Chapter 2: Asset Classes and Financial Instruments
- What are T-bills? How are they quoted?
- Describe the following short-term securities:
- Commercial Paper
- Banker's Acceptances
- Repos and Reverses
- Federal Funds
- Broker's Calls
- What is LIBOR?
- Why determines the spread between the 3-month T-bill rate and the 3-month CD rate?
- How are Treasury Bonds quoted?
- What are TIPs?
- What determines the difference in price between a taxable and a non-taxable security that are otherwise similar?
- What are the different kinds of corporate bonds -- secured bonds, debentures, subordinated debentures, callable bonds and convertible bonds?
- What are mortgage-backed securities?
- What are the two important characteristics of common stock and why are they important?
- What are ADRs?
- What are stock market indices?
- How is the DJIA constructed? How is the Standard & Poor's Index constructed?
- What is an option? A put option? A call option?
- What are futures contracts? What is open interest in the context of a futures contract?
Chapter 3: How Securities are Traded
- What are the different kinds of markets in which securities are traded? What are their characteristics? How do they differ from each other? What are the advantages and disadvantages of each kind of market?
- What are the different kinds of orders? How do they differ? What are the advantages and disadvantages to an investor of using one kind of order versus another?
- Who are specialists? What is their role?
- What are the different kinds of trading costs?
- What does trading on margin mean?
- How do you compute the margin in an account? How do you determine whether an account satisfies margin requirements?
- What are short sales?
- How do you compute the margin in an account in which securities have been short sold? How do you determine whether such an account satisfies margin requirements?
- What are the advantages of investment companies to investors?
- What are the different kinds of investment companies? What are the advantages and disadvantages of each one of them?
- What are the different kinds of mutual funds available to an investor?
- How are mutual funds marketed?
- What are the costs of investing in mutual funds?
- How are the earnings of mutual funds taxed?
- What are ETFs? What are their advantages and disadvantages vis-à-vis mutual funds?
Chapter 5: Introduction to Risk, Return and the Historical Record
- How are interest rates determined?
- What is the difference between real and nominal interest rates?
- What can we infer from changes in nominal interest rates?
- Why is the distinction between nominal and real interest rates important for tax policy?
- How can we compare rates of return on assets that are held for different periods of time?
- We compute annualized rates of return
- What are the ways in which interest rates are annualized?
- How does the frequency of compounding affect the rate of return?
- Why do we bother with continuous compounding since in the real world it’s not possible to compound continuously?
- One, although one cannot physically compound continuously and the bank cannot update a bank balance continuously, nevertheless it is possible to compute the dollar return on a certain investment over a finite period of time, assuming continuous compounding.
- Since the frequency of compounding affects the effective rate of return, given a specific APR, to compare rates of return on securities that are held over different periods of time or to compute the value of an investment on which interest is accruing at a certain rate of interest, it is necessary to specify the frequency of compounding.
Thus, if we have $100 in a bank and we want to know how much it would have grown to, in three years, we need to know the rate of interest. Suppose we specify this as 10% p.a.; then we need to specify how frequently compounding is done. Thus, if compounding is annual, then the value of the investment after three years would be 100 (1.1)3 = $133.10. On the other hand, if compounding is only once in three years, the value of the investment would be 100(1.3) = $130.00. If compounding is once a month, the value of the investment would be 100(1+0.1/12)^12*3 = $134.8182
Whatever compounding period we choose, we need to maintain it across investments (keep in mind that we can convert a given interest rate with given compounding to an equivalent interest rate with continuous compounding; similarly, we can convert a given interest rate with a given frequency of compounding to an equivalent interest rate with annual compounding).
It turns out that choosing continuous compounding is very convenient for computations. For example, if rates are expressed in continuous terms, then the relationship between real and nominal rates and the inflation rate is simply:
R = r + i
- What has been the relationship between nominal rates of return and inflation over the last 75 or so years? Does it support the Fisher hypothesis? Would you say that the market determines the real interest rate or the nominal interest rate?
- How do you compute holding period returns? What is the purpose of computing a holding period return?
- How do you measure the uncertainty of historical rates of return?
- What is a risk premium? How do you measure it?
- What determines the risk premiums on different classes of assets? (Note that we will talk a lot more about this in later chapters. Here we just look at it in a superficial way.)
- What is the difference between the arithmetic and the geometric average return? How do you compute them?
- What is the Sharpe Ratio? What is its function?
- How do you represent uncertainty regarding rates of return?
- What is a probability distribution?
- What is the normal probability distribution?
- How can we talk about deviations from normal distributions?
- How do we measure VaR?
- What is the expected shortfall and how do we measure it?
- The Sharpe Ratio implicitly assumes normality because it uses standard deviation as a measure of uncertainty. What measure of return-to-risk can we use if return distributions are not normal?
- Looking at the historical record, what can you say about the normality of asset return distributions?
- How have mean returns changed over time?
- Has the reward-to-volatility measure (Sharpe ratio) or the Sortino measure improved or deteriorated?
(We will skip 5.9 unless there is a lot of interest…)
Chapter 6: Risk Aversion and Capital Allocation
- Speculation is sometimes defined as “Taking large risks, especially with respect to trying to predict the future;” and “gambling in the hopes of making quick, large gains.” (http://www.investorwords.com/4643/speculation.html). What is an alternative way to define speculation that is socially productive?
- How is a gamble defined in economics/finance?
- What is a fair game?
- Define risk aversion. How would you measure it?
- How would you represent the utility to an investor of a gamble (in the sense in which it is used in the text)?
- What is the certainty equivalent rate of return? Why is the utility score for a quadratic utility function interpretable as the certainty-equivalent rate of return?
- What does an indifference curve represent in E(r),s space?
- What is the mean-variance criterion?
- What is a risk-free asset? Give examples.
- What is the capital allocation line?
- What is the slope of the capital allocation line called?
- How would an investor’s risk-tolerance affect the amount allocated to the risk-free asset?
- Assuming that you have already decided on a risky portfolio, how would you go about deciding the proportion of your wealth to allocate to the risk-free asset versus the risky portfolio?
- How could you determine what assets to put in the portfolio of risky assets?
- What are the advantages of following a passive strategy in constructing the portfolio of risky assets?
Chapter 7: Optimal Risky Portfolios
- How do you compute the expected return and variance of returns of a portfolio of two securities?
- What is covariance? What is correlation?
- What is the weights of a portfolio of two securities, which has minimum variance? (footnote 4, page 204)
- Given the investor’s level of risk aversion, how do you determine the portfolio of two securities that has the highest utility?
- What is the optimal risky portfolio of two assets, for a given level of the risk-free rate?
- If an investor can invest in a risk-free asset and two risky assets, how would s/he go about allocating her/his money?
- If there are more than two risky assets, how, in principle, would an investor go about determining his/her optimal portfolio?
- What is the separation property? What is the importance of the separation property?
- What is more important in the construction of an optimal portfolio, an asset’s variance of returns or its covariance with the returns on other assets?
- If asset returns are not normal, how can we estimate VaR and ES?
(… we will skip Section 7.5)
Chapter 9: The Capital Asset Pricing Model
- What is the CAPM?
- What are the usual assumptions underlying the CAPM?
- What are the characteristics of the equilibrium that would prevail if the assumptions underlying the CAPM were true?
- Since the assumptions underlying the CAPM are obviously not true, why should we pay any heed to the implications of the CAPM?
- What do we mean by the “market portfolio” in the context of the CAPM?
- Why do all investors hold the market portfolio?
- In practice, why might the risky part of individual investors'portfolios differ from the market portfolio of all risky assets?
- What is the meaning of mean-variance efficiency?
- When would it be optimal to follow a passive strategy of investing in the market portfolio?
- What are the determinants of the market risk premium?
- According to the CAPM, what is the most important measure of riskiness of an asset?
- What determines the expected return on an asset, according to the CAPM?
- What is the beta of an asset?
- How do you compute the beta of a portfolio of assets, given their individual betas?
- What is the Security Market Line? How might it be used as a benchmark to compute the fair expected return on an asset or a portfolio? How might it be used to figure out if an asset is overvalued or undervalued?
- How could the CAPM be used in capital budgeting?
- How might one estimate the beta of an asset using an index?
- Can we test the CAPM? What does it mean to test the CAPM?
- What are the extensions to the CAPM?
- What is the Consumption CAPM?
- What are the determinants of the bid-ask spread?
- How can expected illiquidity affect the required rate of return on a security?
- How can unexpected illiquidity affect the required rate of return on a security?
Chapter 10: Arbitrage Pricing Theory and Multifactor models of Risk and Return
- What is the single-factor model? What assumptions does it make?
- Why is it problematic to restrict the number of factors to one? Why can’t we think of the one factor in the single-factor model as a kind of aggregation of the multiple factors that might exist in reality?
- Why is a single-factor or a multi-factor model not a theory?
- How does a multi-factor security market line convert the multi-factor model into a theory? How would this theory be used?
- What are the assumptions of the Arbitrage Pricing Theory (APT)? Are those assumptions realistic? What would be the result of the violation of those assumptions?
- What is the difference between a theory based on the assumption that arbitrage opportunities cannot exist (such as the APT) and a theory based on risk-return dominance arguments that individual investors have private trade-offs between risk and return (such as the CAPM)?
Ans: In a model where the pricing relationship depends on the non-existence of arbitrage opportunities, the pricing relationship is established because of the action of investors attempting to exploit arbitrage opportunities which manifest themselves if there are deviations from the pricing relationship.
Hence, as long as there are a few investors who realize the existence of arbitrage opportunities and act on them, the posited pricing relationship is reestablished.
On the other hand, in a model where the pricing relationship depends on equilibrium, deviations from the equilibrium pricing relationship are due to investors holding suboptimal portfolios. Once they realize that their portfolios are not optimal and make portfolio adjustments to bring their holdings to the optimal position, the pricing relationship is once again established. But if deviations from the equilibrium pricing relationship do not generate arbitrage opportunities, such deviations would continue to exist until all investors readjust their portfolios.
- How does the APT depend upon the notion of diversification?
- Can bubbles (and therefore continued mispricing of securities) exist in an APT world?
- Can single assets be mispriced in the APT? (The answer is yes – well-diversified portfolios cannot be mispriced because it would be possible to create another well-diversified portfolio with similar exposure to systematic factors and with no idiosyncratic risk; if the expected returns were different for the two portfolios, then there would be an arbitrage opportunity. However, individual securities would have exposure to idiosyncratic risk and so pure arbitrage opportunities would not exist to eliminate the mispricing. On the other hand, there would be quasi-arbitrage opportunities and investors would find it worthwhile to short-sell the individual asset that was overpriced relative to the APT model. Furthermore, it would be very unlikely that a single or several assets are mispriced, but that many well-diversified portfolios containing the security are properly priced.)
- How does the APT resolve the problems involved in testing the CAPM?
- What is the multifactor model of Chen, Roll and Ross?
- What is the Fama-French Three-Factor model? Is the model based on assumptions of rational economic actors? Is it an empirically based model? Is the model intuitive? If not, how would you justify it?
- What is the interpretation of the factors in the Fama-French model.
Chapter 11: The Efficient Market Hypothesis
- One would be tempted to say that a market whose movements are not predictable is a completely unanchored market not based on fundamentals. However, many financial economists would assert the contrary. How would you understand this?
- What is the meaning of a random walk?
- If stock prices are based on fundamentals, then they should be equal to the present value of expected future cashflows. If so, how could price changes be random? Explain the seeming contradiction.
- It costs time and money to collect information. If all information is incorporated in stock prices, then there would be no incentive to collect this information. On the other hand, if no information is collected by market participants, then this information cannot be incorporated into market prices. How would you explain this seeming paradox? (Read about Grossman and Stiglitz)
- What are the three versions of the Efficient Markets Hypothesis?
- What are the implications of the EMH for technical analysis?
- What are the implications of the EMH for fundamental analysis?
- Why might the EMH support a passive portfolio strategy for small investors?
- What is the implication of the EMH for portfolio management? If it’s not possible to pick mispriced securities, should investors simply use a dartboard to pick stocks?
- Explain the role of informationally efficient markets in resource allocation.
- What is the difference between an informationally efficient market and a perfect foresight market?
- What are event studies? How can they be used to learn whether markets are efficient or not?
- There have been many tests of proposed investment schemes that have shown their futility. Can we conclude from this that markets are efficient?
- There are also reports of portfolio managers who seem to have done very well. Is this evidence that markets are not efficient?
- What is the market evidence regarding momentum in stock prices? In the short-run? In the long-run?
- What is the evidence regarding the predictability of broad market movements and how can one interpret them?
- What are some of the anomalies uncovered by the market efficiency literature? The P/E effect? The small-firm effect? The January effect? The liquidity effect? The neglected-firm effect? The book-to-market ratio effect?
- How could you explain market drift in predictable directions for many days after an earnings announcement?
- What is the relationship between the EMH and asset price bubbles?
- Do stock market analysts add value?
- What is the evidence regarding the predictive skill of mutual fund managers?
Chapter 12: Behavioral Finance and Technical Analysis
- How is behavioral finance different from conventional financial theory?
- What is the behavioral critique?
- What are the different errors that investors commit in processing information?
- What errors do investors commit with respect to using evidence in making forecasts?
- How does investor overconfidence affect their investment strategies?
- What is investor conservatism and how does it affect stock price movements?
- What is the notion of representativeness with respect to investor behavior?
- What is framing and how might it affect investor behavior?
- How does mental accounting affect investor behavior and stock returns?
- How do investors deal with sample sizes in making inferences from data?
- What is regret avoidance and how does it affect stock price movements?
- What does prospect theory say?
- According to behavioral finance, investor behavior is sometimes irrational. If so, prices would be out of sync with their fundamentals. If so, why can other more rational investors not profit from their price discrepancies?
- What are some of the examples where the law of one price seems to not have held, and arbitrageurs seem not to have taken advantage of it, either?
- Explain the case of “Siamese Twin” companies and the limits to arbitrage.
- Explain the case of closed-end funds and the limits to arbitrage.
- Explain the case of equity carve-outs and the limits to arbitrage.
- What are bubbles? Can they be predicted? Is it possible to know when we are in a bubble? What about, after the bubble has ended?
- What are some of the criticisms of behavioral finance?
- How does behavioral finance support some of the tools used in technical analysis?
- What is the Dow theory and how is it used?
- How are moving averages used in technical analysis?
- How is market breadth used in technical analysis?
- What is the Trin statistic, and how is it used in technical analysis?
- What is the put/call ratio and how is it used in technical analysis?
- What is the confidence index and how is it used in technical analysis?
Chapter 13: Empirical Evidence on Security Returns
- What is the Security Characteristic Line (SCL) and how is it estimated?
- What is the Security Market Line (SML) and how is it estimated?
- Explain the two-stage tests of the CAPM. What are the problems with these tests?
- What is Roll’s critique?
- What did Kandel and Stambaugh find regarding the importance of having a good proxy for the market portfolio in tests of the CAPM?
- How does measurement error in the beta affect tests of the CAPM?
- What does the fact that it is difficult to beat diversified portfolios like the S&P 500 and the NYSE Index imply for the CAPM?
- The market portfolio is supposed to include human capital. How can tests of the CAPM take this into account?
- Initial tests of the CAPM assumed that betas were constant. How can we take time variations of asset betas into account in testing the CAPM?
- The market portfolio is supposed to include all assets, whether or not they are traded. How can tests of the CAPM take non-traded assets into account?
- What macroeconomic factors have been identified as sources of priced risk?
- Explain the three-factor Fama-French model.
- How might you understand the empirical success of the Fama-French model from a rational investor point of view?
- How might you understand the empirical success of the Fama-French model from a behavioral point of view?
- What are some measures of market illiquidity?
- What is a liquidity beta? Interpret it.
- Is there a connection between the momentum effect and compensation for bearing liquidity risk?
- Why should we look at consumption betas instead of stock market wealth betas? Why should consumption growth not parallel growth in wealth?
- What is the equity premium puzzle?
- Why do Fama and French want to use dividend growth rates to measure expected returns, rather than the average of realized capital gains?
- What is survivorship bias and how might it affect tests of asset pricing models?
- How might recognition of liquidity risk mitigate the equity premium puzzle?
Chapter 14: Bond Prices and Yields
- What is a bond?
- How are bond prices quoted?
- What are convertible bonds?
- What are callable bonds?
- What are puttable bonds?
- What are floating-rate bonds?
- What is preferred stock? Why is preferred stock similar to corporate bonds?
- What are some different kinds of international bonds?
- What are inverse floaters?
- What are asset-backed bonds?
- What are catastrophe bonds?
- What are indexed bonds?
- What are TIPS? What does the yield-to-maturity on TIPS measure?
- What is the difference between the current yield and the yield-to-maturity on a bond?
- What is the relationship between coupon yield, yield-to-maturity and bond price?
- What is the yield-to-call?
- What is the difference between realized compound return and yield-to-maturity?
- What is horizon analysis?
- How does the price of bond move over its life?
- What are strips? How are they related to zero-coupon bonds?
- How are zero-coupon bonds treated for tax purposes?
- How are risky bonds classified?
- What are some of the determinants of bond safety?
- What is a bond indenture? What is the importance of a bond indenture?
- What are some common covenants in bond indentures?
- What are sinking funds? What is their function?
- What is the relationship between yield-to-maturity and default risk?
- What is a credit-default swap?
- What are CDOs? How are they structured?
Chapter 15: The Term Structure of Interest Rates
- What is a yield curve?
- What is the difference between the on-the-run yield curve and the pure yield curve?
- What is the difference between a spot rate and a forward rate?
- What is the relationship between the forward rate and the expected future spot interest rate in a world of uncertainty?
- What are the different theories of the term structure?
- Explain the Expectations Hypothesis.
- Explain the Liquidity Preference Hypothesis.
- How do we extract information from the term structure of interest rates?
- How can you synthesize a forward contract using spot securities?
Chapter 16: Managing Bond Portfolios
- What are the factors that affect the interest rate sensitivity of a bond?
- What is Macaulay’s duration and how does it measure the sensitivity of a bond’s price to interest rate changes?
- What are the factors that determine duration?
- What is convexity?
- Why do investors like convexity?
- What is different about the convexity of callable bonds versus non-callable bonds?
- Why is not possible to compute Macaulay’s duration for a callable bond?
- How do we compute the effective duration of a bond?
- How are mortgage-backed securities different from callable bonds?
- What is a collateralized mortgage obligation (CMO)?
- What are the two different strategies followed by passive bond portfolio managers?
- How are bond index funds structured?
- How are immunization strategies implemented?
- Explain dedication strategies. Are they immunization strategies?
- What are the sources of profit in active bond portfolio management?
- Explain the four different kinds of swaps implied in Homer and Liebowitz’s taxonomy of active bond portfolio management.
- Explain horizon analysis. How is it dependent upon interest rate forecasting?
Terms and Questions for Self-Study
Financial Markets and Institutions (Chap. 2 from Bodie, Merton and Cleeton)
costs: costs incurred by the firm due to the conflicts referred to above
-- conflicts between management and shareholders, conflicts between
shareholders and bondholders, etc.
- capital market
- Chief Financial
- financial market
- financial intermediary:
an organization that raises money from investors and provides financing
for individuals, companies and other organizations.
- financial assets
- limited liability
- money market
- mutual funds
- pension fund
- real assets
- What are some examples of financial institutions? What are their functions,
- What are the functions of a chief financial officer (CFO)?
- What are the primary characteristics and advantages of the corporate
form of organization?
- What should the objective of the firm's managers be? Justify your
- If you were coming up with a new form of business organization, how
would you go about it? What principles would you have in mind?
- What are some of the conflicts between managers and stockholders?
How might they be resolved?
- What are some of the conflicts of interest between stockholders and
bondholders? How might stockholders exploit bondholders? How can this
conflict be resolved?
- Why should a firm's manager worry about the impact of his firm's activities
on the environment, or on society, in general? (For the purpose of this
question, assume that the manager is amoral and does not care about
- What does a real asset mean?