Financial Markets Correlation :C1M3 Flashcards

1
Q

What is risk in the context of decision-making?

A

Risk refers to situations where the probabilities of potential outcomes are known.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q

How is uncertainty different from risk?

A

Uncertainty occurs when the probabilities of potential outcomes are unknown.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q

What is expected value (EV) in risk analysis?

A

In risk analysis, Expected Value (EV) is a key concept used to estimate the average or mean outcome of a decision or investment, taking into account the various possible outcomes and their associated probabilities.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q

What is expected value (EV) in risk analysis?

A

Variance measures the spread or variability of potential outcomes around the expected value.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
5
Q

What does the coefficient of variation (CV) indicate?

A

CV compares the standard deviation to the mean, showing relative risk per unit of expected return.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
6
Q

What is risk aversion?

A

Risk aversion is a preference for certain outcomes over risky ones, even if the expected value is higher for the risky option.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
7
Q

What is a risk-neutral decision-maker?

A

Someone who evaluates decisions solely based on their expected value, ignoring risk.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
8
Q

Define risk-seeking behavior.

A

A preference for risky options over certain outcomes, even if the expected value of the certain outcome is higher.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
9
Q

What are “stochastic profits”?

A

Profits subject to variability due to uncertain outcomes.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
10
Q

What role does the risk aversion coefficient (λ) play in decision-making?

A

It quantifies a decision-maker’s tolerance for risk in relation to potential variability of outcomes.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
11
Q

What is the EV-variance model?

A

A model that evaluates trade-offs between the expected value and the variance of outcomes.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
12
Q

What is the formula for certainty equivalent profits (πCE)?

A
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
13
Q

What happens when the cost of debt equals the expected return on assets?

A

The firm may hold negative debt, preferring to lend equity rather than invest in risky assets.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
14
Q

Define the firm’s leverage ratio (l*).

A

The ratio of debt (D*) to equity (E).

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
15
Q

How does increasing expected asset returns (ra) affect leverage?

A

It increases the optimal leverage ratio.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
16
Q

What is the impact of increasing the cost of debt (iD) on leverage?

A

It reduces the optimal leverage ratio.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
17
Q

How does a higher risk aversion coefficient (λ) affect leverage?

A

It reduces the firm’s willingness to take on debt, lowering leverage.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
18
Q

What happens to leverage when the firm’s equity increases?

A

The optimal leverage ratio decreases.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
19
Q

How does increased variance of asset returns (σa²) affect leverage?

A

It reduces the optimal leverage ratio.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
20
Q

What does a leverage ratio of 4.34 indicate compared to 0.78?

A

A firm with a lower risk aversion coefficient may accept higher leverage.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
21
Q

Why is capital structure important for a firm?

A

It determines the mix of debt and equity used to finance operations and growth.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
22
Q

What is the formula for optimal leverage ratio (l*)?

A
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
23
Q

What does HQN’s data illustrate about optimal leverage?

A

That optimal leverage changes significantly based on variables like returns, cost of debt, and risk aversion.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
24
Q

How can risk preferences influence decision-making?

A

Individuals with different risk aversion levels may make varying choices even in the same circumstances.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
25
Q

What role does the standard deviation of returns (σa) play in risk analysis?

A

It measures the extent of variation in returns, influencing the firm’s risk assessment.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
26
Q

Why is it important to measure risk in both percentages and dollars?

A

The scale of measurement can affect the calculation and interpretation of risk aversion coefficients.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
27
Q

How does increasing the expected value of return on assets (ra) to 7% affect leverage?

A

It increases the optimal leverage ratio to 2.56.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
28
Q

What is a key takeaway about firms and risk?

A

Firms generally dislike risk and prefer stable, expected returns.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
29
Q

Why should managers explore their own risk preferences?

A

To make informed decisions that align with their comfort level regarding risk.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
30
Q

What is the main message about optimal leverage ratios?

A

They are highly sensitive to rates of return, cost of debt, and the decision-maker’s attitude toward risk.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
31
Q

What is diversification in finance?

A

Diversification is an investing strategy used to manage risk by spreading investments across different companies, industries, and asset classes.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
32
Q

What is the key goal of diversification?

A

The goal is to own investments that do not move in lockstep, reducing overall portfolio risk.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
33
Q

Why is perfect correlation undesirable in a portfolio?

A

Perfect correlation means all investments move together, eliminating diversification benefits.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
34
Q

How does a correlation of -1 affect a portfolio?

A

A correlation of -1 means perfect negative correlation, maximizing diversification benefits.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
35
Q

What is a “perfect hedge”?

A

A perfect hedge occurs when two securities are perfectly negatively correlated, reducing portfolio volatility to a minimum.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
36
Q

What happens to portfolio volatility as correlation decreases?

A

Portfolio volatility decreases as correlation decreases, enhancing diversification benefits.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
37
Q

What is the impact of zero correlation on portfolio returns?

A

Zero correlation means the returns of securities are independent, providing diversification benefits without a linear relationship.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
38
Q

What is the standard deviation formula influenced by?

A

The formula is influenced by asset weights, individual volatilities, and the correlation between assets.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
39
Q

Why do negatively correlated assets improve a portfolio?

A

They reduce overall volatility and can provide a higher Sharpe ratio for the same level of risk.

40
Q

How does standard deviation combine in the case of perfect positive correlation?

A

With perfect positive correlation, variances add directly, leading to higher portfolio risk.

41
Q

What does Pearson correlation measure?

A

Pearson correlation measures the strength of a linear relationship between two variables.

42
Q

When is Pearson correlation ideal to use?

A

When data is normally distributed and relationships are linear.

43
Q

What is a limitation of Pearson correlation?

A

It fails to detect non-linear relationships.

44
Q

How does Spearman correlation differ from Pearson correlation?

A

Spearman correlation uses ranks of data points, making it better for non-linear or ordinal data.

45
Q

What are the advantages of Spearman’s correlation?

A

It is non-parametric and less sensitive to outliers or skewness.

46
Q

When does Spearman correlation fail?

A

It fails when relationships are non-monotonic.

47
Q

What does Kendall correlation focus on?

A

Kendall correlation focuses on concordant and discordant pairs in ranked data.

48
Q

Why is Kendall’s correlation often preferred over Spearman’s?

A

It is more robust and provides a better measure of ordinal data relationships.

49
Q

What is the significance of a correlation of 0 in portfolios?

A

It provides diversification benefits but does not ensure a linear or monotonic relationship.

50
Q

What happens in a portfolio with correlation -0.77?

A

The portfolio benefits from reduced risk and higher returns compared to individual assets.

51
Q

What is the efficient frontier?

A

The efficient frontier is a curve that represents optimal portfolios offering the highest returns for a given level of risk.

52
Q

Why is normality important for Pearson correlation?

A

Normality ensures the bounds of -1 and 1 for Pearson’s correlation coefficient are achievable.

53
Q

How does ranking affect Spearman’s correlation?

A

Rankings replace data points, allowing for correlation measurement irrespective of linearity.

54
Q

What is the result of perfect monotonicity in ranks?

A

Spearman’s correlation achieves a value of 1.

55
Q

What is the minimum variance portfolio?

A

It is the portfolio with the lowest possible standard deviation, often achieved with negative correlation.

56
Q

Can portfolio variance be less than individual asset variance?

A

Yes, if assets are sufficiently negatively correlated.

57
Q

What determines diversification benefits in multi-asset portfolios?

A

The correlation and weights of the individual assets.

58
Q

What is the Sharpe ratio, and how does diversification affect it?

A

The Sharpe ratio measures return per unit of risk, and diversification can increase it by reducing risk.

59
Q

Why do Pearson and Spearman correlations sometimes fail?

A

They fail when relationships are non-linear or non-monotonic, respectively.

60
Q

How are concordant and discordant pairs used in Kendall correlation?

A

They measure agreement in ranking between two datasets to compute the correlation coefficient.

61
Q

Suppose we have an equally weighted portfolio between A and B and that 𝑟𝐴=5%, 𝑟𝐵=11%, 𝜎𝐴=3%, 𝜎𝐵=8%, and 𝜌𝐴, 𝐵=1.0, 0.5, 0, -0.5, -1. What is the portfolio standard deviation in each case?

A
62
Q

What is the Nashville Area ETF (NASH)?

A

It is an exchange-traded fund (ETF) listed on the New York Stock Exchange that includes 24 companies headquartered in the Nashville area.

63
Q

When was NASH first listed on the New York Stock Exchange?

A

August 1st, at approximately $25 per share.

64
Q

What was the first ETF ever launched?

A

The first ETF launched was the SPY, created to track the S&P 500 Index.

65
Q

How is the Net Asset Value (NAV) of an ETF calculated?

A

NAV is the value of all the securities in the ETF, calculated at the end of the trading day when markets close. For international ETFs, NAV may be calculated before the U.S. market closes.

66
Q

What are Select SPDRs?

A

Select SPDRs are ETFs that focus on individual sectors of the S&P 500. They include sectors like Communication Services, Consumer Discretionary, Energy, Health Care, etc.

67
Q

What is the correlation matrix of S&P 500 sectors?

A

A correlation matrix shows the correlation between various sectors. For example, the correlation between Utilities (XLU) and Energy (XLE) is low, while Industrials and Financials show a high correlation.

68
Q

What are the main disadvantages of ETFs?

A

Disadvantages include broker commissions, bid-ask spread issues (especially for low-volume ETFs), high operating expenses, tracking errors, and potential lack of diversification in sector-specific ETFs.

69
Q

What are the main differences between passive and active ETFs?

A

Passive ETFs track an index with low management costs, while active ETFs aim to outperform the market with higher fees and management costs.

70
Q

How does the demand for a stock in an ETF portfolio change during index rebalancing?

A

Stocks added to an index experience increased demand, while stocks removed or downgraded may see reduced demand, affecting their stock price.

71
Q

What is a tracking error in ETFs?

A

Tracking error occurs when an ETF does not perfectly match the performance of the benchmark or index it is meant to track.

72
Q

What is sector selection in ETFs?

A

Sector selection involves understanding business and economic cycles to identify promising sectors, often using macroeconomic analysis to rotate investments across sectors.

73
Q

How does stock selection differ from sector selection?

A

Stock selection focuses on choosing individual companies based on analysis, while sector selection involves broader economic trends and sector performance.

74
Q

What is the reward of successful stock selection?

A

Successful stock selection can result in significant returns, potentially in the thousands of percent, unlike sector-wide investments.

75
Q

What is the role of active managers in active ETFs?

A

Active managers seek to outperform benchmarks by making decisions based on in-depth research, incurring higher costs but potentially generating higher returns.

76
Q

What is the general outcome when active ETF managers underperform?

A

Underperformance by active managers leads to higher costs and lower returns compared to passive ETFs.

77
Q

What is the main focus of the paper discussed?

A

The relationship between volatility (variance of returns) and the correlations between asset returns, specifically for the DAX and FTSE indices.

78
Q

What do fluctuations in correlations during periods of high volatility suggest according to the paper?

A

They may not represent true changes in the distribution of returns but rather predictable outcomes due to sampling volatility.

79
Q

How does using short-term data for estimating correlations and volatilities pose a risk?

A

Short-term data may understate correlations and overestimate diversification, leading to excessive risk-taking.

80
Q

What could happen if short-term data intervals are atypically stable?

A

Estimated volatilities might be too low, and correlations may be lower than average, misrepresenting the actual market risk.

81
Q

What happens when data from volatile periods is used to estimate correlations?

A

Correlations will be elevated, which could lead to overly cautious or risk-averse decisions.

82
Q

What does the paper recommend for risk managers regarding volatility and correlation?

A

Risk managers should account for both high and low volatility periods when estimating correlations and volatility.

83
Q

How should risk managers use historical data in stress testing?

A

They should incorporate periods of high volatility into stress tests to evaluate potential risks during volatile conditions.

84
Q

What role should supervisors of financial institutions play in assessing risk management practices?

A

Supervisors should be aware of the link between volatility and correlations and consider this when evaluating internal models and risk management practices.

85
Q

Why is it important to use both high and low volatility periods in risk modeling?

A

These periods contain important information that can affect the correlation between asset returns and, ultimately, portfolio risk.

86
Q

What does the paper suggest about the link between volatility and correlations in stress testing?

A

Stress testing must include the empirical fact that higher volatility periods are also likely to have elevated correlations.

87
Q

What are asset allocation ETFs?

A

Asset allocation ETFs invest in different asset classes, such as equities and fixed income. They often track a proprietary index and provide diversification by holding a mix of ETFs, referred to as a fund-of-funds.

88
Q

What are the benefits and drawbacks of asset allocation ETFs?

A

The benefit is extra diversification, but they come with added management fees, which may or may not be justified, depending on the investor’s situation.

89
Q

How did the UK gilt market perform in January 2022?

A

The UK gilt market had high yields, rising to their highest level since the COVID-19 pandemic began, in anticipation of the Central Bank raising interest rates. This led to a decrease in bond prices as interest rates increased.

90
Q

How did Bitcoin perform in January 2022?

A

Bitcoin dropped 17.2% from January 18-22, 2022, but then regained the losses with a 20.9% return between January 22 and February 6, 2022, illustrating Bitcoin’s volatility.

91
Q

How did technology ETFs and NASDAQ perform on February 3, 2022?

A

On February 3, 2022, technology ETFs like Invesco, SMH, and ARKW declined by 2.4%, and the NASDAQ dropped 3% in a single day.

92
Q

What happened to Meta’s market value on February 3, 2022?

A

Meta (formerly Facebook) dropped 26%, losing $251 billion in market value, the largest drop in market capitalization in history.

93
Q

What correlation exists within asset classes and sectors?

A

There are high correlations within asset classes and sectors, especially when the entire industry is affected by a common factor, like the pandemic in 2020.

94
Q

What happens to correlations during times of high volatility?

A

Correlations tend to increase during periods of high volatility, which can reduce diversification when it is most needed.

95
Q

What is the relationship between volatility and correlation?

A

The relationship is that when volatility is low, correlations tend to be lower. However, when volatility is high, correlations between asset classes tend to increase.

96
Q

What does high volatility do to portfolio diversification?

A

High volatility can “pull away” diversification by increasing correlations, making diversification less effective during market stress.

97
Q

How can changing correlations affect portfolio risk?

A

Changing correlations, especially during volatile markets, can alter risk assessments and potentially lead to greater risk exposure than anticipated.