q5fall13

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University of Pennsylvania *

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238

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Finance

Date

Nov 24, 2024

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5

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FIFTH QUIZ FNCE 238/738 November 6, 2013 WRITE ALL ANSWERS ON THE TEST. IF YOUR ANSWER CONTINUES ON THE BACK, MAKE A NOTE OF IT ON THE FRONT. 30 PTS / 25 MINUTES NAME:_____________________________________________ SECTION (12, 1:30 or 3):__________________________________
1. (8 pts) Olga has a good project she could do, call it project G , that would cost $1M, and then pay either $1.6M or $0.8M, each with probability ½. She would like to finance this project by issuing a bond with face value $1M, to be paid from the project’s payoffs. The problem is, she also has a not-so-good project, call it project NSG , that would also cost $1M, and then pay either $1.8M or $0.4M, each with probability ½, and she can’t commit to which project she will choose, once she has issued the bond. Would it help for her to make the bond convertible into ¾ of the firm’s equity? Why or why not?
2. (7 pts) Nobel-prize winner Daniel Kahneman, as quoted in The Observer: Few stock pickers, if any, have the skill needed to beat the market consistently, year after year. Professional investors, including fund managers, fail a basic test of skill: persistent achievement. The diagnostic for the existence of any skill is the consistency of individual differences in achievement. The logic is simple: if individual differences in any one year are due entirely to luck, the ranking of investors and funds will vary erratically and the year-to-year correlation will be zero. Where there is skill, however, the rankings will be more stable. The persistence of individual differences is the measure by which we confirm the existence of skill among car salespeople, orthodontists or golfers. Mutual funds are run by highly experienced and hardworking professionals who buy and sell stocks to achieve the best possible results for their clients. Nevertheless, the evidence from more than 50 years of research is conclusive: for a large majority of fund managers, the selection of stocks is more like rolling dice than like playing poker. Typically at least two out of every three mutual funds underperform the overall market in any given year. More important, the year-to-year correlation between the outcomes of mutual funds is very small, barely higher than zero. Is this logic sound? What considerations are important?
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3. (7 pts) Last week, Moody’s rated the latest CarMax auto-loan securitization, which included securities A1 through A4, B, C and D, and Moody’s awarded a AAA rating to A1 through A4. Briefly, in words, what structural elements of the deal (assuming this is a typical deal) could justify such high ratings, given the moderately risky collateral (i.e., used-car loans to borderline credit risks)? ( bullet points are fine; I’m not looking for paragraphs here)
4. Consider a stock that is worth 10 today, and in one period will be worth either 14 or 5, each with probability ½. The risk-free rate is 5%. a. (4 pts) What is the value today of a European put option on this stock, expiring in one period, with strike price 9? b. (4 pts) What is the value today of a European call option on this stock, expiring in one period, with strike price 9?