Economics 434 Financial Markets Professor Burton University of Virginia Fall 2014 October 23, 2014

Answer to Question 2 on First Mid Term October 23, 2014 Imagine that there are only four assets in the world. Three are publicly traded stocks (ABC, MNO, and XYZ) and the fourth asset is the risk free asset. Price of One ShareShares Outstanding ABC Stock$ 101,000 MNO Stock$ 81,000 XYZ Stock?1,000 Imagine that we are in a CAPM equilibrium with the prices and outstanding shares given in the above table with a risk free rate of 3 percent. Note that the market capitalization of ABC is $ 10,000. If a person we know has a portfolio worth $ 100 with half of his total portfolio in the risk free asset, while one fourth of his total portfolio (including the risk free asset) is held ABC stock. a.How much XYZ stock does he own? Answer: He owns 2.5 shares at $ 2 per share ($ 5 worth) which is 20 percent of the market basket (because since 10 percent of the market basket has to be XYZ stock and hence 10 percent of his risky asset portfolio must also be XYZ stock) b. What is the price of XYZ stock? Answer: $ 2 per share (see reasoning from above) c. If the ABC stock has a beta of 1.2 and MNO has a beta of.5, what is the beta of XYZ stock? Answer: Beta of ABC = 2.00,( so that ½ times 1.2 plus 4/10 times.5 plus.1 times 2.00 = 1.00 the market beta). d. If the expected return of MNO is 5 percent, what is the expected return of ABC stock? Answer: Since risk free rate is 3 %, the excess return of MNO is 2 %. The beta of MNO is.5, so the excess return of the market must be 4 %. Given a beta of 1.2, ABC must have an excess return of 5 percent, which means its expected return must be 8 percent.

Default Free Securites (Sovereign Debt) US Treasuries ($ 13 trillion outstanding) – Bills (less than one year in original maturity) – Notes (ten years or less, longer than one year) – Bonds (greater than ten years at issuance) Random facts – Bills are called coupon and/or discount issues: 3 mo, 6 mo, year bills. Year assumed to be 360 days. – Notes and bonds are “coupon” issues; pay fixed coupons twice yearly October 23, 2014

Naming conventions Bills named by their maturity date – “12/15 14” for example Notes and bonds are named by: (i) their coupon rate; and (ii) their maturity date – “14s of Nov 11” was originally issued in mid- November of 1981 with a 14 coupon. It matured on November 15, (Assume $ 100,000 principal. Then, it paid $ 7,000 on May 15 th and Nov 15 th starting May 15 th 1982, ending Nov 15 th, 2011 October 23, 2014

US Treasury Bill Market 4 week, 13 week, 26 week, 52 week Every non-holiday Monday there is a 4,13, 26 week auction; 52 week is on Tuesday, once a month Settlements are always on non-holiday Thursday (settlement is the day the security “exists” and payment is received Most recent: – 4 wk: Issued 10/23, matures on 11/ % – 13 wk: Issued 10/23 matures on 1/22/ % – 26 week 10/23 matures on 4/23/ % – 52 week 9/18/14 matures on 9/17/ % October 23, 2014

Bills are quoted at a discount 10 % quote means you pay $ 900,000 for a 52 week bill that pays $ 1 million at maturity 10% quote on a 26 week bill means you pay $ 950,000 for $ 1 million on maturity date True yield is higher than discount quote October 23, 2014

Notes and Bonds 3, 10, 30 auctioned monthly 2, 5, 7 auctioned monthly Assume that principal is $ 100,000 (that is the amount paid at maturity plus the last coupon) For, example: Last 30 yr auctioned is the “Aug 3 1/8s of 44” Pays 1/ of %, or $1, twice a year beginning Feb 15 th, ending August 15 th, October 23, 2014