Module 1-4

Question 1

Discuss the three components of an investor’s required rate of return on an investment.

Answer 1

Time factor, inflation factor and risk factor

Question 2

Discuss the two major factors that determine the market nominal risk-free rate (NRFR). Explain which of these factors would be more volatile over the business cycle.

Answer 2

Real growth rate of the economy and the expected rate of inflation.

Question 3

Briefly discuss the five fundamental factors that influence the risk premium of an investment.

Answer 3

Business risk, financial risk, liquidity risk, exchange rate risk and country risk

Question 4

Define market and briefly discuss the characteristics of a good market.

Answer 4

It is not necessary for the market to have a physical location. The market does not necessarily own the goods or services
involved. A market can deal in any variety of goods and services. Both buyers and sellers benefit from the existence of a
market.

Question 5

Secondary markets are important because

Answer 5

The prevailing market price of securities is determined in the secondary market

Question 6

Define liquidity and discuss the factors that contribute to it. Give examples of a liquid asset and an illiquid asset

Answer 6

Liquidity is the ability to sell an asset quickly at a price not substantially different from the current market assuming no new information is available. A share of BHP Billiton is very liquid, while an antique would be a fairly illiquid asset

Question 7

Define market order

Answer 7

A market order is an order to buy/sell a stock at the most profitable ask/bid prices prevailing at the time the order hits the exchange floor. A market order implies the investor wants the transaction completed quickly at the prevailing price.

Question 8

Define limit order

Answer 8

A limit order specifies a maximum price that the individual will pay to purchase the stock or the minimum he will accept to sell it.

Question 9

Define short sale

Answer 9

A short sale is the sale of stock that is not currently owned by the seller with the intent of purchasing it later at a lower price. This is done by borrowing the stock from another investor through a broker

Question 10

Define stop loss order

Answer 10

A stop-loss order is a conditional order whereby the investor indicates that he wants to sell the stock if the price drops to a specified price, thus protecting himself from a large and rapid decline in price.

Question 11

Define dark pools

Answer 11

Orders put into a dark pool are not displayed to other market participants in order to reduce information leakage and minimize market impact costs and are sold to anonymous buyers.

Question 12

Define broker/dealer internalisation

Answer 12

Internalization is when retail broker/dealers internally transact an order by buying or selling the stock against their own account on a consistent basis. Put another way, the firm is the counterparty to all transactions and uses its own capital.

Question 13

Define high frequency traders

Answer 13

HFTs are professionals and institutions who used AT to
create programs that traded thousands of times a day for small profits. They bring significant liquidity to the market, smaller bid-ask spreads, and substantially lower transaction costs

Question 14

Define algorithmic trading

Answer 14

Algorithmic trading is basically creating computer programs
to make trading decisions.

Question 15

Define and discuss the strong-form EMH.

Answer 15

The strong-form efficient market hypothesis asserts that stock prices fully reflect all information, whether public or private. It goes beyond the semistrong-form because it requires that no group of investors ha ve
a monopolistic access to any information.

Question 16

Describe the general goal of behavioural finance

Answer 16

Behavioral finance deals with individual investor psychology and how it affects individuals’ actions as
investors, analysts, and portfolio managers. The goal of behavioral finance is to understand how psychological decisions affect markets and to be able to predict those effects.

Question 17

Technicians contend that stock prices move in trends that persist for long periods of time. What do technicians believe happens in the real world to cause these trends.

Answer 17

Technicians expect trends in stock price behaviour because they believe that new information that causes a change in the relationship between supply and demand does not come to the market at one point in time

Question 18

Technical analysts believe that one can use past price changes to predict future price changes. How do they justify this belief?

Answer 18

The principal contention of technicians is that stock prices move in trends that persist for long periods of time. Because these trends persist they can be detected by analysing past prices.

Question 19

Briefly discuss the problems related to fundamental analysis that are considered advantages for technical analysis.

Answer 19

The problems encountered when doing a fundamental analysis of financial statements are: (1) much of the information in financial statements is not useful; (2) there are comparability problems for firms using alternative accounting practices; and (3) there are important psychological factors not included in financial statements. Also, with technical analysis it is not necessary to invest until the move to a new equilibrium begins

Question 20

Discuss some disadvantages of technical analysis.

Answer 20

past price patterns may not be repeated in the future;
(2) the intense competition of those using the trading rules will render the technique useless; (3) the trading rules require a great deal of subjective judgment; and (4) the values that signal action are constantly changing.