Guiding seminar 2 (2020)

Question 1

Anomalies: The Law of One Price in Financial Markets

What is the law of one price?

Answer 1

The Law of One Price: if there are no transaction costs or other constraints (e.g. short selling), identical goods must have identical prices

Motivation: should two identical goods be traded at different prices, arbitrageurs will immediately step in and exploit the arbitrage opportunity
An arbitrage opportunity is an option to make a riskless profit by trading in misprices assets

Question 2

Anomalies: The Law of One Price in Financial Markets

Why doesn’t the law of price hold?

Answer 2

In financial markets, not all of these conditions hold:
▪ Not all goods have close or any substitutes (GM shares; the whole US stock market)
▪ Financial markets often are fragmented (think of foreign investors)
▪ Arbitrage opportunities are hardly ever completely riskless. Oftentimes, they are good but risky bets
–> short selling forbidden in some countries (?)

Question 3

Anomalies: The Law of One Price in Financial Markets

What is a closed-end country fund and why does the law of one price not hold within it? (Claim and refute)

Answer 3

Closed-end country funds (i) invest significant amounts in foreign securities (e.g. $1bn);

(ii) issue shares representing ownership in the fund (e.g. 10m shares) and list them on a stock exchange;
(iii) the shares are traded like those of a regular company; (iv) the fund’s

CFs (from dividends or sale of company shares) are distributed to shareholders or reinvested (1-2% annual management fee). The relationship between the fund prices and net asset values (NAVs) can vary across
funds and time with both huge discounts and premia (due to manager’s fee) –> NAV and the the price of the fund should be equal

• ->Argument: the two assets (the fund’s shares and the underlying basket) are not precisely identical – the fund portfolio manager charges a fee and incurs other expenses (CF to the basket and to the fund’s shareholders are not identical) or has a superior stock-picking abilities
• ->Refute: This could justify only moderate discounts/premia. + In practice there is little relation between discounts/premia and fund performance

–>Argument: the premium of country funds could be due to legal barriers preventing investors from buying foreign stock (i.e. LOP may not hold due to market fragmentation or in presence of significant transaction costs)
–> Taiwan country fund story: shortly after its launch in the U.S., the country fund traded at a 205%
premium (the premium stayed above 100% for 10 weeks and above 50% for 30 weeks..)

• ->Argument: legal barriers prevented U.S. investors from buying Taiwanese stocks directly
• ->But why pay so much? (equivalent to paying $1 for $0.33 of assets).In other cases premiums persisted even in the absence of trading barriers:

• German country fund story: after Berlin wall fell, the fund value rose more than the value of
underlying stocks – from trading at a 9% discount to a 100% premium; after the euphoria in the
U.S. wore off, the premium fell close to 0%
But U.S. investors were free to invest directly in Germany

Question 4

Anomalies: The Law of One Price in Financial Markets

What examples did the authors provide to show that the law of one price does not hold?

Answer 4

1. Closed-end country funds (market price vs NAV)
2. American Depositary Receipts (ADRs)- Infosys story- American investors pay huge premiums to ADRs to have shares in a company in India, while prices are low in domestic India’s markets.
3. Twin shares (two types of shares with fixed claims of assets and cash flows)- Royal Dutch shares got 60% of company’s profits, while Shell shares only 40% event though the same company.
4. Dual class shares (identical CFs but different voting rights)- Molex story- when voting shares were added to S&P 500, the premium rose 49%.
5. Corporate spinoffs (3com created a new division Palm–> 1 share of 3com had an embedded share of 1.5 Palm shares)

Question 5

Anomalies: The Law of One Price in Financial Markets

What is Long-Term capital management? What is a noice-trader risk?

Answer 5

Long-Term Capital Management: a venerable multi-billion hedge fund trading mainly in fixed income securities (making bets on the convergence of bond spreads). Had a range of converge-divergence exposures in equities as well.
Fell victim of the “noise trader” risk. Even though spreads between identical assets should in theory be eliminated, in practice they can stay constant or even widen for longer than any arbitrageur can sustain their position

Question 6

Anomalies: The Law of One Price in Financial Markets

What prevents arbitraguers from enforcing the law?

Answer 6

What prevents arbitrageurs from enforcing the Law:
i) Short selling constraints:
• Lendable supply of shares or products is limited (most of shares held by noninstitutional investors – Palm) + legal barriers to foreign trading (country funds)
• Transaction costs
ii) Noise trader risk: after an arbitrageur takes a position, the disparity can widen →
margin calls → forced to liquidate the position at a loss (think LTCM)

Question 7

Anomalies: The Law of One Price in Financial Markets

What is the concluson about the violations of law of one price?

Answer 7

Violations of the Law generally do not create arbitrage opportunities (sure profits with no
risk) – they create good but risky bets

Question 8

Forensic Finance

What is forensic investigation?

Answer 8

Forensic investigation: using scientific knowledge (chemical traces, DNA, prices,
quantities, market institutions, etc.) to collect and sift evidence of possible crimes

Question 9

Forensic Finance

What were the findings by forensic investigators?

Answer 9

1. NASDAQ stocks being quoted in even-eights of a dollar, wlthough one-eights were allowed–> dealers colluding to keep the bid ask spread wider
2. Late trading of mutual funds- can trade on the market’s price of the fund’s portfolio (NAV) calculated once per day (4 pm EST), orders received after 4pm should be executed at tomorrow’s NAV, however, some brokerage firms were allowed to submit their orders after 4pm–> not fair since many firms announce news after 4 pm on purpose). firms choose granting date after having observed on what date during month the stock had the lowest price) (Apple example with Steve Jobs). –> Sarbanes-Oxley Act- executives are obligated to report insider trades within 2 business days of the transaction.
3. Spinning of IPOs- IB receives an order to buy shares, but if the order is oversubscribed, the IB can allocate the shares how it wants (since usually IPO offer price is lower than the market price). IB often allocate underpriced (‘hot’) IPOs to the personal brokerage accounts. (Bernie Ebbers scandal).
4. Rewriting the history of market recommendations- I/B/E/S –> Thompson Financial claimed that it was a programming error.

Question 10

Forensic Finance

What is spring loading? Option backdating?

Answer 10

Employee stock option backdating- market price of the stock can’t be higher than the exercise price–> firms choose granting date after having observed on what date during a month the stock had the lowest price).
Spring loading- granting options immediately before the announcement of good news.
Bullet dodging- a shady employee stock option granting practice, in which the granting of the options is delayed until a piece of really bad news involving the company has been made public and the stock’s price falls. (Investopedia)
Sarbanes-Oxley Act- executives are obligated to report insider trades within 2 business days of the transaction.

Question 11

Forensic Finance

What are the reasons for option backdating?

Answer 11

• Managers are receiving an increased value directly if and when the options are exercised
• Employees should be willing to accept lower wages if offered cheap options (boosts reported
profits)
• The value of exercised options is deductible from taxable income (conserving cash through
paying less tax)

Question 12

Forensic Finance

What is meant by spinning?

Answer 12

Spinning of IPOs- IB receives an order to buy shares, but if the order is oversubscribed, the IB can allocate the shares how it wants (since usually IPO offer price is lower than the market price). IB often allocate underpriced (‘hot’) IPOs to the personal brokerage accounts. (Bernie Ebbers scandal).

Question 13

Should We Fear Derivatives?

What are derivatives? What are the types of derivatives?

Answer 13

financial instruments whose promised payoffs are derived from the value of the “underlying” (level of S&P 500, winner of the presidential elections, number of bankruptcies, amounts of rainfall, etc.)
• Plain vanilla: forwards, futures, options, and their combinations (e.g.
swaps)
• Exotic: complicated function of one or more underlyings (rainbow, binary,
cash or share, Bermudan, etc.)
The derivative must be worth the same as the replicating portfolio if financial markets are frictionless, since otherwise there’s an arbitrage
opportunity
First ever options on tulip bulbs in Holland and futures market for rice in Japan

Question 14

Should We Fear Derivatives?

Who uses derivatives and why?

Answer 14

–>Nonfinancial firms (59.8% of them do):
• Reduce their stock volatility by 5%, interest rate risk exposure by 22%, and foreign exchange risk
exposure by 11%
• Minimize accounting earnings volatility
• Reduce the present value of their tax liabilities
• Underuse derivative to increase the value of managerial stock options
• Speculate
–>Financial firms (banks and IBs):
• Trade derivatives to profit (96.6% of the portfolio)
• Manage risk (3.4% of the portfolio)
–>The use of derivatives by individuals is very limited, as they cannot hedge through derivatives the
risk associated with the value of their house or the value of their human capital

Question 15

Should We Fear Derivatives?

What are the benefits of derivatives?

Answer 15

–> Improved risk allocation (risk is taken by investors who are in the best position to
bear the risk)
–> Enhanced information efficiency of the underlying securities’ markets (e.g.
through futures, CDSs, etc.) Especially if the underlying security is illiquid
–> Cheaper than replication (much lower transaction costs, circumvent the need for
continuous trading in replicating portfolios)
–> Hedging: derivatives render previous unhedgeable risks hedgeable (think weather
derivatives). Expanding investment opportunities: with more refined handling of risk, investors’
investment universe is markedly widened

Question 16

Should We Fear Derivatives?

What are the risks of derivatives?

Answer 16

• -> Derivatives are often very difficult to value properly due to their illiquidity and
  complexity. The neat assumptions used in theory (e.g. those underpinning the BMS
  model) are often invalid in practice
• -> Liquidity. Many derivatives are at best thinly traded (non-standardized products in OTC markets). This makes certain derivative positions hard to get out of
• -> Derivatives may create complicated webs of exposures among many financial institutions (systematic risk). If a systemically-important actor (typically large in size and well-connected) faces imminent trouble, its counterparties may rush for the exit (unwind their positions) (LTCM)
• -> Firms’ reporting of derivative positions and related risks is imperfect
• -> Perverse incentives: derivatives may generate superior absolute but not riskadjusted profits. Firms may be incapable of accounting for all the associated risks. Their tools are often too blunt

Question 17

Hedge Funds: Past, Present, and Future

What is the difference between mutual and hedge funds?

Answer 17

Mutual funds- heavily regulated, large in size with small initial investment, passive or active, almost anyone can become an investor, simple investment strategies, investors allowed to withdraw funds daily, obligated to disclose a lot of information.
Hedge funds- relatively unregulated, smaller in size with larger initial investment, actively managed, issue securities privately, fund returns don’t depend on market returns, complex investment strategies, restric the abilitiy of investors to withdraw funds, lack of disclosure makes proper risk evaluation very difficult).

Question 18

Hedge Funds: Past, Present, and Future

What are the 5 hedge fund strategies?

Answer 18

1) Long-short equity (31%) and (more broadly) convergence/divergence strategies seek to exploit temporary mispricings between identical or very similar assets. e.g. two similar oil companies trading at different valuations. Buy the cheap one and short the expensive one (equal $ amounts), obtain a market-neutral strategy
2) Event-driven strategies (20%) are aimed at trading around market-moving events with a view to exploiting erroneous investor sentiment or superior information & timing
3) Macro strategies (10%) seek to identify mispricings in equity markets, interest rates, FX, commodities. Use a top-down approach to research
4) Fixed-income arbitrage (8%) strategies attempt to find arbitrage opportunities in the fixed-income markets
5) Multi-strategy funds (13%) combine two or more of the existing strategies

Question 19

Hedge Funds: Past, Present, and Future

What are funds-of-hedge-funds ?

Answer 19

Since there are no investable hedge fund indices, you can invest in a fund-of-hedge-fund- a fund that invests in many hedge funds providing diversification across multiple HFs for its investors.

Question 20

Hedge Funds: Past, Present, and Future

What are the problems with evaluating the risk-adjusted performance of hedge funds?

Answer 20

▪ Biased sample due to voluntary reporting
▪ Difficult to measure risk-adjusted returns due to complex strategies with complex derivatives
and non-linear payoffs
▪ Black swans or low-probability events of severe magnitudes may not be observed within a single
fund’s lifetime. Thus, the true risks may be underestimated
▪ Problems of valuation of OTC-traded securities. Managerial discretion in such valuation leads to
serially-correlated returns (smoothing returns)
On average, hedge funds generate positive but insignificant alphas
Moreover, performance tends to persist, according to some studies. Hence, it makes sense to invest
in top-performing hedge funds

Question 21

Hedge Funds: Past, Present, and Future

What are the risks associated with hedge funds?

Answer 21

1) Investor protection: Annually, 10% of hedge funds discontinue their operations. Some do so because
of poor performance, other because of fraud
2) Risks to financial institutions: hedge funds borrow extensively to make leverage bets and act as
counterparties in many derivatives positions (think LTCM)
3) Liquidity risk: Hegde funds often tend to pile in and out of the same trades at the same time. Liquidity
may evaporate, prices overreact → asset value plummet → vicious cycle. (i.e. if many hedge funds have established similar positions, they may be unable to get out of these positions when prices turn against
them)
4) Excess volatility risk: Evidence exists on both sides of the argument, no rock-solid conclusions (i.e. in
some cases hedge funds have been praised for having stabilized the markets)

Question 22

Hedge Funds: Past, Present, and Future

What is the future of hedge funds?

Answer 22

▪ The prospects for greater regulation of hedge funds, which will make them more similar to mutual
funds, are very real
▪ The discretion of hedge fund managers will decline as they acquire more institutional investors with
fiduciary duties of their own (less risk taking and more disclosure)
▪ Growing industry will result in more hedge funds chasing the same price discrepancies (less profitable)

Question 23

Prone to Fail: The Pre-Crisis Financial System

What is Dealers/market makers?

Answer 23

Dealers/market makers: make markets by buying securities from investors who want to sell, then selling them to investors who want to buy. Dealers hold securities on their balance sheets in order to provide immediacy to sellers and to have a stock on hand for buyers

Question 24

Prone to Fail: The Pre-Crisis Financial System

What is Repos (repurchase agreements)?

Answer 24

Repos (repurchase agreements): on each repo, a dealer transfers securities as collateral to its creditor, and in turn receives cash. When an overnight repo matures the next morning, the dealer is responsible for returning the cash with interest, and is given back its securities collateral

Question 25

Prone to Fail: The Pre-Crisis Financial System

What is Tri-party repos?

Answer 25

Tri-party repos: cash investors in repos (e.g. money market mutual funds, securities lending firms) often held the collateral securities provided to them by dealers in accounts at two “tri-party” agent banks, J.P. Morgan Chase and Bank of New York Mellon (only 2 in the pre-crisis period). Likewise, these repo investors transferred their cash to the dealers’ deposit accounts at the same two tri-party banks.

Question 26

Prone to Fail: The Pre-Crisis Financial System

What is Credit crunch?

Answer 26

Credit crunch: a decrease in lending by financial institutions —> reduced availability of loans/credit 27 irrespective of interest rates, frequently an outcome of “flight to safety”

Question 27

Prone to Fail: The Pre-Crisis Financial System

The four key sources of fragility

Answer 27

1. Weakly supervised balance sheets of the largest banks and investment banks
   —> The factor receiving the highest average importance rating in both the European and the American polls was “flawed financial sector regulation and supervision”
   —> The greatest danger to the functionality of the core of the financial system was posed by five systemically large dealers: Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley
2. The run-prone designs
3. Weak regulation of the markets for securities financing and over-the-counter derivatives
4. The undue reliance of regulators on “market discipline.”
   —> US regulators often argued that market discipline would support adequate levels of capital and liquidity at the major banks and investment banks, and that aggressive regulation was unnecessary or counter-productive;
   —> The interplay of too-big-to-fail and the failure of market discipline
   —> The socially excessive and weakly supervised leverage of the largest financial institutions was essentially subsidised by the government through the presumption by creditors that these firms were too big to fail, i.e. creditors apparently assumed that the biggest banks were too important to be allowed by the government to fail and thus creditors would not take losses if any of the largest banks or investment banks were to approach insolvency.

Question 28

Prone to Fail: The Pre-Crisis Financial System

Why was the pre-crisis supervision so ineffective?

Answer 28

1. The SEC’s original mission is to protect the customers of financial firms, which crowded out a parallel focus on financial stability —> a financial regulator with inappropriate goals
2. It was simply too difficult for regulators to detect the excessive buildup of risk and flight-prone short- run debt and derivatives in the core of the pre-crisis financial system, especially given significant financial innovation and complexity
3. Investors and policymakers assigned irrationally low probabilities to disaster outcomes, especially with respect to the performance of the housing market
   —> Gennaioli and Shleifer: “put inaccurate beliefs at the center of the analysis of financial fragility.” = underestimated risks
4. Regulators placed undue reliance on market discipline
5. The historical US emphasis on a decentralised banking system —> “financial crises occur when banking systems are made vulnerable by construction, as the result of political choices.”

Question 29

Prone to Fail: The Pre-Crisis Financial System

How did regulation work prior to the crisis?

Answer 29

In 2002, the European Union introduced rules that required financial intermediaries operating in the EU to have a consolidated regulatory supervisor.
All five of these investment banks elected to be supervised by the SEC

Question 30

Prone to Fail: The Pre-Crisis Financial System

What was the SEC actually supervising?

Answer 30

From a financial stability perspective, a key concern is that the SEC’s supervision of risk-taking by the investment banks focused mainly on the protection of the customers of the investment banks from losses rather than on the solvency of their balance sheets and the attendant systemic risks. —> the SEC’s mission “stresses ex post enforcement over ex ante prudential guidance” (Bhatia 2011);
i.e. “the SEC’s job was not to tell the banks how to run their companies but to protect their customers’ assets.”

The lax supervision of capital adequacy by the Securities and Exchange Commission seemed to be clearly understood by the big investment banks. The Financial Crisis Inquiry Commission (2011) noted: “In January 2008, Fed staff had prepared an internal study to find out why none of the investment banks had chosen the Fed as its consolidated supervisor… the biggest reason firms opted not to be supervised by the Fed was the “comprehensiveness” of the Fed’s supervisory approach, “particuarly when compared to alternatives such as Office of Thrift Supervision (OTS) or Securities & Exchange Commission (SEC) holding company supervision”

Question 31

Prone to Fail: The Pre-Crisis Financial System

Background of the situation?

Answer 31

Credit provision in the United States is significantly more dependent on capital markets rather than on conventional bank lending.
The intermediation of US capital markets relies heavily on the largest dealers (subsidiaries of the investment banks and large commercial banks), who, before the crisis, financed enormous quantities of inventoried securities with very short-term debt
—> Risks: (1) creditor runs and (2) fire-sale losses

The crisis of 2007–2009 manifested itself in new forms of short-term debt runs in which repurchase agreements (repos) played a major role. Before the crisis, each of the major dealers—Goldman Sachs, Morgan Stanley, Lehman, Bear Stearns, and Merrill Lynch—obtained hundreds of billions of dollars in overnight credit in the repo market.
Each morning in the pre-crisis period, when the dealers’ repos matured and they repaid the cash investors, the dealers needed intra-day financing for their securities inventories until new repos could be arranged and settled near the end of the same day. This intra-day credit was provided by the tri-party agent banks. Even “term” repos that had not matured on a given day were temporarily cashed out in the morning and financed during the day by the tri-party banks for operational simplicity.
—> up to $2.8 trillion in intra-day financing was provided to the dealers every day by the two tri-party agent banks —> systemic risk (on top of the two agents being large creditors)…

Question 32

Prone to Fail: The Pre-Crisis Financial System

Regulatory response since the crisis?

Answer 32

1. The elimination of intra-day credit provision by tri-party agent banks.
2. The securities inventories themselves are also much smaller —> the need for financing
   has been reduced
3. Because of the declining presumption by bank creditors of “too big to fail,” dealer
   financing costs have gone up substantially, so the incentive to hold giant inventories is
   much reduced.
4. The dependence of dealers on flight-prone financing from money market mutual funds has
   been lowered by a tightening of the regulation of those money funds.
5. Bank capital requirements now apply to all large dealers at the holding company level.
6. The two surviving investment banks, which had not been regulated as “banks,” took
   banking charters and thus became regulated as banks; substantial new bank liquidity coverage regulations have been introduced, forcing runnable short-term financing to be covered by a stock of high-quality liquid and unencumbered assets

Question 33

Prone to Fail: The Pre-Crisis Financial System

Remaining concerns?

Answer 33

the ability to resolve the failure of central counterparties, which have become enormous concentrations of risk under post-crisis regulations
—> e.g. If a clearinghouse has insufficient resources to manage the default of the derivatives obligations of a clearing member, the consequences could be catastrophic, now that hundreds of trillions of derivatives have been cleared by a small number of systemically important central counterparties
—> The cessation of payments to clearing members and tear-ups could be catastrophic, and contagious

Question 34

Prone to Fail: The Pre-Crisis Financial System

Two basic assumptions that are wrong?

Answer 34

! Evidence from the crisis of 2007–2009, however, soundly rejects the power of market discipline to maintain financial stability
—> Two basic assumptions that are wrong:
1. ’Banks can be relied upon to provide rigorous risk control.’
In reality banks’ internal risk management and control functions were often ineffective in the run-up to the crisis and were usually trumped by the pressure to do profitable business.
2. ‘Markets will always self-correct.’
A deference to the self-correcting property of markets inhibited supervisors from imposing prescriptive views on banks.
—> Reliance on market discipline implies an assumption that excessive risk-taking by a financial intermediary will be limited by the intermediary’s cost of debt financing, based in turn on creditors’ perceived risk of losses at insolvency. However, before the financial crisis, there was nothing close to a realistic plan for how to resolve the insolvency of systemically important financial firms without triggering or deepening a crisis. This created a presumption among creditors that the largest banks were “too big to fail.” —> despite their thin pre-crisis solvency buffers, the big banks and investment banks experienced what is in retrospect an amazingly low cost of credit.