Exam 2 Guide

FINA367

Overview of Exam 2
Exam 2 has 14 multiple choice questions and 11 fill-in-blank questions.
Exam 2 has 75 points in total.
Exam date: March 11(Thursday)
Exam 2 is calculation-oriented.
Exam 2 covers Module 2 and Module 3.

Module 2: Prices, yields and returns

Know all of the time-value-of-money calculations for fixed-coupon securities. In other words, be able
to solve for coupon rate, yield to maturity, and price. Be comfortable with more than just annual
coupons – semiannual, quarterly, maybe monthly? – and thus periodicity of not just 1.

Understand the reasons for bond price change: (1) the relationship between interest rate and bond price;
(2) Pull-to-par effect.

Know all of the time-value-of-money calculations for floating-rate securities. In other words, be able to
solve for quoted margin, discount margin, and price. Be comfortable with more than just annual
coupons – semiannual, quarterly, maybe monthly? – and thus periodicity of not just 1.

Understand the relationship between coupon rate, yield to maturity and price for a fixed-coupon
security. When would the security be selling at a premium/discount/par? Similarly, understand the
relationship between quoted margin, discount margin and price for a floating-rate security.

Be able to calculate a current yield and yield to maturity. And what are the three assumptions that would
make yield to maturity equal to realized holding period return?

Understand the yield measures for money market securities: discount basis, add on basis and bond
equivalent basis.

Be able to calculate the coupon reinvestment value, capital gain and holding period return from holding
a bond, and annualize the holding period return on a semiannual compounding basis.

Be able to calculate accrued interest and understand its meaning. Also, be able to calculate the flat and
full price (which price is quoted by bond dealers and why?) of a bond that trades between coupon
payments.

Always remember to annualize your answer if you are asked to find out an interest rate/yield rate.

Module 3: Term Structure

Understand the idea of arbitrage and be able to detect arbitrage opportunities given security
prices/yields. This means that you should be able to calculate whether a security is
underpriced/overpriced (you need be able to figure out the arbitrage-free price), be able to set up a
replicating portfolio to take advantage of the underpricing/overpricing, and be able to calculate the
profits from your arbitrage strategy.

Be able to calculate the price of a bond using spot rates.

Understand the meaning of par curve and spot curve.

Be able to calculate spot rates and forward rates and use them in the context of other problems (i.e., to
calculate bond prices and holding period returns).

Understand each of the three theories of the term structure of interest rates discussed in class and
understand their limitations. Especially, how pure expectation theory helps us to explain the yield curve
shape and how it explains investor’s expectation of future rates.

Be able to work out the practice problem (the last section of Module 3 slides). Understand that over the
same period, all investment should earn the same expected return in an arbitrage-free world.