1.

(10 points)
Calculate the price of a stock that has a one-period horizon, is expected to pay a
dividend of $.20 per share for the period, with the following prices and associated
probabilities forecast at the end of the period:
Probabili
0.3 0.1 0.2 0.3 0.1
ty
$4 $4 $5 $6 $7
Price
0 5 5 2 0
The return on comparable stocks is 8%.
Solution: Computation of the price of a stock that has a one-period
horizon

NOTE: Double click the table to see the formulas used.

Given information

Dividend per share = $0.20

Expected value per share = $53.10 after years

Rate of return = 0.08

Stock price = (0.20/1.08) + (53.10/1.08)

Stock price = (0.185185) + (49.16667)

Stock price = 49.35185

Hence the Stock price is $49.35

2. (15 points)
JetBlue Airways Corporation (JBLU) reports the following in its latest quarterly report:
Authorized shares

500,000,000

Shares issued

317,391,718

Shares outstanding

290,305,387

a. (5 points)
How many shares are in the treasury stock?
Solution:-Computation of the shares is in the treasury stock

Treasury Stock = Share issued Shares Outstanding

Treasury Stock = 317,391,718 290,305,387

Treasury Stock = 27,086,331

Hence the Treasury Stock is 27,086,331

b. (5 points)
If the float is 280,700,408 shares, find the number of restricted shares.
Solution:-Computation of the shares is in the restricted shares
Restricted shares = Shares Outstanding Float
Restricted shares = 290,305,387 280,700,408
Restricted shares = 9,604,979
Hence the Restricted shares is 9,604,979

c. (5 points)
Recently, JBLU closed at $5.51 per share. Based on this price, find the market
capitalization of the company.
Solution:-Computation of the Following
Market Capitalization = Float shares*Stock price
Market Capitalization = 280,700,408*5.51
Market Capitalization = $1,546,659,248.08
Hence the Market Capitalization is $1,546,659,248.08

To answer questions 3 and 4, refer to the articles by Malkiel and Shleifer available
on the course web site, in addition to what we covered in class.
3. (15 points)
a. (5 points)
Why do Malkiel, and those who think like him, believe in efficient market
theory?
b. (5 points)
What are three attacks on EMH that Malkiel attributes to the behavioralists?
c. (5 points)
What does Malkiel believe about the market patterns the behavioralists
claim to
have discovered?
4. (20 points)
a. (5 points)
How does Shleifer define arbitrage? How does he use the concept to argue
against market efficiency?
Solution:
Shleifer defined arbitrage as trading by completely rational investors not subject to
such sentiment is risky and therefore limited.

b. (5 points)
Why would the market value of Royal Dutch equal 1.5 times the market
value of Shell if efficient smarket theory is correct?
Royal Dutch and Shell are incorporated in Netherlands and England respectively. In
1907, two companies formed an alliance and merge their interests on a 60:40 while
remaining separate and distinct companies.
If prices are right, the Royal Dutch market value should always equal 1.5 times the
market value of Shell. In this case, the EMH reflects the law of one price. Identical
securities must sell at the same price at different markets. If not, there would be
clear arbitrage opportunities from dumping the relatively expensive stock and
purchasing the cheap stock.
A shrewd investor, who observed, for example, that in the 1997 summer, Royal
Dutch traded at an 8% to 10% premium relative to Shell, would have sold short the
expensive Royal Dutch stock and hedged his position with the Shell stocks which
are cheaper.

Sadly for this investor, the deviation from the 60-40 parity only

widened in 1998, reaching nearly 20% in the autumn crisis. This bet against market
inefficiency lost money, and a lot of money if leveraged.
In this case, it is said that when long term capital management collapsed during the
Russian crisis, it unwound a large part in the trade of Royal Dutch and Shell. Smart
investors can lose a lot of money at the times when an inefficient market becomes
even less efficient.

In fact, as the long term capital management experience

explains, their businesses might not survive long enough to see markets return to
efficiency.
c. (5 points)
Why is the Royal Dutch/Shell case something of an embarrassment for
EMH?
It is an embarrassment for EMH because the setting is the best case for the theory.
The same cash flows should sell for the same price in different markets. It means
the deviations from efficiency can be persistent and large, especially with no

catalysts to bring markets back to efficiency. It also shows that the forces in market
need not be strong enough to get prices in line even when some risks can be
hedged, and those investors can lose money along the way.

d. (5 points)
How does the fact that arbitrage is risky argue against EMH?
The fact that arbitrage is risky in no way means that the market knows best. To the
contrary, it shows that the mis-valued market can become more mis-valued. It
means the deviations from efficiency can be persistent and large, especially with no
catalysts to bring markets back to efficiency. It also shows that the forces in market
need not be strong enough to get prices in line even when some risks can be
hedged, and those investors can lose money along the way.

5. (10 points)
What is the beta of a stock with an expected return E(r i) = 18%, when the
risk-free rate rF = 6%, and the expected market return E(rM) = 14%? Show
your work.
Solution: Computation of the Beta
E(r1) = 18%
rf

= 6%

E(rM )= 14%
E(r1) = rf + [E(rM ) rf ]
0.18 = 0.06 + [0.14 0.06]
0.18 = 0.06 + 0.08
= 0.12 / 0.08 =

1.5

6. (10 points)
True or false? Explain: Stocks with a beta of zero offer an expected rate
of return of zero.
Answer:

False, if beta = 0, then Er = rf, not zero

7.

(10 points)

Suppose the rate of return on short-term government securities

(perceived to be risk-free) is 5%. Suppose also that the expected rate of
return required by the market for a portfolio with a beta of 1 is 12%.
According to the CAPM:
a.

(5 points)

What is the expected rate of return on the market portfolio?

Portfolios with = 1 earn the market rate.
Formula
E(r1) = rf + [E(rM ) rf ]
E(rM ) = [E(r) rf ]/ 1
E(r1 = [0.12 0.05]/1 + 0.05
= 12%
Expected rate or return is 12%
b. (5 points)
What would be the expected rate of return on a stock with = 0?
Stocks with = 0 have no market risk.
E(r1) = rf + 1[E(rM ) rf ]
= 0.05 + 0[0.12 0.05]
= 5%
The CAPM implies that investors are compensated only for incurring market risk.
The expected rate of return on a stock with = 0 is 5%
8. (10 points)
Describe the two kinds of contracts that an underwriter can negotiate with a
firm wishing to do an IPO. Discuss which is more costly to the issuing firm, and
why.
Solution:

The most common type of contracts is firm commitment contract, best efforts
contract and all-or-none contract.
In the firm commitment contract, the underwriter guarantees the sales of the

issued shares at the agreed-upon price.

In the best efforts contract, the underwriter agrees to sell as many as

possible shares at the agreed-upon price.

In the all-or-none contract, the underwriter agrees either to sell the entire
issued stock or to cancel the deal.
The firm commitment contract is the most costly to the issuing firm, since the
underwriter takes the risk of sale.