FM W4

Question 1

rate of return formula

Answer 1

Rate of return = (Pt+1 - Pt + Cash Payments) / Pt

Question 2

what is the EMH

Answer 2

Rate of return (optimal forecast) = Rate of return (expectation)

Question 3

what are the 3 definitions of EMH

Answer 3

1. Weak form - prices reflect information on past prices.
2. Semi-strong - info on past prices but all publicly available info.
3. strong - past prices, public info and private info that can be possibly acquired.

Question 4

what are the theoretical implications of EMH

Answer 4

1. Weak - asset prices follow a random walk.
2. Semi - prices adjust immediately to news.
3. no fund manager can ever beat the market, other than luck.

Question 5

how to test the weak form

Answer 5

show that price changes are independent over time.

Question 6

how to test semi

Answer 6

check if stock prices jump following any news.

Question 7

how to test strong

Answer 7

check if any fund manager is able to beat the market.

Question 8

what is some unfavourable evidence of weak form

Answer 8

1. Small-firm effect = earned abnormally high returns.
2. Calendar patterns = Days of the week, months etc.
3. Market overreaction = stock prices overeat to news and pricing errors are corrected only slowly.

Question 9

how can one isolate the announcement effect

Answer 9

Abnormal return = Actual return - Expected return.

Question 10

what is a derivative

Answer 10

a financial instrument who’s value depends on the value of some other financial instrument, called the underlying asset.

Question 11

how do they differ to outright purchases of bonds

Answer 11

easy way for investors to profit from price declines. one person’s loss is always another person’s gain.

Question 12

what is the main purpose of derivatives

Answer 12

transfer risk from one person to another

Question 13

what is a forward (contract)

Answer 13

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.

Question 14

what is a future (contract)

Answer 14

a forward contract that has been standardised and sold through an organised exchange.

Question 15

what is a clearing corporation

Answer 15

acts as an insurance company, guarantees parties meet their obligations, lowering risk for buyers and sellers.

Question 16

what is a margin

Answer 16

a deposit placed by both parties, guaranteeing both parties will meet their obligation.

Question 17

what is marking to market

Answer 17

clearing corporations post daily losses/gains on the contract to the margin account of the parties involved.

Question 18

what is arbitrage

Answer 18

the practice of buying and selling financial instruments in order to benefit from temporary price changes.

Question 19

what will happen if the price of a bond is higher in one market than another

Answer 19

1. Arbitrageur buys at low price and sell at high price.
2. Increases demand in one market and increases supply in other.
3. increased demand = increased price in one market.
4. increased supply = decreased price in other market.
5. this continues until prices are equal in both markets.

Question 20

what are options, seller, buyer and call option

Answer 20

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.

Question 21

what is the formula for option price

Answer 21

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.

Question 22

what does the value of a financial instrument depend on

Answer 22

1. size of promised payment.
2. timing of payment.
3. likelihood payment is made.
4. circumstances under the payment will be made.

Question 23

what are swaps

Answer 23

contracts that allow traders to transfer risks just like derivatives.

Question 24

what are interest-rate swaps

Answer 24

allow one swap party, for a fee, to alter the stream of payments it makes or receives.

Question 25

what are credit-default swaps

Answer 25

form of insurance that allow a buyer to buy a bond or mortgage without bearing its full default risk.

Question 26

what is the swap rate

Answer 26

the rate to be paid by the fixed-rate payer. it is the benchmark rate + premium.

Question 27

how did CDS contribute to the Financial Crisis

Answer 27

1. uncertainty about who bears the credit risk on a given loan or security.
2. the leading CDS sellers became vulnerable.
3. became easier for sellers of insurance to assume and conceal risk.