PRACTICE MIDTERM SPRING 2012 1. What purpose do financial asset serve: i) Companies. ii) Investors. iii) Government. 2.

Define and explain the relation among: i) Real Assets. ii) Financial Assets. iii) Liabilities. 3. When does a financial asset become a liability for a company? 4. Give five examples of how financial assets make an economy more efficient. 5. Explain how financial markets adjust prices to reflect the risk-return trade off in the securities market. 6. In an efficient market, what do security prices reflect? 7. For each of the following cases describe the type of market the asset will trade in: i) Post a for sale sign with the intention of selling my car. ii) Call an expert to price my car and to look for buyers. iii) Go to EBAY and find the best bidder for my car. iv) Take my car to the corner shop where they specialized in buying and selling used cars. 8. What are the regulations to control the use of inside information? 9. What dual role do specialists play in the execution of trades? Explain each role. 10. What is an IPO and what role a financial intermediary play in it. (Make sure that your answer includes the following: underwriter syndicate, book building, and prospectus.) 11. Explain the difference between primary and secondary markets. 12. List and explain the type of orders present in the market. 13. State the differences between common and preferred stocks. 14. Give five examples of financial assets that are money markets and five examples of capital markets. 15. What are you entitle to when you own common shares of a company.

IN T E

I M B
T D YS OA' A TVT CI IY Od r r es V lu e o m 2 ,2 1 2 1 12 0 0 1 ,8

L S MT H AT AC Pr e ic T e im 8 .8 0 4 50 1: 1 0 8 80 :2 .5 8

B YO D R U RE S
S A E HR S PR E IC

S L O DR EL R E S
S A E HRS PR E IC

40 0 10 0

8 .8 0 3 00 8 .4 0 3 80

1 0 8 .2 0 0 5 20 4 0 8 .8 0 0 5 00 2 0 8 .1 0 0 6 30 1 0 8 .5 0 0 7 10 5 9 .0 0 0 00 1 0 ,0 0 9 .0 0 0 00

1 0 8 .4 0 0 2 30 1 8 .9 0 1 00 1 2 3 0 2 5 8 .8 0 1 50 7 .6 0 6 00 7 .7 0 5 20

1 9 .0 0 5 1 90 1 0 ,0 0 9 .0 0 4 00

3 7 .4 0 4 10 1 0 2 .0 0 0 00

5 9 .7 0 0 8 00

A o 1 : 34 .4 6 s f 91 : 7 1

16. From the previous table, what will be the average price I will pay if I want to buy 700 shares of IBM at market prices? 17. If I have put a stop order to sell when the stock falls below $76, how big (in number of shares) will a market sell order have to be before my order gets executed? (Use the previous table.) 18. If I put a limit order to sell 300 shares of IBM at $86.50, how many shares of IBM will have been bought if my order is executed? (Use the previous table.) 19. Fill in the missing values in the following table:
PRICES QUARTER 1/2/2000 3/1/2000 6/1/2000 9/1/2000 12/1/2000 RETURNS LN HPR

$100.00 -4.18% $105.06 $122.68 1.51% 9.54% 15.02%

Calculate the appropriate average for the HPR and LOG returns (the averages that take proper account of compounding.)

20. Let us assume that you have an account with a broker that lets you have an initial margin of 30%. If you want to short a security which is currently trading at $150 and you have $10,000 in T-Bills in your account, what is the maximum amount of shares you can short sale in order not to reach your margin limit? Let us assume that you short sale 100 shares, what is the maximum price the shares can have before you get a margin call (when you reach your limit)? 21. How will your answer change in the second part of problem 22 if you expect the company of the shares you shorted to give a $5/shr dividend while you have the short position? 22. Let us assume that you open an account with a broker with an initial deposit of $20,000.00. The margin limit in the account is 0.6. Let us also assume that right after you open the account you bought 1000 shares of a company for $30.00/shr. If after one month the price of a share goes down to $5.00, what is the minimum amount of cash you need to add to your deposits in your account so that your margin is not below the 0.6 limit? 23. Assume that the price of a security is $100.00 in 1/2/2000 and that the average quarter LOG return is 5.10%, calculate the price of the security in 1/2/2001. 24. Make the following transformations: a. Find the 1-year HPR return if the 1-year 10 times compounding return is 35%. b. Find the 1-year continuously compounding return if the 1-year HPR return is 25%. c. Find the 1-year 5 times compounding returns if the 1-year LOG return is 45%. 25. Assume that the price of a security is $100.00 in 1/2/2000 and that the geometric average quarter HPR return is 5.10%, calculate the price of the security in 1/2/2001. Why is the result different than the one obtained in problem 23? 26. If I have an investment with a total expected 12-time compounded return of 5% a year for the next 5 years with expected dividends of $1.0 in the first year, $2 the second year, $3 the third year, $4 the fourth year, and $5 for the fifth year, what will be the value of my investment after 5 years if the value of the investment is $100 today? 27. The following table lists a series of possible scenarios for daily LOG returns of a particular security. Calculate the expected return and volatility for the security.

s
1 2 3 4 5 6

p(s) rLN(s)
0.003% 0.978% 26.619% 60.646% 11.569% 0.185% -2.78% -1.79% -0.79% 0.20% 1.19% 2.18%

Express your answers in annual returns and annual volatility.

28. Using the value from problem 27, what is the probability that I will lose more than 0.79% in a day? 29. If the total probability that the returns of an asset will be within one standard deviation of its average is 68.26%, what is the probability that the return of an asset with average returns of 10.00% and standard deviation of 20.00% will fall below -10.00%. Assume a symmetric probability distribution. 30. You have a pair of assets to construct a risky portfolio. The annual expected return and volatility of each asset as well as their correlation are given in the following table. Calculate the total expected return and volatility of your risky portfolio if you invest $300,000 in asset AAA and $100,000 in asset BBB.

E( r )
AAA BBB
With

( r )
25% 35%

15% 25% -0.15

(rAAA,rBBB)

31. State 6 of the major assumptions of the CAPM model. Explain which two are the most important and what are their implications in the market. 32. If the CAPM is correct, what would you expect the reward is for taking specific risk (idiosyncratic risk)? What does the CAPM imply the reward should be proportional to? 33. You have two assets for which you are to construct a risky portfolio. Asset A has an expected return E(rA) = 15% and volatility of 25%. Asset B has an expected return of E(rB) = 25% and volatility of 35%. The correlation between the two assets is -0.15. Fill in the table below and choose the risky portfolio that will give the

optimal risk-reward to investors choosing to invest in a risky portfolio and a risk free one.

wAAA
0.9 0.7 0.5 0.4 0.1

wBBB
0.1 0.3 0.5 0.5 0.9

E(rP) (rP)
16.00% 20.00% 21.00% 22.25% 19.01% 21.86% 31.22%

SLOPE SCAL
0.76 0.83 0.80

Assume that the risk-free rate is 3.5%. 34. You have two possible scenarios for the future outcome of an economy. In the first scenario, the return on the market will be 25% while the one for company A will be 30%. In the second scenario, the market will have a return of 5% and the companys will be 7%. a. What will be the beta of this company with respect to the market if both scenarios are equally likely? b. What will be the alpha for this company if the risk free rate is going to be 4.5%? c. What will be the volatility of the specific returns for this company? 35. Let us assume that the market portfolio has an expected rate of return E( rM ) = 12.50% annually and an expected volatility of 17.51% annually. If the rate of return that T-bills give you annually is 3.5%, what would be the beta C of the complete portfolio of an investor who has a risk aversion of A=10.0. (Assume that the only two options for the investor to construct her portfolio are between the market and the risk-free asset.) What is the total volatility of the complete portfolio? What is the specific risk of this portfolio? 36. From problem 4, determine the CML line. (Calculate the slope and plot the relation between volatility and expected rate of return for the total portfolio C.) 37. From the following table: Asset A B C D Beta 1.2 0.9 1.1 0.8 Weight w 0.1 0.4 0.3 0.2

Calculate the expected return given by the market for each of the securities assuming that the market expected return is 8.0% annually and the risk-free rate is 2.5% annually. What would be the beta of a portfolio made of these securities with capital allocated to each according to the listed weights? What would be the expected return of this portfolio given by the market? 38. If you know that the expected return of the market is 10% annually and the risk-free rate is 3.0% annually, what would be the expected return (given by the market) for a security with beta of 0.5. 39. Given two securities with expected return given by the market and betas as follows: E(r1) = 10.7% , B1 = 1.1 and E(r2) = 17.0%, B2 = 2.0 What would be the expected return of the market and the risk-free rate? 40. Given that the volatility of the market is M = 15% and the beta of one asset with the market is A = 0.7 with volatility A = 25%, what is the specific (idiosyncratic) volatility of the asset? 41. Given that the volatility of the market is M = 15% and the total volatility of an asset is A = 35% with idiosyncratic volatility of SA = 25%, what is the beta of the asset with respect to the market? 42. If you have two assets, one with beta A = 0.5 and alpha (expected return of the idiosyncratic risk) A = -3.0% and another with B = 1.0 and B = 4.0%, what would your total expected return be if you short $666,000.00 worth of stock A and buy $333,000.00 worth of stock B? What would you expect the percentage of variance given by the market be for this portfolio made of A and B? Also assume that the specific volatilities for both stocks are the same S = 30%, what is the total volatility for this portfolio (the specific returns are not correlated)? 43. Assume you have $1,000,000.00 dollars to invest and that you found two assets with alphas A = -2.0% and B = 3.0%, how much capital you should invest in asset A and B to cancel out the market risk? Assume that A = 0.5 and B = 2.0. 44. If you have an asset with A = 0.85, total expected return equals to 25.0% annually, and annual volatility of 30%, what will be alpha of the asset given that the expected return of the market is 15.% , its volatility is 10%, and the risk free rate is 2.5% annually? For every dollar you invest in asset A, how many dollars you need to invest (long or short) in the market portfolio so that the market risk of the combined s p(s) r(s) R(s) portfolio Asset A Market (asset + or 1 20% -10.0% -5.0% the market) is zero? What 2 50% 5.0% 1.0% will be the 3 30% 25.0% 15.0% total volatility of this portfolio? 45. You have the market and an asset with the following possible returns and their join probabilities:

a.) What is the expected return of the asset and the market? b.) What is the expected beta of the asset with respect to the market? Use the riskfree rate to be 2%. c.) What is the alpha of the asset? d.) What is the specific volatility of the asset? Take the risk free to be 2.0%. 46. You have an asset which price today is $90.00. A year from now the asset will have an expected price of $104.00 and it will pay a dividend of $2.00. If the beta of the asset is 1.1, the expected return on the market is 6%, and the risk free rate is 3.5%, what will be the alpha of the asset? 47. Let us assume that the market is made out of three assets. Asset A has 1,000,000 shares outstanding and the current price of the asset is $15.00. Asset B has 2,000,000 shares outstanding and the current price of the asset is $20.0. Asset C has 3,000,000 shares outstanding and the current price of the asset is $16.00. What would be the weight of each asset in the market portfolio? If the CAPM is right, what is the allocation among these three assets to create the best mean variance portfolio (or the optimal portfolio)? 48. The stock of company A has an expected specific volatility of 10% and a beta of 1.1. The stock of company B has an expected specific volatility of 15% and a beta of 1.2. If you create a portfolio with 30% of the capital in asset A and 70% of the capital in asset B, what would be the total expected volatility of the portfolio if the expected volatility of the market is 20%? 49. The total volatility of an asset is 35%. If the percentage of the total variance given by the market for this asset is 60% and 40% is given by the specific variance, what would be the beta of this asset if the market volatility is 25%? If the market is giving 15% and the risk free is 5%, what would be the expected return, as given by the CAPM, one should expected for taking the 40% specific variance in this asset? What about for taking the market risk? 50. Assume a market index represents the combined securities market, and all stocks in the economy have a beta of 2.0. Firm-specific returns all have a standard deviation of 30%. You also find that half of the stocks in the economy have alphas of 3% while the stocks in the other half have alphas of -3%. You have $1 million dollar to invest and have decided to buy half a million dollars in one of the stocks with positive alpha and short half a million dollars in one of the stocks that have negative alpha. a. What is the expected profit (in dollars), and what is the standard deviation of this profit?

b. How many stocks you need to add to your portfolio (again buying half with positive alpha and shorting have with negative alpha) in such a way that the volatility of your portfolio will be reduced by half?