BF Exam 1 (and 2 (and 3))

b) Equity Premium Puzzle:A rational risk averse investor would demand a higher return from bonds than stocks since holding well diversified portfolios of stock is less risky over the long run. c) Stocks outperformed bonds every 30 year period we have data for. There is no need for an equity risk premium because there is no risk over the very long term. Maybe the risk premium exists because investors have severe loss aversion or they don't believe the data. They also likely have a more short-term outlook than 30 years. 10) Assume the market consists of these three stocks. Write down the formula for an equally weighted index and a value weighted index of these stocks Stock Price Number of Shares A $20 1,000 B $10 20,000 C $40 5,000 a) Equal weighted index = (20+10+40)/3 =23.33 b) Value weights index = (20*1000)+(10*20000)+(40*5000)=420000 (market value of portfolio 20*(20,000/420,000)+10*(200,000/420,000)+$40*(200,000/420,000) = $24.76 11) How is the Russell 3000 index constructed? How does it differ from the S&P 500 a) Russell 3000 = Russell 1000 + Russell 3000 i) Russell 3000 = growth and value ii) Russell 1000 = growth and value iii) Russell 2000= growth and value b) Weights are capitalization weights: capitalization = price * number of shares c) The frank russell company takes all 4000 publicly trade stocks and rank them by market cap d) Weighted by market capitalization. These indexes are generated by determining the total market capitalization of all stocks in the index and dividing by the total number of shares of all the stocks. Capitalization is a company's outstanding shares multiplied by its share price, better known as "market capitalization". However, the Russell 3000 measures the performance of 3,000 publicly held US companies which represents approximately 98% of the investable US equity market whereas the S&P500 is comprised of 500 of the most widely traded stocks in the U.S. and represents about 70% of the total value of U.S. stock markets. Russell 3000 is more frequently and carefully adjusted. 12) Suppose you are an active money manager and your clients ask you to choose a broad based index to be your benchmark. (You will probably respond that broad based indies don’t measure what I am doing, and your client responds he doesn't

19) What is the St. Petersburg Paradox and why is it relevant for expected utility a) How much would you pay to participate in the following gamble? i) Fair coin tossed until head appears. If the first head appears on the nth toss then the payoff is 2^n dollars b) Daniel Bernoulli’s solution: people’s utility from wealth, u(W), is not linearly related to wealth (W) but rather increases at a decreasing rate- the famous idea of diminishing marginal utility, u’(W) >0 and u”(W)<0 i) A person’s valuation of a risky venture is not the expected return of that venture, but rather the expected utility from that venture (1) E[w](U(X[i]))= (2) u(W)=ln(W) (3) Then E[u(W)] = sum u(w) * probability this would be the utils. The wealth that gives this many utils is exp(of that value) which is what a person with log utility would pay for this gamble c) The St Petersburg Paradox is a paradox related to probability and decision theory. It is a situation where a decision criterion which takes only the expected value into account predicts a course of action that presumably no actual person would be willing to take. A person's valuation of a risky venture is not the expected return of that venture but rather the expected utility from that venture. 20) Define the concept of certainty equivalent a) Let x=(x[1],x[2],...,x[n]) be a set of outcomes from a lottery b) Let w=(w[1],...,w[n]) be the probability of each outcome i) W[i] is the probability of outcome x[i] is an element of X occurring ii) W[i]>= 0 for all x[i] in X and sum(i=1) w[i]^n=1 (1) Define X as a set of lotteries (x,w,y,z..) c) Suppose now that decision makers (DMs) have preferences over the simple lotteries in X i) We will write W>= z to denote that the DM weak prefers lottery w to lottery z ii) We will write w> z to denote that the DM strictly prefers lottery w to lottery z d) The certainty equivalent is a guaranteed return that someone would accept rather than taking a chance on a higher but in certain return.If risk premium = expected return → risk neutral function 21) Why does risk aversion require concave utility functions a) because concavity is a necessary (or sufficient?) assumption for a unique equilibrium. b) Making the right assumption on the shape of the utility function allows you to prove the existence or uniqueness of the equilibrium. The exact assumption you

ii) New expected return = R[f] + new beta * MRP (1) 6%+1.103*14.5% = 21.9935% iii) New expected price = price now * (1+expected return) (1) 50*(1+21.9935%) = $60.9967 Current beta: (.14-.06)/(.145-.06)=.94 ->1.88 New E[R]: .06+1.88*(.145-.06)=.2198 Since the cash flows of the company haven’t changed the market price must fall to give an expected return of .2198. Before beta shifted $50 =P/(1.14) so P = $57, the new price is 57/1.2198 =$46.73 27) Are the following true or false? a) (TRUE/ FALSE ) Stocks with a beta of zero offer an expected return of zero. i) False, when beta equals 0 the expected return equals the risk free rate. The excess return is zero b) (TRUE/ FALSE )The CAPM implies that investors require a higher return to hold highly volatile securities. i) False, the CAPM is independent of this and is only determined by the risk premium. Investors require a risk premium only for bearing systemic risk and total volatility includes diversifiable risk c) (TRUE/ FALSE )A portfolio of 75% in the risk free security and the remainder in the market has a beta of .75 i) Would be .25 to get .75 needs to invest 75% in the market and 25% in T-bills 28) Describe the Arbitrage if, Rf = .04, RM= 0.10 and a stock with a β = 1.50 has an expected return of 12%. What exactly do you go long in and what do you go short in if all the assumptions of the CAPM are true? a) The CAPM return is: .04 +1.5(.06)= .13 which is higher than the current expected return of 12% so the stock price is too high (The stock produces a too low return for the price). Action Investment Expected Return Risk Short Stock -$1.00 -.12 -1.5 Long 1.5 of market $1.50 .15 1.5 Short treasury bills -$.50 -.02 0 Total 0 .01 0

37) Consider the following data for a one-factor economy: Assume all portfolios are well diversified. Suppose that another portfolio, C, is well diversified and has a beta of .6 and an expected return of .08. What is the arbitrage strategy? Portfolio E[r] B A .12 1.2 B .06 0 a) 12% = 6% + 1.2(R[m] - 6%) i) R[m] = 11% A one-factor APT states: E(R) = a+bλ. Using this equation, we have from the expected return of B: E(B) = .06= a +0.0λ so a =.06. Then from E(A) = .12 =.06 +1.2λ implies λ = .05 so the APT equation for both well diversified portfolios is: E(R) = a+bλ=.06 +b(.05). This gives E(C) =.06+.6(.05)=.09 but C has an expected return of 8% so it is priced too high. Go short C and long a portfolio that has a risk of .6 (sound familiar?). This portfolio is 1/2 of A and 1/2 of B. This has an expected return of .06 from A and .03 from B. The long + short position has a risk of zero, investment of zero and a return of 1%. 38) Suppose that the market can be described by three sources of systematic risk: What is the expected return on a particular stock generated according to the equation below? 𝑅 = .15 + 1.0 𝐼 P + .5 𝐼 − .75 𝐶 + e a) E(R) = .15 + 1.0(.06)+ .5(.02) -.75(.04) = .19 note the assumption is that E(e) = 0. Factor Risk Premium Industrial Production (IP) .06 Interest Rate (I) .02 Consumer Confidence ( C ) .04 39) What are the Fama-French Factors in the three factor model? What additional factors are in the five factor model? a) CRSP Market-Rf (Risk-Free rate) b) SMB-Small Minus Large (small firm effect/ sixe effect) c) HML-High Minus Low (Value Firms) (Three factors above, all five below d) RMW- return spread Most profitable firms- least profitable firms e) CMA- return spread conservative firms - aggressive firms 40) If a stock has a βSMB= -1.2 and a βHML= -0.75 what type of stock is it? a) It is a large firm that is not a value firm

a) Editing Phase: the possible outcomes of the decision are ordered following some heuristic which may or may not get the probabilities correct. b) Evaluation Phase: people behave as if they would compute value (utillity) based on the potential outcomes and their respective probabilities and then choose the alternative having a higher utility. 52) What is the role of the value function in prospect theory and what is its shape? a) S-shaped and given the same variation in absolute value, there is bigger impact of losses than of gains b) The value function in prospect theory measures losses and gains. c) It is s-shaped and, as its asymmetry implies, given the same variation in absolute value, there is a bigger impact of losses than of gains (loss aversion). 53) What predictions does prospect theory make for losses and gains? a) People tend to overreact to small probability events but underreact to medium and large probabilities b) Investors are risk averse in gain domain and risk seeking in loss domain. They tend to sell winners too early and ride losers too long. 54) How does prospect theory help explain the “equity premium” puzzle? a) Investors are not averse to variability but dislike the fact that stocks show losses more frequently than bond returns. b) Investors require a higher average return on stocks than bonds because they want to be compensated for the losses that are more frequent in stocks than bond returns. 55) What are rational, non-behavioral reasons for selling winners and holding losers? a) Not rational in absence of strong evidence is support of mean reversion of share prices b) Portfolio rebalancing : if an investor wishes to hold positions in particular proportions, he needs to sell shares of stocks that have risen i) Mean reverting ii) Trading costs : costs more to sell low-priced stocks 56) What effect does professional trading have on the disposition effect? a) Tends to mitigate or eliminate the disposition effect. i) Disposition effect diminishes over time with professional trading. 57) If an individual with wealth of $100,000 faces a 10% chance of losing $15,000. An insurance policy to avoid this risk costs $200. Will they buy the policy if : a) They had a utility function of LN(wealth)? i) .1 * LN(100000-15000)+ .9 * ln(100000) = 11.5 regular ii) ln(100000-200) = 11.51 with insurance (1) Would buy the insurance b) they followed prospect theory with v(z) =.88(-z).88 and 𝜋𝜋 (.10)=.10? i) .1 * .88 * (15000)^.88 + .9 * .88 (0)^.88= 416.34 without insurance

d) 1: evolutionarily older, hard-wired, fast, automatic e) 2: analytic, algorithmic, rational, rule-based system - effort filled 69) Define hindsight bias, outcome bias, belief bias and confirmation bias. What are the sources of these biases? a) Hindsight bias: they knew it all along. Past events always look less random than they were a real problem for b) Outcome bias: refers to the distorting effect outcome info can have on our evaluation of decision quality (and decision makers) c) Belief bias: research (and personal experience) shows that we don't treat all information and arguments equally d) Confirmation bias: inclined to seek info that confirms our beliefs i) Part of belief preservation and mental rewards confirming data provide ii) Attributed to positivity bias iii) Motivated reasoning: ask what evidence supports my beliefs e) Source of biases: naive thinkers tend to have basic misconceptions about both nature of their perceptions and their memories i) Naive thinkers believe their perceptions give them a complete and accurate record of the world around them. Its as if their perceptions are like a camera capturing images that are not processed (1) Our perceptions don't operate this way ii) Perception does not just show a picture of reality instead our brain will automatically add meaning. Our perception and reasoning programs have lots of little bugs like this in them. Perceptions are portraits not photographs f) Perception is selection: what part of the data in our field do we consciously register i) Conditioning: background experience and training ii) Beliefs & desires: confirmation bias, selective hearing “ they saw a different game 70) Is your memory like a hard drive where you record an event and then recall it? a) Memory is selective and essentially reconstructive in nature b) Memory is affected by i) Suggestion: distorted speed estimates and recovered memories ii) After acquired info: once we know what happened hard for us to imagine anything else happening or that we didn’t always know it c) Status Quo Bias: equivalent to the endowment effect i) People are resistant to change and fear the regret that may follow (1) Hold what is currently possessed their endowment (a) Could be due to loss aversion or other cognitive bias while consistent with prospect theory

● Rate themselves to high ● Market depth: trade more, earn less, under diversify, volatility increase, monetary depth ○ Deep market: try to buy you will not move the price up or sell and do not move the price down ■ Liquid market: price doesn't move when sell and buy and not costly to get in ○ Limit order book: ○ Liquidity: want to have cash on hand or referring to movement of the market ● Early success not good due to increase in overconfidence ● Disposition effect: investors hold on to losers and sell winners .87. What are the benefits and costs to small investors in a mutual fund? ● Benefits: ability to invest with small amounts of money, diversification, professional management, low transaction costs, tax benefits, and the ability to reduce administrative functions. Cost are lower for small investors, easy to diversify ● Costs: operating expenses, marketing distribution charges, admin cost and loads ○ Loads are fees paid when investors purchase or sell the shares 88. Why can closed end funds sell at a different price than the net asset value while open-end funds do not? ● Closed end funds trade on the open market and are thus subject to market pricing ● Open end funds are sold by the mutual fund and must reflect the NAV of the investment ● Don't sell open end funds on the market. Does not have to small price 89. What is a 12b-1 fee? ● An annual fee charged by a mutual fund to pay for marketing and distribution costs ● Pay brokers, in total expense ratio 90. What are the advantages and disadvantages of an exchange traded fund? ● Exchange traded funds can be traded during the day, just as the stocks they represent. They are most tax effective in that they do not have as many distributions. They have much lower transaction costs and they also do not require load charges, management fees, and minimum investment amounts ● Disadvantages is that ETFs must be purchased from brokers for a fee. Moreover, investors may incur a bid-ask spread when purchasing an ETF. Big ask spread, possible volatility 91. An open end fund has a net asset value of $10.70 per share. It is sold with a 6% load. What is the offering price? ● Price = net asset value / (1- load) ○ 10.7/(1-6%) = $11.38 is the offering price 92. An open end mutual fund has a portfolio of $450 million of assets and $10 million of liabilities. If there are 44 million shares, what is the net asset value? If a large investor redeems 1 million shares what happens to the portfolio value and to the net asset value of the fund?

● Net asset value = (market value of assets - liabilities) / shares outstanding ○ (450- 10)/44 ■ NAV = 10 million 93. A hedge fund charges 3-30 for a fee. If the fund starts the year with $500 million and the assets rise in value to $620 by the end of the year, what is the management fee? What is the return of the shareholders? ● 3 percent fee on the assets under management plus 30 percent on net gains ● 3% of 620 ○ We need to make assume for which 620 or 500. Using 620 will give a lower return ○ 500->.138 ○ 620->.1308 ● 20% of (620-500) 120= 24 million 94. Hedge funds are unregulated. Give some examples of asset classes that hedge funds can invest in and mutual funds will not. ● Hedge funds are funds with almost no restrictions appealing to high net worth individuals and institutions with investment flexibility ○ A hedge fund can invest in land, real estate, stocks, derivatives, and currencies while mutual funds use stocks or bonds as their instrument for long term investment strategies Timber, whatever is an invest but not liquid. 95. What is the definition of “institutional funds”? How do they differ in their cash flow rights and ownership rights from mutual funds and hedge funds? ● Long only funds where the client owns the assets and is usually a pension fund or endowment ○ Mutual funds that manage retirement plans for an institutions’ employees are called institutional funds ○ Institutional funds never give back the assets. ○ Ownership right determined by agreement with client. IU for example will never actually give up their funds. Unregulated. IU is unregulated but manager is not. ○ Hedge funds, client keeps ownership ○ Mutual fund, manager keeps ownership 96. Why does the law get involved with the regulation of mutual funds but not the other types of funds? ● Unlike an individual stock, an investor may also have to pay taxes each year on mutual funds or an ETF's capital gains even if the mutual fund or ETF has had a negative return and the investor hasn't sold any shares. ○ That’s because the law requires mutual funds and ETFs to distribute any net capital gains on the sale of portfolio securities to shareholders. ETFs are typically

more tax efficient in this regard than mutual funds because ETF shares are frequently redeemed in kind by the authorized participants. ○ Law regulates funds for small investor because they the legal system feels they need to regulate them. Law assumes large firms knows what they are doing and will not need that type of protection. 97. If a fund had $350 million under management and the expense ratio is 90 basis points what are total dollars paid by investors to manage the fund? ● 350,000,000* 90 basis points (0.0090)= 3,150,000 98. If a fund has $700 million under management and a 150 percent turnover, what is the total dollar amount of assets sold and bought? If transaction costs are 10 basis points on a dollar trade, what is the transaction cost generated by this turnover? Suppose you see a graph that shows only 10% of mutual funds have outperformed the SP500, what are the problems with the graph? ● Total dollar amount of assets sold and bought 700 mil is overturned 1.5 times throughout the year so 1,050,000,000 ● Transactions cost. 1050 amount of assets sold times 10 basis point (0.0010) = 1,050,000 ● Problems with the graph: People are paying 10 basis points for a fund that will most likely not beat the market. Why would you pay more for an investment that is worst off? Most mutual funds receive cash after an increase in the market. Since it takes time to invest the cash the mutual fund’s beta will fall for a short time. 99. What is the average alpha of mutual funds? What are the average fees for mutual funds? What does the average alpha imply about the ability of mutual fund managers to add value to investor portfolios? ● Average alpha of mutual funds is negative ● Equity fund is 80 basis points, weighted by assets. ● Average Fees .5% to 1.5% for active and .2% for passive funds ● Alpha shows that they are drawing value away from the fund. You could get that return by just investing in S&P 100. What is the evidence that fees are related to performance? Can you give an explanation for the findings? ● Index-mutuals funds that hold the same assets in the same weights have different returns ● Not much evidence for this. Performance is hard to measure ○ Difference is due to management of transaction fees 102. What are the possible heuristics in constructing a momentum portfolio? Is it possible that momentum is driven by both overreaction and underreaction? ● Information heuristics ○ Hindsight bias: the filter where we select as the most probable outcome is what happened

○ Outcome bias: the filter where we reconstruct what happened based on outcomes without paying attention to the actual decision process ○ Belief bias: is the filter where we do not treat all information and arguments equally. We are uncritical of information and arguments in favor of our belief and hypercritical of those against ○ Confirmation bias: is bias where we seek out information that confirms our belief ● Status quo bias: decisions are dependent on reference points ● Loss aversion: risk seeking in the losses ● Overconfidence: over estimation, overplacement, and over precision of information and abilities ● Representative bias: we believe that stocks that go up with go up and down will go down. ● Salience ● Prospective theory and loss aversion: disposition effect (sell winners, keep losers) 103. Exactly how are return momentum portfolios constructed? (Go through the steps). What is the risk of these portfolios? ● Do it has hedge fund, not mutual fund. (will need to do both long and short stocks) ● Picking a series of stocks (often top 500 or russell 1000, ect.) ● Calculate returns of these stocks ● Top decile of stocks should be longed, bottom x% should be shorted ● These should be calculated and reorganized as often as reasonably possible. Often a month, quarter or year. Can be a lot sooner like a week, day, hour, 30 second ● Risk: That the more you rebalance your portfolio, the more fees you incur but the less you rebalance the more your return is constructed correctly. Risk is difference between long and short. Beta will probably be zero. Only long will result in beta above one. ● Additional Risk: Momentum relies heavily that historical trends will determine future returns which is not true. Could, in theory, completely fill. 104. Exactly how reversal portfolios are constructed and what are the risks of these portfolios. Are reversal portfolios held as long as momentum portfolios? ● (constructed the opposite of momentum funds) ● Once again historical trends do not determine future trends. They need information to cause a reversal. How reliable is that information? ● Learning period is same as momentum portfolios and do the reserve of momentum. Normally has a longer term holding period then momentum. Risk is the difference between long and short 105. List five practical problems that AQR faced in constructing momentum portfolios for a mutual fund and describe AQR’s solutions to these practical problems. ● SEC restrictions ○ long only, ○ hot money – need for liquidity ○ stringent reporting ○ compensation requirements (couldn’t take % of profits)

○ 5% of portfolio in one company, no more than 10% of company’s shares ○ Diversification across industry ○ “prudent” strategies ○ No advertising of back-testing but an index provider can publish returns ● Problems with implementing UMD: ○ UMD is long-short, AQR will be long only ○ UMD is rebalanced monthly requiring a large amount of trading ○ UMD used all listed stocks but AQR only wanted to use stocks with a reasonable ○ amount of capitalization and liquidity. ○ Convincing retail investors: ○ Retail investors are divided into channels: direct, broker and retirement. ● How often to trade stocks? ● What to do with stocks on border ● How do they convince people to do this (and will work/make money). SEC stops them will back reportin ● Taxes are an issue for the investors of the fund. Buying and selling a lot with cause taxes ● What do they do with liquidity? ● How diverse will they be? 106. Why is it surprising that the alpha of AQR today is negative? ● The Alpha up until the past few years was positive and often well above the market. Looking at the average it is still positive, however, it seems to still not be a great investment based on how the current market conditions causes AQR worse off than the market in the past 5 years. ● Not as good as the historical data made it seem. Back tested not the real return of the investment 107. What is “representative bias” and why does it exist? ● When a decision maker wrongly compares two situations because of perceived similarity or conversely when he or she evaluates an event without comparing it to similar situations. ● Stereotypes to represent a person, strategy or portfolio. Example, good company is a good stock (not true). Listing portfolio will make people say it is a good portfolio after looking at top 10 stock. Home bias, buying stocks close to home. ● People base judgements on how things appear rather than how statistically likely they are. People are driven by the narrative of the description rather than by the logic of the analysis. (We expect effects to look like causes) ○ Subsets of representativeness ■ Intensitivity to prior probabilities of outcome ● Investments have very different priors (there are not many small cap value firms) ■ Insensitivity to sample size ● There are far more micro cap firms than large cap ■ Misconceptions of chance ● Gambler's fallacy: things will even out ● Reversion to mean

■ Availability heuristic (Recency bias) ● Tendency to form judgment on the basis of information is readily brought to mind. ● Useful since frequent events are easily brought to mind ● Misleading ○ Ignores statistics ○ Factors other than frequency can affect memory ■ Ease of retrieval ■ Recency of example ■ Familiarity 108. Name two other forms of representative biases that often occur in investments. ● Recency Bias (above):a cognitive error identified in behavioral economics whereby people incorrectly believe that recent events will occur again soon. ● Gambler’s fallacy: We tend to believe that luck will somehow even out but if we’re talking about truly random events that simply may not be so 109. Jonathan Golub, the chief “Client Portfolio Manager” for the behavioral finance funds, thinks that Exhibit 5 shows that “even the basic idea of a risk-return tradeoff is not supported by stock market data”. Do you agree? ● SD and return is related-> False. It is about the beta and correlation with return. 110. The CIO, Chris Complin, for behavioral finance products globally, and Silvio Tarca, the lead portfolio manager for the Intrepid funds, believe that overconfidence and loss aversion leads to value and momentum anomalies respectively. Explain their logic. ● Explain what overconfidence and loss aversion is and connect to strategy. ● Overconfidence and focus only on tech of company or losses and makes you believe value stocks are correctly priced. This can lead to momentum strategy as well. ● Loss aversion, hanging on to losers. Can lead to momentum because they hold on 111. Why is it hard to combine value strategy and the momentum strategy in the same portfolio? How did JP Morgan do it? ● The value is longer term, 3-4 years. Some overlap with reversals. Different tools for value, accounting statements for example ● Momentum is more about growth and is short term. Generate more cost No model for either. ● Have a barbell curve and give stocks a score to try to put them together. 112. The critical question of the case is whether behavioral finance will continue to “work” over the next five years. What does “work” mean for JP Morgan? ● 1. A better portfolio (less risk more return) ● 2. Better understand clients (who they are a person) ● 3. Collect assets, trading across the world for marketing purposes 113. Explain how behavioral finance can be used in wealth management. Does using a wealth manager say anything about the behavioral biases of a client?

● Understand the biases, irrationalities, emotions, and goals of investors/clients ○ Be better able to serve their needs and steer them in the right direction ● Wealthy people will have different biases from a middle class person and different goals. Need to take those into consideration when having them for clients. Clients “Admitting” that they have biases that a manager will not have 114. What is a factor model (write down the equation and list the assumptions) and why would anyone use it? (Describe the bases for a model and what the possible uses are). ● Factors ○ Asset pricing: determine the normal return for a given level of risk ○ Benchmark: represent the return of a passive portfolio that is similar to the evaluated portfolio ○ Security analysis: determine the factors that are relevant for security prices ○ industry/market analysis: determine whether any subsets of assets agave outperformed other subsets or outperformed the market as a whole ○ Portfolio attribution: to attribute the returns of an actively managed portfolio to exposure in various market segments ○ Forecasting: estimate expected return ○ Quantitative risk management: simplify the number of risk factors in building a portfolio ■ Most focus on this motivation ● Basis ○ There are limited numbers of factors, K ○ Linear relation between K factors and returns ○ the key assumption is that you have enough factors to do the job but not too much to add noise to the model ○ Generally speaking considerable statistical work finds that there are between five to ten factors driving the market but nobody can agree on which five to ten factors. We know there are more than one but that the “market factor” is the most important. ● Model with ks and beta with error terms. 0 error terms they do not effet over time. None of factors you missed are correlated over time ● 115. Where do factors come from in a factor model? ● Pure Statistical Model ○ The only input is the correlation matrix of returns. The statistical technique of “factor analysis” (from psychology) is used to determine the “significant factors”

● Pre-specified economy-wide variables ○ Value of the factors (Fit ) are the same across all firms. (Examples are interest rates, inflation, unemployment.) The model allows different responses to these variables for each firm. ■ example: Roll and Ross Asset Management allow the investor to specify the economy-wide risk that he wants hedged. ● Pre-specified firm variables ○ Value of the factors (Fit ) are different for each firm. (Examples are leverage, size growth in earnings). The model assumes that each firm has a constant response to these variables over some time period. ● Style Model ○ Value of the factors (Fit ) are the same across all firms. Factors are chosen to represent an asset class. The model allows different responses to these variables for each firm. ● Firm bases factors: (look at spreadsheet ● Economy factors, GDP, inflation, unemployment rate. ● Indices to set up what the managers are doing 116. What are the strengths and weaknesses of a factor model? ● You can put as many factors as you want into the factor model. ● Strengths ○ Objective determinant of alpha (the value added) and risk ○ Assumptions are clear ○ Flexible (can add whatever variables are needed) ○ Risk analysis and portfolio management is simplified ○ Good basis for discussion (will discuss style analysis as a management tool at the end of the course) ○ Cheaper than hiring a group of analysts ● Limitations ○ Must know the factors! ○ Some firms may have non-linear relationships with factors ○ Difficult to incorporate judgment ■ Factors change ■ Firm-specific events cannot be incorporate ○ Impossible to incorporate non-quantitative information 117. What is “equity style analysis” and how is it used in the management of equity portfolios? -will have some assumptions that are violations and have to hope that the violations do not make the portfolios completely invalid. Can ask if a value fund is a value fund. It is subjective. Can the manager beat the benchmark?

● Ultimately, investors do not - or should not - care about the type of stocks a manager is selecting, what matters is how they act together in a portfolio ● Use a set of indices that represent the “style” of the manager by computing the computing the weights of the managed return on each index ● The basic idea: ○ Use a set of indices to construct a passive portfolio that captures the “style” of an actively managed portfolio ○ The difference in returns, Active portfolio returns - passive style portfolio returns is the value-added of the manager over the passive style. ● If the investors are only interested in the “style” of investing, that is only interested in the subset of stocks satisfying the style, then the value-added over the passive style is equivalent to the “alpha” of the manager. ● If the investors are interested in the larger universe of stocks, then the manager’s value added over the style is a positive signal of ability. Even if the style is down, the manager may be a good one. ● Thought question: When will investors be interested only in style? When will they be interested in the universe? 118. Write the equation for “equity style analysis” down and describe why it is NOT a regression equation. Not a regression analysis. Shows what the manager is doing. Very loose and subjective ● Use a set of indices that represent the “style”. We select the following indices for Mutual Fund Shares: ○ I1 = Citigroup Treasury Bill Return ○ I2= Russell 1000 value (large “value”index, low market to book) ○ I3 = Russell 1000 growth (large “growth” index, high market to book) ○ I4 = Russell 2000 value (small value index) ○ I5 = Russell 2000 growth (small growth) ○ I6 = MSCI EAFE Index (non-US, liquid stocks) ● Factor model: Rt= a + b1 I1t+ b2 I2t + b3I3t+ b4I4t + b5I5t + b6I6+ et ○ If this represents a passive strategy the weights must sum to one: Estimate the weights so that so that the b’s sum to 1 ○ If you cannot go short on the indices, then the weights are >0 ○ The constraints on our model are: bj >0 and b1+ b2 + b3+ b4 + b5 = 1 ○ How to choose the weights? ■ Note that ordinary least squares cannot be used since the model places restrictions on the coefficients ■ Use an optimizer! 119. Be able to interpret the weights of an optimization that produces a style portfolio. ● Why you use an optimizer

● Weights and time are subjective to manager and how/what he was doing ● Est. beta are portfolio weights for each factor 120. Discuss how to choose the indices and the time periods for the optimization. ● Purely subjective. Use indexes (normally the different russell indexes). 121. If a manager has a fund that has a positive alpha using the “style benchmark” that we defined in class and a negative alpha using the CAPM do you conclude the manager has earned his fees? (The Intrepid Value fund is an example of this. Would you invest in it in 2006?) ● Answer could be yes or no. Yes because all I can think about is value and the result of the portfolio will pick up the value from the market. Best value manger is the guy with positive alpha for value. ● No- I will invest in S&P to beat this guy. 122. What happened to the JP Morgan Intrepid funds in the five years following the case? What is (are) the best explanation(s) of this five year period? ● They all did poorly in the 5 years. Best explanation is that the value fund outperformed the rest and people are putting money in it because they think value will turn around. Day 20 123. Discuss the various ways that ESG can be defined. Will not be asked, maybe our opinion but that is it ● Environment ● Social/Society (most difference) ● Governance (no arguing) ● The environment-Report amount of pollution, projects to improve these numbers. ● Social- to what extent should companies be concerned about social events? ● Governance-Is it how a company is internally governed (most often). How should this be reported? What should the company be concerned about governing? 124.What is the purpose of ESG investments? What is the intended practical effect of ESG? ● Intent is to give capital to positive ESG impact companies while moving capital away from negative ESG companies ○ Either help fund them directly, take an active role in the companies, or pressure management to take ESG positive measures ● To make investor feel good about themselves, then shorting selling makes perfect sense 125. How is ESG measured? ● Many different measures of ESG, little consensus ● Are you looking for certain services, all services? Should they develop their own ESG measures? Focus on one aspect? ○ Governance is fairly agreed upon, but no clear definition of E and S 126. What challenges does AQR have if they enter this market?

● How to measure ESG / Creating a benchmark universal standard ● Including short selling / does that count toward achieving carbon neutrality ○ If not, can the fund truly reach net 0 ● How to handle companies that are high in some areas of ESG but low in other ● Hard to come up with measures and what to section of ESG to focus on. What services will they focus on? Are they trying to improve companies or invest in only companies that are “good” ESG companies. 127.Assume that you buy one share in a fund at the end of 2019 and at the end of 2020 and that you have the following investment pattern. (Note that you have reinvested the dividend you received in (2020) End of Year Net Asset Value of the Fund Dividend (paid at end of year) Your Account 2018 30 30 2019 25 5 25+5+25=55 (You own 2.2 Shares) 2020 29 6 (2.2)*29+6*(2.2)=77 Arithmetic (future) Return Yr 2: (25+5)/30-1=.20 Return Yr 3: (29+6)/25=.40 Geometric [(1+0)(1+.4)]^(½)-1=.1832 (past) IRR= -30 - (25+5)/(1+t) +77/(1+t)^2 (joint effect of the investment and timing of cash flow a. What is the arithmetic, geometric and dollar-weighted return of the investment? b. Which would you use and why? c. Describe a situation where you might want to use the dollar-weighted return. 128.What is the Closed End Fund puzzle? Why can’t arbitrage resolve this puzzle? ● Funds that hold a portfolio and sells claims against the portfolio ● No inflows or outflows of cash ● Net asset value ○ Value of securities divided by shares outstanding ○ Presumably close or equal to fundamental value ● Share price- what the fund shares actually sell for in the market ● Does share price = NAV ○ Not usually ○ NAV > price more often that not ○ Difference called the fund discount

○ Discounts vary across funds and across time ○ Infrequently a stock fund will trade above the NAV which is referred to as a premium average stock fund discounts are 10-12% bond discounts are lower but still a discount ● When funds begging NAV < price ○ Usually the price is about 10% greater ● Within 120 days the average fund is trading at a discount of 10% ○ Typically a drop after IPO ● Fund discounts vary occasionally rise to a premium ● When funds are terminated prices usually rise to NAV, not the other way around ● New funds appear often, usually when discounts on existing funds are small ● Arbitrage opportunity exists but is difficult to execute in practice ○ Opportunity: NAV > price, then short assets in the fund and buyout the fund itself ○ Issue: when investors become aware of intentions to buy the fund, price increases, or they refuse to sell to the purchaser ● NAV is higher than share price but can’t arbitrage with SEC forcing you say what you are doing 129. What are two rational explanations for the puzzle? ● Agency cost ○ Do management fees lead to discounts ■ Researchers find no correlation between size of fees and discounts ■ Fees don’t fluctuate as discounts do. But transactions cost do ○ Poor investment choices by managers ■ Weak correlation between performance and discount ■ Variation in discount hard to connect to variation in investor expectations of future returns ● Illiquidity in closed end fund holdings- recent evidence is that this explains part of the discount ○ Taxes ■ Value of assets held by fund worth less to investors after taxes implies a discount ■ But tax effect should rise and fall with the market but the opposite occurs ● In addition open-ending causes P to move up to NAV ● Irrational explanation is sentimental about the cost 130. What is “sentiment” and how does it explain the puzzle? ● Funds are started when sentiment is positive ● Discounts vary because sentiment does ● Sentiment is widespread and systematic ○ Discount represents compensation for exposure to this risk ● Sentiment limits arbitrage

● If discounts are affected by sentiment then so should returns on other things that individuals hold ● Optimistic funds start and trade at a premium ● Pessimistic funds have discounts widen ● Presence of noise traders makes arbitrage risky ● How stocks have the same sentiment amount if you can measure correctly. Puzzle is why is it always lower than NAV? Discount for illiquidity? 131.What is the difference between uncertainty and risk? ● Uncertainty: Unsure of results and chances of results. You are not sure what risk you are bearing. You just do not know, data does not help. In different situation/world ● Risk: You know the results and chances of them and choose to bare the chance of the bad results. Data will help (maybe not perfect) but it helps 132. What historical event is the term “Tulipmania” based on? What about the event showed investor irrationality? What evidence that at least some of the trading was rational? ● Tulipmania refers to the 17th century Holland craze for Tulips where Tulip bulbs of certain patterns where highly valued and price speculated on ● futures market for bulbs with cash settlement developed in 1636 (in taverns!) in spite of the fact that futures contracts were illegal. ○ all contracts were enforceable by reputation only. ● large amounts of foreign funds entered the country and people liquidated other assets to participate in the tulip market ● traders in common bulbs were non-professional ● prices crashed by the end of February 1637 for no apparent reason. Most bulbs could not be sold for more than 10 percent of their peak values at the end of February. ● What could make this rational? ○ This speculation was confined to a three to four week period. ○ Serious” traders ignored this market and participants in the market had very little wealth. ○ From 1635-37 Bubonic Plague killed 1/7 of population in Amsterdam, and 1/3 of the population of Leiden. A poor population facing a high probability of death could decide to gamble. 133.The “South Sea Island Bubble” coined the phrase “Greater Fool Theory”, what does this mean? ● created in 1711 to induce government bondholders to exchange bonds for stock in the company ● Trading company had two assets: ○ trading monopoly granted by England in America ○ an annuity of x% of the face value of the debt

● 1720 War with France Ended. Law was passed to exchange all War debt to stock. Interest in the stock exploded. ● Failure in August - October occurred when public realized there were no legitimate plans to build a trading business. ● Greater Fool Theory ○ Many insiders knew the stocks were worthless but subscribed to the “greater fool’ theory: It may be foolish to pay this price but some fool will buy it from me for more. ○ South Sea Company printed “Bubble” playing cards in 1720 ○ Even the King of England lost 100,000£ of personal wealth in the South Sea company 134.The MBS crisis of 2008 was driven by the expansion of toxic debt during the previous three years. ● Toxic debt means you had no idea about the real risk for assets and how things were connected. You just did not know and break it back to original payers ● Extremely high volume in creation, leverage and trading of MBS securities ● Everyone assumed that US housing prices would continue to rise. National average price had not fallen since 1934. ● Investing in US MBS securities was world wide especially by banks. ● Difficult to value MBS securities caused a loss in confidence when housing prices fell in 2008. ● The best banks could not access the short term debt markets because of fear of “counterparty” risk, i.e. the party on the other side of the transaction would go bankrupt. ● World wide markets fell roughly $50 trillion ● To illustrate just how complicated it can get, consider the following “facts” that have become part of the folk wisdom of the crisis: ○ The devotion to the Efficient Markets Hypothesis led investors astray, causing them to ignore the possibility that securitized debt was mispriced and that the real-estate bubble could burst. ■ But collateralized debt obligations, the mortgaged backed bonds at the center of the crisis were offered at much higher yields. The market was efficient for these securities ○ Wall Street compensation contracts were too focused on short-term trading profits rather than longer-term incentives. Also, there was excessive risk-taking because these CEOs were betting with other people’s money, not their own. ■ But a 2011 study of executive compensation at 95 banks found that CEO’s stock and option holdings were more than eight times the value of their compensation. This means that their personal wealth was at risk. If they knew of the impending crisis, they would have avoided it.

■ Ken Lewis of BofA was holding $198 million of company stock which fell to $48 million. ○ Investment banks greatly increased their leverage in the years leading up to the crisis, thanks to a rule change by the U.S. Securities and Exchange Commission (SEC). ● Like World War II no single account of this vast and complicated calamity is sufficient to describe it. ● Even its starting date is not clear: US housing market crested in mid-2006, the money-market industry had a liquidity crisis in 2007, Lehman failed in 2008... ● Considerable distortion in the press about “causes” ○ Lee Pickard, former director of the SEC’s division of Market Regulation claimed that the SEC changed a rule (rule 15c3-1, “net capital rule”) in 2004 that allowed investment banks to borrow more. ○ NY Times (10/3/2008) picked this up ○ But Banks did not borrow more, the SEC did not change the rule which is not a leverage rule in the first place. All this is available in the public domain. ● For a review of 21 books about the crash see: “Reading about the Financial Crisis: A 21 Book Review” Andrew Lo, 2001 (MIT working paper). ● When we agree about the facts, there will be less disagreement about what caused the crash .... 135.What are ETFs? How are they different from open-end and closed-end mutual funds? ● ETFs ○ Exchange Traded Funds ○ Initially introduced to replicate broad-based stock indexes ■ Initially designed as open-ended mutual funds tracking specific indexes ■ Gradually expanded to specific sectors, markets, and diverse asset classes ○ Traded on stock exchanges ■ Ownership of the underlying assets divided into shares ○ Shares created and redeemed based on investor demand ■ Number of shares fluctuates ● ETFs VS mutual funds ○ Similarities ■ ETFs and Opened Ended funds ● Shares created and redeemed based on investor demand ● Number of shares fluctuate accordingly ■ ETFs and Closed Ended Funds ● Continuously traded on exchanges like listed stock shares ○ Differences ■ ETFs and Index mutual Funds ● 5 Main Advantages

○ Liquidity ■ ETFs traded any time during trading hours while traditional mutual funds only traded at the end of each day ■ Real-time efficient pricing ● NAV of mutual funds only calculated once per day ○ Low cost and tax advantage ■ Fees ● ETFs usually do not bundle distribution fees in the expense ratio ● ETFs do not have load fees or marketing fees ● Overall lower fees than mutual funds ■ Taxes ● Did not incur transaction charges in the absence of in-kind trade process ○ High transparency ■ ETF managers obligated to disclose holdings daily ● Mutual funds only required to make quarterly disclosures ○ Lack of cash drag ■ ETF holders can sell shares on exchange when they want to cash out and do not need to redeem the fund ○ Flexibility and accessibility ■ ETF managers could invest with margin purchases, short selling, stop loss or limit orders, and option trading ■ ETFs could have lower minimum investments and are more accessible to investors ● 3 Main Disadvantages ○ ETF Bid-Ask spread could lead to tracking error ■ Impact would be small if underlying assets were very liquid ○ Continuous ETF trading may lead to price fluctuation ○ Investors pay commission to brokers ■ Likely small ■ Differences in ETFs and Closed-Ended Funds ● ETFs were traded close to NAV ○ Arbitrage mechanism

■ If ETF were traded at a discount to the NAV, then shares could be bought and redeemed for the underlying assets ● Closed-end fund prices could deviate largely from NAV ○ Determined solely by supply and demand ○ Closed-end funds were traded continuously on OTC markets, but number of shares was fixed ■ Had no legal obligation to issue new shares or redeem existing shares due to demand 136.How does an investor choose between an ETF and an index open-end mutual fund tracking the same index? ● An ETF will be passively managed and track the market closely with less risk, while a mutual fund may hold the potential to beat the market but with greater risk and cost. ● Long-term Open ended, short-term ETF. When you want to trade? Open-ended if want to trade during the day ● You can trade an ETF. Taxes are a rational reason. Trading based on timing is overconfidence 137. What behavioral biases do investors show in making the choice between an index open-end mutual fund and an ETF tracking the same index? ● Overconfidence. You are trying match an index, representative bias 138. What is a “smart beta” ETF and how is it linked to multifactor models and the efficient markets hypothesis? ● Smart Beta ETFs are a type of ETF that uses a rules based system to select the kind of investments to be included in a portfolio. Smart Beta’s will provide a lower risk and more tax efficiency and more flexibility to the investor to trade in and out of the fund when compared to standard mutual funds.The goal of the smart beta is to get a alpha, lower risk, or increase the diversification at a cost lower than traditional active management strategies. This makes it a combination between efficient market hypothesis and value investing. The advantage of smart beta is investors can choose the smart beta fund for returns above the market average and can align their portfolios with their own strategy and risk aversion. The downside is smart betas are more costly and have more risk. ● Neither entirely active nor entirely passive ○ More active in terms of Trzcinka’s definition ■ Tries to beat the market / capitalize on some form of inefficiency ● Uses factors similar to Fama-French Factor Model ○ Common Factors ■ Size

■ Value ■ Momentum ■ Quality ■ Low volatility ● Advantages ○ Convenience ○ Cost efficiency ○ Transparency ○ Liquidity ○ Low investment hurdle ○ Potential to improve risk-adjusted returns ● Momentum fund was a smart beta fund ● Based around you can pick which factors are most important. Which factors are making the price incorrect and believe in a semi-inefficient market. Says Betas are not a source of risk but a source of return (this is against tradition ideals) 139. Which market is it easier for a sponsor to enter, the open-end mutual fund market or the ETF market? ● Said mutual fund in class but forgot why ● To enter and make money ● May mentioned additional reasons but part was due to competition and differentiation. Both are competitive markets, but mutual funds are easier to differentiate from competitors ○ ex.) difficult to convince investors why they should invest in your ETF vs a competitor that tracks the same index 140. What challenges did Fidelity have in trying to enter the ETF market in 2016? ● Highly competitive market ● Expensive entry ● Switching from Active to Passive ● Cannibalization of clients, resources, and employees from Active Fidelity funds 1. Differentiate between the following terms/concepts: a. Catering and clienteles: taking an action that short term investors want and that is not in the interest of investors who want to maximize NPV. Clienteles are investors who prefer capital gains over dividends a green fund ● Examples: dividends, name change, stock splits (something other than maximizing NPV) ● Benefit to those who sell out/sell off b. Dividend payment and “home-made” dividend:

● Dividend pmt: cash flow that comes out check ● Homemade dividend: when you sell shares (dividend payment through repurchase) ○ Create yourself by selling shares c. Investor sentiment and irrationality: investor sentiment based on mood (finance concept), irrationality is cognitive bias d. Synergy and valuation in mergers and acquisitions: synergy firm A and B merge and gain value from merging. Valuation is the value of the firm 2. Suppose an investment has a negative NPV but many shareholders believe otherwise. These shareholders believe that this investment is value-maximizing. What should be done? Are the age and tenure of management factors? IF you are catering to short term investors you take it if long term you do not. Older managers who will retire soon may do so to satisfy investors since repercussions will occur once gone. 3. A company has 1,000,000 shares outstanding at $15 each. Managers believe that the discount rate appropriate for the risk of the company is 15% and total cash flows, which are expected to be $1 million next year will rise by 5% indefinitely. Discuss a strategy that is beneficial to current shareholders. 1 mil shares * 15 = $15 million market value This is the dividend growth model Price = dividend /(r-g) = 1 mil/ (15-5) 10,000,000 Issuance of new shares to then use capital raised to invest in positive NPV projects to make firm value = market value 4. DRK has just sold 100,000 shares in an IPO. The underwriter’s fees were 7% and the stock moved from the offering price of $30 immediately to $44 where it stayed until the end of the first day of trading. a. How much did this IPO bring to DRK? 100,000 * $30 = 3,000,000 * (100%-7%) =2,790,000 b. What was the explicit cost of this IPO for DRK? (underwriter fees = 3,000,000 * 7% = $210,000

c. How much money was left on the table? (44-30) * 100,000 = 1,400,000 ( for DRK deduct the underwriter fee) 5. Give a non-behavioral reason and a behavioral reason why the average stock price at the end of the first trading day of an IPO is higher than the offering price. Non behavioral: signaling ( IB does not signal it is a good stock or no one trusts the stocks management) and due diligence Behavioral: overconfidence and excited about the shares 6. Goldman Sach’s IPO on May 4, 1999 raised $2,925,600,000 by issuing 55,200,000 shares at an offer price of $53. At the end of the day on May 4, the stock price was $70.375. How much money was left on the table? Why did an investment bank like Goldman price its shares so low at the offering? (70.375-53) * 55,200,000 = 959,100,000 Priced shares low due to overconfidence in Goldman or maybe signaling prof did not give a clear answer 7. If you buy an IPO at the closing price on the first day of trading, what can you expect to earn over the next two years relative to comparable stocks of the same size and book/market? What does this fact imply about the first day average returns? Less returns can be expected but not clear how much, this implies overconfidence 8. What is “governance” and why is governance important if we look at the effect of irrational managers? ESG, the g is governance: inside directors are less likely to monitor management than outside directors and a clear accounting system with reputable auditors and a compensation system that aligns board of directors with shareholders. If managers are irrational and governance is strong then managers can not really affect the firm but switch and can have severe effects. If managers are irrational, agency cost will increase and harm the firm. 9. What behavioral bias suggests looking at “years to payback” rather than NPV in evaluating projects? Salience, ease of understanding, and recency bias but salience is the major factor. 10. ( reading on Mood and Macroeconomics ) What effect does mood have on firm-level decisions?

Can affect firm level decisions, capital expenditures and mood can decrease capital expenditures and expectations 11. ( reading on Manager Sentiment ) How should investors use a manager sentiment index created from the tone of corporate reports? Sentiment bad/negative: long Sentiment good/positive: short 12. ( reading on Distracted Noise Traders ) What happens to adverse selection when noise trading declines? Adverse selection is defined as when trading against someone who knows more about the stock than you do. Noise trading decreases the likelihood of this happening so a decrease means a better chance of encountering a trader who knows more than you. 13. ( reading on Managerial Attitudes). The paper shows that the attitude of managers are important for debt policy. Is this evidence against rational finance? Why or why not? Yes, because rational finance says debt policy should be based on the cash flows however, if it is dependent on manager attitude. Choosing attitude is irrational but it still occurs. 14. ( reading on 52 week reference prices ). What is a possible behavioral explanation for the relationship between the 52 week high and the offer premium? Is this a cognitive bias for the acquirer, the acquirer’s shareholders, the target managers or the target shareholders? Offer premium: the premium offered by the acquirer to the acquired company. Found that it is higher when closer to the 52 week high it is disportionality close and not rational should be based on firm synergy. The cognitive bias for the acquirer is recency bias/salience, the shareholder bias does not exist they are not in decision, and the target shareholders benefit 16. ( reading on MCIC ) What is the most probable explanation for the incorrect trading of MCI by investors intending to trade MCIC? Investors overconfident and not paying attention to the correct ticker symbol, meaning sometimes undervalued and overvalued 17. ( reading on MCIC ) What are some reasons why investors find it hard to profit on arbitrage in these situations?

It is a short term investment with rapid change and hard to short these stocks and not a lot to buy, overconfidence 18. ( reading on Mad Money) What behavioral finance bias could be causing abnormal overnight returns? Recency bias, and overconfidence 19. ( reading on Mad Money) What limits arbitrage on the overnight pricing caused by Jim Cramer? Again hard to short sell and expensive to do so. Agency cost, market is close when show aries, other friction cost. 20. (reading on Anchoring on Credit Spreads) What is the types of evidence supporting anchoring being the reason for mispricing credit spreads in the market for syndicated loans? Looked at loans when interest rates were going up and then going down. It shows that it mattered what the interest rate was (although it should not have) and anchored on what the company used to have. 21. ( reading on IQ and Mutual Fund Choice ) The paper shows that IQ is negatively correlated with fees. Higher IQ clients pay roughly 9% less in fees. What is a behavioral reason for this? What is a rational reason? behavioral biases : People don't understand fees are hurting them (underconfident to enter the market without help), and the rational reason is low IQ people need the help.