HWs Flashcards
Difference b/w real and financial assets
Material wealth of the country is determined by the productive capacity (the goods and services the members can produce). This capacity is a function of the real assets in the economy: land, buildings, knowledge, machines.
Financial securities do not contribute directly to production capacities (computer entries or sheets of paper). These are means by which people in well-developed countries hold claims on real assets.
Financial assets - claims on the income generated from real assets (or income by government)
Real assets generate net wealth. Financial asset define the allocation of this wealth among investors.
Real assets - only asset side of BS. Financial - on both.
Return on financial assets, in fact, comes from income gained from real assets that were financed by issuance of those securities.
Financial engineering - paper shuffling?
Financial engineering allows for a change in the risk and return pattern of traditional securities.
Treasury strips allow lending money to the government without incurring reinvestment risk.
MBS allow for lending money to home buyers with lower prepayment and default risk.
Claims on a large pool of underlying assets may be worth more due to redistribution of risks.
Preferred stock like equity? Like long-term debt?
Debt:
Dividends usually remain constant
Fixed claim on assets in case of bankruptcy
Does not give voting rights
Equity:
Part of stockholders’ equity
Dividends, after all, not interest
The failure to make a payment on preferred stock does bot set trigger bankruptcy.
Money market securities - as cash equivalents?
Liquidity
Low default risk
The prices are very stable and they can be converted to cash on very short notice with low transaction costs
Primary and secondary market transactions?
Primary: investors buy securities directly from the companies issuing them (IPO, private placement, rights issue)
Secondary: investors trade securities among themselves (often more costly, NYSE)
Primary market transactions: purchase of initial shares of publicly traded company stocks by wealthy individuals or institutional buyers
Secondary market transactions: purchases and sales of previously issued securities through regulated stock exchanges
asset allocation/security selection
Asset allocation is a broad strategy that determines the mix of assets to hold in a portfolio for an optimal risk-return balance based on an investor’s risk profile and investment objectives. Security selection is the process of identifying individual securities within a certain asset class that will make up the portfolio. Both are key components of an investment strategy, but they require separate and distinct methodologies.
Financial engineering has been disparaged as nothing more than paper shuffling. Critics argue that resources used for rearranging wealth (that is, bundling and unbundling financial assets) might be better spent on creating wealth (that is, creating real assets). Evaluate this criticism. Are any benefits realized by creating an array of derivative securities from various primary securities?
Over time, traditional financial assets such as stocks, bonds and mortgages have developed specific types of payment patterns, risks and returns. For example, government bonds have semi-annual coupons so the bond holder incurs reinvestment risk if the coupon income is not spent. Mortgage loans have a prepayment option so the mortgage lender risks the return of the loan principal when rates decrease. Almost all debt contracts incur the risk that the borrower will not repay the loan (default or credit risk). Financial engineering allows for a change in the risk and return patterns of traditional securities. Treasury Strips, for example, allow lending money to the US government without incurring reinvestment risk. Mortgage backed securities allow for lending money to home buyers with lower (possibly zero) prepayment and default risks. These financially engineered products, which are claims on a large pool of underlying assets, may be worth more than the value of the underlying assets due to the redistribution of the risks.
In what sense are futures contracts standardized? Which is the advantage implied by such standardization?
futures contract is a standardized agreement that fixes the terms of an exchange that will take place at some future date (details of a contracts are not negotiable)
standardized specifications:
- unit of trading (called underlying asset)
commodity futures (aluminum, barley, cattle, coffee, copper cotton, crude oil,
gold, palm oil, pork bellies, potatoes, rice silver, wool, zinc, etc.)
financial futures are contracts related to financial instruments (bond, foreign
currency, stock index, etc.)
- size of the contract: an excessively large size discourages small investors from
trading while an excessively small size increases transaction costs
- delivery date: usually contracts with only four delivery dates are available (specific
dates in March, June, September and December)
futures contract is referred by its delivery months
- quotation of price
- tick size (minimum price movement)
advantages: futures contracts are extremely liquid because it is possible to unwind a contract at any time by performing a reversing trade
List at least four major differences between forward contracts and futures contracts.
Fundamentally, forward and futures contracts have the same function: both types of contracts allow people to buy or sell a specific type of asset at a specific time at a given price.
However, it is in the specific details that these contracts differ. First of all, futures contracts are exchange-traded and, therefore, are standardized contracts. Forward contracts, on the other hand, are private agreements between two parties and are not as rigid in their stated terms and conditions. Because forward contracts are private agreements, there is a high counterparty risk i.e. a chance that a party may default on its side of the agreement. Futures contracts have clearing houses that guarantee the transactions, which drastically lowers the probability of default to almost never.
Secondly, the specific details concerning settlement and delivery are quite distinct. For forward contracts, settlement of the contract occurs at the end of the contract. Futures contracts are marked-to-market daily, which means that daily changes are settled day by day until the end of the contract. Furthermore, settlement for futures contracts can occur over a range of dates. Forward contracts, on the other hand, only possess one settlement date.
Lastly, because futures contracts are quite frequently employed by speculators, who bet on the direction in which an asset’s price will move, they are usually closed out prior to maturity and delivery usually never happens. On the other hand, forward contracts are mostly used by hedgers that want to eliminate the volatility of an asset’s price, and delivery of the asset or cash settlement will usually take place.
By means of example, explain when an investor may find it useful to send a stop buy order.
There are situations in which traders that utilized technical analysis as a means to make buying decisions may choose to place a buy-stop order at a price higher than the current inside offer. For example, if a market has been range bound for a prolong period of time and the price action is approaching the upper resistance point of the range for the fourth or fifth time, a trader that has a price breakout expectation to the upside and wants to take a long position may choose to place a buy-stop order at a price slightly above the resistance point where confirmation of the breakout is likely. The objective of the trade would be to capture the momentum of the breakout to the next point of resistance.
Another example would be entering a long position based on a double bottom chart pattern. The confirmation/entry point of the “W” shaped pattern is when the price action of the second rebound in the pattern reaches the high of the first rebound. A trader would place a buy-stop order at the high of the first rebound once the second rebound formed.
With reference to IPOs, what is a book? With reference to secondary markets, what is a market order book?
The “book” is the off-market collation of investor demand by the bookrunner and is confidential to the bookrunner, issuer, and underwriter.
Book building is a systematic process of generating, capturing, and recording investor demand for shares during an initial public offering (IPO), or other securities during their issuance process, in order to support efficient price discovery. Usually, the issuer appoints a major investment bank to act as a major securities underwriter or bookrunner.
An order book is an electronic list of buy and sell orders for a specific security or financial instrument, organized by price level. The order book lists the number of shares being bid or offered at each price point, or market depth. It also identifies the market participants behind the buy and sell orders, although some choose to remain anonymous. The order book is dynamic and constantly updated in real time throughout the day. Exchanges such as Nasdaq refer to this order book as the “continuous book.” Orders that specify execution only at market open or market are maintained separately. These are known as the “opening (order) book” and “closing (order) book,” respectively.
Define the following transactional properties of a market: tightness, depth, and resiliency.
Depth: total quantity of buy and sell orders on the order book at the given time. A deep market allows exchanging securities at a minimal impact price. Large block trades do not affect price if enough volume is available at any given price.
Tightness: the difference between the bid and ask. This difference is the cost paid to the deaker to manage orders. Low spread implies high liquidity.
Resiliency: how quickly the market recovers from a trading shock.
Consider the Fishman and Hagerty (RFS 1995) model. By means of examples, please explain why:
a. an insider generally finds it optimal to manipulate the market, when uninformed.
b. an insider would generally prefer not to disclose his/her trades, when informed.
The change in the stock price due to disclosure reduces the subsequent expected trading profit of a trader who actually is informed, but increases the subsequent expected trading profit of an uninformed
trader. Whether the trader’s ex ante (not conditional on whether he is informed) expected trading profit is higher or lower with disclosure depends on the likelihood that he becomes informed. If the likelihood
is low (high), then his ex ante expected trading profit is higher (lower) with disclosure. To see the intuition, consider the following example which is a limiting case of the model presented below.2 Suppose that, with equal probability, a stock is worth 110 or 90 per share, and the initial posted price is 100. With probability q, an insider knows the true stock value and makes an informed trade. With probability 1 -q, he is uninformed and makes a portfolio trade (suppose a buy or a sell
is equally likely). Now suppose the insider sells stock and his trade is small enough so that it is not detected in the order flow. Hence, with no disclosure, the stock price remains at 100. Given the likelihood that
the insider makes an informed trade, if the insider discloses his sell, then the stock price drops to 90q +100(1- q). Now compare the insider’s subsequent expected trading profit with and without disclosure
of his initial sell. First, consider the effect of disclosure on an informed insider’s expected profit. If there is no disclosure and he sells one more share,
based on the information that the stock is worth 90, the expected profit on his second trade is 100 -90 = 10. If there is disclosure and he sells one more share, the expected profit on his second trade is 90q+ 100(1- q) -90 = 10(1- q). Thus, the change in an informed insider’s expected profit due to disclosure is Ar = -10q. Now consider the effect of disclosure on an uninformed insider’s expected profit. If there is no disclosure, his expected profit from trading is 0 since the stock is not mispriced relative to his information. If there is disclosure, an uninformed insider knows that buying stock is profitable. This is because he knows that his initial sell reflects no fundamental information, and thus 90q + 100(1-q) is too low a price for the stock. If he
buys one share his expected profit is 100 -904 - 100(1 -q) = 10q. Thus the change in an uninformed insider’s expected profit due to disclosure is ALr= 10q. Since an informed insider’s loss from disclosure equals an uninformed insider’s gain from disclosure, the insider’s
ex ante expected profit is higher with disclosure if the likelihood that he is informed, q, is less than 0.5. That is, qAl +(1-q)Ariis positive if q < 0.5. In effect, with disclosure, an uninformed insider can manipulate the market. The disclosure of one trade moves the price and creates a profitable subsequent trade. This is why an insider’s expected trading profit can be higher with disclosure
What is a reverse repurchase agreement? What is a Consol? What do we mean by “speculative bonds?”
A reverse repurchase agreement is the purchase of securities with the agreement to sell them at a higher price at a specific future date. For the party selling the security (and agreeing to repurchase it in the future) it is a repurchase agreement (RP) or repo; for the party on the other end of the transaction (buying the security and agreeing to sell in the future) it is a reverse repurchase agreement (RRP) or reverse repo.
A perpetual bond is a fixed income security with no maturity date. One major drawback to these types of bonds is that they are not redeemable. Given this drawback, the major benefit of them is that they pay a steady stream of interest payments forever. A perpetual bond is also known as a “consol”. Notable perpetual bonds in existence are those that were issued by the British Treasury for World War 1.
A junk bond refers to high-yield or noninvestment-grade bonds. Junk bonds are fixed-income instruments that carry a credit rating of BB or lower by Standard & Poor’s, or Ba or below by Moody’s Investors Service. Junk bonds are so called because of their higher default risk in relation to investment-grade bonds.
Junk bonds are risky investments, but they have speculative appeal because they offer much higher yields than bonds with higher credit ratings. Investors demand that junk bonds pay higher yields as compensation for the risk of investing in them. If a junk bond manages to turn its financial performance around and has its credit rating upgraded, the investor may see a substantial appreciation in the bond’s price.
Comment on whether the time series in Mehra and Prescott (JME, 1985) might be too short to make
safe inferences about the implied risk aversion coefficient.
Time series might be too short 1889-1978
The analysis has been extended to include since 1802
Real excess returns on equity would be on average 1% lower than reported by MP
This reduces the magnitude of the risk aversion coefficient but does not solve the puzzle completely.
