Dr. P.V. Viswanath
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### Fall 2013

FIN 632: Intro to Financial Decision Making
Prof. P.V. Viswanath
Fall 2013

Sample Questions

1. What is the difference between a market order and a limit order?
2. The following bonds are available (making annual coupon payments):
 Bond Maturity Coupon Price A 1 0% 909.09091 B 2 5% 913.22314 C 3 10% 1000 D 4 0% 683.01346

What would be your prediction for the yield on three year zero coupon bonds, one year from today, if you knew that the liquidity premium is equal to 1% per year for all maturities?

3. Assume the following term structure (yields on zero coupon bonds)
 Years 0.5 1 1.5 2 2.5 Rate 11 10.5 10 9.5 9

Two-year bonds that are strippable and paying a coupon of 10.374% are selling at a yield of 10%. Is it worthwhile to strip them and sell the stripped pieces? Or is it better to sell them as a unit? (Assume that you own them and that the strips may be sold at spot yields.) (15 points)

Note: Stripping a coupon bond means selling separately the rights to each of the coupons and to the face value of the bond. Assume that coupons are paid semi-annually.

4. The following bonds are available at the present time (making annual coupon payments)
 Bond Maturity Coupon Price A 1 0% 909.09091 B 2 5% 913.22314 C 3 10% 1000 D 4 0% 683.01346
1. If the expectations theory of the yield curve is correct, what is the market expectation of the price that Bond C will sell for next year?
2. If you believe that the liquidity premium is 1% per annum on all bonds with a maturity greater than one year, what is your prediction for the spot rate on one year bonds next year?
3. If you believe that the liquidity premium is 1% per annum on all bonds, and likely to remain at 1% for the foreseeable future, what is your prediction of the spot rate on two year bonds next year?

5. Probabilities for three states of the economy and probabilities for the returns on a particular stock in each state are shown in the table below:
6.  State of the Economy Probability of economic state Stock Performance Probability of Stock Performance in Given Economic State Good 0.3 Good .6 Poor .4 Neutral 0.4 Good .5 Poor .5 Poor 0.3 Good .2 Poor .8
1. (5 points)What is the probability that the economy will be neutral and the stock will experience poor performance?
2. (5 points)Is the stock performance independent of the state of the economy?
3. (5 points)What is the expected return on the stock, assuming that the state of the economy is good?
4. (5 points)If a good stock return is 15% and a bad stock return is 5%, what is the expected return on the stock?

7. Read the following article by Jason Booth from the Wall Street Journal of 3/27/2000 and answer the questions that follow:

Pakistani Stocks Have Soared More Than 70% Since October in Wake of a Military Takeover

Who says a coup d'etat is bad for the market? Five months after Pakistan's military seized power, Karachi's stock market is booming: The KSE 100 index has risen more than 70% since October, making it Asia's best-performing market this year.

Even as President Clinton visited Pakistan during the weekend and pressed for a return to democratic rule, analysts maintain the stock market's recent success is directly related to improved sentiment following the military takeover.

Despite red tape that foreign investors say can delay repatriation of funds, the market has been buoyed by hope that the military government can reduce the alleged corruption and bureaucratic cronyism many felt hobbled efforts to deal with Pakistan's economic difficulties.

"Internationally, there was a negative reaction" to the coup, says Farrukh Sabzwari, Credit Lyonnais country manager in Karachi. "But in Pakistan, there is the realization it is what we needed. Economically, we were at our lowest ebb."

In particular, the financial markets have applauded the appointment of Shaukat Aziz, who formerly headed Citibank's global private-banking operation, as finance minister. "In the previous government, there were so many political appointments that it was hard to expect any economic progress," says Saqib Masood, an analyst at Jardine Fleming in Karachi. "Because the new government has brought in technocrats, people feel the economy can get back on track."

President Clinton's visit also has helped lift the market in recent weeks, analysts say, because it is seen as acceptance of the new regime by the international community. At the same time, closer relations between Pakistan and the U.S. should prompt the government to focus more on economic and social issues than military affairs.

"The market perceives that the visit will prod the government to put more money toward [economic] development," says Arshad Arif, ABN Amro First Capital equity strategist. If the government is serious about focusing on economic development, it will be likelier to ease military tensions on Pakistan's border with India, he says. "The military realizes that Pakistan can't afford a war at this time, so they will try to improve the economy before they take action on that front."

While politics sparked the rally, economic factors have fanned it. The price of cotton, Pakistan's largest export, has rebounded strongly since the start of the year after two years of steady declines. Because Pakistani cotton farmers enjoyed a bumper crop in 1999, they have reaped significant benefit from the gain.

The most popular and most liquid stocks in Pakistan represent three of the country's biggest industries: Pakistan State Oil, Hub Power Co., the country's largest energy company, and Pakistan Telecom, whose shares have gained about 60% this year.

Stocks have become one of the few desirable investments for Pakistanis. Domestic interest rates have fallen by almost half during the past two years, making interest-bearing investments less attractive. The exchange rate between the Pakistani rupee and the U.S. dollar has remained relatively stable for months, making foreign-currency speculation difficult. Investing in property, meanwhile, looks about to become a lot less popular because of pending bankruptcy reforms that will make it easier for banks to seize the personal assets of debtors, primarily property holdings.

But while domestic investors alone have driven Pakistan's rally so far, it may require an influx of foreign investment to sustain further strong gains. The bad news for Karachi, however, is that regional fund managers say they aren't buying Pakistan's recovery story.

Brad Aham, who invests in emerging markets for State Street Global Advisors in Boston, is no stranger to risk. But he is steering clear of Pakistan. "Between nuclear testing, coups and the Kashmir conflict, there are a lot of other places we can place our bets," he says.

Besides the quite-obvious political risks, U.S. investors in Pakistan have complained about problems repatriating funds after selling shares. While the situation isn't as bad as in Malaysia, where punishing exit taxes were removed only recently, some investors say they have experienced delays exceeding two months to get their money out of the country.

"We could sell the securities," says Steven Schoenfeld, head of international equity strategy at Barclays Global Investors in San Francisco. "But we never were 100% sure we could immediately repatriate the money."

1. Is the price shock caused by potential military takeovers diversifiable risk or non-diversifiable risk? (10 points)
2. Comment on the following statement: One should not consider a potential military take-over as a source of risk because military take-overs are good for stocks. (10 points)
3. Is the risk of unexpected legislation increasing the cost of repatriating funds after selling shares, such as occurred a few years ago in Malaysia, diversifiable risk or non-diversifiable risk? (10 points)

8. The following are average yields on U.S. Treasury bonds at two different times.
 Yield to Maturity Term to Maturity January 15, 19XX May 15, 19XX 1 year 7.25 8.05 2 years 7.50 7.90 5 years 7.90 7.70 10 years 8.30 7.45 15 years 8.45 7.30 20 years 8.55 7.20 25 years 8.60 7.10

a. Assuming that the above bonds are zero coupon bonds, calculate the forward rate for a three-year U.S. Treasury zero-coupon bond two years from May 15, 19XX. (10 points)

b. Assuming that the above bonds are coupon bonds selling at par, describe a procedure that would enable you to determine the forward rate for a three-year U.S. Treasury zero- coupon bond two years from May 15, 19XX. What other information do you require, if any? (10 points)

c. i. Discuss how the Unbiased Expectations Hypothesis could explain the January 15, 19XX term structure shown above. (5 points)

c. ii. Discuss how the Liquidity Premium Hypothesis could explain the January 15, 19XX term structure shown above. (5 points)

d. How might you explain the change in the term structure from January to May? (10 points)

9. Suppose that market risk premium is 6% and the risk-free interest rate is 3%. Using the data in the table below, calculate the expected return of investing in Starbucks's stock and Hershey's stock.

10.  Starbucks Hershey Beta 1.04 0.19

11. Revlon's equity beta, according to Yahoo (http://finance.yahoo.com/q/ks?s=REV) is 1.546. The current yield on 10-year Treasuries (as of 1 p.m., May 11, 2004, http://www.bloomberg.com/markets/index.html) is 4.78%. Assume that the market risk premium is 5.5% (this is a fair estimate based on historical data for the last fifty or so years). What is the required rate of return on Revlon's equity, according to the Capital Asset Pricing Model? (5 points)

12. Suppose you have estimated the following Fama-French-Carhart (FFC) factor betas:
Factor GE
Mkt
0.747
SMB
-0.478
HML
-0.232
PR1YR
-0.147

You have also estimated the average monthly return on the four (FFC) factor portfolios over the last eighty-odd years (as given in the table below). However, you believe that investors are much more risk-averse today and you increase each of the factor premiums by 10 basis points over and above the historical average. The risk free rate is assumed to be 12.486%

Factor Average Monthly Return
Mkt - rf
0.64%
SMB
0.17%
HML
0.53%
PR1YR
0.76%
1. (10 points) What is the required rate of return on GE according to the FFC model?
2. (10 points) Your friend Yevgeny believes that the CAPM is a much better model than the FFC model because the FFC is an empirical model, as opposed to the CAPM, which makes sense from a theoretical point of view. Suppose his estimate of the market beta of GE is the same as your estimate and he shares your views on the estimation of the market risk premium? If you believe that GE is currently properly priced, would Yevgeny believe that GE is properly priced, overvalued or undervalued?
3. (Bonus: 10 points) Do you agree with Yevgeny as to the superiority of the CAPM over the FFC model? Explain.
13. Questions on the CAPM (Chapter 9 of Bodie, Kane and Marcus)

Sample Question Solutions

3. The coupons from the 2 year bond would be \$10.374/2 = 5.187 every six months for 2 years, plus \$100 at the end of 2 years. Pricing the bond, using the given yield of 10% gets us \$100.664. However, computing the present value of the strip cash flows separately at the given term structure yields and adding them up gets us 101.94. Hence stripping the bond and selling the pieces is better. (Note that the rates, here, are given in bond-equivalent form, hence the 5.187 coupon has a PV of 5.187/(1.05)3 = 4.48.

 Years 0.5 1 1.5 2 Rate 11 10.5 10 9.5 Strip Cash Flow 5.187 5.187 5.187 105.187 PV 4.92 4.68 4.48 87.36

8. The expected return on investment is: Ri = Rf + Betai * ( E[RMkt] - Rf )

• The expected return of starbucks stock = 3% + 1.04 * 6% = 9.24%.
• The expected return of Hershey stock = 3% + 0.19 * 6% = 4.14%.

10. a. In order to provide the required rate of return, we need to use the risk free rate of return. The annual 12.486% risk-free rate is equivalent to (1.12486)(1/12) -1 = 0.00985 or 0.985% per month; the required rate of return according to the FFC model would be 0.985 + 0.747(0.74) - 0.478(0.27) - 0.232(0.63) - 0.147(0.86) = 0.011361% per month or (1.011361)12 = 14.52% p.a. (Note the risk premia have been increased by 10 bp.)

b. If we use the CAPM and we use the same market beta and the same market risk premium, the required rate of return would be 0.985 + 0.747(0.64) = 1.46308% or 19.04%; hence according to Yevgeny, GE is probably underpriced (assuming that you and Yevgeny share views regarding GE's future cashflows as well).

c. The CAPM is a model based on clearly-stated theory. The FFC model is an empirical model; its success may simply be limited to a particularly sample -- it may not work next year. Furthermore, since we don't know under what circumstances it will work, we don't know under what circumstances it won't work, either.

It is not even clear that the FFC model does better than the CAPM in practice; however, according to Berk and DeMarzo, the FFC factor specification does better than the CAPM in measuring the risk of actively managed funds. Since the FFC model has more degrees of freedom -- the risk measure is four-dimensional, it makes sense to expect it to do better with complex securities and portfolios.