50 Part ONE Elements of Investments

FIGURE 2.11
Corn futures prices on Maturity Last Change High Low
the Chicago Mercantile
Sep-19 3.4500 −4.7500 3.5100 3.4450
Exchange, September
4, 2019 Dec-19 3.5750 −3.5000 3.6300 3.5650
Source: www.cmegroup.com, May-20 3.7925 −3.2500 3.8400 3.7850
September 4, 2019. Dec-20 3.9725 −2.2500 4.0025 3.9700
Jul-21 4.1875 −2.0000 4.2000 4.1825

position must deliver 5,000 bushels for the previously agreed-upon futures price. The short
position’s loss equals the long position’s profit.
The right to purchase an asset at an agreed-upon price versus the obligation to purchase
it distinguishes a call option from a long position in a futures contract. A futures contract
obliges the long position to purchase the asset at the futures price; the call option merely con-
veys the right to purchase at the exercise price. The purchase will be made only if the asset is
ultimately worth more than the exercise price.
Clearly, the holder of a call has a better position than the holder of a long position on a futures
contract with a futures price equal to the option’s exercise price. This advantage, of course,
comes only at a price. Call options must be purchased; futures investments are entered into with-
out cost. The purchase price of an option is called the premium. It represents the compensation
the purchaser of the call must pay for the ability to exercise the option only when it is advanta-
geous to do so. Similarly, the difference between a put option and a short futures position is the
right, as opposed to the obligation, to sell an asset at an agreed-upon price.

SUMMARY ∙ Money market securities are very short-term debt obligations. They are usually highly
marketable and have relatively low credit risk. Their low maturities and low credit risk
ensure minimal capital gains or losses. These securities often trade in large denominations,
but they may be purchased indirectly through money market mutual funds.
∙ Much of U.S. government borrowing is in the form of Treasury bonds and notes. These
are coupon-paying bonds usually issued at or near par value. Treasury bonds are similar in
design to coupon-paying corporate bonds.
∙ Municipal bonds are distinguished largely by their tax-exempt status. Interest payments
(but not capital gains) on these securities are exempt from income taxes. The equivalent
taxable yield offered by a municipal bond equals rmuni/(1 − t), where rmuni is the municipal
yield and t is the investor’s tax bracket.
∙ Mortgage pass-through securities are pools of mortgages sold in one package. Owners of
pass-throughs receive the principal and interest payments made by the borrowers. The firm
that originally issued the mortgage merely services it, simply “passing through” the payments
to the purchasers of the pool. Payments of interest and principal on government agency
pass-through securities are guaranteed, but payments on private-label mortgage pools are not.
∙ Common stock is an ownership share in a corporation. Each share entitles its owner to one
vote on matters of corporate governance and to a prorated share of the dividends paid to
shareholders. Stock (equivalently, equity) owners are the residual claimants on the income
earned by the firm.
∙ Preferred stock usually pays a fixed stream of dividends for the life of the firm: It is a
perpetuity. A firm’s failure to pay the dividend due on preferred stock, however, does not
set off corporate bankruptcy. Instead, unpaid dividends simply cumulate. Adjustable-rate
preferred stock pays a dividend that is indexed to a short-term interest rate.
∙ Many stock market indexes measure the performance of the overall market. The Dow
Jones averages, the oldest and best-known indicators, are price-weighted indexes. Today,
many broad-based, market value–weighted indexes are computed daily. These include the
 Chapter 2 Asset Classes and Financial Instruments 51

Standard & Poor’s Composite 500 stock index, the NASDAQ index, the Wilshire 5000
Index, and several international indexes, including the Nikkei, FTSE, and DAX.
∙ A call option is a right to purchase an asset at a stipulated exercise price on or before
an expiration date. A put option is the right to sell an asset at some exercise price. Calls
increase in value, while puts decrease in value, as the price of the underlying asset
increases.
∙ A futures contract is an obligation to buy or sell an asset at a stipulated futures price on
a maturity date. The long position, which commits to purchasing, gains if the asset value
increases, while the short position, which commits to delivering the asset, loses.

banker’s acceptance, 31 Eurodollars, 31 municipal bonds, 36 KEY TERMS

call option, 48 federal funds, 32 preferred stock, 42
certificate of deposit, 30 futures contract, 49 price-weighted average, 43
commercial paper, 30 London Interbank Offer put option, 48
common stocks, 40 Rate (LIBOR), 32 repurchase agreements
corporate bonds, 39 market value–weighted (repos), 31
derivative asset, 48 index, 45 Treasury bills, 29
equally weighted index, 47 money markets, 29 Treasury bonds, 34
Treasury notes, 34

​r​ ​
Equivalent taxable yield: ___
​1muni
−t
​​where rmuni is the rate on tax-free municipal debt and t is the KEY FORMULAS
combined federal plus state tax rate.
​r​muni​
Cutoff tax bracket (for indifference to taxable versus tax-free bonds): 1​ − ____​​r​taxable ​​

®
Select problems are available in McGraw-Hill’s PROBLEM SETS
Connect. Please see the Supplements section of
the book’s frontmatter for more information.
1. What are the key differences between common stock, preferred stock, and corporate
bonds? (LO 2-1)
2. Why do most professionals consider the Wilshire 5000 a better index of the performance
of the broad stock market than the Dow Jones Industrial Average? (LO 2-2)
3. What features of money market securities distinguish them from other fixed-income
securities? (LO 2-1)
4. What are the major components of the money market? (LO 2-1)
5. Describe alternative ways that an investor may add positions in international equity to
his or her portfolio. (LO 2-1)
6. Why are high-tax-bracket investors more inclined to invest in municipal bonds than are
low-bracket investors? (LO 2-1)
7. What is the LIBOR rate? The federal funds rate? (LO 2-1)
8. How does a municipal revenue bond differ from a general obligation bond? Which
would you expect to have a lower yield to maturity? (LO 2-1)
9. Why are corporations more apt to hold preferred stock than other potential
­investors? (LO 2-1)
10. What is meant by limited liability? (LO 2-1)
11. Which of the following correctly describes a repurchase agreement? (LO 2-1)
a. The sale of a security with a commitment to repurchase the same security at a speci-
fied future date and a designated price.
b. The sale of a security with a commitment to repurchase the same security at a future
date left unspecified, at a designated price.
c. The purchase of a security with a commitment to purchase more of the same security
at a specified future date.
52 Part ONE Elements of Investments

12. Why are money market securities often called “cash equivalents”? (LO 2-1)
13. A municipal bond carries a coupon rate of 2.25% and is trading at par. What would
be the equivalent taxable yield of this bond to a taxpayer in a 35% combined tax
bracket? (LO 2-1)
14. Suppose that short-term municipal bonds currently offer yields of 4%, while comparable
taxable bonds pay 5%. Which gives you the higher after-tax yield if your combined tax
bracket is: (LO 2-1)
a. Zero
b. 10%
c. 20%
d. 30%
15. An investor is in a 30% combined federal plus state tax bracket. If corporate bonds offer
9% yields, what yield must municipals offer for the investor to prefer them to corporate
bonds? (LO 2-1)
16. Find the equivalent taxable yield of the municipal bond in Problem 14 for tax brackets
of: (LO 2-1)
a. Zero
b. 10%
c. 20%
d. 30%
17. Turn back to Figure 2.3 and look at the Treasury bond maturing in February 2039. (LO 2-1)
a. How much would you have to pay to purchase one of these bonds?
b. What is its coupon rate?
c. What is the current yield (i.e., coupon income as a fraction of bond price) of the
bond?
18. Turn to Figure 2.8 and look at the listing for Home Depot. (LO 2-1)
a. What was the firm’s closing price yesterday?
b. How many shares can you buy for $5,000?
c. What would be your annual dividend income from those shares?
d. What must be Home Depot’s earnings per share?
19. Consider the three stocks in the following table. Pt represents price at time t, and Qt
represents shares outstanding at time t. Stock C splits two-for-one in the last
period. (LO 2-2)

P0 Q0 P1 Q1 P2 Q2

A 90 100 95 100 95 100

B 50 200 45 200 45 200
C 100 200 110 200 55 400

a. Calculate the rate of return on a price-weighted index of the three stocks for the first
period (t = 0 to t = 1).
b. What must happen to the divisor for the price-weighted index in year 2?
c. Calculate the rate of return of the price-weighted index for the second period
(t = 1 to t = 2).
20. Using the data in the previous problem, calculate the first-period rates of return on the
following indexes of the three stocks: (LO 2-2)
a. A market value–weighted index
b. An equally weighted index
21. What problems would confront a mutual fund trying to create an index fund tied to an
equally weighted index of a broad stock market? (LO 2-2)
22. What would happen to the divisor of the Dow Jones Industrial Average if FedEx, with a
current price of around $115 per share, replaced Intel (with a current price of about
$55 per share)? (LO 2-2)
 Chapter 2 Asset Classes and Financial Instruments 53

23. A T-bill with face value $10,000 and 87 days to maturity is selling at a bank discount
ask yield of 3.4%. (LO 2-1)
a. What is the price of the bill?
b. What is its bond equivalent yield?
24. Which security should sell at a greater price? (LO 2-3)
a. A 10-year Treasury bond with a 5% coupon rate or a 10-year T-bond with a 6% coupon.
b. A three-month expiration call option with an exercise price of $40 or a three-month
call on the same stock with an exercise price of $35.
c. A put option on a stock selling at $50 or a put option on another stock selling at $60.
(All other relevant features of the stocks and options are assumed to be identical.)
25. Look at the futures listings for corn in Figure 2.11. Suppose you buy one contract for
December 2020 delivery. If the contract closes in December at a price of $4.00 per bushel,
what will be your profit or loss? (Each contract calls for delivery of 5,000 bushels.) (LO 2-3)
26. Turn back to Figure 2.10 and look at the Microsoft options. Suppose you buy a Novem-
ber expiration call option with exercise price $140. (LO 2-3)
a. If the stock price at option expiration is $144, will you exercise your call? What is
the profit on your position?
b. What if you had bought the November call with exercise price $135?
c. What if you had bought the November put with exercise price $140?
27. What options position is associated with: (LO 2-3)
a. The right to buy an asset at a specified price?
b. The right to sell an asset at a specified price?
c. The obligation to buy an asset at a specified price?
d. The obligation to sell an asset at a specified price?
28. Why do call options with exercise prices higher than the price of the underlying stock
sell for positive prices? (LO 2-3)
29. Both a call and a put currently are traded on stock XYZ; both have strike prices of $50
and expirations of six months. (LO 2-3)
a. What will be the profit to an investor who buys the call for $4 in the following sce-
narios for stock prices in six months? (i) $40; (ii) $45; (iii) $50; (iv) $55; (v) $60.
b. What will be the profit in each scenario to an investor who buys the put for $6?
30. What would you expect to happen to the spread between yields on commercial paper
and Treasury bills if the economy were to enter a steep recession? (LO 2-1)
31. Examine the stocks listed in Figure 2.8. For what fraction of these stocks is the 52-week
high price at least 40% greater than the 52-week low price? What do you conclude about
the volatility of prices on individual stocks? (LO 2-1)
32. Find the after-tax return to a corporation that buys a share of preferred stock at $40, sells
it at year-end at $40, and receives a $4 year-end dividend. The firm is in the 21% tax
bracket. (LO 2-1)

Challenge
33. What is the difference between a put option and a short position in a futures
contract? (LO 2-3)
34. What is the difference between a call option and a long position in a futures
contract? (LO 2-3)

CFA Problem
1. Preferred stock yields often are lower than yields on bonds of the same quality because
of: (LO 2-1)
a. Marketability
b. Risk
c. Taxation
d. Call protection
54 Part ONE Elements of Investments

WEB master 1. Go to the website for The Walt Disney Co. (DIS) and download its most recent annual
report (its 10-K). Locate the company’s Consolidated Balance Sheets and answer these
questions:
a. How much preferred stock is Disney authorized to issue? How much has been issued?
b. How much common stock is Disney authorized to issue? How many shares are cur-
rently outstanding?
c. Search for the term “Financing Activities.” What is the total amount of borrowing
listed for Disney? How much of this is medium-term notes?
d. What other types of debt does Disney have outstanding?
2. Not all stock market indexes are created equal. Different methods are used to calculate
various indexes, and different indexes will yield different assessments of “market
performance.” Using one of the following data sources, retrieve the stock price for five
different firms on the first and last trading days of the previous month.
www.nasdaq.com—Get a quote; then select Charts and specify one month. When the
chart appears, click on a data point to display the underlying data.
www.bloomberg.com—Get a quote; then plot the chart; next, use the moving line to see
the closing price today and one month ago.
finance.yahoo.com—Get a quote; then click on Historical Data and specify a date range.
a. Compute the monthly return on a price-weighted index of the five stocks.
b. Compute the monthly return on a value-weighted index of the five stocks.
c. Compare the two returns and explain their differences. Explain how you would
interpret each measure.

S O LU T I O N S TO 2.1 The bid price of the bond is 128.202% of par, or $1,282.02. The asked price is 128.212
or $1,282.12. This asked price corresponds to a yield of 1.754%. The asked price
CONCEPT increased .126 from its level yesterday, so the asked price then must have been 128.086,
checks or $1,280.86.
2.2 A 6% taxable return is equivalent to an after-tax return of 6%(1 − .30) = 4.2%. Therefore,
you would be better off in the taxable bond. The equivalent taxable yield of the tax-free
bond is 4%/(1 − .3) = 5.71%. So a taxable bond would have to pay a 5.71% yield to
­provide the same after-tax return as a tax-free bond offering a 4% yield.
2.3 a. You are entitled to a prorated share of Intel’s dividend payments and to vote in any of
its stockholder meetings.
b. Your potential gain is unlimited because the stock price has no upper bound.
c. Your outlay was $55 × 100 = $5,500. Because of limited liability, this is the most
you can lose.
2.4 The price-weighted index increases from 62.50 [=(100 + 25)/2] to 65 [=(110 + 20)/2],
a gain of 4%. An investment of one share in each company requires an outlay of $125
that would increase in value to $130, for a return of 4% (=5/125), which equals the
return to the price-weighted index.
2.5 The market value–weighted index return is calculated by computing the increase
in the value of the stock portfolio. The portfolio of the two stocks starts with an
initial value of $100 million + $500 million = $600 million and falls in value
to $110 million + $400 million = $510 million, a loss of 90/600 = .15, or 15%.
The index portfolio return is a weighted average of the returns on each stock with
weights of 1​ ⁄6​on XYZ and 5​ ⁄6​on ABC (weights proportional to relative investments).
Because the return on XYZ is 10%, while that on ABC is −20%, the index portfolio return
is (​ 1​ ⁄6​) 10 + (​5⁄6​) (− 20 ) = − 15%​, equal to the return on the market value–weighted index.
2.6 The payoff to the call option is $140 − $130 = $10. The call cost $8.65. The profit
is $10 − $8.65 = $1.35 per share. The put will pay off zero—it expires worthless since
the stock price exceeds the exercise price. The loss is the cost of the put, $1.03.