First Midterm Exam − Solutions

Econ 435 − Financial Economics

University of Michigan
Fall 2020

I Definitions and Main Concepts

1. An arbitrage opportunity is an opportunity for riskless profit.
2. The IRR is the interest rate that sets the NPV of a project equal to zero.
3. The YTM is the interest rate that sets the present value of the bond
payments equal to its current market price.
4. Risk aversion is the preference for a safe payment rather than an uncertain
one with the same expected return. The risk premium is the additional
return investors expect to earn to compensate for a security’s risk.
5. The dividend yield is the return obtained from dividend payments, i.e.
Div1 Pi −P0
P0 . The capital gain is the return derived from price changes, i.e. P0 .

II Valuing Bonds
1. Non-arbitrage with risk-free bonds
(a) The prices of the bonds are given by
100
PA = = $90.70
1.052
100
PB = = $95.24
1.05
4 104
PC = + = $98.14
1.05 1.052
(b) Notice that the cash flows of this bond can be replicated by 5 B
bonds and 25 A bonds. Therefore

P = 5PB + 25PA = 5 · 95.24 + 25 · 90.70 = $2743.76

2. Time and bond prices

(a) The coupon rate is zero, which is below the yield to maturity, so
the bond trades at a discount. Intuitively, whenever a bond offers
a coupon rate below prevailing rates, investors will pay less for it.
Buying at a discount compensates them for the relatively lower yield
offered by the bond.

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 (b) The coupon rate is 10%, which is above the yield to maturity, so
the bond trades at a premium. Intuitively, whenever a bond offers
a coupon rate above prevailing rates, investors will pay more for it.
They are willing to buy at a premium to secure the relatively higher
yield offered by the bond.
(c) First, as the maturity gets closer, the discount factor approaches 1.
Moreover, for bonds that pay coupons, as the payments are made,
the remaining cash flows become closer and closer to the face value
of the bond. These two things together ensure the convergence of
bond prices to the face value.
3. Risky bonds
(a) The bond price is given by
0.5 · 500, 000 + 0.5 · 0.1 · 500.000 275, 000
P = = = $261, 904.76
(1 + 0.03 + 0.02)1 1.05
(b) The YTM is given by
  N1  1
FV FV 500, 000
P = ⇒ Y TM = −1 = −1 = 90.91%
(1 + Y T M )N P 261, 904.76
The yield to maturity is higher than the discount rate used in (a)
because the yield to maturity sets the price of the bond equal to
the present value of promised payments, as opposed to the expected
payments discounted by the discount rate to compute the price.

III Interest Rates

1. Interest-rate conversion
(a) Effective annual rates and effective monthly rates are related as fol-
lows
1 + EAR = (1 + EMR)12
Therefore
1 1
EMR = (1 + EAR) 12 − 1 = (1 + 0.03) 12 − 1 = 0.25%
(b) Effective annual rates and annual percentage rates are related as
follows  k
APR
1 + EAR = 1 +
k
where k is the number of compounding periods in a year. With
semiannual compounding
 2  2
APR 0.05
EAR = 1 + −1= 1+ − 1 = 5.06%
2 2

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 2. Interest rates and inflation
We use the Fisher equation

1 + rN
1 + rR =
1+π
Alternatively, we can note that nominal rates and inflation are relatively
low and so we can also use the approximation rR ≈ rN − π. For 1973 we
get
R 1 + 0.12
r1973 = − 1 = 0%
1 + 0.12
For 2006 we get
R 1 + 0.02
r2006 = − 1 = 0.99%
1 + 0.01
R R
We have that r2006 > r1973 : even though nominal rates were higher in
1973, returns measured in terms of purchasing power were higher in 2006.

IV Valuing Investment Projects

1. NPV and IRR
(a) Location A NPV:
10.2
−10 + =0
1.02
Location B NPV:
1.1
−1 + = 78, 431.37
1.02
We would choose location B as it has higher NPV.
(b) Location A IRR:
10.2
−10 + =0
1 + IRRA
IRRA = 2%
Location B IRR:
1.1
−1 + =0
1 + IRRB
IRRB = 1.1 − 1 = 10%
Normally it would be wrong to choose the project with the highest
IRR since these projects have different scales. In this case it would be
right as the project with the highest IRR also has a higher NPV. Also
both projects have negative cash flows before positive cash flows. So
higher IRR is desirable.

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V Valuing Stocks
1. The dividend-discount model
(a)
3 104
P0 = + = 95.39
1.06 1.062
(b)
104
P1 = = 98.11
1.06
(c)
98.11 + 3
P0 = = 95.39
1.06
(d) The 2-year valuation and the 1-year valuation coincides because of the
law of one price. Otherwise there would be an arbitrage opportunity.

VI Valuing a Perpetuity
1.
∞ ∞
X C X 1
n
= C
n=0
(1 + r) n=0
(1 + r)n
!
1 1
=C 1
1+r 1 − 1+r
!
1 1
=C r
1+r 1+r
1 1+r
=C
1+r r
C
=
r
C C
2. If we deposit r today, we can withdraw rr = C every period as interest.