CFA 45: Market Organization & Structure

Tony Harris is planning to start trading in commodities. He has heard about the use of futures contracts on commodities and is learning more about them. Which of the following is Harris least likely to find associated with a futures contract? Existence of counterparty risk. Standardized contractual terms. Payment of an initial margin to enter into a contract.

A is correct. Harris is least likely to find counterparty risk associated with a futures contract. There is limited counterparty risk in a futures contract because the clearinghouse is on the other side of every contract.

James Beach is young and has substantial wealth. A significant proportion of his stock portfolio consists of emerging market stocks that offer relatively high expected returns at the cost of relatively high risk. Beach believes that investment in emerging market stocks is appropriate for him given his ability and willingness to take risk. Which of the following labels most appropriately describes Beach? Hedger. Investor. Information-motivated trader.

B is correct. Beach is an investor. He is simply investing in risky assets consistent with his level of risk aversion. Beach is not hedging any existing risk or using information to identify and trade mispriced securities. Therefore, he is not a hedger or an information-motivated trader.

A German publicly traded company, to raise new capital, gave its existing shareholders the opportunity to subscribe for new shares. The existing shareholders could purchase two new shares at a subscription price of €4.58 per share for every 15 shares held. This is an example of a(n): rights offering. private placement. initial public offering.

A is correct. This offering is a rights offering. The company is distributing rights to buy stock at a fixed price to existing shareholders in proportion to their holdings.

The usefulness of a forward contract is limited by some problems. Which of the following is most likely one of those problems? Once you have entered into a forward contract, it is difficult to exit from the contract. Entering into a forward contract requires the long party to deposit an initial amount with the short party. If the price of the underlying asset moves adversely from the perspective of the long party, periodic payments must be made to the short party.

A is correct. Once you have entered into a forward contract, it is difficult to exit from the contract. As opposed to a futures contract, trading out of a forward contract is quite difficult. There is no exchange of cash at the origination of a forward contract. There is no exchange on a forward contract until the maturity of the contract.

Currently, the market in a stock is "$54.62 bid, offered at $54.71." A new sell limit order is placed at $54.62. This limit order is said to: take the market. make the market. make a new market.

A is correct. This order is said to take the market. The new sell order is at $54.62, which is at the current best bid. Therefore, the new sell order will immediately trade with the current best bid and is taking the market.

Consider a mutual fund that invests primarily in fixed-income securities that have been determined to be appropriate given the fund's investment goal. Which of the following is least likely to be a part of this fund? Warrants. Commercial paper. Repurchase agreements.

A is correct. Warrants are least likely to be part of the fund. Warrant holders have the right to buy the issuer's common stock. Thus, warrants are typically classified as equity and are least likely to be a part of a fixed-income mutual fund. Commercial paper and repurchase agreements are short-term fixed-income securities.

The current price of a stock is $25 per share. You have $10,000 to invest. You borrow an additional $10,000 from your broker and invest $20,000 in the stock. If the maintenance margin is 30 percent, at what price will a margin call first occur? $9.62. $17.86. $19.71.

B is correct. A margin call will first occur at a price of $17.86. Because you have contributed half and borrowed the remaining half, your initial equity is 50 percent of the initial stock price, or $12.50 = 0.50 × $25. If P is the subsequent price, your equity would change by an amount equal to the change in price. So, your equity at price P would be 12.50 + (P - 25). A margin call will occur when the percentage margin drops to 30 percent. So, the price at which a margin call will occur is the solution to the following equation. Equity/SharePrice/Share=12.50+P−25P=30% The solution is P = $17.86.

You have placed a sell market-on-open order—a market order that would automatically be submitted at the market's open tomorrow and would fill at the market price. Your instruction, to sell the shares at the market open, is a(n): execution instruction. validity instruction. clearing instruction.

B is correct. An instruction regarding when to fill an order is considered a validity instruction.

A German company that exports machinery is expecting to receive $10 million in three months. The firm converts all its foreign currency receipts into euros. The chief financial officer of the company wishes to lock in a minimum fixed rate for converting the $10 million to euro but also wants to keep the flexibility to use the future spot rate if it is favorable. What hedging transaction is most likely to achieve this objective? Selling dollars forward. Buying put options on the dollar. Selling futures contracts on dollars.

B is correct. Buying a put option on the dollar will ensure a minimum exchange rate but does not have to be exercised if the exchange rate moves in a favorable direction. Forward and futures contracts would lock in a fixed rate but would not allow for the possibility to profit in case the value of the dollar three months later in the spot market turns out to be greater than the value in the forward or futures contract.

Pierre-Louis Robert just purchased a call option on shares of the Michelin Group. A few days ago he wrote a put option on Michelin shares. The call and put options have the same exercise price, expiration date, and number of shares underlying. Considering both positions, Robert's exposure to the risk of the stock of the Michelin Group is: long. short. neutral.

A is correct. Robert's exposure to the risk of the stock of the Michelin Group is long. The exposure as a result of the long call position is long. The exposure as a result of the short put position is also long. Therefore, the combined exposure is long.

Caroline Rogers believes the price of Gamma Corp. stock will go down in the near future. She has decided to sell short 200 shares of Gamma Corp. at the current market price of €47. The initial margin requirement is 40 percent. Which of the following is an appropriate statement regarding the margin requirement that Rogers is subject to on this short sale? She will need to contribute €3,760 as margin. She will need to contribute €5,640 as margin. She will only need to leave the proceeds from the short sale as deposit and does not need to contribute any additional funds.

A is correct. She will need to contribute €3,760 as margin. In view of the possibility of a loss, if the stock price goes up, she will need to contribute €3,760 = 40% of €9,400 as the initial margin. Rogers will need to leave the proceeds from the short sale (€9,400 = 200 × €47) on deposit.

Lisa Smith owns a manufacturing company in the United States. Her company has sold goods to a customer in Brazil and will be paid in Brazilian real (BRL) in three months. Smith is concerned about the possibility of the BRL depreciating more than expected against the US dollar (USD). Therefore, she is planning to sell three-month futures contracts on the BRL. The seller of such contracts generally gains when the BRL depreciates against the USD. If Smith were to sell these future contracts, she would most appropriately be described as a(n): hedger. investor. information-motivated trader.

A is correct. Smith is a hedger. The short position on the BRL futures contract offsets the BRL long position in three months. She is hedging the risk of the BRL depreciating against the USD. If the BRL depreciates, the value of the cash inflow goes down in USD terms but there is a gain on the futures contracts.

A market has the following limit orders standing on its book for a particular stock: Buyer Bid Size (Number of Shares) Limit Price (£) Offer Size (Number of Shares) Seller Keith 1,000 19.70 Paul 200 19.84 Ann 400 19.89 Mary 300 20.02 20.03 800 Jack 20.11 1,100 Margaret 20.16 400 Jeff Ian submits a day order to sell 1,000 shares, limit £19.83. Assuming that no more buy orders are submitted on that day after Ian submits his order, what would be Ian's average trade price? £19.70. £19.92. £20.05.

B is correct. Ian's average trade price is: £19.92=300×£20.02+400×£19.89+200×£19.84300+400+200 Ian's sell order first fills with the most aggressively priced buy order, which is Mary's order for 300 shares at £20.02. Ian still has 700 shares for sale. The next most aggressively priced buy order is Ann's order for 400 shares at £19.89. This order is filled. Ian still has 300 shares for sale. The next most aggressively priced buy order is Paul's order for 200 shares at £19.84. A third trade takes place. Ian still has 100 shares for sale. The next buy order is Keith's order for 1,000 shares at £19.70. However, this price is below Ian's limit price of £19.83. Therefore, no more trade is possible.

The Standard & Poor's Depositary Receipts (SPDRs) is an investment that tracks the S&P 500 stock market index. Purchases and sales of SPDRs during an average trading day are best described as: primary market transactions in a pooled investment. secondary market transactions in a pooled investment. secondary market transactions in an actively managed investment.

B is correct. SPDRs trade in the secondary market and are a pooled investment vehicle.

A book publisher requires substantial quantities of paper. The publisher and a paper producer have entered into an agreement for the publisher to buy and the producer to supply a given quantity of paper four months later at a price agreed upon today. This agreement is a: futures contract. forward contract. commodity swap.

B is correct. The agreement between the publisher and the paper supplier to respectively buy and supply paper in the future at a price agreed upon today is a forward contract.

The Standard & Poor's Depositary Receipts (SPDRs) is an exchange-traded fund in the United States that is designed to track the S&P 500 stock market index. The current price of a share of SPDRs is $113. A trader has just bought call options on shares of SPDRs for a premium of $3 per share. The call options expire in five months and have an exercise price of $120 per share. On the expiration date, the trader will exercise the call options (ignore any transaction costs) if and only if the shares of SPDRs are trading: below $120 per share. above $120 per share. above $123 per share.

B is correct. The holder of the call option will exercise the call options if the price is above the exercise price of $120 per share. Note that if the stock price is above $120 but less than $123, the option would be exercised even though the net result for the option buyer after considering the premium is a loss. For example, if the stock price is $122, the option buyer would exercise the option to make $2 = $122 - $120 per share, resulting in a loss of $1 = $3 - $2 after considering the premium. It is better to exercise and have a loss of only $1, however, rather than not exercise and lose the entire $3 premium.

In an underwritten offering, the risk that the entire issue may not be sold to the public at the stipulated offering price is borne by the: issuer. investment bank. buyers of the part of the issue that is sold.

B is correct. The investment bank bears the risk that the issue may be undersubscribed at the offering price. If the entire issue is not sold, the investment bank underwriting the issue will buy the unsold securities at the offering price.

Which of the following statements about exchange-traded funds is most correct? Exchange-traded funds are not backed by any assets. The investment companies that create exchange-traded funds are financial intermediaries. The transaction costs of trading shares of exchange-traded funds are substantially greater than the combined costs of trading the underlying assets of the fund.

B is correct. The investment companies that create exchange-traded funds (ETFs) are financial intermediaries. ETFs are securities that represent ownership in the assets held by the fund. The transaction costs of trading shares of ETFs are substantially lower than the combined costs of trading the underlying assets of the ETF.

An online brokerage firm has set the minimum margin requirement at 55 percent. What is the maximum leverage ratio associated with a position financed by this minimum margin requirement? 1.55. 1.82. 2.22.

B is correct. The maximum leverage ratio is 1.82 = 100% position ÷ 55% equity. The maximum leverage ratio associated with a position financed by the minimum margin requirement is one divided by the minimum margin requirement.

Jim White has sold short 100 shares of Super Stores at a price of $42 per share. He has also simultaneously placed a "good-till-cancelled, stop 50, limit 55 buy" order. Assume that if the stop condition specified by White is satisfied and the order becomes valid, it will get executed. Excluding transaction costs, what is the maximum possible loss that White can have? $800. $1,300. Unlimited.

B is correct. The maximum possible loss is $1,300. If the stock price crosses $50, the stop buy order will become valid and will get executed at a maximum limit price of $55. The maximum loss per share is $13 = $55 - $42, or $1,300 for 100 shares.

You own shares of a company that are currently trading at $30 a share. Your technical analysis of the shares indicates a support level of $27.50. That is, if the price of the shares is going down, it is more likely to stay above this level rather than fall below it. If the price does fall below this level, however, you believe that the price may continue to decline. You have no immediate intent to sell the shares but are concerned about the possibility of a huge loss if the share price declines below the support level. Which of the following types of orders could you place to most appropriately address your concern? Short sell order. Good-till-cancelled stop sell order. Good-till-cancelled stop buy order.

B is correct. The most appropriate order is a good-till-cancelled stop sell order. This order will be acted on if the stock price declines below a specified price (in this case, $27.50). This order is sometimes referred to as a good-till-cancelled stop loss sell order. You are generally bullish about the stock, as indicated by no immediate intent to sell, and would expect a loss on short selling the stock. A stop buy order is placed to buy a stock when the stock is going up.

Jason Schmidt works for a hedge fund and he specializes in finding profit opportunities that are the result of inefficiencies in the market for convertible bonds—bonds that can be converted into a predetermined amount of a company's common stock. Schmidt tries to find convertibles that are priced inefficiently relative to the underlying stock. The trading strategy involves the simultaneous purchase of the convertible bond and the short sale of the underlying common stock. The above process could best be described as: hedging. arbitrage. securitization.

B is correct. The process can best be described as arbitrage because it involves buying and selling instruments, whose values are closely related, at different prices in different markets.

The government of a country whose financial markets are in an early stage of development has hired you as a consultant on financial market regulation. Your first task is to prepare a list of the objectives of market regulation. Which of the following is least likely to be included in this list of objectives? Minimize agency problems in the financial markets. Ensure that financial markets are fair and orderly. Ensure that investors in the stock market achieve a rate of return that is at least equal to the risk-free rate of return.

C is correct. Ensure that investors in the stock market achieve a rate of return that is at least equal to the risk-free rate of return is least likely to be included as an objective of market regulation. Stocks are risky investments and there would be occasions when a stock market investment would not only have a return less than the risk-free rate but also a negative return. Minimizing agency costs and ensuring that financial markets are fair and orderly are objectives of market regulation.

A financial analyst is examining whether a country's financial market is well functioning. She finds that the transaction costs in this market are low and trading volumes are high. She concludes that the market is quite liquid. In such a market: traders will find it hard to make use of their information. traders will find it easy to trade and their trading will make the market less informationally efficient. traders will find it easy to trade and their trading will make the market more informationally efficient.

C is correct. In such a market, well-informed traders will find it easy to trade and their trading will make the market more informationally efficient. In a liquid market, it is easier for informed traders to fill their orders. Their trading will cause prices to incorporate their information and the prices will be more in line with the fundamental values.

Consider an order-driven system that allows hidden orders. The following four sell orders on a particular stock are currently in the system's limit order book. Based on the commonly used order precedence hierarchy, which of these orders will have precedence over others? Order Time of Arrival (HH:MM:SS) Limit Price (€) Special Instruction (If any) I 9:52:01 20.33 II 9:52:08 20.29 Hidden order III 9:53:04 20.29 IV 9:53:49 20.29 Order I (time of arrival of 9:52:01). Order II (time of arrival of 9:52:08). Order III (time of arrival of 9:53:04).

C is correct. Order III (time of arrival of 9:53:04) has precedence. In the order precedence hierarchy, the first rule is price priority. Based on this rule, sell orders II, III, and IV get precedence over order I. The next rule is display precedence at a given price. Because order II is a hidden order, orders III and IV get precedence. Finally, order III gets precedence over order IV based on time priority at same price and same display status.

Akihiko Takabe has designed a sophisticated forecasting model, which predicts the movements in the overall stock market, in the hope of earning a return in excess of a fair return for the risk involved. He uses the predictions of the model to decide whether to buy, hold, or sell the shares of an index fund that aims to replicate the movements of the stock market. Takabe would best be characterized as a(n): hedger. investor. information-motivated trader.

C is correct. Takabe is best characterized as an information-motivated trader. Takabe believes that his model provides him superior information about the movements in the stock market and his motive for trading is to profit from this information.

A market has the following limit orders standing on its book for a particular stock. The bid and ask sizes are number of shares in hundreds. Bid Size Limit Price (€) Offer Size 5 9.73 12 9.81 4 9.84 6 9.95 10.02 5 10.10 12 10.14 8 What is the market? 9.73 bid, offered at 10.14. 9.81 bid, offered at 10.10. 9.95 bid, offered at 10.02.

C is correct. The market is 9.95 bid, offered at 10.02. The best bid is at €9.95 and the best offer is €10.02.

Zhenhu Li has submitted an immediate-or-cancel buy order for 500 shares of a company at a limit price of CNY 74.25. There are two sell limit orders standing in that stock's order book at that time. One is for 300 shares at a limit price of CNY 74.30 and the other is for 400 shares at a limit price of CNY 74.35. How many shares in Li's order would get cancelled? None (the order would remain open but unfilled). 200 (300 shares would get filled). 500 (there would be no fill).

C is correct. The order for 500 shares would get cancelled; there would be no fill. Li is willing to buy at CNY 74.25 or less but the minimum offer price in the book is CNY 74.30; therefore, no part of the order would be filled. Because Li's order is immediate-or-cancel, it would be cancelled.

An investor primarily invests in stocks of publicly traded companies. The investor wants to increase the diversification of his portfolio. A friend has recommended investing in real estate properties. The purchase of real estate would best be characterized as a transaction in the: derivative investment market. traditional investment market. alternative investment market.

C is correct. The purchase of real estate properties is a transaction in the alternative investment market.

A trader has purchased 200 shares of a non-dividend-paying firm on margin at a price of $50 per share. The leverage ratio is 2.5. Six months later, the trader sells these shares at $60 per share. Ignoring the interest paid on the borrowed amount and the transaction costs, what was the return to the trader during the six-month period? 20 percent. 33.33 percent. 50 percent

C is correct. The return is 50 percent. If the position had been unleveraged, the return would be 20% = (60 - 50)/50. Because of leverage, the return is 50% = 2.5 × 20%. Another way to look at this problem is that the equity contributed by the trader (the minimum margin requirement) is 40% = 100% ÷ 2.5. The trader contributed $20 = 40% of $50 per share. The gain is $10 per share, resulting in a return of 50% = 10/20.

Which of the following is not a function of the financial system? To regulate arbitrageurs' profits (excess returns). To help the economy achieve allocational efficiency. To facilitate borrowing by businesses to fund current operations.

A is correct. Regulation of arbitrageurs' profits is not a function of the financial system. The financial system facilitates the allocation of capital to the best uses and the purposes for which people use the financial system, including borrowing money.

A hedge fund holds its excess cash in 90-day commercial paper and negotiable certificates of deposit. The cash management policy of the hedge fund is best described as using: capital market instruments. money market instruments. intermediate-term debt instruments.

B is correct. The 90-day commercial paper and negotiable certificates of deposit are money market instruments.

Jason Williams purchased 500 shares of a company at $32 per share. The stock was bought on 75 percent margin. One month later, Williams had to pay interest on the amount borrowed at a rate of 2 percent per month. At that time, Williams received a dividend of $0.50 per share. Immediately after that he sold the shares at $28 per share. He paid commissions of $10 on the purchase and $10 on the sale of the stock. What was the rate of return on this investment for the one-month period? −12.5 percent. -15.4 percent. -50.1 percent.

B is correct. The return is -15.4 percent. Total cost of the purchase = $16,000 = 500 × $32 Equity invested = $12,000 = 0.75 × $16,000 Amount borrowed = $4,000 = 16,000 - 12,000 Interest paid at month end = $80 = 0.02 × $4,000 Dividend received at month end = $250 = 500 × $0.50 Proceeds on stock sale = $14,000 = 500 × $28 Total commissions paid = $20 = $10 + $10 Net gain/loss = −$1,850 = −16,000 − 80 + 250 + 14,000 − 20 Initial investment including commission on purchase = $12,010 Return = −15.4% = −$1,850/$12,010

A British company listed on the Alternative Investment Market of the London Stock Exchange, announced the sale of 6,686,665 shares to a small group of qualified investors at £0.025 per share. Which of the following best describes this sale? Shelf registration. Private placement. Initial public offering.

B is correct. This sale is a private placement. As the company is already publicly traded, the share sale is clearly not an initial public offering. The sale also does not involve a shelf registration because the company is not selling shares to the public on a piecemeal basis.

An oil and gas exploration and production company announces that it is offering 30 million shares to the public at $45.50 each. This transaction is most likely a sale in the: futures market. primary market. secondary market.

B is correct. This transaction is a sale in the primary market. It is a sale of shares from the issuer to the investor and funds flow to the issuer of the security from the purchaser.

Consider the following limit order book for a stock. The bid and ask sizes are number of shares in hundreds. Bid Size Limit Price (¥) Offer Size 3 122.80 8 123.00 4 123.35 123.80 7 124.10 6 124.50 7 A new buy limit order is placed for 300 shares at ¥123.40. This limit order is said to: take the market. make the market. make a new market.

C is correct. This order is said to make a new market. The new buy order is at ¥123.40, which is better than the current best bid of ¥123.35. Therefore, the buy order is making a new market. Had the new order been at ¥123.35, it would be said to make the market. Because the new buy limit order is at a price less than the best offer of ¥123.80, it will not immediately execute and is not taking the market.

Consider a mutual fund that invests primarily in fixed-income securities that have been determined to be appropriate given the fund's investment goal. Which of the following is least likely to be a part of this fund? Warrants. Commercial paper. Repurchase agreements.

C is correct. When investors want to sell their shares, investors of an open-end fund sell the shares back to the fund whereas investors of a closed-end fund sell the shares to others in the secondary market. Closed-end funds are available to new investors but they must purchase shares in the fund in the secondary market. The shares of a closed-end fund trade at a premium or discount to net asset value.