1. Chapter 11 Securities Markets
Dr. Mariusz Dybał Institute of Economic Sciences
Chapter 11
Securities Markets
© 2014 John Wiley and Sons

2. Chapter Outcomes
Describe the processes and institutions used by businesses to distribute new securities to the investing public.
Outline the recent difficulties and changes in structure of the investment banking industry.
Describe how securities are traded among investors.
Identify the regulatory mechanisms by which the securities exchanges and the over-the-counter markets are controlled.
Explain influences that affect broker commissions.

3. Issuing Securities: Primary Security Markets
Primary versus secondary securities markets
Initial Public Offerings (IPOs)
Investment Banks

4. Functions of Investments Banks
Three Main Functions:
Origination
Underwriting
Selling
Public Offering
Private Placement
Prospectus

5. Investment Bank Functions, continued
Underwriting
“Carrying the risk”
Best efforts
Shelf registration
Private placement
Rights offerings
Competitive bids
Dutch auction

6. Dutch Auction Example Yoogle to offer 100 million shares
Bidder Price Number of shares
A $ million
B $ million
C $ million
D $ million
E $ million
Clearing price: $20.43

7. Investment Bank Functions, continued
Selling
Syndicate
Tombstone Ad
Aftermarket
Underwriting fees in 2012: $60 billion

8. The Costs of Raising Capital
The costs of issuing stocks and bonds are called “flotation costs.”
Out-of-pocket costs
Spread
Underpricing
The sum of these costs can total 20-30% or more of the funds raised
Hot/cold IPO markets

9. Innovations in Investment Banking
Security design to meet needs of issuers/purchases
Offering securities via internet “dutch auctions”—both stocks and bonds (Internotes, Direct Access Notes)

10. Facebook IPO
Syndicate: Morgan Stanley (lead) and 32 other investment banking firms
Offer price: $38 per share
Firm value at offer price: $104 billion
Underwriting fees: $176 million
Underwriters, firm agreed to raise offer price to $38 and increase number of shares to be sold shortly before the IPO

11. Facebook IPO Initial ‘pop’ at IPO…followed by price decline
Computer and trading issues at Nasdaq
Disappointing sales, profit news; GM pullout
Research analysts were reducing profit estimates for FB
Tough market—Groupon, Yelp, and Zynga hi-tech IPOs followed by price declines

12. Facebook IPO

13. What else do Investment Banks do?
Commercial paper
Mergers and acquisitions
Manage investment funds (e.g., company pension funds)

14. Investment Banking Regulations
Securities Act of 1933
Full, fair, and accurate disclosure
Prevent fraud
Securities Exchange Act of 1934
Established SEC
Brokers, dealers register with SEC
State “blue sky” laws

15. Investment Banking Regulations
Glass-Steagall Act
Commercial banks cannot underwrite securities
Gramm-Leach-Bliley Act
Removed many restraints of Glass-Steagall on financial services firms

16. Trading Securities: Secondary Securities Markets
Organized Exchange versus Over-the-Counter (OTC)
Organized Exchange: NYSE
NYSE is a private firm which went “public” in 2006 by acquiring a publicly traded firm (Archipelago) which offers electronic trading of securities

17. Structure of the NYSE Before 2006: members own “seats”
Now: 1500 trading licenses exist—called Stock Exchange Auction Trading System (SEATS)
SEATS allow holders access to the NYSE trading floor (physical location) and electronic trading access.

18. Structure of the NYSE Floor brokers Registered traders
House or commission brokers
Independent brokers
Registered traders
Designated Market Makers
Maintain inventory of stocks assigned to them
Maintain a liquid and orderly market
Took over the role of “specialists” on the NYSE

19. Structure of the NYSE
Companies need to meet listing requirements, pay fees
Original listing fee: $125,000-$250,000
Annual fee: $42,000-$500,000 depending on number of shares
Listing requirements:

20. Security Transactions
Bid price: offered by buyer
Ask: requested by seller
Spread: the difference between them
Narrower spreads imply more liquidity and faster completion of a trade
Typical display:
Bid: x 50900
Ask: x 50800

21. Security Transactions
Market order
Limit order
Stop order
Short sale
Uptick rule
Abolished in 2007, on a trial basis; occasionally consider re-instating it for all or some stocks.

22. Buying on Margin
“Buying on margin” means to use some of your money (equity) and some borrowed funds to purchase a security
Margin: investor’s equity position
Margin requirements: minimum percentage of the purchase price that the investor must pay from his/her funds

23. Margin’s effect on trading profits Assume: 60% margin
Initially buy securities worth $50,000
Initial
position t= t=2
Mkt value $50,000 $55,000 $45,000
Less: borrowed
funds , , ,000
Equity $30,000 $35, $25,000

24. More investing terms Margin call Maintenance margin
Margin = equity/market value
= (MV - $ borrowed)/MV
= (price x # shares - $ borrowed)
price x # shares
Price for margin call:
$ borrowed/[# shares (1-maint. margin)]

25. More terms…
Round lot
Odd lot
Program trading

26. Over-The-Counter Market (OTC)
NASDAQ
Not just for small firms
Intel, Apple, Microsoft
Centralized versus non-centralized location
Specialists versus dealers

27. Other Secondary Markets
Third Market
Large blocks (10,000 shares) traded OTC
Fourth Market
Electronic trading, ECNs

28. Securities Markets and Ethics Issues
In the past, some market makers and specialists have been accused of:
Front running
Negative obligation
Maintaining high spreads

29. What Makes a Good Market?
NYSE, AMEX, NASDAQ, 3rd and 4th market all compete for listings, trades
Four characteristics of a “good” market:
Liquidity (breadth and depth)
Quick, accurate trade execution
Reasonable listing requirements
Low costs

30. Commissions Commission affected by: Type of broker
Full service brokers
Discount brokers
On-line brokers
Size of trade, security price
Liquidity of securities traded
Ethics:
Account churning
Placing funds in high-commission or “fee kickback” products

31. Some issuing firms allow…
Direct investing
Buy shares directly from the firm
Dividend Reinvestment Plan

32. How’s the Market Doing?
Security Market Indexes are used to track overall market and sector performance for stocks, bonds, and other investments
Well-known stock market indexes:
Dow Jones Industrial Average
Based on price
Standard & Poor’s (S&P) 500
Based on market value

33. Wandering from Home: Investing Overseas
Diversification benefits
Harder to do trades
Liquidity
Currency differences
Regulations, tax laws
Solutions:
American Depository Receipts
Global Depository Receipts
Mutual funds--professional investing

34. Ethics Issues Insider trading
An insider: someone with access to important non-public information
can be a corporate officer, investment banker, major shareholder
blue-collar workers, too (e.g., printing press operators)

35. Ethics Regulation FD Churning of accounts
Professional designations (CFA®, CFPTM) have ethics components as a central feature of their certification programs

36. What will the future hold?
Electronic and on-line trading
Technology linking markets together (NYSE, Euronext merger)
Continued globalization

37. Learning Extension 11 Introduction to Futures and Options
What is a derivative security?
Why do they exist?
Future Contracts
Options

38. What is a derivative security?
A derivative security has its value determined by, or derived from, the value of another investment vehicle.
They represent a contract on an underlying security or asset

39. Why do derivatives exist?
Shift risk from those who don’t want to carry risk to those who are willing to do so.
Bring additional information into the market from hedgers, speculators, market expectations.
Lower commissions and margin requirements than in spot market

40. Futures contracts
A futures contract obligates the owner to purchase the underlying asset at a specified price (the exercise or strike price) on a specified date

41. Types of futures contracts
Corn, wheat, soybeans…
Stock indexes, interest rates, foreign currency values…
Gold, copper, silver, oil…
Coffee, sugar, cocoa...

42. Options
An options contract gives the owner the choice of trading the underlying asset at a specified price (the exercise or strike price) on or before a specified date or expiration date.

43. Two basic types of options
Call option: an option to buy the underlying asset at the strike price
Put option: an option to sell the underlying asset at the strike price

44. Call Options
Suppose you buy an option to buy 100 shares of ExxonMobil stock at $75 a share. How much is the option worth if on the expiration date the price of Exxon is:
a) $60 a share? $0
b) $75 a share? $0
c) $80 a share? $5

45. Put Options
Suppose you buy an option to sell 100 shares of ExxonMobil stock at $75 a share. How much is the option worth if on the expiration date the price of Exxon is:
a) $60 a share? $15
b) $75 a share? $0
c) $80 a share? $0

46. 3. Which of the following securities is likely to be the most liquid according to this data?
Stock Bid Ask
R $ $39.55 S T
 The bid-ask spread for each security, expressed in terms of dollars and percentages, is:
Stock Dollar spread Spread (% of ask price)
R $ %
S $ %
T $ %
 Relative to the price that an eager investor will pay (the ask price), stock T has the lowest spread and is the most liquid.
6. The Trio Index is comprised of three stocks, Eins, Zwei, and Tri. Their current prices are as follows:
a) Between now and the next time period, the stock prices of Eins and Zwei increase 10 percent while Tri increases 20 percent. What is the percentage change in the price-weighted Trio Index?
With a 10-percent increase, Eins will rise from $10 to $11 while Zwei rises from $20 to $22. A 20-percent change in the price of Tri has its price rising from $40 to $48:
Stock
Eins
Zwei
Tri
Price at time t
$10
$20
$40
Stock
Price at time t
Price at time t+1
Eins
$10
$11
Zwei
$20
$22
Tri
$40
$48
Sum
$70
$81
Price-weighted average change
15.71%
=$81/$70-1

47. b) Suppose instead that the price of Eins increases 20% while Zwei and Tri rise 10 percent. What is the percentage change in the price-weighted Trio Index? Why does it differ from the answer to part a)?
Now Ein rises in price from $10 to $12 while Tri only rises to $44:
The reason why the index percentage change differs from part a) is the highest price stock had the largest percentage price change in part a). In part b), it was the lowest price stock that had the largest percentage price change. The higher a stock’s price the greater its weight and influence in a price-weighted index. Tri’s large price change was the major influence on the price-weighted index in part a); Tri’s influence was diminished in part b.
7 . The four stocks listed in the text are part of an index.
# OF SHARES PRICE AT PRICE AT
STOCK OUTSTANDING TIME t TIME t+1
Eeny
Meeny
Miney
Moe
Using the prior information,
a. Compute a price-weighted index by adding the stocks’ prices at time t and time t + 1. What is the percentage change in the index?
Price-weighted index
Sum of prices at time t + 1 = $ = $107
Sum of prices at time t = $ = $100
% change = ($107 – $100)/$100 = 7%
Stock
Price at time t
Price at time t+1
Eins
$10
$12
Zwei
$20
$22
Tri
$40
$44
Sum
$70
$78
Price-weighed average change
11.43%
=$78/$70-1

48. b. Compute a value-weighted index by adding their market values at time t and time t+1 What is the percentage change in the index?
  Value-weighted index
Sum of market values at time t + 1 = $15(100) + 22(50) + 28(50) + 42(20) = $4,840
Sum of market values at time t = $10(100) + 20(50) + 30(50) + 40(20) = $4,300
% of change = ($4,840 – 4,300)/$4,300 = 12.56%
  c. Why is there a difference between your answers to Parts a and b?
  Different computation methods. The price change of higher-priced stocks have the
largest impact on Part a. The value change of the higher-value stocks have the
largest impact on Part b.
11. Below are the results of a Dutch auction for an IPO of Bagel’s Bagels, a trendy bagel and coffee shop chain. Bagel’s is offering 50 million shares.
Bidder Bid price Number of Shares
Matthew $ million
Kevin $ million
Amy $ million
Megan $ million
 a) What will be the clearing price?
Bidder Bid price Number of Shares Cumulative total of shares
Matthew $ million 15 million
Kevin $ million 35 million
Amy $ million 55 million
Megan $ million 65 million
With an offering of 50 million shares, the last shares can be sold to Amy; Amy’s bid determines the clearing price of $49.45.

49. b) How many shares will each bidder receive if Bagel’s allocates shares on a prorata basis to all the successful bidders?
There are bids for 55 million shares at the clearing price of $ Under the prorata method, each successful bidder will receive 50/55 of their desired number of shares. Megan received no shares as her bid was below the clearing price.
 Bidder: Bid price Number of Shares Bid Number of shares received
Matthew $ million million
Kevin $ million million
Amy $ million million
Megan $ million 0
 12. Determine the intrinsic values of the following call options when the stock is selling at $32 just prior to expiration of the options.
The intrinsic value of a call option is max [0, V – X]
a. $25 call price $7
b. $30 call price $2
c. $35 call price $0
13. Determine the intrinsic values of the following put options when the stock is selling at $63 just prior to expiration of the options.
The intrinsic value for a put option is max [0, X – V]
a. $55 put price
b. $65 put price
c. $75 put price
$12

50. Case study #11
14. Determine the intrinsic values of the following options when the stock is selling at $55 just prior to expiration of the options.
a. $35 call price
b. $50 call price
c. $65 call price
d. $35 put price
e. $50 put price
f. $65 put price

51. Financial Return and Risk Concepts
Dr. Mariusz Dybał Institute of Economic Sciences
Chapter 12
Financial Return and Risk Concepts
© 2014 John Wiley and Sons

52. Chapter Outcomes
Know how to compute arithmetic averages, variances, and standard deviations using return data for a single financial asset.
Understand the sources of risk
Know how to compute expected return and expected variance using scenario analysis.
Know the historical rates of return and risk for different securities.

53. Chapter Outcomes
Understand the concept of market efficiency and explain the three types of efficient markets.
Explain how to calculate the expected return on a portfolio of securities.
Understand how and why the combining of securities into portfolios reduces the overall or portfolio risk.
Explain the difference between systematic and unsystematic risk.
Understand the importance of ethics in investment-related positions.

54. Historical Return and Risk for a Single Asset
Return: periodic income and price changes
Dollar return = ending price – beginning price + income

55. Historical Return and Risk for a Single Asset
Percentage return =
Dollar return/beginning price
Beginning price = $33.63
Ending price = $34.31
Dividend = $0.13
Dollar return = $ =$0.81
Percentage return = $0.81/$33.63 = or 2.4 percent

56. Historical Return and Risk for a Single Asset
Can be daily, monthly or annual returns
Risk: based on deviations over time around the average return

57. Returns for Two Stocks Over Time

58. Arithmetic Average Return
Look backward to see how well we’ve done:
Average Return (AR) =
Sum of returns
number of periods

59. An Example YEAR STOCK A STOCK B 1 6% 20% 2 12 30 3 8 10 4 –2 –10
1 6% 20%
4 – –10
Sum
Sum/6 = AR= 8% 20%

60. Measuring Risk Variance 2 = (Rt - AR)2 Deviation = Rt - AR
Sum of Deviations (Rt - AR) = 0
To measure risk, we need something else…try squaring the deviations
Variance 2 = (Rt - AR)2
n - 1

61. Since the returns are squared: (Rt - AR)2
The units are squared, too:
Percent squared (%2)
Dollars squared ($ 2)
Hard to interpret!

62. Standard deviation
The standard deviation () helps this problem by taking the square root of the variance:

63. A’s RETURN RETURN
DIFFERENCE FROM DIFFERENCE
YR THE AVERAGE SQUARED
1 6%– 8% = –2% (–2%)2 = 4%2
2 12 – 8 = (4)2 = 16
– 8 = (0)2 = 0
4 –2 – 8 = –10 (–10)2 = 100
5 18– = (10)2 = 100
6 6 – = –2 (-2)2 = 4
Sum %2
Sum/(6 – 1) = Variance %2
Standard deviation = 44.8 = %

64. Using Average Return and Standard Deviation
If the future will resemble the past and the periodic returns are normally distributed:
68% of the returns will fall between AR -  and AR + 
95% of the returns will fall between AR - 2 and AR + 2
99% of the returns will fall between AR - 3 and AR + 3

65. For Asset A 68% of the returns between 1.3% and 14.7%

66. Which of these is riskier?
Asset A Asset B
Avg. Return 8% %
Std. Deviation % %

67. Another view of risk: Coefficient of Variation = Standard deviation
Average return
It measures risk per unit of return

68. Which is riskier? Asset A Asset B Avg. Return 8% 20%
Std. Deviation % %
Coefficient
of Variation

69. Where Does Risk Come From: Risk Sources in Income Statement
Revenue
Business Risk
Purchasing Power Risk
Exchange Rate Risk
Less: Expenses
Equals: Operating Income
Less: Interest Expense
Financial Risk
Interest Rate Risk
Equals: Earnings Before Taxes
Less: Taxes
Tax Risk
Equals: Net Income

70. Measures of Expected Return and Risk
Looking forward to estimate future performance
Using historical data: ex-post
Estimated or expected outcome: ex-ante

71. Steps to forecasting Return, Risk
Develop possible future scenarios:
growth, normal, recession
Estimate returns in each scenario:
growth: 20%
normal: 10%
recession: -5%
Estimate the probability or likelihood of each scenario:
growth: normal: recession: 0.30

72. Expected Return E(R) =  pi . Ri E(R) =
.3(20%) + .4(10%) +.3(-5%) = 8.5%
Interpretation:
8.5% is the long-run average outcome if the current three scenarios could be replicated many, many times

73. Once E(R) is found, we can estimate risk measures:
2 =  pi[ Ri - E(R)] 2
= .3( ) ( )2
+ .3( )2
= percent squared

74. Standard deviation:
 = 95.25%2 = 9.76%
Coefficient of Variation = 9.76/8.5
= 1.15

75. Do Investors Really do These Calculations?
Market anticipation of Fed’s actions
Identify consensus; where does our forecast differ?
Simulation and Monte Carlo analysis

76. Historical Returns and Risk of Different Assets
Two good investment rules to remember:
Risk drives expected returns
Developed capital markets, such as those in the U.S., are, to a large extent, efficient markets.

77. Efficient Markets What’s an efficient market?
Operationally efficient versus informationally efficient
Many investors/traders
News occurs randomly
Prices adjust quickly to news on average reflecting the impact of the news and market expectations

78. More….
After adjusting for risk differences, investors cannot consistently earn above-average returns
Expected events don’t move prices; only unexpected events (“surprises”) move prices or events which differ from the market’s consensus

79. Price Reactions in Efficient/Inefficient Markets
Overreaction(top)
Efficient (mid)
Underreaction
(bottom)
Good news event

80. Types of Efficient Markets
Strong-form efficient market
Semi-strong form efficient market
Weak-form efficient market

81. Source: Author analysis of Morningstar Principia data

82. Implications of “Efficient Markets”
Market price changes show corporate management the reception of announcements by the firm
Investors: consider indexing rather than stock-picking
Invest at your desired level of risk
Diversify your investment portfolio

83. Portfolio Returns and Risk
Portfolio: a combination of assets or investments

84. Expected Return on A Portfolio:
E(Ri) = expected return on asset i
wi = weight or proportion of asset i in the portfolio
E(Rp) =  wi . E(Ri)

85. If E(RA) = 8% and E(RB) = 20% More conservative portfolio:
E(Rp) = .75 (8%) (20%) = 11%
More aggressive portfolio:
E(Rp) = .25 (8%) (20%) = 17%

86. Possibilities of Portfolio “Magic”
The risk of the portfolio may be less than the risk of its component assets

87. Merging 2 Assets into 1 Portfolio
Two risky assets become a low-risk portfolio

88. The Role of Correlations
Correlation: a measure of how returns of two assets move together over time
Correlation > 0; the returns tend to move in the same direction
Correlation < 0; the returns tend to move in opposite directions

89. Diversification
If correlation between two assets (or between a portfolio and an asset) is low or negative, the resulting portfolio may have lower variance than either asset.
Splitting funds among several investments reduces the affect of one asset’s poor performance on the overall portfolio

90. The Two Types of Risk
Diversification shows there are two types of risk:
Risk that can be diversified away (diversifiable or unsystematic risk)
Risk that cannot be diversified away (undiversifiable or systematic or market risk)

91. Capital Asset Pricing Model
Focuses on systematic or market risk
An asset’s risk depend upon whether it makes the portfolio more or less risky
The systematic risk of an asset determines its expected returns

92. The Market Portfolio Contains all assets--it represents the “market”
The total risk of the market portfolio (its variance) is all systematic risk
Unsystematic risk is diversified away

93. The Market Portfolio and Asset Risk
We can measure an asset’s risk relative to the market portfolio
Measure to see if the asset is more or less risky than the “market”
More risky: asset’s returns are usually higher (lower) than the market’s when the market rises (falls)
Less risky: asset’s returns fluctuate less than the market’s over time

94. Blue = market returns over time Red = asset returns over time0% 0%
Time
Time
More systematic risk than market
Less systematic risk than market

95. Implications of the CAPM
Expected return of an asset depends upon its systematic risk
Systematic risk (beta ) is measured relative to the risk of the market portfolio

96. Beta example:  < 1
If an asset’s  is 0.5: the asset’s returns are half as variable, on average, as those of the market portfolio
If the market changes in value by 10%, on average this assets changes value by 10% x 0.5 = 5%

97.  > 1
If an asset’s  is 1.4: the asset’s returns are 40 percent more variable, on average, as those of the market portfolio
If the market changes in value by 10%, on average this assets changes value by 10% x 1.4 = 14%

98. Sample Beta Values accessed December 2012 from http://finance. yahoo
Firm Beta
Caterpillar 1.86
Coca-Cola 0.38
General Electric 1.37
Delta Airlines 0.60
FirstEnergy 0.28

99. Learning Extension 12 Estimating Beta
Beta is derived from the regression line:
Ri = a + RMKT + e

100. Ways to estimate Beta
Once data on asset and market returns are obtained for the same time period:
use spreadsheet software
statistical software
financial/statistical calculator
do calculations by hand

101. Sample Calculation Estimate of beta: n(RMKTRi) - (RMKT)(Ri)
n RMKT2 - (RMKT)2

102. The sample calculation
Estimate of beta =
n(RMKTRi) - (RMKT )( Ri)
n RMKT2 - (RMKT)2
6( 34.77) - (3.00)(0.20)
6(38.68) - (3.00)(3.00)
= 0.93

103. Security Market Line
CAPM states the expected return/risk tradeoff for an asset is given by the Security Market Line (SML):
E(Ri)= RFR + [E(RMKT)- RFR]i

104. An Example E(Ri)= RFR + [E(RMKT)- RFR]i
If T-bill rate = 4%, expected market return = 8%, and beta = 0.75:
E(Rstock)= 4% + (8% - 4%)(0.75) = 7%

105. Portfolio beta
The beta of a portfolio of assets is a weighted average of its component asset’s betas
betaportfolio =  wi. betai

106. 6. Find the real return on the following investments:
5. RCMP, Inc. shares rose 10 percent in value last year while the inflation rate was 3.5 percent. What was the real return on the stock? If an investor sold the stock after one year and paid taxes on the investment at a 15 percent tax rate what is the real after-tax return on the investment?
The nominal return is 10% and the inflation rate is 3.5%. The real return on RCMP’s shares is 10%- 3.5% = 6.5%.
Taking taxes into consideration, using a 15% tax rate the nominal after-tax return is 10% (1-0.15) = 8.5%. Subtracting the inflation rate, the real after-tax return is 8.5% - 3.5% = 5.0%.
6. Find the real return on the following investments:
The real return is computed as nominal return – inflation rate as follows:
Stock A: 10% - 3% = 7%
Stock B: 15% - 8% = 7%
Stock C: -5% - 3% = -8%
7. Find the real return, nominal after-tax return, and real after-tax return on the following:
Real return is nominal return minus the inflation rate:
Stock X: 13.5% - 5% = 8.5%
Stock Y: 8.7% - 4.7% = 4.0%
Stock Z: 5.2% - 2.5% = 2.7%
Nominal after-tax return is nominal return (1-tax rate):
Stock X: 13.5% ( ) = 11.48%
Stock Y: 8.7% ( ) = 6.53%
Stock Z: 5.2% (1-0.28) = 3.74%
The real after-tax return is the nominal after-tax return minus the inflation rate:
Stock X: 11.48% - 5% = 6.48%
Stock Y: 6.53% - 4.7% = 1.83%
Stock Z: 3.74% - 2.5% = 1.24%
Stock
Nominal Return
Inflation A
10% 3% B
15% 8% C
-5% 2%
Stock
Nominal Return
Inflation
Tax Rate X
13.5% 5%
15% Y
8.7%
4.7%
25% Z
5.2%
2.5%
28%

107. a) What is Uma’s expected return forecast for Wallnut stock?
9. Using the information below, compute the percentage returns for the following securities:
12. Ima’s sister, Uma, has completed her own analysis of the economy and Wallnut’s stocks. Uma used recession, constant growth and inflation scenarios but with different probabilities and expected stock returns. Uma believes the probability of recession is quite high, at 60 percent and that in a recession Wallnut’s stock return will -20 percent. Uma believes the scenarios of constant growth and inflation are equally likely and that Wallnut’s returns will be 15 percent in the constant growth scenario and 10 percent under the inflation scenario.
a) What is Uma’s expected return forecast for Wallnut stock?
b) What is the standard deviation of the forecast?
c) If Wallnut’s current price is $20 a share and is expected to pay a dividend of $0.80 a share next year, what price does Uma expect Wallnut to sell for in one year?
With the probability of recession set at 60 percent, the probability of not having a recession is or As the probability of the constant growth and inflation scenarios are equally likely, there probabilities are 0.40/2 or 0.20 (20%) each. Using these probabilities we have:
c) The return is computed as the (change in price + income)/beginning price. If the expected return is -7.00% (or in decimal form) we have:
(Expected price - $20) =
$20
or (Expected price - $20) = ($20) = -$1.40
= Expected price - $ = -$1.40
Solving, we see the expected price = $17.80.
Price today
Price one year ago
Dividends
received
Interest received
Dollar Return=
change in price
+ income
Percentage Return=Dollar return/initial price
a) RoadRunner stock
$20.05
$18.67
$0.50
$1.88
10.07%
b)Wiley Coyote stock
$33.42
45.79
$1.10
-$11.27
-24.61%
c)Acme long-term bonds
$1,015.38
$991.78
$100.00
$123.60
12.46%
d) Acme short-term bonds
$996.63
$989.84
$45.75
$52.54
5.31%
e) Xlingshot stock
$5.43
$3.45
$0.02
$2.00
57.97%
Scenario
Probability
Wallnut return
Recession
60%
-20%
Constant growth
20%
15%
Inflation
10%
a) Expected return
-7.00%
= 60% (-20%) + 20%(15%) + 20% (10%)
Variance
256.00%
= 60% (-20%-(-7%))^2 + 20%(15%-(-7%))^ % (10%-(-7%))^2
b) Standard Deviation
16.00%

108. 15. Below is annual stock return data on Hollenbeck Corp and Luzzi Edit, Inc.
Year Hollenbeck Luzzi Edit
% %
% %
% %
% %
  a. What is the average return, variance, and standard deviation for each stock?
Average return = (Sum of returns)/n
Hollenbeck Corp: 20/4 = 5.0%
Luzzi Edit: 22/4 = 5.5%
Variance = ∑ (Ri – Average)2/ (n – 1)
Hollenbeck Corp = 350/(4 – 1) = %2
Luzzi Edit= 213/(4 – 1) = 71.0%2
Standard deviation
Hollenbeck Corp = √116.67= 10.80%
Luzzi Edit = √ 71.0= 8.43%
b. What is the expected portfolio return on a portfolio comprised of
i. 25% Hollenbeck Corp and 75% Luzzi Edit?
ii. 50% Hollenbeck Corp and 50% Luzzi Edit?
iii. 75% Hollenbeck Corp and 25% Luzzi Edit?
E(portfolio return) = .25(5%) + .75(5.5%) = 5.375%
E(portfolio return) = .5(5%) + .5(5.5%) = 5.25%
E(portfolio return) = .75(5%) + .25(5.5%) = 5.125%
c. Without doing any calculations, would you expect the correlation between the returns on Hollenbeck Corp and Luzzi Edit's stock to be positive, negative, or zero? Why?
Probably negative, as the changes in returns from year-to-year moved in opposite directions in two of the three years ( : return rose for both Hollenbeck Corp and Luzzi Edit; : return fell for Hollenbeck Corp, rose for Luzzi Edit; : return rose for Hollenbeck Corp, fell for Luzzi Edit).

109. Case study #12
16. Below is annual stock return data on AAB Company and YYZ, Inc.
Year AAB YYZ
% %
% %
% %
% %
% %
a. What is the average return, variance, and standard deviation for each stock?
b. What is the expected portfolio return on a portfolio comprised of
i. 25% AAB and 75% YYZ?
ii. 50% AAB and 50% YYZ?
iii. 75% AAB and 25% YYZ?
  c. Without doing any calculations, would you expect the correlation between the returns on AAB and YYZ's stock to be positive, negative, or zero? Why?