Deck 3 - Equity, Fixed Income, Derivatives, Alternatives and Portfolio Management Flashcards
Main functions of the financial system?
- Allow entities to save, borrow, issue equity capital, manage risk, exchange assets, and utilize information
- Determine the return that equates aggregate savings and borrowing.
- Allocate capital efficiently
What is the leverage ratio?
It is the value of the asset divided by the value of the equity position
What is the margin call price?
Margin call price = Initial price ((1-initial margin)/(1-maintenance margin))
What is the difference between execution, validity, and clearing instructions?
Execution - how to trade - market and limit orders
Validity - when an order can be filled - day orders, gtc
Clearing - how to settle a trade
What are the sign of well-functioning financial system?
Complete markets, operational efficiency, informational efficiency, allocational efficiency
What are the objectives of market regulations
- Protect unsophisticated investors
- Establish minimum standards of competency
- Prevent insider trading
- Promote common financial reporting
- Require minimum levels of capital
What is the difference between a price index and total return index
Price uses only the price change and total return includes the price and income (dividends) from the index
What is the difference between a price-weighted, equal-weighted, market cap and fundamental weighted
Price - arithmetic mean of prices. Divisor must be adjusted for stock split
Equal - Same weight to each
Market - Based on the proportion of the total market value
Fundamental - Weights that are independent
Market Capitalization weighted index formula?
(Current total market value of index stocks/base year total market value of index stocks) x base year index value
Equal-weighted index formula?
(1+average percentage change in index stocks) x initial index value
What is the differences between fixed-income and the equity universe?
Fixed-income can be classified by issuer, collateral, coupon, maturity, credit risk, and inflation protection.
It has a much broader universe and higher turnover. Depend on dealers and are illiquid. Can be difficult to replicate
What are global depository receipts?
Issued outside the US and outside the issuer’s home country
What are american depository receipts?
Denominated in US Dollars and are traded on US exchanges
What are global registered shares?
Common shares of a firm that trade in different currencies on different stock exchanges
What is accounting ROE?
It is calculated as the firm’s net income/book value of common equity.
What is the firm’s cost of equity?
The minimum rate of return investors require. It is reflected in the market price.
What are porter’s five forces?
- Rivalry among existing competitors
- Threat of entry
- Threat of substitutes
- Power of buyers
- Power of suppliers
What are the stages of firm growth
- Embryonic
- Growth
- Shakeout
- Mature
- Decline
What is the dividend payment chronology?
- Declaration date
- Ex-dividend date - first day a share of stock trades without the dividend
- Holder-of-record date - date on which share owners who will receive the dividend are identified
- Payment date - the date the dividend checks are sent
What are advantages of discounted cash flows
- Easy to calculate
- Widely accepted and can be used for many firms
What is the FCFE model useful for
Free Cash flow to Equity for firms that do not pay a dividend
What is the Gordon growth model useful for
Stable, mature, non-cyclical firms
What is the disadvantages of discounted cash flow models?
Inputs must be forecast
Estimates are very sensitive to inputs
Required return on equity must be greater than the growth rate
Firm must pay dividends
What are the advantages of price multiples?
Often useful for predicting stock returns
Widely used by analysts
Can be used to calculate over time and between industries
Can be used when it is independent of the value
What are the disadvantages of price multiples?
Very sensitive to inputs, may not be comparable, bad for certain economic conditions, may appear overvalued by comparable method, market value of debt is hard to find
What are advantages of asset-based models?
Can provide floor values, has to have short-term assets, useful for public firms
What are the disadvantages of asset-based models?
Market values of assets can be difficult to obtain
What is the Gordon growth model?
Assumes growth rate is constant. V0 = D1/(ke-gc)
where g = b x ROE
b = earnings retention rate = 1 - dividend payout rate
What is the P/E ratio formula
P0/E1 = (D1/E1)/(k-g)
What is the Enterprise Value formula?
EV = Market value of common and preferred stock + market value of debt - cash and short-term investments if you are doing a multiple then divide by EBITDA
What is a bond with an amortizing structure and what is a sinking fund?
Amortizing structure - repays part of its principal at each payment date
Sinking fund - provision requires the issuer to retire a portion of a bond at specific time periods
What kind of bonds are more sensitive to change?
More sensitive to changes in YTM for bonds with lower coupon rates and longer maturities and less sensitive to changes in YTM for bonds with high coupon rates and shorter maturities
What is the no-arbitrage price?
It is the addition of the cash flow at the time divided by spot rate raised to the period
What is the true yield and current yield
When delayed by weekends or holidays and current yield is the coupon payments / price
What is special about a special purpose entity and a servicer?
It buys financial assets from the seller and issues ABS
Servicer carries out collections and other responsibilities related to the financial assets could be the same as the seller
Sequential pay CMOS
All scheduled principal payments and prepayments are paid to each tranche. The first has the most contraction risk and the last tranche to be paid principal has the most extension risk
What is the difference between prepayment, contraction, and extension risk?
Prepayment - overall uncertainty about timing
Contraction - risk that the loan will be repaid more rapidly
Extension - risk that the loan will be repaid more slowly
Macaulay duration
Weighted average number of coupon periods until a bond’s scheduled cash flows
What is modified duration and approximate modified duration
A percentage change in a bond’s price that would result from a 1% change in YTM.
Approximate modified duration =
(V- – V+) / 2 x V0 x ∆YTM
What is the effective duration
A percentage change in a bond’s price that would result from a 1% change in benchmark yield.
Effective duration =
(V- – V+) / 2 x V0 x ∆curve
What is key rate duration
The measure of the price sensitivity of a bond or a bond portfolio to a change in the sport rate for a specific maturity
How to calculate portfolio duration?
Weighted average number of periods until cash flows will be received using the portfolio’s IRR. OR
Percentage change in portfolio value for a 1% change in yield, only for parallel shifts of the yield curve
What is the money duration of a bond?
Money duration = annual modified duration x full price of bond position
What is the Price Value of a Basis Point?
The change in value of a bond expressed in currency units, for a change in YTM of one basis point or 0.01%
PVBP = [(V- – V+) / 2] x dirty price x 0.0001
What is the effectivity convexity of a bond?
The curvature of a bond’s price-yield relationship with options
Approximate Effective Convexity = (V- + V+ - 2V0) / ((∆curve)^2)V0
What is the formula for percentage change in full bond price?
%∆ full bond price = -annual modified duration(∆YTM) + 1/2 annual convexity (∆YTM)^2
What is a bond’s duration gap
Investment horizon for which a bond’s market price risk and reinvestment risk just offset each other
Duration gap = Macaulay duration - investment horizon
Macaulay Duration = Mod Duration (1+YTM)
What is a bond’s yield spread?
Compared to a benchmark curve includes a premium for credit risk and a premium for illiquidity
-duration(∆spread) + 1/2 convexity (∆spread)^2
What is the order of corporate debt?
Ranked by seniority or priority of claims.
Then secured is over unsecured
Then for the last two senior is over subordinated
Subordinated is always at the bottom
Why can’t we rely on credit ratings from rating agencies
Ratings change over time, unforseen events, market prices can adjust more rapidly than credit ratings
What four things do credit analysts use to assess debt issuer’s capacity?
- Profitability
- Cash Flow
- Leverage ratios
- Coverage ratios
What is the difference between buyout funds and venture capital funds?
Buyout funds - Taking the company private by buying all available shares and then restructuring
Venture capital funds - Companies are purchased in start-up phase and then provide advice and expertise
What is a money-weighted return?
IRR uses periodic cash flows into and out of an account and the discount rate that makes PV of cash inflows equal to the PC of cash outflows. Sensitive to funds added or liquidated.
What is the time-weighted return?
Measures compound growth. The rate at which $1 compounds over a specified performance horizon. It is used to determine manager’s ability with their funds
What is a population variation?
(standard deviation)^2 = ∑(Rt-µ)^2/T
What is covariance
Measures the extent to which two variables move together over time and can be any value?
What is correlation and what is its relation to covariance?
It is the standardized version of covariance bounded by -1 and +1 correlation 1,2 = COV1,2/(stdev1xstdev2)
What is the formula for the standard deviation of a portfolio?
√(w1^2σ1^2 + w2^2σ2^2 + 2w1w2corr1,2σ1σ2)
What is the difference between the minimum-variance frontier and the efficient frontier?
Together, portfolios that have the least amount of risk for a given return are the minimum-variance frontier.
The portfolios that have the greatest return for a given level of risk is the efficiency frontier.
They should intersect at the optimal portfolio
What is the difference between the CAL and CML
The CAL - combinations of a risky asset and the risk-free asset
CML - Specific version of CAL where risky asset is the market portfolio. It contains all risky securities
What is the formula for the Beta
ßi = [Cov(Ri,Rm)]/σm^2 = corri,m (σi/σm)
What is the difference between CAPM and SML
CAPM is a model that assumes investors are risk averse, utility maximizing, and ration and markets are free of friction.
SML is a graphical representation of the CAPM that plots expected return versus beta for any security
What is the sharpe ratio?
Useful for non-diversified portfolio
Sharpe ratio = (Rp - Rf)/σp
What is the M-squared ratio?
It is the extra return above the market portfolio useful for diversified portfolios
M2 = Rf + (σM/σP)(Rp - Rf)
What is Treynor’s measure?
Portfolio’s excess return per unit of systematic risk. Useful for diversified r2 > 70% portfolios
Treynor = (Rp - Rf)/ßp
What is Jensen’s alpha?
Useful for diversified portfolio.
alpha = Rp - [RF + ßp(Rm - Rf)]
What is the difference between cognitive errors and emotional biases?
Cognitive errors result from an inability to analyze information or basing decisions on partial information, while emotional bias is caused by the way individuals frame information and decisions.
What is used to measure derivative risk? and what is used to measure tail or extreme event risk?
It is the greek letters (delta, gamma, vega and rho)
Tail risk is measured with Value at Risk (VAR) or conditional VAR
How can companies manage risk, transfer a risk, and shift a risk?
Manage - diversification
Transfer - insurance or surety bond
Shift - Derivatives
What are the differences in management fees for hedge funds and private capital?
Hedge funds - percentage of assets under management
Private capital - percentage of committed capital
What is the difference between a soft and hard hurdle rate and what is a high water mark?
Soft - incentive fees are based on total increase
Hard - incentive fees are based only on gains above hurdle rate
high-water mark - no incentive fees are paid on gains that only offset prior losses
What is the difference between an American waterfall and European waterfall?
American - profits are distributed as each investment is sold
European - whole of funds LPS received all distributions until they have received 100% of their initial investment plus hurdle rate.
What are private equity funds and what is developmental capital?
Private equity funds usually invest in the equity of private companies or companies wanting to become private.
Developmental capital - providing capital for business growth or restructuring sometimes can be to public firms
What is the futures valuation formula? (hint yield)
Futures price = spot price x (1 + risk-free rate) + storage costs - convenience yield
What is the difference between event and relative value strategies?
Event-driven - merger arbitrage, distressed/restructuring, and special situations
Relative - seeking profits from unusual pricing issues
What are equity hedge strategies?
Bottom-up strategies that take long and short positions in equities and equity derivatives
How should you create a arbitrage condition when the forward price is too high?
They want to sell the forward and buy the underlying
How should you create a arbitrage condition when the forward price is too low?
They want to buy the forward and sell short the underlying.
What is the cost of carry?
It is the benefits of holding the asset minus the costs of holding the asset
What happens when the costs of holding the asset becomes greater? What is the affect on the price?
Increase its no-arbitrage forward price
What are the characteristics of an FRA?
The fixed-rate payer (long) will pay the forward rate on a notional amount of principal at a future date, and the floating rate payer (short) will pay a future reference rate times that same amount of principal.
What is the value of a forward contract over its life?
The forward price is constant but the value will fluctuate with changes in the value of the underlying
How does the value of a futures contract through the course of its life?
The price and value both change when daily mark-to-market gains are settled. The change in the futures price to the settlement price each day returns its value to zero
What are some main differences between forwards and futures?
Futures are more valuable than forwards when interest rates and futures prices are positively correlated and less valuable when they are negatively correlated. If uncorrelated then the prices are the same
How does the value of a swap change?
The value depends on how expected future floating rates change over time. An increase in the rates will increase the value of the position and vice versa
What is the value of contingent claims at inception?
Value at initiation is not equal to zero. It is based on the combination of the option with a pure discount bond and a long or short position in the underlying
If there is an increase in the, price of underlying, exercise price, and risk-free rate then what happens to the call option
The call will increase, decrease and then increase
What is the put call parity for America options?
The Stock price is equal to the Call price - Put price + Bond at the risk free rate
S = c - p + X(1+Rf)^(-T)
What is the put call parity for European options?
An asset is replicated by lending the present value of the forward price at the risk-free rate and taking a long position in a forward
c0 + X(1+Rf)^(-T) = F0(T)(1+Rf)^(-T) + p0
How can we use a binomial model to hedge an asset?
It can be hedged with a position in an option that can be created such that the portfolio has the same value for both an up-move and a down-move. The value is the initial value compounded at the risk-free rate.
What is a synthetic European call
long position in the underlying asset, a long position in a European put option, and a short position in a risk-free bond
What is the hedge ratio?
(-short call payoff - call payoff) / (Up value - down value)
What kind of contract has gains and losses are exchanged at settlement?
Cash settled contract
How to calculate estimated price change of a bond?
-duration × (∆interest rate) × 100 + (½)(convexity) x (∆interest rate)^2 × 100
What is a fiduciary call?
call option and a bond that pays the exercise price of the call at option expiration.
How to calculate Price to Equity position?
(1-retention ratio)/k-g
What is the sustainable growth rate?
Retention Ratio (ROE)
what is the relationship between modified and Macaulay duration
Modified = macaulay/(1+YTM)
What is a synthetic European put?
A long position in a European call option, a long position in a risk-free bond that pays the exercise price on the expiration date, and a short position in the underlying asset.
When do VC companies gain abnormal high returns
When they invest during a business cycle expansion
What is operational risk?
human error or faulty processes will cause losses.
What are sources of financial risk?
Credit, liquidity, and market risk
How to calculate the price of P0
(P1+D1)/(1+K)
What is backwardation?
the futures price is less than the spot price. This is most likely to occur when the convenience yield is high and the net cost of carry is negative
How do you increase call protection for CMBS ?
With sequential-pay tranches, the principal amount of each successive tranche must be repaid in full before principal on the next successive tranche can be paid
What is the difference between a covered bond and secured bond?
“Covered bond” refers to a bond for which specific balance sheet assets are legally segregated as collateral for the bond and for which the bondholder also has a claim against the firm’s overall assets in the event the segregated assets prove insufficient. “Secured bond” refers to any bond that has a priority claim to specific firm assets.
If a holding period is less than a bond’s macauley duration?
bond’s reinvestment risk is less than its price risk.
Direct lending by venture capital funds typically takes what form?
senior secured debt
What does it mean when the quoted margin is greater than the required margin?
the note’s credit quality has improved and its price should revert to a level greater than par value at the next coupon reset date.
How to calculate the covariance of an asset i and the market m
Covi,mkt= betai× varmkt.
What is a REIT?
They are indexes track the prices of shares of publicly traded companies that invest in mortgages or real property.
When are asset-based models useful?
Used to value natural resources companies and companies that are being liquidated.
What is hyperbolic discounting?
Favoring small payoffs in the short term over larger payoffs in the long term and is related to self-control bias.
When does a note trade at a premium?
When the discount margin is less than the quoted margin.
What is the difference between flat (clean) price and full (dirty or invoice) price?
Flat price or clean price does not include accrued interest. Full price (dirty or invoice price) includes accrued interest.
