Stock Investment and Trading

Seminar 1: Security Markets

Seminar Solutions

1. You want to invest in the US stock market but your broker only offers UK stocks.
What are the alternatives you can use to invest there? For each, briefly describe the pros
and cons. Where applicable find a real example investment and quote its current price.

Solution: There are several alternatives and students may suggest others:

(1) Change your broker! Many large UK brokers offer stocks on US and a few
other exchanges e.g. Interactive Brokers.
(2) Buy Global Depository Receipts (GDRs) (like American Depository Receipts
but global)
(3) Open an account with a US broker. Much easier once it’s done but you will
probably need to open a US$ bank account first
(4) Buy a single-country US unit or investment trust, but you won’t get any
choice in what they invest in
(5) Open a CFD trading account and buy US stocks in there. You don’t literally
own US stocks but the payoffs are similar. There may be a limited choice of US
stocks.

2. Describe the difference between a liquid and illiquid investment. Why are art and
antiques considered to be less liquid than coins and stamps? Choose a collectors’ market
which you know something about and compare the steps you would need to go through to
sell an item there compared to selling a stock on the LSE.

Solution: Liquid investments are those that can be sold for cash rapidly at low cost. Art
and antiques are considered illiquid investments because in most cases they are sold at
auctions. The implication of being traded at auctions rather than on a developed exchange
is that there is tremendous uncertainty regarding the price to be received and it takes a
long time to contact a buyer who offers the ‘right’ price. Besides, many buyers of art and
antiques are accumulators rather than traders and this further reduces trading.

Coins and stamps are more liquid than art and antiques because an investor can determine
the ‘correct’ market price from several weekly or monthly publications. There is no such
publication of current market prices of the numerous unique pieces of art and antiques
and owners are forced to rely on dealer estimates. Further, while a coin or stamp can be
readily disposed of to a dealer at a commission of about 10–15 per cent, the commissions
on paintings range from 30–50 per cent.

To sell a portfolio of stocks that are listed on the LSE, an investor simply contacts his/her
broker to sell the shares. Cost of trading stocks varies depending on whether the trade is
handled by a full service broker (up to 1%) or a discount broker (around £10).

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3. Long-term annual returns on various US markets are as follows

Standard deviation
Investment Arithmetic mean Geometric mean
of return
Common stocks 10.28% 8.81% 16.9%
Treasury bills 3.54% 3.49% 3.2%
Long-term
5.1% 4.91% 6.4%
government bonds
Long-term
5.95% 5.65% 9.6%
corporate bonds
Property 9.49% 9.44% 4.5%

a) Why are the mean and geometric means not equal? Which is more useful for
investment purposes?
b) Rank the investments using the coefficient of variation.
c) Assuming normality, calculate the range of mean returns that a stock investor would
expect to see in 19 out of 20 years.

Solution
(a). The geometric mean assumes compounding or interest-on-interest. The more the
returns vary, the wider the difference between the two will be. The geometric
mean internal rate of return is a critical concept in security and portfolio selection
as well as performance measurement in a multi-period framework.

(b). Ranking is best accomplished by using the coefficient of variation (standard

deviation / arithmetic mean, multiplied by 100):
1 – Property 47.4%
2 – Treasury Bills 90.4%
3 – Long Gov’t Bonds 125.5%
4 – Long Corp. Bonds 161.3%
5 – Common Stocks 164.4%

(c). Expected mean plus or minus 1.96 standard deviations:

10.28 +/−16.9 * 1.96 = −22.84% to +43.40%

4. A sophisticated AI computer virus has attacked mainly financial firms. No shares

have traded for several weeks now, but many consumer-orientated web sites seem to
be mostly back to normal. You lost your job as an investment banker and have not
yet even received your back pay.

Luckily, as well as physically owning some gold coins, you had the foresight to put
part of your share portfolio into paper certificates. You now want to sell your
certificate for 10,000 shares in Marston’s Brewery. Before the crash they were
trading at about 31p per share. Their pubs have stayed open so the company has an
income stream and significant property value. That certificate should be worth about

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two ounces of gold. How would you go about realising its value?

Solution: One primary concern is that you as seller may not know what a fair price is
for your stock. In order to try to sell the shares, one possibility is to put an ad in the
paper of your local community or in large cities. Another obvious alternative is an
auction or the use of a website such as eBay. With an ad you would have to specify a
price or be ready to negotiate with a buyer. With an auction (internet-based or
otherwise), you would be very uncertain of what you would receive. In all cases,
there would be a substantial time problem – it may take days, weeks, or longer
before you obtain an acceptable price for your shares.

5. You own 200 shares of Shamrock Enterprises that you bought at €25 per share. The
stock has now risen to €45.
a) You put in a stop loss at €40. Discuss why you might do this.
b) If the stock eventually goes down to €30 what would be your rate of return with and
without the stop loss?

Solution:
5(a). I want to protect some of the profit I have; should prices drop I will still have a
profit of €15/share.

5(b). With the stop loss: (€40 − €25)/€25 = 60%

Without the stop loss: (€30 − €25)/€25 = 20%

6. Two years ago you bought 300 shares of Kayleigh Milk Co. for €30 a share on a
margin of 60%. The Kayleigh stock has now gone up to €45. Compute the annualised
rate of return if a) you had paid cash, and b) buying on margin.

Solution:
(a). Assuming that you pay cash for the stock:

(€45 x 300 ) - (€30 x 300 ) 13 500 - 9000

Rate of Return = = =50 %
( €30 x 300) 9000

This is the return earned over 2 years so the annualised returns is (1 + 0.50) 1/2 − 1
= 22.47%

6(b). Assuming that you used the maximum leverage in buying the stock, the leverage
factor for a 60 per cent margin requirement is = 1/margin requirement = 1/0.60 =
1.67. Thus, the rate of return on the stock if it is later sold at €45 a share = 50% x
1.67 = 83.33%.

The annualised return is (1 + 0.8333)1/2 – 1 = 35.4%