1. Bond returns (10 points) a. Suppose that you buy a five-year 7% bond at 85% of its face value. What will be your real return over the one year if expected inflation is 4,5% per year? b. Now suppose that the bond is a TIPS and that, at the end of the year, the real yield to maturity on the TIPS bond changes to 5%. What will be your nominal return over the one-year period? (Hint: the TIPS initial price is 85% of its face value)

2. Spot Rates (12 points) a. You have the following spot rates: r1=5.20, r2= 5.25, r3= 5.52. Calculate the Year 3 forward rate. b. Calculate the minimum feasible value for year 4 spot rate (r4) c. Suppose that someone told you that year 4 spot rate (r4) is 3.5%. If you have $1,000 to invest, calculate the profit can you make immediately to take advantage of this scenario.

3. Share valuation (8 points) a. NewCo is about to pay a dividend of $1. 35 per share on last year earnings of $1.50 per share. Future EPS and dividends are expected to grow with inflation, which is forecasted at 1.75% per year. The real cost of capital is 5.5%. What is NewCos current stock price? b. Now suppose a new management is able to increase future growth to 4% per year by plowing back 25% of earnings. What will be NewCos stock price?

4. Porfolio Variance (10 points) Take a large, diversified portfolio with n stocks (n>15). a) Demonstrate algebraically that the contribution of the nth stock to the portfolio variance is equal to the relative size of the holding (xn) times the average covariance between stock n and each of the stocks in the portfolio. b) Extend that rationale to the market portfolio to explain the concept of beta