1.(6 Points) Stock X and Stock Z both have an expected return of 10%.The standard deviation of the expected return is 8% for Stock X, and 12% for Stock Z.Assume that these are the only two stocks available in a hypothetical world.

A.Assume that the correlation between the returns of the two stocks is +1.

What is the expected return and standard deviation of a portfolio containing 50% X and 50% Z?

What is the optimal amount of Stock Z for an investor to hold in a portfolio (if the correlation is +1)?

B.Assume that the correlation between the returns of the two stocks is +0.1.

What is the expected return and standard deviation of a portfolio containing 50% X and 50% Z?

What is the optimal amount of Stock Z for an investor to hold in a portfolio (if the correlation is +0.1)?

C.Assume that the correlation between the returns of the two stocks is-1.

What is the expected return and standard deviation of a portfolio containing 50% X and 50% Z?

What is the optimal amount of Stock Z for an investor to hold in a portfolio (if the correlation is -1)?

D.If the Capital Asset Pricing Model is true, explain why it is possible for the two stocks to have the same expected return even though the standard deviation of the expected return is 8% for Stock X, and 12% for Stock Z.(What must be true about the types of risks facing the two companies for the given numbers to make sense?).

2.(3 Points) Assume that a stock is priced at $50 and pays an annual dividend of $2 per share.

A.Assume thatan investor purchases the stock on margin, paying $25 per share and borrowing the remainder from the brokerage firm at 9 percent annual interest.After one year, the investor sells the stock for $65.25 per share (after collecting the dividend).The percentage return on this investment was____.

B.Assume thatan investor purchases the stock paying 100% cash.After one year, the investor sells the stock for $65.25 per share (after collecting the dividend).The percentage return on this investment was _____.

C.Based upon your answers to Parts A and B, would you advise your clients to purchase stocks on margin, or to pay cash?

3.(5 Points) Explain why each of the five independent statements below is false. A good explanation should be between two and four sentences for each part.

If the market is efficient, it is unlikely that an investor will be able to double his or her money over the next 10 to 12 years.

A mutual fund manager is concerned that the value of a portfolio of Treasury Bonds (average maturity = 15 years) will decrease as interest rates increase over the next three months.To construct thebesthedge over this three-month period he should sell T-Bill futures contracts.

Stock A has a Beta of 1.75, Stock B has a Beta of 0.60.These betas make sense if Company A (Stock A) manufactures and sells prescription medications and Company B (Stock B) builds luxury homes.

If the stock market is semi-strong form efficient, historical earnings information - and other public accounting information - cannot help an analyst explain where a stock is currently trading within its 52 week range. (i.e., why the stock price is at the high end, the low end, or the middle of this range).

Purchasing a S&P 500 futures contract can be either an incredibly risky proposition or a very low risk investment.Unfortunately, it is impossible to differentiate between when the use of an S&P 500 futures contracts is risky and when it is not.

4.(2 Points) Boyd Company purchased a futures contract on Treasury bonds that specified a price of 93-20.When the position was closed out, the price of the Treasury bond futures contract was 92-00.

A.Did interest rates increase or decrease?How do you know?

B.What was Boyd's profit or loss from this contract (ignoring transaction costs)?

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5.(3 Points) A call option on an S&P 500 futures contract has an exercise price of 1490; the call premium is currently $6.50.On the same date, a put option on the S&P 500 futures contract has an exercise price of 1490; the put premium is currently $7.50.The two options have the same expiration date.

A.Is the current index value greater than or less than 1490?How do you know?

B.Assume that the S&P 500 index is 1485 at expiration:

Should thecall optionbe exercised or should it be left to expire?What is the net ($) gain or loss after accounting for the premium paid to purchase the option?

Should theput optionbe exercised or should it be left to expire?What is the net ($) gain or loss after accounting for the premium paid to purchase the option?

6.(2 Points) Two stocks (Stock J and Stock K) have the same current stock price, and the same standard deviation. There exists a call option on 100 shares of Stock J, a call option on 100 shares of Stock K, and a call option on a portfolio of 50 shares of J and 50 shares of K.All three call options have the same expiration date,and all three options are trading "at the money."Rank the three options based upon the size of the call premium (from highest call premium to lowest) in each of the following (independent) cases (explain briefly):

A.The correlation between the returns of the two stocks is +1

B.The correlation between the returns of the two stocks is 0

7.(1 Point) A treasury security will pay a $40 coupon one year from today, and is currently selling for $1,000.A one-year futures contract on this security currently locks in a price of $1,020.The risk free interest rate is 2%.Design a trading strategy using these securities that will earn an arbitrage profit (and calculate the arbitrage profit), or explain why this cannot be done.