37-735
CHAPTER 37
Financial Economics
A. Short-Answer, Essays, and Problems
1. What is financial economics? What are the most important investor preferences?
2. What are the two main investor preferences and how do they conflict?
3. What is the difference between an economic investment and a financial investment?
4. Suppose an asset originally costs $200 and earns an interest rate of 10%. Use this information to answer
the following questions.
5. Suppose Anne borrows $500 at an interest rate of 7%, which she will pay off in 5 years. Answer the
following questions.
6. Suppose Frank is considering purchasing an asset that will have a future value of $1000 in 7 years. The
interest rate is 6% and the price of the asset is $600. Should Frank buy the asset? Why or why not?
7. Suppose Jackie is considering purchasing an asset that will have a future value of $650 in 4 years. The
interest rate is 8% and the price of the asset is $500. Should Jackie buy the asset? Why or why not?
8. Suppose Mark has the option of investing in two different investments that cost $200 each. One promises
to earn 5% in compounded interest over the next 5 years. The other promises to earn $255.26 in 5 years.
Assume the interest rate is 5%. Which asset will he choose?
9. Why might a lottery winner decide to take a large lump sum payment rather than receive installments of
their winnings over time? How does the concept of present value influence this decision?
10. David Beckham, a prominent soccer player, is considering signing on for another two years with his current
soccer club. The team managers, however, face a salary cap of $60 million for their team and have already
6.5%. Should he agree to the contract?
11. LeBron James, a prominent basketball player, is considering signing on for another two years with his
current team. The team managers, however, face a salary cap of $90 million for their team and have
6.5%. Should he agree to the contract?
12. What are the three common features of all investments and why are they important?
13. What are the distinguishing features of a stock? What happens to stockholders if the corporation fails?
14. What are the two ways that a stock investor can gain financially from owning stocks?
15. What are the main characteristics of a bond? How does it differ from a stock?
16. What is a mutual fund? How do mutual funds differ from stocks and bonds?
17. Distinguish between the two main kinds of mutual funds.
22.Why do investors engage in arbitrage?
23. Suppose the stocks for two relatively identical auto makers, A and B, are selling for $100 and $150
respectively. Both are predicted to sell for $200 in the coming year. What action do you expect investors
engaging in arbitrage to take? What will be the ultimate effect of this action?
24. Why is it difficult for most investors to take advantage of arbitrage opportunities?
26. Consider the following situations and decide whether they represent diversifiable risk or non-diversifiable
risk. Explain your answer.
27. Suppose an investor is considering investing in three different assets. One asset is equally likely to earn 10,
14 or 20 percent per year. Another is likely to earn 15 percent per year 75% of the time and 25 percent per
year 25% of the time. The final asset is equally likely to earn 15 or 20 percent per year.
28. What countries rank as the lowest and highest risk countries according to the international country risk
guide? What types of risks are included in this measure?
29. How does the fact that asset prices and expected rates of return are inversely related cause asset risk and
expected rates of return to be positively related?
31. What is the risk-free interest rate?
32. Define the relationship between the average expected rate of return, if, and the risk premium.
33. Explain the relationship displayed on the graph based on a risk level of X. Use the other capital letters on
34. Suppose Leslie is considering developing an asset portfolio. She must receive a minimum of 5% to
compensate for her delayed consumption and given her investment bundle, receive 10% in return.
(a) What is if?
(b) What is the risk premium?
(c) What is the average expected return?
35. Suppose Ron is considering developing an asset portfolio. He expects to receive a return of 15% and is
willing to take on a maximum risk premium of 8%.
(a) What is if?
(b) If the Fed engages in open market operations that cause the risk-free interest rate to change to 9%, how
will Ron’s expected return change?
(c) How will Ron’s expected return change if they lower it to 5%?
36. How does investors’ preference for risk affect the slope of the security market line?
37. Fill in the table below and answer the following questions. Assume the slope of the SML = 0.5 for all
investors.
if = 0.05
if = 0.03
if = 0.08
Beta
AERR1
AERR2
AERR3
0
_____
_____
_____
0.5
_____
_____
_____
1
_____
_____
_____
1.5
_____
_____
_____
2
_____
_____
_____
2.5
_____
_____
_____
38. How does arbitrage tend to move any asset divergent from the Security Market Line back to it?
39. Explain the logic behind the fact that if the Federal Reserve raises the risk-free interest rate, return rates of
40. Explain the logic behind the fact that if the Federal Reserve lowers the risk-free interest rate, return rates of
41. Use the security market line model to explain why stock prices did not rise when the Federal Reserve
42. (Last Word) What are two main reasons that actively managed funds perform poorly relative to index
funds?
37-739
B. Answers to Short-Answer, Essays, and Problems
1. What is financial economics? What are the most important investor preferences?
2. What are the two main investor preferences and how do they conflict?
3. What is the difference between an economic investment and a financial investment?
4. Suppose an asset originally costs $200 and earns an interest rate of 10%. Use this information to answer
the following questions.
(a) What value will the asset have after the first year?
(b) What value will the asset have after five years if the interest is compounded?
(c) Suppose the asset can be held for a maximum of 15 years. What is the final value of this asset?
(d) If the asset is held the maximum length of time (15 years), what is its total rate of return? How does it
compare to its interest rate?
5. Suppose Anne borrows $500 at an interest rate of 7%, which she will pay off in 5 years. Answer the
following questions.
(a) How much will she owe at the end of the 5 years, assuming the interest is compounded?
(b) If Anne is planning to invest her loan in an asset that she hopes to turn a profit on, what is the
minimum rate of return she needs to earn?
(c) Suppose Anne is able to pay off her loan in 3 years. What is the size of the repayment she will owe?
What rate of return will she have to earn now to at least break even?
6. Suppose Frank is considering purchasing an asset that will have a future value of $1000 in 7 years. The
interest rate is 6% and the price of the asset is $600. Should Frank buy the asset? Why or why not?
7. Suppose Jackie is considering purchasing an asset that will have a future value of $650 in 4 years. The
interest rate is 8% and the price of the asset is $500. Should Jackie buy the asset? Why or why not?
8. Suppose Mark has the option of investing in two different investments that cost $200 each. One promises
to earn 5% in compounded interest over the next 5 years. The other promises to earn $255.26 in 5 years.
Assume the interest rate is 5%. Which asset will he choose?
9. Why might a lottery winner decide to take a large lump sum payment rather than receive installments of
their winnings over time? How does the concept of present value influence this decision?
10. David Beckham, a prominent soccer player, is considering signing on for another two years with his current
soccer club. The team managers, however, face a salary cap of $60 million for their team and have already
6.5%. Should he agree to the contract?
11. LeBron James, a prominent basketball player, is considering signing on for another two years with his
current team. The team managers, however, face a salary cap of $90 million for their team and have
6.5%. Should he agree to the contract?
37-741
12. What are the three common features of all investments and why are they important?
13. What are the distinguishing features of a stock? What happens to stockholders if the corporation fails?
14. What are the two ways that a stock investor can gain financially from owning stocks?
15. What are the main characteristics of a bond? How does it differ from a stock?
16. What is a mutual fund? How do mutual funds differ from stocks and bonds?
17. Distinguish between the two main kinds of mutual funds.
18. “An investment’s rate of return is inversely related to its price.” Explain.
37-742
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
return has been reduced to 10% (50/500). When the level of earnings is fixed, the higher the price, the
lower the rate of return.
19. Describe (verbally) how to calculate a one-time return on an investment. On an annual return.
20. (Consider This) Historically shares of a company were primarily held by individual investors. This has
changed, to a greater percentage of shares being held by mutual funds. Discuss the effect this has had on
21. (Consider This) Examine the effect rise of mutual funds has had on the salaries of corporate managers.
Critics argue that the lack of security on corporate management by mutual funds has led to an increase in
compensation for corporate management and increased use of accounting gimmicks to make the company
appear in better standing than it actually is. Historically shares of a company were primarily held by
individual investors. When individual investors were the primary holders of company shares, they tended to
be active participants. Many paid close attention to the actions of corporate officers and would reprimand
bad decisions at shareholder meetings.
22. Why do investors engage in arbitrage?
23. Suppose the stocks for two relatively identical auto makers, A and B, are selling for $100 and $150
respectively. Both are predicted to sell for $200 in the coming year. What action do you expect investors
engaging in arbitrage to take? What will be the ultimate effect of this action?
24. Why is it difficult for most investors to take advantage of arbitrage opportunities?
37-744
25. “Don’t put all your eggs in one basket.” Interpret in terms of economic concepts.
26. Consider the following situations and decide whether they represent diversifiable risk or non-diversifiable
risk. Explain your answer.
(a) An automobile maker is concerned about the rising demand for motorcycles.
(b) An investor is considering developing a portfolio, but is concerned with the troubled state of the
market.
(c) An investor wants to purchase stock to add to their portfolio but is concerned it will increase the
volatility of their portfolio’s return.
27. Suppose an investor is considering investing in three different assets. One asset is equally likely to earn 10,
14 or 20 percent per year. Another is likely to earn 15 percent per year 75% of the time and 25 percent per
year 25% of the time. The final asset is equally likely to earn 15 or 20 percent per year.
(a) What are the expected rates of return for each of the assets?
(b) Based on your results in (a), which asset is the investor likely to choose?
(c) Suppose the beta values for each asset were 1.0, 2.0 and 0.75 and the investor is risk averse. Now
which asset is he likely to choose?
28. What countries rank as the lowest and highest risk countries according to the international country risk
guide? What types of risks are included in this measure?
29. How does the fact that asset prices and expected rates of return are inversely related cause asset risk and
expected rates of return to be positively related?
37-745
30. “There is no such thing as risk-free return.” Evaluate.
This statement is incorrect. While risk and return have a positive relationship, meaning that one must take
31. What is the risk-free interest rate?
32. Define the relationship between the average expected rate of return, if, and the risk premium.
33. Explain the relationship displayed on the graph based on a risk level of X. Use the other capital letters on
the graph to identify: (a) the average expected return for a risk-free asset; (b) the average expected return
for a market portfolio with a risk level of X; (c) the compensation for time preference for a risk-free asset;
and (d) the risk premium for the market portfolio’s risk level of X.
34. Suppose Leslie is considering developing an asset portfolio. She must receive a minimum of 5% to
compensate for her delayed consumption and given her investment bundle, receive 10% in return.
(a) What is if?
(b) What is the risk premium?
(c) What is the average expected return?
35. Suppose Ron is considering developing an asset portfolio. He expects to receive a return of 15% and is
willing to take on a maximum risk premium of 8%.
(a) What is if?
(b) If the Fed engages in open market operations that cause the risk-free interest rate to change to 9%, how
will Ron’s expected return change?
(c) How will Ron’s expected return change if they lower it to 5%?
36. How does investors’ preference for risk affect the slope of the security market line?
37-747
37. Fill in the table below and answer the following questions. Assume the slope of the SML = 0.5 for all
investors.
if = 0.05
if = 0.03
if = 0.08
Beta
AERR1
AERR2
AERR3
0
_____
_____
_____
0.5
_____
_____
_____
1
_____
_____
_____
1.5
_____
_____
_____
2
_____
_____
_____
2.5
_____
_____
_____
(a) Suppose David is considering adding a new asset to his portfolio and is deciding between two different
assets. David deviates from the standard SML in that for any asset riskier than his portfolio, he expects
to earn at least 85%. The assets have betas of 1.5 and 2 respectively and the risk-free interest rate at
that time is 5%. Which asset should he choose?
(b) Suppose David is now considering adding some more secure assets to his portfolio. He is deciding
between an asset that has a beta of 1.0 and an asset that has a beta of 0.5. Which asset should he
choose?
(c) Suppose David wants to invest in an asset that earns 30% with the lowest level of risk possible. What
asset should he choose if the risk-free interest rate is 5%? If it is 3%? If it is 8%?
if = 0.05
if = 0.03
if = 0.08
Beta
AERR1
AERR2
AERR3
0
0.05
0.03
0.08
0.5
0.3
0.28
0.33
1
0.55
0.53
0.58
1.5
0.8
0.78
0.83
2
1.05
1.03
1.08
2.5
1.3
1.28
1.33
(a) Since David requires his riskier assets to earn at least 85%, he will choose to invest in the asset with
beta = 2.0 since it earns 105%, compared to the beta = 1.5 asset which only earns 80%.
(b) If David wants to make his portfolio more secure, he shouldn’t choose the asset with beta = 1.0
because it has the same level of risk as his portfolio. Instead he should choose the asset with beta =
0.5, as it will reduce the risk of his portfolio.
(c) If David wants to earn a 30% return with a risk-free interest rate of 5%, he should choose an asset with
beta = 0.5. If the risk-free interest rate is 3%, he will have to choose an asset with a beta > 0.5 to
achieve the 30-percent return he desires. If the risk-free interest rate is 8%, he can choose an asset with
a beta < 0.5 and still earn the 30% return.
38. How does arbitrage tend to move any asset divergent from the Security Market Line back to it?
If an asset lies above the SML, the rate of return exceeds the normal rate of return earned for that given risk
level. Seeing this advantageous rate of return, investors will demand more of the asset, causing its price to
39. Explain the logic behind the fact that if the Federal Reserve raises the risk-free interest rate, return rates of
other assets must rise by the same amount.
40. Explain the logic behind the fact that if the Federal Reserve lowers the risk-free interest rate, return rates of
other assets must fall by the same amount.
41. Use the security market line model to explain why stock prices did not rise when the Federal Reserve
lowered the risk-free interest rate during the Great Recession of 2007–2009.
During the Great Recession investors became more fearful about taking on risk, so they demanded more
42. (Last Word) What are two main reasons that actively managed funds perform poorly relative to index
funds?