(3 points) Under what circumstance will a portfolio manager receive this gain to diversification?

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1 I. Essay/roblem ection (15 points) (6 points) The current profits, which have already been paid in dividends, of a firm equal $500,000. These profits are expected to grow at a rate of 3.8 percent per year into an indefinite future. The market value of the firm equals $21,625,000. If the risk free rate of interest equals 1.4 percent, what is the risk premium built into the underlying rate of time discount of the firm s future profits? HOW ALL WORK AN EXLAIN! (6 points) tate precisely the Gain to iversification of a portfolio of two assets, which offer random returns X and Y. The portfolio manager places a fraction β of her wealth in the asset offering return X, with the remaining fraction in the asset offering return Y. (3 points) Under what circumstance will a portfolio manager receive this gain to diversification? Blue Exam 1 age 1 of 8 Econ 380 Fall 2013

2 II. MULTILE CHOICE (90 points) Mary is considering a portfolio consisting of two assets. The first asset offers a random return X and the second asset offers a random return Y. The probabilities of all possible joint outcomes of these assets are shown in the table below: (xi,yj) y1 = -15 y2 = 45 x1 = x2 = The outcomes are percentage returns per dollar held in the respective assets. 1. The expected return per dollar held in the first asset, X, equals percent. a) 10 b) 11 c) 12 d) 13 e) None of the above are correct. 2. The standard deviation of return, or risk, of the second asset, Y, equals: a) b) c) d) e) None of the above are correct. 3. The correlation between returns to these assets, XY, equals: a) b) c) d) e) None of the above are correct. 4. If Mary holds 60 percent of her wealth in the first asset, offering return X, and the rest of her wealth in the second asset, offering return Y, her expected portfolio return, p, will equal percent. a) 14.6 b) 16.2 c) 17.8 d) 19.4 e) None of the above are correct. 5. If Mary holds 60 percent of her wealth in the first asset, offering random return X, and the rest of her wealth in the second asset, offering return Y, the standard deviation of portfolio return, or risk that Mary confronts, will equal: a) b) c) d) e) None of the above are correct. Blue Exam 1 age 2 of 8 Econ 380 Fall 2013

3 6. Over the business cycle, movements in interest rates are. I.e., in the market for loanable funds, shifts in the supply curve are shifts in the demand curve. a) countercyclical; greater than c) procyclical; less than b) countercyclical; less than d) procyclical; greater than 7. Ellen, having lunch with her friend Kim, remarks: o you remember that coupon bond I bought one year ago, the one that offered a current yield of 2.8 percent? Well, I just collected my first coupon and sold the bond for $1,000 dollars. My rate of return was 4.9 percent. Kim does a few calculations in her head and replies: You must have paid dollars for that bond. a) b) c) d) e) None of the above are correct. 8. The impact of an increase in the risk of equities (stocks) on the bond market is illustrated as: a) b) c) d) e) None of the above are correct. 9. Winners of state lotteries are often given the choice of receiving their winnings either as one lump sum (based upon a rate of time discount used by the state, itate) or as annual payments spread out over a period of twenty or more years. In states where it is allowed, investors will sometimes approach lottery winners and offer to pay them a lump sum in exchange for the lottery winner signing over to the investor the right to receive the stream of annual payments. Under what circumstances if iwinner and iinvestor are the rates of time discount for the winner and investor - might we expect the winner to accept an offer from the investor? a) iwinner < iinvestor < itate d) itate < iinvestor < iwinner b) iinvestor < iwinner < itate e) None of the above are correct. c) itate < iwinner < iinvestor Blue Exam 1 age 3 of 8 Econ 380 Fall 2013

4 10. uppose the Federal Government decided to make interest income from municipal bonds subject to federal income tax. The impact on the municipal bond market from this change in tax law is illustrated as: a) b) c) d) e) None of the above are correct. 11. An increase in expected inflation from 2 to 6 percent will result in a change in real after tax interest return equal to percent for households facing a marginal income tax rate of 40 percent. a) 2.4 b) 1.6 c) 0 d) 1.2 e) None of the above are correct The impact of an increase in expected rate of inflation on the bond market is illustrated as: a) b) c) d) 1 0 e) None of the above are correct According to the preferred habitat or liquidity premium hypothesis, what does a flat (horizontal) yield curve indicate? a) hort-term interest rates are expected to remain stable. b) hort-term interest rates are expected to rise. c) hort-term interest rates are expected to fall. d) Long-term interest rates are expected to remain stable. e) uantities demanded and supplied are distributed equally over all terms to maturity Blue Exam 1 age 4 of 8 Econ 380 Fall 2013

5 In the United tates the quantity demanded of loanable funds d U = i and the quantity s supplied of loanable funds U = 140i 150. In the Rest of the World (ROW), the quantity demanded d s of loanable funds ROW = i and the quantity supplied of loanable funds ROW = 85i If we have zero capital flows between the U and ROW, the interest rate in the U will equal: a) 3.0 b) 4.6 c) 5.2 d) 6 e) None of the above are correct. 15. If we have zero capital flows between the U and ROW, the quantity of loanable funds exchanged in the ROW will equal: a) 180 b) 205 c) 230 d) 255 e) None of the above are correct. 16. If capital is free to flow between the countries, the equilibrium quantity of loanable funds exchanged worldwide will equal: a) 880 b) 900 c) 940 d) 1,000 e) None of the above are correct. 17. If capital is free to flow between the countries, the excess demand for domestic loanable funds in the United tates will equal: a) -90 b) 0 c) 90 d) 180 e) None of the above are correct. Blue Exam 1 age 5 of 8 Econ 380 Fall 2013

6 Consider the following tilt in the Treasury Yield Curve: i Term to Maturity 18. The tilt in the Treasury Yield Curve shown above could be explained under the preferred habitat or liquidity premium hypothesis by: a) an increase in the average term to maturity of the national debt. b) an increase in the expected interest yields to bonds issued in the future. c) an increase in term premiums offered on long term bonds. d) a decrease in the average term to maturity of the national debt. e) Both b) and c) are correct. 19. The tilt in the Treasury Yield Curve shown above could be explained under the expectations hypothesis by: a) an increase in the average term to maturity of the national debt. b) an increase in the expected interest yields to bonds issued in the future. c) an increase in term premiums offered on long term bonds. d) a decrease in the average term to maturity of the national debt. e) Both b) and c) are correct. 20. The tilt in the Treasury Yield Curve shown above could be explained under the market segmentation or segmented markets hypothesis by: a) an increase in the average term to maturity of the national debt. b) an increase in the expected interest yields to bonds issued in the future. c) an increase in term premiums offered on long term bonds. d) a decrease in the average term to maturity of the national debt. e) Both b) and c) are correct. 21. uppose that your marginal federal income tax rate is 30%, the sum of your marginal state and local tax rates is 5%, and the yield on a thirty-year corporate bond is 8%. You would be indifferent between buying this corporate bond and buying a thirty-year municipal bond issued within your state (assuming no differences in liquidity, risk, and costs of information) if the municipal bond offers a yield of percent. a) 5.2 b) 5.6 c) 6.4 d) 7.2 e) 8% Blue Exam 1 age 6 of 8 Econ 380 Fall 2013

7 Consider the graph below: µp A CML B C E rf E p 22. The upward slope of the EE frontier is due to the presence of a) expectations of higher returns in the future. b) risk aversion in financial markets. c) a relative abundance of riskier assets traded in financial markets. d) All of the above. e) None of the above. 23. The concave shape of EE is explained by a) diminishing marginal returns to risk taking. b) gains to diversification of portfolios. c) declining risk premiums as portfolio risk falls. d) All of the above. e) None of the above. 24. The combination(s) of risk and return is (are) unattainable in efficient financial markets. a) A b) A and c) C d) A and C e) None of above are correct. 25. Recalling our classroom discussion, the combination of portfolio risk and return is one that might be (approximately) reached by an average trader (most of us) heeding the advice of Burton Malkiel, offered in his classic book on financial markets A Random Walk own Wall treet. a) A b) B c) C d) e) Both b) and d) are correct. 26. If the government were to simultaneously increase the personal income tax and the corporate profits tax, bond prices: a) would fall. c) would rise. b) would be unaffected. d) might either rise or fall. Blue Exam 1 age 7 of 8 Econ 380 Fall 2013

8 27. As we move from an M1 definition of money to an M2 definition, we include assets and liquidity. a) more; increases d) more; decreases b) fewer; decreases e) None of the above are correct. c) fewer; increases 28. Inflation falls below the level lenders and borrowers expected to prevail. As the result the realized, or ex post, real interest rate is than the expected, or ex ante, real interest rate. Wealth is transferred from. a) greater; debtors to creditors c) greater; creditors to debtors b) less; debtors to creditors d) less; creditors to debtors 29. In 2012, short term interest rates in pain rose above long term interest rates: the yield curve was inverted. A possible explanation for this event would be that bond traders a) expected the rate of inflation in pain to rise in the future. b) believed pain might soon enter a recession. c) found long term bonds to be less liquid than short term bonds in panish secondary markets. d) expected profitability of panish capital to rise in the future. e) preferred short term bonds over long term bonds. Consider the annual percentage yields offered on U.. Treasury Bills, Notes, and Bonds on Wednesday, eptember 25, ate 1 Mo 3 Mo 6 Mo 1 Yr 2 Yr 3 Yr 5 Yr 7 Yr 10 Yr 20 Yr 30 Yr 09/25/ Applying the Expectations Hypothesis to these yields, we can determine that bond traders expect the annual percentage yield offered on twenty (20) year bonds ten (10) years from this date will equal: a) 3.98 b) 4.16 c) 4.21 d) 4.58 e) None of the above are correct. Blue Exam 1 age 8 of 8 Econ 380 Fall 2013