UNIT IV

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4.1 Unit 4
Question 4.1.1. A stock price can increase by 6% or decrease by 5% each day. Sketch
a tree representing possible stock price movements over the next three days, starting from
a price of $100. Calculate how many distinct scenarios are possible by the end of three
days.

Answer:

Question 4.1.2. A stock price can increase by 3% or decrease by 2% each day. Sketch a
tree representing possible stock price movements over the next three days, starting from a
price of $50. Calculate how many distinct scenarios are possible by the end of three days.

Answer:

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Question 4.1.3. Suppose that the stock prices in the following three scenarios are:

Scenario S(0) S(1) S(2)

ω1 100 110 120
ω2 100 105 100
ω3 100 90 100

with probabilities 14 , 14 , and 1

2
respectively. Find the expected returns E(K(1)), E(K(2)),
and E(K(0, 2)). Compare 1 + E(K(0, 2)) with (1 + E(K(1)))(1 + E(K(2))).

Answer:

Question 4.1.4. Suppose that $32, $28, and x are the possible values of S(2). Find x,
assuming that stock prices follow a binomial tree. Can you complete the tree? Can this
be done uniquely?

Answer:

Question 4.1.5. Explain how the price of a bond is calculated.

Answer: The price of a bond (P ) can be expressed as the sum of the present value of
its future cash flows:

n
X C F
P = t
+
t=1
(1 + r) (1 + r)n

Where:

• P = Price of the bond

• C = Coupon payment (annual or semi-annual)

• F = Face value of the bond (also called par value)

• r = Market interest rate (yield to maturity)

• n = Number of periods until maturity

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Question 4.1.6. A 10-year bond with a face value of $1,000 pays a 5% annual coupon.
If the required return is 4%, calculate the bond price.

Answer: The bond price is the sum of the present value of the annuity (coupon pay-
ments) and the face value discounted to the present:

10
X 50 1000
Bond Price = t
+
t=1
(1 + 0.04) (1 + 0.04)10

Calculating each term, the bond price would be higher than $1,000 because the coupon
rate exceeds the required return.

Q4: How does a bond’s price change in relation to changes in market interest rates?

A4: When market interest rates rise, bond prices fall, and vice versa. This inverse
relationship occurs because, as interest rates increase, newly issued bonds offer higher
returns than existing bonds, reducing the latter’s appeal. Therefore, existing bonds with
lower rates must drop in price to attract buyers at a rate competitive with the current
market.

3. Equity Valuation by Dividend Discount Model (DDM)

Q5: What is the Dividend Discount Model, and how is it used in equity valuation?

A5: The Dividend Discount Model (DDM) values a stock by predicting the present
value of expected future dividends. The simplest form, the Gordon Growth Model, as-
sumes dividends grow at a constant rate and is given by:

D0 (1 + g)
Stock Price =
r−g

where D0 is the most recent dividend, g is the dividend growth rate, and r is the required

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rate of return. DDM is suitable for valuing companies with a stable and predictable
dividend growth rate.
Q6: Calculate the intrinsic value of a stock with a recent dividend (D0 ) of $3, a divi-
dend growth rate of 4%, and a required rate of return of 10%.

A6: Using the Gordon Growth Model:

3 × (1 + 0.04) 3.12
Stock Price = = = 52
0.10 − 0.04 0.06

The intrinsic value of the stock is $52.

Question 4.1.7. Show that the relationship between the return over the aggregate period
and one-step returns is given by

1 + K(n, m) = (1 + K(n + 1))(1 + K(n + 2)) · · · (1 + K(m))

and that the aggregate logarithmic return over the period and one-step logarithmic
returns is given by

k(n, m) = k(n + 1) + k(n + 2) + · · · + k(m).

Answer:

Question 4.1.8. In the context of a binomial tree model, prove that the expected stock
price at time n is given by the following expression:

E(S(n)) = S(0) · (1 + E(K(1)))n ,

where, E(S(n)) represents the expected stock price at time n, S(0) denotes the initial
stock price, E(K(1)) is the expected value of the one-step return on the stock.
In a binomial tree model, calculate the expected stock price S(5) given that the initial
stock price is S(0) = 100 dollars. The one-step returns K(n) are defined as follows:

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 
10 with probability 32 ,

K(n) =
−6 with probability 1 ,

3

for each time step n.

Answer:

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