Final Exam Study Material

The Formula Sheet for the final is given at the end of these notes. That exact list will
be provided to you in the final. The two pages for the cumulative normal table will
also be given in the final.

This study material is an addition to your overall preparation for the final.

Market Efficiency
Technical analysis
Bonds
Options
Futures

Market Efficiency
What are the conditions for an efficient market? Consequences of an efficient market?
Weak Form Market Efficiency:
All past price and volume are reflected in prices
Test: Technical Analysis (which uses past prices)
Technical Analysis is not useful  Weak Form Eff.
Technical Analysis is useful  NOT Weak Form Eff.
Semi-strong Form Market Efficiency
All public information is reflected in prices fully and completely
Test: Event studies
Prices change immediately and fully when new information comes out  Semi-strong form
market efficiency
Strong Form Market Efficiency: Prices reflect both public AND private information
Test: Insider trading (who use private information)
Insider trading not profitable  Market is Strong form efficient
Insider trading profitable  Market is NOT Strong form efficient

Market Anomalies are evidence against semi-strong form efficiency.

Technical Analysis
Assumptions: (1) There are trends in stock prices, which can be exploited; (2) Markets are
somewhat inefficient
Tools: Charting and Technical indicators
Oldest method: Dow theory, identify primary trend
Charts: Moving average vs. actual price charts gives you a trading signal
Know how to create Moving Average
Know how to create Relative strength
Indicators: Advance-decline difference, Short interest ratio, TRIN, Investment Advisory
Opinions, Mutual Fund Liquidity.

Bonds
Basis points
Fisher Hypothesis
Interest rates vs. Bond prices
Long vs. short maturity bonds: Their risk differences.
Current yield, Bond valuation, Callable, Convertible, Municipal, Junk Bonds
Duration, Modified Duration: What they are used for, what they represent, how to
calculate duration for bonds with up to 2 years to maturity.
Term Structure Theories
Corporate Bonds
Bond quotations

Options
Call payoff, Put payoff
In the money, at the money, out of money, American vs. European
Option Strategies: Naked option, Long Straddle, Short Straddle. You can create payoff
diagram of any option strategy.
Payoff Tables from different investment alternatives: All stock vs. all option.
Black-Scholes: To find call option value
Put-call parity: To find put option value

Futures and Forwards

Types of futures contracts: Underlying security
What they mean, their differences, margin in futures, 0 sum game, where they are traded
How to calculate the fair futures price on the contract

Final Exam Study Problems

Technical analysis reflects the idea that stock prices:
a. move upward over time.
b. move inversely over time.
c. move in trends.
d. move randomly. Answer: c
In order to have confirmation of a major market trend under the Dow Theory, the:
a. industrial and utility averages must confirm each other.
b. transportation and utility averages must confirm each. other.
c. utility average must lead the transportation average.
d. transportation and industrial average must confirm each other. Answer: d
All of the following are assumptions made by technical analysts except:
a. Changes in trend are caused by shifts in supply and demand relationships.
b. Stock price movements are independent.
c. Security prices tend to move in trends.
d. Markets are inefficient. Answer: b
The short interest ratio is found by dividing the number of shares sold short by the average:
a. number of shares outstanding in the market.
b. daily volume of trading on the exchange.
c. number of stocks reaching new lows.
d. daily number of stocks bought long. Answer: b
Resistance and support areas for a stock market index are viewed as technical indicators of
a. Economic barriers
b. Psychological barriers
c. Circuit breakers
d. Holding patterns Answer: b

On a particular day, the stock market as a whole is up; however, losers outnumber gainers by
2,000 to 1,600. What might be a technical analyst conclude?
A: The fact that the market is up is good news, but market breadth, i.e., advance-decline line
value is negative. To a technical analyst, a market advance on narrow or negative breadth is not a
particularly good event.

Use the data below to construct the advance/decline line values for the stock market. Volume
figures are in thousands of shares.
Advancing Adv. Vol. Declining Dec. Vol.
Monday 1,685 225,000 840 66,000
Tuesday 1,720 164,000 1,000 115,000
Wednesday 560 59,000 2,025 265,000
Thursday 880 100,000 1,625 145,000
Friday 1,550 185,000 950 105,000

Answer is below. The market closes the week on a modestly bullish signal according to this
technical indicator but overall, not a strong signal in any direction in this example.

Monday Tuesday Wednesday Thursday Friday

Adv – Dec 845 720 -1465 -745 600

In order to have a yield to maturity greater than the coupon rate, the bond must be:
a. selling at a discount.
b. selling at par.
c. selling at a premium.
d. a zero coupon bond. (a)

If a bond is callable, this means:

a. the issuer may change the coupon rate.
b. the investor may convert the bond into stock.
c. the issuer may buy back the bond early.
d. the investor may cash in the bond at any time. (c)

A deferred call provision means:

a. the bond cannot be called before a certain time.
b. the bond pays interest on a deferred basis.
c. the bond is called only in the last year of the term.
d. the stockholders must defer to the bondholders regarding the call date. (a)
When calculating the yield-to-call on a bond, the relevant coupon payments are __________
and the face value is replaced by __________.
a. up to the maturity period . . . face value plus call premium
b. up to the call period . . . . face value plus call premium
c. not used in the calculation . . . current market price.
d. shortened to the call period . . . current market price. (b)
Find the price of a 10 percent coupon bond with three years to maturity if the yield to maturity
is now 12 percent. Use semiannual discounting.
a. $1196.70 Solution: N=6, PMT=50, I=12, FV=1000 >> PV=-950.85
b. $950.85
c. $952.20
d. $999.80 (b)

Which of the following bond relationships is NOT inverse?

a. Coupon and duration
b. Bond price and yield to maturity change
c. Interest rate changes and bond prices
d. Duration and maturity (d)

For all bonds paying coupons, duration is

a. less than maturity.
b. greater than maturity.
c. about equal to maturity.
d. not related to maturity. (a)

If the conversion value of a convertible bond is $800, and if the bond has a conversion ratio of
20 shares, then the underlying stock should be trading at
a. $40. Current price = conversion value/conversion ratio
b. $20. = 800/20
c. $4. = $40
d. $25. (a)

ABC Corporation's convertible bond has a face value of $1000 and a conversion ratio of 40. If
the bond is currently quoted at 120:0, while the stock trades at $22.50, what is the bond's
conversion value and straight bond price?
a. $700, 1000 Solution:
b. $900, 1200 Conversion value=(conversion ratio)( stock price)
c. $800, 1200 =(40)(22.50) = $900
d. $187.50, 1100 Straight bond price = 120% * 1000 = 1200 (b)

If the current yield is above the coupon rate, the bond is selling at a premium. (F)

What are three reasons that duration is important in bond analysis and management?
Answer: (a) It measures effective lives and risks of alternative bonds.
(b) It is used in bond management strategies.
(c) It measures bond price sensitivity to interest rate changes.
A 10-year, $1000 corporate bond paying $100 in coupon annually is currently selling for $950:
(a) Calculate its current yield.
(b) Calculate the coupon rate.
(c) Calculate the Total Return for this bond if it is sold one year later for $800.
Solution:
(a) current yield = annual coupon / current market price = 100/950 = 10.53 percent
(b) coupon rate = coupon / face value = 100/1000 =10 percent
(c) TR = coupon + price change
beginning price
= 100 + (-150) = -5.26 percent
950
Which of the following is not a reason U.S. investors invest in foreign bonds?
a. to gain diversification
b. potentially higher returns than U.S. bonds
c. lower transactions costs and taxes.
d. All of the above are reasons U.S. investors invest in foreign bonds. (c)
Junk bonds are also known as:
a. high-risk, low yield bonds
b. zero-coupon bonds
c. high-risk, high yield bonds.
d. indentures. (c)
Which of the following is not a passive bond strategy?
a. an immunization strategy
b. a bond swap strategy
c. a buy and hold strategy
d. a index fund strategy (b)
A bond strategy attempting to immunize the portfolio from interest rate risk is based on the
concept of:
a. buy and hold.
b. horizon analysis.
c. duration concept.
d. indexing. (c)
A portfolio is said to be immunized if:
a. the present value of the cash flows equals the principal.
b. the duration of the portfolio is equal to the term.
c. the present value of the cash flows is greater than the principal.
d. the duration of the portfolio is equal to the investment horizon. (d)

According to the expectations theory, long-term rates must;

a. equal the present value of the expected cash flows from the bonds involved.
b. equal the geometric mean of a series of expected future short-term rates.
c. always be higher than short-term rates.
d. be calculated from short-term rates. (d)

The preferred habitat theory is most similar to the:

a. expectations theory.
b. liquidity preference theory.
c. market segmentation theory.
d. pecking order theory. (c)
According to the preferred habitat theory, which of the following is NOT true?
a. Borrowers and lenders have preferred maturity sectors.
b. The yield curve can take any shape.
c. Borrowers and lenders do not go outside their preferred maturity segments at all. (c)

The term structure of interest rates shows the relationship between yields of several categories
of bonds, such as municipals and corporates, and their maturities. (F)

Municipal bonds typically have lower yields than corporate bonds due to the differences in
maturities. (F)

Briefly explain the four theories explaining the term structure of interest rates.
Answer: Expectations theory – long-term rate is the geometric average of the current short term
yield and expected short-term rates.
Liquidity preference theory – a liquidity premium must be added to long term bond yield to
account for uncertainties about the future.
Preferred habitat theory – investors have preferred maturity sectors but may shift if they expect
adequate compensation.
Market segmentation theory – investors have strictly preferred maturity sectors and will not shift.

To provide insurance against declining prices on previously purchased stock, an investor could
a. buy a call.
b. write a put.
c. buy a stock index option.
d. buy a put. (d)

A writer of a call can terminate that particular contract anytime before its expiration by
a. writing a second call.
b. buying a put.
c. buying a comparable call.
d. writing a put. (c)

 ------Call------ ------Put------
Stock Strike Exp. Vol. Last Vol. Last.
Price
38.625 25 Dec. --- ----- 100 1/8
38.625 30 Nov. 250 8¾ 464 1/16
38.625 30 Dec. --- ----- 572 5/16
38.625 35 Nov. 154 4 1/2 1748 5/16
38.625 35 Dec. 923 5 1/4 580 1 3/16
38.625 35 Mar. --- ----- 33 2 5/8
38.625 40 Nov. 2023 1 1/8 530 2 3/8
Which of the following calls is not "in-the-money?" (38 5/8 is the stock price)
a. 25 Dec
b. 30 Nov
c. 35 Dec
d. 40 Nov (d)
Which of the following statements is FALSE?
a. An in-the-money call occurs if the stock price exceeds the exercise price.
b. An out-of -the money call occurs if the stock price is less than the exercise price.
c. If a call is out of the money, you would not exercise the option.
d. If a call is in the money, the payoff from exercise is zero. (d)
A combination of one put and one call on the same stock with the same exercise price and date
is known as a:
a. strip
b. straddle
c. strap
d. spread (b)

The writer of a put, like the buyer of a call, is bullish about the stock price. (T)
The options clearing corporation ensures fulfillment of option obligations. (T)
Put options are normally bought by investors who expect the stock price to rise. (F)

What does the purchaser of a straddle think about the future of the underlying stock?
Answer: A straddle is a put and call on the same stock with the same exercise price and same
expiration date. The purchaser will make money if the stock makes a strong move in either up or
down. He will lose money if the stock is stable and stays near the purchase price. The purchaser
thinks the stock price will be volatile but is uncertain about the direction it will take.

AB Flex Inc. stock is currently trading at $38. The time left until expiration of a call and put
trading on AB Flex Inc.'s stock is 6 months and the strike price is $45. If the call is currently
trading at $1.96 and the Treasury bill rate is 10 percent per year, what price should the put sell
for?
Solution: Use put-call parity.
P = E/(ert) – S + C = 45/(e0.1*0.5) – 38 + 1.96 = 45/1.051271 – 38 + 1.96 = 6.77

An investor has the alternative of buying 100 shares of XYZ at $50 per share or investing the
same amount of money in XYZ 12-month at the money calls priced at $5. Calculate the profit or
loss from each strategy if the price of XYZ has risen to $60 at the end of 1 year.
Solution:
Buying the stock:
Payoff = $60 per share x 100 shares = $6000; Profit = $1000
Buying 10 option contracts ($5000 to invest, so buy 1000 options or 10 option contracts):
Payoff = 1000 x $10 = $10,000; Profit = $5,000
Use the Black-Scholes model to calculate the value of a DBA December 35 call option.
Assume that the risk free rate of return is 3 percent, the stock has a standard deviation of 34
percent, there are 9 months until expiration of the contract, and DBA stock is currently selling at
$40 in the market.
Solution: Value of Call = SN(d1) – Ee-rtN(d2)
where S= $40, E = $35, r = 0.03, T = = 9/12 = 0.75,  = 0.34
d1 = ln(40/35) + [0.03 + 0.5(.342)](0.75) = 0.677  0.68
(0.34)(0.75)1/2
d2 = 0.677 - 0.34(0.75)1/2 = 0.383  0.38
N(d1) = 0.7518 (from cumulative normal table)
N(d2) = 0.6480 (from cumulative normal table)
C = $40(.7518) - $35e(-0.03)(0.75)(.6480) = 30.07 – 22.1754 = $7.89
Futures exchange members:
a. trade strictly for their own accounts.
b. trade strictly for others.
c. can trade for their own accounts or for others.
d. are all controlled by commodity firms. (c)

Most futures contracts are settled by actual delivery. (F)

Explain a long position and a short position in futures trading.

Answer: A buyer who agrees to purchase an item at contract maturity has a long position. The
seller who agrees to deliver the item at contract maturity has the short position.

Explain the difference between a forward contract and a futures contract.

Answer: A forward contract is an individual agreement for the delivery of an item for a specified
price at a specified future date. Forward contracts are not standardized. Futures contracts are
standardized, transferable agreements for the delivery of specified grades, amounts, and delivery
dates. Futures are traded in organized markets.
Formulas (the ones below will be given in the exam; you are
responsible from the rest):

TRIN = [ Declining Volume / Declines ] / [ Advancing Volume / Advances ]

Fisher Hypothesis: (1+R) = (1+r)(1+inf)

Current Yield = Annual Coupon / Bond Price

C/2  1  FV
Bond Price = 1 − 2n 
+
YTM / 2  (1 + YTM / 2)  (1 + YTM / 2) 2 n

Duration:
PV(CFi )
D = SUM (  ti )
Bond Price

Modified Duration: D* = D / (1 + YTM/2)

Duration of semiannual coupon bond selling at face value:

1 + YTM / 2  1 
D= 1 − 2n 
2

 YTM / 2  (1 + YTM / 2 )  

Bond price change vs. interest rate change:
P
= −D *  r
P

P-C parity: P = C + E/erT – S

Black-Scholes:
C = S e − y T N (d1 ) − E e − r T N (d 2 )

( )
ln S
 2 
+ r − y +  T

E 
d1 =  2 
d 2 = d1 −  T
 T
F0 = S0 (1 + rf )T