ECON215 - Stocks, Bonds, and Financial Markets
VERSION B Midterm I — ANSWER KEY
Spring 2026
Name: _______________________________ ID Number: _____________________
Instructions: Answer all questions in the space provided. No calculators are permitted. Write
clearly and concisely. Total points: 100.
1. (5 points)
a) When was the New York Stock Exchange founded, and how was it originally organized?
Answer: The NYSE was founded in 1792 with the signing of the Buttonwood Agreement. It
was originally organized as a cartel of 24 brokers who agreed to trade securities only among
themselves and to charge clients fixed minimum commissions.
b) What is the most important service provided by a stock exchange, and why?
Answer: The most important service provided by a stock exchange is liquidity, which is the
ability for investors to quickly buy and sell securities at a fair, publicly known price. By
centralizing buyers and sellers in a single marketplace, exchanges reduce search costs as
well as convert holdings to cash when needed. These reduced search and conversion costs
thereby lower the cost of capital.
2. (10 points)
a) Write down the Fisher Equation and define each term. If the real interest rate is 2% and
expected inflation is 3%, what is the approximate nominal interest rate?
Answer: i ≈ r + πᵉ, where i = nominal rate, r = real rate, πᵉ = expected inflation. i ≈ 2% + 3%
= 5%.
b) How accurate is the Fisher equation when the in8%flation rate is extremely high?
Answer: Much less accurate, because the equation assumes away the cross product. The
exact fisher equation is (1+r_{nominal}) = (1 + r_{real})(1+\pi^{e}). Expanding the right-hand
side: 1 + r_{nominal} = 1 + r_{real} + \pi^{e} + r_{real} \times \pi^{e}. Subtracting one from
both sides: r_{nominal} = r_{real} + \pi^{e} + r_{real} \times \pi^{e}. The approximation drops
the cross product. This is justified when r_{real} and \pi^{e} are small, because the product of
two small numbers is neglib le. When inflation is very high, the product becomes large and
can no longer be ignored.
c) EXTRA CREDIT: Write out the derivation of the Fisher equation. Answer: 1 + r_{nominal}
= 1 + r_{real} + \pi^{e} + r_{real} \times \pi^{e}
3. (5 points) Suppose 10-year Treasury yields fall to 2.5% while 2-year Treasury yields are
4.0%. What is this yield curve shape called, and what does it historically signal about the
economy? Explain the economic logic.
Answer: An inverted yield curve. It historically signals an upcoming recession. The logic:
investors expect future rate cuts (due to economic weakness), so they buy long-term bonds
to lock in yields, driving long-term rates below short-term rates.
4. (10 points)
a) Explain in your own words what Macaulay duration measures. Your answer should go
beyond “it measures interest rate risk.”
Answer: Macaulay duration is the weighted average time (in years) until a bondholder
receives the present value of the bond’s cash flows, where weights are the present value of
each cash flow as a share of price paid for the bond. It answers: “On average, how long do I
wait to get my money back in present value terms?”
b) Complete the sentence: “Modified duration tells us ___.”
Answer: “…the approximate percentage change in a bond’s price for a 1 percentage point
change in yield.”
c) For each pair, state which bond has higher/longer duration and briefly explain why:
(i) A 20-year bond vs. a 5-year bond (same coupon rate)
Answer: 20-year bond. Longer maturity pushes cash flows further into the future, raising the
weighted average time.
(ii) A zero-coupon bond vs. a coupon-paying bond (same maturity)
Answer: Zero-coupon bond. Its only cash flow is at maturity, so duration equals maturity
exactly. Coupon payments pull the weighted average earlier.
5. (5 points) When you buy a share of common stock, what do you actually own? Describe
two rights you acquire as a shareholder and one key way that stockholders’ claims differ from
bondholders’ claims.
Answer: You own a partial stake in the corporation. Two rights: (1) voting rights on corporate
decisions (e.g., board elections), (2) residual claim on earnings through dividends and capital
gains. Key difference: stockholders are residual claimants—paid last in bankruptcy, after
bondholders, who have senior contractual claims.
6. (5 points) Consider three bonds, each with a $1,000 face value and 10-year maturity:
Bond A: U.S. Treasury bond, coupon rate = 3%
Bond B: BBB-rated corporate bond, coupon rate = 5%
Bond C: Municipal bond, coupon rate = 2%
Why does Bond B pay a higher coupon than Bond A? Rank all three from lowest to highest
default risk.
Answer: Bond B pays more because of credit/default risk—investors demand a spread over
Treasuries. Expected default risk ranking: A (Treasury) < C (muni) < B (corporate).
7. (10 points) For each of the following scenarios, explain what generally happens to bond
yields and why. Then provide a specific historical example that illustrates the pattern. Your
examples should draw on cases you have encountered in your own research or class
presentations.
a) A severe recession
Answer: Treasury yields fall—central banks cut rates and investors flee to safety. Corporate
spreads widen as default risk rises.
Example (answers vary): 2008 GFC: Fed cut rates to ~0%, 10Y Treasury fell below 2.5%. OR
2020 COVID: 10Y fell below 0.7%.
b) A period of high and rising inflation
Answer: Bond yields rise—investors demand higher nominal rates per the Fisher equation,
and central banks raise rates to fight inflation.
Example (answers vary): Late 1970s/early 1980s: Volcker raised fed funds to ~20%, 10Y
Treasury peaked near 15%. OR 2022: CPI above 9%, Fed raised rates from ~0% to 5%+.
c) An episode of sovereign or corporate default
Answer: Yields on the defaulting entity spike as prices collapse. Contagion may spread to
similar issuers. Safe-haven yields may fall.
Example (answers vary): Greece 2010–2012: 10Y yields rose from ~5% to 35%+. OR
Argentina 2001 default. OR Lehman Brothers 2008.
8. (10 points) A stock has the following probability distribution of annual returns:
Recession (probability = 0.25): Return = –20%
Normal growth (probability = 0.50): Return = 5%
Boom (probability = 0.25): Return = 20%
a) Write down the general formula for the expected return when returns depend on discrete
scenarios. Define any notation you use.
Answer: E(R) = Σ pᵢ × Rᵢ, where pᵢ = probability of scenario i, Rᵢ = return in scenario i.
b) Compute the expected return for this stock.
Answer: E(R) = (0.25)(–20%) + (0.50)(10%) + (0.25)(20%) = –5% + 2.5% + 5% = 2.5%.
c) Write down the general formula for the variance of returns under discrete scenarios.
Answer: Var(R) = Σ pᵢ × (Rᵢ − E(R))².
d) Without computing the exact variance, explain in words which scenario contributes the
most to the variance of this stock’s return, and why. What is the relationship between
variance and standard deviation?
Answer: Recession contributes the most because its return is farthest from the expected
return. Since variance depends on squared deviations from the mean, extreme outcomes
dominate. Standard deviation is the square root of variance and is preferred because it’s
measured in return units.
9. (10 points) A bond has a face value of $1,000, a coupon rate of 6% paid annually, a
maturity of 4 years, and is currently priced at $600.
a) What is the annual coupon payment?
Answer: 0.06 × $1,000 = $60.
b) Calculate the current yield.
Answer: $60 / $600 = 10%.
c) Without computing the exact yield to maturity, is the YTM above or below the current yield?
Explain your reasoning.
Answer: YTM is above the current yield. The bond trades at a discount, so the investor earns
a capital gain at maturity in addition to coupons. YTM captures both sources of return; current
yield only captures the coupon.
10. (10 points)
a) Write down the CAPM equation. Using the CAPM, calculate the expected return on a stock
with β = 2 if the risk-free rate is 3% and the expected market return is 9%. Show your work.
(No calculator necessary!)
Answer: E(Rᵢ) = Rᶠ + βᵢ[E(Rₘ) − Rᶠ]. E(R) = 3% + 2(9% − 3%) = 3% + 12% = 15%.
b) If you estimate that this stock will actually return 17%, is it overpriced or underpriced
according to the CAPM? Explain in 1-2 sentences.
Answer: Underpriced. CAPM requires 15% for this level of risk, but the stock is expected to
return 17% (positive alpha of 2%). The price is too low relative to expected cash flows,
making it a good buy.
11. (10 points) For each of the following scenarios, determine which form(s) of the Efficient
Market Hypothesis (EMH) would be violated if the described pattern were real and
exploitable.
a) A hedge fund discovers that stocks with high price momentum over the past 6 months tend
to outperform the market over the next 3 months, generating abnormal returns of 2% per
month on average.
Answer: Violates the weak form (and therefore semi-strong and strong as well). The
strategy relies entirely on past price data. If past returns can predict future returns and
generate abnormal profits, then past price information is not fully reflected in current prices,
which is exactly what the weak form claims.
b) An analyst finds that stocks experience significant price increases in the 48 hours following
positive earnings announcements, even after accounting for the magnitude of the earnings
surprise.
Answer: Violates the semi-strong form (and strong). The earnings announcement is public
information. If prices are still moving significantly 48 hours after the news is released, then
publicly available information is not being incorporated into prices quickly enough. Under
semi-strong efficiency, the price should adjust almost immediately—not continue drifting for
two days. The weak form is not violated here, since the strategy requires public fundamental
information, not just past prices.
c) A researcher discovers that corporate insiders’ stock purchases are followed by abnormal
returns of 5% over the subsequent 6 months, even after the purchases are publicly disclosed
on SEC Form 4.
Answer: This has two layers. The fact that insiders earn abnormal returns on their trades
violates the strong form—prices aren’t reflecting private/insider information. But the key
detail is “even after public disclosure”: if outsiders can earn abnormal returns simply by
tracking publicly filed Form 4s, that also violates the semi-strong form, because the Form 4
filing is public information. If semi-strong efficiency held, prices should adjust immediately
once the insider purchase becomes public, leaving no exploitable pattern.
12. (10 points) Write down the “magic pricing equation” and answer the following.
a) Write the equation and define each variable. What does the equation say, in plain
language, about how we determine the price of a financial asset? What is the role of time
discounting?
Answer: (not writing the equation here). The price of a financial asset equals the sum of all
its future cash flows, discounted back to today. We discount because a dollar received in the
future is worth less than a dollar in hand today.
b) How is the discount rate determined? Give at least 3 specific factors.
Answer: factors include: the risk-free interest rate, the risk premium demanded, and inflation
expectations.
c) Using the magic pricing equation, explain why asset prices and interest rates move in
opposite directions. Your answer should reference the structure of the equation directly. Do
not just state the conclusion.
Answer: (not writing the equation here). Each term in the sum has (1+r)^{t} in the
denominator. When r increases, every denominator gets larger. Since the cash flows are
fixed, each term gets smaller. Because P is just the sum of these terms, P must fall. The
reverse is true when r falls: smaller denominators mean larger terms and a higher price.