Finance Principles Quiz: Bonds and Stocks

Podcast

Play an AI-generated podcast conversation about this lesson

Questions and Answers

What is required to calculate the price of a two-year risk-free bond with a 20% coupon rate?

Down payment and mortgage rate

Face value and interest rates only

Only the yield to maturity

The coupon payments and the yield to maturity (correct)

Which rate directly affects the price prediction of Company A’s stock after a change in the risk-free interest rate?

The risk-free interest rate (correct)

The risk premium for stocks

The growth rate of dividends

The dividend payout rate

How much is the annual down payment available for purchasing the house?

$300,000

$10,000

$20,000 (correct)

What is the interest rate of the mortgage offered by the bank for the house purchase?

5% per year Signup and view all the answers

If dividends for Company A are predicted to grow by $0.15 each year for two years, what will be the dividend in year two?

$1.65 Signup and view all the answers

What is the duration of the mortgage before the payments change to a constant amount?

5 years Signup and view all the answers

What would be the effect on the price of Company A’s stock if the Fed raises the risk-free interest rate to 4%?

Decrease in stock price Signup and view all the answers

What is the total cost of the house that you are thinking of purchasing?

$300,000 Signup and view all the answers

What minimum house value would justify making the mortgage payment after 6 years?

Higher than the collateral value required for the mortgage Signup and view all the answers

What is the minimum correlation required between the stock you shorted and your portfolio to reduce risk?

-0.5 Signup and view all the answers

Is the broker's suggestion to invest in Hannah Corporation justified?

No, because it increases the overall portfolio's volatility. Signup and view all the answers

What should the finance professor suggest regarding the investment in Hannah Corporation?

Reduce the investment to minimize overall volatility. Signup and view all the answers

Based on the provided information, does CAPM hold in this economy?

No, because expected returns are not linearly related to risk. Signup and view all the answers

What is the expected return of the growth stocks?

17% Signup and view all the answers

What is the volatility of the value stocks?

12% Signup and view all the answers

What correlation is observed between the growth and value portfolios?

0.5 Signup and view all the answers

Study Notes

Question 1: Bond Pricing

A 2-year bond with a 20% coupon rate and annual payments pays $200 per year for 2 years and $1000 face value at maturity
Calculate the present value of these future cash flows using the given YTMs for 1 and 2-year risk-free bonds
Discount the $200 coupon payment at the end of year 1 by the 1-year YTM (3%)
Discount the $200 coupon payment at the end of year 2 and the $1000 principal payment by the 2-year YTM (5%)

Question 2: Dividend Discount Model

Company A's expected dividends are $1.50, $1.65, and $1.81 for years 1, 2, and 3 respectively
Calculate the present value of these dividends using the equity cost of capital (8%) as the discount rate
After year 3, dividends are expected to grow at a constant rate of 6%
Use the Gordon Growth Model to estimate the present value of dividends from year 4 onwards
Add the present values of all future dividends to find the predicted stock price

Question 3: Mortgage Calculations

Calculate the present value of the $10,000 annual payments for the first 5 years using the 5% interest rate
Subtract this present value from the initial loan amount ($300,000 - $20,000 down payment - present value of first 5 years’ payments) to find the remaining principal after 5 years
Calculate the annual payment required for the remaining 25 years using the remaining principal and the 5% interest rate
The minimum value of the house at the end of year 6 must equal the present value of the remaining payments to cover the loan obligation

Question 4: Portfolio Risk Reduction

Short selling a stock with a higher volatility can potentially reduce portfolio risk
The minimum correlation between the shorted stock and the original portfolio must be negative to achieve risk reduction
A negative correlation means that the shorted stock’s returns move in the opposite direction of the portfolio, offsetting the risk

Question 5: Portfolio Optimization

The Natasha Fund has a higher expected return but also higher volatility compared to the risk-free rate
Hannah Corporation has even higher expected return but also significantly higher volatility and zero correlation with the Natasha Fund
Adding Hannah Corporation to the portfolio can improve the overall risk-return trade-off due to the lack of correlation, diversification benefits
However, excessive investment in Hannah Corporation may increase portfolio volatility significantly, reducing its optimality

Question 6: CAPM and Portfolio Characteristics

The CAPM states that the expected return of an asset is equal to the risk-free rate plus a risk premium related to its beta
We cannot determine if CAPM holds in this economy without knowing the beta values of each portfolio
Beta measures the sensitivity of an asset's return to the market return, and knowing this is crucial for verifying whether CAPM holds
While the given information provides expected returns and volatilities, it's insufficient to calculate the betas of each portfolio, hindering the verification of CAPM

Studying That Suits You

Use AI to generate personalized quizzes and flashcards to suit your learning preferences.

Description

Test your knowledge on fundamental finance principles involving bond pricing, the dividend discount model, and mortgage calculations. This quiz covers critical calculations needed for valuing investments and understanding the financial markets thoroughly.