Selasa, 11 Januari 2011

Contoh Soal Analisis Investasi dan Portofolio


Chapter 12
Efficient Markets

Multiple Choice Questions


                The Concept of An Efficient Market

1.                   The central issue of efficient markets concerns:

a.                   regulations
b.                   information
c.                    participants
d.                   structure

(b, easy)

2.                   An efficient market is defined as one in which:

a.                   all participants have the same opportunity to make the make the same returns.
b.                   all participants have the same legal rights and transactions costs.
c.                    securities’ prices quickly and fully reflect all available information.
d.                   securities’ prices are completely in line with the intrinsic value.

(c, easy)

3.                   All “known” information means:

a.                   past information only.
b.                   past and current information.
c.                    past, current, and inferred information.
d.                   past, current, inferred and relative information.

(c, moderate)

4.                   What is the result of the widespread usage of the Internet with regards to efficient markets?

a.                   It makes information cheaper and more accessible thus making markets more efficient.
b.                   It is subject to new regulation thus marking markets less efficient.
c.                    It increases the volatility of security prices thus making markets less efficient.
d.                   It increases competition among brokers thus making markets more efficient.

(a, moderate)
5.                    If a market is inefficient, as new information is received about a security:

a.                   nothing will happen.
b.                   the stock price will fall at first and then later rise.
c.                    there will be a lag in the adjustment of the stock price
d.                   there will be negative demand for the stock.

(c, difficult)

6.                   All of the following conditions must occur for a market to be considered efficient except:

a.                   Information is costless and widely available to market participants at approximately the same time.
b.                   Information is generated in a specific fashion such that announcements are basically dependent of each other.
c.                    There are a large number of rational, profit-maximizing investors who actively participate in the market.
d.                   Investors react quickly and fully to the new information, causing stock prices to adjust accordingly.

(b, difficult)

7.                   Tests of the semistrong EMH include:

a.                   regression analysis.
b.                   correlation tests that compare the security returns to the overall market return.
c.                    tests  of the speed of adjustment of stock prices to company announcements.
d.                   queing line theory tests.

(c, difficult)

8.                   An efficient market does not require that:

a.                   stock prices incorporate all information.
b.                   all known information be reflected in prices.
c.                    price adjustments occur very quickly.
d.                   each adjustment be perfect.

(d, easy)

9.             Weak form market efficiency

a.             implies that the expected return on any security is zero.
                b.             incorporates semi-strong form efficiency.     
                c.             involves price and volume information.
                d.             is compatible with technical analysis.

(c, easy)

10.          The highest level of market efficiency is

a.             weak form efficiency.
b.             semi-strong form efficiency.
c.             random walk efficiency.
d.             strong form efficiency.

(d, easy)

11.          The weak form of the EMH is supported if successive price changes over time are

                a.             independent of each other.
                b.             negative.
                c.             positive.
                d.             lagged.

(a, easy)

12.          Select the FALSE statement concerning efficient markets.

                a.             The current price of a stock reflects all known information.
                b.             Investors will use all relevant data in making their decisions.
                c.             A perfect adjustment in price following any new information occurs.
                d.             Following any adjustment, the new price does not have to be the new
                        equilibrium price.(c, difficult)

13.          Which of the following statements is true regarding the efficiency of foreign securities and foreign markets?

a.             Foreign securities tend to be more analyzed than U.S. securities.
b.             Foreign markets tend to be less efficient than U.S. markets.
c.             Foreign markets often lag behind U.S. markets as much as 6 months.
d.             All of the above are true.

(b, moderate)                                                   

How To Test For Market Efficiency

14.          The random walk hypothesis is most related to the:

a.                   weak-form EMH
b.                   semistrong-form EMH
c.                    semiweak-form EMH
d.                   strong-form EMH

(a, moderate)

15.          The overreaction hypothesis tends to:

a.                   support the weak form EMH.
b.                   not support the weak EMH.
c.                    support the semistrong form EMH.
d.                   not support the semistrong form EMH.

(b, difficult)

16.          Stockholders that own more than ____% of a company's stock are considered insiders by the SEC.

a.             10
b.             20
c.             30
d.             40

(a, moderate)

17.          Which of the following is NOT a test of semi-strong form efficiency?

a.             Insider transactions
b.             Stock splits
c.             Accounting changes
d.             Dividend announcements

(a, moderate)

18.          According to the weak form of the EMH,

                a.             successive price changes are biased.
                b.             successive price changes are dependent.
                c.             specified trading rules can prove to be extremely useful in generating
                        excess returns.
                d.             successive price changes are independent.

(d, moderate)

19.          With regard to market efficiency, identify the INCORRECT statement.

                a.             Information is the central issue of the efficient markets concept.
                b.             The most stringent form of market efficiency is the strong form.
                c.             The efficient market concept does not require a perfect adjustment in price
                         following new information.
                d.             Tests of the usefulness of price data are semi-strong form tests.

(d, difficult)

20.          According to the semi-strong form of the EMH, investors who invest in a stock after a highly positive  announcement concerning the stock can expect to earn a(n)

                a.             normal return because the stock will be fairly priced when purchased.
                b.             extraordinary return because the new information will not affect the price
                         until later.
                c.             loss because things often are not what they seem.
                d.             zero return because the next price is expected to be the same as the last
                       price.

(a, moderate)

21.          A lady  bought 100 shares of a leading diamond mining company with an expected return of 20 percent per year.  The following day the company’s president announced a major new discovery in Arkansas.  The stock price immediately doubled.  This scenario probably best illustrates that the

                a.             weak form EMH is not valid.
                b.             semi-strong form of EMH is not valid.
                c.             market prices are random.
                d.             lady was lucky.

(d, moderate)

22.          According to the random walk hypothesis, price(s)

                a.             over time are independent of one another.
                b.             changes over time are independent.
                c.             levels over time are independent.
                d.             changes today are dependent on yesterday’s price changes.

(b, moderate)

23.          Studies cited in the text show that technical trading rules based on price and volume data lead to investment timing decisions that

                a.             consistently outperform the buy-and-hold strategy.
                b.             minimize brokerage costs.
                c.             do not provide excess returns after all brokerage costs are deducted.
                d.             do provide excess returns to most investors who follow the rules faithfully.

(c, moderate)

24.          The “overreaction hypothesis” states that people overreact to unexpected events.  As a result,

a.             “winner” and “loser” portfolios show no difference in performance over a three-year period.
                b.             “winner” portfolios generally outperform the market over a three-year
                         period.
                c.             “loser” portfolios generally continue losing.
                d.             “loser” portfolios tend to outperform the market over a three-year period.

(d, moderate)

25.          Evidence concerning the “overreaction hypothesis” indicates that

                a.             investors sometimes act irrationally.
                b.             investors are consistently risk-averse value maximizers.
                c.             the market is even more efficient than the weak-form EMH proposes.
                d.             most overreactions occur within the first two days of an economic event.

(a, moderate)

26.          Which of the following is frequently used to test the semistrong form of the EMH?

a.             statistical tests of stock-price change independence
b.             tests of specific trading rules that use past price data
c.             event studies
d.             insider returns

(c, moderate)

Behavioral Finance and Market Anomalies

27.          Based on the research related to market anomalies, investors should prefer

a.             low standardized unexpected earnings (SUE) and high P/E ratios.
b.             low SUE, low P/E stocks.
c.             high SUE, low P/E stocks.
d.             high SUE, high P/E stocks.

(c, moderate)

28.          Which of the following is a market anomaly?

 a.            A relationship between money supply growth and stock prices.
 b.            A relationship between P/E ratios and subsequent stock returns.
 c.            Independence of stock price changes.
 d.            Adjustment of stock prices due to accounting changes.

(b, difficult)

29.          The __________ is NOT a market anomaly.

                a.             size effect
                b.             January effect
                c.             earnings announcement anomaly
                d.             accounting changes effect

(d, difficult)

30.          The January effect concerns:
a.             large cap stocks.
                b.             mid-cap stocks.
                c.             small cap stocks.
                d.             foreign stocks. (c, easy)
31.          Which of the following announcements has NOT been involved in a direct test of the semi-strong form of the EMH?
a.             Dividend announcements
                b.             Accounting changes
                c.             Stock splits
                d.             Corporate insiders' actions
(d, moderate)

32.          Which of the following is NOT an example of a market anomaly?
a.             Low P/E ratio stocks
                b.             The size effect
                c.             The Value Line ranking system
                d.             IPOs
(d, moderate)

33.          The disposition effect relates to the fact that:

a.             investors tend to overconfident regarding potential stock prices.
b.             investors often experience regrets about trading decisions.
c.             investors are more likely to sell winners than losers.
d.             investors tend to dispose of stocks at the end of the year.

(c, difficult)

34.          Which of the following is true regarding large-cap and small-cap firms?

a.             Large caps have outperformed small caps in recent years.
b.             Small caps have outperformed large caps in recent years.
c.             Small caps and large caps have earned similar returns in recent years.
d.             Both small caps and large caps have outperformed the market indexes in recent years.

(c, moderate)       

Some Conclusions About Market Efficiency

35.          The paradox of efficient markets is that

                a.             even though markets are efficient overall, there are pockets of
                        inefficiency.
                b.             investors attempting to uncover and use information about security prices
                        help make the market more efficient.
                c.             news about anomalies makes the market less efficient.
                d.             investors make the market less efficient.

(b, difficult)

36.          If an investor searches for patterns in security returns by examining various techniques applied to a set of data, this is known as:

                a.             fundamental analysis.
                b.             technical analysis.
                c.             data mining.
                d.             random-walk theory.

(c, moderate)

True-False Questions


                The Concept of An Efficient Market

 

1.                   In a perfectly efficient market, investors are not able to use available information to earn abnormal returns.

(T, moderate)

2.                   Under the weak form of the EMH, technical analysis that relies on past history of price information is of little or no value.

(T, moderate)

3.                   Efficient markets are characterized by a large number of speculators.

(F, moderate)

4.                   If there is less efficiency in foreign markets than in U.S. markets, there should be higher performance in foreign markets than in U.S. markets.

(T, moderate)

5.             An investor who believes in the strong form of the EMH should be an active investor.

(F, moderate)

How To Test For Market Efficiency

                6.             A dividend announcement effect would be considered a good test of the                                              weak form of the EMH.

(F, moderate)

                7.             Short-lived inefficiencies appearing on a random basis constitute evidence                           of market inefficiencies.

(F, moderate)

8.             Consecutive stock price changes have been shown to be 100 percent     statistically independent of each other. 

(F, easy)

                9.             The evidence obtained on weak-form efficiency casts serious doubts on                                               fundamental analysis.
                                                                                                               
(F, moderate)

10.          Tests of the strong-form EMH include studies of corporate insiders and                 event studies.

(F, moderate)

Behavioral Finance and Market Anomalies

11.          Overall, the low P/E strategy should be viewed as a short run strategy.

(F, easy)

12.          A belief in the size-effect anomaly should encourage investors to buy    large-firm stocks.

(F, easy)
13.          Careful adherence to a low P/E strategy should lead to a well-diversified               portfolio.

(F, difficult)

Short-Answer Questions

The Concept of An Efficient Market

1.             What types of information are considered in each of the three forms of the EMH?

                Answer: Weak form – past price and volume data
                                Semi-strong form – all public information
                                Strong form – all information, public and private

(moderate)

2.             Insider trading is illegal in the U. S.  How is this related to the strong form EMH?

Answer: If the strong form EMH were valid, insider information would                 have no value to investors because the information would be         reflected in current prices.  There would be no need for laws      against insider trading if the strong form EMH were valid

(moderate)

3.             Technical analysis involves identifying historical price and volume patterns in order to predict future price movements.  What does the EMH say about technical analysis?

                Answer: The weak form EMH indicates that all information from past                 prices is reflected in current prices, so that abnormal profits cannot    be earned by studying historical price patterns.

                (moderate)

4.             If securities are fairly priced, then the portfolio manager, it might be argued, has little to do, since searching for undervalued stocks is a losing proposition.  What other activities do money managers perform?

                Answer: Portfolio managers need to (a) diversify the portfolio, (b) set    appropriate risk levels, (c) determine tax consequences for                 investors, and (d) reduce transactions costs consistent with trading          requirements.

                (moderate)

How To Test for Market Efficiency

5.             What forms of the EMH are strongly supported by economic studies?  What is some evidence?

                Answer: Weak form – Price and volume data show little predictive power.
                                Semi-strong form – Announcements of information are reflected in       security prices rapidly.

(moderate).

6.             An oil company’s P/E ratio is 15; its projected EPS is $8; and its price is $120.  Expectations are that a new field will add $1 EPS the next year. If the P/E remains constant, what should happen to the price in an efficient market?  How soon?  Are investors that pay the price after adjustment paying a fair price and are they expected to earn a normal return? 

Answer: The price should jump to $135 immediately.  Investors are paying         a fair price and should earn a normal return.

(difficult)

Behavioral Finance and Market Anomalies              

                7.             What is a market anomaly?  Give examples of several market anomalies.

                Answer: An anomaly is an exception to a rule.  Market anomalies are   exceptions to the efficient market hypothesis.  Several examples               follow:
                                (a) Standardized unexpected earnings (SUE) have a positive    relationship with future returns.
                                (b) Low P/E ratio stocks tend to outperform the market.
                                 (c) Size effect studies shows that small capitalization stocks tend           to earn higher risk-adjusted returns than large companies.
                                 (d) January effect studies have found abnormal returns for small          stocks in the month of January, especially during the first five           days.

(difficult)

Critical Thinking/Essay Questions

1.             Some market scholars talk about tiers of stocks in the markets. A top tier on the NYSE would be the largest, most widely held stocks. Second and third tiers would consist of stocks that are less widely held and followed by fewer analysts.  Is it possible that the market might be more efficient for the top tier and progressively less efficient for the lower tiers?

Answer: Presumably the top tier stocks are more efficient because the more        analysts that track a stock, the more quickly new information will   be assessed and acted upon.  The lower tiers are neglected and                information will not be reflected in their prices as completely and      quickly.

(difficult)

2.             If an astute (or lucky) market analyst were to find a “money machine” system that consistently beat the market, would the system eventually become self-defeating?

Answer: The money machine would eventually become self-defeating as the      market became efficient in the anomaly that caused the money               machine to work.

(moderate)

Problems

1.             Nike Inc. reports first quarter earnings of $2.00 per share.  As an investor using the SUE technique, you had estimated earnings to be $1.50 per share, with a standard error of estimate (SEE) of 0.15.

(a)           Calculate the SUE for Nike.
(b)           Would this stock be a good buy on the basis of this SUE?

(difficult)

Solution:               

(a)           SUE        =  (actual EPS - predicted EPS)/SEE =  ($2.00 - $1.50)/0.15 = 3.33

                (b)           This would be a good buy because stocks with SUEs greater than 3.0 are attractive.

2.             Calculate the SUE for a stock with expected second quarter earnings of $1.00 and actual second quarter earnings of $0.75.  The standardization variable is 0.20.  Is this stock one of interest to investors using the SUE technique?

(difficult)

Solution:

SUE        =  (actual EPS - predicted EPS)/SEE
=  ($0.75 - $1.00)/0.20 = -1.25

The SUE for this stock is too low to justify selling short.

3.             Listed below are the actual returns on two stocks X and Y, and on the market (RM), along with their  systematic risk measures (Betas) relative to the time period, t.

                Stock                      Ri,t %                      RM,t %                      ai                             Beta
                   X                          12.2                        15.5                         0                            0.8
                   Y                            9.7                           6.0                         0                              1.2

(a)           What is the abnormal return for stock X when you consider its systematic risk measure?
(b)           What is the abnormal return for stock Y when you consider its systematic risk measure?

(moderate)

Solution:
               
(a)           Expected Return(X)            =              Ai + Beta (RM,t)
                                                                =              0 + 0.8(15.5)
                                                                =              12.4
Abnormal Return                =              Actual Return - Expected Return
Abnormal Return (X)          =              12.2 - 12.4             =              -0.20
(b)           Abnormal Return (Y)          =              9.7 - [0 + 1.2(6)]   =              2.5 percent

4.             The Auto Company (AC) had expected returns and realized returns for the periods shown below:
Period                     Expected Return                  Actual Return
                1                     15%                                        16%
                2                     15%                                        13%
                3                     15%                                        17%
                4                     15%                                        15%
Calculate the cumulative abnormal return for the four periods.
(moderate)
Solution:
                ARit         =              Rit            -               E(Rit)
                ARAC1     =              16           -               15           =              1 percent
                ARAC2     =              13           -               15           =              -2 percent
                ARAC3     =              17           -               15           =              2 percent
                ARAC4     =              15           -               15           =              0 percent
CARi      =              SARit
                =              1  +  (-2)  +  2  +  0                =              1 percent

                                        

Chapter 13

Analysis of the Economy/Market

Multiple Choice Questions

                Taking a Global Perspective

1.                   The general trend worldwide is to:

a.                   close economies and deregulate industries.
b.                   limit economies and regulate industries.
c.                    open economies and deregulate industries.
d.                   There is no general trend worldwide.
(c, easy)

2.             By 2002, the euro:

                a.             fell against the dollar.
                b.             replaced the dollar as the most important currency.
                c.             gained significantly against the dollar.
                d.             was replaced by the British pound.
(c, easy)

Assessing the Economy

3.             The beginning and ending of a business cycle is also known as a:

a.                   cycle.
b.                   trough.
c.                    peak.
d.                   contraction.
(b, easy)

                4.             On average, contractions since World War II last:

a.                   slightly less than 6 months.
b.                   slightly less than one year.
c.                    slightly less than 18 months.
d.                   slightly less than two years.
(b, moderate)

5.             The National Bureau of Economic Research is:

a.                   a division of the Department of Commerce.
b.                   the largest association of professional economic forecasters.
c.                    a private nonprofit organization.
d.                   a division of the Federal Reserve.
(c, moderate)

6.             Which of the following is not one of the components of GDP?

a.             investment spending
b.             government spending
c.             net exports
d.             financial transactions

(d, moderate)

7.             The largest component of GDP is:

a.             consumption
b.             government spending
c.             net exports
d.             investment spending
(a, easy)

8.        Indexes of general economic activity are considered all except:

a.                   lagging
b.                   emerging
c.                    leading
d.                   coincident
(b, moderate)

9.         Which of the following is considered a lagging indicator?

a.                   duration of unemployment
b.                   stock prices
c.                    money supply
d.                   interest rate spread
(c, moderate)

10.          The federal agency most involved with the money supply and interest rates is

 a.            the Treasury Department
 b.        the  Federal Reserve
 c.        the Department of Commerce
 d.        the U. S. Mint
(b, easy)

11.   Which of the following statements concerning the stock market and the economy is true?

a.                   The stock market generally leads the economy.
b.                   The stock market generally follows the economy.
c.                    The stock market has an inverse relationship with the economy.
d.                   The stock market has little relationship with the economy.
(a, moderate)

12.   One explanation for stock prices leading the economy involves:

a.                   a political change, such as a change in administration.
b.                   investors switching from domestic to international stocks.
c.                    an investor change in the required return.
d.                   insider trading based on nonpublic information.
(c, difficult)

13.   When speculation pushes asset prices to unsustainable highs, this is known as a:

a.                   crash.
b.                   contraction.
c.                    recession.
d.                   bubble.
(d, easy)

14.      Stock investors pay attention to the bond market because:

a.                   it is more stable than the stock market.
b.                   it can provide daily signals whereas stock market data is weekly, monthly or quarterly.
c.                    it is a more accurate measure of overall economic activity.
d.                   it is privy to more government information, especially from the Federal Reserve.
(b, moderate)

15.          Which of the following is included in MZM?

a.             M3
b.             retail money market mutual funds
c.             wholesale money market mutual funds
d.             All are included in MZM.
(b, moderate)

16.          Generally, when interest rates fall, bond prices

                a.             rise.
                b.             fall.
                c.             remain unchanged.
                d.             rise or fall depending on the expected inflation premium.
(a, easy)

17.          An alternative money measure than includes M2, savings deposits, small time deposits and retail money market mutual funds is:

                a.             M3.
                b.             MBM.
                c.             MZM
      d.    L
(c, moderate)

18.          A steepening yield curve indicates:

a.             the economy is accelerating.
                b.             economic activity is slowing down.
                c.             a pending recession.
                d.             rising inflation.
(c, easy)

19.          _______ is a publication that compiles consensus economic forecasts.

a.             The Wall Street Journal's Economic Letter
b.             The Conference Board's Economic Forecast
c.             Blue Chip Economic Indicators
d.             The Kiplinger Letter
(c, moderate)

Understanding The Stock Market

20.          In order to value the market with the P/E model, it is necessary to analyze

a.             earnings forecasts.
                b.             P/E ratios.
                c.             earnings forecasts and P/E ratios.
                d.             earnings forecasts, P/E ratios, and the required rate of returns.
(c, easy)

21.          In the recent past, operating EPS for the S&P 500:

                a.             grew faster than GDP growth.
                b.             grew slower than GDP growth.
                c.             grew the same as GDP growth.
                d.             showed no relationship to GDP.
(a, moderate)

22.          Which of the following market indexes is favored by most institutional investors and money managers?

a.             DJIA
b.             S&P 500
c.             Wilshire 5000
d.             NYSE Index
(b, moderate)

23.          Current stock prices reflect:

                a.             investors' confidence in the current economy.
                b.             investors' confidence in the current administration.
                c.             investors' expectations of the future.
                d.             investors' attitudes about the past market.
(c, moderate)

24.          If someone was to tell you that "the market" was up by two percent, they generally mean that __________ up by two percent.

                a.             the level of a stock price index was
                b.             retail prices of goods went
                c.             productivity was
                d.             costs were
(a, easy)

25.          Which of the following statements regarding the uses of market indicators is FALSE?

                a.             Historical records of market indicators are used to determine unsystematic
                        risk.
                b.             Historical records of market averages are used for gauging market trends.
c.             The historical returns on market indices are used in computing betas.
d.             Market averages and indices are useful to investors in evaluating portfolio performance.
(a, difficult)

26.          Assume that the dividend payout ratio on the S&P 100 will be 40 percent when the rate on long-term government bonds falls to 9 percent.  Investors being more risk averse demand an equity risk premium of eight percent.  If the growth rate of dividends is expected to be 10 percent, what will be the price of the market index if the earnings expectation is $30?

                a.             $384.00                 Solution:    D1      =   0.40($30)  =  $12
                b.             $213.44                                          k     =   0.09  +  0.08  =  0.17
                c.             $266.56                                         P0    =    D1/(k – g)         
                d.             $171.43                                               =   12/(0.17 - 0.10) = $171.43
(d, difficult)          

27.      P/E ratios are generally depressed when interest rates are _____ and inflation is ________.

a.            high; low

b.            low; high
c.             high; high
d.            low: low
(c, moderate)
Making Market Forecasts

28.       Many market participants believe that when the dividend yield on the Standard and Poor's 500 is ____, the market is in for a downward correction.

a.                   above 6 percent
b.                   below 6 percent
c.                    above 3 percent
d.                   below 3 percent
(d, difficult)

29.       The Fed model, which uses the E/P ratio in its calculations, :

a.          is relatively complex.
b.          uses the yield on the 3-month Treasury bill as the risk-free rate.
c.          assumes investors can easily switch between stocks and bonds.
d.          all of the above
(c, difficult)

30.          Which of the following types of yield curves is typically followed by a declining stock market?

a.             an upward-sloping yield curve
b.             a flat yield curve
c.             an inverted yield curve
d.             a skewed yield curve
(c, moderate)

31.          Warren Buffett thinks long-term movements in stock prices are caused by which of the following two economic variables?

a.             interest rates and corporate profits
b.             interest rates and inflation
c.             inflation and unemployment
d.             corporate profits and growth in GDP
(a, difficult)

32.          Which of the following statements regarding market P/E ratios is true?

a.             P/E ratios are higher when interest rates are lower.
b.             P/E ratios are higher when interest rates are higher.
c.             P/E ratios are higher when inflation is higher.
d.             P/E ratios are lower when unemployment is higher.
(a, moderate)

33.          The earnings yield, which is used in the Fed model, is the:

a.             same as the dividend yield.
b.             inverse of the dividend yield.
c.             same as the P/E ratio.
d.             inverse of the P/E ratio.
(d, moderate)

 

True-False Questions


                A Global Perspective

1.                   Despite political, cultural and economic differences, foreign markets are driven by the same factors that drive U.S. markets. (F, moderate)
Assessing The Economy

2.                   The longest peacetime expansion ran from 1991 to 2000.
(T, moderate)

3.                   To value the market, an investor must analyze both corporate earnings and multipliers.
(T, moderate)

4.                   Most analysts today agree that using money as an indicator of future economic activity is extremely inaccurate.
(F, moderate)

5.                   The stock market is a leading indicator of the economy because investors discount future earnings.
(T, moderate)

6.                   The typical business cycle in the United States seems to lead the stock market’s turning point by a few months.
(F, moderate)

7.                   Most investors should keep a watch on the Federal Reserve because of the effect of the money supply on interest rates.
(T, easy)

Understanding the Stock Market

8.                   Most market indexes are designed to measure the entire stock market.
(F, moderate)

9.                   P/E ratios are generally inflated when interest rates and inflation are high.
(F, moderate)

10.                If interest rates rise, the riskless rate of return declines.
(F, moderate)

11.                If the economy is prospering, investors expect corporate earnings to rise.
(T, easy)

12.          When using the P/E valuation model, it is important to remember that the multiplier is more volatile than the earnings component.
(T, moderate)

Making Market Forecasts

13.          Assuming a constant P/E ratio, the growth in stock prices should equal the growth in earnings.
(T, moderate)

14.          According to available evidence, investors lose more by staying in a bear market than by missing a bull market.
(F, moderate)

15.          Stock prices have almost always risen as the business cycle is approaching a trough.
(T, moderate)

16.          Over the past 30 years, the P/E ratio for the S&P 500 Index has ranged from 5 to 50.
(F, moderate)

17.          During periods of restrictive Federal Reserve monetary policy, the stock market usually performs poorly.
(T, moderate)

Short-Answer Questions

Assessing the Economy

1.             Why is the stock market a leading indicator of the economy?  Use the constant-growth dividend discount model in your explanation.
(moderate)

Answer: Stock prices are based on investors’ expectations about the future          and are, therefore, indicators of the future.  The model P0 = D1/(k –               g) shows that the current price depends on future dividends, thus             making market prices a leading indicator of the economy.

2.             Why do stock investors pay attention to the bond market?
(easy)

Answer: The bond market provides daily information about the economy           through interest rates.  This information is useful to stock investors.

Understanding the Stock Market

3.             Is it useful to do a trend analysis of P/E ratios of the S&P 500 Composite Index over time and extrapolate it to project future expected P/Es?
(easy)

                Answer: No.  P/Es vary too much from year to year.

4.             The financial news reports that the market is overvalued at a near record high based on the earnings multiplier.  What does that mean to you?
(moderate)

                Answer: This suggests that prices are increasing faster than earnings, thus             P/E ratios (also called earnings multipliers) are higher than usual.                Some analysts would prepare for the market to fall back to more           “normal” P/E levels, meaning that price declines are in store.                         Others would expect the exuberance to continue.

5.             Use the constant-growth dividend discount model to explain why stock prices have an inverse relationship to interest rates.
(moderate)

Answer: The stock price (P0) based on the model P0 = D1/(k – g) increases              as the required rate of return (k) decreases.

6.             Why is there an inverse relationship between P/Es and dividend yield?
(moderate)

Answer: Price is in the numerator on P/Es and in the denominator in      dividend yield.  Dividends are paid from earnings, which links the                 other variable in each ratio.

Making Market Forecasts

7.             Explain how dividend yield on the S&P 500 Index can be used to make market forecasts.
(moderate)

                Answer: When dividend yield drops below three percent, the market is   expected to fall in the near future.  Investors will sell stocks and             seek higher yielding bonds, causing prices to adjust.

Critical Thinking/Essay Questions

1.             How does the increased globalization of business and finance affect business cycles and the leading, lagging, and coincident economic indicators?
(difficult)

Answer: It may be that economic cycles may be more attuned to global               economics instead of domestic economics.  Likewise, traditional            domestic economic indicators may lose some of their effectiveness        as global business exercises more influence over the domestic   economy.

2.             What are the implications of the article “Overcoming the Bear Market Blues” for investors?
(moderate)

                Answer: Two  points emerge:  The first is that the investor is better off in               the market than out of the market waiting for the right time to          invest, because  one has more to lose by missing the bull markets            than by avoiding the bear markets.  The second point is that   depressed markets are the best time to buy, so investors should               overcome their emotional inclination to sell when the market is down.
Problems

1.             Assume that the dividends to be paid on a particular market index next period are $20.  Investors require 15 percent to invest in stocks, and expect dividends to grow at 10 percent per year.  What is the value of this index?
(moderate)

Solution:                P0            =              D1/(k – g)               =              20/(0.15 – 0.10)   =              $400

2.             Value Line's estimated dividends on its Industrial Composite for 199X are $2.00 while estimated earnings are $4.30.  The expected spread between k and g is .04.

(a)           What is the P/E ratio?
(b)           What is the estimated price for this Index?
(moderate)

Solution:                (a)           P/E          =              (D1/E1)/(k – g)       =              (2.00/4.30)/(0.04)                                =              11.63

                                (b)           P              =              (P/E)(EPS)             =              (11.63)(4.30)                        =              $50

3.             The earnings per share on a composite stock index this past year was $3.25.  The earnings are expected to grow at a constant rate of 7 percent forever.  The dividend payout ratio is expected to continue at its current rate of 35 percent and the dividend yield is expected to be 4 percent.  Calculate the intrinsic value of the composite stock index.
(moderate)
Solution:                D1            =              D0(1 + g)               
                                                =              (D0/E0)(E0)(1 + g)
=              (0.35)(3.25)(1.07)                =              $1.22

                                D1/P0       =              Dividend Yield
                                1.22/P0   =              0.04
                                P0            =              $30.50
Expected price  =  36.45(20)  =  729
Chapter 15
Analysis of Companies
Multiple Choice Questions
Overview

1.              The last step in fundamental analysis is:

                 a.            economic analysis
                b.             industry analysis
                c.             company analysis
d.             technical analysis
(c, easy)
Fundamental Analysis

2.             Which of the following is not one of the relative valuation multipliers used in fundamental analysis?
a.             P/E ratio
b.             P/S ratio
c.             P/M ratio
d.             P/B ratio
(c, easy)

3.             When analyzing stocks, the major variable of interest to a majority of investors is:

a.             sales.
b.             profit margins.
c.             dividend yield.
d.             earnings per share.
(d, moderate)
The Accounting Aspects of Earnings

4.             EPS are of higher quality if:

a.              the company is a blue chip.
b.              the auditor's reputation is high.
c.              they were derived using conservative principles.
d.              FASB has approved them.
(c, moderate)

5.              Which of the following are shown on the balance sheet on a cost or market value?

a.             cash
b.             stockholders’ equity
c.             marketable securities
d.             fixed assets
(d, moderate)

6.             Which of the following statements regarding retained earnings is not true?

a.             It is part of stockholders’ equity.
                 b.            It represents spendable funds for a company.
c.             It designates that part of previous earnings not paid out as dividends.
d.             All of the above statements are true.
(b, moderate)
7.      The auditor's report:
a.             guarantees accuracy.
b.             guarantees the quality of the earnings.
c.             attests that the statements are a fair presentation of financial position.
d.             all of the above are true……(c, moderate)
8.             Which of the following terms best describes the shareholder's equity item of the balance sheet?
a.             Book value
                b.             Market value
                c.             Current value
                d.             Stock value
(a, moderate)

9.             In which of the following sections of a balance sheet are "Inventories" listed?
a.             Current assets
                b.             Property, plant and equipment, at cost
                c.             Current liabilities
                d.             Shareholders' Equity
(a, easy)

10.          How is EPS computed?  After-tax net income divided by

a.             current common shares outstanding.
b.             previous years common shares outstanding.
c.              treasury shares outstanding.
d.             average common shares outstanding.
 (d, moderate)

11.          The generally accepted accounting principles (GAAP) require that the EPS be calculated using a
a.             conservative treatment.
                b.             liberal treatment.
                c.             standard set of rules developed by the accounting profession.
                d.             standard set of rules developed by the SEC.
(c, easy)

12.          The key item for investors on the income statement is:
a.             sales.
b.             gross profit.
c.             operating expenses.
d.             after-tax net income.
(d, moderate)

13.          Earnings derived under GAAP and shown on the income statement is known as:
a.             reported earnings.
b.             certified earnings.
c.             audited earnings.
d.             verified earnings.
(a, moderate)

14.          Which of the following is not one of the parts of the cashflow statement?
a.             cashflow from operating activities.
                b.             cashflow from sales activities.
                c.             cashflow from investing activities.
e.              cashflow from financing activities.
(b, moderate)

15.          Which of the following mandated that companies, starting in 2004, must submit an annual report to the SEC outlining the effectiveness of their internal accounting controls?
a.             SEC Amendments Act
b.             SIPC
c.             Glass-Stegall Act
d.             Sarbanes-Oxley Act
(d, easy)
16.          Which of the following represents the rate at which a company can grow from internal sources?
a.             return on assets
b.             sustainable growth rate
c.             adjusted EPS
d.             return on equity
(b, moderate)

17.          Which statement about the quality of reported EPS is FALSE?
a.             Earnings quality assessments are difficult to make and require considerable expertise in accounting and financial analysis.
                b.             Reported EPS is not the precise figure that it first appears to be.
                c.             It is necessary to make adjustments to reported EPS figures when
                 making cross-sectional comparisons.      
                d.             Quality of earnings is generally consistent among companies in the same
                                 industry.
(d, difficult)
Analyzing a Company’s Profitability

18.          One way to calculate EPS is:
a.             ROA x Book value per share.
b.             ROE x Book value per share.
c.             ROA/ Book value per share.
d.             ROE/ Book value per share.
(b, moderate)

19.          The two components of EPS are
a.             ROA and leverage.
                b.             book value per share and leverage.
                c.             ROE and book value per share.
                d.             leverage and profit margin.
(c, difficult)

20.          The two components of ROE are
a.             ROA and book value per share.
b.             ROA and leverage.
c.             ROA and profit margin.
d.             leverage and book value.
(b, moderate)

21.          ROA is the product of
a.             net income margin and turnover.
b.             book value and turnover.
                c.             leverage and book value.
                d.             net income margin and leverage.
(a, moderate)

22.          Which of the following statements is true?
a.             Turnover is not related to ROA.
                b.             Leverage affects EPS.
                c.             ROA is a function of turnover and leverage.
                d.             EPS is solely a function of ROE
(b, difficult)

23.          The sustainable growth rate of a firm can be calculated as the product of the
a.             return on assets and the return on equity.
                b.             dividend payout ratio and leverage.
                c.             retention rate and the return on equity.
                d.             net profit margin and total sales……(c, difficult)
24.          If a firm's ROA and ROE are equal, it can be concluded that the firm is
a.             losing money.
                b.             liquid enough to pay some extra dividends.
                c.             financed by all equity.
                d.             financed by a high proportion of debt.
(c, moderate)
Earnings Estimate

25.          One way to obtain earnings forecasts is the mechanical procedure known as:
a.             cross-reference analysis.
b.             exponential trending.
c.             time series analysis.
d.             data mining.
(c, moderate)

26.          Which of the following is true regarding earnings forecasts made by analysts versus forecasts made by statistical models?
a.             The evidence tends to support analysts' forecasts in terms of accuracy over statistical models.
b.             The evidence tends to support statistical models' forecasts in terms of accuracy over statistical models.
c.             The evidence tends to support both types of forecasts equally.
d.             The evidence does not support either type of forecast in terms of accuracy.
(a, difficult)

27.          Which of the following is not true regarding earnings estimates?
a.             Some companies provide guidance on forthcoming earnings announcements.
b.             The guidance number plays a major role in the consensus estimate.
c.             The variance of actual reported earnings from the consensus had typically constituted the "whisper" forecast.
d.             All of the above are true.
(c, difficult)
The P/E Ratio
28.          If the dividend growth rate increases for  a firm, its P/E will ---------, other things the same.
a.             increase
b.             stay the same
c.             decrease
d.             increase or decrease but not stay the same
(a, moderate)

29.          How would you explain P/E ratio differences among companies?  By investor
a.             expectations about the future growth of the market.
                b.             estimates of the recent growth of earnings.
                c.             expectations about the future growth of earnings.
                d.             estimates about the recent growth of dividends.
(c, moderate)

30.          If business risk decreases for Megabucks, Inc., the P/E will __________, other things the same
a.             increase
                b.             stay the same
                c.             decrease
                d.             increase or decrease but not stay the same
(a, difficult)
31.          Other things equal, if the
a.             required rate of return increases, the P/E ratio will rise.
                b.             risk premium increases, the P/E ratio will rise.
                c.             risk-free rate rises, the P/E ratio will fall.
                d.             dividend payout increases, the P/E ratio will fall.
(c, difficult)

32.          Other things equal,
a.             the higher the expected growth rate, the lower the P/E ratio.
                b.             if the risk-free rate rises, the required rate will decline.
                c.             as the required rate rises, the P/E ratio declines.
                d.             if the risk premium rises, the required rate will fall.
(c, difficult)

33.          High P/E stocks are generally associated with
a.             mature companies.
                b.             cyclical companies.
                c.             young fast-growing companies.
                d.             defensive companies.
(c, moderate)

Fundamental Security Analysis in Practice
34.          In modern investment analysis, the risk for a stock is related to its:

a.             leverage factor.
b.             standard deviation.
c.             beta coefficient.
d.             coefficient of variation.
(c, moderate)

35.          The largest investment advisory service in the United States is:

a.             Standard & Poor's
b.             Moody's Industrial Manuals
c.             Morningstar
d.             Value Line Investment Survey
(d, easy)

36.      _______ use a computer program in an attempt to imitate the brain in analyzing securities.

a.         Decision trees
b.         Program trading
c.         Day traders
d.         Neural networks
(d, moderate)

True/False Questions
Fundamental Analysis

1.             It is not necessary to determine a point estimate of the intrinsic value of a stock when using relative valuation techniques.
(T, moderate)

The Accounting Aspects of Earnings

2.             Accounting adjustments are often called nonrecurring gains or losses or extraordinary items.
(T, moderate)

3.             The auditor's report guarantees the accuracy of the earnings reported in the financial statements.
(F, moderate)

4.             The Securities Investor Protection Act was passed by Congress largely in response to the accounting scandals involving Enron, WorldCom, Global Crossing and others.
(F, easy)

5.             EBITDA, sometimes called operating profit, is often emphasized by telecommunications companies because of their lack of real profitability.
(T, moderate)

6.             Current plans call for the International Accounting Standards to replace               local accounting rules in European Union countries.
(T, moderate)

7.       Free cash flow represents money left after all the bill are paid and dividend payments are made.
(T, easy)

Analyzing a Company's Profitability

8.             Leverage can magnify the returns to the stockholders and also reduce the losses to the stockholders.
(F, moderate)

9.             A company may maintain its ROA if the net income margin decreases by increasing its asset turnover.
(T, moderate)

Earnings Estimates

                10.          Investors interested in buying stocks which report bad news and suffer a                                               sharp decline should buy the first day bad news is reported.
(F, difficult)

11.          One earnings surprise tends to lead to another earnings surprise.
(T, easy)

                12.          A favorable earnings surprise occurs when the forecasted earnings are                                   greater than the actual earnings of a company.
(F, easy)

The P/E Ratio

                13.          The P/E ratio can be expected to change as the expected dividend payout                                            ratio changes.
(T, moderate)

14.          Other things being equal, as k rises, the P/E ratio will also rise.
(F, moderate)

15.          According to Peter Lynch, the P/E ratio of a company that is fairly valued will equal its expected growth rate.
(T, moderate)
Short-Answer Questions
The Accounting Aspects of Earnings

1.             What is the relationship of the Financial Accounting Standards Board and the Securities and Exchange Commission?               
(moderate)           
Answer: The FASB and the SEC are separate organizations.  The FASB is a         self-regulatory body of the accounting profession that sets                 accounting standards.  The SEC is part of the federal government          that requires companies to disclose financial data presented under   FASB’s standards.

2.             When an investor buys a share of common stock he/she buys a claim of ownership.  How is this claim represented on the balance sheet?
(moderate)
Answer: The claim is represented by the entire common equity section.  The        three most common accounts are common stock, capital paid in      excess of par, and retained earnings.  The book value of equity is           calculated from the entire common equity section.

Analyzing A Company's Profitability

3.             What is the internal (sustainable) growth rate?  How is it calculated?
(moderate)

Answer: The internal growth rate is the growth rate depending on earnings            retention as the only source of new capital.  It is calculated as g = br = (1 – payout rate)(ROE).

Earnings Estimates

4.             How accurate are professional earnings estimates?  Do purely mechanical models give better results than analysts who add subjective assessment to the data?
(difficult)

Answer: According to a study by Dreman and Berry, the average annual              error in earnings estimates was 44 percent during the period              studied (1974-1990).  Only 25 percent of the consensus estimates           came within plus or minus 5 percent of reported earnings.             Analysts consistently beat purely mechanical models.  Subjective           assessment of the future is required.

5.             What are “earnings surprises?”  How do they affect stock prices?
(moderate)

Answer: Any new information that affects projected earnings creates an              earnings surprise.  The SUE model formalizes the surprise factor.     Stock prices react up or down to the surprise.

6.             Can an investor that wants to use the approach of projected earnings and P/Es find help in Value Line?
(easy)

                Answer: Yes.  In fact Value Line projects EPS, dividends, dividend payout,
                                                growth rates and prices.

The P/E Ratio

7.             What three variables affect the P/E ratio?  How does each affect it?
(moderate)

Answer: Using the model P/E  =  (D1/E1)/(k – g), the variables are the      dividend payout rate, D1/E1, the required rate of return, k, and the dividend growth rate, g.  If the dividend payout rate increases (decreases), the P/E increases (decreases), other things the same.  If the required rate of return increases (decreases), the P/E        decreases (increases).  If the growth rate increases (decreases), the   P/E increases (decreases).

8.             Should an investor seek companies with low P/Es or high P/Es?
(moderate)

Answer: Investors differ in their philosophies.  Investors who seek low P/E            companies are “value” investors.  They think that the stocks are       undervalued and will eventually gain full valuation.  On the other           hand, “growth” investors seek high P/E stocks as ones with high     growth prospects.

9.             How could unexpected inflation affect the P/E ratio?
(moderate)

Answer: Unexpected inflation would increase the risk-free rate of return,              RF, which would increase the required return, k, on stocks.  This    would reduce P/E ratios.

Critical Thinking/Essay Questions

1.             What is meant by “quality of earnings,” and how does it affect the equity analyst’s job?
(difficult)

                Answer: Quality of earnings generally has to do with the accounting      standards applied.  Generally speaking, conservative standards              result in a higher quality of earnings than liberal standards.       Conservative methods often produce higher expenses and lower                 EPS.  An analyst has a hard time comparing the earnings of     companies prepared under differing methods.  An analyst might be             willing to apply a higher P/E to higher quality earnings in                 projecting a future stock price.

2.             In the model P/E  =  (D1/E1)/(k – g), the P/E should increase if the dividend payout rate increases, other things the same.  If the payout rate was intentionally increased by the board of directors, other things are likely not to stay the same.  What is likely to happen to the dividend growth rate and the required return?
(moderate)

Answer: If more earnings are paid out, then there is less to retain.  If there is         less earnings retention, then there is a relatively smaller equity       base to support earning assets.  This would reduce growth.  The               effect of a higher payout on the required return is the center of          considerable controversy, but one scenario would suggest less risk           and slower grow growth, and a reduced required return.
Problems

1.             Don Jorge Shipping Inc. has net income of $40 million, total assets of $300 million, and sales of $800 million.  Its equity is $190 million.
(a)           Calculate ROA.
(b)           Calculate ROE.
(c)           If the book value per share is $7.00, what is EPS?
(moderate)

Solution:                (a)           ROA       =              net income margin x turnover
=              40/800 x 800/300
=              0.05 x 2.67
=              0.1335 or 13.35 percent

(b)                           ROE       =              ROA x Leverage
=              0.1335 x 1.579
=              0.2101 or 21.01 percent

(c)                           EPS         =              ROE x book value per share
=              $7.00 x .2101
=              $1.47

2.             Internet Industries expects to earn $5.00 for the coming year, and pay a $2.00 dividend.  Its ROA is 13 percent, while its leverage factor is 1.7.

(a)           Calculate the expected growth rate in dividends.
(b)           Given a required rate of return of 17 percent, determine the estimated price for High Tech, Inc., common stock.
(c)           Calculate the expected dollar dividend two periods from now.
(moderate)

Solution:                (a)           g              =              br
b              =              1 - payout ratio                   
=              1 - .4       =              .6
ROE       =              ROA x Leverage                 
=              .13 x 1.7                =              .221
                                                g              =              .6 x .221                               
=              .1326 or 13.26 percent

(b)           P0             =              D1/(k - g)
                                                                =              2.00/(0.17 - .1326)              =              $53.48

                                (c)           D2           =              D1(1 + g)
=              $2.00 (1.1326)                     =              $2.265

3.             The risk-free rate of return is 10 percent, and the expected return for the stock market is 16 percent.  Evergreen Industries has a beta of 1.1, and investors expect dividends and earnings to grow at an 8 percent rate per year.  The current dividend is $1.20, and the payout ratio is 50 percent.

(a)           Calculate the P/E ratio for Evergreen Industries.
(b)           Estimate the price of the stock for the next year using the multiplier model.
(moderate)

Solution:                (a)           k              =              RF + B(RM - RF)
=              .10 + 1.1(.16 - .10)                               =              0.166

P/E          =              (D1/E1)/(k – g)
=              ($1.30/$2.59)/(0.166 - .08)                                =              5.81

(b)           P1            =              P/E x E1
=              5.81 x $2.59                                         =              $15.05

4.             Calculate the required rate of return on DCM Corporation's stock if its current price is $35 per share, next year's expected dividend is $2.00 per share, its return on equity is 12 percent, and its dividend payout ratio is 55 percent.
(moderate)

Solution:                g              = retention rate x ROE= (1 - dividend payout ratio) x ROE
                                                = (1 - 0.55) x 12   =              .45 x 12                 =              .054

P0            =              D1/(k – g)  or
k              =              D1/P0  +  g
                                                =              2/35  +  .054                         =              0.1111 or 11.11 percent

5.             A company has sales of $220 million.  These are expected to increase by 15 percent next year and 12 percent in the year after that.  Over each of the next two years, the company expects to have a net profit margin of 8 percent, a payout ratio of 60 percent, and a constant 3 million shares of common stock outstanding.  If the stock is expected to trade at a P/E ratio of 14 at the end of the second year and if the investor requires a 14 percent rate of return, what should the justified price of the stock be today?
(difficult)

Solution:
Current                                                  Year 1                    Year 2
Growth rate                                           + 15 %                   + 12%
Sales                                                       $253m                   $283.36m
Net Profit (8% of sales)                      $20.24m                                $22.67m
Number of shares out                          3m                         3m
EPS                                                         $6.75                      $7.56
DPS (60% of EPS)                               $4.05                      $4.54

Stock price in year 2           =              EPS in year 2 x P/E at end of year 2
                P2                   =              7.56 x 14
=              $105.84

Stock price today                =              Present value of D1 + Present value of D2 + Present value of P2
P0            =              [$4.05/(1.14)] + [4.54/(1.14)2] + [105.84/(1.14)2]
=              $3.55 + $3.49 + $81.44
=              $88.48
6.             Upon analyzing the financial statements of Jain Industries, you discover that it is currently retaining 60 percent of its earnings (which were $6 this past year), and is experiencing a ROE of almost 20 percent. Assuming a risk-free rate of 4 percent and a risk-premium of 8 percent, how much would you be willing to pay for Jain Industries stock on the basis of the P/E ratio approach?
(difficult)

Solution:                k              =              RF + RP=               6 + 8                     
=              14 percent
                                                =              retention rate x ROE           =              0.6 x 20
                                                =              12 percent
                                D1/E1      =              (1 – retention rate)=            (1 – 0.6)=               0.4
                                P/E          =              (D1/E1)/(k – g)       =0.4/(0.14 – 0.12)                =              20
                                EPS1       =              EPS0(1 + g)            =              6(1 + 0.12)            =              $6.72
                                Intrinsic value      =              Justified P/E x Expected EPS
                                                                =              (20)(6.72)              =              $134.40

7.             Given the following for Mighty Manufacturing Company:

Operating efficiency           =              0.1
Net income                           =              $50,000,000
Net income margin              =              0.05
Total asset turnover            =              3
Leverage                               =              1.5
Retention rate                      =              0.3

(a)           Calculate ROA.
(b)           Calculate ROE.
(c)           Find the growth rate of dividends.
(moderate)

Solution:                                The letter m is used to denote millions.

(a)           Net income margin              =              Net income/Sales
                                                0.05        =              $50m/sales
                                                Sales       =              $1,000m

                Total asset turnover            =              Sales/Total assets
                                                3              =              $1,000m/TA
                                                TA          =              $333.333m

                                                ROA       =              Net income/Total assets
                                                                =              $50m/$333.333m
                                                                =              0.15 or 15 percent

(b)                           Leverage               =              Total assets/Equity
                                                                                1.5          =              $333.333m/Equity
                                                                Equity                    =              $222.222m

                                                                                ROE       =              Net income/Equity
                                                                                                =              $50m/$222.222m
                                                                                                =              0.225 or 22.5 percent

                                (c)                                           g              =              br
                                                                                                =              Retention rate x ROE
                                                                                                =              0.3(0.225)
                                                                                                =              0.0675 or 6.75 percent

9.             Find the P/E ratio of a stock with a ROE of 30 percent, a book value per share of $5.00, and a current stock price of $30.00.
(moderate)

                Solution:                EPS         =              ROE(Book value)
                                                                =              0.30($5) =              $1.50 per share

                                                P/E          =              $30/$1.50             =              20

Chapter 16

An Alternative Approach - Technical Analysis

Multiple Choice Questions

Overview

1.                   The oldest approach to common stock selection is:

a.                   fundamental analysis
b.                   technical analysis
c.                    random walk analysis
d.                   value analysis
(b, easy)

What is Technical Analysis?

2.                   Technical analysis reflects the idea that stock prices:

a.                   move upward over time.
b.                   move inversely over time.
c.                    move in trends.
d.                   move randomly.
(c, easy)

3.                   Market data includes all of the following except:

a.                   number of shares traded.
b.                   earnings.
c.                    level of market indices.
d.                   stock price.
(b, moderate)

4.                   The two primary tools of a technical analyst are:

a.                   level of the market index and volume.
b.                   economic indicators and level of the market index.
c.                    price and volume.
d.                   price and technical indicators.
(c, moderate)

5.       Conventional technical analysis emphasizes:

a.                   only the aggregate stock market.
b.                   either the aggregate stock market or individual stocks.
c.                    only individual stocks.
d.                   only corporate securities.

(b, moderate)

6.                   Technical analysis differs from fundamental analysis in that technical analysis:

a.                   is aimed at the market while fundamental analysis is aimed at individual stocks.
b.                   is based on published market data and focuses on internal factors.
c.                    focuses on the long-term trends of production.
d.                   does not consider price and volume.
(b, easy)

7.                   All of the following are assumptions made by technical analysts except:

a.                   Changes in trend are caused by shifts in supply and demand relationships.
b.                   Stock price movements are independent.
c.                    Security prices tend to move in trends.
d.                   Supply and demand of securities are determined by various factors.
(b, difficult)
Stock Price and Volume Techniques

8.                   Which of the following is not true regarding the Dow Theory? 

a.                   It is intended to forecast the start of a primary movement.
b.                   It does not forecast how long a movement will last.
c.                    It has a very high success rate.
d.                   It is subject to many criticisms.
(c, moderate)

9.                   A support level is a price range:

a.                   at which a significant increase in demand for a stock is expected.
b.                   at which a significant increase in supply of a stock is expected.
c.                    below which a stock price cannot go.
d.                   above which a stock price cannot go.
(a, moderate)


10.                Which of the following is not one of the three major variables to be decided by the investor in order to construct a moving average?

a.                   price used.
b.                   time period.
c.                    weight to be used.
d.                   type of moving average to be constructed.
(c, moderate)

11.                In order to have confirmation of a major market trend under the Dow Theory, the:

a.                   industrial and utility averages must confirm each other.
b.                   transportation and utility averages must confirm each. other.
a.                    utility average must lead the transportation average.
b.                   transportation and industrial average must confirm each other.
(d, moderate)


12.                A principal weakness of the Dow Theory is:

a.                   its use of averages instead of indexes.
b.                   its attention to general market movements.
c.                    that it pays too much attention to primary trends.
d.                   the many versions that are available.
(d, moderate)

13.                Which of the following is true regarding the resistance level?

a.                   Resistance levels tend to develop due to profit taking.
b.                   It is the level at which a significant decrease in demand is expected.
c.                    It is the level at which a significant increase in supply is expected.
d.                   Resistance levels usually develop after a stock reaches a new low.
(c, difficult)

14.                Volume and specific calendar time are not considered important in a:

a.                   pie chart.
b.                   point and figure chart
c.                    bar chart.
d.                   histogram.
(b, easy)


15.                One rule of thumb is that a stock is attractive when the relative strength has improved for at least ---------------months.
a.                   1
b.                   2
c.                    3
d.                   4
(d, difficult)

16.                Corrections are often followed by ________.

a.                   channel lines.
b.                   momentum.
c.                    reversals.
d.                   consolidation.
(d, moderate)

17.          What is usually shown at the bottom of a bar chart?

a.             a point and figure chart
b.             advance/decline line
c.             closing price
d.             volume
(d, easy)

Technical Indicators

                18.          Which of the following is a characteristic of the short interest ratio:  It is:

a.                   calculated daily as well as weekly.
b.                   often interpreted without any additional information.
c.                    between 2 and 3 in recent times.
d.                   considered to be a measure of investor sentiment.
(d, moderate)

                19.       The advance-decline line:

a.                   measures the number of stocks hitting new highs and lows.
b.                   can be computed only on a daily basis.
c.                    can be interpreted without reference to any market index.
d.                   is sometimes referred to as the depth of the market.
(d, moderate)

                20.          A high short interest ratio is generally interpreted as:

a.                   a bullish signal.
b.                   evidence of a downside breakout.
c.                    a bearish signal.
d.                   evidence of the presence of odd-lotters.
(a, easy)

                21.          A daily accumulation of stocks advancing or declining is used in:

a.                   volume of trading analysis.
b.                   relative strength analysis.
c.                    breadth of market analysis.
d.                   short interest analysis.
(c, moderate)

                22.          Which of the following is not a contrary trading rule?

a.                   Relative strength ratio
b.                   Investment advisory opinions
c.                    Mutual fund liquidity positions
d.                   Put/call ratio
(a, difficult)

                23.          The short interest ratio is found by dividing the number of shares sold                                    short by the average:

a.                   number of shares outstanding in the market.
b.                   daily volume of trading on the exchange.
c.                    number of stocks reaching new lows.
d.                   daily number of stocks bought long.
(b, difficult)

24.          A put/call ratio of .70 indicates:

a.                   puts have a cost 70% less than the cost of calls.
b.                   there are 7 puts purchased for every one call purchased.
c.                    there are 70% more puts purchased than calls.
d.                   there are 7 puts purchased for every 10 calls purchased.
(b, moderate)





                25.          Technicians that utilize the CBOE put/call ratio generally believe:

a.                   option investors are almost consistent losers.
b.                   option investors are almost consistent winners.
c.                    option investors are true technicians.
d.                   option investors possess inside information.
(a, easy)

                26.          Which of the following would be considered a strong bearish signal?

a.                   High mutual fund liquidity
b.                   Bullish advisory opinion
c.                    Low short interest ratio
d.                   Bearish advisory opinion
(b, moderate)

27.          Which of the following indicates the market is at its peak, according to contrarians?

a.             the short-interest ratio is low
b.             the bearish sentiment index is around 20 percent
c.             mutual fund liquidity is low
d.             all of the above would indicate a market peak to a contrarian
(c. difficult)

Testing Technical Analysis Strategies

28.        Which of the following is not one of the tests of a technical trading rule?

a.          Transaction and other costs
b.          Consistency
c.          Return
d.          Risk
(c, moderate)

29.          If an investor buys a stock when its price has increased 15 percent from its previous low, the investor is employing:

a.             a contrarian indicator.
b.             a filter rule.
c.             a sentiment indicator.
d.             relative strength analysis.
(b, difficult)

30.          If a trading rule has been tried on data other than that used to produce the rule and found to be accurate, this is known as:

a.             consistency.
b.             relative strength.
c.             out-of-sample validity.
d.             a filter rule.
(a, moderate)

Some Conclusions About Technical Analysis

                31.          Conclusions about technical analysis suggest that:

a.                   it is difficult to justify technical analysis.
b.                   it has been found to be completely deficient.
c.                    stock price movements repeat themselves constantly.
d.                   there is complete agreement about the interpretation of technical signals.
(a, easy)

True/False Questions

What Is Technical Analysis?

1.             Technical analysis focuses on economic and political factors which are external to the market itself.
(F,  moderate)

2.             Technical analysis focuses on timing and on the short run.
(T, easy)

3.             Technical analysts agree with the fundamental analysts regarding the   usefulness of accounting data.
(F, moderate)

Stock Price and Volume Techniques

4.             The Dow theory is intended to forecast the start but not the duration of a             primary movement.
(T, easy)

5.             A bar chart is the simplest type of chart used in technical analysis.
(T, easy)

6.             In light of its high success rate, the Dow theory is seldom criticized.
(F, easy)

7.             Relative strength analysis is popular because it is generally not subject to              conflicting interpretations.
(F, moderate)

8.             If a trend exhibits support and resistance levels simultaneously that appear         well defined, the trendlines are referred to as channel lines.
(T, moderate)

9.             Secondary movements are often termed technical "corrections.
 (T, moderate, p. 427)

Technical Indicators

10.          The cash position of mutual funds is a contrarian indicator.
(T, moderate)

11.          A put/call ratio greater than the typical upper limit would be interpreted as           a bullish signal by the contrarians.
(T, moderate)

Testing Technical Analysis Strategies

12.          A filter rule specifies a breakpoint for a stock or average and trades are                 made when the price is greater than the filter.
(T, easy, p. 440)



Short-Answer Questions

Stock Price and Volume Techniques

1.             Explain how profit taking and support levels are related.
(moderate)

Answer: The scenario is as follows:  The stock price increases.  Profit     taking follows, driving the price down.  When investors see the          price as low enough, they buy, stopping the price from dropping              further, thus establishing the support level.

2.             How does a point-and-figure chart compress many price changes into a small space?
(moderate)

Answer: By recording only “significant” price changes, defined as $1 or $2          or more.  Thus, moves of ¼, ½, and so forth are not recorded.

3.             Explain three specific buy signals using a moving average.
(difficult)

Answer: (a) The price is above the moving average, moves toward the average but does not penetrate it, then starts back up.  (b) After a   fall, the moving average flattens out.  The price penetrates the                 average from below.  (c) The stock price falls below the moving       average while it is rising.

4.             What are support and resistance levels?
(moderate)

Answer: If a stock price is falling, a support level is a price at which        sufficient demand is expected to materialize to keep the stock price             from dropping further.  If a stock price is rising, a resistance level            is a price at which sufficient supply is expected to emerge to keep              the price from rising any higher.

5.             How is relative strength calculated and used?
(moderate)

Answer: The relative strength of a stock is a ratio of the stock’s price to a             market index, industry index, or average price of the stock itself.     If a stock is doing well relative to the industry, for example, it is               expected to continue to do so in the future.  A change in relative        strength, however, if often followed by a change in the stock’s                 price trend.  The relative strength of an industry to the market can                be considered as well as the relative strength of individual stocks.
Technical Indicators

6.             Investors who sell short expect to make money when the stock price goes down.  How, then, can a high short-interest ratio be considered bullish?
(easy)

                Answer: Short sales must be covered, which creates demand for the stock at
                                                some point in the future.

7.             Institutional investors are often considered to have the “smart money,” while small, individual investors are not so well informed about the market.  Which two sentiment indicators treat both institutions and individuals alike?
(moderate)

Answer: The odd-lot theory asserts that one should do the opposite of odd-         lot investors, because they are usually wrong.  Thus, if odd-lotters              are selling, smart investors should buy.  Similarly, the mutual fund          liquidity technique asserts that mutual fund managers act like odd-          lotters, buying when the should be selling and vice versa.  When                 the funds accumulate large amounts of cash, they apparently think       the market is going down, and they do not want to be holding all stocks.  The contrarians argue that the opposite will occur.

8.             What four factors should be considered in testing technical trading rules?
(easy)

                Answer: Risk, transactions costs, consistency, and out-of-sample                                           validity.

9.             What is the advance-decline line?  What does it tell the technician?
(moderate)

Answer: The net advance for a day is the number of stocks that advanced in      price minus the number that declined in price.  It is also called the   breadth of the market.  The advance-decline line must be used in           conjunction with a market average, such as the DJIA.  If the    advance-decline line and the index diverge, then the trend is near            an end, according to technical analysts.
Some Conclusions About Technical Analysis

10.          Discuss the difference in beliefs about price adjustments toward equilibrium in technical analysis and the Efficient Market Hypothesis.
(moderate)

Answer: Technical analysis depends on trends over time as prices adjust              slowly toward new equilibrium levels.  The EMH is based on            information being quickly and completely reflected in security                prices.
Critical Thinking/Essay Questions

1.             Which form of the Efficient Market Hypothesis addresses the information used in technical analysis?  Do studies of technical analysis methods tend to support or refute the EMH?
(moderate)

Answer: The weak form EMH addresses market data.  Studies tend to support EMH and refute the predictive power of technical tools,      though not all agree with the findings.  Apparently, technicians do          not agree.

2.             How can relative strength analysis be helpful in a top-down approach to security analysis?
(moderate)

Answer: Analysts can use industry relative strength to identify industries               that are outperforming the market, then use company relative                strength to identify companies that are outperforming the industry.

Chapter 19

Using Puts and Calls

Multiple Choice Questions

Overview

1.                   Another name for securities which give the holder the right to buy or sell shares of stock under specified conditions is:

a.                   CMOs
b.                   options
c.                    treasury stock
d.                   a commitment
(b, easy)

Why Have Derivative Securities?

2.             One important reason for the existence of derivatives is that they:

a.             help lower transactions costs.
b.             have valuable tax benefits.
c.             contribute to market completeness.
d.             are risk-free.
(c, moderate)

3.             Which of the following is not a reason for investors to participate in       options?

a.                   Options eliminate leverage.
b.                   Options are a smaller investment than stock investments.
c.                    Options allow investors to trade on the overall market movements.
d.                   Options can reduce risk.
(a, moderate)

Introduction to Options

4.             The standard option contract is for:

a.                   10 shares of stock
b.                   50 shares of stock
c.                    100 shares of stock
d.                   1 share of stock
(c, easy)

5.             An option that allows the investor to buy stock under specified conditions  is called

a.                   call
b.                   put
c.                    derivative
d.                   future
(a, easy)

6.             An option that allows the investor to sell stock under specified conditions  is called a:

a.                   call
b.                   put
c.                    derivative
d.                   future
(b, easy)

Understanding Options

7.             A major difference between new shares being sold by a corporation and               shares sold under a call option is that:

a.                   there is no profit or loss under the shares sold under the call.
b.                   there is no risk to the investor with the call.
c.                    there is no increase in the shares outstanding with the call.
d.                   there is no commission to the investor with the call.
(c, moderate)

                8.             LEAPS are typically:

a.                   cheaper than short-term options.
b.                   more expensive than short-term options.
c.                    less risky than short-term options.
d.                   more risky than short-term options.
(c, moderate)

9.             The exercise price on an option is also known as the:

a.                   premium.
b.                   strike price.
c.                    theoretical value.
d.                   spot price.
(b, easy)

10.          Which of the following statements is true regarding American and          European options?

a.                   American options can be exercised only at expiration.
b.                   American options can be exercised only in the last week prior to expiration.
c.                    European options can be exercised only at expiration.
d.                   European options can be exercised any time prior to expiration.
(c, moderate)

11.          Which of the following statements is true regarding a call writer:

a.                   The call writer expects the stock to move upward.
b.                   The call writer expects the stock to remain the same or move down.
c.                    The call writer expects the stock to split.
d.                   The call writer expects to sell the stock prior to expiration of the option.
(b, difficult)

12.          To hedge a short sale, an investor could

                a.             buy a call.
                b.             write a call.
                c.             buy a put.
                d.             write a put.
(a, moderate)

13.          Options sold on exchanges are protected against

                a.             stock dividends and splits.
                b.             cash dividends.
                c.             interest rate movements.
                d.             inflation.
(a, easy)

14.          Other things equal, after an option first becomes available in the market

                a.             its time value approaches zero.
                b.             its time value increases into maturity.
                c.             the volatility of the stock is negatively related to the value of the call.
                d.             if it is out of the money, it will have no time value.
(a, moderate)

15.          A writer of a call can terminate that particular contract anytime before its expiration by

                a.             writing a second call.
                b.             buying a put.
                c.             buying a comparable call.
                d.             writing a put.
(c, difficulty)

Payoffs and Profits from Basic Option Positions

16.          A call option written against stock owned by the writer is said to be

a.             naked.
b.             in the money.
c.             out of the money.
d.             covered.
(d, easy)

17.          The writer of a naked call faces

                a.             an unlimited potential gain.
                b.             a specified potential loss.
                c.             no chance of loss because this is a conservative strategy.
                d.             a limited potential gain.
(d, difficult)
Some Basic Option Strategies

18.          To provide insurance against declining prices on previously purchased stock, an investor could

                a.             buy a call.
                b.             write a put.
                c.             buy a stock index option.
                d.             buy a put.
(d, moderate)

19.          Which of the following statements about portfolio insurance is FALSE?

                a.             There are several methods of insuring a portfolio.
                b.             It seeks to provide a minimum return while offering the opportunity to
                         participate in rising prices.
                c.             Futures are typically not used to hedge stock portfolios.
                d.             Puts and calls typically are not used to insure portfolios.
(c, moderate)

Option Valuation

20.          The __________ is NOT a determinant of the value of a call option in the Black-Scholes model?

                a.             interest rate
                b.             exercise price of the stock
c.             price of the underlying stock
                d.             expected beta of the underlying stock
(d, moderate)

21.          If the price of the common stock exceeds the exercise price of a call for the holder the call is said to be

                a.             naked.
                b.             out of the money.
                c.             in the money.
                d.             covered.
(c, moderate)

22.          Option prices usually:

                a.             increase with maturity.
                b.             are less than intrinsic values.
                c.             decrease with a stock's volatility.
                d.             all of the above.
(a, moderate)

23.          An option is a wasting asset because as its expiration date approaches, its

                a.             intrinsic value approaches zero.
                b.             time value approaches zero.
                c.             intrinsic value approaches its time value.
                d.             price approaches zero.
(b, difficult)

Questions 24-26 are based on the following options data for XYZ Corporation:
------Call------         ------Put------
Option/Strike        Exp.        Vol.         Last        Vol.         Last.
XYZ
38 5/8       25         Dec.        ---            -----         100         1/8
38 5/8       30         Nov.       250         8 ¾         464         1/16
38 5/8       30         Dec.        ---            -----         572         5/16
38 5/8       35         Nov.       154         4 1/2       1748       5/16
38 5/8       35         Dec.        923         5 1/4       580         1 3/16
38 5/8       35         Mar.       ---            -----         33           2 5/8
38 5/8       40         Nov.       2023       1 1/8       530         2 3/8

24.          Which of the following calls is not "in-the-money?"

                a.             25 Dec
                b.             30 Nov
                c.             35 Dec
                d.             40 Nov
(d, moderate)

25.          Of the various combinations shown above, how many combinations of put contracts are currently trading "out-of-the-money?"
               
                a.          6
                b.             5
                c.             4
                d.             1
(a, moderate)

26.          The closest quote for the Dec. 25 call, were it to trade, would be

                a.             12.                                          Solution:                Intrinsic value      =38 5/8 - 25
                b.             4 7/8.                                                                                                      =13 5/8
                c.             10 1/2.
                d.             13 5/8.
(d, difficult)

27.           A (an) ---------- seeks to earn a return without assuming risk by constructing riskless hedges.

a.                   speculator
b.                   call writer
c.                    put writer
d.                   arbitrageur
(d, moderate)

28.          Which of the following statements is FALSE?

                a.             An in-the-money call occurs if the stock price exceeds the exercise price.
 b.            An out-of -the money call occurs if the stock price is less than the exercise
            price.
                c.             If a call is out of the money, the intrinsic value is zero.
                d.             If a call is in the money, the intrinsic value is zero.
(d, moderate)

29.          Which of the following statements is FALSE?

                a.             Options are a wasting asset.
                b.             Option prices almost always exceed intrinsic values.
                c.             As expiration approaches, the value of the option declines to zero.
                d.             The intrinsic value of a call is equal to its market value.
(d, moderate)

30.          Which of the following statements is TRUE?

                a.             The speculative premium reflects the option's immediate value.
                b.             If a call is in the money, the intrinsic value is zero.
                c.             An option's premium almost never declines below its intrinsic value.
                d.             If exercise price exceeds stock price, a call is "in the money."
(c, moderate)

31.          A stock is at $68.  A two-month put  (strike price = $70) is available at a $5 premium..  The intrinsic value is ___ and the time value is ____.

                a.             $5 . . . $0.
                b.             $0 . . . $5.
                c.             $3 . . . $2.
                d.             $2 . . . $3.
(d, difficult)

32.          In the Black-Scholes model,

a.             all of the inputs except two are observable.
b.             all of the inputs except one are observable.
c.             the greater the stock price, the lower the price of the call option.
d.             there is an inverse relationship between the value of a call and interest rates in the market.
(b, difficult, p. 526)

An Investor's Perspective on Puts and Calls

33.          Concerning index options, which of the following statements is FALSE?

                a.             Index options appeal to speculators due to the leverage they offer.
                b.             Investors can write index options.
                c.             If exercised the holder of an index option receives the strike price.
                d.             Index options are settled in cash.
(c, difficult)

34.          The best way to protect a stock portfolio in a bear market is to:

a.             Buy stock index calls.
b.             Buy stock index puts.
c.             Write stock index calls.
d.             Write stock index puts.
(b, difficult)

35.          Stock market index options are available on all of the following EXCEPT

                a.             the Standard and Poor's 500 Index.
                b.             the Major Market Index.
                c.             the National OTC Index.
                d.             the Shearson Lehman Hutton Index.
(d, moderate)


APPENDIX 19-A

36.       A combination of one put and one call on the same stock with the same exercise price and date is known as a:

                a.             strip
                b.             straddle
                c.             strap
                d.             spread
(b, easy)

37.          The two basic spreads are the:

a.                   time spread and price spread
b.                   put spread and call spread
c.                    time spread and money spread
d.                   money spread and rate spread
(c, moderate)

38.          A combination of two calls and one put is called a:

a.                   strip
b.                   strap
c.                    straddle
d.                   spread
(b, moderate)

                39.          Spreads are used to:

a.                   increase the return potential
b.                   circumvent option commissions
c.                    reduce risk in an option position.
d.                   all of the above are true.
(c, moderate)
               
True/False Questions

Understanding Options

1.                   An option buyer has only two courses of action available:  exercise the option or let it expire.
(F, moderate)
2.                   The options clearing corporation ensures fulfillment of option obligations.
(T, easy)

3.                   The writer of a put, like the buyer of a call, is bullish about the stock price.
(T, easy)

4.                   Options traded on organized exchanges are protected against cash dividends.
(F, moderate)

5.                   Options cannot be purchased on margin.
(F, moderate)

Some Basic Option Strategies

6.                   A protective put is a strategy in which a short seller buys a put.
(F, moderate)

Payoffs and Profits from Basic Option Strategies

7.                   A covered call is considered a type of spread.
(F, moderate)

Option Valuation

8.                   If the price of the underlying common stock is less than the exercise price of a put, it is in the money.
(T, easy)

9.                   There is an inverse relationship between the price of a call option and the volatility of the underlying common stock.
(F, difficult)

10.                Writing a naked put is riskier than writing a naked call.
(F, difficult)

An Investor's Perspective on Puts and Calls

11.                The strategies with stock index options are considerably different from those for individual stocks.
(F, easy)

Short-Answer Questions
Understanding Options

1.             What organizational feature of options trading prevents individual traders from having to worry about defaults if options are exercised?
(easy)

Answer: All contracts are actually bought and sold through the Options                Clearing Corporation, which stands behind the contracts.

Some Basic Option Strategies

2.             What is meant by portfolio insurance?
(moderate)

Answer: Portfolio insurance involves strategies to provide the portfolio a              minimum return while allowing it to participate in rising prices.          Securities usually include options, futures and synthetic options.             Futures on indexes are commonly used to offset stock portfolio       losses.


3.             A stock investor wants to hedge the Dell stock in his portfolio.  How can he use a covered call to do this?
(difficult)

Answer: The investor owns the stock and will profit if it increases in value            or lose if it decreases.  He can write a call and receive the premium           from it.  The premium will partially offset the loss if the stock price declines.  If the stock price increases, he may be called upon     to sell it at the exercise price.  This would limit his potential gains.

4.             A stock investor wants to hedge the Microsoft stock in his portfolio.  How can he use a protective put to do this?
(difficult)

Answer: The investor owns the stock and will profit if it goes up and lose if           it goes down.  He buys a put.  If the stock increases in value, he          gains on the stock and loses the premium he paid for the put.  If the       stock goes down, he can exercise the put and sell the stock at the                 exercise price.

Payoffs and Profits from Basic Option Strategies

5.             How can the owner of a large stock portfolio use options on individual stocks to enhance the income from the portfolio?
(moderate)

Answer: The owner of a portfolio may enhance the portfolio’s income by            writing calls and puts for the premium received.  If the purchaser   exercises the option, however, the writer will have to deliver the               stock and may have to take capital losses.
Option Valuation

6.             What is a hedge ratio?
(difficult)

Answer: The hedge ratio for a call is N(d1) from the Black-Scholes model.            It is commonly called delta.  It shows the change in the price of the                 option for a $1 change in the price of the underlying stock.  The              hedge ratio for a put is N(d1) – 1.  This knowledge helps the                portfolio manager determine how many options contracts are                 needed to protect the portfolio from price fluctuations.

7.             What is the put-call parity?  How is it related to arbitrage?
(difficult)

Answer: This principle expresses the relationship between the prices of puts          and calls on the same stock that must hold if arbitrage is to be ruled        out.  In other words, unless the price of the put and call have a                certain relationship to each other, there will be opportunities for       earnings riskless profits (arbitrage).
.
Critical Thinking/Essay Questions

1.             What makes the risk-expected return profile attractive to speculators who purchase put and call options?    What is the risk-expected return profile for writers of naked put and call options?
(difficult)

Answer: Put and call options offer leverage compared to purchasing the               common stock.  The upside for puts and calls is unlimited because               the potential increase (decrease) in the stock price is unlimited.                The downside on options is limited to a 100 percent loss because            no margin is allowed.  The loss on highly levered futures contracts                 can be far more.  Thus, the advantage of options to speculators is          the unlimited upside and the limited downside.  In addition,       speculators can enter this market with very small amounts of cash         compared to the investment required for the stocks themselves.
                The writer of naked options faces unlimited loss because the stock         price can move up without limit or down to zero.  The upside gain    is limited to the amount received for the option.

2.             What are the variables in the Black-Scholes option pricing model?  How is each related to the price of the call option?
(moderate)

                Answer: Price of underlying stock. The higher the stock price, the                                         higher the option price.
                                                Exercise price.  The higher the exercise price, the                                                        lower the option price.
                                                Time remaining to expiration.   The longer the time, the                                          higher the option price.
                                                Interest rate.        The higher the interest rate, higher the                                             option price.
                                                Volatility of underlying stock.  The higher the volatility,                                          the higher the option price.

Problems

1.             AB Flex Inc. stock is currently trading at $38.  The time left until expiration of a call and put trading on AB Flex Inc.'s stock is 6 months and the strike price is $45.  If the call is currently trading at $1.96 and the Treasury bill rate is 10 percent per year, what price should the put sell for?
(difficult)

                Solution:                Use put-call parity.
                                                Price of put           =              EP/(ert) – CMP  + CP
                                                                                =              45/(e0.1*0.5) – 38 + 1.96
                                                                                =              45/1.051271 – 38 + 1.96
                                                                                =              6.77

2.             SCORP has puts and calls available for trading for the expiration months of June, September, and December.  For the trading day May 2, 199X, SCORP closed at $40 per share.  Strike prices for SCORP are $35, $40, and $45.  The following prices for the 9 call options (3 expiration dates and 3 strike prices) for this date were (in scrambled order):

                A.            5 ½                         F.             4 7/8
                B.            4                              G.               3/4
                C.            2 1/16                    H.            7 1/4
                D.            6 3/8                       I.             2 7/16
                E.            3 1/8

Fill in the following matrix of prices for these calls, using LETTERS ONLY (i.e., A through I)
(difficult)

                    June                                September                 December
$35         ________                         ________                 ________
$40         ________                         ________                 ________
$45         ________                         ________                 ________

Solution:
                  June                                  September                 December
 $35            A                                           D                                 H
 $40            E                                           B                                 F
 $45            G                                           C                                 I

3.             An investor has the alternative of buying 100 shares of XYZ at $50 per share or investing the same amount of money in XYZ 6-month calls priced at $5.  Calculate the profit or loss from each strategy if the price of XYZ rises to $60 within a week.
(moderate)

Solution:                Buying the stock gain         = $10 per share x 100 shares = $1000

Buying 10 option contracts ($5000 to invest/$500 per option contract):

gain        = 10 options contracts x assumed $10 gain on options
                                                                = 10 x 1000 per contract = $10,000

4.             ABC, which closed at $151, has call options trading in April, July, and October with the following values:

                                                                                ------------Calls-------------
Options/Strike                      April       July         October
ABC       140                         11 ¼       11 ¾           13
151         150                         1 ½         3                   4
151         160                         ¾             1 ½              2

(a)           Calculate the intrinsic value of the April 150 call.
(b)           Calculate the intrinsic value of the April 140 call.
(c)           Should the price of ABC rise to $156, what is the minimum value that the April 150 call should trade at?
(moderate)

(a)           Intrinsic value      =              151 - 150               =              $1.00
(b)           Intrinsic value      =              151 - 140               =              $11
(c)           Minimum value= 156 - 150               =              $6

5.             Listed below are the option quotes on JUP, Inc., in January of this year.

-------Calls-------                    --------Puts--------
                Options/Strike      March            June                March            June
                JUP 35                                           3 1/2               4                      1/2  1 1/8
                37   40                                           1 1/2               2                      4 1/2               5
                37   45                                           1                      1 1/2               8 3/8               s
                37   50                                           1/2                  r                       r       s

(a)           Which calls are in the money?
(b)           Which puts are in the money?
(c)           Why are investors willing to pay 3 1/2 for the MARCH 35 call but only 1/2 for the March 35 put?
(d)           Calculate the intrinsic value of the June 35 call.
(e)           Calculate the intrinsic value of the March 40 put.
(difficult)

Solution:

(a)           In-the-money calls are those whose EP<SP.
Since the SP = 37 only the March 35 calls is in the money.

(b)           In-the-money puts are those whose EP>SP.  Hence the March 40, March 45 and June 40 puts are in-the-money.

(c)           The investors are willing to pay 3 1/2 for the March 35 call option because it has an intrinsic value  of 2 and the rest is speculative premium.  Investors are probably expecting the stock to go up by  March.  On the other hand, the March 35 put is out-of-the money i.e. it's intrinsic value is zero.  There is still some chance that the price may drop below 35, at which time the investor may make  a profit.  Hence there is a small speculative premium of 1/2 on the put option.

(d)           Intrinsic Value of June 35 Call                         =              Stock Price - Exercise Price
=              37 - 35 = $2

(e)           The Intrinsic Value of the March 40 put        =              Exercise Price - Stock Price
=              40 - 37 = $3

6.             Use the Black-Scholes model to calculate the theoretical value of a DBA December 45 call option.  Assume that the risk free rate of return is 6 percent, the stock has a variance of 36 percent, there are 91 days until expiration of the contract, and DBA stock is currently selling at $50 in the market.
(difficult)

Solution:                Value of Call        =              CMP[N(d1)] – [EP/ert][N(d2)]

Where    CMP       =              Current market price           =              $100
EP           =              Strike price                            =              $90
r               =              risk-free rate                         =              0.06
t               =              time till maturity in years   =              91/365   =              0.25
N(d1)       =              cumulative density function of d1

                                d1            =              ln(CMP/EP)          +              (r + 0.5s2)t
                                                                                                st1/2

s2            =              variance of the stock's annual rate of return =              0.36
N(d2)       =              cumulative density function of d2
                                d2                   =              d1   -  st1/2

d1            =              ln(100/90)             +              [0.06 + 0.5(.36)](0.25)
                                                                                                (0.36)1/2 (0.25)1/2
=              [0.10536  +  0.06]/0.3        
=              0.5512

d2            =              0.5512  -  0.6(0.5)
=              0.5512 - .3
=              0.2512

N(d1)       =              0.7088 (from standard normal table)
N(d2)       =              0.5987 (from standard normal table)

Value of the call  =              [$100(.7088)] - [$90/e(0.06)(0.25)][.5987]
=              70.88      -  [90(.9851)(.5987)]
=              $70.88   -  $53.08
=              $17.80

7.             You buy 1,000 shares of Sunbeam at 11 1/8 and write 10 calls at a premium of 4 3/8 with a strike price of  7 1/2.  The stock goes to 20 in 6 months.  You receive a 8 cent dividend per share.  If the calls are exercised (which is the likely assumption), what is your percentage return?
(moderate)

Loss on selling stock =  sell stock at 7.5 x 1,000 =      $7,500
                                 bought stock at 11.125 x 1,000 = 11,125
                                                                                      (3,625)

Dividends received = .08 x 1,000 = $80

Premium received on writing calls = 4.375 x 100 x 10 = $4,375

Total return = $830

Percentage return = $830/11,125 = 7.5%

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