Course Learning Outcomes:
1: Evaluate the investment decisions of funds and individual investors and compare the reality of their behavior to the theory of efficient markets
2: Assess the impact of security selection, investing style and market timing on portfolio performance
3: Review the risks and benefits of investing in developed and emerging markets.
Problem 1: After much research on the developing economy and capital markets of the country of Otunia, your firm, GAC, has decided to include an investment in the Otunia stock market in its Emerging Markets Comingled Fund, GAC has not yet decided whether to invest actively or by indexing. Your opinion on the active versus indexing decision has been solicited. The following is a summary of the research findings:
Otunia's economy is fairly well-diversified across agricultural and natural resources, manufacturing (both consumer and durable goods), and a growing finance sector. Transaction costs in securities markets are relatively large in Otunia because of high commissions and government "stamp taxes" on securities trades. Accounting standards and disclosure regulations are quite detailed, resulting in wide public availability of reliable information about companies' financial performance.
Capital flows into and out of Otunia, and foreign ownership of Otumia securities, is strictly regulated by an agency of the national government. The settlement procedures under these ownership rules often cause long delays in settling trades made by nonresidents. Senior finance officials in the government are working to deregulate capital flows and foreign ownership, but GAC's political consultant believes that isolationist sentiment may prevent much real progress in the short run.
Required: Briefly discuss aspects of the Otunia environment that favor investing actively, and aspects that favor indexing.
Problem 2:
1. Consider the rate of return of stocks ABC and XYZ.(2,6 ,2 marks respectively)
Year rABC rXYZ
1 20% 30%
2 12 12
3 14 18
4 3 0
5 1 -10
a. Calculate the arithmetic average return on these stocks over the sample period.
b. Calculate the geometric average returns of each stock. What do you conclude?
c. If you were equally likely to earn a return of 20%, 12%, 14%, 3%, or 1% in each year (these are the five annual returns for stock ABC), what would be your expected of return?
Problem 3:
1. A 2-year investment of $2,000 results in a cash flow of $150 at the end of the first year and another cash flow of $150 at the end of the second year, in addition to the return of the original investment. What is the Internal rate of return on the investment (IRR)?
2. A U.S. firm has a European subsidiary that earns euros. The subsidiary has borrowed dollars at a floating rate of interest. What kind of risk does the subsidiary have? What kind of swap could be used to limit the subsidiary's risk? Be specific.
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