Economics 349 Fall 2023
Financial Economics Dr. Guzman
TAKE HOME GRADED PROBLEM SET
Please keep in mind the following when completing your problem set:
1. This problem set is to be completed by you alone and with no outside help/contact. All
answers should be your own words/work.
2. You may use the following when completing your test
Lecture Notes
Textbook
Calculator
Nothing else is permitted
3. You have until Friday, November 10, 2023, at 12 noon to submit your answers via
Gradescope (accessed on the EC349 Blackboard site.)
4. Your test must be handwritten (except for those with disabilities where computers are
allowed) and submitted as a single PDF on Gradescope.
5. After uploading your solutions to Gradescope, you must then assign answers to questions to
pages (for example Q1 answers are found on pages 1 and 2). You can assign multiple
questions to a page and multiple pages to a question. Your submission is NOT COMPLETE
until you have completed this step. Failure to do this will result in a five-point penalty.
6. If you have technical difficulties submitting and will likely miss the deadline for submission,
then e-mail your PDF solutions to me prior to the deadline (as a safety measure). In addition,
please (a) document your issues and (b) after the test fill out an ECF (with the documentation)
to get relief from any late penalties. See the Problem Set Guidelines for more detail regarding
problems when submitting.
The problem set guidelines can be found on Blackboard and failure to follow these rules will result
in penalties being applied to your final grade for this coursework.
Finally, if you have questions, please send me an e-mail. However, be aware that I will only
answer questions of clarification.
Economics 349 Fall 2023
Financial Economics Dr. Guzman
TAKE HOME GRADED PROBLEM SET
You have until 12 noon on Friday, November 10, 2023, to submit your handwritten solutions (as a
single PDF) via Gradescope (accessed by way of the EC349 Blackboard site). The points assigned
to each question are indicated, so please allocate your time accordingly. Your answers should be
brief and to the point, and all graphs must be completely and clearly labeled. Make sure you read
the entire question before answering individual parts. Good luck! J
______________________________________________________________________________
1. Asset Supply and Demand (30 points)
a. Explain whether the following statement is true, false, or uncertain. Use graphs and
equations (if relevant) in your explanation.
“Someone who is risk-averse will not buy an asset that has more risk, a lower expected
return, and more liquidity than another asset.”
b. List those factors which influence the supply and demand of a bond issued by Barclays. If
inflation is expected to rise, what will happen to equilibrium price and quantity for the
bond Briefly explain and graphically illustrate your answer.
c. Capita, an outsourcing firm, recently issued a profits warning, cancelled its dividend, and
sought additional funding from investors. Half its income is generated from the private
sector and the other half from the public sector (for example it collects the BBC license
fee and London congestion charge). What would you anticipate would happen in the
market for its shares just after the actions outlined above Concisely explain and illustrate
your answer.
2. Interest Rates and Returns (20 points)
a. Suppose you are interested in buying a 4-year coupon bond with an annual coupon rate of
5% and a face value of ￡1,000. The current market interest rate is 5%. How much are
you willing to pay for the bond
b. Suppose the BoE, through open market operations, forces interest rates up. Three years
after you purchased the bond, the market interest rate is now 20%. How much is a buyer
willing to pay you for that bond now
c. Suppose you sold the bond after three years, calculate your rate of return for the bond.
d. In general (not based on any of the work for parts a-c), what would be the formula for the
rate of return of a discount bond which will be sold in five years. And for a coupon bond
which also will be sold in five years. If the price difference over those five years is ￡100
for each bond, under what conditions on prices would you prefer to hold the discount
bond
3. Mean-Variance Model (20 points)
a. Briefly compare and contrast CAPM with the Mean-Variance Model. What is the
relationship between the risky assets held by individuals and those held by the entire
market
You can invest in asset A with expected return 15% and standard deviation 30% and asset B
with expected return 25% and standard deviation 70%. The correlation between assets is
0.4. There also exists a risk-free asset with return 12%. Suppose you want to construct a
portfolio with expected return 20%.
b. What is the relationship between the share of the portfolio held in asset A and the share
held in the risk-free asset The relationship between the share in asset B and the risk-free
asset
c. What is the equation for the variance of this portfolio
d. What would the shares of asset A, asset B, and the risk-free asset be for the optimal mean_xfffe_variance portfolio with an expected return of 0.2
4. CAPM Model (30 points)
Suppose there exists a mutual fund , whose beta is reported as 0.8. Over the past several
years the fund has averaged an annual expected return 15% above the risk-free rate, which is
equal to 5%. The market has been averaging an annual expected return 10% above the risk free rate. Suppose today’s price of one share of the fund is ￡50.
a. What does the CAPM model predict the price should be Is the fund over or
undervalued Illustrate this graphically.
Consider a world with only two risky assets, and , and a risk-free asset. Stock has 200
shares outstanding, a price per share of ￡3, an expected return of 16% and a volatility of
30%. Stock has 300 shares outstanding, a price per share of ￡4, an expected return of 10%
and a volatility of 15%. The correlation coefficient !” = 0.4. Assume CAPM holds.
b. What is expected return and the volatility of the market portfolio
c. What is the beta of each stock
d. What is the risk-free rate
