MGMT 560 Corporate and International Finance

Sample Midterm

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Cohort (A or B):
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Instructions:

This Exam Question Paper consists of 4 (single-sided) pages including the title page.

The regular time allowance for this exam is 2 hours.

This is a closed book exam.

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

Read carefully all questions. Show all steps in your computations.

Problem Mark Score

1 8
2 6
3 7
4 4
Total 25

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:

(a) [1] Compute the expected rate of return on stock A.

(b) [1] Compute the expected rate of return on stock B.
(c) [1] Compute the risk of sock A.
(d) [1] Compute the risk of stock B
(e) [1] Compute the covariance between stock A’s rate of return on B’s rate of return.
(f) [2] Construct a portfolio p that consists of the two individual stocks A and B such
that the weight of A, wA = 0:4, and the weight of B in the portfolio, wB = 0:6:
Compute the expected rate of return on this portfolio and its measure of risk.
Explain the meaning of this risk measure.Meaning: The ‡uctuation above and
below the mean return of 1.6% is +/-0.47%.
(g) [1] Consider portfolio l such that:
Erl = 2% and l = 0:5%:
If you had a choice between portfolio p and l, and you chose portfolio l; what is
your attitude towards risk? Explain by reverting to the de…nition of risk aversion.

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.

(a) [0.5] Political instability in an economy is considered a non-systematic risk that

is re‡ected in the total volatility of …nancial assets.
(b) [0.5] The assumption that borrowing equals to lending in CAPM implies that
…nancial markets are e¢ cient.
(c) [0.5] An annuity due is just an ordinary annuity for n 1 years.
(d) [0.5] If the beta of an asset is zero, then its sigma, as a measure or risk, ought to
be zero since the asset has no risk.
(e) [0.5] If the market interest is expected to increase above the coupon rate, then
the bond is expected to be traded at a premium.

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.