CHAPTER3:HOWSECURITIESARETRADED

1. a.

Inadditiontotheexplicitfeesof$70,000,FBNappearstohavepaidanimplicit
priceinunderpricingoftheIPO.Theunderpricingis$3/shareor$300,000total,
implyingtotalcostsof$370,000.

b.

No.Theunderwritersdonotcapturethepartofthecostscorrespondingtothe
underpricing.Theunderpricingmaybearationalmarketingstrategy.Without
it,theunderwriterswouldneedtospendmoreresourcestoplacetheissuewith
thepublic.Theywouldthenneedtochargehigherexplicitfeestotheissuing
firm.Theissuingfirmmaybejustaswelloffpayingtheimplicitissuancecost
representedbytheunderpricing.

2. a.

Inprinciple,potentiallossesareunbounded,growingdirectlywithincreasesin
thepriceofIBX

Ifthestopbuyordercanbefilledat$78,themaximumpossiblelosspershareis
$8.IfIBXsharesgoabove$78,thestopbuyorderisexecuted,limitingthe
lossesfromtheshortsale.

3.

b.

a. Thestockispurchasedfor300$40=$12,000.Borrowedfundsare$4,000.
Therefore,theinvestorputupequityormarginof$8,000.
b. Ifthesharepricefallsto$30,thevalueofthestockfallsto$9,000.Theamount
oftheloanowedtothebrokergrowsto$4,0001.08=$4,320.Therefore,
remainingmarginis9,0004,320=$4,680.
Thepercentagemarginisnow4,680/9,000=.52,sotherewillnotbeamargin
call.
c. Therateofreturnoninvestmentovertheyearsis(Endingvalueofaccount
initialequity)/Initialequity=(4,6808,000)/8,000=.415=41.5%.

4.

a. Theinitialmarginwas.501,000$40=$20,000.Thefirmloses$101,000
=$10,000duetotheincreaseinthestockpricesomarginfallsby$10,000.
Moreover,thefirmmustpaythedividendof$2pershare,whichmeansthe
marginaccountfallsbyanadditional$2,000.Soremainingmarginis$8,000

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b. Thepercentagemarginis$8,000/$50,000=.16,sotherewillbeamargincall.
c. Themarginintheaccountfellfrom$20,000to$8,000inoneyear,forarateof
returnof$12,000/$20,000=.60=60%.
5.

Thestoplossorderwillbeexecutedassoonasthestockpricehitsthelimit
price.Ifthestockpricelaterrebounds,theinvestordoesnotparticipateinthe
gainsbecausethestockhasbeensold.Incontrast,theputoptionneednotbe
exercisedwhenthestockpricefallsbelowtheexerciseprice.Aninvestorwho
ownsashareofstockandaputoptioncanholdontobothsecurities.Ifthestock
priceneverrebounds,theputcanbeexercisedeventually,andthestocksoldfor
theexerciseprice.Thisprovidesthesamedownsideprotectionasthestoploss
order.Ifthepricedoesrebound,however,theinvestorbenefitsbecausethestock
isstillheld.Thisadvantageoftheputoverthestoplossorderjustifiesthecost
oftheput.

6.

Callsareoptionstopurchaseastockatanytimepriortoexpiration.Stopbuys
requirepurchaseassoonasthestockpricehitsthelimit.Theadvantageofthecall
overthestopbuyisthattheinvestorneednotcommittobuyinguntilexpiration.
Ifthestockpricelaterfalls,theholderofthecallcanchoosenottopurchase.

7.

ThebrokeristoattempttosellMarriottassoonasasaletakesplaceatapriceof
$38orless.Here,thebrokerwillattempttoexecuteifasaletakesplaceatthe
bidprice,butmaynotbeabletosellat$38,sincethebidpriceisnow$37.80.

8.

Muchofwhatthespecialistdoescrossingordersandmaintainingthelimitorder
bookcanbeaccomplishedbyacomputerizedsystem.Infact,someexchangesuse
anautomatedsystemfornighttrading.Amoredifficultissueiswhetherthemore
discretionaryactivitiesofspecialiststhatinvolvetradingfortheirownaccounts,such
asmaintaininganorderlymarket,canbereplicatedbyacomputersystem.

9. a.

Thebuyorderwillbefilledatthebestlimitsellorder,$50.25.

b.

Atthenextbestprice,$51.50.

c.

Youshouldincreaseyourposition.Thereisconsiderablebuypressureatpricesjust
below$50,meaningthatdownsideriskislimited.Incontrast,sellpressureis
sparse,meaningthatamoderatebuyordercouldresultinasubstantialprice
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increase.

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10.

Thesystemexpeditestheflowofordersfromexchangememberstothespecialists.
Itallowsmemberstosendcomputerizedordersdirectlytothefloorofthe
exchange,whichallowsthenearlysimultaneoussaleofeachstockinalarge
portfolio.Thiscapabilityisnecessaryforprogramtrading.

11.

Thedealer.Spreadsshouldbehigheroninactivestocksandloweronactivestocks.

12.

Overshortperiodsoftime,membershippricegenerallyincreasesalongwithtrading
volume.Thismakessense,sincetradingcommissionsdependontradingvolume.

13.

Costofpurchaseis$40500=$20,000.Youborrow$5,000fromyourbroker,
andinvest$15,000ofyourownfunds.Yourmarginaccountstartsoutwithanet
worthof$15,000.
a. (i)

Networthrisesby$2,000from$15,000to$44500$5,000=$17,000.
Percentagegain=$2,000/$15,000=.1333=13.33%

(ii)

Withunchangedprice,networthremainsunchanged.
Percentagegain=zero

(iii) Networthfallsto$36500$5,000=$13,000.
Percentagegain==.1333=13.33%
Therelationshipbetweenthepercentagechangeinthepriceofthestockandthe
investorspercentagegainisgivenby:
%gain=%changeinprice=%changeinprice1.333
Forexample,whenthestockpricerisesfrom40to44,thepercentagechangein
priceis10%,whilethepercentagegainfortheinvestoris1.333timesaslarge,
13.33%:
%gain=10%=13.33%
b. Thevalueofthe500sharesis500P.Equityis500P5000.Youwillreceivea
margincallwhen:

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=.25orwhenP=$13.33.
c. Thevalueofthe500sharesis500P.Butnowyouhaveborrowed$10,000
insteadof$5,000.Therefore,equityisonly500P$10,000.Youwillreceivea
margincallwhen
=.25orwhenP=$26.67.
Withlessequityintheaccount,youarefarmorevulnerabletoamargincall.
d. Themarginloanwithaccumulatedinterestafteroneyearis$5,0001.08=
$5,400.Therefore,equityinyouraccountis500P$5,400.Initialequitywas
$15,000.Therefore,yourrateofreturnafteroneyearisasfollows:
(i)

=.1067,or10.67%.

(ii) =.0267,or2.67%.
(iii) =.160,or16.0%.
TherelationshipbetweenthepercentagechangeinthepriceofInteland
investorspercentagereturnisgivenby:
%gain=8%
Forexample,whenthestockpricerisesfrom40to44,thepercentagechangein
priceis10%,whilethepercentagegainfortheinvestoris
10%8%=10.67%
e. Thevalueofthe500sharesis500P.Equityis500P5,400.Youwillreceivea
margincallwhen
=.25orwhenP=$14.40
14.

a. Thegainorlossontheshortpositionis500P.Investedfundsare$15,000.
Therefore,rateofreturn=(500P)/15,000.Thereturnsineachofthethree
scenariosare:
(i)

rateofreturn=(500)/15,000=.1333=13.33%
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(ii) rateofreturn=(5000)/15,000=0
(iii) rateofreturn=[500(4)]/15,000=+.1333=+13.33%
b. Totalassetsinthemarginaccountare$20,000(fromthesaleofthestock)+
$15,000(theinitialmargin)=$35,000;liabilitiesare500P.Amargincallwillbe
issuedwhen
=.25,orwhenP=$56.
c. Witha$1dividend,theshortpositionmustalsopay$1/share500shares=
$500ontheborrowedshares.Rateofreturnwillbe(500P500)/15,000.

(i)

rateofreturn=(5004500)/15,000=.167=16.7%

(ii) rateofreturn=(5000500)/15,000=.033=3.33%
(iii) rateofreturn=[500(4)500]/15,000=+.100=+10.0%
Totalassets(netofthedividendrepayment)are$35,000500,andliabilitiesare
500P.Amargincallwillbeissuedwhen
=.25,orwhenP=$55.20.
15.

a. $55.50
b. $55.25
c. Thetradewillnotbeexecutedsincethebidpriceislessthanthepriceonthelimit
sellorder.
d. Thetradewillnotbeexecutedsincetheaskedpriceisgreaterthanthepriceonthe
limitbuyorder.

16.

a. Therecanbepriceimprovementforthetwomarketorders.Brokersforeachof
themarketorders(i.e.,thebuyandthesellorders)canagreetoatradeinsidethe
quotedspread.Forexample,theycantradeat$55.38,thusimprovingtheprice
forbothcustomersrelativetothequotedbidandaskedprices.Thebuyergetsthe
stockfor$.12lessthanthequotedaskedprice,andthesellerreceives$.13more
forthestockthanthequotedbidprice.
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b. Whereasthelimitbuyorderat$55.38wouldnotbeexecutedinadealermarket
(sincetheaskedpriceis$55.50),itcouldbeexecutedinanexchangemarket.A
brokerforanothercustomerwithanordertosellatmarketwouldviewthelimit
buyorderasthebestbidprice;thetwobrokerscouldagreetothetradeandbringit
tothespecialist,whowouldexecutethetrade.
17. a. Youbuy400sharesofAT&T.Thesesharesincreaseinvalueby10%,or$1000.
Youpayinterestof.085,000=$400.Therateofreturnwillbe
=.12,or12%.
b. Thevalueofthe400sharesis400P.Equityis400P5000.Youwillreceivea
margincallwhen
=.30orwhenP=$17.86.
18. a. Youwillnotreceiveamargincall.Youborrowed$20,000andwithanother
$20,000ofyourownequityyoubought1,000sharesofDisneyat$40ashare.At
$35asharethemarketvalueofthestockis$35,000,yourequityis$15,000,andthe
percentagemarginis15,000/35,000=43%,whichisabovetherequiredmaintenance
margin.
b. Amargincallwillbeissuedwhen
=.35,orwhenP=$30.77.
19. a. Initialmarginis50%of$2,500or$1,250.
b. Totalassetsare$3,750,andliabilitiesare100P.Amargincallwillbeissuedwhen
=.30,orwhenP=$28.85.
20.

Theproceedsfromtheshortsale(netofcommission)were$14100$50=
$1,350.Adividendpaymentof$200waswithdrawnfromtheaccount.Coverage
at$9costyou(includingcommission)$900+$50=$950,leavingyouwithaprofit
of$1350$200$950=$200.
Notethatyourprofit,$200,equals100sharesprofitpershareof$2.Yournet
proceedspersharewere:
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$14
$9
$2
$1

$2

salespriceofstock
repurchasepriceofstock
dividendpershare
2trades$.50commissionpershareoneachtrade.

22.

(d)Thebrokerwillattempttosellafterthefirsttransactionat$55orless.

23.

(b)

24.

(d)

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