Chapter Twenty Five
ANSWERS TO QUESTIONS
1. We do not expect to find riskless profits in a well-functioning marketplace. Securities
are priced based on their expected returns and their perceived level of risk. Security
valuation is, therefore, based on arbitrage arguments. Investments that dominate
others will be preferred in the marketplace. It is the activities of security analysts and
individual investors who eliminate arbitrage.
2. Increased volatility in the market is generally considered undesirable. A clear cause
and effect would likely lead to calls for regulatory relief from program trading.
Whether this would happen is a matter of conjecture.
3. If the market is efficient, no one can consistently time the market, and TAA strategies
should be ineffective.
4. Asset class appraisal refers to an investigation of the relative merits of the various
groups of securities into which an investment might be made.
5. With any active portfolio management strategy there is the potential that the active
management might reduce returns rather than augment them. Failure to do at least as
well as the market average is usually viewed as substandard managerial performance.
6. TAA can be consistent with any portfolio strategy that employs both fixed income
securities and common stock. TAA is most commonly associated with an equity
portfolio where capital appreciation is the primary objective.
7. You could switch between the long and short end of the yield curve, but this would be
unusual. TAA is not normally associated with a fixed income portfolio.
8. Portfolio insurance requires alterations to the portfolio based on something that has
already happened rather than on something that is expected to happen.
9. Selling short involves a potentially unlimited loss. Because of this high risk, most
brokerage firms discourage small investors from doing so.
10. Most individual investors are only concerned with the security of their investment, its
potential return and risk, and with their ability to trade out of it at will. Whether stock
is lent is generally unimportant.
11. They have usually not been given permission by the security owner.
12. Facilitating the matching up of those who want to lend stock and those who want to
borrow it.
Chapter Twenty Five
13. It is essentially “free money.” There is no particular increase in risk, and it generates
a reliable return. Only if one party defaults is there added risk.
14. What is the actual incidence of stock lending? Do some firms do more of this as a
percentage of their assets than others do? What rates of interest are paid, and how
does this vary? What evidence is there that interest is ever credited to a customer
account? What evidence is there that securities held in a cash account are sometimes
lent?
15. Student response.
16. Program trading seeks to eliminate arbitrage opportunities as they develop. Without
arbitrage, program trading would be much less attractive.
17. A derivative asset is one whose value stems largely from the value of another asset.
Calls, puts, and futures contracts are common examples.
18. Unless there is incremental benefit from the TAA program, the TAA manager can be
accused of generating unnecessary commissions, which is not in the customer’s best
interest.
19. Stock loans are marked to market. In the event of default, the lender’s liability is the
extent to which the stock’s value exceeds the value of the collateral.
ANSWERS TO PROBLEMS
1. Student response.
2. a. 1,000 x (1.0) + (10 x 100 x -0.317) = 683 (equivalent to a long position of 683
shares)
b. Sell short 317 shares.
3 – 4. Student response.