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1. 5 3 15 ) (1) peso problem (2) Free cash flow hypothesis (3) Implied volatility smile

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2. Equity premium puzzle was first documented by Mehra and Prescott (1985). What is the equity premium puzzle? Give two possible explanations for this puzzle in the literature. (15 )

3. What are the static tradeoff theory and pecking order theory of capital structure? Under these two theories, what is the relationship between leverage ratio and profitability, tangibility of assets, and size of the firm? (20 )

4. One implication of the Modigliani-Miller theorem for hedging is that, in the absence of market frictions, shareholders are indifferent between hedging on their own accounts and having their firms do the hedging for them. Then, why do firms hedge? You can explain which firms should be the most interested in hedging. (15 )

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5. According to modern behavioral finance, there are limits to arbitrage for rational arbitrageurs. These limits usually come from costs and risks of trading and short selling. Discuss which stocks (i.e. stocks with which firm characteristics) belong to hard-to-arbitrage stocks and thus their prices are likely to be affected by investor sentiments. (15 )

6. What is the Fama-MacBeth procedure (method) for running cross-sectional regression tests of linear factor models (e.g. CAPM)? (10 ) 7. In response to recent financial crisis, contingent capital instruments have gained increasing support as a potential option to reduce the need for public bailouts when bank failures occur. Define contingent capital instruments and discuss its economic rationale. (10 )