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Chapter 17 - Financial Economics
Chapter 17 - Financial Economics
McConnell Brue Flynn 20e
DISCUSSION QUESTIONS
1. Suppose that the city of New York issues bonds to raise money to pay for a new tunnel linking
New Jersey and Manhattan. An investor named Susan buys one of the bonds on the same day that
the city of New York pays a contractor for completing the first stage of construction. Is Susan
making an economic or a financial investment? What about the city of New York? LO1
Answer: New York is making an economic investment. Recall that an economic
investment refers either to paying for new additions to the capital stock or new
Susan is making a financial investment. Recall that a financial investment refers to the
2. What is compound interest? How does it relate to the formula: X dollars today = (1 + i )tX
dollars in t years? What is present value? How does it relate to the formula: X/(1 + i)t dollars
today = X dollars in t years? LO2
Answer: Compound interest describes how quickly an investment increases in value
This concept relates to the formula (1+i)tX through the variables i, the interest rate, and t,
The present value model simply rearranges the equation above to make it easier to
3. How do stocks and bonds differ in terms of the future payments that they are expected to
make? Which type of investment (stocks or bonds) is considered to be more risky? Given what
you know, which investment (stocks or bonds) do you think commonly goes by the nickname
“fixed income”? LO3
Answer: Stocks pay dividends out of profits to the shareholders that own them,
with the percentage of the total dividend received being based on the percentage
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Chapter 17 - Financial Economics
Stocks are considered more risky. Stock prices and profits are highly variable, so
the capital gains and dividends tied to them can also fluctuate greatly. There is
4. What are mutual funds? What different types of mutual funds are there? And why do you think
they are so popular with investors? LO3
Answer: Mutual funds pool investors’ money and buy a collection of stocks or
bonds. Some are narrowly defined, focusing on a particular sector of the economy
(technology, health care) or type of asset (small cap stock funds; long-term
Investing in a specific stock or bond can be risky, and some of this risk
(diversifiable or “idiosyncratic” risk) can be reduced by buying many different
5. Corporations often distribute profits to their shareholders in the form of dividends, which are
simply checks mailed out to shareholders. Suppose that you have the chance to buy a share in a
fashion company called Rogue Designs for $35 and that the company will pay dividends of $2
per year on that share every year. What is the annual percentage rate of return? Next, suppose that
you and other investors could get a 12 percent per year rate of return by owning the stocks of
other very similar fashion companies. If investors care only about rates of return, what should
happen to the share price of Rogue Designs? (Hint: This is an arbitrage situation.) LO5
Answer: A yearly dividend of $2 on a $35 share of stock equals a 5.71% annual
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Chapter 17 - Financial Economics
6. Why is it reasonable to ignore diversifiable risk and care only about nondiversifiable risk?
What about investors who put all their money into only a single risky stock? Can they properly
ignore diversifiable risk? LO6
Answer: It is reasonable to ignore diversifiable risk if the investor’s portfolio is
already diversified. By investing in different types of assets, diversifiable
7. If we compare the betas of various investment opportunities, why do the assets that have higher
betas also have higher average expected rates of return? LO7
Answer: The assets with the highest betas are the most risky. Potential investors
8. In this chapter we discussed short-term U.S. government bonds. But the U.S. government also
issues longer-term bonds with horizons of up to 30 years. Why do 20-year bonds issued by the
U.S. government have lower rates of return than 20-year bonds issued by corporations? And
which would you consider more likely, that longer-term U.S. government bonds have a higher
interest rate than short-term U.S. government bonds, or vice versa? Explain. LO7
Answer: U.S. government bonds have lower rates than bonds issued by
A longer-term U.S. government bond would be expected to have a higher interest
9. What determines the vertical intercept of the Security Market Line (SML)? What determines its
slope? And what will happen to an asset’s price if it initially plots onto a point above the SML?
LO8
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Chapter 17 - Financial Economics
Answer: The vertical intercept is the risk-free interest rate (the rate on short-term
U.S. government bonds) that is determined by Federal Reserve monetary policy.
An asset plotting above the SML will be earning a higher rate than the average
10. Suppose that the Federal Reserve thinks that a stock market bubble is occurring and wants to
reduce stock prices. What should it do to interest rates? LO8
Answer: If the Fed wants to decrease stock prices it should raise interest rates.
11. Consider another situation involving the SML. Suppose that the risk-free interest rate stays
the same, but that investors’ dislike of risk grows more intense. Given this change, will average
expected rates of return rise or fall? Next, compare what will happen to the rates of return on low-
risk and high-risk investments. Which will have a larger increase in average expected rates of
return, investments with high betas or investments with low betas? And will high-beta or low-beta
investments show larger percentage changes in their prices? LO8
Answer: Average expected rates of return will rise on all assets except those
paying the risk-free interest rates. Higher beta investments will see a greater
12. LAST WORD Why is it so hard for actively managed funds to generate higher rates of return
than passively managed index funds having similar levels of risk? Is there a simple way for an
actively managed fund to increase its average expected rate of return?
Answer: Actively managed funds have difficulty generating higher rates of return
than passively managed index funds for two reasons. First, arbitrage causes rates
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Chapter 17 - Financial Economics
REVIEW QUESTIONS
1. Identify each of the following investments as either an economic investment or a financial
investment. LO1
a. A company builds a new factory.
b. A pension plan buys some Google stock.
c. A mining company sets up a new gold mine.
d. A woman buys a 100-year-old farmhouse in the
countryside.
e. A man buys a newly built home in the city.
f. A company buys an old factory.
Answer: a. Economic investment: When a company builds a new factory, it is engaging
b. Financial investment: When a pension plan buys some Google stock, it is engaging in
c. Economic investment: When a mining company sets up a new gold mine, it is
d. Financial investment: When a woman buys a 100-year-old farmhouse in the
e. Economic investment: When a man buys a newly built home in the city, he is engaging
f. Financial investment: When a company buys an old factory, it is engaging in financial
2. It is a fact that (1 + 0.12)3 = 1.40. Knowing that to be true, what is the present value of $140
received in three years if the annual interest rate is 12 percent? LO2
a. $1.40.
b. $12.
c. $100.
d. $112.
Feedback: The present value of $140 received in three years will be $100 today if the
interest rate is 12 percent. We know this to be true because we can apply the formula that
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Chapter 17 - Financial Economics
3. Asset X is expected to deliver 3 future payments. They have present values of, respectively,
$1,000, $2,000, and $7,000. Asset Y is expected to deliver 10 future payments, each having a
present value of $1,000. Which of the following statements correctly describes the relationship
between the current price of Asset X and the current price of Asset Y? LO3
a. Asset X and Asset Y should have the same current price.
b. Asset X should have a higher current price than Asset Y.
c. Asset X should have a lower current price than Asset Y.
Feedback: This is true because the present values of their expected future payments are
identical. In fact, both sets of present values sum to exactly $10,000. To see this, note that
4. Tammy can buy an asset this year for $1,000. She is expecting to sell it next year for $1,050.
What is the asset’s anticipated percentage rate of return? LO4
a. 0 percent.
b. 5 percent.
c. 10 percent.
d. 15 percent.
Feedback: The asset’s anticipated percentage rate of return is 5 percent. You can
determine that value by first noting that the asset is expected to generate a gain of $50 (=
5. Sammy buys stock in a suntan-lotion maker and also stock in an umbrella maker. One stock
does well when the weather is good; the other does well when the weather is bad. Sammy’s
portfolio indicates that “weather risk” is a _________ risk. LO6
a. Diversifiable.
b. Nondiversifiable.
c. Automatic.
Feedback: Sammy’s portfolio indicates that “weather risk” is a diversifiable risk. This is
true because Sammy’s portfolio is set up in such a way that whether the weather is good
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Chapter 17 - Financial Economics
6. An investment has a 50 percent chance of generating a 10 percent return and a 50 percent
chance of generating a 16 percent return. What is the investment’s average expected rate of
return? LO7
a. 10 percent.
b. 11 percent.
c. 12 percent.
d. 13 percent.
e. 14 percent.
f. 15 percent.
g. 16 percent.
Feedback: The investment’s average expected rate of return is 13 percent. This is true
because an investment’s average expected rate of return is a probability-weighted average
7. If an investment has 35 percent more nondiversifiable risk than the market portfolio, its beta
will be: LO7
a. 35.
b. 1.35.
c. 0.35.
Feedback: An investment that has 35 percent more nondiversifiable risk than the market
portfolio will have a beta of 1.35. The key to understanding why this is true is to
8. The interest rate on short-term U.S. government bonds is 4 percent. The risk premium for any
asset with a beta = 1.0 is 6 percent. What is the average expected rate of return on the market
portfolio? LO7
a. 0 percent.
b. 4 percent.
c. 6 percent.
d. 10 percent.
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Chapter 17 - Financial Economics
Feedback: The average expected rate of return on the market portfolio is 10 percent.
That is the correct answer because the average expected rate of return on the market
portfolio will be equal to the rate of return that compensates for time preference plus the
rate that compensates for risk. Because we know that investors consider short-term U.S.
9. Suppose that an SML indicates that assets with a beta = 1.15 should have an average expected
rate of return of 12 percent per year. If a particular stock with a beta = 1.15 currently has an
average expected rate of return of 15 percent, what should we expect to happen to its price? LO8
a. Rise.
b. Fall.
c. Stay the same.
Feedback: We should expect this particular stock’s price to rise. The price will go up
10. If the Fed increases interest rates, the SML will shift _________ and asset prices will
________. LO8
a. Down; rise.
b. Down; fall.
c. Up; rise.
d. Up; fall.
Feedback: If the Fed increases interest rates, the SML will shift up and asset prices will
fall. The SML will shift up because the SML’s intercept with the vertical axis is the risk-
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Chapter 17 - Financial Economics
SML shifts up vertically. Simply put, with the average expected rate of return rising for
PROBLEMS
1. Suppose that you invest $100 today in a risk-free investment and let the 4 percent annual
interest rate compound. Rounded to full dollars, what will be the value of your investment 4 years
from now? LO2
Feedback:
After the first year you will have $104 ( = (1+0.04)$100 = $100 (principal) + $4
(interest)).
(principal) + $4.16 (interest)) two years from now.
Rounding to the nearest dollar gives us $117.
An easier way to calculate this value is to recognize that we multiply each consecutive
Which implies we have the value four years from now of:
In general, we have the formula
X is the initial investment.
2. Suppose that you desire to get a lump sum payment of $100,000 two years from now. Rounded
to full dollars, how many current dollars will you have to invest today at a 10 percent interest to
accomplish your goal? LO2
Feedback:
To answer this question we start at the end of the problem.
Rearranging, we have,
Rearranging, we have,
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Chapter 17 - Financial Economics
In general, we can use the following formula.
Present Value = X/(1+i)t where i is the interest rate, t is the number of years of in the
future , and X is the desired future value.
3. Suppose that a risk-free investment will make three future payments of $100 in one year, $100
in two years, and $100 in three years. If the Federal Reserve has set the risk-free interest rate at 8
percent, what is the proper current price of this investment? What is the price of this investment if
the Federal Reserve raises the risk-free interest rate to 10 percent? LO2
Feedback:
Here we need to use the concept of present value.
How much is $100 one year from now worth today at an interest rate of 8%.
How much is $100 two years from now worth today at an interest rate of 8%.
How much is $100 three years from now worth today at an interest rate of 8%.
Since we receive all of the payments above, the present value of this payment stream
equals;
If the interest rate were 10% we use the same procedure.
4. Consider an asset that costs $120 today. You are going to hold it for 1 year and then sell it.
Suppose that there is a 25 percent chance that it will be worth $100 in a year, a 25 percent chance
that it will be worth $115 in a year, and a 50 percent chance that it will be worth $140 in a year.
What is its average expected rate of return? Next, figure out what the investment’s average
expected rate of return would be if its current price were $130 today. Does the increase in the
current price increase or decrease the asset’s average expected rate of return? At what price would
the asset have a zero average expected rate of return? LO4
Feedback:
The first exercise is to calculate the expected payoff for this asset. To do this, multiply the
probability (decimal representation of percentage) for each payoff (state) by the actual
payoff.
For the value above.
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Chapter 17 - Financial Economics
The increase in price reduces the expected return on the asset, as shown above.
5. Suppose initially that two assets, A and B, will each make a single guaranteed payment of $100
in 1 year. But asset A has a current price of $80 while asset B has a current price of $90. LO6
a. What are the rates of return of assets A and B at their current prices? Given these rates of
return, which asset should investors buy and which asset should they sell?
b. Assume that arbitrage continues until A and B have the same expected rate of return. When
arbitrage ends, will A and B have the same price?
Next, consider another pair of assets, C and D. Asset C will make a single payment of $150 in
one year while D will make a single payment of $200 in one year. Assume that the current price
of C is $120 and that the current price of D is $180.
c. What are the rates of return of assets C and D at their current prices? Given these rates of
return, which asset should investors buy and which asset should they sell?
d. Assume that arbitrage continues until C and D have the same expected rate of return. When
arbitrage ends, will C and D have the same price?
Compare your answers to questions a through d before answering question e.
e. We know that arbitrage will equalize rates of return. Does it also guarantee to equalize prices?
In what situations will it equalize prices?
Answer: a. Return on asset A = 25%; Return on asset B = 11.11%; Individuals will buy
asset A and sell asset B.
Feedback:
Part a:
Individuals will buy asset A because it has the higher return. This implies individuals will
sell asset B.
Part b:
or,
(Payoff / price A) - 1 = (Payoff /price B) - 1 and (Payoff / price A) =(Payoff /price B)
then,
Part c:
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Chapter 17 - Financial Economics
Part d:
6. ADVANCED ANALYSIS Suppose that the equation for the SLM is Y = 0.05 + 0.04X, where
Y is the average expected rate of return, 0.05 is the vertical intercept, 0.04 is the slope, and X is
the risk level as measured by beta. What is the risk-free interest rate for this SML? What is the
average expected rate of return at a beta of 1.5? What is the value of beta at an average expected
rate of return is 7 percent? LO8
Feedback: The risk free is the intercept of SLM line, which is 0.05. Thus, the risk free
rate is 5%. (This represents a beta of zero, which implies no risk).
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