Chapter 2 Securities Markets and Transactions 15
Suggested Answers to Discussion Questions
2.1 One reason for the large initial returns is the significant amount of hype surrounding new issues.
This was especially true in the late 1990s, during what is now described as the “tech-stock bubble.”
Investor demand for shares of these firms far exceeded the supply.
Underwriters may intentionally underprice issues to increase their own profits and make it easier
to sell the shares. In addition to serving their clients who are issuing shares in an IPO, underwriters
2.2 The main advantage of listing on the NYSE is the perception of greater prestige and public awareness
of the firm. The main disadvantage is that the NYSE has the strictest listing requirements of any
2.3 Due to global time differences, not all securities markets are open simultaneously, although the
possibility exists of trading in after–hour markets. This assumes the markets are equivalent when it
comes to liquidity and information ability. There is talk of a market that could trade any share in the
world, with the many mergers and cooperative arrangements among securities exchanges enhancing
2.4 The argument in favor of expanded trading sessions is that they would facilitate additional trading,
especially for international investors, and increase liquidity. On the other hand, some market
2.5 a. Long purchases are typically used by conservative investors so that they receive their
expected returns over time.
Solutions to Problems
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16 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
2.1 The $/yen exchange rate is the inverse of the yen/$ exchange rate. If an investor could get 120 yen
per dollar, then 1,000 yen buys (¥1,000/120) dollars, or $8.33.
2.3
Share Price in
Foreign Currency
Exchange Rate
per US$
Share Price
in US$
a. 103.2 euro 0.93 €/US$ $110.97
2.4 a. The euro depreciated relative to the US$, as each US$ is worth more euros. Stated another
way,
Date Transaction
Number
of Shares
Price/
Share (€)
Transaction
Value (€)
Exchange
Rate/
Value in
US$
b. 1 yr. ago Buy 50 64.5 3,225 0.67 €/US$ 4,813.43
Profits/(Losses): 365
d. Sale price $4786.67
2.5. Money spent to acquire the shares (in $): 100 x £260 x $1.50/£ = $39,000
2.7 a. $1,000 loss. This is because her short sale would have realized $6,000, while the
b. A profit of $1,500. The long position would initially cost Courtney Schinke $6,000. When she
c. $1,500 profit. The short sale brings in $6,000, while the return of the shares to the owner costs
only $4,500.
d. A breakeven situation. The long position costs Courtney Schinke $6,000, and the sale of the stock
2.8 a. Debit balance is transaction amount minus margin: (100 $50) 0.60 (100
$50) $2,000.
b. Equity is the margin amount, or 0.60 (100 $50) $3,000.
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Chapter 2 Securities Markets and Transactions 17
2.10 If an individual purchases 100 shares of stock at $35 per share with a 75% margin:
a. The debit balance (or the amount borrowed in the transaction) would be:
$3500
c. If the stock rises to $55, we would use the formula provided in the book to find the new margin:
Margin (%) =Value of securities – Debit balance
Value of securities
=$55´100 –$875
$55´100
=$4,625
$5,500
=0.84
2.11 When he initially purchased the shares, Miguel put up $2,500 in margin (50% of the value of shares
purchased), and he borrowed $2,500. Now, Miguel needs to cover a margin call. After the stock price
2.12 Market value of securities at purchase 100 $80 $8,000
Debit balance in the transaction 0.50 $8,000 $4,000
Given a maintenance margin of 25%, the stock has to fall to $53.33 per share in order to justify a
margin call; that is:
( )
( )
Value of Securities $4,000
.25 Value of Securities
.25 $4,000
.75 $4,000 $5,333
V
V
V V
V
–
=
= –
= =
On a per share basis, this translates to: $5,333/100 $53.33.
Note: This problem could also be solved by using a “hit-and-miss” approach or the Excel Solver
add-in, which finds a value for V in the margin (%) formula that results in a margin of 25%:
2.13 Market value of securities at purchase 200 $80 $16,000
Market value of securities at sale 200 $104 $20,800
Total current dividend income received 200 $1 (6/12) $100
18 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
(6/12 is used since the margin loan will be
outstanding for only half a year.)
Return on invested capital:
Market
value
Market value
Total current Total interest
paid
of securities of securities
income received on margin loan at sale at purchase
Amount of equity invested
Return on invested capital:
– + –
=
=
$100 $256 $20,800 $16,000
$9,600
$4,644
$9,600
48.38% (for the six-month period)
The annualized rate of return is found in the following manner:
Computed return (12/Number of months in holding period)
Annualized rate of return 48.38% (12/6)
48.38% 2 96.76%
= ´
= ´ =
2.14 a. Initial value: 300 shares $55 per share $16,500
Debit balance: $16,500 0.50 margin $8,250
Equity position: $16,500 0.50 margin $8,250
b.
V Debit balance
Margin % V
1.
($45 $300) $8,250
Margin % $45 300
$13,500 $8,250 $5,250 38.89%
$13,500 $13,500
2.
($70 $300) $8,250
Margin % $70 300
$21,000 $8,250 $12, 750 60.71%
$21,000 $21, 000
3.
($35 $300) $8,250
Margin % $35 300
$10,500 $8,250 $2,250 21.43%
$10,500 $10,500
c. 1. Dividends received: 300 shares $1.50 $450
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Chapter 2 Securities Markets and Transactions 19
d. Return on invested capital
Market
value
Market
value
Total current Total interest
paid
of
securities
of
securities
income received on margin loan at sale at purchase
Amount of equity invested
1.
$450 $247.50 300($50) $16,500
Return on invested capital $8,250
$1,297.50
$8,250.00
15.7% (for the four month period)
47.1% annual rate of return
2.
$450 $247.50 300($60) $16,500
Return on invested capital $8,250
$1,702.50
$8,250.00
20.6% (for the four month period)
61.91% annual rate of return
3.
$450 $247.50 300($70) $16,500
Return on invested capital $8,250
$4,702.50
$8,250.00
15. First transaction: Buy 200 shares at $45 per share, using 60% margin.
Second transaction: Buy another 300 shares at $60 per share.
Cost of transaction 300 $60 $18,000
Total value of securities held after second transaction:
Amount of unused credit in new debit balance:
$15,000 $3,600 $11,400
2.16 $2,000 0.5 $1,000
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20 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
2.17 The investor will deposit the margin requirement of 50% $2,000 $1,000, and the proceeds of
2.18 Margin is the account equity divided by the cost to cover. The account equity would be the initial
amount with the broker from the margin deposit of $1,000, plus the proceeds from the short sale of
2.19 Margin is the account equity divided by the cost to cover. The account equity would be the initial
amount with the broker from the margin deposit of $1,000, plus the proceeds from the short sale of
2.20 Intuition: If the stock price falls subsequent to a short sale, the transaction results in a profit. If the
stock price rises subsequent to a short sale, the transaction results in a loss.
Transaction
Stock Sold Short
at Price/Share
Stock Purchased to
Cover Short at
Price/Shares
Profit/Loss per Share
on Each Transaction
(in $)
A 75 83 75 83
8 (Loss)
2.21 Number of Bio International shares short sold by Charlene Hickman: 200 short-selling
price/share $27.50.
Intuition: If the stock price falls below $27.50 in four months, the transaction results in a profit. If
the stock price rises above $27.50 in four months, the transaction results in a loss.
Transaction
Stock Sold Short
at Price/Share
Stock
Purchased to
Cover Short at
Price/Shares
Profit/Loss per
Share on Each
Transaction
(in $)
Total
Profit/Loss
on Each
Transaction
(in $)
A 27.50 24.75 27.50 24.75
2.75
2.75 200
550
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Chapter 2 Securities Markets and Transactions 21
D 27.50 27.00 27.50 27.00
0.50
0.5 200
100
Solutions to Case Problems
Case 2.1 Dara’s Dilemma: What to Buy?
In this case, the student has to evaluate several alternatives, given a limited amount of information. The
instructor can expect a variety of answers for each question, which should provide for lively discussion
and high student interest.
a. In evaluating the four alternatives, one must consider: the volatility of the stock price (large swings in
the price); Dara’s attitude toward risk , and how the new purchases would affect the diversification of
Alternative 1— It appears that Dara is willing to tolerate more risk in an effort to increase the returns
on her fairly conservative portfolio. The NewestHighTech IPO will certainly accomplish this goal.
The stock, by definition, has no track record and the company is only 1 year old. It could turn out to
Alternative 2— Buying say 400 shares of Casino International now at $54 and monitoring closely is a
lower risk alternative than the tech IPO purchase. Dara might decide now how much loss she is
Alternative 3— Short selling Casinos provides a profitable opportunity if things start to look bad for
the company and its floating casino project. Dara really needs to decide which outcome she considers
Alternative 4— If Dara waits to see what happens with the casino permit, it will probably be too late
to earn exceptional profits from either a long or short position because the stock price will have
already moved up or down based on the news. Again, there are ways to exploit the uncertainty with
options, but they will be studied later.
Alternative 1may be the best choice if Dara really wants to accept more risk in exchange for the
possibility of higher returns. If she monitors the investment closely, she might be able to avoid
b. If the stock price rises to $60, under Alternative 2, Dara would have a gain of $6.00 per share or
©2017 Pearson Education, Inc.
22 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
c. If the price falls to $45, under alternative 2 Dara would likely sell the stock, accept her loss and move
on. The lower price would most likely have resulted from denial of the floating casino permit or
Case 2.2 Ravi Dumar’s High-Flying Margin Account
This case requires the student to review the concept of pyramiding. It also requires the student to review
the mechanics of margin trading and to evaluate the risk-return characteristics of a specific pyramiding
example.
a. Pyramiding is a margin trading technique in which the investor uses the paper profits in his or her
margin account to acquire additional securities. Here, Ravi has a margin account with a margin of 60%
b. Ravi currently has an account with a market value of $75,000 and a debit balance of $30,000. His
margin position is:
V D $75,000 $30,000
Margin (%) 60%
V $75,000
c. If Ravi purchases 1,000 shares of RS (a $20,000 transaction):
1. Using $10,000 cash and $10,000 from a margin loan:
Initial New Purchase
Total
Account
Value of securities $75,000 $20,000 $95,000
2. Using $2,500 cash and $17,500 in a margin loan:
Initial New Purchase
Total
Account
Value of securities $75,000 $20,000 $95,000
Therefore, new margin in the account $47,500/$95,000 50%.
3. Ravi can purchase the stock, in question (b) above, with only 12.5% margin ($2,500/$20,000)
because the margin requirements are on the account, not on the transaction. As long as he has
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Chapter 2 Securities Markets and Transactions 23
d. If Ravi purchases 1,000 shares using $2,500 cash and $17,500 in a margin loan and the stock then
goes to $40 per share, he will earn:
1. Return on invested capital:
=$0 –($17, 500 ´.10)+($40 ´1, 000) –($20 ´1, 000)
$2, 500
=$0 –$1, 750 +$40, 000 –$20, 000
$2, 500 =730%
2. If he had purchased the 1,000 shares using $20,000 cash, then return on invested capital
$0 $0 ($40 1,000) ($20 1,000) 100%
$20,000
e. Ravi’s idea to pyramid appears to be a good one since he can make use of his paper profits to gain
additional leverage and magnify his potential profit. If he is right about RS, he will increase his return
even more by pyramiding. The disadvantage is that he has to make interest payments on the margin
loan, and the stock appreciation must be sufficient to compensate him for these interest payments.
Also, given the low margin Ravi will be using (12.5%), it will not take much of a price decline for
Ravi to lose money in a big way.