Securities markets and the economy

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Solutions for Chapter 4: Questions and Problems


Answers to Questions

1. A market is a means whereby buyers and sellers are brought together to aid in the transfer of goods and/or services. It generally has a physical location but does not necessarily have one. Secondly, there is no requirement of ownership by those who establish and administer the market - they need only provide a cheap, smooth transfer of goods and/or services for a diverse clientele.

A good market should provide accurate information on the price and volume of past transactions, and current supply and demand. Clearly, there should be rapid dissemination of this information. Adequate liquidity is desirable so that participants may buy and sell their goods and/or services rapidly, at a price reflecting the supply and demand. The costs of transferring ownership and middleman commissions should be low. Finally, the prevailing price should reflect all available information.
2. This is a good discussion question for class because you could explore with students what are some of the alternatives that are used by investors with regards to other assets such as art and antiques. One primary concern is that you as seller may not know what a fair price is for your stock. In order to try to sell the shares, one possibility is to put ads in the paper of your local community or in large cities. Another obvious alternative is an auction or the use of a website such as eBay. With an ad you would have to specify a price or be ready to negotiate with a buyer. With an auction (internet-based or otherwise), you would be very uncertain of what you would receive. In all cases, there would be a substantial time problem—it may take days, weeks, or longer before you obtain an acceptable price for your shares.
3. Liquidity is the ability to sell an asset quickly at a price not substantially different from the current market assuming no new information is available. A share of AT&T is very liquid, while an antique would be a fairly illiquid asset. A share of AT&T is highly liquid since an investor could convert it into cash within a few cents of the current market price. An antique is illiquid since it is relatively difficult to find a buyer and then you are uncertain as to what price the prospective buyer would offer.
4. The primary market in securities is where new issues are sold by corporations to acquire new capital via the sale of bonds, preferred stock or common stock. The sale typically takes place through an investment banker.
The secondary market is simply trading in outstanding securities. It involves transactions between owners after the issue has been sold to the public by the company. Consequently, the proceeds from the sale do not go to the company, as is the case with a primary offering. Thus, the price of the security is important to the buyer and seller.
The functioning of the primary market would be seriously hampered in the absence of a good secondary market. A good secondary market provides liquidity to an investor if he or she wants to alter the composition of his or her portfolio from securities to other assets (i.e., house, etc.). Thus, investors would be reluctant to acquire securities in the primary market if they felt they would not subsequently have the ability to sell the securities quickly at a known price.
5. An example of an initial public offering (IPO) would be a small company selling company stock to the public for the first time. By contrast, a seasoned equity refers to an established company, such as IBM, offering a new issue of common stock to an existing market for the stock. The IPO involves greater risk for the buyer because there is not an established secondary market for the small firm. Without an established secondary market the buyer incurs additional liquidity risk associated with the IPO.
6. Student Exercise
7. In competitive bid the issuer is responsible for specifying the type of security to be offered, the timing, etc. and then soliciting competitive bids from investment banking firms wishing to act as an underwriter. The high bids will be awarded the contracts. Negotiated relationships are contractual arrangements between an underwriter and the issuer wherein the underwriter helps the issuer prepare the security issue with the understanding that they have the exclusive right to sell the issue.
8. As of 2007, The NYSE had approximately 3,000 issues traded, including common and preferred. NASDAQ NMS had about 2,800 issues and NASDAQ Small Cap had about 700 more issues, for approximately 3,500 total issues. In contrast, the average daily value of issues traded was larger on the NYSE than on the NASDAQ, $52 billion vs. $31 billion, respectively.
9. Level 1 provides a current quote on NASDAQ stocks for brokerage firms that are not regular OTC customers. It is a median quote that is representative of the quotes of the several market makers in the particular security. Level 2 is for serious traders who desire not only current trends but also specific quotes of different market makers. This enables the broker to make a deal with the market maker offering the best price. Level 3 is for investment firms who desire all the information provided in Level 2 but also need the ability to enter their own quotes or change them relative to other market makers. NASDAQ is an electronic quotation system that serves the OTC market. It enables all quotes by all market makers to be immediately available.
10(a). The third market is the OTC trading of exchange-listed securities. It enables the non-members of the exchange to trade in exchange listed securities. Most of the large institutional favourites are traded on the third market - e.g., IBM, Xerox, General Motors.
10(b). The fourth market is the direct trading between two parties without a broker intermediary. Institutions trade in the fourth market since these trades are large volume and consequently substantial savings can be made by trading directly with a buyer, thus avoiding commissions.
11(a). A market order is an order to buy/sell a stock at the most profitable ask/bid prices prevailing at the time the order hits the exchange floor. A market order implies the investor wants the transaction completed quickly at the prevailing price. Example: I read good reports about Shoppers Drug Mart and I’m certain the stock will go up in value. When I call my broker and submit a market buy order for 100 shares of Shoppers, the prevailing asking price is 40. Total cost for my shares will be $4,000 + commission.
11(b). A limit order specifies a maximum price that the individual will pay to purchase the stock or the minimum he will accept to sell it. Example: Shoppers is selling for $40 - I would put in a limit buy order for one week to buy 100 shares at $39.
11(c). A short sale is the sale of stock that is not currently owned by the seller with the intent of purchasing it later at a lower price. This is done by borrowing the stock from another investor through a broker. Example: I expect Shoppers to go to $32 - I would sell it short at $40 and expect to replace it when it gets to $35.
11(d). A stop-loss order is a conditional order whereby the investor indicates that he wants to sell the stock if the price drops to a specified price, thus protecting himself from a large and rapid decline in price. Example: I buy Shoppers at $40 and put in a stop loss at $37 that protects me from a major loss if it starts to decline.
12. The specialist acts as a broker in handling limit orders placed with member brokers. Being constantly in touch with current prices, he is in a better position to execute limit orders since it is entered in his books and executed as soon as appropriate. Second, he maintains a fair and orderly market by trading on his own account when there is inadequate supply or demand. If the spread between the bid and ask is substantial, he can place his own bid or ask in order to narrow the spread. This helps provide a continuous market with orderly price changes.
The specialist obtains income from both his functions: commissions as a broker, and outperforming the market in his dealer function using the monopolistic information he has on limit orders.
13. The purpose of security-market indices is to provide a general indication of the aggregate market changes or market movements. More specifically, the indices are used to derive market returns for a period of interest and then used as a benchmark for evaluating the performance of alternative portfolios. A second use is in examining the factors that influence aggregate stock price movements by forming relationships between market (series) movements and changes in the relevant variables in order to illustrate how these variables influence market movements. A further use is by technicians who use past aggregate market movements to predict future price patterns. Finally, a very important use is in portfolio theory, where the systematic risk of an individual security is determined by the relationship of the rates of return for the individual security to rates of return for a market portfolio of risky assets. Here, a representative index is used as a proxy for the market portfolio of risky assets.
14. A characteristic that differentiates alternative market indices is the sample - the size of the sample (how representative of the total market it is) and the source (whether securities are of a particular type or a given segment of the population (NYSE, TSX). The weight given to each member plays a discriminatory role - with diverse members in a sample, it would make a difference whether the index is price-weighted, value-weighted, or unweighted. Finally, the computational procedure used for calculating return - i.e., whether arithmetic mean, geometric mean, etc.
15. A price-weighted series is an arithmetic average of current prices of the securities included in the sample - i.e., closing prices of all securities are summed and divided by the number of securities in the sample.
A $100 security will have a greater influence on the series than a $25 security because a 10% increase in the former increases the numerator by $10 while it takes a 40% increase in the price of the latter to have the same effect.
16. A value-weighted index begins by deriving the initial total market value of all stocks used in the series (market value equals number of shares outstanding multiplied by current market price). The initial value is typically established as the base value and assigned an index value of 100. Subsequently, a new market value is computed for all securities in the sample and this new value is compared to the initial value to derive the percent change which is then applied to the beginning index value of 100.
17. Given a four security series and a 2-for-1 split for security A and a 3-for-1 split for security B, the divisor would change from 4 to 2.8 for a price-weighted series.
Stock Before Split Price After Split Prices

A $20 $10

B 30 10

C 20 20

D 30 30

Total 100/4 = 25 70/x = 25

x = 2.8

The price-weighted series adjusts for a stock split by deriving a new divisor that will ensure that the new value for the series is the same as it would have been without the split. The adjustment for a value-weighted series due to a stock split is automatic. The decrease in stock price is offset by an increase in the number of shares outstanding.

Before Split

Stock Price/Share # of Shares Market Value

A $20 1,000,000 $20,000,000

B 30 500,000 15,000,000

C 20 2,000,000 40,000,000

D 30 3,500,000 105,000,000

Total $180,000,000

The $180,000,000 base value is set equal to an index value of 100.
After Split

Stock Price/Share # of Shares Market Value

A $10 2,000,000 $20,000,000

B 10 1,500,000 15,000,000

C 20 2,000,000 40,000,000

D 30 3,500,000 105,000,000

Total $180,000,000
which is precisely what one would expect since there has been no change in prices other than the split.
18. In an unweighted price index series (perhaps more appropriately called an “unweighted” or “equally-weighted” index), all stocks carry equal weight irrespective of their price and/or their value. One way to visualize an unweighted series is to assume that equal dollar amounts are invested in each stock in the portfolio, for example, an equal amount of $1,200 is assumed to be invested in each stock. Therefore, the investor would own 15 shares of RIM ($80/share) and 40 shares of THI ($30/share). An unweighted price index that consists of these two stocks would be constructed as follows:

Stock Price/Share # of Shares Market Value

RIM $ 80 15 $1,200

THI 30 40 1,200

Total $2,400

A 20% price increase in RIM:

Stock Price/Share # of Shares Market Value

RIM $ 96 15 $1,440

THI 30 40 1,200

Total $2,640
A 20% price increase in THI:

Stock Price/Share # of Shares Market Value

RIM $ 80 15 $1,200

THI 36 40 1,440

Total $2,640
Therefore, a 20% increase in either stock would have the same impact on the total value of the index (i.e., in all cases the index increases by 10%. An alternative treatment is to compute percentage changes for each stock and derive the average of these percentage changes. In this case, the average would be 10% [(20% + 0%) / 2 = 10%]. So in the case of an unweighted price-index series, a 20% price increase in RIM would have the same impact on the index as a 20% price increase of THI.
19. Based upon the sample from which it is derived and the fact that is a value-weighted index, the Wilshire 5000 Equity Index is a weighted composite of the NYSE composite index, the AMEX market value series, and the NASDAQ composite index. We would expect it to have the highest correlation with the NYSE Composite Index because the NYSE has the highest market value.
20. The high correlations between returns for alternative NYSE price index series can be attributed to the source of the sample (i.e. stock traded on the NYSE). The four series differ in sample size, that is, the DJIA has 30 securities, the S&P 400 has 400 securities, the S&P 500 has 500 securities, and the NYSE Composite over 2,800 stocks. The DJIA differs in computation from the other series, that is, the DJIA is a price-weighted series where the other three series are value-weighted. Even so, there is strong correlation between the series because of similarity of types of companies.
21. The two price indices (Tokyo SE and Nikkei) for the Tokyo Stock Exchange show a high positive correlation even though the two indices represent substantially different sample sizes and weighting schemes. The Nikkei-Dow Jones Average consists of 225 companies and is a price-weighted series. Alternatively, the Tokyo SE encompasses a much larger set of 1,800 companies and is a value-weighted series.
The correlation between the Tokyo SE and the S&P 500 is substantially lower at 0.328.These results support the argument for diversification among countries.
22. Since the equal-weighted series implies that all stocks carry the same weight, irrespective of price or value, the results indicate that on average all stocks in the index increased by 23%. On the other hand, the percentage change in the value of a large company has a greater impact than the same percentage change for a small company in the value weighted index. Therefore, the difference in results indicates that for this given period, the smaller companies in the index outperformed the larger companies.
23. The bond-market series are more difficult to construct due to the wide diversity of bonds available. Also bonds are hard to standardize because their maturities and market yields are constantly changing. In order to better segment the market, you could construct five possible subindices based on coupon, quality, industry, maturity, and special features (such as call features, warrants, convertibility, etc.).
24. Since the Merrill Lynch-Wilshire Capital Markets index is composed of a distribution of bonds as well as stocks, the fact that this index increased by 15%, compared to a 5% gain in the Wilshire 5000 Index indicates that bonds outperformed stocks over this period of time.
25. One would expect that the level of correlation between the various world indices should be relatively high. These indices tend to include the same countries and the largest capitalization stocks within each country.
26. High yield bonds (ML High Yield Bond Index) have definite equity characteristics. Consequently, they are more highly correlated with the NYSE composite stock index than with the ML Aggregate Bond Index.
27. Indices with the broadest representation of U.S. stocks include the Wilshire 5000, the NYSE Composite, and possibly the NASDAQ composite. These indices would be appropriate benchmarks for portfolio managers wishing to construct a broadly diversified portfolio.

Answers to Problems

1(a). Assume you pay cash for the stock:

Number of shares you could purchase = $40,000/$80 = 500 shares.
(1) If the stock is later sold at $100 a share, the total shares proceeds would be $100 × 500 shares = $50,000. Therefore, the rate of return from investing in the stock is as follows:

(2) If stock is later sold at $40 a share, the total shares proceeds would be $40 × $500 shares = $20,000. Therefore, the rate of return from investing in the stock would be:

1(b). Assuming you use the maximum amount of leverage in buying the stock, the leverage factor for a 60% margin requirement is = 1/percentage margin requirement = 1/.60 = 5/3. Thus, the rate of return on the stock if it is later sold at $100 a share = 25.00% × 5/3 = 41.67%. In contrast, the rate of return on the stock if it is sold for $40 a share:

= -50.00% × 5/3 = -83.33%.
2(a). Since the margin is 40% and Shali currently has $50,000 on deposit in her margin account, if Shali uses the maximum allowable margin her $50,000 deposit must represent 40% of her total investment. Thus, $50,000 = .4x then x = $125,000. This sum represents $50,000 of her own funds (equity) and $75,000 of borrowed funds. Since the shares are priced at $35 each, Shali can purchase $125,000 / $35 = 3,571 shares (rounded).
2(b). Total Profit = Total Return - Total Investment

(1) If stock rises to $45/share, Shali’s total return is:

3,571 shares × $45 = $160,695.

Total profit = $160,695 - $125,000 = $35,695

Shali’s profit is computed as: $160,695 - $75,000 borrowing = $85,695;

since her initial equity was $50,000, her profit is $85,695 - $50,000 = $35,695,

which is the same as we computed above.
(2) If stock falls to $25/share, Shali’s total return is:

3,571 shares × $25 = $89,275.

Total loss = $89,275 - $125,000 = -$35,725.


where Market Value = Price per share × Number of shares.
Initial Loan Value = Total Investment - Initial Margin.

= $125,000 - $50,000 = $75,000

Therefore, if maintenance margin is 30%:

.30 (3,571 × Price) = (3,571 × Price) - $75,000.

1,071.3 × Price = (3,571 × Price) - $75,000

-2,499.7 × Price = -$75,000

Price = $30.00

3. Profit = Ending Value - Beginning Value + Dividends - Transaction Costs - Interest

Beginning Value of Investment = $20 × 100 shares = $2,000
Your Investment = margin requirement

= (.55 × $2,000) = $1,100

Ending Value of Investment = $27 × 100 shares

= $2,700

Dividends = $.50 × 100 shares = $50.00
Transaction Costs = (.03 × $2,000) + (.03 × $2,700)

(Commission) = $60 + $81

= $141
Interest = .10 × (.45 × $2,000) = $90.00

Profit = $2,700 - $2,000 + $50 - $141 - $90

= $519
The rate of return on your investment of $1,100 is:
$519/$1,100 = 47.14%

  1. Profit on a Short Sale = Begin.Value - Ending Value - Dividends - Trans. Costs - Interest

Beginning Value of Investment = $56.00 × 100 shares = $5,600

(sold under a short sale arrangement)

Your investment = margin requirement

= (.45 × $5,600) = $2,520
Ending Value of Investment = $45.00 × 100 = $4,500

(Cost of closing out position)

Dividends = $2.50 × 100 shares = $250.00
Transaction Costs = $155 + $145 = $300.00
Interest = .08 × (.55 × $5,600) = $246.40
Profit = $5,600 - $4,500 - $250 - $300 - $246.40

= $303.60

The rate of return on your investment of $2,520 is:
$303.60/$2,520 = 12.05%
5(a). I want to protect some of the profit I have; should prices drop I will still have a profit of


5(b). With the stop loss: ($40 - $25)/$25 = 60%

Without the stop loss: ($30 - $25)/$25 = 20%

(a). Assuming that you pay cash for the stock:

This is the return earned over 2 years so the annualized returns is (1 + 0.50)1/2 -1 = 22.47%

6(b). Assuming that you used the maximum leverage in buying the stock, the leverage factor for a 60% margin requirement is = 1/margin requirement = 1/.60 = 1.67. Thus, the rate of return on the stock if it is later sold at $45 a share = 50% × 1.67 = 83.33%.

The annualized return is (1 + 0.8333)1/2 – 1 = 35.4%

7. Limit order @ $24: When market declined to $20, your limit order was executed $24 (buy), then the price went to $36.

Rate of return = ($36 - $24)/$24 = 50%.

Assuming market order @ $28: Buy at $28, price goes to $36

Rate of return = ($36 - $28)/$28 = 28.57%.

Limit order @ $18: Since the market did not decline to $18 (lowest price was $20) the limit order was never executed.

8(a). Given a three security series and a price change from period t to t+1, the percentage change in the series would be 42.85%.

Period t Period t+1

A $ 60 $ 80

B 20 35

C 18 25

Sum $ 98 $140

Divisor 3 3

Average 32.67 46.67

8(b). Period t

Stock Price/Share # of Shares Market Value

A $60 1,000,000 $ 60,000,000

B 20 10,000,000 200,000,000

C 18 30,000,000 540,000,000

Total $800,000,000
Period t+1

Stock Price/Share # of Shares Market Value

A $80 1,000,000 $ 80,000,000

B 35 10,000,000 350,000,000

C 25 30,000,000 750,000,000

Total $1,180,000,000

8(c). The percentage change for the price-weighted series is a simple average of the differences in price from one period to the next. Equal weights are applied to each price change.

The percentage change for the value-weighted series is a weighted average of the differences in price from one period t to t+1. These weights are the relative market values for each stock. Thus, Stock C carries the greatest weight followed by B and then A. Because Stock B had the greatest percentage increase (75%) and the second largest weight, the percentage change would be larger for this series than the price-weighted series.
9(a). Period t

Stock Price/Share # of Shares Market Value

A $60 16.67 $ 1,000,000

B 20 50.00 1,000,000

C 18 55.56 1,000,000

Total $3,000,000
Period t+1

Stock Price/Share # of Shares Market Value

A $80 16.67 $ 1,333.60

B 35 50.00 1,750.00

C 25 55.56 1,389.00

Total $4,472.60


The answers are the same (slight difference due to rounding). This is what you would expect since Part A represents the percentage change of an equal-weighted series and Part B applies an equal weight to the separate stocks in calculating the arithmetic average.
9(c). Geometric average is the nth root of the product of n items.

The geometric average is less than the arithmetic average. This is because variability of return has a greater affect on the arithmetic average than the geometric average.

10. Student Exercise
Day 1

Company Price/Share

A 12

B 23

C 52

Day 2

(Before Split) (After Split)

Company Price/Share Price/Share

A 10 10

B 22 44

C 55 55

Day 3

(Before Split) (After Split)

Company Price/Share Price/Share

A 14 14

B 46 46

C 52 26

Day 4

Company Price/Share

A 13

B 47

C 25

Day 5

Company Price/Share

A 12

B 45

C 26

11(b). Since the index is a price-weighted average, the higher priced stocks carry more weight. But when a split occurs, the new divisor ensures that the new value for the series is the same as it would have been without the split. Hence, the main effect of a split is just a repositioning of the relative weight that a particular stock carries in determining the index. For example, a 10% price change for company B would carry more weight in determining the percent change in the index in Day 3 after the reverse split that increased its price, than its weight on Day 2.

12(a). Base = ($12 × 500) + ($23 × 350) + ($52 × 250)

= $6,000 + $8,050 + $13,000 = $27,050

Day 1 = ($12 × 500) + ($23 × 350) + ($52 × 250)

= $6,000 + $8,050 + $13,000 = $27,050

Index1 = ($27,050/$27,050) × 10 = 10
Day 2 = ($10 × 500) + ($22 × 350) + ($55 × 250)

= $5,000 + $7,700 + $13,750 = $26,450

Index2 = ($26,450/$27,050) × 10 = 9.778
Day 3 = ($14 × 500) + ($46 × 175) + ($52 × 250)

= $7,000 + $8,050 + $13,000 = $28,050

Index3 = ($28,050/$27,050) × 10 = 10.370
Day 4 = ($13 × 500) + ($47 × 175) + ($25 × 500)

= $6,500 + $8,225 + $12,500 = $27,225

Index4 = ($27,225/$27,050) × 10 = 10.065
Day 5 = ($12 × 500) + ($45 × 175) + ($26 × 500)

= $6,000 + $7,875 + $13,000 = $26,875

Index5 = ($26,875/$27,050) × 10 = 9.935
12(b). The market values are unchanged due to splits and thus stock splits have no effect. The index, however, is weighted by the relative market values.
13. Price-weighted index (PWI)2008 = (20 + 80+ 40)/3 = 46.67
To accounted for stock split, a new divisor must be calculated:

(20 + 40 + 40)/X = 46.67

X = 2.143 (new divisor after stock split)
Price-weighted index2009 = (32 + 45 + 42)/2.143 = 55.53
VWI2008 = 20(100,000,000) + 80(2,000,000) + 40(25,000,000)

= 2,000,000,000 + 160,000,000 + 1,000,000,000

= 3,160,000,000

assuming a base value of 100 and 1998 as base period, then

(3,160,000,000/3,160,000,000) × 100 = 100

VWI2009 = 32(100,000,000) + 45(4,000,000) + 42(25,000,000)

= 3,200,000,000 + 180,000,000 + 1,050,000,000

= 4,430,000,000

assuming a base value of 100 and 2008 as period, then

(4,430,000,000/3,160,000,000) × 100 = 1.4019 × 100 = 140.19

13(a). Percentage change in PWI = (55.53 - 46.67)/46.67 = 18.99%
Percentage change in VWI = (140.19 - 100)/100 = 40.19%
13(b). The percentage change in VWI was much greater than the change in the PWI because the stock with the largest market value (K) had the greater percentage gain in price (60% increase).
13(c). December 31, 2008



# of Shares

Market Value















December 31, 2009



# of Shares

Market Value















(*Stock-split two-for-one during the year.)

Unweighted averages are not impacted by large changes in stocks prices (i.e. price-weighted series) or in market values (i.e. value-weighted series).

Copyright © 2010 by Nelson Education Ltd.

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