Solution Set 2 1.

(10 points) Consider the following analysts expected return on two stocks for two particular market returns. The probability of each state 1/3 (the states are equally likely). The risk-free rate is 2%. a. (4 points) There are four steps in calculating the betas. Step1: Calculate E(Rm), the expected return on the market 2 , the variance of the market Step2: Calculate m Step 3: Calculate the expected returns (E(Ri)) for each stock Step 4: Calculate the covariance between each stock and the market (Cov(Rm,Ri)) Step1: E ( Rm ) = .33 * 25% + .33 * 10% + .33 * 2% =11%
2 Step 2: m = .33 * [ 25% 11%] 2 + .33 * [10% 11%] 2 + .33 * [ 2% 11%] 2 =122.0%

m = 11.0% Step 3: E( R AggressiveStock ) = .33 * 40% + .33 * 15% + .33 * 10% = 15.0% E( R DefensiveStock ) = .33 * 12% + .33 * 8% + .33 * 1% = 7.00%
Step 4:
Bear Bear Cov ( R Agg , R m ) = Pr( BearMarket )[ R Agg E( R Agg )][ R m E( R m )] Bull Bull + Pr( BullMarket )[ R Agg E( R Agg )][ R m E( R m )]

Cov ( R Agg , R m ) = .33 * [ 40% 15%][ 25% 11%] + .33 * [15% 15%][10% 11%] + .33 * [ 10% 15%][ 2 11%] Cov ( R Agg , R m ) = 225.0% Cov ( R Def , R m ) = .33 * [12% 7%][ 25% 11%] + .33 * [ 8% 7%][10% 11%] + .33 * [1% 7%][ 2% 11%] Cov ( R Def , Rm ) = 49.0%
Now we have everything we need to calculate the betas on both stocks. Recall the equation for beta: i = AggStock = DefStock =

Cov ( Ri , Rm )
2 m

Cov ( R Agg , R m ) Cov ( R Def , R m )

2 m 2 m

= =

225.0% = 1.84 122.0% 49.0% = 0.40 122.0%

Notice that in class we defined stocks with >1 as aggressive stocks and stocks with <1 as defensive stocks. So the securities in this example have appropriate names. b. (1 point) There are numerous correct answers for this question and they are not restricted to the industries we mentioned in class. However, some of the Aggressive

industries we talked about in class were luxury goods, consumer goods, wireless companies, on-line retailers, and car manufacturers. Some of the Defensive industries we talked about in class were utilities, beer manufacturers, gaming companies (casinos), and tobacco manufacturers. c. (2 points) Now that we have the betas on both securities it is straight forward to find the expected risk premia that CAPM predicts. CAPM predicts the following relationship:

E ( RStockI ) = r f + StockI [ E ( Rm ) r f ]
That is, the risk premium on a stock equals the stocks beta times the risk premium on the market. E( R Agg ) = r f + Agg [ E( R m ) r f ] = 2.5%+ 1.84*(11%-2.5%)= 18.2%

E ( R Def ) = r f + Def [ E ( Rm ) r f ] = 2.5%+ 0.40*(11%-2.5%)= 5.91%

d. (2 points) According to CAPM, what are the alphas on each stock and what do these alpha values mean in terms of the stock being underpriced, overpriced or perfectly priced? The actual expected returns on both stocks differ from those predicted by CAPM, which means that their prices are out of equilibrium. We calculate the alphas as follows:

stock = ActualExpected Re turn stock EquilibriumExpected Re turn stock

In the case of the aggressive stock aggressuve = 15.0% 18.2% = -3.2%. The return is lower than it should be, which means the stock is overpriced. In the case of the defensive stock, defensive = 7.0% 5.9% = 1.1%. The return is higher than it should be, which means the stock is underpriced. e. (1point) To profit from the mispricings I would do the following: Aggressive: Since Aggressive is overpriced, at its current price demand for the stock should fall, driving down the price, and driving the return up to 14.8% predicted by CAPM. I could profit from this mispricing by shorting aggressive stock. Defensive: Since Defensive is underpriced, at its current price demand for the stock will rise, driving up the price and pushing the return down to the 4.933% predicted by CAPM. I could profit from this mispricing by buying defensive stock on margin. 2. (4 points) Suppose that the return on short-term government securities (perceived to be risk-free) is 5%. Suppose also that the expected return required by the market for a portfolio with a beta of 1.6 is 18%. According to the capital asset pricing model a. (1 point) What is the expected return on the market portfolio?

E( ri ) = r f + i [ E( r m ) r f ] 18% = 5% + 1.6[ E( r m ) 5%] E( r m ) = 13.12%

b. (1 point) The expected return for a security with a zero beta is just the risk-free rate, in this case, 5%. c. (2 points) First we need to calculate the actual expected return on this stock at the current price of $40:

Actual Re turn currentpri ce =

Actual Re turncurrentprice

ExpectedSa le Pr ice Current Pr ice + ExpectedDi vidend Current Pr ice $41 $40 + $3 =10% = $40

Now we need to use find the expected return predicted by CAPM: Equilibriu m Re turn = 5% + 0.5 * [13.12% 5%] =9.06% We calculate the stock's alpha to find the degree of the mispricing: stock = 10% 9.06% =0.94% This stock has a positive alpha, meaning that it is yielding a higher return than it should yield according to CAPM. The stock is therefore underpriced at $40 a share. 3. (2 points) Two investment advisers, 1 and 2 are comparing performance. Investor 1 averaged a 19% rate of return and investor 2 averaged a 16% rate of return. The beta of the first investor is 1.5 while the beta of the second investor is 1.1. a. If the risk free rate is 6% and the return on the market is 14%, which investor did a better job? To answer this we first need to find the returns both investors should have according to CAPM. Investor 1: E( R 1 ) = 1.5 * [ 14% 6%] + 6% =18%

Alpha1 = 19% 18% =1%

Currently Investor 1 is yielding 1% more than he/she needs to according to CAPM. Investor 2: E( R 2 ) = 1.1 * [ 14% 6%] + 6% =14.8%

Alpha1 = 16% 14.8% =1.2% Currently Investor 2 is yielding 1.2% more than he/she needs to according to CAPM.
In this scenario both investors are outperforming other investments with similar risk levels, since both have returns that are higher than those predicted by CAPM. However, since Investor 2 has the higher "extra" return, he/she had the best performance. (Investor 2 is providing a return that is 1.2% higher than that required for the risk level of the investment. According to CAPM if you found an investment with an equal level of risk, as measured by beta, it should yield 14.8%)
b. If the risk free rate is 3% and the return on the market 15%, which investor did a better job? To answer this we first need to find the returns both investors should have according to CAPM. Investor 1: E ( R1 ) = 1.5 * [15% 3%] + 3% =21%

Alpha1 = 19% 21% =-2% Currently Investor 1 is yielding 1% less than he/she needs to according to CAPM. Investor 2: E ( R2 ) = 1.1 * [15% 3%] + 3% =16.2% Alpha1 = 16% 16.2% =-0.2%
Currently Investor 2 is yielding 0.2% less than he/she needs to

according to CAPM. In this scenario both investors are underperforming compared to other investments with the similar risk levels, since both have returns that are lower than those predicted by CAPM. However, Investor 2's underperformance is less than that of Investor 1, which means he/she did a better job. 4. (4 points) 3 year, 7.4% coupon bonds of LuvFin Co. are currently selling for $975. a. What is the current yield on this bond?

CurrentYield =

AnnualCoupon $74 = = 7.59% Quoted Pr ice $975

Because the bond is selling below par, the current yield is greater than the coupon rate.
b. The current yield gives us an approximation of an investors return on this bond if he/she bought it today for a price of $975 and held it until maturity. However, a more precise measure of the return on this bond is the yield to maturity. The yield to maturity (YTM) is the return an investor would get by buying the bond today at $960 and holding it until maturity. The YTM solves the following equation:

coupon $1000 + t (1 + y ) 6 t =1 ( 1 + y ) $37 $37 $37 $37 $37 $37 $1000 Red $975 = + + + + + + 2 3 4 5 6 (1 + y ) ( 1 + y ) (1 + y ) (1 + y ) (1 + y ) (1 + y ) (1 + y ) 6 Quoted Pr ice =
c. Any event that would cause the perceived default risk of LuvFin, the issuer, to increase would increase the yield on these bonds. You received full credit if you listed any event that would increase default risk.

5. (1 points) As we outlined in class, if a bond is selling at a discount, or less than par, then the yield to maturity is greater than the current yield which is greater than the coupon rate. YTM>current yield> coupon rate. This means that that C is true. 6. (2 points) a. (0.5 point) The risk premium on the 5 year General Motors bond equals Yield GMbond Yield 5 yearTBond = 7.9%- 6.7% = 1.2%. Expressing the risk premium in basis points, the spread to Treasury on the GM bond is 120 basis points. This means that GM is paying 1.2% more than the U.S. government to borrow funds over a 5 year period in the market. The risk premium on the Exxon bond equals 7.2%-6.2% = 1%. Thus, the spread to Treasury on the Exxon bond is 100 basis points. This means that Exxon is paying 1% more than the U.S. government to borrow funds over a 1 year period. b. (1 point) If Exxon is selling above par, the yield is lower than the coupon rate on the bond. Since the coupon rate is approximately the yield on the Exxon bond when it was issued, this means that the yield on Exxon has fallen. Given that Treasury yields on one year bonds have stayed the same, this means that the risk premium on the bond is lower today than when the bond was originally issued. The risk premium has declined.

Note: comparing spreads across time can tell us about the evolution of the risk premium on a bond. One key point of comparison is the risk premium when the bond was issued, which we take as the difference between the coupon rate and comparable Treasury yields. c) (0.5 point) If you bought the Exxon bond today and hold it until maturity your annual return is simply the yield to maturity, or 7.2% 7. (2 points) The price of this bond is simply the present discounted value of the stream of future payments, where the discount rate is just the yield to maturity.
80 81 (6.75 / 4) 100 t 80 80 + = 1.69 + 100 = 1.69 Quoted Pr ice = + 100 t 80 (1 + y ) t =1 (1 + y ) t =1 1 80

1 and y is the quarterly yield to maturity. So we need to calculate this quarterly 1+ y yield. Since we have the annual yield (6.95%), we just need to express it in quarterly terms as follows:
Where =

(1 + 0.0695 ) = (1 + y )
Therefore: = So:

y = (1 + 0.0695)

1/4

1 = 0.0169

1 1 = = 0.9834 1 + y 1 + 0.0169

0.9834 0.983481 80 Quoted Pr ice = 1.69 + 100(0.9834) = 1.69 [ 43.7157] + 100(0.2621) = 100.09 1 0.9834
8. Stocks with beta higher than 1, imply a higher risk than the market. Conversely, stocks with beta smaller than 1, imply a lower risk than the market

9. (5 points) The premium on a Microsoft July call option is $2.05 and the premium on a Microsoft July put option is $2.50. Assuming that the stock price at expiration (ST) is $25. Note that we have three scenarios: one where ST<X, one where ST=X, and one where ST>X. The payoffs and profits for the calls and puts vary accordingly. a. Call option X=$22.50: ST>X Exercise the call 1. Payoff for call= max[ST-X, 0] recall, if you exercise the call, your payoff is the difference between what you sell the shares for, ST, and what you buy them for, X. If ST<X this value is negative, so you don't exercise the call and the payoff is zero. Payoff = $25-$22,50 = $2.50 2. Profit = Payoff-Premium=$2.50-$2.05=$0.45 b. Put option X =$22.50: ST>X Don't Exercise the put 1. Payoff for put =max[X-ST, 0]. recall, if you exercise the put, your payoff is the difference between what you buy the stock for, ST and what you sell it for, X. Otherwise, the payoff is zero. Payoff=$0

c.

d.

e.

f.

2. Profit=$0-$2.50=-$2.50 Call option X=$25:ST=X Indifferent between exercising and not exercising 1. Payoff = $25-$25= $0. 2. Profit=$0-$2.05= -$2.05 Put option, X=$25: ST=X Indifferent between exercising and not exercising 1. Payoff = $25-$25= $0. 2. Profit=$0-$2.50= -$2.50 Call option, X=$27.50: ST<X Don't exercise the call 1. Payoff = $0. 2. Profit = $0-$2.05=-$2.05 Put option, X=$27.50: ST<X Exercise the put 1. Payoff=$27.50-$25=$2.50 2. Profit=$2.50-$2.50=$0

10. (3 points) Let's walk through the same payoff and profit exercise for the writers of the option in two cases: one when ST>X and the other when ST<X a. Call option, X=$22.50: Call exercised 1. Since the current market price is greater than the strike price, the call is exercised, and the writer is forced to buy shares in the market at ST and sell them to the owner of the call for X. This means the payoff is negative. Unlike the owner of the call, the writer can realize negative payoffs. Payoff= X-ST =$22.50-$25= -$2.50 2. For the writer the premium helps offset the payoff Profit =Payoff+Premium Profit= -$2.50+$2.05= -$0.45 b. Put option, X=$22.50: Put not exercised 1. Since the current market price is higher than the strike price, the holder of the put does not exercise. The payoff to the writer=$0 2. Profit =$0+$2.50 =$2.50. The writer gains when the option is not exercised. c. Call option, X=$27.50: Call not exercised 1. Payoff=$0 2. Profit= $0+$2.05 = $2.05 d. Put option, X=$27.50: Put exercised 1. Since the put is exercised, the writer is forced to buy the stock at X and sell at a lower ST, leading to a loss. Payoff = $25-$27.50= $2.50 2. Profit = -$2.50+$2.50 = $0. In this case the premium just covers the loss 11. (6 points) Joseph Jones wants to use options to hedge against the price risk of the 10,000 shares he owns. We have identified two different ways, writing calls or buying puts, in which he can use options to protect the value of his investment. We would like to identify the pluses and minuses of these strategies. Keep in mind that

the minimum amount that Joseph needs for his down payment is $350,000 and that $450,000 is more that enough to cover his costs and a cash cushion. a. Advantages of writing the call options: 1. Joseph earns $30,000 from the premium of the call options. Where did this number come from? To cover all 10,000 shares he will have to sell 100 options contracts (each contract is for 100 shares). Each option contract will cost $300 ($3 per share * 100 shares), translating into a total of $30,000. 2. He also sets an upper bound of $45 for the sale price of his shares. This eliminates some uncertainty. b. Disadvantages of writing the call options: 1. Joseph is giving up the chance to benefit if the stock price goes above $45. For the price of the option he is essentially selling his claim to increased earnings if the stock price goes above $45. 2. This written call does not cover Joseph if the stock price falls, leaving him unprotected in a downside scenario. If the price falls below $32, Joseph will not have enough money to make his down payment. (If the price moves to $32, Joseph sells and makes $32,000. Combined with the $30,000 from the premiums just covers the down payment. If the price moves lower than $32, however, he will have insufficient funds). c. Advantages of buying the put options with strike price $35: 1. He puts a lower bound on the sale price of the stock, thus fully protecting himself in the case that the stock price falls below $35. He is now guaranteed to be able to sell his shares for $35. d. Disadvantages of buying the put options with strike price $35 1. Establishing this position is going to cost Joseph $30,000 (premium=$3), which is not a small amount. While he has protected the downside risk, this protection is not cheap. Indeed, if we assume that the $30,000 is coming out of funds for the down payment, then Joseph will need to sell for $38 a share to cover the down payment and the cost of the options position. 12. (6 points) Suppose you purchase one IBM May 100 call contract at $5 and write one IBM May 105 call contract at $2. This is a money spread on calls. a. You benefit most if the price on the expiration date is 105. In this case you can exercise the call option you purchased, earning a payoff of $5 per share, and the one that you wrote will not be exercised. A standard contract has 100 options, which means your payoff will be $500. From this we must add or subtract the difference in the premiums to find the profit. This difference is $2-$5=-$3 that is, you pay $3 per option to obtain this position. Total profit = $2 per option =$200 for a standard contract. (Note, that if the price at expiration is above $107, the total profit is the same as you are in the same situation of buying the stock at $100 and selling it at $105)

b. If at expiration, the price of a share of IBM stock is $103, you will exercise your call option but the holder of the call you wrote will not exercise. By exercising your option you obtain a payoff of $3 per option. However, this exactly offsets the cost of obtaining the position, so the profit=$0. c. The maximum loss you can suffer with this spread is the difference between the two premiums, or -$3 per option =-$300 for a standard contract. This will happen if at the expiration date the price is at or below $100. In this case both calls go unexercised. d. By writing an uncovered call contract, called writing a call naked, your maximum loss is unbounded. If the price of IBM rises dramatically, the holder will exercise the call, and you will be forced to buy IBM for a very high price and sell it for a significantly lower price. Specifically, the loss can be written as X-ST, where X is the strike price and ST is IBM's current price. Technically, ST could reach infinity, which means your losses are also infinite. e. The need for covering the written call position is obvious. You can cover this position by going long IBM stock: you will buy IBM shares when you write the call. Now, if the call is exercised, you have shares on hand which you can sell to the call owner, freeing you from having to buy the shares in the market at the high current price. This reduces your losses. The offsetting stock position is one that hedges your call position. Recall that a good hedge is an asset whose returns move in the opposite direction as those of the original security. So we want to find a stock position that is up when the call position is down and vice versa. The call position is down when the stock price rises; but this is exactly when the stock position is up. Alternatively, the call position is up when the stock price falls; exactly when the stock position is down. By combining these two positions, we have removed much of the risk of our portfolio.