2. Derivative asset pricing Flashcards
“Anomalies: The Law of One Price in Financial Markets”
Authors provide 5 examples in which the LOOP does not hold in practice. Choose any 2 of these examples and explain what might cause the mispricing in each particular case! (4p)
1) Corporate spin-off. Example of 3com and Palm. When only a small portion of a subsidiary is sold in an equity carve-out, the demand for these shares outstrips supply, causing mispricing. Due to the Short selling constraints (most of the shares held by non-institutional investors) it was not possible to exploit arbitrage opportunities and fix the price.
2) Country funds are mispriced. The two assets (the underlying securities and the fund) are not precisely identical – the fund portfolio manager charges a fee and incurs other expenses or has a superior stock-picking ability.
The premium of country funds could be due to legal barriers preventing investors from buying foreign stock (segmented markets – differences in demand and supply in different markets) (Taiwan fund traded at a 205% premium). However, in some cases, the premium persists even in the absence of barriers to trading (the case of Germany).
“Anomalies: The Law of One Price in Financial Markets”
Analyze the Law of One Price (LOP) and anomalies that violate the concept.
(i) Explain what the LOP is. What are the underlying assumptions for LOP to hold, and why should the concept of the LOP hold in real life? (6p)
(ii) Mr. Goblin is a strong believer in the efficiency of markets. Nevertheless, he has just heard of several market anomalies that violate the LOP. Describe 3 market anomalies that violate the LOP. (3p)
(iii) For each of the above mentioned anomalies, provide a possible explanation for the observed anomaly in the market, referring to the relevant articles from your readings packages. (6p)
(i) LOP: identical goods must have identical prices; otherwise rational arbitrageurs could make unlimited profits by buying the cheap one and selling the expensive one without bearing any additional risk (Bayer vs. store brand aspirin, financial markets).
- identical goods
- no transaction costs
- no barriers to trade
(ii)
1. American Depositary Receipts are shares of specific foreign securities held in trust by US financial institutions. Price of ADR in America should cost the same as the price of that stock in the domestic country. But ADR might be more expensive than the domestric stock because it offers better diversification opportunity (e.g. Bombay shares in India trading at 136% of premium).
2. Twin shares (fixed claimes on the cash flows and assets of the firm). E.g. Royal Dutch and Shell. Royal Dutch share was higher as it was included i S&P500, while Shell wasn’t (index funds are obliged to buy particular shares to track S&P).
3. Corporate spin-off often shoots the price up, attracts a lot of attention. Demand outstrips supply causing mispricing. Example of Palm &3COM. Palm traded at 95$ while 3com could have been bought for 82$ which was worth 1.5 shares of Palm.
“Anomalies: The Law of One Price in Financial Markets”
State and explain two reasons why the law of one price does not hold in financial markets! (2p)
1) Short selling constraints:
§ Lendable supply of shares or products is limited (most of shares held by non- institutional investors – Palm, legal barriers to foreign trading – country funds)
§ Transaction costs
2) “Noise trader risk”: after an arbitrageur takes a position, the valuation disparity could widen,
causing the net wealth of arbitrageur to fall and forcing him to close the position
3) Long-Term Capital Management (LTCM) story: the hedge fund placed several bets on price convergence; after the price diverged further, the fund entered financial distress and was liquidated.
“Anomalies: The Law of One Price in Financial Markets”
Please recall the definition and assumptions of the law of one price and explain why it might not hold with such good as aspirin, but should hold in financial markets. (5p)
answer
“Forensic Finance”
What is stale price?
What is stale-price risk arbitrage?
What are the reasons for stale prices?
Stale prices are prices that don’t fully reflect current information.
Orders received after 4 p.m. should be priced at the closing net asset value on the following trading day.
If the stale price is low relative to what would be implied, you can buy mutual fund shares before the price predictably rises; if the stale price is high, you can sell mutual fund shares before the price predictably falls
1) Illiquidity
(small company stocks could trade only a few times per day, and their price at 4 p.m. might not yet reflect movements in the broader markets late in the trading day)
2) Time zones
(mutual fund that invests in international stocks will have different closing prices)
“Forensic Finance”
What is “Spring loading”?
What is “backdating”?
What is the implication which reduced backdating?
“Spring loading”: granting options immediately before the announcement of good news to capture the following positive abnormal returns (e.g., Fortune 500 CEOs)
“Backdating”: firms are choosing an option grant date after having observed on what date during a month the stock was at its lowest price
Solution => top executives in publicly-traded companies had to report insider trades, including the receipt of stock option grants, within 2 business days of the transaction
“Forensic Finance”
Luigi Zingales encouraged scholars to inform people, uncover scandals and raise awareness about fraud. The author documents how scholars affected the financial industry. Discuss three research findings that lead to specific actions/ consequences in the financial industry. (6p)
1) 2005, a Wall Street Journal article reported that three top executives disclosed stock option backdating at the company that was uncovered in an internal investigation. Coincidentally, Heron and Lie send back to the Journal of Financial Economics a revised version of their working paper investigating the magnitude of backdating and the effect that Sarbanes–Oxley had had on it. After reading the Wall Street Journal article, Heron sent an e-mail to the reporters who wrote the article, telling them that this case was just the tip of an iceberg. He included his working paper with Erik Lie as an attachment. Wall Street Journal reporter Mark Maremont realized that this was something big, and the newspaper launched its own investigation.
2) While working on an empirical paper using analyst stock recommendations for U.S. stocks, 3 authors noticed that downloads of the I/B/E/S recommendations database obtained at different points in time were not identical, through all the downloads referred to the same sample period.They decided to investigate this further, resulting in their 2008 paper “Rewriting History.”
=> Thomson Financial has got rid of problems documented by their study. Furthermore, they has changed their data handling procedures -no more unintentional change of data. Thus, the data quality for future research has been improved.
3)
“Forensic Finance”
Snap Inc., a US technology company specializing in superimposing cat ears on photos of human faces, carried out a long-anticipated IPO on March 2. The IPO offering price was set to $17, but at the end of the first trading day the company was trading at $24.53, 44% above its issue price.
a) What are the possible reasons why the investment banks underpriced the company by so much? Why could some of the company’s stakeholders be interested in such an underpricing? Refer to the article “Forensic Finance”. (4p)
IPO broker from investment bank (IB) convinces the company (by bribing CEO) to be underpriced and then allocates the rights of the underpriced share to institutional investors and personal accounts.
Two problems allowing severe underpricing to persist:
1) “Soft dollars”: additional commission payments collected by IBs bookrunners from institutional investors that are competing for the allocation of underpriced shares (money left on the table because of the future underpricing correction)
2) Agency problems: bribing executives, who are also less likely to switch IBs on subsequent deals (greater loyalty)
Only 9% of the incremental money left on the table went to executives; the rest was pocketed by investment banks
“Forensic Finance”
In Private Benefits of Control: An International Comparison? the authors suggest that Private Benefits of Control are not always bad, why? From Forensic Finance name and explain two reasons why option backdating may in fact be beneficial for the company. (5p)
Why BPOC are not always bad?
- CEO var īstenot savus projektus ar NPV>0, kurus iespējams noraidīt uz SH
1) if managers are receiving some of these cheap options, they receive an increased value directly if and when the options are exercised;
2) if employees expect to receive cheap options, they should be willing to accept lower direct wages, which lowers reported employee compensation expense and boosts reported profits; and
3) when backdated options are exercised, the realized value of the options is deductible from taxable income, lowering the company’s tax bill and conserving corporate cash.
“Forensic Finance”
“Sunlight is said to be the best of disinfectants.” How can academia help regulators and law officials? Explain what researchers found in relation to the Thomson Financial database. What was the response from Thomson Financial to this research? (7p)
In some cases, academics have been the first to identify a practice. In other cases, regulators or financial journalists have identified isolated situations, and an academic study has been a catalyst for raising the level of attention. In general, practitioners, journalists, and regulators often have better knowledge of anecdotal evidence, whereas academics can provide large-sample evidence of patterns.
Thomson database had deleted entries, seemingly brokerage firms wanted to delete the entries where they had predicted wrong – for their reputation.
I/B/E/S story: downloads of the recommendation database obtained at different points in time were not identical, although all of the downloads referred to the same sample period (alterations from bullish to bearish, deletions, additions, anonymizations).
Thomson admitted technical issues.
Theyclaimed that most of the changes were the result of a series of programming errors on their part affecting data entry (due to changes in recommendation scales because of business acquisitions of First Call and I/B/E/S)
“Hedge Funds: Past, Present, and Future”
Name 4 problems with measure of hedge fund performance.
1) information is not disclosed - Biased due to voluntary reporting,
2) understated risks,
3) very recent, no track record yet (as of 2008)
4) holds non-publicly traded securities.
“Hedge Funds: Past, Present, and Future”
What are 5 hedge fund strategies?
o Long-short equity (alpha-seeking)
o Event-driven (profit off spinoffs, M&A, bankruptcies; e.g. find insider info)
o Macro events (e.g. commodities mispricings, forecast global events)
o Arbitrage in fixed-income markets (bonds and bills) - “vacuuming pennies”
o Emerging market funds
o multi-strategy funds - combining two or more of the existing strategies
Also, often use leverage ( additional risk on financial institutions).
“Hedge Funds: Past, Present, and Future”
What are the risks associated with hedge funds?
1) No investor protection
2) Risk to financial system due to loss spillovers.
3) Liquidity risks: if too many funds have set up the same trades, they may not be able to exit their positions at the same time when prices move against them (fire sales)
4) Excess volatility risk - funds could lead prices to overreact by making trades that push prices away from fundamentals
“Hedge Funds: Past, Present, and Future”
What is expected to happen with hedge funds in future?
- Returns will decrease, because more hedge funds will chase after the same mispricings.
- Institutional investors will ask for more info.
- More regulation.
=> convergence to mutual funds
“Should We Fear Derivatives?”
Name 5 risks associated with derivatives markets. (3p)
1) Misevaluation/mispricing. BMS has unreal assumptions:
o Market has no frictions (pretestības)
o Stock prices lognormally distributed
o Fixed interest rates
o Trading possible all the time
2) Illiquid markets - low demand especially for exotic, complicated ones, hard to sell.
3) Transparency and reliability of accounting statements - information about derivative’s risks might not be precise and complete.
4) Perverse incentives (low cash investment and high risk)
5) For the economy as a whole, a collapse of a large derivatives user or dealer may create systemic risks.
