Capital Markets Questions Flashcards

Question

What is the difference between current yield and yield to maturity?

Answer 1

Current yield on a bond equals the bond’s coupon payment divided by the bond’s price (not the true yield of a bond as it doesn't capture any yield associated with principal recovery nor it assume the reinvestment of coupon payments.) YTM is the internal rate of return of a bond. YTM considers coupon payments, principal recovery, assumes reinvestment at the same rate (an iterative process), and time to maturity. (Every coupon payment is reinvested at the same rate as the YTM. The reinvested coupons grow over time, contributing to the total return.)

Answer 2

Provide their investors with a stream of fixed periodic interest payments and then the return of principal at the end of its term. The fixed amount of interest is paid in the form of coupon payments, usually semi-annually. While all bonds technically fall under fixed income, fixed income usually refers to low- return, low-risk bonds (as opposed to mezzanine financing and HYBs). Examples include treasury notes, treasury bonds, treasury bills, municipal bonds, money markets, and certificates of deposits (CDs).

Answer 3

The money market refers to the purchase and sale of large quantities of short-term bonds and other debt instruments overnight. The maximum maturity of these short-term bonds is 397 days (~13 months), and the investors are usually risk-averse with limited risk appetite.

Answer 4

1. Government Money Market Funds: T-Bills, Discos (Agency Discount Notes, Reverse Repo) 2. Prime Money Market Funds: Short-Term Bonds, Commercial Paper, Certificates of Deposits

Answer 5

A municipal bond is a debt instrument issued by a state, municipality, or county to finance its capital expenditures needs, including construction needs, road developments, parks, highways, and other public projects. “Munis” could be viewed as loans that investors make to local governments – and for doing so, these bonds are exempt from federal taxes and most state/local taxes.

Answer 6

Unlike coupon bonds, zero-coupon bonds (discount bonds) make no payments between issuance and maturity and are priced at a discount to their face value.

Answer 7

Macaulay duration is the weighted average timing of the present value of all the cash flows, typically denoted in years. The modified duration indicates the percentage change in a fixed income instrument's price given a 1% interest rate change – by making a slight adjustment to Macaulay’s duration to reflect the price movement given a change in yield. For example, a 10-year bond with a modified duration of 8 would lose 8% in price (say from par or $100 to $92) if the yield increased from 1% to 2%.

Answer 8

The duration of any coupon-bearing bond will be less than its years to maturity, as there are coupon payments between now and maturity. Lower Coupon → Longer Duration: The lower the coupon, the longer the duration is and closer the duration is to maturity. The impact of each coupon payment to shorten the payment is reduced. Higher Coupon → Shorter Duration: The higher the coupon, the shorter the duration. Each coupon payment has a higher cash flow, which shortens the duration.

Answer 9

Convexity is a measure of the relationship between the price of a bond and its yield. High convexity portfolio would be more sensitive to interest rate fluctuations. (High convexity means more potential upside if interest rates fall, and more downside if interest rates rise.)

Answer 10

Affirmative Covenants: These covenants require that the obligor (borrower) of the debt to perform certain specific tasks. Examples of affirmative covenants are meeting financial reporting requirements, paying taxes, being insured, maintaining licenses/permits, and legal compliance. Negative Covenants: These covenants restrict the obligor of the debt to refrain from certain specific tasks such as issuing dividends, raising debt, acquiring another company, or pledging assets as collateral. Financial Covenants: For financial covenants, there are two types: 1) maintenance and 2) incurrence covenants. Maintenance covenants are usually included in credit agreements (bank loans), while incurrence covenants are included in indentures (bonds). (indentures=Indenture refers to a legal and binding agreement) contract, or document between two or more parties.

Answer 11

Covenants are contractual agreements between lenders and borrowers meant to protect the interests of the lending parties. Failure to comply with these covenants or breaching a covenant can cause the borrower to be placed into default, allowing lenders to seize the borrower’s assets. Debt-holders desire assurance of the full receipt of their due payments with a high level of certainty and restricting the borrower into making only risk-averse decisions and maintaining healthy credit statistics decreases the risk of not being paid back.

Answer 12

The objective of maintenance covenants is to ensure the borrower maintains sufficient profitability and cash flows to service debt payments. Compliance with maintenance covenants is tested each quarter. Examples of Maintenance Covenants: Total Debt/EBITDA must remain below 5.0x Debt/Equity must never exceed 2.5x Interest Coverage Ratio cannot fall below 3.0x These parameters will change depending on the prevailing market conditions and be industry specific.

Answer 13

The purpose of incurrence covenants is to prevent the borrower from taking specific actions that could put the lender’s payback at risk. Compliance with incurrence covenants is tested when taking a specific action (e.g., new debt issuance, dividends, acquisition) Examples of Incurrence Covenants: - Restricted from making acquisitions or divesting one of its business segments (or major assets) - Prevented from raising additional debt, especially if it has higher seniority than the covenant holder - Cannot distribute dividends to equity shareholders without the approval of the lenders

Answer 14

Maintenance covenants are subject to periodic tests, typically completed at the end of each quarter. The borrower must routinely prove its compliance with its maintenance covenants to avoid default. Incurrence covenants are tested only once a certain action or event “triggers” it.

Answer 15

Definition: Covenant-Lite Loans: Secured 1st lien loans with less restrictive covenants, primarily incurrence covenants rather than traditional maintenance covenants. Characteristics: Compliance Tests: - Triggered only by specific borrower actions (e.g., raising additional debt, issuing dividends). - Unlike maintenance covenants, they are not tested periodically (e.g., quarterly financial ratios). Borrower Flexibility: Provides borrowers with greater operational freedom and reduced risk of covenant breaches. Reason for Trend: Competitive Pressure: Large banks have adopted covenant-lite structures to compete with institutional lenders like private credit funds, which offer more borrower-friendly terms. Implications: For Borrowers: Easier to manage and less restrictive financing terms. For Lenders: Higher risk exposure due to reduced oversight and weaker protections in case of financial distress.

Answer 16

Characterized by longer tenors (duration) and higher-interest rates that compensate investors for undertaking more risk. This layer of debt enables the borrower to increase leverage beyond what risk-averse institutional banks will provide. While subordinate notes have a higher cost of capital relative to bank debt and don't allow prepayments, these notes come with less restrictive covenants.

Answer 17

Mezzanine financing refers to the layer of financing that lies in between traditional debt and common equity. This category is the lowest form of debt in the capital structure and includes preferred stock, convertible debt, bonds coupled with warrants. All mezzanine debt is unsecured and will be of smaller magnitude relative to the other parts of the capital structure. The debt terms involved in mezzanine financing are highly negotiated, flexible, and tailored to meet the specific needs of both parties. The interest rates are the highest compared to other less risky tranches and debt, with the option for interest to be paid-in-cash or payment-in-kind (PIK). Also, the conversion feature that some of these securities carry provides the holder with the optionality to partake in the upside potential of the equity (and create dilution for common shareholders).

Answer 18

Bridge loans provide interim financing should the required debt commitments not be available by the closing of the deal (i.e., the borrower could not secure a firm commitment letter from lenders). Investment banks that can do so will provide this type of bridge loan commitment to prevent a transaction from stalling and give assurance that sufficient funding will be available to close the deal.

Answer 19

Definition: Staple financing is a pre-arranged debt package provided by the sell-side investment bank to potential buyers in an acquisition. The financing details are "stapled" to the back of the acquisition term sheet, offering buyers a clear financing option. Key Features: Typically arranged by large, institutionalized investment banks (e.g., J.P. Morgan, Goldman Sachs). Includes terms such as loan principal, interest rates, fees, and covenants. Buyers can either use the staple financing or negotiate alternative terms with other lenders. Benefits: For Sellers: Increases competition by ensuring all bidders have access to financing. Expedites the sale process and can drive up the sale price through more aggressive bidding. For Buyers: Simplifies financing by providing a ready-made package. Saves time, allowing buyers to focus on due diligence and bid preparation. Potential Drawbacks: Conflict of Interest: The sell-side bank serves both the seller (as an advisor) and the buyer (as a financier), raising ethical concerns. Not Mandatory: Buyers are not obligated to use the staple financing and may seek better terms elsewhere. Use Cases: Common in mergers and acquisitions to streamline bidding and ensure competitive offers. Particularly useful when buyers may struggle to secure independent financing quickly.

Answer 20

Once a financial sponsor or a strategic buyer has met with the target's management team and has proceeded with submitting an LOI, the next step is to get a firm commitment letter from its lender(s). This is done to gain credibility as a buyer, as the most credible bids are the ones with financing commitments prepared with the initial debt terms outlined.

Answer 21

From both the buyer and seller perspective, committed financing is preferred as the lending bank is practically guaranteed to fund it upon closing. Alternatively, highly confident letters mean the lender believes it can raise the amount of capital required, but they'll not commit to it (and not backstop it with their balance sheet).

Answer 22

These provisions collectively safeguard lender interests by mitigating risks and ensuring repayment viability even in adverse scenarios. Material Adverse Effect (MAE) Clauses: Lenders can withdraw their commitment if a significant adverse event occurs that raises doubts about the borrower’s ability to repay. Commonly included in commitment letters to protect lenders from unexpected risks. Security Agreements: Provide lenders with a security interest in collateral, ensuring they can seize and sell assets if the borrower defaults. Collateral can include tangible assets (e.g., property, equipment) or intangible assets (e.g., patents, receivables). Guarantees: A third party (e.g., parent company or key executives) agrees to repay the loan if the borrower defaults, adding an extra layer of protection. Default Provisions: Specify conditions under which the lender can declare a default, such as nonpayment, covenant breaches, or inaccuracies in borrower representations. Include remedies like accelerating loan repayment or foreclosing on collateral. Yield Protection Provisions: Protect lenders from increased costs due to changes in laws or taxes (e.g., gross-up clauses for withholding taxes). Include breakage costs for prepaying loans early, ensuring lenders are compensated for potential losses. Closing Conditionality: Lenders may include conditions precedent to closing, such as satisfactory due diligence or third-party approvals, ensuring they lend only under favorable circumstances. Indemnities: Borrowers indemnify lenders for transaction-related costs (e.g., legal fees) and liabilities arising from the loan agreement.

Answer 23

Commercial paper is issued by large corporations with high credit ratings as short-term borrowing to finance their working capital needs. The typical commercial paper term is ~270 days, and the debt is issued at a discount (i.e., zero-coupon bond) as an unsecured promissory note. The minor concern associated with commercial paper is that they're unsecured, meaning they're not backed by any collateral. Therefore, only large corporations issue this type of debt as they have strong credit ratings.

Answer 24

Default Risk: Default risk means the borrower's creditworthiness has decreased from deteriorating financial performance, and most often, it coincides with a downgrade from a credit agency. The higher the credit rating, the lower the probability of default. Liquidity Risk: Next, liquidity risk refers to when the ability of the bond to be exchanged has unexpectedly decreased. This means that the number of potential buyers in the market has diminished (e.g., changing lending conditions, unexpected company-specific circumstances). Event Risk: Finally, event risk pertains to specific events such as M&A or legal investigations that could change the risk of holding a particular bond. For example, if the SEC announces they have started an investigation into a company for fraud, this would have an immediate negative effect on all stakeholders.

Answer 25

In the best case scenario, lenders receive all interest payments and repayment of debt principal, whereas equity owners theoretically have unlimited upside. This disconnect between debt lenders and equity investors is due to lenders being “backward-looking” and focused on how the company has performed historically. Additional: Particular attention is paid to signs of cyclicality in the borrower's performance and how it was affected by the latest recession. This is because debt lenders are more concerned with the downside case. After all, even if the company performs well, the lenders don't get to participate in the upside alongside the equity investors. Thus, the continued generation of the borrower’s cash flows to satisfy debt obligations is of the utmost highest importance to debt investors.

Answer 26

While they must show that the company can meet the debt obligations to be approved for financing, there's no rational reason for a sponsor to stretch its assumptions beyond this. A distinction when dealing with lenders is that there's little incentive to show aggressive assumptions. Thus, lender case forecasts are lower than the base case for the debt covenants to be set off a lower base. Debt covenants are usually based on this metric of EBITDA – thus, the EBITDA provided to lenders is the starting point. A higher EBITDA as the starting point means a higher EBITDA level is required to abide by the covenants. Then, future covenants will be based on quarterly projections of this initial EBITDA. Therefore, the borrower should desire a sufficient “cushion” to operate where, even if its EBITDA were to drop in an economic downturn, the covenant would still not be breached.

Answer 27

Refinancing (a process through which a company can reorganize its financial obligations by replacing or restructuring existing debts) risk is the concern that a borrower cannot refinance its debt obligations at the same (or similar) rate as before. For example, the credit rating of the company may have been demoted, and lenders are no longer willing to refinance at the same rates.

Answer 28

Interest rate risk becomes a consideration for bonds with longer maturities. For instance, the market rates constantly change, and the lending environment could turn more favorable (interest rates could decrease). If an investor is locked into a long-term bond, they'll face more interest rate risk due to the longer maturities. Therefore, the investor would demand a higher yield to compensate for the additional risk taken on by agreeing to a long-term arrangement.

Answer 29

Prepayment risk (often called reinvestment risk) is the risk that a lender takes on when allowing the borrower to pre-maturely paydown a particular debt. For example, if a borrower has pre-paid their loan and the lender has received the initial principal back – the lender must search for a new borrower. However, there's the risk that the credit market has become less favorable to lenders, and the lender may not achieve the same yield as before. For this reason, many lenders will not allow the optionality for prepayment, or if they do, they'll attach prepayment penalties as compensation for taking on the risk of having to reinvest at the current market rates (which could be significantly lower). SOFR plus a spread

Answer 30

1. What Happens When the Borrower Pays Down the Principal Early? When a borrower pre-pays their loan, the lender receives the principal amount back earlier than anticipated. This disrupts the lender's original plan for earning interest over the life of the loan. Loans are typically structured to provide lenders with steady interest income over time, so early repayment cuts short that stream of income. 2. Why Does the Lender Need Another Borrower? Once the original borrower repays their loan early, the lender now has cash (the returned principal) that they need to reinvest to continue earning returns. However: Finding a new borrower to lend money to isn't always immediate or guaranteed. The terms for new loans may not be as favorable as the original loan, especially if market interest rates have dropped since the initial loan was issued. 3. The Risk for Lenders If interest rates have decreased, the lender might only be able to issue new loans at lower rates, reducing their potential income compared to what they were earning on the original loan. If they cannot find a suitable borrower quickly, the cash returned from prepayment may sit idle and not generate any income. This is why prepayment risk is significant for lenders—they face uncertainty about reinvesting returned principal at an equivalent or better rate of return.

Answer 31

Is often issued as a “deal sweetener” for new debt issuances. Through the inclusion of an equity kicker, mezzanine investors can often increase returns by an extra 100-200 basis points. In return, the cost of financing can be brought down to allow the borrowing company to secure better terms. "Equity Kicker" Types Warrants: Warrants function similar to employee stock options such that the mezzanine investors have the option to exercise their options and turn them into common stock if profitable. This usually amounts to 1-2% of the total equity of the borrower. Co-invest: Mezzanine investors may seek the right to co-invest* equity alongside the controlling shareholder, such as the financial sponsor in the case of funding an LBO. Conversion Feature: If the debt or preferred stock is structured as convertible, the investor has the option to... 1) participate in the common equity's upside or 2) continue to receive interest or dividends. (*a minority investment made by the co-investor into a company. The investment is made alongside a financial sponsor. An example of a co-investor includes institutional investors such as an insurance company, pension fund, or endowment.)

Answer 32

If a startup is currently in the “bootstrapping” stage, operations are currently being funded entirely by the cash flows generated by the business and through the out-of-the-pocket funds from the entrepreneur. This term is often closely aligned with the concept of a startup remaining “lean” and holding off on raising outside, “unnecessary” capital to first maximize the utilization of their resources (e.g., human capital, intellectual property, product, and market strategy ideas/plans). The startup is likely attempting to minimize expenses while building its cash flow to reduce the need to raise outside capital. Alternatively, it may not have the option to raise capital even if it wanted to due to insufficient proof-of-concept. Once the startup has become more established and made more progress, it can raise capital with more negotiating leverage (rather than being at the mercy of early investors).

Answer 33

(Partial cash-out from VC firm, acquired by a strategic) A liquidity event is an opportunity for the founder of a private company and its early investors to sell some or all of their equity ownership. Given the illiquid nature of the investment and the high-risk nature of early-stage companies, it's reasonable to see a liquidity event. Often, this will begin with a minor partial liquidity event to take some profits (i.e., partial “cash-out”), with the provider of the capital being a venture capital firm. Later examples of liquidity events as the startup grows will be raising financing from venture firms and being acquired by a strategic.

Answer 34

A wealthy, accredited individual investing in seed and early-stage companies. Once a startup has exhausted its funding from friends and family members, the angel investor is often the first outside investor to provide capital. The company may often not even have a working product, and therefore, the angel investor is taking on a substantial risk of losing their initial investment. For this reason, the check size of an angel investor is rarely more than $1 million per startup investment.

Answer 35

Venture Funding Rounds: Seed Round (love money): The seed round will involve friends and family of the entrepreneurs and individual angel investors. Seed-stage VC firms can sometimes be involved, but this is typically only when the founder has previously had a successful exit in the past. Series A (Vg invests, development): The first time institutional investment firms will provide financing. During this stage, the startup's focus will be on optimizing its product offerings and business model and developing a better understanding of its users. Series B/C (scale and inc SG&A): The startup has gained initial traction and shown enough progress for the focus is now be trying to scale. Greater investment in SG&A Series D: (and onward) represents late-stage investments where the new investors providing capital will usually be growth equity shops that invest under the belief the company has real chance at undergoing an IPO in the near term.

Answer 36

Primary Purpose: Ensures the business has sufficient funds to operate, especially for startups with high R&D needs or those looking to scale. Uses of Capital: Hiring: Expand the team by hiring more employees and diversifying job functions. Relocation: Move to a better location (e.g., closer to customers, investors, or tax-friendly states). Sales & Marketing: Increase spending on advertising, sales, and other operational roles. Growth Strategies: Implement new strategies that were previously unattainable due to funding limitations. Value Beyond Capital: Venture capitalists often provide more than just funding, acting as mentors and advisors due to their entrepreneurial experience. Their involvement validates the entrepreneur’s business idea and plan, signaling potential viability. Downside: Raising outside capital requires the entrepreneur to give up ownership, diluting their stake in the business. However, this tradeoff is often necessary for growth and achieving a successful exit (e.g., IPO or acquisition).

Answer 37

When a company is at the proof-of-concept stage, there's no working product on-hand. Instead, there's just a proposed idea for a certain product, technology, or service. Thus, it's difficult to raise much capital; however, the amount of funding required is usually very minimal since it's only meant to build a prototype and see if this idea is feasible in terms of product-market fit. At this stage, the investors providing this type of seed investment are usually friends, family, or angel investors.

Answer 38

The focus shifts almost entirely to revenue growth. When the value proposition of a startup and the possibility of a product-market fit has been validated, meaning institutional investors have been sold on this idea and contributed more capital. Profitability is not the priority since the company has more than enough capital raised and investors will contribute more if needed. The commercialization stage usually refers to Series C to D (and beyond), and there'll be several large, institutional venture firms and growth equity firms involved in guiding this high-growth company to help refine the product or service offering, as well as the business model.

Answer 39

Given the rate of failure in startups, VCs only target investments that have the potential to return the value of the entire fund. Considerable emphasis on market size when looking for prospective companies given the risk/return profile. VCs target large industries worth at least ~$500 million to achieve their target of ~$100 million revenue based on their market penetration assumptions with a reasonable margin of safety.

Answer 40

Is a venture capital firm or individual investor that organizes a round of funding for a particular company. The lead investor is usually one of the first institutional investors in the company and will contribute the largest amount of capital (i.e., “lead the round”).

Answer 41

Protects the interests of the majority shareholders (usually the early, lead investors) by enabling them to force major decisions such as exiting the investment. Will prevent minority shareholders from holding back a particular decision or taking a specific action, just because a few shareholders with small stakes are opposed to it and refusing to do so. For example, suppose the stakeholders with majority ownership desire to sell the company to a strategic, but a few minority investors refuse to follow along (i.e., drag-along the process). In that case, this provision allows the majority owners to override their refusal and proceed onward with the sale.

Answer 42

Preferred stock can be best described as a hybrid between debt and equity – and sits right in between the two in the capital structure. Preferred stock has a higher claim on assets than common stock and receives dividends, which can be paid out as cash or “PIK.” Unlike common equity, the preferred stock class doesn't have voting rights but has seniority in the capital structure, but still has a lower claim than any debt holders. Sometimes preferred stock can be convertible into common equity, creating additional dilution.

Answer 43

1. Participating Preferred: The investor receives the preferred proceeds (i.e., dividends) amount + has a claim to common equity afterward (i.e., “double-dip” in the exit proceeds). 2. Convertible Preferred: Also referred to as non-participating preferred, the investor receives either 1) the preferred proceeds or 2) common equity conversion amount – whichever is of greater value.

Answer 44

Liquidation Preference = Investment $ Amount × Liquidation Preference Multiple Determines the relative distribution between the preferred shareholders and the common shareholders.

Answer 45

If an investor owns preferred stock with a 2.0x liquidation preference – this is the multiple on the amount invested for a specific funding round. Thus, if the investor had put in $1 million with a 2.0x liquidation preference, the investor is guaranteed $2 million back before common shareholders receive any proceeds. (Gives a certain class of shareholders the right to be paid ahead of other shareholders in the event of a liquidation. This feature is commonly seen in venture capital investments. Given the high failure rate in venture capital, certain preferred investors desire assurance to get their invested capital back before any proceeds are distributed to common stockholders.)

Answer 46

(preferred shareholders can share in the liquidation proceeds on a pro rata basis until total proceeds reach a certain multiple of the original investment, plus any accrued dividends.) A capped participation preference (often called “capped participating preferred”) indicates that the preferred shareholders can share in the liquidation proceeds on a pro rata basis until total proceeds reach a certain multiple of the original investment, plus any accrued dividends. This is similar to participating preferred equity, but the proceeds are capped once a certain multiple has been reached.

Answer 47

Pre-Money Valuation: The pre-money valuation refers to the company's value prior to the first (or the next) financing round. Post-Money Valuation: The post-money valuation accounts for the new investment amount after the financing round. It can be calculated as simply the new financing amount added to pre-money valuation, or the formula below can be used: Post Money Valuation =New Financing/Amount % of Equity

Answer 48

As long as the startup’s valuation has increased sufficiently (i.e., “up round”), dilution to the founder’s ownership can be beneficial. For example, let’s say that a founder owns 100% of a startup that's worth $5 million. In its seed-stage round, the valuation was $20 million, and a group of angel investors collectively want to own 20% of the company in total. The founder’s stake will be reduced from 100% to 80%, while the value owned by the founder has increased from $5 million to $16 million post-financing despite the dilution.

Answer 49

Up Round: An up round refers to financing in which the valuation of the company raising additional capital increases when compared to its prior valuation. Down Round: A down round refers to when the valuation of a company has decreased after a financing round when compared to the previous financing round. Prior to a new financing round, the pre-money valuation will first be determined. The difference captured between the starting valuation and then the ending valuation after the new round of financing determines whether the financing was an “up round” or a “down round.”

Answer 50

For certain, despite the dilution and potential internal conflict created from the unsuccessful new round of financing – the capital raised could have eliminated the risk of bankruptcy and given it enough money to turn the business around. This down round may have been the lifeline the startup needed to stay afloat and still have a chance at achieving its goals. While a down round is not a positive sign, it's not necessarily a sign that the end is near (although it may be more challenging to raise capital in the future unless clear improvements in performance are made).

Answer 51

The purpose of anti-dilution protection clauses protects shareholders (usually the early investors) following a down round. In effect, their conversion ratio remains the same to shield their investment from potentially losing value due to the additional dilution created post-financing.

Answer 52

Establish the specific agreements of investment between an early-stage company and a venture firm. Although short-lived, the term sheet’s purpose is to list out the initial specifics of an investment, such as the valuation, dollar amount raised, class of shares, investor rights, and investor protection clauses.

Answer 53

A pay-to-play provision incentivizes investors to participate in future rounds of financing. Simply put, these provisions will require existing preferred investors to invest on a pro rata basis in subsequent financing rounds. If not, the investors will lose some (or all) of their preferential rights, which most often include liquidation preferences and anti-dilution protection. In most cases, the preferred shareholder will accept being automatically converted to common stock with a down round.

Answer 54

While a ROFR and co-sale agreement are both provisions intended to protect the interests of a certain group of stakeholders, the two terms are not synonymous. Right of First Refusal: The ROFR provision gives the company and/or the investor the option to purchase shares being sold by any shareholder before any other 3rd party. Co-sale Agreement: The co-sale agreement provides a group of shareholders the right to sell their shares when another group does so (and under the same conditions)

Answer 55

A redemption right is a feature of preferred equity that enables the preferred investor to force the company to repurchase its shares after a specified period. It protects them from a situation when the company’s prospects turn bleak. However, this is a rare occurrence to see exercised, as most of the time, the company would not have sufficient funds to make the purchase even if legally required to so.

Answer 56

Full Ratchet Provision: A full ratchet is an anti-dilution provision that protects early investors and their preferred ownership stakes in the case of a down-round, the investor with the full ratchet's conversion price will be re-priced to the lowest price at which any new preferred stock is issued. In effect, the investor's ownership stake is maintained at the expense of substantial dilution to the management team, employees, and all other investors. Weighted Average: A similar anti-dilution provision used far more often is the weighted average method, which uses a weighted average calculation that adjusts the conversion ratio to account for any past share issuance and the prices they were raised. In effect, the conversion rate is lower than that of a full-ratchet strategy, making the dilutive impact far less severe.

Answer 57

Both broad-based and narrow-based weighted average anti-dilution protections will include common and preferred shares. However, broad-based will also include options, warrants, and shares reserved for purposes such as option pools for incentives. (Because the broad-based weighted average formula includes all outstanding shares-such as common stock, options, and warrants-in its calculation, the dilutive impact of new shares is spread across a larger base. As a result, the conversion price for existing investors is adjusted less dramatically than under narrower formulas, so investors receive fewer extra shares. This means the anti-dilution adjustment is smaller, leading to less severe dilution for founders and other shareholders)

Answer 58

A capitalization table (“cap table”) for any early-stage company tracks the equity ownership of a company in terms of number and type of shares (as well as series) along with any special terms such as liquidation preferences or protection clauses. For this reason, a cap table must be kept up-to-date to calculate the dilutive impact from each funding round, employee stock options, and issuances of new securities or convertible debt. Thus, all stakeholders can accurately calculate their share of the proceeds in a potential exit (i.e., liquidation event such as a sale to a strategic or IPO).

Answer 59

An option pool is a reservation of a certain percentage of shares (usually between 5% and 20%) set aside for future issuance to key employees, investors, or advisors of a company. The option pool is often used to attract talented employees by a cash-strapped startup that cannot afford to pay out high salaries due to insufficient cash and provide an incentive to perform well for the options to vest. Another case an option pool is used is when a private equity firm performing an LBO allots a portion of equity as an incentive tool for the management team to reach their targets (called a “management option pool”).

Answer 60

(ESOP aligns incentives for future employees and is used to hire the top talent once the business scales.) When a startup has an employee stock ownership plan (ESOP), it allocates a certain percentage of shares to early employees and later hires. The key distinction of this specific type of options pool is that it's not intended for the founding team, first employees, or current employees. By the time a startup is nearing its Series A, the ESOP pool size typically ranges around ~10% of the fully diluted equity.

Answer 61

(Venture capital fuels early-stage, high-risk startups to help them prove their concept, while growth equity backs proven companies to accelerate expansion, scale, and efficiency with lower risk and larger investments) Growth equity involves taking minority equity stakes into high-growth companies that have moved beyond the initial startup stages. The investments made by growth equity firms are often called growth capital because they help the company advance into the next development stage. Since the growth equity firm doesn't have a majority stake, the investor has less influence on the portfolio company’s strategy and operations. However, the objective is more related to riding the ongoing, positive momentum and taking part in the IPO ideally.

Answer 62

Traditional buyout funds take majority stakes in stable growth, mature companies (usually ~90-100% equity ownership), whereas growth equity investors take minority stakes in high-growth companies attempting to disrupt a particular industry. For growth-oriented investors, differentiation is a key factor that's often the leading rationale for investing. To these investors, what makes a product worth investing in is the value it derives from its proprietary technology that's difficult to replicate or protected by patents. The end goal in growth equity investing is almost always an IPO.

Answer 63

Growth equity is centered on disruption in “winner-takes-all” industries; whereas traditional private equity is more about defensibility in revenue and free cash flows. In the industries that traditional buyouts take place, there's enough room for there to be multiple “winners." In addition, traditional buyouts typically rely heavily on the use of leverage in their investments, in contrast to growth equity firms, which may not use any debt, and usually are more focused on the pure growth of the equity in their investments.

Answer 64

An initial public offering (IPO) is the process of a privately held company offering its equity to the public in a new stock issuance. For a company to undergo an IPO, specific requirements must be met that are set by the Securities and Exchange Commission (SEC). An IPO presents a company with an opportunity to get further capital by offering shares through the primary market channel. Traditionally, the company will hire several investment banks (often called the “underwriters”) to advise on the transaction as the company “goes public. ” The investment bank will market the company (i.e., the “roadshows”), secure demand from institutional investors, and set the IPO price and listing date.

Answer 65

Loss of Control: Shareholders and boards gain significant influence, potentially replacing management if financial targets are missed. Strategic decisions (e.g., mergers, investments) require shareholder or board approval, limiting autonomy. Increased Scrutiny & Disclosure Requirements: Financials, executive compensation, and business strategies become publicly accessible, exposing sensitive data to competitors. Continuous reporting obligations (e.g., quarterly filings, audits) reduce operational privacy. Short-Term Performance Pressure: Public investors prioritize quarterly earnings, forcing management to focus on near-term results over long-term growth. Missing guidance can trigger stock price declines and shareholder activism. Regulatory & Compliance Burden: Costs for legal, accounting, and regulatory filings escalate (e.g., SEC compliance, audits). Management time is diverted to reporting tasks instead of business operations. Operational Costs & Resource Strain: IPO preparation is expensive (underwriting, legal fees) and time-consuming (1+ years). Post-IPO costs include investor relations, enhanced accounting systems, and ongoing legal compliance. Market Volatility & Performance Risks: Stock prices fluctuate based on market sentiment, unrelated to company fundamentals, affecting valuations and employee morale. Poor post-IPO performance can damage reputation and limit future financing options.

Answer 66

Common Stock: Common stock is often referred to as basic shares and represents ownership in a particular company. Usually, common shares come with voting rights, and the amount of voting power a common shareholder has is directly related to the number of shares owned. Preferred Stock: Preferred stock is a hybrid between bonds and common stock, which can be appealing to more risk-averse investors. Preferred stockholders are usually paid preferred dividends consistently, hence its comparison to bonds. But if dividends cannot be paid out to any equity investors, preferred shareholders have a higher claim on the distributions than equity shareholders – so no dividends can legally be paid to common shareholders without first paying the preferred shareholders. On the downside, preferred shareholders have no (or limited) voting rights in the company's corporate governance and are still below all debt holders in the capital structure. In the event of liquidation, the preferred shareholders will have a higher claim on the liquidated assets relative to common shareholders, assuming there's remaining collateral after the debt holders have received their share.

Answer 67

Preemptive rights allow existing shareholders to purchase a new issuance before it's offered to other potential buyers. This provision protects early shareholders from dilution when the company issues new shares.

Answer 68

Once a company has gone public, it's inevitable for ownership to become diluted for all stakeholders. For many founders, this is the primary concern when considering selling shares to the open public.Create Different Share Classes (Dual-Class Share Structure): This would mean there are distinct classes of common stock with different voting rights or voting power. The most common practice is the issuance of Class A and Class B shares. When a company goes public, the founders and early investors can be given shares with extra voting rights (often called “super-voting shares”). 2. Maintain Majority Control: While it's near impossible for the founders to maintain majority control, close relationships with their early investors and investors with large stakes in the company would be very beneficial to have on their side and a way for them to maintain majority control in the company to an extent. Having the backing of the largest shareholders is reassuring from the perspective of management. 3. Control the Internal Board of Directors (BOD): While regulations are increasingly forcing companies to include more independent board members, the more BOD members that have a close relationship with the founders – the more beneficial it is for management. Ideally, the entire board respects and believes the current management team is the right team to lead the company. The absence of this type of dynamic could lead to management being voted out if performance suffers. Therefore, it's in management's best interest to have as many inside directors as possible (rather than outside directors).

Answer 69

The mainstream IPO that included no-vote common shares was the IPO of Snap Inc. in 2017. While common shares with differing voting rights are frequently seen during IPOs, the no-vote common shares were a rarity. In Snap's IPO, most shareholders were not given voting rights, which was controversial, as investors would be completely hostage to management decisions under the proposed corporate governance. Even Snap’s S-1 filing wrote that “to our knowledge, no other company has completed an initial public offering of non-voting stock on a US stock exchange” and acknowledged this decision could lead to a lower share price and fewer investors. In Snap’s IPO, there were three classes of stock: Class A, Class B, and Class C. Class A would be the shares traded on the NYSE with no voting rights, Class B would be for early investors and executives of the company and come with one vote each, and Class C would be held only by Snap’s two co-founders, CEO Evan Spiegel and CTO Bobby Murphy. The Class C shares would come with ten votes apiece, and the two holders would have a combined 88.5% of Snap’s total voting power post-IPO.

Answer 70

The underwriter, most often an investment bank, will serve as an intermediary between the company issuing securities and the investing public. The underwriter will be tasked with handling the new issuance of stock and to ensure the public, primarily institutional investors (e.g., mutual funds, pension funds, hedge funds), commit to purchasing the issuance before actually becoming available for purchase in the open market. Some key obligations that the underwriter will have are to handle the roadshow strategy, generate interest from potential investors, and price the IPO optimally to maximize the value received.

Answer 71

A group of investment banks, called a syndicate, will purchase the new issuance of securities for a negotiated price and then promote the securities to their network of investors in a process called a roadshow. Doing so spreads the risk across several underwriters instead of placing all the pressure on one underwriter, which maximizes the chance of the entire issuance being sold to the public (but mainly to institutional investors).

Answer 72

A roadshow is when the management of a company raising capital will travel around to give presentations to institutional investors such as large asset management firms, hedge funds, and pension funds. The reason for doing the roadshows is to generate interest from investors for an upcoming issuance of equity or debt.

Answer 73

Primary Market: The primary market is when securities are first issued via an IPO – i.e., this is the first time shares are offered to the public. Secondary Market: The secondary market is when the securities are traded amongst investors, which include institutional firms (e.g., asset managers, hedge funds), as well as individual investors.

Answer 74

More formally called the preliminary prospectus, the red herring provides prospective investors with information regarding an upcoming IPO. Included in the prospectus are details related to the company’s products, growth plans, intended uses of the raised funds, potential risk factors, and more background details on the company (e.g., detailed financial statements, management team biographies). The filing must be filed with the SEC, not just accompany the bankers on the roadshow and be used to raise investor interest, but to describe the issuance of equity and the proposed details of the IPO offering.

Answer 75

(A preliminary prospectus is a first draft registration statement that a firm files prior to proceeding with an initial public offering (IPO)) S-1 is information on the planned usage of the raised capital proceeds, the current business model, full detailed historical financials, commentary on the competition landscape, a prospectus of the planned security issuance, the method for setting the offering share price, and commentary on existing securities and dilution. The red herring is a preliminary prospectus that comes before the S-1 and is circulated during the “quiet period” before the registration has become official with the SEC. Often, the SEC may request additional material to be included or changes to the red herring. The final prospectus, the official S-1, would then be filed before the company can proceed with the distribution of shares.

Answer 76

The 180-day lockup period associated with IPOs prevents insiders from selling their shares immediately once the company has undergone an IPO. The sudden increase in selling volume could cause the share price to drop significantly, as many early investors might want to liquidate their positions as soon as possible.

Answer 77

Seasoned Equity Offering: A SEO is when a company that's already public (i.e., underwent an IPO) issues additional shares. This is often referred to as a “follow-on offering." Rights Offering: A rights offering gives existing shareholders the exclusive right to purchase new shares at a pre-specified price below the current share price on a pro rata basis.

Answer 78

A firm commitment refers to when an investment bank, the underwriter of an IPO, agrees to assume all the risks associated with failing to sell all the shares being listed by purchasing all the securities being issued directly from the company. Under this method, the underwriter would bear all the risk because it purchases the entire issuance of new securities (hence, syndicates are far more common).

Answer 79

An underwriting arrangement based on “best efforts” refers to the equity underwriters' commitment to making their best effort to sell as much as possible of the securities issuance. However, there's no guarantee that all the securities will be sold, so there are no negative implications for them failing to achieve the set capital raising target (other than potential reputational damage).

Answer 80

In an IPO that uses the so-called Dutch auction pricing strategy, the share price is lowered until all the shares would be sold. Then, all the shares are sold at that price, which is the highest price where all the shares would be sold. Rather than setting the price based on valuation alone, the price is based on the bids placed by the interested buyers that will submit how much they would pay and the number of shares they can buy at their proposed price. In effect, bringing in a game theory element to this type of auction pricing strategy.

Answer 81

Definition of Direct Listing: A direct listing allows a company to sell shares directly to the public market without involving investment banks for underwriting. Key Differences from Traditional IPOs: Cost Savings: Direct listings avoid hefty underwriting fees paid to investment banks, reducing transaction costs. No Lock-Up Period: Unlike IPOs, direct listings do not impose a lock-up period, enabling insiders and early investors to sell shares immediately after the listing. Dilution Minimization: Direct listings typically involve selling existing shares rather than issuing new ones, minimizing dilution for current shareholders. Capital Raising: Historically, direct listings were not ideal for raising capital, but recent SEC rule changes now allow companies to raise funds during a direct listing, making it more competitive with IPOs. Pricing Risk: In a direct listing, there is no guarantee of accurate share pricing or sufficient demand since there is no formal price-setting process like in an IPO. Examples of Companies Using Direct Listings: Spotify (2018), Slack (2019), Palantir Technologies (2020), and Asana Inc (2020). Considerations: Direct listings are better suited for companies that do not need to raise capital but want liquidity for existing shareholders while avoiding traditional IPO costs and restrictions.

Answer 82

The greenshoe option (or “over-allotment”) is a clause outlined in the underwriting agreement of an IPO that allows the underwriting syndicate to purchase up to an additional 15% of the shares at the offering price. The option can be exercised, and more shares can be sold if demand from the public exceeded expectations, and the shares are trading above the offering price, which allows the issuing company to raise more capital. Alternatively, the underwriters are granted this right to buy more shares from investors to stabilize the price and decrease the supply if the share price dropped

Answer 83

Definition of the Criticism: IPOs are criticized for underpricing, where shares are priced below their true market value, leading to significant first-day price surges and unrealized gains for the company. Key Issues: Lost Value: Companies miss out on potential proceeds when shares are sold at a discount, with market capitalizations often jumping by $50–$80 million (or more) on the first trading day. This "left money" benefits institutional investors who buy at the IPO price, not the company. Conflict of Interest: Investment banks are accused of balancing competing priorities: Serving the company going public by raising capital. Favoring institutional investors by offering discounted shares to foster relationships and secure future business. Underpricing Rationale: Investment banks argue that underpricing ensures all shares are sold and reduces the risk of a failed IPO. It also incentivizes institutional investors by offering immediate returns, encouraging participation in future IPOs. Prominent Criticism: VC Bill Gurley and others argue that underpricing disproportionately benefits institutional investors at the expense of companies and their early shareholders. Alternative Viewpoint: Pricing shares "to perfection" (with no post-listing price movement) could deter investor interest, as it eliminates potential short-term gains. This debate highlights tensions between maximizing proceeds for companies and maintaining investor relationships in IPO processes.

Answer 84

SPAC deal is more like an M&A negotiation with buyers rather than an underwriter telling you what the market might pay. A SPAC, or "blank check company," is a shell entity created to raise capital through an IPO for the purpose of acquiring or merging with an existing company. Process: Capital Raising: SPACs raise funds via an IPO, with the sponsor retaining ~20% ownership post-IPO. Escrow Account: Raised funds are held in escrow until a target company is identified; if no acquisition occurs, the funds are returned to investors. Advantages for Companies Going Public: Speed: Faster process (~4–6 months) compared to traditional IPOs. Simplicity: Less work required as SPAC sponsors handle capital raising and investor interest. Valuation Accuracy: Valuations resemble M&A negotiations, avoiding underpricing risks associated with IPOs. Certainty of Pricing: No risk of failing to issue shares or "leaving money on the table." Reputable Sponsors: SPAC sponsors are often well-known individuals or firms, lending credibility to the process. SPACs have become a popular alternative for companies seeking a streamlined and efficient path to public markets.

Answer 85

A private placement is when a company raising capital issues shares to only a select few institutional investors. In contrast to a public issuance, the securities are not made available for sale to the open market and are not required to be registered with the SEC. A private placement is a more direct approach to selling to a group of accredited investors, consisting of institutional firms, mutual funds, and pension funds. Both public and privately held companies can partake in private placements.

Answer 86

Filed with the SEC, a shelf offering provision (S-3 registration) enables a company to make an issuance in a three-year period, rather than selling it all in one sale. This can be beneficial as the market conditions could turn more favorable, and it gives the company raising capital more flexibility with the timing of the sales. Hence, many shares will be “on the shelf” until the company sells them.

Answer 87

Private investment in public equity (PIPE) refers to the private placement of securities in a public company bycaccredited investors such as hedge funds, private equity funds, and mutual funds. The purchase will be made atca discounted price, usually as an unregistered convertible or preferred security. PIPEs have become an alternative way for companies to raise capital and this financing structure became more prevalent due to the relative cheapness and efficiency vs. a traditional secondary offering. There are also fewer regulatory requirements, as there's no need for expensive roadshows.

Answer 88

The market would likely be open at the time of the interview, and the interviewer doesn't expect you to have the exact latest numbers. Therefore, saying: “The S&P 500 closed around 3,570 yesterday and opened lower this morning after reports of new coronavirus infections surged” would be sufficient. Instead, it's more important to discuss the recent trends and developments driving equity valuations over the past few months and years rather than memorizing the precise figure at which a certain index closed. If you're preparing for an interview during an important economic period or event (e.g., COVID-19, recent Fed meeting, financial crisis, healthcare reform, tax reform), tariffs, be aware of what’s going on and be prepared for questions on your thoughts on those types of current events.

Answer 89

You just need to answer with an approximation of the current risk-free rate. A response along the lines of “The yield on the 10-year treasury bonds has been around ~0.8% as of late” will do. You could mention that throughout the fall, the risk-free rate has been trending upward since the summer from the increased political risks surrounding the 2020 elections, the rising cases of coronavirus cases as more businesses re-open, and more questions surrounding the timeline of the vaccine development.

Answer 90

Start by answering where the current level of the market is and the prevalent trends in the market. For instance, has the market been rising with strong earnings? Then talk about the key catalysts that could move the market and the specific development you would be looking out for. In addition, try to find out what the bank’s research analysts predict for the market’s Year-End Target. You can find research estimates on Bloomberg or ask an analyst you have networked with to share the latest estimates with you. Many brokerage firms also provide institutional research to retail clients using their online brokerage account, so opening up a Chase or a Merrill account can allow you access to J.P. Morgan and BofA research. Later on in your careers, when you discuss the markets with clients, you'll start with your house view (research), and then you can add your personal views on why you would disagree.

Answer 91

Although the question asked has no right or wrong answer, there are a few unasked questions that will showcase your understanding of the markets: When is the next FOMC meeting? What is the current Fed Funds Target Rate? What was the Fed’s action at the last FOMC meeting? What is the Futures Market implying for the FOMC meeting? To answer this question effectively, you need to list the key facts to the unanswered questions and then express your view. If the market is not expecting a move in the Fed Funds rate, be prepared to discuss the Fed’s balance sheet and changes in its Asset Purchase Programs. Sample Response “The next FOMC meeting will be on November 5th. The current Fed Funds Target rate is between 0 and 25 basis points. The Fed has held this rate steady since the emergency meeting in March when the Coronavirus crisis began. The market is not expecting any change to the Fed Funds Target Rate, and I'm not either. I'll be watching the Fed closely to see if they're planning to change the language or guidance of their asset purchase program. With the stock markets near all-time highs, I would expect the Fed to remove some asset purchases modestly they have promised but gradually as to not spook the markets.

Answer 92

In the US, the two primary stock exchanges are the NYSE and the NASDAQ. Before filing for an IPO, companies must decide which stock exchange to list their shares. NYSE: The NYSE (New York Stock Exchange) is the older stock exchange with roots back to 1817 and physically on Wall Street. Originally, the NYSE was setup with pit trading on an actual trading floor, but today, most trades are electronic, although some market makers still exist. NASDAQ: Launched in 1971, the NASDAQ is newer and a completely electronic exchange with offices in Times Square and data centers in New Jersey. Compared to the NYSE, the NASDAQ is more tech-heavy due to its flexible listing requirements that appeal to former startups that at one point didn't qualify for the NYSE. However, the NYSE has relaxed its listing requirements in recent years, removing the clear divide as there used to be.

Answer 93

The yield curve is just a plot of the relation between the yield and the term of otherwise similar bonds. The treasury yield curve plots treasury bond yields across their terms and is the most widely used yield curve as it sets a “risk-free” benchmark for other bonds (corporate, municipal, etc.). A treasury yield curve is normally upward sloping because, all else being equal, an investor would prefer a one year, 3% bond than being locked into a 30-year, 3% bond. However, investors’ expectations about future interest rates affect the slope as well. When investors expect the Fed to raise short-term interest rates in the future, investors will decrease demand for short-term treasuries to avoid getting locked into a low but soon-to-be higher short-term rate. This decrease in the relative demand for short-term treasuries will raise short-term yields and flatten the yield curve.However, investors’ expectations about future interest rates affect the slope as well. When investors expect the Fed to raise short-term interest rates in the future, investors will decrease demand for short-term treasuries to avoid getting locked into a low but soon-to-be higher short-term rate. This decrease in the relative demand for short-term treasuries will raise short-term yields and flatten the yield curve.

Answer 94

An inverted yield curve means that yields on longer maturities are lower than shorter maturities of otherwise comparable bonds, like treasuries. (Normally, yield curves are upward sloping as issuers must pay a premium to entice investors to keep their capital locked up for a longer-term. When the yield curve inverts, it's usually a harbinger of an economic slowdown and recession. In fact, the last seven recessions were preceded by an inversion of the yield curve, and it's considered a strong leading indicator by economists and investors alike. The inversion happens as investors anticipate market interest rates to decline down the road (presumably because they expect a slowdown and expect monetary policymakers to eventually lower rates to stimulate the soon-to-be slowing economy). Thus, investors prefer the safety of long-term maturities at the current higher rates over investing in shorter maturities and having to reinvest at the lower expected future rates.)

Answer 95

Upward Sloping: Long-Term Government Bond Yields > Short-Term Government Bonds Yields Inverted: Long-Term Government Bond Yields < Short-Term Government Bonds Yields Steepening: The interest rate differential between Short-Term and Long-Term bonds is increasing Flattening: The interest rate differential between Short-Term and Long-Term bonds is decreasing

Answer 96

Low Risk-Free Rates: The US 10-year Treasury yield remained below 1% (0.6%-0.8%), offering minimal returns for investors seeking safe assets. This pushed institutional investors toward equities, particularly large, resilient companies. FAANG Leadership: Tech giants like Facebook, Amazon, Apple, Netflix, and Google outperformed during the recovery, driving the broader market due to their significant weight in indices like the S&P 500. Opportunity Cost: Investors compared low bond yields with potential equity returns, favoring stocks as the only viable option for moderate or high returns. Certainty in Valuations: Discounted cash flow models benefited from lower risk-free rates, leading to higher equity valuations. Investor Confidence: Despite economic turmoil, confidence in certain sectors (e.g., technology) and government support measures (e.g., near-zero interest rates) bolstered market recovery.

Answer 97

Core Points on Comparing the Current Market to the Dot-Com Bubble: Interest Rates: During the Dot-com bubble (2000), the US 10-year Treasury yield averaged ~6%, offering a safe alternative to overvalued equities. Today, interest rates are near zero, leaving investors with fewer risk-free options. Market Valuations: Dot-com valuations peaked at extreme levels (e.g., forward P/E ratios of ~48x). Current valuations, while high (~31x forward P/E for tech stocks), are more modest in comparison. Market Concentration: Today’s market is dominated by a few large-cap tech stocks (e.g., Apple, Microsoft), similar to the outsized influence of tech during the Dot-com era. Quality of Companies: Unlike many speculative Dot-com startups, today’s market leaders are profitable and financially robust, reducing systemic risks. Transformative Technologies: Both periods were driven by revolutionary technologies—Internet during Dot-com and AI today—fueling optimism and speculative excess. While parallels exist, current conditions (e.g., lower rates and stronger fundamentals) suggest a less extreme setup than the Dot-com bubble.

Answer 98

VIX is a measure of overall market sentiment and is often referred to as the “fear gauge. VIX is an index of the implied volatility of the one-month S&P 500 options at different strikes. A low VIX is associated with a strong market with limited volatility. A high VIX is a sign of fear and an uncertain market. The VIX measures S&P 500 options' implied volatility, including how costly options are to hedge your portfolio.

Answer 99

Be careful not to quote the futures prices, as both Bloomberg and Yahoo Finance will show futures prices as well as the price of the spot index. For Oil indices, be specific if you're quoting WTI or Brent, as there's more than one benchmark.

Answer 100

The Federal Open Market Committee (FOMC) targets an inflation rate of ~2% over the long-term. To keep inflation around this target range, the US government has monetary and fiscal policies it can use to maintain a stable, long-term inflation rate. Monetary Policies: Monetary policies involve actions taken by the US central bank to control the money supply and demand to maintain sustainable economic growth. These policies can be classified as either expansionary or contractionary. Expansionary policies increase the liquidity of the money supply, whereas contractionary policy decreases the liquidity of the money supply. Examples of these policies would include strategically adjust Fiscal Policies: Fiscal policies are related to changing tax policies and government spending to increase or decrease the purchasing power of the economy. In effect, this gives the Fed the ability to regulate the economy and influence economic conditions. For example, the corporate tax cut in 2017 from 35% to 21% under the Tax Cuts and Jobs Act (TCJA) was enacted to fuel economic growth and incentivized corporations to return their foreign operations to create more jobs in America.

Answer 101

Quantitative easing (QE) is a form of monetary policy where the central bank will directly make purchases of longer-term securities from the open market to increase the money supply and total liquidity. In effect, QE will decrease interest rates, which will directly encourage more lending and make money flow more into equities since fixed-income instruments will have low yields. This type of monetary policy is controversial, as it's essentially meant to flood the economy with money to spur economic activity. QE became a controversial topic of discussion when the Federal Reserve announced in March 2020 that it would purchase $700 billion worth of government debt, bonds, and mortgage-backed securities over the coming year. This unprecedented decision would not only significantly increase the Fed’s balance sheet risk and increase its already-mounting debt, but has created widespread concerns about this seemingly endless “printing” of money. The broader implications this could have for future generations remains an unknown. Often, to help spark economic growth, the Fed will turn to cut interest rates, but interest rates were already close to zero – hence, the Fed turned to QE.

Answer 102

Open market operations are when the central bank purchases or sells short-term government securities (e.g., treasuries) in the open market to influence the money supply and impact short-term interest rates. If the money supply circulating in the system is increased, it becomes easier for businesses and consumers to get loans at low-interest rates, which has a positive impact on economic activity. Alternatively, the selling of securities from the central bank’s balance sheet will remove money from the system. This reduction makes loans more difficult to be approved for (i.e., more demand from borrowers, less supply of money) and, as a result, makes interest rates on these loans increase.

Answer 103

There is an inverse relationship between bond price and interest rates. If market interest rates go up (due to a Fed interest rate hike or other market conditions), this has the impact of making the interest being offered by currently outstanding debt seem less attractive given the availability of comparable investments with now higher interest rates, all else being equal. The price of outstanding bonds would thus drop in this scenario.

Answer 104

If the Fed wants to lower rates, it can directly purchase treasuries in the open market, and then T-bill yields would directly decline. The buyers, which consist of other foreign governments, individuals, institutional investors, and large banks, will store this cash and raise the supply. Alternatively, the Fed can lower rates through repurchase agreements (RPs). This would lower banks’ demand for reserves and thus the Fed funds rate, which is the basis on which commercial banks lend.

Answer 105

Conversely, if the Fed wants to raise rates, it can sell treasury bills in the open market. The Fed lends cash overnight to a select group of banks (“primary dealers”) while taking treasuries as collateral at the repo rate. These primary dealers will then disseminate this cash throughout the financial system; thus, the fed funds rate increases. If the Fed wants higher rates, it can also do a reverse repo (“RRP”), in which the Fed borrows money from primary dealers. This would tighten the credit markets, and the fed funds rate would increase.

Answer 106

Another policy tool available to the Fed is to adjust the provided interest on bank reserves. The lowering of this rate (called interest on excess reserves, or "IOER") would encourage lending (and vice versa). The IOER is the interest rate the Federal Reserve pays on excess reserves. This rate is typically within the fed funds’ target range. For example, if the fed funds target range is 1.5% to 1.75%, the IOER would be ~1.6%.

Answer 107

Repos (RPs) are short-hand for repurchase agreements (formally called “sale and repurchase agreements”) and refer to when a borrower, usually a government securities dealer, gets short-term funding by selling securities such as treasuries and agency mortgage securities to a lender. The lenders could be money market funds, governments, and financial institutions. For a pre-determined period, the borrower will purchase the securities back for the original price plus interest (e.g., the repo rate), usually completed overnight.

Answer 108

Conversely, a reverse repurchase agreement (reverse repo, or "RRP") is when the purchaser of the security agrees to re-sell the security back to the seller for a pre-determined price at a later date. Essentially, repos and reverse repos are the two sides of a lending agreement from the perspective of the two opposing parties. Note, these are short-dated transactions with a guarantee of repurchase.

Answer 109

Is the monetary policy-making body of the Federal Reserve System. The members meet eight times a year to set the interest rate policy and the federal funds rate. Following these meetings, a statement will be publicly issued to communicate the following changes in rates and commentary on their outlook on the economy and guidance on their forward-view of current policies (i.e., the potential for changes, risks considerations).

Answer 110

The federal funds rate represents the target interest rate set by the Federal Open Market Committee (FOMC) for short-term loans. The fed funds rate target has historically been one rate (e.g., 1.5%) but is now a range (1.5% to 1.75%). Based on the agreed-upon Federal funds rate, commercial banks and institutions will borrow and lend their excess reserves to one other (usually completed overnight) at this rate. This is the rate that banks charge other banks for overnight loans to cover their reserve requirements. Banks with excess reserves can lend to banks with insufficient reserves. The federal funds rate affects the lending market because banks and many institutional lenders tie their lending rates (e.g., Prime, LIBOR) to the fed funds rate. As a result, any adjustments will flow throughout the entire market, including short-term US treasuries.

Answer 111

The federal discount rate refers to the interest rate that the Federal Reserve charges commercial banks and other financial intuitions for short-term loans through the discount window loan process. In contrast to the federal funds rate, the federal discount rate is the rate charged to banks to borrow funds from them, whereas the federal funds rate is the rate that banks lend to each other. Compared to the fed funds target rate, the federal discount rate is typically 50 bps higher.

Answer 112

The reserve requirement is the minimum level of cash a commercial bank is required to keep on-hand to cover its deposits. If this requirement were to be lowered by the Fed, the result would be more loans could be made. Therefore, lowering the reserve requirement is an expansionary policy option.

Answer 113

In an environment with negative interest rates, the payment of interest flips between the borrower and lender. The borrower is being paid interest by the lender, rather than the other way around. Central banks use this drastic monetary policy tool to incentivize commercial bank lenders to make loans rather than sit on the funds.

Answer 114

1. Treasury Bills: T-bills mature within one year of issuance 2. Treasury Notes: T-notes mature between two and ten years 3. Treasury Bonds: T-bonds mature in twenty to thirty years

Answer 115

A certificate of deposit (CD) is an agreement with a bank to deposit money for a specified rate of return (i.e., earn interest). CDs are short-term agreements, issued at par based on the deposit amount, and have the same credit risk as a deposit.

Answer 116

The money market yield is defined as the interest rate earned from holding securities of higher liquidity and short maturities (< one year). Examples of securities included would be certificates of deposit (CDs), US Treasury bills, and municipal bonds. Money Market Yield = [(Final – Initial Cash Flow)/( Initial Cash Flow) ] × ( 360 Actual Days)

Answer 117

A treasury inflated protected securities ("TIPS") are issued by the US Treasury and protect bondholders from the risk of inflation. Periodically, TIPS adjust the par value (and the coupon) by the inflation rate for the bondholder to receive the originally expected return. Based on changes in inflation, the principal amount will be adjusted, which would then affect the coupon paid.

Answer 118

A liquidity trap refers to when short-term interest rates are close to zero, which leaves the central bank unable to lower them further to stimulate economic activity. In effect, a liquidity trap makes monetary policy ineffective and restricts the options available to the Fed. Because of the near-zero interest rates, consumers hoard cash rather than invest it into bonds under the belief that the economy is headed in a negative trajectory.

Answer 119

The consumer price index (CPI) is used to measure the change in prices that consumers pay for goods and services on average over a period. The index considers the prices of consumer goods (e.g., housing, apparel, transportation, education, recreation, food, medical care). CPI is followed by many to measure inflation and as a proxy to assess how effective (or not effective) the government’s current economic policies are.

Answer 120

Definition: Deflation occurs when prices decrease across an economy, the opposite of inflation. Economic Impact: Short-Term Benefit: Consumers enjoy lower prices initially. Negative Cycle: Lower prices reduce company profits, leading to layoffs, pay cuts, reduced spending, and economic contraction. Deflationary Spiral: Results in decreased investments, slower growth, higher unemployment, and increased bankruptcies as debt becomes harder to repay. Severity vs. Inflation: Deflation is considered more dangerous than inflation because it is harder to reverse and can persist for decades despite interventions like near-zero interest rates or quantitative easing (e.g., Japan's prolonged deflation).

Answer 121

Recommendation: State the company, its current price, and your buy/sell recommendation. Company Overview: Provide a brief background on the company, including its business model, products/services, market position, and key financial metrics. Investment Thesis: Present 2-3 key reasons why the stock is undervalued or mispriced, supported by data and analysis. Catalysts: Identify specific events (e.g., product launches, earnings reports, regulatory approvals) that could drive the stock’s value in the next 6-18 months. Valuation: Show how the company’s valuation (e.g., P/E, EV/EBITDA) compares to competitors or intrinsic value and outline potential returns. Risks & Mitigants: Highlight major risks to your thesis and explain why they are unlikely or manageable. This structure ensures clarity and depth while addressing key investment factors.

Answer 122

Recommendation Company overview Competitive advantage Market/competitive landscape Catalysts Price Target Range Investment Risks Closing (See word document for a sample pitch and a structure rundown)

Answer 123

During your analysis, try to first understand where the company has been, where it's at the present day, and then attempt to build an investment thesis on where the company is headed. - What is the company’s mission statement and what value do they provide to their customers? - What is the background of the management team, how long have they been running the company, and what is their track record? - What is the business model? How does the company generate cash flow? - What types of products/services does the company sell? Would you consider them to be valuable? - What is the company’s strategy to achieve growth? Has its strategy adapted alongside the market? - What are the end markets to whom the company sells its products/services? - How has the company’s financial performance been in recent years? - Is the company’s cash flows sustainable? Does its revenue have a recurring component? - What are the risks to the company’s cash flows? How competitive is the market? - What are the growth prospects of the cash flows? Where do you predict revenue growth and opportunities to create profitability to come from? - What has earnings per share (EPS) been historically, and how has it been trending in recent years? Question each of your assumptions carefully from the perspective that your thesis might be flawed, as doing so will help solidify your pitch as you understand the counter-arguments. By identifying the weaker areas of your pitch, you can defend your viewpoints better since you've looked at the investment from both perspectives with an open mind, as opposed to looking for what confirms your pre-existing beliefs.

Answer 124

Long-Short Equity: Involving picking winners and losers based on the fundamental analysis of companies; The long-short offsetting pairs reduce the overall market risk. Event-Driven Investing: Pursues pricing inefficiencies before or after major corporate events such as mergers, acquisitions, and spinoffs – either looking for potential M&A targets or seeking to trade the acquisition premium on announced acquisitions. Activist: Activist funds seek underperforming companies they believe are poorly managed and attempt to be the catalyst for a successful turnaround. Quants: Includes systematic, rules-based, algorithmic trading, proprietary strategies, momentum, mean reversion, and high-frequency trading (HFT). Arbitrage/Relative Value:Seeks pricing inefficiencies/mispricing and trading spreads within an asset class (e.g., volatility arbitrage in the options market, convertible arbitrage in stock vs. convert trading). Long-Only: Often associated with value investing, long-only funds only take long positions on the common equity of companies they believe are undervalued with a longer-term holding horizon. Short-Only: Short-selling specialists pursue overvalued stocks. However, the most prominent short-only funds are associated with uncovering accounting frauds or other types of malfeasance. Market Neutral: Like a long-short fund, but will pair long and short trades to mitigate market risk.

Answer 125

When an investment firm goes “long,” it purchases a stock that it believes will increase to turn a profit. The opposite being the firm goes “short” on companies with share prices they expect to decrease. So if the share price goes down, the firm profits. Each equity investment contains some components of market and industry and company-specific risks. The objective of long-short investing is to hedge the market risk (i.e., cancel out the market risk) and then the industry and company-specific risk to some extent, so they're not on the wrong side in case the economy's trajectory suddenly flips.

Answer 126

Portfolio Balance: EMN Funds: Maintain equal long and short positions to minimize market risk (beta near zero). Long-Short Funds: More flexible, allowing imbalances (e.g., net long or net short) based on market outlook. Market Correlation: EMN Funds: Aim for returns independent of market movements, with minimal correlation to equity markets. Long-Short Funds: Exhibit positive beta, reflecting some correlation with market trends. Return Potential: EMN Funds: Focus on consistent, low-risk returns but with limited upside. Long-Short Funds: Pursue higher returns by capitalizing on market trends, accepting increased risk. EMN funds prioritize stability and hedging, while long-short funds balance hedging with directional market bets.

Answer 127

Hedging is a strategy used by an investor or a company to mitigate the risks of an investment. Hedging usually involves investing in derivative products that will be profitable if the market moves in the opposite direction the investor expects. While it may lower the potential upside, it provides downside protection in return.

Answer 128

What is the difference between gross and net exposure? Two terms that are frequently thrown around in the hedge fund industry when discussing measures of risk are gross and net exposure. Gross exposure is a leverage metric, whereas net exposure is a market risk metric. Gross Exposure: Gross exposure is defined as the percentage of a portfolio invested in longs, plus the percentage that's short. If the gross exposure is in excess of 100%, the portfolio is levered (e.g., using borrowed funds). Gross Exposure = Long Exposure% + Short Exposure% Net Exposure: Net exposure is calculated as the percentage of a portfolio invested in longs minus the percentage of the portfolio that's short. . Net Exposure = Long Exposure% − Short Exposure%

Answer 129

“What is the most an investor might lose?” MDD = (Peak Portfolio Value − Lowest Portfolio Value)/Lowest Portfolio Value MDD formula shows the largest percentage drop in a portfolio's value based on the peak and lowest points of a portfolio. But be mindful that for MDD to be a meaningful measure of risk, the portfolio should have become active in the market for more than a decade at a minimum to ensure the portfolio has undergone at least one full economic cycle and experienced at least one major bear market.

Answer 130

Beta: Roughly, beta is the correlation of your portfolio with the broad market. If your portfolio has a beta of 1.0, then if the stock market goes up 10%, you would expect your portfolio to go up 10% too. Beta strategies track an underlying index, most often the S&P 500. Enhanced Beta: Strategies that track an underlying index but outperform Beta by adding an Alpha strategy (called “overlay”). Enhanced beta is still classified as passive investing and tracks an index, for the most part. However, there are some additional adjustments to the holdings to achieve greater returns, such as taking market capitalization and dividend payments into considerations (i.e., added element of active management to adjust the proportion of the weighting of specific stocks to outperform beta while remaining risk-averse). Alpha: In contrast, alpha is the excess return amount above the market return and measures the out-performance of a certain security or portfolio, achieved with above-market returns. Said another way, alpha involves the uncorrelated returns to the market. When portfolio managers discuss alpha, they're almost always referring to “beating the market.”

Answer 131

The merger arbitrage investment strategy is when an investor purchases the shares of a company undergoing an M&A deal. The investor can take advantage of inefficiencies in pricing surrounding M&A, as it often takes time for the market to digest the recent information and settle on a valuation. The investor can profit from the uncertainty that exists as the market evaluates an announced acquisition. The overarching aim is to profit from the spread between the current market price and the announced acquisition price.

Answer 132

The goal is to capitalize on a particular event, ranging from a regulatory change to a full operational turnaround. The ideal investment characteristics are underperformance vs. peers with a strong, aligned management team. The right team is of high importance because they execute the turnaround strategy. The investor would examine the management team's track record and see if they have any relevant history in turnaround situations and what makes them the right leaders for the job.

Answer 133

In activist investing, poorly run and underperforming companies are targeted by turnaround specialists that will push for changes in either management practices or completely replace the management team. A key distinction is that the catalyst to the turnaround is the entrance of the activist investors themselves. The public announcement of an investment by a well-known activist investor alone can cause a company's share price to spike, as investors expect drastic changes to come. For example, an activist investor could take a large equity stake in a company intending to drive the management's strategic decisions (or maybe even replace the team). Their goal is to convince existing shareholders that there's hidden value in the company that the current management is not extracting (and thus, the company is undervalued). Even though their investment is a minority stake, these activist investors can often change a company's trajectory (e.g., Starboard Value, Elliott Management) and influence an underperforming company.

Answer 134

The convertible bond arbitrage strategy is when an investor will take a long position on a convertible bond and then short the underlying stock. The investor would then benefit from the difference in pricing between the convertible bond and the share price. If the share price declines, the investor can benefit from the short position taken, and thus there'll be more downside protection. But if the share price increases, the investor can convert the bond into shares and then sell, earning enough to cover the short position (and again minimize the downside).

Answer 135

Richard Driehaus, of Driehaus Capital Management, is often credited as being the father of momentum investing. The general theme of momentum investing is: “buy high, sell higher.” The momentum investing strategy strives to capitalize on the continuance of ongoing trends in the market – hoping the trend persists. The difference from GARP investing is that momentum investing relies more on technical indicators to decide trades, rather than being value-oriented and looking for high-growth but still undervalued companies. The holding period is shorter in momentum investing as it intends to take advantage of trends that are often driven by human emotion, which coincides with overvaluations of certain equities.

Answer 136

Momentum Strategies: Momentum-based strategies rely on the continuance of existing market trends to ride the upward trend. Recently, securities (or a specific asset class) have performed well, and these investors believe there's still more upside remaining for profits to be made. Mean Reversion Strategies: Mean reversion based strategies pursue unusually large drops or increases in pricing due to market over-reactions (either oversold or overbought) and then place bets that the price will revert towards the mean.

Answer 137

Systematic Strategies: Rules-Based: Investments are unaffected by emotion – the most frequently cited reason for misjudgment. Data Capacity: Systems can interpret and analyze more data and inputs in volume and speed. Machine Learning (ML): Systematic strategies will adapt and continuously improve over time. Back Tested: These systems can identify which specific strategies would have worked in the past to help guide future decisions (i.e., run simulations of how a strategy would have performed). Human Traders: Adaptability: Traders are more experienced, can adjust to market changes, and can pick up sudden sentiment changes that computers cannot capture. More Resourceful: Capable of capturing more market color and feedback that's not in electronic format (e.g., salesperson calls, investor presentation meetings).

Answer 138

Macro hedge funds are very active in rates, currencies/FX, commodities, and equity indices.

Answer 139

Most institutional investors that manage billions of dollars, such as Blackrock, are considered multi-strat, which is a catch-all term for having a diversified combination of investment strategies. Given the various strategies employed, this type of approach provides more stability in returns and has more downside protection. For example, a multi-strat investment firm will invest in equities, bonds, real estate, and private equity to spread its capital allocation and de-risk its portfolio holdings. Considering their AUM, capital preservation often takes priority over achieving outsized returns.

Answer 140

Original Purpose: Hedge funds were designed to provide risk-adjusted returns, independent of market conditions, rather than outperforming the market. Hedging Strategy: As a “hedge,” these funds aim to protect wealth during bear markets, offering stability rather than maximizing gains during bull markets. Investor Goals: Hedge fund investors prioritize diversification and risk management, not necessarily market outperformance. Shift in Objectives: While some modern hedge funds aim to outperform the market, this is not their traditional role or primary focus. Comparing hedge fund returns directly to market benchmarks overlooks their unique risk-adjusted and hedging strategies.

Answer 141

Market Impact: Large funds are market movers, meaning their trades can significantly impact stock prices, reducing opportunities for mispricing. Limited Investment Options: Large funds are restricted to large-cap stocks, as small-cap stocks are too sensitive to their actions. Large-cap stocks are more efficiently priced due to widespread analyst coverage, limiting return potential. Small-Cap Fund Strategy: Small-cap funds often cap their AUM to avoid diluting returns and focus on finding mispriced securities in less-followed markets. As AUM grows, funds face reduced flexibility and fewer opportunities for high returns due to market efficiency and their own influence on prices.

Answer 142

Definition: Developed by Harry Markowitz, MPT focuses on constructing efficient portfolios that maximize expected returns for a given level of risk. Key Principle: An asset's risk should be evaluated based on its contribution to the overall portfolio, not as a standalone investment. Portfolio Optimization: Risk-return relationships are plotted to identify the optimal asset allocation at each risk level, maximizing returns. Risk Diversification: Diversifying assets with low correlation reduces unsystematic risk, leaving only systematic risk, which cannot be eliminated. MPT aims to balance risk and return through diversification and strategic allocation.

Answer 143

Developed by William Sharpe, the Sharpe ratio measures risk-adjusted returns of a portfolio or investment. The use case is to assess the risk/return of a portfolio, or an individual investment, although most use it for a group of investments (e.g., mutual funds). Sharpe Ratio = (Rp-Rf)/SDp Interpretation: Below 1.0: Sub-par risk-adjusted returns. Above 1.0: Acceptable performance. Above 2.0: Strong performance; 3.0+ is exceptional. Popularity: Widely used due to its simplicity and applicability across portfolios, mutual funds, and individual investments. Criticism: Relies on standard deviation as a risk measure, assuming returns follow a normal distribution, which oversimplifies real-world risks. Alternatives like the Sortino ratio address this by focusing on downside risk instead of total risk

Answer 144

Core Points on Why Many Investors Disregard Equity Research Reports: Conflict of Interest: Analysts often work for investment banks that provide services to the companies they cover, leading to biased recommendations (e.g., overly bullish ratings to maintain relationships or secure future business). Inherent Bias: Analysts may avoid issuing negative ratings (e.g., "sell") to preserve access to company management or avoid backlash from stockholders. A "hold" recommendation is often interpreted as a negative signal by the market. Herding Behavior: Analysts tend to cluster around consensus estimates, avoiding bold or contrarian calls to minimize reputational risk. Regulatory Constraints: Analysts cannot invest in the companies they cover, limiting their alignment with investor interests. Perceived Lack of Value: Reports are often seen as marketing tools rather than independent research, offering little actionable insight for investors seeking undervalued opportunities. These factors contribute to skepticism about the objectivity and utility of equity research reports.

Answer 145

Short selling is when an investor predicts a short-term decline in the price of a particular security. For an investor to short a stock, it means the investor has “borrowed” the security from a broker and sold it in the open market, under the belief they'll repurchase the shares for a lower price later. 1. First, the hedge funds will go onto the exchange and sell the shares that they have borrowed from a securities lender or broker – meaning, they sold a stock that they don't actually own on paper. 2. Once the hedge fund wants to exit their short position, they'll re-purchase the shares and return the shares they bought to the lender. 3. If the short went as planned (i.e., the share price dropped), then the hedge fund’s profit will be the difference between the purchase and sale price, less any associated fees paid to the lender – so the hedge fund has bought it back at a lower price than what they had sold the shares.

Answer 146

Short Interest Ratio: Total number of shares shorted and open positions not bought back as reported by the exchange, divided by average trading volume Short Interest Ratio = Short interest/average trading volume Short % of Free Float: Short interest as a percentage of Free float, or the number of shares available to be traded (excludes insider owned shares) Short % of Free Float = Short interest/Free float

Answer 147

Index Shorting: Index shorting can involve shorting an index such as the S&P 500 or buying put options on an index to hedge out the long positions. Alpha Shorting: Alpha shorting refers to taking individual short positions to make a profit. Funds will employ both approaches, but alpha shorting is much more difficult.

Answer 148

For shorting a stock, the investor has unlimited downside potential. Recall that short-selling means the investor sold a stock that they technically don't actually own, believing that they'll purchase it for a lower price in the future (i.e., the potential share price upside is unlimited). When purchasing put options, the maximum loss is limited to the initial investment amount.

Answer 149

A short squeeze occurs when there's much short interest on a particular stock, and then positive news comes out. Many short sellers simultaneously attempt to cover their short positions at once, which causes a rapid increase in the share price. A short squeeze accelerates a share price’s upward movement as short-sellers attempt to buy back the stock and cut their losses.

Answer 150

Special situations involve event-driven catalysts (e.g., M&A, restructuring) that can significantly impact a company's stock price. Types of Events: Examples include spin-offs, split-offs, merger arbitrage, tender offers, management changes, and recapitalizations. Opportunity for Arbitrage: These events often create mispricing opportunities, allowing investors to capitalize on market inefficiencies. Empirical Evidence: Studies suggest that special situations, such as spin-offs and divestitures, frequently lead to positive value creation for investors. Special situations attract attention due to their potential for outsized returns driven by unique, event-specific catalysts.

Answer 151

Complacent incumbents facing a threat from innovative new entrants – must assess the management’s willingness to adapt and the likelihood of a proper reaction (e.g., Nokia’s failure to adjust). Companies focused on consumer euphoria –significant short-term interest in a consumer-oriented product (i.e., the demand is driven by a consumer-led “fad”). Incumbents that are unlikely to exist in the future (e.g., physical newspaper business) and don't appear to be making any effort to adjust to the changing environment. Signs of accounting fraud or allegations made by credible sources

Answer 152

Contrarian investors seek opportunities that go against the consensus view, often targeting companies the market has overlooked or undervalued. Belief System: Based on the idea that markets overreact or neglect certain factors, leading to mispriced assets. Approach: Contrarians are patient and invest only when they have strong conviction, not simply to oppose the crowd. They focus on developing independent views, thinking critically rather than following market sentiment. Challenge: Success requires not just being contrarian but also being contrarian and correct, which is difficult to achieve consistently.

Answer 153

In aggregate, hedge fund returns have compressed in recent times and underperformed the S&P 500 over the past decade. The increased AUM in the market has made it more difficult to find good investment opportunities. Because of this, many large, brand-name funds have closed and returned capital to their investors. And given the increased competition, some ways that hedge funds are becoming increasingly sophisticated are the usage of satellite imagery, point-of-sale data, credit card data, and the employment of data scientists. The need for a hedge fund to be differentiated and carve out a unique niche to achieve outsized returns has never been greater – but this is far easier said than done in reality.

Answer 154

Portfolio diversification is when a portfolio contains investments in diverse industries, asset classes, and geographies. The end objective is to limit exposure to one asset class or particular risk and construct a portfolio of holdings that are not correlated while still attempting to maximize returns (i.e., nearly all unsystematic risk is eliminated). The chosen investments shouldn't be correlated with one another, or else that would defeat the purpose of diversification.

Answer 155

A margin of safety is one of the fundamental concepts of value investing in which a security is purchased only when the share price is significantly below its intrinsic value. The margin of safety serves as an investor’s downside risk protection and can be thought of as the difference between the estimated intrinsic value and the current share price. Margin of Safety (MOS) = 1 − (Current Share Price/ Intrinsic Value ) Often, many value investors will not invest in a security unless the margin of safety is ~20-30%. If the MOS hurdle is 20%, the investor will only purchase a security if the current share price is 20% below the intrinsic value based on their valuation.

Answer 156

The margin of safety is the buffer that value investors place into their investment decision making to protect them against downside risk if the share price drops post-investment. Rather than shorting stocks or purchasing puts, many value investors view this as their primary method to mitigate investment risk. Margin of Safety (MOS) = 1 −(Current Share Price/Intrinsic Value) Often, many value investors will not invest in a security unless the margin of safety is ~20-30%. If the MOS hurdle is 20%, the investor will only purchase a security if the current share price is 20% below the intrinsic value based on their valuation.

Answer 157

If a company has an "economic moat," sustainable value creation over the long-term is attainable. An economic moat refers to a company’s ability to maintain its competitive edge over its competitors to protect its continued long-term profit generation. The stronger and more defensible a company’s competitive advantage, the more difficult it becomes for other new entrants to breach this moat and take away their market share. An economic moat can be viewed as protecting the competitive positioning of a business.

Answer 158

Coined by Phil Fisher in his book “Common Stocks and Uncommon Profits,” the Scuttlebutt method refers to investing based around going out and conducting your own proprietary research (i.e., listen for rumors, observe surrounding developments, observe stores), rather than just reading equity research reports and financial news, and relying on the opinions of others. This type of diligence involves talking to all kinds of people (e.g., customers, employees, industry experts) to gain their insights and identify trends by gathering your information and then making investment decisions based on your intuition.

Answer 159

Core Points on Why Warren Buffett Dislikes EBITDA: Ignores Real Expenses: EBITDA excludes key costs like depreciation, amortization, interest, and taxes, which are real cash outflows, especially in capital-intensive industries. Misleading Profitability: By neglecting capital expenditures (CapEx), EBITDA can make unprofitable companies appear profitable on paper. Distorts Cash Flow: It fails to reflect a company’s ability to generate actual cash, which Buffett considers the true measure of business health. Room for Manipulation: EBITDA is a non-GAAP metric, allowing management discretion in adjustments, which can obscure financial reality. Buffett prefers metrics like free cash flow that provide a clearer picture of a company’s financial performance and sustainability.

Answer 160

Criticism of Beta: Buffett disagrees with using beta (volatility) as a measure of risk, arguing that price fluctuations can represent opportunities rather than risks. Definition of Risk: He defines risk as the possibility of permanent capital loss or failing to meet financial goals, not short-term volatility. Market Opportunities: Volatility can create chances to buy undervalued assets, making it a friend to informed investors rather than a threat. CAPM's Flaws: Buffett views CAPM as misguided for equating volatility with risk and ignoring business fundamentals like intrinsic value and competitive advantages. Buffett emphasizes long-term fundamentals over mathematical models like CAPM, which he believes oversimplify real-world investing.

Answer 161

Deep value is a subset of value investing but emphasizes extreme price discounts over quality, accepting higher risk for potential outsized returns Valuation Focus: Value Investing: Targets stocks trading below intrinsic value but still considers quality metrics (e.g., earnings, cash flow, competitive position). Deep Value Investing: Seeks extreme discounts (e.g., below liquidation value) and often disregards quality, betting on mispricing due to market overreaction. Quality vs. Price: Value Investors: Prioritize companies with strong fundamentals (e.g., stable earnings, low debt) but temporarily undervalued. Deep Value Investors: Accept deteriorating financials, weak management, or poor growth strategies if the price is sufficiently low. Risk and Catalysts: Deep Value: Relies on catalysts like restructuring, asset sales, or activist intervention to unlock value. Higher risk due to potential value traps (stays cheap due to irreversible issues). Value: Lower risk, with a margin of safety from solid fundamentals and gradual market recognition. Performance and Time Horizon: Deep Value: May outperform during market extremes but underperforms quality value long-term. Often shorter-term bets on specific events. Value: Focuses on long-term growth as fundamentals drive price correction.

Answer 162

Value investors have a long-term thesis and therefore ignore short-term movements. Often, a value investor will hold a security for 5+ years and invest with the mindset of "never selling."

Answer 163

Commonly recommended by practitioners of value investing, the practice of dollar-cost averaging (DCA) refers to committing to buying shares at pre-determined intervals. This can be useful during periods of market volatility and prevent an investor from attempting to “time the bottom. ”If the stock price decreases, then the investor can simply purchase more to lower the average cost paid on a per-share basis. But if the price increases, the investor can either continue purchasing (if still undervalued based on their beliefs) or pursue other opportunities in the market.

Answer 164

Growth at a reasonable price (GARP) is a hybrid investment strategy that combines growth investing and value investing. GARP could be best described as profiting from a company trading at a material discount on an earnings basis but not to the same extent as traditional value investments. The GARP investment strategy is based on finding high-quality companies with a sustainable competitive advantage, above-market consistent earnings growth, and large market potential. Then, the NPV of the cash flows will be determined with the growth potential incorporated to see if the company is undervalued. While this is not necessarily pure value investing, it's a reasonable compromise that many investors have adopted.

Answer 165

Investors new to value investing will frequently fall into the so-called value trap. This fallacy is the false belief that a particular stock is currently undervalued because it has fallen out of favor with the market and dropped significantly in recent weeks or months. Because these investments appear to trade at such low levels compared to the prior levels, many investors will view this as a buying opportunity. However, the fall in price is misleading, as there's usually a good explanation for the decrease in valuation.

Answer 166

Introduced by Eugene Fama, the efficient market hypothesis (EMH) theory asserts that asset prices fully reflect all available information. Following the release of new information or relevant data, prices will automatically adjust instantaneously to reflect the accurate price within a matter of seconds. Weak Form EMH: The weak form of the EMH states that all past information such as historical trading prices and volume data is reflected in current asset prices. Semi-Strong EMH: The semi-strong form of the EMH states that all publicly available information is reflected in current asset prices. Strong Form EMH: The strong form of the EMH states that all public and private information (including inside information) is reflected in current asset prices.

Answer 167

EMH is referring to the long-run. Therefore, if an investor purchased a temporarily undervalued stock (by their definition) and then sold for an above-market return – that doesn't invalidate the EMH theory. Rather, most proponents of EMH suggest that these types ofoccurrences are rare and not worth the effort (and active management fees) over the long-term.

Answer 168

Index funds such as mutual funds and exchange-traded funds (ETFs) are convenient for the everyday investor to participate in the markets. The widely held belief among the passive investing community is that it's very difficult to beat the market, and it would be a futile attempt when investment professionals that spend considerable resources and time on analyzing securities struggle to do so consistently.

Answer 169

The random walk theory is a hypothesis that assumes the share price changes in the financial markets are due to random, unpredictable events that nobody can predict. In contrast, EMH is the theory that asset prices perfectly reflect all the information available in the market, thereby having a company’s share price being neither be undervalued nor overvalued, but it's precisely trading where it should be because the market is efficient.

Answer 170

Sales Division: sales division manages the communication and relationship building with clients on behalf of the investment bank. Trading Division: Traders make a market and execute trades on behalf of the investors they represent. Unique to this role, sometimes traders have their own trading book where they can take positions and generate a personal P&L. Traders need to be quick with mental math, have the quantitative skills to understand complex products, and have an intuitive understanding of markets to spot mispricing.

Answer 171

A derivative refers to a financial instrument in which its value is derived from an underlying asset or index. Some of the most common derivatives include options, futures contracts, forwards, and swaps. For example, a call option tied to a particular stock would be an example of a derivative, since the option's value depends on the company's share price.

Answer 172

Options are financial derivative instruments that give the holder the right, but not the obligation, to purchase or sell an underlying asset at an agreed-upon price. This right will have a set expiration date upon which, if the option is not exercised, it'll expire worthless.

Answer 173

Call Options: Call options are financial contracts that give the owner the right, but not the obligation, to buy an underlying asset at a pre-specified price within a period. If the option holder believes the price of the underlying asset will increase (“bullish”), they'll purchase calls because the value of a call option will increase as the underlying asset's value increases. Put Options: Put options, in contrast, are contracts that give the owner the right, but not the obligation, to sell an underlying asset at a pre-specified price within a period. If the option holder believes the price of the underlying asset will decrease (“bearish”), they'll purchase puts since the value of a put option increases as the underlying asset's value decreases.

Answer 174

In-the-Money (“ITM”): If an option is “in-the-money” (ITM), this means that the option is profitable to exercise. For a call option, an ITM option would mean that the option price of the underlying asset is above the exercise price (or strike price). Out-of-the-Money (“OTM”): If an option cannot be exercised profitably, it's referred to as being “out-of- the-money” since the option has no intrinsic value. At-the-Money (“ ATM”): When an option is at-the-money, this means the option’s strike price is equal to the price of the underlying security. An ATM option, similar to an OTM option, has no intrinsic value but could still have time value depending on the expiration date.

Answer 175

Within investment banks, the equities groups are split between cash equities and derivatives. The term “cash equities” is another term for stock trading commonly used when discussing sales & trading. The set-up of a cash equities group is completely different today due to the diminished requirements for actual traders on the floor or market makers due to the reliance on electronic trading. Nowadays, most investment banks have only a handful of cash equity traders globally, as opposed to the hundreds formally employed in the last decade.

Answer 176

During the period of open-trading (or “continuous market-making”), there's a book of orders that contains bids and offers. Bids: Bids are when there's interest to purchase the security from buyers. Offers: Offers are when existing holders are interested in selling the security to the open market. Each order has a price and the number of shares at that specific price. Orders are then automatically ranked, with the highest bid at the top and the lowest sell offer at the top.

Answer 177

The indicative cross size calculates the number of shares that can connect buyers with sellers at a specific price point. The closing price would be the price with the highest cross size (i.e., the price at which you can get the maximum number of buyers and sellers to exchange shares).

Answer 178

Volume: The total number of shares that are traded within a day. A stock with a higher average daily volume means you can trade more shares before moving the price. VWAP: VWAP stands for the “volume-weighted average price.” This indicator measures the average price based on actual trading volumes. Depth: The depth reflects the total buy and sell orders currently on the order book and is used to measure how much one could purchase in terms of volume without “moving markets.”

Answer 179

There are multiple venues for a sales trader to send an order to: Order to the Floor: The exchange (NYSE or NASDAQ) where the stock is listed. Internalization: The bank executing the trade could provide the other side, offsetting the trade flow with their trade flows. Electronic Communication Network: ECN is a computerized stock exchange that connects buyers with sellers. Stocks are not listed on an ECN, but the ECN pays rebates taken out of the bid-offer spread to participants, which provides liquidity to the ECN. Smart Order Routing (SOR): Alternatively, SOR algorithms can scan the market and spread the order through multiple trading venues.

Answer 180

Block Trades: A large number of shares are traded off the exchange, reporting requirements to FINRA (ticker, size, and the price paid), and typically traded after the market close. Dark Pools: Platforms to allow large trades to be executed without moving prices. Has reporting requirements similar to block trades, lower execution fees than exchanges, and flexibility in order types. OTCBB/Pink Sheets: Over-the-Counter Market (not exchange-traded) can be used by smaller companies that don't meet the exchange listing requirements but still need to file with the SEC.

Answer 181

A stock index is just a tracker of a collection of equities, reflecting the price of stocks included in the index and calculated based on the index provider's rules. The index by itself is not tradable on an exchange, although there are financial instruments such as ETFs that follow these major indices (e.g., SPY, VTI, QQQ).

Answer 182

S&P 500 (Bloomberg Ticker: SPX) DJIA (Bloomberg Ticker: INDU) NASDAQ 100 (Bloomberg Ticker: NDX)

Answer 183

A mutual fund is an investment vehicle for both retail and institutional investors, in which investors are pooled together and each own shares of the fund proportional to the amount invested. Most mutual funds are open- ended, allowing for investors to increase or decrease their investment. Mutual funds are typically bought and sold at the end of the day, at the fund’s net asset value (NAV). The NAV is the total value of all the securities in the fund, plus cash, divided by the number of shares. It's the value of each mutual fund share as determined by closing market prices. A few traits to be aware of are that mutual funds are regulated by the SEC and are managed by an asset manager.

Answer 184

An asset manager would be one that actively manages a mutual fund on behalf of the fund’s investors. These asset managers are considered fiduciaries, meaning that they're hired and compensated for advising their investors and making recommendations and/or investments in the best interests of their clients.

Answer 185

The distinction between hedge funds and mutual funds is that hedge funds are not targeted towards retail investors. Instead, only accredited investors can invest as LPs in hedge funds. Hedge funds come with higher risks of losing capital. Thus, these strict qualification rules were put in place to protect the interests of those that can’t afford to lose a significant sum of money. In addition, hedge funds are more actively managed, use different strategies, and are resultingly compensated more due to the “2 and 20” compensation model.

Answer 186

No, sales and trading professionals are not considered being fiduciaries. Instead, sales and traders work directly with institutional and high-wealth investors that don't require (or request) advisory services. The primary role of S&T is to execute orders on behalf of clients without providing investment advice.

Answer 187

An exchange-traded fund (ETF) is a type of financial product that tracks a specific underlying index (i.e., collection of securities, most often equities). An ETF can be viewed as a blend between a mutual fund (portfolio of investments, passive strategy, benchmarked to index) while being similar to equities by being listed and traded on exchanges. ETFs have become a very popular choice recently due to lower fees and convenience.

Answer 188

Initial Margin - A fixed amount you need to pay to cover your credit risk, set by the Clearing Bank’s Risk Department, which may allow offsetting positions - Varies based on the volatility of the underlying product - Covers the cure period risk of a clearing client not making their variation margin Variation Margin (or Maintenance Margin) - The Market-to-Market gain or loss you have on your position - Cash or collateral is received if your position is in-the-money, but you pay cash or collateral if your position is out-of-the-money

Answer 189

Following 2008, the Dodd-Frank Act required most derivatives (both exchange-traded and over-the-counter) to be formally cleared. Originally, the buyer or seller of an exchange-traded derivative would not be aware of who the counterparty is – but now, clearing houses are required to intermediate the transaction and help mitigate the credit risk. While the counterparty risk associated with derivative instruments is not eliminated by any means, the facilitation of the exchange by a 3rd party seeks to minimize it.

Answer 190

Securitization is when financial instruments are pooled together into one group to become more marketable. The issuer will then sell this pool of repackaged assets to investors (e.g., mortgages pooled together and divided into securitized bonds). By themselves, the assets within the group would not have sufficient liquidity to be sold as a standalone product, but securitization can allow for the grouped assets to be easily tradeable in the market and thus have high liquidity.

Answer 191

CDOs are structured financial instruments backed by a pool of assets, such as loans, bonds, or mortgages, offered as collateral in case of default. Creation Process: Investment banks bundle cash flow-generating assets and repackage them into tranches tailored to investors' risk preferences. Example: Mortgage-backed securities (MBS) are a type of CDO backed by mortgages. Subprime MBS played a central role in the 2008 financial crisis due to lack of transparency and poor-quality collateral. Risks: Securitization can conceal asset quality, enabling the origination of low-quality loans that are quickly offloaded through CDO offerings. CDOs offer diversification but require careful scrutiny to avoid risks tied to asset quality and transparency.

Answer 192

Mortgage-backed securities are a very common way to finance mortgages in the US, UK, and Netherlands. The US MBS market is very large, even of greater size than the corporate bond market. Mortgage loans will first be placed into a special purpose vehicle (SPV), a holding company for the mortgages. The SPV will then issue MBS bonds. As the homeowners that took out the underlying loans make mortgage payments, they go to the MBS bondholders.

Answer 193

1. Agency Mortgages: A government agency (e.g., Freddie Mac or Fannie Mae) guarantees the mortgage loan. If the underlying homeowner defaults, the agency takes on the credit risk and repays the loan. 2. Non-Agency Mortgages: There is no guarantee, and the bond investors take the credit risk of the underlying borrowers. This risk is reflected in the higher interest rate these borrowers pay, as well as over collateralization, having a higher value of loans than MBS bonds issued.

Answer 194

Asset-backed securities (ABS) function similarly to mortgage-backed securities (MBS). Although mortgages are technically classified as an “asset, ” the differences lie in how ABS is typically used to refer to financing (e.g., credit card loans, car loans or leases, student debt). In comparison, the ABS market is smaller than the MBS market since the borrowings related to ABS are typically smaller than mortgages, especially in the US.

Answer 195

Definition: CDOs are structured financial instruments backed by a pool of assets, such as loans, bonds, or mortgages, offered as collateral in case of default. Creation Process: Investment banks bundle cash flow-generating assets and repackage them into tranches tailored to investors' risk preferences. Example: Mortgage-backed securities (MBS) are a type of CDO backed by mortgages. Subprime MBS played a central role in the 2008 financial crisis due to lack of transparency and poor-quality collateral. Risks: Securitization can conceal asset quality, enabling the origination of low-quality loans that are quickly offloaded through CDO offerings. CDOs offer diversification but require careful scrutiny to avoid risks tied to asset quality and transparency.

Answer 196

Forward contracts are formal agreements between two parties in which one party agrees to purchase an underlying asset from the other party at a later date. The future date of purchase and the price at which the purchase will be made will both be stated in the original agreement.

Answer 197

Futures are derivative instruments that serve as a contractual obligation for two parties to exchange an underlying asset at a pre-determined price at a later date. This exchange is completed regardless of the change in the asset's price (whether up or down). The buyer must either buy the underlying asset, or the seller must sell the underlying asset at the pre-specified set price. In today’s market, equity and interest rate futures have significantly higher trading volumes in comparison, which don't involve any physical delivery since they are monetary exchanges (i.e., cash-settled based on the value difference).

Answer 198

The two derivatives, forward and futures contracts, are similar in that both involve agreements between two parties to buy or sell an underlying asset at a pre-determined price by a specified date. The difference is that a forward contract is a private agreement that settles at the end of the agreement term and is traded over-the- counter. A futures contract has more standardized terms (i.e., less customization) and is traded on exchanges, in which the changes in prices can be readily seen daily until the end of the contract term.

Answer 199

Spot Exchange Rate: The spot exchange rate is the exchange ratio of one currency into another currency on a particular day. The key characteristics of spot exchange rates are that they're reported on a real-time basis and determined by the supply/demand of that currency relative to the same supply/demand dynamics of the other currency (i.e., set by the market). Forward Exchange Rates: In forward exchange rates, two parties will exchange currency at a specific date in the future. These deals are executed to hedge against foreign exchange risk, to which many multinational companies are exposed. Forward exchange rates can be quoted for limited durations (e.g., 30 days, 60 days, 90 days, 180 days) Distinction: The key distinction is that the rate is negotiated and agreed upon by the two parties for forward exchange rates (rather than letting the market determine the rate).

Answer 200

Warrants: A warrant gives the holder the right, but not the obligation, to purchase common shares of stock directly from the issuing company at a fixed price for a pre-determined period. The key distinction is that the warrant is issued directly by a company to an investor. Therefore, if the warrant is exercised, the shares required to fulfill the agreement are issued, so warrants have more of a dilutive impact when exercised because the company will actually issue new stock. Stock Options: A stock option gives the holder the right, but not the obligation, to purchase or sell shares at a pre-specified price for a defined period. Options are commonly traded amongst investors. The exercising of a stock option has less of a dilutive impact because no new shares are issued since options are derivatives based on an underlying asset (i.e., the pre-existing common shares of the company).

Answer 201

The implied volatility (“IV”) is the market’s expectations on the movement in a specific security or indexes’ price. Implied volatility has a significant role in the pricing of options contracts, as higher IV results in higher premiums (and vice versa). During periods of bearish sentiment, implied volatility typically increases, whereas when the market is bullish, the implied volatility decreases.

Answer 202

The higher the volatility of the underlying asset (e.g., share price, commodity price), the higher is the price for both call and put options (and vice versa). The reason being higher implied volatility means there's greater price movement being expected by market participants, thus increased upside and downside potential. As a general proxy, higher implied volatility (IV) indicates uncertainty in the markets that can cause swings in either direction, but it's interpreted as a bearish signal because many equity investors exit the market when there's greater uncertainty.

Answer 203

The VIX is an index and not directly tradable, similar to the S&P 500. Market participants can trade VIX futures and take a view of where the calculated index will be in the future. Like other future products, VIX futures can be packaged into Exchange Traded Notes (ETNs) and bought by retail investors.

Answer 204

The return of being long on the VIX is affected by the futures’ roll-yield. In normal times, the VIX curve is in a contango shape, where the level where I can lock VIX in the future is higher than the level today. The return of a long VIX strategy, whether in futures directly or ETNs, needs to factor in the cost of rolling futures due to the contango shape.

Answer 205

This is a test of your understanding of how markets are connected and interrelated. The question to ask is: "Is the move a risk-on move or a risk-off move?" Here, political instability is a risk-off move. Pick one asset class or part of the market you know well and dive a bit deeper. For example, you can talk about options.

Answer 206

Interest Rate Risk: - Scenario: A company with fixed-rate debt fears rising rates will increase borrowing costs. - Hedge: Enter a pay-floating/receive-fixed interest rate swap. This converts fixed-rate payments to floating, offsetting risk if rates fall. Example: A municipal bond investor uses a swap to convert fixed-rate bond payments to floating (e.g., SOFR), hedging against rising rates Credit Default Risk: - Scenario: An investor holds corporate bonds and worries about issuer default. - Hedge: Purchase a credit default swap (CDS). The CDS seller compensates the buyer if the issuer defaults. Example: An investor buys a CDS on a $1M bond, paying an annual premium. If the issuer defaults, the CDS seller covers the principal Foreign Exchange (FX) Risk: - Scenario: A U.S. investor holds euro-denominated bonds and fears EUR depreciation. Hedge: Use an FX swap to exchange EUR cash flows for USD at a predetermined rate. Example: PepsiCo issues bonds in a foreign currency but uses a swap to lock in USD exchange rates, avoiding currency fluctuations Additional Uses: - Inflation Risk: Use inflation-linked swaps to hedge against rising prices by exchanging fixed payments for inflation-indexed ones. - Basis Risk: Float-to-float swaps adjust the floating rate index (e.g., SOFR to Treasury rates) to align with liabilities. Swaps provide tailored solutions to isolate and mitigate specific fixed income risks, enhancing portfolio stability.

Answer 207

Proprietary Trading: - Traders use the firm’s own capital to buy and sell securities for profit, not involving clients. - Heavily restricted by regulations like the Volcker Rule; many prop desks have spun out as independent hedge funds. Flow Trading: - The bank acts as principal, setting prices and taking the opposite side of client trades. - Profits come from high transaction volumes and the bid-offer spread. Agency Trading: - Traders execute orders on behalf of clients, typically on exchanges. - Most common for stocks, futures, and options; large block trades may still involve flow traders. Electronic Trading: - Automated platforms and algorithms execute trades without human intervention. - Best for high-liquidity, standardized products; reduces costs and increases efficiency.

Answer 208

Most trades today are agency trades, in which traders employed at an investment bank will act as an intermediary between the investor and the exchange (and collect a commission). Based on the orders of the client (the investor), the sales trader will execute the trade as directed.

Answer 209

Investment banks could no longer perform proprietary trading. However, they can make markets through flow trading. This rule was imposed because banks were becoming too involved in the monetary gains from their trading divisions instead of focusing more on agency and flow trading (i.e., clients’ interests come first).

Answer 210

A barrier intended to separate the M&A and Capital Markets division from the Equity Research and Sales & Trading divisions. The Chinese Wall is an information barrier protecting Material Non-Public Information (MNPI) from passing from those working on the private-side to those on the public-side.

Answer 211

A CDS is like an insurance policy for debt, allowing investors to hedge or speculate on the risk of default by a borrower. They are widely used for risk management, trading, and arbitrage in the credit markets Definition: A credit default swap (CDS) is a financial derivative contract where one party (the buyer) pays periodic premiums to another party (the seller) in exchange for protection against the default or other credit event of a third-party borrower (the reference entity). How It Works: The CDS buyer receives a payout if the reference entity defaults, fails to pay, restructures its debt, or experiences another agreed-upon credit event. The CDS seller collects premiums and takes on the risk, paying out if a credit event occurs. Purpose and Uses: Hedging: Investors and lenders use CDSs to protect themselves against losses from the default of bonds, loans, or other debt instruments—essentially acting as credit insurance. Speculation: Traders can buy or sell CDSs to bet on the creditworthiness of a company or country, profiting from changes in perceived credit risk even if they do not own the underlying debt. Arbitrage: CDSs can be used to exploit pricing differences between credit markets and CDS markets. Key Features: CDSs are not limited to those who own the underlying debt—any investor can buy or sell protection, including "naked" CDSs. CDS contracts are typically used for corporate bonds, sovereign debt, mortgage-backed securities, and other fixed-income products. Market Impact: CDSs played a significant role in the 2008 financial crisis due to their widespread use and lack of transparency

Answer 212

The credit default swap market (“CDS”) is similar to the options market, in which investors buy or sell options in anticipation of a share price going up or down, usually to hedge an underlying position. The difference lies in how the investor is speculating that the company’s perceived creditworthiness will increase or decrease, rather than share price movement.

Answer 213

The option premium is the total amount that a buyer has paid to purchase an options contract. In all instances, the seller of the option will receive the premium.

Answer 214

Intrinsic Value: The intrinsic value of an option is the amount of profit investors would get if they immediately exercised the option. Time Value: The time value of an option is the amount that an investor will pay in excess of the intrinsic value. As the expiration date nears, the time decay of the option will cause the option premium to decline. Implied Volatility (IV): The pace of the decline will depend on the implied volatility of the stock and any potential catalysts on the horizon (e.g., investor presentation, earning report release).

Answer 215

The option premium would be greater since there's more time for the price of the underlying asset to increase, and more volatility means a greater likelihood of price movement in either direction.

Answer 216

Time decay, which is denoted by the option Greek theta, is the measurement of the rate of decline in the value of an option from the passage of time as the expiration date nears. As the expiration date comes closer, the effect of time decay on the option's value accelerates as there's less time for the underlying asset to change in value. However, the rate of this value erosion will be slower, and the option will retain more of its value if it's currently in-the-money (ITM).

Answer 217

A long-term contract will have a theta close to zero because it doesn't lose value each passing day, and the expiration date is far away. Theta would be significantly higher for short-term options nearing expiration, especially if it's out-of-the-money. Short-term options will lose value each day, as they have more premium to lose relative to a long-term option.

Answer 218

Delta: A measure of the expected change in an option’s price resulting from a $1.00 change in the price of the underlying asset (security or index) – used by many traders to determine the likelihood of an option being in-the-money on the expiration date. Gamma: A measure of the rate of change in the delta of an option per $1.00 change in the price of the underlying asset – gamma is a proxy for the stability of delta.

Answer 219

The main difference is exercise flexibility: American options can be exercised any time before expiration, while European options can only be exercised at expiration, making American options generally more valuable Exercise Timing: American options can be exercised at any time before and including the expiration date. European options can only be exercised on the expiration date itself. Value and Premiums: American options are typically more valuable and have higher premiums due to their flexibility. European options are less flexible and generally trade at lower premiums. Underlying Assets: Most stock and ETF options are American-style, while many index options are European-style. Trading Venue: American options are usually traded on exchanges; European options are often traded over-the-counter (OTC). Practical Note: Despite the flexibility, American options are rarely exercised early in practice; most traders sell the contract if it becomes profitable before expiration

Answer 220

The bid-ask spread is the difference between the highest price that a buyer will pay for a particular asset and the lowest price that a seller will sell it. The more illiquid an asset is, the greater the bid-ask spread will be.

Answer 221

A eurobond is a type of bond that's denominated in a currency different from the currency of the country in which the bond is being issued and sold. When spelled with a non-capitalized “e, ”the term “euro” refers to external rather than Europe.

Answer 222

A black swan event is an unexpected, very improbable event that statistically rarely occurs, but when it does – it brings havoc and severe consequences. These events cannot be predicted and often cause catastrophic damage to the global financial markets and economy.

Capital Markets Questions Flashcards

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