Lecture 1: Introduction, Banks & The Credit Crisis

Question 1

Which of the following statements is/are NOT true for Markowitz’ Mean Variance Model?

A) There is a trade-off between risk and expected return
B) The model assumes that return on all assets are normally distributed
C) If investors only have access to risky assets, they will invest in a combination that lies on the efficient frontier for risky assets
D) Investors care only about the kurtosis and skewness
E) Investors are greedy and risk-averse, and want to maximize returns at a give risk and prefer a sure gain over a risky one
G) All investors can borrow and lend at the same risk-free rate (if we assume access to the risk-free asset)
H) There are no frictions such as taxes, transaction costs, information asymmetry, and competition
I) All investors have homogeneous expectations and agree on expected returns, standard deviations and correlations among all assets available

Answer 1

WRONG: D) Investors care only about the expected return and standard deviation. Since the model assumes normal distribution of returns, skewness and kurtosis are unimportant

Question 2

Following the assumption in Markowitz’ Mean Variance Model about a frictionless world (no taxes, competition, transaction costs, and information asymmetry), which implications does this have on investments?

Answer 2

Given the assumption, it should be infeasible for any given investor to consistently beat the market

Question 3

that the optimal/ rational choice for the investor is to invest in a combination of available assets lying on ______

A) Efficient frontier
B) Security Market Line (SML)
C) Capital Market Line (CML)

Answer 3

that the optimal/ rational choice for the investor is to invest in a combination of available assets lying on (A) Efficient frontier

Question 4

Which of the following statements hold true for the tangency portfolio?
A) It is the optimal portfolio of investment to be combined with the risk-free asset
B) It implies that variance is minimized
C) It implies that the Sharpe ratio is maximized

Answer 4

TRUE:
A) It is the optimal portfolio of investment to be combined with the risk-free asset
C) It implies that the Sharpe ratio is maximized

Question 5

The point where the efficient frontier of risky assets and the efficient frontier of all assets touch implies a 50/50 weight in the tangency portfolio and the risk-free asset

TRUE/FALSE

Answer 5

TRUE

Question 6

On the efficient frontier of all assets, any point above the touch point of the efficient frontier of risky assets and the efficient frontier of all assets implies ______?

Answer 6

On the efficient frontier of all assets, any point above the touch point of the efficient frontier of risky assets and the efficient frontier of all assets implies GEARING –> implies taking a short position in the risk-free asset (lending)

Question 7

On the efficient frontier of all assets, any point below the touch point of the efficient frontier of risky assets and the efficient frontier of all assets implies ______?

Answer 7

On the efficient frontier of all assets, any point below the touch point of the efficient frontier of risky assets and the efficient frontier of all assets implies BORROWING

I.e., that the weight of the risk-free asset surpasses that of the tangency portfolio

Question 8

Under the assumption that the market is in equilibrium (supply = demand, we get from the Mean Variance Model to the CAPM model. This implies what? (Select 1-3)
A) the tangency portfolio becomes the market portfolio
B) The market portfolio consists of all risky assets traded in the economy
C) The efficient frontier of all assets is denoted the capital market line CAPM

Answer 8

All three options are correct

Question 9

The beta of the risk-free asset is ____ and the beta of the market portfolio is ___
Fill in the blanks.

Answer 9

The beta of the risk-free asset is 0: since we assume that it is risk-free

The beta of the market portfolio is 1: since the covariance between the market with itself is equal to the variance of the market

Question 10

The _____ plots the relation between the expected return and beta. Meanwhile, the _____ plots the relation between the expected return and standard deviation

Answer 10

The Security Market Line (SML) plots the relation between the expected return and beta. Meanwhile, the Capital Market Line (CML) plots the relation between the expected return and standard deviation

Question 11

In order for CAPM to be fulfilled, all assets in the market must lie on the SML/ CML
Select one

Answer 11

In order for CAPM to be fulfilled, all assets in the market must lie on the SML

Question 12

In CAPM, the higher the correlation, the lower the risk

TRUE/ FALSE

Answer 12

FALSE: In CAPM, the higher the correlation, the HIGHER the risk –> investors are willing to pay more for an asset with lower correlation with the market (willing to accept a lower return)

Question 13

Why do investors prefer assets with low correlation with the market?

Answer 13

Because when markets are in recession, assets that allow the investor to neutralize this loss by having a low or negative correlation with the market (perform well in recession) are particularly valuable

Question 14

The variance of the return can be decomposed into two terms (two risk types) - Which?

Answer 14

The variance of the return can be decomposed into two terms:
- Systematic (undiversifiable) risk
- Non-systematic (idiosyncratic/ firm-specific/ diversifiable risk)

Question 15

Following CAPM, only the systematic risk (measured by beta) is priced and compensated for. I.e., being exposed to firm-specific non-systematic risk is not compensated by higher expected return. Why?

Answer 15

CAPM says that only the systematic risk is priced. I.e., epsilon (firm-specific risk) is not compensated due to the ability of eliminating this risk by holding a diversified portfolio

Question 16

Under CAPM, the alpha variable must be equal to zero. Why?

Answer 16

If α ≠ 0, CAPM does not hold, since alpha measures the EXTRA RETURN in excess of that predicted by the CAPM

Question 17

If the alpha of an investment is positive (α>0), the investment is UNDERVALUED/ OVERVALUED compared to the market.

Select the right option

Answer 17

If the alpha of an investment is positive (α>0), the investment is UNDERVALUED compared to the market.

This means that the investment is positioned above the SML –> good investment

Question 18

If the alpha of an investment is negative (α<0), the investment is UNDERVALUED/ OVERVALUED compared to the market.

Select the right option

Answer 18

If the alpha of an investment is negative (α<0), the investment is OVERVALUED compared to the market.

This means that the investment is positioned below the SML –> bad investment

Question 19

A portfolio manager has maintained an actively managed portfolio with a beta of 0.2. During the last years, the risk-free rate was 5% and the major equity indices performed very badly, providing returns of about -30%. The portfolio of the manager produced a return of -10% and the manager claims that in the given circumstances it was good.

Do you agree (following CAPM)?

Answer 19

NO.
Given the inputs:
β=0.2 r_f=5% R_m=-30% R_p=-10%
Assuming that CAPM holds, the expected return on the portfolio is:
E[R_i ] = rf + β (R_m - rf) = 0.05 + 0.2 (- 0.3 - 0.05) = -0.02
Thus, the realized -0.1 return is worse than CAPM expectation, implying an alpha of -0.08

Question 20

Roll’s critique of CAPM states that under the CAPM assumptions, the market portfolio consists of all assets available (incl. real estate and human capital). In reality, such a market portfolio is unobservable, and hence you cannot test whether CAPM holds or not.

TRUE/FALSE

Answer 20

TRUE

Question 21

Since shareholders only care about systematic risk, the same is true for company managers - i.e., unsystematic risk is to be neglected in order to align with shareholder interest

TRUE/FALSE

Answer 21

FALSE:
In practice companies are concerned about total risk (systematic + unsystematic). Bankruptcy costs show that managers can be acting in the best interests of shareholders when they consider total risk, and not only the systematic risk. Also financial institutions are concerned with total risk, and not just systematic risk

Question 22

Overall, there are two types of bankruptcy: Chapter 11 and Chapter 7.

Restructuring is when the distressed firm is attempted saved and nurtured back to health by capital restructuring. Which type of bankruptcy is this?

Answer 22

Chapter 11

Question 23

In a Chapter 7 bankruptcy, liquidation happens, meaning that the distressed firm’s assets are sold to repay creditors.
With respect to the repayment order, rank the following parties from first to last in line:

junior debtholders
senior debtholders
equity holders

Answer 23

senior debtholders
junior debtholders
equity holders

Question 24

There are two types of bankruptcy costs. Direct and indirect. Which of the following constitute direct costs?
A) legal costs associated with bankruptcy
B) accounting costs associated with bankruptcy
C) lost sales due to customers’ lack of confidence
D) employee departure due to lack of confidence

Answer 24

DIRECT BANKRUPTCY COSTS:
A) legal costs associated with bankruptcy
B) accounting costs associated with bankruptcy

INDIRECT BANKRUPTCY COSTS:
C) lost sales due to customers’ lack of confidence
D) employee departure due to lack of confidence

Question 25

A commercial bank typically caters to a retail and a wholesale segment. Fill in the blanks in following definitions:

____ banking targets private individuals and small businesses (smaller amounts)
____ banking targets medium to large corporate clients, fund managers, and other financial institutions (large amounts)

Answer 25

RETAIL banking targets private individuals and small businesses (smaller amounts)

WHOLESALE banking targets medium to large corporate clients, fund managers, and other financial institutions (large amounts)

Question 26

What are the 3 main types of risks faced by commercial banks?

A) credit risk (on loan portfolio): lender default
B) interest rate risk: mismatch of fixed and variable interest rates
C) funding risk: mismatch of maturity of loans and deposits
E) bank run risk: market’s loss of confidence in the bank

Answer 26

A) credit risk (on loan portfolio): lender default
B) interest rate risk: mismatch of fixed and variable interest rates
C) funding risk: mismatch of maturity of loans and deposits

E) is a risk faced by the bank, but not per se a category for itself

Question 27

Typically, loans have longer maturities than deposits - this concerns the supply and demand of money at the bank. If deposits are withdrawn too fast, the bank may have issues meeting the payment obligations due to the longer maturity of their loans.

This reflects which risk?

Answer 27

Funding risk

Question 28

Which of the following balance sheet items are considered Tier 1 capital?
A) cash
B) deposits
C) equity capital
D) subordinated long-term debt

Answer 28

C) equity capital

Question 29

Which of the following balance sheet items are considered Tier 2 capital?
A) cash
B) deposits
C) equity capital
D) subordinated long-term debt

Answer 29

D) subordinated long-term debt

Question 30

If the equity capital and subordinated long-term debt (tier 1 +2) are not sufficient to cover losses, and the bank needs to spend some of its deposits, it is in big problems.

TRUE/ FALSE

Answer 30

TRUE

Question 31

Following statement is true about the Equity multiplier - select 1-3
A) it is a measure of financial leverage of a bank
B) it is calculated as: total assets/(total assets-liabilities)
C) it is a measure of tier 1 capital sufficiency

Answer 31

A) it is a measure of financial leverage of a bank
B) it is calculated as: total assets/(total assets-liabilities) = total assets/ equity

Question 32

In the case of the bank experiencing client default, the capital used FIRST to cover the losses is:
A) equity capital
B) subordinated long-term debt
C) deposits

Answer 32

A) equity capital = Tier 1

Tier 1 capital is used first to cover losses suffered from defaulting lenders. If Tier 1 capital is insufficient, the bank uses Tier 2. Only when both tier 1 and tier 2 capital prove insufficient, the bank uses deposits (last resort)

Question 33

Basel III require banks to have a leverage ratio of at least ___%. The higher the leverage ratio, the safer the bank.

A) 3%
B) 5%
C) 8%

Answer 33

Basel III require banks to have a leverage ratio of at least 3%. The higher the leverage ratio, the safer the bank.

Question 34

Investment banks offer two types of public offerings for a firm: best effort basis and firm commitment basis.

Which of the following statements are TRUE about the firm commitment basis? Select 1-4

A) the bank buys the securities from the issuer up-front
B) the bank does as well as it can to place the securities with investors and is paid a fee that depends on its success
C) the firm commitment basis is the cheaper option for the issuer, since the issuer carries the risk
D) the firm commitment basis is the more expensive option for the issuer, since the bank carries the risk
E) unsold securities end up at the bank’s balance

Answer 34

A) the bank buys the securities from the issuer up-front
D) the firm commitment basis is the more expensive option for the issuer, since the bank carries the risk
E) unsold securities end up at the bank’s balance

WRONG: these are the best effort basis public offerings:
B) the bank does as well as it can to place the securities with investors and is paid a fee that depends on its success
C) the BEST EFFORT basis is the cheaper option for the issuer, since the issuer carries the risk

Question 35

To set the price in an IPO, book-building is often used. Book-building means that the investment bank asks investors and test the interest in the market on the stocks to be issued

TRUE/ FALSE

Answer 35

TRUE
Since it is an IPO, it is difficult to set the price, since the market price is unknown prior to IPO. Thus, book-building is a sound method to test the interest

Question 36

Which of the following statements are true about a Dutch Auction?
A) shares are first issued to the highest bidder, then to the next highest bidder, and so on…
B) under-pricing is often less apparent, if it is a hot company
C) a minus is that it does not take advantage of the bank’s relationship to potential investors and makes the IPO go through quickly
D) Price paid by all investors receiving shares is the lowest bid price accepted

Answer 36

All options are true

Question 37

An asset backed security (ABS) consists of a pool of (mortgage) loans, which are sold to the bank’s SPV, which then splits it into three tranches.

TRUE/ FALSE

Answer 37

TRUE

Question 38

The ____ tranche consists of the safest loans pooled. Due to lower risk, expected return is lower. These loans are typically rated AAA

The ___ tranche is when the risk of loan default is higher. Due to higher risk, investors get a higher expected return. These loans are typically rated BBB

The ___ tranche carries very high risk for default, which therefore accompanies a very high expected return for the investors

Fill in the blanks

Answer 38

Senior tranche
Mezzanine tranche
Equity tranche

Question 39

In an ABS, if some of the loans default, the ___ tranche investors are first in line for repayment, and ____ tranche investors are the last ones to get paid.

Fill in the blanks:
A) Senior tranche
B) Mezzanine tranche
C) Equity tranche

Answer 39

In an ABS, if some of the loans default, the SENIOR tranche investors are first in line for repayment, and EQUITY tranche investors are the last ones to get paid.

Question 40

An ABS where the underlying assets are fixed-income securities (e.g. a mortgage) is termed _____

Answer 40

Collateralized Debt Obligation (CDO)

Question 41

In a collateralized debt obligation (CDO), what functions as the collateral for mortgage loans?

Answer 41

Real estate (the property)

Question 42

Investors of the ABS can only make a claim against the SPV or the asset pool, not against the originator of the asset/loan (the bank)
TRUE/FALSE

Answer 42

TRUE

Question 43

A period where an initial below-market interest rate lasting for 2-3 years, followed by a rate that becomes significantly higher is termed _____

Answer 43

Teaser period