Question 1

a) Define breadth and TRIN statistic. Calculate and interpret the breadth and the TRIN ratio for the NYSE, NASDAQ and AMEX using the data provided in the following table.

Students should be aware that investors should not rely on one-day measure.

b) Explain the concept of the efficient market hypothesis (EMH) and each of its three forms – weak, semi-strong, and strong – and briefly discuss the degree to which existing empirical evidence supports each of the three forms of the EMH. (9 Marks)

Suggested Answer:

The efficient market hypothesis (EMH) states that a market is efficient if security prices immediately and fully  reflect all available  relevant  information.  If the  market fully reflects information, the knowledge of that information would not allow an investor to profit from the information because stock prices already incorporate the information.

i. The weak form of the EMH asserts that stock prices reflect all the information that can be derived by examining market trading data such as the history of past prices and trading volume.

A strong body of evidence supports weak-form efficiency in the major U.S. securities markets. For example, test results suggest that technical trading rules do not produce superior returns after adjusting for transaction costs and taxes.

ii. The semistrong form states that a firm’s stock price reflects all publicly available information about a firm’s prospects. Examples of publicly available information are company annual reports and investment advisory data.

Evidence strongly supports the notion of semistrong efficiency, but occasional studies (e.g.,  identifying  market  anomalies  such  as the small-firm-in-January  or  book-to- market  effects)  and  events  (e.g.  stock  market  crash  of  October  19,  1987)  are inconsistent with this form of market efficiency. There is a question concerning the extent to which these “anomalies” result from data mining.

iii. The strong form of the EMH holds that current market prices reflect all information (whether publicly available or privately held) that can be relevant to the valuation of the firm.

Empirical evidence suggests that strong-form efficiency does not hold. If this form were correct, prices would fully reflect all information. Therefore even insiders could not earn excess returns. But the evidence is that corporate officers do have access to pertinent information long enough before public release to enable them to profit from trading on this information.

c) Criticize roles of different parties in the process of mortgage financing during the recent Credit Crisis.

(12 Marks)

Suggested Answer:

Mortgage originators: some  mortgage originators were aggressively seeking  new business without exercising adequate control over quality.

Credit rating agencies: the rating agencies, which are paid by the issuers that want their MBS rated, were criticized for being too lenient in their ratings shortly before the credit crisis.

Financial institutions that packaged MBS: these institutions could have verified the credit ratings assigned by the credit rating agencies by making their own assessment of the risks involved.

Institutional  investors that  purchased  MBS: these  investors  relied  heavily on the ratings  assigned  to  MBS  by  credit  rating  agencies without  the  due  diligence  of performing their own independent assessment.

Financial institutions that insured MBS: these institutions presumed, incorrectly, that the MBS would not default.

Speculators of Credit Default Swaps: Many buyers of CDS contracts on MBS were not holding any mortgages of MBS that they needed to hedge.

Question 2

a) Consider the following expected Stock Gamma) in 4 different states probabilities.

returns for two stocks (Stock Alpha and of the economy, all of which have equal

Assume that the CAPM holds, the risk free interest rate is 1.5%, and that the market risk premium is 6%. If the betas of stocks Alpha and Gamma are 0.1 and 0.95, respectively, what can you say about the relative pricing of the two stocks? Are they over-priced, under-priced, or fairly priced?

(12 marks)

Suggested Answer:

E(R[Alpha]) = 0.25*(-15 - 5 + 10 + 20) = 2.5%

E(R[Gamma]) = 0.25*(25 + 8 + 5 - 10) = 7%

R(Alpha) = Rf + β(Alpha)*(E[Rm] – Rf) = 1.5+ 0.1*6 = 2.1%

R(Gamma) = Rf + β(Gamma)*(E[Rm] – Rf) = 1.5+ 0.95*6 = 7.2%

R(Alpha) - E[R(Alpha)] < 0. Investors’ expected return for Alpha is higher than implied by CAPM. Therefore, LM is under-priced. Investors will go and buy Alpha, pushing its price up. This would in turn lower its return, bringing it back to CAPM equilibrium level.

R(Gamma) - E[R(Gamma)] > 0. Investors’ expected return for Gamma is lower than implied by CAPM. Therefore, Gamma is overpriced. Investors will go and sell Gamma, pushing its price down. This would in turn increase its return, bringing it back to CAPM equilibrium level.

b) Discuss the impact of the 2008 credit crisis on regulatory reform.

(9 marks)

Suggested Answer:

The Federal Reserve’s assistance to Bear Stearns and offer of temporary financing to other securities firms provided a rationale for the Fed to require that securities firms meet specified regulations such as capital requirements just like commercial banks.

Conversion of Securities Firms to BHCs:

•   During the credit crisis, some securities firms were unable to access funds by issuing securities.

•   Firms could apply to become bank holding companies giving them permanent access to Federal Reserve funding.

•   A BHC can have commercial banking and securities subsidiaries.

Financial Reform Act:

•   In July 2010 the Financial Reform Act was implemented, and one of its main goals was ensuring stability in the financial system.

•   The  act  mandated  that  financial  institutions  granting  mortgages verify  the income, job status, and credit history of mortgage applicants before approving mortgage applications.

•   The  act  also  required  that  financial  institutions  that  sell  mortgage-backed securities retain 5 percent of the portfolio unless the portfolio meets specific standards that reflect low risk.

•   Created the Financial Stability Oversight Council, responsible for identifying risks  to  financial  stability   in  the   United  States  and  makes   regulatory recommendations to regulators that could reduce any risks to the financial system.

•   Assigned specific regulators with the authority to determine that any particular securities firm or other financial institution should be liquidated.

•   Requires  that  derivative  securities  be  traded  through  a  clearinghouse  or exchange rather than over the counter.

The Volcker Rule:

•   The  Volcker  Rule,  which  is  issued  in  2014,  restricts  many  short-term speculative investments, which formerly were an important part of financial institutions’ proprietary trading.

c) Discuss how the yield curve will change if the government decides to restructure its debt by retiring £300 billion of long-term treasury securities and increasing its offering of short-term treasury securities.

(12 marks)

Suggested Answer:

This causes a large increase in the demand for short-term funds and a large decrease in the demand for long-term funds. The increase in the demand for short-term funds caused an increase in the ST interest rates and thereby increased the yields offered on newly issued ST securities. Conversely, the decline in demand for long-term funds caused a decrease in LT interest rates and thereby reduced the yields offered on newly issued LT securities. Then, the yield curve is YC2 and it is much flatter than it was.

Question 3

a) Tom is seeking to buy some bonds which have a face value of £100, a coupon rate of 6.4 percent and pay interest semi-annually. If the current yield to maturity is 8.6 percent and the bonds are priced at £88.61, how many years will it be until the bond matures?

(12 marks)

Suggested Answer:

Convert to semi-annual: Coupon rate = 0.064/2 = 0.032

Semi annual coupon = 0.032 x £100 = £3.20

YTM = 0.086, semi annual = 0.086/2 = 0.043

Using bond formula:

88.61 = 3.2 (1 – (1/(1.043)t/0.043) + 100/(1.043)t <