• Document: Solutions for End-of-Chapter Questions and Problems: Chapter Five
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Solutions for End-of-Chapter Questions and Problems: Chapter Five 2. What are money market mutual funds? In what assets do these funds typically invest? What factors have caused the strong growth in this type of fund since the late 1970s? Money market mutual funds (MMMFs) invest in assets that have maturities of less than one year. These assets primarily are Treasury bills, negotiable certificates of deposit, repurchase agreements, and commercial paper. The growth in MMMFs since the late 1970s initially occurred because of rising interest rates in the money markets, while Reg Q restricted interest rates on accounts in depository institutions. Many investors moved their short-term savings from the depository institutions to the MMMFs as the spread in the earnings rate reached double digits. A result of this activity was to introduce many investors to the capital markets for the first time. 3. What are long-term mutual funds? In what assets do these funds usually invest? What factors caused the strong growth in this type of fund during the 1990s and early 2000s? Long-term mutual funds primarily invest in assets that have maturities of more than one year. The most common assets include long-term fixed-income bonds, common stock, and preferred stocks. Some money market assets are included for liquidity purposes. The growth in these funds in the 1990s and 2000s reflected the dramatic increase in equity returns, the reduction in transaction costs, and the recognition of diversification benefits achievable through mutual funds. 4. Using the data in Table 5-3, discuss the growth and ownership holding over the last 26 years of long-term funds versus short-term funds. The dollar investment in the money market mutual funds (MMMF) exceeded the investment in the long-term funds (LTF) in 1980. However, by 2006, the LTFs had more than a two to one advantage on the MMMFs, $7,093 billion to $2,312 billion. The LTF grew at an annualized rate of 93.0 percent, and the MMMF grew at an annualized rate of 75.3 percent. In each type of fund, the largest investment source was the household sector, with growth of 110.4 percent annual rate for the LTF and 89.4 percent for the MMMF. 7. What are the economic reasons for the existence of mutual funds; that is, what benefits do mutual funds provide for investors? Why do individuals rather than corporations hold most mutual funds? One major economic reason for the existence of mutual funds is the ability to achieve diversification through risk pooling for small investors. By pooling investments from a large number of small investors, fund managers are able to hold well-diversified portfolios of assets. In addition, managers can obtain lower transaction costs because of the volume of transactions, both in dollars and numbers, and they benefit from research, information, and monitoring activities at reduced costs. Many small investors are able to gain the benefits of the money and capital markets by using mutual funds. Once an account is opened in a fund, a small amount of money can be invested on a periodic basis. In many cases the amount of the investment would be insufficient for direct access to the money and capital markets. On the other hand, corporations are more likely to be able to diversify by holding a large bundle of individual securities and assets, and money and capital markets are easily accessible by direct investment. Further, an argument can be made that the goal of corporations should be to maximize shareholder wealth, not to be diversified. 5-1 11. How is the net asset value (NAV) of a mutual fund determined? What is meant by the term marked-to-market? Net Asset Value (NAV) is the average market value of each ownership share of the mutual fund. The total market value of the fund is determined by summing the total value of each asset in the fund. The value of each asset can be found by multiplying the number of shares of the asset by the corresponding price of the asset. Dividing this total fund value by the number of shares in the mutual fund will give the NAV for the fund. The NAV is calculated at the end of each daily trading session, and thus reflects any adjustments in value caused by (a) changes in value of the underlying assets, (b) dividend distributions of the companies held, or (c) changes in ownership of the fund. This process of daily recalculation of the NAV is called marking-to-market. 12. A mutual fund owns 400 shares of Fiat, Inc., currently trading at $7, and 400 shares of Microsoft, Inc., currently trading at $70. The fund has 100 shares outstanding. a. What is the net asset value (NAV) of the fund? NAV = (400 x $7 + 400 x $70)/100 = $30,800/100 = $308.00. b. If investors expect the price of Fiat shares to increase to $9 and the price of Microsoft shares to decrease to $55 by the end of the year, what is the expected NAV at the end of the year? Expected NAV = (400 x $9 + 400 x $55)/100 = $25,600/100 = $256.00, or a declin

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