Econ 497 Barry W.

Ickes

Spring 2007

Midterm Exam:Answer Sheet

1. (25%) Consider a portfolio, c, comprised of a risk-free and risky asset, with returns given by
rf and E(rp ), respectively. Let y be the proportion of the portfolio invested in the risky asset.
Let the utility function of the agent be given by
1
U = E(r) − Aσ 2 (1)
2
where A is a constant.

(a) Why does (1) make sense? What does it mean if A < 0? If A = 0? Draw the indifference
curves of an agent who has the preferences described by (1) for each of the three cases:
A < 0, A = 0, A > 0. Which case is the most sensible?
brief answer Utility depends on positively on expected return and negatively on the
risk. This makes sense if people are risk averse or risk loving. Indeed, this equation
can even represent preferences for risk-neutral agents (A = 0). In the latter case
indifference curves will have zero slope: the agent cares only about expected return,
and is indifferent to risk. For A > 0 indifference curves will be positively sloped: the
agent is risk averse, implying that higher expected return is required to get her to
hold more risk. If A < 0 the indifference curves are negatively sloped as the agent is
a risk lover. A > 0 makes more sense given that agents typically purchase insurance.
(b) Denote the standard deviation of the risky asset as σp . What will the standard deviation
of the portfolio, σc , be equal to? What will the variance of the portfolio, σc2 , be equal to?
brief answer The risk-free asset must have zero variance. So σc = yσP . Then σc2 =
y 2 σc2 .
(c) What will the expected return on the complete portfolio, E(rc ) be equal to?
brief answer E(rc ) = yE(rP ) + (1 − y)rf
(d) How will the optimal choice of y vary with (i) the variance of the risky asset; (ii) the
excess return on the risky asset; (iii) the value of A?
brief answer If σP2 increases, then y will decrease given A > 0; this is the case of the
capital allocation line becoming flatter. If E(rP ) − rf increases then y will increase;
this is equivalent to the capital allocation line becoming steeper. If A rises then the
agent is more risk averse, so he will hold less y. Think of it as the indifference curve
becoming steeper.

2. (20%) When Kendall first showed that prices in financial markets evolved randomly he took
this to be disturbing new for economists. It seemed to imply that stock markets are erratic
and irrational. Today this conclusion seems exactly backwards. Why might we expect price
changes in a well-functioning market to evolve randomly? Explain.

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 brief answer If markets function efficiently then any information agents have will be incor-
porated in the price. If you know the price will rise tomorrow, you bid more today.
Hence, arbitrage causes the current price to reveal all available information. If the cur-
rent price reveals all available information, then prices change only on new information.
New information by definition is not yet known. So prices are just as likely to rise or
fall.

(a) If asset prices are determined by some theory (CAPM, APT, etc.) how can price changes
be random? Explain.
brief answer Asset pricing theories explain the current price. They are based on avail-
able current information. New information causes prices to change. So it makes
sense that prices will evolve randomly. Think about pt = Et [mt+1 xt+1 ]. If we ob-
tain new information about future payoffs this will change the price. Since we do
not know what the new information will reveal, we cannot know how the price will
change.
(b) Suppose changes in stock returns were evolving randomly as in an efficient market. At
some date, t1 , the risk premium rises (people become more risk averse). What would
happen to stock prices at t1 ? After t1 what will happen to stock prices? Does this mean
that the market is inefficient? Explain.
brief answer If the risk premium rises stock prices will fall. This is necessary so that
expected returns can rise. (You can think of this as a higher value of A in problem
1. If A rises agents hold less of the risky asset, so its price must fall today given
the supply). With a higher risk premium assets require higher expected returns to
be held. But if prices fall today to reflect the higher risk premium, prices will be
expected to rise in the future — returning to where they were. Indeed, if prices were
not expected to rise in the future returns would not be higher and people would not
hold the assets (this phenomenon is called overshooting). So it seems that prices
are predictable. But this is not a violation of efficient markets. Although the next
period’s price will be a function of the current price, this is because it is the only
way for markets to clear. It is fully compatible with fully informed agents and full
arbitrage. Indeed, there is no way to make excess returns, since the predictable
price is precisely what is required to match the higher risk premium that agents
now demand. Returns are only truly random if agents are risk neutral, or if the risk
premium is uncorrelated with past prices. In this case they are not.
(c) Samuelson convincingly argued that in properly functioning markets it is the change in
the log of the price (e.g., the percentage change in prices), rather than the change in the
absolute price (∆Pt ) itself that evolves randomly. Why would a random walk in the level
(as opposed to the log) of the price of a security be incompatible with economics?
brief answer If ∆P were random then prices could be negative, but asset prices are
bounded below by zero. Negative asset prices make no sense for securities. But if
the growth rate of prices is random then prices no longer can become negative.

3. (30%) Assume the agent is a price taker in the asset (i.e., she can purchase or sell as much
of the payoff xt+1 as she wants at the price pt ). Let xt+1 be the payoff of this asset in period

2
t + 1. The solution to the consumer’s optimal consumption problem yields

pt = Et [mt+1 xt+1 ] (2)

0
where mt+1 = β uu(c0 (ct+1
t)
)
, β is the discount factor, and u0 (ci ) is the marginal utility of consump-
tion in period i.

(a) Explain the logic behind the expression (2). Why does this represent optimal behavior?
brief answer
h 0 It is iuseful to substitute the definition of m in expression (2): pt =
u (ct+1 )
Et β u0 (ct ) xt+1 . I know u0 (ct ) today, so I can write this as u0 (ct )pt = Et [βu0 (ct+1 )xt+1 ].
The left-hand side is the cost of buying a unit of the asset today. It reduces my con-
sumption by pt and the utility cost of that is u0 (ct )pt . The right-hand side is the
expected gain from buying more of the asset. I get the payoff xt+1 and the utility of
that is u0 (ct+1 )xt+1 , but it is in the future, so I discount it by β. If this equation did
not hold true I could raise my utility by rearranging my consumption. One can see
this at point C ∗ in figure 1. If we were at point E, condition (2) is not satisfied, and
utility can be raised by reducing current consumption and having higher expected
future consumption.

Figure 1: Optimal Consumption

(b) Why is expression (2) useful (indeed cool)?

brief answer The stochastic discount factor, mt+1 , can be used to price any asset.
Indeed, the same discount factor can be used to price any asset. That is cool.
(c) Suppose an asset’s payoff, xt+1 , positively covaries with mt+1 . What does (2) imply about
the price of this asset (about your desire to hold it in your portfolio)?
brief answer If the payoff covaries with mt+1 you would like to hold more of it, so its
price will be higher. A higher m means lower future consumption, since marginal
utility decreases with consumption. You would like an asset that pays off higher
when consumption is lower. That is insurance. This is obvious from expression (2)
but it is nice to know why.

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 (d) Suppose the asset’s payoff has zero correlation with mt+1 . What does this imply about
the rate of return that this asset will bear? Explain.
brief answer It must pay the risk-free rate. Only risk correlated with market risk bears
higher return. One could show this formally from the basic price equation again,
p = E(mx). Recall the definition of covariance: cov(m, x) = E(mx) − E(m)E(x).So

p = E(m)E(x) + cov(m, x)
1
Now we can divide through by p to obtain 1 = Et [mt+1 Rt+1 ]or Rf = E(m)
, since it
is a risk-free asset. Thus we have:
E(x)
p= + cov(m, x) (3)
Rf
the first term on RHS is discounted present value, second term is risk adjustment.
Now if the covariance is zero, as in this question last term on the RHS drops off. So
E(x)
p
= E(Rt+1 ) = Rf . We could let σ 2 (x) equal a billion, but if cov(m, x) = 0, it
will still yield only the risk-free rate. Even if people are totally risk averse.
(e) What relationship, if any, does (2) have with the CAPM? Explain.
brief answer Everything! Suppose that m is inversely related to the return on the
market portfolio, RP (This makes sense: when consumption is high, returns are less
valuable to you than when it is low.). Specifically, let m = a − bRP . Then m and RP
are perfectly negatively correlated. So an asset’s payoff depends on its correlation
with the market portfolio. So the CAPM follows from the assumption that investor’s
marginal utility declines linearly when the market goes up. The CAPM says that
the risk premium we require to add asset A to our portfolio is proportional to its β.
If an asset’s return is uncorrelated with the market return — its beta is zero. Such
a risky asset is riskless in the market portfolio so its expected return is the risk-free
interest rate.

4. (25%) Let XU be the future operating income (payoff) of the unlevered firm, and XL be the
same for the levered firm. Assume that they are of the same risk class, i.e., X = XU = XL .
The value of the unlevered firm is equal to the value of the firms equity: VU ≡ SU . For the
levered firm the value is equal to debt plus equity, VL ≡ SL + DL , where S is the current value
of the equity and DL is the current value of the debt. Let r be the rate of return on this debt.

(a) Consider the portfolio that consists of holding α% of the shares of the unlevered firm.
What is the current cost of this portfolio? What is the future payoff equal to?
brief answer It costs you αSU . Its future payoff is αX.
(b) Consider an alternative portfolio that consists of α% of the bonds of the levered firm, and
α% of the equity of the levered firm. What is the current cost of this portfolio? What is
the future payoff of this portfolio equal to?
brief answer The bonds cost you αDL and the equity costs you αSL , or α(SL +DL ). The
payoff from the bonds is the αMin[X, rDL ], since bondholders receive interest unless
the payoff is insufficient to cover this. The equity holders receive the rest, so their

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 payoff is αMax[X−rDL , 0], since there is limited liability. Adding these two terms we
have αMin[X, rDL ] + αMax[X − rDL , 0] = α [Min[X, rDL ] + Max[X − rDL , 0]] =
αX.
(c) Compare the payoffs from the two portfolios. What can you conclude about the current
costs? What does this imply about the relationship between VU and VL ?
brief answer The payoffs from the two portfolios are the same, so the law of one price
says they must cost the same. So α(SL +DL ) = αSU . So SL +DL = SU =⇒ VL = VU .
In words, the value of the firm is independent of its capital structure.
(d) Why is this an important result? Explain.
brief answer We have shown that capital structure is irrelevant. This is the M-M
theorem. This theorem is important because it shows that what matters for firm
value are the firm’s prospects, X, not how it is financed. If leverage does matter for
valuation some assumption of the theorem must be violated. So the theorem makes
us think about what must be true if leverage matters. It also shows us the power
of the LOP. It tells us that if leverage does matter, then the LOP must not hold,
or there must be tax considerations, or costs of bankruptcy. We use 4 assumptions:
(i) No arbitrage (equal-sized bites of the pie have the same taste”). (ii) Operating
income (from assets) is not affected by capital structure. (iii) The proportion of
operating income that is jointly allocated to stocks and bonds is not affected by
the firm’s capital structure (”only stockholders and bondholders eat the pie”). (iv)
The present value function (economy-wide state prices) is not affected by capital
structure (”taste per bite of the pie is fixed”). Notice that assumption (ii) rules
out bankruptcy costs, differential transaction costs, peculiar managerial incentive
schemes based on capital structure. Assumption (iii) rules out differential taxes for
income from stocks and bonds. Assumption (iv) rules out the possibility of creating
or destroying desired patterns of returns not otherwise existing in the market by
changing capital structure.