Principles of Investment: Assignment 3
Due March 21
Introduction to Stock Markets
1. What is an Initial Public Offering (IPO) of a Stock?
When stocks are first issued for sale it is called the Iniial Public Offering (IPO).
2. What is the Primary Market for Stocks?
The market in which IPOs are traded is called the Primary Market.
3. What is the role of an Investment Bank in an IPO?
IPOs are sold by help of Investment Banks. An investment bank is an institution that specializes in determining the market value of a company and their IPO of stock.
4. What does it mean for an investment bank to underwrite a stock?
Underwriting is where the investment bank buys the stock at an agreed upon price from the company and then immediately sells the stock. The investment bank makes money if they sell the stock at a price greater than the price at which they bought the stock
5. What is the Secondary Market for Stocks?
The sale of existing stock is sold in the Secondary Market
6. What is a Stock Exchange?
The most common way to transact in existing stock is on an organized Stock Exchange. A stock exchange is an organized auction market for existing stock.
7. What is the Over-the-Counter market, and how does it differ from the stock exchange?
Another secondary market is called the Over-the-Counter Market. These are stocks not traded on an organized exchange. Rather these are traded on private networks of traded stock.
8. What is a stock broker? And what is the difference between a full service broker and a discount broker?
Intermediaries that represent the buyers and sellers in stock transactions are called brokers. Brokers buy and/or sell stock for their clients. Individual investors are not allowed to trade directly in stock, and thus must rely on brokers.
A full service broker is a broker who supplies his client with his expert advice, as well as other services. A discount broker is a broker who simply executes the buy/sell orders of his clients, without providing any other services
9. What does it mean to buy a stock on margin? What is a margin call?
A margin account allows an investor to engage in margin trading with a broker. Margin trading is when the investor buys a stock but only pays the broker a fraction (or margin) of the price of the stock. The broker loans the money for the rest of the stock to the investor and charges the investor a margin interest rate. This practice allows the invest to engage in speculative trading without having to immediately come up with the cash necessary to buy the stock. If the broker decides to call the loan to the investor it is called a margin call.
10. What is Long Position in a stock? What is a Short Position in a stock?
When you buy a stock with the expectation its price will rise this is known as taking a Long Position.
If you believe the price of a stock will fall, you can take advantage of this by taking a Short Position. In this case you borrow the stock today and sell it at today’s price. When the price falls in the future you buy the stock at the lower price to repay your loan.
11. What is Stock Market Capitalization?
Stock Market Capitalization refers to the total value of stock represented on the stock market. The market capitalization for an individual company is simply the total number of shares of the company multiplied by the price per share. The stock market capitalization is simply the addition of the market capitalization of all companies listed on the stock exchange.
12. What is the Volume of Trade in a Stock Market?
Volume of Trading refers to the total number of shares traded on a stock exchange over a given period of time. It is measuring how active is the market.
13. What is a Stock Market Index, and what is it used for?
An index is a weighted average of the prices of a group of stocks, where the group is meant to be representative of the entire stock market. Hence if the stock market index rises 5% then one can say the average, or typical, stock traded on the market will have risen by 5%.
Because the stock market index measures the performance of the overall stock market, it is used to indicate what is happening at the market level. For example, if the stock market index is falling, then it is probably the case that investors are taking their money out of the stock market as a whole (thereby reducing demand and causing all stock prices to fall) and putting it somewhere else (perhaps the bond market). Similarly, if the stock market index is rising, then it is probably the case that investors are taking their money out of other investments (such as the bond market) and putting it in the stock market (thereby increasing demand and causing all stock prices to rise).
Stock Valuation
1. What is present value?
Present Value is the current market value of an amount that is to be received in the future.
2. What is the present value of RO220 received in one year if the interest rate is 10%? What if the interest is 5%?
3. What is the present value of RO10,000 received in 10 years if the interest rate is 7%?
4. Suppose a stock will pay dividends of 100, 110, 120, 130, and 150 over the next five years, and nothing after. Suppose also the interest rate is 5%. What is the fundamental price of this stock (i.e. what is the present value of these stream of dividends)?
5. Suppose a stock pays a dividend today of D0, and that dividends will grow every year at the rate g forever. Let r be the interest rate. Assuming r > g, what is the formula for the fundamental price of the stock?
6. Suppose the dividend of a stock today is 10. Suppose also the interest rate is 10% and that dividends will grow forever at the rate of 7%. What is the fundamental price of this stock?
7. If the current market price of the stock in question 5 is 250, should you buy or sell the stock?
You should buy
8. For another stock suppose the dividend of a stock today is 5. Suppose also the interest rate is 5% and that dividends will grow forever at the rate of 4%. What is the fundamental price of this stock?
525
9. If the current market price of the stock in question 7 is 550, should you buy or sell the stock?
Sell
10. What are the criticisms of this method of stock valuation?
Criticism 1: Stock dividends do not grow at a constant rate. Hence the model is very inaccurate.
Criticism 2: If compare stocks, what growth rate do we use? Certainly all stocks do not grow at the same rate.
Criticism 3: This pricing method does not take risk into consideration. Certainly more risky stocks will have a lower price than less risky stocks.
11. What is the P/E ratio?
The P/E ratio is simply the price of a stock divided by the earnings per share per year.
12. If Stock A has a higher P/E ratio than Stock B, which is the better investment? Explain.
The P/E ratio tells one the amount of money it takes to get 1RO of earnings from the stock. So since Stock B has the lower ratio, it is the better investment.
13. What are the criticism of using the P/E ratio to value stocks?
Current earnings are not necessarily a good measure of future earnings. For companies in decline, or companies that are new and growing, the P/E ratio is not reliable.