Investments Flashcards
Markowitz’s Portfolio Theory 3 assumptions
- Investors are risk averse
- Security returns are normally distributed
- Investors only care about risk and return
3 elements of market liquidity
- Transaction costs
- Depth
- Price impact > price may move against you
3 roles of sustainable finance
- Capital allocation: finance can influence strategic allocation of capital.
- Influence on business: shareholders can influence firms through voting and engagement.
- Risk management / insurance: finance tools help investors and firms to manage climate risks.
6 roles of financial markets
- Allocation of capital
- Consumption timing / smoothing: early on in your life you need to borrow money, while later on in your life you have spare cash that you want to invest.
- Separation of ownership and control
- Provision of liquidity: because of markets, you’re able to buy/sell whenever you want.
- Allocation of risk: markets allow people to invest according to their risk profile. If you’re risky you invest in equity, otherwise you invest in debt.
- Information aggregation through prices: markets allow to gather information through stock prices.
Explain the difference between portfolio allocation (Portfolio Theory) and equilibrium model of financial market prices in the context of asset pricing
> In investment allocation (Portfolio Theory), E(R) and Variances are exogenous to the investor = you as in investor don’t determine these.
> In equilibrium, the E(R) is determined by the aggregate actions of all investors.
Assumptions of the CAPM
- All agents are atomistic. They’re small relative to the market. So, they’re price takers (however, agens altogether do have an influence on the price).
- All agens have the same planning and decision horizon.
- Agens invest in publicly traded assets.
- There are no transaction or information costs.
- Agens are mean-variance optimisers.
- Agents are rational. They use exactly the same information sets and have exactly the same estimates of E(R), SD, and CORR.
Explain the mechanism of changing prices that alter the efficient frontier. Use CAPM = 8%, Reality = 5%
There’s high demand for this stock > stock price rises > E(R) decreases > stock becomes less attractive and simultaneously the weight will go up until CAPM = Reality
What are the determinants of the Market Risk Premium?
- Amount of market risk (variance of the market sigma squared)
- Overall risk aversion of the market (A-dash)
What is the key takeaway of the CAPM
Assets that covary positively with the market tend to payoff when the market is doing well. These assets are not very useful to investors to smooth their consumption (hedge risk). Therefore, investors will pay low prices ( = demand a high return) for these assets. Thus, assets with high betas will have high expected returns.
Explain the 3 forms of market efficiency
- Weak-form: all, and only, historic information is incorporated into stock prices and trading activity.
- Semi-strong form: historic + all public information is incorporated into stock prices.
- Strong-form: historic + all public + all private information is incorporated into stock prices.
Name 3 strategies to beat the market
- Fundamental analysis > try to find over-/undervalued stocks
- Quant strategies > try to find certain company characteristics that statistically beat the market by using factor/characteristic analysis
- Technical analysis > try to find price trends in the near future by looking at price movements. This ignores the economics of the firm.
According to the EMH, this is not possible!!!
Explain why markets cannot be fully efficient in the long run
If markets are efficient, prices reflect all available information. Nobody would have an incentive to pay attention, because there’s no alpha to be made. Everyone would hold the market portfolio. Nobody would collect information anymore. Nobody would incorporate new information into the price. Now, prices deviate from their fair value. This leads to over-/underpricing. Traders start to act upon this mispricing.
What is the main purpose of the paper and what is the underlying reasoning? Also explain the ‘priced preference’ hypothesis.
This paper addresses the question whether stocks of firms with more distance from carbon neutrality have higher returns.
The pressure for firms to reach carbon neutrality may prompt a disorderly transition toward cleaner energy Investors will be uncertain about what changes will be made to firms that must make such changes.
Priced preferences: firms with a greater carbon footprint may be shunned by investors for ethical reasons (sin stocks / divestment). So, it is not risk related.
Paper: name the 3 scopes of carbon emissions data and 3 ways to measure it.
Scopes:
1. Direct emissions from its productions
2. Direct emissions from energy consumption (e.g., from their facilities)
3. Indirect emissions by their UPSTREAM partners or DOWNSTREAM partners.
Measures:
1. Total level of emissions
2. YOY change in emissions
3. Emission intensity (emissions scaled by sales)
Paper: how to calculate the change in expected return in terms of 1SD change in the independent variable?
Monthly increase in ER per 1 unit increase in the independent variable * 12 * SD of independent variable = the annual return increase per 1-SD increase in annual independent variable
