Past paper questions

Question 1

Consider two riskless bonds that have the same maturity date T and the same face value of £100. The first bond has a positive coupon rate c%. The second bond pays no coupons. Explain intuitively, without doing any calculations, which bond is more sensitive to changes in interest rates.

[2022, 5m]

Answer 1

1. For the first bond, part of its cash flows is paid EARLY and these earlier cash flows are LESS HEAVILY DISCOUNTED than the face value.
2. Consequently, because of the less heavy discounting of early
   cash flows, the first bond is LESS SENSITIVE to changes in interest rates than the zero-coupon bond.

Question 2

Before deciding to invest your savings you look at the past performance of a large number of mutual funds and find a particular fund that has consistently outperformed a passive market index in each of the previous 15 years.
Does this finding violate the efficient market hypothesis? If so, which form of the market efficiency is violated?

[2021, 4m]

Answer 2

1. This finding does NOT NECESSARILY violate the EMH.
2. We need to take into account that there are thousands of funds in the US.
3. Then, even if funds beat the market at random, it is likely that we would be able to find a fund that beats the market many times in a row just by PURE CHANCE.
4. To reject the EMH we need to see the violation for a
   LARGE NUMBER of firms.

Question 3

Empirical findings suggest that mutual fund managers fail to consistently outperform passive
stock indexes. As a result, some mutual funds have turned into index funds that buy an index in such
a way as to minimise the costs of managing their index portfolio.
Why do not all funds transform themselves into passive funds? What would be the consequence of all funds switching to become index funds?

[2021, 4m]

Answer 3

1. If all funds switch and become passive index funds there will be no fund managers who
   collect information and identify profitable investment opportunities.
2. As a result, competition declines and profitable opportunities become available again.
3. As a result, some managers will be tempted to
   re-enter the mutual fund industry again.
4. So, the stable outcome should be that some active mutual funds remain.

Question 4

Assume that the term structure is upward sloping. What is the relation between forward rates and spot interest rates?

[2017, 3m]

Answer 4

It indicates that the forward rate for the coming period is greater than the yield at the same maturity.

Question 5

What can you infer about future interest rates from a downward-sloping term structure?
Describe the three hypotheses regarding the term structure and the implications under each of these hypotheses.

[2017, 3m]

Answer 5

1. Under the unbiased expectations hypothesis, a downward sloping yield curve indicates that investors anticipate a drop in the future short rate.
2. Under the liquidity preference story, we would expect this anyway because term premia are assumed positive and increasing.
3. Under the market segmentation hypothesis, no clear relation
   » {since there is no explicit relation between short-term and long-term interest rates}

Question 6

A month in which the stock market is very volatile is likely to be followed by another volatile month.

Does this statement violate the weak form and/or the semi-strong form of market efficiency?

[2023]

Answer 6

Does not necessarily violate EMH because this statement does not say anything about the predictability of asset returns.