Exercise Sheet 1 Exercies 1.1
Use the monthly data on historical prices in Yahoo to plot the share price of LloydsTSB over the past year. If you had invested £ 10,000 in LloydsTSB in October 2007 what would it be worth now?
Solution 1.1
One year chart
1 October 2007: 496.81 1 October 2008: 197.80 1 October 2009: 87.03 1 October 2010: 68.94 3 October 2011: 32.49 1 October 2012: 40.58 23 January 2013: 52.02 This gives 10000 52:02 496:81 = 1047:10
Five year chart
Exercise 1.2
There are many stocks which have performed even worse than Exeter Equity Growth Fund. Why will many of these be absent from the Yahoo data?
Solution 1.2
When a stock collapses as quickly as Exeter Equity Growth Fund it indicates a company with serious problems of performance. The low stock price makes the company a target for a takeover and, if a takeover goes ahead, the company may be incorporated within a new …rm. Alternatively the collapse in the stock price makes it di¢ cult for the company to conduct business. This compounds the situation and could lead to bankruptcy. Liquidation follows and the …rm’s stock are removed from the market.
Exercise 1.3
If a method was developed to predict future stock prices perfectly, what e¤ect would it have upon the market?
Solution 1.3
If prices could be predicted investors would trade safe in the knowledge that they could not make a losing trade. For instance, if it was known that the price of a stock was to rise tomorrow, all investors would wish to buy it today and sell tomorrow after the rise in price. The perfect prediction would ensure this was a winning strategy. Obviously, the previous statements are self-contradictory. The
strategy described would be followed by all investors. Demand today would rise leading to a higher price. Supply tomorrow would rise, leading to a fall in price. Trading on the perfect prediction alters the prices from what was predicted, so the prediction could not be correct. Perfect prediction cannot be possible since trading leads to a price that di¤ers from what is predicted.
Exercise 1.4
At the start of January 1999 one investor makes a real investment by pur-chasing a house for $300000 while a second investor purchases a portfolio of securities for $300000. The …rst investor lives in the house for the next two years. At the start of January 2001 the house is worth $350000 and the portfo-lio of securities is worth $375000. Which investor has fared better?
Solution 1.4
Over the two-year holding period the returns on the two investments are:
rHOU SE =
350000 300000
300000 = 0:1667;
rSECU RIT IES =
375000 300000
300000 = 0:25:
These returns indicate that the securities have performed best. However, the house has delivered a ‡ow of housing services and will have required main-tainance. The ‡ow of services should be given a monetary value and, along with the costs, included in the calculation of return. For example. assume that a house of equal size rents for $1500 per month and that maintainance csts are $5000. The correct calculation on the return of the house purchase is
rHOU SE =
350000 + 24 1500 300000 5000
300000 = 0:27: Correctly calculated the return on the house is higher.
Exercise 1.5
Is a theory which tells us that we “cannot beat the market” useless? Solution 1.5
The meaning of phrase ”cannot beat the market” refers to the claim that security prices are unpredictable. This prevents any investor from being able to continually earn returns above the market average. In the short term some may succeed but only because the underlying randomness means someone will. There is a second side to this. Even if it is not possible to beat the market it always remains possible to lose, and lose badly. The theory makes the causes of risk clear, relates risks to the structure of the portfolio, and identi…es the risk/return tradeo¤. An investor applying the theory should avoid unnecessary risk and not enter into investments without understanding the consequences.
You are working as a …nancial advisor. A couple close to retirement seek your advice. Should you recommend a portfolio focused on high-technology stock or one focused on corporate bonds? Would your answer be di¤erent if you were advising a young newly-wed couple?
Solution 1.6
An important step in the investment process is to set the objective. One way to think about the objective is in terms of the degree of risk that the investor is willing to accept. An elderly couple may be concerned primarily with protecting their wealth. This would make them unwilling to take on a risky investment. High-technology stock are some of the most risk stock that there are. The expected returns can be very high but the degree of risk is correspondingly high. They would not be a good choice for an elderly couple who care most about protecting their wealth. In contrast coporate bonds can be faily secure investments. If only bonds with high ratings are chosen then the portfolio will be low risk. The answer may well be very di¤erent for a newly-wed couple. At the start of their working life they may be willing to take on risk in the belief that there will be time to recover from the realisation of an adverse outcome.
Exercise 1.7
By searching on the Internet obtain data on the interest rates on savings accounts. How are these rates related to liquidity?
Solution 1.7
http://www.abbey-products.com/bradford-bingley-savings/variable-rate.html Exercise 1.8
If all investors employed technical analysis, would technical analysis work? Solution 1.8
Technical analysis is the use of patterns in the past history of asset prices to make predictions about the path of future prices. It only works if there is repetition in the patterns. Unfortunately if investors traded on the basis of technical analysis then this would disrupt the pattern. As a very simple example if it was observed that two “downs” were always followed by an “up” then investors would buy on the second down and sell in the expectation of the up. This would reverse the up into a down.
Exercise 1.09
Are US treasury bills a safe asset for an investor who lives in Argentina? Solution 1.09
There is very little risk that the bond will not make it promised payments. The US government has never defaulted and there is now chanced it will do so at the present time. The risk in holding the bonds is centred around currency risk. The investor in Argentina will wish to have payment in nuevo peso but the
bonds will make payment in US dollars. The value of these dollars in Argentina will be determined by the exchange rate. This can vary and is unpredictable.
Exercise 1.10
Corporations usually try to keep dividend payments relatively constant even in periods when pro…ts are ‡uctuating. Why should they wish to do this?
Solution 1.10
Financial markets operate on the basis of information ‡ows. All prices and actions are interpreted in terms of the information they convey. This is also true about dividends. A fall in dividend is seen as a signal of very bad news. This leads to conservatism in raising dividends and immense reluctance to reduce.
