Study your flashcards anywhere!

Download the official Cram app for free >

  • Shuffle
    Toggle On
    Toggle Off
  • Alphabetize
    Toggle On
    Toggle Off
  • Front First
    Toggle On
    Toggle Off
  • Both Sides
    Toggle On
    Toggle Off
  • Read
    Toggle On
    Toggle Off

How to study your flashcards.

Right/Left arrow keys: Navigate between flashcards.right arrow keyleft arrow key

Up/Down arrow keys: Flip the card between the front and back.down keyup key

H key: Show hint (3rd side).h key

A key: Read text to speech.a key


Play button


Play button




Click to flip

120 Cards in this Set

  • Front
  • Back
List the 3 themes central to portfolio theory
1) Risk and Reward
2) Quantifying Risk and Return Tradeoffs
3) How Asset Risk is Assessed
List 3 common criticisms of the passive strategy
1) They’re Undiversified
2) They’re Top Heavy
3) They’re Chasing Performance
4) You Can Do Better
List 3 characteristics that US T-Bills have to make them an appropriate choice as “the” risk free asset
1) Free of default risk
2) Short term nature makes them insensitive to interest rate risk
3) Their exposure to inflation uncertainty is minimal
Give the 3 steps involved in portfolio construction when considering the case of many risky securities and a risk-free asset
1) Identify the risk-return combinations available from the set of risky assets
2) Identify the optimal portfolio of risky assets by finding the portfolio weights that result in the steepest CAL
3) Choose an appropriate complete portfolio by mixing the risk free asset with the optimal risky portfolio
List the 3 uses of CAPM
1) Identifying Underpriced Assets
2) Capital Budgeting
3) Utility Rate Setting
Give 2 lessons learned from the liquidity analysis
1) Equilibrium expected rates of return are bid up to compensate for transaction costs
2) Illiquidity premium is not a linear function of transaction costs. Further, incremental illiquidity premium steadily declines as transaction costs increase.
List the 2 general types of risk
1) Market Risk
2) Firm Specific Risk
Give 3 reasons why using and testing CAPM is more difficult than it first appears
1) CAPM assumes that the “market portfolio” contains all risky assets, but this hypothetical portfolio could not be constructed
2) CAPM is stated in terms of expected returns, but we can only observe actual returns
3) Related to the last point, CAPM assumes a linear relationship between expected returns for a stock and the expected market risk premium
List the 3 key propositions that APT rely on
1) Security returns can be described by a factor model
2) There are sufficient securities to diversify away idiosyncratic risk
3) Well-functioning security markets do not allow for the persistence of arbitrage opportunities
List 2 ways in which APT serves many of the same functions as the CAPM
1) APT provides a benchmark for rates of return that can be used in capital budgeting, security evaluation, or investment performance evaluation
2) APT demonstrates that nondiversifiable risk (factor risk) requires a reward in the form of a risk premium and diversifiable does not.
Give the 3 versions of Efficient Market Hypothesis (EMH)
1) Weak Form
2) Semi-Strong Form
3) Strong Form
List 3 key issues that will prevent us from ever settling if markets are efficient
1) Magnitude Issue
2) Selection Bias
3) Lucky Event Issue
List the 5 Market Anomalies
1) Momentum
2) P/E Effect
3) Small Firm Effect (in January)
4) Neglected Firm Effect
5) Book to Market Ratios
List 3 factors that limit the ability of rationale investors to profit from mispricing
1) Fundamental Risk
2) Implementation Costs
3) Model Risk
List 4 factors that will vary an investor’s optimal position
1) Age
2) Tax Bracket
3) Risk Aversion
4) Employment
List the 3 basic steps of the model
1) Setting up the sample data
2) Estimating the SCL
3) Estimating the SML
Despite the findings of the empirical research, list 2 major conclusions of CAPM that are largely supported
1) Expected returns increase linearly with systematic risk
2) Expected returns are not affected by non-systematic risk
List 3 important features of corporate bonds
1) Call Feature
2) Convertible Bonds
3) Putable Bonds
List the 3 types of yields
1) Yield to Maturity
2) Current Yield
3) Yield-to-Call
List the 5 types of ratios looked at when rating bonds
1) Coverage Ratios
2) Leverage Ratios
3) Liquidity Ratios
4) Profitability Ratios
5) Cash Flow to Debt Ratio
List 4 types of protective covenants to prevent firms from dramatically altering probabilities of default
1) Sinking Funds
2) Subordination
3) Dividend Restrictions
4) Collateral
Give 2 reasons why longer-term bonds offer higher yields to maturity
1) Longer-term bonds are riskier. Thus, higher risk premiums for longer term bonds are necessary to compensate investors for interest rate risk.
2) Investors expect interest rates to rise. Therefore, higher yields on long-term bonds reflect anticipation of higher interest rates in the latter years of a bond’s life.
List the 2 theories of the Term Structure of Interest Rates
1) The Expectations Hypothesis: States that forward rates equal expected of the future short interest rates.
2) Liquidity Preference: Advocates of this theory believe that short-term investors dominate the market.
List 3 major risks associated with fixed-interest investments
1) Default Risk (biggest concern)
2) Interest Rate Risk
3) Liquidity Risk
List 4 ways that bonds can exit the original population
1) Defaults
2) Calls
3) Sinking Funds
4) Maturities
Give 4 possible reasons why lower rated bonds have a significantly positive realized spread to investments in Treasuries
1) They are also being compensated for liquidity risk and reinvestment risk
2) They could be compensated for taking on the risk of variability in recovery rates
3) They could be compensated for the systematic risk of default
4) They could be overly compensated due to artificial imbalances between supply and demand
Give 3 reasons why investors have been more than fairly compensated for investing in high-risk bonds
1) Market inefficiency
2) Restrictions as to risk class of investments imposed by institutions
3) Retention values below recovery rate
List 3 interest rates that are important in options and futures markets
1) Treasury Rates
2) London Interbank Offer Rates (LIBOR)
3) Repo (repurchase) Rates
List 6 of the key standardization specifics in a futures contract
1) Asset
2) Contract Size
3) Delivery Arrangements
4) Delivery Months
5) Price Quotes
6) Price Limits and Position Limits
List the 3 main categories of individuals taking positions
1) Hedgers
2) Speculators (Scalpers, Day Traders, and Position Traders)
3) Arbitrageurs
List 4 ways that regulators deal with investor groups to prevent them from “cornering the market”
1) Increase margin requirements
2) Impose stricter position limits
3) Prohibit trades that increase a speculator’s open position
4) Force market participants to close out their positions
List the 2 key tax issues
1) Nature of a taxable gain or loss
2) Timing of the recognition of the gain or loss
Give 2 reasons why a hedger uses futures contracts instead of simply selling the portfolio and investing the proceeds in Treasury Bills
1) The hedger feels that the stocks in the portfolio have been chosen well and will outperform the market
2) The hedger is planning to hold a portfolio for a long period of time and requires short-term protection.
Give 3 reasons for a company not to hedge it’s exposure to a particular risk
1) If the company’s competitors are not hedging, the treasurer might feel that the company will experience less risk if it does not hedge
2) The shareholders might not want the company to hedge
3) It might look bad on the treasurer if there is a loss in good times even though the purpose of the hedge is to minimize volatility whether bad or good
List 4 assumptions that the authors make about market participants
1) They are subject to no transaction costs when they trade
2) They are subject to the same tax rate on all net trading profits
3) They can borrow and lend money at the risk-free rate**
4) They take advantage of arbitrage opportunities when they occur
List the 4 ways that Cost of Carry, c, can vary depending on the asset under consideration
1) For a non-dividend paying stock, the cost of carry is r (no storage costs and no income is earned).
2) For a stock index, it is (r – q) since income is earned at rate q on the asset.
3) For a currency, it is r – r(f).
4) For a commodity that provides income at rate q and requires storage costs at rate u, it is r – q + u.
Give 3 reasons why if hedgers tend to hold short positions and speculators tend to hold long positions, the futures price of an asset will be below the expected spot price
1) Speculators require compensation for the risks they are bearing
2) Speculators will trade only if they can expect to make money on average
3) Hedgers will lose money on average, but they are likely to be prepared to accept this because the futures contract reduces their risks.
List the 2 ways that one can think of when valuing Interest Rate Swaps
1) Value as an Exchange of Bonds
2) Value as Series of Forward Rate Agreements (FRA’s)
As a result of the Tax Relief Act of 1997, list 3 actions of the owner that consider appreciated property “constructively sold”
1) Enters into a short sale of the same or substantially identical property
2) Enters into a futures or forward contract to deliver the same or substantially identical property
3) Enters into one or more positions that eliminate substantially all of the loss and opportunity for gain
List 6 factors that affect the price of a stock option
1) The current stock price, So
2) The strike price, K
3) The time to expiration, T
4) The volatility of the stock price, σ
5) The risk-free interest rate, r
6) The dividends expected during the life of the option
List 4 assumptions of the market participants, such as large investment banks
1) There are no transaction costs
2) All trading profits (net of trading losses) are subject to the same tax rate
3) Borrowing and lending at the risk-free interest rate is possible
4) There are no arbitrage opportunities
List 5 types of Spreads
1) Bull Spread
2) Bear Spread
3) Butterfly Spread
4) Calendar Spread
5) Diagonal Spread
List 4 types of Combinations
1) Straddle
2) Strip
3) Strap
4) Strangle
List the 3 types of stochastic processes
1) Wiener Process
2) Generalized Wiener Process
3) Ito Process
List 7 assumptions used to derive the Black-Scholes-Merton differential equation
1) Stock prices are developed with μ and σ constant
2) Short selling of securities with full use of proceeds is permitted
3) No transactions costs or taxes. All securities are perfectly divisible
4) No dividends during the life of the derivative
5) No riskless arbitrage opportunities
6) Security trading is continuous
7) The risk-free rate of interest, r, is constant
List 2 things that happen when moving from a risk neutral world to a risk-averse world
1) The expected growth rate in the stock price changes
2) The discount rate that must be used for any payoffs from the derivative changes
Give 2 reasons why the cost of hedging increases as the beta of a portfolio increases
1) More put options are required
2) The options have a higher strike price
List the 2 main differences between a forward contract used to hedge vs. an option approach to hedge
1) A forward contract locks in the exchange rate for a future transaction, while an option provides a type of insurance.
2) A forward transaction costs nothing to enter into. An option requires a premium to be paid up front.
Give 2 reasons for the popularity of futures options
1) The main reason is that a futures contract is generally more liquid and easier to trade
2) A futures price is known immediately from trading on the futures exchange (vs. the spot price not being so readily available).
List 10 unrealistic assumptions in the original derivation of the formula
1) The stock’s volatility is known, and doesn’t change over the life of the option
2) The stock price changes smoothly: it never jumps up or down a large amount in a short time
3) The short-term interest rate never changes
4) Anyone can borrow or lend as much as he wants at a single rate
5) An investor who sells the stock or the option short will have the use of all the proceeds of the sale and receive any returns from investing these proceeds
6) There are no trading costs for either the stock or the option
7) An investor’s trades do not affect the taxes he pays
8) The stock pays no dividends
9) An investor can exercise the option only at expiration
10) There are no takeovers or other events that can end the option’s life early
List 2 sorts of risk that are unique to international investments
1) Exchange Rate Risk
2) Country-specific Risk
List the 3 types of risk that make up country-specific risk
1) Political Risk: includes government stability, military in politics, democratic accountability, etc.
2) Financial Risk: includes foreign debt, net liquidity, exchange rate stability, etc.
3) Economic Risk: includes GDP per capita, annual inflation, and current account balance, etc.
List 5 avenues for U.S. investors to invest internationally
1) Purchase securities directly in the capital markets of other countries
2) Purchase American Depository Receipts, or ADRs
3) Purchase single-country mutual funds that invest in the shares of only one country
4) Purchase mutual funds with investments concentrated overseas, generally in Europe, in the Pacific Basin, and in developing economies in an emerging opportunities fund
5) Trade derivative securities based on prices in foreign security markets
List the 3 types of weighting schemes for constructing international indexes
1) Market Capitalization (most common)
2) GDP
3) Import share of various countries
Portfolio managers’ performance from international investments can be broken down into which 4 key sources of total performance
1) Currency Selection
2) Country Selection
3) Stock Selection
4) Cash/bond Selection
List the 3 factors that need to be considered when evaluation the potential benefits of international diversification
1) The riskiness of each asset on its own when measured in its own local currency
2) The impact of the exchange rate risk on the riskiness when measured in US dollars
3) The degree of correlation between the indices
List 6 general properties of Bond Prices
1) Bond prices and yields are inversely related
2) Increases in yield to maturity has a smaller impact than a comparable decrease in yield
3) Long term bonds are more sensitive to changes in yields than short term bonds
4) Sensitivity to changes in yields increases at a decreasing rate as maturity increases
5) High coupon bonds are less sensitive to changes in yields than low coupon bonds
6) The sensitivity of a bond’s price to changes in yields is inversely related to the yield at which it is currently selling
List 3 reasons why Duration is a key concept in fixed-income portfolio management
1) It is a simple statistic of the effective average maturity of the portfolio
2) It is an essential tool in immunizing portfolios from interest rate risk
3) It is a measure of the interest rate sensitivity of a portfolio
List 3 key factors that influence the sensitivity of a bond’s price to changes in market interest rates
1) Time to Maturity
2) Coupon Rate
3) Yield to Maturity
List 2 types of passive bond investment strategies
1) Indexing
2) Immunization
Give 2 ways that Immunization attempts to eliminate interest rate risk form a portfolio
1) Ensuring that changes in interest rates do not affect the total market value (duration based)
2) Ensuring that changes in rates do not affect the expected future value (with reinvestment)
Give 2 reasons for active bond management
1) Interest Rate Forecasting
2) Identification of relative mispricing within the fixed-income market
List the 5 types of Swaps discussed to take advantage of different views of what might happen to bond values
1) Substitution Swap
2) Intermarket Spread Swap
3) Rate Anticipation Swap
4) Pure Yield Pickup Swap
5) Tax Swap
List 3 reasons why the basic immunization approach is unrealistic
1) It assumes that interest rates only change by small amounts
2) It assumes parallel shifts in the term structure
3) It ignores inflation
List 3 ways that interest rate and inflation rate changes affect common stock
1) Value of the firm
2) Supply and demand
3) Investment strategy
List 2 similarities between Equity Cash Flows and P&C Liabilities
1) Both are inflation sensitive
2) Both are subject to considerable risk other than interest rate risk
List the 2 ways to match Assets & Liabilities
1) Cash Flow Matching
2) Duration Matching
List 4 reasons why stocks are not really inflation neutral
1) Economic Shocks (oil price hikes) cause increases in inflation and simultaneous decreases in earnings and dividends
2) Higher inflation leads to greater uncertainty and higher discount rates
3) The tax system is not inflation neutral so inflation leads to lower after tax real earnings
4) Investors tend to undervalue stocks in periods of high inflation because of money illusion (they mistake a rise in nominal rates for a rise in real rates).
List the 2 components that the paper separates the value of a P&C company into
1) Portfolio Equity
2) Franchise Equity
List the 3 ways that portfolio equity can be valued
1) Book Value (Statutory Surplus)
2) Current Value Surplus
3) Market Value Surplus (Economic Accounting)
List the 3 parts that the joint committee’s recommendation is to apportion the assets of the insurance company
1) Valuation Reserves
2) Contingency Surplus
3) Vitality Surplus
List 3 ways to have investment returns keep pace with inflation
1) Invest more heavily in common stocks or real estate, two asset classes that arguably contain an exposure to inflation
2) Have assets that roll over frequently, but this will require more short-term assets and will likely require a deviation from duration matching
3) Simply overstate the liabilities in the form of contingency reserves
List 3 important points about Franchise Value
1) Franchise value is significant for many P&C insurers
2) Franchise value is exposed to interest rate risk
3) Franchise value is often unmeasured, unreported and consequently unmanaged by the firm
Give 3 examples of ways risk management can reduce financial distress costs
1) Reduce Bankruptcy Costs
2) Reduce Payments to Stakeholders
3) Reduce Taxes
List the 2 pillars of modern finance theory
1) Market Efficiency
2) Diversification
List the 3 major costs that Academic Finance Literature has identified are associated with higher variability
1) Higher expected bankruptcy costs
2) Higher expected payments to corporate “stakeholders”
3) Higher expected tax payments
List 2 advantages in using risk management and increasing leverage ratios
1) Debt financing has a tax advantage over equity financing
2) Increasing leverage can strengthen management incentives to improve efficiency and add value
List the 5 Greek Letters and what they monitor
1) Delta – derivative of option value with respect to price
2) Gamma – rate of change of the portfolio’s delta
3) Theta – sensitivity of the option value with respect to changes in time
4) Vega – sensitivity of the option value with respect to volatility of the asset
5) Rho – change in value of option with respect to the interest rate
List 2 approaches in calculating VaR
1) Historical Simulation Approach
2) Model-building Approach
Give 3 alternative approaches for handling interest rates when the model building approach is used to calculate VaR
1) The use of the Duration Model
2) The use of Cash Flow Mapping
3) The use of Principal Components Analysis
Give 3 reasons that VaR’s popularity stems from
1) Its ease of interpretation as a summary measure of risk
2) Its consistent treatment of risk across financial instruments and business activities
3) Its use as a decision support tool in a comprehensive risk management process
List 3 features of VaR that were of particular value to trading firms
1) Consistent
2) Probability Based
3) Common Time Horizon
List 5 uses of VaR
1) Risk Reporting
2) Risk Control
3) Risk Management
4) Capital Allocation
5) Exposure Monitoring
List 3 alternatives to VaR
1) Cash Flow Risk
2) Risk Based Capital
3) Shortfall Risk
List 2 ways financial institutions reduce potential losses in the event of a default
1) Collateralization
2) Use of downgrade triggers
List 4 reasons why traders would expect an excess return on bonds
1) Liquidity Premium
2) Conservatism
3) Systematic Risk and Contagion
4) Skewness
List 3 methods used to mitigate exposure to credit risk
1) Netting
2) Collateral requirements
3) Downgrade triggers
List 2 general approaches that are used to model default correlations
1) Structural methods
2) Reduced Form models
List the 4 main categories of a firm’s aggregate risk profile
1) Market Risk
2) Credit Risk
3) Insurance Underwriting Risk
4) Other Risk
List the 4 choices of income measures for RAROC
1) GAAP Net Income
2) Statutory Net Income
3) IASB Fair Value Basis Net Income
4) Economic Profit
List the 2 types of objectives that the risk capital is intended to achieve
1) Solvency Objective
2) Capital Adequacy Objective
List the 4 Capital Allocation Approaches
1) Proportional Allocation Based on a Risk Measures
2) Incremental Allocation
3) Marginal Allocation (Myers-Read Method)
4) Co-Measures Approach (Kreps, Ruhm-Mango)
List 5 methods of applying risk-adjusted performance metrics
1) Assessing Capital Adequacy
2) Setting Risk Management Practices
3) Evaluating Alternative Risk Management Strategies
4) Risk-Adjusted Performance Measurement
5) Insurance Policy Pricing
List 3 limitations to the measure of Economic Value
1) To accurately reflect the change in value for a firm, changes in the value of its future profits must also be taken into account. This franchise value can be a significant source of value for firms
2) The use of economic profit as an income measure also complicates reconciliation to GAAP income or other more familiar measures of profitability
3) If the economic profit measures are not disclosed to external parties such as investors, regulators or rating agencies, management may have more difficulty communicating the basis for their decisions
List 4 common risk measures
1) Probability of Ruin
2) Percentile Risk Measure (Value at Risk)
3) Conditional Tail Expectation (CTE)
4) Expected Policyholder Deficit Ratio (EPD)
List 5 advantages to separately modeling frequency and severity instead of modeling the loss ratio
1) Growth in volume of business can be more easily accounted for
2) Inflation can be more accurately reflected, particularly when there are deductibles and policy limits
3) Changes in limit and deductible profiles can be directly reflected
4) Impact of deductibles on claim frequency can be reflected
5) Estimates of the split of losses between insured, insurer and reinsurer can be mutually consistent
List 3 criteria for an effective risk based capital method
1) It should be the same for all classes of insureds, all types of insurers, and all types of claimants
2) It should be objectively measured
3) It should discriminate between quantifiable measures of risk
List 3 potential sources of economic benefits from risk management
1) Minimize taxes by reducing earnings volatility
2) Minimize the costs of financial distress
3) Avoid the under-investment problem caused by the difficulty of firms in financial distress to raise capital
List 3 reasons why they are interested in insurance securitization now
1) Catastrophe Experience
2) Capital Market Developments
3) Insurance Industry Structure
List 4 Risk Transfer Products
1) Reinsurance
2) Swaps
3) Catastrophe Bonds
4) Exchange-traded Derivatives
List 3 types of triggers
1) Direct
2) Industry
3) Event
List 4 benefits of an asset-backed securitization process
1) Enhance liquidity of a previously non-rate, illiquid asset
2) The development of market values for certain assets
3) Creation of more efficient and lower cost ways of moving funds from investors to borrowers
4) The potential for improved credit rating for the asset in question
Give 2 reasons for securitizing insurance risks
1) Capacity
2) Investment
List 2 ways to categorize the many types of insurance-related instruments
1) Those that transfer risk
2) Those that provide contingent funding
List 4 possible reasons for the failures of catastrophe bond offerings
1) Newness and unfamiliarity
2) Uncertainty regarding pricing
3) Portfolio issues
4) Traditional reinsurance
List 5 traits common to successful offerings
1) Highly volatile catastrophic risk
2) Relatively high levels of protection
3) Relatively short maturities
4) Some protection of principal is included
5) High coupon rates
Give 3 reasons why it is a mistake for insurers to use RBC in capital allocation
1) There is no theoretical foundation for the formula
2) The formula is of questionable accuracy; based on book values rather than market values
3) The formula also ignores correlations among the firm’s businesses, which should be taken into account
List 2 advantages of the M-R (Myers/Read) Method
1) It avoids the problem of how to deal with the unallocated capital under the M-P approach
2) Most decision making regarding pricing and underwriting is marginal in the sense of M-R
List 3 reasons to allocate capital
1) Pricing, underwriting and other decision making could possibly be enhanced by thinking of capital as being allocated, even though it is not literally allocated
2) Allocation of capital could help to tie together certain financial decisions and regulatory risk-based capital rules
3) Concepts like risk-adjusted return on capital (RAROC) and economic value added (EVA) make use of capital allocation for performance measurement
List the 2 approaches of value maximization
2) EVA
List 5 Capital Allocation Techniques
1) Regulatory (NAIC) Risk-Based Capital
3) Value at Risk
4) Insolvency Put Option (EPD)
5) Marginal Capital Allocation (Merton & Perold vs. Myers & Read)
List the 3 main sources of frictional costs
1) Agency Costs
2) Double Taxation
3) Regulatory Costs
List 3 ways the Constant Growth DDM will imply a greater stock value
1) The larger its expected dividend per share
2) The lower the market capitalization rate, k
3) The higher the expected growth rate of dividends
List 4 Comparative Valuation Ratios
1) Price-to-Book
2) Price-to-Cash-Flow
3) Price-to-Sales
4) Price-to-Earnings
List the 2 factors that have the greatest impact on stock prices
1) Interest Rates
2) Corporate Profits
List the 5 Valuation Methods discussed in the Goldfarb Paper
1) Dividend Discount Model (DDM)
2) Discounted Cash Flow (DCF)
3) Abnormal Earnings (AE)
4) Relative Valuation Using Multiples
5) Option Pricing Theory
Give 5 reasons to be cautious when focusing on transaction multiples
1) Control Premiums
2) Overpricing in M&A Transactions
3) Underpricing in IPO Transactions
4) Uncertainty of Reported Financial Variables
5) Changes in Underlying Economic Assumptions
List 5 types of Real Options for Valuation
1) Abandonment Option: Valued as an American put on the value of the project with a strike equal to the net liquidation proceeds
2) Expansion Option: Valued as an American call option on the (gross) value of the lost capacity with a strike price equal to the cost of creating the capacity
3) Contraction Option: Valued as an American put on the (gross) value of the lost capacity with a strike equal to the cost savings
4) Option to Defer: Otherwise known as the option to wait, this is an American call on the value of a project
5) Option to Extend: Valued as a European call option on the asset’s future value
List 4 types of technical issues that must be considered in the actual valuation formula
1) Valuing the Underlying Business Cash Flows
2) Time to Option Maturity
3) Exercise Type
4) Appropriate Valuation Formula
List 3 characteristics that make real options more valuable
1) Options are more valuable when new information will be discovered prior to their expiration date that will allow for a more informed decision
2) Expansion options are valuable only if there is some exclusive right or ability to exercise them
3) The exercise price must be fixed in order for the option to have value