Final test revision

Question 1

What is the indexing portfolio strategy and what are some benefits to it?

Answer 1

Entails investing in indices rather than individual stocks.
It is a cheap, diversified investment strategy.
Cost effective - low/no commissions
Simplified approach
Market benchmarking
Long-term growth

Question 2

What is an ETF and what are some potential benefits and disadvantages?

Answer 2

An ETF (Exchange-Traded Fund) is a type of investment fund that holds a basket of assets—like stocks, bonds, or commodities—and trades on a stock exchange just like individual stocks.

Advantages:
Diversification
Liquidity
Low Cost
Transparency
Tax Efficiency

Disadvantages:
ETF closures - investors forced to sell at inopportune time
Short-selling and redemption constraints
Securities lending
Flash events and systemic risk

Question 3

Provide the formulas for Treynor, Sharpe, Information and Sortino ratios

Answer 3

Treynor = (Rp - Rf) / Beta
Sharpe = (Rp - Rf) / Std. Dev.
Information = (Rp - Benchmark return) / Tracking Error
Sortino = (Rp - Rf) / Down. Std. dev.

Question 4

Calculate the price today and one year from now of the following bond:
FV = 2000, Coupon = 8% paid semi-annually, Maturity 2 years, annual int. rate = 4%

Answer 4

U get me fam

Question 5

Answer 5

Question 6

Accrued interest definition

Answer 6

The amount of interest that has been incurred as of a specific date on a loan or other financial obligation but has not yet been paid out.

Question 7

What is Macaulay’s duration?

Answer 7

On average, how long does is take to get your money back (in present value terms) from a bond?

Question 8

Calculate Macaulay’s duration:
FV = 2000
Coupon = 7% annually
Maturity = 3 years
Annual interest rate = 3%

Answer 8

Question 9

What is modified duration? Please also provide formula

Answer 9

D* = D/(1+y)
Change in price = -D* x Change in Y

Question 10

Please provide the change in price formula when incorporating convexity

Answer 10

Question 11

Answer 11

Question 12

What is a callable bond?

Answer 12

A bond which gives the issuer the right to redeem the bond before its maturity date at a predetermined call price.
This means the issuer can ‘call’ the bond back from the investors if it becomes financially beneficial for them

Question 13

Why can callable bonds have negative convexity?

Answer 13

Most bonds have positive convexity - when yields fall, prices rise at an increasing rate

Callable bonds likely don’t follow this behavior:

When interest rates fall, the issuer is more likely to call the bond (i.e., repay early and refinance at a lower rate).

So, the price of a callable bond doesn’t rise as much as a non-callable bond would when rates drop.

This creates negative convexity — the bond becomes less sensitive to further rate declines, or even loses value if rates fall too far (due to call risk).

Question 14

Callable bond:
Call price = $1050
Selling for = $980
Yield curve shifts up 0.5% -> price falls to $930
Yield curve shifts down by 0.5%, the bond price will rise to $1010

What is effective duration?

Answer 14

Change r = Inc. - dec.
Change r = 0.5% - (-0.5%) = 0.01

Change P = 930- 1010 = -$80

Effective Duration = (-80/980)/0.01 = 8.16 years

Question 15

Why is the effect of interest changes less tangible with callable bonds?

Answer 15

This is because investors anticipate that the bond will be called should interest rates fall (coupons paid early). Thi makes the price of the bond less afected. This is shown by the lower effective duration and convexity.

Question 16

What is a derivative?

Answer 16

Derivatives are securities whose value is dependent upon (or is derived from) the value of one or more underlying asset, security or variable.

Question 17

What is put-call parity?

Answer 17

Put-call parity is a fundamental principle in options pricing that defines a specific relationship between the prices of European call options and put options with the same strike price and expiration date

Question 18

How can you create a synthetic risk-free security and what is the formula?

Answer 18

Question 19

What is the Black-Scholes formula?

Answer 19

Question 20

Answer 20

Question 21

Distinguish between and draw a long and short straddle

Answer 21

U know the answer. Be precise.

Question 22

Distinguish between and draw a long and short strangle

Answer 22

U know the answer. Be precise.

Question 23

How do you construct a long butterfly and what does it look like?

Answer 23

Question 24

Explain the benefits and dangers of selling a straddle/strangle

Answer 24

If the price remains the same, the seller gets to keep the premium received upon sale. However, should the price increase or decrease, the buyer will exercise the right to buy or sell at the strike price, making potential losses unlimited.

Question 25

Gamestop S0 = $201.3 Expiry in 2 years. Call + Put both have X = $185 Call = $112.17 Put = $87.55 A) Find the Annual risk-free rate B) Rf = 3%, but put premium is unknown

Answer 25

Construct synthetic t-bill: Share + Put Premium - Call premium = (Ex price)/(1+rf)^n B) You know that to do

Question 26

Provide the formulas for: Loss Given Default (LGD) Prob. of default (PD) Expected Loss (EL)

Answer 26

LGD = Loss severity x Expected Exposure Loss severity = 1- recovery rate PD = PS(t-1) = Hazard rate EL = LGD X PD

Question 27

An Empirical Analysis of the Effects of the Dodd–Frank Act on Determinants of Credit Ratings Please list Authors, year and provide an overview and the implications for regulators, Investors and firms

Answer 27

Ahmed, Wang and Xu (2023) Outline: Effects of D-F act on determinants of credit ratings. They predict that D-F will cause CRAs to increase reliance on verifiable quantitative fundamental information in determining ratings. They find that greater reliance on quant. firm fund partially drives the improvement in CR's ability to predict future results Overall, improves credit rating quality Implications: Regulators - Evidence that regulatory interventions like the D-F act can effectively enhance the quality of financial intermediaries' outputs by encouraging more disciplined and transparent practices Investors - Improved CR accuracy enhances investors' ability to assess credit risk, leading to more informed inv. decisions Firms - May need to focus more on maintaining strong, transparent financial reporting

Question 28

Does it matter who pays for bond ratings? Please list Authors, year and provide an overview and the key findings

Answer 28

Jiang, Stanford and Xie (2012) Overview: Study investigates whether the entity paying for bond ratings (issuers or investors) affects the ratings assigned by CRAs. Examines the impact of S&P transition from an investor-pay to issuer-pay model in 1974, using Moody's ratings as a benchmark since Moody's had adopted the issuer-pay model earlier. Key findings: Higher ratings under issuer-pay model Influence or conflict of interest

Question 29

Rating shopping or catering?

Answer 29

Griffin et al (2013) Overview: Investigates whether the inflated credit ratings or CDOs prior to 2007-2009 financial crisis were primarily due to rating shopping - where issuers seek the most favorable ratings - or rating catering, where CRAs adjust their ratings to match comp. more lenient standards. Key findings: Higher default rates for dual-rated CDOs >Suggests that competitive dynamics may have compromised rating quality Evidedence of rating catering >Research provides evidence that CRAs made upward adjustments to their ratings beyond model outputs when competitors had more favorable assumptions

Question 30

Regulating Rating Agencies: A conservative behavioral change

Answer 30

Jones et al. (2012) Overview: Studies the impact of European regulatory reforms on behavior of CRAs - whether those reforms improved the quality 1. Shift to conservative ratings >Authors find evidence of behavioral shift toward more conservative rating practices following the introduction of EU regulatory reforms. 2. Reduction in rating inflation 3. More frequent unwarranted downgrades Implications: - For regulators: EU regulation appears effective in curbing rating inflation, but may have led to over-correction through excessive conservatism and false alarms.