RSM332
Capital Market Theory
University of Toronto · Rotman Commerce
─────────────────────────────────
COMPLETE EXAM Q&A BUNDLE
Midterm + Final Exam Preparation
50 Exam-Style Questions · Verified Answers · Full Rationales
· Graded A+
Topics Covered:
Bond Pricing & Duration · Term Structure · Equity Valuation · Portfolio Theory
CAPM & APT · Market Efficiency · Forwards & Futures · Options · Swaps · Risk Measures
How to Use This Document
This bundle covers all major RSM332 Capital Market Theory exam topics at Rotman Commerce, University
of Toronto, for 2026/2027. Each question mirrors the analytical and case-based style of RSM332 Examplify
assessments. Attempt each question independently before reading the verified answer and rationale.
UNIT 1: Bond Markets & Fixed Income Valuation
Q1. A bond has a face value of $1,000, a 6% annual coupon, 5 years to maturity, and a YTM of 8%.
What is its price?
✔ Answer: P = 60/1.08 + 60/1.08² + 60/1.08³ + 60/1.08⁴ + 1,060/1.08⁵ = 60 × PVIFA(8%,5) + 1,000 × PVIF(8%,5)
= 60 × 3.9927 + 1,000 × 0.6806 = $239.56 + $680.58 = $920.15.
💡 Rationale: When YTM > coupon rate, the bond trades at a discount (price < face value). Conversely, when YTM <
coupon rate, the bond trades at a premium. This inverse relationship between price and yield is fundamental to fixed
income.
Q2. Define Macaulay Duration and explain what it measures.
✔ Answer: Macaulay Duration is the weighted-average time to receive a bond's cash flows, where weights are
the PV of each cash flow as a fraction of the bond's total price. It measures the effective life of a bond and is
the primary measure of interest rate risk — the higher the duration, the more sensitive the bond's price is to
yield changes.
💡 Rationale: A zero-coupon bond's duration equals its maturity. A coupon bond's duration is always less than
maturity. Duration increases with maturity and decreases with coupon rate and YTM.
,Q3. A bond has a Modified Duration of 6.5 years. If YTM rises by 50 bps, what is the approximate
percentage price change?
✔ Answer: ΔP/P ≈ −Modified Duration × ΔYield = −6.5 × 0.005 = −0.0325 = −3.25%. The bond price falls
approximately 3.25%.
💡 Rationale: Modified Duration = Macaulay Duration / (1 + YTM/m). It converts Macaulay Duration into a direct
price sensitivity measure. The negative sign reflects the inverse bond price–yield relationship.
Q4. What is convexity and why does it matter for bond investors?
✔ Answer: Convexity measures the curvature of the price-yield relationship — the second-order effect that
Modified Duration ignores. For a given yield change, a bond with higher convexity gains more in price when
yields fall and loses less when yields rise, relative to a lower-convexity bond with the same duration. Investors
prefer positive convexity.
💡 Rationale: Duration gives a linear approximation of price change; convexity corrects for the actual non-linear
curve. Full price change ≈ −MD × Δy + ½ × Convexity × (Δy)². Higher convexity is always beneficial for non-callable
bonds.
Q5. Compare the yield to maturity (YTM) and current yield of a bond. Which is the better measure
of return?
✔ Answer: Current yield = Annual coupon / Current price (ignores capital gain/loss and time value). YTM is the
IRR of all cash flows — it assumes coupons are reinvested at the YTM rate and the bond is held to maturity.
YTM is the better measure of total return for buy-and-hold investors.
💡 Rationale: YTM is preferred because it accounts for: (1) coupon payments, (2) the difference between purchase
price and face value (capital gain/loss), and (3) time value of money. Its main weakness is the reinvestment rate
assumption.
UNIT 2: Term Structure of Interest Rates
Q6. Explain the Expectations Theory of the term structure and its prediction for the yield curve.
✔ Answer: Expectations Theory: long-term interest rates are geometric averages of expected future short-
term rates. An upward-sloping yield curve implies the market expects short-term rates to rise; a flat curve
implies stable rates; an inverted curve implies expected rate decreases.
💡 Rationale: Under Expectations Theory, investors are indifferent between rolling over short-term bonds and holding
long-term bonds — both strategies yield the same return. A key implication: no risk premium exists for holding
longer-term bonds.
Q7. The 1-year spot rate is 4% and the 2-year spot rate is 5%. Calculate the 1-year forward rate for
Year 2.
✔ Answer: (1 + 0.05)² = (1 + 0.04)(1 + f₁,₂) → 1.1025 = 1.04 × (1 + f₁,₂) → f₁,₂ = 1.1025/1.04 – 1 = 6.01%.
💡 Rationale: The forward rate is the break-even rate that makes investing in two 1-year bonds equivalent to one 2-
year bond. It is implied by the current spot rate curve and is used to price forward rate agreements (FRAs).
, Q8. What is the Liquidity Preference Theory and how does it modify Expectations Theory?
✔ Answer: Liquidity Preference (Hicks): investors demand a liquidity premium for holding longer-term bonds
because they are riskier (more price-volatile). Therefore, long-term yields contain both expected future short
rates AND a positive liquidity premium — which is why the yield curve is typically upward-sloping even when
rates are expected to stay flat.
💡 Rationale: Unlike pure Expectations Theory, Liquidity Preference explains why the yield curve almost always slopes
upward. The premium grows with maturity. This theory is empirically more consistent with observed yield curve
shapes.
UNIT 3: Equity Valuation — DDM & DCF
Q9. A stock just paid a dividend of $2.00 (D₀). Dividends grow at 5% forever. Required return =
10%. What is the stock price?
✔ Answer: D₁ = $2.00 × 1.05 = $2.10. P₀ = D₁ / (r – g) = $2.10 / (0.10 – 0.05) = $2..05 = $42.00.
💡 Rationale: This is the Gordon Growth Model (constant-growth DDM). Valid only when r > g and g is stable and
perpetual. The stock price is highly sensitive to the assumed growth rate — a key limitation.
Q10. A stock pays dividends of $1.00, $1.50, and $2.00 in years 1–3, then grows at 4% forever.
Required return = 11%. Find P₀.
✔ Answer: PV(D₁) = 1.00/1.11 = $0.901; PV(D₂) = 1.50/1.11² = $1.218; PV(D₃) = 2.00/1.11³ = $1.462. Terminal
value at year 3: P₃ = 2.00×1.04/(0.11–0.04) = $29.71. PV(P₃) = 29.71/1.11³ = $21.73. P₀ =
0.901+1.218+1.462+21.73 = $25.31.
💡 Rationale: The multi-stage DDM handles firms with variable near-term growth followed by stable long-run
growth. The terminal value typically accounts for 70–85% of total value — making the long-run growth assumption
the most important input.
Q11. What is the P/E ratio and how can it be derived from the DDM?
✔ Answer: P/E = P₀/EPS₁ = (Payout ratio) / (r – g) = (1 – b) / (r – g), where b is the retention (plowback) ratio. A
higher P/E implies: (1) lower required return, (2) higher growth rate, or (3) higher payout ratio. The P/E is the
market's price per dollar of earnings.
💡 Rationale: The DDM-derived P/E shows that growth opportunities justify a premium P/E only if PVGO (Present
Value of Growth Opportunities) is positive — i.e., if retained earnings are reinvested above the cost of equity. Firms
that retain earnings at below-hurdle returns destroy value.
Q12. Define PVGO and explain when a firm should pay dividends vs. retain earnings.
✔ Answer: PVGO (Present Value of Growth Opportunities) = P₀ − EPS₁/r. A firm should retain earnings
(reinvest) only when ROE > r (its cost of equity). If ROE = r, retention/payout policy is irrelevant. If ROE < r, the
firm should pay out all earnings as dividends — retention destroys value.
💡 Rationale: P₀ = EPS₁/r + PVGO. The first term is the 'cash cow' value (zero growth). PVGO is only positive when
investment opportunities earn above the cost of equity. Many mature firms with limited opportunities should
increase payouts.
Capital Market Theory
University of Toronto · Rotman Commerce
─────────────────────────────────
COMPLETE EXAM Q&A BUNDLE
Midterm + Final Exam Preparation
50 Exam-Style Questions · Verified Answers · Full Rationales
· Graded A+
Topics Covered:
Bond Pricing & Duration · Term Structure · Equity Valuation · Portfolio Theory
CAPM & APT · Market Efficiency · Forwards & Futures · Options · Swaps · Risk Measures
How to Use This Document
This bundle covers all major RSM332 Capital Market Theory exam topics at Rotman Commerce, University
of Toronto, for 2026/2027. Each question mirrors the analytical and case-based style of RSM332 Examplify
assessments. Attempt each question independently before reading the verified answer and rationale.
UNIT 1: Bond Markets & Fixed Income Valuation
Q1. A bond has a face value of $1,000, a 6% annual coupon, 5 years to maturity, and a YTM of 8%.
What is its price?
✔ Answer: P = 60/1.08 + 60/1.08² + 60/1.08³ + 60/1.08⁴ + 1,060/1.08⁵ = 60 × PVIFA(8%,5) + 1,000 × PVIF(8%,5)
= 60 × 3.9927 + 1,000 × 0.6806 = $239.56 + $680.58 = $920.15.
💡 Rationale: When YTM > coupon rate, the bond trades at a discount (price < face value). Conversely, when YTM <
coupon rate, the bond trades at a premium. This inverse relationship between price and yield is fundamental to fixed
income.
Q2. Define Macaulay Duration and explain what it measures.
✔ Answer: Macaulay Duration is the weighted-average time to receive a bond's cash flows, where weights are
the PV of each cash flow as a fraction of the bond's total price. It measures the effective life of a bond and is
the primary measure of interest rate risk — the higher the duration, the more sensitive the bond's price is to
yield changes.
💡 Rationale: A zero-coupon bond's duration equals its maturity. A coupon bond's duration is always less than
maturity. Duration increases with maturity and decreases with coupon rate and YTM.
,Q3. A bond has a Modified Duration of 6.5 years. If YTM rises by 50 bps, what is the approximate
percentage price change?
✔ Answer: ΔP/P ≈ −Modified Duration × ΔYield = −6.5 × 0.005 = −0.0325 = −3.25%. The bond price falls
approximately 3.25%.
💡 Rationale: Modified Duration = Macaulay Duration / (1 + YTM/m). It converts Macaulay Duration into a direct
price sensitivity measure. The negative sign reflects the inverse bond price–yield relationship.
Q4. What is convexity and why does it matter for bond investors?
✔ Answer: Convexity measures the curvature of the price-yield relationship — the second-order effect that
Modified Duration ignores. For a given yield change, a bond with higher convexity gains more in price when
yields fall and loses less when yields rise, relative to a lower-convexity bond with the same duration. Investors
prefer positive convexity.
💡 Rationale: Duration gives a linear approximation of price change; convexity corrects for the actual non-linear
curve. Full price change ≈ −MD × Δy + ½ × Convexity × (Δy)². Higher convexity is always beneficial for non-callable
bonds.
Q5. Compare the yield to maturity (YTM) and current yield of a bond. Which is the better measure
of return?
✔ Answer: Current yield = Annual coupon / Current price (ignores capital gain/loss and time value). YTM is the
IRR of all cash flows — it assumes coupons are reinvested at the YTM rate and the bond is held to maturity.
YTM is the better measure of total return for buy-and-hold investors.
💡 Rationale: YTM is preferred because it accounts for: (1) coupon payments, (2) the difference between purchase
price and face value (capital gain/loss), and (3) time value of money. Its main weakness is the reinvestment rate
assumption.
UNIT 2: Term Structure of Interest Rates
Q6. Explain the Expectations Theory of the term structure and its prediction for the yield curve.
✔ Answer: Expectations Theory: long-term interest rates are geometric averages of expected future short-
term rates. An upward-sloping yield curve implies the market expects short-term rates to rise; a flat curve
implies stable rates; an inverted curve implies expected rate decreases.
💡 Rationale: Under Expectations Theory, investors are indifferent between rolling over short-term bonds and holding
long-term bonds — both strategies yield the same return. A key implication: no risk premium exists for holding
longer-term bonds.
Q7. The 1-year spot rate is 4% and the 2-year spot rate is 5%. Calculate the 1-year forward rate for
Year 2.
✔ Answer: (1 + 0.05)² = (1 + 0.04)(1 + f₁,₂) → 1.1025 = 1.04 × (1 + f₁,₂) → f₁,₂ = 1.1025/1.04 – 1 = 6.01%.
💡 Rationale: The forward rate is the break-even rate that makes investing in two 1-year bonds equivalent to one 2-
year bond. It is implied by the current spot rate curve and is used to price forward rate agreements (FRAs).
, Q8. What is the Liquidity Preference Theory and how does it modify Expectations Theory?
✔ Answer: Liquidity Preference (Hicks): investors demand a liquidity premium for holding longer-term bonds
because they are riskier (more price-volatile). Therefore, long-term yields contain both expected future short
rates AND a positive liquidity premium — which is why the yield curve is typically upward-sloping even when
rates are expected to stay flat.
💡 Rationale: Unlike pure Expectations Theory, Liquidity Preference explains why the yield curve almost always slopes
upward. The premium grows with maturity. This theory is empirically more consistent with observed yield curve
shapes.
UNIT 3: Equity Valuation — DDM & DCF
Q9. A stock just paid a dividend of $2.00 (D₀). Dividends grow at 5% forever. Required return =
10%. What is the stock price?
✔ Answer: D₁ = $2.00 × 1.05 = $2.10. P₀ = D₁ / (r – g) = $2.10 / (0.10 – 0.05) = $2..05 = $42.00.
💡 Rationale: This is the Gordon Growth Model (constant-growth DDM). Valid only when r > g and g is stable and
perpetual. The stock price is highly sensitive to the assumed growth rate — a key limitation.
Q10. A stock pays dividends of $1.00, $1.50, and $2.00 in years 1–3, then grows at 4% forever.
Required return = 11%. Find P₀.
✔ Answer: PV(D₁) = 1.00/1.11 = $0.901; PV(D₂) = 1.50/1.11² = $1.218; PV(D₃) = 2.00/1.11³ = $1.462. Terminal
value at year 3: P₃ = 2.00×1.04/(0.11–0.04) = $29.71. PV(P₃) = 29.71/1.11³ = $21.73. P₀ =
0.901+1.218+1.462+21.73 = $25.31.
💡 Rationale: The multi-stage DDM handles firms with variable near-term growth followed by stable long-run
growth. The terminal value typically accounts for 70–85% of total value — making the long-run growth assumption
the most important input.
Q11. What is the P/E ratio and how can it be derived from the DDM?
✔ Answer: P/E = P₀/EPS₁ = (Payout ratio) / (r – g) = (1 – b) / (r – g), where b is the retention (plowback) ratio. A
higher P/E implies: (1) lower required return, (2) higher growth rate, or (3) higher payout ratio. The P/E is the
market's price per dollar of earnings.
💡 Rationale: The DDM-derived P/E shows that growth opportunities justify a premium P/E only if PVGO (Present
Value of Growth Opportunities) is positive — i.e., if retained earnings are reinvested above the cost of equity. Firms
that retain earnings at below-hurdle returns destroy value.
Q12. Define PVGO and explain when a firm should pay dividends vs. retain earnings.
✔ Answer: PVGO (Present Value of Growth Opportunities) = P₀ − EPS₁/r. A firm should retain earnings
(reinvest) only when ROE > r (its cost of equity). If ROE = r, retention/payout policy is irrelevant. If ROE < r, the
firm should pay out all earnings as dividends — retention destroys value.
💡 Rationale: P₀ = EPS₁/r + PVGO. The first term is the 'cash cow' value (zero growth). PVGO is only positive when
investment opportunities earn above the cost of equity. Many mature firms with limited opportunities should
increase payouts.
