Exercise Sheet 1. Solution 1.1. One year chart

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1 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: October 2008: October 2009: October 2010: October 2011: October 2012: January 2013: This gives =

If you had invested 10,000 in LloydsTSB in October 2007 what would it be worth now? Solution 1.

2 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 firm. Alternatively the collapse in the stock price makes it diffi cult for the company to conduct business. This compounds the situation and could lead to bankruptcy. Liquidation follows and the firm s stock are removed from the market. Exercise 1.3 If a method was developed to predict future stock prices perfectly, what effect 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 2

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 firm.

3 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 differs from what is predicted. Exercise 1.4 At the start of January 1999 one investor makes a real investment by purchasing a house for $ while a second investor purchases a portfolio of securities for $. The first investor lives in the house for the next two years. At the start of January 2001 the house is worth $ and the portfolio of securities is worth $ Which investor has fared better? Solution 1.4 Over the two-year holding period the returns on the two investments are: r HOUSE = r SECURIT IES = = , = These returns indicate that the securities have performed best. However, the house has delivered a flow of housing services and will have required maintainance. The flow 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 r HOUSE = 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 identifies the risk/return tradeoff. An investor applying the theory should avoid unnecessary risk and not enter into investments without understanding the consequences. Exercise 1.6 3

Perfect prediction cannot be possible since trading leads to a price that differs from what is predicted. Exercise 1.

4 You are working as a financial 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 different 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 different 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 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 4

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.

5 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 profits are fluctuating. Why should they wish to do this? Solution 1.10 Financial markets operate on the basis of information flows. 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. 5

Solution 1.10 Financial markets operate on the basis of information flows. All prices and actions are interpreted in terms of the information they convey.

Stock Market Game Test

Stock Market Game Test A test of basic economic concepts and institutions related to saving, investing, risk, the stock market, and productivity 1. A personal investment such as purchasing stocks or corporate