Deck 5: Equity: Markets and Instruments  

Question 1

Paf is an emerging country with severe foreign investment restrictions but with an active stock market open mostly to local investors. The exchange rate of the pif, the local currency, with the U.S. dollar remains fixed at 1 pif/$. A closed-end country fund, called Pafy Country Fund, has been approved
by Paf. Its net asset value per share is $100. It trades in New York with a premium of 20% at $120. Pafy Country Fund holds a well-diversified portfolio of Paf stocks and you expect the value of the portfolio of Paf stocks held by the closed-end fund to closely track the local stock market index. A few weeks later the Paf stock market has gone up by 10%. Media coverage has attracted attention to the potential of the Paf economy, and the demand of Pafy Country Fund by U.S. investors, especially pension funds, has been increasing; the premium has risen to 30%.
a. What is the new price of the fund listed in New York and the rate of return for an American investor?
b. A few weeks later, Paf suffers from bad press coverage because of poor labor practices, such as employing children. Several pension funds decide to sell their holdings in Pafy Country Fund for ethical considerations. The premium drops to 10%.
c. Should those sales have an influence on the Paf stock market?

Answer 1

a. The net asset value (NAV) has gone up from $100 to $110 (with a fixed exchange rate). The new fund price in New York should be equal to:
NAV *(1 + Premium) = $110 * (1.30) =$143.
The dollar rate of return on Pafy Country Fund is equal to: $$\frac { 143 - 120 } { 120 } = 19.17 \%$$ which is much higher than the 10% appreciation of Paf stocks.
b. Pafy Country Fund is a closed-end fund. So the selling pressure on Pafy Country Fund cannot lead to sales by the fund of Paf stocks. The drop of the premium should not have a direct influence on the local stock market. It could be, however, that this negative media coverage could hurt the Paf economy by affecting Paf exports and other forms of foreign investments into Paf.

Question 2

Grupo Televisa S.A. is a Mexican firm listed in Mexico, with an American Depository Receipt (ADR) traded on the NYSE. The stock prices are 300 pesos in Mexico, and 30 dollars in New York; the exchange rate is 10 pesos per dollar. Suddenly, a political problem in Mexico leads to a depreciation of the peso and a drop of the Mexican stock market. The new exchange rate is 11 pesos per dollar, and the new stock price of Grupo Televisa is 275 pesos.
a. What should the price quoted in New York be?
b. Actually the stock price in New York is 20 dollars. Should you buy or sell the stock, and why?

Answer 2

a. The price quoted in New York should be:
275/11 = $25.
b. You should buy the stock in New York and sell it in Mexico. The price dropped too much in New York.

Question 3

Orders for Vivendi Universal have been entered on a crossing network for European shares. There is one order from Participant A to buy 100,000 shares, one order from Participant B to buy 200,000 shares, and one order from Participant C to sell 80,000 shares. Assume that the orders were entered in that chronological order and that the network gives priority to the oldest orders. At the time specified for the crossing session, Vivendi Universal is transacted at 17.40 euros on Euronext in Paris, its primary market.
a. What trades would take place on the crossing network?
b. Assume now that all the orders are AON (all or nothing), meaning that the whole block has to be traded at the same price. What trades would take place?

Answer 3

a. 80,000 shares would be exchanged at 17.40 euros. Participant A would buy 80,000 and Participant C would sell 80,000. Participant A's order has priority over Participant B, so Participant B would not transact. Participant A's order would not be filled entirely (20,000 shares remain unbought).
b. There is no way that the AON condition could be achieved for the three orders; so no trade would take place.

Question 4

You are a French institutional investor and wish to buy 1,000 shares of General Motors. Your U.S. broker quotes 45-45 ¼, with a commission of 0.20% of the transaction value. Your bank quotes the $/€ rate at 1.1000-1.1100 net. What would be your total cost in euros?

Question 5

Which of the following statements best characterizes the taxation of returns on international investments in an investor's country and/or the country where the investment is made?
a. Capital gains normally are taxed only by the country where the investment is made.
b. Tax-exempt investors normally must pay taxes to the country where the investment is made.
c. Investors in non-U.S. common stock normally avoid double taxation on dividend income by receiving a tax credit for taxes withheld by the country where the investment is made.
d. The investor's country normally withholds taxes on dividend payments.

Question 6

Vivendi Universal is a French firm listed on Euronext, the Paris Bourse. You can access the central limit order book directly on the Internet and find the following information:
You wish to buy 2,000 shares and enter a market order to buy those shares. A market order has no limit, so, it will be executed against the best matching order. At what price will you buy the shares?

Question 7

UBS AG is listed as an ADR on the New York Stock Exchange (NYSE) in dollars (USD). It is also listed in Zurich in Swiss francs (CHF). Here are some quotes:
NYSE (in $) $107 \quad1/ 2 - 108\quad3 / 8$
Zurich (in CHF) 187-188
CHF/$ (Swiss francs per dollar) 1.7360-1.7380
In addition, you have to pay a commission of 0.3% in New York or 0.5% in Zurich.
a. Where should you buy UBS shares if you are an American investor?
b. Where should you sell UBS shares if you are an American investor?
c. If all commissions were waived for a large transaction, would your answer be the same?
d. Answer the same questions for a Swiss investor.

Question 8

A Swedish investor bought 100 shares of IBM on January 1 on the New York Stock Exchange at $120. The exchange rate was SEK/USD = 7.00. Over the year, the investor has received a gross dividend of $4 per share; the net dividend received is $3.4 because of a 15% withholding tax levied by the United States. The exchange rate at the time of dividend payment was SEK/USD = 7.1.
By December 31, the investor resells the IBM shares at $140, but the exchange rate has dropped suddenly to SEK/USD = 6.8. Ignoring commissions, what is the rate of return on the investment, in dollars and kronas, gross and net of taxes? The Swedish investor is taxed at 50% on income and 15% on capital gains; the U.S. withholding tax can be used as a tax credit in Sweden.

Question 9

You hold some shares of BMW listed in Frankfurt. The share price is €750, and a gross dividend
of €30 is paid. The current exchange rate is 1.15 $/€. The German government imposes a 15% withholding tax on dividends paid to U.S. investors. Your marginal tax rate is 30%.
a. What dividend per share will you receive in U.S. dollars?
b. What tax will you have to pay to the U.S. government on the dividend received?

Question 10

Four companies belong to a group and are listed on a stock exchange. The cross-holdings of these companies are as follows.
$\bullet$ Company A owns 30% of Company B and 10% of Company C.
$\bullet$ Company B owns 10% of Company C.
$\bullet$ Company C owns 10% of Company A, 10% of Company B, and 25% of Company D.
$\bullet$ Company D owns 10% of company B.
Each company has a market capitalization of $50 billion. You wish to adjust for cross-holding to reflect the weights of these companies in a market-capitalization weighted index.
a. What adjustments would you make in the market capitalization of each company to reflect the free float?
b. What would be the total adjusted market capitalization of the four companies?

Question 11

An asset manager follows an active international asset allocation strategy. The average execution cost for a buy or a sell order is forecasted at 0.6%. On average, the manager turns over the portfolio once a year. Various administrative costs include a custodial cost amount of 0.5% per year of assets under management. The annual management fee is 1% of assets under management. The annual expected return before costs is 14% compared to an expected return of 10% on a passive global benchmark (some global index).
a. What is the annual expected return net of execution costs?
b. What is the net annual expected return for the client?
c. Should the client expect the portfolio to outperform the global index used as a benchmark?

Question 12

Which of the following characteristics of financial markets are good for investors?
I. Availability of timely and accurate information.
II. Liquidity.
III. Large bid-ask spreads.
IV. Rapid price adjustment to new information.
a. I and IV only.
b. II and III only.
c. I, II, and IV only.
d. I, II, III, and IV.

Question 13

You are a U.S. investor and wish to buy 10,000 shares of Club Méditerranée ("Club Med"). You can buy them on the Paris Bourse or on SEAQ International in London. You ask the brokers to quote you net prices (no commissions paid). There are no taxes on foreign shares listed in London. Here are the quotes:
London (in £) $56\quad3 / 4 - 57\quad1 / 4$
Paris (in €) $78\quad1 / 2 - 78\quad3 / 4$
$/£ (dollars per pound) 1.5000-1.5040
€/$ (euros per dollar) 0.91100-0.91200
a. What is your total dollar cost if you buy the Club Med shares at the cheaper place?
b. Are there arbitrage opportunities between London and Paris?

Question 14

Your pension fund decides to invest in many national stock markets in a passive way. The objective is to try to match the performance of the local market capitalization-weighted index in each country. You do not buy national index funds but invest directly in companies listed on each market. Because of the limited size of your portfolios, you can buy only a few issues in each market. In which national markets are you likely to track the index well or poorly?

Question 15

You are the manager of an American pension fund and decide, on January 5, to buy 10,000 shares
of British Airways (BA) listed in London. You sell them on February 5. Here are the quotes that
you can use:
$$\begin{array} { l c c } & \text { January } 5 & \text { February } 5 \\\hline \text { British Airways (E) } & 3.50 - 3.52 & 3.81 - 3.83 \\\$ / € & 1.5000 - 1.5040 & 1.4500 - 1.4540 \\\hline\end{array}$$
You must pay the U.K. broker a commission of 0.2% of the transaction value (on the purchase and on the sale). There is a 0.5% U.K. securities transaction tax on purchase (but not on the sale); this tax cannot be recovered. Foreign exchange rates are the net of commissions and taxes.
a. What is your dollar rate of return on the operation?
b. Would the rate of return be the same for a British investor using the British pound as a reference currency?