Ntroduction: Edited by SM Nahidul Islam (2nd Batch), Dept. of Finance & Banking

Edited by
SM Nahidul Islam (2nd Batch), Dept. of Finance & Banking
Chapter:1 INTRODUCTION
1.Why do secondary security markets not generate capital for the issuers of securities traded in
those markets?
Ans:
Issuers receive the net proceeds of securities sales when their securities are initially sold in
the primary market. These securities represent claims on the issuing entities. For publicly-
traded securities, these claims can be transferred through sales of the securities. This trading
among investors takes place in the secondary markets, where the issuers have no direct
involvement. When an investor sells his or her shares of a particular security in the
secondary market, the issuer has no means or right to receive any additional funds as a result
of the trade.
2. After the overthrow of communist regimes in Eastern Europe, many of the fledgling
democracies placed the development of security markets near the top of Their economic agendas.
Why do you think that they did so?
Ans:
Communism, as a guiding economic philosophy, has demonstrated an inability to efficiently
allocate resources to their most productive uses. Conversely, security markets, a prominent feature
of modern capitalistic economies, have proven effective at directing capital to those industries and
companies which will use it most efficiently. Thus the economic leaders of Eastern European
countries turned to security markets as one means of allocating scarce capital resources without
direct state intervention.
3. Colfax Glassworks stock currently sells for $36 per share. One year ago the stock Sold for
$33.The company recently paid a $3per share dividend. What was the Rate of return for an
investor in Colfax stock over the last year?
Ans:
The return on an investment, as shown in Equation (1.1) in the text, is given by:
Ending Wealth − Beginning Wealth

ROR =
Beginning Wealth
In the case of Colfax stock:
ROR = ($36 + $3 - $33)/($33)
= .182 = 18.2%
4. Flit Cramer owns a portfolio of common stocks that was worth $150,000 at the Beginning of
the year. At the end of the year, Flit's portfolio was worth$162,000. What was the return on the
portfolio during the year?
Ans:
Using the formula for the return on an investment shown above,
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in the case of Flit's portfolio:
($162,000 - $150,000)/($150,000) = .080 = 8.0%
5. At the beginning of the year, Ray Fisher decided to take $50,000 in savings out Of the bank
and invest it in a portfolio of stocks and bonds; $20,000 was placed Into common stocks
and$30,000into corporate bonds.A year later, Ray's stock And bond holdings were worth$
25,000 and $23,000, respectively. During the Year $1,000in cash dividend was received on the
stocks ,and $3,000in coupon Payments was received on the bonds.(The stock and bond income
was not reinvested in Ray's portfolio.)
a. What was the return on Ray's stock portfolio during the year?
b. What was the return on Ray's bond portfolio during the year?
c. What was the return on Ray's total portfolio during the year
Ans:
Using the formula for the return on an investment shown above,
in the case of Ray's portfolio:
a. ($25,000 - $20,000 + $1,000)/($20,000) = .300 = 30.0%
b. ($23,000 - $30,000 + $3,000)/($30,000) = -.133 = -13.3%
c. ($48,000 - $50,000 + $4,000)/($50,000) = .040 = 4.0%
6.Explain why the rate of return on an investment represents the investor's relative increase in
wealth from that investment?
Ans:
The rate of return measures the wealth associated with a particular investment (or
investments) at the end of a period compared to the wealth associated with that investment at the
beginning of the period. Therefore the difference in the beginning and ending wealth figures
represents the increase in the investor's wealth derived from the investment. The rate of return
expresses this difference relative to the initial wealth associated with the investment.
7. Why are Treasury bills considered to be a risk free investment? In what way do investors bear
risk when they own Treasury bills?
Ans:
Because the U.S. Treasury guarantees the payment of interest and principal on Treasury bills,
an investor can be certain of the return that he or she will earn on a Treasury bill investment.
The government has the unlimited authority to tax and print money to repay its debts. Therefore
its ability to make these promised payments is unquestioned.
This certain Treasury bill return, however, does not account for the effects of inflation. Although
the short maturity of Treasury bills makes this issue relatively unimportant, if inflation rose
sharply and unexpectedly during the time that an investor held Treasury bills, he or she would
not be compensated for the resulting lost purchasing power.
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8. Why are corporate bonds riskier than U.S. government bonds?
Ans:
Corporate bonds, no matter how creditworthy the issuer, always bear the risk that the issuer
might default on its debts. The U.S. government, on the other hand, can always raise taxes or
print money to cover its debt obligations. Therefore, as discussed in the answer to the previous
problem, the government has an unlimited ability to satisfy its debt obligations.
9. In 1951the Treasury Department and the Federal Reserve System(the Fed)

Came to an agreement known as the "Accord,"whereby the Fed was no longer
Obligated to peg interest rates on Treasury securities.What were the average returns and standard
deviations on Treasury bills for the ten-year periods from
1942 to 1951and from 1952 to 1961? From these data, does it appear hat the
Fed did indeed stop pegging interest rates? (See endnote2 for the formula for
Standard deviation.)
Ans:
Based on Table 1.1, the average annual return on Treasury bills during the period 1942-1951
was 0.67%. From 1952-1961 the average annual return was 2.08%.
The standard deviation of Treasury bill returns during 1942-1951 was 0.45%. From 1952-1961
the standard deviation was 0.72%.
Given the increase in Treasury bill return volatility from the first period to the second, it does
appear that the Fed stopped pegging interest rates in 1951.
10. The following table shows the annual returns on aportfolio of small stocks during the20-year
period from 1976 to 1995.What are the average return and standard deviation of this portfolio?
How do they compare with the 1976-1995
Average return and standard deviation of the common stock portfolio whose annual returns are
shown in Table1.1?
1976: 57.38% 1981: 13.88% 1986: 6.85% 1991: 44.63%
1977: 25.38 1982: 28.01 1987: -9.30 1992: 23.35
1978: 23.46 1983: 39.67 1988: 22.87 1993: 20.98
1979: 43.46 1984: -6.67 1989: -21.56 1994: 3.11
1980: 39.88 1985: 24.66 1990: -21.56 1995: 34.46
Ans:
The average annual return on small stocks during 1976-1995 was 21.23%. The standard
deviation of small stock returns during this period was 19.94
The average annual return on common stocks during 1976-1995 was 15.37%. The
standard deviation of common stock returns during this period was 13.65%.
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11. Does it seem reasonable that higher return securities historically have exhibited higher risk
than have securities that yielded lower returns? Why?
Ans:
If one assumes that investors dislike risk (a reasonable assumption and one that is discussed later
in the text), then higher-risk securities should exhibit higher returns over long periods of time. If
this relationship did not exist, and higher-risk securities offered the same returns as lower-risk
securities, then investors could not be induced to hold these riskier securities. They could avoid
additional risk and receive the same return by holding the lower-risk securities. Such a situation
could not be an equilibrium. Prices of higher-risk securities would have to adjust to provide
investors with higher returns and therefore increase investors' willingness to hold these
securities.
12. Give an example, outside of the financial markets, in which you commonly face
A trade-off between risk and return.?
Ans:
Examples of non-financial market risk-return trade-offs include: asking the boss for a raise,
underreporting income to the IRS, and self-insuring against damage to your home.
13. Examining Table1.1, you can find many years in which Treasury bills produced
Greater returns than common stocks. How can you reconcile this fact with the
Statements made in the text citinga positive relationship between risk and return?
Ans:
The statement in the text citing a positive relationship between risk and return is made in the
expectational sense. That is, higher-risk securities are expected to produce returns greater than
lower-risk securities. On the other hand, the data contained in Table 1.1 illustrates historical,
single period results. Various factors may have intervened to cause lower-risk securities to
outperform the higher-risk securities in any given year.
14. Again referring to Table1.1, in terms of total returns, what was the worst single calendar
year for common stock investors? What was the worst year in the 1970s?Compare these two
years in terms of return in "constant dollars"(that Is ,purchasing power).Does this comparison
show that the stock market slump Of the 1970s was not as disastrous as the "crash"associated
with the Great Depression? Explain
Ans:
The worst single year for common stock investors was 1931, when they experienced a total
return of -43.34%. In the 1970s, the worst year for common stock investors was 1974, when
they experienced a total return of -26.47%. However, accounting for inflation, the real return
(nominal return less the inflation rate) on common stocks in 1974 was -38.67%, while the real
return on common stocks in 1931 was -33.82%. In fact, inflation rates were negative for several
years during the Great Depression, while they were relatively high during the mid-1970s. As a
result, in terms of total real returns, the market decline of the 1973-74 was as (or more) severe
than the market decline of the Great Depression
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15. Calculate the average annual return on common stocks, government bonds ,and Treasury
bills during the six decades from the 1930sthrough the 1980s. Which Period was clearly the
"decade of the financial asset"?
Ans:
Of the six decades considered, the 1980s were clearly the "decade of the financial asset."
Common stocks averaged a return of 18.19% per year (second only to the 1950s with 20.84%).
Both government bonds and Treasury bills produced their highest decade-average returns in the
1980s, with government bonds averaging 13.50% per year and Treasury bills averaging 8.92%
per year.
Interestingly, although the decade is not yet over as the 6th edition of Investments has
gone to print, the 1990s is shaping up to be a decade that rivals the 1980s in terms of substantial
returns on all financial assets. If this remains the case for the rest of the decade, that would make
for an extremely long period of sustained financial asset returns that has no comparison in the
history of U.S. capital markets.
16. Why might it be reasonable to believe that including securities issued in foreign Countries
will improve the risk-reward performance of your portfolio?
Ans:
Foreign security returns do not necessarily move in the same direction as returns on U.S.
securities. For that reason, including them in a portfolio will tend to dampen the ups and downs
of the portfolio’s total returns. This effect is known as diversification and can significantly
improve the risk performance of a portfolio. In addition, some investors contend that returns on
foreign securities are generally higher than those on comparable U.S. securities. While this
contention is controversial, an investor who believes it could increase both the expected risk and
return performance of his or her portfolio by including foreign securities.
17. Describe how life insurance companies, mutual funds, and pension plans each Act as
financial inter me diaries.
Ans:
Life insurance companies receive cash from individuals in the form of premiums. In
exchange, the insurance companies write policies promising to make payments in the event of
the death of the insured individual. The proceeds from the policy sales are primarily invested in
stocks, bonds, money market instruments, and real estate.
Mutual funds receive cash from investors and, in exchange, issue shares in the respective
funds. The proceeds from the funds' sales are invested in a wide variety of financial assets, with
the specific assets depending on the funds' particular investment objectives.
Pension funds receive employer (and sometimes employee) contributions and issue
promises to pay retirement benefits in exchange. The contributions are primarily invested in
stocks, bonds, and money market instruments.
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18.What are the fives teps to the investment process ?What is the importance of Each step to the
n tire process?
Ans:
The five steps to the investment process are:
1. Investment policy
2. Security analysis
3. Portfolio construction
4. Portfolio revision
5. Portfolio performance evaluation
Setting investment policy is important because it provides the general framework around
which the investment process is conducted. It identifies the investor’s risk tolerance and
investment objectives. Security analysis is at the center of the investment process. It involves
specifically identifying financial assets to be purchased for and sold from the investor’s portfolio.
Portfolio construction moves from identifying the specific assets in the security analysis step to
combining those assets into a portfolio consistent with the investor’s investment objectives.
Portfolio revision is necessary because investing is a dynamic process that responds to changes
in investment opportunities and the investor’s financial circumstances. Finally, portfolio
performance evaluation is a feedback and control procedure intended to help the investor
examine whether his or her investment program is meeting targeted objectives.
19. Why does it not make sense to establish an investment objective of making a lot Of money"
Ans:
Because returns on financial assets are directly related to risk, establishing an
investment objective of "making a lot of money," or equivalently, maximizing returns, might
entail inordinate levels of risk. More appropriate would be an investment objective that jointly
establishes desired levels of return and risk.
20. Financial advisers often contend that elderly people should invest their portfolios more
conservatively than younger people. Should a conservative investment policy for an elderly
person call for owning no common stocks?
Ans: Discussthe reasonsfor youranswerIt is probably not advisable for an elderly person to
hold a portfolio that includes no commons stocks. Common stocks have by far outperformed
other asset classes historically. Moreover, compared to returns on bonds and money market
investments, common stocks are the only asset class to historically produce a large premium over
inflation. An elderly person must be concerned about maintaining the purchasing power of his or
her investments. Given their historical performance, common stocks seem to be well-suited to
helping maintain that purchasing power. Just what proportion of the portfolio should be held in
common stocks is another matter.
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21. What factors might an individual investor take into account in determining his Or her
investment policy?
Ans:
Many factors could influence an investor's investment policy. Some obvious factors would
include the investor's financial objectives (for example, saving for retirement or building a child's
college fund), the investor's willingness to bear risk, the investor's current financial
circumstances, and the investor's investment time horizon (partly a function of age and career
status).
no:22. Distinguish between technical and fundamental security analysis
Ans:
Technical analysis attempts to forecast the movement in the prices of securities based
predominately on historical price trends in those same securities.
Fundamental analysis seeks to determine the intrinsic values of securities based upon
estimates of the securities' future cash flows. These intrinsic values are compared to existing
market prices to estimate current levels of mispricing.
23. Donovan believes that the Board should emphasize the fundamental long-term
Considerations related to investment for Bl's plan and deemphasize the short term performance
aspects. Recognizing that a well-structured investment policy is an essential element in investing,
Donovan requests your help in drafting Such a document.
Ans:
(From The CFA Level III Exams and Guideline Answers 1995, 1996, and 1997)
A. Discuss why the investment time horizon is of particular importance when

Setting investment policy for a corporate pension plan.
Perhaps the single most important factor in any investment program is the holding period of the
assets (i.e., the period for measuring and judging results). The investment time horizon is a
primary determinant of the level of risk an investor can tolerate. If time is shorter, high-risk
assets should be avoided and vice versa. Risk tolerance is an essential component of the asset
allocation decision, which is the primary determinant of long-term investment returns.
Allocation strategies differ when considering limited versus lengthy horizons. With
insufficient time available, some asset classes may be too risky for inclusion in a portfolio that
would otherwise have legitimately held them in a long-horizon context. Therefore, time
constrains strategy.
The “time to maturity” of the corporate workforce is a key strategy element for any
defined benefit pension plan. The younger the work force, the longer the horizon and the more
time available for wealth compounding to occur. More tolerance exists for short-run setbacks in
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exchange for long-run gains. In addition, the funded status of the plan and the financial condition
of the sponsor influences its time horizon and risk-taking ability. BI is financially healthy and
growing, and its work force is young. Strategically, BI should adopt a long investment horizon
and consider a higher allocation to higher risk, higher return asset classes.
B. Briefly explain the importance of specifying each of the following when constructing an
effective pension investment policy
The following factors are important when constructing an effective pension investment policy:
(i) An appropriate risk tolerance.
Risk tolerance is an primary determinant (central component or first step) of the asset allocation
decision. Asset allocation is the primary determinant of return. The specification of risk tolerance
for a plan embodies the ability and willingness of the sponsor to absorb the consequences of
adverse investment outcomes and/or prolonged subpar fund performance, such as its sensitivity
to the possibility of being required to increase contributions at unpredictable times and intervals.
The less risk an investor can tolerate, the less return will be achieved in the long run. Therefore,
careful consideration of risk tolerance is crucial to the long-run success of the pension plan’s
investment program. An inappropriate risk specification can lead the plan sponsor to a portfolio
with more risk than it can tolerate, causing the sponsor to sell underperforming assets at an
inappropriate time, or a portfolio with less risk than it can really tolerate, creating a lower
expected return than otherwise achievable.
(ii) Appropriate asset mix guidelines.
The asset mix strategy is the primary determinant of the Fund’s returns. An
inappropriate asset allocation means an inefficient asset mix in terms of maximum
return for a given level of risk. Asset allocation policy guidelines establish a
framework for carrying out a strategy to achieve stated risk and return goals. These
guidelines provide the asset mix parameters, boundaries and constraints for the
Fund’s operation. These guidelines control and limit the actions of the Fund’s
investment managers. The disciplines established in the policy help prevent panicky
responses to short-term market fluctuations.
(iii) The benchmarks to be used for measuring progress toward plan goals. Benchmarks
provide the ability to measure whether the Fund’s asset allocation policies are achieving or can
achieve its goals and objectives. By using benchmarks, managers can develop a framework to
observe and monitor the Fund’s progress and adjust the strategy if the results are unexpected or
goals are not met. An appropriate set of benchmarks will enable an investment committee to
measure the contributions made by the various components of the plan’s policy or strategy and
determine necessary amendments if objectives are not being met. Benchmarks also provide the
capability to measure whether individual managers are achieving their objectives and performing
as expected.
The choice of benchmarks expresses goals and objectives to the manager and can greatly affect
the strategy the manager employs. For example, benchmarks provide diversification strategies
for guiding managers.
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24. Ambrose Green,63, is a retired engineer and a client of Clayt on Asset Management
Associates("Associates"). His accumulated savings are invested in Diversified Global Fund("the
Fund").an in-house investment vehicle with multiple
Portfolio managers through which Associates manage nearly all client assets on
A pooled basis .Dividend and capital gain distribution shave produced an annual average return
to Green of about 8%on his $900,000 original investment
in the Fund, made six years ago. The$1,000,000 current value of his Fund interest represents
virtually all of Green's net worth.
Green is a widower whose daughter is a single parent living with her young
son. Although Green is not an extravagant person, his spending has exceeded
his after-tax income by a considerable margin since his retirement .As a result,
his non-Fund financial resources have steadily diminished and now amount to
$10,000.Green does not have retirement income from a private pension plan,
But he does receive taxable government benefits of $ I,OOO a month .His marginal
tax rate is 40%.He lives comfortably in a rented apartment ,travels extensively,
and makes frequent cash gifts to his daughter and grandson ,to whom he wants
to leave an estate of at least$1,000,00
Green realizes that he needs more income to maintain his lifestyle. He also
believes his assets should provide an after-tax cash flow sufficient to meet his
present$80,000annuals pending needs ,which he is unwilling to reduce. He is uncertainas to how
to proceed and has engaged you, a CFA charterholder with an
independent advisory practice ,to counsel him.
Your first task is to review Green's investment policy statemen.
Ans:
(From The CFA Level III Exams and Guideline Answers 1995, 1996, and 1997)
A.Key constraints are important in developing a satisfactory investment plan in Green’s

situation, as in all investment situations. In particular, those constraints involving investment
horizon, liquidity, taxes, and unique circumstances are especially important to Green. His
investment policy statement fails to provide an adequate treatment of the following key
constraints:
1.Horizon. At age 63 and enjoying good health, Green still has an intermediate to long
investment horizon ahead. When considered in light of his wish to pass his wealth onto his
daughter and grandson, the horizon extends further. Despite his apparent personal orientation
toward short-term income considerations, planning should reflect a long-term approach.
2.Liquidity. With spending exceeding income and cash resources down to $10,000, Green is
about to experience a liquidity crisis. His desire to maintain the present spending level requires
reorganizing his financial situation. This may involve using some capital and reconfiguring his
investment assets.
3.Tax considerations. Green’s apparent neglect of this factor is a main cause of his cash squeeze
and requires prompt attention as part of reorganizing his finances. He should get professional
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advice and adopt a specific tax strategy. In the United States, such a strategy should include
using municipal securities and possibly other forms of tax shelter.
4.Unique circumstances. Green’s desire to leave a $1,000,000 estate to benefit his daughter and
grandson is a challenge whose effects are primary to reorganizing his finances. Again, the need
for professional advice is obvious. The form of the legal arrangements, for example, may
determine the form the investments take. Green is unlikely to accept any investment advice that
does not address this expressed goal.
Other constraints. Three other constraints are present. First, Green does not mention the need to
protect himself against inflation’s effects. Second, he does not appear to realize the inherent
contradictions involved in saying he needs a “maximum return” with “an income element large
enough” to meet his considerable spending needs. He also wants “low risk,” a minimum
“possibility of large losses” and preservation of the $1,000,000 value of his investments. Third,
his statements are unclear about whether he intends to leave $1,000,000 or some larger sum that
would be the inflation-adjusted future equivalent of today’s $1,000,000 value.
B.Appropriate return and risk objectives for Green are as follows:

Return. In managing Green’s portfolio, return emphasis should reflect his need for maximizing
current income consistent with his desire to leave an estate at least equal to the $1,000,000
current value of his invested assets. Given his inability to reduce spending and his constraining
tax situation, this may require a total return approach. To meet his spending needs, Green may
have to supplement an insufficient yield in certain years with some of his investment gains. He
should also consider inflation protection and a specific tax strategy in determining asset
allocation. These are important needs in this situation given the intermediate to long investment
horizon and his estate-disposition plans.
Risk. Green does not appear to have a high tolerance for risk, as shown by his concern about
capital preservation and the avoidance of large losses. Yet, he should have a moderate degree of
equity exposure to protect his estate against inflation and to provide growth in income over time.
A long horizon and the size of his assets reflect his ability to accept such risk. He clearly needs
counseling in the area because the current risk level is too high given his preferences.
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Chapter2: BUYING AND SELLING SECURITIES

1. Describe the conflict of interest that typically exists in the investment advisory
relationship between a brokerage firm and its clients.
Ans:
Brokers are compensated largely on the basis of the commissions generated by
their customers. The more their customers trade, the more income brokers earn. As a
result, brokers have an incentive to recommend trading activity to their customers
(whether those trades be purchases or sales), even if the trades are not always in the
long-term interests of the customers.
2. How many round lots and what odd lot size are in an order for 511 shares?
Ans:
A round lot is 100 shares. Thus, an order of 511 shares involves 5 round lots and
an odd lot of 11 shares.
3. Discuss the advantages and disadvantages to the investor of the following:

a. Market order
b. Limit order
c. Stop order
Ans:
a. A market order instructs the broker to buy or sell immediately at the best
available price. The investor is virtually assured that the order will be filled.
However, the actual trade price could differ from the price existing when the order
was placed.
b. A limit order instructs the broker to buy or sell at a specified price (or better). The
investor is assured that, if the trade takes place, then it will be done at a price at least
as good as his or her limit price. However, the investor cannot be certain when, or
even if, the order will eventually be filled.
c.
A stop order instructs the broker to buy or sell at the best available price once a stop
price is reached. The investor can be fairly certain that his or her order will be filled if
the stop price is reached. However, the actual trade price could differ from the stop
price.
4. Why are margin account securities held in street name?
Ans:
Holding securities in street name permits a broker to easily liquidate a customer's
securities if such action is necessitated by a need to add cash to the customer's account.
For example, consider an investor who purchased certain securities on margin. Assume
that the securities declined in price sufficiently to trigger a margin call. Further, assume
that the investor was unable to deliver cash to his or her broker to meet the margin call.
With the investor's securities held in street name, the broker can quickly sell some of the
investor's securities to bring the equity in the investor's account up to the required
level.
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5. Lollypop Killefer purchases on margin 200 shares of Landfall Corporation

stock at $75 per share. The initial margin requirement is 55%. Prepare
Lollypop's balance sheet for this investment at the time of purchase.
Ans:
Lollypop's balance sheet at the time of the margin purchase would appear as
follows:
Assets Liabilities & Net Worth
Securities Liabilties
$75/shr × 200 shrs = $15,000 Margin Loan
(1-.55) × $75/shr × 200 shrs = $6,750
Net Worth
$15,000 - $6,750 = $8,250
6. Buck Ewing opened a margin account at a local brokerage firm . Buck's initial
investment was to purchase 200 shares of Woodbury Corporation on margin at
$40 per s hare. Buck borrowed $3,000 from a broker to complete the purchase.
a. At the time of the purchase, what was the actual margin in Buck's account?
b. If Woodbury stock subsequently rises in price to $60 per share, what is the
actual margin in Buck's account?
c. If Woodbury stock subsequently falls in price to $35 per share, what is the
actual margin in Buck's account?
Ans:
market value of assets − loan
Actual m arg in =
market value of assets
a. [(200 shrs × $40/shr) - $3,000]/(200 shrs ×

$40/shr)
$5,000/$8,000 = .625 = 62.5%
b. [(200 shrs × $60/shr) - $3,000]/(200 shrs ×

$60/shr)
$9,000/$12,000 = .750 = 75.0%
c. [(200 shrs × $35/shr) - $3,000]/(200 shrs ×

$35/shr)
$4,000/$7,000 = .571 = 57.1%

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7. Distinguish between the initial margin requirement and the maintenance

margin requirement.
Ans:
The initial margin requirement is the minimum percentage of a security's purchase
price that the investor must pay from his or her own funds. The initial margin
requirement is set by the Federal Reserve Board.
The maintenance margin requirement is the minimum actual margin that an

investor must keep in his or her account at all times. The maintenance margin
requirement is set by the exchanges and brokerage firms.
8. Snooker Arnovich buys on margin 1,000 shares of Rockford Systems stock at

$60 per share. The initial margin requirement is 50% and the maintenance
margin requirement is 30%. If the Rockford stock falls to $50, will Snooker
receive a margin call?
Ans:
An investor's actual margin is given by:
market value of assets − loan

Actual m arg in =
market value of assets
In Snooker's case, the current actual margin is:
Actual Margin = [(1,000 shrs × $50/shr) - (1 - .50)

× 1,000 shrs × $60/shr]/(1,000 shrs ×
$50/shr)
= .400 = 40.0%
Since the maintenance margin requirement is 30%, Snooker will not receive a
margin call.
9. Cap Anson originally purchased 100 shares of Avalon Company's stock for
$13 per share on margin. The initial margin requirement is 60% and the
maintenance margin requirement is 35%. To what price must the stock fall for
Cap to receive a margin call?
Ans:
The equation for calculating an investor's actual margin involving a security
purchased on margin can be solved for the price at which a margin call will occur.
Equation (2.1) can be written as:
(n × mp) − [(1 − im) × pp × n]

Actual M arg in =
n × mp
where n denotes the number of shares owned by the investor, mp denotes the
current market price of the stock, im denotes the initial margin requirement, and pp
denotes the purchase price of the stock. Substituting the maintenance margin
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requirement mm for the actual margin and solving for mp gives the
price at which the actual margin will equal the maintenance margin requirement, or
the price below which the investor will receive a margin call. Thus:
Margin Call Price = [(1 - im) × pp]/(1 - mm)
In Cap's case:
Margin Call Price = [(1 - .60) × $13]/(1 - .35)
= [.40 × $13]/.65
= $8.00
10. Lizzie Arlington has deposited $15,000 in a margin account with a brokerage
firm. If the initial margin requirement is 50%, what is the maximum dollar
amount of stock that Lizzie can purchase on margin?
Ans:
The maximum amount that Lizzie can purchase is found by solving:
Initial Equity = Initial Margin Requirement × Purchase Amount
or
Max Purchase Amount = Initial Equity/Initial Margin Requirement
= $15,000/.50 = $30,000
11. Explain the purpose of the maintenance margin requirement
Ans:
The maintenance margin requirement ensures that an investor maintains sufficient
equity in his or her account to protect the broker against sudden shifts in the value
of the investor's securities purchased on margin. In the case of a margin purchase,
actual margin represents the excess of an investor's assets in his or her account
over the amount of the investor's margin loan relative to the value of the assets in
the account. Therefore the greater the maintenance margin requirement, the greater
is the broker's "cushion" against declines in the value of the investor's portfolio.
12. Penny Bailey bought on margin 500 shares ofSouth Beloit Inc. at $35 per
share. The initial margin requirement was 45% and the annual interest on
margin loans was 12%. Over the next year the stock rose to $40. What was
Penny's return on investment?
Ans:
Penny's initial investment in South Beloit is $17,500 ($35 × 500) of which Penny put
down $7,875 (.45 × $17,500). Over the course of the year Penny must pay interest
of $1,155 (.12 × $9,625). At year-end Penny's investment is worth $20,000 ($40 ×
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500). Thus Penny's return on investment for the year is:
ROR = [($20,000 - $17,500) - $1,155]/$7,875
= .171 = 17.1%
13. Calculate Buck Ewing's rate of return in parts (b) and (c) of Problem 6 under
the assumptions that the margin loan was outstanding for one year and carried
an interest rate of 10% and that the prices of $60 and $35 were observed after
one year during which the firm did not pay any cash dividends.
Ans:
Buck's initial investment in Woodbury was $8,000 ($40 × 200), of which $5,000
was put down as initial equity. Buck borrowed $3,000 and thus paid $300 in
interest over the year (.10 × $3,000).
If the stock rose to $60 per share, Buck's investment was worth $12,000 ($60 ×
200). Thus Buck's return on investment was:
ROR = [($12,000 - $8,000) - $300]/$5,000
= .740 = 74.0%
If the stock fell to $35 per share, Buck's investment was worth $7,000 ($35 × 200).
Thus Buck's return on investment was:
ROR = [($7,000 - $8,000) - $300]/$5,000
= -.260 = -26.0%
14. Ed Delahanty purchased 500 shares of Niagara Corporation stock on margin
at the beginning of the year for $30 per share. The initial margin requirement
was 55%. Ed paid 13% interest on the margin loan and never faced a margin
call. Niagara paid dividends of $1 per share during the year.
a. At the end of the year, if Ed sold the Niagara stock for $40 per share, what
would Ed's rate of return be for the year?
b. At the end of the year, if Ed sold the Niagara stock for $20 per share, what
would Ed's rate of return be for the year?
c. Recalculate your answers to parts (a) and (b) assuming that Ed made the
Niagara stock purchase for cash instead of on margin.
Ans:
Note that the return on an investor's margin purchase can be expressed on a total
dollar basis, as the answers to questions 12 and 13 were presented, or on a per share
basis. That is,
Pt +1 − Pt + Dt − [r × (1 − im) × Pt ]
ROR =
(im × Pt )
In Ed Delahanty's case:
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a. ROR = {($40 - $30 + $1) - [.13 × (1 - .55) × $30]}
/(.55 × $30)
= ($11 - $1.755)/$16.50 = .560 = 56.0%
b. ROR = {($20 - $30 + $1) - [.13 × (1 - .55) × $30]}
/(.55 × $30)
= ($-9 - $1.755)/$16.50 = -.652 = -65.2%
c. ROR = ($40 - $30 + $1)/$30
= $11/$30 = .367 = 36.7%
ROR = ($20 - $30 + $1)/$30
= $-9/$30 = -.300 = -30.0%
15. Individual investors are sometimes contacted by their brokers and told that
they have "unused buying power" in their brokerage accounts. What do the
brokers mean by this statement?
Ans:
Given particular amounts of cash in their margin accounts, some investors may not
have borrowed the maximum amount permitted by margin requirements. These
investors could purchase additional stock on margin with their unused credit, thus
employing their "unused buying power" to make additional investments.
16. Beauty Bancroft short sells 500 shares of Rockdale Manufacturing at $25 per
share. The initial margin requirement is 50%. Prepare Beauty's balance sheet as
of the time of the transaction.
Ans:
Beauty's balance sheet at the time of the short sale
would appear as follows:
Cash Proceeds of Sale Liabilities

$25/shr × 500 shrs = $12,500 Market Value of Short Sold Stock
Initial Margin $25/shr × 500 shrs = $12,500
.50 × $12,500 = $6,250
Total Assets Net Worth
$12,500 + $6,250 = $18,750 $18,750 - $12,500 = $6,250
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17. Through a margin account, Candy Cummings short sells 200 shares of
Madison Inc. stock for $50 per share. The initial margin requirement is 45%.
a. If Madison stock subsequently rises to $58 per share, what is the actual margin
in Candy's account?
b. If Madison stock subsequently falls to $42 per share, what is the actual margin
in Candy's account?
Ans:
The actual margin for an investor who sells short a
security is:
[( proceeds from short sale + initial m arg in) − loan]

Actual m arg in =
loan
For Candy, the actual margin calculations are:
a. {[(200 shrs × $50/shr) × (1 + .45)] - (200 shrs
× $58/shr)}/(200 shrs × $58/shr)
= ($14,500 - $11,600)/$11,600 = .250 = 25.0%
b. {[(200 shrs × $50/shr) × (1 + .45)] - (200 shrs
× $42/shr)}/(200 shrs × $42/shr)
= ($14,500 - $8,400)/$8,400 = .726 = 72.6%
18. Dinty Barbare short sells 500 shares of Naperville Products at $45 per share.
The initial margin and maintenance margin requirements are 55% and 35%,
respectively. If Naperville stock rises to $50, will Dinty receive a margin call?
Ans:
The actual margin for an investor who sells short a
security is:
[( proceeds from short sale + initial m arg in) − loan]

Actual m arg in =
loan
Therefore, with a rise in Naperville's stock to

$50/share, Dinty's actual margin is:
{[(500 shrs × $45/shr) × (1 + .55)] - (500 shrs ×

$50/shr)}
/(500 shrs × $50/shr)

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= ($34,875 - $25,000)/$25,000 = .395 = 39.5%
Because the maintenance margin requirement is 35%,

Dinty will not receive a margin call at this time.
19. Willie Keeler short sold 300 shares of Sun Prairie Foods stock for $42 per
share. The initial margin requirement is 50% and the maintenance margin
requirement is 40%. To what price can the stock rise before Willie receives a
margin call?
Ans:
Similar to Problem 9, the equation for calculating an investor's actual margin for a
short sold security can be solved for the price at which a margin call will occur.
That is, rewriting Equation (2.2) gives:
[(n × sp) × (1 + im)] − (mp × n)

Actual M arg in =
n × mp
where the variables are the same as those in Problem 9, with sp denoting the short
sale price of the stock. Substituting the maintenance margin requirement mm for
the actual margin and solving for mp gives the price above which the investor will
receive a margin call. Thus:
Margin Call Price = [sp × (1 + im)]/(1 + mm)
In Willie's case:
Margin Call Price = [$42 × (1 + .50)]/(1 +.40)

= $45
20. Eddie Gaedel is an inveterate short seller. Is it true that Eddie's potential
losses are infinite? Why? Conversely, is it true that the maximum return that
Eddie can earn on his investment is 100%? Why?
Ans:
The first statement is true. The upside potential of any common stock is unbounded.
Therefore, because a short seller's losses increase as the price of the short sold
stock rises, the short seller's potential losses are infinite.
The second statement is false. It is true that if the initial margin requirement on
short sales was 100%, then the maximum return that a short seller could earn
would be 100%. (This would occur if the shorted stock's price went to zero.)
However, given an initial margin requirement less than 100%, the leveraged
position of a short sale potentially can produce returns in excess of 100%.
21. The stock of DeForest Inc. traded at the beginning of the year for $70 per
share. At that time Deerfoot Barclay short sold 1,000 shares of the stock. The
initial margin requirement was 50%. DeForest stock has risen to $75 at year-
end, and
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Deerfoot faced no margin calls in the interim. Further, the stock paid a $2
dividend at year-end. What was Deerfoot's return on this investment?
Ans:
Calculated on a total dollar basis, Deerfoot's initial investment in the short sale of
DeForest stock is $35,000 (.50 × $70 × 1,000). At year-end, Deerfoot had to
reimburse the owner of the DeForest stock with $2,000 ($2 × 1,000) for dividends
paid on the stock. Further, at year-end, if Deerfoot purchased the stock and repaid
the owner, then the excess proceeds over the amount which Deerfoot originally
received when the stock was sold short would equal -$5,000 ($70 - $75 × 1000).
Thus Deerfoot's return on investment during the year was:
ROR = [($70,000 - $75,000) - $2,000]/$35,000
= -.200 = -20.0%
22. Calculate Candy Cummings's rate of return in parts (a) and (b) of Problem
17, assuming that the short loan was flat but the initial margin deposit earned
interest at a rate of 8% and that the prices of $58 and $42 were observed after
one year during which the firm did not pay any dividends
Ans:
Expressing the return on a short sold security on a per share basis (including
interest on the initial margin deposit) given:
Pt − Pt +1 − Dt + (im × Pt × r ]
ROR =
(im × Pt )
a. If the Madison stock, which was originally sold short at $50 per share, rises
to $58 then:
ROR = [($50 - $58 - $0) + (.45 × $50 × .08)]/(.45 × $50)
= -.276 = -27.6%
b. If the Madison stock, which was originally sold short at $50 per share, falls
to $42 then:
ROR = [($50 - $42 - $0)] + (.45 × $50 × .08)]/(.45 × 50)

= .436 = 43.6
23. What aspects of short selling do brokerage houses typically find to be

especially profitable?
Ans;
In many cases (particularly those involving its small investors) a brokerage firm does
not pay interest to the short seller on the proceeds of the short sale or on the initial
margin deposits. As a result the brokerage firm is able to retain all earnings it can
generate from investing these deposits. (Short sellers who do substantial business
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with a broker typically can negotiate to receive a large portion of these earnings.)
Of course, the brokerage firm receives commissions from executing short sales,
both when the securities are short sold and later when they are repurchased to
repay the loan.
24. Distinguish between an investor's receiving a margin call and having his or
her margin account restricted.
Ans:
When an investor receives a margin call, then the actual margin in his or her margin
account has fallen below the maintenance margin level. The investor's broker will
request that the investor deposit additional cash and/or sell securities to bring the
actual margin up to or above the maintenance margin level.
An investor's margin account is restricted if his or her actual margin falls below the
initial margin requirement. In this case the investor will not be requested to
increase his or her margin, but he or she may not withdraw funds from the account
such that the actual margin would be further reduced.
25. Pooch Barnhart purchases 100 shares of Batavia Lumber Company stock on
margin at $50 per share. Simultaneously, Pooch short sells 200 shares of Geneva
Shelter stock at $20 per share. With an initial margin requirement of 60%:
a.What is the initial equity (in dollars) in Pooch's account?
b. Pooch's equity position (in dollars)?
Ans:
a. The purchase of Batavia stock on margin requires Pooch to put down $3,000
in cash ($50 × 100 × .60). The short sale of Geneva stock requires Pooch to
deposit $2,400 in cash in addition to the proceeds of the sale (.60 × $20 ×
200). Thus Pooch's initial equity position from both investments is $5,400.
b. If the price of Batavia stock rises to $55, Pooch still owes $2,000 on the
margin loan, but the value of Batavia shares is now $5,500 leaving a margin
purchase equity position of $3,500. If Geneva stock also rises to $22, then
Pooch owes $4,400 on the stock. Pooch's assets are the proceeds of the short
sale and the initial margin deposit, together totaling $6,400 (1.6 × $20 ×
200), leaving a short sale equity position of $2,000. Thus, Pooch's equity
position from both investments is $5,500.
26. On May 1, Ivy Olson sold short 100 shares of Minnetonka Minerals stock at
$25 per share and bought on margin 200 shares of St. Louis Park Company
stock for $40 per share. The initial margin requirement was 50%. On June 30,
Minnetonka stock sold for $36 per share and St. Louis Park stock sold for $45
per share.
a. Prepare a balance sheet showing the aggregate financial position on Ivy's
margin account as of June 30.
b. Determine whether Ivy's account is restricted as of June 30.
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Ans:
a.
Cash from Minnetonka sale Liabilities

$25/shr × 100 shrs = $2,500 Market Value of Short Sold Stock
Initial Margin $36/shr × 100 shrs = $3,600
.50 × $25/shr × 100 shrs = $1,250 Margin loan for St. Louis Park stock
Market value of St.Louis Park stock $40/shr × 200 shrs = $4,000
$45/shr × 200 shrs = $9,000
Total Assets Total Liabilities
$2,500 + $1,250 + $9,000= $12,750 $3,600 + $4,000 = $7,600
Net Worth
$12,750 - $7,600 = $5,150
b. To remain unrestricted based on the short sale of
Minnetonka stock, Ivy must have deposited in the
margin account:
100 shares × $36/share × (1 + .50) = $5,400
To remain unrestricted based on the margin purchase

of St. Louis Park stock, Ivy must have deposited in
the margin account:
(200 shares × $40/share × .50)/(1 - .50) =

$8,000
Thus, to remain unrestricted in aggregate, Ivy's margin account must

be worth at least $13,400. Because Ivy actually has assets worth $12,750, the account
is restricted as of June 30.
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Chapter3: SFCURITY MARKETS

1.Virtually all secondary trading of securities takes place in continuous markets as
opposed to call markets. What aspects of continuous markets causes them to
dominate call markets?
Ans:
continuous markets permit investors to trade at any time while the markets are in
operation. Conversely, in a call market, investors must wait until the periodic call sessions
occur to complete their trades. Many investors do not really require the immediate access to
liquidity offered by continuous markets. Nevertheless, this aspect of continuous markets has
proven to be very popular and is something for which investors appear willing to pay a
premium to support the intermediaries (that is, specialists and dealers) who help these
markets function smoothly.
2. Circuit breakers were first instituted after the market crash of October 1987.
Some observers argue that the rapid increase in the stock market's value since 1987
has diminished whatever value the rules may originally have possessed. Why?
Ans:
Rules 80A and 80B define the parameters of the NYSE’s circuit breakers in terms of
point moves in the Dow Jones Industrial Average. For example, Rule 80A limits
index arbitrage orders after the Dow has moved 50 points. When the rule was
instituted in 1987, the Dow was well under 3000. In early 1998, the Dow was well
over 8000.. Thus 50 Dow points represents a much smaller percentage point move in
the Dow today than it did ten years ago. As a result, the index arbitrage circuit
breakers are frequently triggered. It is reasonable to question, therefore, whether the
circuit breakers can be effective if they are a constant part of the trading environment
rather than a special event indicating an unusual move in the market.
Rule 80B was modified in 1998 to determine the Dow point moves relative to the level
of the index. Nevertheless, critics argue that the percentage moves permitted before
Rule 80B is triggered are still much too small.
3. Discuss the advantages and disadvantages of the NYSE specialist system.
Ans:
When functioning effectively, the specialist system should provide continuous, liquid
trading in securities. It should permit investors to buy and sell securities in reasonably
large quantities without the investors bearing significant price concessions. Investors
should not have to conduct extensive searches to find the best available price.
The disadvantages of the specialist system appear when it is unable to provide the
promised continuous liquid trading in securities. The specialist system may not be
adequately capitalized to supply large investors with sufficient liquidity. As a result,
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in large trades investors may have to make sizable price concessions or may even not
be able to complete desired trades through the specialists.
4.Differentiate between the role of a specialist on the NYSE and the role of a dealer
on the OTC market.
Ans:
A specialist is charged by the NYSE with maintaining a "fair and orderly" market in his
or her assigned stocks. To carry out this responsibility, the NYSE designates the
specialist as the sole market maker in those stocks. A specialist carries out his or her
responsibilities, and earns a profit, by playing two roles. First, he or she acts as a
broker, facilitating trades by keeping a limit order book on his or her assigned stocks.
Second, he or she acts as a dealer, buying and selling shares for his or her own account
when there exists a temporary imbalance in supply and demand for his or her assigned
stocks.
A dealer in the OTC market is not assigned by a central organization to make a market
in particular stocks. Rather, the dealer chooses those stocks in which he or she will
make a market and this choice can be changed at any time. Further, beyond certain
disclosure and anti-fraud regulations, the dealer is under no obligation to maintain a
"fair and orderly" market in his or her chosen stocks. The dealer earns a profit by
charging for the service (via the bid-ask spread) of meeting the transactional demands
of customers and by adroitly buying and selling for his or her own account.
5.Give several reasons why a corporation might desire to have its stock listed
on the NYSE.
Ans:
Listing on the NYSE provides several potential advantages to the listed company:
a. A more liquid market for its stock, and therefore perhaps a better stock price for
its shareholders.
b. Greater visibility for the company and its product line among the financial
community, which could result in more advantageous financing opportunities.
c. Enhanced prestige for the company and the associated psychic benefits for
management and employees.
6. Describe the functions of commission brokers, floor brokers, and floor traders.
Ans:
Commission brokers carry out the trading orders of the public that have been
placed with the brokers' respective brokerage firms. Commission brokers are
compensated by the commissions paid by the firm's customers.
Floor brokers are not directly employed by particular brokerage firms. Rather, they
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are independent exchange members who assist commission brokers in executing their
orders, especially during periods of heavy trading. Floor brokers are compensated by
sharing in the commissions paid to the commission brokers.
Floor traders are independent exchange members who trade only for themselves, not
for the public. They earn a profit by recognizing mispriced stocks and appropriately
buying and selling those stocks.
7. Pigeon Falls Fertilizer Company is listed on the NYSE. Gabby Hartnett, the
specialist handling Pigeon Falls stock, is currently bidding 35.5 and asking 35.5.
What would be the likely outcomes of the following trading orders?
a. Through a broker, Eppa Rixey places a market order to buy 100 shares of Pigeon
Falls stock. No other broker from the crowd takes the order.
b. Through a broker, Eppa places a limit order to sell 100 shares of Pigeon Falls
stock at 36.
c. Through a broker, Eppa places a limit order to buy 100 shares of Pigeon Falls
stock at 35.5. Another broker offers to sell 100 shares at 35.5
Ans:
a. The specialist will sell Eppa's commission broker 100 shares of Pigeon Falls at 35 5/8.
b. The specialist will record the limit order of Eppa's broker in his or her limit order
book.
c. Eppa's broker will execute the trade with the other broker at 35 1/2. The
specialist will not participate.
8. Bosco Snover is the NYSE specialist in Eola Enterprises' stock. Bosco's limit
order
book for Eola appears as follows
Limit sell Limit Buy

Price share Price share
$30250 200 $29750 100
30375 500 29000 100
30500 300 28500 200
30875 800 27125 100
31000 200 26875 200
The last trade in the stock took place at $30.

a. If a market order to sell 200 shares arrives , what will happen?
b. If another market order to selllOO shares arrives just moments later, what
will happen?
c. Do you think that Bosco would prefer to accumulate shares or to reduce
inventory,
given the current orders in the limit order book?
Edited by
Ans:
Assuming that Bosco or a broker from the crowd does not participate:
a. Bosco will fill the sell market order from the limit order book by executing the
limit orders to buy 100 shares at $29.75 and 100 shares at $29.
b. Bosco will also fill the second sell market order from the limit order book by
executing the limit order to buy 100 shares at $28.50.
c. Bosco would likely prefer to reduce the inventory of Eola shares given the
relatively large book of sell limit orders just above the most recent trade price of
$30.
9. Because specialists such as Chick Gandil are charged with maintaining a "fair
and orderly" market, at times they will be required to sell when others are buying
and to buy when others are selling. How can Chick earn a profit when required to
act in such a manner?
Ans:
The specialist in a particular stock is the only exchange member with access to that
stock's limit order book. This access provides him or her with valuable information
regarding the stock's price support and resistance levels. Knowledge of this
information permits the specialist to adjust his or her inventory at appropriate times so
as to profit from price movements near these sensitive price points. Earnings from this
activity more than compensates for occasionally having to "fight the tape" by buying
and selling against the market.
10. Why can't all trade orders on the NYSE, no matter how large, be handled
through the Super DOT system?
Ans:
Specialists attempt to adjust their bid and asked prices based on their sense of the
movements in supply and demand for their assigned securities. SuperDOT is simply a
mechanism to send orders quickly and efficiently to the floor. A very large order
transmitted through SuperDOT would likely cause the specialist to adjust the bid-ask
spread significantly enough to disadvantage the trader submitting the order. The
trader would most likely be better off "working" the trade through alternative
channels.
11. Why is Nasdaq so important to the success of the OTC market
Ans:
Nasdaq (National Association of Securities Dealers Automated Quotations) permits
brokers interested in trading an OTC stock to quickly canvass the prices offered by
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dealers making a market in that stock. Prior to the introduction of Nasdaq, this
canvassing process was very time-consuming. The existence of Nasdaq encourages
investors to trade in Nasdaq-listed OTC stocks because of the immediate access to
current prices offered by competing dealers.
12. If the NYSE moved to decimal pricing with prices moving in at $.05
increments, would there be greater opportunities for price improvement over the
current pricing system? Explain.
Ans:
All other things remaining the same, decimal pricing in $.05 increments should
increase the opportunity for price improvement. Prices expressed in increments of
one-sixteenth equate to a decimal unit of $.0625. Thus presently the bid-ask spread
can be no narrower than $.0625. Moving to increments of $.05 would offer the
opportunity to narrow that spread to $.05. If a dealer maintained a spread of $.0625
even though prices could move in $.05 increments, investors could potentially achieve
price improvement through trading inside the dealer’s quotes.
13. Distinguish between two forms of preferencing: payment for order flow and
internalization.
Ans:
Payment for order flow involves a dealer paying cash to a broker in order to have that
broker direct trade orders to the dealer for execution. Internalization involves a
broker-dealer filling orders at its own trading desk rather than routing them to the
exchange floor for execution.
14.Using the model described in the text, calculate the appropriate bid-ask spread
for a dealer making a market in a security under the conditions that 15% of all
traders are information-motivated and there is a 30% chance that the stock is
worth $30 per share and a 70% change that it is worth $50 per share
Ans:
The bid-ask spread model described in the text finds the asked price by solving the
following equation for A:
P i × P U × (U − A) = (1 − P i ) × .5 × [A - (P U × U + P L × L)]
where:
Pi = probability that trader is information-motivated

PU = probability that security is worth its maximum price
U = maximum price that security could be worth
PL = probability that security is worth its minimum price
L = minimum price that security could be worth
A = appropriate asked price
Edited by
In this case we have:
.15 ×.7 × ($50-A) = (1-.15) ×.5 × [A-(.7 × $50 + .3 × $30)]
A = $45.19
Similarly, the bid price is found by solving the following equation for B:
P i × P L × (B − L) = (1 − P i ) × .5 × [(P U × U + P L × L - B)]
In this case we have:
.15 ×.3 × (B-$30) = (1-.15) ×.5 × [(.7 × 50 + .3 × 30)-B]
B = $42.66
15. How might a dealer attempt to discern whether a trader is information motivated?
Ans:
The most direct way a dealer has to discern whether a trade is information-motivated is
to know the identity of the trader. For instance, if the dealer knew that the trader were
representing George Soros, the dealer would be inclined to assume that the trade was
based on knowledge about the traded stock. Less directly, a trader may make
assumptions about the information behind the trade by examining the pattern of
trading. If the trader seems anxious to trade, seemingly at any price, the dealer will
tend to assume that the trader is information-motivated.
16. What are some of the major steps that have been taken toward the ultimate
emergence of a truly nationwide security market?
Ans:
The Securities Acts Amendments of 1975 directed the SEC to move as rapidly as
possible toward creating a competitive nationwide security market.
On May 1, 1975, the NYSE completely eliminated fixed commission rates.
In 1975, the Consolidated Tape began to report trades on the NYSE, ASE, regional
exchanges, and OTC Nasdaq-quoted securities.
In 1978, the SEC instructed the stock exchanges to make their quotations available to
the Consolidated Quotations System.
In 1978, the Intermarket Trading System was created. The ITS links the NYSE, ASE,
several regional exchanges, and certain OTC dealers. Orders can be routed through
the ITS to the market makers offering the best prices.
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17. The NYSE has strongly opposed the creation of alternative market trading
structures such as off-exchange crossing systems. The NYSE claims that these
alternative structures undermine its ability to offer "best execution" to all investors.
Discuss the merits of the NYSE's contention.
Ans:
Proponents of alternatives to the NYSE's central trading system claim that such
alternatives enhance competition among market makers thereby leading to lower
transaction costs for the investing public.
Opponents of alternative trading systems contend that the economies of scale offered
by the NYSE lower transaction costs. Further they claim that the NYSE permits
closer scrutiny of market makers' activities, thereby reducing the chances for unethical
trading practices to occur.
18. Distinguish between the third and fourth markets.
Ans:
The third market refers to the trading of exchange-listed securities in the OTC market
by non-member firms.
The fourth market refers to the trading of securities directly between buyers and sellers
without a broker intermediary. Fourth market trades are facilitated by automated
computer systems that allow traders to communicate anonymously and which handle
the clearing of trades. Generally, the participants in the fourth market are institutional
investors, or high net worth individuals, who trade in large volumes.
19. Why was May Day such an important event for the NYSE?
Ans:
On May 1, 1975 (May Day) the NYSE, as a result of pressure by the Securities and
Exchange Commission, completely ended its system of fixed commission rates. From
that time forward member firms have been permitted to negotiate any desired
commission rate with any customer. The initial result of May Day was to increase
competition among brokerage firms, especially competition for the business of large
institutional clients. May Day was one of the early significant steps toward more
competitive security markets.
20. What is the purpose of SIPe insurance? Given the late 1980s experience of the
ban king and savings and loan deposit insurance programs, under what conditions
might SIPC insurance he expected to be effective? Under what conditions
might it fail to accomplish its objectives?
Ans:
SIPC insurance is designed to protect customers against the possibility of a brokerage
Edited by
firm failing to meet its obligations. SIPC insurance is likely to be most effective in
situations when an individual brokerage firm fails, for example, due to fraud or
mismanagement. In such a case the system's financial resources are not likely to be
overly-strained.
SIPC insurance is likely to be ineffective in situations affecting a large number of

brokerage firms, such as a devastating market crash. In such a case the insurance
funds might not be sufficient to protect customers against losses. While the SIPC has
access to a line of credit with the Treasury in the event that its funds are exhausted, the
ensuing financial dislocations would likely be considerable.
21. After May Day, why did commission rates fall so sharply for large investors but
decline so little (or even increase) for small investors?
Ans:
The economies of scale present in large trades allowed brokers to offer large traders
considerably lower commissions after May Day. On the other hand, small traders,
who had been subsidized by the artificially high commissions charged to large traders,
were now required to pay the full cost of having their trades executed.
22. Transaction costs can be thought of as being derived from three sources. Identify
and describe those sources.
Ans:
Brokerage commissions are the fees charged by a broker for the services involved in
handling a trade for a customer.
The bid-ask spread is the difference between the price at which the market maker will
buy a stock and the price at which the market maker will sell the same stock at a given
point in time.
Price impact is the price concession that a trader must pay to induce a market maker to
immediately add or subtract from his or her inventory to complete the trade. Price
impact is usually an important source of transaction costs only in large volume trades.
23. Why does the price impact of a trade seem to be directly related to the size
of the trade?
Ans:
The price of a security is determined by the supply and demand for the security. In the
short run additional supply of a security can only be obtained by increasing the offered
price for the security. Thus a trader wishing to buy a large amount of the security will
have to increase his or her bid price more than a trader wishing to buy a smaller
amount of the security. The result is price impact. (Similar logic applies to a trader
desiring to sell a security.) In addition, the larger the size of the order, the more a
dealer is likely to view the trade as information-motivated and, therefore, the more he
Edited by
or she is likely to increase the bid-ask spread to protect from the possibility that he or
she will be “picked off” by the trade.
24. What functions does a clearinghouse perform?
Ans:
A clearinghouse is a cooperative venture between brokerage firms, banks, and other
financial institutions. It acts as a central intermediary between members to permit
more efficient processing of security trades. At the end of each day, the clearinghouse
receives records of trades done by its members earlier that day. These trades are
verified for consistency and then netted out. Members receive lists of net amounts of
securities and cash to be delivered or received.
Edited by
Chapter-4
1. In a call market, securities are traded at discrete

times. Traders are brought together to bid on a
particular security at periodic calls. An auctioneer
adjusts the price of the security until the demand
roughly equals the supply.
In a continuous market, securities are traded throughout

the trading day. Dealers or specialists (depending on
the market) adjust the prices to continuously set demand
equal to supply.
2. a. The aggregate demand-to-buy schedule for Fairchild

stock will shift up and to the right. The aggregate
supply-to-sell schedule will shift up and to the
left.Fairchild's stock price will rise.
b. The aggregate supply-to-sell schedule will shift down

and to the right. Fairchild's stock price will fall
and the quantity traded will increase.
c. The demand-to-buy schedule will become flatter (or

more elastic). However, the equilibrium price will
not change and no additional transactions will take
place.
3. If security prices were unrelated to investment values

one might expect that they would behave in a random
fashion. Yet such price behavior is precisely what one
would observe in an efficient market in which investment
value information is quickly impounded in security
prices. As new information arrives randomly, security
prices would likewise move in a random fashion.
4. The market price for any security represents a consensus

view of all investors. Each investor, given his or her
own expectations about those relevant factors affecting
the value of a particular security, will adjust his or
her holdings so that the marginal value of a unit of the
security equals the market price. It is the seemingly
chaotic interaction of all investors that determines the
market price for the security.
5. Weak-form market efficiency implies that past price

information is immediately and fully reflected in
Edited by
security prices. Thus this information cannot be

employed to earn abnormal profits.
Semistrong-form market efficiency implies that all

relevant publicly available information is immediately
and fully incorporated into security prices. Thus this
information is useless to investors seeking abnormal
profits.
Strong-form market efficiency implies that all relevant

information, public or private, is immediately and fully
reflected in security prices. Thus this information
cannot be used to earn abnormal profits.
6. Weak-form efficiency does not imply strong-form

efficiency. However, strong-form efficiency does imply
weak-form efficiency. That is, a market cannot be
strong-form efficient without all available information,
including past security price information, being
incorporated into security prices. Conversely, a market
can be weak-form efficient without non-public information
being incorporated into security prices.
7. a. Semistrong
b. Weak
c. Strong (assuming that these deliberations are
private)
d. Strong
e. Semistrong
f. Weak
8. The process of fundamental security analysis should make

security markets more efficient. Investors engaging in
fundamental security analysis attempt to assess the
various determinants of security values and use that
knowledge to identify mispriced securities. By buying
securities selling for less than their fair values and
selling securities priced above their fair values, these
investors drive security prices toward the securities'
fair values, thereby enhancing the efficiency of security
markets.
9. NYSE specialists should be able to earn abnormal profits

even in a semi-strong efficient market. A specialist has
access to a particular form of inside information - the
limit order book for his or her assigned security. This
information gives the specialist knowledge regarding
Edited by
price levels at which sizable buy or sell orders may be

activated. By buying or selling ahead of those orders, a
resourceful specialist should be able to generate
abnormal profits.
10. Investors transacting in a perfectly efficient market

would be able to consistently earn profits commensurate
with the risk assumed. However, they would not be able
to consistently earn abnormal profits (that is, profits
greater than those justified by the amount of risk that
they incur).
11. The investment world is populated by numerous aggressive,

well-educated, and hardworking individuals. Their
objective is to identify mispriced securities and profit
by appropriately buying and selling such securities. It
seems improbable that these investors would frequently
permit abnormal profit opportunities to go unexploited
for very long. Ironically, it is the combined actions of
these investors that makes the attainment of their goal
so difficult.
12. The earnings information could be considered a pleasant

surprise by some investors (perhaps former pessimists
regarding the stock's prospects) and an unpleasant
surprise by other investors (perhaps former optimists
regarding the stock's prospects). The formerly
pessimistic investors will want to increase their
holdings of the stock. Conversely, the formerly
optimistic investors will want to decrease their
holdings. The net effect of these changes in opinion
will be to generate trades in the stock, yet have little
impact on the stock's price.
13. Technical analysis is predicated on using past price data

to identify future price movements. Weak-form market
efficiency (and, necessarily, the semistrong and strong
forms) means that past price data is immediately and
fully incorporated into security prices. Therefore past
price data, and by implication technical analysis, cannot
be used to earn abnormal profits.
Fundamental analysis is based on using publicly available

information to estimate the "fair" market values of
securities. Semistrong-form market efficiency (and,
hence, strong-form market efficiency) means that publicly
available information is immediately and fully
Edited by
incorporated into security prices. Therefore publicly

available information, and by implication fundamental
analysis, is useless in the search for abnormal profits.
14. a. Successful insider trading, which involves earning

abnormal profits through the use of non-public
information, is consistent with weak-form and
semistrong-form market efficiency. It is not
consistent with strong-form market efficiency.
b. One could argue that insider trading makes the

security markets more efficient. By their actions
traders using inside information make that
information public. Insider trading causes
securities to more quickly reflect all information
relevant to their true investment values.
15. Testing for market efficiency through the use of event

studies involves determining whether a set of returns is
“abnormal.” The definition of “normal return” requires
the use of an equilibrium-based asset pricing model.
However, it is not a given that the asset pricing model
being used is valid. A finding of abnormal returns might
be due to the markets being inefficient or it might be
due to the asset pricing model being incorrect, or it
might be due to both reasons. It is impossible to
disentangle the two issues. Thus a test for market
efficiency using event studies tests both the efficiency
of the market and the validity of the asset pricing
model.
16. In a perfectly efficient market with transaction costs,

it is expensive to collect and process information.
Moreover, investors must pay to alter their portfolios in
response to new information. As a result, some securities
will be priced to yield abnormal returns because it is
not cost effective for market participants to search out
and acquire (or sell) these securities to drive their
prices to “fair value” levels. Investors will incur
research and trading costs to search for and acquire (or
sell) mispriced securities up to the point where these
costs equal the abnormal returns that they earn from
investing in the mispriced securities.
17. In a perfectly efficient market, there should be no

investors who consistently earn abnormal returns.
Superior performance by an investor in a past period
Edited by
should be completely unrelated to how well that same

investor will perform in a future period. An investor
displaying positive historical abnormal returns was
simply lucky, while an investor displaying negative
abnormal returns was unlucky. But luck is random and has
no bearing on future performance.
CFA Exam Questions
18. (From the CFA Candidate Study and Examination Program

Review, 1993)
A. The notion that stock prices already reflect all

available information is referred to as the efficient
market hypothesis (EMH). It is common to distinguish
among three versions of the EMH: the weak, semi-strong,
and strong forms. These versions differ by their
treatment of what is meant by "all available
information."
The weak-form hypothesis asserts that stock prices

already reflect all information that can be derived from
studying past market trading data. Therefore, "technical
analysis" and trend analysis, etc., are fruitless
pursuits. Past stock prices are publicly available and
virtually costless to obtain. If such data ever conveyed
reliable signals about future stock performance, all
investors would have learned already to exploit such
signals.
The semi-strong form hypothesis states that all publicly-

available information about the prospects of a firm must
be reflected already in the stock's price. Such
information includes, in addition to past prices, all
fundamental data on the firm, its products, its
management, its finances, its earnings, etc., etc. that
can be found in public information sources.
The strong-form hypothesis states that stock prices

reflect all information relevant to the firm, even
including information available only to company
"insiders." This version is an extreme one. Obviously,
some "insiders" do have access to pertinent information
long enough for them to profit from trading on that
information before the public obtains it. Indeed, such
trading - not only by the "insiders" themselves, but also
by relatives and/or associates - is illegal under rules
Edited by
of the SEC.
For the weak-form or the semi-strong forms of the

hypothesis to be valid does not require the strong-form
version to hold. If the strong-form version was valid,
both the semi-strong and the weak-form would also be
valid.
B. Even in an efficient market, a portfolio manager would

have the important role of constructing and implementing
an integrated set of steps to create and maintain
appropriate combinations of investment assets. Listed
below are the necessary steps in the portfolio management
process.
1) Counseling the client to help the client to determine

appropriate objectives and identify and evaluate
constraints. The portfolio manager together with the
client should specify and quantify risk tolerance,
required rate of return, time horizon, tax
considerations, the form of income needs, liquidity,
legal and regulatory constraints, and any unique
circumstances that will impact or modify normal
management procedures/goals.
2) Monitoring and evaluating capital market

expectations. Relevant considerations, such as
economic, social, and political
conditions/expectations are factored into the
decision making process in terms of the expected
risk/reward relationship for the various asset
categories. Different expectations may lead the
portfolio manager to adjust a client's systematic
risk level even if markets are efficient.
3) The above steps are decisions derived

from/implemented through portfolio policy and
strategy setting. Investment policies are set and
implemented through the choice of optimal
combinations of financial and real assets in the
marketplace - i.e., asset allocation. Under the
assumption of a perfectly efficient market, stocks
would be priced fairly, eliminating any added value
by specific security selection. It might be argued
that an investment policy which stresses
diversification is even more important in an
efficient market context because the elimination of
Edited by
specific risk becomes extremely important.
4) Market conditions, relative asset category

percentages, and the investor's circumstances are
monitored.
5) Portfolio adjustments are made as a result of

significant changes in any or all relevant variables.
19. (From The CFA Level III Exams and Guideline Answers 1995,
1996, and 1997)
A. i. The semi-strong form of the EMH receives support from

numerous event studies that show that new information
is rapidly assimilated into market pricing. The
market appears to correctly differentiate between
events that have economic importance and those that
do not. A partial list of examples includes the
following:
• Price impact of dividend changes. Various studies
have concluded that dividend changes, which have
economic significance, are quickly reflected in
stock price changes. After the public announcement
of a dividend change, stock prices generally adjust
quickly, without further drift in CAR (cumulative
abnormal return). These results support the semi-
strong EMH because they indicate that the market
quickly and correctly reflects the economic
significance of new information.
• Price impact of takeover announcements. Similar to dividend
announcements, announcements of takeovers have economic significance
and are quickly reflected in market pricing with little further drift in CAR
(in the absence of further information).
• Price impact of stock splits. Stock splits are popularly viewed as having
positive implications for future stock price performance, even thought they
represent no change in a firm’s economic fundamentals. Multiple studies
have concluded that splits do not result in higher rates of return for
shareholders. These results support the semi-strong EMH because they
indicate that the market is correctly reflecting the economic significance
(or lack thereof) of new information.
• Initial Public Offerings (IPOs). Under the premise that underwriters
generally price IPOs below their true economic value, various studies have
examined how quickly the market adjusts for the underpricing. Results
indicate that the price adjustment takes place quickly (one day or less),
which is essentially consistent with the semi-strong EMH.
Edited by
• Unexpected world and economic events. Studies have shown that the
economic significance of world or economic news is quickly reflected in
security market pricing, consistent with the semi-strong EMH.
• Active manager underperformance. Studies have shown that active
managers often underperform the relevant benchmark, which is essentially
consistent with the semi-strong EMH.
ii. Apparent pricing and performance anomalies have been
documented in a growing number of studies. The
ability to consistently predict stock price
performance on the basis of publicly available
information regarding company attributes or calendar
effects is inconsistent with the semi-strong form of
the EMH.
• Calendar effects. Numerous studies have documented
a seasonality to stock price performance. The
January effect (in which small stocks outperform
large stocks in January) and various other calendar
effects appear to refute the semi-strong EMH, under
which known seasonalities would be already
reflected in market pricing.
• Superior returns to small and/or neglected firms.
Small firms, often “neglected” by analysts, have
been found to provide superior risk-adjusted
returns relative to large stocks. Under the semi-
strong EMH, public information regarding company
attributes would already be reflected in pricing.
• Superior returns of “value” stocks. Several studies
(e.g., Haugen, Fama) have observed that, over long
time periods. Stocks of companies with low
valuations (especially those with low price-book
ratios) appear, when adjusted for risk, to earn
higher returns than stocks of companies with high
valuations. Such results are in conflict with the
semi-strong EMH, inasmuch as they imply that
publicly available data and ratios can be used to
produce superior returns.
• Exceptional track records of certain firms and
individuals appear attributable to superior
fundamental analysis of public information (e.g.,
the Value Line enigma). These achievements seem to
refute the semi-strong EMH.
• Extreme market moves, such as those of October
1987, appear to indicate that market pricing is
sometimes driven by more than just the rational
processing of new information. To the extent that
“crowd psychology” or other noneconomic factors
Edited by
drive prices away from “fair values,” exploitable

mispricings exist, in conflict with the semi-strong
EMH.
• Price reversals (reversion to the mean), in which
poorly performing stocks in one period
systematically experience reversals in the
subsequent period, are inconsistent with the semi-
strong EMH. They imply that the market is
overreacting to public information and that
securities are mispriced.
B. There are client-specific needs that must be met for
counsel and management to be effective. Actively managed
portfolios can be constructed to meet client objectives
and constraints not reflected in a (passively managed)
market portfolio, adding a “nonperformance dimension” to
the value of active management. These client-specific
needs include the following:
• Special objectives (e.g., social investing, special
portfolio attributes, and similar nonstandard
preferences); and
• Special constraints (e.g., security exclusions,
special tax circumstances, unusual regulatory limits,
abnormal liquidity needs and similar non-standard
constraints).
Active management is justified when its rewards equal or

exceed its associated costs. Although consistently
superior risk-adjusted performance may be unattainable in
a semi-strong efficient market on average, it may be
possible to identify managers who possess superior
mosaic-assembling abilities to create valuable
information from publicly available data.
Edited by
Chpater-5
1. The relationship between nominal and real rates of return

is given by:
(1 + NIR)/(1 + CCL) = 1 + RIR
or as an approximation:
RIR = NIR - CCL
In this case:
(1 + .113)/(1 + CCL) = (1 + .060)
(1 + CCL) = 1.113/1.06
CCL = .05 = 5.0%
or approximately:
CCL = 11.3% - 6.0% = 5.3%
2. The relationship between nominal and real rates of return

shown in question 1 can be restated as:
(1 + RIR) = (1 + NIR)/(1 + CCL)
or:
RIR = (NIR − CCL)/(1 + CCL)
When the inflation rate is small the term (1+CCL) is

relatively small and can be ignored so that:
RIR ≅ NIR − CCL
However, in a very high inflation economy, the term

(1+CCL) is large and ignoring it will tend to overstate
the RIR.
3. The nominal annual return on Emil's bond portfolio is

calculated as:
NIR = [(V 1981 - V 1974 )/V 1974 ]1/7 - 1

Edited by
= [$16,932/$14,000]1/7 - 1
= .028 = 2.8%
From Table 1.1, the inflation rate over the seven-year

period can be computed by linking the annual inflation
rates and computing an annualized value. That is:
(1 + c 1975-81 ) = [(1 + c 1975 )×(1 + c 1976 )×...×(1 + c 1981 )]1/7
= (1.0701 × 1.0481 × 1.0677 × 1.0903 * 1.1331
* 1.1240 × 1.0894)1/7
=(1.8115)1/7 = 1.0886 = 8.9%
Thus the real annual return on Emil's bond portfolio is:
RIR = 1.028/1.089 = .944 = -5.6%
4. The yield-to-maturity of a bond is that interest rate

that equates the price of the bond to the discounted
value of the bond's cash flows.
The general form of the bond valuation equation is:
I1 I2 IN M
Pb = 1 + 2 ++ N +
(1 + Y ) (1 + Y ) (1 + Y ) (1 + Y ) N
a. In the case of the first bond, the yield-to-maturity

is found by solving the following equation for Y:
$816.30 = $1,000.00/(1+Y)3
(1 + Y)3 = $1,000.00/816.30
(1 + Y) = (1.225)1/3
Y = 1.07 - 1 = .070 = 7.0%
b. In the case of the second bond, the yield-to-maturity

is found by solving the following equation for Y:
$70 $70 $70 $1,000

$949.37 = 1 + 2 + 3 +
(1 + Y ) (1 + Y ) (1 + Y ) (1 + Y ) 3
Edited by
Y must be solved for iteratively. Trying 9.0% gives:
$949.37 = $64.22 + $58.92 + $54.05 + $772.18
= $949.37
Thus the yield-to-maturity on the second bond is

9.0%.
5. The value of a bond is the sum of the discounted value of

its cash flows. In the case of the Camp Douglas bond,
with a 12% discount rate:
$100 $100 $100 $1,100

Pb = 1 + 2 + 3 +
(1 + .12) (1 + .12) (1 + .12) (1 + .12) 4
= $89.29 + $79.72 + $71.18 + $699.07
= $939.26
With an 8% discount rate:
$100 $100 $100 $1,100

Pb = 1 + 2 + 3 +
(1 + .08) (1 + .08) (1 + .08) (1 + .08) 4
=$92.59 + $85.73 + $79.38 + $808.53
= $1,066.23
6. The concept of yield-to-maturity assumes that investors

can reinvest all of the cash flows generated by the
security at the yield-to-maturity. Further the bond is
assumed to be held until it matures. If either of these
assumptions are violated, then the realized return earned
by the investor may differ from the security's yield-to-
maturity at the time that it was purchased.
7. The yield-to-maturity of a bond is that interest rate

that equates the price of the bond to the discounted
value of the bond's cash flows. In the case of Patsy's
bond, the yield-to-maturity is found by solving the
following equation for Y:
$90 $90 $90 $1,000

$975.13 = 1 + 2 + 3 +
(1 + Y ) (1 + Y ) (1 + Y ) (1 + Y ) 3
Edited by
Y must be solved for iteratively. Trying 10.0% gives:
$975.13 = $81.82 + $74.38 + $67.62 + $751.31
= $975.13
Thus the yield-to-maturity on Patsy's bond is 10.0%.
8. The N-period spot rate is the interest rate on a pure

discount bond whose life extends from today through N
future periods. Thus for pure-discount bonds with
maturities of one, two, and three years, spot rates for
one, two, and three years can be determined.
The one-year spot rate can be determined from the price

of the one-year pure discount bond.
$930.23 = $1,000/(1 + Y)1
(1 + Y)1 = $1,000/$930.23
(1 + Y)1 = 1.075
Y = .075 = 7.5%
The two-year spot rate can be determined from the price

of the two-year pure discount bond.
$923.79 = $1,000/(1 + Y)²
(1 + Y)² = $1,000/$923.79
(1 + Y)² = 1.082
Y = .040 = 4.0%
The three-year spot rate can be determined from the price

of the three-year pure discount bond.
$919.54 = $1,000/(1 + Y)3
(1 + Y)3 = $1,000/$919.54
(1 + Y)3 = 1.088
Y = .028 = 2.8%
Edited by
9. The discount factor for period t is given by:
d t = 1/(1 + s t )t
In the case of the three-year pure discount bond, the

three-year spot rate is found by solving for Y:
$810.60 = $1,000/(1 + Y)3
(1 + Y)3 = $1,000/$810.60
(1 + Y)3 = 1.234
Y = .073 = 7.3%
Thus the three-year discount factor is:
d 3 = 1/(1 + .073)3
= 1/1.234
= .810
In the case of the four-year pure discount bond, the

four-year spot rate is found by solving for Y:
$730.96 = $1,000/(1 + Y)4
(1 + Y)4 = $1,000/$730.96
(1 + Y)4 = 1.368
Y = .082 = 8.2%
Thus the four-year discount factor is:
d 4 = 1/(1 + .082)4
= 1/1.368
= .731
In the case of the five-year pure discount bond, the

five-year spot rate is found by solving for Y:
$649.93 = $1,000/(1 + Y)5

Edited by
(1 + Y)5 = $1,000/$649.93
(1 + Y)5 = 1.539
Y = .090 = 9.0%
Thus the five-year discount factor is:
d 5 = 1/(1 + .090)5
= 1/1.539
= .650
10. The N-period spot rate is represented by the interest

rate on a pure discount bond whose life extends from
today through N future periods. The N-period forward
rate M periods hence is represented by the interest rate,
determined today, on a pure discount bond that will come
into existence M periods from today and mature N periods
after M.
11. The forward rate between periods t-1 and t is given by:
(1 + f t-1,t ) = (1 + s t )t/(1 + s t-1 )t-1
Thus in this problem:
(1 + f 1,2 ) = (1 + .055)2/(1 + .050)1
= 1.060
f 1,2 = .060 = 6.0%
(1 + f 2,3 ) = (1.065)3/(1 + .055)2
= 1.085
f 2,3 = .085 = 8.5%
(1 + f 3,4 ) = (1.070)4/(1 + .065)3
= 1.085
f 3,4 = .085 = 8.5%

Edited by
12. The spot rate for t periods is given by:
(1 + s t )t = (1 + f t-1,t ) × (1 + s t-1 )t-1
Thus in this problem:
(1 + s 1 )1 = (1 + .10) × (1 + s 0 )0
= 1.100
s1 = .100 = 10.0%
(1 + s 2 )2 = (1 + .095) × (1 + .10)1
= 1.205
s2 = (1.205)1/2 - 1
= .098 = 9.8%
(1 + s 3 )3 = (1 + .090) × (1 + .098)2
= 1.314
s3 = (1.314)1/3 - 1
= .095 = 9.5%
(1 + s 4 )4 = (1 + .085) × (1.095)3
= 1.425
s4 = (1.425)1/4 - 1
= .092 = 9.2%
13. The value of a bond is sum of the discounted cash flows

generated by the bond. The bond's cash flows should be
discounted at the spot rate applicable to the time period
in which the cash flow is paid.
The problem gives the forward rates from year one to year
two and from year two to year three. To calculate the
value of the bond, these forward rates must be converted
to spot rates for the appropriate periods. We know that:
Edited by
(1 + s t-1 )t-1 × (1 + f t-1,t ) = (1 + s t )t
Furthermore, we are given the information that:
(1 + s 1 )1 = 1.06
(1 + f 1,2 ) = 1.09
(1 + f 2,3 ) = 1.10
Thus (1 + s 2 )2 = (1 + s 1 )1 × (1 + f 1,2 )
= (1.06) × (1.09) = 1.155
And (1 + s 3 )3 = (1 + s 2 )2 × (1 + f 2,3 )
= (1.155) × (1.10) = 1.271
With this information, the value of the bond can now be

calculated.
$80 $80 $1,080

Pb = 1 + 2 +
(1 + s1 ) (1 + s ) (1 + s3 ) 3
$80 $80 $1,080

= + +
(1060
. ) (1155
. ) (1271
. )
= $75.47 + $69.26 + $849.72 = $994.45

14. a. The discount factors on the three bonds can be
determined sequentially. In the case of the first
bond, the one-year discount factor equates the price
of the bond to the discounted cash flow of the bond.
That is:
$909.09 = $1,000.00 × d 1
d 1 = $909.09/$1,000.00 = .909
In the case of the second bond, the one-year discount

factor is applied to the first year cash flow and the
two-year discount factor is that discount factor
that, when applied to the second year cash flow,
equates the price of the bond to the discounted cash
flows of the bond. That is:
$991.81 = ($100.00 × d 1 ) + ($1,100.00 × d 2 )

Edited by
= ($100.00 × .909) + ($1,100.00 × d 2 )
$991.81 - $90.90 = $1,100.00 × d 2
d 2 = $900.91/$1,100.00 = .819
The three-year discount factor is found in a similar

manner:
$997.18 = ($100.00 × .909) + ($100.00 × .819)
+ ($1100.00 × d 3 )
$997.18 - $90.90 - $81.90 = $1,100.00 × d 3
d 3 = $824.38/$1,100.00 = .749
b. Given the discount factors from part (a), the forward

rates can be derived. In general:
(1 + f t-1,t ) = (1 + s t )t/(1 + s t-1 )t-1
= (1/d t )/(1/d t-1 )
The forward rate from today to year one (which is

simply the one-year spot rate) is given by:
(1 + f 0,1 ) = (1/d 1 )/(1/d 0 )
= (1/.909)/(1/1) = 1.100/1 = 1.100
f 0,1 = 10.0%
The forward rate from year one to year two is given

by:
(1 + f 1,2 ) = (1/d 2 )/(1/d 1 )
= (1/.819)/(1/.909)
= 1.221/1.100 = 1.110
f 1,2 = 11.0%
The forward rate from year two to year three is given

Edited by
by:
(1 + f 2,3 ) = (1/d 3 )/(1/d 2 )
= (1/.749)/(1/.819)
= 1.335/1.221 = 1.094
f 2,3 = 9.4%
c. The amount of the loan should be equal to the

discounted value of the cash payments. The one, two,
and three-year discount factors should be applied to
these cash payments in order to calculate their
present value.
PV = (.909 × $500) + (.819 × $600) + (.749 × $700)
= $454.50 + $491.40 + $524.30 = $1,470.20
You should be willing to "pay" $1,470.20 for the

"bond" that Honus is offering to sell you. In other
words, the loan should be for $1,470.20.
15. The effective annual interest rate of r e (given a stated

annual interest rate of r), compounded over n periods per
year, is given by:
(1 + r e ) = (1 + r/n)n
In the case of Mercury National with its 6.0% passbook

savings account:
a. For semiannual compounding:
(1 + r e ) = (1 + .060/2)²
= (1.03)² = 1.061
r e = 6.1%
b. For daily compounding:
(1 + r e ) = (1 + .060/365)365
= (1.0001644)365 = 1.062
Edited by
r e = 6.2%
16. Assuming annual compounding, the investment pays $2,400

(= $30,000 × .08) in the first year. In the second year
the investment pays $3,240 (= $32,400 × .10). Finally,
in the third year the investment pays $4,276.80 (=
$35,640 × .12) plus the $30,000 in principal. Thus at
the end of three years Marty's investment is worth
$39,916.80.
Assuming semiannual compounding, the investment pays

$2,448
[= $30,000 × (1+.08/2)² - $30,000] in the first year. In
the second year the investment pays $3,325.92 [= $32,448
× (1+.10/2)² - $32,448]. Finally, in the third year the
investment pays $4,421.66 [= $35,773.92 × (1+.12/2)² -
$35,773.92] plus the $30,000 in principal. Thus at the
end of three years Marty's investment is worth
$40,195.58.
17. Under terms of the loan, you actually receive only $6,500
and must repay $8,000 at the end of two years.
The interest rate on the loan as calculated by the bank

discount method is:
BDR = [1+($1,500/$8,000)]1/2
= 1.09 = 9.0%
The true interest rate is given by BDR/(1 − BDR) or

.09/(1 − .09) = 9.9%
18. Unique student answer.
19. A downward-sloping yield curve is not inconsistent with

the liquidity preference theory of the term structure of
interest rates. If expected future spot rates are
substantially lower than current one-year spot rates, it
is possible that the yield curve may be downward sloping
even though investors demand a liquidity premium for
holding longer-term securities. In such a situation,
investors expect that interest rates will decline
significantly from current levels in the future, perhaps
due to an anticipated decline in the inflation rate.
Edited by
20. If the current structure of forward interest rates is

upward-sloping, then shorter-term bonds will have lower
yields-to-maturity than longer-term bonds. Thus a ten-
year zero-coupon bond would have a lower yield-to-
maturity than a fifteen-year zero-coupon bond. This is
because the yield-to-maturity can be interpreted as an
"average" of the forward rates over the life of a bond.
With an upward-sloping structure of forward rates, the
longer is the bond's life, the higher will be the
"average" forward rate. Similarly, a 6% coupon ten-year
bond is, in effect, a shorter-term bond than a 5% coupon
ten-year bond since a larger portion of the 6% bond's
present value derives from the earlier years of its life
(in the form of higher interest payments). Thus the 6%
coupon bond will have a lower yield-to-maturity than the
5% coupon bond.
21. If the structure of forward interest rates were downward-

sloping, then shorter-term bonds would have higher
yields-to-maturity than longer-term bonds. Again, this
is due to the yield-to-maturity being essentially an
average of the forward rates over the life of a bond.
Thus a ten-year zero-coupon bond would have higher yield-
to-maturity than a fifteen-year zero-coupon bond. A 6%
coupon ten-year bond would have a higher yield-to-
maturity than a 5% coupon ten-year bond.
22. Unique student answer. The students' supporting

arguments should include a brief explanation of the
particular term structure theory that they are defending,
a presentation of the theory's strong points in relation
to the other theories, and a discussion of how the theory
is supported by empirical evidence.
23. According to the unbiased expectations theory, the

expected future spot rate equals the forward rate. That
is:
es t,t+1 = f t,t+1
Further:
(1 + f 1,2 ) = (1 + s 2 )²/(1 + s 1 )
= 1.188/1.080
f 1,2 = .100 = 10.0%

Edited by
(1 + f 2,3 ) = (1 + s 3 )3/(1 + s 2 )²
= 1.331/1.188
f 2,3 = .120 = 12.0%
With es 1,2 = 10.0% and es 2,3 = 12.0%, then:
es 1,3 = (1.10 × 1.12)1/2 = 1.11 = 11.0%
Therefore the expected yields on one-year and two-year

pure discount bonds one year from today are 10% and 11%.
24. According to the liquidity preference theory:
f 1,2 = es 1,2 + L 1,2
f 1,2 − es 1,2 = L 1,2
As f 1,2 = [(1 + s 2 )2/(1 + s 1 ) − 1], then:
f 1,2 = [(1.07)2/(1.09) − 1] = .0504
Thus:
L 1,2 = 5.04% − 4.50% = .54%
25. If one invested $1 today at 7%, then the dollar would

grow to $2 in N years, where N is found by solving:
$1 × (1.07)N = $2
(1.07)N = 2
Taking the natural logarithm of both sides of the

equation gives:
N × ln(1.07) = ln(2)
N × .0677 = .6931
N = .6931/.0677 = 10.2 years
26. a. The value-relative of Pol's investment over the four

years is given by:
Edited by
VR = (1 + r 1 ) × (1 + r 2 ) × (1 + r 3 ) × (1 + r 4 )
= (1.20) × (1.30) × (1.50) × (.10)
= .234
b. The geometric mean return on Pol's investment is the

fourth root of the value-relative over the four-year
period, less one. That is:
(.234).25 - 1 = -.3045 = -30.5% per year.
27. Calculating the value-relative as the product of the

value-relatives in the three years, we have:
V 1 /V 0 = ($10,100 + $700)/$10,300
= 1.0485
V 2 /V 1 = ($9,900 + $700)/$10,100
= 1.0495
V 3 /V 1 = ($9,500 + 700)/$9,900
= 1.0303
The product of the three value-relatives is:
V N /V 0 = 1.0485 × 1.0495 × 1.0303 = 1.1337
Converting the value-relative to an annual return over

the three years gives:
(1.1337)1/3 = 1.0427 = 4.27%
28. In problem 15, if continuous compounding is applied to

the savings account with a 6.0% stated annual interest
rate, then the effective annual interest rate is:
(1 + r e ) = er
= e.060 = 1.062
re = .062 = 6.2%
Edited by
In problem 16, assuming continuous compounding, the

investment pays $2,498.61 (= $30,000 × e.08 - $30,000) in
the first year. In the second year the investment pays
$3,417.91 (= $32,498.61 × e.10 - $32,498.61). Finally, in
the third year the investment pays $4,579.24 (=
$35,916.52 × e.12 - $35,916.52) plus the $30,000 in
principal. Thus at the end of three years Marty's
investment is worth $40,495.76.
29. The intrinsic value of a bond is the discounted value of

its cash flows. In this case there is only one cash
flow. Thus:
V = C/ert
= $1,000/e.08*1
= $1,000/1.083
= $923.36
30. (From The CFA Candidate Study and Examination Program

Review, 1991.)
a. The forward rate is the expected yield during some

future period - e.g., the forward rate for year three
is the one year rate expected to prevail in year
three (three years from now). To calculate the
forward rate for a three year bond two years from
now, you would use the following formula:
n-m n m
(1 + t+m r n-m,t ) = (1 + t R n ) /(1 + tRm)
where: r = the forward rate for the period n-m

R n = the observable yield for a security with
maturity n
R m = the observable yield for a security with
maturity m
In this case, we are looking for the forward rate for

a three year bond, two years from now (i.e., the
forward three year rate for the period from two to
five years). Therefore, the computation would be as
follows:
5 2 1/3
= [(1 + t R 5 ) /(1 + tR2) ] - 1
Edited by
which in this example would be:
= [(1 + .077)5/(1 + .079)2]1/3 - 1 = 7.566%
b. The January 19XX term structure indicates an upward

sloping yield curve. The pure expectations
hypothesis would contend that investors are expecting
higher short-term rates in the future and, therefore,
the forward rate curve would be even steeper than the
currently prevailing yield curve which is the
geometric average of these future short-term rates.
The market segmentation hypothesis would contend that
there is greater demand for short-term securities by
those who have an interest in this segment of the
market. Put another way, those institutions that
tend to invest in the short-term segment of the yield
curve have greater funds at the present time compared
to those who have an interest in long-term
securities. The liquidity hypothesis would imply
that this upward sloping yield curve is a natural by-
product of risk averse investors who require a higher
yield to invest in longer term securities because of
the higher risk involved - i.e., the greater
volatility of longer maturity securities.
c. The term structure over this period experienced what

is referred to as a "snap down" in that the short-
term rates went up, but the long-term rates went down
substantially. As a result, a portfolio with a
maturity of two years (and a duration of less than
two) would have experienced a fairly small price
decline because the yields for one and two year bonds
went up. Therefore, this portfolio would have had a
small decrease in value during this transition. In
sharp contrast, the long-term rates went down
substantially and, therefore, a portfolio with a
maturity of 10 years (which would have a duration of
about 6 years) would have experience greater
volatility than the two year maturity portfolio, but
also positive price changes during this period
because all the long maturity bonds experienced a
decrease in yields. Therefore, this portfolio would
have experienced an increase in value.
d. In January 19XX, the spread between short-term and

long-term was about 135 basis points compared to the
normal spread of 170 basis points. Under these
Edited by
conditions, you would expect this spread to increase

during the ensuing period, and this could happen in
several ways. Assuming no change in the general
level of rates, you could either expect short rates
to decline or long rates to increase. Alternatively,
if you expected an increase in rates, you would
envision that long rates would experience a larger
increase in order to reestablish the normal spread.
Finally, if you expected a decline in rates, you
would expect long rates to decline by less than short
rates to reestablish the norm. The point is, in all
scenarios, you would expect the change in long rates
to be less than optimal. Put another way, this set
of expectations would discourage you from
aggressively investing in long-term securities.
Obviously, this portfolio decision would have been
suboptimal based upon what happened because the long
bonds had the very best performance because of the
"snap down" in the yield curve. This example
reflects the point made in the Meyer article that
when making a decision with regard to yield spreads,
it is also necessary to have some expectations
regarding the future level of interest rates. If you
really expected that interest rates would decline
substantially in the future, you would have possibly
anticipated the change in the shape of the yield
curve or been willing to invest in long bonds simply
because of the greater volatility during a period of
declining interest rates.
31. (From The CFA Candidate Study and Examination Program

Review,
1992.)
N
Ct F
a. P=∑ t +
t =1 (1 + Rt ) (1 + R N ) N
where: P = bond's price

N = number of periods of maturity
Ct = coupon payment of the bond at time t
F = face value (principal payment) of the
bond
Rt = discount rate applied by the market to a
payment to be received in period t
F + C N = 108
Edited by
100 = 8/(1+R 1 ) + 108/(1+R 2 )2
100 = 8/1.075 + 108/(1+R 2 )2
100 = 7.44186 + 108/(1+R 2 )2
92.55814 = 108/(1+R 2 )2
(1 + R 2 )2 = 1.166834
1 + R 2 = (1.1668)½
1 + R 2 = 1.0802
R 2 = 8.02%
b. The "current coupon" yield curve is constructed with

actual bond yields-to-maturity on actively traded
bonds. The term structure of spot rates is implied
by these data because any coupon bond can be
considered as a portfolio of pure discount bonds
corresponding to the coupon payments and principal
due at maturity. The price or present value of the
coupon bond is the sum of the prices of the component
discount bonds.
c. (1 + R t )t = (1 + R t-j )t-j * (1 + f j,t-j )j [Formula (3)

and page 352 of Latainer article] where R t is the
appropriate discount rate for time period t and f j is
the forward rate for time period t-j.
(1 + .095)2 = (1 + .09)(1 + f j,t-j )

1.199025 = (1.09)(1 + f j,t-j )
1.10002 = 1 + f j
10% = f j
A one year forward rate of 9.60% implies a return of

19.46% for the two-year period [(1.09)(1.096) =
1.19464]. A return of 19.90% is available on a two
year spot security. Investors would raise the supply
of two-year spot money and lower the supply of one-
year spot and forward money. This arbitrage would
drive the returns on the two alternatives together.
d. Spot rates
o Comparing the spot curve with the zero coupon curve

Edited by
or actual yields available on zero coupon

securities helps investors to identify those zeroes
representing good and poor value.
o The spot rate term structure allows an investor to

judge whether coupon bonds are fairly priced by
valuing each piece of the cash flow stream
individually. A bond appearing cheap on a yield-
to-maturity basis may be priced rich when its cash
flows are discounted separately at the appropriate
rates.
o The spot curve permits deriving an implied forward

rate for any maturity, thus providing an implicit
forecast of future rates expected by the market.
o Using the spot curve to value a bond's cash flows

as if they were default free helps in attributing a
bond's value to its features (e.g., calls, puts,
sinking funds) and characteristics (e.g., credit
outlook, tax considerations).
o By focusing on the component cash flows, the spot

curve can be useful in simulating the performance
of various bonds under possible changes in the
level, slope, and shape of the yield curve.
o Spot rates are useful in pricing guaranteed

interest contracts or other similar financial
instruments, determining the returns available in
immunization strategies, and determining profitable
stripping opportunities.
Forward rates
o Understanding the relationship between spot and

forward rates can help in understanding the
relationship between cash and futures market
prices.
o In providing the implicit interest rate forecast of

the market, forward rates are a useful baseline
comparison to other forecasts. They also can
suggest critical questions about the assumptions
underlying the forecast. For example, interest
rate expectations can be tested against currency
exchange rate expectations and inflation
Edited by
expectations.
o Implied forward rates can be compared to many contractual or

derivative instruments in testing for value.
Edited by
Chapter 6: THE PORTFOLIO SELECTION PROBLEM

1. Why must it be the case that an investor with diminishing marginal utility of
wealth is risk-averse?
Ans:
An investor with diminishing marginal utility of wealth is necessarily risk-averse
because the negative utility associated with a one dollar loss is more than the positive
utility of earning one dollar. That is, at any point along a concave utility of wealth
function (which indicates diminishing marginal utility), if one moves one dollar to the
right the corresponding increase in utility is smaller than the decline in utility if one
were to move one dollar to the left. As a result, the risk-averse investor is unwilling to
accept a fair bet, which implies an equal chance of moving right or left on his or her
utility function by an equal amount.
2.Listed below are a number of portfolios and expected returns, standard

deviations, and the amount of satisfaction (measured in utils) these portfolios
provide Arky Vaughn. Given this information, graph Arky's identifiable
indifference curves.
Portfolio Expected Standard Utility

Return Deviation
1 5% 0% 10 Units
2 6 10 10
3 9 20 10
4 14 30 10
5 10 0 20
6 11 10 20
7 14 20 20
8 19 30 20
15 0 30
9
10 16 10 30
11 19 20 30
12 24 30 30
Edited by
25
30 utils
20
20 utils
Expected Return (%)
15
10 utils
10
0
0 10 20 30
Standard Deviation (%)
3. Why are the indifference curves of typical investors assumed to slope upward to
the right?
Ans:
The indifference curves of a "typical" investor are assumed to slope upward to the
right because the investor is assumed to be risk averse. As the standard deviation of
portfolio returns increases, a risk averse investor requires higher expected returns if his or
her level of satisfaction is to be maintained.
4. What does a set of convex indifference curves imply about an investor's tradeoff
between risk and return as the amount of risk varies?
Ans:
Convex indifference curves (that is, indifference curves whose slopes increase when
moving along them from left to right) imply that an investor requires an increasingly
larger increment of expected return for each additional unit of risk incurred.
5. Why are typical investors assumed to prefer portfolios on indifference curves

lying to the northwest?
Ans:
Moving toward the "northwest" on the risk-return mapping produces higher expected
returns and/or lower standard deviation of returns. Assuming that investors prefer
Edited by
more wealth to less and less risk to more, portfolios in the risk-return mapping lying to
the "northwest" are preferred to those lying to the "southeast."
6.
What is meant by the statement that "risk-averse investors exhibit diminishing
marginal utility of income"? Why does diminishing marginal utility cause an
investor to refuse to accept a "fair bet"?
Ans:
Diminishing marginal utility of wealth means that an investor derives less additional
satisfaction from each extra dollar of wealth. That is, when an investor’s wealth
changes by $10,000 based on the results of a gamble , an extra dollar in additional
wealth is less satisfying than an extra dollar in additional wealth when the investor’s
wealth changes by only $100 based on the results of a gamble.
As a result of diminishing marginal utility of income, a risk-averse investor will find

the dissatisfaction associated with losing $1 in a gamble is greater than the pleasure of
winning $1 in the gamble. Therefore, the risk-averse investor will refuse to accept a
"fair bet."
7. Explain why an investor's indifference curves cannot intersect.
Ans:
If an investor's indifference curves could intersect it would create a situation in which
portfolios on two separate indifference curves would be equally desirable to the
investor. However, because each indifference curve defines a different level of
satisfaction it would be contradictory for portfolios on different indifference curves to
be equally desirable.
8. Why are the indifference curves of more risk-averse investors more steeply sloped
than those of investors with less risk aversion?
Ans:
More risk-averse investors require greater increases in expected return than do less risk-
averse investors for each unit of extra risk incurred. This requirement is reflected in
the greater slope of the indifference curves of more risk-averse investors relative to
less risk-averse investors.
9. Consider the following two sets of indifference curves for investors Hack
Wilson and Kiki Cuyler. Determine whether Hack or Kiki:
a. Is more risk-averse
b. Prefers investment A to investment B
c. Prefers investment C to investment D
Explain the reasons for your answers
Edited by
Ans:
a. Hack is less risk averse because Hack's indifference curves are less steeply sloped than
are Kiki's.
b. Hack is indifferent between investments A and B because they lie on the same
indifference curve. Kiki, however, prefers investment A to investment B because
it lies on a higher indifference curve.
c. Both investors prefer investment D to investment C because it lies on higher

indifference curve for both of them.
10. Consider four stocks with the following expected returns and standard
deviations.
Stock Expected Return Standard Deviation
A 15% 12%
B 13 8
C 14 7
D 16 11
Are any of these stocks preferred over another by a risk-averse investor?
Ans:
Stock C is preferred to stock B because it has both a higher expected return and lower
risk. For the same reasons, stock D is preferred to stock A.
11. Do you agree with the assumptions of nonsatiation and risk aversion? Make a
case for or against these assumptions.
Ans:
The assumption of nonsatiation would seem acceptable over most reasonable levels of
income. Few people would turn down an extra dollar offered to them without
conditions attached. However, the anecdotal stories about the psychological problems
experienced by winners of large lottery pools might give one pause before blindly
accepting this assumption.
Risk aversion is more difficult to accept as a generalization of investor behavior.

Many instances can be cited of behavior inconsistent with risk aversion. Nevertheless,
the alternatives to risk aversion, namely risk seeking or risk neutral behavior, seem
even less plausible as general explanations of investor behavior. One might conclude
that investor behavior is complicated and not easily generalized.
Edited by
12.At the beginning of the year, Corns Bradley owned four securities in the
following amounts and with the following current and expected end-of-year prices:
Security Share Amount Current Price Expected Year

End-Price
A 100 $50 $60
B 200 35 40
C 50 25 50
D 100 100 110
What is the expected return on Corns's portfolio for the year?
Ans:
The initial value of Corns's portfolio is:
W 0 = ($50 × 100) + ($35 × 200) + ($25 × 50) + ($100 × 100)
= $23,250
The proportion that each security constitutes of Corns's

initial portfolio is:
X A = ($50 × 100)/($23,250)
= .215
X B = ($35 × 200)/($23,250)
= .301
X C = ($25 × 50)/($23,250)
= .054
X D = ($100 × 100)/($23,250)
= .430
The expected returns on the portfolio securities are:
r A = ($60 - $50)/$50 = 20.0%
r B = ($40 - $35)/$35 = 14.3%

Edited by
r C = ($50 - $25)/$25 = 100.0%
r D = ($110 - $100)/$100 = 10.0%
The expected return on a portfolio is given by:

n
r p = ∑ ( X i × ri )
i =1
In the case of Corns's portfolio:
r p = (.215 × 20.0%) + (.301 × 14.3%) + (.054 × 100.0%)
+ (.430 × 10.0%)
= 18.3%
13. Given the following information about four stocks comprising a portfolio,
calculate each stock's expected return . Then, using these individual securities'
expected returns, calculate the portfolio's expected return.
Stocks Initial Investment Expected End of Proportion of
value Period Investment portfolio initial
Value Market Value
A $500 $700 19.2%
B 200 300 7.7
C 1000 1000 38.5
D 900 1500 34.6
Ans:
Proportion of
Expected Portfolio’s Initial
Stock Return Market Value
A $700/$500 = 40.0% 19.2
B $300/$200 = 50.0% 7.7%
C $1,000/$1,000 = 0.0% 38.5%
D $1,500/$900 = 66.7% 34.6%
The portfolio's expected return is given by:

4
r p = ∑ ( Xi × ri )
i =1
Edited by
r p = (.192 × 40.0%) + (.077 × 50.0%) + (.385 × 0.0%)
+ (.346 × 66.7%)
= 34.6%
14.Squeaky Bluege has been considering an investment in Oakdale Merchandising.

Squeaky has estimated the following probability distribution of returns for Oakdale
stock
Return Probability
-10% .10
0 .25
10 .40
20 .20
30 .05
On the basis of Squeak’s estimates, calculate the expected return and standard
deviation of Oakdale stock.
Ans:
The expected return of security i is given by:

n
ri = ∑( pj × Rj )
j =1
where p j is the probability of return R j occurring. For

Oakdale stock:
r i = (.10 × -10%) + (.25 × 0%) + (.40 × 10%) + (.20 × 20%)
+ (.05 × 30%)
= 8.5%
The standard deviation of security i is given by:

1/ 2
 n 
σ I = ∑ p j × ( R j − r j ) 2 
 j =1 
For Oakdale stock:

Edited by
σ i = {[.10 × (-10% - 8.5%)²] + [.25 × (0% - 8.5%)²]
+ [.40 × (10% - 8.5%)²] + [.20 × (20% - 8.5%)²]
+ [.05 × (30% - 8.5%)²]}½
= [34.2%2 + 18.1%2 + 0.9%2 + 26.5%2 + 23.1%2]½
= 10.1%
15. The expected returns and standard deviations of stocks A and Bare:
Stock Expected Return Standard deviation

A 13% 10%
B 5 18
Mox McQuery buys $20,000 of stock A and sells short $10 ,000 of stock B, using
all of the proceeds to buy more of stock A. The correlation between the two
securities is .25. What are the expected return and standard deviation of Mox's
portfolio?
Ans:
The expected return on a portfolio is given by:

N
rp = ∑(X
i =1
i × ri )
Mox has invested $30,000 in stock A and -$10,000 in stock

B. Thus X A = +1.5 and X B = -0.5. Therefore:
r p = (1.5 × 13.0%) + (-0.5 × 5.0%)
= 17.0%
The standard deviation of a two-security portfolio is:
σ p = [ X Aσ A2 + X Bσ B2 + 2 X A X B ρABσ Aσ B ]
1/ 2
In Mox's case:
σ p = [(1.5)²(10)² + (-0.5)²(18)²
+ (2)(1.5)(-0.5)(.25)(10)(18)]1/2
Edited by
= (238.5)1/2 = 15.4%
16.Both the covariance and the correlation coefficient measure the extent to which
the returns on securities move together. What is the relationship between the two
statistical measures? Why is the correlation coefficient a more convenient
measure?
Ans:
The correlation coefficient is related to the covariance through the following mathematical
expression:
ρ ij = σ ij /(σ i σ j )
The correlation coefficient is a more convenient measure of the extent to which two
random variables move together because it is a standardized measure of the
covariance. The correlation coefficient produces a standardized covariance measure
by dividing the covariance by the product of the standard deviations of the two
random variables. As a result, the correlation coefficient is unit free and bounded by
the values -1 and +1. The standardization of the covariance facilitates comparisons of
the statistical interdependence among pairs of random variables.
17. Give an example of two common stocks that you would expect to exhibit a
relatively low correlation. Then give an example of two that would have a relatively
high correlation.
Ans:
Two stocks in the same industry will often exhibit relatively high correlations. For
example, the correlation of Ford and General Motors is likely to be higher than the
correlation of two randomly selected stocks from different industries.
Two stocks in industries whose fortunes tend to move in opposite directions will often
exhibit relatively low correlations. For example, American Airlines' fuel expenses
will decline when oil prices fall, thus improving the company's profits, everything else
remaining the same. Conversely, lower oil prices hurt Exxon's profits. Hence
American's and Exxon's stock prices are likely to exhibit relatively low correlations.
18. Gibby Brock has estimated the following joint probability distribution of returns
for investments in the stock of Lakeland Halfway Homes and Afton Brewery:
Lakeland Aftion Probability

-10% 15% .15
5 10 .20
10 5 .30
20 0 .35
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On the basis of Gibby's estimates, calculate the covariance and correlation

coefficient between the two investments.
Ans:
The covariance between two securities is given by:
∑[ p ]
N
σ XY = i × ( R Xi − r X ) × ( RYi − r Y )
i =1
In the case of Lakeland and Afton stocks, their expected

returns are:
r L = (.15 × -10%) + (.20 × 5%) + (.30 × 10%) + (.35 × 20%)
= 9.5%
r A = (.15 × 15%) + (.20 × 10%) + (.30 × 5%) + (.35 × 0%)
= 5.8%
Therefore:
σ LA = [.15 × (-10% - 9.5%) * (15% - 5.8%)]
+ [.20 × (5% - 9.5%) × (10% - 5.8%)]
+ [.30 × (10% - 9.5%) × (5% - 5.8%)]
+ [.35 × (20% - 9.5%) × (0% - 5.8%)]
= (-26.9) + (-3.8) + (-0.1) + (-21.3)
= -52.1
The correlation coefficient between two securities is:
ρ XY = σ XY /(σ X × σ Y )
In the case of Lakeland and Afton stocks, their standard

deviations are:
σ L = {[.15 × (-10% - 9.5%)²] + [.20 × (5% - 9.5%)²]

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+ [.30 × (10% - 9.5%)²] + [.35 × (20% - 9.5%)²]}½
= [57.0 + 4.1 + 0.1 + 38.6]½
= 10.0%
σ A = {[.15 × (15% - 5.8%)²] + [.20 × (10% - 5.8%)²]
+ [.30 × (5% - 5.8%)²] + [.35 × (0% - 5.8%)²]}½
= [12.7 + 3.5 + 0.2 + 11.8]½
= 5.3%
Therefore:
ρ LA = -52.1/(10.0 × 5.3)
= -.98
19. Calculate the correlation matrix that corresponds to the variance-covariance

matrix given in the text [or Able, Baker, and Charlie.
From the variance-covariance matrix for Able, Baker, and

Charlie:
σ AB = 187
σ AC = 145
σ BC = 104
σ A2 = 146
σ B2 = 854
σ C2 = 289
Therefore:
ρ AB = 187/(146)½ × (854)½
= .53
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ρ AC = 145/(146)½ × (289)½
= .71
ρ BC = 104/(854)½ × (289)½
= .21
Thus the correlation matrix for Able, Baker, and Charlie

is:
A B C
A 1.00 0.53 0.71
B 0.53 1.00 0.21
C 0.71 0.21 1.00
20. Given the following variance-covariance matrix for three securities, as well as
the percentage of the portfolio for each security, calculate the portfolio's standard
deviation.
Security A Security B Security C

Security A 459
Security B -211 312
Security C 112 215 179
XA=.50 XB=.30 Xc=.20
Ans:
In the three-variable case the standard deviation of a

portfolio is given by:
σ p = [X 1 X 1 σ 11 + X 1 X 2 σ 12 + X 1 X 3 σ 13 + X 2 X 1 σ 21 + X 2 X 2 σ 22
+ X 2 X 3 σ 23 + X 3 X 1 σ 31 + X 3 X 2 σ 32 + X 3 X 3 σ 33 ]½
Thus for this portfolio:
σ p = [(.5)(.5)(459) + (.5)(.3)(-211) + (.5)(.2)(112)
+ (.3)(.5)(-211) + (.3)(.3)(312) + (.3)(.2)(215)
+ (.2)(.5)(112) + (.2)(.3)(215) + (.2)(.2)(179)]½

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= [114.8 + (-31.7) + 11.2 + (-31.7) + 28.1 + 12.9 + 11.2
+ 12.9 + 7.2]½
= [134.9]½ = 11.6%
21. Rube Bressler owns three stocks and has estimated the following joint
probability distribution of returns:
Outcome Stock A Stock B Stock C Probability

1 -10 10 0 .30
2 0 10 10 .20
3 10 5 15 .30
4 20 -10 5 .20
Calculate the portfolio's expected return and standard deviation if Rube invests
20% in stock A, 50% in stock B, and 30% in stock C. Assume that each security's
return is completely uncorrelated with the returns of the other securities
Ans:
The expected returns on the three securities in Rube's

portfolio are:
r A = (.30 × -10%) + (.20 × 0%) + (.30 × 10%) + (.20 × 20%)
= 4.0%
r B = (.30 × 10%) + (.20 × 10%) + (.30 × 5%) + (.20 × -10%)
= 4.5%
r C = (.30 × 0%) + (.20 × 10%) + (.30 × 15%) + (.20 × 5%)
= 7.5%
The expected return on Rube's portfolio is therefore:
r p = (.20 × 4.0%) + (.50 × 4.5%) + (.30 × 7.5%)
= 5.3%
The standard deviations of the portfolio's three

securities are:
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σ A = {[.30 × (-10.0 - 4.0)2] + [.20 × (0.0 - 4.0)2]
+ [.30 × (10.0 - 4.0)2] + [.20 × (20.0 - 4.0)2]}½
= [58.8 + 3.2 + 10.8 + 51.2]½
= 11.1%
σ B = {[.30 × (10.0 - 4.5)2] + [.20 × (10.0 - 4.5)2]
+ [.30 × (5.0 - 4.5)2] + [.20 × (-10.0 - 4.5)2]}½
= [9.1 + 6.1 + 0.1 + 42.1]½
= 7.6%
σ C = {[.30 × (0 - 7.5)2] + [.20 × (10 - 7.5)2]
+ [.30 × (15 - 7.5)2] + [.20 × (5 - 7.5)2]}½
= [16.9 + 1.3 + 16.9 + 1.3]½
= 6.0%
The fact that the three securities are each uncorrelated

with each other simplifies the calculation of the
portfolio's standard deviation. Specifically,
σ p = [(.20)² × (11.1)² + (.50)² × (7.6)² + (.30)² ×

(6.0)²]½
= [4.9 + 14.4 + 3.2]½
= 4.7%
22. If a portfolio's expected return is equal to the weighted average of the expected
returns of the component securities, why is a portfolio's risk not generally equal to
the weighted average of the component securities' standard deviations?
Ans:
A portfolio's risk is not equal to the weighted average of the component securities'
standard deviations because, in addition to the standard deviations of the component
securities, the covariances between the securities will also affect the portfolio's risk.
(However, in the unlikely case when the correlations between securities are all +1, portfolio
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risk is a weighted average of the component securities' standard deviations. This is shown in
the next problem.) The general expression for portfolio standard deviation illustrates this
situation:
1/ 2
n n 
σ P = ∑ ∑ X i X j σ ij 
 i =1 j =1 
The term σ ij reflects not only each security's variance,

but the covariance between securities.
23. When is the standard deviation of a portfolio equal to the weighted

average of the standard deviation of the component securities? Show this
mathematically for a two-security portfolio. (Hint: Some algebra is
necessary to solve this problem . Remember that (pij = Pij(Qj(Qj' Try different
values of Pij')
Ans:
If the correlation coefficients between all securities in
a portfolio are +1, then the portfolio's standard
deviation is the weighted average of the component
securities' standard deviations.
For the two-variable case:
σ p = [X 1 X 1 σ 11 + X 1 X 2 σ 12 + X 2 X 1 σ 21 + X 2 X 2 σ 22 ]½
= [X 1 X 1 σ 11 + 2X 1 X 2 σ 12 + X 2 X 2 σ 22 ]½
= [X 1 X 1 σ 11 + 2X 1 X 2 σ 1 σ 2 ρ 12 + X 2 X 2 σ 22 ]½
Try ρ 12 = 1.00, then:
σ p = [(X 1 σ 1 + X 2 σ 2 )²]½
= X1σ1 + X2σ2
24. Consider two securities, A and B, with expected returns of 15% and 20%,
respectively, and standard deviations of 30% and 40%, respectively. Calculate the
standard deviation of a portfolio weighted equally between the two securities if
their correlation is:
a.0.9
b.O.O
c. -0.9
Ans:
A two-security portfolio's standard deviation is given
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by:
σ P = [ X A2σ A2 + X B2σ B2 + 2 X A X B ρσ Aσ B ]
1/ 2
a. σp = [(.5)²(30)² + (.5)²(40)² +
(2)(.5)²(.9)(30)(40)]1/2
= [225 + 400 + 540]1/2
= [1165]1/2 = 34.1%
b. σ p = [(.5)²(30)² + (.5)²(40)² + (2)(.5)²(0)(30)(40)]1/2
= [225 + 400 + 0]1/2
= [625]1/2 = 25.0%
c. σp = [(.5)²(30)²+ (.5)²(40)² + (2)(.5)²(-

.9)(30)(40)]1/2
= [225 + 400 - 540]1/2
= [85]1/2 = 9.2%
25. Listed here are estimates of the standard deviations and correlation coefficients
for three stocks.
Correlation with stock
C 10 .20 -.20 1.00
a. If a portfolio is composed of 20% of stock A and 80% of stock C, what is the

portfolio's standard deviation?
b. If a portfolio is composed of 40% of stock A, 20% of stock B, and 40% of stock
C, what is the portfolio's standard deviation?
c. If you were asked to design a portfolio using stocks A and B, what percentage
investment in each stock would produce a zero standard deviation?
[Hint: Some algebra is necessary to solve this problem. Remember that
XB = (1 - XA ) · ]
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Ans:
A portfolio's standard deviation is given by:

1/ 2
n n 
σ p = ∑ ∑ X i X j σ ij 
 i =1 j =1 
1/ 2
n n 
= ∑ ∑ X i X jσ iσ j ρij 
 i =1 j =1 
a. σ p = [X 1 X 1 σ 11 + X 1 X 2 σ 12 + X 2 X 1 σ 21 + X 2 X 2 σ 22 ]½
= [(.2)(.2)(12)(12) + (.2)(.8)(12)(10)(.20)
+ (.8)(.2)(10)(12)(.20) + (.8)(.8)(10)(10)]½
= [5.8 + 3.8 + 3.8 + 64.0]½
= [77.4]½ = 8.8%
b. σ p = [X 1 X 1 σ 11 + X 1 X 2 σ 12 + X 1 X 3 σ 13 + X 2 X 1 σ 21 + X 2 X 2 σ 22
+ X 2 X 3 σ 23 + X 3 X 1 σ 31 + X 3 X 2 σ 32 + X 3 X 3 σ 33 ]½
= [(.4)(.4)(12)(12) + (.4)(.2)(12)(15)(-1.00)
+ (.4)(.4)(12)(10)(.20) + (.2)(.4)(15)(12)(-1.00)
+ (.2)(.2)(15)(15) + (.2)(.4)(15)(10)(-.20)
+ (.4)(.4)(10)(12)(.20) + (.4)(.2)(10)(15)(-.20)
+ (.4)(.4)(10)(10)]½
= [23.0 + (-14.4) + 3.8 + (-14.4) + 9.0 + (-2.4) +

3.8
+ (-2.4) + 16.0]½
= [22.0]½ = 4.7%
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c. In the case of two-securities, A and B:
σ p = [X A X A σ AA + 2X A X B σ AB + X B X B σ BB ]½
= [X A X A σ AA + 2X A (1 - X A )ρ AB σ A σ B + (1 - X A )(1 -
X A )σ BB ]½
If ρ AB = -1.00, then:
σ p = [X A X A σ AA + 2X A (1 - X A )(-1.00)σ A σ B + (1 - X A )(1 -
X A )σ BB ]½
Through algebraic manipulation (Note: σ AA = σ A σ A and

σ BB = σ B σ B ):
σ p = [X A X A σ AA + σ BB - 2X A σ BB + X A X A σ BB - 2X A σ A σ B +
2X A X A σ A σ B ]½
= [X A X A (σ AA + 2σ A σ B + σ BB ) - 2X A (σ BB + σ A σ B ) + σ BB ]½
= [X A X A (σ A + σ B )² - 2X A σ B (σ B + σ A ) + σ BB ]½
= X A (σ A + σ B ) - σ B
One should solve for X A such that σ p = 0. Therefore:
0 = X A (σ A + σ B ) - σ B
X A (σ A + σ B ) = σ B
X A = σ B /(σ A + σ B )
In this specific problem:
X A = 15/(12 + 15) = .556 = 55.6%
X B = (1 - X A ) = (1 - .556) = .444 = 44.4%
26. Appendix Question) Calculate the expected return, mode, and median for a
stock having the following probability distribution:
Return Probability of Occurence

-40 .03
-10 .07
Edited by
0 .30
+15 .10
+30 .05
+40 .20
+50 .25
Ans:
The expected return of the distribution is:
E(R) = (-40)(.03) + (-10)(.07) + (0)(.30) + (15)(.10)
+ (30)(.05) + (40)(.20) + (50)(.25)
= 21.6%
The mode is 0% because it is the most likely outcome.
The median can be considered to be any number between 15

and 30 because there is a 50% chance that the return will
be 15 or below and a 50% chance that it will be 30 or
above.
27. (Appendix Question) Bear Tracks Schmitz has estimated the following
probabilitydistribution of next year's dividend payments for Mauston Inc.'s
stock. According to Bear Tracks, what is the standard deviation of Mauston's
dividend?
Dividend Probability
$1.9 .05
1.95 .15
2.00 .30
2.05 .30
2.10 .15
2.15 .05
Ans:
Mauston's expected dividend is given by:

n
E ( D) = ∑(D × p )
i =1
i i
In this case:
E(D) = ($1.90)(.05) + ($1.95)(.15) + ($2.00)(.30)

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+ ($2.05)(.30) + ($2.10)(.15) + ($2.15)(.05)
= $2.03
Calculating the sum of the squared deviations times their

associated probabilities gives the variance of Mauston’s
dividend:
σ2 = .05 × ($1.90 - 2.03)2 + .15 × ($1.95 - $2.03)2
+ .30 × ($2.00 - $2.03)2 + .30 × ($2.05 - $2.03)2
+ .15 × ($2.10 - $2.03)2 + .05 × ($2.15 - $2.03)2
= $2.00365
Or a standard deviation of:
σ = $.06
28. Appendix Question) Given the following joint probability distribution of returns
for Securities A and n, calculate the covariance between the two securities.
State Security A Security B Security C

1 10% 20% .10
2 12 25 .20
3 8 33 .35
4 14 27 .20
5 19 22 .10
Ans:
The expected returns on securities A and B are:
r A = (10)(.10) + (12)(.25) + (8)(.35) + (14)(.20) +

(19)(.10)
= 11.5%
r B = (20)(.10) + (25)(.25) + (33)(.35) + (27)(.20) +

(22)(.10)
= 27.4%
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The sum of the corresponding deviations from the expected

returns times the probabilities of the associated
outcomes gives the covariance between securities A and B:
σ AB = (.10)(10 - 11.5)(20 - 27.4) + (.25)(12 - 11.5)(25 -

27.4)
+(.35)(8 - 11.5)(33 - 27.4) + (.20)(14 - 11.5)(27 - 27.4)
+(.10)(19 - 11.5)(22 - 27.4)
= -10.3
29. (Appendix Question) Using the data given in Tables 6.3 and 6.4, calculate the
correlation coefficient between the returns on Alpha and Omega stock.
Ans:
From Tables 6.3 and 6.4, we know that the standard
deviation of Alpha and Omega stocks are respectively,
7.8% and 5.9%. Also we know that the covariance between
the two stocks is -41.5. Given that:
ρ ij = σ ij /σ i σ j
Then the correlation coefficient between the two stocks

is:
ρ Alpha,Xenith = -41.5/(7.8 × 5.9)
= -.90
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Chapter: PORTFOLIO A NALYSIS

1. Why would you expect individual securities to generally lie in the eastern
portion of the feasible set, whereas only portfolios would lie in the northwestern
portion?
Answer:
Because very few securities will exhibit perfectly positive correlation, diversification
will tend to reduce portfolio risk. Thus, for any given level of expected return, one
would expect that portfolios will exhibit lower risk (lie further to the west in the feasible
set) than individual portfolios (which will therefore lie to the east in the feasible set).
2. Explain why most investors prefer to hold a diversified portfolio of securities

as opposed to placing all of their wealth in a single asset. Use an illustration of
the easible and efficient sets to explain your answer.
Answer:
Diversified portfolios are more efficient than individual securities. That is, diversified
portfolios provide the investor with higher expected returns for given levels of risk
and/or lower risk for given levels of expected return when compared with individual
securities.
Diagrammatically, individual securities will lie in the eastern portion of the feasible set.
Hence they are dominated by diversified portfolios, which lie in the northwestern portion
of the feasible set, including those on the efficient set.
3. Why would you expect most U.S. common stocks to have positive covariances?
Give an example of two stocks th at you would expect to have a very high positive
covariance. Give an example of two stocks that you would expect to have a very
low positive (or even negative) covariance.
Answer:
The macroeconomic forces that impact the U.S. economy tend to have a strong effect on
the earnings (and, hence, stock prices) of all domestic corporations, although the
magnitude of this effect will vary among industries and specific firms. For example, a
recession causes most companies to experience a downturn in earnings. While some
companies may be more severely affected than others, nevertheless, the broad influence
of a recession on general economic activity likely results in most companies' stocks
performing poorly.
Companies whose stocks would be expected to have a high positive covariance are auto
and steel companies. When auto sales are strong (weak), the demand for steel generally
rises (falls). The earnings of companies in both industries would rise and fall at roughly
the same time and this movement would likely be anticipated by the earlier rise and fall
of their stocks' prices.
Companies whose stocks would be expected to have a low covariance are banks and
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gold mining firms. Rising interest rates and poor business conditions generally produce
declining bank earnings. At the same time, a pessimistic economic outlook often causes
investors to increase their demand for gold, which increases the price of gold and,
therefore, the earnings of gold mining firms. The result is that the stock prices of banks
and gold mining firms will not likely move in the same direction.
4. Discuss why the concepts of covariance and diversification are closely related.
Answer:
It is the fact that all stocks do not have high positive covariances that causes
diversification to benefit the investor. That is, by diversifying, investors can reduce
portfolio risk and thereby create more efficient portfolios. If stocks did have high
positive covariances, then holding a well-diversified portfolio would not result in
meaningful reductions in risk relative to holding individual securities.
5. Mule Haas is a portfolio manager. On average, the expected returns on all

securities that Mule is researching are positive. Under what conditions might
Mule be willing to purchase a security with a negative expected return?
Answer:
If the security in question had significant negative correlation with the rest of the
securities in the portfolio, Mule might consider purchasing it even though it had a
negative expected return. The diversifying nature of the security might reduce the risk of
the portfolio sufficiently to make it attractive despite its inferior return potential.
6. In terms of the Markowitz model, explain, using words and graphs, how an
investor goes about identifying his or her optimal portfolio. What specific
information does an investor need to identify this portfolio?
Answer:
Given the expected returns and variance-covariance estimates for all securities, an
investor can construct the efficient set. This information, combined with the unique risk-
return preferences of the investor, allows the investor to determine his or her optimal
portfolio. Diagrammatically, this optimal portfolio lies at the point of tangency between
the investor's indifference curves and the efficient set.
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7. Dode Brinker
owns a Security Expected Standard Weight portfolio
of two Return Dev'atfon securities
with the A 10% 20% .35 following
expected returns,
standard B 15 25 .65 deviations,
and weights:
What correlation between the two securities produces the maximum portfolio
standard deviation? What correlation between the two securities produces the
minimum portfolio standard deviation? Show your calculations.
Answer:
The standard deviation of a two-security portfolio is given by:
σ p = [ X Aσ A2 + X Bσ B2 + 2 X A X B ρABσ Aσ B ]
1/ 2
In Dode's case:
p = [(.35)²(20)² + (.65)²(25)² + 2(.35)(.65)(20)(25)12 ]½
= [49 + 264 + 22812 ]½
The portfolio's standard deviation will be at a minimum when the correlation

between securities A and B is -1.0. That is:
p = [49 + 264 - 228]½
= 9.2%
The portfolio's standard deviation will be at a maximum when the correlation

between securities A and B is +1.0. That is:
p = [49 + 264 + 228]½
= 23.3%
8. Explain why the efficient set must be concave. (Hin t: Think about the
ramifications of the efficient set having a "dent" in it.)
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Answer:
If the efficient set were not concave, it would be possible to construct portfolios that
dominate portfolios on the efficient set. By definition, the efficient set contains
portfolios that offer maximum expected return for given levels of risk and minimum risk
for given levels of expected return. Yet if portfolios not on the efficient set can be
identified that offer lower risk for a given expected return or higher expected return for a
given level of risk, then the efficient set portfolios are not truly "efficient" -- a logical
inconsistency.
That one could construct such portfolios if the efficient set were not concave can be seen
by referring to the situation in which all securities had correlations of +1. In this case,
combinations of two portfolios on the efficient set would lie on a straight line. If the
efficient set had a "dent" in it, it would be possible to produce portfolios that lay to the
northwest of the this "dent" (that is, dominate these efficient portfolios). Because
securities do not have correlations of +1, combinations of efficient portfolios along the
"dent" will lie even further to the northwest, again dominating the efficient portfolios and
producing the logical inconsistency referred to above.
9. Leslie Nunamaker owns a portfolio whose market model is expressed as:

Tp = 1.5% + O.gOT! + 8p!
If the expected return on the market index is 12%,what is the expected return on
Leslie's portfolio?
Answer:
With a 12% expected return on the market index, the market model would imply that the
expected return on Leslie's portfolio would be:
rP = 1.5% + .90 × 12.0%
= 12.3%
10. How is beta derived from a security's market model? Why are high beta
securities termed "aggressive"? Why low beta securities are termed
"defensive"?
Answer:
Beta, as derived from the market model, is the slope of the regression line relating the
return on a security (or portfolio) to the return on a market index.
High beta stocks are termed "aggressive" because they will tend to produce more volatile
returns than the market index. When the market produces a positive return the high beta
security will produce an even higher positive return. When the market generates a
negative return the high beta security will produce an even lower negative return.
Conversely, low beta securities are termed "defensive" because they tend to be relatively
less sensitive to market moves. When the market produces a positive return, the low
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beta security's return will be less positive. When the market produces a negative return
the low beta security will produce a less negative return.
11. The following table presen ts ten years of return data for the stock of Glenwood
City Properties and for a market index. Plot the returns of Glenwood City and the
market index on a graph. with the market index's returns on the horizontal axis
and Glenwood City's returns on the vertical axis. Draw your best guess of the
market model through these points. Examining the graph, estimate the beta of
Glenwood City stock.
Year Glenwood City Market Index
1 8.1% 8.0%
2 3.0 0.0
3 5.3 14.9
4 1.0 5.0
5 -3.1 14.1
6 -3.0 18.9
7 5.0 10.1
8 3.2 5.0
9 1.2 1.5
10 1.3 2.5
Answer:
Glenwood City Return
Estimating the slope of the characteristic line from the graph gives a beta value of
Market index
10 Return
0
-10 -5 0 5 10 15
-5
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roughly 0.5 for Glenwood City Properties.
12. Consider the stocks of two companies, Woodville Weasel Farms and New
Richmond Furriers.
a. If you are told that the slope of Woodville's market model is 1.20 and that the
slope of New Richmond's market model is 1.00, which stock would you say is
likely to be riskier in a portfolio context? Why?
b. If you are now also told that the standard deviation of the random error term
for Woodville stock is 10.0%, whereas for New Richmond stock it is 21.5%, does
your answer change? Explain.
Answer:
a. The slope of the market model equals the beta of the security or portfolio under
analysis, which in turn indicates the relative riskiness of the security or portfolio. That
is, based on the market model, the standard deviation of a well-diversified portfolio, for a
given market index standard deviation, is dependent on the portfolio's beta. Therefore, in
a portfolio context, Woodville's stock is more risky than New Richmond's stock because
Woodville's beta is larger than New Richmond's and, for the same assigned weight, it
contributes more to a portfolio's beta.
b. The answer from (a) remains unchanged despite the additional information. The
standard deviation of the random error term represents unique (or diversifiable) risk.
Thus it is irrelevant to the question of how risky a particular security is in the context of
a well-diversified portfolio.
13. The market model specifies a very simple relationship between a security's
return and the return on the market index. Discuss some real-world complexities
that might diminish the predictive power of the market model.
Answer:
The most important "complexity" potentially undermining the predictive power of the
market model is that other factors besides the return on the market index may be closely
associated with a security's return. For example, the return on General Motors stock
may be associated with economic factors that affect primarily the auto industry.
Ignoring those factors decreases the ability to effectively "explain" the return on General
Motors stock through the market model.
Further, the market model is based solely on the historical relationship between a
security's return and the return on the market index. To the extent that relationship
changes over time, the market model estimated over a past period may not predict the
future well.
In addition, the statistical technique used to generate the market model for a specific
security provides only an estimate of the relationship between the security's return and
that of the market index. The estimation process is subject to sampling error.
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14. Each of two stocks, one the stock ofan electric utility company and the other
the stock of a gold mining company, has a beta of 0.60. Why would a security
analyst be interested to know that the gold mining stock has a much larger
standard deviation of the random error term (unique risk) than the electric
utility stock?
Answer:
The larger standard deviation of the random error term indicates that the market model
less successfully "explains" the return on the gold mining stock than it does the return on
the utility stock. As a result, in deriving an evaluation of the gold mining company's
prospects, an analyst may have to investigate more closely the unique factors that affect
the gold mining company's performance. The analyst's research on the utility company
can focus more on the macroeconomic factors affecting the broad market.
15. Lyndon Station stock has a beta of 1.20. Over five years, the following
returns were produced by Lyndon stock and a market index. Assuming a market
model intercept term of 0%, calculate the standard deviation of the market
model random error term over this period.
Year Lyndon Return Market Index
1 17.2% 14.0%
2 -3.1 -3.0
3 13.3 10.0
4 28.5 25.0
5 9.8 8.0
Answer:
The market model defines a stock's return as:
ri = i + ß i × r I + i
In the case of Lyndon stock over the five years, the random error term can be calculated
as follows (assuming a 0% intercept term):
1 = 17.2 - [(1.2) × (14.0)] = 0.4
2 = -3.1 - [(1.2) × (-3.0)] = 0.5
3 = 13.3 - [(1.2) × (10.0)] = 1.3
4 = 28.5 - [(1.2) × (25.0)] = -1.5
5 = 9.8 - [(1.2) × ( 8.0)] = 0.2

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The average random error term is:
Average = (0.4 + 0.5 + 1.3 - 1.5 + 0.2)/5
= 0.2
The standard deviation of the random error term is therefore:
 = {[(0.4 - 0.2)² + (0.5 - 0.2)² + (1.3 - 0.2)²
+ (-1.5 - 0.2)² + (0.2 - 0.2)²]/(5-1)}½
= {(.04 + .09 + 1.21 + 2.89 + 0)/4}½
= 1.03%
16. Why does diversification lead to a reduction in unique risk but not in market
risk? Explain, both intuitively and mathematically.
Answer:
The market risk of a portfolio depends on events that influence all securities to some
degree. That is, these events are systematic. Because all securities are affected by these
systematic events, diversifying a portfolio will not reduce exposure to them. Only if the
securities added to a portfolio had lower sensitivities to systematic events would
diversification reduce market risk. But there is no reason to assume that randomly
selected securities will have such lower sensitivities.
The unique risk of a portfolio depends on events specific to individual securities

comprising the portfolio. These events are unsystematic in the sense that an event that
impacts one security (in either a good or bad sense) is not expected to impact other
securities. As a result forming a diversified portfolio tends to cause the net impact of
these unsystematic events to cancel each other out. The more diversified is the portfolio,
the greater will be this canceling effect, and the lower is the portfolio's unique risk.
Mathematically:
1/ 2
 n  2 n 2 2
2
σ p =  ∑ X i βi  σ I + ∑ X i σ εi 
 i =1  i =1 
Looking at the market risk term:

2
 n  2
 ∑ X i βi  σ I
 i =1 
Clearly, σ I2 is unaffected by diversification. Further, the term  X i ß i is merely the

average beta of the securities in the portfolio. Again, it is not affected by diversification.
Thus market risk cannot be reduced by diversification.
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Looking at the unique risk term:

n
∑X
i =1
iσ ε2i
2
As the number of securities increases, X i2 becomes small very quickly, while σ ε2i
remains roughly constant. Thus the unique risk term approaches zero as diversification
increases.
17. Siggy Boskie owns a portfolio composed of three securities with the following
characteristics:
security Beta Standard DeviatIon Proportion
Random Error Term
A 1.20 5% .30
B 1.05 8 .50
C 0.90 2 .20
If the standard deviation of the market index is 18%, what is the total risk of
Siggy's portfolio?
Answer:
The beta of a portfolio is defined as the weighted average of the component securities'
betas. In the case of Siggy's portfolio:
3
βP = ∑ X i βi
i =1
= (.30 × 1.20) + (.50 × 1.05) + (.20 × 0.90)
= 1.07
Further, the standard deviation of a portfolio can be expressed as:
( )
1/ 2
σ p = βP2σ I2 + σ ε2p
= [(1.07)²(18)² + (.30)²(5.0)² +(.50)²(8.0)²+ (.20)²(2.0)²]½
= [370.9 + 2.3 + 16.0 + 0.2]½
= [389.4]½ = 19.7%
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18. Consider two portfolios, one composed of four securities and the other of ten
securities. All the securities have a beta of 1 and unique risk of 30%. Each
portfolio distributes weight equally among its component securities. If the
standard deviation of the market index is 20%, calculate the total risk of both
portfolios.
Answer:
The total risk of a portfolio can be expressed as:
σ p = βp2σ I2 + σε2p
Further, the unique risk ( σ ε2p ) is the weighted average of the unique risks of the
portfolio's individual securities.
In the case of the first portfolio with four equal-weighted securities:

4
σ ε2p = ∑ (30.0) × (.25)
2 2
i =1
= 56.25 × 4 = 225.0
Therefore the total risk of the first portfolio is:
σ12 = (100
. ) 2 × (20) 2 + 225.0
= 625.0
1 = 25.0%
In the case of the second portfolio with ten equal-weighted securities:

10
σε2p = ∑ (30.0) × (.10)
i =1
2 2
= 9.0 × 10 = 90.0
Therefore the total risk of the second portfolio is:
σ 22 = (100
. ) 2 × (20) 2 + 90.0
= 490.0
2 = 22.1%
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19. (Appendix Question) what is a corner portfolio? Why are corner portfolios
important for identifying th e composition of the efficient set?
Answer:
A corner portfolio is a portfolio on the efficient set whereby any two adjacent corner
portfolios combined will produce another portfolio on the efficient set.
The efficient set is theoretically composed of an infinite number of portfolios, formed by

infinitesimally altering the allocations among various securities. Using a procedure
known as quadratic programming, a finite number of corner portfolios can be identified.
It can be shown that linear combinations of adjacent corner portfolios are efficient.
Therefore knowing the composition of all corner portfolios allows one to construct the
entire efficient set.
20. (Appendix Question) Why is the market model approach a simpler technique
than the original Markowitz approach for constructing the efficient set?
Answer:
The market model approach is a more practical means of constructing the efficient set
because it requires considerably fewer parameters be estimated than the Markowitz
approach. In particular, by estimating the betas of the available securities, the market
model approach allows the analyst to forego estimating the covariances between all the
available securities. Instead, the covariance between each pair of securities is given by:
σ ij = βi βjσ I2
Without this computational shortcut, it would be practically impossible to estimate all

the necessary parameters needed to construct the efficient set.
21. (Appendix Question) If the variance of the market index is 490 and the
covariance between securities A and B is 470, what is the beta of security B,
knowing that security A's beta is 1.20?
Answer:
The relationship between two securities' covariances, their betas, and the variance of the
market index is given by:
σ ij = βi βjσ I2
In this case:
470 = ß A × 1.20 × 490
ß A = 0.80
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22. (Appendix Question) How many parameters must be estimated to analyze the
risk-return profile of a 50-stock portfolio using (a) the original Markowitz
approach and (b) the market model approach?
Answer:
a. The Markowitz approach requires (N² + 3N)/2 parameter estimates for a N-security
portfolio. Thus in the case of a 50-security portfolio:
Total parameter estimates = [(50)² + (3 × 50)]/2 = 1,325
b. For a N-security portfolio, the market model approach requires (3N + 2) parameter
estimates. Thus in the case of a 50-security portfolio:
Total parameter estimates = (3 × 50) + 2 = 152
23. Explain the concepts of specific (or unique) risk, systematic risk, variance,
covariance, standard deviation, and beta as they are related to investment
management.
Answer:
(From The CFA Level II Exams and Guideline Answers 1994, 1995, and 1996)
Part A
The concepts are explained as follows:
The Foundation’s portfolio currently holds a number of securities from two asset classes.
Each of the individual securities has its own risk (and return) characteristics, described as
specific risk. By including a sufficiently large number of holdings, the specific risks of
the individual holdings offset each other, diversifying away much of the overall specific
risk and leaving mostly nondiversifiable, or market-related, risk.
Systematic risk is this market-related risk that cannot be diversified away. Because
systematic risk cannot be diversified away, investors are rewarded for assuming this risk.
The variance of an individual security is the sum of the probability-weighted average of

the squared differences between the security’s expected return and its mean return. The
standard deviation is the square root of the variance. Both variance and standard
deviation measure total risk, including both systematic and specific risk. Assuming the
rates of return are normally distributed, the likelihood for a range of rates may be
expressed using standard deviations. For example, 68 percent of returns can be expected
to fall within + or - 1 standard deviation of the mean, and 95 percent within 2 standard
deviations of the mean.
Covariance measures the extent to which two securities tend to move, or not move,
together. The level of covariance is heavily influenced by the degree of correlation
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between the securities (the correlation coefficient) as well as by each security’s standard
deviation. As long as the correlation coefficient is less than 1, the portfolio standard
deviation is less than the weighted average of the individual securities’ standard
deviations. The lower the correlation, the lower the covariance and the greater the
diversification benefits (negative correlations provide more diversification benefits than
positive correlations).
The capital asset pricing model (CAPM) asserts that investors will hold fully diversified
portfolios. Hence, total risk as measured by standard deviation is not relevant because it
includes specific risk (which can be diversified away).
Under the CAPM, beta measures the systematic risk of an individual security or
portfolio. Beta is the slope of the characteristic line that relates a security’s returns to the
returns of the market portfolio. By definition, the market portfolio has a beta of 1.0. The
beta of a portfolio is the weighted average of the betas of each security contained in the
portfolio. Portfolios with betas greater than 1.0 have systematic risk higher than that of
the market; portfolios with betas less than 1.0 have lower systematic risk. By adding
securities with betas that are higher (lower), the systematic risk (beta) of the portfolio
can be increased (decreased) as desired.
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Chapter 8: RISKFREE BORROWING AN D LENDING

1. Why is a pure-discount government security (that is, one that does not make
coupon payments, pays interest at maturity, and hence sells at a discount from
par) with no risk of default still risky to an investor who’s holding period. does
not coincide with the maturity date of the security?
Answer:
Any security, even a pure-discount U.S. government security, presents its owner with an
uncertain return if the owner's holding period does not coincide with the maturity of the
security.
If the security's life is less than the owner's holding period, then the owner faces the
uncertainty associated with not knowing at what interest rate the security's proceeds can
be reinvested when the security reaches maturity. If the security's life is greater than the
owner's holding period, then the owner faces the uncertainty associated with not
knowing at what price the security can be sold at the end of the holding period.
2. Distinguish between reinvestment-rate risk and interest-rate risk.
Answer:
Interest rate risk involves the effect that interest rate changes over the investor's holding
period will have on the market value of the security. If the investor's holding period
precedes the maturity date of the security, then the investor will be uncertain as to what
price he or she will ultimately be able to sell the security.
Reinvestment risk involves the effect that interest rate changes will have on the return
that the investor can earn when he or she reinvests the proceeds from a maturing
security, if the investor's holding period is longer than the life of the security.
3. The covariance between a riskfree asset and a risky asset is zero. Explain why
this is the case and demonstrate it mathematically.
Answer:
The standard deviation of a riskfree asset's return is zero by definition. That is, its return
is certain. Thus its return must be completely unrelated to the returns on any other asset.
Therefore, the covariance between a riskfree asset and a risky asset must be zero.
Mathematically:
ij = ij × i × j
and if the ith asset is the riskfree asset then i = 0. Thus:
ij = ij × 0 × j = 0
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4. Lindsay Brown owns a risky portfolio with a 15% expected return. The
riskfree return is 5%. What is the expected return on Lindsay's total portfolio if
Lindsay invests the following proportions in the risky portfolio and the
remainder in the risk free asset?
a.120%
b.90%
c.75%
Answer:
The expected return of a portfolio invested in both a risky portfolio and a riskfree asset is
given by:
rp = X1 r 1 + X2rf
Further, because (X 1 + X 2 ) must equal 1.0, then X 2 = (1 - X 1 ).
a. rp = (1.20 × 15%) + (-.20 × 5%)
= 17.0%
b. r p = (.90 × 15%) + (.10 × 5%)
= 14.0%
c. r p = (.75 × 15%) + (.25 × 5%)
= 12.5%
5. Consider a risky portfolio with an expected return of 18%. With a riskfree

return of 5%, how could you create a portfolio with a 24% expected return?
Answer:
The expected return of a portfolio invested in both a risky portfolio and a riskfree asset is
given by:
r p = X1 r 1 + X2rf
In this case, the expected return of the total portfolio as well as the risky portfolio and
riskfree asset are known. The question is what two weights, X 1 and X 2 will solve the
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equation. That is:
24% = (X 1 × 18%) + (X 2 × 5%)
As (X 1 + X 2 ) must equal 1.0, then X 2 = (1 - X 1 ), so:
24% = (X 1 × 18%) + [(1 - X 1 ) × 5%]
Solving for X 1 yields a value of 1.46, meaning that a weighting of 1.46 for the risky
portfolio (thus involving leverage) and a weighting of -.46 for the riskfree asset will
produce an expected return of 24%.
6. Happy Buker owns a risky portfolio with a 20% standard deviation. If Happy
invests the following proportions in the riskfree asset and the remainder in the
risky portfolio, what is the standard deviation of Happy's total portfolio?
a.130%
b.l0%
c.30%
Answer:
The standard deviation of a portfolio composed of a risky portfolio and a riskfree asset is
given by:
p = X 1 × 1
where X 1 is the weight of the risky portfolio and 1 is the standard deviation of the risky
portfolio. As X 1 = (1 − weight of the riskfree asset), then:
a. X 1 = 1 − (−.30) = 1.30, thus:
p = 1.30 × 20%
= 26.0%
b. X 1 = 1 − .10 = .90, thus:
p = .90 × 20%
= 18.0%
c. X 1 = 1 − .30 = .70, thus:
p = .70 × 20%
= 14.0%
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7. Oyster Burns's portfolio is composed of an investment in a risky portfolio

(with a 12% expected return and a 25% standard deviation) and a riskfree asset
(with a 7% return). If Oyster's total portfolio has a 20% standard deviation,
what is its expected return?
Answer:
The standard deviation of a portfolio invested in a risky portfolio and a riskfree asset is
given by:
p = X 1 × 1
As the standard deviation of Oyster's total portfolio is 20%, solving for the proportion
invested in the risky portfolio (X 1 ) gives:
20% = X 1 × 25%
X1 = .80
The expected return of a portfolio invested in both a risky portfolio (with proportion X 1 )
and a riskfree asset with proportion X 2 or (1 - X 1 ) is:
rp = (.80 × 12%) + [(1 - .80) × 7%]
= 11.0%
8. Hick Cady argues that buying a risky portfolio with riskfree borrowing is
equivalent to a purchase of the risky portfolio on margin. Patsy Cahill contends
that such an investment can be viewed as selling the riskfree asset short and
using proceeds to invest in the risky portfolio. Who is correct? Explain.
Answer:
Both Hick and Patsy are correct. Borrowing at the riskfree rate to invest more than one's
initial wealth in a risky portfolio is equivalent to purchasing the risky portfolio on
margin. Further, borrowing at the riskfree rate is equivalent to taking a short position in
the riskfree asset and investing the proceeds of the short sale in the risky portfolio.
9. How does the efficient set change when riskfree borrowing and lending are
introduced into the Markowitz model? Explain with words and graphs.
The efficient set becomes all the portfolios that can be constructed through a
combination of a single risky portfolio and lending or borrowing at the riskfree rate. The
efficient set will therefore consist of all portfolios along a ray emanating from the
riskfree asset, tangent to the curved Markowitz efficient set (that is, the efficient set
without riskfree borrowing or lending), and continuing on out into risk-return space.
The tangency point represents the optimal combination of risky assets for the investor.
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10. Why does the efficient set with the Markowitz model extended to include
riskfree borrowing and lending have only one point in common with the efficient
set of the Markowitz model without riskfree borrowing and lending? Why are
the other points on the "old" efficient set no longer desirable? Explain with
words and graphs.
Answer:
Riskfree borrowing and lending permits the investor to create any combination of
portfolios allocated between a risky portfolio (contained in the feasible set of risky
portfolios) and the riskfree asset. These combinations lie on rays emanating from the
riskfree asset. The more a ray is tilted to the northwest, the more desirable is the
associated set of portfolios to the investor.
Because the feasible set of risky portfolios is concave, the ray combining the riskfree
asset and a risky portfolio, tilted as far as possible to the northwest, must be tangent to
the feasible set of risky portfolios at only one point. This ray is the efficient set under
riskfree borrowing and lending.
All other portfolios in the feasible set of risky portfolios (including the "old" efficient
set) will lie to the south and/or east of this "new" efficient set and, therefore, are
dominated by the portfolios of the new efficient set. That is, these other portfolios offer
less expected return and/or more risk than the portfolios lying on the efficient set
generated under riskfree borrowing and lending.
11. On the basis of the assumptions developed in this chapter, is it true that all
investors will hold the same risky portfolio? Explain.
Answer:
Assuming that each investor has different opinions about the expected returns and
standard deviations of securities, and covariances between securities, then they will each
face a different feasible set. As a result, they will choose different risky portfolios.
As will be discussed in Chapter 10, if investors exhibit homogeneous expectations

regarding expected returns and risks, then they will all hold the same risky portfolio.
12. How does the feasible set change when riskfree borrowing and lending are
introduced into the Markowitz model? Explain with words and graphs.
The feasible set now becomes the area between two rays, each emanating from the
riskfree asset. The ray to the northwest is the efficient set. The ray to the southeast will
connect the riskfree asset and generally the lowest expected return asset. Any
combination of risk and return between these two rays can be created by appropriately
combining a risky portfolio with riskfree borrowing or lending.
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13. With the Markowitz model extended to include riskfree borrowing and
lending, draw the indifference curves, efficient set, and optimal portfolio for an
investor with high risk aversion and an investor with low risk aversion.
Answer:
The efficient set will be the same for both investors because it represents investment
opportunities, not preferences. (Of course, the two investors may have different
expectations regarding available expected returns and risks.)
The more risk-averse investor's indifference curves will be more steeply sloped than the
indifference curves of the less risk-averse investor.
The optimal portfolio of the more risk-averse investor will lie to the southwest of the less
risk-averse investor's optimal portfolio. Both optimal portfolios, of course, will lie on
the efficient set. The more risk-averse investor's optimal portfolio likely will lie to the
southwest of the tangency portfolio, implying lending at the riskfree rate. Conversely,
the less risk-averse investor's optimal portfolio likely will lie to the northeast of the
tangency portfolio, implying borrowing at the riskfree rate.
14. Given the following expected return vector and variance-covariance matrix
for three assets:
10.1 210 60 0
ER = 7.8 VC = 60 90 0
5.0 0 0 0
and given the fact that Pie Traynor's risky portfolio is split 50-50 between the
two risky assets:
a. Which security of the three must be the riskfree asset? Why?
b. Calculate the expected return and standard deviation of Pie's portfolio.
c. If the risk free asset makes up 25% of Pie's total portfolio, what are the
total portfolio's expected return and standard deviation?
Answer:
a. The riskfree asset has a zero variance and has zero covariance with other assets.
Thus, examining the variance-covariance matrix, the third security must be the
riskfree asset.
b. rp = (X 1 × r 1 ) + (X 2 × r 2 )
= (.50 × 10.1%) + (.50 × 7.8%)
= 9.0%
1/ 2
n n 
σ p = ∑ ∑ X i X jσij 
 i =1 j =1 
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= (X 1 X 1 11 +X 2 X 2 22 + 2X 1 X 2 12 )½
= {[(.50)² × 210] + [(.50)² × 90]

+ (2) × (.50) × (.50) × (60)}½
= [52.5 + 22.5 + 30]½ = [105]½ = 10.2%
c. r tp = (.75 × r p ) + (.25 × r 3 )
= (.75 × 9.0%) + (.25 × 5.0%)
= 8.0%
tp = .75 × p
= .75 × 10.2%
= 7.7%
15. What does the efficient set look like if riskfree borrowing is permitted but no
lending is allowed? Explain with words and graphs.
Answer:
The efficient set would be composed of the southwest portion of the curved Markowitz
efficient set (that is, the efficient set without riskfree borrowing or lending) up to the
tangency portfolio (when both riskfree borrowing and lending are permitted), where it
would then become a ray emanating from the tangency portfolio and extending out into
risk-return space. If this ray were extended to the southwest, it would intersect the return
axis at the riskfree rate.
16. What will be the effect on total portfolio expected return and risk if you
borrow money at the riskfree rate and invest in the optimal risky portfolio?
Answer:
The effect is to increase both expected return and risk.
The investor is leveraging his or her invested position. Since the optimal risky portfolio
has a higher expected return than the riskfree asset, the expected return on the leveraged
risky portfolio is higher than that of the unleveraged portfolio.
However, because the risky portfolio's return is variable, the leveraged risky portfolio's
return is more variable and hence more risky than the return on the unleveraged risky
portfolio.
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17. Suppose that your level of risk aversion decreased as you grew richer. In a
world of risk free borrowing and lending, how would your optimal portfolio
change? Would the types of risky securities you hold change? Explain with
words and graphs.
Answer:
Your optimal risky portfolio would not change (assuming the feasible investment
opportunities did not change). It would remain the only risky portfolio lying on the
efficient set. However, your allocations to the riskfree asset and the risky portfolio
would change as your risk preferences changed. As you became less risk averse, you
would decrease (increase) your riskfree lending (borrowing) and move to the northeast
along the efficient set.
18. (Appendix Question) How does the efficient set change when the condition of
borrowing and lending at the same riskfree rate is changed to borrowing at a
rate greater than the rate at which riskfree lending can be conducted? Explain
with words and graphs.
Answer:
The efficient set becomes divided into three segments. The first segment is a straight
line between the lending rate on the return axis and tangent to the curved Markowitz
efficient set (that is, the efficient set without riskfree borrowing or lending). The second
segment lies to the northeast of the first. It is a straight line tangent to the curved
Markowitz efficient set, extending northeast into risk-return space. While this line does
not extend to the return axis, if it did it would intersect the axis at the borrowing rate.
The third segment lies between the first two. It is the portion of the curved Markowitz
efficient set that lies between the two tangency portfolios.
19. (Appendix Question) Pickles Gerken owns a tangency portfolio composed of

four securities held in the following proportions:
.18
.30
X(T) = .24
.28
The riskfree rate is 4%. The expected return and standard deviation of the
tangency portfolio are respectively, 12% and 18%. What is the composition of
Pickles' optimal portfolio if Pickles has a risk aversion coefficient of 2.47?
Answer:
Equation (8.11b) shows that the optimal allocation to the tangency portfolio is given by:
r T − rf
Y=
2 aσ T2
In Pickles’ case,
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.12 − .04
Y=
2 × 2.47 × .182
=.50
Because the tangency portfolio’s composition is:
 .18 
.30
X(T) =  
.24
 
.28
Multiplying those proportions by .50 produces Pickles’ optimal portfolio which will
be 50% invested in the riskfree asset, 9% invested in security 1, 15% invested in
security 2, 12% invested in security 3, and 14% invested in security 4.
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Chapter 9: THE CAPITAL A SSET PRICING M ODEL

1. Describe the key assumptions underlying the CAPM.
Answer:
There are ten key assumptions underlying the CAPM:
1. Investors evaluate portfolios by analyzing expected returns and standard deviations

over a one-period time horizon.
2. Everything else equal, investors prefer portfolios with greater expected returns.
3. Everything else equal, investors prefer portfolios with lower standard deviations.
4. Assets are infinitely divisible.
5. Investors may borrow or lend at a single risk free interest rate.
6. Taxes and transaction costs are immaterial.
7. All investors have the same one-period time horizon.
8. All investors borrow and lend at the same risk free rate.
9. All investors have immediate and costless access to all relevant information.
10. Investors possess homogeneous expectations regarding the expected returns and
risks of securities.
2. Many of the underlying assumptions of the CAPM are violated to some degree in the
real world. Does that fact invalidate the model's conclusions? Explain.
Answer:
The fact that the many of the CAPM assumptions are violated in the "real world" does not
necessarily invalidate the CAPM's primary conclusions. As the text discusses, simplifying
assumptions are required to provide the degree of abstraction necessary to develop an
explanatory model of any complex system. The "reasonableness" of a model's
assumptions are of little concern. Instead, the true test of a model is its ability to help
interested parties understand and predict the process being modeled.
3. What is the separation theorem? What implications does it have for the optimal
portfolio of risky assets held by investors?
Answer:
The separation theorem states that an investor's optimal risky portfolio can be determined
without reference to the investor's risk-return preferences.
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Assuming that every investor has the same expectations regarding expected returns and
risks for available securities, and assuming that everyone faces the same riskfree rate, then
the efficient set must be the same for all investors. This implies that every investor will
hold the same risky portfolio. (That risky portfolio is represented by the point of tangency
between a ray emanating from the risk free asset and extending into risk-return space and
tangent to the curved Markowitz efficient set.) The only difference in portfolios held by
investors will be with respect to the amount of risk free lending or borrowing undertaken,
which will depend on the investors' individual risk-return preferences.
4. What constitutes the market portfolio? What problems does one confront in specifying
the composition of the true market portfolio? How have researchers and practitioners
circumvented these problems?
Answer:
The market portfolio consists of all securities where the proportion invested in each security
equals the market value of the security (price per unit times the number of units of the security
outstanding) divided by the sum of the market values of all securities.
Specifying the "true" market portfolio is virtually impossible. One must be able to identify
and value all assets held by investors. These assets range from easily enumerated and
valued assets such as publicly-traded U.S. common stocks to difficult-to-value assets such
as foreign real estate.
To overcome these difficulties, researchers and practitioners have restricted their definition
of the market portfolio to a relatively small subset of easily identifiable and valued
securities, such as the stocks constituting the S&P 500.
5. In the equilibrium world of the CAPM, is it possible for a security not to be part of the
market portfolio? Explain
Answer:
The market portfolio is composed of all assets held by investors. Each asset is weighted
by the proportion of its market value relative to the market value of all assets.
As derived from the separation theorem, all investors will hold the same risky portfolio.
Thus in equilibrium every security must be included in the market portfolio. If a security
were not included in the market portfolio, no investor would own it and its equilibrium
market price (and hence its market value) would be zero.
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6. Describe the price adjustment process that equilibrates the market's supply and
demand for securities. What conditions will prevail under such equilibrium?
Answer:
If investors wish to hold more units of a security than are available, then they will bid up the
price of the security, thereby reducing its expected return. The lower expected return will
cause investors to reduce their desired holdings of the security.
Conversely, if investors wish to hold fewer units of a security than are available, then they
will bid down the security's price, thereby increasing its expected return. The higher
expected return will cause investors to wish to hold more units of the security.
This process will drive the price of the security toward its equilibrium value at which point
the number of units investors wish to hold will equal the number of units outstanding.
This equilibrating process will produce market clearing prices for all securities. Further,
the risk free rate will move to a level where the total amount of money borrowed will
equal the supply of money available for lending.
7. Will an investor who owns the market portfolio have to buy and sell units of the
component securities every time the relative prices of those securities change? Why?
Answer:
Just because IBM stock doubles in price relative to other securities in the market portfolio does
not require any adjustments by an investor in the market portfolio. Every security in the
market portfolio is represented in proportion to its market value relative to the market
value of all securities. The market value of a security is the units of the security
outstanding times the market price of the security. Thus as relative prices of securities
change, their relative market values and therefore their proportions of the market portfolio
change concomitantly. No adjustment is required on the part of the investor.
8. Given an expected return of 12% for the market portfolio, a riskfree rate of 6%, and
a market portfolio standard deviation of20%, draw the capital market line.
Answer:
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24
Expected Return (%)
18
M
12
Rf = 6
0
0 5 10 15 20 25 30
Standard Deviation (%)
9. Explain the significance of the capital market line.
Answer:
The Capital Market Line (CML) represents the efficient set in the world of the CAPM. All
investors will hold a portfolio lying on the CML. An investor's portfolio will be composed
of the market portfolio combined with either riskfree borrowing or lending, depending on
the investor's level of risk aversion.
The vertical intercept of the CML is the riskfree rate, often referred to as the reward for
waiting. The slope of the CML is often referred to as the reward for bearing risk. Thus
the CML represents how the securities markets value time and risk.
10. Assume that two securities constitute the market portfolio. Those securities have the
following expected returns, standard deviations, and proportions:
Security Expected Standard Proportion
Return Deviation
A 10% 20% .4
B 15 28 .6
On the basis of this information, and given a correlation of .30 between the two
securities and a riskfree rate of5%, specify the equation for the capital market line.
Answer:
The equation of the Capital Market Line (CML) is:
rp = r f + [( r M - r f )/M ]p
In this case, the market portfolio is composed of two securities, A and B. Thus the
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expected return of the market portfolio is:
rM = (X A × r A ) + (X B × r B )
= (.40 × 10%) + (.60 × 15%)
= 13.0%
The standard deviation of the market portfolio is:
σ M = [ X Aσ A2 + X Bσ B2 + 2 X A X B ρABσ Aσ B ]
1/ 2
= {[(.40)² × (20)²] + [(.60)² × (28)²]
+ [2 × (.40) × (.60) × (.30) × (20) × (28)]}½
= [64 + 282.2 + 80.6]½ = 20.7%
Therefore the equation for the CML is:
r p = 5.0% + [(13.0% - 5.0%)/20.7%] × p
= 5.0% + .39p
11. Distinguish between the capital market line and the security market line.
Answer:
The Capital Market Line is the efficient set of the Markowitz model extended to include risk free
borrowing and lending. It expresses an equilibrium relationship between expected return and
standard deviation only for efficient portfolios. The CML makes no statement about the
equilibrium risk-return relationship for other securities and portfolios.
The Security Market Line is an equilibrium relationship between the expected return and
covariance (or beta) with the market portfolio for all securities and portfolios. Like the CML,
the SML is an equilibrium risk-return relationship. However, the measure of risk of an efficient
portfolio on the CML is simply its standard deviation. On the other hand, the relevant measure
of risk for individual securities is the contribution that they make to the standard deviation of the
market portfolio (as measured by their respective covariance with the market portfolio or their
betas).
12. The market portfolio is assumed to be composed of four securities. Their covariance
with the market portfolio and their proportions are shown below:
Security Covariance Proportion
with Market
A 242 .2
B 360 .3
C 155 .2
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D 210 .3
Given these data, calculate the market portfolio's standard deviation.
Answer:
The standard deviation of the market portfolio can be shown to equal the square root of the
weighted average of the covariances of all its component securities with it. In the case of the
this four security portfolio:
M = [.20 × 242 + .30 × 360 + .20 × 155 + .30 × 210]½
= (250.4)½ = 15.8%
13. Explain the significance of the slope of the SML. How might the slope of the SML
change over time?
Answer:
The slope of the SML indicates the level of aggregate investor risk aversion. That is, it
indicates how much compensation investors as a group demand for bearing the risk associated
with holding the market portfolio.
As investors in aggregate become more (less) risk averse, the slope of the SML will rise
(decline). That is, investors will demand a higher (lower) incremental expected return over the
riskfree rate for bearing the risk associated with the market portfolio.
14. Why should the expected return for a security be directly related to the security's
covariance with the market portfolio?
Answer:
According to the CAPM, all investors will hold the market portfolio combined with
riskfree borrowing or lending. Therefore all investors will be concerned with the risk (or
standard deviation) of the market portfolio. The standard deviation of the market portfolio can
be shown to be a function of the covariances with it of each of the securities that make up the
market portfolio. Therefore the contribution that each security makes to the market portfolio's
risk will be directly related to its covariance with the market portfolio. Risk averse investors
will demand higher returns from securities exhibiting higher covariances with the market
portfolio.
15. The risk of a well-diversified portfolio to an investor is measured by the standard

deviation of the portfolio's returns. Why shouldn't the risk ofan individual security be
calculated in the same manner?
Answer:
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With respect to risk, the investor ultimately is concerned with the standard deviation of
his or her portfolio. Therefore, in evaluating a well-diversified portfolio, the relevant measure of
risk is standard deviation. However, the contribution of an individual security to a portfolio's
standard deviation is not the standard deviation of the security. That is, a portfolio's standard
deviation is not simply the weighted average of the standard deviations of the component
securities. The appropriate measure of a security's risk is the contribution that it makes to the
standard deviation of a well-diversified portfolio. That contribution is reflected in the security's
covariance with the portfolio.
16. The riskfree rate is 5% while the market portfolio's expected return is 12%. If the
standard deviation of the market portfolio is 13%, what is the equilibrium expected
return on a security that has a covariance with the market portfolio of 186?
Answer:
The SML expressed in its covariance (as opposed to beta) form is given by:
 r M − rf 
r i = rf +   σiM
 σ M
2

Thus under the given conditions, the equilibrium expected return on the portfolio is:
12% − 5% 
r p = 5% +  2  × 186
 (13%) 
=12.7%
17. A security with a high standard deviation of returns is not necessarily highly risky to
an investor. Why might you suspect that securities with above-average standard
deviations tend to have above-average betas?
Answer:
The beta of a security is given by the expression:
σ iM
βi =
σ M2
Further:
iM = iM × i × M
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As a result, other things remaining the same, the higher is i , the higher is iM and ß i
Only if iM fell as i rose could ß i be unaffected by a higher i .
However, there is no reason to expect such a relationship typically to hold.
18. Oil Smith, an investments student, argued, "A security with a positive standard
deviation must have an expected return greater than the riskfree rate. Otherwise, why
would anyone be willing to hold the security?" On the basis of the CAPM, is Oil's
statement correct? Why?
Answer:
Oil is incorrect. The CAPM implies that it is possible for a security to have a positive standard
deviation and an expected return less than the riskfree rate. The CAPM relationship specifies
that:
rp = r f + ( r M - r f )iM
Thus a security with a negative covariance with the market portfolio would have an expected
return less than the riskfree rate. In practice, however, few, if any, securities have a negative
covariances with surrogates for the market portfolio.
19. The standard deviation of the market portfolio is 15%. Given the covariance with
the market portfolio of the following securities, calculate their betas.
Security Covariance
A 292 Answer:
B 180
C 225
The beta of a security is calculated as:
σiM
βi =
σ M2
Therefore:
292
βA = = 130
.
152
180
βB = = 0.80
152
225
βC = = 100
.
152
20. Kitty Bransfield owns a portfolio composed of three securities. The betas of those
securities and their proportions in Kitty'S portfolio are shown here. What is the beta of
Kitty's portfolio?
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Security beta Proportion
A .90 .3
B 1.30 .1
C 1.05 .6
Answer:
The beta of a portfolio is given by:

n
βp = ∑ X i βi
i =1
In Kitty's case:
ß p = (.30 × .90) + (.10 × 1.30) + (.60 × 1.05)
= 1.03
21. Assume that the expected return on the market portfolio is 15% and its standard
deviation is 21%. The riskfree rate is 7%. What is the standard deviation of a well-
diversified (no non-market-risk) portfolio with an expected return of 16.6%?
Answer:
Using the Security Market Line relationship:
rp = r f + ( r M - r f )β p
The beta of this portfolio can be calculated. That is:
ß p = ( r p - r f )/( r M - r f )
= (16.6 - 7.0)/(15.0 - 7.0)
= 1.20
Further, the standard deviation of a well-diversified portfolio with no unique risk is given by:
( )
1/ 2
σ p = βp2σ M2
In this case:
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p = [(1.20)² × (21)²]½
= [635.0]½ = 25.2%
(Alternatively, one could solve for the portfolio's standard deviation using the CML
relationship.)
22. Given that the expected return on the market portfolio is 10%, the riskfree rate of
return is 6%, the beta of stock A is .85, and the beta of stock B is 1.20:
a. Draw the SML.
b. What is the equation for the SML?
c. What are the equilibrium expected returns for stocks A and B?
d. Plot the two risky securities on the SML.
Answer:
a.
24
Expected Return (%)
18
12 B
A M
Rf = 6
0
0.00 0.50 1.00 1.50 2.00
Beta
b. ri = r f + ( r M - r f )β i
= 6% + (10% - 6%)ß i
= 6% + (4%)ß i
c. rA = 6% + (4%)(.85)
= 9.4%
rB = 6% + (4%)(1.20)
= 10.8%
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23. You are given the following information on two securities, the market portfolio, and
the riskfree rate:
Expected Return Correlation with Standard Deviation

Market Portfolio
Security 1 15.5% 0.9 20.0%
Security 2 9.2 0.8 9.0
Market portfolio 12.0 1.0 12.0
Riskfree rate 5.0 0.0 0.0
a. Draw the SML.

b. What are the betas of the two securities?
c. Plot the two securities on the SML.
Answer:
a.
25
20
Expected Return (%)
1
15
M
10 2
Rf = 5
0
0.00 0.50 1.00 1.50 2.00
Beta
σ1 M
b. β1 =
σ M2
( ρ1 M × σ1 × σ M )
=
σ M2
= [0.90 × 20 × 12]/(12)²
= 1.50
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σ2 M
β2 =
σ M2
( ρ2 M × σ 2 × σ M )
=
σ M2
= [0.80 × 9 × 12]/(12)²
= 0.60
24. The SML describes an equilibrium relationship between risk and expected return.
Would you consider a security that plotted above the SML to be an attractive
investment? Why?
Answer:
A security that plots above the SML would be considered an attractive investment. The
expected return offered by such a security is greater than that required given its risk. Investors
should wish to add such a security to their portfolios.
25. Assume that two securities, A and B, constitute the market portfolio. Their proportions
and variances are .39, 160, and .61, 340, respectively. The covariance of the two securities
is 190. Calculate the betas of the two securities Answer:
Given the two-security market portfolio, its variance is:
σ M2 = X A2σ A2 + X B2σ B2 + 2 X A X Bσ AB
= (.39)²(160) + (.61)²(340) + 2(.39)(.61)(190)
= [24.3 + 126.5 + 90.4]
= 241.2
Further, the covariance of a security with the market portfolio equals:

n
σ iM = ∑ X jM σ ij
j =1
In the two-security market portfolio case
AM = .39 × 160 + .61 × 190
= 178.3
BM = .61 × 340 + .39 × 190
= 281.5
The beta of a security is defined as:

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σ iM
βi =
σ M2
Therefore:
ß A = 178.3/241.2
= .74
ßB = 281.5/241.2
= 1.17
26. The CAPM permits the standard deviation of a security to be segmented into
market and non-market risk. Distinguish between the two types of risk.
Answer:
Market (or systematic) risk is the portion of a security's total risk that is related to movements in
the market portfolio and hence to the beta of the security. By definition, because the
market portfolio is perfectly diversified, market risk in a portfolio cannot be reduced
through diversification.
Nonmarket (or unique or unsystematic) risk is the portion of a security's total risk that is
not related to moves in the market portfolio. Rather, it is related to events specific to the
security. As a result, unique risk in a portfolio can be reduced through diversification.
27. Is an investor who owns any portfolio of risky assets other than the market portfolio
exposed to some non-market risk? Explain.
Answer:
By definition any portfolio of risky assets other than the market portfolio will possess some
nonmarket risk. Only if the investor's portfolio of risky assets is the market portfolio will p
equal zero (that is, possess no nonmarket risk). However, portfolios typically have near-zero
nonmarket risk if they contain roughly 20 or more randomly-selected securities.
28. On the basis of the risk and return relationships of the CAPM, supply values for the
seven missing numbers in the following table.
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Answer:
Security Expected Return Beta Standard Deviation Non-market

% % Risk
A 0.8 81
B 19.0 1.5 36
C 15.0 12 0
D 7.0 0 8
E 16.6 15
Two relationships are necessary to identify the missing data in the table:
(1) r i = r f + ( r M - r f )β i
(2) σ i2 = (β p2σ M2 ) + σ ε2i
Using these equations, consider security D first:
7.0 = rf + ( r M - rf) × 0
rf = 7.0%
Next consider security B:
19.0 = 7.0 + ( r M - 7.0) × 1.5
r M = 15.0%
Next consider security C:
15.0 = 7.0 + (15.0 - 7.0) ß C
ß C = 1.0
Further:
(12)² = (1.0)² × σ M2 + 0
M = 12%
Next consider security A:
r A = 7.0 + (15.0 - 7.0)(.8)

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r A = 13.4%
Further:
A = [(.8)² × (12)² + 81]½
= 13.2%
Returning to security B:
A = [(1.5)² × (12)² + 36]½
= 19.0%
Finally, consider security E:
16.6 = 7.0 + (15.0 - 7.0) × ß E
ß E = 1.2
Further:
(15)² = (1.2)² × (12)² + σ ε2i
σ ε2i = 17.6
29. (Appendix Question) Describe how the SML is altered when the riskfree borrowing
rate exceeds the riskfree lending rate.
Answer:
The answer to this question depends on the location of the market portfolio on the efficient
combination of risky portfolios. A meaningful answer requires the market portfolio to lie
between the tangency portfolios derived under the assumption of riskless lending taking place at
a rate less than the riskfree borrowing rate. In this case the SML would intersect the vertical axis
at the expected return associated with a zero beta return. Like the original version of the SML,
this altered SML will pass through the market portfolio coordinates (r M ,1). Because the zero
beta return is greater than the riskfree lending rate, the altered SML will have a flatter slope than
the original SML.
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30. The following information describes the expected return and risk relationship for
the stocks of two of WAH's competitors.
Expected Return Standard Deviation Beta
Stock X 12% 20 1.3
Stock Y 9 15 0.7
Market index 10 12 1.0
Risk free rate 5.0
Using only the data shown above:

a. Draw and label a graph showing the security market line and position stocks X and Y
relative to it.
b. Compute the alphas both for stock Xand for stock Y. Show your work. (Hint: Alpha
is the difference between the stock's expected return and the equilibrium expected
return given by the SML.)
c. Assume that the riskfree rate increases to 7% with the other data remaining
unchanged. Select the stock providing the higher expected risk-adjusted return and
justify your selection. Show your calculations.
Answer:
(From The CFA Level II Exams and Guideline Answers 1994, 1995, and 1996)
A.Security Market Line

The security market line (SML) shows the required return for a given level of systematic
risk. The SML is described by a line drawn from the risk-free rate: expected return is 5 percent,
where beta equals 0 through the market return; expected return is 10%, where beta equals 1.0.
15%
Security
Market Line
Stock X
(SML)
12%
Expected Return
10% Stock Y
9% Market
5%
0.7 1.0 1.3 2.0
Beta
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B. The expected risk-return relationship of individual securities may deviate from that
suggested by the SML, and that difference is the asset’s alpha. Alpha is the difference between
the expected (estimated) rate of return for a stock and its required rate of return based on its
systematic risk. Alpha is computed as
ALPHA or α = E(r i ) − [r f + β i (E(r M )− r f )],
where
E(r i ) = expected return on Security I

rf = risk-free rate
βi = beta for Security I
E(r M ) = expected return on the market
Calculation of alphas:
Stock X: α x = 12% − [5% + 1.3(10% − 5%)] = 0.5%
Stock Y: α Y = 9% − [5% + 0.7(10% − 5%)] = 0.5%
In this instance, the alphas are equal and both are positive, so one does not dominate the other.
Another approach is to calculate a required return for each stock and then subtract the required
return from the given expected return. The formula for required return (k) is
k = r f + β i (r M − r f )
Calculations of required returns:
Stock X: k = 5% + 1.3(10% − 5%) = 11.5%

αX = 12% − 11.5 = 0.5%
Stock Y: k = 5% + 0.7(10% − 5%) = 8.5%

αY = 9% − 8.5 = 0.5%
C. By increasing the risk-free rate from 5 to 7 percent and leaving all other factors unchanged,
the slope of the SML flattens and the expected return per unit of incremental risk becomes less.
Using the formula for alpha, the alpha of Stock X increases to 1.1 percent and the alpha of Stock
Y falls to −0.1 percent. In this situation, the expected return (12.0 percent) of Stock X exceeds
its required return (10.9 percent) based on the CAPM. Therefore, Stock X’s alpha (1.1 percent)
is positive. For Stock Y, its expected return (9.0 percent) is below its required return (9.1
percent) based on the CAPM. Therefore, Stock Y’s alpha (−0.1 percent) is negative. Stock X is
preferable to Stock Y under these circumstances.
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Calculations of revised alphas:
Stock X: α x = 12% − [7% + 1.3(10% − 7%)]

= 12% − 10.9% = 1.1%
Stock Y: α Y = 9% − [7% + 0.7(10% − 7%)] = 0.5%

= 9% − 9.1% = −0.1%
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Chapter 10: Factor Models

1. . Included among the factors that might be expected to be pervasive are expectations
regarding growth in real GDP, real interest rates, inflation, and oil prices. For each factor,
provide an example of an industry that is expected to have a high (either positive or
negative) sensitivity to the factor.
Ans:
The auto industry's earnings are highly cyclical. Therefore auto company stocks possess a
high sensitivity (in a positive direction) to the trend in economic activity.
Savings and loan companies (whose primary business is home loans) generally have large
portfolios of fixed-rate loans. When interest rates rise (fall), their cost of funds rises (falls),
while revenues remain relatively stable. As a result, their earnings fall (rise). Thus the stocks of
these companies are often responsive (in a negative direction) to movements in real interest rates.
Electric utilities operate in regulatory environments. They may have trouble passing on cost
increases to consumers, especially in the short run. Thus their stocks are sensitive (in a negative
direction) to unexpected inflation.
Crude oil producers and their stocks clearly are sensitive (in a positive direction) to the level of
oil prices.
2. Why do factor models greatly simplify the process of deriving the curved Markowitz
efficient set?
Ans:
In order to derive the curved Markowitz efficient set, the investor needs to estimate the
expected returns, variances, and covariances for all assets. As Appendix B to Chapter 7 shows,
without a factor model, the investor must estimate (N² + 3N)/2 parameters to derive the efficient
set.
On the other hand, based on the assumptions underlying a factor model, the common
responsiveness of securities to the factor(s) eliminates the need to estimate directly the
covariances between securities. These covariances are captured by the securities' sensitivities to
the factor(s) and the factor'(s) variance(s). As a result the number of parameters that must be
estimated to derive the efficient set with a factor model is significantly reduced.
3.Many investment management firms assign each of their security analysts to research a
particular group of stocks. (Usually these assignments are organized by industry.) How are
these assignments an implicit recognition of the validity of factor-model relationships?
Ans:
The assignment of industry groups to particular analysts implies a common responsiveness
of the securities within an industry group (or groups) to various financial or economic factors. If
Edited by
stocks did not exhibit such responsiveness, it would make no difference whether an analyst
covered both Consolidated Edison (a utility) and General Mills (a food processing company) or
instead covered Con Ed and Pacific Gas and Electric (another utility). All securities would
respond to their own unique factors. But because utility stock prices do tend to respond to the
same factors which in turn may be different than the factors to which food processing company
stock prices respond, it pays for analysts to specialize by industries and familiarize themselves
with the factors that affect stocks within those industries.
4. What are two critical assumptions underlying any factor model? Cite hypothetical
examples of violations of those assumptions.
Ans:
Factor model relationships are based on two critical assumptions. The first is that the
random error term and the factor are uncorrelated, meaning that the outcome of the factor has no
bearing on the outcome of the random error term.
The second assumption is that the random error terms of any two securities are uncorrelated,
meaning that the outcome of the random error term of one security has no bearing on the
outcome of the random error term of any other security.
As a violation of the first assumption, consider a one-factor model where the factor is growth in
GDP. If it were the case that a security had a positive random error term value every time GDP
was higher than expected, then the factor model has been misspecified and should be adjusted to
take into account this unexplained sensitivity.
As a violation of the second assumption, suppose that whenever security A had a positive
random error term value, security B also had a positive random error term value, then the factor
model has been misspecified. In this case there must be some source of common responsiveness
between the two securities that has not been captured by the factor model.
5. Cupid Childs, a wise investment statistician, once said with respect to factor models,
"Similar stocks should display similar returns." What did Cupid mean by this statement?
Ans:
By the term "similar stocks" Cupid presumably means that they display similar sensitivities
to various economic and financial factors. If a factor model is correctly specified, then two
stocks with similar sensitivities to the model's factors should generate returns that are roughly the
same over time. In the short run their returns may differ by the differences in the values of their
respective random error terms. Given that the expected value of the random error term is zero,
over the long-run one would expect the random error term to equal zero and thus the average
return on the two securities to be the same.
6. On the basis ofa one-factor model, consider a security with a zero-factor value of
4% and a sensitivity to the factor of .50. The factor takes on a value of 10%. The security
generates a return of 11%. What portion of the return is related to nonfactor elements?
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Ans:
Given that the return on a security under a one-factor model
equals:
ri = ai + biF + ei
Then in this case:
11% = 4% + (0.50 × 10%) + e i
leaving e i = 2%.
Of the security's return of 11%, 9/11 (or 82%) is related to

the factor (and the zero-factor) and 2/11 (or 18%) is related
to non-factor elements.
7.On the basis of a one-factor model, consider a portfolio of two securities with the
following characteristics:
Security Factor sensitivity Nonfactor risk Proportion

A .20 49 .40
B 3.5 100 .60
a. If the standard deviation of the factor is 15%, what is the factor risk of the portfolio?
b. What is the nonfactor risk of the portfolio?
c. What is the portfolio's standard deviation
Ans:
a.In a one-factor model, a portfolio's factor risk is expressed as bp2σ F2 . Since the sensitivity of the
portfolio to the factor is the weighted average of the component securities' sensitivities (with
their proportions serving as weights), then:
Factor risk = (.40 × .20 + .60 × 3.50)2 × 225
= 1,069.3
b.Non-factor risk (expressed as σ ep2 is the weighted average of the component securities' random
error term variances (with the square of the securities' proportions serving as weights), then:
Non-factor risk = .40² × 49 + .60² × 100
= 43.8
c.The standard deviation of the portfolio is given by:

Edited by
σ p = (b p2σ F2 + σ ep2 )1 / 2
= (1,069.3 + 43.8)½
= 33.4%
8.Recalculate the answers to Problem 7 assuming that the portfolio is also invested in a
riskfree asset so that its investment proportions are:
Security proportion
Riskfree .10
A .36
B .54
Ans:
a. With the riskfree investment (which has a zero factor
sensitivity by definition) the total portfolio's factor
risk is:
Factor risk = (.10 × 0 + .36 × .20 + .54 × 3.50)² × 225
= 866.1
b. With the riskfree investment (which has zero non-factor risk

by definition), the total portfolio's non-factor risk is:
Non-factor risk = .10² × 0 + .36² × 49 + .54² × 100
= 35.5
c. Therefore, with the riskfree investment, the total portfolio's

standard deviation is:
σ p = (866.1 + 35.5)½ = 30.0%
9. On the basis of a one-factor model, security A has a sensitivity of -.50, whereas security B
has a sensitivity of 1.25. If the covariance between the two securities is -312.50, what is the
standard deviation of the factor?
Ans:
The covariance between two securities in a one-factor world is
given by:
σ ij = bibjσ F2
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In this case, the equation should be solved for σ F . That is:
σ F = [σ ij /b i b j ]½
= [(-312.50)/(-0.50 × 1.25)]½
= 22.4%
10. On the basis of a one-factor model, for two securities A and B:??????
Ans:
In a one-factor model world, the standard deviation of a security
is given by:
σi = (bi2σ F2 + σ ei2 )1/2
For security A:
σ A = [(.8)² × (18)² + (25)²]½
= 28.9%
For security B:
σ B = [(1.2)² × (18)² + (15)²]½
= 26.3%
11. On the basis of a one-factor model, if the average nonfactor risk (a~) of all securities is
225, what is the nonfactor risk of a portfolio with equal weights assigned to its 10
securities? 100 securities? 1,000 securities?
Ans:
The nonfactor risk of a portfolio is given by:
n
σ ep = ∑ X i2 σ ei2
i =1
Assuming that the securities in the portfolio are equal-weighted, the portfolio's nonfactor risk is
the average nonfactor risk of the securities divided by the number of portfolio securities. Thus
the nonfactor risks of the various portfolios are:
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10-security portfolio: 225/10 = 22.5
100-security portfolio: 225/100 = 2.25
1,000-security portfolio: 225/1,000 = 0.225
12. On the basis of the discussion of factor and nonfactor risk and given a set of securities
that can be combined into various portfolios, what might he a useful measure of the relative
diversification of each of the alternative portfolios?
Ans:
A useful measure of diversification, in the context of alternative portfolios constructed out of
a given set of securities, is the portfolios' levels of unique risk. A perfectly diversified portfolio
would have zero non-factor risk. The larger is the unique risk of one of these portfolios, the less
diversified is that portfolio.
13. With a five-factor model (assuming uncorrelated factors) and a 30-stock portfolio, how
many parameters must be estimated to calculate the expected return and standard
deviation of the portfolio? How many additional parameter estimates are required if the
factors are correlated?
Ans:
In order to calculate the expected return and standard deviation of a thirty-stock portfolio
based on a five-factor model (with uncorrelated factors), the following parameters must be
estimated:
Zero-factor for each security 30

Sensitivity of each security to each factor (5 × 30) 150
Variance of the random error term for each security 30
Variance of each factor 5
Expected value of each factor 5
Total 220
If the factors are correlated, then there will be (N² - N) factor covariances to estimate in addition
to the parameters listed above. In this case, the number of additional parameters would be (5² -
5) = 20.
14. Beyond the factors discussed in the text, speculate as to other factors that could
reasonably be expected to pervasively affect security returns.
Ans:
Factors thought to pervasively affect security returns are usually viewed as "macroeconomic"
or "microeconomic" in nature. The text discussed several possible macroeconomic factors.
Other such factors might include money supply growth, the size of the budget deficit (or
surplus), the size of the trade deficit (or surplus), or the level of consumer confidence.
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Microeconomic factors (or at least proxies for those factors) that might pervasively
influence security returns include dividend yield, earnings growth rate, earnings growth
momentum (that is, the rate of change in earnings growth), book value-to-price ratio, market
capitalization, and financial leverage.
15.On the basis of a three-factor model, consider a portfolio composed of three securities
with the following characteristics:
Security Factor 1 Factor Factor 3 proportion
sensitivity 2sensitivity sensitivity
A -.20 3.60 .05 .60
B .50 10 .75 .20
C 1.5 2.20 .30 .20
What are the sensitivities of the portfolio to factors 1, 2, and 3?
Ans:
A portfolio's sensitivity to a factor is the weighted average
of the component securities' factor sensitivities. Therefore
in this case:
b p1 = (.60 × -.20) + (.20 × .50) + (.20 × 1.50)
= 0.28
b p2 = (.60 × 3.60) + (.20 × 10.00) + (.20 × 2.20)
= 4.60
b p3 = (.60 × 0.05) + (.20 × .75) + (.20 × 0.30)
= 0.24
16. Smiler Murray, a quantitative security analyst, remarked, "The structure of any factor
model concerns surprise, in particular the nature of correlations between surprises. In
different securities' returns." What does Smiler mean by this statement?
Ans:
In the context of a factor model, the expected return on securities is a function of the values
expected to be attained by the factor (or factors). Surprises in the actual outcomes for the factor
values will determine the actual returns earned on the securities, with the exact nature of those
actual returns depending on the structure of the factor model.
Mathematically, the expected return on security based on a single-factor model can be

expressed as:
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r i = ai + bi F
where r i and F are the expected return for security i and the
expected value of the factor, respectively.
Further, realized returns on a security can be expressed as:
ri = ai + biF + ei
Substituting ( r i - b i F ) for a in the preceding equation gives:
r i = r i + b i (F - F ) + e i
That is, the actual return on the security is a function of

its expected return and the surprise (or unexpected change) in
the value of the factor.
17.Dode Cicero owns a portfolio of two securities. On the basis of a two-factor

model, the two securities have the following characteristics
Security Zero Factor Factor 1 Factor 2 Nonfactor proportion

sensitivity sensitivity risk
A 2% .3 2 196 .70
B 3 .5 1.8 100 .30
The factors are uncorrelated, Factor 1 has an expected value of 15% and a standard
deviation of 20%. Factor 2 has an expected value of 4% and a standard deviation
of 5%. Calculate the expected return and standard deviation of Dode's portfolio. [Hint:
Think about how Equation (l0.6a) could be extended to a two factor model by considering
Equation (10.9).]
Ans:
The expected return of a security in a two-factor world is given
by:
r i = a i + b i1 F 1 + b i2 F 2
Thus the expected returns on the two securities is:
r A = 2% + (.30 × 15%) + (2.0 × 4%)
= 14.5%
r B = 3% + (.50 × 15%) + (1.8 × 4%)

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= 17.7%
The expected return on the portfolio is a weighted average of

the component securities' expected returns. Therefore:
r p = (.70 × 14.5%) + (.30 × 17.7%)
= 15.5%
The variance of a portfolio in a two-factor (uncorrelated)

world is given by:
σ p2 = bp21σ F21 + bp22σ F2 2 + σ ep2
In this case:
b p1 = (.70 × .30) + (.30 × .50)
= 0.36
b p2 = (.70 × 2.00) + (.30 × 1.80)
= 1.94
σ ep2 = [(.70)² × 196] + [(.30)² × 100]
= 105.0
Therefore:
σ p2 = [(.36)² × (20)²] + [(1.94)² × (5)²] + 105.0
= 251.0
σ p = (251.0)½ = 15.8%
18. Compare and contrast the three approaches to estimating factor models.
Ans:
The time-series approach to factor model estimation begins with the assumption that the
factors are known in advance. Typically, the identification of the factors proceeds from an
analysis of the economics of the firms involved. With the factors specified, historical
information concerning the values of the factors and security returns are collected from period to
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period. These data are used to estimate securities' sensitivities to the factors, the securities' zero
factors and unique returns, and the standard deviations of factors and their correlations.
The cross-sectional approach to factor model estimation begins with estimates of the
securities’ sensitivities to certain factors. Then, in a particular time period, the values of the
factors are estimated based on the securities' returns and their sensitivities to the factors. By
repeating the process over multiple time periods, statistically significant estimates of the factors'
standard deviations and correlations can be computed.
The factor analysis approach to factor model estimation begins simply with a set of
securities and their corresponding returns. A statistical procedure known as factor analysis is
used to identify the number of significant factors and the securities' sensitivities to those factors
as well as the standard deviations of the factors and the correlations among the factors.
19. Why are investor expectations about future factor values more relevant to security
returns than are the historical value of the factors?
Ans:
Security prices represent investors’ consensus expectations about the future prospects for the
firms that issue the securities. Thus past factor values will already be incorporated into security
prices. Past factor values will have no effect on security price changes and, therefore, security
returns. Instead it is what investors expect will be the value of factors in the future that should be
related to security price changes and, therefore, security returns.
20. The return on security A can be expressed as a one-factor model of the form:
rAt = -4% + 2.6Ft, + e-At
The response coefficient of security A (CA) to unanticipated changes in the factor is +1.5.
During the period security A returned 13%. If the expected value of the factor was 8% and
security A's random error term (eAt) during the period was +1 %, what must have been the
unexpected change in the factor (EDt)?
Ans:
Applying Equation (10.18), the return on security A can be
expressed as:
rAt = r At + c A FDt + eit
Given the zero-factor value of -4% and the expected value of

the factor of 8%, the expected return on security A is:
r At = −4% + 2.6 × 8% = 16.8%
Further, given that the security returned 13% and the random
error term was +1%:
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13% = 16.8% + 1.5 × FD t + 1%
or
FD t = -3.2
21. Consider a factor model with earnings yield (or earnings/price ratio) and book price\
(or book value/market price ratio) as the two factors. Stock A has an earnings yield of 10%
and a book-price of 2. Stock B's earnings yield is 15% and its book-price is .90. The zero
factors of stocks A and Bare 7% and 9%, respectively. If the expected returns of stocks A
and Bare 18% and 16.5%, respectively, what are the expected earnings-yield and book-
price factor values?
Ans:
The expected returns on stocks A and B are:
r A = 18.0% = 7% + 10 × F 1 + 2 × F 2
r B = 16.5% = 9% + 15 × F 1 + .9 × F 2
With two equations and two unknowns, the factor values for earnings yield and book-
price can be solved for simultaneously. The solutions are .243% for earnings yield and 4.286%
for book-price.
22. On the basis of a two-factor model, consider two securities with the following
characteristics
Characteristics Security A Security B
Factor 1 Sensitivity 1.5 .7
Factor 2 Sensitivity 2.6 1.2
Nonfactor risk 25 16
The standard deviations of factor I and factor 2 are 20% and 15%, respectively, and the
factors have a covariance of 225. What are the standard deviations of securities A and B?
What is their covariance?
Ans:
Based on a two-factor model, the variance of a security is:
σi2 = bi21σ F2 + bi22σ F2 + 2bi1bi 2 COV ( F1 , F2 ) + σ ei2

1 2
Therefore for the two securities in this problem:
σ A2 = [(1.5)² × (20)²] + [(2.6)² × (15)²]
+ (2 × 1.5 × 2.6 × 225) + 25

Edited by
= 4,201
σ A = (4,201)½ = 64.8%
σ B2 = [(0.7)² × (20)²] + [(1.2)² × (15)²]
+ (2 × 0.7 × 1.2 × 225) + 16
= 914
σ B = (914)½ = 30.2%
The covariance between two securities in a two-factor world

is:
σij = bi1b j1σ F2 + bi 2b j 2σ F2 + (bi1b j 2 + bi 2b j1 )COV ( F1 , F2 )

1 2
In this case:
σ AB = [(1.5 × 0.7) × (20)²] + [(2.6 × 1.2) × (15)²]
+ {[(1.5 × 1.2) + (2.6 × 0.7)] × 225}
= 1,936.5
23. Are factor models consistent with the CAPM? If returns are determined by a one-factor
model (where that factor is the return on the market portfolio) and the CAPM holds, what
relationships must exist between the two models?
Ans:
Factor models and the CAPM can coexist. However, if security returns are determined by a
one-factor model (where the factor is the return on the market portfolio) and the CAPM holds,
then the factor sensitivity of a stock must equal its beta and the zero-factor must equal (1 - ß i ) ×
rf.
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Chapter 11: ARBITRAGE PRICING THEORY
1. In what significant ways docs the APT differ from the CAPM?
Ans:
In general, APT is a much less restrictive equilibrium asset pricing theory than is the CAPM.
The CAPM utilizes certain strong assumptions about investor preferences, while APT merely
assumes that investors prefer more wealth to less.
Another important difference between the two pricing theories is that APT, unlike the CAPM,
assumes that security returns are generated by a factor model. The CAPM, on the other hand,
states that security returns must be proportional to the covariance of those returns to the
market portfolio, with no reference to an underlying return-generating process.
2. Why would an investor wish to form an arbitrage portfolio?
Ans:
Arbitrage portfolios involve opportunities for an investor to increase the expected return on his or
her current portfolio without increasing the portfolio’s risk. By definition, this type of
investment should be attractive to all risk-averse and risk-neutral investors. Further, arbitrage
portfolios are self-financing; the investor is not required to put up any additional funds. This
feature permits the investor to avoid the costs of financing the arbitrage portfolio investment.
3. What three conditions define an arbitrage portfolio?
Ans:
An arbitrage portfolio is defined by three conditions:
1. It is self-financing. It does not require any additional funds from the investor.
2. It is riskless. That is, it has no sensitivity to any factor. Further, it has zero variance
and hence zero covariance with other portfolios. It also has negligible nonfactor risk.
3. It has a positive expected return.
4. Assuming a one-factor model, consider a portfolio composed of three securities with the
following factor scnsivities :
Security Factor Sensitivity

1 .90
2 3.00
3 1.80
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If the proportion of security I in the portfolio is increased by .2, how must the proportions
of the other two securities change if the portfolio is to maintain the same factor sensitivity?
Ans:
The weights of securities in any portfolio must add up to 100%, therefore if security 1’s proportion
is increased by .2, then the proportions of the other securities must adjust so that
X1 + X2 + X3 = 0
where the X i ’s are the changes in the proportions of the respective securities in the total
portfolio. Further, if the factor sensitivity of the portfolio is to remain constant then it must be
true that:
.90X 1 + 3.00X 2 + 1.80X 3 = 0
From the first equation, if X 1 = +.2, then:
X 2 = (-.2 - X 3 )
Substituting this expression for X 2 into the second equation

gives:
.18 + 3.00 × (-.2 - X 3 ) + 1.80X 3 = 0
-.42 - 1.2X 3 = 0
X 3 = -.35
Thus:
X 2 = -.2 - (-.35) = .15
5. Assuming a one-factor model of the form:

r, = 4% + b;l'+ P.i consider three well-diversified portfolios (zero nonfactor risk) . The
expected value of the factor is 8%.
Portfolio Factor Sensitivity Expected Return

A .80 10.40%
B 1.00 10.0
C 1.20 13.60
Is one of the portfolio's expected return not in line with the factor model relationship?
Which one? Can you construct a combination of the other two portfolios that has the same
factor sensitivity as the "out-of-line" portfolio? What is
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the expected return of that combination? What action would you expect investors
to take with respect to these three portfolios?
Ans:
Given the expected value for the factor of 8% and the stated factor model relationship, then the
expected return on the three portfolios should be:
r A = 4% + .8 × 8% = 10.4%
r B = 4% + 1.0 × 8% = 12.0%
r C = 4% + 1.2 × 8% = 13.6%
Thus portfolio B's expected return is "out-of-line" with (in

this case greater than) the factor model relationship.
As portfolio B's factor sensitivity is 1.0, then the issue is

what combination of portfolios A and C will yield a factor
sensitivity of 1.0. That is:
X A × .8 + X C × 1.2 = 1.0
It must be that X A + X C = 0 or X C = 1 - X A . Thus:
X A × .8 + (1 - X A ) × 1.2 = 1.0
.8X A + 1.2 - 1.2X A = 1.0
-.4X A = -.2
X A = .50 and X C = .50
A portfolio formed of 50% portfolio A and 50% portfolio C has

an expected return of:
rp = .5 × 10.4% + .5 × 13.6%
= 12.0%
Investors can be expected to create arbitrage portfolios by

short selling portfolio B and buying a portfolio composed of
50% portfolio A and 50% portfolio C.
6. Socks Seybold owns a portfolio with the following characteristics. (Assume that returns
are generated by a one-factor model.)
Edited by
Security Factor Proportion Expected

sensitivity Return
A 2 .2 20%
B 3.5 .4 10
C .05 .4 5
Socks decides to create an arbitrage portfolio by increasing the holdings of security

A by .2 . (Hint: Remember, XB must equal r-X, - X,d
a. What must be the weights of the other two securities in Socks' arbitrage portfolio?
b. What is the expected return on the arbitrage portfolio?
c. If everyone follows Socks' buy-and-sell decisions, what will be the effects on the prices
of the three securities?
Ans:
a. From the conditions required of an arbitrage portfolio, in

a three-asset case:
XA + XB + XC = 0
and
bAXA + bBXB + bCXC = 0
In this case it is required that:
.20 + X B + X C = 0
and
(2.0 × .20) + (3.5 × X B ) + (0.5 × X C ) = 0
Since:
X C = -X B - .20
then:
.40 + (3.5 × X B ) + [.5 × (-X B - .20)] = 0

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.40 + (3.5 × X B ) - (.5 × X B ) - .10 = 0
.30 + (3.0 × X B ) = 0
X B = -.10
X C = -.10
b. The expected return on Socks's arbitrage portfolio equals:
(.20 × 20%) + (-.10 × 10%) + (-.10 × 5%) = +2.5%
c. The market's action of buying security A and selling

securities B and C will drive up the price of security A
(reducing its expected return) and drive down the prices
of securities B and C (increasing their expected returns).
7. Assume that security returns are generated by a one-factor model. Hap Morse holds a
portfolio whose component securities have the following characteristics .
Security Factor Proportion Expected

Sensitivity Return
A .60 .40 12%
B .30 .30 15
C 1.20 .30 8
Specify an arbitrage portfolio in which Hap might invest. (Remember that there are an
infinite number of possibilities; choose one.) Demonstrate that this portfolio satisfies the
conditions of an arbitrage portfolio.
Ans:
Given the relatively high expected return and low factor

sensitivity of security B, one likely arbitrage portfolio is
to increase the holdings of that security. Assume that
security B holdings are increased by .10. In the three-asset
arbitrage portfolio, it is required that:
XA + XB + XC = 0
and
bAXA + bBXB + bCXC = 0
In this case:
Edited by
.10 + X A + X C = 0
and
(.60 × X A ) + (.30 × .10) + (1.20 × X C ) = 0
Since:
X C = -X A - .10
then:
(.60 × X A ) + .03 + [1.20 × (-X A - .10)] = 0
(.60 × X A ) + .03 - [(1.20 × X A ) + .12] = 0
(-.60 × X A ) - .09 = 0
X A = -.15
X C = .05
Therefore, all of the conditions of an arbitrage portfolio are

satisfied:
1. -.15 + .10 + .05 = 0
2. (.60 × -.15) + (.30 × .10) + (1.20 × .05) = 0
3. (-.15 × 12%) + (.10 × 15%) + (.05 × 8%) = +0.10%
8. Why must the variance of a well-diversified arbitrage portfolio be small?
Ans:
By definition, the factor sensitivity of an arbitrage portfolio is zero. Assuming that the arbitrage
portfolio is well-diversified and has no nonfactor risk, its total risk (assume a one-factor world
for simplicity) is given by bp2σ F2 . Because b p equals zero, the arbitrage portfolio's risk
(variance) must equal zero.
9. Why is the concept of arbitrage central to the asset-pricing mechanism of the APT?
Ans:
It is the actions of investors forming arbitrage portfolios that forces securities' expected returns to
Edited by
be proportional to their factor sensitivities. Investors seek arbitrage portfolios to risklessly

enhance their expected portfolio returns. In creating these arbitrage portfolios, investors buy
securities offering expected returns exceeding the amount necessary to compensate for their
associated factor risks. Conversely, investors sell securities with expected returns insufficient
to compensate for their associated factor risks. Once all arbitrage possibilities have been
eliminated, there will exist a linear relationship between security expected returns and security
factor sensitivities.
10. On the basis of a one-factor model, WyeviJle Labs' stock has a factor sensitivity of 3.
Given a risk free rate of5%and a factor risk premium of 7%, what is the equilibrium
expected return on WyeviJle stock?
Ans:
According to APT, given a one-factor model, the equilibrium
return on a security is given by:
r i = r f + λb i
In this case:
r i = 5% + (7.0% × 3.0)
= 26.0%
11 .According to APT, why must the relationship between a security's equilibrium return
and its factor sensitivities be linear?.
Ans:
The process of investors buying and selling securities through arbitrage portfolios will result in
linear relationships between securities' factor sensitivities and securities' equilibrium expected
returns. Securities with expected returns greater than that justified by these relationships will
be purchased by investors, with combinations of other securities sold short to finance the
purchases. These actions will drive up the prices of the excessively-high expected return
securities and push down the prices of the securities sold short, which presumably display
expected returns below those justified by the linear APT relationship. Only when all
securities' expected returns are linearly related to their factor sensitivities will all arbitrage
opportunities have been eliminated.
12. On the basis of a one-factor model, two portfolios, A and B, have equilibrium expected
returns of 9.8% and 11.0%, respectively. If the factor sensitivity of portfolio A is 0.8 and
that of portfolio B is 1.0, what must be the risk free rate?
Ans:
According to APT, for a one-factor model, the equilibrium

Edited by
expected return on a portfolio is given by:
r p = r f + λb p
In this case, with two portfolios:
r A = 9.8% = r f + λ × 0.8
r B = 11.0% = r f + λ × 1.0
There are two equations with two unknowns (r f and λ). Solving
for both unknowns simultaneously gives:
r f = 5.0%
λ = 6.0%
13. What is a pure factor portfolio? How may such a portfolio be constructed?
Ans:
A pure factor portfolio possesses a unit (1.0) sensitivity to the particular factor and zero sensitivity
to any other factor. Further, it has zero non-factor risk.
A pure factor portfolio can be formed by buying and short selling a large number of securities
in appropriate proportions to produce the characteristics cited above.
14. On the basis of a one-factor model, assume that the risk free rate is 6% and the
expected return on a portfolio with unit sensitivity to the factor is 8.5%. Consider a
portfolio of two securities with the following characteristics:
Security Factor Sensitivity Proportion

A 4.00 .3
B 2.50 .70
According to the APT, what is the portfolio's equilibrium expected return?

Based on a one-factor model, APT defines the equilibrium expected return on a portfolio to
be:
Ans:
rp = r f + λb p
The factor sensitivity of the portfolio is given by the

weighted average of the component securities' factor
sensitivities, where the weights are the securities'
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proportions of the portfolio.
In this case:
b p = (.30 × 4.0) + (.70 × 2.6)
= 3.02
The factor risk premium is the expected return over the

riskfree rate offered by a portfolio with unit sensitivity to
the factor. In this case, the unit sensitivity portfolio has
an expected excess return of 2.5% (= 8.5% - 6.0%). Therefore
the equilibrium expected return is equal to:
r p = 6.0% + (2.5% × 3.02)
= 13.6%
15. Assume that security returns are generated by a factor model in which two factors
are pervasive. The sensitivities of two securities and of the risk free asset to each of the two
factors are shown below, along with the expected return on each security.
Security b1 b2 Expected Return

A .5 .8 16.20%
B 1.5 1.4 21.6
rf 0.0 0.0 10
a. If Dots Miller has $100 to invest and sells short $50 of security B and purchases $150 of
security A, what is the sensitivity of Dots's portfolio to the two factors? (Ignore margin
requirements.)
(a), what is the sensitivity of this portfolio to the two factors?
b. If Dots now borrows $100 at the risk free rate and invests the proceeds of the loan along
with the original $100 in securities A and B in the same proportions as described in part
c. What is the expected return on the portfolio created in part (b)?
d. What is the expected return premium of factor 2?
Ans:
a. Dots' positions in the two securities are +1.50 in security A

and -.50 in security B. As a result, the portfolio's
sensitivities to the two factors are:
b p1 = 1.50 × .50 + (-.50) × 1.50
= 0.0
Edited by
b p2 = 1.50 × .80 + (-.50) × 1.40
= .50
b. Dots' positions in the two securities are now 3.0 in

security A ($300/$100), -1.0 in security B (-$100/$100),
and -1.0 in the risk free asset (-$100/$100). Therefore:
b p1 = 3.0 × .50 + (-1.0) × 1.50 + (-1.0) × 0
= 0.0
b p2 = 3.0 × .80 + (-1.0) × 1.40 + (-1.0) × 0
= 1.0
c. The expected return on the portfolio is given by:
r p = 3.0 × 16.2% + (-1.0) × 21.6% + (-1.0) × 10.0%
= 17.0%
d. The portfolio created in part (b) is a pure factor 2

portfolio. The expected return premium for the factor is
the expected return on a pure factor portfolio for that
factor less the risk free rate. Thus:
Expected return premium = 17.0% - 10.0% = 7.0%
16. Dandelion Pfeffer owns a portfolio with the following characteristics:
Security Factor Factor Proportion Expected

Sensitivity Sensitivity Return
A 2.5 1.4 .3 13%
B 1.6 0.9 .3 18
C .8 1.0 .2 10
D 2 1 .2 12
Assume that the returns are generated by a two-factor model. Dandelion decides to create
an arbitrage portfolio by increasing the holding of security B by .05.
a. What must be the weights of the other three securities in Dandelion's portfolio?
b. What is the expected return on the arbitrage portfolio?
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Ans:
a. From the conditions required3 of an arbitrage portfolio, in a

four-asset case it must be true that:
XA + XB + XC + XD = 0
and
b A1 X A + b B1 X B + b C1 X C + b D1 X D = 0
b A2 X A + b B2 X B + b C2 X C + b D2 X D = 0
In this case:
X A + .05 + X C + X D = 0
(2.50 × X A ) + (1.60 × .05) + (.80 × X C ) + (2.00 × X D ) = 0
(1.40 × X A ) + (.90 × .05) + (1.00 × X C ) + (1.30 × X D ) = 0
Since:
X A = -X C - X D - .05
then:
[2.50 × (-X C - X D - .05)] + .08 + (.80 × X C )
+ (2.00 × X D ) = 0
[1.40 × (-X C - X D - .05)] + .045 + (1.00 × X C )
+ (1.30 × X D ) = 0
Setting these two equations equal to each other and

solving for X C gives:
X C = -.015 - (.308 × X D )
X A = -.035 - (.692 × X D )
Substituting these expressions for X C and X D into either

factor sensitivity equation and solving for X D gives:
Edited by
X D = .82
Therefore:
X C = -.27 and X A = -.60
b. The expected return on the arbitrage portfolio is then:
r ap = (-.60 × 13%) + (.05 × 18%) + (-.28 × 10%)
+ (.82 × 12%)
= 0.2%
17. Is it true that if the APT is a correct theory of asset pricing, then the risk-return
relationship derived from the CAPM is necessarily incorrect? Why?
Ans:
The CAPM is consistent with a world in which security returns are generated by a factor
model. The CAPM does require that certain restrictive assumptions be satisfied that APT
does not require. But if these assumptions are met, the CAPM can coexist with APT.
Security betas can be derived from APT by calculating the factor betas (that is, the ratio of
covariance of a factor with the market portfolio, divided by the variance of the market
portfolio) and the sensitivity of each security to the factors. With this information, and
knowledge of the riskfree rate and expected return on the market portfolio, the SML asset
pricing relationship can be stated.
18 .If the CAPM and APT both hold, why must it be the case that the factor-risk premium
is negative for a factor that is negatively correlated with the market portfolio? Explain both
mathematically and intuitively..
Ans:
If both the CAPM and APT hold, it can be shown that a
security's beta (in a one-factor world) equals:
COV ( F , rM )
βi = bi
σ M2
Thus the CAPM expression for a security's equilibrium return

must be:
COV ( F , rM )
r i = rf + bi × ( r M - r f )
σ M2
Edited by
Because the APT expression for a security's equilibrium

expected return is stated as:
r i = r f + λb i
then the factor risk premium, λ, must equal:
λ = ( r M - r f ) × COV ( 2F , rM )
σM
Thus the factor risk premium is directly related to the covariance between the factor and the
market portfolio. If that correlation (or equivalently, the covariance) is negative, then the
factor risk premium must also be negative.
Intuitively, if the correlation between a factor and the market portfolio is negative, a portfolio
with a unit sensitivity to the factor acts as a strong diversifying investment. Investors will
desire to hold this diversifying portfolio, bidding up its price and driving down its expected
return, thereby producing a negative factor risk premium.
19. Some people have argued that the market portfolio can never be measured and
that the CAPM, therefore, is un testable. Others have argued that APT specifies
neither the number of factors nor their identity and, hence, is also untestable.
If these views are correct, docs this mean that the theories arc of no value? Explain
Ans:
It is true that the CAPM and APT are untestable in the literal sense that controlled experiments
cannot be conducted that verify the conclusions of the underlying theories or, for that matter
in the case of APT, identify the factors. Nevertheless, both theories are still quite valuable in
that they describe how investors analyze the tradeoff between risk and return. As a result,
asset pricing models provide a framework around which to develop explanations of how the
capital markets operate and therefore how to go about efficiently applying various long-run
investment strategies and policies.
20. Although APT does not specify the identity of the relevant factors, most empirical
APT research has focused on certain types of factors. What are some of the common
characteristics of those factors?
Ans:
In speculating about the appropriate APT factors, researchers and practitioners typically turn to
economic theory. They focus on broad economic variables that can logically be expected to
affect the performance of all securities to some degree. For example, both the level of
economic activity and inflation affect corporate earnings and dividends. Further, the term
structure of interest rates (as measured by the location and shape of the yield curve) affects the
Edited by
discounted value of future earnings and dividends. Consequently, one can state with some
confidence that investors' expectations concerning these types of economic variables will
systematically affect security returns.
21. Assume that the CAPM holds and that returns on securities are generated by a single-
factor model. You are given the following information: 0';:" = 400 bA= 0.7 bll = 1.1 COV(i';
TM) = 370
a. Calculate the beta coefficients of securities A and B.
b. If the riskfree rate is 6% and the expected return on the market portfolio is 12%, what is
the equilibrium expected return on securities A and B?.
Ans:
a. If the CAPM holds and returns are generated by a one-factor

model, then:
COV ( F , rM )
βi = bi
σ M2
For security A:
ß A = [370/400] × .70
= 0.65
For security B:
ß B = [370/400] × 1.10
= 1.02
b. Given that the CAPM holds, the equilibrium expected return

on a security is given by:
r i = r f + ( r M - r f )ß i
In this case:
r A = 6.0% + [(12.0% - 6.0%)(.65)]
= 9.9%
r B = 6.0% + [(12.0% - 6.0%)(1.02)]
= 12.1%
Edited by
22. Assume that the CAPM holds and that returns are generated by a
two-factor
model. You are given the following information:
O'l, = 324 b'lI = .8 bill = 1.0 COV(1'1, TM) = 156
bA2 = 1.1 bUl = .7 COV(J';, TM) =500.
Ans:
If the CAPM holds and returns are generated by a two-factor
model, then:
COV ( F1 , rM ) COV ( F2 , rM )
ßi = b1i + b2i
σ M2 σ M2
For security A:
ß A = [(156/324) × .80] + [(500/324) × 1.10]
= 0.38 + 1.70
= 2.08
ß B = [(156/324) × 1.00] + [(500/324) × 0.70]
= 0.48 + 1.08
= 1.56
23. As the manager of a large, broadly diversified portfolio of stocks and bonds, you realize
that changes in certain macroeconomic variables may directly affect the performance of
your portfolio. You are considering using an arbitrage pricing theory (APT) approach to
strategic portfolio planning and want to analyze the possible impacts of the following four
factors:
• Industrial production
• Inflation
• Risk premiums or quality spreads
• Yield curve shifts
a. Indicate how each of these four factors influences the cash flows and the discount
rates in the traditional discounted cash flow valuation model. Explain
(From The CFA Candidate Study and Examination Program Review, 1991.)
how unanticipated changes in each of these four factors could affect portfolio returns.
b. You now use a constan t-proportion allocation strategy of 60% stock and 40%
bonds, which you rebalance monthly. Compare and contrast an active portfolio
Edited by
approach that incorporates macroeconomic factors , such as the four.
Ans:
factors listed above, with the constant-proportion strategy currently in use .

a. The value of stocks and bonds can be viewed as the present value of expected
future cash flows, discounted at some discount rate which reflects risk. Unanticipated economic
conditions affect returns because anticipated economic conditions are already incorporated.
Industrial production. Industrial production is related to cash flows in the traditional

discounted cash flow (DCF) formula. The relative performance of a portfolio sensitive to
unanticipated changes in industrial production should move in the same direction as the change
in this factor. When industrial production turns up or down, so too does the return on the
portfolio. Portfolios sensitive to unanticipated changes in industrial production should be
compensated for the exposure to this economic factor.
For example, an unanticipated increase in industrial production is generally associated with

economic growth. Holding other factors constant, this will lead to stronger sales, earnings and
dividends. Therefore, cash flows to security holders will increase and stock prices will rise,
while bond prices may rise reflecting lower credit risks.
Inflation. Inflation is reflected in the discount rate, which is generally as follows: K = real
return + hedge for inflation + risk premium. Unexpected inflation will quickly be factored into
K by the market as investors attempt to hedge the loss of purchasing power. Thus, the discount
rate would move in the same direction as the change in inflation.
High inflation could also impact cash flows in the DCF formula, but the effect
will probably be more than offset by higher Ks. Nominal cash flow growth rates do not always
match expected inflation rates. If the growth in nominal cash flows lags the inflation rate, the
relative performance of a portfolio sensitive to rising inflation should decline over time.
Investments in bonds are subject to significant adverse inflation effects. Hence, higher
unanticipated inflation will negatively effect portfolio values.
Risk premia or quality spreads. Risk premia affect the magnitude of the DCF discount rate.
The risk premium measure represents investor attitudes toward risk-bearing and perceptions
about the general level of uncertainty. When the return in low versus high quality bonds widens,
there is likely to be a negative impact on the values of stocks and bonds, particularly for lower
quality companies. Riskier cash flows require higher discount rates, and widening quality
spreads often signal greater uncertainty about profit levels and debt service requirement.
Yield curve shifts. Yield curve shifts affect the discount rate. If a parallel upward shift occurs,
it would mean investors are requiring higher return to hold all assets. Hence, with high discount
rates, portfolio values would fall. If the curve becomes steeper, longer duration assets such as
long-term bonds and growth stocks would be negatively impacted more than shorter term assets.
b.Active Portfolio Approach Incorporating Macroeconomic Factors

Edited by
Portfolio returns depend on both anticipated and unanticipated events.

Anticipated changes are expected and have already been incorporated into expected returns.
Most of the realized return results from unanticipated changes. Even if two portfolios have the
same beta, they will have different patterns of sensitivities to systematic macroeconomic factors.
Thus, a portfolio's expected risk and return is directly related to its sensitivity to unanticipated
movements in major macroeconomic factors.
APT estimates assets factor sensitivity to economic variables. When using an APT approach to
portfolio strategy, the portfolio manager must first choose the most desirable degree of exposure
to the fundamental economic risks that influence asset returns. Systematic factors that may
influence returns include not only industrial production, inflation, risk premia, and yield curve
shifts but also changes in real GNP growth, real defense spending, rate of growth of real oil
prices (i.e., energy factor), labor market variables, and the interest rate/money supply. Some
report that the stock market index is also an important factor. Yet, finding a significant market
factor suggests that additional return generating factors remain to be identified.
Next, the manager makes the appropriate transactions that can move the fund toward that desired
position. Every portfolio has its own pattern of sensitivities to the systematic macroeconomic
factors. The portfolio manager may also change the sensitivity or exposure of a portfolio to
specific economic variables. A portfolio that is more exposed to unanticipated changes in these
variables will show greater fluctuation in its market values over time but it will be compensated
by a higher total return in the long run.
Using an active APT approach with the four economic variables, portfolio managers would
deviate from 60/40 mix if they have confidence in their forecasts and if they expect the factor
sensitivities will hold in the future. The portfolio will be rebalanced and tilted to the assets
classes which will respond most favorably to the expected changes in the four economic factors.
For example, if there was a high probability of rapid economic growth without inflation, the
portfolio might be tilted to cyclical industrial stocks. If there was a high probability of a
deflation recession, the portfolio would be tilted toward long-term high quality bonds. In other
words, portfolio managers would attempt to achieve superior results by picking assets which
would capitalize on unexpected changes in economic variables.
In summary, macroeconomic variable expectations are useful in establishing long-

term asset class returns and risk expectations for policy asset allocation purposes as well as for
active or tactical asset allocation. Macroeconomic expectations may lead directly to portfolio
decisions concerning investment factors or groupings of securities that are sensitive to changes in
the economic landscape.
Constant Proportion Strategy.
The constant proportion approach does not generally consider economic forecast
or asset sensitivity to economic changes. It assumes investor objectives can be achieved by a
60/40 allocation. This approach has the advantage of being less complicated to administer and it
is contrarian in nature. The approach forces the portfolio manager to sell the asset class that has
Edited by
fallen and thus is "cheap." This approach works well in flat, volatile markets. The approach
does not work well in extended bull or bear markets.
A constant proportion portfolio allocation strategy of 60% stocks and 40% bonds
reduces the flexibility of the portfolio manager. This strategy may be inappropriate if investment
objectives and economic expectations change because the portfolio manager is locked into a
fixed percentage of stocks and bonds. This approach could also needlessly increase the riskiness
of the portfolio by having too much invested in either stocks or bonds at a particular time. Yet,
altering the mix of stocks and bonds in the portfolio will affect the amount and type of risk
exposure and thus the expected return. The constant proportion strategy precludes the portfolio
manager from using alternative investment vehicles such as real estate, which may benefit
investors.
The active portfolio approach gives the manager more flexibility than the constant
proportion strategy in managing the portfolio. The active APT approach will work better than
the constant proportion approach if the portfolio manager has superior economic forecasting
ability and the estimated factor sensitivities are correct. There is always the risk that the APT
manager will be wrong and be invested in the wrong asset classes.
It should be noted that the two approaches are not mutually exclusive and could
be combined. With a constant proportion strategy, the portfolio manager would maintain the
60/40 ratio but select among the stocks and bonds based on the most favorable factor
sensitivities.

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Ending Wealth − Beginning Wealth

In the case of Colfax stock:

ROR = ($36 + $3 - $33)/($33)

in the case of Flit's portfolio:

($162,000 - $150,000)/($150,000) = .080 = 8.0%

a. ($25,000 - $20,000 + $1,000)/($20,000) = .300 = 30.0%

b. ($23,000 - $30,000 + $3,000)/($30,000) = -.133 = -13.3%

c. ($48,000 - $50,000 + $4,000)/($50,000) = .040 = 4.0%

8. Why are corporate bonds riskier than U.S. government bonds?

9. In 1951the Treasury Department and the Federal Reserve System(the Fed)

no:22. Distinguish between technical and fundamental security analysis

A. Discuss why the investment time horizon is of particular importance when

Your first task is to review Green's investment policy statemen.

A.Key constraints are important in developing a satisfactory investment plan in Green’s

B.Appropriate return and risk objectives for Green are as follows:

Chapter2: BUYING AND SELLING SECURITIES

3. Discuss the advantages and disadvantages to the investor of the following:

4. Why are margin account securities held in street name?

5. Lollypop Killefer purchases on margin 200 shares of Landfall Corporation

Assets Liabilities & Net Worth

a. [(200 shrs × $40/shr) - $3,000]/(200 shrs ×

$5,000/$8,000 = .625 = 62.5%

b. [(200 shrs × $60/shr) - $3,000]/(200 shrs ×

$9,000/$12,000 = .750 = 75.0%

c. [(200 shrs × $35/shr) - $3,000]/(200 shrs ×

$4,000/$7,000 = .571 = 57.1%

7. Distinguish between the initial margin requirement and the maintenance

The maintenance margin requirement is the minimum actual margin that an

8. Snooker Arnovich buys on margin 1,000 shares of Rockford Systems stock at

market value of assets − loan

In Snooker's case, the current actual margin is:

Actual Margin = [(1,000 shrs × $50/shr) - (1 - .50)

(n × mp) − [(1 − im) × pp × n]

Margin Call Price = [(1 - im) × pp]/(1 - mm)

Margin Call Price = [(1 - .60) × $13]/(1 - .35)

Initial Equity = Initial Margin Requirement × Purchase Amount

Max Purchase Amount = Initial Equity/Initial Margin Requirement

11. Explain the purpose of the maintenance margin requirement

500). Thus Penny's return on investment for the year is:

ROR = [($20,000 - $17,500) - $1,155]/$7,875

ROR = [($12,000 - $8,000) - $300]/$5,000

ROR = [($7,000 - $8,000) - $300]/$5,000

a. ROR = {($40 - $30 + $1) - [.13 × (1 - .55) × $30]}

= ($11 - $1.755)/$16.50 = .560 = 56.0%

b. ROR = {($20 - $30 + $1) - [.13 × (1 - .55) × $30]}

= ($-9 - $1.755)/$16.50 = -.652 = -65.2%

c. ROR = ($40 - $30 + $1)/$30

= $11/$30 = .367 = 36.7%

ROR = ($20 - $30 + $1)/$30

= $-9/$30 = -.300 = -30.0%

Assets Liabilities & Net Worth

Cash Proceeds of Sale Liabilities

[( proceeds from short sale + initial m arg in) − loan]

For Candy, the actual margin calculations are:

a. {[(200 shrs × $50/shr) × (1 + .45)] - (200 shrs

× $58/shr)}/(200 shrs × $58/shr)

= ($14,500 - $11,600)/$11,600 = .250 = 25.0%