UNIVERSITY OF TORONTO

Joseph L. Rotman School of Management

SOLUTIONS Mock Midterm Examination, October 2019

RSM 332H1F – Capital Market Theory

Duration: 2 hours

1. (a) False. The spot rate rT capture the required rate of return on a payment occuring
at time T . It has nothing to do with discounting nor the time value of money.
(b) True. In this case, the coupon rate c exactly compensate the bondholder for the
required rate of return on the bond y. Since we are considering the clean price, we do
not have to worry about accrued interests.
(c) False. In a DCF analysis, we only care about future dividends, not past ones. It
is possible that XYZ has been avoiding to pay dividends to invest in new projects to
boost future growth.
(d) True. The price of a zero-coupon bond with a maturity of T and a face value of
100 is PT = 100/(1 + rT ). If rT ≥ 0, then it must be that PT ≤ 100. Thus the bond
always trades at a premium.

2. (a) First, we compute the present value at t=0 of the annuity from t=1 to 5:
!
100, 000 1
P V1→5 = 1− = $445, 182.23
4% (1 + 4%)5

Next, we compute the present value at t=0 of the growing annuity from t=6 to 35:

(1 + 3%)30
!
100, 000 × (1 + 3%) 1
P V6→35 = 1− × = $2, 130, 258.82
4% − 3% (1 + 4%)30 (1 + 4%)5

The present value of your earnings is simply the sum of the two:

P Vearnings = P V1→5 + P V6→35 = $445, 182.23 + $2, 130, 258.82 = $2, 575, 441.06

(b) We first find the present value of our savings using the annuity, and then take the
future value of this annuity at the end of year 5. That is,
!
30, 000 1
F Vsavings,1→5 = 1− 5
(1 + 4%)5 = $162, 489.68.
4% (1 + 4%)

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 In order to purchase the condo, we need to put down 20% × 800, 000 = $160, 000.
Therefore, you will have enough savings to purchase the condo.
(c) The future value of the down payment in five years becomes:

F Vdown = 800, 000 × 20%(1 + 2%)5 = $176, 652.93

You will not be able to make the required down payment on the condo.

3. (a) This is a Canadian mortgage. The stated interest rate is quoted semi-annually.
Thus, the effective annual rate on the mortgage is (1 + 0.06/2)2 − 1 = 0.0609 or 6.09%.
The monthly interest rate that, if compounded twelve times each year, will be equiva-
lent to an effective annual rate of 6.09% can be found as (1 + rm )12 − 1 = 0.0609, or,
rm = (1.0609)1/12 − 1 = 0.00494.
The present value of the annuity of monthly mortgage payments is equal to the amount
borrowed. If the house price is $1.2 million and you made a 25 percent down payment,
then you borrowed $900,000. The number of monthly payments is equal to the amor-
tization period times the number of months, 240. Thus

900, 000 = C/0.00494(1 − (1.00494)−240 )

so, C = $6, 410.55

(b) At the end of 3 years (36 months of monthly mortgage payments), the amount you
owe will be equal to the present value of the payments not yet made. There are 204
payments not yet made on the original amortization schedule.

P V = 6, 410.55/0.00494(1 − (1.00494)−204 ) = $822, 805.09

At the end of the 3 years, the borrower still owes $822,805.09.

(c) At the beginning of the mortgage, the borrower owed $900,000. After 3 years, the
borrower still owes $822,805.09. Thus, the borrower has repaid $77,194.91 (= $900,000
-$822,805.09) of the principal amount owing.
The borrower has made 36 payments each in the amount of $6410.55. The borrower
has made payments totaling $230,779.80. Of that total, we know $77,194.91 repaid
principal. The remainder must be payment of interest. Interest paid over the 3-year
term of the mortgage is therefore equal to $230,779.80 − $77,194.91 = $153,584.89.

4. (a) To find the spot rates, you need to solve the following system:
6 106
103.83 = +
1 + r1 (1 + r2 )2
7 107
105.72 = +
1 + r1 (1 + r2 )2

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 Mutliplying the first equation by 7/6 and substracting the second equation:
106 × 7/6 − 107
103.83 × 7/6 − 105.72 =
(1 + r2 )2
⇒ r2 = 4%

From there, we find r1 = 3%.

The forward rates are: f1 = 3%, f2 = (1 + 4%)2 /(1 + 3%) = 5%
8 108
(b) (i) The fair value of the bond is Pf air = 1+r1
+ (1+r2)
2 = $107.62. The fair price is

different from the market price, so there is an arbitrage opportunity.

(ii) We can use a portfolio of A and B to replicate C. Let xA and xB be the units of A
and B in the portfolio.

8 = 6xA + 7xB
108 = 106xA + 107xB

⇒ (xA , xB ) = (−1.00, 2.00)

Since the fair price (see (b)) is lower than the market price of C, we short-sell Bond
C, receiving $ 108.62. Buy the synthetic portfolio above, paying $ 107.62. This is an
arbitrage strategy with a profit of $1 today.
(c) An arbitrage opportunity exists because the rate offered by the bank is different
from the no-arbitrage forward rate computed in (a), 5%. Thus you want to borrow at
the bank rate and invest in the synthetic forward rate.
To do so, you borrow $1m/(1 + r1 ) for one year at r1 . At the end of year 1, you repay
your $1m on the loan using the $1m loan offered by the bank. Thus at the end of year
2, you need to repay $1m × (1 + 4.5%), which you finance using a two year investment
at the spot rate r2 . Today, the profit from this strategy is:

$1m × (1 + 4.5%)
CF0 = $1m/(1 + r1 ) − = $4712.54
(1 + r2 )2
Note that you generate a risk-free profit today without future obligations, so this is an
abitrage.

5. (a) We use a portfolio of the 2-year and 10-year bonds to match the duration of the
5-year zero.
2 × w2 + 10 × (1 − w2 ) = 5,
where w2 is the weight of the 2-year bond. Solving it, we get w2 = 0.625 and the
weight for the 10-year bond is 0.375.
So the manager should buy 3,781.25 units of the 2-year bond (the total present value
of $0.625 × 5 million divided by the current price of the bond $1000/(1 + 10%)2 ) and

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 buy 4,863.27 units of the 10-year bond (a total present value of $0.375 × 5 million
divided by the current price of the bond $1000/(1 + 10%)10 ). Jointly, these match the
face value of the short position. These, combined with the short position of the 5-year
zero-coupon bond, create a portfolio that has duration of 0.
(b) The modified durations:
2 2 10 10
D2∗ = = ∗
and D10 = = .
1+y 1.1 1+y 1.1
We can use duration to approximate the increase of the 2-year bond position:
D2∗ × 0.0001 × 3125000 = 568.18

Meanwhile, the decrease of the 10-year bond position is:

∗
D10 × 0.0001 × 1875000 = 1704.55

So the net change for the overall portfolio is a decrease of $1,136.37.

6. (a)
(i) Company B Sales = Price per share / (P/S) = 40.00 / 8.89 = 4.50
(ii) Company Z Earnings per share = Implied Share Price / (P/E) = 44.75 / 30.13 =
1.49 (notice the 30.13 comes from (v) below)
(iii) Company A CFO = Price per share / (P/CFO) = 25.00 / 8.3 = 3.00
(iv) Company C P/E ratio = Price per share / Earnings per share = 45.00 / 1.50 =
30.00
(v) Average peer P/E = (25.0+44.4+30)/3 = 30.13
(vi) Company Z Implied Share Price using P/S = Sales × P/S = 7.50 × 5.5 = 41.25
(b) As soon as the peer group is not representative of the business of company Z,
valuation by comparables methods would fail. Some reasons include:
- different risk profile and thus discount rate
- different growth rate of dividends
- different accouting practices
(c) We can use the Gordon Growth formula:
2(1 + 4%)
P = = $34.67
10% − 4%

(d) It would seem that Company Z is a good investment as its “fair price” is higher
than its market price. You would recommend investors to buy the stock.
Trading on Z does not constitute an arbitrage opportunity as nothing guarantees that
the profit from such a strategy is riskless (e.g., the firm could go bankrupt).