Summary

The following points have been mainly covered in this chapter:

• Historical return rate investments patterns have been analyzed by Table 7.1 in cash, stock indexes, individual stocks and bonds.
  • On average, stocks had higher return rates in comparison to bonds. In turn, bonds had higher return rates in comparison to cash.
  • The riskiest of all were individual stocks. There was lower risk associated with huge stock market portfolios in comparison to individual holdingsof stock. The risk with bonds was lower, while cash served as the least risky.

• Stocks, along with several other investments, had a tendency of correlating positively. If the overall stock market had a bad or good year, most of the stocks also had a bad or good year.
• It is assumed by most finance that statistic is known. It is just a matter of believing. In reality, historical data is helpful in future predictions, although it isn’t prefect. Historical correlations and goods are good future predictors, while historical means aren’t necessarily.
• Several institutional arrangements that govern equity securities that are traded publicly are explained in Section 7.2. It includes roles of exchanges, funds, prime and retail brokers. Shorting of stocks has also been discussed with the flow of funds to and from financial markets.

Solutions to Solve Them!

Question 7.1  

It is shown by time-series graph how do individual years matter. A histogram can’t any longer show this

Question 7.2

It is made easier by a histogram to view how frequent the various kinds of outcomes, and therefore, where the distribution is centered and also how much spread out it are.

Question 7.3

The interaction of time series of return rates for producing long-term returns is shown by a compound return graph. To put it in different words, it can be seen whether money would have been lost or made by a long-term investment. This is hard to be seen in time-series graph.

Question 7.4

Since the returns in (c) and (b) are alternative, you simply have to calculate the safe two-year returns.  Thereon, they shall continue in their patterns

• 5%
• You earn 10% (1 x 1.10 – 1) over two years. Thus, the annualized return rate is √1.1 – 1 = 4.88%. It is less than the 5% average return rate
• You earn 8% (0.9 x 1.2 – 1) over two years. Thus, the annualized return rate is √1.08 – 1 = 3.92%. It is less than the average return rate of 5%

Yes. For an investment that is more volatile, difference between the average and annualized return rate is greater

Question 7.5

Here risk is lowest for cash, higher for bonds, even higher for stock market portfolio and the individual stocks are the riskiest. For the first 3, average reward sees a growth, but that isn’t necessarily true in case of individual stock.

Question 7.6

Individuals stocks come with more risk generally, although not always.

Question 7.7

Yes. As an example, UAL in Table 7.1 lost everything yet had an average return rate that was positive

Question 7.8

For graphing the market beta, the return rate on market must be on x-axis and the return rate on investment for which market beta needs to be decided must be on the y-axis. The two return rates from a particular time period is called a data point. Market beta is gradient of line of best fit.

Question 7.9

The market beta is 1. Since the return rate on market is plotted on both x-axis and y-axis, the gradient of diagonal line (45°) is the market beta.

Question 7.10

Brokers are responsible for executing orders and keeping track of portfolios of investors. Purchase on margin is also facilitated by them.

Question 7.11

It is generally the larger investors who use prime brokers. These brokers let investors utilize their own trade for executing trades. Margin, securities borrowing and portfolio accounting are provided by prime brokers, just as retail brokers.

Question 7.12

In an ideal world, if you short a stock, your return rate is higher since you get interest on proceeds. In reality, your broker might utilize the interest. Also, it attempts at crossing orders for a certain number of times per day.

Question 7.14

Often, the specialist serves as a monopolist making market on NYSE. Buying and selling is done by the specialist from his own stock inventory, thus making a market. On NASDAQ, the equivalent is market makers, although usually there are many and are in competition with each other. Unlike regular investors, both market makers and specialists can see limit orders that placed by investors.

Question 7.15

Often, the substitutes are electronic. They also often depend on matching trades. Therefore, the trades they can’t match may not be executed. ECNs (Electronic Communication Networks) are a major example of such. Executing trade in OTC (over-the-counter) market is another alternative. OTC market is a network of dealers who are geographically dispersed and who make markets in different securities

Question 7.16

In case of open-end fund, fund shares must be purchased and redemption must be requested by you. If you do not want to suffer the price risk, you may short underlying holdings while you wait to redeem. You shall have to drive out the management for allowing redemption of your shares, in case of a closed-end fund.

Question 7.17

The primary mechanisms of flow of money into firms from investors are first the SEOS andIPOs, secondly the reverse mergers, which then are sold to the investors.

Question 7.18

Funds disappear from public financial markets to the investors through share repurchases and dividends.

Question 7.19

Shares may disappear in a repurchase or a delisting.

Links of Previous Main Topic:-

• Introduction of corporate finance
• The time value of money and net present value
• Stock and bond valuation annuities and perpetuities
• A first encounter with capital budgeting rules
• Working with time varying rates of return
• Uncertainty default and risk
• Risk and return risk aversion in a perfect market

Links of Next Financial Accounting Topics:-

• Investor choice risk and reward
• The capital asset pricing model
• Market imperfections
• Perfect and efficient markets and classical and behavioral finance
• Capital budgeting applications and pitfalls
• From financial statements to economic cash flows
• Valuation comparables financial ratios
• Corporate claims
• Capital structure and capital budgeting in a perfect market
• The weighted cost of capital and adjusted present value in an imperfect market with taxes
• What matters
• Equity payouts
• For value financial structure and corporate strategy analysis
• Capital structure dynamics firm scale
• Capital structure patterns in the united states
• Investment banking and mergers and acquisitions
• Corporate governance
• International finance
• Options and risk management