Topic 4: Economics of Markets for Securities and their derivatives

Question 1

Supply Side - issuers

Answer 1

1. Govt
   - deficit financing / surplus investing
   - privatisation / nationalisation
2. Corporations & other business entities
   - debt, equity, hybrids
3. Financial intermediaries (banks & other depository instos
4. Other Fin Instns and managed funds
5. Unincorporated businesses & household
6. Overseas issuers (supranationals - A$ kangaroo bonds

Question 2

Drivers of government issues

Answer 2

1. budget balance (economic cycle / automatic stabilisers, discretionary measures)
2. other financing measures (asset sales, purchases / nationalisation)
3. debt management (refinancing maturities, maintain market liquidity / management)

Question 3

Drivers of corporate issues

Answer 3

1. investment (economic cycles - very procyclical)
2. access to funds from other sources (banks & owners) - cost of intermediation / loans, cost of debt vs cost of equity
3. Takeovers/mergers and acquisitions (most demand at the highest cost, extent differs according to legal system)

Question 4

Drivers of demand for securities, macro & micro, 5 each

Answer 4

Macro demand: Economic cycle, inflation & interest rates, profits / internal funds, exchange rates, economic policies
Micro: Opportunities for mispricing, funds inflow, indexation, arbitrage, taxation

Question 5

Efficient market hypothesis: 3 forms of efficiency

Answer 5

1. operational efficiency: costs of portfolio management are minimal
2. allocational efficiency (asset allocation into areas of greatest profitability
3. Informational efficiency - prices incorporate all current information

Question 6

Valuation: equities

Answer 6

P = D / (r-g)
P = real price, d = real dividend, r = real discount rate, g = expected growth rate of real divs

Question 7

Tobin’s Q

Answer 7

Tobin’s q = (market value of equities + market value of debt) / replacement cost of assets

ie (MVA + MVD) / TA

Question 8

Tobin’s Q : Relevance

Answer 8

1. if q > 1: market prices may be overvalued (MV > RC)
2. If q < 1, market prices may be undervalued (MV < RC)
3. The greater the deviation of q from 1, the stronger the signal (+ or -)
   Remember: (MVA + MVD) / RC (ie replacement cost) is Tobin’s q

Question 9

Smithers/Wright definition of q (think Tobin’s q)

Answer 9

q = MV Equities / Corp net worth at replacement cost
Where net worth = TA - TL
and MV = price per common share x shares on issue

Question 10

Asset Returns: Gordon Growth Model

Answer 10

Expected Return = Yield + long term growth = risk free rate + risk premium (liquidity, inflation, credit, equity)

Question 11

Issues with models (name 5 such models)

Answer 11

1. Efficient Markets Theory (passive mgmt. good, ETFs became large undermining diversity of views & corporate governance)
2. Modern Portfolio Theory (choose your risk/return point and diversify risk. Crisis shows correlations are not fixed and can move to 1.0 in volatile periods)
3. Modigliani Miller (debt vs equity doesn’t matter - taxpayers will be paying for this for years)
4. Black Scholes (build derivs to mimic price & returns of physicals -> derivs boom & massive interconnectedness & liquidity crisis
5. Agency Theory (shareholders are principals, act as their agent in good faith. May not always be true.