KEY*** Name______________________
FIN 4520 - FIRST MIDTERM EXAM - SPRING 1999
1. Please remember to sign your name.
2. Please ask the instructor if any questions appear unclear.
3. None of the questions are intended to be "trick" questions.
4. Good luck!
Short answer:
1. List two possible components of financial returns from a bond. [6 points]
[coupon payments or interest; capital gains or change in price; may also accept "risk premium"]
2. List two types of risk that a bond may have. [6 points]
[any two of: default risk, interest rate risk, liquidity risk]
3. List three reasons why some bonds have different yields than other bonds. [9 points]
[any 3 of: different default risks, different maturities, different liquidity, different taxes; also accept different definitions of yield reported (such as current yield, yield to maturity, discount yield)]
4. Suppose a large area of the U.S. experiences severe drought for a full year. Analyze the likely effect of this event on interest rates, using the loanable funds framework. Be sure to identify specific ways in which the event may affect the demand for bonds (or money) and ways in which the event may affect the supply of bonds (or money). [10 points]
[Direct effects may include temporary increase in the price level and inflation rate, due to the shortage of crops; lower expected returns on some projects, as agricultural production falls; lower income & wealth to farmers and their creditors & suppliers; might also claim higher risk. Accept any two of these, worth 4 points.
Implications for demand for bonds: higher inflation reduces demand; lower wealth reduces demand; higher risk reduces demand; overall net reduction in demand (2 points).
Implications for supply of bonds: higher inflation increases the supply; lower expected future project returns lowers the supply; ambiguous overall effect on supply (2 points).
Implications for market equilibrium: lower demand and ambiguous supply of bonds leads to lower price of bonds and therefore higher interest rates (2 points).]
5. Define the yield curve and describe its normal shape. [6 points]
[The yield curve is the relationship between bond yields and bond maturities. Usually, longer maturity bonds have higher yields, which we call an upward-sloping yield curve.]
6. Describe the main benefits of diversification, tell the minimum number of assets needed to achieve some diversification, and describe the risk remaining in a fully diversified portfolio. [9 points]
[diversification reduces the overall financial risk in an investment portfolio; as few as two assets can achieve some diversification (unless the assets are perfectly correlated); a fully diversified portfolio will still have "systematic risk" that cannot be diversified away.]
7. Give two reasons why financial intermediaries (such as banks) are successful against competition from the stock market and other forms of direct finance. [6 points]
[transaction costs; asymmetric information; may also accept moral hazard, adverse selection, or economies of scale]
[52 points to here]
True/False (each correct answer is worth 3 points):
T1. __ A bond's market value or price is equal to the present value of its future cash flows to the investor.
F2. __ The current yield is the best measure of an investor's return from holding a bond.
T3. __ An asset's "beta" is a measure of the sensitivity of the asset's return to changes in the value of the entire market portfolio.
F4. __ The current yield goes up as the yield to maturity on a bond falls.
T5. __ The real rate of return on an investment is equal to the nominal rate of return minus the rate of inflation.
T6. __ One reason why financial firms are regulated is their importance in the process of conducting monetary policy.
[+18 = 70 points to here]
Multiple choice (each correct answer is worth 3 points):
a1. What concept is used to value a bond?
a. Present value b. Internal rate of return
c. Default d. Arbitrage
c2. Which of the following answers is NOT a possible explanation of the normal shape of the yield curve?
a. Investors may expect interest rates to rise in the future.
b. Long maturity bonds have higher interest rate risk than short maturity bonds.
c. Corporate bonds have more risk than U.S. Treasury securities.
d. Long maturity corporate bonds have more default risk than short maturity bonds.
c3. Financial economists consider the ______ to be the most accurate measure of interest rates.
a. internal rate of return b. discount rate
c. yield to maturity d. current yield
c4. Which of the following is NOT a possible explanation of an inverted yield curve?
a. The market expects the Fed to ease monetary policy in the near future.
b. The market expects a recession.
c. The market expects long bonds to be riskier.
d. The market expects lower inflation rates in the future.
a5. The loanable funds framework analyzes:
a. Demand for bonds and supply of bonds
b. Demand for bonds and supply of money
c. Supply of bonds and demand for money
d. Demand for money and supply of money
b6. Which of the following events will tend to increase the demand for bonds?
a. An increase in the expected future rate of inflation
b. An increase in wealth
c. An increase in risk
d. A decrease in the bond's liquidity relative to that of other assets
[+18 = 88 pts.]
Problem solving:
1. If a discount bond returns $2000 at the end of two years and the market requires an annual return of 4.5 percent, what price will the bond sell for today? [3 points]
[PV = 2000/(1.045)2 = $1831.46]
2. What is the yield to maturity on a bond that sells for $950 today and pays $1100 at the end of one year? [3 points]
[950 = 1100/(1+i), 1+i= 1100/950 = 1.1579, i=.1579 = 15.79%]
3. What is the total real return on a bond that pays an annual coupon of $50, has a face value of $1000, matures in one year, and sells today for $900, if the annual rate of inflation is 4%? [4 points]
[Nominal yield to maturity, or nominal total return, is found by 900 = 1050/(1 + i) or i = 1050/900 - 1 = 16.67%, worth 2 points. Real total return is 16.67% - 4% = 12.67%, worth 2 points.]
4. What is the yield on a discount basis (that is, the discount yield) of a bond that sells for $780 today and returns $800 after 200 days? [3 points]
[(800-780)/800]x(360/200) = 0.045 or 4.5%
[+13 = 101 pts.]