MANM524: Principles of Finance and Investment

Seminar 1: Financial Securities & Financial Institutions

Question 1. Since the Global COVID-19 pandemic, house prices increases at the fastest rate
in many countries (https://content.knightfrank.com/research/84/documents/en/global-
house-price-index-q4-2020-7884.pdf). Suppose housing prices across the world double.

a. Is society any richer for the change?

b. Are homeowners wealthier?

c. Can you reconcile your answers to (a) and (b)? Is anyone worse off as a result of the
change?
Suggested answer:
a. No. The cash does not directly add to the productive capacity of the economy.

b. Yes.

c. Society as a whole is worse off, since taxpayers, as a group will make up for the
liability.
Question 2. Give an example of three financial intermediaries and explain how they act as a
bridge between small investors and large capital markets or corporations.
Suggested answer:
Commercial Banks take deposits from depositors and make loans to businesses or use the
funds to buy securities of large corporations.
Investment Banks bring together borrowers and lenders through securities-based
transactions (e.g., bonds) in financial markets. They have an additional range of associated
income generating activities made possible by this basic function (e.g., bond dealing, advice
on IPOs of bonds and shares).
Mutual funds accept funds from small investors and invest, on behalf of these investors, in
the national and international securities markets.
Pension funds accept funds and then invest, on behalf of current and future retirees,
thereby channelling funds from one sector of the economy to another.
Venture capital firms pool the funds of private investors and invest in start-up firms.
Question 3. The average rate of return on investments in large stocks has outpaced that on
investments in Treasury bills by about 8% since 1926. Why, then, does anyone invest in
Treasury bills?
Suggested answer:

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Treasury bills serve a purpose for investors who prefer a low-risk investment. The lower
average rate of return compared to stocks is the price investors pay for predictability of
investment performance and portfolio value.

Question 4. You see an advertisement for a book that claims to show how you can make £1
million with no risk and with no money down. Will you buy the book?
Suggested answer:
You should be sceptical. If the author actually knows how to achieve such returns, one must
question why the author would then be so ready to sell the secret to others. Financial
markets are very competitive; one of the implications of this fact is that riches do not come
easily. High expected returns require bearing some risk, and obvious bargains are few and
far between. Odds are that the only one getting rich from the book is its author.
Question 5. Wall Street firms have traditionally compensated their traders with a share of
the trading profits that they generated. How might this practice have affected traders’
willingness to assume risk?

Suggested answer:
It may incentive traders to work harder to gain profit but also encourage traders to
speculate on the market at the expense of capital providers. Briefly explain the agency
problem due to information asymmetric.
Question 6. Why are money market securities sometimes referred to as “cash equivalents”?

Suggested answer:
Money market securities are called “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.
Question 7. In what ways is preferred stock like long-term debt? In what ways is it like
equity?

Suggested answer:
Preferred stock is like long-term debt in that it typically promises a fixed payment each year.
In this way, it is a perpetuity. Preferred stock is also like long-term debt in that it does not
give the holder voting rights in the firm. Preferred stock is like equity in that the firm is
under no contractual obligation to make the preferred stock dividend payments. Failure to
make payments does not set off corporate bankruptcy. With respect to the priority of claims
to the assets of the firm in the event of corporate bankruptcy, preferred stock has a higher
priority than common equity but a lower priority than bonds.

Question 8. Consider the three stocks in the following table. Pt represents price at time t ,
and Qt represents shares outstanding at time t . Stock C splits two for one in the last period.
P0 Q0 P1 Q1 P2 Q2

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 A 90 100 95 100 95 100
B 50 200 45 200 45 200
C 100 200 110 200 55 400

a. Calculate the rate of return on a price-weighted index of the three stocks for the first
period (t=0 to t=1).

b. What must happen to the divisor for the price-weighted index in year 2?

c. Calculate the rate of return for the second period (t=1 to t=2).

Suggested answer:
a.
At t = 0, the value of the index is: (90 + 50 + 100)/3 = 80
At t = 1, the value of the index is: (95 + 45 + 110)/3 = 83.333
The rate of return is: (83.333/80) − 1 = 4.17%

b.
In the absence of a split, Stock C would sell for 110, so the value of the index would be:
250/3 = 83.333

83.333 = (95 + 45 + 55)/d ⇒ d = 2.340

After the split, Stock C sells for 55. Therefore, we need to find the divisor (d) such that:

c.
The return is zero. The index remains unchanged because the return for each stock
separately equals zero.

Question 9. A municipal bond carries a coupon of 6.75% and is trading at par. What is the
equivalent taxable yield to a taxpayer in a combined federal plus state 34% tax bracket?

Suggested answer:
r × ( 1−t ) =r m

r ×(1−34 %)=6.75 %

6.75 %
r= =10.2273 %
(1−34 %)

Question 10. Assume a call is currently traded on stock XYZ. It has a strike price of £50 and
expiration of 6 months. What will the profit be to an investor who buys the call for £4 in the
following scenarios for stock prices in 6 months?

(a) £40
(b) £50
(c) £60
Suggested answer:

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For call option:
Intrinsic Value=max ( Price of Underlying Asset−Strike Price , 0 )

Profit=Intrinsic Value−Premium

Scenario Value of Call at Expiration Initial Cost Profit

(a). 0 [¿ max ( 40−50 , 0 ) =0] 4 -4 [¿ max ( 40−50 , 0 ) −4=0−4=−4 ]
(b). 0 [¿ max ( 50−50 , 0 )=0 ] 4 -4 [¿ max ( 50−50 , 0 )−4=0−4=−4 ]
(c). 10 [¿ max ( 60−50 , 0 )=10 ] 4 6 [¿ max ( 60−50 , 0 )−4=10−4=6]

For put option:

Intrinsic Value=max ( Strike Price−Price of Underlying Asset , 0 )
Profit=Intrinsic Value−Premium

Please study the following materials about Excel as soon as possible

Introduction to Excel: https://support.microsoft.com/en-us/office/introduction-to-excel-starter-601794a9-b73d-4d04-b2d4-
eed4c40f98be

Basic Excel Formulas Guide: https://corporatefinanceinstitute.com/resources/excel/study/basic-excel-formulas-

beginners/

The Beginner's Guide to Excel: https://www.youtube.com/watch?v=rwbho0CgEAE

Excel Crash Course for Finance Professionals (optional): https://www.youtube.com/watch?v=kjoldYi7eH0

Excel 2019 Advanced Tutorial (optional): https://www.youtube.com/watch?v=bezV5U0dlbo

Please load “Analysis ToolPak” and “Solver” add-ins in Excel

Excel Add-ins
https://www.rwu.edu/sites/default/files/downloads/fcas/mns/calculating_and_displaying_regression_statistics_in_excel.pdf

If your laptop cannot load the “Analysis ToolPak” and/or “Solver” add-ins in Excel, please use the
Excel via the Virtual Desktop https://it.surrey.ac.uk/off-campus-access

Load the “Analysis ToolPak” add-in in Excel https://support.office.com/en-gb/article/load-the-analysis-toolpak-in-excel-

6a63e598-cd6d-42e3-9317-6b40ba1a66b4

Load the “Solver” add-in in Excel https://support.office.com/en-gb/article/load-the-solver-add-in-in-excel-612926fc-d53b-

46b4-872c-e24772f078ca

Portfolio optimization in Excel https://www.solver.com/portfolio-optimization-full-markowitz-method

Solving equations with Excel https://support.microsoft.com/en-us/office/define-and-solve-a-problem-by-using-solver-

5d1a388f-079d-43ac-a7eb-f63e45925040

4
MMULT function in Excel: https://support.microsoft.com/en-us/office/mmult-function-40593ed7-a3cd-4b6b-b9a3-
e4ad3c7245eb

The links below are useful for academic writing

Writing Advisory Service at Surrey University (https://study.surrey.ac.uk/study-support/academic-skills-and-

development).

Harvard at Surrey University referencing style (https://surrey-content.surrey.ac.uk/sites/default/files/2019-

08/surrey-business-school-harvard-referencing-guide.pdf).

Endnote for reference management (https://study.surrey.ac.uk/study-support/resources),

(https://www.youtube.com/channel/UCdTDZ4RUT9Jl81oRhpEIIxA), (https://libhelp.ncl.ac.uk/faq/158953), and
(https://it.surrey.ac.uk/software-and-training).
Editing Formulas in Word (https://support.office.com/en-gb/article/write-an-equation-or-formula-1d01cabc-ceb1-
458d-bc70-7f9737722702).

Editing Tables in Word (https://support.office.com/en-gb/article/format-a-table-e6e77bc6-1f4e-467e-b818-

2e2acc488006).

The links below are useful for Bloomberg and Refinitiv Eikon/Datastream

Specialist databases and systems at Surrey University https://it.surrey.ac.uk/software-and-training/specialist-

databases-and-systems

Bloomberg online tutorial (https://www.youtube.com/watch?v=Jy5uDBtl1e4);

(https://www.youtube.com/watch?v=LE8HiHZcgEE); (https://www.youtube.com/watch?v=7wrz2pCSXQg).

Eikon online tutorial (https://www.youtube.com/watch?v=efOK5iLkRK4).

Datastream online tutorial (https://www.youtube.com/watch?v=KW2UimbQ9Zs).

WRDS online tutorial (https://www.youtube.com/watch?v=Kf9X3_TPJTU).