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CHAPTER 1: THE INVESTMENT ENVIRONMENT PROBLEM SETS: 1.

While it is ultimately true that real assets determine the material well-being of an economy, financial innovation in the form of bundling and unbundling securities creates opportunities for investors to form more efficient portfolios. Both institutional and individual investors can benefit when financial engineering creates new products that allow them to manage their portfolios of financial assets more efficiently. Bundling and unbundling create financial products with new properties and sensitivities to various sources of risk that allows investors to reduce volatility by hedging particular sources of risk more efficiently.

Securitization requires access to a large number of potential investors. To attract these investors, the capital market needs: 1. A safe system of business laws and low probability of confiscatory taxation/regulation; 2. A well-developed investment banking industry; 3. A well-developed system of brokerage and financial transactions; and 4. A well-developed media, particularly financial reporting. These characteristics are found in (indeed make for) a well-developed financial market.

Securitization leads to disintermediation; that is, securitization provides a means for market participants to bypass intermediaries. For example, mortgage-backed securities channel funds to the housing market without requiring that banks or thrift institutions make loans from their own portfolios. Securitization works well and can benefit many, but only if the market for these securities is highly liquid. As securitization progresses, however, and financial intermediaries lose opportunities, they must increase other revenue-generating activities such as providing short-term liquidity to consumers and small business and financial services.

The existence of well-developed capital markets and the liquid trading of financial assets make it easy for large firms to raise the capital needed to finance their investments in real assets. If Suncor Energy, for example, could not issue stocks or bonds to the general public, it would have a far more difficult time raising capital. Contraction of the supply of financial assets would make financing more difficult, thereby increasing the cost of capital. A higher cost of capital makes investments in real assets less profitable/viable leading to lower real growth.

Even if the firm does not need to issue stock in any particular year, the stock market is still important to the financial manager. The stock price provides important information about how the market values the firm's investment projects. For example, if the stock price rises considerably, managers might conclude that the market believes the firm's future prospects

are bright. This might be a useful signal to the firm to proceed with an investment such as an expansion of the firm's business. In addition, shares that can be traded in the secondary market are more attractive to initial investors since they know that they will be able to sell their shares. This in turn makes investors more willing to buy shares in a primary offering and thus improves the terms on which firms can raise money in the equity market. Remember that stock exchanges like those in New York, Toronto, and London are the heart of capitalism, in which firms can raise capital quickly in primary markets because investors know there are liquid secondary markets.

a. No. The increase in price does not add to the productive capacity of the economy. b. Yes, the value of the equity held in these assets has increased. c. Future homeowners as a whole are worse off, since mortgage liabilities have also increased. In addition, this housing price bubble will eventually burst and society as a whole (and most likely taxpayers) will suffer the damage.

a. The bank loan is a financial liability for Lanni, and a financial asset for the bank. The cash Lanni receives is a financial asset. The new financial asset created is Lanni's promissory note to repay the loan. b. Lanni transfers financial assets (cash) to the software developers. In return, Lanni receives the completed software package, which is a real asset. No financial assets are created or destroyed; cash is simply transferred from one party to another. c. Lanni exchanges the real asset (the software) for a financial asset, which is 1,250 shares of Microsoft stock. If Microsoft issues new shares in order to pay Lanni, then this would represent the creation of new financial assets. d. By selling its shares in Microsoft, Lanni exchanges one financial asset (1,250 shares of stock) for another ($125,000 in cash). Lanni uses the financial asset of $50,000 in cash to repay the bank loan and retire its promissory note. The bank must return the promissory note (financial asset) to Lanni. The loan is now "destroyed" in the transaction, since it is retired when paid off and no longer exists.

a. Liabilities & Shareholders’ Equity Cash $ 70,000 Bank loan $ 50,000 Computers 30,000 Shareholders’ equity 50,000 Total $100,000 Total $100,000 Ratio of real assets to total assets = $30,000/$100,000 = 0.30 Assets

b. Assets Software product* Computers Total

$ 70,000 30,000 $100,000

Liabilities & Shareholders’ Equity Bank loan $ 50,000 Shareholders’ equity 50,000 Total $100,000

*Valued at cost Ratio of real assets to total assets = $100,000/$100,000 = 1.0 c. Assets Microsoft shares Computers Total

$125,000 30,000 $155,000

Liabilities & Shareholders’ Equity Bank loan $ 50,000 Shareholders’ equity 105,000 Total $155,000

Ratio of real assets to total assets = $30,000/$155,000 = 0.19 Conclusion: when the firm starts up and raises working capital, it is characterized by a low ratio of real assets to total assets. When it is in full production/operation, it has a high ratio of real assets to total assets. When the project "shuts down" and the firm sells it off for cash, financial assets once again replace real assets. 9.

a. This is a primary market transaction in which gold certificates are being offered to public investors for the first time by an underwriting syndicate led by JW Korth Capital. b. The certificates are derivative assets because they represent an investment in physical gold, but each investor receives a certificate and no gold. Note that investors can convert the certificate into gold during the four-year period.

10.

a. A fixed salary means that compensation is (at least in the short run) independent of the firm's success. This salary structure does not tie the manager’s immediate compensation to the success of the firm, so a manager might not feel too compelled to work hard to maximize firm value. However, the manager might view this as the safest compensation structure and therefore value it more highly. b. A salary that is paid in the form of stock in the firm means that the manager earns the most when the shareholders’ wealth is maximized. Five years of vesting helps align the interests of the employee with the long-term performance of the firm. This structure is therefore most likely to align the interests of managers and shareholders. If stock compensation is overdone, however, the manager might view it as overly risky since the manager’s career is already linked to the firm, and this undiversified exposure would be exacerbated with a large stock position in the firm. Bodie et al. Investments 10th Canadian Edition Solutions Manual © 2022 McGraw-Hill Education Ltd. 1-3

c. A profit-linked salary creates great incentives for managers to contribute to the firm’s success. However, a manager whose salary is tied to short-term profits will be risk seeking, especially if these short-term profits determine salary or if the compensation structure does not bear the full cost of the project’s risks. Shareholders, in contrast, bear the losses as well as the gains on the project and might be less willing to assume that risk. 11.

Even if an individual shareholder could monitor and improve managers’ performance and thereby increase the value of the firm, the payoff would be small, since the ownership share in a large corporation would be very small. For example, if you own $10,000 of Loblaw stock and you can increase the value of the firm by 5%, a very ambitious goal, you benefit by only: 0.05  $10,000 = $500. The cost, both personal and financial to an individual investor, is likely to be prohibitive and would typically easily exceed any accrued benefits, in this case $500. In contrast, a creditor, such as a bank that has a multimillion-dollar loan outstanding to the firm, has a big stake in making sure that the firm can repay the loan. It is clearly worthwhile for the bank to spend considerable resources to monitor the firm.

12.

Mutual funds accept funds from small investors and invest, on behalf of these investors, in the domestic and international securities markets. Pension funds accept funds and then invest in a wide range of financial securities, on behalf of current and future retirees, thereby channeling funds from one sector of the economy to another. Venture capital firms pool the funds of private investors and invest in start-up firms. Banks accept deposits from customers and loan those funds to businesses or use the funds to buy securities of large corporations.

13.

Treasury bills serve a purpose for investors who prefer a low-risk investment. The lower average rate of return compared to stocks is the price investors pay for higher liquidity and the predictability of investment performance and portfolio value.

14.

With a top-down investing style, you focus on asset allocation or the broad composition of the entire portfolio, which is the major determinant of overall performance. Moreover, topdown management is the natural way to establish a portfolio with a level of risk consistent with your risk tolerance. The disadvantage of an exclusive emphasis on top-down issues is that you may forfeit the potential high returns that could result from identifying and concentrating in undervalued securities or sectors of the market. With a bottom-up investing style, you try to benefit from identifying undervalued securities. The disadvantage is that investors might tend to overlook the overall composition of your portfolio, which may result in a non-diversified portfolio or a portfolio with a risk level inconsistent with the appropriate level of risk tolerance. In addition, this technique tends to require more active management, thus generating more transaction costs. Finally, the bottomup analysis may be incorrect, in which case there will be a fruitlessly expended effort and money attempting to beat a simple buy-and-hold strategy. Bodie et al. Investments 10th Canadian Edition Solutions Manual © 2022 McGraw-Hill Education Ltd. 1-4

15.

You should be skeptical. If the author actually knows how to achieve such returns, one must question why the author would then be so ready to sell the secret to others. Financial markets are very competitive; one of the implications of this fact is that riches do not come easily. High expected returns require bearing some risk, and obvious bargains are few and far between. Odds are that the only one getting rich from the book is its author.

16.

Financial assets provide for a means to acquire real assets as well as an expansion of these real assets. Financial assets provide a measure of liquidity to real assets and allow for investors to more effectively reduce risk through diversification.

17.

Allowing traders to share in the profits increases the traders’ willingness to assume risk. Traders will share in the upside potential directly in the form of higher compensation but only in the downside indirectly in the form of potential job loss if performance is bad enough. This scenario creates a form of agency conflict known as moral hazard, in which the owners of the financial institution share in both the total profits and losses, while the traders will tend to share more of the gains than the losses.

18.

Answers may vary; however, students should touch on the following: increased transparency, regulations to promote capital adequacy by increasing the frequency of gain or loss settlement, incentives to discourage excessive risk taking, and the promotion of more accurate and unbiased risk assessment.

CHAPTER 2: FINANCIAL MARKETS, ASSET CLASSES, AND FINANCIAL INSTRUMENTS PROBLEM SETS: 1.

Money market securities are called “cash equivalents” 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. a. rBEY

1,000 − P 365  n P

rBEY

1,000 − 960 365  = .083562, or 8.36% 960 182

b. One reason is that the discount yield is computed by dividing the dollar discount from par by the par value, $10,000, rather than by the bill’s price, $9,600. A second reason is that the discount yield is annualized by a 360-day rather than a 365-day year. 3.

P = $1,000 [1 – rBD (n/360)] where rBD is the discount yield. Pask = $1,000[1 – .0681(60/360)] = $988.65 Pbid = $1,000 [1 – .0690(60/360)] = $988.50

rBEY

1,000 − P 365  n P

1,000 − 988.65 365  = 6.98%, 60 988.65

which exceeds the discount yield, rBD = 6.81%. To obtain the effective annual yield, rEAY, note that the 60-day growth factor for invested funds 1,000 is = 1.01148. Annualizing this growth rate results in 988.65 1 + rEAY = ( 5.

1,000 365/60 ) = 1.0719 which implies that rEAY = 7.19%. 988.65

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P = $10,000/[1 + 0.05 × (91/365)] = $ 9,876.88. 4

a. i.

1 + r = ($10,000/$9,764) = 1.1002 r = 10.02% 2

ii.

1 + r = ($10,000/$9,539) = 1.0990 r = 9.90% The three-month bill offers a higher effective annual yield.

b. i.

rBD =

1,000 − 976.4 360  91 = 0.0934 = 9.34% 1,000

ii.

rBD =

1,000 − 953.9 360  182 = 0.0912 = 9.12% 1,000

90 a. Price = $1,000 × [1 – 0.03 × 360 ] = $992.5 b. 90-day return =

1,000 − 992.5 = 0.007557 = 0.7557% 992.5

365 c. rBEY = 0.7557% × 90 = 3.06% d. Effective annual yield = (1.007557)365/90 – 1 = 0.0310 = 3.10% 8.

The bill has a maturity of one half-year (180 days), and an annualized discount of 9.18%. Therefore, its actual percentage discount from par value is half of 9.18% = 9.18% × 1/2 = 4.59%. The bill will sell for $100,000 × (1– 0.0459) = $95,410.

The total before-tax income is $4. Since the dividend income is fully excluded from taxable income for corporations, the after-tax income is also $4, for a rate of return of $4/$40 = 10%.

10. a. The index at t = 0 is ($60 + $80 + $20)/3 = $53.33, or 53.33. At t = 1, it is ($70 + $70 + $25)/3 = $55, or 55, for a rate of return of 3.13%. Please note that index values are unit free, therefore we have used 53.33 instead of $53.33. b. Stock Q P0 Market Value P1 Market Value at Time t = 0 at Time t = 1 (Q * P0) (Q * P1) A 200 $60 $12,000 $70 $14,000 B 500 $80 $40,000 $70 $35,000 C 600 $20 $12,000 $25 $15,000 Total Market Capitalization $64,000 $64,000 Bodie et al. Investments 10th Canadian Edition Solutions Manual © 2022 McGraw-Hill Ryerson Ltd.

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Let’s arbitrarily choose a starting (t = 0) value of the value-weighted index to 100. The change in total market capitalization in t = 1 is 0 (=64000/64000 - 1). That means rate of return is zero. Therefore, the index value for t =1 would be 100 x (1+0.00) = 100.

c. Stock A B C

Before Splits P0 Q $60 200 $80 500 $20 600

After Splits P0 Q $30 400 $20 2,000 $20 600

P1 $35 $17.5 $25

After the splits the index has to remain unchanged so the divisor (which initially was 3) has to be reset. The sum of the three prices after the split is 70, while the index value before splits was 53.33. Therefore, the divisor has to reset in such a way that index value remains unchanged, i.e. $70/d = 53.33 and the new divisor must be 1.3125. The index at t = 1 is ($35 + $17.5 + $25)/1.3125 = 59.05 for a return of 10.71%. d. The total market value of A and B as well as the total market capitalization has remained unchanged after the two splits so that the return on the value-weighted index is not affected by the splits (and it is zero). 11. a. The index at t = 0 is ($90 + $50 + $100)/3 = 80. At t = 1, it is $250/3 = 83.333, for a rate of return of 4.17%. b. In the absence of a split, stock C would sell for 110, and the index would be 250/3 = 83.333. After the split, stock C sells at 55. Therefore, we need to set the divisor d such that 83.333 = (95 + 45 + 55)/d, meaning that d = 2.34. c. The index remains unchanged, as it should, since the return on each stock separately equals zero. Note: Total market capitalization Time (t) Market Cap. t=0 $39,000 t=1 $40,500 t=2 $40,500 If we set index value for t =0 to 100*39,000/39,000 = 100, then Index value for t = 1 would be 100*40,500/39,000 = 103.846 Index value for t = 2 would be 100*40,500/39,000 = 103.846 Therefore, percentage change in index from t=1 to t=2 is zero Bodie et al. Investments 10th Canadian Edition Solutions Manual © 2022 McGraw-Hill Ryerson Ltd.

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12. a. Total market value at t = 0 is ($9,000 + $10,000 + $20,000) = $39,000. Market value at t = 1 is ($9,500 + $9,000 + $22,000) = 40,500. The corresponding indices are 100 and 103.846 for t = 0 and t = 1 respectively. Therefore, the rate of return = $40,500/$39,000 – 1 = 3.85%, or 103.846/100 -1 = 3.85%. b. The return on each stock is as follows: rA = 95/90 – 1 = 0.0556 rB = 45/50 – 1 = –0.10 rC = 110/100 – 1 = 0.10 The equally-weighted index return = (0.0556-0.10+0.10)/3 =0.0185 = 1.85% 13. a. Since these two bonds are identical except in their coupon rate, the bond with higher coupon rate should be selling at higher price. b. The call with the lower exercise price because there is an inverse relationship between value of call option and exercise price. c. The put on the lower priced stock because put option becomes worthier when stock price departures below from its exercise price. d. As there is inverse relationship between T-bill yield and T-bill price, the bill with the lower yield should be selling at higher price. 14.

Preferred stock is like a long-term debt in which the firm (or issuer) typically promises a fixed dividend payment each year. Preferred stock, also, does not give the holder voting rights in the firm.

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Preferred stock is like equity (common stock) in which the firm is under no contractual obligation to make the dividend payments. Failure to make payments does not set off corporate bankruptcy. With respect to the priority of claims to the assets of the firm in the event of corporate bankruptcy, preferred stock has a higher priority than common equity but a lower priority than bonds. Generally preferred stocks like common stocks are perpetual. 15.

Value of call at expiration a. $0 b. $0 c. $0 d. $5 e. $10

–

Initial cost $4 $4 $4 $4 $4

Profit $–4 $–4 $–4 $1 $6

Value of put at expiration

–

Initial cost

Profit

a. b. c. d. e.

$10 $5 $0 $0 $0

$6 $6 $6 $6 $6

$4 $–1 $–6 $–6 $–6

16.

Generally, there are some chances (probabilities) that the option will be in-the-money at some point prior to expiration. Investors will pay something for these chances of positive payoffs.

17.

A call option conveys the right but not the obligation 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 predetermined price.

18.

A put option conveys the right but not the obligation 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 predetermined price.

19.

Individual response. However, on the day that we tried this experiment, 18 of the 25 stocks met this criterion, leading us to conclude that returns on stock investments can be quite volatile.

20.

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.

21. a. Because the stock price exceeds the exercise price, you will choose to exercise. The payoff on the option will be $25 − $20 = $5. The option originally cost $1.92, so the gain is $5.00 − $1.92 = $3.08. Since the contracts are for 100 shares, your gain is $308.00. b. If the exercise price is $20, and the stock price $19, you would not exercise. The loss on the call would be the initial cost, which was $1.92. Your total loss is therefore $192.00. Bodie et al. Investments 10th Canadian Edition Solutions Manual © 2022 McGraw-Hill Ryerson Ltd.

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c. If the put has an exercise price of $22, you would exercise if the stock price is $19 at expiration. The put would be exercised for a gain of $22 – $19 = $3 which would give a total profit of ($3 gain – $2.29 cost)*100 = $71.00. 22. a. Enbridge closed at $39.21. b. Assuming that you buy at the closing price, you could buy $5,000/$39.21 = 127.52 shares, which we will round to 128. c. The annual dividend is 4*.$81= $3.24 per share. Your total dividend income is therefore $3.24*128=$414.72 annually. d. While the earnings per share (EPS) has been provided in the figure 2.8 as $.95, we can find it using the price-to-earnings (P/E) and the stock price. EPS = Price/ P/E ratio = $39.21/41.3 = $.95. 23. a. You bought the contract when the futures price (index points) was 962.9 (the settlement price). The contract closes at an index points of 990, which is 27.1 higher than the original futures index points. The contract multiplier is $200. Therefore, you will incur a gain of 27.1  $200 = $5420. Note: you can find more information about SFX contract it from the Montreal Exchange website: https://www.m-x.ca/produits_indices_sxf_en.php. b. Open interest (the number of outstanding contracts) on the index is 291,708 contracts. CFA PROBLEMS 1.

(d) There are tax advantages for corporations that own preferred shares and a large majority of institutional investors such as pension funds invest in preferred stocks.

(a) Writing a call entails unlimited potential losses as the stock price rises.

The equivalent taxable yield is: .0675/(1 − 0.34) = 10.23%

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 yield on the municipal bond.

The taxable bond. The after-tax yield for the taxable bond is: 0.05  (1 – 0.10) = 4.5%

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The after-tax yield is the same as that of the municipal bond. d.

The municipal bond offers the higher after-tax yield for investors in tax brackets above 20%.

If the after-tax yields are equal, then: 0.056 = 0.08 × (1 – t) This implies that t = 0.30 =30%.

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CHAPTER 3 TRADING ON SECURITIES MARKETS PROBLEMS: 1.

Individual solution—answers to this problem will vary. In general, full-service brokers charge more fees/commission on trading than the discount brokers because full-service entails cost for the resources such as personnel (financial advisors), facilities and technologies.

2. a.

In principle, potential losses are unbounded, growing directly with increases in the share price of Restaurant Brands.

If the stop-buy order can be filled at $78, the maximum possible loss per share is $8. If Restaurant Brand’s shares go above $78, the stop-buy order is executed, limiting the losses from the short sale.

3. a.

The stock is purchased for 300  $40 = $12,000. Borrowed funds are $4,000. Therefore, the investor put up equity or margin of $8,000.

If the share price falls to $30, the total value of the stocks falls to $9,000. The amount of the loan owed to the broker grows to $4,000  1.08 = $4,320. Therefore, remaining margin is $9,000 − $4,320 = $4,680. The percentage margin is now $4,680/$9,000 = 0.52 = 52%, so there will not be a margin call. c. The rate of return on investment over the years is (Ending value of account − Initial equity)/Initial equity = ($4,680 − $8,000)/$8,000 = −0.415 = −41.5%.

a. The initial margin was 0.50  1,000  $40 = $20,000. Old Economy Traders loses $10  1,000 = $10,000 due to the increase in the stock price so margin falls by $10,000. Moreover, the firm must pay the dividend of $2 per share, which means the margin account falls by an additional $2,000. So, the remaining margin is $8,000. b. The percentage margin is $8,000/$50,000 = 0.16 = 16%, so there will be a margin call. c. The margin in the account fell from $20,000 to $8,000 in one year, for a rate of return of −$12,000/$20,000 = −0.60 = −60%. Bodie et al. Investments 10th Canadian Edition Solutions Manual ..

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The stop-loss order will be executed as soon as the stock price hits the limit price. If the stock price later rebounds, the investor does not participate in the gains because the stock has been sold. In contrast, the put option need not be exercised when the stock price falls below the exercise price. An investor who owns a share of stock and a put option can hold on to both securities. If the stock price never rebounds, the put can be exercised eventually, and the stock sold for the exercise price. This provides the same downside protection as the stop-loss order. If the price does rebound, however, the investor benefits because the stock is still held. This advantage of the put over the stop-loss order justifies the cost of the put.

Calls are options to purchase a stock at any time prior to expiration. Stop-buys require purchase as soon as the stock price hits the limit. The advantage of the call over the stop-buy is that the investor need not commit to buying until expiration. If the stock price later falls, the holder of the call can choose not to purchase.

Placing a stop-loss order to sell at $38, you are telling your broker to sell Barrick stock as soon as a sale takes place at a price of $38 or less. Here, the broker will attempt to execute your order considering the bid price. Since the bid price now is $37.80 which is below $38, the broker executes your order (at current market price) and sell the stock at $37.80.

The broker is instructed to attempt to sell your Kinross stock as soon as the Kinross stock trades at a bid price of $11.50 or less. Here, the broker will attempt to execute, but may not be able to sell at $11.50, since the bid price is now $11.47. The price at which you sell may be more or less than $11.50 because the stop-loss becomes a market order to sell at current market prices. If the bid has sufficient quantity you are likely to get $11.47, however.

9. a.

The buy order will be filled at the best limit-sell order, $50.25.

At the next-best price, $51.50.

You should increase your position. There is considerable buy pressure at prices just below $50, meaning that downside risk is limited. In contrast, sell pressure is sparse, meaning that a moderate buy order could result in a substantial price increase.

10. The system expedites the flow of market orders or limit orders from exchange members to the specialists. It allows members to send computerized orders directly to the floor of the exchange, which allows the nearly simultaneous sale of each stock in a large portfolio. This capability is necessary for program trading. 11. The dealer (or market maker). Spreads should be higher on inactive stocks and lower on Bodie et al. Investments 10th Canadian Edition Solutions Manual ..

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