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Question: As a practical matter, most of the


As a practical matter, most of the return you earn from investing in Treasury bills is taxed right away as ordinary income. Thus, if you are in a 40 percent tax bracket and you earn 5 percent on a Treasury bill, your after-tax return is only 0.05 × (1 − 0.40) = 0.03, or 3 percent. In other words, 40 percent of your return goes to pay taxes, leaving you with just 3 percent. Once you consider inflation and taxes, how does the long-term return from Treasury bills look?



> Suppose you identify a situation in which one security is overvalued relative to another. How would you go about exploiting this opportunity? Does it matter if the two securities are both overvalued relative to some third security? Are your profits certa

> Is it possible that a risky asset could have a beta of zero? Explain. Based on the CAPM, what is the expected return on such an asset? Is it possible that a risky asset could have a negative beta? What does the CAPM predict about the expected return on s

> As indicated by examples in this chapter, earnings announcements by companies are closely followed by, and frequently result in, share price revisions. Two issues should come to mind. First, earnings announcements concern past periods. If the market valu

> Indicate whether the following events might cause stocks in general to change price, and whether they might cause Big Widget Corp.’s stock to change price. a. The government announces that inflation unexpectedly jumped by 2 percent last month. b. Big Wid

> Suppose the government announces that, based on a just-completed survey, the growth rate in the economy is likely to be 2 percent in the coming year, compared to 5 percent for the year just completed. Will security prices increase, decrease, or stay the

> Dudley Trudy, CFA, recently met with one of his clients. Trudy typically invests in a master list of 30 securities drawn from several industries. After the meeting concluded, the client made the following statement: “I trust your stock-picking ability an

> In broad terms, why is some risk diversifiable? Why are some risks non diversifiable? Does it follow that an investor can control the level of unsystematic risk in a portfolio but not the level of systematic risk?

> Why is the minimum variance portfolio important in regard to the Markowitz efficient frontier?

> Why should younger investors be willing to hold a larger amount of equity in their portfolios?

> Look at Table 1.1 and Figures 1.5 and 1.6. When were T-bill rates at their highest? Why do you think they were so high during this period? Table 1.1: Figures 1.5: Figures 1.6: TABLE 11 Year-to-Year Total Returns: 1926-2015 LONG-TERM LONG-TE

> (a) What is the relationship between the price of a bond and its YTM? (b) Explain why some bonds sell at a premium to par value, and other bonds sell at a discount. What do you know about the relationship between the coupon rate and the YTM for premium b

> Suppose you buy a 9 percent coupon, 15-year bond today when it’s first issued. If interest rates suddenly rise to 15 percent, what happens to the value of your bond? Why?

> Is the yield to maturity (YTM) on a bond the same thing as the required return? Is YTM the same thing as the coupon rate? Suppose that today a 10 percent coupon bond sells at par. Two years from now, the required return on the same bond is 8 percent. Wha

> What is the difference between a bond’s promised yield and its realized yield? Which is more relevant? When we calculate a bond’s yield to maturity, which of these are we calculating?

> For a premium bond, which is greater, the coupon rate or the yield to maturity? Why? For a discount bond? Why?

> In the United States, what is the normal face value for corporate and U.S. government bonds? How are coupons calculated? How often are coupons paid?

> For callable bonds, the financial press generally reports either the yield to maturity or the yield to call. Often yield to call is reported for premium bonds, and yield to maturity is reported for discount bonds. What is the reasoning behind this conven

> When we observe interest rates in the financial press, do we see nominal or real rates? Which are more relevant to investors?

> Compare and contrast the Fed funds rate and the discount rate. Which do you think is more volatile? Which market do you think is more active? Why?

> Discuss how each of the following theories for the term structure of interest rates could account for a downward-sloping term structure of interest rates: a. Pure expectations b. Maturity preference c. Market segmentation

> When combined with Beta Naught in a 50/50 portfolio, which of the other three funds will produce a portfolio that has the lowest standard deviation? a. New Horizon only. b. Quality Commodity only. c. Either Hi Rise or Quality Commodity.

> Based on the history of interest rates, what is the range of short-term rates that has occurred in the United States? The range of long-term rates? What is a typical value for each?

> In the chapter, we discussed the 3Com/Palm and Royal Dutch/ Shell mis pricings. Which of the limits to arbitrage would least likely be the main reason for these mis pricings? Explain.

> Why do you think the industrial and transportation averages are the two that underlie Dow theory?

> What is noise trader risk? How can noise trader risk lead to market inefficiencies?

> How can frame dependence lead to irrational investment decisions?

> How do prospect theory and the concept of a rational investor differ?

> Gaps are another technical analysis tool used in conjunction with open high-low-close charts. A gap occurs when either the low price for a particular day is higher than the high price from the previous day, or the high price for a day is lower than the l

> A frequent argument against the usefulness of technical analysis is that trading on a pattern has the effect of destroying the pattern. Explain what this means.

> Which of the following statements are true about the efficient markets hypothesis? a. It implies perfect forecasting ability. b. It implies that prices reflect all available information. c. It implies an irrational market. d. It implies that prices do no

> You invest $10,000 in the market at the beginning of the year, and by the end of the year your account is worth $15,000. During the year the market return was 10 percent. Does this mean that the market is inefficient?

> Based on the information in the case, which one of the following portfolios should the Analees choose? a. Portfolio A b. Portfolio B c. Portfolio C Allocation Expected Return Portfolio A Portfolio B Portfolio C U.S. large stocks U.S. small stocks 9

> A hundred years ago or so, companies did not compile annual reports. Even if you owned stock in a particular company, you were unlikely to be allowed to see the balance sheet and income statement for the company. Assuming the market is semi strong-form e

> In the mid- to late-1990s, the performance of the pros was unusually poor—on the order of 90 percent of all equity mutual funds underperformed a passively managed index fund. How does this bear on the issue of market efficiency?

> For each of the following scenarios, discuss whether profit opportunities exist from trading in the stock of the firm under the conditions that (1) the market is not weak-form efficient, (2) the market is weak-form but not semi strong-form efficient, (3)

> Several celebrated investors and stock pickers have recorded huge returns on their investments over the past two decades. Is the success of these particular investors an invalidation of an efficient stock market? Explain.

> Prospectors, Inc., is a publicly traded gold prospecting company in Alaska. Although the firm’s searches for gold usually fail, the prospectors occasionally find a rich vein of ore. What pattern would you expect to observe for Prospectors’ cumulative abn

> Suppose the market is semi strong-form efficient. Can you expect to earn abnormal returns if you make trades based on a. Your broker’s information about record earnings for a stock? b. Rumors about a merger of a firm? c. Yesterday’s announcement of a suc

> The Durkin Investing Agency has been the best stock picker in the country for the past two years. Before this rise to fame occurred, the Durkin newsletter had 200 subscribers. Those subscribers beat the market consistently, earning substantially higher r

> Trans Trust Corp. has changed how it accounts for inventory. Taxes are unaffected, although the resulting earnings report released this quarter is 20 percent higher than what it would have been under the old accounting system. There is no other surprise

> New tech Corp. is going to adopt a new chip testing device that can greatly improve its production efficiency. Do you think the lead engineer can profit from purchasing the firm’s stock before the news release on the device? After reading the announcemen

> Today, the following announcement was made: “Early today the Justice Department reached a decision in the Universal Product Care (UPC) case. UPC has been found guilty of discriminatory practices in hiring. For the next five years, UPC must pay $2 million

> What is their tolerance for risk? a. Average b. Below average c. Above average

> When the 56-year-old founder of Gulf & Western, Inc., died of a heart attack, the stock price immediately jumped from $18.00 a share to $20.25, a 12.5 percent increase. This is evidence of market inefficiency because an efficient stock market would have

> Aero tech, an aerospace technology research firm, announced this morning that it hired the world’s most knowledgeable and prolific space researchers. Before today, Aero tech’s stock had been selling for $100. Assume that no other information is received

> Based on the dividend growth models presented in the chapter, what are the two components of the total return of a share of stock? Which do you think is typically larger?

> You have $100,000 to invest in a portfolio containing stock X, stock Y, and a risk-free asset. You must invest all of your money. Your goal is to create a portfolio that has an expected return of 13 percent and that has only 70 percent of the risk of the

> Using the CAPM, show that the ratio of the risk premiums on two assets is equal to the ratio of their betas.

> In Problem 12, what would the risk-free rate have to be for the two stocks to be correctly priced relative to each other? Data from Problem 12: Stock Y has a beta of 1.05 and an expected return of 13 percent. Stock Z has a beta of 0.70 and an expected

> The returns we have examined are not adjusted for taxes. What do you suppose would happen to our estimated returns and risk premiums if we did account for taxes? What would happen to our volatility measures?

> The returns we have examined are not adjusted for inflation. What do you suppose would happen to our estimated risk premiums if we did account for inflation?

> What is the reason margin requirements exist?

> Are market timing and tactical asset allocation similar? Why or why not?

> What is the difference between asset allocation and security selection?

> Under what two assumptions can we use the constant perpetual growth model presented in the chapter to determine the value of a share of stock? How reasonable are these assumptions?

> What is the probability that the return on small stocks will be less than −100 percent in a single year (think about it)? What are the implications for the distribution of returns?

> A particular stock had a return last year of 4 percent. However, you look at the stock price and notice that it actually didn’t change at all last year. How is this possible?

> How does a high-water mark constrain hedge fund managers from earning excess performance management fees?

> Who actually owns a mutual fund? Who runs it?

> What is the open interest on a futures contract? What do you think will usually happen to open interest as maturity approaches?

> Changes in what price lead to gains and/or losses in futures contracts?

> The current yield on a bond is the coupon rate divided by the price. Thus, it is very similar to what number reported for common and preferred stocks?

> What is the P/E ratio reported for stocks in The Wall Street Journal? In particular, how is it computed?

> What are the distinguishing features of a money market instrument?

> The liquidity of an asset directly affects the risk of buying or selling that asset during adverse market conditions. Describe the liquidity risk you face with a short stock position during a market rally and a long stock position during a market decline

> Suppose Microsoft is currently trading at $50. You want to sell it if it reaches $55. What type of order should you submit?

> Suppose your broker tips you on a hot stock. You invest heavily, but, to your considerable dismay, the stock plummets in value. What recourse do you have against your broker?

> Based on the historical record, rank the following investments in increasing order of risk. Rank the investments in increasing order of average returns. What do you conclude about the relationship between the risk of an investment and the return you expe

> The town of South Park is planning a bond issue in six months and Kenny, the town treasurer, is worried that interest rates may rise, thereby reducing the value of the bond issue. Should Kenny buy or sell Treasury bond futures contracts to hedge the imp

> Jed Clampett just dug another oil well, and, as usual, it’s a gusher. Jed estimates that in two months, he’ll have 2 million barrels of crude oil to bring to market. However, Jed would like to lock in the value of this oil at today’s prices because the o

> A mutual fund that predominantly holds long-term Treasury bonds plans on liquidating the portfolio in three months. However, the fund manager is concerned that interest rates may rise from current levels and wants to hedge the price risk of the portfolio

> Suppose one of Fidelity’s mutual funds closely mimics the S&P 500 Index. The fund has done very well during the year, and, in November, the fund manager wants to lock in the gains he has made using stock index futures. Should he take a long or short posi

> Kellogg’s uses large quantities of corn in its breakfast cereal operations. Suppose the near-term weather forecast for the corn-producing states is drought like conditions, so corn prices are expected to rise. To hedge its costs, Kellogg’s decides to use

> True or false: The most important characteristic in determining the expected return of a well-diversified portfolio is the variances of the individual assets in the portfolio. Explain.

> Classify the following events as mostly systematic or mostly unsystematic. Is the distinction clear in every case? a. Short-term interest rates increase unexpectedly. b. The interest rate a company pays on its short-term debt borrowing is increased by it

> True or false: It is impossible for a single asset to lie on the Markowitz efficient frontier.

> What is a stop-loss order? Why might it be used? Is it sure to stop a loss?

> Assume you are a very risk-averse investor. Why might you still be willing to add an investment with high volatility to your portfolio?

> True or false: If two stocks have the same standard deviation of 45 percent, then any portfolio of the two stocks will also have a standard deviation of 45 percent.

> True or false: If two stocks have the same expected return of 12 percent, then any portfolio of the two stocks will also have an expected return of 12 percent.

> What is an efficient portfolio?

> If the returns on two stocks are highly correlated, what does this mean? If they have no correlation? If they are negatively correlated?

> Suppose two assets have zero correlation and the same standard deviation. What is true about the minimum variance portfolio?

> Based on market history, what is the average annual standard deviation of return for a single, randomly chosen stock? What is the average annual standard deviation for an equally weighted portfolio of many stocks?

> What is interest rate risk? What are the roles of a bond’s coupon and maturity in determining its level of interest rate risk?

> What are the coupon rate and current yield on a bond? What happens to these if a bond’s price rises?

> What are premium, discount, and par bonds?

> What is the difference between a market order and a limit order? What is the potential downside to each type of order?

> Evaluate the following statement: “Treasury inflation protected securities (TIPS) pay a fixed coupon.”

> What are the three different types of Treasury STRIPS that are publicly traded?

> Why do you suppose rates on some money market instruments are quoted on a bank discount basis? (Hint: Why use a 360-day year?)

> What is LIBOR? Why is it important?

> Compare and contrast commercial paper and Treasury bills. Which would typically offer a higher interest rate? Why?

> What are pure discount securities? Give two examples.

> What does it mean to be a contrarian investor? How would a contrarian investor use technical analysis?

> What is the “illusion of knowledge” and how does it impact investment performance?

> In the context of behavioral finance, why do men tend to underperform women with regard to the returns in their portfolios?

> Why do 401(k) plans with more bond choices tend to have participants with portfolios more heavily allocated to fixed income?

> Refer to Figure 4.5. Look at the three-year performance for the funds listed. Why do you suppose there are so few poor performers? Hint: Think about the hit TV show Survivor. Figure 4.5: Mutual Funds: Closing Quotes 00 TO: A|B|C|D|E|G|H|J|K|L|M|N|0

> Briefly explain mental accounting and identify the potential negative effect of this bias.

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