FIN 4310 final exam
Futures contracts are standardized and must stipulate the following five contract terms:
The identity of the underlying commodity or financial instrument. The futures contract size. The futures maturity date, also called the expiration date. The delivery or settlement procedure. The futures price.
portfolio turnover (TO)
($ value of securities sold from the portfolio in a year divided by average $ value of assets managed by the fund) is an indirect measure of the amount of trading that could lead to a higher tax bill for a taxable investor. While the TO ratio is a good indicator of overall trading activity, it does not necessarily indicate that majority of those trades resulted in capital gains that in turn created taxable events.
Momentum Indicators
1. Breadth of Market 2. Stocks above Their 200-Day Moving Average
A. Index Portfolio Construction Techniques: there are three basic techniques
1. Full replication 2. Sampling 3. Quadratic optimization or programming
Challenges to Technical Trading Rules
1. Past price patterns or relationships may not be repeated in the future. This possibility leads most technicians to follow several trading rules so as to arrive at a consensus in order to predict the future market pattern. 2. Moves may be self-fulfilling, but only temporary. E.g. if most technicians expect a stock selling at $50 a share to go to $60 or more if it should rise above its current pattern and hit $55. As soon as it reaches $55, enough technicians will buy to cause the price to rise to $60 as predicted. 3. Competition will neutralize the value of a technique. 4. Most rules are very subjective and critical values can change over time.
Option Trading Strategies
1. Protective Put 2. Covered Call 3. Straddles
Stock Price and Volume Techniques
1. The Dow Theory 2. Importance of Volume 3. Support and Resistance Levels 4. Moving-Average Lines 5. Relative Strength 6. Bar Charting
Option Valuation Basics
A call option is in-the-money if S>X, ie if the intrinsic value >0. It is out-of-the-money if S<X (i.e. if intrinsic value <0), and it's at-the-money if S=X. A put option is in-the-money if S<X, out-of-the-money if S>X, and at-the-money if S=X.
Chicago Board Options Exchange (CBOE) Put-Call Ratio
A higher put-call ratio indicates a bearish attitude for investors, which contrarian technicians consider a bullish indicator. A ratio of above .60 indicates investors are bearish, and so it is considered bullish by contrarians. A ratio of 0.4 is considered indicates bullish, and so it is considered bearish by contrarians.
technical analysis
A method of evaluating securities by analyzing statistics generated by market activity. Involves the examination of past market data such as prices and volume of trading, which leads to an estimate of future price trends, and hence an investment decision. The technical analyst uses data from the market itself because the market is its own best predictor. Technical analysis answers the questions: What securities should an investor buy or sell? When should these investments be made?
Mutual Fund Cash Positions
A mutual fund's cash ratio or liquid asset ratio is simply the ratio of cash to total assets. This ratio has varied in recent years from about 4% to about 11%. Contrarians believe mutual funds are wrong at peaks and troughs. Therefore, they expect mutual funds to have a high percentage of cash near a market trough - the time they should invest more to take advantage of the impending market rise, but they don't (because they feel bearish), and so the contrarian takes the opposite view, bullish. That is when the ratio approaches 11% the contrarian is bullish, and is bearish when the ratio approaches 4%.
2. Sampling
A portfolio manager buys a representative sample of stocks in the benchmark index according to their weights in the index. In this case, fewer stocks mean lower commissions, and reinvestment of dividends is less difficult. The disadvantage is that it will not track the index as closely, so there will be some tracking error.
Challenges to Technical analysis
A. Challenges to Technical Analysis Assumption B. Challenges to Technical Trading Rules
Technical Trading Rules and Indicators
A. Contrary-Opinion rules B. Follow the Smart Money C. Momentum Indicators D. Stock Price and Volume Techniques
Advantages of Technical Trading
A. Technical analysis is not heavily dependent on financial accounting statements. B. Fundamental analyst must process new information and quickly determine a new intrinsic value, but technical analyst merely has to recognize a movement to a new equilibrium C. Technicians trade when a move to a new equilibrium is underway but a fundamental analyst finds undervalued securities that may not adjust their prices as quickly
Assumptions of technical analysis
A. The market value of any good or service is determined solely by the interaction of supply and demand B. Supply and demand are governed by numerous rational and irrational facts C. Stock prices tend to move in trends that persist for appreciable lengths of time D. Changes in trend are caused by shifts in supply and demand factors and these shifts can be detected by an analysis of the market itself.
Forward Contracts
Agreement between a buyer and a seller, who both commit to a transaction at a future date at a price, set by negotiation today. A forward contract gives the holder both right and the obligation to conduct a transaction involving the underlying asset. The forward market is an over-the-counter market and its participants include banks, corporations, and governments. The two parties involved in a forward contract must agree to do business with each other. This means each party accepts the credit risk from the other party. Advantages include: no collateral needed, flexible contracts. Disadvantages include: high default risk, and illiquidity.
1. Full replication
All securities in the index are purchased in proportion to their weights in the index. This helps ensure close tracking. However, this increases transaction costs (b/c you buy many securities), particularly with dividend reinvestment. This is the most obvious technique.
The language and structure of option markets
An option contract gives the holder the right-but not the obligation-to conduct a transaction involving an underlying security or commodity at a predetermined future date (called the expiration date) and at a predetermined price (called the strike price). There are two types of financial options: A call (put) option gives the holder the right to buy (sell) the underlying security.
Futures Traders Bullish on Stock Index Futures
Another relatively contrarian measure is the percentage of speculators in stock index futures. Contrarians would consider it a bearish sign when more than 70% of the speculators are bullish.
Opinions about the assumptions of technical analysis
Both technicians and non-technicians alike agree on assumptions A and B. The disagreement is on C and D. Exhibit 15.1(p.527) shows a technician's view of price adjustment to new information. Technicians look for the start of a change so that they can get on the bandwagon early and benefit from the move to the new equilibrium price by buying if the trend is up or selling if the trend is down. Obviously, if the adjustment of prices to the new information is sudden as expected by the EMH, then the ride on the bandwagon would be too short that investors could not benefit.
Futures contracts
Contract between a seller and a buyer specifying a commodity or financial instrument to be delivered and paid for at contract maturity. Futures contracts are managed through an organized futures exchange. Futures contracts are a zero-sum game
Credit Balances in Brokerage Accounts
Credit balances result when investors sell stocks and leave the proceeds with their brokers, expecting to reinvest them shortly. A build up of credit balances indicates investors are selling more (market is bearish), and so, contrarians consider that as a bullish signal. On the other hand, a decline in credit balances indicates investors aren't selling or they are buying (bullish), and so contrarians consider that as bearish.
Exchange-Traded Funds
EFTs are depository receipts that give investors a pro rata claim on the capital gains and cash flows of the securities that are held in deposit by a financial institution that issued the certificates. Examples include Cubes (QQQQ) - created to mimic the Nadaq 100 index; The Standard and Poor's Depository Receipts or Spiders (SPY) - created to mimic the S&P 500 index; Diamonds (DIA) - created to mimic the Dow Jones industrial average. Exhibit 16.4 gives an overview of the Spiders. Again, the historical return performance is indistinguishable from the benchmark.
The One Period Binomial Pricing Model
Given the current stock price (S), the idea is to compute a theoretical fair value for a call option (C) on that stock. This theoretical value is then compared to the actual market price of the option to determine whether or not the option is correctly priced. To find C, construct a riskless portfolio (hedge portfolio) of stocks and options. A riskless portfolio should earn the risk-free rate, and its value one period from now should be worth the same amount regardless of whether the stock price goes up or down. One way to do this is to be long in h shares of stock (hS) and short one call option (C).This is because calls move directly with the stock price, so to hedge we sell calls. If we were to find the value of a put, P, then we would buy h shares of stock and one put option simply because puts move inversely with the stock price. So, to hedge the long position in a stock, we buy puts].
3. Quadratic optimization or programming
Historical information on price changes and correlations between securities are input into a computer program that determines the composition of a portfolio that will minimize tracking error with the benchmark. A problem with this technique is that it relies on historical correlations, which may change over time, leading to failure to track the index.
B. Tracking Error and Index Portfolio Construction
If the goal of forming a passive portfolio is to replicate a particular equity index, the success of constructing such an investment fund lies not in the absolute returns it produces but, rather, in how closely its returns match those of the benchmark (e.g. the S&P 500 index). In other words the goal of the passive manager should be to minimize the portfolio's return volatility relative to the benchmark. Better still; the manager should try to minimize tracking error, which is the extent to which fluctuations in the managed portfolio are not correlated with return fluctuations in the benchmark.
Contrary-Opinion Rules
Many technical analysts rely on technical trading rules that assume that the majority of investors are wrong as the market approaches peaks and troughs. These technicians try to determine when the majority of investors is either strongly bullish or bearish and then trade in the opposite direction. Contrarian indicators include the following: 1. Mutual Fund Cash Positions 2. Credit Balances in Brokerage Accounts 3. Investment Advisory Opinions 4. Chicago Board Options Exchange (CBOE) Put-Call Ratio 5. Futures Traders Bullish on Stock Index Futures
Investment Advisory Opinions
Many technicians believe that if a large proportion of investment advisory services are bearish, it signals the approach of a market trough and the onset of a bull market.
Breadth of Market
Measures the number of issues that have increased each day and the number of issues that have declined. a. Advance-decline series: A cumulative index of net advances or net declines. The advance/decline line shows the cumulative difference between advancing issues and declining issues. The closing tick is the difference between the number of shares that closed on an uptick, and those that closed on a downtick.
Difference between Forward and Futures contracts
Note that a forward or a futures contract is not an asset. You can buy a futures contract, but you do not actually pay for it. A futures exchange requires both counter parties to post a small margin deposit to protect itself from default, but this is not the price. The margin deposits are held by the exchange's clearing house, and are marked-to-market (i.e. adjusted to contract price movements) on daily basis.Also, while a forward contract can be struck between any two parties, a futures contract must be managed through an organized futures exchange.
Overview of Passive Equity Portfolio Management Strategies
Passive equity portfolio management attempts to design a portfolio to replicate the performance of a specific index e.g. the S&P 500 index. May slightly under perform the target index due to fees and commissions. Many different market indexes are used for tracking portfolios. The S&P 500 is the most common. Strategies include: A. Index Portfolio Construction Techniques, B. Tracking Error and Index Portfolio Construction, C. Methods of Index Portfolio Investing
The Confidence Index
Ratio of Barron's average yield on 10 top-grade corporate bonds to the yield on the Dow Jones average of 40 bonds. When this ratio is high (low), it indicates a bullish (bearish) signal.
T-Bill-Eurodollar Yield Spread
Ratio of T-bill yield to Eurodollar yield. At times of international crises, the spread between the two widens since investors invest in T-bills. This causes a decline in the ratio.
Relative Strength
Relative strength charts measure the performance of one investment or market relative to another. A common technique is to review how a stock did relative to its industry or the market as a whole.
Debit Balances in Brokerage Accounts (Margin Debt)
Represents borrowing (margin debt) by knowledgeable investors from their brokers. An increase in debit balance implies buying by these sophisticate investors, and it's considered a bullish signal. A decline in debit balances will imply selling by these investors and will be considered a bearish signal.
Moving-Average Lines
Sell (buy) when the shorter-day moving average line crosses the longer-day moving average line from above (below). See exhibit 15.9
Follow the Smart Money
Some technical analysts have created a set of indicators and corresponding rules that they believe indicate the behavior of smart, sophisticated investors. Indicators include: 1. The Confidence Index, 2. T-Bill Eurodollar Yield Spread, 3. Debit Balances in Brokerage Accounts (Margin Debt)
Underlying Assumption of Technical Analysis
Technical analysts base trading decisions on examinations of prior price and volume data to determine past markets trends from which they predict future behavior for the market as a whole and for individual securities.
Importance of Volume
Technicians look for a price increase on heavy trading volume relative to the stock's normal trading volume as an indication of a bullish activity. On the other hand, a price decline with heavy trading volume is considered bearish.
Bar Charting
Technicians study past market prices or information, looking for trends or indicators that may signal the direction of the market or a particular stock. There are many charting techniques. However, the most popular is the bar chart. An example is the high-low-close chart. This is a bar chart showing the high price, low price, and closing price each day for a stock or index. The Wall Street Journal presents these charts daily for the Dow averages. Technical analysts use these charts to look for patterns.
options clearing corporation (OCC)
The OCC is a private agency that guarantees that the terms of an option contract will be fulfilled if the option is exercised. It issues and clears all option contracts trading on U.S. exchanges. The OCC is the clearing agency for all options exchanges in the U.S. and it is subject to regulation by the SEC. Since the OCC assumes the writer's obligation in all trades, all default risk is transferred to the OCC.
Support and Resistance Levels
The basic idea is that most stocks have a support level (price the stock is unlikely to go below) and a resistance level (price the stock is unlikely to go above), which can also be viewed as psychological barriers. When a stock goes down to a minimum level, the "bargain hunters" will view the stock as "cheap," buy the stock and, thereby, support the price. When a stock goes up to a maximum level, investors are likely to consider it "topped out" and sell their stock, which will slow down the price increase.
1. Index Funds
The fund manager attempts to replicate the composition of the index exactly (i.e. buying the exact securities in the index in their exact weights). An example of an index fund is the Vanguard's 500 Index Fund (VFINX), which is designed to mimic the S&P 500 index. See exhibit 16.3 for an overview. As you can see, its historical return performance is indistinguishable from the benchmark.
An overview of Active Equity Portfolio Management Strategies
The goal of active equity management is to earn a portfolio return that exceeds the return of a passive benchmark portfolio, net of transaction costs, on a risk-adjusted basis. Practical difficulties of active manager: 1. Transactions costs must be offset 2. Risk can exceed that of the passive benchmark. Note that passive management strategies discussed above, are based on the EMH. However, active management strategies are based on three general categories: fundamental analysis, technical analysis, and anomalies and attributes (see exhibit 16.6).
Challenges to Technical Analysis Assumptions
The major challenge to technical analysis is based on the results of empirical tests of the efficient market hypothesis (EMH). Almost all the studies testing the weak-form EMH using statistical analysis have found that prices do not move in trends. These tests support the EMH.
Stocks above Their 200-Day Moving Average
The market is overbought (bearish) and is subject to negative correction when more than 80% of the stocks are trading above their 200-day moving average. In contrast, if less than 20% of the stocks are selling above their 200-day moving average, the market is oversold (bullish) and is subject to positive correction.
The Binomial Option Pricing Model
The model allows the stock price to go either up or down (possibly at different rates). As a result it is also called a two-state model. The process involves forecasting stock price changes from one sub-period to the next, starting from the known stock price today using u for an up movement and d for a down movement. In other words u = one plus the percentage change in an up movement, d = one plus the percentage change in a down movement. The model assumes that the same values for u and d apply to every up and down price change in all subsequent sub-periods. The model has the following three-step process: 1. Design a riskless hedge with h shares of stock held long and short (long) one call (put) option 2. Calculate the formula's certain values 3. Rearrange values in the equation and solve for the call value (C) or put value (P).
Protective Put
The purchase of a put option on a stock owned. This strategy preserves the investor's upside potential from rising share price but limits her losses when share price falls. As an illustration, suppose you own a share of stock currently worth $45 and you think the price might fall in the near term, but you don't want to sell it. So, you purchase a put option on that stock at $2 with a strike price of $45. Two things can happen: i. If price falls below the strike price of $45, you exercise your put and the put writer will pay you $45 for your stock. No matter how far below $45 the price falls, you are certain that you will receive $45 for your stock less the premium you paid to obtain the option. ii. On the other hand, if price stays at or above $45, your put option expires worthless (since you would not want to exercise it) and you lose only the $2 you paid to obtain the put option.
Straps
The purchase of two calls and one put. This occurs when the investor is more bullish than bearish.
Strips
The purchase of two puts and one call. This happens when the investor is more bearish than bullish.
purchasing protective puts
The purpose is to have a derivative contract that allows stock sales when prices fall but keep the stock when prices rise. The purchase of a put option to hedge the downside risk of an underlying security holding is called a protective put position.
Covered Call
The sale of a call option on a stock owned. The purpose of this strategy is to generate additional income for a stock holding that is not expected to change in value much over the near term.
Straddles
The simultaneous purchase (or sale) of a call and a put option with the same underlying asset, strike price, and expiration date. A long straddle is the purchase of both a call and a put option, while a short straddle is the sale of a call and a put. A straddle strategy is used when the investor expects a move in the market, but is not sure which way the market will move. Variants of straddle include strips, straps, and strangles.
Major problems with accounting statements
The technician contends that there are several major problems with accounting statements: - Lack of information needed by security analysts e.g. information related to sales, earnings, and capital utilized by product line and customers. - GAAP allows firms to select among several procedures for reporting expenses, assets, or liabilities resulting in difficulty comparing statements from two firms - Non-quantifiable and psychological factors do not show up in financial statements e.g. employee training and loyalty, customer goodwill, and general investor attitude toward the industry
C. Methods of Index Portfolio Investing
There are at least two prepackaged more convenient and less expensive ways the small investor can use to construct passive portfolios to mimic a particular equity index: 1. Buying shares in an index mutual fund or 2. Buying shares in an exchange-traded fund (ETF).
The Black-Scholes Valuation Model
This is a model for determining the value of European options. The Black-Scholes option pricing model is probably the most celebrated achievement in financial economics since the last four decades. Pioneered by Fischer Black and Myron Scholes, and later joined by Robert Merton, the end result of the model is a formula for pricing a European style option. It assumes that - prices can also change continuously throughout time rather than discrete - stock price movements can be described by a statistical process known as Geometric Brownian motion - the risk-free rate and volatility are constant - there are no taxes, transaction costs, and dividends
The Dow Theory
This method predicts market direction. It relies on the Dow Industrial (DJIA) and the Dow Transportation (DJTA) averages. The basis of the Dow Theory is that there are three forces at work in the stock market: Primary direction or major trends Secondary reaction or intermediate trends Daily fluctuations or short-run trends This theory indicates that the primary direction is either bullish or bearish, and reflects the long-run direction of the market. The secondary reactions are temporary departures from the primary direction, and the daily fluctuations are just noise and can be ignored. When the DJIA and DJTA move together, it can be interpreted as a primary (major) trend. When they depart from each other, it can be interpreted as a secondary reaction. Even though this method is not as popular today, its basic principles underlie many modern approaches to technical analysis.
tax cost ratio
is a more direct measure of how well managers balance the capital gains and losses resulting from their trades. It represents the percentage of an investor's assets that are lost to taxes on a yearly basis as a result of trading strategies employed by the fund manager - Tax Cost Ratio (%) = [1 - {(1+TAR)/(1+PTR)}]x100. Where TAR=Tax Adjusted Return; and PTR=Pre-Tax Return
derivative security
is a security whose value depends directly on, or is derived from, the value of another security or commodity, called the underlying asset. At the broadest level, there are only two kinds of derivative securities: forward and futures contracts, and option contracts