Class 1

1.

Consumption next year = [40,000 - 30,000 - 50,000]*1.1 + (60,000 + 36,000) = 52,000.

2.

Consumption vs saving:
a. Let x = the amount that Casper should invest now. Then ($200,000 x) is the amount he
will consume now, and (1.08x) is the amount he will consume next year.
Since Casper wants to consume exactly the same amount each period:
200,000 x = 1.08x
Solving, we find that x = $96,153.85 so that Casper should invest $96,153.85 now, he
should spend ($200,000 $96,153.85) = $103,846.15 now, and he should spend (1.08
$96,153.85) = $103,846.15 next year.
b. Since Casper can invest $200,000 at 10% risk-free, he can consume as much as
($200,000 1.10) = $220,000 next year. The present value of this $220,000 is:
($220,000/1.08) = $203,703.70
Therefore Casper can consume as much as $203,703.70 now by first investing $200,000
at 10% and then borrowing, at the 8% rate, against the $220,000 available next year. If
we use the $203,703.70 as the available consumption now, and again let x = the amount
that Casper should invest now, we can then solve the following for x:
$203,703.70 x = 1.08x
x = $97,934.47
Therefore, Casper should invest $97,934.47 now at 8%, he should spend ($203,703.70
$97,934.47) = $105,769.23 now, and he should spend ($97,934.47 1.08) = $105,769.23
next year.
[Note that this approach leads to the result that Casper borrows $203,703.70 at 8% and
then invests $97,934.47 at 8%. We could simply say that he should borrow ($203,703.70
- $97,934.47) = $105,769.23 at 8% against the $220,000 available next year. This is the
amount that he will consume now.]
c. The NPV of the opportunity in (b) is: ($203,703.70 - $200,000) = $3,703.70

Class 2
3.

Valuing a stream of cash flows:

a. Timeline:
0

PV =

10, 000
1.035

10,000

20,000

30,000

20, 000
1.035

30, 000
1.035

= 9, 662 + 18, 670 + 27, 058 = 55, 390

b. Timeline:
0

10,000

20,000

30,000

FV = (10x1.035^2 + 20x1.035 + 30) = 1.035^3x(10/1.035 + 20/1.035^2 + 30)

FV = 55, 390 1.035

= 61, 412

Class 3
4.
a. First, we compute the initial price of the bond by discounting its 10 annual coupons of $6
and final face value of $100 at the 5% yield to maturity:
NPER
10

Given:
Solve For PV:

Rate
5.00%

PV

PMT
6

FV
100

Excel Formula

(107.72)

= PV(0.05,10,6,100)

You can also use the annuity formula to find the price of the bond:

Pr ice =

6
1
100
1
+
= 107.72
10
0.05 (1.05) (1.05)10

Thus, the initial price of the bond = $107.72. (Note that the bond trades above par, as its
coupon rate exceeds its yield).
Next we compute the price at which the bond is sold, which is the present value of the
bonds cash flows when only 6 years remain until maturity:
NPER
6

Given:
Solve For PV:

Rate
5.00%

PV

PMT
6

FV
100

Excel Formula

(105.08)

= PV(0.05,6,6,100)

Therefore, the bond was sold for a price of $105.08. The cash flows from the investment
are therefore as shown in the following timeline:
Year

Purchase Bond
Receive Coupons
Sell Bond
Cash Flows

$6

$6

$6

$6.00

$6.00

$6.00

$6
$105.08
$111.08

-$107.72

-$107.72

b. We can compute the IRR of the investment using the annuity spreadsheet. The PV is the
purchase price, the PMT is the coupon amount, and the FV is the sale price. The length
of the investment N = 4 years. We then calculate the IRR of investment = 5%. Because
the YTM was the same at the time of purchase and sale, the IRR of the investment
matches the YTM.
Given:
Solve For
Rate:

NPER
4

Rate

5.00%

PV
107.72

PMT FV
Excel Formula
6
105.08
= RATE(4,6,107.72,105.08)

Class 4
5.
a. we first need to find the number of share bought from each stock:
nA=200,000*0.5/25=4,000
nB=200,000*0.25/80=625
nC=200,000*0.25/2=25,000
The new value of the portfolio is
P=30nA+60nB+3nC=232,500
b. Return =

232, 500
200, 000

1 = 16.25%

c. The portfolio weight are the fraction of value invested in each stock
wA=30nA/232,500=51.61%
wB=60nB/232,500=16.13%
wC=3nC/232,500=32.26%

Class 5
6.
a. Percivals current portfolio provides an expected return of 9% with an annual standard
deviation of 10%. First we find the portfolio weights for a combination of Treasury bills
(security 1: standard deviation = 0%) and the index fund (security 2: standard deviation =
16%) such that portfolio standard deviation is 10%. In general, for a two security
portfolio:
P2 = x1212 + 2x1x21212 + x2222
(0.10)2 = 0 + 0 + x22(0.16)2
x2 = 0.625 x1 = 0.375
Further:
rp = x1r1 + x2r2
rp = (0.375 0.06) + (0.625 0.14) = 0.11 = 11.0%
Therefore, he can improve his expected rate of return without changing the risk of his
portfolio.
b. With equal amounts in the corporate bond portfolio (security 1) and the index fund
(security 2), the expected return is:
rp = x1r1 + x2r2
rp = (0.5 0.09) + (0.5 0.14) = 0.115 = 11.5%
P2 = x1212 + 2x1x21212 + x2222
P2 = (0.5)2(0.10)2 + 2(0.5)(0.5)(0.10)(0.16)(0.10) + (0.5)2(0.16)2
P2 = 0.0097
P = 0.0985 = 9.85%
Therefore, he can do even better by investing equal amounts in the corporate bond
portfolio and the index fund. His expected return increases to 11.5% and the standard
deviation of his portfolio decreases to 9.85%.

Class 6
7.

One possible procedure is to first form groups of stocks with similar P/E ratios, adjusting
for market risk (using either historical estimates of alpha or estimates based on the
Capital Asset Pricing Model). Then determine whether the alpha of each group is
significantly different from zero. Here are some things to look out for:
a. Dont select samples of stock at the end of the period. You will have omitted the
companies that went bankrupt.
b. Include dividends in the actual rate of return. Low P/E stocks have high yields.
c. Check that earnings are known on the date that you calculate P/E. Stocks whose earnings
subsequently turned out high relative to price naturally perform better.
d. Adjust for risk. Low P/E stocks tend to be more risky.
e. You may need to disentangle the P/E effect from other effects, e.g., size or dividend
yield.

Class 7
8.
a. If stock price at expiration is $10 or less, then the payoff is:
$5 1.04 = $5.2
If stock price at expiration is $11, then the payoff is:
$5 1.06 = $5.3
If stock price at expiration is $12, then the payoff is:
$5 1.08 = $5.4
This is shown in the graph below.

Payoff
5.4
5.3
5.2

10 11 12

Share price

b. The position diagram is equivalent to a risk-free loan of $5 million, at 4% interest, plus

100,000 calls with one year to expiration and exercise price of $10. If stock price is $11
at expiration, the payoff is $5.2 million plus $100,000 from exercise of the calls.

Class 8
9.

Under the CAPM the expected return of a call option can be derived by calculating the
beta of the replicating strategy portfolio. We know that the value of the call in 3-months
if price of stock is $80 is:
Call=delta*Stock+Bond
Where delta=0.28, Stock=$80 and Bond=(low call price-low stock price*delta)/(1+r)=(064*0.28)/1.01=-17.7 (amount of risk free borrowing), therefore:
Beta Call=weight in stock*beta stock (since borrowing is risk free)
We can derive the beta of the stock from its expected return (7%=60%*25%+40%*(20%)). Under the CAPM beta stock=(7%-1%)/4%=1.5.
Weight in stock= delta*stock/call=4.8
Therefore beta of call=4.8*1.5=7.2 and expected return=29.8% (risk free+beta*market
risk premium).
(Note: we can get the same return by calculation the IRR of investing in a call, using the
price of call and its expected return after 3 months)

Class 9
10.

A 6-year spot rate of 1 percent implies a negative forward rate:

(1.016/1.01255) 1 = 0.0024 = 0.24%
To make money, you could borrow $1,000 for 6 years at 1 percent and lend $1000 for 5
years at 1.25 percent. The future value of the amount borrowed is:
FV6 = $1,000 (1.01)6 = $1,061.52
The future value of the amount loaned is:
FV5 = $1000 (1.0125)5 = $1,064.08
This ensures enough money to repay the loan by holding cash over from year 5 to year 6,
and provides a $2.56 inflow in year 5.
The minimum sensible rate satisfies the condition that the forward rate is 0%:
(1 + r6)6/(1.0125)5 = 1.00
This implies that r6 = 1.04 percent.

Class 10
11.

Sell short $8 million of the British market portfolio. In practice rather than sell the
market you would sell futures on $8 million of the market index.