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[Solution] IPA Week 1 - Chapter 3

Investment and Portfolio Analysis (Auckland University of Technology)

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Week 1 Lecture 1 – Chapter 3: How Securities Are Traded

Problem Sets

Question 1:

What are the differences between a stop-loss orders, a limit sell order, and a market order?

The stop-loss order, a limit sell order, and a market order are used by the investors for
different purposes.

 In stop-loss order, broker is asked to buy or sell the stock when it hits certain price.
The investors use this order to limit their loss on a particular stock position.

 In limit sell order, broker is asked to sell the stock at specified price. The investors
use this order to sell the stock for a better price.

The market order is also known as unrestricted order as no restrictions about buy or sell
price will be included in this order. In this order, broker is asked to buy or sell the stock at the
price available in the market.

Question 4:

A market order has:

A. Price uncertainty but not execution uncertainty.

B. Both price uncertainty and execution uncertainty.
C. Execution uncertainty but not price uncertainty.

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Explanation:

Market order is an order to execute the trade immediately at the best possible price. The
emphasis in a market order is on the speed of execution which helps reducing execution
uncertainty. On the other hand, price at which market order will be executed is not known
ahead of time; which in turn leads to price uncertainty of market order.

Question 5:

Where would an illiquid security in a developing country most likely trade?

A. Broker markets.
B. Electronic crossing networks.
C. Electronic limit-order markets.

Explanation:

An illiquid security is most likely to trade in broker markets as it cannot be traded in either
Electronic Crossing Network markets or Electronic Limit-Order Markets.

Electronic Crossing Network executes large block orders without affecting the public quote.
Since this security is illiquid, large block orders are less likely to occur whereas Electronic
Limit-Order Markets deals in securities with high trading volume. Therefore, illiquid security
is unlikely to be traded on an Electronic Limit-Order Markets.

Question 6:

Dée Trader opens a brokerage account and purchases 300 shares of Internet Dreams at
$40 per share. She borrows $4,000 from her broker to help pay for the purchase. The
interest rate on the loan is 8%.

A. What is the margin in Dée’s account when she first purchases the stock?

B. If the share price falls to $30 per share by the end of the year, what is the remaining
margin in her account? If the maintenance margin requirement is 30%, will she
receive a margin call?

C. What is the rate of return on her investment?

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The amount of $4,000 is borrowed by investor D from the broker to pay for purchases. The
number of shares she purchased is 300. The purchased price per share is $40. The
borrower (investor D) needs to pay the interest at 8%.

Part A

The net worth of the account of the investor is known as the margin. It will be calculated by
deducting loan amount from the stock value.

Determine the margin using the following equation:

It is required to calculate the value of the stock to find the margin.

Calculate the value of the stock as follows:

Calculate the margin as follows:

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Part B

If the share price is decreased to $30 per share at the end of the year, the value of the stock
will also be decreased. The investor needs to pay the interest amount also. Hence, the
margin will be changed.

Determine the remaining margin in the account of D by following below steps:

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Calculate the percentage of margin in account of D to know whether she receives the margin
call or not if the maintenance margin requirement is 30%.

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Question 7:

Old Economy Traders opened an account to short sell 1,000 shares of Internet Dreams from
the previous problem. The initial margin requirement was 50%. (The margin account pays no
interest.) A year later, the price of Internet Dreams has risen from $40 to $50, and the stock
has paid a dividend of $2 per share

A. What is the remaining margin in the account?

B. If the maintenance margin requirement is 30%, will Old Economy receive a margin
call?

C. What is the rate of return on the investment?

An account is opened by company O to short-sell 1,000 shares of I. The stock is selling at

$40 per share. 50% is the initial margin requirement. No interest will be paid on margin
account. After one year, the price per share of stock I is increased to $50. The dividend paid
on the stock is $2 per share.

Part A

The net worth of the account (equity value) of the investor is known as the margin.

In short sale, the seller sells the stock without owning it and by borrowing it and buys the
stock at lower price in the future. Generally, the investor believes that the stock price will be
decreased in the future.

The proceeds from the short sale will be in the account until the investor repurchases the
sales and closes the account.

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The remaining margin in the account equals to initial margin less loss from the increase in
price less dividend payment (company O should pay the dividend to the lenders).

Determine the remaining margin by following the following steps:

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Part B

If the required maintenance margin is 30%, the account of the company O should maintain
30% of margin. If the present margin is less than 30%, the company receives a margin call.

Hence, it is required to find the percentage margin.

Determine the percentage margin by following the following steps:

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Part C

Question 8:

Consider the following limit-order book for a share of stock. The last trade in the stock
occurred at a price of $50.

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A. If a market buy order for 100 shares comes in, at what price will it be filled?

B. At what price would the next market buy order be filled?

C. If you were a security dealer, would you want to increase or decrease your inventory
of this stock?

Part A

Buy order price:

Part B

Next markets buy order:

Part C

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Being a specialist, I would increase inventory of this stock because our downside risk is
limited to the extent of $50 and hence demand will be more.

Question 9:

You are bullish on Telecom stock. The current market price is $50 per share, and you have
$5,000 of your own to invest. You borrow an additional $5,000 from your broker at an
interest rate of 8% per year and invest $10,000 in the stock.

A. What will be your rate of return if the price of Telecom stock goes up by 10% during
the next year? The stock currently pays no dividends.

B. How far does the price of Telecom stock have to fall for you to get a margin call if the
maintenance margin is 30%? Assume the price fall happens immediately

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The stock is currently trading at $50 per share. An investor is bullish on stock T. He has the
amount of $5,000 to invest. He wants to invest the amount of $10,000. Hence, the remaining
amount of $5,000 will be borrowed from the broker. The interest rate is 8%.

Part A

If the stock price of stock T increases by 10% over next year, the value of the stock will be
increased. There is another thing to consider, the investor needs to pay the interest on the
borrowed amount.

Determine the rate of return for the investor by following the below stocks:

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Part B

If the required maintenance margin is 30%, the account of the company O should maintain
30% of margin. If the present margin is less than 30%, the company receives a margin call.

Determine the price of the stock to make the margin call using the following equation:

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Question 10:

You are bearish on Telecom and decide to sell short 100 shares at the current market price
of $50 per share

A. How much in cash or securities must you put into your brokerage account if the
broker’s initial margin requirement is 50% of the value of the short position?

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B. How high can the price of the stock go before you get a margin call if the
maintenance margin is 30% of the value of the short position?

The stock of T is currently trading at $50 per share. An investor is bearish on stock T. He
wants to sell short 100 shares.

In short sale, the seller sells the stock without owning it and by borrowing it and buys the
stock at lower price in the future. Generally, the investor believes that the stock price will
decrease in the future.

Part A

The required initial margin is 50%. Thus, the investor needs to put 50% of value of the stock
in the brokerage account.

Hence, it is required to calculate the value of the stock.

Therefore, the value of the stock is $5,000.

Part B

If the required maintenance margin is 30%, the investor should maintain 30% of margin. If
the present margin is less than 30%, the investor receives a margin call.

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Question 11:

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Suppose that Intel currently is selling at $20 per share. You buy 1,000 shares using $15,000
of your own money, 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 Intel immediately changes to: (i) $22; (ii) $20; (iii) $18? What is the
relationship between your percentage return and the percentage change in the price
of Intel?

B. If the maintenance margin is 25%, how low can Intel’s price fall before you get a
margin call?

C. How would your answer to ( b ) change if you had financed the initial purchase with
only $10,000 of your own money?

D. What is the rate of return on your margined position (assuming again that you invest
$15,000 of your own money) if Intel is selling after 1 year at: (i) $22; (ii) $20; (iii) $18?
What is the relationship between your percentage return and the percentage change
in the price of Intel? Assume that Intel pays no dividends.

E. Continue to assume that a year has passed. How low can Intel’s price fall before you
get a margin call?

Part A

Percentage increase in the net worth of brokerage account:

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The relationship between the percentage return and the percentage change in the price of
the stock is given by:

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Suppose price changes to $22 from $20; the percentage change in price is 10%, while the
percentage gain for the investor is:

Part B

If the percentage margin falls below the maintenance margin level, the broker issues a
margin call, which makes the investor to add new cash to the margin account.

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Part C

Margin account of investor must start out with equity of $10,000.

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Part D

Rate of return on your margined position:

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The equity in account will be:

Since the initial equity was $15,000. Therefore, rate of return after one year is as follows:

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The relationship between the percentage return and the percentage change in the price is
given by:

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Part E

By the end of the year, the amount of the loan owed to the broker grows to:

Question 12:

Suppose that you sell short 1,000 shares of Intel, currently selling for $20 per share, and
give your broker $15,000 to establish your margin account.

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A. If you earn no interest on the funds in your margin account, what will be your rate of
return after 1 year if Intel stock is selling at: (i) $22; (ii) $20; (iii) $18? Assume that
Intel pays no dividends.

B. If the maintenance margin is 25%, how high can Intel’s price rise before you get a
margin call?

C. Redo parts ( a ) and ( b ), but now assume that Intel also has paid a year-end
dividend of $1 per share. The prices in part ( a ) should be interpreted as ex-dividend,
that is, prices after the dividend has been paid.

Short Selling:

 Short selling is the process of selling the securities which are not owned currently
rather borrowed and then repurchasing them after some time.

 It is done with the anticipation that its price will decline in the near future, so that
seller can purchase it again at a lower price and thus gaining from the transaction.

 Short selling is usually done in public securities and futures because of their high
liquidity and they have real time price dissemination.

Solution (a) Rate of return after one year

Given information is summarized as below:

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Therefore, the rate of return at price $22 is -13.3333%

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Solution (b) if maintenance margin is 25%, price for margin call

Total assets in the margin account are obtained by adding the sale of stock value and the
initial margin value.

Equity value of 1,000 will be computed as under:

Where P is the price per share

If the maintenance margin level the percentage margin is below 25%, than broker issues a
margin call that makes the investor to add extra to their margin account

Solution (c) Redo parts (a) and (b) when there is dividend paid at the end of the year

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With a $1 dividend, the short position must now pay on the borrowed shares:

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If the percentage margin falls below the maintenance margin level, the broker issues a
margin call, which makes the investor to add new cash to the margin account.

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Investor will receive a margin call when:

Question 13:

Here is some price information on Marriott:

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You have placed a stop-loss order to sell at $40. What are you telling your broker? Given
market prices, will your order be executed?

Stop-loss orders means the stock has to be sold if its price falls below a stipulated level.

Price information on stock is as under:

Ask price is $40.05 indicates that the investor would need to pay $40.05 to purchase a
share, and Bid price means investor could receive $39.95 a share if he wishes to sell some
of the shares owned.

The broker has been instructed to attempt to sell stock as soon as the stock trades at a bid
price of $40 or less. Here, the broker will attempt to execute, but may not be able to sell at
$40, since the bid price is now $39.95.

Question 14:

Here is some price information on FinCorp stock. Suppose that FinCorp trades in a dealer
market.

a. Suppose you have submitted an order to your broker to buy at market. At

what price will your trade be executed?

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b. Suppose you have submitted an order to sell at market. At what price will your
trade be executed?

c. Suppose you have submitted a limit order to sell at $55.62. What will happen?

d. Suppose you have submitted a limit order to buy at $55.37. What will
happen?

Stop-loss orders means the stock has to be sold if its price falls below a stipulated level.

Price information on stock is as under:

Part A

Ask price is $55.50 indicates that the investor would need to pay $55.50 to buy a share.
Therefore, trade will be executed at $55.50 per share.

Part B

Bid price means investor could receive $55.25 a share if he wished to sell some shares
owned. Therefore, trade will be executed at $55.25 per share.

Part C

Limit sell order:

A limit sell instructs the broker to sell if the stock price rises above a specified limit.

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Since limit order to sell is at $55.62 and Bid price is $55.25, the trade will not be executed
because the bid price is lower than the price specified in the limit sell order

Part D

Limit buy order:

A limit buy order instructs the broker to buy some number of shares if and when share price
falls below a stipulated limit.

Since limit order to buy is at $55.37 and Ask price is $55.50, the trade will not be executed
because the asked price is greater than the price specified in the limit buy order.

Question 15:

You’ve borrowed $20,000 on margin to buy shares in Disney, which is now selling at $40 per
share. Your account starts at the initial margin requirement of 50%. The maintenance margin
is 35%. Two days later, the stock price falls to $35 per share.

A. Will you receive a margin call?

B. How low can the price of Disney shares fall before you receive a margin call?

Calculation of margin call

 A margin is a security that the investor needs to deposit to protect some risks related
to the credit of their exchange or broker. This risk may arise in case of selling
financial instruments or getting cash from broker.

 Margin call can be determined by calculating the value of shares and the value of
equity, which further determines the percentage margin.

Part A

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Hence, total investment is $40,000

Hence, total number of shares is 1,000 shares

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Hence, the value of shares is $35,000

Hence, the value of Equity $15,000

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Part B

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Question 16:

On January 1, you sold short one round lot (that is, 100 shares) of Four Sisters stock at $21
per share. On March 1, a dividend of $2 per share was paid. On April 1, you covered the

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short sale by buying the stock at a price of $15 per share. You paid 50 cents per share in
commissions for each transaction. What is the value of your account on April 1?

Value of account means sum total of all the value of accounts. Value of account can be
determined by calculating net proceeds when price is $21 and $15 by subtracting dividends
with the net proceeds.

One round lot consists of 100 shares. Market price of the stock at the time of short sale is
$21 per share. Dividend is $3 per share. New price at the time of buying shares is $15 per
share. Commission is 50 cent per share.

Step 1: Net proceeds from short sale

Hence, net proceeds from the short sale when price was $21 is $2,050

Step 2: Net proceeds from buying

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Step 3: Calculation of dividends

Hence, dividends paid is $300

Step 4: Calculation of value on account

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CFA Problems

Question 1:

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F B N Inc. has just sold 100,000 shares in an initial public offering. The underwriter’s explicit
fees were $70,000. The offering price for the shares was $50, but immediately upon issue,
the share price jumped to $53

A. What is your best guess as to the total cost to FBN of the equity issue?

B. Is the entire cost of the underwriting a source of profit to the underwriters?

Part A

Part B

No, cost of the underwriting is not the only source of profit to the underwriters. Underwriter’s
under-price IPOs to protect their standing. Underwriters reduce their legal liability by
lowering the chance of price declines; therefore, they under-price the IPO offer. Under-
pricing helps in increasing aftermarket trading volume, which amplifies the revenue of
underwriters.

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Question 2:

If you place a stop-loss order to sell 100 shares of stock at $55 when the current price is
$62, how much will you receive for each share if the price drops to $50?

A. $50.
B. $55.
C. $54.87.
D. Cannot tell from the information given

The broker will sell at current market price, after the first transaction at $55 or less

Stop-loss orders means the stock has to be sold if its price falls below a stipulated level.

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Price information on stock is as under:

Broker has received stop-loss order to sell the stock at $55. This indicates that broker has
been instructed to sell the stock if the stock price falls to $55 from $62.

Broker will sell the shares before the price falls from $55 to $50. Therefore, Investor will
receive $55 for each share sold off.

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