Class 1

1. Mr. Smith has an income of $40,000 this year and $60,000 next year. He can invest in a
project that costs $30,000 this year, which generates an income of $36,000 next year. The
market interest rate is 10%. What will be his consumption next year, if Mr. Smith invests in
the project and consumes $50,000 this year and has zero net savings at the end of next year?
2. Casper Milktoast has $200,000 available to support consumption in periods 0 (now) and 1
(next year). He wants to consume exactly the same amount in each period. The interest rate is
8 percent. There is no risk.
a. How much should he invest, and how much can he consume in each period?
b. Suppose Casper is given an opportunity to invest up to $200,000 at 10 percent
risk-free. The interest rate stays at 8 percent. What should he do, and how much
can he consume in each period?
c. What is the NPV of the opportunity in (b)?

Class 2
3. You have just received a windfall from an investment you made in a friends business. He
will be paying you $10,000 at the end of this year, $20,000 at the end of the following year,
and $30,000 at the end of the year after that (three years from today). The interest rate is 3.5%
per year.
a. What is the present value of your windfall?
b. What is the future value of your windfall in three years (on the date of the last
payment)?

Class 3
4. Suppose you purchase a ten-year bond with 6% annual coupons. You hold the bond for four
years, and sell it immediately after receiving the fourth coupon. If the bonds yield to
maturity was 5% when you purchased and sold the bond,
a. What are the cash flows from your investment in the bond per $100 face value?
b. What is the internal rate of return of your investment?

Class 4
5. You are considering how to invest part of your retirement savings. You have decided to put
$200,000 into three stocks: 50% of the money in stock A (currently $25/share), 25% of the
money in stock B (currently $80/share) and the remainder in stock C (currently $2/share). If
stock A goes up to $30/share, stock B drops to $60/share and stock C rises to $3/share,
a. What is the new value of the portfolio?
b. What return did the portfolio earn?
c. If you dont buy or sell any shares after the price change, what are your new
portfolio weights?

Class 5
6. Percival Hygiene has $10 million invested in long-term corporate bonds. This bond
portfolios expected annual rate of return is 9 percent, and the annual standard deviation is 10
percent. Amanda Reckonwith, Percivals financial adviser, recommends that Percival
consider investing in an index fund which closely tracks the Standard and Poors 500 index.
The index has an expected return of 14 percent, and its standard deviation is 16 percent.
a. Suppose Percival puts all his money in a combination of the index fund and
Treasury bills. Can he thereby improve his expected rate of return without
changing the risk of his portfolio? The Treasury bill yield is 6 percent.
b. Could Percival do even better by investing equal amounts in the corporate bond
portfolio and the index fund? The correlation between the bond portfolio and the
index fund is +.1.

Class 6
7. It is sometimes suggested that stocks with low price-earnings ratios tend to be under-priced.
Describe a possible test of this view. Be as precise as possible.

Class 7
8.

Loreley Salvage Co. has just announced a large quarterly loss and approaches you for
emergency financing. Loreley offers a parcel of valuable real estate as collateral for a oneyear, $5 million loan at 4 percent. In addition, it offers bonus interest of 1 percent for every 5
percent increase in Loreleys stock price over the next year. For example, if Loreley stock
appreciates by 10 percent from $10 to $11, you would get bonus interest of 2 percent on the
loan of $5 million.
a. Draw a position diagram of your total payoff, assuming that the collateral will
protect the principal repayment and the 4 percent interest payment.
b. Suppose you can observe the prices of one-year calls on Loreley stock. How
would you evaluate the loan to Loreley?

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Class 8
9. Suppose that in month 3 the CH4 stock price is $80. In each 3 month period the price of the
stock will either increase by 25% (with a probability of 60%) or decrease by 20% (with a
probability of 40%). The risk-free 3-months interest rate is 1% and the stock market 3-month
risk premium is 4%. At that point you decide to buy one 3-month call on CH4 stock with an
exercise price of $90. Under the CAPM what is the expected return on your investment?

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Class 9
10. You have estimated spot rates as follows:
Year
1
2
3
4
5

Spot Rate
0.25%
0.50%
0.75%
1.00%
1.25%

Suppose that someone told you that the six-year spot interest rate was 1 percent. Why would
you not believe him? How could you make money if he was right? What is the minimum
sensible value for the six-year spot rate?

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Class 10
11. You own a $10 million portfolio of UK retailing stocks with a beta of 0.8 against the British
stock market. You are optimistic about the relative performance of retailing stocks but
uncertain about the prospects for the market overall. Explain how you could hedge out your
market exposure by selling the market short. How much would you sell? How in practice
would you go about selling the market?

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