Investment Finance 421-002

Prototype Midterm I
The correct answer is highlighted by a “*”. Also, a concise reasoning is provided in Italics.

1. ______________ are an indirect way U. S. investor can invest in foreign companies.

*a. ADRs
b. HUS
c. SDRs
d. GNMAs
e. Krugerrands

Only ADRs represent an indirect investment in a foreign company.

2. Finns that specialize in helping companies raise capital by selling securities are called

a. commercial banks
*b. investment banks
c. savings banks
d. credit unions
e. all of the above.

An important role of investment banks is to act as middle men in helping firms place new issues in the
market.

3. Derivative securities are:

a. potentially dangerous because they are highly leveraged

b. an effective tool to better manage business returns and risk
c. always structured as option contracts
*d. both a and b are true
e. all of the above are true

Derivative securities were created to allow the transfer of risk from one party to another. They can be
used to effectively reduce risk, or, because of leverage effects, to greatly increase risk. Theoretically,
when firms are taken over, better managers come in and thus increase the price of the stock; existing
management often must either leave the firm, be demoted, or suffer a loss of existing benefits.

4. Individual investors are most likely to trade securities in:

a. a direct search market

*b. an auction market
c. the primary market
d. a brokered market
e. a block transaction
Direct search markets are sporadic markets for specialized goods. Brokered markets, including block
transactions and primary market transactions, are less accessible to individual traders. Most individual
security trades take place in auction markets or dealer markets.

5. Dual funds are:

a. examples of tax- induced innovations

b. examples of derivative assets
c. separated into income shares and capital shares
d. targeted to meet the needs of investors in different income brackets
*e. all of the above are true

All of these statements describe dual funds.

6. Which one of the following terms best describes Eurodollars:

a. dollar-denominated deposits in European banks.

b. dollar-denominated deposits at branches of foreign banks in the U. S.
*c. dollar-denominated deposits at foreign banks and branches of American banks outside the U. S.
d. dollar-denominated deposits at American banks in the U. S.
e. dollars that have been exchanged for European currency.

Although originally Eurodollars were used to describe a, today the term has been extended to apply to
any dollar-denominated deposit outside the U. S.

7. Which of the following indices is (are) market-value weighted?

I. The New York Stock Exchange Composite Index.

II. The Standard and Poors Composite 500 - Stock Index.
III. The Dow Jones Industrial Average.
IV. The Value Line Composite Index.

a. I only
*b. I and II only
C. III only
d. 1, H, and III only
e. I, H, III, and IV

Use the following information to answer questions 18 through 20

Consider the following three stocks:

Stock Price Number of Shares Outstanding

Stock A $40 200

Stock B $70 500
Stock C $10 600

8. The price-weighted index constructed with the three stocks is:

a. 30
*b. 40
c. 50
d. 60
e. 70

($40 + $70 + $10)/3 = $40.

9. The value-weighted index constructed with the three stocks using a divisor of 100 is:

a. 1.2
b. 1200
*c. 490
d. 4900
e. 49

The sum of the value of the three stocks divided by 100 is 490:
[($40 x 200) + ($70 x 500) + ($10 x 600)] /100 = 490.

10. Assume at these prices the value-weighted index constructed with the three stocks is 490. What
would the index be if stock B is split 2 for I and stock C 4 for 1?

a. 265
b. 430
c. 355
*d. 490
e. 1000

Value-weighted indexes are not affected by stock splits.

11. An investor purchases one municipal and one corporate bond that pay rates of return of 8% and 10%,
respectively. If the investor is in the 20% marginal tax bracket, his or her after tax rates of return on
the municipal and corporate bonds would be and respectively.

a. 8% and 10%
*b. 8% and 8%
c. 6.4% and 8%
d. 6.4% and 10%
e. 10% and 10%

rc 0.10(1 - 0.20) = 0.08, or 8%; rm 0.08(l - 0) = 8%.

12. The Value- line Index is an equally- weighted geometric average of the return of about 1,700 firms.
What is the value of an index based on the geometric average returns of three stocks, where the
returns on the three stocks during a given period were 20%, -10%, and 5%?

*a. 4.3%
b. 5.0%
c. 11.7%
d. 13.4%
e. 12.2%

[(1.2)(0.9)(1.05)] 1 = 4.3%.

13. Brokers' calls:

a. are funds used by individuals who wish to buy stocks on margin.

b. are funds bon-owed by the broker from the bank, with the agreement to repay the bank
immediately if requested to do so.
c. carry a rate which is usually about one percentage point lower than the rate on U.S. T-bills.
*d. a and b.
e. a and c.

Brokers' calls are funds borrowed from banks by brokers and loaned to investors in margin accounts.

14. The following statements regarding the specialist are true:

a. Specialists maintain a book listing outstanding unexecuted limit orders.

b. Specialists earn income from commissions and spreads in stock prices.
c. Specialists stand ready to trade at quoted bid and ask prices.
d. Specialists cannot trade in their own accounts.
*e. a, b, and c are all true.

The specialists' functions are all of the items listed in a, b, and c. In addition, specialists trade in their
own accounts.

15. The secondary market consists of:

a. transactions on the AMEX.

b. transactions in the OTC market.
c. transactions regarding the investment banker.
*d. a and b.
e. a, b, and c.

The secondary market consists of transactions on the organized exchanges and in the OTC market. The
investment banker is involved in the placement of new issues in the primary market.

16. Initial margin requirements are determined by:

a. the Securities and Exchange Commission.

*b. the Federal Reserve System.
c. the New York Stock Exchange.
d. b and c.
e. a and b.

The Board of Governors of the Federal Reserve System determines initial margin requirements. The New
York Stock Exchange determines maintenance margin requirements on NYSE-Hsted stocks; however,
brokers usually set maintenance margin requirements above those established by the NYSE.
17. Which one of the following statements regarding orders is false?

a. A market order is simply an order to buy or sell a stock immediately at the preva iling market price.
b. A limit sell order is where investors specify prices at which they are willing to sell a security.
c. If stock ABC is selling at $50, a limit-buy order may instruct the broker to buy the stock if and when
the share price falls below $45.
d. A day order expires at the close of the trading day.
*e. None of the above.

All of the order descriptions above are correct.

18. Assume you purchased 200 shares of XYZ common stock on margin at $70 per share from your
broker. If the initial margin is 55%, how much did you borrow from the broker?

a. $6,000
b. $4,000
c. $7,700
d. $7,000
*e. $6,300

200 shares X $70/share = $14,000 x (1 - 0.55) = $6,300.

19. You purchased 100 shares of common stock on margin at $45 per share. Assume the initial margin is
50% and the stock pays no dividend. What would the maintenance margin be if a margin call is made
at a stock price of $30? Ignore interest on margin.

*a. 0.33
b. 0.53
C. 0.43
d. 0.23
e. none of the above

100 shares X $45/share = $4,500 X 0.5 = $2,250 (loan amount);

X = [100($30) - $2,250]/100($30); X = 0.25.

20. You sold short 300 shares of common stock at $55 per share. The initial margin is 60%. At what stock
price would you receive a margin call if the maintenance margin is 35%?

a. $51
*b. $65
c. $35
d. $40
e. none of the above

Equity = 300($55) X 1.6 = $26,400; 0.35 = ($26,400 - 300P) + 30OP; 105P = 26,400 - 300P
405P = 26,400; P = $65.18

21. The over-the-counter market for exchange- listed securities is called the:
*a. third market
b. fourth market
c. NASDAQ
d. after- market
e. none of the above.

The third market originated when some exchange-listed securities were allowed to be traded in the OTC
market at time when commissions were fixed on exchange listed securities and institutional investors were
trying to find a way to lower commission costs.

22. Quoted spreads on NASDAQ traded companies dropped in January 1997

a. because customer orders were required to be made public beginning at that time.
b. because prices on electronic systems used to trade big orders were made visible and available to
the public after that date.
c. because of widespread allegations of price-fixing by dealers.
d. due to closer regulatory insight.
*e. all of the above contributed to smaller quoted spreads.

See text box page 83.

23. The floor broker is best described as

*a. an independent member of the exchange who owns a seat and handles overload work for
commission brokers.
b. someone who makes a market in one or more securities.
c. a representative of a brokerage firm who is on the floor of the exchange to execute customer
orders.
d. a frequent trader who performs no public function but executes trades for his/her own account.
e. any counter-party to a trade executed on the floor of the exchange.

The floor broker is an independent member of the exchange who handles work for commission brokers
when they have too many orders to handle.

24. Which one of the following statements regarding closed-end mutual funds is false?

a. The funds invest in large volumes of several securities.

*b. The funds redeem shares at their net asset value.
c. The funds offer investors professional management.
d. a and b.
e. None of the above.

Closed-end funds are sold at the prevailing market price.

25. Most actively managed mutual funds

a. beat the market return in all years.

b. beat the market return in most years.
C. exceed the return on index funds.
*d. do not outperform the market
e. None of the above are correct statements.

Most actively managed mutual funds fail to equal the return earned by index funds, possibly due to higher
transactions costs.

26. Pools of money invested in a portfolio that is fixed for the life of the fund are called

a. closed-end funds.
b. open-end funds.
*c. unit investment trusts.
d. REITS.
e. redeemable trust certificates.

Unit investment trusts are funds that invest in a portfolio, often fixed-income securities, and hold it to
maturity.

27. A year ago, you invested $1,000 in a savings account that pays an annual interest rate of 7%. What is
your approximate annual real rate of return if the rate of inflation was 3% over the year?

*a. 4%.
b. 10%.
c. 7%.
d. 3%.
e. none of the above.

7% - 3% = 4%.

28. If the annual real rate of interest is 5% and the expected inflation rate is 4%, the nominal rate of
interest would be approximately:

a. 1%.
*b. 9%.
c. 20%.
d. 15%.
e. none of the above.

5% + 4% = 9%.

Use the following Information to answer questions 29 through 30:

You have been given this probability distribution for the holding period return for XYZ stock:

State of Nature Probability HPR

Boom 0.30 18%
Normal growth 0.50 12%
Recession 0.20 -5%

29. What is the expected holding period return for XYZ stock?
a. 11.67%
b. 8.33%
*c. 10.4%
d. 12.4%
e. 7.88%

E(HPR) = .30 (18%) + .50 (12%) + .20 (-5%) = 10.4%

30. What is the expected standard deviation for XYZ stock? D

a. 2.07%
b. 9.96%
c. 7.04%
d. 1.44%
*e. 8.13%

Std = [ 0.30 × (18 - 10.4)2 + 0.50 × (12 - 10.4)2 + 0.20 × (-5 - 10.4)2 ] ½ = 8.13%

31. An American put option allows the holder to

a. buy the underlying asset at the striking price on or before the expiration date.
b. sell the underlying asset at the striking price on or before the expiration date.
c. potentially benefit from a stock price decrease with less risk than short selling the stock.
*d. b and c.
e. a and c.

An American put option allows the buyer to sell the underlying asset at the striking price on or before the
expiration date. The put option also allows the investor to benefit from an expected stock price decrease
while risking only the amount invested in the contract.

32. The intrinsic value of an out-of-the-money call option is equal to

a. the call premium.

*b. zero.
c. the stock price minus the exercise price.
d. the striking price.
e. none of the above.

The fact that the owner of the option can, buy the stock at a price greater than the market price gives the
contract an intrinsic value of zero, and the holder will not exercise.

33. You write one AT&T February 50 put for a premium of $5. Ignoring transactions costs, what is the
breakeven price of this position?

a. $50
b. $55
*c. $45
d. $40
e. none of the above
+$50 - $5 = $45.

34. Buyers of call options __________ required to post margin deposits and sellers of put options
_________ required to post margin deposits.

a. are; are not

b. are; are
*c. are not; are
d. are not; are not
e. are always; are sometimes

Buyers of call options pose no risk as they have no commitment. If the option expires worthless, the buyer
merely loses the option premium. If the option is in the money at expiration and the buyer lacks funds,
there is no requirement to exercise. The seller of a put option is committed to selling the stock at the
exercise price. If the seller of the option does not own the underlying stock the seller must go into the
open market and buy the stock in order to be able to sell the stock to the buyer of the contract.

35. A covered call position is equivalent to a

a. long put.
*b. short put.
c. long straddle.
d. vertical spread.
e. none of the above.

With a short put, the seller of the contract must buy the stock if the option is exercised; however, this cash
outflow is offset by the premium income as in the covered call scenario.

36. You purchase one IIBM March 100 put contract for a put premium of $6. What is the maximum
profit that you could gain from this strategy?

a. $10,000
b. $10,600
*c. $9,400
d. $9,000
e. none of the above

-$600 + $10,000 = $9,400 (if the stock falls to zero.)

Use the following information to answer questions 37 through 39.

You buy one Xerox June 60 call contract and one June 60 put contract. The call premium is $5 and
the put premium is $3.

37. Your strategy is called

a. a short straddle.
*b. a long straddle.
c. a horizontal straddle.
d. a covered call.
e none of the above.

Buying both a put and a call, each with the same expiration date and exercise price is a long straddle.

38. Your maximum loss from this position could be

a. $500.
b. $300.
*c. $800.
d. $200.
e none of the above.

-$5 + (-$3) = -$8 X 100 = $800.

39. At expiration, you break even if the stock price is equal to

a. $52.
b. $60.
C. $68.
*d. both a and c.
e none of the above.

Call: -$60 + (-$5) + $3 = $68 (Break even); Put: -$3 + $60 + (-$5) = $52 (Break even); Thus, if price
increases above $68 or decreases below $52, a profit is realized.

40. The put-call parity theorem

a. represents the proper relationship between put and call prices.

b. allows for arbitrage opportunities if violated.
c. may be violated by small amounts, but not enough to earn arbitrage profits, once transaction costs
are considered.
*d. all of the above.
e none of the above.

The put-call parity relationship depicts the relationship between put and call prices, which, if violated,
allows for arbitrage profits; however, these profits may disappear once transaction costs are considered.

41. Delta is defined as

*a. the change in the value of an option for a dollar change in the price of the underlying asset.
b. the change in the value of the underlying asset for a dollar change in the call price.
c. the percentage change in the value of an option for a one percent change in the value of the
underlying asset.
d. the change in the volatility of the underlying stock price.
e. none of the above.

42. The percentage change in the stock call option price divided by the percentage change in the stock
price is called:
*a. the elasticity of the option.
b. the delta of the option.
C. the theta of the option.
d. the gamma of the option.
e. none of the above.

Option price elasticity measures the percent change in the option price as a function of the percent
change in the stock price.

43. Portfolio A consists of 400 shares of stock and 400 calls on that stock. Portfolio B consists of 500
shares of stock. The call delta is 0.5. Which portfolio has a higher dollar exposure to a change in
stock price?

a. Portfolio B
*b. Portfolio A
c. The two portfolios have the same exposure
d. A if the stock price increases and B if it decreases.
e. B if the stock price decreases and A if it increases.

400 calls (0.5) = 200 shares + 400 shares = 600 shares; 500 shares = 500 shares.