CHAPTER 1

I. Learning objectives
1. Define an investment.
An investment is the current commitment of money or other resources in the expectation of reaping future benefits. For example, an individual might
purchase shares of stock anticipating that the future proceeds from the shares will justify both the time that her money is tied up as well as the risk of the
investment. The time you will spend studying this text (not to mention its cost) also is an investment. You are forgoing either current leisure or the
income you could be earning at a job in the expectation that your future career will be sufficiently enhanced to justify this commitment of time and effort.
While these two investments differ in many ways, they share one key attribute that is central to all investments: You sacrifice something of value now,
expecting to benefit from that sacrifice later
2. Distinguish between real assets and financial assets.
Real assets are used to produce goods and services (the land, buildings, equipment, and knowledge that can be used to produce goods and services).
Financial assets claim on real assets or the income generated by them (stocks and bonds).
Case: While real assets generate net income to the economy, financial assets simply define the allocation of income or wealth among investors.
Individuals can choose between consuming their wealth today or investing for the future. If they choose to invest, they may place their wealth in financial
assets by purchasing various securities. When investors buy these securities from companies, the firms use the money so raised to pay for real assets,
such as plant, equipment, technology, or inventory. So investors’ returns on securities ultimately come from the income produced by the real assets that
were financed by the issuance of those securities.
3. LO1-3 Explain the economic functions of financial markets and how various securities are related to the governance of the corporation.
Financial assets and the markets in which they trade play several crucial roles in developed economies. Financial assets allow us to make the most of the economy’s
real assets.
The role of financial markets-when the market is more optimistic about the firm, its share price will rise, thus making the potential investment more attractive. In this
manner, stock prices play a major role in the allocation of capital in market economies, directing capital to the firms and applications with the greatest perceived
potential.
Virtually all real assets involve some risk. For example, if Toyota raises the funds to build its auto plant by selling both stocks and bonds to the public, the more
optimistic or risk-tolerant investors can buy shares of stock in Toyota, while the more conservative ones can buy Toyota bonds. Because the bonds promise to provide a
fixed payment, the stockholders bear most of the business risk but reap potentially higher rewards. Thus, capital markets allow the risk that is inherent to all
investments to be borne by the investors most willing to bear that risk. This allocation of risk also benefits the firms that need to raise capital to finance their
investments. When investors are able to select security types with the risk-return characteristics that best suit their preferences, each security can be sold for the best
possible price. This facilitates the process of building the economy’s stock of real assets.
We’ve argued that securities markets can play an important role in facilitating the deployment of capital resources to their most productive uses. But market signals will
help to allocate capital efficiently only if investors are acting on accurate information. We say that markets need to be transparent for investors to make informed
decisions. If firms can mislead the public about their prospects, then much can go wrong. For example, the telecom firm worldcom overstated its profits by at least $3.8
billion by improperly classifying expenses as investments. When the true picture emerged, it resulted in the largest bankruptcy in U.S. his- tory, at least until Lehman
Brothers smashed that record in 2008. Other firms such as Rite Aid, healthsouth, Global Crossing, and Qwest Communications also manipulated and misstated their
accounts to the tune of billions of dollars. And the scandals were hardly limited to the U.S. Parmalat, the Italian dairy firm, claimed to have a $4.8 billion bank account
that turned out not to exist. These episodes suggest that agency and incentive problems are far from solved.
4. LO1-4 Describe the major steps in the construction of an investment portfolio.
INVESTOR'S PORTFOLIO: is simply his collection of investment assets. Once the portfolio is established, it is updated or "rebalanced" by selling existing securities
and using the proceeds to buy new securities, by investing additional funds to increase the overall size of the portfolio, or by selling securities to decrease the size of the
portfolio.
Investors make two types of decisions in constructing their portfolios.
1) asset allocation decision:
-allocation of an investment portfolio across broad asset classes such as (stocks, bonds, real estate, commoditites)
2) security selection decision: choice of specific securities within each asset class.
5. LO1-5 Identify different types of financial markets and the major participants in each of those markets.
Types of financial markets (in book): The Risk-Return Trade-Off, Efficient Markets. The Risk-Return Trade-Off
Investors invest for anticipated future returns, but those returns rarely can be predicted precisely. Actual or realized returns will almost always deviate from the
expected return anticipated at the start of the investment period. There should be a risk-return trade-off in the securities markets, with higher-risk assets priced to
offer higher expected returns than lower-risk assets. Efficient Markets. Another implication of the no-free-lunch proposition is that we should rarely expect to find
bargains in the security markets. One interesting implication of this EMH concerns the choice between active and passive investment-management strategies. If
markets are efficient and prices reflect all relevant information, perhaps it is better to follow passive strategies instead of spending resources in a futile attempt to
outguess your competitors in the financial markets. If the efficient market hypothesis were taken to the extreme, there would be no point in active security analysis;
only fools would commit resources to actively analyze securities.
Participants of financial markets:
1) firms: are net demanders of capital. They raise capital now to pay for investments in plant and equipment. The income generated by those real assets provides the
returns to investors who purchase the securities issued by the firm.
2) households: typically are suppliers of capital. They purchase the securities issued by firms that need to raise funds.
3) governments: can be borrowers or lenders, depending on the relationship between tax revenue and government expenditures.
6. LO1-6 Explain the causes and consequences of the financial crisis of 2008.
Deregulation in the financial industry was the primary cause of the 2008 financial crash. It allowed speculation on derivatives backed by cheap, wantonly-issued
mortgages, available to even those with questionable creditworthiness. It involved reckless speculation, loose credit, and too much debt in asset markets, namely, the
housing market in 2008
The crisis was the worst U.S. economic disaster since the Great Depression. In the United States, the stock market plummeted, wiping out nearly $8 trillion in value
between late 2007 and 2009. Unemployment climbed, peaking at 10 percent in October 2009. Americans lost $9.8 trillion in wealth as their home values plummeted
and their retirement accounts vaporized.
In all, the Great Recession led to a loss of more than $2 trillion in global economic growth, or a drop of nearly 4 percent, between the pre-recession peak in the second
quarter of 2008 and the low hit in the first quarter of 2009.
II. Key Terms
1. Active management - Attempting to identify mispriced securities or to forecast broad market trends.
2. Agency problems - Conflicts of interest between managers and stockholders.
3. Asset allocation - Allocation of an investment portfolio across broad asset classes.
4. Derivative securities - Securities providing payoffs that depend on the values of other assets.
5. Equity - An ownership share in a corporation.
6. Financial assets - Claims on real assets or the income generated by them.
7. Financial intermediaries - Institutions that “connect” borrowers and lenders by accepting funds from lenders and loaning funds to borrowers.
8. Fixed-income (debt) securities - Pay a specified cash flow over a specific period.
9. Investment - Commitment of current resources in the expectation of deriving greater resources in the future.
10. Investment bankers - Firms specializing in the sale of new securities to the public, typically by underwriting the issue.
11. Investment companies - Firms managing funds for investors. An investment company may manage several mutual funds.

12. Passive management-Buying and holding a diversified portfolio without attempting to identify mispriced securities.
13. Primary market-A market in which new issues of securities are offered to the public.
14. Real assets-Assets used to produce goods and services.
15. risk return trade off-Assets with higher expected returns entail greater risk.
16. Secondary market-Previously issued securities are traded among investors.
17. Venture capital (VC)-Money invested to finance a new firm.
18. Private equity-Investments in companies that are not traded on a stock exchange.
19. Securitization- Pooling loans into standardized securities backed by those loans, which can then be traded like any other security.
20. Systemic risk -Risk of breakdown in the financial system, particularly due to spillover effects from one market into others.
21. Security analysis-Analysis of the value of securities.
22. Security selection-Choice of specific securities within each asset class.
III. Problems set (Q for review)
1. What are the differences between equity and fixed-income securities?
Equity is a lower priority claim and represents an ownership share in a corporation, whereas debt has a higher priority claim, but does not have an
ownership interest. Debt also pays a specified cash flow over a specific period and the claim will eventually expire. Equity has an indefinite life.
2. What is the difference between a primary asset and a derivative asset?
A derivative asset provides a payoff that depends on the values of a primary asset. The primary asset has a claim on the real assets of a firm, whereas
a derivative asset does not.
3. What is the difference between asset allocation and security selection?
Asset allocation is the allocation of an investment portfolio across broad asset classes. Security selection is the choice of specific securities within each
asset class.
4. What are agency problems? What are some approaches to solving them?
Agency problems are conflicts of interest between managers and stockholders. They are addressed through the corporate governance process via
audits, compensation structures and board elections.
5. What are the differences between real and financial assets?
Real assets are assets used to produce goods and services. Financial assets are claims on real assets or the income generated by them.
6. How does investment banking differ from commercial banking?
Investment bankers are firms specializing in the sale of new securities to the public, typically by underwriting the issue. Commercial banking processes
the financial transactions of businesses such as checks, wire transfers and savings account management
IV. Intermediate
7. For each transaction, identify the real and/or financial assets that trade hands. Are any financial assets created or destroyed in the
transaction? a. Toyota takes out a bank loan to finance the construction of a new factory. b. Toyota pays off its loan. c. Toyota uses $10
million of cash on hand to purchase additional inventory of spare auto parts.
a. The factory is a real asset that is created. The loan is a financial asset that is created by the transaction.
b. When the loan is repaid, the financial asset is destroyed but the real asset continues to exist.
c. The cash is a financial asset that is traded in exchange for a real asset, inventory
8. Suppose that in a wave of pessimism, housing prices fall by 10% across the entire economy. (L a. Has the stock of real assets of the
economy changed? b. Are individuals less wealthy? c. Can you reconcile your answers to ( a) and ( b)?
a. No. The real estate in existence has not changed, merely the perception of its value.
b. Yes. The financial asset value of the claims on the real estate has changed, thus the balance sheet of individual investors has been reduced.
c. The difference between these two answers reflects the difference between real and financial asset values. Real assets still exist, yet the value of the
claims on those assets or the cash flows they generate do change. Thus, the difference.
9. Lanni Products is a start-up computer software development firm. It currently owns computer equipment worth $30,000 and has cash on
hand of $20,000 contributed by Lanni’s owners. For each of the following transactions, identify the real and/or financial assets that trade
hands. Are any financial assets created or destroyed in the transaction?
a. Lanni takes out a bank loan. It receives $50,000 in cash and signs a note promising to pay back the loan over three years.
b. Lanni uses the cash from the bank plus $20,000 of its own funds to finance the development of new financial planning software.
c. Lanni sells the software product to Microsoft, which will market it to the public under the Microsoft name. Lanni accepts payment in the
form of 5,000 shares of Microsoft stock.
d. Lanni sells the shares of stock for $25 per share and uses part of the proceeds to pay off the bank loan.
a. The bank loan is a financial liability for Lanni. Lanni's IOU is the bank's financial asset. The cash Lanni receives is a financial asset. The new financial
asset created is Lanni's promissory note held by the bank.
b. The cash paid by Lanni is the transfer of a financial asset to the software developer. In return, Lanni gets a real asset, the completed software. No
financial assets are created or destroyed. Cash is simply transferred from one firm to another.
c. Lanni sells the software, which is a real asset, to Microsoft. In exchange Lanni receives a financial asset, 1,500 shares of Microsoft stock. If Microsoft
issues new shares in order to pay Lanni, this would constitute the creation of new financial asset.
d. In selling 1,500 shares of stock for $120,000, Lanni is exchanging one financial asset for another. In paying off the IOU with $50,000 Lanni is
exchanging financial assets. The loan is "destroyed" in the transaction, since it is retired when paid
10. Reconsider Lanni Products from the previous problem. a. Prepare its balance sheet just after it gets the bank loan. What is the ratio of
real assets to total assets? b. Prepare the balance sheet after Lanni spends the $70,000 to develop its software product. What is the ratio of
real assets to total assets? c. Prepare the balance sheet after Lanni accepts the payment of shares from Microsoft. What is the ratio of real
assets to total assets?
 11. What reforms to the financial system might reduce its exposure to
systemic risk?
Ultimately, real assets determine the material well being of an economy. Individuals can benefit when financial engineering creates new products which
allow them to manage portfolios of financial assets more efficiently. Since bundling and unbundling creates financial products creates new securities
with varying sensitivities to risk, it allows investors to hedge particular sources of risk more efficiently.
12. Examine the balance sheet of commercial banks in Table 1.3 . What is the ratio of real assets to total assets? What is that ratio for
nonfinancial firms ( Table 1.4 )? Why should this difference be expected?
For commercial banks, the ratio is: $121.2/$11,426.2 = 0.0106 For non-financial firms, the ratio is: $14,773/$28,507 = 0.5182 The difference should be
expected since the business of financial institutions is to make loans that are financial assets.
13. Why do financial assets show up as a component of household wealth, but not of national wealth? Why do financial assets still matter for
the material well-being of an economy?
National wealth is a measurement of the real assets used to produce the GDP in the economy. Financial assets are claims on those assets held by
individuals. These financial assets are important since they drive the efficient use of real assets and help us allocate resources, specifically in terms of
risk return trade-offs.
14. Discuss the advantages and disadvantages of the following forms of managerial compensation in terms of mitigating agency problems,
that is, potential conflicts of interest between managers and shareholders. a. A fixed salary. b. Stock in the firm that must be held for five
years. c. A salary linked to the firm’s profits.
a. A fixed salary means compensation is (at least in the short run) independent of the firm's success. This salary structure does not tie the manager’s
immediate compensation to the success of the firm. The manager might, however, view this as the safest compensation structure with the most value.
b. A salary paid in the form of stock in the firm means the manager earns the most when shareholder wealth is maximized. When the stock must be held
for five years, the manager has less of an incentive to manipulate the stock price. This structure is most likely to align the interests of managers with the
interests of the shareholders. If stock compensation is used too much, the manager might view it as overly risky since the manager’s career is already
linked to the firm. This undiversified exposure would be exacerbated with a large stock position in the firm.
c. When executive salaries are linked to firm profits, the firm creates incentives for managers to contribute to the firm’s success. The success of the firm
is linked to the compensation of the manager. This may lead to earnings manipulation, but that is what audits and external analysts will look out for.
15. We noted that oversight by large institutional investors or creditors is one mechanism to reduce agency problems. Why don’t individual
investors in the firm have the same incentive to keep an eye on management?
If an individual shareholder could monitor and improve managers’ performance, and thereby increase the value of the firm, the payoff would be small,
since the ownership share in a large corporation would be very small. For example, if you own $10,000 of IBM stock and can increase the value of the
firm by 5%, a very ambitious goal, you benefit by only: 0.05 x $10,000 = $500. In contrast, a bank that has a multimillion-dollar loan outstanding to the
firm has a big stake in making sure the firm can repay the loan. It is clearly worthwhile for the bank to spend considerable resources to monitor the firm.
16. Wall Street firms have traditionally compensated their traders with a share of the trading profits that they generated. How might this
practice have affected traders’ willingness to assume risk? What is the agency problem this practice engendered?
Since the trader benefited from profits but did not get penalized by losses, they were encouraged to take extraordinary risks. Since traders sell to other
traders, there also existed a moral hazard since other traders might facilitate the misdeed. In the end, this represents an agency problem.
17. Why would you expect securitization to take place only in highly developed capital markets?
Securitization requires access to a large number of potential investors. To attract these investors, the capital market needs:
(1) a safe system of business laws and low probability of confiscatory taxation/regulation;
(2) a well-developed investment banking industry;
(3) a well-developed system of brokerage and financial transactions, and;
(4) well-developed media, particularly financial reporting. These characteristics are found in (indeed make for) a well-developed financial market.
18. What would you expect to be the relationship between securitization and the role of financial intermediaries in the economy? For
example, what happens to the role of local banks in providing capital for mortgage loans when national markets in mortgage- backed
securities become highly developed? (LO 1-6)
Progress in securitization facilitates the shifting of default risk from the intermediates to the investors of such a security. Since the intermediates no longer bear the
default risk, their role and motivation in assessing and monitoring the quality of the borrowers is mitigated. For example, when the national market in mortgage-backed
securities becomes highly developed, local banks can easily sell their claims on mortgages to the issuers of mortgage-backed securities and then use the money they
receive to create more mortgages because the local banks make profits both from making loans and selling loans to the issuers of mortgage-backed securities. This way
the local banks are actually incentivized by the volume of the loan that they lend out, instead of by the quality of the loan, and thus they become less cautious in
originating subprime mortgages.
19. Give an example of three financial intermediaries, and explain how they act as a bridge between small investors and large capital markets
or corporations. (LO 1-5)
Mutual funds accept funds from small investors and invest, on behalf of these investors, in the national and international securities markets.
Pension funds accept funds and then invest, on behalf of current and future retirees, thereby channeling funds from one sector of the economy to another.
Venture capital firms pool the funds of private investors and invest in start-up firms.
Banks accept deposits from customers and loan those funds to businesses or use the funds to buy securities of large corporations.
20. Firms raise capital from investors by issuing shares in the primary markets. Does this imply that corporate financial managers can ignore
trading of previously issued shares in the secondary market? (LO 1-4)
Even if the firm does not need to issue stock in any particular year, the stock market is still important to the financial manager. The stock price provides
important information about how the market values the firm's investment projects. For example, if the stock price rises considerably, managers might
conclude that the market believes the firm's future prospects are bright. This might be a useful signal to the firm to proceed with an investment such as
an expansion of the firm's business. In addition, the fact that shares can be traded in the secondary market makes the shares more attractive to
investors since they know that, when they wish to, they will be able to sell their shares. This in turn makes investors more willing to buy shares in a
primary offering, and thus improves the terms on which firms can raise money in the equity market.
21. The average rate of return on investments in large stocks has outpaced that on investments in Treasury bills by about 7% since 1926.
Why, then, does anyone invest in Treasury bills? (LO 1-1)
Treasury bills serve a purpose for investors who prefer a low-risk investment. The lower average rate of return compared to stocks is the price investors
pay for predictability of investment performance and portfolio value. Also, they tend to be more liquid, or at least more stable. So, if someone thought
they might need cash relatively quickly then they would prefer Treasury bills. For example, with college savings plans, they tend to decrease the percent
of the portfolio dedicated to stocks as the child gets older
 22. You see an advertisement for a book that claims to show how you can make $1 million with no risk and with no money down. Will you buy
the book? (LO 1-1)
You should be skeptical. If the author actually knows how to achieve such returns, one must question why the author would then be so ready to sell the secret to others.
Financial markets are very competitive; one of the implications of this fact is that riches do not come easily. High expected returns require bearing some risk, and
obvious bargains are few and far between. Odds are that the only one getting rich from this book is its author.
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CHAPTER 2
I. Learning objectives
1. LO2-1 Distinguish among the major assets that trade in money markets and in capital markets
Money market funds are mutual funds designed to be low-risk, liquid, and short-term investments. They are usually offered by companies that have invested in other
money market instruments and are almost always composed of highly rated paper. Investors can choose between municipal money funds, state-level debt funds,
Treasury funds, or funds that focus on private commercial money market exposure.
· Money market funds are mutual funds designed to be low-risk, liquid, and short-term investments.
· A market can be described as a money market if it is composed of highly liquid, short-term assets.
· Money market funds typically invest in government securities, certificates of deposit, commercial paper of companies, and other highly liquid, low-risk securities.
The term capital market broadly defines the place where various entities trade different financial instruments. These venues may include the stock market, the bond
market, and the currency and foreign exchange markets.
Capital markets are used to sell financial products such as equities and debt securities. Equities are stocks, which are ownership shares in a company. Debt securities,
such as bonds, are interest-bearing IOUs.
2. LO2-2 Describe the construction of stock market indexes.
A stock index, or stock market index, is an index that measures a stock market, or a subset of the stock market, that helps investors compare current price levels with
past prices to calculate market performance. It is computed from the prices of selected stocks (typically a weighted arithmetic mean).
There are approximately 5,000 U.S. indexes. The three most widely followed indexes in the U.S. are the S&P 500, Dow Jones Industrial Average, and Nasdaq
Composite. The Wilshire 5000 includes all the stocks from the U.S. stock market.
3. LO2-3 Calculate the profit or loss on investments in options and futures contracts
A call option gives its holder the right to purchase an asset for a specified price, called the exercise or strike price, on or before some specified expiration date. An
October call option on Apple stock with exercise price $355, for example, entitles its owner to purchase Apple stock for a price of $355 at any time up to and including
the option’s expiration date in October. The holder of the call need not exercise the option; it will make sense to exercise only if the market value of the asset that may
be purchased exceeds the exercise price. When the market price exceeds the exercise price, the option holder may “call away” the asset for the exercise price and reap a
benefit equal to the difference between the stock price and the exercise price. Otherwise, the option will be left unexercised. If not exercised before the expiration date,
the option expires and no longer has value. Calls, therefore, provide greater profits when stock prices increase and so represent bullish investment vehicles.
In contrast, a put option gives its holder the right to sell an asset for a specified exercise price on or before a specified expiration date. An October put on Apple with
exercise price $355 entitles its owner to sell Apple stock to the put writer at a price of $355 at any time before expiration in October even if the market price of Apple is
lower than $355. Whereas profits on call options increase when the asset increases in value, profits on put options increase when the asset value falls. The put is
exercised only if its holder can deliver an asset worth less than the exercise price in return for the exercise price.
A futures contract calls for delivery of an asset (or, in some cases, its cash value) at a specified delivery or maturity date, for an agreed-upon price, called the futures
price, to be paid at contract maturity. The long position is held by the trader who commits to purchasing the commodity on the delivery date. The trader who takes the
short position commits to delivering the commodity at contract maturity
The trader holding the long position profits from price increases. Suppose that at expiration, corn is selling for $6.9225 per bushel. The long position trader who entered
the contract at the futures price of $6.7225 on July 8 would pay the previously agreed-upon $6.7225 for each bushel of corn, which at contract maturity would be worth
$6.9225. Because each contract calls for delivery of 5,000 bushels, the profit to the long position, ignoring brokerage fees, would equal 5,000*($6.9225-
$6.7225)=$1,000. Conversely, the short position must deliver 5,000 bushels for the previously agreed-upon futures price. The short position’s loss equals the long
position’s profit.
ii. Key Terms
a. Bankers’ acceptance - An order to a bank by a customer to pay a sum of money at a future date.
b. A certificate of deposit (CD) - is a time deposit with a bank. Time deposits may not be withdrawn on demand. The bank pays interest and principal to the
depositor only at the end of the fixed term of the CD.
c. Commercial paper - Short-term unsecured debt issued by large corporations.
d. Eurodollars - Dollar-denominated deposits at foreign banks or foreign branches of American banks.
e. Federal funds - Funds in the accounts of commercial banks at the Federal Reserve Bank.
f. LIBOR (London Interbank Offer Rate) - Lending rate among banks in the London market. It is the rate at which large banks in London are willing to lend
money among themselves.
g. T-notes (treasury notes) - are issued with original maturities ranging up to 10 years.
h. T-bonds (treasury bonds) - are issued with maturities ranging from 10 to 30 years.
i. Treasury bills (t-bills) - Short-term government securities issued at a discount from face value and returning the face amount at maturity.
j. The money market - is a subsector of the debt market. It consists of very short-term debt securities that are highly marketable. Include short-term, highly
liquid, and relatively low-risk debt instruments.
k. Municipal bonds - Tax-exempt bonds issued by state and local governments.
l. Repurchase agreements (repos) - Short-term sales of government securities with an agreement to repurchase the securities at a higher price.
m. Сorporate bonds - Long-term debt issued by private corporations typically paying semiannual coupons and returning the face value of the bond at
maturity.
n. Common stocks - Ownership shares in a publicly held corporation. Shareholders have voting rights and may receive dividends.
o. Preferred stock - Non-voting shares in a corporation, usually paying a fixed stream of dividends.
p. Price-weighted average - An average computed by adding the prices of the stocks and dividing by a “divisor.”
q. Market value-weighted index - Index return equals the weighted average of the returns of each component security, with weights proportional to
outstanding market value.
r. Equally weighted index - An index computed from a simple average of returns.
s. Derivative asset - A security with a payoff that depends on the prices of other securities.
t. Call option - The right to buy an asset at a specified price on or before a specified expiration date.
u. Put option - The right to sell an asset at a specified exercise price on or before a specified expiration date.
v. Futures contract - Obliges traders to purchase or sell an asset at an agreed upon price at a specified future date.
III. Problems set (Q for review)
1. Match each example to one of the following behavioral characteristics. (LO 9-1)
a. Investors are slow to update their beliefs when given new evidence - Conservatism bias
b. Investors are reluctant to bear losses due to their
unconventional decisions - Regret avoidance
c. Investors exhibit less risk tolerance in their retirement accounts versus their other stock accounts - Mental accounting
d. Investors are reluctant to sell stocks with "paper" losses - Disposition effect
e. Investors disregard sample size when forming views about the future from the past - Representation bias
2. After reading about three successful investors in The Wall Street Journal you decide that active investing will also provide you with
superior trading results. What sort of behav- ioral tendency are you exhibiting? (LO 9-1)
Representativeness bias. The sample size is not considered when making future decisions.
3. What do we mean by fundamental risk, and why may such risk allow behavioral biases to persist for long periods of time? (LO 9-2)
Fundamental risk means that even if a security is mispriced, it still can be risky to attempt to exploit the mispricing because the correction to price could
happen after the trader's investing horizon. This limits the actions of arbitrageurs who take positions in mispriced securities. Thus, the bias may persist
since no one takes advantage of it.
4. What are the strong points of the behavioral critique of the efficient market hypothesis? What are some problems with the critique? (LO 9-
2)
The premise of behavioral finance is that conventional financial theory ignores how real people make decisions and that people make a difference.
Behavioral finance may cite examples of market inefficiencies, but they give no insight into how to exploit such a phenomenon. The strength of their
argument relies upon observed market inefficiencies and unexplained market behavior. There are many anomalies, yet many can be reverse
engineered or explained. Also, while anomalies exist, they rarely meet the test of statistical significance.
5. What are some possible investment implications of the behavioral critique? (LO 9-1)
An unfortunate consequence of behavioral finance (BF) is a tendency for investors to assume more than actually is claimed by the field. While BF is
highly critical of EMH and claims to offer alternative theories, it does not propose to be a predictor of future returns. Investors should be wary of people
purporting to offer excess returns under the façade of BH. Such claims are likely to be false.
6. Jill Davis tells her broker that she does not want to sell her stocks that are below the price she paid for them. She believes that if she just
holds on to them a little longer, they will recover, at which time she will sell them. What behavioral characteristic does Davis have as the
basis for her decision making? (LO 9-1)
a. Loss aversion
b. Conservatism
c. Representativeness
ans. Loss aversion-Loss aversion is the tendency to prefer avoiding losses to acquiring equivalent gains. The principle is prominent in the domain of
economics. What distinguishes loss aversion from risk aversion is that the utility of a monetary payoff depends on what was previously experienced or
was expected to happen.
7. What is meant by the LIBOR rate? The Federal funds rate?
The fed funds rate is simply the rate of interest on very short-term loans among financial institutions. The London Interbank Offer Rate (LIBOR) is the
rate at which large banks in London are willing to lend money among themselves.
8. How does a municipal revenue bond differ from a general obligation bond? Which would you expect to have a lower yield to maturity?
Municipal Revenue Bonds are repayments that depend upon specific projects and are more risky. General Obligation Bonds have revenues that depend
on an agreement between bondholder and issuer and are less risky. The greater the risk and ROI of the project the higher the yield to maturity.
9. Why are corporations more apt to hold preferred stock than are other potential investors?
Because 70% of the income received by the corporation is tax free and only 30% is taxable.
10. What is meant by Limited Liability?
Limited liability means that the most shareholders can lose in event of the failure of the corporation is their original investment.
11. Which of the following correctly describes a repurchase agreement?
a. The sale of a security with a commitment to repurchase the same security at a specified future date and a designated price.
b. The sale of a security with a commitment to repurchase the same security at a future date left unspecified, at a designated price.
c. The purchase of a security with a commitment to purchase more of the same security at a specified future date.
The sale of a security with the commitment to repurchase the same security at a specified future date and designated price. "Overnight borrowing."
12. What is meant by “limits to arbitrage”? Give some examples of such limits. (LO 9-2)
a theory that, due to restrictions that are placed on funds that would ordinarily be used by rational traders to arbitrage away pricing inefficiencies, prices
may remain in a non-equilibrium state for protracted periods of time example: royal dutch petroleum and shell (twin companies) where the proportion of
value and profit distribution is not the same
13. Following a shock to a firm’s intrinsic value, the share price will slowly but surely approach that new intrinsic value. Is this view
characteristic of a technical analyst or a believer in efficient markets? Explain. (LO 9-3)
this would be a characteristic of the efficient market even if the investors show signs of behavioral, the prices might still be set efficiently arbitragers who
detect mispricing will probably purchase underpriced securities and sell overpriced so profits can be made as prices move toward their intrinsic value
14. Use the data from The Wall Street Journal in Figure 9.7 to verify the trin ratio for the NYSE. Is the trin ratio bullish or bearish? (LO 9-4)
Trin = "Volume Declining/Number Declining " /"Value Advancing/Number Advancing" = "231,468,687/270" /"4,681,742,414/2,787" = 0.5103
This trin ratio, which is below 1.0, would be taken as a bullish signal.
15. Calculate breadth for the NYSE using the data in Figure 9.7. Is the signal bullish or bearish? (LO 9-4)
Breadth:
Advances Declines Net Advancing
2,787 270 2,517
Breadth is positive. This is a bullish signal (although no one would actually use a one-day measure as in this example).
16. Collect data on the DJIA for a period covering a few months. Try to identify primary trends. Can you tell whether the market currently is in
an upward or downward trend? (LO 9-4)
17. Suppose Baa-rated bonds currently yield 7%, while Aa-rated bonds yield 5%. Now suppose that due to an increase in the expected
inflation rate, the yields on both bonds increase by 1%. What would happen to the confidence index? Would this be interpreted as bullish or
bearish by a technical analyst? Does this make sense to you? (LO 9-4)
The confidence index increases from 5%/7% = 0.7143 to 6%/8% = 0.7500.
b.bullish, This indicates slightly higher confidence.
c. But the real reason for the increase in the index is the expectation of higher inflation, not higher confidence about the economy.
18. Turn to Figure 2.8and look at the listing for General Dynamics.
a. What was the firm’s closing price yesterday?
b. How many shares could you buy for $5,000?
c. What would be your annual dividend income from those shares? d. What must be General Dynamics’ earnings per share?
A. 75.6-0.97= 74.63
B. Total AMT/Current price per share= 5000/75.6=66
C. Total number of shares
dividend per share= 66 * 1.88=124.08
D. Share Price/Price P.E= 75.6/10.92= 6.834
19. Consider the three stocks in the following table. Pt represents price at time t, and Qt represents shares outstanding at time t. Stock C
splits two-for-one in the last period.

a. Calculate the rate of return on a price-weighted index of the three stocks for the first period ( t = 0 to t = 1).
At t = 0, the value of the index is: (90 + 50 + 100)/3 = 80
At t = 1, the value of the index is: (95 + 45 + 110)/3 = 83.333
Return = (83.333/80) - 1 = 4.17%
b. What must happen to the divisor for the price-weighted index in year 2?
In the absence of a split, Stock C would sell for 110
So the value of the index would be: 250/3 = 83.333
After the split, Stock C sells for 55.
Therefore, we need to find the divisor (d) such that: 83.333 = (95 + 45 + 55)/d Þ d = 2.340
c. Calculate the rate of return of the price-weighted index for the second period ( t = 1 to t = 2).
The rate of return is zero. The value of the index remains unchanged since the return on each stock separately equals zero.
20. Using the data in the previous problem, calculate the first-period rates of return on the following indexes of the three stocks:
a. A market-value-weighted index
Total market value at t = 0 is: ($9,000 + $10,000 + $20,000) = $39,000
Total market value at t = 1 is: ($9,500 + $9,000 + $22,000) = $40,500
Rate of return = ($40,500/$39,000) – 1 = 3.85%
b. An equally weighted index.
The return on each stock is as follows:
rA = (95/90) – 1 = 0.0556
rB = (45/50) – 1 = –0.10
rC = (110/100) – 1 = 0.10
The equally-weighted average is: [0.0556 + (-0.10) + 0.10]/3 = 0.0185 = 1.85%
21. What problems would confront a mutual fund trying to create an index fund tied to an equally weighted index of a broad stock market?
The fund would require constant readjustment since every change in the price of a stock would bring the fund asset allocation out of balance.
22. What would happen to the divisor of the Dow Jones Industrial Average if FedEx, with a current price of around $95 per share, replaced
AT&T (with a current value of about $31 per share)?
In this case, the value of the divisor will increase by an amount necessary to maintain the index value on the day of the change. For example, if the
index was comprised of only one stock, it would increase by 2.06 points: ($95 - $31) / $31 = 2.06.
23. A T-bill with face value $10,000 and 87 days to maturity is selling at a bank discount ask yield of 3.4%. What is the price of the bill? What
is its bond equivalent yield?
Bank discount of 87 days--> 0.034 × (87/360) = 0.008217
Price--> $10,000 × (1 - 0.008217) = $9,917.83
Bond equivalent yield = (Face value - Purchase Price) / (Purchase price x T) or:
($10,000 - $9,917.83) / ($9,917.83 x (87 days/ 360 days)) = .0348 or 3.48%
24. Which security should sell at a greater price?
a. A 10-year Treasury bond with a 9% coupon rate or a 10-year T-bond with a 10% coupon.
A 10-year T-bond with a 10% coupon.
b. A three-month expiration call option with an exercise price of $40 or a three-month call on the same stock with an exercise price of $35.
A 3-month expiration call option with an exercise price of $35.
c. A put option on a stock selling at $50 or a put option on another stock selling at $60. (All other relevant features of the stocks and options
are assumed to be identical.)
A put option on a stock selling at $50.
25. Look at the futures listings for corn in Figure 2.10 .
a. Suppose you buy one contract for December 2011 delivery. If the contract closes in December at a price of $6.43 per bushel, what will be
your profit or loss? (Each contract calls for delivery of 5,000 bushels.)
your profit / loss on each bushel will be the closing price you receive in December less the futures purchase you contracted for today, multiplied by the
number of bushels per contract
(($6.43 - $6.37) x 5000)
($0.06 x 5000)= $ 300 gain.
b. How many December 2011 maturity contracts are outstanding?
# of outstanding contracts = 6,38
26. Turn back to Figure 2.9 and look at the Apple options. Suppose you buy an August expiration call option with exercise price $355.
a. If the stock price in August is $367, will you exercise your call? What are the profit and rate of return on your position?
Yes. $367 - $355 = $12
$12-$13.7= -$1.7 x 100= -$170 (Loss)
Rate of return = -1.7/13.7= -12.41%
b. What if you had bought the August call with exercise price $360?
Yes. $360 - $355 = $5
Net loss of $415
Rate of return = -37.22%
c. What if you had bought an August put with exercise price $355?
No. RR = -100%
27. What options position is associated with:
a. The right to buy an asset at a specified price?
Long call
b. The right to sell an asset at a specified price?
Long put
c. The obligation to buy an asset at a specified price?
Short put
d. The obligation to sell an asset at a specified price?
Short call
28. Why do call options with exercise prices higher than the price of the underlying stock sell for positive prices?
On speculative ( extrinsic ) value. It's based on the probability that the stock price may rise by the time the option expires.
iv. Intermediate
29. Both a call and a put currently are traded on stock XYZ; both have strike prices of $50 and maturities of six months. What will be the profit
to an investor who buys the call for $4 in the following scenarios for stock prices in six months? ( a) $40; ( b) $45; ( c) $50; ( d) $55; ( e) $60.
What will be the profit in each scenario to an investor who buys the put for $6?
Call option is the right to buy a specified security for a specified price on a future date.
Put option is the right to sell a specified security for a specified price on a future date.
Call option is exercised when the market price is higher than the strike price.
Put option is exercised when the strike price is higher than the market price.
Call Option
Stock price Exercised? Profit/Loss

a. 40 No -4

b. 45 No -4

c. 50 Indifferent -4
 d. 55 Yes 1 (55-50=5; 5-4=1)

e. 60 Yes 6 (60-50=10; 10-4=6)

Put Option
Stock price Exercised? Profit/Loss

a. 40 Yes 4 (50-40=10; 10-6=4)

b. 45 Yes -1

c. 50 Indifferent -6

d. 55 No -6

e. 60 No -6

30. What would you expect to happen to the spread between yields on commercial paper and Treasury bills if the economy were to enter a
steep recession?
The spread will widen because commercial paper is riskier, so the rate of return will increase. Spreads between risky commercial paper and risk-free
government securities (Treasury bills) will widen. Increases chances of default in commercial paper - makes them more risky in general. Hence
investors demand greater premium on them.
31. Examine the stocks listed in Figure 2.8 . For how many of these stocks is the 52-week high price at least 50% greater than the 52-week low
price? What do you conclude about the volatility of prices on individual stocks?

32. Find the after-tax return to a corporation that buys a share of preferred stock at $40, sells it at year-end at $40, and receives a $4 year-end
dividend. The firm is in the 30% tax bracket.
The total before-tax income is $4.
The corporations may exclude 70% of dividends received from domestic corporations in the computation of their taxable income; the taxable income is
therefore: $4 × 30% = $1.20.
Income tax in the 30% tax bracket: $1.2 × 30% = $0.36
After-tax income = $4 - $0.36 = $3.64
After-tax rate of return = $3.64/$40 = 0.091 or 9.10%
The total before-tax income = Dividend received = $4.
After the 70% exclusion for preferred stock dividends, The taxable income = 0.30 × $4= $1.20.
Thus, Taxes = 0.30 × $1.20= $0.36.
Therefore, The After-tax income = $4.00 - $0.36= $3.64.
Hence, Rate of return = [ After-tax income ÷ Buying cost ] × 100%=
[ $3.64 $40.00 ] × 100%= 9.10%.
________________________________________________________________________________________________________________
CHAPTER 4
I. Learning objectives
LO4-1 Cite advantages and disadvantages of investing with an investment company rather than buying securities directly.
Investment companies are financial intermediaries that collect funds from individual investors and invest those funds in a potentially wide range of
securities or other assets. Pooling of assets is the key idea behind investment companies.
Investment companies perform several important functions for their investors:
1. Record keeping and administration. Investment companies issue periodic status reports, keeping track of capital gains distributions, dividends,
investments, and redemptions, and they may reinvest dividend and interest income for shareholders.
2. Diversification and divisibility. By pooling their money, investment companies enable investors to hold fractional shares of many different securities.
They can act as large investors even if any individual shareholder cannot.
3. Professional management. Investment companies can support full-time staffs of security analysts and portfolio managers who attempt to achieve
superior investment results for their investors.
4. Lower transaction costs. Because they trade large blocks of securities, investment companies can achieve substantial savings on brokerage fees and
commissions.

LO4-2 Contrast open-end mutual funds with closed-end funds, unit investment trusts, hedge funds, and exchange-traded funds.

How Funds And UITs Differ

Both mutual funds and UITs are designed to be long-term investments. However, most UITs have a termination or maturity date, whereas mutual funds
typically exist in perpetuity.
Mutual funds can be more liquid than UITs, since you can always sell your mutual fund shares back to the issuing company. Some UIT companies may
honor redemption requests, but you may have to find other investors willing to buy your units from you in the event you want to liquidate.
UITs often invest thematically, with static portfolios backing up that investment thesis. Mutual funds are more likely to be actively managed, with
investment professionals always on the lookout for opportunities.
Hedge Funds vs. Mutual Funds: Similarities and Differences
There are a number of similarities between the two types of funds:
 Both hedge funds and mutual funds are pooled investment vehicles that invest the money of a number of investors in one portfolio.
 Both hedge fund and mutual funds provide investors with a degree of diversification in terms of holding multiple securities aligned with the fund’s
objective, versus just holding one or a few securities. The degree of diversification will vary widely among funds. Some mutual funds and hedge
funds may be highly concentrated in a single sector or they may hold a concentrated position in just a few securities. Mutual funds will often be
focused on a single market sector or asset class, hedge funds will often spread their holding over a number of sectors.
 Both mutual funds and hedge funds are professionally managed, the managers pick the securities to be held in the fund. Hedge funds are
generally actively managed, meaning the manager buys and sells securities based on their analysis, market outlook and other factors. Some
mutual funds are actively managed, others are passively managed, focusing on tracking an index. In the case of an index mutual fund, the
managers still oversee the fund to ensure that its portfolio tracks the index, making periodic adjustments to keep the portfolio in line.
 Both mutual funds and hedge funds have underlying expenses that investors need to be aware of. In the case of mutual funds there is an expense
ratio, in some cases there may also be up-front or back-end sales charges as well. In the case of a hedge fund there is typically an annual
management fee plus a performance fee if certain objectives are met. The fees on hedge funds can often be quite steep. With both types of funds
it's important for investors to understand the costs and weigh them against both the potential returns and other funds and investments they might
be considering.
Some differences between hedge funds and mutual funds include:
 Mutual funds are readily available to most investors, hedge funds are restricted to accredited investors. Additionally, there are other barriers to
entry with hedge funds, such as generally higher minimum initial investments than with mutual funds. By contrast many mutual funds have very low
minimum investment requirements, some as low as $100. This will vary by the share class of the mutual fund and other factors.
 Mutual fund performance will often be highly correlated to the market benchmark or index that corresponds to its stated investment objective. For
an index fund, this correlation should be quite high. It will vary a bit for actively managed funds. For hedge funds, part of the appeal is the fact that
their strategy may not be highly correlated to the broad market. They should hold up better in a down market and may lag in an up market.
 Liquidity is a very different between hedge funds and mutual funds. With a mutual fund investors can sell shares one day and the sale will go
trough at the close of trading that day as long as they have their trade in by the deadline for the fund. Hedge funds often restrict the ability of
investors to access their money to set periods during the year. There may also be an initial lockup period of one year or more.
LO4-3 Define net asset value and measure the rate of return on a mutual fund.
Investors buy shares in investment com- panies, and ownership is proportional to the number of shares purchased. The value of each share is called
the net asset value, or NAV. Net asset value equals assets minus liabilities expressed on a per-share basis:
Net asset value =(Market value of assets minus liabilities)/Shares outstanding.
The rate of return on an investment in a mutual fund is measured as the increase or decrease in net asset value plus income distributions such as
dividends or distributions of capital gains expressed as a fraction of net asset value at the beginning of the investment period. If we denote the net asset
value at the start and end of the period as NAV 0 and NAV 1 , respectively, then
Rate of return = (NAV1- NAV0+ Income and capital gain distributions)/ NAV0
LO4-4 Classify mutual funds according to investment style.
Money market funds. These funds invest in money market securities such as com-mercial paper, repurchase agreements, or certificates of deposit.
Equity funds. Equity funds invest primarily in stock, although they may, at the portfolio manager’s discretion, also hold fixed-income or other types of
securities.
Specialized sector funds. Some equity funds, called sector funds, concentrate on a particular industry. For example, Fidelity markets dozens of
“select funds,” each of which invests in a specific industry such as biotechnology, utilities, precious metals, or telecommuni- cations. Other funds
specialize in securities of particular countries.
Bond funds. As the name suggests, these funds specialize in the fixed-income sector.
International funds. Global funds invest in securities worldwide, including the United States. In contrast, international funds invest in securities of
firms located outside the U.S.
Balanced funds. Some funds are designed to be candidates for an individual’s entire investment portfolio. These balanced funds hold both equities
and fixed-income securities in relatively stable proportions.
Asset allocation and flexible funds. These funds are similar to balanced funds in that they hold both stocks and bonds. However, asset allocation
funds may dramatically vary the proportions allocated to each market in accord with the portfolio manager’s forecast of the relative performance of each
sector.
Index funds. An index fund tries to match the performance of a broad market index. The fund buys shares in securities included in a particular index in
proportion to the security’s representation in that index.
LO4-5 Demonstrate the impact of expenses and turnover on mutual fund investment performance.
There are many fees and expenses for mutual funds and each one affects the performance of mutual funds by subtracting an expense ratio from the
rate of return. Some of the most common expenses are
front-end load, back-end load, and 12b-1 fees. Many mutual funds provide options of different classes of funds that charge different rates for each of
these fees.Front-end load subtracts a sales charge prior to the purchase of shares. The front-end load is only paid on new dollars into the fund.
Back-end funds have a redemption fee when the shares are cashed out.
A fund with a high portfolio turnover rate can be particularly “tax inefficient.” Turnover is the ratio of the trading activity of a portfolio to the assets of
the portfolio. It measures the fraction of the portfolio that is “replaced” each year. For example, a $100 million portfolio with $50 million in sales of some
securities and purchases of other securities would have a turnover rate of 50%. High turnover means that capital gains or losses are being realized
constantly, and therefore that the investor cannot time the realizations to manage his or her overall tax obliga- tion. Turnover rates in equity funds in the
last decade have typically been around 60% when weighted by assets under management. By contrast, a low-turnover fund such as an index fund may
have turnover as low as 2%, which is both tax-efficient and economical with respect to trading costs.
II. Key Terms
investment companies. Financial intermediaries that invest the funds of individual investors in securities or other assets.
net asset value (NAV). Assets minus liabilities expressed on a per-share basis.
unit investment trusts. Money pooled from many investors that is invested in a portfolio fixed for the life of the fund.
open-end fund. A fund that issues or redeems its shares at net asset value.
closed-end fund. Shares may not be redeemed, but instead are traded at prices that can differ from net asset value.
load. A sales commission charged on a mutual fund.
hedge fund. A private investment pool, open to wealthy or institutional investors, that is exempt from SEC regulation and can therefore pursue more
speculative policies than mutual funds.
funds of funds. Mutual funds that primarily invest in shares of other mutual funds.
12b-1 fees. Annual fees charged by a mutual fund to pay for marketing and distribution costs.
soft dollars. The value of research services that brokerage houses provide “free of charge” in exchange for the investment manager’s business.
turnover. The ratio of the trading activity of a portfolio to the assets of the portfolio.
exchange-traded funds. Offshoots of mutual funds that allow investors to trade index portfolios.
III. Problems set (Q for review)
1. What are the benefits to small investors of investing via mutual funds? What are the costs?
Mutual funds offer many benefits. Some of those benefits include: the ability to invest with small amounts of money, diversification, professional
management, low transaction costs, tax benefits, and the ability to reduce administrative functions.
The costs associated with investing in mutual funds are generally operating expenses, marketing, distribution charges, and loads. Loads are fees paid
when investors purchase or sell the shares.
2. Why can closed-end funds sell at prices that differ from net value while open-end funds do not?
Close-end funds trade on the open market and are thus subject to market pricing.
Open-end funds are sold by the mutual fund and must reflect the NAV of the investments.
Close-end funds are sold at IPO and are sold at a specified number of shares, open end funds are essentially mutual funds and there is no limit to the
number of shares they can sell; closed-end fund price differ from NAV because they are sold in the primary and secondary market and are
nonredeemable while open end funds are sold at NAV.
3. What is a 12b-1 fee?
12b-1 fees are annual fees charged by a mutual fund to pay for marketing and distribution costs.
The Securities and Exchange Commission allows the managers of so called 12b-1 funds to use fund assets to pay for distribution costs such as
advertising, promotional literature including annual reports and prospectuses, and, most important, commissions paid to brokers who sell the fund to
investors.
4. What are some differences between a unit investment trust and a closed-end fund?
A unit investment trust is an unmanaged mutual fund. Its portfolio is fixed and does not change due to asset trades, as does a closed-end fund.
Investors who wish to liquidate their holdings of a unit investment trust may sell the shares back to the trustee for net asset value, while a closed-end
fund is traded on the open market.
A close end fund has a set number of shares issued as an IPO and is sold by/managed by an investment advisor while a unit investment trust is sold by
a company without management, it is held in place by a contract and held until maturity.
5. What are the advantages and disadvantages of exchange-traded funds versus mutual funds?
Exchange-traded funds can be traded during the day, just as the stocks they represent. They are most tax effective, in that they do not have as many
distributions. They have much lower transaction costs. They also do not require load charges, management fees, and minimum investment amounts.
The disadvantage is that ETFs must be purchased from brokers for a fee. Moreover, investors may incur a bid-ask spread when purchasing an ETF.
Exchange-traded funds can be traded during the day, just as the stocks they represent.
Advantages:
(a)They are most tax effective, in that they do not have as many distributions.
(b)They have much lower transaction costs.
(c) Do not require load charges, management fees, and minimum investment amounts.
The disadvantage:
Is that ETFs must be purchased from brokers for a fee. Moreover, investors may incur a bid-ask spread when purchasing an ETF.
Exchange traded funds:
A: low cost, tax saving, easily liquid, no minimum on investment cost
D: higher trading cost, broker fees, discrepancies btwn expected trading cost and actual, dividends carried forward for ETF
Mutual funds:
A: no commission fees, dividend reinvestment option, organized by class of security
D: other fees attached, high minimums, slow movement
6. What are some differences between hedge funds and mutual funds? (LO 4-2)
Hedge funds have much less regulation since they are part of private partnerships and free from most SEC regulation. They permit investors to take on
many risks unavailable to mutual funds. Hedge funds, however, may require higher fees and provide less transparency to investors. This offers
significant counter party risk and hedge fund investors need to be more careful about the firm they invest with.
7. Would you expect a typical open-end fixed-income mutual fund to have higher or lower operating expenses than a fixed-income unit
investment trust? Why? (LO 4-2)
An open-end fund will have higher fees since they are actively marketing and managing their investor base. The fund is always looking for new investors
A unit investment trust need not spend too much time on such matters since investors find each other.
8. Balanced funds and asset allocation funds invest in both the stock and bond markets. What is the difference between these types of
funds? (LO 4-4)
Asset allocation funds may dramatically vary the proportions allocated to each market in accord with the portfolio manager's forecast of the relative
performance of each sector. Hence, these funds are engaged in market timing and are not designed to be low-risk investment vehicles.
9. What are some comparative advantages of investing your assets in the following: (LO 4-2)
a. Unit investment trusts.
A unit investment trust offers low costs and stable portfolios. Since they do not change their portfolios, investors know exactly what they own. They are
better suited to sophisticated investors.
b. Open-end mutual funds.
Open-end mutual funds offer higher levels of service to investors. The investors do not have any administrative burdens and their money is actively
managed. These are better suited for less knowledgeable investors.
c. Individual stocks and bonds that you choose for yourself.
Individual securities offer the most sophisticated investors ultimate flexibility. Investors are able to save money since they are only charged the
expenses they incur. All decisions are under the control of the investor
10. Open-end equity mutual funds find it necessary to keep a significant percentage of total investments, typically around 5% of the
portfolio, in very liquid money market assets. Closed-end funds do not have to maintain such a position in “cash-equivalent” securi- ties.
What difference between open-end and closed-end funds might account for their differing policies?
Open-end funds are obligated to redeem investor's shares at net asset value (NAV), and thus must keep cash or cash-equivalent securities on hand in
order to meet potential redemptions. Closed-end funds do not need the cash reserves because there are no redemptions for closed-end funds.
Investors in closed-end funds have to sell their shares to other investors when they wish to cash out.
Intermediate
11. An open-end fund has a net asset value of $10.70 per share. It is sold with a front-end load of 6%. What is the offering price?
Offering price= NAV / (1-load)
NAV= 10.70
Load= 6%
10.70 / (1-0.06)= 11.38
12. If the offering price of an open-end fund is $12.30 per share and the fund is sold with a front-end load of 5%, what is its net asset value?
offering price= NAV / (1-load)
12.30=NAV / (1-0.05)
12.30=NAV / (0.95)
12.30 x 0.95 = NAV
NAV= 11.69
13. The composition of the Fingroup Fund portfolio is as follows:

The fund has not borrowed any funds, but its accrued management fee with the portfolio manager currently totals $30,000. There are 4
million shares outstanding. What is the net asset value of the fund?

NAV= market value of assets - liabilities / shares outstanding

(35 x 200,000 + 40 x 300,000 + 20 x 400,000 + 25 x 600,000) = Total market value
TMV = 42,000,000
liabilities/fees= 30,000
shares outstanding= 4,000,000
NAV= (42,000,000 - 30,000) / (4,000,000)
NAV= 10.49
14. Reconsider the Fingroup Fund in the previous problem. If during the year the portfolio manager sells all of the holdings of stock D and
replaces it with 200,000 shares of stock E at $50 per share and 200,000 shares of stock F at $25 per share, what is the portfolio turnover rate?
Turnover rate = (dollar amount add or replaced / portfolio analysis)
dollar amount add or replaced= whichever is less
portfolio analysis= (200,000 x 35 + 300,000 x 40 + 400,000 x 20 + 600,000 x 25)
portfolio analysis = 42,000,000
stock d: 600,000 x 25 = $15 million
stock ef: 200,000 x 50 + 200,000 x 25= $15 million
*whichever is less+
turnover rate = $15,000,000 / $42,000,000
turnover rate = 35.71

15. The Closed Fund is a closed-end investment company with a portfolio currently worth $200 million. It has liabilities of $3 million and 5
million shares outstanding.
a. What is the NAV of the fund?
b. If the fund sells for $36 per share, what is its premium or discount as a percent of NAV?

NAV = (Market value of assets - market value of liabilities) / shares outstanding

Premium = (Price - NAV) / NAV
16. Corporate Fund started the year with a net asset value of $12.50. By year-end, its NAV equaled $12.10. The fund paid year-end
distributions of income and capital gains of $1.50. What was the rate of return to an investor in the fund?

17. A closed-end fund starts the year with a net asset value of $12. By year-end, NAV equals $12.10. At the beginning of the year, the fund is
selling at a 2% premium to NAV. By the end of the year, the fund is selling at a 7% discount to NAV. The fund paid year-end distributions of
income and capital gains of $1.50.
a. What is the rate of return to an investor in the fund during the year?
b. What would have been the rate of return to an investor who held the same securities as the fund manager during the year?

18. Loaded-Up Fund charges a 12b-1 fee of 1% and maintains an expense ratio of .75%. Economy Fund charges a front-end load of 2%, but
has no 12b-1 fee and an expense ratio of .25%. Assume the rate of return on both funds’ portfolios (before any fees) is 6% per year. How
much will an investment in each fund grow to after:
a. 1 year?
b. 3 years?
c. 10 years?
 19. City Street Fund has a portfolio of $450 million and liabilities of $10 million. (LO 4-3)
a. If there are 44 million shares outstanding, what is net asset value?
Net asset value= (450 mill-10mill)/44mill=$10
b. If a large investor redeems 1 million shares, what happens to the portfolio value, to shares outstanding, and to NAV?
Portfolio value decreases correct to $ 440 million
Shares outstanding decreases to $ 43 million
Net asset value $ 10
20. a. Impressive Fund had excellent investment performance last year, with portfolio returns that placed it in the top 10% of all funds
with the same investment policy. Do you expect it to be a top performer next year? Why or why not?
Empirical research indicates that past performance of mutual funds is not highly predictive of future performance, especially for better-performing funds.
While there may be some tendency for the fund to be an above average performer next year, it is unlikely to once again be a top 10% performer.
b. Suppose instead that the fund was among the poorest performers in its comparison group. Would you be more or less likely to believe its
relative performance will persist into the following year? Why?
On the other hand, the evidence is more suggestive of a tendency for poor performance to persist. This tendency is probably related to fund costs and
turnover rates. Thus if the fund is among the poorest performers, investors would be concerned that the poor performance will persist.
(LO 4-5) 21. Consider a mutual fund with $200 million in assets at the start of the year and with 10 million shares outstanding. The fund
invests in a portfolio of stocks that provides dividend income at the end of the year of $2 million. The stocks included in the fund’s portfolio
increase in price by 8%, but no securities are sold, and there are no capital gains distributions. The fund charges 12b-1 fees of 1%, which are
deducted from portfolio assets at year-end. What is net asset value at the start and end of the year? What is the rate of return for an investor
in the fund? (LO 4-3)
Start of year NAV = $20
Dividends per share = $0.20
End of year NAV is based on the 8% price gain, less the 1% 12b-1 fee:
End of year NAV = $20 *1.08* (1 – 0.01) = $21.384
Rate of return = ($20-$21.384+$20) /$0.20 = 0.0792 = 7.92%
22. The New Fund had average daily assets of $2.2 billion in the past year. The fund sold $400 million and purchased $500 million worth of
stock during the year. What was its turnover ratio? (LO 4-5)
The excess of purchases over sales must be due to new inflows into the fund. Therefore, $400 million of stock previously held by the fund was replaced
by new holdings. So turnover is: $400/$2,200 = 0.182 = 18.2%
23. If New Fund’s expense ratio was 1.1% and the management fee was .7%, what were the total fees paid to the fund’s investment
managers during the year? What were the other administrative expenses? (LO 4-5)
Fees paid to investment managers were: 0.007* $2.2 billion = $15.4 million Since the total expense ratio was 1.1% and the management fee was 0.7%,
we conclude that 0.4% must be for other expenses. Therefore, other administrative expenses were: 0.004 *$2.2 billion = $8.8 million.
24. You purchased 1,000 shares of the New Fund at a price of $20 per share at the begin- ning of the year. You paid a front-end load of 4%.
The securities in which the fund invests increase in value by 12% during the year. The fund’s expense ratio is 1.2%. What is your rate of
return on the fund if you sell your shares at the end of the year? (LO 4-5)
As an initial approximation, your return equals the return on the shares minus the total of the expense ratio and purchase costs: 12% 1.2% 4% = 6.8%
But the precise return is less than this because the 4% load is paid up front, not at the end of the year. To purchase the shares, you would have had to
invest: $20,000/(1 0.04) = $20,833 The shares increase in value from $20,000 to: $20,000 (1.12 0.012) = $22,160 The rate of return is: ($22,160
$20,833)/$20,833 = 6.37%
25. The Investments Fund sells Class A shares with a front-end load of 6% and Class B shares with 12b-1 fees of .5% annually as well as
back-end load fees that start at 5% and fall by 1% for each full year the investor holds the portfolio (until the fifth year). Assume the portfolio
rate of return net of operating expenses is 10% annually. If you plan to sell the fund after four years, are Class A or Class B shares the better
choice for you? What if you plan to sell after 15 years? (LO 4-5)
Suppose you have $1000 to invest. The initial investment in Class A shares is $940 net of the front-end load. After 4 years, your portfolio will be worth:
$940 *(1.10)4 = $1,376.25
Class B shares allow you to invest the full $1,000, but your investment performance net of 12b-1 fees will be only 9.5%, and you will pay a 1% back-end
load fee if you sell after 4 years. Your portfolio value after 4 years will be:
$1,000*(1.095)4 = $1,437.66
After paying the back-end load fee, your portfolio value will be:
$1,437.66 *0.99 = $1,423.28
Class B shares are the better choice if your horizon is 4 years. With a 15-year horizon, the Class A shares will be worth:
$940 * (1.10)15 = $3,926.61
For the Class B shares, there is no back-end load in this case since the horizon is greater than 5 years. Therefore, the value of the Class B shares will
be:
$1,000 * (1.095)15 = $3,901.32
At this longer horizon, Class B shares are no longer the better choice. The effect of Class B's 0.5% 12b-1 fees cumulates over time and finally
overwhelms the 6% load charged to Class A investors.
26. You are considering an investment in a mutual fund with a 4% load and an expense ratio of .5%. You can invest instead in a bank CD
paying 6% interest. (LO 4-5)
a. If you plan to invest for two years, what annual rate of return must the fund portfolio earn for you to be better off in the fund than in the
CD? Assume annual compounding of returns.
After two years, each dollar invested in a fund with a 4% load and a portfolio return equal to r will grow to:
$0.96 * (1 + r – 0.005)^2
Each dollar invested in the bank CD will grow to:
$1 * (1.06)^2
If the mutual fund is to be the better investment, then the portfolio return, r, must satisfy:
0.96 *(1 + r – 0.005)^2 > (1.06)^2
0.96 * (1 + r – 0.005)^2 > 1.1236
(1 + r – 0.005)^2 > 1.1704
1 + r – 0.005 > 1.0819
1 + r > 1.0869
Therefore, r > 0.0869 = 8.69%
b. How does your answer change if you plan to invest for six years? Why does your answer change?
If you invest for six years, then the portfolio return must satisfy:
0.96 * (1 + r – 0.005)^6 > (1.06)^6 = 1.4185
(1 + r – 0.005)^6 > 1.4776
1 + r – 0.005 > 1.0672
1 + r > 1.0722
r > 7.22%
The cutoff rate of return is lower for the six year investment because the "fixed cost" (i.e., the one-time front-end load) is spread out over a greater
number of years.
c. Now suppose that instead of a front-end load the fund assesses a 12b-1 fee of .75% per year. What annual rate of return must the fund
portfolio earn for you to be better off in the fund than in the CD? Does your answer in this case depend on your time horizon?
With a 12b-1 fee instead of a front-end load, the portfolio must earn a rate of return (r) that satisfies:
1 + r – 0.005 – 0.0075 > 1.06
In this case, r must exceed 7.25% regardless of the investment horizon
27. Suppose that every time a fund manager trades stock, transaction costs such as commissions and bid–ask spreads amount to .4% of the
value of the trade. If the portfolio turn- over rate is 50%, by how much is the total return of the portfolio reduced by trading costs? (LO 4-5)
The turnover rate is 50%. This means that, on average, 50% of the portfolio is sold and replaced with other securities each year. Trading costs on the
sell orders are 0.4%; and the buy orders to replace those securities entail another 0.4% in trading costs. Total trading costs will reduce portfolio returns
by: 2 * 0.4% * 0.50 = 0.4%
28. You expect a tax-free municipal bond portfolio to provide a rate of return of 4%. Man- agement fees of the fund are .6%. What
fraction of portfolio income is given up to fees? If the management fees for an equity fund also are .6%, but you expect a portfolio return of
12%, what fraction of portfolio income is given up to fees? Why might management fees be a bigger factor in your investment decision for
bond funds than for stock funds? Can your conclusion help explain why unmanaged unit investment trusts tend to focus on the fixed-income
market? (LO 4-4)
For the bond fund, the fraction of portfolio income given up to fees is:
4.0% /0.6% = 0.150 = 15.0%
For the equity fund, the fraction of investment earnings given up to fees is:
12.0% /0.6% = 0.050 = 5.0%
Fees are a much higher fraction of expected earnings for the bond fund, and therefore may be a more important factor in selecting the bond fund.
This may help to explain why unmanaged unit investment trusts are concentrated in the fixed income market. The advantages of unit investment trusts
are low turnover and low trading costs and management fees. This is a more important concern to bond-market investors.
29. Why would it be challenging to properly compare the performance of an equity fund to a fixed-income mutual fund?
Equity funds and fixed-income funds contain different types of securities.
(a) Equity funds invest primarily in the common stock of publically traded firms.
(a) Fixed-income funds invest in corporate bonds, Treasury bonds, mortgage-backed securities, or municipal (tax-free) bonds.
The risks associated with stocks are primarily related to economic conditions and the success of the business operations. The risks associated with
fixed-income securities are primarily interest rate risk and credit risk.