Concepts Flashcards
What are the three portfolio parameters that has to be adressed in setting up a portfolio?
- Asset allocation
- Strategic allocation: Choice between different asset classes (bonds, stocks, derivatives etc.)
- Tactical allocation: Deviation from weights invested in different asset classes compared to strategic allocation - Choice of portfolio management
- Active portfolio management: Actively searching for “undervalued” assets
- Passive portfolio management: Buy-and-hold approach - Security selection (choice of security within an asset class)
What are the broad categories of “Players” on the financial markets? Main parameters of them?
Companies:
- Are net borrowers
- Raise capital in the security markets (usually common stock and bonds) to invest in real assets.
Households
− Are net savers
Governments
− Can be net savers (e.g., Norway, Singapore) or net borrowers (which is usually the case)
− Borrow funds to invest in infrastructure (streets, bridges, universities etc.)
Financial intermediaries
− They role is to match supply and demand of capital
Financial intermediaries perform a transformation function with respect to?
Liquidity
Maturity
Size
Risk
Financial assets: What is “Money market”? Who invests in them?
- Short-term (
Who issue bonds?
− Governments or related agencies (government bonds, municipal bonds…)
− Companies (corporate bonds)
− Special purpose vehicles (asset backed securities)
Common stock, what are the two main characteristics?
− Residual claim: Holders receive what is left over in the firm after every other claim is settled
− Limited liability: Holders are not liable with their personal wealth for the firm’s obligation
Preferred stock, what is its similarities to debt?
- Holder receives a fixed payment each year → Bond with infinite maturity
- Holder has no voting right
- Are sometimes also callable or convertible (Which bonds also can be if an option is attached)
Preferred stock, what is its similarities to equity? What are its differences to common stock?
Similarities
- The board of directors can decide whether to pay a dividend or not
- Costs for dividends are not deductible on firm level (as are interest payments)
Differences:
- If not: Dividend usually accumulates
- No dividend can be paid out to common stock holders until cumulated divided to preferred stock is paid out
How does equity indices differ?
Weighting of components:
- Price-weighted index (DJIA)
- Value-weighted index (S&P500)
- Equally-weighted index
Treatment of dividends
- Price index (DJIA, FTSE100)
- Performance index, also known as total return index (DAX30)
Asymmetric derivatives, examples and parameters
Call and Put options
- Gives the buyer the right to buy (call) or sell (put) an asset
- For a predefined price (exercise price)
- At a or before a predefined date
- The buyer of the option has the right, but not the obligation to exercise the option
Symmetric derivatives, examples and parameters
Futures and swaps
- Buyer (long) and seller (short) agree to exchange an asset
- For a predefined price
- At a predefined date
Underwriter
Usually investment bank(s), help an issuing firm preparing the prospectus, marketing the securities, and they also track the stock or the bond after the issue
Seasoned equity offering
A subsequent offering of equity by a firm
Public offering
Firms that offer securities to the general public
Private placement
Securities offering sold to a few institutional investors
Direct search markets
− Seller and buyers search each other individually
− Least organized market, sporadic participation, nonstandard goods
− Example: WG-gesucht.de
Brokered markets
− Brokers offer search services to buyers and sellers to find each other
− Example: Primary stock and bond markets, real estate market
Dealer markets
− Dealers buy assets on their own account and resell them at higher prices (the “spread”)
− Requires market activity
− Example: Some bond and equity markets
Auction markets
− Buyers and sellers meet at one place and trade; most integrated form of trading
− Example: Most stock and bond markets, derivative markets trade as continuous auctions
Market orders
− Buy or sell order that is executed immediately at the current market price
− In securities that are rarely traded (“low liquidity”) these trades can be expensive since the price is determined on the market
What is price-contingent orders? Advantage and disadvantage?
− Limit orders:
Buy or sell order that is executed if the prices crosses a certain threshold
− Stop orders:
Similar to limit orders, but aim at preventing losses
− Disadvantage: Questionable whether order will (ever) be executed (immediacy)
− Advantage: Transaction price known beforehand
What happens if investors post limit orders?
They get cumulated in a limit order book where the current limit orders are visible (Order book depth)
Buying on margin
When purchasing securities, investors usually have access to debt financing for the purchase transaction (usually offered by the broker)
− The buyer has to provide the margin
− The broker lends the remainder to the investor and charges him interest and fees; the securities bought serves as collateral for the loan
Short sales, what is it and how does it work in practice?
An asset is sold before it is bought and it allows investors to participate in declining asset prices
In practice, an investor would ask his broker to sell a security short. The broker would lend the security owned by another client to the investor, who would sell it. The position is closed when the investor returns the security to the broker by buying it back on the market.
Pro banning short-sales
− Short-sellers bet on falling prices by spreading rumors, thereby taking companies down that would otherwise survive − Sort-sellers gain by betting on other individual’s misfortune − Short-sales manipulate prices
Contra banning short-sales
− Short sellers correct prices even before bubbles can occur
→ Housing bubble occurred because short selling in houses is impossible
− Practically difficult to stop short sales anyway
The real interest rates are determined by the following factors
− Supply of capital (by households)
− Demand of capital (by companies and the government)
− Government actions (central bank interventions)
Why does the supply curve slope upward with increasing real interest rates?
- Because households are willing to supply more capital by postponing current consumption to the future.
Why is the demand curve downward sloping with increasing real interest rates?
Because companies and the government are willing to borrow more money if the cost of borrowing is lower, i.e. it is more expensive for them and therefore they do not borrow
What can governmental action do in terms of the interest rate graph?
Governmental action can shift both the demand and the supply function
What does it mean with the “inflation penalty” in terms of taxes?
- Taxes payable are determined on nominal income and an investor‘s tax rate (𝑡𝑡), while investors earn real rates of return.
- As income grows due to inflation, individuals are pushed into higher tax brackets in a progressive tax system.
- Even if this is recognized in the tax code (which is not, in most countries), individuals loose purchasing power:
Annual percentage rates (APR)
− Annual interest rate paid
− Does not reflect compounding of interest paid
Effective annual rates (EAR)
− Annual interest rate reflecting compounding of interest paid
→ More interest payments in a given year result increase the effective interest rate
Skewness
Statistical measurement that shows whether a distribution is symmetric or skewed
A distribution with positive skewness is skewed to the right, while a distribution with negative skewness is skewed to the left
Kurtosis
- Measures whether a distribution shows “fat tails”
- A distribution with kurtosis measure > 0 has “fat tails”
→Intuition: “Extreme” realizations are more likely to occur
Various methods allow to test whether a given distribution satisfies the assumption of normal distribution
− Chi-squares-test
− Kolmogorow-Smirnow-test
− Shapiro-Wilk-test
− Maximimum-likelyhood-test
− Shapiro-Wilk-test
- High accuracy in small samples, but sensitive to outliers
Hypotheses:
H0: Population is normally distributed.
H1: Population is not normally distributed.
What are the normal distribution assumptions in finance? Are they correct?
- > In Finance, we usually assume that the log-returns are distributed according to normal distribution
- > There is evidence that returns are not normally distributed (Existence of skewness and kurtosis)
Risk-averse
An investor prefers a risk free investment over a risky investment with the same expected return
→ An investor demands a premium for taking risk
Risk-neutral
An investor compares two investments solely on the basis of expected returns, neglecting risk
→ An investor does not demand a premium for taking risk
Risk-loving
An investor prefers a risky investment over a risk free investment with the same expected return
→ An investor is willing to pay a premium for taking risk
Quadratic utility
- We assume that investors can assign a utility to an investment to evaluate and compare investments only based on expected return and risk
- Under quadratic utility, the utility can be interpreted as the certainty equivalent
What are the implications of “A”, i.e. aversion parameter under quadratic utility
- It follows that the higher the risk aversion (higher 𝐴), the steeper are the indifference curves
- Intuition: Investors with higher risk aversion require a higher premium for a marginal risk increase
Utility maximizing portfolio
- An investor choses the combination of investments in the risky portfolio and the risk-free asset that maximize his utility
- We can identify the portfolio that touches the indifference curve with the highest utility
Insurance principle
By increasing the number of stocks in the portfolio to infinity, we reduce the influence of firm-specific risk-factors to zero
Systematic risk
(also called market risk, non-diversifiable risk)→ Risk that remains in every portfolio
Unsystematic risk
(also called unique risk, firm-specific risk, non-systematic risk, or diversifiable risk)→ Risk that can be eliminated
What happens if the returns show a perfect positive correlation?
In this case both asset prices move together
→ Diversification bears no benefit.
What happens if the returns show a perfect negative correlation?
In this case both asset prices move exactly in the opposite direction
→ Diversification works perfectly
The CAL (also known as the Sharpe ratio)
- Measures the slope of the return-risk relation of a given portfolio
- We can optimize the risk/return tradeoff of our investment by maximizing the slope of the CAL:
The only choice an investor makes in terms of optimal complete portfolio?
Since everyone holds the optimal risky portfolio
→ The only choice an investor makes is how much of his wealth to invest risky and how much to invest risk-free depending on individual investors’ risk preferences
The Markowitz portfolio, three main characteristics
• Minimum variance frontier:
All portfolios with the lowest standard deviation for a given expected return mark the minimum-variance frontier
• The global minimum variance portfolio:
Is the portfolio with the lowest standard deviation possible
• Efficient frontier:
All portfolios with the highest return for a given standard deviation mark the efficient frontier
What happens when the average correlation between assets is zero? Is it realistic?
- Firm-specific risk can be diversified away by increasing the number of stocks and portfolio risk becomes zero
- It is NOT realistic since usuallu fundamental factors influence all stock returns in a similar way, i.e. the portfolio variance remains positive
Investors require a risk-premium for securities with? Why?
Higher correlations, and NOT for securities with higher standard deviations
-> It is correlation that drives portfolio variance NOT the asset variances itself
Idea of single-factor model
− Simplify description of risk, allowing for a smaller but consistent set of estimates of risk and risk premium parameters
− Positive covariances among securities are driven by some common economic factors (business cycles, interest rates, cost of natural resources etc.) that affect most firms, but to varying degree
− Decomposing overall portfolio risk into firm-specific and systematic risk vastly simplifies estimation
The Markowitz optimization has several drawbacks
− Number of input parameters is high (We need to measure correlation between EVERY asset)
− Incorrectly specified parameters lead to suboptimal portfolio composition
Advantages of single-factor model compared to Markowitz
− Number of input parameters necessary is substantially reduced
− Practically: Under Markowitz, analysts would have to come up with covariances for each pair of firms. Now: Analysts can focus on one company (or one industry) and provide their management team with one figure: the beta
− Separation of market-wide and firm/industry-specific analysis adds value
Disadvantages of single-factor model compared to Markowitz
− Simplification might reduce accuracy of estimation and thereby reduce accuracy of selection (e.g., error terms for certain securities might be correlated in the real world)
− Securities are treated as completely different investments, while some might be substitutes
Markowitz optimization
Estimation of the optimal risky portfolio using full information on the returns, variances and covariances of all securities available for portfolio selection.
→ Precise, but exhausting procedure that often requires substantial computing power.
Optimization using index models
Procedure is facilitated by reducing the number of parameters, first and foremost substituting the number of covariances with a sensitivity to a common factor.
→ The number of parameters is reduced at the cost of precision. However, the estimated risk-return-profiles usually do not differ substantially. What differs, however, is the portfolio weights assigned to different securities.
The basic assumptions of the CAPM are:
Frictionless markets:
- Investors are price takers
- Investors can borrow and lend at the same rf rate
- Investors pay no taxes and no transaction costs
Investor behaviour:
- All investors are mean-variance optimizers (Use Markowitz to optimize)
- All investors plan for ONE holding period
- All investors analyze the same way and have the same input factors -> homogenous expectations
All investors are equal except wealth and risk preference
What does it imply when the market portfolio is efficient
It has to hold that the marginal return to marginal risk contribution is the same for any given security and equals the slope of the capital market line
Let‘s assume the stock market is not in equilibrium and the current stock price of company XYZ is too low, what happens according to CAPM?
→ The expected return of this asset is too high (since the current price is too low), while the risk profile remains the same
→ All investors recognize this pattern and rebalance their portfolios accordingly
→ Due to increased demand for the stock, the price increases again until the market is back in equilibrium
→ This happens with all assets continuously so that the prices are always in equilibrium and the market portfolio comprises all assets
Name three CAPM implications
- All investors optimize (with Markowitz) by using the same input parameters. Every investor comes up with the market portfolio as her optimal risky portfolio. Allocates according to wealth and risk preferences.
- The market portfolio will be on the efficient frontier. The capital allocation line (CAL) will become the capital market line (CML). This is the best attainable capital allocation among risky investments into the market portfolio and risk free investments in the entire economy.
- The value of the market portfolio is the aggregate value of ALL traded securities (or the wealth of the entire economy): The relative weight of an asset is the value of the asset scaled by the value of the market portfolio. Note: This is also the weight of the asset in each individual investor’s portfolio!
Mutual fund theorem
In the simple CAPM world, the market portfolio M is the efficient portfolio
This is called the mutual fund theorem: Portfolio selection can be separated into two parts:
- Creation of a mutual fund that represents the market portfolio (technical problem)
- Personal allocation of capital by investors into the market index mutual fund and into the risk free asset
Investors could stop with security analysis by simply holding the market portfolio
In the CAPM-world, an asset’s expected return is determined by?
the return and the risk it contributes to the market portfolio
In the CAPM-world, the covariance of an asset with the market portfolio is the?
Sum of the covariances of the asset with all other assets in the market portfolio
