Tutorial Solutions

As part of efforts to provide feedback on your learning progress, I provide an indicative

difficulty level of questions, measured as the passing rate (e.g., easy questions have higher
passing rates). This is based on the students’ performance in the previous years. For example,
a level “B” multiple choice question means about 70% students passed this question; a level
“B” problem solving question means on average students got about 70% of total marks. You
can use it to assess your performance.
Keep in mind that questions in the Problem Set are highly selective, so the Problem Set on
average is more difficult than the final exam paper.

Difficulty level Passing rate Indicator

Easy >80% A
Moderate 60 – 80% B
Difficult 40 – 60% C
Very difficult 25 – 40% D
Extremely difficult <25% E

1. Which of the following securities are considered to be risk-free instruments:

[I] US Treasury Bills
[II] A diversified portfolio of corporate bonds
[III] Hang Seng Index

A. I only
B. I and II only
C. I, II, and III
D. I and III only
E. None of the statements are true
Difficulty level: B

Answer: (A)

2. Which of the following statements is/are TRUE of a US Treasury Bill:

[I] Is safe because it has the same payout/payment in a bull market or a bear
market
[II] Is safe because it has negligible default risk
[III] Is safe because it protects against inflation

A. I only
B. I and II only
C. I, II, and III
D. I and III only
E. None of the statements are true
Difficulty level: D
Answer: (B). III applies only to inflation-linked bonds, e.g., Treasury Inflation-Protected
Securities (TIPS) in US or inflation-linked gilts in UK.

3. Real assets in the economy include all but which one of the following?
A. Land
B. Buildings
C. Consumer durables
D. Common stock
Difficulty level: B

Answer: (D). Stocks are financial assets.

4. Financial markets allow for all but which one of the following?
A. Shift consumption through time from higher-income periods to lower
B. Price securities according to their riskiness
C. Channel funds from lenders of funds to borrowers of funds
D. Allow most participants to routinely earn high returns with low risk
Difficulty level: B

Answer: (D)

5. Which of the following are TRUE statements regarding short-sale?

[I] Losses are unlimited.

[II] The short-seller must pay out any issued dividends to the party that lent the shares.
[III] The broker does not require any form of collateral from the short-seller.

A. I only
B. I and II
C. I, II and III
D. I and III
E. II and III

Difficulty level: C

Answer: (B) There is no upper limit to the price of a share of stock; therefore potential
losses are unlimited for short selling.

6. Which of the following statements are TRUE about buying securities using a margin account?

[I] It allows the investor to use leverage.

[II] Investors buy on margin when they are cautious about the market.
 [III] Losses are unlimited.

A. I only
B. I and II only
C. I and III only
D. II and III only
E. I, II and III
Difficulty level: C

Answer: (A)

7. Purchases of new issues of stock take place _________.

A. at the desk of the Fed
B. in the primary market
C. in the secondary market
D. in the money markets

Difficulty level: B

Answer: (B)

8. Initial margin requirements on stocks are set by _________ in US.

A. the Federal Deposit Insurance Corporation
B. the Federal Reserve
C. the New York Stock Exchange
D. the Securities and Exchange Commission

Difficulty level: B

Answer: (B) NYSE sets maintenance margin rate for securities traded at NYSE.

9. An order to buy or sell a security at the current price is ______________.

A. a limit order
B. a market order
C. bid price
D. ask price

Difficulty level: A

Answer: (B)
10. You find that the bid and ask prices for a stock are $10.25 and $10.30 respectively. If you
purchase or sell the stock you must pay a flat commission of $25. If you buy 100 shares of
the stock and immediately sell them, what is your total implied and actual transaction cost in
dollars?
A. $50
B. $25
C. $30
D. $55

Difficulty level: C
Answer: (D)

100(10.30 - 10.25) + 2(25) = $55

11. An investor puts up $5,000 but borrows an equal amount of money from their broker to
double the amount invested to $10,000. The broker charges 7% on the loan. The stock was
originally purchased at $25 per share and in one year the investor sells the stock for $28. The
investor's rate of return was ____.

Difficulty level: C

12. You sell short 300 shares of XYZ which are currently selling at $30 per share. You post
the 50% margin required on the short sale. If you earn no interest on the funds in your margin
account what will be your rate of return after one year if XYZ is selling at $27? (Ignore any
dividends)

Difficulty level: C

13. In which markets, can buyers purchase goods or securities from sellers directly?
I. Brokered markets
II. Dealer markets
III. Auction markets

A. All of the above.

B. I and II.
C. I and III.
D. II and III.
E. III only.

Difficulty level: B
Answer: (C)

14. The bid price of a Treasury bill is _________.

A. the price at which the dealer in Treasury bills is willing to sell the bill
B. the price at which the dealer in Treasury bills is willing to buy the bill
C. greater than the ask price of the Treasury bill expressed in dollar terms
D. the price at which the investor can buy the Treasury bill

Difficulty level: B
Answer: (B)

15. You short sell 1000 shares of stock ABC at $40 per share. The initial margin requirement
was 50% (the margin account pay no interest). A year later, the stock price has risen from
$40 to $43, and the stock has paid an annual dividend of $2 per share.

(1) What is the remaining equity in your account?

(2) If the maintenance margin requirement is 30%, will you receive a margin call?
(3) What is your rate of return on the investment?

Difficulty level: C
Answer:
(1) The initial equity you put was: 0.50 x 1000 x $40 = $20,000

Your total initial margin account =1000 x $40 + 20,000 = $60,000

You lose money as a result of the increase in the stock price. Moreover, you also need to pay
the dividend of $2 per share to the lender of the shares. Therefore, the remaining equity is:
$60,000– $43x1000 – $2x1000 = $15,000

(2) The percentage margin is:

$15,000/$43,000 = 34.88 %
So you will not get a margin call.

(3) Your rate of return on this investment over the year is:
(Ending equity in the account − Initial equity) / Initial equity
=(15,000 – 20,000)/20,000 = - 25%

16. Consider the following limit order book for a share of stock. The last trade in the stock
occurred at a price of $50.

Difficulty level: C

a. The market-buy order will be filled at $49.80, the best price of limit-sell orders in the
book.

b. The next market-buy order will be filled at $49.85, the next-best limit-sell order price.

c. As a security dealer, you would want to increase your inventory. There is

considerable buying demand at prices just below $50, indicating that downside risk is
limited. In contrast, limit-sell orders have lower volume, indicating that a moderate
buy order could result in a substantial price increase.
17.

Difficulty level: C

The total cost of the purchase is: $40 × 500 = $20,000.

Investing $15,000 from your own funds and borrowing $5,000 from the broker, you
start the margin account with the net worth of $15,000.

a.
(i) Net worth increases to: ($44 × 500) – $5,000 = $17,000
Percentage gain = ($17,000 – $15,000)/$15,000 = 0.1333 = 13.33%

(ii) With price unchanged, net worth is unchanged.

Percentage gain = zero

(iii) Net worth falls to ($36 × 500) – $5,000 = $13,000

Percentage gain = (($13,000 – $15,000)/$15,000 = –0.1333 = –13.33%

The relationship between the percentage return and the percentage change in the
price of the stock is given by:
Total investment
% return = % change in price ×
Investor's initial equity

= % change in price × 1.3333

For example, when the stock price rises from $40 to $44, the percentage
change in price is 10% (0.10), while the percentage gain for the investor is:
$20,000
% return = 0.10 × = 0.1333 or 13.33%
$15,000
b. The value of the 500 shares is 500P. Equity is (500P – $5,000). You will
receive a margin call when:
500P－$5,000
= 0.25 or 25%, when P = $13.33 or lower.
500P

c. The value of the 500 shares is 500P. But now you have borrowed $10,000
instead of $5,000. Therefore, equity is (500P – $10,000). You will receive a
margin call when:
500P －$10,000
= 0.25 or 25% when P = $26.67.
500P
With less equity in the account, you are far more vulnerable to a margin call.

d. By the end of the year, the amount of the loan owed to the broker grows to:
$5,000 × (1 + 0.08) = $5,400
The equity in your account is (500P – $5,400). Initial equity was $15,000.
Therefore, the rate of return after one year is as follows:

(500 × $44)－$5,400－ $15,000

(iv) = 0.1067 = 10.67%
$15,000

(500 × $40)－$5,400－ $15,000

(v) = –0.0267 = –2.67%
$15,000

(500 × $36)－$5,400－ $15,000

(vi) = –0.1600 = –16.00%
$15,000

The relationship between the percentage return and the percentage change in
the price of XTel is given by:
Total investment
% return = �% change in price × �
Investor's initial equity

Funds borrowed
– �8% × �
Investor's initial equity

For example, when the stock price rises from $40 to $44, the percentage
change in price is 10% (0.10), while the percentage gain for the investor is:
$20,000 $5,000
�.10 × $15,000 � – �.08 × $15,000� = .1067 or 10.67%
e. The value of the 500 shares is 500P. Equity is (500P – $5,400). I will receive
a margin call when:
500P－$5,400
= 0.25 or 25% when P = $14.40 or lower.
500P
18.

Difficulty level: C

a. Given the $15,000 invested funds and assuming the gain or loss on the short
position is (–500 × ∆𝑃𝑃) where ∆𝑃𝑃 is the price change, we can calculate the rate
of return using the following formula:
Rate of return = (–500 × ∆𝑃𝑃)/15,000

Thus, the rate of return in each of the three scenarios is:

(i) Rate of return = (–500 ×$4)/$15,000 = –0.1333 = –13.33%
(ii) Rate of return = (–500 × $0)/$15,000 = 0%
(iii) Rate of return = [–500 × (–$4)]/$15,000 = 0.1333 = 13.33%

b. Total assets on margin are the sum of the initial margin and the proceeds from
the sale of the stock:
$20,000 + $15,000 = $35,000. Liabilities are 500P. A margin call will be
issued when:
$35,000－500P
= 0.25 or 25% when P = $56 or higher.
500P

c. With a $1 dividend, the short position must now pay on the borrowed shares:
($1/share × 500 shares) = $500. Rate of return is now:
[(–500 × ∆𝑃𝑃) – 500]/15,000

(i) Rate of return =[(–500 × $4) – $500]/$15,000 = –0.1667 = –16.67%

(ii) Rate of return = [(–500 × $0) – $500]/$15,000 = –0.0333 = –3.33%
(iii) Rate of return = [(–500) × (–$4) – $500]/$15,000 = 0.1000 = 10.00%

Total assets are $35,000, and liabilities are (500P + 500). A margin call will
be issued when:
$35,000－500P－500
= 0.25 or 25% when P = $55.20 or higher.
500P