ALE20BT –2021
FACULTY OF ECONOMICS AND FINANCE
DEPARTMENT OF ECONOMICS
SUBJECT NAME AND CODE OF MODULE:
APPLIED ECONOMICS IIB: ALE20BT
SUBJECT HEAD:
Giscard Monsengwo
Email address: giscardmons@gmail.com/monsengwogm@tut.ac.za
PRACTICE MATERIAL
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PART 1: Multiple Choice Questions
1. Which of the following is not true with respect to preferred stock?
A) Preferred stock usually does not allow for significant voting rights.
B) If the firm does not have sufficient earnings from which to pay the preferred
stock dividends, the preferred shareholders may force the firm into bankruptcy.
C) Normally, the owners of preferred stock do not participate in the profits of the
firm beyond the stated fixed annual dividend.
D) Payment of preferred dividends is not a tax-deductible expense.
E) All of the above are true.
2. Which of the following statements is incorrect?
A) A stock is a certificate representing partial ownership in a corporation.
B) Like debt securities, common stock is issued by firms to obtain funds.
C) Stocks are issued by corporations to raise short-term funds.
D) The secondary stock market enables investors to sell stocks that they had
previously purchased.
E) None of the above.
3. Boris stock has an average return of 15 percent. Its beta is 1.5. Its standard deviation of
returns is 25 percent. The average risk-free rate is 6 percent. The Sharpe index for Boris
stock is
A) 0.35.
B) 0.36.
C) 0.45.
D) 0.28.
E) none of the above.
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4. Morgan stock has an average return of 15 percent, a beta of 2.5, and a standard
deviation of returns of 20 percent. The Treynor index of Morgan stock is
A) 0.04.
B) 0.05.
C) 0.35.
D) 0.03.
E) none of the above.
5. Tarzak Inc. has earnings of R10 per share, and investors expect that the earnings per
share will grow by 3 percent per year. Furthermore, the mean PE ratio of all other firms
in the same industry as Tarzac is 15. Tarzac is expected to pay a dividend of R3 per share
over the next four years, and an investor in Tarzac requires a return of 12 percent. The
estimated stock price of Tarzak today should be __________ using the adjusted dividend
discount model.
A) R116.41
B) R104.91
C) R161.15
D) R200.25
E) none of the above.
6. The limitations of the dividend discount model are most pronounced for a firm that
A) has a high beta.
B) has high expected future earnings.
C) distributes most of its earnings as dividends.
D) retains all of its earnings.
E) none of the above
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7. ______________ is (are) not a market-related factor(s) that affect(s) stock prices.
A) Interest rates
B) Noise trading
C) Trends
D) January effect
E) All of the above are market-related factors that affect stock prices.
8.
A ______ grants the owner the right to purchase a specified financial instrument for
a specified price within a specified period of time.
A) call option
B) put option
C) sale of a futures contract
D) purchase of a futures contract
E) No answer.
9. When the market price of the underlying security exceeds the exercise price, the
A) call option is in the money.
B) put option is in the money.
C) call option is at the money.
D) call option is out of the money.
E) None of the above.
10. Which of the following is not a typical provision of an interest rate swap?
A) the notional principal value to which the interest rates are applied to determine
the interest payments involved
B) the fixed interest rate
C) the floating interest rate
D) the underwriter of the bond
E) All of the above are provisions of an interest rate swap.
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11. Which of the following statements with regard to hedgers and speculators are correct?
A) A speculator usually takes ownership of the commodity in question
B) A speculator seeks to make a risk-less profit from mispricing in the market.
C) In their derivative dealings, hedgers substitute price risk with basis risk.
D) A hedger may eliminate his or her risk for loss by giving up any potential for gain.
E) ‘A’ and ’B ‘are correct.
F) ‘C’ and ‘D’ are correct.
12. Which of the following is false with respect to initial public offerings (IPOs)?
A) IPOs are first-time offerings of shares by a specific firm to the public.
B) Normally, a firm planning an IPO will hire a securities firm to recommend the
amount of stock to issue and the asking price for the stock.
C) Firms engaging in IPOs are normally not well known to investors.
D) IPOs are typically intended to raise funds so the corporation can expand.
E) All of the above are true.
13. The premium on an existing call option should ______ when there is a reduction in the
expected short-term volatility of the stock price.
A) be negative
B) decline
C) increase
D) be unaffected
E) A and B.
14. The process by which the lead underwriter solicits indications of interest by institutional
investors in an IPO at various possible _______ prices is referred to as ___________.
A) IPO; margin selling
B) offer; secondary market building
C) offer; bookbuilding
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D) IPO; bookbuilding.
E) None of the above.
15. If many investors quickly sell an IPO stock in the secondary market, there will be
___________ on the stock’s price.
A) Upward pressure
B) Downward pressure
C) No additional pressure
D) Inconclusive
E) None of the above.
16. The first-time issuance of shares by a specific firm to the public is referred to as a(n)
A) stock repurchases.
B) secondary stock offering.
C) initial rights issue.
D) initial public offering (IPO).
E) None of the above.
17. The prevailing price per share divided by the firm’s earnings per share is known as the
A) dividend yield.
B) price-earnings ratio.
C) fully diluted earnings per share.
D) annual dividend.
E) All of the above.
18. Which of the following is not a barrier to corporate control?
A) antitakeover amendments
B) proxy contests
C) poison pills
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D) golden parachutes
E) all of the above are barriers to corporate control.
19. A firm is expected to generate earnings of R2.22 per share next year. The mean ratio of
share price to expected earnings of competitors in the same industry is 15. Based on
this information, the valuation of the firm’s shares based on the price-earnings (PE)
method is
A) R2.22.
B) R6.76.
C) R33.30.
D) R5.75.
E) None of the above.
20. Protsky Inc. just paid a dividend of R2.20 per share. The dividend growth rate for
Protsky’s dividends is 3 percent per year. If the required rate of return on Protsky stock
is 12 percent, the stock should be valued at R_______ per share according to the
dividend discount model.
A) 24.44
B) 25.18
C) 18.88
D) 75.53
E) No answer.
21. Sellers (writers) of call options can offset their position at any point in time by
A) selling a put option on the same stock.
B) buying identical call options.
C) selling additional call options on the same stock.
D) A and B
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E) all of the above.
22. When investors buy stock with borrowed funds, this is sometimes referred to as
A) use of proxy.
B) purchasing stock on margin.
C) a margin call.
D) a margin residual claim.
E) None of the above.
23. Assume that Morgan trading stock is priced at R250 per share and pays a dividend of
R20 per share. An investor purchases the stock on margin, paying R150 per share and
borrowing the remainder from the brokerage firm at 12 percent annualized interest. If
after one year, the stock is sold at a price of R300 per share, what is the return to the
investor?
A) 0.386
B) 0.457
C) 2.565
D) 3.758
E) None of the above.
24.
A weak rand may enhance the value of a South African firm whose sales are
dependent on the South African economy.
A) True
B) False
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25. A stock’s beta is estimated to be 1.3. The risk-free rate is 5 percent, and the market
return is expected to be 9 percent. What is the expected return on the stock based on
the CAPM?
A) 5.2 percent
B) 11.7 percent
C) 16.7 percent
D) 4 percent
E) 10.2 percent.
26. The ____________ is not a measure of a stock’s risk.
A)
B)
C)
D)
E)
stock’s price volatility
stock’s return
stock’s beta
value-at-risk method
All of the above are measures of a stock’s risk.
27. Which one of the following statements is (are) true?
A) Financial futures contracts on stock indexes are referred to as interest rate
futures.
B) Financial futures contracts are rarely sold over the counter.
C) Brokers commonly require margin deposits from their customers above those
required by the exchanges.
D) Purchasers of financial futures contracts usually know who the sellers are, and
vice versa.
E) All of the above.
28. __________ risk is the risk that the position being hedged by a futures contract is not
affected in the same manner as the instrument underlying the futures contract.
A)
B)
C)
D)
E)
Market
Liquidity
Credit
Basis
none of the above
29. A put option is “out of the money” when the
A) market price of the security exceeds the exercise price.
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B)
C)
D)
E)
market price of the security equals the exercise price.
market price of the security is less than the exercise price.
premium on the option is less than the exercise price.
None of the above.
30. On an exchange, option trades can be executed
A)
B)
C)
D)
E)
by a floor broker.
electronically.
by a market maker.
all of the above.
A and B only.
31. Which of the following is not a typical provision of an interest rate swap?
A) the notional principal value to which the interest rates are applied to determine
the interest payments involved
B) the fixed interest rate
C) the floating interest rate
D) the underwriter of the bond
E) All of the above are provisions of an interest rate swap.
32. Which one of the following statements is (are) true?
A) A call option is said to be at the money when the market price of the underlying
security exceeds the exercise price.
B) Several call options are available for a given stock, and the risk-return potential
will vary among them.
C) Market makers can execute stock option transactions for customers and do not
trade stock options for their own account.
D) American-style stock options can be exercised only just before expiration.
E) An option with a higher exercise price has a higher call option premium and a
lower put option premium.
33. Market makers
A)
B)
C)
D)
E)
can execute stock option transactions for their customers.
can trade options for their own account.
are subject to the risk of losses from their positions in options.
benefit from the spread.
all of the above
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34. Speculators who anticipate a decline in interest rates may consider ____________ a
________ option on Treasury bond futures.
A)
B)
C)
D)
E)
purchasing; put
selling; call
purchasing; call
none of the above
A and B
35. Which of the following statements is incorrect?
A) Interest rate swaps are sometimes used by financial institutions and other firms for
speculative purposes.
B) A primary reason for the popularity of interest rate swaps is the existence of market
imperfections.
C) Swaps are necessary for some financial institutions to obtain the maturities or rate
sensitivities on funds that they desire.
D) Most financial institutions that anticipate that interest rate will move in an
unfavourable direction to not hedge their positions.
E) None of the above.
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PART 2: Short Answer and Long Answer Questions
Question 1:
1.1 Explain the different between commission brokers (floor brokers) and floor traders
(locals).
1.2 Discuss the difference between common shareholders and preferred shareholders in
terms of ownership and voting rights.
1.3 Describe the general characteristics of a futures contract. How does a clearinghouse
facilitate the trading of financial futures contracts?
1.4 Briefly explain the following terms:
A. Cross-Hedging
B. Dynamic Asset Allocation
1.5 Describe a lockup provision and explain why it is required by the lead underwriter.
1.6 Describe spinning and laddering in the IPO market. How do you think these actions
influence the price of a newly issued stock? Who is adversely affected as a result of
these actions?
1.7 Identify the three major factors affecting the premium paid on a call option. Describe
how each factor affects the size of the premium.
1.8 Credit default swaps were once viewed as a great innovation for making mortgage
markets more stable. Yet, the swaps were sometimes criticized for making the credit
crisis worse. Why?
Question 2:
Investors have been investing into bitcoin since the start of the US-China trade war to weigh
on global growth and market sentiment. Trading of bitcoin flowed 140% during these key
moments. In the other hand, Gold which is a popular asset to hold during times of uncertainty
rose by a less dramatic 73% over the same period. Mention two similarities and two
differences between bitcoin and gold in the financial market.
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Question 3:
3.1 Describe the dividend discount valuation model. What are some limitations of the
dividend discount model?
3.2 Explain the use of circuit breakers in stock market.
3.3 Explain the use of a prospectus developed before an Initial Public Offerings (IPO).
3.4 Why does a firm do a road show before its IPO?
3.5 What factors influence the offer price of stock at time of the IPO?
3.6 What is the meaning of “flipping” shares? Why would investors want to flip shares?
3.7 Explain (using intuition and math) why stock prices may decrease in response to a higher
risk-free rate according to the CAPM.
3.8 In some periods, the risk-free rate rises in response to higher economic growth. Explain
(using intuition instead of math) why stock prices may increase in this situation even though
the risk-free rate increases.
QUESTION 4.
During our class room discussion, we said that economic factors, market related factors, and
firm specific factors affect stock prices through investors’ expectation. Explain the impact of:
4.1 Interest rates on stock prices.
4.2 Exchange rate value on stock prices.
4.3 Investor sentiment on stock prices.
4.4 Acquisitions and Divestitures on stock prices.
4.5 Earnings Surprises.
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Question 5:
Writing Put Options. A put option on Ford stock specifies an exercise price of R26. Today the
stock’s price is R27. The premium on the put option is R6. Assume the option will not be
exercised until maturity, if at all. Complete the following table and briefly conclude your
answers.
Price of
Asset
Will the Option
Buyer Exercise?
Calculation
Asset price-ExP+Pm
Option Writer Profit
or Loss
R23
R24
R25
R26
R27
R28
R29
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