
that the option ill expire in the money resulting in an increase in the time
premium component of the optionCs "alue.
b. i. $hen Auropean options are out of the money! in"estors are essentially
saying that they are illing to pay a premium for the right! but not the
obligation! to buy or sell the underlying asset. (he out-of-the-money option
has no intrinsic "alue! but! since options re#uire little capital )/ust the premium
paid* to obtain a relati"ely large potential payoff! in"estors are illing to pay
that premium e"en if the option may expire orthless. (he 1lack-2choles
model does not reflect in"estorsC demand for any premium abo"e the time
"alue of the option. Oence! if in"estors are illing to pay a premium for an
out-of-the-money option abo"e its time "alue! the 1lack-2choles model does
not "alue that excess premium.
ii. $ith American options! in"estors ha"e the right! but not the obligation! to
exercise the option prior to expiration! e"en if they exercise for non-economic
reasons. (his increased flexibility associated ith American options has some
"alue but is not considered in the 1lack-2choles model because the model only
"alues options to their expiration date )Auropean options*.
+. a. American options should cost more )ha"e a higher premium*. American
options gi"e the in"estor greater flexibility than Auropean options since the
in"estor can choose hether to exercise early. $hen the stock pays a
di"idend! the option to exercise a call early can be "aluable. 1ut regardless of
the di"idend! a Auropean option )put or call* ne"er sells for more than an
otherise-identical American option.
2-2+-
b. C : 2
;
D P P3)X* : =-+ D =- =-0>1.;00 : =-.+-6
Kote8 e assume that Abaco does not pay any di"idends.
c. i* An increase in short-term interest rate P3)exercise price* is loer! and
call "alue increases.
ii* An increase in stock price "olatility the call "alue increases.
iii* A decrease in time to option expiration the call "alue decreases.
-. a. (he to possible "alues of the index in the first period are8
u2
;
: 1.2; J 0; : 6;
d2
;
: ;.9; J 0; : -;
(he possible "alues of the index in the second period are8
uu2
;
: )1.2;*
2
J 0; : 72
ud2
;
: 1.2; J ;.9; J 0; : -9
du2
;
: ;.9; J 1.2; J 0; : -9
dd2
;
: );.9;*
2
J 0; : +2
b. (he call "alues in the second period are8
C
uu
: 72 I 6; : 12
C
ud
: C
du
: C
dd
: ;
2ince C
ud
: C
du
: ;! then C
d
: ;.
(o compute C
u
2
1
-9 72
; 12
ud2 uu2
C C
O
; ;
ud uu
Form a riskless portfolio by buying one share of stock and riting to calls.
(he cost of the portfolio is8 2 @ 2C
u
: =6; @ 2C
u

(he payoff for the riskless portfolio e#uals =-98
,iskless
Portfolio
2 : -9 2 : 72
1uy 1 share -9 72
$rite 2 calls ; -2-
(otal -9 -9
=6; @ 2C
u
: =-9>1.;6 C
u
: =7.+09
2-2+0
(o compute C! compute the hedge ratio8
+67? . ;
-; 6;
; +09 . 7
d2 u2
C C
O
; ;
d u
Form a riskless portfolio by buying ;.+67? of a share and riting one call.
(he cost of the portfolio is8 ;.+67?2 @ C : =19.+?0 @ C
(he payoff for the riskless portfolio e#uals =1-.7168
,iskless Portfolio 2 : -; 2 : 6;
1uy ;.+67? share 1-.716 22.;7-
$rite 1 call ;.;;; I7.+09
(otal 1-.716 1-.716
=19.+?0 @ C : =1-.716>1.;6 C : =-.012
c. (he put "alues in the second period are8
P
uu
: ;
P
ud
: P
du
: 6; I -9 : 12
P
dd
: 6; I +2 : 29
(o compute P
u
2
1
-9 72
12 ;
ud2 uu2
P P
O
; ;
ud uu

Form a riskless portfolio by buying one share of stock and buying to puts.
(he cost of the portfolio is8 2 D 2P
u
: =6; D 2P
u

(he payoff for the riskless portfolio e#uals =728
,iskless
Portfolio
2 : -9 2 : 72
1uy 1 share -9 72
1uy 2 puts 2- ;
(otal 72 72
=6; D 2P
u
: =72>1.;6 P
u
: =+.?62
2-2+6
(o compute P
d
! compute the hedge ratio8
; . 1
+2 -9
29 12
dd2 du2
P P
O
; ;
dd du

Form a riskless portfolio by buying one share and buying one put.
(he cost of the portfolio is8 2 D P
d
: =-; D P
d

,iskless
Portfolio
2 : +2 2 : -9
1uy 1 share +2 -9
1uy 1 put 29 12
(otal 6; 6;
=-; D P
d
: =6;>1.;6 P
d
: =16.6;-
(o compute P! compute the hedge ratio8
6+21 . ;
-; 6;
6;- . 16 ?62 . +
d2 u2
P P
O
; ;
d u

Form a riskless portfolio by buying ;.6+21 of a share and buying one put.
(he cost of the portfolio is8 ;.6+212 D P : =+1.6;0 D P
(he payoff for the riskless portfolio e#uals =-1.9998
,iskless Portfolio 2 : -; 2 : 6;
1uy ;.6+21 share 20.29- +7.?26
1uy 1 put 16.6;- +.?62
(otal -1.999 -1.999
=+1.6;0 D P :
=-1.999
1.;6
P : =7.?12
d. According to put-call-parity8
C : 2
;
D P P3)X* : =0; D =7.?12
2
=6;
1.;6
: =-.012
(his is the "alue of the call calculated in part )b* abo"e.
2-2+7
0. a.)i* Index increases to 1!1?+. (he combined portfolio ill suffer a loss. (he
ritten calls expire in the moneyH the protecti"e put purchased expires orthless.
LetCs analyEe the outcome on a per-share basis. (he payout for each call option is
=-+! for a total cash outflo of =96. (he stock is orth =1!1?;. (he portfolio ill
thus be orth8
=1!1?; =96 : =1!1;-.;;
(he net cost of the portfolio hen the option positions are established is8
=1!1+6 D =16.1; )put* F2 =9.6;G )calls ritten* : =1!1+-.?;
(he portfolio experiences a small loss of =+;.?;
)ii* Index remains at 1!1+6. 1oth options expire out of the money. (he portfolio
ill thus be orth =1!1+6 )per share*! compared to an initial cost +; days earlier of
=1!1+-.?;. (he portfolio experiences a "ery small gain of =1.1;.
)iii* Index declines to 1!;9;. (he calls expire orthless. (he portfolio ill be
orth =1!1+;! the exercise price of the protecti"e put. (his represents a "ery small
loss of =-.?; compared to the initial cost +; days earlier of =1!1+-.?;
b. )i* Index increases to 1!1?+. (he delta of the call approaches 1.; as the stock goes
deep into the money! hile expiration of the call approaches and exercise becomes
essentially certain. (he put delta approaches Eero.
)ii* Index remains at 1!1+6. 1oth options expire out of the money. .elta of each
approaches Eero as expiration approaches and it becomes certain that the options
ill not be exercised.
)iii* Index declines to 1!;9;. (he call is out of the money as expiration approaches.
.elta approaches Eero. Con"ersely! the delta of the put approaches 1.; as exercise
becomes certain.
c. (he call sells at an implied "olatility )22.;;<* that is less than recent historical
"olatility )2+.;;<*H the put sells at an implied "olatility )2-.;;<* that is greater
than historical "olatility. (he call seems relati"ely cheapH the put seems expensi"e.
CHAPTER 22: FUTURES MAR2ETS
PROBLEM SETS
1. (here is little hedging or speculati"e demand for cement futures! since cement prices
are fairly stable and predictable. (he trading acti"ity necessary to support the futures
market ould not materialiEe.
2-2+9
2. (he ability to buy on margin is one ad"antage of futures. Another is the ease ith hich
one can alter oneCs holdings of the asset. (his is especially important if one is dealing in
commodities! for hich the futures market is far more li#uid than the spot market.
+. 2hort selling results in an immediate cash inflo! hereas the short futures
position does not8
Action Initial CF Final CF
2hort 2ale DP
;
@P
(
2hort Futures ;
F
;
@ P
(
-. a. False. For any gi"en le"el of the stock index! the futures price ill be loer
hen the di"idend yield is higher. (his follos from spot-futures parity8
F
;
: 2
;
)1 D r
f
@ d*
(

b. False. (he parity relationship tells us that the futures price is determined by the
stock price! the interest rate! and the di"idend yieldH it is not a function of beta.
c. (rue. (he short futures position ill profit hen the market falls. (his is a
negati"e beta position.
0. (he futures price is the agreed-upon price for deferred deli"ery of the asset. If that
price is fair! then the "alue of the agreement ought to be EeroH that is! the contract
ill be a Eero-KP3 agreement for each trader.
6. 1ecause long positions e#ual short positions! futures trading must entail a
&canceling out' of bets on the asset. %oreo"er! no cash is exchanged at the
inception of futures trading. (hus! there should be minimal impact on the spot
market for the asset! and futures trading should not be expected to reduce capital
a"ailable for other uses.
2-2+?
7. a. (he closing futures price for the %arch contract as 1!1;9.6;! hich has a
dollar "alue of8
=20; J 1!1;9.6; : =277!10;
(herefore! the re#uired margin deposit is8 =27!710
b. (he futures price increases by8 =1!10;.;; @ 1!1;9.6; : =-1.-;
(he credit to your margin account ould be8 -1.-; J =20; : =1;!+0;
(his is a percent gain of8 =1;!+0;>=27!710 : ;.+7+- : +7.+-<
Kote that the futures price itself increased by only +.7+<.
c. Folloing the reasoning in part )b*! any change in F is magnified by a ratio of
)l >margin re#uirement*. (his is the le"erage effect. (he return ill be @1;<.
9. a. F
;
: 2
;
)1 D r
f
* : =10; J 1.;+ : =10-.0;
b. F
;
: 2
;
)1 D r
f
*
+
: =10; J 1.;+
+
: =16+.?1
c. F
;
: 10; J 1.;6
+
: =179.60
?. a. (ake a short position in (-bond futures! to offset interest rate risk.
If rates increase! the loss on the bond ill be offset to some extent by gains on
the futures.
b. Again! a short position in (-bond futures ill offset the interest rate risk.
c. 4ou ant to protect your cash outlay hen the bond is purchased. If bond
prices increase! you ill need extra cash to purchase the bond. (hus! you
should take a long futures position that ill generate a profit if prices increase.
1;. F
;
: 2
;
J )l D r
f
@ d* : 1!1;; J )1 D ;.;+ @ ;.;2* : 1!111
If the (-bill rate is less than the di"idend yield! then the futures price should be less
than the spot price.
11. (he put-call parity relation states that8 1ut spot-futures parity tells us that8

2ubstituting! e find that8
2-2-;
;
)1 *
2
f
A
! P
r
+
+
;
)1 *
2
f
/ r +
;
; ; ;
F )1 * G
)1 *
2
f
2
f
r
P ! ! !
r
+
+ +
+
12. According to the parity relation! the proper price for .ecember futures is8
F
.ec
: F
]une
)l D r
f
*
1>2
: ?-6.+; J 1.;0
1>2
: ?6?.67
(he actual futures price for .ecember is lo relati"e to the ]une price. 4ou should
take a long position in the .ecember contract and short the ]une contract.
1+. a. 12; J 1.;6 : =127.2;
b. (he stock price falls to8 12; J )1 @ ;.;+* : =116.-;
(he futures price falls to8 116.- J 1.;6 : =12+.+9-
(he in"estor loses8 )127.2; @ 12+.+9-* J 1!;;; : =+!916
c. (he percentage loss is8 =+!916>=12!;;; : ;.+19 : +1.9<
1-. a. (he initial futures price is F
;
: 1+;; J )1 D ;.;;0 @ ;.;;2*
12
: =1!+-7.09
In one month! the futures price ill be8
F
;
: 1+2; J )1 D ;.;;0 @ ;.;;2*
11
: =1!+6-.22
(he increase in the futures price is 16.6-! so the cash flo ill be8
16.6- J =20; : =-!16;.;;
b. (he holding period return is8 =-!16;.;;>=1+!;;; : ;.+2;; : +2.;;<
10. (he treasurer ould like to buy the bonds today! but cannot. As a proxy for this
purchase! (-bond futures contracts can be purchased. If rates do in fact fall! the
treasurer ill ha"e to buy back the bonds for the sinking fund at prices higher than
the prices at hich they could be purchased today. Ooe"er! the gains on the
futures contracts ill offset this higher cost to some extent.
16. (he parity "alue of F is8 1!+;; J )1 D ;.;- @ ;.;1* : 1!++?
(he actual futures price is 1!++;! too lo by ?.
Arbitrage Portfolio CF no CF in 1 year
2hort Index 1!+;; I2
(
I );.;1 J 1!+;;*
1uy Futures ; 2
(
I 1!++;
Lend I1!+;; 1!+;; J 1.;-
2-2-1
(otal ; ?
17. a. Futures prices are determined from the spreadsheet as follos8
S8(! Fu!u$es P#$i!& #n@ Time S8$e#@s
2pot price 1!0;;
Income yield )<* 1.0 Futures prices "ersus maturity
Interest rate )<* +.;
(odayMs date 1>1>2;11 2pot price 1!0;;.;;
%aturity date 1 2>1->2;11 Futures 1 1!0;2.67
%aturity date 2 0>21>2;11 Futures 2 1!0;9.71
%aturity date + 11>19>2;11 Futures + 1!01?.7?
(ime to maturity 1 ;.12
(ime to maturity 2 ;.+?
(ime to maturity + ;.99
LE'END:
En!e$ @#!#
V#%ue =#%=u%#!e@
See =(mmen!
b. (he spreadsheet demonstrates that the futures prices no decrease ith
increased income yield8
S8(! Fu!u$es P#$i!& #n@ Time S8$e#@s
2pot price 1!0;;
Income yield )<* -.; Futures prices "ersus maturity
Interest rate )<* +.;
(odayMs date 1>1>2;11 2pot price 1!0;;.;;
%aturity date 1 2>1->2;11 Futures 1 1!-?9.2;
%aturity date 2 0>21>2;11 Futures 2 1!-?-.10
%aturity date + 11>19>2;11 Futures + 1!-96.79
(ime to maturity 1 ;.12
(ime to maturity 2 ;.+?
(ime to maturity + ;.99
LE'END:
En!e$ @#!#
V#%ue =#%=u%#!e@
See =(mmen!
19. a. (he current yield for (reasury bonds )coupon di"ided by price* plays the role of
the di"idend yield.
2-2-2
b. $hen the yield cur"e is upard sloping! the current yield exceeds the short rate.
Oence! (-bond futures prices on more distant contracts are loer than those on
near-term contracts.
1?. a.
Cash Flos
Action Ko
(
1
(
2
Long futures ith maturity (
1
;
P
1
@ F) (
1
*
;
2hort futures ith maturity (
2
; ;
F) (
2
* @ P
2
1uy asset at (
1
! sell at (
2
;
@P
1
P
2
At (
1
! borro F) (
1
*
;
F) (
1
*
@F) (
1
* J )1D r
f
*
) (
2
@(
1
*
(otal ; ; F) (
2
* @ F) (
1
* J )1D r
f
*
) (
2
@(
1
*
b. 2ince the (
2
cash flo is riskless and the net in"estment as Eero! then any
profits represent an arbitrage opportunity.
c. (he Eero-profit no-arbitrage restriction implies that
F) (
2
* : F) (
1
* J )1D r
f
*
) (
2
@ (
1
*

CFA PROBLEMS
1. a. (he strategy that ould take ad"antage of the arbitrage opportunity is a &re"erse
cash and carry.' A re"erse cash and carry opportunity results hen the folloing
relationship does not hold true8
F
;
o 2
;
)1D C*
If the futures price is less than the spot price plus the cost of carrying the goods to
the futures deli"ery date! then an arbitrage opportunity exists. A trader ould be
able to sell the asset short! use the proceeds to lend at the pre"ailing interest rate!
and then buy the asset for future deli"ery. At the future deli"ery! the trader ould
then collect the proceeds of the loan ith interest! accept deli"ery of the asset! and
co"er the short position in the commodity.
b.
Cash Flos
Action Ko 5ne year from no
2ell the spot commodity short D=12;.;; I=120.;;
2-2-+
1uy the commodity futures expiring in 1 year =;.;; =;.;;
Contract to lend =12; at 9< for 1 year I=12;.;; D=12?.6;
(otal cash flo =;.;; D=-.6;
2. a. (he call option is distinguished by its asymmetric payoff. If the 2iss franc
rises in "alue! then the company can buy francs for a gi"en number of dollars
to ser"ice its debt! and thereby put a cap on the dollar cost of its financing. If
the franc falls! the company ill benefit from the change in the exchange rate.
(he futures and forard contracts ha"e symmetric payoffs. (he dollar cost of the
financing is locked in regardless of hether the franc appreciates or depreciates.
(he ma/or difference from the firmCs perspecti"e beteen futures and forards is
in the mark-to-market feature of futures. (he conse#uence of this is that the firm
must be ready for the cash management issues surrounding cash inflos or
outflos as the currency "alues and futures prices fluctuate.
b. (he call option gi"es the company the ability to benefit from depreciation in the
franc! but at a cost e#ual to the option premium. Pnless the firm has some special
expertise in currency speculation! it seems that the futures or forard strategy!
hich locks in a dollar cost of financing ithout an option premium! may be the
better strategy.
+. (he important distinction beteen a futures contract and an options contract is that the
futures contract is an obligation. $hen an in"estor purchases or sells a futures contract!
the in"estor has an obligation to either accept or deli"er! respecti"ely! the underlying
commodity on the expiration date. In contrast! the buyer of an option contract is not
obligated to accept or deli"er the underlying commodity but instead has the right! or
choice! to accept deli"ery )for call holders* or make deli"ery )for put holders* of the
underlying commodity anytime during the life of the contract.
Futures and options modify a portfolioCs risk in different ays. 1uying or selling a
futures contract affects a portfolioCs upside risk and donside risk by a similar
magnitude. (his is commonly referred to as symmetrical impact. 5n the other hand! the
addition of a call or put option to a portfolio does not affect a portfolioCs upside risk and
donside risk to a similar magnitude. Pnlike futures contracts! the impact of options on
the risk profile of a portfolio is asymmetric.
-. a. (he in"estor should sell the forard contract to protect the "alue of the bond
against rising interest rates during the holding period. 1ecause the in"estor
intends to take a long position in the underlying asset! the hedge re#uires a short
position in the deri"ati"e instrument.
2-2--
b. (he "alue of the forard contract on expiration date is e#ual to the spot price of
the underlying asset on expiration date minus the forard price of the contract8
=?79.-; @ =1!;2-.7; : @=-6.+;
(he contract has a negati"e "alue. (his is the "alue to the holder of a long
position in the forard contract. In this example! the in"estor should be short the
forard contract! so that the "alue to this in"estor ould be D=-6.+; since this is
the cash flo the in"estor expects to recei"e.
c. (he "alue of the combined portfolio at the end of the six-month holding period is8
=?79.-; D =-6.+; : =1!;2-.7;
(he change in the "alue of the combined portfolio during this six-month
period is8 =2-.7;
(he "alue of the combined portfolio is the sum of the market "alue of the
bond and the "alue of the short position in the forard contract. At the start
of the six-month holding period! the bond is orth =1!;;; and the forard
contract has a "alue of Eero )because this is not an off-market forard
contract! no money changes hands at initiation*. 2ix months later! the bond
"alue is =?79.-; and the "alue of the short position in the forard contract is
=-6.+;! as calculated in part )b*.
(he fact that the combined "alue of the long position in the bond and the short
position in the forard contract at the forard contractCs maturity date is
e#ual to the forard price on the forard contract at its initiation date is not a
coincidence. 1y taking a long position in the underlying asset and a short
position in the forard contract! the in"estor has created a fully hedged )and
hence risk-free* position! and should earn the risk-free rate of return. (he six-
month risk-free rate of return is 0.;;< )annualiEed*! hich produces a return
of =2-.7; o"er a six-month period8
)=1!;;; J 1.;0
)1>2*
* @ =1!;;; : =2-.7;
(hese results support 3anOusenCs statement that selling a forard contract on
the underlying bond protects the portfolio during a period of rising interest rates.
(he loss in the "alue of the underlying bond during the six month holding period
is offset by the cash payment made at expiration date to the holder of the short
position in the forard contractH that is! a short position in the forard contract
protects )hedges* the long position in the underlying asset.
0. a. Accurate. Futures contracts are marked to the market daily. Oolding a short
position on a bond futures contract during a period of rising interest rates
)declining bond prices* generates positi"e cash inflo from the daily mark to
market. If an in"estor in a futures contract has a long position hen the price of
the underlying asset increases! then the daily mark to market generates a positi"e
2-2-0
cash inflo that can be rein"ested. Forard contracts settle only at expiration
date and do not generate any cash flo prior to expiration.
b. Inaccurate. According to the cost of carry model! the futures contract price is
ad/usted upard by the cost of carry for the underlying asset. 1onds )and other
financial instruments*! hoe"er! do not ha"e any significant storage costs.
%oreo"er! the cost of carry is reduced by any coupon payments paid to the
bondholder during the life of the futures contract. Any &con"enience yield' from
holding the underlying bond also reduces the cost of carry. As a result! the cost
of carry for a bond is likely to be negati"e.
2-2-6

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Chapter 2 - Asset Classes and Financial Instruments

CHAPTER 2: ASSET CLASSES AND FINANCIAL

e#uity initial s In"estorM

b. Premium )or discount* :

: the annual standard de"iation of the risky in"estments and

b. r , i : 9;< 7;< : 1;<

(herefore! +;.9;< of the complete portfolio should be allocated to e#uity and

2ubstitute the folloing8 A)r

2ince all standard de"iations are e#ual to 2;<8

(herefore! in total! 192 estimates.

(he negati"e position is /ustified for the reason stated earlier.

2ince \ is negati"e! the result is a positi"e position in stocks ith positi"e

In contrast! ith a passi"e strategy8

Ad/usting for beta8

(he information ratio of the acti"e portfolio is8

$ith A : 2.9! the optimal position in this portfolio is8

(he final positions in each asset are8

Pnconstrained ;.0690 J 9.-2< : -.7? ;.0690

(he negati"e position is /ustified for the reason gi"en earlier.

12. a. (he current bond price is8

FKote8 slight discrepancies here from rounding errors in 4(% calculationsG

b. Assuming a par "alue of =1!;;;! the bond price is calculated as follos8

CHAPTER 1-: MANA'IN' BOND PORTFOLIOS

(his o"erstates the actual percentage decrease in price by ;.+1<.

,5A : Ket Income>1eginning of year e#uity

b. (he sustainable groth rate of ,io Kational is ?.?7<! calculated as follos8

)2* Asset turno"er :

)+* Interest 1urden :

)0* Income tax rate :

Psing the .u Pont formula8

$rite call )=-;* ; ;

1uy put )=+0*

A portfolio comprised of one share and to puts pro"ides a guaranteed payoff

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