FINC314 Final exam
12. What is the rationale behind a short seller taking his or her case public?
12. What is the rationale behind a short seller taking his or her case public?
The seemingly-speculative episode which culminated in the stock market crash of 1929 has often been pointed at as a clear example of a pricing bubble. What exactly is a speculative bubble? Are speculative bubbles indicative of market efficiency or inefficiency?
A speculative bubble requires high-volume trading at prices which significantly deviate from fundamental values. Speculative bubbles are indicative of market inefficiency as prices, by definition, have to deviate heavily from fundamental values. This is not representative of prices appropriately reflecting all available information and, therefore, being accurate.
For Questions 5-7, assume the following probability distribution for the holding-period return for KMP stock: -State of Economy Boom Normal growth Recession -Probability .30 .50 .20 -HPR 18% 12% -5% What is the expected holding-period return for KMP stock? A. 10.40% B. 9.32% C. 11.63% D. 11.54% E. 10.88%
A. 10.40% (add up all multiples of each other)
What is the expected variance for KMP stock? A. 66.04% B. 69.96% C. 77.04% D. 63.72% E. 78.45%
A. 66.04% (174.2-10.4^2)
Consider the multifactor APT with two factors. Stock A has an expected return of 17.6%, a beta of 1.45 on factor 1 and a beta of .86 on factor 2. The risk premium on the factor 1 portfolio is 3.2%. The risk-free rate of return is 5%. What is the risk-premium on factor 2 if no arbitrage opportunities exit? A. 9.26% B. 3% C. 4% D. 7.75% E. 9.75%
A. 9.26% (17.6%=(1.45*3.2%)+0.86x+5%)
Which of the following is a customizable contractual agreement between a buyer and a seller at time 0 to exchange a pre-specified asset (or group of assets) for a set amount of cash at some later date? A. Forward Contract B. Futures Contract C. Option Contracts D. A and B E. None of the above
A. Forward Contract
Which of the following is NOT an assumption of the CAPM? A. Investors are price makers. B. Market efficiency. C. Investors may borrow and lend at the risk-free rate. D. All investors are ration mean-variance optimizers. E. None of the above.
A. Investors are price makers.
With a long straddle, an investor makes money as long as which of the following occurs? A. The underlying asset price changes significantly B. The underlying asset price does not move C. The options expire unexercised D. B and C E. None of the above
A. The underlying asset price changes significantly
The exploitation of security mispricing in such a way that risk-free economic profits may be earned is called ___________. A. arbitrage B. capital asset pricing C. factoring D. fundamental analysis E. technical analysis
A. arbitrage
Ceteris paribus, a decrease in the demand for loanable funds A. drives the interest rate down. B. drives the interest rate up. C. might not have any effect on interest rates. D. results from an increase in business prospects and a decrease in the level of savings. E. results from an increase in business prospects and an increase in the level of savings.
A. drives the interest rate down.
The risk that can be diversified away is A. firm-specific risk. B. beta. C. systematic risk. D. market risk. E. nondiversifiable risk.
A. firm-specific risk.
The Capital Allocation Line can be described as the A. investment opportunity set formed with a risky asset and a risk-free asset. B. investment opportunity set formed with two risky assets. C. line on which lie all portfolios that offer the same utility to a particular investor. D. line on which lie all portfolios with the same expected rate of return and different standard deviations. E. investment opportunity set formed with multiple risky assets.
A. investment opportunity set formed with a risky asset and a risk-free asset.
The CAPM assumes that investors are __________. A. risk averse B. risk neutral C. risk loving D. irrational E. None of the above.
A. risk averse
According to the Capital Asset Pricing Model (CAPM) a well diversified portfolio's rate of return is a function of A. systematic risk. B. unsystematic risk. C. unique risk. D. reinvestment risk. E. interest rate risk.
A. systematic risk.
The market risk, beta, of a security is equal to A. the covariance between the security's return and the market return divided by the variance of the market's returns. B. the covariance between the security and market returns divided by the standard deviation of the market's returns. C. the variance of the security's returns divided by the covariance between the security and market returns. D. the variance of the security's returns divided by the variance of the market's returns. E. the variance of the security's return divided by the standard deviation of the market's returns.
A. the covariance between the security's return and the market return divided by the variance of the market's returns.
The January and momentum anomalies are examples of ______________ efficiency. A. weak form B. semi-strong form C. strong form D. tests for inside information E. None of the above.
A. weak form
Define market microstructure. Give me a few examples as to its broader significance outside of the academic world.
According to Madhavan, market microstructure studies the processes by which investors' latent demands are ultimately translated into prices and volumes. A major point of the market microstructure literature is that asset prices do not need to equal full-information expectations of value because of a variety of frictions. As such, securities prices may be inaccurate. This matters to investors as forces outside of information may, in fact drive prices (at least to some extent). This matters to corporate managers as mispricing can impact decision-making as to when to issue or buy back stock, when to acquire other companies, or how to interpret changes in price (e.g., a downswing in price may cause management to "learn" and deviate from a previously announced course—but, if the downswing is unrelated to the information, this could be a root of value destruction). Regulators, of course, are concerned with ensuring fair and efficient markets—as such, understanding where imperfections and frictions lie is an important step towards allowing regulators to craft more effective rules and regulations.
Does ABC use a significant amount of debt?
Any of the leverage ratios. I choose to use debt to equity: 2008 = 0.58. 2009 = 0.40. It is hard to answer the question as to whether or not this is a significant amount of debt without a benchmark; however, suffice it to say that anything over 30% may fairly be considered significant.
Is the firm profitable? What do its earnings look like?
Any of the profitability ratios may be used.From a net profit margin standpoint: in 2008 = .03. 2009 = -0.425. ROA in 2008 = 0.043. In 2009 = -0.55. The firm is not profitable—clearly, its earnings are deteriorating.
Are the firm's prospects for the future good?
As far as we can tell, yes—the firm's prospects are at least decent. It is behaving conservatively, is quite liquid, and is still profitable (even during a bad macroeconomic environment). The firm is not overleveraged—as such, it is hard to imagine the firm ceasing to be a going concern—that is, at least in the short-run.
How might inventories cause market makers to be active as opposed to passive participants in the price formation process? Why does this matter to us?
At one time, it was believed that market makers (those who hold inventories in a given security and stand ready to buy or sell at the bid and ask prices) played a passive role with bid and ask prices passively changing to reflect changes in the market for a given security. But, given that market makers hold significant inventories, this gives them exposure to the security and, therefore, risk. As such, perhaps it is reasonable to think that there may be times when market makers are less willing to buy a security or sell a security. Maybe market makers actively adjust their bid and ask numbers in order to shift their exposure (to take on more risk or to shed risk already possessed). The end result: it is possible that the activities of market makers help to set prices (that transactions in a security actually move the needle—not just informational changes).
6. You purchased 100 shares of IBM common stock on margin at $70 per share. Assume the initial margin is 50% and the maintenance margin is 30%. Below what stock price level would you get a margin call? Assume the stock pays no dividend; ignore interest on margin. A. $21 B. $50 C. $49 D. $80 E. none of the above
B. $50
Security A has an expected rate of return of 0.10 and a beta of 1.3. The market expected rate of return is 0.10 and the risk-free rate is 0.04. The alpha of the stock is A. 1.7%. B. -1.8%. C. 8.3%. D. 5.5%. E. -1.7%.
B. -1.8%. (0.10-0.04-1.3*(0.10-0.04)
The market portfolio has a beta of A. 0. B. 1. C. -1. D. 0.5. E. 0.75
B. 1.
What is the expected standard deviation for KMP stock? A. 6.91% B. 8.13% C. 7.79% D. 7.25% E. 8.85%
B. 8.13% (/-66.04)
If the annual real rate of interest is 5% and the expected inflation rate is 4%, the nominal rate of interest would be approximately A. 1%. B. 9%. C. 20%. D. 15%. E. 7%.
B. 9%.
In Modern Portfolio Theory, the capital allocation line (CAL) with the highest Sharpe ratio is called the __________. A. SML B. CML C. Efficient Frontier D. All of the above. E. None of the above.
B. CML
According to the mean-variance criterion, which of the statements below is correct? - Investment A B C D - E(r) 10% 21% 18% 24% - Standard deviation 5% 11% 23% 16% A. Investment B dominates Investment A. B. Investment B dominates Investment C. C. Investment D dominates all of the other investments. D. Investment D dominates only Investment B. E. Investment C dominates investment A.
B. Investment B dominates Investment C.
According to the Capital Asset Pricing Model (CAPM), the expected rate of return on any security is equal to A. Rf+ [E(RM)]. B. Rf+ [E(RM) - Rf]. C. [E(RM) - Rf]. D. E(RM) + Rf. E. Rf- [E(RM) - Rf].
B. Rf+ [E(RM) - Rf].
The relevant measure of risk for individual assets held as parts of well-diversified portfolios is not the asset's standard deviation or variance, but its contribution to the portfolio variance which we measure by the asset's ____________. A. alpha B. beta C. delta D. omega E. None of the above.
B. beta
Consider an investment opportunity set formed with two securities that are perfectly negatively correlated. The global minimum variance portfolio has a standard deviation that is always A. greater than zero. B. equal to zero. C. equal to the sum of the securities' standard deviations. D. equal to -1. E. between zero and -1.
B. equal to zero.
The holding-period return (HPR) on a share of stock is equal to A. the capital gain yield during the period, plus the inflation rate. B. the capital gain yield during the period, plus the dividend yield. C. the current yield, plus the dividend yield. D. the dividend yield, plus the risk premium. E. the change in stock price.
B. the capital gain yield during the period, plus the dividend yield.
Discuss the tradeoffs inherent to both high liquidity and low liquidity.
Believe it or not, you can be too liquid just as easily as you can be too illiquid. Let's start with liquidity. Liquidity is good because it allows you to pay your bills; however, liquid assets usually do not provide particularly good returns. You want to keep enough liquid assets on hand, therefore, to cover or provide for the following: your needed expenditures; survival during a rainy day (or rainy week, month, or year); and, ideally, to be able to exploit any unusual profit opportunities (like the acquisition of distressed assets). But, if you are too liquid, then you are not maximizing the returns to shareholders. If you have, for instance, too much cash on the balance sheet, then you are hurting the shareholders as they could reinvest that cash if it was distributed. It is illiquidity that drives returns—though severe illiquidity cannot keep the lights on. That said, illiquidity can also lead a firm into disaster.
8. Assume you sell short 100 shares of common stock at $45 per share, with initial margin at 50%. What would be your rate of return if you repurchase the stock at $40/share? The stock paid no dividends during the period, and you did not remove any money from the account before making the offsetting transaction. A. 20.03% B. 25.67% C. 22.22% D. 77.46% E. none of the above
C. 22.22%
Over the past year you earned a nominal rate of interest of 8 percent on your money. The inflation rate was 4 percent over the same period. The exact actual growth rate of your purchasing power was A. 15.5%. B. 10.0%. C. 3.8%. D. 4.8%. E. 15.0%.
C. 3.8%
The ____________ provides an unequivocal statement on the expected return-beta relationship for all assets, whereas the _____________ implies that this relationship holds for all but perhaps a small number of securities. A. APT, CAPM B. APT, OPM C. CAPM, APT D. CAPM, OPM E. APT and OPM, CAPM
C. CAPM, APT
The Black-Scholes model is used to value which type of option? A. American Options B. Binary Options C. European Options D. Bermudan Options E. Canary Options
C. European Options
Which of the following statements is (are) true? I) Risk-averse investors reject investments that are fair games.II) Risk-neutral investors judge risky investments only by the expected returns.III) Risk-averse investors judge investments only by their riskiness.IV) Risk-loving investors will not engage in fair games. A. I only B. II only C. I and II only D. II and III only E. II, III, and IV only
C. I and II only
Capital market securities include __________. A. US Treasury Bills B. Negotiable CDs C. Mortgage Backed Securities D. Currencies E. None of the Above
C. Mortgage Backed Securities
Which of the following statements regarding risk-averse investors is true? A. They only care about the rate of return. B. They accept investments that are fair games. C. They only accept risky investments that offer risk premiums over the risk-free rate. D. They are willing to accept lower returns and high risk. E. They only care about the rate of return and accept investments that are fair games.
C. They only accept risky investments that offer risk premiums over the risk-free rate.
An investor will take as large a position as possible when an equilibrium price relationship is violated. This is an example of _________. A. a dominance argument B. the mean-variance efficiency frontier C. a risk-free arbitrage D. the capital asset pricing model E. the SML
C. a risk-free arbitrage
3. You sold JCP stock short at $80 per share. Your losses could be minimized by placing a __________: A. limit-sell order B. limit-buy order C. stop-buy order D. day-order E. none of the above.
C. stop-buy order
The Capital Allocation Line provided by a risk-free security and N risky securities is A. the line that connects the risk-free rate and the global minimum-variance portfolio of the risky securities. B. the line that connects the risk-free rate and the portfolio of the risky securities that has the highest expected return on the efficient frontier. C. the line tangent to the efficient frontier of risky securities drawn from the risk-free rate. D. the horizontal line drawn from the risk-free rate. E. the line that connects the risk-free rate and the global maximum-variance portfolio of the risky securities.
C. the line tangent to the efficient frontier of risky securities drawn from the risk-free rate.
As diversification increases, the total variance of a portfolio approaches ____________. A. 0 B. 1 C. the variance of the market portfolio D. infinity E. -1
C. the variance of the market
Discuss comparable firms (comps) from the standpoint of equity valuation. If markets are efficient, should we see deviations when it comes to the ratios of true comparables?
Comparables (comps) are a very logical place to start when it comes to trying to grasp the value of a company. If an identical company just sold for ten times revenues, doesn't it make sense that your firm should be worth the same amount? If everything that we say about arbitrage holds, then it would seem so (unless something dramatic happens between that transaction and the valuation point). Unfortunately, though comps should make our lives a lot easier, it is very difficult to find true comps. Often, comps will provide us with valuation ranges due to differences in key areas of the balance sheet, P&L, etc. Further, how do you even begin to find a true comp for a diversified MNE? It shouldn't be surprising that comps often yield us nothing more than a range of possible values—a range which can be quite wide. If markets are efficient, we should not see any deviations when it comes to the ratios of true comparables, by definition.
Is the firm profitable?
Consider the net profit margin: 2008 = 0.096. 2009 = 0.033. The firm is profitable; although, its profitability has decreased.
ABC Box Company is in the business of forming and selling specialized corrugated boxes for the agricultural industry. Its financial statements from 2008 and 2009 are as follows (all numbers are in thousands): Is ABC liquid? How has its liquidity changed over time?
Current: 2008 = 2.125. 2009 = 2.909. Quick: 2008 = 0.875. 2009 = 1.273. Cash: 2008 = 0.25. 2009 = 0.73. This firm is fairly liquid and its liquidity position has improved over time as evidenced by the increases in all three ratios.
5. You sold short 200 shares of common stock at $60 per share. The initial margin is 60%. Your initial investment was A. $4,800. B. $12,000. C. $5,600. D. $7,200. E. none of the above.
D. $7,200.
7. You purchased 300 shares of common stock on margin for $60 per share. The initial margin is 60% and the stock pays no dividend. What would your rate of return be if you sell the stock at $45 per share? Ignore interest on margin. A. 25.00% B. -33.33% C. 44.31% D. -41.67% E. -54.22%
D. -41.67%
The risk-free rate and the expected market rate of return are 0.06 and 0.12, respectively. According to the capital asset pricing model (CAPM), the expected rate of return on security X with a beta of 1.2 is equal to. A. 0.06. B. 0.144. C. 0.12. D. 0.132. E. 0.18.
D. 0.132. (0.06+(0.12-0.06)*1.2)
The risk-free rate and the expected market rate of return are 0.056 and 0.125, respectively. According to the capital asset pricing model (CAPM), the expected rate of return on a security with a beta of 1.25 is equal to A. 0.142 B. 0.144 C. 0.153 D. 0.134 E. 0.117
D. 0.134
If a portfolio had a return of 15%, the risk free asset return was 3%, and the standard deviation of the portfolio's excess returns was 34%, the risk premium would be _____. A. 31% B. 18% C. 49% D. 12% E. 29%
D. 12% (15%-3%)
A security has an expected rate of return of 0.15 and a beta of 1.25. The market expected rate of return is 0.10 and the risk-free rate is 0.04. The alpha of the stock is A. 1.7%. B. -1.7%. C. 8.3%. D. 3.5%. E. -8.3%.
D. 3.5%.
You purchase a share of Boeing stock for $90. One year later, after receiving a dividend of $3, you sell the stock for $92. What was your holding-period return? A. 4.44% B. 2.22% C. 3.33% D. 5.56% E. 5.91%
D. 5.56% I (92-90+3)/90
1. Investment bankers A. act as intermediaries between issuers of stocks and investors. B. act as advisors to companies in helping them analyze their financial needs and find buyers for newly issued securities. C. accept deposits from savers and lend them out to companies. D. A and B. E. A, B, and C.
D. A and B
Which one of the following statements regarding orders is false? A. A market order is simply an order to buy or sell a stock immediately at the prevailing market price. B. A limit sell order is where investors specify prices at which they are willing to sell a security. C. If stock ABC is selling at $50, a limit-buy order may instruct the broker to buy the stock if and when the share price falls below $45. D. A market order is an order to buy or sell a stock on a specific exchange (market). E. None of the above.
D. A market order is an order to buy or sell a stock on a specific exchange (market).
Which of the following statements is true A. Inflation has no effect on the nominal rate of interest. B. The realized nominal rate of interest is always greater than the real rate of interest. C. Certificates of deposit offer a guaranteed real rate of interest. D. Certificates of deposit offer a guaranteed nominal rate of interest. E. Inflation has no effect on the nominal rate of interest, the realized nominal rate of interest is always greater than the real rate of interest, and certificates of deposit offer a guaranteed real rate of interest
D. Certificates of deposit offer a guaranteed nominal rate of interest.
Which statement is not true regarding the market portfolio? A. It includes all publicly traded financial assets. B. It lies on the efficient frontier. C. All securities in the market portfolio are held in proportion to their market values. D. It is the tangency point between the capital market line and the indifference curve. E. it lies on a line that represents the expected risk-return relationship.
D. It is the tangency point between the capital market line and the indifference curve.
Which one of the following portfolios cannot lie on the efficient frontier as described by Markowitz? A. Only portfolio W cannot lie on the efficient frontier. B. Only portfolio X cannot lie on the efficient frontier. C. Only portfolio Y cannot lie on the efficient frontier. D. Only portfolio Z cannot lie on the efficient frontier. E. Cannot tell from the information given.
D. Only portfolio Z cannot lie on the efficient frontier.
Which of the following statements regarding the Capital Allocation Line (CAL) is false? A. The CAL shows risk-return combinations. B. The slope of the CAL equals the increase in the expected return of the complete portfolio per unit of additional standard deviation. C. The slope of the CAL is also called the reward-to-volatility ratio. D. The CAL is also called the efficient frontier of risky assets in the absence of a risk-free asset. E. The CAL shows risk-return combinations and is also called the efficient frontier of risky assets in the absence of a risk-free asset.
D. The CAL is also called the efficient frontier of risky assets in the absence of a risk-free asset.
Which of the following measures of risk best highlights the potential loss from extreme negative returns? A. Standard deviation B. Variance C. Upper partial standard deviation D. Value at Risk (VaR) E. Sharpe measure
D. Value at Risk (VaR)
Unique risk is also referred to as A. systematic risk, diversifiable risk. B. systematic risk, market risk. C. diversifiable risk, market risk. D. diversifiable risk, firm-specific risk. E. market risk.
D. diversifiable risk, firm-specific risk.
Firm-specific risk is also referred to as A. systematic risk, diversifiable risk. B. systematic risk, market risk. C. diversifiable risk, market risk. D. diversifiable risk, unique risk. E. nondiversifiable, market risk.
D. diversifiable risk, unique risk.
Non-systematic risk is also referred to as A. market risk, diversifiable risk. B. firm-specific risk, market risk. C. diversifiable risk, market risk. D. diversifiable risk, unique risk. E. nondiversifiable risk, unique risk.
D. diversifiable risk, unique risk.
Elias is a risk-averse investor. David is a less risk-averse investor than Elias. Therefore, A. for the same risk, David requires a higher rate of return than Elias. B. for the same return, Elias tolerates higher risk than David. C. for the same risk, Elias requires a lower rate of return than David. D. for the same return, David tolerates higher risk than Elias. E. cannot be determined.
D. for the same return, David tolerates higher risk than Elias.
2. You purchased JNJ stock at $50 per share. The stock is currently selling at $65. Your gains may be protected by placing a __________ A. stop-buy order B. limit-buy order C. market order D. limit-sell order E. none of the above.
D. limit-sell order
The Security Market Line (SML) is A. the line that describes the expected return-beta relationship for well-diversified portfolios only. B. also called the Capital Allocation Line. C. the line that is tangent to the efficient frontier of all risky assets. D. the line that represents the expected return-beta relationship. E. also called the Capital Market Line.
D. the line that represents the expected return-beta relationship.
4. Assume you purchased 200 shares of GE common stock on margin at $70 per share from your broker. If the initial margin is 55%, how much did you borrow from the broker? A. $6,000 B. $4,000 C. $7,700 D. $7,000 E. $6,300
E. $6,300
You purchased a share of stock for $120. One year later you received $1.82 as a dividend and sold the share for $136. What was your holding-period return? A. 15.67% B. 22.12% C. 18.85% D. 13.24% E. 14.85%
E. 14.85% ((1.82+136-120)/120)
If you wish to short volatility, which of the following positions would be appropriate? A. Write options B. Buy puts C. Short a straddle D. Buy a straddle E. A and C
E. A and C
With a futures contract, which of the following is/are typical? A. The assets to be exchanged are standardized B. The contracts are traded on a centralized exchange C. There is no default risk D. The price of the futures contract changes daily depending on the market value of the underlying asset E. All of the above
E. All of the above
An important difference between CAPM and APT is A. CAPM depends on risk-return dominance; APT depends on a no arbitrage condition. B. CAPM assumes many small changes are required to bring the market back to equilibrium; APT assumes a few large changes are required to bring the market back to equilibrium. C. implications for prices derived from CAPM arguments are stronger than prices derived from APT arguments. D. CAPM depends on risk-return dominance; APT depends on a no arbitrage condition, CAPM assumes many small changes are required to bring the market back to equilibrium; APT assumes a few large changes are required to bring the market back to equilibrium, implications for prices derived from CAPM arguments are stronger than prices derived from APT arguments. E. CAPM depends on risk-return dominance; APT depends on a no arbitrage condition and assumes many small changes are required to bring the market back to equilibrium.
E. CAPM depends on risk-return dominance; APT depends on a no arbitrage condition and assumes many small changes are required to bring the market back to equilibrium.
Which of the following is/are not characteristic of a money market instrument? A. Liquidity B. Marketability C. Short maturity D. Liquidity premium E. Long maturity and liquidity premium
E. Long maturity and liquidity premium
Which of the following statement(s) is (are) true regarding the selection of a portfolio from those that lie on the Capital Allocation Line? A. Less risk-averse investors will invest more in the risk-free security and less in the optimal risky portfolio than more risk-averse investors. B. More risk-averse investors will invest less in the optimal risky portfolio and more in the risk-free security than less risk-averse investors. C. Investors choose the portfolio that maximizes their expected utility. D. Less risk-averse investors will invest more in the risk-free security and less in the optimal risky portfolio than more risk-averse investors and investors will choose the portfolio that maximizes their expected utility. E. More risk-averse investors will invest less in the optimal risky portfolio and more in the risk-free security than less risk-averse investors and investors will choose the portfolio that maximizes their expected utility.
E. More risk-averse investors will invest less in the optimal risky portfolio and more in the risk-free security than less risk-averse investors and investors will choose the portfolio that maximizes their expected utility.
Which of the following is NOT one of the moments of a statistical distribution? A. Mean B. Variance C. Skewness D. Kurtosis E. None of the above.
E. None of the above.
In developing the APT, Ross assumed that uncertainty in asset returns was a result of A. a common macroeconomic factor B. firm-specific factors C. pricing error D. neither common macroeconomic factors nor firm-specific factors. E. both common macroeconomic factors and firm-specific factors
E. both common macroeconomic factors and firm-specific factors
In a multi-factor APT model, the coefficients on the macro factors are often called ______. A. systemic risk B. factor sensitivities C. idiosyncratic risk D. factor betas E. both factor sensitivities and factor betas
E. both factor sensitivities and factor betas
13. What are some of the anti-shorting strategies that management may be inclined to utilize when under attack by shorts? According to Lamont, are these strategies tied to positive stock returns in the ensuing months and years?
Firms sometimes take a variety of legal and regulatory actions that are explicitly designed to hurt short sellers. These actions may include accusing shorts of committing crimes, suing them, hiring private investigators to dig up dirt on them, requesting regulatory reviews of the activities of the shorts, taking technical measures to disrupt short positions (stock splits, dividends, etc.), coordinating the withdrawal of shares from the lending markets (so that short positions are forced to be shut down when the shares on loan are recalled, etc. According to Lamont, these actions are tied to very negative stock returns in the ensuing months and years. In fact, Lamont finds evidence that the firms engaged in these types of behaviors experience negative abnormal returns of up to 2% per month (24% underperformance on a simple annualized basis). It seems that when firms engage in these particular behaviors, the shorts have, indeed, discovered targets which are overvalued for one reason or another—thereby explaining the future underperformance.
Discuss the three primary implications of the CAPM.
First, all investors will choose to hold a portfolio of risky assets in proportions that duplicate representation of the assets in the market portfolio (M), which includes all traded assets. For simplicity, we generally refer to all risky assets as stocks. The proportion of each stock in the market portfolio equals the market value of the stock (price per share multiplied by the number of shares outstanding) divided by the total market value of all stocks. Second, not only will the market portfolio be on the efficient frontier, but it also will be the tangency portfolio to the optimal capital allocation line (CAL) derived by each and every investor. As a result, the capital market line (CML), the line from the risk-free rate through the market portfolio, is also the best attainable capital allocation line. All investors hold the market portfolio as their optimal risky portfolio, differing only in the amount invested in it versus in the risk-free asset. Third, the risk premium on the market portfolio will be proportional to its risk and the risk premium on individual assets will be proportional to the risk premium on the market portfolio and the beta coefficient of the security relative to the market portfolio. Beta measures the extent to which returns on the asset and the market move together. Formally, beta is defined as:And the risk premium on individual securities is:E(Ri) - rf = βi[E(rm)- rf]19.
Discuss the assumptions of the CAPM.
First, there are many investors, each with an endowment (wealth) that is small compared to the total endowment of all investors. Investors are price-takers, in that they act as though security prices are unaffected by their own trades. This is the usual perfect competition assumption of microeconomics. Second, all investors plan for one identical holding period. This behavior is myopic (short-sighted) in that it ignores everything that might happen after the end of the single-period horizon. Third, investments are limited to a universe of publicly traded financial assets, such as stocks and bonds, and to risk-free borrowing or lending arrangements. This assumption rules out investment in non-traded assets such as education (human capital), private enterprises, and governmentally funded assets such as town halls and international airports. It is assumed also that investors may borrow or lend any amount at a fixed, risk-free rate? Fourth, investors pay no taxes on returns and no transaction costs (commissions and service charges) on trades in securities. Fifth, all investors are rational mean-variance optimizers, meaning that they all use the Markowitz portfolio selection model. Finally, all investors analyze securities in the same way and share the same economic view of the world. The result is identical estimates of the probability distribution of future cash flows from investing in the available securities; that is, for any set of security prices, they all derive the same input list to feed into the Markowitz model. Given a set of security prices and the risk-free interest rate, all investors use the same expected returns and covariance matrix of security returns to generate the efficient frontier and the unique optimal risky portfolio. This assumption is often referred to as homogeneous expectations or beliefs.
15. What is front-running? Why is it illegal?
Front-running occurs when a financial intermediary (like a brokerage firm) takes a position in a security ahead of its clients when it is aware of pending client transactions. If clients are looking to buy a security, the intermediary may buy first, hoping that the additional client transactions drive up the price. If clients are looking to sell a security, the intermediary may sell some or all of their holdings first. In either case, the client ends up buying at a higher number or selling at a lower number—money is being transferred, in essence, from the client to institution which should be acting in the best interests of the clients.
Is the firm in a position from which to successfully service its long-term debt (make interest payments which are due)? Has this position strengthened or weakened between 2008 and 2009?
I would suggest using either the times interest earned (TIE) or the cash coverage (CC) ratios. TIE: 2008 = 1.75. 2009 = -3.25. The firm is not in a good position as it does not have EBIT sufficient to cover interest and its position has weakened over time. This firm is a going concern risk as it may slide into bankruptcy.
What are the implications of the following figure?
If we view the expected return-beta relationship as a reward-risk equation, the beta of a security is the appropriate measure of its risk because beta is proportional to the risk that the security contributes to the optimal risky portfolio. The CAPM confirms this intuition, stating further that the security's risk premium is directly proportional to both the beta and the risk premium of the market portfolio: βi[E(rm)- rf]. This relationship is portrayed graphically as the security market line (SML)!
What are the implications of the following figure? Why are Panels A and B different?
In Panel A, we are looking at diversified portfolios—as such, they have no (or negligible) unsystematic risk and will have return levels commensurate with exposure to the systematic factor(s). Panel B, on the other hand, shows individual securities—as such, they have material levels of unsystematic risk and will have return levels commensurate with both systematic factor(s) and unsystematic factors.
10. Describe three equities-related primary market transactions discussed in class.
In class, I discussed IPOs, APOs, and SEOs. An IPO, or Initial Public Offering, is a primary market transaction wherein a firm goes public while raising fresh capital in exchange for ownership. An IPO is the traditional route for going public and necessitates a capital raise. It is expensive and time-consuming—usually requiring the help of one or more investment bankers who serve as intermediaries between the firm and the investors (usually institutional investors like mutual funds, pension funds, endowment funds, etc). APOs, or Alternative Public Offerings, are an alternative to the IPO. APOs combine a reverse merger (the going public event) with PIPE, Private Investment in Public Equities, financing. A reverse merger involves a public shell company (no operations, but up-to-date SEC filings and an active stock price) absorbing a private company. The public company takes on the name, operations, and ownership structure of the private company (the private company is, in effect, the survivor—the original shareholders of the shell will probably get several hundred thousand dollars in cash and, maybe, a small amount of ownership in the surviving entity). PIPE financing is when publicly tradeable shares are sold at a deep discount to investors who agree not to turn around and sell them for a period of time (usually several months). This allows for more liquid aftermarkets to develop before these investors are able to (potentially) dump their stock and cash in on their profits. The discounts associated with PIPE financing make it very expensive; however, it is sometimes the only type of financing possible. The combination of a reverse merger and PIPE yields an APO. It is quicker than an IPO, but has its drawbacks due to the cost. It is often utilized by very small companies with questionable balance sheets and operations who cannot operate in the traditional IPO world. SEOs, or Seasoned Equity Offerings, involve the public sale of stock by a firm which is already public.
Does the firm appear to be behaving in a conservative or an aggressive fashion?
It is behaving conservatively—cash is up, A/R is down (the firm appears to be avoiding problem customers as evidenced by the dip in sales), and leverage is down. Interest is low and long-term debt manageable—both of which also supports my assertion that the firm is behaving conservatively.
Please explain the significance in the figure displayed on the next page in context of the whitepaper published by Dimensional Fund Advisors.
Remembering that the efficient frontier is the result of an optimization problem, the figure shows two sets of portfolios that provide the best return/variability trade-off, given the expected returns and covariances of the asset classes. Why two? Well, one (the ex ante portfolio with an expected return of 11.4% for a 25% standard deviation) is formed using expectations derived from a pricing model (such as the CAPM or Fama-French model) while the other is formed using historical data. The latter is frequently utilized in industry.Here's the problem: historical data includes both the expected return and an average error—the part of the historical return that could not have been anticipated beforehand. So, while the ex ante efficient frontier optimizes with respect to expected returns, the ex post frontier optimizes with respect to both expected returns and errors—treating errors as if they were expected and over-weighting assets with positive errors and underweighting assets with negative errors.With asset prices, we tend to have a small sample problem (which isn't solved by simply going from annual to quarterly or quarterly to monthly data)—so some assets will have average errors that are not close to zero, due to a few large (positive or negative) observations (pushing the boundary northwest). This distorts reality and can seriously mislead investors into believing that their returns for given risk levels are going to be higher in the future than is likely to be the case.Further, this figure is particularly interesting because it uses bad historical market returns; therefore, this provides a very CONSERVATIVE estimate of the possible exaggeration.
11. What are some of the things that short sellers look for as they are seeking out possible positions?
Short sellers seek out a variety of opportunities. Consider, for instance, accounting irregularities or gimmickry. If firms seem to have a rapidly building inventory, this may be a sign of fraud. If firms seem to be generating misleading financial results through multi-tiered marketing strategies (of the pyramidal variety), this may be a sign of fraud. Shorts will also look for firms which appear to be abused by certain insiders. Chesapeake Energy comes to mind as it became a target of shorts a year or so ago due to the fact that the CEO was allowed to co-invest alongside the firm—thereby, directly profiting at the firm's expense. Blatant mispricing of securities (bubbles) is also of interest to short sellers. Think of Paulson and Company's shorting of the housing market several years ago. Additionally, technological obsolescence can make for a good short selling opportunity. If a firm is falling way behind the times, no matter how much of a stalwart it has been in the past, it may be unlikely to remain a going concern in the future (Eastman Kodak comes to mind).
What is the significance of the following table?
Simple: mutual funds destroy value—they don't create it. As you can see, all of the categories considered generate negative alphas. Not all t-stats are significant; however, the implications are clear: professional money managers are not all that great. Mutual funds appear to be a bad gamble.
How is it that stochastic dominance can lead to different decisions vis-à-vis Markowitz's mean-variance approach when it comes to portfolio selection?
Stochastic dominance focuses on every bit of information in the probability distribution (not just the first two moments). When empirical distributions are non-normal, there exists the potential for serious conflicts between choices made by the stochastic dominance criterion and those made by the mean-variance approach. Consider:Though A and B are both efficient and C is inefficient, A is actually inferior (relative to both B and C) from the standpoint of its cumulative probability distribution:The end result: different portfolio selection decisions.
Define and contrast systematic risk and non-systematic risk.
Systematic risk (also known as market risk and non-diversifiable risk) is the risk which cannot be diversified away by simply adding more assets to a portfolio (naïve diversification). These risks are risks which impact the cross-section of securities. Examples include: changes in GDP, changes in taxes, changes in consumption, changes in inflation, changes in interest rates, etc.Unsystematic risk (also known as firm-specific risk, idiosyncratic risk, and diversifiable risk) are those risks which impact only a small number of assets which can be offset via naïve diversification. Examples include labor strikes, part shortages, facility fires, bad managerial decision-making, etc.Because diversifiable risk can be eliminated (without a proportional decrease in expected return), the market will only reward us, on average, for exposure to systematic risk.
Discuss the three propositions of the APT.
The APT makes the following three propositions: 1) security returns can be described by a factor model, 2) there are sufficient securities to diversify away idiosyncratic risk, and 3) well-functioning securities markets do not allow for the persistence of arbitrage opportunities. Keep in mind: APT, by itself, doesn't state what factors should matter—only that one or more do.
Discuss the Sortino ratio. What is the ratio? What is it designed to express? How does this differ from the Sharpe ratio?
The Sortino ratio looks only at the lower partial standard deviation (LPSD)of returns as opposed to the entire standard deviation of returns. The argument is that it is only deviations below the mean which are of concern to (many) investors because deviations above the mean are very beneficial (we make more money as opposed to less). As such, the Sortino ratio is designed to rank securities and/or portfolios based on their respective downside risk relative to the risk premium. The Sharpe ratio, on the other hand, considers all deviations (positive and negative) relative to the risk premium and ranks accordingly. If the distribution of returns is normal, then the Sharpe ratio and the Sortino ratio will yield the same results (the same rankings); however, if higher moments (skewness and/or kurtosis) are significantly different from zero, then the two measures will likely yield different rankings (which impacts our decision-making).
Take a look at the below payoff diagram for the buyer of a call option on a stock. When does the buyer lose money? When does the buyer break even? When does the buyer make money? Ignore the time value of money.
The buyer of a call option pays a premium to have the right but not the obligation to purchase the underlying security at some point in the future for a pre-specified price. In the case above, the buyer pays a premium of $1.30 for the right but not the obligation to purchase the underlying stock for $7.50 at expiration. If the underlying stock price at expiration is $7.50 or less, the buyer's net position will be a loss of the full premium (because a worthless option won't be exercised to cause further losses...the benefit of having the right but NOT the obligation to exercise). As the price inches above $7.50 at expiration, then the call option buyer recovers his or her premium payment a penny at a time. The break-even point is $8.80 because the option would be exercised and a $1.30 gain will be realized to exactly offset the $1.30 premium payment. If the stock price goes beyond $8.80 at expiration, then the buyer will realize a gain—penny-for-penny, dollar-for-dollar above $8.80.
Discuss the joint-hypothesis problem. What issues does this present for studies which look at market efficiency? If we perceive mispricing, what are the possibilities as to what we are actually seeing?
The joint-hypothesis problem is simple: in order to test market efficiency, you need a pricing model, but in order to have a pricing model of any value, markets have to be efficient. As such, if we perceive mispricing in the marketplace, expected rates of return deviating from required rates of return, we may have one of three things (and we cannot be sure): 1) actual mispricing; 2) a misspecified pricing model which is not representative of reality, and 3) a good pricing model, but lousy inputs. The result: market efficiency (and models of equilibrium) are particularly tricky to test.
Discuss the similarities and differences between the following alleged speculative events: the nifty-fifty, the Japanese real estate market of the late 1980s, and the dotcom episode of the late 1990s and early 2000s.
The so-called nifty-fifty were fifty stocks believed to be as stable as stocks could be. They were large cap stocks with stellar histories and prospects. The only problem was this: prices were bid up to ridiculous P/E ratios. Great companies (of large size) may very well produce strong earnings over a long period of time; however, they cannot continually deliver earnings growth of commensurate size—eventually the opportunities dry up. Even for companies of lasting and significant value. Similarly, though real estate in Japan certainly has value, prices were bid up to the point that the real estate in metropolitan Tokyo was worth more than the real estate of the entire United States. Clearly, something was not quite right here. Finally, the dotcom episode followed a similar path with stock prices (of companies both lasting and not) moving to egregiously high levels. Until the market collapsed, as was the case with the prior two examples, and destroyed tremendous amounts of wealth.
Define and discuss the three sub-hypotheses of market efficiency. What do they hold to be true? If representative of reality, what are their respective implications?
The three sub-hypotheses of the efficient markets hypothesis are as follows: strong-form, semi-strong-form, and weak-form. Strong-form market efficiency suggests that security prices accurately reflect all available information—both public and private. This is a particularly ambitious version of the EMH as it suggests that someone with consistent access to non-public information would not be able to achieve abnormal returns. Of course, this is probably a bridge (or two or three) too far, but it is a start. Semi-strong-form market efficiency suggests that security prices reflect all public information. As such, fundamental analysis (of publicly available information such as financial statements, important corporate events, etc.) is hypothesized to be of no use. The evidence or this particular sub-hypothesis is decidedly mixed. Finally, weak-form market efficiency postulates that security prices accurately reflect all past pricing and return data. If this is the case, then technical analysis (conducted by chartists) is of no use as any patterns of interest will have already been incorporated into prices.
9. What are some of the benefits of going public? What are some of the drawbacks of going public?
There are a number of good reasons for going public. First, if a firm needs to raise significant sums of dollars for investment purposes, the public markets may be their only option (there are some very large private companies out there; however, there are for more large public companies). Second, if certain (or all) founders are looking for a liquidity event (exchanging their stock for cash), the public markets offer far superior possibilities in most cases (shares of stock in private companies tend to trade at very large discounts due to an illiquid market for private securities, a lack of transparency, etc). Third, going public raises a firm's profile and, perhaps, increases the likelihood of the firm succeeding in business development efforts, recruitment efforts, etc. Fourth, publicly traded stock makes for an excellent incentive for both potential and current employees—and such an incentive helps to align the interests of management with the interest of the shareholders.On the flip side, going public adds a significant amount of complexity in the form of compliance, regulatory interference, etc. Public firms are obligated to disclose a lot about their operations, finances, etc.—information which becomes easily accessible by not only shareholders, but also employees, creditors, competitors, etc. If things are not going well, it is very difficult to hide without crossing the threshold of illegality. Private companies have quite a bit more flexibility in this respect.
Discuss the significance of the findings of Eling shown below
There are many different ratios—all designed to provide us with different (and more accurate rankings) given certain return distributions, utility profiles, etc. Interestingly, however, the evidence in the above chart suggests that the different ratios have a tendency to point in the same direction (extremely high correlations) across asset-classes.
When it comes to servicing debt, we have talked about the times interest earned and cash coverage ratios. What are these ratios important?
These ratios give us a feel as to whether or not a given debt level is sustainable. Debt level is important as it addresses the portion of the balance sheet attributable to borrowed funds. But, some firms are able to sustain higher debt levels than others—and the times interest earned and cash coverage ratios help to give us a feel for what debt levels respective firms can actually sustain. If you have enough earnings (or cash flow) to cover your interest expenses, then your firm is in a good position from which to borrow. The higher the ratios, the stronger your firm's ability is to cover its debt obligations (and avoid financial distress and/or bankruptcy). But, if your debt coverage ratios are too high, it might mean that you do not have enough debt. Though dangerous, debt allows us to do much more with much less capital.
What can we say about the firm's revenues over time?
They are dropping—2009 was a bad year for most companies, so this is not surprising.
Consider the figure below and expound upon its significance.
This figure shows what happens to the standard deviation of an average portfolio as additional securities are added (moving left to right along the chart). As you can see, simply adding one security to a one security portfolio will lead to an average 30% drop in standard deviation. Portfolios with 20 securities will have approximately 40% of the standard deviation of a one security portfolio. Because this drop in standard deviation comes WITHOUT a PROPORATIONAL drop in expected return, we benefit.
What should the firm do to improve its prospects in the short-, medium-, and long-run?
This firm is in big trouble. It requires major "operating leverage"—that is, top-line growth in revenues. Additionally, costs must be cut dramatically (you'll notice that from 2008 to 2009, costs remained steady even though sales dropped from 6000 to 4000—this is inexcusable. Fixed assets should probably be sold and converted to cash in order to increase current assets and improve the firm's liquidity position. A turnaround for this firm is unlikely.
XYZ Real Estate Management Company is in the business of buying and leasing properties and providing facilities management services. Its financial statements from 2008 and 2009 are as follows (all numbers are in millions): How much leverage is the firm using? Did its use of leverage increase or decrease between 2008 and 2009?
Typically, you can use either the Total Debt Ratio or the Debt to Equity Ratio; however, as the Debt to Equity Ratio is negative, it really doesn't tell us anything, so you must use the Total Debt Ratio.TDR for 2008 = 1.24. For 2009 = 1.87. It's use of leverage clearly increased between 2008 and 2009.
Is the firm in a position from which to successfully service its short-term creditors?
Use any of the liquidity ratios. Current: 2008 = 1.00. 2009 = 0.44. Cash: 2008 = 0.25. 2009 = 0.067. The firm is very illiquid as it has significantly fewer current assets than current liabilities (especially when we consider only the most liquid current assets). This position too is deteriorating.
Describe possible strategies for taking both long and short positions in volatility.
Volatility is a critical variable when it comes to the value of an option. The more volatile the underlying security, the more valuable the option and vice versa. As such, if you believe that underlying volatility is too high, you could speculate by writing options now (and collecting premiums). Assuming that volatility drops (which is what you are banking on), the value of the options will drop. You can simply return to the market and buy (now cheaper) offsetting options. The difference between the premiums paid and the premiums received upfront will be your profit (or loss if you were wrong). You can go long volatility by buying options. If volatility increases, then the value of the options will increase ceteris paribus. To avoid directional exposure, a straddle position may be appropriate which involves simultaneous short or long positions, respectively, in calls and puts with identical strikes and expiration dates.
What is the significance of the figure below? What anomaly are we viewing? Is this indicative of market efficiency or inefficiency? Be sure to describe precisely what the figure is telling us.
We are looking at the Post-Earnings-Announcement Price drift (PEAD) anomaly. At t=0, an earnings announcement is made. If the announcement is completely expected, it is ranked a 5. If the announcement is unexpectedly positive (in the extreme), it is ranked a 10. If unexpectedly negative (in the extreme), it is ranked a 1. If markets are efficient, the price change should be immediate (or very close to it) after an announcement is made; however, it appears that riskless profits can, in fact, be made if folks take positions (long or short, as appropriate) upon the announcement date relative to the magnitude of the earnings surprise. This is indicative of inefficiency.
