Modern Portfolio Theory and Investment Analysis 9th Edition Elton Test Bank CH 4
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MODERN PORTFOLIO THEORY AND INVESTMENT ANALYSIS
9TH EDITION
ELTON, GRUBER, BROWN, & GOETZMANN
The following exam questions are organized according to the text's sections. Within each section, questions
follow the order of the text's chapters and are organized by multiple choice, true-false with discussion,
problems, and essays. The correct answers and the corresponding chapter(s) are indicated below each
question.
PART 4: SECURITY ANALYSIS AND PORTFOLIO THEORY
Multiple Choice
1. The fact that superior returns can not be made by selling stocks that cut dividends is evidence of:
a. weak-form efficiency.
b. semi-strong-form efficiency.
c. strong-form efficiency.
Answer: b
Chapter: 17
2. Tests of market efficiency tend to
a. look for statistical dependencies that exist in price changes over time.
b. measure the nature of the impact of new information on security prices as that new
information becomes available.
c. search for trading systems that might be able to generate supernormal profits.
d. all of the above
Answer: d
Chapter: 17
3. Which of the following is an implication of market efficiency?
a. Resources are allocated among firms that put them to the best use.
b. No investor will do better than the S&P 500 in any time period.
c. No investor will do better than the S&P 500 consistently after adjusting for risk.
d. No investor will do better than the S&P 500 consistently after adjusting for risk and
transactions costs.
Answer: d
Chapter: 17
4. Which of the following statements is (or are) true of the efficient markets hypothesis?
a. It implies perfect forecasting ability.
b. It implies that prices reflect all available information.
c. It results from keen competition among investors.
d. It implies that market is irrational.
e. It implies that prices do not fluctuate.
Answer: b and c
Chapter: 17
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Test Bank Modern Portfolio Theory and Investment Analysis, 9th
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5. Studies of firms classified on the basis of P/E ratios come to the conclusion that low-P/E-ratio
stocks earn much higher returns, after adjusting for risk, than high-P/E-ratio stocks. This is because
a. low-P/E-ratio stocks are riskier than high-P/E-ratio stocks.
b. investors like low-P/E-ratio stocks.
c. low-P/E-ratio stocks are more likely to be undervalued.
Answer: c
Chapter: 18
6. Which of the following investment strategies is inconsistent with a "contrarian" philosophy?
a. buying low, selling high
b. buying when odd-lot buying is lower than normal
c. buying when mutual fund cash positions are low
d. buying when most investment advisory services are bearish
e. selling after a market crash or decline
Answer: e
Chapter: 20
7. Which of the following is not a general conclusion of studies of stock prices?
a. The serial correlation in daily returns in U.S. stocks is positive.
b. The serial correlation in longer period returns (monthly, annual) in U.S. stocks is negative.
c. Filter rules greater than 1% generally do not make money.
d. Stocks that have done well in the past are also likely to do well in the future.
e. There are more runs in daily stock prices than we would expect to find under a random
walk.
Answer: d
Chapter: 19
8. A common stock is expected to generate an end-of-period dividend of $5 and an end-of-period price
of $62. If this security has a beta coefficient of 1.3, the risk-free interest rate is 10%, and the expected return
on the market portfolio is 19%, then what is the value of this security today?
a. $55.50
b. $59.98
c. $55.05
d. $56.30
Answer: c
Chapter: 18
9. If expectation theory holds then:
a. a flat yield curve is an indication that long-run rates are expected to increase.
b. investors must be offered a higher expected return to hold a bond longer
c. the yield curve cannot be downward sloping
d. then an upward sloping yield curve is an indication that short-term rates are
expected to increase.
Answer: d
Chapter: 21
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Modern Portfolio Theory and Investment Analysis, 9th Edition Test Bank
10. Which of the following statement is correct with regard to bond valuation?
a. All else equal, the longer the time to maturity, the smaller the interest rate risk.
b. All else equal, the higher the coupon rate, the greater the interest rate risk
c. Spot interest rates are yields to maturity on loan or bonds that pay multiple cash flows to the
investor.
d. Bond price will fall as the market interest rate rise, as the present value of the bond’s future cash
flows is obtained by discounting at a higher interest rate.
Answer: d
Chapter: 21
11. Which of the following statements is true?
a. An increase in coupons increases the duration of the bond.
b. The longer the maturity of a bond, the greater will be its duration.
c. An increase in the interest rate decreases the duration of the bond.
d. Duration is a measure of the sensitivity of the equities.
Answer: c
Chapter: 22
12. All other things equal, which of the following bond price is more sensitive to interest rate
changes?
a. a 10 year bond with a 10% coupon
b. a 20 year bond with a 7% coupon
c. a 20 year bond with a 10% coupon
d. a 30 year bond with 7% coupon
Answer: d
Chapter 22
13. Which of the following statements is true of warrants?
a. A warrant is almost identical to a put option.
b. When warrants are exercised the number of warrants still outstanding
increases.
c. A warrant is a combination of call and put options.
d. A warrant is issued by the corporation rather than another investor.
Answer: d
Chapter: 23
14. Which of the following is an attribute of futures contract?
a. There are no limits on the size of the position that any investor can take in financial futures
markets.
b. Futures contracts are marked to the market on a daily basis
c. Margins for futures are more relative to other types of markets.
d. Almost all futures positions are settled by delivery.
Answer: b
Copyright © 2014 John Wiley & Sons, Inc. 3
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Chapter: 24
True-False
1. A high positive serial correlation in prices would imply market inefficiency.
a. true
b. false
Answer: a
Chapter: 17
2. Studies of stock splits indicate that one could make excess returns by investing in stocks after splits
occur.
a. true
b. false
Answer: b
Chapter: 17
3. In a strongly efficient market, the price of a firm's stock should not change if no new information
comes out about the firm.
a. true
b. false
Answer: b
Chapter: 17
4. In a strongly efficient market, no mutual fund manager will beat the market in any period.
a. true
b. false
Answer: b
Chapter: 17
5. Studies show that stocks with high dividend yields and low P/E ratios earn excess returns.
a. true
b. false
Answer: b
Chapter: 17
6. A significant portion of the small-firm premium is earned in the first two weeks of the calendar
year.
a. true
b. false
Answer: a
Chapter: 17
7. Stocks that have high P/E ratios are much more likely to be found to be undervalued using the
4 Copyright © 2014 John Wiley & Sons, Inc.
Modern Portfolio Theory and Investment Analysis, 9th Edition Test Bank
dividend-discount model.
a. true
b. false
Answer: a
Chapter: 18
8. The Fed announces a tightening of monetary policy, leading to an increase in interest rates. Other
things remaining equal, P/E ratios for stocks will decrease.
a. true
b. false
Answer: a
Chapter: 18
9. Spot interest rates are yields to maturity on loans or bonds that pay only one cash flow to the
investor.
a. true
b. false
Answer: a
Chapter: 21
10. Everything else remaining equal, the duration of a coupon bond increases with maturity.
a. true
b. false
Answer: a
Chapter: 22
11. The duration of a bond decreases as the coupon rate on the bond increases.
a. true
b. false
Answer: a
Chapter: 22
12. The duration of a perpetual bond is infinite.
a. true
b. false
Answer: b
Chapter: 22
13. The duration of a five year maturity 10% coupon bond will be higher than the duration of a five
year maturity zero coupon bond.
a. true
b. false
Answer: b
Chapter 22
True-False With Discussion
Copyright © 2014 John Wiley & Sons, Inc. 5
Test Bank Modern Portfolio Theory and Investment Analysis, 9th
Edition
1. Discuss whether the following statement is true or false:
If semi-strong efficiency holds, then weak-form efficiency must hold.
Answer: True
Semi-strong form tests of the efficient market hypothesis are tests of whether publicly available information
is fully reflected in current stock prices. On the other hand, Weak-form tests are tests of whether all
information contained in historical prices is fully reflected in current prices. Thus, weak-form efficiency is a
subset of semi-strong efficiency which means weak-form efficiency must hold if semi-strong efficiency
holds.
Chapter: 17
2. Discuss whether the following statement is true or false:
The random walk model implies that the best estimate of tomorrow's price is today's price.
Answer: False
The random walk model assumes that successive returns are independent and that the returns are identically
distributed over time. In other words, the random walk theory says that the historical prices cannot predict
the future prices of the stock and that the prices of stock are independent of each other.
Chapter: 17
3. Discuss whether the following statement is true or false:
If markets are semi-strong-form efficient, one should not observe excess returns after the announcement of a
dividend increase.
Answer: True
The semi-strong form of the efficient market hypothesis states that investors reassess the value of the
security on the availability of any new information. This the reassessment leads to an immediate adjustment
in price. Hence, an investor buying a security based on any new information would be paying on an average
the actual worth of the security. Thus if the semi-strong form of efficiency holds, investors should not be
able to observe excess returns after the announcement of an increase in dividend.
Chapter: 17
4. Discuss whether the following statement is true or false:
A certain retailing firm has a strong seasonal pattern to its sales. Therefore, we would expect to find a
seasonal pattern to its stock price as well.
Answer: False
In an efficient market we should not observe a seasonal pattern in stock prices. If investors observe high
returns in a particular month they will start purchasing the stock just before the month when sales are
expected to rise to take advantage of the extra return. This adjustment of the pattern of investor purchases
should cause the pattern to disappear. Hence, the stock prices of the firm will not follow the same pattern as
sales in an efficient market.
Chapter: 17
5. Your friend claims that, since the market went up seven days in a row recently, there is no way that
the market could follow a random walk. Discuss whether your friend's claim is true or false.
Answer: False
The random walk model assumes that successive returns are independent and that the returns are identically
distributed over time. A trend in a stock or a market’s price does not necessarily mean a deviation from
random walk model. It can, and is very natural, for am market to react to change in the underlying
fundamentals. Semi-strong form of market efficiency states that the prices adjust to reflect any new
information so that excess returns cannot be observed. A seven day uptrend may reflect the increasing risk-
6 Copyright © 2014 John Wiley & Sons, Inc.
Modern Portfolio Theory and Investment Analysis, 9th Edition Test Bank
return functions of the market. Stock prices essentially follow a random and an unpredictable path.
Chapter: 17
6. Discuss whether the following statement is true or false:
The use of a dividend-discount model to value common stocks is inconsistent with strong-form efficiency
but is consistent with weak-form efficiency.
Answer: False
The dividend-discount model calculates the value of a stock by discounting the future expected dividends to
their present value. Strong form of market efficiency all the possible information whether public or private
is reflected in the stock price. Future dividends are no exception. Therefore, dividend discount model is
consistent with the strong form of efficiency of the market. Weak form of efficiency states that all historical
information is reflected in the prices. Since dividend discount model assumes future dividends as inputs, it is
inconsistent with weak form of efficiency.
Chapter: 17
7. Discuss whether the following statement is true or false:
The existence of a downward-sloping yield curve is inconsistent with the liquidity preference theory.
Answer: True
The liquidity preference theory suggests that the premium required by the investors for the cash invested by
them is directly proportional to the term of investment. This means, the longer the maturity, the higher the
premium that would be demanded by the investor. This will result in an upward-sloping yield curve. Under
expectations theory, a downward sloping yield curve indicates that short-term rates are expected to decline.
Chapter: 21
8. Discuss whether the following statement is true or false:
An investor is considering purchasing either a zero-coupon bond with 5 years to maturity or a 10% coupon
bond with 5 years to maturity, but if both bonds have identical yields to maturity and the investor expects to
hold the bond for the full 5 years, then it does not matter which bond is purchased.
Answer: False
Yield to maturity implicitly assumes that any intermediate income received from a bond is reinvested at the
same rate. If the interest rates in the market move, the coupons received on a bond will need to be re-
invested at the new rates, consequently affecting the realized yields. This is commonly known as re-
investment risk. However, for a zero-coupon bond, the yield to maturity will always be equal to the realized
yield.
Chapter: 21
9. Discuss whether the following statement is true or false:
A GNMA (mortgage pool) security with a 20-year maturity should sell at a lower yield to maturity than a
20-year corporate bond, because the interest and principal of the GNMA security are government insured.
Answer: True
Yields on corporate bonds are typically higher than those on GNMA security to compensate for the credit
risk. A corporate may or may not honor its obligation to pay interest and principal, whereas, a GNMA
security has the complete backing by the government of United States. Additionally, the interest payments
on corporate bonds are taxed at the state level whereas interest payments on government bonds are not.
Chapter: 21
10. Discuss whether the following statement is true or false:
Copyright © 2014 John Wiley & Sons, Inc. 7
Test Bank Modern Portfolio Theory and Investment Analysis, 9th
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The promised yield on corporate bonds will in general be higher than the expected yield.
Answer: True
The promised yield on a corporate bond is higher than its expected yield because of default premium.
Default premium is the amount of return that the investor requires to bear the risk of default of the corporate
bond. Unlike government bonds, for corporate bonds there is a risk that the coupon or principal payments
will not be met. Therefore, there is a difference between the promised yield of a corporate bond and the
expected yield on the same bond. A corporate bond may promise a yield of 10% but is there is a risk of
default associated with the bond its expected return could be 8%. This difference in promised and expected
return is referred to as default premium.
Chapter: 21
11. Discuss whether the following statement is true or false:
Two portfolios with matching cash flows are always immunized.
Answer: True
Generally, the portfolios with matching cash flows are immunized to interest rates sensitivities except for
two circumstances. First, if the cash-flows are matched using a callable bond and interest rates rise, there is
always a risk of the bonds being called upon. Second, if the surplus cash flow matching technique is used
there is a re-investment risk. If interest rates fall, the cash flows may not materialize to the extent required to
service the liabilities.
Chapter: 22
12. Discuss whether the following statement is true or false:
Buying a call option on a portfolio of common stocks is the same as buying a futures contract on the same
portfolio.
Answer: False
Payoff on a long call option position is different from that of a long position in a futures contract. Call
option gives a buyer the right but not an obligation to purchase a security at a pre-determined price. The
buyer pays a premium to purchase this right and exercises the option only if the spot prices rise above the
strike price. If the price for the underlying falls, the buyer can simply chose not to exercise the contract. The
maximum loss in this case is the premium amount paid. The payoff in case of futures contract is directly
proportional to the change in the underlying asset’s prices. If the spot price falls, futures price will also fall
simultaneously and the buyer of the futures contract will suffer losses to the extent of the fall. Upside
potential, however, in both the contracts remain same theoretically
Chapter: 23
Problems
1. You have just completed a study of small and large stocks and have obtained the following results:
small stocks large stocks
excess returns 5% 0%
transactions costs 10% 2%
Given the difference in transactions costs, how long would your investment horizon have to be for
small stocks to be a better investment than large stocks?
Answer:
Horizon at which returns on small stocks will at least equal returns on large stocks
8 Copyright © 2014 John Wiley & Sons, Inc.
Modern Portfolio Theory and Investment Analysis, 9th Edition Test Bank
10 2
= = 1.6 years
5
Therefore, any investment horizon greater than 1.6 years will generate greater returns on small stocks.
Chapter: 17
2. ABC Corp. has just paid an annual dividend of $0.50 per share. Dividends are expected to grow
at 15% for each of the next 8 years, at 10% for the 2 years after that, and at 3% thereafter. If the
appropriate discount rate is 10%, what is the intrinsic value of the stock?
Answer:
The timeline for the dividends looks like this (split to fit on the page):
0 1 2 3 4 5 6 7
| | | | | | | |
| | | | | | | |
0.5(1.15) 0.5(1.15)2 0.5(1.15)3 0.5(1.15)4 0.5(1.15)5 0.5(1.15)6 0.5(1.15)7
8 9 10 11 12
| | | | |
| | | | |
0.5(1.15)8 0.5(1.15)8(1.1) 0.5(1.15)8(1.1)2 0.5(1.15) (1.1)2(1.03)
8
0.5(1.15) (1.1)2(1.03)2...
8
Starting with D11, we have a stream of cashflows that continue forever and grow at a constant growth
rate. Hence, we can find the price (at t=10) of D11 and all subsequent dividends by using the growing
perpetuity formula.
P10 = D11/(k – g) = 0.5(1.15)8(1.1)2(1.03) / (0.1-0.03) = $27.2319
Note also that D1 through D8 are an eight-year annuity growing at a constant rate of 15%. Thus, we
can find the PV of D1 through D8 using the growing annuity formula.
P0 (D1 through D8) = = $4.91
The two formulas above found the PV(at t=0) of D1-D8 and the PV(at t=10) of D11 and onward.
Accounting for the PV of D9 and D10 and discounting the $27.2319 back to time 0, we arrive at a
stock price of:
Chapter: 18
3. You are trying to value Godzilla, Inc. You are provided with the following data for the company:
the current earnings per share is $2.50; the expected return on assets is 15%; the current dividend payout
Copyright © 2014 John Wiley & Sons, Inc. 9
Test Bank Modern Portfolio Theory and Investment Analysis, 9th
Edition
ratio is 40%, and this rate is expected to stay constant over the next five years, during which time the firm
expects high growth; the firm has a debt-equity ratio of 0.5; the firm pays an interest rate of 10% on its debt;
after the fifth year, the firm is expected to grow at a constant rate of 8%, and the return on assets will remain
unchanged at 15%; the firm's beta is 0.8; the riskless rate is 7%; the expected return on the market is 15%.
a. Value the firm.
b. Mr. Poone Bickens is attempting to take over Godzilla, Inc. He claims that the managers
are not managing the firm optimally. In particular, he feels that the firm should prune some
of its losing assets and should borrow more money, so that the return on assets will be 20%
and the debt-equity ratio will be 1.5. He agrees with the constant growth estimate for the
stable phase (after the fifth year and on). Assuming Mr. Bickens is right, how much
will he be willing to pay for the firm?
Answer:
a.
=$4.63
Value of the share for first 5 years
Payout ratio after 5 years =
Dividend in the 6th year = $2.42
Therefore,
b.
With the changes in estimates, the new g1 would be 21% which is calculated as [(1−40%) × (20%+1.5 ×
(20% − 10%)]
Dividend in the 6th year; = $3.80
10 Copyright © 2014 John Wiley & Sons, Inc.
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Terminal value of the stock can be calculated using
Value of the stock = $6.099 + $53.35 = $59.44
Chapter: 18
4. Silicon Valley Electronics (SVE) is expected to pay out 40% of its earnings and to earn an average
return of 15% per year forever on its reinvested earnings. Stocks with similar characteristics are priced to
return 12% to investors. By what percentage can SVE's earnings per share be expected to grow each year?
What is the appropriate P/E ratio for the stock? What portion of SVE's total yield is likely to come from
capital gains? What portion will come from dividend yield?
Answer:
g=b×r
g = 9%
To calculate the P/E ratio of Silicon Valley, we will relate the P/E ratio to DVM and arrive at an equation
for the price earnings ratio in terms of dividend payout, required rate of return, and growth:
To calculate the capital and the dividend yield, consider the DVM formula
Or,
This means that the required rate of return is an addition of dividend yield (D1/P0) and the growth rate
(capital yield)
Hence, the yield from capital gains of SVE is 9%.
The dividend yield will be 3% (r – g).
Chapter: 18
5. You have been hired as an analyst by a noted security analysis firm and asked to value two stocks.
You have been given the following data on the two firms:
firm 1 firm 2
required return 20% 12%
dividend payout ratio 20% 60%
current EPS $1 $1
return on investment 25% 15%
stage of growth high stable
Copyright © 2014 John Wiley & Sons, Inc. 11
Test Bank Modern Portfolio Theory and Investment Analysis, 9th
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You estimate that firm 1 will become a stable firm after five years have passed, after which it will have a
constant growth rate of 6%, and that firm 1's return on investment will remain unchanged. Value each firm.
Answer:
Firm 1
Growth rate for the first 5 years = b × r = 20%
Expected dividend = $0.24
Value for the first 5 years =
Value of stock = $6.75
Firm 2
Growth rate = b × r = 6%
Chapter: 18
6. On January 1, 1991, you are considering buying stock in Genetic Biology Systems (GBS), which
has just announced a new type of corn that will provide nitrogen to the soil and thus eliminate the need for
additional fertilizer. GBS had an EPS of $1.20 in 1990. The firm's expected annual growth rate is 50% for
1991 and 1992, 25% for the following two years, and 10% thereafter. Its dividend payout ratio is expected
to be zero in 1990 and 1991, to rise to 20% for the following two years, and then to stabilize at 50%
thereafter. The risk-free rate is 15%, and GBS has a beta of 1.2. The market rate of return is 16%.
a. What is the value of GBS stock?
b. Now assume that you are in the 40% tax bracket but that capital gains are taxed at 16%.
Assume that you can buy GBS stock for $22.26. You can also buy the stock of ISD, Inc.,
which is of equal risk to GBS and sells for $42.86. ISD has just paid a dividend of $6, and
has an expected constant growth rate of 2%. If you plan to hold either investment for four
years and then sell it, which stock is a better investment for you?
Answer:
a.
Cost of equity =
Following table shows the expected dividends in the next five years –
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Modern Portfolio Theory and Investment Analysis, 9th Edition Test Bank
Year 1990 1991 1992 1993 1994 1995+
Growth rate 50% 50% 25% 25% 10%
EPS 1.2 1.8 2.7 3.4 4.2 4.6
P/O ratio 0 0 0.2 0.2 0.5 0.5
DPS 0.00 0.00 0.54 0.68 2.11 2.32
Value for the first four years = present value of the dividends for the first four years discounted at the
cost of equity; $1.988
= $20.52
Value of the stock = $1.988 + $20.52 = $22.52
b.
Marginal tax rate = 40%
Capital gains tax rate = 16%
Investment in GBS stock –
The following table shows the present value of post tax dividends for
the investor –
Year 1990 1991 1992 1993 1994
Growth rate 0.50 0.50 0.25 0.25
DPS 0.00 0.54 0.68 2.11
Post tax dividend 0.00 0.32 0.41 1.27
PV of dividends 0.00 0.24 0.26 0.69
Total present value of post tax dividend income = $1.19
Expected stock price at the end of year 4 = = = $37.42
Post tax capital gains = = $12.74
Present value of capital gains = = $6.99
Return on Investment for the investor = = 36.74%
Investment in ISD stock –
Copyright © 2014 John Wiley & Sons, Inc. 13
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Current stock price = $42.86
Constant growth rate = 2%
The following table shows the present value of post tax dividends for
the investor –
Year 1990 1991 1992 1993 1994 1995+
DPS 6.00 6.12 6.24 6.37 6.49 6.62
Post tax dividend 0.00 3.67 3.75 3.82 3.90
Total present value of post tax dividend income = $15.13
Expected stock price at the end of 4 year = = $46.65
Post tax capital gains = = $3.18
Present value of capital gains = = $1.75
Return on Investment for the investor = = 39.39%
ISD stock is a better investment opportunity since its ROI is higher.
Chapter: 18
7. Firm A has a stock price of $10 per share, an expected dividend for next year of $1 per share, an
expected constant growth rate of 8% per year, and a beta of 0.8 on its stock. Firm B has a stock price
of $50 per share, an expected dividend for next year of $5.50 per share, a retention rate of 40%, a historical
rate of return on investment of 20%, and a beta of 1.3 on its stock. If the riskless rate is 10% and the
expected return on the market portfolio is 18%, is either of these stocks underpriced or overpriced? What is
your buy/sell recommendation for each stock?
Answer:
FIRM A
k = 10% + 0.8(18%-10%) = 16.40%
Therefore, the stock of Firm A is underpriced.
FIRM B
14 Copyright © 2014 John Wiley & Sons, Inc.
Modern Portfolio Theory and Investment Analysis, 9th Edition Test Bank
Therefore, the stock of Firm B is overpriced.
Chapter: 18
8. You have been given the following historical data on XYZ Corporation:
year XYZ return market return
1986 20% 30%
1987 -15% -10%
1988 25% 10%
1989 -20% -10%
1990 40% 20%
a. Estimate the beta for XYZ.
b. The price of XYZ stock was $50 a year ago, and today it is $55. The dividends paid by
XYZ over the last twelve months amount to $3. The T-bill rate a year ago was 6%, and the
NYSE index has risen 10% over the past year. Assume that the average dividend yield on
all stocks is 3% and evaluate the performance of XYZ stock over the past year.
c. If the T-bill rate today is 5.5%, what would you project the price of XYZ stock to be a year
from today? (Assume that XYZ will continue to pay an annual dividend of $1.)
Answer:
a.
Covariance = 0.032
Variance (σ2m) = 0.0256
Beta = 0.032 ÷ 0.0256 = 1.25
b.
The required rate of return (k) of XYZ’s stock is 11% (6% + 1.25 (10% − 6%)) and the actual return on
stock of XYZ is 16% (($55 − $50 + $3) ÷ $50). The stock has outperformed the market and delivered
returns in excess of expected returns as per CAPM pricing model.
c.
Expected return on the stock = = 5.5+ (10-5.5)×1.25 = 11.125%
Expected annual dividend = $1
Expected stock price should yield 11.125%
Therefore, Expected price = ((11.125%×55)-1) +55 =$ 60.12
Chapter: 18
9. You are a financial analyst for General Motors and have been asked to evaluate the effect on risk of
taking over RandomTech, an electronics firm. You have collected the following data for both firms:
GM RandomTech
share price $60 $20
number of shares 13.25 million 10 million
beta 1.0 2.0
standard deviation 20% 80%
Copyright © 2014 John Wiley & Sons, Inc. 15
Test Bank Modern Portfolio Theory and Investment Analysis, 9th
Edition
You estimate the correlation of returns between GM and RandomTech to be 0.3.
a. How will taking over RandomTech affect GM's beta?
b. What will the variance of the combined firm be if the takeover is carried through?
Answer:
a.
Market value of GM = $60 × 13.25 million = $795 million
Market value of RandomTech = $20 × 10 million = $200 million
b.
Chapter: 18
10. You are a research analyst for a major investment bank and have been asked to evaluate three
candidates for a takeover and recommend one. You estimate the risk-free rate to be 5% and the market risk
premium to be 8%. You also have the following data:
MTT Corp. NOR Corp. TECH Corp.
current price $20 $25 $200
number shares 100,000 80,000 10,000
current EPS $4 $2.50 $5
payout ratio 50% 20% 10%
(first 5 yrs)
beta 1.0 1.25 1.5
growth rate:
first 5 yrs. 5% 20% 50%
beyond 5 yrs. 5% 10% 10%
D/E ratio 0 0 0
ROA:
first 5 yrs. 10% 25% 55.56%
beyond 5 yrs. 10% 20% 25%
Which firm is the best candidate for a takeover?
Answer:
MIT Corp.
Expected dividend = $4×1.05×0.5 = $2.1
Expected Return = = 13%
Since the firm is in stable growth phase,
Stock value can be computed using the formula
Intrinsic value = $26.25
NOR Corp.
Expected return =
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Modern Portfolio Theory and Investment Analysis, 9th Edition Test Bank
For first stage-
Expected dividend = $2.5×1.2×0.2 = $0.6
Value for the first five years = = $2.84
For second stage –
Payout ratio = 1-(g/b) = 1-(0.1/0.20) = 0.5
Terminal value - = $34.02
Intrinsic value = $2.84+$34.02 = $36.87
TECH Corp.
Expected return = R f Rm R f = 5+(8)×1.5 = 17%
For first stage-
Expected dividend = $5×1.5×0.1 = $0.75
Value for the first five years = = $5.59
For second stage –
New payout ratio = g/b = 1-(0.1/0.25) = 0.6
Terminal Value = = $163.28
Intrinsic value = $5.59+$163.28 = $168.83
Undervaluation/Overvaluation
MIT Corp. = ($20/$26.25)-1 = −23.81%
Nor Corp. = ($25/$36.87)-1 = −32.2%
Tech Corp. = ($200/$168.82)-1 = 18.43%
Since Nor Corp is the most undervalued stock, it is the best buy.
Chapter: 18
11. You have been asked to evaluate the performance of a firm over the last year and to make some
predictions for performance over the next year. The following data are provided to you:
one year ago today
6-month T-bill rate 5% 6%
firm's estimated beta 1.25 1.5
NYSE index level 130 137.8
firm's stock price 50 52.50
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firm's exp. dividend yield 4% 4%
market's exp. divided yield 3% 3%
a. Evaluate the firm's performance over the last year. (Estimate the excess returns, either
positive or negative, made by this firm.)
b. What would you expect the stock price to be one year from today?
c. You estimate that the standard deviation of this stock next year will be 50% and the
standard deviation of the market will be 20%. What proportion of the firm's total risk is
non-diversifiable?
Answer:
a.
For the firm –
Price appreciation = ($52.5−$50) = $2.5
Dividends = 4%×$50 = $2
Total return = ((2.5+2) ÷ 50) = 9%
For the market –
Price appreciation = 137.8−130 = 7.8
Dividends = 3%×130 = $3.9
Total return = (7.8+3.9) ÷ 130 = 9%
Thus, the firm’s returns are equivalent to market returns.
b.
Market return = (137.8/130)-1 = 6%
Expected return on the stock =
Expected dividend = 4%×52.5 = $2.1
Expected stock price = ($52.5×1.105) − $2.1 = $55.92
c.
Total variance for the firm = =
Systematic risk = = = 9%
Therefore,
Unsystematic risk = Total risk − Systematic risk = 25% − 9% = 16%
Chapter: 18
12. Last year, ABC Corp. earned $10 per share and its retention rate was 40%. You require a 12% rate
of return on the stock and believe that ABC can realize a rate of return of 15% on its retained earnings.
a. If ABC has just paid its annual dividend, and you are planning to buy and hold forever,
what is a share of ABC worth to you now?
b. Assuming that your expectations and the market's expectations are the same, and that these
expectations are met over the next thirty years, what will the market price of a share of
ABC stock be at the end of thirty years from now?
Answer:
a.
The growth rate of ABC is 6% (40% × 15%)
D1 = $6.36
18 Copyright © 2014 John Wiley & Sons, Inc.
Modern Portfolio Theory and Investment Analysis, 9th Edition Test Bank
P0 = $106
b.
The market price of ABC’s share, with a constant growth of 6%, at the end of thirty years would be $608.81
($106 × (1+.06)30)
Chapter: 18
13. You are trying to value a stable firm that has the following characteristics: current EPS = $5.00;
dividend payout ratio = 60%; ROA = 16%; debt/equity ratio = 0.8; interest rate on debt = 11%; required rate
of return = 15%; number of shares outstanding = 100,000. What is your best estimate of the firm's value?
Answer:
Growth rate (g) = 8%
Required rate of return = 15%
D1 = $3.24
Using the formula,
Value of Firm = $46.28 × 100,000 shares = $4,628,571
Chapter: 18
14. You are an analyst looking at the risk-return characteristics of XYZ Corporation. You decide to use
the CAPM as your model for estimating risk. Using a regression of stock returns on market returns, you
come up with the following regression equation: Rjt = 0.02 + 1.2 Rmt.
a. If the current riskless rate is 7% and the stock is currently selling for $50, what is your best
estimate of the stock price a year from today? (Assume that the expected dividend per share
next year is $2 and the market of return is 15%.)
b. The stock was selling for $54 a year ago. You have been asked to judge the performance of
the stock over the last year. (Assume that the NYSE index declined from 150 to 145.5 over
the same period, that the T-bill rate was 7% a year ago, and that the dividend per share last
year was also $2.)
c. XYZ Corp. is considering the acquisition of ABC Co. for $25 million. You have estimated
the beta for ABC Co. to be 2.0, and the correlation between XYZ and ABC stock returns to
be 0.4. If XYZ goes through with the acquisition, what will its beta be afterwards? (There
are one million shares of outstanding XYZ stock.)
Answer:
a.
Given the regression equation, the expected return on the stock will be R jt 0.02 1.2 Rmt
R jt =0.02+1.2(0.15) = 20%
Therefore, expected stock price = =$58
b.
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Test Bank Modern Portfolio Theory and Investment Analysis, 9th
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Return on the market = = −3%
Return on XYZ stock = = −3.7%
XYZ stock has underperformed the market in the last one year.
c.
Beta for the new company will be the weighted average of the acquirer and the target company.
Market capitalization of XYZ = = $50m
Value of ABC = $25m
= 1.467
Chapter: 18
15. You have been given the following information on AD Corporation, and you expect this
information to hold for the next five years: ROA = 20%; debt/equity ratio = 0.5; interest rate on debt = 10%;
dividend payout ratio = 20%. After five years have passed, you expect AD's growth rate to be 10%. The
annualized six-month T-bill rate is 7%, current EPS is $4.00, and the stock's beta is 1.25. Assume a market
rate of return of 15%.
a. Using the dividend-discount model, estimate the intrinsic value of the stock.
b. The company's CFO is considering increasing his payout ratio to 40% for the first five
years. Advise him by estimating the value of the stock with the new payout ratio.
c. The CFO is also considering increasing the debt/equity ratio to one. Estimate the value
of the stock with the new ratio.
Answer:
a. g1 = (1-Payout) (ROA+ D/E (ROA-i)) = 20%
d1 = ($4 × 20%) × (1+20%) = 0.96
ke =
Expected dividend = =$0.96
Value for the first 5 years =
After 5 years –
Payout ratio changes to = 60%
Dividend in the 6th year - = $6.57
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Terminal value -
= $42.80
Value of the stock of AD Corp. = $4.32 + $42.80
= $47.12
b.
If the Payout ratio in the first five years changes to 40%
Growth rate for the first five years = = 15%
Expected dividend = =$1.84
Value for the first 5 years =
After 5 years –
Dividend in the 6th year - = $5.30
Terminal value -
= $34.59
Value of the stock of AD Corp. = $7.59 + $34.59
=$42.19
c.
If the Debt-Equity ratio is increased to 1-
ROE =
Growth rate for the first five years = = 24%
Expected dividend = =$0.992
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Test Bank Modern Portfolio Theory and Investment Analysis, 9th
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Value for the first 5 years - = $4.78
After 5 years –
Payout ratio changes to
Dividend in the 6th year - = $8.59
Terminal value -
Value of the stock of AD Corp. = $4.78 + $56.03 = $60.81
Chapter: 18
16. Assume that you have been asked to evaluate the P/E ratios of five prospective acquisition
candidates. You have the following information:
company P/E ratio beta growth rate payout ratio
A 10 1.0 5% 0.9
B 8 1.25 8% 0.8
C 9 1.25 10% 0.6
D 6 1.5 11% 0.4
E 5 2.0 12% 0.45
a. If the riskless rate is 7% and the above statistics will hold through infinity, which of the
companies are overvalued and which are undervalued?
b. Now assume that you are using a regression methodology to estimate the relationship
between P/E ratios and these variables. Using a cross-sectional sample, you obtain the
following equation: P/E = 2 + 0.3 x growth rate + 5 x payout ratio - 1 x beta. Using this
equation, which of the companies are overvalued and which are undervalued?
Answer:
a.
Cost of equity can be calculated for each stock using -
P/E ratio based on fundamentals can be calculated using -
Company P/E ratio Cost of equity P/E based on fundamentals Valuation
A 10 15% 9.00 overvalued
B 8 17% 8.89 undervalued
C 9 17% 8.57 overvalued
D 6 19% 5.00 overvalued
E 5 23% 4.09 overvalued
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b.
Using the regression equation for P/E of each stock - P/E = 2 + (0.3 x Growth rate) + (5 x Payout
ratio) - (1 x beta)
Given P/E P/E based on
Company ratio fundamentals Valuation
A 10 7 overvalued
B 8 7.15 overvalued
C 9 6.75 overvalued
D 6 5.8 overvalued
E 5 5.85 overvalued
Chapter: 18
17. UV Company has just been formed with $100 million in equity capital to invest in five projects, all
with infinite lives, with the following characteristics:
project return on equity investment needs
A 14% $20 million
B 17% $15 million
C 11% $25 million
D 19% $20 million
E 10% $20 million
If all five projects have a beta of 1 and the riskless rate is 7%, what is the estimated price-to-book-value
ratio of this firm assuming that all five projects are taken? (Assume market rate of return of 15% and the
growth rate for the company is 20%)
Answer:
Cost of capital for the company = 7 15 7 1 = 15%
ROE g
Price-to-book value for each project can be calculated as
kg
Project P/BV
A 1.2
B 0.6
C 1.8
D 0.2
E 2
Therefore, the price-to-book value for the company will be the weighted average of the price-to-book value
for each project, the weights being investment in each project.
20 20 20 20 20 = 1.22
P / BV0 1.2 0.6 1.8 0.2 2
100 100 100 100 100
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Test Bank Modern Portfolio Theory and Investment Analysis, 9th
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Chapter: 18
18. You are responsible for valuing QXR Corporation, given the following data: current EPS = $4.00;
current payout ratio = 40%, ROA = 20%; beta = 1.2; debt/equity ratio = 0.75; interest rate on debt = 12%;
annualized 6-month T-bill rate = 8%; number of shares outstanding = 100,000. You expect the firm to grow
at 8% after the first five years, with the ROA declining to 15%. You also know that QXR has substantial
real estate holdings that are currently unutilized and can be sold for $1,000,000. What is your estimate of
QXR's intrinsic value? Assume a market rate of return of 15%.
Answer:
Cost of equity = = 16.4%
ROE for first 5 years = = 26%
Growth rate for first 5 years = = 15.60%
= = $1.85
Value for the first five years =
After 5 years –
g
Payout ratio = 1 = 0.536
r
D6 =
Terminal value = ;
Value of the stock = $7.84 + $24.64 = $34.48
Intrinsic value of the firm = Market value of stock + Real estate value
=
= $4,448,000
Chapter: 18
19. You are attempting to value MNC Inc., a conglomerate firm with three divisions. Each division is in
a different industry, and you are provided with the following information:
24 Copyright © 2014 John Wiley & Sons, Inc.
Modern Portfolio Theory and Investment Analysis, 9th Edition Test Bank
MNC data industry averages
division earnings payout ratio beta P/E ratio
A $2.0 million 0.40 1.25 8
B $5.0 million 0.25 1.50 10
C $4.0 million 0.75 1.00 6
The corporate tax rate is 40% and all the industries are in their stable growth phases. MNC Inc. pays out
50% of its earnings as dividends and has no debt. The current annualized 6-month T-bill rate is 8%. What is
your best estimate of earnings growth for MNC? Assume a market rate of return of 15%.
Answer:
Based on the industry data, cost of equity for each division in the company can be calculated using CAPM
R f Rm R f
.
P0 1 b
The ROE for each division can be calculated using the price-to-earnings relationship E k br
1
Division Cost of equity ROE
A 16.75% 19.58%
B 18.50% 21.33%
C 15.00% 10.00%
ROE of the firm is the weighted average of ROE’s for different divisions of the firm, with earnings being
the weights.
ROE of the firm = = 16.89%
Given the retention ratio of 0.5
The growth rate of the firm can be calculated using = 0.5 × 16.89% = 8.45%
Chapter: 18
20. You are considering investing your money with Value Max, a professional money management
firm. Value Max's portfolio maintains constant percentages in computer stocks (40%), bio-technology
stocks (20%), and health service stocks (40%). Value Max has sent you the following information on past
performance and investment details: Value Max returns = 40% per annum over the last 5 years; returns on
NYSE index = 20% per annum over last 5 years; average annualized 6-month T-bill rate = 7% over last 5
years. Your research indicates that the average betas for the three sectors Value Max invests in are 1.2 for
computer stocks, 1.5 for bio-technology stocks, and 0.8 for health service stocks.
a. What is the appropriate beta to use to evaluate Value Max's portfolio?
b. Evaluate Value Max's performance over the last five years.
Answer:
a.
Copyright © 2014 John Wiley & Sons, Inc. 25
Test Bank Modern Portfolio Theory and Investment Analysis, 9th
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b.
Using the beta of portfolio, we will calculate the required rate of return as:
The average return of the Value max portfolio (40%) exceeds its expected rate of return.
Chapter: 18
21. The government has just issued two bonds. The first bond pays $1,000 at the end of year 1 and is
now selling for $909.29. The second bond pays $100 at the end of year 1 and $1,100 at the end of year 2 and
is now selling for $976.15.
a. What are the spot and forward rates for 1-year and 2-year bonds?
b. Using the spot rates determined in part a, what is the duration of each of these bonds?
c. If a new bond is offered that pays $60 at the end of year 1 and $60 at the end of year 2,
what must it sell for now?
Answer:
a.
Spot Rate:
First bond
Second Bond
Forward Rate:
Forward rates for one year after one year ( f (1,2) )
f (1,2) = = 12.9747%
b.
As the first bond is a pure discount bond its duration (D) will be equal to its maturity that is 1 year.
For the second Bond the duration would be calculated as:
years
c.
Value of the bond = = $102.91
Chapter: 21
26 Copyright © 2014 John Wiley & Sons, Inc.
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22. Bond A pays $10 at the end of year 1 and $110 at the end of year 2, bond B pays $5 at the end of
year 1 and $105 at the end of year 2, and bond C pays $20 at the end of year 1 and $120 at the end of year 2.
If bond A is selling for $100, bond B for $95, and bond C for $105, does the law of one price hold? If not,
describe the arbitrage that would restore the law of one price.
Answer:
The yield to maturity for each bond can be calculated as solving for I in the following equations –
10 110
Bond A = 100 2 ; i = 10%
1 i 1 i
5 105
Bond B = 95 2 ; i = 8%
1 i 1 i
20 120
Bond C = 105 2 ; i = 17%
1 i 1 i
The law of one price states that two identical items should sell at the same price. In the above scenario,
Bond C is trading relatively cheap to both bonds A and B. The investors can short-sell a portfolio of Bonds
A & B and buy Bond C. This process will continue in the market until the yields on all three bonds are in
equilibrium.
Chapter: 21
23. Consider the following data for bonds A, B, and C:
price cash flows
t=0 t=1 t=2 t=3
A $900 $1,000 0 0
B $1,000 $100 $1,100 0
C $900 $50 $50 $1,050
a. Calculate the forward and spot rates for each period.
b. What is the value of the discount function for the first period?
c. What is the yield to maturity for bond C assuming annual payment periods?
Answer:
a.
1000 1/2
S
One year spot rates ( 02 ) = 1 * 2 = 10.8185%
900
Two year spot rates ( S04 ) –
1/4
100 1110
1000 = 1 * 2 ; S04 =9.7094%
2
4
1 S02 1 S04
2 2
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Test Bank Modern Portfolio Theory and Investment Analysis, 9th
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Three year spot rate - S06 -
50 50 1050
900 =
4 + 6
; S06 = 8.6843%
S02 S04 S
2
1
1 1
06
2 2 2
4 1/2
S
1 04
2
f (1,2) = 1 * 2 ; f (1,2) = 8.60%
2
1 S02
2
6 1/4
1 S
06
2
f (1,3) = 1 * 2 ; f (1,3) = 7.625%
S 2
1 02
2
6 1/2
1 S
06
2
f (2,3) = 1 * 2 ; f (2,3) = 6.65%
S 4
1 04
2
b.
S02 2
Value of discount function = 1 =1.11
2
c.
50 50 1050
900 =
1 i 1 i 1 i 3 = YTM = 9%
2
Chapter: 21
24. Consider the following data for bonds A and B:
price annual cash flows
t=0 t=1 t=2 t=3
A $990 $100 $1,100 0
B $900 $50 $50 $1,050
a. Assuming a flat yield curve of 10%, the expectations theory of the term structure, and semi-
annual compounding, which bond is a superior investment?
b. If you kept everything the same in part a, except for replacing the assumption of the
28 Copyright © 2014 John Wiley & Sons, Inc.
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expectations theory with the assumption of a liquidity premium theory, would your answer
to part a be affected and, if so, how?
Answer:
a.
Given a flat yield curve of 10% and expectations theory holds,
100 1100
Price of Bond A = 2 = $1000
1.1 1.1
50 50 1050
Price of Bond B = 2 3 = $875.65
1.1 1.1 1.1
Bond A is trading below its fair value while Bond B is trading is priced rich. Therefore, Bond A is a
superior investment.
b.
Liquidity premium theory states that yields on longer term securities should be higher than short term
securities.
One year spot rate = 10%
Two-year and Three-year spot rates can be calculated using Boot-strapping.
1/2
1100
Two-year spot rate= 1 = 10.61%
100
990 1.1
1/3
1050
Three-year spot rate= 1 = 8.871%
50 50
900 1.1 1.10612
Assuming a liquidity premium of –
20 basis points for two-year spot rates and 40 basis points for 3 year spot rates –
New two-year spot rates = 10.61% + 0.2% = 10.81%
New three-year spot rates = 8.871% + 0.4% = 9.271%
100 1100
Price of Bond A = 2 = $986.76
1.1 1.1081
50 50 1050
Price of Bond B = 2
3 = $890.95
1.1 1.1081 1.09271
If there is a premium of 20 basis points on two-year spot rates and 40 basis points for three-year spot
rates, and the liquidity premium hypothesis holds, both the bonds are trading cheap.
Chapter: 21
25. Assume that the annual interest rate on 2-period loans is 10% and the annual interest rate on 3-
period loans is 12%.
a. What is the forward rate on loans made in period 2 and repaid in period 3?
b. What is the present value of a security with a cash flow of $300 at the end of period 1 and a
cash flow of $400 at the end of period 3?
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Test Bank Modern Portfolio Theory and Investment Analysis, 9th
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c. What is the future value (at the end of period 3) of the security in part b?
Answer:
Six month spot rates for period 1 - 1.1 1 = 4.881%
1/2
Six month spot rates for period 2 - 1.1 1 = 4.881%
1/2
Six month spot rates for period 3 - 1.12 1 = 5.8301%
1/2
a.
Forward rate on loans made in period 2 and repaid in period 3
1.058313
2
1 ; 7.754%
1.04881
b.
300 400
Present value of the security;
1.04881 1.0583013 = $685.96
c.
1.058313
Forward rate for deposits made at the end of period 1 till the end of period 3 – 1 =13.014%
1.04881
Future value of the security = 300 1.13014 400 = $739.04
Chapter: 21
26. Consider the following interest rates: r01 = 10%, r12 = 11%, r03 = 12%, r34 = 13%, and r05 = 14%,
where r0t is the annual spot rate for period t and rt t+1 is the annual forward rate from period t to t + 1. What is
the price of a $1,000 par bond with 5 years to maturity that has an annual coupon rate of 10% and annual
coupon payments?
Answer:
Solving for S02,
Similarly,
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Chapter: 21
27. Consider the following two bonds: a discount bond paying 100 in one year, selling at 93; a coupon
bond paying 10 in one year, 110 in two years, selling at 95.
a. What is the one-year spot rate? What is the forward rate for the second year?
b. Suppose there is a liquidity premium of 50 basis points on two-year lending. What is the
market's expectation of what the one-year spot rate will be in the second year? What does
the market expect the second bond's price to be at the beginning of the second year?
c. Suppose you are in the 40% effective marginal tax bracket. What is the total amount you
expect to have after taxes at the end of year 2 if you buy the second bond? (Don't forget to
reinvest the first-year coupon.)
d. Suppose you buy the second bond and then the market's expectation of the spot rate in the
second year changes to 10%. What would be the immediate price change on the bond? If
you sold the bond right away, what would be your after-tax profit or loss?
Answer:
a.
b.
c.
After-tax cash flows-
Coupons = $10
Maturity value = [100 – (5× 40%)] = $98
Total Cash flow from second bond = 6(1+19.37%) + 6 + 98 = $111.16
d.
If the expected rate is 10% for the second period,
New price of the bond =
If the bond is sold immediately; post tax gain on the transaction = (100.20 − 95)×(1-0.4) = $3.125
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Test Bank Modern Portfolio Theory and Investment Analysis, 9th
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Chapter: 21
28. Consider the following securities: a fully taxable coupon bond paying 12 in one year, 112 in two
years, selling at 103; a fully taxable coupon bond paying 5 in one year, 105 in two years, selling at 92; a
municipal bond paying 8 in one year, 108 in two years, selling at 98; a bank account paying 10%.
a. Which of the above securities is most attractive to an investor in the 40% effective tax
bracket? (Ignore capital gains tax)
b. Which one is most attractive to a tax-exempt investor?
Answer:
a.
Cash flows for the investor can be tabulated as -
Pre tax returns Post tax return
Price Year 1 Year 2 Year 1 Year 2
Bond A (taxable) 103 12 112 7.2 107.2
Bond B (taxable) 92 5 105 3 103
Municipal bond 98 8 108 8 108
Bank account 100 10 110 6 106
Yield on the four securities can be calculated using –
CF1 CF2
P0
1 i 1 i
1 2
YTM for bond A = 5.58%
YTM for bond B = 7.45%
YTM for Municipal bond = 9.14%
Yield on Bank savings = 6%
Therefore, an investor who is falling in the tax bracket of 40% should invest in the municipal bonds.
b.
Cash flows for the tax exempt investor are -
Price Year 1 Year 2
Bond A 103 12 112
Bond B 92 5 105
Municipal bond 98 8 108
Bank account 100 10 110
Yield on the four securities can be calculated using –
CF1 CF2
P0
1 i 1 i
1 2
YTM for bond A = 10.265%
YTM for bond B = 9.584%
YTM for Municipal bond = 9.14%
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Yield on Bank savings = 10%
The investor should invest in Bond A.
Chapter: 21
29. At the end of years 1 through10, an investor deposits $450 per year in a bank account paying 9%
per year. At the end of years 11 through 20, she withdraws $450 per year. At the end of years 21 through 30,
she deposits $450 per year. What is the account balance at the end of year 30?
Answer:
Annuity amount = $450
Interest rate = 9%
For years 0 to10 the value of deposits would be calculated as:
1 i n 1
$450 = $6,836.82
i
Value at the end of 30 years = = $38,316.34
For years 10 to 20 the value of withdrawals would be calculated as:
−$450 = −$6,836.82
Value at the end of 30 years = = −$16185.2
For years 20 to 30 the value of the deposits would be calculated as
$450 = $6,836.82
Value of the portfolio at the end of 30 years = $6,836.82 + −$16,185.2 + $6,836.82
= $28,967.92
Chapter: 22
30. You have the opportunity to invest at the following rates. Rank them from best to worst.
a. 10% compounded continuously
b. 10.3% compounded monthly
c. 10.7% simple interest (compounded annually)
Answer:
10% compounded continuously –
Effective annual yield: e0.1 1 = 10.517 %
10.3% compounded monthly –
Effective annual yield: = 10.8 %
10.7% simple interest (compounded annually) – will yield 10.7% effectively.
Rate structure Effective annual yield Rank
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10% compounded continuously 10.52% 3
10.3% compounded monthly 10.80% 1
10.7% simple interest (compounded
annually) 10.70% 2
Chapter: 21
31. An annual-coupon corporate bond has a 20-year maturity, an 11.5% coupon rate, and a par value of
$1,000. The yield to maturity on the bond is 11%. An investor plans to buy the bond today and hold it to
maturity, reinvesting the coupon payments at a 9% reinvestment rate.
a. What is the purchase price of the bond?
b. How much will the investor have at maturity?
Answer:
a.
Price of the bond is the present value of the cash flows from a bond.
It can be calculated using
= $1039.82
b.
If the coupon is reinvested at 9%, at the end of 20 years it grows to
= $5,768.414
At the end of 20 years, the investor will have $1115 + $5,768.414 = $6,883.41
Chapter: 21
32. Consider the following spot rates: i01 = 6%, i02 = 7%, i03 = 7.5%, i04 = 8%, i05 = 9%.
a. Based on the pure expectations theory, what does the market expect the one-year spot rate
to be at the end of year 3?
b. Based on the liquidity premium hypothesis, would you expect the actual one-year spot rate
at the end of year 3 to be below the number you computed in part a? Why or why not?
c. Based on the pure expectations hypothesis, what does the market expect the two-year
(annualized) spot rate to be at the end of year 3?
d. Can we say whether the yield to maturity on a four-year coupon bond will be above or
below 8%? Explain.
Answer:
a.
As per pure expectations theory one year spot rates after 3 years –
8 1/2
8
1/2
S
1 08
1 0.08
2 2
f3,4 1 * 2 ; 1 * 2 = 9.50724%
6
6
1 S06 1 0.075
2 2
b.
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The forward rate under liquidity premium theory would be higher because the liquidity premium theory says
that the one period forward rate equals the estimate of the one- period future spot rate plus a liquidity
premium for the same period.
c.
As per pure expectations theory – two year annualized spot rates after 3 years –
10 1/4
10 1/4
1 S
1 0.09
10
2 2
f3,5 1 * 2 ; 1 * 2 = 11.27%
S 6 6
1 06 1 0.075
2 2
d.
The yield curve in this example is upward sloping. The maximum rate at which the cash-flows would be
discounted for a 4 year coupon bond is 8 percent (terminal value), However the coupons are discounted at
rates below 8 percent. This would mean that the YTM of the bond is below the 4th year spot rate of 8
percent.
Chapter: 21
33. It is now time 0. You are a bond portfolio manager using a barbell strategy to immunize. Your
portfolio will consist of two bonds: bond A, which is a $100 par zero coupon bond maturing in five years;
bond B, which is a $100 par zero-coupon bond maturing in ten years. You are trying to immunize a $1
million liability that is due in six years. The yield curve is flat at 10%, so you need a present value of $1
million/(1.10)6 = $564,474.
a. Of the $564,474, how much will you put in bond A and how much will you put in bond B?
How many of the A and B bonds will you buy?
b. One minute after you set up the portfolio, the yield curve shifts up to 15% (staying flat).
How much is your portfolio worth?
c. After the shift in part b, is your liability immunized? If not, what should you do to
immunize it? Be specific, and give numbers if you can.
d. Now assume that the shift in part b never happened. You leave the firm and nobody bothers
to look at the portfolio again until the end of year 4. Interest rates are still at 10%; there
have been no further changes. At the end of year 4, a new bond portfolio manager takes
over, goes through the files, and finds the records of the portfolio. What, if anything, will
she have to do to keep the liability immunized? Be specific, and give numbers if you can.
Answer:
a.
Barbell strategy matches the duration of assets to duration of liabilities to immunize a portfolio.
Duration of liabilities = 6 years.
The portfolio constructed using Bond A and Bond B in such a manner so as to have duration of 6 years.
If x is the proportion of bond A in the portfolio then years
Solving for x , we get the proportion of Bond A in the portfolio as 0.8.
Therefore, proportion of Bond B in the portfolio = (1− 0.8) = 0.2
Copyright © 2014 John Wiley & Sons, Inc. 35
Test Bank Modern Portfolio Theory and Investment Analysis, 9th
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Price of Bond A = = $62.09
Price of Bond B = = $38.55
Investment in Bond A = = $451,479.2
Investment in Bond A = = $112,894.8
Number of Bond A required to be purchased = = 7272.72 7273 bonds
Number of Bond B required to be purchased = = 2928.2 2928 bonds
b.
Price of Bond A after the shift = = $49.72
Price of Bond B after the shift = = $24.72
Value of the portfolio = = $433,964
c.
After the shift in the yield curve, the duration of assets and liabilities change, and hence the
portfolio is not immunized. To immunize the portfolio, a certain number of bonds A and B should be
swapped in order to match the duration of assets the duration of liabilities.
After the shift in yield curve:
Proportion of Bond A in the portfolio = = 0.833
Proportion of Bond B in the portfolio = = 0.167
Therefore duration of the portfolio becomes = 5.84 years
As computed in part(a), the duration of the portfolio should be 6 years.
New proportion required; Bond A = 0.8 and Bond B = 0.2
Present value of liability = = $432,327.6
Investment required in Bond A = = $345,862.1
Investment required in Bond B = = $86,465.52
Number of Bonds A required = = 6956.52 6957 bonds
Number of Bonds B required = = 3498.01 3498 bonds
Number of Bonds A to be sold = 7273−6957 = 316
Number of Bonds B to be bought = 3498−2928 = 570
36 Copyright © 2014 John Wiley & Sons, Inc.
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d.
After four years –
Price of Bond A = = $90.90
Price of Bond B = = $56.45
Value of investment in Bond A = = $661,157.10
Value of investment in Bond A = = $165,289.28
Value of the portfolio = = $826,446.38
Duration of the portfolio = = 2 years
Duration of liabilities = (6-4) = 2 years.
Since the duration of assets matched the duration of liabilities, the investor is immunized from price risk
arising due to interest changes.
Chapter: 22
34. A $1,000 par bond has an annual coupon rate of 12% with semi-annual coupon payments and has a
5-year maturity. Assuming a flat yield curve of 10%, what is the bond's duration?
Answer:
Effective semi-annual rate = = 4.881%
P0 of the bond is the present value of all the cash-flows of the bond.
= + PV of Terminal value
(1000 60
= + 10 = $1086.92
1.04881
Chapter: 22
35. You have been asked to estimate the duration of a ten-year, 8% coupon bond with a yield to
maturity of 10%. It has a sinking fund provision where 10% of the outstanding bonds will be retired each
year. What is the duration of this bond?
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Answer:
To calculate the duration of the bond let us assume that the bond is a $100 par, with coupons being paid
annually.
Annual cash-flow for the investor would be coupon payment of $8 plus 10% of outstanding value.
The following table shows the computations of cash flows and their
present values to the investor.
Years 1 2 3 4 5 6 7 8 9 10
Coupon 8 8 8 8 8 8 8 8 8 8
Outstanding value 100.00 90.00 81.00 72.90 65.61 59.05 53.14 47.83 43.05 52.65
Sinking fund payout 10.00 9.00 8.10 7.29 6.56 5.90 5.31 4.78 4.30 52.65
Total cash-flows 18.00 17.00 16.10 15.29 14.56 13.90 13.31 12.78 12.30 60.65
PV of cash-flows 16.36 14.05 12.10 10.44 9.04 7.85 6.83 5.96 5.22 23.38
P0 of the bond is the present value of all the cash-flows of the bond = $111.24
The duration of a coupon paying bond can be calculated using
Chapter: 22
36. You are evaluating the riskiness of a government bond with a coupon rate of 8% and a
maturity of 5 years. If the current yield to maturity is 10%, what is the duration of this bond?
Answer:
We assume a $100 par, semi-annual coupon paying bond.
Effective semi-annual rate = (1 0.1) 0.5 1 = 4.881%
Price of the bond is the present value of the cash flows from a bond.
It can be calculated using
Duration of the above bond can be calculated using
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Chapter: 22
37. You are the CFO of a small corporation and you anticipate that you will have a significant liability
of $10 million coming due in five years. You are considering investing enough money in one or both of the
following two bonds to protect yourself against interest rate risk: a five-year bond with a coupon rate of
16%, and a ten-year bond with a coupon rate of 12%. Each bond has a yield to maturity of 12%. Assuming
duration is a perfect measure of interest rate risk, what combination of the two bonds would provide you
with complete protection against interest rate risk?
Answer:
To immunize the liability using the duration approach, the duration of liabilities should be equal to
duration of assets (portfolio of bonds)
T
tC (t )
Using -
1 i
t 1
t
D
P0
Duration for Bond A = 3.88 years
Duration of Bond B = 6.33 years
Solving for x, the proportion of investment required in Bond A = 54.287%
Therefore, proportion of investment required in Bond B = 45.713%
c t
P0
1 y
t
Using - t
Price of Bond A = $114.42
Price of Bond B = $100
Number of Bond A required to be purchased = $3,080,390/$114.42 = 26,922
Number of Bond B required to be purchased = $2,593,878/$100 = 25,939
Copyright © 2014 John Wiley & Sons, Inc. 39
Test Bank Modern Portfolio Theory and Investment Analysis, 9th
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Chapter: 22
38. Assume that the yield curve is currently flat at 12.5% and that you are considering the following
four investments, all of which are currently selling for $100, for a holding period of four years: a series of
one-year securities with coupon rate = yield to maturity; a four-year zero-coupon bond; a five-year bond that
pays coupons of $12.50 per year; a perpetuity.
a. What is the duration of each investment?
b. Which investment would you choose for complete immunization?
c. Calculate the rate of return on each investment if interest rates go up to 20%; do the same if
interest rates go down to 5%. How does this relate to the duration measure in part a?
Answer:
A series of one-year securities with coupon rate = yield to maturity – If $100 is invested today, the amount
received will need to be re-invested at the beginning of the second, third and fourth years. Receipt of cash
flow will only be at the end of fourth year. The duration of this investment will be, therefore, 4 years.
A four-year zero-coupon bond – Duration of a zero-coupon bond is always equal to its maturity. Therefore
the duration of this bond will be 4 years.
A five-year bond that pays coupons of $12.50 per year – Duration of a bond with coupon of $12.5 and a
T
tC (t )
YTM of 12.5% can be calculated using
1 i
t 1
t
D
P0 ; 4 years.
1 i
Perpetuity – Duration of a perpetuity can be calculated using - ;
i
1.125
= 9 years.
0.125
b.
The duration of the series of one year securities and the coupon bond will change with the change in the
interest rates. However, it will remain constant for the zero-coupon bond. Therefore, the zero-coupon bond
is the best investment for complete immunization.
c.
If Interest rates change to 20% -
A series of one-year securities - An investment of $100 with a return of 12.5% in the first year and 20% for
the next three years will grow to;
100 1.125 1.2 3 = $194.4.
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194.4 1/4
There rate of return on investment = 1 = 18.08%
100
Since, the cash inflow is only at the end of four years, the duration of the investment still remains 4 years.
A four-year zero-coupon bond – A subsequent change in interest rates will not change the return on the
investment if the bond is held to maturity. Therefore, the rate of return remains at 12.5% while the duration
will be 4 years.
A five-year coupon paying bond – At 5% Coupon payments of $12.5 grows
= 12.5 1.2 12.5 1.2 12.5 1.2 12.5 = $67.1
3 2 1
112.5
Price of the bond at the end of 4 years = = $93.75
1.2
Total cash flow at the end of 4 years = $67.1 + $93.75 = $160.85
160.85 1/4
Rate of return; 1 =12.617 %
100
Duration of a bond with coupon of $12.5 and a YTM of 20% can be calculated using
A 12.5
Perpetuity – Price of the perpetuity at YTM of 12.5% = ; = $100
i 0.125
A 12.5
Price of the perpetuity at YTM of 20%= ; = $62.5
i 0.2
At 20% Coupon payments of $12.5 grows
= 12.5 1.2 12.5 1.2 12.5 1.2 12.5 = $67.1
3 2 1
Total cash flow at the end of 4 years = $67.1 + $62.5 = $129.6
129.6 1/4
Rate of return; 1 = 6.7%
100
1.2
Duration of the perpetuity = = 6 years.
0.2
If Interest rates change to 5% -
A series of one-year securities - An investment of $100 with a return of 12.5% in the first year and 5% for
the next three years will grow to;
100 1.125 1.05 3 = $130.23
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130.23 1/4
There rate of return on investment = 1 = 6.83%
100
Since, the cash inflow is only at the end of four years, the duration of the investment still remains 4 years.
A four-year zero-coupon bond – A subsequent change in interest rates will not change the return on the
investment if the bond is held to maturity. Therefore, the rate of return remains at 12.5% while the duration
will be 4 years.
A five-year coupon paying bond – At 5% Coupon payments of $12.5 grows
= 12.5 1.05 12.5 1.05 12.5 1.05 12.5 = $53.87
3 2 1
112.5
Price of the bond at the end of 4 years = = $107.14
1.05
Total cash flow at the end of 4 years = $53.87 + $107.14 = $161.02
161.02 1/4
Rate of return; 1 =12.65 %
100
Duration of a bond with coupon of $12.5 and a YTM of 5% can be calculated using
A 12.5
Perpetuity – Price of the perpetuity at YTM of 12.5%= ; = $100
i 0.125
A 12.5
Price of the perpetuity at YTM of 20%= = = $250
i 0.05
At 5% Coupon payments of $12.5 grows
= 12.5 1.05 12.5 1.05 12.5 1.05 12.5 = $53.87
3 2 1
Total cash flow at the end of 4 years = $53.87 + $250 = $303.88
303.88 1/4
Rate of return = 1 = 32.03%
100
1.05
Duration of the perpetuity = = 21 years.
0.05
Chapter: 22
39. Assume bond returns are given by a single-index model where the index is the percentage change in
1 plus the interest rate.
a. What is the appropriate measure of how bond returns are affected by the index?
42 Copyright © 2014 John Wiley & Sons, Inc.
Modern Portfolio Theory and Investment Analysis, 9th Edition Test Bank
b. If the above model is used as a return-generating process, what is the corresponding APT
model?
Answer:
a.
Returns on bonds are comprised of interest income and price changes. Price changes in a bond occur due to
shifts in the term structure. However, the sensitivity of changes in the price due to interest rates movements
is different for each bond. This measure of sensitivity is known as duration.
A single index model defines the returns on a bond as –
Ru ( D )i
Where,
Ru
= return on a bond
= return on a bond considering yield curve remains unchanged
D = duration
d 1 i
i = proportional change in the interest rate 1 i
The rate of change in the interest rate can be captured by
1 i . However, the denominator in the i
equation of
1 i
is used to reflect the change of duration to modified duration.
Minus duration time the proportional change in one plus interest rate is the sensitivity of the returns on the
bond due to unanticipated price movements as a result of changes in the interest rates.
The duration of a bond depends on how early cash flows occur in the life of a bond. Therefore a
zero coupon bond will always have a duration equal to its maturity while duration will less than the maturity
for a coupon paying bond.
b.
The Arbitrage pricing theory is a return-generating process that relates the returns on a security to
movement of more than one common and correlated factor.
While a bond’s sensitivity to interest rates can be measured by duration, it is a good approximation in the
local neighbourhood only. Duration is a linear measure of sensitivity while the relationship between a bond
price and interest rates is non-linear. An impact of larger interest rate shock can be measured using
convexity.
Ri 0 1bi1 2bi 2 i
An APT model describing the returns of a bond can be represented as –
Where,
Ri
= Expected return on bond
0 = Expected return on bond assuming interest rates remain constant
1 = change in interest rates
bi1
= duration
2 = change in interest rates
bi 2
= convexity
i = error term with expected mean of zero.
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Test Bank Modern Portfolio Theory and Investment Analysis, 9th
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According to this model,
0 is the yield to maturity of the bond at the time of purchase of the bond. bi1 is the
increase in expected return for a one-unit increase in 1 . i is the error term in the model and represents the
random variations in the returns. It has an expected mean of zero. Although, both duration and convexity are
approximations, sensitivity of bond prices to interest rates can be fairly accurately predicted using both the
parameters.
Chapter: 22
40. Assume you want to get a 5-year mortgage on your house and that the yield curve is flat at 10%.
a. If you want to pay back the mortgage in 5 equal annual installments of $1,000, how much
can you borrow?
b. What would be the duration of the above mortgage?
Answer:
a.
Amount that can be borrowed for five equal instalments of $1000 can be
calculated using =
Duration of the above mortgage can be calculated using
Chapter: 22
41. Assume that the yield curve is flat at 10% and that the expectations theory of the term structure
holds. For a bond with 5 years to maturity, an annual coupon rate of 20%, and semi-annual coupon
payments occurring at the middle and end of each year, what is the duration as of the beginning of year 3
just after a coupon payment?
Answer:
Since the yield curve is flat and the expectations theory holds, the 6 months spot rate will be =
(1 0.1) 0.5 1 = 4.881%
Price of Bond at the end of 3 years is the present value of the cash flows for the next two years at the
beginning of the fourth year.
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Using -
= $118.21
Duration of the bond at the end of 3 years will be
Chapter: 22
42. Consider the following data for a stock and a call option on that stock: S0 = $50, S1 = $75 or $100, E
= $50, and r = 1.10. Derive the hedge ratio (α) and the price of the call option.
Answer:
If the stock rises to $100, the intrinsic value of the call is $50 and if it rises to $75, the intrinsic value of the
call is $25
Su = 100
S d = 75
Cu = 50
Cd = 25
Su S d 100 75
Hedge ratio = ; =1
Cu Cd 50 25
50
Minimum amount required to be borrowed to set up a hedge = = $45.45
1.1
Price of the call = = 1 50 45.45 = $4.545
Chapter: 23
Copyright © 2014 John Wiley & Sons, Inc. 45
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43. Consider the purchase of a put option with an exercise price of $40 and a cost of $5 and the
purchase of a call option with the same expiration date and on the same stock with an exercise price of $45
and a cost of $6. Graph the profit of this combination. Be sure to label all points.
Answer:
a.
Stock price Payoff from call Payoff from put Net pay-off
10 0 30 19
15 0 25 14
20 0 20 9
25 0 15 4
30 0 10 -1
35 0 5 -6
40 0 0 -11
43 0 0 -11
45 0 0 -11
47 2 0 -9
50 5 0 -6
55 10 0 -1
60 15 0 4
65 20 0 9
70 25 0 14
75 30 0 19
25
20
15
10
5 Series1
0
10 15 20 25 30 35 40 43 45 47 50 55 60 65 70 75
-5
-10
-15
Chapter: 23
44. Consider a portfolio consisting of long positions in both 6-month Treasury bills and call options.
What is the payoff pattern (potential cash flows) and what is this portfolio equivalent to? (Hint: Use put-call
parity.)
Answer:
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A portfolio consisting of long positions in call and an amount equal to present value of the strike price
invested in bonds, will always generate a payoff equivalent to a portfolio consisting of a stock and a put (on
the same stock, for the same strike price and same maturity).
Let us consider two portfolios –
Portfolio 1 - consisting of a long position call and a long position in a bond with payoff at maturity equal to
strike price.
Portfolio 2 - consisting of a long position in put and a long position in stock.
Where,
S0 = Stock price
E = Exercise price
E
= Long position in bond
(1 r )
C = Call price
P = Put price
S1 = Stock price at maturity
The following table shows the payoffs for both the portfolios considering two scenarios; call ends in-the-
money and call ends out-of-the money.
If S1 > E
Portfolio 1 Payoff Portfolio 2 Payoff
Bond E Long put 0
Call S1 - E Stock S1
Payoff E + S1 - E Payoff 0+ S1
Net Payoff S1 Net Payoff S1
If S1 < E
Bond E Long put E - S1
Call 0 Stock S1
Payoff E +0 Payoff E
Net Payoff E Net Payoff E
Similarly, the payoffs for the portfolio can also be checked using the put option ending in-the-money and
out-of-the money.
Chapter: 23
45. Consider the following table of partial cash flows:
t=0 t=1
S1 = $50 S1 = $70
put ? $10 0
stock $60 $50 $70
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Test Bank Modern Portfolio Theory and Investment Analysis, 9th
Edition
Assume that the risk-free rate over the period is 10% and price the put option.
Answer:
Given the stock can go up to $70 and go or down to $50
= 1.167
= 0.833
Assuming the time period between T1 and T0 is 1 year
Risk neutral probability; = = 0.8
(1 p ) = (1-.8) = 0.2
At the end of one year, if the stock ends at $70, the option is out-of-money and the value of the option is
zero. If the stock ends at $50, the intrinsic value of the put is $50.
Therefore, price of the put option today = = $1.669
Chapter: 23
46. You are convinced that the next three months are going to be boom or bust months for IBM.
Foreseeing a major increase or decrease in the stock price, you set up a position in options where you buy
July 120 calls at $8.75 and you buy July 120 puts at $8.25. IBM is currently selling for $119.
a. Draw the payoff diagram of cash flows on this position.
b. What are the break-even points on the upside and downside of this position?
c. Now assume that IBM has a variance of 0.08. Using the Black-Scholes model to value
these two options, do you still think that you should take the above position? Why or why
not? (Today is December 21, 2002; the options expire on July 18, 2003; the annualized
riskless rate is 6%; ignore dividends.)
d. What is the implied variance in the July 120 call?
Answer:
a.
Total premium cost = $8.75 + $ 8.25 = $ 17
Pay-off table –
Stock price Pay-off from call Pay-off from put Net pay-off
90 −8.75 21.75 13
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95 −8.75 16.75 8
100 −8.75 11.75 3
105 −8.75 6.75 −2
110 −8.75 1.75 −7
115 −8.75 −3.25 −12
120 −8.75 −8.25 −17
125 −3.75 −8.25 −12
130 1.25 −8.25 −7
140 11.25 −8.25 3
145 16.25 −8.25 8
150 21.25 −8.25 13
160 31.25 −8.25 23
b.
Break-even point – Upside = Current stock price + Premium cost
= $120 + $17 = $137
Break-even point – Downside = Current stock price - Premium cost
= $120 − $17 = $103
c.
S = $119; E = $120; Variance = 8%; Risk-free rate = 6%; Expiration date = 07-18-2003
Annualized time to expiry = 209/365 days = 0.5726 years
= 0.228437
= 0.5910
= 0.014408
= 0.508
= $11.428
= 0.409
Copyright © 2014 John Wiley & Sons, Inc. 49
Test Bank Modern Portfolio Theory and Investment Analysis, 9th
Edition
= 0.492
= $8.375
Since both the call and put are trading below their intrinsic value - both the option can be purchased.
d.
Using trial and error in the Black-Scholes model, an implied volatility of 20.01% gives the market price
of $8.75.
Chapter: 23
47. The following is a listing of option prices on Perdida Enterprises on December 12, 2002:
calls puts
strike price Dec. Jan. Feb. Dec. Jan. Feb.
40 6.00 6.82 7.50 0.125 0.50 0.75
45 1.125 2 2.875 0.375 1.125 1.50
50 0.0625 0.43 0.875 4.50 5.00 5.25
The current stock price is 45.75, and the riskless rate is 7%.
a. Consider the following position: sell one January 40 call; buy two January 45 calls; sell one
January 50 call. Evaluate the net cash flows on this position at expiration for different stock
prices, and draw a payoff diagram.
b. Are the three January put options correctly priced relative to the corresponding call
options? (Assume that there are 42 days on the January option.)
Answer:
a.
Net premium form the positions would be
The payoff at different closing prices would be:
Closing Payoff on Payoff on Payoff on E=50 Net payoff
stock price E=40 E=45
36 0 0 0 3.25
38 0 0 0 3.25
40 0 0 0 3.25
42 -2 0 0 1.25
44 -4 0 0 -0.75
45 -5 0 0 -1.75
46 -6 1 0 -1.75
48 -8 3 0 -1.75
50 -10 5 0 -1.75
52 -12 7 -2 -3.75
54 -14 9 -4 -5.75
56 -16 11 -6 -7.75
58 -18 13 -8 -9.75
60 -20 15 -10 -11.75
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b.
According to the put call parity relationship, the prices of the puts can be calculated by =
Strike Price Price of call Prices of puts under parity Market prices
40 6.82 0.750382671 0.5 Underpriced
45 2 0.890430505 1.125 Overpriced
50 0.43 4.280478339 5 Overpriced
Chapter: 23
48. An investment bank has come up with a new product on the S&P 500 index. It offers an
appreciation share, the owner of which is entitled to all price appreciation over 10% in the first two years
and over 20% in the next three years after that. If the current index value is 250, the riskless rate is 8%, the
dividend yield on the index is 3%, and the annualized standard deviation of the index is 20%, what is the
value of this share? (Hint: There might be more than one option in this share.)
Answer:
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The value of option at each node is calculated using the probability of the option being in the money
considering all possible paths as shown below.
Present value of the option at the end of year 1 –
= $16.23
Present value of the option at the end of year 2 –
= $15.79
Similarly, the PV of option can be calculated for each year.
Therefore the value of the option = $39.82
Chapter: 23
49. Suppose you are holding the following portfolio: 100 shares of XYZ stock plus a call option
contract for 100 shares of XYZ with exercise price of 50 and a June expiration date plus a put option
contract for 100 shares of XYZ with exercise price of 40 and a June expiration date.
a. What will this portfolio be worth on expiration date if XYZ is at 35? At 45? At 55?
b. Can this portfolio ever be worth less than $3500? Can it be worth more than $10,000?
Explain.
c. Answer the questions in part a and part b if your portfolio involves a short position in the
call option contract instead of a long position. (I.e., you are long 100 shares of stock and the
put contract, and short the call option contract.)
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Answer:
a.
The portfolio will have the following payoff:
Pay off from - Stock Call Put Portfolio Value
Stock price
$35 $3500 $0 $500 $3500
$45 $4500 $0 $0 $4500
$55 $5500 $500 $0 $6000
b.
The floor value of the portfolio would be $4,000, as any fall in the price of the stock below $40 would be
offset by a gain on the put option. Upside potential on the portfolio is theoretically unlimited. A rise in the
stock price would result in profits on the stock as well as call option.
c.
Having a short call position instead of long call will have the following pay-off
Pay off from - Stock Call Put Portfolio Value
Stock price
$35 $3500 $0 $500 $4000
$45 $4500 $0 $0 $4500
$55 $5500 $−500 $0 $5000
The maximum that this portfolio can gain is $5000 as gains beyond $50 would be capped by a loss on short
position on the call. The maximum loss on this portfolio will be $4000 as any loss below $40 would be
offset by a gain on long position in put option.
Chapter: 23
50. You have just learned through the grapevine that Pfizer (currently at $50.625 per share) may be a
takeover candidate at $65 per share. You would like to speculate on the rumor, but you are worried that the
stock will drop significantly if the rumor is false. Therefore, you have decided to use options to exploit this
information. You are given the following option data for today, May 15th:
calls puts
strike price May June Sept. May June Sept.
45 s 5.825 7.375 s r 1.125
50 1.25 2.50 4.50 0.75 1.8125 3.00
55 0.1875 0.8125 2.25 4.875 5.00 5.625
60 0.0625 0.375 1.125 9.75 9.875 r
65 r 0.125 0.75 r 15.00 15.00
a. Set up an option position that will best exploit the information you have, assuming that the
takeover will happen by September 16 (the expiration day of the September options).
b. Assume now that the annualized standard deviation of Pfizer's stock price is 0.40 and that
the six-month T-bill rate is 6%. Furthermore, assume that Pfizer pays a quarterly dividend
of 50 cents and that the dividends are paid in April, July, October and January. What would
your Black-Scholes estimates be for the options in the position that you have described in
part a?
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c. If the beta of Pfizer stock is 1.0, what is the beta of the position that you have set up in part
a?
d. What are the deltas of the options that you have chosen for your position?
Answer:
a.
The investor wants to participate on the up-move but is worried about the protection if the rumour is false.
Since the take-over price is $65 and the news is correct the stock is likely to trade at around $65. Setting up
a strategy for a target price of $65 and protecting the downside would be an ideal strategy. Also a further
upside to $65 cannot be ruled out. Under the given scenario, a short position in September $65 put, a long
position in September $50 put and a long position in September $65 call would be an optimal strategy. It
ensures immediate cash inflow of $11.25 and would be the net profit if the stock price ends up at $65. If it
falls below $65, the put is likely to be exercised. A long put position on the $50 strike would ensure that the
downside is limited while a long position on the $65 call would ensure participation in any upside beyond
$65.
Premium inflow on short $65 put = $15
Premium outflow on long $50 put = $3
Premium outflow on long $65 call = $0.75
Net premium inflow = $11.25
The following is the payoff table for the investor under various
possible closing stock price.
Payoff from -
Stock price Short Sep $65 put Long Sep $50 put Long Sep $65 call Net payoff
25 -40 25 0 -3.75
30 -35 20 0 -3.75
35 -30 15 0 -3.75
40 -25 10 0 -3.75
43 -22 7 0 -3.75
45 -20 5 0 -3.75
47 -18 3 0 -3.75
50 -15 0 0 -3.75
52 -13 0 0 -1.75
55 -10 0 0 1.25
54 -11 0 0 0.25
55 -10 0 0 1.25
56 -9 0 0 2.25
58 -7 0 0 4.25
60 -5 0 0 6.25
62 -3 0 0 8.25
64 -1 0 0 10.25
65 0 0 0 11.25
66 0 0 1 12.25
68 0 0 3 14.25
70 0 0 5 16.25
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75 0 0 10 21.25
80 0 0 15 26.25
85 0 0 20 31.25
b.
Dividend payment of $0.40 during the life of the September option occurs only once (in July)
Time to expiry = 4 months = 4/12 years
2
Assuming dividend is paid on July 15th - Present value of the dividend = 12 = $0.495
0.5e
Stock price to be considered = S0 I = $50.625 – 0.495 = $50.13
For $65 put option –
50.13 1 2 4
1 2 ln 0.06 0.4
ln S0 / E r t 65 2 12
d1 2 ; = -0.8802
4
t 0.4
12
50.13 1 2 4
1 2 ln 0.06 0.4
ln S0 / E r t 65 2 12
d2 2 ; = -1.111
4
t 0.4
12
N(-d1) = 0.8106
N(-d2) = 0.8667
65
Value of the put ; (0.06 4/12)
0.8667 50.13 = $14.58
e
For $50 put option –
50.13 1 2 4
1 2 ln 0.06 0.4
ln S0 / E r t 50 2 12
d1 2 ; = 0.2558
4
t 0.4
12
50.13 1 2 4
1 2 ln 0.06 0.4
ln S0 / E r t 50 2 12
d2 2 ; = 0.0249
4
t 0.4
12
N(-d1) = 0.3990
N(-d2) = 0.4900
50
Value of the put ; (0.06 4/12)
0.4900 50.13 = $3.817
e
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For $65 call option –
50.13 1 2 4
1 2 ln 0.06 0.4
ln S0 / E r t 65 2 12
d1 2 ; = -0.8802
4
t 0.4
12
50.13 1 2 4
1 2 ln 0.06 0.4
ln S0 / E r t 65 2 12
d2 2 ; = -1.111
4
t 0.4
12
N(d1) = 0.1893
N(d2) = 0.1332
E
Value of the call option; C S0 N d1 N d2
e rt
c.
Beta of an option portfolio would be weighted average of the delta of the options in the portfolio –
Total exposure in three options = $65 + $50 + $65
= $180
65 50 65
0.8106 0.3990 0.1893
Beta of the portfolio = 180 180 180 = -0.3351
d.
Delta of $65 strike put = N(d1)-1 = -0.8106
Delta of $50 strike put = N (d1)-1 = 0.3990
Delta of $65 strike call = N (d1) = 0.1893
Chapter: 23
51. The trade deficit numbers are expected out on February 19, and you think that market will move a
lot, either up or down. You want to take advantage of this using options. You are given the following stock-
index option data for today, January 14 (the current level of the index is 236.99, and the annualized T-bill
rate is 6%):
56 Copyright © 2014 John Wiley & Sons, Inc.
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calls puts
strike price Jan. Feb. March Jan. Feb. March
230 8.625 14.25 17.625 1.625 9 10.625
235 5 11.5 17.75 3.125 10.75 13.25
240 2.25 8.75 12.75 5.5 12.75 14.5
245 0.875 6.5 10 9.5 14 18
250 0.3125 4.5 8.25 13.5 17.75 19.5
255 0.125 3.125 7.5 17.75 20.5 20
a. Find at least two options in the above listing that violate arbitrage
conditions.
b. How would you set up a position using February options to take advantage
of the volatility from the trade deficit numbers? (The February options expire
on the evening of February 19.)
c. What are the breakeven points for the position in part b? (You can draw a
payoff diagram if you want to.)
d. Assume no dividends are paid and that the variance in the stock index is
0.09, and use the Black-Scholes model to value the February 235 call and
the February 235 put.
Answer:
35
Time to expiration for the February contract is 35 days; = 0.0956 years.
365
According to the put-call parity relationship –
C Xe rt P S0 ;
For February $235 strike, price of the put should be - P C Xe S 0 ;
rt
P 11.5 235e(0.06 236.99 = $8.16
For February $240 strike, price of the put should be - P C Xe S 0 ;
rt
P 8.75 240e(0.06 236.99 = $10.38
Assuming the calls are correctly price according to the black-scholes model, both the puts violate arbitrage
conditions.
b.
If a trader expects huge volatility in the market, but is unsure of the direction, a long straddle is an ideal
strategy. Buying near-the-money (strike price of $235 or $240) one call and one put option would set up a
position to gain from a move on the either side.
c.
Assuming a long straddle at strike $240 –
Premium cost on call = $8.75
Premium cost on Put = $8.75
Total cost = $21.5
Breakeven price on the upside = $240 + $21.5 = $261.5
Breakeven price on the upside = $240 - $21.5 = $218.5
The following is the payoff table for the trader at various closing index levels –
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d.
For February $235 call –
1
ln S0 / E r 2 t
d1 2
t
= 0.19915
1
ln S0 / E r 2 t
d2 2
t
= 0.10625
N(d1) = 0.5789
N(d2) = 0.5423
N(-d1) = 0.4210
N(-d2) = 0.4576
Value of the call option
Value of the Put option
E
P N d 2 S0 N d1
e rt
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Chapter:
52. Leland, O'Brien and Rubinstein (who invented portfolio insurance) came up with a product called
"supershares." The product works as follows. It starts with two conventional funds: an index fund owning
stocks in the S&P 500 and a money-market fund.
The index fund is divided into two securities. One of those securities is called a "dividend share" and gives
the holder the right to all dividends paid during three years and all price appreciation up to 25% during those
three years. The other security is called an "appreciation share" and gives the holder the right to all price
appreciation above 25% during those three years.
The money-market fund is also divided into two securities. One of those securities is called a "money
market income supershare" and the other security is called a "protection supershare". The money market
supershare gives the holder the right to all interest income during three years. At the end of those three
years, the holder may also get back some or all of the principal value, depending on how well the stock
market performs. For every 1% that the S&P 500 has fallen below its current level, the principal value
payable to the holder of a money market supershare is reduced by 1% and is instead paid to the holder of a
protection supershare (which also has a three-year lifetime).
Assume that the current level of the S&P 500 index is 277, that the standard deviation of the index is 25%,
and that the average dividend yield on the index is 4%. Also assume that the current six-month T-bill rate is
8% (which is also the rate on the money-market account) and that money-market fund securities are in units
of $100.
(Hints: Remember that the value of the dividend share plus the appreciation share equals the current level of
the S&P 500 index and that the value of the money market income supershare plus the protection supershare
equals the value of the money market fund. Also, you can adjust for dividends in the Black-Scholes formula
by subtracting the dividend yield from the riskless rate and then using this adjusted rate instead of the
riskless rate in the formula.)
a. Estimate the value of the appreciation share.
b. Estimate the value of the dividend share.
c. Estimate the value of the protection supershare.
d. Estimate the value of the money market income supershare.
Answer:
a.
The value of an appreciation share can be treated like the value of a call option, since the investor receives
benefits only if the underlying asset moves above a certain price. Since the investor will receive the benefits
of the price appreciation only above 25%, the strike of the call option to the investor becomes
277 1.25 = $346.25
1
ln S0 / E r q 2 t
d1 2
t
= − 0.0217
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Test Bank Modern Portfolio Theory and Investment Analysis, 9th
Edition
= 0.4547
N(d1) = 0.4913
N(d2) = 0.3246
E 346.25
Value of the call; C S0 N d 1 N d 2 277 0.4913 (0.08*3) 0.3246
e
rt
e =
= $47.65
b.
Given that the value of the dividend share plus the appreciation share equals the current level of the S&P
500 index;
Value of dividend share = $277 − $47.65 = $329.325
c.
Protection supershare gains its value only if the underlying falls in value from the current levels. It can
therefore, be valued as a put option with a strike price of $277
1
ln S0 / E r q 2 t
d1 2 =
t
= 0.4936
= 0.0606
N (-d1) = 0.3107
N (-d2) = 0.4758
Value of the protection share =
= $17.595
d.
Value of money market supershare can be taken as a long position in a bond and a short position in the put
(value of the protection share).
Therefore, value of the share will be $100 - $17.595 = $82.405
Chapter: 23
53. You are interested in putting together an option position on Flaming Yon, Inc. The current stock
price is 58.25, and The Wall Street Journal of December 11, 2002, reports the following prices for the
various listed options on the stock:
60 Copyright © 2014 John Wiley & Sons, Inc.
Modern Portfolio Theory and Investment Analysis, 9th Edition Test Bank
calls puts
strike price Dec. Jan. Feb. Dec. Jan. Feb.
50 8.25 9.25 r 0.125 0.75 1.125
55 4 5.5 r 0.68 1.82 2.00
60 0.625 1.625 2.06 2.25 2.75 3.5
a. Assume that you buy a January 50 call and a January 60 put. Draw the payoff diagram for
this position at maturity.
b. What are the upside and downside breakeven points for this position?
Answer:
a.
Cost of Jan 50 call 9.25
Cost of Jan 50 put 0.75
Total premium cost 10
The payoff from long positions on both the options can be shown as –
Stock price at expiration Payoff from call Payoff from put Net pay-off
30 0 20 10
32 0 18 8
34 0 16 6
36 0 14 4
38 0 12 2
40 0 10 0
42 0 8 -2
44 0 6 -4
46 0 4 -6
48 0 2 -8
50 0 0 -10
52 2 0 -8
54 4 0 -6
56 6 0 -4
58 8 0 -2
60 10 0 0
62 12 0 2
64 14 0 4
66 16 0 6
68 18 0 8
70 20 0 10
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b.
Breakeven point – upside = Strike price + total premium cost
= $50 + $10 = $60
Breakeven point – downside = Strike price - total premium cost
= $50 − $10 = $40
Chapter: 23
54. By example, diagram, and/or verbal description, demonstrate how put options can be used to
construct a "floor" under the return on a portfolio of common stocks.
Answer:
Put options gives the buyer a right but not an obligation to sell an asset at a pre-determined price on or
before a pre-specified time. It can hence be used to construct a floor on a portfolio by synthetically
gaining from the downside while the portfolio loses its value. In the following example, the portfolio
manager has used the put options on Index to limit the downside potential on his portfolio.
Terry is a fund manager who manages a portfolio replicating the S&P index. He is of the view that the
market may witness a downturn in the short term and wants to buy put options to protect the value of his
portfolio. The value of the S&P index is $250 and the puts on the strike price of $250 are trading at $2.
The payoff table for Terry based on the market movements can be prepared as:
Index level Pay off on put Payoff on portfolio
225 23 -25
230 18 -20
235 13 -15
240 8 -10
245 3 -5
250 0 0
255 0 5
260 0 10
265 0 15
270 0 20
275 0 25
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Modern Portfolio Theory and Investment Analysis, 9th Edition Test Bank
The payoff table shows that if the index falls below $250, the loss on the portfolio is offset by the gain on
the put options position. The difference of $2 in the payoff comes from the premium paid by Terry for
buying the insurance on his portfolio.
Chapter: 23
55. Consider a futures contract on Japanese yen. Derive the relationship between the spot $/yen
exchange rate and the futures contract price. (Hint: Consider an investment in the riskless asset of each
country.)
Answer:
The price of any futures contract is defined by the spot price plus its cost of carry till expiration. In case
of futures contract on currencies the cost of carry is the interest cost to borrow spot currencies. However,
currencies carry an additional benefit of monetary value that it holds. It can be re-invested in the country
of foreign currency.
Let S be the number of yen that can be purchased with one U.S. dollar. Typically rates for yen-
dollar futures are quoted in yen/$ terms. Therefore, the rate used to convert yen to dollars would be 1/S.
Let F be the futures price on yen and the riskless rate in the foreign currency (dollar) be rd . The dollar
1 rd
bought with one yen (1/S) can be invested at rd . The value of debt at the maturity would be . This
S
1 rd
can be converted back to yen using F . If the law of one price holds, the return for an investor
S
investing in yen should be equal to the returns that can be generated by investing in dollars. If the
domestic rate on yen is ry -
1 rd
ry = F 1
S
1 ry
Therefore, the futures price on yen/$ should be ry = F S .
1 rd
Chapter: 24
56. Tribbles are soft, furry creatures that reproduce themselves by dividing (like amoebas do) into two
tribbles every 60 days. If a tribble now costs $1, what should be the price of a forward contract that expires
in 60 days (immediately after the reproduction takes place) for one tribble?
Answer:
Assuming 30 days a month, if one tribble doubles in to two every 60 days – An investor with one tribble
will have 32 tribbles at the end of the year.
32
Annual return on continuous compounding will be - ln ; 346.57%
1
Price of a forward contract can be determined using F0 ( S0 I )e
rt
Where S0 = Spot price
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Edition
I = Present value of dividends
r= Annualized rate of interest
t
= Time period of the forward contract
Considering the extra tribble received at the end of two months as dividends –
Present value of the dividend = 1 e ( rt ) = 1 e (3.462/12) = 0.5612
(3.46572/12)
Price of the forward contract = (1 0.5612)e = $0.7818
Chapter: 23
57. Assume that one can purchase gold bars or 6-month futures on gold bars.
a. Using the law of one price, derive the relationship between the spot price of gold and the
futures contract price.
b. Assume that the futures are underpriced relative to the contract price just derived. What
action should an investor take?
Answer:
a.
The law of one price states that two assets with same cash-flows should sell at the same price.
PV (C )
The relationship can be formed as – F0 P0 1 R 1 R
P0
Where, F0 = Futures contract price
P0 = Spot price
R = Risk free rate of interest
PV (C ) = Present value of cost of carry
b.
If the futures price are underpriced relative to the theoretical price –
At T = 0 At T = 1
1. Buy the gold futures 1. Accept the delivery of gold
2. Sell the spot gold 2. Reverse the short trade in the spot market
3. Invest the proceeds from the sale of 3. Collect the proceeds invested in risk-free assets
spot gold in risk-free assets
Chapter: 24
58. You are a portfolio manager who has just discovered the possibilities of stock-index futures.
Assume that today is January 12.
a. Assume that you have the resources to buy and hold the stocks in the S&P 500. The current
level of S&P 500 index is 258.90, the June S&P 500 futures contract is selling for 260.15,
the annualized rate on the T-bill expiring on the expiration date of the futures contract is
6%, and the annualized dividend yield on S&P 500 stocks is 3%. Assume that dividends
are paid out continuously over the year. Is there a potential for arbitrage, and, if so, how
would you go about setting up the arbitrage?
b. Assume now that you are known for your stock selection skills. You have 10,000 shares of
Texacola (now selling for 38) in your portfolio, and you are worried about the direction of
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the market until June. You would like to protect yourself against market risk by using the
December S&P 500 futures contract (which is currently at 260.15). If Texacola's
beta is 0.8, how would you go about creating this protection?
Answer:
Assuming the June future has exactly six months to expiration,
1 R
PV ( D)
Intrinsic value of the S&P futures can be calculated using - F P 1 R
P
0.03 258.9
1 0.06
0.06
2
1 0.06
F 258.9 1 = 262.7835
2 258.9 2
Since the futures is trading at 260.15 which is below its fair value, a reverse cash and carry arbitrage can
be set up by short-selling S&P spot index, investing the proceeds in the riskless assets, and buying the
futures.
On the expiration date –
Accept delivery to reverse short position 260.15
Reverse short at 258.9
Interest earned 7.767
Dividend paid to lender of the index 3.8835
Arbitrage gain 2.6335
Chapter: 24
59. Assume that you are a mutual fund manager with a total portfolio value of $100 million. You
estimate the beta of the fund to be 1.25. You would like to hedge against market movements by using stock
index futures. You observe that the S&P 500 June futures are selling for 260.15 and that the index is at
256.90.
a. How many stock index futures would you have to sell to protect yourself against market
risk?
b. If the riskless rate is 6% and the market risk premium is 8%, what return would you expect
to make on the mutual fund (assuming you don't hedge)?
c. How much would you expect to make if you hedge away all market risk?
Answer:
a.
Number of contracts required to hedge away market risk =
PV
N P
fp cs
= 961.54
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b.
The portfolio manager needs to sell approximately 962 contracts.
Required rate of return = R f Rm R f = 16%
c.
If the market risk is hedged away, since the beta is zero, the required return = 6%
Chapter: 24
60. Assume that it is now December 2002. You are given the following information: December 2003
gold futures contract price = 515.60/troy oz.;
spot gold price = 481.40/ troy oz.;
annualized interest rate = 6%;
annualized carrying cost of gold = 2%.
a. The above information presents an arbitrage opportunity. Describe what you would have to
do now to set up the arbitrage.
b. What would you have to do in December to unwind the position in part a? What is the
arbitrage profit?
Answer:
a.
Intrinsic value of the futures contract will be spot price plus the cost of carry – =
= $519.912
Since the futures price is less than its fair value, a trader can enter in to reverse cash-and-carry arbitrage.
This would mean he will need to sell spot gold and buy the futures. The proceeds from the short-sale
needs to be invested in the riskless securities.
b.
In December 2003, the following steps would ensure an arbitrage profit
–
Steps in December 2003 Inflow/(Outflow)
Pay for the gold futures and accept delivery ($515.6)
Reverse short position --
Interest earned $28.884
Savings in storage costs $9.628
Arbitrage gain $4.32
Chapter: 24
61. You have been asked to determine the theoretical bounds on a futures contract on gold. You are
supplied with the following information: spot price of gold = $400/troy oz.; time to expiration on futures
contract = 6 months; riskless rate = 10%; borrowing rate for marginal investor = 12%; lending rate for
marginal investor = 8%; storage costs for gold = $20/troy oz. per year. Short sellers can hope to recover
66 Copyright © 2014 John Wiley & Sons, Inc.
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only half of the storage costs that they save by short selling.
a. What is the upper bound on the theoretical futures price?
b. What is the lower bound on the theoretical futures price?
c. Assume that investors are required to put up a 10% margin on all futures transactions and
that only cash (no T-bills) can be used to meet margin requirements. Evaluate the effect this
would have on the upper and lower bounds you estimated in part a and part b. (Recalculate
the new bounds.)
Answer:
a.
20
PV of storage costs = 2 = $9.52
0.1
1 2
RB
Upper No-Arbitrage Bound; F0 S0 I 1
2
Where, S0 = Spot price
I = Present value of storage costs
RB = Borrowing costs
400 9.52 1
0.12
Therefore, F0 or F0 $434.095
2
b.
20
2 0.5
PV of the recoverable storage cost =
= $4.76
0.1
1 2
RL
Lower No-Arbitrage Bound; F0 S0 I 1
2
Where, S0 = Spot price
I = Present value of storage costs
RL = Lending rate
400 4.76 1
0.08
Therefore, F0 = F0 $420.95
2
c.
Taking the 0.5% haircut charged by CME on T-bills;
100
New effective borrowing rate = 1.12 1 = 12.563%
99.5
99.5
New effective lending rate = 1.08 1 = 7.46%
100
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RB
Upper No-Arbitrage Bound; F0 S0 I 1
2
0.12563
Therefore, F0 400 9.52 1 = F0 $435.24
2
Lower No-Arbitrage Bound;
400 4.76 1
0.746
Therefore, F0 = F0 $419.86
2
Chapter: 24
62. You are examining the pricing of futures on the S&P 500. The spot level of the S&P 500 index is
250, and the riskless rate is 5%. It is January 1, 2003, and the futures contract expires March 31, 2003. The
dividend yield by month of year is as follows:
month: Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
yield: 0.1% 0.1% 0.5% 0.1% 0.1% 0.5% 0.1% 0.1% 0.5% 0.1% 0.1% 0.5%
a. What is the theoretical price of this futures contract?
b. Will this contract ever sell for less than the spot level of the index? If so, what is the earliest
time at which this will happen? (Assume that the riskless rate and the dividend yield do
not change between January 1, 2003, and March 31, 2003.)
c. Assume now that this contract is correctly priced (= theoretical price) and that you have a
portfolio of $50 million that you would like insured against market movements until
March. If the portfolio has a beta of 1.25, how would you protect yourself against market
risk?
d. Assuming you protect yourself against market movements, what would your expected
return be on the protected portfolio through March 1990?
Answer:
a.
PV of dividends in Jan = = 0.2489
PV of dividends in Feb = = 0.2479
PV of dividends in Mar = = 1.234
PV of total dividends during the life of the contract = $1.7314
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Using,
F0 = $251.3718
b.
Yes, at the end of Feb (with one month to expiration), the futures contract is likely to trade at discount,
because of the negative cost of carry. The monthly risk free rate is approximately 0.4167%, while the
dividend yield is 0.5%
c.
Futures price 251.3719
Spot price 250.0000
Portfolio value 50,000,000
Beta 1.2500
Market risk can be hedged by selling appropriate number of futures contracts on the index. Number of
contracts to be sold can be calculated using –
or, = 994.54 995 contracts
d. Since the hedged portfolio has a beta of zero, there will be no gain/loss in the portfolio due to
market movements.
Chapter: 24
63. The only significant cost of storing gold is the interest on the money you have tied up in it. Suppose
you can borrow money at 10% to buy gold and that today's price of gold is $460 per troy ounce. Gold
futures contracts are available now. The future for delivery in six months is at $480, and the future for
delivery in twelve months is at $506. Devise two ways you might exploit this situation to make an excess
profit. Are there risks involved?
Answer:
0.1
Fair value of six month gold contract = 460 1 = $483
2
Fair value of twelve month gold contract = 460 (1.01) = $506
Option 1-
Since the six month futures are trading below its fair value, we should sell spot gold and buy the futures.
The proceeds from the short sale should be invested in the riskless assets.
After six months –
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Close the short position in spot market by accepting delivery from futures contract this will result in a
cash outflow of $480.
0.1
Receive proceeds from the investment 460 1 = $483
2
Arbitrage gain = $483 − $480 = $3
Option 2-
We buy a six month future at $480 today and hold the future contract for the next six months and
simultaneously, we sell a twelve month contract for $506.
Assuming a flat yield curve, Interest rates for six months from now should be 5 percent.
After six months –
Accept delivery of gold 480
Interest cost for Six months ($480*1.05) 24
Total cost after 12 months 504
Inflow from sale of gold after 12 months 506
Profit $2
Option 1 is a riskless arbitrage strategy. In Option 2, the investor assumes Basis risk. It is the risk that
arises from loss due to change in the spread between the six month and twelve month contracts. If there
is any news in the market regarding long term supply constraints, the prices longer term futures contract
will rise more than the six month contract, widening the basis. Being short on 12 month contract will lose
more than the gain on 6 month contract.
Chapter: 24
64. You want to invest $1 million in the S&P 500 index for one year. There are two ways to go about it.
You could actually buy all the stocks in the index according to their index investment weights, or you
could buy an S&P index futures contract (and put the $1 million in a risk-free investment for one year). The
S&P index is now at 350, and an S&P index future with a one-year maturity is selling at 355. The riskless
rate is 8%, and the dividend yield on the S&P index is 6%. Assume that the S&P contract size is equal to the
index, and that all cash flows to the future occur at maturity (i.e., there is no daily resettlement).
a. What should you do and why?
b. Under your strategy for part a, how much money will you have at the end of the year if the
S&P index closes at 380?
Answer:
a.
The dividend yield on the S&P is 6% while the risk free rates are 8%. Capital appreciation and erosion
would be approximately equal under both strategies. Since the investment in the risk free assets yields two
percent extra, one should look to buy futures and invest the money in riskless assets.
b.
The contract size of S&P futures is equal to the index
Value of futures position = = $1,070,422.5
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Interest earned on riskless assets = = $80,000
Total portfolio value = $1,150,422.5
Chapter: 24
Essays
1. Consider a forecast of the next period's earnings. How much information is in past earnings?
Answer:
There are two types of studies that try to explain the forecast of earnings based on the behavior of past
earnings. One deals with the concept of growth stocks and how much the past growth influences future
earnings. Another school of thought explores the concept of normal earnings.
A growth stock is one which has had a history of stable and sustained growth in the past. This leads
many to believe that such performance would continue in the future and future earnings would reflect the
past growth. However, a number of studies have found evidence to the contrary. Lintner and Glauber (1969)
studied the correlations between the growths of a number of companies between different buckets of time
period. The study showed that less than ten percent of variations in future growth rate was explained by past
growth. Brealey (1969) studied the patterns of high-growth stocks and low-growth stocks on a year-on-year
basis. In order for past growth to be an indicator of future earnings, a stock needs to exhibit sustained
periods of growth, high or low. However, his study concluded that the switch from a high-growth period to
low growth-period and vice-versa was too frequent to base any forecast on the past earnings. These two
studies along with a number of other studies conclude that in a competitive economy where a number of
influences that affect the earnings year-over-year are beyond management’s control. Thus, past growth may
not necessarily be reflected in future earnings.
The concept of normal earnings assumes two scenarios. First, earnings tend to revert to their mean
over a long-term period and second, forecast earnings are based on past earnings scaled by growth
expectations. In the former, the starting point for forecast is the mean growth and the latter assumes the
starting point of forecast as the previous earnings. A number of studies by different scholars have concluded
contrarian results. While forecast for some companies were more accurate using mean earnings as a starting
point, forecasts for a number of companies were a lot more accurate when prior period earnings was used as
a starting point.
Results of studies on the time series of earnings and their patterns to forecast future earnings seem
to less than conclusive for any judgment on the impact of past earnings on the forecasted earnings.
Chapter: 17
2. You are attempting to allocate your time and effort efficiently. Rank the following markets in terms
of likelihood of finding market efficiency, and elucidate the likely source(s) of inefficiency.
a. The New York Stock Exchange
b. The Over The Counter market
c. Real estate
d. Fine art
e. Baseball cards
f. Government bonds
g. Corporate bonds
h. Foreign stock markets
Answer:
A market is inefficient to the degree that little is known about the future of traded assets and risk positions.
Different classes of assets have different degrees of inefficiencies. Following classes of assets are ranked in
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order of most efficient to least efficient.
a. The New York Stock Exchange – Stock trading in the United States are some of the most tracked
securities in the world. A number of professional individuals and institutions follow and actively research to
“dig out” any possible information to exploit economic value. As such, New York Stock Exchange is
considered a highly efficient market. Only likely source of inefficiency is the marginal cost of acquiring new
information that is not reflected in the price of a security.
b. Foreign stock markets – In a global economic environment where fund managers in the developed
economies are diversifying their portfolios to include stocks listed under foreign market, the information
asymmetry has reduced considerably. A high correlation in the stock markets around the world testifies the
fact. However, there are inefficiencies with information flow to investors on small stocks. Also, transaction
costs and tax structures are potential sources of inefficiencies.
c. Government bond market in any country is also a well tracked and participated market. Typically
these securities tend to set the benchmark riskless rates of borrowing and lending in the country. Although it
is also considered a near efficient market, one like source of inefficiency stems from the fact the information
from government quarters is limited to only as much as the policy makers chose to reveal. Moreover, the
timing of announcements is also, at time, unpredictable.
d. Corporate bonds – Corporate bond market in the United States, particularly for bonds issued by
large corporations, is a liquid and well participated market. The risk in corporate bond is primarily credit
risk, and since the equities of these corporations is widely tracked; the information regarding the financial
health of the company is truly incorporated in the prices. However, the risks of interventions of government
policies on corporate borrowing and tax structures remain a likely source of inefficiency. Also the
transaction costs on these bonds are higher than government bonds.
e. Over-The-Counter market – A significant portion of derivatives trading around the world is done in
over-the-counter market. The very nature of this market (direct trading between two parties and the fact that
the products are highly customized structured products to suit individual needs) lead to information
asymmetry. Lack of understanding of the product and complex payoff structures often result in cases where
a party to a trade discovers the risks associated much after the trades have been entered into. Therefore, the
prices of these securities very seldom reflect all the available information. Also, since the trades are done
through a market maker and not on exchanges, the transaction costs are higher. The marginal costs of
acquiring the information on such trades are also very high. Lack of regulation in the OTC trades also result
in lack of transparency in the market.
f. Real estate –Vested in interests in immovable assets, typically characterized by land and buildings
are known as real estate investments. The biggest source of inefficiency in such market is lack of liquidity.
The fact that trades in the real estate market are done as much by retail individuals as by institutions and the
value in each transaction being high, results in a high bid-ask spreads in the market. The transaction costs,
therefore, associated with each transaction is very high. High prices of assets also cause entry-exit barriers in
the industry. High costs of obtaining information and differentiation of products, volatility in government
regulations, interest rates, and tax laws in the industry also causes the inefficiencies in pricing of assets.
g. Fine art – Investments in fine arts typically involve acquiring assets related to paintings, sculptures,
and architectures. The most striking feature of the assets in consideration is that these are developed more
for aesthetics than practical application purposes. The very nature of these investments is that they may be
held in high esteem for one individual while being worthless for another. This causes information
asymmetry in the pricing of an asset. An investment in fine arts requires the same amount of due diligence
as a stock, or probably more, but the cost of information to make any judgment on the pricing is very limited
and costly. Also, this form of an investment is still considered niche rather than mainstream, resulting in
very limited participants and low liquidity.
h. Baseball cards – Baseball cards are trading cards with a picture, name and other statistics of
baseball players. In terms of investment, it derives its value if it is really old and contains information about
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vintage players. The value is presumably more if it contains an autograph of the player. This is probably one
of the most, illiquid forms of investment. Its value of such investments can be more in the countries where
baseball is popular, with people who would be willing to pay for such cards. The pricing of such assets is
difficult to determine due to lack of information and pricing methodologies.
Chapter: 17
3. Tests of market efficiency are often referred to as joint tests of two hypotheses: that the market is
efficient and that an expected returns model holds. Explain. Is it ever possible to test market efficiency alone
(i.e., without also testing some type of asset-pricing model)?
Answer:
An efficient market always fully reflects all the available information, but to determine how the markets
should reflect such information, it is essential to determine an investor’s risk-return preferences. Therefore,
any test of efficient market hypotheses is always done in conjunction with expected returns of investors.
Any test of efficiency assumes a normal rate of return on the market based on a model that defines
equilibrium returns. A rejection of market efficiency will mean that either the market is actually inefficient
or the equilibrium model is flawed. This is commonly known as joint hypotheses problem and means that
effectively, tests on market efficiencies cannot be rejected.
For an asset pricing model to be consistent markets need to be efficient but it is not necessarily true
the other way round. In fact, “Efficient market hypotheses are not a well-defined and empirically refutable
hypothesis”, says Lo in Lo and Mackinlay (1999). In order to make it operational one needs to specify
additional structures like information pattern, investor preferences, business environment, etc, he adds.
However, to tests efficiency in such cases would also mean testing joint hypotheses of several auxiliary
factors and a rejection of joint hypotheses would provide little information on the aspects of the tests that are
inconsistent.
Therefore, any test of efficient market hypotheses is also jointly a test of the efficiency model that
defines equilibrium returns.
Chapter: 17
4. What is the phenomenon of the size effect in stock performance? How does it relate to the "turn-of-
the-year" ("year-end") effect? Can you suggest any good reason why the returns of small stocks, after
adjusting for beta, still do better than those for large stocks? What strategy would you follow to exploit this
anomaly? What factors do you have to keep in mind?
Answer:
The ‘size effect’ hypothesis states that stocks with smaller market capitalization tend to provide excess
returns as compared to large-cap stocks. Also, the excess return on a stock is inverse function to its market
capitalization. The smaller is the size of the firm, the larger will be the returns. A number of studies show
that a significant portion of the excess returns for smaller size firms are generated in the month of January.
In fact, a paper by Keim (1983) shows, that about half of the excess returns for small stocks for the entire
year are realized in January.
Small firms typically have low production efficiencies and are therefore riskier in the sense that
they have a lower probability of surviving in the market during stress, as pointed out by Chan and Chen
(1991). So size serves as a proxy for fundamental risks in a small company and thus investors demand a
higher return for assuming such risks. Another reason why the expected returns on the stocks are higher is
due to higher transaction costs as a result of illiquidity.
A multi-index model which incorporates the possible factors that affect the required rate of return
on a small stock can be used to select mispriced security and generate excess profits. The biggest risk in
investing in small stocks based on multi-index model is omission of relevant factors in the model. This
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increases the error term or portion of returns unexplained by the model. In addition to some of the risks like
lower liquidity and higher transaction costs cited above, there are several risks inherent risks in an
investment in a small stock. Poor quality of management, high variability in returns, greater vulnerability to
economic shocks, lack of reliable data, risks of a hostile take-over, high financial and operating leverage,
and insider trading are some of the factors that must be considered before investing in a small size company.
Chapter: 17
5. One explanation of the "year-end" ("turn-of-the-year" or "January") effect has to do with sales and
purchases related to the tax year.
a. Present the "tax-effect" hypothesis.
b. Studies have shown that the January effect occurs internationally, even in countries where
the tax year does not start in January. Speculate on a good reason for this.
Answer:
a. The "tax-effect" hypothesis is one of the possible explanations on the excess returns exhibited in a
lot of markets around the world. The hypothesis states that investors tend to sell the securities on which they
have incurred loss in late December, only to buy it back in January. If the losses are substantial, it will create
a tax loss for the investor in excess of transaction costs, resulting in net gain. This phenomenon depresses
the prices in December and pushes the prices up in January, thereby, generating excess returns for the
securities in the month of January.
b. One of the possible reasons of the January effect is ‘Window-dressing’. Many fund managers have
a mandate to invest in only certain class of securities with low-risk low-return characteristics. Also, there
would be other managers who have the mandate to invest in risky securities, and have actually incurred
losses in such securities. Regulations in most countries make it mandatory for fund managers to report the
portfolio and performances periodically to exchanges as well as to investors. Both types of managers
discussed above, therefore, tend to sell in late December to ‘clean up’ the portfolio for reporting purposes.
They usually buy back the securities early January. This also partly explains the fact that excess returns in
January is typically exhibited by smaller-cap stocks.
Chapter: 17
6. What is the Efficient Markets Hypothesis? How efficient are the U.S. financial markets? Is it a sign
of probable inefficiency if:
a. the price of a security does not follow a random walk? (What is a random walk?)
b. capital gains on American Stock Exchange stocks are regularly larger than those on New
York Stock Exchange stocks with the same beta?
c. stocks with high P/E ratios earn lower returns than stocks with low P/E ratios after
adjusting for risk?
d. the stock price for companies that sell ice cream goes up in the summer and down in the
winter every year?
e. stock market prices follow a 2.3-year intermediate cycle superimposed on a 22-year major
cycle?
f. a company announces earnings are down 37% from last year and its stock goes up in price?
g. a company announces it has been awarded a lucrative government contract and its stock
rises for the next four days after the announcement?
h. a stock rises in price when the company announces it is going to split 2 for 1?
Answer:
Markets in which the security prices fully reflect all the available information are considered as
efficient. Efficient market hypotheses are, thus, various forms of tests conducted to test the efficiency of a
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market. Securities market in the United States is one of the most widely tracked markets in the world. A
large number of people follow a significant number of securities professionally. This results in instant
dissemination of any new information, which is quickly incorporated in the price of a security. Markets in
the U.S are, therefore, considered as efficient.
a. Random walk theory states that the successive returns on a security are independent and identically
distributes. However, efficient market hypotheses allow deviations in the random walk if the fundamentals
on which the returns depend are changing. A market may be considered inefficient if a security does not
follow random walk even if there are no changes in the underlying fundamentals.
b. A stock with same risks generating different returns on different exchanges is a sign of market
inefficiency. It implies that the information is not fully reflected in the price of the stock in at least one
exchange.
c. The P/E multiple of a stock is closely related to the growth prospects of a company. A stock of a
corporation commands higher multiple if the market perceives that the growth prospects of the organization
is high and vice-versa. If, however, the returns generated on the stocks does not correspond to the P/E
multiple, it is likely that the market is not correctly pricing the prospects and is inefficient.
d. It is very obvious that companies that sell ice-cream would do a better business during summer as
opposed to winter. An efficient market would quickly incorporate the cyclical nature of the business into the
stock price. Thus, a market where the stock price of ice-cream selling companies go up in summer and
down in winter, is a sign of inefficiency.
e. A 22 year period would tend to have many smaller economic cycles intermittently. Periods of high-
growth and low-growths in the economy tend to vary. However, it would be a reasonable assumption that a
2-3 year period will witness different economic environment. Therefore, a stock market intermediate cycle
of 2-3 years may not necessarily be a sign of market inefficiency.
f. Announcement of a 37 percent drop in earnings, assuming there is no other news which indicates a
value-creation for shareholders, should adjust the stock price downwards. On the contrary, if the stock price
moves up, it is a sign of probable inefficiency in the market.
g. If semi-strong form of market hypothesis holds, any new information is quickly incorporated in a
stock’s price. Any investor would not be able to earn excess returns based on any announcements.
Therefore, if the stock of a company rises for the next four days after the announcement of receiving a
lucrative contract, it is a sign of probable inefficiency.
h. A stock split in itself does not add any financial value to a stock. However, a reduction in face value
increases the affordability for a lot of investors and thus, increases the liquidity in the stock. This
phenomenon could fundamentally drive up the demand for the stock. A rise in the stock price therefore, is
reflective of efficiency of the market.
Chapter: 17
7. You are testing the effect of merger announcements on stock prices. (This type of testing is called
an "event study.") Your procedure is as follows:
Step 1: You select the twenty biggest mergers of the year.
Step 2: You isolate the date the merger becomes effective as the key date around which you will
examine the data.
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Step 3: You look at the returns for the five days after the effective merger date.
After looking at the returns in step 3 (you found an average of 0.13%), you conclude that you could not have
made money on merger announcements. Are there any flaws that you can detect in this test? How could you
correct for them? Can you devise a stronger test?
Answer:
The event study conducted above has a fundamental flaw in selection of dates for the study. The key date
(or day zero) after which the returns are being studied is the effective date of merger. Typically mergers and
acquisitions take considerable time to take effect after the announcement. An efficient market would have
reacted to the information in the few days leading up to and a few days after the date of announcement. A
better selection of key date is therefore announcement date of the merger and not effective merger date.
Another flaw with the model is that only the days after the event are being considered. Often, the news of
new information going to be announced at a certain point in time is known and the price starts reflecting in
anticipation. In specific cases like splits, the announcement is made after enormous price rise. There is also
a possibility of information leakage. So period before zero date must be considered.
A stronger test would revolve around the same idea except the key date is changed and period of
study also includes period prior to announcement. Additionally, abnormal returns over expected returns in
the study period should be calculated for each day. An average of excess results can be then cumulated see
the effect of the merger announcement on the price. The study can be concluded by analyzing potential
returns for investors purchasing the security after the announcement.
Chapter: 17
8. Is it possible for:
a. a stock to have a standard deviation of return lower than the market portfolio if the stock's
beta is greater than 1.0?
b. all of the stockholders of XYZ Corporation to believe XYZ is undervalued?
c. everyone to expect the stock market to go down in the next month?
d. someone who sells stock short to make money even if the stock goes up?
e. everyone to expect the Treasury 14s of 2011 to go down in price over the next month?
Answer:
a. Beta of a stock is calculated as . At a beta of one, covariance equals the product of the
standard deviations of the stock and the market. For the stock to have a beta of greater than one, the
denominator (the product of standard deviations) has to decrease. Given the conditions, only if the standard
deviation of the stock increases does the beta of the stock remain greater than one. Therefore, a stock with
beta greater than one will never have a standard deviation lower than that of the market.
b. Tests of efficient market hypotheses state that the price of a security fully reflects all the available
information and no excess returns can be generated. In an efficient market such a situation cannot occur. In
an inefficient market also, a situation where all the shareholders believe that the stock is undervalued is not
likely as in this case, the stock will witness aggressive buying and the price would quickly adjust upwards.
c. Everyone expecting the stock markets to go down next month implies the presence of some
information which will affect the market returns negatively. Semi-strong hypothesis of efficient market says
that the any new information is incorporated in the prices quickly enough for any investor to take advantage
of such news to generate excess gains. If this holds, by the time everyone is aware of the information, the
market would have corrected to reflect such information. In inefficient markets also when everyone is
having pessimistic view, the markets would adjust downward immediately.
d. For someone who has sold a stock short, the payoff is positive if the stock falls and is negative if the
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stock rises. In such a situation, unless the person has long positions in derivatives, the investor will only lose
money if the stock rises.
e. It is quite normal for a term structure of interest rates to be upward sloping. It means that investors
expect the interest rates to rise in the future. Since the bond prices are inverse functions of interest rates, the
prices are expected to fall. However, the price of a bond at any point in time is the present value of its cash
flows discounted using the term structure. If the interest rates are expected to rise further, and semi-strong
form of efficient market hypothesis holds, the prices will adjust instantly.
Chapter: 17
9. What is an "event study"? Discuss a specific example to explain the objectives, methodology, and
results of an event study.
Answer: An “event study” studies the relationship between a piece of information coming in public domain
and its impact on the price of a security. Earlier, the objectives of an event study were to test the efficiency
of a market and the speed with which any new information was incorporated in the price of a security.
However, many studies have concluded that the process of price reflecting any new information is fairly
quick, and therefore, more recent studies tend to focus on determination of the extent of information that is
already reflected in the price. It may also happen at times that the impact of the news is unclear, and a study
is done to assess the quality and nature of the news for the price of a security.
Let us consider the effect of the announcement of positive earnings surprises in a result season. The
study would entail the following steps-
1. We first need to collect the sample of firms that announced positive earnings surprise in a particular
quarter.
2. Designate the day of announcement as day ‘zero’.
3. Define the study period; we will assume a period of 15 days from day zero.
4. We now compute the abnormal return for each security in the sample for the study period.
Abnormal can be defined as actual returns reduced by expected returns. Expected returns can be calculated
using any model; albeit it should be consistent for the entire sample.
5. The next step is to calculate the average abnormal return for all the firms in the sample.
6. Cumulate the abnormal returns from the -15th day (beginning of the study period) to the 15th day
(end of the study period). This is done in order to see the lead and lag effects of the announcement on the
price.
When the results in the last step are graphed, it will show the effects of the announcement on the prices. The
study can be used to test whether an investor can earn abnormal returns over a long term if he decided to
purchase a security based on the positive announcement. Event studies can therefore be used for the semi-
strong forms of tests of efficient market hypothesis.
Chapter: 17
10. Merle Linch, an up-and-coming security analyst has found an exciting investment strategy
based on a correlation between the television programs a firm sponsors and the market performance of its
stock. Over the period 1970-1982, he finds that those companies that sponsored football and hockey games
did significantly better than the rest of the market, yielding 9.4% a year on average versus 8.4% for the Dow
Jones Industrials and 8.5% for the S&P 500 index. He writes up his findings in a market letter for general
distribution to his firm's clients. His research is also noticed and publicized by the companies whose stock
Linch is recommending on the basis of his "contact sports" theory.
a. How else might you explain what Linch has observed?
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b. Precisely how should one test such a theory statistically?
c. What would you expect to find if you did test Linch's theory rigorously? Explain.
d. Suppose the "contact sports" theory is verified. What will happen in markets now that
everyone is aware of it? How long should people be able to earn excess profits by buying
these stocks?
Answer:
a. Linch has observed an anomaly in the market which can be used to generate greater returns.
Although the returns cited by the analyst are greater than the market in absolute terms, based on
correlation, it is incorrect to conclude that the entire returns generated by the stocks under the study are due
to the sponsorship of football and hockey games. Correlation in itself does not explain the deviations in
returns. Square of correlation coefficient is rather the correct measure that explains the variations in returns
generated due to a particular factor. Therefore, Linch’s observation overstates the returns explained by
sponsorship of the games.
b. A single-factor regression model can be used to compute the expected return on the companies.
Ri bS i
Where,
Ri = Expected return on the stocks
= Expected return if factor is zero
b = sensitivity of the return to the factor S
S = sponsorship expenses of various games
i = Error term of the regression model (with expected value of zero)
We can run a regression of the returns on a stock over its sponsorship expenses to compute the sensitivity of
the stock’s return to the expenses incurred by the companies. The explained sum of squares (commonly
referred to as ESS or R 2 ) of the regression model will show the portion of the increased return which is
explained by the increase in sponsorship of games. The square root of this number is the correlation
coefficient between the stocks return and sponsorship expenses.
c. If the analyst’s theory is tested, except for the situation where there is a perfect positive correlation
between the return and sponsorship expenses (r=1), the explained variation the return of the stock will be
lower than considered in the model. This is because the square of correlation coefficient (which lies between
1) will be lower than correlation coefficient itself.
d. If the ‘contact sport’ theory is verified in the market, effectively implying new positive information
for the stocks, the stock prices would adjust upwards immediately. Semi-strong form of efficient market
hypothesis states that any new information is quickly reflected in the stock price. Thus any investor
purchasing the stocks based on this new information would on an average be paying the new worth of the
stock and will not be able to earn any excess return.
Chapter: 17
11. Returns on Mondays are generally much more negative than returns on other days of the
week. How would you best explain this? (Give only one reason, and specify whether it is consistent with
notions of market efficiency.)
Answer: Returns on Mondays are much lower than on other days of the week on the New York Stock
Exchange. The reason for this can be attributed to Friday announcements. In general, companies tend to
hold the bad news to be announced by the weekend which leads to a decline in stock prices on Monday.
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This is an anomaly to the market efficiency theory. In an efficient market the stock price should reflect all
the information privately or publicly available. Lower returns on Monday indicate that market is inefficient.
Chapter: 17
12. Suppose the U.S. Treasury issues $50 billion of 10-year notes over the next month to finance the
budget deficit. Describe what should happen to the term structure of interest rates according to each of the
following theories:
a. segmented markets
b. pure expectations
c. preferred habitat
d. liquidity preference
What do you think would actually happen?
Answer:
a. Segmented markets theory states that interest rate for any maturity depends solely on the demand
and supply of paper for that particular maturity. An issue of 10-year notes would affect the yield on 10-year
securities. All the other yields on the term structure would remain unaffected.
b. According to pure expectations theory, an investor is indifferent between cash flows from two
different maturity bonds. A large issue of 10-year notes will push the yields up for 10-year securities. For
the indifference in the yield to persist, the longer term forward rates will have to come down. The term
structure in this case is likely to flatten out or at least become less steep than it was before the issue.
c. The preferred habitat theory states that investors tend to prefer assets with maturities matching the
maturities of their liabilities. Any deviation from this preference is only due to premium on yields for other
maturities. The premium generated on the issue of 10-year securities with respect to yields on other
maturities is not clear and therefore, it will be difficult to conclude the shift in the term structure.
d. According to Liquidity premium hypothesis, yields on longer term securities needs to be at a
premium to shorter term securities to compensate an investor for the additional risks undertaken. A large
issue in the 10-year market will tend to push up the yields for 10 year securities. If the liquidity premium
hypothesis holds, premiums will also adjust on longer dated securities. Given the scenario, the term
structure will become steeper than it was prior to the issue.
10-year U.S. treasuries market is the most liquid fixed-income market in the world. Being the
benchmark for long-term riskless rate in the market, there is a huge trading interest in the segment.
Empirical evidences suggest that huge issues in the segment go through in the market without any impact on
the yields. Even if there is a ‘lesser demand’ and considering the size of the issue, it is likely to be absorbed
in the market with a rise in the yields of less than 5 bps.
Chapter: 17
13. In November 1978, the Fed announced a stringent new program to combat inflation, which had
gotten out of hand. The response in the financial markets was the Treasury bill yields increased while long-
term yields dropped. Can you explain why?
Answer:
In 1978, the U.S dollar was under severe market pressure, falling nearly 34 percent against a basket of major
currencies, amidst high oil prices, high inflation, and adverse balance of payments. Additionally, all the
measures of money supply in the economy were well above the Fed’s comfort level. The FOMC took a
series of steps to stem the fall of dollar and curb inflation, including increasing the discount rate to an
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unprecedented level of 9.5 percent.
A steep hike in the discount rate immediately translated into surge in the T-bills yields since banks in the
U.S. typically use the Federal Reserve’s discount window to finance their short term borrowing
requirements. However, higher borrowing costs for the banks meant they would be less inclined to lend and
this will reduce money supply in the economy. Bond markets perceived the tightening monetary policies as
a potential tool that would curb inflation, leading to an eventual decline in the interest rates. This led to a fall
in the long term yields.
Chapter: 18
14. a. Would a 10-year, 15% U.S. Treasury note be priced in the market to yield more, less, or the
same as a 10-year, 8% Treasury note? Explain.
b. How would you expect the yields on the following two bonds to compare with each
other? Both are rated A.
ABC Corp. 18s of 2011, callable in 2007
PDQ Corp. 18s of 2009, non-callable
c. How would the yields on the bonds in part b compare if their coupons were 8 instead of 18?
Answer:
a. The yield on a coupon paying bond, all else being equal, is a decreasing function of coupon rate. A
bond with a higher coupon will always have a lower duration than that of a lower coupon paying bond. This
translates into lower risk for the investor and therefore, a bond with higher coupon will always command a
lower yield, all the other factors remaining constant. A 10-year, 15% U.S. Treasury note, therefore, will be
priced in the market to yield less than a 10-year, 8% Treasury note.
b. Yield on a callable bond is always higher than a straight bond since the investor carries an
additional risk of the bond being called in the event of fall in interest rates. At a significantly high coupon
rate of 18 percent, there is strong likelihood that interest rates may fall below the coupon rate. ABC Corp.
has a good chance of being called upon and thus would command a premium on the yield as compared to
PDQ Corp
c. If coupons were 8, instead of 18, the likelihood of interest rates falling below the coupon rates is
much lower. Thus, ABC corp. is less likely to call back the issued bonds. In such a scenario the yields on
both the bonds are likely to be in close proximity.
Chapter: 21
15. Herbert Avocado has just come up with an idea for a new type of financial intermediary, which is
designed to take advantage of the opportunity presented by an inverted yield cure, such as the one that
existed in 1981 when one-year bonds were yielding 16% and 30-year bonds were at 14%. When the yield
curve becomes inverted, Avocado's firm will issue long-term bonds and use the proceeds to buy one-year
instruments that have higher yields and are less risky. Avocado is now just waiting for the yield curve to
become downward sloping again so that he can get his firm off the ground and make his fortune. What do
you think of his plan?
Answer:
Herbert Avocado’s plan is pure play on the term structure of interest rates; with long position in
short term bonds and a short position in long term bonds. There are two possibilities once the trade is
entered into.
First, the yield curve flattens out or further still becomes upward sloping. Short-term interest rates
will fall pushing up prices of shorter term securities resulting in capital gains on the bonds purchased.
Longer-term interest rates will rise and the prices of securities issued would fall. This would also result in
capital gain on the short position. Herbert can reverse both the trades and make handsome gains.
Second, the yield curve inverts further. This is the risk in the trade. Rise in short-term rates and
further fall in long-term rates, will result in loss on both the positions.
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Inverted yields are a result of bursts in short-term inflation levels. Empirical data and mean reversion
theories suggest that the term structure eventually reverts to upward sloping shape. Liquidity premium
theory also states that longer term investors need to be compensated with a premium on yield for the
additional risk undertaken by the investor.
Chapter: 21
16. a. Define the duration of a bond. Why is duration often thought of as a measure of risk for a
bond?
b. What is the duration of a two-year zero-coupon bond? How about a two year 10% coupon
bond (one coupon per year)?
c. How does a given bond's duration change when interest rates in the market rise?
d. Explain how duration is used in setting up an immunization strategy.
Answer:
a. Duration is defined as a measure of sensitivity of a bond’s price to the changes in the interest rates.
It is often considered as a measure of risk because it can be used to determine the requirements to hedge a
bond or a portfolio.
b. The duration of a zero-coupon bond is always equal to its maturity. Therefore, for a two-year zero-
coupon bond, the duration will be two years. Duration is a decreasing function of present values cash flows
in a bond. A two year coupon paying bond will be slightly lower than two years.
c. The duration of a bond is inversely related to the interest rates and would therefore fall when the
interest rates rise.
d. Immunization involves selection of assets in a manner that completely offsets the gain/loss in the
value of liabilities in the event of changes in the interest rates in the market. This is done by matching the
duration of assets with that of liabilities. Since, duration measures the sensitivity of changes in the interest
rates, the impact on the assets and liabilities would be approximately same when the interest rates change.
This ensures the net value of the assets and liabilities remains same.
Chapter: 22
17. You work for a large insurance company and have been assigned to explain to a customer (a large
pension fund) how strategies of 1) exact matching and 2) duration matching will help in meeting a projected
set of pension fund liabilities. Explain what each technique entails and how it works. Examples would be
useful. Be sure to conclude your report with a discussion of the advantages and disadvantages of each
technique.
Answer:
Exact matching and duration matching are two different methods of hedging interest rate risks in a
portfolio. Let us consider that the insurance company has the following liabilities –
Year 1 2 3
Liability $1,000 $1,500 $10,000
Exact matching involves creating the lowest cost portfolio that produces sufficient outflows at the
maturity to service all the liabilities. It is a passive management technique and involves no changes in the
interim. In the above scenario, the portfolio manager can buy bonds that exactly produce cash-flows
matching the liabilities. Any subsequent change in the interest rates would not alter the cash flows and the
liabilities can be easily serviced.
Another variant of this technique is the fund manager carry-forward cash flows method, where one
can buy bonds such that the cash-flow received at the end of year one is more than $1000, say $1,180. The
excess $180 is then re-invested to produce sufficient cash flows to meet the liabilities of $1,500 at the end of
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year two. If the yield curve is upward sloping and the manager is able to receive a better rate of return in
year two, the cost of investment reduces for the firm.
Duration matching, also known as immunization, is a technique of hedging the risks of shift in the
term structure by matching the duration of assets and liabilities. Since duration is the sensitivity of a bond to
the change in the interest rates, matching the duration would ensure that the change in the value of assets
equals liabilities. Suppose the duration of the liabilities in our example is 2.8 years. The fund manager will
need to select a portfolio of bonds having weighted average duration of 2.8 years. A focused immunization
strategy would entail choosing bonds with maturities close to 3 years while a Barbell strategy will entail
choosing bonds with far away maturities but the duration of the portfolio matches the duration of liabilities.
An advantage of exact matching is complete immunization and the portfolio manager is not required to
make any changes in the portfolio. The only risk in this method is default risk. If the carry-forward of cash
flow method is used, the manager can further reduce the cost of portfolio by earning a superior return. A
major risk in this method is re-investment risk. If interest rates fall, the cash flows will not be sufficient to
service the liabilities. The risk in immunization is that if the yield curve shifts, the duration changes and the
portfolio will need to be re-constituted. This can be a costly affair. Also, duration is a linear approximation
of price changes and is ineffective in correctly predicting price movements in large shifts of term structure.
Also, this method assumes a parallel shift in the term structure, which is not always the case in the markets.
The degree of change in the rates in the long-term and short-term is non-linear.
Chapter: 21
18. For each of the following assets, discuss all of the essential aspects of return, risk, and other factors,
such as marketability, that investors should consider before the asset:
a. three-month T-bills
b. a 20-year, 8% coupon corporate bond selling for 65 (don't calculate the yield to maturity)
c. municipal bonds
d. a house in the suburbs
e. a 20-year, 15% mortgage on a house in the suburbs (i.e, you would be the lender)
f. U.S. Treasury 10 5/8s of 2015
Answer:
a. T-bills are short term securities issued by the U.S. treasury, usually for a maturity of less than a
year. These are backed by the government and are considered risk free. These are extremely liquid securities
and set a benchmark for short term interest rates in the economy. Unless in exceptional circumstances like
inverted yield curve, T-bills yields are very low and are considered as cash parking vehicles for investment
managers. Most of the exchanges also accept T-bills as margin in lieu of cash for derivative trades.
b. A significant discount to the par value implies that the yield on the bond is well above the coupon
rate. Though, this may not necessarily be due to the interest rates in the economy. Corporate bonds usually
trade at a premium yield to government bonds due to credit risk. Also since the maturity of the bond is
twenty years, the duration of the bond will be high and the price will be prone to significant interest rate
risks. Longer term coupon paying bonds also have an additional risk of re-investment of coupons. Except
for highly rated securities, corporate bond market is also less liquid and therefore commands a liquidity
premium.
c. Municipal bonds are issued by the government entities below the state level to finance
infrastructural needs. A striking feature of these bonds is that income from such securities is exempt from
federal taxes as well as state taxes in the state where the bonds are issued. Due to low probability of default
and income tax exemptions, investors often accept low yields on these bonds. Also it translates in lower
borrowing costs to the issuer. Municipal bonds have an active secondary market and can be easily purchased
and sold through exchanges. Until recently, these were considered riskless assets. However after the recent
financial crisis and housing market collapse, some of the local governments have had issues with servicing
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of debts. This implies that the credit risk on the bonds is a function of credit quality of the authorities issuing
the bonds.
d. The payoff structure of a real estate investment is very different compared to any other form of
investment. The risk-return characteristic of a typical house is more dependent on the state of the housing
market in general than its own features. Therefore, purely from an investment standpoint, it is based on
more of a play on the sector rather than the characteristics of the property itself. Real estate investments are
also relatively illiquid compared to any other forms of investment which can be traded on exchanges.
e. As discussed in the previous section, real estate, and particularly housing is a market dependent
sector. Typically, these investments are financed by banks and mortgage finance companies and is highly
capital intensive with long gestation periods. Since a twenty year period is likely to see more than one
economic and interest rate cycle, the lender faces focused credit risk. At 15%, the likely-hood of a borrower
having a negative home equity in the event of further interest rate hikes becomes very high. Coupled with
the illiquid nature of the industry, the risk-return trade-off in the investment is highly skewed.
f. The United States treasury department often issues long term zero-coupon bonds in the form of T-
bonds and T-notes to finance government debt. These are extremely liquid securities and are a proxy for the
long-term riskless rates in the market. Since the securities are auctioned during the issue, they usually yield
the prevailing risk free rate in the market, irrespective of the coupon rate. However, these securities can be
restructured and the interest and principal components can be separated on request. The decomposed
securities are called “STRIPS”. The duration of longer term securities being higher than short term, the
interest rate sensitivity for these securities is higher. Since U.S. treasuries are considered the safest assets in
the world, during times of “flight to safety”, these bonds tend to exhibit excessive demand and result in
suppressed yields. Also, regulatory requirements make it mandatory for a lot of banks and financial
institutions to hold treasuries creating artificial demand and reduced yields.
Chapter: 21
19. a. Explain why futures trading is a zero-sum game. Are options also a zero-sum game? What
about buying warrants?
b. Suppose you are long 100 shares of XYZ stock at 50 and you have written a December 50
call option against your long position. Do you want the stock price to go up or down
tomorrow? Explain.
c. Answer part b if you have written a December 50 put option instead of the call option.
Answer:
a. Futures trading is essentially a zero sum game for the simple reason that for every part that gains on
a contract, there is a counterparty who loses. The trades are matched at a price at which a buyer and seller
are willing to enter into a trade. The clearing house, thereafter, splits each trade to become the counterparty
to each trade to offset credit risk in futures trading. The mark to market profit/loss calculated each day is
credited or debited to both the parties. The party whose account is debited is required to bring in further
margin to continue is position, failing which the money is debited to the margins deposited by the respective
exchange members. This entire process ensures that a futures trade is a zero-sum game.
Options trades are conducted in the same manner as futures trades and are also zero-sum games.
Except for the different risk-reward payoffs for the buyers and sellers, the characteristics of an option trade
remain same.
Warrants are financial instruments much like a call option for a buyer are which gives the right to
convert the debt into equity of a corporation at a pre-specified strike price. Therefore, the gain to an investor
is a loss to an issuer and thus it is a zero sum game. For all practical purposes though, a corporation almost
always, hedges this risk by buying options in the OTC markets to offset the risk.
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b. Owning a stock and writing a call is a covered call strategy and is a hedged position. If the stock
goes up more than the premium collected on the option, call will be exercised and the investor faces an
opportunity loss. The investor would ideally, therefore, want the stock to trade below $50 till the month of
December to gain from the option premium and then hope to gain from the rise in the stock price.
c. Writing a put is essentially a selling protection in a stock. The put option will be exercised if the
stock price falls and the investor will lose on the option. The loss is compounded by the loss on the stock. So
since both the positions are long, the investor would want the stock to rise.
Chapter: 23
20. Describe:
a. the transactions a grain elevator operator would make in using March corn futures to hedge
a silo full of corn from October through February.
b. how the price on a futures contract is related to the price for the underlying commodity.
c. how futures prices are expected to move over time.
Answer:
a. In the United States, corn is planted in April and May and it is harvested during October and
November. The price of corn typically falls as it is being harvested and then steadily rises over the next
twelve months to reflect storage costs. A grain elevator operator is likely to store the corn in a silo till the
next plantation. To hedge away any price risk, the operator should sell the March futures and lock-in the
selling price.
b. Commodity futures are priced in much the same way as financial futures. Futures price is a function
of spot price and carrying cost. Commodities can be primarily classified into investment assets and
consumption assets. Pricing of both the types of commodities is slightly different. For investment
commodities, like precious metals, the price of a futures contract is , where,
F0 = Current futures price
S0 = Spot price
r = riskless rate of interest
= storage costs
t
= time to expiration of the contract
For consumption assets like oil, wheat, etc., the owner of a business which uses the commodity as an input,
owning physical commodity rather than futures creates value. This is called a convenience yield. In such
case the price of a futures contract is scaled down by the benefit. Thus, the price of a futures contract on a
consumption asset becomes ; where c is the convenience yield.
c. To prevent any arbitrage, a futures price at the end of the contract becomes equal to the then spot
price in the market. During the life of the contract, how a futures price moves relative to the spot price
depends on the variables determining the carrying cost. If the futures price prevailing in the market is more
than the spot rates, the market is said to be in a contango with an upward sloping curve. If the futures prices
are below spot prices, it is known as backwardation and has a downward sloping curve. Since the spot price
and futures price converge on expiration, a futures market in contango will experience a downward
trajectory during the life of the contract. On the contrary, a market in backwardation will see an upward bias
during its life. However, the prices of both spot and futures price move approximately linearly and react to
demand-supply factors in the market.
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Chapter: 24
21. Your company, Solid State Gizmo, Inc. (SSG) has just been spun off by its parent firm, Octopus
Industries, into a separate firm. SSG's pension fund, currently amounting to $250 million of assets, has also
been spun off. SSG's board of directors has asked you to study proposals from a number of investment
management firms, each offering to manage the pension fund. You are to give the board a report discussing
the different styles of management that are available and making recommendations about which firms
should be seriously considered and how SSG should instruct them to manage the pension fund if they are
hired. Carefully describe the following:
a. What is "passive" investment management? What kinds of things does a passive manager
do?
b. What factors would you look at to judge if one passive manager is better than another?
c. If passive management is chosen, what instructions might you want to give the fund
manager to tailor the optimal passive strategy for SSG's pension fund?
d. What is "active" investment management? What kinds of things does an active manager
do?
e. How would you judge if one active manager is better than another?
f. If active management is chosen, what instructions might you want to give the fund
manager?
Answer:
a. Passive management is a form of investment management wherein a fund mimics the risk and
return of an index or another portfolio. A passive manager would typically be responsible to replicate and
churn the composition of his portfolio so that the returns generated are as close as possible to the
benchmark’s return.
b. A passive manager’s efficiency can be judged by the percentage of tracking error of the fund.
Tracking error is the difference of returns generated for a passive fund as compared to its benchmark. These
usually result due to transaction costs, management fees, different composition due to rounding off
percentages in each securities, etc. The lower the tracking error, the better is a fund manager’s performance.
c. Since the fund in question is a pension fund, the passive manager should be asked to select a
benchmark such as a broad diversified index which provides a stable return in the long run possibly closer to
the long-term average of equity returns.
d. An active management is a form of fund management with an objective of generating excess returns
as compared to that of its benchmark. A manager of an active fund chases ‘Alpha’ by selecting securities
that generate excess returns and outperforms the market.
e. The performance of two active fund managers can be easily compared by the kind of excess returns
generated by the funds over their respective benchmarks. However a better way of judging would be to
check for every unit of risk undertaken to generate the each unit of alpha.
f. Since active management involves the art of securities selection to generate returns, there is an
inherent risk embedded in the nature of the fund. The fund in question being a pension fund, the fund
manager would be well advised to create an optimal mix of fixed income in the portfolio.
Chapter: 22
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22. Discuss (in list form) the risks associated with the following investment strategies.
a. exact matching
b. immunization
c. portfolio insurance
d. timing
e. sector selection
f. selecting mispriced options using the Black-Scholes formula
Answer:
a. Exact matching involves creating a portfolio that produces sufficient outflows at the maturity to
service all the liabilities. The major risk in such a strategy is that the cash-flows may not materialize as
expected if the bonds are callable. In the event of interest rates rise, these bonds would almost certainly be
called upon. The strategy also involves credit risk such that the bond issuer may default on the payments. If
the strategy involves cash and carry forward, there is also a re-investment risk. A downward shift in the
interest rates will mean insufficient cash-flows at maturity.
b. Immunization involves matching the duration of assets with duration of liabilities to hedge against
the interest rate movements. However, selection of wrong duration based on different assumptions of cash
flows is the major risk involved in this strategy. A shift in the yield curve different from the assumption
would change the duration and expose the portfolio to sensitivities to interest rate movements. Another risk
to immunization is the change in the duration of assets in the event of shift in the yield curve or passage of
time. This requires constant portfolio rebalancing which is a costly process. If a manager ignores small
deviations in durations of assets and liabilities, the portfolio is exposed to large shifts in the yield curve.
c. Portfolio insurance is used to hedge the market risk of a portfolio during uncertain and volatile
periods. A position with reverse payoff to cash/spot market position is created using futures, options or other
derivatives to protect the degradation of a portfolio. However, there still remains what is known as basis risk
in a portfolio hedged using derivatives. Basis is the spread between the price of the asset which is hedged
and price of the instrument used to hedge the risk. It can arise under two circumstances –
Difference in assets – There may be times when hedging instruments may not be available for a particular
class of asset. An asset with similar payoffs and risk is then used as a hedging tool. For example, airline
companies regularly use heating oil contracts to hedge their risks because there are no futures available on
Jet fuel. However, when the prices of jet fuel and heating oil diverge, hedging may not work out as
expected.
Difference in maturity selection – Using a different time horizon to hedge the risk of an asset that is
expected to be volatile in a different period may result in basis risk. A bond portfolio manager who expects
a drop in the value of his portfolio due to rise in short-term interest rates may use long-term maturity futures
to hedge his risk. However, the term structure may not shift parallelly when the rates do actually rise. This
will mean that the hedge may not generate the payoffs as expected.
d. Timing is rebalancing the duration of an immunized portfolio in anticipation of interest rates
movement. The risk, however, is that interest rates may not move in anticipated direction. Moreover, the
quantum of the change may be different from what was anticipated. This leaves the portfolio unimmunized
and exposed to price level changes due to further shifts in the yield curve.
e. Portfolio managers involved in sector selection typically engage in selecting bonds with lower
rating for higher yields. This strategy increases credit risk in the portfolio and the uncertainty of cash flows
in case of default by an issuer.
f. Often managers select bonds based on the mispricing between the market price and the theoretical
price. Theoretical price is often determined by discounting future cash flows and adjusting the price of any
option value. Option values calculated using the Black-Scholes model assumes a certain riskless rate and
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considers historical volatility as parameters. Both of these are subject to change. A change in the interest
rate can result as a policy initiative while volatility can change as a result of change in the market dynamics.
A change in either will result in the change in the theoretical as well as market price of the bond, leaving the
portfolio exposed to price volatility.
Chapter: 23
23. You can form a portfolio from the following assets: T-bill futures, T-bond futures, stock index
futures, and IBM stock. Given the following predictions, indicate which of these assets you would hold and
whether you'd be long or short in the asset, so that you will profit if your prediction is correct. (You don't
have to give numbers.)
a. While the total sales of computers will depend on the overall state of the economy and the
stock market (about which you have no strong beliefs), you firmly believe that IBM is
going to lose market share.
b. The yield curve is currently upward sloping. You don't have any idea where interest rates
on average are headed, but at the end of this year, you firmly believe that the yield curve
will be downward sloping.
c. You believe that the stock market is driven by corporate profits and (inversely) by interest
rates. You think that corporate profits are due for a big surge next year, but you
aren't sure about interest rates.
d. You believe that stocks are going to go up next year, unless there is a spectacular short
crash like the one that occurred in October 1987. If there is a crash, you believe that there
will be a "flight to safety", i.e., that investors will dump stocks and buy government bonds.
Answer:
a. In a scenario where IBM is believed to be certain to lose market share, the firm’s sales and
profitability is going to fall and the stock is most likely to fall. An appropriate strategy in this case would be
to short the IBM stock.
b. T-Bonds futures can be used to take advantage of a shift in the yield curve. Since T-Bonds futures
are priced inversely to the interest rates, an investor can benefit from going long futures and gain from a
drop in the interest rates.
c. If the corporate profits surge, the stock index is most likely to rise. To gain from such a movement,
an investor should go long on Stock index futures. The uncertainty of interest rates rise can be hedged by
going short on the T-Bonds futures.
d. A long exposure to stock index futures would help investor gain from the up-move in the market. If
however there is a crash resulting in “flight to safety”, the prices of bonds would rise, resulting in a decline
in the interest rates. A long position in the T-Bonds futures would gain in such a scenario.
Chapter: 23
24. Steve is a Los-Angeles based software developer for one of the leading firms in the United States.
His entire portfolio of equity investments consists of stocks in the companies based in California. Explain
this kind of investor behavior.
Answer:
Behavior of investing in local companies is one of the several biases that investors tend to make while
making investment decisions and has been a subject of study for many scholars. Local investing can be
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limited to investing in one’s own region, state, or even a country. Empirical evidences suggest that this is a
common tendency among many investors.
Potentially the biggest argument in favor of such behavior is that investors have superior knowledge of
companies operating in their region. However, Ning Zhu (2005) studied a large number of individuals
investing in Iocal stocks and concluded that these trades do not produce superior returns. Another school of
thought is that this behavior is more a result of greater investor confidence in local stocks than superior
knowledge. This behavior is not limited to individuals only. Even institutional investors like mutual funds
tend to invest in stocks closer to home. Studies say there is some evidence of these investors generating
superior returns. Grinblatt and Keloharju (2001) suggest that the choice of investors’ stock selection is
influenced by specific geographies rather than closer to home.
Critics of such an investor behavior strongly argue that lack of diversification in such strategies results in
lower returns in the portfolio. However, the proponents of the theory state that excess returns based on
superior information should offset the lack of benefits of diversification.
How much of the investor behavior to invest in local stocks is driven by informational advantage though
still remains a subject of study.
Chapter: 20
88 Copyright © 2014 John Wiley & Sons, Inc.
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