FINA3324 MSE Potential Questions

Lecture 1 Investing Environment

What is the role of finance? Well functioning capital markets facilitate the intertemporal matching of consumption and productivity, allocation of risk to those best able to bear it and the separation of ownership and management. However there are challenges in matching investors and entrepreneurs, overcoming info asymmetry, enabling circumstances where there is trust between savers and borrowers What are the intertemporal needs for finance? Life-cycle needs i.e. education and pension Emergencies i.e. sickness, natural disaster Opportunities i.e. invest in a business, finance a war What are the varieties of securities available? MONEY MARKET INSTRUMENTS securities short term, low risk and have large denominations CAPITAL MARKET INSTRUMENTS Bonds long term fixed income securities Equities non-fixed income securities with some control right over the asset Derivatives get value from the value of other assets Why do financiers earn so much? Are bankers overpaid? Deregulation of financial market beginning in the 1980s spurred innovation in financial intermediaries which required talent to work with When financial transactions are routine and can be done by applying well tested formula then pay isnt high. Capital Protected Investments What is the catch? Does society benefit? Have to commit for 3-5yrs opportunity cost of other investment opportunities Early exit fees disincentive to withdraw funds

Commission fees provider earns a commission for providing the money managing service May not be good for society i.e. tax evasion is an issue Check with Sachs tutorial answers

Lecture 2 Risk and Return Relationship

Higher Risk Means Higher Returns evaluate this statement. In a competitive market higher risk projects higher expected return to attract capital High returns without risk only persist if there are barriers to entry When high returns persist without barriers to entry it is most likely there is a correspondingly high risk. Why were lenders to MF Global willing to lend money at low interest rates when they could have bought European bonds offering higher returns? Lenders didnt share MF Globals view the bonds were low risk Lenders were lending on a short term basis and reserved right to require more collateral if default risk rose. LENDERS WILLING TO LEND AT A LOWER RATE FOR LOWER RISK AND MORE LIQUIDITY Explain the equity premium puzzle. EPP is the anomalously high historial real return of stocks over government bonds. Difference in required rate of return seems implausibly highequity premium of 6% seems excessive! Explanations: it doesnt exist (selection bias, survivorship bias, low amount of data) modifications to the assumed preferences of consumers, imperfections in model of risk aversion

What is leverage? Why do companies take on high levels of leverage? Leverage is the amount of debt used to finance a firms assets. Debt provides debtholders with lower risk than equity, but also lower returns. Companies can achieve much higher returns to shareholders by taking on more debt (NOTE: this also increases the expected return to S/H as risk is increased) What are the differences between arithmetic mean, geometric mean (time weighted) and internal rate of return (dollar weighted)? Which return measure is best?

Arithmetic return is the average or typical return for an investment Time weighted return (geo mean) return on $1 over the period of timepreferred industry standard Dollar weighted return (IRR) discount rate at which the NPV =0 (PV outflows = PV inflows) . sensitive to contributions and withdrawls (penalises managers when contributions low/withdrawls high) Time weighted return is usually preferred. Check with Sach. MCQ Rate of return calculations

Lecture 3 MPT and CAPM

What is MPT? What is its core insight? What are the issues with using MPT?

Investors who aim to maximise returns whilst minimising risk should select assets that co-vary less with their existing portfolio Issues: Historical returns to determine how assets will vary not always the best guide to how they will covary in the future In times of economic crisis covariance of assets often converges towards onereturns of an asset tend to plunge down together

Assume three stocks, each with std deviation of 40% and expected return of 15%. Ford, Microsoft & Starbucks 1. If you buy all three stocks, what is the expected return to your portfolio? 15% 2. Will the standard deviation of your portfolio be greater or less than 40%? Why?

Less than 40%...the 3 companies are from different industrieslikely to have low covariances relative to each other. 3. Who would pay more for Ford stock: (a) an investor who already owns Microsoft and Starbucks stock or (b) an investor who has just Ford stock in her portfolio? Why? Microsoft investoradding Ford is likely to reduce the s.dev of portfolio, as Ford is from a different industry and it is likely to move in a different direction. What are the benefits of diversification? What determines the limit of reduction in diversification? Diversification is a risk management technique that mixes a variety of different investments in a portfolio to reduce unsystematic risk i.e. the positive performance of some investments will neutralise the negative performance of others. The level of systematic risk (risk inherent to the entire market) determines the limit of diversification benefitsstudies show that maintaining a well diversified portfolio of 25-30 stocks will yield the most cost effective level of risk reduction in a marketfurther diversification benefits can also be achieved by investing in foreign markets. What does the efficient frontier show us? How does the CAL lead all investors to invest in the market portfolio in an efficient market? Why might an investor choose not to invest in the market portfolio? The efficient frontier is a line which shows the combination of assets that provide the highest expected return for any given level of risk. CAL is the capital allocation line plots the return at a given level of risk for all portfolios that can be formed using a combination of a risky asset and a riskless asset.its slope is the Sharpe ratio (excess return over standard dev) The optimal portfolio is the one with the highest possible CAL as it offers the highest return per unit risk.all investors will invest in this portfolio in an efficient marketmore risk averse investors will invest proportionally less than the more risk tolerant investors (the remainder being invested in the risk free-asset). An investor may choose not to invest in the optimal portfolio if they believe the market is inefficient AND they can identify mispriced assets AND the mispricing will correct over your investment horizon. What is systematic risk? Systematic risk is the undiversifiable riskthe risk inherent to the entire market that cant be reduced through further diversification in that marketthese risk factors may include interest rate, recession and wars. What does the CAPM model show us? What is its practical use?

CAPM provides an answer as to how investors should price individual assetsthe discount rate they should value expected cash flows at Expected return above the risk free rate is proportional to the covariance of the security with the market portfolio E(R)=Rf + B(Market Risk Premium) Market risk premium cant be known with certaintypeople estimate it from prior returns to the market. Empirical evidence indicates CAPM is not much help in estimating cost of capitalthis may be because the model may be flawed or perhaps markets arent efficient. However it is useful in showing managers how investors view the risk return relationship of their company.

MCQ Sharpe Ratio = Risk premium / Sdev 1. Other things being equal, you would prefer an asset with a of zero to an asset with a of 1.5 True or False? Beta is the systematic risk of an asset, how sensitive it is to changes in the market. Depends on risk preference. 2. Are businesses that sell mattresses and beds likely to have a beta greater than, less than or equal to 1? Depends if they move in line with the economy. 3. Does a security with a = 0 guarantee a risk-free return? No, it just means it has no relationship whatsoever with the stock market. 4. What is the of an investment of $10,000 placed on the red squares at the roulette wheel in the casino? Beta is 0 as it has no relationship with the stock market.E(R) is ve.

Lecture 4 Market Efficiency

What is the Fama French model? Why do smaller firms and value firms experience consistently higher returns?

Fama-French model is an expansion of CAPM that adds size and value factors into the equation. The model considers that small firms outperform larger firms and value stocks outperform growth stocksit adjusts downward for small cap and value outperformance. There is argument that the outperformance tendency is due to market efficiency or market inefficiency.on the efficiency side it is said that these firms have higher associated risk, whilst on the inefficiency side the outperformance is believed to be that market participants misprice the value of these companies.

Is MPT still relevant? YES The key insight of MPT that rational investors that want to maximise returns whilst minimising risk should select investments that covary less with their existing portfolios remains unchallenged.

The vast majority of active fund managers fail to beat the market, why do they still have clients?
Why is MPT often written off yet CAPM is widely used?

What are the theoretical foundations for market efficiency? What are the theoretical challenges against market efficiency? Theoretical foundations FOR: Investors value securities rationally Irrational investors cancel each other out and/or smart investors arbitrage their influence away. Theoretical challenges AGAINST: Investors arent rationalthey react to irrelevant info, fail to diversify, churn portfolios excessively, sell winning stocks and hold on to losing stock...BIASES are SYTEMATIC and dont cancel each other out. There are limits to arbitragestrategies to correct the mispricing may be risky and costlyfundamental risk (risk that bad/good news occurs causing security to become further underpriced/overpriced), noise trader risk (irrational investors dominating the market making mispricing worse) and implementation costs (wide bid/ask spreads, cost of borrowing to short sell, cost of analysis) On the whole: Markets generally work

There are persistent pricing anomalies (book-to-market, January small firm, post-earnings drift, momentum) It is difficult to profit from these anomalies What are the 3 levels of market efficiency? Weak form asset prices reflect all information contained in the history of past tradingtrend analysis is fruitless Semi-strong form same as weak form except prices also reflect all publicly available informationfundamental analysis is fruitless Strong form same as semi-strong form except prices also reflect all privately available information What 5 factors show empirical evidence for market efficiency?***REVIEW LECTURE*** January Effect Royal Dutch Shell Internet Price Bubble.prices driven up by irrational investors and eventually corrected by rational investors arbitraging against them Momentum Orange Juice Futures What are market anomalies? Give 4 examples. Why do they occur? Market anomalies are price and/or return distortions in the market that seem to contradict EMH. Post-earnings effect tendency for stocks to drift in the direction of an earnings surprise for several weeks following an announcementviolation of weak form efficiency Book to Market effect high book to market firms outperform low book to market firms even when adjusted for riskviolation of semi-strong efficiency Momentum effectstocks giving good returns continue to give good returnsviolation of semistrong efficiency Small firm in January effect.research shows that small firms outperform larger firms even when adjusted for riskthis occurs almost entirely in Januaryviolation of semi-strong efficiency. Efficient market proponents believe these occur because some risk factors have not been factored into pricing by the CAPM.

Lecture 5 Behavioural Finance

How does neo-classical finance differ from behavioural finance?

Neo-classical finance assumes investors are rational in seeking to maximise return whilst minimising risk AND rational in evaluating and acting on information Behavioural finance uses psychology and economics to explain investor behaviourit states that people use heuristics (rules of thumbs or mental shortcuts) to cope with limited capacity and infothese have the potential to be misleading in financial markets. What are criticisms of behavioural finance? Neo-classical model works wellif it aint broke , why fix it? Individual behaviour is irrelevantmarkets are efficient on the aggregate Where is the unified theory of behavioural finance? What are the 3 types of evolutionary adaptation mechanisms that drive peoples behaviour? Simplificationsshortcuts in using info help deal with info overload Self deception.innacurate perceptions may increase odds of survival (illusion of control) Emotional loss of controlsurvival requires emotional commitment What are the 7 heruistic simplifications and how do they relate to personal finance?

Reprensentative .tendency to make judgement about groups membership on the basis of a stereotype rather than available base rate of info i.e. good company is a good investmentnot alwaysshould assess whether growth can be sustained. Preference for familiarity a person is more likely to believe a familiar statement rather than an unfamiliar one i.e. if a view is repeated by media outlets that X is a bad stock then you are more likely to believe it yourself. Anchoring and Adjustmentbasing estimates on known anchors and then adjusting relative to the starting pointnegotiation start far away from real price when bidding.dont accept first bid as the final bid when selling or offer for more than your real price. Illusion of truthpeople are more likely to believe a statement that is easy to process i.e. simple names tend to be more effective that clever names in business. Illusion of controlpeople overestimate their ability to control events i.e. quitting day job and starting as a full time trader Availabilitypeople overweight recent examples and underweight past examples i.e. stocks with more press coverage are more likely to be bought by investors and tend to underperform in subsequent periods. Mental Accountingtendency to separate money into different accounts based on subjective criterianot all money is equal

When investing in the market individual behaviour is irrelevant as on the aggregate markets are efficientirrational investors either cancel each other out OR smart investors arbitrage away inefficiencies making the market efficient.when prices diverge from fundamental value due to systematic biases, behavioural finance can help explain the nature of these bias. What caused the internet price bubble? Why didnt it pop earlier? What caused it to pop eventually? PRESENCE OF IRRATIONAL INVESTORS more retail than institutional investors, first investment foray for many, considerable uncertainty about valuation LIMITED ARBITRAGE little to no ability to short-sell (illiquid market), absence of pension fundsmkt dominated by irrational investors, low float prices Shares of internet companies unlocked circa spring 2000 (250/900 billion market value was unlocked)more informed investors entered the market as they could now borrow stock to short sell

Lecture 6 Global Financial Crisis

What is a financial crisis? How did the GFC 2008 happen? A financial crisis is a sudden collapse in the value of financial assets that leads to a severe credit shortage. Between 2004-2006 US interest rates rose from 1% to 5.35%...leading to record rates of default on US mortgage loans The impact was felt globally as: US is the worlds largest economy US domestic debt levels were high Lenders to US were spread across the world Extent of losses and identity of bearers of losses not easily identified

How did the financial system become so vulnerable? Banks made bad loans on a very large scalewhole system at risk of crashing What are the popular explanations for the financial crisis? Poorly understood risk from financial innovation.collateral debt obligations (CDOs)security that generates payments from the pool of loans made to people (about 40% of CDOs for residential mortgagesMBS mortgage backed securities)theoretically easier to evaluate the risk of a whole group than that of an individualsupply of prime borrowers decreased, so banks decided to lend to subprime borrowers.crisis arose because the risk of subprime borrowers was substantially

underestimated.bond rating agencies have been blamed.insurance against CDOs = credit default swaps, were sold far too cheaply (assumed CDOs had only a small possibility of defaulting) KEY PARTICIPANTS IN THE MBS MARKET HAVE incentive to underestimate risk: Agents work on commission to find borrowers Investment banks get a cut of revenue to sell securities to investors Rating agencies are paid by banks to have rate risk of securities and rely on reputation to have ratings accepted? Greed and bad behaviour in the finance sector Insiders rigging the system in their favour Irrational exuberance Too many speculative (can only repay interest from cash flowsrequire capital appreciation to repay principal) and Ponzi borrowers (cant repay interest from investment cash flowsreliant on cap appreciation for the investment to be profitable)not enough hedge borrowers (can repay interest and principal from cash flows) Proportion of Ponzi borrowers increases in good times (irrational exuberance).when lenders to Ponzi borrowers become disillusioned financial crisis occurs. Deregulation Finance sector lobbied to loosen banking regulations1982 US deregulated financial sector allowing: Banks to get larger (risk of systematic failure if one failed) Take on more risk to achieve higher returns Pass that risk on to others (reduced incentive to assess risk properly)

These changes were backed by prominent economists. Preconditions for crisis Savings glut in Asia led to large pools of money looking for a homeUS was seen as the safest market to invest in (helped keep currencies low, financial system wasnt well developed enough, US institutions found innovative ways to channel Asian deposits to borrowers). US Fed was focused on low CPI (thanks to cheap Asian imports) not asset price inflation IR went very lowpeople could afford to buy assets that were previously unavailable