Practical Investment Management 4th Edition Solution Manual

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1
Chapter 1
The Concept of Investing
OUTLINE
Introduction
Investing Defined
Investment Alternatives
Assets
Securities
Security Groupings
Three Reasons for Investing
Income
Appreciation
Excitement
The Academic Study of Investments
Theoretical Research
Empirical Research
Professors vs. Practitioners
SUMMARY
Even in this short introductory chapter some of the terminology was probably unfamiliar: stock
splits, preferred stock, stop order, buying power, and so on. A substantial vocabulary is specific to
the investment field, and these terms need to become second nature to anyone involved in investing
and investment management. Each chapter begins with a list of the Key Terms covered within that
chapter. A good study technique is to focus on them.
The theoretical discussions presented in this book deal generally with fundamental relationships
we know absolutely. This background—coupled with coverage of market mechanics, folklore, and
institutional detail—should help to develop an ability to speak intelligently about the investment
business and to influence future financial decisions.
ANSWERS TO END OF CHAPTER QUESTIONS AND PROBLEMS
1. Saving is a short or long term activity associated with little chance of loss of principal.
Investing is a long-term activity in a risky venture. The risk can be modest or substantial
depending on the characteristics of the investment.
2. The SIPC provides investors who have accounts at a brokerage firm with protection against
failure of the brokerage firm, loss by theft or fire, or fraud of a firm employee. It does not
provide protection against a loss in market value from making poor investments
3. A financial asset on one person’s personal balance sheet also appears on someone else’s
balance sheet as a liability. Stocks and bonds are financial assets that appear on the right
hand side of the corporate balance sheet. A real asset (such as land or gold) does not have a
corresponding liability.

Chapter 1. The Concept of Investing2
4. The three categories are equity securities, fixed income securities, and derivative assets.
(Note: Futures contracts, a type of derivative, are technically not securities, and are not
under the jurisdiction of the Securities and Exchange Commission. There is little practical
importance to this distinction.)
5. Three motivations for investing are to generate income, to realize capital appreciation, and
for the fun-of-the-chase, or excitement.
6. Suppose a foreign currency dealer sells 100 units of currency A for 1 unit of currency B, sells
50 units of currency C for 1 unit of currency B, and sells 1.8 units of currency A for 1 unit of
currency C. Assume the spread is zero: buying and selling prices are the same. In
equilibrium, two units of currency A should equal one unit of currency C. Because the
dealer sells 1.8 A (instead of 2.0) for each 1.0 C, currency A is overpriced relative to
currency C. This presents an arbitrage opportunity. You want to exchange currency A for C.
Suppose you begin with 100 B and you exchange them for 10,000 A. Next you exchange the
10,000 A for 5,555.55 C. Now convert the 5,555.55 C into 111.11 B. This is an 11.11%
gain with no risk.
7. Theoretical research begins with assumptions about investor behavior, generally assuming
they behave rationally. Mathematical logic then leads to relationships among security prices
that should hold in a rational world. Empirical researchers look at actual market prices and
seek to find statistically significant relationships in the data. Theoretical models are often
tested empirically using market data.
8. An anomaly is an empirical result that is inexplicable by financial theory.
9. Because there is no risk of loss with a U.S. Treasury Bill, many people would consider such
an activity saving rather than investing.

3
Chapter 2
Understanding Risk and Return
OUTLINE
Introduction
Return
Holding Period Return
Yield and Appreciation
The Time Value of Money
Financial calculators
Compounding
Compound Annual Return
Risk
Risk vs. Uncertainty
Dispersion and the Chance of Loss
The Problem with Losses
Risk Aversion
Partitioning Risk
More on the Relationship between Risk and Return
The Direct Relationship
Risk, Return, and Dominance
SUMMARY
The two key concepts in finance are the time value of money and the fact that a safe dollar is worth
more than a risky dollar. The tradeoff between risk and return is the central theme in the investment
decision-making process. Most investors are risk averse, meaning they only take a risk if they believe
they will be rewarded for doing so.
A holding period return is independent of the passage of time and should be used only to compare
investments over identical time periods. The holding period return considers both the yield of an
investment from interest or dividends and appreciation from a change in the investment value.
Time value of money calculations overcome the shortcomings of the holding period return. They
permit a direct comparison between a particular sum today and amounts in the future. The interest rate
that satisfies a time value of money equation is a compound annual return. The number of
compounding periods per year can significantly influence the compound annual return.
A risky situation must involve a chance of loss. Risk is inseparable from time. The greater the time
period, the greater the possible dispersion of results. Investment losses are especially consequential
because an investment that loses x% must rise by more than x% just to break even.
Virtually all investors are risk averse with significant sums of money. In other words, they will not
take a risk with their money unless they believe the risk is warranted by the potential future returns
from the investment.
Total risk encompasses the complete variability of investment results. Total risk can be partitioned
into diversifiable and undiversifiable components. The marketplace only rewards undiversifiable risk.
Risk is unavoidable if an investor seeks more than a trivial return. A direct relationship exists
between expected return and unavoidable risk. Risky investments do not guarantee a return, nor does
unnecessary risk warrant any additional return.

Chapter 2: Understanding Risk and Return4
ANSWERS TO END OF CHAPTER QUESTIONS AND PROBLEMS
1. This statement is generally true, although the concept of risk normally assumes there are certain
adverse outcomes involving a chance of loss.
2. You cannot comment on the relative performance of competing investments without knowing
their relative risk. It is also possible that investment B was a $1 million venture, while investment
A was a $250 activity. Dollars are what matter, not percentages. If you have the choice between
earning 100% on a $250 investment and 20% on a $1 million investment, everyone will prefer the
latter.
3. A single large loss requires substantial subsequent gains to overcome the loss. The same is true of
a series of small losses. A key point is that a loss of x% requires a gain of more than x% to break
even.
4. Individual preference. People do not like risk, and since choice 2 appears more risky, the possible
payoff on choice 2 for 51-100 coming up must be greater than 0 so that the average payoff is
greater than $100. It depends on the individual, however, to make that choice since people also
differ in terms of how risk averse they are.
5. Increasing the investment horizon increases the potential variability of returns, and hence the
range of possible outcomes from the investment. Given that a wider range of values means more
uncertainty about the outcome, from one perspective more time implies more risk.
6. See text discussion under "Partitioning Risk."
Business Risk Variability of sales
Financial Risk Variability of net earnings from financial leverage
Purchasing Power Risk Variability of real return from inflation
Interest Rate Risk Variability of return, given changes in market interest rates
Foreign Exchange Risk Variability of return caused by varying exchange rates in
investment period
Political Risk Variability of return related to change in governmental
decisions
Social Risk Variability of return related to changing consumer and
business reaction to social issues
7. Tobacco investments, environmental protection, sweatshop businesses, child labor laws outside
the U.S.
8. Individual preference.
9. Individual preference.
10. There is a greater difference with annual versus monthly compounding. As the rate of
compounding increases the incremental increase in dollars earned decreases. There is a smaller
difference between daily and continuous compounding compared to going from annual to monthly
compounding.

Chapter 2: Risk and Return 5
11. If interest rates are zero, there is no time value to money. As interest rates increase, present values
decrease and future values increase. The higher the interest rate, the greater the “interest on
interest” earned. The more frequent the compounding, the sooner the “interest on interest” resets.
12. $3,355.04 = PV annuity of 8i, 10n, $500 pmt on financial calculator
13 $2,940.12 = PV of $4000FV, 4n, 8i
14. $2,829.13 = PV of $4000FV, 4.5n, 8i
15. $937.50 = PV of $75 payment perpetuity at 8i, 100n, or $75/.08
16. $2,876.41 = PV of $500 annuity (pmt), 10n, 8i, or $3355.04 discounted (enter as a FV) for 2n, 8i
to present. The first payment of this ordinary annuity, received at the end of the third year, must
be discounted back two years.
17. $7,243.28 = FV of 10n, $500 annuity (pmt), 8i
18. $1,469.33 = FV of $1000PV, 5n, 8i
19. $1,485.95 = FV of $1000PV, 5  4 = 20n, 8/4 = 2i
20. $1,491.82 = FV of $1000, 5 years, continuous compounding = .08 x 5 =.40 ex  $1000
21. Monthly returns:
January 2004

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6
Chapter 3
The Marketplace
OUTLINE
Introduction
The Role of the Capital Markets
Economic Function
Continuous Pricing Function
Fair Pricing Function
The Exchanges
National Exchanges
Regional Exchanges
Trading Systems
Circuit Breakers and Trading Curbs
The Nasdaq Stock Market
The Small Order Execution System (SOES)
The Nasdaq National Market
The Nasdaq Small-Cap Market
The Over-The-Counter Market
Over-the-Counter Bulletin Board (OTCBB)
Pink Sheet Stocks
Third and Fourth Markets
Regulation
The Exchanges
The SEC
The NASD
SIPC
Ethics
Illegal vs. Unethical
The Chartered Financial Analyst Program
The CFA Program Exams
Standards of Professional Conduct
SUMMARY
The capital markets serve three primary functions. The economic function brings buyers and
sellers together. The continuous pricing function enables traders to get market prices quickly. The
fair pricing function is related to the continuous pricing function and assures both buyers and
sellers of getting a market-determined price when they trade.
The two national exchanges in the United States are the New York Stock Exchange and the
American Stock Exchange. Five other smaller exchanges are known as regional exchanges.
Worldwide, approximately 150 exchanges exist in more than 50 countries.
Many securities trade in the Nasdaq system or in the over-the-counter market. In this electronic
linkup of brokerage firms, brokers and institutional investors place orders by computer. Some very
large companies are National Market Issues, with smaller firms listed as small-

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Chapter 3 The Marketplace 7
The initial sale of shares occurs in the primary market. Subsequently, they trade in the secondary market.
The sale of listed securities via the Nasdaq system is called the third market, while direct institutional trading
via the Instinet system is the fourth market.
Numerous organizations regulate the securities industry. The most important pieces of
legislation are the Securities Act of 1933 and the Securities Exchange Act of 1934, which
significantly improved the required level of financial disclosure for public securities. The Securities
Investor Protection Corporation provides protection against fraud or brokerage firm failure.
The Chartered Financial Analyst (CFA) designation is a prestigious credential for those
involved in the money management business. In many businesses, enrollment in the CFA program
is a prerequisite for employment.
ANSWERS TO END OF CHAPTER QUESTIONS AND PROBLEMS
1. The continuous pricing function refers to the fact that current prices are routinely determined
and easily accessible through print media or electronically. The fair price function refers to the
fact that the substantial number of market participants gives assurance that the prevailing price
for an exchange traded security is a fairly determined price.
2. By making it easy to buy and sell securities, money (capital) flows easily and generally without
barrier from sources to uses.
3. The primary market is the sale of securities for the first time, as when Detroit sells new
automobiles to a car dealer. The secondary market is the resale of existing shares, as when
used cars sell through a newspaper classified advertisement.
4. The specialist system ensures that all buyers and sellers present their prices at the same
location. This makes it easy to determine what is the “best” price regardless of the transaction
an investor wishes to make.
5. You must be a member of an exchange in order to go there and make a trade. Most individuals
are not members. They must hire someone (a broker) to make the trade for them.
6. Dual listing is when a security trades on either the NYSE or the AMEX plus one or more of the
regional exchanges.
7. The specialist is charged with making a “fair and orderly market” in his or her assigned
securities. A good measure of such a market is one in which the bid/ask spread is small.
8. The bid price is the highest price anyone has indicated they will pay for a security. The ask
price is the lowest selling price. The spread is the mathematical difference between the bid
price and the ask price. (The spread is always expressed as a positive number.)
9. A specialist system has one single person through whom all trades must pass. In a market
maker system, numerous individuals simultaneously have the opportunity to attempt to get the
opposite side of a trade arriving at the exchange.
10. The SuperDot system is an electronic trading aid that permits certain trades to be electronically
routed to the specialist’s post rather than be hand carried. About 85% of all orders reach the
specialist via this system.

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Chapter 3 The Marketplace8
11. The Nasdaq stock market is a worldwide, computerized linkup of brokerage firms,
investment houses, and large commercial banks for the purpose of trading listed securities.
The OTC market refers to the trading of securities not listed on the Nasdaq or a
national/regional securities exchange.
12. A pink sheet stock is an over-the-counter security about which little information is generally
available. They get their name from the long pink sheets of paper that, in years past, would
hang on a brokerage firm office and show the names of firms that made a market in the
shares. Today the “pink sheet” is electronic and available over the Internet.
13. The third market is over-the-counter trading of a security that trades on either the New
York Stock Exchange or the American Stock Exchange. The fourth market is direct
institutional trading, usually between large banks, insurance companies, or pension funds.
14. The Securities and Exchange Commission seeks to promote “honest and open securities
markets.” It also seeks “full and fair disclosure” of corporate information to potential
investors.
15. A Ponzi scheme is an illegal activity in which a scam artist accepts “investments” from
people and later returns part of their principal investment, claiming it is income or other
profits. The Ponzi scheme is dependent on new deposits to remain in operation.
16. The Securities Act of 1933 provides for the regulation of the initial sale of securities in the
primary market. The Security Exchange Act of 1934 provides for the regulation of the
secondary market (the trading at the exchanges.)
17. The SIPC protects investors against loss due to brokerage firm failure, fraud, theft, or loss
due to natural disaster. It does not provide protection against bad investment decisions.
18. The CFA Code of Ethics is a general statement of ethical conduct to which members of the
CFA Institute subscribe. The Standards of Professional Conduct stem directly from the
Code of Ethics, but are more detailed statements about dealings with the profession, the
employer, the client, and the investing public.

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Chapter 4 Bond Fundamentals10
Bond risk falls into two major classifications. Price risks refer to the chance of monetary loss
due to (1) the likelihood of the firm defaulting on its loan payments (default risk), and (2) the
variability of interest rates (interest rate risk). Convenience risks reflect additional demands on
management time because of bonds being called by their issuer, because of the need to reinvest
interest received, or because of poor marketability of a particular issue. Many bonds have a period
of call protection and subsequently a declining call premium.
ANSWERS TO END OF CHAPTER QUESTIONS AND PROBLEMS
1. No. Because the cash flows vary through time, they can only be estimated, which means the
yield to maturity is also merely an estimate.
2. If neither is callable, these securities should sell for the same price. They are equivalent
financial claims, providing the same income stream from the same issuer, and with the same
degree of risk.
3. The statement is generally true. You would like to know, however, details of the call feature, if
any, and whether or not the period of call protection had expired.
4. A Treasury bond has an initial life greater than 10 years. A Treasury note has an initial life
from 2 - 10 years.
5. Default risk is the same as credit risk. It is important to an investor, as it measures the
likelihood the security issuer will be able to provide the promised cash flow stream.

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