MOCKs

Question 1

In what ways is preferred stock like long-term debt? In what ways is it like equity?

Answer 1

Preferred stock is like long-term debt in that it typically promises a fixed payment each year. In this way, it is a perpetuity. Preferred stock is also like long-term debt in that it does not give the holder voting rights in the firm. Preferred stock is like equity in that the firm is under no contractual obligation to make the preferred stock dividend payments (failure to make payments does not set off corporate bankruptcy). With respect to the priority of claims to the assets of the firm in the event of corporate bankruptcy, preferred stock has a higher priority than common equity but a lower priority than bonds.

Question 2

Explain the difference between limit orders and market orders.

Answer 2

A limit order is a buy order with a maximum price or a sell order with a minimum price. A market order is a limit order with an infinite maximum price or zero minimum price, which will guarantee execution if there are orders waiting in the limit order market.

Question 3

Explain the difference between limit orders and stop-loss and stop-buy orders.

Answer 3

A special class of orders are the contingent orders where the buy order has a minimum price and the sell order has a maximum price—i.e., you sell once the price has gone through a lower barrier (stop loss) or you buy once the price has gone through an upper barrier (stop buy).

Question 4

By means of example, explain when an investor may find it useful to send a stop buy order.

Answer 4

If you have a large short position and you wish to protect the existing profit, you may be giving a stop buy order (the buy order comes into effect if the stock price goes above a certain limit).

Question 5

Discuss SEC Rule 415 (on shelf registration).

Answer 5

Thanks to Rule 415, the securities are “on the shelf,” ready to be issued, for two years after initial registration. Because the securities are already registered, they can be sold on short notice with little additional paperwork. Securities can be sold in small amounts.

Question 6

What is the short-swing rule in SEC Section 16(b) about?

Answer 6

Consider a situation in which officers or directors of the issuer of a security are trading such security. The short-swing rule forces them to give up profits from reversals if undertaken within six months from the first trade.

Question 7

Discuss the relationship between the Futures price and the Spot price of a consumption asset that provides no income but can be subject to significant storage costs.

Answer 7

F0≤(S0+U)erT, where U is the present value of the storage costs.

Question 8

Derive the pricing equation for futures on currencies.

Answer 8

…

Question 9

What is the put-call parity? Derive the put-call parity equation (Hint: explain why a fund manager can obtain a putprotected
portfolio insurance strategy by making a risk free investment and investing in call options).

Answer 9

C + X / (1 + rf)T = S0 + P

If the one above does not hold, arbitrage is possible.

Question 10

List at least four major differences between forward contracts and future contracts.

Answer 10

1 Forward
Futures
1 Private contract between two parties
Traded on an exchange
1 Not standardized
Standardized
1 Usually one specified delivery date
Range of delivery dates
1 Settled at end of contract
Settled daily
1 Delivery or final settlement usual
Usually closed out prior to maturity
1 Some credit risk
Virtually no credit risk

Question 11

With respect to other money market instruments, in what sense is the T-bill atypical?

Answer 11

Different from other money market instruments, the T-bill normally sells in low denominations of US$ 10,000 (thus, also individuals can trade it).

Question 12

What is a Consol?

Answer 12

Consol bonds are a perpetual loan that pays a coupon rate forever.

Question 13

What is a convertible bond?

Answer 13

A convertible bond is a bond that can be converted into a predetermined amount of the company’s equity at certain times during its life, usually at the discretion of the bondholder.

Question 14

What is a putable bond?

Answer 14

A putable bond allows the holder to sell the bond back to the company prior to maturity.

Question 15

Consider the single-auction model in Kyle (1985). In equilibrium, the strategy of the informed investor is linear in the information set. What does it mean?

Answer 15

In the single-auction Kyle model, in equilibrium the quantity traded is a linear function of the asset’s liquidation value. Specifically, the insider trades:

Question 16

The objective of the insider in Kyle (1985) is the maximization of the expected profits. What is causing uncertainty in the insider’s decision problem?

Answer 16

The insider is not sure about the price at which the order is executed. In equilibrium, the insider knows how the price responds to a certain aggregate flow of orders or another. Yet, the insider does not know the realization of the noise traders’ demand. This generate uncertainty.

Question 17

Define the following interest rates on a financial product: i) Nominal rate; ii) periodic rate, iii) and effective annual rate.

Answer 17

Nominal rate: an annual rate that ignores compounding effects. Periodic rate: amount of interest charged each period, e.g. monthly, quarterly. Effective annual rate (EAR): the annual rate of interest actually being earned, accounting for compounding. EAR= [1 + (Nominal rate)/M ] M – 1, where M is the number of periods in one year.

Question 18

Why are money market securities sometimes referred to as “cash equivalents”?

Answer 18

Money market securities are called “cash equivalents” because of their great liquidity. The prices of money market securities are very stable, and they can be converted to cash (i.e., sold) on very short notice and with very low transaction costs.

Question 19

With reference to IPOs, what is a book?

Answer 19

Large investors communicate their interest in purchasing shares of the IPO to the underwriters. These indications of interest are called a book. The book provides valuable information to the issuing firm.

Question 20

With reference to the Tokyo Stock Exchange, what is the role of a saitori?

Answer 20

A saitori maintains a public limit-order book and matches market and limit orders. Saitori are similar to specialists on the NYSE, but do not trade for their own accounts. If order imbalances would result in extreme price movements, the saitori may halt trading and advertise the imbalance (in the hope of attracting trading interest to the “weak” side of the market).

Question 21

Briefly discuss the Grossman-Stiglitz paradox

Answer 21

The argument by Grossman and Stiglitz is as follows: If the market is strong-form efficient and all information is reflected in the price, then no one has an incentive to expend resources to gather information and trade on it. How, then can all information be reflected in the price? Markets cannot be strong-form informationally efficient, since agents who collect costly information have to be compensated with trading profits.

Question 22

How is a round-trip transaction cost generally defined?

Answer 22

A round-trip transaction cost is generally referred to as the sum of all direct and indirect expenses to complete a transaction, including commissions and market impact.

Question 23

The model by Kyle (1985) is an example of batch arrival model, whereas the model by Glosten and Milgrom (1985) is an example of single arrival model. What is the key difference between batch arrival models and single arrival models?

Answer 23

In “single arrival” models, where market orders from individuals arrive at the market center individually, and the terms of trade can change for each arriving market order. Alternatively, in “batch arrival” models, as in Kyle (1985), market orders are aggregated, and the net order flow arrives at the market center.

Question 24

Explain what we mean by money and bond market instruments, and what
distinguishes the two types of financial securities. Name an example of each.

Answer 24

Both types of instruments
are fixed claims – which means that they specify exactly what the cash flow is or how the cash
flows are worked out depending on specific key variables. They differ mainly in two respects:
money market instruments tend to be of larger denominations and shorter maturity than bond
market instruments. This is significant in the sense that the users of the money market
instruments must be able to place large amounts of money on short term loans/deposits –
typically corporations or financing houses or banks. The short maturity means also that the
default risk is typically low so often we find large corporations issuing money market instruments
to raise short term capital on interest rates that are nearly risk free.

Question 25

The shareholders of a company are normally seen as the ‘owners’ of the company.
Explain why, even if there are many other stakeholders such as debt holders and employees who also receive a share of the company’s cash flow, we pick out this
particular group as the firm’s owners. Also, discuss how the equity holders in practice can exert influence over the running of the company

Answer 25

a link between the residual nature of the equity claim and the fact
that this makes the claim the closest to what we mean by ‘ownership’: that you can do what you
like as long as you honour your fixed commitments. In practice, however, the shareholders have
little direct influence over how the company is run. The shareholders get to vote on major
decisions at annual or extraordinary general meetings, and they get to vote on who should
represent the shareholders at the board of directors. The company is effectively run by the CEO
and the management team, under the scrutiny of the board.