Final Flashcards
What is the Weak Form of EMH?
Future asset prices cannot be predicted using historical price and volume data. Such information is widely available from the business press and on investing websites such as Google Finance or Yahoo Finance.
Current price reflects all information we know.
O: Fundamental Analysis
O: Insider Info
What is the Semi-Strong Form of EMH?
Asset prices adjust immediately to all publicly available information, including that which reflects the company’s fundamentals like financial disclosures.
This prohibits fundamental analysis if correct, but you can make money through Insider Information.
X: Fundamental Analysis
O: Insider Info
What is the Strong Form of EMH?
Asset prices adjust immediately to reflect all relevant information, including that available to insiders.
If this is true, it’s impossible to make money other than holding market portfolio. This is the least convincing as we’ve see people make money through insider information.
X: Fundamental Analysis
X: Insider Info
What does lower P/E Ratio indicate?
Low PE ratios correspond with higher returns. PE ratio is very predictive and refutes the semi-strong EMH.
What is Grinold’s Fundamental Law?
Performance = Skill * Sqrt(Breadth)
Performance, Skill, Breadth
IR = IC * Sqrt(Breadth)
What is IR?
Information Ratio - The Sharpe Ratio of the skill component of return of portfolio calculation
mean(alpha_p(t)) / stdev(alpha_p(t))
What is IC?
Information Coefficient
Correlation of manager’s forecasts to returns. Ranges 0 to 1.
What is Breadth?
Number of trading opportunities per year.
What is risk?
Volatility
Standard Deviation of historical daily returns
What is Mean Variance Optimization?
Inputs: Expected Return, Volatility (historically how volatile assets have been), Covariance (matrix between assets), Target Return (Max return asset to min return asset)
Output: Asset weights for portfolio that minimizes risk
What is the Efficient Frontier?
No portfolios past frontier and if within line, it’s suboptimal in some way.
Tangent line from origin to frontier, where it intersects is max Sharpe Ratio portfolio for all assets.
Which version of EMH is correct?
It is likely that different versions apply in different markets. The strongest versions apply in the largest, most transparent, most liquid markets such as for US large cap stocks.
What is an option?
An option is a contract which gives the buyer the right, but not the obligation, to buy or sell the underlying stock at a specific price on or before the expiration date
PROs of Options?
- Can’t lose more than premium paid up front
- Leverage (get most upside potential, cap downside to premium paid, tie up less money and can use it elsewhere)
CONs of Options?
- Premium is lost money
- Expiration dates - add a layer of complexity
- You don’t own the stock
What is Intrinsic Value?
The difference between the option strike price and the underlying spot price for an in-the-money option.
What is “in the money” option?
Can exercise option for profit.
Non-negative intrinsic value
What is Time Value?
The excess premium cost of an option beyond its intrinsic value, attributed to time-to-expiration
e.g. the longer the time is from now until the expiration, the greater the chance it will reach the strike price
What is Time Decay?
The rate at which an option is currently losings its time value.
What is “Buying a Call”?
Similar to LONG position. Profit if the underlying stock goes UP. You’re buying the right to buy the stock.
Pay premium up front. Need stock to rise some amount above stock price that represents extra premium before you break even.
Below Strike: lose premium
Hit Strike: start regaining premium dollar for dollar
Strike + Premium: profit
Max Profit = theoretically unlimited (as high as stock goes)
Max Loss = premium
What is “Buying a Put”?
Opposite of “Buying a Call”. Buying the option to SELL the stock. Don’t have to own stock to do this. Make bet that stock will go down and be able to sell it at strike price and immediately buy it back for less to populate the difference.
Above Strike: lose premium
Hit Strike: start regaining premium dollar for dollar
Strike - Premium: profit
Max Profit = not unlimited (theoretical is strike price - premium)
Max Loss = premium
What is “Writing a Call” aka naked calls (if sole position)?
Forced to sell stock. Collect premium immediately, but until expiration date, can be forced to sell at strike price no matter what. Best case: they won’t exercise option. Worst: forced to make unprofitable trade.
Below Strike: gain premium immediately
Hit Strike: start losing premium dollar for dollar (they will exercise call)
Strike + Premium: loss
Max Profit = premium
Max Loss = unlimited (stock price can go up forever)
What is “Writing a Put”?
We give someone else the option to sell us the stock at strike price should they choose to do so. We want price of stock to go down.
Above Strike: gain premium
Hit Strike: start losing premium dollar for dollar
Strike - Premium: loss
Max Profit = premium
Max Loss = not unlimited (stock - premium)
What is one of the safest things you can do with options?
A Covered Call
Combines 1 option position with a position in the underly stock. Buy a stock, write a call on the same stock.
Outcomes:
Stock ends above strike - called away, sell at strike, lose profit above. Profit = strike - purchase price + premium
Stock ends up, but below strike - Perfect, option not exercised. Made money on stock and still have it. Profit = current price - purchase price + premium
Stock ends down - option not exercised, still have stock. Loss = current price - purchase price + premium. Premium partially offsets loss.
What is a Butterfly Strategy?
Strategy to profit for when the market goes sideways. Buy a call below and above as bracketing pair; in the middle, write 2.
Which type of analysis has to do with EMH?
Fundamental - based on companies business operations and finances e.g. book value, intrinsic value, market cap
What is IR also referred to as?
The Sharpe Ratio of excess return.
mean(alpha_p(t)) / stdev(alpha_p(t))
The Fundamental Law is designed to give us insight into active or passive management?
Passive
