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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 TBills 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 riskfree asset

1) Identify the riskreturn 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) Wellfunctioning 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) SemiStrong 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 nonsystematic 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) YieldtoCall 

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 longerterm bonds offer higher yields to maturity

1) Longerterm 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 longterm 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 shortterm investors dominate the market. 

List 3 major risks associated with fixedinterest 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 highrisk 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 shortterm 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 riskfree 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 nondividend 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 riskfree 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 riskfree 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 BlackScholesMerton 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 riskfree rate of interest, r, is constant 

List 2 things that happen when moving from a risk neutral world to a riskaverse 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 shortterm 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) Countryspecific Risk 

List the 3 types of risk that make up countryspecific 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 singlecountry 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 fixedincome 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 fixedincome 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 shortterm 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) Modelbuilding 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 (MyersRead Method) 4) CoMeasures Approach (Kreps, RuhmMango) 

List 5 methods of applying riskadjusted performance metrics

1) Assessing Capital Adequacy
2) Setting Risk Management Practices 3) Evaluating Alternative Risk Management Strategies 4) RiskAdjusted 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 underinvestment 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) Exchangetraded Derivatives 

List 3 types of triggers

1) Direct
2) Industry 3) Event 

List 4 benefits of an assetbacked securitization process

1) Enhance liquidity of a previously nonrate, 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 insurancerelated 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 MR (Myers/Read) Method

1) It avoids the problem of how to deal with the unallocated capital under the MP approach
2) Most decision making regarding pricing and underwriting is marginal in the sense of MR 

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 riskbased capital rules 3) Concepts like riskadjusted return on capital (RAROC) and economic value added (EVA) make use of capital allocation for performance measurement 

List the 2 approaches of value maximization

1) RAROC
2) EVA 

List 5 Capital Allocation Techniques

1) Regulatory (NAIC) RiskBased Capital
2) CAPM 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) PricetoBook
2) PricetoCashFlow 3) PricetoSales 4) PricetoEarnings 

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 