Week 2: Solutions to homework problems

BKM chapter 3

2. The effective price paid or received for a stock includes items such as bid-ask spread,
brokerage fees, commissions, and taxes (when applicable). These reduce the amount
received by a seller and increase the cost incurred by a buyer.

6. A stop order is an order that is not to be executed unless the stock hits a price limit.
The stop-loss is used to limit losses when prices are falling. An order specifying a
price at which an investor is willing to buy or sell a security is a limit order, while a
market order directs the broker to buy or sell at whatever price is available in the
market.

9. Margin is a type of leverage that allows investors to post only a portion of the value of
the security they purchase. As such, when the price of the security rises or falls, the
gain or loss represents a much higher percentage, relative to the actual money
invested.

15.
a. The stock is purchased for $40  300 shares = $12,000.
Given that the amount borrowed from the broker is $4,000, Dee’s margin is
the initial purchase price net borrowing: $12,000 – $4,000 = $8,000.

b. If the share price falls to $30, then the value of the stock falls to $9,000. By
the end of the year, the amount of the loan owed to the broker grows to:
Principal  (1 + Interest rate) = $4,000  (1 + 0.08) = $4,320.
The value of the stock falls to: $30  300 shares = $9,000.
The remaining margin in the investor’s account is:
Equity in account
Margin on long position =
Value of stock
$9,000 - $4,320
= = 0.52 = 52%
$9,000
Therefore, the investor will not receive a margin call.

Ending equity in account - Initial equity in account

c. Rate of return =
Initial equity in account
$4,680 - $8,000
= = – 0.4150 = – 41.50%
$8,000

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 16.
a. The initial margin was: $40  1,000  0.50 = $20,000.
As a result of the $10 increase in the stock price, Old Economy Traders loses:
$10  1,000 shares = $10,000.
Moreover, Old Economy Traders must pay the dividend of $2 per share to the
lender of the shares: $2  1,000 shares = $2,000.
The remaining margin in the investor’s account therefore decreases to:
$20,000 – $10,000 – $2,000 = $8,000.

Equity
b. Margin on short position =
Value of shares owed
$8,000
= = 0.16 = 16%
$50  1,000 shares
Because the percentage margin falls below the maintenance level of 30%,
there will be a margin call.

Ending equity - Initial equity

c. The rate of return =
Initial equity
$8,000 - $20,000
= = – 0.60 = – 60%
$20,000

17.
a. The market-buy order will be filled at $50.25, the best price of limit-sell
orders in the book.

b. The next market-buy order will be filled at $51.50, the next-best limit-sell
order price.

c. As a security dealer, you would want to increase your inventory. There is

considerable buying demand at prices just below $50, indicating that downside
risk is limited. In contrast, limit-sell orders are sparse, indicating that a
moderate buy order could result in a substantial price increase.

18.
a. Your initial investment is the sum of $5,000 in equity and $5,000 from
borrowing, which enables you to buy 200 shares of Telecom stock:
Initial investment $10,000
= = 200 shares
Stock price $50

The shares increase in value by 10%: $10,000  0.10 = $1,000.

You pay interest of = $5,000  0.08 = $400.
The rate of return will be:
$1,000 － $400
= 0.12 = 12%
$5,000

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 b. The value of the 200 shares is 200P. Equity is (200P – $5,000), and the
required margin is 30%.
200P －$5,000
Solving = 0.30, we get P = $35.71.
200P
You will receive a margin call when the stock price falls below $35.71.

19.
a. Initial margin is 50% of $5,000, which is $2,500.

b. Total assets are $7,500 ($5,000 from the sale of the stock and $2,500 put up
for margin). Liabilities are 100P. Therefore, net worth is ($7,500 – 100P).
$7,500－100P
Solving = 0.30, we get P = $57.69.
100P
A margin call will be issued when the stock price reaches $57.69 or higher.

BKM chapter 4

1. Mutual funds offer many benefits. Some of those benefits include: the ability to invest
with small amounts of money, diversification, professional management, low
transaction costs, tax benefits, and the ability to reduce administrative functions. The
costs associated with investing in mutual funds are generally operating expenses,
marketing, distribution charges, and loads. Loads are fees paid when investors
purchase or sell the shares.
2. Close-end funds trade on the open market and are thus subject to market pricing.
Open-end funds are sold by the mutual fund and must reflect the NAV of the
investments.
11. The offering price includes a 6% front-end load, or sales commission, meaning that
every dollar paid results in only $0.94 going toward the purchase of shares. Therefore:
NAV $10.70
Offering price =  = $11.38
1  load 1  0.06

13. Given that net asset value equals assets minus liabilities expressed on a per-share
basis, we first add up the value of the shares to get the market value of the portfolio:

Stock Value Held by

Fund
A $ 7,000,000
B 12,000,000
C 8,000,000
D 15,000,000
Total $42,000,000

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 Knowing that the accrued management fee, which adjusts the value of the portfolio,
totals $30,000, and the number of the shares outstanding is 4,000,000, we can use the
NAV equation:

Market value of assets - Market value of liabilities

Net asset value =
Shares outstanding

$42,000,000  $30,000
= = $10.49
4,000,000

15.
Market value of assets - Market value of liabilities
a. NAV =
Shares outstanding

$200,000,000－ $3,000,000
= = $39.40
5,000,000

Pr ice  NAV $36  $39.40

b. Premium (or discount) = = = –0.0863 = –8.63%
NAV $39.40
The fund sells at an 8.63% discount from NAV.

16. Given the NAV at the beginning and the end of the period, and the distributions
during the period, we can use the equation below to solve for the rate of return of the
Corporate Fund:

Δ(NAV) + Distributions  $0.40  $1.50

Rate of return = = = 0.0880 = 8.80%
Start of year NAV $12.50

24. Because the 4% load was paid up front and reduced the actual amount invested, only
96% (1.00 - .04) of the contribution was invested. Given the value of the portfolio
increased by 12% and the expense ratio was 1.2%, we can calculate the end value of
the investment against the initial contribution:
1 + r = 0.96  (1 + 0.12  0.012) = 1.0637
Thus, the rate of return was: 1.0637  1 = 0.0637 = 6.37%
Or otherwise, you can calculate the rate of return by the actual amount invested and
value changes:
To purchase the shares, you would have had to invest: $20,000/(1  0.04) = $20,833
The shares increase in value from $20,000 to $20,000  (1.12  0.012) = $22,160
The rate of return was: ($22,160  $20,833)/$20,833 = 0.0637 or 6.37%

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