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The exam has 2 parts in 4 pages and 100 total points. Allocate your time wisely and
answer all questions. Please spread your work over 4 bluebooks as indicated in the
exam. You have to show your calculations in all the quantitative questions. You
have 85 minutes to complete this exam. Please write your name below and submit
this questionnaire with your blue books. We will not read an exam unless this
questionnaire with your name on it is submitted with the blue books.
Name:
Assume that the probability the Patriots will win the Superbowl is 25%. A souvenir shop
outside the stadium will earn net profits of $1.8 million if the Patriots win, and $0.7
million if they lose. You are the loan officer of the bank to whom the shop applied for a
loan. You can assume that your bank is risk-neutral and that the bank can invest in safe
projects that offer an expected rate of return of 6%.
a. What interest rate would you quote if the owner asked you for a loan for
700,000 today? What interest rate would you quote if the owner asked you
for a loan for $1,000,000 today?
Now assume that the bank is risk averse and follows the Capital Asset Pricing Model to
determine its expected rate of return. The risk free rate is 3% and the return on the market
is 8%. The bank is financed with 30% risk-less debt and 70% equity. The beta of the
bank’s equity is 1.5.
b. What interest rate would you quote now if the owner asked you for a loan
for 700,000 today? What interest rate would you quote if the owner asked
you for a loan for $1,000,000 today?
Question 2: Term Structure and Bond Pricing (15 points)
a) What is the forward rate for a 1-year bond issued 2 years from now?
b) What is the yield on a 3-year coupon bond issued at par today? (Hint a coupon
bond issued at par today has a price equal to its face value).
c) After two years, the yield curve is unchanged. Calculate the price and the
yield of the bond in part (b). (You can assume a face value of $1,000).
d) A consultant tells you that you should take advantage of the upward sloping
yield curve by borrowing at one year rate and lending at the five year rate. He
tells you that since you are borrowing at 4% and lending at 7.5%, your
expected revenue will be 3.5%. Is he correct? Why or why not?
bond’s market price which represents the present value of the bond’s future payments.
a) Show the relation between Macaulay duration and the discount-rate elasticity
of the bond price, where the discount-rate elasticity of the bond price is
defined as .
b) What is the duration of zero coupon bond that matures in 7 years if it trades at
par today?
c) Your portfolio is composed of a $70,000 invested in a consol that pays a
constant $1,000 annually forever (starting a year from now), and $30,000 in
cash deposited in the bank. The discount rate is 11% per year, what is the
duration of your portfolio?
Should The Chocolate Store acquire Rose Boutique, and if so what is the maximum
amount they would be willing to pay?
You are applying for a loan from a risk-neutral bank. You want to borrow $350 for one
year. The bank knows that borrowers with the same default risk as you go bankrupt in 5
out of 100 cases and pay $20. A time-equivalent otherwise identical risk-less government
bond promises a 6% interest rate. Both the loan and the bond have no coupons. What is
the default (or credit) spread of the loan in basis points?