Fall 2023 Financial Markets Final Exam Solutions PDF

Examination Cover Sheet COURSE: NUMBER: SECTION(S): Financial Markets Comm 221 AA & BB EXAMINATION: DATE: TIME: 19:00-22:00 PAGES: _X_ FINAL Dec 14, 2023 Exam Length:...

Examination Cover Sheet COURSE: NUMBER: SECTION(S): Financial Markets Comm 221 AA & BB EXAMINATION: DATE: TIME: 19:00-22:00 PAGES: _X_ FINAL Dec 14, 2023 Exam Length: Including cover ___ ALTERNATE 3 Hours 13 ___ DEFERRED VERSION: __________ INSTRUCTOR(S): DIVISION: Dr. David Newton John Molson School of Business Dr. Moein Karami MATERIALS ALLOWED: INSTRUCTIONS: ____ Booklets ___ Return all __X_ IBM (Scantron) ___ Blue ___ Green _X_ Answer on Exam __X_ Printed Translation Dictionary Other_________ ___ Open book __X_ Calculator __X_ Crib sheet __X_ Other: standard 8.5x11 inch single-sided formula sheet Please print your name, I.D. number and section in the appropriate spaces below. STUDENT NAME: ___________________________________________________________ I.D. NO. _________________________ SECTION:____AA or BB____________________ SPECIAL INSTRUCTIONS: NONE 1 1. A stock has just paid, a moment ago, a dividend of $6 and is currently trading for $30. Assuming no taxes and that dividends will grow at the rate of 2% per annum (p.a.) forever, what is the implied discount rate for this stock? A) Cannot be determined with the information provided. B) 18.4% C) 20.4% D) 22% E) 22.4% 2. If you believe the CAPM and a stock has, with that model, an expected annual yield of 22% while the annual risk-free rate is 2% and the expected market return is 12%, then you would estimate the Beta of that stock to be: A) 0 B) 1 C) 1.666 D) 1.833 E) 2 3. Use the information in question 2 to answer this question. If you knew the correlation between the stock in question and the broad market was +0.8 and the standard deviation on the market return was 10%, then the standard deviation of the stock should be: A) Cannot be computed with the information given. B) 16% C) 20.8% D) 22.9% E) 25% 4. A ten-year US treasury bond pays a single annual coupon of $30,000 USD and has a face value of $1M USD. If the bond is currently trading for $983,112.41, then which of the following statements can be made: A) The risk-free rate is 3.2% B) The proxy/estimate/substitute rate for the risk-free rate is 3% C) The proxy/estimate/substitute rate for the risk-free rate is 3.2% D) The US government will never default in any possible outcome in the future. E) A and D 2 5. When you have a quoted rate given as an APR compounded per month on an account then: A) If you divide the APR by 12 you will have the EMR B) If you take 1 plus the APR to the 12th root, you will have the EMR. C) If you want to know the actual balance on the account at the end of one year, take 1 plus the APR and multiply by the initial balance. D) You can never recover the EAR as the APR is not the EAR. E) None of these statements are true. 6. If you wished to value a corporate project for a firm, what method described below would likely give a decent (if not perfectly accurate result)? A) Add benefits and deduct costs, discounting each by a rate determined from a model. If the sum is positive, invest, otherwise do not invest. B) Add benefits and deduct costs. Multiply the sum by the discount rate. If the total is greater than 1, invest, otherwise do not invest. C) Add benefits, divide by total costs. Subtract this figure from the discount rate. If the total is greater than 0, invest, otherwise do not invest. D) Add benefits, divide by total costs. Subtract this figure from the discount rate. If the total is less than 0, invest, otherwise do not invest. E) As investment is inherently risky and certain, there is unfortunately no method to estimate the value of a firm project. 7. An investment account which reduces taxable income in the year of a contribution but eventually taxes those contributions upon withdrawal is known in Canada as _____ and to be attractive relies on ______ A) an RRSP; the assumption that pension liabilities can estimated years ahead of their realization. B) a TFSA; the assumption that pension liabilities can estimated years ahead of their realization C) a 401K; the assumption that pension liabilities can estimated years ahead of their realization D) an RRSP; a progressive tax system where mid-life income is taxed at a higher average rate than income drawn during retirement years. E) a TFSA; a progressive tax system where mid-life income is taxed at a higher average rate than income drawn during retirement years. 8. A fishery is expected to generate $10M profits this year but that amount is shrinking at a rate of 2% a year using industrial fishing methods. Using traditional and sustainable techniques, the fishery would only earn $5M profits this year but would earn it forever (perpetuity). If the discount rate is 5% regardless of the fishing methods, which would the fishery select and why? A) The industrial method as it has greater value. B) The sustainable method as it has greater value. C) The industrial method as it has higher initial profits. D) The sustainable method as it has higher initial profits. E) Both methods should be used in alternating years as this diversifies and maximizes value. 3 9. _____ inefficiency and _____ inefficiency can lead to _____ inefficiency, which will likely result in ________ A) Operational; systematic; idiosyncratic risk; reduced diversification B) Operational; allocational; informational; reduced producer surplus C) Operational; informational; allocational; reduced social welfare D) Informational; allocational; operational; reduced producer surplus E) Informational; operational; allocational; improved consumer surplus 10. The price of goods on offer is given as Ps = 100 + 2Q while the price bid (demand) for such goods is given as Pd = 300 – 3.5Q where Q is the quantity of units produced. What is the expected equilibrium quantity and price for these functions and the estimated total consumer surplus? A) Q = 266.66, P = 633.33, Consumer Surplus = 88,886.66 B) Q = 72.72, P = 45.45, Consumer Surplus = 5,164.93 C) Q = 36.36, P = 172.72, Consumer Surplus = 2,313.95 D) Q = 36.36, P = 172.72, Consumer Surplus = 4,627.90 E) Q = 40, P = 180, Consumer Surplus = 1,600 11. For many years the total sales volume of denim jeans in the competitive Montreal marketplace has been 80,000 units per quarter and the average retail price has been $120. Recently, average prices fell to $105 and demand is seemingly increasing to a forecasted 88,000 units. The price elasticity of demand for denim jeans in this market is apparently: A) -1.25 B) -0.8 C) 10% D) +0.8 E) +1.25 12. Timothy and Sepide are debating the impact of taxes on the economy. Select which statement(s) are true or have merit (in the simple supply-demand models we saw in our course): A) Timothy: “Sale taxes are bad as they often result in deadweight losses” B) Sepide: “Perhaps, but subsidies, such as those given to the oil and gas sector, can only improve social well-being” C) Timothy: “No, I don’t think that’s right. I think I heard subsidies reduce producer surplus” D) A, B and C are true. E) A and C are true. 4 13. Arguably, the bailouts implemented during the MBS crisis: A) Were essential as bankruptcies of “too-big-to-fail” firms/institutions could have ended the modern capitalistic system. B) Decreased morale hazard as the systemic risk was reduced by the bailouts. C) Are an example of idiosyncratic or firm-specific shocks. D) A and B E) A, B and C 14. A stock has historically earned 12% per annum. You believe in the long-run support for the CAPM and the model estimates that the stock should be earning 10% per year. What do you expect to happen over time? A) I believe that the stock’s return must decrease. B) I believe that the stock’s return must increase. C) I believe that the stock price must decrease. D) We cannot make any statement about stock prices as the CAPM only deals with returns. E) A and C 15. You have a utility function given as U(W) = W0.4 where W is your wealth. Your starting wealth is $200, and you have just been gifted a ticket that has a 1% chance of winning $50 and otherwise paying $0. How much would you sell your ticket for? A) 5 Dollars B) 53.3 Cents C) 50 Cents D) 46.7 Cents E) 0, it’s practically worthless since it will pay so infrequently. 16. How was the 16th century Tulip mania like the period preceding the 1929 stock crash? A) The assets gaining value had questionable utility or use. B) Prices ascended rapidly and increasingly disconnected from economic fundamentals. C) Broker loans almost certainly exacerbated the subsequent crash. D) Moral hazard led to excessive lending and speculation by homeowners. E) The burning and looting of areas of commerce lead to a permanently diminished rate of economic growth. 17. At the end of each year for 25 years you have $7500 after-tax income available to deposit to your TFSA. Assuming that you can earn 6% EAR on these deposits and that they respect TFSA contribution limits, what should be the balance on the account at the end of 25 years? A) Unable to compute as I do not know my income tax rates over this period of time B) 95,875.17 C) 198,750 D) 411,483 E) 804,725 5 18. Use the table below to find the average and marginal income federal tax of a person with an annual income of $97,500/year in the province of Quebec: A) 15% and 15% B) 17.49% and 15% C) 17.49% and 20.5% D) 20.5% and 17.49% E) 15% and 20.5% 19. Which of the following are stakeholders in a firm: A) Shareholders B) Creditors C) Government D) The consuming public E) All of the above 20. A bank manager collects the following information about 100 days of cash withdrawals: Withdrawal size $0, $10K[ [$10K,$20K[ [$20K,$30K[ [$30K,$40K[ [$40K,$50K[ Frequency 23 days 15 days 27 days 30 days 5 days How much should she keep in the vault to ensure that she has enough cash reserves to meet 92% of the withdrawal events? A) $10K B) $20K C) $30K D) $40K E) $50K 6 Problem 1 You work for SOLEIL Enterprises and are considering installing a new solar power facility in the high North. If you decide to build the facility, you anticipate that you’d incur immediate licensing and land purchase costs and then must pay a construction company, payment due in one year’s time at completion. Every quarter after construction is complete, you’d expect to earn $300K in profits but also expect that to decline at a rate of 0.25% per quarter as the solar panels age and are damaged. The cost estimates are given below: Expense Land purchase and licensing, Construction fees, and date realized today one year from today Amount $3M $4M SOLEIL Enterprises is all equity financed and the CAPM Beta of your firm is estimated at 1.4. The risk- free rate is 4% EAR while the TMX100 market index has averaged returns of 10%/year over the past few years. A) Value the project for SOLEIL and determine if they should build the facility or not. [Be careful to ensure that cash-flows frequency and timing is considered.] First, we’ll compute the discount rates. We’re given information for the CAPM and not much else, we’ll use that model then to estimate the cost of equity: Re = rf + B[E(Rm)-rf] = 4% + 1.4(10%-4%) = 4%+1.4*6% = 12.4% We’re going to need this rate in quarterly as well, EQR, for the benefits so we’ll just do that now: 1.124^0.25-1 = EQR = 2.9654% Now we can value the different parts of the project and add them together to determine the NPV = -licensing/land (now) – construction (1 year) + profits (DDM) discounted back one year NPV = -3M today – 4M/1.124 +300/(0.029654+0.0025)*1/(1.124) = -3M- 3.5587188M+8.3007996 = 1.7420808 M > 0, positive NPV, we should invest *Note: For the DDM, note that D1 is 300K, we get this after the first completed quarter after construction. Also, this amount needs to be carried back itself, the DDM will give us a value at the end of year 1. 7 B) A prospective industrial client is thinking of buying all the power from your new facility, but they have expressed some concern about the reliability of solar power. To make your case you’ve gathered the following information about the solar output of a similar sized and located facility operated by a competitor: Condition Slightly overcast Sunny Rainy/Snowing Daily Output 800Kwh 1200 Kwh 350Kwh Relative Frequency 55% 30% 15% i) What level of power can you assure the prospective client with 80% confidence? ii) What assumptions have you made to making your claim (give at least 2)? iii) If there was a bad weather event, how substantially would this affect the client? i) We should be able to deliver 800 Kwh/day with 85% confidence (55%+30% = 85% > 80%) ii) We have assumed that the neighboring facility output is similar to our own facility We have assumed that weather is the only source of power disruption We have assumed that weather will be constant over time, the history suggesting the future [Note to grader – any combination of any 2 reasonable assumptions should get full points] iii) It seems as if the weather turning foul, to rain/snow, causes a very dramatic decline in output. From the most common result of 800kwh to just 350 kwh, a decline of 56.25%. That would probably have a very negative impact on the client, their operations would probably slow to less than half 8 C) The government is trying to encourage both green technologies and development in the high North. They are interested in buying a large dollar amount of newly issued SOLEIL junior shares that would get paid dividends last and be paid out after other shareholders in the event of an insolvency. How could this policy encourage the government objectives and what assumptions are needed for it to work as intended? If they buy these shares in SOLEIL they are taking up much of the risk of low dividends or insolvency and yet paying a good price for the shares. The effect will be to reduce the cost of capital to SOLEIL. While it doesn’t seem to affect the current project, which is already profitable, it might make other marginally losing projects positive NPV. In this way SOLEIL may expand operations, building both more solar and northern projects. For this all to work though, it must be that the cost of capital is the constraining factor in their development. If there are no suitable sites or other bottlenecks exist (such as licensing) then simply reducing the cost of capital may not lead to more projects as hoped. 9 Problem 2 Olive is starting today an investment plan where she deposits $500 at month end into her RRSP. She directs her RRSP plan advisor to buy an ETF that mimics the Toronto Montreal Exchange (TMX) 60 index. Her average tax rate may be assumed to be 30% for all RRSP contributions and/or increased earnings. Every December 31st at midnight she plans to file her taxes and instantly gets a refund for her RRSP contributions (it’s the FUTURE!, the CRA is more efficient now). She deposits that refund into her TFSA and then buys Royal Bank of Canada stock (the largest publicly traded company in Canada by market capitalization). Additional information about Olive’s investments: Asset Historical Historical EAR standard deviation of return TMX 60 ETF 8% 11% RBC 9% 22% A) Explain why in equilibrium RBC may have only a slightly higher annual return than the index while having a much higher standard deviation. Be sure to describe various risks to make your argument. RBC may have substantially higher idiosyncratic risk than the broad market but only slightly higher levels of systematic risk. It is only systematic risk, undiversifiable risk, for which we expect to receive compensation. Thus, the much greater idiosyncratic risk of RBC (compared to TMX) does not contribute to the rate of return. If you elect to stay invested in just RBC without diversification you are exposing yourself to a healthy dose of idio(t)…syncratic risk. 10 B) What are some of the limitations of using standard deviation as a measure of risk? List at least three Standard deviation is often computed using historical information and thus may be subject to nonstationarity concerns – the return distribution shifting over time may not be discovered until too late Standard deviation on its own does not distinguish between systematic (compensated) and idiosyncratic (unpriced) risk. You may get an incorrect impression of compensation from this measure alone Standard deviation is a symmetric measure, treating volatility above and below the mean return as the same; this might not make sense if people have a preference for skewness for example. [Note to grader, any 3 reasonable critiques of the measure should get full points] C) If Olive sticks with her investment plan, what do you expect her account balances to be in exactly 5 years time. Recall that she is just starting her plan and opening her accounts today, you may assume today is December 31st, and you may assume that historical patterns of performance continue. Each month she deposits 500 into the RRSP for a total of 6K (500x12) She will be refunded 30% of this based on her average tax, so 0.3*6000 = 1800 will be deposited annually into her TFSA For her RRSP, we need the monthly rate of return since she is depositing monthly, that would be: 1.08^(1/12) -1 = 0.643403% EMR We can use the calculator to find the FV from here: PV = 0 (account just opening), PMT = 500, I/Y = 0.643403, N = 12*5 = 60 months, FV = $36,472.33 RRSP balance at end of 5 years For the TFSA the harder part was determining the contributions (done) so now it’s just a 5 year annual annuity earning 9% EAR PV = 0, I/Y = 9%, PMT = 1800, N = 5 years, FV = $10,772.48 TFSA balance at end of 5 years 11 Problem 3 In a competitive economy the supply and demand prices are given by the respective expressions: Ps = 100 + 0.1Q Pd = 500 – 10Q Where Q is the quantity sold/bought. A) Find the equilibrium price and quantity for this market. Then find the total gains of trade. Equate the supply and demand functions 100 + 0.1Q = 500 – 10Q, solve for Q  400 = 10.1Q, Q = 39.6 units Solve for price, Ps = 100 + 0.1*39.6 = $103.96/unit Total gains of trade = 39.6 units * ($500-$100) * ½ = 7920 B) What would be the effect on quantity and price of a fixed $30/unit tax? How much are government revenues? What has happened to total gains of trade (give a quantitative measure of change and an explanation) We need to find the new equilibrium with taxes driving a wedge between what consumers pay and producers earn, that is: 100 + 0.1Q’ + 30 = 500 – 10Q’  370 = 10.1Q’, Q’ = 36.63 units Ps’ = 100 + 0.1Q’ = 103.66 Pd’ = 500-10Q’ = 133.66 Gov’t revenues = 30/unit*36.63 new units traded= 1098.90 There is a deadweight loss, DWL = ½ (Pd’-Ps’)*(Q-Q’) = 0.5 (30) * (39.6-36.63) = 44.55 lost (of 7920 originally earned, ~0.56% reduction in gains) What has happened is that the government taking a part of the gains of trade has made some marginally beneficial trades unappealing and some volume has been lost. Consumers, producer nor the government can benefit from a nonexistent trade. This is known as a deadweight loss, nobody gets these benefits. 12 C) Employers will sometimes argue that a minimum wage hurts low wage workers. First, state what kind of market distortion is a minimum wage and then explain/support their argument. Next, what assumption regarding elasticity of labor supply and demand have they made and why is that important in this conversation? A minimum wage is a price floor on labor. It compels employers to pay at least a price of some level per hour worked. As with any distortion, this may cause a deadweight loss. Employers may for example have a nonzero value to additional labor but a value that is below the minimum wage. That additional labor will not be hired, and will earn nothing, with the implementation of a minimum wage. In this regard the employers’ argument has merit, minimum wage may cost jobs or leave vulnerable people even more vulnerable. What employers often leave out is that the division of the dwl depends on relative elasticities. If the employer is far less elastic than the labor then they will bear the brunt of the minimum wage. While it is true that a small group of marginally productive laborers may lose their jobs, the implementation of a minimum wage could still greatly improve the wellbeing of most laborers, simply at the expense of the employer – it’s this part that is often not mentioned. 13