solution manual for 《investment analysis and portfolio management》 ch04.doc

chapter 4organization and functioning of securities marketsanswers to questions1.a market is a means whereby buyers and sellers are brought together to aid in the transfer of goods and/or services. while it generally has a physical location it need 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. some possibilities are ads in the paper of your local community or large cities. another obvious alternative is an auction. with an ad you would have to specify a price or be ready to negotiate with a buyer. with an auction you would be very uncertain of what you would receive. in all cases, there would be a substantial time problem.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 1/8 of a point (or less) 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 exercise7.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 bond issue with the understanding that they have the exclusive right to sell the issue.8.the three main factors that would account for the changes in the price of a seat on the new york stock exchange are the relative stature of the nyse, the large trading volume relative to other exchanges and the general performance of the stock market. 9.one reason for the existence of regional exchanges is that they provide trading facilities for geographically local companies that do not qualify for listing on a national exchange. second, they list national firms thus providing small local brokerage firms that are not members of a national exchange the opportunity to trade in securities that are listed on a national exchange.the essential difference between the national and regional exchanges is that the regional exchanges have less stringent listing requirements, thus allowing small firms to obtain listing.10.the otc market is larger than the listed exchanges in terms of the number of issues traded, almost 7,000 issues are traded on the otc market compared to 3,200 stock issues (common and preferred) for the nyse. in sharp contrast, the nyse has a larger total value of trading - in 2000, nyse value of equity trading was about $11,200 billion and nasdaq was about $7,400 billion.11.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.12(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 favorites are traded on the third market - e.g., ibm, xerox, general motors.12(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.13(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 at&t and im certain the stock will go up in value. when i call my broker and submit a market buy order for 100 shares of at&t, the prevailing asking price is 60. total cost for my shares will be $6,000 + commission.13(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: at&t is selling for $60 - i would put in a limit buy order for one week to buy 100 shares at $59.13(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 at&t to go to $48 - i would sell it short at $60 and expect to replace it when it gets to $55.13(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 at&t at $60 and put in a stop loss at $57 that protects me from a major loss if it starts to decline.14.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.15.the saitori members are referred to as intermediary clerks. similar to the u.s. specialists, the saitori members do not deal with public customers. their duties entail matching buy and sell orders for the regular members of the tokyo exchange and they maintain the book for regular limit orders. unlike the u.s. exchange specialist, the saitori are not allowed to buy and sell for their own account and, thus, they do not have the duty or capability to ensure an orderly market.16.much of the change experienced on the secondary equity market can be attributed to changes occurring within the financial industry as a whole. as banks, insurance companies, investment companies and other financial service firms enter the capital markets, the volume and size of transactions continue to grow. this dominance by large institutions in the marketplace caused the following changes in the markets:(1) the imposition of negotiated (competitive) commission rates(2) the influence of block trades(3) the impact of stock price volatility(4) the development of a national market systemthese changes have increased the competition among firms that trade large institutional stocks. however, there is some concern that the individual investor is being “crowded out” and that the equity market for smaller firms will also suffer. the evolving globalization of markets will also have an impact.17.a “give-up” is the practice of the brokerage firm executing the trade paying part of the commission to other brokerage or research firms designated by the institution. typically, these other brokerage firms provided research or sales services to the institution. these commission transfers were referred to as “soft dollars.” “give-ups” existed in the fixed commission world because brokers realized that institutions were charged more for large trades than justified by the cost. 18.a block house is a brokerage firm, either member or non-member of an exchange, which stands ready to buy or sell a block for institutions. block houses evolved because institutions were not getting what they needed from the specialist and, hence, asked institutional brokerage firms to locate other institutions with an interest in buying or selling given blocks.when an institution wishes to sell a stock it typically contacts a block house, who contacts prospective institutional buyers. if the block house does not find buyers for the entire block, it buys the remainder (thus taking a position) with the hope of selling it later. naturally, the block house assumes substantial risk on this position because of the uncertainty of subsequent price changes.19(a).though the exact form of the national market system (nms) remains nebulous, major features of such a market are:(1) centralized reporting of all transactions regardless of where the trade took place. currently, this exists for all nyse stocks. (2)centralized quotation system that would list quotes for a given stock from all market-makers on the national exchanges, the regional exchanges, and the otc. this increased information is beneficial to the investor.(3)central limit order book (clob) that contains all limit orders from all exchanges.(4)competition among market-makers which would force dealers to offer better bids and asks, thus narrowing the bid-ask spread.19(b).the inter-market trading system (its) is a centralized quotation system, currently available, consisting of a central computer facility with interconnected terminals in the participating market centers. brokers and market-makers in each market center can indicate to those in other centers specific buying and selling commitments by way of a composite quotation display. a broker or market-maker in any market center can thus exercise his own best judgment in determining, on the basis of current quotations, where to execute a customers orders. while its provides the centralized quotation system that is necessary for a national market system (nms), it does not have the capability for automatic execution at the best market; it is necessary to contact the market-maker and indicate that you want to buy or sell at his bid or ask. also, it is not mandatory that a broker go to the best market to execute a customers orders.the data in exhibit 4.13 indicate significant growth in the number of issues on the system through 1999, with a drop-off in 2000. the volume of shares traded and the size of the trades continued to grow through 2000.20.student exercisechapter 4answers to problems1(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 x 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 x $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 percent 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% x 5/3 = 41.67%. in contrast, the rate of return on the stock if it is sold for $40 a share:= -50.00% x 5/3 = -83.33%.2(a).since the margin is 40 percent and lauren currently has $50,000 on deposit in her margin account, if lauren uses the maximum allowable margin her $50,000 deposit must represent 40% of her total investment. thus, $50,000 = .4x then x = $125,000. since the shares are priced at $35 each, lauren can purchase $125,000 $35 = 3,571 shares (rounded).2(b).total profit = total return - total investment(1)if stock rises to $45/share, laurens total return is:3,571 shares x $45 = $160,695.total profit = $160,695 - $125,000 = $35,695(2)if stock falls to $25/share, laurens total return is:3,571 shares x $25 = $89,275.total loss = $89,275 - $125,000 = -$35,725.2(c)where market value = price per share x number of shares.initial loan value = total investment - initial margin. = $125,000 - $50,000 = $75,000therefore, if maintenance margin is 30 percent:.30 (3,571 x price)= (3,571 x price) - $75,000.1,071.3 x price= (3,571 x price) - $75,000-2,499.7 x price= -$75,000price= $30.003.profit = ending value - beginning value + dividends - transaction costs - interestbeginning value of investment = $20 x 100 shares = $2,000your investment= margin requirement + commission.= (.55 x $2,000) + (.03 x $2,000)= $1,100 + $60= $1,160ending value of investment= $27 x 100 shares= $2,700dividends = $.50 x 100 shares = $50.00transaction costs= (.03