Problem Set 1
Foundations of Financial Markets
Instructor: Erin Smith
Summer 2011
Due date: Beginning of class, May 31
1. Suppose the debt holders of a cosmetics rm hold debt with a face value of $500,000.
The rest of the rm is owned by stockholders. The
Concept Questions 2
Prof. Itamar Drechsler
1. As you increase the interest rate of an annuity, what happens to the present
value and the future value?
(a) They both go up.
(b) They both go down.
(c) The present value goes up and the future value goes down
Problem Set 2
Foundations of Financial Markets
Instructor: Erin Smith
Summer 2011
Due date: Tuesday, June 7
1. Suppose you have 2 mutual funds whose annual returns are shown in the following
table. Assume you invest $1000 in each, and the proceeds from ye
Solutions to Concept Questions 7
Prof. Itamar Drechsler
1. The Law of One Price states that
(a) any two securities must have the same price.
(b) a dealer has to charge the same price to every investor.
(c) any two securities with the same cash ows must ca
Concept Questions 7
Prof. Itamar Drechsler
1. The Law of One Price states that
(a) any two securities must have the same price.
(b) a dealer has to charge the same price to every investor.
(c) any two securities with the same cash ows must carry the same
Concept Questions 6
Prof. Itamar Drechsler
1. Which of the following statements accurately describes the ecient market
hypothesis?
(a) No one can ever outperform the market
(b) Stock prices must go up upon good news, even if the news was expected
(c) Pric
Concept Questions 4
Prof.Itamar Drechsler
1. The set of ecient portfolios with 1 risky portfolio and 1 risk-free asset is
found as:
(a) the straight line through the risk-free rate and the risky portfolio.
(b) the tangency of the indierence curves with th
Concept Questions 3
Prof. Itamar Drechsler
1. Suppose that the return on the S&P 500 is a normally distributed random variable with mean (=expected value) of 12% and standard deviation
(=volatility) of 20%. What is (approximately) the 95% condence interva
Concept Questions 5
Prof. Itamar Drechsler
1. What is the capital market line?
(a) It is the ecient frontier formed by the risk-free asset and the market portfolio
(b) It is the investment opportunity set formed by 2 risky assets and 1 riskless asset
(c)
Concept Questions 8
Prof. Itamar Drechsler
1. The book value of a companys equity is equal to
(a) How much it would cost to set up a new company with the same assets and
liabilities than the existing company (replacement cost).
(b) How much you would earn
Concept Questions 11
Prof. Itamar Drechsler
1. Which one-year option strategy will give the highest expected net prot if
a. you are very condent that the stock price will move VERY LITTLE
over the next year,
b. out-of-the-money options are much cheaper th
Concept Questions 1
Prof. Itamar Drechsler
1. Rank the following bonds from the most risky to the least risky:
(a) Treasury bonds, Corporate bonds, Municipal bonds.
(b) Municipal bonds, Corporate bonds, Treasury bonds.
(c) Corporate bonds, Treasury bonds,
Concept Questions 9
Prof. Itamar Drechsler
1. A bond with face value $100 that is issued at a price of $105:
(a) is a discount bond
(b) is a par bond
(c) is a premium bond
(d) does not exist because nobody would want to buy an asset for 105 that ultimatel
Solutions to Concept Questions 4
Prof.Itamar Drechsler
1. The set of ecient portfolios with 1 risky portfolio and 1 risk-free asset is
found as:
(a) the straight line through the risk-free rate and the risky portfolio.
(b) the tangency of the indierence c
Solutions to Concept Questions 6
Prof. Itamar Drechsler
1. Which of the following statements accurately describes the ecient market
hypothesis?
(a) No one can ever outperform the market
(b) Stock prices must go up upon good news, even if the news was expe
Solutions to Concept Questions 5
Prof. Itamar Drechsler
1. What is the capital market line?
(a) It is the ecient frontier formed by the risk-free asset and the market portfolio
(b) It is the investment opportunity set formed by 2 risky assets and 1 riskle
=
SOLUTIONS AND EXPLANATION FOR MINI-QUIZ 1
The original question is in bold below. I only graded parts (1) and (2) of the
question as many of you seemed confused on the third section. Additionally, I
realize I wasnt clear that when I ask for the value of
MINI-QUIZ 2
Your sister owes you $500. She doesnt have the money today, however she oers
you two options:
(1) She will pay you $600 in two years
(2) She will pay you $250 in one year and $300 in two years
Which option do you choose? Why?
I forgot to menti
MINI-QUIZ 3 SOLUTION
NAME:
The return on the equity market is 10% and the risk-free rate is 2%.
You have $100 to invest and you want an expected return of 8%.
How much should you invest in the equity market and how much
in the risk-free asset. Your answer
Solutions to Concept Questions 12
Prof. Itamar Drechsler
1. What does the prot or loss look like on settlement date of a futures contract
for the person who sells the contract?
(a) It looks like a long put position
(b) It looks like a short put position
(
Solutions to Concept Questions 11
Prof. Itamar Drechsler
1. Which one-year option strategy will give the highest expected net prot if
a. you are very condent that the stock price will move VERY LITTLE
over the next year,
b. out-of-the-money options are mu
Solutions to Concept Questions 9
Prof. Itamar Drechsler
1. A bond with face value $100 that is issued at a price of $105:
(a) is a discount bond
(b) is a par bond
(c) is a premium bond
(d) does not exist because nobody would want to buy an asset for 105 t
Solutions to Concept Questions 10
Prof. Itamar Drechsler
1. Question Which of the following factors unambiguously cause an increase
in the duration of a coupon paying bond?
(a) an increase in maturity, an increase in coupon rate and an increase in the YTM
Solutions to Concept Questions 8
Prof. Itamar Drechsler
1. The book value of a companys equity is equal to
(a) How much it would cost to set up a new company with the same assets and
liabilities than the existing company (replacement cost).
(b) How much y
Solutions to Concept Questions 3
Prof. Itamar Drechsler
1. Suppose that the return on the S&P 500 is a normally distributed random variable with mean (=expected value) of 12% and standard deviation
(=volatility) of 20%. What is (approximately) the 95% con
Problem Set 1
Foundations of Financial Markets
Instructor: Erin Smith
Summer 2011
Due date: Beginning of class, May 31
1. Suppose the debt holders of a cosmetics rm hold debt with a face value of $500,000.
The rest of the rm is owned by stockholders. The