Principles of Investment: Final Exam Study Guide 2023
(Short Answer)
5. The process of securitization is likely to allow banks to originate loans. True or
False. Explain. (No more than five lines)
True. During class we discussed the process that banks practice securitization in order
to diversify their portfolio in different types of debt such as commercial mortgages,
residential mortgages etc. This gives the banks a cash flow that allows them to further
invest into other opportunities.
6. Investigate what is known as the May 6, 2010, Flash Crash. Explain one
potential cause of this crash (No more than 20 lines)
On May 6th 2010, a very odd thing happened to the DOW Jones. It plummeted 700
points in roughly a half hour, which was called the "Flash Crash". Oddly enough, those
loses were recouped within a matter of minutes. A report released later by the
Securities and Exchange Commission and the Commodity Futures Trading Commission
narrowed down the potential causes to a single trading firm. This trading firm used a
computer sell order which caused investors to panic and decide to pull their money. The
algorithm the investor chose to use for the computer completely ignored price and time
as factors which is why the trade it placed happened so quickly. A small fact that also
may have helped cause this was the stress on the market due to the credit crisis in
Europe that was happening at the time. This stress along with the very quick
transactions by the computer based trading created this 30-minute panic on the market.
This is one reason that computer based trading can be dangerous, a wrong or misused
algorithm can cause something of this size to occur to the market.
12. Indicate the market represented by the following indices. For example, TSX
index represents the performance of the stock market in Canada.
Hang Seng
DAX
FTSE
Nikkei
Hang Seng (Hong Kong)
DAX (Germany)
FTSE (UK)
Nikkei (Japan)
TSX (Canada)
13. Stock A: P₀: $70 Q₀: 200 | P₁: $72 Q₁: 200 | P₂: $36 Q₂: 400
Stock B: P₀: $85 Q₀: 500 | P₁: $81 Q₁: 500 | P₂: $81 Q₂: 500
Stock C: P₀: $105 Q₀: 300 | P₁: $98 Q₁: 300 | P₂: $98 Q₂: 300
Based on the information given, for a price-weighted index of the three stocks
calculate
A. the rate of return for the first period (t = 0 to t = 1).
, B. the value of the divisor in the second period (t = 2). Assume that Stock A had a
2-1 split during this period.
C. the rate of return for the second period (t = 1 to t = 2).
A. The price-weighted index at time 0 is (70 + 85 + 105) / 3 = 86.67. The price- weighted
index at time 1 is (72 + 81 + 98) / 3 = 83.67. The return on the index is 83..67 - 1
= -3.46%.
B. The divisor must change to reflect the stock split. Because nothing else
fundamentally changed, the value of the index should remain 83.67. So the new divisor
is (36 + 81 + 98) / 83.67 = 2.57. The index value is (36 + 81 + 98) / 2.57 = 83.67.
C. The rate of return for the second period is 83..67 - 1 = 0.00%.
21. How would you describe the long-run returns on IPOs in the U.S. for the
period 1980-2014 according to the results of Professor Ritter's research? (No
more than 10 lines)
In the long-run (3 years, according to the slide in the notes), the results are negative
after adjusting for market or style. The results without adjusting are still positive (Except
for small companies). These results contrast with the average first day return that is
highly positive. Additionally, if the results are decomposed by sales, big firms do better
than small firms. Without reading the paper, you might guess that part of the results are
driven by the .com bubble.
22. You sold short 100 shares of common stock at $75 per share. The initial
margin is 50%. At what stock price would you receive a margin call if the
minimum margin is 30%? Assume the stock pays no dividend; ignore interest on
margin.
Initial Margin = 100($75) * .5 = $3,750;
Market Value of assets = $7,500 + $3,750 = $11,250
At 30% of minimum margin:
Let P be the price of the stock, then, 1.30 = $11,250/100P
130P = $11,250
P = $86.54
23. You invest $250 in a risky asset with an expected rate of return of 15% and a
standard deviation of 35% and a T-bill with a rate of return of 4%. Determine the
slope of the Capital Allocation Line formed with the risky asset and the risk-free
asset.
Sol:
(0.15 - 0.04)/0.35 = 0.314
24. Problem 4 Homework 3
25. Suppose that MSN stock currently is selling at $500 per share. You buy 300
shares, using $100,000 of your own money and borrowing the remainder of the
purchase price from your broker. The rate on the margin loan is 8%.
A) What is the percentage increase in the net worth of your brokerage account if
the price of MSN stock immediately changes to (i) $550; (ii) $500; (iii) $450?
(Short Answer)
5. The process of securitization is likely to allow banks to originate loans. True or
False. Explain. (No more than five lines)
True. During class we discussed the process that banks practice securitization in order
to diversify their portfolio in different types of debt such as commercial mortgages,
residential mortgages etc. This gives the banks a cash flow that allows them to further
invest into other opportunities.
6. Investigate what is known as the May 6, 2010, Flash Crash. Explain one
potential cause of this crash (No more than 20 lines)
On May 6th 2010, a very odd thing happened to the DOW Jones. It plummeted 700
points in roughly a half hour, which was called the "Flash Crash". Oddly enough, those
loses were recouped within a matter of minutes. A report released later by the
Securities and Exchange Commission and the Commodity Futures Trading Commission
narrowed down the potential causes to a single trading firm. This trading firm used a
computer sell order which caused investors to panic and decide to pull their money. The
algorithm the investor chose to use for the computer completely ignored price and time
as factors which is why the trade it placed happened so quickly. A small fact that also
may have helped cause this was the stress on the market due to the credit crisis in
Europe that was happening at the time. This stress along with the very quick
transactions by the computer based trading created this 30-minute panic on the market.
This is one reason that computer based trading can be dangerous, a wrong or misused
algorithm can cause something of this size to occur to the market.
12. Indicate the market represented by the following indices. For example, TSX
index represents the performance of the stock market in Canada.
Hang Seng
DAX
FTSE
Nikkei
Hang Seng (Hong Kong)
DAX (Germany)
FTSE (UK)
Nikkei (Japan)
TSX (Canada)
13. Stock A: P₀: $70 Q₀: 200 | P₁: $72 Q₁: 200 | P₂: $36 Q₂: 400
Stock B: P₀: $85 Q₀: 500 | P₁: $81 Q₁: 500 | P₂: $81 Q₂: 500
Stock C: P₀: $105 Q₀: 300 | P₁: $98 Q₁: 300 | P₂: $98 Q₂: 300
Based on the information given, for a price-weighted index of the three stocks
calculate
A. the rate of return for the first period (t = 0 to t = 1).
, B. the value of the divisor in the second period (t = 2). Assume that Stock A had a
2-1 split during this period.
C. the rate of return for the second period (t = 1 to t = 2).
A. The price-weighted index at time 0 is (70 + 85 + 105) / 3 = 86.67. The price- weighted
index at time 1 is (72 + 81 + 98) / 3 = 83.67. The return on the index is 83..67 - 1
= -3.46%.
B. The divisor must change to reflect the stock split. Because nothing else
fundamentally changed, the value of the index should remain 83.67. So the new divisor
is (36 + 81 + 98) / 83.67 = 2.57. The index value is (36 + 81 + 98) / 2.57 = 83.67.
C. The rate of return for the second period is 83..67 - 1 = 0.00%.
21. How would you describe the long-run returns on IPOs in the U.S. for the
period 1980-2014 according to the results of Professor Ritter's research? (No
more than 10 lines)
In the long-run (3 years, according to the slide in the notes), the results are negative
after adjusting for market or style. The results without adjusting are still positive (Except
for small companies). These results contrast with the average first day return that is
highly positive. Additionally, if the results are decomposed by sales, big firms do better
than small firms. Without reading the paper, you might guess that part of the results are
driven by the .com bubble.
22. You sold short 100 shares of common stock at $75 per share. The initial
margin is 50%. At what stock price would you receive a margin call if the
minimum margin is 30%? Assume the stock pays no dividend; ignore interest on
margin.
Initial Margin = 100($75) * .5 = $3,750;
Market Value of assets = $7,500 + $3,750 = $11,250
At 30% of minimum margin:
Let P be the price of the stock, then, 1.30 = $11,250/100P
130P = $11,250
P = $86.54
23. You invest $250 in a risky asset with an expected rate of return of 15% and a
standard deviation of 35% and a T-bill with a rate of return of 4%. Determine the
slope of the Capital Allocation Line formed with the risky asset and the risk-free
asset.
Sol:
(0.15 - 0.04)/0.35 = 0.314
24. Problem 4 Homework 3
25. Suppose that MSN stock currently is selling at $500 per share. You buy 300
shares, using $100,000 of your own money and borrowing the remainder of the
purchase price from your broker. The rate on the margin loan is 8%.
A) What is the percentage increase in the net worth of your brokerage account if
the price of MSN stock immediately changes to (i) $550; (ii) $500; (iii) $450?
