Investment Finance Prototype Midterm I

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1 Investment Finance Prototype Midterm I The correct answer is highlighted by a *. Also, a concise reasoning is provided in Italics. 1. are an indirect way U. S. investor can invest in foreign companies. *a. ADRs b. HUS c. SDRs d. GNMAs e. Krugerrands Only ADRs represent an indirect investment in a foreign company. 2. Finns that specialize in helping companies raise capital by selling securities are called a. commercial banks *b. investment banks c. savings banks d. credit unions e. all of the above. An important role of investment banks is to act as middle men in helping firms place new issues in the market. 3. Derivative securities are: a. potentially dangerous because they are highly leveraged b. an effective tool to better manage business returns and risk c. always structured as option contracts *d. both a and b are true e. all of the above are true Derivative securities were created to allow the transfer of risk from one party to another. They can be used to effectively reduce risk, or, because of leverage effects, to greatly increase risk. Theoretically, when firms are taken over, better managers come in and thus increase the price of the stock; existing management often must either leave the firm, be demoted, or suffer a loss of existing benefits. 4. Individual investors are most likely to trade securities in: a. a direct search market *b. an auction market c. the primary market d. a brokered market e. a block transaction

2 Direct search markets are sporadic markets for specialized goods. Brokered markets, including block transactions and primary market transactions, are less accessible to individual traders. Most individual security trades take place in auction markets or dealer markets. 5. Dual funds are: a. examples of tax-induced innovations b. examples of derivative assets c. separated into income shares and capital shares d. targeted to meet the needs of investors in different income brackets *e. all of the above are true All of these statements describe dual funds. 6. Which one of the following terms best describes Eurodollars: a. dollar-denominated deposits in European banks. b. dollar-denominated deposits at branches of foreign banks in the U. S. *c. dollar-denominated deposits at foreign banks and branches of American banks outside the U. S. d. dollar-denominated deposits at American banks in the U. S. e. dollars that have been exchanged for European currency. Although originally Eurodollars were used to describe a, today the term has been extended to apply to any dollar-denominated deposit outside the U. S. 7. Which of the following indices is (are) market-value weighted? I. The New York Stock Exchange Composite Index. II. The Standard and Poors Composite Stock Index. III. The Dow Jones Industrial Average. IV. The Value Line Composite Index. a. I only *b. I and II only C. III only d. 1, H, and III only e. I, H, III, and IV Use the following information to answer questions 18 through 20 Consider the following three stocks: Stock Price Number of Shares Outstanding Stock A $ Stock B $ Stock C $ The price-weighted index constructed with the three stocks is:

3 a. 30 *b. 40 c. 50 d. 60 e. 70 ($40 + $70 + $10)/3 = $ The value-weighted index constructed with the three stocks using a divisor of 100 is: a. 1.2 b *c. 490 d e. 49 The sum of the value of the three stocks divided by 100 is 490: [($40 x 200) + ($70 x 500) + ($10 x 600)] /100 = Assume at these prices the value-weighted index constructed with the three stocks is 490. What would the index be if stock B is split 2 for I and stock C 4 for 1? a. 265 b. 430 c. 355 *d. 490 e Value-weighted indexes are not affected by stock splits. 11. An investor purchases one municipal and one corporate bond that pay rates of return of 8% and 10%, respectively. If the investor is in the 20% marginal tax bracket, his or her after tax rates of return on the municipal and corporate bonds would be and respectively. a. 8% and 10% *b. 8% and 8% c. 6.4% and 8% d. 6.4% and 10% e. 10% and 10% r c 0.10(1-0.20) = 0.08, or 8%; r m 0.08(l - 0) = 8%. 12. The Value-line Index is an equally-weighted geometric average of the return of about 1,700 firms. What is the value of an index based on the geometric average returns of three stocks, where the returns on the three stocks during a given period were 20%, -10%, and 5%? *a. 4.3% b. 5.0% c. 11.7%

4 d. 13.4% e. 12.2% [(1.2)(0.9)(1.05)] 1 = 4.3%. 13. Brokers' calls: a. are funds used by individuals who wish to buy stocks on margin. b. are funds bon-owed by the broker from the bank, with the agreement to repay the bank immediately if requested to do so. c. carry a rate which is usually about one percentage point lower than the rate on U.S. T-bills. *d. a and b. e. a and c. Brokers' calls are funds borrowed from banks by brokers and loaned to investors in margin accounts. 14. The following statements regarding the specialist are true: a. Specialists maintain a book listing outstanding unexecuted limit orders. b. Specialists earn income from commissions and spreads in stock prices. c. Specialists stand ready to trade at quoted bid and ask prices. d. Specialists cannot trade in their own accounts. *e. a, b, and c are all true. The specialists' functions are all of the items listed in a, b, and c. In addition, specialists trade in their own accounts. 15. The secondary market consists of: a. transactions on the AMEX. b. transactions in the OTC market. c. transactions regarding the investment banker. *d. a and b. e. a, b, and c. The secondary market consists of transactions on the organized exchanges and in the OTC market. The investment banker is involved in the placement of new issues in the primary market. 16. Initial margin requirements are determined by: a. the Securities and Exchange Commission. *b. the Federal Reserve System. c. the New York Stock Exchange. d. b and c. e. a and b. The Board of Governors of the Federal Reserve System determines initial margin requirements. The New York Stock Exchange determines maintenance margin requirements on NYSE-Hsted stocks; however, brokers usually set maintenance margin requirements above those established by the NYSE.

5 17. Which one of the following statements regarding orders is false? a. A market order is simply an order to buy or sell a stock immediately at the prevailing market price. b. A limit sell order is where investors specify prices at which they are willing to sell a security. c. If stock ABC is selling at $50, a limit-buy order may instruct the broker to buy the stock if and when the share price falls below $45. d. A day order expires at the close of the trading day. *e. None of the above. All of the order descriptions above are correct. 18. Assume you purchased 200 shares of XYZ common stock on margin at $70 per share from your broker. If the initial margin is 55%, how much did you borrow from the broker? a. $6,000 b. $4,000 c. $7,700 d. $7,000 *e. $6, shares X $70/share = $14,000 x (1-0.55) = $6, You purchased 100 shares of common stock on margin at $45 per share. Assume the initial margin is 50% and the stock pays no dividend. What would the maintenance margin be if a margin call is made at a stock price of $30? Ignore interest on margin. *a b C d e. none of the above 100 shares X $45/share = $4,500 X 0.5 = $2,250 (loan amount); X = [100($30) - $2,250]/100($30); X = You sold short 300 shares of common stock at $55 per share. The initial margin is 60%. At what stock price would you receive a margin call if the maintenance margin is 35%? a. $51 *b. $65 c. $35 d. $40 e. none of the above Equity = 300($55) X 1.6 = $26,400; 0.35 = ($26, P) + 30OP; 105P = 26, P 405P = 26,400; P = $ The over-the-counter market for exchange-listed securities is called the:

6 *a. third market b. fourth market c. NASDAQ d. after-market The third market originated when some exchange-listed securities were allowed to be traded in the OTC market at time when commissions were fixed on exchange listed securities and institutional investors were trying to find a way to lower commission costs. 22. Quoted spreads on NASDAQ traded companies dropped in January 1997 a. because customer orders were required to be made public beginning at that time. b. because prices on electronic systems used to trade big orders were made visible and available to the public after that date. c. because of widespread allegations of price-fixing by dealers. d. due to closer regulatory insight. *e. all of the above contributed to smaller quoted spreads. See text box page The floor broker is best described as *a. an independent member of the exchange who owns a seat and handles overload work for commission brokers. b. someone who makes a market in one or more securities. c. a representative of a brokerage firm who is on the floor of the exchange to execute customer orders. d. a frequent trader who performs no public function but executes trades for his/her own account. e. any counter-party to a trade executed on the floor of the exchange. The floor broker is an independent member of the exchange who handles work for commission brokers when they have too many orders to handle. 24. Which one of the following statements regarding closed-end mutual funds is false? a. The funds invest in large volumes of several securities. *b. The funds redeem shares at their net asset value. c. The funds offer investors professional management. d. a and b. e. None of the above. Closed-end funds are sold at the prevailing market price. 25. Most actively managed mutual funds a. beat the market return in all years. b. beat the market return in most years. C. exceed the return on index funds. *d. do not outperform the market

7 e. None of the above are correct statements. Most actively managed mutual funds fail to equal the return earned by index funds, possibly due to higher transactions costs. 26. Pools of money invested in a portfolio that is fixed for the life of the fund are called a. closed-end funds. b. open-end funds. *c. unit investment trusts. d. REITS. e. redeemable trust certificates. Unit investment trusts are funds that invest in a portfolio, often fixed-income securities, and hold it to maturity. 27. A year ago, you invested $1,000 in a savings account that pays an annual interest rate of 7%. What is your approximate annual real rate of return if the rate of inflation was 3% over the year? *a. 4%. b. 10%. c. 7%. d. 3%. 7% - 3% = 4%. 28. If the annual real rate of interest is 5% and the expected inflation rate is 4%, the nominal rate of interest would be approximately: a. 1%. *b. 9%. c. 20%. d. 15%. 5% + 4% = 9%. Use the following Information to answer questions 29 through 30: You have been given this probability distribution for the holding period return for XYZ stock: State of Nature Probability HPR Boom % Normal growth % Recession % 29. What is the expected holding period return for XYZ stock?

8 a % b. 8.33% *c. 10.4% d. 12.4% e. 7.88% E(HPR) =.30 (18%) +.50 (12%) +.20 (-5%) = 10.4% 30. What is the expected standard deviation for XYZ stock? D a. 2.07% b. 9.96% c. 7.04% d. 1.44% *e. 8.13% Std = [ 0.30 ( ) ( ) ( ) 2 ] ½ = 8.13% 31. An American put option allows the holder to a. buy the underlying asset at the striking price on or before the expiration date. b. sell the underlying asset at the striking price on or before the expiration date. c. potentially benefit from a stock price decrease with less risk than short selling the stock. *d. b and c. e. a and c. An American put option allows the buyer to sell the underlying asset at the striking price on or before the expiration date. The put option also allows the investor to benefit from an expected stock price decrease while risking only the amount invested in the contract. 32. The intrinsic value of an out-of-the-money call option is equal to a. the call premium. *b. zero. c. the stock price minus the exercise price. d. the striking price. The fact that the owner of the option can, buy the stock at a price greater than the market price gives the contract an intrinsic value of zero, and the holder will not exercise. 33. You write one AT&T February 50 put for a premium of $5. Ignoring transactions costs, what is the breakeven price of this position? a. $50 b. $55 *c. $45 d. $40 e. none of the above

9 +$50 - $5 = $ Buyers of call options required to post margin deposits and sellers of put options required to post margin deposits. a. are; are not b. are; are *c. are not; are d. are not; are not e. are always; are sometimes Buyers of call options pose no risk as they have no commitment. If the option expires worthless, the buyer merely loses the option premium. If the option is in the money at expiration and the buyer lacks funds, there is no requirement to exercise. The seller of a put option is committed to selling the stock at the exercise price. If the seller of the option does not own the underlying stock the seller must go into the open market and buy the stock in order to be able to sell the stock to the buyer of the contract. 35. A covered call position is equivalent to a a. long put. *b. short put. c. long straddle. d. vertical spread. With a short put, the seller of the contract must buy the stock if the option is exercised; however, this cash outflow is offset by the premium income as in the covered call scenario. 36. You purchase one IIBM March 100 put contract for a put premium of $6. What is the maximum profit that you could gain from this strategy? a. $10,000 b. $10,600 *c. $9,400 d. $9,000 e. none of the above -$600 + $10,000 = $9,400 (if the stock falls to zero.) Use the following information to answer questions 37 through 39. You buy one Xerox June 60 call contract and one June 60 put contract. The call premium is $5 and the put premium is $ Your strategy is called a. a short straddle. *b. a long straddle. c. a horizontal straddle. d. a covered call.

10 e none of the above. Buying both a put and a call, each with the same expiration date and exercise price is a long straddle. 38. Your maximum loss from this position could be a. $500. b. $300. *c. $800. d. $200. e none of the above. -$5 + (-$3) = -$8 X 100 = $ At expiration, you break even if the stock price is equal to a. $52. b. $60. C. $68. *d. both a and c. e none of the above. Call: -$60 + (-$5) + $3 = $68 (Break even); Put: -$3 + $60 + (-$5) = $52 (Break even); Thus, if price increases above $68 or decreases below $52, a profit is realized. 40. The put-call parity theorem a. represents the proper relationship between put and call prices. b. allows for arbitrage opportunities if violated. c. may be violated by small amounts, but not enough to earn arbitrage profits, once transaction costs are considered. *d. all of the above. e none of the above. The put-call parity relationship depicts the relationship between put and call prices, which, if violated, allows for arbitrage profits; however, these profits may disappear once transaction costs are considered. 41. Delta is defined as *a. the change in the value of an option for a dollar change in the price of the underlying asset. b. the change in the value of the underlying asset for a dollar change in the call price. c. the percentage change in the value of an option for a one percent change in the value of the underlying asset. d. the change in the volatility of the underlying stock price. 42. The percentage change in the stock call option price divided by the percentage change in the stock price is called:

11 *a. the elasticity of the option. b. the delta of the option. C. the theta of the option. d. the gamma of the option. Option price elasticity measures the percent change in the option price as a function of the percent change in the stock price. 43. Portfolio A consists of 400 shares of stock and 400 calls on that stock. Portfolio B consists of 500 shares of stock. The call delta is 0.5. Which portfolio has a higher dollar exposure to a change in stock price? a. Portfolio B *b. Portfolio A c. The two portfolios have the same exposure d. A if the stock price increases and B if it decreases. e. B if the stock price decreases and A if it increases. 400 calls (0.5) = 200 shares shares = 600 shares; 500 shares = 500 shares.

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