1 ECN 226 Capital Markets 1 Midterm test The midterm test will cover material from the first 4 weeks of your module. Particularly, the required reading is: o Bodie, Z., Kane, A., & Marcus, A.J., 2021. Investments. 12th Ed., International Student Edition. New York, NY: McGraw Hill Education. – Chapter 1: The Investment Environment – Chapter 14: Bond prices and yields – Chapter 18: Equity Valuation Models – Chapter 5: Risk, return and historical record (except for section 5.8 Normality and Long-term Investments) o Students are required to know ALL lecture notes and Problem Sets for these first four weeks (material can be found in Aula and QM+). Marking Criteria: A 70-100 mark is awarded to the work, generally ‘outstanding’ – where all questions are addressed in a comprehensive way, showing an authoritative grasp of the concepts involved in the questions. – that selects and organises the material with consistent relevance. – that explains in full definitions – that presents the material in a good format with use of correct notations. – high levels of ability in the analysis of quantitative and/or qualitative information; it always demonstrates an understanding of numerical questions. Students can use MS Excel for the calculations. 2 ECN 226 Capital Markets 1 Mid-term test -MOCK TEST- Duration 75 minutes Students must attempt ALL Questions. Type your answers on this document below each question under ‘Answer:’ Question 1 a) In no more than 100 words, explain the relationship between securitisation and the role of financial intermediaries in the economy. (15 marks) Answer: b) A firm’s stock that must be held for 5 years is used to compensate managers. Explain, in no more than 100 words, the advantages and disadvantages of this form of managerial compensation in terms of mitigating agency problems, that is, potential conflicts of interest between managers and shareholders. (10 marks) Answer: (Total marks: 25 marks) Question 2 a) In no more than 100 words, explain why bond prices go down when interest rates go up. (10 marks) Answer: b) A 20-year maturity 9% coupon bond paying coupons semiannually is callable in five years at a call price of $1,050. Its par value is $1,000 and the bond currently sells at a yield to maturity of 8%. What is the yield to call (15 marks) Answer: (Total marks: 25 marks) 3 Question 3 a) In no more than 100 words, explain how the relationship between a stock’s current price and its intrinsic value determines the relationship between its market capitalisation rate and its expected rate of return. (15 marks) Answer: b) A company is expected to pay a dividend in year 1 of $1.70, a dividend in year 2 of $1.77, and a dividend in year 3 of $1.87. After year 3, dividends are expected to grow at the rate of 4% per year. An appropriate required return for the stock is 7%. How much is the stock worth today (10 marks) Answer: (Total marks: 25 marks) Question 4 a) Comment, in no more than 100 words, on the following statement. “It makes sense to borrow during times of high inflation because you can repay the loan in cheaper money.” (10 marks) Answer: b) Explain, in no more than 100 words, the effect of the following scenario on the level of real interest rates: Businesses become more pessimistic about the future demand for their products and decide to reduce their capital spending. (8 marks) Answer: c) Suppose that the monthly rate of return on your portfolio is normally distributed with a mean of 7% and standard deviation of 10%. What is the probability that the return on your portfolio will be negative (7 marks) Answer: (Total marks: 25 marks) END OF TEST PAPER 4 There are many ways to answer a discursive question but here I include some indicative ones that will help you prepare for the midterm test. Model Answer: Question 1 a) Financial intermediaries bring the suppliers of capital together with the demanders of capital. They pool the funds of small investors and they have well diversified loan portfolios and combined with their expertise and the economies of scale they grant large loans to higher credit risk borrowers. Securitisation involves pooling and transforming relatively small, homogeneous and illiquid financial assets into liquid securities that can be traded directly in secondary markets by firms. -definitions will be 4 marks each as in this question they set the background for answering the question- So, it provides the means for market participants to bypass intermediaries. For example, mortgage-backed securities channel funds to the housing market without requiring that banks or thrift institutions make loans from the
ir own portfolios. As securitization progresses, the financial intermediaries will lose job. -The other 7 marks are given for the specific answer (the ability to combine definitions). The last sentence is awarded 3 marks (shows the exact link between securitization and financial intermediaries)- This answer will award you full grades. Its length is 114 words, so, it is around 100 words as required by the question. b) This type of compensation will tie managers’ remuneration to the shareholders’ long- term wealth and can result in goal congruence between shareholders and managers. Now there will be no conflicts of interest, and managers have further economic incentives to make decisions that will increase shareholders’ wealth. -4 marks; alignment of goals and conflicts of interest being the key words- Overuse of stock options, however, can create its own agency problem by creating incentives to manipulate profits and short-termism (e.g., earnings’ management). Moreover, the manager’s career/wealth is already linked with the firm’s success (more than that of the shareholders) and, thus, overuse of stock compensation can potentially exacerbate this undiversified exposure. So, managers might become more risk averse at the expense of shareholders’ interests. -6 marks; short-termism/incentives creation and undiversified exposure being the key terms- Question 2 a) Higher interest rates mean that a higher discount rate is going to be used in order to discount all the fixed payments from holding the bond. The bond’s coupon interest payments and principal repayment are not affected by the changes in market rates. So, 5 this means that the present value of all expected cash flows and, therefore, the bond price will fail. After all, the price of the security is given as the present value of its expected cash flows. The opposite is going to be the impact of lower interest rates. -definition of bond price is 3 marks; distinction between coupon rate and amount of principal from market interest rate 3 marks; 4 marks for explanation- (10 marks) b) First, we find the price of the bond now: In Excel ‘=PRICE(DATE(2020,2,1),DATE(2040,2,1),0.09,0.08,100,2)’=109.89 (5 marks) And the yield to call is: =YIELD(DATE(2020,2,1),DATE(2025,2,1),0.09,109.89,105,2)= 7.44% (10 marks) Question 3 a) Intrinsic value is the “true” value of an equity, and can be obtained as the PV of all cash flows (dividends and sale proceeds) from holding the stock discounted at an appropriate risk-adjusted interest rate. If the intrinsic price of an equity is different to its market value, then the investor disagrees with market’s assessment of expected dividend, price or discount rate. If the intrinsic value of the stock is equal to its price, then the market capitalization rate is equal to the expected rate of return. On the other hand, if the individual investor believes the stock is underpriced (i.e., intrinsic value > price), then that investor’s expected rate of return is greater than the market capitalization rate. -Definitions of intrinsic 4 marks; explanation of difference between intrinsic and market price 4 marks; 7 marks for relation between mispricing and the rates- b) Yr. Dividend PV of Dividend@9% 1 $ 1.7 $ 1.7/1.09 = $ 1.5596 2 $ 1.77 $ 1.77/(1.09 )2 = $ 1.4898 3 $ 1.87 $ 1.87/(1.09 )3 = $ 1.4440 Sum $ 4.4934 -6 marks- P3 = d4 / r-g => $1.87 x (1.04)/(0.07 0.04) = $64.83 PV of P3 = $64.83/(1.07)3 = $52.92; P0 = $4.49 + $52.92 = $57.41. -4 marks- Question 4 a) According to the Fisher effect, nominal interest rates should increase one-to-one with expected inflation to take into account the effects of inflation on the real cost of repaying a loan. Thus, borrowing during times of inflation is profitable only if inflation turns out to be higher than expected at the time the loan was made. By definition, however, it is impossible to expect to profit from the unexpected. 6 -here the answer that can award you 100% of the marks can be given in 68 words- -Definition/identification of Fisher effect is 4 marks; 6 marks for the distinction between expected and unexpected inflation- b) One of the fundamental factors driving the equilibrium level of real interest rates is the demand for funds to be used for capital expenditure. Lower profitability of real investment will reduce demand for funds from businesses. So, lower demand for funds, ceteris paribus, will result in lower level of equilibrium real rate of interest, as it shifts the demand curve of funds to the left. -here the answer that can award you 100% of the marks can be given in 65 words- -Definition/identification of Fisher effect is 4 marks; 6 marks for the distinction between expected and unexpected inflation- c) =NORM.DIST(0,0.07,0.1,TRUE) 24.20%