Part B END-OF-CHAPTER SOLUTIONS Fundamentals of Investments, 5th edition Jordan and Miller Chapter 1 A Brief History of Risk and Return Concept Questions 1. For both risk and return, increasing order is b, c, a, d. On average, the higher the risk of an investment, the higher is its expected return. 2. Since the price didn’t change, the capital gains yield was zero. If the total return was four percent, then the dividend yield must be four percent. 3. It is impossible to lose more than –100 percent of your investment.

Therefore, return distributions are cut off on the lower tail at –100 percent; if returns were truly normally distributed, you could lose much more. 4. To calculate an arithmetic return, you simply sum the returns and divide by the number of returns. As such, arithmetic returns do not account for the effects of compounding. Geometric returns do account for the effects of compounding. As an investor, the more important return of an asset is the geometric return. 5. Blume’s formula uses the arithmetic and geometric returns along with the number of observations to approximate a holding period return.

When predicting a holding period return, the arithmetic return will tend to be too high and the geometric return will tend to be too low. Blume’s formula statistically adjusts these returns for different holding period expected returns. 6. T-bill rates were highest in the early eighties since inflation at the time was relatively high. As we discuss in our chapter on interest rates, rates on T-bills will almost always be slightly higher than the rate of inflation. 7. Risk premiums are about the same whether or not we account for inflation.

The reason is that risk premiums are the difference between two returns, so inflation essentially nets out. 8. Returns, risk premiums, and volatility would all be lower than we estimated because aftertax returns are smaller than pretax returns. 9. We have seen that T-bills barely kept up with inflation before taxes. After taxes, investors in T-bills actually lost ground (assuming anything other than a very low tax rate). Thus, an all T-bill strategy will probably lose money in real dollars for a taxable investor. 10.

It is important not to lose sight of the fact that the results we have discussed cover over 70 years, well beyond the investing lifetime for most of us. There have been extended periods during which small stocks have done terribly. Thus, one reason most investors will choose not to pursue a 100 percent stock (particularly small-cap stocks) strategy is that many investors have relatively short horizons, and high volatility investments may be very inappropriate in such cases. There are other reasons, but we will defer discussion of these to later chapters. Solutions to Questions and Problems

NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Core Questions 1. Total dollar return = $988. 00 2. Capital gains yield = 12. 33% Dividend yield = 1. 21% Total rate of return = 13. 53% 3. Dollar return = –$2,790. 00 Capital gains yield = –6. 30% Dividend yield = 1. 21% Total rate of return = –5. 10% . a. average return = 5. 8%, average risk premium = 2. 0% b. average return = 3. 8%, average risk premium = 0% c. average return = 12. 3%, average risk premium = 8. 5% d. average return = 17. 4%, average risk premium = 13. 6% 5. Cherry average return = 9. 20% Straw average return = 13. 80% 6. Stock A: RA = 9. 80% Var = 0. 02077 Standard deviation = 0. 1441 or 14. 41% Stock B: RB = 11. 80% Var = 0. 01987 Standard deviation = 0. 1410 or 14. 10% 7. The capital gains yield is ($59 – 65)/$65 = –. 0923 or –9. 23% (notice the negative sign). With a dividend yield of 1. 7 percent, the total return is –7. 3%. 8. Geometric return = . 0982 or 9. 82% 9. Arithmetic return = . 1167 or 11. 67% Geometric return = . 0982 or 9. 82% Intermediate Questions 10. That’s plus or minus one standard deviation, so about two-thirds of the time or two years out of three. In one year out of three, you will be outside this range, implying that you will be below it one year out of six and above it one year out of six. 11. You lose money if you have a negative return. With a 7 percent expected return and a 3. 5 percent standard deviation, a zero return is two standard deviations below the average.

The odds of being outside (above or below) two standard deviations are 5 percent; the odds of being below are half that, or 2. 5 percent. (It’s actually 2. 28 percent. ) You should expect to lose money only 2. 5 years out of every 100. It’s a pretty safe investment. 12. The average return is 5. 8 percent, with a standard deviation of 9. 2 percent, so Prob( Return < –3. 4 or Return > 15. 0 ) ? 1/3, but we are only interested in one tail; Prob( Return < –3. 4) ? 1/6, which is half of 1/3 . 95%: = –12. 6% to 24. 2% 99%: = –21. 8% to 33. 4% 13. Expected return = 17. 4% ; ? = 32. 7%.

Doubling your money is a 100% return, so if the return distribution is normal, Z = (100 – 17. 4)/32. 7 = 2. 53 standard deviations; this is in-between two and three standard deviations, so the probability is small, somewhere between . 5% and 2. 5% (why? ). Referring to the nearest Z table, the actual probability is = 0. 577%, or less than once every 100 years. Tripling your money would be Z = (200 – 17. 4)/ 32. 7 = 5. 58 standard deviations; this corresponds to a probability of (much) less than 0. 5%, or once every 200 years. (The actual answer is less than once every 1 million years, so don’t hold your breath. |14. |Year |Common stocks |T-bill return |Risk premium | | |1973 |–14. 69% |7. 29% |–21. 98% | | |1974 |–26. 47% |7. 99% |–34. 46% | | |1975 |37. 23% |5. 87% |31. 36% | | |1796 |23. 93% |5. 07% |18. 86% | | |1977 |–7. 6% |5. 45% |–12. 61% | | | |12. 84% |31. 67% |–18. 83% | a. Annual risk premium = Common stock return – T-bill return (see table above). b. Average returns: Common stocks = 2. 57% ; T-bills = 6. 33%; Risk premium = –3. 77% c. Common stocks: Var = 0. 072337 Standard deviation = 0. 2690 = 26. 90% T-bills: Var = 0. 0001565 Standard deviation = 0. 0125 = 1. 25% Risk premium:Var = 0. 077446 Standard deviation = 0. 2783 = 27. 83% d.

Before the fact, the risk premium will be positive; investors demand compensation over and above the risk-free return to invest their money in the risky asset. After the fact, the observed risk premium can be negative if the asset’s nominal return is unexpectedly low, the risk-free return is unexpectedly high, or any combination of these two events. 15. = . 1065 or 10. 65% 16. 5 year estimate = 11. 97% 10 year estimate = 11. 68% 20 year estimate = 11. 10% 17. Small company stocks = . 1269 or 12. 69% Long-term government bonds = . 0542 or 5. 42% Treasury bills = . 0372 or 3. 72% Inflation = . 0303 or 3. 03% 18.

RA = . 0900 or 9. 00% RG = . 0819 or 8. 19% 19. R1 = 20. 41% R2 = 7. 14% R3 = –15. 80% R4 = 19. 65% R5 = 15. 07% RA = . 0929 or 9. 29% RG = . 0838 or 8. 38% 20. Stock A: RA = . 1200 or 12. 00% Var = 0. 000000 Standard deviation = 0. 000 or 0. 00% RG = . 1200 or 12. 00% Stock B: RA = . 1200 or 12. 00% Var = 0. 001900 Standard deviation = 0. 0436 or 4. 36% RG = . 1193 or 11. 93% Stock C: RA = . 1200 or 12. 00% Var = 0. 047950 Standard deviation = 0. 2190 or 21. 90% RG = . 1019 or 10. 19% The larger the standard deviation, the greater will be the difference between the arithmetic return and geometric return.

In fact, for lognormally distributed returns, another formula to find the geometric return is arithmetic return – ? variance. Therefore, for Stock C, we get . 1200 – ?(. 047950) = . 0960. The difference in this case is because the return sample is not a true lognormal distribution. Spreadsheet Problems [pic] Chapter 2 Buying and Selling Securities Concept Questions 1. Purchasing on margin means borrowing some of the money used to buy securities. You do it because you desire a larger position than you can afford to pay for, recognizing that using margin is a form of financial leverage.

As such, your gains and losses will be magnified. Of course, you hope you only experience the gains. 2. Shorting a security means borrowing it and selling it, with the understanding that at some future date you will buy the security and return it, thereby “covering” the short. You do it because you believe the security’s value will decline, so you hope to sell high now, then buy low later. 3. Margin requirements amount to security deposits. They exist to protect your broker against losses. 4. Asset allocation means choosing among broad categories such as stocks and bonds.

Security selection means picking individual assets within a particular category, such as shares of stock in particular companies. 5. They can be. Market timing amounts to active asset allocation, moving money in and out of certain broad classes (such as stocks) in anticipation of future market direction. Of course, market timing and passive asset allocation are not the same. 6. Some benefits from street name registration include: a. The broker holds the security, so there is no danger of theft or other loss of the security. This is important because a stolen or lost security cannot be easily or cheaply replaced. b.

Any dividends or interest payments are automatically credited, and they are often credited more quickly (and conveniently) than they would be if you received the check in the mail. c. The broker provides regular account statements showing the value of securities held in the account and any payments received. Also, for tax purposes, the broker will provide all the needed information on a single form at the end of the year, greatly reducing your record-keeping requirements. d. Street name registration will probably be required for anything other than a straight cash purchase, so, with a margin purchase for example, it will be required. . Probably none. The advice you receive is unconditionally not guaranteed. If the recommendation was grossly unsuitable or improper, then arbitration is probably your only possible means of recovery. Of course, you can close your account, or at least what’s left of it. 8. If you buy (go long) 500 shares at $18, you have a total of $9,000 invested. This is the most you can lose because the worst that could happen is that the company could go bankrupt, leaving you with worthless shares. There is no limit to what you can make because there is no maximum value for your shares – they can increase in value without limit. 9.

If the asset is illiquid, it may be difficult to quickly sell it during market declines, or to purchase it during market rallies. Hence, special care should always be given to investment positions in illiquid assets, especially in times of market turmoil 10. The worst that can happen to a share of stock is for the firm to go bankrupt and the stock to become worthless, so the maximum gain to the short position is $60,000. However, since the stock price can rise without limit, the maximum loss to a short stock position is unlimited. Solutions to Questions and Problems NOTE: All end of chapter problems were solved using a spreadsheet.

Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Core questions 1. Maximum investment = $21,667 Number of shares = 305. 16 or 305 shares 2. Margin loan = $15,500 Margin requirement = 0. 4151 or 41. 51% 3. Terminal price = $62 Without margin = 16. 98% With margin = 40. 91% Terminal price = $44 Without margin = –16. 98% With margin = –40. 91% 4. Initial deposit = $7,950

Terminal price = $62 Without margin = 16. 98% With margin = 56. 60% Terminal price = $44 Without margin = –16. 98% With margin = –56. 60% A lower initial margin requirement will make the returns more volatile. In other words, a stock price increase will increase the return, and a stock price decrease will cause a greater loss. 5. Maximum purchase = $21,818. 18 6. Amount borrowed = $16,500 Margin call price = $58. 93 7. Amount borrowed = $11,610 Margin call price = $36. 38 Stock price decline = –15. 38% 8. Proceeds from short sale = $63,900 Initial deposit = $38,340 Account value = $102,240

Margin call price = $87. 38 9. Proceeds from short sale = $63,000 Initial deposit = $34,650 Account value = $97,650 Margin call price = $75. 12 Account equity = $22,530 10. Pretax return = 10. 00% Aftertax capital gains = $6. 30 Aftertax dividend = $1. 53 Aftertax return = 7. 25% Intermediate questions 11. AssetsLiabilities and account equity 305 shares$21. 655. 00Margin loan $ 8,662. 00 Account equity 12,993. 00 Total$21,655. 00Total $21,655. 00 Stock price = $84 AssetsLiabilities and account equity 305 shares$25,620. 00Margin loan $ 8,662. 00 Account equity 16,958. 00 Total$25,620. 00Total $25,620. 0 Margin = $16,958/$25,620 = 66. 19% Stock price = $62 Assets Liabilities and account equity 305 shares $18,910. 00Margin loan $ 8,662. 00 Account equity 10,248. 00 Total$18,910. 00Total $18,910. 00 Margin = $10,248/$18,910 = 54. 19% 12. 600 shares ? $46 per share = $27,600 Initial margin = $11,000/$27,600 = 39. 86% Assets Liabilities and account equity 600 shares$27,600Margin loan$16,600 Account equity 11,000 Total$27,600Total$27,600 13. Total purchase = $42,000 Margin loan = $27,000 Margin call price = $77. 14 To meet a margin call, you can deposit additional cash into your trading ccount, liquidate shares until your margin requirement is met, or deposit additional marketable securities against your account as collateral. 14. Interest on loan = $1,755 a. Proceeds from sale = $48,000 Dollar return = $4,245 Rate of return = 28. 30% Without margin, rate of return = 14. 29% b. Proceeds from sale = $42,000 Dollar return = –$1,755 Rate of return = –11. 70% Without margin, rate of return = $0% c. Proceeds from sale = $31,000 Dollar return = –$12,755 Rate of return = –85. 03% Without margin, rate of return = –26. 19% 15. Initial equity = $20,400 Amount borrowed = $30,600

Interest = $2,662 Proceeds from sale = $57,000 Dollar return = $3,338 Rate of return = 16. 36% 16. Total purchase = $34,400 Loan = $19,400 Interest = $1,610. 20 Proceeds from sale = $46,400 Dividends = $512 Dollar return = $10,901. 80 Return = 72. 68% 17. = $1,234. 60 18. = $454. 55 19. = 15. 92% 20. = 22. 98% All else the same, the shorter the holding period, the larger the EAR. 21. Holding period return = –8. 36% EAR = –18. 90% 22. Initial purchase = $27,600 Amount borrowed = $16,600 Interest on loan = $591. 22 Dividends received = $150. 00 Proceeds from stock sale = $31,800 Dollar return = $3,758. 78

Rate of return = 34. 17% per six months Effective annual return = 80. 02% 23. Proceeds from sale = $70,500 Initial margin = $70,500 Assets Liabilities and account equity Proceeds from sale $70,500Short position $70,500 Initial margin deposit 70,500Account equity 70,500 Total$141,000Total$141,000 24. Proceeds from sale = 1,500 ? $47 = $70,500 Initial margin = $70,500 ? .75 = $52,875 AssetsLiabilities and account equity Proceeds from sale $70,500Short position $70,500 Initial margin deposit 52,875Account equity 52,875 Total$123,375Total$123,375 25. Proceeds from short sale = $144,000

Initial margin deposit = $72,000 Total assets = Total liabilities and equity = $216,000 Cost of covering short = $129,750 Account equity = $86,250 Cost of covering dividends = $1,125 Dollar profit = $13,125 Rate of return = 18. 23% 26. Proceeds from sale = $115,200 Initial margin = $57,600 Initial Balance Sheet AssetsLiabilities and account equity Proceeds from sale$115,200Short position$115,200 Initial margin deposit 57,600Account equity 57,600 Total$172,800Total$172,800 Stock price = $63 AssetsLiabilities and account equity Proceeds from sale$115,200Short position$100,800

Initial margin deposit 57,600Account equity 72,000 Total$172,800Total$172,800 Margin = 71. 43% Five-month return = 25% Effective annual return = 70. 84% Stock price = $79 AssetsLiabilities and account equity Proceeds from sale$115,200Short position$126,400 Initial margin deposit 57,600Account equity 46,400 Total$172,800Total$172,800 Margin = 36. 71% Five-month return = –19. 44% Effective annual return = –40. 48% Chapter 3 Overview of Security Types Concept Questions 1. The two distinguishing characteristics are: (1) all money market instruments are debt instruments (i. e. IOUs), and (2) all have less than 12 months to maturity when originally issued. 2. Preferred stockholders have a dividend preference and a liquidation preference. The dividend preference requires that preferred stockholders be paid before common stockholders. The liquidation preference means that, in the event of liquidation, the preferred stockholders will receive a fixed face value per share before the common stockholders receive anything. 3. The PE ratio is the price per share divided by annual earnings per share (EPS). EPS is the sum of the most recent four quarters’ earnings per share. 4.

The current yield on a bond is very similar in concept to the dividend yield on common and preferred stock 5. Volume in stocks is quoted in round lots (multiples of 100). Volume in corporate bonds is the actual number of bonds. Volume in options is reported in contracts; each contract represents the right to buy or sell 100 shares. Volume in futures contracts is reported in contracts, where each contract represents a fixed amount of the underlying asset. 6. You make or lose money on a futures contract when the futures price changes, not the current price for immediate delivery (although the two are closely related). . Open interest is the number of outstanding contracts. Since most contract positions will be closed before maturity, it will usually shrink as maturity approaches. 8. A futures contact is a contract to buy or sell an asset at some point in the future. Both parties in the contract are legally obligated to fulfill their side of the contract. In an option contract, the buyer has the right, but not the obligation, to buy (call) or sell (put) the asset. This option is not available to the buyer of a futures contract. The seller of a futures or options contract have the same responsibility to deliver the underlying asset.

The difference is the seller of a future knows she must deliver the asset, while the seller of an option contract is uncertain about delivery since delivery is at the option purchasers discretion. 9. A real asset is a tangible asset such as a land, buildings, precious metals, knowledge, etc. A financial asset is a legal claim on a real asset. The two basic types of financial assets are primary assets and derivative assets. A primary asset is a direct claim on a real asset. A derivative asset is basically a claim (or potential claim) on a primary asset or even another derivative asset. 0. Initially, it might seem that the put and the call would have the same price, but this is not correct. If the strike price is exactly equal to the stock price, the call option must be worth more. Intuitively, there are two reasons. First, there is no limit to what you can make on the call, but your potential gain on the put is limited to $100 per share. Second, we generally expect that the stock price will increase, so the odds are greater that the call option will be worth something at maturity. Core Questions 1. Dividend yield = . 013 thus P0 = $66. 15 Stock closed up $. 6, so yesterday’s closing price = $65. 89 18,649,130 shares were traded, which means 18,649,130 / 100 = 186,491 round lots of stock were traded. 2. PE = 16; EPS = $4. 135 EPS = NI / shares; so NI = $392,788,462 3. Dividend yield is 2. 8%, so annualized dividend is = $2. 80. This is just four times the last quarterly dividend, which is thus $2. 80/4 = $. 70/share. 4. PE = 21. 5; EPS = $4. 48 5. The total par value of purchase = $3,000,000 Next payment = $126,000 Payment at maturity = $3,126,000 Remember, the coupon payment is based on the par value of the bond, not the price. . Contract to buy = 14 Purchase price = $602,000 P = $1,595: Gain = $45,500 P = $1,493: Gain = –$25,900 7. Cost of contracts = $4,050 If the stock price is $83. 61, the value is= $8,610 Dollar return = $4,560 If the stock price is $69. 56, the call is worthless, so the dollar return is –$4,050. 8. The stock is down 2. 70%, so the price was = $55. 36 9. The YTM is given in the quote as 6. 846%. Price = $1,034. 53 Current yield = 6. 621% 10. Next payment = $856. 25 Intermediate Questions 11. Open interest in the March contract is 597,913 contracts.

Since the standard contract size is 5,000 bushels, sell 150,000/5,000 = 30 contracts. You’ll deliver 30(5,000) = 150,000 pounds of cotton and receive 30(5,000)($4. 52) = $678,000 12. The price you sold the contracts was 468 ($4. 68) and you closed the position at 460 4/8 ($4. 605). So, the total profit was ($4. 68 – 4. 605) ? 5,000 ? 25 = $9,375. 00 13. Initial value of position = $354,187. 50 Final value of position = $351,937. 50 Dollar profit = –$2,250. 00 14. The right to sell shares is a put option on the stock; the August put with a strike price of $45 has an ask price of $7. 00.

Since each stock option contract is for 100 shares of stock, you’re looking at 2,000/100 = 20 option contracts. Thus, the cost of purchasing this right is = $14,000 15. The cheapest put contract (that traded on this particular day) is the $37. 50. The most expensive option is the $47. 50. The first option is the furthest out of the money, while the second option is the furthest in the money 16. Case 1: Payoff = $6. 87/share. Dollar return = –$260 Return on investment per 3 months = –1. 86% Annualized return on investment = –7. 22% Case 2: The option finishes worthless, so payoff = $0.

Dollar return = –$14,000 Return on investment = –100% over all time periods. 17. The very first call option listed has a strike price of 10 and a quoted premium of $5. 50. This can’t be right because you could buy an option for $5. 50 and immediately exercise it for another $10. You can then sell the stock for its current price of $20. 25, earning a large, riskless profit. To prevent this kind of easy money, the option premium must be at least $10. 25. Similarly, the September 30 put is quoted at $8. 75. You could buy the put and immediately exercise it. The put premium must be at least $9. 5. 18. If you buy the stock, your $30,000 will purchase 6 round lots, meaning 600 shares. A call contract costs $750, so you can buy 40 of them. If, in six months, MMEE is selling for $63, your stock will be worth 600 shares ? $63 = $37,800. Your dollar gain will be $37,800 less the $30,000 you invested, or $7,800. Since you invested $30,000, your return for the six-month period is $7,800/$30,000 = 26%. To annualize your return, we need to compute the effective annual return, recognizing that there are two six-month periods in a year. 1 + EAR = 1. 262 = 1. 5876 EAR = . 5876 or 58. 6% Your annualized return on the stock is 58. 76%. If MMEE is selling for $44 per share, your loss on the stock investment is –12. 00%, which annualizes as follows: 1 + EAR = . 88002 = . 7744 EAR = –. 2256 or –22. 56% At the $63 price, your call options are worth $63 – 50 = $13 each, but now you control 4,000 shares (40 contracts), so your options are worth 4,000 shares ? $13 = $52,000 total. You invested $30,000, so your dollar return is $52,000 – 30,000 = $22,000, and your percentage return is $22,000/$30,000 = 73. 33%, compared to 26 on the stock investment. This annualizes to: + EAR = 1. 73332 = 3. 0044 EAR = 2. 0044 or 200. 44% However, if MMEE is selling for $44 when your options mature, then you lose everything ($30,000 investment), and your return is –100%. 19. You only get the dividend if you own the stock. The dividend would increase the return on your stock investment by the amount of the dividend yield, $. 80/$50 = . 016, or 1. 6%, but it would have no effect on your option investment. This question illustrates that an important difference between owning the stock and the option is that you only get the dividend if you own the stock. 20. At the $40. 7 stock price, your put options are worth $50 – 40. 37 = $9. 63 each. The premium was $6. 25, so you bought 48 contracts, meaning you control 4,800 shares. Your options are worth 4,800 shares ? $9. 63 = $46,224 total. You invested $30,000, so your dollar return is $46,224 – 30,000 = $16,224, and your percentage return is $16,224/$30,000 = 54. 08%. This annualizes to: 1 + EAR = 1. 54082 = 2. 3741 EAR = 1. 3741 or 137. 41% Chapter 4 Mutual Funds Concept Questions 1. Mutual funds are owned by fund shareholders. A fund is run by the fund manager, who is hired by the fund’s directors.

The fund’s directors are elected by the shareholders. 2. A rational investor might pay a load because he or she desires a particular type of fund or fund manager for which a no-load alternative does not exist. More generally, some investors feel you get what you pay for and are willing to pay more. Whether they are correct or not is a matter of some debate. Other investors simply are not aware of the full range of alternatives. 3. The NAV of a money market mutual fund is never supposed to change; it is supposed to stay at a constant $1. It never rises; only in very rare instances does it fall.

Maintaining a constant NAV is possible by simply increasing the number of shares as needed such that the number of shares is always equal to the total dollar value of the fund. 4. A money market deposit account is essentially a bank savings account. A money market mutual fund is a true mutual fund. A bank deposit is insured by the FDIC, so it is safer, at least up to the maximum insured amount. 5. If your investment horizon is only one year, you probably should not invest in the fund. In this case, the fund return has to be greater than five percent just to make back your original investment.

Over a twenty-year horizon, you have more time to make up the initial load. The longer the investment horizon, the better chance you have of regaining the amount paid in a front-end load. 6. In an up market, the cash balance will reduce the overall return since the fund is partly invested in assets with a lower return. In a down market, a cash balance should help reduce the negative returns from stocks or other instruments. An open-end fund typically keeps a cash balance to meet shareholder redemptions. A closed-end fund does not have shareholder redemptions so very little cash, if any, is kept in the portfolio. 7. 2b-1 fees are designed to pay for marketing and distribution costs. It does not really make sense that a closed-end fund charges 12b-1 fees because there is no need to market the fund once it has been sold at the IPO and there are no distributions necessary for the fund since the shares are sold on the secondary market. 8. You should probably buy an open-end fund because the fund stands ready to buy back shares at NAV. With a closed-end fund another buyer must make the purchase, so it may be more difficult to sell at NAV. We should note that an open-end fund may have the right to delay redemption if it so chooses. . Funds that accumulate a long record of poor performance tend to not attract investors. They are often simply merged into other funds. This is a type of survivor bias, meaning that a mutual fund family’s typical long-term track record may look pretty good, but only because the poor performing funds did not survive. In fact, several hundred funds disappear each year. 10. It doesn’t matter! For example, suppose we have a fund with a NAV of $100, a two percent fee, and a 10 percent annual return. If the fee is charged up front, we will have $98 invested, so at the end of the year, it will grow to $107. 0. If the fee is charged at the end of the year, the initial investment of $100 will grow to $110. When the two percent fee is taken out, we will be left with $107. 80, the same amount we would have if the fee was charged up front. Core Questions NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. . NAV = $41. 43 2. Load = 2. 01% 3. NAV = $27. 11; Market value of assets = $422,916,000 4. Initial shares = 20,000. Final shares = 21,040, and final NAV = $1 because this is a money market fund. 5. Total assets = $2,565,400 NAV = $51. 31 6. NAV = $49. 11 7. Offering price = $51. 69 8. = 43. 85% 9. NAV = $22. 06 = –16. 73% 10. = 13. 51% Intermediate 11. Turnover = X/$3,400,000,000 = . 42; X = $1,428,000,000. This is more than the $1. 25 billion in sales, so the turnover with the sales figure is $1,250,000,000 / $3,400,000,000 = . 368. 12. Management fee = $28,900,000

Miscellaneous and administrative expenses = $13,600,000 13. Initial NAV = $51. 13 Final NAV = $56. 27 Sale proceeds per share = $55. 14 Total return = 2. 45% You earned 2. 45% even thought the fund’s investments grew by 12%! The various fees and loads sharply reduced your return. Note, there is another interpretation of the solution. To calculate the final NAV including fees, we would first find the final NAV excluding fees with a 12 percent return, which would be: NAV excluding fees = $57. 26 Now, we can find the final NAV after the fees, which would be: Final NAV = $56. 15 Notice this answer is $0. 2 different than our original calculation. The reason is the assumption behind the fee withdrawal. The second calculation assumes the fees are withdrawn entirely at the end of the year, which is generally not true. Generally, fees are withdrawn periodically throughout the year, often quarterly. The actual relationship between the return on the underlying assets, the fees charged, and the actual return earned is the same as the Fisher equation, which shows the relationship between the inflation, the nominal interest rate, and the real interest rate. In this case, we can write the relationship as: 1 + Return on underlying assets) = (1 + Fees)(1 + Return earned) As with the Fisher equation, effective annual rates must be used. So, we would need to know the periodic fee withdrawal and the number of fee assessments during the year to find the exact final NAV. Our first calculation is analogous to the approximation of the Fisher equation, hence it is the method of calculation we will use going forward, that is: Return earned = Return on underlying assets – Fees Assuming a small fee (which we hope the mutual fund would have), the answer will be closest to the actual value without undue calculations. 4. Initial NAV = $53. 82; Final NAV = $59. 77 = Sale proceeds Total return = 11. 05% 15. Since we are concerned with the annual return, the initial dollar investment is irrelevant, so we will calculate the return based on a one dollar investment. 1 year: = 4. 90% 2 years: = 7. 90% 5 years: = 9. 75% 10 years: = 10. 37% 20 years = 10. 69% 50 years: = 10. 89% 16. After 3 years: (For every dollar invested) Class A: = $1. 29039 Class B: = $1. 31401 After 20 years: Class A: = $7. 65368 Class B: = $7. 06557 17. R = 9. 03% R = 6. 84% 18. National municipal fund: after-tax yield = 3. 77%

Taxable fund: after-tax yield = 3. 71% New Jersey municipal fund: after-tax yield = 3. 80% Choose the New Jersey fund. 19. Municipal fund: after-tax yield = 4. 10% Taxable fund: after-tax yield = 4. 23% New Jersey municipal fund: after-tax yield = 3. 80% Choose the taxable fund. 20. NAV = $21. 21 Shares outstanding = 19,330,504 For closed-end funds, the total shares outstanding are fixed, just as with common stock (assuming no net repurchases by the fund or new share issues to the public). 21. NAV at IPO = $25. 76 P = $22. 67 The value of your investment is = $113,350, a loss of $26,650 in one day.

Chapter 5 The Stock Market Concept Questions 1. The new car lot is a primary market; every new car sold is an IPO. The used car lot is a secondary market. The Chevy retailer is a dealer, buying and selling out of inventory. 2. Both. When trading occurs in the crowd, the specialist acts as a broker. If necessary, the specialist will buy or sell out of inventory to fill an order. 3. A market order is an order to execute the trade at the current market price. A limit order specifies the highest (lowest) price at which you are willing to purchase (sell) the stock.

The downside of a market order is that in a volatile market, the market price could change dramatically before your order is executed. The downside of a limit order is that the stock may never hit the limit price, meaning your trade will not be executed. 4. A stop-loss order is an order to sell at market if the price declines to the stop price. As the name suggests, it is a tool to limit losses. As with any stop order, however, the price received may be worse than the stop price, so it may not work as well as the investor hopes. For example, suppose a stock is selling for $50.

An investor has a stop loss on at $45, thereby limiting the potential loss to $5, or so the naive investor thinks. However, after the market closes, the company announces a disaster. Next morning, the stock opens at $30. The investor’s sell order will be executed, but the loss suffered will far exceed $5 per share. 5. You should submit a stop order; more specifically, a stop buy order with a stop price of $120. 6. No, you should submit a stop order to buy at $70, also called a stop buy. A limit buy would be executed immediately at the current price. 7.

With a multiple market maker system, there are, in general, multiple bid and ask prices. The inside quotes are the best ones, the highest bid and the lowest ask. 8. What market is covered; what types of stocks are included; how many stocks are included; and how the index is calculated. 9. The issue is index staleness. As more stocks are added, we generally start moving into less frequently traded issues. Thus, the tradeoff is between comprehensiveness and currency. 10. The uptick rule prohibits short selling unless the last stock price change was positive, i. e. an uptick.

Until recently, it applied primarily to the NYSE, but the NASDAQ now has a similar rule. It existed to prevent “bear raids,” an illegal market manipulation involving large-scale short selling intended to force down the stock price, however, the increase in electronic exchanges where the rule was not enforced may it less of a constraint than it had once been. Core Questions NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred.

However, the final answer for each problem is found without rounding during any step in the problem. 1. d = 2. 23256 2. d = 1. 97674 3. a. 100 shares at $70. 56 b. 100 shares at $70. 53 c. 100 shares at $70. 56 and 300 shares at $70. 57 4. Beginning index value = 60. 50 Ending index value = 72. 00 Return = 19. 01% 5. Beginning value = $3,422,500 Ending value = $4,099,500 Return = 19. 78% Note you could also solve the problem as: Beginning value = $6,845,000 Ending value = $8,199,000 Return = 19. 78% The interpretation in this case is the percentage increase in the market value of the market. . Beginning of year = 100. 00 End of year: = 119. 78 Note you would receive the same answer with either initial valuation method: Beginning of year: = 100. 00 End of year: = 119. 78 7. = 488. 90 8. Year 1: = 500. 00 Year 2: = 532. 37 Year 3: = 573. 51 Year 4: = 549. 35 Year 2: = 611. 92 Intermediate Questions 9. d = 3. 90698 10. Jan. 4? P = 1574. 65 Jan 5: Index level = 12,840. 89 11. IBM: ? P = 1579. 71; Index level = 12,841. 28 Intel: ? P = 1575. 78; Index level = 12,809. 39 12.? P = 1604. 65; Index level = 13,044. 05 13. d = 0. 20859408 14. a. 1/1/07: Index value = 74. 00 b. /1/08: Index value = 69. 33 2007 return = –6. 31% 1/1/09: Index value = 83. 33 2008 return = 20. 19% 15. Share price after the stock split is $34. 33. Index value on 1/1/08 without the split is 69. 33 (see above). (34. 33 + 39 + 63)/d = 69. 33; d = 136. 33 / 69. 33 = 1. 980769 1/1/09: Index value = (39. 33 + 53 + 79)/1. 980769 = 86. 4984 2008 return = (86. 4984 – 69. 33)/69. 33 = 24. 76%. Notice without the split the index return for 2008 is 20. 19%. 16. a. 1/1/07: Index value = 8561. 00 b. 1/1/08: Index value = 7942. 00 2007 return = –7. 23% 1/1/09: Index value = 9636. 00 2008 return = 21. 3% 17. The index values and returns will be unchanged; the stock split changes the share price, but not the total value of the firm. 18. 2007: Douglas McDonnell return = 2. 91% Dynamics General return = –13. 33% International Rockwell return = –14. 86% 2007:Index return = –8. 43% 1/1/08: Index value = 91. 57 2008:Douglas McDonnell return = 11. 32% Dynamics General return = 35. 90% International Rockwell return = 25. 40% 2008: Index return = 24. 21% 1/1/09: Index value = 113. 74 19. Looking back at Chapter 1, you can see that there are years in which small cap stocks outperform large cap stocks.

In years with better performance by small companies, we would expect the returns from the equal-weighted index to outperform the value-weighted index since the value-weighted index is weighted toward larger companies. In years where large cap stocks outperform small cap stocks, we would see the value-weighted index with a higher return than an equal-weighted index. 20. 2007: Douglas McDonnell return = 2. 91% Dynamics General return = –13. 33% International Rockwell return = –14. 86% 2007:Index return = –8. 77% 1/1/08: Index value = 91. 23 2008:Douglas McDonnell return = 11. 2% Dynamics General return = 35. 90% International Rockwell return = 25. 40% 2008: Index return = 23. 79% 1/1/09: Index value = 112. 94 21. A geometric index is most suitable to capture the short-term price movements of the stocks in the index, but is not suitable for long-term investment performance measurement. A geometric index is an attempt to capture the median stock return. There are two reasons for the difference in the index levels. First, the geometric index systematically understates performance. The second reason is volatility.

The geometric index, by its construction, filters out volatility. On the other hand, an equal-weighted index tends to capture market upswings. 22. For price-weighted indices, purchase an equal number of shares for each firm in the index. For value- weighted indices, purchase shares (perhaps in fractional amounts) so that the investment in each stock, relative to your total portfolio value, is equal to that stock’s proportional market value relative to all firms in the index. In other words, if one company is twice as big as the other, put twice as much money in that company.

Finally, for equally-weighted indices, purchase equal dollar amounts of each stock in the index. Assuming no cash dividends or stock splits, both the price-weighted and value-weighted replication strategies require no additional rebalancing. However, an equally weighted index will not stay equally weighted through time, so it will have to be rebalanced by selling off investments that have gone up in value and buying investments that have gone down in value. A typical small investor would most likely use something like the equally-weighted index replication strategy, i. . , buying more-or-less equal dollar amounts of a basket of stocks, but the portfolio probably would not stay equally weighted. The value-weighted and equally-weighted index replication strategies are more difficult to implement than the price-weighted strategy because they would likely involve the purchase of odd lots and fractional shares, raising transactions costs. The value-weighted strategy is the most difficult because of the extra computation needed to determine the initial amounts to invest. Chapter 6 Common Stock Valuation Concept Questions 1.

The basic principle is that we can value a share of stock by computing the present value of all future dividends. 2. P/E ratios measure the price of a share of stock relative to current earnings. All else the same, future earnings will be larger for a growth stock than a value stock, so investors will pay more relative to today’s earnings. 3. As you know, firms can have negative earnings. But, for a firm to survive over a long period, earnings must eventually become positive. The residual income model will give a negative stock value when earnings are negative, thus it cannot be used reliably in this situation. . It is computed by taking net income plus depreciation and then dividing by the number of shares outstanding. 5. The value of any investment depends on its cash flows; i. e. , what investors will actually receive. The cash flows from a share of stock are the dividends. 6. Investors believe the company will eventually start paying dividends (or be sold to another company). 7. In general, companies that need the cash will often forgo dividends since dividends are a cash expense. Young, growing companies with profitable investment opportunities are one example; another example is a company in financial distress. . The general method for valuing a share of stock is to find the present value of all expected future dividends. The constant perpetual growth model presented in the text is only valid (i) if dividends are expected to occur forever, that is, the stock provides dividends in perpetuity, and (ii) if a constant growth rate of dividends occurs forever. A violation of the first assumption might be a company that is expected to cease operations and dissolve itself some finite number of years from now. The stock of such a company would be valued by the methods of this chapter by applying the general method of valuation.

A violation of the second assumption might be a start-up firm that isn’t currently paying any dividends, but is expected to eventually start making dividend payments some number of years from now. This stock would also be valued by the general dividend valuation method of this chapter. 9. The two components are the dividend yield and the capital gains yield. For most companies, the capital gains yield is larger. This is easy to see for companies that pay no dividends. For companies that do pay dividends, the dividend yields are rarely over five percent and are often much less. 10. Yes.

If the dividend grows at a steady rate, so does the stock price. In other words, the dividend growth rate and the capital gains yield are the same. Solutions to Questions and Problems NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Core Questions 1. P0 = $40. 00 2. P0 = $50. 00 LD = $55. 74 3. P0 = $7. 63 P0 = $13. 67 P0 = $27. 65

P0 = $36. 40 4. P0 = $40 ; D = $5. 59 5. P0 = $401. 46 P0 = $140. 75 P0 = $72. 51 P0 = $42. 11 P0 = $29. 08 6. P0 = $32. 65 7. P0 = $, k = 10. 714% 8. P0 = $53 ; g = 5. 24% 9. P0 = $83 ; D1 = $3. 74 D1 = $4. 08 10. Retention ratio = . 7581 Sustainable growth rate = 12. 13% 11. Sustainable growth = . 06 = . 17r ; retention ratio = . 3529 Payout ratio = . 6471; EPS = $2. 55 P/E = 19, EPS = $2. 55, so P0 = $48. 45 12. E(R) = . 1530 or 15. 30% E(R) = . 1233 or 12. 33% 13. P0 = $75. 78 14. P0 = $78. 90 Intermediate Questions 15. P0 = $58. 54 16. P0 = $68. 70 17. P9 = $63. 16 P0 = $17. 95 18. D0 = $2. 89 ; D1 = $3. 61 19. P4 = $33. 3 P0 = $45. 44 20. P6 = $72. 73 P3 = $58. 87 P0 = $42. 45 21. P/E ratio: values are: 21. 77, 19. 88, 18. 98, 16. 16, 17. 36, 17. 10 ; average = 18. 54 EPS growth rates: 16. 36%, 3. 37%, 16. 09%, 15. 51%, 14. 29% ; average = 13. 12% Expected share price using P/E = 18. 54($8. 00)(1. 1312) = $167. 80 P/CFPS: values are: 13. 00, 12. 18, 11. 38, 9. 67, 10. 30, 10. 44 ; average = 11. 16 CFPS growth rates = 13. 34%; 5. 70%, 16. 19%, 16. 60%, 11. 02% ; average = 12. 57% Expected share price using P/CFPS= 11. 16($13. 10)(1. 1257) = $164. 61 P/S: values are: 1. 797, 1. 716, 1. 712, 1. 613, 1. 697, 1. 738 ; average = 1. 12 SPS growth rates: 11. 25%, –1. 06%, 4. 82%, 17. 98%, 9. 92% ; average = 8. 58% Expected share price = 1. 712 ($78. 70)(1. 0858) = $146. 30 A reasonable price range would seem to be $146 to $167 per share, although both the P/E and P/CFPS are at the high end of the price range. 22. k = 12. 65% Dividend growth rates: 8. 00%, 8. 33%, 6. 84%, 8. 00%, 3. 70% ; average = 6. 97% P2009 = $1. 40(1. 0697)2 / (. 1265 – . 0697) = $28. 23 Notice the last dividend is for 2008. To find the price in 2009, we must use the dividend in 2010 in the constant perpetual dividend growth model. 23. P/E ratio: N/A, N/A, N/A, N/A, 2,075. 0, 225. 00 ; average = 1,150. 00 EPS growth rates: 17. 50%, 45. 45%, 69. 44%, 107. 27%, 50. 00% ; average = 57. 93% Expected share price using P/E = 1,150($0. 06)(1. 5793) = $108. 97 P/CFPS: N/A, N/A, N/A, N/A, 2,766. 67, 168. 75 ; average = 1,467. 71 CFPS growth rates: 27. 78%, 56. 92%, 91. 07%, 112. 00%, 166. 67% ; average = 90. 89% Expected share price using P/CFPS = 1,467. 71($0. 08)(1. 9089) = $224. 13 P/S: values are 1. 600, 3. 296, 6. 409, 9. 507, 3. 487, 0. 615 ; average = 4. 152 SPS growth rates: 170. 00%, 34. 07%, 12. 15%, 17. 24%, –7. 77% ; average = 45. 14% Expected share price using P/S = $132. 29

This price range is from $109 to $224! As long as the stellar growth continues, the stock should do well. But any stumble will likely tank the stock. Be careful out there! 24. P/E ratios and P/CFPS are all negative, so these ratios are unusable. P/S: values are 16. 615, 14. 017, 12. 817; average = 14. 482 SPS growth rates = 65. 85%, 19. 56% ; average = 42. 71% Expected share price using SPS = $168. 02 This price is ridiculous, $168! Notice that sales have been exploding, but the company still can’t make money. A much lower market price might be fair considering the risks involved. Might be a buyout candidate, but at what price? 5. Parador’s expected future stock price = $76. 84, and expected future earnings per share is = $4. 07. Thus, Parador’s expected future P/E ratio is = 18. 90. 26. Parador’s expected future stock price is = $76. 84, and expected future sales per share = $20. 44. Thus, Parador’s expected future P/E ratio is = 3. 760. 27. b = . 54; g = 15. 14% k = 9. 53% P0 = –$30. 73 Since the growth rate is higher than required return, the dividend growth model cannot be used. Notice that we needed to square the growth rate since we have the dividend from 2007 and we need the 2009 dividend to find the 2008 stock price. 8. Average stock price: $40. 50, $42. 95, $43. 75, $44. 55, $54. 15 P/E ratio: 18. 33, 18. 92, 17. 50, 17. 68, 19. 13; Average P/E = 18. 31 EPS growth rates: 2. 71%, 10. 13%, 0. 80%, 12. 30%; Average EPS growth = 6. 49% P/E price: 18. 31(1. 0649)($2. 83) = $55. 18 P/CF ratio: 13. 46, 14. 08, 12. 79, 12. 69, 13. 37; Average P/CF = 13. 28 CF growth rates: 1. 33%, 12. 13%, 2. 63%, 15. 38%, Average CF growth rate = 7. 87% P/CF price = 13. 28(1. 0787)($4. 05) = $58. 01 P/S ratios: 3. 253, 3. 439, 3. 015, 3. 047, 3. 252; Average P/S = 3. 201 SPS growth rates: 0. 32%, 16. 17%, 0. 6%, 13. 89%; Average SPS growth rate = 7. 78% P/S price = = $57. 45 29. EPS next year = $3. 26 Book value next year = $11. 92 P0 = –$30. 17 We still have the problem that the required return is less than the growth rate. 30. Clean dividend = $1. 69 P0 = –$30. 17 31. Based on price ratio analysis, it appears the stock might be slightly overpriced at $57. All three ratios give remarkably consistent prices for Abbott. The constant perpetual growth model and RIM model cannot be used because the growth rate is greater than the required return. 32. The values for the end of the year are:

Book value = $14. 57 EPS = $3. 79 Note, to find the book value in the first year, we can use the following relationship: B2 – B1 = B1(1 + g) – B1 = B1 + B1g – B1 = B1g We will use this relationship to calculate the book value in the following years, so: P0 = [pic] + [pic] + [pic]+ [pic] + [pic] + [pic] P0 = $148. 90 33. ROE = 11. 87%; Retention ratio = . 70 Sustainable growth = 8. 3086% 34. An increase in the quarterly dividend will decrease the growth rate as it will lower the retention ratio. A stock split affects none of the components, therefore will have no effect. 35. P0 = $44. 04 36.

P/E on next year’s earnings = 30. 00 37. Using the following relationships: P0 = D1 / k – g; DPS1 = EPS1(1 – b); g = ROE? b; k = Rf + ((MRP) The P/E ratio can be re-written as: P/E = (1 – b) / {[Rf +((MRP)] – (ROE ? b)} a. As the beta increases, the P/E ratio should decrease. The required return increases, decreasing the present value of the future dividends. b. As the growth rate increases, the P/E ratio increases. c. An increase in the payout ratio would increase the P/E ratio. Although b is in the numerator and the denominator, the effect is greater in the denominator d.

As the market risk premium increases, the P/E ratio decreases. The required return increases, decreasing the present value of the future dividends. 38. Signaling theory can explain the paradox. If investors believe that the increased dividend is a signal of no potential growth opportunities for the company, investors may re-evaluate the expected growth rate of the company. A lower growth rate could offset the higher dividend. It is also possible that investors believe the company does have potential growth opportunities, but is not exploiting them. In this case, the growth rate of the company would also be lowered.

Chapter 7 Stock Price Behavior and Market Efficiency Concept Questions 1. The market is not weak-form efficient. 2. Unlike gambling, the stock market is a positive sum game; everybody can win. Also, speculators provide liquidity to markets and thus help promote efficiency. 3. The efficient markets paradigm only says, within the bounds of increasingly strong assumptions about the information processing of investors, that assets are fairly priced. An implication of this is that, on average, the typical market participant cannot earn excess profits from a particular trading strategy.

However, that does not mean that a few particular investors cannot outperform the market over a particular investment horizon. Certain investors who do well for a period of time get a lot of attention from the financial press, but the scores of investors who do not do well over the same period of time generally get considerably less attention. 4. a. If the market is not weak-form efficient, then this information could be acted on and a profit earned from following the price trend. Under 2, 3, and 4, this information is fully impounded in the current price and no abnormal profit opportunity exists. b.

Under 2, if the market is not semistrong form efficient, then this information could be used to buy the stock “cheap” before the rest of the market discovers the financial statement anomaly. Since 2 is stronger than 1, both imply a profit opportunity exists; under 3 and 4, this information is fully impounded in the current price and no profit opportunity exists. c. Under 3, if the market is not strong form efficient, then this information could be used as a profitable trading strategy, by noting the buying activity of the insiders as a signal that the stock is underpriced or that good news is imminent.

Since 1 and 2 are weaker than 3, all three imply a profit opportunity. Under 4, the information doesn’t signal a profit opportunity for traders; pertinent information the manager-insiders may have is fully reflected in the current share price. d. Despite the fact that this information is obviously less open to the public and a clearer signal of imminent price gains than is the scenario in part (c), the conclusions remain the same. If the market is strong form efficient, a profit opportunity does not exist.

A scenario such as this one is the most obvious evidence against strong-form market efficiency; the fact that such insider trading is also illegal should convince you of this fact. 5. Taken at face value, this fact suggests that markets have become more efficient. The increasing ease with which information is available over the internet lends strength to this conclusion. On the other hand, during this particular period, large-cap growth stocks were the top performers. Value-weighted indexes such as the S&P 500 are naturally concentrated in such stocks, thus making them especially hard to beat during this period.

So, it may be that the dismal record compiled by the pros is just a matter of bad luck or benchmark error. 6. It is likely the market has a better estimate of the stock price, assuming it is semistrong form efficient. However, semistrong form efficiency only states that you cannot easily profit from publicly available information. If financial statements are not available, the market can still price stocks based upon the available public information, limited though it may be. Therefore, it may have been as difficult to examine the limited public information and make an extra return. . Beating the market during any year is entirely possible. If you are able to consistently beat the market, it may shed doubt on market efficiency unless you are taking more risk than the market as a whole or are simply lucky. 8. a. False. Market efficiency implies that prices reflect all available information, but it does not imply certain knowledge. Many pieces of information that are available and reflected in prices are fairly uncertain. Efficiency of markets does not eliminate that uncertainty and therefore does not imply perfect forecasting ability. b. True.

Market efficiency exists when prices reflect all available information. To be efficient in the weak form, the market must incorporate all historical data into prices. Under the semi-strong form of the hypothesis, the market incorporates all publicly-available information in addition to the historical data. In strong form efficient markets, prices reflect all publicly and privately available information. c. False. Market efficiency implies that market participants are rational. Rational people will immediately act upon new information and will bid prices up or down to reflect that information. . False. In efficient markets, prices reflect all available information. Thus, prices will fluctuate whenever new information becomes available. e. True. Competition among investors results in the rapid transmission of new market information. In efficient markets, prices immediately reflect new information as investors bid the stock price up or down. 9. Yes, historical information is also public information; weak form efficiency is a subset of semi-strong form efficiency. 10. Ignoring trading costs, on average, such investors merely earn what the market offers; the trades all have zero NPV.

If trading costs exist, then these investors lose by the amount of the costs. 11. a. Aerotech’s stock price should rise immediately after the announcement of the positive news. b. Only scenario (ii) indicates market efficiency. In that case, the price of the stock rises immediately to the level that reflects the new information, eliminating all possibility of abnormal returns. In the other two scenarios, there are periods of time during which an investor could trade on the information and earn abnormal returns. 12. False.

The stock price would have adjusted before the founder’s death only if investors had perfect forecasting ability. The 12. 5 percent increase in the stock price after the founder’s death indicates that either the market did not anticipate the death or that the market had anticipated it imperfectly. However, the market reacted immediately to the new information, implying efficiency. It is interesting that the stock price rose after the announcement of the founder’s death. This price behavior indicates that the market felt he was a liability to the firm. 13.

The announcement should not deter investors from buying UPC’s stock. If the market is semi-strong form efficient, the stock price will have already reflected the present value of the payments that UPC must make. The expected return after the announcement should still be equal to the expected return before the announcement. UPC’s current stockholders bear the burden of the loss, since the stock price falls on the announcement. After the announcement, the expected return moves back to its original level. 14. The market is generally considered to be efficient up to the semi-strong form.

Therefore, no systematic profit can be made by trading on publicly-available information. Although illegal, the lead engineer of the device can profit from purchasing the firm’s stock before the news release on the implementation of the new technology. The price should immediately and fully adjust to the new information in the article. Thus, no abnormal return can be expected from purchasing after the publication of the article. 15. Under the semi-strong form of market efficiency, the stock price should stay the same. The accounting system changes are publicly available information.

Investors would identify no changes in either the firm’s current or its future cash flows. Thus, the stock price will not change after the announcement of increased earnings. 16. Because the number of subscribers has increased dramatically, the time it takes for information in the newsletter to be reflected in prices has shortened. With shorter adjustment periods, it becomes impossible to earn abnormal returns with the information provided by Durkin. If Durkin is using only publicly-available information in its newsletter, its ability to pick stocks is inconsistent with the efficient markets hypothesis.

Under the semi-strong form of market efficiency, all publicly-available information should be reflected in stock prices. The use of private information for trading purposes is illegal. 17. You should not agree with your broker. The performance ratings of the small manufacturing firms were published and became public information. Prices should adjust immediately to the information, thus preventing future abnormal returns. 18. Stock prices should immediately and fully rise to reflect the announcement. Thus, one cannot expect abnormal returns following the announcement. 9. a. No. Earnings information is in the public domain and reflected in the current stock price. b. Possibly. If the rumors were publicly disseminated, the prices would have already adjusted for the possibility of a merger. If the rumor is information that you received from an insider, you could earn excess returns, although trading on that information is illegal. c. No. The information is already public, and thus, already reflected in the stock price. 20. The statement is false because every investor has a different risk preference.

Although the expected return from every well-diversified portfolio is the same after adjusting for risk, investors still need to choose funds that are consistent with their particular risk level. 21. The share price will decrease immediately to reflect the new information. At the time of the announcement, the price of the stock should immediately decrease to reflect the negative information. 22. In an efficient market, the cumulative abnormal return (CAR) for Prospectors would rise substantially at the announcement of a new discovery.

The CAR falls slightly on any day when no discovery is announced. There is a small positive probability that there will be a discovery on any given day. If there is no discovery on a particular day, the price should fall slightly because the good event did not occur. The substantial price increases on the rare days of discovery should balance the small declines on the other days, leaving CARs that are horizontal over time. Solutions to Questions and Problems NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps.

Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Core Questions 1. To find the cumulative abnormal returns, we chart the abnormal returns for the days preceding and following the announcement. The abnormal return is calculated by subtracting the market return from the stock’s return on a particular day, Ri – RM. Calculate the cumulative average abnormal return by adding each abnormal return to the previous day’s abnormal return. | |Daily |Cumulative | | |Days from |Abnormal |Abnormal | | |Announcement |Return |Return | | |-5 |-0. 1 |-0. 1 | | |-4 |0. 1 |0. 0 | | |-3 |-0. 1 |-0. 1 | | |-2 |0. 1 |0. 0 | | |-1 |-0. 2 |-0. 2 | | |0 |1. |1. 7 | | |1 |0. 0 |1. 7 | | |2 |-0. 2 |1. 5 | | |3 |0. 1 |1. 6 | | |4 |0. 2 |1. 8 | | |5 |-0. 1 |1. 7 | [pic] Given that the battle with the current CEO was acrimonious, it must be assumed that investors felt his performance was poor, so we would expect the stock price to increase.

The CAR supports the efficient markets hypothesis. The CAR increases on the day of the announcement, and then remains relatively flat following the announcement. 2. The diagram does not support the efficient markets hypothesis. The CAR should remain relatively flat following the announcements. The diagram reveals that the CAR rose in the first month, only to drift down to lower levels during later months. Such movement violates the semi-strong form of the efficient markets hypothesis because an investor could earn abnormal profits while the stock price gradually decreased. 3. a.

Supports. The CAR remained constant after the event at time 0. This result is consistent with market efficiency, because prices adjust immediately to reflect the new information. Drops in CAR prior to an event can easily occur in an efficient capital market. For example, consider a sample of forced removals of the CEO. Since any CEO is more likely to be fired following bad rather than good stock performance, CARs are likely to be negative prior to removal. Because the firing of the CEO is announced at time 0, one cannot use this information to trade profitably before the announcement.

Thus, price drops prior to an event are neither consistent nor inconsistent with the efficient markets hypothesis. b. Rejects. Because the CAR increases after the event date, one can profit by buying after the event. This possibility is inconsistent with the efficient markets hypothesis. c. Supports. The CAR does no