Investments

Front 1

Name six functions of financial markets.

Back 1

Consumption timing, allocation of capital, allocation of risk, information aggregation through prices, separation of ownership and management, and provision of liquidity

Front 2

Name the advantages of delegating investment decisions to "agents".

Back 2

Diversification, specialization, cost reduction through economies of scale, and better monitoring through block holding

Front 3

Name the disadvantages of delegating investment decisions to "agents".

Back 3

Agency problems, herd behavior, and marketing costs

Front 4

Example: rf=7%, E(R1) = 20%, s1= 20%. What will an investor put into risky stocks if A=4? A=8?

Back 4

A=4: w1*=0.81 and A=8: w1*=0.41

Front 5

How to perform the first step of the Fama-MacBeth regression?

Back 5

Estimate the risk loadings betas of the individual stocks (or portfolios of stocks) using time-series regressions for each stock (portfolio) on the relevant risk factors

Front 6

How to perform the second step of the Fama-MacBeth regression?

Back 6

Each period (usually each month), run a cross-sectional regression of stock returns on (multiple) characteristics (or betas)

Front 7

Name and briefly explain four origins of anomalies relating to individual investor behavior.

Back 7

Under-diversification: typical investor holds less than 10 stocks.

Familiarity bias: investors favor investments in companies they are familiar with.

Excessive trading: according to theory investors should hold risk-free assets in combination with "relatively" passive portfolios of risky securities.

Overconfidence: leads to excessive trading, and investors believe they can pick winners and losers when, in fact, they cannot.

Front 8

Briefly describe the momentum anomaly.

Back 8

Momentum is the strategy of buying stocks that have gone up over the past twelve (or so) months (Winners) and shorting stocks with the lowest returns over the same period (Losers), hence WML. It persists because (i) risk - momentum crashes during crises, and (ii) liquidity (limits to arbitrage) - short selling illiquid loser stocks is expensive.

Front 9

Describe anomalies in investment theory.

Back 9

Anomalies are strategies that consistently earn superior returns above the returns determined by the equilibrium models without being obviously relatable to the systematic risk. For some anomalies behavioral explanations are proposed and for some both rational and behavior explanations exist.

Front 10

Briefly describe the betting against beta anomaly.

Back 10

The strategy of buying low beta assets and selling high beta assets such that the portfolio is beta neutral. It persists because leverage constraints - many investors face leverage constraints which takes portfolios away from CAPM's optimal portfolios. Agency problems - if portfolio managers are required to follow a benchmark they simply cannot do arbitrage.