Solutions to Essay Questions  Midterm Exam
Econ 423
1
51) What is the expected return on a bond if the return is 9% twothirds of the time
and 3% onethird of the time?
What is the standard deviation of returns on this
bond?
Would you prefer this bond or one with an identical expected return and a
standard deviation of 4.5?
Why?
Solution:
Recall from class that The
expected return
on an asset is the weighted average of all
possible returns:
R
e
= p
1
R
1
+ p
2
R
2
+ … + p
n
R
n
Using the information provided in the question,
R
e
= 0.66 x 9% + 0.33 x 3% = 7%
We also know that the standard deviation is a measure of an asset's risk, and is equal
to:
Using our calculation of expected value above as well as the distribution of returns
provided in the problem, we find:
Simplifying,
028284
.
0
0008
.
0
000533
.
0
000267
.
0
0016
.
0
3
1
0004
.
0
3
2
,
or approximately 2.828%.
As someone who is risk averse, I would prefer a bond with a lower standard
deviation of returns, holding all else equal.
For this reason, I would prefer this bond
to one with the same expected return and a standard deviation of 4.5%.
52) Explain what the market reaction will be in an efficient market if a firm
announces a fully anticipated filing for bankruptcy.
Solution:
2
2
2
2
2
1
1
...
e
n
n
e
e
R
R
p
R
R
p
R
R
p
0016
.
0
3
1
0004
.
0
3
2
%
4
3
1
%
2
3
2
%
7
%
3
3
1
%
7
%
9
3
2
2
2
2
2
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Solutions to Essay Questions  Midterm Exam
Econ 423
2
According to the efficient markets hypothesis, we know that an efficient market
fully reflects all available information, and that current prices in a financial market
are set so that the optimal forecast of a security's return is equal to the security's
actual return in equilibrium.
Applying this to the efficient market described in the
problem, we know that if the market is efficient and the bankruptcy filing is fully
anticipated, then the price of a security issued by the firm should already account
for the anticipated bankruptcy before the official announcement.
For this reason, the
price of such a security should remain unchanged as a result of the announcement.
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 Summer '08
 VD
 Monetary Policy, Supply And Demand, Federal Reserve, MIDTERM EXAM ECON

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