r= rf + risk premium

FV of portfolio= PV of portfolio*(1+required rate of return)

Present value =FV/ (1+r)n
U= E(r)- 0.5Aσ2
E(r)= p(r)
Sharp ratio= expected return - risk free/standard deviation
E(rc)=rf+y*[E(rp)-rf]
Y= E(rp)-rf/Aσ2p
Wmin(s) = (σb²-ρsbσsσb) / (σs² + σb² – 2ρsbσsσb)
Wmin(b)= 1 - Wmin(s)
Variance= w2σ2 + w2σ2 + 2wswb ρsbσsσb
E(rC) = rf +{[E(rP)-rf]/σP}σC

Wa=SDb/(SDb+SDa)

Expected rate of return for a stock = [D1 + (p1-p0)]/p0

PV of perpetuity= cash flow/ interest rate

How much more willing to offer = 两个 PV of perpetuity 对减

E(rp)= rf+β(rm-rf)

Abnormal profit (α) = 题目给的 E(rp) - 自己算的 E(rp)

Effective annual rate = (1 + r)2 – 1

Bond price = C* [1-(1 + r)-t] / r + [F/ (1 + r)t]

Bond price = [coupon/ (1 + r )n] + [ par value / ( 1 + r )n]

Total rate of return = [interest + (End of period value – Initial value) / initial value] *100

P0 = D1 / (k-g)

g = ROE*b

Required return (k) = rf + β [E(rm) – rf]

D0 = E (1 – b) 
D1 = D0 (1 + g) 

P/E ratio = P0 / E0

Expected P/E = P0/E1

Pv of growth opportunity P0 = E1 / k + PVGO

                                        PVGO = P0 – E1 / k

ROE > k, so the PV is negative

ROE = (1 – T)*[ROA + (ROA – r)*(D/E)]

ROE = NI/E = tax burden (NI/EBT)* interest burden (EBT/EBIT)* margin (EBIT/sales) *
turnover (sales/assets) * leverage (assets/equity)

Tutorial 1: The Investment Environment

2. Why would you expect securitization to take place only in highly developed capital
market?
Securitization is expected to take place in highly developed capital market as it requires
access to a large number of potential investors. To attract these investors, the capital
market needs to have (1) a safe system of business laws and low probability of
confiscatory taxation/regulation, (2) a well-developed investment banking industry, (3) a
well-developed system of brokerage and financial transactions, and (4) well-developed
media, particularly financial reporting.

3. What is the relationship between securitization and the role of financial

intermediaries in the economy? What happens to financial intermediaries as
securitization progresses?
Securitization leads to disintermediation; that is, securitization provides a means for
market participants to bypass intermediaries. For example, mortgage-backed securities
channel funds to the housing market without requiring that banks or thrift institutions
make loans from their own portfolios. As securitization progresses, financial
intermediaries must increase other activities such as providing short-term liquidity to
consumers and small business, and financial services.

4. Although we stated that real assets constitutes the true productive capacity of an
economy, it is hard to conceive of a modern economy without well-developed
financial markets and security types. How would the productive capacity of the U.S.
economy be affected if there were no markets in which to trade financial assets?
Financial assets make it easy for large firms to raise the capital needed to finance their
investments in real assets. If General Motors, for example, could not issue stocks or
 bonds to the general public, it would have a far more difficult time raising capital.
Contraction of the supply of financial assets would make financing more difficult,
thereby increasing the cost of capital. A higher cost of capital results in less investment
and lower real growth.

5. Firms raise capital from investors by issuing shares in the primary markets. Does
this comply that corporate financial managers can ignore trading of previously
issued shares in secondary market?
Even if the firm does not need to issue stock in any particular year, the stock market is
still important to the financial manager. The stock price provides important information
about how the market values the firm's investment projects. For example, if the stock
price rises considerably, managers might conclude that the market believes the firm's
future prospects are bright. This might be a useful signal to the firm to proceed with an
investment such as an expansion of the firm's business.
In addition, the fact that shares can be traded in the secondary market makes the shares
more attractive to investors since investors know that, when they wish to, they will be
able to sell their shares. This in turn makes investors more willing to buy shares in a
primary offering, and thus improves the terms on which firms can raise money in the
equity market.
7. Lanni Products is a start-up computer software development firm. It currently owns
computer equipment worth $30,000 and has cash on hand of $20,000 contributed by
Lanni’s owners. For each of the following transactions, identify the real and/or
financial assets that trade hands. Are any financial assets created or destroyed in the
transaction?
a. Lanni takes out a bank loan. It receives $50,000 in cash and signs a note
promising to pay back the loan over 3 year
The bank loan is a financial liability for Lanni. Lanni's IOU is the bank's financial
asset. The cash Lanni receives is a financial asset. The new financial asset created
is Lanni's promissory note held by the bank.

b. Lanni uses the cash from the bank plus $20,000 of its own finds to finance the
development of new financial planning software.
The cash paid by Lanni is the transfer of a financial asset to the software
developer. In return, Lanni gets a real asset, the completed software. No financial
assets are created or destroyed. Cash is simply transferred from one firm to
another.

c. Lanni sells the software product to Microsoft, which will market it to the
public under the Microsoft name. Lanni accepts payment in the form of
1,250 shares of Microsoft stock.
Lanni sells the software, which is a real asset, to Microsoft. In exchange Lanni
receives a financial asset, 1,250 shares of Microsoft stock. If Microsoft issues new
 shares in order to pay Lanni, this would constitute the creation of new financial
asset.

d. Lanni sells the shares of stock for $100 per share and uses part of the
proceeds to pay off the bank loan.
In selling 1,250 shares of stock for $1,250,000, Lanni is exchanging one financial
asset for another. In paying off the IOU with $50,000, Lanni is exchanging
financial assets. The loan is "destroyed" in the transaction, since it is retired when
paid.
8. Reconsider Lanni Products from the previous problem.
(a) Prepare its balance sheet just after it gets the bank loan. What is the ratio of real
assets to total assets?
Debit cash 50,000
Credit bank loan 50,000
balance sheet
cash   70000 bank loan   50000
computer 30000 share equity 50000
total 100000   100000
 

Ratio of real to total assets 30,000/100,000= 0.30

(b) Prepare the balance sheet after Lanni spends the $70,000 to develop its software
product. What is the ratio of real assets to total assets?
balance sheet
computer 30000 bank loan   50000
software development 70000 shareholders's equity 50000
100000   100000
 

Ratio of real to total assets 100,000/100,000= 0.30

(c) Prepare the balance sheet after Lanni accepts the payment of shares from
Microsoft (assuming the share price is $80 per share). What is the ratio of real
assets to total assets?

13. Give an example of three financial intermediaries and explain how they act as a
bridge between small investors and large capital markets or corporations.
- Mutual funds accept funds from small investors and invest, on behalf of these
investors, in the national and international securities markets.
- Pension funds accept funds and then invest, on behalf of current and future retirees,
thereby channeling funds from one sector of the economy to another.
 - Venture capital firms pool the funds of private investors and invest in start-up firms.
- Banks accept deposits from customers and loan those funds to businesses, or use the
funds to buy securities of large corporations.

14. The average rate of return on investments in large stocks have outpaced that on
investments in Treasury bills by about 8% since 1926. Why, then, does anyone
invest in Treasury bills?
Treasury bills serve a purpose for investors who prefer a low-risk investment. The lower
average rate of return compared to stocks is the price investors pay for predictability of
investment performance and portfolio value.

15. What are some dis/advantages of top-down versus bottom-up investing style?
- With a "top-down" investing style, you focus on asset allocation or the broad
composition of the entire portfolio, which is the major determinant of overall
performance. Moreover, top-down management is the natural way to establish a
portfolio with a level of risk consistent with your risk tolerance. The disadvantage of
an exclusive emphasis on top-down issues is that you may forfeit the potential high
returns that could result from identifying and concentrating in undervalued securities
or sectors of the market.
- With a "bottom-up" investing style, you try to benefit from identifying undervalued
securities. The disadvantage is that you tend to overlook the overall composition of
your portfolio, which may result in a non-diversified portfolio or a portfolio with a
risk level inconsistent with your level of risk tolerance. In addition, this technique
tends to require more active management, thus generating more transaction costs.
Finally, your analysis may be incorrect, in which case you will have fruitlessly
expended effort and money attempting to beat a simple buy-and-hold strategy.

Tutorial 1: Chap 2 Assets Classes and Financial Instruments

1. In what ways is preferred stock like long-term debt? In what way is it like equity?
- Preferred stock is like long-term debt in that it typically promises a fixed payment
each year. In this way, it is a perpetuity. Preferred stock is also like long-term debt in
that it does not give the holder voting rights in the firm.
- Preferred stock is like equity in that the firm is under no contractual obligation to
make the preferred stock dividend payments. Failure to make payments does not set
off corporate bankruptcy. With respect to the priority of claims to the assets of the
firm in the event of corporate bankruptcy, preferred stock has a higher priority than
common equity but a lower priority than bonds.
2. Why money market securities are sometimes referred to as cash equivalents?
 Money market securities are called "cash equivalents" because of their great liquidity.
The prices of money market securities are very stable, and they can be converted to cash
(i.e., sold) on very short notice and with very low transaction costs.

4. What would you expect to happen to the spread between yields on commercial
paper and Treasury bills if the economy were to enter steep recession?
The spread will widen. Deterioration of the economy increases credit risk, that is, the
likelihood of default. Investors will demand a greater premium on debt securities subject
to default risk.

5. What are the key differences between common stock, preferred stock, and
corporate bonds?
- Common stock represents an ownership share in a publicly held corporation.
Common shareholders have voting rights and may receive dividends.
- Preferred stock also represents an ownership in a corporation. They differ from
common stock as they pay a fixed dividend for the life of the stock.
- Corporate bonds are long-term debt issued by corporations, typically paying
semiannual coupons and returning the face value of the bond at maturity.
11. Consider the three stocks in the following table. Pt represents price at time t, and Q
represents shares outstanding at time t. Stock C splits two for one in the last period.
P0 Q0 P1 Q1 P2 Q2
A 90 100 95 100 95 100
B 50 200 45 200 45 200
C 100 200 110 200 55 400

a. Calculate the rate of return on a price-weighted index of the three stocks for the
first period (t = 0 to t = 1).
At t= 0, the value of the price-weighted index is: ($90 + $50 + $100)/3 = 80
At t= 1, the value of the price-weighted index is: ($95 + $45 + $110)/3 = 83.33
The rate of return = ((current value-original value)/original value)*100
= ((83.33-80)/80)*100 = 4.1625%
= (index 1/index 0)-1
=(83.33/80)-1=0.0416225=4.1625
b. What must happen to the divisor for the price-weighted index in year 2?
In the absence of a split, Stock C would sell for 110, the value of the index = 83.33
83.33 = (95+45+55)/d
d = 195/83.33 = 2.340

c. Calculate the rate of return of the price-weighted index for the second period (t = 1
to t = 2).
The return is zero. The index remains unchanged because the return for each stock
separately equals zero.
(P1  P2, the Price unchanged)
13. An investor is in a 30% combined federal plus state tax bracket. If corporate bonds
offer 6% yields, what yield must municipals offer for the investor to prefer them to
corporate bonds?
The after-tax yield on the corporate bonds is: 0.09 x (1 - 0.30) = 0.063 or 6.3%.
Therefore, the municipals must offer at least 6.3% yields.
Tutorial 2: Chap 3 How Securities are traded
1.what are the differences among a limit buyer order, a limit sell order, and a market order?
 Limit buy order instructs the broker to buy the shares if and when the price of those
shares below the specific price.
 Limit buy order is when a person order the broker to sell the shares if and when the price
of those shares above the specific price.
 Market order refers to the buy or sell orders that are to be executed immediately.

3. How does buying on margin magnify both the upside potential and the downside risk of an
investment portfolio?
 The use of borrowed money/leverage
 May have a lot of profit or loss
 If total investment =RM1k (total assets), we have only RM500 (equity), thus need to
borrow RM500 (liabilities) in order to have RM1k to invest to Toyota shares.
 Loan of RM500: interest rate=10%, interest payment per year: RM50 (RM500*10%)
 Case 1: Stock price increase… therefore your investment has increase to RM1100 in year
2021
Profit earned from investment= RM1100-RM1000 = RM100
Profit after interest = RM100 - RM50 = RM50
Rate of return= RM50/RM500 =10%
 Case 2: Stock price decrease… therefore your investment has decrease to RM800 in year
2021
Loss incurred from investment= RM1000-RM800 = RM200
Loss after interest = RM200+ RM50 = RM250
Rate of return= RM250/RM500 = -50%
 Margin is a type of leverage that allows investors to post only a portion of the value of
the security they purchase. As such, when the price of the security rises or falls, the gain
or loss represents a much higher percentage, relative to the actual money invested.
6. Dee Trader opens a brokerage account and purchases 300 shares of Internet Dreams at $40 per
share. She borrow $4,000 from her broker to help pay for the purchase. The interest on the loan
is 8%
a. What is the margin in Dee’s account when she first purchase the stock?
The value of shares purchase=300 shares*$40
= $12,000
Loan form broker = $4,000
Equity = ($12000-$4000) = $8,000
Initial margin percentages = equity in account/ value of stock
= $8,000/$12,000
 =66.67%

b. If the share price falls to $30 per share by the end of the year, what is the remaining
margin in her account?
The value of shares purchase = 300 shares*$30
= $9,000
Loan form broker = $4,000+ interest expense at 8%
=$4000*1.08
= 4,320 (liabilities)
Equity = $9,000-$4,320 = $4,680
Margin ratio = equity in account/value of stock
= $4,680/9,000
= 52%

c. If the maintenance margin requirement is 30%, will she receive a margin call?
Since 52% is above the 30%, she won’t receive a margin call.

d. What is the rate of return on her investment?

Rate of return = (current equity –initial equity)/initial equity
= (4680-8000)/8000
= -0.415/-41.5%
Alternative:
[(initial value of stock- Ending value of stock) + interest on loan)]/ initial equity
[(12000-9---) +4000*8%]/4680 =-0.415
7. Old Economy Traders opened an account to short sell 1,000 shares of Internet Dreams at $40
per share. The initial margin requirement was 50%. (The margin account pays no interest.) A
year later, the price of Internet Dreams has risen from $40 to $50, and the stock has paid a
dividend of $2 per share.
a. What is the remaining margin in the account?
(Value=40,000, margin 50%, equity=?)
50% = equity/value of stock
Equity = 0.5*(1000*40)
= 20,000
Total assets = short sale value (L-borrow) + initial margin require (E)
= (1,000shares*$40) + ((1,000shares*$40)*50%)
= $40,000 + $20,000
= $60,000
The value of shares at the end of the year + dividend = (1000 shares*$50) +
(1000shares*$2)
= $52,000
Remaining margin on account = $60,000 - $52,000
= $8,000
 (40-50)*1000 = -10,000
Therefore, margin decrease by 10,000. In addition, need to pay dividend 2000
(1000shares*2)
The remaining margin = 20,000-10,000-(1000*2) = 8000

b. If the maintenance margin requirement is 30%, will Old Economy receive a margin call?
Margin ratio = equity/ value of stock
= 8,000/50,000
= 0.16/16%
Since 16% is below the 30%, Old Economy Trade will received a margin call.

c. What is the rate of return on the investment?

Rate of return = (new equity –old equity)/old equity
= (8,000-20,000)/20,000
= -0.6/-60%
[(40-50(*1000)-(2*1000))/(40*1000)
9. You are bullish on Telecom stock. The current market price is $50 per share, and you have
$5,000 of you own to invest. You borrow an additional $5,000 from your broker at an interest
rate of 8% per year and invest $10,000 in the stock.
a. What will be your rate of return if the price of Telecom stock goes up by 10% during the
next year? The stock currently pays no dividend.
Number of shares own = $10,000/$50
= 200 shares
Increase in shares value = $10,000*10%
= $1,000 (profit before interest)
Interest expense paid = $5,000*8%
= $400
Rate of return = (1,000-400)/5,000
= 0.12/12%

b. How far does the price of Telecom stock have to fall for you to get a margin call if the
maintenance margin is 30%? Assume the price fall happens immediately.
Maintenance margin = (equity in account/ value of shares)
0.30 = ((No. of shares*shares price) - amount borrowed) / (No. of
shares*SP)
0.30 = ((200*SP))-$5,000)/ (200*SP)
0.30*200*SP = 200*SP - $5,000
60Sp = 200Sp - $5,000
140Sp= $5,000
Sp = 5,000/140= 35.71
Therefore. The price should be $35.71 or lower to get a margin call
14. Here is some price information on FinCorp stock. Suppose that FinCorp in a dealer market.
Bid: 55.25(selling price) Ask: 55.50(buying price)
a. Suppose you have submitted an order to your broker to buy at market. At which price
will your trade be executed?
The trade will be executed at ask price, 55.50

b. Suppose you have submitted an order to sell at market. At what price will your trade be
executed?
The trade will be executed at ask price, 55.25

c. Suppose you have submitted a limit order to sell at $55.62. What will happen?
The trade will not be executed as the selling price (55.62) is above the selling price
(55.25)
d. Suppose you have submitted a limit order to buy at $55.37. What will happen?
The trade will not be executed as the purchase price (55.37) is lower than the ask
price(55.50)
15. You’ve borrowed $20,000 on margin to buy shares in Ixnay, which is now selling at $40 per
shares. Your account starts at the initial margin requirement of 50%. The maintenance margin is
35%. Two days later, the stock price falls to $35 per share.
(value of share=?, Borrowed= 20,000, margin= 50%)
a. Will you receive a margin call?
Margin= equity/value of shares
0.5= (value of share-borrowed)/value of shares
0.5 = value of shares - $20,000/value of shares
0.5 value of shares = value of shares - $20,000
0.5 value of shares = $20,000
Value of shares = $40,000
No. of shares own = $40,000/$40
= 1,000 shares
Value of shares as price fall to $35 = 1,000 shares*$35
= $35,000
Margin ratio = equity/value of shares
= ($35,000 - $20,000)/ $35,000
= 0.4286/42.8571%
Since the margin ration of 42.8571% exceed the required maintenance margin, there is
not margin call received.
b. How low the price of Ixnay shares fall before you receive a margin call?
Maintenance margin = (equity in account/ value of shares)
0.35 = ((No. of shares*shares price) - amount borrowed) / (No. of
shares*SP)
0.35 = ((1,000*SP))-$20,000)/ (1,000*SP)
 0.35*1,000*SP = 1,000*SP - $20,000
350Sp = 1,000Sp - $20,000
650Sp= $20,000
Sp =$30.77
To receive a margin call, the shares price need to be $30.77 or lower.
Tutorial 3: Chap 4 Mutual Fund and other Investment companies
1. Would you expect a typical open-end fixed income mutual fund to have higher or lower
expenses than a fixed-income unit investment trust? Why?
 The unit investment trust should have lower operating expenses. Because the
investment trust portfolio is fixed once the trust is established, it does not have to
pay portfolio managers to constantly monitor and re balance the portfolio as
perceived needs or opportunities change. Because the portfolio is fixed, the unit
investment trust also incurs virtually no trading costs.

3. Open-end equity mutual funds find it necessary to keep a small fraction of total
investments, in very liquid money market assets. Closed-end funds do not have to
maintain such a position in ‘cash-equivalent’ securities. What difference between open-
end and closed-end funds might account for their differing policies?
 Open-end funds are obligated to redeem investor's shares at net asset value
(NAV), and thus must keep cash or cash-equivalent securities on hand in order to
meet potential redemptions. Closed-end funds do not need the cash reserves
because there are no redemptions for closed-end funds. Investors in closed-end
funds have to sell their shares to other investors when they wish to cash out.

6. What are the advantages and disadvantages of exchange-traded funds versus mutual
funds?
 Advantages of an ETF over a mutual fund is that ETFs are continuously traded
during the day and can be sold or purchased on margin. There are no capital gains
tax triggers when an ETF is sold (shares are just sold from one investor to
another). Investors buy from brokers, thus eliminating the cost of direct marketing
to individual small investors. This implies lower management fees.
 Disadvantages of an ETF over a mutual fund is that the prices can depart from
NAV (unlike an open-end fund) and the broker commissions are incurred when
buying and selling (unlike a no-load fund)

7. An open-end fund has a net assets value of $10.7 per share. It is sold with a front-end
load of 6%. What is the offering price?
 NAV= offering price*(1-load)
NAV= offering price*(100%-6%)
$10.7= offering price*94%
Offering price= $11.38
8. If the offering price of an open-end fund is $12.30 per share and the fund is sold with a
front-end load of 5%, what is its net assets value?
 NAV= $12.30*95%
= $11.69
12. Corporate Fund started the year with a net asset value of $12.50. By year-end, its NAV
equaled $12.10. The fund paid year-end distributions of income and capital gains of $1.50.
What was the (pretax) rate of return to an investor in the fund?
 rate of return= (NAV1 – NAV0 + Income and capital Gain distribution)/NAV0
= ($12.1- $12.5+ $1.5)/$12.5
= 0.088/ 8.8%

13. A closed-end fund starts the year with a net asset value of $12. By year-end, NAV equals
$12.10. At the beginning of the year, the fund was selling at a 2% premium to NAV. By the
end of the year, the fund is selling at a 7% discount to NAV. The fund paid year-end
distributions of income and capital gains of $1.50.
a. What is the rate of return to an investor in the fund during the year?
 Price = NVA0*(1+premium/discount) = 12*(100+2%) =12.24
 Price = NVA1*(1+premium/discount) = 12.1*(100-7%) =11.25
 rate of return= (NAV1 – NAV0 + Income and capital Gain distribution)/NAV0
= ($11.253- $12.24+ $1.5)/$12.24
= 0.0419/ 4.19%

b. What would have been the rate of return to an investor who held the same securities
as the fund manager during the year?
 rate of return= (NAV1 – NAV0 + Income and capital Gain distribution)/NAV0
= ($12.1- $12.0+ $1.5)/$12.0
= 0.13333/ 13.33%

16. The new fund had average daily assets of $2.2 billion last year. The fund sold $400
million worth of stock and purchased $500 million during the year. What was its turnover
ratio?
 Turnover ratio= Total assets sold/Total assets held
= $400 million/ $2,200 million
= 0.1818/18.18%

18. You purchased 1,000 shares of the New Fund at a price of $20 per share at the beginning
of the year. You paid a front-end load of 4%. The securities in which the fund invests
increase in value by 12% during the year. The fund’s expense ratio is 1.2%. What is your
rate of return on the fund if you sell your shares at the end of the year?
 NAV0= offering price*(100%-4%)
1000 shares*$20= offering price*96%
Offering price= 20,000/0.96
= 20,833.33
Shares increase in value= $20,000*(12%-1.2%)
= $20,000(10.8%)
= $2,160
NAV after increase in share value= $20,000+$2,160
 = $22,160
Rate of return= (NAV1 – NAV0 + Income and capital Gain distribution)/NAV0
= ($22,160- $20,833.33)/$20,833.33
= 0.06368 /6.368%

Tutorial 4: Chap 5 Risk, Return, and the Historical Record

1. The fisher equation tells us that the real interest rate approximately equals the nominal
rate minus the inflation rate. Suppose the inflation rate increases from 3% to 5%. Does
Fisher equation imply that this increase will result in a fall in real rate of interest?
 The Fisher equation predicts that the nominal rate will equal the equilibrium real
rate plus the expected inflation rate. Hence, if the inflation rate increases from 3%
to 5% while there is no change in the real rate, then the nominal rate will increase
by 2%. On the other hand, it is possible that an increase in the expected inflation
rate would be accompanied by a change in the real rate of interest. While it is
conceivable 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.

3. The Narnian stock market had a rate of return of 45% last year, but the inflation rate was
30%. What was the real rate of return to Narnian investors?
 Real rate of return= (Nominal interest rate-inflation rate)/(1+ inflation rate)
= (0.45 -0.30)/(1+0.30)
= 0.1154/11.54%
 Exact fisher effect
(1+nominal interest rate)= (1+real interest rate) (1+ inflation rate)
(1+0.45)= (1+real interest rate)*(1+0.3)
Real rate = 1.45/1.3-1 = 11.54%
 Approximated fisher effect
Nominal interest rate= real interest rate inflation rate
45% = real rate +30%
Real rate = 15%

4. You have $5,000 to invest for the next year and are considering three alternatives:
a. A money market fund with an average maturity of 30 days offering a current yield of
3% per year.
b. A 1 year savings deposit at a bank offering an interest rate of 4%.
c. A 20 year U.S treasury bond offering a yield to maturity of 5% per year
What role does your forecast of future interest rates play in your decisions?
 For the money market fund, your holding-period return for the next year depends
on the level of 30-day interest rates each month when the fund rolls over maturing
securities. The one-year savings deposit offers a 4% holding period return for the
 year. If you forecast that the rate on money market instruments will increase
significantly above the current 3% yield, then the money market fund might result
in a higher HPR than the savings deposit.
 The 20-year Treasury bond offers a yield to maturity of 5% per year, which is 150
basis points higher than the rate on the one-year savings deposit; however, you
could earn a one year HPR much less than 4% on the bond if long-term interest
rates increase during the year.
 If Treasury bond yields rise above 5%, then the price of the bond will fall, and the
resulting capital loss will wipe out some or all of the 5% return you would have
earned if bond yields had remained unchanged over the course of the year.

7. Suppose your expectations regarding the stock price are as follow:

State of the Probability Ending HPR (including
Economy Price dividend)
Boom 0.35 $140 44.5%
Normal growth 0.30 $110 14.0%
Recession 0.35 $80 -16.5%
Use the Equation 5.11 and 5.12 to compute the mean and standard deviation of the HPR
on stocks.
Mean= sum of periodic return/ number of periods
= (44.5% + 14% + -16.5%) / 3
= 14%
E(r) = p(r)
=0.35(44.5%) + 0.30(14%) +0.35(-16.5%)
= 14%
Standard deviation=p*(r-E(r))
=0.35(44.5-14)^2 + 0.30(14-14)^2 + 0.35(-16.5-14)^2
= 325.5875 + 0 + 325.5875
= 651.175
= 25.5181

8. Derive the probability distribution of the 1-year HPR on a 30-year U.S. Treasury bond
with an 8% coupon if it is currently selling at par and the probability distribution of its
yield to maturity a year from now is as follows:
State of the Probability YTM
Economy
Boom 0.2 11.0%
Normal growth 0.5 8.0%
Recession 0.3 7.0%

For simplicity, assume the entire 8% coupon is paid at the end of the year rather than
every 6 months.
 9. Determine the Standard deviation of a random variable q with the following probability
distribution:
Value of q Probability
0 0.25
1 0.25
2 0.50
E(r) = p(r)
= (0.25*0) + (0.25*1) + (0.50*2)
= 1.25
Standard deviation= p*(r-E(r))
=0.25(0-1.25)^2 + 0.25(1-1.25)^2 + 0.5(2-1.25)^2
= 0.390625 + 0.0156 + 0.2815
= 0.6877
= 0.8293 / 82.93%

13. During a period of severe inflation, a bond offered a nominal HRP of 80% per year. The
inflation rate was 70% per year.
a. What was the real HRP on the bond over the year?
Real rate of return= (Nominal interest rate-inflation rate)/ (1+ inflation rate)
= (0.80 -0.70)/ (1+0.70)
= 0.05882 / 5.882%

b. Compare this real HRP to the approximation real interest rate=nominal rate –
inflation rate
Approximation real interest rate=nominal rate –inflation rate
= 0.8-0.7 = 0.1/10%

Fisher effect equation

(1+nominal interest rate)= (1+real interest rate) (1+ inflation rate)
(1+nominal interest rate)= 1+real interest rate + Inflation rate+ real rate*inflation rate
Nominal interest rate = real interest rate + Inflation rate+ real rate*inflation rate
Real rate*inflation rateamount very small, hence ignore (real rate*inflation rate)
Tutorial 5: Chap 6 Capital Allocation to Risky Assets
4. Consider a risky portfolio. The end-of- year cash flow derived from the portfolio will be
either $70,000 or $200,000 with equal probabilities of 0.5. The alternative risk-free pays
6% per year.
a. If you require a risk premium of 8%, how much will you be willing to pay for the
portfolio?
Possibility 1: 50% of your portfolio value will be 70,000 (economy is getting worst)
Possibility 1: 50% of your portfolio value will be 200,000 (economy is getting better)
The expected cash flow= (0.5*70,000) + (0.5*200,000)
= $135,000
Rate of required return when risk premium is 8 %
r= rf + risk premium = 6%+8% =14%
Present value of portfolio =FV/ (1+r)n
= $135,000/(1+0.14)1
= $118,421.0526

b. Suppose that the portfolio can be purchased for the amount you found in (a). What
will be the expected rate of return on the portfolio?
FV of portfolio= PV of portfolio*(1+required rate of return)
$118,421 × [1 + E(r)] = $135,000
1 + E(r) = 1.14
E(r) = 0.14/14%

c. Now suppose that you require a risk premium of 12%. What price are you willing to
pay?
The expected cash flow= (0.5*70,000) + (0.5*200,000)
= $135,000
Rate of required return = 6%+12% =18%
Present value =FV/ (1+r)n
= $135,000/(1+0.18)1
= $114,407

d. Comparing your answers to (a) and (c), what do you conclude about the relationship
between the required risk premium on a portfolio and the price at which the portfolio
will sell?
8% , 118421
12% , 114407
Risk premium on a portfolio and its price have a negative relationship. When risk
premium is higher, price is lower, vise versa.
 5. Consider a portfolio that offers an expected rate of return of 12% and a standard
deviation of 18%. T-bills offer a risk-free 7% rate of return. What is the maximum level
of risk aversion for which the risky portfolio is still preferred to T-bills?
For risky portfolio
U= E(r)- 1/2Ao2
= 0.12- (1/2)*A*(0.182)
= 0.12-0.0162A
For risk free assets
U= 7%-0.5*(0)2*A
0.7 = 7%-0.5*(0)2*A
In order for the risk portfolio to be preferred to T-bill, Utility of your risky portfolio>
Utility risk-free assets
0.12-0.0162A>0.07
-0.0162A>-0.05
A>3.09
Use these inputs for problem 13 through 19: You manage a risky portfolio with an expected rate
of return of 18% and a standard deviation of 28%. The T-bill rate is 8%
13. Your client choose to invest 70% of a portfolio in your fund and 30% in an essentially
risk-free money market fund. What are the expected value and standard deviation of the
rate of return of his portfolio?
Expected rate of return for client
E(r)= p(r)
= 0.70(0.18)+0.30(0.08)
= 0.15/15%
Standard deviation= 0.70*0.28 =0.196/19.6%

14. Suppose that your risky portfolio includes the following investments in the given
proportions:
Stock A 25%
Stock B 32%
Stock C 43%
What are the investment proportions of your client’s overall portfolio, including the
position in T-bills?
Stock A = 0.25*0.7 = 0.175/17.5%
Stock B = 0.32*0.7 = 0.224/22.4%
Stock C = 0.43*0.7 = 0.301/30.1%
Total weight of risky assets= 0.7
T-bill : 0.3

15. What is the reward-volatility (Sharpe) ratio (S) of your risky portfolio? Your client’s?
Sharp ratio= expected return-risk free/standard deviation
= (18%-8%)/28%
 = 35.71%
Expected rate of return for client= E(r)of risky asset* Weight of risky assets+ E(r) of risk-
free*weight of risk-free assets
= 0.7*0.18+0.3*0.08=15%
Sharp ratio for client= (15%-8%)/0.196
= 0.3571

17. Suppose that your client decides to invest in your portfolio a proportion y of the total
investment budget so that the overall portfolio will have an expected rate of return of
16%.
a. What is the proportion
E(rc)=rf+y*[E(rp)-rf]
16%= 8%+y(18%-8%)
Y= (16-8)%/10%
Y= 0.8/80%

b. What are your client’s investment proportions in your three stocks and the T-bill
find?
Stock A = 0.25*0.8 = 0.2
Stock B = 0.32*0.8 = 0.256
Stock C = 0.43*0.8 = 0.344
T-bill=0.2

c. What is the standard deviation of the rate of return on your client’s portfolio?
Standard deviation= y*standard deviation
=0.8*0.28
= 0.224 / 22.4%

19. Your client’s degree of risk aversion is A=3.5

a. What proportion, y of the total investment should be invested in your fund?
Y= E(rp)-rf/Ao2p
= (18%-8%)/3.5*0.282
= 36.44%

b. What are the expected value and standard deviation of the rate of return on your
client’s optimized portfolio?
E(rc)=rf+y*[E(rp)-rf]
= 8%+36.44%*(18-8)%
= 11.64%
Standard deviation= y*standard deviation
= 36.44%*28%
= 10.203%
Tutorial 6: Chap 7 Efficient Diversification
1. Which of the following factors reflect pure market risk for a given corporation
a. Increased short-term interest rates (systematic risk, cannot control)
b. Fire in the corporate warehouse (non-systematic risk, only certain industry)
c. Increased insurance costs (non-systematic risk, insurance charged based on capital
loss, if consider lower risk, charged lower)
d. Death of the CEO (non-systematic risk)
e. Increase labor cost (systematic risk)
(a) and (e). Short-term rates and labour issues are factors that are common to all firms
and therefore must be considered as market risk factors. The remaining three factors are
unique to this corporation and are not a part of market risk.
2. When adding real estate to an assets allocation program that currently includes only
stocks, bonds, and cash, which of the properties of real estate returns most affects
portfolio risk? Explain. (portfolio variance= w2σ2 + w2σ2 + 2wswb ρsbσsσb)
a. Standard deviation
b. Expected return
c. Correlation with returns of the other asset classes
(a) and (c). After real estate is added to the portfolio, there are four asset classes in the
portfolio: stocks, bonds, cash and real estate. Portfolio variance now includes a variance
term for real estate returns and a covariance term for real estate returns with returns for
each of the other three asset classes. Therefore, portfolio risk is affected by the variance
or standard deviation of real estate returns and the correlation between real estate returns
and returns for each of the other asset classes. (Note that the correlation between real
estate returns and returns for cash is most likely zero.)
3. Which of the following statement about the minimum-variance portfolio of all risky
securities is valid? (Assume short sales are allowed) Explain.
Minimum-varaince means lower standard deviation
a. Its variance must be lower than those of all other securities or portfolios.
b. Its expected return can be lower than the risk-free rate. (default risk is associated
with)
c. It may be the optimal risky portfolio.
d. It must include all individual securities.
The statement “Its variance must be lower than those of all other securities or portfolios”,
about the minimum variance portfolio of all risky securities is valid because the standard
deviation of the minimum variance portfolio is smaller than that of the standard deviation
of either of the individual assets, which illustrates the effect of diversification.
The following data apply to Problem 4 through 10: A pension fund manager is
considering three mutual funds. The first is a stock fund, the second is a long-term bond
fund, and the third is a money market fund (always represents risk-free assets) that provides a
safe return of 8%. The characteristics of the risky funds are as follows:

Expected Standard Deviation

Return
Stock fund (S) 20% 30%
Bond fund (B) 12% 15%
The correlation between the fund return is 0.10
4. What are the investment proportions in the minimum-variance portfolio of the two risky
funds, and what are the expected value and standard deviation of its rate of return?
Covariance matrix
Stock Bond
Stock 302 = 900 30*15*0.1
(s) =45
Bond 30*15*0.1 152=225
=45
Wmin(s) = (σb²-ρsbσsσb) / (σs² + σb² – 2ρsbσsσb)
= (225-45)/(900+225-(2*45))
= 0.1739

Wmin(s) = (σb²-ρsbσsσb) / (σs² + σb² – 2ρsbσsσb)

= (0.152-0.1*0.30*0.15)/ (0.302+0.152-2*0.1*0.3*0.15)
= 0.018/0.1035
= 0.1739/17.39%

Wmin(b)= 1-0.1739
= 0.8261/82.61%
Expected return= WsE(rs) + WbE(rb)
= (0.1739*0.2) + (0.8261*0.12)
= 0.1339/ 13.39%
Variance= w σ + w2σ2 + 2wswb ρsbσsσb
2 2

= (0.17392*302) + (0.82612*152) + 2*0.1739*0.8261*45

= 193.6956
Standard deviation = 0.1392/13.92%
portfolio variance= we2σe2 + wd2σd2 + 2wewd ρedσeσe
portfolio variance= we2σe2 + (1-we2)σd2 + 2wewd ρedσeσe
insert formula

9. You are require that your portfolio yield an expected return of 14%, and that it be
efficient, that is, on the steepest feasible CAL
a. What is the standard deviation of your portfolio
 E(r) overall= 0.14
E(rC) = rf +{[E(rP)-rf]/σP}σC
0.14 = 0.08+[(0.1339-0.08)/0.1496] σC
0.06 = 0.3603 σC
σC= 0.1665/16.65%

b. What is the proportion invested in the money market fund and each of the two risky
fund?
Optimal risky portfolio

10. If you were to use only the two risky funds and still require an expected return of 14%,
what would be the investment proportions of your portfolio? Compare its standard
deviation to that of the optimized portfolio in Problem 9. What do you conclude?
E(rp)=WsE(rs) + WbE(rb)
0.14= 0.2ws+0.12(1-ws)
0.14=0.2ws+0.12-0.12ws
0.02=0.08ws
Weight of stock = 0.25
Weight of bond = 1-0.25=0.75
Variance= w12sd12+w22sd22+2w1w2Cov(sd1,sd2)
= 0.252 (900)+0.752(225)+2(0.25)(0.75)(45)
= 199.6875
SD= 14.13%

12. Suppose that there are many stocks in the security market and that the characteristics of
stocks A and B are given as follows:
Stoc Expected Standard
k return Deviation
A 10% 5%
B 15 10
Suppose that it is possible to borrow at the risk-free rate rf. What must be the value of the
risk-free rate? (Hint: Think about constructing a risk-free portfolio from stocks A and B)
When correlation= -1
Wa=SDb/(SDb+SDa)
= 10/(10+5)
= 0.6667
Wb= 1-0.6667=0.3333
E(r)= (0.6667*0.1)+(0.3333*0.15)
= 0.11667/11.667%

Variance= w12sd12+w22sd22+2w1w2Cov(sd1,sd2)
Variance= w12sd12+w22sd22+2w1w2sd1sd2
0= w1252+(1-w1)102+2w1(1-w1)*5*10
Tutorial 8: Chapter 9 The capital Asset Pricing Model
1. What must be the beta of a portfolio with E(rp)=18%, if rf=6% and E(rm)=14%?
E(rp)= rf+β(rm-rf)
0.18= 0.06+ β(0.14-0.06)
β(0.08)= 0.12
β= 1.5

2. The market price of a security is $50. Its expected rate of return is 14%. The risk-free rate
is 6%, and the market risk premium is 8.5%. What will be the market price of the security
if its correlation coefficient with the market portfolio doubles (and all other variables
remain unchanged)? Assume that the stock is expected to pay a constant dividend in
perpetuity.
Expected retrun higher, stock price lower)
Current market risk premium =8.5
New market risk premium= 8.5%*2=17%
New rate of return on portfolio
E(rp)= rf+β(rm-rf)
= 6%+1(17%)
= 23%
Price= Dividend/rate of return
$50= Dividend/0.14
Dividend= $7
New market price= Dividend/ new rate of return
New market price= $7/0.23
= $30.43
For problem 17 through 19: Assume that the risk-free rate of interest is 6% and the
expected return rate of return on the market is 16%.(rm)
17. A share of stock sells for $50 (p0) today. It will pay a dividend of $6 per share at the end
of the year. It beta is 1.2. What do investors expect the stock to sell for at the end of the
year?
E(rp)= rf+β(rm-rf)
= 6%+1.2(16%-6%)
= 18%
Expected rate of return for a stock = [D1 + (p1-p0)]/p0
18% = [6+(p1-50)]/50
9 = 6+ p1-50/50
9 =-44+p1
P1=53
18. I am buying a firm with an expected perpetual cash flow of $1,000 but am unsure of its
risk. If I think the beta of the firm is 0.5, when in fact the beta is really 1, how much more
will I offer for the firm than it is truly worth
When β=0.5, rate of return:
E(rp)= rf+β(rm-rf)
= 6%+0.5(16%-6%)
= 11%
PV of perpetuity= cash flow/ interest rate
=$1,000/0.11
= $9,090.91
When β=1
E(rp)= rf+β(rm-rf)
= 6%+1(16%-6%)
= 16%
PV of perpetuity= cash flow/ interest rate
=$1,000/0.16
= $6,250
$9,090.91-$6,250 = $2,840.91

20. Two investment advisers are comparing performance. One averaged a 19% rate of return
and other a 16% rate of return. However, the beta of the first investor was 1.5, whereas
that of the second investor was 1.
a. Can you tell which investor was a better selector of individual stocks (aside from the
issue of general movements in the market)?
Compare the advisor’s realized return to what the return should have been according
the
CAPM. The difference is the advisor’s α. A positive α indicates a positive risk
-adjusted abnormal return, after correcting for market risk, the advisor “beat the
market.” A negative α indicates a negative risk -adjusted abnormal return, after
correcting for market risk, the advisor did not “beat the market.” The single factor
CAPM is not sufficient for correctly assessing risk- adjusted abnormal returns (α).

b. If the T-bill rate was 6% and the market return during the period was 14%, which
investor would be considered the superior stock selector?
E(rp)= rf+β(rm-rf)
= 6%+1.5(14%-6%)
= 18%
Abnormal profit (α) = 19%-18%=1%
E(rp)= rf+β(rm-rf)
= 6%+1(14%-6%)
= 14%
Abnormal profit (α) = 16%-14%=2%
 Although both advisors earned positive CAPM risk-adjusted excess returns, the
second advisor is the superior stock picker. The first advisor achieved a greater return
than the second advisor only by incurring more risk (higher beta), not through skill. In
other words, according to the CAPM, the first advisor should have earned 18% but
earned19%, for a risk-adjusted excess return of 1%. The second advisor should have
earned 14% but earned 16%, for a risk-adjusted excess return of 2%.

c. What if the T-bill rate was 3% and the market return was 15%?
E(rp)= rf+β(rm-rf)
= 3%+1.5(15%-3%)
= 21%
α= 19%-21%=-3%
E(rp)= rf+β(rm-rf)
= 3%+1(15%-3%)
= 15%
α= 16%-15%=1%
Now only the second advisor earned a positive CAPM risk-adjusted excess return. So
the second advisor is the superior stock picker. Again, the first advisor achieved a
greater realized return than the second advisor only by incurring more risk (higher
beta), not through skill.

21. Suppose the rate of return on short-term government securities (perceived to be risk-free)
is about 5%. Suppose also that the expected rate of return required by the market for a
portfolio with a beta of 1 is 12%. According to the capital assets pricing model:
a. What is the expected rate of return on the market portfolio?
E(rp)= rf+β(rm-rf)
= 5%+1(12%-5%)
= 12%

b. What would be the expected rate of return on a stock with beta=0? (rate of
return=risk-free rate)
E(rp)= rf+β(rm-rf)
= 5%+0(12%-5%)
= 5%

c. Suppose you consider buying a share of stock at $40. The stock is expected to pay $3
dividend next year and you expect it to sell then for $40. The stock risk has been
evaluated at beta=-0.5. Is the stock overpriced or underpriced?
E(rp)= rf+β(rm-rf)
= 5%-0.5(12%-5%)
= 1.5%
Price = dividend/ rate of return
= $3/0.015
 = $200
The stock is underpriced. (The stock has a value of 200, but sold only at 40)
FV of stock = PV(1+r)
$41+$3= PV (1+0.015)
PV of stock = $43.35
Underpriced= $43.35- $40
= $3.35
Since the market price is $40, the stock is underpriced. Therefore market participants
will buy the stock and drive up the price until it reaches $43.35 so that holders of the
stock are compensated only for the market risk they incur.

22. Suppose that borrowing is restricted so that the zero-beta version of the CAPM holds.
The expected return on the market portfolio is 17% and the zero-beta portfolio it is 8%.
What is the expected return on a portfolio with a beta of 0.6?
E(rp)= rf+β(rm-rf)
= 8%+0.6(17%-8%)
= 13.4%

Chapter 11: The Efficient Market Hypothesis

1. If markets are efficient, what should be the correlation coefficient between stock returns
for two non-overlapping time periods?
The correlation coefficient between stock returns for two non-overlapping periods should
be zero. If not, one could use returns from one period to predict returns in later periods
and make abnormal profits.

2. A successful firm like Microsoft has consistently generated large profits for years. Is this
the violation of EMH?
No. Microsoft's continuing profitability does not imply that stock market investors who
purchased Microsoft shares after its success was already evident would have earned an
exceptionally high return on their investments.

3. “If all securities are fairly priced, all must offer equal expected rates of return.”
Comment.
No. Expected rates of return differ because of differential risk premiums.
The phrase would be correct if it were modified to say "expected risk adjusted returns."
Securities all have the same risk adjusted expected return if priced fairly. However, actual
results can and do vary. Unknown events cause certain securities to outperform others.
This is not known in advance, so expectations are set by known information

4. Steady Growth Industries has never missed a dividend payment in its 94-year history.
Does this make it more attractive to you as a possible purchase for your stock portfolio?
No. The value of dividend predictability would be already reflected in the stock price.
5. At cocktail party, your co-worker tells you that he has beaten the market for each of the
last three years. Suppose you believe him. Does this shake your belief in efficient
markets?
No. Random walk theory naturally expects there to be some people who beat the market
and some people who do not. The information provided, however, fails to consider the
risk of the investment. Higher risk investments should have higher returns. As presented,
it is possible to believe him without violating the EMH.

6. “Constantly fluctuating stock price suggest that the market does not know how to price
stock.” Comment.
Incorrect. In the short term, markets reflect a random pattern. Information is constantly
flowing in the economy and investors each have different expectations that vary
constantly. A fluctuating market accurately reflects this logic. Furthermore, while
increased variability may be the result of an increase in unknown variables, this merely
increases risk and the price is adjusted downward as a result.

7. Why the following “effects” are considered efficient market anomalies? Are there
rational explanations for these effects?
a. P/E effect (high P/E, means high E lower P)
b. Book-to-market effect
c. Momentum effect
d. Small-firm effect (book value of the firm=A-L)
An anomaly is considered an EMH exception because there is historical data to
substantiate a claim that said anomalies have produced excess risk adjusted abnormal
returns in the past. Several anomalies regarding fundamental analysis have been
uncovered. These include the P/E effect, the small-firm-in-January effect, the neglected-
firm effect, post-earnings-announcement price drift, and the book-to-market effect.
Whether these anomalies represent market inefficiency or poorly understood risk
premiums is still a matter of debate. There are rational explanations for each, but not
everyone agrees on the explanation. One dominant explanation is that many of these
firms are also neglected firms, due to low trading volume, thus they are not part of an
efficient market or offer more risk as a result of their reduced liquidity.
21. Investors expect the market rate of return in the coming year to be 12%. The T-bill rate is
4%. Changing Fortunes Industries’ stock has a beta of 0.5. The market value of its
outstanding equity is $100 million.
a. Using the CAPM, what is your best guess currently as to the expected rate of return
on Changing Fortunes’s stock? You believe that the stock is fairly priced.
E(rp)= rf+β(rm-rf)
= 4%+0.5(12%-4%)
= 8%
b. If the market return in the coming year actually turns out to be 10%, what is your best
guess as to the rate of return that will be earned on Changing Fortunes’s stock?
E(rp)= rf+β(rm-rf)
= 4%+0.5(10%-4%)
= 7%

c. Suppose now that Changing Fortunes wins a major lawsuit during the year. The
settlement is $5 million. Changing Fortunes’ stock return during the year turns out to
be 10%. What is your best guess as to the settlement the market previously expected
Changing Fortunes to receive from the lawsuit? (Continue to assume that the market
return in the year turned out to be 10%). The magnitude of the settlement is the only
unexpected firm-specific event during the year.
Expected market return = 10%
Forecast return = 7% / 7million
Actual return = 10% /10million
Surprise = 10%-7% = 3%
Because the firm is initially worth $100 million, the surprise amount of the settlement
is $3 million, implying that the prior expectation for the settlement was only
$2million.

10m – 5m = 5m
Expected to get 7 million return, but get 5 million, so extra 2 million.
Tutorial 9: chap 12 Behavioral Finance and Technical Analysis
1. Explain how some of the behavioral biases discussed in the chapter might contribute to
the technical trading rules.
Technical analysis can generally be viewed as a search for trends or patterns in market
prices. Technical analysts tend to view these trends as momentum, or gradual adjustments
to 'correct' prices, or, alternatively, reversals of trends. A number of the behavioral biases
discussed in the chapter might contribute to such trends and patterns. For example, a
conservatism bias might contribute to a trend in prices as investors gradually take new
information into account, resulting in gradual adjustment of prices towards their
fundamental values. Another example derives from the concept of representativeness,
which leads investors to inappropriately conclude, on the basis of a small sample of data,
that a pattern has been established that will continue well into the future. When investors
subsequently become aware of the fact that prices have overreacted, corrections reverse
the initial erroneous trend.

2. Why would an advocate of the efficient market hypothesis believe that even if many
investors exhibit the behavioral biases discussed in the chapter, security prices might still
be efficiently?
Even if many investors exhibit behavioral biases, security prices might still be set
efficiently if the actions of arbitrageurs move prices to their intrinsic values. Arbitrageurs
who observe mispricing in the securities markets would buy underpriced securities or
possibly sell short overpriced securities in order to profit from the anticipated subsequent
changes as prices move to their intrinsic values. Consequently, securities prices would
still exhibit the characteristics of an efficient market.

4. Even if behavioral biases do not affect equilibrium asset process, why might it still be
important for investors to be aware of them?
There are two reasons why behavioral biases might not affect equilibrium asset prices.
First, behavioral biases might contribute to the success of technical trading rules as prices
gradually adjust towards their intrinsic values. Second, the actions of arbitrageurs might
move security prices towards their intrinsic values. It might be important for investors to
be aware of these biases because either of these scenarios might create the potential for
excess profits even if behavioral biases do not affect equilibrium prices.

6. Jill Davis tells her broker that she does not want to sell her stocks that are below the price
she paid for them. She believes that if she just holds on to them a little longer they will
recover, at which time she will sell them. Which behavioral characteristics is the basis for
Davis’s decision making?
a. Loss aversion
b. Conservatism
c. Representativeness
 Davis uses loss aversion as the basis for her decision making. She holds on to stocks that
are down from the purchase price in the hopes that they will recover. She is reluctant to
accept a loss.
9. Match each example to one of the following behavioral characteristics.
 Disposition effect = Investors are reluctant to sell stocks with "paper" losses.
 Representativeness bias = Investors disregard sample size when forming views
about the future from the past.
 Regret avoidance = Investors are reluctant to bear losses due to their
unconventional decisions.
 Conservatism bias = Investors are slow to update their beliefs when given new
evidence.
 Mental accounting = Investors exhibit less risk tolerance in their retirement
accounts versus their other stock accounts.
16. Baa-rated bonds currently yield 6%, while Aa-rated bonds yield 5%. Suppose that due to
an increase in the expected inflation rate, the yields on both bonds increase by 1%.
a. What would happen to the confidence index?
Confidence index increase from 0.8333(5%/6%) to 0.8571 (6%/7%)

b. Would this be interpreted as bullish or bearish by a technical analyst?

Bullish, as this indicates slightly higher confidence.

c. Does this make sense to you?

No. Because the real reason for the increase in the index is the expectation of higher
inflation, not higher confidence about the economy.
Tutorial 10 chap 14: Bond Prices and Yields
2. Two bond have identical times to maturity and coupon rates. One is callable at 105,
the other at 110. Which should have the higher yield to maturity? Why?

T0 T1 T2 T3 T4
Cn + FV
P0 P1 P2 P3 105/110
Call provision give the issuer to right to call the bond back after a period. i.e. 4 years (this
4 years, investor can enjoy fixed interest rate earning.) (Attractive Clause#1)
Interest rate = 8%
The price of a bond with a call provision is therefore will be lower than the price of a
bond without a call provision. (Attractive Clause#2)
Future interest rate is expected to below 8%
The call provision gives the bond issuer the benefit of being able to borrow money in
future at a lower rate.
The bond with call provision will place you at risk that the bond will cease at any times.
Price for bond with a callable price of 105 < Price for bond with a callable price of 110
Bond value lower, the r will be higher
Generally, a firm issue callable bonds with an intention to call back such bond and
refinance the debt if the market rate of interest has declined since the issue of the callable
bonds. The reduction in market rate of interest makes a callable bond costlier for the
issuer.
The chances of being called make the callable bond riskier than the non-callable bond.
Thus, the yield to maturity of callable bond will be higher. Also, the bond with lower
callable price would have higher yield to maturity. This is because the chances of being
called a bond will be higher if its callable price is lower.
Therefore, the bond callable at 105 will provide more return than bond callable at 110 to
its investors because of its lower price and all other things like time to maturity and
coupon rates being same. Thus, the bond callable at 105 will provide higher yield to
maturity than bond callable at 110.

3. The stated yield to maturity and realized compound yield to maturity of a (default-
free) zero-coupon bond are always equal. Why?

T0 T1 T2 T3 T4
FV
P0
YTM = FV – P0 (no coupon rate given)
Yield to maturity and realized compounded yield to maturity of a zero coupon bond are
always equal because the coupon rates are reinvested at the rate of interest which is equal
to the yield to maturity of the bond.
5. A bond with an annual coupon rate of 4.8% sells for $970. What are the bond’s
current yield?
Annual coupon payment = face value x annual coupon rate
= $1,000*4.8%
= $48
Current yield on bond = annual coupon / current market price
= $48 / $970
= 4.94%

6. Which security has a higher effective annual interest rate?

a. A 3-month T-bill selling at $97,645 with par value $100,000

T0 3 month
P0 = 97,645 FV = 100,000
Future value = Present value*(1+r)(3/12)
$100,000 = $97,645* (1 + r)4
R = ($100,000 / $97,645)4 – 1
= 0.1000 / 10%
97,645*(1+ interest rate for 3 month) = 100,000
Interest rate for 3 month = (100,000/97,645) – 1
= 0.0241 / 2.41%
1 + effective interest rate for 1 year = (1 + interest rate for 3 month)4 = (1+0.0241)4 =
1.0999
Effective interest / year = 9.99%
b. A coupon bond selling at par and paying a 10% coupon semiannually.
Assume the par value is $1,000
Coupon payment per year = 10%*1000 = $100
Coupon payment per 6 month = $100/2 = $50
Bond price = [(coupon/(1+r)n)] + [(payment/(1+r)n)]
1000=50/ (1+interest rate)1 + 1050/(1+interest rate)2
If R= 0.05
50/(1.05)1 + (1050/1.05)2
47.619 + 952.381 = 1000.00
Interest rate = 5%
Effective annual rate = (1 + r)2 – 1
= (1 + 0.05)2 – 1
= 0.1025 / 10.25%

The coupon bond is provides the higher effective annual rate.

14. Consider a bond paying a coupon rate of 10% per year semiannually when the
market interest rate is only 4% per half-year. The bond has three years until
maturity.
a. Find the bond’s price today and six months from now after the next coupon is
paid.
Coupon rate =10% per year (5% per 6 month)
Coupon payment is made on semiannual basic
Interest rate = 4% per 6 month
Maturity = 3 years (6 semiannual)

T0 T1 T2 T3 T4 T5 T6 FV =1000
C1=10%*1000/2=50
C2=50 C3=50 C4=50 C5=50 C6=50
P0 =1052.42 P2 =1044.52
Bond price at today (P0)
P = C* [1-(1 + r)-t] / r + [F/ (1 + r)t]
= (10%/2)*1000 * [1-(1 + 0.04)-(3*2)] / 0.04 + [$1,000/ (1 + 0.04)3*2]
= 50 * [1-(1.04)-6] / 0.04 + [$1,000/ (1.04)6]
= $1052.42
P0= 50/(1+4%)1 + 50/(1+4%)2 +50/(1+4%)3 + 50/(1+4%)4 + 50/(1+4%)5 +50/(1+4%)6
+ 1000/(1+4%)6
= 48.08 + 46.23 + 44.45 + 42.74 + 41.1 + 39.51 + 790.31
= 1,052.42

Bond price after next coupon payment (6 month later, bond have 5 half-year left need
to paid, pending maturity)
P = C* [1-(1 + r)-t] / r + [F/ (1 + r)t]
= 50 * [1-(1.04)-5] / 0.04 + [$1,000/ (1.04)5]
= $1044.52
P1= 50/(1+4%)1 + 50/(1+4%)2 +50/(1+4%)3 + 50/(1+4%)4 + 50/(1+4%)5
+1000/(1+4%)5
= 48.08 + 46.23 + 44.45 + 42.74 + 41.1 + 821.93
= 1044.52

b. What is the total (6-month) rate of return on the bond?

Total rate of return = [interest + (End of period value – Initial value) / initial value]
*100
= [50 + (1,044.52 – 1,052.42) / 1,052.42] *100
= 0.04*100
= 4%
Total rate of return = [interest + (End of period value – Initial value) / initial value]
*100
= [50 + (1,044.22 – 1,052.42) / 1,052.42] *100
= 3.97%
 16. A bond has a current yield of 9% and a yield to maturity of 10%. Is the bond selling
above or below par value? Explain.
As the YTM (10%) was greater than current yield (9%), the bond was sell at discount.
The current yield is equal to the bond’s annual coupon payment divided by its price.
Therefore, if YTM is greater than the current yield, the bond must have the prospect of
price increases before its maturity date. Therefore, the selling price of the bond is lower
than the par value.

Tutorial 11 Chapter 17: Macroeconomic and Industry Analysis

1. What monetary and fiscal policies might be prescribed for an economy in a deep
recession?
When economy is in a deep recession, both expansionary monetary policies and
expansionary fiscal policy is apply.
Expansionary monetary policy tend to lower the interest rate, which will stimulate both
investment and expenditures on consumer durables. (People will borrow when interest
rate is lower, and buying by loan)
Under expansionary fiscal policy, the government will tend to lower taxes and increase
the government expenditure. As a result, the money flow in the market will increase as
the tax burden bear by the people will be lower.

2. If you believe the U.S dollar will depreciate more dramatically than other investors
anticipate, what will be your stance on investments in U.S auto producers?
The cost of US car is cheaper as compared to import cars.it is a good news for US car
producers. (Buyer will feel US car is cheaper)
A depreciating dollar makes imported cars more expensive and American cars less
expensive to foreign consumers. This should benefit the U.S. auto industry.

4. What are the differences between bottom-up and top-down approaches to security
valuation? What are the advantages of a top-down approach?
A top-down approach to security valuation begins with an analysis of the global and
domestic economy. Analysts who follow a top-down approach then narrow their attention
to an industry or sector likely to perform well, given the expected performance of the
broader economy. Finally, the analysis focuses on specific companies within an industry
or sector that has been identified as likely to perform well.
 A bottom-up approach typically emphasizes fundamental analysis of individual company
stocks, and is largely based on the belief that undervalued stocks will perform well
regardless of the prospects for the industry or the broader economy.
The major advantage of the top-down approach is that it provides a structured approach
to incorporating the impact of economic and financial variables, at every level, into
analysis of a company's stock. One would expect, for example, that prospects for a
particular industry are highly dependent on broader economic variables. Similarly, the
performance of an individual company's stock is likely to be greatly affected by the
prospects for the industry in which the company operates.

8. Which of the following forecasts is consistent with a steeply upwardly sloping yield
curve?
a. Monetary policy will be expansive and fiscal policy will be expansive.
b. Monetary policy will be expansive while fiscal policy will be restrictive.
c. Monetary policy will be restrictive while fiscal policy will be restrictive.
The yield curve shows a relationship between the interest rates with time. The normal
shape of yield curve is upward sloping which indicates improved economic conditions for
long-run. Here, short-run interest rates would be lower than the long-run interest rates.
The restrictive monetary policies are used by a government to slowdown economic
growth by restricting liquidity. The tight monetary policy reduces demand for goods and
services due to increased interest rates. This is because people would be more interested
in savings rather the spending.
The restrictive fiscal policy is used by a government to reduce the pace of growth and
decrease inflationary pressure. This in result decrease industrial production, decrease in
government spending. Here, the short-term rates would be higher than the long-run. Thus,
both b and c are incorrect.
When both fiscal and monetary policies are expansive, the yield curve is sharply upward
sloping (i.e. short-term rates are lower than long-term rates) and the economy is likely to
expand in the future.
10. Consider two firms producing smartphones. One uses a highly automated robotics
process, whereas the other uses workers on an assembly line and pays overtime
when there is heavy production demand.
a. Which firm will have higher profits in a recession?
Firm using human workers. This is because the labor cost was a variable, when there
is low production, the labor cost will also decrease. The cost on robotics is fixed, such
cost will remains unchanged no matter whether there is a change in production level.
Thus, when the production falls, production through workers will allow cost saving.
The robotics process entails higher fixed costs and lower variable (labor) costs.
Therefore, this firm will perform better in a boom and worse in a recession. For
 example, costs will rise less rapidly than revenue when sales volume expands during
a boom.

b. In a boom?
Firms using robotics. There is because in boom, the production will increase, so the
labor cost will also increase. Whereas the cost of using robotics in production will
remain the same.

c. Which firm’s stock will have higher beta?

Firms using robotics. Because firm using robotics will have a high operating leverage,
which will make it more sensitive to the economy state. Because its profits are more
sensitive to the business cycle, the robotics firm will have the higher beta.

11. Here are four industries and four forecasts for the macro economy. Match the
industry to the scenario in which it is likely to be the best performer.
a. Housing construction (cyclical but interest-rate sensitive): (iii) Healthy expansion:
rising GDP, mild inflation, low unemployment.
Housing construction is cyclical industry but at the same time, it is interest rate
sensitive. It is highly correlated to the interest rate as increasing in interest rate
scenario will decrease the demand of the housing. Similarly, at the time of recession,
the demand of housing will decrease.

b. Health care (a noncyclical industry): (I) Deep recession: falling inflation, interest
rate, and GDP.
c. Gold mining (counter-cyclical): (IV) Stagflation: falling GDP, high inflation.
d. Steel production (cyclical industry): (ii) Superheated economy: rapidly rising GDP,
increasing inflation and interest rate.

12. In which stage of the industry life cycle would you place the following industries?
(Note: There is considerable room for disagreement concerning the ‘correct’ answer to
this question)
a. Oil well equipment
Relative decline (Environmental pressures, decline in easily developed new oil fields)
b. Computer hardware
Consolidation stage
c. Computer software
Consolidation stage
d. Genetic engineering
Start-up stage
e. Railroads
Relative decline
Tutorial 12: Chap 18 Equity Valuation Model
8. a. Computer stocks currently provide an expected rate of return of 16%. MBI, a
large computer company, will paid a year-end dividend of $2 per share. If the stock
is selling at $50 per share, what must be the market’s expectation of the dividend
growth rate?
k =16% D1 = $2 P0 = $50
P0 = D1 / (k-g)
50 = 2 / (0.16 – g)
0.16 – g = 2/50
g = 0.16 – (2/50)
g = 0.12 / 12%

b. If dividend growth forecasts for MBI are downward to 5% per year, what will
happen to the price of MBI stock?
P01 = D1 / (k-g)
= 2 / (0.16-0.05)
= $18.18

c. What (qualitatively) will happen to the company’s price-earnings ratio?

g: 12%  5%
P: 50  18.18
When the price falls from $50 to $18.18, the numerator in the ratio will be less, so the
price-earnings ratio will falls.

9. a. MF Corp. has an ROE of 16% and a plowback ratio of 50%. If the coming year’s
earnings are expected to be $2 per share, what price will be the stock sell? The
market capitalization rate is 12%.(k)
Net income – RE, dividend payout
ROE = Net income / average shareholder equity
g = ROE*b = NI / Equity*b = RE/E
Some earning per share will be retained.
D1 = EPS*(1 – b)
= $2*(1 – 0.5)
= $1
g = ROE*b
= 0.16*0.5 = 0.08
P0 = D1 / (k-g)
= 1 / (0.16 – 0.08)
= $25

b. What price do you expect MF shares to shares to sell for in three years?
 P0 p1 P2 P3 g=8%

P3 = D4 / (k – g)
P3 = P0 * (1 + g) 3
= $25 * (1 + 0.08) 3
= $31.49

10. The market consensus is that Analog Electronic Corporation has an ROE = 9%, a
beta of 1.25, and plans to maintain indefinitely its traditional plowback ratio of 2/3.
This year’s earnings were $3 per share. The annual dividend was just paid. The
consensus estimate of the coming year’s market return is 14%, and T-bills currently
offer a 6% return.
ROE = 9% β=1.25 b=2/3 E/share =$3 rm=14% rg = 6%
a. Find the price at which Analog stock should sell.
D0 = E (1 – b)
= $3 (1 – 2/3)
= $1
Sustainable dividend growth (g) = ROE*b
= 0.09*2/3
= 0.06 / 6%
Required return (k) = rf + β [E(rm) – rf]
= 0.06 + 1.25(0.14 – 0.06)
= 0.16 / 16%
P0 = D1 (k – g)
=D0 (1 + g) / (k – g)
= $1 (1 + 0.06) / (0.16 – 0.06)
= $10.6

b. Calculate the P/E ratio.

P0 / E0 = $10.6 / 3
= $3.53
Expected P/E = P0/E1
= P0 / E0 (1+g)
=10.6 / 3(1+0.08)
= 3.33

c. Calculate the present value of growth opportunities.

P0 = E1 / k + PVGO
PVGO = P0 – E1 / k
= 10.6 – div (1+g) / 0.16
= 10.6 - $3(1+0.06) / 0.16
= - 9.28
ROE > k, so the PV is negative
 d. Suppose your research convince you Analog will announce momentarily that it
will immediately reduce its plowback ration to 1/3. Find the intrinsic value of the
stock.
D0 = EPS*(1 – b)
= $3*(1-1/3)
= $2
Sustainable dividend growth (g) = ROE*b
= 0.09*1/3
= 0.03 / 3%
E1 = E0 (1+g) = $3 (1+0.03) = 3.09
D1 = E1 (1-1/3) = 3.09*2/3 = 2.06
V0 = D1 / (k – g)
= 2.06 / (0.16-0.03)
= 15.85
V0 = D1 / (k – g)
= D0 (1 + g) / (k – g)
= $2(1 + 0.03) / (0.16-0.03)
= $15.85

e. The market is still unaware of this decision. Explain why V0 no longer equals P0
and why V0 is greater or less than P0.
V0 is different from P0 because the market price does not reflect the new information.
V0 is greater than P0 because there is a reduction of the investment in the bad
project (ROE<k) which increases the firm value.

11. Sisters Corp. expects to earn $6 per share next year. The firm’s ROE is 15% and its
plowback ratio is 60%. If the firm’s market capitalization rate is 10%, what is the
present value of its growth opportunities?
D1 = EPS1*(1-b)
= $6*(1 – 0.6)
= $2.4
Sustainable dividend growth (g) = ROE*b
= 0.15*0.6
= 0.09 / 9%
P0 = D1 / (k – g)
= $2.4 / (0.10 – 0.09)
= $240
P0 = E1 / k + PVGO
PVGO = P0 – E1 / k
= $240 – $6 / 0.1
= $180
14. The FCI Corporation’s dividends per share are expected to grow indefinitely by 5%
per year.
a. If this year’s year-end (D1) dividend is $8 and the market capitalization rate is
10% per year, what must the current stock price be according to the DDM?
P0 = D1 / (k – g)
= $8 / (0.10 – 0.05)
= $160

b. If the expected earnings per share are $12, what is the implied value of the ROE
on future investment opportunities?
Dividend payout ratio = $8 / $12 = 0.67
Retention ratio (b) = 1 – dividend payout ratio = 1 – 0.67 = 0.33
Sustainable dividend growth (g) = ROE*b
0.05 = ROE*0.33
ROE = 0.15 / 15%

c. How much is the market paying per share for growth opportunities (i.e., for an
ROE on future investments that exceeds the market capitalization rate)?
P0 = E1 / k + PVGO
PVGO = P0 – E1 / k
= $160 - $12 / 0.1
= $40
P0 = E1 /k
= $12/10% = $120

16. The risk-free rate of return is 8%, the expected rate of return on the market
portfolio is 15%, and the stock of Xyrong Corporation has a beta coefficient of 1.2.
Xyrong pays out 40% of its earnings in dividends, and the latest earnings
announced (E0) were $10 per share. Dividends were just paid and are expected to be
paid annually. You expect that Xyrong will earn an ROE of 20% per year on all
reinvested earnings forever.
a. What is the intrinsic value of a share of Xyrong stock? Cal P0
D0 = $10*40% = $4
g = ROE*b
= 0.2*(1-0.4)
= 0.12
Required return (k) = rf + β [E(rm) – rf]
= 0.08 + 1.2(0.15 – 0.08)
= 0.164 / 16.4%

P0 = D1 / (k – g)
= D0 (1 + g) / (k – g)
= $4(1 + 0.12) / (0.164 – 0.12)
 = $101.82

Compare P0 with market value, if P0 greater, overprice, sell it

b. If the market price of a share is currently $100, and you expect the market price
to be equal to the intrinsic value one year from now, what is your expected 1-
year holding-period return on Xyrong stock?

P0 P1
D1
P0 = 100
P1 = V 1
P1 = P0 (1 + g)
= $101.82(1 + 0.12)
= $114.04
D1 = D0 (1 + g)
= $4(1 + 0.12)
= $4.48
E(r) = Benefit / cost
= D1 + (P1 – P0 )/ P0
= $4.48 + $114.0384 – 100 / 100
= 0.1852 / 18.52%
E(r) = D1 / P0 + g
= $4.48 / 100 + 0.12
= 0.1648 / 16.48%
Tutorial 13: Chap 19 Financial Statement Analysis
2. What is the major difference between the approaches of international financial
reporting standards versus U.S. GAAP accounting? What are the advantages and
disadvantages of each?
Valuation of inventory: Under U.S. GAAP, any of LIFO or FIFO method of inventory
valuation can be used. Whereas IFRS does not allow using LIFO method of inventory
valuation.
Intangible assets: U.S. GAAP allows recognizing acquired intangible assets at fair value.
Under IFRS, acquired intangible assets can be recognized only if the assets will have
future economic benefits.
Statement of Income: Under U.S. GAAP, they are shown below the net income, while,
under IFRS, extraordinary items are not segregated in the income statement.
Earnings per share: Under U.S. GAAP, the computation averages the individual interim
period incremental shares. While under IFRS, the earning-per-share calculation does not
average the individual interim period calculations.
The major difference in approach of international financial reporting standards and U.S.
GAAP accounting stems from the difference between principles and rules. U.S. GAAP
accounting is rules-based, with extensive detailed rules to be followed in the preparation
of financial statements; many international standards, European Union adapted IFRS,
allow much greater flexibility, as long as conformity with general principles is
demonstrated. Even though U.S. GAAP is generally more detailed and specific, issues of
comparability still arise among U.S. companies. Comparability problems are still greater
among companies in foreign countries.

3. If markets are truly efficient, does it matter whether firms engage in earnings
management? On the other hand, if firms manage earnings, what does that say
about management’s view on efficient markets?
Earnings management should not matter in a truly efficient market, where all publicly
available information is reflected in the price of a share of stock. Investors can see
through attempts to manage earnings so that they can determine a company’s true
profitability and, hence, the intrinsic value of a share of stock. However, if firms do
engage in earnings management, then the clear implication is that managers do not view
financial markets as efficient.

4. What financial ratios would a credit rating agency such as Moody’s or Standard &
Poor’s be most interested in? Which ratios would be of most interest to a stock
market analyst deciding whether to buy a stock for a diversified portfolio?
Both 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 well as many other ratios and
forms of analysis). Since the Moody’s and Standard and Poor’s ratings assess bond
default risk, these agencies are most interested in leverage ratios. A stock market analyst
would be most interested in profitability and market price ratios.
5. The Crusty Pie Co., which specializes in apple turnovers, has a return on sales
higher than the industry average, yet its ROA is the same as the industry average.
How can you explain this?
Asset turnover ratio is low and through this the company is balancing other ratios high
profit margin ratio is accompanied by low asset turnover atop which is measured as the
ratio of sales divide by total assets. ROA = ROS  ATO
The only way that Crusty Pie can have an ROS higher than the industry average and an
ROA equal to the industry average is for its ATO to be lower than the industry average.

6. The ABC Corporation has a profit margin on sales below the industry average, yet
its ROA is above the industry average. What does this imply about its assets
turnover?
A low gross profit margin means a big disadvantage to any kind of business. Return on
assets shows how well a firm is controlling its expenses and utilizing the resources
properly. ABC’s asset turnover must be above the industry average.

13. A firm has an ROE of 3%, a debt-equity ratio of 0.5, and a tax rate of 21% and pays
an interest rate of 6% on its debt. What is its operating ROA?
ROA = EBIT ( Gross profit) / Total assets
ROA = NI / TA
ROE = (1 – T)*[ROA + (ROA – r)*(D/E)]
= (1 – T) *((EBIT/TA) + (EBIT/r – r) *(D/E))
= (1 – T)* (ROE*E+ (ROA-r)*D)/E
= (1 – T)*(ROA (E+D) – r*D)/E
= (1 – T)*(EBIT/TA)*TA – R*D)

ROE = (1 – T)*[ROA + (ROA – r)*(D/E)]

0.03 = (1 – 0.21)*(ROA + (ROA – 0.06)*0.5)
0.03/ (1 – 0.21) = ROA + (ROA – 0.06)*0.5
0.038 = ROA + 0.5ROA – 0.03
1.5ROA = 0.068
ROA = 0.045 / 4.5%
ROA = 5.08%

14. A form has a tax burden ratio of 0.75, a leverage ratio of 1.25, an interest burden of
0.6, and a return on sales of 10%. The firm generates $2.40 in sales per dollar of
assets. What is the firm’s ROE?
ROE = NI/E = tax burden (NI/EBT)* interest burden (EBT/EBIT)* margin (EBIT/sales)
* turnover (sales/assets) * leverage (assets/equity)
= 0.75 * 0.6 * 0.10 * 2.4 * 1.25
= 0.135 / 13.5%
Tutorial 12: Chapter 20 Options markets introduction
2. What are the trade-offs facing an investor who is considering buying a put option on
an existing portfolio? (Financial assets)
Put option give the right to sell at the specific price agreed upon today.
If exercise price today = RM20/kg,
If the price going up to TM25/kg, don’t need to exercise, go and sell at market.
 When not exercise, loss/cost is the premium paid (trade-off)
If the price going down to RM15/kg, exercise the option and sell at RM30/kg
Buy if believe that the price of commodity will be drop. If price drop, able to exercise at
strike price.
Buying a put option on an existing portfolio provides portfolio insurance, which is
protection against a decline in the value of the portfolio. In the event of a decline in
value, the minimum value of the put-plus-stock strategy is the exercise price if the out.
As with any insurance purchased to protect the value of an asset, the trade-off an investor
faces is the cost of the put versus the protection against a decline in value. The cost of the
protection is the cost of acquiring the protective put, which reduces the profit that results
should the portfolio increase in value.

3. What are the trade-offs facing an investor who is considering writing a call option
on an existing portfolio?
Call option give the holders right to buy
Call option writer
- Expect price of assets increase
- Premium
Call option buyer
- Price of assets increase to RM50/kg, exercise the option and earn the premium.
- Price of assets drop to RM10/kg, not exercise the option and buy at market.
- If market move unfavorable for you, not only loss the premium, but also the
depreciation of the assets.
An investor who writes a call on an existing portfolio takes a covered call position. If, at
expiration, the value of the portfolio exceeds the exercise price of the call, the writer of
the covered can expect the call to be exercised, so that the writer of the call must sell the
portfolio at the exercise price. Alternatively, if the value of the portfolio is less than the
exercise price, the writer of the call keeps both the portfolio and the premium paid by the
buyer of the call. The tradeoff for the writer of the covered call is the premium income
received versus forfeits of any possible capital appreciation above the exercise price of
the call.

5. Turn back to figure 20.1, which lists price of various Microsoft options. Use the data
in the figure to calculate the payoff and the profits for investments in each of the
following January 18 expiration options, assuming that the stock price on the
expiration date is $100.

Microsoft (MSFT) Underlying stock

price: 101.51 100
(market price)
Expiration Strike Call Put
18-Jan-19 95 7.65 0.98
18-Jan-19 100 3.81 2.2
18-Jan-19 105 1.45 4.79
       
8-Feb-19 95 9.5 2.86
8-Feb-19 100 5.6 3.92
8-Feb-19 105 3.08 6.35

a. Call option, X = $95.

Payoff = stock price at expiration – strike price
= $100 - $95
= $5 (benefit)
Profit/loss = payoff – call price
= $5 - $7.65
= - $2.65, loss
b. Put option, X = $95. (expect price to drop below 95, but price not drop as expected,
no exercise)
Net Payoff = 0 – 0.98
= -0.98

c. Call option, X = $100.

Payoff = stock price at expiration – strike price
= $100 - $100
= $0
Profit/loss = payoff – call price
= $0 - $3.81
= - $3.81, loss

d. Put option, X = $100.

Payoff = 0
Loss = -2.2
e. Call option, X = $105. (not to exercise when agree price is higher, just buy at market
at $100)
Payoff = 0
Profit/loss = payoff – call price
= 0 - $1.45
 = $1.45, loss

f. Put option, X = $105.

Profit = 5 – 4.79 = 0.21

Tutorial 13: Chap 22 Future Markets

2. Why might individuals purchase futures contracts rather than the underlying
assets?
Someone would do this to invest in the future value of an asset without actually having to
take delivery of the asset. This allows average people to invest in crops or oil, and control
the asset until the delivery date.
The ability to buy on margin is one advantage of futures. Another is the ease with which
one can alter one’s holdings of the assets. This is especially important if one is dealing in
commodities, for which the futures market is far more liquid than the spot market.

4. Are the following statements true or false?

a. All else equal, the futures price on a stock index with a high dividend yield
should be higher than the futures price on an index with a low dividend yield.
False. For any given level of the stock index, the futures price will be lower when the
dividend yield is higher. This follows from spot-futures parity. F1 = S1 (1 + rf – d)T

b. All else equal, the futures price on a high-beta stock should be higher than the
futures price on a low-beta stock.
False. The parity relationship tells us that the futures price is determined by the stock
price, the interest rate, and the dividend yield. It is not a function of beta.

c. The beta of a short position in the S&P 500 futures contract is negative.
True. The short futures position will profit when the S&P 500 index falls. This is a
negative beta position.

5. What is the difference between the futures price and the value of the futures
contract?
The futures price is the agreed-upon price for deferred delivery of the assets.
Scenario 1
Future price = future market price  the contract value = 0
Scenario 2
Future price > future market price
 The contract value < negative if you take a long position because you need to pay at
the future price.
 The contract value > negative if you take a short position because you need to sell at
the future price.
Scenario 3
Future price> future market price
  The contract value < 0 if you take a short position because you need to sell at the
future price.
 The contract value > 0 if you take a long position because you need to pay at the
future price.
If that price is fair, then the value of the agreement ought to be zero; that is, the contract
will be zero-NPV agreement for each trader.
Over time, however, the price of the underlying assets will change and this will affect the
value of the contract.
9. Determine how a portfolio manager might use financial futures to hedges risk in
each of the following circumstances:
a. You own a large position in a relatively illiquid bond that you want to sell.
A take a short position in T-bond futures, to offset interest rate risk. If rates increase,
the loss on the bond will be offset to some extend by gains on the futures.
b. You have a large gain on one of your Treasuries and want to sell it, but you
would like to defer the gain until the next tax year.
Again, a short position in T-bond futures will offset the increase rate risk.

c. You will receive your annual bonus next month that you hope to invest in long-
term corporate bonds. You believe that bonds today are selling quite attractive
yields, and you are concerned that bond prices will rise over the next few weeks.
You want to protect your cash outlay when the bond is purchased. If bond prices
increase, you will need extra cash to purchase the bond. Thus, you should take a long
futures position that will generate a profit if prices increase.