Fall 2008_Midterm_II_A_Answer_Key

Fall 2008_Midterm_II_A_Answer_Key - Department of Economics...

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Unformatted text preview: Department of Economics ‘ Professor O’Brien Lehigh University Fall 2008 Eco 129 Midterm H A Name: 67/ TA’S Name and Recitation Time: 1. Take time to think before answering. Make sure your answers to the short—answer questions are clear and legible. In order to receive full credit, you must show your work. 2. In order that everyone has the same amount of information available to answer the problems, we won’t be able to respond to requests for clarification or elaboration. 1. (4 pts) a. The following is fi‘orn a recent article in the Wall Street Journal: “Renewed concerns about the financial system swept through bond markets on Tuesday, as investors fled to safe—haven, short-term Treasury bills as doubts gathered about the effectiveness of the rescue package before Congress.” Did these actions by investors make the Treasury yield curve more steep or tess steep? Briefly explain. f‘fr Ctr/Y: [W76 cam/emf! oé kiln, “Men/fling; LMW (are QM {$190, jgwahwy VMICM? m \{jg/L/ @az/N Y [13th Witt “QLH I WW8 b. Use the data in the foiiowing table on Treasury securities of different maturities to answer the question: Date 1 yr 2 yr 3 yr 10/17/08 1.34 1.64 1.90 Assuming the expectations hypothesis is correct, on October 17, 2008, what did investors expect the interest rate to be on the one-year Treasury bill two years from now? : (53% Lit re '9 (-39”ch (L +~ L it: {4:41 :> H 2. (4 pts) a. Consolidated Edison, Inc. (Con Ed) is a regulated utility company servicing the New York City area. Suppose Con Ed plans to pay a dividend of $5.75 per share at the end of the current year. If its equity cost of capital is 8% and dividends are expected to grow by 6% per year in the future, estimate the value of Con Ed’s stock. Now suppose that Con Ed will pay a dividend of $5.75 per share at the end of the year, but announces that the dividend will not be increased in future years. If its equity cost of capital is still 8%, now estimate the value of Con Ed’s stock. ei7r . v. ..._.___. . age-750 .demoe b. Acme is currently paying a dividend of $2 per share and the dividend is expected to grow at a rate of 4% per year. An investor is Willing to pay $50 per share for Acme’s stock, but not a penny more. What is the investor’s required rate of return on this stock? Briefly explain. {has (E ":08! was“; 3. (4 pts) The following list of call and put options for IBM is from the Wall Street Journal: B M (M) Underlying stock price: 90.78 Call Put Expiration Strike . ................... __ Last Volume Open Interest Last Volume Open Interest Nov. . 4-81, 4103. 9-00 910 Jan 95-00 7:59.... 464 3328. 1.1.-.oc.>...... 140 1462.4... Apr 95.00 10.30 62 84314.50 1 1441 Nov 100.00; 2.90 10879 3321 11.30 67 6363 Jan __ _109299..3....-..5-.50 . 151 __ _.........._........l..999§-13-30 . ., ,, 32. 17021 Apr 100-00? 7-9.0-.. . 33 ll_63.2..........~.-.-... 22.51- Nov 105.00 1.70 1710 694651430 94 1852 Jan 105.00 3.80 326 742916.90 17 11530 105-00: , 964 ,, 1434-. a. What is the intrinsic value of the call option that expires in April and has a $95 strike price? What is the intrinsic value of the put option that expires in January and has a $105 strike price? Briefly explain Why a call with a $105 strike price sells for less than a call with a $95 strike (for all expiration dates) While a put with a $105 strike price sells for more than a put with a $95 strike price (for all expiration dates). m (Ali (.5 MWWWUV, 8:) [fl [Ma/1mm: Valuing a $7 , :u-tvm'stc. «Jane 6 m pad: 1 ’fof— Sara/1.75 ‘/.L.L s16;ch {Di/cw W Cab/[5' ten "fix-Mm BM mam mm 2%” (#5in Wm” Slhlcepnus awe Waist/Wat ' >270- 79. Wu Warm/L; Bath. We Fail (/UH’DL _ I r 7% A L wt‘m Warm/Hag paw avte [M7711 w: VIM/Ll 'fh 237W sit/{(62 (pt/1m awe 421% m WW/ 54 m MM Otth [MW b. A recent article in the Wall Street Journal noted that: While other airlines were struggling to stayafloat, Southwest Airlines posted quarter afler quarter of positive results as a result of its extensive hedging program, one of the few airlines that hedged fuel costs aggressively. Briefly explain why Southwest Airlines would want to hedge fuel costs and how they would go about doing so. Your answer should include a definition of hedging. Emil/kww [3 “MM M MW cur-H LUSH WW [fl {Mt/94H E $th own ‘60 Nata/u WW, _ r ac‘fj LIA" ‘W MWW Wt/‘EH 0) ijmmf \ (Db/[Le L"; OJ pW‘W Vi e. A recent article in the Wall Street Journal observed that: “The higher the expected volatility in stock prices, the higher the prices of put and call options will be.” Briefly explain the reasoning behind this observation. W MW UdiouLHe 4w (Mil? 0&5 a Swami/5% ijkwiw um Mme/[#7 eta W36 05%ch bet/WW mat/(ad We at W MICK am? “We sit/{ice [Met dam/L3 W 7am Q’pflm EX [Ni/Lu. Optim [Oi/Cw W W Sax/v1 when option? men/[m mam abuth QM Wm} «M gotta/1. ll. Multiple Choice. Select the best answer. 1/2 point each. 1. Which of the following is NOT true of the expectations theory? a. It assumes that bonds with different maturities are perfect substitutes. b. It implies that a long—term bond rate equals the average of short—term rates covering the same investment period. It implies that the yield curve will usually slope upward. , d. It implies that the shape of the yield curve depends on the expected pattern of future short- term rates. . With respect to futures contracts, “basis” refers to 2 the difference between the futures price and the spot price of the underlying asset. b the interest rate in a financial futures contract. 0. the date on which the contract expires. d. whether the contract is traded as an exchange product or over-the-counter. Since the beginning of the semester, the target for the federal funds rate has risen. 3 a. ® fallen. c. stayed the same. 4. A put option is said to be in the money if a. it is written on a Treasury bill or other money market asset. b. it has increased in price since it was first written. ©the price of the underlying asset is currently less than the strike price. (1. the price of the underlying asset is currently less than the strike price plus the option price. 5. A specalator who believes strongly that interest rates will fall would be likely to buy futures contracts on Treasury bills. . sell futures contracts on Treasury bills. 0. sell Treasury bonds in the spot market. d. a. and c. r e. b. and c. 6. When market participants have rational expectations, the deviation of the expected future price from the actual future price is ' a. zero. b. predictable, provided all relevant information is made use of. @wt predictable. d. predictable under certain circumstances, but not others. 7. The long position in a futures contract is the party that will a. deliver a commodity or financial instrument to the buyer at a future date. b. assume all the risk in the transaction. c. suffer a reduction in liquidity. @ benefit from increases in the price of the underlying asset. 8. In March 2008, which investment bank merged with JP Morgan Chase, setting off a controversy with respect to the Federal Reserve’s role in the transaction? a. Goldman Sachs @ Bear Stearns c. Lehman Brothers cl. Merrill Lynch 9. In September 2008, Fannie Mae and Freddie Mac were placed under a conservatorship of which agency? a. Federal Reserve b. Department of the Treasury c. Securities and Exchange Commission Cd? Federal Housing Finance Agency 10. Last Friday, the DJIA closed at approximately a. 941. b. 10529. ll. To help offset the cost to it from loan defaults Wachovia Bank decides to increase the interest rate it charges on its business loans. As a result Of this increase in the interest rate it charges, the creditworthiness of Wachovia’s loan applicants is likely to a. improve. (h) deteriorate. c. be unchanged. (1. be unchanged, unless the economy enters a recession at the same time as the interest rate is increased. 12. Moral hazard in financial markets arises from a. the difficulty of distinguishing good—risk borrowers from bad-risk borrowers. b. the likelihood that bad—risk borrowers are more likely to accept a loan than are good—rick borrowers. ©savers’ difficulties in monitoring borrowers. d. borrowers’ difficulties in locating savers. 13. Moral hazard is not eliminated in debt financing because borrowers have an incentive to assume greater risk than is the interest of lenders. b. firms with a great deal of debt often go bankrupt. c. principal—agent problems are greater with debt financing than with equity financing. d. the use of restrictive covenants tends to increase moral hazard. 14. If the preferred habitat theory is correct, a reduction by the Treasury in the supply of 30—year bonds should a. lower their price and increase their yield. increase their price and lower their yield. 6. lower both their price and their yield. d. increase both their price and their yield. 15 . “Counterparty risk” a. refers to the additional risk of price fluctuations as the maturity of a bond increases. is lower for futures contracts than for forward contracts. c. is greater for Treasury bonds than for corporate bonds. d.' refers to the greater variance in the return on stocks compared with the return on bonds. 16. Which of the following stock market indexes failed to reach an all—time high in October 2007‘? a. Dow Jones Industrial Average ‘0. S&P 500 @Nasdaq ...
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Fall 2008_Midterm_II_A_Answer_Key - Department of Economics...

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