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BU.232.701.32 Investments > Module 1: Microeconomics > Flashcards

Module 1: Microeconomics Flashcards

1
Q

What is a budget set?

A

affordable consumption bundles at prices (p1, p2) and income m

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2
Q

What is a composite good?

A

everything else that the consumer might want to consume other than good 1

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3
Q

What is the equation for a budget line?

A

P1X1 + P2X2 = m

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4
Q

What does the slope of the budget line measure?

A

opportunity cost of consuming good 1

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5
Q

What does an increase in income do to the budget line?

A

An increase in income will result in a parallel shift outward of the budget line

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6
Q

What are ad valorem taxes?

A

Taxes based on the assessed value of an item

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7
Q

What happens to the budget line when good 1 becomes more expensive but income is fixed?

A

Line becomes steeper as good 1 becomes more expensive.

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8
Q

What is a quantity subsidy?

A

Government gives an amount to the consumer that depends on the amount of the good purchased (p1 — s)

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9
Q

What is a lump sum tax/subsidy?

A

Government adds or takes away some fixed amount of money, regardless of the individual’s behavior. Means that the budget line of a consumer will shift inward because his money income has been reduced. Budget line will shift outward.

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10
Q

What is a rationing constraint?

A

Level of consumption of some good is fixed to be no larger than some amount.

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11
Q

How is a perfectly balanced inflation defined?

A

One in which all prices and all incomes rise at the same rate—doesn’t change anybody’s budget set, and thus cannot change anybody’s optimal choice.

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12
Q

What is a perfect substitute?

A

Goods where indifference curves have a constant slope and parallel to each other.

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13
Q

What are perfect complements?

A

Goods that are always consumed together in fixed proportions. Consumer prefers to consume the goods in fixed proportions, not necessarily that the proportion is one-to-one.

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14
Q

What is meant by satiation?

A

Where there is some overall best bundle for the consumer, and the “closer” he is to that best bundle, the better off he is in terms of his own preferences.

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15
Q

What is the assumption monotonicity?

A

We are going to examine situations before that point is reached—before any satiation sets in—while more still is better. Implies that they have a negative slope.

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16
Q

Why do we want to assume that well-behaved preferences are convex?

A

Because, for the most part, goods are consumed together.

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17
Q

What is meant by strict convexity?

A

The weighted average of two indifferent bundles is strictly preferred to the two extreme bundles. Must have indifferences curves that are “rounded”.

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18
Q

What is the marginal rate of substitution (MRS)?

A

Slope of an indifference curve. Measures the rate at which the consumer is just on the margin of trading or not trading.

At any rate of exchange other than the MRS, the consumer would want to trade one good for the other. But if the rate of exchange equals the MRS, the consumer wants to stay put.

Measures the rate at which the consumer is just on the margin of being willing to substitute good 1 for good 2.

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19
Q

What is utility?

A

Utility is seen only as a way to describe preferences.

In contrast to preferences of the consumer - the fundamental description useful for analyzing choice, and utility is simply a way of describing preferences.

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20
Q

What is the Utility Function?

A

A way of assigning a number to every possible consumption bundle such that more-preferred bundles get assigned larger numbers than less-preferred bundles.

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21
Q

What is a Monotonic transformation?

A

A way of transforming one set of numbers into another set of numbers in a way that preserves the order of the numbers.

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22
Q

Does a monotonic transformation of a utility function is a utility function that represent the same preferences as the original utility function?

A

Yes

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23
Q

What is the cardinal utility?

A

Size of the utility difference between two bundles of goods is supposed to have some sort of significance.

To tell whether one bundle or another will be chosen, we only have to know which is preferred—which has the larger utility (analogous to effect size).

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24
Q

Why are cardinal utilities problematic?

A

Knowing how much larger doesn’t add anything to our description of choice. Since cardinal utility isn’t needed to describe choice behavior and there is no compelling way to assign cardinal utilities anyway, we will stick with a purely ordinal utility framework.

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25
Q

What is a level set?

A

Utility set: all (x1, x2) such that u(x1, x2) equals a constant

If you are given a utility function, u(x1, x2), it is relatively easy to draw the indifference curves: you just plot all the points (x1, x2) such that u(x1, x2) equals a constant.

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26
Q

What utility function can represent perfect substitutes?

A

u(x1, x2) = ax1 + bx2

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27
Q

What utility function can represent perfect complements?

A

u(x1, x2) = min{ax1, bx2}

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28
Q

What is the Cobbs-Douglas Indifference Curve?

A

u(x1,x2) = x1^c * x2^d

Indifference curves look just like the nice convex monotonic indifference curves that we referred to as “well-behaved indifference curves”.

Option: Can always take a monotonic transformation of the Cobb-Douglas utility function that make the exponents sum to 1

29
Q

What is the marginal utility?

A

Rate of change in utility (ACT) associated with a small change in the amount of good 1 (Azi).

MU1 = ∆U/∆x1 = [u(x1 + ∆x1,x2) - u(x1,x2)] / ∆x1

30
Q

What does the marginal rate of substitution (MRS) measure?

A

Slope of the indifference curve at a given bundle of goods.

MRS = ∆x2/∆X1 = -MU1/MU2

31
Q

Can the utility function be used to measure MRS?

A

Yes. The MRS can be measured by observing a person’s actual behavior—we find that rate of exchange where he or she is just willing to stay put.

MU1∆x1 + MU2∆x2 = ∆U = 0

32
Q

How can one forecast consumer + good selection using the utility function?

A

Marginal rate of substitution to estimate the value that each consumer places on each good.

33
Q

What is the effective annual rate (EAR)?

A

Total return as a rate of return over a common period (typically annually).

34
Q

When would one typically express EAR as an annual rate?

A

For investments longer than a year, the convention is to express the EAR as the annual rate that would compound to the same value as the actual investment.

Effective annual rates explicitly account for compound interest.

EAR =[(1 + APR/n)^n] -1

35
Q

How is the holding period of return estimated?

A

r(T) = (Price increase + Income)/p(T)

36
Q

How is short range interest references?

A

APR which ignores compounding.

APR = n[(1+EAR)^1/n -1]

37
Q

What is continuous compounding (CC)?

A

The relation of EAR to the annual percentage rate, denoted by rcc for the continuously compounded case, is given by the exponential function

1 + EAR = exp(rcc) = e^rcc

38
Q

How do we estimate the rcc from the effective annual rate?

A

rcc = ln(1 + EAR)

39
Q

How do we estimate the compounding rate?

A

exp ( T x rcc)

40
Q

How are budget constraints interpreted by the budget line?

A

Top right = not affordable
On the line = just affordable
Bottom left = affordable

41
Q

Why does the shape of a budget constraint matter for investments?

A

Shape of budget constraints is essential to understand expected return and risk (“the bad”) when engaging with investments.

42
Q

How do real and nominal interest rates differ?

A

Nominal: rate at which the dollar value of your
account grows

Real: rate at which the goods you can buy
with your funds grows

43
Q

How is the real interest rate calculated?

A

r_real = (r_nom - i) / (1 + i)

r_real_approx = r_nom - i

44
Q

How can the continuously compounded real rate of return, rcc(real), can be derived from the effective annual real rate, rreal?

A

r​  cc​​ (real) = ln(1 + ​ r​  real​​ ) = ln​​ (1 + ​ r​  nom/(1 + i​​)) = ln(1 + ​ r​  nom​​ ) − ln(1 + i ) =  ​ r​  cc​​ (nom) − ​ i​ cc

45
Q

How is the nominal interest rate estimated from the Fisher hypothesis?

A

r_nom = r_real + E(i)

E(i) = expected inflation

46
Q

Are tax liabilities based on nominal income?

A

Yes

47
Q

What determines the tax rate of an individual?

A

The Investor’s tax bracket.

48
Q

What don’t index-linked tax brackets provide relief from inflation on taxation of savings?

A

This is so given that the real after-tax rate is approximately the after-tax nominal
rate minus the inflation rate.

Because you pay taxes on even the portion of interest earnings that is merely compensation for inflation, your after-tax real return falls by the
tax rate times the inflation rate.

49
Q

What is the holding period return?

A

Realized return after a specified period of time.

HPR = (Ending Price of Share - Beginning Price + Cash Dividend)/Beginning Price

50
Q

What are dividend yields?

A

Percent return from dividends on a given stock gain.

51
Q

How are mean rates of return (E(r)) estimated given the distribution of possible HPRs?

A

E(r) = sum(p(s) * r(s))

p = probability of each scenario
r = HPR of each scenarios
s = index of scenario

52
Q

How are variance rates of return (E(r)) estimated given the distribution of possible HPRs?

A

Var(r) = sigma^2 = sum(p(s) *[r(s) - E(s)]^2)

53
Q

What is an example of a risk-free rate?

A

T-bills, money market funds, or the bank.

54
Q

How is a risk premium defined?

A

Difference between expected HPR and risk free asset.

55
Q

What the Sharpe ratio?

A

Attraction of a portfolio by the ratio of its risk premium to the SD of its excess returns.

Sharpe ratio = Risk premium/(SD of excess return)

56
Q

How is skew estimated?

A

Averaged cubed deviation from the mean.

Skew = average [(R-mean(R)^3)/sigma^3]

57
Q

What does kurtosis concern itself with?

A

Likelihood of extreme values on either side of the mean at the expense of a smaller likelihood of
moderate deviations.

Kurtosis = average [(R-mean(R)^4)/sigma^4]

58
Q

What type of loss described by the value at risk?

A

Looks to understand worst-case outcomes for a portfolio. VaR aka quantile of a distribution.

Loss corresponding to a very low percentile of the entire return distribution.

Example:

Va(1%, normal) = Mean - 2.33SD

2.33 represents the z score at the first percentile. when normally distributed. Can use observed sample distribution when not normally distributed.

59
Q

What is the expected short fall or conditional tail expectation?

A

Informative view of downside exposure would focus instead on the expected
loss given that we find ourselves in one of the worst-case scenarios.

The latter emphasizes that this expectation is conditioned on being in the left tail of
the distribution. ES is the more commonly used terminology.

ES = (1/.05) * ​​ exp(μ)N [−σ − F(.95)]​​ − 1

60
Q

What are complications when using standard deviation as a measure of portfolio risk?

A

(1) The asymmetry of the distribution suggests we should look at negative outcomes separately

(2) because an alternative to a risky portfolio is a
risk-free investment, we should look at deviations of returns from the risk-free rate rather than from the sample average, that is, at negative excess returns.

61
Q

What is the Lower partial standard deviation (LPSD)?

A

Computed like the usual standard deviation, but using only “bad” returns or only negative deviations from the risk-free rate.

Essentially the square root to obtain a “left-tail standard deviation.”

62
Q

What the Sharpe ratio alternative paired with the LPSD?

A

Sortino ratio.

63
Q

How is the arithmetic average of historic rates of returns obtained?

A

E(r) = 1/n ​​ ​​ ∑​​​ r(s)

Provides an unbiased estimate of the expected future return

64
Q

What is an intuitive measure of average performance over the sample period?

A

Geometric or compound rate of return (g). Often referred to time-weighted. Each past return receives an equal weight in the process of averaging.

Terminal value = 1+rn * 1 + rn_1

g = Terminal value ^1/n

65
Q

What is the relationship between the geometric and average rate of return?

A

E[Geometric] = E[Arithmetic] - 1/2*SD

66
Q

What is the relationship to market value to book value?

A

Firms with high ratios of market value to book value are viewed as “growth firms” because, to justify their high prices relative to current book values, the market must anticipate rapid growth.

Following the Fama-French classifications, we drop the medium B/M portfolios
and identify firms ranked in the top 30% of B/M ratio as “value firms” and firms
ranked in the bottom 30% as “growth firms.”

67
Q

What is a lognormal distribution?

A

Lognormal” means that the log of the final portfolio value, ln(WT), is normally distributed.

68
Q

Why don’t investments in risky portfolios become safer overtime?

A

Investments in risky portfolios do not become safer in the long run.

On the contrary, the longer
a risky investment is held, the greater the risk.

The basis of the argument that stocks are safe in
the long run is the fact that the probability of an investment shortfall becomes smaller. However,
probability of shortfall is an incomplete measure of the safety of an investment because it ignores
the magnitude of possible losses.

BU.232.701.32 Investments (3 decks)

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