Chapter 7 Practice Question Answers
- 1. Answer: B. Selling short exposes an investor to gains that are limited, but losses that are theoretically unlimited. A long position and a long call expose the investor to unlimited gains and limited losses. A short put exposes an investor to limited losses and limited gains.
- 2. Answer: C. A Designated Market Maker works in an auction market. The NYSE is the largest auction market. Market makers work in negotiated markets such as the NASDAQ, OTCBB, and the Pink Sheets.
- 3. Answer: A. Securities are issued and first sold to investors in the primary market. The issuer sells these securities to an investment bank at a discount, and receives the proceeds of their sale. The investment bankers then sell these securities to investors. When these investors decide to sell these securities to others, it is considered the secondary market. The money that is received from the sales of securities in the secondary market goes to the shareholders who are selling the shares, not the issuer.
- 4. Answer: B.
total return = (appreciation or loss in value + dividends and interest) / original investment
annualized total return = (($1,000 + $200) / $5,000) / 2 = 12%
- 5. Answer: B. If one wants to calculate an investment’s annualized return, including compounded interest, the appropriate formula is the geometric mean.
- 6. Answer: A.
holding period return = (investment’s value at sale – original investment) / original investment
original investment = 500 x $20 = $10,000
investment’s value at sale = 500 shares x $30 = $15,000
Sharon’s holding period return = ($15,000 – $10,000) / $10,000 = 50%
- 7. Answer: C.
expected return = probability x return + probability x return
expected return = (0.20 x 0.20) + (0.80 x 0.10) = 0.040 + 0.08 = 0.12 = 12%