Final Exam Econ 351 Flashcards
types of market efficiency: security prices reflect all historical information, can’t profit from looking at past trends (using technical analysis)
weak form
type of market efficiency: security prices reflect all publicly available information, doesn’t pay to over analyze annual reports looking for undervalued stocks(technical and fundamental analysis)
semi-strong form
type of market efficiency: security prices relfect all information-public and private, not true- it is possivle to earn above-average returns by trading on insider information, but that’s illegal(does not hold in reality)
strong form
changes in price of commodities such as crude oil, corn, etc
commodity risk
change in price of one currency in relation to another
foreign exchange risk
own or buy financial assets
long position
sell financial assets
short position
a financial transaction that eliminates or reduce risk (used as insurance against price change in the underlying asset)
Hedging
interest rate fluctuates due to fundamental factors, changes in monetary policy, expectations, etc, changes in interest rate impacts price of bonds
interest rate risk
prices of stocks can fluctuate, impacting rate of return on stocks(equity)
equity risk
place financial bets to profit from movements in asset prices(buy and sell derivatives to profit from price changes in the underlying asset)
speculating with financial derivatives
right to buy an asset
call options
right to sell an asset
put options
price agreed to in contract
strike price
date option exercised
expiration date or maturity
price paid to get the option
option premium
gives right to buy or sell asset (choose whether to exercise), at a specified date, at a specified/guaranteed price
options
which options are more flexible american or european(one can be exercised at any date up to maturity the other can only be exercised at maturity)
american
an investor who wants to bet that the price of the underlying asset will increase would buy a … option.
call
an investor who wants to bet that the price of the underlying asset will decrease would buy a … option.
put
intrinsic value(value of an option if exercised today) for a call option vs put option.
call: Spot-Strike
put: Strike-Spot
call vs put option (profit/loss)?
call: (spot-strike-premium)(# of options)
put: (strike-spot-premium)(# of options)
The rational expectations theory is applied to financial markets using what?
The Efficient Market Hypothesis
What is the key implication of the Efficient Market Hypothesis?
Stock prices are not predictable and follow a random walk(as likely to increase as to decrease)
What type of market is defined as one in which securities prices quickly and fully reflect all available information?
Efficient Market
The Efficient Market Hypothesis says a security’s price fully reflects all available information in an efficient mark therefore price only adjusts if … or … information becomes available.
new, unexpected
Arbitrage opportunity arises if the optimal forecast is … than the … …
greater than the equilibrium return(current price is different from optimal forecast)
Type of Market Efficiency: security prices reflect all historical information, meaning you … profit from looking at past trends (using … analysis)
weak
can’t
technical
- price movements assumed to be random, a past decline is no reason to think stock prices will go up or down in the future
Type of Market Efficiency: security prices reflect all publicly available information, meaning it does not pay to over analyze annual reports looking for undervalued stocks(… analysis)
Semi-strong
fundamental
- suggests that there are no under or over-valued stocks and rules out technical and fundamental analysis
Type of Market Efficiency: security prices reflect all information- public and private, this is … - it is possible to return above-average returns be trading on insider information, but that is …
strong form
untrue
illegal
- does not hold in reality, money managers and actively traded funds would not outperform the average market return
Implications of EMH for investing: better to “… and …”, based on EMH, cannot out-perform the market average return, costs associated with trading are reduced
buy, hold
Trading
Implications of EMH for investing: better to hold a diversified portfolio, index preferred to individual shares or actively managed mutual funds because they are as well off as each other, no manager of an actively managed fund has been able to … beat the returns on an index fund, the stock of a more profitable firm will not be a better investment than the stock of a less profitable firm.
Portfolio allocation
consistently(due to arbitrage)
Implications of EMH for investing: these do not beat the markets(do not pay them)
Investment analysts (cannot earn abnormally high returns in the long term due to arbitrage)
Implications of EMH for investing: if you are ONE OF THE FIRST to get the information then above average returns are possible INITIALLY(once information becomes widely known, any … profit opportunities will be … due to arbitrage)
“Hot Tips”
unexpected
eliminated
Implications of EMH for investing: security prices will only adjust if … or … information is available that impacts the long-term profitability of the firm, sometimes stock price … when good news is announced
Stock Prices and Good News
declines
You hear in the news that Bank of America is going to expand its branch network. If the market is semi-strong efficient, can you expect to take advantage of this information by purchasing stock in Bank of America?
No
if you hear about the expansion on the news, it suggests information already available, not new information, so it is already reflected in the Stock price
Evidence Against EMH: use of trading strategies that can result in above-average returns, which should not be possible if EMH holds
Pricing Anomalies(the small-firm effect, January effect, Days of the Week effect)
Type of Pricing Anomaly: over the long run, investment in small firms has yielded a higher return than has investment in large firms (take advantage of price …) this is due to … risk, … liquidity, … information costs, … growth potential
Small-firm effect
mismatch
higher
low
high
larger
Type of Pricing Anomaly: during some years, rates of return on stocks have been abnormally high during January due to tax loss selling (investors sell … performing stocks at the end of the year and make a capital…(offset tax liability)
January effect
low, loss
Evidence Against EMH: some price changes are predictable using all available information
Mean Reversion and Momentum Investing
Stocks that have recently been earning high returns to experience low returns in the future (stocks revert to … price), suggest that you can earn abnormal profits by … stocks with high returns now and … stocks with low returns now
Mean Reversion
mean
selling
buying
Trading strategy based on the idea that there can be persistence in stock price movements, suggests to … when stock prices are rising and … when they are falling
Momentum Investing
buy
sell
Evidence Against EMH: strategy: selling stocks when they have fluctuated above their fundamental values and buying them when they are below their fundamental values
Excess Volatility
Evidence Against EMH: strategy: suggests that buying past losers while selling past winners (securities are overbought or oversold due to psychological reasons rather than fundamentals, stock prices overshoot)
Market overreaction
Evidence Against EMH: allows investors to earn above-normal returns until information becomes widely known
New information is not always immediately incorporated into stock prices
Empirical studies suggest that the stock market is:
… efficient in the weak form
… efficient in the semi-strong form
… efficient in the strong form
highly, reasonable, not
a financial security whose economic value depends on the value of an underlying asset
derivatives
stocks, bonds and foreign currency are which type of underlying asset
financial derivative
oil, wheat, and gold are which type of underlying asset
commodity derivative
involves taking an offsetting position to protect against risk
hedging risk
offset … position by taking a … position
long(own asset), short(agreement to sell asset at given price to protect against price decrease)
short(do not own asset), long(agreement to buy asset at given price to protect against price increase)
Hedging … flow of funds in the financial system and … investment and consumption impacting real GDP and economic growth
increases
increases
A financial institution has bought(or own) Treasury notes(long position) and plans to sell the security at some point in the future.
Risk:
Hedge:
interest rate risk(worried the YTM will change), increase in interest rate –> decrease in the price–> capital loss
short position–> contract to sell, at specified time in the future, at some guaranteed price
A financial institution has sold a security(short position) and needs to repurchase the security at some point in the future.
Risk:
Hedge:
equity risk if stocks/interest rate risk if bonds
long position–> contract to buy, at specified time, at guaranteed price
The manager at Tropicana is concerned that orange prices will rise in the future.
Risk:
Hedge:
commodity risk
long position –> contract to buy oranges, at a specified time, a guaranteed price
Why is speculating important?
the counterparty to hedging (hedgers transfer risk to speculators who are in pursuit of profit)
provides liquidity(increases the number of buyers and seller so market operates efficiently)
An investor thinks that Microsoft shares will decrease in the future(bearish) (currently do not own shares in Microsoft)
Action:
short position to sell Microsoft shares at a specified date at a guranteed price(if correct and price decreases–> buy shares in the spot market at a lower price and sell at contract price)
A US speculator thinks that the British pound will strengthen relative to the US dollar over the next 2 months(bullish)
Action:
take a long position(enter into a contract to buy pounds, at a specified date and guaranteed price)
if correct and the pound strengthens, sell at the current market price to make a profit
options contracts stipulate which three things?
strike price(exercised price), expiration date or maturity, option premium
The higher the strike price everything else being equal means what for the premiums on call vs put options?
call: lower premiums, strike price> spot (current market price) means it is cheaper to purchase at spot price in the market making call options less valuable
put: higher premiums, strike price> spot (current market price) means it is more valuable as higher selling price so premium on put option will be higher
What are the three determinants of the option premium?
Intrinsic value(relative spot to strike price)
Term to Expiration( increased time to maturity–> greater possibility asset price will change, premium on option will be higher on both call and put options)
Volatility of prices of the underlying asset(bonds, stocks, oil, etc)( increased volatility–> higher demand for options, higher premium on both call and put options)
when are call options out of the money, at the money, and in the money?
spot<strike>strike</strike>
when are put options out of the money, at the money, and in the money?
spot>strike
spot=strike
spot<strike
When to exercise, allow to expire, and sell to close a call option?
spot>strike
spot<strike
any time
When to exercise, allow to expire, and sell to close a put option?
spot<strike>strike
at any time</strike>
What is the Taylor’s Rule formula?
Federal funds rate target= current inflation + equilibrium real federal funds rate + (0.5 x Inflation gap) + (0.5 x output gap)
How to calculate the inflation gap?
current-targeted inflation
How to calculate the output gap?
percentage deviation in Real GDP from potential GDP
(Ya-Yp)/Yp x 100
If the inflation rate is above the Fed’s target, the FOMC will raise target for the federal funds rate, The Fed should raise the nominal interest rate by more than the inflation rate so that the real interest rate increases
The Taylor Principle
Determines a target for the federal funds rate
Taylor rule for the Federal Funds Rate
What does the Fed use as its main policy instrument?
the federal funds rate
Assume that the equilibrium real federal funds rate is 2% and the target for inflation is 2%. Suppose that the inflation rate is 3.5% and real GDP is 0.5% above its potential. Determine the federal funds rate predicted by the Taylor rule.
6.5%
What provides the fed with feedback on whether they are on target to achieve its goals(closely linked to the goals of monetary policy?
Intermediate Targets
What are examples of intermediate targets
money aggregates(M1+M2), short-term interest rates
Operating and Intermediate Target Example: Which of the following would be considered the goal, intermediate, operating, tool, and feedback?
- If the Fed realizes that the monetary base is growing too slowly they can adjust OMOs
- To increase M2, the Fed needs to increase the monetary base by 3.5%
- The Fed wants to increase economic growth by 5%
- OMOs could be carried out to achieve growth in the monetary base
- The Fed feels this can be achieved by a 4% growth rate of M2
Goal: The Fed wants to increase economic growth by 5%
Intermediate: The Fed feels this can be achieved by a 4% growth rate of M2
Operating: To increase M2, the Fed needs to increase the monetary base by 3.5%
Tool: OMOs could be carried out to achieve growth in the monetary base
Feedback: If the Fed realizes that the monetary base is growing too slowly, they can adjust OMOs
The central bank can choose either … or … targeting as its intermediate target
monetary or inflation
Where the central bank sets a target for the annual growth rate of M1 or M2
Monetary Targeting
What is M1 referred to as and what does it encompass?
Narrow Money
currency, demand deposits, and saving deposits
What is M2 referred to as and what does it encompass?
Broad Money
M1, time deposits, money market funds
What are the advantages and disadvantages of monetary targeting?
advantages:
- Accountable(accountable for hitting the target)
- Immediate signal(M1+M2 data is released every two weeks/monthly)
disadvantages:
- Relies on a stable relationship between money and inflation(impacts the effectiveness of monetary policy)
What is the order that the central bank completes its goals?
tools–> operating(reserves, federal funds rate)–> intermediate(M1+M2, short-term rates)–> goals
When the central bank sets a target for the inflation rate for a period of time(average 2%)?
Inflation Targeting