GS5 Flashcards

Question

Credit default swaps and the credit crisis. | Drawbacks of CDS?

Answer 1

- Less incentives in loan monitoring - Perverse incentives of investors - Investors take riskier positions - Lower regulatory capital requirements in case of protection by CDS - Web exposure - short positions destabilize the market

Answer 2

1) A clearinghouse can diversify and manage risks associated with the failure of individual investors→ counterparty risk reduced 2) If a single clearing house is used, it can net out all the dealer’s exposure → counterparty exposure reduced 3) A clearinghouse can monitor the exposure of counterparties and prevents them from taking additional exposures

Answer 3

1) Investors and financial institutions did not expect such a dramatic fall in real estate prices - > large falls and in the value of mortgages-backed securities 2) Many financial institutions were operating with extremely high levels of leverage in investing in subprime securitizations → losses on these investments made market participants insolvent Larger CDS market might have benefited the financial system if it was even larger (and more robust)→ more useful information about the development of the market

Answer 4

• Does not interact with capital markets directly • ETF manager is in a legal contract with “Authorized Participants” – typically large financial institutions who interact with the market Investors mostly do not trade the fund directly. Instead, they trade on an exchange or with Authorized Participants -> no transactions in the underlying securities -> reduced transaction costs Trades occur at a market-determined price (Mutual fund - net asset value)

Answer 5

1) Investors may have poor financial knowledge to distinguish between the types of ETFs (e.g. levered funds, or based on unsecured debt) 2) Intraday liquidity can cause “too much” trading. Investors who trade actively suffer lower returns than those who trade less. 3) Rapid growth in index investing poses challenges for ordinary investors.

Answer 6

1. Equity ETFs (Market cap based ETFs, Sector ETFs, Smart Beta ETFs); 2. Fixed income ETFs; 3. Commodity ETFs.

Answer 7

1) Bond ETFs are traded on electronic exchanges – convenient (unlike opaque OTC markets for traditional bonds) 2) Offer higher transparency - bid/ask quotes are readily available 3) Offer greater liquidity and diversification

Answer 8

1) Closures of exchange-traded funds (the price should converge to its NAV - if debt obligations are secured) 2) Short selling of ETFs (number of simultaneous redemptions would exceed available assets to be redeemed) 3) Liquidity mismatch (ability of Authorized Participants (APs) to acquire the underlying assets and transfer them to the ETF. The chance that an AP steps away in a crisis may pose systematic risk).

Answer 9

• Index trackers are typically based on market capitalization weighted schemes -> pricing errors in underlying stocks might feed on themselves • Index funds are price-takers, not price-makers • The impact of a “basket” security on liquidity and distortion of prices of the underlying market is unclear • Relative scale of index investing is fastly growing

Answer 10

1) it no longer meets the listing requirements, which is typically due to financial distress 2) it has been acquired (There is evidence that mergers are the dominant reason for delisting) 3) it voluntarily delists

Answer 11

1) The number of listed firms is decreasing; | 2) Public firms are more old than private

Answer 12

1) firms have become larger (increase by 290% in the 18 years since 1997); 2) concentration within industries can increase, which could possibly adversely affect competition. Herfindahl Index: industries are on average much more concentrated now than 20 years ago, but less than 40 years ago

Answer 13

1) The increase in the importance of intangible assets: listed firms have a much lower average ratio of capital expenditures to assets and a much higher ratio of R&D expenditures to assets in 2015. 2) Inventory holdings fall due to the introduction of just-in-time production processes. 3) Hold more cash – especially firms with more intangible assets and more R&D expenditures.

Answer 14

- Larger firms have a higher ratio of cash flow to assets à firms have been performing poorly on average, except for the largest firms. - A dramatic increase in the concentration of the profits and assets of US firms - top 30 firms earn 50% of the total earnings of the US public firms.

Answer 15

1) leverage falls dramatically 2) asset weighted book leverage ratio rises but drops sharply after the financial crisis 3) “net leverage ratio” (debt minus cash over total assets) - falls steadily and in almost all years since 2003, !the average public firm has more cash than debt! - bank loans have become less important.

Answer 16

Institutional ownership of common stock is much higher now.

Answer 17

Fraction of small public firms has dropped dramatically. May be due to: 1) firms don’t want to disclose their projects 2) public markets have become dominated by institutional investors (small firms don’t have enough scale) 3) developments in financial intermediation and regulatory changes have made it easier to raise funds as a private firm (from PE and VCs) 4) economies of scope hypothesis: small firms have become less able to grow on their own 5) increased concentration could also make it harder for small firms to succeed on their own 6) difficult for small firms to grow without acquiring patents 7) it has become easier to put a new product on the market without hard assets -> Via renting & outsourcing, capex is smaller -> no need to go public & raise large amounts