Foundations of Finance

Solutions to Homework 1
Alexi Savov

Topic 1: Financial Markets

1. You are a market maker in the stock of Eli Lilly (LLE) and quote a bid of $102.25 and
an ask of $102.50. Suppose that you have zero inventory.
(a) On Day 1, you receive market buy orders for 10,000 shares and market sell orders
for 4,000 shares. How much do you earn on the 4,000 shares that you bought and
sold? What is the value of your inventory at the end of the day?
(Hints: It is possible to have negative inventory. Further, there is more than one cor-
rect way to value your inventory, but please state what assumption your valuation
is based on.)
You have sold 10,000 shares at the ask price of $102.50. You bought 4,000 shares at
a bid price $102.25. Thus, 6,000 shares are sold short (sold without already owning
the security). Your revenue from the 4,000 “round trip” purchase and sale produces
a profit equal to the bid minus the ask times the volume done. Hence, the profit on
the round trip trades is $0.25 × 4, 000 = $1, 000.
The value of your inventory is equal to the value of your short position of 6,000
shares. Since there is both a bid and an ask price, this question can answered is
various ways depending on what you assume:
The “conservative” valuation is to value your position at the ask price of $102.50.
Then, you have a position of −$615,000. This conservative valuation is useful be-
cause, if you cover your short position by buying from another dealer at his ask
price of $102.50, you would have to pay $615,000. (Also, in this example it is the
price for which you sold the securities.)

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The “aggressive” valuation is to value your position at the bid price of $102.25.
Then, you have a position of -$613,500 (i.e. less negative than above). This value
is implicitly based on an expectation that some investors will come to you and sell
you 6000 shares at your current bid price.
Often, real-world market makers will value their inventory at the mid price, in this
case $102.375. Then, you have a position of −$614,250.
(b) Before trading begins on Day 2, the company announces promising clinical trial
results for its latest weight-loss drug. Your quoted bid and ask jump to $110.25 and
$110.50, respectively.
During Day 2, you receive market sell orders for 8,000 shares and buy orders for
2,000 shares. What is your total profit or loss over the two-day period? What is the
value of your inventory at the end of Day 2?
You have bought 8,000 shares during Day 2 at $110.25 and sold 2,000 shares at
$110.50. On the 2,000 you bought and sold during the day you earn 2, 000 × $0.25 =
$500. You also added 6,000 shares to your inventory at a price of $110.25. Since you
were short 6,000 shares at $102.50 from yesterday’s trading, your loss on these 6,000
shares is −$7.75 × 6, 000 = −$46, 500. Thus your total profit/loss over the two-day
period is $1, 000 + $500 − $46, 500 = −$45, 000. Your inventory at the end of Day 2
is zero since you purchased 6,000 shares that offset the 6,000 share short position at
the end of Day 1.
(c) Discuss the following. What is a market maker’s objective? Is there anything
you could have done during Day 1, consistent with a market maker’s objective, that
would have improved your performance over the two-day period?
A market maker’s objective is to earn the bid-ask spread, and not (necessarily) to
speculate on equilibrium price movements. The 6,000 share short position at the
end of Day 1 left you vulnerable to a jump in quoted prices. Perhaps you should
have increased the prices during Day 1 as you observed more buying than selling.
Also, you could have reduced your short inventory position by buying from other
dealers at $102.50 as the market closed on Day 1. There are two factors that may
have prevented you from doing this: (1) Your expected profit of $.25 on the 6,000
shares if market prices remained unchanged at $102.25 (bid) and $102.50 (ask). (2)
Unwillingness of other dealers to accommodate your purchase of 6,000 shares at the
$102.50 ask price.

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 Topic 2: Performance Measures

2. Suppose a 5-year zero-coupon Treasury bond with face value $1,000 has a 5% yield
to maturity (annually compounded).

(a) What price does this bond sell for?

It sells for 1000 × 1.05−5 = 783.53.
(b) Suppose another zero-coupon Treasury bond also has a 5% yield, but sells for
$325.57. What is the maturity of this bond?
We have to solve T in 1000 × 1.05−T = 325.57. Either use the financial calcula-
tor, or notice that we can solve it as

1000 × 1.05−T = 325.57

1.05−T = 0.32557
− T log {1.05} = log {0.32557}
log {0.32557}
T = −
log {1.05}
T = 23

where the third equation follows from the second by using the property that
log { x y } = y log { x }.1

3. Which of the following investments do you prefer?

(a) Purchase a zero-coupon bond, which pays $1,000 in ten years, for a price of $550.
(b) Invest $550 for ten years in Chase at a guaranteed annual interest rate of 5.5%.
The annual return on the bond is:

r = (1000/550)1/10 − 1 = .0616

The interest on the Chase deposit is only 5.5%. Therefore, the bond is a better in-
vestment.
Note also that the Chase deposit after 10 years will have grown to:

F = 550(1.055)10 = 939.48,
1 This property holds for both the 10-log and the natural log (often denoted "ln"), so both can be used to

solve this problem.

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 which is lower than the face value of the bond.

4. Suppose you get for free one of following two securities: (a) an annuity that pays
$10,000 at the end of each of the next 6 years; or (b) a perpetuity that pays $10,000
forever, but it does not begin until 10 years from now (i.e., the first cash payment from
this perpetuity is 11 years from now).
Which security would you choose if the annual interest rate is 5%?
Does your answer change if the interest rate is 10%? Explain why or why not.
To determine whether it is better to get for free (a) or (b), we must calculate which
security has the higher present value.
It is always helpful to show a time line of the cash flows (to simplify the picture we
omit the 000s in 10,000).
(a)
+10 +10 +10 +10 +10 +10 +10 +10 · · ·
| | | | | | | | |
| | | | | | | | |
0 1 2 3 4 5 6 7 8

(b)

+10 +10 +10 +10 +10 +10 +10 +10 +10 +10 +10 +10 +10 · · ·
| | | | | | | | | | | | | |
| | | | | | | | | | | | | |
0 1 2 3 4 5 6 7 8 9 10 11 12 13

Cash flow (a) is a straightforward annuity whose present value is given by:
 
1 1
PV = C −
r r (1 + r ) t

You can calculate the present value by entering the appropriate values for C, r, and
t into the formula above or by using the annuity keystrokes programmed into your
calculator. In both cases make certain to enter the numbers and do the calculations
carefully. Given the values of C = $10,000 and t = 6, when the interest rate, r, is equal
to 5%, the present value is $50,757. When an interest rate of 10% is used with the
same cash flows, the present value is $43,552

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 Cash flow (b) is a perpetuity that begins 10 years from now. We can value it in two
parts. First, we know that a perpetuity has a value, P, given by:

C
P=
r

Thus, with C = $10, 000 and r = .05 the perpetuity is worth $200,000. But it is worth
$200,000 ten years from now, not today. We can get the present value of $200,000
received with a 10 year delay by treating that sum as though it were a zero coupon
bond with a face value of $200,000 payable in 10 years. Hence,

$200, 000
PV =
(1 + r )10

When we substitute r = .05 in the formula above we find that the present value
of the perpetuity beginning 10 years from now is $122,782. Hence, we prefer the
perpetuity because its present value of $122,782 is larger than the $50,757 present
value of the annuity in (a).
When r = .10 we have to first recalculate the value of the perpetuity:

$10, 000
P= = $100, 000
0.10

With $100,000 ’payable’ in 10 years at 10% interest we have

$100, 000
PV == = $38, 554
1.1010

Thus at 10% we prefer the annuity in (a), with a present value of $43,552, to the
perpetuity, which is worth only $38,554.
This result stems from the fact that even though the perpetuity has infinite cash
flows compared with the annuity, those cash flows begin with a 10- year delay. At a
10% interest rate the delayed cash flows are penalized very heavily.

5. Suppose a hedge fund manager earns 1% per trading day. There are 250 trading
days per year. Answer the following questions:
(a) What will be your annual return on $100 invested in her fund if she allows you
to reinvest in her fund the 1% you earn each day?
Allowing you to reinvest at 1% per day means that you are earning compound in-
terest on your initial $100 investment. The formula for P growing to F for one year

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at a compound rate r per annum is:
 r n
F = P 1+
n

where n is the number of compounding periods per year and hence r/n is the rate
per compounding period. We are given r/n = 1% per day and are asked to calculate
the annual yield. This is equivalent to asking for the effective annual rate.

EAR = (1 + .01)250 − 1 = 11.0321

Multiplying by 100 puts this into percentage terms: 1103.21% per annum.
Looked at another way, investing $100 in the hedge fund produces

$100(1 + .01)250 = $1203.21

at the end of one year.

(b) What will be your annual return assuming she puts all of your daily earnings
into a zero-interest checking account and pays you everything earned at the end of
the year?
If the hedge fund manager insists on putting your daily 1% earnings into a zero-
interest bearing checking account, then you will earn only the daily rate (1%) mul-
tiplied by the number of days, or,

1% × 250 = 250%

Notice that this is equivalent to the annual percentage rate (APR) calculation:

APR = periodic rate × n = 1% × 250

The value at the end of the year includes interest earnings plus original investment,
that is, 100+250=350.
(c) Can you summarize when it is proper to “annualize” using APR (annual per-
centage rate) versus EAR (effective annual rate)?
Whether you use APR or EAR to annualize a periodic rate depends upon the process
for reinvesting the proceeds of your investment. If you can reinvest at the periodic
rate (as in (a)) then EAR is appropriate. If the reinvestment rate is zero (as in (b))

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 then APR is appropriate. Since the reinvestment rate is rarely zero, the APR usually
understates the annual rate.

6. Here are some alternative investments you are considering for one year. (i) Bank A
promises to pay 8% on your deposits, compounded annually. (ii) Bank B promises
to pay 8% on your deposits, compounded daily. Compare the effective annual rates
(EARs) on these investments.
(i) EAR = .08
(ii) EAR = (1 + 0.08/365)365 − 1 = .08328
In general, the greater the compounding frequency, the higher the EAR. This is be-
cause with more frequent compounding, you earn more interest on interest.

7. (a) Suppose that you have purchased a 3-year zero-coupon bond with face value of
$1000 and a price of $850. If you hold the bond to maturity, what is your annual rate
of return?
The annual rate of return is the rate r that solves:

$1000
$850 = .
(1 + r )3

(Note that, in this case, the annual rate of return is equivalent to the yield to maturity
and to IRR.) Solving this equation as in class, we find:
 1/3
$1000
r= − 1 = 0.056
$850

(b) Now suppose you have purchased a 3-year bond with face value of $1,000, 7%
annual coupon rate, and a price of $975. Assuming that you hold the bond to matu-
rity, is the IRR greater or less than the return on the bond in part (a)?
Recall that the IRR is defined as the interest rate that makes the present value of the
payments equal to the price. Hence, the IRR (annual compounding) solves

$70 $70 $1070

$975 = + 2
+ .
(1 + IRR) (1 + IRR) (1 + IRR)3

When we put in IRR = 5.6%, we find:

$70 $70 $1070

+ + = $1037.70
1.056 1.0562 1.0563

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 Thus to make the present value equal to the price of $975, the IRR must be greater
than 5.6%. Hence, the IRR of the coupon bond is greater than 5.6%.

8. Excel Question. Download monthly S&P 500 data from January 1985 to today:
Go to https://finance.yahoo.com and search for “ˆSPX”. Click “Historical Data” in
the menu on the left. Change the frequency from “Daily” to “Monthly”. Change the
date range to “Max”. Click “Download” and save the file. Open it in Excel. Use the
“Adjusted Close” field to calculate the monthly returns of the S&P 500 and answer
the following questions:
(a) What is your best forecast for next month’s return?
Best to use arithmetic average return. Compute monthly returns as

AdjCloset
rt = − 1.
AdjCloset−1

Then calculate AVERAGE(r1 , r2 , . . .) = 0.819%. Your numbers may differ as new

data comes in.
(b) What would have been your annualized holding period return (ann.HPR) if you
invested at the start of the period?
Use the GEOMEAN function in Excel. GEOMEAN (1 + r1 , 1 + r2 , . . .) − 1 = 0.721%
is the monthly HPR. To get the annualized HPR, calculate GEOMEAN (1 + r1 , 1 +
r2 , . . .)12 − 1 = 9.01% is the annualized HPR.
Equivalently, divide the final value of the index, V ( T ), by the initial value, V (0),
and raise to the power (1/T) where T is the number of years. So, for example, if
there are 474 months, then T = 474/12. This method should give the same answer.
(c) In what month occurred the lowest monthly return? What happened?
October 1987 (not September 1987!) with a return of −21.76%. This was mainly
concentrated on Monday October 19, 1987 known as Black Monday. See, e.g.
https://en.wikipedia.org/wiki/Black_Monday_(1987).