1 Before the 1969 Truth-in-Lending law, a finance company using the "add-on" method could loan you $1000; charge you $100 interest (with $1100/12 = $91.67 due each month for 12 months); and say that the interest rate was 10%.

  a. What is the true annual percentage rate on such a loan?

  b. If the annual percentage rate were really 10%, how big would the monthly payments be?

2 "It is reasonable, for example, to assume that a U.S. government bond with an 8% coupon will achieve an annual total return of +8% if held to its 20-year maturity." [John C. Bogle, Bogle on Mutual Funds, Burr Ridge, IL: Irwin, 1995, p. 14.]

  a. Why did the author specify a U.S. government bond?

  b. Explain why the author's conclusion is either correct or incorrect.

3 John Bogel (p. 47) used historical data to rank-order three types of financial assets by the each of the criteria shown in the table below (1 is best, 2 next best, and 3 worst; the two NAs represent not applicable.) Fill in the blanks in this table, putting 1, 2, and 3 in the appropriate places in each column. For example, if you believe that common stocks have had the highest total return, long-term bonds the next highest, and Treasury bills the lowest, then in the Total Return column, you would write 1, 2, and 3 in that order. In the two columns with NAs, just put 1 and 2 in the right order.

4 In his book Bogle on Mutual Funds, John Bogle, founder and chief executive office of The Vanguard Group of Investment Companies, warned investors that a long-term bond fund's current yield (income divided by current market value) may be a misleadingly high measure of the investor's rate of return, particularly for funds that hold lots of bonds issued at par when interest rates were higher than they are today (p. 101). (Ignore taxes, transaction costs, and default risk; assume that the current level of interest rates is expected to persist indefinitely.) Explain why this is so

  a. if the bonds are callable after some future date.

  b. even if the bonds are not callable.

5 "A century ago, when buying stock was a lot like placing a bet at the tracks, science had little to do with what we now know as market analysis. If there was anything close to a market theory, it was that a company was worth the net value of its visible assets. Any amount that its stock price rose above that level was somehow illegitimate. The difference between a stock's market price and the value of its underlying assets was known as •water,' a term used with derision." [Robert Sobel, "The Way it Works," The Wall Street Journal, May 28, 1996.] Use fundamental analysis to explain why a stock's market price may be larger than what it would cost to replace the firm's visible assets.

6 In September of 1997, The Wall Street Journal reported that corporate insiders were increasingly using "collars" to hedge their holdings in the company's stock without actually selling the stock. [Greg Ip, "Collars Give Insiders Way to Cut Risk," The Wall Street Journal, September 17, 1997.] In a typical collar, the insider simulataneously sells a call and buys a put at a lower strike price, with the price of the put approximately equal to the price of the call. For example, on December 4, 1997, Microsoft stock traded for 142 9/16, an April 1998 call at an exercise price of 150 traded for 3 and an April 1998 put at an exercise price of 135 traded for 2 1/8. Show the profit diagram on the April exercise date for an investor who buys one share of Microsoft, sells one call, and buys one put.

7 The graph below was used to argue that sharply higher stock prices were justified by sharply higher corporate profits. (Ed Yardeni, "Profits-Led Exuberance?," Weekly Economic Briefing, Deutsche Morgan Grenfell," June 12, 1997.]

8 Identify the most important error in this reasoning:

If FishTop is selling for $50 per share and you expect it to rise, you could buy ‘October $55’ calls....If, just before your option expires, FishTop is selling for $75 per share, you ... make $20, right? Not exactly. That option wasn’t free. Let’s say the premium you paid was $6 per share. That means your profit is down to $14. Which would be OK, but remember—if you had just bought shares of FishTop instead of spending money on options, you would have made a much better profit.

[The Motly Fool, “Not Your Best Option,” The Los Angeles Times, July 29, 1997.]

9 Shown below is a graph of R-squared for the equation B = a + bS + e, where B is the monthly return for the Lehman Aggregate Bond Index and S is the monthly return for the S&P500. [In the Vanguard, Vanguard Marketing Corporation, Autumn, 1996.]

  a. Provide a logical explanation for the fact that R-squared is sometimes near 0 and sometimes near 0.4.

  b. When R-squared is 0.36, is R equal to +0.6 or -0.6?

  c. This figure was used to support an argument for either: (i) adding bonds to a stock portfolio, or (ii) excluding bonds from a stock portfolio. Which and why?

10 Explain the flaw in this investment strategy:

Stockholders and investors often like to buy just before an ex-dividend date to capture an additional payment. For example, if you buy shares two days before an ex-dividend day and hold them for a year and one day, you should qualify for five dividend payments, not the four that holding shares for a year usually permits

[Carla Lazzareschi, “Money Talk,” Los Angeles Times, November 9, 1997.]