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Quiz 6 :

Stocks and Other Assets

Quiz 6 :

Stocks and Other Assets

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What is the role of a stock exchange? Give two examples of stock exchanges and explain how they differ.
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Stock Exchange is the market place where the buyer and seller trade their stocks. The Stock Exchanges contributes the utmost for the Joint Stock Enterprise to flourish and develop dealing with the securities.
The Stock Exchange performs certain functions that help the company in the process of capital formation and in raising resources for the corporate sector.
• The Stock Exchange offers purchase and sale of securities such as shares, bonds, debentures etc.
• It ensures the free transferability of securities
• It provides the association between the savings in the household sector and investment in corporate economy.
• It provides a market quotation of the prices of shares and bonds;
• It serves as the role of barometer, which reveals the state of health of individual companies and of the nation's economy.
• It enables active trading, which helps in liquidity to financial assets.
Some Stock Exchanges exist as physical places and few exist through a network of system. Such as the examples of stock exchanges are New York Stock Exchange and NASDAQ (National Association of Securities Dealers Automated Quotation) Stock Exchange.
New York Stock Exchange has a physical place and is located at lower Manhattan and NASDAQ Stock Exchange. It has no fixed physical location tangible but works through a network of computers.
They differ in manner way of in New York Stock Exchange, since as a place exits the people who want to buy or sell stocks can meet at this place and trade. Whereas in case of NASDAQ, the seller or buyer of stocks need not go to a particular place and search for trade of stocks, it can via net basis make its transactions easily transacted and promptly.

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How does the lock-in effect cause the stock market to be ineffi cient?
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The gains earned by the investors are liable to taxes. The capital gains earned by investors are even liable to taxes, along with dividends; investors should also pay taxes on their realized capital gains. Capital gains are of two forms realized capital gains and implicit capital gains.
Realized capital gains is the actual profit earned by investor on selling stocks whereas the Implicit capital gains are the profit which is accrued but not yet realized. The investor is liable to pay taxes on dividends and capital gains earned on the stocks. Therefore, the investors even thou the stock value increase cannot significantly invest in other stock easily to avoid paying capital gains taxes.
For instances if Mr. John invested in GENINE Ltd., Stock at a price of $50 and it gradually increased to $80 in two years and rate of return in 10% in the meantime if the OPTIMISTIC Ltd., is issuing Stock at the price of $70 and expected to increase to $120 in coming year and rate of return is 20%.
Therefore, if Mr. John wants to invest in OPTIMISTIC Ltd., he will not go for purchasing it because Mr. John has to sell the GENINE Ltd., first and pay taxes on capital gains and then invest in OPTIMISTIC Ltd., and for this, he has to forego an amount for taxes. Therefore the investor (Mr. John) doesn't goes for purchase in OPTIMISTIC Ltd., and this type of holding of investment leads to lock-in-effect for the stock market.
This lock-in-effect leads to unhealthy price discrimination of the stocks. Since the stocks are being held, even though it gets less rate of returns, compared to present and holds it for a longer period and on other hand, the other stock, which can have a boom and high rate of returns does not get adequate investors and will suffer a fall in the price.
This leads to inefficiency in discovery of the worth of the stocks properly and affect the stock market. Therefore, it is clear that the lock-in effect cause the stock market to be inefficient.

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Why is it important for an investor to diversify? How does a mutual fund help an investor achieve this goal?
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Investments by investors depends on various factors such as on the basis of maturity period, credit-worthiness nature of the instrument or security, variability of the rates of returns, liquidity of an investment, forecasted factors etc. Thus, investments associated with risks along with returns.
Therefore, if an investor invests all his savings or surplus only in one type of stocks of a company there is a heavy threat of risks, therefore its considerable to invest in a diversified number of securities so that the risks pertain to those can also be diversified and the investor can easily manage his portfolio and perform well. Because even one investment earns losses then it can be offset by the other investment which earns gains.
Diversification is important because for sure there is no possibility for a single class of assets or investment to perform best in all economic environments. Therefore, it is best to go for diversified portfolio, as it is helping in the best way to match the decline securities with the better performing securities.
Diversification does not eliminate risk or guaranteed returns of securities, but it just a way to earn potential returns overtime without exposing to higher risks.
Mutual Funds are money-managing institutions which are set up for professionally invest the money pooled in from the public. These are managed by AMC Asset Management Companies, which are sponsored by different financial institutions or companies. Therefore, these mutual funds consist of various schemes and each scheme invest in diversified elected number of securities.
Therefore, if an investor invests in mutual funds then indirectly it means he has invested in diversified portfolio of securities. Hence, in this way, mutual fund help an investor achieve this diversification goal.

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Describe three major stock indexes. In what ways are they similar? In what ways are they different?
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What is the longest period the stock market took to return to its previous peak after declining? What is the shortest period in which the stock market doubled in value?
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Why does frequently buying and selling stocks lead to lower returns?
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What is the effi cient markets hypothesis? What are the most important characteristics of markets that are necessary for them to be effi cient?
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How do stock prices behave if stock markets are effi cient and if investors do not care about risk?
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Describe three anomalies in the stock market. In what way are they anomalous?
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What are the basic ideas that motivate the CAPM and the APT? Which theory is more general? Explain.
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A stock was priced at $150 per share at the end of 2007. The following table shows dividends per share paid during each year and the price of the stock at the end of the year for the following four years: img For each year from 2008 to 2011, calculate the dividend yield, the capital-gains yield, and the total return to the stock. Express your calculations in percentage terms.
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Suppose that an investor purchased 100 shares of IBM stock at a price of $100 on December 31, 2010. During the year 2011, IBM paid dividends of $2.00 per share, and at the end of the year, the investor sold the stock at a price of $115. a If there were no taxes or infl ation, what was the total return? b If there were no taxes but infl ation was 5 percent, what was the real return? c If the tax rate was 15 percent on dividends and capital gains, what was the after-tax real return?
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Some people have the opportunity to invest in stocks in a tax-advantaged retirement plan, such as a 401(k) plan. Consider the difference between Andy, who is able to save in a taxadvantaged plan, and Ben, who must pay taxes on his return each year. Both invest $100,000 in the same mutual fund at the same time and always reinvest their earnings in the fund. Suppose that the return on the mutual fund is 7 percent each year and that the tax rate is 15 percent. (Note that Ben must pay taxes each year on his earnings, so he can reinvest only his after-tax earnings; Andy, however, pays the 15 percent tax rate when he retires and withdraws his funds.) a How much do Andy and Ben each accumulate over 10 years? b How much do Andy and Ben each accumulate over 30 years?
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Suppose that the CAPM is a good model of risk in the stock market. Suppose also that the average excess return on stocks is 10 percent and that the risk-free interest rate is 1 percent. What would you expect to be the return to stocks with each of the following beta coeffi cients? a _0.5 b 0.3 c 1.0 d 2.0
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Suppose that the following version of the APT is a good model of risk in the stock market. Consider three factors: the stock market's excess return in percentage points, the change over the last year in the price of oil in dollars, and the spread between 10-year Treasury bonds and three-month Treasury bills in percentage points. Suppose that the stock market's average excess return is 9 percent and that the average risk-free interest rate is 1 percent, the average change in the price of oil is $0.25, and the average spread between 10-year Treasury bonds and threemonth Treasury bills is 1.25. Each of the following stocks has the beta coeffi cients shown in the table below: img a What is the expected return to each of the three stocks? b If the market's excess return were to be above average by 1 percent (that is, it rose 10 percent in a particular year instead of the usual 9 percent), what would you expect the effect to be on the return to each of the three stocks? c If the price of oil were to fall by $3.00 in a particular year (that is, $3.25 less than the average change of _$0.25), what would you expect the effect to be on the return to each of the three stocks? d If the interest-rate spread rose to 2.00 percent in a particular year (that is, 0.75 percentage point higher than average), what would you expect the effect to be on the return to each of the three stocks?
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Which of these three stocks would you rather own if your rate of discount is 5 percent? a A stock that currently earns $2 per share whose earnings are growing 3 percent each year. b A stock that currently earns $1 per share whose earnings are growing 4 percent each year. c A stock that currently earns $5 per share whose earnings are growing 2 percent each year.
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If you want to trade stocks on the fl oor of the New York Stock Exchange, you must purchase a "seat," which is really a license to buy or sell stocks. Can you explain why the price of such seats rose sharply in the 1980s and early 1990s but has been declining rapidly in recent years?
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If the government invested a portion of the Social Security trust fund in the stock market, would you expect people to change the way they invest their other savings? That is, suppose that someone currently has a portfolio with a $50,000 investment in the stock market and $25,000 in debt securities. Now suppose that their share of the Social Security trust fund is $30,000, and the government invests it all in the stock market. How might someone adjust his or her own portfolio in response?
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If the effi cient markets hypothesis is true, is it worthwhile for an investor to spend a lot of time investigating different companies to decide what to invest in?
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Suppose that investors were stubborn and pessimistic about corporate earnings growth, so they consistently forecast lower earnings than actually materialized. How might this affect the return to the stock market? Do you think that the equity premium would be higher or lower than if investors' expectations were accurate?
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