FE Readings

Question 1

How does a target’s asset beta affect the bidder’s cumulative abnormal return (CAR) around the bid announcement in CAPM-based valuations? (CAPM-Based Company (Mis)valuations)

Answer 1

The bidder’s cumulative abnormal return (CAR) around the bid announcement increases with the target’s asset beta​​.

Question 2

How does the relative size of a bid compared to the bidder’s market capitalization influence the relationship between the bidder’s CAR and the target’s asset beta? (CAPM-Based Company (Mis)valuations)

Answer 2

The positive relation between the bidder’s CAR and the target’s asset beta is stronger if the relative size of the bid vis-à-vis the bidder’s market capitalization is larger​​.

Question 3

What strengthens the positive relationship between the bidder’s CAR and the target’s asset beta in CAPM-based valuations? (CAPM-Based Company (Mis)valuations)

Answer 3

The positive relation between the bidder’s CAR and the target’s asset beta is stronger if the growth rate of the target’s expected operating free cash flows on a stand-alone basis is larger​​

Question 4

What are the two pillars or Siamese twins of asset pricing in financial theory? (Two Pillars of Asset Pricing)

Answer 4

The two pillars of asset pricing are efficient capital markets and the development and testing of asset pricing models​​.

Question 5

What is the first formal model of market equilibrium in asset pricing, and what is its key risk measure?(Two Pillars of Asset Pricing)

Answer 5

The first formal model of market equilibrium in asset pricing is the Capital Asset Pricing Model (CAPM) developed by Sharpe (1964) and Lintner (1965). In this model, market beta (β), which is the slope in the regression of an asset’s return on the market return, is the only relevant measure of an asset’s risk​​.

Question 6

What is the title of section C in the “Two Pillars of Asset Pricing” reading?

Answer 6

The title of section C in the “Two Pillars of Asset Pricing” reading is “The Three-Factor Model”​​.

Question 7

How do investor opinions expressed on social media platforms impact financial markets? (Wisdom of Crowds)

Answer 7

Investor opinions transmitted through social media platforms have been found to predict future stock returns and earnings surprises. This includes both the views expressed in articles and the commentaries written in response to these articles on popular social media platforms for investors​​.

Question 8

What role do peer opinions play in financial markets, and what is the study’s goal in assessing these opinions? (Wisdom of Crowds)

Answer 8

Peer opinions are increasingly influencing financial markets, with nearly one in four adults in the U.S. relying on investment advice from social media as of 2008. The study aims to assess the performance of investors who act as advisors and determine if peer-provided investment advice is genuinely useful, rather than being random chatter or intentionally misleading information​​.

Question 9

What specific findings did the study observe regarding the predictability of stock returns based on social media content? (Wisdom of Crowds)

Answer 9

The study found that both the fraction of negative words in articles and comments on a social media platform (SA) negatively predicted stock returns over the following three months. This predictability was particularly evident when a higher number of comments were analyzed. The results remained robust even when controlling for factors like analyst recommendation changes and earnings surprises​​.

Question 10

What is the fundamental difference between an Exchange-Traded Fund (ETF) and a mutual fund?(Exchange-traded funds 101 for economists)

Answer 10

Unlike mutual funds, ETFs do not interact directly with capital markets. Instead, ETFs are managed by ETF sponsors who enter into contracts with Authorized Participants (APs), typically large financial institutions or specialized market-makers, who interact with the markets. This structure allows ETFs to be traded like stocks on exchanges, offering intraday trading opportunities and greater flexibility​​.

Question 11

How are transaction costs handled differently in ETFs compared to mutual funds?(Exchange-traded funds 101 for economists)

Answer 11

In ETFs, transaction costs are “externalized,” meaning they are borne by the individual trading the ETF shares rather than being shared by all investors in the fund. This is in contrast to mutual funds, where transaction costs are shared by all investors, including those who did not engage in the trading causing these costs​​.

Question 12

What are the potential risks and concerns associated with ETFs? (Exchange-traded funds 101 for economists)

Answer 12

Some concerns include investors’ potential lack of financial sophistication to understand different types of ETFs, the possibility of excessive trading due to intraday liquidity, and challenges with custom or concentrated indices. There are also systemic risks, such as those related to “flash events” in the markets and liquidity mismatches, which could impact financial stability​​.

Question 13

How did the US Federal Reserve’s actions during the COVID-19 pandemic impact the stock markets?(Free markets to Fed markets)

Answer 13

The US Federal Reserve’s aggressive unconventional monetary policy, including doubling its balance sheet, explained at least one-third of the stock market rebound during the COVID-19 pandemic. This impact was predominantly through bond yields (discount rates) and expectations of future macroeconomic conditions (future cash flows)​​.

Question 14

What was the perceived disconnect between stock markets and the real economy during the COVID-19 pandemic?(Free markets to Fed markets)

Answer 14

Despite deteriorating economic conditions and setbacks in controlling the pandemic, stock markets, such as the US S&P 500 index, saw significant increases. This led many market observers to conclude that stock markets were disconnected from the real economy, a phenomenon attributed to strong intervention in markets by central banks through asset purchases and balance sheet expansion​​.

Question 15

What is the relationship between the Federal Reserve’s balance sheet and stock markets, according to the reading?(Free markets to Fed markets)

Answer 15

There is a strong symbiotic relation between the Federal Reserve’s balance sheet and stock markets. The Fed typically responds to stock market declines or a deteriorating economic outlook with a lag of 2–5 weeks by expanding its balance sheet through asset purchases. Subsequently, stock markets respond positively to the Fed’s balance sheet expansion within 1–4 weeks following the Fed’s actions​​.

Question 16

How has the participation of sovereign issuers in the GSS bond market changed since the pandemic? (Sovereigns and sustainable bonds)

Answer 16

Since the pandemic, sovereign issuance in the GSS bond market has notably increased. By end-June 2022, the share of sovereign issuers in total outstanding GSS bonds rose from 4.2% at the end of 2019 to 7.5%, with 38 sovereigns from five continents issuing debut GSS bonds​​.

Question 17

What challenges do sovereign issuers face when issuing green bonds, and how do sustainability-linked bonds (SLBs) offer a solution? (Sovereigns and sustainable bonds)

Answer 17

Sovereign issuers face challenges with the fungibility of fiscal revenues, which makes it difficult for them to commit legally to using bond proceeds for specific green purposes. Sustainability-linked bonds (SLBs) offer more flexibility in the use of proceeds, as they are based on pre-defined sustainability performance targets and are not limited by the fungibility requirements of public debt​​.

Question 18

What is the difference between conventional green bonds and sustainability-linked bonds (SLBs) in terms of use of proceeds and incentives? (Sovereigns and sustainable bonds)

Answer 18

Unlike conventional green bonds, which don’t guarantee new green investments and can be used to refinance past expenditures, SLBs have pre-defined sustainability performance targets. If these targets are not met, the issuer is subject to a penalty. This penalty mechanism, absent in conventional green bonds, provides more freedom for issuers to use the proceeds and aligns their incentives with sustainability objectives​​.

Question 19

What are some key themes observed in corporate finance decision-making processes? (Corporate Finance and Reality)

Answer 19

Corporate finance decision-making processes often exhibit several unifying themes: they are near-term focused, based on miscalibrated forecasts, conservative (valuing flexibility), sticky, simple, and often involve attempts to time the market​​.

Question 20

How do current corporate decision rules compare to those from 20 years ago? (Corporate Finance and Reality)

Answer 20

Current corporate decision rules are generally conservative, sticky, and geared towards timing the market. They rely on internal forecasts that are considered reliable only for about two years and focus increasingly on stakeholders and revenues​​.

Question 21

In what ways can the practice of corporate finance inform academic models? (Corporate Finance and Reality)

Answer 21

The practice of corporate finance, with its emphasis on specific decision-making processes and economic decision rules, can help in developing academic models that better explain real-world outcomes. This includes considering models of satisfying decision-making or costly managerial biases​​.

Question 22

What is the relative performance ranking of different multiples for equity valuation? (Equity Valuation Using Multiples)

Answer 22

The relative performance ranking of different multiples is as follows: forward earnings measures perform the best, followed by historical earnings measures, cash flow measures and book value of equity are tied for third, and sales perform the worst. This ranking is observed consistently across almost all industries examined​​.

Question 23

What are the key assumptions underlying the use of multiples in equity valuation? (Equity Valuation Using Multiples)

Answer 23

The key assumptions underlying the use of multiples in equity valuation include the efficient markets framework for traded stocks, where stock prices can be replicated by comprehensive valuations that convert all available information into detailed projections of future flows. This assumption is crucial for understanding the role multiples play in situations where market valuations are absent, such as for privately-held equity or proposed publicly traded entities like mergers and spinoffs​​.

Question 24

How well do multiples derived from forward earnings explain stock prices? (Equity Valuation Using Multiples)

Answer 24

Multiples derived from forward earnings explain stock prices remarkably well, with pricing errors within 15 percent of stock prices for about half of the sample examined in the study. This suggests a high degree of accuracy and reliability in using forward earnings multiples for equity valuation​​.

Question 25

What impact did the COVID-19 pandemic have on corporate cash flows and financial stability? (The COVID-19 Pandemic Crisis and Corporate Finance)

Answer 25

The pandemic severely affected corporate cash flows, leading to financial distress for many firms. Businesses incompatible with social distancing measures, like those in the industrial and energy sectors, faced falling product demand. Financial firms engaged in more reaching for yield in zero short-term rate scenarios. The nonfinancial corporate sector in the U.S. entered the crisis with high levels of debt, exacerbating the financial distress​​.

Question 26

How did corporations respond to the liquidity challenges during the COVID-19 pandemic? (The COVID-19 Pandemic Crisis and Corporate Finance)

Answer 26

Corporations focused on a “dash for cash” to survive, raising funds through banks (via drawdowns under existing or new credit lines, term loans) and accessing public markets through bond and equity issuances. This strategy was critical to prevent liquidity challenges from turning into solvency problems​​.

Question 27

What role did banks play in supporting corporations during the early stages of the COVID-19 pandemic? (The COVID-19 Pandemic Crisis and Corporate Finance)

Answer 27

Banks played a crucial role as “lenders of first resort,” providing substantial funding through existing lines of credit. Large banks, in particular, offered most of the required funding, with banks located in communities most affected by COVID-19 showing significantly larger lending increases​​.

Question 28

What factors have contributed to the growth and consolidation of private markets over the last two decades? (The Rise of Private Markets)

Answer 28

The growth and consolidation of private markets have been driven by light regulation, long investor horizons, low interest rates, and the involvement of private market funds (like private equity or venture capital firms) in firms’ investment financing and restructuring​​.

Question 29

How do the roles of banks and “alternative asset managers” (AAMs) differ in external financing? (The Rise of Private Markets)

Answer 29

While banks and institutions active in public capital markets remain key financing sources for large and mature corporates, AAMs, originally private equity firms that later expanded into credit, have become pivotal for smaller firms globally, including in emerging market economies. AAMs act as one-stop capital providers for firms less able or willing to access traditional sources​​.

Question 30

What are the three distinguishing features of private markets compared to public markets? (The Rise of Private Markets)

Answer 30

The three distinguishing features of private markets are: limited liquidity transformation with extended capital commitment periods, investors (like pension funds) who are large and sophisticated with a focus on long-term returns, and relatively light regulation, reflecting lesser liquidity mismatches and limited presence of retail investors​​.

Question 31

What trend did Jensen (1989) predict for public corporations, and how did the number of public firms change over time? (Is the US Public Corporation in Trouble)

Answer 31

Jensen (1989) predicted the demise of the public corporation, arguing that public corporations are inefficient compared to private firms financed by debt and private equity. The number of public firms increased sharply in the first half of the 1990s but peaked in 1997 and has since fallen by half, leading to fewer public corporations than 40 years ago.

Question 32

How have US public corporations changed over the last 40 years? (Is the US Public Corporation in Trouble)

Answer 32

Over the last 40 years, US public corporations have experienced significant changes. They are now older, larger, operate in different industries, invest more in R&D and less in physical assets, finance themselves differently, and have higher profitability that increases with size.

Question 33

What are the implications of the aging trend of US public firms? (Is the US Public Corporation in Trouble)

Answer 33

The aging of US public firms implies that these firms might innovate less and become more rigid. Older firms have different operational and strategic behaviors compared to younger firms, potentially affecting their competitiveness and adaptability in the market.

Question 34

What are the two main forms of property loans securitization, and how do they differ? (A 30-Year Perspective on Property Derivatives)

Answer 34

The two main forms of property loans securitization are Covered Bonds and Mortgage-Backed Securities. Covered Bonds are debt securities issued by financial institutions under specific legislative measures and are backed by a pool of mortgage loans. Mortgage-Backed Securities are off the issuer’s balance sheet and only pro-rata to their equity tranche absorbs the default risk. Covered Bonds remain on the issuer’s balance sheet and absorb both default and prepayment risks.

Question 35

What was the main challenge faced by the Chicago Board of Trade (CBOT) when considering the launch of a house price futures market in 1993? (A 30-Year Perspective on Property Derivatives)

Answer 35

In 1993, a survey conducted by the CBOT indicated that the house price market was very one-sided, with many investors willing to purchase futures contracts to protect against a decline in housing prices, but few investors wanting to sell such contracts. This imbalance led the CBOT to decide against launching a house price futures contract at that time.

Question 36

How did the Chicago Mercantile Exchange (CME) approach the creation of property derivatives? (A 30-Year Perspective on Property Derivatives)

Answer 36

The CME introduced house price futures contracts and options on May 22, 2006, based on the S&P/Case-Shiller® Home Price Indices. This included both a national composite index and indices for 10 major cities. The contract was a collaboration between the CME and MacroMarkets LLC, marking the first lasting house price futures contract.

Question 37

How does the Capital Asset Pricing Model (CAPM) alpha compare to alphas from more sophisticated models in explaining hedge fund flows? (Alpha or Beta in the Eye of the Beholder)

Answer 37

CAPM alpha explains hedge fund flows better than alphas from more sophisticated models, indicating that investors pool together sophisticated model alpha with returns from exposures to traditional and exotic risks​​.

Question 37

What is the investor response to performance components in hedge funds? (Alpha or Beta in the Eye of the Beholder)

Answer 37

Investors chase both traditional and exotic risk components in hedge fund performance, but place greater relative emphasis on returns associated with exotic risk exposures unique to hedge funds. However, there is little evidence of persistence in performance from these risks​​.

Question 38

What is the central focus of the study in “Alpha or Beta in the Eye of the Beholder”? (Alpha or Beta in the Eye of the Beholder)

Answer 38

The study focuses on understanding what drives hedge fund flows, particularly examining how investor flows respond to different components of hedge fund return, including the role of performance persistence​​.

Question 38

What are some key differences in the operational structure and regulatory constraints between hedge funds and mutual funds? (Hedge Funds: Past, Present, Future)

Answer 38

Hedge funds are unregulated pools of money managed with a great deal of flexibility, allowing short positions, borrowing, and extensive use of derivatives. They are limited to “accredited investors” such as institutional investors or high net worth individuals, unlike mutual funds which are more regulated, generally do not have short positions, do not borrow, and make limited use of derivatives​​.

Question 39

How do hedge funds typically approach investment opportunities, and what is an example of their strategy? (Hedge Funds: Past, Present, Future)

Answer 39

Most hedge funds seek almost arbitrage opportunities – low-risk profits from pricing mistakes in the market. For instance, Long-Term Capital Management specialized in identifying mispriced bonds, selling overvalued bonds short, and hedging against interest rate risk and other risks, so their returns depended mainly on the correction of the mispricing​​.

Question 40

What are some of the future trends expected in the hedge fund industry, and how might these affect the industry’s performance and regulation? (Hedge Funds: Past, Present, Future)

Answer 40

The hedge fund industry is expected to: 1) perform less well over the next ten years compared to the last ten years; 2) become more institutionalized; and 3) face increased regulation. These changes will likely reduce the gap between mutual funds and hedge funds, although some hedge funds will choose investors and organizational structures to be less affected by these changes​​.

Question 41

What fundamental technological innovations have enabled the emergence of Automated Market Makers (AMMs)? (Automated Market Makers)

Answer 41

The emergence of blockchains and smart contracts has expanded the technological toolkit, enabling a new wave of innovation in market design and the rise of AMMs, particularly in the domain of decentralized finance (DeFi)​​.

Question 42

How do AMMs differ from traditional market designs in terms of price setting? (Automated Market Makers)

Answer 42

Unlike traditional market designs where market makers have the ability to set and modify quoted prices, AMMs flip the price-setting process. This means that AMMs operate with a different mechanism, automating and democratizing liquidity provision using new technologies​​.

Question 43

What are the potential benefits of AMMs when applied to traditional real-world asset classes? (Automated Market Makers)

Answer 43

AMMs could provide very deep markets for high-volume, low-volatility assets, potentially offering lower trading costs than traditional markets in several asset classes, including foreign exchange, bonds, major commodities, and some equities​​.

Question 44

What are the potential benefits and challenges of decentralized finance (DeFi) compared to the traditional financial system? (Cryptocurrencies and Decentralized Finance (DeFi))

Answer 44

DeFi has the potential to reduce transaction costs similar to the traditional financial system, but it faces challenges in enforcing tax compliance, anti-money laundering laws, and preventing financial malfeasance due to its permissionless and pseudonymous design​​.

Question 45

How do DeFi applications compare to traditional financial market solutions in terms of solving key financial system problems? (Cryptocurrencies and Decentralized Finance (DeFi))

Answer 45

DeFi and traditional financial market solutions both address important problems in financial systems, such as data privacy, transparency, extraction of rents, transaction costs, governance issues, and systemic risk. However, the specific approaches and effectiveness of these solutions can vary significantly between the two regimes​​.

Question 46

What are the challenges of regulating DeFi applications, and how do they impact the economy?
(Cryptocurrencies and Decentralized Finance (DeFi))

Answer 46

The current design of DeFi applications, built on permissionless and pseudonymous blockchains, creates challenges for tax enforcement, exacerbates money laundering and other financial malfeasance issues, and creates negative externalities on the economy. Excessive rents can accumulate in DeFi due to endogenous constraints to competition, network externalities, economies of scale, and customer-level frictions. The design also limits regulators’ ability to restrict unscrupulous operators​​.

Question 47

What is Decentralized Finance (DeFi) and on what technology is it primarily built?
(Decentralized Finance on Blockchain and Smart Contracts)

Answer 47

Decentralized Finance (DeFi) refers to an alternative financial infrastructure built on top of the Ethereum blockchain. It utilizes smart contracts to create protocols that replicate existing financial services in a more open, interoperable, and transparent way​​.

Question 48

How does DeFi differ from traditional financial systems and what are its key features?
(Decentralized Finance on Blockchain and Smart Contracts)

Answer 48

DeFi is an open, permissionless, and highly interoperable protocol stack built on public smart contract platforms, such as the Ethereum blockchain. Unlike traditional systems, it operates without intermediaries and centralized institutions, relying instead on open protocols and decentralized applications (DApps). Its architecture offers an immutable and highly interoperable financial system with transparency, equal access rights, and minimal need for custodians or escrow services​​.

Question 49

What are some applications of DeFi and what is the role of smart contracts in this ecosystem? (Decentralized Finance on Blockchain and Smart Contracts)

Answer 49

DeFi offers a range of applications, such as buying USD-pegged assets (stablecoins) on decentralized exchanges, using them on decentralized lending platforms to earn interest, and adding interest-bearing instruments to decentralized liquidity pools or on-chain investment funds. Smart contracts, which are small applications stored and executed on a blockchain, form the backbone of all DeFi protocols and applications, ensuring secure and verifiable transaction execution​​.

Question 50

What is the core characteristic of the future monetary system, and how does it benefit from new digital technologies? (The Future Monetary System)

Answer 50

The future monetary system should integrate new technological capabilities with a superior representation of central bank money at its core. This integration, rooted in trust in the currency, allows the system to exploit the advantages of digital technologies through interoperability and network effects, enabling new payment systems to scale and effectively serve the real economy. It adapts to new demands while ensuring the uniformity of money across innovative activities​​.

Question 51

What is the second fundamental role of the central bank in the future monetary system? (The Future Monetary System)

Answer 51

In the future monetary system, the second fundamental role of the central bank, building on its foundational role, is to provide the means for the ultimate finality of payments using its balance sheet. The central bank acts as the trusted intermediary that debits the account of the payer and credits the account of the payee, ensuring that once the accounts are adjusted, the payment is final and irrevocable​​.

Question 52

What are the key components of the future monetary system and how do they interact? (The Future Monetary System)

Answer 52

The future monetary system builds on the traditional division of roles between the central bank, which provides the system’s foundation, and private sector entities that handle customer-facing activities. Added to this traditional structure are new standards like application programming interfaces (APIs) which significantly enhance service interoperability and associated network effects. These components are complemented by new technical capabilities​​.