E1 PA - Compounding, Market Efficiency, Asset risks

Question 1

If an amount has compounded from 1965-1985, what is the value of .t?

Answer 1

21 ((1985-1965) +1) as 1965 = year.0

Question 2

What is an EAR? How does it help borrowers?

Answer 2

Effective Annual Rate. Means they don’t underestimate a loan as the true interest rate is reflected.

Question 3

How can the EAR be used by borrowers when considering different investments of loans?

Answer 3

It can help compare the annual interest paid on investments or loans with different compounding periods, showing the same end-of-investment wealth after one year.

Question 4

What is the EAR equation when considering APR?

Answer 4

EAR = (1 + APR/m),m -1

, = to the square of

Question 5

When can EAR and APR be the same?

Answer 5

Only one occasion, when m =1, otherwise EAR > APR

Question 6

How do interest rates effect asset values and why?

Answer 6

high IR = lower asset valuation and vice versa.
This is because future cash flows are discounted more heavily and capital gains are reduced and vice versa

Question 7

What are capital gains/ losses?

Answer 7

The profit / loss you gain when you sell an asset

Question 8

Why are low coupon rate bonds and long terms bonds more interest rate risky than high C rate bonds?

Answer 8

Low coupon rate and long term bonds are more reliant on redemption for capital gains so IR can discount future cash flows.

High coupon rate and short term are more reliant on C rate for gains

Question 9

Credit risk is a major price determinant. What do credit rating agencies provide?
2 things

Answer 9

• the liklihood the bond issuers can pay the interest payments
• the extent the lenders are protected in the event of a default

Question 10

Name 3 things that affect asset risk

Answer 10

• credit risk
• interest risk
• inflation risk

Question 11

What are the two grades of bonds?

Answer 11

• Investment grade
• speculative grade

Question 12

What bond grade is more sought after?

Answer 12

Investment grade as they provide far less credit risk.

Question 13

Are speculative grade bonds bad?

Answer 13

They should be a red flag for risk averse investors
However, their high risk characteristics can sometimes yield high returns

Question 14

What equation helps identify inflation risk?

Answer 14

Fisher’s (1930) equation

(1+r)(1+i) = (1+R)

where r = real interest rate, i = inflation and R = nominal interet rate

Question 15

What is a limitation of Fisher’s equation?

Answer 15

It does not consider unexpected inflation

Question 16

What bonds are great at protecting you from inflation risk ?

Answer 16

Index-linked bonds - payments are linked to inflation

Question 17

How can you benefit from index-linked bonds during times of high inflation?

Answer 17

When i is high, index-linked bonds become more valuable and can be traded at a premium, sometimes exceeding par value, leading to capital gains

Question 18

What are index-linked bonds?

Answer 18

Index-linked bonds are such that Interest and redemption payments are adjusted to account for movement in the retail price index (RPI) with a time lag of 3 months.

Question 19

Do index-linked bonds completely protect you from inflation movements?

Answer 19

No, because of the time lag

Question 20

How do you distinguish a premium and a discount bond?

Answer 20

• premium - par value exceeds £100
• discount - par value is below £100

Question 21

Define an efficient capital market

Answer 21

• one in which stocks prices fully reflect all available information

Question 22

What is the Efficient Market Hypothesis (EMH)?

Answer 22

That security prices rationally reflect available information

Question 23

What are the implications of the EMH? 3 things

Answer 23

• for firms and govs selling securities there is no financial illusion so they should only expect fair values
• if prices adjust quickly to info, the investor has no time to act. So they cannot expect anything other than ‘normal’ returns
• doesn’t assume that in reality investors have heterogeneous beliefs and interpret info differently

Question 24

Does the EMH say that share prices are always equal to true value?

Answer 24

No, errors are still made in pricing shares, these deviations from true value are random

Question 25

Does the EMH suggest you cannot ever beat the market?

Answer 25

No, an investor can always beat the market, just not systematically

Question 26

What are FAMA (1970s) forms of efficiency? Define each form

Answer 26

• weak form - security prices reflect all information found in past
• semi-strong form - security prices reflect all publicly available information
• strong form - prices reflect all relevat information to a stock (public and private)

Question 27

What model is used for weak form efficiency?

Answer 27

Random walk model:
P.t = P.t-1 + Expected return + random error .t

Question 28

When is technical analysis of no use?

Answer 28

When markets are weak-form efficient as this form states that you cannot predict future pices using past prices - markets have no memory!

Question 29

What analysis is helpful for weak-form efficient?

Answer 29

Fundamental analysis as it instead focuses on the intrinsic value of an asset, its financial info etc to pick a stock

Question 30

Where is fundamental analysis not profitable?

Answer 30

semi-strong form efficient market

Question 31

What is one way you can prove a market is not strong-form efficient and why?

Answer 31

If insider trading is profitable because if one investor knows something about the stock that other dont it should be reflected in the price already.

Question 32

Explain the Grossman-stiglitz paradox.

Answer 32

• if prices fully reflect all information then it isn’t possible to make a profit by trading on information
• therefore, there is no incentive to collect information
• and if it is not all collected then how can a price fully reflect it
• ultimately, there must be an amount of noise in asset prices to compensate the informed traders for collecting information

Question 33

What does m stand for in compounding equations?

Answer 33

Compounding frequency