1) What is the significant difference between a top-down and a bottom-up investment style? List one advantage and one disadvantage of each. What are the differences, if any, between a traditional investment bank and a commercial bank? Yes or no: is either of these banks financial intermediaries? What is the function of a financial intermediary? What phenomenon does principal-agent theory literature seek to address? What is the estimated price/earnings ratio (P/E) of the S&P 500 for 2016?
Answer 1
Top-Down & Bottom-Up Investing Approach
The top-down approach starts from general and moves towards being specific while the bottom-up approaches start from specific and move towards generalization. The top-down approach is credited with looking at the macroeconomics factors and then moving to individual stocks, while the bottom down approach focuses more on the evaluation of the individual stocks.
Advantages and disadvantages:
Top-down investing has the benefit that it focuses on the asset allocation of the complete portfolio. The disadvantage of this approach is that it may ignore undervalued securities.
The bottom-down approach has the advantage that it leads to improved accuracy; however, its disadvantage is that it may lead to high costs for the investor.
Difference between Investment and Commercial Banking:
The main difference is that investment banking is more about the sale and purchase of the stocks and bonds of companies, while commercial banking is dealing more with deposits and loans for individuals and companies.
The function of Financial Intermediary:
Yes, the investment bank and commercial bank both are financial intermediaries. The function of financial intermediary is to provide connection between the deficient and surplus agents.
Principal-Agent Theory:
The principal-agent theory addresses the dilemma which may occur when one person or organization is given the authority to make decisions for another person or firm.
Price per Earnings Ratio of S&P 500 Index:
It is 22.18
2) What is the difference, if any, between a venture capital and a private equity fund? Which, if either, is considered an alternative asset (versus a traditional asset)? With respect to the market, briefly explain the informational content of (a) the current 10- to 20-year US government bond market with respect to real interest rates and inflation; (b) the current US dollar exchange market (to a basket of other currencies); and (c) the current Brent Crude oil price. In sum, what is the market saying about interest rates, inflation rates, real economic growth, and energy prices into the foreseeable future?
Answer 2
Private Equity and Venture Capital Firms:
Private Equity Firms is the equity shares ownership representative, or the interest representing for an entity and is not listed publicly. The financing comes from high worth companies and individuals. Venture capital, on the other hand, is the financing that is provided to small businesses that are seen to have some potential to break out. The funding comes from other financial institutions, investors and banks.
Alternative Asset:
Venture capital is considered an alternative asset as this is a more unexpected option for investment and less traditional.
10-20 Year US Treasury bonds:
The 10-20 year US treasury bonds interest rates have been falling. The investors, when becoming nervous, purchase the government bonds. This led the fixed interest rates for the bonds to fall. Thus, the falling interest rate of the US Treasury bonds is showing that there could be some concern for an upcoming recession. In terms of inflation, inflation has also been declining, which is also a concerning fact.
USD Exchange:
The USD Euro Exchange rate as per the weekly chart shows that EUR/USD has moved to 1647 PIPS lower to 1.0898. This bearish move is aligned with the wave of the first Elliot. And it is at the end of the weekly cycle. Overall, the currency pair is swinging upwards because of the US-Sino trade talks.
Brent Crude Oil Price:
The price for Brent Oil is up by 1.98%. The prices of crude oil declined in the first week but then became stable. The attack on the Iranian oil tanker has aided the market to rise.
Market Analysis:
Overall, the bond market, its interest rates, and inflation are giving hints of an upcoming economic crisis. On the other hand, the US exchange rate market is showing the bearish trend because of the ongoing trade wars, Brexit hope, and other economic problems. The Brent Oil prices are also depicting the pressure from which the market is recovering.
3) Can a derivative security’s value be determined by an underlying single stock (e.g., IBM, MMM, GE)? If no, explain. Can a derivative security’s value be determined by an underlying fixed income index? If yes, explain. What is the difference objective, if any, between a long futures contract, a put option contract, and a long forward contract? What are the two primary functions of derivative securities (i.e., what classifications of participants do they serve)? Finally, what does “market efficiency” suggest?
Answer 3
Derivatives:
The derivatives are financial security, which is dependent on the underlying assets. These derivatives deriving their prices from the changes in the prices of the underlying assets. If a derivative is reliant on one stock, then its price can be determined from the single stock; however, for a group of stocks, only one stock cannot yield information about the derivative price.
Fixed Income Derivative:
The fixed income derivatives value is derived from fixed income securities. Thus, a derivative or security can be derived by the underlying fixed income index.
Long futures Contract:
The long futures contract is the position that offers unlimited risk and unlimited profits position offered by the speculator of the future to gain profit from the increase in the price of the underlying asset.
Put Option Contract:
An option contract in which the person is holding the security is given the right to sell a security at a specific quantity at a particular price within the period specified.
Long Forward Contract:
It is the position in a forward contract in which the investor agrees to purchase the underlying asset at a specific price at a specific date.
Functions of Derivative Securities:
- It enables improvement in the liquidity of the underlying asset
- It also serves as a hedging instrument.
Market Efficiency:
Market efficiency suggests that the prices of the efficient market reflect all of the relevant and all available information, which makes it impossible for the market securities to be under or overvalued.
4) Explain the significant advantage and disadvantage of Inflation Protected Treasury Bonds (TIPS). Who or what investor would likely prefer a municipal bond issued by the Commonwealth of Virginia? If a corporate bond yields 8%, to be competitive (e.g., indifferent), what would a municipal bond need to yield for an investor in the 40% tax bracket? In municipals, what, if any, is the difference between a general obligation and revenue bond? What is a pass-through security, a conforming mortgage, and a collateralized mortgage obligation?
Answer 4
TIPS Advantage and Disadvantage:
The main advantage of TIPS is it may increase in value during periods of inflation as well. On the contrary, its main disadvantage is that it is affected by the changes in the real interest rate significantly.
Municipal Bonds:
Investors who are looking to hold several tax advantages would prefer the municipal bonds. The rate of default is also very low for municipal bonds. The bonds preserve capital and generate interest.
Marginal Tax Rate:
Corporate Bonds Yield X (1-Tax Rate) = Municipal Bonds Yield
Municipal Bonds Yield= 8% x (1-40%)
Municipal Bonds Yield= 4.8%
Revenue Bonds and General Obligation Bonds:
The general obligation bonds are backed with credit and full faith of the issuer, while the revenue bond is the one in which the interest and principal of the bond are paid from the source of the revenue that is pledged to the bond.
Pass-through security:
It is a pool for the securities of fixed income, which are based on the package assets.
Conforming Mortgage:
The conforming mortgage is the loan that is aligned with the GSE or the Fannie Mae and Freddie Mac guidelines.
Collateralized mortgage obligation:
It’s the security which is mortgage-backed containing the mortgages bundled together and sold as investment.
5) What does “residual risk” imply with respect to common stock? To corporate debt? What does the strike price imply with respect for a call option and a put option? What does an exercise price imply? If an investor owns a put option with a per-share strike price of $50 and the stock is selling at $48, what, if anything, is the option worth at expiration? If the investor paid a $2 per share premium for the put, what is his/her profit? Explain. What, if any, is the real difference between the capitalization rate in real estate, the yield to maturity in fixed income, and the required return in equities?
Answer 5
Residual Risk:
The residual risks are the risks for loss after all the other remaining risks are covered. In terms of Common stock, this residual risk is very low as the risk is spread over the claimants of the stock. In terms of corporate debt, it is company-specific and is because of the outcomes of legal proceedings, natural disasters or strikes.
Strike Price for Put and Call option:
For call options, the strike price is the price at which the security is bought by the holder of the option, while for the put option, the strike price is the price at which the holder of the put option can sell the security.
Exercise Price:
It is the price at which the holder of the option can buy or sell the option or security.
Put option worth at Expiration Date:
The exercise price – the stock price = Worth of Put option at Expiration = (50-48) = $2
Profit of Investor on Put option:
Profit is $200 as $2 per share premium x by the 100 shares per option gives a profit of $200 per option.
Difference between Capitalization rates, YTM, Required Return:
The capitalization rate is similar to the yield as it is the percentage which an investor gets by dividing the operating income of real estate with the price of the estate. The YTM is the percentage investor receives when it holds onto something. The Required return is the required return, which security needs to have to make it NPV near zero.
6) What is an initial public offering (IPO)? What is the longer-term return record of initial public offerings? Have IPOs generally been good long-term investments? Have IPOs generally been good short-term investments? What does the history of electronic trading suggest about the path of bid-ask spreads in securities? What are bid-ask spreads? Who gains from bid-ask spreads; who loses? What is your opinion of the impact of algorithmic trading on overall market liquidity?
Answer 6
Initial Public Offering:
It is the procedure of going public of a private company by selling its stock to the public.
Long Term Performance of IPOs:
The study conducted on 9000 stocks that went under IPO since 1968 showed that the IPOs performed lower than the market by 2 to 3% on average per year.
IPOS, Long term, or Short-Term Investments:
IPOs are considered as more of short-term investments as it can give well enough starting gains; however, in terms of long-term gains, the benefits are lower than the market returns.
Electronic Trading and Ask-Bid Spread:
Electronic trading has shown evidence for the decline in the bid-ask spread, after the control of the changes in the trading volume and price volatility.
Bid/ask Spread:
It is the difference between the price that the buyer is willing to give and the lowest price which the seller is willing to accept for an asset.
Gain and loss of the Bid/Ask Spread:
The broker or the specialist handling the transactions gains the spread. No one loses in terms of the spread.
Algorithm trading effect on Market Liquidity:
The bid/ask spread is expected to increase with the use of algorithm trading; however, the market depth does not fall after the announcements of the earnings, as is expected in the pre-AT periods.
7) What is margin? Why is margin potentially attractive to an investor? If an investor purchases a stock that appreciates from $40 per share to $60 per share over that six-month period, what is his/her return with 50% margin? Assume a 5% annual interest rate on the margin. What is the return assuming no margin? What is his/her return if the stock depreciates from $40 to $20 (assuming the same annual interest rate on margin)? What is the return assuming no margin?
Answer 7
Margin and its attractiveness to investors:
A margin is the money that is borrowed to buy an investment from a brokerage company. The money is the difference between the loan amount taken from the broker and the total value of the securities held by the investor. It is like borrowing money to buy any securities. It is attractive for the investors because it gives them access to broker money and it confers higher profit potential as compared to traditional trading.
Profit on 50% Margin:
Stock price = $40
Margin =50% = 50%x 40 = 20
Interest Rate =5%
6 months interest rate = 20 x 5% x 6/12 = 0.5
Profit – interest = (60-40)-0.5 = 19.5
With no Margin:
Profit – Interest = 60-40 = 20
Depreciated to $20 and Margin of 50%:
= (20-40) -0.5 = -20.5
Depreciated to $20 and Margin of 0%:
= (20-40) = -20
8) What is a short sale? What might be contended with respect to short sales and market efficiency? What is an investor’s profit or loss if he/she shorts a stock at $40, it appreciates to $60, and then depreciates to 20%? What does the potential distribution of profits and losses look like for any short sale?
Answer 8
Short Sale:
It is the sale in which the investor is borrowing the stock and then within minimum time selling it to scoop immediate gains and then returns it back to the lender, after pocketing the gains. It is very riskier in nature as compared to long position.
Short Sale and Market Efficiency:
The investors have considered the short sale as ethical. Even though the practice of short sale is indicative of someone’s misery and even though it aids in the depression of the share price of a successful company, academics, and the analysts consider that the short sale results in market efficiency.
Profit on Short Sale:
Stock = $ 40
Appreciates to =$ 60
Depreciates to = 20%
Investor Profit =
Depreciates to = 20% x 60 = $12
Difference of Short Sale = (40-12) = $ 38
Profit = (38/40) =95%
Short Selling Profit & Loss:
The short sellers are in actual borrowing stocks, which they are not the owner from any of their broker accounts and selling it in the market at the current price. The short-selling aims to buy back these stocks when the price is down. This results in a profit for the short seller, which is more than the costs of borrowing the stocks. The stocks are then given back to the actual owners whose stocks value has declined.
9) With respect to mutual funds, explain what net asset value (NAV) is. What is a REIT? What are the usual cost categories that an investor will need to consider when investing in a mutual fund? Explain the link, if any, between the historical underperformance of individual investors and these mutual fund costs. Does the taxation of mutual fund returns and transaction costs exacerbate or alleviate the underperformance? Explain. In your opinion, why do investors, given the empirical evidence, continue to invest in active equity mutual funds?
Answer 9
Net Asset Value:
The net assets value for a mutual fund is the value of the asset minus the value of the liabilities per unit of the fund. It is the value that is associated with the mutual funds and enables the investors to determine if the mutual fund is over or undervalued.
REITs:
The Real Estate Investment Trust is also known as real estate stocks. These are in actual a corporation that owns, finances, and operates the income-producing real estates or properties. REITs give the investors the chance to own and operate real estate as their investment portfolio. The REITs provide the investors the opportunity to have a share of the income of real estate ownership without actually buying the property.
Costs of Mutual Funds:
There are numerous costs associated with Mutual Funds, which the investors need to consider before investing. The expense ratio is the cost of the management or operating of the mutual funds. Similarly, another cost that is associated with the mutual funds is the commission or the sales charge which is also known as the front-end load. Another important cost to consider is that of the redemption fees. This is also known as the bank end load. Service, fee, 12 b fees, distribution fees are some other fees that the financial services company charge against the marketing of the fund. The short-term trading fees are another important fee which is charged to discourage the investors from trade in and out of the funds as its main goal is long term investment.
Individual Investors and Mutual Funds Costs:
Stocks are a much riskier investment as compared to mutual funds. The mutual funds tend to be managed by an active manager who is working to outperform the index or matches its returns. Thus, the costs of the mutual funds are higher as compared to the individual investing costs. The individual stocks tend to usually outperform as compared to the mutual funds, even though the costs of the mutual funds are higher.
Taxation and Transaction Costs:
The high transaction costs, the management fees, the underperformance of the funds, along with the taxation costs make asset management a highly expensive practice. Numerous active fund managers are trying to come up with strategies that aid the investors in keeping higher percentage of their returns. This is done by managing not only the performance of the fund but also for the operational efficiency and taxation costs coverage. Therefore, it can be said that it has worsened the underperformance of the funds.
Why investors keep investing in Actively Managed Funds:
There is a strong body of evidence which has shown that actively managed funds underperform as compared to passive funds. However, still, investors invest actively inactive managed funds. The reason is found to be a lack of financial sophistication. The investors of the mutual funds are unaware of the risks and returns of the funds. Similarly, investors become overconfident in terms of their abilities, which causes them to invest in actively managed funds.
10) What are ETFs? List two emerging markets ETFs and two leveraged short ETFs (from any markets). What are one advantage and disadvantage of ETFs? What was Sarbanes-Oxley designed to address? Yes or no: Sarbanes-Oxley, by all accounts (e.g., political, economic, and financial), eliminated the need for the Securities and Exchange Commission (SEC).
Answer 10
ETFs:
Exchange-traded funds are the collection or basket of securities which is traded on an exchange like stocks. It tracks an index. An example is SPDR, which tracks the S&P 500 Index.
Emerging Markets ETFs and Leverage Short ETFs:
- Vanguard FTSE Emerging market ETF
- iShares JP Morgan USD Emerging Markets Bond ETF
- BIS – ProShares UltraShort NASDAQ Biotechnology
- DGLD – VelocityShares 3x Inverse Gold ETN
Advantage and Disadvantage of ETFs:
The advantage is that it diversifies by giving exposure to several market segments and equities. The disadvantage is that in comparison to other funds, the trading costs of ETFs are very high.
Sarbanes-Oxley Act:
This act was designed to address the overseeing of the financial reporting functions of finance and to review the legislative framework for the audit requirements and to provide protection to the investors by improving the reliability and accuracy of the disclosures of the companies.
Securities Exchange Commission:
No
11) Explain the link between nominal and real rates. Who is Irving Fisher? Why are the effective annual rate (EAR) and annual percentage rate (EFF) necessary in financial discussions? Link the EAR and EFF in an equation, labeling the components. Why should one care to learn about continuous compounding (with respect to financial mathematics)? Explain the significance of table 5.2 (page 125) with regard to today’s interest rate environment. Intuitively, explain the rationale for “scenarios” in the calculation of expected returns.
Answer 11
The link between nominal and real rates:
The real rates are the nominal rates, which are adjusted for the inflation rate as well.
Irving Fisher:
He was an economist who described the link between the nominal and real interest rates in terms of inflation.
EAR and APR:
Effective Annual Rate is the interest rate that is adjusted for the compounding of the periods. The Annual Percentage Rate, on the other hand, does not take the compounding factor into account and is based on simple interest rate. It is important to consider both in financial decisions as it shows if the data series compounding effect is taken into consideration or not.
Here,
EAR=(1+(APR/N)N)-1
EAR is the Effective Annual Rate
APR is the Annual Percentage Rate
N is the number of compounding periods per year
Importance of Compounding Interest:
Consideration of compounding interest is important as it provides the investors with knowledge about the interest that they are going to be paying or collecting. The compounding practice enables the profit to be earned not only on the principal amount but also on the interest payable amount, making it larger than the main principal amount.
Figure 5.2:
The table of 5.2 shows the annualized average rates for T-Bills, inflation, Real T-Bills for all months for the period 1969 to 2012, its recent half, and it’s the first half. It also shows the standard deviations for these particulars for the same periods. In terms of the economic environment, the recent half shows a higher rate for the T-bill as the economic environment has become more unpredictable and volatile. This is also evident in the higher standard deviation in the recent half as compared to all months and first half.
Scenario Analysis:
The scenario analysis allows for the analysis of possible future events and alternative outcomes, which are expected. In financial perspective, it is very beneficial as it provides the forecasting as per various scenarios of the economy and financial markets, resulting in different returns for the investors.
12) If one calculated a standard deviation of 18.38% for a security with an expected return of 9.19%, how would one explain the importance and message of these statistical moments to a political science major? What does skew and kurtosis add, if anything, to the distribution discussion? Link the concept to a “black swan” event to this discussion. Finally, what is the definition of an excess market return in the equity markets?
Answer 12
Standard Deviation:
As per the question, the expected return of a security is 9.19% while its standard deviation is around 19%. To an audience of political science majors, I will explain it using the Sharpe Ratio. I will tell them that by using the Sharpe Ratio, one gets the value of the return for the risk taken. Similarly, the standard deviation is also the measure that shows how far the returns can be from the expected figure. Thus, the 19% standard deviation shows how much far the results can be in terms of the expected returns.
Skew and Kurtosis
Skew is the measure that shows the asymmetry of data or the deviation of the data from the normal distribution that is the bell curve. The right skewed data implies that the risk is overestimated while the left-skewed data shows that the risk is underestimated. Kurtosis is the measure used for fat tails or the probability measurement of tails of the normal distribution.
Black Swan:
The black swan shows the events which are highly unpredictable and not within the expected lines; the example of the 2008 financial crisis can be one of black swan.
Excess Return:
It is the difference between the actual free rate and the rate of return on a high-risk asset.
13) Under what circumstances would one apply degrees of freedom to the variance and standard deviation formulas? With respect to standard deviation and variance, what happens to the degrees of freedom modifier when the n increases materially? How should one interpret the Sharpe ratio, and why is it important (i.e., what investment elements does it link)?
Answer 13
Degrees of Freedom:
The calculation of the degrees of freedom helps in the determination of the critical value at which a hypothesis is accepted or rejected. The degree of freedom is used to achieve the level of confidence aimed in tests.
Change in Degree of Freedom:
The change in the value of “n” would eventually increase the degrees of freedom as the degrees of freedom have the formula of “n-1”.
Sharpe Ratio:
The Sharpe ratio shows how much excess of the return the security is going to earn for the excess volatility or risk that it bears. It is important as it aids in the decision making of the investors. The high value of the ratio shows that there are higher returns of the investment. The elements of the Sharpe ratio include.
S (x)= ((r_x-R_f ))/((StDev(r_x))
X = investment
Rx = the mean rate of return x
Rf = Best available rate of return for T-Bills
StDev (x) = Standard Deviation of Rx
14) Discuss this statement: The probability of a shortfall is an incomplete measure of investment risk. (Hint: is it complete, or is it missing an element?)
Answer 14
The use of the probability of shortfall as the measure for the assessment of risk gives the investor some disadvantages. The choice of the benchmark in this measure is arbitrary. Furthermore, for a portfolio of bonds, this measure does not give information on the potential downside of the returns when the benchmark is exceeded and the upside returns, which are above the level of the benchmark. Thus, it is incomplete.
15) Explain the importance of figure 5.12 on page 159. In particular, what does the inset suggest to the risk-averse investor? Explain why lognormal mathematics is used with security returns, especially with, but not limited to, exercises that may involve continuously compounding.
Answer 15
Figure 5.11:
Figure 5.11 shows directions of the wealth indices for the 25-year investment in large stocks and its possible outcomes as compared to the average outcome for wealth indices of T-Bills. The range of the outcomes is from worst, representing bottom 1% to 5% of their terminal values to mean and the median values of terminal values. The graph shows clearly that the stocks do not become less risky with time. This is evident from the 5% bottom which has resulted in a substantial shortfall as compared to the T-Bill index.
Log-Normal Distribution:
The lognormal distribution is used to explain the distributions of the financial assets like share prices or returns. It is used because asset prices are never negative. The lognormal distribution is better suited to the stock prices because the returns of the stock when constantly compounded become normally distributed, and the prices of the stocks then follow log-normal distribution.
