Econ 156 Fall 1999 Second Test

1. Suppose that the term structure is flat with 6% yields to maturity and that one year from now the term structure will be flat with 5% yields to maturity. If so, what will be the one-year rate of return on a 20-year zero purchased today? (Calculate the exact return, not an approximation.)

2. In June 1991 Prudential Securities advised clients that

If a slowdown in the economy begins and a recession seems imminent, longer maturities can be used to lock in the current high rate of return. The traditional theory behind this latter scenario is that the economy needs to be stimulated to effect a turnaround. The most direct way to do this is by reducing interest rates.
Explain
     a. why long-term bonds may do better than short-term bonds when interest rates fall.
     b. what federal body will lower interest rates to bolster the economy and how they will lower interest rates.
     c. why lower interest rates bolster the economy.
     d. why Prudential's advice is of little value if the recession seems imminent to investors.

3. Mean-variance analysis was recently used to assess the opportunities available for investors dividing all of their wealth among these three asset classes: 1-year T-bills, 20-year Treasury zeros, and an S&P 500 index fund. The analyst assumed that the investments will be made for one year with no adjustment during the year. Explain the major conceptual error in this argument: "We should not assume that T-bills are safe, since their returns vary from year to year. From 1962-1998, the return on 1-year T-bills had a mean of 6.2% and a standard deviation of 2.4%."

4. Suppose that an investor who expects the S&P 500 to increase by 20% over the coming year could buy the S&P 500 today for 1400 or could buy a one-year S&P 500 futures contract for 1400. Which would you recommend?

5. Many investors look at the beta coefficients provided by investment advisors. Explain why this advice is misleading: "A stock with a low beta is safer than a high-beta stock, because the lower beta is, the less the stock's price fluctuates."

6. Show the profit picture (as a function of the stock price at expiration) for this butterfly strategy: simultaneously buy one call option with an exercise price of $100, sell two calls with an exercise price of $110, and buy one call with an exercise price of $120.

7. Explain why you either agree or disagree with this recent argument by a Bank of America employee about his holdings of Bank of America stock: "The stock market continues to beat up our stock, along with most other financial companies. Not a big problem since I cannot get to most of my stock until I'm at least 55. (For your information, that's more than 10 years out)."

8. Here is information about two companies:

  Company 1 Company 2
Earnings E1 E2
Shares n1 n2
Earnings per share E1/n1 = 1.50 E2/n2 = 2.75
Price per share P1 = 24 P2 = 36
If company 1 wants to acquire company 2 by exchanging x new shares of Company 1 stock for each outstanding share of Company 2 stock, what is the largest possible value of x that will not reduce Company 1's earnings per share? (Assume that the new earnings will be E1 + E2.) Why is it a bad idea for company 1 to exchange this number of new shares of Company 1 stock for each outstanding share of Company 2 stock?

9. A 54-year old woman involved in a recent divorce had to choose between (a) $430,000 now or (b) $2,000 a month for the next 15 years and, thereafter, $5,000 a month for the rest of her life. What would you advise? Explain your reasoning.

10. Warren Buffett has described a "wonderful business" as one that grows without borrowing or retaining a substantial amount of earnings and the "worst business" as one that grows a lot, but does so by reinvesting virtually all of its earnings. Consider two companies that do not acquire other companies, issue new debt or equity, or engage in financial chicanery. How can a company that retains 20% of its earnings grow faster than one that retains all of its earnings?

back