The price-earnings (P/E) ratio

• Identify two reasons for the existence of different valuations produced by the Price-Earnings Method. Which would you use and why?

The price-earnings (P/E) ratio shows the relationship between the company share price and the earnings accruing to the shares. The reasons there exist different valuations methods produced by the price-earning method is to give the investor an accurate sense of the company value (Shah, et al, 2019). Also shows the expectations of the market and the price one has to pay per unit of stock using the current earnings. As an investor, I would use that indicating the market expectations since it will help me in gauging my investment or Forward P/E Ratio

• Briefly distinguish each of the three forms of market efficiency from each other. Which do you think best represents US markets?

The weak form market inefficiency holds that today’s stock prices represent the past prices data and technical analysis has little help to give to investors while the semi-strong form of market inefficiency holds that the information available to the public forms part of stock prices and an investor cannot benefit from use of technical or fundamental analysis (Ali, et al,2018). However, the information not in the public domain may prove instrumental to investors. On the contrary, the strong form of market inefficiency holds that both public and non-public information is accounted for in stock prices. Thus no information gives an investor advantage over the market. The strong form better represents the US market since the passing on of the Sarbanes-Oxley Act of 2002.

• Stock ABC has a beta of 1.5, a risk-free rate of 2.5 percent, and a market return of 7.5 percent. What is the expected return for this stock?

Expected Return = Risk- free rate + Beta (market return – risk- free rate)

Expected Return = 2.5% + 1.5 (7.5 % -2.5%)

Expected Return = 10%.

• Company QRS just paid a dividend of $0.75. It is expected this dividend will grow at a constant rate of 4 percent indefinitely. What is the price of this stock if the required return is 10 percent?

Constant Growth Model = 0.75 (1+0.04) / (0.1 -0.04) = 13

• You make the following investments in stocks: $5,000 in GE, $7,000 in BA, and $8,000 in XON. The betas for the stocks are GE: 1.05; BA: 0.97, and XON: 1.24. What is the portfolio beta?

Total Value = $ (5,000 + 7,000 + 8,000) = $ 20,000.

GE Weight = 5000/20,000 = 25%

BA Weight = 7000/20,000 = 35 %

XON Weight = 8000/20,000 = 40%

Portfolio Beta = (0.25 * 1.05) + (0.35 * 0.97) + (0.40 * 1.24) = 1.098

• Why would a bank be interested in a long hedge?

Commercial banks will be interested in long hedges since they are used as a strategy to control prices. Thus the hedges help the bank to stabilize the prices of the money it pays for loans or other financial assets it acquires due to higher interest rates in the future (Shah, et al, 2019).

• Briefly describe the characteristics of a single stock future. What type of investor might be interested in this?

The contract exists between two investors in which the buyer agrees to purchase a stock at a given price in the future upon which the stock is delivered by the seller. The contract is standardized and controls 100 shares of stock (Ali, et al, 2018). These stocks are not traded in over the counter market rather in an organized market with designated physical locations. The investor suited for a single stock future is those willing to hedge and manage the risks.

• You decided to buy Treasury bill futures contracts with a quoted price was 96-50. When you close this position, the quoted price was 95-25. Determine the profit or loss per contract, ignoring transaction costs.

Purchase Price = $ 965,000

Selling Price = $ 952,500

Profit = Selling price – Purchase Price = $ 952,500 – $ 965,000 = -$ 12,500

• You decided to sell Treasury bill futures contracts with a quoted price was 92-50. When you close this position, the quoted price was 91-75. Determine the profit or loss per contract, ignoring transaction costs.

Selling Price = $ 925,000

Purchase Price = $ 917,500

Profit = $ 925,000 – $ 917,000 = -$ 8,000

• You sell S&P 500 stock index futures that specified an index of 1,725. When you close this position, the index specified by the futures contract was 1,815. Determine the profit or loss, ignoring transaction costs.

Selling Price = $ 250 * 1,725 = $ 431,250

Purchase Price = $ 250 * 1,815 = $ 453,750

Profit = $ 431,250 – $ 453,750 = -$ 22,500

References

Ali, S., Shahzad, S. J. H., Raza, N., & Al-Yahyaee, K. H. (2018). Stock market efficiency: A comparative analysis of Islamic and conventional stock markets. Physica A: Statistical Mechanics and Its Applications, 503, 139-153.

Shah, D., Isah, H., & Zulkernine, F. (2019). Stock market analysis: A review and taxonomy of prediction techniques. International Journal of Financial Studies, 7(2), 26.