Sample Problems with Solution

Chapters 10-11, 13-16

Chapter 10
3. If the APT is to be a useful theory, the number of systematic factors in the economy must be
small. Why?

6. Assume that both portfolios A and B are well diversified, that E(rA) = 12%, and E(rB) = 9%. If
the economy has only one factor, and A = 1.2, whereas B = .8, what must be the risk-free rate?

7. Assume that stock market returns have the market index as a common factor, and that all stocks
in the economy have a beta of 1 on the market index. Firm-specific returns all have a standard
deviation of 30%.

Suppose that an analyst studies 20 stocks, and finds that one-half have an alpha of +2%, and
the other half an alpha of 2%. Suppose the analyst buys $1 million of an equally weighted
portfolio of the positive alpha stocks, and shorts $1 million of an equally weighted portfolio of
the negative alpha stocks.

a. What is the expected profit (in dollars) and standard deviation of the analyst's profit?

b. How does your answer change if the analyst examines 50 stocks instead of 20 stocks? 100
stocks?

8. Assume that security returns are generated by the single-index model,

where Ri is the excess return for security i and RM is the market's excess return. The risk-free rate
is 2%. Suppose also that there are three securities A, B, and C, characterized by the following
data:

1
a. If M = 20%, calculate the variance of returns of securities A, B, and C.

b. Now assume that there are an infinite number of assets with return characteristics identical to
those of A,B, and C, respectively. If one forms a well-diversified portfolio of type A securities,
what will be the mean and variance of the portfolio's excess returns? What about portfolios
composed only of type B or C stocks?

c. Is there an arbitrage opportunity in this market? What is it? Analyze the opportunity
graphically.

2
Answers
3. Any pattern of returns can be “explained” if we are free to choose an indefinitely large number
of explanatory factors. If a theory of asset pricing is to have value, it must explain returns
using a reasonably limited number of explanatory variables (i.e., systematic factors).

6. Substituting the portfolio returns and betas in the expected return-beta relationship, we obtain
two equations with two unknowns, the risk-free rate (rf) and the factor risk premium (RP):
12% = rf + (1.2 × RP)
9% = rf + (0.8 × RP)
Solving these equations, we obtain:
rf = 3% and RP = 7.5%

7. a. Shorting an equally-weighted portfolio of the ten negative-alpha stocks and investing the
proceeds in an equally-weighted portfolio of the ten positive-alpha stocks eliminates the
market exposure and creates a zero-investment portfolio. Denoting the systematic
market factor as RM , the expected dollar return is (noting that the expectation of non-
systematic risk, e, is zero):
$1,000,000 × [0.02 + (1.0 × RM )] − $1,000,000 × [(–0.02) + (1.0 × RM )]
= $1,000,000 × 0.04 = $40,000
The sensitivity of the payoff of this portfolio to the market factor is zero because the
exposures of the positive alpha and negative alpha stocks cancel out. (Notice that the
terms involving RM sum to zero.) Thus, the systematic component of total risk is also
zero. The variance of the analyst’s profit is not zero, however, since this portfolio is not
well diversified.
For n = 20 stocks (i.e., long 10 stocks and short 10 stocks) the investor will have a
$100,000 position (either long or short) in each stock. Net market exposure is zero, but
firm-specific risk has not been fully diversified. The variance of dollar returns from the
positions in the 20 stocks is:
20 × [(100,000 × 0.30)2] = 18,000,000,000
The standard deviation of dollar returns is $134,164.

b. If n = 50 stocks (25 stocks long and 25 stocks short), the investor will have a $40,000
position in each stock, and the variance of dollar returns is:
50 × [(40,000 × 0.30)2] = 7,200,000,000
The standard deviation of dollar returns is $84,853.
Similarly, if n = 100 stocks (50 stocks long and 50 stocks short), the investor will have a
$20,000 position in each stock, and the variance of dollar returns is:
100 × [(20,000 × 0.30)2] = 3,600,000,000

3
 The standard deviation of dollar returns is $60,000.
Notice that, when the number of stocks increases by a factor of 5 (i.e., from 20 to 100),
standard deviation decreases by a factor of 5 = 2.23607 (from $134,164 to $60,000).

8. a. σ 2 = β 2 σ 2M + σ 2 (e)
σ 2A = (0.8 2 × 20 2 ) + 25 2 = 881
σ 2B = (1.0 2 × 20 2 ) + 10 2 = 500
σ C2 = (1.2 2 × 20 2 ) + 20 2 = 976

b. If there are an infinite number of assets with identical characteristics, then a well-
diversified portfolio of each type will have only systematic risk since the non-systematic
risk will approach zero with large n:
Well-Diversified σ A2 ; 256
Well-Diversified σ B2 ; 400
Well-Diversified σ C2 ; 576

The mean will equal that of the individual (identical) stocks.

c. There is no arbitrage opportunity because the well-diversified portfolios all plot on the
security market line (SML). Because they are fairly priced, there is no arbitrage.

4
Chapter 11
3. “If all securities are fairly priced, all must offer equal expected rates of return.” Comment.

4. Steady Growth Industries has never missed a dividend payment in its 94-year history. Does this
make it more attractive to you as a possible purchase for your stock portfolio?

5. At a cocktail party, your co-worker tells you that he has beaten the market for each of the last 3
years. Suppose you believe him. Does this shake your belief in efficient markets?

16. “If the business cycle is predictable, and a stock has a positive beta, the stock's returns also must
be predictable.” Respond.

19. The monthly rate of return on T-bills is 1%. The market went up this month by 1.5%. In
addition, AmbChaser, Inc., which has an equity beta of 2, surprisingly just won a lawsuit that
awards it $1 million immediately.

a. If the original value of AmbChaser equity were $100 million, what would you guess was the
rate of return of its stock this month?

b. What is your answer to (a) if the market had expected AmbChaser to win $2 million?

20. In a recent closely contested lawsuit, Apex sued Bpex for patent infringement. The jury came
back today with its decision. The rate of return on Apex was rA = 3.1%. The rate of return on
Bpex was only rB = 2.5%. The market today responded to very encouraging news about the
unemployment rate, and rM = 3%. The historical relationship between returns on these stocks
and the market portfolio has been estimated from index model regressions as:

On the basis of these data, which company do you think won the lawsuit?

5
Answers
3. Expected rates of return differ because of differential risk premiums.

4. No. The value of dividend predictability would be already reflected in the stock price.

5. No, markets can be efficient even if some investors earn returns above the market average.
Consider the Lucky Event issue: Ignoring transaction costs, about 50% of professional
investors, by definition, will “beat” the market in any given year. The probability of beating it
three years in a row, though small, is not insignificant. Beating the market in the past does not
predict future success as three years of returns make up too small a sample on which to base
correlation let alone causation.

16. While positive beta stocks respond well to favorable new information about the economy’s
progress through the business cycle, they should not show abnormal returns around already
anticipated events. If a recovery, for example, is already anticipated, the actual recovery is not
news. The stock price should already reflect the coming recovery.

19. a. Based on broad market trends, the CAPM indicates that AmbChaser stock should have
increased by: 1.0% + 2.0 × (1.5% – 1.0%) = 2.0%
Its firm-specific (nonsystematic) return due to the lawsuit is $1 million per $100 million
initial equity, or 1%. Therefore, the total return should be 3%. (It is assumed here that
the outcome of the lawsuit had a zero expected value.)

b. If the settlement was expected to be $2 million, then the actual settlement was a “$1 million
disappointment,” and so the firm-specific return would be –1%, for a total return of 2% – 1% =
1%.

20. Given market performance, predicted returns on the two stocks would be:
Apex: 0.2% + (1.4 × 3%) = 4.4%
Bpex: –0.1% + (0.6 × 3%) = 1.7%
Apex underperformed this prediction; Bpex outperformed the prediction. We conclude that
Bpex won the lawsuit.

6
Chapter 13
1. Suppose you find, as research indicates, that in the cross-section regression of the CCAPM, the
coefficients of factor loadings on the Fama-French model are significant predictors of average
return factors (in addition to consumption beta). How would you explain this phenomenon?

2. Search the Internet for a recent graph of market volatility. What does this history suggest about
the history of consumption growth?

7
Answers
1. Even if the single-factor CCAPM (with a consumption-tracking portfolio used as the index)
performs better than the CAPM, it is still quite possible that the consumption portfolio does
not capture the size and growth characteristics captured by the SMB (i.e., small minus big
capitalization) and HML (i.e., high minus low book-to-market ratio) factors of the Fama-
French three-factor model. Therefore, it is expected that the Fama-French model with
consumption provides a better explanation of returns than does the model with
consumption alone.

2. Wealth and consumption should be positively correlated and, therefore, market volatility
and consumption volatility should also be positively correlated. Periods of high market
volatility might coincide with periods of high consumption volatility. The ‘conventional’
CAPM focuses on the covariance of security returns with returns for the market portfolio
(which in turn tracks aggregate wealth) while the consumption-based CAPM focuses on the
covariance of security returns with returns for a portfolio that tracks consumption growth.
However, to the extent that wealth and consumption are correlated, both versions of the
CAPM might represent patterns in actual returns reasonably well.
To see this formally, suppose that the CAPM and the consumption-based model are
approximately true. According to the conventional CAPM, the market price of risk equals
expected excess market return divided by the variance of that excess return. According to
the consumption-beta model, the price of risk equals expected excess market return divided
by the covariance of RM with g, where g is the rate of consumption growth. This
covariance equals the correlation of RM with g times the product of the standard deviations
of the variables. Combining the two models, the correlation between RM and g equals the
standard deviation of RM divided by the standard deviation of g. Accordingly, if the
correlation between RM and g is relatively stable, then an increase in market volatility will
be accompanied by an increase in the volatility of consumption growth.

8
Chapter 14
3. The stated yield to maturity and realized compound yield to maturity of a (default-free) zero-
coupon bond will always be equal. Why?

4. Why do bond prices go down when interest rates go up? Don't lenders like high interest rates?

5. A bond with an annual coupon rate of 4.8% sells for $970. What is the bond's current yield?

7. Treasury bonds paying an 8% coupon rate with semiannual payments currently sell at par value.
What coupon rate would they have to pay in order to sell at par if they paid their
coupons annually? (Hint: What is the effective annual yield on the bond?)

9. Consider an 8% coupon bond selling for $953.10 with 3 years until maturity
makingannual coupon payments. The interest rates in the next 3 years will be, with certainty,r1 =
8%, r2 = 10%, and r3 = 12%. Calculate the yield to maturity and realized compound yield of the
bond.

13. Fill in the table below for the following zero-coupon bonds, all of which have par values of
$1,000.

20. A newly issued 10-year maturity, 4% coupon bond making annual coupon payments is sold to
the public at a price of $800. What will be an investor's taxable income from the bond over the
coming year? The bond will not be sold at the end of the year. The bond is treated as an

9
 original-issue discount bond.

23. A 2-year bond with par value $1,000 making annual coupon payments of $100 is priced at
$1,000. What is the yield to maturity of the bond? What will be the realized compound yield to
maturity if the 1-year interest rate next year turns out to be (a) 8%, (b) 10%, (c) 12%?

10
Answers
3. Zero coupon bonds provide no coupons to be reinvested. Therefore, the investor's proceeds
from the bond are independent of the rate at which coupons could be reinvested (if they were
paid). There is no reinvestment rate uncertainty with zeros.

4. A bond’s coupon interest payments and principal repayment are not affected by changes
in market rates. Consequently, if market rates increase, bond investors in the secondary
markets are not willing to pay as much for a claim on a given bond’s fixed interest and
principal payments as they would if market rates were lower. This relationship is
apparent from the inverse relationship between interest rates and present value. An
increase in the discount rate (i.e., the market rate) decreases the present value of the
future cash flows.

5. Annual Coupon Rate: 4.80% à $48 Coupon Payments

Current Yield:
⎛ $48 ⎞
⎜ ⎟ = 4.95%
⎝ $970 ⎠

7. The effective annual yield on the semiannual coupon bonds is 8.16%. If the annual
coupon bonds are to sell at par they must offer the same yield, which requires an annual
coupon rate of 8.16%.

9. Yield to maturity: Using a financial calculator, enter the following:

n = 3; PV = −953.10; FV = 1000; PMT = 80; COMP i
This results in: YTM = 9.88%
Realized compound yield: First, find the future value (FV) of reinvested coupons and
principal:
FV = ($80 * 1.10 *1.12) + ($80 * 1.12) + $1,080 = $1,268.16
Then find the rate (yrealized ) that makes the FV of the purchase price equal to $1,268.16:
$953.10 × (1 + yrealized )3 = $1,268.16 ⇒ yrealized = 9.99% or approximately 10%

13.
Maturity Bond equivalent
Price
(years) YTM
$400.00 20.00 4.688%
$500.00 20.00 3.526%
$500.00 10.00 7.177%

11
 $385.54 10.00 10.000%
$463.19 10.00 8.000%
$400.00 11.91 8.000%

20. The bond is issued at a price of $800. Therefore, its yield to maturity is: 6.8245%
Therefore, using the constant yield method, we find that the price in one year (when
maturity falls to 9 years) will be (at an unchanged yield) $814.60, representing an increase
of $14.60. Total taxable income is: $40.00 + $14.60 = $54.60

23. The bond is selling at par value. Its yield to maturity equals the coupon rate, 10%. If the
first-year coupon is reinvested at an interest rate of r percent, then total proceeds at the end
of the second year will be: [$100 * (1 + r)] + $1,100
Therefore, realized compound yield to maturity is a function of r, as shown in the following
table:
r Total proceeds Realized YTM = Proceeds/1000 – 1
8% $1,208 1208/1000 – 1 = 0.0991 = 9.91%
10% $1,210 1210/1000 – 1 = 0.1000 = 10.00%
12% $1,212 1212/1000 – 1 = 0.1009 = 10.09%

12
Chapter 15
1. What is the relationship between forward rates and the market's expectation of future short rates?
Explain in the context of both the expectations and liquidity preference theories of the term
structure of interest rates.

9. Consider the following $1,000 par value zero-coupon bonds:

According to the expectations hypothesis, what is the expected 1-year interest rate 3 years from
now?

10. The term structure for zero-coupon bonds is currently:

Next year at this time, you expect it to be:

a. What do you expect the rate of return to be over the coming year on a 3-year zero-coupon
bond?

b. Under the expectations theory, what yields to maturity does the market expect to observe on 1-
and 2-year zeros at the end of the year? Is the market's expectation of the return on the 3-year
bond greater or less than yours?

11. The yield to maturity on 1-year zero-coupon bonds is currently 7%; the YTM on 2-year zeros is
8%. The Treasury plans to issue a 2-year maturity coupon bond, paying coupons once per year

13
 with a coupon rate of 9%. The face value of the bond is $100.

a. At what price will the bond sell?

b. What will the yield to maturity on the bond be?

c. If the expectations theory of the yield curve is correct, what is the market expectation of the
price that the bond will sell for next year?

d. Recalculate your answer to (c) if you believe in the liquidity preference theory and you believe
that the liquidity premium is 1%.

15. The yield to maturity (YTM) on 1-year zero-coupon bonds is 5% and the YTM on 2-year zeros
is 6%. The yield to maturity on 2-year-maturity coupon bonds with coupon rates of 12% (paid
annually) is 5.8%. What arbitrage opportunity is available for an investment banking firm? What
is the profit on the activity?

14
Answers
1. In general, the forward rate can be viewed as the sum of the market’s expectation of the
future short rate plus a potential risk (or ‘liquidity’) premium. According to the
expectations theory of the term structure of interest rates, the liquidity premium is zero so
that the forward rate is equal to the market’s expectation of the future short rate. Therefore,
the market’s expectation of future short rates (i.e., forward rates) can be derived from the
yield curve, and there is no risk premium for longer maturities.
The liquidity preference theory, on the other hand, specifies that the liquidity premium is
positive so that the forward rate is greater than the market’s expectation of the future short
rate. This could result in an upward sloping term structure even if the market does not
anticipate an increase in interest rates. The liquidity preference theory is based on the
assumption that the financial markets are dominated by short-term investors who demand a
premium in order to be induced to invest in long maturity securities.

9. If expectations theory holds, then the forward rate equals the short rate, and the one year
interest rate three years from now would be
(1.07)4
− 1 = .0851 = 8.51%
(1.065)3

10. a. A 3-year zero coupon bond with face value $100 will sell today at a yield of 6% and a
price of:
$100/1.063 =$83.96
Next year, the bond will have a two-year maturity, and therefore a yield of 6% (from
next year’s forecasted yield curve). The price will be $89.00, resulting in a holding
period return of 6%.

b. The forward rates based on today’s yield curve are as follows:

Year Forward Rate
2 (1.052/1.04) – 1 = 6.01%
3 (1.063/1.052) – 1 = 8.03%
Using the forward rates, the forecast for the yield curve next year is:
Maturity YTM
1 6.01%
2 (1.0601 × 1.0803)1/2 – 1 = 7.02%
The market forecast is for a higher YTM on 2–year bonds than your forecast. Thus,
the market predicts a lower price and higher rate of return.

15
 $9 $109
11. a. P= + = $101.86
1.07 1.08 2

b. The yield to maturity is the solution for y in the following equation:

$9 $109
+ = $101.86
1 + y (1 + y) 2
[Using a financial calculator, enter n = 2; FV = 100; PMT = 9; PV = –101.86; Compute i]
YTM = 7.958%

c. The forward rate for next year, derived from the zero-coupon yield curve, is the
solution for f 2 in the following equation:
(1.08) 2
1+ f2 = = 1.0901 ⇒ f 2 = 0.0901 = 9.01%.
1.07
Therefore, using an expected rate for next year of r2 = 9.01%, we find that the
forecast bond price is:
$109
P= = $99.99
1.0901

d. If the liquidity premium is 1% then the forecast interest rate is:

E(r2) = f2 – liquidity premium = 9.01% – 1.00% = 8.01%
The forecast of the bond price is:
$109
= $100.92
1.0801

15. The price of the coupon bond, based on its yield to maturity, is:
[$120 × Annuity factor (5.8%, 2)] + [$1,000 × PV factor (5.8%, 2)] = $1,113.99
If the coupons were stripped and sold separately as zeros, then, based on the yield to
maturity of zeros with maturities of one and two years, respectively, the coupon payments
could be sold separately for:
$120 $1,120
+ = $1,111.08
1.05 1.06 2
The arbitrage strategy is to buy zeros with face values of $120 and $1,120, and respective
maturities of one year and two years, and simultaneously sell the coupon bond. The profit
equals $2.91 on each bond.

16
Chapter 16
2. How can a perpetuity, which has an infinite maturity, have a duration as short as 10 or 20 years?

9. An insurance company must make payments to a customer of $10 million in 1 year and $4
million in 5 years. The yield curve is flat at 10%.

a. If it wants to fully fund and immunize its obligation to this customer with a single issue of a
zero-coupon bond, what maturity bond must it purchase?

b. What must be the face value and market value of that zero-coupon bond?

12. You will be paying $10,000 a year in tuition expenses at the end of the next 2 years. Bonds
currently yield 8%.

a. What is the present value and duration of your obligation?

b. What maturity zero-coupon bond would immunize your obligation?

c. Suppose you buy a zero-coupon bond with value and duration equal to your obligation.
Now suppose that rates immediately increase to 9%. What happens to your net position,
that is, to the difference between the value of the bond and that of your tuition obligation?
What if rates fall to 7%?

14. You are managing a portfolio of $1 million. Your target duration is 10 years, and you can
choose from two bonds: a zero-coupon bond with maturity of 5 years, and a perpetuity, each
currently yielding 5%.

a. How much of each bond will you hold in your portfolio?

b. How will these fractions change next year if target duration is now 9 years?

15. My pension plan will pay me $10,000 once a year for a 10-year period. The first payment will
come in exactly 5 years. The pension fund wants to immunize its position.

a. What is the duration of its obligation to me? The current interest rate is 10% per year.

b. If the plan uses 5-year and 20-year zero-coupon bonds to construct the immunized position,

17
how much money ought to be placed in each bond? What will be the face value of the
holdings in each zero?

18
Answers
2. Duration can be thought of as a weighted average of the ‘maturities’ of the cash flows paid
to holders of the perpetuity, where the weight for each cash flow is equal to the present
value of that cash flow divided by the total present value of all cash flows. For cash flows
in the distant future, present value approaches zero (i.e., the weight becomes very small) so
that these distant cash flows have little impact, and eventually, virtually no impact on the
weighted average.

9. a.
(1) (2) (3) (4) (5)
Time until PV of CF
Column (1) ×
Payment Cash Flow (Discount rate = Weight
Column (4)
(years) 10%)
1 $10 million $9.09 million 0.7857 0.7857
5 $4 million $2.48 million 0.2143 1.0715
Column Sums $11.57 million 1.0000 1.8572
D = 1.8572 years = required maturity of zero coupon bond.

b. The market value of the zero must be $11.57 million, the same as the market value of
the obligations. Therefore, the face value must be:
$11.57 million × (1.10)1.8572 = $13.81 million

12. a. PV of the obligation = $10,000 × Annuity factor (8%, 2) = $17,832.65

(1) (2) (3) (4) (5)
Time until PV of CF
Column (1) ×
Payment Cash Flow (Discount Weight
Column (4)
(years) rate = 8%)
1 $10,000.00 $9,259.259 0.51923 0.51923
2 $10,000.00 $8,573.388 0.48077 0.96154
Column Sums $17,832.647 1.00000 1.48077
Duration = 1.4808 years

b. A zero-coupon bond maturing in 1.4808 years would immunize the obligation. Since
the present value of the zero-coupon bond must be $17,832.65, the face value (i.e.,
the future redemption value) must be:
$17,832.65 × 1.081.4808 = $19,985.26

c. If the interest rate increases to 9%, the zero-coupon bond would decrease in value to:
$19,985.26
= $17,590.92
1.091.4808
The present value of the tuition obligation would decrease to: $17,591.11
19
 The net position decreases in value by: $0.19
If the interest rate decreases to 7%, the zero-coupon bond would increase in value to:
$19,985.26
= $18,079.99
1.07 1.4808
The present value of the tuition obligation would increase to: $18,080.18
The net position decreases in value by: $0.19
The reason the net position changes at all is that, as the interest rate changes, so does
the duration of the stream of tuition payments.

14. a. The duration of the perpetuity is: 1.05/0.05 = 21 years

Call w the weight of the zero-coupon bond. Then:
(w × 5) + [(1 – w) × 21] = 10 ⇒ w = 11/16 = 0.6875
Therefore, the portfolio weights would be as follows: 11/16 invested in the zero and
5/16 in the perpetuity.

b. Next year, the zero-coupon bond will have a duration of 4 years and the perpetuity
will still have a 21-year duration. To obtain the target duration of nine years, which is
now the duration of the obligation, we again solve for w:
(w × 4) + [(1 – w) × 21] = 9 ⇒ w = 12/17 = 0.7059
So, the proportion of the portfolio invested in the zero increases to 12/17 and the
proportion invested in the perpetuity falls to 5/17.

15. a. The duration of the annuity if it were to start in 1 year would be:
(1) (2) (3) (4) (5)
Time until PV of CF
Column (1) ×
Payment Cash Flow (Discount Weight
Column (4)
(years) rate = 10%)
1 $10,000 $9,090.909 0.14795 0.14795
2 $10,000 $8,264.463 0.13450 0.26900
3 $10,000 $7,513.148 0.12227 0.36682
4 $10,000 $6,830.135 0.11116 0.44463
5 $10,000 $6,209.213 0.10105 0.50526
6 $10,000 $5,644.739 0.09187 0.55119
7 $10,000 $5,131.581 0.08351 0.58460
8 $10,000 $4,665.074 0.07592 0.60738
9 $10,000 $4,240.976 0.06902 0.62118
10 $10,000 $3,855.433 0.06275 0.62745
Column Sums $61,445.671 1.00000 4.72546
D = 4.7255 years

20
 Because the payment stream starts in five years, instead of one year, we add four
years to the duration, so the duration is 8.7255 years.

b. The present value of the deferred annuity is:

10,000 × Annuity factor (10%,10)
= $41,968
1.10 4
Call w the weight of the portfolio invested in the 5-year zero. Then:
(w × 5) + [(1 – w) × 20] = 8.7255 ⇒ w = 0.7516
The investment in the 5-year zero is equal to:
0.7516 × $41,968 = $31,543
The investment in the 20-year zeros is equal to:
0.2484 × $41,968 = $10,423
These are the present or market values of each investment. The face values are
equal to the respective future values of the investments. The face value of the 5-
year zeros is:
$31,543 × (1.10)5 = $50,801
Therefore, between 50 and 51 zero-coupon bonds, each of par value $1,000, would be
purchased. Similarly, the face value of the 20-year zeros is:
$10,425 × (1.10)20 = $70,123

21