the stock market and the mutual fund industry

Question 1

What is a stock? (5)

Answer 1

1. represent ownership of the firm
2. paid out over two days: stock prices will rise and fall over time, dividend is paid out
3. stockholders have claim on all assets
4. Right to vote for directors and on certain issues
5. Two types:
   - common stock: right to vote, receive dividends
   - preferred stock: receive fixed dividend, do not usually vote

Question 2

What is the risk of stocks? (5)

Answer 2

1. Usually riskier than bonds, because firms don’t prioritise stockholders if firm is in payment, as debts have to be paid out first
2. Dividends is not guaranteed: firm has to turn a profit first
3. Stock prices fluctuate much more than bond prices:
4. stockholders are residual claimants: so can claim after al others, such as debtors have been satisfied
5. if nothing is left over, stockholders get nothing

Question 3

How are stocks traded by firms? (7)

Answer 3

Firms can finance their operation in essentially two ways:

• issuing bonds: short term borrowings to finance investments
• Selling equity and shares to investors: part of the company
• when firm decides to raise capital by selling stocks they contact an investment bank to issue an IPO initial public offering), this happens in primary market.
• investment bank arranges for IPO to be listed on one or more stock exchanges
• arranges for it to be sold to institutional and retail investors
• after IPO, stocks will be traded in the secondary market (organised security exchanges, OTC, alternative trading systems (US and Europe)

Question 4

How are stocks physically traded?

Answer 4

• used to be a physical market where traders would shout prices of buyers and sellers
• today: everything is automated through technology (orders sent and executed)
• orders are sent and executed by computers (no human interaction)

Question 5

What is algorithmic and high frequency trading? (2)

Answer 5

• Algorithmic trading (AT) is a generic term that refers to strategies that use computers to automate trading decisions.
• High Frequency Traders (HFT) refer to the subset of algo trading that are characterised by their reliance on speed differences relative to other trader to make profits.
=The main difference between AT and HFT is the speed of trades.

Question 6

What are organised exchanges? (5)

Answer 6

1. a marketplace where stocks, derivatives and commodities are traded
2. the core function of an exchange: is to ensure orderly and fair trading, as well as efficient disclosure of price information for any securities traded on that exchange
3. offer various services: listing, data and trading
4. firms that list on exchange have to pay a listing fee (depending on how big they are)
5. a security is said to be exchange traded when the trading process has been structured, monitored and standardised

Question 7

What are stock indices and EFT’s? (2)

Answer 7

• A stock index (CAC 40, S & P 500, Dow Jones etc…) is the composite value of a group of secondary market-traded stocks.
• For example, the S&P 500 is a value-weighted index (i.e., proportional to market capitalization) consisting of the stocks of the top 500 of the largest U.S corporations listed on the NYSE and Nasdaq.

Question 8

Wha are the various ways to buy a stock index?

Answer 8

1. Buy shares in a mutual fund that follows the index (eg the Vanguard 500 Index fund has as its benchmark the S&P 500 Index).
2. Purchase shares in an Exchange-Traded Fund (ETF) that tracks the index. ETFs are similar in many ways to mutual funds, but they are traded as individual stocks on a stock exchange
3. Buying all the individual stocks in the index (in the correct proportions) so as to replicate the return of the index.

Question 9

Why is speed an issue? (arbitrage) (4)

Answer 9

• Arbitrage is a common form of algorithmic trading.
• The idea is very simple : it is to exploit situations where two securities that
offer identical cash-flows have different market prices.
• If a trader finds such a situation, he will buy the lower-priced security and simultaneously sell the higher-priced security, making an instantaneous, riskless profit.
• Such an arbitrage can however not persist. Why ?
• Because if many traders exploit the price difference at the same time, their trading activity will push prices back to an equilibrium value, and the difference will disappear.

Question 10

What is statistical arbitrage? (3)

Answer 10

1. This typically involves simultaneous long (bought) and short (sold) positions in different groups of stocks or securities, while remaining (mostly) neutral to overall market movements. (copying same shares as the index or buying an ETF share)
2. If price of the ETF is above (below) the value of the index, an arbitrageur can immediately buy (sell) the portfolio of constituent stocks and sell (buy) the ETF, at a profit. = keep ETF prices in line with the basket of stocks.
3. extremely short lived, with a duration of milli seconds

Question 11

What does HFT (high frequency trading) have the reputation of? (3)

Answer 11

1. Improve the liquidity of markets, and decrease transaction costs, i.e., the spread bid-ask.
2. Have an impact on volatility, positive or not…
3. Have a possible destabilizing effect on markets (flash-crash). See the next slide.

Question 12

What are the risks of owning stocks? (2)

Answer 12

• The main risk of owning stock is market risk, ie the possibility of losses due to fluctuations in the price of the stock.= Typically measured using the standard deviation of returns (also known as the volatility of the stock
• Another source of risk is market liquidity, a broad term that summarizes the level of cost and difficulty that an investor faces when he wants to trade.

Question 13

What three properties is liquidity based on? (3)

Answer 13

1. Immediacy: the ability to trade quickly
2. Tightness: of bid-ask spread
3. Depth: existence of buyers and sellers at market price

Question 14

How does price evolution work? (3)

Answer 14

1. stochastic
2. time independent
3. no memory
   = drunk guy walking

Question 15

What is the self-fulfilling prophecy? 81)

Answer 15

in the beginning, a false definition of the situation evoking a new behavior which makes the original false conception come true.

Question 16

What is the efficient market hypothesis? (4)

Answer 16

1. States that markets are “informationally efficient”, i.e. one cannot achieve significant excess returns on a risk- adjusted basis, given the information available at the time the investment is made.
2. Stock prices fully and accurately reflect publicly available information
3. Once information becomes available, market participants analyse it
4. Competition insures prices reflect information

Question 17

what are the 3 forms of EMH?

Answer 17

• Weak : Prices reflect all past information (arbitrages are possible through inclusion of new information)
• Semi-strong: Prices reflect past information and instantly react to new information (prospects are included) (No arbitrage opportunities)
• Strong: All information, even hidden or insider. (Impossible to achieve given insider trading laws, …)

Question 18

What are the critics of EMH saying? (4)

Answer 18

Impossible to achieve perfect efficiency
1. Pro’s and con’s of EMH makes markets sufficiently efficient and sufficiently inefficient. (Arbitrage theory)
2. Behavioural biases
(overconfidence, overreaction, selection, information bias, disposition effect, herding).
3. Mixed empirical evidence: Studies do not reach a consensus regarding efficiency
4. Presence of well-known anomalies (Or is it more risk?) E.g. The January effect, weekend effect, …

Question 19

What are the behaviours of traders? (types) (7)

Answer 19

1. Overconfidence: “I think I can predict the future”.
2. Self-attribution: good results = my skills, bad results =
   bad luck!
3. Bounded rationality: People can not evaluate the whole set of possible outcomes.
4. Overreaction: Traders have excessive actions.
5. Selection bias: Choose only stocks from the breaking
   news
6. Disposition effect: Keeping losers and selling winners
7. Herding: Everybody trades in that direction, I will do the same. They should be right!

Question 20

Distinguish between passive and active portfolio management?

Answer 20

Passive:

1. strong belief in the EHM
2. Impossible to achieve excess returns
3. no forecasting of future events
4. invests only in indexes
5. tries to profit in long term growth of businesses: buy and hold strategy

Active:

1. exploits the market inefficiencies
2. selling overvalued stocks and buying undervalued stocks
3. Goal: beating the market
4. implies higher fees, and is influences by the performance of the fund manager and their choices
5. higher transaction costs, and time consuming
6. should yield higher profit, to cover significant additional costs

Question 21

What is the Grossman Stieglitz paradox? (2)

Answer 21

1. If market is efficient and all information is reflected in price, No one has an incentive to use resources to collect information.
   Then how can all information be reflected in the price?
   ⇒ Strong-form may not exist.
2. A balance between proponents and opponents of efficiency makes the markets sufficiently (in)efficient. If everybody believes that markets are not efficient, they will trade using past information, making prices efficient …
   The equilibrium is based on this coexistence!

Question 22

What is the difference between fundamental versus technical analysis?

Answer 22

1. Technical Analysis ‐ using prices and volume information to predict future prices
   =Weak form efficiency
2. Fundamental Analysis - using economic and accounting information to predict stock prices =Semi strong form efficiency

Question 23

What does trading strategy state? (1) and what are the different ways to build TS? (4)

Answer 23

1. A trading strategy refers to technical analysis and states the way buy and sell signals are obtained in order to get a higher return.
   • E.g. I buy every morning at 10:00 AM and I sell at 4:00 PM or I buy when the previous return is negative and I sell after it has increased with 5%,

• One can use maths (indicators)
• One can use charts (graphical signals)
• One can combine both of them
• Often charts are translated into maths in order to reach a high automation level.

Question 24

What is the difference between price and value? (2)

Answer 24

1. The price of a stock is the amount of money it currently costs to buy the stock. Affected by the mood, news about a company and liquidity.
2. The intrinsic value of a stock is a measure of the worth of the stock, based on fundamentals, usually calculated using a discounted cash flow model. Driven by cash flows of existing assets in the firm, and expectations of growth in these areas.

Question 25

How do we compute the price of a common stock? (2)

Answer 25

1. determine the cash flows (dividends paid) - analysis of dividends policy should be done
2. consider an investor which will hold the stock for a long time

Question 26

How to understand the cash flows: bonds versus stocks?

Answer 26

Stocks: have to forecast the future dividends (difficult)
bonds: this is already known, the coupon value (interest rate multiplied by face value).

stock hence are harder to evaluate and this could explain why they have higher volatility.

Question 27

Lets assume we know the dividends, How do we determine the discount rate of a stock?

Answer 27

1. the discount rate should be consistent with the level of risk and the type of cash flow being discounted.
2. discount rate for stocks is called= cost of equity, reflecting the risk of the stock.
3. should use an asset pricing model (APM): assumes the risk is measured on the basis of a marginal investor holding a diversified portfolio, in that case what matters is the amount of risk that a stock adds to that portfolio