PROBLEM SETS - SECURITY ANALYSIS AND INVESTMENTS

CHAPTER 1: Investments: Background and Issues

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1. Fixed income securities and equity?
- Fixed income (debt) securities: a higher-priority claim that pays a specified CF over a specific period until
maturity, does not represent an ownership interest, least closely tied to the financial condition of the issuer
- Equity: a lower-priority claim that represents an ownership share in a corporation and has infinite life,
performance of equity investments tied directly to the success of firm and its real assets
2. Primary assets and derivative assets?
- Primary asset has a claim on the real assets of a firm
- Derivative asset provides a payoff that depends on the prices of a primary asset but not the claim on real assets.
3. Asset allocation and security selection?
- Asset allocation is the allocation of an investment portfolio across broad asset classes
- Security selection is the choice of specific securities within each asset class.
4. Agency problems and approaches?
- Agency problems are conflicts of interest between managers and stockholders.
- They are addressed through the corporate governance process via audits, compensation structures and board
elections.
5. Real and financial assets?
- Real assets: Tangible and intangible assets used to produce goods and services
- Financial assets: Claims on real assets or the income generated by them
=> Real assets generate net income to the economy while financial assets allocate income or wealth among investor
6. Investment banking and commercial banking?
Investment bankers are firms specializing in the sale of new securities to the public, typically by underwriting the issue.
Commercial banking processes the financial transactions of businesses such as checks, wire transfers and savings account
management.
7. Identify real and financial assets?
a/ Takes out bank loan to finance construction of a new factory => Toyota creates a real asset—the factory. The loan is a
financial asset that is created in the transaction.
b/ Pays off loan => When the loan is repaid, the financial asset is destroyed but the real asset continues to exist.
c/ Uses $10m of cash on hand to purchase additional inventory of spare auto parts => The cash is a financial asset that is
traded in exchange for a real asset, inventory.
8. In a wave of pessimism, housing prices fall by 10%
a/ The stock of real assets of the economy has not changed because the fall does not affect productivity.
b/ Individuals are less wealthy. The financial asset value of the claims on the real estate has changed, thus
the balance sheet of individual investors has been reduced.
c/ Can a reconciliation be done? The difference between these two answers reflects the difference between real
and financial asset values. Real assets still exist, yet the value of the claims on those assets or the cash flows they generate
do change. Thus, the difference.
9. Currently owns computer equipment worth $30,000 and cash on hand $20,000 contributed by owners.
a/ Takes out a bank loan and receive $50,000 in cash and sign a note promising to pay back the loan over 3 years
=> Bank loan is Lanni’s financial liability. Lanni’s IOU is the bank’s financial asset. The cash Lanni received is a
financial asset. The new financial asset created is Lanni's promissory note held by the bank.
b/ Uses cash from the bank plus $20,000 of its own to finance development of new software.
=> The cash paid by Lanni is the transfer of a financial asset to the software developer. In return, Lanni gets a real asset,
the completed software. No financial assets are created or destroyed. Cash is simply transferred from one
firm to another.
c/ Sells software product to Microsoft which will market it to the public under Microsoft name. Lanni accepts payments
in the form of 2500 shares of Microsoft stock.
=> Real asset (software product) is exchanged for 2500 shares (financial asset). If Microsoft issued new shares to pay for
Lanni, a financial asset would be created.
d/ Sells shares for $50 per share and uses part of the proceeds to pay off the bank loan.
=> Shares (financial asset) that worth $125,000 are exchanged for bank loan (financial asset) that worths $50,000. The
bank loan will be destroyed.
10. Balance sheet
a/ After Lanni gets the bank loan
Asset L+E

Computer equipment = $30,000 Bank loan = 50,000

Cash = $70,000 Equity = 50,000
Real asset/ Total asset = 30,000/100,000 = 0.3
b/ After spending $70,000 to develop software
Asset L+E

Computer equipment = $30,000 Bank loan = 50,000

Cash = 0 Equity = 50,000
Software = $70,000
Real asset/ Total asset = 100,000/100,000 = 1
c/ After accepting payment of shares from Microsoft
Asset L+E

Computer equipment = $30,000 Bank loan = 50,000

Shares = 125,000 Equity = 50,000+(125,000-70,000) = 105,000
Real asset/ Total asset = 30,000/155,000 = 0.193
=> Conclusion: when the firm starts up and raises working capital, it will be characterized by a low ratio of real to total
assets. When it is in full production, it will have a high ratio of real assets. When the project "shuts down" and the firm
sells it, it will have a low ratio of real assets.
11. What reforms to the financial system might reduce its exposure to systematic risk?
Ultimately, real assets determine the material well being of an economy. Individuals can benefit when financial
engineering creates new products which allow them to manage portfolios of financial assets more efficiently. Since
bundling and unbundling creates financial products and creates new securities with varying sensitivities to risk, it allows
investors to hedge particular sources of risk more efficiently.
12. Calculate
a/ Real asset/Total asset = 148.6/15164.6 = 1.0%
b/ That ratio for nonfinancial firms = 18569/34997 = 53.1%
c/ The difference should be expected since the business of financial institutions is to make loans that are financial assets.
13. Why do financial assets show up as a component of household wealth but not of national wealth?
National wealth is a measurement of the real assets used to produce the GDP in the economy. Financial assets are
claims on those assets held by individuals.
Why do financial assets matter for the material well-being of an economy?
These financial assets are important since they drive the efficient use of real assets and help us allocate resources,
specifically in terms of risk return trade-offs.
14. Adv/ Disadv of these forms of managerial compensation in terms of mitigating agency problems?
a. A fixed salary means compensation is (at least in the short run) independent of the firm's success. This salary
structure does not tie the manager’s immediate compensation to the success of the firm. The manager might,
however, view this as the safest compensation structure with the most value.
b. A salary paid in the form of stock in the firm means the manager earns the most when shareholder wealth is
maximized. When the stock must be held for five years, the manager has less incentive to manipulate the stock
price. This structure is most likely to align the interests of managers with the interests of the shareholders. If stock
compensation is used too much, the manager might view it as overly risky since the manager’s career is already
linked to the firm. This undiversified exposure would be exacerbated with a large stock position in the firm.
c. When executive salaries are linked to firm profits, the firm creates incentives for managers to contribute to the
firm’s success. The success of the firm is linked to the compensation of the manager. This may lead to earnings
manipulation, but that is what audits and external analysts will look out for.
 15. If an individual shareholder could monitor and improve managers’ performance, and thereby increase the value of
the firm, the payoff would be small, since the ownership share in a large corporation would be very small. For
example, if you own $10,000 of IBM stock and can increase the value of the firm by 5%, a very ambitious goal,
you benefit by only: 0.05 x $10,000 = $500. In contrast, a bank that has a multimillion-dollar loan outstanding to
the firm has a big stake in making sure the firm can repay the loan. It is clearly worthwhile for the bank to spend
considerable resources to monitor the firm.
16. Since the trader benefited from profits but did not get penalized by losses, they were encouraged to take
extraordinary risks. Since traders sell to other traders, there also existed a moral hazard since other traders might
facilitate the misdeed. In the end, this represents an agency problem.
17. Securitization requires access to a large number of potential investors. To attract these investors, the capital
market needs: (1) a safe system of business laws and low probability of confiscatory taxation/regulation; (2) a
well-developed investment banking industry; (3) a well-developed system of brokerage and financial transactions,
and; (4) well-developed media, particularly financial reporting. These characteristics are found in (indeed make
for) a well-developed financial market.
18. Securitization leads to disintermediation; that is, securitization provides a means for market participants to bypass
intermediaries. For example, mortgage-backed securities channel funds to the housing market without requiring
that banks or thrift institutions make loans from their own portfolios. As securitization progresses, financial
intermediaries must increase other activities such as providing short-term liquidity to consumers and small
business, and financial services.
19. Mutual funds accept funds from small investors and invest, on behalf of these investors, in the national and
international securities markets. Pension funds accept funds and then invest, on behalf of current and future
retirees, thereby channeling funds from one sector of the economy to another. Venture capital firms pool the
funds of private investors and invest in start-up firms. Banks accept deposits from customers and loan those funds
to businesses, or use the funds to buy securities of large corporations.
20. Even if the firm does not need to issue stock in any particular year, the stock market is still important to the
financial manager. The stock price provides important information about how the market values the firm's
investment projects. For example, if the stock price rises considerably, managers might conclude that the market
believes the firm's future prospects are bright. This might be a useful signal to the firm to proceed with an
investment such as an expansion of the firm's business. In addition, the fact that shares can be traded in the
secondary market makes the shares more attractive to investors since investors know that, when they wish to, they
will be able to sell their shares. This in turn makes investors more willing to buy shares in a primary offering, and
thus improves the terms on which firms can raise money in the equity market.
21. Treasury bills serve a purpose for investors who prefer a low-risk investment. The lower average rate of return
compared to stocks is the price investors pay for predictability of investment performance and portfolio value.
22. You should be skeptical. If the author actually knows how to achieve such returns, one must question why the
author would then be so ready to sell the secret to others. Financial markets are very competitive; one of the
implications of this fact is that riches do not come easily. High expected returns require bearing some risk, and
obvious bargains are few and far between. Odds are that the only one getting rich from the book is its author.

CHAPTER 3: Securities Markets

1. Difference between an IPO and SEO
- Initial public offering (IPO): first public sale of stock by a formerly private company
- Seasoned equity offering (SEO): sale of additional shares in firm that already are publicly traded
2. Components of effective costs of buying or selling shares?
- The dealer’s bid-ask spread
- Broker’s commissions
- Price concession forced to make for trading in quantities greater than associated with the posted bid/ask price.
=> These reduce the amount received by a seller and increase the cost incurred by a buyer.
3. Primary market and secondary market
The primary market is the market where newly-issued securities are sold, while the secondary market is the market for
trading existing securities. After firms sell their newly-issued stocks to investors in the primary market, new investors
purchase stocks from existing investors in the secondary market
 4. How do security dealers earn profit?
The primary source of income for a securities dealer is the bid-ask spread. This is the difference between the price at
which the dealer is willing to purchase a security and the price at which they are willing to sell the same security.
5. In what circumstances are private placements more likely to be used than public offerings?
When a firm is a willing buyer of securities and wishes to avoid the extensive and costly registration statements
associated with preparing a public issue, it may issue shares privately.
6. What are the differences between a stop-loss over, a limit sell order, and a market order?
- A stop order is a trade not to be executed unless stock hits a price limit. The stop-loss is used to limit losses when
prices are falling.
- A limit order is an order specifying a price at which an investor is willing to buy or sell a security.
- A market order directs the broker to buy or sell at whatever price is available in the market.
7. Why have average trade sizes declined in recent years?
Many large investors seek anonymity for fear that their intentions will become known to other investors. Large block
trades attract the attention of other traders. By splitting large transactions into smaller trades, investors are better able to
retain a degree of anonymity
8. Role of underwriter (người bảo hiểm): Investment bankers who purchase securities from issuing company and
resell them
Prospectus: Description of firm and security being issued
9. How do margin trades magnify both the upside potential and downside risk of an investment portfolio?
Margin is a type of leverage that allows investors to post (đặt) only a portion of the value of the security they purchase.
As such, when the price of the security rises or falls, the gain or loss represents a much higher percentage, relative to the
actual money invested.
10. A market order has price uncertainty but not execution uncertainty
11. Illiquid security in a developing country most likely trades in broker markets.
12. You short sell 100 shares, now selling at 200$
a/ In principle, potential losses are unbounded, growing directly with increases in the price of IBX.
b/ If the price of IBX shares goes above $210, then the stop-buy order would be executed, limiting the losses from the
short sale. If the stop-buy order can be filled at $210, the maximum possible loss per share is $10. The total loss is: $10 ×
100 shares = $1,000.
13. Call one full service broker and one discount broker
Full-service broker: broker that provides a large variety of financial services to the client including advise, research, and
planning which usually costs service fees to the client instead of brokerage fees
Discount broker: carrying out the buying and selling of the orders at a discounted rate (which is less than the full service
brokers because it doesn't include commission and other fees); they are in service of the trading not the planning, etc.
14. Firm sold 100,000 shares in the IPO, underwriter’s explicit fee of $60,000. Offering price $40 but immediately
upon issue, the share price jumped to $44.
a/ Total cost to firm of the equity issue = 60,000 + 100,000*(44-40) = $460,000
In addition to the explicit fees of $60,000, we should also take into account the implicit cost incurred to DRK from the
underpricing in the IPO. The underpricing is $4 per share, or a total of $400,000, implying total costs of $460,000.
b/ No, the entire cost of underwriting is NOT a source of profit to the underwriters.
The underwriters do not capture the part of the costs corresponding to the underpricing. However, the underpricing may
be a rational marketing strategy to attract and retain long-term relationships with their investors. Without it, the
underwriters would need to spend more resources in order to place the issue with the public. The underwriters would then
need to charge higher explicit fees to the issuing firm. The issuing firm may be just as well off paying the implicit
issuance cost represented by the underpricing.
15. Purchase 300 shares at $40, borrows $4000 from broker to help pay for the purchase, interest on loan 8%
a/ Initial margin = 40*300-4000 = 8000
b/ Share price fell to $30
Remaining margin = 30*300-4000*1.08 = 4680 => MR = 4680/9000 = 52%
MMR = 30% still < than MR = 52% => not receive a margin call
Asset L+E
 Value position = 40*300 = 12000 Borrowings = 4000
Equity = 8000

Asset L+E

Value position = 30*300 = 9000 Borrowings = 4000*(1+8%)

Equity = 4680
c/ Rate of return = (Ending equity in account-Initial equity in account)/(Initial equity in account)
= (4680-8000)/8000 = -41.5%
16. Short sell 1000 shares, IMR 50%. A year later, stock price has risen from $40 to $50 and has paid dividend of
$2/share
a/ Remaining margin = Total account - Market value of shares - Dividend liability
= 40k+20k-50k-2k = 8,000
OR Remaining margin = Initial margin - spread of market value - dividend liability
= 20k - (50-40)*1000 - 2k = 8k
Asset L+E

Cash = 40,000 Short position of 1000 shares = 40,000

Tbill = 20,000 Equity = 20,000

Asset L+E

Cash = 40,000 Short position of 1000 shares = 50,000

Tbill = 20,000 Dividend payable = 2000
Equity = 60,000 - 52,000 = 8,000

Asset L+E

Cash = 40,000 Short position of 1000 shares = 50,000

Tbill = 20,000 - 2000 = 18,000 Equity = 58,000-50,000 = 8,000
b/ Margin ratio = Equity/Market value = 8000/50000 = 16% < MMR=30% => receive a margin call
c/ Rate of return = (8000-20000)/20000 = -60%

17. Last trade in the stock occurred at $50

a/ A market buy order would be filled instantly at the best offer price i.e. the sell order with the lowest price which will
also be the sell order that is topmost on the order book.
=>If a market buy order for 100 shares comes in, it will be filled at $50.25
b/ The next market buy order will be filled at 51.5
c/ As a security dealer, you would want to increase your inventory. There is considerable buying demand at prices just
below $50, indicating that downside risk is limited. In contrast, limit-sell orders are sparse, indicating that a moderate buy
order could result in a substantial price increase.
18. Bullish. Current market price = $50, you have $5000 to invest, borrow additional $5000 from broker at interest
rate of 8% and invest $10,000 in the stock
a/ If price goes up by 10% during the next year
Initial margin = 5000
Remaining margin = 10,000*1.1 - 5000*1.08 = 5600
Rate of return = (5600-5000)/5000 = 12%
b/ MMR = 30% = (200*P-5000)/(200*P) => P=35.7 to get a margin call
19. Bearish. Sell short 100 shares at current market price of $50
a/ IMR=50% => You must put 100*50*0.5 = 2500 in cash or securities
b/ MMR = 30% = (100*50*1.5-100*P)/100*P => P=57.69 to get a margin call
 20. Bid=67.95, Ask=68.05
The broker is instructed to attempt to sell your Marriott stock as soon as the Marriott stock trades at a bid price of $68 or
less. Here, the broker will attempt to execute but may not be able to sell at $68, since the bid price is now $67.95. The
price at which you sell may be more or less than $68 because the stop-loss becomes a market order to sell at current
market prices. (muốn bán khi giá thấp hơn 68 mà mng chỉ muốn mua ở giá 67.95 => lệnh sẽ dc thực hiện
21. Bid=55.25 (giá mng willing to buy), Ask=55.5 (giá mng willing to sell)
a/ Market buy order will be executed at 55.5
b/ Market sell order will be executed at 55.25
c/ Limit sell order at 55.62 => not executed because current bid price (55.25) is lower than the price specified in the limit-
sell order. (muốn bán khi giá cao hơn 55.62 nhưng ng khác chỉ chấp nhận mua ở giá 55.25)
d/ Limit buy order at 55.37 => not executed because current ask price (55.5) is higher than the price specified in the limit-
buy order. (muốn mua khi giá thấp hơn 55.37 nhưng mng chỉ muốn bán ở giá 55.5)
22. You borrow $20,000 on margin to buy shares which are now selling at $40. IMR 50%, MMR 35%. 2 days later
the stock price falls to $35.
a/ Initial margin = 50% = (40*V-20000)/(40*V) => V=1000 shares
Remaining margin = (35*1000-20000)/(35*1000) = 42.86% > MMR 35% => not receive a margin call
b/ MMR = 35% = (P*1000-20000)/(P*1000) => P = 30.77 to get a margin call
23. Jan 1: sell short 100 shares at $21. March 1: a dividend of $3 was paid. April 1: you cover the short sale by
buying stock at $15, you paid $0.5 per share in commissions for each transaction. Value of account on April 1?
Jan 1: when you sell short 100 shares at $21+ pay commission of $50
Asset L+E

Cash = 2100-50 = 2050 Short position of 100 shares = 2100

Equity = -50
Mar 1: pay dividend of 300$
Asset L+E

Cash = 2050-300=1750 Short position of 100 shares = 2100

Equity = -350
Apr 1: when price falls to $15
Asset L+E

Cash = 1750 Short position of 100 shares = 1500

Equity = 250
Ảpr 1: when you cover short position and pay commission
Asset L+E

Cash = 1750-1500-50 = 200 Short position of 100 shares = 1500-1500 = 0

Equity = 200
=> Value of your account on April 1 = net profit = $200
24. Current price = $40. You buy 500 shares using $15,000 of your own money, borrowing the remainder from
broker at an 8% rate.
a/ Borrowing = 40*500-15000 = 5000
Price change to Remaining margin Percentage return Percentage change in price

44 44*500-5000 = 17000 (17000-15000)/15000 = 13.3% (44-40)/40 = 10%

40 40*500-5000 = 15000 (15000-15000)/15000 = 0% (40-40)/40 = 0%

36 36*500-5000 = 13000 (13000-15000)/15000 = -13.3% (36-40)/40 = -10%

b/ MMR = 25% = (500*P-5000)/(500*P) => P=13.3 to get a margin call
c/ If you only used 10,000 of your money, you borrow 40*500-10000=10000 => MMR = 25% = (500*P-10000)/(500*P)
=> P=26.67 to get a margin call
d/ After 1 year
Price change to Remaining margin Percentage return Percentage change in price

44 44*500-5000*1.08 = 16600 (16600-15000)/15000 = 10.67% (44-40)/40 = 10%

40 40*500-5000*1.08 = 14600 (14600-15000)/15000 = -2.67% (40-40)/40 = 0%

36 36*500-5000*1.08 = 12600 (12600-15000)/15000 = -16% (36-40)/40 = -10%

e/ MMR = 25% = (500*P-5000*1.08)/(500*P) => P=14.4 to get a margin call
25. sell short 500 shares currently at $40 and give broker $15,000 to establish margin account
a/ No interest on loan, after 1 year?
Price change to Remaining margin Percentage return

44 40*500+15,000-44*500 = 13000 (13000-15000)/15000 = -13.33%

40 40*500+15,000-40*500 = 15000 (15000-15000)/15000 = 0%

36 40*500+15,000-36*500 = 17000 (17000-15000)/15000 = 13.33%

b/ MMR=25% = (40*500+15,000-P*500)/(P*500) => P=56 to get a margin call
c/ Paid a year end dividend of $1 per share
Price change to Remaining margin Percentage return

44 40*500+15,000-500-44*500 = 12500 (12500-15000)/15000 = -16.67%

40 40*500+15,000-500-40*500 = 14500 (14500-15000)/15000 = -3.33%

36 40*500+15,000-500-36*500 = 16500 (16500-15000)/15000 = 10%

26. Stop loss order to sell 100 shares at $55 when current price is $62, how much will you receive for each share if
the price drops to $50
d) Cannot tell from the information given. The broker will start to sell when the stock price hits $55 and keep doing so if
the price further tumbles.
27. Specialists on NYSE traditionally did all (act as dealers for their own account, execute limit order, help provide
liquidity) except acting as odd-lot dealers.

CHAPTER 12: Macroeconomic and Industry analysis

1.
Differences between Top down and Bottom up approaches? Adv of Top down?
- A top-down approach begins with an analysis of the overall economy which focuses on the big picture. Analysts
that rely on this approach then narrow their attention to a sector or an industry to be expected to do well, given the
predictable performance of the broader economy.
- A bottom-up approach is the opposite of another approach which typically emphasizes fundamental analysis of
individual company stocks and basically relies on the confidence that undervalued stocks will perform well
nevertheless of the prospects for the industry or the broader economy. The analysis focuses on selected companies
or stocks within a sector or an industry.
- The main advantage of the top-down approach is that it provides to the investors several advantages such as
flexibility of allocating their investments in any type of market. Also, this approach helps investors picking stocks
that can bear the descending trend with less risk. The top-down approach is structured more than a bottom-up
approach which combines macro-economic viable conditions such as growth rates, exchange rates, and inflation.

2.
 Why does it make intuitive sense that the slope of the yield curve is considered a leading economic indicator?
- A leading indicator is the variable that changes before any cyclical changes happen in the economy. So, it is a way
to predict the state of the economy.
- Yield curve illustrates the connection between interest that a bond pays and the time period when a bond matures.
The slope of the yield curve gives an idea of future interest rate changes and economic activity.
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- Because the line demonstrates how a bond will impact on the economy either positively or negatively, it turns out
to be a great leading economic indicator. Thus, the slope of yield curve provides an initial indication of state of
the economy and consequently considered as the leading indicator

3.
Below average sensitivity to the state of economy
- a defensive firm because the return does not change or get affected by the changes in the market, these firms are
usually not competitive
- not asset play firm because the value of their firm doesn't reflect their stock
- not cyclical firm because their stock prices depend on economic fluctuation
- not a stalwart firm because they are big brand names and have slow growth

4.
Price of oil fell dramatically in 2015 => Supply shock
5.
How do each of the following affect the sensitivity of profits to the business cycle?
- Financial leverage
The higher the firm borrow money (loans & debentures) the higher leverage a company has, but since their debt
requires interest payments they have limited control over being able to handle fluctuations in economic
downturns
- Operating leverage
The higher the fixed cost, the higher the leverage a company is considered to have which also can be make it hard
to adjust in economic downturns however if they just have high variable costs and not fixed they may be able to
suffice some fluctuations easier
6. Asset play because the stock values of the company do not accurately depict the value of the firm
7. Define each of the following in the context of a business cycle.
- peak: rising prices and good services which lead to high interest rates and inflation; invest in natural materials
such as oil/gas
- contraction: inflationary period ends and demand eases, invest in pharmaceuticals or other unaffected markets
- trough: the low of the economy when the market is ready to recover from recession; investors can invest in capital
goods industries because firms are investing in equipment, etc. getting ready to expand
- expansion: firms start producing more to meet increasing demand, wages and salaries will increase & it will be
good to invest in luxury goods, possibly cars
8. When monetary and fiscal policy are expansive, income, supply of money, government revenue, and taxes
increase which results in inflation => short term yield is greater than long term yield, therefore creating a steeper
slope
9. Which of the following is not a governmental structural policy that supply-side economists believe would
promote long-term growth in an economy?
=> a redistributive tax system: all tax actions for the purpose of stabilizing the economy are part of demand side
management; redistributive tax system refers to one having more and one having less therefore not promoting a long-term
growth economy.
10. Corporate dividend payout rates in the early stages of an industry life cycle are very low because they have to use
excess capital to reinvest in the company.
11. Real interest rate =1.94%
12. Atech DOL = 1 + 7m/4m =2.75 while Ztech DOL = 1 + 5/4 = 2.25 => Atech has higher operating leverage =>
Atech will likely have higher profits if the economy strengthens since small swings in business conditions have a
large impact on profitability for firms with high operating leverage => Atech will also have higher beta cuz it’s
more sensitive to the business cycle.
13. Industry
14. Economy in deep recession => Expansive monetary: print more money, buy treasury stock, reduce reserve
requirement, reduce discount + Expansive fiscal: decrease tax rate, increase government spending
15. If you believe the US dollar is about to depreciate more dramatically than do other investors, what will be your
stance on investments in US auto producers?
=> Foreign cars will cost more to import, so they will cost more in general => boosts exports because it means US can get
more dollars for their cars, making business profitable => so, make investments in US auto stocks
16. Fed is going to dramatically loosen monetary policy (expansive)
=> Invest in gold mining because increased money supply leads to higher consumption; demand is backed by increase in
purchase power
=> Invest in construction because loose monetary policy will lead to lower interest rates therefore making loans cheaper
and increasing the demand for houses, which makes construction a good investment because demand for new
development will be high
17. a/The automated process will be expensive and will cost the same when there is a recession making profits low
while human workers wages will fall with the recession so their costs will lower making them more profitable
b/ The automated system will be more profitable because wages don't rise with the state of the economy
c/ Beta of robotics company is high because it's profits are sensitive to the lows of an economy & therefore it is
more risky
18. Supply side economists believe that a reduction in income tax rates will make workers more willing to work at
current or even slightly lower (gross-of-tax) wages. Such an effect ought to mitigate cost pressures on the
inflation rate and thus the price level.
19. Deep recession: falling inflation, falling interest rates, falling GDP. => health care (defensive)
Superheated economy: rapidly rising GDP, increasing inflation and interest rates. => Steel construction (cyclical)
Healthy expansion: rising GDP, mild inflation, low unemployment. => Housing construction (cyclical, but
interest rate sensitive)
Stagflation: falling GDP, high inflation. => => gold mining (gold as hedging, counter cyclical)
20. More sensitive to business cycle: a/ Autos over Pharma; b/ Airlines over Cinemas
21. a.Oil well equipment: Decline (environmental pressures, decline in easily-developed oil fields)
b.Computer hardware: Consolidation stage
c.Computer software: Consolidation staged.
d. Genetic engineering: Start-up stage .
e. Railroads: Relative decline
22. The index of consumer expectations is a useful leading economic indicator because, if consumers are optimistic
about the future, then they are more willing to spend money, especially on consumer durables. This spending will
increase aggregate demand and stimulate the economy.
23. Labor cost per unit of output is a lagging indicator because wages typically start rising well into an economic
expansion. At the beginning of an expansion, there is considerable slack in the economy and output can expand
without employers bidding up the price of inputs or the wages of employees. By the time wages start increasing
due to high demand for labor, the boom period has already progressed considerably.

CHAPTER 14: Financial statements analysis

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exam-3-2020/7320503
1. Calculations
 2. a/ Net cash in investing = -33 (Purchase of bus) +72 (Sale of old equipment) = 39
b/ Net cash in financing = -80 (cash dividend) - 55 (repurchase of stock) = -135
c/ Net cash in operating = 300 (collections from customers)-95 (payments to suppliers)-25(interest paid on debt)
= 180 => Net cash increase = 180+39-135 = 84
3. Return on sales higher than industry average and ROA same as industry average
ROA = margin x turnover => With similar ROA, the company has higher profit margin but lower asset turnover rate than
industry average
4. Profit margin lower than industry average and ROA above the industry average
ROA = margin x turnover => The company’s asset turnover ratio is much higher than the industry average to compensate
for the lower profit margin (to reach a higher ROA)
5. Use cash to retire current liability => current asset and current liability both decline by the same amount =>
current ratio increases
Asset turnover ratio increases since total asset decreases
6. CF investing excludes inventory increase due to any reason or any product line
7. CF operating includes interest paid to bondholders
8. Lower allowance for doubtful accounts => Reduce bad debt expense, increase operating income
No change in operating CF until the company actually collects the receivables
12. ROE = Asset/equity * Sales/assets * Net profit/sales = leverage ratio*asset turnover*profit margin
= 2.2*2*5.5% = 24.2%
13. ROE = (1-tax)(ROA + (ROA-int)*D/E) => 3% = (1-35%)(ROA + (ROA-6%)*0.5) => ROA = 5.08%
14. ROE = tax burden*leverage*interest burden*return on sales*asset turnover = 13.5%
15. Total equity = 20k*20 + 5000k + 70k = 5,470,000
=> Book value per share = 5470k/20k = 273.5
16. EVA = (ROC-cost of capital)*capital invested
a/ EVA (Acme) = (17%-9%)*(100+50)=12m
EVA (Apex) = (15%-10%)*(450+150)=30m => higher
b/ EVA per dollar of capital invested (Acme) = 12m/150m = 8% => higher
EVA per dollar of capital invested (Apex) = 30m/600m = 5%

CHAPTER 13: Equity valuation

1. What circumstances would you choose DDM rather than free cash flow?
Theoretically, dividend discount models can be used to value the stock of rapidly growing companies that do not
currently pay dividends; in this scenario, we would be valuing expected dividends in the relatively more distant
 future. However, as a practical matter, such estimates of payments to be made in the more distant future are
notoriously inaccurate, rendering dividend discount models problematic for valuation of such companies; free
cash flow models are more likely to be appropriate. At the other extreme, one would be more likely to choose a
dividend discount model to value a mature firm paying a relatively stable dividend.
2. What circumstances would you use multistage DDM rather than the constant-growth models?
It is most important to use multi-stage dividend discount models when valuing companies with temporarily high
growth rates. These companies tend to be companies in the early phases of their life cycles, when they have
numerous opportunities for reinvestment, resulting in relatively rapid growth and relatively low dividends (or, in
many cases, no dividends at all). As these firms mature, attractive investment opportunities are less numerous so
that growth rates slow.
3. Stock is underpriced => Er ??? k
The intrinsic value of a share of stock is the individual investor's assessment of the true worth of the stock. The
market capitalization rate is the market consensus for the required rate of return for the stock. If the intrinsic value
of the stock is equal to its price, then the market capitalization rate is equal to the expected rate of return. On the
other hand, if the individual investor believes the stock is underpriced (i.e., intrinsic value < price), then that
investor's expected rate of return is greater than the market capitalization rate.
4. Current dividend $1, growth rate 20% for 2 years and 4% thereafter. k=8.5%
Intrinsic value = 1.2/0.085 + 1.2^2/1.085^2 + 1.2^2*1.04/[(0.085-0.04)*1.085^2] = 30.6
5. Current dividend $1.22, grow indefinitely at 5%. current value of shares based on constant growth DDM is 32.03
=> Required rate of return = 9%
6. Current dividend $1, grow indefinitely at 5%. Current value of shares is $35 => Required rate of return = 8%
7. PVGO = P0 - E1/k = 41-3.64/9% = 0.56
8. Book value of current asset = market value of current asset = 10m, book value of fixed asset = 60m but could be
sold for 90m today. Firm has total debt with book value 40m, but interest rate declines caused market value of
debt increase to 50m
=> Market to book ratio = (90+10-50)/(60+10-40) = 1.67
9. k=8%, ROE 10%, EPS $5, plowback ratio 60% => PE = (1-0.6)/(8%-10%*0.6) = 20
10. Firm will pay a year end dividend of $4, dividend thereafter grows constantly at 4%. k= 10%.
Intrinsic value = 4/(10%-4%) = 66.67
11. Firm expects to earn $6 per share next year. ROE 15%, plowback 60%, k 10% => PVGO = 180
12. EBIT $300, tax rate 35%, dep $20, capex $60, planned increase in NWC $30 => FCFF=300*0.65+20-60-30= 125
13. FCFF=205m, int expense 22m, tax rate 35%, net debt increases by 3m, FCFE grow at 3% indefinitely and cost of
equity is 12%
FCFE = 205-22*0.65+3=193.7
Market value of equity = 193.7*1.03/(12%-3%)=2216.8
14. Dividend 2.1, k=11% => P = 19.09
15. k=12.5%, D1 next year = 2.5, g = 4% => P = 29.4
16. T/F/Uncertain
a/ All else constant, firm has higher PE if its beta is higher. FALSE
b/ PE tends to be higher when ROE is higher, assuming plowback is positive. TRUE cuz higher ROE means more growth
opportunities.
c/ PE tends to be higher when plowback rate is higher. UNCERTAIN, it depends on a comparison between the expected
rate of return on reinvested earnings with the market capitalization rate. If ROE is higher than k, P/E increases as
plowback ratio increases.
17. a/ k 16%. will pay a year end dividend $2. If stock sells at $50, what is market’s expectation of the growth rate of
dividends? 12%
b/ If dividend growth is 5% => P=18.2
c/ What happens to PE ratio? decline since Price declines
18. ROE 20%, plowback 0.3. Earnings this year will be $2, k 12%
a/ P= 2*0.7/(0.12-0.2*0.3) = 23.33
PE = (1-0.3)/(0.12-0.2*0.3) = 11.67
b/ PVGO = 23.33-2/12% = 6.66
c/ If firm reinvest only 20% => PE=10, PVGO=3.33
19. a/ ROE 16%, plowback 50%, k 12%. Next year earnings $2 => P=25
b/ Price to sell for in 3 years => P=25*1.08^3= 31.49
20. ROE 9%, k=16%, plowback ⅔. This year earnings 3$ was just paid.
a/ P0=3*⅓*(1+9%*⅔)/ (16%-9%*⅔)=10.6
b/ PE= 3.33
c/ PVGO = 10.6 - 3.18/16% = -9.275
d/ Immediately reduce plowback ratio to ⅓ => Intrinsic value = 3*2/3*(1+9%*1/3)/ (16%-9%*1/3)=15.85
e/ V0 is different from P0 because the market price does not reflect the new information. V0 is greater than P0 because
there is a reduction of the investment in the bad project (ROE<k) which increases the firm value
21. Dividend grows indefinitely by 5%
a/ If year end dividend is 8 and k 10% => P=160
b/ If EPS $12 => plowback ratio = (12-8)/12 = ⅓ => ROE=5%/(⅓)=15%
c/ PVGO= 160-12/10% = 40
22. Stock selling at $10. EPS next year $2. dividend payout ratio 50%. The rest is retained and invested in projects
that earn 20% rate of return. Continue indefinitely.
a/ Assume current market price reflects intrinsic value => 10=1/(k-20%*0.5) => k = 20%
b/ PVGO = 10 - 2/20% = 0
c/ Dividend payout ratio 25% => Stock price = 2*0.25/(20%-20%*0.75) = 10
d/ If firm eliminates the dividend => Stock price = 2/20% = 10
23. k 16.4%, dividend payout ratio 40%, latest earnings were $10 per share. Dividends were just paid. ROE 20%
forever.
a/ growth rate = 20%*0.6 = 12%
Intrinsic value = 10*1.12*0.4/(16.4%-12%) = 101.82
b/ Market price is currently 100, market price equals intrinsic value one year from now => Intrinsic value one year from
now = 101.82*1.12=114, Dividend one year from now = 10*0.4*1.12^2 = 5.0176
=> Expected HPR = (5.0176+114-100)/100 = 19%
24. Operating CF 2m in the year just ended, expect to grow by 5% forever. Invest 20% of pretax CF each year. tax
rate 35%, dep 200k in the year just ended and expected to grow at same rate as operating CF. k 12%, currently
has debt 4m outstanding.
CF before interest and tax was 2m, Dep 200k => EBIT was 1800k
FCFF1 = 1800k*1.05*(1-0.35) + 200k*1.05 - 2000k*20%*1.05 = 1018.5k
Value of firm = FCFF1/(12%-5%) = 14550k
Value of equity = 14550-4000 = 10550k

CHAPTER 10: Bond prices and yields

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1. a. Catastrophe bond. Typically issued by an insurance company. They are similar to an insurance policy in that
the investor receives coupons and par value, but takes a loss in part or all of the principal if a major insurance
claim is filed against the issuer. This is provided in exchange for higher than normal coupons.
b. Eurobonds are bonds issued in the currency of one country but sold in other national markets.
c. Zero-coupon bonds are bonds that pay no coupons, but do pay a par value at maturity.
d. Samurai bond. Yen-denominated bonds sold in Japan by non-Japanese issuers are called Samurai bonds.
e. Junk bond. Those rated BBB or above (S&P, Fitch) or Baa and above (Moody’s) are considered investment
grade bonds, while lower-rated bonds are classified as speculative grade or junk bonds.
f. Convertible bond. Convertible bonds may be exchanged, at the bondholder’s discretion, for a specified number
of shares of stock. Convertible bondholders “pay” for this option by accepting a lower coupon rate on the
security.
g. Serial bond. A serial bond is an issue in which the firm sells bonds with staggered maturity dates. As bonds
mature sequentially, the principal repayment burden for the firm is spread over time just as it is with a sinking
fund. Serial bonds do not include call provisions.
 h. Equipment obligation bond. A bond that is issued with specific equipment pledged as collateral against the
bond.
i. Original issue discount bonds are less common than coupon bonds issued at par. These are bonds that are issued
intentionally with low coupon rates that cause the bond to sell at a discount from par value.
j. Indexed bond. Indexed bonds make payments that are tied to a general price index or the price of a particular
commodity.
2. Callable bonds give the issuer the option to extend or retire the bond at the call date, while the extendable or
puttable bond gives this option to the bondholder.
3. a. YTM will drop since the company has more money to pay the interest on its bonds.
b. YTM will increase since the company has more debt and the risk to the existing bondholders is now increased.
c. YTM will decrease since the firm has either fewer current liabilities or an increase in various current assets.
4. Invoice price = 117%*1000 + 30*⅙ = 1175
5. 1000 = 746.22*(1+YTM)^5 => YTM = 6.03%
Price falls immediately to 730 => YTM = 6.5%
6. A bond’s coupon interest payments and principal repayment are not affected by changes in market rates.
Consequently, if market rates increase, bond investors in the secondary markets are not willing to pay as much for
a claim on a given bond’s fixed interest and principal payments as they would if market rates were lower. This
relationship is apparent from the inverse relationship between interest rates and present value. An increase in the
discount rate (i.e., the market rate) decreases the present value of the future cash flows.
7. The bond callable at 105 should sell at a lower price. Therefore, its yield to maturity should be higher.
8. 10% coupon > YTM 8% => Premium bond: as time passes, bond price approaches par value => lower
9. Current yield = 1000*4.8%/970 = 4.95%
10. An investor believes that a bond may temporarily increase in credit risk. Which of the following would be the
most liquid method of exploiting this? The purchase of a credit default swap
11. Behavior of CDS: When credit risk increases, credit default swaps increase in value because the protection they
provide is more valuable. Credit default swaps do not provide protection against interest rate risk however.
12. Coupon = 60, Selling price = 60/6% = 1000
Price in 1 year = 946.1
HPR = [60+ (946.1-1000)]/1000 = 0.61%
13. Zero coupon bonds provide no coupons to be reinvested. Therefore, the final value of the investor's proceeds from
the bond is independent of the rate at which coupons could be reinvested (if they were paid). There is no
reinvestment rate uncertainty with zeros.
14. a/ rate 1 month = 0.798% => EAR = (1+ 0.798%)^12-1 = 10%
b/ EAR = (1+10%/2)^2-1 = 10.25%
15. 8% coupon semiannual currently sells at par value. If they want to sell at par and pay coupons annually =>
coupon rate?
The effective annual yield on the semiannual coupon bonds is 8.16%. If the annual coupon bonds are to sell at par
they must offer the same yield, which requires an annual coupon of 8.16%.
16. 10% coupon semiannually when the market interest rate is only 4% per half-year (YTM). 3 years until maturity.
a/ Coupon = 50 => Price = 1052.42
Price 6 months from now = 1044.52
b/ Rate of return = [50+1044.52-1052.42]/1052.42 = 4% per 6 months
17. 20 year, semiannual coupon 8%
a/ Bond price = 950 => Bond equivalent yield = 4.263%*2 = 8.526%, EAR = 8.708%
b/ Bond price = 1000 => Bond equivalent yield = 4%*2 = 8%, EAR = 8.16%
c/ Bond price = 1050 => Bond equivalent yield = 3.756%*2 = 7.51%, EAR = 7.65%
18. 20 year, annual coupon 8%
a/ Bond price = 950 => Bond equivalent yield = EAR = 8.53%
b/ Bond price = 1000 => Bond equivalent yield = EAR = 8%
c/ Bond price = 1050 => Bond equivalent yield = EAR = 7.51%
 The yields computed in this case are lower than the yields calculated with semi-annual coupon payments. All else
equal, bonds with annual payments are less attractive to investors because more time elapses before payments are
received. If the bond price is the same with annual payments, then the bond's yield to maturity is lower.

19.
Year Nominal rate of return = (Coupon + Price Real rate of return
appreciation)/ Initial price

2 [42.02+(1050.6-1020)]/1020 = 7.12% 1.0712/1.03 - 1 = 4%

3 [42.44+(1061.11-1050.6)]/1050.6 = 5.04% 1.0504/1.01 - 1 = 4%

20. The convention is to use semiannual payments => YTM = căn bậc 40(1000/400) -1 = 2.32% semiannual = 4.63%
annual
21. 10 years, coupon rate 8% annually. current market price 800
=> YTM = 11.46% => Price next year = 811.7 => Capital gain = (811.7-800) = 11.7
22. Quoted price = 100.125% *1000 = 1001.25
Invoice price = 1001.25 + 35*15/182 = 1004.13
23. Current yield 9%, YTM 10% => Selling below par value (discount bond)
24. Discount bond YTM>Current yield>Coupon rate => coupon rate lower than 9%
25. avadks
26. jksbdj
27. 10 year 14% annual coupon, sells for 900. reduce coupon payment to ½ the contracted amount.
Stated YTM = 16.075%
Expected YTM = 8.526%
28. 2 year bond, annual coupon = 100, sell at 1000 => YTM = 10%. Realised compound YTM if 1 year interest rate
next year is:
a/ 8% => Value next year = 100+100*1.08+1000 = 1208 = 1000*(1+r)^2 => r = 9.91%

29. Invoice price = 1001.25 + 50*3/6 = 1026.25

30. lower coupon on ABC: has collateral so it’s a senior claim, less risk of default, not callable so less risk of being
called, no sinking fund so less risk of being called at lower market price, shorter term so less sensitive to interest
rates
31. a. The floating-rate note pays a coupon that adjusts to market levels. Therefore, it will not experience dramatic
price changes as market yields fluctuate. The fixed rate note therefore will have a greater price range.
b. Floating rate notes may not sell at par for any of the several reasons: The yield spread between one-year
Treasury bills and other money market instruments of comparable maturity could be wider than it was when the
bond was issued. The credit standing of the firm may have eroded relative to Treasury securities that have no
credit risk. Therefore, the 2% premium would become insufficient to sustain the issue at par. The coupon
increases are implemented with a lag, i.e., once every year. During a period of rising interest rates, even this brief
lag will be reflected in the price of the security.
c. The risk of a call is low. Because the bond will almost surely not sell for much above par value (given its
adjustable coupon rate), it is unlikely that the bond will ever be called.
d. The fixed-rate note currently sells at only 93% of the call price, so that yield to maturity is above the coupon
rate. Call risk is currently low, since yields would have to fall substantially for the firm to use its option to call the
bond.
 e. The 9% coupon notes currently have a remaining maturity of fifteen years and sell at a yield to maturity of
9.9%. This is the coupon rate that would be needed for a newly issued fifteen-year maturity bond to sell at par.
f. Because the floating rate note pays a variable stream of interest payments to maturity, its yield-to-maturity is
not a well-defined concept. The cash flows one might want to use to calculate yield to maturity are not yet
known. The effective maturity for comparing interest rate risk of floating rate debt securities with other debt
securities is better thought of as the next coupon reset date rather than the final maturity date. Therefore, “yield-
to-recoupon date” is a more meaningful measure of return.
32. 30 year 8% coupon semiannual is callable in 5 years at call price 1100. Currently sells at YTM 7% (3.5% per half
year)
a/ Price = 1124.72 => YTC = 3.368% semiannual = 6.736% annual
b/ Call price 1050 => YTC = 2.98% semiannual = 5.95% annual
c/ Call price 1100 but bond called in 2 years => YTC = 3.03% semiannual = 6.06% annual
33. 20 year zero coupon bond, YTM 8%. Price today = 1000/1.08^20 = 214.55
Price in 1 year = 231.71 => Imputed interest income = 17.16
34. Newly issued 10 year, 4% coupon annual, sell at 800.
=> YTM = 6.824% => Price next year = 814.6, representing an increase of 14.6
=> Taxable income = 14.6 + 40 = 54.6
35. 2 bonds 20 year, callable at 1050. 1st bond is issued at a deep discount with coupon rate 4% and price of 580 to
yield 8.4%. 2nd bond is issued at par value with coupon rate 8.75%
a/ The yield to maturity of the par bond equals its coupon rate, 8.75%. All else equal, the 4% coupon bond would be more
attractive because its coupon rate is far below current market yields, and its price is far below the call price. Therefore, if
yields fall, capital gains on the bond will not be limited by the call price. In contrast, the 8.75% coupon bond can increase
in value to at most $1050, offering a maximum possible gain of only 5%. The disadvantage of the 8.75% coupon bond in
terms of vulnerability to a call shows up in its higher promised yield to maturity.
b/ If an investor expects rates to fall substantially, the 4% bond offers a greater expected return
c/ Implicit call protection is offered in the sense that any likely fall in yields would not be nearly enough to make the firm
consider calling the bond. In this sense, the call feature is almost irrelevant.
36. True. Under the expectations hypothesis, there are no risk premia built into bond prices. The only reason for long-
term yields to exceed short-term yields is an expectation of higher short-term rates in the future.
37. If the yield curve is upward sloping, you cannot conclude that investors expect short term interest rates to rise
because the rising slope could be due to either expectations of future increases in rates or the demand of investors
for a risk premium on long-term bonds. In fact the yield curve can be upward sloping even in the absence of
expectations of future increases in rates.
38. 1 year investment horizon, maturity 10 years. 1st: zero coupon bond, 2nd: 8% coupon, pays 80$ coupon annually.
3rd: 10% coupon rate, pays 100$ coupon annually
a/ YTM all 8% => Price B1 = 1000/1.08^10 = 463.2, Price B2 = 1000, Price B3 = 1134
b/ YTM next year = 8% => Price B1 = 500.25, Price B2 = 1000, Price B3 = 1125
Rate of return during 1 year = Total income/ Purchase price
B1 B2 B3

Coupon 0 80 100

Capital gain 37.05 0 -9

Rate of return 8% 8% 8%
39. Uncertain. Lower inflation usually leads to lower nominal interest rates. Nevertheless, if the liquidity premium is
sufficiently great, long-term yields can exceed short-term yields despite expectations of falling short rates
40. Maturity 1 year ~ YTM 10%, Maturity 2 year ~ YTM 11%, Maturity 3 year ~ YTM 12%
a/ Implied 1 year forward rate in year 2 = 1.11^2/1.1 - 1 = 12%
Implied 1 year forward rate in year 3 = 1.12^3/1.11^2 - 1 = 14%
b/ What will the pure yield curve (YTM on 1-year and 2-year coupon bonds) be next year?
YTM of 1 year bond next year = 1-year forward rate from today = 12%
YTM of 2 year bond next year = 2-year forward rate from today => (1+12%)^3 = (1+10%)*(1+f)^2 => f = 13%
c/ If you buy a 2 year bond now, what is the expected total rate of return over the next year?
Price at the beginning of next year = 1000/1.11^2 * 1.1 = 892.78 (or 1000/(1+1year forward rate next year)^1 = 892.78),
Price today = 811.6
=> Rate of return = (892.78-811.6)/811.6 = 10%
d/ If you buy a 3 year bond now, what is the expected total rate of return over the next year?
Price at the beginning of next year = 1000/1.12^3 * 1.1 = 782.96 (or 1000/(1+2year forward rate next year)^2 = 782.9),
Price today = 711.8
=> Rate of return = (782.9-711.8)/711.8 = 10%
41. YTM on 1 year zero coupon bond is 8%, 2 year is 9%
a/ forward rate for 2nd year = 1.09^2/1.08 -1 = 10%
b/ Expectations hypothesis: Expected value of the short term interest rate next year = 10%
c/ Liquidity preference theory: Next year’s expected short term interest rate will be lower than forward rate
(<10%)
42. Top row = spot rate (int rate on a loan that begins immediately/ YTM of n year bond)
Bottom row = forward rate
43. Expected values of next year’s yield on bonds with maturity:
a/ 1 year => 7%
b/ 2 year => 7.5%
c/ 3 year => 8.5%
44. coupon annual 5%, 20 year, YTM 8% => Price = 705.46
a/ Price in 1 year at YTM 7% = 793.29
1 year HPR = 19.54%
b/ Price in 1 year if YTM is still 8% = 711.89
Interest income tax = 0.4*(50+711.89-705.46) = 22.572
Capital gain tax = 0.3*(793.29-711.89) = 24.42
Total tax = 46.992
c/ After tax HPR = [0.6*50+0.6*(711.89-705.46)+0.7*(793.29-711.89)]/705.46
or = [50+793.29-705.46-total tax]/705.46 = 12.88%
d/ Price in 2 years at YTM 7% = 798.82
Value in 2 years = 50+50*1.03+798.82 = 900.32
900.32 = 705.46*(1+r)^2 => r=12.97%
e/ Year 1:
Coupon received in 1st year = 50
Interest income tax = 0.4*(50+711.89-705.46) = 22.572
Net cash flow in 1st year = 27.43
After tax rate of reinvestment = 3%*0.6 = 1.8%
By year 2, net cf in year 1 will grow to 27.43*(1+1.8%) = 27.92
Year 2:
* Sell bond in 2nd year for =PV(7%,18,50,1000) = 798.82
* Coupon received = 50
Price in 2 years if YTM is still 8% = 718.84
Price in 1 year if YTM is still 8% = 711.89
=> Tax on interest income = 0.4*(50+718.84-711.89) = 22.78
Tax on capital gains = 0.3*(798.82-718.84) = 23.994
* Total tax = 46.774
* After tax net CF reinvested in year 1 = 27.92
=> Total value in year 2 = 798.82+50-46.774+27.92 = 829.966
829.966 = 705.46*(1+r)^2 => r = 8.47%

1. a-(3) The yield on the callable bond must compensate the investor for the risk of call.
b-(3)
c-(2) lower
 d-(3)
3. Conversion premium = Bond value - market conversion value = 775- 20.83*28 = 191.76

CHAPTER 15: Options Markets

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1. We said that options can be used either to scale up or reduce overall portfolio risk. What are some examples of
risk-increasing and risk-reducing options strategies? Explain each.
Options provide numerous opportunities to modify the risk profile of a portfolio. The simplest example of an option
strategy that increases risk is investing in an 'all options' portfolio of at the money options (as illustrated in the text). The
leverage provided by options makes this strategy very risky, and potentially very profitable. An example of a risk-
reducing options strategy is a protective put strategy. Here, the investor buys a put on an existing stock or portfolio, with
exercise price of the put near or somewhat less than the market value of the underlying asset. This strategy protects the
value of the portfolio because the minimum value of the stock-plus-put strategy is the exercise price of the put.
2. Why do you think the most actively traded options tend to be the ones that are near the money?
Options at the money have the highest time premium and thus the highest potential for gain. Since they highest potential
gain is at the money, the logical conclusion is that they will have the highest volume. A common phrase used by traders is
"avoid the cheaps and the deeps." Cheap options are those with very little time premium. Deep options are those that are
way out of or in the money. None of these provide profit opportunities.
3. A buyer has to pay 7.25 for 1 call option. 1 call options contract has 100 shares => For 1 call option contract a
buyer has to pay 7.25*100 = 725$

4. Price at expiration date is

5. Buy one 80 put contract for a premium of 5.72 => Max profit = (80-0-5.72)*100 = 7428 when Price = 0
6. Buy a call at 4.5 with X 40. Break even => 0=X-40-4.5 => X=44.5
7. Establish a straddle using a call and a put with X 80. Call premium 7, put premium 8.5
a/ Most you can lose = 7+8.5 = 15.5 per share when stock price remains unchanged
b/ Price 88 => Gain on call = 88-80-7 = 1, Loss on put = -8.5 => Loss = -7.5
Gain/loss = Final value - Original investment = (88-80)-(7+8.5) = -7.5
c/ Break even => Profit of the buyer = |St-X| - (P+C) = 0 => |St-80| = 7.5 => St = 87.5 or 72.5
8. a/ False, b/ False, c/ True, d/ False
9. a/ Long straddle due to price volatility, b/ Long put due to large stock price losses
10. Purchase a stock for 38 and a put for 0.5 with X 35. Sell a call for 0.5 with X 40
a/ Max profit = 40, Max loss = 35
b/ Diagram
St<35 35<St<40 St>40

Purchase stock St St St

Buy put at 35 35-St-0.5 -0.5 -0.5

Sell call at 40 0.5 0.5 40-St+0.5

35 St 40
11. Holding 5000 shares currently selling at 40. Use a collar. Call option 45 at 2, Put option 35 at 3.
X<35 35<X<45 X>45
 Purchase stock St St St

Buy put at 35 at 3 35-St-3 -3 -3

Sell call at 45 at 2 2 2 45-St+2

34 St-1 44
a/ If stock price is 30 => Value of portfolio = 34*5000
b/ If stock price is 40 => Value of portfolio = 39*5000
c/ If stock price is 50 => Value of portfolio = 44*5000
12. rate of return
10,000 80 100 110 120

All stock (100 shares) 8000 10000 11000 12000

All options (1000 -10*1000 = -10,000 -10*1000 = -10,000 (-10+110-100)*1000 (-10+120-100)*1000

shares) X 100, sell at =0 = 10,000
10

1000 for 100 options 9000*1.04 -10*100= 9000*1.04 -10*100= 9000*1.04 +(- 9000*1.04 +(-
+ 9000 invest in Bills 8360 8360 10+110-100)*100= 10+120-100)*100=
4% 9360 10360
rate of return
10,000 80 100 110 120

All stock (100 shares)

All options (1000

shares) X 100, sell at
10

1000 for 100 options

+ 9000 invest in Bills
4%
13. You believe stock price is going to break far out of that range but do not know which direction. Current price 100,
price of 3 month call option with X 100 is 10, a put with same expiration date and exercise price costs 7.
a/ Buy a straddle
b/ Break even => |St-100| = 17 => St = 117 or 83 => St moves 17 in either direction to start making profit
14. Has been trading around 50, you believe it is going to stay in that range. Put option 50 at 4, call option with same
expiration date and exercise price costs 7.
a/ Sell a straddle
b/ Most money = 11
c/ You will start losing money when stock price moves by 11 in either direction
d/ How can you create a position involving a put, a call, and riskless lending that would have the same payoff
structure as the stock in expiration? Buy call, sell put, riskless lending the present value of 50
e/ Net cost of establishing that position = 7 + 4 + 50/(1+r)^3/12
15. Receive 10,000 shares currently at 40. If the value of his holdings falls below 35,000 his ability to come up with a
down payment would be jeopardized. If stock value rises to 45,000 he would be able to maintain a small cash
reserve.
a/ Write call 45 at 3. This strategy offers some premium income but leaves the investor with substantial downside
risk. At the extreme, if the stock price falls to zero, Jones would be left with only $30 000. This strategy also puts
a cap on the final value at $480,000, but this is more than sufficient to purchase the house.
b/ Buy put 35 at 3. By buying put options with a $35 strike price, Jones will be
paying $30,000 in premiums in order to insure a minimum level for the final value
 of his position. That minimum value is ($35*10 000) − $30 000 = $320 000. This
strategy allows for upside gain, but exposes Jones to the possibility of a
moderate loss equal to the cost of the puts.
c/ Zero cost collar by writing call and buying put. The net cost of the collar is zero.
Stock price <35 35<St<45 St>45

Portfolio value 350000 10000 * stock price 450000

The best strategy in this case is (c) since it satisfies the two requirements of preserving the $350 000 in principal while
offering a chance of getting $450000. Strategy (a) should be ruled out because it leaves Jones exposed to the risk of
substantial loss of principal.
16. a/ Butterfly spread

b/ Vertical combination

17. Bearish spread is buying call with higher X, selling call with lower X.

18. Stock market index is at 1800

a/
Protective put St<1560 St>1560

Buy shares St St
 Buy put at X 1560 1560-St 0

1560 St

Your uncle St<1680 St>1680

Buy call at X 1680 0 St-1680

Buy T bills with face value 1680 1680 1680

1680 St
b/ The bills plus call strategy has a greater payoff and never a lower payoff. Since its payoff are always at least as
attractive and sometimes greater, it must be more costly to purchase

c/ The initial cost of protective put is 1812, that of the bills plus call is 1860

Protective put St = 0 St = 1400 St = 1600 St = 1800 St = 1920

Payoff 1560 1560 1600 1800 1920

Initial cost 1812 1812 1812 1812 1812

Profit -252 -252 -212 -12 108

Your uncle St = 0 St = 1400 St = 1600 St = 1800 St = 1920

Payoff 1680 1680 1680 1800 1920

Initial cost 1860 1860 1860 1860 1860

Profit -180 -180 -180 -60 60

d/ The stock and put option is riskier because it does worse when the market goes down and does better when the market
goes up => Beta is higher
19. Spreadsheet
20. Owning a bond vs. Writing a put: The bondholders have, in effect, made a loan which requires repayment of B
dollars, where B is the face value of bonds. If, however, the value of the firm (V) is less than B, then the loan is
satisfied by the bondholders taking over the firm. In this way, the bondholders are forced to "pay" B (in the sense
that the loan is cancelled) in return for an asset worth only V. It is as though the bondholders wrote a put on an
asset worth V, with exercise price B.
Owning a bond vs. Writing a call: one can view the bondholders as giving to the equity holders the right to
reclaim the firm by paying off the B dollar debt. The bondholders have issued a call to the equity holders.
 21. An executive compensation scheme might provide a manager a bonus of $1,000 for every dollar by which the
company's stock price exceeds some cutoff level. In what way is this arrangement equivalent to issuing the
manager call options on the firm's stock?
=> The executive receives a bonus if the stock price exceeds a certain value, and receives nothing otherwise. This
is the same as the payoff to a call option.
22. acndjs
23. Write a put at 90 and buy a put at 95
Stock price <90 90<St<95 St>95

Write put at 90 St-90 0 0

Buy put at 95 95-St 95-St 0

5 95-St 0
24. Put at X 60 sells for 2. Put X 62 also sells for 2.
Zero-net-investment arbitrage strategy: It is a strategy that can be made by buying and selling of securities together to
obtain a zero net value of investment, which means buying and selling of securities in such a manner that the net
investment comes out to be zero.
25. Buy a share, write a 1 year call X 10, buy 1 year put X 10. Net outlay to establish portfolio is 9.5

CHAPTER 17: Futures Markets and Risk Management

1. Profit = 250*(1800-1850)= -12500
2. F=1800*(1+1%-2%)^1 = 1782
3. a/ Futures price should be = 1200*(1+2%) = 1224
b/ Current futures price is too low => Strategy: Long futures contract, short gold, lends money at risk free rate
 CF at 0 CF at T

Lends at 2% -1200 +1200*1.02 = +1224

Short gold 1200 -St

Long futures position (F=1141) 0 St-1141

Total 0 83
4. Initial equity = 115098*0.15 = 17264.7
Borrowing = 97833.3
When futures price falls to 108000 => Equity = 108000-97833.3 = 10166.7
Rate of return = -41.11%
5. jnsdj
6. Why might individuals buy futures contracts rather than the underlying asset => Leverage effect of margin
7. Difference
CF at 0 CF at T

short selling an asset So -St

short futures position 0 Fo-St

8. a/ F=1800*(1+3%-2%)=1818
b/ T bill rate =1% => F=1800*(1+1%-2%)=1782
9. Future Price (Dec) = Future price (June)*(1+3%/12)^6 = 1265.11 > current futures price in Dec 1251
=> Arbitrage opportunity since Dec current price is too low => long Dec contract + short June contract
10. a/ Buy the stock, short a futures contract on the stock, borrows So dollars (So=current price of stock). After 1 year
stock pays dividend D
CF at 0 CF at T

buy stock -So St+D

short futures position 0 Fo-St

borrows So dollars +So -So(1+rf)

0 D+Fo-So(1+rf)
b/ To avoid arbitrage => D+Fo-So(1+rf)=0 => Fo = So(1+rf) - D
c/ Dividend yield d= D/So => Fo = So(1+rf) - So*D = S0*(1+rf-d)
11. a/ F=150*1.03 = 154.5
12. niwjd
13. Each contract ~ 1000 shares on stock in 1 year. T bill rate 6% per year
a/ F=120*(1+6%) = 127.2
b/ Stock price drops by 3% => Stock price falls to 116.4 => Futures price falls to 123.384
The investor loses: ($127.20 – $123.384) * 1,000 = -$3,816
c/ The percentage return is: –$3,816/$12,000 = –31.8%
14. Multiplier 250$.. After 1 month, stock index is at 2010.
a/ Initial futures price Fo=2000*1.003^12=2073.2
After 1 month, F1 = 2010*1.003^11 = 2077.33
=> Mark to market proceeds =4.134*250 = 1033.5
b/ 1 month HPR if initial margin is $10,000 => HPR = 1033.5/10000
15. F=1800*1.01=1818 < current futures price 1833 (too high)
=> Short futures contract, buy stock, borrows money at rf
16. skmfovs
 17. Before the swap firm pays 7%. After the swap Sahali receives 6% minus LIBOR. The cost is of the swap is 7% -
(6% - LIBOR) = LIBOR + 1%
18. Interest rates will soon fall => swap a fixed rate for a variable rate
19. Margin requirement 10%, stock index is currently 1800, each contract multiplier $250
a/ Margin = 250*1800*10% = 45000
b/ Futures price falls to 1782 => Investor loses = (1782-1800)*250 = -4500
c/ Percentage return = ((45000-4500)-45000)/45000 = -10%
20. a/ Fo = 1012.07, F1 = 1031.28 => Mark to market proceeds = 19.21*250 = 4802.5
b/ HPR if initial margin 10,000 = 4802.5/10,000
21. Rates will fall, prices will rise => long bonds futures contract. If rates do in fact fall, the treasurer will have to
buy back the bonds for the sinking fund at prices higher than the prices at which they could be purchased today.
However, the gains on the futures contracts will offset this higher cost to some extent.
24. The S&P 500 Index is currently at 2,000. You manage a $10 million indexed equity portfolio. The S&P 500 futures
contract has a multiplier of $50.
a/ If you are temporarily bearish on the stock market, how many contracts should you sell to fully eliminate your exposure
over the next six months?
Each contract is for $50 times the index, currently valued at 2,000. Therefore, each contract has the same exposure to
the market as $100,000 worth of stock, and to hedge a $10 million portfolio, you need: $10 million/$100,000 = 100
contracts.
b/ If T bills pay 2% per 6 months and the semiannual dividend yield is 1%, what is the parity value of the futures price?
The parity value of the futures price = 2,000 × (1 + 0.02 – 0.01)^2 = 2,040.20
Action Initial Cash Flow Cash Flow at Time T

Short 100 futures contracts 0 100 × $50 × (2,040.20 – ST)

Buy 5,000 “shares” of index (each –$10 million ($10 million × 0.01) + (5,000 × ST)
share equals $2,000)

Total –$10 million $10.20 million [which is riskless]

26. A corporation has issued a $10 million issue of floating-rate bonds on which it pays an interest rate of 1% over the
LIBOR rate. The bonds are selling at par value.The firm is worried that rates are about to rise, and it would like to lock in
a fixed interest rate on its borrowings. The firm sees that dealers in the swap market are offering swaps of LIBOR for 7%.
a/ What swap arrangement will convert the firm's borrowings to a synthetic fixed-rate loan?
Before Swap, the Interest cost on the bond to the corporation is: LIBOR + 1%
After the swap, the company will be receiving a fixed rate in exchange for a floating rate i.e. -LIBOR+7%
Total swap gain: LIBOR+1% -LIBOR+7% =8%
Now this 8% shared by both the parties i.e. 8%/2= 4% gain shared by both the parties
=> Therefore Swap arrangement converts corporation's borrowing into the synthetic fixed-rate loan i.e. Fixed-rate - gain =
7%-4%=3%
b/ What interest rate will it pay on that synthetic fixed-rate loan? LIBOR-4%

27. Suppose the 1 year futures price on a stock -index portfolio is 1,624, the stock index currently is 1,600, the 1 year risk
free interest rate is 3% and the year end dividend that will be paid on a $1,600 investment in the market index portfolio is
$20.
a/ By how much is the contract mispriced?
F = 1600*(1+3%-20/1600) = 1628 > current futures price 1624
Thus Futures is mispriced by 1628 - 1624 = $4
b/ Formulate a zero net investment arbitrage portfolio and show that you can lock in riskless profits equal to the futures
mispricing.
- Long future contract => CF long position = St - 1624
- Short the stock and invest the proceed in bank => CF short asset = -St - 20
- Proceed after 1 yr of lending 1600 at rf 3% = 1600*1.03 = 1648
Net Arbitrage profit = 1648-1644 = $ 4
c/ Now assume (as is true for small investors) that if you short sell the stocks in the market index, the proceeds of the
short sale are kept with the broker, and you do not receive any interest income on the funds. Is there still an arbitrage
opportunity (assuming that you don't already own the shares in the index)? Explain.
If we do not receive interest income with broker then
- Short the stock and invest the proceed in bank
- Enter into long future contract
- Proceed after 1 yr = 1600* e(0*1) = 1600
Execute Futures to buy the stock and pay the dividend also CF = - 1624 +20 = 1644
Net Arbitrage profit = 1600-1644 = $ -44 that is Loss of $ 44
d/ Given the short sale rules, what is the no-arbitrage band for the stock futures price relationship? That is, given a stock
index of 1,600, how high and low can the futures price be without giving rise to arbitrage opportunities?
Dividend yield = $20/1600 = 0.0125
Upper Bound = S *e(r+q)t = 1600 * e (0.03+0.0125) = 1669.47
Lower Bound = S *e(r-q)t = 1600 * e (0.03-0.0125)= 1628.25