FIN3IPM Exam Preparation

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FIN3IPM Exam Preparation
2013-11-18 05:24:51
FIN3IPM Exam Preparation

FIN3IPM Exam Preparation
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  1. The value of an investment at the end of each of four years is 7%, 17%, -2.4% and 2%. What does the equation to calculate the geometric return look like?
    [(1+0.07)(1+0.17)(1-0.024)(1+0.02)]1/4-1=0.0566 or 5.66%
  2. A bill with 90 days to maturity initially has a yield of 8% p.a. and a face value of $100 000. This bill is held for 45 days and sold as a 45-day bill at a yield of 6%. What is the continuously compounding holding period rate of returns over the 45 days?
    The initial price would be 100000/[1 + (90/365) x (8.0/100)] = $98065.56. The price for the 45-day bill would be 100000/[1 + (45/365) x (6.0/100)] = $99265.71. Hence, the continuously compounded holding period return would be ln(99265.71/98065.56) = 0.0122 or 1.22% continuously compounding for 45 days.
  3. Suppose a two-year 9% p.a. bond with a face value of $100 000 has a yield of 8% p.a. The price of this bond is $101814.95 and its duration is 3.7515. Assume the yield on this bond decreases instantaneously from 8% p.a. to 7.75% p.a. What would be the expected increase in the bond price?
    - {[(0.0775/2) – (0.080/2)]/(1 + 0.080/2)} x 3.752 x 101814.95 =  - $459.15.
  4. Calculate the beta for an asset with a variance of 10%, where the market has a variance of 15% and a covariance with the asset of 20%.
    • βi = covim2m
    • 0.2/0.15 = 1.33
  5. The three factors that appear to be most relevant when testing the APT relate to: A. unexpected changes in interest rates, inflation and economic growth
    B. Expected changes in interest rates, inflation and economic growth
    C. expected and unexpected interest rates and economic growth
    D. expected and unexpected interest rates and inflation
    Despite a large volume of work, there is no clear consensus as to which particular variables are relevant pricing factors. For instance, Cho, Eun and Senbet (1986) test the APT at the international level for 11 industrial economies and report between one and five factors. However, in the main, variables related to (unexpected) interest rate structures, inflation and economic growth appear to be relevant most frequently.
  6. What are the three types of market efficiency?
    Fama (1970) originally proposed a three-way classification of market efficiency based directly on information. Weak form efficiency referred to past price information, semi-strong form efficiency referred to public information and strong form efficiency referred to all information.
  7. The hypothesis that argues that there is a downward price pressure at the end of the tax year on shares that have experienced recent price declines as investors attempt to sell in order to realise capital losses is the:
    A. tax-loss selling hypothesis
    B. price rebound hypothesis
    C. share price declines hypothesis
    D. tax on capital gains hypothesis
    A. The tax-loss selling hypothesis has been put forward as an explanation of the seasonality in the size premium in the USA and extended to other monthly seasonal in other markets, such as July in Australia. The hypothesis that argues that there is a downward price pressure at the end of the tax year on shares that have experienced recent price declines as investors attempt to sell in order to realize the capital loss.
    (this multiple choice question has been scrambled)
  8. An indexed-linked bond is one where the price is linked to the:
    A. All-Ordinaries
    B. Consumer Price Index
    C. world equity market index
    D. industrial production index
    B. While inflation will affect the discount rate, in general it has no effect on the coupon payments, though notable exceptions include floating rate bonds and index-linked bonds, where the coupons are indexed to an inflation benchmark such as the Consumer Price Index.
    (this multiple choice question has been scrambled)
  9. Shares that are classified as __________ have a high book-to-market ratio.
    A. value shares
    B. growth shares
    C. blue-chip shares
    D. green-chip shares
    A. Broadly defined, growth shares have low book-to-market ratios while value shares have high book-to-market ratios. It is argued that firms coming off a low profit base, but undertaking expansion through growth opportunities, will have a relatively low book value, as the firm will have a relatively low value of historical assets in place. However, the market value will be higher, as it incorporates the present value of the growth opportunities. Thus, the book-to-market ratio will be low. In contrast, value shares are those with a relatively high value of historical assets in place. These firms are generally viewed by the market as having low growth opportunities, and hence their market price is low in a relative sense. Therefore, value shares have a high book-to-market ratio.
    (this multiple choice question has been scrambled)
  10. Research from Arthur, Cheng, Czernkowski (2010), report that models of future earnings that use disaggregated cash flows based on components of firm cash flows produce:
    A. better forecasts of future earnings than methods based on aggregate net cash flows
    B. earnings forecasts that will not help the firms directors in the decision making   process
    C. earnings numbers comparable in quality to those of only the best analyst
    D. capital structure changes that could potentially affect cash flow
    A. Research from Arthur, Cheng, Czernkowski (2010), report that earnings predictability has found that disaggregated cash flow models based on components of firm cash flows produce better forecasts of future earnings than methods based on aggregate net cash flows.
    (this multiple choice question has been scrambled)
  11. What the GFC taught advisers and __________________ in the most powerful and painful way possible was that _________________ is/are the most important factor/s for investors.
    A. self-directed investors; asset allocation
    B. bankers; bottom up analysis
    C. governments; top down analysis
    D. analysts; a combination of fundamental and technical analysis
    A. What the GFC taught advisers and self-directed investors in the most powerful and painful way possible was that asset allocation is the most important factor for investors. In 2008 what determined whether you had a good or bad year was the percentage you had in each asset class.
    (this multiple choice question has been scrambled)
  12. __________ is an approach to manage bond portfolios by choosing portfolios with duration matching the duration of liability cash flows.
    A. Immunisation
    B. Hedging
    C. Cash matching
    D. none of the above
    A. Immunisation is a method of management of bond portfolios that involves choosing portfolios with duration that matches the duration of liability cash flows, and thus immunises these cash flows from changes in interest rates. This approach ensures sufficient cash flows to meet liabilities when they fall due. As with cash matching, the cash flows may be modelled as either certain or uncertain (that is, stochastic).
    (this multiple choice question has been scrambled)
  13. A criticism of Jensen’s alpha is that:
    A. it can only be applied to individual shares B. it can only be used on portfolios
    C. it is strongly influenced by outliers and fails to measure consistent performance
    D. none of the above
    C. As Jensen’s alpha assumes that the CAPM is the appropriate benchmark, to the extent that the validity of the CAPM is questioned, so too is the validity of Jensen’s alpha. The measure relies upon an estimate of beta that may be problematic. Further, the measure is claimed to measure only depth and not breadth. For instance, a fund manager may have invested in a large number of stocks on which several small losses have been made, but also picked a stock on which a substantial profit was made. The resultant value of Jensen’s alpha could be positive, but this is due to one lucky winner and not consistent performance across the portfolio. In such a case, it could be incorrectly concluded that the manager had superior skills. The measure also equally weights superior and inferior performance. Arguably, investors are more concerned with underperformance than overperformance.
  14. What are the key strategies that a company can use to respond to a threat to its competitive position in an industry?
    • Low cost strategy: Seeks to be the low-cost leader in its industry. Must still company prices near industry average, so must still differentiate. Too much discounting erodes superior rates of return.
    • Differentiation strategy: Identify something unique in the industry that is important to customers. Above average rate of return only comes if the price premium exceeds extra cost of uniqueness.
  15. Briefly describe what is meant by passive and active bond portfolio management. Give examples of passive and active management techniques.
    • Passive management can be divided into buy and hold strategies (based on a traditional diversification approach where the investor chooses a portfolio so that the overall portfolio risk is reduced by including a wide variety of assets, buys them and holds them) such as index tracking (a portfolio is formed that closely tracks price changes in a chosen index and cash flow generation strategies, such as cash matching, which involves the acquisition of a portfolio of bonds that produce cash flows that match those of an underlying liability.
    • Active management may include highly speculative investment strategies such as 'plunging' into bonds which are believed to be mispriced or taking positions on the basis of expected yield curve changes from expectations about information releases or perhaps change in government policies. It could also include some combination of speculative trading and passive strategy such as immunisation, which is designed to protect the initial investment while speculative strategies are undertaken. Examples include 'riding the yield curve' and 'bond swapping'.
  16. Briefly discuss the key problems that arose when people attempted to test the CAPM using actual data and statistical methods.
    • The CAPM is an ex-ante model: Do the ex-post returns that are typically used adequately approximate expectations by the investors, e.g. expected returns? Which returns should be used in estimation, arithmetic, geometric or continuously compounded? Identification of index: Roll's critique.
    • Beta estimation: In practice, we encounter thin and infrequent trading in the market. The CAPM assumes betas are stable over time, but they may not be Estimation over longer periods may be better statistically but less likely for beta to be stable as estimation window increases.
    • Survivorship bias: failed companies are excluded, which induces a bias in returns and betas.
  17. Because of the problems of the CAPM, the APT model was proposed as an alternative. How does the APT model overcome the shortcomings of the CAPM? What are the shortcomings of the APT model?
    The APT appears to be less restrictive and empirically testable. However, there is no theoretical basis for choosing the factors to be included in the estimation. Selection of empirical factors (as in Chen, Roll and Ross 1986) claimed to be subjective.
  18. What are money market securities?
    Money market securities involve an initial cash flow from the buyer (lender) to the seller (borrower) with repayment of the loan, including interest at maturity. These might be discount bonds where the face value of the bond is paid at maturity or bullet bonds where the face value plus interest is paid at maturity. The zero coupon bond is probably one of the simplest forms of debt traded in the Australian money market. Other examples include commercial bills, Treasury notes and promissory notes.
  19. What is a bank-accepted bill?
    A bank-accepted bill is a type of bill of exchange endorsed by a bank. This avoids the difficulties of assessing the risk of the ultimate borrower because the risk of the bill is directly related to the risk of the bank that accepted or endorsed the bill
  20. What are the four basic theories of term structure?
    • Expectations theory
    • Liquidity premium theory
    • Segmentation theory
    • Preferred habitat theory
    • These theories are concerned with the relationship found between yield and time to maturity for assets, identical in all but time to maturity
  21. What is the expectations theory?
    The Expectations Theory suggests that longer maturity yields are a function of the current yield and expected future yields. In this theory the expected future yields are unbiased predictors of realised future yields. Investors are assumed to care only about the expected return from the security. For example under this theory the yield on a six-month bill could be equated with a series of two consecutive three-month investments.
  22. What is the liquidity premium theory?
    In this theory an additional term is added as an adjustment for risk, to compensate a short-term investor for holding a security with a term to maturity that does not match the investor’s preferred investment horizon. In this theory it is assumed the majority of investors require the shorter term bonds and thus the longer term yields exhibit a liquidity premium, which tends to increase the longer the time to maturity. In this case a premium is required to encourage investors to buy the18-month bond instead of a 12-month bond. In effect, the liquidity premium drives a wedge between the short rates and the long rates, providing one reason for the failure of the expectations theory to adequately explain or predict future interest yields.
  23. What is the segmented market theory?
    The segmented market theory is consistent with the observed concentration of investors in particular segments of the term structure. Risk aversion results in market participants only operating at that position on the yield curve that most suits their business needs. This grouping of participants could lead to quite separate markets operating at different positions on the yield curve with substantial risk premiums required to encourage participants to move out of their optimal segment of the market. The use of the yield curve for forecasting purposes is limited in this model as expected future yields may bear little resemblance to the relationship between currently observed yields suggested by the expectations hypothesis.
  24. What is the preferred habitat theory?
    In this theory participants match asset life and liability life to establish the lowest possible risk position. Substantial premiums may be required to encourage participants to invest in other than the preferred habitat and so risk premiums would tend to be greatest where demand is least. This theory is similar to the liquidity premium theory but it allows both positive and negative premiums to exist rather than the positive premium predicted by the liquidity premium theory. The premium is set by supply and demand in particular interest rate habitats. If there is borrowing pressure (lenders selling bonds) the rates will rise (prices will fall). If there is investing pressure (investors buying bonds) the rates will fall (prices will rise). Again, predictive power of the term structure is under some doubt with this theory.
  25. True or false: a $100 000 90-day bill with yield of 8% is purchased now. Assuming the term structure is flat at 8% and does not change, in 30 days time the price of the bill increases.
    • TRUE. As the time to maturity has decreased and the term structure is flat at 8% then the yield to maturity must have decreased and so the price must increase.
    • Price now $98 065.56 (time to maturity is 90 days) =  100,000 / (1 + 0.08 x 90/365)
    • Price in 30 days $98 702.00 (time to maturity is 60 days) 100,000 / (1 + 0.08 x 60/365)
    • Price increase $636.44
  26. True or false: the yield of a $50 000 45-day bill decreases from 7% to 5%, so the bill price decreases too.
    FALSE. The yield to maturity has decreased and so the price must increase.
  27. In the case of risk of fixed interest securities, how do risks differ from money market securities?
    • The cash flows from money market securities and bonds give rise to a number of risks. These include interest rate risk, default risk, inflation risk, foreign n exchange risk, and marketability risk. However, there are two additional risks that affect bonds but not money market securities. These are reinvestment risk and call risk.
    • The price of a bond usually has the assumption that interest or coupon payments can be reinvested at an interest rate equivalent to the bond yield. Yet, interest rates change over time and we can only invest the coupons at the available market rates. While reinvestment risk does not affect zero-coupon bonds or money market securities, it is a potential problem where bonds pay regular coupon payments. As each coupon is received it must be reinvested at some unknown future interest rate and this coupon reinvestment gives rise to reinvestment risk.
    • Call risk refers to the likelihood that the call provision, found in corporate bond issues, will be exercised. A call provision gives the borrower the right, but not the obligation to buy back the issue at some specified price and at some time prior to maturity. This is generally found with bonds paying fixed interest rates. It is important for the investor because it introduces further uncertainty in terms of bond maturity date, bonds cash flows, reinvestment risk and interest rate risk. If the bond can be brought back at a set price, this will tend to occur when interest rates fall because the borrower can lower borrowing costs by buying back the debt and issuing new debt at a lower cost. When this occurs the investor is faced with both lower yields and higher prices, as the price paid by the borrower is generally not the market price but a previously agreed price written into the bond contract. The investor can be compensated for this source of risk by means such as a lower initial purchase price or higher coupon payments.
  28. What is duration?
    Duration is the negative of the bonds price elasticity with respect to yield and so is a measure of the sensitivity of the bond price to changes in the yield. Yield risk (or interest rate risk) is perhaps the key factor in the management of coupon paying bonds as it is changes in interest rates which accounts for much of the volatility in bond prices.
  29. What is convexity and why is it important?
    Convexity provides a measure of the level of curvature evident in the relationship between price and yield. While duration approximates the relationship between price and yield assuming a linear relationship which is generally accurate enough for most purposes, it does measure the relationship with error. Thus where greater accuracy is required convexity may also be useful to the investor.
  30. What is the relationship between bond yield and price?
    As the yield increases the price decreases.
  31. What are the key assumptions of expected utility and their related problems?
    • Assumptions:
    • The investor is assumed to be able to rank all possible alternatives.
    • If asset A is preferred to asset B and asset B is preferred to asset C then asset A is also preferred to asset C. This principle is generally called transitivity.
    • The ranking is assumed to be strongly independent, which suggests a chosen ranking will hold no matter what other assets are held.
    • The ranking is measurable. It is important to be able to assign a number to a portfolio which allows comparison of that portfolio with other portfolios.
    • It is possible to rank assets and uncertain gambles.

    • Problems:
    • independence and the existence of complements
    • individuals do not always rank alternatives in a consistent manner
    • ranking of alternatives may not be independent of the environment within which the ranking is made
    • non-satiation may not be a reasonable assumption for individuals especially at extreme consumption levels.
  32. What are indifference curves?
    Indifference curves can be used to compare different combinations of assets. Indifference curves are curves drawn where expected utility is held constant and expected return and standard deviation are allowed to change. This curve lists all possible combinations of standard deviation and expected return which yield the same level of utility or alternatively investors are indifferent between all the portfolios which fall on the indifference curve.
  33. What is prospect theory, and how does it differ from traditional views of expected utility theory?
    Traditional methods of analysing expected utility focus on the total wealth of investors. In contrast, prospect theory models choice in terms of gains or losses rather than total wealth. Investors were found to be twice as concerned about losses as they were about gains (Tversky and Kahneman, 1992). This results in an indifference curve that assigns a greater absolute change in utility from losses, than for gains (known as a subjective value function).
  34. What is the difference between the Markowitz approach and the Sharpe approach to solving the portfolio choice problem?
    Solving the portfolio choice problem involves determining the portfolio weights that either maximise return given a particular level of risk, or minimises the variance for a particular level of portfolio return. As such, three inputs are required: asset expected returns, variances and covariances. The standard Markowitz approach requires the estimation of the full covariance matrix. For example, if there are 20 shares in a portfolio, the Markowitz approach requires 20 expected returns, 20 variance estimates and N(N–1)/2 covariances (e.g. 20(19)/2 = 190 covariance estimates), or 230 estimates in total. The Sharpe approach uses the market model to simplify this step by reducing the number of parameters which must be estimated. By relating to an index, the number of estimates required is three for every asset and then another two to describe the behaviour of the market. This makes 3N+2 which equates to 62 estimates for a 20 asset portfolio. Since each of these terms may be estimated with error, it is advantageous to minimise the number of required calculations.
  35. In estimating the opportunity set, does the assumption that the expected returns, variances and covariances are known with certainty matter?
    The expected returns may be estimated with error and the error may not be consistent across securities. For example the level of information varies across securities and so the precision of the estimates will also vary across securities. If estimates are prone to error the opportunity set may concentrate on those securities with greatest error rather than those companies which best meet the needs of the investor. This result is often termed error maximisation and can result in a portfolio that concentrates on a fairly small subset of the available securities. These are the securities with greatest expected returns and/or least variance and covariance effect, often the most likely to suffer from data entry errors and errors in analysis. The key point to note is the importance of accurate measures of expected return, variance and covariance and the possibility that a number of ‘approximately optimal’ portfolios may exist in practice.
  36. What is the capital market line?
    The capital market line (CML) is a line passing through the risk-free rate of return, tangent to the opportunity set. In equilibrium investors choose that combination of the risk-free asset and one risky portfolio, which ensures the maximum expected return for any given variance. The set of portfolios that meets this requirement is described by the line drawn from the risk free rate of return on the vertical axis and extends to touch the opportunity set of risky assets at a tangency point. Investors then choose that combination of the risky portfolio and the risk free asset, which maximises utility.
  37. What is the security market line?
    The security market line (SML) is the relationship between expected returns on the vertical axis and beta on the horizontal axis. The slope term is commonly called the risk premium and it represents a premium for taking on undiversifiable risk (also called market risk or covariance risk).
  38. What is the difference between efficient and inefficient portfolios?
    Efficient portfolios are those that plot on the CML while inefficient portfolios are portfolios which do not plot on the CML. Efficient portfolios form part of the efficient set and so are those portfolios which risk-averse value maximising investors would choose given a particular level of standard deviation (or variance). If an inefficient portfolio were held the investor could increase utility by changing the composition of the portfolio until it became an efficient portfolio. For the CML these portfolios consist of some combination of the market portfolio of risky assets and the risk-free asset.
  39. Can the beta of a portfolio be estimated using the betas of the individual assets in the portfolio? How?
    • Yes. The beta estimates of the individual assets are weighted using the proportion of total wealth invested in each of the assets to give the portfolio beta.
    • βp = w1β1+ w2β2+ ... + wnβn
    • where βi = beta of portfolio i
    • wi = value weighting of asset i (proportion of asset i value to total investment value)
  40. How do different borrowing and lending rates affect the CAPM?
    If differential borrowing and lending rates exist, the traditional capital market line fails. It is no longer a line including the risk-free asset and the market portfolio. Investors no longer consistently choose to invest in the one-market portfolio of risky assets. There are an infinite number of possible portfolios that investors would choose and their choice is now determined by their preference function. The CAPM no longer applies to pricing assets. There is no longer a single CML given a particular efficient set and so there is no longer a unique market portfolio (tangency point).
  41. What are the key predictions of the CAPM?
    • completely determines the expected return of the portfolio
    • explains return variation to the exclusion of all other alternative explanatory variables
    • that there is a linear relationship in beta
    • predicts that the beta coefficient is equal to the risk premium, (E(Rm)–Rf)
    • predicts that over long periods of time the market rate of return will be greater than the risk-free rate of return to compensate for the greater risk associated with the market portfolio. (i.e. E(Rm) > Rf).
  42. What is the empirical evidence on the CAPM?
    Early tests of the CAPM generally found support for the model's predictions. For example, Blume and Friend (1973) found that a cross-sectional regression run with mean return regressed against beta estimates supported the predictions made by CAPM, but also suggested the possibility of other factors driving expected returnsHowever Roll's critique cast doubt on whether any test of the CAPM was reliable. Roll argues that to test the CAPM researchers must identify the market portfolio, which is impossible as there is no observable portfolio of all risky assets. This criticism is perhaps a little extreme as econometric theory can cater for situations where a suitable proxy for the market portfolio is found but the basic problem still remains with identifying such a proxyLater, the study of Fama and French (1992) provided perhaps the most damning evidence against the CAPM in which other factors were found to explanatory power over returns. However, doubts of where they are true sources of risk and concerns over the estimation of risk premia have slowed the death of beta. This again focuses the discussion to whether CAPM is a useful model as if we do not use CAPM to price risky assets then what is the alternative?
  43. What is a unit trust?
    Unit trusts are pooled investment vehicles which enable investors to invest and withdraw through individual tradeable units. Unit trusts, like any trust, have an independent trustee who is responsible for overseeing the trust. They are governed by a Trust Deed which sets out specific guidelines for the trust’s activities. Some unit trusts are listed on the stock exchange, such as listed property trusts. A listed unit trust initially sells a fixed number of units to investors which are subsequently listed on the stock exchange. The value of each unit depends upon market forces of supply and demand. As the number of units is fixed, the only way investors can enter the trust is to buy units on the stock exchange or wait for a possible future new issue. As such, these trusts are known as closed-end funds. In comparison, an unlisted unit trust may issue new units at any time and similarly may redeem (ie. buy-back) units at any time. The value of each unit depends upon the value of the underlying investments. These trusts are known as open-ended or mutual funds.
  44. What is a superannuation fund?
    In general, superannuation funds are designed to set aside money during the working lives of people to cater for their financial needs during retirement. The superannuation industry provides for a future national pool of capital for the use in retirement of current workers. Superannuation involves employer sponsored funds and personal superannuation schemes. Employer sponsored funds are set up specifically for an employer and their employees. No one else is permitted to make contributions to the fund. In some funds, only the employer makes contributions and these are known as non-contributory funds. However, the more common arrangement is for both employers and employees to make contributions. Superannuation funds are managed by life insurance companies, external fund administrators, master trust superannuation funds (which bring a number of managers and products under the one umbrella) and pooled superannuation trusts.
  45. What is a life office fund?
    Life office funds include life insurance, life assurance, annuities, pensions and superannuation products. In Australia, life insurance companies are established under specific legislation which places restrictions on the company’s activities. Life insurance companies make investments directly, rather than acting as an agent. While most fund managers are appointed as an agent, life insurance companies act as principals. Hence, investments are taken directly onto the balance sheets of life insurance companies through the special vehicle known as a statutory fund. Life insurance companies make contractual commitments to make a return (guaranteed or expected) on client money.
  46. What is a growth fund?
    Growth funds have the objective of reinvesting earnings such as interest and dividends to take a medium risk position to achieve capital growth. Growth funds suit investors with a medium to long-term horizon. The return to investors is through capital growth. These funds typically have a high weighting in equities.
  47. What is an income fund?
    Income funds have the primary objective of providing a steady income stream to investors through periodic distributions. These funds require regular cash inflows and typically select fixed interest securities and stocks with high dividend yields. Income funds also have a secondary objective of capital growth.
  48. What is a capital stable fund?
    Capital stable funds have the objective of ensuring long-term stability and growth. Typically, investments will be of low risk. These funds are sometimes referred to as capital funds or capital guarantee funds. These funds suit investors who have a long-term horizon and are relatively risk averse. Capital stable funds will commonly have a high weighting in property and fixed interest.
  49. What sort of asset allocation would you expect  of a growth fund?
    Growth funds have the objective of reinvesting earnings such as interest and dividends to take a medium risk position to achieve capital growth. Therefore they have a medium to long-term horizon and look to asset classes of medium risk. Typically, equities suit growth funds as they provide the possibility of strong growth without excessive risk. Moreover, equity growth is expected to be ongoing and the market is generally perceived as relatively liquid.
  50. What sort of asset allocation would you expect of an income fund?
    Income funds have the primary objective of providing a steady income stream to investors through periodic distributions. Hence, income funds require regular cash inflows which typically arise through interest and dividends. Asset classes which suit this objective include coupon-paying bonds and shares with high dividend yields.
  51. What sort of asset allocation would you expect of a capital stable fund?
    Capital stable funds have the objective of ensuring long-term stability and growth. These funds suit investors who have a long-term horizon and are relatively risk averse. Capital stable funds will commonly have a high weighting in low risk investments such as property and fixed interest. In particular, inflation-linked securities may be attractive because of their guaranteed return component.
  52. To what extent do investors rely on past performance when making investment decisions?
    Past performance is regarded as a key input into investor decisions. Survey research shows that past performance is the most important factor that investors consider when selecting a managed fund investment. For example, Sweeney Research (2001) found that 54% of investors regard long-term performance as the most important factor when selecting managed fund investments. This result was a long way ahead of the second factor: the risks associated with investment (which 17% of investors nominated). Chartwell investment Management Ltd (2001) also found in an English survey of 2000 investors conducted in 2001, 58% of respondents regard performance as the most important factor to consider, followed by risk profile in second place at 35%. Similarly, in the funds management industry, many believe that past performance is a key factor in attracting investors to their products. A review by the Australian Securities and Investments Commission (ASIC) in 2002 revealed that past performance is included in 70% of commercial advertisements designed to attract investors to managed funds. Moreover, empirical studies have shown that past performance is correlated with future fund flows. Sirri and Tufano (1998) find that investors are attracted to good performers in the USA, while Sawicki (2000) and Frino, Heaney and Service (2005) also document this finding in the Australian market.
  53. Explain the circumstances in which the Sharpe and Treynor indices can provide conflicting fund rankings.
    The inconsistency is due to differences in the unit risk measure, particularly in poorly diversified funds. The Sharpe Index uses standard deviation whereas the Treynor Index uses beta risk. However, if the fund is well diversified then non-systematic risk will be largely eliminated and the Sharpe and Treynor Indices will provide very similar rankings.
  54. What is the purpose of Carhart's 1997 model?
    It is used to control for market biases.
  55. How does the Carhart alpha differ from the Jensen alpha?
    Carhart’s alpha is a measure of superior performance after controlling for the forces generated by the market return, size premium, value premium and momentum premium. Hence, any fund managers that construct portfolios designed to capture these premiums will find that their returns are captured within the model, and so they will not exhibit any alpha performance. Rather, managers that have strategies that do not follow mainstream premiums are expected to have alpha performance. In this sense, Carhart’s alpha is regarded in the industry as a more appropriate measure of individual performance. Jensen’s alpha, on the other hand, assumes that the CAPM is the appropriate benchmark, to the extent that the CAPM is valid. Hence, Jensen’s alpha relies upon an estimate of beta that may be problematic. Further, the measure is claimed to only measure depth and not breadth. For instance, a fund manager may have invested in a large number of stocks on which several losses have been made, but also picked a stock on which a substantial profit was made. The resultant value of Jensen’s alpha could be positive, but this is due to one lucky winner and not consistent performance across the portfolio. In such a case, it could be incorrectly concluded that the manager had superior skills.
  56. What is the information ratio and how does it differ from other ratios such as the Sharpe and Treynor indices?
    The information ratio is an efficiency measure. The ratio analyses the excess return (to the benchmark) and then standardises the measure by the amount of ‘risk’ involved in earning the excess return. That is, the information ratio provides an insight into how much risk was undertaken to earn the excess return. An efficient portfolio manager is claimed to have a low standard deviation of tracking errors relative to the overall excess return. As a rule of thumb, values close to one are considered to be consistent with very good performance. The information ratio requires a benchmark to be specified. But this raises the problem of selecting appropriate benchmarks such as the CAPM. The Sharpe ratio (below) measures the risk premium per unit of overall risk. But the Sharpe index does not rely on an asset pricing model such as the CAPM. The Sharpe index measure jointly captures the concepts of return and risk. Hence, it allows for investments of varying risk to be assessed on a comparative basis. But critics of the Sharpe index argue that it is reliant on the capital market line, which is based on unrealistic assumptions that do not hold in practise. The Treynor (1965) index is similar to the Sharpe index except that it is based on the ex-post security market line (rather than the ex-post capital market line). The result is that the standardised measure is beta risk rather than standard deviation. The The Treynor index value for the market will always equal the market risk premium (Rm-Rf) because the beta measure of the market is always 1.0. Hence, a fund is claimed to exhibit superior performance if the value of the Treynor index exceeds the market risk premium. The Treynor index is subject to the same type of criticism as that directed at using the CAPM as an appropriate benchmark.
  57. What is meant by performance persistence? What are the implications of performance persistence for poorly performed funds?
    • Performance persistence is the degree to which funds are able to maintain consistent performance across time. This can be assessed by examining the correlation of fund returns over time.
    • A degree of persistence in performance suggests that past returns and rankings are useful in predicting future returns and rankings. If this is the case then poorly performed funds will continue to be poor performers. Moreover, if this information becomes known and accepted them the predicted returns will reveal a poor outlook for these funds. Consequently, investors will shy away from the funds resulting in an outflow of invested funds and a downsizing of the fund, such that it may struggle to survive.
  58. Performance persistence implies some predictability of future performance. How does this sit with the notion of an efficient market?
    There is anecdotal evidence that funds exhibit performance persistence. Research has supported this claim and the results from the USA indicate a degree of persistence in performance in the US funds market. The results suggest that past returns and rankings are useful in predicting future returns and rankings. Specifically, some evidence shows that winners repeat, particularly extremely good performers. Performance persistence is also documented among poorly performed funds. However the evidence is inconsistent and research in the Australian and New Zealand equity funds market has not yet revealed any evidence of performance persistence. If performance persistence exists then it implies that future fund returns are in some sense predictable. If this is the case, then past information can be used to make profitable forecasts which tend to be perceived as inconsistent with a truly efficient market. However, the problem for investors is that by chasing the best performed funds they hold diversifiable risk because the positive correlation among the winning funds means that an investment in them is not well diversified across the market. Hence we may argue that expected return is higher but must also note that (diversifiable) risk is higher. In this sense, there is still consistency with the notion of an efficient market as higher expected returns come at a cost of higher risk (although this is dependent upon the view taken of the appropriate risk measure).
  59. What is similar between the basic pricing models for the CCAPM, the arbitrage pricing theory, the Fama and French model, and the international CAPM?
    All of the equations describe the factors that are important in determining the expected return for each security. The models differ in terms of their underlying assumptions regarding how expected returns are generated.
  60. What are the difficulties of the approach to estimate consumption betas?
    First, the CCAPM requires a measure of aggregate economy-wide consumption. This data is generally not available and some proxy measure must be used. Ideally, we want to measure the actual value of consumption; however, consumption statistics tend to be expenditures rather values. This implies that goods are consumed immediately following their purchase, which of course is not true. Further, in order to implement the CCAPM, we require consumption levels at a particular point in time. However, reported expenditure figures are for expenditure over a period rather than at a fixed point. A final issue relates to the accuracy of the consumption data. Consumption data inevitably provided in aggregate do not span the entire universe of consumption transactions and are therefore measured with error.
  61. Explain why the APT should hold.
    The Ross (1976) approach is based on the argument that if a portfolio which is formed with no risk and requires no investment it will have zero expected return. It is argued that arbitrage portfolios can be formed whose returns are not correlated with the underlying factors. This means there is no systematic risk associated with the arbitrage portfolios and so no systematic return is earned by these arbitrage portfolios. Further, the large number of securities used in the construction of the arbitrage portfolios ensures there is no residual risk. If an arbitrage portfolio is formed with these characteristics the portfolio expected return must be equal to zero. If this is the case then the full correctly specified set of pricing factors should explain expected returns.
  62. What are factor sensitivities in the APT model?
    The factor sensitivities are estimates of the sensitivity of an asset to particular factors. They are similar in effect to the beta measure used in CAPM. That is, the sensitivities measure the rate at which return on the asset varies with a change in the underlying factor all else held constant.
  63. What are the factors used in the Chen, Roll and Ross 1986 model?
    • VWNY: return on a value-weighted portfolio of NYSE. An index composed of listed stocks.
    • MP: monthly growth in industrial production. The continuously compounding rate of change in industrial production during the month.
    • DEI: Change in expected inflation. Expected inflation is obtained from a time series analysis of rates of return on Treasury bills and subtracted from the change in the CPI for the period.
    • UI: Unexpected inflation. The difference between the actual inflation rate and the expected inflation rate estimates used in calculation of DEI.
    • UPR: Risk premium. The difference between the returns on risky bonds rated as "baa or under" and the returns on a portfolio of long-term government bonds.
    • UTS: Term structure. The return on a portfolio of long-term government bonds less the return on one-month Treasury bills.
  64. Does the empirical evidence support the pricing of the factors used in Chen, Roll and Ross?
    The empirical evidence suggests that this approach is difficult since there is no correct set of factors. Rather, the variables are selected by reference to theoretical justifications as to what type of variables we expect to be related to returns. As indicated in Table 9.3 (p.291), the average premium on the market index is significant. This suggests that the market portfolio has little ability to explain cross-sectional equity returns, in contrast to the CAPM. Although monthly growth in production, unanticipated change in risk premium and unanticipated change in the term structure appear to have significant explanatory power for the full period, statistically significant results are concentrated in one sub-period (1968–1977). Hence, the explanatory power of the chosen economic variables changes over time. Given the inconclusive results, it may well be that other explanatory variables not selected here provide greater explanatory power.
  65. Explain the Fama and French model and its supporting empirical evidence.
    Fama and French (1993) test the relationship between returns on individual shares and the various underlying characteristics by creating 25 USA portfolios ranked by size and book-to-market value. Seven bond portfolios are also obtained, with the range of default risk varying from the government bonds with little risk to risky corporate bonds. Thus, the model is applied to both equities and bonds. Time series analysis is then conducted on these portfolios using proxies for size, book-to-market, term premium and default premium. Fama and French conclude that these variables help explain cross-sectional variation in stock returns. The power of the market risk premium, size premium and book-to-market premium on share returns are the strongest among all factors and fairly stable across time.
  66. What is the value of a security?
    The value of a security is the expected future cash flows accruing from holding the security discounted at an opportunity cost of capital that reflects relative risk. Different investors have different expectations of cash flows and risk and hence different views on value.
  67. What is the price of a security?
    The price is the exchange rate established in the market set by the forces of supply and demand in competition. In an efficient market, the price is set equal to the expected value of the asset.
  68. Explain mispricing.
    Value could be determined by the present value of the expected stream of future (risky) cash flows. If price does not equal value, then assets would be mispriced. For instance, suppose that the market price was below the estimated present value such that the asset was priced at a discount. There would be incentive for investors to purchase the asset at the lower market price and hold onto the asset to reap the future cash flows. These cash flows are known to have an expected present value higher than what was paid to obtain them. In a competitive market, the price would not remain at a discount for long as increased demand for the asset would push its price up.
  69. Explain what is meant by the joint test problem and its significance
    Any test of market efficiency necessarily compares returns against some benchmark. For instance, an inefficient market may be one in which excess returns are persistently observed for a particular trading strategy. But how do we define excess returns? A benchmark for the expected return is required before we can measure excess returns. One possible benchmark is a formal asset pricing model, such as the CAPM. But the use of the CAPM as the benchmark implies that the model is appropriate. Hence, in order to define excess returns to test market efficiency, a model for expected return is first required. Thus, any test of market efficiency is inherently a joint test of market efficiency and the model of expected return. This problem of the joint test also applies in reverse. Implicit in tests of asset pricing models is the assumption that market prices are set in a rational and efficient manner. Thus, in order to test the asset pricing models, we implicitly assume something about market efficiency. Therefore, we cannot test either market efficiency or an asset pricing model without first assuming that one or other holds. As such, any conclusion about market efficiency must be tempered with the knowledge that the results are based on an implicit assumption about the appropriateness of the return benchmark.
  70. What are the forces at work that are helping to maintain perceptions of market inefficiency?
    • In relation to market structure forces
    • We expect to observe winners and losers as uncertain returns have a dispersion about a mean. There is a tendency to interpret the observation of large positive returns and wealthy investors as evidence of inefficiency. However, in a world of uncertainty we expect to encounter some observations from the extremes of the distribution.
    • It is difficult to distinguish skill from luck. Some investors may earn substantial excess profits from a trading strategy but it is difficult to separate these investors from those that simply get lucky. After all, it is in an investor’s best interest to convince others that they have some unique skills. It is rare for an investor, particularly those investing other people’s money, to admit that their profits have been generated by sheer chance. Ex-post explanations as to why certain investments were chosen are always possible. The truly skilful investor will have ex-ante reasoning which is then supported by ex-post observation. These circumstances are very difficult to observe and test.
    • There are rarely many observations to test under the same conditions. The background against which investment decisions are made such as the environment and the skills and knowledge of individual investors is constantly changing.
    • There are vested interests in maintaining the view of market inefficiency. Billions of dollars each year are made around the world by fund managers, stock brokers, merchant banks and financial specialists from investment advising and selling investment products. If everyone suddenly accepted the notion of market efficiency and was content to take a buy-and-hold strategy in a diversified portfolio, then it is possible that much of the demand for financial services would disappear.
    • In relation to behavioural forces
    • Individuals have an aversion to loss realisation. Paper losses are somehow better than real losses. Individuals have a tendency to view unrealised paper losses as less significant than realised losses. Consequently, people hang onto unrealised losses for too long in the hope that these losses will eventually be recouped. In terms of tests of efficiency, we do not observe as many losses as we should. 
    • People believe that they know more than they do. This belief is termed the ‘illusion of knowledge’. People tend to overestimate their ability and hence acceptance of an efficient market contradicts what people would like to believe.
    • There is a tendency for individuals to place too much faith on small sample sizes and overvalue anecdotal information. Hence, there is a misconception of an abnormally high frequency of winners in the market. 
    • Individuals have a tendency to attribute successes to skill and failures to external forces. In the context of investment, investors carry through with attribution theory and ascribe profitable investments to their ability to make superior investment decisions.
  71. Why is it that brokers have recommended growth stocks as sound investments for many years, but value stocks appear to have consistently outperformed growth stocks?
    Growth forecasts contain an element of error. If the market overreacts to recent news then forecasts may be incorrect. If the market does overreact, then shares with recent growth will be overvalued. Conversely, shares with a recent poor earnings record and low growth will be undervalued. In both cases, the market fails to incorporate the correct value of information in current earnings and does not capture the reversion in growth rates. The reason for the overreaction is that in the short-run, earnings are indeed good indicators of next period’s earnings. However, the market may place too much faith in current earnings to predict earnings over a number of periods. Growth shares may turn into value shares in a shorter period than anticipated. Over time as future earnings become known, the market realises its mistake; growth shares earn rates of return below expected, and value shares earn rates of return above expected.
  72. Derivatives markets and program trading have been blamed for the crash of October 1987. Do you agree?
    Various explanations have been put forward for the Crash of October 1987 including irrationality before the Crash, irrationality during the Crash, bad news releases, misalignment with market fundamentals, major revisions in expectations and institutional failure. The last argument has support through a documented failure of the order system on the New York Stock Exchange. The market procedure was unable to cope with the large volume of sell transactions on the day which exacerbated the price decline and created a massive order imbalance. At the time of the Crash, the derivatives markets were more computerised and did not face the same order delays. Further, the ability to take a short position attracts investors in a falling market. The derivatives markets were better equipped for the transaction pressure and hence did not experience the same fall in prices as the equity market. The difference in order balances between the equity and derivatives markets manifested itself as a delinkage between the markets. Hence, the derivatives and equity markets may not have been as separated as the regulators have implied.
  73. What caused the GFC?
    The origins of sub-prime lending date back to just after the Second World War when the US government established Freddie Mac and Fannie Mae, which were charged with the responsibility of getting loan capital to lower socio-economic households (sub-prime lending) in order for them to secure a housing mortgage. Several key events and economic circumstances occurred that sparked the interest of mainstream banks and lending institutions to enter the sub-prime market. First, the Glass-Steagall Act of 1933 was repealed in 1999, allowing banks to engage in both commercial activities and investment banking. Glass-Steagall was originally enacted because it was believed that the combination of the two led to excessive risk taking. Second, the economic conditions in the early 2000s were very stable, highlighted by low inflation, steady economic growth and general prosperity. These conditions spurred an investment appetite for new opportunities. Meanwhile, banks had entered the sub-prime mortgage market and through a series of lending innovations created securities called collateralised debt obligations (or CDOs).CDOs were securitised mortgage portfolios that contained both risky subprime mortgages and lower risk mortgages. An underlying assumption behind sub-prime lending practises was that house prices would continue to rise as this provides protection to lenders against default on the loan. However, in early 2007, the residential housing market started to show signs of weakness and as house prices fell, loans began to default. As borrowers started to default, the situation spiralled as defaulting properties were sold onto a depressed housing market by the lenders, thereby putting further downward pressure on prices. As the underlying mortgages defaulted, it was a natural extension for the CDO package to start defaulting on payments. The first major signal of collapse was the near failure of two large hedge funds run by Bear Sterns. The first major institution to collapse was Lehman Brothers, which triggered widespread fear that the entire financial system was on the brink. Banks reacted by tightening their available capital and calling in loans. In the wake of capital rationing, businesses deferred major projects and tightened their control of cash. This in turn, put pressure on spending, investment and employment. The consequence was a major decline in economic conditions that we now refer to as the global financial crisis. There is great debate as to the primary causes of the global financial crisis and this should be an open question. However, some key elements include the relaxation of regulations that allowed banks to take on excessive risk through financial engineering, lending practises that encouraged financing to people that could least afford loans, decreasing house prices, and uncertainty in the financial markets.
  74. Why do fund managers devote resources to research?
    Fund managers undertake research because they may believe the market to be inefficient. The results of their research may lead to profitable opportunities. As fund managers are rewarded partly on the basis of performance, there is a clear incentive to search for profitable opportunities. Moreover, even if a fund manager did believe in market efficiency, they might need to be seen by their clients as believers in inefficiency. Hence, in order to maintain confidence with their investor base, the fund manager undertakes research. Further, research activity may be a form of insurance to a fund manager. That is, the fund manager may not have a deep conviction one way or another in relation to the efficiency debate but undertakes research to assure themselves and to make sure that any profitable opportunities are not missed. Note that if fund managers and other investors do not take perceived profits as they arise, then perceptions of inefficiency would remain.
  75. If fund managers devoting resources to research was suddenly stopped because of a widely held belief in market efficiency, what would be the implications?
    Arguably, research is in action which makes the market efficient. Believers of market efficiency argue that it is the existence of believers in market inefficiency that keeps the market efficient. The irony is that investors who seek to exploit market inefficiencies by their own actions ensure that any inefficiency is eliminated. Competition among investors trading on perceived inefficiencies helps to maintain efficient prices. Research by fund managers may fit within this argument. That is, it is the research activity undertaken by funds which helps maintain an efficient market. If this research was stopped, inefficiencies may prevail.
  76. What are the implications of a difference between price and value of a security?
    When considering any investment, the investor will assess the value of the asset and then compare this value to the current price of the asset. The assessment of value is subjective and investor specific, whereas price is objective and determined in the market. If the asset’s value is less than its current price then the asset is over-priced and the investor will either leave the asset out of their portfolio or seek to short sell the asset at the prevailing market price. Conversely, if the asset’s value exceeds its current price then the asset represents a bargain to the purchaser and its purchase is expected to increase the net wealth of the investor’s portfolio.
  77. How can we move from the general present value model and arrive at the dividend discount model?
    The present value model applied to shares becomes the discounted value of all future dividends. The key is to invoke an assumption of constant growth indefinitely such that all future dividends can be expressed as a function of the current dividend. For example, next period’s dividend is the current dividend plus the incremental growth. The growth assumption enables the valuation formula to collapse to three components: the current dividend, the constant growth rate and the discount factor (cost of capital).
  78. Compare the dividend discount model (DDM) ad earnings capitalisation model (ECM)
    The dividend discount model (DDM) and earnings capitalisation model (ECM) are both based upon the present value model. Hence, both models start from the same base of attempting to forecast future cash flows and discount them back to the current time. The difficulty with the present value model is forecasting the future cash flows. To make this task easier, various assumptions can be invoked. The DDM invokes the assumption of a constant growth rate indefinitely while the ECM assumes zero growth. It can be shown that the ECM flows from the DDM. Hence, the models are internally consistent. The key is to recognise that each model makes different assumptions about future cash flows and therefore their applicability depends upon the relationship of these assumptions to the actual circumstances.
  79. The dividend discount model has been criticised because of its simplistic assumption about a constant rate of growth. As such, it is unable to cope with situations of no growth, delayed growth and variable growth. How would you respond to this criticism?
    Most valuation models have a sound theoretical base. However, as valuation models require estimates of future events these are subject to the problems of forecasting. Hence, necessarily there is subjectivity in the practical implementation of valuation models. That is, the problem is not the model itself, but rather obtaining the necessary values of the input parameters to implement the model. The present value model requires estimates of future cash flows and assumptions can be made to simplify the forecasting task. However, the assumptions themselves usually require further subjective input such as a growth rate in the case of the dividend discount model. Moreover, any model which is based on the present value concept requires a discount rate which incorporates the time value of money and relative risk. There are many different approaches to obtaining values for the input parameters, especially the growth rate of cost of capital. Most approaches seek to utilise available data to provide some objectivity to the task. Examples include trend lines based on past data, time-series models such as martingales, expert forecasts, formal models (e.g. the CAPM), inverting of valuation models where the price is known and the use of other financial data (e.g. the plowback technique). No one approach will always provide the most accurate estimate and hence each technique results in estimation, and ultimately, valuation errors. The extent of the error depends upon individual circumstances prevailing at the time. However, it is not uncommon for small input errors to result in large valuation errors, especially when the values of the cost of capital and growth rate are close to each other.
  80. What is the free cash flow model and what is its relationship to the present value concept?
    Free cash flows (FCF) are generally defined as those cash flows which remain in the business after meeting all expenditure and investment outlays. That is, FCF can be viewed as the residual cash available for distribution to shareholders. If the FCF is valued then this is the same as valuing the potential cash dividend stream. The advantage of using FCF rather than dividends as the focus of valuation is that dividends are difficult to forecast because of such factors as sticky dividend policies. FCF is a different way of viewing dividends. First, FCF are derived from reported numbers on which future estimates are usually available. Second, FCF are taken from the overall firm perspective (rather than per share). The FCF approach still involves present value principles as the FCFs are discounted back to a present value. Thus, the concept is simply another way of estimating future cash flows within the context of the general present value model. The FCF approach requires a forecast of each of the component FCF items and arrives at a series of FCFs which are then discounted at the appropriate cost of equity. However, the components in the FCF calculation are linked. The rate of return on investment outlays yields the earnings figure, and the growth of the firm yields the investment outlay. An advantage of the FCF approach is that these links reduce the need for many separate forecasts.
  81. Distinguish between growth shares and value shares
    • If the recorded value of equity is divided by the number of shares, we arrive at a value of equity per share which is known as the ‘book value’. This value is simply one way of measuring the worth of equity. Another, more realistic value is to rely upon the market’s current assessment of value by measuring value at the current market price. The market value of the total equity is the number of shares on issue multiplied by the market price per share.
    • Broadly defined, growth shares have low book-to-market ratios while value shares have high book-to-market ratios. It is argued that firms coming off a low profit base but undertaking expansion through growth opportunities will have a relatively low book value as the firm will have a relatively low value of historical assets in place. However, the market value will be higher as it incorporates the present value of the growth opportunities. Thus, the book-to-market ratio will be low. In contrast, value shares are those with a relatively high value of historical assets in place. These firms are generally viewed by the market as having low growth opportunities and hence their market price is low in a relative sense. Therefore, value shares have a high book-to-market ratio. Empirical evidence has shown that value shares outperform growth shares in the long-term.
  82. Why is the book-to-market ratio useful?
    The book-to-market ratio can be shown to be a function of sub-components. The first factor is the cost of equity capital: The higher the cost of equity capital, the greater the ‘riskiness’ of the firm’s equity, which in turn implies a higher book-to-market ratio. Thus, in general, we expect value firms to be of higher risk than growth firms. The second factor is growth: The higher the level of expected growth, the lower the book-to-market ratio. Thus, in general, we expect growth firms, as their name suggests, to have higher expected growth rates than value firms, all else held constant. The last factor is the rate of return on (net) assets in place which is essentially expected profitability: The higher the level of r, the lower the book-to-market ratio. Thus, in general, we expect growth firms to have higher levels of expected profitability than value firms.
  83. What are the relationships between book-to-market ratio, dividend yield, PE ratio, EPS growth, beta and return on assets (ROA).
    P/E ratios and dividend yield are often used as alternative classifications of growth and value. These measures are related to the BV/MV measure because stocks with high growth tend to have high P/E ratios, pay lower dividends and hence have inflated share prices. This is because growth companies have a greater incentive to invest their earnings into profitable projects, potentially resulting in lower dividend payouts and hence, lower dividend yield. The reverse is true for value stocks. As shown in Table 13.1 (in the previous question) the low BV/MV companies (e.g. Woodside Petroleum) are located in high-growth industries such as energy, materials and information technology and are shown to have higher EPS growth, high beta and high ROA. Conversely, companies with the highest BV/MV (e.g. Stockland) usually have low cost of equity capital (as measured by beta), low returns on assets (ROA) and high dividend yield.
  84. What is SWOT analysis and how is it useful?
    SWOT analysis is a useful framework for evaluating competitive position and the effectiveness of corporate strategies. SWOT is the acronym for ‘strengths, weaknesses, opportunities and threats’. SWOT analysis involves a consideration of each of these features. The analysis is designed to aid in the evaluation of a firm’s strategies within the context of the firm’s external and internal environments.
  85. What are technical and fundamental analysis, and are they complements or substitutes?
    Technical analysis relies on the past trends of price and trading volume, whereas fundamental analysis relies upon information about the underlying company’s products, markets and environments. Technicians believe that the market and its trading history convey all the information it requires, whereas fundamentalists believe that a share has some intrinsic value that is reliant upon fundamental economic factors. The two techniques can be viewed as complements. That is, if fundamentalists trade on fundamental information then that information will be reflected in the share price and, therefore, technicians need not worry about the fundamentals. But this point is ironic; the reason why technicians can ignore fundamentals is because there are others in the market that is not ignoring the fundamentals. A similar argument applies in reverse. That is, fundamentalists can ignore the information in past trends because the actions of the technicians ensure that information on past price sequences are incorporated into current market prices. In reality, markets, and therefore market prices, are determined by the actions of both types of investors. In this light, while investors may consider themselves to be technicians and fundamentalists, the prudent investor would likely benefit from both approaches during the stock selection process. In this light, technical analysis should be considered a complement to rather than a substitute for fundamental analysis.
  86. Outline the regulatory framework for financial reporting that operates in Australia.
    In Australia, all companies and securities regulation is governed by the Corporations Act 2001 which is administered by the Australian Securities and Investments Commission (ASIC) and its subsidiary bodies. Under the law, all companies are required to lodge an annual return with ASIC. The level of additional reporting requirements then depends upon the nature and constitution of the company. The Corporations Act 2001 requires every company to keep an accurate set of accounts from which annual financial statements can be prepared. The financial statements must be drawn up in accordance with approved accounting standards. In circumstances where this results in a departure from a ‘true and fair’ view, the directors are required to make additional disclosures to present a true and fair view. For most large companies, the financial statements must comprise a profit and loss statement, a balance sheet, a cash flow statement and any notes and reports connected with these items. Generally, the annual accounts must be audited. Approved accounting standards are issued by the Australian Accounting Standards Board (AASB). These standards govern the recognition, measurement and disclosure rules for corporate accounting. In addition, the Corporations Act requires disclosure of specific key items. Companies listed on the Australian Stock Exchange (ASX) must also comply with business and listing rules issued by the ASX. The listing rules require disclosures in addition to that required under the Corporations Act.
  87. What is the continuous disclosure regime?
    The continuous disclosure regime requires disclosing entities to lodge with the Australian Securities and Investments Commission any information that is not generally available and that it is reasonable to expect to have a material effect on the price or value of the entity’s securities. In the case of listed companies, continuous disclosures must be made with the ASX. In addition to price sensitive information associated with the company’s activities, projects and financing, this information includes items such as alterations in share capital, changes in directors, shareholder resolutions, dividend recommendations and results from drilling tests for mining companies. However, there is an exemption from disclosure if the information is considered confidential. The criterion of confidentiality is difficult because of its subjectivity but examples may include new major contracts, executive pay, plans for expansion and research and development findings.
  88. What is DuPont analysis?
    Involves breaking the ROE into its component parts. ROE has three components representing profit margin, asset turnover and leverage. Profit margin represents how efficient the firm is at converting revenues to profits. Asset turnover represents how efficient the firm is at making investment decisions involving capital expenditure and utilising those resources in generating revenue. Leverage represents the impact of financing decisions on the overall profitability of the firm. DuPont analysis provides information about the strengths and weaknesses of a firm by focussing on these three components. Differences in rates of return may be observed across firms but DuPont analysis provides the analyst with some insight as to what factors cause the differential ROEs.
  89. How do we calculate Net Profit Margin?
    Net Profit Margin = Operating Profit After Tax / Operating Revenue
  90. How do we calculate interest coverage?
    Operating Profit Before Interest and Taxes / Interest Expense
  91. How do we calculate business risk?
    • As measured by the coefficient of variation of operating profit (CVOP):
    • CVOP  =  Standard deviation of operating profit before interest / Average Operating Profit Before Interest
  92. How do we calculate sales variability?
    • As measured by the coefficient of variation of sales (CVS):
    • CVS  = Standard Deviation of Sales Revenue / Average Sales Revenue