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7/27/2019 Prac Misc Sol

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BUS 365: Investments

Solution to Practice Problems

Miscellaneous

1) BRIEFLY answer the following. Under what circumstances is the bid-ask spread likely to besmall? Justify your opinion by considering the decision-making process of the market maker.

Answer: The bid-ask spread is likely to be small for high volume stocks with relatively

stable prices. In that case, the market maker faces little risk and therefore can keep the

spread narrow without placing him/herself in a dangerous situation. With the high

volume, the market maker can still earn a decent living despite the spread being small.

2) BRIEFLY answer the following. What is the role of an investment bank in the function offinancial markets?

Answer: The investment bank acts as an intermediary between firms who wants to raise

money and investors who want to invest. They also act as an intermediary between firms

who wish to acquire other firms and firms who wish to be bought.

3) BRIEFLY answer the following. Why is it so difficult to earn abnormal returns consistently?

Answer: To do so, we must be among the first to get new information and/or among the

best to interpret information. The former rarely happens. The latter requires us to be

better interpreters than the market itselfwe have to believe that the market is wrong and

that we are right! Furthermore, the market must subsequently come to agree with ourassessment.

4) Consider two hypothetical commodities: widgets and tribbles. Historical evidence suggeststhat a tribble is worth 10 times the value of widget. You believe this is likely to be trueindefinitely. Current market prices are $36.75 for a tribble and $8.50 for a widget. Whatspecific investment strategy would you recommend?

Answer: Widgets appear to be overvalued relative to tribbles. We therefore should form a

market-neutral portfolio in which we short 10 widgets for every tribble we buy. If and

when the prices move back to equilibrium, you will earn a profit of 10

$8.50-$36.75 =$48.25 for every tribble you bought.

5) BRIEFLY discuss the importance of benchmarks to portfolio management.

Answer: Benchmarks are important because they allow an investor to assess the

performance of a portfolio in order to 1) identify and correct weaknesses in the investment


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strategy and 2) determine whether the investor would be better off by just investing in an

index.

6) Some people believe that the stock market crash of 1987 was caused, in part, by the executionof stop orders (and other similar strategies). BRIEFLY discuss how stop orders might have

made the crash worse than it would have been otherwise.

Answer: If many investors held stop loss orders to sell stock, those orders would have been

triggered as prices fell. This would have introduced even more supply into the market,

causing the price to fall further. This in turn would have triggered more of the stop loss

orders, and so on.

7) BRIEFLY evaluate the validity of the following statement. Bubbles cannot exist if marketsare efficient. In doing so, assume that markets are efficient if one cannot earn abnormal profitsconsistently.

Answer: The statement is not true. Although prices deviate from intrinsic value during a

bubble, we may not be able to earn abnormal profits consistently because of the difficulty

in predicting when the bubble will burst. Remember that to make abnormal profits, the

market must come to believe as you believe.

8) What is a market neutral portfolio? Under what circumstances might you choose one?

Answer: A market-neutral portfolio is a zero beta portfolio designed to take advantage of

relative mispricings. If, for example, you believe that Pfizer is underpriced relative to

Merck, you might buy Pfizer and short Merck. This remove much of the market risk

allows you to profit if your beliefs are right.

9) You wish to invest $20,000 by buying two stocks on margin. Your brokerage account allowsyou to buy on margin with terms of 70% initial margin and 45% maintenance margin. If amargin call occurs, you will be required to deposit three times the amount needed to get back tothe maintenance margin. You wish to invest equal amounts of money in General Motors, whichcurrently trades at $34 per share, and Apple, which currently trades at $14 per share. Assumingthat you fully margin your account, how many shares of each stock can you buy (assume you canbuy a fractional number of shares)?

Suppose that the stocks price subsequently change as follows.

Date GM Price Apple Price0 $34 $141 $28 $132 $22 $113 $21 $9


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4 $20 $8

Calculate the actual margin for each day. Note any margin calls and the amount of the margincall.

Answer: With $20,000, we can borrow $8,571 from and invest $14,286 in each of the twostocks. This allows us to buy 420.2 shares of GM and 1020.4 shares of AAPL.

Date Account Value Actual Margin Required Deposit

0 $28,571 70% $0

1 $25,030 65.8% $0

2 $20,468 58.1% $0

3 $18,007 52.4% $0

4 $16,567 48.3% $0

10) TRUE/FALSE. Feel free to provide a brief explanation if you like.

a. Based on long-term historical data, the S&P 500 index has been asignificantly better investment than both the average mutual fund andnearly all specific mutual funds.

TRUE

b. Generally speaking, the instincts of a given investor are criticallyimportant to the investment process and add to the accuracy of thatinvestors analyses.

FALSE

c. The CAPM is a valuable theory, but it is problematic in that the theorydeals with historical happenings whereas we want to apply it on a goingforward basis.

FALSE

d. One result of time diversification is that stocks, which are riskier thanbonds in the short-run, have historically dominated bonds over longerinvestment periods.

TRUE

e. A market-neutral strategy is one in which an investor attempts to profitfrom a relative mispricing by forming a portfolio that is uncorrelated withthe market.

TRUE

f. In his book A Random Walk Down Wall Street, Burton Malkielrecommends that investors in their twenties invest their money in stockand real estate, but not bonds.

FALSE

g. The leverage multiplier gives us substantial information concerning thefirms ability to pay off its debt.

FALSE

h. The EAR measures the actual return whereas the APR measures theaccounting return.

TRUE

i. Assets that lie above the Security Market Line tend to be poorinvestments because their risk is high for the given level of expectedreturn.

FALSE

j. To compute the beta of a portfolio that includes short positions, wesimply use negative betas for the short assets.

FALSE

k. The stocks of widely-followed companies are more likely to be FALSE


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mispriced than those of lesser-followed stocks because the whims of themarketplace are more likely to push the prices of widely-followed stocksaway from their true values.

l. Lessons we learn from great investors include 1) investing for the longrun, 2) recognizing that the market might tend to overreact to bad news,

and 3) understanding that we can be successful by finding a few bigwinners, even if most of our individual investments perform poorly.

TRUE

11) Based only on the historical evidence we considered in homeworks 1 and 2, BRIEFLYdiscuss the optimal investment strategy for individuals. Be sure to support your answer byreferring to specific findings from the homeworks.Answer: Based the historical evidence, all long-term investors should invest in the S&P500

index (or some similarly-managed index). The evidence from homework #1 suggests that

for all holding periods more than a few years, stocks dominate other investments in both

return and risk (when viewed in an opportunity cost framework). The evidence from

homework #2 suggests that mutual funds tend to dramatically underperform the S&P 500index. Short-term investors may want to take on less risk (by investing some or all of their

money in bonds) if their wealth is low and/or their level of risk aversion is high.

Note that this argument depends entirely on the historical data. It is of course possible that

future investment returns will paint a different picture.

12) BRIEFLY discuss a situation in which a rational fundamental investor would choose to use astop order to buy a stock.Answer: Suppose that an investor has shorted a stock and that the investor will be out-of-

touch with the market for some period of time. The investor might rationally choose to

place a stop buy order to limit losses in the event that the stock appreciates substantially.

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