Workshop & Past paper questions Flashcards
When firm W has made the decision to invest in the new project, but before the investment decision has been announced to the public, a dishonest director of firm W buys shares under an assumed name and makes an enormous profit by selling them just after the new investment is eventually disclosed to the world (but before the investment generates any cashflows). What do these facts tell us about the efficiency of this stock market?
[5m, WS4 2018]
- The fact that the insider can profit means no strong form efficiency.
- The fact that the price jumps on the announcement day is supportive of efficiency.
- As the price jumps before the project actually take place and on release of public information, sounds like semi-strong form efficiency.
When firm W has made the decision to invest in the new project, but before the investment decision has been announced to the public, a dishonest director of firm W buys shares under an assumed name and makes an enormous profit by selling them just after the new investment is eventually disclosed to the world (but before the investment generates any cashflows). What do these facts tell us about the efficiency of this stock market?
[5m, WS4 2018]
- The fact that the insider can profit means no strong form efficiency.
- The fact that the price jumps on the announcement day is supportive of efficiency.
- As the price jumps before the project actually takes place and on release of public information, sounds like semi-strong form efficiency.
If an investor can construct a portfolio of stock that has a long-run mean return that is reliably above the mean return on the market, is this evidence that the investor has some skill in picking stocks? Justify your answer.
[5m, WS4 2018]
Clearly not.
- Simply beating the market or risk-free rate is not evidence of investing skill.
- In relation to CAPM if a portfolio has a β>1, then its mean return should be greater than the market.
- Only if one can earn extra return w/o bearing extra risk is there evidence of skill.
“The efficient markets hypothesis implies that the expected future return on any portfolio of assets must be zero, otherwise every investor would end up buying portfolios with positive expected returns and selling those with negative expected returns.”
True or false? Justify.
[4m, WS4 2016]
Portfolios can earn +ve expected returns if they carry risk.
eg. the aggregate stock market
In terms of risk management, explain what your concern is for the investment management firm from holding all their assets in cash.
(Info given are PV assets, PV liabilities, flat term structure = 4%)
[2m, 2020]
If the TERM STRUCTURE DECREASES, then the risk is that the PV of the liabilities is MORE than the PV of the assets and the firm has a DEFICIT.
Explain the current term structure of interest rates from part (i) using term structure theories.
r1 = 0.05 and r2 = 0.1
[6m, 2020]
- The current term structure from (i) is UPWARD SLOPING which means that spot rates for long maturities are higher than for short maturities
- If the EXPECTATIONS HYPOTHESIS holds, long interest rates reflect expectations of future short interest rates. If the term structure slopes upwards then it implies the market expects rates to rise.
- According to LIQUIDITY PREFERENCE THEORY investors prefer bonds with short maturities. Long term bonds are more sensitive to interest rate movements than short term bonds.
- Risk adverse investors require higher yields for the greater risk of loss on longer term bonds. Term structure slopes up on average. - The MARKET SEGMENTATION THEORY implies that the current upward sloping term structure is due to the short-rate being set through trade amongst those interested in
short-term securities and long-rates set separately among investors with a LONG HORIZON.
Prove that it is never optimal to exercise early an American call option on a non-dividend paying stock.
[4m, 2020]
C = P + S - PV(K)
Define PV(K) = K - dis(K)
where dis(K) is the amount of the discount from face value to account for interest
C = (S-K) intrinsic value + (dis(K) + P) time value
so long as INTEREST RATES are +ve then TIME VALUE is +VE & value of call option exceeds intrinsic value
-> never optimal to exercise early
Discussion of the optimality of the net present value (NPV) rule.
[2021 paper]
- Everyone, regardless of their preferences (patient or impatient), should use the NPV rule to decide on which projects to invest in.
- The decision as to WHICH payments to INVEST in can be SEPARATED from the decision regarding WHEN to CONSUME.
Interpret the forward rate 1f1
[2017 paper]
- 1f1 is the NO-ARBITRAGE one year rate agreed today for a loan to start in one year’s time
- Using the EXPECTATIONS HYPOTHESIS, 1f1 is the market forecast of the one-year spot rate that prevails in one year’s time
~ Use your answers to (a) and (b) to ~ comment on the way in which risk preferences may impact upon portfolio selection.
(Ref. to MVP and equally-weighted portfolio)
[3m, WS3 2017 paper]
- The MVP is appropriate for someone who cares about experiencing the smallest possible risk.
eg. in the Q, the MVP has 80% in the safe asset cash - The EWP is preferred by someone who is willing to take a little risk to earn more return
eg. The EWP investor obviously invests more in the riskier asset (A) because it has a greater mean return. - Also as soon as the investor starts to worry about RISK, then DIVERSIFICATION plays a role.
What is the Correlation coefficient that minimises risk…
1. if hold LONG positions in BOTH stocks
2. if one stock is sold SHORT & another is a LONG position
- If long both stocks, correlation coefficient that minimises risk = -1
- If short one and long another, correlation coefficient = +1 to best minimise portfolio risk
How to test whether the CAPM is empirically valid?
[2016 paper]
- BETA is the only pricing factor
- Slope of the SML is positive
- No intercepts (?)
