Lecture 1
1. What is a financial market?
A financial market is a platform or system where individuals, institutions, and
entities can buy and sell financial assets, such as stocks, bonds, currencies,
derivatives, and commodities. It provides a mechanism for participants to trade
these assets, establish their values, and facilitate capital allocation and risk
management.
2. Give several examples of financial markets.
Stock market: a stock market is where shares of publicly traded companies
are bought and sold, allowing investors to become partial owners of those
companies.
Bond market: The bond market is where debt securities, such as government
bonds, corporate bonds, and municipal bonds, are bought and sold. It allows
entities to raise capital by issuing debt and investors to earn interest income.
Commodity Market, Derivatives market, Foreign Exchange Market.
3. What is security?
A security is a financial instrument that represent a tradeable financial asset. It
is a legal claim on an entity, typically issued by corporations, governments, or
other organizations, and it can be representing ownership (equity securities) or
debt (debt securities). Securities are bought and sold in financial markets and
provide investors with various rights, such as ownership rights, income rights,
or repayment of principal.
4. How has the security exchange/trading changed over time?
The security exchange and trading landscape has undergone significant
changes over time. Some key changes include:
Electronic Trading: The advent of electronic trading platforms has
revolutionized securities exchanges. It has replaced traditional floor trading
and manual transactions with computerized systems, allowing for faster and
more efficient order matching, increased transparency, and broader market
access.
Globalization: Advances in technology and communication have facilitated the
globalization of securities trading. Investors can now easily access and trade
securities in markets around the world, leading to increases cross-border
investments and integration of global financial markets.
Regulatory Change: Regulatory frameworks have evolved to adapt to market
developments and protect investors. Regulatory bodies have implemented
measures to enhance transparency, prevent market manipulation, ensure fair
trading practices, and safeguard the integrity of financial markets.
High-Frequency Trading: The rise of HFT has brought about new trading
strategies and increased market liquidity. HFT involves the use of powerful
computers and algorithms to execute trades at incredibly high speeds, often
taking advantage of small price discrepancies and short-term inefficiencies.
Innovation in Financial Instruments: The introduction of new financial
instruments, such as exchange-traded funds (ETFs), options, and structured
products, has expanded the range of investment opportunities for traders and
investors. These instruments offer different risk profiles and investment
strategies, allowing for greater diversification and customization of portfolios.
5. What are the differences between money markets and capital markets?
Money Market: The money market is a sector of the financial market where
short-term debt securities with maturities of one year or less traded. Its primary
deals with highly liquid and low-risk instruments, such as Treasury bills,
certificates of deposits, commercial paper, and short-term government bonds.
Money markets facilitates borrowing and lending for short durations and
provide a means for managing short-term liquidity needs.
Capital market: The capital market is a segment of the financial market where
long-term securities with maturities exceeding one year are bought and sold.
Equity securities (stocks) and debt securities (bonds) issued by corporations
and governments to raise capital for long-term investment projects. The capital
market allows companies and governments to finance their operations and
growth while providing investors with opportunities for long-term investment
and income generation.
6. What is the role of financial markets?
Allocation of capital: Facilitates the efficient allocation of capital by connecting
savers and investors. Enable savers to channel their funds to productive
investments, providing capital to businesses, governments, and individuals
who require funds for various purposes.
Price Discovery: Platform for determining the prices of financial assets.
Through the forces of supply and demand, market participants collectively
establish the value of securities, currencies, commodities, and other financial
instruments based on available information and market conditions.
Risk management: Financial markets provide tools and instruments for
managing risk. Investors can hedge against price fluctuations, interest rate
changes, or currency movements through derivatives and other risk
management products available in financial markets.
Liquidity Provision: Offers liquidity, allowing investors to buy or sell financial
assets with relative ease. Liquidity enhances market efficiency and ensures
that investors can convert their investments into cash when needed.
Facilitation of Economic Growth: Financial markets provide a crucial role in
promoting economic growth by providing capital for investment and
entrepreneurship. They support the expansion of businesses, job creation,
technological innovation, and infrastructure development.
7. What does a utility function represent? Why do we use utility functions
in finance?
Utility function represents an individual’s or investor´s preferences for different
levels of wealth or consumption. It assigns a numerical value or utility to each
possible outcome or level of wealth. Utility functions capture an individual’s
risk aversion, time preferences, and overall satisfaction or well-being
associated with different wealth levels.
We use it in finance to model and analyze investor behavior and decisionmaking under uncertainty. By quantifying an individual´s preferences and
trade-offs between risk and reward, utility functions help assess the
attractiveness of different investment options and enable optimization of
investment portfolios. It provides framework for understanding risk tolerance,
determining optimal asset allocations, and evaluating the expected utility or
satisfaction derived from different investment strategies.
8. First derivative of the utility function is positive. What does it tell us
about investor preferences?
It indicates that the marginal utility of wealth or consumption is positive. This
means that as wealth or consumption increases, the additional satisfaction or
utility derived from each additional unit of wealth is positive. It suggests that
individual’s preferences exhibit diminishing marginal utility, where the increase
in satisfaction from additional wealth becomes smaller as wealth increases.
Positive marginal utility of wealth is consistent with risk aversion, as individual
tend to value additional wealth more when they have less of it.
9. Why do we assume that second derivative of the utility function is
negative?
This assumption reflects the concept of diminishing marginal utility of wealth or
consumption. It suggest that as individual’s wealth or consumption increases,
the additional satisfaction or utility gained from each additional becomes
smaller.
10. What is an indifference curve?
An indifference curve is a graphical representation that shows different
combinations of two goods or attributes that provide the same level of utility or
satisfaction to an individual. Points along an indifference curve represent
bundles of goods or attributes that are considered equally preferable or
indistinguishable in terms of the individual’s utility. The slope of an indifference
curve reflects the rate at which one good or attribute can be substituted for
another while maintaining the same level of utility.
11. What does consumption smoothing mean? Does everyone want to
smooth his/her consumption?
Consumption smoothing refers to the practice of maintain a relatively stable
and consistent level of consumption over time, even in the face of varying
income or windfalls and dis-saving or borrowing during periods of lower
income or financial constraints. Consumption smoothing aims to avoid sharp
fluctuations in consumption levels and to ensure a more consistent standard of
living.
Not everyone necessarily wants to smooth their consumption. It depends on
individual preferences and circumstances. Some individuals may prioritize
immediate consumption and prefer to spend more when they have higher
income or windfalls, even if it means experiencing fluctuations in their
consumption levels over time. Others may value stability and prefer to smooth
their consumption, even if it requires scarifying some immediate spending.
12. Explain what risk sharing is.
Risk shares refers to the practice of distributing or transferring risks among
individuals or entities to reduce the potential negative impact of risk. In the
context of finance, risk sharing involves mechanism or arrangements that
allow individuals or organizations to pool and share risks, thereby reducing the
overall exposure to any single risk. By sharing risks, the burden and potential
losses associated with adverse events are spread across multiple parties,
enhancing risk mitigation and providing a degree of financial protection.
Risk sharing can occur through various means, such as insurance contracts,
financial derivatives, diversification of investments, or social safety nets. It
plays a crucial role in promoting economic stability, ensuring the availability of
funds in times of need, and facilitating efficient allocation of resources by
allowing individuals and organizations to undertake riskier activates with
reduced individual risk exposure.
13. How is investors impatience reflected in the utility function?
Investor impatience is typically reflected in the utility function through a higher
discount rate or lower coefficient of risk aversion. A higher discount rate
implies that the investor places a higher weight on present consumption
compared to future consumption. This reflects a preference for immediate
gratification and a lower willingness to delay consumption or wait for future
benefits. A lower coefficient of risk aversion indicates a higher tolerance for
risk and a greater willingness to accept uncertain outcomes in exchange for
potentially higher returns.
14. Give a real-life example of risk sharing.
Insurance. When an individual purchases an insurance policy, they transfer
the risk of potential losses or damages to the insurer in exchange for paying
premium. If an insured event occurs, the insurer bears the financial burden by
compensating the policyholder for the losses. Insurance allows individuals to
share the risk associated with unforeseen events, providing financial
protection and reducing the potential impact of individual finances.
15. Give a real-life example of consumption smoothing.
Retirement savings plan. Many got retirement saving accounts, such as 401(k)
throughout their working lives. These contributions serve the purpose of
saving and investing a portion of current income to ensure a astable and
consistent level of consumption during retirement. By saving and investing
over the long term, individuals can smooth their consumption patterns and
maintain a desired lifestyle even when they are no longer actively earning
income.
16. What are the typical features of an investors? (In terms of preferences)
Risk aversion: Investors generally exhibit some degree of risk aversion,
meaning they prefer lower levels of risk and uncertainty. Willing to accept
lower expected return in exchange for reduced risk.
Time preferences: Investors have varying time preferences, indicating their
preference for immediate consumption vs. future consumption. Some
investors may be more impatient and prioritize immediate consumption, while
others may be more patient and willing to delay consumption for future
benefits.
Diversification: Investors often prefer to diversify their portfolios to spread risk
and reduce exposure to any single investment. Diversification allows them to
achieve a balance between risk and return by investing in different asset
classes, industries, or regions.
Profit maximization: Many investors seek to maximize their profits or returns
on investment. They aim to allocate their resources in a way that maximizes
the expected return given their preferences.
Utility maximization: Investors aim to maximize their overall satisfaction or
utility derived from their investment decisions. They consider not only financial
returns but also personal preferences, goals, and constraints when making
investment choices.
17. How do financial markets help with communication?
Price Discovery: Financial markets provide a mechanism for determining the
prices of financial assets. Through the process of buying and selling, market
participants collectively establish the value of securities, currencies,
commodities, and other financial instruments.
Information Transmission: Financial markets act as a conduit for the
transmission of information. News, economic indicators, corporate earnings
reports, and other relevant information are quickly incorporated into assets
prices. Market participants, through their actions, react to and incorporate new
information, contributing to efficient price formation and information
dissemination.
Risk assessment and disclosure: Financial markets provide a platform for
companies, governments, and other entities to raise capital by issuing
securities. As part of this process, these entities are required to disclose
relevant financial and non-financial information to investors. This disclosure
facilitates risk assessment and allows investors to make informed investment
decision based on available information.
Investors relations: companies communicate with their shareholders and
potential investors. Through public disclosures, annual reports, investor
presentations, and shareholders meetings, companies can update investors
on their performance, strategies, and future. This communication helps build
trust, transparency, and investor confidence.
18. How can financial markets contribute to productivity and economic
growth?
Efficient capital allocation: financial markets connect savers with borrowers
and investors with investment opportunities. Provides a platform for
companies, governments, and individuals to raise funds for productive
investments, such as business expansion, research and development,
infrastructure development, and tech innovation.
Risk management: financial markets enable individuals and organizations to
manage and transfer risks. Provide instruments such as insurance,
derivatives, and hedging strategies that allow market participants to mitigate
risk associated with price fluctuations, interest rate changes, currency
movements, and other uncertainties. Effective risk management reduces
uncertainty and promotes stability.
Encouraging saving and investments: financial markets provide access to
capital for start-up ventures, small and medium-sized enterprises, and
innovative projects.
Liquidity and market efficiency: Financial markets provide liquidity, allowing
investors to buy or sell financial assets with relative ease. This liquidity
ensures that capital is readily available and can be efficiently deployed in
productive activities. Moreover, liquid and efficient markets enhance price
discovery, reduce transaction costs, and facilitate the flow of information,
making it easier for investors to make investment decision and allocate
resources effectively.
Lecture 2
1. Why do we tend to assume that prices represent the fair value of a
stock/securitiy?
There are several reasons why people tend to assume that the price of a stock
or security represents its fair value:
Market efficiency: the idea of market efficiency suggests that all available
information is quickly and accurately reflected in stock prices. This means that
if a stock is trading at a certain price, it must be the fair value because all
market participants have access to the same information and have already
taken it into account when making their trading decisions.
Supply and demand: The basic economic principle of supply and demand
suggests that when there is high demand for a stock, its price will rise until it
reaches a point where the supply meets the demand. This implies that if a
stock is trading at a certain price, it must be because there are enough buyers
and sellers who are willing to trade at that price, indicating that it is the fair
value.
Historical prices: People may also use historical prices as a benchmark for
determine the fair value of a stock. If a stock has traded at a certain price
range for extended period, people may assume that it represents its fair value.
2. Describe mean-variance utility. What does it tell us about investor’s
preferences
Mean-variance utility is a concept in finance and economics that aims to
explain investors make investment decisions based on their preferences for
expected returns and risk.
In simple terms, mean-variance utility is a measure of the average return an
investor expects to earn on their investment (the mean) and the degree of
uncertainty or risk associated with the return (the variance). An investor´s
mean-variance utility function represents their preferences for these two
factors when making investment decisions.
The mean-variance utility function is used to construct the efficient frontier,
which is a curve that represents the optimal combination of risk and return for
a given set of investments. The efficient frontier shows that investors can
achieve higher expected returns by taking on more risk, but only up to a
certain point. Beyond that point, the additional risk does not result in higher
returns.
Investors who have a higher level of risk aversion tend to prefer investments
that have lower variance (or volatility) and lower expected returns. On the
other hand, investors who are more risk-tolerant tend to prefer investments
with higher variance and higher expected return.
3. What is risk aversion? Is it the same for everyone?
Risk aversion refers to a behavioral bias or preference for avoiding or
minimizing potential losses or uncertainties when making decisions involving
irks. Risk-averse individuals typically prioritize the preservation of their wealth
or assets and are willing to accept lower expected return in exchange for a
reduced level of risk.
Risk aversion is not the same for everyone. Different individuals have varying
degrees of risk tolerance or aversion based on their personal circumstances,
financial situation, psychological makeup, and individual preferences. Some
individuals may have a high tolerance for risk and are more comfortable taking
on greater risks, while others may be extremely risk-averse and prefer to avoid
any possibility of loss.
4. Would a risk-averse person buy a lottery ticket?
Generally, a risk-averse person would not buy a lottery ticket. Lotteries are
typically considered high-risk investments as the chances of winning are
usually very low, and the expected return value of the ticket is often negative.
Risk-averse investors would prioritize risk mitigation and would be inclined to
invest in low-risk or diversified assets with more predicable returns.
5. What does a no-arbitrage condition mean?
A no-arbitrage condition refers to a situation in financial markets where it is not
possible to make risk-free profits without investing any capital or taking any
risk. It is a fundamental principle in financial economics that assumes markets
are efficient and that there are no opportunities for investors to exploit price
discrepancies or imbalances to generate guaranteed profits without assuming
any risk.
6. Two securities trade at different prices on different exchanges.
Assuming there is no arbitrage on the market, describe how the
mispricing disappears.
If two securities trade at different prices on different exchanges in a market
where no arbitrage exists, the mispricing would eventually disappear due to
the actions of arbitrageurs. These arbitrageurs would exploit the price
difference by simultaneously buying the lower-price security and selling the
higher-priced security, aiming to profit from the price convergence. The
increased demand for the lower-priced security and the increased supply of
the higher-priced security would push their prices towards equilibrium until the
price difference disappears. This process is known as arbitrage and helps
ensure efficient market pricing.
7. What does it mean that a market is efficient?
An efficient market is one where prices of assets or securities reflect all
available information and adjust rapidly to new information. In an efficient
market, prices are believed to be fair and accurately represent the underlying
value of the assets. Investors cannot consistently generate abnormal profits by
exploiting any predictable patterns or information asymmetry.
8. Describe the three forms of market efficiency.
Weak form efficiency: In a weak-form efficient market, prices fully reflect all
historical price and trading volume information. In other words, past prices and
trading patterns cannot be used to predict future prices consistently. Technical
analysis techniques, such as chart patterns or trend analysis, are not expected
to provide an advantage in weak-form efficient markets.
Semi-strong efficiency: In a semi-strong form efficient market, prices reflect all
publicly available information, including not only historical price data but also
news announcements, financial statements, economic indicators, and other
publicly disclosed information. In this form, fundamental analysis techniques,
such as analyzing financial statements, are unlikely to consistently provide
abnormal returns.
Strong Form Efficiency: In a strong-form efficient market, prices reflect all
public and private information, including insider information. In this form, even
privileged or insider information does not provide an advantage as it is already
fully incorporated into the asset prices. Strong-form efficiency is considered
the most stringent form of efficiency and is rarely observed in practice.
9. Can a market be strong-from efficient but not weak form efficient.
Explain
No, a market cannot be strong-form efficient but not weak form efficient. If a
market is strong-form efficient, it means that all information, including both
public and private information, is already incorporated into assets prices. If this
is the case, it also implies that historical price and trading volume information
(which is a part of weak form efficiency) and public available information
(semi-strong efficiency) are already reflected in the prices. So, if a market is
strong-form efficient, it automatically implies that it is also weak-form and
semi-strong form efficient.
10. What can we say about asset prices if the market is efficient?
If the market is efficient, it suggests that asset prices are fairly valued and
reflect all available information. In an efficient market, it is generally believed
that it is difficult to consistently beat the market or generate abnormal profits
by trading on public information. Therefore, asset prices in an efficient market
are expected to be rational and difficult to predict based on historical prices or
publicly available information.
11. What is an abnormal return? Is it easy to earn it?
An abnormal return, also known as excess return, refers to the difference
between the actual return on an investment and the expected return based on
its risk and market conditions. It represents the portion of the return that
cannot be explained by systematic risk factors or general market movements.
Abnormal returns can be positive or negative, indicating performance that
deviates from what would be expected.
Earning abnormal return consistently is not easy. In efficient markets, where
prices reflect all available information, it is difficult to consistently outperform
the market and generate abnormal returns. Many investors and fund
managers actively try to identify mispriced assets or market inefficiencies to
earn abnormal returns, but achieving consistent success in this regard is a
complex and competitive endeavor.
12. What is the evidence on stock return predictability?
Evidence is mixed. While some studies have found evidence of short-term
predictability in stock returns based on factors such as past returns, earnings
announcements, or price patterns, the predictability tend to be weak and often
disappears after accounting for transaction costs and other factors. In the long
run, stock return is generally believed to follow random or unpredictable
patterns, suggesting that it is challenging to consistently predict stock returns
based on historical data or public available information.
13. How can capital constraints lead to arbitrage opportunities?
Capital constraints can lead to arbitrage opportunities when certain investors
or market participants are unable to fully exploit mispricing or imbalances in
the market due to limited capital resources. If an asset is mispriced, but
investors with the ability to correct the mispricing lack the necessary capital to
take advantage of it, the mispricing may persist until other investors enter the
market or capital constraints are lifted. This delay in capital deployment
creates an opportunity for arbitrageurs to step in and profit from the price
discrepancy.
14. How can transaction costs lead to arbitrage opportunities?
Transaction costs can also create arbitrage opportunities. When transaction
costs, such as brokerage fees or market impact costs, are high relative to the
potential profits from exploiting a price discrepancy, it may deter some market
participants from engaging in arbitrage activities. If the cost of trading to
correct the mispricing is higher than the potential gain, then the mispricing may
persist until transaction costs decreases or market condition change. This
creates an opportunity for arbitrageurs who can trade at lower costs or have
strategies to minimize transaction expenses to profit from the price
discrepancy.
15. Describe an investment strategy that can bring you momentum returns.
A common investment strategy that aims to capture momentum returns is
called momentum investing. This strategy involves buying assets or securities
that have exhibited strong positive price momentum and selling assets that
have shown weak price momentum. The underlying principle is that assets
that have recently performed well are more likely to continue performing well in
the short term, while assets that have underperformed are more likely to
continue underperforming.
Momentum investing typically involves identifying assets with positive price
trends over a specific period, such as several months or a year, and
constructing a portfolio that include these assets. The strategy relies on the
belief that market trends and investor behavior can persist for some time
before reversing. However, it´s important to note that momentum investing
carries risk, as momentum can reverse abruptly, and past performance is not
always indicative of future results.
16. Do anomalies contradict market efficiency?
Anomalies, which are persistent patterns or deviations from expected market
behavior, do not necessarily contradict market efficiency. Anomalies can exist
in efficient markets, but they are typically short-lived or may be explained by
risk factors or other economic phenomena. Market efficiency implies that asset
prices reflect all available information and adjust rapidly to new information.
However, it does not imply that market prices are always perfectly accurate or
that anomalies cannot exist.
Efficient markets can still exhibit temporary inefficiencies or pricing
discrepancies due to factors like investor sentiment, behavioral bias, liquidity
constraints, or limits to arbitrage. Anomalies are often subject of academic
research and provide opportunities for investors to exploit market inefficiencies
in the short term. The presence of anomalies does not invalidate the concept
of market efficiency, but it highlights that markets are complex and can exhibit
deviations from efficient pricing under certain circumstances.
Lecture 3 – CAPM
1. Does quick response of the stock markets to various news implies
market efficiency? Explain
The quick response of the stock market to various new does not necessarily
imply market efficiency by itself. Market efficiency refers to the degree to which
stock prices reflect all available information about the underlying companies,
and there are three levels of market efficiency: weak, semi-strong and strong.
A weak-form efficient market reflects all historical price information, while a
semi-strong efficient market reflects all publicly available information, including
news and financial statements. Finally, a strong-form efficient market reflects
all information, both public and private.
While a quick repones to news may indicate that market participants are
processing information rapidly, it does not necessarily mean that the market is
efficient. For instance, if the news is misleading or incorrect the stock prices´
quick response may be a result of the market´s irrational or emotional reaction,
leading to market inefficiency.
Furthermore, market efficiency can be affected by a variety of factors, such as
trading costs, institutional constraints, and behavioral biases. Thus, market
efficiency cannot be inferred based solely on how quickly the market responds
to news.
2. What is an excess return?
An excess return, also known as an alpha, is the return on an investment or
portfolio that exceeds the return of a benchmark or index. It is a measure of a
portfolio´s performance that is attributable to the skill of the portfolio manager
or the effectiveness of the investment strategy, rather than market movements
or other external factors.
For example, if a stock portfolio generates a return of 10% while the
benchmark index returns only 8%, the excess return or alpha I 2%. This
means that the portfolio outperformed the benchmark index by 2%.
Excess returns are commonly used in evaluating the performance of active
investment managers. They are also used in academic research to test the
efficiency of financial markets and to determine whether investors can
consistently generate higher returns than what can be explained by market or
other factors.
3. What is an asset pricing model? What does it explain?
An asset pricing model is a financial model that explains the relationship
between expected return and risk of an asset or portfolio of assets. The model
attempts to explain the price or value of an asset based on various factors
such as the asset´s risk, expected future cash flows, and other economic
variables.
Asset pricing models are used to help investors and financial analysts
evaluate the attractiveness of an investment by estimating the expected
return, given its risk and other relevant factors. Most popular assets models
are CAPM and APT.
4. Why do we need asset pricing models?
Investment decision making: Asset pricing models provide a framework for
investors to evaluate the expected return and risk of different investments. By
estimating the expected return on an asset or portfolio, investors can make
more informed investment decision and better allocate their investment capital.
Portfolio management: Asset pricing models help portfolio managers to
construct portfolios that maximize return while minimizing risk. By
understanding the relationship between risk and return, portfolio managers
can create a well-diversified portfolio that meets the investment objectives of
their clients.
Risk management: Asset pricing models are also used in risk management to
measure and hedge against various types of risks, including market risk, credit
risk and interest rate risk.
Financial research: Asset pricing models are widely used in academic
research to test the efficiency of financial markets, to examine the impact of
various factors on asset prices, and to develop new investment strategies.
Overall, asset pricing models play a critical role in the investment process,
providing a framework for understanding the risk and return trade-off off
different assets and for estimating the expected return on asset based on it
risk and other relevant factors.
5. What does it mean that CAPM is a static model?
The Capital Market Pricing Model is a static model because it assumes that
the relationships between the variables in the model are constant and
unchanging over time. In other words, the model assumes that the risk and
return characteristics of an asset or portfolio will remain the same over the
investment period, and that the asset´s expected return will be determined by
its beta, the risk-free rate, and the market risk premium, regardless of the
market conditions or changes in the asset´s risk and return characteristics.
This assumption can be useful in certain situations where the asset´s risk and
return characteristics are stable, and there is not expectation of changes in the
future. However, in practice, the risk and return characteristics of an asset are
rarely static, and they are subject to change over time due to various factors
such as changes in the market conditions, changes in the company´s financial
condition, and other external events.
Thus, the static nature of the CAPM may limit its ability to provide accurate
estimates of expected returns for assets or portfolios, particularly in situations
where the underlying market conditions and assets characteristic are rapidly
changing. As a result, some research and investors have turned to more
dynamic models that can better capture the changing nature of market
conditions and asset risk and return characteristics, such as multi-factor
models, which incorporate additional factors such as size, value and
momentum.
6. How do investors optimize according to CAPM?
According to the CAPM, investors can optimize their portfolios by selecting
assets that provide the highest expected return for a given level of risk. The
optimal portfolio is one that lies on the efficient frontier, which is the set of
portfolios that provide the maximum expected return for a given level of risk, or
the minimum level of risk for a given expected return.
To optimize their portfolios, investors need to determine the expected return
and risk of each asset, as well as the correlation between assets. The
expected return of an asset is determined by its beta, which measures the
asset´s sensitivity to the market. The risk of an asset is measured by its
standard deviation or volatility.
Investors can use the CAPM to determine the required rate of return for an
asset, given its beta and the market premium. The market premium is the
excess return that investors require for investing in the stock market over the
risk-free rate.
Once the expected return and risk for each asset have been determined,
investors can construct an optimal portfolio that lies on the efficient frontier.
This portfolio provides the highest expected return for a given level of risk or
the lowest level for risk for a given expected return.
Investors can also use CAPM to evaluate the performance of their portfolios
by comparing their actual return to the expected return of their portfolio based
on the CAPM. If the actual return is higher than the expected return, the
portfolio has generated excess return or alpha, which is a measure of the
portfolio manager´s skill or the effectiveness of the investment strategy. If the
actual return is lower than the expected return, the portfolio has
underperformed.
7. According to CAPM, do all investors hold exactly the same portfolio?
No, the CAPM does not imply that all investors hold exactly the same portfolio,
In fact, the optimal portfolio for an investor depends on their individual
preferences and circumstances, such as their risk tolerance, investment
horizon, and liquidity needs.
However, the CAPM does suggest that investors with similar risk and return
expectations should hold similar portfolios, which would be determined by the
intersection of their indifference’s curves and the efficient frontier. The
indifference curve represents the combination of risk and return that an
investor is willing to accept, and the efficient frontier represents the
combination of risk and return that an investor is willing to accept, and the
efficient fronter represents the set of portfolios that provide the maximum
expected return for a given level of risk, or the minimum level of risk for a
given expected return.
Therefore, under the assumptions of the CAPM, investors with same risk
tolerance and investment horizon, who share the same expectations about risk
and return of assets, will hold similar portfolios. However, the exact
composition of the portfolios will vary based on individual preferences and
circumstances, such as liquidity needs and tax considerations.
In practice, investors may have different views on the expected return and risk
of assets, and they may hold different portfolios based on their unique
circumstances and preferences. Therefore, the CAPM is a useful model for
understanding the relationship between risk and return for determining the
required rate of return for an asset, but it is not precise predictor of actual
investment behavior.
8. What does Capital Allocation Line represent?
The CAL is a graphical representation of the risk-return tradeoff for a portfolio
of risky assets and a risk-free asset. The CAL represents all the combinations
of the risk-free asset and a risky portfolio that provide a given level of expected
return for a certain level of risk. It also sometimes called the “reward-tovariability” ratio or the “efficient frontier”.
The slope of the CAL is known as the Sharpe ratio, which represents the
excess return per unit of risk for the portfolio. The Sharpe ratio is calculated as
the differences between the expected return of the portfolio and the risk-free
rate, divided by the standard deviation of the portfolio.
The CAL is derived by combing the risk-free asset with a portfolio of risky
assets to form a new portfolio that provides a higher expected return than the
risk-free asset for a given level of risk. The composition of the portfolio on the
CAL varies depending on the investor´s risk tolerance and preferences.
Investors can choose any portfolio along the CAL that suits their risk
preferences. For example, an investor who is more risk-averse may choose a
portfolio with a lower level of risk, such as one with a higher allocation to the
risk-free asset. On the other hand, an investor who is more risk-tolerant may
choose a portfolio with higher level of risk, such as on with a higher allocation
to the risky assets.
The CAL is an important tool for portfolio optimization because it shows the
risk-return tradeoff for different portfolios and allows investors to select the
portfolio that best meets their risk preferences and return objectives. It also
allows investors to compare the risk and return of their portfolios to the market
portfolio and to evaluate their portfolio´s performance.
9. How does risk aversion impact portfolio choice?
Risk aversion is an important factor that influences portfolio choice because it
reflects an investor´s attitude towards risk and their willingness to accept
uncertain outcomes. Risk-averse investors prefer portfolios with lower levels of
risk, while risk-tolerant investors are willing to accept higher levels of risk in
pursuit of potentially higher returns.
In general, risk-averse investors seek to minimize the potential downside of
their investments, and they prefer portfolios that provide a more predictable
stream of returns. They may allocate a higher percentage of their portfolio to
low-risk assets, such as government bonds or high-quality corporate bonds, to
reduce the overall level of risk.
On the other hand, risk-tolerant investors may allocate a higher percentage of
their portfolio to high-risk, high-reward assets, such as stocks or alternative
investments, in pursuit of potentially higher returns. They are willing to accept
the potential downside risk associated with these investments in exchange for
the possibility of higher returns.
Investors ‘risk aversion can be quantified through their utility function, which
represents the investor´s level of satisfaction or happiness as a function of the
potential returns and risk associated with their investments. The utility function
reflects the investor´s risk preferences and their willingness to trade off
potential returns for higher or lower level of risk.
Portfolio choice is also influenced by investor´s investment horizon, liquidity
needs, tax considerations, and other factors. Therefore, portfolio choice is a
complex decision that requires a careful assessment of the investor´s risk
tolerance, return objectives and investment constraints.
10. Write down the equation of the Capital Allocation Line.
CAL is a straight line that represents all the combinations of the risk-free asset
and a risky portfolio that provide a given level of expected return for a ceratin
level of risk. The equation of CAL is:


E(r_p) = rf + [E(r_m) – rf] * (𝜎_p/𝜎_m)
(market prem) (beta)
Where:
 E(r_p) is the expected return on the portfolio.
 Rf is the risk risk-free rate of return
 E(r_m) is the expected return on the market portfolio
 𝜎_p is the standard deviation (or risk) of the portfolio
 𝜎_m is the standard deviation (or risk) of the market portfolio
11. What defines the supply of assets in CAPM?
In the CAPM, the supply of assets is assumed to be infinite and that all
investors have access to the same universe of assets. This is known as the
“one-period, pure exchange economy” assumption, which simplifies the model
by assuming that all assets are tradable, and that investors can buy and sell
them freely without any transaction costs.
Under this assumption, the supply of assets is not a factor that affects the
equilibrium price of an asset, and the market is assumed to be in equilibrium at
all times. The equilibrium price of an asset is determined solely by the
interaction of the demand for that asset by investors with different levels of risk
aversion, and the expected return and risk of that asset relative to the overall
market.
In the CAPM, the market portfolio is assumed to include all risky assets, and
its supply is equal to the total supply of risky assets in the market. The market
portfolio is defined as the portfolio that includes all risky assets in the market,
weighted according to their market value. This means that the supply of assets
in the market portfolio is equal to the supply of all risky assets in the market.
Therefore, the supply of assets is not a key factor in the CAPM.
12. What is the market portfolio? According to CAPM, what special features
does it have
The market portfolio is a theoretical portfolio that includes all risky assets in
the market, weighted according to their market values. The market portfolio
represents the aggregate investment of all investors in the market and serves
as a benchmark for evaluating the performance of individual portfolios.
The market portfolio is assumed to have two special features in the CAPM.
First, the market portfolio is assumed to efficient, meaning that it provides the
highest expected return for a given level of risk. This assumption is based on
the idea that in a competitive market, all available information is reflected in
asset prices, and any portfolio that deviates from the market portfolio will not
offer a higher expected return without a commensurate increase in risk.
Second, the market portfolio is assumed to be the only portfolio that is
required for the purposes of portfolio selection. This is because the market
portfolio contains all risky assets in the market, and any other portfolio can be
considered a combination of the market portfolio and the risk-free asset. This
is known as the “two-fund separation theorem,” which states that any investor
can achieve the optimal portfolio by holding a combination of the market
portfolio and the risk-free asset.
These special features of the market portfolio in the CAPM have important
implications for portfolio theory and practice. The assumption of market
efficiency implies that it is not possible to consistently beat the market through
security selection or market timing, and that the optimal portfolio for any
investor is a combination for the market portfolio and the risk-free asset. This
simplifies the process of portfolio selection and provides a framework for
understanding the relationship between risk and return in a competitive
market.
13. What do we know about the market portfolio in equilibrium in CAPM?
In the CAPM, the market portfolio is the portfolio that contains all risky assets
in the market, weighted according to their market values. The market portfolio
is the benchmark portfolio aginst which all other risky assets are compared.
In equilibrium, the market portfolio is assumed to be efficient, meaning that it
lies on the efficient frontier, which is the set of portfolios that maximize
expected return for a given level of risk, or minimize risk for a given level of
expected return. This means that the market portfolio is the portfolio that
provides the highest expected return for a given level of risk, or the lowest risk
for a given level of expected return.
According to the CAPM, the expected return of a security is determined by its
beta, which is a measure of its sensitive to market risk. The beta of a security
is defined as the covariance between the security´s returns and the market
portfolio. Therefore, the market portfolio has a beta of 1, and the expected
return of any security is given by the risk-free rate plus the market risk
premium times its beta.
In summary, the market portfolio in equilibrium in the CAPM is the efficient
portfolio that contains all risky assets in the market and has a beta of 1.
14. What does Sharpe ratio measure? Why is it useful?
The Sharpe ratio is a financial metric that measures the risk-adjusted return of
an investment or a portfolio. Specifically, it measures the excess return earned
by an investment above the risk-free rate, relative to the amount of risk taken
to earn that excess return. The formula for calculating the Sharpe ratio is as
follows:
Sharpe ratio = (average portfolio return – risk free rate) / standard deviation of
portfolio return.
The Sharpe ratio is useful for comparing the performance of different
investments or portfolios, as it takes into account both the return and the risk
of the investment. A higher Sharpe ratio indicates that an investment is
earning a higher return for the amount of risk taken, while a lower Sharpe ratio
indicates the opposite.
The Sharpe ratio particularly useful in evaluating the performance of actively
managed investment funds, where the fund manager is actively selecting
investments with the goal of outperforming the market. By calculating the
Sharpe ratio of an actively managed fund, investors can determined whether
the fund is generating excess returns that are commensurate with the
additional risk taken on by the manager. Additionally, the Sharpe ratio can be
used to compare the performance of the fund to a benchmark index, such as
the S&P 500, to see if the fund is outperforming or underperforming the
market.
15. Write down the equation of the Security Market Line.
The security Market Line (SML) is a graphical representation of the CAPM,
which describes the relationship between the expected return and the risk of
an asset.

R= rf + beta * (rm-rf)

where
R is the expected return non asset



Rf is the risk-free risk of return
Beta is the systematic risk of the asset, which measure the asset´s
sensitivity to market risk
Rm is the expected return on the market portfolio.
16. Do all securities lie on SML? Discuss theory and practice.
According to CAPM, all securities should lie on the SML because the SML
represents the expected return for a given level of risk. The CAPM assumes
that the market portfolio includes all risky assets, and that investors hold a
diversified portfolio that includes the market portfolio.
In theory, the CAPM implies that the expected return of a security can be
determined by its systematic risk, which is measured by beta. The systematic
risk is the risk that cannot be diversified away by holding a well-diversified
portfolio. The CAPM assumes that the only risk that investors are
compensated for is systematic risk, and that securities with higher beta should
have a higher expected return to compensate for the additional risk.
In practice, however, not all securities lie on the SML. There are several
reasons for this:
Non-systematic risk: While the CAPM assumes that investors hold a welldiversified portfolio that eliminates non-systematic risk, in practice investors
may not be fully diversified. As a result, some securities may have higher or
lower returns than predicated by the CAPM due to their exposure to nonsystematic risk.
Market inefficiencies: The CAPM assumes that all investors have access to
the same information and make rational decision based on that information. In
reality, markets can be inefficient, and some investors may have access to
information that others do not, leading to securities having higher or lower
returns than predicated by the CAPM.
Factors not captured by beta: The CAPM assumes that beta captures all
relevant systematic risk factors. However, there may be other risk factors that
are not captured by beta, such as liquidity risk or political risk, which can affect
the returns of securities.
17. Discuss abnormal return in the context of the SML.
In the context of the SML, an abnormal return is a return on a security that is
different from what would be predicted by the CAPM. Specifically, an abnormal
return is the difference between the actual return on a security and the
expected return based on the security´s beta and the return on the market
portfolio.
If a security has a positive abnormal return, it means that the security has
earned a higher return than what would be expected based on its systematic
risk. Similarly, if a security has a negative abnormal return, it means that the
security has earned a lower return than what would be expected based on its
systematic risk.
Abnormal return can be caused by a variety of factors, such as unexpected
news about the company or the economy, changes in interest rates, or shifts
in investor sentiment. In practice, abnormal returns are often used by investors
to identify undervalued or overvalued securities.
18. What does CAPM beta measure?
CAPM beta, also known as asset beta or systematic risk, is a measure of the
sensitivity of a security´s returns to market-wide or systematic risk.
Specifically, beta measures the degree to which the returns of a security move
in response to changes in the overall market. In other words, beta measures
how much a security´s returns are affected by changes in the return of the
market portfolio.
A security with beta of 1 is expected to have returns that move in tandem with
the market. A security with a beta greater than 1 is expected to have returns
that are more sensitive to market movements, while a security with beta less
then 1 is expected to have returns that are less sensitive to market
movements. A security with a negative beta would be expected to move in the
opposite direction of the market.
The beta of a security can be calculated using historical data by regressing the
security´s returns against the returns of the market portfolio. The CAPM
assumes that the only risk that investors are compensated for is systematic
risk, as opposed to idiosyncratic or non-systematic risk. Therefore, the
expected return of a security is determined by its beta, which represents its
systematic risk.
19. What is the source of systematic risk in CAPM?
In the context of CAPM, systematic risk refers to the risk that is inherent in the
overall market or economy and affects all securities to some degree. It is the
non-diversifiable risk that cannot be eliminated by holding a well-diversified
portfolio.
The source of systematic risk in CAPM is the market portfolio, which is
assumed to include all risky assets and reflect the overall level of economic
activity. Systematic risk is measured by beta, which is the degree to which the
returns of a security move in repones to changes in the overall market.
The CAPM assumes that the market portfolio includes all risky assets and is
efficient, meaning that is composed of assets that are priced fairly based on
their risk and return characteristics. According to the CAPM, the only risk that
investors are compensated for is systematic risk, because diversifiable or
idiosyncratic risk can be eliminated.
Therefore, the source of systematic risk in CAPM is the underlying economic
and financial factors that affect the market portfolio, such as changes in
interest rates, inflation, government policies, geopolitical events, and overall
economic growth. These factors affect all securities to some extent, regardless
of their individual characteristics or the specific company or industry they
belong to.
20. Explain the difference between systematic and idiosyncratic risk.
Systematic risk and idiosyncratic risk are two different types of risks that
investors face when investing in financial assets.
Systematic risk, also known as market risk, refers to the risk that is inherent in
the overall market or economy and affects all securities to some degree. This
risk cannot be diversified away, and is therefore non-specific to any individual
security or asset. Systematic risk is caused by factors that affect the overall
market, such as changes in interest rates, inflation, government policies,
geopolitical events, and overall economic growth. Since systematic risk is
unavoidable, investors are compensated for this risk through the risk premium.
Idiosyncratic risk, on the other hand, is specific to a particular security or
asset, and is not related to the overall market. It is the risk that is unique to a
particular company, industry, or geographic region. Examples of idiosyncratic
risks include management decisions, changes in regulations, unexpected
events such as natural disasters or accidents, and other factors that affect a
specific company´s operations or financial health. Idiosyncratic risk can be
reduced or eliminated through diversification, since it is specific to individual
securities or assets.
The main differences between systematic and idiosyncratic risk that
systematic risk is non-diversifiable, while idiosyncratic risk is diversifiable.
Systematic risk affects all securities to some degree and cannot be eliminated
through diversification, while idiosyncratic risk can be reduced by holding a
diversified portfolio of assets that are not perfectly correlated with each other.
21. Why the idiosyncratic risk should not be priced?
Idiosyncratic risk, also known as firm-specific risk, is a type of risk that is
specific to a particular company or asset and is unrelated to the overall market
or economy. This type of risk can be diversified away.
CAPM assumes that investors are only compensated for bearing systematic
risk, which is the risk that is common to all securities and cannot be diversified
away. In other words, investors should be rewarded for taking on risk that they
cannot eliminate through diversification, since that is the only type of risk that
is priced in the market.
Since idiosyncratic risk can be eliminated by diversification, it is not priced in
the market, and investors are not compensated for bearing the risk.
Therefore, according to the CAPM, investors should only be compensated for
bearing systematic risk. The expected return of an asset should be based on
the level of systematic risk it carries, and not on the level of idiosyncratic risk.
22. What are the weaknesses of the CAPM model?
Assumptions may not hold in practice: The CAPM is based on several
assumptions, such as the efficient market hypothesis.
thesis, the existence of a risk-free rate, and the use of historical data to
estimate future returns. In practice, these assumptions may not hold, and the
model may not accurately reflect market conditions or provide accurate
estimates of expected returns.
Difficulty in estimating inputs: The CAPM requires estimation of several
inputs, such as the expected market return, the risk-free rate and the asset´s
beta. These inputs can be difficult to estimate accurately, particularly for the
assets with limited historical data or for assets that are difficult to benchmark
against a market index.
Lack of consideration for non-systematic risk: The CAPM assumes that all
non-systematic risk, or firm-specific risk, can be eliminated through
diversification. However, in practice, some non-systematic risk may not be
diversifiable and may affect the overall risk of a portfolio.
Sensitivity to the choice of market index: The CAPM assumes that the
market index used to calculate beta represents the overall market. However,
different market indices may have different levels of risk or may not be
representative of the overall market, which can affect the accuracy of beta
estimates and expected returns.
Limited usefulness for international investments: The CAPM assumes that
investors have access to a single, integrated global market. However, in
practice, there may be significant differences in market conditions and risk
across different countries and regions, which may not be accurately captured
by the model.
Lecture 4 – Revision
1. Explain briefly what a stock is.
A stock represent ownership in a company. When a company wants to
raise capital to finance its operations, it may issue stocks, also known as
shares, to the public in exchange for cash. Each share represents a portion
of ownership in the company, and stockholders are entitled to a portion of
the company´s profits, known as dividends, if the company decides to
distribute them.
Stocks are traded on stock exchanges, and their prices can fluctuate based
on a variety of factors, such as the company´s financial performance,
industry trends, and broader economic conditions.
2. Compare debt and equity. Discuss differences in the investment
horizon, riskiness and promised future payments.
Debt and equity are two common type of investments that are used to
finance companies and provide different benefits and risks to investors.
Here are some key differences between the two:
Investment Horizon:
Debt investments, such as bonds, typically have a fixed matuirty date and
investors can expect to receive regular interest payments until the bond
matures. Equity investments, on the other hand, have no fixed matuirty
date, and the investor´s return is dependent on the company´s profitability
and share price appreciation over time. Therefore, equity investments have
a longer investment horizon and may require a higher level of patience’s
from investors.
Riskiness:
Debt investments are generally considered less risky than equity
investments because they are backed by a promise of regular payments
and a return of principal upon matuirty. In the case of default, bondholders
may have priority over equity holders in receiving their investment back.
Equity investments, on the other hand, are subject to more market volatility
and are dependent on the company´s success in generating profits and
increasing its share price over time.
Promised Future Payments:
Debt investments promise regular interest payments and the return of
principal upon matuirty, which can provide a predictable stream of income
for investors. Equity investments, however, do not provide any guaranteed
payments and the investor´s return is dependent on the company´s
financial success, which can vary over time.
3. What is a dual-class stock structure? Why would a company choose
such a structure?
A dual-class stock structure is a system in which a company issue two
different classes of shares to its investors, with different voting rights and
dividend payout. One class of shares, typically designated as Class A, has
more voting rights and typically receives a lower dividend payout, while the
other class of shares, typically designated as Class B shares, has fewer
voting rights but a higher dividend payout.
Companies may choose a dual-class stock structure for a variety of
reason. One primary reason is to allow company founders and
management to retain control of the company even as it goes public or
raises additional capital. By issuing a class of shares with more voting
rights to insiders, they can maintain control and make decisions without
interferences from outside investors. This can be especially important for
companies with a strong founder-led culture or mission.
Another reason a company may choose a dual-class structure is it insulate
the company from short-term market pressure and give it more flexibility to
focus on long-term strategic goals. By limiting voting power of outside
investors, the company can be less influenced by the demand of short-term
shareholders who may prioritize short-term profits over long-term growth.
However, a dual-stock structure can also be controversial, as it can create
a governance structure that concentrates power in the hands of a small
group of insiders and limits the influence of outside shareholders. This can
be seen as unfair and potentially harmful to the long-term interest of the
company and its other stakeholders. Some investors and corporate
governance experts argue that dual-class structures can lead to a lack of
accountability and a lack of alignment between insiders and outside
shareholders.
4. What is a preferred stock?
Preferred stock is a type of equity investment that has characteristics of
both stocks and bonds. Like common stocks, preferred stock represents
ownership in a company, but is typically has a fixed dividend payment and
higher priority over common stock in receiving dividend payments and in
the event of a company´s liquidation.
Preferred stockholders typically receive a fixed dividend payment that is
paid before any dividends are paid to common stockholders. The dividend
rate is typically sated as a percentage of the stock´s par value and is often
higher than the dividend paid on common stock. In addition, in the event of
a company´s liquidation, preferred stockholders have a higher priority in
receiving their investment back compared to common stockholders, but
lower priority than bondholders.
One advantage of preferred stock for investors is the potential for a steady
income stream from the fixed dividend payments, which can be appealing
to investors seeking a more stable source of income compared to the
potential volatility of common stock dividends. However, preferred stock
does not typically have the same potential for capital appreciation as
common stock and may be less liquid in the market.
5. Why do we have two prices on the stock market?
The two prices on the stock market typically refer to the bid price and the
ask price particular stock or other security.
The bid price is the highest price a buyer is willing to pay for a stock at a
given point in time, while the ask price is the lowest price a seller is willing
to accept for the same stock at the same point in time. The differences
between the bid and ask prices is known as the bid-ask spread.
The bid and ask prices constantly fluctuate based on supply and demand
for the stock, and tother market conditions. This means that the price an
investor can buy or sell a stock for can also vary based on when they
execute the trade, and the size of the trade.
Having two prices on the stock market is important because it allows
investors to determine the market value for a particular stock at any given
time, based on the most recent trades and the supply and demand for the
stock. The bid and ask prices provide a guide for investors to decide
whether they want to buy or sell a stock, and at what price. The bid-ask
spread also represent a cost to investors, as it is the differences between
what they can buy a stock for and what they can sell it for.
6. What is the bid-ask spread?
A bid-ask spread is the differences between the highest price a buyer is
willing to pay (the bid) and the lowest price a seller is willing to accept (the
ask) for a particular security, such as a stock or bond. The bid-ask spread
is a measure of the liquidity of the security, and it reflects the supply and
demand for the security in the market.
The bid price is the price that a buyer is willing to pay to purchase the
security, while the ask price is the price that a seller is willing to accept to
sell the security. The bid-ask spread represents the cost of trading a
security, as it is the differences between the highest price a buyer is willing
to pay and the lowest price a seller is willing to accept.
Bid-ask spread can vary based on a number of factors, such as the liquidity
of the security, market volatility, and the size of the trade.
A narrow bid-ask spread indicates that there is a high level of liquidity for
the security, while a wide bid-ask spread suggests that the security may be
less liquid and be more difficult to trade. In general, smaller bid-ask
spreads are preferred by investors, as they represent lower transaction
costs and better opportunities to execute trades at favorable prices.
7. What are the differences between stock exchanges and ATSs?
Stock exchanges and Alternative Trading Systems are both platforms for
buying and selling securities, but there are some key differences between
the two.
Stock exchanges are public markets that are highly regulated and have
centralized trading locations where buyers and sellers come together to
trade securities. (NYSE, NASDAQ). Stock exchanges typically have strict
listing requirements and are subject to high level of regulation, with the aim
of ensuring fair and transparent trading practices and protecting inventors.
ATS are electronic trading platform that are not as highly regulated as
stock exchanges. They operate outside of the public markets and are
typically used by institutional investors to trade securities among
themselves. Examples include dark pools and electronic communication
networks (ECNs). ATSs are generally less transparent than stock
exchanges, with less information available to the public about the securities
being traded and the volume of trading taking place.
One key advantage of ATSs is that they can offer faster execution times
and lower transaction costs compared to stock exchanges. This can make
them more appealing to institutional investors who are looking to execute
large trades quickly and at lower costs. However, because they are less
regulated, there is higher level of risk associated with trading on ATS, and
investors need to be aware of the potential for market manipulation and
other risks.
8. What is an OTC market?
An OTC (over-the-counter) market is a decentralized market where
financial instruments, such as stocks, bonds and derivatives, are traded
directly between two parties, rather than on a centralized exchange. OTC
markets operate through a network of dealers and brokers who negotiate
the terms of the trade directly with one another, rather than through a
centralized order book or matching engine.
Typically, less regulated than organized exchanges, many trades on OTC
markets are not required to be reported to a public exchange. As a result,
OTC markets can be less transparent than organized exchanges, and
there may be less information available to investors about the securities
being traded and the volume of trading taking place.
However, OTC markets offer several advantages to investors, including
greater flexibility in terms of the securities that can be traded faster
execution times, and lower transaction costs compared to organized
exchanges. This makes OTC markets particularly attractive to institutional
investors, who may be trading large blocks of securities or more complex
financial instruments that may not be available on centralized exchange.
Examples: OTC Bulletin Board and the Pink Sheets, which are used for
trading smaller or emerging companies, as well as international markets
such as the London Stock Exchange´s International Order Book and the
Japanese OTC.
9. Describe differences between brokers and dealers.
A broker is an intermediary who facilities trades between buyers and
sellers in financial markets. Brokers act on behalf of their clients, helping
them to find suitable securities to buy or sell, and then executing those
trades on their behalf. Brokers earn commissions on the trades they
execute, and may offer additional services such as research, analysis, and
investment advice to their clients. Brokers do not take positions in the
securities they trade, and do not own the securities themselves.
A dealer, on the other hand, is a market participant who buys and sells
securities for their own account. Dealers take positions in the securities
they trade, buying securities at one price and then selling them at a higher
price to make profit. Dealers may also buy securities from investors who
are looking to sell, and then hold these securities in their inventory until
they can a find a buyer. Dealers earn profits from the difference between
the buy and sell price of the securities they trade and may also earn
additional income from interest or dividends on the securities they hold.
They key differences between brokers and dealers is that brokers act as
intermediaries between buyers and sellers, while dealers are themselves
buyers and sellers of securities. Brokers earn commissions on the trades
they execute, while dealers earn profits on the securities they trade. Both
brokers and dealers play important roles in financial markets, providing
liquidity and helping to match buyers and sellers of securities, but their
functions and business models are distinct.
10. Describe a dealer market.
A dealer market is a type of financial market where trading activates occur
through intermediaries, also known as dealers or market makers, who buy
and sell securities, such as stocks or bonds, on their own behalf. In a
dealer market, buyers and sellers do not interact directly with each other,
but instead, they trade through a network of dealers who facilitate trades by
taking positions in the securities they deal in.
In a deal market, the dealers act as market makers by quoting bid and ask
prices for securities. The bid price is the price at which a dealer is willing to
buy a security, while the ask price is the price at which a dealer is willing to
sell a security. The differences between the bid and ask prices is known as
the bid-ask spread, which represents the dealer´s profit margin.
Dealers in a dealer market are typically financial institutions, such as
banks, investment banks, or brokerage firms. These dealers make money
by buying securities at lower prices and selling them at higher prices,
profiting from the differences. They also provide liquidity to the market by
holding an inventory of securities and being ready to buy and sell at any
time.
Examples of dealer markets include over-the-counter (OTC) markets,
where securities are traded directly between dealers and investors, and
foreign exchange (forex) markets, where dealers trade different currencies
on behalf of their clients.
11. Why do we need regulations on a stock market?
Protecting investors: Regulations help protect investors from fraudulent
activates, such as insider trading, market manipulation, and misleading
financial disclosures. Regulations can help ensure that companies provide
accurate and complete information to investors so that they can make
informed decisions.
Maintaining market integrity: Regulations help maintain the integrity of the
market by preventing abusive practices and promoting fair and orderly trading.
This helps prevent market failures and promotes trust in the market.
Ensuring transparency: Regulations promote transparency by requiring
companies to disclose relevant information to investors, such as financial
statements, disclosures, and other reports. This helps investors make
informed decisions and fosters confidence in the market.
Promoting stability: Regulations can help promote market stability by
establishing rules that limit risk-taking behavior and ensuring that financial
institutions are adequately capitalized.
Facilitating capital formation: Regulations can also facilitate capital
formation by creating a regulatory environment that encourages investment,
which can help companies access the capital they need to grow and expand.
Overall, regulations help ensure that the stock market operates in fair,
transparent, and efficient manner, which benefits both investors and
companies. With regulations, the stock market could be vulnerable to abuse,
manipulation, and other harmful practices, which could undermine investors
confidence and damage the broader economy.
12. What is the role of transparency on the stock market?
Transparency plays a crucial role in the stock market. It refers to the
openness and accessibility of information regarding the financial health and
operations of publicly traded companies, as well as the trading activity and
price movements of stocks.
The availability of accurate and timely information is essential for investors
to make informed decision about buying, holding, or selling stocks. If
relevant information is not transparently disclosed, it can lead to market
inefficiencies and distortions that may harm investors and the overall
functioning of the market.
Therefore, stock exchanges, regulatory bodies, and publicly-traded
companies have implemented rules and regulations to promote
transparency, such as mandatory disclosure requirements and insider
restrictions. Investors and analysts also use various tools and resources,
such as financial statements, earnings reports, and market research, to
evaluate and monitor the performance and prospects of individual
companies and the market as a whole.
In summary, transparency is a critical element for a healthy and efficient
stock market, as it facilitates fair and informed investment decision,
enhances market integrity, and fosters trust among market participants.
13. What is a limit order?
A limit order is a type of order to buy or sell a security (such as a stock) at
a specified price or better. When you place a limit order, you are essentially
setting a maximum price (for a sell limit order) or a minimum price (for a
buy limit order) at which you are willing to trade a certain number of shares.
The order will only execute if the market price reaches your specified limit
price or better.
Limit orders are useful for investors who want to have more control over
the price at which they buy or sell a security. However, there is no
guarantee that a limit order will be executed, as the market price may not
reach the specified limit price. In addition, if the limit order is only partially
filled. The remaining shares will stay on the market as a limit order until
they are executed or cancelled.
14. Describe differences between a market order and a limit order
including differences in uncertainty.
A market order and a limit order two different types of orders used to buy or
sell securities In the financial market. The key differences between the two
are as follows:
Price: The most significant differences between a market order and a limit
order is the price at which the order is executed. A market order executes
immediately at the current market price, while a limit order is only executed
if the market price reaches the specified limit price.
Certainty: A market order offers a higher degree of certainty in terms of
execution because its guaranteed to execute immediately at the current
market price. However, the execution price is not guaranteed, as the
market price can change rapidly. In contrast, a limit order offers a lower
degree of certainty in terms of execution because it is only executed when
the market price reaches the specified limit price. However, the execution
price is guaranteed to be at or better than the specified limit price
Timing: A market order executes immediately, while a limit order may take
time to execute. If the market price does not reach the limit price, a limit
order may remain unfilled indefinitely.
Risk: Market orders carry a higher degree of risk because the execution
price is not guaranteed, and the market price can change rapidly. In
contrast, limit orders carry a lower degree of risk because the execution
price is guaranteed to be at or better than the specified limit price.
Flexibility: Market orders are more flexible than limit orders, as they can
be used to buy or sell a security at the current market price. Limit orders
are more inflexible, as they require a specific limit price.
15. What is liquidity? How can you measure liquidity?
Liquidity refers to the degree to which an asset or security can be quickly
bought or sold in the market without significantly affecting its price. In other
words, it refers to the ease with which an asset can be converted into cash.
High liquidity implies that an asset can be easily bought or sold with little
impact on its price, whereas low liquidity implies that buying or selling an
asset may significantly affects its price.
There are several ways to measure liquidity, including:
Bid-ask spread: The differences between the highest price a buyer is
willing to pay for an asset (the bid) and the lowest price a seller is willing to
accept (the ask). A smaller bid-ask spread indicates higher liquidity.
Volume: The number of shares or contracts traded in a particular period.
Higher trading volume indicates higher liquidity.
Open interest: The number of outstanding contracts or positions in a
particular market. Higher open interest indicates higher liquidity.
Market depth: The number of buy and sell orders available at different
price levels. Greater market depth indicates higher liquidity.
Implied volatility: A measure of the expected future price fluctuations of
an asset. Higher implied volatility may indicate lower liquidity, as it
suggests that the market may have difficulty finding a price for the assets.
16. Why is it difficult to measure liquidity?
Lack of transparency: Not all market data is publicly available, and some
transactions may take place over-the-counter or through private
negotiations, making it difficult to gauge the true liquidity of an asset.
Time sensitivity: Liquidity can change rapidly in response to market
conditions, news events, or other factors. Therefore, a measure of liquidity
at one point in time may not accurately reflect liquidity of an asset in the
future.
Fragmentation: The market for a particular asset may be divided among
multiple exchanges, making it difficult to get a complete picture of the
supply and demand for that asset.
Heterogeneity: Different assets have different liquidity characteristics, and
even within the same asset class, there may be variation in liquidity across
different maturities, credit ratings, or other factors.
Illiquidity is difficult to observe: If an asset has a low level of trading
activity, it may be difficult to gauge its true liquidity since there may be a
lack of trading data or price quotes.
17. What are the three dimensions of liquidity based on Kyle’s theory?
Kyle´s theory of liquidity is widely cited framework for understanding
liquidity in financial markets. According to the theory, there are three
dimensions of liquidity.
Time to execute: This refers to the time it takes to complete a trade in an
asset without affecting its price. The time to execute a trade depends on
the depth of the market, the trading volume, and the availability of
information about the asset.
Price impact: This refers to the effect that a trade has on the price of an
asset. The price impact depends on the size of the trade relative to the
trading volume, the information available about the asset, and the market´s
perception of the asset´s risk.
Adverse selection: This refers to the risk that a trader faces when they
have incomplete information about the asset, they are trading. Adverse
selection can arise when a trader lacks information about the quality or
value of an asset, or when the counterparty has better information about
the asset.
Taken together, these dimensions help to explain the degree of liquidity in
a particular market.
18. Explain the relationship between the liquidity and bid-ask spread.
The bid-ask spread is a key measure of liquidity, as it reflects the
differences between the highest price a buyer is willing to pay for an asset
(the bid) and the lowest price a seller is willing to accept (the ask). The bidask spread represents the transaction cost of trading asset, and a narrower
spread indicates lower transaction costs, which can make it easier and
cheaper to trade the asset.
There is an inverse relationship between liquidity and the buy-ask spread.
When an asset is highly liquid, there is typically a large number of buyers
and sellers in the market, and the differences between the bid and ask
prices tends to be small. This is because buyers and sellers can easily find
counterparties to trade with, and the market can quickly absorb trades
without significantly affecting the price of the asset. In contrast, when an
asset is illiquid, there may be few buyers and sellers, and it may be more
difficult to find counterparties to trade with. This can lead to wider bid-ask
spreads, as buyers and sellers may need to offer better prices to entice
counterparties to trade with them.
Overall, the bid-ask spread is an important measure of liquidity, as it
reflects the cost of trading an asset and can provide insights into supply
and demand dynamics of a particular market.
19. Give three examples of securities traded on capital markets.
Capital markets financial markets where long-term securities are traded,
including stocks, bonds, and other debt instruments.
Common stocks: Common stocks represent ownership in a company and
give shareholders the right to vote on corporate decisions, receive
dividends, and potentially benefit from capital appreciation.
Corporate bonds: Corporate bonds are debt instruments issued by
corporations to raise capital. Investors who purchase corporate bonds lend
money to the corporation in exchange for regular interest payments and
the return of their principal at the end of the bond´s term. Corporate bonds
can be traded on bond markets or over-the-counter markets.
Exchange-traded funds (ETFs): ETFs are investment vehicles that track
a particular index, sector, or asset class. ETFs trade on public stock
exchanges, instead of representing ownership in in a single company, they
provide exposure to diversified portfolio or underlying assets.
Others: stocks, government bonds, municipal bonds, and various
derivatives products like options and future contracts.
20. What is the role of an underwriter during the IPO?
An underwriter plays a critical role during an IPO by helping the issuing
company to sell its shares to the public. Here are some key functions of an
underwriter during an IPO.
Price setting: The underwriter helps the issuing company to determine the
optimal price for its hares. This involves condutcing market research,
analyzing financial data, and assessing investor demand for the shares.
The underwriter then sets the initial offer price for the shares.
Risk management: As part of the underwriting process, the underwriter
assumes some of the risk of selling the shares. This means that the
underwriter buys the shares from the issuing company and then resells
them to the public at the offer price. If the shares do not sell as expected,
the underwriter may be left with unsold shares, which can lead to financial
losses.
Marketing and distribution: The underwriter helps to market and
distribute the shares to potential investors. This involves advertising the
IPO, reaching out to potential buyers, and coordinating the logistics of the
sale.
Regulatory compliance: The underwriter is responsible for ensuring that
the IPO complies with all applicable securities regulations. This includes
preparing the necessary documents, such as the prospectus, and ensuring
that the sale of the shares adheres to all relevant legal requirements.
21. What is IPO overpricing? What problems does it cause?
IPO overpricing occurs when the price of the shares offered to the public is
set too high relative to the acutal value of the company. In other words, the
stock is priced above what the market is willing to pay for it, based on its
fundamentals and other factors.
Reduced demand: If the stock is overpriced, there may not be enough
demand for it, as investors may be hesitant to buy shares at a premium.
This can result in lower-than-expected sales and may cause the company
to raise less money than it intended to.
Negative impact on company reputation: If the stock price drops
significantly after the IPO, it can damage the company´s reputation and
make it difficult for the company to raise capital in the future.
Unfair to investors: If investors buy shares in an overpriced IPO, they
may end up losing money if the stock price drops after the IPO. This can
lead to legal action against the company and underwriters for
misrepresenting the value of the shares.
Underwriters make higher profits: IPO underwriters, who help set the
stock price and sell the shares to the public, may benefit from overpricing,
as they receive higher fees based on the size of the offering. This may
create a conflict of interest between the underwriters and the company
going public.
22. What is IPO underpricing? What problems does it cause?
The stock is priced below what the market is willing to pay for it.
Loss of potential capital: If the stock is underpriced, the company may
raise less capital than it would have if the stock had been priced correctly.
This can limit the company´s ability to invest in growth and expansion.
Dilution of ownership: If the company has to issue additional shares to
make up for the underpricing, it can dilute the ownership stake of existing
shareholders, including founders and early investors.
Missed opportunities for investors: If the stock price rises significantly
after the IPO, investors who did not get in on the offering may miss out on
the opportunity to profit.
Increased volatility: If the stock price jumps significantly on the first day of
trading, it can create increased volatility and may lead to a “bubble” that
eventually bursts.
Negative perception of the company: If the stock price drops
significantly after the initial surge, it can create a negative perception of the
company and may damage its reputation.
23. Why an IPO may not be a good option to raise financing for a small
firm?
Cost: An IPO can be a very expensive process, with high underwriting
fees, legal fees, accounting fees, and other costs associated with
regulatory compliance. These costs can be prohibitively expensive for a
small firm, which may not have the resources to bear them.
Complexity: The process of going public can be complex and timeconsuming, requiring extensive legal, financial, and regulatory work. Small
firms may not have the expertise or resources to navigate this process
successfully.
Lack of investor interest: small firms may not have the same level of
investor interest as larger, more established companies, making it more
difficult to attract investors and sell shares in an IPO.
Risk: Going public can be risky, as the company will be subject to greater
scrutiny and regulation and will be required to meet higher reporting
standards. Small firms may not able to handle this increased risk.
Pressure to perform: Once a company goes public, it is subject to the
pressure of public markets and shareholder expectations. This can be
especially challenging for small firms, which may not have the same level
of resources or stability as larger companies.
24. What is rights issue?
A rights issue is a type of offering in which a company issues new shares
to its existing shareholders in proportion to their current holdings. The
shareholders are given the right to purchase a certain number of additional
shares at a discounted price, which is usually lower than the current market
price.
Rights issues are a way for companies to raise additional capital from their
existing shareholders without diluting the value of their shares by issuing
new shares to new investors. This existing shareholders are given the
opportunity to main their ownership percentage in the company by
purchasing the new shares at a discounted price.
Steps:
The company announces that it intends to issue new shares through a
rights issue.
The company sets a record date, which is the date on which shareholders
must own shares In order to be eligible for the rights issue.
Eligible shareholders are given a certain number of rights based on their
current holdings.
Shareholders can choose to exercise their rights by purchasing new shares
at the discounted price.
Any unexercised rights can be sold on the open market, typically through a
trading platform.
The company issues the new shares to those shareholders who have
exercised their rights.
25. Are existing stockholders better off exercising their rights and buying
more shares or selling their rights? Why?
Whether existing shareholders should exercise their rights and buy more
shares or sell their rights depends on a number of factors, including the
current market price of the stock, the discounted price of the shares offered
in the rights, issue, the financial health and future prospects of the
company, and the individual financial goalss and circumstances of the
shareholders.
In general, if the market price of the stock is higher than the discounted
price of the shares offered in the rights issue, it may make sense for
shareholders to exercise their rights and buy more shares. This would
allow them to purchase additional shares at a discount, which could result
in a profit if the market price of the stock increases in the future.
On the other hand, if the market price of the stock is lower than the
discounted price of the shares offered in the right issue, it may make more
sense for shareholders to sell their rights rather than exercise them. This
would allow them to realize a profit by selling their rights at a higher price
than they would receive by exercising them and purchasing the discounted
shares.
However, this decision is not always straightforward and should be based
on careful analysis of the financial health and future prospects of the
company, as well as the individual financial goals and circumstances of the
shareholder.
Lecture 5 – Revision
1. What is a coupon payment on a bond? Does every bond pay a coupon?
A coupon payment on a bond is a periodic interest payment made by the bond
issuer for the bondholder. It represents the fixed rate of return that the
bondholder receives for holding the bond until maturity. The coupon payment
is calculated as a percentage of the bond´s face value (also called the “par
value” or “principal”) and is typically paid annually or semi-annually.
Not all bonds pay a coupon, however. Zero-coupon bonds, also known as
“discount bonds”, do not pay any periodic interest payments. Instead, these
bonds are issued at a discount to their face value, and the bondholder
receives the full-face value of the bond when it matures. The return for the
bondholder comes from the differences between the discounted purchase
price and the face value.
2. What is bond face value?
The bond face value, also known as “par value” or “principal”, is the amount of
money that a bond issuer promises to pay the bondholder at the bond´s
maturity. It is the nominal or “face” amount of the bond that is used to calculate
coupon payments and the final payment at maturity.
It is important to note that the face value of a bond is not necessarily equal to
the price at which the bond is bought or sold in the secondary market.
3. What risks are associated with investment in bonds?
Interest rate risk: The risk that bond price will fall when interest rates rise,
and vice versa. This is because existing bonds with lower interest rates
become less attractive to investors as market interest rates rise, leading to a
decline in bond prices.
Credit risk: The risk that the bond issuer may default on its debt obligations or
become unable to make interest or principal payments. This risk is particularly
relevant for bonds issued by lower-rated companies or governments, which
may have higher probability of default.
Inflation risk: The risk that the purchasing power of the income generated by
the bond eroded by inflation over time. This is particularly relevant for bonds
with longer maturities, as they are exposed to inflation over a longer period.
Currency risk: The risk that fluctuations in exchange rates between the
currency in the bond is denominated and the investor´s home currency can
affect the bond´s value. This is particularly relevant for international bonds,
which are denominated in foreign currencies.
Liquidity risk: The risk that the bond may be difficult to sell or trade in the
secondary market, particularly during periods of market stress or low trading
volumes.
Call risk: The risk that the bond may be called or redeemed by the issuer
before its matuirty date, particularly when market interest rate have fallen,
leading to a loss of potential future interest payments and the need to reinvest
the proceeds at a lower interest rate.
4. What is a real interest rate?
A real interest rate is the interest rate adjusted for inflation. It represents the
actual purchasing power of the interest rate after taking into account the
effects of inflation on the value of money over time.
The nominal interest rate, which is usually quoted by financial institutions and
the media, represents the actual interest rate charged on a loan or earned on
investment. However, the nominal rate does not take into account changes in
the value of money due to inflation.
To calculate the real interest rate, the inflation rate is subtracted from the
nominal rate. The resulting real interest rate indicates the true rate of return on
an investment or the true cost of borrowing.
If nominal interest rate in a saving account is 3% per year and inflation is 2%
per year, the real interest rate would be 1%.
5. Why is difficult to measure real interest rates?
It requires accurate and reliable data on inflation, which can be challenging to
calculate accurately. Inflation is measured using various indices, such as the
CPI, PPI or GDP deflator, which may have different weight for different goods
and services.
Inflation rates can be affected by various factors, including changes in
government policies, economic conditions, and external factors such as
commodity prices which can make it difficult to predict and measure.
Another challenge is that the real interest rate may vary depending on the time
horizon on the investment. Inflation rates can fluctuate over time, and the
longer investment horizon, the greater the uncertainty about the future rate of
inflation, making it difficult to accurately measure the real interest rate.
6. Describe how inflation-linked bonds work
Type of bond that provides protection against inflation by adjusting the value
of the bond´s principal and interest payments to changes in the inflation rate.
If inflation rate increases, the principal value of the bond is adjusted upwards,
and vice versa for decrease in inflation.
10-year inflation-linked bond with principal value of $10000 and fixed interest
rate of 2%. If inflation rate increases by 2% in the first year, the principal value
of the bond will be adjusted to $10200, and the interest payment for the year
will be calculated based on the adjusted principal value of $10200, resulting in
a payment of $204.
7. What is a callable bond? Who benefits from the embedded call option issuer or a holder?
A callable bond, also known as a redeemable bond, is a bond that gives the
issuer the right to redeem or “call” the bond before its scheduled maturity date,
usually at a specified call price. The embedded call option in a callable bond
benefits the issuer rather than the bondholder.
When an issuer calls a bond, they typically do so because market interest rate
have declined, allowing them to refinance their debt at a lower cost. By calling
the bond, the issuer can retire the high-cost debt and issue new bonds at a
lower interest rate, which reduces their borrowing cost and increases their
profitability.
It can provide some benefits to investors, such as the potential for higher
yields than non-callable bonds, they also carry a higher level of risk. If the
issuer call the bond, the bondholder may not receive the full value of the bond,
losing out on the remaining interest payments that they would received if the
bond had remained outstanding until matuirty.
8. Discuss differences between secondary bond and stock markets. List at
least three.
Market structure: Bond markets are typically more centralized, with a smaller
number of large dealers dominating the market. In contrast, stock markets are
more decentralized, with a larger number of broker and market makers
facilitating trading.
Trading mechanisms: Bonds are typically traded over-the-counter, which
means that trades occur directly between buyers and sellers, rather than on
organized exchange. In contrast, stocks are traded on organized exchanges,
such as NYSE or the Nasdaq.
Liquidity: Stocks markets are generally more liquid than bond markets,
meaning that it is easier and quicker to buy or sell stocks. This is partly due to
the greater number of market participants in the stock market, as well as the
fact that many stock are highly traded and have deep pools of liquidity. Bond
markets, on the other hand, can be less liquid, particularly for less frequently
traded or illiquid bonds.
Risk and return: Bonds are generally considered to be less risky than stocks,
and they typically offer lower returns as a result. However, the specific risk and
returns associated with any particular bond or stock will depend on a variety of
factors, such the creditworthiness of the issuer, the prevailing interest rates,
and the economic and market conditions at the time of the investment.
9. What is a clean bond price? Why is it not a price paid during a trade?
A clean bond, also known as the quoted price, is the market value of a bond
that does not include any accrued interest or other associated costs. It is the
price that the buyer is willing to pay for a bond in the secondary market, and
the price that a seller is willing to accept.
When a bond is traded, the actual price paid Is the dirty price, which the clean
price plus the accrued interest that the accrued on the bond since the last
interest payment date. The accrued interest represent the amount of interest
that has accumulated on the bond between the last interest payment date and
the settlement date of the trade.
The reason why the clean price is not paid during a trade is that the buyer of
the bond is entitled to receive the next coupon payment when it is due. This
means that the buyer must compensate the seller for the interest that has
accursed on the bond since the last payments, which is reflected in the dirty
price.
Example: face value $1000, coupon rate 5%, payable semi-annually, and the
last interest payment was made three months ago.
If the current clean price of the bond is $1050, the dirty price would be $1050,
plus the accrued interest for the three-month period, which is $12.50
(calculated as 5% of the $1000 divided by 2, multiplied by 3/12). The actual
price paid for the bond would be $1062.50, which is the dirty price.
10. Briefly explain how US government bonds are issued.
Auction: The Treasury holds auctions to sell new T-bonds to investors. The
auctions are conducted through the Federal Reserve Bank of New York, and
investors can submit bids to purchase the bonds.
Price determination: The Treasury determines the price of the new bonds
based on the bids received during the auction. The price is set so the yield on
the bond is close the prevailing market interest rate.
Settlement: After the auction, the Treasury settles the bond sales with the
winning bidders. The settlement date is typically a few days after the auction.
Trading in the secondary market: Once the new bonds are issued, they can
be traded in the secondary market, where investors buy and sell them based
on their current market value.
Interest payments: T-bonds pay interest to their holders twice a year. The
interest rate is set at the of issuance and remains fixed for the life of the bond.
When the bond matures, the holder revies the face value of the bond.
11. What are the common features of stock and bond issuances?
Legal documents: Both stocks and bonds require legal documents to be
drafted and filed with the appropriate regulatory agencies. These documents
outline the terms of the securities being issued, such as the amount, interest
rate (in the case of bonds), matuirty date, and other relevant details.
Public offering: Both stocks and bonds can be publicly offered, meaning that
they are available for purchase by individual investors on a stock exchange or
through a broker. This allows companies to raise a large amount of capital by
selling shares or bonds to a wider range of investors.
Secondary market: Once issued, both stocks and bonds can be traded on a
secondary market. This means that investors can buy and sell shares or
bonds among themselves, without involving the issuing company. The
secondary market provides liquidity and allows investors to easily exit or adjust
their positions in the securities.
Investors rights: Both stocks and bonds provide investors with certain rights,
such as the rights to receive dividends (stocks) or interest payments (bonds),
the right to vote on important company decisions, and the right to receive
information about the company´s performance and financials.
Risk and return: Both involve some level of risk and potential reward for
investors. Stocks is risker than bonds, generally, because their price can be
more volatile, but also offer the potential for higher returns. Bonds considered
less risky but offer lower returns.
Issuer creditworthiness: The creditworthiness of the issuing company is an
important factor to consider for both stocks and bonds. If a company is highly
leveraged or has a weak financial position, it may be more likely to default on
its bond payments or experience a decline in stock price. As a result, investors
should carefully evaluate the creditworthiness of the issuing company before
investing in the securities.
12. What are the benefits and risks of high-yield bonds?
High-yield bonds, also known as junk bonds, are bonds that are issued by
companies with lower credit ratings that investment-grade bonds. While they
offer the potential for higher returns than investment-grade bonds, they also
come with higher risks. Here are some benefits and risk of high-yield bonds:
Benefits of High-Yield Bonds:
High-Yield: As the name implies, high-yield bonds offer higher yields than
investment-grade bonds. This is because they are issued by companies with
lower credit ratings and are therefore riskier than investment-grade bonds.
Diversification: Including high-yield bonds in a portfolio can provide
diversification benefits because they have low correlation with other asset
classes like stocks and investment-grade bonds.
Income Generation: High-yield bonds can provide a source of income for
investors seeking higher yields than those offered by investment-grade bonds.
Risks of High-Yield Bonds:
Default Risk: Companies that issue high-yield bonds have a higher risk of
default than investment-grade companies. This means that investors may not
receive the principal and interest payments they were expecting.
Market Risk: The market value of high-yield bonds can be more volatile than
investment-grade bonds, and the price can be affected by changes in interest
rates, credit spreads and market conditions.
Credit Risk: High-yield bonds are issued by companies with lower credit
ratings, which means they are more vulnerable to economic and market
conditions that could cause their creditworthiness to decline.
Call Risk: High-yield bonds are often callable, meaning that the issuer can call
the bonds back before matuirty. This can be disadvantageous to investors if
the bonds are called back when interest rates are low and they have to
reinvest their money at a lower rate.
Lecture 6 – Revision
1. What is an interest rate?
An interest rate is the percentage of the principal amount of a loan or
investment that is charged or earned as a fee for borrowing or lending money.
It is the amount of money that is paid or earned on top of the original amount
of money borrow or invested, usually calculated as an annual percentage rate
(APR).
2. Why are interest important?
Interest rates are important for several reasons:
Influence borrowing and lending decisions. Plays a crucial role in
determining the cost of borrowing money. Higher interest rates make it more
expensive for individuals or businesses to borrow money, which can
discourage them from taking loans or investing
Affect economic growth: can influence consumer spending, investment, and
inflation. Low interest rate, consumers and businesses may be more like to
spend and invest, which can stimulate economic growth.
Impact investment decisions: Higher rates can make investments in fixedincome securities, such as bonds and certificates of deposits, more attractive,
while lower interest rates can make stocks and other riskier investments more
appealing.
Impact currency exchange rates: Higher rates can make a currency more
attractive to investors, which can increase demand and raise the value of the
currency relative to others. Conversely, lower interest rates can make a
currency less attractive and decrease its value.
3. Why are interest rates crucial for bond valuation?
Interest rates are crucial for bond valuation because they directly impact the
bond´s price and yield.
A bond´s price is determined by the present value of its future cash flows,
which includes both the interest payments and the principal repayment.
The discount rate used in the future cash flow calculation, is typically a market
interest rate. When the interest rate rise, the discount rate also increases
which reduces the present value.
In addition to affecting the bond´s price, changes in interest rates also affect
the bond´s yield. The yield represents the return that an investor can expect to
earn on the bond, taking into account its current price and the amount of
interest its pays. As bonds prices and interest rates move in opposite
directions, the bond´s yield will also change in response to change in interest
rates.
4. What is the main rule underlying bond pricing? Briefly explain.
The main rule underlying bond pricing is that the price of a bond is determined
by the present value of its future cash flow. This means that the price of a
bond today is equal to the sum of the present value to all of its future interest
payments plus the present value of its principal repayment at maturity.
Present value of future cash flows is discounted. The discount rate reflects the
time value of money, which is the idea that a dollar received in the future is
worth less than a dollar received today because of factors such as inflation
and opportunity cost of money.
In practice, the calculation of a bond´s price involves using a formula that
takes into account the bond´s face value, coupon rate, time to maturity, and
current market interest rates.
5. Briefly explain how loanable funds theory explains the level of interest
rates in the economy.
The loanable funds theory is an economic concept that explain how the supply
and demand for loans in a market economy determines the level of interest
rates.
According to the loanable funds theory, the supply of funds comes from
savings, while the demand for loanble funds comes from investment. Saving
represent the amount of money that households, businesses, and
governments save from their current income, while investment represent the
amount of money that businesses and governments spend on capital goods
and other long-term projects.
When there is a high level of saving relative to investment, the supply of
loanable funds exceeds the demand for loans, causing interest rates to fall.
This is because lends have excess funds to lend, which means they must offer
lower interest rates to attract borrowers. Conversely, when the level of
investment exceeds the level of savings, the demand for loanable funds
exceeds the supply, causing interest rate to rise. In this case, borrowers must
offer higher interest rates to attract lenders.
Therefore, the loanable funds theory suggests that interest rates act as a price
that balances the supply and demand for loans in an economy. When the
supply and demand for loanable funds are in equilibrium, interest rates are at
a level that is attractive to both borrowers and lenders.
6. Give examples of agents in the economy who drive the demand for
loanable funds. Explain
Households: Households often require loans to finance purchases of big-ticket
items, such as homes, cars and appliances.
Businesses: Businesses also require loans to finance investments in new
equipment, facilities, and technology.
Governments: Governments at all levels often require loans to finance public
projects, such as infrastructure investments, education, or healthcare. They
also may need to borrow to cover budget deficits.
Financial institutions: financial institutions such as banks, credit unions, and
other lenders require loanable funds to lend to borrowers. They typically
borrow from depositors or other sources of capital and then lend those funds
to other borrowers at a higher interest rate.
All these agents create demand for loanable funds in the economy, as they
seek to borrow money to finance their various activates. This demand, in turn,
affects the overall level of interest rates in the economy, as lenders compete to
supply the funds demanded by borrowers. Higher demand for loanable funds
will typically lead higher interest rates, while lower demand will lead to lower
rates.
7. Give examples of agents in the economy who drive the demand for
supply funds. Explain
The demand for supply funds refers to the desire of individuals or institutions
to invest their money in financial assets or savings accounts, rather than
spend it on consumption or investment. Here are some examples of agents in
the economy who drive the demand for supply funds:
Households: Households often save a portion of their income for future needs
or emergencies. They may also save to accumulate wealth or achieve specific
financial goals, such as retirement or college education for their children. In
addition, households may invest in financial assets, such as stocks, bonds, or
mutual funds, to generate a return on their savings.
Businesses: Businesses may also save part of their porfits for future
investments or to build up cash reserves. They may invest their savings in
financial assets or use them to finance expansion or research and
development projects.
Financial Institutions: Financial institutions also demand supply funds, as they
seek to accumulate reserves to meet regulatory requirements or to lend to
other borrowers. They may also invest in financial assets, such as
governments bonds, to earn a return on their excess reserves.
Governments: Governments also demand supply funds, as they seek to
finance their budget deficits by issuing bonds. These bonds are purchased by
investors, who lend money to the government in exchange for a return in the
form of interest payments.
Overall, the demand for supply funds is driven by the desire to save, invest, or
accumulate reserves for future use. This demand affects the overall level of
interest rate, as lenders compete to attract funds from savers and investors.
Higher demand for supply funds will typically lead to lower interest rates, while
lower demand will lead to higher rates.
8. Give examples of three actions/events that will lead to a positive shift in
demand for loanable funds.
Increase in business investment: If businesses become more optimistic
about the future and decide to increase their investment in new equipment,
facilitates, or technology, they will likely require more loanable funds to finance
those investments. This would shift the demand for loanable funds to the right,
as businesses compete to borrow more money from lenders.
Population growth: If the population of a country or region grows, this will
increase the demand for housing and other consumer goods, which will
require more borrowing by households. In addition, the increased demand for
goods and services may stimulate business investment, as mentioned above.
This would also lead to a positive shift in demand for loanable funds.
Government spending: If the government increases its spending on public
projects, such as infrastructure, education, or healthcare, it will require more
loanable funds to finance those projects. This could shift the demand for
loanable funds to the right, as governments competes with other borrowers for
available funds.
Overall, any event or action that leads to an increase in the demand for
borrowing in the economy could lead to a positive shift in demand for loanable
funds.
9. Give examples of three actions/events that will lead to a positive shift in
supply for loanable funds.
Increase in savings rate: If households, businesses, or financial institutions
decide to save more of their income or profits, this will increase the supply of
loanable funds in the economy. This would shift the supply for loanable funds
to the right, as more money is available for lending at every interest rate.
Foreign Investment: If foreign investors become more interested in investing
in a particular country or region, this could increase the supply of loanable
funds in that economy. Foreign investment can provide additional sources of
capital for businesses or governments and can also put downward pressure
on interest rates. This would lead to a positive shift in supply for loanable
funds.
Fiscal or monetary policy: Fiscal or monetary policy actions by government
or central bank can affect the supply for loanable funds. For example, if the
government reduces its budget deficit, this could free up more funds for
lending, which could increase the supply of loanable funds. Similarly, if the
central bank implements an expansionary monetary policy, such as lowering
interest rates or increasing the money supply, this can increase the supply for
loanable funds as well.
Overall, any event or action that leads to an increase in the supply of loanable
funds in the economy could lead to a positive shift in supply for loanable funds.
10. In the context of the loanable funds theory, discuss and plot what will
happen with interest rates when the government significantly increases
the deficit.
According to the loanable funds theory, the interest rate in a market economy
is determined by supply of and demand for loanable funds. When the
government significantly increases the budget deficit, it will need to borrow
more funds to finance its spending. This increase in demand for loanable
funds will lead to an upward pressure on interest rates, as lenders will
compete for the available funds.
The demand for loanable funds will increase, shifting the demand curve to the
right. This will lead to an increase in the equilibrium interest rate.
Thus, when the government significantly increases the deficit, the interest rate
in the loanable funds market is likely to increase. The magnitude of the
increase will depend on the size of the deficit and the responsiveness of the
supply and demand curves to change in interest rates. In addition, other
factors such as inflation expectations, international capital flows, and changes
in monetary policy can also influences the direction and magnitude of the
interest rate reasons to a government deficit.
11. Why do interest rates vary across different securities? List at least three
reasons.
Credit risk: Interest rates can vary depending on the creditworthiness of the
borrowers. Securities issued by borrowers with a higher credit risk, such as
high-yield (junk) bonds, will typically have higher interest rates to compensate
investors for the higher risk of default. On the other hand, securities issued by
borrowers with lower credit risk, such as U.S. Treasury bonds, will typically
have lower interest rates as investors perceive these securities to be less
risky.
Liquidity risk: Interest rates can also vary depending on the liquidity of the
security. Securities that are easily tradable and have high demand in the
market, such as U.S. Treasury bills or highly rated corporate bonds, tend to
have lower interest rates compared to securities that are less liquid or have
lower demand.
Time to maturity: The time remaining until a security matures can also affect
its interest rate. Generally, securities with longer maturates tend to have
higher interest rates than those with shorter maturities, because investors
require a higher return to compensate for the additional risk associated with
holding a security for a longer period of time.
Other factors that can affect interest rate on securities include inflation
expectations, changes in monetary policy, global economic conditions, supply
and demand in the market, and market sentiment. It is important for investors
to understand these factors and their impact on interest rates in order to make
informed investment decisions.
12. What is bond yield? How is it related to the bond price and to the
observed interest rates?
A bond yield is the rate of return earned on a bond investment, expressed as
percentage of the bond´s face value. In other words, it is the amount of
interest that an investor can expect to earn on a bond, based on the bond´s
current market price.
Bond yields are related to bond prices and observed interests’ rates through
basic mathematical relationship knows as the yield-to-maturity (YTM) formula.
This formula takes into account the bond´s current price, its face value, the
time remaining until maturity, and the coupon rate, which is the fixed annual
interest payment that the bond issuer promises to pay to bondholders.
As bond prices change in response to changes in supply and demand, the
yield-to-maturity of the bond also changes. When bond prices rise, the bond´s
yield-to-maturity falls, and vice versa. This is because the fixed coupon
payment becomes a smaller percentage of the bond´s price as the price rises,
reducing the overall yield-to-matuirty. Conversely, if bond prices fall, the
bond´s yield-to-maturity rises, since the fixed coupon becomes a larger
percentage of the bond´s price.
In addition to changes in bond price, observed interest rates can also affect
bond yields. If interest rates rise, the yields on newly issued bonds will also
rise, making existing bonds with lower yields less attractive to investors. This
can lead to a decline in the market price of the existing bonds, which in turn
causes their yield to rise. On the other hand, if interest rates fall, the yield on
newly issued bonds will also fall, making existing bonds with higher yields
more attractive to investors. This can lead to an increase in the market price of
the existing bonds, which in turn causes their yields to fall.
Overall, bond yields are a key factor in the valuation of bonds and are closely
related to bond prices and observed interest rates. As such, investors and
analyst closely monitor changes in bond yields as an indicator of market
sentiment and economic conditions.
13. Discuss what yields would you expect on TIPS compared to standard
Treasuries.
Treasury Inflation-Protected Securities is designed to protect investors from
inflation. Unlike standard Treasuries, which offer a fixed interest rate and a
fixed principal amount, the principal value of TIPS is adjusted for inflation,
providing investors with protection against rising prices.
Because TIPS offers this inflation protection, their yields are typically lower
than those of standard Treasuries with same matuirty. This is because
investors are willing to accept a lower yield on TIPS in exchange for the added
inflation protection. The difference between the yield on a standard Treasury
security and the yield on TIPS of the same matuirty is known as the breakeven
inflation rate.
For example, if 10-year Treasury bond has a yield of 2% and a 10-year TIPS
bond has a yield of 1%, the breakeven inflation would be 1%. This means that
if inflation the next 10 years is less then 1%, the standard Treasury bond
would provide a higher return than the TIPS bond. If inflation is greater than
1%, the TIPS bond would provide a higher return,
In general, the yields on TIPS are influenced by a variety of factors, including
expectations for future inflation, changes in interest rates, supply and demand
in the market, and global economic conditions. When inflation is expected to
rise, the yields on TIPS will tend to rise as well, as investors demand a higher
return to compensate for the increased inflation risk. And vice versa.
Overall, the yields on TIPS are typically lower than those for standard
Treasuries with the same matuirty, reflecting the added inflation protection
provided by these securities. As such, investors who are concerned about
inflation risk may consider including TIPS in their investment portfolio as a way
to hedge against rising prices.
14. Discuss what yields would expect on municipal bonds compared to
corporate bonds.
Municipal bonds, also known as “munis”, are issued by state and local
governments to fund public projects such as schools, highways, and water
treatment facilities. Corporate bonds, on the other hand, are issued by
corporations to fund their operations or other capital expenditures.
Municipal bonds typically offer lower yields than corporate bonds with same
credit rating and maturity. There are several reasons for this:
Tax-exempt status: Municipal bonds are often exempt from federal income
taxes and, in some cases, state and local income taxes as well. This taxexempt status makes Municipal bonds more attractive to investors, particularly
those in higher tax brackets, and allows issuers to offer lower yields than
corporations must pay to attract investors.
Credit risk: Municipal bonds are generally considered to be lower-risk
investments than corporate bonds, since state and local governments have
the ability to raise taxes or cut spending to meet their obligations. This means
that the municipal bonds issuers can offer lower yields than corporations with
same credit rating.
Supply and demand: The market for Municipal bonds is generally smaller
than the market for corporate bonds, which can result in higher demand for
Municipal bonds and lower yields.
Differences in yields between Municipal bonds and corp bonds can vary
depending on a variety of factors, including credit rating of the issuer, the
matuirty of the bond, and current market conditions. In times of economic
uncertainty, investors may be more willing to accept lower yields on corp
bonds than on Municipal bonds, which could narrow the yield spread between
the two types of bonds.
In general, investors who are in higher tax brackets and seeking taxadvantaged income may find Municipal bonds to be more attractive option
than corp bonds, while investors seeking higher yield may prefer corp bonds.
15. How do we interpret the yield to matuirty?
YTM is the expected rate of return on a bond if the bond is held until it
matures, and all interest payments are reinvested at the YTM. It considers the
bond´s current market price, face value, coupon rate, and the time remaining
until matuirty.
YTM represents the average annual return an investor can expect.
16. How can you calculate yield to matuirity?
Formula:
YTM = [(C+(F-P)/n) / ((F+P)/2)] – 1
Where:
C= the annual coupon payment
F = the face value of the bond
P=the current market price of the bond
N=the number of years to matuirty
17. What is the relationship between the yield to maturity and bond price?
YTM and bond price is inverse, meaning that as YTM increases, bond prices
decrease, and as YTM decreases, bond price increases.
Reason: bond price determined by present value of bond´s cash flow. As the
YTM increases, the present value of the bond´s future cash flows decrease,
and thus the bond´s price decreases.
If interest rate in the market increases, the YTM of a bond will increase,
causing its price to decrease.
18. What is the yield to matuirty on a zero-coupon bond?
Zero-coupon bonds do not pay any periodic interest payments, but is sold at a
discount to its face value and pays its face value at matuirty.
Formula:
YTM = [(FV/PV)^1/n)] – 1
In this formula, the pv of the bond is calculated using the current market price
of the bond, the price the investor paid to purchase it. The YTM represents the
discount rate that equates the pv of the bond to its face value at matuirty.
19. What does it imply for the price when the yield to matuirty is higher than
the coupon rate?
YTM > coupon rate = selling at a discount. It means that the bond´s current
market price is lower than its face value, because investors are demanding a
higher rate of return that the coupon rate to compensate for the risk of owning
the bond. Common reasons: changes in market interest rates, credit risk.
20. What does it mean that a bond is sold at par?
The bond is sold at its face value, which is the amount the bond issuer
promises to pay the bondholder at matuirty. If the bond has a face value of
$1000 and is sold at par, an investor will pay $1000 to purchase the bond.
21. What is the yield curve? What slope does it usually have?
Graph that shows the relationship between yields on bonds of different
maturities. Visual representation of the term structure of interest rates, which is
the relationship between the time to matuirty and the yield on a bond.
Typically slopes upwards, meaning that longer-term bonds have higher yields
than shorter-term bonds. This reflects the fact that investors usually demand a
higher rate of return to invest in longer-term bonds, because there is more
uncertainty and risk associated with future economic and financial
environment.
A flat or inverted yield curve can occur when short-term yields are higher than
long-term yields, which can be a sign of economic slowdown or recession.
A steep yield curve, on the other hand, can occur when there is high demand
for long-term bonds, which can be a sign of growing economy and inflationary
pressures.
22. Why is it useful to study the shape of the yield curve?
Economic forecasting: Shape of yield curve can provide valuable information
about the current state and future direction of the economy. Given the shape
of the yield curve.
Investment decisions: Provide information about expected returns and risk
associated with different types of investments. Example: If an investors
expects interest rates to rise in the future, they may want to invest in shortterm bonds or money market funds to avoid the risk of holding longer-term
bonds thar may lose value as interest rates rise.
Credit risk assessment: Provide information about the credit risk associated
with different type of bonds. Example: a steep curve may indicate that
investors expect higher inflation in the future, which can increase the risk of
default for bonds that are more sensitive to inflation. Info useful for credit rating
agencies, investors and lenders who need to assess the creditworthiness of
borrowers and the risk of default on their bonds or loans.
23. According to the expectations hypothesis, what can we learn from the
shape of the yield curve?
The theory suggests that the shape of the yield curve can provide information
about the market´s expectations of future interest rates.
The yield curve reflects the market´s expectations of future short-term interest
rates, and the slope of the yield curve reflects the differences between the
expected future short-term interest rates and the current short-term interest
rate.
In particular, the expectations hypothesis suggests that a steep upwardsloping yield curve indicates that the market expects short-term interest rates
to rise in the future. This expectation of rising interest rates is reflected in the
higher yields on longer-term bonds, which compensate investors for the
additional risk of holding bonds with longer maturities.
A flat or inverted yield curve indicates that the market expects short-term
interest rates to remain the same or even fall in the future. In a inverted yield
curve, short term interest rate are expected to be lower than long-term interest
rates, which can be sign of potential economic slowdown or recession.
By analyzing the shape of the yield curve, investors and economist can gain
insights into the market´s expectations of future interest rates and the overall
health of the economy.
24. What are the main assumptions of the liquidity premium hypothesis?
Theory suggests that investors require an additional return, or liquidity
premium, for holding long-term bonds relative to short-term bonds. Based on
the idea that long-term bonds are risker and less liquid than short-term bonds,
and that investors demand compensation for the additional risk and
inconvenience of holding these bonds.
Main assumptions of the liquidity premium hypothesis include:
Investors prefer short-term bonds over long-term bonds: Investors are
generally prefer the flexibility and liquidity provided by short-term bonds. This
means that long-term bonds must offer a higher return to compensate
investors.
Long-term bonds are risker than short-term bonds: Due to factors such as
inflation risk and interest rate risk. Investors demand compensation in the form
of a liquidity premium to hold these bonds.
The liquidity premium is stable over time: Assumes that the liquidity
premium is relatively stable over time, meaning that it does not vary
significantly based on market conditions or investors sentiment.
25. Why are long-term bonds considered more risky than short-term bonds?
Interest rate risk: Long-term bonds more exposed to changes in interest rate
than short-term bonds. When interest rate goes up, value of existing long-term
bonds decreases, because investors can buy newly issued bonds with higher
yields.
Inflation risk: Long-term bonds more exposed to inflation risk then short-term
bonds. Inflation erodes the purchasing power of future bond payments. This
means that long-term bondholders face the risk of receiving payments that are
worth less in real terms that they originally anticipated.
Credit risk: Long-term bonds are generally issued by companies or
governments with longer-term financial obligations, and these entities may be
more vulnerable to credit risk than those with shorter-term obligations. Longterm bondholders face the risk of default by the issuers, which could result in a
loss of principal,
Liquidity: Long-term bonds are often less liquid than short-term bonds,
meaning that they are more difficult to buy and sell. Makes it harder for
investors to exit their positions if they need to raise cash quickly or respond to
changing market conditions.
26. According to the liquidity premium hypothesis, what does the shape of the
yield curve reflect?
Shape of yield curve reflects the market´s expectations of future short-term
interests’ rates, as well as the market´s perception the liquidity premium.
Upward yield curve: long-term interest rate is higher than short-term interest
rates. Investors expect short-term interest rates to rise in the future. Can also
reflect market´s perception of a positive liquidity premium, meaning that
investors are demanding a higher return to hold long-term bonds.
Flat or inverted curve: long-term interest rate is similar to or lower than shortterm interest rate, may reflect market expectation that short-term interest rates
will remain stable or decline in the future. May also reflect market perception
that liquidity premium is negative or non-existent, meaning that investors are
not demanding a higher return to hold long-term bonds.
27. According to the market segmentation hypothesis, what does the shape
of the yield curve reflect?
Theory suggest that different maturities of bonds are not substitutes for each
other, and that investors prefer holding certain maturities over others.
Shape of yield curve reflect supply and demand for bonds with different
maturities, rather than expectations of future interest rates or liquidity
premium.
Theory: If there is a high demand for a particular matuirty of bonds relative to
the supply of those bonds, the yield for that maturity will be lower than for
other maturities. Conversely, if there is a low demand for a particular matuirty
of bonds relative to the supply of those bonds, the yield for that matuirty will be
higher than for other maturities.
Overall, the market segmentation hypothesis suggests that the shape of the
yield curve reflects the relative supply and demand for bonds with different
maturities, rather than expectations of future rates or liquidity premiums.
28. Why may it be a reasonable to assume that long-term and short-term bond are
not perfect substitutes?
Different investors preferences: For the timing of cash flows and the risk
associated with different maturities for bonds. Example: some prefer the
stability of cash flow associated with short-term bonds, while others may prefer
the potentially higher returns associated with long-term bonds.
Different risk exposures: Long-term bonds are generally more exposed to
interest rate risk and inflation risk than short-term bonds, which may make
them less attractive to some investors. In addition, short-term bonds may be
less exposed to credit risk than long-term bonds, which could make them more
attractive to risk-averse investors.
Regulatory or legal constraints: Some institutional investors may be subject
to regulatory or legal constraints that limit their ability to hold long-term bonds.
Example: pension funds that may be required to hold a certain percentage of
their assets in short-term or intermediate-term bonds.
Market segmentation: As mentioned in the previous question, investors may
have a preference for certain maturities of bonds over others, which could
result in different supply and demand dynamics and yield differentials between
long and short-term bonds.
29. According to the market segmentation hypothesis, describe what changes in
the investors’ demand for bonds would make a yield curve flatter.
IF the demand for long-term bonds increases relative to the supply of longterm bonds, this can make the yield curve flatter. Because the increase in
demand will result in a decrease in their yield (i.e. an increase in their price),
while the yield on short-term bonds remains relatively stable due to their
relatively stable demand. As a result, the yield differential between long-term
and short-term bonds decreases which leads to a flatter yield curve.
Similarly, if the demand for short-term bonds increases relative to the supply of
short-term bonds, this can also make the yield curve flatter. Because the
increase in demand for short-term bonds will result in a decrease in yield,
while the yield on long-term bonds remains relatively stable. This decrease in
yield differential between short-term and long-term bonds again leads to a
flatter yield curve.
Lecture 7 – Revision
1. What is the role of financial institution in the financial system?
Financial institutions plays a crucial role in the financial system by
providing a range of financial services and products to individuals,
businesses, and governments. These institutions act as intermediaries
between borrowers and lenders, and they help to channel funds from
savers to borrowers. The following are some of they key role that financial
institution plays in the financial system:
Mobilizing Savings: Financial institutions play a key role in mobilizing
savings from individuals, businesses, and governments. They offer a
variety of saving and investment products, such as savings accounts,
certificates of deposits, mutal funds, and pension plans, that enable savers
to earn a return on their funds.
Providing credit: Financial institutions also provide credit to individuals,
businesses and governments. They offer a range of credit products, such
as loans, mortgages, and credit cards, that enable borrowers to access
funds for a variety of purposes.
Facilitating Payments: Financial institutions facilitate payments between
individuals, businesses, and og governments by providing payment and
settlement services. These services include electronic funds transfers, wire
transfers, and checks.
Managing Risk: Financial institutions also help to manage risk by
providing insurance products, such as life insurance, health insurance, and
property and casualty insurance, that protect individuals and businesses
from financial loss.
Creating Liquidity: Financial institutions help to create liquidity in the
financial system by providing secondary markets for securities and other
financial instruments. This enables investors to buy and sell securities
easily and quickly, which helps to ensure that the financial market remain
efficient and liquid.
2. Explain the differences between the direct and indirect financing?
Direct financing and indirect financing are two different methods of
financing used by individuals, businesses, and governments to obtain
funds from lenders to investors.
Direct financing occurs when a borrower obtains funds directly from a
lender or investor without the involvement of a financial intermediary, such
as a bank or a financial institution. Examples of direct financing include
issuing shares of stock or bonds directly to investors, obtaining loans from
family or friends, or crowdfunding. In direct financing, the borrower has a
direct relationship with the lender or investor, and there are no
intermediaries involved.
Indirect financing, on the other hand, occurs when a financial instruments,
such as a bank or a financial institution, facilitates the flow of funds from
savers or investors to borrowers. Indirect financing involves the use of
financial instruments, such as bank loans, mortgages, or bonds, which are
issued by financial intermediaries and then sold to investors. The
intermediary collects funds from investors and then lends or invests those
funds in various projects or ventures. In direct financing, the borrower does
not have a direct relationship with the investor, but instead has a
relationship with the financial intermediary.
The main difference between direct and indirect financing is the
involvement of a financial intermediary. In direct financing, there is not
intermediary, and the borrower has a direct relationship with the lender or
investor. In direct financing, there is a financial intermediary that facilitates
the flow of funds between the borrower and the investor. Direct financing
may be less costly for borrowers because there are no intermediary fees
involved, but it may be more difficult to obtain because there are fewer
potential investors. Indirect financing may be more convenient for
borrowers because intermediaries can provide a range of financial
services, but it may be more expensive because of the fees charged by
intermediaries.
3. Explain what asset transformation is. What purpose does it serve?
Asset transformation is a process that financial intermediaries use to
transform the risk characteristics of assets. In asset transformation,
financial intermediaries acquire financial assets with certain risk
characteristics, such as short-term loans or mortgages, and then transform
those assets into financial liabilities with different risk characteristics, such
as long-term bonds or deposits.
The purpose of asset transformation is to match the risk prefernces of
savers with the needs of borrowers. Savers typically prefer to invest in lowrisk assets, such as deposits or short-term loans, while borrowers may
need to borrow for longer periods of time or may be willing to accept higher
level of risk. Financial intermediaries use asset transformation to brigde
this gap by acquiring low-risk assets from savers and transforming them
into higher-risk assets that meet the needs of borrowers.
For example, a bank might acquire short-term deposits from savers and
then use those deposits to make long-term loans to borrowers, such as
mortgages. In this case, the bank is transforming the risk characteristics of
the assets by converting short-term, low-risk deposits into long-term,
higher-risk loans. The bank is able to earn a profit by charging a higher
interest rate on the loans than it pays on the deposits, while providing a
valuable service to borrowers.
Asset transformation is a key function of financial intermediaries, such as
bank, and it helps to facilitate the flow of funds between savers and
borrowers. By transforming assets, financial intermediaries are able to
provide a range of financial services to bot savers and borrowers, while
also managing risk and earning a profit. However, asset transformation
also involves risk, such as interest rate risk, credit risk, and liquidity risk,
which financial intermediaries must manage carefully to ensure their
financial stability and viability.
4. In what dimensions do transformed securities differ? Provide
examples.
Transformed securities differ in several dimensions, including maturity,
liquidity, credit risk, and return. The following are some examples of how
securities can be transformed in each of these dimensions:
Matuirty: Financial intermediaries can transform securities by changing
their maturity. For examples, a ban might use short-term deposits to make
long-term loans, such as mortgages. In this case, the bank is transforming
the matuirty of the assets from short-term to long-term.
Liquidity: Financial intermediaries can also transform securities by
changing their liquidity. For example, a bank might use a illiquid asset,
such as mortgages or loans, to create liquid liabilities, such as deposits or
certificates of deposit. In this case, the bank is transforming the liquidity of
the asset from illiquid to liquid.
Credit Risk: Financial intermediaries can transform securities by changing
their credit risk. For example, a bank might use high-quality assets, such
as government bonds or highly rated corporate bonds, to create lower
quality liabilities, such as loans to small businesses. In this case, the bank
is transforming the credit risk of the assets from low-risk to higher-risk.
Return: Financial intermediaries can also transform securities by changing
their return. For example, a bank might use low-yielding assets, such as
government bonds or short-term loans, to create higher-yielding liabilities,
such as long-term bonds or mortgage-backed securities. In this case, the
bank is transforming the return of the assets from low-yield to high-yield.
Overall, transformed securities differ in their characteristics and risk
profiles, depending on the needs of savers and borrowers. Financial
intermediaries use asset transformation to create a range of financial
products that meet then needs of both savers and borrowers, while also
managing risk and earning a profit.
5. Using the example of a bank loan, explain why it is indirect financing.
A bank loan is an example of indirect financing because it involves a
financial intermediary, such as a bank, that facilitates the flow of funds
between savers and borrowers. In a bank loan, the borrower obtains funds
from the bank, which collects those funds from savers or investors, such as
depositors or bondholders.
Here is how a bank loan works as an example of indirect financing:
A) The borrower approaches the bank and requests a loan, providing
information about their creditworthiness and the purpose of the loan.
B) The bank evaluates the borrower´s creditworthiness, assesses the risk
of the loan, and determines the terms of the loan, such as the interest
rate, repayment period, and collateral require.
C) If the bank approves the loan, it creates a new financial liability, such as
a loan agreement, and disburses the loan proceeds to the borrower.
D) The borrower is the responsible for repaying the loan to the bank over
the agreed-upon period, typically with interest.
E) The bank collects the loan repayments from the borrower and uses
those funds to pay its own expenses, such as salaries, rent and interest
payments to depositors or bondholders.
In this example, the ban is acting as a financial intermediary that
collects funds from savers, such as depositors or bondholders, and
lends those funds to borrowers, such as individuals, businesses, or
governments. The bank is transforming short-term deposits or other
financial assets from savers into longer-term loans or other financial
liabilities to borrowers, while also managing risk and earning a profit.
This process of intermediation is what makes the loan an example of
indirect financing.
6. Provide three reasons why individuals prefer to hold cash compared
to financial investment.
Individuals may prefer to hold cash instead of investing in financial assets
for a variety of reasons. Here are three possible reasons:
Liquidity: Cash is highly liquid and can be readily used to make purchases
or meet expenses, whereas financial investments may require time and
effort to convert into cash. Individuals may prefer to hold cash to have easy
access to funds in case of unexpected expenses or emergencies.
Risk aversion: Some individuals may have a low tolerance for risk and
prefer to hold cash instead of investing in financial assets, which may
involve higher levels of risk. Cash is generally considered a low-risk asset,
as it is not subject to fluctuations in market value of credit risk.
Lack of financial literacy: Individuals who are not familiar with financial
markets or do not have access to financial advice may prefer to hold cash
as a simple and familiar option. They may be hesitant to invest in financial
assets due to a lack of knowledge or understanding of the risk and returns
involved.
It is worth noting that holding cash may also have drawbacks, such as
inflation risk and the opportunity cost of forgoing potential returns from
financial investments. As with any financial decision, the optimal balance
between holding cash and investing in financial assets depends on an
individual´s financial goals, risk tolerance, and personal circumstances.
7. Provide at least three reasons why there are more fund flows in the
financial system if we have intermediaries.
Risk reduction: Intermediaries can help reduce risk in the financial system
by pooling funds from many different investors and allocating them across
a diversified portfolio of assets. This diversification can help reduce the risk
of losses due to defaults or market fluctuations, which can increase
investor confidence and attract more funds to the system.
Information asymmetry: Intermediaries can also help address information
asymmetry in the financial system by providing expertise and information to
investors that they may not have access to on their own. This can increase
investor confidence and trust, which can in turn lead to greater investment
activity.
Liquidity: Intermediaries can provide liquidity to investors by offering a
market where they can buy and sell financial assets. This can make it
easier for investors to enter and exit the market and manage their cash
flows, which can increase overall fund flows.
Reduced transaction costs: Intermediaries can also help reduce
transaction costs for investors by aggregating smaller trades and providing
economies of scale in execution. This can make it more cost-effective for
investors to participate in the market and increase overall fund flows.
Credit intermediation: Financial intermediaries can act as credit
intermediaries, meaning that they can facilitate the flow of credit from
savers to borrowers by assessing the creditworthiness of borrowers and
allocating funds accordingly. This can help match the supply of funds with
the demand for credit, which can increase overall fund flows in the system.
Overall, intermediaries can play an important role in facilitating fund flows
in the financial system by reducing risk, providing expertise and liquidity,
reducing transaction costs, and facilitating credit intermediation.
8. List at least five different risk that financial intermediaries face.
Financial intermediaries face a variety of risks that can impact their
operations and financial performance. Here are five different types of risks
that financial intermediaries may face:
Credit risk: Financial intermediaries face credit risk when borrowers fail to
repay their loans or obligations. This can happen due to factors such as
borrowers’ default, bankruptcy, or economic downturns. Financial
intermediaries can mitigate credit risk by performing due diligence on
borrowers, setting appropriate lending standards, and maintaining
diversified portfolios.
Market risk: Financial intermediaries are exposed to market risk, which is
the risk of losses due to changes in the market conditions such as interest
rates, foreign exchange rates, and market volatility. Market risk can impact
the value of financial assets held by intermediaries and their ability to
generate returns. Financial intermediaries can mitigate market risk through
diversification, hedging strategies, and active risk management.
Liquidity risk: Financial intermediaries face liquidity risk when they cannot
meet their financial obligations due to lack of available cash or assets that
can be easily converted into cash. Liquidity risk can arise due to factors
such as unexpected withdrawals from depositors, a decline in market value
for assets, or a loss of confidence in the financial system. Financial
intermediaries can manage liquidity risk through prudent asset-liability
management, maintaining adequate reserves, and having access to
emergency funding sources.
Operational risk: Financial intermediaries face operational risk, which is
the risk of losses to due to inadequate or failed internal processes, systems
or people. Operational risk can arise due to factors such as fraud, errors,
technology failures, or natural disasters. Financial intermediaries can
mitigate operational risk by implementing robust internal controls, investing
in technology and infrastructure, and providing ongoing training and
education to employees.
Reputation risk: Financial intermediaries face reputation risk when their
reputation is damaged due to negative publicity, regulatory action, or other
factors that erode trust and confidence in the institution. Reputation risk
can impact a financial intermediary´s ability to attract and retain customers,
access funding sources, and generate revenue. Financial intermediaries
can mitigate reputation risk by maintaining high standards of ethical and
professional conduct, engaging with stakeholders and the community, and
having effective crisis management plans in place.
9. What is credit risk? What financial intermediaries are exposed to
credit risk?
Credit risk refers to the risk of financial loss that a lender or investor may
face if a borrower or debtor fails to repay a loan or meet its financial
obligations. In other words, credit risk is the risk of default.
Financial intermediaries that lend money or provide credit customers, such
as banks, credit unions, and other financial institutions, are exposed to
credit risk. Credit risk can also arise in other forms of lending or financing,
such as corporate bonds or mortgage-backed securities.
In addition, individual investors who lend money though peer-to-peer
lending platforms or invest in corporate bonds or other debt securities are
also exposed to credit risk. Even governments and other public sector
entities can be exposed to credit risk if they lend money or guarantee loans
to private sector borrowers or other governments.
10. How can credit risk be managed.
Credit analysis: Financial intermediaries can conduct credit analysis on
potential borrowers to determine their creditworthiness. This involves
analyzing their financial statements, credit history, and other relevant
factors to assess the likelihood of default.
Credit limits: Financial intermediaries can set credit limits for borrowers to
limit their exposure to credit risk. This involves determining the maximum
amount of credit that a borrower can receive based on their
creditworthiness.
Collateral: Financial intermediaries can require borrowers to provide
collateral as a form of security for the loan. This means that if the borrower
default, the lender can seize the collateral to recover some or all of the
loan.
Diversification: Financial intermediaries can diversify their lending
portfolios to reduce their exposure to credit risk. This means spreading
their loans across different sectors and borrowers with different credit
profiles.
Credit insurance: Financial intermediaries can purchase credit insurances
to protect themselves against credit risk. This involves paying premiums to
an insurance company in exchange for coverage in the event of a borrower
default.
Loans covenants: Financial intermediaries can include loan covenants in
their lending agreements to limit the borrower´s risk-taking behavior. These
covenants may require the borrower to maintain certain financial ratios or
take other actions to mitigate credit risk.
11. What is liquidity risk (in the context of financial intermediation). How
does liquidity mismatch arise on the balance sheet of the financial
intermediaries?
Liquidity risk is the risk of a financial intermediary being unable to meet its
short-term financial obligations when they come due without incurring
significant costs or losses. In other words, it´s the risk that a financial
intermediary may not have enough cash or liquid assets to meet its
payment obligations.
Liquidity mismatch arises on the balance sheet of financial intermediaries
when they fund long-term assets, such as loans or mortgages, with shortterm liabilitites, such as deposits or short-term borrwings. This creates a
liquidity risk because the financial intermediary may not be able to easily
convert its long-term assets into cash to meet its short-term obligations.
For example, a bank may fund a 30-year mortgage loan with epostits that
can be withdrawn by depositors on demand. If many depositors withdraw
their funds at once, the bank may face a liquidity criss because it may not
have enough cash or liquid assets to meet all of the withdrawals requests.
Similarly, financial intermediaries that rely heavily on short-term funding,
such as commercial paper or repurchase agreements, are also exposed to
liquidity risk because they may not able to easily rool over their short-term
liabilities in a market downturn or if investor sentiment. Changes.
12. Describe how liquidity risk materialize and lead to a bank run?
Liquidity risk can materialize when a bank experiences a sudden demand
for cash withdrawals or fails to obtain adequate funding from the market if a
bank is unable to meet its financial obligations due to insufficient cash
reserves or unable to access short-term funding markets, it may trigger a
bank run. In a bank run, depositors may start to withdraw their deposits
simultaneously, leading to a further shortage of cash reserves, which can
ultimately lead to insolvency.
13. What is interest rate risk? Explain the differences between the
refinancing and reinvestment risk.
Interest rate risk refers to the potential loss that a financial institution may
face due to a change in interest rates. It can arise from two main sources:
refinancing risk and reinvestment risk. Refinancing risk is the risk that an
institution may not be able to refinance its maturing debts at a reasonable
cost or rate, while reinvestment risk is the risk that the institution may not
be able to invest its funds at the same or better rate when its existing
investments mature.
14. What is operational risk?
Financial regulators face a trade-off between promoting financial stability
and promoting economic growth. Stricter regulations can help reduce the
risk of financial crises, but they can also limit credit availability and hinder
economic growth. Looser regulations can boost economic growth, but they
can also increase the risk of financial instability. Regulators need to
balance these competing interest and strike the right balance between
promoting growth and ensuring financial stability.
15. Describe the tradeoff between growth and stability that financial
regulators face.
Financial regulators face a trade-off between promoting economic growth
and maintaining financial stability. On one hand, regulators want to
encourage economic growth by promoting lending and investment, which
can help stimulate economic activity and create jobs. However, too much
growth can lead to excess risk-taking and instability in the financial system.
Therefore, regulators must balance the need for growth with need for
stability, which may require imposing regulations and limits on certain
activities.
16. Why it may be reasonable to limit risk taking by financial institutions?
It may be reasonable to limit risk-taking by financial institutions because
excessive risk-taking can lead to financial instability and systematic risks
that can have far-reaching consequences. For example, if a large financial
institution takes on too much risk and fails, it could trigger a domino effect
that spreads throughout the financial system, causing widespread
economic disruption. By limiting risk-taking, regulators can help prevent
such events and promote stability in the financial system.
17. What do regulators do to ensure safety and stability of the financial
system? List at least three activities.
To ensure the safety and stability of the financial system. Regulators
undertake a range of activities including:
-Monitoring and regulating financial institutions to ensure they comply with
relevant laws, regulations, and standards.
-Conducting stress tests to assess the ability of financial institutions to
withstand adverse market conditions and shocks.
-Maintaining financial stability by providing liquidity support, oversight, and
supervision to prevent and mitigate financial crises.
18. Which regulatory body supervises derivatives trading?
The regulatory body that supervises derivatives trading varies depending
on the country. In the USA, the Commodity Futures Trading Commission
(CFTC) is the primary regulatory body responsible for overseeing
derivatives trading. In the European Union, derivatives trading is regulated
by the European Securities and Markets Authority (ESMA) and national
regulatory authorities of member states.
19. Who supervises bank holding companies?
In the United States, bank holding companies (BHCs) are primarily
supervised by the Federal Reserve, which is responsible for ensuring their
safety and soundness. The Federal Reserve supervises BHCs through its
Division of Supervision and Regulation, which oversees and regulates
bank holding companies with more than $100 billion in total consolidated
assets, as well as nonbank financial companies designated as
systematically important by the Financial Stability Oversight Council. The
Federal Reserve also collaborates with other regulatory agencies, such as
the Office of the Comptroller of the Currency and the Federal Depost
Insurance Corporation, in supervising certain BHCs.
Lecture Revision 8
1. To whom would you recommend investment in a passive strategy?
Passive strategies, such as index funds, are often recommended to investors
who are looking for low-cost, diversified approach to investing. This is because
passive strategies seek to replicate the performance of a market index, rather
than trying to beat it, which can be difficult and expensive to achieve through
active management. Passive strategies may be especially suitable for
investors who are focused on long-term, buy-and-hold investing, as they tend
to be less volatile and can help reduce the impact of market fluctuations on a
portfolio.
2. Describe at least four differences between active and passive strategies.
Some differences between active and passive investment strategies include:




Active strategies involve actively managing a portfolio of securities with
the aim of outperforming a benchmark or the broader market, while
passive strategies seek to replicate the performance of a market index
or other benchmark.
Active strategies tend to be more expensive, as they require more
research, analysis, and trading activity, while passive strategies
typically have lower fees and expenses.
Active strategies may have higher portfolio turnover, which can lead to
higher transaction costs and potential tax liabilities, while passive
strategies tend to have lower turnover and can be more tax efficient.
Active strategies may have higher potential returns but also higher
potential risk, as they rely on the skill and expertise of the investment
manager, while passive strategies aim to capture the market as a
whole.
3. Why does active and passive strategies, on average, have equal returns?
Active and passive strategies, on average, have equal returns because active
managers must earn enough to cover their higher costs, including, research,
trading, and salaries. While some active managers may be able to generate
higher returns than the market, on average, they tend to underperform their
benchmarks after accounting for fees and expenses. In contrast, passive
strategies, which simply track the performance of a market index, tend to have
lower costs and fees and can therefore deliver similar returns to the broader
market over the long term.
4. What does empirical evidence tell us about the returns earned by mutual
fund managers?
Empirical evidence suggest that the returns earned by mutual fund managers,
on average, tend to underperform their benchmarks after accounting for fees
and expenses. This is known as the “active management fee drag” and is a
major reason why passive strategies, such as index funds, have become
increasingly popular with investors. While some active managers may be able
to outperform the market, the evidence suggests that this is difficult to do
consistently over time, and that many active managers are unable to generate
higher returns than the market after accounting for their higher costs.
5. Should active strategies bring higher/abnormal returns? (This is a
discussion question, in which various aspects can be disused, and
arguments are important, not a yes/no answer).
The question of whether active strategies should bring higher or abnormal
returns is a subject of debate among investment professionals and academics.
On one hand, proponents of active management argue that skilled managers
can identify mispricing in the markets and generate excess returns by
exploiting these inefficiencies. They argue that active managers have the
flexibility to deviate from the benchmark and take advantage of market
opportunities, which can lead to higher returns than passive strategies. On the
other hand, critics of active management argue that markets are highly
efficient, and that the cost of active management outweighs the benefits. They
argue that is difficult to consistently identify mispricing’s and generate excess
returns, and that active managers are unlikely to beat the market over the long
term. Ultimately, the question of whether active strategies should bring higher
or abnormal returns depends on a variety of factors, including market
efficiency, the skill of the manager, and the cost of active management.
6. Why are returns not a good measure of mutual fund manager skills?
Returns are not a good measure of mutual fund manager skills because they
are influenced by factors beyond the manager´s control, such as market
conditions, interest rates, and economic cycles. A manager may have made
good investment decisions, but if these decisions were made in a favorable
market environment, the returns may not necessarily reflect the manager´s
skill. Additionally, returns may be influenced by the level of risk taken by the
manager, and it can be difficult to compare returns across different types of
funds with varying level of risk.
7. Why is it difficult (or impossible), even for a skilled manager to produce
continuously abnormal returns?
It is difficult, if not impossible, for even a skilled manager to produce
continuously abnormal returns because markets are highly efficient, and
mispricings are quickly exploited by other investors. As more investors identify
mispricings and try to take advantage of them, the mispricings disappear, and
abnormal returns become harder to achieve. Additionally, even if a manager is
able to identify a mispricing, they may not be able to act on it quickly enough
to generate abnormal returns. The competition among investors, combined
with speed and volume of information available in today´s markets, makes it
increasingly difficult for even skilled managers to consistently generate
abnormal returns.
8. Why ale in equilibrium all mutual fund managers supposed to earn the
same returns? (Rely on the Berk and Green theory).
According to the Berk and Green theory, in equilibrium, all mutual fund
managers are expected to earn the same return, net of fees. This is because
competition among managers ensures that any profitable investment
opportunities are quickly identified and exploited, eliminating abnormal returns.
The theory assumes that investors are rational and well-informed, and that
markets are efficient. In such a market, any information that could lead to
abnormal returns is quickly incorporated into prices, making it difficult for any
manager to consistently generate abnormal returns over time. While some
managers may be able to generate higher returns than other in the short term,
the theory suggest that over the long term, all managers will converge to the
same returns.
9. How can you measure performance of the mutual fund?
There are several measures of performance for a mutual fund, including:


Total return: This is the percentage increases in the value of the fund´s
assets over a specific period, including both capital appreciation and
income generated by the fund´s investments.
Risk-adjusted return: This measures the fund´s return in relation to the
amount of risk taken to achieve that return. Common measures of riskadjusted return include the Sharpe ratio, which measures return per unit
of risk, and the Sortino ratio, which measures return per unit of
downside risk.

Expense ratio: This is the cost of managing the fund, expressed as a
percentage of the fund´s assets. Lower expense ratios generally
indicate better value for investors.
10. Why does good performance of a mutual fund manager not prove that he
is skilled? What does?
Good performance of a mutual fund manager does not necessarily prove that
they are skilled, as performance can be influenced by factors outside of the
manager´s control. A manager who has experienced good performance may
have been lucky or may have benefited from favorable market conditions. To
determine whether a manager is truly skilled, investors should consider factors
such as the manager´s investment philosophy, process, and experiences, as
well as their track record over a longer period of time and in different market
environments.
11. Should you invest in a fund that reported high returns last year? Why or
why not.
Investing in a fund that reported high returns last year is not necessarily a
good strategy. Past performance is not a reliable indicator of future returns,
and funds that have performed well in the past not continue to do so in the
future. Additionally, funds that report high returns may have taken on higher
levels of risk to achieve those returns, which may not be suitable for all
investors. Before investing in fund, investors should carefully consider their
investment objectives, risk tolerance, and investment time horizon, and should
conduct thorough research to understand the fund´s investment philosophy,
process, and track record.
Lecture 9
1. What characterizes financial crisis?
Financial crises are characterized by severe disruptions in the financial
system, typically involving a combination of widespread asset price declines,
sharp increases in credit defaults, liquidity shortages, and a loss of confidence
among market participants.
Credit Crunch: tightening of credit conditions. Lenders become more cautious
and reduce lending.
Banking system stress: banks may face increased loan defaults, liquidity
pressures, and solvency concerns. Can lead to bank failures, a loss of
confidence in banking sector, overall decrease in stability of the financial
system.
Contagion: Financial crises can spread across countries and regions, causing
a contagion effect.
2. What is the fundamental value of a stock?
Fundamental value of a stock refers to the intrinsic value of the underlying
company or the expected present value of its future cash flows. Based on
factors such as the company´s earnings, growth prospects, assets, liabilities,
and industry dynamics.
3. What is a speculative bubble?
Refers to a situation in which the price of an asset becomes detached from its
fundamental value and rises to excessive levels based on expectations of
further price increases. Often fueled by investors optimism, herd behavior, and
the belief that prices will continue to rise indefinitely. Eventually, the bubble
burst, leading to a sharp decline in prices and significant losses for those who
bought at inflated levels.
4. How can a speculative bubble persist on the market?
Herd behavior: Following the actions of others and if prices will continue to
rise. Can lead to self-fulfilling prophecy, as more investors join the buying
frenzy, pushing prices higher despite the lack of fundamental support.
Positive feedback loop: As prices rise in a speculative bubble, investors may
experience positive feedback, reinforcing their belief that prices will continue to
increase. Can create a momentum effect, attracting more investors and
sustaining the bubble for a period.
Irrational Exuberance: Investors become overly optimistic and ignore or
downplay the risk associated with inflated asset prices. This irrational optimism
can contribute to the persistence of the bubble, as investors continue to buy
into market, even at high prices.
Lack of information efficiency: in some cases, a speculative bubble can persist
due to a lack of accurate information or a misinterpretation of available
information. Market participants may not fully understand the true value or risk
associated with the asset, leading to a prolonged period of overvaluation.
However, it is important to note that speculative bubble is inherently
unstainable, and they eventually burst when market dynamics.
5. Why is liquidity risk inherent in bank operations?
Mismatched maturities: bank typically engage in maturity transformation,
where they borrow short-term funds (e.g., through deposits) and provide
longer-term loans (e.g., mortgages, business loans). This maturity mismatch
exposes bank to liquidity risk, as they may face difficulties in meeting their
short-term obligations if depositors or creditors demand their funds back
before the maturity of the loans.
Withdrawal of deposits: Banks rely on customer deposits as a source of
funding for their lending activates. If a significant number of depositors
withdraw their funds simultaneously, it can strain the bank´s liquidity position.
A bank run can occur, when a large number of depositors try to withdraw their
funds due to concerns about the bank´s solvency, exacerbating liquidity risk.
Interbank market dependence: Banks often rely on borrowing from other
banks or participating in the interbank lending market to meet their short-term
funding needs. If there is a loss of confidence in the banking sector or
disruptions in the interbank market, it can lead to a shortage of available
funds, making it challenging for banks to obtain liquidity.
6. What is a sub-prime mortgage?
Type of mortgage loan that is granted to borrowers with a lower
creditworthiness or higher risk of default. Lower credit scores, limited income
documentation, or a history of financial difficulties. Subprime mortgages often
have higher interest rates compared to prime mortgages to compensate for
the higher risk. Got a lot of attention during the global financial crisis of 20072008.
7. What is securitization?
Process in which financial assets, such as mortgages, loans or receivables,
are pooled together and transformed into securities that can be traded in
financial markets. Involves creating a special purpose vehicle (SPV) that
acquires the underlying assets, issues securities backed by these assets, and
distributes the cash flows generated from the assets to the investors in the
securities.
Objective is to transform illiquid or less liquid assets into tradable securities,
allowing financial intuitions to access additional funding and diversify their risk.
Provides investors with an opportunity to invest in specific cash flows
generated by the underlying asset.
8. What are the main types of securities created through securitization?
Explain the main differences between them.
Mortgage-Backed Securities (MBS): MBS are created by pooling residential or
commercial mortgage loans. Cash flows from the mortgage payments made
by borrowers are passed through to the MSB holders. MBS can be further
categorized into different types, such as collateralized mortgage obligations
(CMOs), pass though securities, and mortgage-backed bonds.
Asset-Backed Securities (ABS): ABS are created by pooling various types of
assets, such as auto loans, credit card receivables, student loans, or
consumer loans. Cash flows generated from these underlying assets are used
to make payments to ABS holders. ABS can offer different levels of credit
quality based on the composition and creditworthiness of the underlying
assets.
Collateralized debt obligations (CDOs): CDS are created by pooling various
types of debt instruments, such as corporate bonds, mortgage-backed
securities, or asset-backed securities. Also pays cash flows to holders.
Tranches of CDOs are divided into senior, mezzanine, and equity tranches,
with senior tranches having the highest credit quality and lowest risk. Equity
tranches having the highest risk and potential for higher returns.
9. What is the role of GSEs?
GSE (Government-Sponsored Enterprises) play a significant role in the
housing and mortgage markets. They are financial institutions that are created
or sponsored by government to promote certain public policy objectives,
primarily in the housing sector. Role varies across countries, but their main
function typically include:
Providing liquidity: GSEs purchase mortgages from banks and other lenders,
which help inject liquidity into the mortgage market.
Standardizing Mortgage products: GSEs establish guidelines and standards
for mortgage underwriting, which promotes uniformity and consistency in the
mortgage market. Helps to facilities the flow of mortgage credit and improves
market efficiency.
Promoting affordable housing: often have mandate to support affordable
housing initiatives. May provide financing or facilitate the availability of
mortgage credit to borrowers who might not meet traditional underwriting
availability of mortgage credit to borrowers who might not meet traditional
underwriting standards, promoting homeownership among low and moderateincome households.
10. Why do banks sell loans?
Liquidity management: selling loans allows banks to manage their liquidity
position. By selling loans, banks can convert illiquid assets into cash, which
can be used to meet funding needs, make new loans, or invest in other assets.
Risk mitigation: banks sell loans to reduce their exposure to specific types of
risk. Example: bank has a large concentration of loans in a particular sector or
geographic region, selling a portion of those loans can help diversify risk and
reduce potential losses in case of a downturn or default.
Regulatory compliance: banks are subject to regulatory requirements, such as
capital adequacy ratios. Selling loans can help banks free up capital and
improve their capital position, allowing them to meet regulatory requirements
more effectively.
Profit generation: banks can generate profits by originating and selling loans.
By selling loans at a premium, banks can earn a profit on the difference
between the loan´s origination value and the selling price.
11. Characterize the economic environment before the financial crisis
emphasizing the features that led to the bubble on the housing market.
Loose monetary policy: Central banks pursued expansionary monetary
policies, keeping interest rates low to stimulate economic growth and
increasing lending. Low interest rate made borrowing cheaper, encouraging
increased demand for housing and mortgage loans.
Easy credit conditions: lenders relaxed their lending standards, offering
subprime mortgages to borrowers with lower creditworthiness or without
adequate income documentation. This led to a significant increase in
availability of credit, allowing more people to enter the housing market.
Housing market speculation: investor speculation and expectations of
continuous price appreciation fueled demand for housing. Speculators
purchased properties with expectation of quick profits, further driving up
housing prices.
Securitization and Mortgage-Backed securities: the securitization of mortgage
loans, particulary subprime mortgages, allowed lenders to offload the risk of
these loans to investors. This led to a significant increase in the supply of
mortgage credit and further contributed to the housing bubble.
Lack of regulatory oversight: regulatory oversight and supervision of financial
institutions were inadequate, allowing excessive risk-taking, predatory lending
practices, and the proliferation of complex.
12. What are the risks of financing with short-term asset-backed securities?
Liquidity risk: short-term asset-backed securities typically have maturities
ranging from a few days to a few months. If there is a sudden loss of
confidence in the market or a disruption in the funding market, investors may
be hesitant to roll over or purchase new issues of these securities, leading to
liquidity crunch for the issuer.
Refinancing risk: issuers of short-term asset-backed securities rely on the
ability to refinance or roll over their maturing securities by issuing new ones. If
market conditions deteriorate or investor demand diminishes, issuers may face
challenges in refinancing their existing obligations, potentially lending to a
default or funding shortfall.
Market value volatility: short-term asset-backed securities can be subject to
price fluctuations based on changes in market conditions, interest rates, and
investor sentiment. Market value volatility can impact the value of the
securities and the ability of the issuer to raise funds in the market.
13. Why has the lending standard deteriorated during the pre-crisis housing
boom?
High demand for mortgage-backed securities: As a result, there was
significant pressure on lender to originate more mortgage-backed loans to
meet the demand for securitization. In response, lender relaxed their lending
standards to approve loans for borrowers with lower creditworthiness or
insufficient income documentation.
Incentives and compensation structure: Incentive structure within the financial
industry, such as commission-based compensation for loan originators,
motivated individuals to approve more loans to earn higher commissions. This
led to a loosening of lending standards as the focus shifted towards loan
quantity rather than quality.
Financial innovation and securitization: The ability to securitized mortgage
loans and sell them in the secondary market allowed lenders to offload the risk
associated with these loans. This, in turn, reduced their incentives to closely
scrutinize borrowers´ creditworthiness, leading to relaxed lending standards.
14. What was the problem with the risk assessment of the securitized
mortgages?
The problem with risk assessment of securitized mortgages was the
underestimation of the default and loss probabilities associated with these
mortgages.
Flawed assumptions: risk assessment models used by financial institutions
and credit rating agencies relied on historical data that did not fully capture the
potential risks and vulnerabilities of the subprime mortgage market. These
models failed to account for the possibility of a nationwide decline in housing
prices and a simultaneous increase in mortgage defaults.
Limited information and transparency: the complex nature of securitized
mortgages made it difficult for investors and rating agencies to assess the
underlying credit quality of the loans. The lack of transparency in loan
documentation and inadequate information about borrowers ‘creditworthiness
contributed to the inaccurate risk assessment.
Conflict of interest: there was a conflict of interest in the risk assessment
process. Rating agencies, which were responsible for assessing the
creditworthiness of mortgage-backed securities, were paid by the issuers of
these securities. This created incentives for rating agencies to provide
favorable ratings, potentially leading to an underestimation of the risk involved.
15. How can we interpret an increase in TED spread (LIBOR – Treasury bill)?
The TED spread, which represent the difference between the London
Interbank Offered Rate (LIBOR) and Treasury bill rates, is often used as an
indicator of credit risk and market stress. An increase in the TED spread
suggests a higher perceived credit risk and reduced confidence in the banking
system.
Typically, LIBOR reflect the rate at which banks lend to each other, while
Treasury bills are considered risk-free. An increase in the TED spread implies
heightened credit risk, market stress, potential liquidity concerns, and a shift in
investor sentiment towards safer assets.
16. Describe why the crisis amplified so much causing huge losses on the
US stock market?
Subprime mortgage crisis: crisis originated in the housing market, specifically
in the subprime mortgage sector. Lenders had issued a large number of
mortgages to borrowers with weak credit profiles, and when housing prices
started to decline, many of these borrowers defaulted on their loans. This led
to a wave of foreclosures and a significant decline in the value of mortgagebacked securities and other financial instruments tied to these mortgages.
Contagion and interconnectedness: crisis spread throughout the financial
system due to interconnectedness of financial institutions and the complexity
of financial instruments. Financial institutions had significant exposure to
mortgage-backed securities and related derivatives, which suffered from
significant losses. This interconnectedness amplified the impact of the crisis
and led to a loss of confidence in the financial sector as a whole.
Systematic risk and Lehman brothers collapse: the bankruptcy of Lehman
Brothers in September 2008 was a pivotal moment in the crisis. It caused
widespread panic and uncertainty in the financial markets, leading to a
freezing of credit markets, liquidity shortages, and a loss of trust among
market participants. The collapse highlighted the systematic risks within the
financial system and triggered a severe contraction in lending and investment
activity.
Investor panic and market sell-off: Crisis led to a period of intense investor
panic and a sharp decline in market confidence. As losses mounted and
financial institutions faced solvency concerns, investors rapidly sold off their
holdings, including stocks, leading to a significant decline in stock prices. The
fear and uncertainty surrounding the crisis further fueled the market sell-off
causing substantial losses for investors.
Lack of regulatory oversight and risk management: the crisis exposed
weaknesses in regulatory oversight and risk management practices. Financial
institutions had taken on excessive risk, often relying on complex financial
instruments and inadequate risk assessment models. The lack of.
Transparency and accurate valuation of these instruments contributed to the
amplification of losses and the severity of the crisis.
17. Explain the difference between the market liquidity and funding liquidity.
Market liquidity: Market liquidity refers to the ease with which an asset can be
bought or sold in the market without causing a significant impact on its price. It
relates to the ability to quickly convert an asset into cash without incurring
excessive costs or price volatility. High market liquidity implies a deep and
active market with ample trading volume, tight bid-ask spreads, and low
transaction costs.
Funding liquidity: Refers to the availability and ease of obtaining financing or
funding in the market. It relates to the ability of market participants, such as
financial institutions, to obtain necessary funding to support their operations or
meet their financial obligations. Funding liquidity is crucial for functioning of
financial markets and institutions, as it enables them to maintain their liquidity
and solvency.
18. Think about the liquidity spiral. Explain, why when assets prices fall it is
more difficult to obtain financing.
The liquidity spiral refers to a self-reinforcing cycle of declining asset prices
and tightening access to financing. When asset prices fall, several factors
contribute to increased difficulties in obtaining financing:
Collateral value: falling asset prices erode the value of collateral used for
borrowing. Lenders typically require collateral to secure loans, and as the
value of the collateral declines, borrowers may face margin calls or reduced
access to credit. This reduces their ability to obtain financing or forces them to
provide additional collateral, further exacerbating the downward pressure on
asset prices.
Risk Aversion and losses: declining asset prices increase risk aversion among
lender and investors. Lenders become more cautious about extending credit,
demanding higher interest rates or imposing stricter lending terms. Investors
concerned about further losses and may withdraw funds.
19. Why during a crisis do investors decrease lending?
Due to heightened risk aversion and uncertainty:
Risk perception: during a crisis, there is heightened perception of risk in the
market. Investors become more cautious and concerned about potential
losses and defaults. They may decrease lending to mitigate their exposure to
risky assets or counterparties.
Lack of Trust: A crisis erodes trust and confidence in the financial system.
Investors may be skeptical about the financial health and stability of borrowers
and counterparties, leading them to reduce lending to minimize their potential
losses.
Funding constraints: Investors may face funding constraints. They may need
to preserve liquidity or raise capital to meet their own obligations or cover
loses. This can limit their ability to lend or provide financing to others.
Market disruptions: crisis often result in disruptions in financial markets,
including lack of liquidity and increased price volatility. These conditions can
make it more investors to assess fair value and evaluate creditworthiness,
leading to a decrease in lending activity.
20. Why lack of transparency is problematic when financial institutions are
interconnected via a net of financial positions?
It hinders the ability to accurately assess and understand the potential risks
and exposures within the financial systems.
Counterparty risk: interconnectedness means that financial institutions have
exposures to each other through various financial instruments and
transactions. If there is a lack of transparency regarding these positions, it
becomes difficult to evaluate the counterparty risk, i.e., the risk that one party
may default on its obligations. Without a clear understanding of counterparty
risk, it becomes challenging to assess the potential impact of a default on
other institutions and the overall stability of the financial system.
Contagion risk: when financial intuitions are interconnected, a problem or
shock in one part of the system can spread rapidly to other institutions. Lack of
transparency hampers the ability to identify and assess the extent of contagion
risk. This can lead to loss of confidence in the financial system and exacerbate
systematic risk.
Risk management: Lack of transparency makes it difficult for regulators,
investors and market participants to assess the risk management parties of
financial institutions. It becomes challenging to identify potential vulnerabilities,
such as excessive leverage or concentration of risk, which can amplify the
impact of a crisis or market downturn.
Valuation and pricing: can be challenging to accurately value assets and
assess their true market prices. Can lead to mispricing of assets and
distortions in the allocation of capital, ultimately impacting efficiency and
stability of the financial system.
21. What were the new regulations introduced after the financial crisis?
Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank
Act): This comprehensive legislation was enacted in 2010 and introduced
significant reforms to the financial system. Aimed to enhance financial stability,
increase transparency, and strengthen consumer protection. Dodd-Frank Act
introduced measures such as the Volcker Rule (restricting proprietary trading
by banks), increased regulation of derivatives, establishment of the Consumer
Financial Protection Bureau, and enhanced oversight of systematic risk.
Basel III: The Basel Committee on Banking Supervision introduced Basel III, a
set of international banking regulations, in respons to the financial crisis. Basel
III aimed to strengthen banks´ capital requirements, enhance risk
management and supervision, and improve the overall resilience of the
banking sector. It introduced higher capital ratios, liquidity requirements, and
the measures the address systematic risk and leverage.
Volcker Rule: Part of the Dodd-Frank Act, the Volcker Rule prohibits banks
from engaging in proprietary trading and restrict their investment in hedge
funds and private equity funds.