1

INTI INTERNATIONAL COLLEGE, SUBANG JAYA

BRITISH BUSINESS STUDIES DEGREE PROGRAMME
FIN 409 / FIN 415: FINANCIAL ENGINEERING AND MODELS
TEST 1: AUGUST 2013 SESSION
This paper consists of TWO (2) sections. Answer ALL questions in SECTION A and any ONE
(1) question in SECTION B in the answer booklet provided. All questions carry equal marks.
Section A: Answer ALL questions
Question 1
(a)

(b)

You bought 3,000 shares of a listed company for $3.12 per share with an initial
investment of 60% and the balance using a margin facility from your broker. The
maintenance margin is set at 35%.
(i)

At what price will you receive a margin call? (5 marks)

(ii)

If the stock price drops to $2.78 per share, calculate how much cash per share will
be required from you by your broker to deliver. (4 marks)

(iii)

If the stock suddenly drops to $1.80 per share, calculate how much cash per share
will be required from you by your broker to deliver. (5 marks)

You sold short 4,000 shares of BNN Corporation at $2.60 per share. The initial margin
requirement is 55% and the maintenance margin is set at 35%.
(i)

At what price will you receive a margin call?

(4 marks)

(iii)

Now assume that you have simultaneously bought 2,000 shares of e-Audio
Corporation for $3.12 on margin, and the same initial margin requirement and
maintenance margin requirement apply. If the stock of e-Audio Corporation is
selling $3.45 and the stock of BNN Corporation is selling at $3.20, calculate the
weighted average rate of return in these two investments. (7 marks)

Question 2
(a) IOI Corporation (IOI) and PG Corporation (PG) are public listed companies on the Bursa
Malaysia. By using their daily stock return which is in percentage form and the estimation
window as from 2 January 2010 to 31 December 2010, we get the following information:

Des criptive Statis tics

N
KIOI
KPG
V alid N (lis tw ise)

239
239
239

Minimum
-9.09
-14.22

Max imum
5.50
11.24

Mean
.0205
.0303

Std. Deviation
1.83795
3.52680

Note: KIOI and KPG are daily stock returns for IOI Corporation and PG Corporation, respectively.

FBMKLCI is treated as the market portfolio in Malaysia. A simple linear regression

k i k m is run over the same estimation window, for both the daily stock return of IOI
and PG. The Alphas () and Betas () of the linear regression for both stocks are shown in the
following two tables:
Coe fficientsa

Model
1

(Cons tant)
KM

Unstandardiz ed
Coef f icients
B
Std. Error
.011
.104
1.175
.134

Standardized
Coef f icients
Beta
.495

t
.104
8.776

Sig.
.918
.000

a. Dependent Variable: KIOI

Coe fficientsa

Model
1

(Cons tant)
KM

Unstandardiz ed
Coef f icients
B
Std. Error
.021
.222
1.104
.287

Standardized
Coef f icients
Beta
.243

t
.095
3.849

Sig.
.924
.000

a. Dependent Variable: KPG

On 25 January 2010 and 5 September 2010, which are treated as day 0 in the following table, IOI
and PG announced acquisition activities, respectively. The daily prices of FBMKLCI, IOI
Corporation, and PG around the announcement day are as follows:
day
-1
0
1
2
3
day
-1
0
1
2
3

KLCI
808.61
804.89
807.56
818.53
821.49

Daily Stock Price

IOI Corporation
11.50
11.70
11.80
11.80
11.90

KLCI
824.37
820.10
816.81
820.78
821.45

Daily Stock Price

PG Corporation
2.17
2.19
2.16
2.18
2.20

(i)

Calculate the stock returns of each company from day 0 to day 3. (4 marks)

(ii)

By applying the Market Model method, calculate the average abnormal return
(AAR) and Cumulative average abnormal return (CAAR) of these two stocks from
day 0 to day 3. (8 marks)

(iii)

By applying the Mean Adjusted Return method, calculate the average abnormal
return (AAR) and Cumulative average abnormal return (CAAR) of these two stocks
from day 0 to day 3. (8 marks)

(b) Explain the differences between the market model method and the market adjusted return
method. (5 marks)

Question 3
The price of a call and a put on the same stock is as follows:
Strike price Option Premium
Call $45
$3
Put $40
$4
A trader buys a call option and a put option at the same time.
(a) Draw a diagram showing the variation of the traders profit with the asset price. Your
diagram should also include the graphs of the call option and the put option and the breakeven points of these two graphs. (18 marks)
(b) Under what circumstances will this strategy be appropriate for the investors? Explain your
answer. (7 marks)

SECTION B
Answer any of one the following two questions. All questions carry equal mark.
Question 4
(a) Empirical researches, especially those in the US, found evidences of five possible events in
relation to the long-run performance of IPO companies in the securities markets. Explain and
comment on any three of these events as reported in the evidence of the researchers.
(15 marks)

(b)

Empirical evidences show that the initial public offer company performs poorly in the
long run. Explain and comment the three theories that explain long-run underperformance
of the Initial Public Offer companies. (10 marks)

Question 5
(a) Distinguish between covered call strategies and protective put strategies in hedging the
unfavorable movements in stock markets. Under what circumstances would an investor
choose one of the following transactions over another? (15 marks)
(b) Show how the purchase of one type of options and the sale of another type of options can
protect you against the risk of a drop in the value of the underlying share, without costing
you anything if you give up the profit on a possible rise in the value of the underlying asset
over a given threshold. (10 marks)

INTI INTERNATIONAL COLLEGE

SUBANG JAYA
BRITISH BUSINESS STUDIES DEGREE PROGRAMME
FIN 409 / FIN 415: FINANCIAL ENGINEERING AND MODELS
TEST 1: AUGUST 2013 SESSION
Suggested Solution:
Question 1
(a)
(i) [5 marks]
Initial position (Period =0, when the share price is $3.12 per share)
Extracted Balance Sheet
Asset
Liabilities and Equity
Value of stock
$9,360
Loan from broker
$3,744
Equity
$5,616
$9,360
$9,360
Assume that you will receive margin call if the stock price is lower than P
New Position (Period =1, when the share price is P per share)
Extracted Balance Sheet
Asset
Liabilities and Equity
Value of stock
3000P
Loan from broker
$3,744
Equity
3000P - $3,744
3000P
3000P
Margin = Equity / value of stock
[3000P - $3,744] / 3000P = 0.35
P = $1.92
(ii) [4 marks] If the stock drops to $2.78 per share, no cash will be required. The reason is the
margin of your account is still higher than maintenance margin requirement.
(iii). [5 marks] If now the stock drops to $1.80 per share:
While receiving margin call, enough new money must be added to the account balance to bring it
up to the initial margin requirement.
New Position (Period =1, when the share price is $1.80 per share)
Extracted Balance Sheet
Asset
Liabilities and Equity
Value of stock
$5,400
Loan from broker
$3,744
Equity
$1,656

In order to fulfil the maintenance margin requirement, the equity should be at least equal to:
Margin = Equity / value of stock
Equity = (0.60) ($5,400)
Equity = $3,240
Short of $1,584 (i.e. $3,240 - $1,656) and thus you need to add in $0.528 per share (i.e. $1,584/
3000 shares)

(b)
(i)
Initial position (Period =0, when the share price is $2.60 per share)
Extracted Balance Sheet
Asset
Liabilities and Equity
Cash proceed
$10,400
Value of stock owed
$10,400
Initial margin
$5,720
Equity
$5,720
$16,120
$16,120

New position (Stock Price =P)

If the stock price is higher than P, you will receive margin call.

Asset
Cash proceed
Initial margin

Extracted Balance Sheet

Liabilities and Equity
$10,400
Value of stock owed
$5,720
Equity
$16,120

4000P
$16,120 4000P
$16,120

Margin = 0.35
($16,120 4000P) / 4000P = 0.35
P = $2.9852 [3 marks]
You will receive the margin call if the price of the stock is higher than $2.9852. [1 mark]
(ii)
BNN Corporation:
Initial position (Period =0, when the share price is $2.60 per share)
Extracted Balance Sheet
Asset
Liabilities and Equity
Cash proceed
$10,400
Value of stock owed
$10,400
Initial margin
$5,720
Equity
$5,720
$16,120
$16,120

7
New position (Period =1, when the share price is $3.20 per share)
Extracted Balance Sheet
Asset
Liabilities and Equity
Cash proceed
$10,400
Value of stock owed
$12,800
Initial margin
$ 5,720
Equity
$ 3,320
$16,120
$16,120

Return = ($3,320 - $5,720) / $5,720 = - 41.96% [2 marks]

e-Audio Corporation:
Initial position (Period =0, when the share price is $3.12 per share)
Extracted Balance Sheet
Asset
Liabilities and Equity
Value of stock
$6,240
Loan from broker
$2,808
Equity
$3,432
$6,240
$6,240
Assume that you will receive margin call if the stock price is lower than P
New Position (Period =1, when the share price is $3.45 per share)
Extracted Balance Sheet
Asset
Liabilities and Equity
Value of stock
$6,900
Loan from broker
$2,808
Equity
$4,092
$6,900
$6,900

Return = ($4,092 - $3,432) / $3,432 = 19.23% [2 marks]

Weighted average rate of return

= ($5,720 / $9,152) (-41.96%) + ($3,432 / $9,152) (19.23%)
= -19.01% [3 marks]

Suggested solution for Question 2:

(a)
(i) 0.25 marks for each point * 16 points = 4 marks
(ii) marks for each AR * 8 = 4 marks
marks for each AAR * 4 = 2 marks
marks for each CAAR * 4 = 2 marks
(iii) marks for each AR * 8 = 4 marks

8
marks for each AAR * 4 = 2 marks
marks for each CAAR * 4 = 2 marks
(c) [5 marks]
Explain the differences between the market model method and the market adjusted return
method.

Question 3:

Q3 (a)
Correct indication of each turning and break-even points i.e. 40, 45, 36, 48 (4 x 1 marks) and the
put and call option lines (2 x 2 marks).
Correct indication of overall results: break-even and turning points i.e. 7, 33, 40, 45, 52 (5 x 1
marks) and overall result line (1 x 5 marks)
Overall marks = 18 marks
15
10
5

45

-5
-10

30

40

50

60

Q3 (b)
The trader will make profit when the stock price is below $37 and above $52. He/she will incur
losses when the price of the stock is between $37 and $52. Therefore this strategy is appropriate
when the investor is certain of there will be a large movement of the stock prices but is uncertain
of the direction of movement of stock price i.e. either moving up or moving down. One of the
examples of such stock will be the stock of the company which is under litigation. The stock may
move up drastically if the decision of the litigation is favouring the company and will downward
if the decision of the litigation is otherwise.
(5 marks)

Question 4
(a) Students are expected to explain any three of the following evidences of the long-run
performance of the IPO companies. (3 X 5 marks = 15 marks)

9
Evidence I:
Measured from the market price at the end of the 1st day of trading, the stock prices of
IPO in the long run perform poorly.
US: 1970 1993 average return of 7.7% /year for the first 5 years after the offering
A control group of non-issuing firms, matched by market capitalization produced average
annual returns of 13.1%
Evidence II
Most firms going public have relatively high market-to-book ratios, and mostly are
small-cap stock.
Small growth stocks have very low returns
If IPO are compared with non-issuers that are chosen on the basis of market-to-book
ratios and size, the under-performance is less than when the non-issuers are chosen on the
basis of size alone.
Evidence III
Low returns in the aftermarket for IPO partly reflect the pattern that IPO volume is high
near market peaks when market-to-book ratios are high.
The under-performance is concentrated among firms that went public in the heavyvolume years and for younger firms.
For more established firms going public, and for those that went public in the light
volume years, there is no long-run underperformance
Evidence IV
IPO that are not associated with venture capital financing, and those not associated with
high-quality investment bankers, also tend to do especially poorly.
Older firms going public including reverse LBO do not seem to be subject to long-run
abnormal performance.
Reverse LBO are companies going public that previously had been involved in leveraged
buyout.
Evidence V
EPS of companies going public typically grows rapidly in the years prior to going public,
but then actually declines in the first few years after the IPO.
During the first two quarters after going public firms rarely have negative earnings
surprise.

(b) The students are expected to explain any two of the following three hypotheses and discuss
how it explains the long-run under-performance of the IPO companies.
(2 X 5 marks = 10 marks)
(I)

Opinion Hypothesis
Investors who are most optimistic about an IPO will be the buyers.
If there is high uncertainty about the value of an IPO, the valuations of optimistic
investors will be much higher than those of pessimistic investors

10

When more information available, the divergence of opinion between optimistic and
pessimistic investors will narrow and consequently the market price will drop.

(II)

The Impresario Hypothesis

The market for IPO is subject to fads and that IPO are under-priced by investment
bankers (impresarios) to create the appearance of excess demand.
This hypothesis predicts that companies with highest initial lreturns should have the
lowest subsequent returns.

(III)

The Windows of Opportunity Hypothesis

When there are periods when investors are especially optimistic about the growth
potential of companies going public, the large cycles in volume may represent a response
byu firms attempting to time their IPO to take advantage of these swings in investor
sentiment.
Due to normal business cycle activity, one would expect to see some variation through
time in the volume of IPO.
This hypothesis predicts that firms going public in high volume periods are more likely to
be overvalued than other IPO.

Question 5
Q5 (a) [15 marks]
A coved call is a position in which you own the underlying and sell a call. One should also view
selling a covered call as a strategy that reduces not only the risk but also the expected return
compared with simply holding the underlying. Hence, one should not expect to make a lot of
money writing calls on the underlying. It should be apparent that in fact the covered call writer
could miss out on significant gains in a strong bull market. The compensation for this willingness
to give up potential upside gains, however, is that in a bear market the losses on the underlying
will be cushioned by the option premium.
Because selling a call provides some protection to the holder of the underlying against a fall in
the price of the underlying, buying a put should also provide protection. A put, after all, is
designed to pay off when the price of the underlying moves down. In some ways, buying a put to
add to a long stock position is much better than selling a call. As we shall see here, it provides
downside protection while retaining the upside potential, but it does so at the expense of
requiring the payment of cash up front. In contrast, a covered call generates cash up front but
removes some of the upside potential.
Holding an asset and a put on the asset is a strategy known as a protective put. The value at
expiration and the profit of this strategy are found by combining the value and profit of the two
strategies of buying the asset and buying the put.
Note how the protective put provides a limit on the upside. Therefore, we can say that the upper
limit is infinite.

11

The protective put is often viewed as a classic example of insurance. The investor holds a risky
asset and wants protection against a loss in value. he then buys insurance in the form of the put,
paying a premium to the seller of the insurance, the put writer. The exercise price of the put is
like the insurance deductible because the magnitude of the exercise price reflects the risk
assumed by the party holding the underlying. The higher the exercise price, the less risk assumed
by the holder of the underlying and the more risk assumed by the put seller. The lower the
exercise price, the more risk assumed by the holders of the underlying and the less risk assumed
by the put seller.
Protective puts provide protection against large price declines, whereas covered calls provide
only limited downside protection. Covered calls bring in the option premium, while the
protective put requires a cash outlay.
Strategy
Covered Call

Under what circumstance?

Covered call strategy is used to generate additional
portfolio income when the investor believes that
the underlying stock price will remain unchanged
over the short-term.

Protective Put

An investor could use a protective put to limit the

downside risk at the cost of the put premium. It is
an ideal strategy for an investor who thinks the
stock may go down in the near future, yet the
investor want to preserve upside potential.

Q5 (b) [10 marks]

One way to get around paying the put premium is to sell another option with a premium equal to
the put premium, which can be done by selling a call with an exercise price above the current
price of the underlying stock. In effect, the holder of the asset gains protection below a certain
level, the exercise price of the put, and pays for it by giving up gains above a certain level, the
exercise price of the call. This strategy is called a collar. When the premiums offset, it is
sometimes called a zero-cost collar. The cost takes the form of forgoing upside gains. The term
zero-cost refers only to the fact that no cash is paid up front. For example, Sale of a call option
with a strike price of $120, and using the price obtained on this option to purchase a put option at
say $100. You will then be protected against a drop below $100, but will not benefit from a rise
above $120.

12

(III) Test I (25%)

INTI IINTERNATIONAL COLLEGE, SUBANG JAYA
BRITISH BUSINESS STUDIES DEGREE PROGRAMME
FIN 415: FINANCIAL ENGINEERING AND MODELS
TEST 1: APRIL 2014 SESSION
This paper consists of TWO (2) sections. Answer ALL questions in SECTION A and any ONE
(1) question in SECTION B in the answer booklet provided. All questions carry equal marks.
Section A: Answer ALL questions
Question 1
On July 3, you ask your broker to buy 2,000 share of Apple at market, using the 60%
allowed initial margin. The broker charges a commission of 2% and the brokerage firm
has a 30% maintenance margin. The broker later calls you and says that the trade was
executed at $70 per share.
(a)

Critically explain why you might use a market order as opposed to limit or stop
order. (5 marks)

(b)

Since the stock was bought on margin, at what price will you receive a margin
call? (7 marks)

(c)

If the stock falls to $30 and you intend to deposit more cash into the account to
bring it back to the initial margin, calculate how much cash you must deposit.
(6 marks)

(d)

If the stock falls to $30 and you intend to sell stock to repay some of the debt to
bring it back to the initial margin, calculate how much shares you must deposit.
(7 marks)

Question 2
Assume that Stock 1 and Stock 2 are the two public listed companies on Bursa Malaysia. On 15th
January 2014 and 1st March 2014 respectively, which are treated as day 0 in the following table,
Stock 1 and Stock 2 announced seasoned offerings. In order to examine the influence of the
announcement on the stock prices of the companies, the daily stock returns of Kuala Lumpur
Composite Index (KLCI), Stock 1, and Stock 2 around the announcement day are provided as
follows:

13

day
-8
-7
-6
-5
-4
-3
-2
-1
0
1
2
3

day
-8
-7
-6
-5
-4
-3
-2
-1
0
1
2
3

Daily Stock Return (%)

KLCI
Stock 1
1.10
2.09
-2.24
-3.08
2.98
-2.12
1.23
0.54
0.17
0.54
-0.09
3.21
-0.80
-2.59
0.93
-2.13
0.51
-13.04
-0.02
3.75
-1.11
-0.60
1.09
-3.03

Daily Stock Return (%)

KLCI
Stock 2
2.78
-1.71
-1.51
0.00
-1.26
-4.35
-1.03
-6.36
1.69
2.91
2.95
0.94
-1.34
0.93
0.38
-2.78
-4.73
-6.67
1.76
-2.04
1.34
2.08
-0.37
-2.04

Assume that the estimation window is [-8, -1] and the event window is [0, 3].
(a)

By applying the Mean Adjusted Return method, calculate the average abnormal return
(AAR) and Cumulative average abnormal return (CAAR) of these two stocks from day 0
to day 3.
(12 marks)

(b)

By applying the Market Adjusted Return method, calculate the average abnormal return
(AAR) and Cumulative average abnormal return (CAAR) of these two stocks from day 0
to day 3.
(8 marks)

(c)

Explain and discuss the one (1) hypothesis justify the underperformance of right issues in
short run.
(5 marks)

14
Question 3
(a) The following are the market price of Group X, a group of companies which have
made initial public offerings (IPOs), and Group Y, a group of matching companies
which have made no IPOs over the same period. Companies in Group Y, the control
group, have a similar market capitalization with those companies in Group X.
Group X: Companies which have made IPOs
Stock

IPO

1
2
3

$1.20
$2.25
$5.15

Market Price
Shortly after trading
commences
$1.22
$2.32
$5.30

Group Y: Companies which have made no IPOs over the same period
Market Price
Stock
At the beginning of the period
4
$2.23
5
$1.94
6
$3.14

(b)

4 years later
$1.36
$2.02
$7.00

4 years later
$2.50
$1.81
$3.40

(I)

Calculate the equally weighted average buy-and-hold return of Group

X on the IPOs from the market price shortly after trading commences
until 3 years later.
(4 marks)

(II)

Similarly to Part (c) (i), calculate the equally weighted average buyand-hold return of Group Y over the same period.
(4 marks)

(III)

Calculate the total abnormal returns and justify whether the

performance of Group X is better than Group Y.
(7 marks)

Describe the book-building method for the Initial Public Offerings (IPOs) of common
stock. Provide any ONE (1) of its advantages and any ONE (1) of its disadvantages.
(10 marks)

15
SECTION B
Answer any one of the following questions.
Question 4
(a) A seasoned new issue of common stock may be made by using a cash offer or a rights
offer. Critically explain any TWO (2) advantages of selling stock in a seasonal equity
offering (SEO) using a cash offer and any TWO (2) advantages using a rights offer.
(16 marks)
(b) Explain how the information asymmetry hypothesis could justify the stock market
announcement effect of rights issues.
(9 marks)
Question 5
(a)

There are a number of hypotheses that could justify why short-term performances of new
issues are underpriced. Explain any Three (3) of these hypotheses in detail.
(15 marks)

(b)

Selling mechanisms of new securities include Fixed Price, Offer for Sale, Book-building
Placing, and Auctions. Compare and contrast between Book-building Placing and
Auctions.
(10 marks)

16
INTI INTERNATIONAL COLLEGE, SUBANG
BRITISH BUSINESS STUDIES DEGREE PROGRAMME
FIN 415: FINANCIAL ENGINEERING AND MODELS
TEST 1: APRIL 2014 SESSION
Suggested Solutions:

Question 1
(a) [5 marks]
A market order assures that a trade takes place at the existing be price. A limit order would be
transacted only if prices are at the limit price or better. The timing of the execution, or even
whether the execution happens at all, is determined by the ebb and flow of the market. A stock
order specified a price at which trade becomes a market order.
(b) [Total: 7 marks]
Initial position (Period =0, when the share price is $70 per share) (3 marks)
Extracted Balance Sheet
Asset
Liabilities and Equity
Value of stock
$140,000
Loan from broker
$56,000
Equity
$84,000
$140,000
$140,000
New position (Period =1, when the share price is P per share) (3 marks)
Extracted Balance Sheet
Asset
Liabilities and Equity
Value of stock
2000P
Loan from broker
$56,000
Equity
2000P - $56,000
2000P
2000P
Margin = 0.3
[2000P - $56,000]/2000P = 0.3
P = $40
If the stock is below $40, you will receive the margin call. [1 mark]
(c) [Total: 6 marks]
New position (Period =1, when the share price is $30 per share) (3 marks)
Extracted Balance Sheet
Asset
Liabilities and Equity
Value of stock
$60,000
Loan from broker
$56,000
Equity
$4,000
$60,000
$60,000

17
Margin = 0.6
[$4,000 + Cash] / [$60,000 + Cash] = 0.6
Cash = $80,000 (3 marks)
(d) [Total: 7marks]
New position (Period =1, when the share price is $30 per share)
You decide to sell N shares to repay part of your debt, and thus we have the following Balance
sheet: (4 marks)
Extracted Balance Sheet
Asset
Liabilities and Equity
Value of stock
$30 (2,000 N)
Loan from broker
$56,000 - $30*N
Equity
[$30 (2,000 N)]
[$56,000 - $30*N]
$30 (2,000 N)
$30 (2,000 N)
Margin = 0.6
[$30 (2,000 N)] [$56,000 - $30*N] / $30 (2,000 N) = 0.6
N = 1,777.78 shares (1,778 actually) (3 marks)

Question 2
(a) By applying the Mean Adjusted Return method
Step 1: calculate the average daily stock returns of Stock 1 and Stock 2 in the estimation
window. [2 marks for each average * 2 averages = 4 marks]
Daily Stock Return (%)
Stock 1
Stock 2
-8
2.09
-1.71
-7
-3.08
0
-6
-2.12
-4.35
-5
0.54
-6.36
-4
0.54
2.91
-3
3.21
0.94
-2
-2.59
0.93
-1
-2.13
-2.78
Average
-0.44%
-1.30%
Step 2: Calculate the abnormal returns of Stock 1 and Stock 2 from day 0 to day 3.
[0.5 mark for each point * 8 points = 4 marks]
day

day
0
1
2

Abnormal Return (%)

Stock 1
Stock 2
-12.6
-5.37
4.19
-0.74
-0.16
3.38

18
3

-2.59

-0.74

Step 3: Calculate the AAR and CAAR of Stock 1 and Stock 2 from day 0 to day 3.
[0.5 mark for each point * 8 points = 4 marks]
day

AAR

CAAR

0
1
2
3

-8.99
1.73
1.61
-1.67

-8.99
-7.26
-5.65
-7.32

(b) By applying the Market Adjusted Return method

Step 1: Calculate the abnormal returns of Stock 1 and Stock 2 from day 0 to day 3.
[0.5 mark for each point * 8 points = 4 marks]

day
0
1
2
3

Abnormal Return (%)

Stock 1
Stock 2
-13.55
-1.94
3.77
-3.8
0.51
0.74
-4.12
-1.67

Step 3: Calculate the AAR and CAAR of Stock 1 and Stock 2 from day 0 to day 3.
[0.5 mark for each point * 8 points = 4 marks]
day

AAR

CAAR

0
1
2
3

-7.75
-0.01
0.63
-2.90

-7.75
-7.76
-7.14
-10.03

(c) [5 marks]
Students are expected to discuss any one of the following hypotheses on short-term stock
underperformance of right issues.
1. The information asymmetry hypothesis: Managers with superior private information have
incentives to issue equity when the prevailing market price of shares is larger than their
intrinsic value. Knowing that managers will avoid issuing undervalued shares, investors
interpret an equity issue as a signal of overvaluation

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2. The overinvestment of free cash flows hypothesis: Corporate managers prefer to increase
the amount of assets under their control even if doing so causes reduction in firm value.
Equity offerings thus convey higher probability of overinvestment of free cash flows on
the part of managers. Share price would decline because stockholders are faced with
higher agency costs.
3. The window of opportunity hypothesis: Managers decide on equity issues based on
favourable economic conditions like business cycle expansions and hot issue periods.
Stock price reaction is, therefore, expected to be less negative for equity issues
announced during good time periods

Question 3
(a)
(I) [4 marks]
Stock

Buy-and-hold return on the IPOs from the

market price shortly after trading commences
until 4 years after IPOs
($1.36 - $1.22) / $1.22
=11.48%

($2.02 - $2.32) / $2.32

= - 12.93%

($7.00 - $5.30) / $5.30

= 32.08%

Equally weighted
average buy-andhold return (Ra)

10.21%

(II) [4 marks]
Stock

Buy-and-hold return over the same period

($2.50 - $2.23) / $2.23

= 12.11%

($1.50 - $1.94) / $1.94

= -22.68%

($3.40 - $3.14) / $3.14

= 8.28%

Equally weighted
average buy-andhold return (Rm)

-0.76%

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(III) [7 marks]
Total abnormal return
= [100 * (1+Ra)/(1+Rm)] -100
= [100 * (1+10.21%) / (1-0.76%)] -100
= 11.05% (4 marks)
The result shows that the group of companies which have made IPOs performed better than the
group of companies which have made no IPOs over the same time period. This results is not
consistent with the empirical findings done in this area. (3 marks)
(b)
Describe the book-building method for the Initial Public Offerings (IPOs) of common stock. [4
marks]
Provide any ONE (1) of its advantages [3 marks] and any ONE (1) of its disadvantages [3
marks].

Question 4
(a) [4 marks for each point * 4 points = 16 marks]
Cash offers are sold to all interested investors, and rights offers are sold to existing shareholders.
Equity is sold by both the cash offer and rights offers, though almost all debt is sold by cash
offer.
Advantages of cash offer:
1. Underwriters increase the stock price because of increased public confidence or by the
selling effort of the underwriting group (i.e. Credit enhancement).
2. The underwriter buys the shares at the agreed-upon price. This provides insurance to the
firm.
3. Other arguments include:
(a) the proceeds of underwritten issues are available sooner than are the proceeds from a
rights offer.
(b) underwrites provide a wider distribution of ownership than would be true with a rights
offering.
(c) consulting advice from investment bankers may be beneficial.
(d) stockholders find exercising rights a nuisance
Advantages of rights offer:
1. Reduce issuance costs.
2. Do not dilute the ownership of existing shareholders (pre-emptive right).
3. Provide shareholders with more flexibility: they could either exercise or sell their rights.

21
(b) [9 marks]
Information asymmetry hypothesis
Managers (the insider) with superior private information have incentives to issue equity when the
prevailing market price of shares is larger than their intrinsic value. They are the insider.
Insiders: Who know more about the operation of a particular firm have incentives to raise
funds by using equity financing. They will sell shares when they are overvalued.

Investors (the outsider) knowing that managers will avoid issuing undervalued shares, they
interpret an equity issue as a signal of overvaluation
Outsiders: Who know less about the operation of a particular firm will avoid to buy new
shares and thus the stock price drops on announcement day.

Question 5
(a) [5 marks for each point * 3 points = 15 marks]
Answer any four of the following hypotheses in detail.
The winner's curse hypothesis
The market feedback hypothesis
The bandwagon hypothesis
The investment banker's monopsony power hypothesis
The lawsuit avoidance hypothesis
The signaling hypothesis
The ownership dispersion hypothesis

(b) [5 marks for each selling mechanisms * 2 = 10 marks]

Book-building Pricing

During and after the road show period, the investment banker studies potential buyers
and records who is interested in buying how much at what price.

This method provides an opportunity to the market to discover price for securities.

The determination of the offer price is after information acquisition.

Auctions

The clearing price is determined by investor demand, as revealed through the bidding
process, rather than set in advance by the underwriters.

Once the bids are collected, they are aggregated to create a demand curve for the
shares. The clearing price is determined at the price which the firm can sell the
prespecified number of shares.

Investors bidding a price above this clearing price will be allocated shares at the
clearing price not at the price of their bid. Those who bid below the strike price will
not receive any shares.

This clearing price is then paid by all who submitted bids at or above the clearing price.

22

If there is excess demand at the clearing price, the shares are sold pro rata (in equal
proportion to the bidding) to all investors who bid at or above the clearing price.
This method is useful where it is very difficult to value a company, where there is no
comparable company already listed.