1.

Money Market Securities

 Definition: Money market securities are short-term debt instruments, which means they are debt
obligations that mature quickly, often within a year.
 Characteristics:
o Highly Marketable: They are easy to buy and sell quickly without significant loss in
value.
o Low Credit Risk: Generally, there is a very low chance that the issuer will default on
payment.
o Minimal Capital Gains/Losses: Due to their short maturity, there is little opportunity for
price fluctuation, making them stable investments.
 Denominations and Access: While they usually trade in large amounts, investors can access
them through money market funds (which pool investments for retail investors).
2. Treasury Bonds and Notes
 Definition: These are debt instruments issued by the U.S. government to fund its spending.
 Structure:
o Coupon-Paying: They pay regular interest (coupon) payments, unlike zero-coupon
bonds that pay only at maturity.
o Issued Near Par Value: Often issued close to face value (par), meaning they are not
significantly above or below their stated value.
 Comparison with Corporate Bonds: Treasury bonds and notes are similar to corporate bonds in
their design but are considered lower-risk because they are backed by the government.
3. Municipal Bonds
 Tax Benefits: The main distinguishing feature of municipal bonds is their tax-exempt status—
interest income is not subject to federal income tax.
 Capital Gains Tax: However, if sold for a profit, any capital gain on municipal bonds is taxable.
4. Mortgage Pass-Through Securities
 Structure: These are pools of mortgage loans sold together. Investors who buy pass-through
securities receive principal and interest payments made on the underlying mortgages.
 Role of Issuer: The original lender (e.g., a bank) services the mortgage but simply “passes
through” payments to the investor.
 Guarantees:
o Government Agency Pass-Throughs: Payments are guaranteed (e.g., Ginnie Mae).
o Private-Label Mortgage Pools: Not guaranteed, thus higher risk.
5. Common Stock
 Ownership Rights: Common stock represents ownership in a corporation.
 Voting Rights: Each share typically provides one vote on corporate governance matters.
 Residual Claims: Shareholders are last to be paid in the event of liquidation, after debt
obligations and preferred shareholders.
6. Preferred Stock
 Fixed Dividends: Preferred stock generally pays a steady dividend, similar to a bond’s interest.
 Perpetual: It is a perpetuity, meaning it pays dividends indefinitely.
 No Bankruptcy Trigger: If dividends aren’t paid, it doesn’t lead to bankruptcy; unpaid
dividends accumulate instead.

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  Varieties: Includes convertible (can be converted to common stock) and adjustable-rate
(dividends may change with interest rates).
7. Stock Market Indexes
 Purpose: Stock market indexes track the performance of selected groups of stocks, serving as
barometers for the overall market or specific sectors.
 Key Types:
o Price-Weighted Index: (e.g., Dow Jones Industrial Average) calculated by averaging
stock prices; stocks with higher prices have more impact.
o Market Value–Weighted Index: (e.g., S&P 500, NASDAQ) based on the market
capitalization of constituent stocks; larger companies have more influence.
 Examples of Indexes: Includes U.S.-based indexes (S&P 500, Wilshire 5000) and international
indexes (Nikkei, FTSE, DAX).
Key Terms
1. Bankers' Acceptance: A short-term debt instrument often used in international trade.
2. Call Option: Right to buy an asset at a specified price by a certain date.
3. Put Option: Right to sell an asset at a specified price by a certain date.
4. Futures Contract: An obligation to buy or sell an asset at a future date at a predetermined price.
The buyer (long) benefits if the asset’s price rises; the seller (short) benefits if it falls.
Key Differences Recap:
1. Short-term vs. Long-term Debt:
o Money market securities are very short-term, while Treasury bonds and municipal bonds
are longer-term.
2. Tax Treatment:
o Municipal bonds offer tax-exempt interest, whereas Treasury bonds and corporate bonds
are typically taxable.
3. Ownership and Claims:
o Common stock represents ownership and includes voting rights, unlike bonds or
preferred stock.
4. Risk Level:
o Treasury bonds are considered very low risk. Private-label mortgage pass-throughs and
common stocks generally involve more risk.
5. Index Weighting:
o Indexes differ in weighting: price-weighted (Dow Jones) vs. market value–weighted
(S&P 500).

Problem sets

1. Key Differences Between Common Stock, Preferred Stock, and Corporate Bonds

 Common Stock: Represents ownership in a company, with voting rights. Dividends are not
guaranteed and depend on company performance.
 Preferred Stock: Also represents ownership but typically lacks voting rights. Preferred
shareholders have priority over common shareholders for dividends, which are usually fixed.

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  Corporate Bonds: Debt instruments where investors lend money to the company. Bondholders
receive fixed interest payments and have priority over both common and preferred shareholders
in asset claims if the company liquidates.

2. Wilshire 5000 vs. Dow Jones Industrial Average (DJIA) as a Market Index

 The Wilshire 5000 includes a vast number of U.S. stocks across various industries, providing a
broad market view, whereas the DJIA includes only 30 large U.S. companies, primarily
industrials. This broader coverage makes the Wilshire 5000 a more comprehensive reflection of
the overall market performance.

3. Features of Money Market Securities

 Money Market Securities: Characterized by short maturities (usually less than one year), high
liquidity, low default risk, and typically issued in large denominations. Examples include
Treasury bills, commercial paper, and certificates of deposit.

4. Major Components of the Money Market

 Major components include:

o Treasury Bills (T-Bills): Short-term government debt.
o Commercial Paper: Unsecured short-term corporate debt.
o Certificates of Deposit (CDs): Issued by banks with fixed interest rates.
o Federal Funds: Short-term loans between banks, influenced by the Federal funds rate.
o Repurchase Agreements (Repos): Short-term borrowing agreements backed by
securities.

5. Adding International Equity to a Portfolio

 Investors can add international equity through:

o Direct Investment in Foreign Stocks
o American Depositary Receipts (ADRs): Allow investment in foreign companies
through U.S.-listed shares.
o International Mutual Funds or ETFs: Provide diversified exposure to foreign markets.

6. Preference for Municipal Bonds by High-Tax-Bracket Investors

 Municipal Bonds: Often provide tax-exempt income, which is more beneficial for high-tax-
bracket investors since the tax-exemption increases their after-tax yield compared to taxable
bonds.

7. LIBOR and Federal Funds Rate

 LIBOR (London Interbank Offer Rate): The rate at which banks lend to each other in the
London market, used as a reference for many financial products.
 Federal Funds Rate: The rate at which U.S. banks lend excess reserves to each other overnight,
directly influencing U.S. monetary policy.

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8. Municipal Revenue Bond vs. General Obligation Bond

 Revenue Bonds: Funded by the revenue from a specific project or source.

 General Obligation Bonds: Secured by the issuer’s general tax revenues. General obligation
bonds typically have a lower yield due to their broader backing by tax revenue.

9. Corporations and Preferred Stock Investment

 Corporate Preference for Preferred Stock: Corporations may invest in preferred stock because
of preferential tax treatment for dividends, where a portion of dividends received by a corporation
may be tax-exempt.

10. Limited Liability

 Limited Liability: Investors in common and preferred stock are not personally liable for the
company's debts beyond their investment amount. This structure limits investor risk.

11. Correct Definition of a Repurchase Agreement

 Answer: (a) A repurchase agreement is the sale of a security with a commitment to repurchase
the same security at a specified future date and a designated price.

12. Why are Money Market Securities Sometimes Referred to as “Cash Equivalents”?

 Answer: Money market securities are short-term, low-risk, and highly liquid, making them easily
convertible to cash with minimal loss. These characteristics make them suitable as near
substitutes for cash, hence the term "cash equivalents."

13. Equivalent Taxable Yield for a Municipal Bond

 Problem: A municipal bond with a coupon rate of 6¾% (6.75%) trading at par, for an investor in
a 35% tax bracket.
 Solution: Equivalent Taxable Yield=Municipal Yield/ (1−Tax Rate) =6.75%/(1−0.35) =10.38%

14. After-Tax Yield Comparison

 Problem: Compare after-tax yields for a 4% municipal bond versus a 5% taxable bond for
various tax brackets.

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  Solution: Calculate after-tax yield for the taxable bond:

15. Required Yield on Municipals

 Problem: For an investor in a 30% tax bracket, what yield must municipals offer to be preferred
over 9% taxable bonds?
 Solution: Rearrange the formula to find the municipal yield:

So, municipals must offer at least 12.86% to be preferable.

16. Equivalent Taxable Yield for Problem 14

 Using the formula:

Equivalent Taxable Yield=Municipal Yield/(1−Tax Rate)

 For each bracket:

o (a) 0%: 4%/1−0=4%

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 o (b) 10%: 4%/1−0.10=4.44%
o (c) 20%: 4%/1−0.20=5%
o (d) 30%: 4%/1−0.30=5.71%

17. Treasury Bond Maturing in February 2036

 Solution Steps:
o (a) Calculate purchase price based on bond listing.
o (b) Find coupon rate directly from listing.
o (c) Calculate current yield: Current Yield=Coupon PaymentBond Price\text{Current
Yield} = \frac{\text{Coupon Payment}}{\text{Bond
Price}}Current Yield=Bond PriceCoupon Payment

18. General Dynamics Listing in Figure 2.8

 Solution Steps:
o (a) Use closing price from listing.
o (b) Calculate number of shares: Shares=5000Price per Share
o (c) Annual dividend income:
o Dividend Income=Shares×Dividend per Share.
o (d) Earnings per share (EPS) from listing.

19. Price-Weighted Index of Three Stocks

 Solution Steps:
o (a) Calculate rate of return for a price-weighted index.
o (b) Adjust divisor after stock split.
o (c) Calculate return for the second period using the adjusted divisor.

20. Rates of Return on Alternative Indexes

 Solution Steps:
o (a) Market value–weighted index: Use share price and outstanding shares for weights.
o (b) Equally weighted index: Calculate average return across stocks.

21. Challenges for Equally Weighted Index Funds

 Answer: Equally weighted funds need frequent rebalancing, incurring higher transaction costs
and complexities in managing capital allocation due to the need to maintain equal weights.

22. Dow Jones Industrial Average Divisor Adjustment

 Answer: If a high-priced stock like FedEx replaced a low-priced one like AT&T, the DJIA
divisor would be adjusted downward to maintain index consistency.

23. T-Bill with Bank Discount Yield

 Solution Steps:

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 o (a) Calculate price using the bank discount formula.
o (b) Calculate bond-equivalent yield for comparability with other investments.

24. Which security should sell at a greater price? (LO 2-3)

a. 10-year T-bond with a 10% coupon - A bond with a higher coupon rate is more valuable as it pays
more interest.

b. Three-month call option with exercise price of $35 - The lower the exercise price, the more valuable
the call option, as it has a greater chance of being in the money.

c. Put option on the stock selling at $60 - The put option on the stock selling at a higher price is more
valuable, as it allows the holder to sell at a higher market price.

25. Futures Listings for Corn (LO 2-3)

a. If you buy one contract for December 2015 delivery and it closes at $3.95 per bushel, your profit or
loss would be calculated as follows:

 Contract size: 5,000 bushels

 Sale price: $3.95
 Purchase price (assuming you bought it at a previous price, say P): Profit/Loss = (3.95 - P) *
5,000

Assuming you bought the contract at a different price, you would need that purchase price to calculate
your exact profit or loss.

b. To determine the number of December 2015 maturity contracts outstanding, you would need to refer to
the specific figure or dataset mentioned (Figure 2.11) which you might not have provided here.

26. Apple Options (LO 2-3)

a. Exercise the call if stock price is $102 - You would profit by the difference between the stock price
and the exercise price minus the cost of the option:

 Profit = (102 - 100 - option cost).

 Rate of return = Profit / option cost.

b. If bought with exercise price $95 - You would also exercise this option, with a higher profit:

 Profit = (102 - 95 - option cost).

c. If bought an October put with exercise price $100 - You would not exercise this option if the stock
is at $102, as it’s out of the money. Profit = - option cost.

27. Options Positions (LO 2-3)

a. Call Option - The right to buy an asset at a specified price.

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b. Put Option - The right to sell an asset at a specified price.

c. Written Call Option - The obligation to buy an asset at a specified price (when shorting a call).

d. Written Put Option - The obligation to sell an asset at a specified price (when shorting a put).

28. Call Options with Higher Exercise Prices (LO 2-3)

Call options with higher exercise prices sell for positive prices because they still provide the right to buy
the underlying asset at a future date, which has value if the asset’s price increases above the exercise
price. They can also serve as a hedge against price movements, providing a safety net.

29. Profit Scenarios for Call and Put on Stock XYZ (LO 2-3)

a. Profit from buying the call for $4:

 i) Stock at $40: Profit = -4

 ii) Stock at $45: Profit = -4
 iii) Stock at $50: Profit = -4
 iv) Stock at $55: Profit = (55 - 50 - 4) = 1
 v) Stock at $60: Profit = (60 - 50 - 4) = 6

b. Profit from buying the put for $6:

 i) Stock at $40: Profit = (50 - 40 - 6) = 4

 ii) Stock at $45: Profit = (50 - 45 - 6) = -1
 iii) Stock at $50: Profit = (50 - 50 - 6) = -6
 iv) Stock at $55: Profit = (50 - 55 - 6) = -11
 v) Stock at $60: Profit = (50 - 60 - 6) = -16

30. Spread Between Yields on Commercial Paper and Treasury Bills (LO 2-1)

If the economy enters a steep recession, the spread between yields on commercial paper and Treasury
bills is expected to widen. During a recession, the risk associated with corporate debt increases, leading to
higher yields on commercial paper, while Treasury yields generally remain low due to their safe-haven
status.

31. Volatility of Prices on Individual Stocks (LO 2-1)

To determine how many stocks have a 52-week high at least 40% greater than the 52-week low, you
would analyze the specific stocks in Figure 2.8. A greater difference indicates higher volatility,
suggesting that those stocks may have more price fluctuation over the year.

32. After-Tax Return on Preferred Stock (LO 2-1)

The after-tax return can be calculated as follows:

 Initial investment = $40

 Dividend received = $4

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  Sale price = $40
 Total income = $4 (since the sale price equals the purchase price)
 Tax on dividend = 30% of $4 = $1.2
 After-tax income = $4 - $1.2 = $2.8

After-tax return = After-tax income / Initial investment = $2.8 / $40 = 0.07 or 7%.

2.1 Bond Pricing and Yield Calculation

 Bid Price of the Bond: 108.8906% of par = $1,088.906

 Asked Price of the Bond: 108.9375% of par = $1,089.375
 Yield Corresponding to Asked Price: 1.880%
 Change in Ask Price: Increased by 0.0938, so the previous ask price was:
o Previous Asked Price = Current Asked Price - Increase
o Previous Asked Price = $1,089.375 - 0.0938 = $1,088.437

2.2 Equivalent Taxable Yield

 Taxable Return: 6%
 Tax Rate: 28%
 After-Tax Return on Taxable Bond:

After-Tax Return=6%×(1−0.28)=6%×0.72=4.32%

 Equivalent Taxable Yield of Tax-Free Bond: Given a tax-free bond offering a 4% yield,

Equivalent Taxable Yield=4%/ (1−0.28) =4%/ 0.72≈5.55%

2.3 Stockholder Rights and Potential Gains

a. Prorated Share of Dividends: As a stockholder, you are entitled to a prorated share of IBM’s dividend
payments and the right to vote in stockholder meetings.

b. Potential Gain: Your potential gain is unlimited because the stock price can rise indefinitely.

c. Outlay Calculation:

 Shares Purchased: 190 shares at $100 each

 Total Outlay:

Outlay=190×100=$19,000

 Price-Weighted Index Calculation:

o Initial index = (100 + 25) / 2 = 62.50
o New index = (110 + 20) / 2 = 65
o Gain = 65−62.50=2.50
o Return = 2.50/ 62.50 ×100=4%
 Investment in Each Company:
o Initial investment per share = $125; new value = $130

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 o Return = (130−125)/ 125=4%

2.5 Market Value-Weighted Index Return Calculation

 Initial Portfolio Value: $100 million (XYZ) + $500 million (ABC) = $600 million
 Final Portfolio Value: $110 million (XYZ) + $400 million (ABC) = $510 million
 Loss:

Loss= (600−510)/ 600=90/600=0.15 or 15%

 Weights of Each Stock:

o Weight of XYZ = 100/600=16
o Weight of ABC = 500/600=56
 Index Portfolio Return:


2.6 Call and Put Option Payoff

 Payoff to Call Option:

Payoff=110−100=10

 Cost of Call Option: $2.62

 Profit from Call Option:

Profit=10−2.62=7.38 per share

Put Option Payoff: Since the stock price exceeds the exercise price, the put expires worthless, so
the payoff is 0.

 Loss from Put Option: Cost of put = $1.55

Summary of Results

 2.1: Previous ask price = $1,088.437

 2.2: After-tax return of taxable bond = 4.32%; Equivalent taxable yield = 5.55%
 2.3: You are entitled to dividends and voting; unlimited potential gain; total outlay = $19,000.
 2.5: Market value-weighted index return = -15%
 2.6: Call profit = $7.38; Put loss = $1.55

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