Chapter 1

QUESTIONS AND APPLICATIONS  
1. Surplus and Deficit Units Explain the meaning of surplus units and deficit units.  
Surplus unit – More money than they spend – can invest.  
Deficit Unit – less money than they spend 
  
2. Types of Markets  
Primary Market – Issuance of new securities 
Secondary Market – Trading of existing securities.  
Money Market – short term debt securities – 1 year or less. Usually low return but low risk. High liquidity. EG:
Treasury bills & commercial paper 
 
Capital Market – Long term securities. Bonds, stocks & mortgages. 
3. Imperfect Markets  
Perfect Market – 1. Equal info to everyone. 2.  Depth (can buy and sell large quantities without affecting price).
3. securities can be sold at any size desired by investors. 
Imperfect Market – The absence of the above conditions.  
 
Explain why the existence of imperfect markets creates a need for financial intermediaries.  
Hard for Surplus units to have all info and to sell varying amounts – so would limit their ability/desire to do so –
reducing money available to markets. They also don’t have info to determine credit worthiness of potential
borrowers.  
4. Efficient Markets  
Where securities are rationally priced.  
 
. Why might we expect markets to be efficient most of the time?  
If security underpriced, investors will act, increasing demand, therefore increasing price to rational level.  
 
In recent years, several securities firms have been guilty of using inside information when purchasing
securities, thereby achieving returns well above the norm (even when accounting for risk). Does this suggest
that the security markets are not efficient? Explain.  
Inefficiencies occur due to asymmetric information. Regulation attempts to minimize this, however there will
always be inefficiencies. Overall the markets will be efficient on a large scale. 
5. Securities Laws What was the purpose of the Securities Act of 1933? 
Ensure complete disclosure of relevant financial info for public companies.   
What was the purpose of the Securities Exchange Act of 1934?  
Extended disclosure to secondary markets. Made certain deceptive practices illegal (misleading
statements/manipulation)  and created the SEC. 
Do these laws prevent investors from making poor investment decisions?  
No, it just ensures that they have the complete and correct info to make their decision.  
6. International Barriers If barriers to international securities markets are reduced, will a country’s interest rate
be more or less susceptible to foreign lending and borrowing activities?  
More – if entities can borrow/loan internationally at better rates – they will – country will have to select rates
that remains competitive.  
7. International Flow of Funds In what way could the international flow of funds cause a decline in interest
rates?  
If there is high flow of funds, interest rates will drop because money is readily available.  
8. Securities Firms What are the functions of securities firms?  
Act as broker, dealer, underwriting and advisory services (investment banking), Issue new securities to primary
markets, assist with mergers and corporate restructuring  
Distinguish between the functions of a broker and those of a dealer, and explain how each is compensated.  
Broker – execute securities transaction between 2 parties. Make money from diff between bid and ask quote.  
Dealer – Make market in specific securities by maintaining inventory of securities. Make money by
performance of portofolio.  
9. Standardized Securities Why do you think securities are commonly standardized?  
Simplifies process of trading. Saves time and therefore increases volume.  
Explain 
why some financial flows of funds cannot occur through the sale of standardized securities.  
Special securities for certain situations need to be set up with individualised terms and conditions.  
If securities were not standardized, how would this affect the volume of financial transactions conducted by
brokers?  
Lower volume if had to negotiate every single transaction. 
10. Marketability Commercial banks use some funds to purchase securities and other funds to make loans.
Why are the securities more marketable than loans in the secondary market?  
In secondary market a bond will sell at below it's face value. It loses yield due to interest that has already been
paid. They also have lower returns due to lower risk. There is a higher degree of uncertainty with securities,
therefore higher potential returns.  
11. Depository Institutions Explain the primary use of funds by commercial banks versus savings institutions.  
Commercial Banks – provide direct loans or purchase debt securities.  
Savings Institutions – focus on residential mortgage loans.  
12. Credit Unions With regard to the profit motive, how are credit unions different from other financial
institutions?  
Operate as not for profit, and restrict their business to credit union members.  
13. Nondepository Institutions  
Finance companies – issue securities (to raise funds) and then lend funds to individuals and businesses.  
Insurance companies – Charge premiums, then invest funds in stocks/bonds 
Pension funds – Take contributions and invest in stocks/bonds. 
14. Mutual Funds What is the function of a mutual fund?  
Small savers are able to invest in diversified portfolio of securities with small amount of funds. 
Why are mutual funds popular among investors?  
Diversification and ability to invest with small amount of funds.  
How does a money market mutual fund differ from a stock or bond mutual fund?  
Money market mutual fund concentrates in money market securities.  
15. Impact of Privatization on Financial Markets  
Explain how the privatization of companies in Europe can lead to the development of new securities markets.  
Where businesses have been privatized, their need for underwriting services has increased. They can also
provide more loans in the region.  
 
Chapter 6
1. Primary Market Explain how the Treasury uses the primary market to obtain adequate funding.  
When the US gov needs to borrow funds, the treasury issues short term secs (T-bills) with maturities of 52
weeks or less. 
2. T-Bill Auction How can investors using the primary T-bill market be assured that their bid will be accepted? 
Use non competitive bids – under $5 million.  
 Why do large corporations typically make competitive bids rather than noncompetitive bids for T-bills?  
They usually require large amounts >$5 mill. 
 
3. Secondary Market for T-Bills Describe the activity in the secondary T-bill market. How can this degree of
activity benefit investors in T-bills?  
Very marketable security and has very active secondary mkt. This is beneficial as investors know they can
offload t-bills quickly and easily if they need the funds.  
 
Why might a financial institution sometimes consider T-bills as a potential source of funds?  
If future cash inflow/outflow is uncertain, can keep T-bill as source of liquidity. Also v marketable and safe. 
4. Commercial Paper (short term thatthat is usally unsecured)Who issues commercial paper?  
Well known, credit worthy firms  
What types of financial institutions issue  
commercial paper?  
Finance companies and bank holding companies   
 
Why do some firms create a department that can directly place commercial paper?  
They do it with such regularity that having an in-house team will save them money. 
What criteria affect the decision to create such a department?  
Regularity of use – if regularly have liquidity needs. 
5. Commercial Paper Ratings Why do ratings agencies assign ratings to commercial paper?  
So borrowers know the default risk of each paper and so interest rates can be judged accordingly. Also MM
funds can only invest in top 2 rating levels. 
6. Commercial Paper Rates Explain how investors’ preferences for commercial paper change during a
recession.  
Commercial paper is viewed as riskier during a recession as perceived/actual rate of default increases. Either
due to systemic risk or the firm specific risk. Firms issuing CP may also be expected to offer credit guarantees.  
How should this reaction affect the difference between commercial paper rates and T-bill rates during
recessionary periods?  
Commercial paper rates should offer a higher premium than normal above T-bill rates to compensate for the
extra risk.  
7. Negotiable CDs How can small investors participate in investments in negotiable certificates of deposits
(NCDs)?  
They can be purchased by MM Funds, who have pooled investor's money, and as such can be indirectly
invested. This creates a more active market.  
8. Repurchase Agreements Based on what you know about repurchase agreements, would you expect them to
have a lower or higher annualized yield than commercial paper? Why?  
Lower, as they are backed by securities (usually gov secs) and as such, are less risky. 
9. Banker’s Acceptances Explain how each of the following would use banker’s acceptances:  
(a) exporting firms,  
If unsure of credit worthiness of importer, will ask the bank to back the transaction. The importers bank will
guarantee the payment. The exporter will then send the goods, the importer pays their bank, then the bank
pays the exporter. If the importer doesn’t pay the bank – the bank is still liable to pay the exporter.  
(b) importing firms,  
Instead of paying upfront when dealing with new company, they will be able to negotiate credit terms due to
their bank guaranteeing the payment.  
(c) commercial banks,  
The banks issue the BA for the requestor for a fee.  
(d) investors.  
Investors can buy the acceptance from the exporter. They will buy the BA at a lower price than the face value
and can collect at maturity or can sell it in the secondary market.  
10. Foreign Money Market Yield Explain how the yield on a foreign money market security would be affected if
the foreign currency denominating that security declined to a greater degree.  
If the foreign currency denominating that security declined, the value of the yield drops. If the foreign currency
declines to a great value, the yield can be negative.  
11. Motive to Issue Commercial Paper The maximum maturity of commercial paper is 270 days. Why would a
firm issue commercial paper instead of longer- term securities, even if it needs funds for a long period of
time?  
The firm would have to register it if it went longer than 270 days. Short term maturity and as such, lower
chance of default so lower interest rate = more attractive to the issuing company. 
12. Risk and Return of Commercial Paper You have the choice of investing in top-rated commercial paper or
commercial paper that has a lower risk rating. How do you think the risk and return performances of the two
investments differ?  
The commercial paper that has a poorer risk rating will have a higher interest rate and at a shorter term
maturity, may be more attractive as the risk of default is still very low, even if it is higher than the other – and
you will have a better rate of return.  
For a longer term maturity, the rate of default will increase, and as such the interest rate will be higher, but the
risk will be much more materially significant.  
13. Commercial Paper Yield Curve How do you think the shape of the yield curve for commercial paper and
other money market instruments compares to the yield curve for Treasury securities? Explain your logic.  
In non-recessionary times, the yield curve will closely match the YC for treasury securities, accounting for a risk
premium. However in recessionary times, where these securities are viewed as much riskier, they will deviate
from the treasury YC and will be much higher.  
 
 
Chapter 7
 
1. Bond Indenture  
What is a bond indenture?  
Legal document specifying rights & obligations of issuing firm & bondholders  
What is the function of a trustee with respect to the bond indenture? 
Ensure firm's compliance; If violated, initiate legal action. 
2. Sinking-Fund Provision  
Explain the use of a sinking-fund provision.  
Retire certain amount of bond issue each year.  Reduces payment amount at maturity.   
How can it reduce the investor’s risk? 
Get % of investment back sooner -  Firm will have less outstanding liabilities – Decreases investor
risk.  
3. Protective Covenants  
What are protective covenants?  
Restrictions on issuer - protect bondholders 
Limit; dividends, salaries, additional debt  
Why are they needed? 
Prevent unnecessary risk - Align shareholder/bondholder expectations. Shareholders want more risk
for higher ROI – bondholders want money back so less risk. 
4. Call Provisions  
Explain the use of call provisions on bonds.  
Firm pay a price above par value when calling bonds.  
1. If interest rates decline after bond issued – firm paying higher rate than market level
– issue new bonds at lower rate – pay off old bonds – pay less overall.  
2. Retire bonds by sinking fund provision  
How can a call provision affect the price of a bond? 
Increases price of bond for issuer – higher rate for sinking fund, even higher for any other reason.  
5. Bond Collateral  
Explain the use of bond collateral 
Guarantee payment in case of default.  
 Identify the common types of collateral for bonds. 
First Mortgage bond –  claim on specified assets 
Chattel Mortgage bons –    secured by personal property 
6. Debentures  
What are debentures?  
Bonds unsecured by specific property. Issued by large, financially sound firms 
How do they differ from subordinated debentures? 
Receive nothing until Mortgage bonds/Regular debentures & others are paid.  
7. Zero-Coupon Bonds  
What are the advantages and disadvantages to a firm that issues low- or zero- coupon bonds? 
ADV; Low or no cash outflow during lifetime of bond 
Firm can deduct amortized discount as interest expense, even though no interest paid. 
8. Variable-Rate Bonds  
Are variable-rate bonds attractive to investors who expect interest rates to decrease. Explain.  
NO – If rate decrease, they make less. Want an increase 
Would a firm that needs to borrow funds consider issuing variable-rate bonds if it expects that
interest rates will decrease? Explain. 
Yes, will have to pay less if rates decrease.  
9. Convertible Bonds  
Why can convertible bonds be issued by firms at a higher price than other bonds? 
Investors can convert to stock – if stock price rises – investors can make higher returns than
expected from bond.  
10. Global Interaction of Bond Yields  
If bond yields in Japan rise, how might U.S. bond yields be affected? Why? 
Less demand for US bonds – higher ROI investing in Japanese bonds. US bonds may need to raise
rates.  
11. Impact of Credit Crisis on Junk Bonds  
Explain how the credit crisis affected the default rates of junk bonds and the risk premiums offered
on newly issued junk bonds. 
Default rates rose – investors required a higher risk premium – rates rose.  
12. New Guidelines for Credit Rating Agencies 
Explain the new guidelines for credit rating agencies resulting from the Financial Reform Act of
2010. 
 
13. Impact of Greek Debt Crisis  
Explain the conditions that led to the debt crisis in Greece. 
Weak economy & large deficit. Investors concerned that Greece couldn't pay debt – Bond prices rose
– making it more expensive for them to finance activities/pay old debt.  
14. Bond Downgrade  
Explain how the downgrading of bonds for a particular corporation affects the prices of those bonds,
the return to investors that currently hold these bonds, and the potential return to other investors
who may invest in the bonds in the near future. 
Makes the bond more expensive for the issuer as they are riskier. Current bondholders don't benefit
as they have their rates fixed (unless variable), higher potential returns for new investors – with
higher default risk.  
Chapter 8  
1. Based on your forecast of interest rates, would you recommend that investors purchase bonds
today? Explain. 
Interest rate on bonds can't go much lower, so I would advise not to buy bonds. The return will be
greater in equities or in future bonds.  
2. How Interest Rates Affect Bond Prices 
Lower interest rates yield lower bond rates, as a number of them are tied to prevailing interest rates
within that economy.  
Explain the impact of a decline in interest rates on: 
a. An investor’s required rate of return. 
Will drop as the investors risk free premium based on lower rates 
b. The present value of existing bonds. 
Will increase as the rates on future bonds will be lower 
c. The prices of existing bonds. 
Will increase as the rates on future bonds will be lower 
3 Why is the relationship between interest rates and bond prices important to financial
institutions? 
They need to be able to know/what to expect when interest rates change, so they can adapt their
financial planning accordingly. They adjust the size of their bond portfolio  
When they expect interest rates to rise, the sell bonds and buy shorter term securities – less
sensitive to int rates movements 
4. Determine the direction of bond prices over the last year and explain the reason for it. 
10 year treasury bonds have dropped significantly this year. Financial crisis due to coronavirus. US
Gov had to increase supply of money to rescue companies and as such the interest rates went to
0/close to 0 – bond prices followed and dropped by over 1% to a low pt of .53% in August.  
5. How would a financial institution with a large bond portfolio be affected by falling interest
rates? Would it be affected more than a financial institution with a greater concentration of bonds
(and fewer short-term securi- ties)? Explain. 
Drops in interest rates usually increase the market value of their assets, and a company with more
bonds would see their value increase in line with their extra bond holdings. Companies with fewer
short term securities and more bonds are more susceptible to interest rate changes.  
6. Comparison of Bonds to Mortgages Since fixed-rate mortgages and bonds have similar payment
flows, how is a financial institution with a large port- folio of fixed-rate mortgages affected by
rising interest rates? Explain. 
They will be making less money than if they had variable rate holdings.  
7. Coupon Rates If a bond’s coupon rate were above its required rate of return, would its price be
above or below its par value? Explain. 
If Coupon rate is above required rate of return, the price would be above it's par value.  
For a bond with a 10 percent coupon and a par value of $1,000. If investors require a return of 5
percent and desire a 10-year maturity, they will be willing to pay $1,390 for this bond. If they require
a return of 10 percent on this same bond, they will be willing to pay $1,000. If they require a 15 per-
cent return, they will be willing to pay only $745. 
8. Is the price of a long- term bond more or less sensitive to a change in interest rates than to the
price of a short-term security? Why? 
Long Term Bond is more sensitive to change in interest rates – as it is further from maturity date –
more volatility can occur. If interest rates decrease, the longer term bond will increase in value more
than shorter term as it will offer the same coupon rate over a longer period. The inverse is true an
increase in interest rates – longer term bonds will drop by more than shorter. 
9. Why does the required rate of return for a particular bond change over time? 
As interest rates increase/decrease the risk premium over the interest rates will rise drop
accordingly – altering the required rate of return.  
The economic conditions may change – so if the economy is poor, there will be lower expectations of
returns, so the required rate of return will be lower. Or if the company is at risk, the risk premium
will rise and the required rate of return will rise.  
10.Assume that inflation is expected to decline in the near future. How could this affect future
bond prices? Would you recommend that financial institutions increase or decrease their
concentration in long-term bonds based on this expectation? Explain. 
Declining interest rates will push down bond prices and on the required rate of return on bonds. I
would recommend increasing bond holdings – as interest rates will drop if inflation reduces and
bonds will provide a greater return going forward.  
11. Explain the concept of bond price elasticity.  
The sensitivity in bond prices to the change in required rate of return.  
Would bond price elasticity suggest a higher price sensitivity for zero-coupon bonds or high-
coupon bonds that are offering the same yield to maturity? Why?  
Higher price sensitivity for 0 coupon bonds. 0 coupon bond is more sensitive to changes in required
rate of return because the adjusted discount rate is applied to one lump sum in the distant future.
Bonds that pay their yield in coupon payments will pay some of the sum in payments in the near
future.  
What does this suggest about the market value volatility of mutual funds containing zero-coupon
Treasury bonds versus high-coupon Treasury bonds? 
Mutual funds holding zero coupon bonds will be more sensitive to changes in interest rates. It will be
more sensitive to declining interest rates as the price sensitivity for bonds is greater for declining
rates.  
12.An analyst recently suggested that there will be a major economic expansion that will favorably
affect the prices of high-rated, fixed-rate bonds because the credit risk of bonds will decline as
corporations improve their performance. Assuming that the economic expansion occurs, do you
agree with the analyst’s conclusion? Explain. 
If the credit risk of bonds decline, that means in the future, companies will be able to issue bonds
with lower interest rates- and as such, previously issued fixed rate bonds won't be as attractive as
they were at their initial issuing. I don't agree with the analysts conclusion if they are talking about
previously issued bonds – if talking about newly issued /future issues, then I agree.  
13. Impact of War When tensions rise or a war erupts in the Middle East, bond prices in
many coun- tries tend to decline. What is the link between problems in the Middle East and bond
prices? Would you expect bond prices to decline more in Japan or in the United Kingdom as a
result of the crisis? (The answer is tied to how interest rates may change in those countries.)
Explain. 
The middle east is a large supplier of oil to the worldwide economy, a disruption in this can affect
the economy globally. As economic conditions worsen, bond prices will drop due to decreasing
interest rates.  
14. Bond Price Sensitivity Explain how bond prices may be affected by money supply growth, oil
prices, and economic growth. 
Increasing money supply will drive the interest rates down, and will therefore decrease the prices of
bonds.  
An increase in the price of oil will make economic activity more expensive and will therefore increase
the interest rates, and therefore bond prices.  
Economic growth will decrease the price of bonds as  there is an expectation that interest rates will
rise. They will sell bonds and put downward pressure on bond prices.  
Chapter 9

1.Distinguish between FHA and conventional mortgages. 

FHA (Federal Housing Administration) guarantee loan repayment to the lending financial institution,
thereby protecting it against the possibility of default by the borrower 
Maximum lending amount applied by law 
2. What is the general relationship between mortgage rates and long-term government security
rates? 
Closely linked – as they are sold in the secondary mkt, they are valued by investors.  
The required rate of return on a mortgage is primarily determined by the existing risk-free rate for
the same maturity. However, other factors such as credit risk and lack of liquidity will cause the
required return on many mortgages to exceed the risk-free rate. The difference between the 30-year
mortgage rate and the 30-year Treasury bond rate, for example, is due mainly to credit risk and
therefore tends to increase during periods when the economy is weak  
Explain how mortgage lenders can be affected by interest rate movements. Also explain how they
can insulate against interest rate movements. 
Value of mortgage declines as interest rates rise. 
Can sell mortgages shortly after buying them 
Can offer adjustable rate residential mortgages.  
3. How does the initial rate on adjustable-rate mortgages (ARMs) differ from the rate on fixed-rate
mortgages? Why?  
Initial Fixed rate is typically higher than ARM. 
interest rate risk is significantly less than that of fixed-rate mortgages. 
Explain how caps on ARMs can affect a financial institution’s exposure to interest rate risk. 
Most ARMs specify a maximum allowable fluctuation in the mortgage rate per year and over the
mortgage life, regardless of what happens to market interest rates. These caps are commonly 2
percent per year and 5 percent for the mortgage’s lifetime. To the extent that market interest rates
move outside these boundaries, the financial institution’s profit margin on ARMs could be affected
by interest rate fluctuations.  
4. Why is the 15-year mortgage attractive to homeowners? Is the interest rate risk to the financial
institution higher for a 15-year or a 30- year mortgage? Why? 
Over 15 years you will pay less interest than 30 years. Interest rate risk is greater to the FI over 30-
years as there can be more/larger fluctuations over a longer period.  
5. xplain the use of a balloon-payment mortgage. Why might a financial institution prefer to offer
this type of mortgage? 
Collect interest payments over a fixed period then a lump sum at the end – only given to very credit
worthy customers. - as such – lower risk.  
Also, over a shorter period, they have less interest rate risk.  
6. Describe the graduated-payment mortgage. What type of home- owners would prefer this type
of mortgage? 
Small payments at the start of the term that gradually increase over time, then eventually level off.
This would suit people who anticiapte to earn more money over the period of the loan.  
7. Describe the growing-equity mortgage. How does it differ from a graduated-payment
mortgage? 
GEM doesn’t level off, keeps growing over time. Typically by 4% a year and typically will be paid off
sooner than equivalent GPM.  
8. Why are second mortgages offered by some home sellers? 
Can make the property more affordable  
9. Describe the shared-appreciation mortgage. 
Lender offers mortgage holder very favorable rates, but they will agree to share in the appreciation
of the value of the home.  
10. Movements Mortgage lenders with fixed-rate mortgages should benefit when interest rates
decline, yet research has shown that this favorable impact is dampened. By what? 
Borrowers tend to re-finance when interest rates drop.  
Refinancing is obtaining a new loan at better rates and then prepaying the mortgage.  
11. Mortgage Valuation Describe the factors that affect mortgage prices. 
Prevailing interest rates on equivalent Treasury bills.  
The riskiness of the borrower.  
The length of the mortgage. More expensive the longer it is.  
12. Explain why some financial institutions prefer to sell the mortgages they originate. 
They pass on the risk to other investors. If they sell it quickly, they don’t have to account for interest
rate risk over time.  
13. Compare the secondary market activity for mortgages to the activity for other capital market
instruments (such as stocks and bonds). Provide a general explanation for the difference in the
activity level. 
The secondary market is quite active for mortgages, and like the equity market, many derivatives
exist which people can speculate on.  
common purchasers of mortgages in the secondary market are savings institutions, commercial
banks, insurance companies, pension funds, and some types of mutual funds 
 
14. What types of financial institution finance residential mortgages? What type of financial
institution finances the majority of commercial mortgages? 
Savings institutions and commercial banks typically finance residential mortgages. 
Commercial banks typically finance commercial mortgages.  
15. Explain how a mortgage company’s degree of exposure to interest rate risk differs from that of
other financial institutions. 
Mortgage companies typically offer longer term loans than other companies and as such, they are
more exposed to interest rate risk. A number of their loans are tied to the prevailing interest rates
and a change in these rates can be beneficial/harmful to them at a greater rate than financial
institutions.  
Chapter 10

1. Explain the rights of common stockholders that are not available to other individuals. 
. Can vote on key matters concerning the firm 
. Election of Board of Directors, issuing new stock 
 
2.What is the danger of issuing too much stock?  
Can Dilute ownership – lose control of the company.  
What is the role of the securities firm that serves as the underwriter, and how can it ensure that
the firm does not issue too much stock? 
 
3. Why do firms engage in IPOs?  
What is the amount of the fees that the lead underwriter and its syndicate charge a firm that is
going public?  
Typically 7% of the funds raised,  
Why are there many IPOs in some periods and few IPOs in other periods? 
IPO's listed more frequently in Bull markets as they can get a higher price – and investors more likely
to purchase. 
4. Explain the difference between obtaining funds from a venture capital firm and engaging in an
IPO. 
VC privately takes a high % ownership stake in the company. VC negotiates requirements that firms
must meet and typically has an exit strategy for 4-7 years where they hope to sell or take the
company public.  
Explain how the IPO may serve as a means by which the venture capital firm can cash out. 
VC firms that take companies public will typically sell their shares after 6-24 months after they take
the firm public.  
5. Explain the use of a prospectus developed before an IPO.  
Provides investors with detailed info about the firm, financial statements and risks involved.  
Why does a firm do a road show before its IPO?  
Attract institutional investors 
What factors influence the offer price of stock at the time of the IPO? 
Amount of people interested/hype around the company 
During bookbuilding process, would have gauged how much demand there was and set a price
based on that, even if individual institutions would have paid more. This is done to ensure all of the
shares are sold  
6. Describe the process of book- building.  
During the road show, the lead underwriter solicits indications of interest in the IPO by institutional
investors as to the number of shares that they may demand at various possible offer prices 
Why is bookbuilding sometimes criticized as a means of setting the offer price? 
Can leave money on the table, if the wrong price is chosen.  
7. Describe a lockup provision and explain why it might be required by the lead underwriter. 
Prevents owners of company/VC firms from selling their shares for a certain amount of time after
IPO. Prevents downward pressure on price if these shareholders all sold in secondary mkt
immediately. 
8. What is the meaning of an initial return for an IPO?  
First day returns on IPO – increase in stock price on that day. 
Were initial returns of Internet IPOs in the late 1990s higher or lower than normal? Why? 
Much higher. People had high expectations for internet stocks and people invested more when they
saw the high returns that people were getting. This caused prices to rise further.  
9. What does it mean to “flip” shares? Why would investors want to flip shares? 
No intention of investing long term. Buy to sell quick, capitalising on the IPO initial return.  
10. How do IPOs perform over the long run? 
Typically perform poorly over a longer period.  
11. Discuss the concept of asymmetric information. Explain why it may motivate firms to
repurchase some of their stock. 
If one side of a transaction has more info than the other side. If a firm knows internally that it is
performing well, and its stock is undervalued, it will decide to repurchase some existing shares. 
12. Explain why the stock price of a firm may rise when the firm announces that it is repurchasing
its shares. 
It indicates that the management of the firm believe that the stock is undervalued and the firm is
performing well. Signals strong positive signs to investors. Also decreases amount of stock
available.  
13. Describe how the interaction between buyers and sellers affects the market value of a firm,
and explain how that value can subject a firm to the market for corporate control. 
If a firm notices that another firm has an undervalued stock price, it may look to take it over. They
hope to improve its performance and increase its value.  
14. Explain how ADRs enable U.S. investors to become part owners of foreign companies. 
Non US companies create ADRs in order to attract US investors in order to increase their
reputability.  
15. Explain why stocks traded on the New York Stock Exchange generally exhibit less risk than
stocks that are traded on other exchanges. 
Firms have to pay to list on the NYSE and meet regulations – such as minimum 1 dollar stock
price, minimum number of shares outstanding and a minimum level of earnings, cash flow, and
revenue over a recent period 
16. Are organized stock exchanges used to place newly issued stock? Explain. 
No – they are used to trade issued stock in the secondary market. Stocks first become available on
an exchange after a company conducts its IPO. A company sells shares to an initial set of public
shareholders in an IPO known as the primary market. After the IPO floats shares into the hands of
public shareholders, these shares can be sold and purchased on an exchange or the secondary
market. 
Chapter 11

1. Explain the use of the price–earnings ratio for valuing a stock.  

Calculate the AVG PE ratio for similar firms in similar industires and compare them. Expected
earnings per share are multiplied by the  by the mean industry PE ratio to give the stock valuation.  
Why might investors derive different valuations for a stock when using the PE method?  
Using different versions of earnings – or excluding large one time expenses 
Why might investors derive an inaccurate valuation of a firm when using the PE method? 
Previous year earnings aren't indicative of future earnings, use the wrong firms to determine the
average PE ratio, use incorrect forecasting for future PE estimates.  
2. Describe the dividend discount valuation model.  
The price of the stock should reflect the present value of future dividends. 
What are some limitations of the dividend discount model? 
Errors can be made estimating the dividend paid next year or estimating the growth rate or future
required rate of return.  
3.Explain how economic growth affects the valuation of a stock 
Favourable economic conditions increase stock price valuation – poor conditions typically decrease. 
4.How are the interest rate, the required rate of return on a stock, and the valuation of a stock
related? 
High interest rate should raise the required rate of return, therefore reducing present value of future
cash flows – reducing stock price. Lower interest rates should increase stock prices.  
5. Assume that the expected inflation rate has just been revised upward by the market. Would the
required return by investors who invest in stocks be affected? Explain. 
The required returns for investors would be higher in periods of high inflation.  
6. Impact of Exchange Rates Explain how the value of the dollar affects stock valuations. 
Stock prices of US firms involved in exporting could benefit from weak dollar, and negatively affected
by strong dollar.  
A weaker dollar could inflate a multinationals subsidary reported earnings. 
If a weak dollar stimulates the US economy, it could increase the stock price of a firm who relies on
US sales.  The opposite is also true.  
7. Explain why investor sentiment can affect stock prices. 
If investor sentiment is optimistic for the future, it will increase stock prices. Even if the economy is
weak, investor sentiment can increase stock prices of certain companies if investors believe they will
perform strongly in the future.  
8. January Effect Describe the January effect. 
Portfolio managers take more risks at the beginning of the year, and then switch to more
safe investments at the end of the year to lock in their profits as they are judged on an
annual basis. As such, this increases stock prices of smaller firms in January.  
9. How do earnings surprises affect valuations of stocks? 
When earnings are greater than anticipated, investors raise their estimates of future cash flows and
stock prices increase accordingly.  
10. Why can expectations of an acquisition affect the value of the target’s stock? 
Investors recognize that the target firms stock price will be bid up, and as such, they purchase now
to get benefit from that, pushing the price up.  
The acquiring firm's stock is less predictable. Investors aren't sure if they will get the synergies
needed to justify the acquisition.  
11. What are the risks of investing in stocks in emerging markets? 
Emerging markets can be less efficient and more difficult to judge. As these markets are typically
smaller, they are susceptible to manipulation by larger traders. Insider trading is more common in
these markets as it is not as firmly regulated.