Section A: Multiple Choice (10 Points)
Circle the letter corresponding to your answer for each question. If you circle more than one response you will not receive credit for that question.
1) The equity premium puzzle of Mehra and Prescott (1985) says that
A. Given reasonable risk aversion levels, equity should earn a bigger premium
B. Equity earns returns commensurate with its risk level
C. Equity returns should be adjusted for risk using the CAPM
D. Given reasonable risk aversion levels, equity earns returns that are too high
2) Tail dependence refers to
A. A situation where all markets are well diversified
B. A situation where many markets are well diversified
C. A situation where some markets experience small moves at the same time
D. A situation where all markets experience extreme moves at the same time
3) You are worried that the financial system will undergo a period of systemic risk, where all the asset markets in the US and Europe rise and/or fall together. If you want to model such dependence, you would need
A. A normal copula only
B. A Gumbel copula only
C. A t copula or a Gumbel copula
D. None of the above
4) According to Cappiello, Engle and Shepard (2006) and Longin and Solnik (2001), international equity markets feature
A. Symmetric volatility
B. Asymmetric correlations
C. Small returns
D. Independence
5) Equity volatility tends to
A. Fall during periods of economic and political crises
B. Remain Constant during periods of economic and political crises
C. Increase during periods of economic and political crises
D. None of the above
6) The HJ distance of Hansen and Jagannathan (1997) measures is an asset pricing test that measures
A. The distance between the candidate pricing kernel and the CAPM pricing kernel
B. The distance between the candidate pricing kernel and the Behavioral pricing kernel
C. The distance between the candidate pricing kernel and the true pricing kernel
D. The distance between CAPM pricing kernel and the Behavioral pricing kernel
7) When Acharya and Pedersen (2005) develop their asset pricing model, they document that
A. Liquidity matters for asset pricing, and so the CAPM has to be extended with another beta
B. The CAPM works well, once extended for volatility
C. Liquidity matters for asset pricing, and so the CAPM has to be extended with three more betas
D. Human capital is a neglected asset pricing factor
8) In generalized method of moments estimation, the estimator is found by
A. Finding the parameters that satisfy a moment condition
B. Reducing the likelihood function
C. Maximizing the sum of squared residuals
D. None of the above
9) Using our Supply-Demand analysis, the effect of an increase in tariffs is the following:
A. A permanent improvement in the domestic economy
B. A permanent worsening in the domestic economy
C. A temporary improvement in both domestic and foreign economies
D. Unclear
10) According to the stochastic discount factor approach, stock returns satisfy the following expression:
A. E[mr]=0
B. ri – rf = βrm
C. y = α + βx
D. None of the above
Section B: Short Answers (20 points)
For Section B, you should write a maximum of 1 page: For this Section I will not read anything beyond the first page of what you submit. The attached article from the Economist, entitled ‘Some Pleasant Fiscal Arithmetic’, deals with Government debt.
1) a. According to the article, what has happened to government debt around the world?
b. What does this imply about the valuation of stocks around the world?
c. What does it imply about risk and return of stocks?
Be specific and use notation and terminology based on our class lectures.
2) Because of your excellent training, you are asked to advise Jerome Powell, Chairman of the Federal Reserve System. Powell is worried about the growth of government debt in the USA. He and the European Central Bank both understand that if debt continues to grow, eventually global financial markets as a whole will be affected. In particular, they worry that private investment will be `crowded out’. Powell is receiving two types of advice, from Politicians and Bankers. The Politicians say it is best to intervene in markets immediately, cut interest rates, and let investors know they can borrow cheaply—this will boost investment. The Bankers assert that it is best to let the US and global financial markets equilibrate slowly on their own, since after all the main reason for expanded debt is a public health issue, and if there is any mispricing, smart traders will quickly pick up the deals and eliminate mispricing. How would you advise Chairman Powell?
Be sure to use the most relevant techniques and concepts from class.
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