C H A PT E R 1

The Investment Environment

31

1 4 , The average rate of return on investments in large stocks has outpaced that on investments in Treasurybills by about 77o since 1926.Why then, does anyoneinvest in Treasurybills? 1 5 . What are some advantages and disadvantages of top-down versusbottom-up investing styles? 1 6 . You see an advertisement for a book that claims to show how you can make $1 million with no risk and with no money down. Will you buy the book?

1 7 . Why do financial assetsshow up as a component of household wealth, but not of national

wealth? Why do financial assetsstill matter for the material well-being of an economy? 1 8 . Wall Street firms have traditionally compensatedtheir traders with a share of the trading profits that they generated. How might this practice have affectedtraders' willingness to assumerisk? What is the agencyproblem this practice engendered?

19. What reforms to the financial systemmight reduceits exposureto systemicrisk?

Market

Regulators

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1. Go to the Securities and Exchange Commission Web site, www.sec.gov. What is the m i s s i o no f t h e S E C ? W h a t i n f o r m a t i o na n d a d v i c ed o e s t h e S E Co f f e r t o b e g i n n i n g investors? 2. Go to the FINRAWeb site, www.finra.org What is its mission? What information and advicedoes it offer to beginners? 3. Go to the IOSCO Web site, www.iosco.org. What is its mission? What information and advicedoes it offer to beginners?

S*fw{i*ysst# CO
1. a. Real b. Financial c. Real d. Real e. Financial

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2. The central issue is the incentive to monitor the quality of loans when originated as well as over time. Freddie and Fannie clearly had incentive to monitor the quality of conforming loans that they had guaranteed,and their ongoing relationshipswith mortgage originators gave them opportunities to evaluate track records over extended periods of time. In the subprime mortgage market, the ultimate investors in the securities(or the CDOs backed by those securities),who were bearingthe credit risk, should not have beenwilling to investin loans with a disproportionate likelihood of default. If they properly understood their exposure to default risk, then the (correspondinglylow) prices they would have been willing to pay for thesesecuritieswould have imposed discipline on the mortgageoriginators and servicers.The fact thatthey were willing to hold such large positions in theserisky securitiessuggests that they did not appreciatethe extent of their exposure.Maybe they were led astrayby overly optimistic projectionsfor housing prices or by biased assessments from the credit reporting agencies.In principle, either arrangement for default risk could have provided the appropriate discipline on the mortgage originators; in practice. however, the informational advantagesof Freddie and Fannie probably made them the better "recipients" of default risk. The lessonis that information and transparency are some of the preconditionsfor well-functioning markets.

PA R T I

In tro d u c ti o n

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1. In what ways is preferred stock like long-term debt?In what ways is it like equity? 2. Why are money market securitiessometimesreferred to as "cash equivalents"? agreement? 3. Which of the following correctly describesa repurchase a. The sale of a security with a commitment to repurchase the same security at a specified price. future date and a designated b. The sale of a security with a commitment to repurchasethe same security at afuture date left price. at a designated unspecified. c. The purchaseof a security with a commitment to purchasemore of the same security at a specifiedfuture date. 4. What would you expectto happento the spreadbetweenyields on commercialpaper and Treasury bills if the economy were to enter a steeprecession? 5. What are the key differencesbetweencommon stock, preferred stock, and corporatebonds? 6. Why are high-tax-bracketinvestorsmore inclined to investin municipal bonds than low-bracket investors?.

I(APLAN

{;1. ,'tutnback to Figure 2.3 andlook at the Treasurybond maturing in February 2039. a. How much would you have to pay to purchaseone of thesenotes? b. What is its couponrate? c. What is the current yield of the note? 8. Supposeinvestors can earn a return of 27o per 6 months on a Treasury note with 6 months remaining until maturity. What price would you expect a 6-month maturity Treasurybill to se11 for? 9. Find the after-tax return to a corporation that buys a shareof preferred stock at $40, sells it at year-endat $40, and receivesa $4 year-enddividend. The firm is in the 307otax bracket. 10. Turn to Figure 2.6 andlook at the listin-efor GeneralDynamics. rz. How many sharescould you buy for $5,000? b. What would be your annual dividend income from those shares? c. What must be GeneralDynamics earningsper share? d. What was the firm's closing price on the day before the listing? price at trme t, and Q, represents 11. Consider the three stocksin the following table.P, represents sharesoutstandingat time r. Stock C splits two for one in the last period.
Po Qo
P1

Qr 100 200 200 95

4tr,

Qz 100 200 400

A B C

90 50 100

100 200 200

95 45 110

55

a. Calculate the rate of return on a price-weighted index of the three stocks for the first perioc (r:0tor:1). b. What must happento the divisor for the price-weightedindex tnyear 2? c. Calculatethe rate of return for the secondperiod (t : I to t : 2). 12. Using the data in the previousproblem, calculatethe first-period ratesof return on the following indexesof the three stocks: index. a. A market-value-weighted b. An equally weighted index.

CHAPTE R 2

AssetClasses and Financial Instruments

59

-\rr irvestor is in a 307o tax bracket. If corporate bonds offer 97o yields, what must municipals l.fier for the investor to prefer them to colporate bonds? Find the equivalenttaxableyield of a short-termmunicipal bond currently offering yields of 47o ror tax brackets of zero, IjVo,207a, and307o. \\hat problems would confront a mutual fund trying to create an index fund tied to an equally x eightedindex of a broad stock market? \\l-rich security should sell at a greaterprice? -;. A 10-yearTreasurybgnd with a97o couponrate versusa 10-yearT:bond with a l\Vo coupon. :. A 3-month expiration call option with an exerciseprice of $40 versusa 3-month call on the samestock with an exerciseprice of $35. --. A put option on a stock selling at $50, or a put option on another stock selling at $60 (al1 other relevantfeaturesof the stocks and options may be assumedto be identical). n ook at the futures listings for the coffi contractin Figure 2.8. -;. Supposeyou buy one contract for March delivery. If the contract closesin March at a level of 3.875,what will your profit be? i. How many March maturity contractsare outstanding? Turn back to Figure 2J andlook at the Intel options. Supposeyou buy a November expiration --alloption with exerciseprice $21. -:. Supposethe stock price in November is $21.75 Will you exerciseyour call? What is the profit on your position? :. What if you had bought the November call with exerciseprice $22? -'. What if you had bought a November put with exerciseprice $22? 't\h1' do call options with exerciseprices greaterthan the price of the underlying stock sell for :'-rsitive prices? Both a call and a put currently are traded on stock XYZ; both have strike prices of $50 and ::ipirations of 6 months. What will be the proflt to an investor who buys the call for $4 in the -ollowing scenariosfor stock prices in 6 months?What will be the profit in each scenarioto an -lvestor who buys the put for $6? -;. S40 r. S45

c. $50
d. b))

e. $60

Erplain the differencebetweena put option and a short position in a futures contract. Erplain the differencebetweena call option and a long position in a futures contract.

-{ tfrm's preferredstock often sells at yieids below its bonds because -;. i. '. :. Prefered stock generally carries a higher agency rating. Owners of preferredstock have a prior claim on the firm's earnings. Owners of preferredstock have a prior claim on a firm's assets in the event of liquidation. Corporations owning stock may exclude from income taxes most of the dividend income they receive.

Cffi\
goBLEMS

-\ municipal bond carries a coupon of 63/q7o and is trading atpaL What is the equivalent taxable y. ield to a taxpayer in a combined federal plus state 347o tax bracket? \\trich is the most rislcy transactionto undertakein the stock index option markets if the stock narket is expectedto increasesubstantiallyafter the transactionis completed? r. Write a call option. b. Write a put option. c. Buy a call option. d. Buy a put option.

C H A P TE R 3

A re Traded H ow S ecuri ti es

91

t.

Old Economy Tradersopenedan accountto short sell 1,000 sharesof Internet Dreams from the previousproblem. The initial margin requirementwas 507o.(The margin accountpays no interest.) A year later,the price of Internet Dreams has risen from $40 to $50, and the stock has paid a dividend of $2 per share.

a. What is the remaining margin in the account? margin requirementis 307o,will Old Economy receivea margin call? b. If the maintenance c. What is the rate of return on the investment? 8 . Considerthe following limit-order book of a specialist.The last trade in the stock occurredat a price of $50.

Limit Buy Orders

Price
q,/.q 75

Limit Sell Orders

Price s $50.2 51.50 54.75 58.25 Shares 100 '100 300 100

Shares 500 800 500 200 600

49.50 49.25 49.00 48.50

a.

If a market buy order for 100 sharescomesin, at what price will it be filled? b. At what price would the next market buy order be filled? If you were the specialist,would you want to increaseor decreaseyour inventory of this stock? 9 . You are bullish on Telecom stock. The current market price is $50 per share,and you have $5,000 of your own to invest. You borrow an additional $5,000 from your broker at an interest
L.

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rate of 87o per year and invest $10,000 in the stock. a. What will be your rate of return if the price of Telecom stock goes up by 107oduring the next year? The stock currently pays no dividends. b. How far doesthe price of Telecom stock have to fa1lfor you to get a margin call if the maintenancemargin is 307o?Assume the price fall happensimmediately.

1 0 . You are bearish on Telecom and decide to sell short 100 shares at the current market price of
$50 per share. a. How much in cash or securitiesmust you put into your brokerage account if the broker's initial margin requirementis 507oof the value of the short position? b. How high can the price of the stock go before you get a margin call if the maintenancemargin is 307oof the value of the short position?
1 1

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Supposethat Intel curently is selling at $40 per share.You buy 500 sharesusing $15,000 of your own money, borrowing the remainder of the purchaseprice from your broker. The rate on the margin Ioanrs 87o. a. What is the percentage increase in the net worth of your brokerage account if the price of InteI immediately changesto: (i) $aa, (ii) $a0; (iii) $36? What is the relationship between your percentagereturn and the percentagechange in the price of Intel? b. If the maintenancemargin rs 257o,how low can Intel's price fall before you get a margin call? c. How would your answer to (b) change if you had financed the initial"purchasewith only $10,000of your own moneY? d. Whatis the rate of return on your marginedposition (assumingagainthat you invest $15,000 of your own money) if Intel is selling after 1 year at (i) $aa, (ii) $40; (iii) $36? What is the relationship between your percentagereturn and the percentagechange in the price of Intel? Assume that Intel pays no dividends' e. Continue to assumethat a year has passed.How low can Intel's price fall before you get a marsin call?

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PART I

Introduction 12. Supposethat you sell short 500 sharesofIntel, currently selling for $40 per share,and give your
your marginaccount. broker$ 15,000to establish a. If you earn no interest on the funds in your margin account, what will be your rate of return after 1 year if Intel stock is selling at: (i) $aa; (ii) $a0; (iii) $36? Assume thar Intel pays no dividends. b. ii,ft. -.i"tenance margin is Z5Vo.howhigh can Intel's price rise beforeyou get a margin call? c. Redo parts (a) and (b), but now assume that Intel also has paid a year-end dividend of as ex-dividend, $l per share.The pricesin part (a) shouldbe interpreted that is. pricesafter the dividendhas beenpaid.

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t3.

Here is someprice informationon Marriott: Bid Marriott 1 99 5 Asked 20.05

You have placed a stop-loss order to sell at $20. What are you telling your broker? Given market prices, will your order be executed? 14. Here is some price information on Fincorp stock. Suppose that Fincorp trades in a dealer market. Bid 55.25 Asked 55 . 5 0

a. Suppose you have submitted an order to your broker to buy at market. At what price will your trade be executed? b. Suppose you have submitted an order to sell at market. At what price will your trade be executed? c. Supposeyou have submitteda limit order to sell at $55.62.What will happen? d. Supposeyou have submitteda limit order to buy ar $55.37.What will happen?

1 5 . Now reconsiderthe previous problem assumingthat Fincorp sells in an exchangemarket like

the NYSE. a. Is there any chance for the market buy order considered in part (a) to be executed at a price below $55.50, and the sell order in part (b) at aprice above$55.25? b. Is there any chanceof an immediate trade at $55.37 for the limit-buy order in part (Q?

1 6 . You've borrowed $20,000 on margin to buy sharesin Disney, which is now selling at $40 per
share.Your account starts at the initial margin requirement of 507o.The maintenancemargin is 357o.Two days later, the stock price falls to $35 per share. a. Will you receivea margin call? b. How low can the price of Disney sharesfall before you receive a margin call?

n.

On January1, you sold short one round lot (that is, 100 shares)of Lowes stock at $21 per share. On March 1, a dividend of $2 per sharewas paid. On April 1, you coveredthe short saleby buying the stock at a price of $15 per share.You paid 50 cents per sharein commissionsfor each transaction. What is the valueof your accounton April 1?

Cfr\
\-PIOBLEMS

1. FBN, Inc., hasjust sold 100,000sharesin an initial public offering. The underwriter's explicit fees were $70,000. The offering price for the shareswas $50, but immediately upon issue,the sharepricejumped to $53. a. What is your bestguessas to rhe total cost to FBN of the equity issue? b. Is the entirecost of the underwritinga sourceof profit to the underwriters?