CHAPTER 1: THE INVESTMENT ENVIRONMENT

PROBLEM SETS

11.
a. A fixed salary means that compensation is, in the short run, independent of the
firm’s success. This salary structure does not tie the manager’s immediate
compensation to the success of the firm, so a manager might not feel too compelled
to work hard to maximize firm value. However, the manager might view this as the
safest compensation structure and therefore value it more highly.

b. A salary that is paid in the form of stock in the firm means that the manager
earns the most when the shareholders’ wealth is maximized. Five years of vesting
helps align the interests of the employee with the long-term performance of the
firm. This structure is therefore most likely to align the interests of managers and
shareholders. If stock compensation is overdone, however, the manager might view
it as overly risky since the manager’s career is already linked to the firm, and this
undiversified exposure would be exacerbated with a large stock position in the firm.

c. A profit-linked salary creates great incentives for managers to contribute to the

firm’s success. However, a manager whose salary is tied to short-term profits will
be risk seeking, especially if these short-term profits determine salary or if the
compensation structure does not bear the full cost of the project’s risks (e.g., docked
pay for failed projects). Shareholders, in contrast, bear the losses as well as the
gains on the project and might be less willing to assume that risk.

12 Even if an individual shareholder could monitor and improve managers’

performance and thereby increase the value of the firm, the payoff would be small,
since the ownership share in a large corporation would be very small. For example,
if you own $10,000 of Ford stock and can increase the value of the firm by 5%, a
very ambitious goal, you benefit by only: 0.05 × $10,000 = $500. The cost, both
personal and financial to an individual investor, is likely to be prohibitive and
would typically easily exceed any accrued benefits (in this case $500).
In contrast, a creditor, such as a bank, that has a multimillion-dollar loan outstanding
to the firm has a big stake in making sure that the firm can repay the loan. It is clearly
worthwhile for the bank to spend considerable resources to monitor the firm. Large
institutional investors will also have commensurately large positions in companies
and will therefore monitor more closely.

14. Treasury bills serve a purpose for investors who prefer a low-risk investment with
immense liquidity. The lower average rate of return compared to stocks is the price
investors pay for predictability of investment performance and portfolio value.
16. You should be skeptical. If the author knows how to achieve such returns, why
would the author then be so ready to sell the secret to others? Financial markets are
very competitive; one of the implications of this fact is that riches do not come
easily. High-expected returns require bearing some risk, and obvious bargains are
few and far between. Any bargains, once discovered by the broad market, disappear
quickly. Odds are that the only one getting rich from the book is its author.

18. Allowing traders to share in the profits increases the traders’ willingness to assume
risk. Traders will share in the upside potential directly in the form of higher
compensation but only in the downside indirectly in the form of potential job loss if
performance is bad enough. This scenario creates a form of agency conflict known
as moral hazard, in which the owners of the financial institution share in both the
total profits and losses, while the traders will tend to share more of the gains than
the losses.
 CHAPTER 3: HOW SECURITIES ARE TRADED

PROBLEM SETS

1. Limit buy order: an order that purchases stock if the price falls below a
predetermined level. Limit sell order: sells stock when the price rises above a
predetermined level. Limit orders are not guaranteed to execute since the price may
not reach the trigger point. Market order: either a buy or sell order that is executed
immediately at the current market price

3. The use of leverage necessarily magnifies returns to investors. Leveraging

borrowed money allows for greater return on investment if the stock price
increases. However, if the stock price declines, the investor must repay the loan,
regardless of how far the stock price drops and incur a negative rate of return.

For example, if an investor buys an asset at $100 and the price rises to $110, the
investor earns 10%.
$110 − $100
𝑟asset = = 10.00%
$100

If an investor takes out a $40 loan (thus $60 margin) at 5% and buys the same
stock, the return will be 13.3%:
$110 − $100 − $100 × 0.40 × 0.05
𝑟asset = = 13.33%
$60

Of course, if the stock price falls below $100, the negative return will be greater for
the leveraged account. For example, if the price falls 10% to $90:

$90 − $100 − $100 × 0.40 × 0.05

𝑟asset = = −20.00%
$60

6.
a. The stock is purchased for: 300  $40 = $12,000
The amount borrowed is $4,000. Therefore, the investor put up equity, or
margin, of $8,000.

b. If the share price falls to $30, then the value of the stock falls to $9,000. By the
end of the year, the amount of the loan owed to the broker grows to:
$4,000  1.08 = $4,320
Therefore, the remaining margin in the investor’s account is:
 $9,000 − $4,320 = $4,680

c. The percentage margin is now: $4,680/$9,000 = 0.52, or 52% > 30%.

Therefore, the investor will not receive a margin call.

d. Using an end price of $30, the rate of return on the investment is:

(Ending equity−Initial equity) $4,680−$8,000

= = −0.415 or −41.5%
Initial equity $8,000

Alternatively, divide the initial equity investments into the change in value
plus the interest payment: ($3,000 loss + $320 interest) /$8,000 = −0.415.

7. a. The initial margin was: 0.50  1,000  $40 = $20,000

As a result of the increase in the stock price, Old Economy Traders loses:
$10  1,000 = $10,000
Margin decreases by $10,000. Old Economy Traders must pay the dividend of
$2 per share to the lender of the shares; the margin in the account decreases by
an additional $2,000. Therefore, the remaining margin is:
$20,000 − $10,000 − $2,000 = $8,000

b. The percentage margin is: $8,000/$50,000 = 0.16 or 16% < 30%

There will be a margin call.

c. The equity in the account decreased from $20,000 to $8,000 in 1 year, for a rate of
return of:

$40,000−$50,000−$2×1,000
$20,000
= −0.60 or −60%
10.
a. Initial margin is 50% of $5,000, or $2,500.

b. Total assets are $7,500 ($5,000 from the sale of the stock and $2,500 put up for
margin). Liabilities are 100P. Therefore, equity is ($7,500 − 100P). A margin
call will be issued when:
$7,500−100×𝑃
= 0.30 ⇒ when P = $57.69 or higher
100×𝑃

11. The total cost of the purchase is: $20  1,000 = $20,000
You borrow $5,000 from your broker and invest $15,000 of your own
funds. Your margin account starts out with equity of $15,000.
a.
(i) Equity increases to: ($22  1,000) − $5,000 = $17,000
Percentage gain = $2,000/$15,000 = 0.1333 or 13.33%

(ii) With price unchanged, equity is unchanged.

Percentage gain = zero

(iii) Equity falls to ($18  1,000) − $5,000 = $13,000

Percentagegain(−$2,000/$15,000) = −0.1333 or −13.33%
The relationship between the percentage return and the percentage change
(%Δ) in the price of the stock is given by:
Total investment
Perecntage return = % Δ in price ×
Investor's initial equity
= % Δ in price × 1.333
For example, when the stock price rises from $20 to $22, the percentage change in
price is 10%, while the percentage gain for the investor is:
$20,000
Perecentagereturn = 10% × = 13.33%
$15,000

b. The value of the 1,000 shares is 1,000P. Equity is (1,000P − $5,000). You will
receive a margin call when:
1,000×𝑃−$5,000
= 0.25 ⇒ when P = $6.67 or lower
1,000×𝑃

c. The value of the 1,000 shares is 1,000P. But now you have borrowed $10,000
instead of $5,000. Therefore, equity is (1,000P − $10,000). You will receive a
margin call when:
1,000×𝑃−$10,000
= 0.25 ⇒ when P = $13.33 or lower
1,000×𝑃

With less equity in the account, you are far more vulnerable to a margin call.

d. By the end of the year, the amount of the loan owed to the broker grows to:
$5,000  1.08 = $5,400
The equity in your account is (1,000P − $5,400). Initial equity was $15,000.
Therefore, your rate of return after 1 year is as follows:
(1,000×$22)−$5,400−$15,000
(i) = 0.1067 or 10.67%
$15,000

(1,000×$20)−$5,400−$15,000
(ii) = −0.0267 or −2.67%
$15,000
 (1,000×$18)−$5,400−$15,000
(iii) = −0.1600 or −16.00%
$15,000

The relationship between the percentage return and the percentage change in
the price of X tel is given by:
Total investment
(Percentage change in price × )
Investor's initial equity
Funds borrowed
− (8% × )
Investor's initial equity

For example, when the stock price rises from $40 to $44, the percentage
change in price is 10%, while the percentage gain for the investor is:
$20,000 $5,000
(10% × ) − (8% × ) = 10.67%
$15,000 $15,000

e. The value of the 1,000 shares is 1,000P. Equity is (1,000P − $5,400). You will
receive a margin call when:
1,000×𝑃−$5,400
= 0.25 ⇒= 0.25 ⇒ when P = $7.20 or lower
1,000×𝑃

14.
a. $55.50

b. $55.25

c. The trade will not be executed because the bid price is lower than the price
specified in the limit-sell order.

d. The trade will not be executed because the asked price is greater than the price
specified in the limit-buy order.
 CHAPTER 5: INTRODUCTION TO RISK, RETURN, AND THE
HISTORICAL RECORD

PROBLEM SETS

2. If we assume that the distribution of returns remains reasonably stable over the
entire history, then a longer sample period (i.e., a larger sample) increases the
precision of the estimate of the expected rate of return; this is a consequence of
the fact that the standard error decreases as the sample size increases. However, if
we assume that the mean of the distribution of returns is changing over time but
we are not in a position to determine the nature of this change, then the expected
return must be estimated from a more recent part of the historical period. In this
scenario, we must determine how far back, historically, to go in selecting the
relevant sample. Here, it is likely to be disadvantageous to use the entire data set
back to 1880.

7. E(r) = (0.35 × 44.5%) + (0.30 × 14.0%) + (0.35 × [−16.5%]) = 14%

𝜎 2 = (0.35 × [44.5 − 14]2 ) + (0.30 × [14 − 14]2 )
+ (0.35 × [−16.5 − 14]2 ) = 651.175
 = 25.52%
The mean is unchanged, but the standard deviation has increased, as the
probabilities of the high and low returns have increased.

CFA PROBLEMS

3. 𝐸(𝑟𝑋 ) = (0.2 × [−20%]) + (0.5 × 18%) + (0.3 × 50%) = 20%

𝐸(𝑟𝑌 ) = (0.2 × [−15%]) + (0.5 × 20%) + (0.3 × 10%) = 10%

4.𝜎𝑋 2 = (0.2 × [– 20 – 20]2 ) + (0.5 × [18 – 20]2 ) + (0.3 × [50 – 20]2 ) =

= 592
𝜎𝑋 = 24.33%

𝜎𝑌 2 = (0.2 × [– 15 – 10]2 ) + (0.5 × [20 – 10]2 ) + (0.3 × [10 – 10]2 )

= 175
𝜎𝑌 = 13.23%

5 .E(r) = (0.9 × 20%) + (0.1 × 10%) =19% → $1,900 in returns

 CHAPTER 24: PORTFOLIO PERFORMANCE EVALUATION

3. The IRR (dollar-weighted return) cannot be ranked relative to either the geometric
average return (time-weighted return) or the arithmetic average return. Under
some conditions, the IRR is greater than each of the other two averages or the IRR
can also be less than each of the other averages. Several scenarios illustrate this
conclusion. Consider a scenario where the rate of return each period consistently
increases over several time periods. If the amount invested also increases each
period, then all the proceeds are withdrawn at the end of several periods; the IRR
is greater than either the geometric or arithmetic average since more money is
invested at the higher rates than at the lower rates. If withdrawals gradually
reduce the amount invested as the rate of return increases, then the IRR is less
than the other averages. Numerical examples in the text illustrate scenarios where
the geometric average exceeds the IRR, and, in Concept Check 1, where the IRR
exceeds the geometric average (although the solutions to this concept check
focused on arithmetic average rather than the geometric average.).

4. a. Arithmetic average: ̅rABC = 10%; ̅rXYZ = 10%

b. Dispersion: σABC = 7.91%; σXYZ = 15.56%

Stock XYZ has greater dispersion. Note: We used 4 degrees of freedom in
calculating standard deviations, since it is a sample.

c. Geometric average:
rABC = (1.20 × 1.12 × 1.14 × 1.03 × 1.01)1/5 − 1 = 0.0977 = 9.77%
rXYZ = (1.30 × 1.12 × 1.18 × 1.00 × 0.90)1/5 − 1 = 0.0911 = 9.11%
Even though the two stocks have the same arithmetic average, the geometric
average for XYZ is less than the geometric average for ABC. The reason for this
result is the fact that the greater variance of XYZ drives the geometric average
further below the arithmetic average.

d. Your expected rate of return would be the arithmetic average, or 10%.

e. Even though the dispersion is greater, your expected rate of return would
still be the arithmetic average or 10%.

f. In terms of “forward-looking” statistics, the arithmetic average is the better

estimate of expected rate of return. Therefore, if the data reflect the probabilities
of future returns, 10% is the expected rate of return for both stocks.
 6. a. Time-weighted average returns are based on year-by-year rates of return:

Year Return = (Capital gains + Dividend)/Price

2018–2019 ([$120 − $100] + $4)/$100 = 24.00%
2019–2020 ([$90 − $120] + $4)/$120 = −21.67%
2020–2021 ([$100 − $90] + $4)/$90 = 15.56%
Arithmetic mean: (24% − 21.67% + 15.56%)/3 = 5.96%
Geometric mean: (1.24 × 0.7833 × 1.1556)1/3 − 1 = 0.0392 = 3.92%
b.
Date Cash Explanation
Flow
1/1/18 −$300 Purchase of three shares at $100 each
1/1/19 −$228 Purchase of two shares at $120 less dividend income on three
shares held
1/1/20 $110 Dividends on five shares plus sale of one share at $90
1/1/21 $416 Dividends on four shares plus sale of four shares at $100 each

Dollar-weighted return = Internal rate of return = −0.1607%

(CF0 = − $300; CF1 = − $228; CF2 = $110; CF3 = $416; Solve for IRR = − 0.1607%.)
7.
Time Cash Flow Holding Period Return
0 3×(−$90) = −$270
1 $100 (100−90)/90 = 11.11%
2 $100 0%
3 $100 0%
a. Time-weighted geometric average rate of return =
(1.1111 × 1.0 × 1.0)1/3 − 1 = 0.0357 = 3.57%

b. Time-weighted arithmetic average rate of return = (11.11% + 0 + 0)/3 = 3.70%

The arithmetic average is always greater than or equal to the geometric
average; the greater the dispersion, the greater the difference.

c. Dollar-weighted average rate of return = IRR = 5.46%

(Using a financial calculator, enter: n = 3, PV = −270, FV = 0, PMT = 100.
Then compute the interest rate, or use the CF0 = −300, CF1 = 100, F1 = 3,
then compute IRR). The IRR exceeds the other averages because the
investment fund was the largest when the highest return occurred.