Investment Analysis Final

post midterm material focusing on portfolio variance, expected return, standard deviation, duration, convexity

risk

the potential for divergence between the actual outcome and what is expected (an investment sustained a permanent loss of value)

volatility

rate at which the price of the stock increases or decreases over a particular period. (measured by standard deviation, the square root of variance)

sell-offs

a period of when many investors rapidly sell their assets (stocks, bonds, or other securities), causing prices to fall quickly

market depth

how much buying & selling interest exists at different prices for security. ask-side depth is the supply of shares offered for sale (sellers) bid-side depth is demand waiting to buy (buyers)

order flow & market depth

price changes depends on order flow and market depth. buyers consume supply at the ask and sellers consume demand at the bid. (ask=supply, sell liquidity) (bid=demand, buy liquidity)

Warren Buffett

“volatility does not measure risk” & “diversification is a protection against ignorance”

risk-adverse

prioritize the safety of principal over the possibility of a higher return

risk-seeing

volatility & uncertainty in investments in exchange for the potential for higher returns

sigma

measures how much the returns of the portfolio move around the average return. (standard deviation grows bigger as the return moves further above or below average)

covariance

measures the directional relationship between the returns on two assets. “positive” means asset returns move together; '“negative ” means they move opposite directions (-infinity and +infinity)

correlation

measures to represent how strongly 2 random variables are related to each other, measures both the strength & direction of linear relationship between 2 variables (-1 and +1), positive moves in the same direction & negative moves in opposite direction

portfolio

group of assets with individual attributes (not collective sum) risk-return trade-off for a portfolio is measured by the portfolio's expected return and standard deviation

diversified risk

risk that can be eliminated by combining assets into a portfolio (unsystematic or asset specific risk)

diversification

substantially reduces the risk of returns without an equivalent reduction in expected returns

systematic risk

cannot be diversified away

unsystematic risk

can be diversified away

beta

the higher the beta, the greater the risk premium should be. (B=1, the asset has the same systemic risk as market. B<1, the asset has less systematic risk than market. B>1, the asset has more systematic risk than market).

skewness

standard measure of asymmetry in the probability distribution of returns

kurtosis

the likelihood of extreme values on either side of the mean, smaller likelihood of moderate deviations. normal distribution = 3, excess is defined as -3

black swan

rare, extreme in impact, retrospectively explainable but unpredictable

efficient frontier

represents portfolios that offer the highest possible return for a given risk & they are diversified portfolios that offer the best possible return for a given level of risk

negative skewness

long-left tail, frequent small gains, and occasional large losses. suggests large downside risk & excess kurtosis indicates higher-tail risk than normal

positive skewness

long-right tail, small gains and occasionally huge gains

why should an investment analyst consider kurtosis along with standard deviation?

standard deviation shows average dispersion, but kurtosis detects tail risk (important in stress scenarios)

in a portfolio, a postive skewed return distribution is preferred, why?

positive skew means more potential for large upside moves, favorable to most investors

which of the following is true about a bond selling above par value?

a bond sells above par at a premium when the coupon rate is higher than the market yield

which bond is most sensitive to interest rate changes, assuming all else equal?

a 10-year zero-coupon bond. (longer maturity and zero coupons = higher duration, duration is highest for long-term zero-coupon bonds, making them more sensitive to rate changes.)

callable bonds

bonds that may be repurchased by the issuer at a specified call price during the call period, usually occurs after a fall in market interest rates that allows issuers to refinance outstanding debt with new bonds.

call protected

bonds are usually callable during the first few years of a bond’s life

for stocks

the bid price will always be lower than the ask or “offer” price. the difference between the bid price and the ask price is called the “spread”

for bonds

bid yields are always higher than ask yields, bond price and bond yield are inversely related

term structure of interest rates

the relationship between time to maturity and yields, all else equal. the shapre of the yield curve is based upon the lenght of term or maturity of bonds

normal

upwards-sloping, long-term yields are higher than short-term yields

inverted

downward-sloping, long-term yields are lower than short-term yields

interest rate risk

the coupons and face value are fixed at the time of issue of bonds, but the value (PV) fluctuates. if the opportunity cost changed after a bond has been issued, the value of these guaranteed cash flows will change, along with the PV.

lower coupon rates & higher interest rate risk

bonds with lower coupon rates have a higher interest rate risk, this is due to them having fewer cash flows occurring early in its life. the value of the bond relies more heavily on the cash flow at maturity makin its value more sensitive to changes in a discount rate

higher-coupon bonds

receive larger cash flows early on, making it less sensitive to changes in the discount rate since the future cash flows make up a smaller portion of its total value. when interest rate change, the impact on the bond’s value is more muted

tulip mania

rare tulip bulbs become status symbols & speculative assets. traded as future-like contracts. they were exchanged for other forms of value. it collapsed in feb 1637, a failed auction sent confidence shock, disappearing bids, prices dropped down 90% in weeks, contracts defaulted (legal disputes & liquidity freeze)

bullish investors

believed prices would keep rising, speculation based on social trends, not fundamentals

bearish skeptics

questioned the sustainability of such prices, many stayed out or sold early

2008 global financial crisis

caused by deregulation in the financial industry, permitted banks to engage in hedge fund trading, banks demanded more mortgages. this created interest-only loans affordable to subprime borrowers

will behavioral traders be overwhelmed by rational arbitrageurs?

collective selling pressure of arbitrageurs more than suffices to burst the bubble, rational arbitrageurs understand that an eventual collapse is inevitable (delicate, difficult, dangerous timing game)

formation of financial bubbles

1. initial price appreciation

2. media hype & investor psychology

3. speculative behavior & leverage

4. disconnect from fundamentals

burst mechanism

1. catalyst event or trigger

2. rapid selling & loss of liquidity

3. panic selling & market collapse

4. return to fundamentals

confirmation bias

tendency to interpret new information in a way that confirms one’s prior beliefs, disregards information that challenges poor beliefs

representativeness bias

act as if small sample is just as informative as a large sample; individuals are adept at discerning patterns, even perceiving patterns that may be illusory

information processing

limited attention, underreaction, and overreaction, overconfidence, and conservatism

behavioral biases

framing: decisions affected by how choices are described (whether uncertainity is posed as potential gains from a low baseline lines or losses from a higher baseline value) mental accounting: specific form of framing in which people segregate certain decisions. regret avoidance: individuals who make decisons that turn out badly have more regret. affect & feelings: investors choose stocks with high affect, driving up prices while driving down returns.

bond duration

is a composite measure of interest rate risk that incorporates both the magnitude of the coupons and the maturity of the bond. the higher the duration of the bond, the more sensitive it is to interest rate movements.

macaulay duration

measured by the weighted average time until cash flows are recieved. it is the time it would take for an investor to retreive the money initially invested in the bond.

modified duration

converts macaulay duration into a price sensitivity measure of how much the bond’s price will change for a 1% change in yield

maturity mismatch

banks’ assets (mainly loans) usually have longer maturities than their liabilities (mostly deposits)

interest rate effect

when rates rise, the market value of assets falls more than liabilities reducing the bank’s equity value

bank immunization

strategy that aligns the durations of assets and liabilities to protect net worth from rate changes

positive duration gap

means asset duration > liability duration when rates rise, equity value falls

price risk (interest rate risk)

bond prices move inversely with yield. if you plan to sell the bond before maturity, even after one year, you are primarily exposed to price risk

reinvestment risk

the coupons you receive must be reinvested, but the rate available in the future is uncertain. this risk is greater when you hold for a long period or until maturity because you receive many coupon payments

credit risk

an investor who lends money by purchasing a bond is exposed to credit risk

default risk

the risk the issuer fails to pay interest or principal

credit spread risk

the risk that the bond’s yield spread widens due to market conditions (triggered by markey perception)

downgrade risk

the risk that the issuer’s credit rating is lowered, causing the bond price to fall (triggered by rating action)

determinants of default risk

capacity to generate cash flows, volatlity of cash flows, and fixed fiancial commitments