1.

What are the key differences between common stock, preferred stock, and corporate
bonds?

Common stock

Represents ownership shares in a corporation.

Each share of common stock entitles its owners to one vote.

Common stock of most large corporations can be bought or sold freely on one or more
of the stock markets.

Preferred stock

Hybrid security

It promises to pay to its holder fixed stream of income each year and it does not give the
holder voting power regarding the firm’s management.

Cumulative

It can be callable by the issuing firm

It can be convertible into common stock at some specified conversion ratio

Corporate bonds

Long-term debt issued by private corporations typically paying semi-annual coupons

and returning the face value of the bond at maturity .

Default risk is real consideration in the purchase of corporate bonds

Corporate bonds sometimes come with options attached

2. Why do most professionals consider the Wilshire 5000 a better index of the
performance of the broad stock market than the Dow Jones Industrial Average?

Due to several factors : a. Comprehensive b. Market capitalisation weighting c.

Diverse sector representation

3. What features of money market securities distinguish them from other fixed-income
securities?

a. Short-term maturity b. High liquidity c. Low default risk

d. Low yield e. Discount pricing

4. What are the major components of the money market?

a. Treasury bills : At the bill’s maturity, the holder receives from the government a
payment equal to the face value of the bill

b. Certificates of Deposit : the bank pays interest and principal to the depositor only at
the end of the fixed term of the CD

C. Commercial Paper : cp is backed by bank line of credit which gives the borrower
access to cash that can be used if needed to pay off the paper at maturity

d. Bankers acceptances : originate when purchaser authorise a bank to pay a seller for
goods at later date

5. Describe alternative ways that an investor may add positions in international equity to
his or her portfolio.

a. Direct Purchase of Foreign Stocks

b. American Depositary Receipts (ADRs)

C. International Mutual Funds

d. Exchange-Traded Funds (ETFs)

e. Global/International Index Funds

6. Why are high-tax-bracket investors more inclined to invest in municipal bonds than
are low-bracket investors?

Because these bonds offer Tax-Exempt Interest , Higher After-Tax Returns , Tax-
Equivalent Yield Advantage , and Capital Preservation

7. What is meant by the LIBOR rate? The Federal funds rate?

The federal funds market allows banks to lend excess reserves

LIBOR is a benchmark interest rate for interbank lending.

8. How does a municipal revenue bond differ from a general obligation bond? Which
would you expect to have a lower yield to maturity?
Municipal revenue bond is project-specific and generally riskier, while a GO bond is
backed by tax revenue and considered more secure. Therefore, GO bonds are expected
to have a lower yield to maturity than revenue bonds.

9. Why are corporations more apt to hold preferred stock than are other potential
investors?

due to specific tax advantages and its unique characteristics which are Stable, Fixed
Income , enhance a corporation’s balance sheet and Priority in Dividends and
Liquidation

10. What is meant by limited liability?

Limited liability is a legal principle that limits the financial responsibility of

shareholders or owners to the amount they have invested in the company.

11. Which of the following correctly describes a repurchase agreement?

a. The sale of a security with a commitment to repurchase the same security at a

specified future date and a designated price.

b. The sale of a security with a commitment to repurchase the same security at a future
date left unspecified, at a designated price.

c. The purchase of a security with a commitment to purchase more of the same

security at a specified future date.

Intermediate

12. Why are money market securities sometimes referred to as “cash equivalents”?

because they share several characteristics high liquidity, low risk, short term maturity
and stable value

13. A municipal bond carries a coupon rate of 6¾% and is trading at par. What would be
the equivalent taxable yield of this bond to a taxpayer in a 35% tax bracket?

Equivalent taxable yield = 0.0675 / 1 – 0.35 × 100 = 10.38%

14. Suppose that short-term municipal bonds currently offer yields of 4%, while
comparable taxable bonds pay 5%. Which gives you the higher after-tax yield if your tax
bracket is:

a. Zero ( 5% × ( 1- 0 ) = 5%

b. 10%

c. 20%

d. 30%

15. An investor is in a 30% combined federal plus state tax bracket. If corporate bonds
offer 9% yields, what must municipals offer for the investor to prefer them to corporate
bonds?

After-tax yield = Taxable yield × ( 1 – tax rate ) × 100

= 9 % × ( 1 – 30% ) × 100 = 6.3 %

16. Find the equivalent taxable yield of the municipal bond in Problem 14 for tax
brackets of zero, 10%, 20%, and 30%.

1. Tax Bracket: Zero (0%)

After-Tax Yield of Taxable Bonds:

5% × (1 – 0) = 5%

2. Tax Bracket: 10%

After-Tax Yield of Taxable Bonds:

5% × (1 – 0.10) = 5% × 0.90 = 4.5%

3. Tax Bracket: 20%

After-Tax Yield of Taxable Bonds:

5% × (1 – 0.20) = 5% × 0.80 = 4%

4. Tax Bracket: 30%

After-Tax Yield of Taxable Bonds:

5% × (1 – 0.30) = 5% - 0.7 = 3.5%

17. Turn back to Figure 2.3and look at the Treasury bond maturing in November 2040.

a. How much would you have to pay to purchase one of these bonds?

Price = asked price X face value

= 0.98 × 1000 = 980

b. What is its coupon rate?

Coupon rate = 4.25

c. What is the current yield (i.e., coupon income as a fraction of bond price) of the
bond?

Current yield = annual coupon / market price

= 0.0 4.25 / 980 = 4.34 %

18. Turn to Figure 2.8and look at the listing for General Dynamics.

a. What was the firm’s closing price yesterday?

75.60 $

b. How many shares could you buy for $5,000?

No. Of shares = Investment / closing price =

= 5000 / 75.60 = 66

c. What would be your annual dividend income from those shares ?

Annual dividend income = no. Of shares × dividend per share

= 66 × 1.88 = 124

d. What must be General Dynamics’ earnings per share ?

EPS = Closing price / P/E RATIO

= 75.60 / 10.92 = 6.93

19. Consider the three stocks in the following table. Pt represents price at time t, and Qt
represents shares outstanding at time t. Stock C splits two-for-one in the last period.

P0 Q0 P1 Q1 P2 Q2
A 90 100 95 100 95 100
B 50 200 45 200 45 200
C 100 200 110 200 55 400
a. Calculate the rate of return on a price-weighted index of the three stocks for the first
period .

Initial index ( I _ 0 ) = 90 + 50 + 100 / 3 = 80 %

Index at t1 ( I _ 1 ) = 95 + 45 + 110 / 3 = 83.33 %

R = I _ 1 - I_0 / I_0 = 83.33 – 80 / 80 = 4.16 %

b. What must happen to the divisor for the price-weighted index in year 2?

I_1=I_2

250 / 3 = 195 / D2

83.33 = 195 / D2

D2 = 2.34

The divisor changed

c. Calculate the rate of return of the price-weighted index for the second period .

I _ 2 = 95 + 45 + 55 / 3 = 65

R=I_2–I_1/I_1

= 65 – 83.33 / 83.33 = 22%

20. Using the data in the previous problem, calculate the first-period rates of return on
the following indexes of the three stocks:

a. A market value–weighted index

The initial market value for each stock at time t0 :

Stock A:

90 \times 100 = 9000

Stock B:

50 \times 200 = 10000

Stock C:

100 \times 200 = 20000

Total Market Value at :

9000 + 10000 + 20000 = 39000

The market value for each stock at time t1 :

Stock A:

95 \times 100 = 9500

Stock B:

45 \times 200 = 9000

Stock C:

110 \times 200 = 22000

Total Market Value at :

9500 + 9000 + 22000 = 40500

The rate of return on the market value-weighted index:

R = Total Market Value at t=1 / Total Market Value at t=0 - 1

= 40500 / 39000 -1 = 3.85 %

b. An equally weighted index

INDEX VALUE at t0

I- 0 = 90 + 50 + 100 / 3 = 80

Index value at t1

I -1 = 95 + 45 + 110 / 3 = 83.33

R = I -1 / I – 0 -1 = 83.33 / 80 - 1= 4.16 %

1. What problems would confront a mutual fund trying to create an index fund tied to an
equally weighted index of a broad stock market?

An equally weighted index fund for a broad stock market would face high costs due to
rebalancing, liquidity issues, tax inefficiency, and operational complexity, which could
result in lower net returns and make it challenging to track the performance of an
equally weighted index.

22. What would happen to the divisor of the Dow Jones Industrial Average if FedEx, with
a current price of around $95 per share, replaced AT&T (with a current value of about
$31 per share)?

The divisor would be adjusted downward to reflect the higher stock price of FedEx,
keeping the index stable and accurately reflecting market performance rather than the
price difference between AT&T and FedEx.

23. A T-bill with face value $10,000 and 87 days to maturity is selling at a bank discount
ask yield of 3.4%. What is the price of the bill? What is its bond equivalent yield?
Price = par (1 – discount yield ×days to maturity / 360 )

= 10000 ( 1 – 0.034 × 87 / 360 ) = 9917.83

BEY = PAR – PRICE / PAR × 360 /n

= 10000 – 9917.83 / 10000 × 360 / 87 = 3.4 %

24. Which security should sell at a greater price?

a. A 10-year Treasury bond with a 9% coupon rate or a 10-year T-bond with a 10%
coupon.

the 10-year T-bond with a 10% coupon rate will sell at a greater price than the one with a
9% coupon rate because it pays a higher interest payment.

b. A three-month expiration call option with an exercise price of $40 or a three-month

call on the same stock with an exercise price of $35.

the call option with an exercise price of $35 has more intrinsic value (or potential
intrinsic value) than the call option with an exercise price of $40.

C. A put option on a stock selling at $50 or a put option on another stock selling at $60.
(All other relevant features of the stocks and options are assumed to be identical.)

the put option on the stock selling at $60 would have a higher potential value compared
to the put option on the stock selling at $50.

25. Look at the futures listings for corn .

a. Suppose you buy one contract for December 2011 delivery. If the contract closes in
December at a price of $6.43 per bushel, what will be your profit or loss? (Each contract
calls for delivery of 5,000 bushels.)

Profit = ( closed price – contract price ) × No of bushels

= ( 6.43 – 6.37 ) × 5000 = 300 $

b. How many December 2011 maturity contracts are outstanding?

Maturity contracts outstanding are 71122

26. Turn back to Figure 2.9and look at the Apple options. Suppose you buy an August
expiration call option with exercise price $355.

a. If the stock price in August is $367, will you exercise your call? What are the profit
and rate of return on your position?

Intrinsic value = stock price – strike price

 = 367 – 355 = 12

Profit = intrinsic value – call option premium

= 12 – 5.6 = 6.4

R = Profit / call option premium

R = 6.4 / 5.6 = 114%

b. What if you had bought the August call with exercise price $360?

Intrinsic value = stock price – strike price

= 367 – 360 = 7

Profit = intrinsic value – call option premium

= 7 – 3.15 = 3.85

R = Profit / call option premium

R = 3.85 /3.15 = 122%

C. What if you had bought an August put with exercise price $355?

Intrinsic value = strike price - stock price

= 355 – 367 = - 12

Profit = - put option premium = - 5.6

resulting in a loss equal to the premium paid, which is -$5.60.

27. What options position is associated with:

a. The right to buy an asset at a specified price?

Call option

b. The right to sell an asset at a specified price?

Put option

c. The obligation to buy an asset at a specified price?

Short put

d. The obligation to sell an asset at a specified price?

Short call

28. Why do call options with exercise prices higher than the price of the underlying
stock sell for positive prices?
Call options with exercise prices higher than the current price of the underlying stock
still have positive prices due to time value. Even if the option is currently out of the
money, there's potential for the stock price to rise above the strike price before the
option expires. This potential adds value to the call option.

29. Both a call and a put currently are traded on stock XYZ; both have strike prices of
$50 and maturities of six months. What will be the profit to an investor who buys the call
for $4 in the following scenarios for stock prices in six months? ( a) $40; ( b) $45; ( c) $50;
( d) $55; ( e) $60. What will be the profit in each scenario to an investor who buys the put
for $6?

30. What would you expect to happen to the spread between yields on commercial
paper and Treasury bills if the economy were to enter a steep recession?

During a steep recession, yields on commercial paper typically increase relative to

Treasury bills due to a higher perceived credit risk in the corporate sector, leading to a
wider spread. Treasury bills, being safer investments, retain lower yields.

31. Examine the stocks listed in Figure 2.8 . For how many of these stocks is the 52-
week high price at least 50% greater than the 52-week low price? What do you conclude
about the volatility of prices on individual stocks?

32. Find the after-tax return to a corporation that buys a share of preferred stock at $40,
sells it at year-end at $40, and receives a $4 year-end dividend. The firm is in the 30% tax
bracket.

After-tax return = 4 – 30% ×4 = 2.8 $

Challenge

33. Explain the difference between a put option and a short position in a futures
contract.

Put option : Right to sell an asset at a specified exercise price on or before a specified
expiration date

Short futures contract : Contract seller (short) delivers underlying commodity at

contract expiration for agreed-upon price

34. Explain the difference between a call option and a long position in a futures
contract.

Call option : Right to buy an asset at a specified price (exercise or strike price) on or
before a specified expiration date

Long futures contract : Purchaser (long position) buys specified quantity at contract
expiration for set price
CFA Problems

1. Preferred stock yields often are lower than yields on bonds of the same quality
because of:

a. Marketability

b. Risk

c. Taxation

d. Call protection