(e)What is the covariance between the equally weighted portfolio of all three assets and asset 2?QUESTION 2.Fund A has an expected return of 30% and a standard deviation of 40%. Fund B has an expected return of 20% and a standard deviation of 30%. The riskless rate is 10%. You may hold either mutual fund (but not both) in combination with riskless borrowing and lending. Which fund should you buy and why?

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QUESTION 3.Consider a firm with current value of $5,000,000 and outstanding debt of $4,000,000 thatmatures in 5 years. The firm’s asset rate-of-return variance is .3. The interest on the debt is paidat maturity, and the firm has a policy of not paying cash dividends. Use the Black/Scholes modelto determine the change in the prices of the firm’s debt and equity if there is an unanticipated risein the rate of inflation of 5%, which raises the riskless nominal interest rate from 5% to 10%.Which class of security holders benefits from the rise in rf
?

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QUESTION 4.Assume a firm has three claims outstanding: equity, ordinary (zero coupon) bonds, andsubordinated convertible (zero coupon) bonds. What factors should be important in valuingthese claims and how do they affect these values?

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QUESTION 5.Your boss tells you that he has been trading stock options but he has a problem. He calculates animplied volatility (finding the volatility that plugged into the Black-Scholes formula gives backthe quoted option price). He says that implied volatilities had been relatively stable over the lasttwo years but, as the market has fallen in the last several months, the implied volatilities haverisen. He asks if he should use the old numbers or the new ones in deciding to trade?

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- Fall '11
- WilliamHandorf
- Corporate Finance, 5%, 20%, $5,000,000, $4,000,000