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Chapter 17: Q4. (page 368)

What are mutual funds? What different types of mutual funds are there? And why do you think they are so popular with investors?

Short Answer

Expert verified

The funds are a pool of money that the mutual fund company invests.

Actively managed funds and index funds are the types of mutual funds.

They are so popular with investors because they are less risky.

Step by step solution

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Step 1. Mutual funds

A mutual fund is a company that gathers a pool of investments and maintains a professionally managed portfolio. The company purchases the portfolio by pooling the money of many investors. Because these investors provide the money to purchase the portfolio, they own it and any gains or losses generated by the portfolio flow.

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Step 2. Types of mutual funds

Actively managed funds have portfolio managers who continuously buy and sell assets to earn high returns. On the other hand, index funds are passively managed funds. The assets in their portfolios are chosen to match whatever stocks or bonds are contained in their respective underlying indexes exactly.

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Step 3. Popularity of mutual funds

The funds are so popular with investors because it is less risky than other investments like the stock market. As the pool is larger, the investments are made in large and hence receive better returns. One more benefit to investors is that the mutual fund's companies have the expertise, and the investors need not hold the knowledge of investments.

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Most popular questions from this chapter

Corporations often distribute profits to their shareholders in the form of dividends, which are quarterly payments sent to shareholders. Suppose that you have the chance to buy a share in a fashion company called Rogue Designs for \(35 and that the company will pay dividends of \)2 per year on that share. What is the annual percentage rate of return? Next, suppose that you and other investors could get a 12 percent per year rate of return on the stocks of other very similar fashion companies. If investors care only about rates of return, what should happen to the share price of Rogue Designs? (Hint: This is an arbitrage situation.)

Suppose that the Federal Reserve thinks that a stock market bubble is occurring and wants to reduce stock prices. What should it do to interest rates?

How do stocks and bonds differ in terms of the future payments that they are expected to make? Which type of investment (stocks or bonds) is considered to be more risky? Given what you know, which investment (stocks or bonds) do you think commonly goes by the nickname “fixed income”?

Next, consider another pair of assets, C and D. Asset C will make a single payment of \(150 in one year while D will make a single payment of \)200 in one year. Assume that the current price of C is \(120 and that the current price of D is \)180.

c. What are the rates of return of assets C and D at their current prices? Given these rates of return, which asset should investors buy and which asset should they sell?

d. Assume that arbitrage continues until C and D have the same expected rate of return. When arbitrage ends, will C and D have the same price?

Compare your answers to questions a through d before answering question e.

e. We know that arbitrage will equalize rates of return. Does it also guarantee to equalize prices? In what situations will it equalize prices?

What determines the vertical intercept of the Security Market Line (SML)? What determines its slope? And what will happen to an asset’s price if it initially plots onto a point above the SML?
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