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Department of Business Administration

SOLVED Mid Term Exam NOV 2011 (MBA 1.5)
Course Title: Stock Market Efficiency

Time Allowed: 1 Hour

Maximum Marks: 30

Please attempt all questions.

Question No. 01
Suppose that National Bank of Pakistans (NBP) share is selling at Rs. 45 per share. You buy a lot of 500
shares using Rs 16,000 of your own money and borrowing the remainder of the purchase price from your
broker. The rate on the margin loan is 7%.
a) What is the percentage increase in the net worth of your brokerage account if the price of NBP
immediately changes to: (i) Rs. 51; (ii) Rs. 38? Please prepare Margin Trade Account to
represents changes in your margin.
SOLUTION
Margin Account (At the time of purchase of 500 shares)
Rs.
Rs.
16000
Equity (Initial Margin)
Shares held as Collateral
6500
22500 Loan (Bal. Fig)
500@45=
22500

22500

Margin Account (If price immediately changes to Rs. 51)

Rs.
Rs.
19000
Equity (Bal. Fig)
Shares held as Collateral
6500
25500 Loan (Remain constant
500@51=
as in above case)
25500

25500

a) % change in Margin = (Rs. 19000 Rs. 16000) / Rs. 16000 = 18.75%

Margin Account (If price immediately changes to Rs. 38)

Rs
Rs
12500
Equity (Bal. Fig)
Shares held as Collateral
19000 Loan (Remain constant
6500
500@38=
as in above case)
19000

19000

% change in Margin = (Rs. 12500 Rs. 16000) / Rs. 16000 = -21.8%

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b) If the maintenance margin is 24%, how low can NBPs price fall before you get a margin call
after marking to market?
Let P be the price per share
Maintenance Margin =
(500P-6500) / 500P
0.24
=
(500P-6500) / 500P
120P
=
500P 6500
6500
=
380P
P
=
Rs. 17.10
c) How would your answer to (b) change if you had financed the initial purchase with only Rs.
9,000 of your own money?
Let P be the price per share (If 9000 is initial margin then Rs. 13500 would be the amount of loan
i.e Rs. 22500 Rs. 9000)
Maintenance Margin =
(500P-13500) / 500P
0.24
=
(500P-13500) / 500P
120P
=
500P 13500
13500
=
380P
P
=
Rs. 35.52
d) What is the rate of return on your margined position (assuming again that you invest Rs. 16000 of
your own money) if NBP is selling after one year at: (i) Rs. 51; (ii) Rs. 38? Please prepare Margin
Trade Account to represents changes in your margin.
Margin Account (If price changes to Rs. 51, AFTER ONE YEAR)
Rs
Rs
18545
Equity (Bal. Fig)
Shares held as Collateral
6500
25500 Loan (Remain constant
500@51=
as in initial case)
Interest on Loan @ 7%
p.a

455
25500

25500

% change in Margin = (Rs. 18545 Rs. 16000) / Rs. 16000 = 15.91%

Margin Account (If price changes to Rs. 38, AFTER ONE YEAR)
Rs
Rs
12045
Equity (Bal. Fig)
Shares held as Collateral
19000 Loan (Remain constant
6500
500@38=
as in initial case)
Interest on Loan @ 7%
p.a
19000

455
19000

% change in Margin = (Rs. 12045 Rs. 16000) / Rs. 16000 = -24.72%

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e) Continue to assume that a year has passed. How low can NBPs price fall before you get a margin
call after marking to market?
Let P be the price per share (Amount of loan after one year would be 6500 (1.07) here 1.07
represents, principal + interest @7% p.a.)
Maintenance Margin =
(500P-6955) / 500P
0.24
=
(500P-6955) / 500P
120P
=
500P 6500
6955
=
380P
P
=
Rs. 18.30
Question No. 02
Assume the total market value of an investors portfolio is Rs 300,000. Of that, Rs. 90,000 (i.e. 30% of
Rs. 300,000) is invested in the SBP a risk-free asset. The remaining Rs 210,000 (i.e. 70% of Rs. 300,000)
is in risky securities, say Rs 113,400 in the Fauji Fertilizers (i.e. 54% of Rs. 210,000) and Rs 96,600 (i.e.
46% of 210,000) in Engro. If y is the percentage of investments in risky securities then 1-y should be the
percentage of investment in risk free securities.
Further, assume expected return on risky securities = 15%, with the standard deviation of 22%, and risk
free return= 7%.
a) If you invest all of your funds in the risky asset, that is, if you choose y= 1.0, what will be the
expected return and risk on your complete portfolio?

E(rrp) = 15%
rp = 22%
b) If you invest all of your funds in risk free assets, what will be the expected return and risk of your
portfolio?

E(rf) = 7%
f= 0%

(Because it is risk free)

c) If you make a portfolio of risky and risky portfolio (according to the situation given in paragraph
above) what would be the expected return and risk of the portfolio?
= Risk free return (Weight of Risk free asset) + Risky Return (Weight of Risky assets)
E(rp)
=
7%
(30%)
+
15% (70%)
=
12.6%

rp

22% (70%)
15.4%

CAL

d) Draw capital market line (CAL) for the above situations.

RiskyReturn15%
70/30PortfolioReturn=12.6%

RiskFree7%

Portfolio
Risk=15.4%

RiskofRisky
Portfolio

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Question No. 03
a) Define different forms of stock market efficiency
Weak Form Efficiency: Prices of the securities instantly and fully reflect all information of the past prices.
This means future price movements cannot be predicted by using past prices.

Semistrong Form Efficiency: Asset prices fully reflect all of the publicly available information.
Therefore, only investors with additional inside information could have advantage on the market.
Strong Form Efficiency: Asset prices fully reflect all of the public and inside information available.
Therefore, no one can have advantage on the market in predicting prices since there is no data that
would provide any additional value to the investors.

b) Read the following paragraph (taken from an empirical study on KSE Pakistan) and explain, what
type of market efficiency has been tested in this study and what is authors conclusion regarding
form market efficiency persists in KSE, Pakistan?

Read the highlighted Paragraphs carefully: The author has emphasized KSE as
WEAK FORM EFFICIENT MARKET
Empirical Analysis on Stock Market Efficiency in Pakistan
In order for the capital to be allocated to where it makes most use from a public economy point of view, it
is important that prices give the right signals, i.e. contain all the important information. Thus, the society
needs the market to be efficient (Claesson, 1987). Historically, there has been a large body of academic
people, primarily economists and statisticians, who subscribe to the theory of random walks in stockmarket prices. Random-walk theorists usually start from the premise that the major security exchanges are
good examples of efficient markets. In an efficient market, the actions of the many competing
participants, leads to actual prices already reflecting the effects of current information and the actual price
of a security to wander randomly about its intrinsic value. Thus, a market where successive price changes
in individual securities are independent is, by definition, a random-walk market (Fama, 1965).
The empirical studies on Karachi Stock Exchange (KSE), Pakistan lead us to the conclusion that the
Random-walk hypothesis can be accepted for both monthly and daily returns in KSE. There is no day of
the week effect or the month effect. This is compatible with Famas conclusion of existence of random
walk phenomena. This result indicates that daily stock market returns are independent and cannot be used
to make forecasts of next trading session stock returns. So the market prices quoted at KSE at any point in
time, are representing good estimates of intrinsic or fundamental values and are reflecting the judgments
of the market participants on stock potential. Therefore, the stock returns in KSE are independent and
they cannot be used to predict future returns. Since changes in stock prices are random, we can do no
better than to predict that the next periods price will be somewhere around where it was the last time we
knew it. This conclusion is consistent with modern efficient market studies.

The End