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Chapter 02 – Asset Classes and Financial Instruments
CHAPTER 2
ASSET CLASSES AND FINANCIAL INSTRUMENTS
1. Common stock is an ownership share in a publicly held corporation. Common
shareholders have voting rights and may receive dividends. Preferred stock represents
nonvoting shares in a corporation, usually paying a fixed stream of dividends. While
corporate bonds are long-term debt issued by corporations, the bonds typically pay
semi-annual coupons and return the face value of the bond at maturity.
2. While the DJIA has 30 large corporations in the index, it does not represent the
overall market nearly as well as the more than 5000 stocks contained in The Wilshire
index. The DJIA is simply too small.
3. Money market securities are short-term, relatively low risk, and highly liquid. Also,
their unit value almost never changes.
4. The major components of the money market are Treasury bills, certificates of deposit,
commercial paper, bankersโ acceptances, Eurodollars, repos, reserves, federal funds,
and brokersโ calls.
5. American Depositary Receipts, or ADRs, are certificates traded in U.S. markets that
representownership in shares of a foreign company. Investors may also purchase
shares of foreign companies on foreign exchanges. Lastly, investors may use
international mutual funds to own shares indirectly.
6. The coupons paid by municipal bonds are exemptfrom federal income tax and from
state tax in many states. Therefore, the higher the tax bracketthat the investor is in, the
more valuable the tax-exempt feature to the investor.
7. The London Interbank Offer Rate (LIBOR)โa key reference rate in the money
marketโis the rate at which large banks in London are willing to lend money among
them.The Federal funds rate is the rate of interest on very short-term loans among
financial institutions in the U.S.A.
8. General obligation bonds are backed by the taxing power of the local governments,
while revenue bonds have proceeds attached to specific projects. A revenue bond has
fewer guarantees, it is riskier in terms of default, and,therefore,you expect itto have a
higher yield.
9. Corporations may exclude 70% of dividends received from domestic corporations in
the computation of their taxable income.
10. Limited liability means that the most shareholders can lose in event of the failure of
the corporation is their original investment.
Copyright ยฉ 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 02 – Asset Classes and Financial Instruments
11. (a)A repurchase agreement is the sale of a security with a commitment to repurchase
the same security at a specified future date and a designated price.
12. Money market securities are referred to as โcash equivalentsโ because of their great
liquidity. The prices of money market securities are very stable, and they can be
converted to cash (i.e., sold) on very short notice and with very low transaction costs.
13. Equivalent taxable yield =
Rate on municipal bond
1๏ผ Tax rate
=
rm
=
.0425
=.0654 or 6.54%
1๏ผt 1 ๏ผ0.35
14. After-tax yield = Rate on the taxable bond x (1 ๏ผ Tax rate)
a. The taxable bond. With a zero tax bracket, the after-tax yield for the taxable
bond is the same as the before-tax yield (5%), which is greater than the 4%
yield on the municipal bond.
b. The taxable bond. The after-tax yield for the taxable bond is:0.05x (1 โ 0.10)
= 0.045 or 4.50%.
c. Neither. The after-tax yield for the taxable bond is:0.05x (1 โ 0.20) = 0.4 or
4%. The after-tax yield of taxable bond is the same as that of the municipal
bond.
d. The municipal bond. The after-tax yield for the taxable bond is: 0.05 x (1 โ
0.30) = 0.035 or 3.5%. The municipal bond offers the higher after-tax yield
for investors in tax brackets above 20%.
15. The after-tax yield on the corporate bonds is: 0.09 x (1 โ 0.30) = 0.063 or 6.3%.
Therefore, the municipals must offer at least 6.3% yields.
16. Using the formula of Equivalent taxable yield (r) =
a. r =
b. r =
c. r =
d. r =
0.04
rm
1๏ผt
, we get:
=0.04 or4.00%
1๏ผ0
0.04
1 ๏ผ0.10
0.04
1 ๏ผ0.20
0.04
1 ๏ผ0.30
= 0.0444 or 4.44%
= 0.05 or 5.00%
= 0.0571 or 5.71%
Copyright ยฉ 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 02 – Asset Classes and Financial Instruments
17.
a. You would have to pay the asked price of:
105.48 = 105.48% of par = $1,054.84
b. The coupon rate is 3.125%, implying coupon payments of $31.25 annually or,
more precisely, $15.625(= 31.25/2) semiannually.
c. Given the asked price and coupon rate, we can calculate current yield with the
formula:
Annual coupon income
Current yield =
= 3.125/105.4844= 0.0296 = 2.96%
Price
18.
a. The closing price today is $194.55, which is $0.37 aboveyesterdayโs price.
Therefore, yesterdayโs closing price was: $194.55๏ผ $0.37 = $194.18.
b. You would buy 25shares: $5,000/$194.55 = 25.70.
c. Your annual dividend incomeon 25shares would be 25x $3.36 = $84.00.
d. Earnings per share can be derived from the price-earnings (PE) ratio:
Given price/Earnings = 20.03 and Price = $194.55, we know that Earnings per
Share = $194.55/20.03 = $9.71
19.
a. At t = 0, the value of the index is: ($90 + $50 + $100)/3 = 80
At t = 1, the value of the index is: ($95 + $45 + $110)/3 = 83.33
V1
The rate of return is: ๏ผ 1 = (83.33/80) โ 1 = 0.0417 or 4.17%
V0
b. In the absence of a split, stock C would sell for $110, and the value of the
index would be the average price of the individual stocks included in the
index: ($95 + $45 + $110)/3 = $83.33.
After the split, stock C sells at $55; however, the value of the index should not
be affected by the split. We need to set the divisor (d) such that:
83.33 = ($95 + $45 + $55)/d
d = 2.34
c. The rate of return is zero. The value of the index remains unchanged since the
return on each stock separately equals zero.
Copyright ยฉ 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 02 – Asset Classes and Financial Instruments
20.
a. Total market value at t = 0 is:
($90 x 100) + ($50 x 200) + ($100 x 200) = $39,000
Total market value at t = 1 is:
($95 x 100) + ($45 x 200) + ($110 x 200) = $40,500
V1
Rate of return = ๏ผ 1 = ($40,500/$39,000) โ 1 = 0.0385 or 3.85%
V0
b. The return on each stock is as follows:
V1
RA= ๏ผ 1 = ($95/$90) โ 1 = 0.0556 or 5.56%
V0
V1
RB = ๏ผ 1 = ($45/$50) โ 1 = โ0.10 or โ10.00%
V0
RC =
V1
๏ผ 1 = ($110/$100) โ 1 = 0.10 or 10.00%
V0
The equally-weighted average is: [5.56% + (โ10.00%) + 10.00%]/3 = 1.85%
21. The fund would require constant readjustment since every change in the price of a
stock would bring the fund asset allocation out of balance.
22. In this case, the value of the divisor will increase by an amount necessary to maintain
the index value on the day of the change. For example, if the index was comprised of
only one stock, it would increase by 2.06 points: ($180 โ $34) / $34 = 4.29.
23. Bank discount of 87 days: 0.034 x
87 days
360 days
= 0.008217
a. Price: $10,000 x (1โ0.008217) = $9,917.83
b. Bond equivalent yield=
Face value ๏ผ Purchase price
Purchase price x T
$10,000 ๏ผ$9,917.83
=
87 days = 0.0348 or 3.48%
$9,917.83 x365 days
24.
a. The higher coupon bond: The 10-year T-bond with a 6% coupon
b. The call with the lower exercise price: The call with the exercise price of $35
c. The put option on the lower priced stock: The put on the stock selling at $50
Copyright ยฉ 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 02 – Asset Classes and Financial Instruments
25. The December maturity futures price is $3.8575 per bushel. If the contract closes at
$3.95 per bushel in December, your profit / loss on each contract (for delivery of
5,000 bushels of corn) will8 be: ($3.95โ$3.8575) x 5000 = $462.50gain.
26.
a. Yes. As long as the stock price at expiration exceeds the exercise price, it
makes sense to exercise the call.
Gross profit is: ($144โ $140) x 100 shares = $400
Net profit = ($4 โ $4.80)x 100 shares = $80loss
Rate of return = โ$.80/$4.80 = โ0.1667or 16.67% loss
b. Yes, exercise.
Gross profit is: ($144โ $135) x 100 shares = $900
Net profit = ($9 โ $8.05)x 100 shares= $95 gain
Rate of return = $.95/$8.05 = 0.1108 or 11.08 % gain
c. A put with an exercise price of $140 would expire worthless for any stock
price equal to or greater than $140 (in this case $144). An investment in such
a put would have a rate of return over the holding period of โ100%.
27.
a.
b.
c.
d.
Long call
Long put
Short put
Short call
28. There is always a chance that the option will expire in the money. Investors will pay
something for this chance of a positive payoff.
29. Long call for $4:
a.
b.
c.
d.
e.
Value of call
at expiration
0
0
0
5
10
Initial Cost
Profit
4
4
4
4
4
-4
-4
-4
1
6
Copyright ยฉ 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 02 – Asset Classes and Financial Instruments
Long put for $6:
Value of put
at expiration
a.
10
b.
5
c.
0
d.
0
e.
0
Initial Cost
Profit
6
6
6
6
6
4
-1
-6
-6
-6
30. The spread will widen. Deterioration of the economy increases credit risk, that is, the
likelihood of default. Investors will demand a greater premium on debt securities
subject to default risk.
31. Seven (of ten) stocks have a 52-week high at least 50% above the 52-week low. It can
be concluded that individual stocks are much more volatile than a group of stocks.
52-wk
high
32.67
16.48
30.74
25.20
64.46
34.05
14.99
20.81
196.97
33.00
52-wk
low
20.10
7.30
17.00
17.26
40.66
22.06
3.62
11.65
132.68
28.19
Price ratio
(High-Low)/Low
63%
126%
81%
46%
59%
54%
314%
79%
48%
17%
32. The total before-tax income is $4. The corporations may exclude 70% of dividends
received from domestic corporations in the computation of their taxable income; the
taxable income is therefore: $4 x 30% = $1.20.
Income tax in the 30% tax bracket: $1.2 x 30% = $0.36
After-tax income = $4 โ $0.36 = $3.64
After-tax rate of return = $3.64/$40 = 0.091 or 9.10%
33. A put option conveys the right to sell the underlying asset at the exercise price. A
short position in a futures contract carries an obligation to sell the underlying asset at
the futures price.
34. A call option conveys the right to buy the underlying asset at the exercise price. A
long position in a futures contract carries an obligation to buy the underlying asset at
the futures price.
Copyright ยฉ 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 02 – Asset Classes and Financial Instruments
CFA 1
Answer: c. Taxation
Copyright ยฉ 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.

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