F10_Midterm_A_Answers

F10_Midterm_A_Answers - York University Economics 4400A,...

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Unformatted text preview: York University Economics 4400A, Midterm Examination November 4, 2010 Instructions. Write your name and student number at the top of this page. Answer four out of six questions below. Each question answered is worth 10 points, the total is 40 points. Be clear what formulas you use to arrive at a solution, the actual numerical answers are not important. If you think a question is ambiguous or not enough information is provided to answer it, explain why.You have 75 minutes. 1. Brie&y evaluate all statements. True/False/Uncertain? Explain your answers. (a) Under imperfect capital markets, investors choice between alternative income streams is based only on comparing present values. (b) Under perfect capital markets, investment decisions are not aected by interest rate. (c) In class it was said that under perfect capital markets, we should "almost never" observe individuals with neither savings nor debt. Explain why. Explain whether that still holds under imperfect markets. (d) Assume interest rate this year is 5%; interest rate next year is 15%. If a two-year long business project has IRR=10%, does this project necessarily have positive NPV? Necessarily negative? Neither? Explain. (e) Income stream A is (50, 50). Income stream B is 40, 61. Under perfect capital markets, for what interest rates is stream A better? Now assume that nancial markets are im- perfect: the lending interest rate is 8%, the borrowing interest rate is 12%. Under what conditions is A better (only give intuition)? a. Not true. The choice also depends on whether they he/she has funds for investment or needs to borrow. That depends on timing of earnings stream and on time preference. b. Not true. You decide to invest in a project if expected return beats rate of return available to you in nancial markets. That rate of return is the interest rate (plus possibly some risk premium). So interest rate is a relevant factor. c. Because only for one particular slope of utility function, your endowment is the exact point of tangency (and there are innitely many possible slopes). Under imperfect markets the budget set has a kink d.(d) was not graded; I mistakenly picked numbers that made this question more di cult than planned. The intended interest rates were 5% in rst year and 20% in second year. Homework problem 1: whats the answer then? Homework problem 2: Answer the question as written.Hint: The two-period discount rate r satises 1 + r = (1 + 5%)(1 +15%) ; so that r = 20 : 75% . If interest rates were 10% in each period, the two-period discount rate would be 21% , which is more. e. E cient mkts: r > 10% ; Ine cient: A better if youre a net borrower, B better if you are a net saver. Intuition: picking A is equivalent to {picking B and borrowing ten dollars at 10% interest rate }. This is better than B for an idividual who plans to consume a lot in rst period and therefore needs to borrow. Borrowing ten dollars at 10% rate is better than borrowing them at 12%. On the other hand, for a person who plans to consume less than $40 in rst period and isat 12%....
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F10_Midterm_A_Answers - York University Economics 4400A,...

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