Chapter 02 - Asset Classes and Financial Instruments

CHAPTER2:ASSETCLASSESAND
FINANCIALINSTRUMENTS
PROBLEMSETS

1.

Preferredstockislikelongtermdebtinthatittypicallypromisesafixedpaymenteach
year.Inthisway,itisaperpetuity.Preferredstockisalsolikelongtermdebtinthatit
doesnotgivetheholdervotingrightsinthefirm.
Preferredstockislikeequityinthatthefirmisundernocontractualobligationtomakethe
preferredstockdividendpayments.Failuretomakepaymentsdoesnotsetoffcorporate
bankruptcy.Withrespecttothepriorityofclaimstotheassetsofthefirmintheeventof
corporatebankruptcy,preferredstockhasahigherprioritythancommonequitybutalower
prioritythanbonds.

2.

Moneymarketsecuritiesarecalledcashequivalentsbecauseoftheirgreatliquidity.
Thepricesofmoneymarketsecuritiesareverystable,andtheycanbeconvertedto
cash(i.e.,sold)onveryshortnoticeandwithverylowtransactioncosts.

3.

Thespreadwillwiden.Deteriorationoftheeconomyincreasescreditrisk,thatis,the
likelihoodofdefault.Investorswilldemandagreaterpremiumondebtsecurities
subjecttodefaultrisk.

4.

Onthedaywetriedthisexperiment,36ofthe50stocksmetthiscriterion,leadingusto
concludethatreturnsonstockinvestmentscanbequitevolatile.

5.

a.

Youwouldhavetopaytheaskedpriceof:
118:31=118.96875%ofpar=$1,189.6875

b.

Thecouponrateis11.750%implyingcouponpaymentsof$117.50annuallyor,more
precisely,$58.75semiannually.

c. Currentyield=Annualcouponincome/price
=$117.50/$1,189.6875=0.0988=9.88%
6.

P=$10,000/1.02=$9,803.92
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Chapter 02 - Asset Classes and Financial Instruments

7.

Thetotalbeforetaxincomeis$4.Afterthe70%exclusionforpreferredstockdividends,the
taxableincomeis:0.30$4=$1.20
Therefore,taxesare:0.30$1.20=$0.36
Aftertaxincomeis:$4.00$0.36=$3.64
Rateofreturnis:$3.64/$40.00=9.10%

8.

a.

GeneralDynamicsclosedtodayat$74.59,whichwas$0.17higherthanyesterdays
price.Yesterdaysclosingpricewas:$74.42

b.

Youcouldbuy:$5,000/$74.59=67.03shares

c.

Yourannualdividendincomewouldbe:67.03$0.92=$61.67

d.

Thepricetoearningsratiois16andthepriceis$74.59.Therefore:
$74.59/Earningspershare=16Earningspershare=$4.66

9.

a.

Att=0,thevalueoftheindexis:(90+50+100)/3=80
Att=1,thevalueoftheindexis:(95+45+110)/3=83.333
Therateofreturnis:(83.333/80)1=4.17%

b.

Intheabsenceofasplit,StockCwouldsellfor110,sothevalueoftheindex
wouldbe:250/3=83.333
Afterthesplit,StockCsellsfor55.Therefore,weneedtofindthedivisor(d)
suchthat:
83.333=(95+45+55)/dd=2.340

10.

c.

Thereturniszero.Theindexremainsunchangedbecausethereturnforeach
stockseparatelyequalszero.

a.

Totalmarketvalueatt=0is:($9,000+$10,000+$20,000)=$39,000
Totalmarketvalueatt=1is:($9,500+$9,000+$22,000)=$40,500
Rateofreturn=($40,500/$39,000)1=3.85%

b. Thereturnoneachstockisasfollows:
rA=(95/90)1=0.0556
rB=(45/50)1=0.10
rC=(110/100)1=0.10
Theequallyweightedaverageis:
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Chapter 02 - Asset Classes and Financial Instruments

[0.0556+(0.10)+0.10]/3=0.0185=1.85%

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Chapter 02 - Asset Classes and Financial Instruments

11.

Theaftertaxyieldonthecorporatebondsis:0.09(10.30)=0.0630=6.30%
Therefore,municipalsmustofferatleast6.30%yields.

12.

Equation(2.2)showsthattheequivalenttaxableyieldis:r=rm/(1t)

13.

14.

a.

4.00%

b.

4.44%

c.

5.00%

d.

5.71%

a.

Thehighercouponbond.

b.

Thecallwiththelowerexerciseprice.

c.

Theputonthelowerpricedstock.

a.

Youboughtthecontractwhenthefuturespricewas1427.50(seeFigure2.12).The
contractclosesatapriceof1300,whichis127.50lessthantheoriginalfuturesprice.The
contractmultiplieris$250.Therefore,thelosswillbe:
127.50$250=$31,875

15.

b.

Openinterestis601,655contracts.

a.

Sincethestockpriceexceedstheexerciseprice,youwillexercisethecall.
Thepayoffontheoptionwillbe:$42$40=$2
Theoptionoriginallycost$2.14,sotheprofitis:$2.00$2.14=$0.14
Rateofreturn=$0.14/$2.14=0.0654=6.54%

b.

Ifthecallhasanexercisepriceof$42.50,youwouldnotexerciseforanystockpriceof
$42.50orless.Thelossonthecallwouldbetheinitialcost:$0.72

c.

Sincethestockpriceislessthantheexerciseprice,youwillexercisetheput.
Thepayoffontheoptionwillbe:$42.50$42.00=$0.50
Theoptionoriginallycost$1.83sotheprofitis:$0.50$1.83=$1.33
Rateofreturn=$1.33/$1.83=0.7268=72.68%

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Chapter 02 - Asset Classes and Financial Instruments

16.

Thereisalwaysapossibilitythattheoptionwillbeinthemoneyatsometimepriorto
expiration.Investorswillpaysomethingforthispossibilityofapositivepayoff.

17.
a.
b.
c.
d.
e.

Valueofcallatexpiration InitialCost
0
4
0
4
0
4
5
4
10
4

Profit
4
4
4
1
6

a.
b.
c.
d.
e.

Valueofputatexpiration
10
5
0
0
0

Profit
4
1
6
6
6

InitialCost
6
6
6
6
6

18.

Aputoptionconveystherighttoselltheunderlyingassetattheexerciseprice.Ashort
positioninafuturescontractcarriesanobligationtoselltheunderlyingassetatthe
futuresprice.

19.

Acalloptionconveystherighttobuytheunderlyingassetattheexerciseprice.Along
positioninafuturescontractcarriesanobligationtobuytheunderlyingassetatthe
futuresprice.

CFAPROBLEMS
1.

(d)

2.

Theequivalenttaxableyieldis:6.75%/(10.34)=10.23%

3.

(a)

Writingacallentailsunlimitedpotentiallossesasthestockpricerises.

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Chapter 02 - Asset Classes and Financial Instruments

4.

a.

Thetaxablebond.Withazerotaxbracket,theaftertaxyieldforthetaxablebondis
thesameasthebeforetaxyield(5%),whichisgreaterthantheyieldonthemunicipal
bond.

b. Thetaxablebond.Theaftertaxyieldforthetaxablebondis:
0.05(10.10)=4.5%
c. Youareindifferent.Theaftertaxyieldforthetaxablebondis:
0.05(10.20)=4.0%
Theaftertaxyieldisthesameasthatofthemunicipalbond.
d.

5.

Themunicipalbondoffersthehigheraftertaxyieldforinvestorsintaxbracketsabove
20%.
Iftheaftertaxyieldsareequal,then:0.056=0.08(1t)

Thisimpliesthatt=0.30=30%.

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