1. Assume that Fund A charges a front-end load of 6%, an expense ratio of 0.4% a
ID: 2801979 • Letter: 1
Question
1. Assume that Fund A charges a front-end load of 6%, an expense ratio of 0.4% and no 12b-1 fees. Assume that Fund B charges no front-end load, 12b-1 fees of 0.5% an expense ratio of 1% and back-end fees of 2%. If both funds’ portfolios have an average return of 12%, which is the better investment after 5 years given an initial investment of $5,000?
2. Assume that you purchase a call option costing $10/share which would allow you to purchase 100 shares of stock at a strike price of $90. If, at the exercise date, the stock was trading at $115, would you exercise the option? What would be your return? What about if the stock was trading at $95 on the exercise date?
Explanation / Answer
1) Value of investment in Fund A after 5 years, FV = 5,000 x (1 - 6%) x (1 + 12% - 0.4%)^5 = $8,136.15
Value of investment in Fund B after 5 years, FV = 5,000 x (1 + 12% - 0.5% - 1%)^5 x (1 - 2%) = $8,072.49
Hence, Fund A is a better investment.
2) Yes, you would exercise the option as the stock price is above exercise price.
Profits = 100 x (115 - 90 - 10) = 1500, Returns = 1500 / 100 x 10 = 150%
If the stock trades at $95, then you would still exercise the option in order to reduce your losses.
Profits = 100 x (95 - 90 - 10) = -500 (losses)
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