Question 1:

a. State the characteristics of bonds.

 Issuer
 Face Value
 Coupon Rate
 Yield
 Credit Rating
 Market Price
 Callable/Non-callable
 Security
 Interest Payment Frequency
b. Define premium bonds and discount bonds. Why are bonds traded at premiurn or discount?
 Premium Bonds: These are bonds that trade at a price higher than their face value or par
value. This situation occurs when the bond's coupon rate is higher than the prevailing
market interest rate. Investors are willing to pay more for the higher fixed interest
payments offered by the bond compared to the current lower rates available in the market.
 Discount Bonds: Conversely, discount bonds are bonds that trade at a price lower than
their face value. This happens when the bond's coupon rate is lower than the prevailing
market interest rate. Investors are attracted to these bonds despite the lower coupon
payments because they can buy them at a discount, which compensates for the lower
interest payments.
Bonds are traded at a premium or discount primarily due to changes in market interest rates after
the bond is issued. If market interest rates decrease after a bond is issued, existing bonds with
higher coupon rates become more attractive, leading investors to pay a premium for those bonds.
Conversely, if market interest rates increase, older bonds with lower coupon rates become less
attractive, causing them to trade at a discount to compensate for the lower interest payments.
Question 2
What is the security market line (SML)? How.can the SML be used to identify over- and
undervalued securities? Give an example.
- The Security Market Line (SML) is the graphical depiction of the CAPM equation. The
SML depicts the relationship between risk and expected rate of return for any asset,
security, or portfolio.

 The formula for the SML is:

Expected Return=Risk-Free Rate+(Beta×(Market Return−Risk-Free Rate)

 - The assets that appear above the SML are considered overvalued. It suggests that the
expected returns of the assets are higher than the justified required returns.
 The assets that lie below the SML are undervalued. It suggests that the expected returns
of the assets are lower than the justified required returns.

 For example, let's say a stock has a beta of 1.5, the risk-free rate is 3%, and the expected
return of the market is 8%. According to the SML, the expected return for this stock
would be:
 E(Ri)=3%+1.5×(8%−3%)=3%+1.5×5%=3%+7.5%=10.5%
 If the actual expected return for this stock, considering its risk, is 12%, it would be
considered undervalued based on the SML since the expected return predicted by the
SML (10.5%) is lower than the actual expected return (12%).
Question 3
a. What is the risk-expected retum tradeoff? How about the slope of the tradeoff?
- The risk-expected return tradeoff is a fundamental concept in finance that describes the
relationship between the level of risk an investor is willing to take and the expected
return they anticipate from their investments.
- The slope of the risk-expected return tradeoff, often represented by the Security Market
Line (SML) in the Capital Asset Pricing Model (CAPM), shows this relationship. It's a
positive slope indicating that as the level of risk (typically measured by beta or standard
deviation) increases, the expected return also increases. This slope illustrates the
compensation investors demand for taking on additional risk.
b. Rank these securities from low to high risk: Large firm common stocks, private equity,
treasury bills, corporate bonds, and small firm common stocks.
1. Treasury Bills: These are generally considered the least risky among the options listed.
They are short-term, low-risk debt securities issued by the government and are often seen
as virtually risk-free because they are backed by the full faith and credit of the
government.
2. Corporate Bonds: Bonds issued by corporations come next in terms of risk. They can
vary in risk depending on the credit rating of the corporation. Higher-rated bonds are
generally less risky compared to lower-rated or high-yield bonds, but overall, they're less
risky than equities.
3. Large Firm Common Stocks: Common stocks of large, well-established companies are
generally less risky compared to smaller firms or start-ups. They tend to be more stable
and have a more established track record, making them relatively less risky in
comparison.
4. Small Firm Common Stocks: Stocks of smaller companies or start-ups typically carry
higher risk. They can be more volatile, have less-established financials, and might be
more sensitive to market fluctuations or changes in business conditions. As a result,
they're considered riskier than stocks of larger, more established firms.
 5. Private Equity: Private equity investments involve buying shares in private companies
or acquiring control over public companies. These investments often entail higher risk
due to limited liquidity, longer investment horizons, and higher potential for business
failure compared to publicly traded securities.
Question 4: State the definition and the characteristics of the options. What is the difference
between call options and put options?
Characteristics of Options:
1. Underlying Asset: Options are linked to an underlying asset, which could be stocks,
indices, commodities, currencies, or other financial instruments.
2. Strike Price (Exercise Price): This is the price at which the option holder can buy (in
the case of a call option) or sell (in the case of a put option) the underlying asset.
3. Expiration Date: Options have a predetermined expiry date. The holder must exercise
the option (if profitable) before or on this date; otherwise, the option becomes invalid.
4. Premium: The price paid by the option buyer to the option seller for the right conveyed
by the option contract.
5. Call Option: This type of option gives the holder the right to buy the underlying asset at
the strike price within the specified timeframe. Call options are typically purchased if the
investor expects the price of the underlying asset to increase.
6. Put Option: A put option grants the holder the right to sell the underlying asset at the
strike price within the specified timeframe. Investors often buy put options if they
anticipate a decline in the price of the underlying asset.
Difference between Call Options and Put Options:
 Call Options: These give the holder the right to buy the underlying asset at the strike
price within a specific period. Call option holders profit if the market price of the
underlying asset increases above the strike price. Buyers of call options are bullish on the
underlying asset.
 Put Options: Put options provide the holder the right to sell the underlying asset at the
strike price within a specific period. Put option holders profit if the market price of the
underlying asset falls below the strike price. Buyers of put options are typically bearish
on the underlying asset.
Question 5
Define yield and capital gain (loss). Give 2 examples of yield and capital gain (loss) of stock and
bond (One example for stock, one example for bond).
Yield: Yield represents the income generated by an investment over a specific period, usually
expressed as a percentage of the investment's cost or current value. There are various types of
yield, including:
  Dividend Yield (for Stocks): This is the annual dividend income received from a stock
divided by its current market price, expressed as a percentage. For example, if a stock
pays a $2 dividend per share annually and the stock price is $50 per share, the dividend
yield would be 4% ($2 / $50).
 Yield to Maturity (for Bonds): It's the total return anticipated on a bond if held until its
maturity date. It considers the bond's current market price, par value, coupon interest rate,
and time to maturity. For instance, a bond with a face value of $1,000, a coupon rate of
5%, and trading at $900 with five years remaining until maturity would have a yield to
maturity of approximately 6.7%.
Capital Gain (Loss): Capital gain (or loss) refers to the increase (or decrease) in the value of an
investment when its selling price is higher (or lower) than its purchase price. It's calculated as the
difference between the selling price and the original purchase price.
 Stock Capital Gain: Suppose an investor buys 100 shares of a stock at $50 per share and
sells them later for $70 per share. The capital gain per share would be $20 ($70 - $50),
resulting in a total capital gain of $2,000 ($20 * 100 shares).
 Bond Capital Loss: If an investor purchases a bond with a face value of $1,000 at par
and sells it before maturity at a price of $950, they incur a capital loss of $50 ($1,000 -
$950).
Examples:
 Stock Yield Example: Consider a stock with a market price of $80 per share and an
annual dividend of $3 per share. The dividend yield would be 3.75% ($3 / $80).
 Bond Yield Example: Suppose an investor buys a bond with a face value of $1,000, a
coupon rate of 6%, and it's currently priced at $950. The yield to maturity would be
approximately 6.32%.
 Stock Capital Gain Example: If an investor purchases 200 shares of a stock at $30 per
share and later sells them at $40 per share, the capital gain would be $2,000 ($40 - $30)
for the entire investment.
 Bond Capital Loss Example: If an investor buys a bond at $1,100 and sells it at $1,000
before maturity, they would incur a capital loss of $100.
Question 6
Define the capital market line (CML). How does the slope of CML measure?
- The capital market line (CML) depicts the equilibrium conditions that prevail in the
market for efficient portfolios consisting of the optimal portfolio of risky assets and the
risk‐free asset. All combinations of the risk‐free asset and the risky portfolio M are on the
CML, and, in equilibrium, all investors end up with a portfolio somewhere on the CML
based on their risk tolerance
- The slope of the Capital Market Line (CML) measures the risk premium per unit of risk
(standard deviation). Mathematically, the slope of the CML is the difference between the
expected return on the market portfolio and the risk-free rate divided by the standard
deviation of the market portfolio.
- The equation for the CML is:
- E(Rp)=Rf+σmE(Rm)−Rf×σp