Financial Economics

ASB-3207
Theory

IMP With reference to the Capital Asset Pricing Model (CAPM), explain what is
meant by the following statement: The total variance in the return on any
security can be partitioned into two components,

representing systematic risk and

unsystematic risk.
var(Ri) = i2var(RM) + var(i)
The total variance in the return on security i can be partitioned into two
components:
Systematic risk, given by i2var(RM). This is the risk arising from the
correlation between the return on security i and the return on the market
portfolio. For any given value of var(RM), the amount of systematic risk is
measured by beta. Systematic risk cannot be eliminated by diversification,
because the returns on all securities are similarly correlated with the return
on the market portfolio. To compensate for systematic risk, investors require
higher returns on securities with higher betas (as shown by the security
market line).
Unsystematic risk, given by var(i), known as the residual variance. This is
the risk that is specific to security i, and independent of what is happening to
the

market.

In

theory,

investors

should

not

be

concerned

about

unsystematic risk, because this type of risk can be always eliminated

completely through diversification. If we create a portfolio comprising many
securities with random (and uncorrelated) is, the contribution that this
component makes to the total variance of the portfolio return becomes zero.

What is the main prediction of the CAPM?

The central prediction of the CAPM is that the premium per unit
expected market return minus the risk-free

of beta is the

interest rate linear relationship

between beta and expected return for a security.

Assumptions of CAPM:
1. Risk-averse investors and portfolio choices based solely on expected return
and variance/standard deviation of asset returns (which are Normally
distributed).
2. Identical expectations about security returns.
3. There is a risk-free asset, and individuals can borrow or lend infinite amounts
at the risk-free rate of return.
4. The total quantities of all assets are fixed; all assets are marketable and
perfectly divisible.
5. Asset markets are frictionless (no transaction costs), and there are no taxes
or regulations/restrictions on trade in assets.

IMP Outline and compare the following theories of the term structure of
interest rates:
(i) Market expectations theory,
(ii) Liquidity preference theory,
(iii) Preferred habitat theory,
(iv) Market segmentation theory.
The yield curve shows the term structure of interest rates: the relationship between
the term to maturity or the number of years until the last promised payment and

the yield to maturity or the average rate of return of a bond that is held until
maturity and there is no default (or delay) in any of the promised payments.

In (a), the yield curve is positively sloped. Long-term borrowers pay a higher interest
rate than medium or short-term borrowers.
In (b), the yield curve is negatively sloped: short-term borrowers pay the most.
In (c), the yield curve is hump-shaped: medium-term borrowers pay the most.
In (d), the yield curve is flat: all borrowers pay the same.

Market expectations theory: the term structure is determined solely by the

markets expectations concerning future interest rates (i.e. future expected
yields on one-year bonds. If the future course of interest rates were known
with certainty, then the market expectations theory would hold, because

bonds with different terms to maturity would be perfect substitutes for one
o

another.
Liquidity Preference Theory: In practice, there is uncertainty about the future
course of interest rates there may be differentials in expected returns
between bonds of different terms to maturity, because investors require risk

premiums (or liquidity premiums), to compensate them for accepting risk.

Preferred habitat theory: Similar to the liquidity preference theory, but with
one important difference: the liquidity premium does not necessarily increase
with the term to maturity (i.e., it could be increasing or decreasing). Different
investors have different objectives, and will tend to match the terms to
maturity of their assets and liabilities. For a 35-year-old who is saving for
retirement, a bond with a 30-year term to maturity is a less risky investment
than a one-year or two-year bond (therefore, the risk premium will decrease

with maturity).
Market segmentation theory: the market is populated by individuals and
institutions that demand and supply loanable funds, over different time
periods. As in the preferred habitat theory, these individuals and institutions
attempt to match up the terms to maturity of their assets and liabilities. For
instance, banks deposits are mostly short-term, so they prefer to lend shortterm; pension funds receive contributions that are held long-term, so they
prefer to buy long-term bonds. Because individuals and institutions are risk
averse, and prefer to keep the terms to maturity of their assets and liabilities
balanced, the flow of funds between segments is unresponsive to yield
differentials.

The market expectations theory and the market segmentation theory imply two
different responses of the yield curve with respect to monetary policy:
Market expectations theory: a change in short-term interest rates has implications
for the entire term structure.
Market segmentation theory: a change in short-term rates has little or no effect on
yields at longer terms to maturity.

IMP With reference to the efficient markets hypothesis, explain carefully

the different forms of market efficiency. Your answer should be followed
by evidence for the different forms of market efficiency.

Different types of market efficiency

o
o

Operational efficiency: transaction costs as low as possible

Allocative efficiency: funds are allocated to firms that can provide the best

risk-adjusted return
Informative efficiency: prices reflect all information pertaining to a stock in
this lecture, we will focus on this type of efficiency

The Efficient Market Hypothesis: Market process information efficiently. Any kind
of information which is relevant to evaluate a stock is immediately impounded in
prices. No investor can profit from any piece of information about a stock.
3 levels of market efficiency: Refer to lecture 9 for evidence.
o
o

Weak form efficiency: prices reflect all information about historical prices
Semi strong-form efficiency: prices reflect all relevant publicly available

information
Strong-form efficiency: prices reflect both publicly and privately available
information

Describe what distinguishes multifactor risk models from the CAPM.

Describe the main assumptions of APT

Perfect competition in capital market

All investors have same expectations

covariances
Short-selling is allowed and there are no transaction costs
Investors prefer more wealth than less wealth, however no assumption made
about their risk aversion.

about

means,

variances

and

A very large number of assets is available in the economy non-systematic

risk approaches zero and it is possible to obtain any desirable values for the

beta with respect to each factor

All securities should be priced so that it is impossible to change the portfolio
weights in a way that generates an increase in the portfolio return, while
holding the level of systematic risk constant.

IMP Explain briefly the following terms:

(i) Call and Put option: A call/put option gives the holder the right to buy/sell an
asset, often a specified number of company shares, at a specified exercise price on
(or in some cases before) a specified expiration date
(ii) European option: give the holder the right to exercise only on the expiration
date

(iii) In-the-money, out-of-the-money and at-the-money options: in-themoney if the current share price is above/below the exercise price, and outof-the-money if the current share price is below/above the exercise price. At
the money is when they are equal.
(iv) American Option: American options give the holder the right to exercise on or
before the expiration date
(v) Macaulay duration: is a weighted average of the periods the investor has to
wait before receiving each payment. The weights are ratios of the present
values of each payment to the total present value of the bond. The larger is
D, the higher is the volatility.
(vi)Immunization: ensures that the present value of your assets rises and falls in
line with the present value of your liabilities. Whatever happens to interest
rates, you are guaranteed to have sufficient assets to meet your liabilities.

(vii) Interest rate Swap: A swap is an agreement between two parties to

exchange two
different schedules of payment obligations. An I.R.S. is an agreement whereby two
parties exchange
streams of periodic interest payments.

IMP What are the main differences between forward and futures
contracts?

Definition: A forward (FWD) or futures (FTS) contract obliges the holder to buy or
sell a specific asset at a specific price on a specific delivery date . In contrast, with
an option the holder can choose whether or not to buy or sell.
Future contract: are standardized in terms of their specifications, and are traded
through organized exchanges such as the CME (Chicago Mercantile Exchange), the
LIFFE (London International Financial. FTS are highly liquid, and can be bought and
sold at any time before expiration just like shares listed on a stock exchange . FTS
can be physical commodities (agricultural products, metals, petroleum) or financial
(stock market indexes, treasury bonds, interest rates, currencies) - for physicals, the
grade or quality of the commodity must be specified. Traditionally, trades were
matched and executed in the pit of the exchange (open outcry). Electronic trading
platforms have eliminated the need for trade to take place in a physical location.
There is no direct dealing with a counterparty. The initial value of a FTS is zero
(symmetric gain/losses) .MARKING-to-MARKET procedure: the terms of a FTS are
adjusted daily so as to maintain a zero market value. The contract holder maintains
an account, where sums are credited or debited daily, in order to keep the value of
the contract at zero. A minimum balance must be maintained in the account, and
the account must be topped up immediately if losses cause the balance to fall
below the minimum.

Forward contract: The purchaser of FWD deals directly with a counterparty (such as
bank or other financial institution) which writes such contracts. There is no
organized exchange; they use over the counter (OTC) markets, enabling the
purchaser to compare terms offered by different counterparties. The counterparty
(dealers) bears the credit risk. Prices differ among different counterparties and
contain a bid-ask spread. A FWD is initially priced so that its value is zero (FW0=0).
The value subsequently becomes positive or negative (FWt0), depending on the
movement of the expected price of the asset at expiration, E(CT), relative to FW0. In
contrast to FTS, FWD creates no cash flows before the expiration date (no markingto-market mechanism).

IMP With reference to the Capital Asset Pricing Model (CAPM) with a riskfree asset, explain what is meant by the following:
(i)

Capital market line,

(ii)

Security market line,

(iii)

Characteristic line.

Answer: Tutorial 2 Q1.

Discuss, using examples, the main reasons for using derivatives. Discuss,
using an example, how currency swaps work
Four fundamental purposes:

1. Hedging: FWD and FTS allow to lock in the price at which a transaction will take
place at some date in the future
2. Arbitrage: to take advantage of small discrepancies between spot and
forward/futures prices
3. Speculation: to profit from P by short-selling
4. Portfolio diversification: to construct portfolio with the desired degree of risk

Examples:
1. HEDGING: I have to buy silver in 2 months time. Silver prices can fluctuate,
but my revenues are fixed. I lock in the price by buying a FWD or FTS (Long
Hedge). Whatever the price of silver in 2 months, I will pay the price agreed
today. If i have to sell a certain commodity and I want to lock in the price, Ill
SELL FWD or FTS (short hedge).
2. SPECULATING: If an investor believes that stocks in the FTSE100 index will
rise (fall) in the next month, he can buy (sell) FWD or FTS whose price
depends on that of the FTSE100. While hedgers buy/sell FWD or FTS to offset
an existing long or short position, speculators seek profit by exposing
themselves to risk.
3.
4. ARBITRAGE: a synthetic asset is created from an original asset, to exploit
differences in the price of the two. Price differences between the FTSE100
and a number of FTS or FWD contracts on the FTSE100 are exploited to
obtain riskless profits.
5. PORTFOLIO DIVERSIFICATION: if a pension fund wants to decrease the
sensitivity of its portfolio to the FTSE100, it can buy a FWD/FTS portfolio on
gold or other commodities, whose returns are generally negatively correlated
with stock market returns.
6.
Suppose Firm C is a UK firm that currently operates only in the UK, but wishes to set
up in the US. Firm D is a Japanese multinational that already operates in the US, and
wishes to set up (for the first time) in the UK.

Briefly explain the relation between expected future spot price and
current futures price in the case of normal backwardation.
If the forward price tends to be less than the expected commodity price, i.e., F0,t <
E(S0), we are in a situation called normal backwardation, while if the forward price
is higher than the expected commodity price, i.e., F0,t > E(S0), we are in a situation
called normal contango. In the former case, the forward price will tend to increase
as it approaches expiration. In the latter case, it tends to decrease as it approaches
expiration. Whether we are in normal backwardation or in normal contango depends
on the specific features of the commodity. Most commodity futures prices behave
consistently with normal backwardation because their underlying asset value is
positively correlated with aggregate wealth. Note that, if investors are risk neutral,

they exhibit linear utility functions, and the marginal utility is a constant (i.e. it does
not change as consumption increases). Because their need for money does not
change from recessions to booms, the forward price is equal to the expected
commodity price.

How successfully does the Arbitrage Pricing Theory (APT) address any
weaknesses of the CAPM?
Expected returns according to APT depend on multiple observable factors;
according to CAPM on one unobservable factor (return on market portfolio recall:
Rolls critique)
APT can be tested on a subset of securities no need for test on the whole market
portfolio (which is unobservable)

Discuss the main theoretical limitations of the CAPM

1. Investors might disagree about the expected returns and variances of the
returns on available securities. In this case, a market portfolio based on the
weighted averages of all investors expectations will still be efficient, but
individual investors may prefer to take positions on their own perceived riskreturn frontiers
2. Some investors may be unable to sell short without restriction. These
investors would operate on a constrained efficient frontier
3. If different investors (perhaps including foreign investors) face different
marginal tax rates on income or capital gains, each investors after-tax riskreturn frontier will be different
4. Different investors have different human capital, and they should take this
into account in determining their efficient portfolios. A worker in a car factory
perhaps should not include shares in car manufacturers in his portfolio.
Therefore each investors perceived risk-return frontier is different
5. The idea that expected return and standard deviation of return are the only
two properties of the distribution of returns that matter to investors is based

on an assumption that returns are normally distributed. However, in practice

returns may be non-normally distributed, and investors may have preferences
(for characteristics such as skewness) different to those we have assumed.
6.
Describe Rolls critique of the early empirical tests of the CAPM.
The observed average returns on each security are linear functions of beta i, but
they are also linear functions of betai. In either case, the observed average returns
will lie on the measured security market line. The only way in which they could fail
to do so is if the market portfolio that we started from did not form part of the
efficient set This argument implies that the supposed empirical tests of the CAPM
were really just tests of the efficiency of the chosen market index. Assuming the
chosen index was efficient, the tests were tautological. The observed average
returns must have been linear functions of the measured betas According to Roll,
the only valid way to test the CAPM empirically is to establish whether the true
market portfolio is efficient. But the true market portfolio is impossible to observe!
Therefore it is impossible to test the CAPM!