{[ promptMessage ]}

Bookmark it

{[ promptMessage ]}

# econ423midtermessayanswer - Solutions to Essay Questions...

This preview shows pages 1–3. Sign up to view the full content.

Solutions to Essay Questions - Midterm Exam Econ 423 1 51) What is the expected return on a bond if the return is 9% two-thirds of the time and 3% one-third 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

This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document
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.
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

### Page1 / 5

econ423midtermessayanswer - Solutions to Essay Questions...

This preview shows document pages 1 - 3. Sign up to view the full document.

View Full Document
Ask a homework question - tutors are online