Certificate of

Financial Assets deposits

loans
repo
Fixed income derivative
stocks LIBOR
securities

Zero-coupon Treasury
bonds Bonds Commercial
Corporate paper
Bonds

Real Assets

property
Class B common stock possesses dividend and distribution rights equal to one-fifteen-
hundredth (1/1,500) of such rights of
Class A common stock. Each Class A common share is entitled to one vote per share. Each
Class B common share possesses
voting rights equivalent to one-ten-thousandth (1/10,000) of the voting rights of a Class A
share. Unless otherwise required
under Delaware General Corporation Law, Class A and Class B common shares vote as a
single class.
Exchange preferred stock
Minor shareholder have
with new common stock
option to purchase
at HIGHEST price
shares at price below
market price during
merger
VXY < VX + VY
Dilute interest
 Amount to receive in ‘N’ year(s)
Amount to pay now =
(1+r)
Suppose the one year and two year spot rate are both 5%. You wish to invest an
amount of money now that will deliver 100 exactly in two years’ time. The amount of
zero coupon bond should be be: 100/1.052 = 100/1.1025 = 90.70.

If you place this amount in a 6% coupon bond trading at:

[6/1.05] + [106/1.052] = [6/1.05] + [106/1.1025] = 5.71 + 96.15 = 101.86
You need to buy 90.70/101.86 or 0.8904 units at a cost of 90.70.

If the one year spot rate increases to 5.5% in one year time, the payoff on the position
in one year time is:
[0.8904 x 106] + [0.8904 x 6(1.055)]
[0.8904 x 106] + [0.8904 x 6.33]
94.38 + 5.64 = $100.02

If the one year spot rate increases to 4.5% in one year time, the payoff on the position
in one year time is:
[0.8904 x 106] + [0.8904 x 6(1.045)]
[0.8904 x 106] + [0.8904 x 6.27]
94.38 + 5.58 = $99.96
In either case, you are not receiving the exact amount you need.
Bond pays interest every year until its maturity date and principal
amount at its maturity date.

C C2 CT
Price = 1+r1 + (1+r)2 + … + (1+r)N
 OR
C C2 CT
Price = 1+r1 + (1+r)2 + … + (1+r)N

LIBOR(London Interbank
offering Rate)
Consider one bond has 4 years less one day and the bond have an coupon payment
with the rate of 5%. The holder of this bond has received interest payment one day
ago. Suppose the discount rate is 5%. The actual price/dirty price of the bond is:
0 364 day 1yr + 364 day 2yr + 364 day 3yr + 364 day 4yr + 364 day

1 day 5 + 100 5 + 100 5 + 100 5 + 100 5 + 100

105 105 105 105

(1.05)1 (1.05)1 (1.05)1 (1.05)1

100 + 5
PV = Dirty Price =
(1.05)364/365
= 100.013

Consider one bond has 4 years plus one day and the bond have an coupon payment
with the rate of 5%. The holder of this bond has received interest payment in one day
time. Suppose the discount rate is 5%. The actual price/dirty price of the bond is:
0 1 day 1yr + 1 day 2yr + 1 day 3yr + 1 day 4yr + 1 day

364 day 5 + 100 5 + 100 5 + 100 5 + 100 5 + 100

105 105 105 105

(1.05)1 (1.05)1 (1.05)1 (1.05)1

100 + 5
PV = Dirty Price =
(1.05)1/365
= 104.986
 Dirty Price = Clean Price + Accured Interest

The accrued interest can be obtained by the following equation:

days since last coupon payment
Accrued Interest = Coupon Payments x
days separating coupon payment

Assume there are 4 years and 140 days until maturity of bond with 5% annual coupon.
The next coupon is due in 140 days. The spot rate is 5% flat. Work out the ‘clean’
price and the ‘dirty’ price for the bond.

Assume there are 4 years and 140 days until maturity of bond with 5% annual coupon.
The next coupon is due in 140 days. The spot rate is 5% flat. Work out the ‘clean’
price and the ‘dirty’ price for the bond.
0 140 day 1yr + 140 day 2yr + 140 day 3yr + 140 day 4yr + 140 day

225 day 5 + 100 5 + 100 5 + 100 5 + 100 5 + 100

105 105 105 105

(1.05)1 (1.05)1 (1.05)1 (1.05)1

225
PV = Dirty Price =
100 + 5 or 100 + [5 x 365 ]
(1.05)140/365
= 103.053 = 103.082
225
Clean Price = 103.053 - [5 x 365 ]
= 103.053 – 3.082
= 100
Explain how bond prices are quoted in the financial pages. Suppose you are
looking at a 3 year and 40 day bond with an annual coupon of 6% of nominal
capital (of $100, say). State the expressions for the actual price of this bond, and
the quoted price, given a yield of 5%.
0 40 day 1yr + 40 day 2yr + 40 day 3yr + 40 day

325 day 6 + 100 6 + 100 6 + 100 6 + 100

106 106 106

(1.05)1 (1.05)1 (1.05)1

6 6 6 106
PV = Dirty Price = + + +
(1.05)40/365 (1.05)405/365 (1.05)770/365 (1.05)1135/36
= 6 (1.05-40/365 + 1.05-405/365+ 1.05-770/365)+ 106(1.05-1135/365)
325
Clean Price = Dirty Price -
365
[6 x ]
The clean price is equal to the dirty price when the accrued interest is exactly zero. In
this case, it happens when a coupon payment has just been made. Therefore, the dirty
price is equal to the present value of next coupon payment plus the present value of
the clean price at the time of the next coupon payment:
Dirty = PV(coupon) + PV(Clean) (1)
Therefore, the accrued interest is:
Accrued interest = Dirty – Clean (2)
Substitute equation (1) into equation (2)
Accrued Interest = PV(coupon) + PV(Clean) – Clean (3)
As we get closer to the next coupon payment, the second and third right hand side
terms in equation (3) vanishes. So, we are left with the PV(coupon) which also
becomes close to the coupon payment itself. Therefore, accrued interest is in the limit
equal to the coupon payment itself. As the time to the next coupon payment becomes
maximally large, the difference between the clean price and the present value of the
clean price at the date of the next coupon payment must be equal to the present value
of the coupon payment itself. Therefore, accrued interest must go to zero. The formula
used is an approximation to the ‘true’ accrued interest, and will be fairly accurate
unless the yield is very high.
 Certificate of
Financial Assets deposits
loans
Exchange
trading Over the counter
repo
Fixed income derivative
stocks LIBOR
securities
swaps
forward future options
Zero-coupon Treasury
bonds Bonds Commercial
Corporate paper
Bonds

Real Assets

property
For example, suppose an investor initially pays $6,000 toward the purchase of
$10,000 worth of stock (100 shares at $100 per share). He borrows the remaining
$4,000 from the broker. The initial balance sheet look like this:
Assets Liability and Owners’ Equity
Value of Stock $10,000 Loan From Broker $4,000
Equity $6,000
$10,000 $10,000
The initial percentage margin is:
Equity in Account $6,000
Margin = = = 60%
Value of stock $10,000
If the price decline to $70 per share, the account balance becomes:
Assets Liability and Owners’ Equity
Value of Stock $7,000 Loan From Broker $4,000
Equity (7,000-4,000) $3,000
$7,000 $7,000
The assets in the account fall by the full decrease in the stock value, as does the
equity. The percentage margin is now:
Equity in Account $3,000
Margin = = = 43%
Value of stock $7,000
Suppose that the maintenance margin is 50%. To maintain this margin of 50%, the
cash investor needs to inject is
x
50% = $7,000
x = $7,000 x 50%
x = $3,500
x = $3,500
Cash needed to be injected = $3,500 - $3,000 = $500.
In this case, the margin is worth $3,500 and the loan is worth $3,500.

Suppose the maintenance margin is 30%. How far could the stock price fall before the
investor get the margin call?

Let P be the price of the stock. The value of the investor’s 100 shares is then 100P,
and the equity in the account is 100P- $4,000.
100P – 4,000
Margin = 100P = 30%

30% x 100P = 100P – 4,000

100P - 30P = 4,000
70P = 4,000
P = 4,000
70
P = $57.14
Suppose an investor is bullish on IBM stock, which is selling for $100 per share. An
investor with $10,000 to invest expects IBM to go up in price by 30% during the next
year. Suppose that there is no dividend. In next year, IBM stock price is worth $130
(= 130% x $100 per share)
$13,000 – $10,000 $3,000
Expected return = = = 30%
$10,000 $10,000
Assume that investor borrows another $10,000 from the broker and invests it in IBM
too. The total investment in IBM would be $20,000 ($100 per share x 200 shares).
Assume that the interest rate on the margin of 9% per year.
IBM shares will be worth $26,000 (= $20,000 x 130%).
Interest payment is $900 (= $10,000 x 9%). After paying the principal and interest on
the margin loan worth $10,900, the value of equity is worth $15,100 (=$26,000-
$10,900)
$15,100 - $10,000 $5,100
Expected return = = = 51%
$10,000 $10,000
The investor has parlayed a 30% rise in the stock’s price into a 51% rate of return on
the $10,000 investment.

In the case of purchasing IBM stock with $10,000 margin the expected return is:
Suppose that, the price of IBM goes down by $30% to $70 per share. The IBM share
is worth $7,000. In the case of purchasing IBM stock worth $10,000 with no margin,
the expected return is:
$7,000 – $10,000 - $3,000
Expected return = = = - 30%
$10,000 $10,000
In the case of purchasing IBM stock worth $20,000 with $10,000 margin, after paying
the principal and interest on the margin loan worth $10,900, the value of equity is now
worth $3,100 ($14,000-$10,900). In this case, the expected return is:
$3,100 – $10,000 - $6,900
Expected return = = = - 69%
$10,000 $10,000
 t=0 t=1
Cash Flow 1,000 x £1.50 -[(1,000 x £1.85) + (1,000 x £0.12)]
= £1,500 = -[1,850 + 120] = -1970
Margin Account -(£1,500 x 50%) 750
= -750
Net Cash Flow 1,500+(-750) -1970 + 750
= £750 = -£1,220
The margin based on ending price is: 750 - (1220-750) = 750 – 470 = £280
Using IRR method to obtain the rate of return on the investment:
750 - [1220/(1+IRR)] = 0
750 = [1220/(1+IRR)]
(1+IRR) = 1220/750
(1+IRR) = 1.6267
IRR = 1.6267 -1
IRR = 0.6267 or 62.67% or (750 – 1,220)/ 750 = -470/750 = -62.67%

Assets Liability and Owners’ Equity

Cash from short sale £450 Shares sold short £900
Cash £450
£900 £900

t=0 t=1
Cash Flow 1,200 x £0.75= -[(1,200 x £0.50) + (1,200 x £0.10)]
900 = -[600 + 120] = -720
Margin Account -450 450
Net Cash Flow 900+(-450) -720+450
=450 = - 270
The value of 1,200 XYZ shares you short-sell is worth £900 (=£0.75 x 1,200 shares).
The initial equity required is £450 while the other £450 is your cash inflow. The
dividend of 1,200 XYZ share is £120(1,200 shares x £0.10). At the end of the year,
1,200 XYZ share price you unwind the short position is worth £600(£0.50 x £1,200).
You pay £450 from the margin account and the remaining £150 by cash. This short
position has cash inflow of £450 at the beginning of the year and cash outflow of
£270 at the end of the year.
Using the IRR method to obtain the rate of return on short transaction:
450 – [270/(1+IRR)] = 0
450 = [270/(1+IRR)]
You open an account to buy 10,000 shares of XX, priced at $7.75. The initial
margin requirement is 60% and the interest rate on a margin loan is 9%. A
year later the share pays a dividend of $1 per share. What is the return to
the investor if the price
i. rises to $8.75?
ii. falls to $6.75?
How does it compare with an un-margined investment?
Answer:
t=0 t=1
Cash Flow -(10,000 x $7.75) (10,000 x $8.75) + (10,000 x $1)
= -$77,500 = $97,500
Margin Account (1-0.6) x $77,500 -($31,000 x 109%)
= $31,000 = -$33,790
Net Cash Flow -$77,500 + $31,000 $97,500 + (-$33,790)
= -$46,500 = $63,710
Using IRR method to obtain rate of return on investment:
-46,500 + [63,710/(1+IRR)] = 0
[63,710/(1+IRR)] = 46,500 t=0 t=1
(1+IRR) = 63,710/46,500 Cash Flow -(10,000 x $7.75) (10,000 x $6.75) + (10,000 x $1)
(1+IRR) = 1.3701 = -$77,500 = $77,500
IRR = 1.3701 – 1 Margin Account (1-0.6) x $77,500 -($31,000 x 109%)
IRR = 0.3701 or 37.01% = $31,000 = -$33,790
Or: (63,710 – 46,500)/46,500 = 17,210/46,500 = 37.01% Net Cash Flow -$77,500 + $31,000 $97,500 + (-$33,790)
= -$46,500 = $43,710
Using IRR method to obtain rate of return on investment:
-46,500 + [43,710/(1+IRR)] = 0
[43,710/(1+IRR)] = 46,500
(1+IRR) = 43,710/46,500
(1+IRR) = 0.94
IRR = 0.94 – 1
IRR = -0.06 or -6%
or: (43,710-46,500)/46,500 = -0.06 or -6%
Using IRR to obtain rate of return on un-margined investment when share price rises:
-$77,500 + [$97,500/(1+IRR)] = 0
-$77,500 + [$77,500/(1+IRR)] = 0
[$97,500/(1+IRR)] = $77,500
[$77,500/(1+IRR)] = $77,500
(1+IRR) = [$97,500/$77,500]
(1+IRR) = [$77,500/$77,500]
(1+IRR) = 1.2581
(1+IRR) = 1
IRR = 1.2581 – 1
IRR = 1 – 1
IRR = 0.2581 or 25.81%
IRR = 0%
You make a short sales transaction using a margin account with your broker. The
stock is currently trading at 100. Assume that at the end of the year it trades at 110,
and at the end of year 2 it trades at 95. This year the dividend is 5, next year there is
no dividend. The initial margin requirement is 70% and the maintenance margin is
60%. There is no interest on the margin account. You short 100 units of the stock
now and buy back the shares after 2 years. What is the return on your investment?
Answer:
t=0 t=1 t=2
Cash Flow 100 x 100 -(5 x 100) 100 x 95
= 10,000 = - 500 = -9,500
Margin Account -(0.7 x 10,000) 7,000-[0.6 x (100 x 6,600
= -7,000 110)]
= 7,000-6,600=400
Net Cash Flow 10,000 + (– 7,000) -500 + 400 -9,500 + 6,600
= 3,000 = -100 = - 2,900
We can use internal rate of return (IRR) to obtain the return on your investment.
Formally, this can be expressed as:
3000 – [(100)/(1+IRR)] – [(2,900)/(1+IRR)2] = 0
Rearrange the above equation:
3000 = [(100)/(1+IRR)] + [(2,900)/(1+IRR)2]
Simplify the above equation:
3000 = [100/(1+IRR)][(1+ [(29)/(1+IRR)]]
Rearrange the above equation:
30(1+IRR) = 1+ [(29)/(1+IRR)]
Expand the above equation:
30 + 30IRR = 1 + [(29)/(1+IRR)]
Rearrange the above equation:
30 – 1 + 30IRR = [(29)/(1+IRR)]
29 + 30IRR = [(29)/(1+IRR)]
Multiply both sides of above equation by (1+IRR):
29(1+IRR) + 30IRR(1+IRR) = 29
Expand the above equation:
29 + 29IRR + 30IRR + 30IRR2 = 29
Rearrange:
29IRR + 30IRR + 30IRR2 = 0
59IRR + 30IRR2 = 0
Simplify the above equation:
IRR(59 + 30IRR) = 0
From this above equation, we infer that there are two IRRs.
One of two IRRs is 0 for that the right side to be zero. Because of that the other IRR
can be obtained as follows
59 + 30IRR = 0
IRR = -59/30 = -1.97
In short, IRR is either 0% or -197%
Now, we have to identify the question whether the transaction is either an investment
or a loan. An investment is a transaction, where you have an initial cash outflow
followed by a cash inflow. A loan is a transaction, where you have an initial cash
inflow followed by a cash outflow. Investment transaction usually has decreasing
NPV in discount rate. In contrast, loan transaction usually has increasing NPV in
discount rate. We can rule out the one of two IRRs, -197%. This is because at 197%,
the NPV is decreasing in discount rate. Therefore, the loan position is at the rate of
0% and is, therefore, a good transaction. This implies that the discount rate is almost
certainly positive.
 Condition
Price below the limit Price above the limit
Action

Buy Limit-Buy Order Stop-Buy Order

Sell Stop-Loss Order Limit-Sell Order
 Open- end
fund
Managed fund

Closed end
ETF
fund
Questions to practise:
Q1a ZA 2007
Q1c ZA 2007
Q1a ZA 2009
Q5a ZA 2009
Q7a ZA 2009
Q1a ZB 2006
Q1a ZB 2008
Q1a ZB 2009
Q7a ZB 2010
Q8a ZB 2011