Chapter 2 Practice Question Answers
1. Answer: A. Value investors are looking for stocks they believe to be underpriced by the market. Such a stock will have a low P/E ratio. Reliable payment of dividends is a focus of income investors. Growth and aggressive growth investors seek very high rates of return. A relatively low price/earnings ratio in light of the potential for growth would appeal to a GARP (growth at a reasonable price) investor.
2. Answer: A. Short selling is when an investor believes the price of a stock is going to drop, and tries to profit from this by borrowing shares (usually from a broker-dealer for a fee) and selling them at market price. At some point before the shares must be returned, the investor buys back the same number of shares, again at market price, and returns those shares to the lender. If the market price falls in between selling the borrowed shares and buying them back, the investor gets to pocket the difference. If the investor makes more than the fee the broker-dealer charged for lending the shares, the investor turns a profit.
3. Answer: C. Ann is most likely following a special situation strategy. Special situation investors buy shares after unusual circumstances (such as bad publicity) have caused a stock to drop below its expected value. (She could also be following a deep value strategy, if the companies’ fundamentals seem sound.) She probably is not following a distressed strategy, as there is no indication that the companies she invests in are in financial distress, and because individual investors rarely pursue this strategy. Momentum investors buy stocks that are trending strongly higher on high volume, which is not the case here. (Momentum investors could also capitalize on downward momentum, but they would do so by selling short, not by buying shares.) An arbitrage strategy involves the exploitation of disparities in the price of a security or other financial instrument between two different markets.
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