Quiz4_A(Answers)

Quiz4_A(Answers) - BADM 115 – Section 11 Prof. Isabelle...

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Unformatted text preview: BADM 115 – Section 11 Prof. Isabelle Bajeux‐Besnainou Fall 2008 Form A QUIZ #4 1. (2 points) Investors expect a company to announce a 16% increase in earnings, but instead the company announces a 2% increase. If the market is semistrong‐from efficient, which of the following would you expect to happen? a. The stock’s price falls because the earnings increase was less than expected b. The stock’s price increases slightly because the company had a slight increase in earnings c. The stock’s price stays the same because earnings announcements have no effect if the market is semistrong‐form efficient ANSWER: If the market is semistrong‐form efficient and the company announces a 2% increase when investors had expected it to announce a 16% earnings increase, you would expect the stock’s price to fall because the earnings increase was less than expected, which is Statement a. In fact, if the assumption were made that weak‐form efficiency existed then you would expect the stock’s price to increase slightly because the company had a slight increase in earnings, which is Statement b. If the assumption were made that strong‐form efficiency existed then you would expect the stock’s price to remain the same because earnings announcements have no effect because all information, whether publicly available or privately held, is already reflected in the stock price. 2. (3 points) You read in the Wall Street Journal that 30‐day T‐bills are currently yielding 6.5%. Your brother‐in‐law, a broker at Safe and Sound Securities, has given you the following estimates of current interest rate premiums Inflation premium = 2.85% Liquidity premium = 1.10% Maturity risk premium = 0.90% Default risk premium = 1.45% On the basis of these data, what is the real risk‐free rate of return? ANSWER: T‐bill rate = r* + IP 6.5% = r* + 2.85% r* = 3.65%. A ‐ 1 3. (2 points) An investor in Treasury securities expects inflation to be 1.80% in Year 1, 3.55% in Year 2, and 2.80% each year thereafter. Assume that the real risk‐free rate is 3.40%, and that this rate will remain constant. Three‐year Treasury securities yield 6.77%, while 5‐year Treasury securities yield 7.34%. What is the difference in the maturity risk premiums (MRPs) on the two securities; that is, what is MRP5 – MRP3? ANSWER: First, calculate the inflation premiums for the next three and five years, respectively. They are, IP3 = (1.80% + 3.55% + 2.80%)/3 = 2.72% IP5 = (1.80% + 3.55% + 2.80% + 2.80% + 2.80%)/5 = 2.75% The real risk‐free rate is given as 3.40%. Since the default and liquidity premiums are zero on Treasury bonds, we can now solve for the maturity risk premium. Thus, 6.77% = 3.40% + 2.72% + MRP3 MRP3 = 0.65%. Similarly, 7.34% = 3.40% + 2.75% + MRP5 MRP5 = 1.19%. Thus, MRP5 – MRP3 = 1.19% – 0.65% = 0.54%. 4. (3 points) A 9% semiannual coupon bond matures in 12 years. The bond has a face value of $1,000 and a current yield of 6.73%. What are the bond’s price and YTM? ANSWER: The problem asks you to solve for the YTM and Price, given the following facts: N = 12 2 = 24, PMT = 90/2 = 45, and FV = 1000. In order to solve for I/YR we needPV. However, you are also given that the current yield is equal to 6.73%. Given this information, we can find PV (Price). Current yield = Annual interest/Current price 0.0673 = $90/PV PV = $90/0.0673 = $1,337.30. Now, solve for the YTM with a financial calculator: N = 24, PV = ‐1,337.30, PMT = 45, and FV = 1000. Solve for I/YR = 2.59%. However, this is a periodic rate so the nominal YTM = 2.59%(2) = 5.19%. A ‐ 2 ...
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