Essentials of Investments. Ninth Edition. Bodie, Kane, and Marcus. Investments. Tenth Edition. Hirt and Block. Fundamentals of Investment. Investments / Zvi Bodie, Boston University, Alex Kane, University of .. the CFA Institute administers an education and certifi- Investments, Tenth Edition, see http:// ruthenpress.info BKM_10e_Chappdf BKM_10e_IM_Chpdf BKM_Ess_10e_Ch02_Student. pdf BKM_10e_Chpdf Chapter 02 - Asset Classes and Financial Instruments.
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In this case all investors will have the same optimal risky portfolio. True or false? The standard deviation of the portfolio is always equal to the weighted average of the standard deviations of the assets in the portfolio. Suppose you have a project that has a. What is the standard deviation of the rate of return on this investment?
The following data are for Problems 17 through The correlation coefficients between pairs of stocks are as follows: Corr A, B 5. If your entire portfolio is now composed of stock A and you can add some of only one stock to your portfolio, would you choose explain your choice : a. Need more data. Would the answer to Problem 17 change for more risk-averse or risk-tolerant investors?
Suppose that in addition to investing in one more stock you can invest in T-bills as well. The following table of compound annual returns by decade applies to Challenge Challenge Problems 20 and Input the data from the table into a spreadsheet. Compute the serial correlation in decade returns for each asset class and for inflation. Also find the correlation between the returns of various asset classes. What do the data indicate?
Convert the asset returns by decade presented in the table into real rates. Repeat the analysis of Challenge Problem 20 for the real rates of return.
The following information applies to Problems 22 through Greta, an elderly inves- tor, has a degree of risk aversion of A53 when applied to return on wealth over a 3-year horizon.
All rates are annual, continuously compounded. The return on each of these portfolios in any year is uncorrelated with its return or the return of any other portfo- lio in any other year. Compute the estimated 3-year risk premiums, SDs, and Sharpe ratios for the two portfolios.
Assuming the correlation between the annual returns on the two portfolios is indeed zero, what would be the optimal asset allocation? What should be Gretas capital allocation? If the correlation coefficient between annual portfolio returns is 0. With correlation of 0.
Repeat Problem 15 using an annual correlation of 0. If you cannot calculate the 3-year covar- iance in Problem 17, assume it is 0. Jason Jones, financial vice president of Wilstead, noted that Hennessy had rather consistently achieved the best record among the Wilsteads six equity managers. In the one less-favorable year, the shortfall was trivial.
Hennessy is a bottom-up manager. The firm largely avoids any attempt to time the market. It also focuses on selection of individual stocks, rather than the weighting of favored industries. There is no apparent conformity of style among Wilsteads six equity managers. Jones is convinced that Hennessy is able to apply superior skill to stock selection, but the favor- able returns are limited by the high degree of diversification in the portfolio.
The reason Hennessy seemed to do well most years was that the firm was able to identify each year 10 or 12 issues that registered particularly large gains. On the basis of this overview, Jones outlined the following plan to the Wilstead pension committee: Lets tell Hennessy to limit the portfolio to no more than 20 stocks. Hennessy will double the commitments to the stocks that it really favors, and eliminate the remainder.
Except for this Visit us at www. All the members of the pension committee generally supported Joness proposal because all agreed that Hennessy had seemed to demonstrate superior skill in selecting stocks. Yet the proposal was a considerable departure from previous practice, and several committee members raised ques- tions. Respond to each of the following questions. Will the limitation to 20 stocks likely increase or decrease the risk of the portfolio?
Is there any way Hennessy could reduce the number of issues from 40 to 20 without signifi- cantly affecting risk? One committee member was particularly enthusiastic concerning Joness proposal.
He suggested that Hennessys performance might benefit further from reduction in the number of issues to After covering money markets, the chapter discusses the major capital market instruments. The capital market discussion is divided into three parts, long- term debt, equity and derivatives.
The construction and purpose of indexes is also covered in the capital markets section. Readers should understand the differences between discount yields and bond-equivalent yields and some money-market-rate- quote conventions.
The student should have an insight as to the interpretation, composition, and calculation process involved in the various market indexes presented on the evening news. Finally, the student should have a basic understanding of options and futures contracts. This material can be used to discuss the chapter outline and the purposes of these markets. Instruments may be classified by whether they represent money market instruments, which are primarily used for savings, or capital market instruments.
Savings may be defined as short-term investments that pay a low rate of return but do not risk the principal invested. Capital market investments will entail chance of loss of some or even all of the principal invested but promise higher rates of return that allow significant growth in portfolio value. Chapter 02 - Asset Classes and Financial Instruments 1.
Treasury bills, certificates of deposit CDs and commercial paper are covered in the most detail.
The issuer, typical or maximum maturity, denomination, liquidity, default risk, interest type and tax status are presented for these instruments. The majority of undergraduate students will have very little knowledge of the workings of these investments and this is very useful information for them.
PPT slides through give data on money market rates, the amounts of the different security types and spreads between CDs and T-bills. Notice the big run up in spreads during the financial crisis.
Make sure students understand the meaning of credit spreads as this is a major predictor of market conditions. You may wish to reference the following online article: After years of declining growth rates, MMMF inflows accelerated rapidly as investors fled risky assets during the crisis and sought safety in money funds.
However, MMMFs had their own crisis in after Lehman Brothers filed for bankruptcy on September 15 because some money funds had invested heavily in Lehman commercial paper. On Sept. Some investors use these funds to pay bills as most have a checking feature and count on the shares maintaining their value. A run on money market funds ensued. The U. Treasury temporarily offered to insure all money funds for an insurance fee to stop the run. Money Market Yields: Note that the following relationship will normally hold: To convert from add on to BEY use the following: The Treasury and Agency issues have the direct or implied guarantee of the federal government.
As state and local entities issue municipal bonds, performance on these bonds does not have the same degree of safety as a federal government issue. The interest income on municipal bonds is not subject to federal taxes so the taxable equivalent yield is used for comparison.
Fixed-income securities have a defined stream of payments or coupons. Treasury notes have a maturity up to and including 10 years; bonds mature beyond 10 years.
Treasury bonds pay interest semiannually with principal repaid at maturity non-amortizing. Most are callable after an initial call-protection period. Investors pay federal taxes on capital gains and interest income, but interest income is exempt from state and local taxes. Agency issues have either explicit or implicit backing by the Federal Government and their securities normally carry an interest rate only a few basis points over a comparable-maturity Treasury instrument.
Federal agencies have different charters but are generally charged with assisting socially deserving sectors of the economy in obtaining credit. The major example is housing, although farm lending and small business loans are other good examples. GNMA has always been a government agency. FHLMC was created in to assist in financing of conventional mortgages. Municipal bonds are issued by state and local governments.
Interest on municipal bonds is not taxed at the federal level and is usually not subject to state and local taxes if the investor downloads a bond issued by an entity in their state of residence. To compare corporate yields with municipal yields you must calculate the taxable equivalent yield. Industrial development bonds are municipal issues where the money is used for industrial development in the local municipality.
This may involve using the money to assist a specific business to encourage that firm to locate a facility in the municipality.
Private Issues: Private issues include corporate debt and equity issues and asset-backed securities, including mortgage- backed securities. Bonds issued by private corporations are subject to greater default risk than bonds issued by government entities.
Corporate bonds often contain imbedded options such as a call feature which allows an existing corporation to redownload the bond from issuers when rates have fallen. Some bonds are convertible which allows the bond investor to convert the bond to a set number of shares of common stock.
Most bonds are rated by one or more of the major ratings agencies approved by the federal government. The rating measures default risk. The higher the rating the lower the interest rate required to issue the bonds. The two major classes of bonds with respect to default risk are investment grade and speculative grade.
Investment grade bonds are much more marketable and carry significantly lower interest rates than speculative grade bonds. Spreads on junk bonds reached record highs in and The mortgage market is now larger than the corporate bond market. Securities backed by mortgages have also grown to compose a major element of the overall bond market.
A pass- through security represents a proportional pro-rata share of a pool of mortgages. The mortgage- backed market has grown rapidly in recent years as shown in Text Figure 2.
Until about , Fannie and Freddie only underwrote or guaranteed conforming mortgages. Most of the mortgages in the lower-quality categories originated since have deteriorated in value. First, common stock owners have a residual claim on the earnings dividends of the firm. Debt holders and preferred stockholders have priority over common stockholders in the event of distress or bankruptcy. Stockholders do have limited liability and a shareholder cannot lose more than their initial investment.
Common stockholders typically have the right to vote on the board of directors and the board can hire and fire managers. Even though stockholders have the right to vote it may be difficult to effect change because of a low concentration of stock holdings among many small investors. Michael Jacobs, a former Treasury official, wrote in The Wall Street Journal that Citicorp had few directors with experience in the financial markets and GE had only one director with experience in a financial institution even though GE Capital is a major component of the firm.
Ordinary preferred stockholders are limited to the fixed dividend while common shareholders do not have limits. The partial tax exemption on dividends of one corporation being received by another corporation is important in discussing preferred stock. Preferred and common dividends are not tax deductible to the issuing firm. What were your dividend yield, capital gain yield and total return? Ignore taxes o Dividend yield: Key factors to consider in constructing an index include a what the index is supposed to measure, b whether a representative sample of firms can be used or whether all firms must be included, c how the index should be constructed.
The examples of domestic indexes displayed in the PPT slides illustrate the diversity of indexes in use. The Wilshire, being the broadest of the indexes, captures the overall domestic market.
The sample of domestic indexes also fit well with discussion of uses of the index. The creator of an index must decide how to weight the securities included in the index. Price-weighted averages are probably the poorest form of index because high price stocks have a bigger weight in the index there is no theoretical reason for this and stock splits arbitrarily reduce that weight.
The other choices are market-value weighted most common and equal-value weighted. Which of these two is better depends on your objectives. In a value-weighted index the amount invested in each stock in the index is proportional to the market value of the firm. The market value of the firm is the weight for each stock. Changes in the value of larger firms affect the index more than changes in the value of the stock of a firm with smaller market capitalization.
The theoretical market portfolio of all risky assets is value weighted. In constructing an equal-weighted index, an equal amount of money is assumed to be invested in each stock. Changes in the value of small firm and large firm stocks affect the index value identically.
While not as commonly used in many published indexes, the equal-weighted method is commonly used in research. This method is important in describing results of empirical examinations on market efficiency discussed in later chapters.
Also if an investor actually does put equal dollar amounts into various stocks then an equal-weighted index is probably the better benchmark. The PPT slides contain sample calculations of price-weighted, value-weighted and equal-weighted indexes for a simple three-stock index. The effect of exercise price and time to expiration on a call and a put are illustrated with this figure. A very basic definition of a futures contract is provided on PPT slide Figure 2. The main point to emphasize in the option and futures discussion is that futures entail a commitment to a future download or sale whereas options give the holder the right to download with a call or sell with a put the underlying commodity.
The instructor should be aware that options and futures markets are highly competitive. On the whole many futures markets are cheaper and more liquid than options markets. Which gives you the highe after-tax yield?