ECON UN3025
Sample Midterm
MIDTERM FROM A PRIOR SEMESTER
If there’s a question on a topic we haven’t covered in class before the review
session or I mentioned is not in the Midterm, that type of question would not
be in the Midterm
Write your answers in the Bluebook, make sure you write your name and student ID on the cover page
General Instructions
• For the following questions that require a numerical answer and for full credit, clearly write
down your work to demonstrate how you arrived to the answer.
• You are allowed to use a calculator that can perform financial calculations.
• You will not receive credit if you just write in one number as an answer from your calculator for
numerical calculations. Write down the formula(s) you used or the inputs and functions used
for your calculator.
• For scratchwork, use your Bluebook.
• For final numerical answers, round to cents (two decimals) if it’s an amount. Round to four
digits if providing rates as decimals or to two decimals if providing rates as percentages.
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1. NPV and IRR (15 points)
Consider an asset that provides the following annual cash flows:
CF Year 1 CF Year 2
40 200
(a) You observe the cost to buy the asset is 130. What is the NPV of investing in the asset if
your annual discount rate is 15%? (5 points)
(b) What is the asset IRR? (5 points)
(c) You hear someone say that they always pick investments with the highest IRR, no matter
what. What are two cautions or considerations you would tell them? (5 points)
2. Bonds (15 points)
You observe a Treasury Note with 6% coupon and 3 years maturity. It has a face value = 1000.
(a) If the Treasury Note price is 980, what is its YTM? (5 points)
(b) You decide to buy the Treasury Note at the price you calculated above. Now exactly six-
months have passed, the Treasury Note has made one semi-annual coupon payment to you.
It’s still a Treasury Note with 6% coupon but now has 2.5 years maturity. Its YTM is now
4%. What is its price? (5 points)
(c) You decide to sell the Treasury Note right after the making the calculation above. What is
the yield of the buy, receive one coupon payment and then sell the Treasury Note strategy?
Per market convention, report your yield as an APR.
For simplicity, you can assume the following sequence occurs almost instantly 6 months af-
ter you buy the Treasury Note: you receive the semi-annual coupon payment, then observe
the Treasury Note price (with 2.5 years maturity) and finally decide to sell and receive
payment from the buyer. In other words, your first cash flow is buying the bond and your
second cash flow is receiving the coupon payment and proceeds from selling the note right
after. (5 points)
3. Spot Rates and Yield Curve (25 points)
Prices of Zeros for 6 months, 1 year and 1.5 years (remember always with face value = 100) are
given by:
• Z0.5 = 98.60
• Z1 = 96.70
• Z1.5 = 95.30
(a) What are the spot rates for each of the three Zeros? (5 points)
(b) Assume you’re a true believer in the Expectations Hypothesis, what do the spot rates you
calculated in part a) imply is the future (spot) 6-month rate in sixth months (r0.5,0.5 from
the perspective of seeing prices and rates at time 0)? What does it imply happening to the
six-month spot rate in six months compared to the six-month spot rate today? (5 points)
Instructor Note: as mentioned in the review session, r0.5,0.5 could also be written as r1,0.5
depending on how you prefer to phrase the timing and Zero maturity
(c) You have a friend skeptical of your prediction of r0.5,0.5 and instead predicts that the 6-
month spot rate will stay stable such that r0.5,0.5 = r0.5,0 . What would be one reason they
would give to observe an upward sloping spot rate yield curve between the 6 month and 1
year spot rate? More specifically, what reason would they give for thinking r0.5,0.5 = r0.5,0
while observing that r1,0 > r0.5,0 ? Only one reason and its explanation is needed for full
credit. A sentence or two will suffice. (5 points)
(d) Still assuming you’re a true believer in the Expectations Hypothesis, what do the spot rates
you calculated in part a) imply is the future (spot) 6-month rate in one year (r1.5,1 from the
perspective of seeing prices and rates at time 0)? (5 points)
(e) What do your calculations above imply of spot rate yield curve between 6 months and 1.5
years, and its implications in the future rates? Why does the market (investors and media)
care about it when it happens in practice? (5 points)
4. Short Questions (15 points)
(a) What is the final payment at maturity (including face value and coupon payment) of the
following TIPS bond? (8 points)
TIPS bond:
• Maturity = 2 years and bond pays annually
• Coupon rate: 5%
• Inflation in year 1 is 7% and in year 2 is 4%
• Face value = 100
(b) Give three assumptions for the CAPM to hold. (7 points)
5. Stock Return Analysis (10 points)
You are given the power to know the population distribution for two stocks (Stock A and Stock
B) returns for the next period. You know there are only two states that can occur overall in the
economy: Normal and Low-Growth.
State Probability Stock A Return Stock B Return
Normal 60% 9% 3%
Low-Growth 40% 3% -1%
What is the correlation between Stock A and B? For full credit, show all your work and the inter-
mediate steps.
6. Risk Aversion and Portfolio Theory (20 points)
You’re an investor that only has access to one risky asset (Stock A) and one risk-free asset. You
have a standard mean-variance preference utility function: U = E(R) − 12 × AσR2 . The risky asset
has an expected rate of return of 7% and a standard deviation of 18%. The risk-free asset has a
3% rate of return.
(a) What is the portfolio Sharpe Ratio? (4 points)
(b) Assume your risk aversion parameter A = 3. What fraction of your investment do you
optimally allocate to the risk-free asset? (4 points)
(c) What would have to be the risk-free rate of return for you to be indifferent between allo-
cating all your investment in the risk-free asset versus the optimal allocation you found in
part (b)? (4 points)
(d) Suppose another risky assets exists, Stock B. Its expected rate of return is 9% and a standard
deviation of 40%. What is the Sharpe Ratio of a portfolio between only Stock B and the
risk-free asset? If an investor can only invest in one risky asset, which one would they
choose and why based on your calculations so far? (4 points)
(e) Suppose the correlation between Stock A and B is zero. Describe the mean-variance
frontier of the risky portfolio composed by Stock A and B. No need for exact extra calcu-
lations but describe the shape of the frontier, points it crosses (or does not cross) and its
boundaries based on knowing the means of, standard deviations of and correlation between
Stock A and B. You can provide a drawing but you must write a few sentences describing
the mean-variance frontier. (4 points)