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1Spring, 2019 ECON 445Quiz #1

Fill the blanks or choose the correct word. Each blank is worth 2 points unless specified otherwise.

[1] Financial assets are often classified into three major classes which are the fixed income securities, equities and

derivatives. An example of derivatives is the stock option which is a contract whose value is derived from the

price of underlying stock. Options are traded in the market and the Options Clearing Corporation (OCC) serves as

an intermediary in the transaction. That is, buyers and sellers of options buy from and sell to the OCC. The buyer

of call option has the (i), but no (ii), to (iii) specified number of shares of the underlying stock at a (iv) price by

the (v) date. The seller of call option has the (vi) to (vii) the share if the holder (viii) the option.

(i) (right, obligation) (ii) (right, obligation) (iii) (sell, buy) (iv)

(v) expiration (vi) (right, obligation) (vii) (sell, buy) (viii)

[2] 1The price of XYZ stock is $201.09, and the bid/ask prices of call and put options on this stock which expire

in two months are shown below (all in dollars).

Call option Put option

Strike Bid Ask Strike Bid Ask

180 20.90 21.30 180 0.17 0.22

If you buy an option, the price you pay is the (i) price and if you sell an option, the price you receive is the (ii)

price. Suppose you expect that the price of XYZ stock will be $195 by the expiration date. Will you buy a call

option? The short answer is (iii). This can be explained as follows: If you buy a call option, you pay (iv) for the

option. If price reaches your expected price of $195, the option is (v) money. So, you (vi) the option. If you

exercise the option, you pay the strike price $180 and receive a share of stock. Then you sell it in the market at

price $195, making a profit of $15 from this transaction. Your net profit is (vii). Therefore, you will (viii) the call

option if you expect the stock price will be $195. If you do not exercise option, your net profit is (ix).

(i) (bid, ask) (ii) (bid, ask) (iii) (yes, no) (iv) (v) (in the, out of)

(vi) (exercise, don’t exercise) (vii) (viii) (buy, not buy) (ix)

[3] If you sell a call option at (i) price, you face two cases by the expiration date: the buyer of your option either

exercises the option or lets it expire. The buyer will exercise the call option only if the call option is (ii) the

money, that is, only if the market price is (iii) than the strike price. If the buyer lets the option expire, your

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profit/loss is the price of the option you sold at. If the buyer exercises the call option, you buy shares of stock in

the market at the market price, deliver it to the buyer, and receive the (iv) price. Your net profit/loss is equal to (v)

price + (vi) price - (vii) price.

(i) (bid, ask) (ii) (in, out of) (iii) (lower, higher) (iv) strike or exercise (v) (bid, ask)

(vi) (vii)

[4] John sells shares of XYZ stock short at the current market price $69.

(a) Short sale means that you borrow shares of stock from a broker and sell them. The proceeds are kept in your

account. You also have to put up (i)% additional fund in the account, which is called the (ii) requirement.

(i) (iii)

(b) John plans to close his short sale account on February 13. He wants to protect his investment using a call

option. The call option of strike price $70 that expires on February 13 is traded at price $0.5 per share. Will he

buy this call option to protect from a higher price of $71? That is, will he buy the call option if he thinks the price

can rise to $71?

If he does not buy the call option and price rises to $71, his loss is $(i)-$(ii)=$(iii) per share. If he buys the call

option and exercises the option, he buys shares at $(iv) and return them to the broker, incurring $(v) loss per share

from the transaction of shares. Since he paid $(vi) per share for the option, his total loss will be $(vii) per share.

Therefore, his loss is (viii) when he buys and exercises the call option.

(i) (ii) (iii) (iv) (v) (vi) (vii) (vii) (smaller, larger)

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[1] 1(a) The federal government issues Treasury (i), (ii) and bonds. Companies which pool the fund from many

investors and manage the funds for investors are called (iii) companies. Institutes which specialize in the IPO,

which stands for the (iv), are called (v).

(i) (ii) (iii) (iv) (v)

1(b) Eurodollar is the (ii) denominated deposits held (iii) the U.S. Federal fund is the fund in the account of

depository institutions such as commercial banks at the Federal Reserve Bank to meet the (iv) reserve. When a

bank does not have a sufficient reserve, it borrows from another bank overnight. The interest rate on such a loan is

called the (v) rate.

(i) (Dollar, Euro) (ii) (outside, inside) (iii) (iv)

(c) The LIBOR stands for (i) and it has served as a benchmark rate that some of the world’s leading banks charge

each other for unsecured short-term loans. It used be administered by the British Bankers’ Association (BBA), but

it was reformed because of the scandal in recent years and became the ICE LIBOR where ICE stands for the (ii).

It now sets the rates for 5 major currencies with 7 maturities for each currency. The currencies included in ICE

LIBOR are US dollars, Pound Sterling, Euro, Japanese Yen and (iii).

(i) (ii) (iii)

[2] (a) The online WSJ reports daily data on the T-Bills as followsTuesday, February 12, 2019

Maturity Bid Asked ChgAskedyield

2/14/2019 2.323 2.313 -0.010 2.345

2/19/2019 2.353 2.343 unch. 2.376

2/21/2019 2.350 2.340 unch. 2.374

The date February 12, 2019 is called the settlement date. The date under Maturity is the date when you receive the

face (par) value if you hold the bill till the maturity date. The numbers under "Bid" and "Asked" represent the

annualized (i) rate based on the bid price and the asked price, respectively. The bid price is the price that an

investor (ii) from brokers when she (iii) the T-bill, and the asked price is price that an investor (iv) when she (v)

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the T-bill. The number under "Asked yield" represents the annualized (vi) yield based on the (vii) price. If you

want to sell a T-bill of face value $100 that matures on 2/21/2019 you receive $(viii).

(ii) (ii) (receives, pays) (iii) (sells, buys) (iv) (receives, pays) (v) (sells, buys)

(vi) (vii) (viii)

(b) Let FV and P denote the face value and the asked price of a Bill, respectively. How do you compute the bank

discount rate r BD and the bond equivalent yield r BE over the holding period from the settlement date to the

maturity date. Write the formulas. (4 point each)

r BD=¿ r BE=¿

1(c) Let DSM be the number of days from the settlement date to maturity. Write the formulas for the annualized

bank discount rate r ABD, the annualized bond equivalent yield r ABE, and the annualized money market yield r AMM .

(4 point each)

r ABD=rBD × r ABE=rBE × r AMM=¿

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1[1] Treasury notes and bonds pay interest every (i) months until they mature. The interest rate on these securities are called the (ii) rate. Maturities of Treasury notes range from (iii) years to (iv) years, and the maturity of a Treasury bond is typically (v) years. To compute the yield to maturity of T-notes or T-bonds, we need to find the interest rate that makes the (vi) value of all coupon and face value be equal to the price of security. TIPS, which stands for Treasury Inflation Protected Securities, are designed to protect investment from the effect of inflation. The coupon rate of TIPS is fixed over time, but the face value is adjusted by the (vii) every (viii) months

(i) (ii) (iii) (iv) (v) (vi) (vii) (viii)

(b) Asset backed securities are created by pooling financial assets that generate cash flows. An example is the

MBS which stands for the (i). Two primary risk of MBS is the (ii) risk and the (iii) risk.

(i) (ii) (iii)

[2] (a) A bond that a US company issues in denomination of US dollars in Australia is called a (i) bond.

A bond that a US company issues in Australia in denomination of Austrian dollars is called a (ii) bond. If a

Canadian company sells a bond in denomination of US dollars in the US, it is called (iii) bond.

(i) (Euro, Kangaroo) (ii) (Euro, Kangaroo) (iii) (Euro, Maple, Yankee)

(b) Municipal governments can issue two types of bonds. The (iv) bonds are backed by the taxing authority of local governments and the (v) bonds are backed by the revenues from the projects the bonds are issued for.

(iv) (v)

[3] Local governments usually issue bonds at a fixed interest rate. But, some local governments issued them at a floating rate and then entered the interest rate swap (IRS) agreement with the banks. To understand how the IRS works, consider two firms, A and B. Firm A wants a floating rate loan because it expects the interest rate will decline while firm B wants a fixed rate loan because it expects a rise in interest rate. The current interest rate they face in the market are as follows.

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firm fixed floating

A 5% LIBOR+0.3%

B 6% LIBOR+0.9%

If they borrow what they want, firm A will pay LIBOR+0.3% floating rate and firm B will pay 6% fixed rate.(a) Firm B has to pay a higher interest rate than firm A in either market. But, firm B has a comparative advantage in the (i) interest rate market. Therefore, they agree on an IRS, in which firm B borrows a (ii) rate loan and firm A borrows a (iii) rate loan. Firm A agrees to pay a floating rate LIBOR+0.2% to firm B and firm B pays a fixed rate x% to firm A. We need to determine x that benefits both firms. To do this, we need to figure out the net interest rate each firm pays when they sign on the IRS. Firm A pays (iv) to the lender and pays (v) to firm B, and receives x% from firm B. Therefore, the net interest rate firm A pays is (vi). Similarly, the net rate that firm B has to pay is (vii).

(i) (floating, fixed) (ii) (floating, fixed) (iii) (floating, fixed) (iv) (v)

(vi) (vii)

(b) Each firm's net interest rate must be lower than what each firm can borrow their preferred loans. This requires that firm A’s net rate must be lower than (i) and firm B's nest rate must be lower than (ii). These two conditions require that x% must be greater than (iii) and less than (iv). If x% is closer to the lower bound, firm B is better off than firm A. Suppose we choose a fair split by taking the average of the two bounds. Then, x=(v), and the net interest rate for firm A is (vi) and the net interest rate for firm B is (vii). These results show that both firms are better off.

(i) (ii) (iii) (iv) (v)

(vi) (vii)

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1Spring, 2019 ECON 445Midterm Exam


[1] Financial assets are often classified into three major classes which are the fixed income securities, (i) and

derivatives. An example of derivatives is the stock option which is a contract whose value is derived from the

price of underlying stock. Buyers and sellers of options buy from and sell to the OCC which stands for the (ii). A

buyer of put option has the (iii), but no (iv), to (v) specified number of shares of the underlying stock at a (vi)

price by the (vii) date. A put option is in the money if the current market price is (viii) than the strike price.

(i) (ii) (iii) (right, obligation) (iv) (right, obligation)

(v) (sell, buy) (vi) (vii) (viii) (higher, lower)

[2] The IBM stock was traded at $139 per share last Friday. There are call and put options on IBM stock with

strike price $138 that expire on April 5. The bid and ask prices of call option are $3.40 and $3.60 and the bid and

ask prices of put option are $1.87 and $2.00. Assume that there are no other transactions cost. If John bought this

call option, he expects the stock price will (i) at least to $(ii) and more. If Alice bought this put option, she expects

the stock price will (iii) at least to $(iv) and more. If Mary sold this call option, she expects either the stock price

will (v) or will not (vi) beyond $(vii) and more.

(i) (rise, fall) (ii) (iii) (rise, fall) (iv) (v) (rise, fall)

(vi) (rise, fall) (vii)

[3] (a) A Canadian firm needs to raise fund by issuing bonds in denomination of US dollars. If the company sells

such bond in the US, it is called (i) bond. If it sells that bond in China, it is called (ii) bond.

(i) (ii)

(b) The LIBOR stands for (i) and it has served as a benchmark rate that some of the world’s leading banks charge

each other for unsecured short-term loans. It used be administered by the British Bankers’ Association (BBA), but

it was reformed because of the scandal in recent years and became the ICE LIBOR where ICE stands for the (ii).

It now sets the rates for 5 major currencies with 7 maturities for each currency. The currencies included in the ICE

LIBOR are US dollars, Pound Sterling, and the other three currencies are (iii).

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(i) (ii)

(iii)

[4] Consider two firms, A and B. Firm A wants a floating rate loan because it expects the interest rate will decline

while firm B wants a fixed rate loan because it expects a rise in interest rate. The current interest rate they face in

the market are as follows: Fixed and floating rates for firm A are 4% and LIBOR+0.2% and for firm B are 5% and

LIBOR+0.8%

(a) Firm A and B enter an IRS contract. Firm A borrows a fixed rate loan and firm B borrows a floating rate loan.

Firm A agrees to pay a floating rate LIBOR+0.4% to firm B and firm B pays a fixed rate x% to firm A. We need

to determine x that benefits both firms. To do this, we need to figure out the net interest rate each firm pays when

they sign on the IRS.

Firm A

pays (i)% to the lender

pays LIBOR+0.4% to firm B

receives x% from firm B

Net rate = (ii)% - x% = (iii)%

Firm B

pays (iv)% to the lender

pays x% to firm A

receives LIBOR+0.4% from firm A

Net rate=(v)%-(vi)%=(vii)%

(i) (ii) (iii) (iv)

(v) (vi) (vii)

(b) Determine the range of x that is profitable for both firms compared to the case in which they borrow their

preferred loans. [10 points all or none]

[5] (a) The online WSJ reports daily data on the T-Bills. The current date is called the settlement date. The date

under "Maturity" is the date when you receive the face value if you hold the bill till the maturity date. The number

under “Bid” and "Asked" represent the annualized (i) rate based on the bid and asked price, respectively, and the

number under “Asked yield” represents the annualized (ii) yield based on the asked price.

(i) (ii)

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(b) Let FV and P denote the face value and the asked price of a Bill, respectively. Let DSM be the number of days

from the settlement date to maturity. The annualized bank discount rate r ABD, the annualized bond equivalent

yield r ABE, and the annualized money market yield r AMM are computed by

(i) r ABD=¿ (ii) r ABE=¿ (iii) r AMM=¿

(c) You paid price P to buy a Treasury Note on the day of coupon payment and you will receive the first coupon

payment C in 6 months. The maturity date of your coupon is two years after the date of your purchase. Let FV

denote the face value (par value) of your Note. Write the equation from which you compute the semiannual Yield

to Maturity (YTM) r. [6 points]

[6] (a) Three major stock market indexes are the Dow Jones Industrial Average (DJIA), the S&P 500 composite

index, and the NASDAQ composite index. The DJIA index is a (i) weighted index of (ii) blue chip companies.

The S&P500 index and the NASDAQ index are the (iii) weighted index of 500 large cap companies and all stocks

registered at the NASDAQ market, respectively. Less known index such as S&P500 EWI allocates equal weight

to each of 500 stocks.

(i) (price, market capitalization, equally) (ii) (30, 100, 500) (iii) (price, market capitalization, equally)

(b) You have $24,000 to invest in two stocks: ABC and XYZ. The share prices of ABC and XYZ are $25 and

$75, respectively, and their outstanding shares are 20 million and 4 million, respectively. If you want to track the

DJIA index, the amount you allocate to ABC is computed by $24000*(i)=$(ii) and allocate the remainder $(iii) to

XYZ. If you want track the S&P500 composite index, the amount you allocate to ABC is computed by

$24000*(iv)=$(v) and allocate the remainder $(vi) to XYZ. If you want to track the equally weighted index, you

allocate $(vii) to each stock.

(i) (ii) (iii) (iv) (v) (vi) (vii)

(c) ABC took a reverse stock split of one for two, i.e., stock holders receive one new stock for two old stocks they

hold. The share price of the new stock is doubled to $50. To track the market indexes, you need to rebalance the

account that tracks the (i) index. The new amount allocated to ABC is computed by 24000*(ii)=(iii).

(i) (DJIA, S&P500) (ii) (iii)

risk

ER

A

CB

D

P1

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[1] You have $24,000 to invest in two stocks: ABC and XYZ. The share prices of ABC and XYZ are $25 and

$75, respectively, and their outstanding shares are 20 million and 4 million, respectively. If you want to track the

DJIA index, the amount you allocate to ABC is computed by $24000*(i)=$(ii) and allocate the remainder $(iii) to

XYZ. If you want track the S&P500 composite index, the amount you allocate to ABC is computed by

$24000*(iv)=$(v) and allocate the remainder $(vi) to XYZ. If you want to track the equally weighted index, you

allocate $(vii) to each stock.

(i) (ii) (iii) (iv) (v) (vi) (vii)

[2] (a) An indifference curve in the risk and expected return space represents all combinations of risk and

expected return that give the same level of utility. Indifference curves slope (i) for a risk averse agent, and

indifference curves slope (ii) for a risk loving agent, and indifference curves for a risk neutral agent slope (iii).

(i) (upward, downward, flat) (ii) (upward, downward, flat) (iii) (upward, downward, flat)

(b) To explain the indifference curve of a risk averse agent, consider the figure below where P1 represents the risk

and ER of the portfolio that the agent is currently holding.

Can we find a portfolio in quadrant A that can be indifferent to P1? The answer is (i) because any portfolio in that

quadrant has a (ii) expected return and has a (iii) risk than P1. Therefore, the agent prefers (iv). A similar line of

thought indicates that the risk averse agent prefers (v). Can we find a portfolio in quadrant B that can be

indifferent to P1? The answer is (vi) because any portfolio in that quadrant has a (vii) expected return and has a

(viii) risk than P1. Therefore, a portfolio in that quadrant (ix) give the same utility. A similar logic can apply to a

(i) (ii)

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portfolio in quadrant D. These considerations lead us to conclude that the indifference curve of a risk averse agent

has sloped (x).

(i) (no, yes) (ii) (higher, lower) (iii) (greater, smaller) (iv) (P1, a portfolio in A)

(v) (P1, a portfolio in C) (vi) (no, yes) (vii) (higher, lower) (viii) (greater, smaller)

(ix) (can, cannot) (x) (downward, upward)

[3] 1 You have two choices in allocating your investment fund: a risk-free asset and a risky asset. Let r f and r p be

returns of the risk-free asset and risky asset, respectively. Let μp=E(r p) and σ p2=var (r p). Let w be the fraction

of fund to be invested in the risky asset. The investor is concerned only about the expected return μc and the risk

σ c of the complete portfolio in their decision on w. The figure below shows the choice set, i.e., all combinations

of the expected return and risk that an investor faces as she chooses different values of w. This line is called the

CAL which stands for the (i) and it is shown in the figure below. Points marked on the CAL are equally spaced

along the line. The value of w at each point is (ii), (iii), (iv), (v) and (vi).

(i) (ii) (iii) (iv) (v) (vi)

[4] A risk averse agent's indifference curve may exhibit increasing, decreasing and constant marginal rate of

substitution (MRS) of risk for expected return. Consider an agent whose indifference curve has an increasing

MRS. Show an indifference curve of a diversifier on the left hand side figure and an indifference curve of a

plunger into risky asset only (w=1) on the right hand side figure.

ER (μc)

risk (σ c)

μf

μp

σ p

CAL

ER (μc)

risk (σ c)

μf

μp

σ p

CAL

ER (μc)

● (vi)

● (iii)

μp

r f

σ prisk (σ c)

(ii)

● (iv)

● (v)

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[1] Consider the choice set of expected return and risk when two risky assets are available. Let ri, μi, and σ i2 be

the return, expected return and variance of risky asset i, respectively, i=1,2, and let σ 12 and ρ be the covariance

and correlation coefficient between risky assets. . We construct a portfolio by investing w i fraction of fund on

asset i, where w1+w2=1. The curve in the risk and expected return space that represents all pairs of risk and

expected return that are attainable by changing w i is called the portfolio possibility curve (PPC). To compute the

PPC, we need to compute the return, expected return and variance of portfolio which are denoted by r p, μp, and

σ p2, respectively.

(a) Write r p, μp and σ p2 [4 points each]

r p=¿

μp=¿

σ p2=¿

(b) The figure below shows three shapes of PPC. The correlation coefficient ρ= (i) for dotted line, it is equal to

(ii) for dashed line, and it is equal to (iii) for the solid line.

(i) (-1, 0, 1), (ii) (-1, 0, 1), (iii) (-1, 0, 1)

μp

μ2

μ1

σ 1 σ 2σ p

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(c) To prove the PPC is the solid line in case (iii), derive the equation for the line. [12 points]

[2] The following figure shows risk and return of two risky assets and one risk-free asset. Explain how you find the best capital allocation line when ρ between the two risky assets is between 0 and 1 (i.e., not 0 nor 1). Draw in appropriate curves/lines in the figure below to help your explanation. Label each axis. [6 points]

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[3] Work out both excel files Quiz05a and Quiz05b posted on the class website and send them to the TA by noon tomorrow.

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[1] Consider a single-index model which specifies the excess return of asset i as

Ri=αi+β i Rm+ei

where all notations are as used in the lecture. The index model makes the following assumptions:

(A1) E (e i|Rm )=0

(A2) cov (e i , e j )=0 , i≠ j

Assumption (A1) implies

(A1a) E (e i )=0

(A1b) cov (ei , Rm)=0

Let var ( ei )=σe i

2 .

(a) Assumption (A1) implies the conditional and unconditional means of Ri are as given below:

E ( Ri|Rm )=α i+ βi Rm μi=E (Ri)=α i+ βi μm

Under assumptions (A1) and (A2), derive (i) σ i2, (ii) σ ij, and (iii) σ ℑ. For each case, specify which assumptions

are used. [6 points each. All or None for each]

(i) σ i2=¿

Assumption(s) used:

(ii) σ ij=¿

Assumption(s) used:

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(iii) σ ℑ=¿

Assumption(s) used:

(b) β i is called the "beta" of asset i and it represents the marginal effect of a change in Rm on Ri or on E ( Ri|Rm ). The equation in (i) of question (a) above indicates that, given the market excess return Rm, the expected excess return of asset i is the sum of two components. One component that is attributable to the market condition as a whole is equal to (i), and another component is the (ii) of asset i and it represents the expected excess return of stock i beyond any return induced by market’s excess return. (i) (ii)

(c) The result in question (a) shows two components in the risk of Ri. The risk of asset i attributable to the uncertainty common to the entire market is the term (i) and it is called the (ii) risk, and the risk from the changes in the firm-specific factor is the term (iii) and it is called the (iv) risk. The former is also called the (v) risk and the latter is also called the (vi) risk. The risk that can be removed by diversification is the (vii) risk.

(i) (β i2 σm

2 , σ ei

2) (ii) (systematic, non-systematic) (iii) (β i2 σm

2 , σ ei

2) (iv) (systematic, non-systematic)

(v) (market, firm specific) (vi) (market, firm specific) (vii) (market, firm specific)

(d) If β i>1, the return of asset i is (i) volatile and it is (ii) than the market as a whole. The converse holds when the beta of asset i is less than 1. The beta of Walmart is expected to be (iii) than 1 and the beta of Bank of America is expected to be (iv) than 1.

(i) (less, more) (ii) (riskier, safer) (iii) (greater, smaller) (iv) (greater, smaller)

[2] Parameters of the single index model are estimated by the ordinary least squares (OLS) method. This method

assumes that alpha and beta stay constant during the sample period. This is usually not true. It has been observed

empirically that betas tend to converge toward the average of betas of all equities, which is 1. This property is

called the (i) property. Merrill Lynch incorporates this property into the computation of beta by taking a weighted

average of estimated historical beta ( β̂) and 1.

Adjusted beta β̂adj = (ii)

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An alternative way to take changing beta into account is the method that Blume developed. Blume’s idea is to

find the common trend of betas over time and use the trend to predict the betas in forecasting period. Explain the

steps to follow to execute Blume’s method.

step 1. Select two (non-overlapping) periods, period 1 and period 2.

step 2. Estimate the beta of each stock in each period separately. Let them be denoted by β̂ i 1 and β̂ i 2 for each

stock i=1,2,,n.

step 3. The common time trend between these two sets of estimates is modeled as a linear regression model (iii).

Use notations δ and γ for the coefficients.

step 4. Let the estimates of coefficients be denoted by δ̂ and γ̂, respectively. Compute the forecast of beta in

period 3 using equation (iv).

(i) (ii)

(iii) (iv)

[4] Work out the Excel part of Quiz 6 posted on the website and send the file to the TA by 5 p.m. tomorrow.

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1Spring, 2019 ECON 445Final Exam


[1] An option is a contract whose value is derived from the price of underlying asset. The holder (buyer) of the

put option has the (i), but no (ii), to (iii) a share of the underlying stock at a (iv) price on or by the (v) date. A put

option is out of money if the current market price is (vi) than the (vii) price.

(i) (right, obligation) (ii) (right, obligation) (iii) (sell, buy) (iv)

(v) (vi) (higher, lower) (vii)

[2] You sell shares of XYZ stock short at the current market price $69 and plans to close your short sale account

on June 30.

(i) What is short sale?

(ii) A call option of strike price $70 that expires on June 30 is traded at price $1 per share. Will you buy this call

option if you think the price can rise to $72? Explain your reason in detail.

[3] (a) The federal government issues Treasury Bills, Notes and Bonds. A difference between Bills and Notes is

the maturity date: maximum maturity of 1 year for the Bills and 2 to 10 years for the Notes. The other two major

differences between Bills and Notes are (i) and (ii)

(i)

(ii)

(b) The Treasury also issues TIPS, which stands for (i) and they are designed to protect investment from the effect

of inflation. (ii) How does it work to offset the effect of inflation?

(i)

(ii)

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(c) A Canadian firm needs to raise fund by issuing bonds in denomination of Japanese Yen. If the company sells

such bond in the Japan, it is called (i) bond. If it sells that bond in Ausralia, it is called (ii) bond.

(i) (ii)

(d) After the scandal in the interbank unsecured short term loan market, the LIBOR is replaced by the ICE LIBOR

which stands for (i). It now reports the rates for 5 major currencies with (ii) maturities for each currency. The

currencies included in the ICE LIBOR are US dollars, Pound Sterling, and the other three currencies are (iii).

(i)

(ii) (iii)

(e) Asset backed securities are created by pooling financial assets that generate cash flows. An example is the

MBS which stands for the (i). Two primary risk of MBS is the (ii) risk and the (iii) risk. To protect their positions

from default, issuers of MBS purchased the CDS which stands for the (iv). Many sellers of the CDS hedged their

liability by buying CDS. The exception was the AIG which only sold CDS and this led to the demise of the AIG.

(i) (ii) (iii) (iv)

[4] The online WSJ reports daily data on the T-Bills as followsFriday, February 09, 2018

Maturity Bid Asked ChgAskedyield

4/12/2018 1.455 1.445 unch. 1.469

4/19/2018 1.485 1.475 0.008 1.500

The date February 9, 2018 is called the settlement date. The date under Maturity is the date when you receive the

face (par) value if you hold the bill until the maturity date. The numbers under "Bid" and "Asked" represent the

annualized (i) rate based on the bid price and the asked price, respectively. If an investor buys a T-Bill, she pays

(ii) price. The number under "Asked yield" represents the annualized (iii) yield based on the asked price. Let FV

and P denote the face value and the asked price of a Bill, respectively. The bank discount rate is computed by (iv)

and the bond equivalent yield is computed by (v).

(i) (bank discount, bond equivalent) (ii) (Bid, Asked) (iii) (bank discount, bond equivalent)

(iv) ((FV-P)/FV, (FV-P)/P) (v) ((FV-P)/FV, (FV-P)/P)

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[5] Consider two firms, A and B. Firm A wants a floating rate loan because it expects the interest rate will decline

while firm B wants a fixed rate loan because it expects a rise in interest rate. The current interest rate they face in

the market are as follows. Firm A can borrow at 5% rate in fixed rate market and at LIBOR+0.2% at floating rate

market. Firm B can borrow at 6% rate in fixed rate market and at LIBOR+1.0% at floating rate market.

(a) Firm B has to pay a higher interest rate than firm A in either market. But, firm B has a comparative advantage

in the (i) interest rate market because firm B has to pay (ii)% higher than firm A in the fixed rate market, while

firm B has to pay (iii)% higher rate than firm A in the floating rate market. Therefore, they agree on an IRS, in

which firm B borrows a (iv) rate loan and firm A borrows a (v) rate loan. Firm A agrees to pay a floating rate

LIBOR+x% to firm B and firm B pays a fixed rate y% to firm A. We need to determine x and y that benefit both

firms. To do this, we need to figure out the net interest rate each firm pays when they sign on the IRS. Firm A

pays (vi) to lender, pays (vii) to B, and receives (viii) from B. A’s net payment is (ix). Similarly, firm B pays (x)

to lender, pays (xi) to A, and receives (xii) from A. B’s net payment is (xiii). For the IRS to benefit both firms, net

payment under IRS must be smaller than the payment to the lender they prefer. This requires for firm A that

(xiv)<(xv), which is simplified to (xvi), and for firm B that (xvii)<(xviii), which is implied to (xix). If they first

agreed on x=0.2, the range of y they can negotiate is from (xx) to (xxi).

(i) (floating, fixed) (ii) (iii) (iv) (floating, fixed) (v) (floating, fixed)

(vi) (vii) (viii) (ix) (x)

(xi) (xii) (xiii) (xiv)

(xv) (xvi) (xvii) (xviii) (xix) (xx) (xxi)

[7] Below is the daily report by the WSJ on stock prices.

A Symbol Open High Low Close Div Yield PE YTD

%Chg

ABB ADS ABB 23.81 23.91 23.61 23.74 0.72 3.03 19.75 14.19Abbott Labs ABT 33.75 33.87 33.48 33.66 0.56 1.66 13.24 7.4

Numbers under "Close" shows the closing price in that day. Numbers under "Div" shows the dollar amount of annualized quarterly (i) paid most recently. The actual dollar amount paid out most recently is $(ii) for Abbot Laboratories. Numbers under "Yield" is computed by dividing the number under (Div) with closing price. Numbers under "PE" is called the (iv) ratio and it is computed by the ratio of current closing price to (v) year's earnings per share. The last column YTD%Chg shows the percentage change in price from the beginning of the (v) to (vi)

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(i) (ii) (iii) (iv) (v) (current, last) (v) (vi)

[8] (a) Three major stock market indexes are the Dow Jones Industrial Average (DJIA), the S&P 500 composite

index, and the NASDAQ composite index. The DJIA index is a (i) weighted index of (ii) blue chip companies.

The latter two indexes are the (iii) weighted index of 500 (iv) companies and all stocks registered at the NASDAQ

market, respectively.

(i) (ii) (iii) (iv) (large cap, medium cap)

(b) You have $24,000 to invest in two stocks: ABC and XYZ. The share prices of ABC and XYZ are $25 and

$75, respectively, and their outstanding shares are 20 million and 4 million, respectively.

(i) If you want to track the DJIA index, how do you allocate your fund? Show your work.

ABC: XYZ:

(ii) If you want track the S&P500 composite index, how do you allocate your fund? Show your work.

Value of firms are $500 million for ABC and $300 for XYZ. Therefore,

ABC: XYZ:

[9] Consider the choice set of expected excess return and its risk when two risky assets are available. Let Ri, μi,

and σ i2 be the excess return (Ri=ri−r f), expected excess return and variance of risky asset i, respectively, i=1,2,

and let σ 12 and ρ be the covariance and correlation coefficient between two risky assets. . We construct a portfolio

by investing w i fraction of fund on asset i, where w1+w2=1. (a) To compute the PPC, we need to compute the return, expected return and variance of portfolio which are

denoted by Rp, μp, and σ p2, respectively. It is easy to show Rp=¿(i), μp=¿(ii), and σ p

2 is (iii).

(b) The optimum portfolio P of risky assets on the PPC is found by finding the portfolio that maximizes the (iv) ratio which is equal to (v). Graphically, it is found where the CAL is (vi) to the PPC.(c) The PPC stands for the (vii) and the CAL stands for the (viii). The slope of the CAL represents the additional (ix) that the investor can gain as she takes one more unit of risk.(i) (ii)

(iii)

(iv) (v) (vi) (vii)

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(viii) (ix)

[10] Consider a single-index model which specifies the excess return of asset i as Ri=αi+β i Rm+ei

where all notations are as used in the lecture. The index model makes the following assumptions:

(A1) E (e i|Rm )=0, (A2) cov (e i , e j )=0 , i≠ j

(a) Derive the followings. Show your work. [6 points each]

(i) σ i2=¿

(ii) σ ℑ=¿

(b) There are two components in the risk of Ri. The risk of asset i attributable to the uncertainty common to the entire market is (i) and it is called the (ii) risk, and the risk from the changes in the firm-specific factor is (iii) and it is called the (iv) risk. The former is also called the (v) risk and the latter is also called the (vi) risk. The risk that can be removed by diversification is the (vii) risk.

(i) (β i2 σm

2 , σ ei

2) (ii) (systematic, non-systematic) (iii) (β i2 σm

2 , σ ei

2) (iv) (systematic, non-systematic)

(v) (market, firm specific) (vi) (market, firm specific) (vii) (market, firm specific)

<<THERE IS ANOTHER QUESTION ON THE NEXT PAGE>>

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[13] The table on the next page shows information that is necessary to compute the PPC and the CAL for three

risky assets. Write proper excel commands. For (f) and (j), write the proper choice of words. (4 points each)

(a)= (b)=

(c)=

(d)=

(e) (f) (g) (h) (i) (j) (k)

A B C D E F G H I1 Sample means and variances-covariances of annualized monthly excess returns2 sample means and SD’s sample var and cov

IBM McD P&G IBM McD P&G14 mean i 8.19 16.17 3.63 4148.20 IBM15 SD i 64.41 54.26 51.08 1082.38 2943.86 McD16 1975.21 1311.65 2609.64 P&G

A B C D E F G H I23 Opportunity set (portfolio possibility curve PPC) Use Excel's SOLVER24 target25 p

t w1 w2 w3 p p

26 3 0.3 0.2 (a) (b) (c)27 4 0.063 0.007 0.93 4 50.242829 Optimal Portfolio30 w1 w2 w3 p p Sharpe31 0.37 1.26 -0.63 21.14 65.50 (d)

Solver to find the PPC Solver to find the optimal portfolio

Set Objective: (e) Set Objective: (i)

To (f) Omax Omin value of To (j) Omax Omin Ovalue of

By changing variable cells By changing variable cells

(g) (k)

Subject to the Constrains Subject to the Constrains

(h)

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