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THE UNIVERSITY OF HONG KONG

The School of Economics and Finance
FINA2802_FINA2320_D – Investments and Portfolio Analysis
1st SEMESTER, 2017-2018

Chapter 3 How Securities are Traded (Continued)

 3.2 How Securities are Traded (Continued)

 Types of Orders
 Market Orders
- Buy or sell orders that are to be executed immediately at current market
prices.
- Investors always buy at the ask price and sell at the bid price.

 Limit Orders
- A limit order is an instruction to trade shares at a specific price or better.
 Limit Buy Order: buy shares at or below the limit
 Limit Sell Order: sell shares at or above the limit

 Stop Orders
- A stop order is an instruction to trade shares at a specific price or worse.
 Stop-Buy Order: buy shares at or above the limit (usually
accompany with short sale)
 Stop-Loss Order: buy shares at or below the limit

 3.7 Short Sales

 A short sale allows investors to profit from a decline in stock prices.
 Investors can borrow stocks from brokers and sell them. Later, the investors must
purchase back the same stocks in order to replace the shares that were borrowed.
 Short-sellers also have to pay the lender any dividends paid during the short sale.
 Short-sellers are also required to post margin with the broker to cover losses should the
stock price rise during the short sale.
 If the stock price rises, the margin in the account will fall and may hit the maintenance
level.
 Initial margin requirement and maintenance margin requirement also apply in short
sales.

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PROBLEM SET 1 (Types of Orders)

A market order has:
a. Price uncertainty but not execution uncertainty
b. Both price uncertainty and execution uncertainty
c. Execution uncertainty but not price uncertainty

PROBLEM SET 2 (Types of Orders)

Ritz purchased Starbucks stock in NYSE at $100 per share. The stock is trading at $120. In
order to realize at least $20 gain, which order should Ritz place with her broker?
a. limit-buy order
b. limit-sell order
c. stop-buy order
d. stop-loss order

PROBLEM SET 3 (Types of Orders)

Here is some price information on Fincorp stock. Suppose first that Fincorp trades in a
dealer market.
Bid Asked
55.25 55.50

a. Suppose you have submitted an order to your broker to buy at market. At what price will
your trade be executed?
b. Suppose you have submitted an order to sell at market. At what price will your trade be
executed?
c. Suppose you have submitted a limit order to sell at $55.62. What will happen?
d. Suppose you have submitted a limit order to buy at $55.37. What will happen?

PROBLEM SET 4 (Short Sales)

Old Economy Traders opened an account to short sell 1,000 shares of Internet Dreams from
the previous problem. The initial margin requirement was 50%. (The margin account pays
no interest.) A year later, the price of Internet Dreams has risen from $40 to $50, and the
stock has paid a dividend of $2 per share.
a. What is the remaining equity in the account a year later?
b. If the maintenance margin requirement is 30%, will Old Economy receive a margin call?
c. What is the rate of return on the investment?
d. How high can the price of Internet Dreams rise in order to get a margin call before any
dividend incur?
e. How high can the price of Internet Dreams rise in order to get a margin call when the
dividend has been paid?

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Chapter 4 Mutual Funds and Other Investment Companies

 4.1 Investment Companies

 Investment companies collect funds from individual investors and do large-scale
investment by invest those funds in a potentially wide range of securities or other
assets. Each investor has a claim to the portfolio established by the investment
company in proportion to the amount invested.

 Functions provided by investment companies:

 Record keeping and administration.
 Diversification and divisibility.
 Professional management.
 Lower transaction costs.

 Investors buy shares in investment companies, and ownership is proportional to the

number of shares purchased. The value of each share is

𝐌𝐚𝐫𝐤𝐞𝐭 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐀𝐬𝐬𝐞𝐭𝐬 − 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬

𝐍𝐞𝐭 𝐀𝐬𝐬𝐞𝐭 𝐕𝐚𝐥𝐮𝐞 (𝐍𝐀𝐕) =
𝐍𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐒𝐡𝐚𝐫𝐞𝐬 𝐎𝐮𝐭𝐬𝐭𝐚𝐧𝐝𝐢𝐧𝐠

 4.2 Types of Investment Companies

 Unit Investment Trusts
 portfolio composition is fixed for the life of the fund.
 sponsor of a unit investment trust buys a portfolio of securities that are deposited
into a trust. It then sells to the public shares or units in the trust at a premium to
the cost of acquiring the underlying assets. All income and payments of principal
from the portfolio are paid out by the fund’s trustees (a bank or trust company) to
the shareholders.
 little active management (unmanaged)
 tend to invest in relatively uniform types of assets
 Investors who wish to liquidate their holdings of a unit investment trust may sell
the shares back to the trustee for net asset value.

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 Managed Investment Companies

 Open-end funds
- redeem or issue shares at NAV after establishment.
- price equals NAV (except when it is sold with a load and commission)
- do not traded on exchanges; trades are executed once per day as NAV is
determined after the market close.

 closed-end funds
- no redemption and issuance of shares after establishment.
- price may be at premium or discount to NAV.
- traded continuously on exchanges.

 Other Investment Organizations

 Real Estate Investment Trusts (REITs)
 Hedge Funds

 4.3 Mutual Funds

 Types of Mutual Funds
 Money Market Funds
 Equity Funds
 Sector Funds
 Bond Funds
 International Funds
 Balanced Funds
 Asset Allocation and Flexible Funds
 Index Funds

 4.4. Costs of Investing in Mutual Funds

 Fee Structure
 Operating Expenses
- Operating expenses are administrative expenses and advisory fees paid. The
expenses periodically are deducted from the assets of the fund.

 Front-End Load
- One-time commission paid when you purchase the shares. Loads effectively
reduce the amount of money invested.

 Back-End Load

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- One-time exit fee incurred when you sell your shares. Typically, funds that
impose back-end loads reduce them by certain percentage for every year the
funds are left invested.

 12b-1 Charges (in US only)

- advertising, promotional literature including annual reports and prospectuses,
and commissions paid to brokers who sell the fund to investors. The fees are
periodically deducted from the assets of the fund.
- must be added to operating expenses to obtain the total expense ratio of the
fund.

 Fees and Mutual Fund Returns

𝐍𝐀𝐕𝟏 − 𝐍𝐀𝐕𝟎 + 𝐈𝐧𝐜𝐨𝐦𝐞 𝐚𝐧𝐝 𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐆𝐚𝐢𝐧 𝐃𝐢𝐬𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧𝐬

𝐑𝐚𝐭𝐞 𝐨𝐟 𝐑𝐞𝐭𝐮𝐫𝐧 =
𝐍𝐀𝐕𝟎
 It assumes price = NAV.
 It ignores any commissions such as front-end loads paid to purchase the fund.
 the rate of return is affected by the fund’s expenses and 12b-1 fees. This is because
such charges are periodically deducted from the portfolio, which reduces net asset
value.
 Thus the net rate of return on the fund equals the gross return on the
underlying portfolio minus the total expense ratio.

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PROBLEM SET 1 (NAV)

The composition of the Guardian Fund portfolio is as follows:
Stock Number of Shares Price
A 200,000 $35
B 300,000 40
C 400,000 20
D 600,000 25
The fund has not borrowed any funds, but its accrued management fee with the portfolio
manager currently totals $30,000. There are 4 million shares outstanding. What is the net
asset value of the fund?

PROBLEM SET 2 (Open-End Fund and Close-End Fund)

A closed-end fund starts the year with a net asset value of $12. By year-end, NAV equals
$12.10. At the beginning of the year, the fund was selling at a 2% premium to NAV. By the
end of the year, the fund is selling at a 7% discount to NAV. The fund paid year-end
distributions of income and capital gains of $1.50.
a. What is the rate of return to an investor in the fund during the year?
b. What would have been the rate of return to an investor who held the same securities in an
open-end fund?

PROBLEM SET 3 (Mutual Fund)

You purchased 1,000 shares of the New Fund at a price of $20.83 per share at the beginning
of the year. You paid a front-end load of 4%. The securities in which the fund invests
increase in value by 12% during the year. The fund’s expense ratio is 1.2%. What is your
rate of return on the fund if you can sell your shares equals to NAV at the end of the year?

PROBLEM SET 4 (Fee Structure)

The Investments Fund sells Class A shares with a front-end load of 6% and Class B shares
with 12b-1 fees of 0.5% annually as well as back-end load fees that start at 5% and fall by 1%
for each full year the investor holds the portfolio (until the fifth year). Assume the portfolio
rate of return net of operating expenses is 10% annually. If you can buy both classes of
shares at beginning for $1,000 and plan to sell the fund after 4 years, are Class A or Class B
shares the better choice for you? What if you plan to sell after 15 years?

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