FIN 500R Exam Answers. By nature of the exam, almost none of the answers are unique. In a few places, I give examples of alternative correct answers.

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1 FIN 500R Exam Answers Phil Dybvig October 14, 2015 By nature of the exam, almost none of the answers are unique. In a few places, I give examples of alternative correct answers. Bubbles, Doubling Strategies, Suicidal Strategies, and Verification 1. (a) What is a bubble in an asset market? A bubble is an asset whose price is obviously too high. One formal definition is that the price is higher than the price of the cheapest replicating strategy. (b) Is money a bubble? Is this good or bad? Money is a bubble, since it has positive value but its cash flows can be replicated at zero cost by doing nothing. I think it is good that money is a bubble: as pointed out by Shell, it can do better than a competitive market in allocating consumption over time. or, Money is a bubble, since it has positive value but its cash flows can be replicated at zero cost by doing nothing. Although Shell argued it is good that money is a bubble because that allows it to do better than a competitive market in allocating consumption over time, I don t think this is important because the inefficiency is in not consuming enough, and this can be remedied easily at any time in the future. 2. (a) In Limited Arbitrage in Equity Markets, Mitchell, Pulvino, and Stafford use what argument to say markets are inefficient? They say that the value of positions in marketed subsidiaries less debt exceeds the value of a lot of firms, which shows one or the other is mispriced. (b) Do you agree or not? I agree, the measures they use based on market prices and balance sheet items are persuasive.

One formal definition is that the price is higher than the price of the cheapest replicating strategy. (b) Is money a bubble? Is this good or bad?

2 or, I disagree (or at least I don t think they have proven anything), since the firms may have off-balance-sheet liabilities not included in their analysis. Understanding the financial crisis 3. (a) What is the repo market and how is it related to the financial crisis? The repo (or repurchase agreement) market is an OTC market for collateralized loans structured as the sale and repurchase of some underlying collateral. (b) Do you think the loss of liquidity from the collapse of the repo market was important for the economy? Why or why not? I think it was important, since the market was huge and provided a lot of liquidity. Its collapse seems to have been associated with persistent problems in the economy. High Frequency Trading 4. (a) In Equilibrium Fast Trading, Biais, Foucault, and Moinas argue that high-frequency trading can have both costs and benefits for society. What are the costs and benefits? The benefits are a potential increase in liquidity and price efficiency, and the costs come from the adverse selection. (b) If the costs of high-frequency trading exceed the benefits, they argue that banning fast trading is dominated by what policy? Do you agree? They recommend a Pigouvian tax on the technology for fast trading. I am skeptical this will work because it is hard to know how big the tax should be, especially since the technology is changing all the time. 2

The repo (or repurchase agreement) market is an OTC market for collateralized loans structured as the sale and repurchase of some underlying collateral.

3 5. (a) Maureen O Hara s paper High Frequency Market Microstructure gives a survey of recent work and a description of new institutions not described well by current models. Give an example of the type of institution she is talking about. dark pools (b) Do you think these new institutions are important? Why or why not? I think they are. Traders and investors face many more trade-offs than they used to. 6. (a) In High Frequency Trading With Speed Hierarchies, Wei Li argues that high-frequency traders might trade at different speeds. How does this affect market efficiency (compared to all highfrequency traders trading at the same speed)? Trading at different speeds reduces competition and decreases market efficiency. (b) Do you believe this result? Why or why not? Although I am not so happy with all details of the model (especially the Kyle market makers), the result probably holds in a more reasonable model. Ross s Recovery Theorem 7. (a) According to Ross s Options and Efficiency, we can use option prices to compute risk-neutral probabilities. According to the Ross recovery theorem, what else can we recover? actual probabilities(or equivalently given that we have risk-neutral probabilities, the state-price density) (b) Do you think Ross s recovery is useful in practice? Why or why not? Knowing the market consensus beliefs about actual probabilities would be extremely useful, but I am skeptical how well the model will do in practice given the restrictive and important compactness assumptions. 3

Traders and investors face many more trade-offs than they used to. 6. (a) In High Frequency Trading With Speed Hierarchies, Wei Li argues that high-frequency traders might trade at different speeds.

4 Investing with Transaction Costs 8. (a) How do transaction costs affect the optimal trading pattern in continuous time? Instead of trading continuously, we spend most of our time in a region in which it is optimal not to trade. (b) Do you think transaction costs are an important consideration for investors? Why or why not? Although transaction costs are smaller than they used to be, transaction costs are still important and most managers seem to trade more than is optimal. Performance of Mutual Fund Managers 9. (a) Carhart studies persistence of mutual fund performance. What does he find? He finds that mutual funds as a group underperform the market and it is hard to find any group that predictably outperforms the market. Funds in the top decile outperform slightly next period, but also have a high probability of being in the bottom decile. (b) Do you believe active mutual funds are a good investment? Why or why not? No, index funds have lower volatility and perform only slightly less well than rotating among mutual funds with recent good performance. Picking Stocks 10. (a) How are accruals used to manage earnings? Typically accruals have a more subjective or discretionary basis than actual cash flows; increasing accrual of net income or reducing accrual of cost can create artificially inflated earnings. 4

Why or why not? Although transaction costs are smaller than they used to be, transaction costs are still important and most managers seem to trade more than is optimal.

5 (b) Is management of earnings beneficial to shareholders? Why or why not? No, hiding information from shareholders does not benefit them. Risk Management 11. (a) Name two possible reasons we might want to hedge risk in a firm. i) Reduction of the probability of costly financial distress and bankruptcy. ii) Making accounting numbers a more accurate measure of managerial performance. (b) Do you think hedge accounting makes it easier or harder to hedge risks? Why? It makes it harder because it is very hard to qualify as a hedge and as a result a good hedging program likely makes thefirmmore risky. 12. (a) What is a stress test? How is it used? (b) Do you think the CLASS model presented in class gives a good methodology for performing stress tests? Pricing of Credit Risk 13. (a) In a reduced-form model of pricing corporate debt, what is the default rate? What is the recovery rate? The default rate is the hazard rate (probability per unit time) of default. The recovery rate is how much is recovered after default (either as a fraction of the face value, or stranger but more convenient as a function of the current market price). (b) Do we need to model the default and recovery rates separately? Why or why not? For a single bond, we could just consider the product of the hazard rate and the price less the recovery amount, but we need both to analyze in a single model bonds with different priorities in bankruptcy. 5

ii) Making accounting numbers a more accurate measure of managerial performance. (b) Do you think hedge accounting makes it easier or harder to hedge risks? Why?

6 Chinese Markets 14. (a) In relatively mature markets like the NYSE, professionals tend to stabilize the market by buying when the price is too low and selling when the price is too high. Agree or disagree? I agree for the most part although there are exceptions (for example the flash crash which involved only HFTs trading with each other (and they are all professionals). (b) How about in China? In China s market, the professionals are swamped by the huge number of naive retail traders, and professionals seem to be able to create profits by trading against retail customers who are goaded into pushing the price out of line. Hedging Mortality Risk 15. (a) What is a reverse mortgage? There are different varieties, but the usual reverse mortgage trades equity in a house for monthly payments to the homeowner. (b) Wang, Hsieh, and Chiu recommend using reverse mortgages to hedge mortality risk. Do you think this is a good idea? Why or why not? This is a retail product and may end up hedging other things in a mortality shop s portfolio, but the quantity supplied should be based on market conditions and profitability, not on its usefulness in building a hedge. Performance Measurement 16. (a) What is Jensen s alpha? Jensen s alpha is the mean excess return above the leverage-adjusted market return, α = E[r f +β(r M r f )]. There are analogous versions for multi-factor (APT) models. 6

7 (b) Do you think Jensen s alpha gives an accurate picture of a manager s investment performance? Why or why not? Jensen s alpha is a good measure of performance if you look at stock-picking ability, not ability to time the market. Predicting Returns 17. (a) Give an example of a possible trigger of a regime change. A change in Fed policy, e.g. ending of the zero-interest-rate regime or changing from a focus on targeting the Fed Funds rate from a focus on targeting the money supply. (b) Do you think regime changes are useful for modeling stock returns? No, because it is hard enough to estimate the unconditional mean return and even harder to estimate the mean return conditional on regime. 18. (a) What is technical analysis? Using past stock price as the basis for trading or predicting returns. (b) Do you think automating technical analysis is a good way to beat the market? Why or why not? Yes, at least for low- to medium-frequency trading, since this style is relatively unpopular now and faces little competition. 7

(a) Give an example of a possible trigger of a regime change. A change in Fed policy, e.g. ending of the zero-interest-rate regime or changing from a focus on targeting the Fed Funds rate from a focus on targeting the money supply.

FIN 500R Exam. Phil Dybvig October 14, 2015

FIN 500R Exam. Phil Dybvig October 14, 2015 FIN 500R Exam Phil Dybvig October 14, 2015 This is a closed-book examination. You may not use texts, notes, a crib sheet, calculator, cell phone, listening device, or any other electronics. Answer 10 questions