Solution Manual for Investments , Ninth Canadian Edition

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Bodie et al.Investments9thCanadian EditionSolutions Manual1-1CHAPTER 1:THEINVESTMENTENVIRONMENTPROBLEM SETS:1.While it is ultimatelytrue that real assets determine the material well-being of an economy,financial innovation in the form of bundling and unbundling securities createsopportunitiesfor investors to form more efficient portfolios. Both institutional and individual investorscan benefit when financial engineering creates new products that allow them to managetheir portfolios of financial assets more efficiently. Bundling and unbundling createfinancial products with new properties and sensitivities to various sources of riskthatallowsinvestors toreduce volatility by hedgingparticular sources of risk more efficiently.2.Securitization requires access to a large number of potential investors.To attract theseinvestors, the capital market needs:1.Asafe system of business laws and low probability of confiscatorytaxation/regulation;2.Awell-developed investment banking industry;3.Awell-developed system of brokerage and financial transactions;and4.Awell-developed media, particularly financial reporting.These characteristics are found in (indeed make for) a well-developed financial market.3.Securitization leads to disintermediation; that is, securitization provides a means formarket participants to bypass intermediaries.For example, mortgage-backed securitieschannel funds to the housing market without requiring that banks or thrift institutionsmake 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 otherrevenue-generating activities such as providing short-term liquidity to consumers andsmall business and financial services.4.The existence of efficient capital markets and the liquid trading of financial assets makeiteasy for large firms to raise the capital needed to finance their investments in real assets.IfFord, for example, could not issue stocks or bonds to the general public, it would havea far more difficult time raising capital.Contraction of the supply of financial assetswould make financing more difficult, thereby increasing the cost of capital.A higher costof capitalresults inless investment and lower real growth.5.Even if the firm does not need to issue stock in any particular year, the stock market is stillimportant to the financial manager.Thestock price provides important information abouthow the market values the firm's investment projects.For example, if the stock price risesconsiderably, managers might conclude that the market believes the firm's future prospectsare bright.This might be a useful signal to the firm to proceed with an investment such as anexpansion of the firm's business.

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Bodie et al.Investments9thCanadian EditionSolutions Manual1-2In addition, sharesthatcan be traded in the secondary marketare moreattractive toinitialinvestors sincethey know thatthey will be able to sell their shares.This in turn makesinvestors more willing to buy shares in a primary offering and thus improves the terms onwhich firms can raise money in the equity market.Remember that stock exchanges like those in New York,Toronto, andLondon are the heartof capitalism, in which firms can raise capital quickly in primary markets because investorsknow there are liquid secondary markets.6.a.No.The increase in price did not add tothe productive capacity of the economy.b.Yes, the value of the equity held in theseassetshasincreased.c.Future homeownersas a wholeareworse off, sincemortgage liabilities have alsoincreased.In addition,this housing price bubble will eventually burst andsociety as awhole (and most likelytaxpayers) willsufferthe damage.7.a.Primary-market transactionin which gold certificates are being offered to publicinvestors 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 physicalgold, but each investor receives a certificate and no gold. Note that investors can convertthe certificate into gold during the four-year period.c.Investors who wish to hold gold without the complication, risk,and cost of physicalstorage.8.a.A fixed salarymeans that compensation is (at least in the short run) independent of thefirm's success.This salary structure does not tie the manager’s immediate compensationto the success of the firm, so a manager might not feel too compelled to work hard tomaximize firm value.However, the manager might view this as the safest compensationstructure 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 mostwhen the shareholders’ wealth ismaximized.Five years of vesting helps align the interests ofthe employee with the long-term performance of the firm.This structure is therefore mostlikely 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 alreadylinked to the firm, and this undiversified exposure would be exacerbated with a large stockposition in the firm.c.Aprofit-linked salarycreatesgreat incentives for managers to contribute to the firm’ssuccess.However, a managerwhose salary is tied to short-term profits will be risk seeking,especially if these short-term profits determine salaryor if the compensation structure doesnotbear thefullcost of theproject’srisks.Shareholders, in contrast, bear the losses as wellas the gains on the project and might be less willing to assume that risk.

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Bodie et al.Investments9thCanadian EditionSolutions Manual1-39.Even if an individual shareholder could monitor and improve managers’ performance andthereby increase the value of the firm, the payoff would be small, since the ownership sharein a large corporation would be very small.For example, if you own $10,000 ofFordstockand 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, islikely to be prohibitive and would typically easily exceed any accrued benefits, in this case$500.In contrast,an institutional investor holds a much larger position in the stock and as such,there is a greater payoff to monitoring the firm. Acreditor,such as abank that has amultimillion-dollar loan outstanding to the firm,has a big stake in making sure that the firmcan repay the loan.It is clearly worthwhile for the bank to spend considerable resources tomonitor the firm.10.Mutual funds accept funds from small investors and invest, on behalf of these investors,in thedomesticand international securities markets.Pension funds accept funds and then investin a wide range of financial securities, on behalfof current and future retirees, thereby channeling funds from one sector of the economy toanother.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 tobuy securities of large corporations.11.Treasury bills serve a purpose forinvestors who prefer a low-risk investment.Thelower average rate of return compared to stocks is the price investors pay forpredictability of investment performance and portfolio value.12.Witha top-down investing style, you focus on assetallocation or the broad composition ofthe entire portfolio, which is the major determinant of overall performance.Moreover, top-down management is the natural way to establish a portfolio with a level of risk consistentwith your risk tolerance.The disadvantage of anexclusiveemphasis on top-down issues isthat you may forfeit the potential high returns that could result from identifying andconcentrating in undervalued securities or sectors of the market.With abottom-up investing style, you try to benefit from identifying undervalued securities.The disadvantage is thatinvestors mighttend to overlook the overall composition of yourportfolio, which may result in a non-diversified portfolio or a portfolio with a risk levelinconsistent withthe appropriatelevel of risk tolerance.In addition, this technique tends torequire more active management, thus generating more transaction costs.Finally,the bottom-upanalysis may be incorrect, in which casethere will be afruitlessly expended effort andmoney attempting to beat a simple buy-and-hold strategy.13.You should be skeptical.If the author actually knowshow to achieve such returns, one mustquestion why the author would then be so ready to sell the secret to others.Financial marketsare 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 farbetween.Odds arethatthe only one getting rich from the book is its author.

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Bodie et al.Investments9thCanadian EditionSolutions Manual1-414.Financialassets provide for a means to acquire real assets as well as an expansion of thesereal assets.Financial assets provide a measure of liquidity to real assets and allow forinvestors tomore effectivelyreduce risk through diversification.15.Allowing traders to share in the profits increases the traders’ willingness to assumerisk.Traders will share inthe upside potential directly in the form of higher compensation butonly in the downside indirectly in the form of potential job loss if performance is badenough. This scenario creates a form of agency conflict known as moral hazard, in whichthe owners of the financial institution share in both the total profits and losses, while thetraders will tend to share more of the gains than the losses.16.Answers mayvary;however, students should touch on the following: increasedtransparency, regulations to promote capital adequacy by increasing the frequency of gainor loss settlement, incentives to discourage excessive risk taking, and the promotion ofmore accurate and unbiased risk assessment.

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Bodie et al. Investments 9th Canadian Edition Solutions Manual2-1CHAPTER 2:FINANCIAL MARKETS, ASSET CLASSES,AND FINANCIAL INSTRUMENTSPROBLEM SETS:1.Money market securities are called “cash equivalents” because of their great liquidity. Theprices of money market securities are very stable, and they can beconverted to cash (i.e., sold)on very short notice and with very low transaction costs.2.a.𝑟஻ா௒=ଵ0,000ି௉௉×365௡𝑟஻ா௒=ଵ0,000ିଽ,600ଽ600×365ଵ82=.083562,𝑜𝑟8.36%b.One reason is that the discount yield iscomputed by dividing the dollar discount from par bythe par value, $10,000, rather than by the bill’s price, $9,600. A second reason is that thediscount yield is annualized by a 360-day rather than a 365-day year.3.P= $1,000 [1–rBD(n/360)] whererBDis the discount yield.Pask= $1,000[1–.0681(60/360)] = $988.65Pbid= $1,000 [1–.0690(60/360)] = $988.504.rBEY=PP000,1365n=65.98865.988000,136560= 6.98%,which exceeds the discount yield,rBD= 6.81%.To obtain the effective annual yield,rEAY, note that the 60-day growth factor for invested fundsis65.988000,1=1.01148. Annualizing this growth rate results in1 +rEAY=(65.988000,1)365/60=1.0719 which implies thatrEAY= 7.19%.5.According to equation 2.2:

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Bodie et al. Investments 9th Canadian Edition Solutions Manual2-2P= $10,000/[1 +rBEY× (n/365)]P= $10,000/[1 + 0.05 × (91/365)] = $ 9,876.88.6.a.i.1 +r= ($10,000/$9,764)4= 1.1002r= 10.02%ii.1 +r= ($10,000/$9,539)2= 1.0990r= 9.90%The three-month bill offers a higher effective annual yield.b.i.rBD=000,14.976000,136091= 0.0934 = 9.34%ii.rBD=000,19.953000,1360182= 0.0912 = 9.12%7.a.Price = $1,000 × [1–0.03 ×90360] = $992.5b.90-day return =5.9925.992000,1= 0.007557= 0.7557%c.rBEY= 0.7557% ×36590= 3.06%d.Effective annual yield =(1.007557)365/90–1 = 0.0310 = 3.10%8.The bill has a maturity of onehalf-year, and an annualized discount of 9.18%. Therefore, itsactual percentage discount from par value is 9.18% × 1/2 = 4.59%. The bill will sell for$100,000 × (1–0.0459) = $95,410.9.The total before-tax income is $4. Since the dividend income is fully excluded from taxableincome, the after-tax income is also $4, for a rate of return of 10%.10.a. The index att= 0 is ($60 + $80 + $20)/3 = $53.33. Att= 1, it is ($70 + $70 + $25)/3 = $55, fora rate of return of 3.13%.b.

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Bodie et al. Investments 9th Canadian Edition Solutions Manual2-3StockQP0Market ValueP1Market ValueA200$60$12,000$70$14,000B500$80$40,000$70$35,000C600$20$12,000$25$15,000The index att= 0 is ($12,000 + $40,000 + $12,000)/100 = 640. Att= 1, it is also 640, so therate of return is zero.c.Before SplitsAfter SplitsStockP0QP0QP1A$60200$30400$35B$80500$202,000$17.5C$20600$20600$25After the splits the index has to remain unchanged so the divisor (which initially was 3) has tobe reset. The sum of the three prices after the split is 70, while the index value before splits was53.33. Therefore $70/d= 53.33 and the new divisor must be 1.3125. The index att= 1 is ($35+ $17.5 + $25)/1.3125 = 59.05 for a return of 10.71%.d. The total market value ofAandBas well as that of the market remain unchanged after the twosplits so that the return on the value-weighted index is not affected by the splits (and it is zero).11.a.The index att= 0 is ($90 + $50 + $100)/3 = 80. Att= 1, it is $250/3 = 83.333, for a rate ofreturn of 4.17%.b.In the absence of a split, stockCwould sell for 110, and the index would be 250/3 = 83.333.After the split, stockCsells at 55. Therefore, we need to set the divisordsuch that 83.333 =(95 + 45 + 55)/d, meaning thatd= 2.34.c.The return is zero. The index remains unchanged, as it should, since the return on each stockseparately equals zero.12.a.Total market value att= 0 is ($9,000 + $10,000 + $20,000) = $39,000. Market value att= 1 is($9,500 + $9,000 + $22,000) = 40,500. Rate of return = $40,500/$39,000–1 = 3.85%.b.The return on each stock is as follows:rA= 95/90–1 = 0.0556rB= 45/50–1 =–0.10rC= 110/100–1 = 0.10The equally-weighted average is 0.0185 = 1.85%

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Bodie et al. Investments 9th Canadian Edition Solutions Manual2-413.a.The higher coupon bond.b.The call with the lower exercise price.c.The put on the lower priced stock.d.The bill with the lower yield.14.Preferred stock is like a long-term debt in which it typically promises a fixed payment eachyear. In this way, it is a perpetuity. Preferred stock, also, does not give the holder voting rightsin the firm.

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Bodie et al. Investments 9th Canadian Edition Solutions Manual2-5Preferred stock is like equity in which the firm is under no contractual obligation to make thepreferred stock dividend payments. Failure to make payments does not set off corporatebankruptcy. With respect to the priority of claims to the assets of thefirm in the event ofcorporate bankruptcy, preferred stock has a higher priority than common equity but a lowerpriority than bonds.15.Valueof call at expiration–Initial cost=Profita.$0$4$–4b.$0$4$–4c.$0$4$–4d.$5$4$ 1e.$10$4$ 6Value of put at expiration–Initial cost=Profita.$10$6$ 4b.$5$6$–1c.$0$6$–6d.$0$6$–6e.$0$6$–616.There is always a chance that the option will be in the money at some point prior to expiration.Investors will pay something for this chance of a positive payoff.17.A call option conveys therightto buy the underlying asset at the exercise price. A longposition in a futures contract carries anobligationto buy the underlying asset at the futuresprice.18.A put option conveys therightto sell the underlying asset at the exercise price. A shortposition in a futures contract carries anobligationto buy the underlying asset at the futuresprice.19.Individual response. However, on the day that we tried this experiment, 18 of the 25stocks met this criterion, leading us to conclude that returns on stock investments can bequite volatile.20.The spread will widen. Deterioration of the economy increases credit risk, that is, thelikelihood of default. Investors will demand a greater premium on debt securities subjectto default risk.21.a.Because the stock price exceeds the exercise price, you will choose to exercise. The payoff onthe option will be $41$39 = $2. The option originally cost $1.35, so the gain is $2.00$1.35 = $0.65. Since the contracts are for 100 shares, your gain is $65.00.

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Bodie et al. Investments 9th Canadian Edition Solutions Manual2-6b.If the exercise price were $40, and the stock price $39, you would not exercise. The loss on thecall would be the initial cost, which was $0.59. Your total loss is therefore $59.00.c.If the put has an exercise price of $42, you would not exercise for any stock price of $42 orabove. The loss on the put would be the initial cost, which was $1.88*100=$188.00. With ashare price of $40, the put would be exercised for a gain of $2 ($42–$40) which would give aprofit of $12.00 (($2 gain–$1.88 cost)*100).22.a.Aecon closed at $17.81.b.Assuming thatyou buy at the closing price, you could buy $5,000/$17.81 = 280 shares.c.The dividend is 2.8% of $17.81, which is probably an annual amount of $.50; your dividendincome would be 280$ .50 = $140 annually.d.The price-to-earnings ratio is 25.8, and price is $17.81. Therefore,Earnings (E.P.S.) = $17.81/25.8E.P.S. = $0.6923.a.You bought the contract when the futures price was 885.5 (see Figure 2.12). The contractcloses at a price of $900, which is $14.5 higher than the original futures price. The contractmultiplier is 200. Therefore, you will incur a gain of $14.5200 = $2,900.b.Open interest on the index is240,890contracts.24.d25.a. Writing a call entails unlimited potential losses as the stock price rises.

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Bodie et al.Investments9thCanadian EditionSolutions Manual3-1CHAPTER 3:HOW SECURITIES ARE TRADEDPROBLEMSETS:1.Individual solution—answers to this problem will vary.2.a.In principle, potential losses are unbounded, growing directly with increases in the priceof Alcan.b.If the stop-buy order can be filled at $78, the maximum possible loss per share is $8. IfAlcan’s shares go above $78, the stop-buy order is executed, limiting the losses from theshort 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.b.If the share price falls to $30, the value of the stock falls to $9,000. The amountof theloan owed to the broker grows to $4,0001.08 = $4,320. Therefore, remaining marginis$9,000$4,320 = $4,680.The percentage margin is now$4,680/$9,000 =0.52= 52%, so there will not be amargin call.c.The rate of return on investment over the years is (Ending value of accountInitialequity)/Initialequity= ($4,680$8,000)/$8,000 =0.415 =41.5%.4.a.The initial margin was0.501,000$40 = $20,000. The firm loses $101,000 = $10,000due to the increase in the stock price so margin falls by $10,000. Moreover, the firm must paythe dividend of$2 per share, which means themargin account falls by an additional $2,000. Sotheremaining 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%.5.The stop-loss order will be executed as soon as the stock price hits the limit price. If thestock price later rebounds, the investor does not participate in the gains because thestock has been sold. In contrast, the put option need not be exercised when the stock

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Bodie et al.Investments9thCanadian EditionSolutions Manual3-2price falls below the exercise price. An investor who owns a share of stock and a putoption can hold on to both securities. If the stock price never rebounds, the put can beexercised eventually, and the stock sold for the exercise price. This provides the samedownside protection as the stop-loss order. If the price does rebound, however, theinvestor benefits because the stock is still held. This advantage of the put over the stop-loss order justifies the cost of the put.6.Calls are options to purchase a stock at any time prior to expiration. Stop-buys requirepurchase 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 laterfalls, the holder of the call can choose not to purchase.7.The broker is to attempt to sell Barrickstockas soon as a sale takes place at a price of$38 or less. Here, the broker will attempt to execute if a sale takes place at the bid price,but may not be able to sell at $38, since the bid price is now $37.80.8.The broker is instructed to attempt to sell your Kinross stock as soon as the Kinross stocktrades at a bid price of $38 or less. Here, the broker will attempt to execute, but may not beable to sell at $38, since the bid price is now $37.85. The price at which you sell may bemore or less than $38 because the stop-loss becomes a market order to sell at current marketprices. If the bid has sufficient quantity you are likely to get $37.85, however.9.a.The buy order will be filled at the best limit-sell order, $50.25.b.At the next-best price, $51.50.c.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 thata moderate buy order could result in a substantial price increase.10.The system expedites the flow ofmarketordersor limit ordersfrom exchange members tothe specialists. It allows members to send computerized orders directly to the floor of theexchange, which allows the nearly simultaneous sale of each stock in a large portfolio. Thiscapability is necessary for program trading.11.The dealer(or market maker). Spreads should be higher on inactive stocks and lower on activestocks.12.Cost of purchase is $80×250 = $20,000. You borrow $5,000 from your broker, andinvest $15,000 of your own funds. Your margin account starts out with a net worth of$15,000.a.(i)Net worth rises by $2,000 from $15,000 to $88×250–$5,000 = $17,000.Percentage gain = $2,000/$15,000 =0.1333 = 13.33%

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Bodie et al.Investments9thCanadian EditionSolutions Manual3-3(ii)With unchanged price, net worth remains unchanged.Percentage gain = zero(iii)Net worth falls to $72×250–$5,000 = $13,000.Percentage gain =–$2,000$15,000=–0.1333 =–13.33%The relationship between the percentage change in the price of the stock and theinvestor’s percentage gain is given by:% gain = % change in price×Total investmentInvestor’s initial equity= % change in price×1.333For example, when the stock price rises from$80 to$88, the percentage change in price is10%, while the percentage gain for the investor is 1.333 times as large, 13.33%:% gain = 10%×$20,000$15,000= 13.33%b.The value of the 250 shares is 250P. Equity is 250P–$5,000. You will receive a margincall whenPP250000,5250=0.3 or whenP= $28.57c.The value of the 250 shares is 250P. But now you have borrowed $10,000 instead of$5,000. Therefore, equity is only$250P–$10,000. You will receive a margin call when3.250000,10250PPor whenP= $57.14With less equity in the account, you are far more vulnerable to a margin call.d.The margin loan with accumulated interest after one year is $5,000×1.08 = $5,400.Therefore, equity in your account is$250P–$5,400. Initial equity was $15,000. Therefore,your rate of return after one year is as follows:(i)000,15$000,15$)400,5$88$250(=0.1067, or 10.67%.

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Bodie et al.Investments9thCanadian EditionSolutions Manual3-4(ii)000,15$000,15$)400,5$80$250(=–0.0267, or–2.67%.(iii)000,15000,15$)400,5$72$250(=–0.160, or–16.0%.The relationship between the percentage change in the price of Intel and investor’spercentage return is given by% gain =% changein price×Total investmentInvestor’sinitial equity–8%×Funds borrowedInvestor’sinitial equityFor example, when the stock price rises from$80 to$88, the percentage change in priceis 10%, while the percentage gain for the investor is% gain =10%×20,00015,000–8%×500015,000= 10.67%e.The value of the 250 shares is$250P. Equity is$250P–$5,400. You will receive amargin call whenPP250400,5250=0.3or whenP= $30.8613.a.The gain or loss on the short position is (–250×P). Invested funds are $15,000.Therefore, rate of return = (–250×P)/$15,000. The returns ineach of the threescenarios are(i)Rateof return = (–250×$8)/$15,000 =–0.1333 =–13.33%(ii)Rateof return = (–250×$0)/$15,000 = 0(iii)Rateof return = [–250×(–$8)]/$15,000 = +0.1333 = +13.33%b.Total assets in the margin account are $20,000 (from the sale of the stock) + $15,000 (theinitial margin) = $35,000; liabilities are$250P. A margin call will be issued whenPP250250000,35= .30,or whenP= $107.69.c.(aa.) With a $2 dividend, the short position must also pay $2/share×250 shares = $500on the borrowed shares. Rate of return will be (–250×P–$500)/$15,000.

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Bodie et al.Investments9thCanadian EditionSolutions Manual3-5(i)Rateof return = (–250×$8–$500)/$15,000 =–0.1667 =–16.67%(ii)Rateof return = (–250×$0–$500)/$15,000 =–0.033 =–3.33%(iii)Rateof return = [–250×(–$8)–500]/$15,000 = +0.100 = +10.0%(bb.)Total assets (net of the dividend repayment) are $35,000–$500, and liabilities are$250P. A margin call will be issued when35,000–500–250P250P=0.30, or whenP= $106.1514.a.The trade will beexecuted atthe price of$55.50.b.The trade will beexecuted atthe price of$55.25.c.The trade will not be executed since the bid price is less than the price on the limit sellorder.d.The trade will not be executed since the asked price is greater than the price on the limitbuy order.15.The proceeds from the short sale (net of commission) were $14×100–$50 = $1,350.A dividend payment of $200 was withdrawn from the account. Coverage at $9 cost you(including commission) $900 + $50 = $950, leaving you with a profit of $1350–$200–$950 = $200.Note that your profit, $200, equals 100 shares×profit per share of $2. Your net proceedsper share were:$14sales price of stock–$ 9repurchase price of stock–$ 2dividend per share–$ 12 trades×$.50 commission per share on each trade.–––––––$ 216.a.You buy 200 shares of BCE. These shares increase in value by 10%, or $1000. You payinterest of .08×$5,000 = $400. The rate of return will be1000–4005000=0.12, or 12%.b.The value of the 200 shares is 200P. Equity is 200P–$5,000. You will receive a margin

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