bestttt Exam 2

5. At a cocktail party, your co-worker tells you that he has beaten the market for each of the last 3 years. Suppose you believe him. Does this shake your belief in efficient markets?

5. No, markets can be efficient even if some investors earn returns above the market average. Consider the Lucky Event issue: Ignoring transaction costs, about 50% of professional investors, by definition, will "beat" the market in any given year. The probability of beating it three years in a row, though small, is not insignificant. Beating the market in the past does not predict future success as three years of returns make up too small a sample on which to base correlation let alone causation.

7. Treasury bonds paying an 8% coupon rate with semiannual payments currently sell at par value. What coupon rate would they have to pay in order to sell at par if they paid their coupons annually? (Hint: What is the effective annual yield on the bond?)

7. The effective annual yield on the semiannual coupon bonds is 8.16%. If the annual coupon bonds are to sell at par they must offer the same yield, which requires an annual coupon rate of 8.16%. ((1+.04)^2)-1 The formula for calculating effective yield is as follows: i = [1 + (r/n)]n - 1 Where: i = effective yield r = nominal rate n = number of payments per year

Q6 (4 pts) There are two possible states of the world tomorrow: rain or sun. Asset A has a price of $1.60 and pays off $1.50 if it rains and $2.00 if it is sunny. Asset B has a price of $2.25 and pays off $2.50 if it rains and $2.00 if it is sunny. Assuming there is no arbitrage opportunity, what is the price of an asset that pays off $1.00 if it rains and nothing if it is sunny? A. $0.65 B. $1.00 C. $1.15 D. $2.25 E. $3.85

A. $0.65

Q7 (4 pts) One-year, two-year, and three-year zero-coupon bonds with $1,000 face values are selling for $950, $900, and $850, respectively. A three-year coupon bond with annual coupons of 10% and a face value of $1,000 is selling for $1,100. Is there an arbitrage opportunity? If so, do you need to buy or sell the three-year bond to exploit the arbitrage opportunity? How much can you make per three-year coupon bond that you buy or sell? A. Buy the three-year coupon bond. Can make $20 per three-year coupon bond bought. B. Buy the three-year coupon bond. Can make $40 per three-year coupon bond bought. C. Sell the three-year coupon bond. Can make $20 per three-year coupon bond sold. D. Sell the three-year coupon bond. Can make $40 per three-year coupon bond sold. E. No arbitrage opportunity.

A. Buy the three-year coupon bond. Can make $20 per three-year coupon bond bought.

Q9 (4 pts) Suppose there are two bonds, bond A and bond B. Both of them mature in 10 years and have the same coupon rates with the same coupon payment frequency. However, the face value of bond A is $500, while the face value of bond B is $1,000. The price of bond A is $460 and the price of bond B is $990. Is there an arbitrage opportunity? If so, which of the following correctly describes the arbitrage strategy? A. There is no arbitrage opportunity [Acceptable answer on the basis that the question does not clarify that the bonds are both risk-free] B. Buying one bond A and selling one bond B creates arbitrage profit of $530 today C. Buying two bond A and selling one bond B creates arbitrage profit of $70 today D. Selling one bond A and buying one bond B creates arbitrage profit of $530 today E. Selling two bond A and buying one bond B creates arbitrage profit of $70 today

C. Buying two bond A and selling one bond B creates arbitrage profit of $70 today

Use the following information for the next three problems: Bond A is a one-year zero-coupon bond with $1,000 face value and a current price of $909.09. Bond B is a two-year zero-coupon bond with $1,000 face value and a current price of $907.03. Q14 (4 pts) What are the one-year and two-year spot rates? A. R1 = 10.00%; R2 = 0.00% B. R1 = 0.00%; R2 = 10.00% C. R1 = 10.00%; R2 = 5.00% D. R1 = 5.00%; R2 = 5.00% E. R1 = 5.00%; R2 = 0.00% Q15 (4 pts) What is the forward rate starting one year from now, lasting for one year? A. 1f1 = 0.00% B. 1f1 = 0.23% C. 1f1 = 4.92% D. 1f1 = 5.00% E. 1f1 = 10.00% Q16 (4 pts) Under the pure expectations hypothesis, what would you expect the price of Bond B to be one year from now? A. $907.03 B. $923.76 C. $952.38 D. $997.71 E. $1,000

C. R1 = 10.00%; R2 = 5.00% B. 1f1 = 0.23% D. $997.71

Use the following information for the next three problems: Consider a bond with a face value of $1,000, 10% annual coupons, and two years of maturity. Its current yield to maturity is 0%. Q17 (4 pts) What is the bond's price? A. $826.45 B. $1,000 C. $1,100 D. $1,200 E. Not enough information to determine. Q18 (4 pts) What is the bond's duration? A. 1.75 years B. 1.83 years C. 1.92 years D. 2 years E. Not enough information to determine. Q19 (4 pts) Using duration to approximate the effect of an interest rate change, estimate the percent change in the bond's price if yields increase from 0% to 10%. A. The bond's price will decrease by 16.7% B. The bond's price will increase by 17.5%. C. The bond's price will decrease by 17.5% D. The bond's price will increase by 19.2% E. The bond's price will decrease by 19.2%

D. $1,200 C. 1.92 years E. The bond's price will decrease by 19.2%

Q5 (4 pts) Pfizer has 5.6 billion shares outstanding, and its current share price is $43.16. Assume that the semi-strong version of the EMH holds and that investors currently expect the present value of future profits associated with its COVID vaccine for children under 12 in the United States to be $500 million. If the FDA makes a surprise announcement that they are not approving vaccines for children under 12 and will never approve them in the future, Pfizer's share price will be: A. $36.43 B. $40.95 C. $42.16 D. $43.07 E. $43.16

D. $43.07

Q21 (4 pts) A two-year bond has annual coupons of 10.00% and a YTM of 10.00%. The one-year spot rate is 5.00%. What is the two-year spot rate? A. 9.82% B. 10.00% C. 10.15% D. 10.26% E. 15.00%

D. 10.26%

Q2 (4 pts) Assume the semi-strong form of the Efficient Market Hypothesis holds. A company's market cap increases by $5 billion when it announces a new product. If the announcement is of a product that the company was widely known to be working on, what can we infer about how much the market believes the product is worth to the company? What if instead they announce a product that nobody outside the company knew about? A. The product has no value in either case B. $5 billion in either case. C. $5 billion when the company was widely known to be working on the product. Cannot infer when the product was not known to the public. D. Cannot infer when the company was widely known to be working on the product. $5 billion when the product was not known to the public. E. Cannot infer in either case.

D. Cannot infer when the company was widely known to be working on the product. $5 billion when the product was not known to the public.

Q11 (4 pts) Which of the following is NOT a common behavioral bias? A. Investors are overconfident in their ability to profit from trading. B. Investors extrapolate trends from a small number of data points. C. Investors pay too much attention to irrelevant metrics, such as whether their portfolio is up on a given day. D. Investors hold onto stocks that are up more than those that are down. E. All of these are common behavioral biases. [Accepted answer due to grading mistake]

D. Investors hold onto stocks that are up more than those that are down.

Q13 (4 pts) "Pension fund managers mainly invest in long term bonds because their investment horizon is long while money market fund managers focus on short term bonds to provide liquid and risk-free assets to their investors." Which term structure theory does this description of fixed income markets support? A. Pure Expectations Hypothesis B. Expectations Hypothesis C. Liquidity Preference Theory D. Market Segmentation Theory E. B and C

D. Market Segmentation Theory

Q3 (4 pts) Compared to historical averages, the current Shiller Price-Earnings ratio is _________, which predicts future returns will be __________. A. low; low B. low; high C. low; future returns cannot be predicted based on the Price-Earnings ratio D. high; low E. high; high

D. high; low

Q30 (4 pts) Immunization based on matching the duration of a firm's assets and liabilities perfectly hedges interest rate risk. Do you agree or disagree with this statement? Why? [Make sure your answer is clear and try to limit it to a few sentences.]

Disagree. Duration matching is an important tool for hedging most interest rate risk, but it is important to remember that it is an approximation. If the firm's assets and liabilities have different convexity, the interest rate hedge may not be perfect. Additionally, duration matching hedges shifts up and down in the yield curve but does not necessarily hedge changes to the shape of the yield curve.

Q26 (4 pts) DFA embraces the strong form of the efficient markets hypothesis. Do you agree or disagree with this statement? Why? [Make sure your answer is clear and try to limit it to a few sentences.]

Disagree. The strong form of the EMH states that prices reflect all information, even including inside information. DFA does not believe that they have information, but they are worried that counterparties may have inside information that is not yet reflected in prices. This is why they use the penalty box and other protections against trading with informed insiders. Q27

Q29 (4 pts) An investor who believes markets are efficient should always passively hold the market portfolio. Do you agree or disagree with this statement? Why? [Make sure your answer is clear and try to limit it to a few sentences.]

Disagree. This statement is only true if the CAPM is the correct measure of risk. More generally, if markets are efficient, the average investor should hold the market portfolio. However, investors with different risk preferences or different background risk exposures might deviate from the market portfolio to hold more or less of different risk factors.

Q12 (4 pts) It is documented that value stocks have higher CAPM alpha compared to growth stocks. Based on evidence that we discussed in class, which of the following are potential explanations for the value premium? A. Data snooping B. The value stocks are riskier than the growth stocks C. Investors are behavioral D. A, B, and C E. B and C

E. B and C

Q10 (4 pts) You are looking for a trading strategy that creates alpha. You test different trading strategies discussed in Finance 367, and you determine that the value strategy creates alpha relative to the CAPM. Assuming the CAPM is the correct model of risk, what does this imply about the efficient market hypothesis? A. The market is not weak form efficient B. The market is not semi-strong form efficient C. The market is not strong form efficient D. A and B are both correct E. B and C are both correct

E. B and C are both correct

Q1 (4 pts) Assume that the strong form of the Efficient Market Hypothesis holds. Which of the following is true? A. An insider with private information can make profits by trading. B. The stock market has an expected return of zero. C. A risk averse investor should not invest in stocks. D. Using technical analysis is helpful. E. None of the above are true.

E. None of the above are true.

An arbitrage opportunity generates a

Example 1: Zero-cost investment that has only positive payoffs in the future Example 2: Investment that generates a positive payoff today without any risk of a negative cash flow in the future

3 implications of EMH

Implication 1:Prices react to new information and only to new information e.g. Price reacts to merger announcement, not actual merger •Implication 2:Price changes are unpredictable (random walk) Anything predictable is already incorporated into current prices •Implication 3:Investors cannot "beat the market" Expected returns are commensurate with risk Active investing will generate the same risk-adjusted returns as passive investing (and is likely costlier due to management fees, transaction costs, loss of diversification, extra taxes, etc.)

APT implies "almost all" securities have alphas close to

Individual securities still have residual risk Positive alpha stocks may look like a good deal (and I should probably overweight them in my portfolio) but they are not riskless arbitrage opportunities Alphas cannot be too large, though, or else you can form a portfolio of securities (including the market portfolio) and make a riskless profit

Market Index Model APT

Key assumptions: Arbitrageurs eliminate riskless profit opportunities Market index model describes security returns Statistical assumption that residuals are uncorrelated Well-diversified portfolio result approximates individual asset risk premia •Advantages: Weak preference assumptions Small number of investors seek out and eliminate arbitrage opportunities Market portfolio need not include all risky assets Just needs to capture co-movement of stocks

Investors typically provide (and are compensated for) two things

Provision of capital Risk bearing

Lots of things other than beta predict returns...

Small stocks outperform large stocks (Banz, 1981) But this pattern does not show up in more recent data Stocks with high E/P ratios (value) stocks outperform other stocks (Basu, 1977) Stocks that performed well in the past year tend outperform other stocks (momentum, Jegadeeshand Titman, 1994)

1. Say there are three states of the world and three assets with returns summarized as follows: Asset State 1 State 2 State 3 1 20% 0% -20% 2 10% 10% -5% 3 25% 5% -30% a. If there is no arbitrage, what must the risk-free rate be? b. Assume there is a risk-free asset with a rate higher than the value you calculated for part a). How would you take advantage of this arbitrage?

a. A portfolio with weights = 1, = 1, and = −1 has return equal to 5% in all three states of the world. No arbitrage/law of one price therefore implies risk-free rate must be 5%. b. If risk-free rate was more than 5%, could create arbitrage by shorting the portfolio in a. (effectively borrowing at 5%), and using the proceeds to buy the risk-free asset. This would have zero cost today and a guaranteed positive profit.

A2. The current prices of five U.S. Treasury securities are shown in the follow- ing table. Assume all securities have a face value of $1000, and are zero-coupon bonds. Years to Maturity: 1 2 3 4 5 Price: $884.96 $797.19 $731.19 $683.01 $649.93 a. Compute the yields for the different maturities. Plot the current yield curve. b. Compute the implied forward rates for 3, 4, and 5 years ( f3, f4, f5). c. Compute the price of a 5-year Treasury note with an annual coupon of 9%. d. Suppose someone offers you a risk-free investment opportunity. Today you can lock in the right to borrow $1000 in 3 years, and pay it back 2 years later (5 years from now) at an annual interest rate of 7%. Is this a fair con- tract given the current yield curve? e. Using the information from (d), is there an arbitrage opportunity? Assume you can buy and sell all the zero-coupon bonds given and also the contract offered in (d). If so, how would you take advantage of it (describe the trades, amounts)?

a. For each time to maturity n, yn= (1000/P)^(1/n)−1 from which we can calculate: y1 =13%; y2 =12%; y3 =11%; y4 =10%; y5 =9%; d. To figure out the fair borrowing rate from year 3 to year 5, call it b, calculate the forward rate that would make you indifferent between investing for five years and investing for three years and reinvesting for two. (1+y5)^5 = (1+y3)^3(1+b)^2 1.095 = 1.11^3(1 + b)^2 b = 6.1% You should be able to lock in an annual future borrowing rate of 6.1% today, so a borrowing rate of 7% is not a fair contract. e. From (d) we know that the borrowing rate is too high, and we should be able to construct a synthetic loan that allows us to borrow at a cheaper rate. To take advantage of the arbitrage opportunity, we should sell the contract offered, which means lending at 7% from year 3 to year 5. In year 3 we lend $1000 and in year 5 we are repaid $1000(1.07)2 = $1149.90. To offset these cashflows, we can buy a 3-year bond with face value $1000 for $731.19 and sell a 5-year bond with face value $1149.90 for ($1.1499 × $649.93) = $744.10.

5. A bond with an annual coupon rate of 4.8% sells for $970. What is the bond's current yield?

5. Annual Coupon Rate: 4.80% -> $48 Coupon Payments Current Yield: $48/$970 = 4.95%

1. What is the relationship between forward rates and the market's expectation of future short rates? Explain in the context of both the expectations and liquidity preference theories of the term structure of interest rates.

1. In general, the forward rate can be viewed as the sum of the market's expectation of the future short rate plus a potential risk (or 'liquidity') premium. According to the expectations theory of the term structure of interest rates, the liquidity premium is zero so that the forward rate is equal to the market's expectation of the future short rate. Therefore, the market's expectation of future short rates (i.e., forward rates) can be derived from the yield curve, and there is no risk premium for longer maturities. The liquidity preference theory, on the other hand, specifies that the liquidity premium is positive so that the forward rate is greater than the market's expectation of the future short rate. This could result in an upward sloping term structure even if the market does not anticipate an increase in interest rates. The liquidity preference theory is based on the assumption that the financial markets are dominated by short-term investors who demand a premium in order to be induced to invest in long maturity securities.

1. Empirical evidence indicates that the risk-adjusted returns of high beta portfolios are ___________ the risk adjust returns of low beta portfolios (choose one) a. Greater than b. Equal to c. Less than d. Unrelated to

1. Less than. Average returns are very similar for high and low beta stocks, but high beta stocks are exposed to much more systematic risk, by definition. They therefore underperform Low beta stocks on a risk adjusted basis.

CAPM makes two empirical predictions

1.Expected returnsincrease with betas. Specifically, the slope of expected returns vs. beta is the market risk premium 2.Nothing other than beta affects expected returns

15. My pension plan will pay me $10,000 once a year for a 10-year period. The first payment will come in exactly 5 years. The pension fund wants to immunize its position. a. What is the duration of its obligation to me? The current interest rate is 10% per year. b. If the plan uses 5-year and 20-year zero-coupon bonds to construct the immunized position, how much money ought to be placed in each bond? What will be the face value of the holdings in each zero?

15. a. The duration of the annuity if it were to start in 1 year would be: (1) (2) (3) (4) (5) Time until Payment (years) Cash Flow PV of CF (Discount rate = 10%) Weight Column (1) × Column (4) 1 $10,000 $9,090.909 0.14795 0.14795 2 $10,000 $8,264.463 0.13450 0.26900 3 $10,000 $7,513.148 0.12227 0.36682 4 $10,000 $6,830.135 0.11116 0.44463 5 $10,000 $6,209.213 0.10105 0.50526 6 $10,000 $5,644.739 0.09187 0.55119 7 $10,000 $5,131.581 0.08351 0.58460 8 $10,000 $4,665.074 0.07592 0.60738 9 $10,000 $4,240.976 0.06902 0.62118 10 $10,000 $3,855.433 0.06275 0.62745 Column Sums $61,445.671 1.00000 4.72546 D = 4.7255 years Because the payment stream starts in five years, instead of one year, we add four years to the duration, so the duration is 8.7255 years.

16. "If the business cycle is predictable, and a stock has a positive beta, the stock's returns also must be predictable." Respond.

16. While positive beta stocks respond well to favorable new information about the economy's progress through the business cycle, they should not show abnormal returns around already anticipated events. If a recovery, for example, is already anticipated, the actual recovery is not news. The stock price should already reflect the coming recovery.

2. How can a perpetuity, which has an infinite maturity, have a duration as short as 10 or 20 years?

2. Duration can be thought of as a weighted average of the 'maturities' of the cash flows paid to holders of the perpetuity, where the weight for each cash flow is equal to the present value of that cash flow divided by the total present value of all cash flows. For cash flows in the distant future, present value approaches zero (i.e., the weight becomes very small) so that these distant cash flows have little impact, and eventually, virtually no impact on the weighted average.

2. Richard Roll argued in his famous critique that tests of the expected return/beta relationship are invalid because we cannot observe the true market return, and that it is doubtful that the CAPM can never be tested. Why can't we observe the true market return? And why would this affect empirical tests of the expected return/beta retlationship?

2. We can't observe the true market return because it includes all risky assets in the world, including private equity, debt, real estate, human capital, etc. These assets are impossible to observe and incorporate into the empirical market portfolio. This would adversely affect empirical tests of the expected return/beta relationship because the betas would be mismeasured. A stock with a high beta on the true market portfolio may have most of its systematic risk exposure coming from the unobserved part of market returns, and therefore falsely be categorized as a low/medium beta stock when using only the US equity market to measure market beta.

20. In a recent closely contested lawsuit, Apex sued Bpex for patent infringement. The jury came back today with its decision. The rate of return on Apex was rA = 3.1%. The rate of return on Bpex was only rB = 2.5%. The market today responded to very encouraging news about the unemployment rate, and rM = 3%. The historical relationship between returns on these stocks and the market portfolio has been estimated from index model regressions as: Apex: rA = .2% + 1.4rM B_pex.: r11 = -.1% + .6rM On the basis of these data, which company do you think won the lawsuit?

20. Given market performance, predicted returns on the two stocks would be: Apex: 0.2% + (1.4 × 3%) = 4.4% Bpex: -0.1% + (0.6 × 3%) = 1.7% Apex underperformed this prediction; Bpex outperformed the prediction. We conclude that Bpex won the lawsuit.

3. "If all securities are fairly priced, all must offer equal expected rates of return." Comment.

3. Expected rates of return differ because of differential risk premiums.

4. Why do bond prices go down when interest rates go up? Don't lenders like high interest rates?

4. A bond's coupon interest payments and principal repayment are not affected by changes in market rates. Consequently, if market rates increase, bond investors in the secondary markets are not willing to pay as much for a claim on a given bond's fixed interest and principal payments as they would if market rates were lower. This relationship is apparent from the inverse relationship between interest rates and present value. An increase in the discount rate (i.e., the market rate) decreases the present value of the future cash flows.

4. Steady Growth Industries has never missed a dividend payment in its 94-year history. Does this make it more attractive to you as a possible purchase for your stock portfolio?

4. No. The value of dividend predictability would be already reflected in the stock price.

Q28 (4 pts) Empirically, the Fama-French 3-factor model does a better job of explaining stock returns than the CAPM does. Do you agree or disagree with this statement? Why? [Make sure your answer is clear and try to limit it to a few sentences.]

Agree. The CAPM does a poor job of explaining stock returns. Its main empirical predictions are that stocks with higher market betas should have higher returns and that nothing other than market betas should predict returns. Both of these predictions are false empirically. By contrast, the 3-factor model does a reasonably good (though not perfect) job of explaining returns to portfolios sorted by size and value.

Q27 (4 pts) The HML factor has almost no risk under the CAPM. Do you agree or disagree with this statement? Why? [Make sure your answer is clear and try to limit it to a few sentences.]

Agree. Under the CAPM, market beta is the correct measure of risk, and HML's long-term beta with respect to the market is close to zero.

Q20 (4 pts) The yield-to-maturity of a one-year bond is 2% and the forward rate starting a year from now with a maturity of one year (i.e., the 1f1) is 4%. What is the price of a two-year zero-coupon bond that has a face value of $1000? Round your answer to the nearest dollar. A. $925 B. $943 C. $962 D. $980 E. $1,000

B. $943

Q8 (4 pts) Suppose the market risk premium is 7%, SMB is 3%, and HML is 5%. There are two stocks in the market: Stock A has an expected return of 20% with βM=1.2, βSMB=2, βHML=1. Stock B has an expected return of 10% with βM=0.5, βSMB=0, βHML=1. The risk-free rate is 0%. Which of the following portfolios will have the highest three-factor alpha based on the Fama-French three factor model? A. 100% in Stock A B. 100% in Stock B C. 25% in Stock A and 75% in Stock B D. 75% in Stock A and 25% in Stock B E. 50% in Stock A and 50% in Stock B

B. 100% in Stock B

Q22 (4 pts) A three-year coupon bond with 10% annual coupons is selling for $1,100. If you purchase this bond and reinvest each of your coupon payments at a 5% interest rate, what will be your realized compounded annual return over the three-years? A. 6.00% B. 6.14% C. 9.56% D. 10.00% E. 19.57%

B. 6.14%

Q4 (4 pts) Use the Fama-French 3 Factor Model for the following problem. A firm has βMKT = 1.5, βSMB = -0.25, and βHML = 1. The SMB risk premium is 5%, the HML risk premium is 3%, and the risk-free rate is 2%. If the firm is indifferent to investing $100 today for an expected payoff of $115 next period, what must be the market risk premium? A. 6% B. 6.5% C. 7.5% D. 8% E. Not enough information to determine.

C. 7.5%

3. Define the payout yield of a stock to be its annual (aggregate) dividend, plus its annual dollar value of share repurchases dividend by its current market capitalization: payout yield = (dividends + repurchases)/market cap a. Two otherwise identical firms have different expected returns due to risk. Does the firm with higher expected returns have a lower or higher payout yield? b. Imagine you discovered that over the past 90 years, stocks with high payout yields have had higher future returns than stocks with low payout yields. What is a mispricing story for this finding? Think about both investor sentiment and manager behavior. c. How would you use the information that high payout yield stocks outperform in making a portfolio choice decision if your believed the difference was due to risk? What about if the difference was due to mispricing?

a. Higher payout yield. It's market cap would be lower due to a higher discount rate. b. The mispricing story has two components. First, investors are irrational and sometimes over or underprice stocks relative to their true values due to their current sentiment about the company. This mispricing affects the denominator of payout yield but not the numerator, meaning a high payout yield potentially indicates underpricing and a low payout yield indicates overpricing. This argument is the same as we made in class for the value premium. A second mispricing story is that managers may notice this mispricing and time their company's share repurchases to occur more when the stock is underpriced. This would further increase the payout yield of underpriced stocks. Overpriced stocks, on the other hand, would have very little share repurchase activity, further lowering their payout yield. Both channels combine to potentially make payout yield a strong indicate of any mispricing. c. If payout yield predicted returns due to risk, only particularly risk-tolerant investors should buy stocks with high payout yields. Others should avoid them. If instead payout yield predicted returns due to mispricing, all investors who are able to should tilt their portfolios towards high payout yield stocks.

Mutual funds

allow investors to pool resources to invest in a diversified portfolio of assets Active funds pick stocks and/or bonds and attempt to beat the market Passive funds track an index and have lower fees

One implication of no-arbitrage pricing is the...

arbitrage pricing is the Law of One Price: two securities with the same payoffs should have the same price

Hedge funds

are actively managed with looser regulation High fees (e.g., 2% management fee + 20% performance fee) Typically come with lockup periods on withdrawing capital and may invest in less liquid assets

Q24 (4 pts) A one-year zero-coupon bond with a face value of $1000 is being issued by a corporation at a price of $947.87. The one-year spot rate for Treasury bonds is 2%. What is the corporation's credit spread? A. 2% B. 3.5% C. 4% D. 5% E. 5.5%

b

Q23 (4 pts) Suppose the term structure for zero-coupon bonds is the following: Maturity (Years) 1, 2, 3 YTM (%) 2%, 4%, 5% Suppose there is no arbitrage. You are interested in investing in two types of bonds. The first bond has a face value of $1,000 and it pays annual coupon of 5%. The maturity is 2 years. The second bond is a zero coupon bond with the maturity of 3 years. The face value of the second bond is also $1,000. You create a portfolio by purchasing each of the two bonds. What is the price of your portfolio? A. $1,800.00 B. $1,837.41 C. $1,883.64 D. $1,962.94 E. $2,000.00

c

Q25 (4 pts) A one-year zero-coupon bond with a face value of $1000 is being issued by a corporation at a price of $947.87. You expect that the corporation has a 5% probability of defaulting on its debt within the next year and that your recovery rate will be 75% if there is a default. What is your expected return from investing in this bond? A. -1.3% B. 1.5% C. 3.5% D. 4.2% E. 5.5%

d

Implication: No (pure) arbitrageis a less restrictive equilibrium condition than the CAPM

equilibrium condition than the CAPM A few well-financed investors can eliminate arbitrage opportunities; we don't have to worry about modeling everyone else

Idea: returns composed of •Expected return 𝐸𝑟𝑖,

from CAPM or alternative

Efficient Market Hypothesis says that asset

prices reflect all available information

ETFsshare many of the features of mutual funds but are bought

share many of the features of mutual funds but are bought and sold on secondary exchanges Typically passive, but can also be active High growth in ETF investing over time