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Unformatted text preview: CHAPTER 3: HOW SECURITIES ARE TRADED PROBLEM SETS 1. Answers to this problem will vary. 2. The dealer sets the bid and asked price. Spreads should be higher on inactively traded stocks and lower on actively traded stocks. 3. a.In principle, potential losses are unbounded, growing directly with increases in the price of IBM. b. If the stop-buy order can be filled at $128, the maximum possible loss per share is $8, or $800 total. If the price of IBM shares goes above $128, then the stop-buy order would be executed, limiting the losses from the short sale. 4. (a) A market order is an order to execute the trade immediately at the best possible price. The emphasis in a market order is the speed of execution (the reduction of execution uncertainty). The disadvantage of a market order is that the price it will be executed at is not known ahead of time; it thus has price uncertainty. 5. (a) The advantage of an Electronic Crossing Network (ECN) is that it can execute large block orders without affecting the public quote. Since this security is illiquid, large block orders are less likely to occur and thus it would not likely trade through an ECN. Electronic Limit-Order Markets (ELOM) transact securities with high trading volume. This illiquid security is unlikely to be traded on an ELOM. 6. 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. 3-1 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% 7. 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% So there will be a margin call....
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This note was uploaded on 03/23/2011 for the course FIN 301 taught by Professor 3213 during the Three '11 term at Curtin.

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