Combined Test 3

Random walk

Stock price movements are unpredictable

Efficient market

Securities reflect all possible information quickly and accurately

In order to have an efficient market, one needs:

1. Many knowledgeable investors actively analyzing and trading stocks

2. Information widely available to all investors

3. Events, such as labor strikes or accidents, that tend to happen randomly

4. Investors who react quickly and accurately to new information

Prices are a way for the economy to determine how to ________ well.

allocate resources

What are the 3 levels of market efficiency?

1.     Weak Form: past data on stock prices is of no use in predicting future stock price changes;

strategy implication: use a ”buy-and-hold” strategy.

2.     Semi-Strong Form: Cannot make a profit using public information; any price anomalies are quickly adjusted for;

strategy implication: very hard to beat the market unless you are “fast.”

3.     Strong Form: all information, including private information is already priced into the stock market price. 

There is evidence that the market is not strong form efficient.  (Note: Insiders and Specialists do outperform the market over time).

What are some observed abnormalities of the EMH?

1. Calendar effect: January performance higher

• Tax-loss selling effect  people sell companies in Dec to record a loss on taxes and then repurchase in Jan, moving stock prices up

2. Small firm effect: Small firm’s returns are higher than large firm’s returns adjusted for risk

• Small firms have more growth-potential and fast growth than large firms

3. Earnings announcement: Prices adjust slowly

• Market doesn’t react immediately

4. Value P/E effect: Low P/E stocks outperform high P/E stocks

• Investor overreaction to negative news → stock P decreases = low P/E

Even if the anomalies above exist, it may be hard to profit after __________.

transaction costs

If you believe markets are very efficient, you should buy __________.

low cost index funds

Behavioral finance

A theory positing that investing behaviors are influenced by psychological factors

• It is argued to slightly disprove the EMH by examining irrational investor behavior

Prospect theory

A theory of behavioral finance explaining investors’ satisfaction is a function of a change in their wealth

• This differs from the conventional belief that investors’ satisfaction is a function of their level of wealth, which supports the risk averse investor argument

Technical Analysis

A method of analyzing stock value and performance based on historical movements

• Technical analysis values stocks based on historical prices whereas fundamental analysis values stocks based on financial data analysis

Bubbles

A period of rapidly increasing prices of a particular asset that eventually exceed its true value

• When a bubble pops, values decrease rapidly

Dow Theory

A theory positing that when a Dow Jones average price exceeds an important previous high accompanied by a similar trend in another average, it indicates a positive market trend

• This assumes validity of the EMH

Support and Resistance levels

A support level is a price point that a security’s price is not expected to fall below. A resistance level is a price point that a security’s price is not expected to exceed.

• Technical analysts use support and resistance levels to recognize when a security’s price trend will reverse

Chart formations

A pattern identified when price data is plotted on a chart

• Technical analysts use charts to identify different patterns in stock price and predict future trends

Sentimental indicators

Calculations of values meant to reveal market sentiment/expectations

• Sentimental indicators reveal investors’ psychological position, which under behavior finance theory help explain price trends

Contrary Opinion rules

Invest contrary to market sentiment: buy losers. The worse the market, the better opportunities to profit

• Historically, market declines during panics are a good time to buy potentially undervalued securities

Smart money rules

Knowledgeable investing usually by making long-term, large investments in securities with large growth potential identified by fundamental analysis

• Smart money is often handled by knowledgeable institutional investors, central banks or other finance professionals

T/F: The coupon is the interest the issuer of the bonds pays regardless of what interest rates do.

T

T/F: Debentures will normally carry a higher coupon rate than income issues of the same corporation.

T

T/F: Interest rates are high and are expected to go lower. I would like my bond to have a freely callable provision.

F

T/F: Corporations are the largest users of the debt market.

F → the govt is

T/F: Municipal bonds cannot default and are virtually risk free.

F

T/F: Zero coupon bonds provide return to the investor in the form of a discounted price.

T

T/F: A "split bond rating" means different ratings by different rating agencies.

T

T/F: Agency bonds are backed by the U.S. treasury.

F

T/F: Par value 1000. 72 1/4 quote means bond has price of $722.50.

T

T/F: A bankers acceptance is a draft which is drawn on a bank for approval for future payment.

T

What is the purpose of duration?

To measure a fixed-income’s sensitivity to changes in interest rates

What are the primary factors that influence a bond’s duration?

1. Time to maturity

2. Coupon rate

What are the 2 main risks that duration helps us quantify?

1. Credit risk

2. Interest rate risk

When is the best time to implement a long-duration strategy?

During a recession, when interest rates are falling

When is the best time to implement a short-duration strategy?

When interest rates are expected to rise

What is the relationship of maturity and duration for a zero-coupon bond and explain why?

A zero-coupon bond’s duration equals its time to maturity because it pays no coupon. Thus, the bondholder will not be repaid the bond’s price until the bond matures.

Bond strategy: Passive “Buy and Hold”

Purchasing individual bonds and holding them until maturity

• Good for investors who want predictable income

  • CFs from coupon payments

  • ex. retirees

• key = hold

  • through ST interest rate fluctuations

• horizon: LT

• conservative risk

  • guaranteed interest pmts except if bond defaults

• low-maintenance, income investing

• consistent w/ EMH

• ex.

Bond strategy: Index Matching

A bond portfolio constructed to reflect the movements of a bond index

• This is quasi-passive, similar to the passive “buy and hold” strategy but with a little more flexibility

  • have to rebalance portfolio

  • consistent w/ EMH

• tracking error → returns differ b/c fees or imperfect construction

• benchmark index: type of bond (US govt, corp, municipal, etc.)

• horizon: LT

• benefits as opposed to active management: lower costs, broad-based diversification, and lower taxes

• will never outperform the market, will perform like it

• some are better than others: pick

• good for: investors seeking to matching bond market return, income investing, and institutional investors wanting exposure to bonds

Bond strategy: Immunization

Matches the duration of assets and liabilities

• Set up so the price and reinvestment risk offset each other, immunizing the portfolio against interest rate changes

• quasi-active

  • have to rebalance to ensure duration remains the same for bond and liability

• hedge against interest rate risk

  • to ensure a future liability is met

• fail if: yield curve steepens or flattens

• good for: corporations (pension funds, insurance co’s), risk-adverse planners

• ex. liability of 500k in 7yrs; buy a bond w/ duration of 7 yrs whose PV matches the PV of the 500k liability. hold and rebalance until end of 7 yrs

  • this is target date matching (lump sum)

    • also, CF match → to provide payments: $20k in 3 yrs, $50k in 5yrs; buy bonds that match those

    • also, net worth match → duration of assets to duration of liabilities (pension fund planning)

Bond strategy: Rate Anticipation Swap

Swap bond holdings in anticipation of changing interest rates. For example, trading shorter duration bonds for longer duration ones when interest rates are expected to fall and vice versa when rates are expected to rise

• This is inherently speculative

Bond strategy: Riding the yield curve

Buying long-term bonds to get a higher yield but selling before they mature and the yield falls

• This strategy is not very effective when interest rates rise

Bond strategy: Barbell

Buying very short-term and long-term bonds but no mid-term bonds

• The long-term bonds help the investor when yields fall and short-term bonds help when yields rise

Bond strategy: Laddered

Buying bonds with different maturity lengths

• Spreads risk along the interest rate curve to hedge against interest rate movements

Bond strategy: Intermarket spread swap

Trading one bond for another with slightly different terms from a different bond sector

• This is done to capitalize on wider-than-usual yield discrepancies between bond sectors

Bond spread

The difference between the quoted rate of return on different bonds

• Wider bond spreads are associated with greater risk and narrower spreads with lower risk

Bond strategy: Five Against bond strategy (FAB)

Futures trading strategy that takes offsetting positions in futures contracts for 5-yr Treasury notes and long-term Treasury bonds

• Seeks to capitalize on mis-pricing in yield spreads

  • rate and yield movements

• active management plus immunization

• either buy a futures contract on 5-yr T-notes and sell a LT T-bond or vice versa

• speculate on interest rate movements

  • based on US economic health, fed reserve policies, etc.

Bond

A security that obligates the issuer to make specified payments to the holder over a period of time

Par value

the payment to the bondholder at the maturity of the bond

• AKA face value

Coupon rate

a bond’s annual interest payment per dollar of par value

Callable bonds

Bonds that may be repurchased by the issuer at a specified call price during the call period

Collateral

A specific asset pledged against possible default on a bond

Debenture

A bond not backed by specific collateral

Convertible bonds

A bond w/ an option allowing the bondholder to exchange the bond for a specified number of shares of common stock in the firm

Credit default swap (CDS)

An insurance policy on the default risk of a corporate bond or loan

Current yield

Annual coupon divided by bond price

Premium bonds

Bonds selling above par value

Discount bonds

Bonds selling below par value

Default premium

the increment to promised yield that compensates the investor for default risk

Expectations hypothesis

The theory that yields to maturity are determined solely by expectations of future ST interest rates

Floating-rate bonds

Bonds w/ coupon rates periodically reset according to a specified market rate

Forward rate

The inferred ST rate of interest for a future period that makes the expected total return of a LT bond equal to that of rolling over ST bonds

Horizon analysis

Analysis of bond returns over a multiyear horizon, based on forecasts of the bond’s yield to maturity and the reinvestment rate of coupons

Indenture

the document defining the contract b/w the bond issuer and bondholder

Investment grade bond

A bond rated BBB and above by S&P’s or Baa and above by Moody’s

speculative grade or junk bond

A bond rated BB or lower by S&P’s, Ba or lower by Moody’s, or unrated

Liquidity preference theory

the theory that investors demand a risk premium on LT bonds

Liquidity premium

The yield spread demanded by investors as compensation for the greater risk of longer-term bonds

Put bond

A bond that the holder may choose either to exchange for par value at some date or to extend for a given number of years

realized compound return

compound rate of return on a bond w/ all coupons reinvested until maturity

reinvestment rate risk

uncertainty surrounding the cumulative future value of reinvested bond coupon payments

Sinking fund

a bond indenture that calls for the issuer to periodically repurchase some proportion of the outstanding bonds prior to maturity

Spot rate

the yield to maturity on a zero-coupon bond of a given maturity

Subordination clauses

Restrictions on additional borrowing that stipulate that senior bondholders will be paid first in the event of bankruptcy

term structure of interest rates

the relationship b/w yields to maturity and terms to maturity across bonds

yield curve

a graph of yield to maturity as a function of term to maturity

yield to maturity (YTM)

the dsct rate that makes the present value of the bond’s payments equal to its price

zero-coupon bond

a bond paying no coupons that sells at a dsct and provides only a payment of par value at maturity

What type of management is consistent with EMH: active or passive?

passive

active management assumes market inefficiency

Technical analysis assumes which type of EMH: weak, semi-strong, strong?

semi-strong or strong

Dow theory (technical analysis)

There are 3 major movements in the market:

1. daily fluctuations

2. secondary movements: 2wks - month (only important if reflect LT primary market trend)

3. primary trends (bullish or bearish)

Which type of market movement do you make money on?

primary trends

Which type of movement should analysts not be confused by?

secondary movements

T/F: The bond market is dominated by large institutional investors.

T → >85% of trading

T/F: Banks are strong participants in the municipal bond market.

T

T/F: Domestic investors bank roll 10-15% of US Govt debts.

F → Foreign investors

T/F: The bond market is a strong primary market but a relatively weak secondary market.

T

What are 3 reasons for a bond to be rated a junk bond?

1. “Fallen Angel” → Firm w/ historically good performance that now face hard times

2. Growth companies that have not yet earned an investment quality rating

3. Companies going through a restructuring due to a leveraged buyout or in response to a hostile takeover attempt

How many basis points is a 1% change?

100 basis points

How much change is 1 basis point?

.01%

T/F: Bond prices and interest rates are directly related.

F → inversely related

Which are more sensitive to a change in yields: ST or LT bonds?

LT bonds

T/F: Bond price sensitivity increases at a decreasing rate as maturity increases.

T

T/F: Bond prices are more sensitive to a decline in market YTM than to a rise in YTM.

T

Which are more sensitive to a change in YTM: low- or high-coupon bonds?

low-coupon bonds

T/F: Bond prices are more sensitive when YTM is low than when YTM is high.

T

T/F: Margin trading magnifies profits and losses of bond investments by a factor of 1/margin requirement.

T

If interest rates fall, do you want high or low duration?

high

want more sensitive, so price rises higher

If interest rates rise, do you want high or low duration?

low

want less sensitive, so prices don’t fall as much

Which 3 characteristics determine duration?

1. maturity

2. coupon rate

   1. market rate of interest

Greater/Lesser: The longer the maturity or duration, the __________ the impact of a given change in interest rates on price.

greater

T/F: Market rates of interest (YTM) and duration are inversely related.

T

T/F: For any bonds with coupons, duration will always be shorter than term to maturity.

T