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financial markets institutions

Questions and Answers of Financial Markets Institutions

Describe how you might design a portfolio of the 40 largest stocks that mimic the S&P 500. Why might you prefer to do this instead of investing in all 500 of the S&P 500 stocks?AppendixLO1
Prove that i(1 i)rf in equation (6.3), assuming the CAPM holds. To do this, take expected values of both sides of this equation and match up the values with those of the equation for the CAPM’s
Compute the firm-specific variance and firmspecific standard deviation of a portfolio that minimizes the firm-specific variance of a portfolio of 20 stocks. The first 10 stocks have firm-specific
Find the weights of the two pure factor portfolios constructed from the following three securities:Then write out the factor equations for the two pure factor portfolios, and determine their risk
Assume the factor model in exercise 6.11 applies again. If there exists an additional asset with the following factor equationdoes an arbitrage opportunity exist? If so, describe how you would take
Use the information provided in Example 6.10 to determine the coordinates of the intersection of the solid and dotted red lines in Exhibit 6.7.AppendixLO1
Explain the basic put-call parity formula, how it relates to the value of a forward contract, and the types of options to which put-call parity applies.AppendixLO1
Relate put-call parity to a boundary condition for the minimum call price and know the implications of this boundary condition for pricing American call options and determining when they should be
Gather the information needed to price a European option with (a) the binomial model and (b) the Black-Scholes Model, and then implement these models to price an option.AppendixLO1
Understand the Black Scholes formula in the following form:and interpret N(d1).AppendixLO1 SoN(d) - PV(K)N(d - VT).
Provide examples that illustrate why an American call on a dividend-paying stock or an American put (irrespective of dividend policy) might be exercised prematurely.AppendixLO1
Understand the effect of volatility on option prices and premature exercise.AppendixLO1
You hold an American call option with a $30 strike price on a stock that sells at $35. The option sells for $5 one year before expiration. Compare the cash flows at expiration from (1) exercising the
Combine the Black-Scholes formula with the put-call parity formula to derive the Black-Scholes formula for European puts.AppendixLO1
Intel stock has a volatility of .25 and a price of$60 a share. AEuropean call option on Intel stock with a strike price of $65 and an expiration time of one year has a price of $10. Using the
Take the partial derivative of the Black-Scholes value of a call option with respect to the underlying security’s price, S0. Show that this derivative is positive and equal to N(d1).AppendixLO1 1
Take the partial derivative of the Black-Scholes value of a call option with respect to the volatility parameter. Show that this derivative is positive and equal to 6. If take the partial derivative
Suppose you observe a European call option on a stock that is priced at less than the value of S0 PV(K) PV(div). What type of transaction should you execute to achieve arbitrage? (Be specific
Consider a position of two purchased calls (AT&T, three months, K 30) and one written put (AT&T, three months, K 30). What position in AT&T stock will show the same sensitivity to price changes
The present price of an equity share of Strategy Inc.is $50. The stock follows a binomial process where each period the stock either goes up 10 percent or down 10 percent. Compute the fair market
Steady Corp. has a share value of $50. At-themoney American call options on Steady Corp. with nine months to expiration are trading at $3. Sure Corp. also has a share value of $50. At-the-money
FSA is a privately held firm. As an analyst trying to determine the value of FSA’s common stock and bonds, you have estimated the market value of the firm’s assets to be $1 million and the
In the chapter’s opening vignette, Chrysler Corporation argued that there was little risk in the government guarantee of Chrysler’s debt because Chrysler also was offering a senior claim of
Describe what happens to the amount of stock held in the tracking portfolio for a call (put) as the stock price goes up (down). Hint: Prove this by looking at delta.AppendixLO1
Callable bonds appear to have market values that are determined as if the issuing corporation optimally exercises the call option implicit in the bond. You know, however, that these options tend to
The following tree diagram outlines the price of a stock over the next two periods:The risk-free rate is 12 percent from date 0 to date 1 and 15 percent from date 1 to date 2. A European call on this
A nondividend-paying stock has a current price of$30 and a volatility of 20 percent per year.(a) Use the Black-Scholes equation to value a European call option on the stock above with a strike price
Compute both the covariance and the correlation between two returns given historical data.AppendixLO1
Identify a mean-standard deviation diagram and be familiar with its basic elements.AppendixLO1
Use means and covariances for individual asset returns to calculate the mean and variance of the return of a portfolio of N assets.AppendixLO1
Use covariances between stock returns to compute the covariance between the return of a stock and the return of a portfolio.AppendixLO1
Understand the implications of the statement that “the covariance is a marginal variance” for small changes in the composition of a portfolio.AppendixLO1
Compute the minimum variance portfolio of a set of risky assets and interpret the equations that need to be solved in this computation.AppendixLO1
Prove that using the following steps:AppendixLO1 E[GF]=E)-72
Derive a formula for the weights of the minimum variance portfolio of two stocks using the following steps:a. Compute the variance of a portfolio with weights x and 1 - x on stocks 1 and 2,
Compute the expected return and the variance of the return of the stock of Gamma Corporation.Gamma stock has a return of 24 percent with probability 1/4 8 percent with probability 1/8 4 percent with
If the ratio of the return variances of stock A to stock B is denoted by q, find the portfolio weights for the two stocks that generate a riskless portfolio if the returns of the two stocks are (a)
John invests $10,000 in IBM stock with a $3 annual dividend selling at $100 per share, and $15,000 in real estate partnership shares with $6 annual rental income at $25 per share. The following year,
Sara decides to buy a 6 percent, 10-year straightcoupon bond for $100, which pays annual coupons of $6 at the end of each year. At the end of the first year, the bond is trading at $115. At the end
Sara’s portfolio consists of $10,000 in face value of the bonds described in exercise 4.6 and an $8,000 bank CD that earns 3.5 percent per year for the first year and 3.0 percent the second year.
Show that the return of the minimum variance portfolio in Example 4.16—75 percent IBM and 25 percent IBM’s put option—has the same covariance with IBM’s stock return as it does with the put
Assuming that the three economic outcomes (1)have an equal likelihood of occurring and (2) that the good economy is twice as likely to take place as the other two:a. Calculate individual expected
Assume in exercise 4.9 that ABCO also has a pension fund, which has a net asset value of $5 billion, implying that ABCO’s stock is really worth$9 billion instead of $4 billion. The $5 billion in
Assume in exercise 4.9 that ABCO decides to borrow $8 billion at 5 percent interest to triple its current investment in each of its four lines of businesses. Assume this new investment has the same
ABCO’s head of risk management now warns of focusing on expected returns to the exclusion of risk measures such as variance. ABCO decides to measure return variance.a. For each ABCO subsidiary,
Assuming that the three economic scenarios are equally likely, compute the covariances and the correlation matrix for the four ABCO subsidiaries.Show that an alternative covariance formula, generates
ABCO is considering selling off two of its four subsidiaries and reinvesting the proceeds in the remaining two subsidiaries, keeping the same relative investment proportions in the surviving two.
For each of the six cases in exercise 4.14, ABCO wants to consider what would happen to the return variance of ABCO’s $4 billion in stock if it revised the relative investment proportions in the
Draw six mean-standard deviation diagrams, one for each of the six remaining pairs of subsidiaries in exercise 4.15. Mark the individual subsidiaries, the minimum variance combination assuming no
How does your answer to exercise 4.16 change if short sales are permitted?ABCO is a conglomerate that has $4 billion in common stock. Its capital is invested in four subsidiaries:entertainment (NET),
The three-stock portfolio in Example 4.15(portfolio variance: .03) is combined with a riskfree investment.a. What is the variance and standard deviation of the return of the new portfolio if the
Assume that the covariances between the returns of Nike, Cisco, and GE are given in the matrix below:Compute the minimum variance portfolio of these three stocks.AppendixLO1 Nike Cisco GE Nike .001 0
Graph a generalization of Exhibit 4.5 that includes portfolios with short positions in one of the two investments.AppendixLO1
The S&P 500 stock index portfolio had returns of 30.55 percent in 1991, 7.67 percent in 1992, 9.99 percent in 1993, 1.31 percent in 1994, and 37.43 percent in 1995. What is the estimate of the
A portfolio consists of the following three stocks, whose performance depends on the economic environment:Investment($) good bad stock 1 500 13% 20%stock 2 1,250 6% 3%stock 3 250 7% 2%Assuming
In July 1995, First Quadrant, a fund management firm in Pasadena, California, estimated the covariances between the returns of four portfolios:a popular portfolio of U.S. stocks (asset 1), of
Understand what a present value is.AppendixLO1
Know how to define, compute, and forecast the unlevered cash flows used for valuation.AppendixLO1
Compute incremental cash flows for projects.AppendixLO1
Mechanically compute present values and future values for single cash flows and specially patterned cash flow streams, like annuities and perpetuities, in both level and growing forms.AppendixLO1
Apply the principle of value additivity to simplify present value calculations.AppendixLO1
Translate interest rates from one compounding frequency into another.AppendixLO1
Understand the role that opportunity cost plays in the time value of money.AppendixLO1
Let PV be the present value of a growing perpetuity(the “time 1 perpetuity”) with an initial payment of C beginning one period from now and a growth rate of g. If we move all the cash flows back
How long will it take your money to double at an annualized interest rate of 8 percent compounded semiannually? How does your answer change if the interest rate is compounded annually?AppendixLO1
A30-year fixed-rate mortgage has monthly payments of $1,500 per month and a mortgage interest rate of 9 percent per year compounded monthly. If a buyer purchases a home with the cash proceeds of the
What is the annualized interest rate, compounded daily, that is equivalent to 10 percent interest compounded semiannually? What is the daily compounded rate that is equivalent to 10 percent
A self-employed investor who has just turned 35 wants to save for his retirement with a Keogh account. He plans to retire on his 65th birthday and wants a monthly income, beginning the month after
If r is the annually compounded interest rate, what is the present value of a deferred perpetuity with annual payments of C beginning t years from now?AppendixLO1
An investor is comparing a 30-year fixed-rate mortgage with a 15-year fixed-rate mortgage. The 15-year mortgage has a considerably lower interest rate. If the annualized interest rate on the 30-year
Graph the relation between the annually compounded interest rate and the present value of a zero-coupon bond paying $100 five years from today. Graph the relation between present value and years to
The value of a share of stock is the present value of its future dividends. If the next dividend, occurring one year from now, is $2 per share and dividends, paid annually, are expected to grow at 3
A 35-year-old employee, who expected to work another 30 years, is injured in a plant accident and will never work again. His wages next year will be$40,000. A study of wages across the plant found
Bob invests $1,000 in a simple interest account.Thirty months later, he finds the account has accumulated to $1.212.50.a. Compute the annualized simple interest rate.b. Compute the equivalent
A nine-month T-bill with a face value of $10,000 currently sells for $9,600. Calculate the annualized simple interest rate.AppendixLO1
Which of the following rates would you prefer:8.50 percent compounded annually, 8.33 percent compounded semiannually, 8.25 percent compounded quarterly, or 8.16 percent compounded continuously?
The treasurer of Small Corp. is considering the purchase of a T-bill maturing in seven months. At a rate of 9 percent compounded annually:a. Calculate the present value of the $10,000 face value
Daniela, a junior in high school, is considering a delivery program for a local grocery store to earn extra money for college. Her idea is to buy a used car and deliver groceries after school and on
Jones Inc. is considering a prospective project with the following future cash inflows: $9,000 at the end of year 1, $9,500 at the end of 15 months, $10,500 at the end of 30 months, and $11,500 at
If the future value of $10,000 today is $13,328, and the interest rate is 9 percent compounded annually:a. What is the holding period t (in years)?b. How does t change if the interest rate is 9
You have just won the California state lottery! As the winner, you have a choice of three payoff programs. Assume the interest rate is 9 percent compounded annually: (1) a lump sum today of$350,000
You need to insure your home over the next 20 years. You can either pay beginning-of-year premiums with today’s premium of $5,000 and future premiums growing at 4 percent per year, or prepay a lump
Your rich uncle has recently passed away and left you an inheritance in the form of a varying perpetuity. You will receive $2,000 per year from year 3 through year 14, $5,000 per year from year 15
You have just had a baby boy and you want to ensure the funding of his college education. Tuition today is $15,000, and it is growing at 4 percent per year. In 18 years, your son will enter a
Your financial planner has advised you to initiate a retirement account while you are still young. Today is your 35th birthday and you are planning to retire at age 65. Actuarial tables show that
You are considering a new business venture and want to determine the present value of seasonal cash flows. Historical data suggest that quarterly flows will be $3,000 in quarter 1, $4,000 in quarter
Assume that a homeowner takes on a 30-year,$100,000 floating-rate mortgage with monthly payments. Assume that the floating rate is 7.0 percent at the initiation of the mortgage, 7.125 percent is the
The Allied Corporation typically allocates expenses for CEO pay to each of its existing projects, with the percentage allocation based on the percentage of book assets that each project represents.
Assume that the analyst who developed Exhibit 9.1 simply forgot about inflation. Redo Exhibit 9.1 assuming 2 percent inflation per year, and 2 percent growth due to inflation in EBITDA, in column
Find the present value of the hydrogenerator’s unlevered cash flows for the revised exhibit you constructed in exercise 9.26. Assume a discount rate of 10 percent.AppendixLO1
Using the assumptions of exercise 9.26, provide inflation-adjusted figures for Exhibit 9.1.a. Compute the real discount rate if the nominal discount rate is 10 percent.b. Discount the
Compute ExxonMobil’s unlevered cash flow from its most recent financial statements.AppendixLO1
Comprehend why sunk costs do not affect the incremental cash flows for projects.AppendixLO1
Apply the net present value (NPV) criterion to evaluate riskless projects both when there are no constraints and when there are constraints that make projects mutually exclusive.AppendixLO1
Understand how value additivity relates to the proper application of NPV for project evaluation when projects are mutually exclusive.AppendixLO1
Understand the concept of Economic Value Added (EVA) and the relation between EVA and the NPV criterion.AppendixLO1
Compute hurdle rates for the internal rate of return (IRR) criterion when bond interest rates vary according to bond maturity.AppendixLO1
Apply the IRR criterion to evaluate projects and be able to distinguish cases for which it is possible to obtain appropriate evaluations with the IRR criterion from those that preclude proper
Your firm has recently reached an expansion phase and is seeking possible new geographic regions to market the newly patented chemical compound Glupto. The five regional projections are as follows:a.
The Wheatena Company is considering the purchase of a new milling machine. What purchase price makes the NPV of the project zero? Base your analysis on the following facts:• The new milling machine

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