1.      Asset Supply and Demand     (30 points)

a.   Explain whether the following statement is true, false, or uncertain.  Use graphs and equations (if relevant) in your explanation.

“ Someone who is risk-averse will not buy an asset that has more risk, a lower expected return, and more liquidity than another asset.”

b.   List those factors which influence the supply and demand of a bond issued by Barclays.  If inflation is expected to rise, what will happen to equilibrium price and quantity for the

bond?  Briefly explain and graphically illustrate your answer.

c.   Capita, an outsourcing firm, recently issued a profits warning, cancelled its dividend, and sought additional funding from investors.  Half its income is generated from the private

sector and the other half from the public sector (for example it collects the BBC license

fee and London congestion charge).  What would you anticipate would happen in the

market for its shares just after the actions outlined above?  Concisely explain and illustrate your answer.

2.      Interest Rates and Returns    (20 points)

a.   Suppose you are interested in buying a 4-year coupon bond with an annual coupon rate of 5% and a face value of £1,000. The current market interest rate is 5%. How much are

you willing to pay for the bond?

b.   Suppose the BoE, through open market operations, forces interest rates up.  Three years  after you purchased the bond, the market interest rate is now 20%. How much is a buyer willing to pay you for that bond now?

c.   Suppose you sold the bond after three years, calculate your rate of return for the bond.

d.   In general (not based on any of the work for parts a-c), what would be the formula for the rate of return of a discount bond which will be sold in five years.  And for a coupon bond which also will be sold in five years.  If the price difference over those five years is £100 for each bond, under what conditions on prices would you prefer to hold the discount

bond?

3.      Mean-Variance Model           (20 points)

a.   Briefly compare and contrast CAPM with the Mean-Variance Model.  What is the

relationship between the risky assets held by individuals and those held by the entire market?

You can invest in asset A with expected return 15% and standard deviation 30% and asset B with expected return 25% and standard deviation 70%.  The correlation between assets is

−0.4.  There also exists a risk-free asset with return 12%.  Suppose you want to construct a portfolio with expected return 20%.