# To receive full credit, you must EXPLAIN your answers and/or show supporting calculations.

• (4 Points) You have the following information:

Stock ABC

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Stock JKL

Expected Return

10%

8%

Standard Deviation

6%

9%

Note: In B., C., and D., the optimal amount could be a single number, or a range of weights.

• If you can invest in one and only one of these two stocks (and will hold the security in isolation), which stock should you choose, and why?
• Assume that the correlation between the returns of the two stocks is +1.
• Assume that the correlation between the returns of the two stocks is +0.1.
• Assume that the correlation between the returns of the two stocks is –1.
• What is the expected return and standard deviation of a portfolio containing 50% ABC and 50% JKL?
• What is the optimal amount of Stock JKL for an investor to hold in a portfolio (if the correlation is +1)? (The optimal amount can be a range: 0% to _____% JKL).
• What is the expected return and standard deviation of a portfolio containing 50% ABC and 50% JKL?
• What is the optimal amount of Stock JKL for an investor to hold in a portfolio (if the correlation is +0.1)? (The optimal amount can be a range: 0% to _____% JKL).
• What is the expected return and standard deviation of a portfolio containing 50% ABC and 50% JKL?
• What is the optimal amount of Stock JKL for an investor to hold in a portfolio (if the correlation is –1)? (The optimal amount can be a range: 0% to _____% JKL).

2. (1.5 Points) Nicholas Manufacturing announced yesterday that its fourth quarter earnings were 10% higher than last year’s fourth quarter earnings. You observe that Nicholas stock lost 5% of its value following this announcement, while the market was up 2%. Explain how this counter-intuitive price movement could happen (and make sense) if the market is semi-strong efficient.

• (1.5 Points) Explain briefly why the underlined sentence in the italicized statement below is false (approximately 2 or 3 sentences).
• (2 Points) Boyd Company sold a futures contract (one) on Treasury bonds that specified a price of 98-19. When the position was closed out, the price of the Treasury bond futures contract was 100-09.
• (3 Points) The price of Stock ABC is currently \$50. A call option on 100 shares of Stock ABC has an exercise price of \$49 and the call premium is \$3.

Assume that the market is efficient. Stock A is selling for a price near the top of its price range for the past 52 weeks; Stock B is selling for a price near the bottom of its 52 week range. Stock A is the better investment today because it has been successful in the past year and has a positive price trend.

• Did interest rates increase or decrease? How do you know?
• What was Boyd’s profit or loss from this contract (ignoring transaction costs)?
• Is the option currently “in” or “out” of the money?
• What is the intrinsic value and the time value of the option today?
• What is the break-even future stock price associated with the option?
• What is the NET payoff from writing this option if the stock price at expiration is \$45?
• What is the NET payoff from buying this option if the stock price at expiration is \$50?
• What is the NET payoff from buying this option if the stock price at expiration is \$58?

6. (2 Points) There is both a call option and a put option available on PQA Co. stock.

Both options have a strike price of \$23. Both options have a premium of \$4. Is the current stock price higher or lower than \$23 in the following two cases? (Explain why)

• Both options expire in three months.
• The put option expires in one month while the call option expires in three months.

7. (1.5 Points) If Sam Wright believes that the stock market is efficient, will he ever buy a put option on an individual company’s stock? Why or why not?

• (3 Points) Assume that a stock is priced at \$25 and pays an annual dividend of \$1 per share.
• (2 Points) During the past year, when the S&P 500 produced a return of 12%, Joe Cool’s portfolio earned a return of 16%. This was the third year in a row that Joe’s portfolio earned a higher (positive) return that the S&P 500. Identify two reasons why these investment results do not necessarily refute the efficient markets hypothesis.
• (1.5 Points) Two stocks (Stock J and Stock K) have the same current stock price, and the same standard deviation. There exists a call option on 100 shares of Stock J, a call option on 100 shares of Stock K, and a call option on a portfolio of 50 shares of J and 50 shares of K. Is the following statement true or false (you must explain why!)? If the correlation between Stocks J and K is +0.3, the call premium for the option on the two stock portfolio will be higher than either of the individual stock option call premiums due to the benefits of diversification.
• Assume that an investor purchases the stock paying 100% cash. After one year, the investor sells the stock for \$32.75 per share (after collecting the dividend). The percentage return on this investment was _____.
• Assume that an investor purchases the stock on margin, paying \$15 per share and borrowing the remainder from the brokerage firm with a 10% annual interest rate. After one year, the investor sells the stock for \$32.75 per share (after collecting the dividend). The percentage return on this investment was ____.
• If the market is efficient, will any rational investor buy stocks on margin? If so, which investors will do this? If not, why not?

Reason 1 =

Reason 2 =