Chapter 9: Investment Analysis Flashcards
State a formula for the security market line, and define the terms.
Security market line
E[Rp] = Rf + B * (Rm - Rf)
where:
r p is the return on the portfolio
r f is the risk-free rate of return (however defined)
r m is the market return, or the return on a fully-diversified portfolio
b represents the systematic risk in the portfolio.
Outline four issues that make investment analysis using statistical techniques difficult in practice.
Four issues that make investment analysis using statistical techniques difficult in practice
- Correlation does not imply causation.
Simply because two things occur together does not mean either one has influenced or caused the other.
For example, statistical evidence might show that noise from roosters and sunrise is highly correlated, but saying roosters cause sunrise would be erroneous. - There is a danger of omitted variables that can lead to spurious selection.
- Samples might not be as random as they initially appear.
- Cointegration or other econometric problems can exist, invalidating the underlying statistical assumptions and invalidating the results.
Outline the two stages of fundamental analysis of equity shares.
Two stages of fundamental analysis of equity shares:
- The first stage is the construction of a model of the company which allows future cash flows and earnings to be estimated.
- The second involves the use of the output from the first stage to determine whether the company’s securities are over-or undervalued by the market.
In practice, a wide range of techniques is used, and the degree of sophistication employed varies greatly.
List the four fundamental factors that influence supply and demand for one equity share rather than another.
List the underlying factors that drive investor expectations for the fundamental factors above.
Fundamental factors that influence supply and demand:
1. The future dividend payments from the share
2. future capital growth expected on the share
3. the risks of the business and thus the uncertainty of estimates of the above
4. the sustainability of the company’s business.
Factors that drive investor expectations for the above:
1. estimates of profits
2. free cash flow
3. total enterprise value.
List the eight important factors that will influence an individual’s estimates of the future performance of a company.
(# MRS CHIMP)
Seven important factors for the prospects for a company
(#MRS CHIMP)
- management ability
- retained profits
- sustainability and environmental impacts of the business
- competition
- history
- input costs
- prospects for market growth 8. quality of products.
Plus:
ESG considerations.
Ethical considerations
List eight features that an analyst would investigate in order to form an opinion on the seven factors listed on the previous card.
Eight features to investigate:
- the financial accounts and accounting ratios
- dividend and earnings cover
- profit variability and growth (by looking at all sources of revenue and expenditure)
- the level of borrowing
- the level of liquidity
- growth in asset values
- how well the company is positioned to transition to a low-carbon / sustainable future
- comparative figures for other similar companies.
List seven methods that technical analysts may use to form a view on the prospects for a share price.
Seven techniques used by technical analysts
- relative strength index (RSI):
looking at charts of the share price relative to the market or the sector, and anticipating trends or reversals of performance. - moving averages (MA/EMA):
for example, when a price moves above its 12-month average, it is deemed expensive. - regressions:
(eg finding high correlation between price A and B by regression analysis, and then buying A because B has risen) - inter-market and intra-market price correlations:
this makes comparisons between correlated markets. - business cycles
- stock market cycles:
overlay the economic cycle over the share price performance and determine whether the share has performed too poorly or too well. - Chartism:
classically, through recognition of chart patterns.
List eight examples of the technical competencies that a long-term investment (bond or equity) analyst, or a short-term trader might possess.
(#CCPPPLSS)
Eight examples of technical competencies
(#CCPPPLSS)
- Cycles; knowing how the instruments are priced in the market at the current stage in the economic cycle.
- Sensitivities of the instruments to other factors eg interest rates, and convexity.
- Conventions of instruments (eg coupon calculation) and how they trade.
- Liquidity of the instruments and what happens during periods of stress.
- normal bid/offer Spreads and other trading costs.
- who are the main Liquidity providers in the market.
- historical Price performance in isolation and relative to other instruments data on historic price moves during distress in absolute terms and relative to other instruments.
- recognition of chart Patterns
List four items of information that a trader would know about their own portfolio positioning at any time.
(#HRWL)
Four items of information about portfolio positioning
(#HRWL)
- the current holdings
- the portfolio risk eg VaR or PV01
- why are these positions in the portfolio eg in-house view; for market making purposes; strategic holding etc
- risk or position limits imposed by the client or investment mandate
When constructing a trade, outline six issues that a dealer or trader will consider.
Six issues that a dealer or trader would consider when constructing a trade
- what is the theme that the investment is trying to capture, eg a ratings change; a monetary policy move; an emerging market rally?
- how much of this theme has yet to play out?
- through which instruments can this theme be best captured, ie how sensitive is the instrument to the theme?
- which instrument has the least of this theme already priced in?
- what is the risk / reward profile? What losses will be incurred if the thesis is wrong and what is the potential gain?
- when to take profits and when to cut losses?
Explain how the following behavioural biases can affect a trader:
* loss aversion and fear
* regret aversion
* hindsight bias
* general overconfidence.
Behavioural biases
Loss aversion and fear:
can cause a trader to stop making a trade due to a realisation of the risk that is being created for the client.
Regret aversion:
can cause a trade to be cancelled if the regret of getting the bet wrong is too high.
Hindsight bias:
can cause a trader to believe that they are better than they are, due to believing that they have anticipated more things in the past than they actually have. This can in turn lead to overconfident decisions.
Overconfidence:
can lead a trader to believe their own gut reactions and block out other wise and educated advice.
Explain how the following behavioural biases can affect a trader:
* greed
* ego-defence mechanisms
* confirmation bias
* gambler’s fallacy.
Behavioural biases
Greed:
can make a trader overlook the potential risk by focusing only on the potential reward.
Ego-defence mechanisms:
can make a trader talk up their own success to boost their ego, which in turn might lead them to make unwise and dangerous trades.
Confirmation bias:
might make a trader block out information and opinions that are opposing to their own.
Gambler’s fallacy:
might make a trader believe that something that has happened a number of times cannot happen again.
This might lead to a dangerous trade.
Explain how the following behavioural biases can affect a trader:
* representation bias
* conjunction fallacy
* groupthink.
Behavioural biases
Representation bias:
can lead a trader to take a view based on too little evidence, for example looking at one single quarter earnings growth when taking a view on a company.
Conjunction fallacy:
can make a trader believe that a combination of events is highly likely to occur, even when any one of the events in the chain may seem unlikely.
Groupthink:
refers to the fact that a particular view or opinion may be accepted as the ‘correct’ opinion for a group or population.
People find it hard to contradict the opinion and easier to change their views to match the opinion.
List twelve characteristics of actions taken by traders that tend to lose money.
(This material is in the Appendix and therefore not directly examinable.)
Characteristic actions of loss-making trades
- not respecting stop losses
- taking profits prematurely due to fear of losing profits
- overconfidence leading to belief that the trade could not go wrong
- using overly simplistic logic to justify a trade
- believing hype from the press
- trading in excess to relieve boredom
- executing panic trades
- executing ‘fear of missing out’ trades
- trading where the move in price did not justify the costs
- trading in too large a size, resulting in being psychologically overwhelmed
- increased exposure to a losing trade
- not acting on new analysis information.
List four characteristics of actions taken by traders that tend to make money.
(This material is in the Appendix and therefore not directly examinable.)
Characteristic actions of profit-making trades
- letting winning trades run
- not getting caught up in a market/media frenzy
- increased exposure to a winning trade
- respecting stops when the trend is reversed.
