I need the answer of problem 3, 4, and 5 in pdf file.

Homework 1 UNIVERSITY OF MINNESOTA ECON 4751 - Financial Economics Due Thursday, January 28, 2016 Instructions: Please answer all questions clearly and concisely. Show all work. This can include screenshots of an appropriately set-up Excel spreadsheet. If Excel is used, please indicate which formulas were used in which cells. Illegible homework will not be graded and will receive an automatic 0. You may handwrite or type up problem sets. Problem 1 is worth 2 points, Problems 2 and 3 are worth 4 points, and Problems 4 and 5 are worth 5 points. Problem 1: Dene the following terms: Real vs. Financial Assets Asset vs. Security Allocation Risk-Return Tradeo LIBOR Treasury Notes vs. Treasury Bonds Problem 2: Briey summarize (i.e. 1-2 paragraphs at most) the following events. The summaries must be in your own words. Credit is given based on the quality of the summary. A quality summary is short, clear, emphasizes the main components of the event (not necessarily every single element of the event), and gives insight as to why the event is important or relevant. You are not limited to using the book for information on these events. A. The LIBOR Scandals B. The Financial Crisis of 2008 1 Problem 3: Suppose the only nancial instruments available in Minneapolis are a taxable Federal Treasury Bill (T-Bill) and a municipal bond from the city of Minneapolis. The municipal bond is tax exempt. Assume both the municipal bond and the taxable bond are risk free, i.e. there is no chance of default for each. A. The before-tax rate of return on the T-Bill is 4 percent, while the municipal bond returns 2.75 percent. Minnesota taxes all eligible interest income at a rate of 30 percent. What fraction of his wealth, w, will the investor invest in the municipal bond? Why? B. Now, the before-tax rate of return on the T-Bill is 4 percent. The state taxes all eligible interest income at a rate of 8 percent. The municipal bond has a rate of return of r percent. What should the City of Minneapolis set r equal to so that investors are indierent between investing in the taxable bond and investing in the municipal bond? C. Now, the before-tax rate of return on the T-Bill is r percent, where 0 r 1. Tax on all eligible interest income is levied at a rate of t percent, 0 t 1. The municipal bond provides the investor a rate of return rm percent, 0 rm 1. Suppose investors are indierent between investing in the T-Bills and investing in the municipal bond. Write an equation that describes the relationship between r, t, and rm . D. Call G = (t, rm ) a goverment policy. Given r, illustrate in a graph that has rm on the vertical axis and t in the horizontal axis the collection of all government policies that leave the investor indierent between investing in the two types of bonds. Problem 4: Data on ve dierent stocks is given in the following table: Stock Initial Price XYZ 10 UVW 40 RST 55 OPQ 80 LMN 15 Final Price 15 55 30 120 30 Shares (million) 50 35 50 20 30 A: Suppose that both the DJIA and the S&P 500 are composed of only these ve stocks. - Find both the initial and nal index values as well as the percentage change (to the nearest whole percent) in the DJIA index using the initial and nal prices given in the table. - Find both the initial and nal index values as well as the percentage change (to the nearest whole percent) in the S&P 500 index using the initial and nal prices given in the table. 2 B: Now, suppose at the beginning of the intial period, stock OPQ splits two for one, so now the initial share price of OPQ is $40. The price of OPQ rises by 50 percent just as suggested in the table. - Find the new index values and the percentage change (to the nearest whole percent) of the DJIA index. - Find the new index values and the percentage change (to the nearest whole percent) of the S&P 500 index. Problem 5: Stock returns in dierent market conditions are given in the table. Suppose that a Bear market occurs 20% of the time, normal markets occur 50% of the time, and Bull markets occur 30% of the time. Stock Bear Normal Bull X -4 2 12 Y -6 7 18 A. Find the expected return and standard deviation of stock X B. Find the expected return and standard deviation of stock Y. C. Find the expected return and standard deviation of the portfolio holding 1 X and 3 Y . 4 4 3 ECON-4751 Financial Economics Chapter 1 An investment is the current commitment of money or other resources in expectation of future benefits. We distinguish between real and financial assets. This course focuses on investments in financial assets. Real Assets Real assets directly determine the productive capacity of the economy, which in turn determines material wealth and generates the net income of the economy Examples: land, machinery, buildings, knowledge (human capital), technology, commodities Financial Assets Financial assets are the means by which individuals hold claims on real assets or income They define the allocation of income or wealth among investors The financial assets of the holders are the liabilities of the issuers, so there is no net creation of wealth Classes of Financial Assets Debt Securities, also called \"Fixed Income\" securities Equity (Common Stock) Derivatives Financial Assets Fixed Income (Debt Securities) Money Markets Capital Markets Equities Derivative Securities Financial Assets Fixed Income (Debt Securities) Money Markets Longer-Term Debt Securities Equities Derivative Securities Capital Markets Fixed Income Securities Promise either a fixed stream of income or a stream of income determined by a specified formula Income is paid unless the borrower defaults Examples: corporate bond, floating-rate bond (TIPS, I-Bonds), money market Equity (Common Stock) Represents part ownership in a corporation (shares of stock) Firms may choose to issue dividend to shareholders or re-invest profits in the company The amount of dividend can be changed at the discretion of management Derivatives Are derived from other assets (real and financial) Provide payoffs that are determined by the prices of other assets Can be used to hedge risk - and distribute risk to those willing to accept it Examples: Options, Futures, Swaps Purposes of Financial Markets Information: investors' opinions of company's prospects determine its stock price Consumption Timing: financial assets represent a way to store wealth and shift it to the future Allocation of risk from those who are riskaverse to those who can tolerate risk Separation of Ownership and Management Separation of Ownership & Mgmt Financial assets make it easy for owners to sell their shares to other investors Stockholders can elect a new board of directors if unhappy with present board Company is subject to takeover and replacement of management Review Is cash a real or financial asset? Does a financial asset create wealth? What are the three broad classes of financial assets? What would the world be like without financial assets? Do financial markets encourage gambling? Investment Process The Saving decision is between consumption and accumulation of (financial) assets The Investment decision is how to allocate savings into different assets - One could also invest in real assets such as real estate and education, but that is not discussed in this course Definitions Portfolio is a collection of assets Asset Allocation is a choice among broad classes of assets (stocks, bonds, cash, real estate, etc). More in chapters 6-7. Security Selection is choice among individual securities within each class Security Analysis involves valuation of particular securities being considered Top-down portfolio choice starts with asset allocation, then proceeds to security selection example: \"I want 50% in stocks, 30% in bonds, 20% in cash.\" Bottom-up strategy results from selection of individual securities with less concern for overall asset allocation \"This stock looks good - let's buy 200 shares.\" Competitive Markets Active vs. Passive Management: Spend time analyzing securities and looking for mispriced assets or just own a highly diversified portfolio? In equilibrium, there will be a certain amount of active investing and analysis but bargains are not easy to find. Markets are Competitive Few, if any obvious bargains exist. \"No free lunch\" Risk-Return tradeoff: Higher returns are generally accompanied by higher risk. Efficient Market Hypothesis: new information is quickly absorbed into the price of a security, so that at any given time the market price is the consensus about value. (more in ch. 11) The Players in Financial Markets Firms Households Government Financial Intermediaries: banks, investment companies, insurance companies, mutual funds, hedge funds, ... Who does what? Firms: are net borrowers. Sell stock and issue bonds to raise capital. Pay investors dividends and interest Households: save and invest in securities issued by firms and government Government: can borrow or pay down debt Financial Intermediaries: facilitate interactions between parties Government U.S. Government sells Treasury Bills, Notes, and Bonds Sets rules for financial transactions and types of financial assets Can establish government agencies which participate in financial transactions Financial Intermediaries Examples: banks, investment companies, mutual fund companies, insurance companies, credit unions Banks make profit by borrowing money from depositors then lending at higher rate Economies of scale: - Can pool resources of many small investors to lend to big borrowers - Can lend to many borrowers to achieve diversification for investors/depositors Investment Banks Advise firms on the prices they can charge for issuing securities: stock price, interest rate on bonds Market the securities in the primary market It is in an I-Bank's interest to protect its reputation for honesty and quality of securities issued. Recent Trends Globalization - Wider range of investment choices Securitization - Pooling a group of loans into tradable securities Financial Engineering - Synthesis of new financial products Examples: CDOs, CDS, leveraged ETFs Recent Trends Information and Computer Networks - Online trading: direct access - Software for quick matching of buy and sell orders - Information available to individual investors - More active players in the \"game\" Chapter 2 Asset Classes and Financial Instruments Segments of a Financial Market Money Markets (debt securities) - Short term - Liquid - Less risky Capital Markets (debt, equity, derivatives) - Longer term - Less liquid - More risky Money Markets Treasury Bills Commercial Paper Certificates of Deposits Interbank Loans Bankers Acceptance and Brokers Calls Repurchase Agreements Money Markets: Treasury Bills U.S. Treasury Bills (T-Bills) - Sell in denominations of $100 - Price determined in public auction - Maturities of 4, 13, 26, 52 weeks - Interest is exempt from tax at state and local levels - www.treasurydirect.gov Properties of Bonds Par Value: the face value of the bond, or what it is worth at maturity date Maturity: the length of time from issue until the bond reaches its par value and is repaid in full. Coupon Rate: percentage of par value paid annually in interest A zero-coupon bond makes no interest payments Properties of Bonds Discount: percentage by which bond is priced under par value Yield: Implicit rate of return on the bond. On the secondary market: - Bid & Ask prices: amount at which dealer is willing to buy & sell a bond - Bid-Asked spread: difference between ask and bid price. Formulas for Yields and Discounts The Discount of a zero coupon bond is: The Yield for a zero-coupon bond is What do we do if we do not have yearly bonds? Annualizing Discount and Yield We simply scale the yield. What is the appropriate fraction to scale it by? Depends on the accounting convention, sometimes use a \"bank discount method\" of using a 360 day year for ease of computation. If a 28 day T-bill has a 0.1% yield, what is it's annual yield? - We call the annualized yield the \"bond equivalent yield.\" Allows us to compare bonds of different maturity What do we do if we have a bond equivalent yield and want to determine the yield to maturity for a bond? Security Term 13-WEEK Issue Date Maturity Date Example Discount Rate % 09-06-2012 12-06-2012 0.100 Investment Price Rate % Per $100 0.101 CUSIP 99.974722 9127956V8 U.S. T-Bill: $100 par value Maturity of 13 weeks (91 days) 13-wk discount = 0.025278% To annualize, multiply by 365/91 = 0.101389% 13-week yield = 0.02528439% Yield = 0.02528439% *365/91 = 0.101415% Money Markets: Commercial Paper Issued by companies that are usually wellestablished. Used as a short-term patch. - Unsecured debt - Credit ratings will affect price - Short-term - Maturities up to 270 days do not need to be registered with SEC (usually