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Sample Midterm PDF
Sample Midterm PDF
Sample Midterm
This Exam Question Paper consists of 4 (single-sided) pages including the title page.
Only …nancial or scienti…c calculators that do not display text are allowed.
Formulas
Erp = wA ErA + wB ErB
2 2 2 2 2
p = wA A + wB B + 2wA wB AB :
1 1
P V (annuity) = CF
r r (1 + r)n
CF
P V (perpetuity) =
r
m
AP R AP R
1 + EAR = 1+ ; where = pp (the per-period rate)
m m
n
or 1 1 1
B0 = P V (bond) = C +F :
r r (1 + r)n 1+r
F B
C=m + number of periods
Y TM F +B
; m is the frequency (m = 1 if annual)
2
1
1. [8] Let today be period 0 and the future (or tomorrow) be period 1: Consider an investor
in period 0, who is contemplating making the decision to invest in a portfolio that
consists of two stocks: A and B. The economic conditions in period 1 are probabilistic
and, thus, uncertain. Suppose the investor is expecting three states of nature: s1 ; s2 ;
and s3 in period 1, with probabilities 12 ; 14 ; and 14 respectively. Let PA0 and PA1 denote
stock A’s price in period 0 and period 1 respectively. Also, since period 1 depends on
the state of nature, let (PA1 )s1 , (PA1 )s2 , and (PA1 )s3 denote stock A’s price in period 1
in states 1,2, and 3 respectively. Similar notation is used to denote period 0 and period
1 prices of stock B. The following data pertain to our two-period-three-states setup:
PA0 = $5;
(PA1 )s1 = $5; (PA1 )s2 = $5:1; and (PA1 )s3 = $5:1;
PB0 = $10;
and
(PB1 )s1 = $10:3; (PB1 )s2 = $10; and (PB1 )s3 = $10:2:
Given the previous data, answer the following questions:
2. [6] Suppose you are the manager of a fund F: Historical data on the annual rate of
return, rF ; of your fund over the last four years are as follows:
Y ear rF (%)
1 14
2 12
3 18
4 16
Your fund consists of two assets 1 and 2, traded in a market M , with weights w1 = 0:5,
w2 = 0:5, and betas 1 = 0:4 and 2 = 0:8 respectively. Historical data suggests that
the risk-free rate of return is 5% and the market risk premium is 6%. Answer the
following questions:
2
(a) [1] De…ne what it means by the E¢ cient Markets Hypothesis.
(b) [2] De…ne what it means by the Security Market Line (SML) and write down its
equation. Explain why assets 1 and 2 must fall on this line?
(c) [1] Find a measure of this fund’s systematic risk and explain its meaning.
(d) [1] What is the expected rate of return on this fund as predicted by CAPM?
(e) [1] What is the alpha of this fund? Explain the meaning of this measure.
3. [7] Consider a four years bond with face value F = 1000 and a coupon rate c = 10%
paid semi-annually. Suppose the bond is traded at a price B0 = 1020: Answer the
following questions:
(a) [0.5] What is the current yield on this bond? Keep your answer to two decimal
places.
(b) [0.5] What is the capital gain on this bond if the investor decided to hold the
bond till maturity? Keep your answer to two decimal places.
(c) [0.5] What is the rate of return on this bond if the investor decided to hold the
bond till maturity? Keep your answer to two decimal places.
(d) [1] De…ne what it means by yield to maturity and explain why it is better than
the conventional rate of return.
(e) [2] Compute the yield to maturity on this bond. Keep your answer to four decimal
places; that is, write 6.789% as 0.0679.
(f) [2] Suppose you bought that bond from this investor at the end of year 2. How
much would you pay for that bond if the market interest rate is 5%? Keep your
answer to four decimal places; that is, write 6.789% as 0.0679.
(g) [0.5] What will happen to the price of the bond if the market interest rate goes
up? Explain by referring to the relation between the market rate and the bond
price. No calculations are needed.
4. [4] In each of the following statements, identify whether or not each statement is true
or false and write a brief explanation (one-two line at most) to support your argument.
All credits will be given to the explanations.
3
(f) [0.5] Bond holders are considered residual claimants since shareholders, being the
true owners, are the …rst claimants.
(g) [0.5] The yield to maturity is the discount rate that is used to compute the fun-
damental price of any corporate bond.
(h) [0.5] Money market instruments are long term instruments that are more liquid
than capital market instruments.