Econ 400 Midterm Exam (Provide brief responses based on the directions. Keep answers short
and to the point. You are not required to write in complete sentences but your answers must
printed and easy to read.
1. Basic ideas/terms (Undergrads answer 3)
a. Briefly state the Modigliani Miller Theorem:
the choice of debt or equity (stock) finance does not effect firm value;
assumes absence of tax differences, transactions costs differences, bankruptcy differences
b. Express an arbitrage-based model of prices in two different markets or at two different points in
time:
Futures Price(i) = Spot Price(i) + carrying costs
(or prices at location i and location j)
d. What are the two primary economic ideas/propositions behind the efficient markets hypothesis:
i) a model of pricing behavior such as discounted presented values or CAPM
ii) a model of expectations such as expected value
e. What is a “stochastic discount factor”?
discount factors that change over time in (somewhat) unpredictable ways
f. Express the fundamental insurance equation for a 2 outcome scenario
expected payout = probability event 1 x cost of event 1 + probability event 2 x cost event 2
2a. Provide the general equation that expresses how to turn payments (P) for a series of periods (t)
into a lump sum value:
present value equation pv = Sum[(Pt)/(1+r)t
b. If applying the equation above to the case of a specific firm (or group of firms), what are the
key variables that determine the size of the computed values?
firm-specific revenues and costs (earnings), discount factor, and time horizon
3. What in the nature of stock price movements over the short run and variables that are predictive
for future movements?
near random walk; movement in stock prices unpredictable
b. What is the nature of stock price movements over the long run and variables that are predictive
for future movements?
upward drift/movement
price/dividend, price/earnings, price/gdp ratios are all predictive; when those ratios are
high, markets over next 5-10 years tend to have low returns, when those ratios low, returns
high
4. How is a “fundamental” explanation of asset price movements different from a “bubble”
explanation” (or how would one discriminate between the two?
fundamentals explanation uses a standard economic model such as present value and
considers if (reasonable) values for revenues, costs, discount rates can explain outcomes;
bubble explanation when movements not reasonably explained by a fundamentals model;
highvaluation increases, high volume of trades, large declines
5. Using a formula/equation, explain difference in 1970s views of efficient markets theory versus
current views in terms of what why markets move. .
PV formula: 1970s focused on numerator (earnings)
current focused on denominator (variable discount rates)
6. a. Express the idea of stock prices as a “random walk” in equation form.
P(t) = P(t-1) + random change
b. How does a random walk differ from a random selection of numbers from 1 to 100?
changes (movements) in stock prices are random or unpredictable
random selection of numbers from 1 to 100 is “white noise”; random “level”
random walk is random in changes (levels may give appearance of predictability)
7. Name and briefly explain two of the “macro-finance” puzzles:
equity premium puzzle; risk-free rate puzzle; excess volatility puzzle; aggregate return
predictability puzzle; characteristics v. covariances puzzle; yield curve slope puzzle; long
term bond predictability puzzle; credit spread puzzle; options puzzles
(explanations of each term)
8. Information from specific studies/events (Undergrads answer 4)
a. According to Ray Fair’s study, name two facts about “what moves the stock market”
*most movements not easily tied to any news or event
*some macro news matters sometimes (especially Fed announcements)
b. Name and provide two facts about a famous “bubble-crash” episode other than 2008:
c. Provide 2 key facts about factors behind the 2008 macro-finance crash
-- huge increases in overall debt and debt to income across US economy in 2000s and
not just or even primarily in mortgage markets
-- concerns about risk in payments system as reflected by interest rate spreads, Bear Stearns
failure, Lehman failure
d. Why would problems in mortgage come to light before problems with commercial loans?
-- mortgage loans bundled and traded in markets with daily/transparent changes in value
-- commercial loans held on bank balance sheets with lagging/bank-reported changes in
value
e. What is meant by the term “financialization” and how might it have influenced the 2008 crash?
-- increasing size of financial sector relative to the economy
-- reflects less diversification; more leverage of same funds
f. Provide two facts about rare disasters and asset prices
-- about 3% chance of large stock market decline per year
-- wars and other disasters influential in large asset price drops
g. How might holding period for an asset influence its risk?
-- it changes possible value within the holding period