MARKET O RGANIZATION AND STRUCTURE
LOS 46.1 The objectives of market regulation are to
• Protect unsophisticated investors.
• Establish minimum standards of competency.
• Help investors to evaluate performance.
• Prevent insiders from exploiting other investors.
• Promote common financial reporting requirements so that information gathering is less expensive.
• Require minimum levels of capital so that market participants will be able to honor their commitments and be more careful about their risks.
CONCEPT CHECKERS
1 . Daniel Ferramosco is concerned that a long-term bond he holds might default.
He therefore buys a contract that will compensate him in the case of default.
What type of contract does he hold?
A. Physical derivative contract.
B. Primary derivative contract.
C. Financial derivative contract.
2. A financial intermediary buys a stock and then resells it a few days later at a higher price. Which intermediary would this most likely describe?
A. Broker.
B. Dealer.
C. Arbitrageur.
3. Which of the following is most similar to a short position in the underlying asset?
A. Buying a put.
B. Writing a put.
C. Buying a call.
4. An investor buys 1 ,000 shares of a stock on margin at a price of $50 per share.
The initial margin requirement is 40o/o and the margin lending rate is 3o/o. The investor's broker charges a commission of $0.0 1 per share on purchases and sales. The stock pays an annual dividend of $0.30 per share. One year later, the
investor sells the 1 ,000 shares at a price of $56 per share. The investor's rate of return is closest to:
A. 12o/o.
B. 27o/o.
c. 36o/o.
5. A stock is selling at $50. An investor's valuation model estimates its intrinsic value to be $40. Based on her estimate, she would most likely place a:
A. short-sale order.
B. stop order to buy.
C. market order to buy.
6. Which of the following limit buy orders would be the most likely to go unexecuted?
A. A marketable order.
B. An order behind the market.
C. An order making a new market.
7. New issues of securities are transactions in the:
A. primary market.
B. secondary market.
C. seasoned market.
Study Session 13
Cross-Reference to CFA Institute Assigned Reading #46 -Market Organization and Structure
8.
9.
10.
In which of the following types of markets do stocks trade any time the market is open?
A. Exchange markets.
B. Call markets.
C. Continuous markets.
A market is said to be informationally efficient if it features:
A. market prices that reflect all available information about the value of the securities traded.
B. timely and accurate information about current supply and demand conditions.
C. many buyers and sellers that are willing to trade at prices above and below the prevailing market price.
Which of the following would least likely be an objective of market regulation?
A. Reduce burdensome accounting standards.
B. Make it easier for investors to evaluate performance.
C. Prevent investors from using inside information in securities trading.
ANSWERS - CONCEPT CHECKERS
1 . C Daniel holds a derivative contract that has a value determined by another financial contract; in this case, the long-term bond.
2. B This situation best describes a dealer. A dealer buys an asset for its inventory in the hopes of reselling it later at a higher price. Brokers stand between buyers and sellers of the same security at the same location and time. Arbitrageurs trade in the same security simultaneously in different markets.
3. A Buying a put is most similar to a short position in the underlying asset because the put increases in value if the underlying asset value decreases. The writer of a put and the holder of a call have a long exposure to the underlying asset because their positions increase in value if the underlying asset value increases.
4. B The total purchase price is 1 ,000 x $50 = $50,000. The investor must post initial margin of 40% x $50,000 = $20,000. The remaining $30,000 is borrowed. The
commission on the purchase is 1 ,000 x $0.01 = $ 1 0 . Thus, the initial equity investment is $20,010.
In one year, the sales price is 1,000 x $56 = $56,000, so the capital gain is $56,000 - $50,000 = $6,000. Dividends received are 1 ,000 x $0.30 = $300. Interest paid is
$30,000 x 3o/o = $900. The commission on the sale is 1 ,000 x $0.01 = $ 10.
The gain on the transaction in one year is $6,000 + $300 - $900 - $ 1 0 = $5,390. The return on the equity investment is $5,390 I $20,010 = 26.94%.
5. A If the investor believes the stock is overvalued in the market, the investor should place a short-sale order, which would be profitable if the stock moves toward her value estimate.
6. B A behind-the-market limit order would be least likely executed. In the case of a buy, the limit buy order price is below the best bid. It will likely not execute until security prices decline. A marketable buy order is the most likely to trade because it is close to the best ask price. In an order that is making a new market or inside the market, the limit buy order price is between the best bid and ask.
7. A The primary market refers to the market for newly issued securities.
8. C Continuous markets are defined as markets where stocks can trade any time the market is open. Some exchange markets are call markets where orders are accumulated and executed at specific times.
9. A Informational efficiency means the prevailing price reflects all available information about the value of the asset, and the price reacts quickly to new information.
10. A Market regulation should require financial reporting standards so that information gathering is less expensive and the informational efficiency of the markets is enhanced.
The fo llo wing i s a revi ew o f the Equity: M arket O rganiz atio n, M arket Indices, and Market Effi ci ency princi ples designed to address the learni ng o utcome statements set fo rth by CFA Insti tute. Thi s topi c i s also co vered in: