1. Provide a rational explanation for the fact that the price of Adobe Systems stock fell immediately after it announced on September 18, 1995 that its third-quarter profits were 63 percent higher than a year earlier.

2. Explain this observation by a vice-president of P.R. Taylor Inc., a Palo Alto investment banking and financial advisory firm: "One nice thing is that the zero-coupon [bonds] have no 'reinvestment risk.'"

3. Carefully explain the inadequacies in this stock-selection advice from Peter Lynch, the legendary manager of Fidelity's Magellan Fund: "The p/e ratio can be thought of as the number of years it will take the company to earn back the amount of your initial investment--assuming of course that the company's earnings stay constant....If you buy shares in a company selling at two times earnings (a p/e of 2), you will earn back your initial investment in two years, but in a company selling at 40 times earnings (a p/e of 40) it would take forty years to accomplish the same thing."

4. A June 1995 Wall Street Journal article argued that people buying 30-year Treasury bonds with 6.7% yields were imprudent speculators. Among the reasons: "room for further slippage is limited. Interest rates have never been less than zero yet," and while interest rates might decline "a bit more," "the premium for making this bet is all of four-fifths of a percentage point, since one can get 5.84% without the risk on a two-year note."

   a. Explain why interest rates will never be negative.

   b. Explain why investors in 30-year Treasuries will, in comparison to two-year notes, make much more than four-fifths of a percentage point if interest rates decline.

   c. Explain why investors in 30-year Treasuries will, in comparison to two-year notes, make much more than four-fifths of a percentage point even if interest rates don't decline.

5. In 1992 MG Corp, a U.S. subsidiary of the German giant Metallgesellschaft AG, contracted to sell gasoline, heating oil, and diesel fuel at fixed prices for the next 10 years. MG tried to hedge by purchasing short-term oil futures. An added bonus was that energy futures were "backward" at the time, with futures prices below spot prices. However, oil prices fell by more than $4 a barrel in 1993 and MG lost $1 billion on its futures contracts, threatening bankruptcy and prompting MG to wind down its fuel contracts and its hedging program.

   a. Should MG have bought or sold oil futures to hedge their gasoline, heating oil, and diesel fuel contracts? Explain your reasoning.

   b. Explain how crude-oil futures protect, but not perfectly, against fluctuations in the price of refined gasoline.

   c. Explain why oil futures prices are usually above the current spot price for oil.

   d. Ignoring its fuel contracts, if spot prices had been constant would MG have made profits or losses on its oil futures? Explain.

   e. Explain why Nobel laureate Merton Miller was confident that, in the long run, MG would have made back the $1 billion they lost in 1993.

6. The prime rate is the interest rate banks charge their most credit-worthy customers on short-term loans. Why is the prime rate generally above the T-bill rate? If a corporation borrows from a bank at a floating interest rate that is linked to the prime rate and then swaps the payments due on this loan for payments indexed to the T-bill rate, is this an implicit wager that the spread between the prime rate and the T-bill rate will widen or narrow?

7. In November of 1995, Columbia/HCA Healthcare, the nation's largest for-profit hospital company, issued $200 million in 100-year debt, rated A3 by Moody's and BBB+ by Standard & Poor's. A Wall Street Journal article said that "most investors avoid 100-year bonds like the plague," forcing the company to offer a 7.5% yield, compared to the 6.25% yield then prevailing on 30-year Treasury bonds. The Journal asked, (a) "Why would investors buy the IOU of a company when chances are they won't live to see their principal returned?" and also pointed out that (b) "even though investors get interest every year, by the time they get their principal back, inflation, even at its current low levels, would have eroded the principal's value to virtually nothing." Explain why these two concerns are of little importance and identify two much more important risks.

8. Value Line recommends that an investor who owns fewer than 15 stocks gauge riskiness by looking at Value Line's "safety ratings" for these stocks, and that an investor who owns more than 15 stocks instead calculate the average beta. Why are the safety ratings not identical to the beta coefficients, and why does the appropriate risk measure depend on the number of stocks in the portfolio?

9. R. Foster Winans, who leaked the contents of stories to be published in The Wall Street Journal, wrote that, "the only reason to invest in the market is because you think you know something others don't." If everyone had exactly the same information, would anyone buy stocks?

10. A November 30, 1995 article in The Wall Street Journal included the following graph [of the S&P500 earnings yield E/P and the interest rate on 30-year Treasury bonds, from 1985 to 1995]:

   a. Use fundamental analysis to explain why there should be a connection between these two series.

   b. Use fundamental analysis to explain why the earnings yield should sometimes be larger than the bond rate, and why sometimes the reverse should be true, even if there is no misleading accounting or temporary fluctuation in earnings. Don't simply argue that the earnings yield may not equal the bond rate; explain why in some situations the earnings yield should be low and in other situations it should be high.

   c. On theoretical grounds, do you expect the earnings yield, on average, to be above or below the 30-year Treasury bond yield? Explain your reasoning.

   d. Identify the largest gap in this graph between these two time series.

11. Between 1989 and 1992, Treasury-bill interest rates fell from 9 percent to below 4 percent, provoking a half-joking commentary that "there could be interest riots in Florida. The American Association of Retired Persons (AARP) might start a campaign to force the Fed to raise interest rates." [Edward Yardeni, Weekly Economic Analysis, C.J. Lawrence, March 4, 1992.] Explain Yardeni's reasoning. Don't investors make capital gains when interest rates decline and suffer capital losses when interest rates increase?

12. A German government agency issued dollar-denominated bonds, using the dollars raised to buy marks, which were used to build an airport. The agency will use some of its future mark-denominated tax revenue to buy dollars in order to pay the coupons and principal on these bonds.

   a. Explain why this German agency will either benefit or suffer financially from an appreciation of the mark relative to the dollar.

   b. To reduce its exposure to exchange-rare risk on the bonds it has issued, should this government agency swap dollar liabilities for mark liabilities, or vice versa?

13. Many companies have dividend-reinvestment plans that allow shareholders to specify that their dividends be used to purchase additional shares of stock, newly issued by the company. The shareholders avoid brokerage fees, and the company raises some cash without paying fees to an underwriter. Shareholders still pay taxes on their dividends. Carefully explain why shareholders who take advantage of a dividend-reinvestment plan would prefer instead that the firm eliminate its dividend altogether and instead repurchase shares.
   For concreteness, consider a company with 100 million shares outstanding, valued at $5 apiece, that will either (a) pay a dividend of $1 a share, with half the shareholders reinvesting their dividend; or (b) spend $50 million repurchasing shares. Assume further that there are two shareholders, each owning 50 million shares. Stockholder 1 will participate fully in the dividend reinvestment plan and will not sell shares in the stock repurchase plan. Stockholder 2 will not participate in the dividend reinvestment plan and will sell shares in the stock repurchase plan. Be sure to compare how these policies affect each shareholder's stake in the company.

14. TCW used monthly data for the period January 1986 through June 1994 to estimate the correlation coefficients among the returns from three different types of assets: S&P 500 stock index, Lehman Brothers Treasury bond index, and TCW's high-yield bond index. The correlation coefficient between stocks and Treasury bonds was 0.2; the correlation coefficient between stocks and high-yield bonds was 0.5; and the correlation coefficient between Treasuries and high-yield bonds was 0.4. Explain the following:

   a. why Treasuries and high-yields are positively correlated.

   b. why Treasuries and stocks are positively correlated.

   c. why the correlation between Treasuries and stocks is far from perfect.

   d. why high-yield bonds are more closely correlated with stocks than with Treasury bonds.

15. Using the correlation coefficients in the preceding exercise and these expected returns and standard deviations,

   mean-variance analysis gives the following opportunity locus:

   a. Which asset is labeled 2 in the graph?

   b. Explain why Asset 2 is not on the opportunity locus.

   c. Explain why a risk-neutral investor either would or would not buy any stocks.

   d. Show how the opportunity locus would change if we introduced risk-free T-bills with a 4 percent return. (Show your answer on the graph.)

16. The following two statements sound contradictory: "Dividend policy is irrelevant" and "Stock price is the present value of expected future dividends." This question is designed to show that they are fully consistent.
   The current price of the shares of Charles River Mining Corporation is $50. Next year's earnings and dividends per share are $4 and $2, respectively. Investors expect perpetual growth at 8 percent per year. The expected rate of return demanded by investors is R = 12 percent. We can use the perpetual-growth model

   Suppose that Charles River Mining announces that it will switch to a 100% payout policy, issuing shares as necessary to finance growth. Show what happens to the current stock price.

17. Ian MacKinnon, who is in charge of fixed-income investments for the Vanguard Group, suggests that retirees with more than $500,000 in assets buy a portfolio of Treasury zeros with various maturities (1 year, 2 years, 3 years, and so on up to 20 years) that will give a constant cash flow they can live off for the next 20 years. What advantage do you see in this strategy, in comparison to investing the same amount of money in a 20-year coupon-paying Treasury bond? What risk do you see in MacKinnon's strategy?

18. Suppose you are 65 years old, have $500,000, and want to implement MacKinnon's strategy, as described in the preceding exercise. The term structure is flat, with all Treasury bonds priced to yield 10 percent, and you want to have a constant annual cash flow from your bond portfolio for the next 20 years.

   a. How much should you invest in twenty Treasury zeros with maturities of 1 year, 2 years, and so on up to 20 years? How large is the constant annual cash flow? (Just set up.)

   b. What will your annual cash flow be if you instead use your $500,000 to buy 20-year Treasury bonds with 10 percent annual coupons?

19. Here are two graphs showing the return from two different combination strategies, involving stock and options, as a function of the price of the stock at expiration:

   Identify each of these combination strategies (e.g., buy 1 share of stock and sell two call options with an exercise price equal to the current price of the stock) You can give your answers on the above graphs.

20. Here are recent financial data on Pisa Construction Company:

   Thus, EPS declines, book value per share declines, and share price will decline proportionately to $38.70." Evaluate this argument with particular attention to the assumptions implicit in the numerical example.