Lectures Flashcards
What are the agency problems in capital budgeting if a manager has a fixed salary?
- Reduced effort
- Perks
- Empire building
- Entrenching investment (choosing lower NPV projects just because the manager not qualified enough to do higher NPV projects)
- Avoiding risk
- Increasing exposure (building a good reputation for himself)
What are the methods of reducing agency costs?
- Monitoring
- Market for corporate control (e.g. legal environment for hostile takeovers)
- Managerial compensation based on input (effort) or output (returns)
- Issue stock options to management
- Accounting based measures of performance (accounting earnings do not necessarily translate to shareholder value).
What are the disadvantages of stock options as remuneration (solution for agency problems)?
- They reward absolute, not relative performance
- Create incentives for managers to withhold bad news from the market
- Create incentives to manipulate earnings
- Option backdating
- Insider trading
- Short-termism (increase stock value now at the expense of the future
- Markets are forward-looking (new information is immediately incorporated into prices –> to incentive to do well on long-term projects, if positive NPV projects immediately increase the stock value).
When a firm is in financial trouble, what are the 5 “games” often played by the managers at the expense of creditors?
- Overinvestment (take on risky bets (NPV<0) since equity owners face unlimited upside, and the downside is only observed by debt holders).
- Underinvestment (equity owners do not invest in a positive NPV project because since the firm is already in distress (shareholders unlikely to get anything), all gains from the project would go to debt holders).
- Cashing out (shareholders withdraw money from the firm- sell all the assets ASAP- cheaper than their actual worth –> deadweight loss (wealth destruction & wealth transfer from bondholders to shareholders)
- Playing for time (creditors would like to salvage what they can quickly, but shareholders want to delay the process in hope that the firm might recover and they might get something back from equity).
- Bait and switch (start with issuing a small amount of safe debt, then suddenly switch and issue a lot more equally senior debt–> all debt becomes riskier and the old bondholders lose, while equity owners gain from the old debt being locked in at low rates).
A company is worth less by the expected value of these games
Who and how gets hurt from the “games” played when a company is in distress?
- Debt holders - conditional on the game being played
- Equity owners- they had already paid ex ante for the bankruptcy costs (debt holders had already incorporated the bankruptcy information into prices, hence paid less for the bonds).
Leverage can encourage managers and shareholders to act in ways that reduce firm value. When a firm adds leverage to its capital structure, what two effects it has on the share price?
- Share price benefits from the equity owners ability to exploit debt holders in times of distress
- Debt holders recognize that and pay less for the dent when it is issued.
Debt holders lose more than shareholders gain –> net effect is a reduction in the initial share price of the firm.
How can debt holders reduce the possible “games” played in distress? How does that hurt the company’s value?
Debt holders might impose debt covenants on shareholders (restrictions on management).
If there are many constraints, then the management loses flexibility –> cannot borrow at their optimal capital structure level, cannot achieve the most efficient outcome for the company.
Less debt due to covenants–> forgone tax shields –> EV decreases
What are the benefits of leverage in the reduction of agency costs?
- Ownership concentration (more debt–> less equity issues–> concentration of less shareholders–> no free riding and agency costs decrease).
- Free cash flow hypothesis/ debt discipline (if a firm has debt, then managers must pay to the debt holders, hence less money for managers to waste)
- Leverage can reduce the degree of managerial entrenchment (managers worried about repaying debt–> take less entrenchment (same as debt discipline)).
- When a firm is highly levered, creditors themselves will closely monitor. (more oversight for managers).
What are the three trade-offs in financial systems?
- Innovation vs volatility (more innovation creates more volatility)
- Deregulation vs Risk-taking (less regulation–> more risk taking)
- Reduced cost of intermediation vs lack of monitoring
What are the two types of financial systems?
- Bank orientated (commercial banks are also owners of many firms, few IPOs, ownership closely held by the owners, weak minority protection, investors control orientated, universal banking) - Germany and Japan
- Market orientated (firms obtain financing through the issuance of securities, many IPOs- dispersed ownership, investors portfolio orientated, separation of investment banking from commercial banking, strong minority protection; hostile bids important) - UK and US
What are the challenges of corporate governance?
- Agency problem (incomplete contracts and PBOC)
- Management incentives (how to limit financial benefits)
- Financing without governance (e.g. reputation or excessive optimism)
- Legal protection (for minority shareholders and for all shareholders if managers not fulfilling fiduciary duty).
- Takeovers
- Benefits vs costs of large shareholders (more monitoring vs not diversified)
- State ownership
With what is better corporate governance associated?
- A better developed financial system
- More outside investors
- Higher growth and valuation
- Faster and more flexible response to new competitive challenges
- Easier and cheaper ways to attract new capital
What is corporate governance?
Corporate governance deals with agency problems at a micro (firm) level (ways in which suppliers of finance to corporations assure themselves of getting a return on investment).
What are the approaches to corporate governance (how to measure agency problems)?
- Quantifying legal shareholder protection
- Measuring PBOC (Dyck and Zingales)
- Survey of institutional investors (McCahery, Sautner, and Starks)
- Measuring agency problems at dual-class companies (Masulis, Wang, Xie)
- Political economy view (Pagano and Volpin)
What are the characteristics of a system of ethical reasoning?
- Completeness- system applies to all cases
- Coherence- doesn’t change opinion depending on context
- Connection to the theory of ethics and beliefs
- Practicability- the system can be implemented
What are the CFA standards of practice?
CFA standards- rigorous ethic guidelines specific to the financial industry.
-> Professionalism
A. Knowledge of and compliance with the law
B. Independence and objectivity (e.g. can’t take bribes)
C. Honest in both representation and conduct (can’t knowingly misrepresent)
-> Integrity of financial markets
A. Insider trading (can’t act upon non-public information)
B. Market manipulation
-> Duties
A. Loyalty, prudence, and care to clients/ employees
B. Disclosure of conflicts of interest
C. Fair and objective dealings with clients
D. Accurate and complete performance
E. Preservation of client confidentiality
What is skewness? Kurtosis?
Skewness- a measure of symmetry, or the lack of symmetry. If negative- data skewed left. If positive- data skewed right.
Kurtosis- a measure of whether the data is peaked or flat relative to a normal distribution. (for normal distribution minus 3) –> then, if positive - peaked distribution. If negative- flat distribution.
What is APT (arbitrage pricing theory)?
If there is no arbitrage, then we can price assets relative to one another based on their co-movement with these factors.
What are the three types of investors? (in options (?) )
- Hedgers (protect themselves from price movements)
- Speculators (make bets that the price/ volatility will increase/ decrease)
- Arbitrageurs (lock in profits from mispricings by simultaneously entering into transactions in 2 or more markets)
What is immunization?
strategy to shield pverall financial status from interest rate flactuations –> matching duration of assets to the duration of liabilities (rebalance by changing the weights each period).
What are the three theories that explain why interest rates differ for bonds of different maturities ?
- Expectations theory (2 year rate must be equal to 1 year * spot rate, otherwise arbitrage)
Fisher theory: must account for inflation –> inflation premium - Liquidity preference theory (higher premium for long term bonds) –> i/r risk premium
- Market segmentation/ preferred habitat theory (different demands/ supplies for bonds of different maturities –> i/r adjust accordingly).
What is CDS? What is a naked CDS? What is a synthetic CDO?
Credit default swap- risk hedged by buying insurance against default
Naked CDS- when you do not own the underlying asset you are insuring for –> possible manipulation
Synthetic CDO- use CDSs to make CDOs
What is market microstructure?
Market microstructure is about making markets work well- studies how does trading actually occurs in markets and what determines the amount, liquidity & how do market arrive at prices.
What are the roles of markets?
- Match buyers and sellers to realize gains of trade
- Efficiently channel resources to their best use
- Provide information and efficient resource allocation
What makes a quality market?
- Liquidity (large amounts can be traded quickly with no large impact on the price)
- Information efficiency (market aggregate disparsed information more accurately than individuals (residuals on avg are zero)
- Integrity (people want to take part in fair markets).
What are the different types of markets?
- Limit order (order driven) - list all unexecuted orders and wait for them to be executed –> can get a better price, but has to wait a long time and risk of the order not being executed at all
- Dealer (quote driven) markets) - can buy/ sell faster, but you pay more for the execution. Dealers post quotes and then traders decide whether to trade and with which dealer (intermediary) –> costly and less transparent
- Upstairs markets- dealers/ brokers negotiate traders directly with other brokers and only then report the trade–> otherwise the price would be impacted. Reporting delay can vary.
- Downstairs markets- trading on the market with other participants
- Floor/ open outcry markets- trading live on spot with the hand signals, etc. Trading “pit” or “floor” brings excitement & can see others’ emotions in real life.
- Electronic markets- trading on the internet
What is the difference between limit order and dealer markets?
- Limit order (order driven) - list all unexecuted orders and wait for them to be executed –> can get a better price, but has to wait a long time and risk of the order not being executed at all
- Dealer (quote driven) markets) - can buy/ sell faster, but you pay more for the execution. Dealers post quotes and then traders decide whether to trade and with which dealer (intermediary) –> costly and less transparent
What is the difference between downstairs and upstairs markets?
- Upstairs markets- dealers/ brokers negotiate traders directly with other brokers and only then report the trade–> otherwise the price would be impacted. Reporting delay can vary.
- Downstairs markets- trading on the market with other participants
What are the three types of traders?
- Informed- earned profits from price discrepancies
- Uninformed (‘liquidity’ traders)- trade because they want to diversify, invest (save) their money, gamble, etc
- Liquidity suppliers- designated market makers (obligation to provide quotes- they buy today if higher supply to sell tomorrow at a higher demand & earn a spread). Ask for a spread (compensation) due to high fixed costs, takes on market exposure (prices might change overnight),(inventory holding costs), risk on making loss to the informed traders. Adverse selection- liquidity suppliers earn money from uninformed traders, but lose money from informed traders (if suddenly too high demand, that means that his prices are too low).
What are liquidity suppliers? Why do they ask for a bigger spread? What is meant by adverse selection in this case?
Liquidity suppliers- designated market makers (obligation to provide quotes- they buy today if higher supply to sell tomorrow at a higher demand and earn a spread). Ask for a spread (compensation) due to high fixed costs, takes on market exposure (prices might change overnight) (inventory holding costs), risk on making a loss to the informed traders.
Adverse selection- liquidity suppliers earn money from uninformed traders, but lose money from informed traders (if suddenly too high demand, that means that the prices are too low).
When are markets less liquid?
- When inventory holding costs are high
- Adverse selection risk is high (many informed traders)
- Fixed order processing costs are high
- Lack of competition
Why do uninformed traders participate in trade if they are losing money to the informed traders?
- Behavioral biases (overconfidence)
2. Gains from trade (diversification, gambling, etc)
Why don’t more people become informed traders?
Information production is costly. Profits are just enough to cover their costs of producing information.
What is changing the trading landscape? What are the pros and cons of that?
Drivers: competition (more than 1 stock market per country) and technology (more complex markets)
Issues: market fragmentation, automation (AT), dark trading (e.g. brokers trading against their clients)
PROS: more competition–> trading costs decreased & more platforms to suit different interests
CONS: less participants per market (since more markets)–> difficult to match them –> decreased liquidity & increased search costs
What are the reasons for hedging?
- Reduce risk
- Mitigate agency costs (if risk hedged (no huge volatility), then can see if earning increased due to manager’s efforts and not just volatility)
- but by hedging you give up both - upside and downside (e.g. if huge earnings, you get only the fixed amount).
What is the difference between forwards and futures?
Forwards are traded OTC, tailor made with counterparty risk
Futures are standardized, exchange traded, marked-to-market & eliminates counter party risk since the intermediary takes CFs all the time based on current market rates).
What is the hedge ratio?
Fraction of the underlying stock needed to create a perfect hedge portfolio
How can you close a futures position?
- Unwind prior to expiry (offset the position 1 Long + 1 Short = 0)
- Deliver of cash settle at maturity (end of the contract)
- Roll contract over to a later delivery date (1 year= 4*3month contracts
What are the three ways to value a stock?
- Dividend discount model (PV(stock)=PV(expected future dividends).
- Valuation using multiples (multiply firm’s earnings by the average P/E ratio of comperable firms)
- Discount free CF model (value of the firm for ALL investors (equity+debt)).
How can a firm raise equity finance?
- Angel investors
- Crowdfunding
- Venture capital firm
- Strategic investor
- IPOs
What are the advantages and disadvantages of an IPO?
PROS: \+ great liquidity \+ better access to capital (by issuing new shares) CONS: - equity holders dispersed - many requirements to be listed
What are the types of dividends?
- Regular
- Special (one time)
- Stock split (like a stock dividend)
- Liquidating dividend (return of capital to shareholders from a business operation that’s being terminated)
What are the types of share repurchases (buybacks)?
- Open market repurchase
- Tender offer (offer a special price to all shareholders)
- Dutch auction (to find out the worth of shares)
- Targeted repurchase (buyback from a specific shareholder)
What is “greenmail”?
An investor quickly buys the majority of shares and then threatens the management of a takeover and them being fired. Then offers to sell his shares for a premium to the management.
What is the sequence of actions when paying the dividends?
- Declaration day
- Ex-dividend date (everyone who bought stock after ex-dividend date will not be eligible for the dividend)
- Record date (when all shareholders who will receive the dividends are locked in)
- Payable/ payment/ distribution date
What are the key assumptions of Modigliani and Miller proposition?
- Fixed investment plan
- No personal or corporate taxes
- No costs of issuing new shares
- No costs of trading shares
- Homogenous information
Why are stock repurchases overtaking traditional dividends?
- Personal tax savings’
- Preserves financial flexibility
- Corrects undervaluation
- Removes low valuation shareholders
- Improves reported EPS (as # of shares decreases)
- Avoid disadvantaging stock option holders
What tradeoff does payout policy create?
Agency costs vs capital raising costs
- If paying dividends –> Probability of needing more capital increases –> wasted value since raising more capital is costly
- If not paying dividends–> retained earnings increase –> managers have money to waste and agency costs increase –> wasted value
What are the leaks in the payout policy?
M&M proposition does not hold, because not all investors are indifferent between their payouts due to the leaks of money, When a firm pays dividends to stock holders, there is a leak to the government (taxes).
When the stock holders buy shares, there is a leak to the Investment bank (fee for the IPO).
Why should we distinguish between equity and debt?
- Different tax implications
2. Different legal obligations
What are the advantages and disadvantaged of leverage?
+ tax benefit
+ added discipline –> lowers some agency costs
- increased bankruptcy costs
- bond and equity holder conflict costs
- loss of financial flexibility due to covenants
What is the tradeoff theory?
A firm should increase its leverage until it reaches the level at which firm’s value is maximized (MR=MC).
V(levereged)= V(unlevereged) + PV(TS) - PV(financial distress costs) - PV(agency costs) + PV(agency benefits)
What does tradeoff theory explain? And what doesn’t in explain?
Tradeoff theory explains:
- Why firms choose debt levels too low to fully exploit the tax shield
- Differences in the use of leverage across industries
- Why managers often say their firms have target D/E ratios
Tradeoff theory does not explain why the most profitable firms borrow the least (since they would benefit very mush from the tax shield and their probability of default is very low) –> pecking order theory
What is the order of preferred financing in the pecking order theory?
- Retained earnings (no costs)
- Bonds –> smallest costs since the bond holders only care about getting their CFs and do not care about information asymetry–> smaller discount
- Hybrids (convertable bonds, preference stock)
- Equity –> big costs due to information asymetry and adverse selection. Investors believe that the firm is offering stock only if it is bad and overprices –> hence they ask for huge discount)
What is the information asymmetry? Adverse selection? And what do they both imply?
Asymetric information- managers know the true value of shares and would do an IPO only if it is an NPV postive projects, hence equity overpriced --> investors should ask for a huge discount Adverse selection (lemons principle)- seller will sell ony the faulty items and will withhold the information from the buyer. Information asymetry and adverse selection imply that stock price will drop after an announcement of equity issue.
What are the three main methods of capital budgeting with leverage? And when do you use each?
- WACC method- fixed D/E ratio and the new investment has a comparable risk to the other firm’s projects
- The adjusted PV method- can also use when D/E not fixed & easy to use when you have other side effects
- FCFE method- D/E fixed, calculated FCF for equity holders only, not all shareholders.
What are the two types of growth?
- Organic (from within firm)- slow
2. Inorganic (from outside the firm)- rapid (e.g. M&As)
What is the motivation for M&As?
Combining two firms adds economic value (synergies)
What are synergies? What are the types of synergies?
Synergies- additional value created by combining two firms
- Cost reduction-reduction of excess capacity, economies of scale, economies of scope, learning economies
- Revenue enhancement: increased market power (more like a monopoly), network externalities, acquisition of complementaries
- Other synergies as a bonus: asset reduction, tax reduction (increased depreciation expense–> tax benefits & ability to use carried-forward losses), financial (expansion of borrowing capacity).
Explain vertical and horizontal integration
Vertical- a merger of two companies in the same industry at different stages of production (e.g. factory+ shipping)
Horizontal- a merger of two companies at the same stage in the production cycle (e.g. BMW buy audi)
What is a conglomerate merger?
Merging firms in different industries or countries (diversification, decreased probability of default, expanded debt capacity).
What is industry consolidation?
For example, many banks merging over time together into one bank. (no further growth opportunities on your own).
What are some questionable reasons for mergers?
- Diversification- shareholders can replicate (more easily and cheap)
- Empire building (NPV=0 mergers)
- Managerial overconfidence (some deals very risky)
- Acquisitions only for EPS growth (no synergies)
What are the key considerations in deal negotiations in M&As?
- Taxation
- Risk exposure
- Control (how voting power affected)
- Continuity (which legal entity moves forward)
How do the acquirer and target decide upon the price of acquisition?
Through negotiations and bargaining (acquirer wants the smallest price, target wants the highest price) till they end up in Zone Of Potential Agreement
What are the three main tax gains for the company after M&A?
- Exploitation of net operating loss tax credits’
- Increase in depreciation tax shields due to revaluation of assets
- Increase in debt tax shields from increased financial leverage
What are the structures of debt in M&As?
- Cash purchase of all assets (voting stock for assets)
- Cash purchase of stock (voting stock for stock)
- Statutory merger (statutory consolidation - buy all shares)
- Triangular merger (get your subsidiary to do everything)
What are the sources of risk in M&As?
- Post-merger integration (a major risk!)
- Decline in buyer’s share price (deal can take yr+ to complete)
- Competing bidders
- Disappointed sellers (hostile shareholders)
- Hidden liabilities
- Problems in target’s accounting statements
- Loss of customers/staff of target
- Regulatory intervention
- Litigation by competitors
- Controversy/reputation effects
- Managerial overconfidence
What is a friendly deal? A hostile deal?
Friendly takeover
– When a target’s board of directors supports a merger, negotiates
with potential acquirers, and agrees on a price and deal structure
that is ultimately put to shareholders
• Hostile takeover
– Board of directors/management fight the takeover attempt. The
acquiring individual or organization purchases a large fraction of
a target corporation’s stock and in doing so gets enough votes to
replace the target’s board of directors and CEO
• Corporate raider
– The acquirer in a hostile takeover
What is a corporate raider?
Corporate raider– the acquirer in a hostile takeover
What could be the possible motivations for takeover defenses?
Possible motivations for defence
– Target seeks a better price
– Management believes the target would perform better as
independent firm
– Management is seeking to entrench itself
What are the three defence tactics against acquisitions?
- Proactive defenses
•Deterrence of any bidder
•Does not actively discriminate amongst potential bidders - Deal-embedded defenses
•Deterrence of competing bidders
•Raise the ante for competing bidders - Reactive defenses
•Repelling a known specific bidder or bidders
Give an example of proactive defenses
• Charter amendments: in firm’s charter, impose
conditions on control transfer (“shark repellent”)
– Supermajority amendments – require over 2/3 vote to approve merger
– Fair-price amendments – requirement that “fair price” is paid by bidder for all purchased shares (prevents acquisitions occurring at multiple prices)
– Staggered boards – delay effective transfer of control following takeover
– Dual class recapitalization – creation of new class of securities with special voting rights and allocate these to management,
• Golden parachute: an extremely lucrative severance
package that is guaranteed to a firm’s senior
management in the event that the firm is taken over and the managers are let go
• Poison pills: securities with embedded rights to buy
shares in either the target or an acquirer at a deeply
discounted price
• Poison puts: give bondholders the right to put, at par or better, target bonds in event of change in control
Give an example of reactive defenses
• White knight: target looks for another, friendlier company to acquire it
• White squire: a variant of the white knight defense, in
which a large, passive investor or firm agrees to
purchase a substantial block of shares in a target with
special voting rights
• Pac man defense: target firm counteroffers for bidder
firm
– Effective if target much larger than bidder
– Implies target finds combination desirable but seeks control of surviving entity
• Leveraged recapitalization: target changes capital
structure to make itself less attractive as a target
What is the vinner’s curse in IPO?
The winner’s curse is a tendency for the winning bid in an auction to exceed the intrinsic value or true worth of an item. Because of incomplete information, emotions or any other number of factors regarding the item being auctioned, bidders can have a difficult time determining the item’s intrinsic value (wikipedia).
Explain why targets have such high price increases in M and As
- free-rider problem (shareholders from one firm might free ride and get all the benefits) –> nesaprotu, pls explain in the comment
- Competition from other companies drives the price up –> like the winner’s curse in IPOs
- Bargaining power of the acquiree
Hence, the M&A will be worth NPV=0 to the acquirer
Why does the acquirer acquires the target, if it is an NPV=0 project for him?
– High degree of variation in returns to acquirer
– Managerial overconfidence
– “Empire building” (agency costs)
What is a leverage buyout (LBO)?
Generally: acquisitions involving a high proportion of
debt financing
– Done by
• Private equity funds
• Management (MBO: management buyout)
• Large shareholder (OBO: owner buyout)
– Often sell off non-key assets after acquisition to reduce debt
• One way of doing an LBO: corporate raider announces a conditional bid for half the outstanding shares of a firm.
– Instead of using his own cash to pay for the shares, he borrows the money and pledges the shares as collateral on the loan.
• Because the only time he will need the money is if the deal succeeds, the banks lending the money can be certain that he will have control of the collateral.
• If the deal succeeds, the corporate raider takes control of the company.
What are private equity funds and firms? How does PE reduce agency costs?
Private equity (PE) firms and funds:
– Specialize in doing leveraged buyouts
– Collect a portfolio of companies in which they have controlling ownership
– Differ from venture capital (VC) in that VC looks for young firms and often does not take a controlling stake
– Large leverage (from LBOs) and diversification within the PE fund/firm creates attractive returns
• PE occurs in waves
– Arguably PE exploits favorable market conditions (cheap debt, mispriced stocks)
• PE adds value, largely in the way of reduced agency
costs:
– Synergies in monitoring firms (reduces agency costs)
– Often make management take large stake in companies
– High leverage creates managerial financial discipline
What is an efficient market hypothesis? What are the three types of information, which lead to forms of market efficiency?
Under the efficient market hypothesis (EMH), prices fully and correctly reflect all relevant information.
• Relevant information, Ω, can take three broad types, which lead to three forms of market efficiency:
– Weak form: all past prices and returns
– Semi-strong form: all publicly available information (including past
prices and returns)
– Strong form: all information that can possibly be known, including that
of insiders
Why should markets be efficient?
- Arbitrage (or more generally, investors actively searching for opportunities to earn abnormal profits). They become the marginal investor and drive prices to their efficient levels.
- Aggregate many opinions/forecasts/beliefs –> averaging out errors (wisdom of crowds)
Why might markets be inefficient?
- ‘Limits to arbitrage’ (transaction costs, forbidden short-selling, noise-trader risk, counterparty risk, legal clauses risk, withdrawal limits).
- ‘Behavioural biases’
– Attitude towards risk
• Not final wealth – gains and losses relative to a reference point
• Loss aversion – Prospect theory
– Non-Bayesian expectation formation
• Representativeness rather than conditional expectations
– Sensitivity of decision making to framing of problems
– Overconfidence
• Trade too much
• Non-ignorance of sunk costs
– e.g., All-you-can-eat restaurant with random sample of cost refunds
• Ignorance of opportunity costs
– e.g., buy Olympics closing ceremony ticket at $100, secondary market they are being resold for $5000, still go to the ceremony despite the fact that you wouldn’t pay $5000 to go
• Overweight small probabilities; underweight near certainty
– Gambling + insurance
• Disposition effect (hold onto losers and sell winners)
• Self-attribution bias + overconfidence
• Ambiguity aversion (betting on balls from an urn)
• Availability (murders vs suicides)
• Representativeness (the shy salesperson/librarian) - Bubbles
– A significant volume of trade at prices that significantly deviate from their fundamental value (the risk-adjusted NPV of the associated sequence of
cash flows).
(Upward price revision might be due to information received by the investors that
warranted re-evaluation of risk-adjusted NPV and same for the downward revision.)
What are the hidden risks in arbitrage?
Hidden risks in arbitrage:
– Counterparty risk
– Legal clauses risk (e.g., LV political betting market)
– Simultaneous execution risk (e.g., currency arbitrage)
– Model risk if doing stat arb (e.g., long-short distress risk)
– The rules change (e.g., SPP)
– Withdrawal limits (cryptomarkets)
What are the behavioral biases associated with arbitrage?
– Attitude towards risk (loss aversion, marginal utility theory, prospect theory)
– Non-Bayesian expectation formation (representativeness rather than conditional expectations)
– Sensitivity of decision making to framing of problems
– Overconfidence
• Trade too much
• Non-ignorance of sunk costs
• Ignorance of opportunity costs
• Overweight small probabilities; underweight near certainty
– Gambling + insurance
• Disposition effect (hold onto losers and sell winners)
• Self-attribution bias + overconfidence
• Ambiguity aversion (betting on balls from an urn)
• Availability (murders vs suicides)
• Representativeness (the shy salesperson/librarian)
• Confirmation bias- a tendency for people to favor information that confirms their preconceptions or hypothesis
How can bubbles occur?
The literature documents a few ways that ‘bubbles’ can occur:
– Asymmetric information + iterative expectations –> if I short now, I face a noise trader risk, rather profit now and short later–> everyone does so (iterative beliefs)–> bubbles raise
– Behavioral biases + limits to arbitrage
– Heterogeneous beliefs + trading frictions
– Information cascades and herding (following others’ actions–> herding arises (deviation from the fundamental value))
What is herding and information cascade?
Herding can be the cause of an initial deviation from
fundamental value (which becomes a bubble via limits to arbitrage or a beauty contest)
• Herding can arise as a result of an information cascade
– When people observe the actions of others and then make the same choice that others made, independent of their private
information signals
– Such behaviour can be rational when the information contained
in observing a series of others’ actions overweighs the
individuals private information signal
• “It’s more likely that I’m wrong than that all those other people are wrong.
Therefore, I will do as they do.”
– Can lead to reduced collection of private information
• e.g., umbrella choice, garbage bin decision
– Which can become a bubble if by chance the signals of the first
few actors are wrong, e.g., tech wreck
What are the different strategies based on three types of market efficiency?
• IF markets are at least weak form efficient (relevant info includes past returns), then:
– Technical analysis (e.g., charting) should have no value
• IF markets are at least semi-strong form efficient
(relevant info includes public information), then:
– Fundamental analysis (e.g., DCF) should have no value
• IF markets are efficient then:
– Investment strategies should involve:
• Buy-and-hold (minimise transaction costs, reduce chances of being exploited by informed insiders)
• Not try to “pick winners”
• Diversification (still works)
• Optimise portfolio with regard to taxes
• Rebalance asset allocation (risky vs risk free) as weights change or as risk preferences change
– Turning hedging activities into speculation is pointless (e.g., deliberately taking a position on future interest rate movements)
– Markets have no memory: price declines don’t make future price increases any more likely and vice versa
– There is no point in giving preference to equity issues over debt issues after price increases or vice versa
– Prices provide important information about the company’s prospects
• e.g., if bonds are trading at low prices there is probably something wrong with the company
– Engaging in M&A simply on the basis that a target company
seems underpriced is pointless (unless if there are synergies or
operational improvements to be made)
– Price reactions to new information (e.g., an announcement) are fast and accurate (prices do not over- or under-react on average)
• Therefore price changes around announcements/news tell you the market’s
expectation of how the news impacts the company
• E.g., HP + Autonomy deal market knew in minutes it was a bad deal
What are the three main tests on market efficiency?
Three broad classes of tests:
1. Tests of whether excess (abnormal) returns at time t+k are independent of information at time t.
2. Tests of whether the market can be outperformed on a risk-adjusted basis, e.g.:
• Can trading rules (e.g., automated buy/sell signals based on patterns of past returns) generate abnormal returns
• Can active fund managers outperform the market (or passive managers) on a risk-adjusted basis
3. Tests of whether prices equal fundamental value (calculated from DCF), or, whether the variation in prices can be explained by variation in fundamental value
Assumptions of CAPM?
Investors are risk averse and have the same information about the market
• Investors are rational and care only about the mean and variance of their returns (seek mean-variance-efficient portfolios)
• All investors face the same choice of investable assets
• Predictions about the return distribution are the same for all investors (E[r], volatility, covariance)
• Borrowing and lending at a risk-free rate
• Perfect capital markets (unrestricted short-selling, no transaction costs, costless information, infinitely divisible assets, no taxes)
