FIN 352 – Investments I

Review Notes for Midterm Exam

Chapter 1
1. Investment vs. investments
2. Real assets vs. financial assets
3. Financial markets and the economy
4. Investment process
Investment policy, asset allocation, security selection and analysis, portfolio
construction and analysis, and portfolio rebalance
5. Competitive markets and efficient market hypothesis
6. Players in investment markets
7. Homework problems and examples discussed in class

Chapter 2
1. Money markets and securities: concepts and calculations
2. Bond markets and securities: concepts and calculations
3. Equity markets and securities
4. Market indexes and averages: concepts and calculations
5. Homework problems and examples discussed in class

Chapter 3
1. New issues
2. Market structure: direct search, brokered, dealer, auction markets
3. Transactions
Bid price, asked price, and bid-asked spread
Types of orders: concepts and applications
Types of transactions: long vs. short
4. Margin trading and short sales: concepts and calculations
Margin requirements
Initial margin
Maintenance margin
Margin call
5. Homework problems and examples discussed in class

Chapter 4
1. Investment companies and mutual funds
2. Characteristics of investment companies
NAV (net asset value)
Open-end funds vs. closed-end funds
Load funds vs. no-load funds
Low-load funds
Redemption fee (back-end load) and other fees
3. Types of mutual funds
4. Mutual fund performance
5. Investing in mutual funds
6. Homework problems and examples discussed in class

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 Chapter 5
1. Risk and return
2. Risk premium
3. Mean and standard deviation
4. Inflation and real return
5. Asset allocation: concepts and calculations
6. Homework problems and examples discussed in class

Sample Problems

1. Consider the following limit order book of a specialist. The last trade in the stock
occurred at a price of $45.55.

Limit Buy Orders Limit Sell Orders

Price Shares Price Shares
$45.50 500 $45.75 100
45.45 600 45.80 200
45.40 800 45.85 500

If a market buy order for 300 shares comes in, at what price(s) will it be filled?

Answer: first 100 at $45.75 and next 200 at $45.80

2. Intermediate 2.13-2.14, 2.18-2.20, and 2.23 from the textbook

3. Assume that you bought 100 shares of stock X at $50 per share in your margin
account that has an initial margin of 60%. What would be the debt balance? How
much equity capital should you provide? What would be the actual margin if the
price rises to $70? If the maintenance margin is 30%, how low the price could drop
before you receive a margin call? If the price dropped to $25, how much money do
you need to put in the account to keep the minimum maintenance margin?

Answer:
Total cost = $5,000
Loan = $2,000 (debt balance or money you borrow)
Equity = $3,000 (equity capital or money you put in)

Actual margin = (100*70 – 2,000) / (100*70) = 71.43% if the price rises to $70

Let X be the critical price

(100*X – 2,000) / (100*X) = 0.30, solve for X = $28.57
Critical price = $28.57, if the price drops below $28.57, you receive a margin call

Let X be the amount of money added to reduce the loan

[100*25 – (2,000 – X)] / (100*25) = 0.30, solve for X = $250
You need to add at least $250 in your margin account to keep the minimum
maintenance margin

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4. You are bearish on stock ABC and decide to sell short 100 shares at the price of $50.
If the initial margin is 50%, how much cash should you provide? How high can the
price of the stock go before you receive a margin call if the maintenance margin is
25%? If the price dropped to $40, what would be your rate of return, ignoring the
interest charge?

Answer:
Short sale proceeds = $5,000
Initial margin = $2,500
Total assets = $7,500

Margin = (7,500 – 100*P) / (100*P) = 0.25, you solve for P = $60.00

Rate of return = Money made / Money invested = (1,000) / (2,500) = 40%

5. An investor buys a 90 day T-bill at a discount of 1.50 (1.50%). What is the price an
investor should pay for the T-bill if the denomination is $10,000? What is the actual
annual rate of return on this investment? (hint: T-bills are quoted on actual/360 basis
but annual returns are calculated using 365 days)

0.015*(90/360) = 0.00375
10,000*(1 – 0.00375) = $9,962.50
0.00375*(365/90) = 1.52%

6. Assume that, when a stock’s price is $25, an investor directs a stockbroker to sell the
stock if the price rises to $30. In this case, the investor is issuing a (c)

a. Stop (or stop-loss) order.

b. Market order.
c. Limit order.
d. Stop-limit order.

7. Which of the following most appears to contradict the proposition that the stock
market is semi-strong efficient? (d)

a. Insiders can earn abnormal trading profits using private information

b. Investors can earn abnormal returns by buying “winners” and selling “losers”
c. Over 25% of mutual funds outperform the market on average.
d. Small size stocks earn higher average risk-adjusted returns

8. Which of the following markets is the least efficient market? (c)

a. A brokered market
b. A dealer market
c. A direct search market
d. An auction market

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9. You are given the following information regarding stocks X, Y, and Z:
Stock price _ # of shares outstanding___
Date X* Y Z X* Y Z
0 $50 $50 $50 100 100 100
1 26 51 51 200 100 100
2 27 52 52 200 100 100
* Stock X has a 2-for-1 stock split before trading on day 1. Date 0 is the base date. The
current divisor is 3.0 and the base value for an S&P type of index is supposed to be10.

Q1. What would be the value of an S&P type index at the end of date 1?

26*200 + 51*100 + 51*100

S&P index = ------------------------------------- x 10 = 10.27
50*100 + 50*100 + 50*100
Rate of return on date 1 = (10.27/10) – 1 = 2.7%

Q2. What would be the value of an S&P type index at the end of date 2?

27*200 + 52*100 + 52*100

S&P index = ------------------------------------- * 10 = 10.53
50*100 + 50*100 + 50*100
Rate of return on two days = (10.53/10) – 1 = 5.3%

Q3. What would be the value of a DJIA type average at the end of date 2?

At the end of date 0: DJIA type average = (50 + 50 + 50) / 3 = 50

Need to adjust the divisor before date 1

DJIA type average = (25 + 50 + 50) / d = 50, solve for d = 2.5

At the end of date 2: DJIA type average = (27 + 52 + 52) / 2.5 = 52.4
Rate of return on two days = (52.4 / 50) – 1 = 4.8%

10. Which of the following most appears to contradict the proposition that the stock market
is weak-form efficient? (d)

a. Insiders earn abnormal trading profits.

b. Over 40% of mutual funds outperform the market on average.
c. Low P/E ratio stocks earn higher average risk-adjusted returns than high P/E ratio
stocks.
d. Every January, the stock market earns above normal returns.

11. Intermediate 4.11-4.14 and 4.21 from the textbook

12. Intermediate 5.12-5.16 from the textbook

13. All assigned CFA questions