2. Financial Investments

Question 1

2.1. Name the main money market characteristics.

Answer 1

Money market characteristics:
-Trading of short-term securities that are usually very liquid
- Investment in these securities do not produce high returns
- Reduces the opportunity costs of having very liquid assets

Question 2

2.1. Name the purpose of the money markets

Answer 2

Purpose of the money markets: manage short-term cash needs (liquidity)

Question 3

2.1. What motivates investments in the money market?

Answer 3

The investments in this market are caused by precaution issues: mutual funds, treasuries and firms in the process of liquidation.

Question 4

2.1. Identify the money market participants, and briefly describe them.

Answer 4

Money market participants:

1. Governments (treasuries)
   - management of the taxes cycle
   - issue Treasury Bills
2. Central banks
   - open market operations
   management of the yield curve
3. Commercial banks
   - issue deposit certificates and repurchase agreements
   - hold the greatest part of the debt securities issued by the treasuries
   - manage the liquidity and trade
4. Large firms
   - issue most of the commercial paper

Question 5

2.1. Definition of Interbank money market.

Answer 5

Interbank money market: subset of bank-to-bank money transactions that take place in the money market.

Question 6

2.1. Point the instruments traded in the money markets.

Answer 6

Instruments traded in the money markets:
1. Treasury Bill (T-Bills)
2. Commercial paper
3. Certificates of deposit
4. Repurchase agreements (repos)

Question 7

2.1. Briefly explain what are treasury bills.

Answer 7

Treasury bills :
- Maturities =< 1 year
- Issued below par
- No default risk
- Low inflation risk
- High liquidity
- Low transaction costs

Question 8

2.1. Briefly explain what is commercial paper.

Answer 8

Commercial paper:
- used by large firms to get short-term liquidity
- minimum maturity varies from country to country ( 1d -2 y)
- Issued below par
- Lower costs than bank loans
- used as bridge financing (temporary loan that will be replaced by a + permanent financing)

Question 9

2.1. Briefly explain what are Certificates of Deposit.

Answer 9

Certificates of deposit:
- security issued by a bank
- it’s a deposit with a specific interest and maturity date
- can be bought/sold before the maturity date
- the holder gets the capital and the interest at the
- maturity between 1-4 months
- interest rate slightly higher than the treasury bill’s rate
- higher default risk than T-Bills

Question 10

2.1. Briefly explain what are Repurchase agreements .

Answer 10

Repurchase agreements:
- sale of securities with an agreement to buy them back later at a certain price (on the termination day, it repurchases the asset at the same price he sold it, and pays interest for the use of the funds)
- usually a short-term agreement, 1 to 14 d
(although it can reach three months)
- very safe in terms of credit risk
- agents can manage liquidity and profit from changes in interest rates

Question 11

2.1. How do the interest rates of these securities behave ?

Answer 11

The interest rates of all these securities tend to move in the same direction at the same time and by similar amounts
- short-term securities with low risk and are traded in a competitive market.

Question 12

2.2. What are the characteristics of stock markets?

Answer 12

Stock markets Characteristics:

• one of the capital markets, where takes places the trading of long-term securities
• market participants are households, treasuries, and firms

From the perspective of …
-Issuers, it’s used to obtain long-term financing
- Investors, it’s used to make long-term investments

Question 13

2.2. Describe the main points about stock’s value.

Answer 13

The Stocks’ value is:

• Very difficult to compute, because it’s future value is uncertain, and because there are too many models that try to explain it
• Stocks have no intrinsic value, they are only instruments representing other rights, that are uncertain

Question 14

2.2. Define equity risk premium and it’s several concepts.

Answer 14

Equity risk premium can also be called as: market risk premium, market premium, and risk premium.
It represents premium investors demand on an annual basis for investing in stocks instead of a risk-free investment and it should be a function of how much risk they perceive in stocks.

It can be:

1. Historical (historical differential return)
2. Expected (expected differential return)
3. Required (incremental return required by an investor to hold the market portfolio)
4. Implied (return that arises from a pricing model by assuming that the market price is correct).

Question 15

2.2. An estimate of the premium is central to the following:

Answer 15

• projecting future investment returns
• calculating the cost of equity capital
• valuing companies and shares
• appraising investment proposals
• determining fair rates of return

Question 15

2.2. Name some possible explanations for the equity risk premium puzzle.

Answer 15

1. Selection bias.
2. Insurance against catastrophes.
3. Tax reasons.
4. Preference for stable consumption and income.
5. Myopic loss aversion.

Question 15

2.2. The observation of such a high historical equity risk premium suggests that …

Answer 15

• investors are risk- averse
• risk-aversion varies over time (higher in timed of uncertainty)
• when stock prices’ trend is in an upward movement, the historical risk premium will increase to reflect past returns

Question 16

2.2. What is the selection bias?

Answer 16

1. Selection bias:
   - Equity risk premium in the US is exceptionally high because it is an atypical economy
   - in other markets, the equity risk premium tends to be lower

Note: However, it is still too high on other countries to be solely explained by this.

Question 17

2.2. Explain the Insurance against catastrophe point of view.

Answer 17

2. Insurance against catastrophe:
   - the observed risk of the shares in the past does not include the possibility of an extreme drop in prices
   - as a result, a high equity premium risk reflects the possibility of such an event

Question 18

2.2. Regarding the equity premium risk puzzle, in what consists the argument based on “Tax reasons”?

Answer 18

3. Tax Reasons:
   - the lowering of taxes on capital income could justify higher stock returns as well as high historical risk premiums

Note: the observed variation on taxes is not sufficient to explain the puzzle

Question 19

2.2. In what consists the preference for stable consumption and income?

Answer 19

4. Preference for stable consumption and income:
   - the share price tends to be procyclical (the market rises in times of higher economic growth).
   - economic agents tend to have a preference for stable income over time, so they require a higher risk premium for holding shares

Question 20

2.2. Explain the Myopic loss aversion.

Answer 20

5. Myopic loss aversion:
   - It’s included in the field of behavioral finance (Benartzi and Thaler, 1995, 1999; Barberis and Huang, 2008)
   - Investors are more sensitive to losses than to gains and have difficulty in dealing with long-term (financial myopia)
   - investors evaluate their portfolios over too short periods of time and become very sensitive to losses in these periods

As a result they require a higher return for holding stocks than the ones predicted by the rational models to compensate them for the losses.

Question 21

2.3. Identify and briefly describe other financial investments.

Answer 21

• The bond market is slightly smaller than the world equity market
• Differences in macroeconomic policy, government borrowing, and budget deficits strongly influence the bond market size
• Companies operating in countries with bank-based financial systems tend prefer debt other than equity financing