FIN 367 Final

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

Consider European call options with a maturity of one year on a stock that does not pay dividends. The stock's current price is $100, its annual volatility is 20%, and the risk-free rate is 0%. Which of the following call options has the highest total value (i.e., which will have the highest price)? A. A call option with a strike price of $20 B. A call option with a strike price of $60 C. A call option with a strike price of $100 D. A call option with a strike price of $140 E. A call option with a strike price of $180

A. A call option with a strike price of $20

Consider European call options with a maturity of one year on a stock that does not pay dividends. The stock's current price is $100, its annual volatility is 20%, and the risk-free rate is 0%.Which of the following call options has the highest intrinsic value? A. A call option with a strike price of $20 B. A call option with a strike price of $60 C. A call option with a strike price of $100 D. A call option with a strike price of $140 E. A call option with a strike price of $180

A. A call option with a strike price of $20

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.

Suppose there is no arbitrage opportunity. You want to replicate the payoff of a long position in a put option that matures in 1 year and has a strike price of $150. The underlying asset of this put option is stock A. Stock A does not pay dividends. The current price of stock A is $130, and the 1-year call option with a strike price of $150 is valued at $6. The annual risk-free rate is 1% and both options are European options. Which portfolio replicates the put option? A. Long a call; short a stock A; long a risk-free asset with the face value of $150 B. Short a call; short a stock A; long a risk-free asset with the face value of $150 C. Long a call; long a stock A; short a risk-free asset with the face value of $148.51 D. Long a call; short a stock A; long a risk-free asset with the face value of $148.51 E. Long a call; short a stock A

A. Long a call; short a stock A; long a risk-free asset with the face value of $150

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 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

A. There is no arbitrage opportunity [Acceptable answer on the basis that the question does not clarify that the bonds are both risk-free] C. Buying two bond A and selling one bond B creates arbitrage profit of $70 today

You write a put option with strike price $80. The option matures in 1 year. The underlying stock price is currently $75, and the stock does not pay dividends. The underlying stock price increases to $90 in economic expansion and decreases to $60 in economic recession. You are going to create a hedging portfolio by investing ∆ shares in the underlying stock and $B in risk-free bond. The risk-free rate is 0%. Calculate ∆ and B. A. ∆ = −2/3, B = 60 B. ∆ = 2/3, B = −60 C. ∆ = 1/3, B = −20 D. ∆ = − 1/3, B = 20 E. ∆ = 1/3, B = − 60

A. ∆ = −2/3, B = 60

Stocks with more potential for private information (e.g., inside information) will tend to have larger bid-ask spreads. 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. One of the reasons for a bid-ask spread is to protect the market maker from informed traders. If there is more risk of trading against an informed counterparty, we should expect bid-ask spreads to be wider.

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.

The Harvard Management Company's investment decisions implicitly reject 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. The CAPM predicts that the market portfolio is the tangency portfolio and is therefore an optimal portfolio for all investors. HMC's portfolio clearly differs from the market portfolio. Its policy portfolio overweights some asset classes and underweights others, and HMC's internal and external manager's pursue active investing strategies in contrast to the passive investment strategies implied by the CAPM.

You can replicate a call option by buying its hedge ratio number of shares of the underlying asset combined with risk-free borrowing. Then buy more of the asset as its price goes up or sell part of the underlying asset as its price goes down such that your ownership of the asset is always equal to the call option's hedge ratio. 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. To replicate a call option you want a position in the stock with the same exposure to stock price changes. You accomplish this by using the call option's hedge ratio to determine how many shares of the asset to purchase. As the stock price goes up, the hedge ratio will increase, and you will need to buy more shares, and vice versa as the stock price goes down. This is exactly what we did in the simulation exercise in case 3.

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.

Suppose a stock is trading at $1,000 currently will pay a dividend of $40 in 6 months. If the risk-free rate is 5%, what should be the cost on one 1-year futures contract on this stock? Round to the nearest dollar. A. $1,000 B. $1,009 C. $1,010 D. $1,011 E. $1,040

B. $1,009

A trader buys shares of a stock that has a current price of $50 per share on margin with a 60% initial margin. If the maintenance margin is 40%, what price would the stock need to fall to in order for the investor to receive a margin call? Assume the interest rate on the margin loan is 0%. A. $30.00 B. $33.33 C. $36.67 D. $40.00 E. $43.33

B. $33.33

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

A stock has an expected return of 10%, a standard deviation of 25%, and a beta of 1.6. The risk-free rate is 2%. What is the Sharpe ratio of a portfolio that invests 50% in the stock and 50% in the risk-free asset? A. 0.16 B. 0.32 C. 0.40 D. 1.28 E. Not possible to determine based on the given information.

B. 0.32

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

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. 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%

B. 1f1 = 0.23%

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. 3.5%

Peter invests in three stocks: A, B, and C. A, B, and C have alphas of 3%, 5%, and 8%, respectively. The weight of each stock in the portfolio is 20%, 30%, and 20%, for A, B, and C, respectively. Peter invests the rest in the risk-free asset and the risk-free rate is 1%. What is the alpha of his portfolio? A. 3.3% B. 3.7% C. 4.0% D. 5.3% E. 5.7%

B. 3.7%

Domestic equities have an expected return of 10% and standard deviation of 20%. Domestic bonds have an expected return of 2% and standard deviation of 5%. Assume that domestic equities and domestic bonds are uncorrelated. You want to combine domestic equities and domestic bonds to form the portfolio with the minimum risk possible. What weight do you put on domestic equities? A. 3.17% B. 5.88% C. 8.39% D. 10.28% E. 13.59%

B. 5.88%

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%

You believe the market will be very volatile over the next year, so you decide to long a straddle by purchasing 1-year call and put options on Walmart with strike price of $120. The premiums of the call and put options are $3.40 and $15.00, respectively. The current stock price for Walmart is $110. If the stock price becomes $150 a year from now, what is the holding period return? A. 25% B. 63% C. 117% D. 700% E. 1076%

B. 63%

Which of the following has the highest effective annual rate (EAR)? A. 7.4% APR with monthly compounding. B. 7.5% APR with quarterly compounding. C. 7.6% APR with annual compounding. D. They all have the same EAR. E. There is not enough information to determine which has the highest EAR.

B. 7.5% APR with quarterly compounding.

Which investment had the highest real return? A. A stock bought for $100 and sold for $80 during a time with 0% inflation. B. A stock bought for $100 and sold for $120 during a time with -5% inflation. C. A stock bought for $100 and sold for $180 during a time with 50% inflation. D. A stock bought for $100 and sold for $120 during a time with 5% inflation. E. A stock bought for $100 and sold for $130 during a time with 5% inflation.

B. A stock bought for $100 and sold for $120 during a time with -5% inflation.

Which of the following is true about the historical record of US markets? A. US equity returns have been abnormally high compared to other countries. B. Equities have significantly outperformed bonds over the long term. C. The market Sharpe ratio has been near 1. D. Excess returns have been nearly constant over time. E. Large cap stocks have outperformed small caps.

B. Equities have significantly outperformed bonds over the long term.

Which of the following is true about securities trading? A. To place a market order, the investor needs to specify a price at which to buy/sell. B. Investors who submit market orders typically sell at the bid price and buy at the ask price. C. Limit orders are always executed immediately. D. The difference between bid and ask prices is seen as a transaction cost for market makers. E. None of the above are true.

B. Investors who submit market orders typically sell at the bid price and buy at the ask price.

Which of the following is the main reason why the London Interbank Offered Rate (LIBOR) was able to be manipulated? A. It was based on an illiquid market. B. It was based on a survey of banks and not actual borrowing activity. C. It was based on too few banks. D. One bank could easily change it on their own. E. It was calculated for too many different currencies and borrowing periods.

B. It was based on a survey of banks and not actual borrowing activity.

After taking FIN 367, you have a great insight into the market and determine that Amazon stock will not have a price change for next year and that Amazon will not pay any dividends. The current price of Amazon is $3,500. If your prediction is true, which of the following strategies is most profitable? (Assume the risk-free rate is 0% and all options have a maturity of one year.) A. Long straddle (purchase call and put with strike price of $3,500) B. Short straddle (write call and put with strike price of $3,500) C. Purchase a put with strike price $3,300 and purchase a put with strike price $3,700 D. Write a put with strike price $3,300 and write a call with strike price $3,700 E. None of the given strategies creates profit

B. Short straddle (write call and put with strike price of $3,500)

Suppose that the CAPM is true. Stock A has a market beta of 1.2; stock B has a market beta of 1.8; and stock C has a market beta of 1. Which of these stocks has the highest expected return? A. Stock A. B. Stock B. C. Stock C. D. All three stocks have the same expected return. E. There is not enough information to determine which stock has the highest expected return.

B. Stock B.

Which of the following is NOT TRUE: A. Beta is a useful tool to measure common movement between a stock and the market. B. Stocks with high betas have earned higher average returns than stocks with low betas in recent decades. C. According to the CAPM stocks with high betas should earn higher returns than stocks with low betas. D. The CAPM is a useful model for understanding why only systematic risk is priced. E. All of the above are true statements.

B. Stocks with high betas have earned higher average returns than stocks with low betas in recent decades.

A stock has a forecasted return of 12% with a standard deviation of 20% and a beta of 1.3 with respect to the market. The risk-free rate is 2% and the market risk premium is 6%. Relative to predictions of the CAPM: A. The stock is underpriced with an alpha of 4.8% B. The stock is underpriced with an alpha of 2.2% C. The stock is correctly priced. D. The stock is overpriced with an alpha of 2.2%. E. The stock is overpriced with an alpha of 4.8%.

B. The stock is underpriced with an alpha of 2.2%

Analysts may use regression analysis to estimate the index model for a stock. When doing so, the slope of the regression line is an estimate of: A. The α of the asset. B. The unadjusted β of the asset. C. The adjusted β of the asset. D. The σ of the asset. E. The δ of the asset.

B. The unadjusted β of the asset.

What does it mean when Harvard Management Company says they have a "Hybrid Model" for fund management? A. They use a mixture of different asset classes. B. They use a mixture of internal and external asset managers. C. They use a mixture of top-down and bottom-up strategies. D. They use a mixture of passive and active management.

B. They use a mixture of internal and external asset managers.

Suppose the term structure for zero-coupon bonds is the following: Maturity (Years) YTM (%) 1 2% 2 4% 3 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. $1,883.64

A European call option has the following characteristics: strike price of $100, time to maturity of 1 year, and volatility of 40% per year. Additionally, the risk-free rate is 5% and the current price of the underlying asset is $90. Use the Black-Scholes formula to find the price of this option. To ease your computation, you are given CDF values for the standard normal distribution at various points: N(-0.44) = 0.330, N(-0.34) = 0.367, N(-0.24) = 0.405, N(-0.14) = 0.444, N(-0.04) = 0.484, N(0.06) = 0.524, N(0.16) = 0.564, N(0.26) = 0.603. A. $11.96 B. $12.18 C. $12.25 D. $12.30 E. $12.43

C. $12.25

Suppose there is no arbitrage opportunity. The premiums of 1-year call option and put option on Apple's stock with strike price $120 are $8 and $3, respectively. The annual risk free rate is 1%, and both of the options are European options. Assume that Apple does not pay dividends. What is the current price of the Apple's stock? A. $113.81 B. $120.00 C. $123.81 D. $125.00 E. $139.81

C. $123.81

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%. 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.

C. 1.92 years

Stock A has an expected return of 10% and standard deviation of 20%. Stock B has an expected return of 8% and standard deviation of 25%. Assume that stock A and B have a correlation of 0.5. You form a portfolio with an expected return of 9%. What is the portfolio's standard deviation? A. 3.81% B. 17.85% C. 19.53% D. 22.50% E. 25.25%

C. 19.53%

A trader short sold a share of Tesla when its price was $1,200 with an initial margin of 50%. If the current price of Tesla is $1,000, what is the trader's rate of return on this investment? Assume the interest rate on any cash balances is 0%. A. 20.00% B. 26.67% C. 33.33% D. 40.00% E. 46.67%

C. 33.33%

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%

Consider European call options with a maturity of one year on a stock that does not pay dividends. The stock's current price is $100, its annual volatility is 20%, and the risk-free rate is 0%. Which of the following call options has the highest time value? A. A call option with a strike price of $20 B. A call option with a strike price of $60 C. A call option with a strike price of $100 D. A call option with a strike price of $140 E. A call option with a strike price of $180

C. A call option with a strike price of $100

ou bought an option that is expiring the next day, but forgot its type (i.e., call or put) and exercise price. Suppose that the price of the underlying asset dropped from $50 to $40 the day after you bought the option (i.e., immediately before the option expires), which of these options do you hope you bought? In other words, which of these options' values will increase by the most upon this stock price decrease? A. A call with exercise price of $55 B. A call with exercise price of $45 C. A put with exercise price of $45 D. A put with exercise price of $35 E. Indifferent between at least two of the above.

C. A put with exercise price of $45

You invest 40% of your portfolio in a risky portfolio that has 12% expected return and 20% standard deviation. The rest of your portfolio is invested in the risk-free asset with a risk-free rate of 3%. What is the expected return and standard deviation of your portfolio? A. Expected return is 4.8%, standard deviation is 8% B. Expected return is 8%, standard deviation is 4.8% C. Expected return is 6.6%, standard deviation is 8% D. Expected return is 6.6%, standard deviation is 20% E. Expected return is 8%, standard deviation is 20%

C. Expected return is 6.6%, standard deviation is 8%

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. 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%

C. R1 = 10.00%; R2 = 5.00%

Which of the following is true? A. A risk averse individual will choose to play a fair game (e.g., a coin flip where you win $100 if heads, lose $100 if tails). B. We generally assume that investors are risk neutral. C. The riskiness of an overall portfolio is usually quantified using its variance or standard deviation. D. A risk averse individual will always pick the portfolio with the lowest standard deviation. E. A risk neutral individual will always pick the portfolio with the lowest standard deviation.

C. The riskiness of an overall portfolio is usually quantified using its variance or standard deviation.

A zero-coupon risk-free asset with two years of maturity has a face value of $150. Its current price is $130. At the same time, European call and put options on IBM with a maturity of two years and strike price of $150 are traded at $3.40 and $5.20, respectively. The current price of IBM is $137. Is the risk-free asset overpriced or underpriced? If it is overpriced or underpriced, what is the arbitrage profit of the strategy that uses one risk-free asset? A. Fairly priced B. Overpriced; arbitrage profit = $8.80 C. Underpriced; arbitrage profit = $8.80 D. Overpriced; arbitrage profit = $1.60 E. Underpriced; arbitrage profit = $1.60

C. Underpriced; arbitrage profit = $8.80

Suppose all the options are priced based on Black-Scholes formula. Which European call option has the highest price? (Strike price is X, years to maturity is T, all options share the same underlying stock, which does not pay dividends, and the risk-free rate is 0%.) A. X=50, T=1 B. X=100, T=1 C. X=50, T=2 D. X=100, T=2 E. Not enough information

C. X=50, T=2

A stock currently has a bid price of $112.50 (for 500 shares) and an ask price of $113.00 (for 300 shares). An investor submits a market buy order for 200 shares. Will it be immediately executed and at what price? A. Yes, it will be executed at $112.50 per share. B. Yes, it will be executed at $112.75 per share. C. Yes, it will be executed at $113.00 per share. D. No, it will not be executed immediately.

C. Yes, it will be executed at $113.00 per share

Joseph is a passive investor. He invests 60% of his portfolio in the market portfolio and 40% in the risk-free asset. The risk-free rate is 3% and the market portfolio produces 7% expected return. What is the CAPM alpha and beta of his portfolio? A. alpha=0%, beta=1 B. alpha=5.9%, beta=1 C. alpha=0%, beta=0.6 D. alpha=5.9%, beta=0.6 E. alpha=0%, beta=0.4

C. alpha=0%, beta=0.6

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%. What is the bond's price? A. $826.45 B. $1,000 C. $1,100 D. $1,200 E. Not enough information to determine.

D. $1,200

There is a forward contract on GameStop stock with forward price of $250 and maturity of 5 years. The present value of the dividends is $30. The 5-year spot rate is 3%. What is the current price of GameStop stock? Assume no arbitrage holds. A. $185.65 B. $215.65 C. $220.00 D. $245.65 E. $250.00

D. $245.65

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

European call and put options on a stock, with the same exercise price and maturity of 1 year, are trading for $10.26 and $2.17, respectively. The current price of the stock is $50, and the risk-free rate is 5%. What must be the exercise price of the options if no arbitrage holds? A. $41 B. $42 C. $43 D. $44 E. $45

D. $44

A share of Tesla is currently trading at $1,000. Suppose the stock price will either go up 10% or down 10%, with equal likelihood, in each of the next two years. What is the price of a call option that expires in two years and has a strike price of $1,000 based on a binominal tree with annual periods? Assume a risk-free rate of 0%. A. $45.00 B. $47.50 C. $50.00 D. $52.50 E. $55.00

D. $52.50

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. 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

D. $997.71

Assume the CAPM is true. Suppose that the standard deviation of Apple's stock (AAPL) is 10% and that its expected return is 9%. AAPL has a CAPM beta of 1.5. The risk-free rate is 0%. If the correlation between AAPL and the market portfolio is 0.75 what is the Sharpe Ratio of the market portfolio? A. 0.9 B. 1.0 C. 1.1 D. 1.2 E. 1.3

D. 1.2

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%

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. 4.2%

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

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

A stock currently has a bid price of $112.50 (for 500 shares) and an ask price of $113.00 (for 300 shares). An investor submits a limit buy order for 200 shares at a price of $112.75 per share. Will it be immediately executed and at what price? A. Yes, it will be executed at $112.50 per share. B. Yes, it will be executed at $112.75 per share. C. Yes, it will be executed at $113.00 per share. D. No, it will not be executed immediately.

D. No, it will not be executed immediately.

Which of the following is true about the market index model when applied to a sample of past monthly returns for a stock and the US equity market: A. The stock's beta (𝛽𝛽) varies from month to month in the sample depending on news about the market index. B. The stock's alpha (𝛼𝛼) varies from month to month in the sample depending on news about the firm. C. The stock's residual return (𝜖𝜖 or 𝑒𝑒) varies from month-to-month in the sample depending on news about the market index. D. The stock's residual return (𝝐𝝐 or 𝒆𝒆) varies from month-to-month in the sample depending on news about the firm. E. None of the above.

D. The stock's residual return (𝝐𝝐 or 𝒆𝒆) varies from month-to-month in the sample depending on news about the firm.

Which of the following is true about forwards? A. Their payoffs are non-linear in the spot price of the underlying at maturity. B. The buyer is not obligated to complete the purchase of the underlying at maturity. C. Forwards are standardized and traded on exchanges. D. They are typically priced based on a no arbitrage relation. E. None of the above are true.

D. They are typically priced based on a no arbitrage relation.

Suppose all the options are priced based on Black-Scholes formula. Which European put option has the highest price? (Strike price is X, years to maturity is T, all options share the same underlying stock, which does not pay dividends, and the risk-free rate is 0%.) A. X=50, T=1 B. X=100, T=1 C. X=50, T=2 D. X=100, T=2 E. Not enough information

D. X=100, T=2

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

You started a new job and you are opening a 401K account. Your employer offers two mutual funds for your 401K plan, a domestic equity fund that has expected returns of 10% and a standard deviation of 20%, and an international equity fund that has expected returns of 10% and a standard deviation of 30%. You should invest all of your retirement savings in the domestic equity fund because it offers the same returns with lower 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. 100% invested in the domestic portfolio dominates 100% invested in the international portfolio, but investing some of your savings domestically and some internationally is likely even better because the diversification will decrease your portfolio's standard deviation below the standard deviation of either fund on its own.

You are planning to invest your savings in stocks and hoping to invest well so that you have enough money for the down payment on a house when you graduate. However, you want to limit downside risk. To avoid risk, you should invest in a portfolio of at least 50 stocks. Then all the risk will be diversified away. 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. By forming the portfolio you can diversify (eliminate) idiosyncratic risk but not systematic (market) risk. Therefore the claim that you will get rid of all the stock risk by forming the portfolio is wrong.

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.

Exercising a call option early can be a good idea, even if the stock doesn't pay dividends, if there is a violation of the EMH and you predict that the stock's price will soon fall. 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. Even if you believe the stock's price is about to fall and you want to exit your option position early, you will get a higher price from selling your option than you would generate by exercising it. Specifically, put-call parity tells us that the option's value is C = P + S - PV(X), which is greater than S - X, the payoff you would generate by exercising the option early.

Money market investments are risk free. Do you agree or disagree with this advice? Why? [Make sure your answer is clear and try to limit it to a few sentences.]

Disagree. Money market investments are low-risk, but they are not risk-free. Widening money market spreads (i.e., increased interest rates) and defaults on money market instruments such as commercial paper issued by Lehman Brothers during the financial crisis are an important reminder that money market investments are not risk-free.

You own a portfolio of Texas municipal bonds. Your financial advisor suggests that you diversify your portfolio by adding municipal bonds from California, Florida, and New York. Do you agree or disagree with this advice? Why? [Make sure your answer is clear and try to limit it to a few sentences.]

Disagree. New York and California municipal bonds are exempt from New York and California state taxes. This is a valuable benefit for New York and California state tax payers, which will cause them to push up the price of New York and California municipal bonds. As a result, their yields will likely be unattractive to a Texas investor. By contrast, Florida has no state income tax, so Florida municipal bonds could be attractive to a Texas investor.

If short selling is not regulated it can lead to inflated asset prices. 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. Short selling tends to have the opposite effect. Allowing traders to trade on negative information should make prices more accurate, and in particular should better incorporate negative information. Limiting short sales can prevent this from happening and may lead to inflated prices and bubbles in some cases.

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.

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.

In March of 2020, the spot price of West Texas Intermediate (WTI) crude oil fell to less than $20 a barrel while the WTI futures contract for December 2020 delivery remained above $30 per barrel. Because interest rates were close to 0%, this created an arbitrage opportunity. 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. To replicate the futures contract, you would need to buy a barrel of oil in March and store it until December. In March 2020 oil storage capacity was almost completely full everywhere in the world. Thus, the marginal cost to store an additional barrel of oil was very high. If the effective cost to store another barrel of oil from March to December was $10, this would explain the difference between the spot and futures prices.

You are a financial engineer and create a new financial security that pays off $140 in economic recession and $80 in economic expansion after 1 year. You want to find out the current price of this asset. You decide to apply binomial pricing using a stock and a risk-free bond. The stock price is $90 and it becomes $70 in recession and $110 in expansion next year. The risk-free rate is 0%. What is the current price of the new financial security if there is no arbitrage? A. $70 B. $80 C. $90 D. $100 E. $110

E. $110

suppose you predict that the market portfolio will have a 5% return next year if the economy is in expansion and a -5% return if the economy is in recession. The probability of an expansion is 50%, and the probability of a recession is 50%. There is a 2x leveraged market ETF (you can think of this as a stock) which doubles the market portfolio return. In other words, in expansion, it has a 10% return, and in recession, it has a -10% return. What is the correlation between the market portfolio and the 2x leveraged market ETF? A. -1 B. -0.5 C. 0 D. 0.5 E. 1

E. 1

Jessica wants to invest in two stocks, Tesla (TSLA) and GameStop (GME). TSLA has an 8% expected return and a 20% standard deviation. GME has a 16% expected return and a 40% standard deviation. The correlation between the two stocks is 0.75. Jessica chooses a portfolio that has an expected return of 10%. What is the standard deviation of her portfolio? A. 5.5% B. 7.2% C. 16.64% D. 18.76% E. 23.45%

E. 23.45%

Assume that the CAPM is true. Stock A has a beta of 0.5 and a risk premium of 7%. The risk-free rate is 2%. Prateek wants to create a portfolio that invests 50% of its asset in risk-free asset and the rest in the market portfolio. What is the expected return of Prateek's portfolio? A. 3.5% B. 6% C. 7% D. 8% E. 9%

E. 9%

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.

E. All of these are common behavioral biases. [Accepted answer due to grading mistake]

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

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

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.

Which of the following is true about options pricing? A. The price of an option increases if the volatility of the underlying asset decreases. B. The intrinsic value of an option decreases as you approach expiration. C. Put-call parity works equally well for European and American options. D. The Black-Scholes formula incorporates time-varying interest rates and volatility. E. None of the above are true.

E. None of the above are true.

You are forming a portfolio consisting of stock A and B. Stock A has an expected return of 8% and standard deviation of 15%. Stock B has an expected return of 8% and standard deviation of 20%. What is the optimal weight to put on each stock for a risk averse investor? A. 100% stock A. B. 100% stock B. C. 50% in each. D. 57% in stock A and 43% in stock B. E. Not possible to determine based on the given information.

E. Not possible to determine based on the given information.

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%. 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%

E. The bond's price will decrease by 19.2%

Stock A has an expected return of 8%. Stock B has an expected return of 10%. Which of the following cannot be consistent with the CAPM? A. Stock A has a standard deviation of 20%, and stock B has a standard deviation of 40%. B. Stock A has a variance of 0.04, and stock B has a variance of 0.08. C. Stock A has a Sharpe Ratio of 0.2, and stock B has a Sharpe Ratio of 0.4. D. Stock A has a beta of 0.5, and stock B has a beta of 1.0. E. These statements could all be consistent with the CAPM.

E. These statements could all be consistent with the CAPM.

Stock A has an expected return of 8%. The market portfolio has an expected return of 10%. Which of the following cannot be consistent with the CAPM? A. Stock A has a standard deviation of 20%, and the market has a standard deviation of 40%. B. Stock A has a variance of 0.04, and the market has a variance of 0.08. C. Stock A has a Sharpe Ratio of 0.2, and the market has a Sharpe Ratio of 0.4. D. Stock A has a beta of 0.5, and the market has a beta of 1.0. E. These statements could all be consistent with the CAPM.

E. These statements could all be consistent with the CAPM.

When an investor who likes portfolio-level expected returns, dislikes portfolio-level variance, and doesn't care about anything else chooses the most efficient risky portfolio to combine with the risk-free asset, they maximize: F. Beta. G. The expected return. H. The Treynor measure. I. Jensen's alpha. J. The Sharpe ratio.

J. The Sharpe ratio.