Section A and B Flashcards
What option is there to employees of labor-intensive companies and what does that imply?
One of the only options is for employees to avoid purchasing shares of their own employer, or even companies from their own industry. As a result, securities offered by labor intensive firms will have a lower demand, and therefore may appear to have a positive α according to the traditional CAPM
BKM9
What are the 2 options for an investor with a small portfolio, according to EMH?
1) Invest in a mutual fund
2) Passive investment
BKM11
What does EMH states about fundamental analysis?
According to EMH, fundamental analysis will usually not work. The exception is that it may be successful for investors who have a unique insight.
Briefly describe the Equity carve-outs example ((Law of One Price violation)
In 1999, 3Com span off its Palm division. Each 3Com shareholder was to receive 1.5 shares of Palm. In the period between the initial trading of the Palm shares, and the spinoff, 3Com shares should have been trading for at least 1.5 times the value of Palm. Instead Palm traded for more than 3Com! Arbitrageurs could not exploit the mispricing by buying 3Com and selling Palm short, because no Palm shares were available: they had already all been short sold.
BKM12
Describe Indexing challenges and its solutions
This involves creating a portfolio that resembles the composition of a market index. There are several problems associated with forming this portfolio:
- The index could consist of thousands of securities
- The composition of the bond index changes more often than that of the stock index
Due to the difficulties, stratified sampling is utilized. This involves stratifying the bond market into several classes
BKM16
List expected characteristics of the SML
Need the slope to be constant, which implies a constant β.
Intercept of should be 0.
BKM9
List the 3 Market Structure assumptions of the CAPM
All assets are publicly traded, and short positions are allowed: investors can borrow/lend at a common risk free rate. Assumption that assets are tradable is necessary for investors to be able to derive identical input lists.
All information is publicly available
No taxes: if investors had different tax rates, they would earn different after tax rates on the same stock, and could therefore derive different after tax optimal risky portfolios.
No transaction costs
BKM9
Explain 2 ways a sinking fund may operate
- The firm may repurchase a portion of the outstanding bonds in the open market annually
- The firm may purchase a fraction of the bonds at a special call price that is associated with the sinking fund provision
BKM14
What will the owner of privately held business with similar characteristic to traded assets can do to achieve diversification?
Owners can still achieve diversification by reducing their portfolio holdings of similar traded assets, so they will still essentially hold the market portfolio.
BKM9
Define preferred stocks and its difference with bonds
Promise to pay a specified stream of dividends. The difference is that if the preferred stock issuer is unable to pay the dividend, it does not enter corporate bankruptcy, but rather the dividends owed cumulate. Common stockholders are not eligible to receive any dividends until the preferred stockholders have been paid.
BKM14
List the 3 Individual Behavior assumptions of the CAPM
Investors are rational mean-variance optimizers: investors are only concerned about mean and variance, and are not concerned about the correlation of the asset returns with inflation/prices of consumption items
Their planning horizon is a single period: longer periods would result in extra-market risk factors.
Investors use identical input lists
BKM9
Briefly describe an alternative strategy to reduce the duration of the total economic value without alarming regulators. (+ advantage and disadvantage)
An alternative strategy is to adopt a pricing strategy that reduces the sensitivity of the franchise value to interest rates. One such strategy is to alter the values of a and b
Advantage:
- Avoids rating agency and regulatory risk that are associated with managing the duration of the invested assets
Disadvantage:
- The desired combination of target return on surplus and target duration can be maintained only for small interest rate changes
Panning
Define the mutual fund theorem
he mutual fund theorem states that if all investors would hold a common risky portfolio, they would not object if all the stocks in the market were replaced with shares of a single mutual fund holding the market portfolio.
BKM9
List the 3 passive bond management strategies
- Indexing
- Immunization
- Cash flow matching
BKM16
Contrast a sinking fund call and a conventional bond call
- The firm can only repurchase a limited fraction of the bonds at the sinking fund call price
- The call price of callable bonds usually exceeds par value, whereas the sinking fund call price is usually set at the par value
BKM14
Contrast Asset allocation and Security selection
Asset allocation: allocation of a complete portfolio to the various asset categories
Security selection: Within each category of assets, investors can select specific securities in order to try increase return
BKM7
List and describe the two types of portfolio risk
1) Market / Systematic / Nondiversifiable : Risk that cannot be diversified away
2) Unique / Firm-Specific / Nonsystematic / Diversifiable: Portion of risk that can be eliminated via diversification
BKM7
List and briefly describe examples of bond indenture
- Sinking Funds: issuer may establish a sinking fund to spread the burden of the principal repayment, over several years
- Subordination of Further Debt: prevent the firm from borrowing a huge amount of money, thus increasing the risk of financial difficulty.
Dividend Restrictions: this would force the firm to retain assets rather than pay them out to the stockholders.
Collateral: Some bonds may be supported by collateral.
BKM14
Define risk sharing and 2 problems with this
Risk sharing: Taking a fixed amount of risk, and sharing it among several investors.
Sharpe ratio will increase, total risk will decrease.
There are some problems with this approach though:
- There are some disadvantages of managing a very large firm. These disadvantages will put pressure on the profit margins.
- The impact of any error when estimating the risk of the insured will be compounded over many policies
BKM7
List and describe 2 types of swap
- Foreign exchange swap: exchange currencies on specific future dates
- Interest rate swap: exchange of cash flows at future dates based on the difference between fixed and floating rates at those dates
BKM23.4
How can investment on additional period reduce risk?
We can think of extending an investment horizon for an additional period to be the same as adding an additional risky asset to a pool.
Invest half the budget in the risky asset and half of the budget in risk-free asset for both periods
BKM7
Define certainty equivalent
Rate that a risk free investment would need to offer to provide the same level of utility as the investment being analyzed.
BKM6
Explain use of an active strategy even in a efficient market
If all investors would use passive strategy, no effects are put to exploit arbitrage opportunities. Therefore, even if there are inefficiencies in the markets, there are no pressures to correct them. Eventually, the market will become inefficient.
BKM11
What is an indifference curve?
Curves that contain different portfolios that the investor is indifferent about (same utility levels)
BKM6
List 3 reasons why short positions may be limited
There is no cap on the liability of short positions: a large short position will require significant collateral
There is a limited supply of stocks that can be borrowed by short sellers
Many investment companies are prohibited from short sales.
BKM9
List relationships between bonds and yields (6)
- Bond prices & yield are inversely related
- An increase in the yield produces a smaller price change than the same size decrease in yield
- As the term of the bond increases, the price becomes more sensitive to yield changes
- The sensitivity of bond prices to yield increases at a decreasing rate as the maturity increases
- Lower coupon bonds are more sensitive to changes in yields
- The sensitivity of bond prices to yield are inversely related to the yield
BKM16
Give 2 explanations for test results that prove market inefficiency (market anomalies)
The properties are proxies for fundamental determinants of risk
The properties arise just due to data mining. One supporting factor for this argument is that many of these anomalies disappear after discovered. One way to test for this is to see if the relationship holds in a different database.
BKM11
List the 3 assumptions of the Arbitrage Pricing Theory
1) Security returns can be described by a factor model
2) There are a sufficient number of securities to diversify away idiosyncratic (specific) risk
3) Well-functioning securities markets do not allow for the persistence of arbitrage opportunities
BKM10
Define a hedge asset
A hedge asset is defined as one that has a negative correlation with other assets in the portfolio.
BKM7
Define floating rate bonds
Provide interest payments that are based on the current market rates. There is therefore less interest rate risk: as interest rates rise, the increase in interest offsets the higher discounting rate. (Still a limited range of possible yields)
Opposite is an inverse-floater.
BKM14
Why do the slope of the CAL may be kinked to the left?
CAL needs to be adjusted to reflect the fact that in reality, normal investors cannot borrow at the risk free rate. If this is the case, the CAL will be kinked at P. (CAL with borrowing rate)
BKM6
Briefly describe the advantage and disadvantage of the optimisation procedure under Single index model to build the risky portfolio (vs passive strategy)
The advantage of using the procedure is that by using security analysis, we can hopefully identify assets with non zero alphas, and over/underweight these relative to the market in order to increase returns.
The disadvantage of this is that it will introduce firm specific risk.
BKM8
Contrast the risk return dominance argument to the arbitrage argument
RRD: Many investors will make limited changes to their portfolios, depending on their degree of risk aversion.
A: The investor who discovers the arbitrage opportunity will want to maximize his position in order to maximize profits
BKM10
Identify 2 challenges with event study and ways to counter
1) The stock price may respond to a wide range of economic news in addition to the specific event
- Abnormal return (Actual over benchmark)
2) Information about the event may be leaked prior to the actual event. (Price may start to move earlier)
- Cumulative abnormal return : Look for large delta on date of announcement and no drift after
BKM11
GIve 3 reasons why many economists disagree with behvioural finance
- The behavioral approach is too unstructured: it allows virtually any anomaly to be explained by a combination of irrationalities.
- Some anomalies are inconsistent in their support for one irrationality vs another.
- Selecting the wrong benchmark can produce an apparent abnormality.
BKM12
Explain how the term structure may be interpreted and one problem with this approach
- If the curve has a steep positive rise, it is still likely that the market expects an expansion in economic activity
- If the curve is sloping downward, it is likely that interest rates are expected to decline
One problem with this approach is that in addition to expectations, the term structure may be impacted by other factors, like the liquidity premium.
BKM15
Describe 3 sentiment indicators according to behavioural finance model
Trin Statistic: Market advances are considered to be stronger when they are accompanied by stronger trading volumes. Trin = (Volume declining / Number declining) / (Volume advancing / Number advancing) Ratios over 1 are bearish
- Confidence Index: This is based on data from the bond market, under the assumption that the actions of bond traders reveal trends that will later follow in the stock market.
- Put/Call Ratio: this equals the ratio of outstanding put options to outstanding call options. Since put options profit from falling markets, an increase in the ratio is a bearish sign.
BKM12
Describe 5 issues that explain the difficulty to assess market efficiency
- Magnitude Issue: Assume a portfolio did 0.1% better than last year. It is very small compared to the normal volatility of the market. It is therefore hard to assess how much the manager actually contributed
- Selection Bias Issue: once an investment scheme becomes known by others, it will no longer generate abnormal returns. It is possible that techniques that do actually work exist, but are not being reported.
- Lucky Event Issue: There are several cases of investors who have made huge investment returns over a period. However, this does not disprove EMH, because the number of investors is so large, just by chance, some have to make huge returns.
- More risk was taken to achieve higher returns
- Wide variance in returns, so difficult to say if difference due to randomness or not
BKM11
What are 2 elements making duration not constant
- It will change as the rates change
- It will fall as time passes
BKM16
What conclusion can be drawn from portfolio with ρ=1 and ρ=-1?
If ρ =1, then 100% of funds will be in the asset with the lowest σ
If ρ = -1, σ will be 0 as there is a portfolio that has no risk
BKM7
Describe fundamental analysis and types of fundamentals (3)
This type of analysis uses the fundamentals of a firm to determine the appropriate price. Fundamentals examined include:
Earnings & dividends prospects
Future interest rate expectations
Risks
BKM11
Contrast Foreign bonds and Eurobonds
- Foreign bonds: issued by a borrower from a country other than the one where the bond is sold. It is denominated in the currency of the country in which it is marketed
Eurobonds: denominated in currency of the issuer, but sold in other markets
BKM14
What is the problem with Fama French 3 factor model?
None of the factors can be identified as hedging a specific significant source of uncertainty
BKM10
Describle the 3 versions of the EMH
Weak form: Stock prices reflect all information that can be derived from examining market data. Technical only.
Semistrong form: stock prices reflect all publicly available information about the firm’s prospects. Technical and fundamental.
Strong form: stock prices reflect all information relevant to the firm, including that not publicly available (insider information). Technical, fundamental and non public info.
BKM11
Describe an event study
Determine the importance of an event by measuring the resulting price changes
1) The stock price may respond to a wide range of economic news in addition to the specific event (Identification)
2) Information about the event may be leaked prior to the actual event. (Timing)
BKM11
Briefly described the logic behind a consumption based CAPM
This is based on the assumption that in a period, investors need to allocate the current wealth between consumption today; and savings/investment to support future consumption.
Investors will value the additional income from the savings more during tough economic times. Therefore assets that have a positive covariance with consumption growth are viewed as being riskier. The equilibrium risk premium for these assets will be higher.
BKM9
