Check Your Understanding Ch 1-5,17,19 & 20

What does is mean to say a call buyer has a right but not an obligation? What about the seller? Ch 19

A call buyer has a right to exercise the call, but does not have the obligation. Even if the buyer forgets about the option, the worse that can happen is that it will expire worthless. The writer, however, could be assigned to deliver the stock. Once assigned, the writer must carry out the contract.

Why would a closed end fund trade at a premium? Ch 3

A closed end fund typically trades at a premium when investors are convinced that the future performance of the fund will be so strong that paying a premium of the shares is warranted.

What is the essential difference between a hedger and a speculator when it comes to owing the underlying asset in a futures contract? Ch 20

A hedger owns the underlying asset- he or she is said to be long the cash position, or asset. Therefore, the hedger is trying to reduce risk by selling a futures contract. A speculator, on the other hand, does not typically have a position in the asset. He or she is simply trying to profit by anticipated price changes in the underlying item.

Why might investors prefer a hybrid fund to either a stock fund or a bond fund? Ch 3

A hybrid holds both bonds and stocks, thereby offering a combination to investors in one fund. Typically, such funds should have higher returns, on average, than bond funds while offering lower risk than stock funds.

Municipal bond yields are stated on an after tax basis while corporate bond yields are stated on a before tax basis. Ch 2

AGREE. Municipal bond yields must be adjusted to a before tax basis to make them comparable to corporate bond yields. This is done by calculating the TEY

Investors are routinely quoted to yield to maturity on a bond, but the chance of them actually earning this quoted yield at the termination of the investment is almost 0 Ch 17

AGREE. The YTM is a promised yield, and to realize this yield as in investor must hold the bond to maturity and reinvest the coupons at exactly the calculates YTM. The chance of the reinvestment assumption occurring is practically 0

Why does am option's price almost always exceed its intrinsic value? Ch 19

An option's price generally exceeds its intrinsic value because of the speculative (time) value. Investors are willing to pay an additional amount for the chance that the option will have value

What does it mean to say the losses from short selling are infinite while the gains are finite? Ch 5

Because there is no theoretical limit to how hight a stock price can rise, the theoretical losses from short selling are said to be infinite. In practice, of course, the majority of all stocks don't rise in price to thousands of dollars a share. In contrast, the most a stock price can drop to is zero, so the gains from short selling are finite.

Why is it necessary for brokerage accounts to be market to the market every day?Ch 5

Brokerage firms must calculate the actual margin in their customer's accounts daily to determine if a margin call is required.

Suppose, you buy car insurance that can be renewed annually, thinking in general terms, can this be considered an option? Ch 19

Car insurance in this case can be thought of as an American put option, with the insurance company as the writer of the option. The insured is long the put option & can choose to exercise or not in the case of an accident.

Why might a company opt to have its shares traded on the NASDAQ vs the NYSE, & reverse? Ch 4

Companies may have to disclose less info on the NASDAQ, or may prefer having multiple market makers for their stock. Companies may prefer to have their shares traded on the NYSE, long considered to be the premier secondary mkt for the trading of equities.

Distinguish between the D/P, D/E, & P/E. Ch 2

D/P= Div Yield= Div/Current Price D/E= Payout Ratio= Div/Earnings P/E= Price/Earnings & indicated the multiple of earnings that investors pay for a stock

Rational investors always attempt to minimize their risks. Ch 1

DISAGREE. If rational investors always minimized their investing risk, they would likely own nothing but T Bills.

Investors should always seek to maximize their returns from investing. Ch 1

DISAGREE. In this case investors would seek the assets expected to return the most regardless of their risk

The Securities Act of 1933 ensures investors that every new issue of stock has met its quality standards and is likely to be a good investment. Ch 5

DISAGREE. The securities act of 1933 ensures investors only that the issuer has complied with all regulations, particularly those involving disclosure of information. The company may still be a weak company without good prospects for success.

ETFs and closed end funds both trade on exchanges. Why, then, are ETFs having a big negative impact on closed end funds? Ch 3

ETFs have largely eliminated the issue of discounts and premiums which plague closed end funds. They typically offer targeted diversification while closed end funds often resemble mutual funds.

Given the development of futures markets, & the disadvantages of forwards contracts, what advantages does a forwards contract offer? Ch 20

Forward contracts can be tailored to individual requirements in terms of quantities, time, etc. Futures contracts are specific and fixed as to characteristics such as those, & may not match a buyer or seller's requirements.

The short position's loss is equal to the long position's gain. Ch 20

Futures trading is a 0 sum game. The aggregate gains must equal the aggregate losses. Futures contracts are market to the daily market. The buyer's gains (losses) must equal the seller's losses. (gains)

Given the widely availability of no load funds, why do many investors chose to buy load funds and pay sales charges? Ch 3

Investors may choose to buy no load funds and pay sales charge because of ignorance about the alternatives available, or carelessness in seeking out the lower cost alternative of no load funds. Of course if investors believe that a particular fund/manager offers better opportunities than the alternatives, and such fund charges a sales charge, they will be willing to pay the load fees.

Historically, stocks on average have outperformed other asset classes such as bonds. Should all intelligent investors own stocks? Ch 1

Investors should select assets consistent with their tolerance. Some investors may not be able to deal with the risk of common stocks. Therefore, it is not correct to argue that all intelligent investors should own common stocks.

Why is it reasonable to expect growth funds and value funds to perform well over different periods of time? Ch 3

Investors tend to favor value stocks for certain periods of time, & growth stocks at other times based on perceived economic conditions. Therefore, growth funds and value funds will reflect these varying expectations.

Assume an investor buys a put on a stock. Describe 3 different outcomes that could occur for the investor holding this put. Ch 19

Let it expire worthless Exercise it Sell it in the options market to another investor Most sell

When resolving investor disputes with brokers, what is the major difference between mediation and arbitration? Ch 5

Mediation is voluntary, mediation decisions are non binding Arbitration is a binding process that can determine damages.

Why are money market funds the safest type of mutual find an investor can hold? Ch 3

Money market funds by definition hold money market assets, the safest financial assets because of their high credit quality and short maturity. Therefore, they are simply a reflection of the type of assets they hold.

Why are money market securities referred to as impersonal assets, while the non marketable financial assets are not? Ch 2

Money market securities can be sold in financial markets, where neither the buyer or seller is identified to each other. Non marketable financial assets must be handled by the owner of the asset.

Why do you think Mutual Funds are by far the most popular type of investment company with investors as measured by assets under management?Ch 3

Mutual Funds are by far the most popular type of investment company because they have existed for many years, as have closed end funds, but the latter feel out of flavor with investors a long time ago. ETFs are relatively new and while growing rapidly, have a long way to go to catch up with mutual funds. very heavy promotion and publicity also accounts for the popularity of mutual funds.

Distinguish between NASDAQ & the OTC market Ch 4

NASDAQ is a marketplace distinguishable by its trading mechanisms and processes. The term OTC market has traditionally referred to the trading of securities not listed on the organized exchanges .

Assume an investor holds a bond that is guaranteed not to default. Can the YTM on this bond be described as the actual return the investor will receive, rather than a promised return? Ch 17

NO, the actual return will depend upon the rate at which the coupons are reinvested. The YTM is still a promised rate.

What are some important differences between NYSE & NASDAQ? Ch 4

NYSE oldest stock exchange in US, NASDAQ is recent NYSE trades many large & well known companies, NASDAQ trades smaller and not well known, as well as some of the most important tech companies. NASDAQ has more companies listed. NYSE is physical location, NASDAQ dealers & mkt makers. Merger between NYSE and ARCA changed the way NYSE operates.

NAV Equation Ch 3

Net Asset Value= Mkt Value of Securities-Liabilities/# of investor shares outstanding

Consider a corporate bond rated AAA vs another corporate bonds rated BBB. Can you say with confidence that the first bond will not default while the second bond there is some reasonable probability of default? Ch 2

No, because bond ratings are a measure of the relative probability of default. There is some absolute probability, although it is extremely small, than an AAA will default.

Assume you wish to take advantage of an expected change in exchange rates. Would ADRs (American Depository Receipts) be an effective way? Ch 2

No. ADRs do not involve foreign currencies, but rather are stated on a dollar basis.

In terms of payoff and profit profiles, what is the distinguishing characteristic for the various options positions? How does this differ from simply buying a stock, or shorting a stock? Ch 19

Options positions truncate the distribution of returns available to investors. This reflects the fact that most profiles involve two different line segments. In contrast, buying a stock or shorting a stock involves a straight line profile which investors move up or down.

Why might investors opt to hold preferred stocks rather than bonds in their portfolios? Ch 2

Preferred stocks could have higher expected returns and have no maturity date. Also, preferred stocks ban be much easier to buy and sell than individual bonds.

Why sell short instead of using puts? Ch 5

Puts are only available on a limited number of stocks. Therefore, to profit from an expected decline in price, short selling is often the only alternative. Also, there is no time limit on short selling, while puts have a very shot life of several months at most.

Should risk averse investors avoid junk bonds? Ch 2

Risk Averse investors can buy junk bonds, or any financial asset, if they expect to be adequately compensated for the risk. The greater the risk, the greater the expected return should be.

What is the rationale for buying class B shares? Class C shares? Ch 3

Some investors simply wish to avoid paying an upfront sales charge, which can be avoided by buying B or C class shares. Of course, what really matters is what an investor pays in total in fees during the period the shares are owned. Therefore investors in mutual funds with share classes should do some calculations to try to determine which class of shares will be least expensive during the time period the shares are owned

Why does the T Bill serve as a benchmark security? Ch 2

T Bill is the benchmark security for the economy because bill are auditioned of every week, and the rates offered on them reflect current demand and supply conditions for short term funds without credit risk. Other interest rates are scalped up from this short term, diskless rate by adding time and risk premiums.

We know that the prices of long term bonds are more sensitive to interest rate changes than the prices of short term bonds. Why, then, is maturity alone not sufficient to measure interest rate sensitivity? Ch 17

Taking only maturity into account ignores the coupon on a bond, which also affects the bond's sensitivity to interest rate changes.

TEY Ch 2

Taxable Equivalent Yield= Tax Exempt Municipal Yield/ 1-Marginal Tax Rate

Assume you buy several futures contracts that, at the expiration date, are worthless considerably more than when you purchased so that you will have a large gain. How can you be assured that they losers on these same positions will make good on their obligations?Ch 20

The CH acts as the seller to every buyer, thereby assuring the performance of the contracts. The CH, in turn, will look to its clearing members to make good on all obligations. Finally, the clearing members will have to deal with any individual customer who may have shortages in their accounts. Of course, by marking to the market, most of the gains and losses have been settled prior to the expiration date.

What is the major presumed deficiency of the DJIA? Ch 4

The DJIA is a price weighted index, while almost all others are market value weighted. also it is only consisted to 30 stocks

Is the S&P 500 Index affected by the size of the companies in the index? Ch 4

The S&P is affected by the size of companies in the index because it is a market value weighted index. Therefore, each stocks weight in the index is proportionate to its market value.

How does the clearinghouse help to ensure the fulfillment of put and call contracts? Ch 19

The clearinghouse stands between buyers and sellers. It keeps the books on all transactions. Therefore, a seller can simply cancel the seller's position.

The price of a bond will not remain constant if it is selling for wither a discount or a premium. Ch 17

The price of a discount and premium bonds must more toward $1,000 as the bond approaches its maturity date. On the date the bond will be worth $1,000, because that is what the issuer will redeem it for.

A chance for larger returns than those available domestically is the primary reason U.S. investors should hold foreign securities. Ch 1

The primary reason for holding foreign securities is to diversify one's portfolio. Diversification is a major tenet of portfolio management.

In a typical underwriting, the procedure is referred to as a firm commitment. What does this mean? Ch 4

The term "underwriting" technically involves a firm commitment, meaning the investment bankers have agreed to purchase the securities outright from the issuer. This is different, for ex, from a "best effort", where the risk of selling the issue is shares by the suer and the underwriters.

It is said that IPOs are often underpriced relative to the price at which they could be marketed. Why? Ch 4

The underwriters have an incentive to quickly sell an issue, thereby reducing their risk as well as enchanting their reputation as successful investment bankers

What are the boundaries for the price of a call? Ch 19

The upper boundary for a call option is the price of the underlying stock. The lower boundary for a call is the price of the option at expiration, which must be either 0 or its in the money value.

The tradeoff between risk and return can be, and has been, both upward sloping and downward sloping, how? Ch 1

This is possible because the tradeoff is always upward sloping for rational investors before one invests-that is ex ante. However, for various periods that have occurred, the tradeoff can be downward sloping, because the returns on the risk free asset are positive while the returns on stocks may be lower, or even negative.

Assume you bought a stock for $50 and it has now increased to $75. You think it might go higher, but you want to protect most of your current profit, realizing a minimum gain for about $23 a share. What type of order? Ch 5

To realize a minimum gain of approx $23 a share, you place a stop loss order (to sell) at $73. If the price declined below $73, your order would become a market order and be executed close to $73, thereby giving you a profit of approx $23, since you bought the stock for $50

Why might an investor prefer to buy a put on a particular stock rather than sell it short? Ch 19

To sell a stock short, an investor must have a margin account, meet margin requirements, pay interest, make up any dividends on the stock sold short, and worry about possible large losses if the stock price rises sharply. Buying a put, an investor has a maximum loss that is known at the outset. No other requirements have to be met. On the other hand, the put has a relatively short maturity and could expire worthless.

Rational investors assume risk if they expect to be compensated adequately for doing so. Ch 1

True

Rational investors should seek to maximize their returns for a given level of risk. Ch 1

True

Individual investors make investing decisions under conditions of uncertainty, while professional investors make such decisions under conditions of controlled risk taking, thereby eliminating uncertainty. Ch 1

Uncertainty can not be eliminated, only reduced.

The maturity date of a contract does not dictate realization of an investor's gains & losses. Ch 20

With a forward contract, the gains and losses involved are settled at contract expiration. No money changes hands until then. With a futures contract, each account is marked to the market daily; therefore, gains and losses are recorded daily. On the last day of the contract's life, there is only one day of gains and losses to account for.

Why is covered call writing considered a conservative strategy? Ch 19

Writing covered calls is considered a conservative strategy, because it reduces the cost of stock ownership by the amount of the premium received for writing the calls.

Holding maturity constant, would you expect the yields on money market securities to be within a few tenths of a percent of each other? Ch 2

You should expect the yields on money market securities to be within a few tenths of a percent of each other because they are very short term, very high quality assets with little risk of default.

Explain why, for a bond selling at discount, the coupon rate is less than the current yield, which is less than the YTM Ch 17

a bond sells at a discount if interest rates rise, leading to declines in the bond price. The lower price raises the current yield above the coupon rate, which is fixe. The YTM will be higher because the bond is being purchased at a discount.

State 2 reasons why an investor establishing a brokerage account might prefer a wrap account to the more traditional asset management account. Ch 5

a wrap account means that all costs are included in the wraps fee, which some investors prefer. Also, some investors want to have a constant in the form of a money manager for their account, a wrap account can provide for this.