International Financial Markets Final_Exam_Fall_2021

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Professor Elie Canetti THE JOHNS HOPKINS UNIVERSITY School of Advanced International Studies INTERNATIONAL FINANCIAL MARKETS , Fall 2021 FINAL EXAM: D ECEMBER 14, 2021 YOUR NAME _____Ruta Karpauskaite_____________________________________ You have two and a half hours to complete the exam. Do not struggle unduly over any single question. Maximum possible points for each question are in square brackets (the total for each numbered question is in all capital letters) and for multipart questions, the possible point total for each sub-question is indicated in lower case within parentheses. Judge the amount of time you spend on each question accordingly. You can earn 120 points . The amount of space following a question should be used to gauge the approximate length of answer I am looking for . While I tried to give ample room, you may write on the back if you need more space, but indicate you have done so on the front of the relevant page. PLEASE WRITE AS LEGIBLY AS YOU CAN!!!!! Good luck! 1. [4 POINTS] The chart below shows the real yield from U.S. Treasury Inflation- Protected Securities at 10-year maturity in 2021 (year-to-date). What do Lines A and B represent? (Note that I have labeled Line A and the TIPS Real Yield line twice since they Scoring Key (please do not write in this box) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Total /120 Letter Grade_______

2 cross and in case the exam does not print out in color. I thought otherwise you might not be able to tell which line was which). a. Line A represents implied inflation for 10-years and Line B represents the nominal 10-year treasury yield. b. Line A represents the nominal 10-year treasury yield and Line B represents the nominal 2-year treasury yield. c. Line A represents implied inflation for 20-years and Line B represents implied inflation for 10-years. d. Line A represents the nominal 10-year treasury yield and Line B represents implied inflation for 10-years. e. Line A represents the nominal 2-year treasury yield and Line B represents the nominal 10-year treasury yield. Answer:____________ 2. [4 POINTS] Suppose you expect Zoom shares to rise in price . Which of the following strategies could you use to make money if your expectation turns out to be correct (choose all that apply, either by circling them or writing down the corresponding letters in the space below):

3 a. Short Zoom shares. b. Sell Zoom shares forward. c. Buy Zoom shares forward. d. Buy credit protection on Zoom. e. Sell a put option on Zoom shares. f. Buy a put option on Zoom shares. g. Buy a call option on Zoom shares. Answer: _____________ 3. [9 POINTS] Investment Styles - Compare and contrast the investment styles implied by belief in each of the following: a. Efficient Markets Hypothesis (3 points) The key idea in the efficiency of markets purports that there is no point to try to actively beat the market, and just to try to remove idiosyncratic risk by maximal diversification. There is also no point in paying high fees to managers to try to find alpha as you are better off to just passively invest. Furthermore, there is no reason to try to get popular managers that are allegedly beating the market as outperformance is completely random. Overall, your optimal strategy is to hold passively managed and cheap funds instead of paying high fees. b. Value Investing (as associated with Benjamin Graham) (3 points) Value investors such as Graham or Dodd, believe that markets are not always efficient due to the human factor in it and irrational behavior. They think that good investment opportunities where you can beat the market are but a good investor can find them when they to come along. The best strategy for value investors is to be patient and when you do see undervalued asset that is unpopular you should buy it. c. Black Swans (as associated with Mandelbrot/Taleb and power laws) (3 points)

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4 Black Swans were coined by Nassim Taleb who has advocated for Mandelbrot’s ideas. As value investors, they do not believe that markets are efficient. Taleb thinks that when market underprice a certain asset consistently the market may see extreme outcomes (Black Swan event) risk where an investor can benefit. He believes that investors should hold a majority of fairly safe assets but also buy some assets that could benefit from above mentioned extreme options. He suggests speculating on tail risk and invest in both positive and negative options. If there is a certain asset consistently underpriced in extreme outcomes it could eventually pay off really big. Such investing requires patience like value investing, but unlike value investing when you wait for an asset to come along an investor should keep the strategy and wait for a Black Swan event to come along for this strategy to pay off. 4. [6 POINTS] Behavioral Finance a. Describe how behavioral finance theorists test whether an individual is “irrational”. In other words, what is the basic way to set up a test for a failure of invariance? (3 points) Behavioral finance uses use the Prospect Theory that shows that the individual choices are no consistent with the expected utility theory. They set up tests with different conditions, where individuals are asked to make a choice between two outcomes. If the individual is persuaded to change her choices just because of how the variation of choices is framed they exhibit failure of invariance. Invariance is measured against expected utility. This in turn shows bias in their decision making that violated expected utility and allows such test to show that they are “irrational”. b. According to behavioral finance theory, if someone does not accept a fair bet, does it follow that they are irrational? Are they irrational if they do not accept a bet whose expected value exceeds the value of not accepting the bet? Explain your answers (i.e. not just yes or no). (3 points) Both of the scenarios do not show irrationality of the someone. If the individual does not accept a fair bet or do not accept a bet where the expected value exceeds the value of not accepting the bet, it is not irrational. Such individuals are just showing risk aversion which is a preference to them rather than a failure of invariance showing irrationality.

5 5. [4 POINTS] Which of the following is the best description of Fama’s notion of a market being semi-strong efficient? a. That all public information, including past financial prices is incorporated into current financial prices. b. That all public information, excluding past financial prices, is incorporated into current financial prices. c. That all public information is known. d. That all information is incorporated into current financial prices. e. That private and public information is incorporated into current financial prices. f. That past financial prices are not used to figure out current financial prices. Answer: _________ 6. [5 POINTS] Financial Systems - Discuss briefly how and why capital market-based financial systems are more complex than purely bank-based financial systems. In other words, give a brief description of the difference in institutional arrangements, but also, why those differences are necessary. A purely bank-based financial system banks finance activities by giving out loan, with only few players, those who deposit, loan takers and banks. While the bank based system is fairly system, the capital-market based financial system is more complex. There are different institutions that can finance market activities. There are separate buy side and sell sides because investments of those who invest their money is more at risk than the safer bank deposits. The investors who invest their money have to rely on other players making investments on their behalf and have to rely on brokers that are good at assessing risk return tradeoff. In order to ensure transparency and honesty, there has to be separate interests between the buy and sell side – that’s why these two separate sides (sell side and buy side) exist in capital based financial systems. It is also further complicated by the existence of market infrastructure that is needed for the buy side to obtain investment information. There are also further systems such as exchanges, regulators or clearing systems that allow both of the sides to conduct financial transactions. So overall because of the need to have separate sides, capital market financial systems end up being much more complex than simple banking systems. 7. [8 POINTS] Relative Value Trading a. For each trade depicted below, circle whether it is a directional trade or a relative value trade: (5 points)

6 i. Directional or Relative Value (circle one) – Buy credit default protection on both Bank of America and Barclays Bank ii. Directional or Relative Value (circle one) – Buy 10-year treasury bonds and short 2-year treasury bonds iii. Directional or Relative Value (circle one) – Buy Tesla stock and buy out-of-the-money put options on Tesla stock iv. Directional or Relative Value (circle one) – Buy a call option on the S&P 500 index v. Directional or Relative Value (circle one) – Buy shares of Tesla (an electric car company) and short shares of Rivian (an electric truck company) b. Under what circumstance is the trade described in option ii) above profitable? (3 points) Directional trade is conducted based on your expectation of where the market will move. For example, if you expect markets to go up, you invest (long position) in any stock in the market. If you expect the market to go own, you sell or short stocks. In the relative value trade, the direction of the market does not matter. What matters is the performance of one stock compared to another. You buy the stock that you think will outperform the other and short the stock you think will have a worse performance 8. [15 POINTS] - Emerging Market Financing - Briefly define and describe the importance of the following concepts in emerging market financing a. The sell-side (3 points) The sell side underwrites the new bond or equity issues. It advises the issuer when to tap into EM markets, identifies potential investors, markets the issues and conducts the sale. It also agrees to buy any unsold securities. b. Brady Bonds (3 points) The Brady bonds stem from the emerging markets in Latin America debt default crises in the 80s. Defaulted economies of the countries and high US bank and stock exposures in these

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7 countries led to US government intervention. US treasury secretary at the time, Nicholas Brady decided to negotiate debt relief with the Latin American countries starting with Mexico. Brady negotiated a structure between Mexican government and its bank creditors where banks could choose between the three options of either accepting the bonds at fixed rates at full value, accepting new bonds at floating rates but with lower face value or lastly lend additional money to existent exposures. The two first options were popular, as it the loans US treasury pledges and turned illiquid loans into easily tradable US bonds, and were subsequently called Brady. c. Dedicated Investors (3 points) Dedicated investors have specialized knowledge in particular asset class as for example emerging markets. Institutional investors that are no as aware of EM financing use dedicated investment funds for their own investment as the dedicated investors are more knowledge and can potentially obtain better returns with their expertise. d. Indices (3 points) Indices track a group of companies or countries and their performance. There are dedicated investors who invest by broadly following an EM index or who invest in the index fund if such fund is created. Therefore, you have access to a larger market if you are a part of an index. e. The “search for yield” (3 points) The search for yield happens when investors are tempted to experiment for riskier assets or strategies in hope to get higher returns. This phenomena occurs often when investors look for assets in emerging market assets that could potentially lead to higher returns, particularly if interest rates are low in domestic markets. 9. [5 POINTS] Ratings Agency Roles - Discuss the roles that ratings and ratings agencies play in financial markets. Include in your answer the main criticisms of ratings/ratings agencies. A rating agency is a company that assesses the financial strength of companies and government entities, especially their ability to meet principal and interest payments on their debts. The rating assigned to a given debt shows an agency’s level of confidence that the borrower will honor its debt obligations as agreed.

8 10. [9 POINTS] Derivatives: Short vs. Long - For each of the following, say whether the position described represents a long or short position in corn . Explain briefly . a. A farmer sells a corn futures contract (i.e. allowing him to sell corn in the future) on the Chicago Board of Trade (3 points) The futures contract gain if corn prices fall, so this is a short position. b. {Background: Green Giant is one of the largest brands of frozen corn and is owned by B&G Foods. Hence, B&G is one of the largest buyers of corn in the U.S.. Assume that B&G cannot pass on the cost of an increase in the price of corn to its customers.} An investor buys a put option on B&G stock (3 points) The put potion will gains if B&G stock will falls, as the costs cannot be passed on and the stock would fall if corn prices increase and B&G costs increase. Thus because of this, this is a short on B&G stock but a long on corn since you benefit from the put if corn prices increase. c. An investor sells a call option on corn (3 points) With a call option, you'll benefit if corn prices fall, since you'll make profit out of the premium. This is a short position. Buying a call option on corn is a long position in corn. By virtue of the fact that derivatives have zero-sum payoffs, the seller of an option must be short corn. In other words, the call option gets triggered, and the option seller's profits start falling, if the corn price rises above the strike price. 11. [18 POINTS] Options

9 a. (4 points) Suppose you thought that during the next 12-months, the stock market would not exhibit much volatility. Which of the following would be the best to make money off of such a prediction (assume all options described below are on the relevant stock market index and expire in 12- months): i. Buy an at-the-money call and buy an at-the-money put. ii. Buy an at-the-money call and sell an at-the-money put. iii. Sell an at-the-money call and buy an at-the-money put. iv. Buy an out-of-the-money call and sell an out-of-the money put. v. Sell an out-of-the-money call and sell an out-of-the-money put. vi. Sell an at-the-money call and buy an out-of-the-money put. Answer: _______ b. (2 points) Is it necessarily true that an investor will make money when they exercise an in-the-money option? Explain. c. (4 points) Why are options payoffs asymmetric? Is it riskier to buy or to sell an option, and why? d. (4 points) Draw the payoff diagram for an options strategy consisting of the following two options:

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10  Buying an in-the money put option  Selling an out-of-the-money put option e. (4 points) Why would you use the strategy described in part d) (choose the best answer below)? i. You expect the price of the underlying to rise a lot ii. You expect the price of the underlying to fall a lot iii. You expect the price of the underlying to rise, but not too much iv. You expect the price of the underlying to fall, but not too much v. You expect a lot of volatility vi. You expect very little volatility Answer _______

11 12. [11 POINTS] Credit Default Swaps (CDS) a. What is the difference between the counterparties in a CDS transaction versus the reference entity? (2 points) b. What is the significance of a “credit event” with reference to CDS and what is an example of a credit event? (2 points) c. Suppose Peter sells protection via a credit default swap (CDS) to Paul on Fly by Night Corporation (FNC). More specifically Peter sells a 5-year CDS to Paul, who pays Peter $150,000 a year on $10 million worth of FNC bonds. Describe the obligations of Peter and Paul if the CDS is triggered. (3 points) d. How large (in basis points) is the CDS spread on FNC and what is it a measure of? (2 points)

12 e. Which party is long and which party is short FNC? (2 points) 13. [4 POINTS] During the U.S. financial crisis, senior tranches of mortgage-related CDOs … (choose the best answer): a. … were a good hedge against falling house prices. b. … were riskier than anticipated because of high correlations of house prices across the U.S. c. … were less risky than anticipated because of high correlations of house prices across the U.S. d. … were riskier than anticipated because of low correlations of house prices across the U.S. e. … were less risky than anticipated because of low correlations of house prices across the U.S. Answer: ______ 14. [4 POINTS] Minsky’s model … (choose the best answer) a. …is a procylical model based on increasingly risky lending and borrowing behavior, predicated on rising collateral values. b. …is a model of how credit markets tend to return to equilibrium over time as undervalued assets rise in value and overvalued assets sink in value. c. …is a model based on a banking crisis in the 1890s that was centered in the Belarusian city of Minsk d. …is a procyclical model of financial crises based on an insufficiency of aggregate demand, leading to a rise in credit risk as the economy slows down

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13 e. …is a countercyclical model of financial crises based on insufficiently stringent financial regulation f. …is a countercyclical model of financial crisis based on excessively stringent financial regulation Answer: _______ 15. [6 POINTS] Shadow Banking – Describe the risks inherent in shadow banking, with reference to a specific example of a type of shadow banking entity or instrument. 16. [8 POINTS] Essay Question: U.S. Financial Crises - Below is the annual percentage change in house prices in the United States from 1976 to 2021 (the last observation is for the second quarter of 2021). Based on what you learned about the

14 subprime mortgage crisis in the United States, what would you look for now to ascertain whether you think there is an unsustainable housing bubble in the United States forming?

15 16 (cont.) Extra Page in Case You Need the Space

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