Chapters 1&2 - Investments, Investment Markets, and Transactions

FIN 432 Investment Analysis and Management

Review Notes for Midterm Exam

Chapter 1

1. Investment vs. investments

2. Real assets vs. financial assets

3. Investment process

Investment policy, asset allocation, security selection and analysis, portfolio construction and analysis, and portfolio rebalance

4. Players in investment markets

5. Homework problems and examples discussed in class

Chapter 2

1. Money markets

2. Bond markets

3. Equity markets

4. Market indexes and averages: concepts and calculations5. Derivative markets

6. Homework problems and examples discussed in class

Chapter 3

1. New issues

2. Market structure

Direct search, brokered, dealer, auction markets

3. Transactions

Bid price, asked price, and bid-asked spread

Types of orders: concepts and applications

Types of transactions: long vs. short

4. Margin trading and short sales

Margin requirements; Initial margin; Maintenance margin

Margin call

Up-tick, down-tick, and zero-tick5. Homework problems and examples discussed in class

Chapter 4

1. Investment companies and mutual funds

2. Characteristics of investment companies

NAV (net asset value)

Open-end funds vs. closed-end fundsLoad funds vs. no-load funds

Low-load funds

Redemption fee (back-end load) and other fees

3. Types of mutual funds

4. Mutual fund performance

5. Investing in mutual funds

6. Homework problems and examples discussed in class

Chapter 5

1. Risk and return

2. Risk premium3. Mean and standard deviation4. Inflation and real return

5. Asset allocation: concepts and calculations

6. Homework problems and examples discussed in class

Chapters 6&7

1. Portfolio construction with two risky assets: concepts and calculations2. Diversification

Why portfolios can reduce total risk

3. Modern portfolio theory: concepts and applications

With n risky assets (no risk-free asset)

Efficient portfolios

Efficient frontier and MVP

Indifference curves

Choosing the optimal portfolio

If a risk-free asset exists and borrowing and lending are allowedEfficient portfolios

Efficient frontier and MVP

Indifference curves

Choosing the optimal portfolio

4. Beta coefficient: concepts and calculations5. CAPM: concepts and calculations

6. Capital market line and security market line

7. Single index model

8. APT model9. Multi-factor models

10. Homework problems and examples discussed in class

Chapter 8

1. EMH: three forms, concepts, and implications

2. Evidence of market efficiency: concepts and tests3. Evidence of market anomalies: concepts and tests4. The role of portfolio manager in efficient market

5. Interpretation of EMH

6. Homework problems and examples discussed in class

Sample Problems

1. Consider the following limit order book of a specialist. The last trade in the stock

occurred at a price of $45.55.

Limit Buy Orders

Limit Sell Orders

Price Shares

Price Shares

$45.50 500

$45.75 100

45.25 600

45.80 200

45.00 800

46.00 500

If a market buy order for 300 shares comes in, at what price(s) will it be filled?

Answer: first 100 at $45.75 and next 200 at $45.80

2. Intermediate 2.12-2.14, 2.18-2.19 from the textbook

3. Assume that you bought 100 shares of stock X at $50 per share in your margin

account that has an initial margin of 60%. What would be the debt balance? How

much equity capital should you provide? What would be the actual margin if the

price rises to $70? If the maintenance margin is 30%, how low the price could

drop before you receive a margin call?

Answer:

Total cost = $5,000

Loan = $2,000 (debt balance)

Equity = $3,000 (equity capital)

100*70 2,000

Actual margin = --------------------- = 71.43% if the price rises to $70

100*70

Critical price = $28.57, if the price drops below $28.57, you receive a margin call

4. You are bearish on stock ABC and decide to sell short 100 shares at the price of $50.

If the initial margin is 50%, how much cash should you provide? How high can the

price of the stock go before you receive a margin call if the maintenance margin is

30%?

Answer:

Short sale proceeds = $5,000

Initial margin = $2,500 Total assets = $7,500

7,500 100P

Margin = ------------------- = 0.30, solve for P = $57.69

100P

5. Intermediate 4.11-4.14 and 4.21 from the textbook 6. Choose the portfolio from the following set that is not on the efficient frontier.

a. Portfolio A: expected return of 12% and standard deviation of 13%

b. Portfolio B: expected return of 18% and standard deviation of 15%

c. Portfolio C: expected return of 38% and standard deviation of 28%

d. Portfolio D: expected return of 15% and standard deviation of 12%

Answer: a By comparing a and d, we find that d provides a higher return and a lower risk. Therefore, if d is available we will never choose a7. Given the utility function: U = E(r) 0.5A, where A = 4 and four investments, choose the one that maximizes your utility. Investments Expected returnStandard deviation

1

.12

.30

2

.15

.50

3

.21

.16

4

.24

.21

Answer: Investment 3. For each portfolio: Utility = E(r) (0.5 ( 4 ( (2)InvestmentE(r)(U

10.120.30-0.0600

20.150.50-0.3500

30.210.16 0.1588

40.240.21 0.1518

You should choose the portfolio with the highest utility value. If you are risk neutral what investment should you choose?

Answer: Investment 4. When an investor is risk neutral, A = 0 so that the portfolio with the highest utility is the portfolio with the highest expected return.

8. Intermediate 5.12-5.16 from the textbook9. Intermediate 6.8-6.12 from the textbook

10. Intermediate 7.17-7.19 from the textbook11. Intermediate 8.10- 8.17 from the textbook12. All assigned CFA questions34

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