Investment analysis

Fall 2020 Homework Essays                                                              

The following Questions link to their respective textbook Chapters.  For example, Question 1 is linked to Chapter 1 in the text.  Answer each question that is asked, paying attention to the multiple components to many of the questions.  The due dates – in four installments – are provided on the syllabus.

• What is an investment? What is a real versus a financial asset?  Explain the “informational role” of financial markets.  Use the oil market as the basis of your embedded expectations analysis and informational commentary.  Conceptually and with respect to investments, explain the importance of consumption timing, separation of ownership & management, and allocation of risk?

An Investment is an activity that requires current input of monetary resources in exchange of benefits return in the future. A real asset is the asset which directly generates value while values can be generate through financial assets on the contrary. Stock price has played a significant informational role that helps the organization to raise the capital and ease the difficulties of allocation of capitals. The stock price in the market has represented the perspective of the investors towards that company. The stock price will increase if the investors and the markets think the performance of that company is optimal and will be better in the future as well.  As the price raise, the company will be able to raise more capital for the company development. Consumption timing is also important during the course of people’s lifetime. When an individual is under employment, he/she probably spend less than what they earn with respect of they are tending to spend more when they are retired. To allocating the limited amount of financial resources on hand, deciding when and how to consume the financial resource is significant. With the financial market, it will be able to help us easily to achieve the goal that we can still wish to spend the same amount as before retired through investing in multiple products in the financial markets. Therefore, financial market allows individuals have higher chance to generate more wealth for the consumption during the course of their lifetime. The allocation of risk in the capital market has allowed both investors and the company to bear their most affordable risk with the return of the security purchased. For instance, a company to raise capitals for the development can issued both shares and bonds which shares contained higher risk with high reward and bonds have a fixed payment and lower risks. It is reciprocal for both company and the investors to allocate the risks on their financial management. With the liquidity of financial market, the separation of ownership and management has become inevitable globally. Shareholders can trade their shares without affecting the management of the company because the CEO of the company is hired by the board of directors, who is elected by the shareholders, and he/she is obligated to perform based on maximizing the interests of shareholders.

• Explain the basis of an Asset / Liability based funding strategy. What is the difference between the money markets and the capital markets?  Explain ownership with respect to fixed income and equity instruments.   With respect to equities, what does residual claim and limited liability imply?  What is a derivative market?  What is the role of a stock market index?

an Asset / Liability based funding strategy is a mechanism that explains how the bank resolving the risks when there is a mismatch between assets and liabilities which might cause the increase in liquidity or change in interest rate.

Money Markets are the markets involved with trade in short-term and Capital Markets are involved with long-term trading and have four different categories.

The Equity owner has somewhat degree of controlling of the company where they can have a voice on board and have the voting rights. Also, they are paid based on dividends. On the other hand, the Fixed Income owner only has the fixed return and maturity of the company which they do not have any voting rights or voices on the board.  They are just creditors to the company.

With respect to the equities, residual claim tells the shareholder and other parties have the rights to split the residual income of the company after all the required payments have been paid. The limited liability means that any liability from the company cannot extended over the amount investors invested and it do not relate to their personal assets.

The Derivative market is the financial market that provides value depends of other assets such as commodity prices, bond and stock.

As the ever-increasing of the globalization, the international trade and investments have increased, and role of stock market index is more significant. In the past, Dow Jones Industrial Average is the leading favorable new report. However, there are more market indexes have grown preferably and accurately nowadays which they are all performing a good job on indicating of market activities.

• What is an IPO? What is the performance record of IPOs generally, specifically short and long term?  What is a price contingent versus market order?  What is a “stop loss” and why does it matter to an investor?  How does the path of the effective bid-ask spread look?  What is algorithmic trading? Explain.  What is buying on margin?  What is a short sale?

The IPO is the process of the company first time issuing shares to the public. According to the performance record, the majority of IPOs is generally underpriced in order to attract more investors into bookbuilding and most likely will have a price jump on the first day to the IPO and largely doing poor job over the long term.  Market order is the order of buy or sell that are to be executed immediately at the moment while pricing contingent order is the order of sell or buy can be set up at a timely manner of which price of share the investor wants to purchase or sell. The stop-loss order is the order to sell the stock at a stipulated price where the investors can stop the accumulating loss or any further loss. The path of the effective bid-ask spread did not look very efficient to the investor which the best price offer might change before the sell or buy order arrive. Algorithmic trading is the modern tool that used on computer to do the analysis in order to capture the optimal price for the investors. Buying on margin is the action where investors is financing money from broker, whose money is from the bank, with a serving fee to form a partnership of purchasing securities. A shore sale allow investor to profit from the decline of the price of the share, when the investor borrow shares from the broker and sell it at the beginning.

• What is the difference between a limited liability partnership (LLP), a mutual fund, and an ETF (what is an ETF)? What is the performance record of an S&P500 ETF?  What are the long-term performance records of equity mutual funds relative to benchmarks, linking your answer to the AUM growth of passive investing?  Explain the fee structure and operating expense trends of mutual funds.

An LLP is the company with no limit of partner required but all partners are possessed of limited liability of the firm. Mutual funds are common name for open-end investment companies, and they are sold through various channels. Also, Mutual funds are not listed on the stock exchange. On the other hand, ETF, which is exchange traded fund, is purchased and sold by broker and dealer. ETF is listed on stock exchange and the price is ever-continuing daily. S&P500 is a standard index which EFT use it to match with their investment decision.

Investors should not only consider the fund’s investment policy but also the fee structure where how they charge the fee during the whole process in order to save the unnecessary cost. There are four classes of fees investors need to be aware of: Operating expense, Front-end load, Back-end load, and 12b-1 charges. Operating expenses do not explicit on the bill and it is usually charged as percent on the asset of the customers. Advisory fee and administration fee are operating expense as example.

• What is the difference between real and nominal rates of interest? Explain the four moments with respect to investing and specifically, to risk-return.  How does this link to normality assumptions?  What information does each contain?  Which of the four risky portfolios outlined at the chapter’s close should longer term investors bias their portfolios? Why?  What is a risk premium (on equities)?  What is risk aversion?  What is the difference between arithmetic and geometric average returns?

The real rate of interest is the growth rate of purchasing power and the nominal rates of interest is the growth rate of money which, in other words, real rate of interest is the nominal rate of interest with the reduction of purchasing power-loss from inflation. The four moments are: Holding-period return, expect return, excess return, and time-weighted average return.  The four risky portfolios outlined at the chapter’s close are Big/Value, Big/Growth, Small/Value, and Small/Growth. Risk premium on the equity market is the reward received from investment. Risk aversion is a psychological activity that expressed the investors are highly aware of the risks they will going to take on the investment they chose, and they do not like the risk. The arithmetic average return calculates the HPR whereas geometric average return calculates the gross HPR.

• What is the Capital Allocation Line (CAL)? How do indifference curves inform positioning along the CAL?  What is the utility equation?  What is the indifference curve?  Explain the risk aversion metric employed in utility modeling?  What is the (approximate) range?

Capital Allocation Line is line which is created on a graph of all the possible combinations of risk-free and the risky assets.  This particular graph shows the return investors could possibly earn through assuming a particular level of risk with their investment. The indifference curves touch at the beginning along with the CAL and it goes in a less-curvy shape than CAL since it is less-risk curve.  The utility equation expressed from the text as utility score is equal to the expected return, which represents as r, minus half of the index A times the variance of return.  Indifference curve connected all the points that represent as each high-risk portfolio in the graph that will attract the investor as these portfolios are same attractive to them. The risk aversion in corelated to the utility model which the lowest degree of risk aversion investors tends to choose higher risk portfolio which will result in a higher utility score respectively.

• What is the difference between systematic and unsystematic risk? Which one can be diversified away? Which one is priced?  What is the efficient frontier?  Define and link the Sharpe Ratio, the Efficient Frontier, and the CAL to the focus of portfolio theory.  What is the separation property (first noted by Tobin)?

A systematic risk is as an outcome of external and uncontrollable variables, which are not industry or security specific and affects the whole market resulting to the fluctuation in costs of all the securities. While an unsystematic risk is the risk that arises from controlled and known variables which industry or security are specific. The systematic risk is undiversifiable while the unsystematic risk is diversifiable. The portfolio theory refers to the investment theory that permits investors to accumulate an asset portfolio that exploits predictable return for a given level of risk. The theory accepts that stockholders are risk-averse; for a given level of predictable return, stockholders will continuously prefer the less risky portfolio. In the case of efficient frontier, the upper part of the curve is the efficient frontier which is the combination of the risky assets which exploits the expected return for a particular level of standard deviation. Hence, some portfolios on this part of the curve gives the best possible expected returns for a particular given level of risk. In the case of CAL, the slope is referred to as the Sharpe ratio, which is the upsurge in the probable return per every additional unit of standard deviation; this is the highest and is a combination that comes up with the optimal portfolio basing on the portfolio theory.

• Explain the components of the single index model, linking diversifiable and systematic risk to your answer. What is the Security Characteristic Line and what information does it convey?  What is the information ratio and what important information does it convey?  Is the full covariance efficient frontier or the index model efficient frontier better?

Single index model= R_i = α_i + β_ir_m + e_i     βirm signifies the return of the stock because of the movement of the market modified by the stock’s beta (βi), while ei represents the unsystematic risk of the security due to firm-specific factors. αi is a constant. The security characteristic line is the description based on Hewlett-Packard and it is a straight line with intercept α_HP and slope β_HP.  The information ratio is the contribution of active ratio that to the sharp ratio of the overall risky portfolio is determined by the ratio of its alpha over its residual standard deviation. The information ratio measures the extra return from the security analysis compared to the firm specific risks. The single index model would be more efficient than the full covariance frontier in the following ways. Although the full covariance frontier provides more flexibilities, it is hard to estimate the covariance with a sufficient degree of accuracy. Also, single index model aid in decentralizing macro and security analysis. Moreover, single index model minimizes the errors from time to time practice which the full covariance efficient frontier is difficult to do so.

• In a sentence, what is the essence of CAPM (what is the intent of its simplistic elegance)? With respect to CAPM and employing The Economist Group’s “Tales from the Far Side”, what five simple ideas can CAPM be reduced to?  What are the assumptions of the CAPM?  Are they limiting or which assumptions are most worrisome?  Explain the extension of CAPM that includes aggregate human capital (Mayers).  What is the consumption based CAPM designed to include and / or answer?
• Link the economic cycle to Stephen Ross’ arbitrage pricing theory (APT) framework, explaining where the economy is positioned and where the portfolio should be positioned with respect to APT betas, respectively. Explain the foundational elements of the Fama-French (FF) Three Factor Model, linking it to the Morningstar Box framework.  What does Carhart add to the FF model?
• What does the Efficient Market Hypothesis (EMH) portend? What is does the weak, semi-strong and strong forms state about efficiency?  What five anomalies appear difficult to reconcile with the EMH?  What is the difference between fundamental and technical analysis?    What is the lucky event issue?  What is a bubble and how does it relate to efficiency?
• Explain behavioral finance in the context of heuristics, biases, and anomalies. What are overconfidence, representativeness, conservatism, mental accounting, and prospect theory? What is a market bubble, how do bubbles confirm or disaffirm the EMH, and who wrote Manias, Panics and Crashes (MP&Cs)? Finally, what are the five stages outlined in MP&Cs?  What are relative strength, breadth, and moving averages in technical analysis?
• Explain “liquidity” as a priced market factor? When is liquidity particularly valuable? What is the Equity Risk Premium Puzzle?  What are the three dominant multifactor models used today by practitioners?
• What is the directional link between interest rates and bond prices? What is the difference between Yield-to-Maturity, Realized-Yield-to-Maturity, and Yield-to-Call? What is a premium bond versus a discount bond? Explain how default is measured – and then depicted to investors – on the Street?  What are five determinants of bond safety?  What is a CDO?
• When constructing a yield curve, what is the role of zero-coupon bonds? What is a yield curve? What is the difference between a spot rate, a short rate, and a forward rate?  How is a one-year forward rate five years out easily calculated?  What does the expectations hypothesis suggest?  What does the liquidity preference suggest?  Importantly, how does the expectations and liquidity preference theories complicate the interpretation of the message of the yield curve?
• What is duration? What is modified duration and what determines duration? What is effective duration? What is convexity? What do duration and convexity measure? If the benchmark duration is 5, what duration are you targeting in rising rate environment? Why?  If the benchmark duration is 2, what duration are you targeting in a falling rate environment?   Why?  What is immunization (and how does it link to asset / liability management)?  Can you have a passive bond fund?
• Explain the difference between monetary and fiscal policy? What are the main tools of each?  What is operating leverage? What is financial leverage? What is the industry life cycle, linking how it may relate to valuation discussions? What is sector rotation, linking it to where you would want to position yourself in today’s marketplace? Why?
• Link equity valuation to discounted cash flow models from your Intro to Finance course. In theory, is it similar, different?  What is the importance of comparing intrinsic value and market price in investments?  Link the Price/Earnings Ratio to Growth Opportunities, using today’s S&P500 Index as an example.  How are FCFF and FCFE defined? What does “consistency” refer to in valuation theory?  Why is the constant growth model important and /or how is it used in determining intrinsic value (hint: think about the Security Analysis Project)?  What fundamental metrics do P/E, P/B and P/S link, respectively?
• Explain how the Dupont Decomposition can inform one’s comparative analysis of two companies? Is ROE, ROA, or ROIC the best measure to decompose? Why? What are some comparability problems when performing fundamental analysis (and how can they be potentially overcome)?  Explain the concept of quality of earnings and why it is important.
• Draw a long call, short call, long put, short put, labeling the two axes. What is the difference between a theoretical option value and an actual payoff?  What does the put-call parity relationship represent?  Provide an example of combining options into a strategy that is long volatility.  Describe the construction of and rationale for a covered call? A protective put?
• What are the six determinants of call option values? What pricing model is most used for option pricing?  Explain it intuitively? Which determinant of option value can be effectively discerned implicitly for trading? Explain how. What is the VIX and how is it calculated?  What is a delta and how is it used in hedging?
• Explain what links the spot and futures “financial” prices (hint: look at the formula)? Explain what links the spot and futures “commodity” prices (hint: look at the formula)? What is contango? What is backwardation? Why is the margin account needed in futures contracts? What is a basis in futures contracts and why is it important?
• How can futures be used to manage interest rate risk in a fixed income portfolio? How can futures be used to manage beta in an equity portfolio? Explain the mechanics of a fixed-floating swap, describing the rationale for each participant entering the contract. What is a credit default swap?
• Define the Sharpe, Treynor, Jensen, and Information measures. In short, what do they all seek to measure?  Which one is best?  How should these measures be best employed in a portfolio analysis?  What is style analysis and how is it most useful in portfolio return analyses?  What is the difference between strategic, tactical, and dynamic asset allocation?
• Explain the two sets of questions a PM must ask – and answer – in making an international investment decision. Explain exchange rate risk.  Explain the difference between developed and emerging markets?  Which is riskier? What has higher returns?  Explain the nature of the correlation between US and international equities in a period of financial stress.  What is interest rate parity and why is it important to discuss?  What is the EAFE Index?
• What are the major categories of hedge funds?  Provide an example of a hedge fund recommendation you would make if asked in a macro interview.
• What is the J-Curve with respect to Venture Capital investing? What is the VC portfolio model?  What is the business / portfolio model of the Private Equity LLC?  What is a CDO and a CMO? What functions do structured products seek to address (hint: look to question 1).  What is the attraction to investing in real assets (hint: what risk does it appear to lessen)?