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mock_exam_guide - EC371-mock 1 EC371 Economic Analysis of...

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EC371-mock 1 EC371 Economic Analysis of Asset Prices Mock Exam Answer Guidelines Section A Answer TEN questions. 1. An asset will pay a dividend of $11 at date t + 1 at which date its market value will be $77 (with certainty). The risk-free interest rate between t and t + 1 equals 10%. Calculate the asset price at t , assuming markets are frictionless. Answer guidelines : In a frictionless market, it would be possible to make arbitrage profits (unlimited payoff, with zero outlay) unless the risk-free interest rate equals the rate of return on the asset. Hence, the asset price, p , must satisfy: r = 0 . 10 = 77 + 11 - p p 1 + r = 1 . 10 = 77 + 11 p p = 88 1 . 10 p = 80 Hence, in the absence of arbitrage opportunities, the asset price must equal $80 . 2. Explain, using an example, the meaning of ‘buying shares on margin’. Answer guidelines : When an investor buys shares on margin, only a proportion of the purchase value is paid up-front (the margin). Eventually, the balance must be paid before the shares are delivered to the investor, or the shares are sold. For example, suppose that an investor purchases 100 shares at price £ 5 per share, paying an initial margin of 50% to a broker. This means that the investor pays £ 250 = 0 . 5 × 100 × 5 into a margin account. In the event that the shares are sold at a price greater than £ 5 , the investor gains, without having had to pay the full purchase price. In the event that the share prices fall, the margin falls, e.g. if the price falls to £ 4 , the margin falls to 0 . 375 = (400 - 250) / 400 , i.e. 37 . 5% . If this is below the maintenance margin , the investor is required to pay funds into the margin account, typically to restore the margin to its initial proportion. For example, if the maintenance margin is 40% , the investor would be required to pay an additional £ 50 into the account, thus restoring the margin to 0 . 50 = (400 - 200) / (400) .
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EC371-mock 2 3. What is meant by the ‘Efficient Markets Hypothesis’ for stock market prices? Answer guidelines : The ‘Efficient Markets Hypothesis’ (EMH) is usually interpreted to mean that asset prices fully reflect all available information. The typical justification for the EMH is that, if it did not hold, then investors would perceive the opportunity to gain from the information: their attempts to realise this gain would then force prices to change to eliminate the gain so that EMH holds. Stated this way, the EMH is incomplete because (a) it does not explain what ‘fully reflects’ means (this requires a model of asset prices to express ‘efficiency’), and (b) it does not stipulate which ‘information’ is available (and who possesses the information). Sometimes it is assumed that the information relevant for the EMH is restricted to ‘fundamental’ information. But this resolves nothing unless fundamental information is distinguished from non-fundamental information. Even if such a distinction is pro- vided, the issue of the model used to identify the meaning of ‘fully reflects’ remains open.
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