Lectures Flashcards

Question

What makes a quality market?

Answer 1

1. Liquidity (large amounts can be traded quickly with no large impact on the price) 2. Information efficiency (market aggregate disparsed information more accurately than individuals (residuals on avg are zero) 3. Integrity (people want to take part in fair markets).

Answer 2

1. 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 2. 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 3. 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. 4. Downstairs markets- trading on the market with other participants 5. 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. 6. Electronic markets- trading on the internet

Answer 3

1. 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 2. 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

Answer 4

1. 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. 2. Downstairs markets- trading on the market with other participants

Answer 5

1. Informed- earned profits from price discrepancies 2. Uninformed ('liquidity' traders)- trade because they want to diversify, invest (save) their money, gamble, etc 3. 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).

Answer 6

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).

Answer 7

1. When inventory holding costs are high 2. Adverse selection risk is high (many informed traders) 3. Fixed order processing costs are high 4. Lack of competition

Answer 8

1. Behavioral biases (overconfidence) | 2. Gains from trade (diversification, gambling, etc)

Answer 9

Information production is costly. Profits are just enough to cover their costs of producing information.

Answer 10

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

Answer 11

1. Reduce risk 2. 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).

Answer 12

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).

Answer 13

Fraction of the underlying stock needed to create a perfect hedge portfolio

Answer 14

1. Unwind prior to expiry (offset the position 1 Long + 1 Short = 0) 2. Deliver of cash settle at maturity (end of the contract) 3. Roll contract over to a later delivery date (1 year= 4*3month contracts

Answer 15

1. Dividend discount model (PV(stock)=PV(expected future dividends). 2. Valuation using multiples (multiply firm's earnings by the average P/E ratio of comperable firms) 3. Discount free CF model (value of the firm for ALL investors (equity+debt)).

Answer 16

1. Angel investors 2. Crowdfunding 3. Venture capital firm 4. Strategic investor 5. IPOs

Answer 17

``` PROS: + great liquidity + better access to capital (by issuing new shares) CONS: - equity holders dispersed - many requirements to be listed ```

Answer 18

1. Regular 2. Special (one time) 3. Stock split (like a stock dividend) 4. Liquidating dividend (return of capital to shareholders from a business operation that's being terminated)

Answer 19

1. Open market repurchase 2. Tender offer (offer a special price to all shareholders) 3. Dutch auction (to find out the worth of shares) 4. Targeted repurchase (buyback from a specific shareholder)

Answer 20

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.

Answer 21

1. Declaration day 2. Ex-dividend date (everyone who bought stock after ex-dividend date will not be eligible for the dividend) 3. Record date (when all shareholders who will receive the dividends are locked in) 4. Payable/ payment/ distribution date

Answer 22

1. Fixed investment plan 2. No personal or corporate taxes 3. No costs of issuing new shares 4. No costs of trading shares 5. Homogenous information

Answer 23

1. Personal tax savings' 2. Preserves financial flexibility 3. Corrects undervaluation 4. Removes low valuation shareholders 5. Improves reported EPS (as # of shares decreases) 6. Avoid disadvantaging stock option holders

Answer 24

Agency costs vs capital raising costs 1. If paying dividends --> Probability of needing more capital increases --> wasted value since raising more capital is costly 2. If not paying dividends--> retained earnings increase --> managers have money to waste and agency costs increase --> wasted value

Answer 25

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).

Answer 26

1. Different tax implications | 2. Different legal obligations

Answer 27

+ tax benefit + added discipline --> lowers some agency costs - increased bankruptcy costs - bond and equity holder conflict costs - loss of financial flexibility due to covenants

Answer 28

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)

Answer 29

Tradeoff theory explains: 1. Why firms choose debt levels too low to fully exploit the tax shield 2. Differences in the use of leverage across industries 3. 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

Answer 30

1. Retained earnings (no costs) 2. Bonds --> smallest costs since the bond holders only care about getting their CFs and do not care about information asymetry--> smaller discount 3. Hybrids (convertable bonds, preference stock) 4. 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)

Answer 31

``` 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. ```

Answer 32

1. WACC method- fixed D/E ratio and the new investment has a comparable risk to the other firm's projects 2. The adjusted PV method- can also use when D/E not fixed & easy to use when you have other side effects 3. FCFE method- D/E fixed, calculated FCF for equity holders only, not all shareholders.

Answer 33

1. Organic (from within firm)- slow | 2. Inorganic (from outside the firm)- rapid (e.g. M&As)

Answer 34

Combining two firms adds economic value (synergies)

Answer 35

Synergies- additional value created by combining two firms 1. Cost reduction-reduction of excess capacity, economies of scale, economies of scope, learning economies 2. Revenue enhancement: increased market power (more like a monopoly), network externalities, acquisition of complementaries 3. 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).

Answer 36

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)

Answer 37

Merging firms in different industries or countries (diversification, decreased probability of default, expanded debt capacity).

Answer 38

For example, many banks merging over time together into one bank. (no further growth opportunities on your own).

Answer 39

1. Diversification- shareholders can replicate (more easily and cheap) 2. Empire building (NPV=0 mergers) 3. Managerial overconfidence (some deals very risky) 4. Acquisitions only for EPS growth (no synergies)

Answer 40

1. Taxation 2. Risk exposure 3. Control (how voting power affected) 4. Continuity (which legal entity moves forward)

Answer 41

Through negotiations and bargaining (acquirer wants the smallest price, target wants the highest price) till they end up in Zone Of Potential Agreement

Answer 42

1. Exploitation of net operating loss tax credits' 2. Increase in depreciation tax shields due to revaluation of assets 3. Increase in debt tax shields from increased financial leverage

Answer 43

1. Cash purchase of all assets (voting stock for assets) 2. Cash purchase of stock (voting stock for stock) 3. Statutory merger (statutory consolidation - buy all shares) 4. Triangular merger (get your subsidiary to do everything)

Answer 44

* 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

Answer 45

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

Answer 46

Corporate raider– the acquirer in a hostile takeover

Answer 47

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

Answer 48

1. Proactive defenses •Deterrence of any bidder •Does not actively discriminate amongst potential bidders 2. Deal-embedded defenses •Deterrence of competing bidders •Raise the ante for competing bidders 3. Reactive defenses •Repelling a known specific bidder or bidders

Answer 49

• 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

Answer 50

• 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

Answer 51

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).

Answer 52

1. free-rider problem (shareholders from one firm might free ride and get all the benefits) --> nesaprotu, pls explain in the comment 2. Competition from other companies drives the price up --> like the winner's curse in IPOs 3. Bargaining power of the acquiree Hence, the M&A will be worth NPV=0 to the acquirer

Answer 53

– High degree of variation in returns to acquirer – Managerial overconfidence – “Empire building” (agency costs)

Answer 54

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.

Answer 55

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

Answer 56

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

Answer 57

1. 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. 2. Aggregate many opinions/forecasts/beliefs --> averaging out errors (wisdom of crowds)

Answer 58

1. ‘Limits to arbitrage’ (transaction costs, forbidden short-selling, noise-trader risk, counterparty risk, legal clauses risk, withdrawal limits). 2. ‘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) 3. 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.)

Answer 59

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)

Answer 60

– 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

Answer 61

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))

Answer 62

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

Answer 63

• 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

Answer 64

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

Answer 65

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)