FM W4 Flashcards
rate of return formula
Rate of return = (Pt+1 - Pt + Cash Payments) / Pt
what is the EMH
Rate of return (optimal forecast) = Rate of return (expectation)
what are the 3 definitions of EMH
- Weak form - prices reflect information on past prices.
- Semi-strong - info on past prices but all publicly available info.
- strong - past prices, public info and private info that can be possibly acquired.
what are the theoretical implications of EMH
- Weak - asset prices follow a random walk.
- Semi - prices adjust immediately to news.
- no fund manager can ever beat the market, other than luck.
how to test the weak form
show that price changes are independent over time.
how to test semi
check if stock prices jump following any news.
how to test strong
check if any fund manager is able to beat the market.
what is some unfavourable evidence of weak form
- Small-firm effect = earned abnormally high returns.
- Calendar patterns = Days of the week, months etc.
- Market overreaction = stock prices overeat to news and pricing errors are corrected only slowly.
how can one isolate the announcement effect
Abnormal return = Actual return - Expected return.
what is a derivative
a financial instrument who’s value depends on the value of some other financial instrument, called the underlying asset.
how do they differ to outright purchases of bonds
easy way for investors to profit from price declines. one person’s loss is always another person’s gain.
what is the main purpose of derivatives
transfer risk from one person to another
what is a forward (contract)
an agreement between a buyer and a seller to exchange a commodity or financial instrument for a specified amount of cash on a specified date.
what is a future (contract)
a forward contract that has been standardised and sold through an organised exchange.
what is a clearing corporation
acts as an insurance company, guarantees parties meet their obligations, lowering risk for buyers and sellers.
what is a margin
a deposit placed by both parties, guaranteeing both parties will meet their obligation.
what is marking to market
clearing corporations post daily losses/gains on the contract to the margin account of the parties involved.
what is arbitrage
the practice of buying and selling financial instruments in order to benefit from temporary price changes.
what will happen if the price of a bond is higher in one market than another
- Arbitrageur buys at low price and sell at high price.
- Increases demand in one market and increases supply in other.
- increased demand = increased price in one market.
- increased supply = decreased price in other market.
- this continues until prices are equal in both markets.
what are options, seller, buyer and call option
options = agreement between 2 parties.
seller = writer.
buyer = holder.
call option = the right to buy a given quantity of an underlying asset at a predetermined price called the strike price.
what is the formula for option price
option price = intrinsic value + time value of the option.
intrinsic value is the value of option if it exercised immediately.
time value of the option is the fee paid for the option’s potential benefits.
what does the value of a financial instrument depend on
- size of promised payment.
- timing of payment.
- likelihood payment is made.
- circumstances under the payment will be made.
what are swaps
contracts that allow traders to transfer risks just like derivatives.
what are interest-rate swaps
allow one swap party, for a fee, to alter the stream of payments it makes or receives.
what are credit-default swaps
form of insurance that allow a buyer to buy a bond or mortgage without bearing its full default risk.
what is the swap rate
the rate to be paid by the fixed-rate payer. it is the benchmark rate + premium.
how did CDS contribute to the Financial Crisis
- uncertainty about who bears the credit risk on a given loan or security.
- the leading CDS sellers became vulnerable.
- became easier for sellers of insurance to assume and conceal risk.
