ECNM08019 Introductory Financial Economics 2021
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SCHOOL OF ECONOMICS
Introductory Financial Economics
ECNM08019
2021
Q1 In the following computations you may assume risk premia are zero and the
expectations hypothesis holds
a) If the expected (ex ante) real rate of interest is 3% during the next year and nominal short rates for the year are 5% what is the expected rate of inflation?
b) Explain in one line yield to maturity in intuitive approximate and simple terms.
A 2 year discount bond has a face value of 1000 and a price of 900. What is its yield to maturity?
c) A 2 year bond has a yield to maturity of 2%, a face value of 100 and a coupon rate of 1%. What is its current price?
d) A consol pays a coupon of 1 per year. If short (one year) interest rates are 1% and expected to stay like that for the infinite future what is the price of the consol today?
Q2
a) A stock sells for 100 and is expected to pay a dividend of 10 in the next year. If its required rate of return is 5% what is its expected price in one year's time assuming markets are efficient?
b) If the one year ahead forecasted return on a portfolio is always 3% and dividends on the portfolio are known to be 2 per year in the future what is the efficient markets price of the portfolio?
c) A share has required return of 5% a dividend growth rate of 2% and a required return of 5%. Good news arrives about future dividend growth ; they are expected to be 1% higher than before. Use the Gordon Growth Model to compute the percentage increase in price that occurs when the news arrives.
Q3
Two assets have the uncertain end period values A and B with the following probabilities
a) Without doing any numerical computations at this point, briefly comment (two lines max) on the differences between the assets.
b) What are fair prices for each asset?
c) What are the standard deviations of each asset value?
d) Janet and John do not wish to buy these assets at their fair prices. What does this tell you about Janet and John?
e) Janet gets asset A for Xmas and John gets B for Xmas. Afterwards they agree to swap assets. What more does this tell you about the two?
Q4
Firm A has 10 shares. The present value (PV) of the firm is 500 i.e. 50 per share. It has an investment opportunity requiring an investment of 200 but it must sell new shares to raise this amount and take this opportunity. If it succeeds in issuing and investing, the end period firm PV will be 800.
a) What is the lowest market price of firm A's shares that will allow the project to proceed and how many shares will it issue at this price?
b) Explain in two lines why the share price might be lower than in a).
Q5
A firm with initial equity E has an option to invest in a safe or a risky project, both of which require a loan L from a bank to get off the ground. The posted interest rate for the loan is R. The safe project yields S extra value to the firm for sure. The risky project gives high and low extra values to the firm of G and -G with probability p and 1-p respectively.
a) Suppose L.R < S+E. What is the interpretation and importance of this?
b) Suppose also that L.R>E-G. What is the interpretation and importance of this?
c) If additionally S<p.G-(1-p).G then show (or argue) that the firm will always strongly prefer the risky project.
d) Show (or argue) that in this scenario the effective rate of interest the bank earns will always be lower than the posted rate R.
e) Can the bank raise it’s effective rate of return by raising R?
2022-02-15