Economics 136. Financial Economics
Midterm 1, Fall 2008, Suggested solutions
1. True or false.
(20 points, 5 each)
(i) True. The price of a zerocoupon bond is
P
=
F=
(1 +
R
)
T
and when
R >
0
, this is
les than
F
.
(ii) False. A price weighted portfolio means that you hold an equal number of shares of
each company in your portfolio, and hence requires no rebalancing when prices change.
(iii) False. By putcall parity,
C
0
=
S
0
+
P
0
°
X=
(1 +
R
f
)
. Since
S
0
,
X
and
R
f
are
unchanged, an increase in the put price
P
0
must result in an increase in the call price
C
0
.
2. Mortgagebacked securities
(28 points, 7 each)
Stock index
Treasury
Mortg pool
Tranch A
Tranch B
State 1: good times
16
10
20
10
10
State 2: recession
8
10
8
0
8
Price today
10
9
(a) To construct AD1, consider a portfolio of
x
shares of the stock index and
y
shares
of the bond.For this to be a replicating portfolio, we need
16
x
+ 10
y
= 1
8
x
+ 10
y
= 0
:
Solving these, we °nd
x
= 0
:
125
and
y
=
°
0
:
1
. Hence by the LOOP, the price of AD1 must
be
10
±
(0
:
125) + 9
±
(
°
0
:
1) = $0
:
35
. To price AD2, note that the price of a portfolio of AD1
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 Fall '08
 SZEIDL
 Economics, mortgagebacked securities

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