Test

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Test 1-A, Fall 2002

• Explanations and Answers
• FINC434 - Financial Markets
• Prof David Eagle

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Questions 1-4 WSJ articles

• 1. IPOs, especially good IPOs are often
  rationed by investment banks, with greater
  allocations being given as favors to good
  clients. The article something Ventured and
  Something Gained? discussed how investment banks
  were giving greater allocations to the venture
  capitalists who helped bring the companies to the
  investment banks.
• 2. B, survivorship bias has to do with the fact
  that mutual funds that do not survive do not have
  their performances reported, which creates an
  overstatement of the long-term performance
  averages for active funds.
• 3. A.
• 4. D. Goodyear made a contribution this year
  even though they were not required to do so by
  law.

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Problem 5
The equilibrium call premium is 11.42
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Problem 6
(a) buy futures, sell the underlying stock short
Futures
Overall
Stocks
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Problem 7 (Futures Arbitrage)
Note An area of confusion that many students had
concerned how the futures were used one year from
now. You buy the futures contract now (although
no money is exchanged now). A year from now, you
buy the stock via the futures contract and use
those stocks to return the stocks you owe the
broker.
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Problem 8
Jennifers broker must sell 284 shares on her
behalf.
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Problem 9
Justin can buy 202 more shares
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Problem 10
They can borrow 2562 more.
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11 Essay
(a) Selling short is selling securities you do
not own by borrowing those securities, for
example from ones broker. For example, suppose
Joe sold stock short to Jill by borrowing the
stock from his broker who in turn borrows the
stock from Bill. (b) the stock comes from Bills
street name. (c) the stock goes to Jill who
bought it (d) the proceeds for the sale are put
in a collateral account. Joe must also put
additional funds in the collateral account. He
will be able to put those funds in a Treasury
Bill and thus still earn interest on them and
still have them meet his collateral
requirements. (e) When Kmart pays a dividend, it
pays it to Jill who now owns the stock. (f) Joe
must pay the amount of the dividends to Bill to
make up for the dividend. (g) Joe must pay
interest to the broker. (h) To reverse the short
sale, Joe must buy the stock on the open market
and returns it to the broker to back up Bills
account. Joe is then free to take any left over
money in the collateral account.
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Problem 12

• Note All future contracts are marketed to market
• (a) No money exchanges hands between Chad and
  Angela on Oct. 24th. However, both of them must
  put funds into a margin account
• (b) Angela must pay 300 to Chad as a result of
  marking to market.
• (c) Chad must pay 200 to Angela as a result of
  marking to market.

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13 Risk Arbitrage vs. Riskless Arbitrage

• Riskless arbitrage involves buying and selling at
  the same time to take into account price
  disparities between two markets or involves
  engaging in derivatives hedging that should make
  the arbitrage riskless.
• Risk Arbitrage is really a form of speculation.
  The term risk arbitrage was coined by
  practitioners not academics. It means buying or
  selling a security before bankruptcy, a merger,
  or an acquisition, to profit from the price
  disparity that exists now versus what should
  exist after the bankruptcy, merger, or
  acquisition.

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14 Closed-End Fund vs. Unit Trust

• In a closed-end fund, the number of shares in the
  fund is fixed after the fund is closed. However,
  the closed-end fund can be actively managed.
  With a unit trust, the fund is passively managed,
  not in the sense of an index fund, but in the
  sense that it is mostly a buy and hold fund.

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15. D.

• Collision coverage is an example of property and
  casualty insurance.

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16. Passive vs. active stock funds

• An actively managed stock fund is a fund where
  stocks are continually being monitored and
  analyzed and the money manager is continually
  making decisions about which stocks to hold, buy,
  and sell. In a passive stock fund, the manager
  does not make such decisions. Instead, the fund
  either continues holding stocks, like in a unit
  trust, or in the case of an index fund merely
  tries to replicate an index and buys and sells
  securities only to the extent necessary to handle
  new funds, redemptions, or changes in the
  composition of the index.

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17. ETFs and ECNs

• ETFs are open-ended mutual funds that are traded
  like stocks on a stock exchange (originally on
  the Amex exchange). When the book was written
  only stock index funds were allowed to be so
  traded. ETFs are similar to closed-end funds in
  that small discounts or premiums can exist but
  arbitrageurs can actually create the ETFs or
  redeem the ETFs, which keeps these discounts or
  premiums small. ETFs have a tax advantage to new
  investors -- old investors redeaming ETFs do not
  result in the new investor being taxed.
• ECNs, see pp. 237-238.

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18. SEC rule 144A

• This rule relates to the allowance of privately
  placed securities to institutional investors,
  which the SEC allows to take place with less
  registration requirements than a public offering.
  Before this rule was past, the SEC required
  these privately placed securities to be held for
  two years before the institutional investor can
  sell the securities. However, rule 144A now
  allows these institutional investors to trade the
  securities among themselves.

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19. Basis risk

• Basis equals the futures price less the spot
  price. Basis risk is that the basis will move in
  ways other than predicated which could cause a
  less than perfect hedge or a loss even though the
  spot price changed as predicted. (Note the
  basis usually is predicted to disappear by the
  expiration of the futures contract.

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20. B.

• the accumulated investment value of the life
  insurance is tax exempt, which is one of the tax
  advantages of life insurance as an investment
  vehicle.

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21. C

• Underwriters make decisions about whether or not
  insure particular applicants and to some extent
  what premiums to change the insured.