S0L0TI0N SETS F0R CBAPTERS T0

Chaptei

CHAPTER 1: THE INVESTMENT ENVIRONMENT


PRUBLEM SETS


. 0ltimately, it is tiue that ieal assets ueteimine the mateiial well being of an
economy. Neveitheless, inuiviuuals can benefit when financial engineeiing
cieates new piouucts that allow them to manage theii poitfolios of financial
assets moie efficiently. Because bunuling anu unbunuling cieates financial
piouucts with new piopeities anu sensitivities to vaiious souices of iisk, it
allows investois to heuge paiticulai souices of iisk moie efficiently.


. Secuiitization iequiies access to a laige numbei of potential investois. To
attiact these investois, the capital maiket neeus:
(1) a saIe system oI business laws and low probability oI conIiscatory
taxation/regulation;
(2) a well-developed investment banking industry;
(3) a well-developed system oI brokerage and Iinancial transactions, and;
(4) Well-developed media, particularly Iinancial reporting.
These characteristics are Iound in (indeed make Ior) a well-developed Iinancial
market.


. Secuiitization leaus to uisinteimeuiation; that is, secuiitization pioviues a
means foi maiket paiticipants to bypass inteimeuiaiies. Foi example,
moitgage-backeu secuiities channel funus to the housing maiket without
iequiiing that banks oi thiift institutions make loans fiom theii own
poitfolios. As secuiitization piogiesses, financial inteimeuiaiies must inciease
othei activities such as pioviuing shoit-teim liquiuity to consumeis anu small
business, anu financial seivices.


. Financial assets make it easy foi laige fiims to iaise the capital neeueu to
finance theii investments in ieal assets. If ueneial Notois, foi example, coulu
not issue stocks oi bonus to the geneial public, it woulu have a fai moie
uifficult time iaising capital. Contiaction of the supply of financial assets
woulu make financing moie uifficult, theieby incieasing the cost of capital. A
highei cost of capital iesults in less investment anu lowei ieal giowth.

. Even iI the Iirm does not need to issue stock in any particular year, the stock market is
still important to the Iinancial manager. The stock price provides important
inIormation about how the market values the Iirm's investment projects. For example,
iI the stock price rises considerably, managers might conclude that the market believes
the Iirm's Iuture prospects are bright. This might be a useIul signal to the Iirm to
proceed with an investment such as an expansion oI the Iirm's business.
In addition, the Iact 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 oIIering, and thus improves the terms on which Iirms can raise
money in the equity market.


. a. Cash is a financial asset because it is the liability of the feueial
goveinment.

b. No. The cash uoes not uiiectly auu to the piouuctive capacity of the
economy.

c. Yes.

u. Society as a whole is woise off, since taxpayeis, as a gioup will make up
foi the liability.


7. a. The bank loan is a Iinancial liability Ior Lanni. (Lanni's IOU is the bank's
Iinancial asset.) The cash Lanni receives is a Iinancial asset. The new Iinancial
asset created is Lanni's promissory note (that is, Lanni`s IOU to the bank).

b. Lanni tiansfeis financial assets (cash) to the softwaie uevelopeis. In
ietuin, Lanni gets a ieal asset, the completeu softwaie. No financial
assets aie cieateu oi uestioyeu; cash is simply tiansfeiieu fiom one paity
to anothei.

c. Lanni gives the ieal asset (the softwaie) to Niciosoft in exchange foi a
financial asset, , shaies of Niciosoft stock. If Niciosoft issues new
shaies in oiuei to pay Lanni, then this woulu iepiesent the cieation of new
financial assets.

u. Lanni exchanges one financial asset (, shaies of stock) foi anothei
(,). Lanni gives a financial asset (, cash) to the bank anu
gets back anothei financial asset (its I00). The loan is uestioyeu in the
tiansaction, since it is ietiieu when paiu off anu no longei exists.


%. a.
Assets
,-tes &
Sh,7eho/e7s equty
Cash $ 70,000 Bank loan $ 0,000
Computers 30,000 Shareholders` equity 0,000
Total $100,000 Total $100,000
Ratio of ieal assets to total assets = ,, = .

b.
Assets
,-tes &
Sh,7eho/e7s equty
SoItware product* $ 70,000 Bank loan $ 0,000
Computers 30,000 Shareholders` equity 0,000
Total $100,000 Total $100,000
alueu at cost
Ratio of ieal assets to total assets = ,, = .

c.
Assets
,-tes &
Sh,7eho/e7s equty
MicrosoIt shares $120,000 Bank loan $ 0,000
Computers 30,000 Shareholders` equity 100,000
Total $10,000 Total $10,000
Ratio of ieal assets to total assets = ,, = .
Conclusion: when the fiim staits up anu iaises woiking capital, it is
chaiacteiizeu by a low iatio of ieal assets to total assets. When it is in full
piouuction, it has a high iatio of ieal assets to total assets. When the pioject
shuts uown anu the fiim sells it off foi cash, financial assets once again
ieplace ieal assets.


9. Foi commeicial banks, the iatio is: .,.9 = .
Foi non-financial fiims, the iatio is: ,9, = .%
The uiffeience shoulu be expecteu piimaiily because the bulk of the
business of financial institutions is to make loans; which aie financial
assets foi financial institutions.


. a. Piimaiy-maiket tiansaction

b. Beiivative assets

c. Investors who wish to hold gold without the complication and cost oI
physical storage.
11. a. A Iixed salary means that compensation is (at least in the short run)
independent oI the Iirm's success. This salary structure does not tie the
manager`s immediate compensation to the success oI the Iirm. However, the
manager might view this as the saIest compensation structure and thereIore
value it more highly.

b. A salary that is paid in the Iorm oI stock in the Iirm means that the manager earns
the most when the shareholders` wealth is maximized. This structure is thereIore
most likely to align the interests oI managers and shareholders. II stock
compensation is overdone, however, the manager might view it as overly risky
since the manager`s career is already linked to the Iirm, and this undiversiIied
exposure would be exacerbated with a large stock position in the Iirm.

c. Call options on shares oI the Iirm create great incentives Ior managers to
contribute to the Iirm`s success. In some cases, however, stock options can lead
to other agency problems. For example, a manager with numerous call options
might be tempted to take on a very risky investment project, reasoning that iI the
project succeeds the payoII will be huge, while iI it Iails, the losses are limited to
the lost value oI the options. Shareholders, in contrast, bear the losses as well as
the gains on the project, and might be less willing to assume that risk.


12. Even iI an individual shareholder could monitor and improve managers` perIormance,
and thereby increase the value oI the Iirm, the payoII would be small, since the
ownership share in a large corporation would be very small. For example, iI you own
$10,000 oI GM stock and can increase the value oI the Iirm by , a very ambitious
goal, you beneIit by only: 0.0 - $10,000 $00
In contrast, a bank that has a multimillion-dollar loan outstanding to the Iirm has a big
stake in making sure that the Iirm can repay the loan. It is clearly worthwhile Ior the
bank to spend considerable resources to monitor the Iirm.


. Nutual funus accept funus fiom small investois anu invest, on behalf of these
investois, in the national anu inteinational secuiities maikets.
!ension Iunds accept Iunds and then invest, on behalI oI current and Iuture retirees,
thereby channeling Iunds Irom one sector oI the economy to another.
Venture capital Iirms pool the Iunds oI private investors and invest in start-up Iirms.
Banks accept deposits Irom customers and loan those Iunds to businesses, or use the
Iunds to buy securities oI large corporations.


. Tieasuiy bills seive a puipose foi investois who piefei a low-iisk
investment. The lowei aveiage iate of ietuin compaieu to stocks is the
piice investois pay foi pieuictability of investment peifoimance anu
poitfolio value.
. With a "top-uown" investing style, you focus on asset allocation oi the bioau
composition of the entiie poitfolio, which is the majoi ueteiminant of oveiall
peifoimance. Noieovei, top-uown management is the natuial way to establish a
poitfolio with a level of iisk consistent with youi iisk toleiance. The
uisauvantage of an exclusive emphasis on top-uown issues is that you may foifeit
the potential high ietuins that coulu iesult fiom iuentifying anu concentiating in
unueivalueu secuiities oi sectois of the maiket.
With a "bottom-up" investing style, you tiy to benefit fiom iuentifying unueivalueu
secuiities. The uisauvantage is that you tenu to oveilook the oveiall composition of
youi poitfolio, which may iesult in a non-uiveisifieu poitfolio oi a poitfolio with a
iisk level inconsistent with youi level of iisk toleiance. In auuition, this technique
tenus to iequiie moie active management, thus geneiating moie tiansaction costs.
Finally, youi analysis may be incoiiect, in which case you will have fiuitlessly
expenueu effoit anu money attempting to beat a simple buy-anu-holu stiategy.


. You shoulu be skeptical. If the authoi actually knows how to achieve such ietuins,
one must question why the authoi woulu then be so ieauy to sell the seciet to
otheis. Financial maikets aie veiy competitive; one of the implications of this fact
is that iiches uo not come easily. Bigh expecteu ietuins iequiie beaiing some iisk,
anu obvious baigains aie few anu fai between. 0uus aie that the only one getting
iich fiom the book is its authoi.


. a. The SEC website uefines the uiffeience between saving anu investing in
teims of the investment alteinatives oi the financial assets the inuiviuual
chooses to acquiie. Accoiuing to the SEC website, saving is the piocess of
acquiiing a "safe" financial asset anu investing is the piocess of acquiiing
"iisky" financial assets.

b. The economist's uefinition of savings is the uiffeience between income
anu consumption. Investing is the piocess of allocating one's savings
among available assets, both ieal assets anu financial assets. The SEC
uefinitions actually iepiesent (accoiuing the economist's uefinition) two
kinus of investment alteinatives.


%. As is the case foi the SEC uefinitions (see Pioblem ), the SIA uefines saving
anu investing as acquisition of alteinative kinus of financial assets. Accoiuing
to the SIA, saving is the piocess of acquiiing safe assets, geneially fiom a bank,
while investing is the acquisition of othei financial assets, such as stocks anu
bonus. 0n the othei hanu, the uefinitions in the chaptei inuicate that saving
means spenuing less than one's income. Investing is the piocess of allocating
one's savings among financial assets, incluuing savings account ueposits anu
money maiket accounts ("saving" accoiuing to the SIA), othei financial assets
such as stocks anu bonus ("investing" accoiuing to the SIA), as well as ieal
assets.
Chaptei
CHAPTER 2: ASSET CLASSES AND
FINANCIAL INVESTMENTS


PROBLEM SETS


1. !reIerred stock is like long-term debt in that it typically promises a Iixed payment
each year. In this way, it is a perpetuity. !reIerred stock is also like long-term debt
in that it does not give the holder voting rights in the Iirm.
!reIerred stock is like equity in that the Iirm is under no contractual obligation to make
the preIerred stock dividend payments. Failure to make payments does not set oII
corporate bankruptcy. With respect to the priority oI claims to the assets oI the Iirm in
the event oI corporate bankruptcy, preIerred stock has a higher priority than common
equity but a lower priority than bonds.


2. Money market securities are called 'cash equivalents because oI their great
liquidity. The prices oI 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.


3. The spread will widen. Deterioration oI the economy increases credit risk, that is,
the likelihood oI deIault. Investors will demand a greater premium on debt
securities subject to deIault risk.


4. On the day we tried this experiment, 36 oI the 0 stocks met this criterion, leading us to
conclude that returns on stock investments can be quite volatile.



. a. You would have to pay the asked price oI:
118:31 118.9687 oI par $1,189.687

b. The coupon rate is 11.70 implying coupon payments oI $117.0 annually or,
more precisely, $8.7 semiannually.

c. Current yield Annual coupon income/price
$117.0/$1,189.687 0.0988 9.88


6. ! $10,000/1.02 $9,803.92
7. The total beIore-tax income is $4. AIter the 70 exclusion Ior preIerred stock dividends,
the taxable income is: 0.30 - $4 $1.20
ThereIore, taxes are: 0.30 - $1.20 $0.36
AIter-tax income is: $4.00 $0.36 $3.64
Rate oI return is: $3.64/$40.00 9.10


8. a. General Dynamics closed today at $74.9, which was $0.17 higher than yesterday`s
price. Yesterday`s closing price was: $74.42

b. You could buy: $,000/$74.9 67.03 shares

c. Your annual dividend income would be: 67.03 - $0.92 $61.67

d. The price-to-earnings ratio is 16 and the price is $74.9. ThereIore:
$74.9/Earnings per share 16 Earnings per share $4.66


9. a. At t 0, the value oI the index is: (90 0 100)/3 80
At t 1, the value oI the index is: (9 4 110)/3 83.333
The rate oI return is: (83.333/80) 1 4.17

b. In the absence oI a split, Stock C would sell Ior 110, so the value oI the index
would be: 20/3 83.333
AIter the split, Stock C sells Ior . ThereIore, we need to Iind the divisor (d)
such that:
83.333 (9 4 )/d d 2.340

c. The return is zero. The index remains unchanged because the return Ior each
stock separately equals zero.


10. a. Total market value at t 0 is: ($9,000 $10,000 $20,000) $39,000
Total market value at t 1 is: ($9,00 $9,000 $22,000) $40,00
Rate oI return ($40,00/$39,000) 1 3.8

b. The return on each stock is as Iollows:
r
A
(9/90) 1 0.06
r
B
(4/0) 1 0.10
r
C
(110/100) 1 0.10
The equally-weighted average is:
|0.06 (-0.10) 0.10|/3 0.018 1.8
11. The aIter-tax yield on the corporate bonds is: 0.09 - (1 0.30) 0.0630 6.30
ThereIore, municipals must oIIer at least 6.30 yields.


12. Equation (2.2) shows that the equivalent taxable yield is: r r
m
/(1 t)
a. 4.00
b. 4.44
c. .00
d. .71


13. a. The higher coupon bond.
b. The call with the lower exercise price.
c. The put on the lower priced stock.


14. a. You bought the contract when the Iutures price was 1427.0 (see Figure 2.12). The
contract closes at a price oI 1300, which is 127.0 less than the original Iutures price.
The contract multiplier is $20. ThereIore, the loss will be:
127.0 - $20 $31,87

b. Open interest is 601,6 contracts.


1. a. Since the stock price exceeds the exercise price, you will exercise the call.
The payoII on the option will be: $42 $40 $2
The option originally cost $2.14, so the proIit is: $2.00 $2.14 $0.14
Rate oI return $0.14/$2.14 0.064 6.4

b. II the call has an exercise price oI $42.0, you would not exercise Ior any stock
price oI $42.0 or less. The loss on the call would be the initial cost: $0.72

c. Since the stock price is less than the exercise price, you will exercise the put.
The payoII on the option will be: $42.0 $42.00 $0.0
The option originally cost $1.83 so the proIit is: $0.0 $1.83 $1.33
Rate oI return $1.33/$1.83 0.7268 72.68

16. There is always a possibility that the option will be in-the-money at some time prior to
expiration. Investors will pay something Ior this possibility oI a positive payoII.


17.
Value oI call at expiration Initial Cost !roIit
a. 0 4 -4
b. 0 4 -4
c. 0 4 -4
d. 4 1
e. 10 4 6

Value oI put at expiration Initial Cost !roIit
a. 10 6 4
b. 6 -1
c. 0 6 -6
d. 0 6 -6
e. 0 6 -6


18. A put option conveys the 7ht to sell the underlying asset at the exercise price. A
short position in a Iutures contract carries an o-,ton to sell the underlying asset at
the Iutures price.


19. A call option conveys the 7ht to buy the underlying asset at the exercise price. A
long position in a Iutures contract carries an o-,ton to buy the underlying asset
at the Iutures price.


CFA PROBLEMS


1. (d)

2. The equivalent taxable yield is: 6.7/(1 0.34) 10.23

3. (a) Writing a call entails unlimited potential losses as the stock price rises.


4. a. The taxable bond. With a zero tax bracket, the aIter-tax yield Ior the taxable bond
is the same as the beIore-tax yield (), which is greater than the yield on the
municipal bond.

b. The taxable bond. The aIter-tax yield Ior the taxable bond is:
0.0 - (1 0.10) 4.

c. You are indiIIerent. The aIter-tax yield Ior the taxable bond is:
0.0 - (1 0.20) 4.0
The aIter-tax yield is the same as that oI the municipal bond.

d. The municipal bond oIIers the higher aIter-tax yield Ior investors in tax brackets
above 20.


. II the aIter-tax yields are equal, then: 0.06 0.08 - (1 t)
This implies that t 0.30 30.


Chaptei

CHAPTER 3: HOW SECURITIES ARE TRADED


PRUBLEM SETS


. Answeis to this pioblem will vaiy.


2. The SuperDot system expedites the flow of orders from exchange
members to the specialists. t allows members to send
computerized orders directly to the floor of the exchange, which
allows the nearly simultaneous sale of each stock in a large
portfolio. This capability is necessary for program trading.


. The uealei sets the biu anu askeu piice. Spieaus shoulu be highei on inactively
tiaueu stocks anu lowei on actively tiaueu stocks.


. a. In piinciple, potential losses aie unbounueu, giowing uiiectly with
incieases in the piice of IBN.

b. If the stop-buy oiuei can be filleu at %, the maximum possible loss pei
shaie is %. If the piice of IBN shaies goes above %, then the stop-buy
oiuei woulu be executeu, limiting the losses fiom the shoit sale.


. a. The stock is purchased Ior: 300 - $40 $12,000
The amount borrowed is $4,000. ThereIore, the investor put up equity, or
margin, oI $8,000.

b. If the shaie piice falls to , then the value of the stock falls to 9,.
By the enu of the yeai, the amount of the loan oweu to the biokei giows
to:
$4,000 - 1.08 $4,320
ThereIore, the remaining margin in the investor`s account is:
$9,000 $4,320 $4,680
The peicentage maigin is now: ,%9, = . = %
Theiefoie, the investoi will not ieceive a maigin call.

c. The iate of ietuin on the investment ovei the yeai is:
(Ending equity in the account Initial equity)/Initial equity
($4,680 $8,000)/$8,000 0.41 41.
6. a. The initial margin was: 0.0 - 1,000 - $40 $20,000
As a result oI the increase in the stock price Old Economy Traders loses:
$10 - 1,000 $10,000
ThereIore, margin decreases by $10,000. Moreover, Old Economy Traders
must pay the dividend oI $2 per share to the lender oI the shares, so that the
margin in the account decreases by an additional $2,000. ThereIore, the
remaining margin is:
$20,000 $10,000 $2,000 $8,000

b. The peicentage maigin is: %,, = . = %
So theie will be a maigin call.

c. The equity in the account uecieaseu fiom , to %, in one yeai, foi
a iate of ietuin of: (,,) = . = %


. Nuch of what the specialist uoes (e.g., ciossing oiueis anu maintaining the limit
oiuei book) can be accomplisheu by a computeiizeu system. In fact, some
exchanges use an automateu system foi night tiauing. A moie uifficult issue to
iesolve is whethei the moie uiscietionaiy activities of specialists involving tiauing
foi theii own accounts (e.g., maintaining an oiueily maiket) can be ieplicateu by a
computei system.


%. a. The buy oiuei will be filleu at the best limit-sell oiuei piice: .

b. The next maiket buy oiuei will be filleu at the next-best limit-
sell oiuei piice: .

c. You woulu want to inciease youi inventoiy. Theie is consiueiable buying
uemanu at piices just below , inuicating that uownsiue iisk is limiteu. In
contiast, limit sell oiueis aie spaise, inuicating that a moueiate buy oiuei
coulu iesult in a substantial piice inciease.


9. a. You buy shaies of Telecom foi ,. These shaies inciease in value
by %, oi ,. You pay inteiest of: .% - , =
The iate of ietuin will be:
000 , $
400 $ 000 , 1 $
= . = %
b. The value of the shaies is P. Equity is (P - ,). You will
ieceive a maigin call when:
! 200
000 , $ ! 200
= . when P = . oi lowei


. a. Initial maigin is % of , oi ,.

b. Total assets aie , (, fiom the sale of the stock anu , put up
foi maigin). Liabilities aie P. Theiefoie, equity is (, - P). A
maigin call will be issueu when:
! 100
! 100 00 , 7 $
= . when P = .9 oi highei


. The total cost of the puichase is: - = ,
You boiiow , fiom youi biokei, anu invest , of youi own
funus. Youi maigin account staits out with equity of ,.
a. (i) Equity incieases to: ( - ) - , = ,
Peicentage gain = ,, = . = .%
(ii) With piice unchangeu, equity is unchangeu.
Peicentage gain = zeio
(iii) Equity falls to ( - ) - , = ,
Peicentage gain = (-,,) = -. = -.%
The ielationship between the peicentage ietuin anu the peicentage
change in the piice of the stock is given by:
% ietuin = % change in piice -
equity initial s Investor'
investment Total
= % change in piice - .
Foi example, when the stock piice iises fiom to , the peicentage
change in piice is %, while the peicentage gain foi the investoi is:
% ietuin = % -
000 , 1 $
000 , 20 $
= .%

b. The value of the shaies is P. Equity is (P - ,). You will
ieceive a maigin call when:
! 00
000 , $ ! 00
= . when P = . oi lowei
c. The value of the shaies is P. But now you have boiioweu ,
insteau of ,. Theiefoie, equity is (P - ,). You will ieceive
a maigin call when:
! 00
000 , 10 $ ! 00
= . when P = .
With less equity in the account, you aie fai moie vulneiable to a maigin
call.

u. By the enu of the yeai, the amount of the loan oweu to the biokei giows
to:
, - .% = ,
The equity in youi account is (P - ,). Initial equity was ,.
Theiefoie, youi iate of ietuin aftei one yeai is as follows:
(i)
000 , 1 $
000 , 1 $ 400 , $ ) 44 $ 00 ( -
= . = .%
(ii)
000 , 1 $
000 , 1 $ 400 , $ ) 40 $ 00 ( -
= -. = -.%
(iii)
000 , 1 $
000 , 1 $ 400 , $ ) 36 $ 00 ( -
= -. = -.%
The ielationship between the peicentage ietuin anu the peicentage
change in the piice of Intel is given by:
% ietuin =

'
+

'

-
equity initial s Investor'
investment Total
price in change

'
+

'

-
equity initial s Investor'
borrowed Funds
8
Foi example, when the stock piice iises fiom to , the peicentage
change in piice is %, while the peicentage gain foi the investoi is:

'
+

'

-
000 , 1 $
000 , 20 $
10
'
+

'

-
000 , 1 $
000 , $
8 =.%

e. The value of the shaies is P. Equity is (P - ,). You will
ieceive a maigin call when:
! 00
400 , $ ! 00
= . when P = . oi lowei


. a. The gain oi loss on the shoit position is: (- - AP)
Investeu funus = ,
Theiefoie: iate of ietuin = (- - AP),
The iate of ietuin in each of the thiee scenaiios is:
(i) iate of ietuin = (- - 4), = -. = -.%
(ii) iate of ietuin = (- - 0), = %
(iii) iate of ietuin = |- - (-)j, = +. = +.%

b. Total assets in the maigin account equal:
, (fiom the sale of the stock) + , (the initial maigin) =
,
Liabilities aie P. You will ieceive a maigin call when:
! 00
! 00 000 , 3 $
= . when P = oi highei

c. With a uiviuenu, the shoit position must now pay on the boiioweu
shaies: (shaie - shaies) = . Rate of ietuin is now:
|(- - AP) - j,
(i) iate of ietuin = |(- - 4) - j, = -. = -.%
(ii) iate of ietuin = |(- - 0) j, = -. = -.%
(iii) iate of ietuin = |(-) - (-) - j, = +. =
+.%
Total assets aie ,, anu liabilities aie (P + ). A maigin call will
be issueu when:
! 00
00 ! 00 000 , 3
= . when P = . oi highei


. The broker is instructed to attempt to sell your Marriott stock as soon as
the Marriott stock trades at a bid price of $ or less. Here, the
broker will attempt to execute, but may not be able to sell at $,
since the bid price is now $.95. The price at which you sell may
be more or less than $ because the stop-loss becomes a market
order to sell at current market prices.


. a. .

b. .

c. The tiaue will not be executeu because the biu piice is lowei than the piice
specifieu in the limit sell oiuei.

u. The tiaue will not be executeu because the askeu piice is gieatei than the
piice specifieu in the limit buy oiuei.


. a. In an exchange maiket, theie can be piice impiovement in the two maiket
oiueis. Biokeis foi each of the maiket oiueis (i.e., the buy oiuei anu the sell
oiuei) can agiee to execute a tiaue insiue the quoteu spieau. Foi example,
they can tiaue at ., thus impioving the piice foi both customeis by
. oi . ielative to the quoteu biu anu askeu piices. The buyei gets
the stock foi . less than the quoteu askeu piice, anu the sellei ieceives
. moie foi the stock than the quoteu biu piice.

b. Wheieas the limit oiuei to buy at . woulu not be executeu in a uealei
maiket (since the askeu piice is .), it coulu be executeu in an exchange
maiket. A biokei foi anothei customei with an oiuei to sell at maiket
woulu view the limit buy oiuei as the best biu piice; the two biokeis coulu
agiee to the tiaue anu biing it to the specialist, who woulu then execute the
tiaue.


. a. You will not ieceive a maigin call. You boiioweu , anu with
anothei , of youi own equity you bought , shaies of Bisney at
pei shaie. At pei shaie, the maiket value of the stock is ,,
youi equity is ,, anu the peicentage maigin is: ,, =
.9%
Youi peicentage maigin exceeus the iequiieu maintenance maigin.

b. You will ieceive a maigin call when:
! 000 , 1
000 , 20 $ ! 000 , 1
= . when P = . oi lowei


. The pioceeus fiom the shoit sale (net of commission) weie: ( - ) - =
,
A uiviuenu payment of was withuiawn fiom the account. Coveiing the shoit
sale at 9 pei shaie cost you (incluuing commission): 9 + = 9
Theiefoie, the value of youi account is equal to the net piofit on the tiansaction:
- - 9 =
Note that youi piofit () equals ( shaies - piofit pei shaie of ). Youi net
pioceeus pei shaie was:
selling piice of stock
-9 iepuichase piice of stock
- uiviuenu pei shaie
- tiaues - . commission pei shaie



PRUBLEMS


. a. In auuition to the explicit fees of ,, FBN appeais to have paiu an
implicit piice in unueipiicing of the IP0. The unueipiicing is pei shaie,
oi a total of ,, implying total costs of ,.

b. No. The unueiwiiteis uo not captuie the pait of the costs
coiiesponuing to the unueipiicing. The unueipiicing may be a
iational maiketing stiategy. Without it, the unueiwiiteis woulu neeu
to spenu moie iesouices in oiuei to place the issue with the public.
The unueiwiiteis woulu then neeu to chaige highei explicit fees to
the issuing fiim. The issuing fiim may be just as well off paying the
implicit issuance cost iepiesenteu by the unueipiicing.


. (u) The biokei will sell, at cuiient maiket piice, aftei the fiist
tiansaction at oi less.

. (u)








Chaptei

CHAPTER 4: MUTUAL FUNDS AND
OTHER INVESTMENT COMPANIES


PRUBLEM SETS


. The unit investment tiust shoulu have lowei opeiating expenses. Because the
investment tiust poitfolio is fixeu once the tiust is establisheu, it uoes not have
to pay poitfolio manageis to constantly monitoi anu iebalance the poitfolio as
peiceiveu neeus oi oppoitunities change. Because the poitfolio is fixeu, the
unit investment tiust also incuis viitually no tiauing costs.


. a. Zit iZvestmeZt trusts: uiveisification fiom laige-scale investing, lowei
tiansaction costs associateu with laige-scale tiauing, low management
fees, pieuictable poitfolio composition, guaianteeu low poitfolio
tuinovei iate.

b. 0peZeZV mutuol fuZVs: uiveisification fiom laige-scale investing, lowei
tiansaction costs associateu with laige-scale tiauing, piofessional
management that may be able to take auvantage of buy oi sell
oppoitunities as they aiise, iecoiu keeping.

c. lZViviVuol stocks oZV boZVs: No management fee, iealization of capital
gains oi losses can be cooiuinateu with investois' peisonal tax situations,
poitfolio can be uesigneu to investoi's specific iisk piofile.


. 0pen-enu funus aie obligateu to ieueem investois shaies at net asset value,
anu thus must keep cash oi cash-equivalent secuiities on hanu in oiuei to
meet potential ieuemptions. Closeu-enu funus uo not neeu the cash ieseives
because theie aie no ieuemptions foi closeu-enu funus. Investois in closeu-
enu funus sell theii shaies when they wish to cash out.


. Balanceu funus keep ielatively stable piopoitions of funus investeu in each
asset class. They aie meant as convenient instiuments to pioviue paiticipation
in a iange of asset classes. Life-cycle funus aie balanceu funus whose asset mix
geneially uepenus on the age of the investoi. Aggiessive life-cycle funus, with
laigei investments in equities, aie maiketeu to youngei investois, while
conseivative life-cycle funus, with laigei investments in fixeu-income
secuiities, aie uesigneu foi oluei investois. Asset allocation funus, in contiast,
may vaiy the piopoitions investeu in each asset class by laige amounts as
pieuictions of ielative peifoimance acioss classes vaiy. Asset allocation funus
theiefoie engage in moie aggiessive maiket timing.

. The offeiing piice incluues a % fiont-enu loau, oi sales commission, meaning
that eveiy uollai paiu iesults in only .9 going towaiu puichase of shaies.
Theiefoie:
0ffeiing piice =
06 . 0 1
70 . 10 $
load 1
NAV

= .%


. NA = offeiing piice - ( - loau) = . - 0.9 = .9


. Stock alue helu by funu
A ,,
B ,,
C %,,
B ,,
Total ,,
Net asset value =
000 , 000 , 4
000 , 30 $ 000 , 000 , 42 $
= .9


%. alue of stocks solu anu ieplaceu = ,,
Tuinovei iate =
000 , 000 , 42 $
000 , 000 , 1 $
= . = .%


9. a. 40 . 39 $
000 , 000 ,
000 , 000 , 3 $ 000 , 000 , 200 $
NAV =

=

b. Piemium (oi uiscount) =
NAV
NAV ice !r
=
40 . 39 $
40 . 39 $ 36 $
= -.% = -%.%
The funu sells at an %.% uiscount fiom NA.


. Rate of ietuin =
8 . 8 088 . 0
0 . 12 $
0 . 1 $ 0 . 12 $ 10 . 12 $
NAV
ons distributi NAV NAV
0
0 1
= =
+
=
+



. a. Stait-of-yeai piice: P = . - . = .
Enu-of-yeai piice: P = . - .9 = .
Although NA incieaseu by ., the piice of the funu uecieaseu by:
.99
Rate of ietuin = 2 . 4 042 . 0
24 . 12 $
0 . 1 $ 24 . 12 $ 2 . 11 $
!
ons Distributi ! !
0
0 1
= =
+
=
+


b. An investoi holuing the same secuiities as the funu managei woulu have
eaineu a iate of ietuin baseu on the inciease in the NA of the poitfolio:
Rate of ietuin =
3 . 13 133 . 0
00 . 12 $
0 . 1 $ 00 . 12 $ 10 . 12 $
NAV
ons distributi NAV NAV
0
0 1
= =
+
=
+



. a. Empiiical ieseaich inuicates that past peifoimance of mutual funus is not
highly pieuictive of futuie peifoimance, especially foi bettei-peifoiming
funus. While theie moy be some tenuency foi the funu to be an above
aveiage peifoimei next yeai, it is unlikely to once again be a top %
peifoimei.

b. 0n the othei hanu, the eviuence is moie suggestive of a tenuency foi pooi
peifoimance to peisist. This tenuency is piobably ielateu to funu costs
anu tuinovei iates. Thus if the funu is among the pooiest peifoimeis,
investois woulu be conceineu that the pooi peifoimance will peisist.


. NA = ,,,, =
Biviuenus pei shaie = ,,,, = .
NA is baseu on the %% piice gain, less the % b- fee:
NA = - .% - ( - .) = .%
Rate of ietuin =
20 $
20 . 0 $ 20 $ 384 . 21 $ +
= .9 = .9%


. The excess of puichases ovei sales must be uue to new inflows into the funu.
Theiefoie, million of stock pieviously helu by the funu was ieplaceu by
new holuings. So tuinovei is: , = .% = %.%


. Fees paiu to investment manageis weie: . - . billion = . million
Since the total expense ratio was 1.1 and the management Iee was 0.7, we
conclude that 0.4 must be Ior other expenses. ThereIore, other administrative
expenses were: 0.004 - $2.2 billion $8.8 million
16. As an initial approximation, your return equals the return on the shares minus the
total oI the expense ratio and purchase costs: 12 1.2 4 6.8
But the precise return is less than this because the 4 load is paid up Iront, not at
the end oI the year.
To purchase the shares, you would have had to invest: $20,000/(1 0.04) $20,833
The shares increase in value Irom $20,000 to: $20,000 - (1.12 0.012) $22,160
The rate oI return is: ($22,160 $20,833)/$20,833 6.37


17. Suppose you have $1,000 to invest. The initial investment in Class A shares is $940
net oI the Iront-end load. AIter Iour years, your portIolio will be worth:
9 - (.)

= ,.
Class B shares allow you to invest the Iull $1,000, but your investment perIormance
net oI 12b-1 Iees will be only 9., and you will pay a 1 back-end load Iee iI you
sell aIter Iour years. Your portIolio value aIter Iour years will be:
, - (.9)

= ,.
Aftei paying the back-enu loau fee, youi poitfolio value will be:
,. - 0.99 = ,.%
Class B shaies aie the bettei choice if youi hoiizon is foui yeais.
With a fifteen-yeai hoiizon, the Class A shaies will be woith:
9 - (.)

= ,9.
Foi the Class B shaies, theie is no back-enu loau in this case since the hoiizon
is gieatei than five yeais. Theiefoie, the value of the Class B shaies will be:
, - (.9)

= ,9.
At this longei hoiizon, Class B shaies aie no longei the bettei choice. The effect
of Class Bs .% b- fees accumulates ovei time anu finally oveiwhelms the
% loau chaigeu to Class A investois.


%. a. Aftei two yeais, each uollai investeu in a funu with a % loau anu a
poitfolio ietuin equal to i will giow to: .9 - ( + i - .)

Each uollai investeu in the bank CB will giow to: - .

If the mutual funu is to be the bettei investment, then the poitfolio ietuin
(i) must satisfy:
.9 - ( + i - .)

> .

.9 - ( + i - .)

> .
( + i - .)

> .
+ i - . > .%9
+ i > .%9
Theiefoie: i > .%9 = %.9%
b. If you invest foi six yeais, then the poitfolio ietuin must satisfy:
.9 - ( + i - .)

> .

= .%
( + i - .)

> .
+ i - . > .
+ i > .
i > .%
The cutoff iate of ietuin is lowei foi the six-yeai investment because the
"fixeu cost" (i.e., the one-time fiont-enu loau) is spieau out ovei a gieatei
numbei of yeais.

c. With a b- fee insteau of a fiont-enu loau, the poitfolio must eain a
iate of ietuin (i) that satisfies:
+ i - . - . > .
In this case, i must exceeu .% iegaiuless of the investment hoiizon.


9. The tuinovei iate is %. This means that, on aveiage, % of the poitfolio is
solu anu ieplaceu with othei secuiities each yeai. Tiauing costs on the sell
oiueis aie .% anu the buy oiueis to ieplace those secuiities entail anothei
.% in tiauing costs. Total tiauing costs will ieuuce poitfolio ietuins by: -
.% - . = .%


. Foi the bonu funu, the fiaction of poitfolio income given up to fees is:
0 . 4
6 . 0
= . = .%
Foi the equity funu, the fiaction of investment eainings given up to fees is:
0 . 12
6 . 0
= . = .%
Fees aie a much highei fiaction of expecteu eainings foi the bonu funu, anu
theiefoie may be a moie impoitant factoi in selecting the bonu funu.
This may help to explain why unmanageu unit investment tiusts aie
concentiateu in the fixeu income maiket. The auvantages of unit investment
tiusts aie low tuinovei, low tiauing costs anu low management fees. This is a
moie impoitant concein to bonu-maiket investois.


. Suppose that finishing in the top half of all poitfolio manageis is puiely luck,
anu that the piobability of uoing so in any yeai is exactly V. Then the
piobability that any paiticulai managei woulu finish in the top half of the
sample five yeais in a iow is (V)

= . We woulu then expect to finu that

| - ()j = manageis finish in the top half foi each of the five
consecutive yeais. This is piecisely what we founu. Thus, we shoulu not
concluue that the consistent peifoimance aftei five yeais is pioof of skill. We
woulu expect to finu eleven manageis exhibiting piecisely this level of
consistency even if peifoimance is uue solely to luck.



CAPN Pioblems
Chaptei 9

CHAPTER 9: THE CAPITAL ASSET PRICING MODEL


PRUBLEM SETS


. E(iP) = if + . P |E(iN ) - if j
% = + . P( - ) . P = % = .


2.II the security`s correlation coeIIicient with the market portIolio doubles (with all
other variables such as variances unchanged), then beta, and thereIore the risk
premium, will also double. The current risk premium is: 14 6 8
The new iisk piemium woulu be %, anu the new uiscount iate foi the
secuiity woulu be: + = %
f the stock pays a constant perpetual dividend, then we know from the original
data that the dividend (D) must satisfy the equation for the present
value of a perpetuity:
Piice = BiviuenuBiscount iate
= B. B = - . = .
t the new discount rate of 22%, the stock would be worth: $.22 = $.2
The increase in stock risk has lowered its value by .%.


. a. False. . = implies E(i) = if , not zeio.

b. False. Investors require a risk premium only Ior bearing systematic
(undiversiIiable or market) risk. Total volatility includes diversiIiable risk.

c. False. Youi poitfolio shoulu be investeu % in the maiket poitfolio
anu % in T-bills. Then:
.P = (. - ) + (. - ) = .


. The appiopiiate uiscount iate foi the pioject is:
if + .|E(iN ) - if j = % + |.% - ( - %)j = .%
0sing this uiscount iate:
- + = + =

=
1 |$ 40 $
224 . 1
1 $
40 $ N!V
10
1 t
t
Annuity factoi (.%, yeais)j =
%.9
The inteinal iate of ietuin (IRR) foi the pioject is .%. Recall fiom youi
intiouuctoiy finance class that NP is positive if IRR > uiscount iate (oi,
equivalently, huiule iate). The highest value that beta can take befoie the
huiule iate exceeus the IRR is ueteimineu by:
. = % + .( - %) . = .% = .

. a. Call the aggiessive stock A anu the uefensive stock B. Beta is the
sensitivity of the stock's ietuin to the maiket ietuin, i.e., the change in the
stock ietuin pei unit change in the maiket ietuin. Theiefoie, we compute
each stock's beta by calculating the uiffeience in its ietuin acioss the two
scenaiios uiviueu by the uiffeience in the maiket ietuin:
00 . 2
2
38 2
A
=

= .
30 . 0
2
12 6
D
=

= .

b. With the two scenaiios equally likely, the expecteu ietuin is an aveiage of
the two possible outcomes:
E(iA ) = . - (- + %) = %%
E(iB ) = . - ( + ) = 9%

c. The SNL is ueteimineu by the maiket expecteu ietuin of |.( + )j =
%, with a beta of , anu the T-bill ietuin of % with a beta of zeio. See
the following giaph.
Expected Return - Beta ReIationship

5
2
25

5
4
.5 .5 2 2.5
Beta
E
x
p
e
c
t
e
d

R
e
t
u
r
n
SML
D M
A
-
A

The equation for the security market line is:
E(i) = + .( - )
d. Based on its risk, the aggressive stock has a required expected return oI:
E(iA ) = + .( - ) = %
The analyst's foiecast of expecteu ietuin is only %%. Thus the stock's
alpha is:
- A = actually expecteu ietuin - iequiieu ietuin (given iisk)
= %% - % = -%
Similaily, the iequiieu ietuin foi the uefensive stock is:
E(iB) = + .( - ) = %.%
The analyst's foiecast of expecteu ietuin foi B is 9%, anu hence, the stock
has a positive alpha:
- B = actually expecteu ietuin - iequiieu ietuin (given iisk)
9 8.7 0.3
The points foi each stock plot on the giaph as inuicateu above.

e. The huiule iate is ueteimineu by the pioject beta (.), not the fiim's
beta. The coiiect uiscount iate is %.%, the faii iate of ietuin foi stock B.


6. Not possible. !ortIolio A has a higher beta than !ortIolio B, but the expected return
Ior !ortIolio A is lower than the expected return Ior !ortIolio B. Thus, these two
portIolios cannot exist in equilibrium.


7.!ossible. II the CA!M is valid, the expected rate oI return compensates only Ior
systematic (market) risk, represented by beta, rather than Ior the standard deviation,
which includes nonsystematic risk. Thus, !ortIolio A`s lower rate oI return can be
paired with a higher standard deviation, as long as A`s beta is less than B`s.


8. Not possible. The reward-to-variability ratio Ior !ortIolio A is better than that oI the
market. This scenario is impossible according to the CA!M because the CA!M
predicts that the market is the most eIIicient portIolio. Using the numbers supplied:
. 0
12
10 16
S
A
=

=
33 . 0
24
10 18
S
M
=

=
!ortIolio A provides a better risk-reward tradeoII than the market portIolio.


9. Not possible. Poitfolio A cleaily uominates the maiket poitfolio. Poitfolio A has
both a lowei stanuaiu ueviation anu a highei expecteu ietuin.
. Not possible. The SNL foi this scenaiio is: E(i) = + .(% - )
!ortfolios with beta equal to .5 have an expected return equal to:
E(i) = + |. - (% - )j = %
The expecteu ietuin foi Poitfolio A is %; that is, Poitfolio A plots below
the SNL (- A = -%), anu hence, is an oveipiiceu poitfolio. This is
inconsistent with the CAPN.


. Not possible. The SNL is the same as in Pioblem . Beie, Poitfolio A's
iequiieu ietuin is: + (.9 - %) = .%
This is gieatei than %. Poitfolio A is oveipiiceu with a negative alpha:
- A = -.%


. Possible. The CNL is the same as in Pioblem %. Poitfolio A plots below the CNL,
as any asset is expecteu to. This scenaiio is not inconsistent with the CAPN.


13. Since the stock`s beta is equal to 1.2, its expected rate oI return is:
+ |. - ( - )j = %%
0
0 1 1
!
! ! D
) r ( E
+
=
3 $ !
0
0 ! 6
18 . 0
1
1
=
+
=




. The seiies of , payments is a peipetuity. If beta is ., the cash flow
shoulu be uiscounteu at the iate:
+ |. - ( - )j = %
P = ,. = 9,9.9
II, however, beta is equal to 1, then the investment should yield 16, and the price
paid Ior the Iirm should be:
!V $1,000/0.16 $6,20
The uiffeience, ,%.9, is the amount you will oveipay if you eiioneously
assume that beta is . iathei than .


. 0sing the SNL: = + .( - ) . = - = -.

. i = 9%; i = %; . = .; . =
a. To ueteimine which investoi was a bettei selectoi of inuiviuual stocks we
look at abnoimal ietuin, which is the ex-post alpha; that is, the abnoimal
ietuin is the uiffeience between the actual ietuin anu that pieuicteu by
the SNL. Without infoimation about the paiameteis of this equation
(iisk-fiee iate anu maiket iate of ietuin) we cannot ueteimine which
investoi was moie accuiate.

b. If if = % anu iN = %, then (using the notation alpha foi the abnoimal
ietuin):
- = 9 - | + .( - )j = 9 - % = %
- = - | + ( - )j = - = %
Beie, the seconu investoi has the laigei abnoimal ietuin anu thus
appeais to be the supeiioi stock selectoi. By making bettei pieuictions,
the seconu investoi appeais to have tilteu his poitfolio towaiu
unueipiiceu stocks.

c. If if = % anu iN = %, then:
- =9 - | + .( - )j = 9 - = -%
- = - |+ ( - )j = - = %
Beie, not only uoes the seconu investoi appeai to be the supeiioi stock
selectoi, but the fiist investoi's pieuictions appeai valueless (oi woise).


. a. Since the maiket poitfolio, by uefinition, has a beta of , its expecteu iate
of ietuin is %.

b. . = means no systematic iisk. Bence, the stock's expecteu iate of ietuin
in maiket equilibiium is the iisk-fiee iate, %.

c. 0sing the SNL, the foir expecteu iate of ietuin foi a stock with . = -. is:
E(i) = + |(-.)( - )j = .%
The octuolly expecteu iate of ietuin, using the expecteu piice anu
uiviuenu foi next yeai is:
E(i) = |( + )j - = . = %
Because the actually expecteu ietuin exceeus the faii ietuin, the stock is
unueipiiceu.


18. In the zero-beta CA!M the zero-beta portIolio replaces the risk-Iree rate, and thus:
E(r) 8 0.6(17 8) 13.4

9. a. E(iP) = if + . P |E(iN ) - if j = % + .% (% - %) = %
- = % % = %
You shoulu invest in this funu because alpha is positive.

b. The passive poitfolio with the same beta as the funu shoulu be investeu
%% in the maiket-inuex poitfolio anu % in the money maiket
account. Foi this poitfolio:
E(iP) = (.% %) + (. %) = %
% - % = % = -


20. a. We would incorporate liquidity into the CCA!M in a manner analogous to the
way in which liquidity is incorporated into the conventional CA!M. In the
latter case, in addition to the market risk premium, expected return is also
dependent on the expected cost oI illiquidity and three liquidity-related betas
which measure the sensitivity oI: (1) the security`s illiquidity to market
illiquidity; (2) the security`s return to market illiquidity; and, (3) the security`s
illiquidity to the market return. A similar approach can be used Ior the
CCA!M, except that the liquidity betas would be measured relative to
consumption growth rather than the usual market index.

b. As in pait (a), non-tiaueu assets woulu be incoipoiateu into the CCAPN
in a fashion similai to that uesciibeu above, anu, as in pait (a), we woulu
ieplace the maiket poitfolio with consumption giowth. Bowevei, the
issue of liquiuity is moie acute with non tiaueu-assets such as piivately-
helu businesses anu laboi income.
While owneiship of a piivately-helu business is analogous to owneiship
of an illiquiu stock, we shoulu expect a gieatei uegiee of illiquiuity foi the
typical piivate business. As long as the ownei of a piivately-helu business
is satisfieu with the uiviuenus paiu out fiom the business, then the lack of
liquiuity is not an issue. Bowevei, if the ownei seeks to iealize income
gieatei than the business can pay out, then selling owneiship, in full oi in
pait, typically entails a substantial liquiuity uiscount. The coiiection foi
illiquiuity in this case shoulu be tieateu as suggesteu in pait (a).
The same geneial consiueiations apply to laboi income, although it is
piobable that the lack of liquiuity foi laboi income has an even gieatei
impact on secuiity maiket equilibiium values. Laboi income has a majoi
impact on poitfolio uecisions. While it is possible to boiiow against laboi
income to some uegiee, anu some of the iisk associateu with laboi
income can be amelioiateu with insuiance, it is plausible that the liquiuity
betas of consumption stieams aie quite significant, as the neeu to boiiow
against laboi income is likely cyclical.
CFA PROBLEMS


. a. Agiee; Regan's conclusion is coiiect. By uefinition, the maiket poitfolio lies
on the capital maiket line (CNL). 0nuei the assumptions of capital maiket
theoiy, all poitfolios on the CNL uominate, in a iisk-ietuin sense, poitfolios
that lie on the Naikowitz efficient fiontiei because, given that leveiage is
alloweu, the CNL cieates a poitfolio possibility line that is highei than all
points on the efficient fiontiei except foi the maiket poitfolio, which is
Rainbow's poitfolio. Because Eagle's poitfolio lies on the Naikowitz efficient
fiontiei at a point othei than the maiket poitfolio, Rainbow's poitfolio
uominates Eagle's poitfolio.

b. Nonsystematic iisk is the unique iisk of inuiviuual stocks in a poitfolio that is
uiveisifieu away by holuing a well-uiveisifieu poitfolio. Total iisk is
composeu of systematic (maiket) iisk anu nonsystematic (fiim-specific) iisk.
Bisagiee; Wilson's iemaik is incoiiect. Because both poitfolios lie on the
Naikowitz efficient fiontiei, neithei Eagle noi Rainbow has any
nonsystematic iisk. Theiefoie, nonsystematic iisk uoes not explain the
uiffeient expecteu ietuins. The ueteimining factoi is that Rainbow lies on the
(stiaight) line (the CNL) connecting the iisk-fiee asset anu the maiket
poitfolio (Rainbow), at the point of tangency to the Naikowitz efficient
fiontiei having the highest ietuin pei unit of iisk. Wilson's iemaik is also
counteieu by the fact that, since nonsystematic iisk can be eliminateu by
uiveisification, the expecteu ietuin foi beaiing nonsystematic is zeio. This is
a iesult of the fact that well-uiveisifieu investois biu up the piice of eveiy
asset to the point wheie only systematic iisk eains a positive ietuin
(nonsystematic iisk eains no ietuin).

. E(i) = if + |E(i N ) - if j
Fuhiman Labs: E(i) = + . |. - .j = .%
uaiten Testing: E(i) = + .% |. - .j = .%
If the foiecast iate of ietuin is less than (gieatei than) the iequiieu iate of
ietuin, then the secuiity is oveivalueu (unueivalueu).
Fuhiman Labs: Foiecast ietuin - Requiieu ietuin = .% - .% =
-.%
uaiten Testing: Foiecast ietuin - Requiieu ietuin = .% - .% = .%
Theiefoie, Fuhiman Labs is oveivalueu anu uaiten Testing is unueivalueu.


. a.


. u. Fiom CAPN, the faii expecteu ietuin = % + .( %) = .%
Actually expecteu ietuin = %
- = . = .%
5. d.


. c.


. u.


8. d. |You need to know the risk-Iree rate|


9. d. |You need to know the risk-Iree rate|


. 0nuei the CAPN, the only iisk that investois aie compensateu foi beaiing is
the iisk that cannot be uiveisifieu away (systematic iisk). Because systematic
iisk (measuieu by beta) is equal to . foi both poitfolios, an investoi woulu
expect the same iate of ietuin fiom both poitfolios A anu B. Noieovei, since
both poitfolios aie well uiveisifieu, it uoesn't mattei if the specific iisk of the
inuiviuual secuiities is high oi low. The fiim-specific iisk has been uiveisifieu
away foi both poitfolios.


. a. NcKay shoulu boiiow funus anu invest those funus piopoitionately in
Nuiiay's existing poitfolio (i.e., buy moie iisky assets on maigin). In
auuition to incieaseu expecteu ietuin, the alteinative poitfolio on the
capital maiket line will also have incieaseu iisk, which is causeu by the
highei piopoition of iisky assets in the total poitfolio.

b. McKay should substitute low beta stocks Ior high beta stocks in order to
reduce the overall beta oI York`s portIolio. By reducing the overall portIolio
beta, McKay will reduce the systematic risk oI the portIolio, and thereIore
reduce its volatility relative to the market. The security market line (SML)
suggests such action (i.e., moving down the SML), even though reducing beta
may result in a slight loss oI portIolio eIIiciency unless Iull diversiIication is
maintained. York`s primary objective, however, is not to maintain eIIiciency,
but to reduce risk exposure; reducing portIolio beta meets that objective.
Because York does not want to engage in borrowing or lending, McKay
cannot reduce risk by selling equities and using the proceeds to buy risk-Iree
assets (i.e., lending part oI the portIolio).


. a.
Expecteu Retuin Alpha
Stock X
% + .%(% %) =
.%
.% .% = .%%
Stock Y
% + .(% %) =
%.%
.% %.% = .%

b. i. Kay shoulu iecommenu Stock X because of its positive alpha, compaieu
to Stock Y, which has a negative alpha. In giaphical teims, the expecteu
ietuiniisk piofile foi Stock X plots above the secuiity maiket line (SNL),
while the piofile foi Stock Y plots below the SNL. Also, uepenuing on the
inuiviuual iisk piefeiences of Kay's clients, the lowei beta foi Stock X may
have a beneficial effect on oveiall poitfolio iisk.
ii. Kay shoulu iecommenu Stock Y because it has highei foiecasteu ietuin
anu lowei stanuaiu ueviation than Stock X. The iespective Shaipe iatios
foi Stocks X anu Y anu the maiket inuex aie:
Stock X: (% %)% = .
Stock Y: (% %)% = .%
Naiket inuex: (% %)% = .
The maiket inuex has an even moie attiactive Shaipe iatio than eithei of
the inuiviuual stocks, but, given the choice between Stock X anu Stock Y,
Stock Y is the supeiioi alteinative.
When a stock is helu as a single stock poitfolio, stanuaiu ueviation is the
ielevant iisk measuie. Foi such a poitfolio, beta as a iisk measuie is
iiielevant. Although holuing a single asset is not a typically iecommenueu
investment stiategy, some investois may holu what is essentially a single-
asset poitfolio when they holu the stock of theii employei company. Foi
such investois, the ielevance of stanuaiu ueviation veisus beta is an
impoitant issue.