F RSM 230 Final SOLN S2011 2 PDF

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UNIVERSITY OF TORONTOFaculty of Arts and Science & Rotman School of ManagementFinal Examination, April, 2011RSM 230H1S – Financial MarketsINSTRUCTIONS:You have <2> hours for this exam.Complete your Scantron in PENCIL and use it to answer Part A of the exam. Answer Part B of the...

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UNIVERSITY OF TORONTO Faculty of Arts and Science & Rotman School of Management Final Examination, April, 2011 RSM 230H1S – Financial Markets INSTRUCTIONS: You have hours for this exam. Complete your Scantron in PENCIL and use it to answer Part A of the exam. Answer Part B of the exam on this paper in the space provided. All cell phones and portable electronic devices must be turned off. Non-programmable calculators are permitted Please remain in your seats during the last 15 minutes of the exam period so you do not disturb others. PLEASE SUPPLY THE FOLLOWING INFORMATION: Student #__________________

Student Name___________________

Please circle your Instructor’s Name:

Stapleton Tolias

For Ms. Stapleton’s sections, please indicate your class time: Monday 8-10am ___ Monday 10-12 ___

Wednesday 3-5pm ___ Wednesday 5-7pm ___

PLEASE check that you have filled in your SCANTRON sheet correctly in PENCIL: 1) Write in and bubble your student ID number (one entry per column) as well as your Last Name and Initials. Hyphenated last names should be bubbled in without spaces or dashes. 2) Do not make any marks outside the shaded area This exam paper has pages including the cover page .

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PART A – Multiple choice questions. (70% of total grade) Please answer in pencil on the Scantron provided. All questions have equal weight. There is only ONE correct answer for each question. Each question is worth 2%. 1. A call option with an exercise price of $16 and a put option with an exercise price of $11 on a stock with a $20 share price have the following intrinsic values: B a) b) c) d) e)

$2 and $6 $4 and $0 $0 and $3 $0 and $2 None of the above

2. With the price of oil reaching $100 and with gold and other commodity prices continuing to increase, investors expect that inflation will also increase. What effect, if any, will this have on your portfolio of bonds? C a) b) c) d)

Bond prices will increase along with commodity prices Bond prices will decrease while commodity prices increase Bond prices will decrease because yields will increase Bond prices will remain unchanged as inflation and commodity prices have no effect e) None of the above

3. Which of the following would be the best approximation of the risk-free rate? B a) b) c) d) e)

Rate of inflation as measured by CPI Yield on government treasury bills Yield on bankers' acceptances Return on the TSX/S&P Index None of the above

4. The “know your client” rules require an IA to: E a) b) c) d) e) f) g)

Learn the essential facts about every client Provide recent research reports to the client Consult with the client on a regular basis Ensure recommendations are appropriate for the client a) and d) above a) and c)) above b) and c) above

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5. In valuing stocks key fundamental valuation ratios are: E a) b) c) d) e)

The price-earnings ratio The price to book ratio The dividend yield The return on equity All of the above

6. Mutual funds are normally not allowed to do the following except: B a) b) c) d) e)

Invest in commodities Use derivatives for risk management X Take large positions in illiquid securities Take short positions Use leverage

7. The offering price of a fund with a net asset value of $50 and a 5% front end load would be B a) b) c) d) e)

$50 $52.63 $36 $44.44 None of the above

8. If you want to hedge a short position to avoid a very bad loss you should: E a) b) c) d) e)

Buy an in the money put option Buy an out of the money call option Sell a call option Buy an out of the money put option Buy an in the money call option

9. An investor enters into a long position in 40,000 futures contracts that requires a $40,000 initial margin and has a maintenance margin of 75% of this amount. The futures price is $20. Assume the spot price on the underlying asset closes at $20.50. What is the investor's equity position on that day?: B a) b) c) d) e)

$40,000 $60,000 $30,000 $50,000 None of the above

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10. The main methods by which securities commissions maintain the integrity of the financial market are through all of the following except: C a) b) c) d) e)

Registration of participants Disclosure of information Inspecting all security offerings to ensure they are suitable X Enforcing securities laws All of the above

11. A stock has a required return of 15%, an expected growth rate of 10% and a dividend payout ratio of 50%. What should the stock’s P/E ratio be? D a) b) c) d) e)

3 4.5 9 11 X None of the above

12. You purchased a stock at the beginning of the year for $80.25. Your total return for the year was 10.2%, and the stock had a dividend yield of 1.8%. What was the stock price at the end of the year? C a) b) c) d) e)

$84.73 $85.02 $86.99 X $88.44 $89.56

13. In terms of tax treatment all of the following are correct EXCEPT: A a) Dividend income received from Canadian corporations is taxed at a lower rate than capital gains for individual investors in the top tax bracket b) Dividend income from Canadian sources is taxed at a lower rate than earned income for individual investors c) Interest income is fully taxable for individual investors d) Corporations pay dividends out of after-tax income e) Capital gains are taxed at ½ the ordinary tax rate for individual investors

14. Which of the following statements about ETF’s is NOT TRUE? D

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a) b) c) d) e)

ETF’s allow investors to trade index portfolios like shares of stock ETF’s are a lower cost alternative, relative to investing in mutual funds ETF’s can provide tax advantages, relative to investing in mutual funds Securities regulations prevent investors from short selling ETF’s None of the above

15. Which of the following is true? D a) Preferred stock has the same voting rights as common stock b) Cumulative preferred shares require the dividend to be paid at all times c) Non-cumulative preferred shares require that if a dividend is missed, it must be paid before the next dividend is paid d) Preferred shares have features of both bonds and stocks e) Investors buy preferred shares for their growth potential 16. Which of the following types of investment should make up the majority of a portfolio for a 30 year old lawyer? C a) b) c) d) e)

Commercial paper Cash Domestic stocks Bonds Derivatives

17. In the event of bankruptcy and the dissolution of the company E a) Common shareholders can lose their original investment in the company b) Common shareholders are first in line to receive the liquidated assets of the company c) Bondholders have a claim on the residual assets of the company after payments to the preferred shareholders and the common shareholders d) The claims of preferred shareholders are ahead of common shareholders but behind bondholders e) a) and d) are correct

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18. Which of the following statements about PPN’s is false? E a) Performance is often linked to a fund or market index b) Have poor liquidity c) Protect investors against capital losses d) Use zero coupon bonds and derivatives to alter the performance profile of the underlying asset e) Performance will always match the performance of the underlying fund or index 19. In what instance is a chemical company's prospectus not providing 'full, true and plain' disclosure?. E a) Management is withholding a material fact that will positively impact the stock price b) Management is withholding a material fact that will negatively impact the stock price c) Management is withholding information on a law suit brought on by investors d) Management is withholding information on a possible chemical spill at one of their plants e) All of the above 20. All of the following are major sub indexes of the TSX EXCEPT: C a) b) c) d)

Utilities, Consumer Staples and Industrials Telecommunications, Materials and Energy Media, Information Technology and Precious Metals X Health care, Financial Services and Energy

21. Based on the Dividend Discount Model, with everything else remaining constant, a firm’s P/E ratio will increase if: D a) b) c) d) e)

The growth rate of earnings decreases The dividend payout ratio decreases The required discount rate increases Inflation expectations decrease X None of the above would cause the P/E ratio to increase

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22. The current price of XYZ stock is $50. Dividends are expected to grow at 7% indefinitely and the most recent dividend was $1. What is the required rate of return on XYZ stock? B a) b) c) d) e)

9.0% 9.1% X 9.3% 10.6% 11.2%

23. The expected dividend on a stock is $3, its earnings per share is $5 and its growth rate is 5% . If the investor’s required discount rate is 10%, the stock price would be: D a) b) c) d) e)

$50 $100 $30 $60 X None of the above

24. The following technical indicator would be a bearish signal: A a) b) c) d) e)

The 50 day moving average crosses the 200 day moving average from above Advances exceed declines Low volume on a downtick Bid-ask spreads decrease None of the above are bearish signals

25. A corporation pays dividends on its common stock: C a) At the discretion of management who are appointed by shareholders b) At the discretion of shareholders who are the owners of the corporation c) At the discretion of the company’s board of directors, who are elected by shareholders d) At the discretion of the company’s board of directors, who are appointed by management e) Quarterly, and as specified in the trust indenture 26. The price paid for an option contract is referred to as the D a. b. c. d. e.

Forward price. Exercise price. Strike price. Option premium. X Call price.

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27. There are a number of differences between forward and futures contracts. Which of the following statements is false? C a. Futures have less liquidity risk than forward contracts b. Futures have less credit risk than forward contracts c. Futures have more default risk than forward contracts d. In futures, the exchange becomes the counterparty to all transactions e. None of the above (that is, all statements are true 28. ____________ orders are executed only if a specific price or better can obtained. A a) b) c) d) e)

Limit Market Stop Buy Stop Loss None of the above

29. In terms of tax treatment all of the following are correct EXCEPT: A a) Dividend income received from Canadian corporations is taxed at a lower rate than capital gains for individual investors in the top tax bracket b) Dividend income from Canadian sources is taxed at a lower rate than earned income for individual investors c) Interest income is fully taxable for individual investors d) Corporations pay dividends out of after-tax income e) Capital gains are taxed at ½ the ordinary tax rate for individual investors

30. A ____ occurs when the stock price passes through a support or resistance line: C a) b) c) d) e)

Bear market Primary trend Breakout Reversal Bull market

31. In a business cycle trough tactical asset allocation involves the following strategy: A a) b) c) d) e)

Selling long term bonds and increasing equity exposure to cyclical stocks Reducing equity exposure and increasing money market exposure Increasing equity exposure and moving to defensive stocks Increasing bond exposure and reducing equity exposure None of the above

32. The net asset asset value (NAV) of a mutual fund is determined by: B RSM 230H1S Final Exam

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a. The total market value of all its assets multiplied by the number of fund shares outstanding. b. The total market value of all its assets divided by the number of fund shares outstanding. c. The total market value of all its assets divided by the number of shareholders. d. Supply and demand for shares of the mutual fund in the secondary market. e. Supply and demand for the shares of the mutual fund in the primary market.

33. Which group of funds is subject to the least amount of regulation? C a) b) c) d) e)

Mutual Funds Segregated Funds Hedge Funds None are regulated All are equally regulated

34. Which of the following is true about the historic performance of Canadian stocks, as compared with other Canadian financial assets? C a) b) c) d) e)

Returns have not compensated investors for inflation Highest income yield; moderate risk Highest rate of return; highest risk Highest total return; moderate risk Lowest performance and lowest risk

35. If a commodity has a spot price of $5 and a one year futures price of $7 with a 10% interest rate and $0.50 storage cost you would do the following: B a) b) c) d) e)

Sell spot and buy forward and earn $0.50 Buy spot and sell forward and earn $1 Buy spot and sell forward and earn $0.50 Sell forward and buy spot and earn $1.50 Nothing as there are no arbitrage opportunities

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PART B – Short Answer Questions. (30% of total grade) Please answer briefly on this paper in the space provided. All questions have equal weight of 6%. 1. Assume that you are a retired individual (over the age of 65). List and briefly explain three important differences between common shares and preferred shares and why those differences are important to you.

ANSWER: Most importance should be placed on a discussion of: 1) Preference in terms of dividend; 2) Voting rights; 3) right on dissolution which is why prefs have a par value (usually $25).

The other two differences can involve features of different types of prefs such as cumulative dividends and limited voting rights if not declared, purchase funds; maturity date, retraction features etc, but these are all design features of particular types of prefs .

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2. With the recent political unrest in Libya and the Middle East, the price of crude oil is $105 per barrel. Airline companies, such as Air Canada, have increased their price of air fares (and therefore their profitability) because of the increased price of oil. You own 500 shares of Air Canada and the stock has risen by 25% in the last 2 months. You believe that the turmoil will not last for a long time and you fully expect that oil prices will come down in the near future. Use this information to answer the following questions: (a) What two strategies would you use to protect the profit on your Air Canada shares? ANSWER: (i) Sell your Air Canada shares (ii) Buy a protective put option on Air Canada shares with exercise price at or just below the current market price (Any other strategy that makes sense to protect your profit (b) Are these strategies 'bullish' or 'bearish' on the stock? ANSWER: Bearish RSM 230H1S Final Exam

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(c) Identify two additional strategies you could use to earn a profit if your forecast of falling oil prices and falling share prices is correct? Give a very brief explanation of how each strategy works. ANSWER: (Any 2 of the following, or any other strategy that makes sense) (i) Sell oil futures (short) to profit from the expected decline in oil prices. (ii) Short sell shares of companies whose stock price will fall in response to falling oil prices (ie short oil company stocks). Buy the stock(s) back to cover when prices have fallen

3. You just opened a margin account with the Royal Bank and believe the following: the stock price of Manulife Financial is going to increase in the next 3 months and the stock price of Westjet s will likely decrease over the same time period. You would like to own 200 shares of Manulife in your portfolio and sell short 100 shares of Westjet. You have $5,000 in cash. The current stock price of Manulife Financial is $22 and the current stock price of Westjet is $15. Calculate the cost of executing your strategy from above under two scenarios:1) if you buy the shares of Manulife for cash 2) if you buy the Manulife shares on margin. Are you able to execute your strategy and if yes, how?

ANSWER: Scenario 1 1) Buy 200 shares of Manulife Financial @ $22: 200 shares at $22 = $4,400 2) Short 100 shares of Westjet @15: Minimum account balance needed (150%) Proceeds from short sale: Minimum margin required:

+$2,250 $1,500 $750

Total cost of this strategy = $4,400 + $750=$5,150. You can't execute because you do not have enough cash in your margin account.

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ANSWER: Scenario 2 1) Buy 200 shares of Manulife on margin @ $22: Cost: Margin loan @ 50%: Margin: ie., cash put up by you: 2) Short 100 shares of Westjet @$15: Minimum account balance needed (150%) Proceeds from short sale: Minimum margin required:

$+4,400 $2,200 $2,200

+$2,250 $1,500 $750

Total cost of this strategy=$2,200 + $750=$3,150. You are able to execute this option with the $5,000 cash.

4. Describe the differences between the following: (a) Bond coupon payment and common stock dividend

Bond coupon payment is required; Stock dividend payment is not Bond coupon paid from pretax income; dividend paid from after tax income Bond coupon is generally fixed for the life of the bond; Dividend amount can change RSM 230H1S Final Exam

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(b) What is a bondholder versus a shareholder?

Bond holder is a lender; Common shareholder is an owner of the corporation

(c) The enforceability of a coupon payment versus a dividend

Bond issuer is required to pay coupon or there is an act of default. Dividend payment on stock is not mandatory…paid only at discretion of board of directors

(d) Personal income tax - which type of income would you rather receive if you are in a high tax bracket and why?

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Prefer capital gains income which is taxed at 50% rate

5. Suppose an investor is considering the purchase of 100 shares of the Royal Bank. The stock currently pays a $5 dividend. This dividend is expected to grow at 10 % per year for the foreseeable future. The investor thinks that the required return (r) on the stock is 15%. What is the value of a share of Royal Bank stock?

P = $5(1.1)/0.05 = $110

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YOU ARE ALL DONE – HAVE A GOOD SUMMER!

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