LUBIN SCHOOL OF BUSINESS
MBA 653 Financial Reporting, Analysis and Modeling of Corporate Activities
Prof. P.V. Viswanath
1. Read the article below and answer these questions:
Investors' View Of Risk Returns To Normal
Wall Street Journal, September 10, 2007; Page C1
For investors hoping the markets will settle down, here is a simple, sobering message: Don't hold your breath.
After a long period of unusual stability in stock and bond markets, the wrenching losses of the past few months may have merely brought investors' perceptions of risk back to where they should have been in the first place.
"People were pricing things as if there was never going to be another
recession, or even a financially difficult period or corporate default,"
says Byron Wien, chief investment strategist at hedge fund Pequot Capital Management.
"We're moving toward normal."
And normal might not be as stable as investors had come to believe.
The Chicago Board Options Volatility Index, or VIX, which tracks the prices of call and put options on the S&P 500 index, is a popular measure of risk tolerance. Options can be used as insurance against losses from market swings, because an option allows an investor to buy or sell a stock at a preset price. The more worried investors get about losing money on investments, the more options cost, and the higher the VIX goes.
On the heels of Friday's disappointing jobs report and the nearly 250-point loss in the Dow Jones Industrial Average, the VIX rose 2.24 points to 26.24. That puts it well above the multiyear low of 9.89 it hit in January. But it is far from unusually high by historical standards.
"If the VIX was at 40, I think you could comfortably say this risk aversion is extreme. But the VIX at 26? This is sort of the midpoint in 1999 and 2000," says Douglas Cliggott, chief investment officer at money manager Dover Management.
Similarly, junk-bond prices have fallen sharply in recent months, driving yields higher. At the beginning of June, the Merrill Lynch High Yield Bond Index yielded 2.41 percentage points more than comparable Treasurys. Friday, that "spread" over low-risk Treasurys had widened to 4.73 percentage points. That's a massive shift. But interest-rate spreads on junk bonds are still a bit smaller than the historical norm.
The risk tolerance of investors had been rising for many months, in part because there was a growing perception that the economy was becoming more stable. With a recession now possibly in the cards, that view will be reassessed.
Hedge funds and other large investors appear to have been reducing the amount of leverage -- or borrowed money -- they use to invest. Leverage is safe when the economy is stable, but dangerous in a downturn. If investors use less of it, that will cut back on the flow of cash into the markets.
"People are waiting for credit spreads and volatility to go to the levels of the past three years, but that shouldn't be the base comparison," says Brett Gallagher of Julius Baer Investment Management.
Short-term credit markets, on the other hand, are showing extreme levels of risk aversion. The London interbank offered rate, or Libor, has risen far above the Fed's overnight target rate, a rare occurrence that suggests banks around the world are very wary of what lurks on each other's balance sheets.
Maybe they know something everyone else should be more worried about.
2. (10 points) Ford Corporation has a lot of convertible bonds on its balance sheet. Suppose one of them is a 10 year bond with a coupon rate of 3.5% selling at par. You know, however, that comparable bonds that are not convertible actually sell at a yield-to-maturity of 8% per annum. What is the value of the convertibility feature? Assume bi-annual coupon payments, as well as a face value of $1000 per bond.
3. (10 points) In 2005, Ford Motor Company paid dividends of 40 cents per share to common stockholders (10 cents per quarter). However, in the third quarter of 2006, this was reduced to 5 cents, and in the last quarter, the dividends were eliminated altogether. A footnote in the firm's 10-K has the following information:
On December 15, 2006, we entered into a new secured credit facility which contains a covenant prohibiting us from paying any dividends (other than dividends payable solely in stock) on our Common and Class B Stock, subject to certain limited exceptions. As a result, it is unlikely that we will pay any dividends in the foreseeable future.
If Ford Motor Company does not expect to pay any dividends in the foreseeable future, would it be right to conclude that the stock is worthless? Why or why not?
4. a. (10 points) According to Yahoo (http://finance.yahoo.com/q/ks?s=goog),
Google's beta is 1.21. Assume that the market risk premium is 6% per annum.
The 10 year T-bond currently yields 4.15% (http://finance.yahoo.com/). What
is the rate of return that investors should require to invest in Yahoo, according
to the CAPM?
b. ( 15 points) The Free Cash Flow to Equity for Google is $1.09b., according to Yahoo (actually, this is Levered Free Cash, as defined at http://help.yahoo.com/l/us/yahoo/finance/tools/research-12.html). This is the cashflow that Google had available to it, last year, after it took care of its short-term and long-term investment needs, and after adjusting for payments to and from bondholders. According to some researchers, this could be considered a measure of how much the company could afford to pay out in dividends. Google currently has 312.84m. shares outstanding, and it sold for $718.42 as of the end of trading on Monday, December 10, 2007. If you believe that Google's current price is correct, what is the implied rate of growth of dividends, assuming that Google is going to grow at the same rate of growth forever? (Hint: If you use the usual formula to compute the growth rate, you should get a surprising answer.)
c. (5 points) Does your answer make sense? If not, how will you change your assumptions about Google's growth?
5. a. (7 points) Options are traded on the CBOE on Ford Motor Company stock
with an exercise price of 8 with an expiration date six months from now. The
current stock price is around $7. Assume that the stock price can rise to $9
in six months or drop to $6.50. What should the price of the call be if the
risk-free rate is 5% per six months?
b. (7 points) What should the price of a put option on Ford stock be, with an exercise price of $8?
c. (6 points) Show that your answer satisfies the put-call parity relationship.