MFIN1151_Fall21_Midterm_Version_A

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MFIN 1151 Midterm Exam: Fall 2021 Page 1 MFIN1151: Investments Fall 2021 Midterm Exam Prof. David Solomon INSTRUCTIONS You have one hour and fifteen minutes to complete this exam. This exam is closed book and closed notes, except for one sheet of 8.5x11 notes (both sides). Calculators are allowed. There are 11 questions for a total of 180 points This exam is taken under the Academic Integrity Policy, which stipulates: Cheating is the fraudulent or dishonest presentation of work. Cheating includes but is not limited to: -the use or attempted use of unauthorized aids in examinations or other academic exercises submitted for evaluation; -copying from another student's work; -actions that destroy or alter the work of another student; -unauthorized cooperation in completing assignments or during an examination; -dishonesty in requests for make-up exams, for extensions of deadlines for submitting papers, and in any other matter relating to a course. Please sign your name below to acknowledge and accept the Academic Integrity Policy. SIGNATURE: (Please sign) NAME: (Please print) STUDENT ID:

MFIN 1151 Midterm Exam: Fall 2021 Page 2 1. (30 points total) You are an investment manager, and can combine a risk-free T-Bill which earns 1% (which you can either buy or short) with a single risky asset. You only care about the mean and variance of your portfolio. You can choose your single risky asset from two alternatives Your current stock index has an expected return of 9% and a standard deviation of 24% You are considering switching to a bond index, with an expected return of 5% a) (15 points) What standard deviation of returns for the bond index would make you switch, and why?

MFIN 1151 Midterm Exam: Fall 2021 Page 3 b) (15 points) Suppose that the bond portfolio has a standard deviation of 10%, with other parameters the same as before. You are currently invested 100% in the stock portfolio, as per the wishes of your client, Andropov. You are suggesting switching to the bond portfolio plus some position in the T-Bill. Andropov says “You know, I don’t really care a great deal about risk, I mostly just care about mean returns. Reducing risk from 24% to 10% doesn’t appeal to me much , and the bond index has lower average returns. I’m fine with a standard deviation of 24%, so I don’t want to switch.” Given this set of preferences, should the client switch? If so, explain why, and how those preferences can be satisfied. If not, explain why not.

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MFIN 1151 Midterm Exam: Fall 2021 Page 4 2. (20 points) Suppose your friend Chernenko is trading on Robinhood, and he sees a stock with a bid of $10 and an ask of $10.10. He buys 100 shares of the stock using a market order, and pays no commission to Robinhood. The stock rises in price to a bid of $10.50, and an ask of $10.60. He sells the 100 shares of the stock using a market order. Chernenko explains to you “I don’t pay any fees to Robinhood, and since the stock went up in price, my trades are free.” Do you agree? Please explain your reasoning , and show the costs of the trade, if any. Hint: For purposes of comparison, you may consider the profits from the trade relative to the bid-ask midpoint prices.

MFIN 1151 Midterm Exam: Fall 2021 Page 5 3. (20 points) You currently hold a portfolio that is 100% invested in US stocks, with an expected return of 12% and a standard deviation of 18%. The risk-free rate is 2%. You are considering investing some of your portfolio in French stocks, which have a standard deviation of 21%, and a correlation with the US of 0.4 For what expected return on French stocks will you want to take a short position in France if you want a higher Sharpe Ratio?

MFIN 1151 Midterm Exam: Fall 2021 Page 6 4. (10 points) Which of the following are true about short selling an equity market index and leaving your sale proceeds in cash? Circle all that apply (no explanations needed) i) The equity premium puzzle means that the equities you are selling on average have higher expected returns relative to treasury bills you are purchasing ii) Under the Shiller argument about discount rates, shorting the market can generate high expected returns if the price/earnings ratio is low. iii) Under the Capital Allocation Line, you will end up with a portfolio that has both a lower mean and a higher volatility than the risk-free asset, as long as the market has higher returns than the T-Bill. iv) You will have to both pay a short lending fee to the person you borrowed the stock from, and deposit additional collateral 5. (10 points) Suppose that a stock has risen in price on a given day. Which of the following would be an example of a cash flow explanation for the observed price movement? Circle all that apply (no explanation necessary). i) Investors perceive the stock to have less exposure to macroeconomic shocks ii) The firm loses a major patent lawsuit, which reduces their likely profits for the next decade iii) A change in sentiment causes investors to irrationally push up the price of the stock iv) A new product launch generates unexpectedly high sales

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MFIN 1151 Midterm Exam: Fall 2021 Page 7 6. (20 points total) Consider the following 7 portfolios, A through G. The expected returns and standard deviations of each are plotted on the graph below. a) (10 points) Which portfolios lie on the efficient frontier for an investor who can invest at the risk-free rate, but not borrow? E(R) σ (R) B C E D A F G

MFIN 1151 Midterm Exam: Fall 2021 Page 8 b) (10 points) Your friend Malenkov is considering the above portfolios, and says: “I was told in my investments class that I should put all my money in the tangency portfolio. Is that portfolio labeled in the diagram above? Also, is that what I want to do?” Please respond.

MFIN 1151 Midterm Exam: Fall 2021 Page 9 7. (20 points) In February and March 2020, equity markets experienced large negative returns on initial news of Covid-19. Since then, there have been large positive equity returns that occurred between mid-April 2020 and October 2021. Explain, using a present value framework, how these might be consistent with: i) Cash flow news ii) Discount rate news through mispricing iii) Discount rate news through risk i.e. Explain plausible versions of each of the above channels, not necessarily which one is the truth

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MFIN 1151 Midterm Exam: Fall 2021 Page 10 8. (20 points) Suppose you have $1m to invest. Stock A has a current price of $8, and in one year will pay a dividend of $1 and have a price of $6. The return on treasury bills is 4%. Assume that to short sell each unit of A has round-trip transaction costs of 1%, while purchasing each unit of the treasury bill has round-trip transaction costs of 0.2%. If you decide to short $0.5m of stock A and invest the entire amount (short sale proceeds plus your initial amount) in treasury bills, what is your expected return over the next year?

MFIN 1151 Midterm Exam: Fall 2021 Page 11 9. (10 points) Which of the following statements are true ? Circle all that apply (no explanation necessary). i) Higher leverage increases a portfolio’s risk, for almost every model of risk ii) The Sharpe Ratio of an asset represents the reward-to-risk ratio for a choice of how much to lever up or down an asset iii) To lever up an asset requires a positive weight in the risk-free rate iv) The Capital Allocation Line is straight even if risk-free borrowing and lending rates are different 10. (10 points) Which of the following statements are true ? Circle all that apply (no explanation necessary). i) Market orders trade with certainty, and result in better prices than limit orders ii) Sophisticated investors tend to split up larger orders into smaller orders to conceal their trades iii) Market orders can have unexpectedly large price impact if they get submitted when liquidity is low, like during the Flash Crash iv) In modern equity markets, there is a positive bid-ask spread because of high frequency traders

MFIN 1151 Midterm Exam: Fall 2021 Page 12 11. (10 points) In Homework 1, you constructed both an equal-weighted and a value- weighted portfolio of returns for five tech companies. Explain conceptually how you can use these two sets of portfolio returns to work out whether in general the larger or smaller of the five stocks had had greater average returns (you don’t have to remember the answer itself from the homework, just how you would come up with it).

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