2.5 Financial Economics Foundations

Question 1

What is informational market efficiency?

Answer 1

Extent to which asset prices reflect available information. Efficient market: Price = Value based on all available info, investors will not be able to use information to earn superior risk-adjusted returns.

Question 2

What are the various forms of informational market efficiency, including efficient inefficiency?

Answer 2

1. Weak: historical data price and volume. in this market, pure technical analysis can generate superior return
2. Semistrong: all publicly available information, in this market, technical and fundamental analysis can generate superior return
3. Strong: all public + private available information, in this market, insider trading can generate superior return
4. Efficiently inefficient: amount of inefficiency balances the marginal costs of additional skill-based trading with the marginal revenues from the skill-based trades

Question 3

Six factors driving informational market efficiency

Answer 3

1. higher value = greater competition for profit
2. greater trading frequency = lower bid/ask spread
3. lower trading friction (e.g. fees) = encourages arbitrage
4. fewer regulatory constraints = improved efficiency
5. better information = better analysis
6. better valuation model = better analysis

Question 4

Factors influencing informational efficiency in alternative asset markets

Answer 4

Substantial nonpublic information and substantial uncertainty lead to less efficient pricing.

Question 5

Three Primary Theories of the Term Structure of Interest Rates:
1. U___ E___
2. L___ P___
3. M___ S___

Answer 5

1. Unbiased Expectations: all fixed income securities offer same expected return over same time period (no risk premium)
2. Liquidity Preference: longer term rates must be higher
3. Market Segmentation: differences in preference result in varying risk premiums and varying expected returns across maturity that are not eliminated by arbitrageurs

Question 6

Binomial Tree

Answer 6

Projects possible outcomes in a variable such as a security price or interest rate by modeling uncertainty as two movements: an upward movement (multiply) and a downward movement (divide)

Question 7

Duration

Answer 7

Elasticity of bond price with respect to change in bond’s yield. Continuously compounded

Question 8

Challenges of Duration:
1. Rates are ____

Answer 8

1. Discrete. Need Modified Duration.
2. Shift in term structure of interest rates is not parallel, instant, infinitesimal

Question 9

Single-factor asset pricing model

Answer 9

Explains return and risk using one risk factor

Question 10

Capital Asset Pricing Model (CAPM)

Answer 10

Expected Return = Risk-free + Beta (Expected Return - Risk-free), where Beta (Expected Return - Risk-free) refer s to Asset Risk Premium which compensates you to bearing systematic risk

Question 11

CAPM Assertions

Answer 11

1. Only rewarded for bearing market risk
2. Not be compensated for bearing any other risk.

Question 12

Implications of ex-ante CAPM

Answer 12

1. Exposed to same single risk
2. Every investor holds all risky asset in proportion to size
3. Investor allocation to market depends on risk aversion
4. Investor does not try to outperform or time market

Question 13

Assumptions of CAPM

Answer 13

1. One trader cannot affect price
2. Care only about mean return and variance
3. Publicly traded
4. Can short sell, borrow and lend at risk free rate
5. No taxes
6. Equal expectation about security return

Question 14

Ex-post CAPM and its application

Answer 14

Ex-post: realised returns which differ from expected return due to unexpected systematic and idiosyncratic effect

Question 15

What is the Fisher effect used to determine?

Answer 15

Real Interest Rate = Nominal Interest Rate - Inflation

Real Interest Rate: the annualized rate earned on default-free fixed-income instruments

Question 16

How does Modified Fisher equation differ from Fisher

Answer 16

Modified includes taxes

Nominal Interest Rate = (Real Interest Rate + Expected Inflation) / ( 1 + Tax)

Question 17

What is error term in the context of ex-post CAPM?

Answer 17

Portion of excess return due to IDIOSYNCRATIC risk

Question 18

What differentiates a relative pricing model from an absolute pricing model?

Answer 18

Relative: relationship between two prices
Absolute: underlying economic factors

Question 19

What are the carrying costs (and benefits) of physical inventory such as a commodity?

Answer 19

The carrying costs of physical inventory include interest (r) and storage (c), the benefit of physical inventory is the convenient yield.

Question 20

What two spot interest rates imply the value of a six-month forward contract from a six-month Treasury bill?

Answer 20

current 6 month spot + 12 month spot

Question 21

What is the relationship between a forward interest rate and its expected value at settlement under the unbiased expectations hypothesis and the liquidity premium hypothesis?

Answer 21

Forward bond prices (whether implied by spot rates or observed in the forward price of forward contracts) are unbiased predictors of subsequent spot or cash market prices.

Question 22

What is maintenance margin?

Answer 22

A maintenance margin is collateral put up by the investor on an ongoing basis until the position is closed out.

Question 23

What two assets form a long straddle?

Answer 23

Long call, long put, same strike price