FI 414 test 1
Which of the following correctly describes a repurchase agreement?
(a) A repurchase agreement is the sale of a security with a commitment to repurchase the same security at a specified future date and a designated price.
Suppose that short-term municipal bonds currently offer yields of 4%, while comparable taxable bonds pay 5%. Which gives you the higher after-tax yield if your tax bracket is:
14. After-tax yield = Rate on the taxable bond x (1 － Tax rate) a.The taxable bond. With a zero tax bracket, the after-tax yield for the taxable bond is the same as the before-tax yield (5%), which is greater than the 4% yield on the municipal bond. b.The taxable bond. The after-tax yield for the taxable bond is: 0.05 x (1 - 0.10) = 0.045 or 4.50%. c.Neither. The after-tax yield for the taxable bond is: 0.05 x (1 - 0.20) = 0.4 or 4%. The after-tax yield of taxable bond is the same as that of the municipal bond. d.The municipal bond. The after-tax yield for the taxable bond is: 0.05 x (1 - 0.30) = 0.035 or 3.5%. The municipal bond offers the higher after-tax yield for investors in tax brackets above 20%.
Find the after-tax return to a corporation that buys a share of preferred stock at $40, sells it at year-end at $40, and receives a $4 year-end dividend. The firm is in the 30% tax bracket.
32. The total before-tax income is $4. The corporations may exclude 70% of dividends received from domestic corporations in the computation of their taxable income; the taxable income is therefore: $4 x 30% = $1.20. Income tax in the 30% tax bracket: $1.2 x 30% = $0.36 After-tax income = $4 - $0.36 = $3.64 After-tax rate of return = $3.64/$40 = 0.091 or 9.10%
call option in a futures contract
A call option conveys the right to buy the underlying asset at the exercise price.
long position in a futures contract
A long position in a futures contract carries an obligation to buy the underlying asset at the futures price.
What is the role of A prospectus?
A prospectus is a description of the firm and the security it is issuing
put option in futures contract
A put option conveys the right to sell the underlying asset at the exercise price.
SEO
A seasoned issue is the issuance of stock by a company that has already undergone an IPO.
short position in a futures contract.
A short position in a futures contract carries an obligation to sell the underlying asset at the futures price.
What are the differences between a stop-loss order, a limit sell order, and a market order?
A stop order is a trade is not to be executed unless stock hits a price limit. The stop-loss is used to limit losses when prices are falling. An order specifying a price at which an investor is willing to buy or sell a security is a limit order, while a market order directs the broker to buy or sell at whatever price is available in the market.
Specialists on the New York Stock Exchange traditionally did all of the following except:
Act as odd-lot dealers.s
Describe alternative ways that an investor may add positions in international equity to his or her portfolio
American Depositary Receipts, or ADRs, are certificates traded in U.S. markets that represent ownership in shares of a foreign company. Investors may also purchase shares of foreign companies on foreign exchanges. Lastly, investors may use international mutual funds to own shares indirectly.
IPO
An IPO is the first time a formerly privately-owned company sells stock to the general public
Where would an illiquid security in a developing country most likely trade?
An illiquid security in a developing country is most likely to trade in broker markets.
A T-bill with face value $10,000 and 87 days to maturity is selling at a bank discount ask yield of 3.4%. (LO 2-1) a. What is the price of the bill? b. What is its bond equivalent yield?
Bank discount of 87 days: 0.034 x (87/360)=.008217 a) Price: $10,000 x (1 - 0.008217) = $9,917.83 b) bond equivalent yield= (face value-purchaseprice)/ purchase price x T ($10,000-$9,917.83)/($9,917.83 x 87/365)=.0348
Why are corporations more apt to hold preferred stock than are other potential investors?
Corporations may exclude 70% of dividends received from domestic corporations in the computation of their taxable income
How does a municipal revenue bond differ from a general obligation bond? Which would you expect to have a lower yield to maturity?
General obligation bonds are backed by the taxing power of the local governments, while revenue bonds have proceeds attached to specific projects. A revenue bond has fewer guarantees, it is riskier in terms of default, and, therefore, you expect it to have a higher yield.
What would happen to the divisor of the Dow Jones Industrial Average if FedEx, with a current price of around $180 per share, replaced AT&T (with a current value of about $34 per share)?
In this case, the value of the divisor will increase by an amount necessary to maintain the index value on the day of the change. For example, if the index was comprised of only one stock, it would increase by 2.06 points: ($180 - $34) / $34 = 4.29.
What is meant by limited liability
Limited liability means that the most shareholders can lose in event of the failure of the corporation is their original investment
Why have average trade sizes declined in recent years? (
Many large investors seek anonymity for fear that their intentions will become known to other investors. Large block trades attract the attention of other traders. By splitting large transactions into smaller trades, investors are better able to retain a degree of anonymity
How do margin trades magnify both the upside potential and downside risk of an investment portfolio?
Margin is a type of leverage that allows investors to post only a portion of the value of the security they purchase. As such, when the price of the security rises or falls, the gain or loss represents a much higher percentage, relative to the actual money invested.
Why are money market securities sometimes referred to as "cash equivalents"?
Money market securities are referred to as "cash equivalents" because of their great liquidity. The prices of money market securities are very stable, and they can be converted to cash (i.e., sold) on very short notice and with very low transaction costs
The Federal funds rate?
The Fed funds rate is the rate of interest on very short-term loans among financial institutions in the U.S
What is meant by the LIBOR rate?
The London Interbank Offer Rate (LIBOR)—a key reference rate in the money market—is the rate at which large banks in London are willing to lend money among themselves.
An investor is in a 30% combined federal plus state tax bracket. If corporate bonds offer 9% yields, what must municipals offer for the investor to prefer them to corporate bonds?
The after-tax yield on the corporate bonds is: 0.09 x (1 - 0.30) = 0.063 or 6.3%. Therefore, the municipals must offer at least 6.3% yields.
Why are high-tax-bracket investors more inclined to invest in municipal bonds than are low-bracket investors
The coupons paid by municipal bonds are exempt from federal income tax and from state tax in many states. Therefore, the higher the tax bracket that the investor is in, the more valuable the tax-exempt feature to the investor.
What are some different components of the effective costs of buying or selling shares of stock?
The effective price paid or received for a stock includes items such as bid-ask spread, brokerage fees, commissions, and taxes (when applicable). These reduce the amount received by a seller and increase the cost incurred by a buyer.
What problems would confront a mutual fund trying to create an index fund tied to an equally weighted index of a broad stock market?
The fund would require constant readjustment since every change in the price of a stock would bring the fund asset allocation out of balance.
What are the major components of the money market
The major components of the money market are Treasury bills, certificates of deposit, commercial paper, bankers' acceptances, Eurodollars, repos, reserves, federal funds, and brokers' calls
What is the difference between a primary and secondary market?
The primary market is the market where newly-issued securities are sold, while the secondary market is the market for trading existing securities. After firms sell their newly-issued stocks to investors in the primary market, new investors purchase stocks from existing investors in the secondary market.
How do security dealers earn their profits?
The primary source of income for a securities dealer is the bid-ask spread. This is the difference between the price at which the dealer is willing to purchase a security and the price at which they are willing to sell the same security.
What would you expect to happen to the spread between yields on commercial paper and Treasury bills if the economy were to enter a steep recession?.
The spread will widen. Deterioration of the economy increases credit risk, that is, the likelihood of default. Investors will demand a greater premium on debt securities subject to default risk.
Why do call options with exercise prices higher than the price of the underlying stock sell for positive prices?
There is always a chance that the option will expire in the money. Investors will pay something for this chance of a positive payoff.
What is the role of an underwriter? A prospectus?
Underwriters purchase securities from the issuing company and resell them.
What features of money market securities distinguish them from other fixed-income securities?
What features of money market securities distinguish them from other fixed-income securities?
In what circumstances are private placements more likely to be used than public offerings?
When a firm is a willing buyer of securities and wishes to avoid the extensive time and cost associated with preparing a public issue, it may issue shares privately.
Why do most professionals consider the Wilshire 5000 a better index of the performance of the broad stock market than the Dow Jones Industrial Average?
While the DJIA has 30 large corporations in the index, it does not represent the overall market nearly as well as the more than 5000 stocks contained in The Wilshire index. The DJIA is simply too small
DRK, Inc., has just sold 100,000 shares in an initial public offering. The underwriter's explicit fees were $60,000. The offering price for the shares was $40, but immediately upon issue, the share price jumped to $44. (LO 3-1) a. What is your best guess as to the total cost to DRK of the equity issue? b. Is the entire cost of the underwriting a source of profit to the underwriters?
a. In addition to the explicit fees of $60,000, we should also take into account the implicit cost incurred to DRK from the underpricing in the IPO. The underpricing is $4 per share, or a total of $400,000, implying total costs of $460,000. b. No. The underwriters do not capture the part of the costs corresponding to the underpricing. However, the underpricing may be a rational marketing strategy to attract and retain long-term relationships with their investors. Without it, the underwriters would need to spend more resources in order to place the issue with the public. The underwriters would then need to charge higher explicit fees to the issuing firm. The issuing firm may be just as well off paying the implicit issuance cost represented by the underpricing.
Suppose you short-sell 100 shares of IBX, now selling at $200 per share. (LO 3-4) a. What is your maximum possible loss? b. What happens to the maximum loss if you simultaneously place a stop-buy order at $210?
a. In principle, potential losses are unbounded, growing directly with increases in the price of IBX. b. If the price of IBX shares goes above $210, then the stop-buy order would be executed, limiting the losses from the short sale. If the stop-buy order can be filled at $200, the maximum possible loss per share is $10. The total loss is: $10 100 shares = $1000.
The right to buy an asset at a specified price
a. Long call
Look at the futures listings for corn in Figure 2.11. (LO 2-3) a. Suppose you buy one contract for December 2015 delivery. If the contract closes in December at a price of $3.95 per bushel, what will be your profit or loss? (Each contract calls for delivery of 5,000 bushels.) b. How many December 2015 maturity contracts are outstanding?
a. The December maturity futures price is $3.88 per bushel. If the contract closes at $3.95 per bushel in December, your profit / loss on each contract (for delivery of 5,000 bushels of corn) will be: ($3.95 - $3.88) x 5000 = $ 337.50 gain. b. There are 99,741 contracts outstanding, representing 498,705,000 bushels of corn.
Dée Trader opens a brokerage account and purchases 300 shares of Internet Dreams at $40 per share. She borrows $4,000 from her broker to help pay for the purchase. The interest rate on the loan is 8%. (LO 3-4) a. What is the margin in Dée's account when she first purchases the stock? b. If the share price falls to $30 per share by the end of the year, what is the remaining margin in her account? If the maintenance margin requirement is 30%, will she receive a margin call? c. What is the rate of return on her investment?
a. The stock is purchased for $40 300 shares = $12,000. Given that the amount borrowed from the broker is $4,000, Dee's margin is the initial purchase price net borrowing: $12,000 - $4,000 = $8,000. b. If the share price falls to $30, then the value of the stock falls to $9,000. By the end of the year, the amount of the loan owed to the broker grows to: Principal (1 + Interest rate) = $4,000 (1 + 0.08) = $4,320. The value of the stock falls to: $30 300 shares = $9,000. The remaining margin in the investor's account is: Margin on long position= equity in account/value of stock =$9,000-$4,320/$9,000=.52 Therefore, the investor will not receive a margin call rate of return= ending equity in account- inital equity in account/initial equity in account =$4,680-$8,000/$8,000=-.4150
Turn back to Figure 2.10 and look at the Apple options. Suppose you buy an October expiration call option with exercise price $100. (LO 2-3) a. If the stock price in October is $102, will you exercise your call? What are the profit and rate of return on your position? b. What if you had bought the October call with exercise price $95? c. What if you had bought an October put with exercise price $100?
a. Yes. As long as the stock price at expiration exceeds the exercise price, it makes sense to exercise the call. Gross profit is: ($102 - $100) x 100 shares = $200 Net profit = ($2 - $2.62) x 100 shares = $62 loss Rate of return = -$.62/$2.62 = -0.2366 or 23.66% loss b. Yes, exercise. Gross profit is: ($102 - $95) x 100 shares = $700 Net profit = ($7 - $6.35) x 100 shares = $65 gain Rate of return = $65/$6.35 = 0.1024 or 10.24 % gain c. A put with an exercise price of $100 would expire worthless for any stock price equal to or greater than $100. An investment in such a put would have a rate of return over the holding period of -100%.
Which security should sell at a greater price? (LO 2-3) a. A 10-year Treasury bond with a 9% coupon rate or a 10-year T-bond with a 10% coupon. b. A three-month expiration call option with an exercise price of $40 or a three-month call on the same stock with an exercise price of $35. c. A put option on a stock selling at $50 or a put option on another stock selling at $60. (All other relevant features of the stocks and options are assumed to be identical.)
a.The higher coupon bond: The 10-year T-bond with a 10% coupon b.The call with the lower exercise price: The call with the exercise price of $35 c.The put option on the lower priced stock: The put on the stock selling at $50
The right to sell an asset at a specified price
b. Long put
The obligation to buy an asset at a specified price
c. Short put
Preferred stock yields often are lower than yields on bonds of the same quality because
c. Taxation
The obligation to sell an asset at a specified price?
d. Short call
1. Common stock
is an ownership share in a publicly held corporation. Common shareholders have voting rights and may receive dividends
A market order has
price uncertainty but not execution uncertainty
Find the equivalent taxable yield of the municipal bond in Problem 14 for tax brackets of: (LO 2-1) a. Zero b. 10% c. 20% d. 30%
r=rm/1-t a) r=.04/1-0=.04 b) r=.04/1-.10=.0444 c) r=.04/1-.20=.05 d) r=.04/1-.30=.0571
A municipal bond carries a coupon rate of 6¾% and is trading at par. What would be the equivalent taxable yield of this bond to a taxpayer in a 35% tax bracket?
rate on municipal bond/1-tax rate .0675/1-.35=.1038
Preferred stock
represents nonvoting shares in a corporation, usually paying a fixed stream of dividends. While corporate bonds are long-term debt issued by corporations, the bonds typically pay semi-annual coupons and return the face value of the bond at maturity.
