Chap # 01: THE INVESTMANT SETTING

Questions
1. Discuss the overall purpose people have for investing Define investment. Answer: When an individuals current money income exceeds his current consumption desires, he saves the excess. Rather than eep these savings in his possession, the individual may consider it worthwhile to forego immediate possession of the money for a larger future amount of consumption. !his trade"off of present consumption for a higher level of future consumption is the essence of investment. An investment is the current commitment of funds for a period of time in order to derive a future flow of funds that will compensate the investor for the time value of money, the expected rate of inflation over the life of the investment, and provide a premium for the uncertainty associated with this future flow of funds. #. As a student, ate you saving or $orrowing% Why% Answer: &tudents in general tend to $e $orrowers $ecause they are typically not employed so have no income, $ut o$viously consume and have expenses. !he usual intent is to invest the money $orrowed in order to increase their future income stream from employment " i.e., students expect to receive a $etter 'o$ and higher income due to their investment in education. (. Divide a persons life from ages #) to *) into 1)"year segments and discuss the li ely saving or $orrowing patterns during each period. Answer: +n the #)"() year segment an individual would tend to $e a net $orrower since he is in a relatively low"income $rac et and has several expenditures " automo$ile, dura$le goods, etc. +n the ()",) segment again the individual would li ely dissave, or $orrow, since his expenditures would increase with the advent of family life, and conceiva$ly, the purchase of a house. +n the ,)"-) segment, the individual would pro$a$ly $e a saver since income would have increased su$stantially with no increase in expenditures. .etween the ages of -) and /) the individual would typically $e a strong saver since income would continue to increase and $y now the couple would $e 0empty"nesters.1 After this, depending upon when the individual retires, the individual would pro$a$ly $e a dissaver as income decreases 2transition from regular income to income from a pension3.

,. Discuss why you would expect the saving $orrowing pattern to differ $y occupation 2for example, for a doctor versus a plum$er3. Answer:

!he saving"$orrowing pattern would vary $y profession to the extent that compensation patterns vary $y profession. 4or most white"collar professions 2e.g., lawyers3 income would tend to increase with age. !hus, lawyers would tend to $e $orrowers in the early segments 2when income is low3 and savers later in life. Alternatively, $lue"collar professions 2e.g., plum$ers3, where s ill is often physical, compensation tends to remain constant or decline with age. !hus, plum$ers would tend to $e savers in the early segments and dissavers later 2when their income declines3. -. !he wall street 'ournal reported that the yield on common stoc s is a$out # percent, whereas a study at the 5niversity of 6hicago contends that the annual rate of return on common stoc s since 17#/ has averaged a$out 1# percent. Reconcile these statements. Answer: !he difference is $ecause of the definition and measurement of return. +n the case of the WSJ, they are only referring to the current dividend yield on common stoc s versus the promised yield on $onds. +n the 5niversity of 6hicago studies, they are tal ing a$out the total rate of return on common stoc s, which is the dividend yield plus the capital gain or loss yield during the period. +n the long run, the dividend yield has $een ,"- percent and the capital gain yield has averaged a$out the same. !herefore, it is important to compare alternative investments $ased upon total return. /. &ome financial theorists consider the variance of the distri$ution of expected rates of return to $e a good measure of uncertainty. Discuss the reasoning $ehind this measure of ris and its purpose. Answer: !he variance of expected returns represents a measure of the dispersion of actual returns around the expected value. !he larger the variance is, everything else remaining constant, the greater the dispersion of expectations and the greater the uncertainty, or ris , of the investment. !he purpose of the variance is to help measure and analy8e the ris associated with a particular investment. *. Discuss the three components of an investors re9uired rate of return on an investment. Answer: An investors re9uired rate of return is a function of the economys ris free rate 2R4R3, an inflation premium that compensates the investor for loss of purchasing power, and a ris premium that compensates the investor for ta ing the ris . !he R4R is the pure time value of money and is the compensation an individual demands for deferring consumption. :ore o$'ectively, the R4R can $e measured in terms of the long"run real growth rate in the economy since the investment opportunities availa$le in the economy influence the R4R. !he inflation premium, which can $e conveniently measured in terms of the 6onsumer ;rice +ndex, is the additional protection an individual re9uires to compensate for the erosion in purchasing power resulting from increasing prices. &ince the return on all investments is not certain as it is with !"$ills, the investor re9uires a premium for ta ing on additional ris . !he ris premium can $e examined in terms of $usiness ris , financial ris , li9uidity ris , exchange rate ris and country ris .

<. Discuss the two ma'or factors that determine the mar et nominal ris "free rate 2=R4R3.>xplain which of these factors would $e more volatile over the $usiness cycle. Answer: !wo factors that influence the R4R are li9uidity 2i.e., supply and demand for capital in the economy3 and the real growth rate of the economy. ?$viously, the influence of li9uidity on the R4R is an inverse relationship, while the real growth rate has a positive relationship with the R4R " i.e., the higher the real growth rate, the higher the R4R. +t is unli ely that the economys long"run real growth rate will change dramatically during a $usiness cycle. @owever, li9uidity depends upon the governments monetary policy and would change depending upon what the government considers to $e the appropriate stimulus. .esides, the demand for $usiness loans would $e greatest during the early and middle part of the $usiness cycle. 7. .riefly discuss the five fundamental factors that influence the ris premium of an investment. Answer: !he five factors that influence the ris premium on an investment are $usiness ris , financial ris , li9uidity ris , exchange rate ris , and country ris . .usiness ris is a function of sales volatility and operating leverage and the com$ined effect of the two varia$les can $e 9uantified in terms of the coefficient of variation of operating earnings. 4inancial ris is a function of the uncertainty introduced $y the financing mix. !he inherent ris involved is the ina$ility to meet future contractual payments 2interest on $onds, etc.3 or the threat of $an ruptcy. 4inancial ris is measured in terms of a de$t ratio 2e.g., de$tAe9uity ratio3 andAor the interest coverage ratio. Bi9uidity ris is the uncertainty an individual faces when he decides to $uy or sell an investment. !he two uncertainties involved are: 213 how long it will ta e to $uy or sell this asset, and 2#3 what price will $e received. !he li9uidity ris on different investments can vary su$stantially 2e.g., real estate vs. !"$ills3. >xchange rate ris is the uncertainty of returns on securities ac9uired in a different currency. !he ris applies to the glo$al investor or multinational corporate manager who must anticipate returns on securities in light of uncertain future exchange rates. A good measure of this uncertainty would $e the a$solute volatility of the exchange rate or its $eta with a composite exchange rate. 6ountry ris is the uncertainty of returns caused $y the possi$ility of a ma'or change in the political or economic environment of a country. !he analysis of country ris is much more su$'ective and must $e $ased upon the history and current environment in the country. 1). Cou own stoc in the Dentry 6ompany and you read in the financial press that recent $ond offering has raised the firms de$tAe9uity ratio from (- percent to -- percent. Discuss the effect of this change on the varia$ility of the firms net income stream, other factors $eing constant. Discuss how this change would affect your re9uired rate of return on the common stoc of the Dentry 6ompany. Answer: !he increased use of de$t increases the fixed interest payment. &ince this fixed contractual payment will increase, the residual earnings 2net income3 will $ecome more varia$le. !he re9uired rate of return on the stoc will change since the financial ris 2as (

measured $y the de$tAe9uity ratio3 has increased. 11. Draw a properly la$eled graph of the security mar et line 2&:+3 and indicate where you would expect the following investments to fall along that line Discuss your reasoning. a. 6ommon stoc of large firms $. 5.&. government $onds c. 5.E. government $onds d. Bow"grade corporate $onds e. 6ommon stoc of a Fapanese firm Answer: According to the 6apital Asset ;ricing :odel, all securities are located on the &ecurity :ar et Bine with securities ris on the hori8ontal axis and securities expected return on its vertical axis. As to the locations of the five types of investments on the line, the 5.&. government $onds should $e located to the left of the other four, followed $y 5nited Eingdom government $onds, low"grade corporate $onds, common stoc of large firms, and common stoc s of Fapanese firms. 5.&. government $onds have the lowest ris and re9uired rate of return simply $ecause they virtually have no default ris at all.

1#. >xplain why you would change your nominal re9uired rate of return if you expect the rate of inflation to go from ) 2no inflation3 to , percent. Dive an example of what would happen if you did not change your re9uired rate of return under these conditions. Answer: . +f a mar ets real R4R is, say, ( percent, the investor will re9uire a ( percent return on an investment since this will compensate him for deferring consumption. @owever, if the inflation rate is , percent, the investor would $e worse off in real terms if he invests at a rate of return of , percent " e.g., you would receive G1)(, $ut the cost of G1)) worth of goods at the $eginning of the year would $e G1), at the end of the year, which means you could consume less real goods. !hus, for an investment to $e desira$le, it should have a return of *.1# percent H21.)( x 1.),3 " 1I, or an approximate return of * percent 2(J K ,J3.

1(. Assume the long"run growth rate of the economy increased $y 1 percent and the expected rate of inflation increased $y , percent. What would happen to the re9uired rate of return on government $onds and common stoc s% &how graphically how the effects of these changes would differ $etween these alternative investments. Answer: .oth changes cause an increase in the re9uired return on all investments. &pecifically, an increase in the real growth rate will cause an increase in the economys R4R $ecause of a higher level of investment opportunities. +n addition, the increase in the rate of inflation will result in an increase in the nominal R4R. .ecause $oth changes affect the nominal R4R, they will cause an e9ual increase in the re9uired return on all investments of - percent. !he graph should show a parallel shift upward in the capital mar et line of - percent.
> x p e c te d R e tu r n = ew & : B ? ld & : B

=R4RL =R4R
R 4 R

> x p e c te d R is

1,. Cou see in !he Wall &treet Fournal that the yield spread $etween .aa corporate $onds and Aaa corporate $onds has gone from (-) $asis points 2(.- percent3 to #)) $asis points 2# percent3. &how graphically the effect of this change in yield spread on the &:B and discuss its effect on the re9uired rate of return for common stoc s. Answer: &uch a change in the yield spread would imply a change in the mar et ris premium $ecause, although the ris levels of $onds remain relatively constant, investors have changed the spreads they demand to accept this ris . +n this case, $ecause the yield spread 2ris premium3 declined, it implies a decline in the slope of the &:B as shown in the following graph.

> x p e c te d R e tu r n

? rig in a l & : B = ew &: B

R 4R > x p e c te d R is

1-. Dive an example of a li9uid investment and an illi9uid investment. Discuss why you consider each or them to $e li9uid or illi9uid. Answer: !he a$ility to $uy or sell an investment 9uic ly without a su$stantial price concession is nown as li9uidity. An example of a li9uid investment asset would $e a 5nited &tates Dovernment !reasury .ill. A !reasury .ill can $e $ought or sold in minutes at a price almost identical to the 9uoted price. +n contrast, an example of an illi9uid asset would $e a speciali8ed machine or a parcel of real estate in a remote area. +n $oth cases, it might ta e a considera$le period of time to find a potential seller or $uyer and the actual selling price could vary su$stantially from expectations.

Answers to Problems 1. ?n 4e$ruary, you $ought 1)) shares of a stoc for G(, a share and a year later you sold it for G(7 a share. During the year, you received a cash dividend of G1.-) a share. 6ompute your @;R and @;C on this stoc investment. &olution:
1. >nding Malue of +nvestment 2including 6ash 4lows3 .eginning Malue of +nvestment (7 +1.-) ,).-) = = = 1.171 (, (, @;C = @;R " 1 =1.171 " 1 = .171 =17.1J @;R =

#. ?n August 1-, you purchased 1)) shares of a stoc at G/- a share and a year later you sold it for G/1 a share. During the year, you received dividends of G( a share. 6ompute your @;R and @;C on this investment. &olution:
#. /1 + ( /, = = .7<//@;C = @;R " 1 = .7<- " 1 = " .)1- = " 1.-J @;R =

(. At the $eginning of last year, you invested G,))) in <) shares of the 6hang 6orporation. During the year, 6hang paid dividends of G- per share. At the end of the year, you sold the <) shares for G-7 a share. 6ompute your total @;C on these shares and indicate how much was due to the price change and how much was due to the dividend income. /

&olution:

G,,))) used to purchase <) shares N G-) per share

2-7 x <)3 + 2- x <)3 ,,*#) + ,)) -,1#) = = = 1.#<) ,,))) ,,))) ,,))) @;C = @;R " 1 =1.#<) " 1 = .#<) = #<J @;R =
-7 x <) ,,*#) = = 1.1<) ,,))) ,,))) @;C 2;rice +ncrease Alone3 =1.1<) " 1 =.1<) =1<J @;R 2;rice +ncrease Alone3 =

!herefore: @;C 2!otal3 N @;C 2;rice +ncrease3 K @;C 2Div3 .#<) N .1<) K @;C 2Div3 .1) N @;C 2Dividends3 ,. !he rates of return computed in ;ro$lems 1, # and ( are nominal rates of return. Assuming that the rate of inflation during the year was , percent, compute the real rates of return on these investments. 6ompute the real rates of return if the rate of inflation were < percent. &olution:
,. P RealP Rate of Return = @olding ;eriod Return 1 1 + Rate of +nflation

4or ;ro$lem O1: @;R N 1.171

1.171 1.171 1 = 1 = 1.1,- 1 = .1,- = 1,.-J 1 + .), 1.), 1.171 1.171 at <J inflation : 1 = 1 = 1.1)( 1 = .1)( = 1).(J 1 + .)< 1.)< at ,J inflation :

4or ;ro$lem O#: @;R N .7<.7<1 = .7,* 1 = .)-( = -.(J 1.), .7<at <J inflation : 1 = .71# 1 = .)<< = <.<J 1.)< at ,J inflation :

4or ;ro$lem O(: @;R N 1.#<)

1.#<) 1 = 1.#(1 1 = .#(1 = #(.1J 1.), 1.#<) at <J inflation : 1 = 1.1<- 1 = .1<- = 1<.-J 1.)< at ,J inflation :

-. During the past five years, you owned two stoc s that had the following annual rates of return. Cear 1 # ( , &toc ! ).17 ).)< ").1# ").)( ).1&toc . ).)< ).)( ").)7 ).)# ).),

a. 6ompute the arithmetic mean annual rate of return for each stoc . Which stoc is most desira$le $y this measure% $. 6ompute the standard deviation of the annual rate of return for each stoc . 25se 6hapter 1 Appendix if necessary3..y this measure, which is the prefera$le stoc % c. 6ompute the coefficient of variation for each stoc . 25se the 6hapter 1 Appendix if necessary3. .y this relative measure of ris , which stoc is prefera$le% d. 6ompute the geometric mean rate of return for each stoc . Discuss the difference $etween the arithmetic mean return and the geometric mean return for each stoc . Relate the differences in the mean returns to the standard deviation of the return for each stoc . &olution:

-2a3.

@;Ci n i =1 2.173 + 2.)<3 + 2.1#3 + 2 .)(3 + 2.1-3 A: ! = .#* = = .)-, 2.)<3 + 2.)(3 + 2.)73 + 2.)#3 + 2.),3 A: . = .)< = = .)1/ Arithemetic :ean 2A:3 =
n

&toc ! is more desira$le $ecause the arithmetic mean annual rate of return is higher.

-2$3. &tandard Deviation 2 3 =

; HR
i =1 i

>2R i 3I#

! = 2.17 .)-,3 # + 2.)< .)-,3 # + 2 .1# .)-,3 # + 2.)( .)-,3 # + 2.1- .)-,3 # = .)1<-) +.)))/< + .)()#< + .))*)/ +.))7## = .)/-*,

= .)/-*, A - = .)1(1#

<

! = .)1(1, = .11,/*

. = 2.)< .)1/3 # + 2.)( .)1/3 # + 2.)7 .)1/3 # + 2.)# .)1/3 # + 2.), .)1/3 # = .)),1) + .)))#) + .)11#, + .))))# + .)))-< = .)1/1,

= .)1/1, A - = .))(#(
#

! = .))(#( = .)-/<1

.y this measure, . would $e prefera$le

&tandard Deviation >xpected Return

-2c3.

6oefficient of Mariation = .11,// = #.1#( .)-, .)-/<# 6M. = = (.--1( .)1/ 6M! =

.y this measure, ! would $e prefera$le. -2d3. Deometric :ean 2D:3 N 1An Q 1 where N ;roduct of the @Rs D:! N H21.173 21.)<3 2.<<3 2.7*3 21.1-3I1A- "1 N H1.#/1/)I 1A- Q1 N 1.),*-* Q1 N .),*-* D:. N H21.)<3 21.)(3 2.713 21.)#3 21.),3I1A- "1 N H1.)*(<(I 1A- Q1 N 1.)1,(- Q 1 N .)1,(&toc ! has more varia$ility than &toc .. !he greater the varia$ility of returns, the greater the difference $etween the arithmetic and geometric mean returns.

/. Cou are considering ac9uiring shares of common stoc in the :adison .eer 6orporation. Cour rate of return expectations are as follows: :adison .eer 6orp ;ossi$le Rate of Return ").1) ).)) ).1) ).#. ;ro$a$ility ).() ).1) ).() ).() 7

6ompute the expected return H>2R3I on your investment in :adison .eer. &olution: >2R:.63 N 2.()3 2".1)3 K 2.1)3 2).))3 K 2.()3 2.1)3 K 2.()3 2.#-3 N 2".)(3 K .))) K .)( K .)*- N .)**. A stoc holder calls you and suggests that you invest in the Bauren 6omputer 6ompany. After analy8ing the firms annual report and other material, you $elieve that the distri$ution of rates of return is as follow: Bauren 6omputer 6o. ;ossi$le Rate of Return ;ro$a$ility ")./) ).)").() ).#) ").1) ).1) ).#) ).() ).,) ).#) ).<) ).16ompute the expected return H>2R,3I on Bauren 6omputer stoc . &olution: >2RA663 N 2.)-3 2"./)3 K 2.#)3 2".()3 K 2.1)3 2".1)3 K 2.()3 2.#)3 K 2.#)3 2.,)3 K 2.1-3 2.<)3 N 2".)(3 K 2".)/3 K 2".)13 K .)/ K .)< K .1# N .1/

<. Without any formal computations, do you consider :adison .eer in ;ro$lem / or Bauren 6omputer in pro$lem * to present greater ris % Discuss your reasoning. &olution: !he Anita 6omputer 6ompany presents greater ris as an investment $ecause the range of possi$le returns is much wider. 7. During the past year, you had a portfolio that contained 5.&. government !"$ills, long" term government $onds, and common stoc s. !he rates of return on each of them were as follows: 5.&. government !"$ills -.-)J 5.&. government long"term $onds *.-) 5.&. common stoc 11./) During the year, the consumer price index, which measure the rate of inflation, went from 1/) to 1*# 217<#"17<,N 1))3.6ompute the rate of inflation during this year. 6ompute the

1)

real rates of return on each of the investments in your portfolio $ased on the inflation rate. &olution:
7. Rate of +nflation = 6;+ n +1 6;+ n 6;+ n

where 6;+ =the 6onsumer ;rice +ndex 1*# " 1/) 1# Rate of +nflation = = =.)*1/) 1/) @;R Real Rate of Return = 1 1 +rate of inflation 1.)-5.&. Dovernment ! " .ills = 1 =.7<1, 1 = .)1</ 1.)*1.)*5.&. Dovernment B! $onds = 1 = ) 1.)*1.11/) 5.&. 6ommon &toc s = 1 =1.)(<1 1 =.)(<1 1.)*-

1). Cou read in .usiness Wee that a panel of economists has estimated that the long"run real growth rate of 5.&. economy over the next this five"year period will average ( percent. +n addition, a $an newsletter estimates that the average annual rate of inflation during this five"year period will average ( percent. +n addition, a$out , percent. What nominal rate of return would you expect on 5.&. government !"$olls during this period% &olution: =R4R N 21 K .)(3 21 K .),3 Q 1 N 1.)*1# Q 1 N .)*1# 2An approximation would $e growth rate plus inflation rate or .)( K .), N .)*.3 11. What would your re9uired rate of return $e on common stoc s if you wanted a - percent ris premium to own common stoc s given what you now from ;ro$lem 1)% +f common stoc investors $ecame more ris averse, what would happen to the re9uired rate of return on common stoc s% What would $e the impact on stoc prices% &olution: Return on common stoc N 21 K .)*1#3 21 K .)-3 Q 1 N 1.1#,< Q 1 N .1#,< or 1#.,<J 2An approximation would $e .)( K .), K .)- N .1# or 1#J.3

11

As an investor $ecomes more ris averse, the investor will re9uire a larger ris premium to own common stoc . As ris premium increases, so too will re9uired rate of return. +n order to achieve the higher rate of return, stoc prices should decline. 1#. Assume that the consensus re9uired rate of return on common stoc s is 1, percent. +n addition, you read in 4ortune that the expected rate of inflation is - percent and the estimated long"term real growth rate of the economy is ( percent. What interest rate would you expect on 5.&. government !"$ills% What is the approximate ris premium for common stoc s implied $y these data% &olution: =ominal rate on !"$ills 2or ris "free rate3 N 21 K .)(3 21 K .)-3 Q 1 N 1.)<1- Q 1 N .)<1- or <.1-J 2An approximation would $e .)( K .)- N .)<.3 !he re9uired rate of return on common stoc is e9ual to the ris "free rate plus a ris premium. !herefore the approximate ris premium for common stoc s implied $y these data is: .1, " .)<1- N .)-<- or -.<-J. 2An approximation would $e .1, " .)< N .)/.3

Chapter # 05 :Security market indicator series

1. Discuss $riefly several uses of security mar et indicator series. Answer: !he purpose of mar et indicator series is to provide a general indication of the aggregate mar et changes or mar et movements. :ore specifically, the indicator series are used to derive mar et returns for a period of interest and then used as a $enchmar for evaluating the performance of alternative portfolios. A second use is in examining the factors that influence aggregate stoc price movements $y forming relationships $etween mar et 2series3 movements and changes in the relevant varia$les in order to illustrate how these varia$les influence mar et movements. A further use is $y technicians who use past aggregate mar et movements to predict future price patterns. 4inally, a very important use is in portfolio theory, where the systematic ris of an individual security is determined $y the relationship of the rates of return for the individual security to rates of return for a mar et 1#

portfolio of ris y assets. @ere, a representative mar et indicator series is used as a proxy for the mar et portfolio of ris y assets. #. What ma'or factors must $e considered when constructing a mar et index% ;ut another way, what characteristics differentiate indexes% Answer: A characteristic that differentiates alternative mar et indicator series is the sample " the si8e of the sample 2how representative of the total mar et it is3 and the source 2whether securities are of a particular type or a given segment of the population 2=C&>, !&>3. !he weight given to each mem$er plays a discriminatory role " with diverse mem$ers in a sample, it would ma e a difference whether the series is price"weighted, value"weighted, or unweighted. 4inally, the computational procedure used for calculating return " i.e., whether arithmetic mean, geometric mean, etc.

(. >xplain how a mar et indicator series is price weighted. +n such a case, woild you expect a G1)) stoc to $e more important than a G#- stoc % Why or why not% Answer: A price"weighted series is an unweighted arithmetic average of current prices of the securities included in the sample " i.e., closing prices of all securities are summed and divided $y the num$er of securities in the sample. A G1)) security will have a greater influence on the series than a G#- security $ecause a 1) percent increase in the former increases the numerator $y G1) while it ta es a ,) percent increase in the price of the latter to have the same effect. ,. >xplain how to compute a mar et"value"weighted series. Answer: A value"weighted index $egins $y deriving the initial total mar et value of all stoc s used in the series 2mar et value e9uals num$er of shares outstanding times current mar et price3. !he initial value is typically esta$lished as the $ase value and assigned an index value of 1)). &u$se9uently, a new mar et value is computed for all securities in the sample and this new value is compared to the initial value to derive the percent change which is then applied to the $eginning index value of 1)).

-. >xplain how a price"weighted series and a mar et"value"weighted series ad'ust for stoc splits. Answer: Diven a four security series and a #"for"1 split for security A and a ("for"1 split for security ., the divisor would change from , to #.< for a price"weighted series.
&toc

.efore &plit ;rice

After &plit ;rices

1(

G#) . 6 D !otal1))A, N #-

G1) () #) () *)Ax N #-

1) #) ()

x N #.< !he price"weighted series ad'usts for a stoc split $y deriving a new divisor that will ensure that the new value for the series is the same as it would have $een without the split. !he ad'ustment for a value"weighted series due to a stoc split is automatic. !he decrease in stoc price is offset $y an increase in the num$er of shares outstanding. Before Split &toc ;riceA&hare O of &hares A G#) . () 6 #) #,))),))) D () !otal :ar et Malue 1,))),))) -)),))) ,),))),))) (,-)),)))

G#),))),))) 1-,))),))) 1)-,))),))) G1<),))),)))

!he G1<),))),))) $ase value is set e9ual to an index value of 1)). After Split &toc ;riceA&hare O of &hares A G1) . 1) 6 #) #,))),))) D () !otal
=ew +ndex Malue = =

:ar et Malue #,))),))) 1,-)),))) ,),))),))) (,-)),)))

G#),))),))) 1-,))),))) 1)-,))),))) G1<),))),)))

6urrent :ar et Malue x .eginning +ndex Malue .ase Malue 1<),))),))) x 1)) 1<),))),)))

= 1))

which is precisely what one would expect since there has $een no change in prices other than the split. /. Descri$e an unweighted price indicator series and descri$e how you would construct such a series. Assume a #) percent price change in D: 2G,)AshareR -) million shares outstanding3 and 6oors .rewing 2G#-Ashare and 1- million shares outstanding3. >xplain which stoc s change will have the greater impact on such an index. Answer: +n an unweighted price indicator series, all stoc s carry e9ual weight irrespective of their price andAor their value. ?ne way to visuali8e an unweighted series is to assume that 1,

e9ual dollar amounts are invested in each stoc in the portfolio, for example, an e9ual amount of G1,))) is assumed to $e invested in each stoc . !herefore, the investor would own #- shares of D: 2G,)Ashare3 and ,) shares of 6oors .rewing 2G#-Ashare3. An unweighted price index that consists of the a$ove three stoc s would $e constructed as follows: &toc ;riceA&hare D: G ,) 6oors #!otal A 20 O of &hares #,) :ar et Malue G1,))) 1,))) G#,)))

price increase in !": O of &hares #,) :ar et Malue G1,#)) 1,))) G#,#))

&toc ;riceA&hare D: G ,< 6oors #!otal A 20

price increase in Coors: O of &hares #,) :ar et Malue G1,))) 1,#)) G#,#))

&toc ;riceA&hare D: G ,) 6oors () !otal

!herefore, a #)J increase in either stoc would have the same impact on the total value of the index 2i.e., in all cases the index increases $y 1)J. An alternative treatment is to compute percentage changes for each stoc and derive the average of these percentage changes. +n this case, the average would $e 1)J 2#)J " 1)J33. &o in the case of an unweighted price"indicator series, a #)J price increase in D: would have the same impact on the index as a #)J price increase of 6oors .rewing. *. +f you correlated percentage changes in the Wilshire -))) e9uity index with percentage changes in the =C&> composite and the =asda9 composite index, would you expect a difference in the correlations% Why or why not% Answer: .ased upon the sample from which it is derived and the fact that is a value"weighted index, the Wilshire -))) >9uity +ndex is a weighted composite of the =C&> composite index, the A:>S mar et value series, and the =A&DAT composite index. We would expect it to have the highest correlation with the =C&> 6omposite +ndex $ecause the =C&> has the highest mar et value. <. !here are high correlations among the monthly percentage price changes for the alternative =C&> indexes. Discuss the reason for this similarity: +s it si8e of sample. &ource of sample, or method of computation% Answer:

1-

!he high correlations $etween returns for alternative =C&> price indicator series can $e attri$uted to the source of the sample 2i.e. stoc traded on the =C&>3. !he four series differ in sample si8e, that is, the DF+A has () securities, the &U; ,)) has ,)) securities, and the &U; -)) has -)) securities and the =C&> 6omposite over #,<)) stoc s. !he DF+A differs in computation from the other series, that is, the DF+A is a price" weighted series where the other three series are value"weighted. >ven so, there is strong correlation $etween the series $ecause of similarity of types of companies. 7. Cou learn that the Wilshire -))) mar et"value"weighted series increased $y 1/ percent during the same period. Discuss what this difference in results implies. Answer: &ince the e9ual"weighted series implies that all stoc s carry the same weight, irrespective of price or value, the results indicate that on average all stoc s in the index increased $y #( percent. ?n the other hand, the percentage change in the value of a large company has a greater impact than the same percentage change for a small company in the value weighted index. !herefore, the difference in results indicates that for this given period, the smaller companies in the index outperformed the larger companies. 1). Why is it contended that $ond mar et indexes are more difficult to construct and maintain than stoc mar et indexes% Answer: !he $ond"mar et series are more difficult to construct due to the wide diversity of $onds availa$le. Also $onds are hard to standardi8e $ecause their maturities and mar et yields are constantly changing. +n order to $etter segment the mar et, you could construct five possi$le su$ indexes $ased on coupon, 9uality, industry, maturity, and special features 2such as call features, warrants, converti$ility, etc.3. 11. !he Wilshire -))) mar et"value"weighted index increased $y - percent, wheras the :errill Bynch"Wilshire 6apital :ar ets +ndex increases $y 1- percent during the same period. What does this difference in results imply% Answer: &ince the :errill Bynch"Wilshire 6apital :ar ets index is composed of a distri$ution of $onds as well as stoc s, the fact that this index increased $y 1- percent, compared to a - percent gain in the Wilshire -))) +ndex indicates that $onds outperformed stoc s over this period of time. 1#. !he Russell 1))) increased $y < percent during the past year, whereas the Russell #))) increased $y 1- percent. Discuss the implication of these results. Answer: !he Russell 1))) and Russell #))) represent two different samples of stoc s, segmented $y si8e. !he fact that the Russell #))) 2which is composed of the smallest #,))) stoc s in the Russell ()))3 increased more than the Russell 1))) 2composed of the 1)))

1/

largest capitali8ation 5.&. stoc s3 indicates that small stoc s performed $etter during this time period. 1(. .ased on what you now a$out the 4inancial !imes 24!3 World +ndex, the :organ &tanley 6apital +nternational World +ndex, and the Dow Fones World &toc +ndex. What level of correlation would you expect among monthly rates of return% Discuss the reasons for your answer $ased on the factors that affect indexes. Answer: ?ne would expect that the level of correlation $etween the various world indexes should $e relatively high. !hese indexes tend to include the same countries and the largest capitali8ation stoc s within each country.

Answer to Problems: 1. Cou are given the following information regarding prices for stoc s of the following are: ;rices &toc Bauren 6orp Eay Beigh 6o. :adison Btd. =um$er of shares 1,))),))) 1),))),))) (),))),))) ! /) #) 1< !K1 <) (#-

a. 6onstruct a price"weighted index for these three stoc s, and compute the percentage change in the series for the period from ! to !K1. $. 6onstruct a mar et"value"weighted index for these three stoc s, and compute the percentage change in the series for the period from ! to !K1. c. .riefly discuss the difference in the results for the two stoc indexes.

&olution:
12a3. Diven a three security series and a price change from period t to tK1, the percentage change in the series would $e ,#.<- percent. Bauren Eayleigh :adison &um Divisor Period t G /) #) 1< G 7< ( Period t#$ G <) (#G1,) ( 1*

Average

(#./*

,/./*
,/./* " (#./* 1,.)) = = ,#.<-J (#./* (#./*

;ercentage change =

12$3. &toc Bauren Eayleigh :adison !otal &toc Bauren Eayleigh :adison !otal

Period t ;riceA&hare O of &hares G/) 1,))),))) #) 1),))),))) 1< (),))),))) Period t#$ ;riceA&hare O of &hares G<) 1,))),))) (1),))),))) #(),))),)))

:ar et Malue G /),))),))) #)),))),))) -,),))),))) G<)),))),))) :ar et Malue G <),))),))) (-),))),))) *-),))),))) G1,1<),))),)))

;ercentage change =

1,1<) " <)) (<) = = ,*.-)J <)) <))

12c3. !he percentage change for the price"weighted series is a simple average of the differences in price from one period to the next. >9ual weights are applied to each price change. !he percentage change for the value"weighted series is a weighted average of the differences in price from one period t to tK1. !hese weights are the relative mar et values for each stoc . !hus, &toc 6 carries the greatest weight followed $y . and then A. .ecause &toc 6 had the greatest percentage increase and the largest weight, it is easy to see that the percentage change would $e larger for this series than the price"weighted series.

#. a. Diven the data in pro$lem 1, construct an e9ual"weighted index $y assuming G1,))) is invested on each stoc . What is the percentage change in wealth for this e9ual"weighted portfolio% $. 6ompute the percentage of price change for each of the stoc s in pro$lem 1. 6ompute the arithmetic average of these percentage changes. Discuss how this 1<

answer compares to the answer in #a. 6ompute the geometric average of the three percentage changes in #$. Discuss how this result compares to the answer in #$.

&olution:
&toc ;riceA&hare Bauren G/) Eayleigh #) :adison 1< !otal &toc Bauren Eayleigh :adison !otal #2$3. O of &hares 1/./* -).)) --.-/ :ar et Malue G 1,))),))) 1,))),))) 1,))),))) G(,))),))) :ar et Malue G 1,(((./) 1,*-).)) 1,(<7.)) G,,,*)./)

Period t#$ ;riceA&hare O of &hares G<) 1/./* (-).)) #--.-/

,,,*#./) " (,))) 1,,*#./) ;ercentage change = = = ,7.)7J <) /) #) (,))) (,))) Bauren = = = ((.((J /) /) Eayleigh = (- #) 1= = *-.))J #) #) #- " 1< * = = (<.<7J 1< 1<

:adison =

Arithmetic average =

((.((J + *-.))J + (<.<7J ( 1,*.##J = ,7.)*J (

!he answers are the same 2slight difference due to rounding3. !his is what you would expect since ;art A represents the percentage change of an e9ual" weighted series and ;art . applies an e9ual weight to the separate stoc s in calculating the arithmetic average.

17

Arithmetic average = =

((.((J + *-.))J + (<.<7J ( 1,*.##J = ,7.)*J (

!he answers are the same 2slight difference due to rounding3. !his is what you would expect since ;art A represents the percentage change of an e9ual" weighted series and ;art . applies an e9ual weight to the separate stoc s in calculating the arithmetic average.

#V. Deometric average is the nth root of the product of n items.

Deometric average =H21.((((3 21.*-3 21.(<<73I1A( 1 =H(.#,)*I1A ( 1 =1.,*7< 1 =.,*7< or ,*.7<J Deometric average =H21.((((3 21.*-3 21.(<<73I1A( 1 =H(.#,)*I1A ( 1 =1.,*7< 1 =.,*7< or ,*.7<J

!he geometric average is less than the arithmetic average. !his is $ecause varia$ility of return has a greater affect on the arithmetic average than the geometric average. (. 4or the past five trading days, on the $asis of figures in The Wall Street Journal, compute the daily percentage price changes for the following stoc indexes.. a. DF+A. $. & U ; -)). c. =asda9 6omposite +ndex. d. 4!"1)) &hare +ndex. e. =i ei &toc ;rice Average. Discuss the difference in results for a and $, a and c, a and d, a and e, d and eR what do these differences imply regarding diversifying within the 5nited &tates versus diversifying $etween countries% &olution: &tudent >xercise ,. ;rice &hares

#)

6ompany Day 1 Day # Day ( Day , Day -

A 1# 1) 1, 1( 1#

. #( ## ,/ ,* ,-

6 -# --# ##/

A -)) -)) -)) -)) -))

. (-) (-) 1*1*1*-

6 #-) #-) #-) -)) -))

L &plit at close of Day # L split at close of Day ( a. 6alculate a Dow Fones +ndustrial Average for Days 1 through -. $. What effects have the splits had in determining the next days index% 2hint: !hin of the relative weighting of each stoc .3 c. 4rom a copy of The Wall Street Journal. 4ind the divisor that is currently $eing used in calculating the DF+A. 2=ormally this value can $e found on pages 6# and 6(.3

&olution:
,2a3. DF+A = ;it A D ad'
i =1 ()

%ay $ 6ompany A B 6 ;riceA&hare 12 23 -#

Day 2
6ompany A 10 B 22 6 2.efore &plit3 ;riceA&hare 10 44 --2After &plit3 ;riceA&hare

#1

Day 3
6ompany A 14 B 46 6 2.efore &plit3 ;riceA&hare 14 46 -# #/ 2After &plit3 ;riceA&hare

Day 4
6ompany A B 6 ;riceA&hare 13 47 #= DF+A = 1( + ,* + ##.<</1 <= #7.,-# #.<</1

%ay 5
6ompany A B 6 ;riceA&hare 12 45 #/
= DF+A = 1# + ,- + #/ #.<</1 <( = #<.*-7 #.<</1

,2$3. &ince the index is a price"weighted average, the higher priced stoc s carry more weight. .ut when a split occurs, the new divisor ensures that the new value for the series is the same as it would have $een without the split. @ence, the main effect of a split is 'ust a repositioning of the relative weight that a particular stoc carries in determining the index. 4or example, a 1)J price change for company . would carry more weight in determining the percent change in the index in Day ( after the reverse split that increased its price, than its weight on Day #. ,2c3. &tudent >xercise

##

-.

5tili8ing the price and volume data in pro$lem ,. a. calculate a &tandard U ;oors +ndex for Days 1 through - using a $eginning index value of 1). $. identify what effects the splits had in determining the next days index.2@int: !hin of the relative weighting of each stoc .3

&olution:
-2a3. .ase N 2G1# x -))3 K 2G#( x (-)3 K 2G-# x #-)3 N G/,))) K G<,)-) K G1(,))) N G#*,)-)

Day 1 N 2G1# x -))3 K 2G#( x (-)3 K 2G-# x #-)3 N G/,))) K G<,)-) K G1(,))) N G#*,)-) +ndex1 N 2G#*,)-)AG#*,)-)3 x 1) N 1) Day # N 2G1) x -))3 K 2G## x (-)3 K 2G-- x #-)3 N G-,))) K G*,*)) K G1(,*-) N G#/,,-) +ndex# N 2G#/,,-)AG#*,)-)3 x 1) N 7.**< Day ( N 2G1, x -))3 K 2G,/ x 1*-3 K 2G-# x #-)3 N G*,))) K G<,)-) K G1(,))) N G#<,)-) +ndex( N 2G#<,)-)AG#*,)-)3 x 1) N 1).(*) Day , N 2G1( x -))3 K 2G,* x 1*-3 K 2G#- x -))3 N G/,-)) K G<,##- K G1#,-)) N G#*,##+ndex, N 2G#*,##-AG#*,)-)3 x 1) N 1).)/Day - N 2G1# x -))3 K 2G,- x 1*-3 K 2G#/ x -))3 N G/,))) K G*,<*- K G1(,))) N G#/,<*+ndex- N 2G#/,<*-AG#*,)-)3 x 1) N 7.7(-2$3. !he mar et values are unchanged due to splits and thus stoc splits have no effect. !he index, however, is weighted $y the relative mar et values.

/. .ased on the following stoc price and shares outstanding information, compute the $eginning and ending values for a price"weighted index and a mar et"value"weighted index. Decem$er (1, #))# Decem$er (1, #))(

#(

;rice &toc E &toc B &toc : #) <) ,)

shares outstanding 1)),))),))) #,))),))) #-,))),)))

price (# ,,#

shares outstanding 1)),))),))) ,,))),))) #-,))),)))

L&toc split two"for" one during the year. a. 6ompute the percentage change in the value of each index. $. >xplain the difference in results $etween the two indexes. c. 6ompute the results for an unweighted index and discuss why these results differ from the others.

&olution:
/. ;rice"weighted index 2;W+3#))# N 2#) K <)K ,)3A( N ,/./* !o accounted for stoc split, a new divisor must $e calculated: 2#) K ,) K ,)3AS N ,/./* S N #.1,( 2new divisor after stoc split3 ;rice"weighted index#))( N 2(# K ,- K ,#3A#.1,( N --.-( MW+#))# N #)21)),))),)))3 K <)2#,))),)))3 K ,)2#-,))),)))3 N #,))),))),))) K 1/),))),))) K 1,))),))),))) N (,1/),))),)))

assuming a $ase value of 1)) and 177< as $ase period, then 2(,1/),))),)))A(,1/),))),)))3 x 1)) N 1)) MW+#))( N (#21)),))),)))3 K ,-2,,))),)))3 K ,#2#-,))),)))3 N (,#)),))),))) K 1<),))),))) K 1,)-),))),))) N ,,,(),))),)))

assuming a $ase value of 1)) and #))# as period, then 2,,,(),))),)))A(,1/),))),)))3 x 1)) N 1.,)17 x 1)) N 1,).17 /2a3. ;ercentage change in ;W+ N 2--.-( " ,/./*3A,/./* N 1<.77J ;ercentage change in MW+ N 21,).17 " 1))3A1)) N ,).17J /2$3. !he percentage change in MW+ was much greater than the change in the ;W+ $ecause the stoc with the largest mar et value 2E3 had the greater percentage gain in price 2/)J increase3.

#,

/2c3. &toc

%ecember &$' 2002 ;riceA&hare O of &hares

:ar et Malue

E
: R !otal

G#)
<) ,)

-).)
1#.#-.)

G1,))).))
1,))).)) 1,))).)) G(,))).))

%ecember &$' 200&

&toc

;riceA&hare

O of &hares

:ar et Malue

E
: R !otal ,,#

G(#
#-.-L #-.)

-).)

G1,/)).))
1,1#-.)) 1,)-).)) G(,**-.))

2L&toc "split two"for"one during the year.3

;ercentage change = (,**-.)) " (,))) **-.)) = = #-.<(J (,))) (,)))

Deometric average =H21./)3 21.1#-3 21.)-3I1A( " 1 =H1.<7I1A( 1 =1.#(/, 1 =.#(/, or #(./,J

5nweighted averages are not impacted $y large changes in stoc s prices 2i.e. price" weighted series3 or in mar et values 2i.e. value"weighted series3.

#-