Professor Smith was bragging about her abilities as an investor in the stock market: “In the last

month, I earned 8% on my portfolio,” she told her friends. “That’s nothing special,” commented
Mr. Jackson. “Last month I made 20% on my portfolio, without studying 15 years at university.”
Did Mr. Jackson really outperform Mrs. Smith?
risk depends on a portfolio context—it is not just the asset’s returns by themselves that determine the asset’s riskiness, but th
or. So I think with just the word of mounth and without much more information about about the portfolio, we cannot conclude if Mr. Jack
we cannot conclude if Mr. Jackson really outperform Mrs. Smith.
Can a corporate bond have a lower expected return than a government bond? Can it have lower ex post return?
yes, and yes.
It’s 1 January 2007 and you’re considering buying a $1,000 face-value U.S. Treasury bill that
matures in 1 year. The interest rate is 7% annually.

a. If you buy the T-Bill now, how much will you pay?

TREASURY BILL PURCHASE PRICE

Face Value 1000
Maturity 1
Interest Rates 7%
Purchase Price 934.58

b. If the interest rate remains 7% annually, how much will the bill be worth on 1 February 2007? 1 March? 1 April? . . . 1 Decem

Percentage Yield
<= (1+7)^1/12-1
<= (107%)^1/12-1
<=.565%

THE PRICE OF THE TREASURY BILL THROUGHOUT THE YEAR

Date Bill Price
1-Jan-07 934.58 <-- FV = PV (1 + i)^t
1-Feb-07 936.56 <-- =B21*((0.7/330)+1)^1
1-Mar-07 938.75 <-- =B22*((0.7/300)+1)^1
1-Apr-07 941.18 <-- =B23*((0.7/270)+1)^1
1-May-07 943.93 <-- =B24*((0.7/240)+1)^1
1-Jun-07 947.07 <-- =B25*((0.7/210)+1)^1
1-Jul-07 950.76 <-- =B26*((0.7/180)+1)^1
1-Aug-07 955.19 <-- =B27*((0.7/150)+1)^1
1-Sep-07 960.76 <-- =B28*((0.7/120)+1)^1
1-Oct-07 968.24 <-- =B29*((0.7/90)+1)^1
1-Nov-07 979.53 <-- =B30*((0.7/60)+1)^1
1-Dec-07 1002.39 <-- =B31*((0.7/30)+1)^1
 It will be $1,000, because the face value is 1,000.

INTEREST ON THE TREASURY BILL

Purchase Price 934.58
Payoff on Maturity 1000
Interest 7%

007? 1 March? 1 April? . . . 1 December?

Annual Interest Rate 7%

Monthly Interest Rate 0.57
Face Value 1000
e ZZZ company, a small high-tech company from Newfoundland. The bond is zero-coupon, has a face value of $1,000, and matures in 2 ye

a. If the price of the bond is $756.14, what is the annual expected return of Diana’s bond?
b. One day after Diana bought her bond, ZZZ was purchased by the electronic giant ABA, which has a very low default probabi
takeover?

Annual Expected Return NEW PRICE OF ZZZ BONDS

1,000=756.14(1+r/100)^2 PV=1,000/(1+6.5/100)^2
√1,000/756.14=(1+r/100) 881.66
r=14.97
f $1,000, and matures in 2 years. Diana intends to keep the bond until maturity.

as a very low default probability. Investors demand only a 6.5% annual return on ABA’s bonds. What will be the new price of the ZZZ bond

a. If the price of the bond is $756.14, what

is the annual expected return of Diana’s
bond?
the new price of the ZZZ bonds and how much will Diana gain from the
value of $10,000 and a 4% coupon (payable semiannually). The price
of the bond was $9,750. The bond promises a coupon of $200 on 15
September 2002, 15 March 2003, 15 September 2003, and 15 March
a. Based on the following, compute the annualized IRR of the bond
purchase.

Date Cash Flow

2-Mar-15 -9,750
2-Mar-15 200
3-Mar-15 200
3-Mar-15 200
4-Mar-15 10,200

Semiannual IRR 2.67% =IRR(B7:B11)

Annualized IRR
This is the YTM! 5.41% =(1+B13)^2-1

b. Immediately after receiving the $200 bond interest payment on 15 September 2002, you sold the bond for $10,000. What w
COMPUTING THE EX-ANTE YIELD
Month the T-bill 2-Mar-15
Price 9,750
YIELD TO MATURITY
Per month 1.0042 =(10000/B19)^(1/6)
Annualized 5.19% =B21^12-1

COMPUTING THE EX-POST YIELD

Bought March 15, 9,750
Sold September 1 10,000
YIELD TO MATURITY
Per month 1.0042 =(B26/B25)^(1/6)
Annualized 5.19% =(B28)^12-1
ond for $10,000. What was your ex post annualized yield? What was the ex ante annualized yield of the buyer of the bond?
er of the bond?
6. During a stamp collector convention the chairman spoke about the profi tability of investing in rare stamps. “Last year I inve
I used the three concepts of an asset's risk for the problems that I saw from the chairman's argument:
1. HORIZON - The chairman states that he invested in rare stamps last year and they are now worth $200,000, implying an ann
2. SAFETY - The chairman claims that the rare stamps are worth $200,000 according to the catalog. However, the catalog valu
3. LIQUIDITY - Rare stamps are not as liquid as stocks, which are traded on stock exchanges and can be easily bought or sold. T
n rare stamps. “Last year I invested $150,000 in rare stamps. These stamps are now worth $200,000 according to the catalog, meaning an

orth $200,000, implying an annual return of 33%. However, this statement does not specify the exact time period over which the investme
og. However, the catalog value may not necessarily reflect the actual market value of the stamps. Rare stamps can be illiquid assets, mean
can be easily bought or sold. The chairman's statement does not provide information on the liquidity of the rare stamps he invested in. Th
ng to the catalog, meaning an annual return of 33%. For comparison the average return in the stock market in the last 30 years was only 16

eriod over which the investment has been held. Without knowing the specific time period, it is difficult to determine the true annual retur
ps can be illiquid assets, meaning they may be difficult to sell or convert into cash quickly. Therefore, the safety of investing in rare stamps
rare stamps he invested in. This lack of liquidity can pose challenges when it comes to realizing the value of the investment
n the last 30 years was only 16%.” Find (at least) three problems with the chairman’s argument.

termine the true annual return and compare it accurately to the average return in the stock market over the last 30 years.
ety of investing in rare stamps can be questionable, especially when compared to the stock market which generally offers higher liquidity.
the investment
e last 30 years.
enerally offers higher liquidity.
7. A basic assumption of economics is that investors are risk averse, meaning when they view Asset A as riskier than Asset B th

Will a risk-aversive investor agree to a fair bet?

The risk-aversive investor won't be willing to invest in such a fair bet knowing that the return is low, and there is an expected r
set A as riskier than Asset B they will demand a higher expected return. A “fair bet” is a bet whose expected return is zero. Here’s an exam

ow, and there is an expected return of zero. The risk-aversive investor would probably demand more return because of the risk, but it is h
return is zero. Here’s an example of a fair bet: Pay $1 to get $2 if a coin fl ip yields heads or to get $0 if the coin fl ip yields tails. Note that

because of the risk, but it is highly possible that the investor won't because, again, the expected return is zero.
oin fl ip yields tails. Note that this bet has an expected return of zero.
8. A risk-neutral investor is willing to make bets with an expected return of zero. Suppose a riskneutral investor is offered the c
Die Result
1
2
3
4
eutral investor is offered the chance to participate in a die-toss game. If the die comes up 1, the payoff is $1, if the die comes up 2, the pa
, if the die comes up 2, the payoff is $2, . . . . What is the maximum price the riskneutral investor is willing to pay to play this game?
pay to play this game?
9. On Planet Apathy all investors are indifferent to risk. The annual expected returns of government bonds are 5%. Does that m

No, the average stock returns should not necessarily be 5%. This is
because the expected return of an asset is based on its risk and potential
for returns. Government bonds are typically considered less risky than
stocks, which means they have a lower expected return. Stocks, on the
other hand, have higher potential returns but also higher risk. Therefore,
the average stock returns can be higher or lower than 5%, depending on
the specific characteristics and performance of the stocks in question.
ent bonds are 5%. Does that mean that the average stock returns should be 5%?
10. One of the ways in which the United States helps foreign countries is to guarantee their bank loans. Explain (in short) the b

The benefits for foreign countries in getting guarantees on their bank loans from the
United States include increased access to capital and reduced borrowing costs. When
the United States guarantees a foreign country's bank loan, it provides assurance to
lenders that the loan will be repaid even if the borrower defaults. This reduces the
perceived risk for lenders and encourages them to provide loans to the foreign
country at lower interest rates. The guarantee can help improve the foreign country's
credit rating as well, making it easier for them to borrow money in the future.
k loans. Explain (in short) the benefi ts for foreign countries in getting those guaranties. (Footnote 1 is a good place to start your answer.)
d place to start your answer.)