Chapter 2 - Asset Classes and Financial Instruments

CHAPTER 2: ASSET CLASSES AND FINANCIAL

INSTRUMENTS
PROBLEM SETS
1. Preferred stock is like long-term debt in that it typically promises a fixed payment
each year. In this ay! it is a perpetuity. Preferred stock is also like long-term debt
in that it does not gi"e the holder "oting rights in the firm.
Preferred stock is like e#uity in that the firm is under no contractual obligation to
make the preferred stock di"idend payments. Failure to make payments does not set
off corporate bankruptcy. $ith respect to the priority of claims to the assets of the
firm in the e"ent of corporate bankruptcy! preferred stock has a higher priority than
common e#uity but a loer priority than bonds.
2. %oney market securities are called cash equivalents because of their high le"el
of li#uidity. &he prices of money market securities are "ery stable! and they can
be con"erted to cash 'i.e.! sold( on "ery short notice and ith "ery lo
transaction costs. )xamples of money market securities include &reasury bills!
commercial paper! and banker*s acceptances! each of hich is highly marketable
and traded in the secondary market.
+. 'a( A repurchase agreement is an agreement hereby the seller of a security
agrees to ,repurchase- it from the buyer on an agreed upon date at an agreed
upon price. .epos are typically used by securities dealers as a means for
obtaining funds to purchase securities.
/. 0preads beteen risky commercial paper and risk-free go"ernment securities
ill iden. 1eterioration of the economy increases the likelihood of default on
commercial paper! making them more risky. In"estors ill demand a greater
premium on all risky debt securities! not 2ust commercial paper.
3.
Corp. 4onds Preferred 0tock Common 0tock
5oting rights 'typically( 6es
contractual obligation 6es
Perpetual payments 6es 6es
Accumulated di"idends 6es
Fixed payments 'typically( 6es 6es
Payment preference First 0econd &hird
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Chapter 2 - Asset Classes and Financial Instruments
7. %unicipal bond interest is tax-exempt at the federal le"el and possibly at the
state le"el as ell. $hen facing higher marginal tax rates! a high-income in"estor
ould be more inclined to in"est in tax-exempt securities.
8. a. 6ou ould ha"e to pay the ask price of9
161.1875% of par value of $1,000 = $1611.875
b. The coupon rate is 6.25% implyin coupon payments of
$62.50 annually or, more precisely, $!1.25 semiannually.
c. &he yield to maturity on a fixed income security is also knon as its re#uired
return and is reported by The Wall Street Journal and others in the financial
press as the ask yield. In this case! the yield to maturity is 2.11+:. An in"estor
buying this security today and holding it until it matures ill earn an annual
return of 2.11+:. 0tudents ill learn in a later chapter ho to compute both
the price and the yield to maturity ith a financial calculator.
;. &reasury bills are discount securities that mature for <1=!===. &herefore! a specific &-
bill price is simply the maturity "alue di"ided by one plus the semi-annual return9
P > <1=!===?1.=2 > <@!;=+.@2
@. &he total before-tax income is </. After the 8=: exclusion for preferred stock
di"idends! the taxable income is9 =.+= </ > <1.2=
&herefore! taxes are9 =.+= <1.2= > <=.+7
After-tax income is9 </.== A <=.+7 > <+.7/
.ate of return is9 <+.7/?</=.== > @.1=:
1=. a. 6ou could buy9 <3!===?<7/.7@ > 88.2@ shares. 0ince it is not possible to trade in
fractions of shares! you could buy 88 shares of B1.
b. 6our annual di"idend income ould be9 88 <2.=/ > <138.=;
c. &he price-to-earnings ratio is @.+1 and the price is <7/.7@. &herefore9
<7/.7@?)arnings per share > @.+ )arnings per share > <7.@7
d. Beneral 1ynamics closed today at <7/.7@! hich as <=.73 higher than
yesterdayCs price of <7/.=/
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Chapter 2 - Asset Classes and Financial Instruments
11. a. At t > =! the "alue of the index is9 '@= D 3= D 1==(?+ > ;=
At t > 1! the "alue of the index is9 '@3 D /3 D 11=(?+ > ;+.+++
&he rate of return is9 ';+.+++?;=( 1 > /.18:
b. In the absence of a split! 0tock C ould sell for 11=! so the "alue of the
index ould be9 23=?+ > ;+.+++ ith a di"isor of +.
After the split! stock C sells for 33. &herefore! e need to find the di"isor
'd( such that9 ;+.+++ > '@3 D /3 D 33(?d d > 2.+/=. &he di"isor fell!
hich is alays the case after one of the firms in an index splits its
shares.
c. &he return is Eero. &he index remains unchanged because the return for
each stock separately e#uals Eero.
12. a. &otal market "alue at t > = is9 '<@!=== D <1=!=== D <2=!===( > <+@!===
&otal market "alue at t > 1 is9 '<@!3== D <@!=== D <22!===( > </=!3==
.ate of return > '</=!3==?<+@!===( A 1 > +.;3:
b. &he return on each stock is as follos9
rA > '@3?@=( A 1 > =.=337
rB > '/3?3=( A 1 > A=.1=
rC > '11=?1==( A 1 > =.1=
&he e#ually eighted a"erage is9
F=.=337 D '-=.1=( D =.1=G?+ > =.=1;3 > 1.;3:
1+. &he after-tax yield on the corporate bonds is9 =.=@ '1 A =.+=( > =.=7+ > 7.+=:
&herefore! municipals must offer a yield to maturity of at least 7.+=:.
1/. )#uation '2.2( shos that the e#ui"alent taxable yield is9 r > r
m
?'1 A t(! so simply
substitute each tax rate in the denominator to obtain the folloing9
a. /.==:
b. /.//:
c. 3.==:
d. 3.81:
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Chapter 2 - Asset Classes and Financial Instruments
13. In an e#ually eighted index fund! each stock is gi"en e#ual eight regardless of its
market capitaliEation. 0maller cap stocks ill ha"e the same eight as larger cap
stocks. &he challenges are as follos9
Bi"en e#ual eights placed to smaller cap and larger cap! e#ual-
eighted indices ')$I( ill tend to be more "olatile than their market-
capitaliEation counterpartsH
It follos that )$Is are not good reflectors of the broad market that they
representH )$Is underplay the economic importance of larger
companies.
&urno"er rates ill tend to be higher! as an )$I must be rebalanced
back to its original target. 4y design! many of the transactions ould be
among the smaller! less-li#uid stocks.
17. a. &he ten-year &reasury bond ith the higher coupon rate ill sell for a higher
price because its bondholder recei"es higher interest payments.
b. &he call option ith the loer exercise price has more "alue than one ith a
higher exercise price.
c. &he put option ritten on the loer priced stock has more "alue than one
ritten on a higher priced stock.
18. a. 6ou bought the contract hen the futures price as <8.;+23 'see Figure
2.11 and remember that the number to the right of the apostrophe represents an
eighth of a cent(. &he contract closes at a price of <8.;823! hich is <=.=/ more
than the original futures price. &he contract multiplier is 3===. &herefore! the
gain ill be9 <=.=/ 3=== > <2==.==
b. Ipen interest is 1+3!88; contracts.
1;. a. Ining the call option gi"es you the right! but not the obligation! to buy at
<1;=! hile the stock is trading in the secondary market at <1@+. 0ince the
stock price exceeds the exercise price! you exercise the call.
&he payoff on the option ill be9 <1@+ - <1;= > <1+
&he cost as originally <12.3;! so the profit is9 <1+ - <12.3; > <=./2
b. 0ince the stock price is greater than the exercise price! you ill exercise the call.
&he payoff on the option ill be9 <1@+ - <1;3 > <;
&he option originally cost <@.83! so the profit is <; - <@.83 > -<1.83
c. Ining the put option gi"es you the right! but not the obligation! to sell at <1;3!
but you could sell in the secondary market for <1@+! so there is no "alue in
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Chapter 2 - Asset Classes and Financial Instruments
exercising the option. 0ince the stock price is greater than the exercise price!
you ill not exercise the put. &he loss on the put ill be the initial cost of
<12.=1.
1@. &here is alays a possibility that the option ill be in-the-money at some time prior to
expiration. In"estors ill pay something for this possibility of a positi"e payoff.
2=.
5alue of Call at )xpiration Initial Cost Profit
= / -/
= / -/
= / -/
3 / 1
1= / 7
5alue of Put at )xpiration Initial Cost Profit
1= 7 /
3 7 -1
= 7 -7
= 7 -7
= 7 -7
21. A put option con"eys 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. 4oth positions! hoe"er! benefit if the price of the underlying
asset falls.
22. A call option con"eys 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. 4oth positions! hoe"er! benefit if the price of the underlying
asset rises.
CFA PROBLEMS
1. 'd( &here are tax ad"antages for corporations that on preferred shares.
2. &he e#ui"alent taxable yield is9 7.83:?'1 =.+/( > 1=.2+:
+. 'a( $riting a call entails unlimited potential losses as the stock price rises.
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Chapter 2 - Asset Classes and Financial Instruments
/. a. &he taxable bond. $ith a Eero tax bracket! the after-tax yield for the
taxable bond is the same as the before-tax yield '3:(! hich is greater than
the yield on the municipal bond.
b. &he taxable bond. &he after-tax yield for the taxable bond is9
=.3 '1 A =.1=( > /.3:
c. 6ou are indifferent. &he after-tax yield for the taxable bond is9
=.=3 '1 A =.2=( > /.=:
&he after-tax yield is the same as that of the municipal bond.
d. &he municipal bond offers the higher after-tax yield for in"estors in tax
brackets abo"e 2=:.
3. If the after-tax yields are e#ual! then9 =.=37 > =.=; J '1 A t(
&his implies that t > =.+= >+=:.
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