Chapter 03 - How Securities are Traded

CHAPTER3:HOWSECURITIESARETRADED
PROBLEMSETS
1.

Answerstothisproblemwillvary.

2.

TheSuperDotsystemexpeditestheflowofordersfromexchangememberstothe
specialists.Itallowsmemberstosendcomputerizedordersdirectlytothefloorofthe
exchange,whichallowsthenearlysimultaneoussaleofeachstockinalargeportfolio.
Thiscapabilityisnecessaryforprogramtrading.

3.

Thedealersetsthebidandaskedprice.Spreadsshouldbehigheroninactivelytradedstocks
andloweronactivelytradedstocks.

4.

a.

Inprinciple,potentiallossesareunbounded,growingdirectlywithincreasesinthe
priceofIBM.

b.

Ifthestopbuyordercanbefilledat$128,themaximumpossiblelosspershareis
$8.IfthepriceofIBMsharesgoesabove$128,thenthestopbuyorderwouldbe
executed,limitingthelossesfromtheshortsale.

a.

Thestockispurchasedfor:300$40=$12,000

5.

Theamountborrowedis$4,000.Therefore,theinvestorputupequity,ormargin,
of$8,000.
b. Ifthesharepricefallsto$30,thenthevalueofthestockfallsto$9,000.Bytheend
oftheyear,theamountoftheloanowedtothebrokergrowsto:
$4,0001.08=$4,320
Therefore,theremainingmarginintheinvestorsaccountis:
$9,000$4,320=$4,680
Thepercentagemarginisnow:$4,680/$9,000=0.52=52%
Therefore,theinvestorwillnotreceiveamargincall.
c. Therateofreturnontheinvestmentovertheyearis:
(EndingequityintheaccountInitialequity)/Initialequity
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Chapter 03 - How Securities are Traded

=($4,680$8,000)/$8,000=0.415=41.5%

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Chapter 03 - How Securities are Traded

6.

a.

Theinitialmarginwas:0.501,000$40=$20,000
AsaresultoftheincreaseinthestockpriceOldEconomyTradersloses:
$101,000=$10,000
Therefore,margindecreasesby$10,000.Moreover,OldEconomyTradersmust
paythedividendof$2persharetothelenderoftheshares,sothatthemarginin
theaccountdecreasesbyanadditional$2,000.Therefore,theremainingmarginis:
$20,000$10,000$2,000=$8,000

b.

Thepercentagemarginis:$8,000/$50,000=0.16=16%
Sotherewillbeamargincall.

c.

Theequityintheaccountdecreasedfrom$20,000to$8,000inoneyear,forarateof
returnof:($12,000/$20,000)=0.60=60%

7.

Muchofwhatthespecialistdoes(e.g.,crossingordersandmaintainingthelimitorderbook)
canbeaccomplishedbyacomputerizedsystem.Infact,someexchangesuseanautomated
systemfornighttrading.Amoredifficultissuetoresolveiswhetherthemorediscretionary
activitiesofspecialistsinvolvingtradingfortheirownaccounts(e.g.,maintainingan
orderlymarket)canbereplicatedbyacomputersystem.

8.

a.

Thebuyorderwillbefilledatthebestlimitsellorderprice:$50.25

b.

Thenextmarketbuyorderwillbefilledatthenextbestlimitsellorder
price:$51.50

c.

Youwouldwanttoincreaseyourinventory.Thereisconsiderablebuyingdemandat
pricesjustbelow$50,indicatingthatdownsideriskislimited.Incontrast,limitsell
ordersaresparse,indicatingthatamoderatebuyordercouldresultinasubstantial
priceincrease.

a.

Youbuy200sharesofTelecomfor$10,000.Thesesharesincreaseinvalueby10%,
or$1,000.Youpayinterestof:0.08$5,000=$400

9.

Therateofreturnwillbe:
$1,000 $400
=0.12=12%
$5,000

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Chapter 03 - How Securities are Traded

b.

Thevalueofthe200sharesis200P.Equityis(200P$5,000).Youwillreceivea
margincallwhen:
200P $5,000
=0.30whenP=$35.71orlower
200P

10.

a.

Initialmarginis50%of$5,000or$2,500.

b.

Totalassetsare$7,500($5,000fromthesaleofthestockand$2,500putupfor
margin).Liabilitiesare100P.Therefore,equityis($7,500100P).Amargincall
willbeissuedwhen:
$7,500 100P
=0.30whenP=$57.69orhigher
100P

11.

Thetotalcostofthepurchaseis:$40500=$20,000
Youborrow$5,000fromyourbroker,andinvest$15,000ofyourownfunds.Your
marginaccountstartsoutwithequityof$15,000.
a.

(i)

Equityincreasesto:($44500)$5,000=$17,000
Percentagegain=$2,000/$15,000=0.1333=13.33%

(ii)

Withpriceunchanged,equityisunchanged.
Percentagegain=zero

(iii) Equityfallsto($36500)$5,000=$13,000
Percentagegain=($2,000/$15,000)=0.1333=13.33%
Therelationshipbetweenthepercentagereturnandthepercentagechangeinthe
priceofthestockisgivenby:
Total investment

%return=%changeinprice Investor' s initial equity =%changeinprice1.333

%return=10% $15,000 =13.33%

Thevalueofthe500sharesis500P.Equityis(500P$5,000).Youwillreceivea
margincallwhen:
500P $5,000
=0.25whenP=$13.33orlower
500P

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Chapter 03 - How Securities are Traded

c.

Thevalueofthe500sharesis500P.Butnowyouhaveborrowed$10,000instead
of$5,000.Therefore,equityis(500P$10,000).Youwillreceiveamargincall
when:
500P $10,000
=0.25whenP=$26.67
500P

Withlessequityintheaccount,youarefarmorevulnerabletoamargincall.
d. Bytheendoftheyear,theamountoftheloanowedtothebrokergrowsto:
$5,0001.08=$5,400
Theequityinyouraccountis(500P$5,400).Initialequitywas$15,000.
Therefore,yourrateofreturnafteroneyearisasfollows:
(i)

(500 $44) $5,400 $15,000

(ii)

(500 $40) $5,400 $15,000

(iii)

(500 $36) $5,400 $15,000

Therelationshipbetweenthepercentagereturnandthepercentagechangeinthe
priceofIntelisgivenby:

%return= % change in price

Total investment
Funds borrowed
8%

Investor' s initial equity

Forexample,whenthestockpricerisesfrom$40to$44,thepercentagechangein
priceis10%,whilethepercentagegainfortheinvestoris:

10%

e.

$20,000
$5,000 =10.67%

8%

$15,000
$15,000

Thevalueofthe500sharesis500P.Equityis(500P$5,400).Youwillreceivea
margincallwhen:
500P $5,400
=0.25whenP=$14.40orlower
500P

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Chapter 03 - How Securities are Traded

12.

a.

Thegainorlossontheshortpositionis:(500P)
Investedfunds=$15,000
Therefore:rateofreturn=(500P)/15,000
Therateofreturnineachofthethreescenariosis:
(i)

rateofreturn=(500$)/$15,000=0.1333=13.33%

(ii)

rateofreturn=(500$)/$15,000=0%

(iii) rateofreturn=[500($4)]/$15,000=+0.1333=+13.33%
b.

Totalassetsinthemarginaccountequal:
$20,000(fromthesaleofthestock)+$15,000(theinitialmargin)=$35,000
Liabilitiesare500P.Youwillreceiveamargincallwhen:
$35,000 500 P
=0.25whenP=$56orhigher
500P

c. Witha$1dividend,theshortpositionmustnowpayontheborrowedshares:
($1/share500shares)=$500.Rateofreturnisnow:
[(500P)500]/15,000
(i)

rateofreturn=[(500$4)$500]/$15,000=0.1667=16.67%

(ii)

rateofreturn=[(500$0) $500]/$15,000=0.0333=3.33%

(iii) rateofreturn=[(500)($4)$500]/$15,000=+0.1000=+10.00%
Totalassetsare$35,000,andliabilitiesare(500P+500).Amargincallwillbe
issuedwhen:
35,000 500P 500
=0.25whenP=$55.20orhigher
500P

13.

ThebrokerisinstructedtoattempttosellyourMarriottstockassoonastheMarriott
stocktradesatabidpriceof$38orless.Here,thebrokerwillattempttoexecute,but
maynotbeabletosellat$38,sincethebidpriceisnow$37.95.Thepriceatwhichyou
sellmaybemoreorlessthan$38becausethestoplossbecomesamarketordertosell
atcurrentmarketprices.

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Chapter 03 - How Securities are Traded

14.

15.

16.

a.

$55.50

b.

$55.25

c.

Thetradewillnotbeexecutedbecausethebidpriceislowerthanthepricespecified
inthelimitsellorder.

d.

Thetradewillnotbeexecutedbecausetheaskedpriceisgreaterthantheprice
specifiedinthelimitbuyorder.

a.

Inanexchangemarket,therecanbepriceimprovementinthetwomarketorders.
Brokersforeachofthemarketorders(i.e.,thebuyorderandthesellorder)canagree
toexecuteatradeinsidethequotedspread.Forexample,theycantradeat$55.37,
thusimprovingthepriceforbothcustomersby$0.12or$0.13relativetothequoted
bidandaskedprices.Thebuyergetsthestockfor$0.13lessthanthequotedasked
price,andthesellerreceives$0.12moreforthestockthanthequotedbidprice.

b.

Whereasthelimitordertobuyat$55.37wouldnotbeexecutedinadealermarket
(sincetheaskedpriceis$55.50),itcouldbeexecutedinanexchangemarket.A
brokerforanothercustomerwithanordertosellatmarketwouldviewthelimitbuy
orderasthebestbidprice;thetwobrokerscouldagreetothetradeandbringittothe
specialist,whowouldthenexecutethetrade.

a.

Youwillnotreceiveamargincall.Youborrowed$20,000andwithanother
$20,000ofyourownequityyoubought1,000sharesofDisneyat$40pershare.
At$35pershare,themarketvalueofthestockis$35,000,yourequityis$15,000,
andthepercentagemarginis:$15,000/$35,000=42.9%
Yourpercentagemarginexceedstherequiredmaintenancemargin.

b.

Youwillreceiveamargincallwhen:
1,000P $20,000
=0.35whenP=$30.77orlower
1,000P

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Chapter 03 - How Securities are Traded

17.

Theproceedsfromtheshortsale(netofcommission)were:($14100)$50=$1,350
Adividendpaymentof$200waswithdrawnfromtheaccount.Coveringtheshortsaleat$9
persharecostyou(includingcommission):$900+$50=$950
Therefore,thevalueofyouraccountisequaltothenetprofitonthetransaction:
$1350$200$950=$200
Notethatyourprofit($200)equals(100sharesprofitpershareof$2).Yournetproceeds
persharewas:
$14
$9
$2
$1
$2

sellingpriceofstock
repurchasepriceofstock
dividendpershare
2trades$0.50commissionpershare

CFAPROBLEMS
1.

a.

Inadditiontotheexplicitfeesof$70,000,FBNappearstohavepaidanimplicit
priceinunderpricingoftheIPO.Theunderpricingis$3pershare,oratotalof
$300,000,implyingtotalcostsof$370,000.

b.

No.Theunderwritersdonotcapturethepartofthecostscorrespondingtothe
underpricing.Theunderpricingmaybearationalmarketingstrategy.Without
it,theunderwriterswouldneedtospendmoreresourcesinordertoplacethe
issuewiththepublic.Theunderwriterswouldthenneedtochargehigher
explicitfeestotheissuingfirm.Theissuingfirmmaybejustaswelloff
payingtheimplicitissuancecostrepresentedbytheunderpricing.

2.

(d)

Thebrokerwillsell,atcurrentmarketprice,afterthefirsttransactionat$55
orless.

3.

(d)

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