FINANCIAL ECONOMICS – Group 2

Problem set 1

1. Consider the following data for a hypothetical two-stock market

Stock Initial price Final price Shares outstanding

ABC 30 25 45

XYZ 80 100 12

a. Calculate the initial and final values of both price-weighted and market-value-weighted
indexes and their percentage change.
b. Suppose that right after the release of the initial price, XYZ share splits two-for-one so
that its share price fell to $40, and its final price is $50. Calculate the initial and final
values of the price-weighted index and its percentage change.
c. Does the stock split affect the market-value-weighted index? Why?
2. Suppose you buy 100 shares share of stock initially selling for $50, borrowing 25% of the
necessary funds from your broker. You pay an annual interest rate of 8% on margin loans.
a. How much of your own money do you invest?
b. How much do you borrow from your broker?
c. What will be your rate of return for the following stock prices at the end of a 1-year
holding period?
i. $40 ii. $50 iii. $60
3. Repeat the previous question assuming your initial margin was 50%. How does margin
affect the risk and return of your position?
4. Suppose an investor initially pays $6,000 toward the purchase of $10,000 worth of stock
(100 shares at $100 per share) borrowing the remaining $4,000 from a broker.
Calculate how far the stock price could fall before the investor would get a margin call, if
the maintenance margin is
(1) 30% (2) 40%
5. Suppose you sell short 100 shares of stock initially selling for $100 a share. Your initial
margin requirement is 50% of the value of the stock sold. You receive no interest on the
funds placed in your margin account.
a. How much do you need to contribute to your margin account?
b. What will be your rate of return for the following stock prices at the end of a 1-year
holding period? Assume the stock pays no dividends.
i. $90 ii. $100 iii. $110
6. Repeat part b of the previous question assuming now that the stock pays dividends of $2
per share at year-end.
What is the relationship between the total rate of return on the stock and the return to your
short position?
7. Suppose you are bearish (pessimistic) on Dot Bomb stock, and its market price is $100 per
share. You tell your broker to sell short 1,000 shares. The broker borrows 1,000 shares either
from another customer’s account or from another broker.
The $100,000 cash proceeds from the short sale are credited to your account. Suppose the
broker has a 50% margin requirement on short sales.
a. Calculate your profit/loss and the return of this transaction if
i. Share price falls to $70
ii. Share price goes up to $110
b. Suppose the broker has a maintenance margin of 30% on short sales. How much can
the price of Dot Bomb stock rise before you get a margin call?
8. Read pages 25 and 26 of the book by Elton et al. Then answer the following question: what
type of trading order might you give to your broker in each of the following circumstances?
a. You want to buy shares of FedEx, to diversify your portfolio. You believe the share price
is approximately at the “fair” value, and you want the trade done quickly and cheaply.
b. You want to buy shares of FedEx, but believe that the current stock price is too high
given the firm’s prospects. If the shares could be obtained at a price 5% lower than the
current value, you would like to purchase shares for your portfolio.
9. Read pages 31-34 of the book by Elton et al. Then write down the precise definition of the
following terms (you can consult or look up the definitions in other books or on the web).

a. Liquidity
b. Continuity
c. Depth
d. Limit order book
e. Best bid and offer (BBO)
f. Passive order
10. Read the following article https://www.bloomberg.com/news/articles/2018-08-24/so-
you-want-to-short-tesla-here-s-what-you-pay-to-pull-it-off. Then answer the following
questions
a. What is Tesla inc.?
b. At the time of publication of the article, what is Tesla’s stock loan fee?
c. Look up the definition of rebate rate in the context of securities lending. What is Tesla’s
rebate rate?
d. What is the maintenance requirement on the margin account in order to sell short
shares of Tesla?