Financial Economics - Short Answers

Question 1

The Jan 2018 EU MIFID2 regulations on unbundling of securities research are good for investors. True/ False / Uncertain.

Answer 1

• What is Bundling of research
  
  • built into trade execution commission fees
• How this changed in MIFID II
  
  • create more transparency
  • unbundled research to see how much it is costing (is their inefficient over production)
• It is good
  
  • brings price paid in line with marginal cost and discourages inefficient overproduction
• It is bad
  
  • Because of the new costs associated with distributing research, she said that brokers might avoid covering smaller companies in their research, which in turn might impact those firms’ ability to access investors. Investors often base their decisions on whether to invest in a certain stock on research reports.

Question 2

The introduction of alternative equity trading venues through Reg NMS (US) and MIFID 1 (EU) has been good for investors True/ False / Uncertain.

Answer 2

• Key features if RegNMS (US) and MIFID 1 (EU)
  
  • Both represent major changes in the structure of the markets for equities trading in the US and EU
  • The goal of MiFID is to increase transparency across EU financial markets and standardize regulatory disclosures for particular markets
  • allowing investors and fund managers a choice of venues where they can buy, fair and equitable market place. provide pre and post transaction transparency. or sell shares and supporting of electronic trading
• Good for investors
  
  • increased competition will put downards pressure on costs
  • promote growth, competition, jobs more liquidity and depth in the market to benefit investors

Question 3

The introduction of computerised, high frequency trading in the leading global equity markets, has made markets more liquid but also more risky True/ False / Uncertain.

Answer 3

• What is high frequency trading:
  
  • High-frequency trading, also known as HFT, is a method of trading that uses powerful computer programs to transact a large number of orders in fractions of a second. It uses complex algorithms to analyze multiple markets and execute orders based on market conditions
  • . Typically, the traders with the fastest execution speeds are more profitable than traders with slower execution speeds.
• Effect on Liquidity
  
  • HFT has added even more liquidity, eliminating bid-ask spreads that would have been too small to do so before.
  • marketplaces now provide incentive –> Although the spreads and incentives amount to a fraction of a cent per transaction, multiplying that by a large number of trades per day amounts to sizable profits for high-frequency trader
• Effect on Risk
  
  • As an example, on May 6, 2010, the Dow Jones Industrial Average (DJIA) suffered its largest intraday point drop ever, declining 1,000 points and dropping 10% in just 20 minutes before rising again. A government investigation blamed a massive order that triggered a sell-off for the crash.

Question 4

Order-book trading systems, used for example in buying and selling of equities, result in volatile prices because there is no dealer providing liquidity True/ False / Uncertain.

Answer 4

• What is limit order book trading
• What cause volatile prices?
• Who creates the liquidity in the order-driven markets?
• Why dealers actually dont effect volatility?

Question 5

Perfect competition would drive bid-ask spreads in quote-driven markets to zero True/ False / Uncertain.

Answer 5

• What determines the bid offer spreak in a quote-driven market
  
  • Profit for the dealer
  • Compensation for risk
  • Liquidity and Volatility
• Competition
  
  • lowers the profit margin of the delath and hence the narrower the spread between bid and ask –> lower profit margin
  • reduced spreads are more favourable for investors which will force spread to zero
• Perfect competition
  
  • no because of dealers costs
  • in particular the costs of the financial risks that arise when the dealer agrees to buy or sell from clients, otherwise just wouldn’t be worthwhile
  • adverse selection - main determinant of the bid–ask spread is adverse selection, and that most of the volatility comes from trade impact. à Wyart et al. (2007)

Question 6

There is no bid-ask spread in an order driven market, only in a quote driven market True/ False / Uncertain. ​

Answer 6

• What is a Limit Order Book
  
  • The term order book refers to an electronic list of buy and sell orders for a specific security or financial instrument organized by price level.
  • An order book lists the number of shares being bid on or offered at each price point, or market depth. It also identifies the market participants behind the buy and sell orders, though some choose to remain anonymous.
  • These lists help traders and also improve market transparency because they provide valuable trading information.
  • Limit order or market order can be places
• How does a dealer function in a quote-driven market
  
  • Have an inventory and have a bid and ask price to connect buyers and sellers taking the spread as profit à adjust to market conditions and whether they want to decrease or increase the participation in the market
• How do they both create bid-offer spreads
  
  • Dealers will create the spread, for the risk they take only always apparent
  • While high frequency trading has completely gotten rid of some spread in some markets there are still bid-ask spread in order driven market
  • The spread is determined by supply and demand of what buyers and sellers want
  • This can be affected by volatility or the depth of the market, because if its too shallow
  • For thinly traded stocks the increase with larger orders can be dramatic . In a shallow market the bids and offers are for small amounts of shares and larger amounts require higher buy prices and lower sell prices à illiquid stock cause a larger spread because of the differences in demand

Question 7

Interdealer brokers accept positions that are too large for OTC dealers to carry on their own balance sheets True/ False / Uncertain.

Answer 7

• What is an interdealer broker
  
  • IDBs sit between investment banks helping buyers and sellers of large, usually illiquid blocks of securities at other investment banks or dealers. IDBs are characterised as sales and networking professionals in less liquid market
• Why a dealer may need one
  
  • If dealers build up large positions they regard as too risky need to sell as soon as possible but OTC markets are less transparent are harder to find a potential buyers, they can reduce them by trading through an interdealer broker(
  • the broker does not take the exposure themselves, instead they help find a counterparty, another dealer, willing to take the other side of the trade).
  • It is critical for these transactions to be anonymous and through an entity that is not themselves active in the market.
  • This is because if the market is aware that a dealer is exposed to risk and may be forced to liquidate their inventory, market prices are likely to move sharply against them in anticipation, precipitating large losses.
    *

Question 8

In highly volatile markets OTC dealers widen bid-ask spreads compared to those in normal trading conditions True/ False / Uncertain.

Answer 8

• For this you need to be aware that OTC dealers are exposed to risk
  
  • exposed to risk, as they accept customer orders they build up a position (or ‘inventory’) on one side of the market or the other, either a long position where they are exposed to risk of a price fall or a short position where they are exposed to a risk of a price rise.
• During Volatile periods dealers to protext against losses:
  
  • Widening their ‘bid-ask’ spread outside of current market prices in order to reduce customer demand ;
  • lowering their ‘bid’ and ‘ask’ prices below those of other dealers, in order to sell more to clients and reduce a long position. raising their ‘bid’ and ‘ask’ prices relative to other dealers, in order to persuade more clients to sell to them and reduce a short position. These responses eliminate their risk exposure, but at the expense of reducing profits or even (if prices have moved far enough) crystallising a loss.
  • Greater risk of going the other way so to protect themselves and hedge against going the other way
• Gain from Volatility:
  
  • Volatility usually increases during periods of rapid market decline or advancement. When securities are increasing in value, investors are willing to pay more, giving market makers the opportunity to charge higher premiums and make more profits

Question 9

Auctions rather than underwriting are used for issuing UK government debt because of the large volume and value issued. True/ False / Uncertain.

Answer 9

• How auctions work
  
  • with offers invited for buying a stated amount at a stated price; and provide reasons why there is substantial demand for holding government debt and many bids submitted to these auctions à people like to balance their portfolio with (risk free assets) à used for hedging –
  • so lots of demand
• Why they cannot be used for equities
  
  • There are lots of government bonds out there –> and those around the same date are fairly similar
  • • therefore it is very simple to price the bonds, but how many are willing to buy at that price? Well to find out they auction them
  • People put up bids and then the price and interest is set based off demand
  • If an equities are already traded, and you want to issue more equity, a secondary offering, you can get the price based off the current shares available à while it is easy to get someone to by a a new government debt so there is no need to package it up and determine the price like in equities to convince people to buy them
• Why you need underwriting
  
  • • However when shares first come to market in a IPO, how much should they be worth? as there is no share price available equity bookbuilding takes a role here

Question 10

An equity IPO cannot take place without an investment bank book builder. True/ False / Uncertain.

Answer 10

• Why is it difficult to judge appropriate prices for a security that is not already actively traded
  
  • while on the secondary market can just look up the price
  • Keynesian Beauty Contest –>. financial markets depends not just on what investors think is an appropriate price, but on what investors think other investors think is an appropriate price (or even ‘higher degree’ what investors think other investors think other investors think is an appropriate price etc.).
  • This is applicable whenever investors are concerned with the short run performance of their investments, over a few days; and especially so with the issue of a new security
    No investor need pay more than the average view of other investors, because the security can always be bought later in the after-IPO secondary market
• How bookbuilding helps overcome this problem
  
  • • Book building is the process by which an underwriter attempts to determine the price at which an initial public offering (IPO) will be offered.
  • An underwriter, normally an investment bank, builds a book by inviting institutional investors (fund managers et al.) to submit bids for the number of shares and the price(s) they would be willing to pay for them
• Although not needed
  
  • did Duction auction IPO
    
    1. Often called a “Dutch” auction, this type of sale allows any investor—institution or individual—to put in a bid over the Web for a certain number of shares at a certain price without knowing what others are offering to pay.
    2. On paper, the Dutch auction process is supposed to bring better results for the seller since the bidding process is supposed to target the top demand in the market. In practice, there’s mixed evidence regarding its success, with some claiming that it actually yields worse results than regular IPOs.

Question 11

The charges for equity book building by the major investment banks (often about 7.5% of capital raised) are unjustifiably high. True/ False / Uncertain.

Answer 11

• Hard to determine price on your own​
  
  • Keynes beauty contest à financial markets depends not just on what investors think is an appropriate price, but on what investors think other investors think is an appropriate price (or even ‘higher degree’ what investors think other investors think other investors think is an appropriate price etc.).
• bookbuilding helps over come this issue
  
  • Bookbuilding is the process of figuring out the price- Investment bank on the sell side have a large number of contacts on the buy side of the market from whom they can get information about what price investors are willing to pay à generates interest, companies might no have invested without hearing about the company, a form of marketing
  • Reduces the risk of offering shares an no one will buy them à under expectations, bad publicity might not be able to generate all the funds you need which puts you in an awkward situation
• dont need bookbuilders
  
  • Google did a dutch auction IPO - but went wrong
  • lost a lot of money as they didnt accurately determine the price investors though and didnt generate as much money as expected
• Is 7.5% really that high
  
  • (Chen and Ritter, 2000) à underwriting market is not competitive, Investment bankers admit IPOs is very profitable and don’t want to compete of fees as they don’t want to turn it into a commodity business (lose out of profit)
  • (Hansen, 2001) à He provides evidence that 7% is not abnormal profits and argues that it is part of the competitive nature and efficiency of the market
  • From PWC, Where 1111 IPO between (1995 and 1998) between 20-80 mil, 90% charge 7%

Question 12

An Exchange Traded Fund (ETF) is more liquid than an Investment Trust (or in US terminology “closed end fund”.) True/ False / Uncertain

Answer 12

• Whats an ETF
  
  • is a type of security that involves a collection of securities—such as stocks—that often tracks an underlying index
• Whats a Close end fund
  
  • A closed-end fund (CEF) or closed-ended fund is a combined investment model based on issuing a specified quantity of shares that are not redeemable from the fund which are traded on the secondary market.
• ETF are liquid because:
  
  • The trading volume of the individual securities that make up the ETF à as based on liquid large caps stocks that have large trading volume and market depth, its stands to reason that ETFs that are traded like stock in themselves are also very liquid
  • Redemption and release of new shares
    
    1. ETF shares are created by a process called creation and redemption, which occurs on fund level in the primary market. It allows authorised participants to exchange baskets of securities or cash for ETF shares (and back again).
  • The ability to create and redeem shares keeps an ETF’s price in line with its underlying net asset value and is not pushed away from target by investors buying or selling the fund.
• Close ended funds arent liquid because:
  
  • But A CEF always has a fixed amount of shares outstanding. If you are buying shares in the secondary market, there is no way for your counterparty to access the primary market for the issuer to create more shares, so you actually will create pressure on the fund price.

Question 13

Mutual funds (or unit trusts) are active funds, Exchange Traded funds are passive funds. True/ False / Uncertain.

Answer 13

• Passive investment
  
  • Passive investment means following a benchmark index – such as for equities the Ft- All shares, FT 250 or S&P500 with the minimum amount of trading, only trading in order to closely match the preferred index
• Active Investment
  
  • Active investment means trying to outperform a preferred index, by spotting opportunities for high levels of profit while still maintaining a similar risk level to the index - trying to take full advantage of short-term price fluctuations
• Mutual Funds
  
  • In an “active” mutual fund, investors pool their money and give it to a manager who picks investments based on his or her research, intuition and experience
  • Can be passive à seek to keep close to the preferred index with minimal trading cost
• ETF
  
  • ETFs were originally constructed to provide a single security that tracks an index and trades intraday. à inherently
    
    • A passively managed fund, by contrast, simply follows a market index. It does not have a management team making investment decisions
  • A smart Beta ETF is a type of exchange-traded fund (ETF) that uses a rules-based system for selecting investments to be included in the fund portfolio à mix of active and passive
  • Smart beta ETFs build on traditional ETFs and tailor the components of the fund’s holdings based on predetermined financial metrics

Question 14

Asset managers act as trustees for pension funds True/ False / Uncertain.

Answer 14

• What is a trustee
  
  • The trustees are responsible for the broad management of the fund, ensuring that there are sufficient pension contributions to support future pension payments and that the overall investment strategy – the division of the funds amongst different asset classes – e.g. equities, bonds, property, overseas investments – serves the interests of the beneficiaries.
  • deciding how the pension scheme assets will be invested
  • getting regular scheme valuations and ensuring there is enough money in a defined benefits scheme to pay the members’ pensions
  • giving information to members about their pension savings under the scheme
  • giving The Pensions Regulator information about the pension scheme
• What is an asset manager
  
  • The asset managers are responsible for portfolio decisions within asset classes.
    
    • The asset managers are individuals or firms hired to manage or advise on the management of the assets held within the fund. à they offer portfolio management assistance and grow the fund but don’t effect the direction

Question 15

The investor carries all the risk in a defined contribution pension fund True/ False / Uncertain.​

Answer 15

• Defined Benefit
  
  • It’s all in the nomenclature. Defined-benefit plans define the benefit ahead of time: a monthly payment in retirement, based on the employee’s tenure and salary, for life. Usually, the funding expense accrues entirely to the company.
  • Employees are not expected to contribute to the plan, and they do not have individual accounts. Their right is not to an account but to a stream of payments
• Defined Contribution
  
  • the benefit is not known, but the contribution is. It comes in a designated amount from the employee, who has a personal account within the plan and chooses investments for it.
  • As investment results are not predictable, the ultimate benefit at retirement is undefined. Nevertheless, the employee owns the account itself and can withdraw or transfer the fund, within plan rules. à depends how much they contribute out of their lifetime income (how high their retirement ratio is)
• Risk can fall on investors in defined benefit plans when:
  
  • Note that for the case of a defined benefit fund the answer is more complicated. When the benefits are defined then the risk are carried by the fund as a whole, not by individual investors/ beneficiaries, and by the employer sponsoring the pension fund. If the funds returns are low then nothing will change for a while.
  • But if returns are low for a long period and there are doubts about the ability to continue paying all future pensions then both company and beneficiaries may have to increase their contributions.
  • If the company fails then the taxpayer may help ensure pensions are paid. In the UK there is a detailed regulatory regime covering such defined benefit schemes to ensure pensions are not lost.