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Securities Markets
1. When investment banks underwrite IPOs, they typically sell stock for 5–10 percent
more than they pay for it. When they underwrite new stock for companies that are al-
ready public, the typical markup is 3 percent. What explains this difference?
ANSWER: The process of underwriting an IPO (initial public offering) is quite costly
for the investment bank since it has to prepare registration statements, comply with
regulatory requirements, and compile and disseminate information on the company
issuing the stock. This often takes the form of “road shows” in which investment
2. As in Section 5.4, assume that bonds pay a real return of 2 percent. Stocks pay 22
percent half the time and –6 percent half the time. Suppose you initially have wealth
of $100, and let Xbe your wealth after 1 year. What fraction of your wealth should you
hold in stock under each of the following assumptions?
a. You want to maximize the average value of X.
ANSWER: Expected real return of stocks = 0.5(0.22) + 0.5(–0.06) = 0.08 (8%). Your
average wealth Xif you hold 100 percent of your wealth in stocks will be $108. Your
b. You want to maximize the value of Xwhen the return on stocks is –6 percent.
ANSWER: If you hold 100 percent of your wealth in stocks and the bad outcome (a
negative 6 percent real return) materializes, then your wealth will decline by 6 percent
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c. You want to be certain that Xis at least $100 (that is, you don’t lose any of your
initial wealth). Subject to that constraint, you maximize the average value of X.
ANSWER: The share of stock as a percentage of your wealth is s. You want to make
sure that even when the bad outcome occurs, your stock-holding will not reduce your
Or you can write the equation in terms of the return on wealth, picking sso that the
return on wealth is 0 percent in the case of the bad (low return) outcome:
You maximize the average value of Xwithout incurring any losses if you hold 25 percent
of your wealth in stock and 75 percent of your wealth in bonds. Increasing the amount
of stocks held will reduce your wealth below $100 when the bad outcome occurs.
3. Suppose two people are the same age and have the same level of wealth. One has
a high-paying job and the other has a low-paying job. Who should hold a higher frac-
tion of his or her wealth in stock? Explain.
ANSWER: The person with the low-paying job is in much the same position as a re-
tiree. Earning a low income is as much a barrier to falling back on future earnings as
4. Chapter 3 presented the classical theory of asset prices. In this chapter, we discussed
two ideas that follow from the classical theory: the Modigliani-Miller theorem and the
efficient markets hypothesis. How well do these two ideas fit real-world financial mar-
kets? Where does each fit on a spectrum from literally true to completely unrealistic?
ANSWER: The Modigliani-Miller (MM) theorem postulates that stocks and bonds are
equally good ways to finance a company. This is neither literally true nor completely
unrealistic. Firms need to consider institutional realities such as taxes and bankruptcy
in order to decide whether to issue stocks or bonds. Since these institutional differ-
CHAPTER 5 Securities Markets A-29
5. Suppose everyone in the world becomes convinced that the efficient markets hy-
pothesis is true. Will it stay true? Explain.
ANSWER: Efforts by analysts to identify undervalued assets, as in the Boeing ex-
ample in the text, actually help to bring about efficient market outcomes. By identify-
ing news that will result in higher future earnings, for example, analysts recommend
the purchase of particular stocks. This increases the demand for those stocks and re-
6. Research around 1980 showed that stocks of small firms had higher average re-
turns than stocks of large firms. This finding gained much attention, as it seemed to
contradict the efficient markets hypothesis. It suggested a simple way to beat the
market: purchase only small-firm stocks.
a. Can you explain this deviation from market efficiency? (Hint: Think about the
behavior in financial markets that leads to efficiency, and why this behavior might
not occur.)
ANSWER: In the 1970s, there were fewer (and possibly less talented) analysts in-
volved in gathering data and monitoring small firms. Large companies were well-
b. Would you guess that small stocks have done better than large stocks since
1980? Why or why not?
ANSWER: The research result that small company stocks outperformed large com-
pany stocks would have prompted more savers to buy small company stocks. Also,
more mutual funds would have evolved that specialize in small companies. These
7. Recall that U.S. mutual fund companies offer about 8,000 separate funds. Suppose
each fund has a 50 percent chance of beating the S&P 500 each year.
a. Over a 5-year period, how many funds will beat the market in every year? How
about a 15-year period?
ANSWER: The probability of beating the market over a 5-year period is (0.5)5 = 0.03,
or 3 percent. This implies that over a 5-year period, 250 funds [0.03(8,000)] will beat
b. Based on the performance of William Miller’s mutual fund from 1981 through
2005, would you say Miller is a genius? Explain.
8. In 1989, the economist Paul Samuelson rated Warren Buffett the greatest stock picker
in the country. Yet Samuelson warned against buying Berkshire Hathaway stock. He
wrote that “knowledge of Buffett’s skills may be already fully discounted in the market-
place. Now that B-H has gone up more than a hundredfold, it is at a premium.”
a. Explain Samuelson’s reasoning in your own words.
ANSWER: Samuelson reasoned that Buffett is indeed a genius, but that the wide-
spread knowledge of this fact was fully taken into account in pricing Berkshire Hath-
b. People who followed Samuelson’s advice have regretted it, because the re-
turns on B-H stock since 1989 have been similar to earlier returns. What does this
tell us about Buffett and/or the efficient markets hypothesis?
ANSWER: This is an example of when the efficient markets hypothesis does not
9. On its Web site, one mutual fund company describes its “disciplined and sophisti-
cated investment strategies.” (The term investment is used to mean the choice of se-
curities.) Let’s change the company’s name to “Smith.” With this alteration, the site
says:
At the center of Smith’s investment process is the Smith Investment Committee. It
consists of a select group of senior investment professionals who are supported by
an extensive staff. This staff provides multilevel analyses of the economic and in-
vestment environments, including actual and projected corporate earnings, interest
rates, and the effect of economic forecasts on market sectors, individual securities,
and client portfolios.
Does this statement convince you to buy Smith mutual funds? Why or why not?
ANSWER: It is hard to see how Smith’s investment strategies are different from the
strategies employed by any other mutual fund company. With the knowledge that
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10. Suppose you hold most of your wealth in stock. What kinds of options should you
buy or sell in each of the following circumstances?
a. You think the stock market will probably do well, but you worry about a crash.
ANSWER: Since you worry about a crash, you need to look for a way to protect your-
self from losses in the case of a crash. This can be achieved by purchasing a put op-
tion on a stock index (S&P 500) that allows you to sell the stocks at a fixed strike
b. You want to get a steady return on your assets. You don’t care whether you get
rich from a big rise in the market.
ANSWER: Holding most of your wealth in stocks is generally not the way to go if you
want a steady return on assets. You should buy Treasury bonds that pay a fixed
amount of interest each period. In order to protect against changes in the value of
c. You think there will soon be big news about a firm’s earnings, but you don’t
know whether the news will be good or bad.
ANSWER: You should buy a put option on the firm’s stock. This put option allows
you to sell the stock for this particular firm for a given price in the case the news turns
11. Suppose you buy call options on Microsoft stock. Each option costs $2 and has
a strike price of $40 and an expiration date of July 1. Discuss whether you would ex-
ercise the options in each of the following situations and why.
a. It is March 1 and Microsoft’s stock price is $30.
ANSWER: You would not exercise the option. You would have to pay $40 for a stock
b. It is March 1 and the stock price is $40.10.
ANSWER: Although the stock price is above the price you have to pay, the extra
CHAPTER 5 Securities Markets A-31
c. It is March 1 and the stock price is $50.
d. It is June 30 and the stock price is $50.
e. It is June 30 and the stock price is $40.10.
ANSWER: If you exercise the option you will earn $0.10 per share. This will cover at
12. Suppose company A has a stable stock price. The price is not likely to change
much in the next year. Company B has an uncertain stock price: it could either rise
or fall by a lot. Would you pay more for a call option on A’s stock or B’s stock? Explain.
ANSWER: A call option allows its owner to buy a stock at a fixed price. A call option
is particularly valuable to the owner when the stock price rises substantially above the
ONLINE AND DATA QUESTIONS
www.worthpublishers.com/ball2
13. Use bloomberg.com to answer the following questions.
a. Which has done better over the last year, the U.S. stock market or the Brazil-
ian stock market?
b. Which have done better over the last year, the stocks in the Dow Jones index
or the NASDAQ index.
c. What is the rate of return on Boeing stock over the last year?
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14. The text Web site provides data on rates of return for selected mutual funds.
Choose 20 actively managed funds and rank them by their average returns over the
period 2000–2004. Then rank the same funds by their average returns over 2005–
2009. What is the relationship between the two rankings? Are the results surprising?
Explain.
ANSWER: Two types of mutual funds exist, actively managed funds and index funds.
Actively managed funds generally charge higher fees than index funds. After con-
15. Link through the text Web site to buffettsecrets.com and study Warren Buffett’s
principles for choosing stocks. Do you think you could beat a stock index by follow-
ing these principles? Explain.
ANSWER: A quote from the Web site states: “Stock investments should be looked at
in the same way as buying a business. The stock investor is really buying a tiny share
or partnership and should apply the same principles that they would in buying a busi-
CHAPTER 5 Securities Markets A-33
