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== 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-
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
Topic 4: Modern
Portfolio Concepts
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-
scheme
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
Topic 8: Stock
valuation
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
-5-
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 13:
Commodities and
Financial Futures
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
-6-
3.
Financial futures
Reading List
Method of Assessment
Marks
100 marks
100 marks
200 marks
Weightage of Total
Assessment
20%
20%
40%
Reminder
-7-
== Tutorial 2 (Topic 1) ==
1.1
1.2
1.5
1.6
1.7
1.12
1.14
1.16
-9-
- 10 -
== Tutorial 3 (Topic 2) ==
2.1
2.11
2.12
- 11 -
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.
Learning Outcome: Explain long purchases, margin transaction, and short
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.
Learning Outcome: Explain long purchases, margin transaction, and short
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 -
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 -
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 -
Learning Outcome: Describe the basic types of orders, and online transactions.
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
Learning Outcome: Describe the basic types of orders, and online transactions.
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
Learning Outcome: Describe the basic types of orders, and online transactions.
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
Learning Outcome: Describe the basic types of orders, and online transactions.
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 -
Learning Outcome: Describe the basic types of orders, and online transactions.
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
== Tutorial 4 (Topic 3) ==
4.1
4.3
4.6
4.9
4.10
c)
d)
e)
f)
g)
P4.4
- 19 -
$14,000
Income
$ 6,000
3,000
5,000
2,000
1,000
- 20 -
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 -
- 23 -
== Tutorial 5 (Topic 4) ==
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
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 -
5.12
5.13
- 25 -
5.14
P5.3
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%
=
=
=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 -
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
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 -
Beta
1.40
0.80
-0.90
- 30 -
Asset Beta
1.30
0.70
1.25
1.10
0.90
Total
- 31 -
== Tutorial 6 (Topic 5) ==
12.1
12.3
12.4
- 33 -
- 36 -
- 37 -
== Tutorial 7 (Topic 6) ==
13.3
(c) Jensensmeasure
- 38 -
Fund A
1.8
20%
80%
Fund B
1.1
80%
20%
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 -
- 40 -
- 41 -
== Tutorial 8 (Topic 7) ==
6.1
6.4
6.5
7
6.11
P6.7
$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
7.4
7.5
- 44 -
7.12
- 46 -
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
8.5%
22.5%
32.2%
expense
- 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.
- 49 -
== Tutorial 9 (Topic 8) ==
8.3
8.5
8.8
- 50 -
- 51 -
= $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 -
- 54 -
== Tutorial 10 (Topic 9) ==
- 55 -
9.1
9.2
9.5
Learning Outcome: Explain the idea of random walks and efficient markets
- 56 -
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
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.
- 59 -
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 -
- 61 -
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.
- 62 -
- 63 -
- 64 -
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 -
- 66 -
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.
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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:
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Bond B
c)
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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%
Assume is callable:PMT = 160, FV = 1250, PV = -1684.76, N = 5, CPT I/Y
Yield to call = 4.8089%
c) Using financial calculator:PMT = 55, FV = 1000, PV = -510.65, N = 18, CPT I/Y
Yield to maturity = 12.42%
Assume is callable:PMT = 55, FV = 1050, PV = -510.65, N = 3, CPT I/Y
Yield to call = 35.89%
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
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14.3
14.5
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?
LearningOutcome:Describetheprofitpotentialofputsandcalls
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
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Price
$1.55
$1.20
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.
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.
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b.
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?
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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
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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.
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