Work Hard. HA! you finally missed 3, you wrotehard test,geez Risk vs Reward. Exam – Risk and Reward YOUR SCORE You got 7 questions right out of 10, for a score of 70%. Questions missed: 3, 9, 10 ANSWERS 1) The Florida lottery offers a “cash-three” game, which offers a top prize of $500. Lotto, on the other hand, usually has a $7,000,000 first prize. Since both games cost $1, you should only play Lotto since it has a better payout. a) True b) False While Lotto has a better payout, that must be balanced by having more risk. In fact, you can verify that Cash-Three offers odds of 1:1,000 while Lotto is nearly 1:14,000,000. The higher risk in Lotto means that its payoff must be higher. 2) You are deciding between two mutual funds to place in your IRA (Individual Retirement Account). You find that ING Russia A (LETRX) has earned 55.5% over the past three years while the Perritt Micro Cap (PRCGX) returned only 24.4% over the same period. The Russia fund is obviously better since it returned more money over the same time frame. a) True b) False The Russia Fund posted higher numbers but we cannot say that it is therefore the better fund. It obviously comes with a lot of risk because it beat the market by so much. However, it’s dangerous to assume that this is where you should immediately invest your money just because of the impressive numbers. On a risk-adjusted scale, these numbers may be better - or worse. A lot more investigation is needed before you should jump to that conclusion! 3) You have several mutual funds that have collectively earned 12% per year over the past couple of years. An acquaintance tells you he manages money and you should let him handle your account because he made 30% last year and 25% the year before. He claims you’re foolish to leave your money in such low-performing assets. You should: a) Transfer your money to him immediately b) Ask what he’s investing in to see if that’s in line with your risk tolerances c) Sue your mutual funds d) Be very impressed with his stock picking skills Just because he beat the market, we dont know if he did it on a risk-adjusted basis. If he only took a little more risk and returned those numbers, then maybe it is worth putting your money with him. But if he invested in speculative oil drilling ventures, you’ll want to reconsider. These numbers are not directly comparable since we do not know in which assets he’s investing. 4) You are with a friend at a casino and decide to bet $20 on red at a roulette wheel while your friend decides to play $20 worth of quarters on a slot machine. He tells you that roulette is a bad pick because, if you win, you’ll only make $20. But the slot machine he’s playing has a $5,000,000 prize! He says it is common sense that it’s better to bet 25 cents for the chance to win $5,000,000 rather than to bet $20 for the chance to make $20. You should: a) Cash in your $20 bill for quarters b) Realize that slots are better and hunt for a machine with an even higher payout c) Be very impressed with his game picking skills d) Understand that there are different risks between the games and make your choice accordingly The higher payout reflects that there must be more risk involved with the slot machines. This doesn’t mean that roulette is better. It just means that if you wish to go for the $5,000,000 prize, you need to understand that you’re taking a lot more risk and will probably lose your money. Betting on red at roulette however, you will win a little less than half the time. This performance is far from true for those playing slot machines! 5) After the September 11 attacks, the Dow Jones Industrial Average plunged nearly 7% once it reopened for trading on September 17. As for the 30 companies representing that index, nothing changed on their part from September 10 to September 17 yet their prices fell. Why do you suppose that happened? a) It was due to insider trading b) Investors were less certain about corporate future earnings due to the attacks. In other words, there was more risk with being invested in stocks and investors bid the prices lower c) The specialists on the exchange were manipulating prices d) It was just a coincidence and stock prices could have easily risen on the news Because investors are less certain about the future earnings of corporations, they will demand a risk premium for investing in the stock market. This means the prices will fall. 6) Why do you suppose that a used car sold through a dealership is more expensive than an identical one sold through a private seller? a) Dealerships are a rip-off b) The dealerships check out the cars and put their “seal of approval” on them. It is less risky buying through a dealership and the market is willing to bid the price higher c) Private sellers just want to get rid of the car quicker d) Dealerships mark up the cars too much so that the new cars appear to be a better buy Dealerships thoroughly inspect cars and replace any parts that may be ready to go. They do this because they have their reputation to be concerned with whereas individual sellers do not. So if a dealer sells a used car, there is theoretically less risk involved in buying it. If there’s a problem with it, they are far more likely to take it back or work with you when compared to an individual seller. Because there is less risk in buying a used car through a dealer, there will be a higher price tag on those cars. 7) You work for a bank’s loan department and find they have loaned money to a dentist at 5% and at 8% to a car salesman for the same loan. Both the dentist and car salesman earned the same amount of money last year and have excellent credit. Why did the bank give a higher rate to the salesman? a) The bank is just taking advantage of the salesman b) The dentist must be related to one of the bank employees c) The salesman’s earnings are not as certain as they are for the dentist. Therefore, there is more risk in loaning money to the salesman and the bank needs a higher interest rate to compensate for the risk d) The salesman didn’t negotiate and took their first offer While the two people earned the same amounts of money last year, the quality of those earnings are probably not the same. We are very confident the dentist will earn about the same next year but are not so sure for the car salesman. This uncertainty makes it riskier for the bank to loan to the salesman and they will want a higher return for their investment. That’s why they loaned at 8% rather than 5%. 8) You wish to buy a bond and find that General Motors has issued a one-year bond that pays 2% while the Fly-by-night company has issued a bond that pays 10%. What can you determine by these numbers? a) The Fly-by-night bond must be riskier and that’s why the return on your money is higher (assuming you ever see it). b) The General Motors bond is riskier and that’s why the returns are lower c) The Fly-by-night bond is a better deal since you make more on your money d) General Motors is just trying to exercise its power and is offering investors a horrible deal The Fly-by-night company has more risk associated with it. Because of this, you should be willing to pay less for a $10,000 bond as compared to one issued by General Motors. If you pay less for the bond, your return must be higher and that’s why you’ll get 10% from Fly-by-night - but you may end up losing it all. There is virtually no risk in General Motors and that’s why you’re not going to get a lot of money from that bond. 9) You find a watch on eBay for $1,000. It is brand new but the seller says that all sales are final. The same watch sells for $1,200 in your local mall that does accept returns. Which is a reason it is cheaper on eBay? a) It is riskier to buy at the mall so their price is higher b) It is riskier to buy on eBay since you cannot return it. The seller must therefore drop the price in order to compete with the malls c) It is less risky to buy on eBay so its price is lower d) The mall just takes advantage of people and charges the highest price Many items sold through the web are not returnable. In addition, you cannot pick them up and look at them like you can at a store. There is less risk in buying through a store. Consequently, web retailers must offer lower prices to account for the risks. Of course, there are other reasons why it’s cheaper through the web such as overhead, employees, etc. but the differences in risk certainly account for some of the price reduction. 10) For each dollar bet at roulette, a casino offers a $1 payout for betting on red, an $8 payout for a four-number bet, and a $35 payout for a single number. Which bet is riskiest? a) Red b) Single number c) Four number d) Can’t be determined The single-number bet is the riskiest of all the roulette bets and therefore carries the highest payout. Mike Klatt updated his status. You even got the difficult strategies correct! genius.. YOUR SCORE You got 10 questions right out of 10, for a score of 100%. ANSWERS 1) Assume you are looking at $50, $55 and $60 strike call options. How would you construct a butterfly spread? a) Buy a $50, sell a $55, buy a $60 b) Buy a $50, buy 2 $55, sell a $60 c) Sell a $50, sell a $55, buy a $60 d) Buy a $50, sell 2 $55, buy a $60 The basic butterfly spread is constructed in a 1-2-1 pattern; that is, buy one strike, sell 2 of a higher strike, and buy 1 of yet a higher strike. With these three quotes, the investor would buy the $50, sell 2 $55 strikes and buy a $60. 2) The butterfly can be viewed as the combination of a: a) Bull spread and condor spread b) Bull spread and bear spread c) Bear spread and condor spread d) None of the above Using the example in the previous question, the investors trade can be broken down into two parts: (1) Buy the $50 call and sell a $55 call and (2) Sell a $55 call and buy a $60 call. The first trade is a bull spread and the second is a bear spread. Market makers, trying to capture pricing differences between spreads, most often use butterflies. 3) The owner of an at-the-money butterfly spread (middle strike equal to the stock price) wants the underlying stock to: a) Move sharply upward b) Move slowly upward c) Fall sharply d) Sit still Continuing with the above trade, if the butterfly is initiated with the stock at $55 (the middle strike), the investor will maximize profits if the stock sits still. It is possible to create bull and bear butterfly spreads as well depending where the stock is in relation to the center strike. If the above trade were initiated with the stock at $50, it would be called a bull butterfly, as the investor would want the stock to rise first and then sit still. The key point is that the butterfly maximizes profits if position expires with the stock at the center strike. 4) A trader enters a $50/$55/$60 butterfly. The maximum value this spread can ever be worth is: a) $5 b) $10 c) $60 d) None of the above The maximum value of a butterfly is the center strike minus the lowest strike. In this case, $55 - $50 = $5. If the stock remains at $55 at expiration, the butterfly will be worth $5 to this trader (less the amount paid). 5) If you can ever enter a butterfly spread for a net credit you should: a) Never do it as it is a sure loser b) Always do it as you can never lose c) Not enough information as butterfly spreads are always executed for credits A butterfly spread entered for a credit can never lose -- thats an arbitrage situation. While you will likely never find one of these, this does not mean you cannot use them as a hedging tool at a later date to hedge a spread position and take advantage of a neutral outlook. 6) The butterfly spread is generally a great strategy for retail customers. a) True b) False Butterfly spreads are generally used by market makers to take advantage of pricing discrepancies between spreads. They can make the strategy work due to the low transaction costs. However, retail investors who pay full commissions will almost always end up losing with butterfly spreads. Please understand that this assumes the retail investor places all three pieces (or more in some cases) of the butterfly spread at one time. If the butterfly is used as a hedging tool, it can be a great asset for retail investors. 7) Compared to the butterfly spread, the condor is a higher risk, higher reward spread. a) True b) False The condor is similar to the butterfly spread except that it sells two middle strikes instead of one. There are four strikes total (and sometimes more) for the condor. Because the profit zone is extended, it is a lower risk strategy and will also be lower reward. 8) The owner of a calendar spread wants the spread to: a) Narrow b) Widen Mike Klatt updated his status. You wrote me telling me , this was difficult to understand Yet you got them all correct! YOUR SCORE You got 10 questions right out of 10, for a score of 100%. ANSWERS 1. The Reg T amount is: a) 20% b) 30% c) 40% d) 50% 2. You just opened a brokerage account with $2,000 cash. You then bought 100 shares of a $20 stock on margin. What is your initial Reg T amount? a) $500 b) $1,500 c) $1,000 d) $2,000 Remember that your intital Reg T deposit is 50% but that you must have a minimum of $2,000 equity in the account. If you buy $2,000 worth of stock, your Reg T will be for the full amount. Another way of looking at this is that you could have purchased up to $4,000 worth of stock and not had to deposit any additional money. With a $4,000 purchase, your Reg T amount of 50% would be $2,000, which satisfies the $2,000 minimum requirement. 3. Your account has a market value of $30,000 and a debit balance of $10,000. What is your equity percentage? a) 50% b) 33% c) 66% d) 75% MVL = $30,000 Debit = $10,000 Equity = $20,000 You have $20,000 equity with a $30,000 market value. This means your equity percent is $20,000/$30,000 = 66%. 4. Your account has a market value of $20,000 and a debit balance of $12,000. Which market value will just keep you out of maintenance? (Assume your broker has a 35% requirement.) a) $17,443 b) $18,461 c) $16,950 d) $18,005 MVL = $20,000 Debit = $12,000 Equity = $8,000 If you have a market value long (MVL) of $20,000 and a debit balance of $12,000 then your equity is $8,000. This puts you at $8,000/$20,000 = 40% equity. This question is asking you to find the MVL that puts you at 35% equity. If you are at 35% equity, you are right on the edge of a maintenance call. We can find this algebraically: (MVL - $12,000)/MVL = 0.35 We’re trying to solve for the MVL. The above expression is saying to find the MVL that, after subtracting $12,000 and dividing by MVL, leaves us with 35%. We can multiply both sides by MVL and get: MVL - $12,000 = 0.35 MVL Next, collect like terms. We can bring the 0.35 over to the left of the equal sign and the -$12,000 over to the right: MVL – 0.35MVL = $12,000 0.65 MVL = $12,000 MVL = $12,000/0.65 MVL = $18,461 Fortunately, there is a shortcut formula you can remember. All you have to do is take the complement of 35% and divide that into the debit balance. The complement is the value that would make the two numbers add up to one. In this example, the complement of 35% is 65% since 0.35 + 0.65 = 1. Next, all we have to do is divide 0.65 into the $12,000 debit balance and we get $18,461. (Please see Question 10.) 5. If your equity falls below 50%, the account is: a) Restricted b) Closed c) In maintenance d) Cannot be traded If your equity falls below 50%, the account is called a restricted account. This means that you will probably have to send in money if you buy additional stocks. (There are times when this is not true if you have sufficient SMA.) But the restricted notation is just something of which you should be aware as you may see it tagged on your brokerage account. This just means that your account has fallen below 50%. 6. What is perhaps the biggest disadvantage in having a margin account? a) You can lose more money than what you have in it b) You gain SMA c) You lose SMA d) You must post 50% margin 200 shares * $30 = $6,000 market value. If you deposit 50% then you are depositing $3,000 and your account looks like this: MVL = $6,000 Debit = $3,000 Equity = $3,000 If the stock falls to $28, then the market value is 200 shares * $28 = $5,600 and your account looks like this: MVL = $5,600 Debit = $3,000 Equity = $2,600 Your equity percent is then $2,600/$5,600 = 46% 7. You bought 200 shares of stock for $30 and deposited 50% of the amount. Later, the stock falls to $28 per share. What is your percent equity? a) 55% b) 46% c) 42% d) 37% 8. If you open a “cash” account, all purchases must be paid for by which amount? a) 100% b) 50% c) 35% d) You cannot buy stock in a “cash” account 9. “Equity divided by market value” is the formula for: a) Market value percent b) Debit balance c) Maintenance call level d) Equity percent 10. Which of the following formulas shows how far the value of your market value can fall before falling into maintenance? a) Debit balance / complement of house percent b) Debit balance / house percent c) House percent * Market value d) House percent * complement of market value Remember, the complement of any decimal is the number that makes it add to one. For example, the complement of 0.40 is 0.60 since those two numbers add to one. If your broker has a 30% house requirement, then 70%, or 0.70 is the complement. Assume that your account looks like this: MVL = $25,000 Debit = $15,000 Equity = $10,000 How far can the market value fall before your equity percentage is 30%? All we have to do is take the debit balance and divide it by the complement, or 0.70. In this example, $15,000/0.70 = $21,428 and that’s the lowest MVL that your account could fall to without getting a maintenance call. We can check the answer as follows: MVL = $21,428 Debit = $15,000 Equity = $6,428 $6,428/$21,428 = 30% ...
Posted on: Tue, 21 Oct 2014 16:46:06 +0000
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