Financial management

Part 1: Short Answer Questions (12 questions in total)

 

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  1. You have $45,000 in your margin account which requires a 50% initial margin. If the current stock price of Facebook (NASDAQ:FB) is $150 per share, how many shares of FB stock can you buy using margin?

 

 

$45,000/(1-50%)/$150 = 600 shares

 

 

  1. You sold short 100 shares of Bank of America (NYSE:BAC) at a price of $20, and its current stock price is $25. What is your capital gain or loss?

 

($20 – $25)*100 = -$500

 

  1. Please answer “true” or “false” to the following statements about IPO.

 

  • An important step in an IPO is the “road show” in which underwriters meet potential investors and learn the demand. _true______________________
  • Mandatory information disclosure is one disadvantage of IPOs because some firms don’t want to release information to their competitors. ____true____________
  • Successful IPOs are often considered good signals of firm quality. _true____
  • Stocks tend to have negative returns on the first trading day after the IPO. _false_
  • Underwriters of an IPO sometimes get over-allotment options, also known as the “green shoe” options. __true_______________

 

 

 

  1. According to the dividend discounting model (DDM), what determines the current stock price?

 

Answer: Future dividends (including the dividend growth rate) and the discount rate

 

 

  1. Firm X owns 50% of Firm Y’s outstanding shares; Firm Y owns 60% of Firm Z’s outstanding shares. If Firm X doesn’t directly own any shares of Firm Z, then Firm X indirectly owns ________ of Firm Z’s shares, but has 100% control over Firm Z.

 

 

Answer: 50%*60% = 30%______________________________

 

  1. Please briefly explain why a concentrated ownership structure can sometimes cause problems.

 

Answer: a concentrated ownership means a small number of large shareholders will have control over the firm. They can make suboptimal decisions to benefit themselves (like in a pyramidal structure) and hurt minority shareholders.

 

  1. Recall the required reading article “The Quiet Coup” by Simon Johnson (May 2009, The Atlantic). Which of the following is one of the major concerns of the author?
    1. Economic recovery will fail if the US does not break its financial oligarchy.
    2. In the US, there are too many financial firms but too few manufacturing firms.
  • The manufacturing industry is led by a group of incompetent people.
  1. The US manufacturing industry needs more regulations to stay healthy.
  2. The financial crisis of 2007-2008 was fundamentally different from previous crises in other countries; as a result, policy reforms recommended by the IMF are ill-fated.

 

Answer: _i

 

 

  1. Please list at least three ways to earn higher returns in an inefficient stock market.

 

 

Answer: taking more risk; insider trading; technical analysis; front-running on public information;

 

 

 

  1. Recall the required reading article “The Super Investors of Graham-and-Doddsville” by Warren Buffett. Please answer “true” or “false” to the following statements.
    • The main purpose of the article is to show that technical analysis is useless. _false
    • Super investors can consistently beat the market because they have inside information from political connections. __false_
    • Value investing can beat the market consistently because the US market is not entirely efficient. __true__
    • The US banking industry is manipulated by “super investors” like Ben Graham. _false_
    • The purpose of the article is to show that the stock market is efficient and no one can really beat the market. _false_

 

  1. Please briefly explain what diversification means and why it may be good for your portfolio.

 

Answer: Diversification is the practice of having multiple assets, ideally assets with low correlations, in a portfolio. Diversification can effectively reduce portfolio risk without necessarily lowering portfolio expected return.

 

  1. Please list two behavioral biases in financial investing and briefly describe them.

 

Answer: any two of disposition effect (prospect theory), overconfidence, attention affect, memory bias, conservatism, home bias, and so on.

 

  1. What do the following anomalies mean?
    • Momentum: “winner” stocks with good recent performance continue to outperform.
    • The value effect: “value” stocks with high book-to-market ratios outperform “growth” stocks with low book-to-market ratios__
    • The size effect: stocks with smaller market capitalization outperform stocks with bigger market capitalization.

 

 

 

 

 

 

 

 

 

Part 2: Comprehensive Word Problems (2 problems in total)

Please show your steps to get partial credit.

 

Problem 1

A mutual fund has three assets in its portfolio: Stock A, Stock B and the risk-free asset. Stock A has a beta of 3 and Stock B has a beta of 1.5. The risk-free asset has an expected return of 1%. The expected market return is 12%.

  1. What is the market risk premium?

 

 

12% – 1% = 11%

 

 

  1. If Stock A currently has an expected return of 30% and Stock B currently has an expected return of 20%, what suggestion would you give to the mutual fund manager?

 

Use CAPM: E(rA) = 1% + 3*(12%-1%) = 34% > 30% è overpriced è short (sell);

E(rB) = 1% + 1.5*(12%-1%) = 17.5% <20% è underpriced è long (buy)

 

  1. If the weights of Stock A, Stock B and the risk-free asset are 30%, 35% and 35%, respectively, what are the mutual fund’s beta and expected return?

Beta = 30%*3 + 35%*1.5 + 35%*0 = 1.425

CAPM: E(rp) = 1% + 1.425*(12%-1%) = 16.675%

Problem 2

In a simple economy, there are three economic states: good, normal and bad. A hedge fund invests in two stocks: Cats Company and Dogs Company. Stock returns of the two stocks in each economic state is given in the table below (Table 1). The risk-free rate is 1%.

Table 1: Stock Returns in Different Economic States
  Probability Cats Co. Dogs Co.
Good 25% 25% 12%
Normal 40% 5% 0%
Bad 35% -10% 5%

 

  1. What are the expected returns of the two stocks?

 

E(r_cats) = 25%*25%+40%*5%+35%*(-10%) = 4.75%

E(r_dogs) = 25%*12%+40%*0%+35%*5% = 4.75%

 

  1. Which stock has a higher standard deviation? Which stock has a higher Sharpe Ratio?

 

Stock Cats: Var = 25%*(25%-4.75%)^2 + 40%*(5%-4.75%)^2 + 35%*(-10%-4.75%)^2 = 1.7869% %; Std Dev = 13.37%

Stock Dogs: Var = 25%*(12%-4.75%)^2 + 40%*(0%-4.75%)^2 + 35%*(5%-4.75%)^2 = 0.2219%; Std Dev = 4.71% è Stock Cats has a higher standard deviation.

 

Because Cats and Dogs have the same expected return but Cats has a higher standard deviation, Dogs has a higher Sharpe Ratio.

 

Sharpe ratio:

Cats: (4.75%-1%)/13.37% = 28.05%

Dogs: (4.75%-1%)/4.71% = 79.61%

 

  1. A mutual fund has $40 million of Cats Co. shares and $60 million of Dogs Co. shares, and nothing else. What are expected return, standard deviation and Sharpe ratio of the fund’s portfolio? Is it better to invest in this mutual fund than in either of Cats or Dogs?

Weights = 40% for cats and 60% for dogs; Portfolio return in the good, normal and bad states are 17.2%, 2% and -1%, respectively.

 

E(rp) = 17.2%*25%+2%*40%+-1%*35% = 4.75%

Var(portfolio) = 25%*(17.2%-4.75%)^2 + 40%*(2%-4.75%)^2 + 35%*(-1%-4.75%)^2 = 0.5335%

Std. Var. of portfolio = 7.30%; Sharpe ratio = (4.75%-1%)/7.3% = 0.514

 

The portfolio is better than cats but not better than dogs.

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