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97 Cards in this Set
- Front
- Back
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Define investment |
current commitment of money or other resource with expectation of reaping future benefits (income/appreciation) |
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Real assets & financial assets |
Real assets: Land, buildings, machines, knowledge etc. Financial assets: Claims to the income generated by real assets |
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3 types of Financial assets |
Fixed income (debt securities): A (fixed) stream of income determined by a specified formula (e.g. corporate bond, government bond); Income determined by interest Money market: short term, generally low risk (e.g. t-bill) Capital market: Longer term, range from very safe to risky |
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Equity |
Ownership share in corporation; income determined by dividends (if any) and by increase/decrease in stock price |
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Derivatives |
Income determined by prices of other assets (e.g. options and futures determined by stocks and commodities) |
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3 Clients of the financial system |
Households: Consumption vs. savings and investment Firms: Raise money for investments in real assets Government: Finance the expenditure using financial assets |
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4 functions of financial markets |
Risk sharing: splits ownership (and therefore risk) among many investors Provide information: Stock prices (and related data) provides information to investors Smooth consumption over time: Investing money allows money to be “saved” and multiplied for the future Allocation of capital: Allocates the economy’s savings to its highest value uses |
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Primary market |
Market which issues new securities through an Initial Public Offering (IPO) or Secondary Equity Offering (SEO) |
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Secondary market |
Market where securities which are already owned are traded (e.g. stock exchanges, over-the-counters (OTC)) |
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Discounted value & formula |
See formula sheet |
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Firm-foundation theory |
Firm-foundation theory: Asses firms based on their intrinsic value (determined by present, past, and future conditions) - When market price < IV then buy, otherwise sellDifficult to correctly assess (joint-hypothesis problem) |
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Castle in the air theory |
Castle in the air theory: Assesses firms based on behaviour of investors - When E (future price) > current price then buy, otherwise sellDifficult to assess behaviour of investors |
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Fundamental analysis |
Analysis of stocks based on characteristics of a firm (firm-foundation theory) |
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Technical analysis |
Analysis of stocks/firms based on price movements in the market (castle in the air theory) |
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Return rate formula |
see formula sheet |
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Risk free rate |
the theoretical rate of return of an investment with zero risk (usually t-bill) |
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Risk Premium & formula |
additional return (over and above the risk-free rate) resulting from bearing risk - see formula sheet for formula |
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Systematic risk, unsystematic risk |
Unsystematic risk (idiosyncratic risk): risk specific to each investment Systematic risk (market risk): risk inherent to the entire market |
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Portfolio return formula |
weighted average of the returns of individual stocks (see formula sheet) |
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Mean-variance efficiency |
portfolio that provides the highest returns for a given standard deviation |
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Minimum variance portfolio |
portfolio with the lowest standard deviation |
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Draw graph including: showing diversification, efficient frontier, minimum variance portfolio, and risk free asset |
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Capital Market Line (CML) |
Line that shows the risk and return for portfolios that consist of different ratios of the risk free asset and the market portfolio |
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Optimal portfolio |
Portfolio with the highest sharpe ratio |
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Efficient market hypothesis (EMH) |
The market is efficient when it fully and correctly reflects all relevant information in determining security prices |
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3 Types of efficiency in EMH |
Operating efficiency: Conduct operations at lowest possible costs Information efficiency: all relevant information impacting on value is immediately and fully impounded into share prices Allocation efficiency: allocate the economy’s savings to their highest value uses |
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Data snooping (data mining) |
if you try enough trading strategies, a few of them are bound to do well just by luck |
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3 Types of Efficiency |
Weak form: Security prices reflect all price history information Semi-strong form: Security prices reflect all publicly available information, including price history Strong form: Security prices immediately and fully reflect all information |
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Strategies that can be used in an efficient market |
Buy and hold strategy Use a passive strategy (select desired portfolio, avoid high expenses) |
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Strategies that can be used in an inefficient market |
Trading strategies Search for undervalued stocks Technical analysis Fundamental analysis |
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Joint hypothesis problem |
It is impossible to test EMH since it requires a benchmark to test against the performance of a portfolio- i the portfolio performs well/poorly compared to a benchmark one can never know if it is because the market is inefficient or if the benchmark is wrong |
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Alpha (α) |
average difference in return between the strategy and the market portfolio; risk adjusted performance i.e. measure of risk-adjusted performance |
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Beta(β) |
Measure of how much an asset/portfolio moves with the market i.e. measures systematic risk of an asset/portfolio |
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4 ways to measure risk of investment |
- Sharpe ratio (SR) - Comparison with a benchmark - Comparison against a static strategy - Using an asset pricing model |
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Sharpe ratio (SR) |
average excess return / standard deviation of return (see formula sheet) |
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Advantages & disadvantages of Sharpe ratio for measuring risk |
- Based on estimates of mean and standard deviations means short sample periods make the sharpe ratio noisy and hard to interpret -Does not use benchmarks (which can be used with short samples) -Measures only total risk; therefore cannot whether a strategy adds value to a portfolio |
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Tracking error (TE) |
residual risk; excess risk of a portfolio compared to the benchmark (see formula sheet) |
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Information ratio (IE) |
average returns, in excess of the benchmark, in relation to the tracking error |
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Passive strategies |
Strategies that try to be on par with a benchmark |
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Active strategies |
Strategies that try to outperform a benchmark |
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Comparison against a static strategy |
Using an endogenously determined benchmark (benchmark is chosen that is as similar as possible to the investment strategy e.g. with same level of risk) |
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Why and how to test alpha for accuracy |
Since α denotes the estimated intercept (i.e. the average intercept), the estimated alpha must be tested for accuracy |
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CAPM formula |
Ri: Expected return of an asset Rf: Risk free rate α: risk adjusted performance β: Measure of how much a stock/portfolio moves compared to the market Rm: Market return rate εi: an (unobserved) term with zero mean (shows how correct the estimated line is i.e. if it is perfectly averaged through all points the ε will be 0) |
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Fama-french risk factors |
SMB (small minus big): return on a portfolio of small firms minus the return on a portfolio of large firms HML (high minus low): return on a portfolio with high ratio of book-to-market value minus return on a portfolio with low ratio of book-to-market value WML (winners minus losers) (momentum): return on portfolio of the 10% winners stocks over previous 6 months minus the return of the 10% loser stocks over the previous 6 months |
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4 characteristics of art as an asset |
- Returns above inflation and bonds but below equities - Upward trend of art prices - Low liquidity -Return and volatility results are very sensitive - Low correlation between art sectors; therefore useful to hold a portfolio of art from different art sectors -Increase in collectors from emerging markets |
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Wealth effect |
(Art) prices strongly impacted by global wealth |
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Art-market home-bias |
Theory that art investors prefer to buy art from their own countries |
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4 Methods used to construct art price indices |
- Geometric returns - Average prices - Repeat sales regression: estimation of an art portfolio in each time period based on purchase and sale prices - Hedonic pricing framework: Estimation of returns of art by attributing implicit prices based on characteristics (e.g. size, signed, style) |
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Sample selection bias**** |
... |
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Survivorship bias*** |
... |
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Repeat-sales bias |
Repeat-sales do not account for items that are not re-sold |
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Smoothed vs desmoothed prices**** |
... |
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FX Currency Carry Trade (CT) |
Borrowing funds (shorting) at a low interest rate in one currency (funding currency) and buying (longing) a higher-yielding asset in another (the target currency) |
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5 Characteristics of FX Currency Carry Trade |
- Zero-net investment strategy - Annual return of about 4-5% - Negative kewness i.e. Crash-risk: distribution is skewed to the left - High kurtosis: return distribution is fat-tailed (more mass in tails than with normal distribution) - High liquidity market |
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Arithmetic average |
average that assumes the same amount is invested in each period (e.g. 100 invested in period 1 and 100 invested in period 2 etc.) |
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Geometric average |
average that assumes the return gained in the first period is reinvested in the second (and so forth), rather than assuming the same amount is reinvested in each period (e.g. if 100 is invested in period 1 and a return of 50 is received then a return of 150 is invested in period 2) |
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2 definitions of exchange rates |
Definition 1: Price of unit of domestic currency in terms of the foreign currency i.e. how much 1 unit of the domestic currency would buy of the foreign currency (e.g. 1 euro buys 1.5 USD) Definition 2: Price of unit of the foreign currency in terms of the domestic currency i.e. how much 1 unit of the foreign currency would buy of the domestic (e.g. 1 USD = .75 EURO) |
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How to find inverse exchange rate |
1 unit of 1st currency /amount of 2nd currency equal to 1 unit of 1st currency (e.g. if $1 = €.64, 1/.64 = 1.56) |
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Uncovered Interest Rate Parity (UIP) Theory |
Theory that the expected return on domestic investment should be the same as the expected return on foreign investment i.e. currency cary trades should not be profitable |
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Implication of UIP for FX investments |
- if the foreign interest rate is higher (lower) than the domestic interest rate then the domestic (foreign) currency is expected to appreciate -Means fx trades are unprofitable |
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UIP formula |
see formula sheet |
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UIP formula with ln transformation |
see formula sheet |
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How to test UIP |
see formula sheet |
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UIP Puzzle/forward premium puzzle & FX trade implication |
Most studies find that β does not equal 1, but is actually closer to 0 and often negative result: if the foreign (domestic) interest rate is higher then the foreign (domestic) currency is expected to appreciate |
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5 Conditions under which UIP holds better |
- Longer horizons - Developing countries - Crisis periods - Large interest rate differentials - High volatility |
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Spot exchange rate (st) |
exchange rate for the current period |
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Forward contract |
an agreement between two parties to buy (one party) or sell an asset (the other party) at a certain price at a certain future date |
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Forward exchange rate |
the predetermined value of a currency relative to another currency |
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How to test UIP with forward exchange rates |
see formula sheet |
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Limits to speculation hypothesis (LSH) |
Theory that there is a non-linear relation between the interest rate differential (IRD) and the exchange rate return |
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How IRD Size affects investment in CT trades |
- When IRD is small investors may not exploit currency carry trades because: - IRD may not cover transaction costs - Other investment opportunities may have higher expected performance - Increase in IRD results in increase in investors - When IRD is large enough to attract investors, CT trades will be exploited until the risk-arbitrage opportunity disappears and UIP holds |
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Extreme sampling (regressions conditional on large and small UIP deviations) |
tests whether UIP tolerates small deviations but not large deviations |
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Method of exploiting UIP puzzle |
investors go short in currencies with low interest rates (funding currencies) and go long in currencies with high interest rates (target currencies) |
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Backward vs forward risk measures |
- Standard deviation: Uses past data to determine risk (backward looking) - Option: Right to buy an asset by a certain date at a certain price (predicts option price at a future time, which implies a volatility) |
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CT trades risk return puzzle |
The higher the volatility, the lower the return (opposite of what would be expected i.e. higher risk = higher return) |
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Limits to speculation explanation of high risk, low return of CT trades |
- Small IRD’s: Fewer investors results in fewer trades which lowers the volatility - Large IRD’s: Increases investors which results in more trades which raises the volatility but IRD will be risk-arbitraged away (i.e. UIP will hold) |
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ETF’s (exchange traded products) |
Product that tracks an underlying asset class, while taking the form of a stock |
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Characteristics of real estate investment |
- Low liquidity - Positive returns - Low growth opportunities - Long time horizons - Investors expertise needed (heterogeneity) - High size and capital constraints |
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2 Types of real estate investment |
Direct real estate: Directly owning real estateIndirect real estate: Owning a share in a real estate investment fund |
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5 Examples of Indirect real estate investments |
- Real estate stocks: owning a share in real estate - Real estate investment trusts (REITs) - Providing mortgages (pension funds) - Mortgage backed securities - Real estate industry (e.g. construction, materials) |
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4 methods of real estate valuation |
- Sales comparison approach: Used for homogenous, liquid real estate (e.g. houses) - Hedonic analysis - Income capitalization approach: Used for heterogeneous, moderately liquid real estate - Cost equivalent approach: Used for unique, illiquid real estate |
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Mutual fund |
Portfolio of securities that goes long only |
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Hedge funds |
Portfolio of securities that goes both long and short |
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4 Hedge fund strategies |
- Long short equity: Investing long and short in stocks - Macro-systematic: Funds that invest both long and short in stock markets, bond markets, fx markets, commodity markets etc. - Event driven: Funds that focus on events (related to firms) affecting stock prices -Multi-strategy: Fund that uses multiple strategies |
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Private investment structures |
- Used by most alternative investments - Exempt from major securities regulations - Maximum investment flexibility - Fees structure can attract top talent (e.g. 2 and 20) -non-transparent |
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Public investment structures |
- Used by mutual funds - Registered with regulators - Must provide transparency - Must provide diversification and liquidity |
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Call & Put option |
right to buy(sell) an asset at a previously agreed on price |
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Strike/exercise price (x), advantage, expiration |
Strike: Price when using option Advantage: Price difference between stock price and strike Expiration: Time at which the option expires |
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European vs American options |
European: Can only be exercised at the maturity of the contract American: Can be exercised at any point in the contract |
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Backfill bias |
When firms/funds report returns only if they choose to, they may only do so when fund/firms perform well, leading to an upward bias |
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Survivorship bias |
Failed funds/firm cease to drop out of the database leading to an upward bias |
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5 differences between hedge funds and mutual funds |
- Subjected to minimal regulation - Open only to small number of wealthy investors - very flexible, wide range of investments - Often use shorting, options (since, unlike mutual funds, there is no regulation to prevent it) - Illiquid |
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Lock-up period |
Period in which investors cannot withdraw money (up to several years); used to invest in illiquid assets |
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2 and 20 structure |
1-2% management fee, incentive fee of 20% of profits Used by hedge funds |
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Possible explanations for high performance of hedge funds |
- Skilled managers - Illegal insider trading - Changing factor loadings - Backfill bias, survivorship bias - Higher returns may represent compensation for liquidity risk |
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4 Fees charged by mutual funds |
- Operating expenses: administrative fees, percentage of AUM - Front-end load fees: Fee charged when purchasing shares - Back end load fees (redemption/contingent/exit fee): Fees charged when shelling shares - 12b-1 charge: Distribution costs (e.g. advertising) |
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Net Asset Value (NAV) |
(market value of assets - liability) / shares |
