Christopher Robinson, chairman of the board of directors for a private endowment fund, believes that the endowment fund for which he is responsible has diverged too far from its stated objectives. Over several years the board has increased the size of the fund's equity position beyond the stated limits of the investment policy statement. In an effort to realign the fund's investments, Robinson has elected to choose a mortgage-backed security (MBS) for inclusion in the endowment's portfolio. After surveying the MBS market, Robinson has selected four MBS securities to present as potential investments at the next investment committee meeting. Details on the selected MBS securities are presented below:

At the investment committee meeting, a fellow board member raises his concerns over the potential MBS investments stating, "While we all agree that the fixed-income proportion of the endowment is much too small, I am not sure the suggested MBS securities will fulfill the cash flow requirements of the endowment. What risks are we taking on by allocating a portion of the portfolio to these investments? We cannot afford to end up with a timing mismatch between the cash needs of the endowment and the cash provided from its investments. Also, we have given no consideration to commercial mortgage backed securities (CMBS). Isn't our analysis incomplete if we fail to give proper discussion of potential CMBS investment opportunities?"

Robinson responded to his fellow board member by addressing the board member's concerns as follows:

"Since the cash requirements of the endowment fund fluctuate directly with interest rates, the cash flows provided from the MBS will provide adequate protection against cash shortfalls arising from differences in the timing of cash needs and cash sources. In addition, we can further reduce uncertainty surrounding the timing of cash flows by purchasing planned amortization class CMOs, which are securities issued against pools of MBS. CMBS were not presented due to the unacceptable risk profile of the comparable CMBS trading in the marketplace."

Assuming that the outstanding principal of MBS-Z is $183 million at the beginning of Month 20 and the total mortgage principal payment for the month is $0.42 million, the expected prepayment for Month 20 using 125 PSA is closest to:

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Rogcrt Markets is the nation's third largest retail grocery chain, and usually has the largest or second largest market share in every city in which it competes. In its most successful large cities, Rogert has as much as a 25% market share, although its share is sometimes greater in small cities. Rogert is known for its excellent customer service and has a wide variety of grocery selections in almost every part of its stores. Its profit margins on sales are slightly above industry averages, and its return on assets and return on equity are above average.

Rogert has an equity beta of 0.78 and a debt-to-capital ratio of approximately 50%. Recent economic difficulties, including higher commodity prices and higher unemployment, resulted in lower profit margins for Rogert. Still, Rogert's decline in profit margin was less than for its competitors. Rogert did not experience substantial losses of sales from customers switching to lower-priced competitors as its market share remained substantially constant.

Zephine Markets is one of Rogert's smaller competitors. Zephine operates in roughly 15% of the same cities as Roger. Zephine is publicly traded, and one of the members of Rogert's board of directors has asked the staff to evaluate an acquisition of Zephine. The staff believes that Zephine is slightly underpriced and that it could be acquired for a 20% premium over its current price. In recommending against the acquisition, staff member Pierre Chiraq says:

"I agree that eliminating Zephine as a rival would probably enhance our profit margins. However, I am skeptical about this acquisition. First, because our market share is almost never dominant, much of the benefit of eliminating a smaller rival will be shared by our other rivals. They will free-ride on our investment. Second, if our profit margins do increase, wc will eventually attract new rivals into our markets. And finally, our cost of capital should increase substantially because the firm will be diversifying horizontally instead of vertically, increasing the firm's risk."

Over the last several years, grocery industry growth has tended to follow the general economy. The competitors in the industry, like Rogert, compete for market share in a stable industry. The industry's cyclical behavior has shown stable performance in both the ups and downs of the business cycle.

In assessing Rogert's competitive position, Chiraq makes comments about the threat of new entrants:

"My concern about new entrants into our business is low for several reasons. Economies of scale are achievable at a low size of operations relative to that of our firm. Our brand identity is high in the markets in which we compete. And, finally, access to distribution channels is difficult to achieve in the grocery business. While there are many competitive forces that concern mc, new entrants is low on my list."

Finally, the staff discusses industry changes that might have a negative effect on Rogert's industry position. Three phenomena are mentioned that could have such an effect. They are:

1. Industry growth rates are low and declining;

2. Several suppliers are sponsoring national television advertisements for their products;

3. The government has approved a new method of extending the shelf life of fruits and vegetables.

Which industry change mentioned by the staff is least likely to reduce Rogert's profitability?

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Valentine notes that a share of Trailblazer's stock is currently priced at $32. Moreover, she expects the dividend for next year to be $1.47 and forecasts that the price of one share of Trailblazer stock at the end of the year wilt be $35.

In her report, Valentine makes the following statements about Trailblazer dividends:

Statement 1: Trailblazer is expected to pay a dividend next year and will continue to do so for the foreseeable future.

Statement 2: The required rate of return for Trailblazer stock will likely exceed the growth rate of its dividends.

Statement 3: Trailblazer is in a mature sector of its industry, and accordingly,

I expect dividends to decline to a constant rate of 4% indefinitely.

In speaking to a colleague at her firm, Valentine makes the following additional statements after her report is released:

Statement 4: Trailblazer has a 10-year history of paying regular quarterly dividends.

Statement 5: Over a recent 10-year period, Trailblazer has experienced one 3-year period of consecutive losses and another period of two annual losses in a row but has been extremely profitable in the remaining five years.

Valentine is concerned about the theoretical validity of using the APT to obtain an estimate of the required rate of return on equity. She decides to attend a conference dealing specifically with estimation techniques that analysts can employ. At one of the conference seminars, the following points are made:

Statement 6: The APT is a better approach than the CAPM because even though the factor risk premiums are difficult to estimate, the CAPM is more problematic because it relies on a single market risk premium estimate, which in turn leads to greater input uncertainty.

Statement 7: Model uncertainty is a problem with the APT but not with the CAPM.

Valentine is also analyzing the stock of Farwell, Inc. Farwell shares are currently trading at $48 based on current earnings of $4 and a current dividend of $2.60. Dividends are expected to grow at 5% per year indefinitely. The risk-free rate is 3.5%, the market risk premium is 4.5%, and Farwell's beta is estimated to be 1.2.

The justified leading and justified trailing P/E ratios of Farwell are closest to:

Justified leading P/E Justified trailing P/E

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Lena Pilchard, research associate for Eiffel Investments, is attempting to measure the value added to the Eiffel Investments portfolio from the use of 1-year earnings growth forecasts developed by professional analysts.

Pilchard's supervisor, Edna Wilms, recommends a portfolio allocation strategy that overweights neglected firms. Wilms cites studies of the "neglected firm effect," in which companies followed by a small number of professional analysts are associated with higher returns than firms followed by a larger number of analysts. Wilms considers a company covered by three or fewer analysts to be "neglected."

Pilchard also is aware of research indicating that, on average, stock returns for small firms have been higher than those earned by large firms. Pilchard develops a model to predict stock returns based on analyst coverage, firm size, and analyst growth forecasts. She runs the following cross-sectional regression using data for the 30 stocks included in the Eiffel Investments portfolio:

Ri = b0 + b,COVERAGEi + b2 LN(SIZEi) + b3(FORECASTi) + ei

where:

Ri = the rate of return on stock i

COVERAGEi = one if there are three or fewer analysts covering stock

i, and equals zero otherwise

LN(SIZEi) = the natural logarithm of the market capitalization

(stock price times shares outstanding) for stock i,

units in millions

FORECASTi = the 1-year consensus earnings growth rate forecast for stock i

Pilchard derives the following results from her cross-sectional regression:

The standard error of estimate in Pilchard's regression equals 1.96 and the regression sum of squares equals 400.

Wilrus provides Pilchard with the following values for analyst coverage, firm size, and earnings growth forecast for Eggmann Enterprises, a company that Eiffel Investments is evaluating.

Wilms asks Pilchard to derive the lowest possible value for the coefficient on the FORECAST variable using a 99% confidence interval. The appropriate lower bound for the FORECAST coefficient is closest to;

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Shirley Nolte, CFA, is a portfolio manager for McHugh Investments. Her portfolio includes 5,000 shares of Pioneer common stock (ticker symbol PNER), which is currently trading at $40 per share. Pioneer is an energy and petrochemical business that operates or markets its products in the United States, Canada, Mexico, and over 100 other countries around the world. Pioneer's core business is the exploration, production, and transportation of crude oil and natural gas. Pioneer also manufactures and markets petroleum products, basic petrochemicals, and a variety of specialty products.

Nolte would like to fully hedge her exposure to price fluctuations in Pioneer common stock over the next 90 days. She determines that the continuously compounded risk-free rate is 5%. She also gathers some information on exchange-traded options available on Pioneer stock. This data is shown in Exhibit 1.

From this data, she determines that the put option deltas are equal to:

* 1 -month put option delta = -0.46.

* 3-month put option delta = -0.36.

* 6-month put option delta - - 0.29.

* 9-month put option delta = -0.17.

She also concludes that the 9-month put option is mispriced relative to the 9-month call option, and an arbitrage opportunity is possible, but that the 3-month put option is correctly priced relative to its comparable call option. She also estimates the gamma of the 3-month call option to be 0.023.

In an unrelated transaction, Nolte is also considering the purchase of a put option on a futures contract with an exercise price of $22. Both the option and the futures contract expire in six months. The call price is $1 and the futures price today is $20.

The value of the put option on the futures contract is closest to:

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