2. 2
Chapter Outcomes
Describe the processes and institutions used by
businesses to distribute new securities to the
investing public.
Outline the recent difficulties and changes in
structure of the investment banking industry.
Describe how securities are traded among
investors.
Identify the regulatory mechanisms by which the
securities exchanges and the over-the-counter
markets are controlled.
Explain influences that affect broker commissions.
4. 4
Functions of Investments Banks
Three Main Functions:
– Origination
– Underwriting
– Selling
Origination
– Public Offering
– Private Placement
– Prospectus
5. 5
Investment Bank Functions,
continued
Underwriting
– “Carrying the risk”
– Best efforts
– Shelf registration
– Private placement
– Rights offerings
– Competitive bids
– Dutch auction
6. 6
Dutch Auction Example
Yoogle to offer 100 million shares
Bidder Price Number of shares
A $20.50 25 million
B $20.47 25 million
C $20.45 25 million
D $20.43 25 million
E $20.40 25 million
Clearing price: $20.43
8. 8
The Costs of Raising Capital
The costs of issuing stocks and
bonds are called “flotation costs.”
– Out-of-pocket costs
– Spread
– Underpricing
The sum of these costs can total 20-
30% or more of the funds raised
Hot/cold IPO markets
9. 9
Innovations in Investment
Banking
Security design to meet needs of
issuers/purchases
Offering securities via internet “dutch
auctions”—both stocks and bonds
(Internotes, Direct Access Notes)
10. Facebook IPO
Syndicate: Morgan Stanley (lead) and
32 other investment banking firms
Offer price: $38 per share
– Firm value at offer price: $104 billion
– Underwriting fees: $176 million
– Underwriters, firm agreed to raise offer
price to $38 and increase number of
shares to be sold shortly before the IPO
10
11. Facebook IPO
Initial ‘pop’ at IPO…followed by price
decline
– Computer and trading issues at Nasdaq
– Disappointing sales, profit news; GM
pullout
– Research analysts were reducing profit
estimates for FB
– Tough market—Groupon, Yelp, and
Zynga hi-tech IPOs followed by price
declines
11
13. 13
What else do Investment Banks
do?
Commercial paper
Mergers and acquisitions
Manage investment funds (e.g.,
company pension funds)
14. 14
Investment Banking Regulations
Securities Act of 1933
– Full, fair, and accurate disclosure
– Prevent fraud
Securities Exchange Act of 1934
– Established SEC
– Brokers, dealers register with SEC
State “blue sky” laws
15. 15
Investment Banking Regulations
Glass-Steagall Act
– Commercial banks cannot underwrite
securities
Gramm-Leach-Bliley Act
– Removed many restraints of Glass-
Steagall on financial services firms
16. 16
Trading Securities: Secondary
Securities Markets
Organized Exchange versus Over-the-
Counter (OTC)
Organized Exchange: NYSE
NYSE is a private firm which went “public”
in 2006 by acquiring a publicly traded firm
(Archipelago) which offers electronic
trading of securities
17. 17
Structure of the NYSE
Before 2006: members own “seats”
Now: 1500 trading licenses exist—
called Stock Exchange Auction
Trading System (SEATS)
SEATS allow holders access to the
NYSE trading floor (physical
location) and electronic trading
access.
18. 18
Structure of the NYSE
Floor brokers
– House or commission brokers
– Independent brokers
Registered traders
Designated Market Makers
– Maintain inventory of stocks assigned
to them
– Maintain a liquid and orderly market
– Took over the role of “specialists” on
the NYSE
19. 19
Structure of the NYSE
Companies need to meet listing
requirements, pay fees
Original listing fee: $125,000-
$250,000
Annual fee: $42,000-$500,000
depending on number of shares
Listing requirements:
http://usequities.nyx.com/regulation/listed-companies-
compliance/listings-standards/us
20. 20
Security Transactions
Bid price: offered by buyer
Ask: requested by seller
Spread: the difference between them
– Narrower spreads imply more liquidity
and faster completion of a trade
Typical display:
– Bid: 30.42 x 50900
– Ask: 30.43 x 50800
21. 21
Security Transactions
Market order
Limit order
Stop order
Short sale
– Uptick rule
– 19.95 19.95 20.00 20.00
– 20.07 20.01 20.01
– Abolished in 2007, on a trial basis;
occasionally consider re-instating it for
all or some stocks.
22. 22
Buying on Margin
“Buying on margin” means to use
some of your money (equity) and
some borrowed funds to purchase a
security
Margin: investor’s equity position
Margin requirements: minimum
percentage of the purchase price that
the investor must pay from his/her
funds
26. 26
Over-The-Counter Market (OTC)
NASDAQ
Not just for small firms
– Intel, Apple, Microsoft
Centralized versus non-centralized
location
Specialists versus dealers
27. 27
Other Secondary Markets
Third Market
– Large blocks (10,000 shares) traded
OTC
Fourth Market
– Electronic trading, ECNs
28. 28
Securities Markets and Ethics Issues
In the past, some market makers and
specialists have been accused of:
–Front running
–Negative obligation
–Maintaining high spreads
29. 29
What Makes a Good Market?
NYSE, AMEX, NASDAQ, 3rd and 4th
market all compete for listings,
trades
Four characteristics of a “good”
market:
– Liquidity (breadth and depth)
– Quick, accurate trade execution
– Reasonable listing requirements
– Low costs
30. 30
Commissions
Commission affected by:
Type of broker
– Full service brokers
– Discount brokers
– On-line brokers
Size of trade, security price
Liquidity of securities traded
Ethics:
– Account churning
– Placing funds in high-commission or
“fee kickback” products
31. 31
Some issuing firms allow…
Direct investing
– Buy shares directly from the firm
Dividend Reinvestment Plan
32. 32
How’s the Market Doing?
Security Market Indexes are used to
track overall market and sector
performance for stocks, bonds, and
other investments
Well-known stock market indexes:
– Dow Jones Industrial Average
• Based on price
– Standard & Poor’s (S&P) 500
• Based on market value
33. 33
Wandering from Home: Investing
Overseas
Diversification benefits
Harder to do trades
– Liquidity
– Currency differences
– Regulations, tax laws
Solutions:
– American Depository Receipts
– Global Depository Receipts
– Mutual funds--professional investing
34. 34
Ethics Issues
Insider trading
An insider: someone with access to
important non-public information
can be a corporate officer,
investment banker, major
shareholder
blue-collar workers, too (e.g.,
printing press operators)
35. 35
Ethics
Regulation FD
Churning of accounts
Professional designations (CFA®,
CFPTM) have ethics components as a
central feature of their certification
programs
36. 36
What will the future hold?
Electronic and on-line trading
Technology linking markets together
(NYSE, Euronext merger)
Continued globalization
38. 38
What is a derivative security?
A derivative security has its value
determined by, or derived from, the
value of another investment vehicle.
They represent a contract on an
underlying security or asset
39. 39
Why do derivatives exist?
Shift risk from those who don’t want
to carry risk to those who are willing
to do so.
Bring additional information into the
market from hedgers, speculators,
market expectations.
Lower commissions and margin
requirements than in spot market
40. 40
Futures contracts
A futures contract obligates the
owner to purchase the underlying
asset at a specified price (the
exercise or strike price) on a
specified date
42. 42
Options
An options contract gives the owner
the choice of trading the underlying
asset at a specified price (the
exercise or strike price) on or before
a specified date or expiration date.
43. 43
Two basic types of options
Call option: an option to buy the
underlying asset at the strike price
Put option: an option to sell the
underlying asset at the strike price
44. 44
Call Options
Suppose you buy an option to buy
100 shares of ExxonMobil stock at
$75 a share. How much is the option
worth if on the expiration date the
price of Exxon is:
a) $60 a share? $0
b) $75 a share? $0
c) $80 a share? $5
45. 45
Put Options
Suppose you buy an option to sell
100 shares of ExxonMobil stock at
$75 a share. How much is the option
worth if on the expiration date the
price of Exxon is:
a) $60 a share? $15
b) $75 a share? $0
c) $80 a share? $0
46. 46
3. Which of the following securities is likely to be the most liquid according to this data?
Stock Bid Ask
R $39.43 $39.55
S 13.67 13.77
T 116.02 116.25
The bid-ask spread for each security, expressed in terms of dollars and percentages, is:
Stock Dollar spread Spread (% of ask price)
R $0.12 0.30%
S $0.10 0.73%
T $0.23 0.20%
Relative to the price that an eager investor will pay (the ask price), stock T has the lowest spread and is the
most liquid.
6. The Trio Index is comprised of three stocks, Eins, Zwei, and Tri. Their current prices are as follows:
a) Between now and the next time period, the stock prices of Eins and Zwei increase 10 percent while Tri
increases 20 percent. What is the percentage change in the price-weighted Trio Index?
With a 10-percent increase, Eins will rise from $10 to $11 while Zwei rises from $20 to $22. A 20-percent
change in the price of Tri has its price rising from $40 to $48:
Stock Eins Zwei Tri
Price at time t $10 $20 $40
Stock
Price at
time t
Price at
time t+1
Eins $10 $11
Zwei $20 $22
Tri $40 $48
Sum $70 $81
Price-weighted average change 15.71% =$81/$70-1
47. 47
b) Suppose instead that the price of Eins increases 20% while Zwei and Tri rise 10 percent. What is the
percentage change in the price-weighted Trio Index? Why does it differ from the answer to part a)?
Now Ein rises in price from $10 to $12 while Tri only rises to $44:
The reason why the index percentage change differs from part a) is the highest price stock had the largest
percentage price change in part a). In part b), it was the lowest price stock that had the largest
percentage price change. The higher a stock’s price the greater its weight and influence in a price-
weighted index. Tri’s large price change was the major influence on the price-weighted index in part a);
Tri’s influence was diminished in part b.
7 . The four stocks listed in the text are part of an index.
# OF SHARES PRICE AT PRICE AT
STOCK OUTSTANDING TIME t TIME t+1
Eeny 100 10 15
Meeny 50 20 22
Miney 50 30 28
Moe 20 40 42
Using the prior information,
a. Compute a price-weighted index by adding the stocks’ prices at time t and time t + 1. What is the
percentage change in the index?
Price-weighted index
Sum of prices at time t + 1 = $15 + 22 + 28 + 42 = $107
Sum of prices at time t = $10 + 20 + 30 + 40 = $100
% change = ($107 – $100)/$100 = 7%
Stock
Price at time
t
Price at time
t+1
Eins $10 $12
Zwei $20 $22
Tri $40 $44
Sum $70 $78
Price-weighed average change 11.43% =$78/$70-1
48. 48
b. Compute a value-weighted index by adding their market values at time t and time t+1 What is the
percentage change in the index?
Value-weighted index
Sum of market values at time t + 1 = $15(100) + 22(50) + 28(50) + 42(20) = $4,840
Sum of market values at time t = $10(100) + 20(50) + 30(50) + 40(20) = $4,300
% of change = ($4,840 – 4,300)/$4,300 = 12.56%
c. Why is there a difference between your answers to Parts a and b?
Different computation methods. The price change of higher-priced stocks have the
largest impact on Part a. The value change of the higher-value stocks have the
largest impact on Part b.
11. Below are the results of a Dutch auction for an IPO of Bagel’s Bagels, a trendy bagel and coffee shop
chain. Bagel’s is offering 50 million shares.
Bidder Bid price Number of Shares
Matthew $50.25 15 million
Kevin $49.75 20 million
Amy $49.45 20 million
Megan $49.00 10 million
a) What will be the clearing price?
Bidder Bid price Number of Shares Cumulative total of shares
Matthew $50.25 15 million 15 million
Kevin $49.75 20 million 35 million
Amy $49.45 20 million 55 million
Megan $49.00 10 million 65 million
With an offering of 50 million shares, the last shares can be sold to Amy; Amy’s bid determines the clearing
price of $49.45.
49. 49
b) How many shares will each bidder receive if Bagel’s allocates shares on a prorata basis to all the successful
bidders?
There are bids for 55 million shares at the clearing price of $49.45. Under the prorata method, each successful
bidder will receive 50/55 of their desired number of shares. Megan received no shares as her bid was
below the clearing price.
Bidder: Bid price Number of Shares Bid Number of shares received
Matthew $50.25 15 million 13.64 million
Kevin $49.75 20 million 18.18 million
Amy $49.45 20 million 18.18 million
Megan $49.00 10 million 0
12. Determine the intrinsic values of the following call options when the stock is selling at $32 just prior to
expiration of the options.
The intrinsic value of a call option is max [0, V – X]
a. $25 call price
$7
b. $30 call price
$2
c. $35 call price
$0
13. Determine the intrinsic values of the following put options when the stock is selling at $63 just prior to
expiration of the options.
The intrinsic value for a put option is max [0, X – V]
a. $55 put price
$0
b. $65 put price
$2
c. $75 put price
$12
50. 50
Case study #11
14. Determine the intrinsic values of the following options when the stock is selling
at $55 just prior to expiration of the options.
a. $35 call price
b. $50 call price
c. $65 call price
d. $35 put price
e. $50 put price
f. $65 put price
52. 52
Know how to compute arithmetic
averages, variances, and standard
deviations using return data for a single
financial asset.
Understand the sources of risk
Know how to compute expected return
and expected variance using scenario
analysis.
Know the historical rates of return and
risk for different securities.
Chapter Outcomes
53. 53
Understand the concept of market efficiency and
explain the three types of efficient markets.
Explain how to calculate the expected return on a
portfolio of securities.
Understand how and why the combining of
securities into portfolios reduces the overall or
portfolio risk.
Explain the difference between systematic and
unsystematic risk.
Understand the importance of ethics in
investment-related positions.
Chapter Outcomes
54. 54
Historical Return and Risk for a
Single Asset
Return: periodic income and price
changes
Dollar return = ending price –
beginning price + income
55. 55
Historical Return and Risk for a
Single Asset
Percentage return =
Dollar return/beginning price
Beginning price = $33.63
Ending price = $34.31
Dividend = $0.13
Dollar return = $34.31-33.63+0.13 =$0.81
Percentage return = $0.81/$33.63 = 0.024
or 2.4 percent
56. 56
Historical Return and Risk for a
Single Asset
Can be daily, monthly or annual
returns
Risk: based on deviations over time
around the average return
58. 58
Arithmetic Average Return
Look backward to see how well
we’ve done:
Average Return (AR) =
Sum of returns
number of periods
59. 59
An Example
YEAR STOCK A STOCK B
1 6% 20%
2 12 30
3 8 10
4 –2 –10
5 18 50
6 6 20
Sum 48 120
Sum/6 = AR= 8% 20%
60. 60
Measuring Risk
Deviation = Rt - AR
Sum of Deviations (Rt - AR) = 0
To measure risk, we need something
else…try squaring the deviations
Variance
2
=
(Rt - AR)2
n - 1
61. 61
Since the returns are squared:
(Rt - AR)2
The units are squared, too:
Percent squared (%2)
Dollars squared ($ 2)
Hard to interpret!
64. 64
Using Average Return and
Standard Deviation
If the future will resemble the past and the
periodic returns are normally distributed:
68% of the returns will fall between AR -
and AR +
95% of the returns will fall between AR -
2 and AR + 2
99% of the returns will fall between AR -
3 and AR + 3
65. 65
For Asset A
68% of the returns between 1.3% and
14.7%
95% of the returns between -5.4%
and 21.4%
99% of the returns between -12.1%
and 28.1%
66. 66
Which of these is riskier?
Asset A Asset B
Avg. Return 8% 20%
Std. Deviation 6.7% 20%
67. 67
Another view of risk:
Coefficient of Variation =
Standard deviation
Average return
It measures risk per unit of return
68. 68
Which is riskier?
Asset A Asset B
Avg. Return 8% 20%
Std. Deviation 6.7% 20%
Coefficient
of Variation 0.84 1.00
69. 69
Where Does Risk Come From:
Risk Sources in Income Statement
Revenue Business Risk
Purchasing Power Risk
Exchange Rate Risk
Less: Expenses
Equals: Operating Income
Less: Interest Expense Financial Risk
Interest Rate Risk
Equals: Earnings Before Taxes
Less: Taxes Tax Risk
Equals: Net Income
70. 70
Measures of Expected Return
and Risk
Looking forward to estimate future
performance
Using historical data: ex-post
Estimated or expected outcome:
ex-ante
71. 71
Steps to forecasting Return, Risk
Develop possible future scenarios:
– growth, normal, recession
Estimate returns in each scenario:
– growth: 20%
– normal: 10%
– recession: -5%
Estimate the probability or likelihood
of each scenario:
growth: 0.30 normal: 0.40 recession: 0.30
72. 72
Expected Return
E(R) = pi
. Ri
E(R) =
.3(20%) + .4(10%) +.3(-5%) =
8.5%
Interpretation:
8.5% is the long-run average
outcome if the current three
scenarios could be replicated
many, many times
73. 73
Once E(R) is found, we can
estimate risk measures:
2 = pi[ Ri - E(R)] 2
= .3(20 - 8.5)2 + .4(10 - 8.5)2
+ .3(-5 - 8.5)2
= 95.25 percent squared
75. 75
Do Investors Really do These
Calculations?
Market anticipation of Fed’s actions
Identify consensus; where does our
forecast differ?
Simulation and Monte Carlo analysis
76. 76
Historical Returns and Risk of
Different Assets
Two good investment rules to
remember:
Risk drives expected returns
Developed capital markets, such as
those in the U.S., are, to a large
extent, efficient markets.
77. 77
Efficient Markets
What’s an efficient market?
Operationally efficient versus
informationally efficient
Many investors/traders
News occurs randomly
Prices adjust quickly to news on
average reflecting the impact of the
news and market expectations
78. 78
More….
After adjusting for risk differences,
investors cannot consistently earn
above-average returns
Expected events don’t move prices;
only unexpected events (“surprises”)
move prices or events which differ
from the market’s consensus
82. 82
Implications of “Efficient Markets”
Market price changes show
corporate management the reception
of announcements by the firm
Investors: consider indexing rather
than stock-picking
Invest at your desired level of risk
Diversify your investment portfolio
84. 84
Expected Return on A Portfolio:
E(Ri) = expected return on asset i
wi = weight or proportion of asset i in
the portfolio
E(Rp) = wi
. E(Ri)
85. 85
If E(RA) = 8% and E(RB) = 20%
More conservative portfolio:
E(Rp) = .75 (8%) + .25 (20%) = 11%
More aggressive portfolio:
E(Rp) = .25 (8%) + .75 (20%) = 17%
87. 87
Merging 2 Assets into 1 Portfolio
Two risky assets become a low-risk portfolio
88. 88
The Role of Correlations
Correlation: a measure of how
returns of two assets move together
over time
Correlation > 0; the returns tend to
move in the same direction
Correlation < 0; the returns tend to
move in opposite directions
89. 89
Diversification
If correlation between two assets
(or between a portfolio and an
asset) is low or negative, the
resulting portfolio may have
lower variance than either asset.
Splitting funds among several
investments reduces the affect
of one asset’s poor performance
on the overall portfolio
90. 90
The Two Types of Risk
Diversification shows there are two
types of risk:
Risk that can be diversified away
(diversifiable or unsystematic risk)
Risk that cannot be diversified away
(undiversifiable or systematic or
market risk)
91. 91
Capital Asset Pricing Model
Focuses on systematic or market
risk
An asset’s risk depend upon whether
it makes the portfolio more or less
risky
The systematic risk of an asset
determines its expected returns
92. 92
The Market Portfolio
Contains all assets--it represents the
“market”
The total risk of the market portfolio
(its variance) is all systematic risk
Unsystematic risk is diversified away
93. 93
The Market Portfolio and Asset
Risk
We can measure an asset’s risk
relative to the market portfolio
Measure to see if the asset is more or
less risky than the “market”
More risky: asset’s returns are
usually higher (lower) than the
market’s when the market rises (falls)
Less risky: asset’s returns fluctuate
less than the market’s over time
94. 94
Blue = market returns over time
Red = asset returns over time
More systematic risk
than market
Less systematic risk
than market
Return
Time
0%
Asset Market
Time
0%
95. 95
Implications of the CAPM
Expected return of an asset depends
upon its systematic risk
Systematic risk (beta ) is measured
relative to the risk of the market
portfolio
96. 96
Beta example: < 1
If an asset’s is 0.5: the asset’s
returns are half as variable, on
average, as those of the market
portfolio
If the market changes in value by
10%, on average this assets changes
value by 10% x 0.5 = 5%
97. 97
> 1
If an asset’s is 1.4: the asset’s
returns are 40 percent more variable,
on average, as those of the market
portfolio
If the market changes in value by
10%, on average this assets changes
value by 10% x 1.4 = 14%
98. 98
Sample Beta Values
accessed December 2012 from
http://finance.yahoo.com
Firm Beta
Caterpillar 1.86
Coca-Cola 0.38
General Electric 1.37
Delta Airlines 0.60
FirstEnergy 0.28
100. 100
Ways to estimate Beta
Once data on asset and market
returns are obtained for the same
time period:
use spreadsheet software
statistical software
financial/statistical calculator
do calculations by hand
102. 102
The sample calculation
Estimate of beta =
n(RMKTRi) - (RMKT )( Ri)
n RMKT
2 - (RMKT)2
6( 34.77) - (3.00)(0.20)
6(38.68) - (3.00)(3.00)
= 0.93
103. 103
Security Market Line
CAPM states the expected return/risk
tradeoff for an asset is given by the
Security Market Line (SML):
E(Ri)= RFR + [E(RMKT)- RFR]i
104. 104
An Example
E(Ri)= RFR + [E(RMKT)- RFR]i
If T-bill rate = 4%, expected market
return = 8%, and beta = 0.75:
E(Rstock)= 4% + (8% - 4%)(0.75) = 7%
105. 105
Portfolio beta
The beta of a portfolio of assets is a
weighted average of its component
asset’s betas
betaportfolio = wi
. betai
106. 106
5. RCMP, Inc. shares rose 10 percent in value last year while the inflation rate was 3.5 percent. What was the
real return on the stock? If an investor sold the stock after one year and paid taxes on the investment at a
15 percent tax rate what is the real after-tax return on the investment?
The nominal return is 10% and the inflation rate is 3.5%. The real return on RCMP’s shares is 10%- 3.5% =
6.5%.
Taking taxes into consideration, using a 15% tax rate the nominal after-tax return is 10% (1-0.15) = 8.5%.
Subtracting the inflation rate, the real after-tax return is 8.5% - 3.5% = 5.0%.
6. Find the real return on the following investments:
The real return is computed as nominal return – inflation rate as follows:
Stock A: 10% - 3% = 7%
Stock B: 15% - 8% = 7%
Stock C: -5% - 3% = -8%
7. Find the real return, nominal after-tax return, and real after-tax return on the following:
Real return is nominal return minus the inflation rate:
Stock X: 13.5% - 5% = 8.5%
Stock Y: 8.7% - 4.7% = 4.0%
Stock Z: 5.2% - 2.5% = 2.7%
Nominal after-tax return is nominal return (1-tax rate):
Stock X: 13.5% (1- 0.15) = 11.48%
Stock Y: 8.7% (1- 0.25) = 6.53%
Stock Z: 5.2% (1-0.28) = 3.74%
The real after-tax return is the nominal after-tax return minus the inflation rate:
Stock X: 11.48% - 5% = 6.48%
Stock Y: 6.53% - 4.7% = 1.83%
Stock Z: 3.74% - 2.5% = 1.24%
Stock Nominal Return Inflation
A 10% 3%
B 15% 8%
C -5% 2%
Stock Nominal Return Inflation Tax Rate
X 13.5% 5% 15%
Y 8.7% 4.7% 25%
Z 5.2% 2.5% 28%
107. 107
9. Using the information below, compute the percentage returns for the following securities:
12. Ima’s sister, Uma, has completed her own analysis of the economy and Wallnut’s stocks. Uma used
recession, constant growth and inflation scenarios but with different probabilities and expected stock
returns. Uma believes the probability of recession is quite high, at 60 percent and that in a recession
Wallnut’s stock return will -20 percent. Uma believes the scenarios of constant growth and inflation are
equally likely and that Wallnut’s returns will be 15 percent in the constant growth scenario and 10 percent
under the inflation scenario.
a) What is Uma’s expected return forecast for Wallnut stock?
b) What is the standard deviation of the forecast?
c) If Wallnut’s current price is $20 a share and is expected to pay a dividend of $0.80 a share next year, what
price does Uma expect Wallnut to sell for in one year?
With the probability of recession set at 60 percent, the probability of not having a recession is 1-0.60 or 0.40.
As the probability of the constant growth and inflation scenarios are equally likely, there probabilities are
0.40/2 or 0.20 (20%) each. Using these probabilities we have:
c) The return is computed as the (change in price + income)/beginning price. If the expected return is -7.00%
(or -0.07 in decimal form) we have:
(Expected price - $20) + 0.80 = -0.07
$20
or (Expected price - $20) + 0.80 = -0.07 ($20) = -$1.40
= Expected price - $19.20 = -$1.40
Solving, we see the expected price = $17.80.
Price today
Price one
year ago
Dividends
received
Interest
received
Dollar Return=
change in price
+ income
Percentage Return=Dollar
return/initial price
a) RoadRunner stock $20.05 $18.67 $0.50 $1.88 10.07%
b)Wiley Coyote stock $33.42 45.79 $1.10 -$11.27 -24.61%
c)Acme long-term bonds $1,015.38 $991.78 $100.00 $123.60 12.46%
d) Acme short-term bonds $996.63 $989.84 $45.75 $52.54 5.31%
e) Xlingshot stock $5.43 $3.45 $0.02 $2.00 57.97%
Scenario Probability Wallnut return
Recession 60% -20%
Constant growth 20% 15%
Inflation 20% 10%
a) Expected return -7.00% = 60% (-20%) + 20%(15%) + 20% (10%)
Variance 256.00% = 60% (-20%-(-7%))^2 + 20%(15%-(-7%))^2 + 20% (10%-(-7%))^2
b) Standard Deviation 16.00%
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15. Below is annual stock return data on Hollenbeck Corp and Luzzi Edit, Inc.
Year Hollenbeck Luzzi Edit
2010 10% -3%
2011 15% 0%
2012 -10% 15%
2013 5% 10%
a. What is the average return, variance, and standard deviation for each stock?
Average return = (Sum of returns)/n
Hollenbeck Corp: 20/4 = 5.0%
Luzzi Edit: 22/4 = 5.5%
Variance = ∑ (Ri – Average)2/ (n – 1)
Hollenbeck Corp = 350/(4 – 1) = 116.67%2
Luzzi Edit= 213/(4 – 1) = 71.0%2
Standard deviation
Hollenbeck Corp = √116.67= 10.80%
Luzzi Edit = √ 71.0= 8.43%
b. What is the expected portfolio return on a portfolio comprised of
i. 25% Hollenbeck Corp and 75% Luzzi Edit?
ii. 50% Hollenbeck Corp and 50% Luzzi Edit?
iii. 75% Hollenbeck Corp and 25% Luzzi Edit?
E(portfolio return) = .25(5%) + .75(5.5%) = 5.375%
E(portfolio return) = .5(5%) + .5(5.5%) = 5.25%
E(portfolio return) = .75(5%) + .25(5.5%) = 5.125%
c. Without doing any calculations, would you expect the correlation between the returns on
Hollenbeck Corp and Luzzi Edit's stock to be positive, negative, or zero? Why?
Probably negative, as the changes in returns from year-to-year moved in opposite directions in two of the
three years (2010-2011: return rose for both Hollenbeck Corp and Luzzi Edit; 2011-2012: return fell for
Hollenbeck Corp, rose for Luzzi Edit; 2012-2013: return rose for Hollenbeck Corp, fell for Luzzi Edit).
109. 109
Case study #12
16. Below is annual stock return data on AAB Company and YYZ, Inc.
Year AAB YYZ
2009 0% 5%
2010 5% 10%
2011 10% 15%
2012 15% 20%
2013 -10% -20%
a. What is the average return, variance, and standard deviation for each stock?
b. What is the expected portfolio return on a portfolio comprised of
i. 25% AAB and 75% YYZ?
ii. 50% AAB and 50% YYZ?
iii. 75% AAB and 25% YYZ?
c. Without doing any calculations, would you expect the correlation between the
returns on AAB and YYZ's stock to be positive, negative, or zero? Why?
