Chapter 15
An investment bank is exposed to the greatest risk with: A a rights offering. B a best efforts offering. C an underwritten offering.
C is correct. In an underwritten offering, the investment bank buys the secu- rities from the issuer at an offering price that is negotiated with the issuer. The objective of the investment bank is to set a price at which it can sell all of the securities and not become a long-term shareholder. If all the shares are not sold, the investment bank risks its own capital in the residual shareholding. A is incorrect because a rights offering allows existing shareholders to buy shares at a fixed price and does not involve the investment bank's capital. B is incorrect because with a best efforts offering, the investment bank acts only as a broker and thus does not expose its own capital to buy the securities.
an investor takes a short position in a security by: A) buying the security B) lending the security to another trader C) borrowing the security and then selling it to another trader
C is correct. Investors take short positions when they sell securities that they do not own, a process that involves borrowing securities, selling them, and repur- chasing them later to return them to their owner. If the security falls in price, the investor profits because she can repurchase the security at a lower price than the price at which she sold it. If the security rises in price, she loses. A is incorrect because if the investor buys the security, she takes a long, not short, position in the security. B is incorrect because if the investor lends the security to another trader, she becomes the security lender.
Whichofthefollowingstatementsaboutthesettlementcycleiscorrect? A The settlement cycle is the same across markets. B A long settlement cycle reduces counterparty risk. C The settlement cycle refers to the timing of the procedures used to settle trades.
C is correct. The settlement cycle refers to the timing of the procedures used to settle trades. Settlement may occur in real time (instantaneously), or it may take up to three trading days. A is incorrect because settlement cycles vary across markets. B is incorrect because a short, not long, settlement cycle reduces counterparty risk.
Compared with exchanges, alternative trading systems: A may be less transparent. B require the use of brokers. C exercise regulatory authority over their subscribers.
A is correct. Alternative trading systems may be less transparent than exchanges. Many alternative trading systems are known as dark pools because of a lack of transparency; they do not display the orders that their clients send to them. Large investment managers especially like these systems because market prices often move to their disadvantage when other traders know about their large orders. B is incorrect because alternative trading systems do not require the use of brokers. Most of them allow institutional traders to trade directly with each other without the intermediation of dealers or brokers, which makes them lower-cost trading venues. C is incorrect because alternative trad- ing systems are trading venues that function like exchanges but do not exercise regulatory authority over their subscribers whereas exchanges do.
An investor's loss is limited to the amount of the initial investment in a: A) long position B) short position C) leveraged position
A is correct. Investors have long positions when they own assets or securities, such as stocks, bonds, currencies, commodities, or real assets. The potential gain in a long position generally is unlimited. But the potential loss on a long position is limited to no more than 100%—a complete loss of the initial invest- ment—for a long position with no associated liabilities (debt). B is incorrect because the potential gains and losses in a short position are mirror images of the potential losses and gains in a long position. Thus, the potential gain on a short position is limited to no more than 100%, but the potential loss is unlim- ited. C is incorrect because a leveraged position involves buying securities on margin—that is, by borrowing some of the purchase price. Buying securities on margin increases the potential gains or losses for a given amount of equity in a position because the buyer can buy more securities on margin than otherwise. The buyer thus earns greater profits when prices rise. But the buyer suffers greater losses when prices fall—losses that potentially could exceed the amount of the initial investment.
Markets that can absorb large orders without substantial price impacts are clas- sified as: A operationally efficient. B allocationally efficient. C informationally efficient.
A is correct. Operationally efficient markets have relatively low transaction costs, and they can absorb large orders without substantial price impacts. B is incorrect because allocationally efficient is used to describe economies that use resources where they are most valuable. C is incorrect because informationally efficient markets are markets in which prices reflect all available information about fundamental values.
The price concessions that occur as large-trade buyers push prices up and large- trade sellers push prices down are called: A price impact. B bid-ask spreads. C opportunity costs.
A is correct. Price impact is the price concessions that occur as large-trade buyers push prices up and large-trade sellers push prices down. B is incorrect because the bid-ask spread is the difference between the bid price and the ask price and is not the price concession associated with large-trade buys or sells. C is incorrect because opportunity costs are the costs of not trading and not the price concessions associated with large-trade buys and sells.
The costs associated with orders failing to execute are best described as: A opportunity costs. B price impact costs. C brokerage commissions.
A is correct. The costs associated with orders failing to execute are called opportunity costs. Traders lose the opportunity to profit if their buy ordersfail to execute when prices are rising, and they lose the opportunity to avoid losses if their sell orders fail to execute when prices are falling. Thus, oppor- tunity costs represent the costs of not trading. B and C are incorrect because price impact costs and brokerage commissions are only incurred if orders execute—that is, if trading happens. Price impact costs are price concessions that often occur over time as large-trade buyers push prices up and large-trade sellers push them down in multiple transactions. For large institutions, the price impact of trading large orders generally is the biggest component of their trans- action costs. Brokerage commissions are the commissions that market partici- pants pay their brokers to arrange their trades. These commissions usually are a fixed percentage of the principal value of the transaction or a fixed price per security or contract.
From the investor's perspective, the main drawback to using a limit order to buy shares is that it may: A not execute. B execute immediately. C execute at an unacceptable price.
A is correct. The main drawback with a limit order is that it may not execute. Limit orders do not execute if the limit price on a buy order is too low or if the limit price on a sell order is too high. B is incorrect because a limit order will only execute immediately if the limit price matches the bid or ask price of other traders. C is incorrect because by placing a limit order, the investor ensures that the buy order is executed at an acceptable price.
The proportional ownership of shareholders who fail to exercise their options under a rights offering will: A decrease. B remain the same. C increase.
A is correct. The proportional ownership of existing shareholders who do not exercise their option in a rights offering will decrease. They will hold the same number of shares of the company but the total number of shares outstanding has increased.
An economy that uses resources where they are most valuable can be described as being: A operationally efficient. B allocationally efficient. C informationally efficient.
B is correct. Allocationally efficient economies are economies that use resources where they are most valuable. A is incorrect because markets in which trades are easy to arrange and have low transaction costs are operationally efficient. C is incorrect because informationally efficient prices reflect all available informa- tion about fundamental values. Informationally efficient prices are crucial to an economy's welfare because they help ensure that the resources available to the economy, such as labour, capital, material, and ideas, are used wisely.
If the price of a security falls, the loss experienced by an investor who bought the security on margin relative to the loss experienced by an investor who did not use leverage will most likely be: A lower. B higher. C the same.
B is correct. Buying securities on margin is risky, because leverage (debt) mag- nifies gains and losses. Thus, if the price of a security falls, the loss experienced by an investor who bought the security on margin (leveraged position) will be higher than the loss experienced by an investor who did not use leverage (debt- free position).
Stock exchanges most likely use trading systems that are: A price-driven B order-driven. C quote-driven.
B is correct. Many shares trade on exchanges that use order-driven trading sys- tems. Order-driven markets arrange trades by using rules to match buy orders with sell orders. A and C are incorrect because price-driven and quote-driven markets are the same thing; they are also called over-the-counter markets. They are markets in which investors trade with dealers at the prices quoted by the dealers. Almost all bonds and currencies and most commodities for immediate delivery (spot commodities) trade in price-driven/quote-driven markets.
A company sells new shares to the public in the: A call market. B primary market. C secondary market.
B is correct. Primary markets are the markets in which issuers sell their secu- rities to investors. If the company is selling shares in a public market for the first time, it is an initial public offering (IPO). If the company has previously sold shares in a public market, the sale of new shares is a seasoned offering.A is incorrect because a call market is where participants can arrange trades only once per day and is not the sale of newly issued shares to the public. C is incorrect because secondary markets are the markets in which securities trade between investors.
Relative to public offerings, private placements provide: A slower access to capital and less regulatory oversight. B quicker access to capital and less regulatory oversight. C quicker access to capital and higher regulatory compliance costs.
B is correct. Private placements allow for quicker access to capital with less reg- ulatory oversight and lower cost of regulatory compliance than public offerings. A is incorrect because access to capital is quicker. C is incorrect because the cost of regulatory compliance is lower.
Dealers arrange all trades in: A a brokered market. B a quote-driven market. C an order-driven market.
B is correct. Quote-driven markets (also called dealer markets), price-driven markets, or over-the-counter markets are markets in which investors trade with dealers at the price quoted by the dealers. A is incorrect because brokered markets are markets in which brokers arrange trades between their clients. Assets traded in brokered markets are usually unique and of interest to only a limited number of people or institutions; they are also infrequently traded and expensive to carry in inventory. C is incorrect because order-driven markets are markets in which a broker, an exchange, or an alternative trading system arranges trades using rules to match buy orders and sell orders.
The market where an investor sells shares of a publicly traded company she bought in an initial public offering (IPO) three years ago is known as the: A primary market. B secondary market. C private placement.
B is correct. The investor will sell the shares to another investor, and trading of securities between investors takes place in the secondary market. A is incorrect because the purchase of the shares in the IPO three years ago took place in the primary market—that is, the market in which the company sold shares to inves- tors for the first time. C is incorrect because a private placement is a primary market transaction in which a company sells shares to a small group of qualified investors.
Which activity is a clearing activity? A Exchanging cash for securities B Confirming the terms of the trade C Reporting the trade to the company's transfer agent
B is correct. The most important clearing activity is confirming the terms of the trade. A and C are incorrect because exchanging cash for securities and report- ing the trade to the company's transfer agent are activities that occur after clearing activities and are settlement activities.
Unique assets, such as real estate, are most likely traded in: A) a dealer market B) a brokered market C) an order-driven market
B is correct. Unique assets, such as real estate, are likely to be traded in a bro- kered market. Brokers organise markets for assets that are unique and thus of interest to only a limited number of buyers and sellers. Successful brokers spend most of their time building their client networks. A is incorrect because dealer markets are markets in which investors trade with dealers at the prices quoted by the dealers. Dealers are not likely to make markets in real estate because real estate is infrequently traded and expensive to carry in inventory. C is incorrect because unique assets, such as real estate, are not likely to be traded in order- driven markets because too few traders would participate.
Which of the following orders will most likely be executed immediately? A Stop order B Limit order C Market order
C is correct. A market order instructs the broker or exchange to obtain the best price immediately available when filling an order. B is incorrect because a limit order also instructs the broker or exchange to obtain the best price immediately available, but it sets conditions on price. The price to be paid on a purchase cannot be higher than the specified limit price, or the price to be accepted on a sale cannot be lower than the specified limit price. Thus, the order may not execute. A is incorrect because a stop order is an order for which the trader has specified a stop condition. The order may not be filled until the stop condition has been satisfied.
Compared with a regular public offering, in a shelf registration, a company: A sells the shares in a single transaction. B faces lower public disclosure requirements. C can sell shares over a longer period of time.
C is correct. A shelf registration allows a company to sell the shares directly into the secondary market over time when it needs additional capital. A shelf registration gives a company more flexibility with the timing of selling the shares. A is incorrect because in a shelf registration, unlike in a regular public offering, a company that issues shares does not have to sell the shares in a single transaction. The sale of additional shares can be timed over several months or even years. B is incorrect because in a shelf registration, the company makes the same public disclosures that it would for a regular offering. Companies face lower public disclosure requirements when they issue shares via a private placement.