Package 2 Flashcards
Anomalies: The Law of One Price in
Financial Markets
Name 5 case why LOOP can fail
- closed-end-country funds
- ADR’s (America Depository Receipts) - when foreign security is traded with a huge premium
- Twin Share (e.g. Royal Dutch 60% / Shell Group 40%)
- Corporate Spinoffs
- Dual Class Shares
Anomalies: The Law of One Price in
Financial Markets
Assumptions for LOOP
- No transaction costs
- Markets are competitive
- No barriers to trade
Anomalies: The Law of One Price in
Financial Markets
4 reasons why LOOP should hold in financial market
- Investors are adequate
- Transactions are almost for free and immediate
- Short-selling is allowed
- Arbitrage opportunities should be exploited
Anomalies: The Law of One Price in
Financial Markets
Explanation of anomalies
- Transaction costs still exist
• Lack of instruments
• “Noise trader risk”
• Short-selling isn’t possible
Anomalies: The Law of One Price in
Financial Markets
Explain the Law of One Price
Identical goods must have identical prices. In capital markets- identical securities must have identical prices, otherwise, smart investors are able to recognize arbitrage opportunities and make unlimited profits buy buying the cheap one and selling expensive one.
Forensic Finance
Examples of FF
- Late trading
- Stock option backdating
- Spinning of IPO’s
- Rewriting history: market recommendation
Forensic Finance
the scheme of late trading
1) Mutual funds close at 4 p.m.
2) Investors put offers after the deadline and get better
price
3) Mispricing (“stale price”) due to time zones and
illiquidity
Forensic Finance
What is “Market timing”
“Market timing” – taking advantage of difference in the
time that markets close
Forensic finance
Specify 4 activities of forensic finance that are illegal and makes speculators better off.
- Late closed mutual funds;
- Stock option backdating;
- The allocation of underpricing IPO’s (i.e. spinning of IPO’s);
- Rewriting history: market recommendation
Forensic finance
What is logic behind allocation of underpricing IPO’s (i.e. spinning of IPO’s).
Company goes IPO->goes to an organization->organization provides a dealer->dealer offers to sell the company cheaper->investors who buy-better of, dealer-better of (bribed)
Forensic finance
What is logic behind rewriting history.
IBES analysts recommend investors to buy some stocks or sell some stocks, EVEN if it was not good idea for them. Then, they changed the information about what to do for investors, and a lot of people suffered from this.
Forensic finance
Results of Late trading scandal
Many of the large mutual fund families that knowingly permitted the late trading were forced to hire independent consultants, to estimate damages and oversee reforms.
*A number of financial professors were hired for the role
- hire consultants, evaluate losses, develop reforms;
- mnogih posadili (investorov, rukovoditelej);
- companies how did late trading - clients were gone;
- big fines;
Forensic finance
What is effect of stock backdating on stock price?
it falls (in average 7%)
- effect: new regulations (10 days versus 3 days);
- managers have to pay fines;
Forensic finance
What is the result of spinning of IPO’s
Company get less money in the
company (as their company is underpriced)
- nothing said, fail…
Forensic finance
What is the result of re-writing history research
Thomson has changed its data handling procedures going forward to prevent inadvertent alterations of the data occurring. Thus, the data quality for future research has been improved.
- database was improved;
Should We Fear Derivatives?
Benefits of derivatives
• Better risk allocation (risk is taken by riskseeking
investors)
• Informational efficiency (e.g. about expected
interest rates)
• Cheaper than replication (low transaction
costs, no need to pay each time the underlying
price changes)
• Hedging
• Expand investment opportunities
Should We Fear Derivatives?
List 4 examples of derivatives
• Forwards/ futures • Options • Swaps • Exotics (combination of derivatives, binary options, …)
Should We Fear Derivatives?
Dodgy benefits of derivatives
- Smoothing accounting earnings
- Speculation
- Regulatory arbitrage
- Optimize tax
Should We Fear Derivatives?
Risks of derivatives
• Room for speculation
• Hard to understand and value (assumptions of BS
don’t hold)
• Liquidity of derivative markets (complex
derivatives are illiquid)
• Transparency and reliability of accounting
(companies rarely report the derivatives they use)
• Perverse incentives
• Systematic risk (example of LTCM collapse)
Should We Fear Derivatives?
What is derivative
Derivatives- financial instruments whose promised payoffs are derived from the value of something else, called the underlying.
Should We Fear Derivatives?
Pricing of Derivatives
Derivatives are priced with the assumptions that there are no frictions in financial markets. They have replicating portfolio – which doesn’t use derivatives and requires such initial investment that it would pay the same as the derivative at maturity.
Should We Fear Derivatives?
Size determination of derivatives market:
- Notional amount;
- Aggregate value of OTC derivatives outstanding;
- Measure how much trading takes place.
Should We Fear Derivatives?
Why derivatives are almost never redundant asset for individuals and non-financial firms?
1) Individuals and non-fin. firms face much higher trading costs than the most efficient financial institution.
2) For derivatives that include option features, the replicating portfolio strategy typically requires trades to be made whenever the price of the underlying changes otherwise rep.port. works only approximately.
3) Identifying correct replicating strategy is often a problem.
Hedge Funds: Past, Present, and Future
List main differences between hedge fund and mutual fund
Mutual funds: – Heavily regulated – Low risk – Underperform the market – Transparency and accountability – A bad benchmark – Fund withdrawal
Hedge funds: – Little regulated – High risk – Outperform the market – Typically hide their (complex) strategies from competition – Hard to evaluate success – Limited withdrawal
Hedge Funds: Past, Present, and Future
List hedge fund strategies
• Long – short equities (exploit mispricing)
• Bets on convergence and divergence
• Event driven (spin-offs, M&A, reorganization,
bankruptcies, other extraordinary transactions)
• Macro-economics event driven (exploit
mispricing in FX, interest rates, commodities,
stocks)
• Fixed income
Hedge Funds: Past, Present, and Future
Risks and problems for Hedge fund
• Lack of transparency makes it hard to evaluate
• Look for arbitrage, but when things go wrong,
make big loses
• No incentive for investor protection
• Illiquidity risk- because lots of hedge funds take
similar positions they can all mess up at the same
time → spillovers to financial system/institutions
• Low diversification
• Excess volatility
Hedge Funds: Past, Present, and Future
The future of hedge fund
- More competition
- More regulation
- Institutionalized
- So, returns will decrease
Hedge Funds: Past, Present, and Future
What is Hedge Fund?
Hedge funds- unregulated pools of money managed by an investment advisor (hedge fund manager) who has a great deal of flexibility. These managers have the right to have short positions, to borrow, and to make extensive use of derivatives. Hedge funds must limit the number of investors who can invest (accredited investors consisting of institutional investors, companies or high net worth individuals) and they cannot make public offerings (in order to avoid regulations which are imposed on mutual funds).
Hedge Funds: Past, Present, and Future
What is a fund-of-funds
A fund-of-funds is a hedge fund that invests in individual hedge funds and monitors these investments, thereby providing investors a diversified portfolio of hedge funds, risk management services, way to share due diligence costs with other investors. The compensation of fund-of-funds managers also has a fixed fee and a performance fee.
Hedge Funds: Past, Present, and Future
Why does hedge fund exist?
Hedge fund exist because mutual funds do not deliver complex investment strategies, because they are regulated.
Hedge Funds: Past, Present, and Future
How HF can avoid the regulations?
To avoid the regulations hedge funds must limit the number of investors who can invest and they cannot make public offering.
Hedge Funds: Past, Present, and Future
the main difference between onshore and offshore fund
The onshore fund is generally a limited partnership if investors are taxed, so that gains and losses flow through to investors and there is no taxation in the fund level.
Offshore fund is usually based in tax haven (ex. Berfmuda).
Hedge Funds: Past, Present, and Future
What is the difference between Futures and Forwards
Futures: *Standardized * Exchange traded *Physical delivery or cash settled Forwards: * Taylor made * OTC *Only physical delivered *Counterpart risk
