with suggested solutions

Financial Management
Mid-Term Exam October 13, 2012 9:3o - 11:00 This exam consists of 5 exercises. Some questions are more difficult than others. To avoid getting hopelessly stuck on some questions: move forward and come back to the problematic question(s) later if time permits. Please do not forget to identify all your answer sheets. This is a closed book exam. Calculators are permitted. Good luck!

Exercise 1 (3 points) TRUE/FALSE questions Are the following statements true or false? Justify all your answers in maximum 3 lines each. a) According to the Capital Asset Pricing Model (CAPM), in equilibrium, all securities lie on

the security market line. (1 point)
TRUE: The SML depicts risk/return relationships where the risk measure is beta. In equilibrium, all securities are fairly priced and lie on the SML (not below or above the SML as overpriced or underpriced securities, respectively). b) Other things equal, diversification is most effective when securities' returns are

uncorrelated. (1 point)
FALSE: The greatest reduction of portfolio risk (=the goal of diversification) results from negative correlation among securities. Financial Management Mid-Term exam, 13/10/2012 1

c) Relative to European puts, otherwise identical American put options are less valuable.
(1 point)

FALSE: Otherwise identical American put options are more valuable; it is valuable to exercise a put option early if the stock drops below a threshold price; thus American puts should sell for more than European puts.

Exercise 2 (4.5 points) Consider the following information on a set of government bonds (the face value is 100 for all bonds):
Maturity 1 month 6 months 1 year Price 98.53 Coupon rate 5% Frequency of coupon semi-annual Spot rate (effective annual) 2.0% 3.5%

a) Are you willing to pay 98.5 for the Treasury bill that matures in one