Asset Markets (1st half)

Question 1

EAR & APR

Answer 1

EAR: indicates the total amount of interest that will be earned at the end of the year (need to use powers)
APR: indicates the amount of simple interest earned in one year

Question 2

Replicating a floater + value at reset

Answer 2

A dynamic strategy of rolling one-year bonds until the floater’s maturity and collecting the coupons along the way replicates the cash flows of the floater
(on reset dates, a floater is worth par ex-current coupon)

Question 3

Two things we should not use YTM for

Answer 3

1. measure a bond’s return (using the YTM for comparing bonds is correct only when the bonds have the same coupon and time to maturity
2. a tool for choosing different bonds

Question 4

Upward vs downward sloping yield curve

Answer 4

Upwards: economics expansion
Downwards: economic recession

Question 5

Empirical violation of EH

Answer 5

1. long-maturity bonds return more, on average, than short-term maturity bonds (since the term structure slopes upwards in general)
2. excess return of long-maturity bonds over short-maturity bonds is positively related to slope of term structure…?

Question 6

Direction of movements that is consistent with EMH

Answer 6

Steep positive slope - short rates are likely to increase

Negative slope - short rates are likely to decrease

Question 7

Factors that affect the term structure

Answer 7

1. inflation: positive inflation means that the purchasing power of money decreases -> the higher the expected inflation, the lower the demand for bonds is.
2. monetary policy: open market operations, standing facilities, reserve requirements, QE

Question 8

Suppose investors want to ensure a real return

Answer 8

They would invest in nominal bonds only if their expected returns are higher than that of real (inflation-linked) bonds

Question 9

Bond prices vs. interest rates

Answer 9

Bond prices go down when interest rates go up and vice versa.

Question 10

Macaulay duration for T-year zero coupon bond

Answer 10

T

Question 11

Modified duration meaning

Answer 11

Tells us what happens to the value of a dollar invested in the portfolio for a unit change in yield

Question 12

Properties of Macaulay duration

Answer 12

1. D always decreases with coupon rate

2. D generally increases with time to maturity (but not always)

Question 13

Error of duration (vs convexity)

Answer 13

• understates the capital gain if IR decreases
• overstates the capital loss if IR increases
  (note diagram)

Question 14

CAPM assumptions

Answer 14

• N risky assets & riskless assets
• trading of assets is costless
• investors care only about mean & variance
• investors have the same information
• investors have a one-period horizon

Question 15

Uses of CAPM

Answer 15

• valuation of stocks
• valuation of firms’ investments
• portfolio selection