How Securities are Traded

a. protect the bid-ask spread and exchange participants’ profits

b. protect corporations and investors

c. protect investors and ensure market integrity

d. ensure market integrity

Ans: c

Difficulty: Easy

Ref: How Orders Work

15. The Securities Investor Protection Corporation (SIPC) insures customer accounts at member brokers against brokerage failure as follows:

a. securities totaling $250,000, cash totaling $100,000

b. securities totaling $250,000, cash totaling $250,000

c. securities totaling $500,000, cash totaling $100,000

d. securities totaling $500,000, cash totaling $250,000

Ans: c

Difficulty: Moderate

Ref: How Orders Work

16. The NYSE requires customers to deposit a minimum of how much in securities for margin accounts

a. $2,000

b. $2,500

c. $5,000

d. $10,000

Ans: a

Difficulty: Moderate

Ref: Margin

17. Margin accounts cannot be used to:

a. purchase securities using leverage

b. borrow money from a brokerage account to fund a frivolous vacation

c. provide overdraft protection

d. take physical delivery of an underlying asset on maturity of a futures contract

Ans: d

Difficulty: Moderate

Ref: Margin

18. Open orders, if not cancelled or renewed, remain in effect for:

a. one week.

b. one month.

c. six months

d. twelve months.

Ans: c

Difficulty: Difficult

Ref: How Orders Work

19. If an investor is attempting to buy a stock that is very volatile, it would be best to use a:

a. market order

b. limit order

c. stop-loss order

d. contingency order

Ans: b

Difficulty: Moderate

Ref: How Orders Work

20. An order that must be filled immediately in its entirety, or otherwise must be canceled, is known as:

a. an immediate or cancel order.

b. an all or none order.

c a fill or kill order.

d. a full or bust order.

Ans: c

Difficulty: Moderate

Ref: How Orders Work

21. The NYSE is:

a. a free agent market.

b. an agency auction market.

c. a negotiated market.

d. a dealer market.

Ans: b

Difficulty: Moderate

Ref: How Orders Work

22. The independent, quasi-judicial agency of the U.S. government that administers laws in the securities field and protects investors and the public in securities transactions is:

a. FINRA

b. SIPC

c. The Federal Reserve Bank

d. SEC

Ans: d

Difficulty: Easy

Ref: How Orders Work

23. Which of the following statements regarding specialists is FALSE? Specialists:

a. are expected to maintain a fair and orderly market in their assigned stocks.

b. perform a dual role as brokers and dealers.

c. must be approved by the Federal Reserve Board.

d. must often go "against the market."

Ans: c

Difficulty: Difficult

Ref: How Orders Work

24. Ms. Brown sold short 100 shares of common stock at $78 per share. The price has declined to $69. The outlook for the stock is mixed, so she would cover her short position if the stock moves up as much as $1 but hold if it continues down. Ms. Brown should place a

a. sell stop order at $70.

b. buy stop order at $70.

c. sell limit order at $70.

d. buy limit order at $70.

Ans: b

Difficulty: Difficult

Ref: How Orders Work

25. Mr. King has researched a small company, whose stock is selling at $7.50. He wants to buy 1,000 shares but thinks that he might get the stock at $7.25. To try to buy the stock at the lower price, he should place a

a. sell stop order at $7.25.

b. buy stop order at $7.25.

c. sell limit order at $7.25.

d. buy limit order at $7.25.

Ans: d

Difficulty: Difficult

Ref: How Orders Work

26. A sell stop order is placed:

a. above the current price.

b. below the current price.

c. at the current price.

d. at the breakeven point.

Ans: b

Difficulty: Moderate

Ref: How Orders Work

27. Which of the following has helped to eliminate the use of stock certificates by placing stock transactions on computers.

a. Federal Reserve

b. Securities Exchange Commission

c. Depository Trust Company

d. Federal Depository Insurance Corporation

Ans: c

Difficulty: Moderate

Ref: How Orders Work

28. The law that requires that all new issues being offered for public sale to be

registered with the SEC is the:

a. Securities Act of 1933

b. Securities Exchange Act of 1934

c. Maloney Act of 1936

d. Securities Investor Protection Act of 1970

Ans: a

Ref: moderate

Ref: Investor Protection in the Securities Markets

29. Which of the following statements regarding the SEC is not true?

a. The SEC is an independent, quasi-judicial agency of the U.S. government

b. The SEC has the power to disapprove securities for lack of merit

c. The SEC has nine regional offices and approximately 200 examiners

d. The SEC administers all U.S. securities laws

Ans: b

Difficulty: Moderate

Ref: How Orders Work

30. A trading halt on the NYSE occurs:

a. when the SEC declares one

b. when the market declines more than 10 percent during the day

c. typically lasts less than an hour but can be longer—is called during the trading day to allow a company to announce important news or where there is a significant order imbalance between buyers and sellers in a security.

d. any time specialists exhaust their capital

Ans: d

Difficulty: Difficult

Ref: How Orders Work

31. Which of the following statements regarding arbitration of broker-client disputes is not true?

a. There is a cost to arbitration.

b. Arbitration is a binding process that can determine damages.

c. It is advised that investors hire a lawyer for the arbitration process.

d. Arbitration rulings are frequently appealed.

Ans: d

Difficulty: Moderate

Ref: How Orders Work

32. The initial margin requirement on security trades is set by the:

a. SEC

b. FINRA

c. SIPC

d. Federal Reserve

Ans: d

Difficulty: Easy

Ref: Margin

33. Since 1974, the current initial margin requirement on stock is:

a. 30 percent.

b. 40 percent.

c. 50 percent.

d. 60 percent.

Ans: c

Difficulty: Easy

Ref: Margin

34. The interest rate charged on margin accounts is determined by:

a. adding a percentage to the broker call rate.

b. adding a percentage to the margin interest rate.

c. subtracting a percentage to the broker call rate.

d. subtracting a percentage to the margin interest rate.

Ans: a

Difficulty: Moderate

Ref: Margin

35. Margin Call price is the amount borrowed divided by:

a. number of shares x (1 – initial margin proportion)

b. number of shares x (1 – maintenance margin proportion)

c. current value of the shares purchased x (1 – initial margin proportion)

d. current value of the shares purchased x (1 – maintenance margin proportion)

Ans: b

Difficulty: Moderate

Ref: Margin

36. If maintenance margin is not maintained, the broker will place:

a. a sell order on sufficient securities to ensure the portfolio is compliant with maintenance margin requirements

b. a sell order on sufficient securities to ensure the portfolio is compliant with initial margin requirements

c. contact the investor with a margin put

d. contact the investor with a margin call

Ans: d

Difficulty: Easy

Ref: Margin

NOTE: Questions 37-38 are based on the following information:

An investor buys 100 shares of Walmart at $45 per share on margin with an initial margin of 70 percent and a maintenance margin of 25% percent. In two months, the stock goes to $56.

37. What is the actual margin of the stock when it’s at $56?

a. 65.9%

b. 75.9% Solution: 5600-1350 =

c. 79.9% 5600

d. 80.9%

Ans: b

Difficulty: Difficult

Ref: Margin

38. Below what price will a margin call occur?

a. $13.50

b. $54.00 Solution = 1350 = $18

c. $42.00 100(1-.25)

d. $18.00

Ans: d

Difficulty: Difficult

Ref: Margin

39. Which of the following statements is true regarding short sales?

a. An investor can only remain in a short sale 6 months or less.

b. Short sales can be done on either a cash or margin account.

c. Short sellers borrow the stock sold short from the exchanges.

d. Dividends paid during the short sale must be covered by the seller.

Ans: d

Difficulty: Difficult

Ref: Short Sales

42. Which of the following statements regarding the short interest ratio is true?

a. It is calculated by the total shares sold short divided by total shares outstanding

b. It indicates the dollar amount needed to cover all short positions

c. The higher the ratio, the more bullish investors are

d. It is the amount of shares sold short divided by average trading volume

Ans: c

Difficulty: Moderate

Ref: Short Sales

Fill-in-the-blank Questions

1. The SIPC limit for insurance coverage on cash is _____________________.

Ans: $100,000

Difficulty: Moderate

Ref: Investor Protection in the Securities Markets

2. The NYSE regulatory triad consists of: _____________________________, _________________, and _______________________________________.

Ans: the Exchange/NYSE (self-regulation), the SEC, and member firms

Difficulty: Moderate

Ref: Investor Protection in the Securities Markets

True-False Questions

1. Most full-service stockbrokers derive over 80% of their income from customer commissions.

Ans: F

Difficulty: Easy

Ref: Brokerage Transactions

2. Charles Schwab, Fidelity and Vanguard are examples of premium discount brokers.

Ans: T

Difficulty: Easy

Ref: Brokerage Transactions

3. All asset management accounts offer automatic reinvestment of credit balances in shares of a money market or other fund.

Ans: T

Difficulty: Moderate

Ref: Brokerage Transactions

4. Negotiated commissions are the norm for institutional investors; whereas most individual investors pay specified commissions set by the brokerage firms.

Ans: T

Difficulty: Moderate

Ref: Brokerage Transactions

5. Dollar cost averaging, in which more shares are purchased at low prices than at high prices, is one advantage of dividend reinvestment plans.

Ans: T

Difficulty: Moderate

Ref: Brokerage Transactions

6. Buying Treasury securities through the Treasury Direct Program eliminates all brokerage commissions and other fees.

Ans: F

Difficulty: Moderate

Ref: Brokerage Transactions

7. Specialist trading on the NYSE now accounts for the majority of share volume on a yearly basis.

Ans: F

Difficulty: Moderate

Ref: How Orders Work

8. The Specialist’s Electronic Book, which is part of the SuperDot system, records and reports limit and market orders.

Ans: T

Difficulty: Moderate

Ref: How Orders Work

9. “Street names” are the nicknames used for commonly-held securities, such as “IBM” for International Business Machines.

Ans: F

Difficulty: Easy

Ref: How Orders Work

10. The use of stock certificates, compared to book-entry systems, is on the rise due, in part, to increased computer fraud.

Ans: F

Difficulty: Easy

Ref: How Orders Work

11. A sell stop loss order is placed above the current market price.

Ans: F

Difficulty: Moderate

Ref: How Orders Work

12. Most securities are sold on a regular way basis, which means the settlement date is one week after the trade date.

Ans: F

Difficulty: Moderate

Ref: How Orders Work

13. The Securities and Exchange Commission is a division of the Department of Justice.

Ans: F

Difficulty: Easy

Ref: Investor Protection in the Securities Markets

14. Insider trading often occurs when mergers and takeovers are imminent.

Ans: T

Difficulty: Moderate

Ref: Investor Protection in the Securities Markets

15. If a security issue is registered with the SEC, there is less chance the investor will lose money on the investment.

Ans: F

Difficulty: Moderate

Ref: Investor Protection in the Securities Markets

16. Sidecars, trading halts and Rule 80A are all types of circuit breakers employed by the NYSE.

Ans: T

Difficulty: Moderate

Ref: Investor Protection in the Securities Markets

17. “Circuit breakers” are program traders that attempt to bypass the exchange regulations.

Ans: F

Difficulty: Difficult

Ref: Investor Protection in the Securities Markets

18. Under SIPC, customer accounts with brokerage firms are insured for up to $1 million.

Ans: F

Difficulty: Easy

Ref: Investor Protection in the Securities Markets

19. Under margin accounts, investors can purchase more stock without putting up additional cash by leveraging the value of the eligible shares.

Ans: T

Difficulty: Moderate

Ref: Margin

20. A margin call occurs anytime the equity position of the margin account falls below the initial margin.

Ans: F

Difficulty: Moderate

Ref: Margin

21. Most short sales are executed by the broker acting as the “lender” of the security sold.

Ans: T

Difficulty: Easy

Ref: Short Sales

22. Investors who sell short are expecting the price of the security to fall.

Ans: T

Difficulty: Easy

Ref: Short Sales

23. Specialists often sell short to meet public buy orders.

Ans: T

Difficulty: Moderate

Ref: Short Sales

24. The short interest ratio indicates the number of days it would take for short sellers to cover all the shares sold short.

Ans: T

Difficulty: Moderate

Ref: Short Sales

Short-Answer Questions

1. What is the chief advantage of a market order?

Answer: A market order is executed immediately.

Difficulty: Easy

2. What are the advantages to investors’ of keeping their securities in street name?

Answer: Investors don't have to worry about lost certificates and it simplifies record

keeping.

Difficulty: Easy

3. What costs and risks are incurred in using a margin account that are not present in a cash account?

Answer: There is the cost of interest on the amount borrowed and the risk of losing the borrowed funds as well as your original equity, and dividend payments must be covered on the borrowed stock.

Difficulty: Moderate

4. What is the rationale for different margin requirements on different types of securities? (For example, 50 percent on common stock, and 30 percent on bonds corporate bonds)

Answer: In general, the higher the risk of loss, the higher the margin requirement. This is why stocks have higher margins than bonds. Unfortunately, margins on futures are very small and do not follow this logic.

Difficulty: Moderate

5. What is insider trading? Does it only affect large investors?

Answer: Insider trading is a breach of fiduciary responsibility by "insiders" such as officers and directors of corporations who trade on corporate information that is available to the public. Both large and small investors can be charged with possessing "material, nonpublic information."

Difficulty: Difficult

6. Mr. Whiner bought 1,000 shares of Sure-Fire, Inc., common stock at 85 and sold three months later at 73. He lost $12,000 plus commissions on this ill-fated stock purchase. He then contacted the SIPC saying that he wanted to file a claim for his investment losses. Is this loss covered by SIPC? What losses are covered?

Answer: No. Losses due to a brokerage firm bankruptcy (causing an investor’s account to be worth less than full value) are covered.

Difficulty: Moderate

7. Does the expression “you get what you pay for” apply to full-service brokers and discount brokers?

Answer: By and large the expression applies. Full-service brokers offer advice and suggest securities, whereas, discount brokers simply handle the transaction.

Difficulty: Moderate

8. What are two methods of investing in stocks without a broker?

Answer: Automatic dividend reinvestment plans and no-load stock purchase programs.

Difficulty: Moderate

9. Small investors often pay brokerage commissions according to the firm’s chart of fees. How can this be when rates are negotiable?

Answer: Small investors are free to negotiate with the broker, but often they negotiate from a position offering little. It’s not worth it to the brokerage house to negotiate every small trade.

Difficulty: Difficult

10. What are some of the functions of the NASD?

Answer: The NASD is the major organization licensing stockbrokers as well as providing compliance examinations of member firms. In addition, the NASD provides automated market surveillance, reviews member advertising and underwriting arrangements and provides for arbitration of disputes between member firms and their clients.

Difficulty: Moderate

Critical Thinking/Essay Questions

1. Compare and contrast the functions and responsibilities of a NYSE specialist with those of an OTC dealer.

Answer: Specialists must maintain a fair and orderly market on the NYSE. They keep limit orders. They buy and sell from their own accounts as dealers to maintain a continuous market. OTC dealers buy and sell from their own accounts to satisfy public demand, thereby making markets in the securities. Specialists are more restricted in their trading by the NYSE while the OTC choose which securities to make a market in and when to buy and sell.

Difficulty: Moderate

2. What is the difference between the potential gains and losses on long positions versus the potential gains and losses on short sales?

Answer: On long positions, the potential gain is unlimited because there is no limit to how high a stock price can go. The potential loss on a long position is just what you paid for the stock. With short sales, on the other hand, the potential gain is limited since you make a gain on a short sale when the stock falls and stocks can only fall to 0. But the potential loss is unlimited since you lose money on a short sale when the stock's price rises and there is again no limit to how high a stock price can go.

Difficulty: Difficult

Problems

1. An investor purchases 100 shares of a $60 stock when the initial margin requirement is 50 percent and the maintenance margin is 30 percent.

(a) How much must the investor put up initially in order to purchase the stock?

(b) Calculate the actual margin if the price of the stock drops to $55.

(c) At what stock price will a margin call occur?

(d) If the stock price falls to $58, is the account restricted?

Solution: (a) initial margin = 50 percent

50% of ($60 x 100) = $3000 in equity

(b) actual margin

= $5500 - $3000

$5500 = 45.5 percent

(c) A margin call occurs when the actual margin declines below the maintenance margin. This point can be found (with a 30 percent maintenance margin) as follows:

MC price = Amount borrowed_____________

# of shares (1-maintenance margin) =

3000_____

100(1-.30) = 3000/70 = $42.86

If the stock price declines below $42.86, a margin call will be issued.

(d) At a price of $58, the account is restricted since the margin will be below the initial margin requirement but above the maintenance margin.

Margin at 58 = 5800 - 3000

5800 = 48%

Difficulty: Difficult

2. An investor sells 100 shares of stock short at $40.

(a) Ignoring commissions, at what price will the investor earn $700?

(b) Ignoring commissions, what is the gain or loss if the stock price goes to $53 and the investor closes out the position?

Solution: (a) When the stock drops 7 points to $33, the investor will earn $700.

(b) If the stock goes to $53, the loss will be:

purchase at $53 x 100 shares = $5300

sold short at $40 x 100 shares = 4000

loss = ($1300)

Difficulty: Moderate

3. Joe Edwards purchased 150 shares of XYZ at $100 per share. Currently the stock is selling at $120. If he wants to be assured of a profit of at least $4050, what type of order should he place and at what price per share?

Solution: Profit per share = $4050/150 shares = $27

He should place a limit order to sell the shares at a price of $127 (original price of $100 + $27)

Difficulty: Moderate

4. An investor who short sold 120 shares of stock at $150 per share wishes to realize a gross profit of $2400. At what price must the investor cover the short sale?

Solution: Sales Proceeds from short sale = $150 x 120 = $18,000

Gross Profit desired = - 2,400

Purchase Price of 120 shares must be $15,600

He must cover the short sale at a price of $130 ($15,600/120 shares) to have a $2,500 profit

Difficulty: Difficult