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Midterm Exam Fall 2006

# Midterm Exam Fall 2006 - Finance 748 Professor Bill Reese...

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Finance 748 Professor - Bill Reese Midterm Exam Fall, 2006 Instructions : The first five pages consist of four problems. The first problem is worth 15 points and the other three are worth 10 points each. You need to show your work for problems 1 and 4. You will need to email me the spreadsheet you use for problem 2. You may use Excel for any of these problems, but in each case, you must start with a blank workbook. If anything else appears on your screen, it will be considered a violation of the honor code. The next six pages contain seven short-answer questions (some with multiple parts). Question 1 is worth 10 points, question 7 is worth 20 points, and the others are worth 5 points each. You should be able to answer each question in the space provided, but if you need extra space, continue working on the back of the page and leave me a note on the front that you are doing so. The formula for Bayes Rule as shown in class is: Pr (P H | buy) = . Pr (buy | P H ) Pr (P H ) . Pr (buy | P H ) Pr (P H ) + Pr (buy | P L ) Pr (P L ) Come to the front to see me if you have any questions. You have until 9:30 to complete this test. I will post your grade for this exam and the course on the website by your number as soon as I have them all graded. Good luck! Name : _____________________________________________

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1. Trading Models Problem – be sure to show all your work You are a marketmaker for Dell, which trades on Nasdaq. Due to some recent problems with the batteries on their laptops, you believe that at this time next year, Dell’s price will have either exploded to \$28 or fizzled to \$18 with equal probability. The risk-based required rate of return has already been included in these probabilities, so you can assume that the required return is zero. a. If everyone has the same information, what should the price of one share of Dell stock be? b. During a typical day, the percentage of insiders (those who know whether Dell’s price will be \$28 or \$18 next year) is estimated to be 25%. Use the single period model to determine the bid and the ask price you will post for one share of Dell.
c. A market buy order for one share of Dell comes in and you are the dealer who fills it. You have no idea who was on the other side of the transaction. Use Bayesian updating to determine the

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Midterm Exam Fall 2006 - Finance 748 Professor Bill Reese...

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