Flashcards in Section A and B Deck (116):
What option is there to employees of labor-intensive companies and what does that imply?
One of the only options is for employees to avoid purchasing shares of their own employer, or even companies from their own industry. As a result, securities offered by labor intensive firms will have a lower demand, and therefore may appear to have a positive α according to the traditional CAPM
What are the 2 options for an investor with a small portfolio, according to EMH?
1) Invest in a mutual fund
2) Passive investment
What does EMH states about fundamental analysis?
According to EMH, fundamental analysis will usually not work. The exception is that it may be successful for investors who have a unique insight.
Briefly describe the Equity carve-outs example ((Law of One Price violation)
In 1999, 3Com span off its Palm division. Each 3Com shareholder was to receive 1.5 shares of Palm. In the period between the initial trading of the Palm shares, and the spinoff, 3Com shares should have been trading for at least 1.5 times the value of Palm. Instead Palm traded for more than 3Com! Arbitrageurs could not exploit the mispricing by buying 3Com and selling Palm short, because no Palm shares were available: they had already all been short sold.
Describe Indexing challenges and its solutions
This involves creating a portfolio that resembles the composition of a market index. There are several problems associated with forming this portfolio:
- The index could consist of thousands of securities
- The composition of the bond index changes more often than that of the stock index
Due to the difficulties, stratified sampling is utilized. This involves stratifying the bond market into several classes
List expected characteristics of the SML
Need the slope to be constant, which implies a constant β.
Intercept of should be 0.
List the 3 Market Structure assumptions of the CAPM
All assets are publicly traded, and short positions are allowed: investors can borrow/lend at a common risk free rate. Assumption that assets are tradable is necessary for investors to be able to derive identical input lists.
All information is publicly available
No taxes: if investors had different tax rates, they would earn different after tax rates on the same stock, and could therefore derive different after tax optimal risky portfolios.
No transaction costs
Explain 2 ways a sinking fund may operate
- The firm may repurchase a portion of the outstanding bonds in the open market annually
- The firm may purchase a fraction of the bonds at a special call price that is associated with the sinking fund provision
What will the owner of privately held business with similar characteristic to traded assets can do to achieve diversification?
Owners can still achieve diversification by reducing their portfolio holdings of similar traded assets, so they will still essentially hold the market portfolio.
Define preferred stocks and its difference with bonds
Promise to pay a specified stream of dividends. The difference is that if the preferred stock issuer is unable to pay the dividend, it does not enter corporate bankruptcy, but rather the dividends owed cumulate. Common stockholders are not eligible to receive any dividends until the preferred stockholders have been paid.
List the 3 Individual Behavior assumptions of the CAPM
Investors are rational mean-variance optimizers: investors are only concerned about mean and variance, and are not concerned about the correlation of the asset returns with inflation/prices of consumption items
Their planning horizon is a single period: longer periods would result in extra-market risk factors.
Investors use identical input lists
Briefly describe an alternative strategy to reduce the duration of the total economic value without alarming regulators. (+ advantage and disadvantage)
An alternative strategy is to adopt a pricing strategy that reduces the sensitivity of the franchise value to interest rates. One such strategy is to alter the values of a and b
- Avoids rating agency and regulatory risk that are associated with managing the duration of the invested assets
- The desired combination of target return on surplus and target duration can be maintained only for small interest rate changes
Define the mutual fund theorem
he mutual fund theorem states that if all investors would hold a common risky portfolio, they would not object if all the stocks in the market were replaced with shares of a single mutual fund holding the market portfolio.
List the 3 passive bond management strategies
- Cash flow matching
Contrast a sinking fund call and a conventional bond call
- The firm can only repurchase a limited fraction of the bonds at the sinking fund call price
- The call price of callable bonds usually exceeds par value, whereas the sinking fund call price is usually set at the par value
Contrast Asset allocation and Security selection
Asset allocation: allocation of a complete portfolio to the various asset categories
Security selection: Within each category of assets, investors can select specific securities in order to try increase return
List and describe the two types of portfolio risk
1) Market / Systematic / Nondiversifiable : Risk that cannot be diversified away
2) Unique / Firm-Specific / Nonsystematic / Diversifiable: Portion of risk that can be eliminated via diversification
List and briefly describe examples of bond indenture
- Sinking Funds: issuer may establish a sinking fund to spread the burden of the principal repayment, over several years
-Subordination of Further Debt: prevent the firm from borrowing a huge amount of money, thus increasing the risk of financial difficulty.
Dividend Restrictions: this would force the firm to retain assets rather than pay them out to the stockholders.
Collateral: Some bonds may be supported by collateral.
Define risk sharing and 2 problems with this
Risk sharing: Taking a fixed amount of risk, and sharing it among several investors.
Sharpe ratio will increase, total risk will decrease.
There are some problems with this approach though:
- There are some disadvantages of managing a very large firm. These disadvantages will put pressure on the profit margins.
- The impact of any error when estimating the risk of the insured will be compounded over many policies
List and describe 2 types of swap
- Foreign exchange swap: exchange currencies on specific future dates
- Interest rate swap: exchange of cash flows at future dates based on the difference between fixed and floating rates at those dates
How can investment on additional period reduce risk?
We can think of extending an investment horizon for an additional period to be the same as adding an additional risky asset to a pool.
Invest half the budget in the risky asset and half of the budget in risk-free asset for both periods
Define certainty equivalent
Rate that a risk free investment would need to offer to provide the same level of utility as the investment being analyzed.
Explain use of an active strategy even in a efficient market
If all investors would use passive strategy, no effects are put to exploit arbitrage opportunities. Therefore, even if there are inefficiencies in the markets, there are no pressures to correct them. Eventually, the market will become inefficient.
What is an indifference curve?
Curves that contain different portfolios that the investor is indifferent about (same utility levels)
List 3 reasons why short positions may be limited
There is no cap on the liability of short positions: a large short position will require significant collateral
There is a limited supply of stocks that can be borrowed by short sellers
Many investment companies are prohibited from short sales.
List relationships between bonds and yields (6)
- Bond prices & yield are inversely related
- An increase in the yield produces a smaller price change than the same size decrease in yield
- As the term of the bond increases, the price becomes more sensitive to yield changes
- The sensitivity of bond prices to yield increases at a decreasing rate as the maturity increases
- Lower coupon bonds are more sensitive to changes in yields
- The sensitivity of bond prices to yield are inversely related to the yield
Give 2 explanations for test results that prove market inefficiency (market anomalies)
The properties are proxies for fundamental determinants of risk
The properties arise just due to data mining. One supporting factor for this argument is that many of these anomalies disappear after discovered. One way to test for this is to see if the relationship holds in a different database.
List the 3 assumptions of the Arbitrage Pricing Theory
1) Security returns can be described by a factor model
2) There are a sufficient number of securities to diversify away idiosyncratic (specific) risk
3) Well-functioning securities markets do not allow for the persistence of arbitrage opportunities
Define a hedge asset
A hedge asset is defined as one that has a negative correlation with other assets in the portfolio.
Define floating rate bonds
Provide interest payments that are based on the current market rates. There is therefore less interest rate risk: as interest rates rise, the increase in interest offsets the higher discounting rate. (Still a limited range of possible yields)
Opposite is an inverse-floater.
Why do the slope of the CAL may be kinked to the left?
CAL needs to be adjusted to reflect the fact that in reality, normal investors cannot borrow at the risk free rate. If this is the case, the CAL will be kinked at P. (CAL with borrowing rate)
Briefly describe the advantage and disadvantage of the optimisation procedure under Single index model to build the risky portfolio (vs passive strategy)
The advantage of using the procedure is that by using security analysis, we can hopefully identify assets with non zero alphas, and over/underweight these relative to the market in order to increase returns.
The disadvantage of this is that it will introduce firm specific risk.
Contrast the risk return dominance argument to the arbitrage argument
RRD: Many investors will make limited changes to their portfolios, depending on their degree of risk aversion.
A: The investor who discovers the arbitrage opportunity will want to maximize his position in order to maximize profits
Identify 2 challenges with event study and ways to counter
1)The stock price may respond to a wide range of economic news in addition to the specific event
-Abnormal return (Actual over benchmark)
2)Information about the event may be leaked prior to the actual event. (Price may start to move earlier)
-Cumulative abnormal return : Look for large delta on date of announcement and no drift after
GIve 3 reasons why many economists disagree with behvioural finance
- The behavioral approach is too unstructured: it allows virtually any anomaly to be explained by a combination of irrationalities.
- Some anomalies are inconsistent in their support for one irrationality vs another.
- Selecting the wrong benchmark can produce an apparent abnormality.
Explain how the term structure may be interpreted and one problem with this approach
-If the curve has a steep positive rise, it is still likely that the market expects an expansion in economic activity
- If the curve is sloping downward, it is likely that interest rates are expected to decline
One problem with this approach is that in addition to expectations, the term structure may be impacted by other factors, like the liquidity premium.
Describe 3 sentiment indicators according to behavioural finance model
Trin Statistic: Market advances are considered to be stronger when they are accompanied by stronger trading volumes. Trin = (Volume declining / Number declining) / (Volume advancing / Number advancing) Ratios over 1 are bearish
- Confidence Index: This is based on data from the bond market, under the assumption that the actions of bond traders reveal trends that will later follow in the stock market.
- Put/Call Ratio: this equals the ratio of outstanding put options to outstanding call options. Since put options profit from falling markets, an increase in the ratio is a bearish sign.
Describe 5 issues that explain the difficulty to assess market efficiency
1.Magnitude Issue: Assume a portfolio did 0.1% better than last year. It is very small compared to the normal volatility of the market. It is therefore hard to assess how much the manager actually contributed
2.Selection Bias Issue: once an investment scheme becomes known by others, it will no longer generate abnormal returns. It is possible that techniques that do actually work exist, but are not being reported.
3.Lucky Event Issue: There are several cases of investors who have made huge investment returns over a period. However, this does not disprove EMH, because the number of investors is so large, just by chance, some have to make huge returns.
4.More risk was taken to achieve higher returns
5.Wide variance in returns, so difficult to say if difference due to randomness or not
What are 2 elements making duration not constant
- It will change as the rates change
- It will fall as time passes
What conclusion can be drawn from portfolio with ρ=1 and ρ=-1?
If ρ =1, then 100% of funds will be in the asset with the lowest σ
If ρ = -1, σ will be 0 as there is a portfolio that has no risk
Describe fundamental analysis and types of fundamentals (3)
This type of analysis uses the fundamentals of a firm to determine the appropriate price. Fundamentals examined include:
Earnings & dividends prospects
Future interest rate expectations
Contrast Foreign bonds and Eurobonds
- Foreign bonds: issued by a borrower from a country other than the one where the bond is sold. It is denominated in the currency of the country in which it is marketed
Eurobonds: denominated in currency of the issuer, but sold in other markets
What is the problem with Fama French 3 factor model?
None of the factors can be identified as hedging a specific significant source of uncertainty
Describle the 3 versions of the EMH
Weak form: Stock prices reflect all information that can be derived from examining market data. Technical only.
Semistrong form: stock prices reflect all publicly available information about the firm’s prospects. Technical and fundamental.
Strong form: stock prices reflect all information relevant to the firm, including that not publicly available (insider information). Technical, fundamental and non public info.
Describe an event study
Determine the importance of an event by measuring the resulting price changes
1)The stock price may respond to a wide range of economic news in addition to the specific event (Identification)
2)Information about the event may be leaked prior to the actual event. (Timing)
Briefly described the logic behind a consumption based CAPM
This is based on the assumption that in a period, investors need to allocate the current wealth between consumption today; and savings/investment to support future consumption.
Investors will value the additional income from the savings more during tough economic times. Therefore assets that have a positive covariance with consumption growth are viewed as being riskier. The equilibrium risk premium for these assets will be higher.
Describe the liquidity preference theory
Bond investors would ideally select a bond which matures around the time that they need the money. The investor is subject to risk otherwise.
As longer bonds is subject to more risk, they offer a higher rate or return, which is known as the liquidity premium. F = E(R) + liquidity premium
Define the optimal risky portfolio
The available portfolio that has the highest Sharpe ratio, which happens where the CAL is tangential to the portfolio opportunity set. (Highest indifference curves that touches the CAL)
Describe credit default swap and the difference with standard insurance
It is an effectively insurance policy that is written on particular credit events.
A difference from standard insurance is that the swap holder does not necessarily have to hold the bonds that underlie the CDS contract. As a result, the CDS can be used to speculate on the changes in the credit standing of the reference firms.
What restrictive assumption does the Zero-Beta CAPM answers?
No restriction on borrowing at risk-free rate
Describe Cash Flow matching and dedication
Buy a 0-coupon which will make a payment that exactly matches the future cash obligation.
Dedication is cash flow matching over multiple periods
What is the tax treatment of bonds?
The difference between the price in 1 yr with actual interest rate and with the new interest rate would be treated as capital gains income and taxed at the capital gains tax rate in addition to the imputed interest (if sold). If the bond was not sold, that difference would instead be treated as unrealized gains. (not taxed)
List 2 possible reasons to reject hypothesis that alpha value is 0 (Single Index Model)
The magnitude of α would need to be large enough for it to be deemed economically significant
α would also need to be statistically significant. To reject this, we would require an absolute value of t greater than 2
Briefly describe 4 bond swaps (PF re-balancing strategies)
1. Substitution swap: exchange bond with a similar one that is mispriced
2. Intermarket spread swap: if yield spread between 2 sectors is temporarily out of line
3. Rate anticipation swap: move to longer duration bonds if you forecast that rates will decrease
4. Pure yield pickup swap: increase returns by moving to a higher yield bond.
Describe the concept of refunding within bond investments
Issuers of callable bonds will typically repurchase the bonds if the interest rates fall, as they can replace them with new bonds that have a lower coupons.
Define minimum-variance frontier, global minimum-variance portfolio and efficient frontier
The minimum-variance frontier is made up of the portfolios that have the lowest variance for each level of expected return.
The global minimum-variance portfolio is the single portfolio with the lowest variance.
The portion of the frontier above the minimum-variance portfolio is called the efficient frontier.
What is a disadvantage of the single index model?
The disadvantage of this approach is that it oversimplifies the true uncertainty (simplifies correlation)
Ignore industry event (factors that impact many firm in the industry without materially impacting the overall economy)
Ignore correlation between security return
What are the two offsetting risk when interest rate change?
1. Bond prices will fall (Price risk) (interest rate increases)
2. Reinvested coupon income would grow (reinvestment risk)
List 2 implications of the CAPM model
The market portfolio is efficient
The premium on a risky asset is proportional to its beta
Describe the weak form tests of the EMH
- Returns over short horizons: Looks at whether investors can use historic trends to earn abnormal profits over the short term, by measuring the serial correlation of stock market returns. If efficient, no correlation between periods.
- Returns over long horizons: similar to prior test, but looks at the long term returns.
Empirical results have shown a negative correlation over the long term: this may be explained by the fads hypothesis. (Market overreact when a relevant news is announced, and needs to readjust afterwards.)
What does the Treynor-Black model adds to the APT model?
If residual risk does exist (not perfectly diversified), the T-B model produces an optimal risky portfolio with a specific investment in the portfolio, which reflects the risk. APT however will ignore the level of residual risk. Therefore, the T-B has more flexibility than APT in reflecting the residual risk that may exist.
Describe forward rates in term of short rates
The future expected short rates are referred to as “forward rates”.
Explain the problem (2) with the assumption of a constant liquidity premium
1. It is very difficult to accurately estimate the liquidity premium
2. There is no reason to believe that the liquidity premium is constant
Describe a collaterized debt obligation (CDO)
A collateralized debt obligation (CDO) is a tool that can reallocate credit risk. They pooled together portfolios of bonds/loans, and then split into different tranches. Each tranche can be sold as a stand-alone security. Lower seniority tranches would suffer the default losses before the higher seniority. Due to the different priorities, each tranche would have a different exposure to credit risk.
According to behavioural finance, what are the limitations to actions of arbitrage
Fundamental Risk: Actions are actually not risk free, because the mispricings are not necessarily going to disappear. In fact, they can get worse.
- Implementation Costs: Arbitrageurs usually need to rely on short selling in order to exploit overpricing. However, there are often limitations to short selling:
- Model Risk: it is possible that the prices are indeed valid. Instead, there may be issues with the arbitrageur’s model that are causing it to falsely indicate a mispricing.
Give 2 disadvantages of the consumption based CAPM
Disadvantages that the consumption growth figures are published infrequently, and are measured with significant error
Describe briefly the 3 types of risk appetite
1. Risk averse: Investors prefer lower risk (A > 0)
2. Risk neutral: Investors ignore risk and base decisions only on expected return (A = 0)
3. Risk lover: Investors prefer investments with a higher level of risk, and will in fact be willing to accept a lower return to gain a higher level of risk (A < 0)
Give 2 sources of potential value in active management
1. Interest rate forecasting
2. Identification of relative mispricing
List 2 interpretations of the SML
Farther are the stocks from the line, more firm-specific risk they have.
β represents the systematic risk, and return only rewards systematic risk. Thus, higher β implies higher returns.
What is of the problems with asset liability analysis of most firms?
It does not account for the franchise value of the firm: the franchise value represents the economic value of the profits that will be earned in the future years from the future renewals of the current policies.
What does the selection principle dictates about steps in portfolio selection
1. Selection of the optimal risky portfolio
2. Allocation between risk free vs risky assets: depends on level of risk aversion
Give an advantage and a disadvantage of the Arbitrage Pricing Theory
A: Does not require an all-inclusive PF (Unobservable true market PF) and no mea-variance optimizers investors (vs CAPM)
D: Based on the existence of well-diversified PF, but even large portfolios have non-negligible residual risk. If residual risk is small, the APT SML should still approximate the risk premium.
What is the Capital Allocation Line (CAL)
Shows on a graph the risk and return levels of the various investment options available to the investor, based on the distribution of the complete portfolio.
List 2 ways to test a model
Normative: tests model assumptions
Positive: examines the predictions
Define risk pooling and the problem with this
Risk pooling involves merging several uncorrelated projects together.
Risk/unit will decrease, Sharpe ratio will increase, total risk will increase
As the investor increases the risk pooling to include n assets, both the Sharpe ratio and Stdev will increase by n0.5. Therefore, it can be seen that risk pooling does not reduce the level of risk.
List 2 problems with Markowitz procedure fixed by Index Models
1) As the number of securities increases, the number of variables that need to be calculated/estimated increase dramatically
2) Due to the large number of required estimates, it is likely that some variables are estimated incorrectly. In this case, the model may produce nonsensical results
Explain the impact on CAPM formula from zero-beta borrowing restrictions modification
Investors who face borrowing restrictions will invest more heavily in high beta stocks, and less in low beta. The price of high beta stocks will therefore increase. Replace risk--free rate with return on zero-beta portfolio, which is higher, reducing risk premium.
What is the particularity of the convexity of a callable bond?
When the yield falls enough, the value of the bond is compressed to the call price. The shape of the curve at this region is said to have negative convexity.
This negative convexity is unfavorable to investors, as an increase in interest rates produces a larger price decline than the price increase produced by an equivalent decrease in interest rates
Describe a credit default swap
A credit default swap (CDS) is essentially an insurance policy on the default risk of a bond/loan.
This will artificially increase bond rating.
What will tbe the impact of privately held business with different characteristic to traded assets on the market?
owners would demand a portfolio of traded assets that hedge the risk of a typical private business. The price of these hedge assets will be bid up, reducing the expected return, which will cause them to appear to have a negative α according to the traditional CAPM.
Give 2 examples of non-traded assets
Privately held businesses
Describe the clientele effect and its implication on security price, according to CAPM with liquidity adjustment
Clientele effect: frequent traders tend to hold more liquid assets, and long term traders tend to hold less liquid assets.
The security price should be discounted to reflect any illiquidity. However, this increase in discount will not be proportional to the increase in the trading costs, due to the clientele effect.
Briefly describe 5 types of behavioural biases
1.Framing: Decisions are often materially impacted by how the question is framed
2. Mental Accounting: investors may segregate decisions, into pieces which go towards different goals, and they will have different risk attitudes to each piece.
3. Regret Avoidance: investors who make decisions that turn out badly have more regret if it were an unconventional decision
4. Affect: the “affect” is the good or bad feeling that investors may associate with investing in a stock.
5. Prospect Theory: This modifies the standard financial theory’s definition or risk averse investors, making utility depend on change in wealth instead of overall wealth.
Define the tracking portfolio
Tracking portfolio: will match the systematic component of the portfolio’s return. Need to have the same β as the security. Will achieve this by having a levered position in the S&P500
Describe a type of bond that does not require a sinking fund
Serial bond issue, in which the firm issues bonds with staggered maturity date. A sinking fund is not as necessary here because the repayment burden is spread.
The main disadvantage is that the bonds with different maturities are not interchangeable, thus reducing the liquidity of the issue
Describe the 2 components franchise value practical dilemma
1. The greater the franchise value of the firm, the more difficult it is to manage the interest rate risk
2. The firm could reduce the duration of invested assets to try offset the positive contribution of franchise value to the duration. However, this strategy may puzzle regulatory authorities/rating agencies, as they only see the accounting numbers, and therefore do not account for the franchise value when analyzing the actions of the firm. So they may think this strategy is increasing risk instead of decreasing it.
What is the advantage of the multi-factor model over the single factor model?
Varying sensitivities of securities to the different factors can be incorporated
What may make the optimal risky portfolio vary between investors?
The optimal risky portfolio may vary between clients b/c of their unique portfolio constrains. The efficient frontier subject to these constraints will generate a Sharpe ratio that is inferior to that from a less constrained one.
Describe the expectation hypothesis theory
The forward rate equals the expected future short rate. Therefore an upward sloping yield curve is a signal that investors expect rate increase. F = E(R)
Why is credit risk not as high for a swap than a loan
With a loan, one party provides the principal to the other. Therefore, if the borrower defaults, the lender will lose the entire unpaid balance.
On the other hand, with a swap, the money owed from party A to party B is partially offset by the money owed from party B to party A. Because of these offsetting balances, the credit loss would be less than the notional principal.
List duration properties (5)
- The duration of a 0-coupon bond equals its time to maturity
- Duration decreases as the coupon rate increases
- Duration generally increases as the maturity increases
- Duration increases as the yield to maturity reduces
- The duration of a perpetuity = (1+y)/y
Give examples of market anomalies that invalidates the semi-strong form of the EMH
Small-Firm-in-January Effect: Small firms have historically generated superior returns, particularly in January.
Neglected Firm Effect: Some firms are neglected by large investors, and so less information is available. A premium is required to compensate for the risk associated with less information. Note that this may explain the superior returns of small firms discussed above.
Book-to-Market Ratios: High Book-to-Market firms have historically outperformed the rest of the market.
Post-Earnings-Announcement Price Drift: the cumulative abnormal return of stocks has been shown to continue to increase even after the information about the event becomes public
P/E Effect: firms with lower P/E ratio earns higher risk-adjusted returns than firms with higher P/E ratios.
Describe a put bond
Similar to a callable bond, but gives the option to “retire” the bond to the bondholder.
Define liquidity risk and a possible adjustment to CAPM
Liquidity risk: risk of unanticipated changes in liquidity.
Investors are going to demand additional return if there is a possibility that the stock will lose liquidity at a time when it is needed. The CAPM can be adjusted to include a liquidity beta: this reflects the sensitivity of the return of the security to changes in market liquidity
Define conversion ratio, market conversion value and conversion premium within convertible bonds
Conversion ratio: Number of shares that each bond can be exchanged for
- Market conversion value: current value of shares for which the bond can be exchanged
- Conversion premium: Excess of bond value over its conversion value
Briefly describe the Closed-End funds example ((Law of One Price violation)
Many close-end funds trade for a discount or premium to their net asset value. The authors mention that this however is not a true violation, as there are a few reasons why the 2 values can diverge. For example, the fund incurs expenses which will reduce the share price.
Describe consequences of linearity assumption in duration effect in price change
The actual graph of bond prices is convex. As a result, the approximation always understate the bond value:
- It understates the increase when yields fall
- It overstates the losses when yields rise
Briefly describe the 4 types of information processing errors by investors
1. Forecasting Errors: consists of 2 parts:
a. Too much weight is assigned to recent experience
b. Forecasts are too extreme given the actual level of uncertainty
2. Overconfidence: Many investors overestimate their abilities
3. Conservatism: Investors are too slow to update their beliefs in response to new evidence
4. Sample Size Neglect & Representativeness: Investors do not account for sample size, and therefore may infer a pattern based on too small a sample.
Describle advantages and disadvantages of cash flow matching (and dedication)
- Automatically immunizes the portfolio from changing interest rates
- Rebalancing will not be necessary
- Hard to implement because they impose strong constraints on the bonds that can be selected
Immunization is the process where an investor creates a portfolio with duration equal to the investment horizon
What does the elimination of all the correlation assumptions allows for with the Index Model?
The single index model allows for specialization of effort in security analysis.
Briefly describe the Siamese twin company example (Law of One Price violation)
In 1907, the Royal Dutch Petroleum and Shell Transport companies merged. They agreed to split the total profits on a 60/40 basis. With this structure, Royal Dutch shares should have sold for 150% the price of Shell’s. However, the price relativity did deviate from this 150% level for extended periods. Arbitrageurs who tried to profit from this may have lost money because there were periods of time where the deviations actually grew in size.
Name some uses of the duration
- Summary statistic of the effective average maturity
- Helps immunize portfolios from interest rate risk
- Measures interest rate sensitivity
Give 3 uses of a portfolio manager in an efficient market
1. Diversification: selects a diversification strategy to eliminate firm-specific risk
2. Reflects tax considerations of the individual investor
3. Adjusts portfolio to reflect the unique risk profile of the investor.
Briefly describe problems with immunization
a. It is based on a measure of duration that makes the assumption that the yield curve is flat
b. Immunizing the portfolio is only effective for parallel shifts in the yield curve
c. Immunization is inappropriate in an inflationary environment
What will be the composition of the minimum variance portfolio depending on the value of ρ?
As long as ρ < σD/σE, the minimum variance portfolio will consist of both bonds and stocks.
If ρ > σD/σE, the minimum variance portfolio will consist exclusively of bonds.
Give 3 reasons why technical analysis could work according to behavioural finance
Disposition effect: where investors hold on to losing investments, because they are reluctant to realize losses. This slows down the adjustment of the share price to the appropriate value.
- The technical analysts’ use of volume data: this arises due to the behavioral characteristic of overconfidence. Overconfident investors trade more, which produces a relationship between trading volume and market returns.
- Market fundamentals will be disturbed by irrational factors. It is possible for technical analysis to exploit the corrections.
Define horizon analysis
The realized compound return is forecasted over specific holding periods.
The realized compound return will differ from the Yield to Maturity in situations where the reinvestment rate differs from the Yield to Maturity
What is the Capital Market Line
The Capital Market Line is simply the CAL that uses a passive portfolio as the risky portfolio.
Describe 3 approaches to identify trends in behavioural finance model
- Moving Averages: The moving average of a stock price is the price over an interval. If prices have been falling, the moving average will exceed the current price. If the market breaks through the moving average line from below, this is a bullish signal, as it is a sign of a shift from a falling trend to a rising trend.
- Relative Strength: This measures how the stock has performed relative to the industry, or the market as a whole.
- Breadth: This measures how widely the movement in the market index is reflected in the price movements of all stocks. As the advances outnumber the declines by a wider margin, the market is viewed as being stronger.
How is treated imputed interest and explain the reason for it
Imputed Interest (difference between IFRS price at t and price at t-1) are treated as an implicit interest, for tax purposes. As a result, the bondholder has to pay tax each year, rather than waiting till the bond is sold or matures. The IRS is essentially accelerating the collection of the tax
Describe Technical Analysis and 2 types of metrics
Technical Analysis is the search for predictable patterns of stock prices, which can be used to derive a profit from trading.
1) Resistance levels: levels above prices should not rise
2) Support levels: levels below which prices should not fall
Not successful in efficient market (even weak)
Give examples of determinants of bond safety (5)
Coverage ratios = Ratio of company earnings to fixed costs. Low/falling ratios may signify possible cash flow difficulties.
Leverage ratio = ratio of debt to equity. If this is too high, the firm may be unable to satisfy its obligations.
Liquidity ratios: measures the insurer’s ability to pay bills with its most liquid assets. Current and Quick (excluding inventories) ratio
Profitability ratios: ROA, ROE
Cash flow to debt ratio = total cash flow / outstanding debt
List 2 advantages to passive approach
1) Significantly cheaper than an active strategy
2) Free rider benefit: b/c some investors are implementing the active strategy, mispricings should disappear. Therefore, most assets should be fairly priced at any given point in time.
Give a few examples of factor from the multi-factor model (4)
Gross Domestic Product (GDP)
Interest Rate Changes