Security Valuation Priciples

1
CHAPTER 11
INTRODUCTION TO SECURITY VALUATION
TRUE/FALSE QUESTIONS
(f)
The three step valuation process consists of 1) analysis of alternative economies

and markets, 2) analysis of alternative industries and 3) analysis of industry
influences.
(t)
The two components that are required in order to carry out asset valuation are 1)
the stream of expected cash flows and 2) the required rate of return.
(t)
The general economic influences would include inflation, political upheavals,

monetary policy, and fiscal policy initiatives.
(f)
Given an optimistic economic and stock-market outlook for a country, the

investor should underweight the allocation to this country in his/her portfolio.
(t)
The importance of an industry's performance on an individual stock's performance

varies across industries.
(t)
If the intrinsic value of an asset is greater than the market price, you would want
to buy the investment.
(t)
The most difficult part of valuing a bond is determining the required rate of return
on this investment.
(f)
The required rate of return is determined by 1) the real risk free rate, 2) the
expected rate of inflation and 3) liquidity risk.
(f)
The price of a bond can be calculated by discounting future coupons over the
bonds life by the yield to maturity.
(f)
10
The growth rate of dividends and profit margin are the main determinants of the
P/E ratio.
(t)
11
The dividend growth models are only meaningful for companies that have a
required rate of return that exceeds their dividend growth rate.
(t)
12
An example of a relative valuation technique is the Price/Cash Flow ratio.
(f)
13
Discounted cash flow techniques for equity valuation may use one of the
following 1) dividends, 2) Free cash flow or 3) coupons.
2
(f)
14
In dividend discount models (DDM) with supernormal growth, supernormal

growth may continue indefinitely.
(t)
15
The real risk free rate depends on the real growth in the economy and for short
period by temporary tightness or ease in capital markets.
(t)
16
The risk premium is impacted by business risk, financial risk, and liquidity risk.
3
MULTIPLE CHOICE QUESTIONS
(e)
Which of the following is not a consideration in the three-step valuation process?

a)
b)
c)
d)
e)
(d)
Which of the following is not considered a basic economic force?

a)
b)
c)
d)
e)
(d)
The time pattern of returns.

The economy's real risk-free rate.
The risk premium for the asset.
The times series of stock prices.
The expected rate of inflation.
Which of the following is correct?

a)
b)
c)
d)
e)
(c)
Fiscal policy
Monetary policy
Inflation
P/E ratio
None of the above (that is, all are basic economic forces)
The process of fundamental valuation requires estimates of all the following

factors, except
a)
b)
c)
d)
e)
(e)
Analysis of alternative economies

Analysis of security markets
Analysis of alternative industries
Analysis of individual companies
None of the above (that is, all are considerations in the three-step valuation
process)
If intrinsic value > Market price, you should buy.

If intrinsic value > Market price, you should sell.
If intrinsic value < Market price, you should sell.
Choices b and c.
Choices a and c.
The value of a corporate bond can be derived by calculating the present value of
the interest payments and the present value of the face value at the bond's
a) Current yield.
b) Coupon rate.
c) Required rate of return.
4
d) Effective rate.
e) Prime rate.
(d)
Which securities can be valued by dividing the annual dividend by the required
rate of return?
a)
b)
c)
d)
e)
(d)
Low coupon bonds

Junk bonds
Common stocks
Preferred stocks
Constant growth common stocks
According to the dividend growth model, if a company were to declare that it

would never pay dividends, its value would be
a) Based on earnings.
b) Based on expectations regarding.
c) Higher than similar firms since it could reinvest a greater amount in new
projects.
d) Zero.
e) Based on the capital asset pricing model.
(d)
Dividend growth is a function of

a)
b)
c)
d)
e)
(c)
The real growth rate of an economy and condition in capital markets determine
the
a)
b)
c)
d)
e)
(d)
10
Return on equity.
The retention rate.
The payout ratio.
a) and b).
b) and c).
Dividend payout ratio.

Beta.
Real risk free rate.
Nominal risk free rate.
Risk premium.
The growth rate of equity earnings without external financing is equal to
5
a)
b)
c)
d)
e)
(d)
11
Which of the following factors influence an investors required rate of return?

a)
b)
c)
d)
e)
(e)
12
Retention rate plus return on equity.

Retention rate minus return on equity.
Retention rate divided by return on equity.
Retention rate times return on equity.
Return on equity divided by retention rate.
The economys real risk-free rate (RFR)

The expected rate of inflation (I)
A risk premium
All of the above
None of the above
The P/E ratio is determined by

a)
b)
c)
d)
e)
The required rate of return.

The expected dividend payout ratio.
The expected growth rate of dividends.
Choices a and b
All of the above
6
MULTIPLE CHOICE PROBLEMS
USE THE FOLLOWING INFORMATION FOR THE NEXT TWO PROBLEMS
A major retailer is reevaluating its bonds since it is planning to issue a new bond in the current
market. The firm's outstanding bond issue has 10 years remaining until maturity. The bonds
were issued with a 8 percent coupon rate (paid semiannually) and a par value of $1,000.
Because of increased risk the required rate has risen to 10 percent.
(c)
What is the current value of these securities?

a)
b)
c)
d)
e)
(e)
$686.50
$699.00
$875.38
$868.50
$902.00
What will be the value of these securities in one year if the required return
declines to 6 percent?
a)
b)
c)
d)
e)
$699.00
$802.50
$1259.05
$1012.17
$1137.54

A major manufacturer is reevaluating its bonds since it is planning to issue a new bond in the
current market. The firm's outstanding bond issue has 8 years remaining till maturity. The
bonds were issued with an 8 percent coupon rate (paid quarterly) and a par value of $1,000.
(a)

a)
b)
c)
d)
e)
(c)
$796.11
$797.84
$826.73
$862.98
$904.00
a)
b)
c)
d)
e)
$699.50
$885.50
$1000.00
$998.36
$936.72

A large grocery chain is reevaluating its bonds since it is planning to issue a new bond in the
current market. The firm's outstanding bond issue has 6 years remaining until maturity. The
bonds were issued with a 6 percent coupon rate (paid semiannually) and a par value of $1,000.
(c)

a)
b)
c)
d)
e)
(d)
a)
b)
c)
d)
e)
(d)
$656.40
$899.00
$822.70
$569.50
$962.00
$899.43
$862.50
$869.88
$918.93
$946.98
In 1998, Talbott Inc. issued a $110 par value preferred stock that pays a 9 percent
annual dividend. Due to changes in the overall economy and in the company's
financial condition investors are now requiring a 10 percent return. What price
would you be willing to pay for a share of the preferred if you receive your first
dividend one year from now?
a)
b)
c)
d)
e)
$68.38
$65.35
$71.54
$61.87
$78.37
(a)
In 1998, Smitman Corp. issued a $50 par value preferred stock that pays a 8
percent annual dividend. Due to changes in the overall economy and in the
company's financial condition investors are now requiring an 15 percent return.
What price would you be willing to pay for a share of the preferred if you receive
your first dividend one year from now?
a)
b)
c)
d)
e)
(e)
In 1998, Green Leaf Co. issued a $63 par value preferred stock which pays a 7
company's financial condition investors are now requiring a 10 percent return.
a)
b)
c)
d)
e)
(a)
10
11
$44.98
$40.50
$41.44
$45.38
$44.10
In 1998, Drowny Inc. issued a $52 par value preferred stock that pays an 8
company's financial condition investors are now requiring an 11 percent return.
a)
b)
c)
d)
e)
(b)
$26.67
$30.00
$31.54
$33.38
$38.37
$37.82
$38.50
$39.44
$41.38
$44.10
Using the constant growth model, an increase in the required rate of return from
15 to 17 percent combined with an increase in the growth rate from 7 to 9 percent
would cause the price to
a) Rise more than 2%.
9
b)
c)
d)
e)
(b)
12
16 to 19 percent combined with an increase in the growth rate from 8 to 11
percent would cause the price to
a)
b)
c)
d)
e)
(b)
13
14
15
Rise more than 1%

Rise less than 1%.
Remain constant.
Fall more than 1%.
Fall less than 1%.
a)
b)
c)
d)
e)
(d)
Rise more than 3%

Rise less than 3%.
Remain constant.
Fall more than 3%.
Fall less than 3%.
14 to 15 percent combined with an increase in the growth rate from 6 to 7 percent
would cause the price to
a)
b)
c)
d)
e)
(b)
Rise less than 2%.

Remain constant.
Fall more than 2%.
Fall less than 2%.
Rise more than 3%

Rise less than 3%.
Remain constant.
Fall more than 3%.
Fall less than 3%.
a) Fall more than 4%
b) Fall less than 4%.
c) Rise more than 4%
10
d) Rise less than 4%.
e) Remain constant.

Ridgemont Can Company's last dividend was $1.55 and the directors expect to maintain the
historic 5 percent annual rate of growth. You plan to purchase the stock today because you feel
that the growth rate will increase to 8 percent for the next three years and the stock will then
reach $22.50 per share.
(b)
16
How much should you be willing to pay for the stock if you require a 15 percent
return?
a)
b)
c)
d)
e)
(d)
17
$16.97
$18.90
$21.32
$32.63
None of the above
How much should you be willing to pay for the stock if you feel that the 8 percent
growth rate can be maintained indefinitely and you require a 15 percent return?
a)
b)
c)
d)
e)
$18.90
$19.28
$22.14
$23.91
$25.46

The National Motor Company's last dividend was $1.25 and the directors expect to maintain the
historic 4 percent annual rate of growth. You plan to purchase the stock today because you feel
that the growth rate will increase to 7 percent for the next three years and the stock will then
reach $25.00 per share.
(d)
18
How much should you be willing to pay for the stock if you require a 16 percent
return?
a)
b)
c)
d)
e)
$17.34
$18.90
$19.09
$19.21
None of the above
11
(c)
19
How much should you be willing to pay for the stock if you feel that the 7 percent
growth rate can be maintained indefinitely and you require a 16 percent return?
a)
b)
c)
d)
e)
(e)
20
Ross Corporation paid dividends per share of $1.20 at the end of 1990. At the end
of 2000 it paid dividends per share of $3.50. Calculate the compound annual
growth rate in dividends.
a)
b)
c)
d)
e)
(a)
21
22
23
37%
63%
50%
0%
100%
The beta for the DAK Corporation is 1.25. If the yield on 30 year T-bonds is
5.65%, and the long term average return on the S&P 500 is 11%. Calculate the
required rate of return for DAK Corporation.
a)
b)
c)
d)
e)
(c)
52.17%
34.28%
23%
19.17%
11.29%
Hunter Corporation had a dividend payout ratio of 63% in 1999. The retention
rate in 1999 was
a)
b)
c)
d)
e)
(a)
$11.15
$14.44
$14.86
$18.90
$19.24
12.34%
7.06%
13.74%
5.35%
5.65%
Micro Corp. just paid dividends of $2 per share. Assume that over the next three
years dividends will grow as follows, 5% next year, 15% in year two, and 25% in
year 3. After that growth is expected to level off to a constant growth rate of 10%
12
per year. The required rate of return is 15%. Calculate the intrinsic value using a
multistage dividend discount model.
a)
b)
c)
d)
e)
(a)
24
$5.56
$66.4
$49.31
$43.66
none of the above
The P/E ratio for BMI Corporation 21, and the P/Sales ratio is 5.2. The industry
P/E ratio is 35 and the industry P/Sales ratio is 7.5. Based on relative valuation,
BMI is
a) Undervalued on the basis of relative P/E and relative P/S.
b) Overvalued on the basis of relative P/E and undervalued on the basis of
relative P/S.
c) Undervalued on the basis of relative P/E and overvalued on the basis of
relative P/S.
d) Overvalued on the basis of relative P/E and relative P/S.
e) None of the above.
USE THE FOLLOWING INFORMATION FOR THE NEXT FOUR PROBLEMS

Consider a firm that has just paid a dividend of $2. An analyst expects dividends to grow at a
rate of 8% per year for the next five years. After that dividends are expected to grow at a normal
rate of 5% per year. Assume that the appropriate discount rate is 7%.
(d)
25
The dividends for years 1, 2, and 3 are

a)
b)
c)
d)
e)
(e)
26
$2, $2.08, $2.16

$2, $2.05, $2.10
$2.16, $2.24, $2.32
$2.16, $2.33, $2.52
$2.07, $2.14, $2.21
The future price of the stock in year 5 is

a)
b)
c)
d)
e)
$113.40
$122.47
$132.27
$142.85
$154.35
13
(b)
27
The present value today of dividends for years 1 to 5 is

a)
b)
c)
d)
e)
(c)
28
$4.06
$10.28
$12.40
$8.19
$6.11
The price of the stock today (P0) is

a)
b)
c)
d)
e)
$136.29
$133.03
$120.33
$123.43
$126.60
USE THE FOLLOWING INFORMATION FOR THE NEXT FOUR PROBLEMS

Consider a firm that has just paid a dividend of $1.5. An analyst expects dividends to grow at a
rate of 9% per year for the next three years. After that dividends are expected to grow at a
normal rate of 5% per year. Assume that the appropriate discount rate is 7%.
(b)
29
The dividends for years 1, 2, and 3 are

a)
b)
c)
d)
e)
(d)
30
The future price of the stock in year 3 is

a)
b)
c)
d)
e)
(a)
31
$1.5, $2.0, $2.05

$1.64, $1.78, $1.94
$1.64, $1.94, $2.24
$1.5, $2.40, $3.30
$2.07, $2.14, $2.21
$81.75
$84.81
$92.56
$101.85
$111.16
The present value today of dividends for years 1 to 3 is

a) $4.67
14
b)
c)
d)
e)
(b)
32
The price of the stock today (P0) is

a)
b)
c)
d)
e)
(a)
33
$3.08
$5.67
$4.5
$1.53
$84.81
$87.81
$91.09
$94.32
$97.61
Tayco Corporation has just paid dividends of $3 per share. The earnings per share
for the company was $4. If you believe that the appropriate discount rate is 15%,
and the long term growth rate is 6%, then the firms P/E ratio is
a)
b)
c)
d)
e)
8.33
33.33
44.44
11.11
None of the above
15
CHAPTER 11
ANSWERS TO PROBLEMS
1 (1 .05) 20
P = 40
.05
1000
= $875.38
20
(1 .05)
1 (1 .03)18
P = 40
.03
1000
= $1137.54
18
(1 .03)
1 (1 .03) 32
P = 20
.03
1000
= $796.11
32
(1 .03)
1 (1 .02) 28
P = 20
.02
1000
= $796.11
28
(1 .02)
1 (1 .05)12
P = 30
.05
1000
= $822.70
12
(1 .05)
1 (1 .04)10
P = 30
.04
1000
= $918.93
10
(1 .04)
Dividend = .09 x $110 = $9.90
Price = 9.90 0.16 = $61.87
Dividend = .08 x $50 = $4.00
Price = 4.00 0.15 = $26.67
16
9
Dividend = .07 x $63 = $4.41
Price = 4.41 0.10 = $44.10
10
Dividend = .08 x $52 = $4.16
Price = 4.16 0.11 = $37.82
11
% = P2/P1 = [(D0)(1 + g2)/(k2 - g2)] [(D0)(1 + g1)/(k1 - g1)] - 1

= [(D0)(1 + 0.09)/(0.17 - 0.09)] [(D0)(1 + 0.07)/(0.15 - 0.07)] 1
= (13.625 13.375) - 1 = 1.87% < 2%
12
% = P2/P1 = [(D0)(1 + g2)/(k2 - g2)] [(D0)(1 + g1)/(k1 - g1)] - 1

= [(D0)(1 + 0.11)/(0.19 - 0.11)] [(D0)(1 + 0.08)/(0.16 - 0.08)] 1
= (13.875 13.50) - 1 = 2.78% < 3%
13
% = P2/P1 = [(D0)(1 + g2)/(k2 - g2)] [(D0)(1 + g1)/(k1 - g1)] - 1

= [(D0)(1 + 0.07)/(0.15 - 0.07)] [(D0)(1 + 0.06)/(0.14 - 0.06)] 1
= (13.375 13.25) - 1 = 0.94% < 1%
14
% = P2/P1 = [(D0)(1 + g2)/(k2 - g2)] [(D0)(1 + g1)/(k1 - g1)] - 1

= [(D0)(1 + 0.11)/(0.20 - 0.11)] [(D0)(1 + 0.08)/(0.17 - 0.08)] 1
= (12.33 12.00) - 1 = 2.75% < 3%
15
% = P2/P1 = [(D0)(1 + g2)/(k2 - g2)] [(D0)(1 + g1)/(k1 - g1)] - 1

= [(D0)(1 + 0.12)/(0.18 - 0.12)] [(D0)(1 + 0.08)/(0.14 - 0.08)] 1
= (18.66 18.00) - 1 = 3.77% < 4%
16
P = 1.55(1.08) + 1.55(1.08)2 + 1.55(1.08)3 + 22.50

(1.15)3
(1.15)3
1.15
(1.15)2
= $1.456 + $1.367 + $1.284 + $14.794 = $18.90
17
P = (1.55 x 1.08) (0.15 - 0.08) = $23.91
18
P = 1.25(1.07) + 1.25(1.07)2 + 1.25(1.07)3+ 25.00

1.16
(1.16)2
(1.16)3 (1.16)3
= $1.153 + $1.064 + $0.981 + $16.016 = $19.21
19
P = (1.25 x 1.07) (0.16 - 0.07) = $14.86
17
20
g = (3.50/1.20)1/10 1 = 11.29%
21
retention rate = 1 - 0.63 = 37%
22
required return = .0565 + 1.25(.11 - .0565) = 12.34%
23
2(1.05) 2(1.05)(1.15) 2(1.05)(1.15)(1.25)

price =
1.15
1.15 2
1.15 3
24
Relative P/E = 21/35 = undervalued
2(1.05)(1.15)(1.25)(1.1)
.15 .1
= $49.31
1.15 3
Relative P/S = 5.2/7.5 = undervalued

25
Year 1 Dividends = 2(1 + .08) = $2.16

Year 2 Dividends = 2(1 + .08)2 = $2.33
Year 3 Dividends = 2(1 + .08)3 = $2.52
26
Future price of stock in year 5 = P5 = D6/(k g)

where g is the normal growth rate = 5%
D6 = 2(1 + .08)5(1 + .05) = $3.087
P5 = 3.087/(.07 - .05) = $154.35
27
The present value today of dividends from years 1 to 5 =

2.16/(1.07) +2.33/(1.07)2 + 2.52/(1.07)3 + 2.72/(1.07)4 + 2.94/(1.07)5 = $10.28
28
P0 = PV of dividends yr1 to yr5 + PV of P5

= 10.28 + 154.35/(1.07)5 = $120.33
29
Year 1 Dividends = 1.5(1 + .09) = $1.64

Year 2 Dividends = 1.5(1 + .09)2 = $1.78
Year 3 Dividends = 1.5(1 + .09)3 = $1.94
30
Future price of stock in year 3 = P3 = D4/(k g)

where g is the normal growth rate = 5%
D4 = 1.5(1 + .09)3(1 + .05) = $2.037
P3 = 2.037/(.07 - .05) = $101.85
31
The present value today of dividends from years 1 to 3 =

1.64/(1.07) +1.78/(1.07)2 + 1.94/(1.07)3 = $4.67
18
32
P0 = PV of dividends yr1 to yr5 + PV of P3

= 4.67 + 101.85/(1.07)3 = $87.81
33
3(1.06)
4(1.06
= 8.33
P/E =
.15 .06
CHAPTER 12
19
FIXED-INCOME ANALYSIS
(f)
1
The price of a bond is the presents value of
future coupons and face value discounted by the
coupon rate.
(t)
2
The yield to maturity of a bond the interest
rates that equates the present value of all future
coupons and face value to the current price of the
bond.
(f)
3
The current yield is the annual coupon payment
divided by the face value of the bond.
(t)
4
Yield to maturity assumes that all interim cash
flows are reinvested at the computed YTM.
(t)
5
Yield to maturity and current yield are equal
when the bond is selling for exactly par value.
(t)
6
The promised yield to call measures the
expected rate of return for a bond held to first
call date.
(f)
7
The promised yield to maturity measures the
expected rate of return for a bond held for a
minimum period of ten years.
(t)
8
Realized yield measures the expected rate of
return of a bond if the bond is sold prior to its
maturity.
(t)
9
The fully taxable equivalent yield of a
nontaxable bond with a promised yield of 7 percent
is 10.29 percent, assuming
a tax rate of 32
percent.
(f)
10 The major problem facing a bond analyst valuing

a U.S. government bond is the ability to forecast
the real risk-free rate of interest.
(t)
11 When investing in a foreign bond versus a

domestic bond, the additional risk factors you must
consider are exchange rate risk and country risk.
(t)
12 The fundamental determinants of interest rates

are the real risk free rate, inflation, and the
risk premium.
20
(f)
13 According to the expectations hypothesis, a

rising yield curve indicates that investors demand
for long maturity bonds is expected to rise.
(t)
14 According to the segmented market hypothesis

yields for a particular maturity segment depend on
supply and demand within the maturity segment.
(f)
15 For a given change in yield bond price

volatility is inversely related to term to
maturity.
(t)

volatility is inversely related to coupon.
(t)

volatility is directly related to duration.
(t)
18 Convexity is a measure of how much a bonds

price-yield curve deviates from the linear
approximation of that curve.
21
(a)
If you expected interest rates to fall, you would prefer to own bonds with
a) Long durations and high convexity.
b) Long durations and low convexity.
c) Short durations and high convexity.
d) Short durations and low convexity.
(c)
If you expected interest rates to fall, you would prefer to own bonds with
a) Short maturities and low coupons.
b) Long maturities and high coupons .
c) Long maturities and low coupons.
d) Short maturities and high coupons.
(d) 3
If you expected interest rates to rise, you would prefer to own bonds with
a) Short maturities and low coupons.
b) Long maturities and high coupons.
c) Long maturities and low coupons.
d) Short maturities and high coupons.
(a)
4
According to the liquidity preference hypothesis yield curves generally
slope upward because
a) Investors prefer short maturity obligations to long maturity obligations.
b) Investors prefer long maturity obligations to
short maturity obligations.
c) Investors prefer less volatile long maturity obligations.
d) Investors prefer more volatile short maturity
obligations.
(b)
5
According to the segmented-market hypothesis a downward sloping yield
curve indicates that
a) Demand for long-term bonds has fallen and demand for short-term
bonds has fallen.
b) Demand for long-term bonds has risen and demand
for short-term bonds has fallen.
22
c) Demand for long-term bonds has fallen and demand for short-term
bonds has risen.
d) Demand for long-term bonds has risen and demand
for short-term bonds has risen.
(c)
6
According to the segmented-market hypothesis a rising yield curve
indicates that
a) Demand for long-term bonds has fallen and demand for short-term
bonds has fallen.
b) Demand for long-term bonds has risen and demand
for short-term bonds has fallen.
c) Demand for long-term bonds has fallen and demand for short-term
bonds has risen.
d) Demand for long-term bonds has risen and demand
for short-term bonds has risen.
(b)
7
According to the expectations hypothesis a rising yield curve indicates
that investors expect
a) Future short term rates to fall
b) Future short term rates to rise
c) Future long term rates to rise
d) Future long term rates to fall
e) None of the above
(e)
8
The annual interest paid on a bond relative to
its
prevailing
market
price
is
called
its
.
a) Promised yield
b) Yield to maturity
c) Coupon rate
d) Effective yield
e) Current yield
(b)
9
For a domestic
determined by
bond
the
risk
premium
is
a) Credit quality, term to maturity and exchange

rate risk.
b) Credit quality, term to maturity and call
features.
c) Call features, sinking fund provisions and
country risk.
d) Term to maturity, call features and inflation.
23
e) Credit
rate.
(d)
quality,
inflation
and
the
risk
free
10 If the holding period is equal to the term to

maturity for a corporate bond the rate of discount
.
represents the
a) Coupon yield
b) Effective yield
c) Yield to call
d) Yield to maturity
e) Reinvestment rate
(d)
11 Which of the following could be an explanation

for a downward sloping yield curve
a) Borrowers prefer to sell short maturity issues
while lenders prefer to invest in long maturity
issues.
b) Demand for long term bonds has risen and demand
for short term bonds has fallen.
c) Investors prefer short maturity obligations to
long maturity obligations.
d) a) and b).
e) b) and c).
(a)
12 The promised
assumes that
yield
to
maturity
calculation
a) All coupon interest payments are reinvested at

the current market interest rate for the bond.
b) All coupon interest payments are reinvested at
the coupon interest rate for the bond.
c) All coupon interest payments are reinvested at
short tem money market interest rates.
d) All coupon interest payments are not reinvested.
(a)
13 If the coupon payments are not

during the life of the issue then the
reinvested
a) Promised yield is greater than realized yield.

b) Promised yield is less than realized yield.
c) Nominal yield declines.
d) Nominal yield is greater than promised yield.
e) Current yield equals the yield to maturity.
24
(c)
14 Consider a bond portfolio manager who expects

interest rates to decline and has to choose between
the following two bonds.
Bond A: 10 years to maturity, 5% coupon, 5% yield
to maturity
Bond B: 10 years to maturity, 3% coupon, 4% yield
to maturity
a) Bond A because it has a higher coupon rate.
b) Bond A because it has a higher yield to
maturity.
c) Bond B because it has a lower coupon rate.
d) Bond A or Bond B because the maturities are the
same.
(c)
measures the expected rate of

15
return of a bond assuming that you sell it prior to
its maturity.
a) Yield to maturity
b) Current yield
c) Realized yield
d) Coupon rate
(a)
16 The yield to call is a more conservative yield

measure whenever the price of a callable bond is
quoted at a value
a) Equal to or greater than par plus one year's
interest.
b) Equal to par.
c) Equal to par less one year's interest.
d) Less than par.
e) Five percent over par.
25

(c)
1
Assume that you purchase a 3-year $1,000 par
value bond, with a 15% coupon, and a yield of 8%.
After you purchase the bond, one- year interest
rates are as follow, year 1 = 8%, year 2 = 10%,
year 3 = 14% (these are the reinvestment rates).
Calculate the realized horizon yield if you hold
the bond to maturity. Interest is paid annually.
a) 9.37%
b) 7.28%
c) 8.53%
d) 10.67%
e) 14.0%
(e)
2
Immediately after you purchase the bond, yields
fall to 7% and remain at that level to maturity.
Calculate the realized horizon yield, if you hold
the bond for 5 years and then sell. Interest is
paid annually.
a) 16.25%
b) 12.15%
c) 7.75%
d) 9.05%
e) 10.15%
(b)
3
Immediately after you purchase the bond, yields
rise to 8% and remain at that level to maturity.
Calculate the realized horizon yield if you hold
the bond to maturity. Interest is paid annually.
a) 7.0%
b) 7.18%
c) 8.0%
d) 15.25%
e) 8.18%
THE FOLLOWING INFORMATION IS FOR THE NEXT FOUR PROBLEMS

A $1000 par value bond with 5 years to maturity and a 6% coupon has a yield to maturity of 8%.
Interest is paid semiannually.
26
(b)
Calculate the current price of the bond.
a) $1579.46
b) $918.89
c) $789.29
d) $1000
e) $743.29
(b)
Calculate the Macaulay duration for the bond
a) 4.19
b) 4.36
c) 8.72
d) 8.38
e) 9.52
(a)
Calculate the modified duration for the bond
a) 4.19
b) 4.36
c) 8.72
d) 8.38
e) 9.52
(a)
years
years
years
years
years
years
years
years
years
years
7
Estimate the percentage price change for this 5-year $1,000
par value bond, with a 6% coupon, if the yield rises from 8% to 8.5%. Interest is
paid semiannually.
a) 2.1%
b) 2.1%
c) 4.4%
d) 4.4%
(c)
8
Calculate the Macaulay duration for a 5-year
$1,000 par value bond, with a 6% coupon and a yield
to maturity of 8%. Interest is paid annually.
a) 6.44
b) 5.25
c) 4.44
d) 2.50
e) None
(a)
years
years
years
years
of the above
9
A 15-year bond has a $1,000 par value bond, a 4% coupon
and a yield to maturity of 3.3%. Interest is paid annually. The bond's current
yield is
27
a) 3.7%
b) 4.0%
c) 3.3%
d) 7.3%
(d)
10
A 5-year bond has a $1,000 par value bond, a 12% coupon
and a yield to maturity of 8%. Interest is paid semiannually. The bond's price is
a) $864.65
b) $1081.78
c) $852.80
d) $1162.22
(b)
11
A 15-year bond, purchased 5 years ago, has a $1,000 par
value bond, a 10% coupon and a yield to maturity of 12%. Interest is paid
annually. The bond's price is
a) $864
b) $887
c) $1152
d) $1123
(d)
12
A 20-year, $1,000 par value bond has an 11% coupon and is
currently priced at par. Interest is paid semiannually. The bond's effective annual
yield is
a) 5.50%
b) 5.65%
c) 11.00%
d) 11.30%
Five years ago your firm issued $1,000 par, 20 year bonds with a
6% coupon rate and an 8% call premium. The price of these bonds
now is $1103.80. Assume annual compounding.
(b)
13 Calculate the yield to maturity of these bonds

today.
a) 6%
b) 5%
c) 8%
d) 7.31%
28
e) 7.81%
(b)
14 If these bonds are now called, what is the

actual yield to call for the investors who
originally purchased them?
a) 6.83%
b) 7.38%
c) 7.81%
d) 7.92%
e) 8.47%
You purchase an 8% coupon, 25 year, $1,000 par, semiannual

payment bond priced at $980 when it has 15 years remaining until
maturity.
(c)
15
What is its yield to maturity?
a) 4.12%
b) 4.66%
c) 8.24%
d) 9.32%
e) 14.82%
(d)
16
What is the yield to call if the bond is called 5

years from today with a 5% premium?
a) 4.12%
b) 4.66%
c) 8.24%
d) 9.32%
e) 14.82%
(b)
17
The current market price of MCB Corporation's bond is
$1122.50. A 12% coupon interest rate is paid annually, and the par value is equal
to $1,000. What is the yield to maurity if the bond matures ten years from today?
a) 9%
b) 10%
c) 12%
d) 13%
e) 14%
(d)
18 Calculate the duration of a 6 percent, $1,000

par bond maturing in three years if the yield to
29
maturity is 10
semiannually.
a) 1.35
b) 1.78
c) 2.50
d) 2.78
e) 2.95
(d)
and
interest
is
paid
years
years
years
years
years
19
Calculate the modified duration for a 10-year, 12 percent
bond with a yield to maturity of 10 percent and a Macaulay duration of 7.2 years.
Assume semiannual compounding.
a) 6.43
b) 6.55
c) 6.79
d) 6.86
e) 7.01
(a)
percent
years
years
years
years
years
20
A 12-year, 8 percent bond with a YTM of 12 percent has a
Macaulay duration of 9.5 years. If interest rates decline by 50 basis points, what
will be the percent change in price for this bond? Assume semiannual
compounding.
a) +4.48%
b) +4.61%
c) +8.48%
d) +8.96%
e) +17.92%
30
CHAPTER 12
ANSWERS TO MULTIPLE CHOICE PROBLEMS
The purchase price is = $1180.40 =

1
1
3
150 1.08
.08
1000
1.08 3
The terminal value of cash flows = $1509.10 =

150(1.1)(1.14) + 150(1.14) + 150 + 1000
The realized horizon yield = 8.53% =
1509.10
1180.40
2
1/ 3

1
1
10
50 1.09
.09
1000
1.0910
The selling price after 5 years is = $918 =
1
5
50 1.07
.07
1000
1.07 5
The terminal value of cash flows at year 5 = $1205.53 =

1.07 5 1
+ 918
50
.07
31
1205.53
743.29
3
1/ 5

1
1
10
40 1.07
.07
1000
1.0710
The terminal value of cash flows at year 10 = $1579.46 =
1.0810 1
+ 1000
40
.08
1579.46
789.29
4
1 / 10
The price of the bond = $918.89 =
1
10
30 1.04
.04
1000
1.0410
The present value of the weighted cash flows = $8015.41 =

30/(1.04) + 60/(1.04)2 + 90/(1.04)3 +120/(1.04)4+150/(1.04)5
180/(1.04)6 + 210/(1.04)7 + 240/(1.04)8 + 270/(1.04)9 +
10300/(1.04)10
Macaulay duration = 8015.41/918.89 = 8.72
Or 8.72/2 = 4.36 years
Modified duration = 4.36/(1 + .04) = 4.19 years.
%price change = -(4.19 x 0.5) = -2.1%
32
1
5
60 1.08
.08
1000
1.08 5
The present value of the weighted cash flows = $4084.82 =

60/(1.08) + 120/(1.08)2 + 180/(1.08)3
+ 240/(1.08)4 + 5300/(1.08)5
Macaulay duration = 4084.41/920.15 = 4.44 years
9
1
15
40 1.033
.033
1000
1.03315
Current yield = 40/1081.78 = 3.7%

10
1
10
60 1.04
.04
11
1000
1.0410
The price of the bond = $887 =
1
10
100 1.12
.12
1000
1.1210
12
Since the bond is priced
maturity is 11% or 5.5% semiannual.
at
par
the
yield
Effective annual yield = (1 + .055)2 - 1 = 11.30%
to
33
13
1
(1 ytm) 15
1103.80 = 60
ytm
1000
(1 ytm)15
annual ytm = 0.05 or 5%
14
1
(1 ytc) 5
1000 = 60
ytc
1000
(1 ytc) 5
ytc = 7.38% nominal yield
15
1
(1 ytm) 30
980 = 40
ytm
1000
(1 ytm) 30
annual ytm = 0.0412 x 2 or 8.24%
16
1
(1 ytc) 10
980 = 40
ytc
1050
(1 ytc) 10
annual ytc = 0.0466 x 2 = 0.0932 or 9.32%
17
1
(1 ytm) 10
1122.50 = 120
ytm
1000
(1 ytm) 10
annual ytm = 0.10 or 10%
34
18
Macaulay Duration = PV of weighted cash flows/Current
price = 5552.25/1000
= 5.55225 six month periods or 2.77613 years.
PV of weighted cash flows =
30 x1 30 x 2 30 x3 30 x 4 30 x5 1030 x6
= 5552.25
1.051 1.05 2 1.05 3 1.05 4 1.05 5 1.05 6

Current price =$1000 since coupon rate is equal to yield
to maturity.
19
Dmod = 7.2/(1 + .10/2)

= 7.2/1.05 = 6.86 years
20
Dmod = 9.5/(1 + .12/2)

= 9.5/1.06 = 8.96 years
%P = -Dmod x i
= -(8.96) x (-0.005) = 0.0448
= 4.48% increase
35
CHAPTER 17
AN INTRODUCTION TO DERIVATIVE INSTRUMENTS
(t)
A cash or spot contract is an agreement for the

immediate delivery of an asset such as the purchase
of stock on the NYSE.
(t)
Forward and futures contracts, as well as options,

are types of derivative securities.
(t)
If an investor wants to acquire the right to buy or

sell an asset, but not the obligation to do it, the
best instrument is an option rather than a futures
contract.
(f)
Investment costs are generally higher in the

derivative markets than in the corresponding cash
markets.
(t)
Forward contracts are traded over-the-counter and

are generally not standardized.
(t)
The forward currency market has low

relative to the currency futures market.
(f)
A futures contract is an agreement between a trader

and the clearinghouse of the exchange for delivery
of an asset in the future.
(t)
A primary function of futures markets is to allow

investors to transfer risk.
(f)
The futures market is a dealer market where all the

details of the transactions are negotiated.
(t)
10
For futures, the initial margin requirement is

quivalent to 3-6 percent of the contract's value.
(t)
11
Since futures contracts are "marked-to-market"

daily, the gains and losses are settled daily.
(f)
12
Due to daily marking-to-market, the clearinghouse

experiences major swings in their net balances to
ensure stability for the investors.
(t)
13
If you have entered into a currency futures hedge

for the Japanese yen in connection with buying
Japanese equipment, if the yen goes from 110 yen/$1
to 100 yen/$1, you will lose in the spot market but
have an offsetting gain in the futures market.
liquidity
36
(f)
14
According to put call parity:

Call Price + Put Price = Stock Price + Risk Free
Bond Price
(f)
15
The intrinsic value of a call option is Max[0,

Exercise Price Stock Price]
(f)
16
The intrinsic value of a put option is Max[0, Stock

Price Exercise Price]
(f)
17
Options that can be exercised at any up to and

including the expiration day are called European
Options.
(f)
18
Options that can only be exercised on

expiration day are called American Options.
(t)
19
A call option with an exercise price of $45 and a

price of $5.50 will be in the money if the price of
the underlying stock is $50.
(f)
20
A put option with an exercise price of $60 and a

price of $0.50 will be in the money if the price of
the underlying stock is $70.
the
37
(a)
Which of the following

existence of derivatives?
is
reason
for
the
a) They help shift risk from risk-averse investors

to risk-takers.
b) They help shift risk from risk-takers to riskaverse investors.
c) They allow investors to speculate.
d) They allow investors to purchase assets with
less risk.
e) They allow investors to earn above average
returns.
(b)
If you enter into a forward contract agreeing to

purchase an asset at a specified price at a future
specified date
a) You would be short forward.
b) You would be long forward.
c) You would be long futures.
d) You would be short futures.
(b)
Futures differ from forward contracts because

a) Forwards have less liquidity risk.
b) Futures have less credit risk.
c) Futures have less maturity risk.
d) Forwards are marked to market.
e) Forwards have less credit risk.
(e) 4
Future contracts can be used by portfolio managers to?

a) Protect
the
investment
portfolio
against
inflation in the economy.
b) Seek
protection
against
the
increasing
volatility of interest rates.
c) Adjust asset allocation.
d) a) and b).
e) b) and c)
(c)
A call option differs from a put option in that

a) a call option obliges the investor to purchase a
given number of shares in a specific common
stock at a set price; a put obliges the investor
38
to sell a certain number of shares in a common
stock at a set price.
b) both give the investor the opportunity to
participate in stock market dealings without the
risk of actual stock ownership.
c) a call option gives the investor the right to
purchase a given number of shares of a specified
stock at a set price; a put option gives the
investor the right to sell a given number of
shares of a stock at a set price.
d) a put option has risk, since leverage is not as
great as with a call.
(b)
Which of the following statements is

definition of an out-of-the-money option?
true
a) A call option in which the stock price exceeds

the exercise price.
b) A call option in which the exercise price
exceeds the stock price.
c) A call option in which the exercise price
exceeds the stock price.
d) A put option in which the exercise price exceeds
the stock price.
e) A call option in which the call premium exceeds
the stock price.
(d)
If you were to sell a June call option with an

exercise price of 50 for $8 and simultaneously buy
a June call option with an exercise price of 60 for
$3, you would be
a)
b)
c)
d)
e)
(a)
Bullish and
Bullish and
Bearish and
Bearish and
Neutral.
taking a high risk.

conservative.
taking a high risk.
conservative.
The value of a call option just prior to expiration

is (where V is the underlying asset's market price
and X is the option's exercise price)
a) Max
b) Max
c) Min
d) Min
e) Max
[0,
[0,
[0,
[0,
[0,
V
X
V
X
V
>
X]
V]
X]
V]
X]
39
(c)
A horizontal spread involves buying and

call options in the same stock with
selling
a) The same expiration date and strike price.

b) The same expiration date but different strike
price.
c) A different expiration date but same strike
price.
d) A different expiration date and different strike
price.
e) Options in different markets.
(b)
10
According to put/call parity

a) Stock price
Bond Price
b) Stock price
Bond Price
c) Put price +
Bond Price
d) Stock price
Bond Price
e) Stock price
Bond Price
(b)
11
+ Call Price = Put Price + Risk Free

+ Put Price = Call Price + Risk Free
Call Price = Stock Price + Risk Free
- Put Price = Call Price + Risk Free
+ Call Price = Put Price - Risk Free
Which of the following statements does not apply to

a put option?
a) You can sell a put option as a means to buy a
stock at a price below the current market price.
b) To protect against a decline in prices of a
stock you own, you could sell a put option
against your position.
c) You would buy a put option for a volatile stock
you want to buy with good long-term prospects
but uncertain near term prospects.
d) You would sell an option on a stock you expect
to increase in price to earn extra income.
e) If you hedge a long profit position and the
stock continues to increase in price, your put
option will expire worthless.
(a)
12
You own a stock which has risen from $10 per share
to $32 per share.
You wish to delay taking the
profit but you are troubled about the short run
behavior of the stock market. An effective action
on your part would be to
a) Purchase a put.
b) Purchase a call.
40
c) Purchase an index option.
d) Utilize a bearish spread.
e) Utilize a bullish spread.
(b)
13
If you were to purchase an October call option with

an exercise price of $50 for $8 and simultaneously
sell an October call option with an exercise price
of $60 for $2, you would be
a) Bullish and
b) Bullish and
c) Bearish and
d) Bearish and
e) Neutral.
(b)
14
taking a high risk.

conservative.
taking a high risk.
conservative.
A vertical spread involves buying and selling call

options in the same stock with
a) The same expiration date and strike price.
b) The same expiration date but different strike
price.
c) A different expiration date but same strike
price.
d) A different expiration date and different strike
price.
e) Options in different markets.
(b)
15
A stock currently sells for $75 per share. A call
option on the stock with an
exercise price $70 currently sells for $5.50. The
call option is
a) At-the-money.
b) In-the-money.
c) Out-of-the-money.
d) At breakeven.
(c)
16
A stock currently sells for $150 per share. A call
call option is
a) At-the-money.
b) In-the-money.
d) At breakeven.
41
(c)
17
A stock currently sells for $75 per share. A put
put option is
a) At-the-money.
b) In-the-money.
d) At breakeven.
(a)
18
put option is
a) At-the-money.
b) In-the-money.
d) At breakeven.
(b)
19
put option is
a) At-the-money.
b) In-the-money.
d) At breakeven.
42
(a)
1
A stock currently trades for $25. January call
options with a strike price of
$20 sell for $6. The appropriate risk free bond has
a price of $30. Calculate
the price of the January
put option.
a) $11
b) $24
c) $19
d) $30
e) $25
(e)
2
A stock currently trades for $115. January call
options with a strike price of
$100 sell for $16,
and January put options a strike price of $100 sell for $5.
Estimate the price of a risk free bond.
a) $120
b) $15
c) $105
d) $116
e) $104
(d)
3
Assume that you have purchased a call option
strike price $60 for $5.
At the same time you purchase a put option
same stock with a strike price of $60 for
the stock is currently selling for $75 per
calculate
the
dollar
return
on
this
strategy.
with a
on the
$4. If
share,
option
a) $10
b) -$4
c) $5
d) $6
e) $15
(c)
4
Assume that you purchased shares of a stock at a
price of $35 per share. At
this time you purchased a put option with a $35
strike price for $3. The
stock currently trades at
$40. Calculate the dollar return on this option
strategy.
a) $3
b) -$2
c) $2
d) -$3
e) $0
43
(c)
5
Assume that you purchased shares of a stock at a
price of $35 per share. At
this time you wrote a call option with a $35 strike
and received a call price
of
$2.
The
stock
currently trades at $70. Calculate the dollar return on this
option strategy.
a) $25
b) -$2
c) $2
d) -$25
e) $0
(b)
6
A stock currently trades at $110. June call options
on the stock with a strike
price of $105 are priced at $4. Calculate the
arbitrage profit that you can
earn
a)
b)
c)
d)
e)
$0
$1
$5
$4
None of the above
(c)
7
Datacorp stock currently trades at $50. August call
options on the stock
with a strike price of $55 are priced at $5.75.
October call options with a
strike price of $55 are
priced at $6.25. Calculate the value of the time
premium between the August and October options.
a) -$0.50
b) $0
c) $0.50
d) $5
e) -$5
(a)
8
A stock currently trades at $110. June put options
price of $115 are priced at $5.25. Calculate the
dollar return on one put
contract.
a)
b)
c)
d)
e)
-$25
$500
$0
-$75
$525
44
(d)
9
A stock currently trades at $110. June call options
price of $105 are priced at $5.75. Calculate the
dollar return on one call
contract.
a)
b)
c)
d)
e)
-$50
$500
$575
-$75
$0
(e)
10
Consider a stock that is currently trading at $50.
Calculate the intrinsic
value for a put option that has an exercise price
of $55.
a)
b)
c)
d)
e)
$0
$50
$55
$105
$5
(a)
11
Calculate the intrinsic value
for a put option that has an exercise price of $35.
a)
b)
c)
d)
e)
$0
$50
$35
$15
$85
(e)
12
value for a call option that has an exercise price
of $35.
a) $25
b) $35
c) $10
d) -$10
e) $0
(c)
13
value for a call option that has an exercise price
of $15.
a)
b)
$25
$35
45
c)
d)
e)
$10
$60
$0
USE THE FOLLOWING INFORMATION FOR THE NEXT THREE PROBLEMS

December futures on the S&P 500 stock index trade at 250 times
the index value of 1187.70. Your broker requires an initial
margin of 10% percent on futures contracts. The current value of
the S&P 500 stock index is 1178.
(c)
14
How much must you deposit in a margin account if
you wish to purchase
one contract?
a)
b)
c)
d)
e)
$267,232.5
$29,450
$29,692.50
$30,000
$265,050
(c)
15
Suppose at expiration the futures contract price is
250 times the index value
of
1170. Disregarding transaction costs, what is
your percentage return?
a) 1.87%
b) -0.68%
c) -14.90%
d) 10.36%
(b)
16
Calculate the return on a cash investment in the

S&P 500 stock index over
the same time period
a) 1.87%
b) -0.68%
c) -14.90%
d) 10.36%

A futures
contract on Treasury bond futures with a December

expiration date currently trade at
103:06. The face value of a Treasury bond futures contract is
$100,000. Your broker requires an
initial margin of 10%.
46
(c)
17
Calculate the current value of one contract

a) $100,000
b) $103,600.5
c) $103,187.5
d) $102,306.3
e) $104,293.5
(c)
18
Calculate the initial margin deposit

a) $10,000
b) $10,360.50
c) $10,318.75
d) $10,230.63
e) $10,429.35
(b)
19
If the futures contract is quoted at 105:08 at
expiration calculate the
percentage return
a) 1.99%
b) 19.99%
c) 20.62%
d) 25.37%
e) -13.65%
(e)
20
In your portfolio you have $1 million of 20 year,

8 5/8 percent bonds which are selling at 83.15 (or
83 15/32) against this position. Because you feel
interest rates will rise you sell 10 bond futures
at 81:15 (or 81 15/32) against this position. Two
months later you decide to close your position.
The bonds have fallen to 78 and the futures
contracts are at 75:16 (75 16/32).
Disregarding
margin and transaction costs, what is your gain or
loss?
a) $5,000 loss
b) $500 loss
c) Breakeven
d) $500 gain
e) $5,000 gain

On the last day of October, you are considering the purchase of
100 shares of Trivia Corporation common stock selling at $32 3/8
per share and also considering one Trivia option contract.
47
Price
35
(d)
21
Calls
December
March
30
3 3/4
2
2 1/2
3 1/2
22
5
4 1/2
1 1/4
4 3/4
If you decide to buy a March call option with an

exercise price of 30, what is your dollar gain
(loss) if you close the position when the stock is
selling at 38 7/8?
a) $187.50
b) $225.00
c) $287.50
d) $387.50
e) $427.50
(b)
Puts
December
March
gain
gain
gain
gain
gain
If Bruce buys a March put option with an exercise

price of 35, what is his dollar gain (loss) if he
closes his position when the stock is at 38 7/8?
a) $600.00 loss
b) $475.00 loss
c) $387.50 loss
d) $25.00 loss
e) He has a gain

John Shamrock is considering the following alternatives for
investing in Clover Industries, which is now selling for $27 per
share:
1) Buy 100 shares,
2) Buy 100 shares with a 60 percent margin deposit
and
3) Buy a six month call option with a strike price
of $25 for $500.
(d)
23
Assuming no commissions or taxes what is the

annualized percentage gain if the stock reaches $32
in four months and was purchased on margin?
a) 18.56%
b) 30.86%
c) 46.30%
d) 92.59%
e) 128.90%
48
(b)
24
Assuming no commissions or taxes what is the

annualized percentage gain if the stock reaches $32
in four months and a call was purchased?
a) 40%
b) 120%
c) 180%
d) 300%
e) 360%
49
CHAPTER 17

1
P = 6 + 30 25 = $11
Bond price = 115 + 5 16 = $104
Profit on call = (75 60) 5 = 10

Profit on put = -4
Total = $6
Profit on stock = 40 35 = 5
Profit on put = -3
Total = $2
Profit on stock = 70 35 = 25
Profit on call = 35 70 + 2 = -23
Total = $2
Arbitrage profit = 110 105 4 = $1
Time premium = 6.25 5.75 = $0.50
Dollar return = (115 110 5.25)(100) = -$25
Dollar return = (110 105 5.75)(100) = -$75
10
Put = Max[55 50, 0] = $5
11
Put = Max[35 50, 0] = $0
12
Call = Max[25 35, 0] = $0
13
Call = Max[25 15, 0] = $10

14 Margin = 0.10 x 250 x 1187.70 = $29,692.50
15
Purchase December contract

250 x 1187.7 = $296,925
Sell December contract
250 x 1170 = $292,500
Loss in futures = $292,500 - $296,925 = -$4425
Rate of return = -$4425/29,692.50 = -.1490 or -14.9%
16
Return on cash investment in the

1178)/1178 = -0.0068 or 0.68%
index
(1170
50
17
Current price
$100,000
is
103
6/32
percent
of
face
value
of
= 1.031875 x 100,000 = $103,187.50

18
Margin deposit = 0.10 x 103,187.5 = $10,318.75
19
Purchase December contract

103 6/32 percent of 100,000 = $103,187.50
Sell December contract
105 8/32 percent of $100,000 = $105,250
Gain in futures = $105,250 - $103,187.50 = $2,062.50
Rate of return = 2062.5/10318.75 = 0.1999 or 19.9%
20
Bonds
Value of portfolio (now)
Value of portfolio (2 mo.)
$834,687.50
780,000.00
Loss in value
$54,687.50
Futures
Sell 10 bond futures (now) $814,687.50

Buy 10 bond futures (2 mo.)
755,000.00
Gain in futures
$59,687.50
Net gain = Gain in futures - loss in bond value

= $59,687.50 - $54,687.50
= $5,000
21 Max[0, 38 7/8 - 30] - 5 = $3 7/8 per share or $387.50 per 100 shares
22
Max[0, 35 - 38 7/8] - 4 3/4 = -4 3/4 per share or $475 loss

per 100 shares
23
Margin = .60 x ($27 x 100 shares) = $1,620

Rate of return = (3200 2700)/1620 = 30.86%
Annualized rate of return = 30.86% x 12/4 = 92.59%
51
24
Max[0,32 - 25] - 5 = $2 per share or $200 per contract

Rate of return = $200/$500 = 40%
Annualized rate of return = 40% x 12/4 = 120%
52
CHAPTER 18
DERIVATIVES: ANALYSIS AND VALUATION
(f)
The owner of a call option on a futures contract

has the obligation to buy the futures contract at a
predetermined strike price during a specified time
period.
(f)
Options on futures expire at the same time the

futures contract expires.
(t)
A warrant is an option to buy a stated number of

shares of common stock at a specified price at any
time during the life of the warrant.
(f)
A major difference between a call option and a

warrant is that call options are issued by the
company so that any proceeds from the sale of stock
go to the issuing firm.
(f)
According to the cost of carry model the futures

price is the present value of the spot price
discounted at the risk free rate.
(t)
In the cost of carry model the inclusion of storage

costs will increase the futures price.
(f)
The inclusion of dividends in the cost of carry

model will increase the futures price.
(t)
The basis (Bt,T) at time t between the spot price

(St) and a futures contract expiring at time T
(Ft,T) is: St - Ft,T.
(f)
A riskless stock index arbitrage profit is possible

if the following condition holds: F0,T = S0(1 + rf
d)T, where spot price now is S0, value now of a
futures contract expiring at time T is (F0,T), rf is
the risk free rate and d is the dividend.
(f)
10
One S&P 500 stock index futures option contract is

priced at $500 times the premium.
(f)
11
The underlying stock price and the value of the put

option are factors that impact the value of an
American call option.
(t)
12
The cost of carry is the foregone interest from

investing in a risk free asset.
53
(t)
13
The binomial option pricing model approximates the

price of an option obtained using the Black-Scholes
option pricing model as the number of subintervals
increases.
(f)
14
Callable bonds allow the issuer the option selling

the bonds a fixed price.
(f)
15
The intrinsic value of a warrant = (Market price of

common stock + Warrant exercise price) x Number of
shares specified by warrant.
(t)
16
By attaching a convertible feature to a bond issue

a firm can often get a lower rate of interest on
its debt.
(t)
17
The investment value of a convertible bonds is the

price which it would be expected to sell as a
straight debt instrument.
(f)
18
The conversion parity price is equal to the par

value of a convertible bond divided by the number
of shares into which it can be converted.
54
(a)
According
to
the
cost
relationship between the
price (F0,T) is
a) S0
b) S0
c) S0
d) S0
e) S0
=
=
+
=
-
of
carry
model
the
spot (S0) and futures
F0,T/(1 + rf)T
F0,T(1 + rf)T
F0,T = (1 + rf)T
F0,T + (1 + rf)T
F0,T = (1 + rf)T
(b)
2
The inclusion of the following in the cost of carry
model will increase the
futures price
a) Dividends
b) Storage costs
c) Interest rate
d) a) and b)
(b)
The basis (Bt,T) at time t between the spot price

(St) and a futures contract expiring at time T
(Ft,T) is
a) Bt,T = St + Ft,T
b) Bt,T = St - Ft,T
c) Bt,T = St x Ft,T
d) Bt,T = St / Ft,T
(d)
4
A riskless stock index arbitrage profit is possible
if the following condition
holds:
a) F0,T = S0(1 + rf d)T
b) F0,T > S0(1 + rf d)T
c) F0,T < S0(1 + rf d)T
d) a) and b)
e) b) and c)
(d)
to:
The value of a call option is positively related

a) Underlying stock price.
b) Time to expiration
c) Exercise price.
d) a) and b)
e) b) and c)
55
(c)
The value of a call option is inversely related to:

a) Underlying stock price.
b) Time to expiration
c) Exercise price.
d) a) and b)
e) b) and c)
(b)
The intrinsic value of a warrant is calculated as:

a) (Market price of common stock + Warrant exercise
price) x Number of shares specified by warrant.
b) (Market price of common stock - Warrant exercise
price) x Number of shares specified by warrant.
c) (Market price of common stock + Warrant exercise
price) / Number of shares specified by warrant.
d) (Market price of common stock - Warrant exercise
price) / Number of shares specified by warrant.
(e)
An advantage of convertible bonds is

a) Investors get the upside potential of a bond.
b) Investors get the upside potential of a stock.
c) Issuing firms can get a lower rate of interest
on its debt.
d) a) and b).
e) b) and c).
(d)
Warrants differ from options in a number of ways.

Which of the following statements about warrants
and options is false?
a) When originally issued, the life of a warrant is
usually much longer than that of a call option.
b) Warrants are usually issued by the company on
whose stock the warrant is written.
c) Warrants
are
often
used
by
companies
as
sweeteners to make new issues of debt or equity
more attractive.
d) Warrant holders have voting rights while option
holders do not.
e) None of the above (that is, all statements are
true)
(b)
10
If the hedge ratio is 0.50, this indicates that the

portfolio should hold
56
a. Two shares of stock for every call option
written.
b. One share of stock for every two call options
written.
c. Two shares of stock for every call option
purchased.
d. One share of stock for every two call options
purchased.
e. Two call options for every put option written.
(a)
11
All of the following are normal characteristics of

a convertible bond, except
a) Conversion at the option of the issuer.
b) Conversion into a fixed number of shares of
common stock.
c) A conversion price initially above the market
price of the common stock.
d) An interest rate lower than that on straight
debentures.
e) Subordination.
(b)
12
The minimum price of a convertible bond is

a) Min (Bond Value, Conversion Value).
b) Max (Bond Value, Conversion Value).
c) Min (Stock Value, Conversion Value).
d) Max (Stock Value, Conversion Value).
(d)
13
The conversion premium for a convertible bond is
calculated as:
a) (Market
b) (Market
c) (Market
d) (Market
e) (Market
Price
Price
Price
Price
Price
+
/
+
x
Minimum
Minimum
Minimum
Minimum
Minimum
Value)
Value)
Value)
Value)
Value)
/
x
x
/
/
Minimum
Minimum
Minimum
Minimum
Minimum
Value.
Value.
Value.
Value.
Value.
(a)
14
The conversion price parity for a convertible bond
is defined as:
a) Market
Ration.
b) Market
Ration.
c) Market
Ration.
d) Market
Ration.
e) None of
Price of Convertible Bond / Conversion

Price of Convertible Bond x Conversion
Price of Convertible Bond - Conversion
Price of Convertible Bond + Conversion
the above.
57
THE following INFORMATION IS FOR THE NEXT TWO PROBLEMS

A stock currently trades for $120 per share. Options on the stock are available with a strike price
of $125. The options expire in 30 days. The risk free rate is 3% over this time period, and the
expected volatility is 0.35.
(d)
Use the Black-Scholes option pricing

calculate the price of a call option.
model
to
a) $5.935
b) $4.935
c) $3.935
d) $2.935
(a)
Calculate the price of the put option.

a) $7.623
b) $8.623
c) $9.623
a) $10.623
b) None of the above
THE following INFORMATION IS FOR THE NEXT THREE PROBLEMS

A 3-month T-bond futures contract (maturity 20 years, coupon 6%, face $100,000) currently
trades at $98,781.25 (implied yield 6.11%). A 3-month T-note futures contract (maturity 20
years, coupon 6%, face $100,000) currently trades at $101,468.80 (implied yield 5.80%).
(b)
If you expected the yield curve to steepen, the

appropriate NOB futures spread strategy would be
a) Go long the T-bond and short the T-note
b) Go short the T-bond and long the T-note
c) Go long the T-bond and long the T-note
d) Go short the T-bond and short the T-note
58
(a)
If you expected the yield curve to flatten, the

appropriate NOB futures spread strategy would be
a) Go long the T-bond and short the T-note
b) Go short the T-bond and long the T-note
c) Go long the T-bond and long the T-note
d) Go short the T-bond and short the T-note
A) NONE OF THE ABOVE
(c)
Suppose the yield curve did flatten so the that the

yield on the T-bond contract fell to 5.95% and the
yield on the T-note rose to 5.85%. Calculate the
Profit on the NOB futures spread. (Assume coupons
are paid annually)
a) -$5850.92
b) -$2144.17
c) $2144.17
b) $5850.92
c) None of the above
THE following INFORMATION IS FOR THE NEXT FOUR PROBLEMS

The S&P 500 stock index is at 1106.59. The annualized interest rate is 5% and the annualized
dividend is 2%.
(b)
Calculate the
contract .
price
now
of
one
year
futures
a) 1106.59
b) 1112.12
c) 1139.79
d) 1123.19
(b)
If the futures contract was currently available for

1250, indicate the appropriate strategy that would
earn an arbitrage profit.
a) Long futures, and short the index.
b) Short futures and long the index.
c) Long futures and long the index.
d) Short futures and short the index.
59
(a)

1050, indicate the appropriate strategy that would
earn an arbitrage profit.
a) Long futures, and short the index.
b) Short futures and long the index.
c) Long futures and long the index.
a) Short futures and short the index.
b) None of the above.
(d)

1250, calculate the arbitrage profit.
a) 0
b) 143.41
c) 143.41
d) 137.84
e) -137.84
The following information is for the next FIVE problems

A coffee dealer expects to purchase 120,000 pounds of coffee in three months. To hedge the
price of coffee he plans to take a long position in a 3-month coffee futures contract prices at
$0.5595 per pound. Each coffee futures contract is for 37,500 pounds and therefore the dealer
purchases 3 contracts. The current spot price for coffee is $0.485 per pound. Assume that three
months from now the spot and futures prices are both $0.60 per pound.
(d)
10
Calculate the number of pounds, of the

120,000 pound purchase, that is unhedged
a) 45000
b) 75000
c) 5000
d) 7500
e) 4000
(b)
11
Calculate the basis now.

a) $0
b) -$0.0745
c) $0.0745
d) -$0.0405
e) $0.115
(a)
12
Calculate the basis three months from now.

a) $0
b) -$0.0745
planned
60
c) $0.0745
d) -$0.0405
e) $0.115
(e)
13
Calculate the profit or loss on

position at the end of three months.
the
futures
a) $0
b) -$4500.25
c) $4500.25
d) -$4556.25
e) $4556.25
(c)
14
Calculate the effective price at which the dealer

purchased the coffee.
a) $0.5595
b) $0.485
c) $0.562
d) -$0.60
e) $0.5223
(e)
15
Consider an asset that has a spot price of $650.

The asset has a monthly dividend yield of 0.15%.
Storage and insurance cost are 0.3% per month and
the monthly T-bill rate is 0.67%. Transaction costs
are 0.45%. Calculate the non arbitrage price range
for a 6 month futures contract.
a) $683.54
b) $679.57
c) $650.00
d) $650.00
e) $679.57
(c)
16
17
$705.63
$715.13
$685.71
$679.57
$685.71
Consider an asset that has a spot price of $650.

The asset has a monthly dividend yield of 0.15%.
Storage and insurance cost are 0.3% per month and
the monthly T-bill rate is 0.67%. Calculate the
futures price for a 9-month contract.
a)
b)
c)
d)
e)
(a)
and
and
and
and
and
$705.63
$715.13
$699.57
$680.58
$665.75
Three-month corn futures contracts currently sell

for 510 cents per bushel. Storage and insurance
61
cost are 0.3% per month. The three-month T-bill
rate is 2% over this three month period. Calculate
the spot price for corn.
a)
b)
c)
d)
e)
(d)
18
$5.3515
$5.2323
$6.2515
$6.2323
$5.1015
The spot price of a commodity is $1200. If the Tbill rate is 9% annualized, calculate the price for
a 9-month futures contract on the commodity.
a)
b)
c)
d)
e)
$2606.27
$1312.56
$1227.20
$1283.47
$1200.00
USE THE FOLLOWING INFORMATION TO ANSWER THE NEXT THREE QUESTIONS

The information provided is relevant in the context of a one
period (one year) binomial option pricing model. A stock
currently trades at $50 per share, a call option on the stock has
an exercise price of $45. The stock is equally likely to rise by
25% or fall by 25%. The one-year risk free rate is 2%.
(b)
19
Calculate the possible prices of the stock one year

from today
a) $37.50 or $17.50.
b) $62.50 or $37.50.
c) $62.50 or $17.50.
d) $50 or $45.
(a)
20
Estimate n, the number of call options that must be

written
a) -1.4286
b) -2.9286
c) -2.8571
d) -2.5714
e) -1.1111
(c)
21
Calculate the price of the call option today (C0)

a) $7.56
62
b) $17.48
c) $9.26
d) $5.0
e) $17.15
USE THE FOLLOWING INFORMATION TO ANSWER THE NEXT FOUR QUESTIONS
The following information is provided in the context of a two
period (two six month periods) binomial option pricing model. A
stock currently trades at $60 per share, a call option on the
stock has an exercise price of $65. The stock is equally likely
to rise by 15% or fall by 15% during each six month period. The
one-year risk free rate is 3%.
(c)
22
Calculate the possible prices of the stock at the

end of one year
a) $69, $51, $79.35
b) $51, $79.35, $58.65
c) $79.35, $58.65, $43.35
d) $58.65, $43.35, $14.35
(a)
23
Calculate the price of the call option after the

stock price has already moved up in value once (Cu)
a) $7.77
b) $14.35
c) $0
d) $4.21
e) $6.44
(c)
24
Calculate the price of the call option after the

stock price has already moved down in value once
(Cd)
a) $7.77
b) $14.35
c) $0
d) $4.21
e) $6.44
(d)
25
Calculate the price of the call option today (C0)

a) $7.77
b) $14.35
c) $0
d) $4.21
e) $6.44
63
(d)
26
The exercise price of warrants for the stock of ABC

Corporation is $17. You purchase the warrants for
$4 each when ABC's stock price is $20 a share. Each
warrant entitles you to purchase one share of ABC
Corporation.
Calculate your rate of return
assuming the warrant premium drops by 50 percent
and you sell your warrants when the stock reaches
$30 per share.
a)
b)
c)
d)
e)
37.5%
87.5%
137.5%
237.5%
337.5%

BioTech Industries has debentures outstanding (par value $1,000)
convertible into the company's common stock at $30. The coupon
rate is 11 percent payable semiannually and they mature in 10
years.
(d)
27
Calculate the conversion value of the bond if the

stock price is $27.00 per share.
a)
b)
c)
d)
e)
(c)
28
Calculate the straight-bond value assuming that

bonds of equivalent risk and maturity are yielding
13 percent per year compounded semiannually.
a)
b)
c)
d)
e)
(d)
29
$ 600.00
$ 700.00
$ 800.00
$ 900.00
$1,000.00
$757.37
$796.83
$889.82
$902.65
$942.65
At present, what would be the minimum value of the

bond?
a)
b)
c)
d)
e)
$600.00
$796.83
$889.82
$900.00
$1000.00
64
65
CHAPTER 18
1
Price using the B-S option pricing model

d1 = ln(120/125) + [(.03 + 5(.352))(.0833)]/(.35(.0833.5))
= -0.3288
d2 = -0.3288 - (.35(.0833.5)) = -0.4298
N(d1) = 0.3712
N(d2) = 0.3337
Call price = Pc = 120[0.3712 125(e-.03(.0833))(0.3337]
= $2.935
Put price = 2.935 + 125(e-.03(.0833)) 120 = $7.623
If you expected the yield curve to steepen, the

appropriate NOB futures spread strategy would be go short
the T-bond and long the T-note
If you expected the yield curve to flatten, the appropriate NOB futures spread strategy would
be go long the T-bond and short the T-note
First calculate the new prices of the T-bond and T-notes contracts using bond valuations
formulas with annual compounding. T-bond price = $100,580.21. T-note price =
$101,123.59.
NOB profit = (100580.21
101123.59) = $2144.17
98781.25)
(101468.80
F(0, T) = 1106.59 + 1106.59(.00833 - .0033) = 1112.12
Since the futures contract is trading above its

theoretical value the appropriate strategy would be to
short the futures contract and go long the index.
Since the futures contract is trading below its

theoretical value the appropriate strategy would be to go
long the futures contract and short the index.
You should short futures at $1250. Borrow at the rate of 0.833% (5%/(360/60)) to buy the
index at $1106.59. Hold for 60 days, then collect dividends and repay
loan.
The net profit =
1250 1106.59 1106.59(.00833 - .0033) = $137.84
10 Number of unhedged pounds = 120,000 3(37,500) = 7500
66
11
Basis now = 0.485 0.5595 = -$0.0745
12
Basis three months from now = 0.60 0.60 = $0
13
Profit on the futures contract

= (0.60 0.5595)(3)(37,500) = $4556.25
14
Effective price = [(120,000)(0.60) 4556.25]/120,000

= $67,443.75/120,000 = $0.5620
15
The price range is

650(1 0.0045)(1
$679.57
0.0067
0.003
0.0015)6
650(1
$685.71
0.0067
0.003
0.0015)6
0.0045)(1
16
F(0, 9)) = 650( 1 + 0.0067 + 0.003 0.0015)9 = $699.57
17
S(0) = 550/(1 + 0.0067 + 0.003)3 = $5.3515
18
F(0, 9) = 1200(1 + 0.0075)9 = $1283.47
19
If the stock rises the price one year for now will be =
50(1 + 0.25) = $62.50
If the stock falls the price one year for now will be =
50(1 - 0.25) = $37.50
20
Current stock price = $50

Exercise price = $45
Risk free rate = 2%
Price in one year if stock rises = 50(1.25) = $62.50
Price in one year if stock declines = 50(1.25) = $37.50
Intrinsic value of
Max[0, 62.50 45]
Intrinsic value of
Max[0, 37.50 45]
call option if stock rises to $62.50 =

= $17.50
call option if stock falls to $37.50 =
= $0
Estimate the number calls needed by setting:

The hedge portfolio will consist of one share of stock held
long plus some number of call options written.
Value of hedge portfolio if stock rises = Value of hedge
portfolio if stock falls
62.50 + (17.5)(n) = 37.50 + (0)(n)
n = -1.4286
21
Value of hedge portfolio today = 50 (1.4286)(C0) =

37.5/(1.02)
67
C0 = $9.26
22

Price in one year if stock rises 15% per six month period=
60(1.15)(1.15) = $$79.35
Price in one year if stock rises 15%, then falls 15% =
60(1.15)(0.85) = $58.65
Price in one year if stock declines 15% per period =
60(0.85)(0.85) = $43.35
23

Exercise price = $65
Risk free rate = 3% or 1.49% per six month period = (1.03)0.5
1 = 0.0149
Price in six months if stock rises 15% = 60(1.15) = $69
Price in six month if stock falls 15% = 60(0.85) = $51
Price in one year if stock rises 15% per six month period=
60(1.15)(1.15) = $$79.35
Price in one year if stock rises 15%, then falls 15% =
60(1.15)(0.85) = $58.65
Price in one year if stock declines 15% per period =
60(0.85)(0.85) = $43.35
Intrinsic value of
Max[0, 79.35 65]
Intrinsic value of
Max[0, 58.65 65]
Intrinsic value of
Max[0, 43.35 65]
call option if stock rises to $79.35 =

= $14.35
call option if stock falls to $58.65=
= $0
call option if stock falls to $43.35 =
= $0
Estimate the number calls needed by constructing a hedge

portfolio.
The hedge portfolio will consist of one share of stock held
long plus some number of call options written.
At the end of the first six month period:
79.35 + (14.35)(n) = 58.65 + (0)(n)
n = -1.44251
Value of hedge portfolio at the end of first six months = 69
(1.44251)(Cu) = 58.65/(1.0149)
Cu = $7.7719
68
24
Cd = 0. Since the ending stock prices of $58.65 and $43.35

are both below the exercise price.
25
To solve for the value of the call today (C0), first

determine the number of calls by constructing a hedge
portfolio where:
Right now:
69 + (7.7719)(n) = 51 + (0)(n)
n = -2.31603
Value of hedge portfolio now = 60 (2.31603)(C0) =
51/(1.0149)
C0 = $4.2092
26
Intrinsic value = $20.00 - $17.00 = $3.00, therefore

Speculative value = $4.00 - $3.00 = $1.00
New intrinsic value = $30 - $17.00 = $13.00
Warrant price = $13.00 + $0.50
= $13.50
Rate of return = (13.50 - 4)/4 = 237.5%

27
The bond is convertible into 33.333 shares of common stock

since $1000/$30 = 33.333
shares.
The conversion value is 33.333 x $27 = $900.00
28
29
1
(1.065) 20
Price = 55
0.065
1000
(1.065) 20
= $889.82
The minimum value of the bond would be at least the greater

of the two values, the
straight-debt value or the conversion value. In this case,
the minimum value is $900.00
69
(its conversion value).

Security Valuation Priciples

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1

The three step valuation process consists of 1) analysis of alternative economies

The general economic influences would include inflation, political upheavals,

Given an optimistic economic and stock-market outlook for a country, the

The importance of an industry's performance on an individual stock's performance

An example of a relative valuation technique is the Price/Cash Flow ratio.

In dividend discount models (DDM) with supernormal growth, supernormal

Which of the following is not a consideration in the three-step valuation process?

Which of the following is not considered a basic economic force?

The time pattern of returns.

Which of the following is correct?

The process of fundamental valuation requires estimates of all the following

Analysis of alternative economies

If intrinsic value > Market price, you should buy.

Low coupon bonds

According to the dividend growth model, if a company were to declare that it

Dividend growth is a function of

Dividend payout ratio.

The growth rate of equity earnings without external financing is equal to

Which of the following factors influence an investors required rate of return?

Retention rate plus return on equity.

The economys real risk-free rate (RFR)

The P/E ratio is determined by

The required rate of return.

What is the current value of these securities?

USE THE FOLLOWING INFORMATION FOR THE NEXT TWO PROBLEMS

What is the current value of these securities?

USE THE FOLLOWING INFORMATION FOR THE NEXT TWO PROBLEMS

What is the current value of these securities?

Rise more than 1%

Rise more than 3%

Rise less than 2%.

Rise more than 3%

USE THE FOLLOWING INFORMATION FOR THE NEXT TWO PROBLEMS

USE THE FOLLOWING INFORMATION FOR THE NEXT TWO PROBLEMS

USE THE FOLLOWING INFORMATION FOR THE NEXT FOUR PROBLEMS

The dividends for years 1, 2, and 3 are

$2, $2.08, $2.16

The future price of the stock in year 5 is

The present value today of dividends for years 1 to 5 is

The price of the stock today (P0) is

USE THE FOLLOWING INFORMATION FOR THE NEXT FOUR PROBLEMS

The dividends for years 1, 2, and 3 are

The future price of the stock in year 3 is

$1.5, $2.0, $2.05

The present value today of dividends for years 1 to 3 is

The price of the stock today (P0) is

Dividend = .09 x $110 = $9.90

Price = 9.90 0.16 = $61.87

Dividend = .08 x $50 = $4.00

Price = 4.00 0.15 = $26.67

Dividend = .07 x $63 = $4.41

Price = 4.41 0.10 = $44.10

Dividend = .08 x $52 = $4.16

Price = 4.16 0.11 = $37.82

% = P2/P1 = [(D0)(1 + g2)/(k2 - g2)] [(D0)(1 + g1)/(k1 - g1)] - 1

% = P2/P1 = [(D0)(1 + g2)/(k2 - g2)] [(D0)(1 + g1)/(k1 - g1)] - 1

% = P2/P1 = [(D0)(1 + g2)/(k2 - g2)] [(D0)(1 + g1)/(k1 - g1)] - 1