Exam 4: Security Analysis and Portfolio Theory

Which of the following investment strategies is inconsistent with a "contrarian" philosophy?

a. Would a 10-year, 15% U.S. Treasury note be priced in the market to yield more, less, or the same as a 10-year, 8% Treasury note? Explain. b. How would you expect the yields on the following two bonds to compare with each other? Both are rated A. ABC Corp. 18s of 2011, callable in 2007 PDQ Corp. 18s of 2009, non-callable c. How would the yields on the bonds in part b compare if their coupons were 8 instead of 18?

Assume you want to get a 5-year mortgage on your house and that the yield curve is flat at 10%. a. If you want to pay back the mortgage in 5 equal annual installments of $1,000, how much can you borrow? b. What would be the duration of the above mortgage?

What is an "event study"? Discuss a specific example to explain the objectives,methodology,and results of an event study.

You work for a large insurance company and have been assigned to explain to a customer (a large pension fund)how strategies of 1)exact matching and 2)duration matching will help in meeting a projected set of pension fund liabilities.Explain what each technique entails and how it works.Examples would be useful.Be sure to conclude your report with a discussion of the advantages and disadvantages of each technique.

Returns on Mondays are generally much more negative than returns on other days of the week.How would you best explain this? (Give only one reason,and specify whether it is consistent with notions of market efficiency.)

Consider the following two bonds: a discount bond paying 100 in one year,selling at 93; a coupon bond paying 10 in one year,110 in two years,selling at 95. a. What is the one-year spot rate? What is the forward rate for the second year? b. Suppose there is a liquidity premium of 50 basis points on two-year lending. What is the market's expectation of what the one-year spot rate will be in the second year? What does the market expect the second bond's price to be at the beginning of the second year? c. Suppose you are in the 40% effective marginal tax bracket. What is the total amount you expect to have after taxes at the end of year 2 if you buy the second bond? (Don't forget to reinvest the first-year coupon.) d. Suppose you buy the second bond and then the market's expectation of the spot rate in the second year changes to 10%. What would be the immediate price change on the bond? If you sold the bond right away, what would be your after-tax profit or loss?

Spot interest rates are yields to maturity on loans or bonds that pay only one cash flow to the investor.

You are a research analyst for a major investment bank and have been asked to evaluate three candidates for a takeover and recommend one.You estimate the risk-free rate to be 5% and the market risk premium to be 8%.You also have the following data: current price \ 20 \ 25 \ 200 number shares 100,000 80,000 10,000 current EPS \ 4 \ 2.50 \ 5 payout ratio 50\% 20\% 10\% (First 5 yrs) beta 1.0 1.25 1.5 growth rate: first 5 yrs. 5\% 10\% 50\% beyond 5 yrs. 5\% 0 10\% D/E ratio 0 0 ROA: 10\% 25\% 55.56\% first 5 yrs. 10\% 20\% 25\% beyond 5 yrs. 10\% Which firm is the best candidate for a takeover?

A significant portion of the small-firm premium is earned in the first two weeks of the calendar year.

Tests of market efficiency tend to

Which of the following statement is correct with regard to bond valuation?

Bond A pays $10 at the end of year 1 and $110 at the end of year 2,bond B pays $5 at the end of year 1 and $105 at the end of year 2,and bond C pays $20 at the end of year 1 and $120 at the end of year 2.If bond A is selling for $100,bond B for $95,and bond C for $105,does the law of one price hold? If not,describe the arbitrage that would restore the law of one price.

Assume that the annual interest rate on 2-period loans is 10% and the annual interest rate on 3-period loans is 12%. a. What is the forward rate on loans made in period 2 and repaid in period 3? b. What is the present value of a security with a cash flow of $300 at the end of period 1 and a cash flow of $400 at the end of period 3? c. What is the future value (at the end of period 3) of the security in part b?

Leland,O'Brien and Rubinstein (who invented portfolio insurance)came up with a product called "supershares." The product works as follows.It starts with two conventional funds: an index fund owning stocks in the S&P 500 and a money-market fund. The index fund is divided into two securities.One of those securities is called a "dividend share" and gives the holder the right to all dividends paid during three years and all price appreciation up to 25% during those three years.The other security is called an "appreciation share" and gives the holder the right to all price appreciation above 25% during those three years. The money-market fund is also divided into two securities.One of those securities is called a "money market income supershare" and the other security is called a "protection supershare".The money market supershare gives the holder the right to all interest income during three years.At the end of those three years,the holder may also get back some or all of the principal value,depending on how well the stock market performs.For every 1% that the S&P 500 has fallen below its current level,the principal value payable to the holder of a money market supershare is reduced by 1% and is instead paid to the holder of a protection supershare (which also has a three-year lifetime). Assume that the current level of the S&P 500 index is 277,that the standard deviation of the index is 25%,and that the average dividend yield on the index is 4%.Also assume that the current six-month T-bill rate is 8% (which is also the rate on the money-market account)and that money-market fund securities are in units of $100. (Hints: Remember that the value of the dividend share plus the appreciation share equals the current level of the S&P 500 index and that the value of the money market income supershare plus the protection supershare equals the value of the money market fund.Also,you can adjust for dividends in the Black-Scholes formula by subtracting the dividend yield from the riskless rate and then using this adjusted rate instead of the riskless rate in the formula.) a. Estimate the value of the appreciation share. b. Estimate the value of the dividend share. c. Estimate the value of the protection supershare. d. Estimate the value of the money market income supershare.

Discuss whether the following statement is true or false: If markets are semi-strong-form efficient,one should not observe excess returns after the announcement of a dividend increase.

You are a financial analyst for General Motors and have been asked to evaluate the effect on risk of taking over RandomTech,an electronics firm.You have collected the following data for both firms: share price \ 60 \ 20 number of shares 13.25 million 10 million beta 1.0 2.0 standard deviation 20\% 80\% You estimate the correlation of returns between GM and RandomTech to be 0.3. a. How will taking over RandomTech affect GM's beta? b. What will the variance of the combined firm be if the takeover is carried through?

Discuss whether the following statement is true or false: The random walk model implies that the best estimate of tomorrow's price is today's price.

Last year,ABC Corp.earned $10 per share and its retention rate was 40%.You require a 12% rate of return on the stock and believe that ABC can realize a rate of return of 15% on its retained earnings. a. If ABC has just paid its annual dividend, and you are planning to buy and hold forever, what is a share of ABC worth to you now? b. Assuming that your expectations and the market's expectations are the same, and that these expectations are met over the next thirty years, what will the market price of a share of ABC stock be at the end of thirty years from now?

You are considering investing your money with Value Max,a professional money management firm.Value Max's portfolio maintains constant percentages in computer stocks (40%),bio-technology stocks (20%),and health service stocks (40%).Value Max has sent you the following information on past performance and investment details: Value Max returns = 40% per annum over the last 5 years; returns on NYSE index = 20% per annum over last 5 years; average annualized 6-month T-bill rate = 7% over last 5 years.Your research indicates that the average betas for the three sectors Value Max invests in are 1.2 for computer stocks,1.5 for bio-technology stocks,and 0.8 for health service stocks. a. What is the appropriate beta to use to evaluate Value Max's portfolio? b. Evaluate Value Max's performance over the last five years.