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The trader holding the long position profits from price increases. Suppose that at expira-
tion, corn is selling for $2.255 per bushel. The long position trader who entered the contract at
the futures price of $2.055 on October 26 would pay the previously agreed-upon $2.055 for
each unit of the index, which at contract maturity would be worth $2.255.
Because each contract calls for delivery of 5,000 bushels, the profit to the long position, ig-
noring brokerage fees, would equal 5,000 ($2.255 $2.055) $1,000. Conversely, the
short position must deliver 5,000 bushels for the previously agreed-upon futures price. The
short position™s loss equals the long position™s profit.
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Fifth Edition

2 Global Financial Instruments

The distinction between the right to purchase and the obligation to purchase the asset is the
difference between a call option and a long position in a futures contract. A futures contract
obliges the long position to purchase the asset at the futures price; the call option merely conveys
the right to purchase the asset at the exercise price. The purchase will be made only if it yields a
Clearly, the holder of a call has a better position than the holder of a long position on a fu-
tures contract with a futures price equal to the option™s exercise price. This advantage, of
course, comes only at a price. Call options must be purchased; futures investments are con-
tracts only. The purchase price of an option is called the premium. It represents the compen-
sation the purchaser of the call must pay for the ability to exercise the option only when it is
profitable to do so. Similarly, the difference between a put option and a short futures position
is the right, as opposed to the obligation, to sell an asset at an agreed-upon price.

• Money market securities are very short-term debt obligations. They are usually highly
marketable and have relatively low credit risk. Their low maturities and low credit risk
ensure minimal capital gains or losses. These securities trade in large denominations, but
they may be purchased indirectly through money market funds.
• Much of U.S. government borrowing is in the form of Treasury bonds and notes. These
are coupon-paying bonds usually issued at or near par value. Treasury bonds are similar in
design to coupon-paying corporate bonds.
• Municipal bonds are distinguished largely by their tax-exempt status. Interest payments
(but not capital gains) on these securities are exempt from income taxes.
• Mortgage pass-through securities are pools of mortgages sold in one package. Owners of
pass-throughs receive all principal and interest payments made by the borrower. The firm
that originally issued the mortgage merely services the mortgage, simply “passing
through” the payments to the purchasers of the mortgage. The pass-through agency
usually guarantees the payment of interest and principal on mortgages pooled into these
pass-through securities.
• Common stock is an ownership share in a corporation. Each share entitles its owner to one
vote on matters of corporate governance and to a prorated share of the dividends paid to
shareholders. Stock, or equity, owners are the residual claimants on the income earned by
the firm.
• Preferred stock usually pays a fixed stream of dividends for the life of the firm: It is a
perpetuity. A firm™s failure to pay the dividend due on preferred stock, however, does not
set off corporate bankruptcy. Instead, unpaid dividends simply cumulate. New varieties of
preferred stock include convertible and adjustable-rate issues.
• Many stock market indexes measure the performance of the overall market. The Dow

Jones averages, the oldest and best-known indicators, are price-weighted indexes. Today,
many broad-based, market value-weighted indexes are computed daily. These include the
Standard & Poor™s composite 500 stock index, the NYSE, the Nasdaq index, the Wilshire
5000 Index, and several international indexes, including the Nikkei, FTSE, and Dax.
• A call option is a right to purchase an asset at a stipulated exercise price on or before an
expiration date. A put option is the right to sell an asset at some exercise price. Calls increase
in value, while puts decrease in value as the value of the underlying asset increases.
• A futures contract is an obligation to buy or sell an asset at a stipulated futures price on a
maturity date. The long position, which commits to purchasing, gains if the asset value
increases, while the short position, which commits to delivering the asset, loses.
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Fifth Edition

54 Part ONE Elements of Investments

bankers™ acceptance, 28 equally weighted index, 46 preferred stock, 41
call option, 48 Eurodollars, 28 price-weighted average, 42
capital markets, 26 Federal funds, 29 put option, 49
certificate of deposit, 27 futures contract, 51 repurchase agreements, 29
commercial paper, 28 LIBOR, 29 Treasury bills, 27
common stocks, 39 market value-weighted Treasury bonds, 31
corporate bonds, 35 index, 45 Treasury notes, 31
derivative asset/contingent money markets, 26
claim, 48 municipal bonds, 33

PROBLEM 1. Preferred stock
SETS a. Is actually a form of equity.
b. Pays dividends not fully taxable to U.S. corporations.
c. Is normally considered a fixed-income security.
d. All of the above.
2. Straight preferred stock yields often are lower than yields on straight bonds of the same
quality because of
a. Marketability
b. Risk
c. Taxation
d. Call protection
3. Turn back to Figure 2.3 and look at the Treasury bond maturing in May 2008.
a. How much would you have to pay to purchase one of these bonds?
b. What is its coupon rate?
c. What is the current yield of the bond?
4. In what ways is preferred stock like long-term debt? In what ways is it like equity?
5. Why are money market securities sometimes referred to as “cash equivalents?”
6. Find the after-tax return to a corporation that buys a share of preferred stock at $40,
sells it at year-end at $40, and receives a $4 year-end dividend. The firm is in the 30%
tax bracket.
7. Turn to Figure 2.9 and look at the listing for General Dynamics (GenDynam).
a. What was the firm™s closing price yesterday?
b. How many shares could you buy for $5,000?
c. What would be your annual dividend income from those shares?
d. What must be its earnings per share?
8. Consider the three stocks in the following table. Pt represents price at time t, and Qt
represents shares outstanding at time t. Stock C splits two-for-one in the last period.
P0 Q0 P1 Q1 P2 Q2

A 90 100 95 100 95 100
B 50 200 45 200 45 200
C 100 200 110 200 55 400

a. Calculate the rate of return on a price-weighted index of the three stocks for the first
period (t 0 to t 1).
b. What must happen to the divisor for the price-weighted index in year 2?
c. Calculate the rate of return of the price-weighted index for the second period
(t 1 to t 2).
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Fifth Edition

2 Global Financial Instruments

9. Using the data in problem 8, calculate the first period rates of return on the following
indexes of the three stocks:
a. a market value-weighted index.
b. an equally weighted index.
10. An investor is in a 28% tax bracket. If corporate bonds offer 9% yields, what must
municipals offer for the investor to prefer them to corporate bonds?
11. Suppose that short-term municipal bonds currently offer yields of 4%, while
comparable taxable bonds pay 5%. Which gives you the higher after-tax yield if your
tax bracket is:
a. Zero
b. 10%
c. 20%
d. 30%
12. Find the equivalent taxable yield of the municipal bond in the previous question for tax
brackets of zero, 10%, 20%, and 30%.
13. Which security should sell at a greater price?
a. A 10-year Treasury bond with a 9% coupon rate or a 10-year T-bond with a 10%
b. A three-month maturity call option with an exercise price of $40 or a three-month
call on the same stock with an exercise price of $35.
c. A put option on a stock selling at $50 or a put option on another stock selling at
$60. (All other relevant features of the stocks and options are assumed to be
14. Look at the futures listings for gold in Figure 2.12.
a. Suppose you buy one gold contract for December 2001 delivery. If the
contract closes in December at a price of $283 per ounce, what will your
profit be?
b. How many December 2001 maturity contracts are outstanding? How many ounces
of gold do they represent?
15. Turn back to Figure 2.11 and look at the IBM options. Suppose you buy a November
maturity call option with exercise price 105.
a. If the stock price in November is 107, will you exercise your call? What are the
profit and rate of return on your position?
b. What if you had bought the call with exercise price 100?
c. What if you had bought a put with exercise price 105?
16. Why do call options with exercise prices higher than the price of the underlying stock
sell for positive prices?
17. Both a call and a put currently are traded on stock XYZ; both have strike prices of $50

and maturities of six months. What will be the profit to an investor who buys the call for
$4 in the following scenarios for stock prices in six months? (a) $40; (b) $45; (c) $50;
(d) $55; (e) $60. What will be the profit in each scenario to an investor who buys the
put for $6?
18. Explain the difference between a put option and a short position in a futures contract.
19. Explain the difference between a call option and a long position in a futures contract.
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Fifth Edition

56 Part ONE Elements of Investments

20. What would you expect to happen to the spread between yields on commercial paper
and Treasury bills if the economy were to enter a steep recession?
21. Examine the first 25 stocks listed in Figure 2.9. For how many of these stocks is the
52-week high price at least 50% greater than the 52-week low price? What do you
conclude about the volatility of prices on individual stocks?

Interest Rates
Go to http://www.bloomberg.com/markets/index.html. In the markets section under
Rates & Bonds, find the rates in the Key Rates and Municipal Bond Rates sections.
1. Describe the trend over the last six months in
a. Municipal bond yields
b. AAA-rated industrial bonds
c. 30-year mortgage rates

SOLUTIONS TO 1. Compare the 4.81% yield on the Federal Home Loan Bank bond maturing in 9-08 (September

2008) with the 4.31% yield on the November 2008 T-bond. The differential can be attributed
Concept largely to the difference in default risk.
CHECK 2. A 6% taxable return is equivalent to an after-tax return of 6(1 .28) 4.32%. Therefore, you
would be better off in the taxable bond. The equivalent taxable yield of the tax-free bond is
4/(1 .28) 5.55%. So a taxable bond would have to pay a 5.55% yield to provide the same
after-tax return as a tax-free bond offering a 4% yield.
3. a. You are entitled to a prorated share of IBM™s dividend payments and to vote in any of IBM™s
stockholder meetings.
b. Your potential gain is unlimited because IBM™s stock price has no upper bound.
c. Your outlay was $95 100 $9,500. Because of limited liability, this is the most you can lose.
4. The price-weighted index increases from 62.50 [ (100 25)/2] to 65 [ (110 20)/2)], a gain of
4%. An investment of one share in each company requires an outlay of $125 that would increase in
value to $130, for a return of 4% (5/125), which equals the return to the price-weighted index.
5. The market value-weighted index return is calculated by computing the increase in value of the
stock portfolio. The portfolio of the two stocks starts with an initial value of $100 million $500
million $600 million and falls in value to $110 million $400 million $510 million, a loss of
90/600 .15, or 15%. The index portfolio return is a weighted average of the returns on each stock
with weights of 1„6 on XYZ and 5„6 on ABC (weights proportional to relative investments). Because

the return on XYZ is 10%, while that on ABC is 20%, the index portfolio return is (1„6)10 (5„6)
( 20) 15%, equal to the return on the market value-weighted index.
6. The payoff to the call option is 104 100 $4. The call cost $1.80. The profit is $2.20 per share.
The put will pay off zero”it expires worthless since the stock price exceeds the exercise price. The
loss is the cost of the put, $0.80.
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