bkmsol_ch03 - CHAPTER 3 HOW SECURITIES ARE TRADED 1 a In...

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CHAPTER 3: HOW SECURITIES ARE TRADED 1. a. In addition to the explicit fees of $70,000, FBN appears to have paid an implicit price in underpricing of the IPO. The underpricing is $3 per share, or a total of $300,000, implying total costs of $370,000. b. No. The underwriters do not capture the part of the costs corresponding to the underpricing. The underpricing may be a rational marketing strategy. Without it, the underwriters would need to spend more resources in order to place the issue with the public. The underwriters would then need to charge higher explicit fees to the issuing firm. The issuing firm may be just as well off paying the implicit issuance cost represented by the underpricing. 2. a. In principle, potential losses are unbounded, growing directly with increases in the price of IBX. b. If the stop-buy order can be filled at $78, the maximum possible loss per share is $8. If the price of IBX shares goes above $78, then the stop-buy order would be executed, limiting the losses from the short sale. 3. a. The stock is purchased for: (300 × $40) = $12,000 The amount borrowed is $4,000. Therefore, the investor put up equity, or margin, of $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: ($4,000 × 1.08) = $4,320. Therefore, the remaining margin in the investor’s account is: ($9,000 - $4,320) = $4,680. The percentage margin is now: ($4,680/$9,000) = 0.52 = 52%. Therefore, the investor will not receive a margin call. c. The rate of return on the investment over the year is: (Ending equity in the account - Initial equity)/Initial equity = ($4,680 - $8,000)/$8,000 = - 0.415 = - 41.5% 3-1
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4. a. The initial margin was: (0.50 × 1,000 × $40) = $20,000 As a result of the increase in the stock price, Old Economy Traders loses: ($10 × 1,000) = $10,000. Therefore, margin decreases by $10,000. Moreover, Old Economy Traders must pay the dividend of $2 per share to the lender of the shares, so that the margin in the account decreases by an additional $2,000. Therefore, the remaining margin is: ($20,000 - $10,000 - $2,000) = $8,000 b. The percentage margin is: ($8,000/$50,000) = 0.16 = 16% Therefore, there will be a margin call. c. The rate of return on the investment is: (Ending equity in the account - Initial equity)/Initial equity = ($8,000 - $20,000)/$20,000 = - 0.60 = - 60.0% 5. The stop-loss order will be executed once the stock price decreases to the limit price. If the stock price later rebounds, the investor does not participate in the gains because the investor no longer owns the stock. In contrast, the put option need not be exercised when the stock price falls below the exercise price. An investor who owns a share of stock and a put option can hold on to both securities. If the stock price never rebounds, the investor can eventually exercise the put by selling the stock for the exercise price. This provides the same downside protection as the
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This note was uploaded on 03/10/2011 for the course FMIS 3601 taught by Professor Vizanko during the Spring '08 term at University of Minnesota Duluth.

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bkmsol_ch03 - CHAPTER 3 HOW SECURITIES ARE TRADED 1 a In...

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