1. The first professional football player was W. W. Pudge Heffelfinger, a former All-American at Yale, who was working on the railroad in 1892 when he was paid $500 to play one game for the Allegheny Athletic Association against the Pittsburgh Athletic Club. (Pudge scored the game's only touchdown, on a 25-yard run, as Allegheny shut out Pittsburgh.) Using a scale of 100 in 1967, the consumer price index was 27 in 1892 and 419 in 1992. What was the value in 1992 dollars of Pudge's 1-game salary in 1892?

2. Give brief, logical explanations for each of these three Wall Street Journal headlines:

   a. "Fears of Stronger Economy Hit 30-Year Bond" [October 3, 1993.]

   b. "Industrials Rise Despite Bond Drop" [October 19, 1993.]

   c. "Bond Slump Sends Stocks Tumbling" [November 23, 1993.]

3. A life insurance company wants to make an investment that is certain to be worth $1,000,000 20 years from now, regardless of whether interest rates rise or fall. Which of the following U.S. Treasury bonds is most appropriate? Explain your reasoning.

4. Critically evaluate the following quotation:

It’s true that interest rates are rising, but that shouldn’t affect growth stocks since they don’t yield much anyway.
[Julius Westheimer, “Wall Street Week,” April 14, 1975.]

5. In 1992 a financial writer advised that short-term bond funds occupy an important niche on the risk-reward spectrum, halfway between money-market funds and regular bond portfolios: "The short-term funds, which generally hold domestic bonds coming due in one to three years seek a sufficiently lucrative but not too volatile middle ground." For short-term bond funds to occupy the middle ground between funds with low capital risk and low yields to maturity and funds with high capital risk and high yields to maturity, must the term structure be upward or downward sloping? Explain your reasoning.

6. In October of 1992, The Wall Street Journal reported that many corporations were repurchasing their shares, and quoted this explanation from one money manager: "When alternative investments such as Treasury bills are paying 2.9%, companies' own shares become more attractive." Explain why this reasoning is unpersuasive.

7. The money manager cited in the preceding exercise "cautions against buying the stocks of companies that are borrowing money to finance share repurchases." Do shareholders always lose when companies borrow money in order to repurchase their shares?

8. A 1989 Financial Analysts Journal article showed a hypothetical scatter diagram of the expected returns and standard deviations for several stocks. The authors make the following "important observation:" "there are many stocks at each level of risk, but only one has the highest return. (It is all too easy to take high risks without getting commensurate rewards, especially in the short run.)"
   Explain the difference between the expected return in the graph and the short-run highest return described by the authors. Explain why it can be perfectly rational for someone to invest in a particular stock even if they believe that another stock with the same standard deviation has a higher expected return.

9. Explain why this headline is puzzling: "T-Bill Investors Bet on Lower Interest Rates." [Tom Petrino, Los Angeles Times, November 7, 1990.]

10. I want a 10% return on my investment. I have $80,000 to invest and will borrow $364,076 at 8% for 25 years in order to buy a $444,076 apartment building with 4 units, each of which can be rented for $1,166.67 a month. My monthly mortgage payments will be $2,810 and my other monthly expenses will be $1,190. Therefore I will make $8,000 a year, which is a 10% return on my investment:

11. After Iraq invaded Kuwait in 1990, crude oil prices increased by more than 50%. As the market price neared $30 a barrel, the managers of Royal Caribbean Cruise Lines felt fortunate that they had locked in a price of $18.41 a barrel.

    a. To protect itself against an increase in oil prices, should a company buy or sell oil futures?

    b. Why might such a company be protected even if the delivery dates for its futures contracts do not coincide with its need for oil?

    c. Which do you expect to be higher, the price of crude oil or the price of crude-oil futures?

    d. A 1990 Wall Street Journal article on companies using oil futures to protect themselves against an increase in the price of oil noted that, "The purpose of hedging isn't to minimize cost but to minimize risk." Explain their reasoning.

12. In 1992 the Vanguard Group estimated that a 1-percentage-point increase in interest rates would reduce the market value of a portfolio of 20-year bonds by about 9 percent. Use these data to estimate the duration of a portfolio of 20-year bonds. Why is the duration of a portfolio of 20-year bonds not 20 years?

13. During the 10-year period 1982-1992, three-fourths of professionally managed bond mutual funds did worse than the Salomon Brothers Broad Investment Grade Bond Index. A managing director of Pacific Investment Management Co. (PIMCO), one of the few funds that beat the index, said that regulatory and accounting rules compel many investors to buy 1-year securities, making their yields artificially low. Investors who are not subject to such constraints can do better buying a portfolio of 6-month and 2-year securities. [Barbara Donnelly Granito, "Bond Managers Beat the Pack By Finding Market Inefficiencies," The Wall Street Journal, July 20, 1993.]
   Consider a 6-month Treasury zero with an annual yield of 4.0%, a 1-year Treasury zero with an annual yield of 3.5%, and a 2-year Treasury zero with an annual yield of 4.0%. Instead of investing $1 million for 6 months in the 1-year zero, how should an investor divide her $1 million between the 6-month and 2-year zeros to ensure that she will have a higher return over the next 6 months, no matter whether interest rates go up or down, as long as the difference between the yields on these 1-year and 2-year zeros does not widen?

14. The PIMCO director cited in the preceding exercise also stated that bargains can frequently be found among putable bonds, which give investors the right to sell the bond back to the issuer at a specified price. Consider a 30-year putable bond with a maturation value of 100, 5% annual coupons, an exercise price of 95, and a market price of 98 1/2. Assume (unrealistically) that the investor who buys this bond for 98 1/2 will sell it in one year (after receiving one coupon) either for its market price or by exercising the put option. Graph the dollar profit as a function of the market price of the bond at the time of the sale.

15. In general, should the market price of putable bonds be higher or lower than the market price of otherwise identical non-putable bonds? Explain your reasoning.

   Explain why the absolute value of the difference between the market prices of putable bonds and otherwise identical non-putable bonds should, in theory, be affected either positively or negatively by an increase in

   a. the expected value of future interest rates, with no change in the degree of uncertainty about future interest rates.

   b. uncertainty about future interest rates, with no change in the expected value of future interest rates.

16. In 1992 New York City issued "mini-munis"--municipal bonds in unusually small denominations that were intended to appeal to people with modest amounts to invest. The price of a 5-year New York mini-muni with a $5,000 maturation value was $3,649.

   a. Calculate the yield to maturity on this zero.

   b. Calculate the taxable equivalent yield: the before-tax return on a fully taxable corporate security that would give the same after-tax return as this mini-muni for a New York investor in a 31 percent federal tax bracket and 12.3 percent New York tax bracket. (Remember that New York taxes can be deducted from federal taxable income.)

17. Here is an excerpt from the Encyclopedia of Investments:

In the 1980s, the average annual return on Topps baseball cards issued since 1952 was 25%....In general, sports collectible items are relatively easy to acquire and do not require the collector to possess any special level of expertise.
  Although price appreciation in the sports memorabilia market has been excellent, there still is significant price risk in these items. Price risk means the extent of variability in the market price of these collectibles over time. The authors have examined the price risk of baseball cards over the period 1978 to 1987. Baseball cards were found to be about 30% more risky than the general stock market and less risky than many other commodities and collectibles. Financial theory suggests that investors assuming additional risk should be compensated with higher expected return. Baseball cards provide sufficient additional return for those investors deciding to bear the risk.

   a. How do you suppose the authors measured price risk, in order to obtain the 30% figure?

   b. Why are their empirical measures of risk and expected return unpersuasive? Be specific.

18. In August of 1992, the chairman of Salomon Brothers Asset Management wrote that

The current yield on ten-year U.S. government bonds is 6.55%; U.K. ten-year “gilts” yield 9.29%; and German ten-year “bunds” yield 8.05%. Adjusted for the inflation rate in each country, the real yields are 3.5% in the U.S.; 3.5% in the U.K.; and 3.25% in Germany.

   a. What were the inflation rates in these three countries?

   b. What does purchasing power parity predict about the value of the dollar relative to the pound?

   c. If this prediction about the value of the dollar is correct, what will be the rate of return in dollars on the U.K. pound-denominated investment?

19. "Target-payout funds" are closed-end investment companies that guarantee that the annual distribution to the fund's shareholders will exceed a specified minimum amount, for example 7 percent of assets. If the dividends and realized capital gains on the investment company's portfolio are less than this minimum amount, the company sells some of its portfolio in order to make the target payout. A 1992 Shearson Lehman report called the yields for target-payout funds "illusionary" and "artificially high." Explain why, even if the fund's shares sell for net asset value, a 7 percent target payout does not guarantee that the fund's investors will get at least a 7 percent return on their investment.

20. Target-payout funds (described in the preceding exercise) were intended to combat the tendency of closed-end funds to sell at a discount from net asset value. Use a numerical example to explain why a target-payout policy might be beneficial for the shareholders of a closed-end fund that sells at a discount.