Exam 4: Security Analysis and Portfolio Theory

Merle Linch,an up-and-coming security analyst has found an exciting investment strategy based on a correlation between the television programs a firm sponsors and the market performance of its stock.Over the period 1970-1982,he finds that those companies that sponsored football and hockey games did significantly better than the rest of the market,yielding 9.4% a year on average versus 8.4% for the Dow Jones Industrials and 8.5% for the S&P 500 index.He writes up his findings in a market letter for general distribution to his firm's clients.His research is also noticed and publicized by the companies whose stock Linch is recommending on the basis of his "contact sports" theory. a. How else might you explain what Linch has observed? b. Precisely how should one test such a theory statistically? c. What would you expect to find if you did test Linch's theory rigorously? Explain. d. Suppose the "contact sports" theory is verified. What will happen in markets now that everyone is aware of it? How long should people be able to earn excess profits by buying these stocks?

On January 1,1991,you are considering buying stock in Genetic Biology Systems (GBS),which has just announced a new type of corn that will provide nitrogen to the soil and thus eliminate the need for additional fertilizer.GBS had an EPS of $1.20 in 1990.The firm's expected annual growth rate is 50% for 1991 and 1992,25% for the following two years,and 10% thereafter.Its dividend payout ratio is expected to be zero in 1990 and 1991,to rise to 20% for the following two years,and then to stabilize at 50% thereafter.The risk-free rate is 15%,and GBS has a beta of 1.2.The market rate of return is 16%. a. What is the value of GBS stock? b. Now assume that you are in the 40% tax bracket but that capital gains are taxed at 16%. Assume that you can buy GBS stock for $22.26. You can also buy the stock of ISD, Inc., which is of equal risk to GBS and sells for $42.86. ISD has just paid a dividend of $6, and has an expected constant growth rate of 2%. If you plan to hold either investment for four years and then sell it, which stock is a better investment for you?

You are evaluating the riskiness of a government bond with a coupon rate of 8% and a maturity of 5 years.If the current yield to maturity is 10%,what is the duration of this bond?

You are an analyst looking at the risk-return characteristics of XYZ Corporation.You decide to use the CAPM as your model for estimating risk.Using a regression of stock returns on market returns,you come up with the following regression equation: R_jt = 0.02 + 1.2 R_mt. a. If the current riskless rate is 7% and the stock is currently selling for $50, what is your best estimate of the stock price a year from today? (Assume that the expected dividend per share next year is $2 and the market of return is 15%.) b. The stock was selling for $54 a year ago. You have been asked to judge the performance of the stock over the last year. (Assume that the NYSE index declined from 150 to 145.5 over the same period, that the T-bill rate was 7% a year ago, and that the dividend per share last year was also $2.) c. XYZ Corp. is considering the acquisition of ABC Co. for $25 million. You have estimated the beta for ABC Co. to be 2.0, and the correlation between XYZ and ABC stock returns to be 0.4. If XYZ goes through with the acquisition, what will its beta be afterwards? (There are one million shares of outstanding XYZ stock.)

Which of the following is an implication of market efficiency?

The following is a listing of option prices on Perdida Enterprises on December 12,2002: The current stock price is 45.75,and the riskless rate is 7%. a. Consider the following position: sell one January 40 call; buy two January 45 calls; sell one January 50 call. Evaluate the net cash flows on this position at expiration for different stock prices, and draw a payoff diagram. b. Are the three January put options correctly priced relative to the corresponding call options? (Assume that there are 42 days on the January option.)

Which of the following statements is true of warrants?

Stocks that have high P/E ratios are much more likely to be found to be undervalued using the dividend-discount model.

The fact that superior returns can not be made by selling stocks that cut dividends is evidence of:

The only significant cost of storing gold is the interest on the money you have tied up in it.Suppose you can borrow money at 10% to buy gold and that today's price of gold is $460 per troy ounce.Gold futures contracts are available now.The future for delivery in six months is at $480,and the future for delivery in twelve months is at $506.Devise two ways you might exploit this situation to make an excess profit.Are there risks involved?

Which of the following statements is true?

Studies of stock splits indicate that one could make excess returns by investing in stocks after splits occur.

You have been given the following historical data on XYZ Corporation: year XYZ return market return 1986 20\% 30\% 1987 -15\% -10\% 1988 25\% 10\% 1989 -20\% -10\% 1990 40\% 20\% a. Estimate the beta for XYZ. b. The price of XYZ stock was $50 a year ago, and today it is $55. The dividends paid by XYZ over the last twelve months amount to $3. The T-bill rate a year ago was 6%, and the NYSE index has risen 10% over the past year. Assume that the average dividend yield on all stocks is 3% and evaluate the performance of XYZ stock over the past year. c. If the T-bill rate today is 5.5%, what would you project the price of XYZ stock to be a year from today? (Assume that XYZ will continue to pay an annual dividend of $1.)

The government has just issued two bonds.The first bond pays $1,000 at the end of year 1 and is now selling for $909.29.The second bond pays $100 at the end of year 1 and $1,100 at the end of year 2 and is now selling for $976.15. a. What are the spot and forward rates for 1-year and 2-year bonds? b. Using the spot rates determined in part a, what is the duration of each of these bonds? c. If a new bond is offered that pays $60 at the end of year 1 and $60 at the end of year 2, what must it sell for now?

Consider the following data for bonds A,B,and C: price cash flows t=0 t=1 t=2 t=3 A \ 900 \ 1,000 0 0 B \ 1,000 \ 100 \ 1,100 0 C \ 900 \ 50 \ 50 \ 1,050 a. Calculate the forward and spot rates for each period. b. What is the value of the discount function for the first period? c. What is the yield to maturity for bond C assuming annual payment periods?

Steve is a Los-Angeles based software developer for one of the leading firms in the United States.His entire portfolio of equity investments consists of stocks in the companies based in California.Explain this kind of investor behavior.

By example,diagram,and/or verbal description,demonstrate how put options can be used to construct a "floor" under the return on a portfolio of common stocks.

You have been asked to evaluate the performance of a firm over the last year and to make some predictions for performance over the next year.The following data are provided to you: 6-month T-bill rate 5\% 6\% firm's estimated beta 1.25 1.5 NYSE index level 130 137. firm's stock price 50 52.5 firm's exp. dividend yields 4\% 4\% market's exp. divided yield 3\% 3\% a. Evaluate the firm's performance over the last year. (Estimate the excess returns, either positive or negative, made by this firm.) b. What would you expect the stock price to be one year from today? c. You estimate that the standard deviation of this stock next year will be 50% and the standard deviation of the market will be 20%. What proportion of the firm's total risk is non-diversifiable?

ABC Corp.has just paid an annual dividend of $0.50 per share.Dividends are expected to grow at 15% for each of the next 8 years,at 10% for the 2 years after that,and at 3% thereafter.If the appropriate discount rate is 10%,what is the intrinsic value of the stock?

Silicon Valley Electronics (SVE)is expected to pay out 40% of its earnings and to earn an average return of 15% per year forever on its reinvested earnings.Stocks with similar characteristics are priced to return 12% to investors.By what percentage can SVE's earnings per share be expected to grow each year? What is the appropriate P/E ratio for the stock? What portion of SVE's total yield is likely to come from capital gains? What portion will come from dividend yield?