Lecture 1

Question 1

What are the core functions of financial system in the economy?

Answer 1

• capital savers: allocation, provision of liquidity
• firms/ entrepreneurs: obtain liquidity
• treasury: (government) provider of save assets
• central bank: stability
• shadow bunks: hedge funds, investment banks,

Question 2

How do you price assets?

Answer 2

• look at its realized returns: e.g. equity contracts, standardized contracts
• what is the price of risk?
  -> being able to find over- or underpriced assets is very profitable

Question 3

How would you evaluate the argument: “ Equity markets are safe in the long-run” rigorously.
Give some intuition and cite some research findings that evaluate it.

Answer 3

• benchmark: e.g a US treasury bond as a safe benchmark
  -> depends on when you would have started your investment, the outcome might have been a lot better or worse than the benchmark
• we see a very high equity premium over the last 30 years
• consumption is quite stable over time
• Anarkulova et al (2022): look at the distribution of cumulative real returns from investing 1$ over different horizons -> similar expected wealth for US and devloped countries, US market seems to generate less negative returns

Question 4

How do returns develop after a crash?
Give some intuition and research.

Answer 4

• returns after a crash are pretty high
• from 1950 to 2020, the S&P had a real compounded return of 7%
• the 12 months following crashes averaged returns of 14%
• Goetzmann & Kim (2018): drastically low returns in previous year has a high probability to bounce back with positive returns in the following year

Question 5

How large is the average equity premium?

Answer 5

7%

Question 6

Are equity markets safe in the long run?

Answer 6

No.

Question 7

What consequences/ implications does the equity premium have?

Answer 7

• implied risk-return relationship should hold for other assets if markets are integrated (otherwise we have arbitrage)
• price of loan, options and derivatives, transaction feed, projected returns on investment for firms’s investment

Question 8

Define macrofinance.

Answer 8

• study of the relationship between assets prices and (macro) economic conditions
• fields that emerged after the global financial crisis
• identify the “bad times” (high marginal utility of money)

Question 9

How does the investors’ willingness to bear risk depend on economic conditions?

Answer 9

• higher willingness to bear risk in good times: stocks become more attractive, higher prices and lower future returns

Question 10

What is the equation for the dividend discount model for stock price evaluation?

Answer 10

p = d/r = sum (d/(1+r)^t)

Goal: get the right multiple to appraise the value of a firm

Question 11

Explain how evaluation based on multiples works?

Answer 11

Multiple = Numerator (what you are paying for the asset) / Denominator (what you are getting in return)

Question 12

What is the Gordon Growth formula?

Answer 12

With constant growth rate:
p = sum ( (1+g)/ (1+r)) ^t d = d/(r - g)

Limit: notion of risk

Question 13

Explain Mean-Variance Portfolio Optimization (1958)

Answer 13

• optimal portfolio weights on N risky assets and on the risk-free asset by solving a maximization problem
• take trade-off a between mean and variance as given
• theory of demand, do not say anything about asset prices

Learning: Diversify!
Shortcoming: does not work in real life becauase portfolio weights are off

Question 14

Explain the Capital Asset Pricing Model (1965).

Answer 14

• E (r_t) = r_f + cov (r_i,r_M) / sigma^2_M x ( E (r_M) - r_f) = r_f + ß_i E( (r_M) - r_f)
• if not correct, then not at equilivirum, arbitrage opportunity
• p_i adjusts until demand = supply
• r = d/p
• riskiness of an asset should be measured in terms of covariance with aggregate returns
• implies that the excess returns should be zero, that is, we should reject the hypothesis that a ≠ 0 with the following regressions:
• r_i - r_f = a + ß_i (r_M - rf) + e