Portfolio Tutorial

FACULTY OF ENGINEERING AND SCIENCE
UKFF3283 PORTFOLIO MANAGEMENT
== Tutorial 1 ==
1.
Objective:
This unit aims to present the issues and strategies needed to function in complex
global markets. This includes the investment terms and concepts as well as being able
to understand and apply many of the techniques used in analyzing and managing
investments. It aims at understanding the steps necessary to group different financial
assets into a portfolio to solve the asset allocation problem faced by investors, and
portfolio performance evaluation.
2.
Learning Outcomes:
Topic
Topic 1:
Introduction to
investing
Topic 2: Trading of
Securities:
- Market and
transactions
- Investment
information and
securities
transaction
Learning outcomes
Explain the principles of
investment and differentiate
the different types of
investments.
Explain the transactions in
money markets and capital
markets.
Describe the investment
process and types of
investors.
Explain the investment
process and types of
investors.
Explain the steps in investing,
investing over the life cycle
and in different economic
environments.
-1-
Differentiate the transactions

in money markets and capital
markets.
Explain the general
conditions of securities
markets.
Explain long purchases,
margin transaction, and short
sales.
Identify major types and
sources of traditional and
online investment
information.
Content
Investments and
the investment
process
Investment
vehicles
Making
investment
plans
Meeting
liquidity needs:
Investing in short
tem vehicles
Securities
markets
Globalization of
securities
markets
Trading hours
and regulation
of securities
markets
Basic types of
securities
transactions
Online investing

Explain the key aspects of the

commonly cited stock and
bond market averages and
indexes.
Describe the basic types of

orders, online transactions,
transaction costs, and legal
aspects of investor protection.
Topic 3: Return and

Risks:
- Introduction to
Financial calculators
Measure and analyze risk and

return of single asset and
portfolio using financial
calculators and interest factor
tables.
Explain the forces that affect
the level of return, and
historical returns.
Explain the key sources that
affect potential investment
vehicles.
Topic 4: Modern
Portfolio Concepts
Explain portfolio objectives

and the procedures used to
calculate portfolio return and
standard deviation.
Measure and analyze risk and
return of portfolios.
Explain the concepts of
correlation and
diversification.
Explain and measure required
rate of return using capital
asset pricing model.
Compare traditional portfolio
Types and
sources of
investment
information.
Understanding
market averages
and indexes
Making
securities
transactions
Investment
advisers and
investment
clubs
The concept of
return
The time value
of money
Measuring
return
Risk: The other
side of the coin
Interest: The
basic Return to
Savers
Computational
aids for use in
time value
calculations
Future value
Present value
Principles of
portfolio
planning
The Capital
Asset Pricing
Model (CAPM)
Traditional
versus modern
portfolio
management
Constructing a
portfolio using
asset allocation
-2-

Topic 5: Mutual
Fund: Professionally
Managed Portfolios
Topic 6: Managing
Your Own Portfolio
-3-
management with modern

portfolio theory.
Explain; measure and analyze
portfolio betas and the riskreturn tradeoff.
scheme
Explain the basic features of

mutual funds and how
diversification and
professional management are
the cornerstones of the
industry.
Explain and differentiate the
types of funds available and
the variety of investment
objectives these funds seek to
fulfill.
Analyze the factors to
consider when assessing and
selecting funds for
investment purposes.
Explain the sources of return
and compute the rate of
return earned on a mutual
fund investment.
Explain how the economic,

industry and company factors
affect investment decisions.
Develop a procedure for
building a portfolio using an
asset allocation scheme.
Explain the ways to use an
asset allocation scheme to
construct a portfolio
consistent with investor
objectives.
Analyze the investment
performance using data and
indexes.
Analyze the portfolios
performance using riskadjusted measures.
Explain the role and logic of
dollar-cost averaging,
constant-dollar plans,
constant-ratio plans, and
The mutual
fund concept
and
phenomenon
Types of funds
and services
Investing in
mutual funds
Investment
company
performance
Constructing a
portfolio using
an asset
allocation
scheme
Portfolio
planning in
action
Evaluating the
performance of
individual
investments
Assessing
portfolio
performance
Timing
transactions

variable-constant plans.
Topic 7: Investing
Common Stock
Explain the basic features of

common stocks.
Differentiate the different
kinds of common stock
values.
Explain common stock
dividends; differentiate types
of dividends and dividends
reinvestment plans.
Compare and contrast various
types of common stocks.
Analyze and apply the
theories surrounding
investment, and be able to
make investment decisions.
Explain the security analysis.
Ensure financial ratios to
gauge the financial vitality of
a company.
Topic 8: Stock
valuation
Explain the role that a

companys future plays in the
stock valuation process and
use various models to value
equity instruments.
Develop a forecast of a
stocks expected cash flow,
starting with corporate sales
and earnings, and then
moving to expected dividends
and share price.
Explain and apply the
concepts of intrinsic value
and required return.
Differentiate and measure the
underlying value of a stock
using the zero-growth,
constant-growth and variablegrowth dividend valuation
models.
Differentiate and measure the
What stocks
have to offer?
Basic
characteristics
of common
stock
Common stock
dividends
Types and uses
of common
stock
Analyzing and
managing
common stocks
Security
analysis
Economic
analysis
Industry
analysis
Fundamental
analysis
Valuation:
Obtaining a
standard of
performance
Preferred Stock
valuation
models
Common Stock
valuation
models
-4-

Topic 9: Technical
Analysis, Market
Efficiency and
Behavioral Finance
Topic 10: Fixed

Income Securities
-5-
intrinsic value of a stock

using present-value based
models and price-relative
procedures.
Explain and analyze the
technical condition of the
market using technical
analysis.
Explain the random walks
and efficient markets.
Differentiate efficient market
hypothesis and market
anomalies.
Explain how the
psychological factors can
affect investors decision and
challenge the concept of
market efficiency.

attributes of bonds and their
use as investment vehicles.
Describe the essential
features of a bond and the
roles of bond ratings.
Analyze components of bond
returns and types of risk to
which bond investors are
exposed, and use various
models to value debt
instruments.
Explain how bonds are priced
in the market and analyze the
volatility of bonds.
Differentiate the types of
bonds and kinds of
investment objectives these
securities can fulfill.
Technical
analysis
Random walks
and efficient
markets
Behavioral
finance: A
challenge to the
efficient market
hypothesis
Why invest in
bonds?
Essential
features of a
bond
The market for
debt securities
Convertible
securities
Trading bonds

Topic 11: Bond

Valuation
Topic 12: Options:

Puts and Calls
Topic 13:
Commodities and
Financial Futures
Explain the behavior of

market interest rates, and
identify the forces that cause
interest rate to change.
Describe the term structure of
interest rates, and how yield
curves can be used by
investors.
Analyze components of bond
returns and types of risk to
which bond investors are
exposed, and use various
models to value debt
instruments.
Calculate and analyze value
of bonds in the market place.
Explain and measure yield
and return of bonds.
Explain the concepts of
duration and various bond
investment strategies.

attributes of options (puts and
calls) and their use as
investment vehicles.
Analyze the risk and return
behavior of various put and
call investment strategies.
Explain and measure the
profit potential of puts and
calls from option holders and
writers perspectives.
Explain the ways to use
options as a strategy for
enhancing investment returns.

attributes of futures and their
use as investment vehicles.
Explain the role that hedgers
and speculators play in the
futures market.
The futures
market
The mechanics of
trading
Commodities
The behavior of
market interest
rates
The pricing of
bonds
Measures of
yield and return
Duration and
immunization
Bond
investment
strategies
Analysis and
management of
bonds
Put and call

options
Options pricing
and trading
Stock index
and other types
of options
Warrants
An investors
perspective on
puts and calls
-6-

3.
Differentiate commodity and

financial futures.
Discuss the trading

techniques that can be used
with financial and commodity
futures.
Financial futures
Reading List
Main Text Book:

1. Smart, S.B., Gitman, L.J. & Joehnk, M.D. (2014). Fundamentals of Investing.
(12th ed.). U.S.A: Pearson/Prentice Hall.
Supplementary Reading:
1. Bodie, Z., Kane, A., Marcus, A. & Jain, R. (2014). Investments AGE (Asia Global
Edition). Singapore: McGraw Hill/Irwin.
2. Jones, C.P. (2013). Investments: Principles and Concepts. (12th ed.). Singapore:
John Wiley & Sons.
3. Reilly, F.K. & Brown, K.C. (2012). Analysis of Investments & Management of
Portfolios (10th ed.). Canada: South-Western/Cengage Learning.
4.
Method of Assessment
Coursework (40% of Total Assessment) with the following specification:

Components of
Coursework
a. Mid-Term Test
b. Group Assignment
Total
Marks
100 marks
100 marks
200 marks
Weightage of Total
Assessment
20%
20%
40%
Final Examination (60% of Total Assessment)

5.
Reminder
-7-
Mid-term test: WEEK 9, 21st July, 2014 (Monday).

Assignment hand-in date: Week 11, ending 5th August, 2014 (Tuesday).

== Tutorial 2 (Topic 1) ==
1.1
1.2
1.5
1.6
1.7
Learning Outcome: Explain the meaning of investment

Define the term investment, and explain why individuals invest.
Any vehicle into which funds can be placed with the expectation that it will
generate positive income and/or that its value will be preserved or increased
Learning Outcome: Identify the factors used to differentiate types of
investments
Differentiate among the following types of investments, and cite an
example of each: (a) securities and property investments; (b) direct and
indirect investments; (c) debt, equity, and derivative securities; and (d)
short-term and long-term investments.
a) Securities are stocks, bonds and options, real property are land buildings,
tangible personal property are gold, artwork and antiques
b) Direct means investor directly acquire a claim, eg: stock market, indirect
means investors owns and interest in a professionally managed collection
of securities or properties, eg: mutual fund
c) Debt means investor lends funds in exchange for interest income and
repayment of loan in future (bonds), equity represents ongoing ownership
in a business or property (common stocks), derivative securities is neither
debt nor equity, derive value from an underlying asset (options)
d) Short term means mature within one year (money market), long term
means maturities of longer than one year ( capital market)
Learning Outcome: Describe the investment process
Describe the structure of the overall investment process. Explain the role
played by financial institutions and financial markets.
Suppliers of funds (individuals) deposit money to financial market and
financial institution and the money is then borrowed to demanders of funds
(government, business)
Learning Outcome: Describe types of investors
Classify the role of (a) government, (b) business, and (c) individuals as net
suppliers or net demanders of funds.
a) Demanders of funds, federal, state and local projects & operations
b) Demanders of funds, investments in production of goods and services
c) Suppliers of funds, some need for loans
Learning Outcome: Describe types of investors
Differentiate between individual investors and institutional investors.
Individual investors: invest for personal finance goal
Institutional investors: paid to manage other peoples money, trade large
volume of securities, include banks, life insurance companies, mutual funds
and pension funds
Learning Outcome: Describe the steps in investing
-8-

1.11
1.12
1.14
1.16
-9-
What should an investor first establish before developing and executing

an investment program? Briefly describe each of the seven steps involved
in investing.
1) Meeting Investment prerequisites
2) Establishing investment goals
3) Adopting an investment plan
4) Evaluating investment vehicles
5) Selecting suitable investments
6) Constructing a diversified portfolio
7) Managing the portfolio
Learning Outcome: Describe the steps in investing
What are four common investment goals?
1) accumulating retirement funds
2) enhancing current income
3) Saving for major expenditures
4) Sheltering income from taxes
Learning Outcome: Discuss investing over the life cycle
Describe the differing investment philosophies typically applied during
each of the following stages of an investors life cycle.
a) Youth (ages 20 to 45)
Growth-oriented investment, higher potential growth; higher potential risk,
stress capital gains over current income. Common stocks, options or
futures
b) Middle age (ages 45 to 60)
Family demands & responsibilities become important (edu expenses,
retirement savings), move towards less risky investments to preserve
capital, transition to higher-quality securities with lower risk. Low-risk
growth and income stocks, preferred stocks, convertible stocks, high grade
bonds
c) Retirement years (age 60 on)
Preservation of capital becomes primary goal, highly conservative
investment portfolio, current income needed to supplement retirement
income. Low-risk income stocks and mutual funds, government bonds,
quality corporate bonds, bank certificates of deposit
Learning Outcome: Identify the short-term investment vehicles
What makes an asset liquid? Why hold liquid assets? Would 100 shares of
IBM stock be considered a liquid investment? Explain.
The ability of the asset to be converted into cash quickly with little or no loss
in value. For emergency cash reserve or to save for a specific short-term
financial goal. No, because it might take time to be sold on the stock market
and its value is not stable, depending on market

Learning Outcome: Discuss investing over the life cycle

Q1.1 Assume that you are 35 years old, are married with two young children,
are renting a condo, and have an annual income of $90,000. Use the
following questions to guide your preparation of a rough investment plan
consistent with these facts.
a) What are your key investment goals?
b) How might your stage in the life cycle affect the types of risk you
might take?
Case Problem 1.1 Investments or Golf?
Judd Read and Judi Todd, senior accounting majors at a large Midwestern
university, have been good friends since high school. Each has already found a
job that will begin after graduation. Judd has accepted a position as an internal
auditor in a medium-sized manufacturing firm. Judi will be working for one of
the major public accounting firms. Each is looking forward to the challenge of a
new career and to the prospect of achieving success both professionally and
financially.
Judd and Judi are preparing to register for their final semester. Each has one
free elective to select. Judd is considering taking a golf course offered by the
physical education department, which he says will help him socialize in his
business career. Judi is planning to take a basic investments course. Judi has
been trying to convince Judd to take investments instead of golf. Judd believes he
doesnt need to take investments, because he already knows what common stock
is. He believes that whenever he has accumulated excess funds, he can invest in
the stock of a company that is doing well. Judi argues that there is much more to
it than simply choosing common stock. She feels that exposure to the field of
investments would be more beneficial than learning how to play golf.
Questions
Learning Outcome: Describe the investment process
a. Explain to Judd the structure of the investment process and the economic
importance of investing
Learning Outcome: Discuss the principal types of investment vehicles
b. List and discuss the other types of investment vehicles with which Judd is
apparently unfamiliar.
Learning Outcome: Discuss the meaning of investment
c. Assuming that Judd already gets plenty of exercise, what arguments
would you give to convince Judd to take investments rather than golf?
- 10 -

2.1
2.11
2.12
Learning Outcome: Differentiate different securities markets

Differentiate between each of the following pairs of terms
a) Money market and capital market
Short-term securities are traded in the money market (T-bills and bankers
acceptance)
Long-term securities are traded in capital markets. (stocks & bonds)
b) Primary market and secondary market
A new security is issued in the primary market (IPO)
After it has been issued, it is sell and buy in the secondary market.
(BURSA)
Learning Outcome: Explain long purchases, margin transaction, and short
sales.
What is a long purchase? What expectation underlies such a purchase?
What is margin trading, and what is the key reason why investors
sometimes use it as part of a long purchase?
When an investor purchases a security in the hope that it can be sold later for a
profit, the investor is making a long purchase. The long purchase, is the
difference between the purchase price and the sale price. (to get current
income and capital gain)
Margin trading involves buying securities in part with borrowed funds.
Therefore, investors can use margin to reduce their money and use borrowed
money to make a long purchase. When the investment gain money, they will
use the profit to pay off the loan.
sales.
How does margin trading magnify profits and losses? What are the key
advantages and disadvantages of margin trading?
When buying on margin, the investor puts up part of the required capital. The
investors broker then lends the rest of the money required to make the
transaction. Financial leverage is created when the investor purchases stocks
or other securities on margin.
Through leverage, an investor can increase the size of his or her total
investment, or purchase the same investment with less of his or her own funds.
Either way, the investor increases the potential rate or return. Both profits and
losses are magnified using leverage.
Advantages: Margin trading provides the investor leverage and the ability to
magnify potential profits. It can also be used to improve current.
Disadvantages: Greater leverage comes greater risk. High interest rates on the
debit balance, which mean that return is lower
sales.
- 11 -

2.14
2.16
P2.6
What is the primary motive for short selling? Describe the basic shortsale procedure. Why must the short seller make an initial equity deposit?
An investor attempting to profit by selling short intends to sell high and buy
low. The investor borrows shares and sell them, hoping to buy them back
later and return to the lender. Short sales are regulated by the SEC and can be
executed only after a transaction where the price of the security rises. Equity
capital must be put up by a short seller; the amount is defined by an initial
margin requirement that designates the amount of cash the investor must
deposit with a broker. The margin and proceeds of the short sale provide the
broker with assurance that the securities can be repurchased at a later date,
even if their price increases.
sales.
Describe the key advantages and disadvantages of short selling. How are
short sales used to earn speculative profits?
Advantage: the chance to convert a price into a profit-making situation. The
technique can also be used to protect profits already earned and to defer taxes
on those profits
Disadvantage: High risk exposure in the face of limited return opportunities.
Short sellers never earn dividends, but must pay them as long as the
transaction is outstanding.
Speculative profits. The investor is betting against the market, which involves
considerable risk exposure. If the market moves up instead of down, the
investor could lose all the short sale proceeds and margin.
sales.
Elmo Inc.'s stock is currently selling at $60 per share. For each of the
following situations (ignoring brokerage commissions), calculate the gain
or loss that Maureen Katz realizes if she makes a l00-share transaction.
a. She sells short and repurchases the borrowed shares at $70 per share.
A loss of $1000. ($6000-$7000)
The short sale gain is $6000, while the replacement of the shares cost her
$7000
b. She takes a long position and sells the stock at $75 per share.
A profit of $1500. ($6000+$7500)
The long position would initially cost her 6000 but gain $7500 when she
sells at $75 per share
c. She sells short and repurchases the borrowed shares at $45 per share.
A profit of $1500. ($6000-$4500)
The short sale brings in $6000, while return of the shares to the owner
costs only $4500
d. She takes a long position and sells the stock at $60 per share.
A breakeven situation. The long position costs $6000 and the sale of the
stock brings in $6000, thereby providing neither a profit nor a loss
- 12 -

sales.
P2.10 James purchased 100 shares of CantWin.com for $50 per share, using as
little of his own money as he could. His broker has a 50% initial margin
requirement and 30% maintenance margin requirement. This price of the
stock falls to $30 per share. What does James need to do?
James needs to cover a margin call.
Margin = (value of securities debit balance)/value of securities
Debit balance = amount borrowed in the transaction
= value of securities (margin x value of securities)
His new margin is 16.7% = ($3000-$2500)/$3000, below the 30%
maintenance requirement
Value of securities = $30 x 100 = $3000
Old debit balance = $5000 (0.5x$5000) = $2500
New debit balance = $3000 (0.3x$3000) = $2100
In order to get back to the maintenance margin requirement of 30%, James
must top up the difference between the old and new debit balance which is
$400

sales.
P2.17 An investor short sells 100 shares of a stock for $20 per share. The initial
margin is 50%, and the maintenance margin is 30%. The price of the
stock falls to $12 per share. What is the margin, and will there be a
margin call?
Margin = (value of securities debit balance / value of securities
= Account equity / calue of securities at purchase
Value of securities at purchase = $1200
Value of securities at sale = $2000
Account equity = margin deposit of $1000 + net proceeds from the short sale
= $1000 + ($2000-$1200)
= $1800
The new margin 1800/1200 = 150%
Since the margin of 150% is far above the maintenance margin of 30%, there is no
margin call.
Learning Outcome: Explain long purchases, margin transaction, and short sales.
Case Problem 2.1
Daras Dilemma: What to Buy?
Dara Simmons, a 40-year-old financial analyst and divorced mother of two
teenage children, considers herself a savvy investor. She has increased her
investment portfolio considerably over the past 5 years. Although she has been
- 13 -

fairly conservative with her investments, she now feels more confident in her
investment knowledge and would like to branch out into some new areas that
could bring higher returns. She has between $20,000 and $25,000 to invest.
Attracted to the hot market for technology stocks, Dara was interested in
purchasing a tech IPO stock and identified "NewestHighTech.com," a company
that make sophisticated computer chips for wireless Internet connections, as a
likely prospect. The 1-year-old company had received some favorable press when
it got early-stage financing and again when its chip was accepted by a major cell
phone manufacturer.
Dara also was considering an investment in 400 shares of Casinos International
common stock, currently selling for $54 per share. After a discussion with a
friend who is an economist with a major commercial bank, Dara believes that the
long-running bull market is due to cool off and that economic activity will slow
down. With the aid of he stockbroker, Dara researches Casinos International's
current financial situation and finds that the future success of the company may
hinge on the outcome of pending court proceedings on the firm's application to
open a new floating casino on a nearby river. If the permit is granted, it seems
likely that the firm's stock will experience a rapid increase (in value, regardless
of economic conditions. On the other hand, if the company fails to get the permit,
the falling stock price will make it a good candidate for a short sale.
Dara felt that the following alternatives were open to her:
Alternative 1: Invest $20,000 in NewestHighTech.com when it goes public.
Alternative 2: Buy Casinos International now at $54 per share and follow the
company closely.
Alternative 3: Sell Casinos short at $54 in anticipation that the company's
fortunes will change for the worse.
Alternative 4: Wait to see what happens with the casino permit and then decide
whether to buy or short the Casinos International stock.
Questions
a. Evaluate each of these alternatives. On the basis of the limited information
presented, recommend the one you feel is best.
Alternative 4
b. If Casinos International's stock price rises to $60, what will happen under
alternatives 2 and 3? Evaluate the pros and cons of these outcomes.
Alternative 2: the stock should be sold, yielding a total profit of
$2,400 ($6 per share 400 shares). A disadvantage of Alternative 2 is that if the
stock price had risen to, say, $59 and then fallen, the order would not have been
executed.
- 14 -

Alternative 3: the stop-loss order would not have been executed. Alternative 3 would
have helped Dara minimize her losses in the event of a price decline.
c. If the stock price drops to $45, what will happen under alternatives 2 and 3?
Evaluate the pros and cons of these outcomes.
Alternative 2: would be meaningless, and the limit order would expire unexecuted. If
any sale then would bring in approximately $18,000 (400 shares $45 per share).
Thus, Daras loss would be held to $3,600 (400 shares $54 per share 400 shares
$45 per share).
Alternative 3: the loss could be greater if the price fell below $45 before the sell
order was actually executed.
Learning Outcome: Describe the basic types of orders, and online transactions.
Differentiate among market orders, limit orders, and stop-loss orders. What
is the rationale for using a stop-loss order rather than a limit order?
market order
an order to buy or sell a security at the best price available when order is
placed
fastest way to make transactions.
limit order
an order to buy stock at or below or to sell stock at or above a specified price
If price limits are not met, order will not be executed
stop-loss order
Suspended order is placed to sell a stock if price reaches or falls below a
specific level
used to protect investors from stock price decline
Once activated, becomes a market order
The stop-loss order gives them the opportunity to sell the stock when
the price declines to the stop price, thereby reducing their potential losses
3.15
3.16
- 15 -
What is day trading, and why is it risky? How can you avoid problems as
an online trader?
Day Trader:
an investor who buys and sells stocks quickly throughout the day in hopes of
making quick profits, it is risky because it often used with margin trading and
high brokerage commissions due to frequent trading
slide 2-32
Know how to place and confirm orders
Verify stock ticker symbols
Use limit orders
Check and recheck ordersyou pay for typos
Dont get carried away
Follow a strategy

Dont churn
Avoid or limit margin orders
Open accounts with two brokers
Double-check orders for accuracy after completion
P3.6 Imagine that you have placed a limit order to buy 100 shares of Sallisaw
Tool at a price of $38, though the stock is currently selling for $41. Discuss
the consequences, if any, of each of the following.
a. The stock price drops to $39 per share 2 months before cancellation of
the limit order.
The limit order will be executed only if the stock price falls to $38 or less
than $38, thus, the order will not be executed.
b. The stock price drops to $38 per share.
The order will be executed, your broker will buy 100 shares of Sallisaw
Tool stock with $38 per share, total costs is $3800
c. The minimum stock price achieved before cancellation of the limit
order was $38.50. When the limit order was canceled, the stock was
selling for $47.50 per share.
Since the stock price is more than $38, the order will not be executed. If
you buy the stock at $41 per share instead of placing the order limit, you
can now sell it at $47.50 per share, earning $6.5 per share with total profit
of $650
P3.7 If you place a stop-loss order to sell at $23 on a stock currently selling for
$26.50 per share, what is likely to be the minimum loss you will
experience on 50 shares if the stock price rapidly declines to $20.50 per
share? Explain. What if you had placed a stop-limit order to sell at $23,
and the stock price tumbled to $20.50?
Minimum loss = $3.5/share, total minimum loss = $175 ($3.5*50)
When the stock price falls to $23, the stop-loss order is converted to market
order to sell at best price available at that time. For stop limit order, if the
stock price drop to $20.50, the loss would be $6 per share or in total $300.
P3.8
You sell 100 shares of a stock short for $40 per share. You want to limit
your loss on this transaction to no more than $500. What order should
you place?
Stop-loss order to buy shares at $45/share. (limit your loss not more than
$5/share)
- 16 -

P3.9
- 17 -
You have been researching a stock that you like, which is currently
trading at $50 per share. You would like to buy the stock if it were a little
less expensive - say, $47 per share. You believe that the stock price will go
to $70 by year-end, and then level off or decline. You decide to place a
limit order to buy 100 shares of the stock at $47, and a limit order to sell it
at $70. It turns out that you were right about the direction of the stock
price, and it goes straight to $75. What is your current position?
Since the stock did not fall to the limit order buy price, so it will not be
executed, you are not buying it. However, you sold it at $70 per share. Since
the stock is currently selling for $75, you loss $5/share, total loss = $500

4.1
4.3
4.6
4.9
4.10
Learning Outcome: Review the concept of return and its components.

Explain what is meant by the return on an investment. Differentiate
between the two components of return current income and capital gains
(or losses).
Return is the level of profit from an investment or the reward of investing.
Total return is the sum of the current income and the capital gain (or loss)
earned on an investment over a specified period of time.
Current income is cash or near cash that is received as a result of owning an
investment.
Capital gains is the difference between the proceeds from the sale of an
investment and its original purchase price
Learning Outcome: Define a satisfactory investment.
What is a satisfactory investment? When the present value of benefits
exceeds the cost of an investment, what is true of the rate of return earned
by the investor relative to the discount rate?
Satisfactory investment is one for which the present value of benefits equals or
exceed the present value of its costs.
When PV inflow > PV outflow, net PV is positive.
This IRR > discount rate
Hence acceptable (satisfactory) investment.
Learning Outcome: Explain the concept of yield.
Define yield (internal rate of return). When is it appropriate to use yield
rather than the HPR to measure the return on an investment?
IRR determines the compound annual rate of return earned on an investment
held for longer than one year. For long term investment.
Learning Outcome: Discuss the key sources of risk.
Define risk. Explain what we mean by the risk-return tradeoff. What
happens to the required return as risk increases? Explain.
Risk is the chance that the actual return from an investment may differ from
what is expected. Risk-return tradeoff is the relationship between risk and
return, in which investments with more risk should provide higher return and
vice versa. Return should be higher as risk increases.
Learning Outcome: Discuss the key sources of risk.
Define and briefly discuss each of the following sources of risk.
a) Business risk
Degree of uncertainty associated with an investments earnings and the
investments ability to pay the returns owed to investors. Types of
investments affected are common stocks and preferred stocks. Examples:
decline in company profits or market share
b) Financial risk
Degree of uncertainty of payment resulting from a firms mix of debt and
equity; the larger the proportion of debt financing, the greater the risk.
- 18 -

c)
d)
e)
f)
g)
P4.4
- 19 -
Types of investments affected are common stocks and corporate bonds.

Example: company cant get additional loans for growth or to fund
operations
Purchasing power risk
Chance that changing price levels (inflation or deflation) will adversely
affect investment returns. Types of investments affected are bonds (fixed
income) and fixed deposits. Example: Movie that was RM8 last year is
RM9 this year
Interest rate risk
Chance that changes in interest rates will adversely affect a securitys
value. Types of investments affected are bonds(fixed income) and
preferred stocks. Example: market value of existing bonds decreases as
market interest rates increase.
Liquidity risk
Risk of not being able to liquidate an investment conveniently and at a
reasonable price. Affects all types of investments. Example: Decrease in
value of insurance company stock after a major hurricane.
Market risk
Risk of decline in investment returns because of market factors
independent of the given investment. Affects all types of investments.
Example: changes in economic conditions.
Event risk
Unexpected event that has a significant and unusually immediate effect on
the underlying value of an investment. Affects all types of investments.
Example: decrease in value of real estate after a major earthquake
Learning Outcome: Review the concept of return and its components.

Assume you purchased a bond for $9,500. The bond pays $300 interest
every 6 months. You sell the bond after 18 months for $10,000. Calculate
the following:
a. Current income.
$300x3 = $900
b. Capital gain or loss.
$10000-$9500 = $500
c. Total return in dollars and as a percentage of the original investment.
Total return in dollars = dividend income + capital gain / beginning
investment
= (900+500)/9500 = 14.74%

Learning Outcome: Calculation and application of holding period return
P4.10 You are considering two investment alternatives. The first is a stock that
pays quarterly dividends of $0.50 per share and is trading at $25 per
share; you expect to sell the stock in 6 months for $27. The second is a
stock that pays quarterly dividends of $0.60 per share and is trading at
$27 per share; you expect to sell the stock in 1 year for $30. Which stock
will provide the better annualized holding period return?
Investment 1:
Dividend = $0.50 * 2 = $1
Capital gain = 27-25 = $2
Holding period return = (1+2) / 25 = 0.12
Annualized holding period return = 0.12 * 2 = 0.24 = 24%
Investment 2:
Dividend = $0.60 * 4 = $2.40
Capital gain = 30-27 = $3
Holding period return = (2.40+3) / 27 = 0.2
Annualized holding period return = 0.2 * 1 = 0.20 = 20%
Therefore, the first option is better because it provides better annualized
holding period return.
Learning Outcome: Calculation of yield
P4.14 Your friend asks you to invest $10,000 in a business venture. Based on
your estimates, you would receive nothing for 4 years, at the end of years
5 you would receive interest on the investment compounded annually at
8%, and at the end of year 6 you would receive $14,500. If your estimates
are correct, what would be the yield on this investment?
Interest = 10000 (1+0.08 )5 - 10000 = 4693.28
IRR = 12.02%
Learning Outcome: Calculation of yield
P4.18 Elliott Dumack must earn a minimum rate of return of 11% to be
adequately compensated for the risk of the following investment.
Initial Investment
End of Year
1
2
3
4
5
$14,000
Income
$ 6,000
3,000
5,000
2,000
1,000
a. Use present-value techniques to estimate the yield on this investment.

IRR = 8.85%
b. On the basis of your finding in part a, should Elliott make the proposed
investment? Explain.
No, because IRR < min. rate of return
- 20 -

Learning Outcome: Assess the risk of assets
P 4.23 The historical returns for two investments A and B are summarized in
the table below for the period 2004 to 2008. Use the data to answer the
questions that follow.
Investment_____
Year
A
B
2004
19%
8%
2005
1
10
2006
10
12
2007
26
14
2008
4
16
Average
12%
12%
a. On the basis of a review of the return data, which investment appears
to be more risky? Why?
A has 2 outliers (1% and 4%) compared to B.
A has a larger percentage range of return than B
b. Calculate the standard deviation and the coefficient of variation for
each investments returns.
Std deviation of A = 10.416%
Std deviation of B = 3%
Coefficient of Variation of A = 0.868
Coefficient of Variation of B = 0.25
c. On the basis of your calculations in part b, which investment is more
risky? Compare this conclusion to your observation in part a.
A is more risky than B : Std dev A > B, CV A > CV B
d. Does the coefficient of variation provide better risk comparison than
the standard deviation in the case? Why or why not?
No. Since both have the same expected return and CV is useful in
comparing risks of assets with differing expected return.
Learning Outcome: Apply the concept of time value of money & calculation of yield
Case Problem 4.1 Solomons Decision
Dave Solomon, a 23-year-old mathematics teacher at Xavier High School,
recently received a tax refund of $1,100. Because Dave didn't need this money for
his current living expenses, he decided to make a long-term investment. After
surveying a number of alternative investments costing no more than $1,100,
Dave isolated 2 that seemed most suitable to his needs.
Each of the investments cost $1,050 and was expected to provide income over a
10-year period. Investment A provided a relatively certain stream of income.
Dave was a little less certain of the income provided by investment B. From his
search for suitable alternatives, Dave found that the appropriate discount rate
for a relatively certain investment was 12%. Because he felt a bit uncomfortable
with an investment like B, he estimated that such an investment would have to
provide a return at least 4% higher than investment A. Although Dave planned
to reinvest funds returned from the investments in other vehicles providing
- 21 -

similar returns, he wished to keep the extra $50 ($1,100 - $1,050) invested for the
full 10 years in a savings account paying 5% interest compounded annually.
As he makes his investment decision, Dave has asked for your help in answering
the questions that follow the expected return data for these investments.
Year
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
Expected Returns
A
B
$ 150
$100
150
150
150
200
150
250
150
300
150
350
150
300
150
250
150
200
1,150
150
Questions
a. Assuming that investments A and B are equally risky and using the 12%
discount rate, apply the present-value technique to assess the acceptability of
each investment and to determine the preferred investment. Explain your
findings.
NPV A = 119.51
NPV B = 164.74
Hence, investment B is preferred as NPV of investment B is higher than NPV of
investment A
b. Recognizing that investment B is more risky than investment A, reassess the 2
alternatives, adding the 4% risk premium to the 12% discount rate for
investment A and therefore applying a 16% discount rate to investment B.
Compare your findings relative to acceptability and preference to those found for
question a.
NPV A = -98.33
NPV B = -30.63
Hence, both investments are not acceptable, never invest in projects which has
negative NPV.
c. From your findings in questions a and b, indicate whether the yield for
investment A is above or below 12% and whether that for investment B is above
or below 16%.
Explain.
Since the investment A is acceptable at 12%, its yield should be above 12%.
Since the investment B is acceptable at 12%, its yield should be above 12%.
However, the yield of investment should be below 16% because the PV of benefit is
less than the cost. Its yield should be at 15.31.
- 22 -

d. Use the present-value technique to estimate the yield on each investment.
Compare your findings and contrast them with your response to question c.
Investment A = 14.04
Investment B = 15.31
For A, yield > 12% = 14.04%
For B, yield < 16% = 15.31%
e. From the information given, which, if either, of the two investments would you
recommend that Dave make? Explain your answer.
Investment A. This is because the IRR of investment is 14.04 which is higher than the
expected 12% rate.
f. Indicate to Dave how much money the extra $50 will have grown to by the end
of 2018, assuming he makes no withdrawals from the savings account.
- 23 -

Learning Outcome: Discuss the concepts of correlation and diversification
What is correlation, and why is it important with respect to asset returns?
Describe the characteristics of returns that are (a) positively correlated,
(b) negatively correlated, and (c) uncorrelated. Differentiate between
perfect positive correlation and perfect negative correlation.
Correlation is a statistical measure of the relationship between two series of
numbers representing data. It combines two assets to reduce overall risk in our
portfolio.
a) Positively correlated both assets returns move in same direction
b) Negatively correlated both assets returns move in opposite direction
c) Uncorrelated two series that lack any relationship and have a correlation
coefficient of nearly zero
5.3
Perfect positive correlation two positively correlated series having a

correlation coefficient of +1
Perfect negative correlation two negatively correlated series having a
correlation coefficient of -1
Learning Outcome: Discuss the concepts of correlation and diversification
What is diversification? How does the diversification of risk affect the
risk of the portfolio compared to the risk of the individual assets it
contains?
Diversification is a process of risk reduction achieved by including in the
portfolio a variety of vehicles having returns that are less than perfectly positive
correlated with each other. The goal is to reduce overall risk in a portfolio.
It allows investor to reduce the risk by combining negatively correlated assets so that
the risk of the portfolio is less than the risk of the individual assets.
5.4
5.7
Learning Outcome: Describe the components of risk and the use of beta to
measure risk
Briefly define and give examples of each of the following components of
total risk. Which is the relevant risk, and why?
(a) Diversifiable risk
(b) Nondiversifiable risk
a) Diversifiable risk is the results from uncontrollable or random events that
are firm-specific. It can be eliminated through diversification. Examples are
labor strikes and lawsuits.
b) Nondiversifiable risk is also known as relevant risk/market risk. It is
attributable to forces that affect all similar investments. It cannot be eliminated
through diversification. Examples are war, inflation, political events. It is
considered the only relevant risk because diversifiable (unsystematic) risk can
be removed by creating a portfolio of assets which are not perfectly positively
correlated or through diversification.
Learning Outcome: Describe the components of risk and the use of beta to
measure risk
- 24 -

5.8
5.12
5.13
- 25 -
Explain what is meant by beta. What is the relevant risk measured by

beta? What is the market return? How is the interpretation of beta
related to the market return?
Beta is a measure of systematic risk. It indicates how the price of a security
responds to market forces and compares historical return of an investment to
the market return. The higher the beta, the riskier the security.
The relevant risk measured by beta is the nondiversifiable risk of an
investment since the investor can eliminate the unsystematic risk by holding a
diversified portfolio of securities.
Market return is measured by the average return of all stocks.
Beta for the overall market is the benchmark beta and is 1.0. The positive or
negative sign on a beta indicates whether the stocks return changes in the
same direction as the general market or opposite direction. Stocks with betas
greater than 1.0 are more risky than the overall market and vice versa.
Learning Outcome: Review the traditional & modern approaches to portfolio
management
Describe traditional portfolio management. Give three reasons why
traditional portfolio managers like to invest in well-established
companies.
Traditional portfolio management emphasizes balancing the portfolio using
a wide variety of stocks or bonds. The three reasons are:a) perceived as less risky
b) stocks are more liquid and available in large quantities
c) familiarity provides higher comfort levels for investors
Learning Outcome: Review the traditional & modern approaches to portfolio
management
What is modern portfolio theory (MPT)? What is the feasible or
attainable set of all possible portfolios? How is it derived for a given
group of investment vehicles?
MPT emphasizes statistical measures to develop a portfolio plan. It focuses on
expected returns, standard deviation of returns and correlation between
returns. It combines securities with negative or low positive correlation to
reduce risk through diversification.
The feasible or attainable set of all possible portfolios refers to the risk-return
combinations achieved with all possible portfolios. It is derived by calculating
the return and risk of all possible portfolios and then plotting them on a set of
risk-return axes.

5.14
P5.3
Learning Outcome: Describe risk-return tradeoff of portfolio

What is efficient frontier? How is it related to the attainable set of all
possible portfolios? How can it be used with an investors utility function
to find the optimal portfolio?
Efficient frontier is the site of all efficient portfolios (with the best risk-return
tradeoff). All portfolios on the efficient frontier are preferable to the others in
the feasible or attainable set.
Investors utility function is plotted on the graph with the feasible or attainable
set of portfolios indicate the investors optimal portfolio (curve meets the
efficient frontier). This represents the highest level of satisfaction for that
investor
Learning Outcome: Calculate portfolio return and standard deviation,
correlation
Assume you are considering a portfolio containing two assets, Land M.
Asset L will represent 40% of the dollar value of the portfolio, and asset
M will account for the other 60%. The expected returns over the next 6
years, 2009-2014, for each of these assets are summarized in the following
table.
Year
2009
2010
2011
2012
2013
2014
Expected Return (%)

Asset L
Asset M
14
20
14
18
16
16
17
14
17
12
19
10
- 26 -

a. Calculate the expected portfolio return, rp, for each of the 6 years.
Expected Return (%)
Portfolio return calculation
Expected portfolio return
Year
Asset L
Asset M
2009
14
20
(0.4x14%)+(0.6x20%)=
17.6%
2010
14
18
(0.4x14%)+(0.6x18%)=
16.4%
2011
16
16
(0.4x16%)+(0.6x16%)=
16%
2012
17
14
(0.4x17%)+(0.6x14%)=
15.2%
2013
17
12
(0.4x17%)+(0.6x12%)=
14%
2014
19
10
(0.4x19%)+(0.6x10%)=
13.6%
b. Calculate the average expected portfolio return, r p, over the 6-year

period.
The average expected portfolio return,
=
over the 6-year period

= 15.47%
c. Calculate the standard deviation of expected portfolio returns, s p over

the 6-year period.
=
=
=1.51%
d. How would you characterize the correlation of returns of the two assets
L and M?
Expected Return (%)
Year Asset L
Asset M Asset L
Asset M Asset L * Asset M
RM
RL
RL R L
RM R M ( RL R L )( RM R M )
2009 14
20
-2.17
5.0
-10.85
- 27 -

2010
2011
2012
2013
2014
Mean
14
16
17
17
19
16.17
Year
18
16
14
12
10
15.0
-2.17
-0.17
0.83
0.83
2.83
Asset L
RL R L
-2.17
-2.17
-0.17
0.83
0.83
2.83
2009
2010
2011
2012
2013
2014
3.0
1.0
-1.0
-3.0
-5.0
( RL R L )
4.71
4.71
0.03
0.69
0.69
8.01
Sum=18.84
2
-6.51
-0.17
-0.83
-2.49
-14.15
Sum = -35
Asset M
RM R M
5.0
3.0
1.0
-1.0
-3.0
-5.0
( RM R M ) 2
25.0
9.0
1.0
1.0
9.0
25.0
Sum=70.0
=
rLM
COVLM
S L SM
7
18.84
70
(
)(
)
6 1
6 1
0.96
=
=
3.74
Correlation,
Correlation,
3.74
=
The correlation of returns of the two assets L and M are negatively correlated.
e. Discuss any benefits of diversification achieved through creation of the
portfolio.
By combining two assets L and M that have a negative correlation will be
reducing overall risk more effectively compare invest in high positive
correlation.
- 28 -

P5.9
Learning Outcome: Use of beta to measure risk

Imagine you wish to estimate the betas for 2 investments, A and B. You
have gathered the following return data for the market and for each of the
investments over the past 10 years, 1999-2008.
Year
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
Historical Returns Investment

Market
A
B
6%
11%
16%
2
8
11
-13
-4
-10
-4
3
3
-8
0
-3
16
19
30
10
14
22
15
18
29
8
12
19
13
17
26
a. On a set of market return (x-axis)-investment return (y-axis) axes, use

the data to draw the characteristic lines for investments A and B on the
same set of axes.
b. Use the characteristic lines from part a to estimate the betas for
investments A and B.
A 0.79, B 1.38
c. Use the betas found in part b to comment on the relative risks of
investments A and B.
Investment B is more risky than A because of higher beta value. For example,
when the market went down 10%, a stock with beta of A will decrease only
7.9% but a stock with beta B will decrease by 13.8%
- 29 -


P5.10 You are evaluating 2 possible stock investments, Buyme Co. and Getit
Corp. Buyme Co. has an expected return of 14%, and a beta of 1. Getit
Corp. has an expected return of 14%, and a beta of 1.2. Based only on this
data, which stock should you buy and why?
I would buy the stock of Byeme Co., because it has same expected return as
Getit Corp. but with lesser risk.
P5.12 A security has a beta of 1.20. Is this security more or less risky than the
market? Explain. Assess the impact on the required return of this security
in each of the following cases.
The security is more risky than the market because it has a beta of 1.20 which
is higher than the beta of market which is 1.00
a. The market return increases by 15%.
Change in security return = Beta X change in market return
1.20 * 15% = 18% increase
b. The market return decreases by 8%.
1.20 * (-8%) = -9.6% decrease
c. The market return remains unchanged.
1.20 * 0% = 0% no change
P5.13 Assume the betas for securities A, B, and C are as shown here.
Security
A
B
C
Beta
1.40
0.80
-0.90
a. Calculate the change in return for each security if the market

experiences an increase in its rate of return of 13.2 % over the next
period.
Security A return = 1.40 * 13.2% = 18.48%
Security B return = 0.80 * 13.2% = 10.56%
Security C return = -0.90 * 13.2% = -11.88%
b. Calculate the change in return for each security if the market
experiences a decrease in its rate of return of 10.8% over the next period.
Security A return = 1.40 * (-10.8%) = -15.12%
Security B return = 0.80 * (-10.8%) = -8.64%
Security C return = -0.90 * (-10.8%) = 9.72%
- 30 -

c. Rank and discuss the relative risk of each security on the basis of your
findings. Which security might perform best during an economic
downturn? Explain.
Through the beta values and changes of security As return in the market
return, it shows that security A is most risky of all. Security C moves in the
opposite direction from the market in a defensive manner. While security B is
the least responsive in the market which makes it in the category of least risky.
The market can probably be assumed that the market return will decrease
during the economic downturn. In this situation, Security C will outperform
others. If security C did not perform as expected, the least responsive will be
the best which is security B.
Learning Outcome: Calculate portfolio betas
P5.23 Rose Berry is attempting to evaluate 2 possible portfolios consisting of the
same 5 asset but held in different proportions. She is particularly
interested in using beta to compare the risk of the portfolios and, in this
regard, has gathered the following data:
Asset
1
2
3
4
5
Asset Beta
1.30
0.70
1.25
1.10
0.90
Total
Portfolio Weights (%)

Portfolio A Portfolio B
10
30
30
10
10
20
10
20
40
20
100
100
a. Calculate the betas for portfolios A and B.

Beta of portfolio A = 1.30(0.1) + 0.70(0.3) + 1.25(0.1) + 1.10(0.1) + 0.90(0.4)
= 0.935
Beta of portfolio B = 1.30(0.3) + 0.70(0.1) + 1.25(0.2) + 1.10(0.2) + 0.90(0.2)
= 1.11
b. Compare the risk of each portfolio to the market as well as to each
other. Which portfolio is more risky?
The risk of Portfolio A is slightly less than the market while the risk of
Portfolio B is more than the market. Therefore, Portfolio B is more risky
- 31 -

12.1
12.3
12.4
Learning Outcome: Describe the basic features of mutual funds

What is a mutual fund? Discuss the mutual fund concept, including the
importance of diversification and professional management.
A mutual fund invests in a diversified portfolio of securities and issues shares in the
portfolio to individual investors; mutual funds represent ownership in a managed
portfolio of securities. The mutual fund concept, therefore, revolves around
diversification. Diversification, which reduces the overall risk borne by the investor, is
available through a mutual fund. This, coupled with the fact that mutual funds have
professional management, which frees the individual investor from managing his own
portfolio, makes mutual funds attractive to individuals.
Learning Outcome: Describe the basic features of mutual funds
Briefly describe how a mutual fund is organized. Who are the key players
in a typical mutual fund organization?
Mutual funds are frequently open-ended investment companies; investors in mutual
funds are essentially buying a small piece of a large, well-diversified portfolio of
securities. A mutual fund is a financial services organization that receives money from
its shareholders and invests those funds in a portfolio of securities. The investors in a
given mutual fund are all part-owners of that portfolio. Individual mutual funds are
created by management companies, like Fidelity, Dreyfus, and Vanguard. They also run
the funds daily operations and usually serve as the investment advisor. The investment
advisor buys and sells securities and otherwise oversees the funds portfolio. This is
normally carried out by: the money manager, who actually runs the portfolio; security
analysts, who look for viable investment candidates; and traders, who attempt to trade
large blocks of securities at the best possible price. In addition, there are fund
distributors, who actually buy and sell the fund shares; custodians, who take physical
possession of the funds securities and other assets; and the transfer agent, who keeps
track of fund shareholders. (Note: All these participants are part of open-end mutual
funds; however, closed-end investment companies do not require a distributor. Shares
in these funds trade in the open markets.)
Learning Outcome: Discuss the various types investment companies
Define each of the following:
a) Open-end investment companies
An open-end investment company is a mutual fund in which investors actually buy
their shares from and sell them back to the mutual fund itself. There is no limit on
the number of shares an open-end fund can issue, and this is by far the most
common type of mutual fund.
b) Closed-end investment companies
A closed-end investment company is a fund that operates with a fixed number of
outstanding shares and does not regularly issue new shares of stock. These funds,
which are few in number relative to open-end funds, operate with a fixed capital
structure and trade in the stock marketmost are listed on the NYSE
c) Exchange-traded funds
An exchange-traded fund (ETF) is a type of open-end investment company that
trades as a listed security on one of the stock exchanges.
- 32 -

d) Real estate investment trusts
A real estate investment trust (REIT) is a type of closed-end investment company
that invests money in mortgages and various types of real estate investments.
REITs allow investors to receive both the capital appreciation and current income
from real estate ownership without having to manage the property.
e) Hedge funds
Like mutual funds, hedge funds sell shares (or participation) units in a
professionally managed portfolio of securities. However, hedge funds are private
partnerships that tend to limit their clientele to rich individuals. The manager is a
general partner, while the investors are limited partners. Hedge funds have very
limited reporting requirements and are generally unregulated. Some hedge funds
attempt to limit the downside risk through employment of options and futures,
while others invest in any opportunity that has the potential of a positive return.
12.7
- 33 -
Learning Outcome: Discuss the various types of funds

Briefly describe each of the following types of mutual funds:
a) Aggressive growth funds
Aggressive growth funds are highly speculative funds that concentrate on obtaining
large capital gains. These funds tend to be small and their portfolios consist of
speculative common stocks. Returns on these funds generally move with the
market, but in larger increments: when the markets up, these funds do great, but
when the market falls, they do really poorly.
b) Equity-income funds
Equity-income funds emphasize current income by investing primarily in high
yielding common stocks. In addition to high-grade common stocks, these funds
also invest in convertible securities, preferred stocks and even bonds. They like
securities that provide high current yields, but also consider potential price
appreciation over the longer haul. These funds are generally viewed as a fairly low
risk way of investing in stocks.
c) Growth-and-income funds
Growth-and-income funds seek a balanced return made up of both current income
and long-term capital gains, with the greatest emphasis placed on growth of capital.
Unlike balanced funds, growth and income funds have 8090 percent of their
capital in common stocks). They tend to invest in growth-oriented blue chips (for
their capital gains) and high-yield common stocks (for their current income due to
high dividends).
d) Bond funds
Bond funds come in all shapes and colors (from government bond funds to high
yield [junk] corporate bond funds) and they all have one thing in common: they
invest principally (or exclusively) in some type(s) of fixed-income security. While
current income is the primary objective of these funds, capital gains is not ignored
altogether. Today, theres a full range of bond funds, ranging from the very
conservative to the very risky.

e) Sector funds
Sector funds are mutual funds that concentrate their holdings in one or more
industries that make up a target sector. For instance, a health care sector fund may
hold drug companies, medical suppliers, biotech companies, and hospital
management companies. They are not widely diversified and therefore are riskier
than diversified funds.
f) Socially responsible funds
Socially responsible funds are mutual funds that actively and directly incorporate
ethics and morality into the investment decision. These funds will consider only
socially responsible companies for inclusion in their portfolios. For example, these
funds generally will not invest in companies that derive revenues from tobacco,
alcohol, or gambling; companies that are weapons contractors; or that operate
nuclear power plants.
Learning Outcome: Discuss the various types of funds
Q12.3 For each pair of funds listed below, select the one that is likely to be the
less risky. Briefly explain your answer.
a) Growth versus growth-and-income funds
Growth versus growth and income funds: Growth funds have more risk due to
greater investment for capital gain and therefore newer growing companies.
b) Equity-income versus high-grade corporate bond funds
Equity-income versus high-grade corporate bond funds: Bonds are less risky since
they are rated investment quality as compared to ordinary common stock dividends
that are declared after interest income to bondholders is paid.
c) Balanced versus sector funds
Balanced versus sector funds: Sector funds lack diversification and therefore may
contain higher nonsystematic risk than a balanced more diversified fund.
d) Global versus aggressive growth funds
Global versus aggressive growth funds: This depends on what type of global fund
is used. Global funds may also have aggressive growth targets but have political
risk not associated with domestic aggressive growth funds.
e) Intermediate-term bonds versus high-yield municipal bond funds
Intermediate-term bonds versus high-yield municipal bond funds: High-yield
municipal bonds usually have less risk since they are associated with cities and
municipalities. However, these governmental units can have high risk depending
on their credit ratings.
Case Problem 12.1
Reverend Billy Bob Ponders Mutual Funds
Reverend Billy Bob is the minister of a church in the San Diego area. He is
married, has one young child, and earns a "modest income." Because religious
organizations are not notorious for their generous retirement programs, the
reverend has decided he should do some investing on his own. He would like to
set up a program that enables him to supplement the church's retirement
program and at the same time provide some funds for his child's college
education (which is still some 12 years away). He is not out to break any
- 34 -

investment records but wants some backup to provide for the long-run needs of
his family.
Although he has a modest income, Billy Bob believes that with careful planning,
he can probably invest about $250 a quarter (and, with luck, increase this
amount over time). He currently has about $15,000 in a savings account that he
would be willing to use to begin this program. In view of his investment
objectives, he is not interested in taking a lot of risk. Because his knowledge of
investments extends to savings accounts, Series EE savings bonds, and a little bit
about mutual funds, he approaches you for some investment advice.
Questions
Learning Outcome: Discuss the variety of investment objectives
a. In light of Reverend Billy Bob's long-term investment goals, do you think
mutual funds are an appropriate investment vehicle for him?
Yes, since Reverend Billy Bob earns a modest amount of income, it should be
sufficient to start investing in a mutual fund. Also, since he has little knowledge about
investment, it would be wise to invest in mutual fund becayse investments are done by
professional money managers.
b. Do you think he should use his $15,000 savings to start a mutual fund
investment program?
Yes, he should invest as soon as possible because generally the earlier you invest the
more interests you will get by time to time
Learning Outcome: Assess and select funds for investment purposes
c. What type of mutual fund investment program would you set up for the
Reverend?
Include in your answer some discussion of the types of funds you would consider,
the investment objectives you would set, and any investment services (e.g.,
withdrawal plans) you would seek. Would taxes be an important consideration in
your investment advice? Explain.
Since Reverend Billy Bob goals are to supplement his retirement and college
education for his child, it would be best to invest in a growth fund or growth-income
fund. He can also invest in a retirement plan if he wants to defer the tax payment until
he decides to withdraw the investment at retirement
Case Problem 12.2 Tom Lasnicka Seeks the Good Life
Tom Lasnicka is a widower who recently retired after a long career with a major
Midwestern manufacturer. Beginning as a skilled craftsman, he worked his way
up to the level of shop supervisor over a period of more than 30 years with the
firm. Tom receives Social Security benefits and a generous company pension.
Together, these two sources amount to over $4,500 per month (part of which is
tax-free). The Lasnickas had no children, so he lives alone. Tom owns a two- 35 -

bedroom rental house that is next to his home, and the rental income from it
covers the mortgage payments for both the rental house and his house.
Over the years, Tom and his late wife, Camille, always tried to put a little money
aside each month. The results have been nothing short of phenomenal. The value
of Tom's liquid investments (all held in bank CDs and savings accounts) runs
well into the six figures. Up to now, Tom has just let his money grow and has not
used any of his savings to supplement his Social Security, pension, and rental
income. But things are about to change. Tom has decided, "What the heck, it's
time I start living the good life!" Tom wants to travel and, in effect, start reaping
the benefits of his labors. He has therefore decided to move $100,000 from one of
his savings accounts to one or two high-yielding mutual funds. He would like to
receive $1,000-$1,500 a month from the fund(s) for as long as possible, because
he plans to be around for a long time.
Questions
Learning Outcome: Assess and select funds for investment purposes
a. Given Tom's financial resources and investment objectives, what kinds of
mutual funds do you think he should consider?
Given Toms existing financial condition, he can take on a certain amount of risk.
Also, Tom wants to consume immediately. In that sense, an income fund seems
attractive. He could obviously use the current income such a fund can provide.
Although he seems financially capable of assuming increased risk to generate a higher
return, he has also stated that he intends to be around for a long time. Therefore,
preservation of capital would seem to be another of Toms objectives. As a result, he
might also consider a money market fund, or perhaps an intermediate-term bond fund.
The choice will boil down to Toms greatest need; or perhaps he can invest in both.
b. What factors in Tom's situation should be taken into consideration in the fund
selection process? How might these affect Tom's course of action?
The factors that must be taken into consideration are (1) Toms existing wealth level,
(2) his ability to take on risk, (3) his demand for current income, and (4) his desire for
capital preservation. These considerations will clearly dictate the kind of mutual fund
Tom should select. His demand for current income and his desire for preservation of
capital should be paramount in the selection process. He is financially well off; he has
no children and is a widower, so he can afford to take some risk. But he is also in his
retirement years, and he knows the importance of capital preservation. Taxes are not
an issue, so he should avoid municipal bond funds and similar tax-sheltered funds.
Some viable investment candidates could include one or more of the following: highyield money funds for yield and capital preservation; corporate bond funds that invest
heavily in A and Baarated issues for high yield (note that extensive portfolio
diversification would be essential to keep risk to a minimum); government bond funds
with intermediate (three- to ten-year) maturities for safety, yield, and preservation of
capital; or possibly even equity-income funds, which could provide not only current
income but also some capital appreciation for the long-haul. However, Tom should
- 36 -

understand that this option could involve some periodic/short-term sacrifice of his
capital preservation goal.
Learning Outcome: Discuss the investor services offered by mutual funds
c. What types of services do you think he should look for in a mutual fund?
Tom is clearly not in need of any savings plan. He already has a considerable amount
of savings and is able to manage things well on his own. What he needs is a
withdrawal plan because Tom would like to receive the income periodically and at
regular intervals. There are several popular variations of withdrawal plans, and he
should pick the one that best suits his needs. Since Tom would like to receive $1,000
$1,500 monthly, he should initiate a fixed dollar amount withdrawal plan. A
conversion privilege would also be a plus.
Learning Outcome: Identify the sources of return and compute the rate of return
d. Assume Tom invests in a mutual fund that earns about 10% annually from
dividend income and capital gains. Given that Tom wants to receive $1,000 to
$1,500 a month from his mutual fund, what would be the size of his investment
account 5 years from now? How large would the account be if the fund earned
15% on average and everything else remained the same? How important is the
fund's rate of return to Tom's investment situation? Explain.
Fund earns 12 percent: Starting balance is $100,000. At the end of the first year, this
would be worth $100,000 1.10 = $110,000. Let us assume (for ease of calculation)
that Tom withdraws $15,000 per year at the end of each year and compute the value
after he makes his fifth withdrawal:
Year Initial Sum
Ending
Less
Annual
Balance
Sum
Withdrawal
1
100000*1.10 = 110000
- 15000
= 95000
2
95000*1.10 = 104500
- 15000
= 89500
3
91400*1.10 = 98450
- 15000
= 83450
4
83450*1.10 = 91795
- 15000
= 76795
5
76795*1.10 = 84474
- 15000
= 69474
Thus, at a 10% earning rate, the value of his $100,000 investment will steadily decline
to $69,474 by the end of the 5th year. The reason for this is simple: hes taking out
more than hes earning. This will eventually result in total capital consumption,
something Tom would like to avoid. Obviously, the earning rate is important to the
preservation of capitalin fact, the only way to avoid depletion of capital in this case
is to invest in a fund earning at least 15 percent. Such a rate will yield $15,000 a year
from a $100,000 investment. Short of this (i.e., finding a fund that yields 15%), Tom
has three choices:
(1)
accept the fact that his capital will decline over time.
(2)
reduce the size of his withdrawals to something closer to the earning rate on
the fund (e.g., to $10,000 per year from a fund that earns 10%); or
(3)
increase the size of the initial investment so the annual pay-off is closer to his
needse.g., he would have to invest $150,000 to receive $15,000 per year from a
fund that earns 10%.
- 37 -

13.3
Learning Outcome: Explain what is asset allocation

What is asset allocation? How does it differ from diversification? What
role does asset allocation play in constructing an investment portfolio?
Asset allocation is the process of dividing a portfolio into various asset classes
to preserve capital by protecting against negative developments while taking
advantage of positive ones.
It is based on the belief that the total return of a portfolio is influenced more
by the way investments are allocated than by the actual investments.
Asset allocation has a much greater impact on reducing total risk exposure
than picking an investment vehicle in any single category (diversification)
For example, you may allocate 60% of your savings in common stock and
40% in bonds.
Learning Outcome: Explain Sharpe, Treynor, and Jensen measures

13.17 Briefly describe each of the following return measures available for
assessing portfolio performance, and explain how they are used.
(a) Sharpes measure
(b) Treynors measure
(c) Jensensmeasure
- 38 -

Learning Outcome: Discuss portfolio revision
13.19 Explain the role of portfolio revision in the process of managing a
portfolio.
Portfolio revision is the process of selling securities in a portfolio and
replacing them with the new one. It is important to revise the portfolio by
reallocating and rebalancing it as economic conditions and personal goal
change periodically.
Learning Outcome: To construct a portfolio consistent with investor objectives
P13.1 Refer to the table below:
Beta
Investor A
Investor B
Fund A
1.8
20%
80%
Fund B
1.1
80%
20%
As between Investor A and Investor B, which is more likely to represent a

retired couple? Why?
Investor A is more likely to represent the retired couple. It is because they
would like to invest more in Fund B which has a lower risk with lower beta.
Learning Outcome: To construct a portfolio consistent with investor objectives
P13.2 Portfolio A and Portfolio B had the same holding period return last year.
Most of the returns from Portfolio A came from dividends, while most of
the returns from Portfolio B came from capital gains. Which portfolio is
owned by a single working person making a high salary, and which is
owned by a retired couple? Why?
Portfolio A is owned by the retired couple while portfolio B is owned by the
single working person. It is because the retired couple has the main goal to
gain a steady income and preserve capital gain. Hence they will look for low
risk securities.
Portfolio B is owned by the single working person who can afford to take risk.
(Pay little or no dividend but high capital gain.)
Learning Outcome: Use the Sharpe, Treynor, and Jensen measures to compare
a portfolios return
P13.16 The risk-free rate is currently 8.1 %. Use the data in the accompanying
table for Fio family's portfolio and the market portfolio during the year
just ended to answer the questions that follow.
Data Item
Fios' Portfolio
Rate of return
12.8%
Standard deviation of return
13.5%
Beta
1.10
Market Portfolio
11.2%
9.6%
1.00
a. Calculate Sharpe's measure for the portfolio and the market. Compare
the 2 measures, and assess the performance of the Fios' portfolio during
the year just ended.
- 39 -

Sharpes measure (Fios) = (12.8-8.1)/13.5 = 0.348
Sharpes measure (market) = (11.2-8.1)/9.6 = 0.323
Fios portfolio outperformed the market on a risk/reward basis. Fios risk
premium was higher relative to Fios risk taken than the market. This can be
seen by the higher Sharpe's Measure for the Fios than for market portfolio.
b. Calculate Treynor's measure for the portfolio and the market.
Compare the two, and assess the performance of the Fios' portfolio
during the year just ended.
Treynors measure (Fios) = (12.8-8.1)/1.10 = 4.273
Treynors measure (market) = (11.2-8.1)/1.00 = 3.100
Fios portfolio outperformed the markets return/risk (reward to variability)
ratio
c. Calculate Jensen's measure (Jensen's alpha). Use it to assess the
performance of the Fios' portfolio during the year just ended.
Jensens measure (Fios) = (12.8-8.1) (1.10 x (11.2-8.1)) = 1.29
The portfolio earned an excess return over the risk adjusted required rate of
return of 1.29%
A positive JM indicates that the actual return exceeds the required return.
d. On the basis of your findings in parts a, b, and c, assess the
performance of the Fios' portfolio during the year just ended.
The risk taken by Fios portfolio was treated well. He get a good return
because the higher risk taken by Fios from market in Treynors measure. (High
risk, high return). Jensens alpha guaranteed there was return for Fios
portfolio because the positive figure of the measure. Fios portfolio brings a
good return.
Learning Outcome: Apply the logic of different formula plans
MM Mutual
Time Period
Stock Price Shares
Fund NAV Shares
1
$20.00
1,000
$20.00
1,000
2
$25.00
$21.00
_____
Assume you are using a constant-dollar plan with a rebalancing trigger of $1,500.
The stock price represents your speculative portfolio, and the MM mutual fund
represents your conservative portfolio. What action, if any, should you take in
time period 2? Be specific.
Without any action, (Period 2)
Speculatives portfolio worth = $25,000
MMs fund worth
= $21,000
(-) $4,000
The difference is more than rebalancing trigger ($1,500). Therefore, the portfolio
should be rebalanced.
- 40 -

Since there is $4000 more in Speculatives portfolio, you should move half of that
sum to MMs fund which is $4000/2 = $2000
With this sum of $2000:
$2000/$25 = 80 shares (sell)
$2000/$21 = 95 shares (purchase)
P13.19 Refer to P13.18 above. Now assume you are using a constant-ratio plan
with a rebalance trigger of speculative-to-conservative of 1.25. What
action, if any, should you take in time period 2? Be specific.
Since $25000/$21000 = 1.19
The rebalance trigger of speculative-to-conservative is 1.25. Therefore, the trigger has
not been hit.
MM Mutual
Time Period
Stock Price
Shares
Fund NAV Shares
1
$20.00
1,000
$20.00
1,000
2
$30.00
1,000
$19.00
1,000
Assumeyouareusingavariableratioplan.Youhavedecidedthatwhenthe
speculativeportfolioreaches60%ofthetotal,youwillreduceitsproportion
to45%,whataction,ifany,shouldyoutakeintimeperiod2?
Duringtheperiod2,thetotalvalueis:
($30X1000)+($19X1000)=$49000
Speculativeportfolio:$30000/$49000X100%=61%
Thespeculativeportfoliohasreached61%thuswereduceitsproportionto45%:
(0.45X$49000)=$22050
Withthis$22050,weshouldhave:
$22050/$30=735shares
Therefore,youshouldsell1000735=265
- 41 -

6.1
6.4
6.5
7
Learning Outcome: Explain the investment appeal of common stocks

What is a common stock? What is meant by the statement that holders of
common stock are the residual owners of the firm?
A common stock is an equity investment that represents ownership in a corporate form
of business. Each share represents a fractional ownership interest in the firm. The key
attribute of this investment security is that it enables investors to participate in the
profits of the firm. As residual owners of the company, common stockholders are
entitled to dividend income and a prorated share of the firms earnings after all other
obligations of the firm have been met. They have no guarantee they will ever receive
any return on their investment.
Learning Outcome: Identify the sources of stock returns
How important are dividends as a source of return to common stock?
What about capital gains? Which is more important to total return?
Which causes wider swings in total return?
While they dont provide the bang that capital gains do, dividends are an important
source of return to stockholders. Dividend returns are always positive, although the
dividend yield has been under 2.5 percent during the past decade. Theres no question
that capital gains provide the really big returns, though they also lead to wider swings
in year-to-year yields. Dividends, in contrast, provide an element of stability and tend
to shore up returns in off years.
Learning Outcome: Explain the investment appeal of common stocks
What are some of the advantages and disadvantages of owning common
stock? What are the major types of risk to which stockholders are
exposed?
The major advantage of common stock ownership is the returns it offers. Because
stockholders are entitled to participate in the prosperity of a firm, there is almost no
limit to a stocks capital gains potential. In addition, many stocks provide regular
current income in the form of annual dividendsand for most income-producing
stocks, those dividends tend to grow over time, adding even more to the stockholders
return. Common stocks are also highly liquid and easily transferable; their transaction
costs are relatively low, market information is readily available, and unit price is
nominal. The risky nature of common stocks is the most significant disadvantage of
common stock ownership. As residual owners of the firm, no return is guaranteed.
Furthermore, prices are subject to wide swings, making valuation difficult. Finally, the
sacrifice in current income is a disadvantage relative to other investments (like bonds,
for instance) that pay higher and more certain returns.
The principal risks to stockholders include: business and financial risk, purchasing
power risk, and, of course, market risk. Business risk is related to the kind of business
the company is in and deals with both sales volatility and the amount of variability in
the firms earnings. Financial risk is associated with the mix of debt and equity
financing. The more debt (financial leverage) the firm uses, the greater the likelihood
that it will default on its principal and interest paymentswhich in turn will have a
negative impact on the stock. Purchasing power risk refers to the possibility of price
increases and the corresponding decline in the value of the dollars invested in common
- 42 -

stock. Market risk is caused by factors independent of the firm that affect the return on
the firms common stock. Such things as economic fluctuations, threat of war, and
political factors affect market risk and therefore can have a bearing on the market price
of a stock. The market itself has an impact on the price performance of a stockwhich,
of course, is what beta is all about (i.e., a stocks beta is a measure of the extent to
which the stock reacts to the market).
6.11
P6.7
Learning Outcome: Discuss common stock dividends

Why is the ex-dividend date important to stockholders? If a stock is sold
on the ex-dividend date, who receives the dividend the buyer or the
seller? Explain.
The ex-dividend date (which occurs two business days prior to the date of record)
determines who is eligible to receive the declared dividend when the stock is sold. If
the stock is sold on or after the ex-dividend rate, the owner (seller) receives the
dividend; if it is sold prior to the ex-dividend rate the new shareholder (buyer) receives
the dividend. Thus, if the stock is sold on the ex-dividend date, the seller receives the
dividendgoing ex-dividend means the buyer is not entitled to the dividend since
the stock is being sold without the dividend
Learning Outcome: Calculate the different kinds of common stock ratios
Consider the following information about Truly Good Coffee, Inc.
Total assets
Total debt
Preferred stock
Common stockholders' equity
Net profits after taxes
Number of preferred stock outstanding
Number of common stock outstanding
Preferred dividends paid
Common dividends paid
Market price of the preferred stock
Market price of the common stock
$240 million
$115 million
$25 million
$100 million
$22.5 million
1 million shares
10 million shares
$2/share
$0.75/share
$30.75/share
$25.00/share
Use the information above to find the following.

a. The company's book value.
b. Its book value per share.
c. The stock's earnings per share (EPS).
d. The dividend payout ratio.
e. The dividend yield on the common stock.
f. The dividend yield on the preferred stock.
(a) Book value = Total assets Total debt Preferred stock
For Truly Good Coffee: Book value = $240M $115M $25M = $100M which is equal to
common stockholders equity
(b) Book value per share = Book Value Number of shares of common stock outstanding =
$100,000,000 10,000,000 = $10 per share
- 43 -

c) Earnings per share (EPS) = (Net profits after taxes - Preferred dividends) Number of shares
of common stock outstanding = ($22,500,000 $2,000,000) 10,000,000 shares = $2.05 per
share
d) Dividend payout ratio = Dividends per share Earning per share = $0.75 $2.05 = 36.59%
e) Dividend yield on common stock = Cash dividends per share Market price per share =
$0.75 $25.0 = 3.0%
(f) Dividend yield on preferred stock = Preferred dividends per share Market price of
preferred share = $2.00 $30.75 = 6.5%
7.1
7.4
7.5
Learning Outcome: Discuss the security analysis process

Identify the three major parts of security analysis, and explain why
security analysis is important to the stock selection process.
The three major parts of security analysis are economic analysis, industry analysis, and
fundamental analysis. Security analysis is important because it enables the investor to
establish the expected return and risk for a stock and to evaluate its desirability in a
logical, rational manner.
Learning Outcome: Discuss the security analysis process
Would there be any need for security analysis if we operated in an
efficient market environment? Explain.
If the stock market is efficient in the strongest form, then securities are never
substantially mispriced and hence there would be no need for security analysis. But in
reality, the financial markets are not perfectly efficient and pricing errors are inevitable.
With thorough security analysis, individuals can profit whenever pricing errors occur.
Paradoxically, financial market efficiency is achieved only due to the existence of
traders who invest time and money in fundamental analysis to root out pricing errors.
Security analysis is also useful in assessing an assets liquidity, current income, and risk
and in verifying that these match investor criteria.
Learning Outcome: Explain the purpose and contributions of economic
analysis
Describe the general concept of economic analysis. Is this type of analysis
necessary, and can it really help the individual investor make a decision
about a stock? Explain.
Economic analysis involves studying the underlying nature of the economic
environment in which a firm operates. Economic analysis also helps the investor form
expectations about the future course of the economy. Such an analysis could be a
detailed examination of the economy, sector by sector, or it may be done on a very
informal basis. In any event, it deals with such aspects as production and
unemployment statistics, inflation, fiscal and monetary policies, and their effects on
security returns. This analysis is, indeed, essential to an investors decision-making
framework. We live in an economy where firms are affected by general economic
conditions; therefore, we cannot talk of security analysis without addressing economic
analysis. Theres plenty of real world evidence to demonstrate the high correlation
between the performance of stocks and general economic activityi.e., when the
economy starts improving, so do stock returns, all of which indicate the importance of
economic analysis to the stock selection process.
- 44 -

Learning Outcome: Describe industry analysis
7.9
What is industry analysis, and why is it important?
Industry analysis is the part of the security analysis process involving the study of
stocks in terms of their industry groupings. Industry analysis is important because stock prices
are influenced, at least in part, by industry effects. Industry analysis can be used to establish the
competitive position for a particular industry and to assess the nature of the opportunity the
industry offers for the future. It also enables the investor to identify promising firms in an
industry.
Learning Outcome: Describe industry analysis
Identify and briefly discuss several aspects of an industry that are
important to its behavior and operating characteristics. Note especially
how economic issues fit into industry analysis.
Some important aspects of industry analysis include:
(a) The nature of the industry: whether it is monopolistic or competitive.
(b) The extent of regulation: whether regulation is minimal or intense.
(c) The role of big labor: the status of contract talks and general labor regulations.
(d) Technological progress: are any technological breakthroughs likely?
(e) Financial and operating characteristics: considerations involving labor, material, and capital.
Economic forces important to the industry include the demand for the industrys
goods and services and the correlation with key economic variables. To the extent that
an industry is influenced by economic forces, we would want to determine the
economic variables that are of primary importance to an industry; it might be GDP, or
the level of interest rates, or the unemployment rate. Also, the future outlook for these
variables would be important since they are likely to set the tone for future industry
performance.
7.10
7.12
Learning Outcome: Explain fundamental analysis

What is fundamental analysis? Does the performance of a company have
any bearing on the value of its stock? Explain.
Fundamental analysis is the study of the financial affairs of a business. It is essential to
the valuation process to the extent that the value of a stock is influenced by the
performance of the company that issues the stock. An equivalent statement is that the
value of a security depends not only on return, but also on riskboth of which are
affected to a large extent by the operating characteristics and financial condition of the
firm. Fundamental analysis helps to capture insights to these dimensions from financial
statements and other information about a company and incorporates them in the
valuation process.
Case Problem 7.1

Some Financial Ratios Are Real Eye-Openers
Jack Arnold is a resident of Lubbock, Texas, where he is a prosperous rancher
and businessman. He has also built up a sizable portfolio of common stock,
which, he believes, is due to the fact that he thoroughly evaluates each stock he
invests in. As Jack says, "Y'all can't be too careful about these things! Anytime
I'm fixin to invest in a stock, you can bet I'm gonna learn as much as I can about
the company." Jack prefers to compute his own ratios even though he could
- 45 -

easily obtain analytical reports from his broker at no cost. (In fact, Billy Bob
Smith, his broker, has been volunteering such services for years.) Recently, Jack
has been keeping an eye on a small chemical stock. The firm, South Plains
Chemical Company, is big in the fertilizer business-which is something Jack
knows a lot about. Not long ago, he received a copy of the firm's latest financial
statements (summarized here) and decided to take a closer look at the company.
South Plains Chemical Company Balance Sheet

($ Thousands)
__________________________________________________________________
Cash
$ 1,250
Accounts receivable
8,000
Current liabilities
$ 10,000
Inventory
12,000
Long-term debt
8,000
Current assets
21,250
Stockholders' equity
12,000
Fixed and other assets
8,750
Total liabilities and
Total assets
$30,000
stockholders' equity $ 30,000
Income Statement
($ Thousands)
_________________________________________________________
Sales
$50,000
Cost of goods sold
25,000
Operating expenses
15,000
Operating profit
10,000
Interest expense
2,500
Taxes
2,500
Net profit
$ 5,000
Dividends paid to common stockholders
($ in thousands)
$1,250
Number of common shares outstanding
5 million
Recent market price of the common stock
$25
Questions
Learning Outcome: Calculate financial ratios
a. Compute the following ratios, using the South Plains Chemical Company
figures.
- 46 -

Latest Industry
Averages
Liquidity
a. Net working capital
b. Current ratio
N/A
1.95
Activity
c. Receivables turnover
d. Inventory turnover
e. Total asset turnover
5.95
4.50
2.65
Leverage
f. Debt-equity ratio
g. Times interest earned
0.45
6.75
Latest Industry
Averages
Profitability
h. Net profit margin
i. Return on assets
j. ROE
Common Stock Ratios

k. Earnings per share
$2.00
l. Price/earnings ratio
20.0
m. Dividends per share $1.00
n. Dividend yield
2.5%
o. Payout ratio
50.0%
p. Book value per share $6.25
q. Price-to-book-value ratio 6.4
(a) Net working capital

=
Current assets Current liabilities
=
$21,250 $10,000
=
$11,250
(b) Current ratio
= Current assets /Current liabilities
=
$21,250 / $10,000
=
2.125
(c) Receivables turnover
=
Sales / Accounts receivable
=
$50,000 / $8,000
=
6.25
(d) Inventory turnover
=
Sales/Inventory
=
$50,000/$12,000
=
4.17
(e) Total asset turnover
=
Sales/Total assets
=
$50,000/$30,000
=
1.67
(f) Debt-equity ratio
=
Long-term debt / Stockholders equity
=
$8,000 / $12,000
=
0.67
(g) Times interest earned
=
Earnings before interest and taxes/ interest
=
$10,000 / $2,500
=
4.0
(h) Net profit margin
= Net profits after taxes / Sales
= $5,000/$50,000
= 0.1 or 10%
- 47 -
8.5%
22.5%
32.2%
expense

(i) Return on total assets
= Net profits after taxes / Total assets
= $5,000/$30,000
= 0.166 or 16.67%
(j) Return on equity
= Net profits after taxes / Stockholders equity
= $5,000/$12,000
= 0.4167 or 41.67%
(k) Earnings per share
=
(Net profits after taxes Preferred dividends) /No. of shares of
common shares outstanding
=
($5,000 0) / 5,000
=
$1 /share
(l) Price/Earnings ratio
=
Market price of common stock / EPS
=
$25 / $1
=
25 times
(m)
Dividends per share
=
Dividends paid to common stockholders / No. of common shares
outstanding
=
$1,250 / 5,000
=
$0.25 /share
(n) Dividend yield
= Dividends per share/Market price of common stock
= $0.25/$25.00
= 0.01 or 1%
(o) Payout ratio
= Dividends per share/EPS
= $ 0.25 / $1.00
= 0.25 or 25%
(p) Book value per share
= Stockholders equity/No. of common shares outstanding
= $12 million/5 million
= $2.40
(q) Price-to-book value
= Market price of common stock/Book value per share
= $25/$2.40 = 10.42
Learning Outcome: Compare financial ratios and assess companys performance

c. Compare the company ratios you prepared to the industry figures given
in part a. What are the company's strengths? What are its weaknesses?
Company is more liquid than the industry.
The efficiency ratio of the company is very weak here. The low ratios suggest
poor utilization of assets. The deviation of account receivable and inventory
are very close to the industry, it seems to come from the excess fixed assets.
- 48 -

Company is using more debt to support its business than industry, and it has
lower ability to cover interest compare to industry.
Mixed profitability. The company has higher margin and ROE. The lower
return on assets reflect the poor activity ratio mentioned above. But as a
shareholder we concern more on ROE. The high ROE is due to the high
leverage, the high debt financing. Shareholder prefers to take high risk to get
high return.
Low dividend, but P/E ratio is higher than industry. The market anticipates
above average profitability and return in future. Thats why investor is willing
to pay a high P/E ratio. P/E ratio is long term, while dividend is short term. So
low dividend is acceptable for investor point of view.
The price to book value is much higher than industry and provide further
support that the market is anticipating good things from the company.
Learning Outcome: Assess companys performance

c. What is your overall assessment of South Plains Chemical? Do you think Jack
should continue with his evaluation of the stock? Explain.
The company seems to have a good prospect for attractive return, but in high risk. For
Jack to continue with his evaluation of South Plains Chemical, he must feel the
opportunities for the company are promising and commensurate with the risk
involved.
- 49 -

8.3
8.5
8.8
Learning Outcome: Discuss P/E multiple

Can the growth prospects of a company affect its price/earnings multiple?
Explain. How about the amount of debt a firm uses? Are there any other
variables that affect the level of a firms P/E ratio?
Both the growth prospects of a company and the amount of debt it uses can affect the
P/E ratio. As the growth rate increases, a higher P/E ratio can be expected. Likewise, as
the debt level decreases, the financial risk inherent in the firm decreases, and the P/E
ratio can be expected to increase. Other factors that affect the P/E ratio are general
market psychology (higher P/E ratios accompany optimistic markets) and the level of
dividends (a higher P/E ratio can be expected with higher dividends, so long as the firm
is also able to maintain a respectable rate of growth in earnings).
Learning Outcome: Discuss the concepts of intrinsic value and required rates
of return
In the stock valuation framework, how can you tell whether a particular
security is a worthwhile investment candidate? What roles does the
required rate of return play in this process? Would you invest in a stock if
all you could earn was a rate of return that just equaled your required
return? Explain.
If the computed rate of return equals or exceeds the yield the investor feels is
warranted, based on the stocks risk behavior, or if the justified price is equal to or
greater than the current market price, the stock under consideration should be
considered a worthwhile investment candidate. The required rate of return provides a
standard so that an investor can determine if the expected return on a stock is
satisfactory or not. The required rate of return is positively related to the underlying
risk involved in an investment. The higher the risk, the higher the return the investor
would expect the investment to generate. The investor who picks a stock whose return
is less than the required rate of return has really invested in a stock that is overvalued at
the current time. This is because the stock is not yielding returns commensurate with
the risk exposure. Since the market will learn of such overvaluation in time, market
forces will bid down the price of such a security. The investor will incur capital losses
when the stock price drops below the purchase price.
Learning Outcome: Discuss expected return
How would you go about finding the expected return on a stock? Note
how such information would be used in the stock selection process.
Expected return on a stock can be found by using the (present-value based) internal rate
of return (IRR). The expected rate of return on a stock would be the discount rate that
equates the future stream of benefits from the stock (i.e., the future annual dividends
and future price of the stock) to its current market value. In order to accept a stock as
an investment vehicle, its expected return (IRR) must at least equal its required rate of
return (e.g. using CAPM). If the expected return on a stock is higher than its required
rate of return, then it is certainly a good buy.
- 50 -

Learning Outcome: Calculate P/E ratio and EPS
P8.1 An investor estimates that next year's sales for New World Products
should mount to about $75 million. The company has 2.5 million shares
outstanding, generates a net profit margin of about 5%, and has a payout
ratio of 50%. All figures are expected to hold for next year. Given this
information, compute the following.
a. Estimated net earnings for next year.
b. Next year's dividends per share.
c. The expected price of the stock (assuming the PIE ratio is 24.5 times
earnings).
d. The expected holding period return (latest stock price: $25 per share).
(a) Estimated net earnings = Estimated sales Expected net profit margin = $75,000,000 0.05
= $3,750,000
(b) Estimated EPS = Estimated Net Earnings Expected Shares Outstanding = $3,750,000
2,500,000 = $1.50
(c) Expected price = Estimated EPS Expected P/E ratio = $1.50 24.5 = $36.75
(d) HPR = (Future dividend + Future sale price - Current stock price) Current stock price =
($0.75 $36.75 $25.00) $25.00 = 50%
Learning Outcome: Explain and calculate intrinsic value
P8.7 Charlene Lewis is thinking about buying some shares of Education, Inc.,
at $50 per share. She expects the price of the stock to rise to $75 over the
next 3 years. During that time she also expects to receive annual dividends
of $5 per share.
a. What is the intrinsic worth of this stock, given a 10% required rate of
return?
b. What is its expected return?
(a) Intrinsic value = PV(dividends) + PV(future price) = $5(0.909)* + $5(0.826)* + ($75 + $5)
(0.751)*= $68.76
(b) $50. The rate of return which discounts future cash flows such that their sum equals the
current stock price is 23%. Hence the expected return of the stock is 23%.
No matter how you look at it, Education, Inc. should be viewed as a viable investment
candidate. It has a justified price ($68.76) that far exceeds the stocks current price ($50),
suggesting that the stock is undervalued (so long as Charlenes expectations are right), and its
yield (23%) is far above Charlenes required rate of return (10%).
Learning Outcome: Apply dividend valuation model and PV-based models
P8.10 Larry, Moe, and Curley are brothers. They're all serious investors, but
each has a different approach to valuing stocks. Larry, the oldest, likes to
use a I-year holding period to value common shares. Mae, the middle
brother, likes to use multiyear holding periods. Curley, the youngest of the
three, prefers the dividend valuation model.
As it turns out, right now, all three of them are looking at the same stock
American Home Care Products, Inc. (AHCP). The company has been
listed on the NYSE for over 50 years, and is widely regarded as a mature,
- 51 -

rock-solid, dividend-paying stock. The brothers have gathered the
following information about AHCP's stock:
Current dividend (Do) = $2.50/share
Expected growth rate (g) = 9.0%
Required rate of return (k) = 12.0%
All three of them agree that these variables are appropriate, and they will
use them in valuing the stock. Larry and Moe intend to use the D&E
approach; Curley is going to use the constant-growth DVM. Larry will
use a 1-year holding period; he estimates that with a 9% growth rate, the
price of the stock will increase to $98.80 by the end of the year. Mae will
use a 3-year holding period; with the same 9% growth rate, he projects
the future price of the stock will be $117.40 by the end of his investment
horizon. Curley will use the constant-growth DVM, so his holding period
isn't needed.
a.
Use the information provided above to value the stocks first for
Larry, then for Moe, then for Curley.
b.
Comment on your findings. Which approach seems to make the
most sense?
a) Larrys valuation (D&E approach, 1 year holding period) :
PV of a share of stock = PV of future dividends + PV of price of stock at
date of sale
=
= $ 90.65
b) Moes valuation (D&E approach, 3 year holding period) :
PV of a share of stock = PV of future dividends + PV of price of stock at
date of sale
=
= $90.67
c) Curleys valuation (constant growth Dividend Valuation Model) :
Value
of
a
stock
=
= $90.83
b) The difference between maximum and minimum of share price is $0.18
cents which is less than
0.2. This inconsequential difference highlights the fact that AHCPs value
is not dependent upon
the holding period of the investor.
- 52 -

P8.12 Let's assume that you're thinking about buying stock in West Coast
Electronics. So far in your analysis, you've uncovered the following
information: The stock pays annual dividends of $2.50 a share (and that's
not expected to change within the next few years-nor are any of the other
variables). It trades at a PIE of 18 times earnings and has a beta of 1.15.
In addition, you plan on using a risk-free rate of 7% in the CAPM, along
with a market return of 14%. You would like to hold the stock for 3 years,
at the end of which time you think EPS will peak at about $7 a share.
Given that the stock currently trades at $70, use the IRR approach to find
this security's expected return. Now use the present-value (dividends-andearnings) model to put a price on this stock. Does this look like a good
investment to you? Explain.
The expected future price of stock = Future EPS x multiple
= $7 x 18 = $126
Expected return using IRR
=($2.50 PVIF1YR) + ($2.50 PVIF2YRS) + ($2.50 PVIF3YRS) + ($126
PVIF3YRS) = $70
Required Return = Riskfree rate + [Stocks beta (Market return Risk-free
rate)]
= 7 + [1.15 (14.0 7.0)]
= 7 + [1.15 7]
= 7 + 8.05
= 15.05
The expected rate of return which discounts future cash flow = 24.63%.
Required Return = Riskfree rate + [Stocks beta (Market return Risk-free
rate)]
= 7 + [1.15 (14.0 7.0)]
= 7 + [1.15 7]
= 7 + 8.05
= 15.05
The expected rate of return which discounts future cash flow = 24.63%.
Using 15% as the interest, we calculate the price of the stock.
Present-value model
= PV(dividends) + PV(future price of the stock)
= ($2.50)(0.870)* + ($2.50)(0.756)* + (2.50 + $126.00)(0.658)*
= $88.62
Since the justified price is higher than market price and the expected rate of
return is greater than the required rate of return, this stock seems to be a good
investment.

- 53 -

P8.15 Assume there are three companies that in the past year paid exactly the
same annual dividend of $2.25 a share. In addition, the future annual rate
of growth in dividends for each of the three companies has been estimated
as follows:
Buggies-Are-Us
g=0
(i.e., dividends are
expected to remain
at $2.25/share)
Steady Freddie. Inc.

g= 6%
(for the
foreseeable future)
Gang Buster Group

Year 1 $2.53
2 $2.85
3 $3.20
4 $3.60
Year 5 and beyond: g = 6%
Assume also that as the result of a strange set of circumstances, these

three companies all have the same required rate of return (k = 10%).
a. Use the appropriate DVM to value each of these companies.
Valuation using the DVM: Intrinsic value = D0 (1 + g) (k g)
Buggies-Are-Us: $2.25(1 + 0) (0.10 0.06) = $22.50
Steady Freddie, Inc.: $2.25(1+.06) (0.10 - 0.06) = $59.63
Gang Buster Group: Step 1: Present value of dividends using a required rate of return
of 10 percent:
Year
Dividends PVIF, 10% Present Value
1
$2.53
0.909
$2.30
2
2.85
0.826
2.35
3
3.20
0.751
2.40
4
3.60
0.683
2.46
Total $9.51
Step 2: Price of stock at the end of year 4:
P4 = D5 (k g) = D4(1 + g) (k g) = $3.60(1 + 0.06) (0.10 - 0.06) = $95.50
Step 3: Present value of the stock price:
PV $95.50 x PVIF10%, 4yrs = $95.50 x 0.683 = $65.23
Step 4: Value of stock = $9.51 (Step 1) + $65.23 (Step 3) = $74.74
b. Comment briefly on the comparative values of these three companies.
What is the major cause of the differences among these three valuations?
The intrinsic value of Gang Busters is $74.74 which is higher than BuggiesAre-Us ($22.50) and Steady Freddie ($59.63). This is mainly due to the
different growth rates of each company. As the growth rate of Buggies-Are-Us
is 0, the company has low intrinsic value for its stock while the dividend of
Steady Freddie is growing at a constant rate of 6% has higher intrinsic value of
its stock. Gang Busters has a constant rate during the first four years and 6%
from year 5 onwards. Due to the high growth rate of Gang Busters, its stock
worth more than Steady Freddie company.
Learning Outcome: Calculate required rate of return and apply PV-based

models
- 54 -

P8.18 Assume a major investment service has just given Oasis Electronics its
highest investment rating, along with a strong buy recommendation. As a
result, you decide to take a look for yourself and to place a value on the
company's stock. Here's what you find: This year, Oasis paid its
stockholders an annual dividend of $3 a share, but because of its high rate
of growth in earnings, its dividends are expected to grow at the rate of 12
% a year for the next 4 years and then to level out at 9% a year. So far,
you've learned that the stock has a beta of 1.80, the risk-free rate of
return is 6%, and the expected return on the market is 11 %. Using the
CAPM to find the required rate of return, put a value on this stock.
CAPM:
Required rate of return = risk-free rate + stocks beta market return risk-free rate
= 6% + [1.80 (11% 6%)]
= 6% + 9% = 15%
(ii) Value the stock using the variable growth dividend model:
For the next 4 year, dividends growth rate is 12%.
D1 = D0 (1 + g) = $3(1.12) = $3.36
D2 = D1 (1 + g) = $3.36(1.12) = $3.76
D3 = D2 (1 + g) = $3.76(1.12) = $4.21
D4 = D3 (1 + g) = $4.21(1.12) = $4.72
Value of stock = (D1 PVIF1) + (D2 PVIF2) + (D3 PVIF3) + (D4 PVIF4) +
PVIF4
= ($3.36 PVIF 15%,1) + ($3.76 PVIF 15%,2) + ($4.21 PVIF 15%,3) + ($4.72
PVIF 15%,4) + PVIF 4
= 2.92 + 2.84 + 2.77 + 2.70 + 49.05
= $60.28
How to calculate each part for:
($3.36 PVIF 15%,1)
1) By financial calculator:
FV= dividend on time t= 3.36
I/Y= required return= 15
N= no. of years= 1
Press CPT PV.
- 55 -

9.1
9.2
9.5
Learning Outcome: Discuss the purpose of technical analysis

What is the purpose of technical analysis? Explain how and why it is used
by technicians; note how it can be helpful in timing investment decisions.
Technical analysis involves the study of the various forces at work in the marketplace.
Technical analysts argue that internal market factors, such as trading volume and price
movements, often reveal the markets future direction before the cause is evident in
financial statistics. Thus, by revealing the markets future direction, technical analysis
provides insight that is supposed to be helpful to investors in timing their investment
decisions. If technical analysis indicates the market is about to move up, it signals a
good time to buy; if it indicates the market is about to turn down, it signals a good time
to sell.
Learning Outcome: Discuss how market performance affects stock valuation
Can the market really have a measurable effect on the price behavior of
individual securities? Explain.
The market can definitely have an impact on the prices of individual securities, and a
significant one at that. In fact, studies have indicated that between 20 and 50 percent of
stock price behavior can be traced to market forces. When the market is bullish, stock
prices rise in general. When market participants become bearish, most prices fall. This
is because stock prices are simply the result of supply and demand forces in the market.
Since the demand for and supply of securities depends on the general condition of the
market, stock prices are affected by the general behavior of the marketplace
Learning Outcome: Describe some approaches to technical analysis
Briefly describe each of the following, and note how it is computed and
how it is used by technicians:
a. Relative strength index.
b. Moving averages.
The relative strength index (RSI) is a measure of the average price change on up days
to the average price change on down days. If the average price change is the same on
up and down days, the RSI value will be 50. If the average price change is twice as
high on up days as down days, the RSI value will be 67. High values actually suggest
that there is more buying than the fundamentals will justify.
Moving averages compare current share price to the average share price over a
specified period. The period might, for instance, be 200 days. Every new day is added
to the average and the oldest day is dropped from the average. When current share
prices advance above their 200-day moving average, share prices are expected to
continue to rise, whereas when stock prices drop below their moving average, they are
expected to continue to decline.
Learning Outcome: Explain the idea of random walks and efficient markets
- 56 -

9.7
9.8
What is the random walk hypothesis, and how does it apply to stocks?
What is an efficient market? How can a market be efficient if its prices
behave in a random fashion?
The random walk hypothesis claims that stock prices follow a random or erratic
pattern. That is, people who believe in this theory claim that price movements are
unpredictable and as a result, theres little that you can do to predict future behavior. An
efficient market is one in which the market price of the security always fully reflects all
available information, so it is difficult, if not impossible to consistently outperform the
market by picking undervalued stocks. It is argued that in an efficient market, random
price movements simply reflect a highly competitive market where investors quickly
use and digest any new information. This competition holds security prices close to
their correct (justified) level; as new information becomes available (in a random
manner), adjustments in price are random and quick to follow.
Learning Outcome: Explain the idea of efficient markets
Explain why it is difficult, if not impossible, to consistently outperform an
efficient market.
a. Does this mean that high rates of return are not available in the stock
market?
b. How can an investor earn a high rate of return in an efficient market?
To outperform the market, one must consistently earn more than the required rate of
return on securities. In other words, one must be able to consistently find stocks selling
below their justified prices, and then realize the expected return on the security. In an
efficient market, current prices reflect all information, therefore, current prices equal
justified prices, and investors can expect to earn only the required (risk-adjusted) rate
of return.
(a) Efficient markets do not make high rates of return unavailable, but they make it
(nearly) impossible to consistently earn returns higher than the rates of return required
for the risk levels of the securities purchased. Hence a stock with high rates of return
will also be more risky.
(b) Investors can earn high rates of return through luck, or through accepting stocks
with higher risks. They can also minimize transaction and tax expenses, along with
unnecessary risk, to make their returns more satisfactory
Learning Outcome: Explain market anomalies

- 57 -

9.9
9.10
What are market anomalies and how do they come about? Do they
support or refute the EMH? Briefly describe each of the following:
a. The January effect.
b. The PIE effect.
c. The size effect.
Market anomalies are deviations from what one would expect in an efficient market
and hence refute the efficient market hypothesis. Most of these anomalies are empirical
anomalies, suggesting that over a specified period certain information could have been
used to earn abnormal, risk-adjusted returns. There is no guarantee that they will
provide anomalous returns in the future. Some popular ones are:
(a) The January effect is the term applied to the tendency for small stocks prices to go
up during the month of January.
(b) The P/E effect is the term applied to the tendency for low P/E stocks to outperform
high P/E stocks.
(c) The size effect is the term applied to the tendency for investments in the common
stock of small firms to outperform investment in large firms.
Learning Outcome: Explain the challenges of random walks & efficient
market theories
What are the implications of random walks and efficient markets for
technical analysis? For fundamental analysis? Do random walks and
efficient markets mean that technical analysis and fundamental analysis
are useless? Explain.
Random walks offer a serious challenge to technical analysis. If price fluctuations are
purely random, charts of past behavior cannot produce significant trading profits. If the
market is efficient, shifts in supply and demand occur so rapidly that technical
measures simply measure the past and have no implications for the future. Whats
more, in an efficient market, extreme competition among investors will keep security
prices at or very close to their justified levels, so fundamental analysis will not lead to
returns above those required by the amount of risk exposure.
If markets are efficient, benefits from technical analysis are minimal. Fundamental
analysis should still be utilized, however, to identify fundamentally strong (and weak)
firms. So, even if firms are not undervalued, analysis can be directed to and used in the
selection of fundamentally strong stocks.
Learning Outcome: Explain psychological factors that affect investors decisions

9.12 Briefly explain how behavioral finance can affect each of the following:
a. The predictability of stock returns.
b. Investor behavior.
c. Analyst behavior.
(a) Since investors tend to extrapolate past bad news into the future to an extent that
would not be justified based on the information alone, one should sell firms that have
done poor recently (say over the past 6 to 12 months) and buy firms that have done
poorly over a longer period of time (say over the past 3 or 5 years). Also, investors tend
to be overly optimistic about growth stocks, resulting in lower subsequent returns than
earned on value stocks.
(b) Investors who feel they have superior information tend to trade more, and
consequently earn lower net returns due to higher transactions costs. Investors tend to
- 58 -

exhibit loss aversion, by hanging on to shares that have declined and selling those that
have increased.
(c) Analysts tend to exhibit herding behavior, by issuing similar recommendations or
earnings forecasts for stocks. They also tend to be optimistic. Research has shown that
hyped stocks tend to underperform the market.
Learning Outcome: Explain psychological factors that affect investors decisions
Q9.5 Briefly define each of the following terms, and describe how it can affect
investors decisions:
a. Loss aversion
b. Representativeness
c. Narrow framing
d. Overconfidence
e. Biased self-attribution
Several of the key assumptions about investor behavior that serve as a basis for
behavioral finance are given below.
(a) Loss aversion is the tendency for individuals to dislike losses more than they like
gains. As a consequence, investors hold on to losing stocks in hopes that they will
bounce back.
(b) Representativeness reflects an individuals tendency to make strong conclusions
from limited samples. A successful stock analyst over the past three years is not
necessarily going to be correct again. Across the thousands of stock analysts, there are
some that make good decisions by random chance.
(c) Investors guilty of narrow framing analyze an investment on its own merits without
considering how that security correlates with the other investments in their portfolio.
They might end up with an undiversified portfolio.
(d) Investors might become overconfident in their judgments. Three consequences are
that they might underestimate the amount of risk, make unduly positive forecasts, and
participate in excessive trading.
(e) Investors guilty of biased self-attribution will take undue credit for good selections
and blame others for bad decisions. If these investors pick an above-average mutual
fund, it is to their supposed credit, but if the mutual fund does poorly these individuals
will blame the portfolio manager for bad selection and/or timing. These individuals
place more value on information that agrees with their selections
Learning Outcome: Compute moving average
- 59 -

P9.10 You find the closing prices for a stock you own. You want to use a 10-day
moving average to monitor the stock. Calculate the 10-day moving
average for days 11 through 20. Based on the data in the table below, are
there any signals you should act on? Explain.
Day
1
2
3
4
5
6
7
8
9
10
Closing Price
$25.25
26.00
27.00
28.00
27.00
28.00
27.50
29.00
27.00
28.00
Day
11
12
13
14
15
16
17
18
19
20
Closing Price
$30.00
30.00
31.00
31.50
31.00
32.00
29.00
29.00
28.00
27.00
MA 11 = $ 27.75
MA 12 = $ 28.15
MA 13 = $ 28.55
MA 14 = $ 28.90
MA 15 = $ 29. 30
MA 16 = $ 29.30
MA 17 = $ 29.85 > closing price ( selling signal)
MA 18 = $ 29.85
MA 19 = $ 29.95
MA 20 = $ 29.85
If the closing price fell below the 10-day moving average, it indicates a selling
signal. In this case, stock on 17th day should be sold.
- 60 -


10.3
Learning Outcome: Explain basic investment attributes of bonds

Identify and briefly describe the five types of risk to which bonds are
exposed. What is the most important source of risk for bonds in general?
Explain.
Bonds are exposed to the following five major types of risk:
(1) Interest rate risk: This affects the market as a whole and therefore translates into
market risk. When market interest rates rise, bond prices fall, and vice versa.
(2) Purchasing power risk: This is the risk caused by inflation. When inflation heats up,
bond yields lag behind inflation rates. A bond investor is locked into a fixed-coupon
bond even though market yields are rising with inflation.
(3) Business/financial risk: This refers to the risk that the issuer will default on interest
and/or principal payments. Business risk is related to the quality and integrity of the
issuer, whereas financial risk relates to the amount of the issuers leverage. Treasury
securities are free of this risk, although it is an important consideration for corporate
and municipal bonds.
(4) Liquidity risk: This is the risk that a bond will be difficult to sell if the investor
wishes to do so. The bond market is primarily over-the-counter in nature, and much of
the activity occurs in the primary/new issue market. With the exception of the Treasury
market and most of the agency market, there is not much of a secondary market for
most bonds.
(5) Call risk: This refers to the risk that a bond will be retired before its scheduled
maturity date. When a bond is called, the bondholders are cashed out of their
investment and must then find alternative investment outlets that may have lower
yields. The most important source of risk for bonds in general is interest rate risk. It is
the major cause of price volatility in the bond market. As interest rates become more
volatile, so do bond prices.
- 61 -

10.4
10.6
Can issue characteristics (such as coupon and call features) affect the
yield and price behavior of bonds? Explain.
Issue characteristics (such as call feature and coupon) do indeed affect the yield and
price behavior of a bond. For example, high-coupon bonds have higher yields than lowcoupon bonds; bonds that are freely callable provide higher yields than bonds that are
non-callable; usually (although not always) long maturities yield more than short
maturities. With respect to price volatility, bonds with lower coupons and/or longer
maturities will respond more vigorously to changes in market interest rates and
therefore have greater price volatility than short-maturity and/or high-coupon bonds.

What is the difference between a premium bond and a discount bond?
What three attributes are most important in determining an issues price
volatility?
The difference between a premium and a discount bond illustrates the inverse
relationship between bond prices and market interest rates. A premium bond sells for
more than its par value, which occurs when market interest rates drop below the bonds
coupon rate. In contrast, a discount bond sells for less than par and is the result of
market rates rising above the coupon rate.
- 62 -

The factors that affect a bonds price, volatility are interest rates, coupon and maturity
of the issue. The greater the moves in interest rates, the greater the swings in bond
prices. Bonds with lower coupons and/or longer maturities respond more vigorously to
changes in market rates and therefore undergo sharper price swings.
10.7

What are bond ratings, and how can they affect investor returns? What
are split ratings?
Bondratings:lettergradesthatdesignateinvestmentquality
Ratingsbasicallypointtothedefaultriskofanissue.Higherratingsmeanthatissues
areinvestmentgrade.Lowerratingsmeanthatissuesareinthejunkcategoryand
morespeculative.Thehighertherating,thelowerthedefaultriskand,hence,the
lowertheyieldofanobligation.Alowerratingmeansthattheinvestormustassume
moreof thedefaultriskandhastobe compensatedwithahigher yield. Further,
investmentgradesecuritiesarefarmoreinterestsensitiveandtendtoexhibitmore
uniformpricebehaviorthanjunkbondsandotherlowerratedissues.
Splitratings:asecuritywhichisgivendifferentratingsbytwoormoremajorrating
agencies
Learning Outcome: Explain the behavior of market interest rates

Q11.1 Briefly describe each of the following theories of the term structure of
interest rates.
a. Expectations hypothesis
b. Liquidity preference theory
c. Market segmentation theory
According to these theories, what conditions would result in a downwardsloping yield curve? What conditions would result in an upward-sloping
yield curve? Which theory do you think is most valid, and why?
Expectations hypothesis: The yield curve reflects investor expectations above all else.
Future behavior of interest rates with respect to the present is affected most by
expectations regarding inflation. Higher expected inflation requires higher interest rates
today. The result is an upward-sloping yield curve. To produce a downward-sloping
yield curve under this hypothesis, the expected future inflation would be lower, but the
current rates would remain higher.
Liquidity preference theory: Long-term bond rates should be higher than shorter-term
due to the condition there are more liquid market rates in the short term. Uncertainty
increases over time causing the demand for a higher risk premium (bond interest rate).
This theory expects upward-sloping yield curves. Downward-sloping curves would not
occur in this theory since it would contradict the basic notion that uncertainty increases
with time and the risk premium adjusts accordingly.
- 63 -

Market Segmentation theory: The debt market is segmented according to length of
maturity and preferences. An equilibrium exists in the short term between suppliers and
demanders of funds.
There are different inhabitants in each segment with different motivations. In the short
term, banks predominate, but in the long term, life insurance and real estate firms
determine the equilibriums. In this theory, yield curves may be either upward- or
downward-sloping, as determined by the general relationship between rates in each
market segment

P10.11 In early January 2001, you purchased $30,000 worth of some Baa-rated
corporate bonds. The bonds carried a coupon of 8 7/8% and mature in
2015. You paid 94.125 when you bought the bonds. Over the 5-year period
from 2001 through 2005, the bonds were priced in the market as follows:
Quoted Prices
Beginning of
End of
Year-End
Year
the Year
the Year
Bond Yields
2001
94.125
100.625
8.82%
2002
100.625
102
8.70
2003
102
104.625
8.48
2004
104.625
110.125
8.05
2005
110.125
121.250
7.33
Coupon payments were made on schedule throughout the 5-year period.
a. Find the annual holding period returns for 2001 through 2005. (See
Chapter 5 for the HPR formula.)
b. b. Use the return information in Table 10.1 to evaluate the investment
performance of this bond. How do you think it stacks up against the
market? Explain.
HPR = (Annual interest income + Capital gains) Price at beginning of year
(a)
(1)
(2)
(3)=(1)-(2)
(4)
(5)=(3)+(4)
(6)=(5)(2)
Year
Ending price Beginning Price capital gain Annual income Total return HPR
2001
$1,006.25
$941.25
$65
$88.75
$153.75 16.33%
2002
1,020.00 1006.25 13.75
.88.75
102.50 10.19
2003
1,046.25 1020.00 26.25
88.75
115.00
11.28
2004
1,101.25 1,046.25 55.00
88.75
143.75
13.74
2005
1,212.50
1,101.25 111.25
88.75
200.00
18.16
(b) Evaluation of return performance:
Annual HPR (%)
Year A-rated corporate
Bond market
2001
16.33%
9.16%
2002
10.19
5.76
2003
11.28
9.18
2004
13.74
12.16
2005
18.16
11.95
Average 13.94
7.34
Looking at the average HPRs over the five-year period, we can conclude that the A-rated corporate bond
has outperformed the market: 13.94 percent versus 7.34 percent. Also note that the A-rated corporate
bond returns were less volatile(Minimum = 10.19% & Maximum = 18.16%) compared to the volatility
of the bond market (Minimum = 5.76% & Maximum = 12.16%).
- 64 -

Learning Outcome: Identify different types of bonds
P10.12 Rhett purchased a 13% zero-coupon bond with a l5-year maturity and a
$20,000 par value 15 years ago. The bond matures tomorrow. How much
will Rhett receive in total from this investment, assuming all payments are
made on these bonds as expected?
ANS : $20,000.
A zero-coupon bond trades at a discount to face value and pays no interest
during its lifetime. At maturity, it pays par value.
Learning Outcome: Assess bond ratings
Case Problem 10.2 The Case of the Missing Bond Ratings
It's probably safe to say that there's nothing more important in determining a
bond's rating than the underlying financial condition and operating results of the
company issuing the bond. Just as financial ratios can be used in the analysis of
common stocks, they can also be used in the analysis of bonds-a process we refer
to as credit analysis. In credit analysis, attention is directed toward the basic
liquidity and profitability of the firm, the extent to which the firm employs debt,
and the ability of the firm to service its debt.
A Table of Financial Ratios
(All ratios are real and pertain to real companies)
Company Company Company Company Company Company
Financial Ratio
1
2
3
4
5
6_______
1.Current ratio
1.13 x
1.39 x
1.78 x
1.32 x
1.03 x
1.41 x
2. Quick ratio
0.48 x
0.84 x
0.93 x
0.33 x
0.50 x
0.75 x
3. Net profit margin 4.6%
12.9% 14.5% 2.8%
5.9%
10.0%
4. Return on total 15.0% 25.9% 29.4% 11.5%
16.8%
28.4%
capital
5. Long-term debt 63.3% 52.7% 23.9% 97.0%
88.6%
42.1%
to total capital
6. Owners' equity 18.6% 18.9% 44.1% 1.5%
5.1%
21.2%
ratio
7. Pretax interest
2.3 x
4.5 x
8.9 x
1.7 x
2.4 x
6.4%
coverage
8. Cash flow to
34.7% 48.8% 71.2% 20.4%
30.2%
42.7%
total debt__________________________________________________________
Notes:
Ratio (2)-Whereas the current ratio relates current assets to current liabilities,
the quick ratio considers only the most liquid current assets (cash, short-term
securities, and accounts receivable) and relates them to current liabilities.
Ratio (4)-Relates pretax profit to the total capital structure (long-term debt +
equity) of the firm.
- 65 -

Ratio (6)-Shows the amount of stockholders' equity used to finance the firm
(stockholders' equity + total assets).
Ratio (8)-Looks at the amount of corporate cash flow (from net profits +
depreciation) relative to the total (current + long-term) debt of the firm the other
four ratios are as described in Chapter 6.
The financial ratios shown on the previous page are often helpful in carrying out
such analysis: (1) current ratio, (2) quick ratio, (3) net profit margin, (4) return
on total capital, (5) long-term debt to total capital, (6) owners' equity ratio, (7)
pretax interest coverage, and (8) cash flow to total debt. The first 2 ratios
measure the liquidity of the firm, the next 2 its profitability, the following 2 the
debt load, and the final 2 the ability of the firm to service its debt load. (For ratio
5, the lower the ratio, the better. For all the others, the higher the ratio, the
better.) The following table lists each of these ratios for 6 different companies.
Questions
a. Three of these companies have bonds that carry investment-grade ratings. The
other 3 companies carry junk-bond ratings. Judging by the information in the
table, which 3 companies have the investment-grade bonds and which 3 have the
junk bonds? Briefly explain your selections.
b. One of these 6 companies is a AAA-rated firm and one is B-rated. Identify
those 2 companies. Briefly explain your selection.
c. Of the remaining 4 companies, 1 carries a AA rating, 1 carries an A rating, and
2 are BB-rated. Which companies are they?
- 66 -


11.3
Learning Outcome: Explain the behavior of market interest rates

What is the term structure of interest rates, and how is it related to the
yield curve? What information is required to plot a yield curve? Describe
an upward-sloping yield curve and explain what it has to say about the
behavior of interest rates. Do the same for a flat yield curve.
The term structure of interest rates is the relationship between the interest rate or yield
and the time to maturity for any class of similar risk securities. The yield curve is just a
graphic representation of the term structure of interest rates at a given point in time. To
plot a yield curve, you need to know the yield to maturity for different maturities of
similar risk bonds. As market conditions change, the yield curves shape and location
also change.
The upward-sloping yield curve indicates that yields tend to increase with longer
maturities. The longer a bond has to go to maturity, the greater the potential for price
volatility and the risk of loss. Thus, investors require higher yields on longer maturity
bonds. Flat yield curves indicate that yields will be the same across maturities. Given
that longer-term bonds have more default and maturity rate risk, a flat yield curve
implies that inflation rates are expected to decline.
Learning Outcome: Explain the basic concept of duration

11.10 What does the term duration mean to bond investors, and how does the
duration of a bond differ from its maturity? What is modified duration,
and how is it used?
Duration is a measure of bond price volatility. It captures both price and reinvestment
risks in a single measure and indicates how a bonds price will react to different interest
rate environments. It is the effective maturity of a fixed-income security. On the other
hand, the bonds actual maturity does not consider all of the bonds cash flows nor does
it consider the time value of money. Duration is a far superior measure of the effective
timing of a bonds cash flows, because it explicitly considers both the time value of
money and the bonds coupon and principal payments.
When the market undergoes a big change in yield, duration will understate price
appreciation when rates fall and overstate the price decline when rates increase.
Modified duration is used to overcome this problem by linking interest rate changes to
changes in bond price. First, you can compute the modified duration using the bonds
computed duration and the computed yield-to-maturity. Then, the change in bond price
based upon a change in interest rates can be computed as follows:
Percent change in bond price = 1 Modified duration Change in interest rates
Learning Outcome: Identify various bond investment strategies
11.13 What strategy would you expect an aggressive bond investor (someone
whos looking for capital gains) to employ?
An aggressive bond investor would employ the highly risky forecasted interest rate
behavior strategy. The intent of this strategy is to take advantage of interest rate swings
by timing the market. Usually these swings are short-lived, so aggressive bond traders
will try to magnify their returns by trading on margin. These investors try to generate
capital gains when interest rates are expected to decline and to preserve capital when an
increase in interest rates is expected.
- 67 -

Learning Outcome: Calculate bond price and return
P10.3 Zack buys a 10% corporate bond with a current yield of 6%. How much
did he pay for the bond?
Interest = 0.1 $1,000 = $100
$100/Price = 0.06 $100/0.06 = Price = $1,666.67
LearningOutcome:Calculatebondpriceandreturn
P10.8 Which of the following three bonds offers the highest current yield?
a. A 9 %, 20-year bond quoted at 97
b. A 16%, 15-year bond quoted at 164 5/8.
c. A 5 1/4 %, 18-year bond quoted at 54.
LearningOutcome:Calculatebondsprice
P11.2 Using semiannual compounding, find the prices of the following bonds:
a. A 10.5%, 15-year bond priced to yield 8%.
b. A 7%, 10-year bond priced to yield 8%.
c. A 12%, 20-year bond priced at 10%.
Repeat the problem using annual compounding. Then comment on the
differences you found in the prices of the bonds.
- 68 -

Overall, the difference between bond prices computed using either method are
very small, ranging from 0.85 to 2.16.
As the comparison demonstrates, if a bond sells at a premium its value is
higher with semi-annual compounding.
When it sells at a discount, its value is greater with annual compounding.
LearningOutcome:Applyvariousmeasuresofyieldandreturn
P11.12 Assume that an investor is looking at 2 bonds: Bond A is a 20-year, 9%
(semiannual pay) bond that is priced to yield 10.5%. Bond B is a 20-year, 8%
(annual pay) bond that is priced to yield 7.5%. Both bonds carry 5-year call
deferments and call prices (in 5 years) of $1,050.
a. Which bond has the higher current yield?
b. Which bond has the higher YTM?
c. Which bond has the higher YTC?
Current Yield:
- 69 -

b) Bond A
Bond B
c)
- 70 -

LearningOutcome:Applyvariousmeasuresofyieldandreturn
P11.17 Using annual compounding, find the yield-to-maturity for each of the
following bonds.
a. A 9.5%, 20-year bond priced at $957.43.
b. A 16%, 15-year bond priced at $1,684.76.
c. A 5.5%, 18-year bond priced at $510.65.
Now assume that each of the above three bonds is callable as follows:
Bond a is callable in 7 years at a call price of $1,095; bond b is callable in
5 years at $1,250; and bond c is callable in 3 years at $1,050. Use annual
compounding to find the yield-to-call for each bond.
a) Using financial calculator:PMT = 95, FV = 1000, PV = -957.43, N = 20, CPT I/Y
Yield to maturity = 10%
Assume is callable:PMT = 95, FV = 1095, PV = -957.43, N = 7, CPT I/Y
Yield to call = 11.37%
b) Using financial calculator:PMT = 160, FV = 1000, PV = -1684.76, N = 15, CPT I/Y
Yield to maturity = 8%
c) Using financial calculator:PMT = 55, FV = 1000, PV = -510.65, N = 18, CPT I/Y
Yield to maturity = 12.42%
LearningOutcome:Applythebasicconceptofduration
P11.21 Find the Macaulay duration and the modified duration of a 20-year, 10%
corporate bond priced to yield 8%. According to the modified duration of
this bond, how much of a price change would this bond incur if market
yields rose to 9%? Using annual compounding, calculate the price of this
bond in 1 year if rates do rise to 9%. How does this price change compare
to that predicted by the modified duration? Explain the difference.
To calculate the duration of the bond, first calculate the bonds current market
price:
Bond terms: 10% coupon, 20 years, 8% YTM
Price = $100 PVIFA8%,20 yrs. + $1,000 PVIF8%,20 yrs. = $100 9.818 + $1,000
0.215 = $981.80 + $215 = $1,196.80
- 71 -

Modified duration = Duration in years (1 +

Yield to maturity) = 10.19
1.08 = 9.44
% change in bond price = 1 Modified
duration change in interest rates
= 1 9.44 1% = 9.44%
If market yields rise 1 percent, the price of the
bond will fall by 9.44
percent:
Price in one year = $100 PVIFA9%,19 yrs. +
$1,000 PVIF9%,19 yrs =
$100 8,950 +
$1,000 0.194= $1,089
The change in bond price is $107.80, or 9 percent of the purchase price. The
change in price using the modified duration method is 9.44 percent,
overstating the actual price change by 0.44 percent.
Duration is therefore not a good predictor of price volatility if interest rates
undergo a big swing. Since the price-yield relationship of a bond is convex in
formbut duration is notthe duration measure will overstate the price
decline as the market experiences a big increase in rates. Here, although better,
the modified duration overstated the decline by almost 0.5 percent.
- 72 -


14.1
Learning Outcome: Discuss the basic nature of options

Describe put and call options. Are they issued like other corporate
securities?
14.3

What are the main investment attractions of put and call options? What
are the risks?
14.5

What is a strike price? How does it differ from the market price of the
stock?
14.6
LearningOutcome:Discussthebasicnatureofoptions
Why do put and call options have expiration dates? Is there a market for
options that have passed their expiration dates?
14.7
LearningOutcome:Describetheprofitpotentialofputsandcalls
Explain briefly how you would make money on (a) a call option and (b) a
put option. Do you have to exercise the option to capture the profit?
P14.6 You believe that oil prices will be rising more than expected, and that
rising prices will result in lower earnings for industrial companies that
use a lot of petroleum related products in their operations. You also
believe that the effects on this sector will be magnified because consumer
demand will fall as oil prices rise. You locate an exchange traded fund,
XLB, that represents a basket of industrial companies. You don't want to
short the ETF because you don't have enough margin in your account.
XLB is currently trading at $23. You decide to buy a put option (for 100
shares) with a strike price of $24, priced at $1.20. It turns out that you are
correct. At expiration, XLB is trading at $20. Calculate your profit.
XLB: Materials-$23.00
Calls
Puts
Strike Expiration Price Strike Expiration
$20
November
$0.25 $20
November
$24
November
$0.25 $24
November
- 73 -
Price
$1.55
$1.20

Learning Outcome: Describe the profit potential of puts and calls
P 14.7 Refer to the table for XLB in Problem 14.6. What happens if you are
wrong and the price of XLB increases to $25 on the expiration date?
Learning Outcome: Explain how put and call options are valued
Learning Outcome: Describe the profit potential of puts and calls
Case Problem 14.1
The Franciscos Investment Options
Hector Francisco is a successful businessman in Atlanta. The box-manufacturing
firm he and his wife, Judy, founded several years ago has prospered. Because he
is self employed, Hector is building his own retirement fund. So far, he has
accumulated a substantial sum in his investment account, mostly by following an
aggressive investment posture. He does this because, as he puts it, "In this
business, you never know when the bottom's gonna fall out." Hector has been
following the stock of Rembrandt Paper Products (RPP), and after conducting
extensive analysis, he feels the stock is about ready to move. Specifically, he
believes that within the next 6 months, RPP could go to about $80 per share,
from its current level of $57.50. The stock pays annual dividends of $2.40 per
share. Hector figures he would receive two quarterly dividend payments over his
6-month investment horizon.
In studying RPP, Hector has learned that the company has 6-month call options
(with $50 and $60 strike prices) listed on the CBOE. The CBOE calls are quoted
at $8 for the options with $50 strike prices and at $5 for the $60 options.
Questions
a.
How many alternative investment vehicles does Hector have if he wants to

invest in RPP for no more than 6 months? What if he has a 2-year
investment horizon?
b.
Using a 6-month holding period and assuming the stock does indeed rise
to $80 over this time frame:
1. Find the value of both calls, given that at the end of the holding period
neither contains any investment premium.
2. Determine the holding period return for each of the 3 investment
alternatives open to Hector Francisco.
c.
Which course of action would you recommend if Hector simply wants to

maximize profit? Would your answer change if other factors (e.g.,
comparative risk exposure) were considered along with return? Explain.
- 74 -

LearningOutcome:Explainhowputandcalloptionsarevalued
Case Problem 14.2
Freds Quandary: To Hedge or Not to Hedge
A little more than 10 months ago, Fred Weaver, a mortgage banker in Phoenix,
bought 300 shares of stock at $40 per share. Since then, the price of the stock has
risen to $75 per share. It is now near the end of the year, and the market is
starting to weaken. Fred feels there is still plenty of play left in the stock but is
afraid the tone of the market will be detrimental to his position. His wife, Denise,
is taking an adult education course on the stock market and has just learned
about put and call hedges. She suggests that he use puts to hedge his position.
Fred is intrigued by the idea, which he discusses with his broker, who advises
him that the needed puts are indeed available on his stock.
Specifically, he can buy 3-month puts, with $75 strike prices, at a cost of $550
each (quoted at 5.50).
Questions
a.
Given the circumstances surrounding Fred's current investment position,

what benefits could be derived from using the puts as a hedge device?
What would be the major drawback?
b.
What will Fred's minimum profit be if he buys 3 puts at the indicated

option price? How much would he make if he did not hedge but instead
sold his stock immediately at a price of $75 per share?
c.
Assuming Fred uses 3 puts to hedge his position, indicate the amount of
profit he will generate if the stock moves to $100 by the expiration date of
the puts. What if the stock drops to $50 per share?
d.
Should Fred use the puts as a hedge? Explain. Under what conditions
would you urge him not to use the puts as a hedge?
- 75 -


15.1
15.2
15.8
LearningOutcome:Describetheessentialfeaturesofafuturescontract
What is a futures contract? Briefly explain how it is used as an investment
vehicle.
LearningOutcome:Describetheessentialfeaturesofafuturescontract
Discuss the difference between a cash market and futures market.
LearningOutcome:Describefuturescontractsincome
What is the one source of return on futures contracts? What measure is
used to calculate the return on a commodities contract?
LearningOutcome:Explainthedifferencebetweenaphysicalcommodityand
afinancialfuture
15.10 What is the difference between physical commodities and financial
futures? What are their similarities?
LearningOutcome:Describestockindexfutures
15.12 Discuss how stock-index futures can be used for speculation and for
hedging. What advantages are there to speculating with stock-index
futures rather than specific issues of common stock?
LearningOutcome:Calculatefuturescontractsreturn
P15.1 Jeff Rink considers himself a shrewd commodities investor. Not long ago
he bought one July cotton contract at $0.54 a pound, and he recently sold
it at $0.58 a pound. How much profit did he make? What was his return
on invested capital if he had to put up a $1,260 initial deposit?
Learning Outcome: Explain the role and apply approaches to trade stockindex
futures
Case Problem 15.2
Jim and Polly Pernelli Try Hedging with Stock-Index Futures
Jim Pernelli and his wife, Polly, live in Augusta, Georgia. Like many young
couples, the Pernellis are a 2-income family. Jim and Polly are both college
graduates and hold high paying jobs. Jim has been an avid investor in the stock
market for a number of years and over time has built up a portfolio that is
currently worth nearly $375,000. The Pernellis' portfolio is well diversified,
although it is heavily weighted in high-quality, mid-cap growth stocks. The
Pernellis reinvest all dividends and regularly add investment capital to their
portfolio. Up to now, they have avoided short selling and do only a modest
amount of margin trading.
Their portfolio has undergone a substantial amount of capital appreciation in the
last 18 months or so, and Jim is eager to protect the profit they have earned. And
that's the problem: Jim feels the market has pretty much run its course and is
about to enter a period of decline. He has studied the market and economic news
very carefully and does not believe the retreat will cover an especially long period
- 76 -

of time. He feels fairly certain, however, that most, if not all, of the stocks in his
portfolio will be adversely affected by these market conditions-though some will
drop more in price than others.
Jim has been following stock-index futures for some time and believes he knows
the ins and outs of these securities pretty well. After careful deliberation, Jim and
Polly decide to use stock-index futures-in particular, the S&P MidCap 400
futures contract-as a way to protect (hedge) their portfolio of common stocks.
Questions
a.
Explain why the Pernellis would want to use stock-index futures to hedge
their stock portfolio, and how they would go about setting up such a
hedge. Be specific.
1. What alternatives do Jim and Polly have to protect the capital value of
their portfolio?
2. What are the benefits and risks of using stock-index futures as hedging
vehicles?
b.
Assume that S&P MidCap 400 futures contracts are currently being
quoted at 769.40. How many contracts would the Pernellis have to buy (or
sell) to set up the hedge?
1. Say the value of the Pernelli portfolio dropped 12 % over the course of
the market retreat. To what price must the stock-index futures contract
move in order to cover that loss?
2. Given that a $16,875 margin deposit is required to buy or sell a single
S&P 400 futures contract, what would be the Pernellis' return on invested
capital if the price of the futures contract changed by the amount
computed in part b1, above?
c.
Assume that the value of the Pernelli portfolio declined by $52,000, while
the price of an S&P 400 futures contract moved from 769.40 to 691.40.
(Assume that Jim and Polly short sold one futures contract to set up the
hedge.)
1. Add the profit from the hedge transaction to the new (depreciated)
value of the stock portfolio. How does this amount compare to the
$375,000 portfolio that existed just before the market started its retreat?
2. Why did the stock-index futures hedge fail to give complete protection
to the Pernelli portfolio? Is it possible to obtain perfect (dollar-for-dollar)
protection from these types of hedges? Explain.
- 77 -

Portfolio Tutorial

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Portfolio Tutorial

Uploaded by

Copyright:

Available Formats

FACULTY OF ENGINEERING AND SCIENCE

UKFF3283 PORTFOLIO MANAGEMENT

Differentiate the transactions

FACULTY OF ENGINEERING AND SCIENCE

Explain the key aspects of the

Describe the basic types of

aspects of investor protection.

Topic 3: Return and

Measure and analyze risk and

Explain portfolio objectives

FACULTY OF ENGINEERING AND SCIENCE

management with modern

Explain the basic features of

Explain how the economic,

FACULTY OF ENGINEERING AND SCIENCE

Explain the basic features of

Explain the role that a

FACULTY OF ENGINEERING AND SCIENCE

Topic 10: Fixed

intrinsic value of a stock

Explain the investment

FACULTY OF ENGINEERING AND SCIENCE

Topic 11: Bond

Topic 12: Options:

Explain the behavior of

Explain the investment

Explain the investment

Put and call

FACULTY OF ENGINEERING AND SCIENCE

Differentiate commodity and

Discuss the trading

Main Text Book:

Coursework (40% of Total Assessment) with the following specification:

Final Examination (60% of Total Assessment)

Mid-term test: WEEK 9, 21st July, 2014 (Monday).

FACULTY OF ENGINEERING AND SCIENCE

Learning Outcome: Explain the meaning of investment

FACULTY OF ENGINEERING AND SCIENCE

What should an investor first establish before developing and executing

FACULTY OF ENGINEERING AND SCIENCE

Learning Outcome: Discuss investing over the life cycle

FACULTY OF ENGINEERING AND SCIENCE

Learning Outcome: Differentiate different securities markets

FACULTY OF ENGINEERING AND SCIENCE

FACULTY OF ENGINEERING AND SCIENCE

Learning Outcome: Explain long purchases, margin transaction, and short

FACULTY OF ENGINEERING AND SCIENCE

FACULTY OF ENGINEERING AND SCIENCE

FACULTY OF ENGINEERING AND SCIENCE

FACULTY OF ENGINEERING AND SCIENCE

FACULTY OF ENGINEERING AND SCIENCE

Learning Outcome: Review the concept of return and its components.

FACULTY OF ENGINEERING AND SCIENCE

Types of investments affected are common stocks and corporate bonds.

Learning Outcome: Review the concept of return and its components.

FACULTY OF ENGINEERING AND SCIENCE

a. Use present-value techniques to estimate the yield on this investment.

FACULTY OF ENGINEERING AND SCIENCE

FACULTY OF ENGINEERING AND SCIENCE

FACULTY OF ENGINEERING AND SCIENCE

FACULTY OF ENGINEERING AND SCIENCE

Perfect positive correlation two positively correlated series having a

FACULTY OF ENGINEERING AND SCIENCE