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ERIC WANG
Chapter2solution.pptx
2. Asset classes and financial instruments
Instructor: Seongcheol Paeng
7/2/2020
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Solution
1. Explain Treasury Bills.
The government raises money by selling bills to the public. Investors buy the bills at a discount from the stated maturity value. At the bill’s maturity, the government pays the investor the face value of the bill. The ask price is the price you would have to pay to buy a T-bill from a securities dealer. The bid price is the slightly lower price you would receive if you wanted to sell a bill to a dealer. The bid–ask spread is the difference in these prices, which is the dealer’s source of profit.
7/2/2020
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2. Explain Treasury Notes and Bonds.
The U.S. government borrows funds in large part by selling Treasury notes and Treasury bonds. T-notes are issued with maturities ranging up to 10 years, while bonds are issued with maturities ranging from 10 to 30 years. Figure 2.3 is a listing of Treasury issues. The bid price of the highlighted note, which matures in May 2019, is 99.8125. This is the decimal version of . The minimum tick size, or price increment in the Treasury-bond market, is generally 1⁄128 of a point. Although bonds are typically traded in denominations of $1,000 par value, prices are quoted as a percentage of par. Thus, the bid price should be interpreted as 99.8125% of par, or $998.125 for the $1,000 par value bond. Similarly, the ask price at which the bond could be sold to a dealer is 99.8281% of par, or $998.281. The −.0859 change means that the closing price on this day fell by .0859% of par value (equivalently, by 11⁄128 of a point) from the previous day’s close. Finally, the yield to maturity based on the ask price is .933%.
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3. Explain Municipal Bonds.
Municipal bonds are issued by state and local governments. They are similar to Treasury and corporate bonds except that their interest income is exempt from federal income taxation. General obligation bonds are backed by the “full faith and credit” (i.e., the taxing power) of the issuer, while revenue bonds are issued to finance particular projects and are backed either by the revenues from that project or by the particular municipal agency operating the project. Typical issuers of revenue bonds are airports, hospitals, and turnpike or port authorities. Obviously, revenue bonds are riskier in terms of default than general obligation bonds. Figure 2.4 plots outstanding amounts of both types of municipal securities. ; ; . If we let t denote the investor’s combined federal plus local marginal tax bracket and denote the total before-tax rate of return available on taxable bonds, then (1 − t) is the after-tax rate available on those securities. Figure 2.5 plots the ratio of 20-year municipal debt yields to the yield on Baa-rated corporate debt. The default risk of these corporate and municipal bonds may be comparable, but certainly will fluctuate over time. For example, the sharp run-up in the ratio in 2011 probably reflects increased concern at the time about the precarious financial condition of several states and municipalities, leading to higher credit spreads on their bonds.
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4. Explain Characteristics of Common Stock.
The two most important characteristics of common stock as an investment are its residual claim and limited liability features. Residual claim means that stockholders are the last in line of all those who have a claim on the assets and income of the corporation. In a liquidation of the firm’s assets the shareholders have a claim to what is left after all other claimants such as the tax authorities, employees, suppliers, bondholders, and other creditors have been paid. Limited liability means that the most shareholders can lose in the event of failure of the corporation is their original investment. Unlike owners of unincorporated businesses, whose creditors can lay claim to the personal assets of the owner (house, car, furniture), corporate shareholders may at worst have worthless stock. They are not personally liable for the firm’s obligations.
7/2/2020
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5. Explain the difference between Price-Weighted Index and Value-Weighted Index.
(Table2.3) Initial value = $25 + $100 = $125 Final value = $30 + $90 = $120 Percentage change in portfolio value = −5/125 = −.04 = −4%. Initial index value = (25 + 100)/2 = 62.5 Final index value = (30 + 90)/2 = 60 Percentage change in index = −2.5/62.5 = −.04 = −4%. The portfolio and the index have identical 4% declines in value. Notice that price-weighted averages give higher-priced shares more weight in determining performance of the index. We conclude that a high-price stock can dominate a price-weighted average.
(Table2.4) The final value of all outstanding stock in our two-stock universe is $690 million. The initial value was $600 million. Therefore, if the initial level of a market-value-weighted index of stocks ABC and XYZ were set equal to an arbitrarily chosen starting value such as 100, the index value at year-end would be 100 × (690/600) = 115. The increase in the index reflects the 15% return earned on a portfolio consisting of those two stocks held in proportion to outstanding market values. Unlike the price-weighted index, the value-weighted index gives more weight to ABC. Note also from Tables 2.3 and 2.4 that market-value-weighted indexes are unaffected by stock splits.
7/2/2020
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Solution
6. Explain Call Option and Put Option with examples.
A call option gives its holder the right to purchase an asset for a specified price, called the exercise or strike price, on or before a specified expiration date. Calls therefore provide greater profits when stock prices increase and thus represent bullish investment vehicles. In contrast, a put option gives its holder the right to sell an asset for a specified exercise price on or before a specified expiration date. Whereas profits on call options increase when the asset increases in value, profits on put options increase when the asset value falls.
Call Option (Today 6/24/2020)
Ex) Purchasing Digital Camera $300 (8/1/2020), Option Premium: $10
If the price on 8/1/2020: $350, the holder will buy it because she/he can gain $40 ($350-$300-$10=$40).
If the price on 8/1/2020: $250, the holder will give it up because she/he will lose $60 ($250-$300-$10=-$60).
Put Option (Today 6/24/2020)
Ex) Selling Digital Camera $300 (8/1/2020), Option Premium: $10
If the price on 8/1/2020: $350, the holder will give it up because she/he will lose $60($300-$350-$10=-$60).
If the price on 8/1/2020: $250, the holder will sell it up because she/ he will gain $40($300-$250-$10=$40).
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