Ch.1-4: End of Chapter Problems

(Ch.1) What is the difference between asset allocation and security selection?

Asset allocation is the allocation of an investment portfolio across broad asset classes.
Security selection is the choice of specific securities within each asset class.

(Ch.1) How does investment banking differ from commercial banking?

Investment bankers are firms specializing in the sale of new securities to the public, typically by underwriting the issue.
Commercial banks accept deposits and lend the money to other borrowers

(Ch.2) What are the key differences between common stock, preferred stock, and corporate bonds?

Common stock is an ownership share in a publicly held corporation. Common shareholders have voting rights and may receive dividends.
Preferred stock represents nonvoting shares in a corporation, usually paying a fixed stream of dividends.
While corporate

(Ch.2) Why do most professionals consider the Wilshire 5000 a better index of performance of the broad stock market than the Dow Jones Industrial Average?

While the DJIA has 30 large corporations in the index, it does not represent the overall market nearly as well as the more than 5000 stocks contained in The Wilshire index. The DJIA is simply too small

(Ch.2) What features of money market securities distinguish them from other fixed-income securities?

Money market securities are short-term, relatively low risk, and highly liquid. Also, their unit value almost never changes

(Ch.2) What are the major components of the money market?

1. Treasury bills
2. certificates of deposit
3. commercial paper
4. bankers' acceptances
5. Eurodollars
6. repos
7. reserves
8. federal funds
9. brokers' calls

(Ch.2) Why are high-tax-bracket investors more inclined to invest in municipal bonds than are low-bracket investors?

The coupons paid by municipal bonds are exempt from federal income tax and from state tax in many states. Therefore, the higher the tax bracket that the investor is in, the more valuable the tax-exempt feature to the investor

(Ch.2) What is meant by the LIBOR rate? The Federal funds rate?

The London Interbank Offer Rate (LIBOR) is the rate at which large banks in London are willing to lend money among themselves.
The Fed funds rate is the rate of interest on very short-term loans among financial institutions in the U.S

(Ch.2) Why are corporations more apt to hold preferred stock than are other potential investors?

Corporations may exclude 70% of dividends received from domestic corporations in the computation of their taxable income

(Ch.2) Why are money market securities sometimes referred to as "cash equivalents"?

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

(Ch.2) Which of the following correctly describes a repurchase agreement?
a) The sale of a security with a commitment to repurchase the same security at a specified future date and a designated price
b) The sale of a security with a commitment to repurcha


(Ch. 2) What options position is associated with:
a) The right to buy an asset at a specified price
b) The right to sell an asset at a specified price
c) The obligation to buy an asset at a specified price
d) The obligation to sell an asset at a specified

a) Long call
b) Long put
c) Short put
d) Short call

(Ch.2) What would you expect to happen to the spread between yields on commercial paper and T-bills if the economy were to enter a steep recession?

The spread will widen. Deterioration of the economy increases credit risk, that is, the likelihood of default. Investors will demand a greater premium on debt securities subject to default risk.

(Ch.3) What is the difference between an IPO (initial public offering) and an SEO (seasoned equity offering)?

An IPO is the first time a formerly privately-owned company sells stock to the general public.
A seasoned issue is the issuance of stock by a company that has already undergone an IPO.

(Ch.3) What is the difference between a primary and secondary market?

The primary market is the market where newly-issued securities are sold, while the secondary market is the market for trading existing securities. After firms sell their newly-issued stocks to investors in the primary market, new investors purchase stocks

(Ch.3) How do security dealers earn their profits?

The primary source of income for a securities dealer is the bid-ask spread. This is the difference between the price at which the dealer is willing to purchase a security and the price at which they are willing to sell the same security.

(Ch.3) In what circumstances are private placements more likely to be used than public offerings?

When a firm is a willing buyer of securities and wishes to avoid the extensive time and cost associated with preparing a public issue, it may issue shares privately

(Ch.3) What are the differences between a stop-loss order, a limit sell order, and a market order?

A stop order is a trade is not to be executed unless stock hits a price limit. The stop-loss is used to limit losses when prices are falling. An order specifying a price at which an investor is willing to buy or sell a security is a limit order, while a m

(Ch.3) Why have average trade sizes declined in recent years?

Many large investors seek anonymity for fear that their intentions will become known to other investors. Large block trades attract the attention of other traders. By splitting large transactions into smaller trades, investors are better able to retain a

(Ch.3) What is the role of an underwriter? A prospectus?

Underwriters purchase securities from the issuing company and resell them. A prospectus is a description of the firm and the security it is issuing

(Ch.3) How do margin trades magnify both the upside potential and downside risk of an investment portfolio?

Margin is a type of leverage that allows investors to post only a portion of the value of the security they purchase. As such, when the price of the security rises or falls, the gain or loss represents a much higher percentage, relative to the actual mone

(Ch.3) A market order has:
a) Price uncertainty but not execution uncertainty
b) Both price uncertainty and execution uncertainty
c) Execution uncertainty but not price uncertainty


(Ch.3) Here is some price information on Marriott:
Bid = 19.95
Ask = 20.05
You have placed a stop-loss order to sell at $20. What are you telling your broker? Given the market prices, will your order be executed?

The broker is instructed to attempt to sell your Marriott stock as soon as the Marriott stock trades at a bid price of $20 or less. Here, the broker will attempt to execute but may not be able to sell at $20, since the bid price is now $19.95. The price a

(Ch.3) If you place a stop-loss order to sell 100 shares of stock at $55 when the current price is $62, how much will you receive for each share if the price drops to $50?
a) $50
b) $55
c) $54.87
d) Cannot tell from the information given

Cannot tell from the information given.
The broker will start to sell when the stock price hits $55 and keep doing so if the price further tumbles.

(Ch.4) What are the benefits to small investors of investing via mutual funds? What are the costs?

Mutual funds offer many benefits. Some of those benefits include: the ability to invest with small amounts of money, diversification, professional management, low transaction costs, tax benefits, and the ability to reduce administrative functions.
The cos

(Ch.4) Why can closed-end funds sell at prices that differ from net value while open-end funds do not?

Closed-end funds trade on the open market and are thus subject to market pricing. Open-end funds are sold by the mutual fund and must reflect the NAV of the investments

(Ch.4) What is a 12b-1 fee?

12b-1 fees are annual fees charged by a mutual fund to pay for marketing and distribution costs.

(Ch.4) What are the advantages and disadvantages of exchange-traded funds versus mutual funds?

Exchange-traded funds can be traded during the day, just as the stocks they represent. They are most tax effective, in that they do not have as many distributions. They have much lower transaction costs. They also do not require load charges, management f

(Ch.4) What are some differences between hedge funds and mutual funds?

Hedge funds have much less regulation since they are part of private partnerships and free from most SEC regulation. They permit investors to take on many risks unavailable to mutual funds.
Hedge funds, however, may require higher fees and provide less tr

(Ch.4) Impressive Fund had an excellent investment performance last year, with portfolio returns that placed it in the top 10% funds with the same investment policy. Do you expect it to be a top performer next year? Why or why not?

Empirical research indicates that past performance of mutual funds is not highly predictive of future performance, especially for better-performing funds. While there may be some tendency for the fund to be an above average performer next year, it is unli