Pace University
MBA 653 Financial Reporting, Analysis and Modeling of Corporate Activities
Prof. P.V. Viswanath
Fall 2007

Superquiz

Notes:

  1. If your answers are not legible or are otherwise difficult to follow, I reserve the right not to give you any points.
  2. If you cheat in any way, I reserve the right to give you no points for the exam, and to give you a failing grade for the course.
  3. You may bring in sheets with formulas, but no worked-out examples, or definitions, or anything else.
  4. You must explain all your answers. For the quantitative questions, you must show your formulas and youc computation, else you may get no credit at all.

1. Tamako wants to buy a car, but the sort of car that she wants costs $45,000. Unfortunately, she only has $23,000. Fortunately, she has access to a banker, who is willing to lend her the additional money at a stated interest rate of 10% per year. Tamako has to start making payments on the loan, two years after she has taken out the loan. If she wants to be done with repaying the loan in five years (that is, she will make 36 equal payments), what is the amount of her monthly payment? (10 points)

Another banker (let's call him Lazard) wants to compete with the first banker (let's call him JP). Lazard is willing to allow Tamako to make bi-monthly payments (once in 2 months), which Tamako finds attractive. However, the stated interest rate is 11%. What will Tamako's bi-monthly payments be, and will she go with JP or Lazard? Assume that the payments are not delayed as in the JP case (that is, there will be 30 payments, starting in two months). (10 points)

2. (40 points) Gerber Scientific Inc. (GRB) and SPSS Inc. (SPSS) are two stocks that Punita has been considering for her portfolio. Although she knows that diversification reduces risk and she would be better off investing in many assets, she believes that GRB and SPSS are good deals, right now, and she decides to put all of her money into these two stocks. Since the two stocks are in different industries (SPSS in Software and GRB in Scientific machinery), the correlation coefficient between the two stocks is quite low, on the order of 0.25. Punita has, in addition, come up with the following additional estimates for the two stocks:
 
SPSS
GRB
Expected Return
22%
18%
Standard deviation of returns
10%
23%

  1. Punita wants an expected return of 19% on her portfolio. How much should she invest in SPSS and how much in GRB?
  2. What would the standard deviation of returns on this portfolio be?
  3. Punita also has the opportunity to lend at a guaranteed rate of 5%. If she likes higher expected returns and lower standard deviation of returns, how should she combine the two risky stocks? What is the expected return on this portfolio of risky stocks?
  4. If Punita wanted to invest in the riskfree asset, as well as in the risky portfolio, how much should she invest in both, in order to get an expected reutrn of 10%?

3. (10 points each) Define and write two sentences about any four of these terms:

  1. moral hazard
  2. adverse selection
  3. volatility
  4. actuaries
  5. hedgers
  6. diversifying

4. (Bonus; 10 points): You expect to close on a house purchase in 2 months. You have already agreed on a price of $300,000. You only have $50,000 of the money needed for the purchase, but a bank has agreed to lend you the additional $250,000. The interest rate that you will have to pay on the loan depends on market conditions in 2 months, when you will actually need the money. You are worried that interest rates might go up, and you sell futures contracts on 10 year US Treasury Notes, with a nominal value of $250,000. This futures contract is a commitment to sell U.S. Treasury notes having a face value at maturity of $100,000 with a maturity of 10 years.

Will this increase or decrease your risk of interest rates changing between now and the time you buy your house? Why?