UOL Theory Flashcards
What do we mean by statistical arbitrage (also known as algorithmic trading or program trading)? Explain briefly the idea behind the so called ‘pairs trading’ rule.
Statistical arbitrage is a method whereby you seek to identify statistical patterns in asset prices which are used to form trading strategies.
An example is the ‘pairs trading’ rule where you identify two portfolios which historically have the same price relative to each other – then you form a trading rule whereby if the prices diverge you bet on a convergence – i.e. if the price of one becomes expensive relative to the other, you buy the cheap one and sell the expensive one.
What is a hedge fund, what types of investment strategies do hedge funds use and how are they funded and regulated? Explain why the practice of selling deep out of the money options can make it very hard to measure accurately the performance of hedge funds.
Hedge funds are investment funds that employ a wide variety of investment strategies – often relying on borrowing and/or short selling – and often protected through various lock-up agreements with its investors. They are generally unregulated but are prevented from advertising their services to ordinary investors. Often funds finance their investments through the sale of options that are deep out of the money – this implies that there is a high likelihood their funding is free (when the options end up out of the money) but a small likelihood of a highly costly funding (when the options do occasionally end up in the money). Statistically, it can be hard to measure the ‘true’ cost of the fund’s capital because in most periods the funding is free.
What do we mean by limit order markets? Explain how the priority rules (with respect to price and submission time) work in such markets.
Limit order markets are markets which match directly the orders of traders. Traders can choose whether to trade quickly by using market orders, or to trade at favourable prices by using limit orders.The priority rules are such that the buy or sell order with the best price is always served first, which means that all market orders get first priority. If there is equality with respect to price, time priority applies, where the orders that were first submitted are served first.
Explain what we mean by hedge funds, and discuss problems associated with
measuring the performance of hedge funds accurately
hedge funds are characterised by a high degree of flexibility in their investment strategies, that they often trade in complex financial instruments, and that
investors are often asked to commit their capital for a fixed term – i.e. that the ‘cost’ of the superior return that such funds often promise is that the investor must sacrifice a tie-up of their funds (unlike many other managed funds where you can trade units relatively freely). Hedge funds are also relatively unregulated – but cannot therefore advertise their products to ordinary investors so must instead target instead rich individuals (or other managed funds) who commit
large amounts of money for investment. The problem with measuring the performance of hedge
funds is linked to the flexibility in investment strategies. We know that variability in risk taking can cause a downward bias in the Sharpe ratio so the funds will look worse than they actually are (see Chapter 8 – section ‘Changing Risk’), but hedge funds have also learned tricks that can make them look better than they really are. One of these strategies involves selling deep
out-of-the-money options, which are rarely exercised so the fund tends not to lose money on
them, but will of course generate a revenue since the fund can collect the value of the options
when they’re sold. This can lead to long periods with apparent high revenues for the fund with
little risk – but the position is actually hiding the actual risk of the fund because the options
tend not to be exercises except with extreme market movements.
What do we mean by market microstructure, and what issues are typically studied
in this area?
key issues that are discussed in this area,
which essentially looks in detail at the trading process – or the trading mechanisms – that
facilitates trade in financial securities. You should highlight how the motivation for trade can
affect the trading process – if somebody wishes to trade for liquidity reasons you are typically
less worried about being a counterparty in the market than if somebody wishes to trade because
he or she has private information. This is the adverse selection effect of trading, and is often a
central part of many market microstructure models. The adverse selection effect explains
liquidity – the bid-ask spread or the elasticity of prices – where you should expect to pay a
higher price if you buy an asset than if you sell an asset, and you should expect to move prices
more the greater quantities you trade. Liquidity is a measure of the trading costs of investors.
Another issue that is often discussed is transparency, which is a measure of how much
information is fed to the traders before they place their orders. Transparency is also an
important determinant of liquidity and trading costs in financial markets.
Explain what we mean by a Treasury bill, a certificate of deposit and
commercial paper. What is the essential difference between the three classes
of securities?
All of these are money market instruments, or short term debt claims, and
the only way they differ is in terms of the issuing body. A T-Bill is issued by
the US government and has a credit risk that reflects the US government’s
ability to honor its debt; a certificate of deposit is issued by a private bank
and has a credit risk reflecting the bank’s ability to honour its debt; and
finally a commercial paper is issued by a corporation and has a credit risk
reflecting the corporation’s ability to honour its debt.
Explain what we mean by exchange traded funds. What benefits do these funds offer to investors?
index tracking funds
flexibility of trading and of
diversification at low cost
Explain what we mean by floating-rate debt. Discuss ways in which these instruments are helpful to borrowers?
the essential ingredients of a floating rate
debt contract – which are a market rate (such as LIBOR) and a contractual coupon rate which is
linked to this rate (for instance LIBOR + 3%)
they give the borrower a
natural hedge against inflation shocks as inflation can be a large component of the nominal
interest rate (fixed rate debt gets relatively more expensive in low-inflation times and relatively
less expensive in high-inflation times)
Explain what we mean by the term structure of interest rates. Name three different types of hypotheses explaining the shape of the term structure of interest rates.
The term structure of interest rates is the collection of spot rates of various maturities, reflecting
the varying cost of capital over the various time horizons. The term structure often has a certain
shape, leading to patterns in the future forward rates, which is explained by a number of
hypotheses: the expectation hypothesis – which states that the implied forward rates reflect the
market’s expectation about the future spot rates; the liquidity preference theory – which states
that longer investment horizons imply higher risk to investors and that the longer spot rates are
therefore higher (which leads to a permanent pattern of today’s forward rates being higher than
future spot rates); money substitute hypothesis – which states that short, dated bonds are
effectively a substitute for cash (which offer zero return) and therefore have low return (which
leads to the same pattern between forward and future spot rates as above); and segmentation
hypothesis – which states that the bonds traded in the various maturity classes are serving
different needs for investors, and that te spot rates are not necessarily very related over the various maturities.
Explain how we can make use of bond duration in
practice.
The duration is used in practice to manage balance sheets and in particular as a tool to design hedge/immunisation strategies to protect the balance sheet from interest rate changes.
