## Sample Syllabi & Assignments: Finance

**Course Name:** Investments

**Instructor(s):** Thomas Rietz

**Discipline:** Finance

**Level:** Undergraduate

**Comments:**

Questions prepared by Thomas A. Rietz for use with "Essentials of Investments, 3^{rd} Edition," by
Zvi Bodie, Alex Kane and Alan Marcus. Copyright 1998. Irwin/McGraw-Hill, Burr Ridge, Illinois.

Thanks go to Puneet Handa, the TA's and students of the Introductory Financial Management Classes at the University of Iowa for help in developing the questions used in that course.

### Contents

Chapter 1

Chapter 2

Chapter 3

Chapter 4

Chapter 5

Chapter 6

Chapter 7

Chapter 8

Chapter 9

Chapter 11

Chapter 12

Chapter 13

Chapter 14

Chapter 15

Chapter 16

Chapter 18

Chapter 20

### Chapter 1

- What kind of assets are traded on the IEM?
- Real
- Financial
- Both
- Neither
- What kind of assets are traded on the IEM?
- Fixed income
- Equity
- Derivative
- All three
- None of the above
- What kind of market is the IEM?
- Primary
- Secondary
- Both
- Neither
- What kind of market is the IEM?
- Continuous
- Periodic
- Both
- Neither
- When you choose between putting cash in an IEM account or in your bank account, you are engaging in:
- An asset allocation decision
- A security selection decision
- Both
- Neither

- When you choose between purchasing AAPLm
^{(1)}and IBMm contracts in the Computer Industry Returns Market on the IEM, you are engaging in: - An asset allocation decision
- A security selection decision
- Both
- Neither
- If you choose to buy MSxxxmH
^{(2)}in the MSFT (Microsoft) Price Level Market in the IEM and hold this contract until it pays off in the IEM, you are following what kind of investment strategy: - Passive
- Active
- Both
- Neither

### Chapter 2

- What kind of market is the IEM?
- A stock market
- A bond market
- A contingent claim market
- All of the above
- None of the above
- The IEM contract SP500m is based on the return on the S&P500 index. What kind of index is the S&P500?
- Market value weighted
- Price weighted
- Both
- Neither
- Describe how returns are calculated to determine the payoffs to contracts in the IEM Computer Industry Returns Market. Find price and dividend information for the stock or index underlying each contract in the market for the last month and determine the return to each.
- Connect to the IEM and look at the market "F"undamental information under the "I"nformation menu in the Computer Industry Returns Market. What have the monthly returns to the S&P500 been over the last year? What was the high return? What was the low return? Why do returns vary from month to month?
- How would you go about constructing a price weighted index for the computer industry using Apple, IBM and Microsoft stock? How would you go about constructing a market value weighted index for the computer industry using the same stocks? What other stocks might you want to include in your index?

### Chapter 3

- What kind of market is the IEM?
- Direct search
- Over the counter
- Exchange
- All of the above
- None of the above
- Describe the process through which securities are created on the IEM? (Hint: suppose you were the first trader on the IEM and there were no asks outstanding for securities, how would you obtain securities?)
- How are secondary transactions carried out on the IEM? (Hint: how do traders buy and sell securities from each other?)
- Look up the prospectuses for the Computer Industry Returns Market and the MSFT (Microsoft) Price Level Market on the IEM. (These can be found in the "N"ews windows of the market "I"nformation menu.) Describe the important features of the contracts traded in these markets.
- Look up and record the current bid and ask for MSFTm on the Computer Industry Returns Market. What does this bid mean? What does this ask mean? What is the bid/ask spread and what does it mean?
- Using the IEM, how would you:
- Submit a market order to buy SP500m?
- Submit a market order to sell MSxxxmH?
- Submit a limit order to buy MSxxxmL for $0.646?
- Submit a limit order to sell AAPLm for $0.745?
- Can you buy on margin on the IEM?
- While you cannot directly short sell on the IEM, you can "synthetically" construct the same payoffs on your portfolio. For example, you could

Buy both MSxxxmH and MSxxxmL from the IEM itself for $1 (using 1$m as the purchase contract name to buy the unit portfolio) and

Sell MSxxxmL at the outstanding bid of $0.455.

Why does this result in the same net payoffs as short selling MSxxxmL for $0.455? (Hint: If you actually could short sell MSxxxmL, you would have to pay its owner $1 if its payoff were $1 at maturity and $0 otherwise. What happens to the value of your portfolio as a result of your synthetic position when MsppmL pays off $1 or $0.)

### Chapter 4

- Describe your IEM investment objective and trading strategy. Are you an active investor or a passive investor? Why?

### Chapter 5

Look up the last price for the IBMm contract in the Computer Industry Returns Market. Suppose you purchased this contract at this price and held it until maturity. Based on this information, answer questions 1 through 3.

- What is your holding period return if the IEMm contract pays off $1?
- What is your holding period return if the IEMm contract pays off $0?
- Financial theory predicts that the price should equal the probability that IBMm will pay off $1. If this is true, calculate your expected return, its variance and its standard deviation.
- How do you construct a risk free portfolio on the IEM?
- How do you take a risky portfolio position on the IEM?
- Connect to the IEM and look at the market "F"undamental information under the "I"nformation menu in the Computer Industry Returns Market. What are the historical average monthly returns and standard deviations for this period? Since the T-Bill rate varies, how is it risk free?

### Chapter 6

- In the IEM, there are two ways to hold risk free investment:
- Suppose you purchase 1 share each of MSxxxmH and MSxxxmL in the MSFT (Microsoft) Price Level Market. Suppose further that the prices were $0.400 and $0.600, respectively. Finally, suppose the price of each contract is the probability that it will pay off $1. What is the unique risk to MSxxxmH? What is the unique risk to MSxxxmL? What is the portfolio risk? What is the systematic risk to MSxxxmH and MSxxxmL? What is the correlation between the returns on MSxxxmH and MSxxxmL?
- Suppose you purchase 1 share each of MSFTm and SP500m in the Computer Industry Returns Market. Suppose further that the prices were $0.200 and $0.300, respectively. Suppose the price of each contract is the probability that it will pay off $1. Finally, suppose that the correlation coefficient between these returns is -0.3273. What is the unique risk to MSFTm? What is the unique risk to SP500m? What is the portfolio risk? What happens to the portfolio risk as the correlation coefficient varies between -1, 0 and 1? Compare the portfolio risk to the risk of an IEM contract with a price of $0.500.
- Suppose you purchase 1 share each of AAPLm and SP500m in the Computer Industry Returns Market. Suppose further that the prices were $0.500 and $0.200, respectively. Suppose the price of each contract is the probability that it will pay off $1. This implies that the price of the portfolio containing 1 share each of AAPLm and SP500m is $0.700. This should be the probability that the portfolio will pay off $1. What is the expected return and standard deviation to each individual contract and the portfolio? What correlation coefficient between AAPLm and IBMm returns equates the portfolio standard deviation according to the portfolio price of $0.700 with the portfolio standard deviation according to the the two individual contracts that form the portfolio (AAPLm and IBMm)?

Hold cash in your trading account.

Hold a complete unit portfolio (e.g., 1 share each of AAPLm, IBMm, MSFTm and SP500m or 1 share each of MSxxxmH and MSxxxmL).

Given this, what should the return to holding a unit portfolio be? Given that you can purchase a unit portfolio farm the IEM at any time for $1 (using the contract name $1m), what will the return to holding a unit portfolio actually be?

### Chapter 7

- What is the market portfolio in the IEM Computer Industry Returns Market? What should the return on this portfolio be? Should there be risk premiums in the IEM?
- Suppose the following bids and asks exist in the MSFT (Microsoft) Price Level Market:
- Find and record beta's for the common stock of each company traded on the IEM Computer Industry Returns Market. Beta's can be found from the following sources, among others:
- Given the beta's you find in Question 3, you should calculate the one-month CAPM expected return for each company according to the following assumptions:
- Given the beta's you estimate from IEM data in Question 3, calculate the one-month CAPM expected return for each company according to the following rates:
- Given your estimated beta's from questions 4 or 5, determine which security in the Returns Market should be priced the highest on the day that trading opens for a given month in this Computer Industry Returns Market and explain why this should be the case.

Contract | Bid | Ask |

MSxxxmH | 0.463 | 0.472 |

MSxxxmL | 0.546 | 0.550 |

An arbitrage opportunity exists! Describe how you exploit it to make a certain profit?

1. Value Line Investment Survey or Value Screen

2. Standard & Poor's Reports

3. S&P Stock Market Encyclopedia

4. Bloomberg Information Services

5. From various sources on the WWW. (See the IEM webpages at tippie.uiowa.edu/iem for current links to sources of betas.)

Compare these betas from those you estimate using a regression and the data from the IEM's Computer Industry Returns Market, "F"undamental Information page under the "I"nformation menu.

1. The one-month T-Bill return is: 0.45%.

2. The one-month expected market return is: 1.00%

1. The current one-month T-Bill return from the WSJ.

2. The average one-month return for the S&P500 from the IEM data.

### Chapter 8

- What the implications for IEM prices of:
- According to each form of efficiency, which of the following activities should be profitable for you as an IEM trader:
- Looking up current AAPL, IBM, MSFT and S&P500 prices in the newspaper to see which IEM contract is most likely to pay off.
- Statistical analysis of past IEM prices to look for trends, patterns, etc.
- An in depth analysis of Apple, IBM and Microsoft annual reports to look for company strengths and weaknesses.
- Calling a friend at MSFT and getting the inside scoop on the next product that they are planning to release.
- Suppose everyone believes that the IEM is so efficient that none of the activities in Question 2 will prove profitable and no one undertakes any of these activities. Do you expect that the IEM prices will still be efficient? Will they still reflect the relative probabilities that each contract will payoff $1? How do you explain this paradox?

Weak form efficiency?

Semi-strong form efficiency?

Strong form efficiency?

### Chapter 9

- In the IEM, some traders buy particular contracts (e.g., IBMm and MSFTm) and hold them until they pay off regardless of prices. This would lead to a market characterized by:
- Expectations Theory
- Liquidity Preference Theory
- Market Segmentation Theory
- All of the above
- None of the above
- What are the implications of this kind of behavior for IEM market prices?

### Chapter 11

- Suppose you conduct an extensive macro-economic analysis and complete it just before trade opens for a month in new IEM contracts on the Computer Industry Returns and MSFT (Microsoft) Price Level Markets. In what ways would this analysis help you in predicting what will happen on the IEM in these two markets?
- Build a price and news log for the companies trading in the Computer Industry Market along with the S&P500 for one trading month on the IEM. Record the following information once a week on the same day each week:
- Wall Street Journal closing prices for each underlying security. (IBM stock prices can be found in the NYSE Composite Index each day; Microsoft and Apple stock prices can be found in the NASDAQ Index each day and the S&P500 Index is listed in the upper left corner of page C1 each day.)
- IEM last trade prices for each IEM traded security. (These prices can be found under "C"ontract Daily Prices in the Market "I"nformation screen on the IEM.)

During this time, find four news articles from any source on general economic conditions. For each article, explain how you believe the information should effect prices for the companies' stock and the S&P500 on the stock markets and how this information should effect prices for the contracts on the IEM. Finally, compare your predictions to the actual price changes recorded in your price log.

### Chapter 12

- Fixed Dividend Model. Find the most recent quarterly dividend for one of the companies (AAPL, IBM or MSFT). (The IEM news sections with contain recent dividend information for each contract.) Given this, the CAPM required returns from Questions 5 or 6 of Chapter 7 to calculate prices according to the following assumptions:
- The company pays fixed, quarterly dividends equal to the last dividend paid.
- The next dividend will be paid in exactly one quarter.
- Historical Growth Model. Look up the five year historical growth rate in dividends (using Bloomberg, ValueScreen or company annual reports). Use this as the growth rate along with last quarter's dividend and the CAPM required return to find the price of the company's stock using the Gordon growth model.
- A Simple Projected Growth Model. To get an alternative estimate of the company's stock price, look up the company's ROE and retention rate (using Bloomberg, ValueScreen or company annual reports). Determine the projected growth rate in dividends from these numbers and find the price of the company's stock using the Gordon grown model, the CAPM required return and this projected growth rate.
- The Implied Growth Rate. As an alternative way of determining growth rates, use the current dividend, the CAPM required return and the current stock price to solve for the growth rate according to the Gordon growth model.
- Given your answers to Questions 1-4, what do you believe the current stock price and growth rate in dividends should be? Be sure to be consistent and justify your answer.
- Build a price and news log for the companies trading in the Computer Industry Market along with the S&P500 for one trading month on the IEM. Record the following information once a week on the same day each week:
- Wall Street Journal closing prices for each underlying security. IBM stock prices can be found in the NYSE Composite Index each day; Microsoft and Apple stock prices can be found in the NASDAQ Index each day and the S&P500 Index is listed in the upper left corner of page C1 each day.
- IEM last trade prices for each IEM traded security. These prices can be found under "C"ontract Daily Prices in the Market "I"nformation screen on the IEM.

Explain why the stock prices calculated here might differ from those found the Wall Street Journal.

During this time, find two news articles from any source on each company. For each article, you should explain how you believe the information should effect prices for the company's stock on the stock market and how this information should effect prices for the contracts on the IEM. Finally, compare your predictions to the actual price changes recorded in your price log.

### Chapter 13

- Obtain last years balance sheets and cashflow statements for the companies traded on the IEM Computer Industry Returns Market using the annual report, Edgar, Bloomberg, ValueScreen or some other source. Conduct a financial analysis as discussed in this chapter. Based on your analysis which stock do you think are undervalued and overvalued? What does your analysis imply for prices of the IEM contracts that are currently trading in the Computer Industry Returns Market?

### Chapter 14

- Chart the IEM prices for contracts in the Computer Industry Returns Markets for a month of trading. (Daily price summaries can be found on the IEM from the "C"ontract Daily Prices section under the Market "I"nformation screen. They can also be found from the IEM web pages under the Computer Industry Returns Market.) Identify any trends, turning points and patterns that you see based on this analysis. Do you think this is a valuable exercise in helping you predict what will happen during future IEM markets?

### Chapter 15

IEM Computer Industry Returns and MSFT (Microsoft) Price Level Market contracts are actually specialized options contracts called "Binary Options" (because they have payoffs of either $0 or $1 depending on the underlying securities).- Are IEM options:
- American Style
- European Style
- Both
- Neither
- Plot the payoff and profit function for the currently traded MSxxxmH and MSxxxmL contracts in the MSFT (Microsoft) Price Level Market on the IEM. Base your diagrams on the last trade price. In what ways do these functions differ from the exchange traded options?
- Notice that the value of holding 1 share of each contract MSxxxmH and MSxxxmL always equals $1. Explain how this is equivalent to "put call parity" as described in the chapter.

### Chapter 16

IEM Computer Industry Returns and MSFT (Microsoft) Price Level Market contracts are actually specialized options contracts called "Binary Options" (because they have payoffs of either $0 or $1 depending on the underlying securities).- Plot the payoff and profit function for the currently traded MSxxxmH and MSxxxmL contracts based on the last trade price. In what ways does these functions differ from the exchange traded options?
- If risk-neutral pricing holds for MSxxxmH, what must the probabilities of paying off $1 and $0 be for this contract? (Recall that the risk free rate in the IEM is zero.)
- If you knew the probabilities that MSFT stock would finish a particular month at a price above or below the cutoff level for the MSFT (Microsoft) Price Level Market on the IEM, how would you value the contracts traded on the IEM (MSxxxmH and MSxxxmL)?
- Given today's price of MSFT stock on the stock market and its variance, how would you go about determining what the prices of MSxxxmH and MSxxxmL on the IEM should be?

### Chapter 18

- Calculate the return to date for your IEM account using both dollar weighted and time weighted methods. When using time weighted methods, use both geometric and arithmetic time averaging. Explain any differences you find.
- Have you tried active portfolio management with your IEM portfolio in the form of Market Timing? Have you tried Security Selection? How have you done this and why?
- How is your IEM portfolio doing relative to the risks you have undertaken?

### Chapter 20

- Over a one month IEM market period, determine what would happen to the value of your portfolio of you engage in market timing and always purchased securities that subsequently went up in value and sold securities that went down in value. Determine what would happen if you selected securities perfectly (invested your entire portfolio in the security that ultimately paid off $1 when its price was at its historical low.)
- Why are the possible IEM profits from Question 1 mostly illusionary?

### NOTES

1. The letter "m" designates the contract month with "a" representing January, "b" representing February, etc.

2. Here, "xxx" designates a cutoff price level for Microsoft stock and "m" designates the contract month with "a" representing January, "b" representing February, etc.