Exams Flashcards
Why are money market securities sometimes referred to as “cash equivalents”?
Money market securities are called “cash equivalents” because of their great liquidity. The prices of money market securities are very stable, and they can be converted to cash (i.e., sold) on very short notice and with very low transaction costs.
With reference to IPOs, what is a book?
Large investors communicate their interest in purchasing shares of the IPO to the underwriters. These indications of interest are called a book. The book provides valuable information to the issuing firm.
With reference to the Tokyo Stock Exchange, what is the role of a saitori?
A saitori maintains a public limit-order book and matches market and limit orders. Saitori are similar to specialists on the NYSE, but do not trade for their own accounts. If order imbalances would result in extreme price movements, the saitori may halt trading and advertise the imbalance (in the hope of attracting trading interest to the “weak” side of the market).
If investors raise inflation expectations by 3%, what happens to the Security Market Line? What happens to the Securities Market Line if an increase in the investors’ risk aversion causes the market risk premium to increase by 3%? (hint: you can answer to this question with graphs)
shift upwards by 3%
steeper by 3% in beta=1
Consider the three-factor model for expected returns proposed by Fama and French (1993).
What are SMBt and HMLt?
SMBt (small minus big) is the difference between the returns on diversified portfolios of small and big stocks. HMLt (high minus low) is the difference between the returns on diversified portfolios of high and low B/M stocks.
Define absolute and relative risk aversion. In asset allocation situations where the investors split their investments into a safe and a risky asset, how do investors with constant absolute risk aversion optimally choose their portfolios as their wealth changes? What about investors with constant relative risk aversion?
This question assumes that individuals preferences can be expressed as a utility function u over wealth, x, or u(x). Then we can define risk aversion in terms of the concavity of this function, specifically the absolute risk aversion coefficient is –u’’(x)/u’(x), and the relative risk aversion coefficient is the absolute risk aversion coefficient times wealth itself, or –u’’(x)x/u’(x).
Individuals’ choices in terms of risk taking can be related to these two concepts, and in particular, individuals who have a constant absolute risk aversion will take a constant amount of risk in their portfolio. For instance, they will invest $1,000 in a risky assets and hold the rest in a risk-free asset regardless how wealthy they are. In contrast, individuals with constant relative risk aversion coefficient will hold a constant fraction of their wealth in the risky assets. For instance, they will hold half their wealth in risky and half their wealth in safe assets regardless of how wealthy they are.
Briefly explain how the Value-at-Risk method measures risk exposures, and why this method is useful in risk management for banks.
Explanation of how the method measures risk exposures: The key element here is that risk is measured by calculating the tail-probability of losses. Changes in the upside risk (i.e., the tail-probability of gains) will not affect the Value-at-Risk measure. Explanation of the role that this method plays in the risk management of banks: The key factor here is that the banks are regulated and will need to hold risk capital, which is costly and will be depleted only when the banks incur losses. This method will, therefore, allow banks to compete for profits freely (since VaR won’t be influenced by the probability of gains) while, at the same time, keeping the probability of losses below a certain threshold.
What is the basis risk?
Basis = Spot price of asset to be hedged – Futures price of contract used
When hedging with futures, why is it best to choose a delivery month that is as close as possible to, but later than, the end of the life of the hedge?
Given a hedge with a certain expiration month, a contract with a later delivery month is usually chosen. The reason is that futures prices are in some instances quite erratic during the delivery month. Moreover, a long hedger runs the risk of having to take delivery of the physical asset if the contract is held during the deliver month. Taking delivery can be expensive and inconvenient. (Long hedgers normally prefer to close out the futures contract and buy the asset from their usual suppliers.) In general, basis risk increases as the time difference between the hedge expiration and the delivery month increase. A good rule of thumb is therefore to choose a delivery month that is as close as possible to, but later than, the expiration of the hedge (notice that this rule of thumb assumes that there is sufficient liquidity in all contracts to meet the hedger’s requirements).
Behavioral finance argues that some features of asset prices are most plausibly interpreted as deviations from fundamental value, and that these deviations are brought about by the presence of traders who are not fully rational. A long-standing objection to this view that goes back to Friedman (1953) is that rational traders will quickly undo any dislocations caused by irrational traders. Briefly explain the assertions on which Friedman’s line of argument is based. With which step of this argument does behavioral finance take issue?
Friedman’s line of argument is based on two assertions. First, as soon as there is a deviation from fundamental value – in short, a mispricing – an attractive investment opportunity is created. Second, rational traders will immediately snap up the opportunity, thereby correcting the mispricing. Behavioral finance does not take issue with the second step in this argument: when attractive investment opportunities come to light, it is hard to believe that they are not quickly exploited. Rather, it disputes the first step. The argument is that even when an asset is wildly mispriced, strategies designed to correct the mispricing can be both risky and costly, rendering them unattractive. As a result, the mispricing can remain unchallenged.
Convexity measures the curvature of the bond’s price-yield curve. Explain whether or not convexity is desirable for investors.
Convexity is generally considered a desirable trait. Bonds with greater curvature gain more in price when yields fall than they lose when yields rise. Consider two bonds, A and B, with the same duration at the initial yield, but such that bond A is more convex than bond B. Bond A enjoys greater price increases and smaller price decreases when interest rates fluctuate by larger amounts. If interest rates are volatile, this is an attractive asymmetry that increases the expected return on the bond, since bond A will benefit more from rate decreases and suffer less from rate increases. Of course, if convexity is desirable, it will not be available for free: investors will have to pay more and accept lower yields on bonds with greater convexity.
The equity premium puzzle originates from the observation that equity returns exceeded the risk-
free rate to an extent that is inconsistent with reasonable levels of risk aversion—at least when average rates of return are taken to represent expectations. Discuss the interpretation by Fama and French (JF, 1992) to the equity premium puzzle.
Fama and French show that the puzzle emerges primarily from excess returns over the period 1950– 1999. They use the constant-growth dividend-discount model to estimate expected returns. They find that for the period 1872–1949, the dividend discount model yields similar estimates of the expected risk premium as the average realized excess return. For the period 1950–1999, the dividend discount model yields a much smaller risk premium, which suggests that the high average excess return in this period may have exceeded the returns investors actually expected to earn at the time. In particular, over the latter period, capital gains significantly exceeded the dividend growth rate. Hence, the equity premium puzzle in the latter period may be due at least in part to unexpected large capital gains.
In what ways is preferred stock like long-term debt? In what ways is it like equity?
Preferred stock is like long-term debt in that it typically promises a fixed payment each year. In this way, it is a perpetuity. Preferred stock is also like long-term debt in that it does not give the holder voting rights in the firm. Preferred stock is like equity in that the firm is under no contractual obligation to make the preferred stock dividend payments (failure to make payments does not set off corporate bankruptcy). With respect to the priority of claims to the assets of the firm in the event of corporate bankruptcy, preferred stock has a higher priority than common equity but a lower priority than bonds.
a. Explain the difference between limit orders and market orders.
b. Explain the difference between limit orders and stop-loss and stop-buy orders.
c. By means of example, explain when an investor may find it useful to send a stop buy order.
A limit order is a buy order with a maximum price or a sell order with a minimum price. A market order is a limit order with an infinite maximum price or zero minimum price, which will guarantee execution if there are orders waiting in the limit order market. A special class of orders are the contingent orders where the buy order has a minimum price and the sell order has a maximum price—i.e., you sell once the price has gone through a lower barrier (stop loss) or you buy once the price has gone through an upper barrier (stop buy).
If you have a large short position and you wish to protect the existing profit, you may be giving a stop buy order (the buy order comes into effect if the stock price goes above a certain limit).
Discuss SEC Rule 415 (on shelf registration).
What is the short-swing rule in SEC Section 16(b) about?
a) Thanks to Rule 415, the securities are “on the shelf,” ready to be issued, for two years after initial registration. Because the securities are already registered, they can be sold on short notice with little additional paperwork. Securities can be sold in small amounts.
b) Consider a situation in which officers or directors of the issuer of a security are trading such security. The short-swing rule forces them to give up profits from reversals if undertaken within six months from the first trade.
