THEORY

Explain what it means that a financial market is efficient?

EMH states that asset prices fully reflect all available information, i.e. it is
impossible to beat/outperform the market. Stock prices should follow a
random walk, which means that price changes should be random and
unpredictable and only change due to new information. There are three
versions of EMH:
- Weak-form claims that stock prices reflect all historical information
- Semi-strong form claims that both prices reflect all publicly available
information, and that prices instantly change to reflect new public
information
- Strong form claims that prices instantly reflect even hidden insider
information
However, active management portfolio and the search for mispriced
security play a role in market efficiency. As they buy and sell mispriced
securities, prices will be driven to fair levels. This means that people
outside the financial sector can buy securities in fair prices like aunt
Olga. Two economists are walking down the street. They spot a $20 bill
on the sidewalk. One stops to pick it up while the other one says: Dont
bother, if the bill were real someone should have picked it up already.
Empirical evidence suggests that firm size and book-to-market
ratios may explain stock returns. Is this consistent with market
efficiency? Discuss.
It has been generally observed that stocks of companies with high bookto-market ratios outperform stocks with low book-to-market ratios. Studies
have shown that this effect seems to be independent of the stocks beta,
and therefore, independent of systematic risk. This effect could be
explained by the fact that companies with low book-to-market ratios tend
to be companies that investors expect to grow rapidly. However, rapid
growth continually declines as companies grow larger, hence, growth in
stock prices will be diminished as the P/E-ratio declines as future
expectations of further growth are lowered. As the P/E-ratio drops, the
return also drops. Furthermore, stocks with high book-to-market ratios
tend to decline less in bear markets, since there is less risk when the
market value of a company is close to its book value. In general, market
anomalies are market patterns that seem to lead to abnormal returns
more often, and since some of these patterns are based on info in financial
reports, market anomalies present a challenge to the semi-strong form of
the EMH, indicating that fundamental analysis does have some value for
the individual investors.
Explain the difference between spot rates, short rates and
forward rates.

The n-period spot rate is the yield to maturity on a zero-coupon bond with
a maturity of n periods.
The short rate for period n is the one period interest rate that will prevail in
period n.
The forward rate for period n is the short rate that would satisfy a breakeven condition equating the total return on two n period investment
strategies. The first strategy is an investment in an n-period zero-coupon
bond; the second is an investment in an n-1 period zero-coupon bond
rolled over into an investment in a one-period zero.
Briefly describe APT and CAPM. What are the similarities and
differences?
CAPM is a model that describes the relationship between risk and
expected return and that is used in the pricing of risky securities.
APT is an asset pricing model based on the idea that an assets return can
be predicted using the relationship between that same asset and many
common risk factors. This theory predicts a relationship between the
returns of a portfolio and the returns of a single asset through a linear
combination of many independent macroeconomic variables.
APT VS. CAPM
- The single factor APT predicts the same expected return-beta relationship
as the CAPM
- APT does not impose any specific preference structure on investors. APT
only says that any arbitrage opportunities will quickly be traded away. In
CAPM all investors are mean variance optimizers.
- APT does not guarantee that the expected return-beta relationship holds
for single securities, only for well-diversified portfolios. CAPM states an
exact pricing relationship for every asset in the economy. Therefore, APT is
often said to impose much weaker assumptions than the CAPM
- In APT, the benchmark portfolio does not need to be the market portfolio
Describe the equity premium puzzle.
The equity premium puzzle is a phenomenon that describes the
anomalously higher historical real returns of stocks over government
bonds. The equity premium, which is defined as equity returns minus bond
returns, has been about 6% on average for the past century. It is supposed
to reflect the relative risk of stocks compared to risk-free government
bonds, but the puzzle arises because this unexpectedly large percentage
implies a suspiciously high level of risk aversion among investors.
The equity premium puzzle is a mystery to financial academies; the
difference is too large to reflect a proper level of compensation that
would occur as a result of investor risk aversion. Therefore, the premium
should actually be much lower than the historic average of 6%.

Explain a notion of an abnormal return.

Abnormal return is a measure of the deviation between the
actual/observed return for a given period and the CAPM predicted return
on the stock.
Briefly explain skewness, kurtosis and VaR.
Skewness: 3rd moment measuring asymmetry of distribution
Kurtosis: 4th moment measuring fat tails of distribution
VaR: The 5% VaR may be viewed as the best rate of return out of the 5%
worst-case future scenarios.
Explain the Markowitz model.
The Markowitz model identifies the minimum variance frontier of efficient
portfolios:
For given return requirements, portfolios with absolute smallest risk
(standard deviation) are identified (estimated). The models objective is to
find the minimum risk for given return or maximum expected return for
given level of risk.
Briefly explain the SML.
SML graphs individual asset risk premiums as a function of the assets
systematic (beta) risk. Fairly priced assets plot exactly on the SML, i.e.
their expected returns are commensurate with their (systematic) risk. In
market equilibrium, all securities must be priced to lie on the SML
according to the formula: E(ri) = Rf + [E(rm) Rf].
If a stock is perceived to be a good buy or underpriced, it will provide an
expected return in excess of the fair return stipulated by the SML:
Underpriced stocks plot above the SML; given their betas, their expected
returns are greater than CAPM-requirement.
Explain the expectation and liquidity preference theory.
According to the expectations theory of the term structure of interest
rates, the liquidity premium is zero so that f2 = E(r2). Therefore, the market
expectation of future short rates can be derived from the yield curve, and
there is no risk premium for longer maturities.
The liquidity preference theory, on the other hand, specifies that the
liquidity premium is positive so that the forward rate is greater than the
markets expectation of the future short rate. The liquidity preference
theory is based on the assumption that the financial markets are
dominated by short-term investors who demand a premium in order to be
induced to invest in long maturity securities.

What is the Expectation Theory of interest rates? Why may it not

be true in reality?
According to the expectations theory of the term structure of interest
rates, the liquidity premium is zero so that f2 = E(r2). Therefore, the market
expectation of future short rates can be derived from the yield curve, and
there is no risk premium for longer maturities.
This may not be true in reality because the theory postulates that you
would earn the same amount of interest by investing in a one-year bond
today and rolling that investment into a new one-year bond a year later
compared to buying a two-year bond today.

What is the Term Structure of interest rates? Why does it on

average slope upwards?
The term structure of interest rates refers to the interest rates for various
terms to maturity embodied in the prices of default free zero-coupon
bonds. In general terms, yields increase in line with maturity, giving rise to
an upward sloping yield curve. One basic explanation for this is that
lenders demand higher interest rates for longer-term loans as
compensation for the greater risk associated with them, in comparison to
short-term loans.
Briefly explain the economic meaning of duration.
Duration is a measure of the average life of a bond, defined as the
weighted average of the times until each payment is made to the present
value of the payment.
Explain in your own words why the duration estimate of the price
change is inaccurate.
Duration approximation always understates the value of the bond: it
underestimates the increase in bond price when the yields fall, and it
overestimates the decline in price when the yield rises. Convexity adjusted
duration estimate is more precise.
Duration is an imperfect way of measuring a bonds price change, as it
indicates that this change is linear (first derivative) in nature, when it fact
it exhibits a sloped or convex shape.
Therefore, there will be a discrepancy between duration estimate of the
change in bond price and the actual change in bond price.

Describe the Fama French Three-Factor Model

Fama French Three-Factor Model expands on the CAPM by adding size and
value factors in addition to the market risk factor in CAPM. This model
considers the fact that value and small cap stocks outperform markets on
a regular basis. By including these two addition factors, the model adjusts
for the outperformance tendency, which is thought to make it a better tool
for evaluating manager performance.

Explain the
difference
between the
CML and SML.
- The CML is a line that is used to show the rates of return, which depends
on risk-free rates of return and levels of risk for a specific portfolio. SML is
a graphical representation of the markets risk and return at a given time.
- While standard deviation is the measure of risk in CML, Beta coefficient
determines the risk factors of the SML.
- While the CML graphs define efficient portfolios, the SML graphs define
both efficient and non-efficient portfolios.
What are the advantages of the index model compared to the
Markowitz procedure for obtaining an efficiently diversified
portfolio? What are the disadvantages?
The advantage of the SIM, compared to the MM procedure, is the vastly
reduced number of estimates required. In addition, the large number of
estimates required for the MM procedure can result in large aggregate
estimation errors when implementing the procedure. The disadvantage of
the SIM arises from the models assumptions that return residuals are
uncorrelated. This assumption will be incorrect if the index used omits a
significant risk factor.

Discuss when it is appropriate to use the different measures.

Sharpe ratio: When the portfolio represents the entire investment fund.
Information ratio: When the portfolio represents the active portfolio to be
optimally mixed with the passive portfolio.
Treynor or Jensens ratio: When the portfolio represents one sub-portfolio
of many.
What do we mean by pure factor portfolios in APT? And what is a
tracking portfolio?
Factor portfolio: A well-diversified portfolio constructed to have a beta of 1
on one of the factors and beta of 0 on any other factor.
Tracking portfolio: A portfolio designed to track the movements of an
asset or investment.
Applications: hedging, benchmarking and arbitrage.
Briefly explain the Separation Property and the Mutual Fund
Theorem.
Separation property tells us that the portfolio choice problem can be
separated into two stages:
(1) To determine the optimal risky portfolio.
(2) Capital allocation depends on personal preference; therefore, risk
aversion must be taken into consideration.
Mutual fund theorem states that all investors should hold an identically
comprised portfolio of risky assets combined with some proportion of
risk-free assets.
Briefly explain the equation of the Security Characteristic Line
(SCL).
The SCL is a regression line. The SCL graphs the excess return on a
security over the risk-free return as a function of the excess return over
the market. The slope of the SCL is the securitys beta and the intercept is
its alpha.
What is meant by the term bond-convexity?
Convexity refers to the curvature of a bonds price-yield relationship.
Accounting for convexity can substantially improve on the accuracy of the
duration approximation.
Explain the notion and significance of stock market efficiency.
Stock market efficiency: The presence of market efficiency is measured by
the speed with which traded stocks adjust to unexpected news pertaining
to firm-specific characteristics and market-wide macro-factors. Three

measures are commonly used to measure the degree of efficiency: weak,

semi-strong, and strong form. The measures differ with respect to type of
information or news (public versus private, historic versus non-historic)
impounded into stock prices.
Weak form market efficiency implies that stock prices reflect all historical
information. As such, (i) historical trends are of no use when predicting
future prices, and (ii) only fair (required rate of) returns are possible when
using information based on historical prices.
Semi-strong form claims both that prices reflect all publicly available
information and that prices instantly change to reflect new public
information.
Strong-form market efficiency states that stock prices fully reflect all
information; public as well as private. Thus, there exist no set information
that allows investors to earn more than the fair rate of return on a stock.

CAL: A graph showing all feasible risk

return combinations of a risky and riskfree asset.

The characteristic line is a

regression line. The SCL
graphs the excess return on a
security over the risk free
return as a function of the
excess return over the market.
The slope of the SCL is the
securitys beta and the
intercept is its alpha.

The expected returnbeta relationship

can be portrayed graphically as the
security market line (SML) in Figure 9.2.
Because the markets beta is 1, the
slope is the risk premium of the market
portfolio. It is useful to compare the
security market line to the capital
market line. The CML graphs the risk
premiums of efficient portfolios (i.e.,
portfolios composed of the market and
the risk-free asset) as a function of
portfolio standard deviation. This is
appropriate because standard deviation
is a valid measure of risk for efficiently
diversified portfolios that are candidates
for an investors overall portfolio. The
SML, in contrast, graphs individual asset
risk premiums as a function of asset risk. The relevant measure of risk for
individual assets held as parts of well-diversified portfolios is not the
assets standard deviation or variance; it is, instead, the contribution of
the asset to the portfolio variance, which we measure by the assets beta.

Figure 11.1
illustrates
the
response of
stock prices
to new
information
in an
efficient market. The graph plots
the
price response of a sample of firms that were targets of takeover attempts.
In most takeovers, the acquiring firm pays a substantial premium over
current market prices. Therefore, announcement of a takeover attempt
should cause the stock price to jump. The figure shows that stock prices
jump dramatically on the day the news becomes public. However, there is
no further drift in prices after the announcement date, suggesting that
prices reflect the new information, including the likely magnitude of the
takeover premium, by the end of the trading day.
Semi-strong form market efficiency focuses on the speed with which public
information is impounded into stock prices. News, that by definition are
unexpected, as they arrive, immediately impounded in prices. Therefore
the market is efficient at semi strong form.

The figure shows the reaction of stock prices to on air stock reports. The
chart plots cumulative returns beginning before the stock report.
Is this in accordance with EMH? There is no further drift in prices after the
announcement on TV, suggesting that prices reflect the new information.
This is in accordance to EMH.

They calculate earnings surprises for a large sample of firms, rank the
magnitude of the surprise, divide firms into 10 deciles based on the size of
the surprise, and calculate abnormal returns for each decile. Figure 11.5
plots cumulative abnormal returns by decile. Their results are dramatic.
The correlation between ranking by earnings surprise and abnormal
returns across deciles is as predicted. There is a large abnormal return (a
jump in cumulative abnormal return) on the earnings announcement day
(time 0). The abnormal return is positive for positive-surprise firms and
negative for negative-surprise firms. The more remarkable, and
interesting, result of the study concerns stock price movement after the
announcement date. The cumulative abnormal returns of positive-surprise
stocks continue to risein other words, exhibit momentumeven after the
earnings information becomes public, while the negative-surprise firms
continue to suffer negative abnormal returns. The market appears to
adjust to the earnings information only gradually, resulting in a sustained
period of abnormal returns. Evidently, one could have earned abnormal
profits simply by waiting for earning announcements and purchasing a
stock portfolio of positive-earnings-surprise companies. These are
precisely the types of predictable continuing trends that ought to be
impossible in an efficient market.