Arizona State University - FIN 421 / FIN421 Practice Final EXAM Questions & Answers

Shares outstanding (St), stock prices (Pt), and Dividends (Dt+1) for assets A and B are given below. All dividends are paid out at the end of the year, 12/31/2017. Asset B performed a 1:2 inverse stock split at the beginning of the year, 01/01/2017, where two old shares were combined into one new share. What is the value weighted portfolio return? Date Asset A Asset B St Pt Dt St Pt Dt 12/31/2016 (t) 12/31/2017 (t+1) 100 22 2 5* 130 10 Asset B performed a 1:2 inverse stock split on 01/01/2017. A) -13.33% B) -5% C) 73.33% D) 3.33% E) 126.67% Answer: D Weights are wA = 100 × 20=(100 × 20 + 10 × 100) = 2=3 and wB = 1 − wA = 1=3 Returns are rA = (22 + 2)=20 − 1 = 0:2; rB = 1 2(130 + 10)=100 − 1 = −0:3: The value weighted return is 2=3 × 20% + 1=3 × (−30%) = 3:33%. 2. You regress 5-year excess returns on the dividend yield, i.e. you run the regression RStocks t:t+5 − RtT:t−+5 bills = α + β · Dt=Pt + "t+5 Your OLS estimates are ^ α = −0:1 and β^ = 13:6. If the current dividend yield equals 0:03, what is your forecast of the 5-year excess return today? A) 31:8% B) 3:0% C) 40:8% D) 6:2% E) none of the above Answer: E The forecast equals the fitted value of the regression, i.e. RtStocks :t+5− RtT:t−+5 bills = −0:1+13:6· 0:03 = 0:308 = 30:8%. 33. Market timing is possible based on which of the following asset allocation rules / portfolios? A) tangency portfolio B) minimum variance portfolio C) risk parity D) 1=N E) A, B, and C Answer: A Market timing can be used in conjunction with an allocation rule that uses mean returns as an input. This is only true for the mean-variance efficient portfolio, i.e. the tangency portfolio. 4. The relevant measure of the risk for your overall portfolio is A) non-systematic risk B) beta C) standard deviation of returns D) correlations of returns E) both A and B Answer: C The relevant risk metric for your overall portfolio is standard deviation (or variance). Nonsystematic risk is diversifiable, beta is the appropriate metric for individual securities, and correlations scaled inappropriately to serve as a systematic risk measure. 45. If you believe that the value effect represents an anomaly, you should A) buy stocks whose book value of equity is high relative to their market value of equity B) buy stocks whose book value of equity is low relative to their market value of equity C) sell stocks whose book value of equity is high relative to their market value of equity D) sell stocks whose book value of equity is low relative to their market value of equity E) A) and D) F) B) and C) Answer: E The value effect states that stocks that with high book-to-market ratios (value firms") tend to outperform stocks with low book-to-market ratios (growth stocks"). If you believe that this difference in average returns represents an anomaly you should buy value stocks and sell growth stocks. 6. An American call option with a strike price of $45 and three month to maturity... A) is worth more than an American call option with a strike price of $45 and six month to maturity B) is worth more than an American call option with a strike price of $50 and three month to maturity C) is worth more than an European call option with a strike price of $45 and three month to maturity D) cannot be exercised prior to it’s maturity date E) A and D F) B and C Answer: F The value of a call option is decreasing in it’s strike price, but increasing in it’s time to maturity. Because it can be exercised early, it is worth more than an otherwise equivalent European call. 57. An annual coupon bond with a coupon rate of 5% has a par value of $1,000, matures in 2 years, and is selling today at $991.50. The current yield on this bond is . A) 4.34% B) 4.76% C) 5.00% D) 5.46% E) 5.94% Answer: D Without computer (or good calculator), it’s trial and error. You can eliminate A, B and C since the yield has to be higher than the coupon (price is below par!). Try $50=1:0546 + $1050=(1:0546)2 = 991:50 8. A European call option with a maturity of one year and a strike price of $60 is selling for $9.06. A European put option with the same maturity and strike price is selling for $5.58. The underlying trades at $62. In the absence of arbitrage, what is the one year risk-free rate? Assume annual compounding. A) 2.53% B) 1.48% C) 58.52% D) 2.47% E) 3.00% Answer: A Using the put-call parity, S = C − P + 1+ Xr gives 62 = 9:06 − 5:58 + 1+ 60r. Solving for r yields r = 2:53%. 6Part II. Short Answer Questions (5 points each) Answer each of the following questions in 2-3 sentences. Provide an explanation of similar length for true/false question(s). 1. You purchase a call option with a strike price of $50 and a put option with a strike price of $30, both on the same underlying stock and with identical maturities. Draw a payoff diagram for this strategy, i.e. plot the strategy’s payoff (not it’s profit!) as a function of the future stock price. Label all relevant points on the axes with the appropriate numbers. (No explanation is necessary for this question, just a plot.) Answer: 2. You are looking at a mutual fund that is rated by Morningstar. The rating agency states it is a large growth fund. You perform your own analysis, and find that the fund has a Fama-French alpha of α = 2:8% (t-stat= 3:3) a market beta of βM = 1:05 (for the hypothesis H0 : βM = 1, you find t-stat= 0:7) a size beta βSMB = −0:3 (t-stat= −2:1), and a value beta βHML = 0:4 (t-stat= 3:0). Do your results support Morningstar’s analysis? Answer: It is a large value fund as indicated by the significantly negative SMB beta and the significantly positive HML beta. 73. True or False (Explain): Two assets that have identical expected cash flows must have the same price. Answer: FALSE The two assets could differ in terms of the riskiness of their cash flows. Riskier assets have higher discount rates and therefore lower prices. 4. True or False (Explain): The yield curve is currently flat at 5%. You expect rates of all maturities to increase by 2% over the next year. A strategy that buys short-term bonds and sells long-term bonds will generate positive returns if the anticipated increase in yields occurs. Answer: TRUE The increase in rates will lead to a drop in bond prices. Because longer-term bonds have larger durations, their prices will drop more than those of short term bonds. The proposed strategy will therefore generate a positive return if yields do increase