Exam Flashcards
how do financial markets create value?
- storage and exchange of value
- inter-temporal matching of consumption and productivity
- efficient risk sharing
- seperation of ownership and management
what are the negative consequences of growth in finance?
- While greater access to credit has arguably improved the ability of households to smooth consumption, it has also made it easier for many households to over invest in housing and consume in excess of sustainable levels.
- This increase in credit was facilitated by the growth of “shadow banking,” … The financial crisis that erupted late in 2007 and proved so costly to the economy was largely a crisis in shadow banking
what financial workers achieve the value of finance?
Finance work involves intermediation:
* Matching savers with spenders
* Analysis: (a) pricing risk; (b) designing, advising, selling products to protect against risk
* Monitoring and enforcing contractual obligations
what is signaling theory?
Quality is ojen difficult to observe directly and so to infer level of quality people use subsJtute measures that they believe are correlated with quality.
* One tacJc to convey quality credibly is to send an indicaJve measure of quality that is too costly to provide unless it is true
what is the profitability of finance work affected by?
- economics
- Increased financialisaJon (e.g., Sony’s purchase of rights to Michael Jackson’s songs for US$1.2 billion)
Increased trading of financial assets
- Barriers to entry and psychological (?) impediments - technology
- allowing greater and swifter access to more detailed and timely information
- more efficient and lower cost exchange of value
- increase in dominance of larger institutions as their economies of scale allow them to invest in more technology. - politics
- social values, law, power structures, lobbying: all these influences are often reflected in regulation
what are the implications for finance graduates?
High paying jobs in finance are non-routine and require specialised knowledge, creativity and competence in:
1. financial intermediation
2. analysis
3. monitoring and enforcing contracts
what are the value-adding catergories of intermediaries?
- Partners - experts who create value for themselves and their clients (competent, warm). Eg banks lending money for housing mortgages
- Predators - experts who capture disproportionate. gain (competent, cold). eg banks provided incentives to agents to sell financial products not in their clients best interest.
- Pets - non-experts who mean well (incompetent, warm). credit unions
- Parasites – non-experts who gain without adding value (incompetent, cold).
what is investment analysis about?
- Investment analysis is about value
- No “intrinsic value” independent of people.
- Price is determined by supply and demand.
- Investment analysis is about estimating supply and demand
- We make the simplifying assumption in finance that the value of an asset is approximated by its expected cash flows adjusted for risk and its “real option” value.
- Not true for many assets but close enough for most assets to be good enough.
what is fungible and commensurable goods?
Fungible goods: replaceable by identical good
Commensurable goods: different goods that may be compared and exchanged (e.g., five goats for one cow or $75 for one goat)
is price value?
- If something has a price, it is commensurable in money terms
- Price is not value. Value is connected with ethics.
- Investment analysis is about analysing price, not value
how is price a function of demand and supply?
- To predict price, investors must analyse demand & supply
- Finance theory assumes demand & supply determined by expected return & risk.
- Investors compare investments to obtain highest return for lowest risk (“Ketchup economics”).
how to distinguish between price and value?
- Price refers to what you must give up to buy something and/or
what the seller demands. - Value is the worth that you place on an object or service
- finance is silent on ethics and presumes the buyer and seller improve their respective welfare when they engage in voluntary exchange.
- assumptions are that each person is the best judge of their own interest, are content in advancing their interests and their transactions do not have negative effect on society
is finance ethics-free”?
- Every transaction is embedded in a moral context.
- Most of the time, for most investments, it is unproblematic. You can just consider price, expected return, and risk
- There are other times when the ethical implications must be explicitly considered and/or they are less obvious
is investment analysis about intrinsic value?
- Investment analysis is about identifying price: what something
will sell for now and/or in future. - The key questions in investment analysis are:
(a) How and when and by how much will demand change?
(b) How and when and by how much will supply change?
Intrinsic value
how does a smile affect sales?
- Smiling is usually helpful for sales assistants.
- Experiment showed that people value mundane products higher when they saw a smiley face than a neutral or a negative face.
*However ,for luxury items they valued a product higher if the sales assistant had a neutral expression … social distance enhances the value of a luxury good.
what is risk-free return and risk premium?
- risk-free rate = opportunity cost of waiting + expected inflation
- Risk-free rate is set by demand and supply of capital
- Risk- free rate is high when there are many profitable investment opportunities and capital is scarce and/or inflation is high
- Risk-free rate is low when demand for capital is low, i.e., investment is low.
- risk premium = extra return required by investors for accepting risk.
– Size of risk premium depends on investors’ appetite for risk.
– More risk averse investors require higher risk premium.
formula
what is the framework for analysis of investment value?
This formula represents the
1. This is the summation symbol, indicating that we are summing over all time periods from t=1 to infinity.
2.This represents the expected cash flow at time t. The E denotes expectation, meaning we are looking at the anticipated cash flow.
3. This is the discount factor.
E[R] represents the expected return rate, and raising it to the power of 𝑡 discounts the cash flow back to the present value.
This term accounts for the potential future growth in profits, often called “real options.” These are opportunities the company has to invest in projects that could generate additional profits in the future.
what are the consequences of an increase in investors risk aversion?
- Investors increase purchases of risk-free government bond which increases their price and pulls down risk-free rates
- Corporate bonds become relatively more popular
- Equity of companies with high pay-out ratios and perceived as low risk (ie, equities with “bond-like” characteristics) become more popular and increase in price
- Equities from companies with low pay-out ratios and risky projects become less popular and their prices decrease.
what is the relevance of growth options
- The major part of the value of many companies comes from their real options, not from the present value (PV) of their expected cash flows.
- Many assets that seem “irrationally over-priced” or in a “bubble state” are not necessarily so if one takes into account the value of their
growth or “real” options”
what is call option and put option?
- Call option: The right to buy an asset at a specified exercise price on or before a specified expiration date
- Put option: The right to sell an asset at a specified exercise price on or before a specified expiration date.
what are option values a function of?
- Value of underlying asset
- Exercise price
- Volatility
- Time to maturity
- Risk-free rate of interest
what is valuing tech companies as options?
- Underlying asset: – size of recruitment market: cash flows from advertising, subscriptions & recruitment services for businesses and headhunters
- Exercise price: Further investment to develop business
- Variance: Potential size of market
- Time to expiry: Period before someone else develops similar network.
- Interest rates: Current opportunity cost of capital is low
what are real options?
- Financial option: The right to buy a security for a given price at a given time in the future.
- Real option: The right to be flexible in one’s future decisions about risky investments
- Examples: After learning new information about a risky investment we may exercise an option to expand. Or,
exercise an option to abandon. Or, exercise an option to delay further investment. - The choice we make will be one that maximizes our profits. The relevant point is that having real options increases our expected profit
how is risk in efficient markets?
- In efficient markets:
- High expected returns come with high risk
- To earn high returns investors must take more risk
- An investor who believes markets are efficient and prefers low risk will diversify
how does change in cash flows affect the value?
if cash flows increase proportionally with interest rates then value is unchanged. If cash flows increase at a lower (higher) rate than interest rates then asset values decrease (increase).
what are the factors of ideal investment
High return
Low risk, maintains value over time
Highly liquid, widely traded
In actual markets, no asset has all these characteristics … there are trade-offs; to get high return, you need to accept high risk and/or low liquidity
Bonds offer lower risk and liquidity relative to equities but investors must accept lower expected return
what are fixed income securities?
fixed income securities (ie, bonds) promise defined stream of income over fixed number of periods with repayment of principal at end.
Nominal payments are “fixed” but if expected inflation and/or perceived risk changes then the discount rate, E(R), changes and affects price
what is the relationship between interest rates and bond prices
- interest rates decrease, bond prices increase = inverse
A bond’s change in value is driven largely by current and forecasted interest rates. For example if interest rates decrease, the value of a fixed coupon bond would typically increase. This increase in bond value would mean the fixed coupon, as a percentage of bond value, would decrease to be in line with interest rates. Alternatively, if market interest rates increase, the value of bonds would typically decrease.
what is the relationship between credit stress and bond prices
- inverse = credit stress increases, bond prices decrese
If a bond issuer becomes financially stressed, they may propose varying the terms of their borrowing. This may include such measures as reducing the periodic coupon, extending the maturity or reducing a bond’s face value (principal amount borrowed). In extreme cases an issuer may default, meaning they are unable to make coupon or principal repayments to bond holders
what are the main types of bonds?
Government bonds
risk-free if issued in own country’s currency
Band bonds
bank raises capital by selling bonds and uses proceeds to lend at higher interest. Bank guarantees payment to bond holders.
Corporate bonds
company raises capital by issuing bonds directly to public rather than borrowing via the bank. Generally only cost effective for very large, well regarded companies.
Asset backed securities
what are the steps of asset-backed securities?
Step 1: A financial intermediary lends money to borrowers to allow them to purchase specific assets (e.g., house, cars, factory equipment).
Note: the loan made to the borrowers is an asset in the balance sheet of the financial intermediary.
Step 2: The loans are then sold to investors wishing to buy the income stream from the payments made by the borrowers. If the borrowers default on their loan, the assets are seized as collateral.
The ultimate risk is borne by the investors who bought the loans from the financial intermediary.
The financial intermediary makes money from the commissions it charges to the borrowers and the investors.
what is the importance of debt rating agencies?
Debt rating agencies play a significant role in the pricing of fixed income securities;
The variety of different kinds of fixed income securities and lack of information about issuers makes the evaluations provided by credit rating agencies very important
Why don’t retail (ie, small) investors pay more attention to the bond market, given its large size
- Bonds are less liquid and usually sold in large parcels.
- Most bonds are traded over-the-counter (OTC).
- Bonds have lower volatility, making them less exciting.
- The bond market has less visibility.
- Investing in bonds can be complex, involving individual bonds or bond indices.
How to invest – either via bonds issued by individual companies or by buying into a bond index via active bond index or passive index
4 strategies
how does bond fund get a return
Trading for Capital Appreciation: Buying and selling bonds to benefit from price changes.
Duration Strategy: Managing the portfolio’s sensitivity to interest rate changes by adjusting bond durations.
Yield Curve Strategy: Positioning bonds based on expected changes in the shape of the yield curve (e.g., focusing on short-term or long-term bonds).
**Security Allocation, Sector Allocation, and Country Allocation: **Diversifying investments across different types of bonds, sectors, and countries to optimize returns and manage risk.
how does the duration strategy work
percentage change in PV of bond decreases as interest rate increases
interest rates are affected by the price of a bond
price of bonds with longer maturity are more sensitive to changes interest rate
what is the yield curve strategy?
Interest rates on bonds are expressed on an annual basis
The yield curve plots the interest rates (at a given point in time) of bonds having different maturities but same credit risk.
◦ If you were lending $100,000 to a business for one year at 12% , would you charge a different rate if the business wished to borrow for two years?
◦ If so, would the interest rate for the two-year loan be less than or equal to 12%?
^ rate would be lower to increase inventive to borrow for longer
Why bond yields (i.e., interest rates) historic lows from around 1982 to 2020
Interest rates are a function of demand and supply of money
Supply of money depends on savings
Demand for money depends on investment opportunities
Over the long-term, the prevailing trend has been an increase in supply of money (from savings) and a decrease in demand for money
◦ An increase in supply and decrease in demand lowers interest rates
Why has supply of funds increased and demand for funds decreased?
Secular stagnation theory:
Interest rates are a function of demand and supply of funds
R* is the interest rate that ensures enough investment takes place to maintain full employment and keep inflation stable at the target rate
R* is unobservable – economists have to guess what it is
- Slower population growth decrease demand for investment
- Aging populations also tend to have lower demand
- Low productivity growth reduces demand for new investments
- Older populations tend to save more therefore increasing supply of money.
- Older people have higher preference for for ”safe assets”
- Government bonds are “safe assets” and so demand for them is high
how does secular stagnation explain long run trend in interest rates
During the pandemic, developed country governments issued cash to stimulate their economies. This increased aggregate demand but supply chains were disrupted due to Covid and war in Ukraine. The lack of supply resulted in increase in inflation and interest rates rose.
As supply chains return to normal capacity, interest rates may decline unless artificial intelligence technology causes demand to increase and/or there are further disruptions to supply
why was silicon valley bank successful for so long?
SVB was unique in really understanding and trusting their clients and building relationships with these companies, venture capitalists and entrepreneurs
what are the benefits of identifying the right banking partner?
- Banks with a focus on the innovation economy can provide startup-centric financial advice, investment and payments solutions, sector insights, and networking assistance to complement the support provided by your investors.
- The most experienced banks can also provide institutional resources to startups and in some cases your financial partner may become an active advocate for your business.”
“The value of reputation is paramount. The venture capital industry is relationship-driven, which applies equally to debt and equity.
why did silicon valley bank fail?
Silicon Valley Bank’s failure boils down to a simple misstep: It grew too fast using borrowed short-term money from depositors who could ask to be repaid at any time, and invested it in long-term assets that it was unable, or unwilling, to sell.
When interest rates rose quickly, it was saddled with losses that ultimately forced it to try to raise fresh capital, spooking depositors who yanked their funds in two days.
what are the assets that cannot be valued using the model
– Gold
– Works of art
– Crypto-currencies
– Regular currencies
– Shoes worn by Michael Jordan
what is a portfolio
- Collection of investments or financial assets held by an entity.
- Examples of assets:
Shares
Housing
Bonds
Cryptocurrencies
Cash
Human capital
(i.e., your competencies, knowledge and skills)
how do you choose your portfolio?
Two often competing objectives:
- Have what you need when you need it:
This means ensuring your investments are accessible and safe enough to meet your financial needs when they arise. - Take advantage of opportunities to increase your wealth:
This means seeking out investments that have the potential to grow your wealth over time, even if they come with some risks.
- Trade-off between risk and expected return:
Generally, investments that offer higher potential returns come with higher risks. Conversely, safer investments tend to offer lower returns. - Safety vs. Expected Return:
If you prioritize safety and want to avoid risks, you’ll likely need to accept lower expected returns. On the other hand, if you’re aiming for higher returns, you’ll need to be willing to take on more risk.
what is the cost of capital?
The cost of capital refers to the required return necessary to make a capital budgeting project, such as building a new factory, worthwhile.
It is the rate of return that a company needs to earn on its investment projects to maintain its market value and attract funds.
expected rate of return E(r) = discount rate
E(r) = risk free rate + risk premium
what is the modern portfolio thoery
building an optimal portfolio, one that has highest expected return for a given level of risk (or, put differently, lowest risk for a given level of expected return)
what is the sharpe ratio for securities?
- Sharpe ratio=(expected
return–risk free rate)/ standard deviation of return above the risk-free rate
Rational, risk averse investors aim to maximize the Sharpe ratio of their portfolios
what is co variance
The extent the prices of different assets move together
how to diversify using correlation?
- To diversify efficiently (i.e., maximise expected return whilst minimizing risk) do not invest equally across available assets.
- Add assets whose performance is less than perfectly correlated with your portfolio.
- The less correlated the performance of assets, the greater the reduction in risk.
- Beta (symbol=B) is the measure of correlation
what is the relationship between beta and return?
Stocks with higher betas should, on average, earn higher return. Actual returns do not line up very well with beta
Why is beta not associated with risk in practice?
(a) The covariance of asset returns is not stable over time and so estimates of beta based on past returns become out-of-date and therefore inaccurate.
(a) Investors’ preferences for particular characteristics of assets change and they change in ways that are difficult to predict, e.g.,
what is the fama french three factor model
**The Fama-French Three-Factor Model **is an extension of the Capital Asset Pricing Model (CAPM) that aims to explain stock returns through three factors instead of just one. These factors are:
- Market Risk (Beta):
The risk related to the overall market movements, similar to CAPM. - Size (SMB - Small Minus Big):
This factor accounts for the tendency of smaller firms (in terms of market capitalization) to outperform larger firms. Smaller firms generally experience higher returns. - Value (HML - High Minus Low):
High book-to-market ratio firms (value stocks) tend to have higher returns compared to low book-to-market ratio firms (growth stocks).
Book-to-Market Ratio:
Formula: Book Value of Equity / Market Value of Equity.
whats the practical use of the CAPM
- The evidence indicates that the CAPM is not much help in estimating cost of capital (poor prediction)
- However , it is useful in showing how investors view the risk- return relationship of assets. Investors are not concerned about total risk. They are (or should be) concerned about risk relative to their portfolio
The empirical failure of the CAPM does not invalidate the foundation of modern portfolio theory: to minimise risk for a given level of expected return, investors should look for assets with uncorrelated returns.
invest in what you know
Investing in what you know may result in you lowering asset- specific risk but you are still exposed to sector-risk
You can understand only a few sectors well so if you limit yourself to those sectors you are undiversified and exposing yourself to that risk.
what is a hedge asset?
Definition: An asset that is uncorrelated or negatively correlated with another asset or portfolio on average.
Key Point: It means the hedge asset’s value does not move in the same way as the other asset’s value.
Important Note:
Hedge in Market Stress:
A hedge might not always reduce losses during market stress or turmoil.
The asset could show positive correlation (moving similarly) during stressful times, even if it shows negative correlation (moving oppositely) on average during normal times.
what is a safe haven asset
A “safe haven” is an asset that is uncorrelated or negatively correlated with another asset or portfolio in times of market stress or turmoil.”
