Models

Question 1

Practical use of a positive model?

Answer 1

identify mispricing of securities by recognizing patterns in actual price movement.(technical analysis)

Question 2

Practical use of a normative model?

Answer 2

identify the potential mispricing of securities by identifying how securities should be priced (e.g. arbitrage free models).

Question 3

Difference between an Abstract and an Applied model?

Answer 3

• Applied models are designed to address immediate real-world challenges and opportunities.
• Abstract models, also called basic models, tend to solve real-world challenges of the future.

Question 4

Cross-sectional model

Answer 4

Cross-sectional models analyze relationships across characteristics or variables observed at a single point in time

Question 5

Time-series model

Answer 5

Time-series models analyze behavior of a single subject or set of subjects through time.

Question 6

Panel data sets

Answer 6

tracking multiple subjects through time and is combination of Cross-Sectional and Time-Series

Question 7

Vasicek model

Answer 7

Vasicek’s model is a single-factor model that assumes constant volatility and that the short-term rate is mean reverting.

Question 8

Cox, Ingersoll, and Ross model (CIR model)

Answer 8

Alters the Vasicek model to make the variance of the short-term interest rate proportional to the rate itself (no negative interest rates)

Question 9

In Fixed Income what is the difference between Equilibrium models and Arbitrage-free models

Answer 9

Equilibrium make assumptions about the structure of the market and then use economic reasoning to model bond prices and the term structure.

Arbitrage-free models take the current interest as a given and model bond prices and the yield curve from there.

Question 10

Ho and Lee model

Answer 10

Single-factor model that assumes that the short-term interest rate follows a normally distributed process, with a drift parameter (to match the observed curve)

Question 11

Black–Derman–Toy Model (BDT model)

Answer 11

Interest rate model that centers on two relations: one focused on average forward rates and one on interest rate volatilities

Question 12

What is the difference between a Q Measure and P Measure?

Answer 12

A Q-Measure is a biased measure (typicaly assumes risk neutrality) and P-Measure indicates an actual statistical probability

Question 13

Examples of credit events

Answer 13

bankruptcy, downgrading, failure to make timely payments, certain corporate events, and government actions

Question 14

Adverse selection

Answer 14

parties to a transaction have access to different information (information asymetry). Typically present before a transaction.

Question 15

Moral Hazard

Answer 15

occurs when one party takes on more risk while the counter party bears the risk (after the transaction)

Question 16

Three types of credit risk modeling approaches

Answer 16

the structural approach, the reduced-form approach, and the empirical approach

Question 17

Merton Model

Answer 17

Structural Model whereby it assumes that default happens at the maturity of the debt if the asset value falls below the face value of the debt. (Highly restrictive model due to its assumptions)

Question 18

4 important properties of the Merton Model

Answer 18

1. Sensitivity to maturity (cum. PD increases as time increases).
2. Sensitivity to asset volatility (PD increases as volatitlity increases)
3. Sensitivity to leverage (PD increases as leverage increases)
4. Sensitivity to Riskless rate (PD decreases as RF is higher)

Question 19

What is the KMV model and what is its main output?

Answer 19

A structural credit risk model based on Merton that produces a credit score

Question 20

Reduced-Form Models assume

Answer 20

Default is exogenous

Question 21

Default intensity

Answer 21

Expected time to default (1/λ) and the probability of survival. The higher the default intensity, the shorter the expected time to default.

Question 22

Jarrow–Turnbull

Answer 22

reduced form model that assumes that regardless of timing of default, recovery is received at the maturity date (extended version includes credit ratings)

Question 23

Duffie–Singleton model

Answer 23

reduced form model that allows the recovery process to occur at any time and sets the recovery amount to be a fraction.

Question 24

Main beliefs empirical credit model

Answer 24

1. the default process is too difficult to be modeled

2. primary goal is to give a credit score

Question 25

Altman’s Z-Score Model

Answer 25

Uses financial ratios to generate a Z-score which gives a relative rank of likelyhood of default. Higher score is better.

Question 26

Five determinants Altman’s Z-Score

Answer 26

X1 = Working Capital / Total Assets
X2 = Retained Earnings /Total Assets
X3 = EBIT / Total Assets
X4 = MVE / Book value total liabilities
X5 = Sales / Total Assets

Question 27

What is a factor?

Answer 27

factor represents a unique source of return and a unique premium in financial markets

Question 28

Three major categories of factors

Answer 28

Macroeconomic, Fundamental, Statistical

Question 29

Which two factors are added in the Fama-French Five Factor Model

Answer 29

Robust minus Weak (strong accounting profit)

Conservative minus Aggressive (Conservative=lower rate of investment in corporate assets)

Question 30

Why are Fama-French models are of limited application to alternative asset returns that do not involve public equities?

Answer 30

Alternative assets do not tend to have the same factor exposures as traditional assets

Question 31

What are the three observations on Factor investing from Ang (2014)

Answer 31

1. Factors matter not assets (assets are merely a way to access factors).
2. Assets are bundles of factors
3. Different investors should focus on different factors

Question 32

What are the 4 important practical implications of an adaptive view of the markets?

Answer 32

1. Time-Varying Risk Premiums (risk premiums vary over time)
2. Market Efficiency is a Relative Concept (it has varying degrees)
3. Adaptation for Success and Survival (trading strategies should evolve with the time)
4. Inevitable degredation of Alpha

Question 33

Two popular approaches to modeling time-varying volatility as a stochastic process

Answer 33

Heston: volatility is a continuous stochastic process and volatility reverts to a long term mean.

Bates: Similar to Heston model but allows for a jump process

Question 34

Explain negative volatility risk premium

Answer 34

Lower expected return from positive exposure to volatility because positive exposure has negative beta

Question 35

An important implication of time-varying volatility

Answer 35

non-normality of returns

Question 36

What does it mean if a portfolio dominates another portfolio

Answer 36

higher returns with the same level of risk

Question 37

Risk averse investor

Answer 37

Has a concave utility function (increasing at a decreasing rate) and requires higher expected return to bear risk

Question 38

What does mean-variance optimization lead to and how can this be overcome?

Answer 38

typically leads to unrealistic weights which can be overcome by imposing limits on the weights

Question 39

Hurdle rate

Answer 39

hurdle rate is the minimum expected rate of return that a new asset must offer in order to be a beneficial inclusion in an otherwise existing optimal portfolio.

Question 40

two types of illiquidity risks

Answer 40

Market liquidity risk arises when an event forces an investor to sell an asset that is not actively traded and there are a limited number of active market participants.

Funding liquidity risk arises when a borrower or investor is unable to immediately pay what is owed. A forced liquidation of assets may occur

Question 41

Primary innovation of the Black–Litterman approach

Answer 41

it allows the investor to blend asset-specific views of each asset’s expected return

Question 42

Three steps in implementing a Risk-Parity approach

Answer 42

1. Define the total risk of the portfolio
2. Define a method to measure marginal risk contribution
3. Determine portfolio weights

Question 43

new investment model

Answer 43

Beta is sought through investment products that cost-effectively offer returns driven by beta and Alpha is sought independently of beta.