Quiz for Lecture 1

Q1. Assume a stock has a bid price of £10 and an ask price of £11. Assume that after bought
this stock its price increased by 50%, and that at hat pint we sold it. What return (in %) did
we actually earn?
(a) 50%
(b) 43%
(c) 37%
(d) 33%
(e) 30%
Answer:
Recall that we buy at ask and sell at bid.
In this case the bid-ask spread as a proportion of the ask price is: $(10-11)/11, so
approximately 9%.This means that whenever we want to sell we will earn 9\% less than the
ask price that the stock is currently trading at.
Given that the stock has increased by 50%, both the bid and ask will increase by this
proportion.

return= ( 16.5
11 ) (
− 16.5×
11 )
0.9
−1=36.5 %

The first element in the above is the gross return of 50%, which of course we do not get. The
second is the loss we incur due to the bid-ask spread.
Price new bid 10 ×1.5
A quicker way to do this: =1= −1=36.5 %
Priceold ask 11

Q2. Suppose that the average annual return earned by owing stock in SShady over a period
of time is 10%. SShady’s market beta is 0.75, and the average annual return on the market
index over the same period was 7%. The risk free rate is 2% per year. What is the
"abnormal" return of SShady, according to the CAPM (to the closet %)?
(a) 0%
(b) 2%
(c) 4%
(d) 7%
(e) 10%
 Answer:
According to the CAPM this company should offer an annual return of 2%+0.75×(7%-
2%)=5.75%.
The actual average return is 10%, so we can estimate the abnormal return as 10%-
5.75%=4.25%. In other words this stock has earned an average return that is by 5% higher
according to its systematic risk, as given by the CAPM, so it was initially under-priced
according to this model.

Q3: Annie opens a brokerage account and purchases 300 units of the sneakers brand 2Air3,
which currently trades at \pounds40 a share. She partly finances this trade by borrowing
4,000 from her broker, at 8% per year. What is the remaining margin in her account if at the
end of the year the price of 2Air3 falls to 30 per share (to the closest %)?
(a) 50%
(b) 52%
(c) 54%
(d) 58%
(e) 60%

Answer:
If the share price falls to £30, then the value of the stock in Annie account falls to 30 x
300=£9,000.
By the end of the year, the amount of the loan owed to the broker grows to:
$4,000  1.08 = $4,320
Therefore, the remaining margin in the investor’s account is:
$9,000  $4,320 = $4,680
The percentage margin is now: $4,680/$9,000 = 0.52, or 52%

Q4. A mutual fund with £200 million in assets at the start of the year with 10 million shares
outstanding. The fund invests in a portfolio of stocks that provide dividend income at the
end of the year, equal to £2 million. The stocks included in the fund’s portfolio have
increased by 8% in value, during the year. The fund charges a fee of 1%, which is deducted
from the fund’s value at the end of the year. What is the rate of return for an investor who
invests in the fund over the year?
(a) 7.1%
(b) 7.3%
(c) 7.5%
(d) 7.7%
(e) 7.9%

NAV0 = $200,000,000/10,000,000 = $20

So the investor bought the shares in the fund for this price in the beginning of the
year.
Dividends per share = $2,000,000/10,000,000 = $0.20
NAV1 is based on the 8% price gain, less the 1% fee:
NAV1 = $20  1.08  (1 – 0.01) = $21.384
$ 21 . 384−$ 20+$ 0. 20
Rate of return = $ 20 = 0.0792, or 7.92%