Investments

Solutions Manual

Ravi Shukla

Finance Department School of Management Syracuse University

c 1995, Ravi Shukla.

A Typeset in TEX and L TEX 2 .

To the Students
This manual provides solutions to the end-of-the-chapter-exercises in Investments. While I have made every eort to correct any errors in the solutions, some may still exist. I will reward your eort in bringing any remaining errors to my attention by buying you a soft drink of your choice! While reading the solutions, keep in mind that the calculations were done using full precision. For printing purposes, however, only a few decimal places have been shown. Therefore, it is possible, that your answers using the printed numbers may dier from those shown in the solutions manual. I should not need to stress the importance of doing the problems yourself before looking at the solutions. You should at least formulate a mental picture as to how you would solve the problem before you peek at the solution.

August 16, 1995

Ravi Shukla

ii

Chapter 1

Securities Markets
1.1 Return Rebecca made a prot of $2,000 on her investment of $98,000 over three months. Her return, therefore, was 2,000/98,000 = 0.0204 or 2.04% per quarter. Return Johns initial investment was 100 $24.50 = $2,450. The nal value of his investment was 100 $27.75 = $2,775. He made a prot of $2,775 $2,450 = $325. His return, therefore, was 325/2,450 = 0.1327 or 13.27% per year. Round and Odd Lots The receipts from the trade will be the selling price minus the commissions. The selling price is 375 $2.75 = $1,031.25. The commission on the three round lots is 3 $12 = $36, and on the 75 shares sold in odd lot is 75$0.15 = $11.25. The net proceeds to Mr. Williams, therefore, will be $1,031.25$36$11.25 = $984. 1.4 Transaction Costs and Return 1.3 1.2

(a) The cash outow was 200 13.25 (1 + 0.02) = $2,703. (b) The cash inow was 200 15.50 (1 0.02) = $3,038. (c) The monthly rate of return was r = ($3,038 $2,703)/$2,703 = 0.1239 = 12.39%. 1.5 Round Trip Transaction Cost The shares were purchased at 47 1/2. Alice had to send in 100 $47.50 = $4,750. The shares were sold at 47 1/4. The proceeds were 100 47.25 = $4,725. The round trip transaction cost was $4,750 $4,725 = $25. This cost arose from the bid-ask spread. The money went to the trader or the specialist who made the market in Kodak. With 2% commission, there would be the extra cost of 0.02 $4,750 = $95 while buying the shares, and 0.02 $4,725 = $94.50 while selling the shares. The round trip cost, therefore, would be $25 + $95 + $94.50 = $214.50. 1.6 Long and Short

(a) The maximum prot you can make is because the share price can keep rising without any limit. Your maximum possible loss is $30 per share because it is possible for the share price to come down to zero. The maximum and the minimum returns corresponding to these prots and losses are and 100%.

(b) Your friend will prot when the share price goes down and lose when the share price goes up. Therefore, her maximum and minimum prots and returns will be mirror images of yours, i.e., maximum loss of and maximum prot of $30. The corresponding returns are and +100%. 1.7 Short Interest

(a) Ramones short interest is zero because he hasnt sold any shares short. (b) Sheilas net position is 100 shares long on Kodak. Therefore, her short interest is zero. (c) The two positions taken by Andrew cancel each other out. His short interest in AT&T is zero. (d) Brenda has a net short position of 300 shares on Sears. So her short interest is 300 shares of Sears. (e) Glens short interest is 300 shares of McDonalds. (f) Susan is short on McDonalds. Therefore, her short interest is 500 shares of McDonalds. 1.8 Shorting Against the Box The opening transaction on 3/15/88 resulted in a cash outow of $19 per share. On 8/30/88, Gorba borrowed his friends shares and gave his own shares of Purex to his friend as collateral. Then Gorba sold his friends shares. Therefore, there was a cash inow of $35 per share and a net prot of $16 per share. On 1/1/89, there would be no cashow regardless of the price because Gorba would use his 500 shares kept with his friend as collateral to return the shares he borrowed. 1.9 Margin Accounts

(a) The market value of shares was 500 $40 = $20,000. Since she borrowed as much as she could for the opening transaction, her loan was (1 0.60) $20,000 = $8,000. The equity, therefore, was $12,000. Therefore, the account position was: Assets ($) Mkt. Val. of Shares Total Liabilities and Equity ($) Loan 8,000 Equity 12,000 Total 20,000

20,000 20,000

(b) Suppose the stock price at which she receives the margin call is P . The market value of securities at that price is 500P . The loan has not been changed and it stays at $8,000, and therefore the equity is 500P $8,000. For margin call: 0.40 = 500P $8, 000 Equity = Mkt. Val. of securities 500P

which gives P = $26.67. Therefore, the margin call will go out at the price of $26.67. (c) At the price of $20, the market value of securities is $10,000. The loan is unchanged at $8,000 and therefore the equity is $2,000. The account position is: Assets ($) Mkt. Val. of Shares Total Liabilities and Equity ($) Loan 8,000 Equity 2,000 Total 10,000

10,000 10,000 2

The margin, therefore, is 20%, which is below the maintenance level requirement. Suppose Ms. Miller should add C in cash to the account then the new value of equity would be $2,000 + C . To make the account current, C must be such that: 0.60 = $2,000 + C $10,000

which gives C = 4,000. Therefore, $4,000 should be added to the account to make it current. (d) Let us say the AE has to sell n shares, then 500 n shares remain in the account. The cash created by selling the shares will be kept in the account. The market value of shares is (500 n) $20. The loan is still $8,000 and the equity is $2,000. To restore the account to initial margin: 0.60 = 2000 (500 n) 20

which gives n = 333.33. Since fractional number of shares cant be sold, the AE will sell 334 shares and leave 166 shares in the account to keep the account above the initial margin level. 1.10 Margin Accounts

(a) The positions of his account after the initial sale and before liquidation are: After the Initial Sale Assets ($) Liabilities and Equity ($) Mkt. Val. of Shares 9,000 Loan 3,600 Equity 5,400 Total 9,000 Total 9,000

Before Liquidation Assets ($) Liabilities and Equity ( Mkt. Val. of Shares 10,000 Loan 3,6 Equity 6,4 Total 10,000 Total 10,0

(b) The gross prot is $1,000. The net prot must consider the interest payment on the loan of $3,600. The interest amount is 0.11 $3,600 = $396. The net prot, therefore, is $1,000 $396 = $604. The rate of return is 604/5,400 = 0.11185 or 11.185% per year. (c) Suppose the margin call would have gone out at the price of P . The account would have looked as follows: Assets ($) Liabilities and Equity ($) Mkt. Val. of Shares 500P Loan 3,600 Equity 500P 3,600 Total Total 500P 500P (d) The margin call price, therefore, can be determined as: 0.40 = 500P $3,600 500P P = $12

(e) The margin call, therefore, would have gone out at $12.

1.11

Margin Accounts

(a) The shares were purchased at 24 1/2 or $24.50. The total value of the shares was $2,450. Kate needed equity worth 0.75 $2,450 = $1,837.50 in the account. The remaining $612.50 was advanced as loan to her. She also paid 0.03 $2,450 = $73.50 in commissions. The total cash outow, therefore, was $1,837.50 + $73.50 = $1,911. (b) The sell order was executed at $27. The gross proceeds were $2,700. The commission of 0.03 $2,700 = $81 were deducted from this amount leaving $2,619. The loan amount due was the principal of $612.50 plus the interest $612.50 0.092 = $56.35, i.e., a total of $668.85. This means that Kate received a check for $2,619 $668.85 = $1,950.15. (c) Kate realized a net prot of $1,950.15 $1,911 = 39.15. Her return, therefore, was $39.15/$1,911 = 0.0205 or 2.05% per year. 1.12 Margin Accounts

(a) The buy order was lled at 12 3/8. Since Dr. Lecter paid 90% cash, and borrowed only 10%, the account position was: Assets ($) Liabilities and Equity ($) Mkt. Val. of Shares 6,187.50 Loan 618.75 Equity 5,568.75 Total 6,187.50 Total 6,187.50 (b) Suppose the margin call will go out at the price of P per share, then the account position at the time of margin call will be: Assets ($) Mkt. Val. of Shares Total For margin call: Liabilities and Equity ($) Loan 618.75 Equity 500P 618.75 Total 500P

500P 500P

500P 618.75 500P which gives P = 2.0625. Therefore, the margin call will go out when the price drops to $2.0625 per share (or below). 0.40 = (c) The only way the shares can be converted to cash is by selling. Therefore, it is the bid price at which the shares are recorded. (Note that we should have done this in part a also.) Assets ($) Mkt. Val. of Shares Total Liabilities and Equity ($) Loan 618.75 Equity 6,506.25 Total 7,125.00

7,125.00 7,125.00

The margin, therefore, is 6,506.25/7,125=0.913 or 91.3%.

1.13

Short Selling and Margin

(a) The $1,200 generated by short selling were kept as deposit in the account. Freddie was required to deposit cash equal to 70% of the market value of shares, i.e., 0.70 $1,200 = $840. The account position after this transaction was: Assets ($) Cash 840 Deposit 1,200 Total 2,040 Liabilities and Equity ($) Mkt. Val. of Shares 1,200 Equity 840 Total 2,040

(b) Suppose the margin call will go out at P . The account position when margin call goes out is: Assets ($) Cash 2,040 100P Deposit 100P Total 2,040 For margin call: Liabilities and Equity ($) Mkt. Val. of Shares 100P Equity 2,040 100P Total 2,040

2040 100P 100P which gives P = 14.57. At this time, the cash balance is 2,040 100($14.57) = $583. 0.40 = (c) The two choices available to Freddie are Add some cash to the account. Buy back and replace some shares. (d) Let us consider them one at a time: Suppose Freddie adds C in cash. Then the account position would be: Assets ($) Cash 583 + C Deposit 1,457 Total 2,040 + C For the account to be current: 0.70 = Liabilities and Equity ($) Mkt. Val. of Shares 1,457 Equity 583 + C Total 2,040 + C 583 + C 1,457

which gives C = 436.90. Therefore, Freddie would have to add $436.90 in cash. The account position after the cash has been added would be: Assets ($) Cash 1,019.90 Deposit 1,457 Total 2,476.90 Liabilities and Equity ($) Mkt. Val. of Shares 1,457 Equity 1,019.90 Total 2,476.90

 Suppose Freddie buys back n shares and return them. Then the account position would be: Assets ($) Cash 583 Deposit 14.57(100 n) Total 583 + 14.57(100 n) For the account to be current: 0.70 = Liabilities and Equity ($) Mkt. Val. of Shares 14.57(100 n) Equity 583 Total 583 + 14.57(100 n)

583 14.57(100 n) which gives n = 43. The account position after this transaction would be: Assets ($) Cash 583 Deposit 830.49 Total 1,413.49 Liabilities and Equity ($) Mkt. Val. of Shares 830.49 Equity 583 Total 1,413.49

1.14

Long, Short, and Margin

(a) The market value of shares is 200 $30 = $6,000. Since the initial margin is 60%, he had to have 0.60 $6,000 = $3,600 in equity. Therefore, Earl sent in $3,600 (plus some amount to cover the commissions). The position of the account after this transaction was: Assets ($) Mkt. Val. of AT&T Total Liabilities and Equity ($) Loan 2,400 Equity 3,600 Total 6,000

6,000 6,000

(b) The position of his account just before the short sale of IBM was: Assets ($) Mkt. Val. of AT&T Total Liabilities and Equity ($) Loan 2,400 Equity 4,000 Total 6,400

6,400 6,400

Short selling 100 shares of IBM generated 100 $104 = $10,400 which were kept as collateral. The margin in the account was $4,000/($6,400+$10,400)=0.238 or 23.8% which was much below the maintenance level. Therefore, Earl had to send some cash. Suppose he sent cash worth C , then his equity became 4,000 + C . To meet the maintenance margin: 0.35 = 4,000 + C , 6,400 + 10,400

which gives C = $1,880. After the completion of the transactions, the account position was: Assets ($) Mkt. Val. of AT&T Collateral Cash Total Liabilities and Equity ($) Mkt. Val. of IBM 10,400 Loan 2,400 Equity 5,880 Total 18,680

6,400 10,400 1,880 18,680 6

(c) The position of the account on April 1, was: Assets ($) Mkt. Val. of AT&T Collateral Cash Total Liabilities and Equity ($) Mkt. Val. of IBM 10,100 Loan 2,400 Equity 6,580 Total 19,080

6,800 10,100 2,180 19,080

The margin was 6,580/(6,800 + 10,100) = 0.389 or 38.9%. (d) If Earl decided to liquidate his account, he would buy back 100 shares of IBM using the collateral and return them. He would sell his shares of AT&T and generate cash. The total cash, therefore, would be $6,800 + $2,180 = $8,980. He would pay o the loan of $2,400 leaving him with $6,580. This would amount to a prot of $6,580 $3,600 $1,880 = $1,100. If he had to pay transaction costs and interest, they would have to be subtracted from his net proceeds. The transaction costs would be on both the buying and selling transactions. On AT&T, they would be 0.015 $6,000 = $90 for buying the shares, and 0.015 $6,800 = $102 for selling the shares. On IBM, the transaction costs would be 0.015 $10,400 = $156 for buying the shares and 0.015 $10,100 = $151.50 for selling the shares. The interest on the loan would be 0.021 $2,400 = $50.40. The total transactions and interest cost, therefore, would be: $90+$102+$156+$151.50+$50.40=$549.90. The net proceeds to Earl, therefore, would be $6,580 $549.90 = $6,030.10. Similarly, his net prot would be $1,100 $549.90 = $550.10. 1.15 Shorting Against the Box and Margin Status of Ms. Forsythes account: August 1, 1987 Assets ($) Liabilities and Equity ($) Mkt. Val. of Shares 21,500 Loan 10,750 Equity 10,750 Total 21,500 Total 21,500 October 1, 1987 Assets ($) Liabilities and Equity ($) Mkt. Val. of Shares 45,750 Loan 10,750 Equity 35,000 Total 45,750 Total 45,750

Interest on the loan: $10,750 0.01 2 = $215. Prot: $35,000 $10,750 $215 = $24,035. The position of her account after short selling: Assets ($) Mkt. Val. of UBM Collateral Total 45,750 45,750 91,500 Liabilities and Equity Mkt. Val. of UBM Loan Equity Total ($) 45,750 10,750 35,000 91,500

The margin 35,000/91,500 = 0.3825 or 38.25% is above the maintenance level. Therefore, Ms. Forsythe would not have to add any cash to the account. January 1, 1988, Price=$50: As the price rises, the collateral deposit would need to be increased.The broker would advance this as additional loan. Assets ($) Mkt. Val. of UBM Collateral Total 50,000 50,000 100,000 7 Liabilities and Equity Mkt. Val. of UBM Loan Equity Total ($) 50,000 15,000 35,000 100,000

Interest on the loan between October 1, 1987 and January 1, 1988, assuming that the extra loan would be made halfway between the two dates: ($10,750 + $15,000)/2 0.01 3 = $386.25. The prot to Ms. Forsythe, therefore, would be $35,000 $10,750 $215 $386.25 = $23,648.75. January 1, 1988, Price=$20: As the price declines, cash would be released from the collateral. Ms. Forsythe would use this cash to pay o the loan Assets ($) Mkt. Val. of UBM Collateral Cash Total Liabilities and Equity Mkt. Val. of UBM Loan Equity Total ($) 20,000 0 35,000 55,000

20,000 20,000 15,000 55,000

Interest on the loan between October 1, 1987 and January 1, 1988, assuming that loan would be paid o halfway between the two dates: ($10,750 + $0)/2 0.01 3 = $161.25. The prot to Ms. Forsythe, therefore, would be $35,000 $10,750 $215 $161.25 = $23,873.75. The brokers claims about shorting against the box locking in the prots are correct. Ms. Forsythes prots remain more or less unchanged regardless of the stock price. The small change comes from the extra interest on the margin loan in the account.

Chapter 2

Return and Risk

Return The rate of return was r = (31.25 30+0.30)/30 = 0.052 or 5.2% per quarter, or (1+0.052)4 1 = 0.2232 or 22.32% per year. Dividend Yield The dividend yield to Sylvia Potter would be 1.10/98=0.0112 or 1.12% per quarter or (1.0112)4 1 = 0.0457 or 4.57% per year. 2.3 Conversion of Units 2.2 2.1

(a) (1 + 0.01)12 1 = 0.1268 or 12.68% per year. (b) (1 + 0.12)1/12 1 = 0.0095 or 0.95% per month. (c) I am assuming 180 days in six months. (1 + 0.0003)180 1 = 0.0555 or 5.55% semiannually. (d) (1 + 0.005)52 1 = 0.2961 or 29.61% per year. Conversion of Units 1% per month is equal to (1 + 0.01)3 1 = 0.030301 or 3.0301% per quarter. 3.0301% per quarter is equal to (1 + 0.030301)4 1 = 0.12682503 or 12.68% per year. 1% per month is equal to (1 + 0.01)12 1 = 0.126802503 or 12.68% per year. 2.5 Comparison of Returns To compare these rates, we have to convert them to identical units. Let us convert 4% per quarter to the annual rate: (1 + 0.04)4 1 = 0.16985856 or 16.99% per year. Therefore, my investment earned a higher return. 2.6 Compounding and Eective Rates The eective rates for the banks can be calculated as: 2.4

A: (1 + 0.07/4)4 1 = 0.0719 or 7.19% per year. B: (1 + 0.069/12)12 1 = 0.0712 or 7.12% per year. C: e0.068 1 = 0.0704 or 7.04% per year. I will put my money in bank A, because it has the highest eective rate.

2.7

Compounding and Eective Rates

(a) Suppose the compounding is being done m times a year. Then the basic equation is: 1+ 0.10 m
m

= 1 + 0.1047

Let us try the usual values of m that banks use: m = 2, for semiannual, m = 4 for quarterly, m = 12 for monthly. One of those should t the equation. Try m = 2 Try m = 4 Try m = 12 lhs = 1.102500 lhs = 1.103812 lhs = 1.104713 no! no! yes!

Therefore, this bank is compounding monthly. (b) Again, the basic equation is: 1+ 0.10 m
m

= 1 + 0.1052

From part a, we know that m has to be higher than 12. Try m = 365 lhs = 1.105155 maybe! Try continuous compounding (m ) under which the basic equation transforms to e0.10 = 1 + 0.1052, lhs = 1.1051709, maybe! Therefore, this bank is compounding either daily or continuously. To tell the continuous compounding from daily compounding here, we need to know the eective rate with more precision. 2.8 Compounded Returns Let us say Mr. Fish started out with $100. The changes in his invested wealth are: His $100 got reduced to $85 because of a 15% loss in the rst year. The second year he had a gain but only on his $85 leaving him with $85(1+0.15)=$97.75. A position of net loss! So he is not back where he started. The nal result would be the same if the portfolio had gone up rst and then down: $100 up to $100(1 + 0.15) = $115 and then down to $115(1 0.15) = $97.75. Compounding Mr. Fox is not giving the client interest on interest and therefore giving him less than he should receive. After the rst year, the deposit would have grown to $105 because of interest. During the second year, the interest would have to be paid on the full $105. The interest amount, therefore, would be 0.04 105 = 4.20. Therefore, the balance at the end of the second year would be $109.20. Similarly, the interest during the third year would be paid on the full $109.20 and would equal 109.20 0.06 = 6.552 making the ending balance equal 115.752 or approximately $115.75. The client, therefore, should receive $115.75. 2.10 Leverage Suppose the investor has E amount of equity. The investor borrows D amount at an interest rate of i. The combined funds, E + D are invested and they earn a rate equal ROA. The total income, therefore, would be (E + D)(ROA). Of this income, Di will have to be paid as interest on the loan. The net income, therefore, would be (E + D)(ROA) Di = E (ROA) + D(ROA i). The return on equity is calculated by dividing the net prot by the equity investment to get: ROE = ROA + D (ROA i) E 2.9

10

2.11 Statistical Analysis The following table presents the calculation details: t 1 2 3 4 . . . 18 19 20 rH 0.0100 0.0200 0.0100 0.0200 . . . 0.0300 0.0200 0.0200 0.2400 rM 0.0100 0.0200 0.0100 0.0200 . . . 0.0100 0.0500 0.0300 0.7000
2 rH 2 rM

0.0001 0.0004 0.0001 0.0004 . . . 0.0009 0.0004 0.0004 0.0140

0.0001 0.0004 0.0001 0.0004 . . . 0.0001 0.0025 0.0009 0.0642 rM = 0.7000,

2 rH =

(a) From the table, we get the following information: T = 20, rH = 0.2400, 2 = 0.0642. Now the statistics can be calculated as: 0.0140 and rM H M = = 0.2400 rH = = 0.0120 T 20 0.7000 rM = = 0.0350 T 20
2 rH T 1 2 rM T 1 ( ( r H )2 T

0.0140 0.2400 20 = 0.0242 19 0.0642 0.7000 20 = 0.0457 19

2

r M )2 T

(b) For the 90% condence interval, the z value is approximately 1.65. Therefore, the intervals are calculated as [ 1.65, + 1.65 ]. The intervals are [0.0279, 0.0519] for Huge and [0.0404, 0.1104] for Micro. (c) The probability of losing money is the probability of getting a return less than zero. The z scores for this possibility are (0 0.0120)/0.0242 = 0.496 for Huge and (0 0.035)/0.0457 = 0.766 for Micro. The corresponding probabilities from the normal distribution table are 0.31 and 0.22. So the probabilities of losing money on Huge and Micro are 31% and 22%, respectively. (d) The z score for making more than 3% on Huge is (0.03 0.0120)/0.0242 = 0.744. The probability, therefore, is 0.23 or 23%. (e) To double the money, the return has to be 100% or 1. Therefore, the z score for this condition is (1 0.035)/0.0457 = 21.11. Without even looking up the normal distribution table, we know that the probability of earning 100% or more is zero for all practical purposes. 2.12 Statistical Calculations Before we can calculate the statistics, we have to convert the prices into returns as rt = (pt pt1 )/pt1 .

11

The following table shows the basic calculations: t 0 1 2 3 4 5 6 7 8 9 10 10 From the table we get T = 10, = r = 0.4393, r T = p 10 11 12 14 15 14 13 14 14 14 15 r 0.1000 0.0909 0.1667 0.0714 0.0667 0.0714 0.0769 0.0000 0.0000 0.0714 0.4393 r2 0.0100 0.0083 0.0278 0.0051 0.0044 0.0051 0.0059 0.0000 0.0000 0.0051 0.0717

r2 = 0.0717, So that,

0.4393 = 0.0439 10
( r )2

r2 T T 1

0.0717 9

0.43932 10

= 0.0763

Therefore, the expected return is 0.0439 or 4.39% and the standard deviation of returns is 0.0763 or 7.63%. 2.13 Security Statistics From the information given in the problem we can make the following table: Wk 0 1 2 3 4 5 6 7 8 9 10 PABC 39.50 40.00 41.00 41.50 41.00 41.50 42.00 41.50 42.00 41.00 41.00 PXYZ 10.75 11.00 10.50 11.25 11.75 11.50 11.75 12.00 11.75 12.00 12.50 T rABC 0.01266 0.02500 0.01220 0.01205 0.01220 0.01205 0.01190 0.01205 0.02381 0.00000 10 0.003838 0.015200 rXYZ 0.02326 0.04545 0.07143 0.04444 0.02128 0.02174 0.02128 0.02083 0.02128 0.04167 10 0.015752 0.035283

The entries for T , , and were calculated using the Excel functions count, average, and stdev. The table answers parts (a) and (b) of the problem. 12

(c) There is no dominant choice. ABC has a lower expected return with a lower risk and XYZ has a higher expected return with a higher risk. The stock one chooses to invest in will be a function of ones taste about risk. For example, I would choose XYZ, because I believe that the extra weekly expected return of 0.015752 0.003838 0.011 is a good compensation for the extra risk of 0.035283 0.015200 = 0.020 in XYZ. (d) The 95% condence interval is calculated as [ 1.96 ]. For ABC it is [0.026, 0.034] while for XYZ it is [0.053, 0.085]. (e) The prices are related to the returns through the formula rt+1 = (pt+1 pt )/pt . Therefore, pt+1 = pt (1 + rt+1 ). pt for XYZ is 12.50. Therefore, pt+1 can be calculated corresponding to the lowest, expected, and the highest returns for each stock. The values turn out to be $11.83, $12.70, $13.56. (f) If the price doubles, the return will be 100% or 1. Therefore, the z score for this event would be (1 0.003838)/0.0152 = 65.54. There is no need to look up the normal distribution table for this. We know that the probability of a z score equal to or higher than 65.54 is zero up to many decimal places. So the chance of the price of ABC doubling is practically zero. 2.14 (a) = r T = 0.58 = 0.0121 or 1.21% per month, 48
( r )2

Statistical Analysis

r2 T T 1

0.063 47

0.582 48

= 0.0345 or 3.45% per month.

(b) The 95% condence range is [ 1.96 ] or [0.0556, 0.0797]. (c) For losing money, the return should be less than zero. The z score for this possibility is (0.0 0.01208)/0.033 = 0.35. The probability, from the normal distribution table, is (0.5-0.1368)= 0.3632 or 36.32%. 2.15 Risk, Return, and Wealth The table below shows the monthly returns for A and B and the growth of $100 invested in each stock. The assumption in calculating the growth is that all the wealth at the end of a month (W ) is reinvested in the same stock. Wealth at the end of a month is calculated as the wealth at the end of the previous month (1 + r). The bottom part of the table shows the statistics.

13

A t 1 2 3 4 5 6 7 8 9 10 11 12 T r 0.01 0.03 0.02 0.04 0.03 0.04 0.05 0.02 0.02 0.04 0.02 0.06 12 0.015 0.0326 W 101.00 104.03 101.95 106.03 109.21 104.84 110.08 112.28 110.04 114.44 112.15 118.88 r 0.07 0.03 0.05 0.05 0.06 0.04 0.05 0.06 0.08 0.07 0.05 0.07 12 0.015 0.0589

B W 107.00 103.79 108.98 103.53 109.74 114.13 108.43 114.93 124.13 115.44 109.66 117.34

Clearly, stock A dominates stock B because it oers the same average return as B for a lower risk. A is superior in terms of accumulated wealth also. Starting with $100, A results in more money at the end of the year than B does, although both have equal average returns. This dierence is attributable to the uctuation in returns measured by variance. 2.16 Returns and Prices We are given = 0.03 and = 0.04. We can calculate the 95% condence range as [ 1.96 ] = [0.03 1.96(0.04)] = [0.0484, 0.1084]. The highest and lowest possible returns with 95% condence, therefore, are 0.1084 and 0.0484. The formula for return is r = (P1 P0 )/P0 which gives us P1 = P0 (1 + r). We know that P0 = 12. Therefore, we can calculate the value of P1 . We will get the expected value of P1 if we use the expected value of r, the highest value of P1 if we use the highest value of r, and the lowest value of P1 if we use the lowest value of r. On doing the calculation we nd that the expected value of the price next period is $12.36, the highest value (with 95% condence) is $13.30, and the lowest value (with 95% condence) is $11.42. 2.17 Risk Premium Denote risk of A by riskA . Then risk of B , riskB , is equal to 2 riskA . The equation for average returns and risk is: average return = risk-free rate + risk premium per unit of risk Apply this equation to security A: 0.08 = 0.06 + riskA premium per unit of risk, so that 0.02 = riskA premium per unit of risk. Now, for B : average return = = 0.06 + 2 riskA premium per unit of risk 0.06 + 2 0.02 = 0.10.

Therefore, the average return on B should be 10% per year. 14

2.18 Eect of Ination Mr. Johnsons $100 will become $100(1 + 0.13) = $113 in one year. However, due to ination, they would lose 5% in purchasing power. Therefore, the purchasing power of the amount received at the end of the year would be $113/1.05 = $107.62. Therefore, the real rate of return expected by Mr. Johnson is 7.62%. 2.19 Term Premium Let us say you lend $100 today for one year. At the end of one year you will receive $100(1+0.12) = $112. You will lend the whole amount again during the second year, and at the end of the second year you will receive $112(1+0.14) = 127.68. If you lend for two years at some rate r, then at the end of one year your $100 would grow to 100(1+ r). At the end of the second year, the amount would be 100(1+ r)(1+ r) = 100(1+ r)2 . For you to be indierent between lending for two years at rate r or lending one year at a time, the ending balances should be the same, i.e., 100(1 + r)2 = 127.68 which gives r = 0.1299. Therefore, for a two year loan, you should charge 12.99% per year. 2.20 Tax Premium What matters to you is the net income after all taxes because the two bonds are identical as far as risk is concerned. The Treasury bonds will yield 0.09 (1 0.28) = 0.0648 or 6.48% per year, after taxes. Since the income from the Thruway bonds will not be taxed at all, you will be interested in the Thruway bonds as long as they yield 6.48% or more per year.

15

Chapter 3

Portfolio Analysis
Portfolio of Portfolios Henrys overall portfolio composition is 0.3 {0.2, 0.4, 0.3, 0.1} + 0.7 {0.1, 0.2, 0.5, 0.2} = {0.3 0.2 + 0.7 0.1, 0.3 0.4 + 0.7 0.2, 0.3 0.3 + 0.7 0.5, 0.3 0.1 + 0.7 0.2} = {0.13, 0.26, 0.44, 0.17} 3.2 Security and Portfolio Statistics 3.1

(a) The following table was created using Lotus 1-2-3 to calculate the statistics: t 1 . . . 10 T r1 0.15 . . . 0.17 10. 0.156 0.021 r2 0.12 . . . 0.20 10. 0.135 0.038

2 2 The variances are calculated by squaring the standard deviations. So, 1 = 0.000449 and 2 = 0.001472. The correlation between the returns of two securities was calculated by running a regression between the returns of the stocks. The regression was run by invoking /Data Regression commands. The returns on one of the stocks were assigned to the X-range and the other one to the Y-range. An empty area of the worksheet was used for Output range and then the regression was run by choosing Go. The regression output is reproduced below:

Regression Output: Constant 0.161094 Std Err of Y Est 0.022419 R Squared 0.004670 No. of Observations 10 Degrees of Freedom 8 X Coefficient(s) -0.03773 Std Err of Coef. 0.194769

16

From this output, the correlation is determined as the square root of R Squared. Negative square root is taken because the X Coefficient is negative. Therefore, 12 = 0.004670 = 0.0683. The covariance is calculated as 12 = 1 2 12 = (0.021)(0.038)(0.0683) = 0.000055555 = 0.000056. The information is presented below: 2 0.000449 0.001472 Covariance 1 0.000449 0.000056 2 0.000056 0.001472 Correlation 1 1.0000 0.0683 2 0.0683 1.0000

Stock 1 2

0.156 0.135

0.021 0.038

(b) The following formulae were used for the portfolio calculations: P P =
2 x2 1 1

= x1 1 + x2 2
2 + x2 2 2 + 2x1 x2 1 2 12

The answers are shown in the following table. Portfolio 1 2 3 4 5 x1 0.2 0.2 0.6 0.3 0.5 x2 1.2 0.8 0.4 0.7 0.5 P 0.1308 0.1392 0.1476 0.1413 0.1455 P 0.0465 0.0307 0.0192 0.0272 0.0213

3.3

Optimal Portfolio Selection This portfolio calculations for this problem will be done using the formulae: p p = xA A + xB B + xC C =
2 2 2 2 2 x2 A A + xB B + xC C + 2xA xB AB + 2xA xC AC + 2xB xC BC

For Mr. Vestors portfolio: P P = = (1/3)(0.13) + (1/3)(0.14) + (1/3)(0.18) = 0.15 (1/3)2 (0.05) + (1/3)2 (0.08) + (1/3)2 (0.11) + 2(1/3)2 (0.02) + 2(1/3)2(0.03) = 0.1944

For the alternative portfolio: P P = = (0.40)(0.13) + (0.25)(0.14) + (0.35)(0.18) = 0.15 (0.40)2 (0.05) + (0.25)2 (0.08) + (0.35)2 (0.11) + 2(0.40)(0.25)(0.02) + 2(0.25)(0.35)(0.03) = 0.1890

Even though Mr. Vestor has diversied among the three stocks, his distribution does not give him as good a combination as {0.4, 0.25, 0.35}. His portfolio has the same amount of expected return as the alternative portfolio but a higher risk (standard deviation). Ill tell Mr. Vestor to not act too naive and try to nd an ecient portfolio.

17

Portfolio Calculations Bob wants a portfolio such that p = 0.14. He will accept the lowest return to be 8%. Obviously, nobody can guarantee that. So Larry assumed a 95% condence range. In other words, Larry decided that as long as there is only a 2.5% chance that the return will be less than 8%, it is ok. So he computed the acceptable standard deviation as: Lowest return = 1.96 . Therefore, 8 = 14 1.96 which gave = 3.06%. Therefore, Bob would be satised a portfolio that has expected return of 14% per year and standard deviation of 3.06% per year. If Larry can nd a better portfolio that will be an added bonus! Now we go to do the calculations. The security statistics are given to us. So we calculate the portfolio statistics using the following formulae: p p = x1 1 + x2 2 + x3 3 =
+ 2 2 2 2 x2 1 1 x2 2 + x3 3 + 2x1 x2 1 2 12 + 2x1 x3 1 3 13 + 2x2 x3 2 3 23

3.4

The following table shows the results: x1 0.3 0.2 0.2 0.1 0.5 x2 0.3 0.4 0.6 0.8 0.3 x3 0.4 0.4 0.6 0.1 0.2 P 0.140 0.144 0.156 0.154 0.136 P 0.131 0.141 0.209 0.208 0.127

The rst portfolio has the expected return that Bob desires but the standard deviation is much too high. Other portfolios show similar magnitudes for standard deviations. So, a portfolio to meet Bobs specications cannot be designed. The reason is that Bob has a mistaken notion about the level of risk in the market. Bob is being too naive if he expects to be able to make 14% per year with a standard deviation of only 3%. Portfolios Involving a Risk-free Security We are given that r1 = 0.06, r2 = 0.13, 2 = 0.04. Since the rst security is risk-free, 1 = 0.00 and 12 = 0.00 Various portfolios of the two securities were constructed and the statistics for these portfolios were calculated using: P P = = x1 1 + x2 2
2 2 2 x2 1 1 + x2 2 + 2x1 x2 1 2 12

3.5

0.16 Port 1 2 3 4 5 6 7 8 x1 1.20 1.00 0.80 0.60 0.40 0.20 0.00 0.20 x2 0.20 0.00 0.20 0.40 0.60 0.80 1.00 1.20 p 0.0460 0.0600 0.0740 0.0880 0.1020 0.1160 0.1300 0.1440 p 0.0080 0.0000 0.0080 0.0160 0.0240 0.0320 0.0400 0.0480 p 0.12 0.08 0.04
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

0.00 0.00

0.02 p

0.04

0.06

18

The expected return-standard deviation plot is shown in the gure above. The plot shows that the risk-return tradeo for the portfolios of a risky and a risk-free security indeed falls on straight line segments. Note: You may want to think about the segment that reverts back after hitting the y -axis. 3.6 Portfolio Calculations Two of the three correlations are equal to zero. This makes calculations a little easier. The portfolio formulae are: p
2 p

= =

xA A + xB B + xC C = xA (0.16) + xB (0.20) + xC (0.10)

2 2 2 2 2 x2 A A + xB B + xC C + 2xB xC B C BC

2 Note that the other two cross-product terms are not there in P formula because AB = 0 and AC = 0. 2 equation to get: Substitute the numbers in P 2 2 2 2 2 2 = x2 p A (0.08) + xB (0.10) + xC (0.06) + 2xB xC (0.08)(0.10)(0.02)

The calculations are done using these formulas and the following table results. The p and p for the rst three portfolios are lled in just from the information matrix for securities given in the problem statement. 0.24 0.18 xA 1.0 0.0 0.0 0.1 0.2 0.4 xB 0.0 1.0 0.0 0.2 0.7 0.4 xC 0.0 0.0 1.0 0.7 0.1 0.2 P 0.16 0.20 0.10 0.13 0.18 0.16 P 0.08 0.10 0.06 0.05 0.07 0.05 p 0.12 0.06 0.00 0.00
. . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

0.03

0.06 p

0.09

0.12

The graph between p and p is also shown above. The mean-standard deviation frontier has been drawn approximately. Using 9% as the risk-free rate we draw the tangency line and nd that the tangency portfolio is approximately portfolio number 6! So we do not have to do any further guessing. We know that Liz wants to get an expected return of 15%. The horizontal line shows her desired level of expected return. To nd how she should divide her money between the risk-free and the tangency portfolio use the familiar equation: L = x rf + (1 x) T L is the expected return on Lizs overall portfolio which is made up of investing x fraction of her money in the risk-free rate and (1 x) in the tangency portfolio. Substitute for L = 0.15, rf = 0.09 and T = 6 = 0.16 and solve for x to get x = 0.14 so that 1 x = 0.86. Therefore, Liz should put 14% of her 250,000, i.e., $35,000 in the bank CD and the remaining $215,000 in the tangency portfolio. She should divide the $215,000 into the three stocks in the proportions for portfolio #6. In other words, she should put 0.4 $215, 000 = $86,000 in ALM, 0.4 $215, 000 = $86,000 in BPI, and 0.2 $215, 000 = $43,000 in CRN. The standard deviation of her overall portfolio return can be calculated using a similar procedure as we used for the expected return. This approach will work here because the correlation between the CD (risk-free) and the tangency portfolio is zero. So we get: L = x 0.00 + (1 x) 0.05 = 0.86 0.05 = 0.04 19

This number is conrmed by the graph also. The highest and the lowest returns would be based on some reasonable condence estimates. I am going to use a 95% level of condence. Then the highest and the lowest returns are given by L 1.96L which gives us that the highest and lowest possible return on her $250,000 investment would be 0.23 and 0.07, respectively. 3.7 Portfolio Analysis Suppose x fraction should be invested in security C and (1 x) in B , then to meet the objective: x(0.13) + (1 x)(0.19) = 0.15 Which gives, x = 2/3 and (1 x) = 1/3. Now, the standard deviation of this portfolio can be calculated as: p = =
2 + (1 x)2 2 + 2x(1 x) x2 C BC B

( 2/3)2 (0.26) + ( 1/3)2 (0.38) + 2( 2/3)( 1/3)(0.16)

= 0.478423 The standard deviation of A is A = 0.32 = 0.565685. Since the portfolio oers the same expected return as security A, but has a lower standard deviation, it dominates security A. 3.8 Portfolio Calculations The covariance form of the portfolio variance formula should be used in this problem, i.e.: p p = = x1 1 + x2 2 + x3 3
2 2 2 2 2 x2 1 1 + x2 2 + x3 3 + 2x1 x2 12 + 2x1 x3 13 + 2x2 x3 23

(a) For Mr. Thomass portfolio: p p = (0.33)(0.15) + (0.33)(0.12) + (0.34)(0.17) = 0.1469 = (0.33)2 (0.0484) + (0.33)2 (0.0625) + (0.34)2 (0.0906) +2(0.33)(0.33)(0.033) + 2(0.33)(0.34)(0.026) + 2(0.33)(0.34)(0.038)] = 0.2098 (b) For Ms. Walkers portfolio: p p = (0.50)(0.15) + (0.15)(0.12) + (0.35)(0.17) = 0.1525 = (0.50)2 (0.0484) + (0.15)2 (0.0625) + (0.35)2 (0.0906) +2(0.50)(0.15)(0.033) + 2(0.50)(0.35)(0.026) + 2(0.15)(0.35)(0.038)]0.5 = 0.2064 (c) Ms. Walker has the better portfolio because she is getting a higher expected return for a lower risk.
0.5

20

3.9 by:

Tangency Line The expected return and the risk for portfolios of a risk-free security and the tangency portfolio are given p p = = = = xrf + (1 x)T
2 + (1 x)2 2 + 2x(1 x) x2 f f T fT T 2 + 2x(1 x)(0) x2 (0) + (1 x)2 T T fT

(1 x)T

We are given rf = 0.07, T = 0.17, T = 0.214. (a) Directly apply the equations: p p = (0.25)(0.07) + (0.75)(0.17) = 0.145 = 14.5% per year. = (0.75)(0.214) = 0.1605 = 16.05% per year.

(b) Apply the equation for expected return: p = 0.15 = 0.15 = x = (x)(0.07) + (1 x)(0.17) 0.17 0.10x 0.02 = 0.20 0.10

So, the investor should invest 20% of her wealth in the risk-free security and the remaining 80% in the tangency portfolio. For risk, apply the standard deviation equation: p = (0.80)(0.214) = 0.1712 = 17.12% per year 3.10 Hedge Portfolios For the hedge portfolio, we set the standard deviation of the portfolio equal to zero: p =
2 2 2 x2 1 1 + x2 2 + 2x1 x2 1 2 (+1) = 0.

Since x1 + x2 = 1, substitute x2 = 1 x1 in the equation, and square both sides to get:

2 2 2 x2 1 1 + (1 x1 ) 2 + 2x1 (1 x1 )1 2 = 0,

which can be factored and written as:

2

x1 1 + (1 x1 )2 so that,

= 0,

x1 1 + (1 x1 )2 = 0. Now we can solve for x1 and then for x2 = 1 x1 to get: x1 = 2 1 2 and x2 = 1 x1 = 1 . 1 2

21

3.11 Hedge Portfolios With perfectly negative correlation, we use equation (3.16): x1 x2 = = 2 0.20 = 0.5263 = 1 + 2 0.18 + 0.20 1 x1 = 1 0.5263 = 0.4737

The statistics for the portfolio are: p p = = (0.5263)(0.10) + (0.4737)(0.12) = 0.1095 (0.5263)2(0.18)2 + (0.4737)2(0.20)2 + 2(0.5263)(0.4737)(0.18)(0.20)(1) = 0.0000

With perfectly positive correlation, we use the result from the previous exercise: x1 x2 The statistics for the portfolio are: p p = = (10)(0.10) + (9)(0.12) = 0.08 (10)2 (0.18)2 + (9)2 (0.20)2 + 2(10)(9)(0.18)(0.20)(1) = 0.0000 = = 2 0.20 = 10 = 1 2 0.18 0.20 1 x1 = 1 10 = 9

3.12 Rate of Return on a Mutual Fund To calculate the rate of return, we should use the total wealth here because the number of shares have grown due to reinvestment. The initial wealth was 98 10.27 = 1006.46. The value of my investments today is 130 9.54 = 1240.20. The three year rate of return is (1240.20 1006.46)/1006.46 = 0.2322. Therefore, the annual rate is (1 + 0.2322)1/3 1 = 0.07209 or approximately 7.21%. 3.13 Risk-free and Market Betas From the denition of : i = im Therefore, f m = = (0) f = (0) =0 m m m mm = (1)(1) = 1 m f m

i m

3.14 CAPM Calculations The of Canon stock is: C = Cm Therefore, the proper expected return is: kC = rf + C (m rf ) = 0.07 + 0.668(0.12 0.07) = 0.103, or 10.3% per year. The proper expected rate of return from the stock based on its risk is 0.103 or 10.3% per year. 22 (0.30) C = 0.668. = (0.49) m (0.22)

3.15

and CAPM

2 2 , we need im , the covariance between security and market returns, and m , the (a) Since i = im /m variance of market returns. Let us calculate those rst:

im
2 m

= =

ri rm

T 1
(

ri T r m )2 T

rm

.337) 0.019455 (0.420)(0 12 = 0.000696363 11 (0.337)2 12

2 rm T 1

0.016319 = 11

= 0.000623174

Now, we can calculate the : = 0.000696363 im = 1.117 = 2 m 0.000623174

(b) Before doing the calculations, we need to convert the annual risk-free rate to monthly rate: rf = (1 + 0.07)1/12 1 = 0.00565 per month. The market return is expected to be equal to the historical rm /T = 0.337/12 = 0.028 per month. Therefore, the proper expected return average, therefore, m = on the stock (k ) is: k = rf + (m rf ) = 0.00565 + 1.117(0.028 0.00565) = 0.0306 or 3.06% per month. (c) Based on the historical returns, the stock has expected return of 0.420/12 = 0.035 or 3.5% per month. Since the stocks expected return is higher than its proper expected return, it is underpriced and should be bought. 3.16 CAPM and Equilibrium

(a) The proper (` a la CAPM) expected return for Elwin is calculated as: ki = rf + i (m rf ) = 0.08 + 1.7(0.14 0.08) = 0.182 = 18.2% (b) The proper stock price (P ), therefore, is calculated using the rate of return equation: 0.182 = which gives us P = $16.92. (c) The stock is currently underpriced because the market price ($16.25) is less than its proper value ($16.92). Investors should buy the stock. (d) The expected return, if the stock were bought, would be calculated as: r= 18 + 2 16.25 = 0.2308 = 23.08% 16.25 18 + 2 P P

Since the stock is oering a higher return (23.08%) than what it should (18.2%), investors should buy the stock. (e) Since investors will buy the stock, the demand pressure will push the stock price up till the stock is properly priced. 23

(f) If the market price were $17.50, the stock would be overpriced. The expected rate of return based on this price would be 14.29% which is less than the proper return. The stock should be sold. The supply pressure will bring the market price down so that the actual market price becomes equal to the proper price. 3.17 of a Portfolio Suppose x fraction should be invested in security A and (1 x) in security B , then of the portfolio, P , is given by: p = xA + (1 x)B = x(0.7) + (1 x)(1.5) Since the objective is to create a portfolio with of 1, we get: 1 = 0.7x + 1.5(1 x) = 0.7x + 1.5 1.5x = 1.5 0.8x which leads to 0.5 = 0.625 0.8 Therefore, the investor should put 62.5% of his money in security A and the remaining 37.5% in security B . 0.8x = 0.5 x= 3.18 The Various Expected Returns

The rst number, 1.1%, is the monthly expected return based on the past behavior of the stock returns. The second set of information can be used to calculate a monthly expected return based on other (fundamental) information about the stock. This number is (15.10 + 0.15 15.00)/15.00 = 0.0167 or 1.67%. The last set of numbers can be used to estimate what the expected return should be based on the risk of the stock. This expected return is 1.15%. The last calculation is what we call the proper expected rate of return, or the discount rate. The investor should compare the other expected returns with the discount rate to determine if this is a good investment or not. For example, based on the historical information, the stock is not a good investment but based on the investors expectation about the stocks future, this is a good investment.

24

Chapter 4

Security Selection and Performance Evaluation

4.1 Present Value Calculations The PV expressions and the nal answers are shown below: a. b. c. d. e. f. g. h. 4.2 Present Value is a growing perpetuity. Let us rst calculate the growth rates: g12 = (33/30) 1 = 0.1, = (36.3/33) 1 = 0.1, g34 = (37.03/36.3) 1 = 0.02, g45 = (37.77/37.03) 1 = 0.02, = (38.52/37.77) 1 = 0.02. So the growing perpetuity begins at t = 3 and has a growth rate of The discount rate is 9% per period or 0.09. Therefore: PV = = = 36.3 df 0.09 0.09 0.02 2 33 1 30 36.3 + + 1.09 (1.09)2 0.09 0.02 (1.09)2 491.77
.09 .09 + 33df 0 + 30df 0 1 2 .10 PV = 10(af 0 ) 4

= = = = = = =
0.10 2

31.70 28.82 37.91 30.39 100.00 75.13 200.00 165.29

PV = 10(af PV = 10(af PV = 10(af PV =

0.10 .10 )(df 0 ) 4 1 0.10 ) 5 0.10 .10 ) 10(df 0 ) 5 3

PV = 10/0.1
.10 (10/0.1)df 0 3

PV = 10/(0.1 0.05) PV = [10/(0.1 0.05)]df

(a) This g23 g56 0.02.

(b) This one has an annuity and a growing perpetuity. Just to make sure that there is no change in growth rate, calculate the growth rates: g56 = (315/300) 1 = 0.05, g67 = (330.75/315) 1 = 0.05, g78 = (347.29/330.75) 1 = 0.05, g89 = (364.65/347.29) 1 = 0.05, g910 = (382.82/364.65) 1 = 0.05. The 25

growth rate, therefore, is 0.05 per period. The discount rate is 11.5% per period or 0.115. Therefore, PV 300 df 0.115 0.115 0.05 4 1 1 1 300 = 300 1 + 0.115 (1.115)3 0.115 0.05 (1.115)4 = 3712.91
.115 + = 300af 0 3

4.3

Annuity Formula I will derive the formula for a growing annuity and then set the growth rate equal to zero to get the formula for a simple annuity. A growing annuity, with a growth rate of g , is shown in the time line below: c 0 1 c(1 + g ) 2 c(1 + g )2 3 c(1 + g )n2 c(1 + g )n1 ... n1 n

This growing annuity can be written as a dierence between the following two growing perpetuities: c 0 1 c(1 + g ) 2 c(1 + g )2 3 c(1 + g )n2 c(1 + g )n1 ... n1 n c(1 + g )n n+1 c(1 + g )n ... 0 1 2 3 n1 n n+1 c(1 + g )n+1 n+2 ...

c(1 + g )n+1 n+2 ...

Therefore, the present value of the growing annuity can be written as: PV = = c(1 + g )n 1 c kg k g (1 + k )n c (1 + g )n 1 kg (1 + k )n

Note that with limn , the term in square brackets will go to 1 because with k > g , (1 + k )n approaches faster than (1 + g )n . The formula for an annuity is obtained by setting g = 0 in the above expression to get: PV = 4.4 1 c 1 k (1 + k )n

Rate of Return Calculations In the equations in problem 4.1, we replace PV by the initial cash outow, i.e., $30, and instead of using a known discount rate of 0.10, use the unknown r. Then we solve for r using algebraic or trial-and-error and

26

interpolation methods. The nal answers are given below: a. b. c. d. e. f. g. h. 4.5 30 = 10(af r 4) 30 = 10(af 30 = 10(af 30 = 10(af 30 = 10/r 30 = (10/r)df 30 = [10/(r
r 3 r r 4 )(df 1 ) r 5) r r 5 ) 10(df 3 )

r = 0.126 r = 0.087 r = 0.199 r = 0.105 r = 0.333 r = 0.196 r = 0.383 r = 0.260

30 = 10/(r 0.05) 0.05)]df r 2

Rule of 72 Suppose it take n years for c to double at rate r, then c must be the PV of 2c to be received in n years from now: 2c . c= (1 + r)n n= log(2) log(1 + r)

This equation can be solved for n as:

The Rule of 72 n is determined using 72/r where r is expressed as a % rather than a decimal fraction. Let us see how well the rule of 72 holds up: r 0.0400 0.0500 0.0600 0.0700 0.0785 0.0800 0.0900 0.1000 0.1100 0.1200 0.1300 0.1400 0.1500 0.1600 0.1700 0.1800 Exact n 17.6730 14.2067 11.8957 10.2448 9.1744 9.0065 8.0432 7.2725 6.6419 6.1163 5.6714 5.2901 4.9595 4.6702 4.4148 4.1878 Rule of 72 n 18.0000 14.4000 12.0000 10.2857 9.1743 9.0000 8.0000 7.2000 6.5455 6.0000 5.5385 5.1429 4.8000 4.5000 4.2353 4.0000 Error 0.3270 0.1933 0.1043 0.0409 0.0000 0.0065 0.0432 0.0725 0.0964 0.1163 0.1330 0.1472 0.1595 0.1702 0.1796 0.1878

The rule of 72 is exact for r = 7.85% per year. The rule is in error for other rates. The farther we move from 7.85% the more the error. 4.6 Continuous Compounding

27

The Treasury bill is maturing in 2/12 years and the compounding is continuous. The equation for annual rate, r, therefore, is: 10000 9823 = r 2 e 12 which gives: 10000 2 e 12 r = 9823 or, by taking logs: 10000 2 r = ln 12 9823 which gives r = 0.10715 or 10.72% per year, compounded continuously. 4.7 Present Value and IRR

(a) The following time line shows the cashows on a per share basis. 45.00 1/1/88 0.30 3/31/88 0.30 6/30/88 0.35 9/30/88 44.30 12/31/88

(b) The equation for present value is: PV = 0.30 0.35 44.30 0.30 + + + (1 + k ) (1 + k )2 (1 + k )3 (1 + k )4

The discount rate k is given to us as 14% per year. For our calculation we need it in the units of per quarter. Let us convert it to a quarterly rate as: (1 + 0.14)1/4 1 = 0.033299. Using this value as k in the equation above we get PV = 39.74819 or approx $39.75. Rather than converting the rate from annual to quarterly, we can write the equation in terms of annual rates, but we will have to measure distances in years, rather than quarters. With annual rate, the present value equation would be: PV = 0.30 0.35 44.30 0.30 + + + (1 + k )0.25 (1 + k )0.5 (1 + k )0.75 (1 + k )1

In this equation, k would be 0.14. The nal answer given by this equation is exactly the same as above. (c) The following equation can be written for the quarterly rate of return r: 45 = 0.30 0.35 44.30 0.30 + + + (1 + r) (1 + r)2 (1 + r)3 (1 + r)4

Now solve for r using the trial-and-error and interpolation: r 0.020 0.010 0.005 0.003 0.001 r 28 rhs 41.83863 43.50225 44.36529 44.71654 45.07129 45

r = 0.003 +

0.001 0.003 (45 44.71654) 45.07129 44.71654

which gives us r = 0.001401 per quarter. We convert it to an annual rate as: (1 + 0.001401)4 1 = 0.005619 or 0.562% per year. 4.8 Rate of Return The following equation can be written from the time line diagram:
r 200 = 30af r 4 + 280df 5 .

To solve it, we proceed with trial-and-error and linear interpolation: r 0.10 0.20 0.18 0.19 r r = 0.19 + af r 4 3.1699 2.5887 2.6901 2.6386 df r 5 0.6209 0.4019 0.4371 0.4190 rhs 268.9539 190.1878 203.0924 196.4914 200

0.18 0.19 (200 196.4914) = 0.1847 203.0924 196.4914

Therefore, the rate of return is 18.47% per year. 4.9 Rate of Return

(a) The time line shows the cashows on a per share basis. I have combined 12/31/88 and 1/1/89 into one time point because they are so close. 30.00 1/1/87 0.60 3/31/87 0.60 6/30/87 0.60 9/30/87 0.60 12/31/88 0.60 3/31/88 6/30/88 1.25 9/30/88 32.60 12/31/88

(b) The following equation can be written for calculating the quarterly rate of return:
r r 30 = 0.60(af r 5 ) + 1.25(df7 ) + 32.60(df8 )

We solve it using trial-and-error and interpolation: r 0.020 0.030 0.027 0.028 r r = 0.027 + af r 5 4.713460 4.579707 4.619201 4.605977 df r 7 0.870560 0.813092 0.829864 0.824230 df r 8 0.853490 0.789409 0.808047 0.801780 rhs 31.74006 29.49893 30.15117 29.93189 30

0.028 0.027 (30 30.15117) = 0.027689 29.93189 30.15117

Therefore, the rate of return is 0.027689 per quarter which is compounded to give 0.115443 or 11.54% per year. 29

(c) The discount rate is the rate of return Ms. Houston expected from the stock based on its risk. Since she earned a higher rate of return than she expected, it was a good investment. 4.10 Return on Investment The following time line shows the cash ows: 32 0.30 87 Q1 0.30 87 Q2 0.30 87 Q3 0.30 87 Q4 0.35 88 Q1 0.35 88 Q2 0.35 88 Q3 0.35 88 Q4 0.40 89 Q1 0.40 89 Q2 0.40 89 Q3 31.40 89 Q4

The following equation can be written for the quarterly rate of return, r:
r r r r r 32 = 0.30af r 4 + 0.35af 4 df 4 + 0.40af 4 df 8 + 31df 12

Now we solve for r using trial-and-error and interpolation: r 0.050 0.030 0.020 0.010 0.005 0.007 r af r 4 3.5460 3.7171 3.8077 3.9020 3.9505 3.9310 df r 4 0.8227 0.8885 0.9238 0.9610 0.9802 0.9725 df r 8 0.6768 0.7894 0.8535 0.9235 0.9609 0.9457 df r 12 0.5568 0.7014 0.7885 0.8874 0.9419 0.9197 rhs 20.3068 25.1875 28.1168 31.4353 33.2580 32.5150 32

r = 0.007 +

0.005 0.007 (32 32.5150) = 0.0084 33.2580 32.5150

Therefore, the return was 0.0084 per quarter which can be compounded to give the annual rate of (1 + 0.0084)4 1 = 0.0340 per year, or 3.40% per year. 4.11 Expected Rate of Return

(a) The following time line shows the quarterly expected cashows: 12.00 0 0.20 1 0.20 2 0.20 3 0.20 4 0.20 5 0.20 6 0.20 7 14.20 8

(b) We can write the following equation to solve for the quarterly rate of return r:
r 12 = 0.20(af r 7 ) + 14.20(df8 )

Now we go for trial-and-error and interpolation: r 0.02 0.03 0.04 r af r 7 6.471991 6.230282 6.002054 df r 8 0.853490 0.789409 0.730690 rhs 13.41396 12.45566 11.57621 12

30

r = 0.03 +

0.04 0.03 (12 12.45566) = 0.035181. 11.57621 12.45566

This is the quarterly rate. The annual rate, therefore, is (1 + 0.035181)4 1 = 0.148327 or 14.83%. (c) Since the rate Ms. Raitt requires from the stock based on its risk is 14% per year, and the stock is oering 14.83% per year, it is a good investment. 4.12 Expected Rate of Return

(a) The future expected dividends from the stock of Grandmas Kitchen are shown in the time line below: 0.58 0 1 0.66 2 0.76 3 0.80 4 0.84 5 0.84 6 0.84 7 ...

The dividend amounts were calculated as follows: Year 1 2 3 4 5 6 7 Growth Rate 0.15 0.15 0.15 0.05 0.05 0.00 0.00 Dividend 0.50(1.15) = 0.575 0.575(1.15) = 0.66125 0.66125(1.15) = 0.7604375 0.7604375(1.05) = 0.7984593 0.7984593(1.05) = 0.8383823 0.8383823(1.00) = 0.8383823 0.8383823(1.00) = 0.8383823

(b) The following equation can be written to solve for the rate of return r:
r r r 9.75 = 0.58df r 1 + 0.66df 2 + 0.76df 3 + 0.80df 4 +

0.84 r df 4 r

Now we proceed with the usual process of trial-and-error and interpolation: r 0.100 0.090 0.080 0.085 r df r 1 0.909090 0.917431 0.925925 0.921658 df r 2 0.826446 0.841679 0.857338 0.849455 df r 3 0.751314 0.772183 0.793832 0.782908 df r 4 0.683013 0.708425 0.735029 0.721574 rhs 7.912165 8.836165 9.992824 9.380275 9.75

r = 0.085 +

0.08 0.085 (9.75 9.380275) = 0.081982 9.992824 9.380275

or approximately 8.20% per year. (c) Since the expected return of 8.20% per year is less than the required return of 16%, Ms. Child should not buy the stock. If she owns the stock, she should sell it. If she does not own the stock, she may even consider short selling the stock.

31

4.13 Security Valuation i 0.24 = 0.8 0 I will use m to denote market and i to denote Murphy. i = im .16 = 1.2. Therefore, m ki = rf + i (m rf ) = 0.08 + 1.2(0.14 0.08) = 0.152. The discount rate, therefore, is 0.152 or 15.2% per year. Since the problem involves quarterly dividend payments, we need the quarterly discount rate. The quarterly discount rate is calculated as (1 + 0.152)1/4 1 = 0.036 or 3.6%. Now we can calculate the proper price (the present value) of the stock:
.036 .036 + 15df 0 = 14.042 PV = 0.40af 0 8 8

Clearly, at the current market price of $10.50, the stock is underpriced. Ziggy should buy it. 4.14 Security Selection We know the following: O = 1.08, rf = 0.08 per year, or (1.08)1/12 1 = 0.006434 per month, and m = 0.012 per month. Therefore, kO = rf + O (m rf ) = 0.006434 + 1.08(0.012 0.006434) = 0.012445 per month. Since the stock can be sold for $12 a month from now, the proper price (present value) of Orpheus is: 12/(1 + 0.012445) = 11.85. Since the current market price is $10.20, the stock is underpriced and should be bought. Since the stock can be bought today for $10.20 and be sold a month later for $12, the internal rate return from the stock for the coming month would be (12 10.20)/10.20 = 0.1765. Since this is higher than the discount rate, the stock is underpriced. 4.15 Security Selection The following facts can be collected from the information given: Expected dividend for the next quarter = d = Dividend growth rate = g = Stocks Risk-free rate = rf Expected return on the market = m = = = 0.20(1.015) = 0.203 0.015 per quarter 1.2 0.078 per year 0.135 per year 0.078 + 1.2(0.135 0.078) 0.1464 per year (1 + 0.1464)0.25 1 = 0.034746 per quarter d kg 0.203 = 10.28020 0.034746 0.015 $10.28

Therefore, Stocks discount rate = k = rf + (m rf ) = = = Therefore, Stocks proper price = PV = = =

Since the market price of 10 7/8=$10.875 is higher than the proper price, the stock is overpriced. It should be sold. If the stock is not currently owned, it may be sold short. 4.16 Security Selection

(a) The quarterly dividends expected by Carol are shown on the time line below. 0.50 ... 0 1 2 16 17 32 18 0.50 ... 28 29 30 0.50 0.505 0.51005 ...

(b) The following equation can be written equating the present value of the future dividends to the current stock price. r in this equation is the unknown expected return.
r 8 = 0.50af r 12 df 16 +

0.505 df r r 0.01 28

To solve for the expected return, r, we use the trial-and-error and interpolation techniques. The details are shown below: r 0.0200 0.0400 0.0450 0.0410 0.0405 r r = 0.0405 + af r 12 10.575340 9.385073 9.118580 9.330853 9.357905 df r 16 0.728445 0.533908 0.494469 0.525760 0.529817 df r 28 0.574374 0.333477 0.291570 0.324623 0.329019 rhs 32.857690 8.118921 6.461377 7.741116 7.926692 8

0.0405 0.04 (8 7.926692) = 0.040309 7.926692 8.118921

The expected rate of return, therefore, is 0.040309 or 4.0309% per quarter. (c) The risk-premium oered by the average stock is 0.12 0.07 = 0.05. Therefore, being twice as risky as the average stock, Surya should oer twice the risk premium, i.e., 0.10. Therefore, the rate of return on Surya should be 0.07 + 0.10 = 0.17 or 17% per year. (d) The expected return on Surya, based on the dividends, is 4.0309% per quarter or (1 + 0.040309)4 1 = 0.17125 or 17.125% per year. From part c we know that for the amount of risk contained in Surya, it should pay 17% per year. Since the stock is expected to pay a higher rate of return than it should based on its risk, Carol should invest in the stock. 4.17 Market Eciency

(a) High volatility does not imply market ineciency. Market prices uctuate because of the release of news and information. Continuous release of new information and its instantaneous availability to investors implies that in an ecient market, investors will react to the news and this reaction will be evident in the price uctuations, which is the cause of volatility. (b) An ecient market does not mean that investors cannot make any returns in the market. What it means is that they cannot make any more returns than justied by the amount of risk they take. Therefore, this statement is misguided. 4.18 Performance Evaluation Realized return: (11.60 10.00)/10.00 = 0.16 per month. Based on the market conditions (rf = (1 + 0.09)1/12 1 = 0.0072 per month, and rm = 0.026 per month), and the risk of the stock (O = 1.08), its return should have been: 0.0072 + 1.08(0.026 0.0072) = 0.0275. The abnormal return, therefore, is 0.16 0.027 = 0.133. Since the abnormal return is positive, her stock returned more than what it should have and therefore it was a good investment.

33

4.19 Performance Evaluation The expected return is calculated as per the CAPM: J = rf + J (m rf ) = 0.08 + 1.5(0.18 0.08) = 0.23 Therefore, the proper expected return from Jupiter over the next year is 23%. Knowing the actual conditions at the end of the year, Jupiters return should have been: rJ = rf + J (rm rf ) = 0.07 + 1.5(0.20 0.07) = 0.265 Since, Jupiter actually only provided a return of 25%, it provided less than what would be expected of Jupiter based on its risk and the market conditions. Jupiter managers, therefore, have no reason to celebrate. 4.20 Performance Evaluation The managers of Alliance Fund are comparing their funds return with that of the S&P 500. This is not a valid comparison if the risk of the two portfolios (the Alliance Fund and the S&P 500) are not equal. A proper comparison should take the risk dierences into account. 4.21 Performance Measurement

(a) The abnormal returns are calculated as the actual average returns minus the proper returns as: ar J arD = 0.172 [0.082 + 1.3(0.145 0.082)] = 0.172 0.1639 = 0.0081 = 0.189 [0.082 + 1.5(0.145 0.082)] = 0.189 0.1765 = 0.0125

The abnormal returns for the John and Denny portfolios, therefore, are 0.81% per year and 1.25% per year, respectively. (b) Both the portfolios performed better than what would be expected from them based on their risks. In a relative sense, the Denny fund had a higher abnormal return than the John fund. However, The Denny fund also had a higher systematic risk. One can calculate abnormal return per unit of systematic risk. This quantity for the John fund is 0.00623 and for the Denny fund is 0.00833. Clearly, even on this relative basis, Denny fund is a better performer. From an investors point of view, both funds are good investments. The risk faced by the investor will be the total risk of the fund because it is the total risk that will cause the investors returns to uctuate. From this point of view, Denny fund is clearly superior. It oers a higher return for a lower risk. 4.22 Performance Measurement

S &P = 17.713%, (a) The following statistics can be calculated from the given information: r MF = 33.077%, r MF = 36.651%, S &P = 19.699%, and MF = 1.665. (b) Comparison with S&P is invalid because this does not take the risk into account. People do not just pick investments by average returns. They also take the risk into account. CAPM is one way to take risk into account. (c) Since the risk-free rate during the past 10 years averaged to 6.2%, we can calculate the proper average rate of return on the fund to be 6.2 + 1.665(17.713 6.2) = 25.37%. Since the average return earned by the fund is 33.077%, which is actually more than what it should be even compared to its proper expected return, we can agree that the fund has indeed performed well during the 1980s.

34

4.23 Performance Measurement The following facts can be collected from the information given: Average fund return = r i Average market return = r m Average risk-free rate = r f Std Dev of market = m Std Dev of fund = i Correlation between fund and mkt. = im Funds = i = = = = = = = 0.126 per year 0.142 per year 0.074 per year 0.42 per year 0.33 per year 0.60 im

Funds abnormal return

i m 0.33 = 0.471428 = 0.60 0.42 rf + i ( rm r f )] = r i [ = 0.126 [0.074 + 0.471428(0.142 0.074)] = 0.019942 per year

Since the abnormal return is positive, the fund did exhibit superior performance. 4.24 Performance Measurement

(a) Comparing fund returns with the S&P 500 is not appropriate if the funds risk is not the same as that of the S&P 500. (b) Statistical analysis of the data shows that the of the fund is 1.35559 and the average return on the fund and the S&P 500 during the 10 years were 19.5% and 17.7%, respectively. The average abnormal return for the fund, therefore, is: ar = 19.5 [8.2 + 1.35559(17.7 8.2)] = 1.578% per year. Since the abnormal return is positive, the fund performed well.

35

Chapter 5

Common Stocks
5.1 Stock Splits and Stock Dividends A stock split of 5-for-3 gives 2 extra shares for every 3 shares. Therefore, it is equivalent to a stock dividend of 2/3 or 66.67%. A stock split of 7-for-5 gives 2 extra shares for every 5 shares. Therefore, it is equivalent to 2/5 or 40% stock dividend. 5.2 Dividend Preference Case 1: Since they sold the shares on the evening of March 12, they did not receive the dividend. The investors realized a capital gain of ($12 $10) = $2 between January 2, 1989 and March 12, 1989. The cashow, net of taxes to the investors were: $2(1 0.28) = $1.44 to the individual. $2(1 0.34) = $1.32 to the American corporation. $2(1 0.30) = $1.40 to the Japanese corporation. Case 2: Since they sold the shares on the morning of March 13, they received the dividend. The investors realized a dividend of $1 and a capital gain of ($11.20 $10) = $1.20 between January 2, 1989 and March 12, 1989. The cashow, net of taxes to the investors were: $1(1 0.28) + $1.20(1 0.28) = $1.584 to the individual. $1(1 0.08) + $1.20(1 0.34) = $1.712 to the American corporation. $1(1 0.00) + $1.20(1 0.30) = $1.84 to the Japanese corporation. From the results, it is clear that all investors would be better o selling the shares on the morning of March 13, so that they receive the dividend. 5.3 Common Stock Valuation

(a) The entries in the listing are explained below:



indicates that the stock price reached a new high during the days trading.

41 7/8 and 40 3/8 are the highest and the lowest prices reached by the stock during the past 52 weeks. Khilona is the name of the company and KHL is the ticker symbol. 36

 The stock paid $2.55 in dividends during the past year. The dividend yield of the stock is 6.07% per year. The dividend yield is calculated by dividing the annual dividend by the closing price. Since the closing price for the day (as we see later) is $42, the dividend yield is 2.55/42 = 0.0607, which agrees with the reported value. The ratio of price per share to earnings per share is 7. 2000 shares of the stock were traded in the market. The high, low, and closing prices for the stock were all $42. The stock closed up by 41 5/8.
3/8.

Therefore, the closing price on the previous trading day must have been

(b) The dividend payout ratio is calculated by dividing the dividends per share by the earnings per share. We know that the dividends per share for the last year were $2.55. The earnings per share can be calculated using the PE ratio. Since, the PE ratio is dened as the price per share (p) divided by earnings per share (e), 7 = p/e = 42/e which gives us earnings per share of 6. The dividend payout ratio, therefore, is 2.55/6=0.425 or 42.5%. I would classify this rm as a growing rm. (c) The cash ows expected from the stock are: 0.60 1 0.60 2 0.80 3 46.60 4

To calculate the proper price (present value) of the stock we need the discount rate. The for the stock is calculated as im i /m = 0.80 0.22/0.14 = 1.257. The discount rate for the stock is then calculated as rf + (m rf ) = 0.07 + 1.257(0.12 0.07) = 0.13285. This rate is on a per year basis. We estimate the quarterly rate needed for computation as (1 + 0.13285)1/4 1 = 0.03168. Now we can calculate the present value as: PV =
0.60 1+0.03168

0.60 (1+0.03168)2

0.80 (1+0.03168)3

46.60 (1+0.03168)4

= 43.01 The proper price, therefore, is $43.01. Since the stock is selling for $42, it is underpriced and should be purchased. 5.4 Common Stock Valuation

(a) The entries in the listing are explained below: 30 and 18 are the highest and the lowest prices reached by the stock during the past 52 weeks. Jumbo Peanuts is the name of the company and JP is the ticker symbol. The stock paid $2.70 in dividends during the past year. The dividend yield of the stock is 12.3% per year. The dividend yield is calculated by dividing the annual dividend by the closing price. Since the closing price for the day (as we see later) is $22, the dividend yield is 2.70/22 = 0.1227 0.123, which agrees with the reported value. The ratio of price per share to earnings per share is 6. 2000 shares of the stock were traded in the market. The high, low, and closing prices for the stock were $23, $21, and $22, respectively. 37

 The stock closed up by 1. Therefore, the closing price on the previous trading day must have been 21. (b) The earnings per share can be determined using the PE ratio. 22/e = 6. Therefore, e = 3.67. The dividend payout ratio is 2.70/3.67 = 0.74. Therefore, only 26% percent of the earnings were retained last year. If company retains this much earnings every year, it is growing but at a low rate. (c) The annual discount rate is calculated using the CAPM as: k = rf + (m rf ) = 0.0614 + 1.4(0.1255 0.0614) = 0.15114 or 15.114% per year. The quarterly discount rate needed for PV calculations is (1 + 0.15114)1/4 1 = 0.0358 or 3.58% per quarter. (d) Suppose the growth rate is expected to be g per quarter. Then the next dividend is expected to be 0.70(1 + g ). The price must equal the present value of all future dividends, so: p= d kg 22 = 0.70(1 + g ) 0.0358 g

which gives g = 0.00385 or 0.385% per quarter. Valuation of Common Stock Using the information given in the problem, we can make the following table for returns. rC and rm are the monthly returns on Curio and S&P 500, respectively. Curio Price Dividend 20.40 20.00 19.50 18.50 19.00 19.60 18.90 19.10 19.00 18.50 18.70 19.00 19.20 21.50 22.00 21.00 19.00 18.00 17.00 17.50 18.00 18.00 18.50 19.00 19.20 0.60 0.00 0.00 0.60 0.00 0.00 0.60 0.00 0.00 0.60 0.00 0.00 0.60 0.00 0.00 0.60 0.00 0.00 0.60 0.00 0.00 0.60 0.00 0.00 0.60 5.5

Month 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

S &P 500 230 235 237 235 239 242 245 243 246 249 255 258 262 264 267 264 270 265 278 282 282 287 290 292 293

rC 0.019608 0.025000 0.020513 0.027027 0.031579 0.005102 0.010582 0.005236 0.005263 0.010811 0.016043 0.042105 0.119792 0.023256 0.018182 0.095238 0.052632 0.022222 0.029412 0.028571 0.033333 0.027778 0.027027 0.042105

rm 0.021739 0.008511 0.008439 0.017021 0.012552 0.012397 0.008163 0.012346 0.012195 0.024096 0.011765 0.015504 0.007634 0.011364 0.011236 0.022727 0.018519 0.049057 0.014388 0.000000 0.017730 0.010453 0.006897 0.003425

38

(a) The for Curio is calculated by running the market model regression. The result gives C = 0.017831. Since no growth or cyclical behavior is apparent in the S&P 500 returns, we can estimate the expected return on the market by the average of past returns. Therefore, on calculation, we see m = 0.010227. The proper rate of return expected from Curio is calculated using CAPM as: C = rf + C (m rf ) = 0.006 + (0.017831)(0.010227 0.006) = 0.005924 . (b) The current price of Curio is $19.20 and the next months price is expected to be $20. Therefore, based on the private information, the rate of return is expected to be (20 19.20)/19.20 = 0.041666. (c) Since the rate of return expected based on private information is higher than that based on the risk, the stock is underpriced and should be purchased. 5.6 Price Earning Ratio With constant growth, the price is equal to the present value of growing perpetuity beginning with the next periods dividend which equals d(1 + g ) where d is the current periods dividend. Therefore: p= e (1 + g ) d(1 + g ) = kg kg p (1 + g ) = e kg

where the second step follows from the denition of the payout ratio. From this equation we can see that a stock with high growth (g ) will have a high price earnings ratio. The ratio could also be high if the discount rate k is low. At rst glance, it appears that the price earnings could also be high if the payout ratio ( ) is high. However, a high payout ratio would lower the growth rate g so that which will bring the price earnings ratio down. The net eect of a high payout ratio on the price earnings ratio is negative. 5.7 Price Earning Ratio

(a) PE ratio = price/earnings. Therefore, earnings = Price/PE ratio. So, earnings=31 5/8/52=0.6082, or approximately $0.61 per share. (b) The dividend payout ratio is dened as dividends per share divided by earnings per share which equals 0.92/0.61=1.508. So the company paid 150% of its earnings as dividends. This situation may arise if the company has low earnings during the year but the company does not want to change its dividend policy. (c) k = rf + (m rf ) = 0.065 + 1.2(0.13 0.065) = 0.143 or 14.3% per year. (d) Suppose the annual growth rate is g , then: p = 31.625 = which gives g = 0.1104 or 11.04% per year. 5.8 PVGO PVGO = p 1.20 e = 14 = 14 12 = 2 k 0.10 0.92(1 + g ) 0.143 g

39

5.9

PVGO PVGO, for a constant growth stock, is dened as PVGO = P V e k

The PV for a growth company is calculated using growing perpetuity, so that: PVGO = e d kg k

Now substitute g = (1 )i from equation (5.4) and d = e from the denition of payout ratio and simplify: PVGO = = = = = = =
e k(1 )i

e k

ekek+e(1 )i k(k(1 )i) ekek+eiei k(k(1 )i) e(ik)e (ik) k(k(1 )i) (ee )(ik) k(k(1 )i) e(1 )(ik) k(k(1 )i) (1 ) k

e(ik) k(1 )i

If i = k , the second term goes to zero, making PVGO=0. 5.10 Valuing a Growth Stock The growth rates in dividends for the previous three years are calculated as (0.62/0.55) 1 = 0.127, (0.70/0.62) 1 = 0.129, (0.79/0.70) 1 = 0.129. The average annualized growth rate therefore seems to be 0.129 or 12.9%. The expected dividend next year, therefore, is 0.79 (1 + 0.129) = 0.89. The discount rate is 15% per year. Assuming that the company will be able to maintain this growth rate forever, we can calculate the present value of the stock as: 0.89/(0.15 0.129) = $42.38. 5.11 Delayed Growth The earnings per share in Qtr 1 of 1995 would be 0.75(1 + 0.02)21 = 1.136749. Therefore, the dividends per share would be 0.60 1.136749 = 0.682049. Thereafter, the dividends will grow at the rate of 1.4% or 0.014 per quarter. The discount rate for the stock can be calculated using the CAPM to be 0.065 + 1.4(0.125 0.065) = 0.149 per year. For present value calculation, this has to be converted to per quarter basis as (1 + 0.149)0.25 1 = 0.035333. Now we can calculate the present value as: PV = 5.12 1 0.682049 = 15.96 (0.035333 0.014) (1 + 0.035333)20

Information and Price Reaction

(a) The proper expected return is calculated using CAPM as: k = rf + (m rf ). We need to know to use this equation. can be calculated as: i = im i m = 0.20 0.25 0.20 = 0.25

Now, the discount rate is calculated as: k = 0.06 + 0.25(0.13 0.06) = 0.0775, or 7.75% per year. 40

(b) The dividend payments from Merit constitute a perpetuity. Therefore, p= which gives d = $1.55 per share. (c) With the new tax law, the dividends per share will become $1.62. This change will not have any eect on the discount rate. Therefore, the new price will be: p= 1.62 = 20.90 0.0775 d k 20 = d 0.0775

So, the price of Merit company will go up by $0.90 after the announcement.

41

Chapter 6

Fixed Income Securities

Bond Valuation The annual coupon rate is 5 5/8 or 5.625% per year. Therefore, the bond will pay annual coupon of $56.25 in two equal payments of $28.125. The promised cashows from the bond are shown below: $28.125 0 7/1/91 1 12/31/91 $28.125 ... 2 6/30/92 8 6/30/95 9 12/31/95 $28.125 $1028.125 6.1

We can write the following equation for the semiannual yield to maturity:
r 910 = 28.125af r 8 + 1028.125df 9

To solve it, we resort to trial-and-error. Since the bond is selling at a discount rate, the yield to maturity must be higher than the coupon rate. So we start with a value higher than 2.8125%. r 0.030 0.035 0.040 0.041 r r = 0.040 + af r 8 7.0197 6.8740 6.7327 6.7050 df r 8 0.7664 0.7337 0.7026 0.6995 rhs 985.4010 947.6971 911.7054 904.7048 910

0.041 0.040 (910 904.7048) = 0.040243 904.7048 911.7054

or 4.0243% per six month or 8.21% per year. 6.2 Yield of a Bond Selling at Par The semiannual coupon rate is 3.5%. So the cemiannual coupon amount is $35. The equation for calculating the semiannual yield to maturity may be written as:
r 1000 = 35af r 12 + 1000df 12

To solve for r, we use the trial-and-error. r 0.035 af r 12 9.66333 df r 12 0.66178 42 rhs 1000.0000

So the semiannual yield to maturity is equal to the semiannual coupon rate, i.e., 3.5%. The annual yield to maturity is (1 + 0.035)2 1 = 0.071225 or 7.1225%. 6.3 Convertible Bonds Since the risk of the ABC9s92 and ABC8s91 are identical, the yield to maturity of the two bonds should be identical. The semiannual yield to maturity of ABC8s91 is calculated as:
r 920 = 40df r 1 + 1040df 2 =

1040 40 + (1 + r) (1 + r)2

which can be solved using trial-and-error or an algebraic method. Let us use the algebraic method. Multiply the whole equation by (1+r) and take all terms to the left hand side to get: 920(1 + r)2 40(1 + r) 1040 = 0 This is a quadratic equation for (1 + r). The solutions for (1 + r) are: (1 + r) = = = = so that r = 0.0852 or 2.0417 (40) 40 (40)2 4(920)(1040) 2(920)

3828800 1840 40 1956.7320 1840 1.0852 or 1.0417

Since the yield to maturity cannot be negative, the proper yield to maturity is 0.0852 or 8.52% semiannually. Now, as we mentioned above, the yield to maturity of ABC9s92 should also be 8.52% semiannually. So the value of the bond can be calculated as:
.0852 .0852 + 10450 = 868.38 PV = 45af 0 3 4

So ABC9s92 should be selling for $868.38. However, this bond also has a convertibility feature. Therefore, the value of the bond, if converted to shares would be 50 18 = $900. The bond is worth more if converted to shares. Therefore, this will be the determining factor in bond price. The price of the bond, therefore, will be $900 or more because of the possibility that the prices of shares may go up even more making the bond more valuable. 6.4 Pre-tax and After-tax Yields The pre-tax semiannual yield to maturity is calculated using the equation:
r 920 = 50af r 10 + 1000df 10

which, when solved using trial-and-error and interpolation, gives r = 0.060916. The after-tax coupon income to the investor paying 28% on interest income and capital gains would be $50(1 0.28) = $36. The total income on maturity would be $1,000 but $1, 000 $920 = $80 of this would be capital gains. The investor will have to pay 0.28 $80 = $22.4 in capital gains taxes making his net cashow to be $1, 000 22.40 = $977.60. The semiannual yield to maturity based on the after-tax cashows would be calculated as: r 920 = 36af r 10 + 977.60df 10 which, when solved using trial-and-error and interpolation, gives r = 0.044243. Using the intuitive formula, the after-tax rate would have been calculated to be 0.060916(1 28) = 0.0438592 which is a little less than the true after-tax yield of 0.044243. 43

6.5

Basic Bond Calculations

(a) The bond is below its face value. So it is selling at a discount or below par. (b) The current yield of the bond is 90/985 = 0.0914 or 9.14%. It is an approximate measure of the next years rate of return the investor can expect from the interest income alone. (c) The semiannual yield to maturity can be calculated using the following equation:
r 985 = 45af r 34 + 1000df 34

which, when solved using trial-and-error and interpolation, gives r = 0.045879 semiannually or an annual rate of 9.3864%. This is the annual rate of return expected from the bond if the bond is held to maturity and the bond makes all the promised cashows. (d) The yield to call is calculated assuming the bond will be called the rst chance the issuer has to call the bond. Since the bond is callable in 1997, let us assume that the bond will be called on January 1, 1997, which is essentially the same as calling it on December 31, 1997. The semiannual yield to maturity can be calculated using the following equation:
r 985 = 45af r 16 + 1075df 16

which, when solved using trial-and-error and interpolation, gives r = 0.049561 semiannually or an annual rate of 10.1578%. This is the annual rate of return expected from the bond if the bond is held till call and the bond makes all the promised cashows. 6.6 Bond Pricing There are two steps required to solve this problem. In the rst step, we determine the yield to maturity of CRX and then, use it as the discount rate for Lauras bond. The cashows from the CRX bond are given below. In drawing this diagram I assumed that the bond pays its coupon interests on June 30 and December 31, and that the bond will mature on December 31, 1995. Since today is May 12, 132 days have passed since the previous coupon payment date and 50 days remain to the next coupon payment. $41.25 #1 6/30/88 $41.25 12/31/88 ... $41.25 6/30/95 $1041.25 12/31/95

We can write the following equation to solve for the yield to maturity, r: 952.50 + 132 41.25 = 182 982.42 = 1 r [41.25 + 41.25af r 15 + 1000df 15 ] (1 + r)50/182 1 r [41.25 + 41.25af r 15 + 1000df 15 ] (1 + r)50/182

We can solve for r using trial-and-error and interpolation: r 0.040 0.050 0.045 0.046 y af r 15 11.1184 10.3797 10.7395 10.6661 df r 15 0.5553 0.4810 0.5167 0.5094 rhs 1043.8399 937.7736 988.9452 978.4224 982.4200

44

Now we use interpolation: r = 0.046 + 0.045 0.046 (982.4200 978.4224) = 0.0456201 988.9452 978.4224

Since Lauras bond has identical risk as the CRX, then under market equilibrium, the discount rate for Lauras bond would also be 0.0456201. Assuming that the discount rate for Lauras bond on July 1 would also be be 0.0456201 the price of Lauras bond on July 1 would be calculated as:
y P = 45.00af y 23 + 1000df 23

where y = 0.0456201. Again, I have assumed that the coupon payments are made on June 30 and December 31, and that the bond matures on December 31. On calculation we nd the price to be 991.28. Bond Yields using Real Data The bond is to be purchased on February 9, 1988: 40 days after the December 31, 1987 coupon payment. The semiannual coupon rate is 4.3125%. The semiannual coupon payment, therefore, is $43.125 per bond. 40 or $9.48. I used 182 The bond has a face value of $1,000. The accrued interest, therefore, is 43.125 182 because the number of days between January 1, 1988 and June 30, 1988 is 182. This leads to the purchase price of $940+$9.48=$949.48. This is the price to be paid for the bond regardless of whether the investor has to pay taxes or not. The total number of semiannual coupon payments are 42 because 21 years pass between the beginning of 1988 and the end of 2008. The time between the day of purchase and the rst coupon payment is 182 40 or 142 days. This translates into 0.78 semiannual periods. (a) The yield to maturity r is solved using the following equation:
r 949.48 = [43.125 + 43.125af r 41 + 1000df 41 ]

6.7

1 (1 + r)0.78

The value of r is determined by the trial and error method. r 0.0400 0.0450 0.0460 0.0470 0.0465 0.0464 r af r 41 19.9930 18.5661 18.3000 18.0400 18.1692 18.1953 df r 41 0.200277 0.164525 0.158197 0.152119 0.155128 0.155737 (1 + r)0.78 1.031073 1.034939 1.035711 1.036484 1.036098 1.036021 1072.2830 1072.2830 974.2730 956.3588 938.9624 947.5970 949.3391 949.48

Now we interpolate using the last two iterations to get the semiannual yield as: r = 0.0464 + 0.0465 0.0464 (949.48 949.3391) = 0.04639. 947.5970 949.3391

The annualized yield is (1 + 0.04639)2 1 = 0.09493 or 9.48% per year. (b) The transaction cost is 0.03 949.48 or $28.48. The total cash outow on February 9, therefore, would be 949.48 + 28.48 or $977.96. Taxes would reduce the coupon amounts. The after-tax coupon amount would be 43.125 (1 0.28) or $31.05. On maturity, capital gain tax would have to be paid. The capital gain is $1,000 $949.48 = $50.52. The capital gain tax would be 50.52 0.28 or $14.15. The net nal cashow, therefore, would be 1,000 14.15 or $985.85. 45

I have made a simplifying assumption that the taxes are deducted at the source, i.e., at the time the coupon income is received. In reality, the coupon incomes may be received in June and December but the taxes may not be paid till the following April. A very careful analysis will take that into account also. To solve for the yield to maturity r we set up the following equation:
r r + 985.85df41 ] 977.96 = [31.05 + 31.05af41

1 (1 + r)0.78

Using trial-and-error and interpolation, we nd the yield to be 6.53% per year. (c) With possibilities of default, the pricing and yield calculations should be based on the expected values rather that the promised values. Since in this particular problem default is possible only during the payment of the face value we do not have to make too many changes from part b. The expected nal cashow is calculated as 0.80 1000 + 0.20 850 = 970. This means that the expected capital gain would be 970 949.48 or $20.52 on which the capital gain tax would be $5.75 resulting in the net nal expected payment of $964.25. The yield to maturity r is solved by trial and error using the following equation:
r 977.96 = [31.05 + 31.05af r 41 + 964.25df 41 ]

1 (1 + r)0.78

to give an annual rate of approximately 6.48% per year. 6.8 Treasury Note

(a) The annual coupon rate on the note is 13 7/8 or 13.875%. The note matures in June 1992. Its bid and asked prices were 105 13/32 and 105 17/32. The bid price had changed by 2/32 since the previous trading. The yield to maturity is estimated to be 8.85% per year. (b) The semiannual yield to maturity may be calculated using the the ask price of 105.53125 using following equation: 105.53125 + 6.9375 (123/182) = 1 (1 + r)59/182
r [6.9375 + 6.9375af r 8 + 100df 8 ]

which, when solved using trial-and-error and interpolation gives r = 0.060647. The annual yield, therefore, is 12.4972% per year. 6.9 Comparing Bond Investments The annual yield to maturity on the 15 year Treasury strip is calculated as: 100 26.02 = (1 + r)15 r= 100 26.02
1 ( 15 )

1 = 0.0939

or 9.39% per year. The semiannual yield to maturity of the 15 year 12% Treasury bond is calculated as:
r 123.14 = 6af r 30 + 100df 30

which, when solved using trial-and-error and interpolation, gives r = 0.045680 semiannually or an annual rate of 9.3446%. The 12% coupon bond is yielding a little less than the Treasury strip. The interest rate risk of the 12% coupon bond is also a little bit higher because the coupon income has to be reinvested and if the rates go down the coupons will earn a lower rate. 46

6.10 Treasury Bill The bid and ask prices can be calculated using the corresponding discounts using the equation: p = 100 100nd 360

So that the bid and ask prices are 98.8065 and 98.81078, respectively. The 77-day ask yield is (100 98.81078)/98.81078 = 0.012035. Therefore, the annual yield as reported in The Wall Street Journal is 0.012035 (365/77) = 0.0571 or 5.71%. The eective annual yield is (1 + 0.012035)365/77 1 = 0.058347 or 5.83% per year. Suppose the continuously compounded annual rate is r, then: 98.81078 = 100/e(77/365)r or 5.67% per year. 6.11 Yield of a Bond Portfolio r = 0.0567

(a) The semiannual yield to maturity for bonds are calculated as:
rA A 1050 = 80af r 6 + 1000df 6 rA A 940 = 60af r 4 + 1000df 4

which give rA = 0.069525 and rB = 0.078036. (b) Cost of 3 A bonds is 3 1050 = 2100 and cost of 3 B bonds is 3 940 = 2820. The portfolio, therefore, will cost 2100 + 2820 = 4920. The fraction of money invested in bonds A and B are 2100/4920 = 0.426829 and 2820/4920 = 0.573171. The weighted average yield of the portfolio, therefore, is 0.426829rA + 0.573171rB = 0.426829 0.069525 + 0.573171 0.078036 = 0.074403 or 7.44% semiannually. (c) The coupon income from a portfolio of 2 A bonds and 3 B bonds would be 2 80 + 3 60 = 340 for the rst two years and 2 80 = $160 for the third year. The face value of A will be received 3 years from now and that of B, two years from now. The cashows are shown below on a semiannual time line: 4920 0 340 1 340 2 340 3 3340 4 160 5 2160 6

The yield to maturity, rp , from these cashows is calculated using the following equation: 4920 = 340af 3p + 3340df 4p + 160df 5p + 2160df 6p which, when solved, gives rp = 0.073768 or 7.3768% semiannually. 6.12 Interest Rate Sensitivity
r r r r

(a) The semiannual yield to maturity r can be solved using the following equation:
r 978 = 25af r 16 + 1000df 16

which gives r = 0.026708. The annual yield to maturity, therefore, is (1 + 0.026708)2 1 = 0.054129 or 5.4129% per year.

47

(b) With a 1% increase, the annual yield will be 6.4129%. The semiannual yield will be (1+0.064129)0.5 1 = 0.031566. The price of the bond can now be calculated as:
r PV = 25af r 16 + 1000df 16

where r = 0.031566. Upon calculation, we get PV = 918.5015. So the bond price drops from $978 to $918.5015 because of a 1% increase in yield. This is a 6.084% price in drop. Therefore, a 1% increase in interest rate results in a 6.084% price drop for this bond.

48

Chapter 7

Options
7.1 OptionsTerminology and Strategy

(a) In the money call: Dig Eq May 95. Payo (intrinsic value) = Max[Ps E, 0] = Max[106.625 95, 0] = 11.625. Time value=Pc payo = 11.875 11.625 = 0.25. Out of the money call: Dig Eq Jun 120. Payo (intrinsic value) = Max[Ps E, 0] = Max[106.625 120, 0] = 0. Time value=Pc payo = 0.875 0 = 0.875. In the money put: Dig Eq Sep 130. Payo (intrinsic value) = Max[E Ps , 0] = Max[130 106.625, 0] = 23.375. Time value=Pc payo = 23.75 23.375 = 0.375. Out of the money put: Dig Eq Jun 100. Payo (intrinsic value) = Max[E Ps , 0] = Max[100 106.625, 0] = 0. Time value=Pc payo = 1.75 0 = 1.75. (b) The prices of May 100, Jun 100, and Sep 100 call options are 7 3/4, 9 1/2, 12 7/8, showing that the option price increases as the time to maturity increases. The prices of May 95, May 100, May 105, and May 110 call options are 11 8/8, 7 3/8, 3 5/8, and 1 3/8, showing that the call option price goes down as the exercise price goes up. (c) The payo diagram is shown below: P a y . . . . . . . . . . .. . . . .. . . . .. . . . . . .. . . . . o 100 . . . . . . . ... . . . . . .. . . . . . .. . . . . . . . . . . ... . . . . . . .. . . . . .. . . . . . . . . .... f . . . . . . .. . . . . . .. . . . . . . . . ..... . . . . . .. . . . . .. . . . . . . . . . ..... . . . . . .. . f . . . . .. . . . . . . . . ... . . . . . . . . ... . .

. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . . . . . . . . . . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . . . . . .. . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . .. . . . . .. . .. . . . . . . . .. . . . .. . . . . . . . .. .

. . .. . . ...... . .. . . .. . .. ..... . . . . . . . . . . . . . . . . . ... . .. . . .. . .. ..... . ..... . .... . . . . . . . ...... . . . . . ...... . . . . . ...... . .. . ...... .. . . ..... ...... . . . . . . . . . . . . . . . . . . . . . . . . . . . .. .
100 110 Ps

This combination is like a straddle, except that the call and put do not have the same exercise price. This combination costs only 3 3/8+1 3/4=5.125. As the payo diagram shows, the investor will not receive any payo if the stock price stays between 100 and 110. The investor will receive a payo if the price goes below $100 or above $110.

49

Option Pricing Ps = 58 1/4, E = 55, Pc = 3 7/8. Intrinsic value = Max[Ps E, 0] = Max[58 1/455, 0] = 3.25. Time value = Pc Intrinsic value = 3.875 3.25 = 0.625 If the stock price were $60, the options intrinsic value would be 60 55 = 5. The time value should still be about 0.625. It may be a little bit less, because the higher the price, the lesser the chance of price going even higher. So the option price would be just slightly below $5.625. If the option were expiring on April 20, it would have zero or negligible time value. Therefore, the option price would be $3.875. 7.3 Payo Diagrams The payo diagram is shown below: P a y o 10 f f

7.2

... . . . .. .. . . .. ... . . . . .. . . . .. . . . ... . . . . . .. . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . .. . . . . . . . . . . . . . .. . . . . . . . . . . . . . .. . . . . . . . . . . . . .. . . . . . . . . . . . . . .. . . . . . . . . . . . . . .. . . . . . . . . . . . . .. . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . .. . . . . . . .. . . . . . . . .. . . . . . . . .. . . . . . . .. . . . . . . . .. . . . . . . . .. . . . . . . .. . . . . . . . .. . . . . .

100 110 120 Ps 7 3/8
1/8

The cost of this combination is + prot if the stock price does not move much. 7.4 Put-call Parity The put-call parity relationship is:

2(1 3/8)

= 4.75. The combination allows an investor to make

Ps + Pp Pc =

E . (1 + rf )T

We are given Pc = 6.75, E = 40, rf = 0.08 per year, T = 0.5 years, Ps = 45. So: 40 45 + Pp 6.75 = (1.08)0.5 which gives Pp = 0.24. The price of the put option should be $0.24. Binomial Option Pricing Consider a portfolio that is long 1 share and short m puts with $45 exercise price. The payo on this portfolio, if the future stock price is $48, would be $48 because the option would be worthless. If the future stock price is $34, the portfolio would be worth 34 11m. For the payo to be free of risk, it should be same regardless of the stock price. So 48 = 34 11m which gives us m = 1.2727. So the portfolio should actually be long 1.2727 puts. The payo on the portfolio will be $48, regardless of the stock price. The present value of the portfolio, therefore, should be 48/(1 + 0.06)0.5 = 46.622. The cost of the portfolio is 40 + 1.2727Pp should be equal 46.622. From that condition we get Pp = 5.203. 7.6 Black-Scholes Formula First we calculate d1 and d2 : d1 d1 = =
s ln( P ln( 30 1 E ) + rf T 20 ) + (0.08)(0.25) + (0.5)0.10 0.25 = 8.51 + T = 2 0.10 0.25 T 30 s ) + r T ) ln( P ln( 1 f E 20 + (0.08)(0.25) T = (0.5)0.10 0.25 = 8.46 2 0.10 0.25 T

7.5

So that, N (d1 ) = N (8.51) = 1.00, N (d2 ) = N (8.46) = 1.00. Finally: Pc = Ps N (d1 ) Eerf T N (d2 ) = (30)(1.00) (20)e(0.08)(0.25) (1.00) = 10.39

50