CFA Level 1 - Equity Investments Session 13 - Reading 47

CFA Level 1 - Equity Investments Session 13 - Reading 47 (Notes, Practice Questions, Sample Questions) 1. The main functions of the financial system least likely include: A)preventing investors from generating abnormal profits by trading on information. B)allocating financial resources to their most productive uses. C)bringing together savers and borrowers [Explanation: (A) One of the purposes of the financial system is to allow investors to trade on (public) information. Other purposes of the financial system include allocating financial capital to its most productive uses, and bringing together those who wish to save with those who wish to borrow] 2. The main functions of the financial system most likely include: A)determining equilibrium interest rates and allocating capital to its most productive uses. B)determining the supply of money and determining equilibrium interest rates. C)allocating capital to its most productive uses and determining the supply of money [Explanation: (A) The main functions of the financial system are to allow individuals and organizations to save, borrow, raise capital, and manage risks; to determine equilibrium rates of return that equate the amounts of lending and borrowing; and to allocate capital to its most productive uses. The money supply is typically controlled by countries’ central banks] 3. Markets for financial assets with maturities of one year or less are best characterized as: A)primary markets. B)capital markets. C)money markets [Explanation: (C) “Money markets” generally refers to markets for debt securities maturing in one year or less. Capital markets refer to markets for equities and for debt securities with maturities greater than one year. Primary markets are the markets for newly issued securities] 4. The “real assets” classification most likely includes: A)bonds. B)stocks. C)commodities [Explanation: (C) Real assets include commodities, real estate, durable equipment, and other physical assets. Bonds and stocks are classified as financial assets] 5. A securities exchange where traders buy and sell long-term government bonds from and to other traders would best be described as part of the: A)capital market. B)primary market. C)money market. [Explanation: (A) The exchange can be described as part of the secondary capital markets. A security is first issued in the primary market, and then it trades among investors in the secondary market. The money market refers to the market for short-term debt instruments (usually with maturities of less than one year) such as T-bills] 6. The prospectus for the Horizon Fund states that it invests only in real assets. Which of the following would the Horizon Fund most likely include in its portfolio? A)Holdings of foreign currencies. B)Common stock of a technology company. C)An investment in an apartment complex. [Explanation: (C) Real assets are assets with a physical presence such as real estate, equipment, and commodities. Financial assets include stocks, bonds, derivatives, and currencies. An investment in an apartment complex is a real estate investment and therefore would be considered a real asset] 7. Jorman Inc. stock is cross-listed on exchanges in Tokyo and New York. Jorman stock is best described as a: A)private security. B)public security. C)primary market security. [Explanation: (B) Jorman stock is a public security because it is traded on public exchanges that are subject to regulatory oversight. A private security is a security that is not offered for sale on a public exchange and is not subject to regulation. Securities are issued in the primary market (i.e., initial public offerings) and subsequently trade in the secondary market (e.g., stock exchanges)] 8. Which of the following assets are best characterized as contracts? A)Currency swaps. B)Commercial paper. C)Depository receipts. [Explanation: (A) Contracts include forwards, futures, options, swaps, and insurance contracts. Commercial paper is a debt security. Depository receipts are shares in a pooled investment vehicle, such as a mutual fund or an exchange-traded fund] 9. Equity securities most likely include: A)preferred stock and certificates of deposit. B)commercial paper and repurchase agreements. C)common stock and warrants [Explanation: (C) Common stock, preferred stock, and warrants are equity securities. Certificates of deposit, commercial paper, and repurchase agreements are debt securities] 10. In contrast with a typical forward contract, futures contracts have: A)standardized terms. B)greater counterparty risk. C)less liquidity. [Explanation: (A) Futures are forward contracts that trade on exchanges and have standardized terms, in contrast with forward contracts, which are customized instruments. A futures clearinghouse reduces counterparty risk by guaranteeing the performance of buyers and sellers. Futures contracts trade on organized exchanges and are more liquid than forward contracts] 11. Financial intermediaries that issue securities which represent interests in a pool of similar financial assets are best characterized as: A)block brokers. B)arbitrageurs. C)securitizers [Explanation: (C) Securitizers are financial intermediaries that assemble large pools of similar financial assets, such as mortgages or loans, and issue securities that represent interests in the pool. Block brokers assist their clients with large trades of securities. Arbitrageurs simultaneously buy and sell the same asset in different markets to take advantage of different prices for the same asset.] 12. Which of the following statements about financial intermediaries is most accurate? A)Brokers seek out traders that are willing to take the opposite sides of their clients’ orders. B)Arbitrageurs buy securities with the anticipation that they will be able to sell the securities in the future at higher prices. C)Dealers buy a security in one market and simultaneously sell the same security in a different market [Explanation: (A) Brokers seek out traders that are willing to take the opposite side of their clients’ orders. Arbitrageurs buy an instrument in one market and simultaneously sell the same instrument in a different market at a higher price. Dealers buy securities from clients, with the expectation that they will be able to sell the securities to other clients in the future at higher prices] 13. Regarding the technical points affecting the short sales of a stock, which of the following statements is most accurate? A)The lender must deposit margin to guarantee the eventual return of the stock. B)Stocks can only be shorted in a down market. C)The short seller must pay all dividends due to the lender of the shorted stock [Explanation: (C) The short seller must pay any dividends on the stock to the owner of the borrowed shares. The short seller must also deposit margin money to guarantee the eventual repurchase of the security] 14. An investor can profit from a stock price decline by: A)placing a stop buy order. B)selling short. C)purchasing a call option [Explanation: (B) Short selling provides a way for an investor to profit from a stock price decline. In order to sell short, the broker borrows the security and then sells it for the short seller. Later, if the investor can replace the borrowed securities by repurchasing them at a lower price, then the investor will profit from the transaction] 15. Which of the following statements about selling a stock short is least likely accurate? A)The seller must return the securities at the request of the lender. B)The seller must inform their broker that the order is a short sale before completing the transaction. C)The short seller may withdraw the proceeds of the short sale [Explanation: (C) Proceeds from the short sale must remain in the brokerage account along with the required margin deposit] 16. A short seller: A)often also places a stop loss sell order. B)does not receive the dividends. C)loses if the price of the stock sold short decreases [Explanation: (B) The short seller pays all dividends to the lender, loses if stock prices rise, and is required to post a margin account. A short seller often places a stop buy order to protect the short sale position from a rising market] 17. An investor purchases 200 shares of Merxx on margin. The shares are trading at $40. Initial and maintenance margins are 50% and 25%.If the investor sells the stock when the price rises to $50 at year-end, the return on the investment would be closest to: A)25.00%. B)18.75%. C)50.00% [Explanation: (C) Profit = 10,000 – 8,000 = 2,000 Return = 2,000 / 4,000 = 50%] 18. If the company pays a dividend of $0.75, the return on the investment would be closest to: A)39.55%. B)53.75%. C)15.75%. [Explanation: (B) Dividends income = (0.75) × (200) = $150 Profit = 10,000 – 8,000 + 150 = 2,150 Return = 2,150 / 4,000 = 53.75%] 19. Lynne Hampton purchased 100 shares of $75 stock on margin. The margin requirement set by the Federal Reserve Board was 40%, but Hampton’s brokerage firm requires a total margin of 50%. Currently the stock is selling at $62 per share. What is Hampton’s return on investment before commission and interest if she sells the stock now? A)-35%. B)-40%. C)-17%. [Explanation: (A) Hampton originally purchased 100 shares at $75 for a total value of $7500. Half of the value ($3750) was borrowed and Hampton paid cash for the other half. The current total market value of the stock is $6200. If Hampton sells her holdings she will have $2450 left after she pays off the loan. Hampton’s return on her original investment is: $2450/3750 – 1 = 0.65 – 1 = -0.35 = -35%] 20. Mark Ritchie purchased, on margin, 200 shares of TMX Corp. stock at a price of $35 per share. The margin requirement was 50%. The stock price has increased to $42 per share. What is Ritchie’s return on investment before commissions and interest if he decides to sell his TMX holdings now? A)20%. B)40%. C)10%. [Explanation: (B) 200 shares × $35 = $7000 Initial Market Value $7000 × .50 = $3500 cash payment and $3500 borrowed. The new market value of the stock after price increase is (200 × $42) = $8400. If Ritchie sold his holdings he would have $4900 ($8400 × $3500) left after the loan was paid. So Ritchie’s return on his original $3500 investment is: $4900/3500 – 1 = 1.4 – 1.0 = 0.40 = 40%.] 21. An investor buys 200 shares of ABC at the market price of $100 on full margin. The initial margin requirement is 40% and the maintenance margin requirement is 25%. If the shares of stock later sold for $200 per share, what is the rate of return on the margin transaction? A)250%. B)400%. C)100%. [Explanation: (A) One quick (and less than intensive) way to calculate the answer to this on the examination (and it is very important to save time on the examination) is to first calculate the return if all cash, then calculate the margin leverage factor and then finally, multiply the leverage factor times the all cash return to obtain the margin return. Calculations: Step 1: Calculate All Cash Return: Cash Return % = [(Ending Value / Beginning Equity Position) – 1] × 100 = [(($200 × 200) / ($100 × 200)) – 1] × 100 = 100% Step 2: Calculate Leverage Factor: Leverage Factor = 1 / Initial Margin % = 1 / 0.40 = 2.50 Step 3: Calculate Margin Return: Margin Transaction Return = All cash return × Leverage Factor = 100% × 2.50 = 250% Note: You can verify the margin return as follows: Margin Return % = [((Ending Value − Loan Payoff) / Beginning Equity Position) – 1] × 100 = [(([$200 × 200] – [$100 × 200 × 0.60]) / ($100 × 0.40 × 200)) – 1] × 100 = [ ((40,000 − 12,000) / 8,000) − 1] × 100 = 250%] 22. If an investor buys 100 shares of a $50 stock on margin when the initial margin requirement is 40%, how much money must she borrow from her broker? A)$2,000. B)$4,000. C)$3,000. [Explanation: (C) An initial margin requirement of 40% would mean that the investor must put up 40% of the funds and brokerage firm may lend the 60% balance. Therefore, for this example (100 shares) * ($50) = $5,000 total cost. $5,000 * 0.60 = $3,000] 23. Becky Kirk contacted her broker and placed an order to purchase 1,000 shares of Bricko Corp. stock at a price of $60 per share. Kirk wishes to buy on margin. Assuming the margin requirement is 40%, how much money does Kirk have to pay up front to make the purchase? A)$60,000. B)$24,000. C)$36,000. [Explanation: (B) The margin requirement represents the amount of money an investor must put down on the purchase. So Kirk must put $24,000 down ($60,000 x .40 = $24,000) and can borrow the balance] 24. The initial margin is the: A)equity represented in the margin account at any time. B)minimum amount of funds that must be supplied when purchasing a security on margin. C)amount of cash that an investor must maintain in his/her margin account [Explanation: (B) Margin is the amount of equity in the account at a given time. Initial margin is the amount of equity required initially to execute an order] 25. Which of the following statements regarding margin accounts is most accurate? A)Margin accounts can be used to purchase securities by borrowing part of the purchase price. B)The total equity in the margin account cannot fall below the initial margin requirement. C)Maintenance margin refers to the amount of funds the investor can borrow. [Explanation: (A) Margin accounts are brokerage accounts that allow investors to borrow part of the purchase price from the broker] 26. An investor bought a stock on margin. The margin requirement was 60%, the current price of the stock is $80, and the investor paid $50 for the stock 1 year ago. If margin interest is 5%, how much equity did the investor have in the investment at year-end? A)67.7%. B)60.6%. C)73.8% [Explanation: (C) Margin debt = 40% × $50 = $20; Interest = $20 × 0.05 = $1. Equity % = [Value – (margin debt + interest)] / Value $80 - $21 / $80 = 73.8%] 27. Assume 100 shares purchased at $75/share with an initial margin of 50%. The initial cost to the investor is: A)$3,750. B)$7,500. C)$0. [Explanation: (A) $75/share × 100 shares = $7,500 50% margin means investor only pays ½ of the $7,500 = $3,750] 28. Now, assume that the stock rose to $112.50. The return on investment to the investor is: A)50%. B)200%. C)100%. [Explanation: (C) (market value – initial own investment – margin loan repayment)/initial equity =($11,250 – $3,750 – $3,750) / $3,750 = 100%. (Assuming no interest on the call loan and no transactions fees.)] 29. Sonia Fennell purchases 1,000 shares of Xpressoh Inc. for $35 per share. One year later, she sells the stock for $42 per share. Xpressoh Inc. pays no dividends. The initial margin requirement is 50%. Fennell's one-year return assuming an all-cash transaction, and if she buys on margin (assume she pays no transaction or borrowing costs and has not had to post additional margin), are closest to: All-cash 50% margin A) 20% 40% B) 20% 80% C) 40% 80% [Explanation: (A) All-cash return = 42/35 − 1 = 20% Margin return = (42 − 35)/[(35)(0.5)] = 40%] 30. An investor purchases stock on 25% initial margin, posting $10 of the original stock price of $40 as equity. The position has a required maintenance margin of 20%. The investor later sells the stock for $45. Ignoring transaction costs and margin loan interest, which of the following statements is most accurate? A)Return on investment is 50%. B)Leverage ratio is 3:1. C)Margin call price is $36. [Explanation: (A) Return on invested equity is ($45 – $40) / $10 – 1 = 50%. The leverage ratio is purchase price / equity = $40 / $10 = 4. Margin call price is $40 × [(1 – 0.25) / (1 – 0.20)] = $37.50] 31. An investor buys 400 shares of a stock for $25 a share. The initial margin requirement is 50%, and the maintenance margin requirement is 25%. At what price would an investor receive a margin call? A)$16.67. B)$21.88. C)$30.00. [Explanation: (A) Margin call trigger price = [25(1 - 0.5)] / (1 - 0.25) = 16.67] 32. An investor purchases 100 shares of Lloyd Computer at $26 a share. The initial margin requirement is 50%, and the maintenance margin requirement is 25%. The price below which the investor would receive a margin call is closest to: A)17.33. B)19.45. C)15.25 [Explanation: (A) 26 * (1 - 0.5)/(1 - 0.25) = $17.33] 33. An investor buys 200 shares of ABC at the market price of $100 on full margin. The initial margin requirement is 40% and the maintenance margin requirement is 25%. At what price will the investor get a margin call? A)$112. B)$48. C)$80. [Explanation: (C) In a long stock position, the equation to use to determine a margin call is: long = [(original price)(1 − initial margin %)] / [1 − maintenance margin %] = $100(1 − 0.4) / (1 − 0.25) = $80] 34. Which of the following statements about the maintenance margin requirement is least accurate? A)The Federal Reserve sets the maximum maintenance margin. B)The purpose of the maintenance margin requirement is to protect the broker in the event of a large stock decline. C)Generally the maintenance margin requirement is lower than the initial margin requirement [Explanation: (A) The Federal Reserve sets the minimum maintenance margin and individual investment companies may set higher margins if they wish] 35. Toby Jensen originally purchased 400 shares of CSC stock on margin at a price of $60 per share. The initial margin requirement is 50% and the maintenance margin is 25%. CSC stock price has fallen dramatically in recent months and it closed today with a sharp decline bringing the closing price to $40 per share. Will Jensen receive a margin call? A)No, he meets the minimum maintenance margin requirement. B)Yes, he does not meet the minimum maintenance margin requirement. C)No, he meets the minimum initial margin requirement [Explanation: (A) Total original value held by Jensen is 400 x $60 = $24,000. Amount of equity is 50% ($24,000) = $12,000. Current total value is 400 x $40 = $16,000. So Jensen’s equity is $16,000 - $12,000 = $4,000 which is 4,000/16,000 = 25% of the total market value] 36. A primary market transaction involves: A)the direct trading of securities between institutional investors. B)primarily preferred stocks. C)the sale of new securities to investors. [Explanation: (C) A primary market is a market for new issues of securities] 37. Which of the following statements about securities markets is least accurate? A)A market that features low transactions costs is said to have operational efficiency. B)Initial public offerings (IPOs) are sold in the secondary market. C)In a continuous market, a security can trade any time the market is open [Explanation: (B) IPOs are sold in the primary market] 38. Which of the following is least likely a service provided by an underwriter in the primary market? A)Origination. B)Diversification. C)Risk Bearing [Explanation: (B) The underwriter provides the following services to the issuer: ● Origination, which involves the design, planning, and registration of the issue. ● Risk bearing, which means the underwriter guarantees the price by purchasing the securities. ● Distribution, which is the sale of the issue.] 39. Which of the following statements regarding primary and secondary markets is least accurate? A)Prevailing market prices are determined by primary market transactions and are used in pricing new issues. B)Secondary market transactions occur between two investors and do not involve the firm that originally issued the security. C)New issues of government securities can be sold on the primary market. [Explanation: (A) Prevailing market prices are determined by the transactions that take place on the secondary market. This information is used to determine the price of new issues sold on primary markets] 40. Which of the following statements about primary and secondary markets is least accurate? A)The proceeds from a sale in the secondary market go to the issuer. B)A primary market is a market in which new securities are sold. C)The primary market benefits from the liquidity provided by the secondary market [Explanation: (A) Proceeds in a primary market go to the issuing firm. Proceeds from a sale in the secondary market go to the current owner who is selling the securities] 41. Which of the following is a difference between primary and secondary capital markets? A)Primary markets are where stocks trade while secondary markets are where bonds trade. B)Primary capital markets relate to the sale of new issues of bonds, preferred, and common stock, while secondary capital markets are where securities trade after their initial offering. C)Secondary capital markets relate to the sale of new issues of bonds, preferred, and common stock, while primary capital markets are where securities trade after their initial offering [Explanation: (B) Bonds and stocks are traded on both the primary and secondary markets] 42. Which of the following statements regarding secondary markets is least accurate? Secondary markets are important because they provide: A)investors with liquidity. B)firms with greater access to external capital. C)regulators with information about market participants. [Explanation: (C) Secondary markets are important because they provide liquidity and continuous information to investors. The liquidity of the secondary markets adds value to both the investor and firm because more investors are willing to buy issues in the primary market, when they know these issues will later become liquid in the secondary market. Therefore, the secondary market makes it easier for firms to raise external capital] 43. A trading system that matches buyers and sellers based on price and time precedence is most likely a(n): A)quote-driven market. B)brokered market. C)order-driven market. [Explanation: (C) In an order-driven market, buy orders and sell orders are matched up by the exchange according to order matching rules. In a quote-driven market, customers trade with dealers at bid and ask prices set by the dealers. In a brokered market, brokers organize trades among their clients] 44. Which of the following statements about securities exchanges is NOT correct? A)In call markets, there is only one negotiated price set to clear the market for a given stock. B)Securities exchanges may be structured as call markets or continuous markets. C)In continuous markets, prices are set only by the auction process [Explanation: (C) In continuous markets, the price is set by either the auction process or by dealer bid-ask quotes] 45. Which of the following statements about securities exchanges is most accurate? A)Call markets are markets in which the stock is only traded at specific times. B)Continuous markets are markets where trades occur 24 hours per day. C)Setting a negotiated price to clear the market is a method used to set the closing price in major continuous markets. [Explanation: (A) Continuous markets are markets where trades occur at any time the market is open (i.e. they do not need to be open 24 hours per day). Setting one negotiated price is a method used in major continuous markets to set the opening price] 46. A unique item such as fine art is most likely to be exchanged in a(n): A)quote-driven market. B)brokered market. C)order-driven market [Explanation: (B) Brokered markets are typically the best market structure for unique items. A broker adds value by locating a counterparty to take the opposite side of a trade of such an item] 47. Which of the following is least likely a characteristic of a well-functioning market? A)Reliable information is available on price and volume. B)Prices adjust quickly when new information becomes available. C)Prices change significantly from one transaction to the next [Explanation: (C) In a well-functioning market, prices should not typically change much from one transaction to the next because many buyers and sellers are willing to trade at prices near the current price. Characteristics of a well-functioning market include availability of reliable information on prices and transaction volume; liquidity (marketability and price continuity); prices that react quickly to new information; and low transactions costs] 48. An objective of financial market regulation is to: A)reduce information gathering costs by requiring common financial reporting standards. B)ensure that inside information is made public in a timely manner. C)prevent uninformed investors from participating in financial markets. [Explanation: (A) One of the objectives of market regulation is to require firms to report their financial performance according to a single set of standards, such as those of the IASB or FASB, thereby reducing market participants’ cost of gathering information. Market regulation is not designed to prevent uninformed investors from trading, but to protect unsophisticated investors and thereby preserve trust in the financial markets. An objective of market regulation is to prevent those with non-public information from profiting at the expense of other investors, but not necessarily to make all inside information public]