2624 Final Ans

Final Exam Preparation Questions: Solutions
Lecture 7: Portfolio Management in Practice
Multiple Choice Questions
1. Answer: C
Rationale: As more and more securities are added to the portfolio; unsystematic risk decreases
and most of the remaining risk is systematic; as measured by the variance of the market
portfolio.
2. Answer: A
Rationale: As more and more securities are added to the portfolio; unsystematic risk decreases
and most of the remaining risk is systematic; as measured by the variance (or standard
deviation) of the market portfolio.
3. Answer: B
Rationale: As more and more securities are added to the portfolio, unsystematic risk decreases
and most of the remaining risk is systematic, as measured by the variance (or standard
4. Answer: B
Rationale: As more and more securities are added to the portfolio, unsystematic risk decreases
and most of the remaining risk is systematic, as measured by the variance (or standard
5. Answer: A
Rationale: The single-index model uses a market index, such as the S&P 500, as a proxy for
the market, and thus for systematic risk.
6. Answer: D
Rationale: Cov(RA,RB) = bAbBs2M = 0.7(0.9)(0.35)2 = 0.0772.

7. Answer: E
Rationale: Most securities move together most of the time, and move with a market index, or
market proxy.
8. Answer: B
Rationale: The slope of the regression line, , estimates the volatility of the stock versus the
volatility of the market and the estimates the intercept.
9. Answer: A
Rationale: The slope of the regression line, , estimates the volatility of the stock versus the
volatility of the market and the estimates the intercept.
10. Answer: D
Rationale: The return on a stock is related to both firm-specific and macroeconomic events.
11. Answer: D
Rationale: If the index model is valid A, B, and C are determinants of the covariance between
GE and GM.
12. Answer: D
HPQ and KMP.
13. Answer: D
K and L.
14. Answer: C
Rationale: 11% = 0% + b(11%); b = 1.0.
15. Answer: C
Rationale: s2p/s2m = b2; (0.2)2/(0.16)2 = 1.56; b = 1.25.
16. Answer: B

17. Answer: A
18. Answer: B
19. Answer: C
Rationale: A = [(0.8)2(0.2)2 + (0.2)2]1/2 = 0.2561.
20. Answer: B
Rationale: B = [(.8)2(0.2)2 + (0.1)2]1/2 = 0.1886.
21. Answer: E
Rationale: Stock returns are usually highly positively correlated with each other. Stock returns
are affected by both macro economic events and firm-specific events.
22. Answer: D
Rationale: The single index model both greatly reduces the number of calculations and
enhances the understanding of the relationship between systematic and unsystematic risk on
security returns.
23. Answer: B
Rationale: The expected value of unanticipated macroeconomic events is zero, because by

definition it must average to zero or it would be incorporated into the expected return.
24. Answer: B
Rationale: The textbook discusses a model in which macroeconomic events are used as a
single index for security returns. The ei term represents the impact of unanticipated firm-
specific events. The ei term has an expected value of zero. Only unanticipated events would
affect the return.
25. Answer: E
Rationale: One "cost" of the single-index model is that it allows for only two kinds of risk
macro risk and micro risk.
26. Answer: E
Rationale: The benefits of diversification are limited to the level of systematic risk.
27. Answer: A
Rationale: 7% = 0% + b(11%); b = 0.636.
28. Answer: B
29. Answer: C
30. Answer: E
31. Answer: C
Rationale: 5% = 0% + b(5%); b = 1.0.
32. Answer: B
33. Answer: A
34. Answer: D
Rationale: 0.30 + 0.70(0.82) = 0.874.
35. Answer: A
Rationale: In the Treynor-Black model portfolio weight are sensitive to large alpha values
which can lead to infeasible long or short positions for many portfolio managers.
36. Answer: A
Rationale: In efficient markets, alpha should be assumed to be zero.
37. Answer: A
Rationale: Tracking error is defined as the difference between the returns on the overall risky
portfolio versus the benchmark return.
38. Answer: C
Rationale: The Treynor-Black model is a model that shows how an investment manager can
use security analysis and statistics to construct an active portfolio.
39. Answer: A
Rationale: The manager with the highest Sharpe measure presumably has true forecasting
abilities.
40. Answer: D
Rationale: Although one can engage in various degrees of active portfolio management
(security selection without market timing and vice versa), the most active portfolio
management strategy consists of engaging in both pursuits.
41. Answer: C
Rationale: Although one can engage in various degrees of active portfolio management
(security selection without market timing and vice versa), the most active portfolio
management strategy consists of engaging in both pursuits. Passive management is an
indexing strategy.
42. Answer: B
Rationale: A portfolio with a positive alpha is outperforming the market. If this portfolio also
has a low degree of nonsystematic risk, the portfolio is adequately diversified.
43. Answer: B
Rationale: Estimates of alpha, beta, and residual risk are required to determine the optimal
weight of each security in the portfolio.
44. Answer: A
Rationale: A higher Sharpe measure than a passive strategy is indicative of the benefits of
active management.
45. Answer: E
Rationale: s = [(1.2)2(0.2)2 + 0.01]1/2 = [0.0676]1/2 = 26.0%.
46. Answer: B
Rationale: s = [(1.36)2(0.22)2 + 0.012]1/2 = [0.10152]1/2 = 31.86%.
47. Answer: D
Rationale:
48. Answer: C
Rationale: wO = [1%/1%]/[(16% 8%)/4%] = 0.5; w* = 0.5/[1 + (1 1.05)0.5] = 0.513, or

51.3%.
49. Answer: E
Rationale: There appears to be a role for a theory of active portfolio management because
some portfolio managers have produced sequences of abnormal returns that are difficult to
label as lucky outcomes, the "noise" in the realized returns is enough to prevent the rejection
of the hypothesis that some money managers have outperformed a passive strategy by a
statistically small, yet economic, margin, and some anomalies in realized returns have been
persistent enough to suggest that portfolio managers who identified these anomalies in a
timely fashion could have outperformed a passive strategy over prolonged periods.
50. Answer: A
Rationale: The Treynor-Black model considers both macroeconomic and microeconomic

risks.
51. Answer: E
Rationale: The Treynor-Black model considers both macroeconomic and microeconomic

risks. Other answers are false.
52. Answer: D
Rationale: A purely passive strategy is one that calls for no market analysis.
53. Answer: C
Rationale: Strategy 2 dominates Strategy 1, even though it is riskier, because it always returns
at least as much as Strategy 1 and sometimes more.
54. Answer: C
Rationale: Strategy 2 dominates Strategy 1, even though it is riskier, because it always returns
at least as much as Strategy 1 and sometimes more.
55. Answer: D
Rationale: All of the statements correctly describe assumptions of the Treynor-Black model.
56. Answer: D
Rationale: The Treynor-Black model does not assume that the objective of security analysis is
to form an active portfolio of a limited number of mispriced securities, the cost of less than
full diversification comes from the nonsystematic risk of the mispriced stock, and the optimal
weight of a mispriced security in the active portfolio is a function of the degree of mispricing,
the market sensitivity of the security, and its degree of nonsystematic risk.
57. Answer: D
Rationale: wO = [3%/2.25%]/[(18% 6%)/6.25%] = 0.6944; w* = 0.6944/[1 + (1

1.2)0.6944] = 0.8064, or 80.6%.
58. Answer: A
Rationale: The weight of the mispriced security in the active portfolio depends on the degree
of mispricing (alpha) in proportion to the nonsystematic risk added by holding the security.
59. Answer: B
Rationale: When optimized, a property of the overall risky portfolio is that its squared Sharpe
measure increases by the square of the active portfolio's information ratio.
60. Answer: A
Rationale: A purely passive strategy uses only index funds and keeps the proportions constant
when there are changes in perceived market conditions.
61. Answer: D
Rationale: The optimal portfolio will be the one with the highest reward-to-variability ratio.
Investors can choose for themselves how they want to combine this portfolio with the risk-
free asset to take on more or less risk.
62. Answer: C
Rationale: The Sharpe measure is commonly used to measure the performance of professional
managers. A good manager has a steeper CAL than the one from following a passive strategy.
63. Answer: C
Rationale: The active manager can use both the Sharpe measure and mean-variance analysis.
The risk-free asset can be included as called for by market conditions. The active manager is
seeking out mispricings and will want to exploit them. If there are a few very attractive
securities the manager might have a concentration of these in the portfolio, which could lead
to poor diversification.
64. Answer: A
Rationale: The two factors combine to determine the optimal risky portfolio.
65. Answer: A
Rationale: s = [(1.45)2(0.22)2 + 0.03]1/2 = [0.13176]1/2 = 36.3%.
66. Answer: A
Rationale: wO = [1%/2%]/[(11% 4%)/6%] = .4286, or 42.86%; w* = .4286/[1 + (1

1.1).4286] = 0.4478.
67. Answer: B
Rationale: wO = [3%/2%]/[(10% 3%)/4%] = 0.857; w* = 0.857/[1 + (1 1.15)0.857] =
.983., or 98.3%.
68. Answer: C
Rationale: wO = [2%/2%]/[(12% 3%)/4%] = 0.444; w* = 0.444/[1 + (1 1.15) 0.444] =

.476., or 47.6%.
Short Answer Questions
69. Discuss the Treynor-Black model.
The Treynor-Black estimates the alpha, beta, and residual risk of securities under
consideration for a portfolio. The model uses these estimates to determine the optimal weights
of each of these securities in the portfolio. These composite estimates for the active portfolio
and the macroeconomic forecasts for the passive index portfolio are used to determine the
optimal risky portfolio, which will be a combination of the passive and active portfolios.
70. You have a record of an analyst's past forecasts of alpha. Describe how you would use this
information within the context of the Treynor-Black model to determine the forecasting
ability of the analyst.
You can use the index model and valid estimates of beta, you can estimate the ex-post alphas
from the average realized return and the return on the market index. The equation is
.
Then you would estimate a regression of the forecasted alphas on the realized alphas as in the
equation . The coefficients a0 and a1 reflect the bias in the forecasts. If
there is no bias a0=0 and a1=1. The forecast errors are uncorrelated with the true alpha, so the
variance of the forecast is .
To measure the value of the forecast, you would use the squared correlation coefficient
between the forecasts and the realizations. This can also be determined by the
formula . If the analyst has perfect forecasting ability the correlation

coefficient will be 1. If the analyst has no ability then the correlation coefficient will be 0. For
values in between 0 and 1 you can adjust the forecasts by multiplying by the correlation.
Lecture 8: Behavioral Finance and Market Efficiency
1. Answer: A
Rationale: The semistrong form of the EMH maintains that stock prices immediately reflect
all historical and current public information, but not inside information.
2. Answer: A
Rationale: Random price changes were originally thought to be driven by irrationality. Now,
financial economists believe random price changes occur because markets are informationally
efficient.
3. Answer: E
Rationale: Believers of market efficiency advocate passive investment strategies, and an

investment in an index fund is one of the most practical passive investment strategies,
especially for small investors.
4. Answer: C
Rationale: Believers of market efficiency advocate passive investment strategies, and an

investment in an index fund is one of the most practical passive investment strategies,
especially for small investors.
5. Answer: C
Rationale: The information described above is market data, which is the data set for the weak
form of market efficiency. The semistrong form includes the above plus all other public
information. The strong form includes all public and private information.
6. Answer: B
Rationale: The strong form includes all public and private information.
7. Answer: C
Rationale: The reversal effect states that stocks that do well in one period tend to perform
poorly in the subsequent period, and vice versa.
8. Answer: D
Rationale: Technicians attempt to predict future stock prices based on historical stock prices.
9. Answer: C
Rationale: An economic return is the expected return, based on the perceived level of risk and
market factors. When returns exceed these levels, the returns are called abnormal returns.
10. Answer: D
Rationale: The lucky event issue, magnitude issue, and selection bias issue all exist and make
rigid testing of market efficiency difficult or impossible.
11. Answer: A
Rationale: The index fund is, by definition, passively managed. The other investment
alternatives may or may not be managed passively.
12. Answer: E
Rationale: Technical analysts attempt to predict future stock prices from historic stock prices;
proponents of EMH believe that stock price changes are random variables.
13. Answer: A
Rationale: 11/22: $39.50/600.30 = 0.0658; 11/25: $40.25/605.20 = 0.0665; Thus, WalMart's

relative strength is improving and technicians using this technique would recommend buying.
14. Answer: D
Rationale: This happened on October 19, 1987. Although this specific event is not mentioned
in this edition of the book, it is an example of something that would be considered a violation
of the EMH.
15. Answer: E
Rationale: Security prices react quickly to new information, security prices are seldom far
above or below their justified levels, and security analysis will not enable investors to realize
superior returns consistently; however, even in an efficient market one should be able to earn
the appropriate risk-adjusted rate of return.
16. Answer: E
Rationale: The weak form of the efficient market hypothesis asserts that future changes in
stock prices cannot be predicted from past prices; therefore, technicians cannot expect to
outperform the market.
17. Answer: E
Rationale: Both low P/E stocks tending to have positive abnormal returns and the ability to
consistently outperform the market by adopting the contrarian approach exemplified by the
reversals phenomenon are inconsistent with the semistrong form of the EMH.
18. Answer: D
Rationale: The weak form of the efficient market hypothesis contradicts technical analysis,
but is silent on the possibility of successful fundamental analysis.
19. Answer: C
Rationale: Technicians follow market data such as price changes and volume of trading (as
indicator of supply and demand) believing that they can identify price trends as security prices
adjust gradually.
20. Answer: C
Rationale: The probability of successful prediction for 3 consecutive years is 12.5%.
21. Answer: C
Rationale: In an efficient market there should be no serial correlation between returns from
non-overlapping periods.
22. Answer: A
Rationale: In an efficient market the price of the stock should drop immediately when the bad
news is announced. If later news changes the perceived impact to Florida Orange, the price
may once again adjust quickly to the new information. A gradual change is a violation of the
EMH.
23. Answer: B
Rationale: AR = 17% (5% + 1.2 (8%)) = +2.4%. A positive abnormal return suggests that
there was firm-specific good news.
24. Answer: C
Rationale: Anticipated earnings changes are impounded into a security's price as soon as
expectations are formed. Therefore a negative market response indicates that the earnings
surprise was negative, that is, the increase was less than anticipated.
25. Answer: D
Rationale: A random walk means that the changes in prices are random and independent.
26. Answer: D
Rationale: The main difference is that weak form encompasses only historical data,
semistrong form encompasses historical data and current public information, and strong form
encompasses historical data, current public information, and inside information. All of the
other definitions remain the same.
27. Answer: C
Rationale: Fundamental analysts look at factors such as earnings, dividend prospects,

expectation of future interest rates, and risk of the firm. The information is used to determine
the present value of future cash flows to stockholders. Technical analysts use trendlines and
resistance levels.
28. Answer: E
Rationale: Individual investors tend to have relatively small portfolios and are usually unable
to realize economies of size. The best strategy is to pool funds with other small investors and
allow professional managers to invest the funds.
29. Answer: B
Rationale: AR = 14% (5% + 1.0 (6%)) = +3.0%. A positive abnormal return suggests that
there was firm-specific good news.
30. Answer: A
Rationale: AR = 15% (4% + 2.25 (8%)) = 7.0%. A negative abnormal return suggests that
there was firm-specific bad news.
31. Answer: C
Rationale: AR = 20% (3% + 1.7 (10%)) = 0.0%. A positive abnormal return suggests that
there was firm-specific good news and a negative abnormal return suggests that there was
firm-specific bad news.
32. Answer: C
Rationale: Anticipated earnings changes are impounded into a security's price as soon as
expectations are formed. Therefore a negative market response indicates that the earnings
surprise was negative, that is, the increase was less than anticipated.
33. Answer: D
Rationale: The positive abnormal return suggests that investors view the international joint
venture as good news.
34. Answer: C
Rationale: The negative abnormal return suggests that investors expected the sales increase to
be larger than what was actually announced.
35. Answer: D
Rationale: The approval was already anticipated by the market.
36. Answer: B
Rationale: This is an example of selection bias.
37. Answer: D
Rationale: This is an example of the lucky event issue.
38. Answer: B
Rationale: Conventional theories presume that investors are rational and behavioral finance
presumes that they may not be rational.
39. Answer: A
Rationale: The premise of behavioral finance is that conventional financial theory ignores
how real people make decisions and that people make a difference.
40. Answer: D
Rationale: Some economists believe that the anomalies literature is consistent with investors
inability to always process information correctly and therefore they infer incorrect probability
distributions about future rates of return and given a probability distribution of returns, they
often make inconsistent or suboptimal decisions.
41. Answer: C
Rationale: Single men trade far more often than women. This is due to greater overconfidence
among men.
42. Answer: B
Rationale: Overconfidence may be responsible for the prevalence of active versus passive
investments management.
43. Answer: A
Rationale: An example of framing is that a person may reject an investment when it is posed
in terms of risk surrounding potential gains but may accept the same investment if it is posed
in terms of risk surrounding potential losses.
44. Answer: B
Rationale: Arbitrageurs may be unable to exploit behavioral biases due to fundamental risk,
implementation costs, and model risk.
45. Answer: E
Rationale: The efficient market hypothesis implies that security prices properly reflect
information available to investors and active traders will find it difficult to outperform a buy-
and-hold strategy.
46. Answer: D
Rationale: Tests of market efficiency have focused on strategies that would have provided
superior risk-adjusted returns and results of actual investments of professional managers.
47. Answer: C
Rationale: The anomalies literature suggests that several strategies would have provided
superior returns.
48. Answer: D
Rationale: Behavioral finance argues that even if security prices are wrong it may be difficult
to exploit them and the failure to uncover successful trading rules or traders cannot be taken
as proof of market efficiency.
49. Answer: C
Rationale: Markets would be inefficient if irrational investors existed and actions if

arbitragers were limited.
50. Answer: A
Rationale: If prices are correct there are no easy profit opportunities and if prices are not
correct there are no easy profit opportunities.
51. Answer: A
Rationale: Information processing errors can lead investors to misestimate the true
probabilities of possible events or associated rates of return.
52. Answer: A
Rationale: Errors in information processing can lead investors to misestimate true

probabilities of possible events and associated rates of return.
53. Answer: A
Rationale: If information processing were perfect, many studies conclude that individuals
would tend to make less-than-fully rational decisions using that information due to behavioral
biases.
54. Discuss the various forms of market efficiency. Include in your discussion the information
sets involved in each form and the relationships across information sets and across forms of
market efficiency. Also discuss the implications for the various forms of market efficiency for
the various types of securities' analysts.
The weak form of the efficient markets hypothesis (EMH) states that stock prices immediately
reflect market data. Market data refers to stock prices and trading volume. Technicians
attempt to predict future stock prices based on historic stock price movements. Thus, if the
weak form of the EMH holds, the work of the technician is of no value.
The semistrong form of the EMH states that stock prices include all public information. This
public information includes market data and all other publicly available information, such as
financial statements, and all information reported in the press relevant to the firm. Thus,
market information is a subset of all public information. As a result, if the semistrong form of
the EMH holds, the weak form must hold also. If the semistrong form holds, then the
fundamentalist, who attempts to identify undervalued securities by analyzing public
information, is unlikely to do so consistently over time. In fact, the work of the fundamentalist
may make the markets even more efficient!
The strong form of the EMH states that all information (public and private) is immediately
reflected in stock prices. Public information is a subset of all information, thus if the strong
form of the EMH holds, the semistrong form must hold also. The strong form of EMH states
that even with inside (legal or illegal) information, one cannot expect to outperform the
market consistently over time.
Studies have shown the weak form to hold when transactions costs are considered. Studies
have shown the semistrong form to hold in general, although some anomalies have been
observed. Studies have shown that some insiders (specialists, major shareholders, major
corporate officers) do outperform the market.
55. Why might the degree of market efficiency differ across various markets? State three
reasons why this might occur and explain each reason briefly.
1. Market efficiency depends on information being essentially free and costless to market
participants. In the U.S. this is the case to a large extent. The U.S. markets are well developed
and professional analysts often follow securities. Information is available on television, in the
press, and on the Internet. The opposite may be true in other markets, such as those of
developing countries, where there are fewer or no analysts and few market participants with
these resources. 2. Accounting disclosure requirements are different across markets. In the
U.S. firms must meet SEC requirements to be publicly traded. In other countries the
requirements may be different or nonexistent. This has implications about the ease with which
analysts can evaluate the company to determine its proper value. 3. Markets for "neglected"
stocks may be less efficient than markets for stocks that are heavily followed by analysts. If
analysts feel that it is not worthwhile to give their attention to particular stocks then ample
information about these stocks will not be readily available to investors.
56. With regard to market efficiency, what is meant by the term "anomaly"? Give three
examples of market anomalies and explain why each is considered to be an anomaly.
Anomalies are patterns that should not exist if the market is truly efficient. Investors might be
able to make abnormal profits by exploiting the anomalies, which doesn't make sense in an
efficient market.
Possible examples include, but are not limited to, the following.
The small-firm effectaverage annual returns are consistently higher for small-firm
portfolios, even when adjusted for risk by using the CAPM.
The January effectthe small-firm effect occurs virtually entirely in January.
The neglected-firm effectsmall firms tend to be ignored by large institutional traders and
stock analysts. This lack of monitoring makes them riskier and they earn higher risk-adjusted
returns. The January effect is largest for neglected firms.
The liquidity effectinvestors demand a return premium to invest in less-liquid stocks. This
is related to the small-firm effect and the neglected-firm effect. These stocks tend to earn high
risk-adjusted rates of return.
Book-to-market ratiosfirms with the higher book-to-market-value ratios have higher risk-
adjusted returns, suggesting that they are underpriced. When combined with the firm-size
factor, this ratio explained returns better than systematic risk as measured by beta.
The reversal effectstocks that have performed best in the recent past seem to underperform
the rest of the market in the following periods, and vice versa. Other studies indicated that this
effect might be an illusion. These studies used portfolios formed mid-year rather than in
December and considered the liquidity effect.
Investors should not be able to earn excess returns by taking advantage of any of these. The
market should adjust prices to their proper levels. But these things have been documented to
occur repeatedly.
57. Compare and contrast the efficient market hypothesis with the school of thought termed
behavioral finance.
The efficient market hypothesis posits that investors are fully informed, rational, utility
maximizers. Thus, security prices will fully reflect all information available to the investors.
If any security becomes mispriced, the collective buying and selling actions of investors will
quickly cause prices to change. Given an efficient market, it would be difficult to find a
trading rule that would consistently outperform the market. Moreover, failure to uncover
profitable trading strategies may be taken as proof of market efficiency. Behavioral finance
argues that conventional theory ignores how real people make decisions and that people make
a difference. Behavioral finance says that investors possess two "irrationalities". First,
investors do not always process information correctly and secondly they often make
systematically suboptimal decisions. Given less than perfectly rational investors, prices may
be wrong and it still may be hard to exploit them. Thus, failure to uncover profitable trading
strategies may not be taken as proof of market efficiency.
58. Behavioral finance posits that investors possess information processing errors. Discuss the
importance of information processing errors then list and explain the four information
processing errors discussed in the text.
Information processing errors are important because they can lead investors to misestimate
the true probabilities of possible events or associated rates of return. The four information
processing errors are forecasting errors, overconfidence, conservatism, and sample size
neglect. Forecasting errors arise when people give too much weight to recent experience. This
leads to forecasts that are too extreme. Overconfidence refers to traders believing that they are
better than average. This belief that they are superior leads to frequent trading (and according
to empirical evidence, lower returns). Conservatism refers investors being slow in responding
to new information rather than acting immediately. Sample size neglect refers to investors
ignoring the size of a sample and making inferences based on a small sample.
59. Behavioral finance posits that investors possess behavioral biases. Discuss the importance
of behavioral biases then list and explain the four behavioral biases discussed in the text.
Behavioral biases are important because even if information processing was perfect,
individuals may tend to make less-than-fully rational decisions using that information. The
four behavioral biases are framing, mental accounting, regret avoidance, and prospect theory
(or loss aversion). Framing refers to the tendency of investors to change preferences due to
the way an investment is "framed" (i.e., in terms of risk or in terms of return). Mental
accounting is a specific form of framing where an investor takes a lot of risk with one
investment account but little risk with another account. Regret avoidance refers to the
tendency of investors to blame themselves more for an unconventional investment that was
unsuccessful than a conventional investment that was unsuccessful. Prospect theory (loss
avoidance) suggests that the investor's utility curve is not concave and defined in terms of
wealth. Instead, the investor's utility function would be defined in terms of losses relative to
current wealth. Thus, the utility curve is convex to losses and concave to gains giving rise to
an s-shaped utility curve.
60. Discuss what technical analysis is, what technical analysts do, and the relationship
between technical analysis, fundamental analysis, and behavioral finance.
Technical analysis attempts to exploit recurring and predictable patterns in stock prices to
generate superior portfolio performance. To determine recurring patterns, technical analysts
examine historical returns by means of charts and or time-series analysis (such as moving
averages). Technical analysts do not deny fundamental analysis but believe that prices adjust
slowly to new information. Therefore, the key is to exploit the slow adjustment to the correct
new price when information is released. Technical analysts also use volume and other data to
assess market sentiment in an attempt to ascertain the future direction of the market.
Behaviorists believe that behavioral biases may be related to both price and volume data.
Thus, technical analysis can be related to behavioral finance.
Lecture 9: Performance Measures
1. Answer: A
Rationale: Michael Jensen, William Sharpe, and Jack Treynor developed popular models for
mutual fund performance evaluation.
2. Answer: D
Rationale: Michael Jensen, William Sharpe, and Jack Treynor developed popular models for
mutual fund performance evaluation.
3. Answer: B
Rationale: Most mutual funds do not consistently, over time, outperform the S&P 500 index
on the basis of either raw or risk-adjusted return measures.
4. Answer: B
Rationale: The Sharpe index is a measure of average portfolio returns (in excess of the risk
free return) per unit of total risk (as measured by standard deviation).
5. Answer: C
Rationale: The Treynor index is a measure of average portfolio returns (in excess of the risk
free return) per unit of systematic risk (as measured by beta).
6. Answer: A
7. Answer: B
8. Answer: C
9. Answer: A
free return) per unit of unit of systematic risk (as measured by beta).
10. Answer: B
11. Answer: B
12. Answer: A
13. Answer: C
14. Answer: A
Rationale: 1% = 14% [4% + 1.2(x 4%)]; x = 11.5%.
15. Answer: B
Rationale: 0% = 16% [3% + 1.75(x 3%)]; x = 10.4%.
16. Answer: A
Rationale: 3% = 18% [6% + 1.5(x 6%)]; x = 12%.
17. Answer: B
Rationale: Information ratio = P/(eP); A: P = 20 6 .8(19 6) = 3.6; 3.6/4 = 0.9; B: P =
21 6 1(19 6) = 2.0; 2/1.25 = 1.6; C: P = 23 6 1.2(19 6) = 1.4; 1.4/1.20 = 1.16.
18. Answer: C
Rationale: A: (24% 6%)/30% = 0.60; B: (12% 6%)/10% = 0.60; C: (22% 6%)/20% =

0.80; S&P 500: (18% 6%)/16% = 0.75.
19. Answer: B
Rationale: A: (18% 4%)/38% = 0.368; B: (15% 4%)/27% = 0.407; C: (11% 4%)/24% =

0.292; S&P 500: (10% 4%)/22% = 0.273.
20. Answer: D
Rationale: A: (23% 5%)/30% = 0.60; B: (20% 5%)/19% = 0.789; C: (19% 5%)/17% =

0.824; S&P 500: (18% 5%)/15% = 0.867.
21. Answer: A
Rationale: A: (13% 6%)/0.5 = 14; B: (19% 6%)/1.0 = 13; C: (25% 6%)/1.5 = 12.7; S&P
500: (18% 6%)/1.0 = 12.
22. Answer: C
Rationale: A: 17.6% [6% + 1.2(18% 6%)] = 2.8%; B: 17.5% [6% + 1.0(18% 6%)] =
0.5; C: 17.4% [6% + 0.8(18% 6%)] = +1.8.
23. Answer: D
Rationale: (20% 3%)/44% = 0.386, or 38.6%.
24. Answer: D
Rationale:
25. Answer: A
Rationale: P = 20% [3% + 1.8(11% 3%)] = 2.6%.
26. Answer: B
Rationale: P = 20% [3% + 1.8(11% 3%)] = 2.6%, 2.6%/2.00% = 1.3.
27. Answer: B
Rationale: P = 16% [4% +1.15(12% 4%)] = 2.8%; P/(eP) = 2.8%/1% = 2.8, or 280%.
28. Answer: B
Rationale: (16 4)/26 = .46
29. Answer: A
Rationale: (16 4)/1.15 = 10.4
30. Answer: B
Rationale: 16 [4 + 1.15 (12 4)] = 2.80%
31. Answer: E
Rationale: 22/30 = .7333 or 73.33% invested in Seminole Fund and 1 73.33% = 26.67% in
T-Bills
32. Answer: D
Rationale: 22/30 = .7333; 1 .7333 = .2667; M2 = [.7333 (18) + .2667 (6)] 14 = 0.8%.
33. Answer: E
Rationale: These characteristics are shown in Figure 24.5. If the proportions are constant the
beta of the portfolio stays constant. If the investor switches the proportions in favor of the
marker portfolio to take advantage of bull markets the beta will increase during times of
higher market risk premiums. This will cause the slope of the curve to increase.
34. Answer: D
Rationale: P = 18% [7% +1.25(15% 7%)] = 1%; P/(eP) = 1%/2% = 0.50, or 50.00%.
35. Answer: C
Rationale: (18 7)/25 = .44
36. Answer: B
Rationale: (18 7)/1.25 = 8.8
37. Answer: A
Rationale: 18 [7 + 1.25 (15 7)] = 1.00%
38. Answer: E
Rationale: (19% 6%)/35% = 0.3714, or 37.14%.
39. Answer: C
Rationale: (19% 6%)/1.5 = 8.67%.
40. Answer: B
Rationale: P = 19% [6% + 1.5(12% 6%)] = 4.00%.
41. Answer: A
Rationale: P = 19% [6% + 1.5(12% 6%)] = 4.00%, 4.00%/3.00% = 1.33.
42. Answer: B
Rationale: 1% 2% = 1%.
43. Answer: A
Rationale: See table below.
44. Answer: C
45. Answer: D
Rationale: 15% 10% = 5%.
46. Answer: C
47. Answer: A
48. Answer: A
Rationale: The Sharpe measure is a measure of average excess average portfolio returns
divided by the total risk of the portfolio returns (standard deviation).
49. Answer: D
Rationale: Risk-adjusted mutual fund performance measures have decreased in popularity
because in nearly efficient markets it is extremely difficult for portfolio managers to
outperform the market and the measures usually result in negative performance results for the
portfolio managers.
50. Answer: B
Rationale: The Sharpe measure uses standard deviation, or total risk, as the risk measure; the
Treynor measure uses beta, or systematic risk, as the risk measure.
51. Answer: B
Rationale: The measure of return per unit of risk, as measured by standard deviation is the
Sharpe measure, the measure of return per unit of risk, as measured by beta is the Treynor
measure.
52. Answer: B
Rationale: The M-squared measure adjusts the fund by hypothetically borrowing or lending
until the total portfolio matches the risk level of an index, then ranks the fund on the basis of
this risk-adjusted return.
53. Answer: B
Rationale: This sequence is appropriate if his entire risky investment is in this portfolio. If
other risky assets are involved other factors need to be considered.
54. Answer: C
Rationale: Both measures are percentages and are similar. Both can be used to rank portfolios
in terms of performance relative to risk. But the measures might give different rankings.
55. Answer: A
Rationale: Performance evaluation is difficult because of high-variance stock returns. To

compensate, a large number of observations is required to obtain statistical significance.
56. Define and discuss the Sharpe, Treynor, and Jensen measures of portfolio performance
evaluation, and the situations in which each measure is the most appropriate measure.
Sharpe's measure, (rP - rf)/sP, is a relative measure of the average portfolio return in excess of
the average risk-free return over a period time per unit of risk, as measured by the standard
deviation of the returns of the portfolio over that time period.
Treynor's measure, (rP - rf)/bP, is a relative measure of the average portfolio return in excess of
the average risk-free return over a period of time per unit of risk, as measured by the beta of
the portfolio over that time period.
Jensen's measure, P = rP -[rf + P(rM - rf)], is a measure of absolute return (average return on
the portfolio over a period of time) over and above that predicted by the CAPM.
As the risk measure in the Sharpe measure of portfolio performance evaluation is total risk,
this measure is appropriate for portfolio performance evaluation if the portfolio being
evaluated represents the investor's complete portfolio of assets.
As the risk measure in the Treynor measure of portfolio performance evaluation is beta, or
systematic risk, this measure is the appropriate portfolio performance evaluation measure if
the portfolio being evaluated is only a small part of a large investment portfolio. This measure
is also appropriate for evaluation of managers of "subportfolios" of large funds, such as large
pension plans.
As the Jensen measure, or Jensen's alpha, measures the return of a portfolio relative to that
predicted by the CAPM, this measure is appropriate for the evaluation of managers of
"subportfolios" of large funds. However, the Treynor measure is an even better measure for
such a scenario.
57. What is the problem with using the Sharpe measure for evaluation of an active portfolio
management strategy?
The Sharpe measure penalizes for portfolio variance. If a portfolio is actively managed, the
variance of returns is likely to vary considerably over any time period, thus reflecting poor
performance as indicated by the Sharpe measure (unless the portfolio returns are much higher
as a result of the active management).
58. Discuss, in general, the performance attribution procedures.

The portfolio management decision process typically involves three choices: (1) allocation of
funds across broad asset categories, such as stocks, bonds, and the money market; (2) industry
(sector) choice within each category; and (3) security selection within each sector. The returns
resulting from each of these decisions are measured against a benchmark return resulting from
a passive, index-investment approach. The excess returns (if any) resulting from these
decisions over and above those earned from a passive indexing strategy are attributed to the
success of the portfolio manager.
Feedback: The rationale of this question is to ascertain whether the student understands the
general performance attribution procedures.
59. Discuss the M2 measure of performance by answering the following questions. Why is M2
better than the Sharpe measure? What measure of risk does M2 use? How do you construct a
managed portfolio, P, to use in computing the M2 measure? What is the formula for M2?
Draw a graph that shows how M2 would be measured. Be sure to label the axes and all
relevant points.
The Sharpe measure indicates whether a portfolio underperformed the market index, but the
difference between the market's Sharpe measure and the portfolio's Sharpe measure is difficult
to interpret. M2 uses the same measure of risk as the Sharpe measurevariation in total
return, calculated as the standard deviation. For managed portfolio P an adjusted portfolio P*
is formed by combining P with borrowing or lending at the risk-free rate to the point where P*
has the same volatility as a market index (M). Then since M and P have the same standard
deviation they can be directly compared using the M2 measure. M2 = rP* rM. If P*
outperforms M the measure will be positive, which means the CAL on which P* lies will have
a steeper slope than the CML on which M lies. M2 is the distance between the CAL and the
CML.
The graph should look like the one in Figure 24.2.
Lecture 10: Option Strategies
1. Answer: E
Rationale: The price that the buyer of a call option pays to acquire the option is called the
premium.
2. Answer: E
Rationale: The price that the writer of a call option receives to sell the option is called the
premium.
3. Answer: E
Rationale: The price that the buyer of a put option pays to acquire the option is called the
premium.
4. Answer: A
Rationale: The price that the writer of a put option receives to sell the option is called the
premium.
5. Answer: E
Rationale: The price that the buyer of a call option pays for the underlying asset if she
executes her option is strike price or exercise price.
6. Answer: D
Rationale: The price that the writer of a call option receives for the underlying asset if the
buyer executes her option is called the strike price or exercise price.
7. Answer: E
Rationale: The price that the buyer of a put option receives for the underlying asset if she
executes her option is called the strike price or exercise price.
8. Answer: E
Rationale: The price that the writer of a put option receives for the underlying asset if the
option is exercised depends on the market price at the time.
9. Answer: E
Rationale: An American call option may be exercised (allowing the holder to buy the
underlying asset) on or before expiration; the option contract also may be sold prior to
expiration.
10. Answer: E
Rationale: A European call option may be exercised (allowing the holder to buy the
underlying asset) on the expiration date; the option contract also may be sold prior to
expiration.
11. Answer: B
Rationale: An American put option allows the buyer to sell the underlying asset at the striking
price on or before the expiration date.
12. Answer: D
Rationale: A European put option allows the buyer to sell the underlying asset at the striking
price only on the expiration date. The put option also allows the investor to benefit from an
expected stock price decrease while risking only the amount invested in the contract.
13. Answer: A
Rationale: American options can be exercised on or before expiration date.
14. Answer: A
Rationale: American options can be exercised on or before expiration date.
15. Answer: B
Rationale: European options can be exercised at expiration only.
16. Answer: B
Rationale: European options can be exercised at expiration only.
17. Answer: E
Rationale: If the striking price on a call option is less than the market price, the option is in
the money and sells for more than an out of the money option.
18. Answer: E
the money and sells for more than an at the money option.
19. Answer: E
the money and sells for more than a less in the money option.
20. Answer: A
Rationale: If the striking price on a call option is more than the market price, the option is out
of the money and cannot be exercised profitably.
21. Answer: C
Rationale: If the striking price on a call option is equal to the market price, the option is at the
money.
22. Answer: C
money.
23. Answer: C
money.
24. Answer: B
Rationale: An out of the money put option gives the owner the right to sell the shares for less
than market price.
25. Answer: A
Rationale: An in the money put option gives the owner the right to sell the shares for more
than market price.
26. Answer: C
Rationale: A put option on a stock is said to be at the money if the exercise price is equal to
the stock price.
27. Answer: A
Rationale: An out of the money call option gives the owner the right to buy the shares for
more than market price.
28. Answer: B
Rationale: An in the money call option gives the owner the right to buy the shares for less
than market price.
29. Answer: C
Rationale: A call option on a stock is said to be at the money if the exercise price is equal to
the stock price.
30. Answer: E
Rationale: If the striking price on a put option is less than the market price, the option is out of
the money and sells for less than an in the money option.
31. Answer: E
the money and sells for less than an at the money option.
32. Answer: A
33. Answer: E
Rationale: If the striking price on a put option is more than the market price, the option is in
the money.
34. Answer: E
the money and can be profitably exercised.
35. Answer: D
36. Answer: A
the money and sells for less than an at the money option.
37. Answer: A
38. Answer: E
the money and can be exercise profitably.
39. Answer: E
Rationale: If the striking price on a put option is less than the market price, the option is in the
money and can be profitably exercised.
40. Answer: C
Rationale: If an option expires worthless all the buyer has lost is the price of the contract
(premium).
41. Answer: C
Rationale: If an option expires worthless all the buyer has lost is the price of the contract
(premium).
42. Answer: A
Rationale: +$70 $5 = $65.
43. Answer: D
Rationale: +75 + $3 = $78.

44. Answer: C
Rationale: +$50 $5 = $45.
45. Answer: C
Rationale: +70 + $6 = $76.
46. Answer: E
Rationale: Options are merely contracts between buyer and seller and sold on various
organized exchanges and the OTC market.
47. Answer: D
Rationale: The buyer of the put option hopes the price will fall in order to exercise the option
and sell the stock at a price higher than the market price. Likewise, the seller of the call option
hopes the price will decrease so the option will expire worthless.
48. Answer: D
Rationale: Writing a covered call is a very safe strategy, as the writer owns the underlying
stock. The only risk to the writer is that the stock will be called away, thus limiting the upside
potential.
49. Answer: B
Rationale: P = C SO + PV(X) + PV(dividends), where SO = the market price of the stock,

and X = the exercise price.
50. Answer: A
Rationale: If you invest in a stock and purchase a put option on the stock you are guaranteed a
payoff equal to the exercise price; thus the protection of the put.
51. Answer: C
Rationale: $500 + $5 = $505 (Breakeven). The price of the stock must increase to above $505
for the option holder to earn a profit.
52. Answer: C
Rationale: $100 + $5 = $105 (Breakeven). The price of the stock must increase to above $105
for the option holder to earn a profit.
53. Answer: B
Rationale: The difference between the actual call price and the intrinsic value is the time value
of the option, which should not be confused with the time value of money. The option's time
value is the difference between the option's price and the value of the option were the option
expiring immediately.
54. Answer: E
Rationale: The risk-free rate, the riskiness of the stock, and the time to expiration are directly
related to the price of the option; the expected rate of return on the stock does not affect the
price of the option.
55. Answer: D
Rationale: The risk-free rate, the riskiness of the stock, and the time to expiration are directly
related to the price of the option; the expected rate of return on the stock does not affect the
price of the option.
56. Answer: C
Rationale: The time to expiration and striking price are positively related to the value of a put
option; the stock price is inversely related to the value of the option.
57. Answer: E
Rationale: The time to expiration and striking price are positively related to the value of a put
option; the stock price is inversely related to the value of the option.
58. Answer: A
Rationale: $200 + $5,000 = $4,800 (if the stock falls to zero.)
59. Answer: D
60. Answer: C

61. Answer: C
Rationale: 3 1/8 = $3.125 X 100 = $312.50. Price quotations are per share; however, option
contracts are standardized for 100 shares of the underlying stock; thus, the quoted premiums
must be multiplied by 100.
62. Answer: C
63. Answer: B
64. Answer: C
Rationale: $100 $5 = $105; + $2 + $105 = $107; $2 100 = $200.
65. Answer: C
Rationale: $103 $100 = $3 ($5 $2) =0; $0 100 = $0.
66. Answer: B
Rationale: $5 + $2 = $3 100 = $300.
67. Answer: C
Rationale: x = $100 + $5 $2; x = $103.
68. Answer: B
Rationale: Buying both a put and a call, each with the same expiration date and exercise price
is a long straddle.
69. Answer: C
Rationale: $5 + ($3) = $8 100 = $800.
70. Answer: D
Rationale: Call: $60 + ($5) + $3 = $68 (Break even); Put: $3 + $60 + ($5) = $52 (Break
even); thus, if price increases above $68 or decreases below $52, a profit is realized.
71. Answer: D
Rationale: The put-call parity relationship states the relationship between put and call prices,
which, if violated, allows for arbitrage profits; however, these profits may disappear once
transaction costs are considered.
72. Answer: D
Rationale: The collar brackets the value of a portfolio between two bounds.
73. Answer: D
Rationale: P = 10 53 + 58/(1.055); P = 11.97
74. Answer: B
Rationale: P = 9 48 + 55/(1.06); P = 12.89
75. Answer: E
Rationale: P = 9 38 + 45/(1.04); P = 14.26
76. Answer: B
Rationale: There is an active over-the-counter market for exotic options.
77. Answer: C
Rationale: C = 48 [45/(1.04)] + 1.50; C = $6.23.
78. Answer: B
Rationale: C = 103 [100/(1.05)] + 7.50; C = $15.26.

79. Answer: D
Rationale: The values of derivatives depend on the values of the underlying stock,
commodity, index, etc.
80. Answer: B
Rationale: If the call is exercised the gross profit is $51 45=$6. The net profit is $6
3.45=$2.55. The holding period return is $2.55/$3.45=.739 (73.9%). If the call is not
exercised, there is no gross profit and the investor loses the full amount of the premium. The
return is ($0 3.45)/$3.45= 1.00 (100%).
81. Answer: C
Rationale: This is the definition of "at the money". The option has a market value and may
increase in value if there are favorable price movements in the underlying asset before the
expiration date.
82. Answer: B
Rationale: The holder of the put would prefer to sell the asset to the writer at a higher exercise
price. The holder of the call would prefer to buy the asset from the writer at a lower exercise
price.
83. Answer: D
Rationale: When an index option is exercised the writer of the option pays cash to the option
holder. The amount of cash equals the difference between the exercise price of the option and
the value of the index. In this case, you will receive 720 680 = 40 times the $100 multiplier,
or $4,000. In other words, you are implicitly buying the index for 680 and selling it to the call
writer for 720.
84. Answer: B
Rationale: When an index option is exercised the writer of the option pays cash to the option
holder. The amount of cash equals the difference between the exercise price of the option and
the value of the index. In this case, you will receive 760 700 = 60 times the $100 multiplier,
or $6,000. In other words, you are implicitly buying the index for 700 and selling it to the call
writer for 760.
85. Describe the protective put. What are the advantages of such a strategy?
A protective put consists of investing in stock and simultaneously purchasing a put option on
the stock. Regardless of what happens to the price of the stock, you are guaranteed a payoff
equal to the put option exercise price.
86. Discuss the differences in writing covered and naked calls. Are risks involved in the two
strategies similar or different? Explain.
Writing a covered call is selling a call on stock the investor owns. Thus, this strategy is very
conservative; the investor receives the premium income from writing the call. If the call is
exercised, the stock is called away from the investor; thus the investor has limited his or her
upside potential.
Writing a naked call is a very risky strategy. The investor sells a call on a stock the investor
does not own. If the price of the stock increases, the option will be exercised and the investor
must go into the open market and buy the stock at the prevailing market price.
Theoretically, the price to which the stock can increase is unlimited; thus, the investor's
potential loss in unlimited.
87. Draw a graph that shows the payoff and profit to the holder of a call option at expiration.
Draw another graph that shows the payoff to the holder of a put option at expiration. Draw a
third graph that shows the payoff of a long straddle at expiration. Be sure to label the axes and
all other relevant features of the graphs.
The first graph should look like Figure 20.2. The second graph should look like Figure 20.4.
The third graph should look like panel C in Figure 20.9. The labels on the graph should
include Stock Price on the horizontal axis, Value of the Option on the vertical axis, profit,
exercise price, and price of the option, as shown in the textbook figures.
Lecture 11: Option Valuation
1. Answer: B
Rationale: The difference between the actual option price and the intrinsic value is called the
time value of the option. Time value is always positive before expiration.
2. Answer: C
3. Answer: A
4. Answer: D
5. Answer: A
time value of the option. Time value is always zero at expiration.
6. Answer: A
7. Answer: B
8. Answer: A
9. Answer: E
Rationale: Intrinsic value can never be negative; thus it is set equal to zero for out of the
money and at the money options.
10. Answer: E
Rationale: Intrinsic value can never be negative; thus it is set equal to zero for out of the
money and at the money options.
11. Answer: C
Rationale: Prior to expiration, any option will be selling for a positive price, thus the actual
value is greater than the intrinsic value.
12. Answer: C
Rationale: Prior to expiration, any option will be selling for a positive price, thus the actual
value is greater than the intrinsic value.
13. Answer: A
Rationale: As stock prices increase, call options become more valuable (the owner can buy
the stock at a bargain price). As stock prices increase, put options become less valuable (the
owner can sell the stock at a price less than market price).
14. Answer: C
Rationale: As stock prices decrease, call options become less valuable (the owner cannot buy
the stock at a bargain price). As stock prices decrease, put options become more valuable (the
owner can sell the stock at a price greater than market price).
15. Answer: D
Rationale: The exercise price is negatively correlated with the call option price.
16. Answer: E
17. Answer: D
18. Answer: A
Rationale: The put option price is negatively correlated with the stock price.
19. Answer: E
Rationale: The put option price is negatively correlated with the stock price.
20. Answer: A
Rationale: The exercise price is negatively correlated with the stock price.
21. Answer: B
Rationale: The lower the stock price, the more valuable the put option. The higher the striking
price, the more valuable the put option.
22. Answer: D
Rationale: The higher the stock price, the more valuable the call option. The lower the striking
price, the more valuable the call option.
23. Answer: D
Rationale: The variance of the returns of the underlying asset is not directly observable, but
must be estimated from historical data, from scenario analysis, or from the prices of other
options.
24. Answer: E
Rationale: The variance of the returns of the underlying asset is not directly observable, but
must be estimated from historical data, from scenario analysis, or from the prices of other
options.
25. Answer: A
Rationale: An option's hedge ratio (delta) is the change in the price of an option for $1
increase in the stock price.
26. Answer: C
Rationale: The hedge ratio is the slope of the option value as a function of the stock value. A
slope of 0.70 means that as the stock increases in value by $1, the option increases by
approximately $0.70. Thus, for every call written, 0.70 shares of stock would be needed to
hedge the investor's portfolio.
27. Answer: C
Rationale: The hedge ratio is the slope of the option value as a function of the stock value. A
slope of 0.85 means that as the stock increases in value by $1, the option increases by
approximately $0.85. Thus, for every call written, 0.85 shares of stock would be needed to
hedge the investor's portfolio.
28. Answer: C
Rationale: Call option hedge ratios must be positive and less than 1.0, and put option ratios
must be negative, with a smaller absolute value than 1.0.
29. Answer: C
30. Answer: D
31. Answer: A
Rationale: The slope of the call option valuation function is less than one.
32. Answer: D
Rationale: The gamma of an option is the sensitivity of the delta to the stock price.
33. Answer: D
Rationale: Delta neutral means the portfolio has no tendency to change value as the
underlying portfolio value changes.
34. Answer: B
Rationale: Dynamic hedging is the continued updating of the hedge ratio as time passes.
35. Answer: B
Rationale: Volatility risk is the risk incurred from unpredictable changes in volatility.
36. Answer: A
Rationale: 300 calls (0.7) = 210 shares + 150 shares = 360 shares; 575 shares = 575 shares.
37. Answer: C
38. Answer: B
39. Answer: B
40. Answer: C
Rationale: $100 + [$1,500(0.7)] = $1,150.
41. Answer: B
Rationale: $800 + [$100(0.5)] = $850.
42. Answer: A
Rationale: $225 + [$300(0.4)] = $345.
43. Answer: D
Rationale: $400 + [$200(0.6)] = $520.
44. Answer: C
Rationale: Call hedge ratio = N(d1); Put hedge ratio = N(d1) 1; 0.3 1.0 = 0.7.
45. Answer: D
46. Answer: D
47. Answer: D
48. Answer: C
Rationale: The S&P 500 index is more like a portfolio that corresponds to the S&P 500 and
thus is more protective of such a portfolio than of any of the other assets.
49. Answer: D
Rationale: Option prices are less than stock prices, thus changes in stock prices (market or
exercise) are greater (in absolute terms) than are changes in prices of options.
50. Answer: D
Rationale: All of these variables affect call option prices.
51. Answer: D
Rationale: All of these variables affect put option prices.
52. Answer: C
Rationale: An American call option buyer will not exercise early if the stock does not pay
dividends; exercising forfeits the time value. Rather, the option buyer will sell the option to
collect both the intrinsic value and the time value.
53. Answer: B
Rationale: It is valuable to exercise a put option early if the stock drops below a threshold
price; thus American puts should sell for more than European puts.
54. Answer: A
Rationale: When ST = $150; P = $0; when ST =$80: P = $40; ($0 $40)/($150 $80) = 4/7.
55. Answer: B
Rationale: d2 = 0.1530277 (0.020506)(70)1/2 = 0.01853781; N(d1) = 0.5600; N(d2) =

0.4919; C = 0.5600($70) $70[e-(0.0001648)(70)]0.4919 = $5.16.
56. Answer: D
Rationale: Studies have shown that the model tends to undervalue deep in the money calls and
to overvalue deep out of the money calls.
57. Answer: C
Rationale: Options sellers who are delta-hedging would most likely sell when markets are
falling and buy when markets are rising.
58. Answer: B
Rationale: 43 35 = $8.
59. Answer: D
Rationale: 12 (43 35) = $4.
60. Answer: B
Rationale: As an approximation, subtract the present value of the dividend from the stock
price and recompute the Black-Scholes value with this adjusted stock price. Since the stock
price is lower, the option value will be lower.
61. Answer: B
Rationale: The fact that the owner of the option can buy the stock at a price greater than the
market price gives the contract an intrinsic value of zero, and the holder will not exercise.
62. Answer: E
Rationale: The time value of an option is described by I, and is different from the time value
of money concept frequently used in finance.
63. Answer: E
Rationale: The time value of an option is described by I, and is different from the time value
of money concept frequently used in finance.
64. Answer: B
Rationale: The fact that the owner of the option can buy the stock at a price equal to the
market price gives the contract an intrinsic value of zero.
65. Answer: C
Rationale: The fact that the owner of the option can buy the stock at a price less than the
market price gives the contract a positive intrinsic value.
66. Answer: D
Rationale: The risk-free rate and stock price volatility are assumed to be constant but the
option value does not depend on the expected rate of return on the stock. The model also
assumes that stock prices will not jump markedly.
67. Answer: D
Rationale: The intrinsic value of an in-the-money put option contract is the strike price less
the stock price, since the holder can buy the stock at the market price and sell it for the strike.
68. Answer: D
Rationale: The two terms mean the same thing.
69. Answer: C
Rationale: The intrinsic value of an at-the-money put option contract is zero.
70. Answer: C
Rationale: 50 42 = $8.
71. Answer: C
Rationale: 14 (50 42) = $6.
72. Answer: B
Rationale: As an approximation, subtract the present value of the dividend from the stock
price and recompute the Black-Scholes value with this adjusted stock price. Since the stock
price is lower, the option value will be lower.
73. Answer: C
Rationale: The intrinsic value of an out-of-the-money put option contract is zero.
74. Answer: E
Rationale: An option's hedge ratio (delta) is the change in the price of an option for $1
increase in the stock price.
75. Discuss the relationship between option prices and time to expiration, volatility of the
underlying stocks, and the exercise price. The longer the time to expiration, the higher the
premium because it is more likely that an option will become more valuable (more time for
the stock price to change). The greater the volatility of the underlying stock, the greater the
option premium; the more volatile the stock, the more likely it is that the option will become
more valuable (e. g., move from an out of the money to an in the money option, or become
more in the money). For call options, the lower the exercise price, the more valuable the
option, as the option owner can buy the stock at a lower price. For a put option, the lower the
exercise price, the less valuable the option, as the owner of the option may be required to sell
the stock at a lower than market price.
76. Which of the variables affecting option pricing is not directly observable? If this variable
is estimated to be higher or lower than the variable actually is how is the option valuation
affected?
The volatility of the underlying stock is not directly observable, but can be estimated from
historic data. If the implied volatility is lower than the actual volatility of the stock, the option
will be undervalued, as the higher the implied volatility, the higher the price of the option.
Investors often use the implied volatility of the stock, i.e., the volatility of the stock implied
by the price of the option. If investors think the actual volatility of the stock exceeds the
implied volatility, the option would be considered to be underpriced. If actual volatility
appears to be higher than the implied volatility, the "fair price" of the option would exceed the
77. What is an option hedge ratio? How does the hedge ratio for a call differ from that of a put
(or are the two equivalent)? Explain.
An option's hedge ratio is the change in the price of an option for a $1 increase in the stock
price. A call option has a positive hedge ratio; a put option has a negative hedge ratio. The
hedge ratio is the slope of the value function of the option evaluated at the current stock price.
78. You are evaluating a stock that is currently selling for $30 per share. Over the investment
period you think that the stock price might get as low as $25 or as high as $40. There is a call
option available on the stock with an exercise price of $35. Answer the following questions
about hedging your position in the stock. Assume that you will hold one share.
What is the hedge ratio?
How much would you borrow to purchase the stock?
What is the amount of your net investment in the stock?
Complete the table below to show the value of your stock portfolio at the end of the holding
period.
How many call options will you combine with the stock to construct the perfect hedge? Will
you buy the calls or sell the calls?
Show the option values in the table below.
Show the net payoff to your portfolio in the table below.
What must the price of one call option be?

The answers are shown below.
What is the hedge ratio? The hedge ratio equals the range of the call values divided by the
range of the stock values, which equals (5 0)/(40 25) = 1/3. [If the stock price ends at $40
the call is worth $5; if it ends at $25 the call is worth $0.
How much would you borrow to purchase the stock? Borrow the present value of the
anticipated minimum stock price = $25/1.06 = $23.58
What is the amount of your net investment in the stock? The net amount of investment is $30
23.58 = $6.42.
Complete the table below to show the value of your stock portfolio at the end of the holding
period.
How many call options will you combine with the stock to construct the perfect hedge? Will
you buy the calls or sell the calls? Since the hedge ratio is 1/3 buy one stock and sell three call
options.
Show the option values in the table below.
Show the net payoff to your portfolio in the table below.
What must the price of one call option be? The value of the stock portfolio equals the value of
three calls. The net investment in the stock portfolio is $6.42 so this must equal the value of
the three calls. $6.42 = 3C, and C = $2.14. Alternatively, the value of the whole position must
equal the present value of the certain payoff: S 3C = $23.58, $30 3C = $23.58, and C =
$2.14.

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Final Exam Preparation Questions: Solutions

Lecture 7: Portfolio Management in Practice

Multiple Choice Questions

Rationale: Cov(RA,RB) = bAbBs2M = 0.7(0.9)(0.35)2 = 0.0772.

Rationale: 11% = 0% + b(11%); b = 1.0.

Rationale: s2p/s2m = b2; (0.2)2/(0.16)2 = 1.56; b = 1.25.

Rationale: s2p/s2m = b2; (0.22)2/(0.19)2 = 1.34; b = 1.16.

Rationale: s2p/s2m = b2; (0.18)2/(0.24)2 = 0.5625; b = 0.75.

Rationale: Cov(RA,RB) = bAbBs2M = 0.5(1.3)(0.25)2 = 0.0406.

Rationale: A = [(0.8)2(0.2)2 + (0.2)2]1/2 = 0.2561.

Rationale: B = [(.8)2(0.2)2 + (0.1)2]1/2 = 0.1886.

Rationale: The expected value of unanticipated macroeconomic events is zero, because by

Rationale: 7% = 0% + b(11%); b = 0.636.

Rationale: s2p/s2m = b2; (0.25)2/(0.21)2 = 1.417; b = 1.19.

Rationale: s2p/s2m = b2; (0.18)2/(0.22)2 = 0.669; b = 0.82.

Rationale: Cov(RA,RB) = bAbBs2M = 0.8(1.1)(0.30)2 = 0.0792.

Rationale: 5% = 0% + b(5%); b = 1.0.

Rationale: s2p/s2m = b2; (0.24)2/(0.18)2 = 1.78; b = 1.33.

Rationale: s2p/s2m = b2; (0.14)2/(0.19)2 = 0.54; b = 0.74.

Rationale: 0.30 + 0.70(0.82) = 0.874.

Rationale: In efficient markets, alpha should be assumed to be zero.

Rationale: s = [(1.2)2(0.2)2 + 0.01]1/2 = [0.0676]1/2 = 26.0%.

Rationale: s = [(1.36)2(0.22)2 + 0.012]1/2 = [0.10152]1/2 = 31.86%.

Rationale: wO = [1%/1%]/[(16% 8%)/4%] = 0.5; w* = 0.5/[1 + (1 1.05)0.5] = 0.513, or

Rationale: The Treynor-Black model considers both macroeconomic and microeconomic

Rationale: The Treynor-Black model considers both macroeconomic and microeconomic

Rationale: wO = [3%/2.25%]/[(18% 6%)/6.25%] = 0.6944; w* = 0.6944/[1 + (1

Rationale: s = [(1.45)2(0.22)2 + 0.03]1/2 = [0.13176]1/2 = 36.3%.

Rationale: wO = [1%/2%]/[(11% 4%)/6%] = .4286, or 42.86%; w* = .4286/[1 + (1

Rationale: wO = [2%/2%]/[(12% 3%)/4%] = 0.444; w* = 0.444/[1 + (1 1.15) 0.444] =

Short Answer Questions

69. Discuss the Treynor-Black model.

formula . If the analyst has perfect forecasting ability the correlation

Multiple Choice Questions

Rationale: Believers of market efficiency advocate passive investment strategies, and an

Rationale: Believers of market efficiency advocate passive investment strategies, and an

Rationale: 11/22: $39.50/600.30 = 0.0658; 11/25: $40.25/605.20 = 0.0665; Thus, WalMart's

Rationale: The probability of successful prediction for 3 consecutive years is 12.5%.

Rationale: Fundamental analysts look at factors such as earnings, dividend prospects,

Rationale: The approval was already anticipated by the market.

Rationale: This is an example of selection bias.

Rationale: This is an example of the lucky event issue.

Rationale: Markets would be inefficient if irrational investors existed and actions if

Rationale: Errors in information processing can lead investors to misestimate true

Multiple Choice Questions

Rationale: 1% = 14% [4% + 1.2(x 4%)]; x = 11.5%.

Rationale: 0% = 16% [3% + 1.75(x 3%)]; x = 10.4%.

Rationale: 3% = 18% [6% + 1.5(x 6%)]; x = 12%.

Rationale: A: (24% 6%)/30% = 0.60; B: (12% 6%)/10% = 0.60; C: (22% 6%)/20% =

Rationale: A: (18% 4%)/38% = 0.368; B: (15% 4%)/27% = 0.407; C: (11% 4%)/24% =

Rationale: A: (23% 5%)/30% = 0.60; B: (20% 5%)/19% = 0.789; C: (19% 5%)/17% =

Rationale: (20% 3%)/44% = 0.386, or 38.6%.

Rationale: P = 20% [3% + 1.8(11% 3%)] = 2.6%, 2.6%/2.00% = 1.3.

Rationale: (16 4)/26 = .46

Rationale: (16 4)/1.15 = 10.4

Rationale: 16 [4 + 1.15 (12 4)] = 2.80%

Rationale: (18 7)/25 = .44

Rationale: (18 7)/1.25 = 8.8

Rationale: 18 [7 + 1.25 (15 7)] = 1.00%

Rationale: (19% 6%)/35% = 0.3714, or 37.14%.

Rationale: (19% 6%)/1.5 = 8.67%.

Rationale: P = 19% [6% + 1.5(12% 6%)] = 4.00%.

Rationale: P = 19% [6% + 1.5(12% 6%)] = 4.00%, 4.00%/3.00% = 1.33.

Rationale: See table below.