Part 2 Models Flashcards
In the context of Factor Returns vs Marginal Utility - What is utility?
Satisfaction of an outcome (return)
Three types of factor
Macroeconomic
Fundamental
Statistical
How to identify Empirical and Theoretical Factors
Empirical - Derived through regression
Theoretical - Derived from reasoning about relationships
Fama French Factors
Market
Value - HML
Size - SMB
Fama French Carhart
Market
Value - HML
Size - SMB
Momentum - WML
Fama French 5 Factor
Market Value - HML Size - SMB Robust - RMW Conservative - CMA
Four Implications of Adaptive Market Hypothesis - adapt to survive
- Risk premiums vary over time
- Market efficiency is a relative concept
- Adaption for success and survival
- Degradation of alpha is inevitable
Two Time Varying Volatility Models - stochastic
Heston - volatility follows a mean reverting process
Bates - Heston with jumps
Five Credit Events
- Bankruptcy
- Credit Downgrade
- Failure to Make Payments
- Corporate Events
- Government Actions
Moral Hazard and Credit Risk
Occurs when borrower takes on more risk, knowing that the counter party bears the risk of the transaction
Types of credit risk modelling
- Structural - direct relationship between capital structure and default
- Reduced Form - default is a random factor
- Empirical - credit score
Shortcomings of the Merton Model
- Model parameters are not readily observable
- Model does not explain short-term securities well
- Model does not look at true PD, rather looks at probability implied by market prices determined by risk neutral investors
Four Important Properties of the Merton Model
1 - Sensitivity to maturity - as maturity increases, PD rises
2 - Sensitivity to asset volatility - as volatility increases, so does PD
3 - Sensitivity to leverage - as leverage increases, so does PD
4 - Sensitivity to risk free rate - as RF rate increases so does return expectation. Merton assumes RR is RF rate plus risk premium
What does the implied volatility factor premium involve?
Long in realised volatility through delta hedging and short in implied volatility
Five determinants of Altman’s z-score model
- Working capital / total assets
- Retained earnings / total assets
- Earnings before interest and taxes / total assets
- Market value of equity / book value of total liabilities
- Sales / total assets
