Analyzing RBA's Tools & Modern Portfolio Theory: Bond Prices, Rates, & Monetary Policy, Exams of Finance

Download Analyzing RBA's Tools & Modern Portfolio Theory: Bond Prices, Rates, & Monetary Policy and more Exams Finance in PDF only on Docsity! Capital Markets (Additional) - Wall Street Prep Study Guide What did the S&P 200 close at last night The S&P 200 closed around (figure) yesterday and opened lower this morning after reports of (reports). - Important to discuss recent trends and developments driving equity valuations over the past few months and years. What's your near-term and long-term outlook on the equity markets? - State current level of the market and the prevalent trends in the market. - Then, talk about key catalysts that could move the market and specific developments you would be looking out for. - Try to mimic the banks own research and views.  Sample: “First off, I know your bank’s Year-End target for the S&P500 is 4,000. I am personally slightly more bearish with the view that the S&P 500 will trade range bound and close the year at the same point we are now. Overall, the S&P 500 is trading at a P/E ratio of 36, which is quite high on a historical context. Most of the positive news on the COVID recovery has already been priced in, and I feel a shift in sentiment or flows can send stocks lower. We are approaching quarter-end, and with stocks outperforming bonds this quarter, I would expect some investors to sell stocks and buy bonds for rebalancing. Although I am slightly more bearish, I don't think there's a risk for a broad market crash. The Fed has shown strong support for the market. We are seeing the Fed ease up on some support in the market. The S&P 500 is already higher than where we were pre-COVID, and my view is that the Fed will continue to remove support for the market if we move higher, limiting the upside gains in the market and causing us to trade on a range- bound basis.” Brainpower Read More What do you think the RBA is going to do at their next meeting? - When is the next RBA meeting? - What is the current RBA Target Cash Rate? - What was the RBA's action at the last meeting? - What is the RBA implying? Sample Response: The next FOMC meeting will be on November 5th. The current Fed Funds Target rate is between 0 and 25 basis points. The Fed has held this rate steady since the emergency meeting in March when the Coronavirus crisis began. The market is not expecting any change to the Fed Funds Target Rate, and I'm not either. I'll be watching the Fed closely to see if they're planning to change the language or guidance of their asset purchase program. With the stock markets near all-time highs, I would expect the Fed to remove some asset purchases modestly they have promised but gradually as to not spook the markets. What is the treasury yield curve, and what does it shape tell you? The yield curve is just a plot of the relation between the yield and the term of otherwise similar bonds. The treasury yield curve plots treasury bond yields across their terms and is the most widely used yield curve as it sets a "risk-free" benchmark for other bonds (corporate, state government, etc.) A treasury yield curve is usually upward sloping because, all else being equal, an investor would prefer a one year, 3% bond than being locked into a 30-year, 3% bond. However, investors' expectations about future interest rates affect the slope as well. When investors expect the RBA to raise short-term interest rates in the future, investors will decrease demand for short-term treasuries to avoid getting locked into a low but soon-to-be-higher short-term rate. This decrease in the relative demand for short-term treasuries will raise short-term yields and flattens the yield curve. What does an inverted yield curve tell you? An inverted yield curve means that yields on longer maturities are lower than shorter maturities of otherwise comparable bonds, like treasuries. Normally, yield curves are upward sloping as issuers must pay a premium to entice investors to keep their capital locked up for a longer term. When the yield curve inverts, it is usually an indicator of an economic slowdown and recession. In fact the last 7 recessions were preceded by an inversion of the yield curve and it is considered a strong leading indicator by economists and investors alike. The inversion happens as investors anticipate market interest rates to decline down the road (presumably because they expect a slowdown and thus expect monetary policy makers to eventually lower rates to stimulate the soon-to-be slowing economy) and thus prefer the safety of long term maturities at the current higher rates over investing in shorter maturities and having to re-invest at the lower expected future rates. In terms of yield curve jargon, what does an upward sloping yield curve, inverted yield curve, steepening yield curve, and flattening yield curve imply? Upward Sloping: Long-Term Government Bond Yields > Short-Term Government Bonds Yields Inverted Sloping: Long-Term Government Bond Yields < Short-Term Government Bonds Yields Steepening: The interest differential between Short-Term and Long-Term bonds is increasing Flattening: The interest rate differential between Short-Term and Long-Term bonds is decreasing.  Why amongst the economic turmoil in 2020 did the equity markets recover faster and the economy? While there are many potential for the strong market performance, one potential reason is due to the role risk-free rates has when valuing equities. Since 10-year government bonds were trading at very low yields, many institutional investors felt they had no choice but to invest in stock of large, multinational companies with a high likelihood of making it through this period, if not benefit from the lock-downs. What tools does the Australian government have to combat inflation or hyperinflation? The Australian government targets an inflation rate of 2-3% on average, over time. To keep inflation around this target range, the Australian government has monetary and fiscal policies it can use to maintain a stable, long-term inflation rate. Monetary Policies: Monetary policies involve action taken by the RBA to control the money supply and demand to maintain substantial economic growth. These policies can be classified as either expansionary or contractionary. Expansionary policies increase the liquidity of the money supply, whereas contractionary policy decreases the liquidity of the money supply. Examples of these policies would include The consumer price index (CPI) is used to measure the change in prices that consumers pay for goods and service on average, over a period. It measures the cost of purchasing a given basket of goods and services relative to a base year. Would you agree with the statement that deflation is worse than inflation? Deflation is the macroeconomic condition when a country experiences decreased prices. While initially, consumers may enjoy the lower prices, this cuts into the profit margin of companies. THen begins the cycle of employee layoffs, reduced pay, cutbacks on spending by companies and a overall contraction in the economy. This deflationary spiral will eventually lead to reduced investments made by companies to conserve cash, less overall economic growth, and increases in bankruptcies as borrowers cannot pay back loans. So from many economists' perspective, deflation is more serious than inflation as deflation is more difficult to control. An example of the deflation's long lasting effects can be seen in Japan, where even after decades of near-zero interest rates and quantitative easing efforts, the country still struggles to get prices rising (albeit they are too high now). Stock Pitch Structure Sample Fundamental Initial Pitch “The company that I’ve chosen to pitch a long-position on is Genasys (NASDAQ: GNSS), a provider of mission- critical communications and emergency management solutions. Genasys has three business segments, with the first segment being its Public Warning System (PWS) software, a location-based messaging platform for emergency messages sent out via mobile devices. This software benefits from the trend of critical communications solutions, and its use case is comparable to AMBER Alert. In 2019, the EU mandated its member nations to deploy country-wide PWS by June 2022 (Regulation Article 110 of the EECC), which should serve as a secular tailwind for Genasys. Next, Genasys offers Long Range Acoustic Device (LRAD) and Acoustic Hailing Devices (AHD), which are types of speaker systems that provide long-range audio sirens to bring attention to an emergency or hazard in real- time. This segment is a legacy business, and industry growth has been on the lower end, but there are very few competitors of comparable size, and Genasys appears to have carved a defensible niche. Most of the customers for these products are specialized for the defense, law enforcement, and the military end markets, which fluctuate based on governmental budgets and depend on securing contracts. However, Genasys is becoming the global leader for LRAD systems, as shown by a recent $14.5mm follow-on AHD order with the US Army and a $4.3mm IDIQ contract with the US Navy. Genasys’ third segment offers Integrated Solutions, which combines hardware and software in a single system and represents the company's greatest growth potential, as it has a significantly larger market to sell. Large enterprises are signing contracts now, as shown by the recent telecom carrier contracts announced in Australia. In terms of M&A, Genasys made a complementary acquisition of the Ottawa-based emergency communications company, Amika Mobile. This continued geographic expansion through M&A, the long-term customer contracts, and how the company's products are gradually becoming requirements by regulatory bodies worldwide all decrease the downside risk of Genasys. Genasys’ software business represents a relatively minor percentage of total revenue at the present day. I am under the belief that the continued build-out of its software platform and the upcoming regulations on public safety will be catalysts leading to significant incremental value creation over the next few years and drive higher profitability, as seen by its Q3 2020 ~$12mm in revenue (35% YoY growth) and ~54.1% gross margin. The latest closing price of Genasys was $6.78. The share price has appreciated 100%+ from trading around $3 at the beginning of 2020 and may no longer be undervalued, but this could be a growth play with more upside potential remaining. I believe the future growth (especially in the EU) and the value of the multi-year contracts are being ignored at the current share price. Based on my valuation, I believe Genasys should be trading around ~$8.15 (approximately 20% upside), and this positive upward trajectory should continue to gain momentum as we enter 2021 and get closer to 2022. By then, more countries, other than just the EU and US, would have increase regulatory requirements for PWS and LRAD related hardware and force adoption – thus, making this opportunity a promising long-term investment. Sample Trading Initial Pitch: “The stock I would like to pitch is Medpace Holdings (NASDAQ: MEDP). They're a mid-sized contract research organization that performs clinical trials for biotech firms to get new drugs approved. Medpace primarily operates on a fee-for-service basis, meaning they get paid whether or not the drug is successful but get paid more for successful trials as those run longer and have more fees. Medpace focuses on smaller biotech firms, which have seen a surge of venture capital funding. This VC funding pays for the services of Medpace to see if potential drugs can get FDA approval. There is a lag in timing, so the funding we are seeing now will show up on Medpace’s future earnings. Compared to its peers, Medpace is well- positioned. Labor costs are a big input in Medpace’s business but are lower when compared to its peers. Medpace has consistently delivered above averages, strong profit margins. The stock is trading at $116, which is in the middle of a wide 52-week trading range of $58 to $144. The current trailing or backward-looking P/E ratio is 41x, which feels high on a standalone basis, but is negatively impacted by COVID related lockdowns slowing existing clinical trials. On a normalized forward basis, it's a quite reasonable 24x. I believe that stronger revenue growth and EPS growth will drive the stock price higher. I think we can easily see the stock trading closer to $130 in the next six months with annual EPS ticking up to $4.33 with a 30x P/E ratio." Let's say you're about to analyse an investment opportunity on a public company. What are some questions you would ask? - What is the company's mission statement and what value do they provide to their customers? - What is the background of the management team, how long have they been running the company, and what is their track record? - What is the business model? How does the company generate cash flow? - What types of products/services does the company sell? Would you consider them to be valuable? - What is the company's strategy to achieve growth? Has its strategy adapted alongside the market? - What are the end markets to whom the company sells its products/services? - How has the company's financial performance been in recent years? - Is the company's cash flows sustainable? Does its revenue have a recurring component? - What are the risks to the company's cash flows? How competitive is the market? - What are the growth prospects of the cash flows? Where do you predict revenue growth and opportunities to create profitability to come from? - What has earnings per share (EPS) been historically, and how has it been trending in recent years? What are some of the various investment strategies employed by hedge funds? 1. Long-Short Equity: Involving picking winners and losers based on the fundamental analysis of companies; The long-short offsetting pairs reduce the overall market risk. 2. Event-Driven Investing: Pursues pricing inefficiencies before or after major corporate events such as mergers, acquisitions, and spinoffs - either looking for potential M&A targets or seeking to trade the acquisition premium on announced acquisitions.  3. Activist: Activist funds seek underperforming companies they believe are poorly managed and attempt to be the catalyst for a successful turnaround. 4. Quants: Includes systematic, rules-based, algorithmic trading, proprietary strategies, momentum, mean reversion, and high-frequency trading (HFT). 5. Arbitrage/Relative Value: Seeks pricing inefficiencies/mispricing and trading spreads within an asset class (e.g., volatility arbitrage in the options market, convertible arbitrage in stock vs. convert trading).  6. Long-Only: Often associated with value investing, long-only funds only take long positions on the common equity of companies they believe are undervalued with a long-term holding horizon. 7. Short-Only: Short-selling specialists pursue overvalued stocks. However, the most prominent short-only funds are associated with uncovering accounting frauds or other types of malfeasance.  8. Market Neutral: Like a long-short fund, but will pair long and short trades to mitigate market risk.  What is the investment rationale behind the long-short strategy? When an investment firm goes "long," it purchases a stock that it believes will increase to turn a profit. The opposite being the firm goes "short" on companies with share prices they expect to decrease. So if the share price goes down, the firm profits. Each equity investment contains some components of market and industry and company-specific risks. The objective of long-short investing is to hedge the market risk (i.e., cancel out the market risk). and then the industry and company- specific risk to some extent, so they're not on the wrong side in case the economy's trajectory suddenly flips. How does a long-short fund differ from an equity market-neutral (EMN) fund? A long-short fund and an equity market-neutral fund ("EMN") are closely aligned, and at an initial glance, they appear to share the same goal. The difference is that a market-neutral fund will ensure the total value of long and short positions are close to being equal as possible to lower the portfolio risk, which is closer to the original intent of a hedge fund. trends in the market - hoping the trend persists. The difference from GARP investing is that momentum investing relies more on technical indicators to decide trades, rather than being value-oriented and looking for high-growth but still undervalued companies. The holding period is shorter in momentum investing as it intends to take advantage of trends that are often driven by human emotion, which coincides with overvaluations of certain equities. How does momentum investing differ from mean reversion? Momentum Strategies: Momentum-based strategies rely on the continuance of existing market trends to ride the upward trend. Recently, securities (or a specific asset class) have performed well, and these investors believe there's still more upside remaining for profits to be made. Mean Reversion Strategies: Mean reversion based strategies pursue unusually large drops or increases in pricing due to market over-reactions (either oversold or overbought) and then place bets that the price will revert towards the mean.  How does quant vs. human investment strategies compare? Systematic Strategies Rules-Based: Investments are unaffected by emotion - the most frequently cited reason for misjudgement. Data Capacity: Systems can interpret and analyse more data and inputs in volume and speed. Machine Learning (ML): Systematic strategies will adapt and continuously improve over time.  Back Tested: These systems can identify which specific strategies would have worked in the past to help guide future decisions (i.e., run simulations of how a strategy would have performed).  Human Traders Adaptability: Traders are more experienced, can adjust to market changes, and can pick up sudden sentiment changes that computers cannot capture.  More Resourceful: Capable of capturing more market colour and feedback that's not in electronic format (e.g., salesperson calls, investor presentation meetings).  How does a hedge fund with a global macro strategy invest? A hedge fund with a global macro strategy bases its investments on the overall economic and political environment. The relations between countries and macroeconomic trends can affect numerous financial instruments. Thus, a global macro fund holdings are more diverse relative to traditional hedge funds and include common equity, fixed income, currencies, futures on commodities, and other specialised options. The strategy will shift based on changes in economic policies, global events, and changes in foreign policies/regulations as these present the investment opportunities that these global macro funds seek and then actively pursue. The fund's focus will often be on liquid broad indices rather than specific equities, which is why macro hedge funds are very active in rates, currencies/FX, commodities, and equity indices. Most large institutional asset management firms are multi-strict. What does this mean? Most institutional investors that manage billions of dollars, such as Blackrock, are considered multi-strat, which is a catch-all term for having a diversified combination of investment strategies. Given the various strategies employed, this type of approach provides more stability in returns and has more downside protection. For example, a multi-strart investment firm will invest in equities, bonds, real estate, and private equity to spread its capital allocation and de-risk its portfolio holdings. Considering their AUM, capital preservation often takes priority over achieving outsized returns. Why would it be incorrect to compare a hedge fund's returns to the market return? Traditionally, hedge funds were never intended to be investment vehicles to "outperform" the markets. Instead, hedge funds provided their investors with decent risk-adjusted returns regardless of the market conditions. As the name suggests, they serve as a "hedge" against the market, and wealthy investors would park a small portion of their wealth into funds, rather than placing 90% + of their net worth into these funds, as many people falsely assume that they do. During both bull and bear markets, funds would have relatively decent returns. Many investors, particular those in favour of long-term value investing, criticize the high active management fees. and argue that index funds would be a better strategy, but under the false presumption that hedge funds LPs share the same belief system as them. However, over the years, the objective of hedge funds has significantly shifted, and many fund managers explicitly aim to outperform the market in both bull and bear markets. Why does it become more difficult to achieve high returns as a fund grows in AUM? If the assets under management (AUM) of a firm grow, achieving high returns becomes increasingly difficult. The reason being large firms are considered "market movers," meaning each of their actions is closely followed and the sheer size of their investment alone cause the pricings of a stock to move up or down. For example, if a large firm sells its shares, other investors in the market could assume they're selling for a reason (i.e., under the belief the firm has more information than them), purchase demand will shrink, and the price will fall. Given the reasons above, large asset managers cannot invest in small-cap stocks, and instead, they're limited to invest in large-cap stocks since the impact their decisions have is lessened. But because large-cap stocks are widely followed by equity research analysts and investor alke, these assets are more efficiently priced. Hence, many small-cap oriented funds place a cap on their AUM, even if they could raise more capital. These firms specialise in small-cap companies, where they believe the likelihood of finding mispriced securities in higher and they could achieve the highest returns for their investors. Tell me about the Modern Portfolio Theory (MPT) Introduced by Economist Harrow Markowitz, the premise on which the Modern Portfolio Theory (MPT) is built upon is that "efficient portfolios" can be constructed in which the expected return can be maximised for a level of market risk with proper allocation. Simply put, MPT is maximising the return investors could achieve from their portfolio while bearing the least amount of risk possible (for their targeted return). A central idea of MPT is that an asset shouldn't be assessed as a standalone investment from a risk standpoint but based on its contribution to the overall portfolio. Meaning, the portfolio beta matters more when selecting investments for a portfolio, rather than considering only the asset's individual beta. The relationship between risk and return of various portfolios would be plotted to determine the optimal asset allocation at each risk level where the expected return is maximised. Although systematic risk is unavoidable, diversified assets in a portfolio that are not correlated with one another can reduce the unsystematic risk of a portfolio. In a well-diversified portfolio, the total risk in the portfolio should be mostly systematic risk. What is the Sharpe ratio and why does it have such popularity among investors? The Sharpe ratio was developed by William Sharpe, who is also responsible for the CAPM model. The ratio is one of the most widely referenced metrics in academics, certain institutional investors, and everyday investors due to its simplicity. The use case is to assess the risk/return of a portfolio, or an individual investment, although most use it for a group of investments (e.g., mutual funds). The Sharpe ratio begins by subtracting the risk-free rate to isolate the excess return of the portfolio. The excess return is then divided by the portfolio's standard deviation (a proxy for portfolio risk). A risk below 1.0 would be considered a sub-par portfolio return considering the risk undertaken, while a ratio above 1.0 being acceptable and beyond 2.0 is rated as a well-performing portfolio on a risk-adjusted return basis (with 3.0+ being exceptional). The frequent critique of the Sharpe ratio is how total portfolio risk is proxied by the portfolio's standard deviation, which is an oversimplified assumption that all equity returns are on a normal distribution. For this reason, there are many variations of the Sharpe ratio that account for portfolio risk in different ways, such as the Sortino ratio, which uses downside deviation rather than the total standard deviation of portfolio returns. Why do many investors disregard equity research reports? An equity research report is a document that provides a formal recommendation on whether investors should buy, hold, or sell shares in a specific public company. However, most equity research analysts have an inherent bias to be more positive about a stock. Equity research analysts have an incentive to give "buy" recommendations to maintain close relationships with the company's management team being assessed. If an equity research analyst structinises a company, it may not take future calls from that analyst. THe investment banking division may also indirectly benefit if the company has a close relationship with the equity research division. This could lead to assignments helping the company if it raises capital or makes an acquisition in the future. The skewed rating system is well known across the market; for example, if an analyst issues a "hold" recommendation for a company, this is usually interpreted as a very negative signal by the investor community. In addition, equity research analysts are legally restricted from investing in the companies under their coverage group due to regulations to prevent a conflict of interest. For these reasons, it's important for investors to not take equity research reports at face value and instead make their own decisions. What is the argument for and against quarterly earnings reports? Many prominents CEOs and investors such as Jamie Dimon and Warren Buffett expressed their agreement with modifying the quarterly filing requirement, under the reasoning that quarterly reporting places too much pressure on the management teams to meet quarterly EPS and earnings expectations.  Counter Arguments - Management teams that desire longer gaps between reporting periods could be hoping to conceal their poor performance. Although many acknowledge quarterly reports can lead to short-term oriented decision-making at the expense of a long- class or particular risk and construct a portfolio of holdings that are not correlated while still attempting to maximise returns (i.e., nearly all unsystematic risk is eliminated). The chosen investments shouldn't be correlated with one another, or else that would defeat the purpose of diversification. Broadly, could you define what value investing entails? Value investing could be best described as the strategy of finding temporarily mispriced stocks trading for less than their intrinsic values, under the belief that the market is undervaluing these companies. From their viewpoint, these opportunities arise because the market is emotional and often overreacts to good or bad news, resulting in share price movements that incorrectly align with the company's long- term fundamentals in question. By purchasing equities at deflated prices, they seek to profit from share price appreciation once the market corrects itself. To recap, value investing is essentially attempting to capture some level of disconnect between the current trading price and the company's true intrinsic value (that's not immediately apparent to the market). The value investor will then attempt to identify the catalyst that would make the market realise the company is undervalued, but by then, the investor would have purchased the security at the discounted price. What does it mean when a security has a sufficient margin of safety? A margin of safety is one of the fundamental concepts of value investing in which a security is purchased only when the share price is significantly below its intrinsic value. The margin of safety serves as an investor's downside risk protection and can be thought of as the difference between the estimated intrinsic value and the current share price. Said another way, the margin of safety is the buffer that value investors place into their investment decision making to protect them against downside risk if the share price drops post-investment. Rather than shorting stocks or purchasing puts, many value investors view this as their primary method to mitigate investment risk. Often, many value investors will not invest in a security unless the margin of safety is ~20-30%. If the MOS hurdle is 20%, the investor will only purchase a security if the current share price is 20% below the intrinsic value based on their valuation. How do you determine whether a company has an "economic moat" or not? An "economic moat" is the competitive advantage of a company and the factors that protect its profits from competitors. The moat will be evident in the company's unit economics (e.g., consistent operational performance, high margins) and is caused by any unique advantages. Such as patents, proprietary technology, branding/reputation, product or service value, switching costs, or network effects. These traits shouldn't be easy to replicate by other competitors in the market and come with barriers such as high switching costs or capital requirements. It is a company's ability to maintain its competitive edge over its competitors to protect its continued long-term profit generation. The strong and more defensible a company's competitive advantage, the more difficult it becomes for other entrants to breach this moat and take away their market share. Why would an investor use the "Scuttlebutt method?" Coined by Phil Fisher in his book "Common Stocks and Uncommon Profits," the Scuttlebutt method refers to investing based around going out and conducting your own proprietary research (i.e., listen for rumours, observe surrounding developments, observe stores), rather than just reading equity research reports and financial news, and relying on the opinions of others. This type of diligence involves talking to all kinds of people (e.g., customers, employees, industry experts) to gain their insights and identify trends by gathering your information and then making investment decisions based on your intuition. Why does Warren Buffet dislike the EBITDA metric? Warren Buffett and Charlie Munger are both known for having a particular distaste for management teams and equity research analysts using the EBITDA metric. In Berkshire Hathaway's 2000 shareholder letter, Buffett famously wrote, "References to EBITDA make us shudder - does management think the tooth fairy pays for capital expenditures? We're very suspicious of any accounting methodology that's vague or unclear since too often that means management wishes to hide something." Given how EBITDA neglects capex, Buffet doesn't believe EBITDA is a true representation of a company's financial performance. Failing to account for capex would particularly apply to capital-intensive industries such as manufacturing. What is Warren Buffett's view on the capital asset pricing model (CAPM)? Warren Buffet has a negative view on the capital asset pricing model (CAPM) due his disagreement with beta as a measure of risk. From his perspective, CAPM is ineffective because it mistakes volatility as a risk when in reality, it could represent an opportunity to purchase undervalued securities (rather than being a sign it's a risky, less valuable investment that should be avoided). Buffet has been very outspoken about this topic, going as far as calling beta nonsense, and has stated how in his and Charlie Munger's opinion, "Volatility is no measure of risk to us.: Instead, Buffet defined risk as "the possibility of harm or injury." Contrary to what's taught in academic literature, volatility doesn't equate to risk according to Buffett. This means that the higher the chance you might lose your initial capital, the riskier the investment is. How you determine the probability of losing your capital is based on the quality of the fundamentals of the business, the margin of safety (pricing vs. intrinsic value), and doing enough research into every aspect of the business as risk comes from ignorance. What is the difference between value investing and deep value investing? Value investing and deep value investing are price-focused strategies to profit from companies trading at a discount to their NPV. While the definition is subjective, deep value investors are distinct for refusing to pay a higher price for quality. This means they're often willing to make reasonable bets on cheap equities despite a clear deterioration in quality, including weak recent financials, ineffective growth strategies, and incompetent management teams. The reasoning behind this is that deep value investors believe quality is already priced in. Thus, the only way to make outsized returns in the market is by searching for opportunities where the investors have overreacted to bad news (often terrible news) on underperforming companies. Many deep value investors speculate on a new turnaround strategy once rock bottom has been reached, as this would imply a restructuring of some sort, such as a new management team and the sale of non- core assets. An activist investor may frequently step in and help initiate a change of course for the business, precisely the type of catalyst the deep value investor is waiting on. How do value investors deal with volatility in share price movement? Simply put, value investors have a long-term thesis and therefore ignore short-term movements. Often, a value investor will hold a security for 5+ years and invest with the mindset of "never selling". Explain to me what the purpose of dollar-cost averaging (DCA) is. Commonly recommended by practitioners of value investing, the practice of dollar- cost averaging (DCA) refers to committing to buying shares at predetermined intervals. This can be useful during periods of market volatility and prevent an investor from attempting to "time the bottom." If the stock price decreases, then the investor can simply purchase more to lower the average cost paid on a per-share basis. But if the price increases, the investor can either continue purchasing (if still undervalued based on their beliefs) or pursue other opportunities in the market. Explain the growth at a reasonable price (GARP) investment strategy? Growth at a reasonable price (GARP) is a hybrid investment strategy that combines growth investing and value investing. GARP could be best described as profiting from a company trading at a material discount on an earnings basis but not to the same extent as traditional value investments. The GARP investment strategy is based on finding high-quality companies with a sustainable competitive advantage, above-market consistent earnings growth, and large market potential. Then, the NPV of the cash flows will be determined with the growth potential incorporated to see if the company is undervalued. While this is not necessarily pure value investing, it's a reasonable compromise that many investors have adopted. What are value traps? Investors new to value investing will frequently fall into the so-called value trap. This fallacy is the false belief that a particular stock is currently undervalued because it has fallen out of favour with the market and dropped significantly in recent weeks or months. Because these investments appear to trade at such low levels compared to prior levels, many investors will view this as a buying opportunity. However, the fall in price is misleading, as there's usually a good explanation for the decrease in valuation. Explain the efficient market hypothesis (EMH) and its three forms? Introduced by Eugene Fama, the efficient market hypothesis (EMH) theory asserts that asset prices fully reflect all available information. Following the release of new information or relevant data, prices will automatically adjust instantaneously to reflect the accurate price within a matter of seconds. Weak Form EMH: The weak form of the EMH states that all past information such as historical trading prices and volume data is reflected in current asset prices. Semi-Strong EMH: The semi-strong form of the EMH states that all publicly available information is reflected in current asset prices. Strong Form EMH: The strong form of the EMH states that all public and private information (including inside information) is reflected in current asset prices.  If the efficient market hypothesis were true, what implication would this have on active management? Since the EMH theory contends the current prices reflected in the market already reflect all information, an attempt by an investment manager to outperform the market by finding mispriced securities or timing the performance of a certain asset class in an industry is a game of chance rather than skill. If the efficient market hypothesis were strong form efficient, there would be no point in active management. It is important to note that EMH by its definition is referring to the long-run. Therefore, the amount invested. Most mutual funds are open-ended, allowing for investors to increase or decrease their investment. Mutual funds are typically bought and sold at the end of the day, at the fund's net asset value (NAV). The NAV is the total value of all securities in the fund, plus cash, divided by the number of shares. It's the value of cash mutual fund share as determined by closing market prices. Can you define what an asset manager is? An example of an asset manager would be one that actively manages a mutual fund on behalf of the fund's investors. These asset managers are considered fiduciaries, meaning that they're hired and compensated for advising their investors and making recommendations and/or investments in the best interests of their clients. How do hedge funds differ from mutual funds? The distinction between hedge funds and mutual funds is that hedge funds are not targeted towards retail investors. Instead, only accredited investors can invest as LPs in hedge funds. Hedge funds come with higher risks of losing capital. Thus, these strict qualification rules were put in place to protect the interests of those that can't afford to lose a significant sum of money.In addition, hedge funds are more actively managed, use different strategies, and are resultingly compensated more due to the "2 and 20" compensation model. Would sales & traders be considered as fiduciaries? No, sales and trading professionals are not considered being fiduciaries. Instead, sales and traders work directly with institutional and high-wealth investors that don't require (or request) advisory services. The primary role of S&T is to execute orders on behalf of clients without providing investment advice. What is an ETF? An excchange-traded fund (ETF) is a type of financial product that tracks a specific underlying index (i.e., collection of securities, most often equities). An ETF can be viewed as a blend between a mutual fund (portfolio of investments, passive strategy, benchmarked to index) while being similar to equities by being listed and traded on exchanges. ETFs have become a very popular choice recently due to lower fees and convenience. What is the difference between the initial margin vs. the variation margin? Initial Margin - a fixed amount you need to pay to cover your credit risk - varies based on the volatility of the underlying product - covers the cure period risk of a clearing client not making their variation margin Variation Margin (or Maintenance Margin) - the market-to-market gain or loss you have on your position - cash or collateral is received if your position is in-the-money, but you pay cash or collateral if your position is out-of-the-money.  What is securitsation? Securitisation is when financial instruments are pooled together into one group to become more marketable. The issuer will then sell this pool of repackaged assets to investors (e.g., mortgages pooled together and divided into securitised bonds). By themselves, the assets within the group would not have sufficient liquidity to be sold as a standalone product, but securitisation can allow for the grouped assets to be easily tradable in the market and thus have high liquidity. What are collateralized debt obligations (CDOs)? A collateralized debt obligation (CDO) is a structured-financial instrument backed by a collateral pool, which can include loans and other assets. These underlying assets are offered as collateral in case the loan defaults. Often put together by investment banks, the bankers will collect cash flow-generative assets (e.g., mortgages, bonds, debt) and then repackage them into a pool and customise it based on the level of credit risk the investor is comfortable taking on. The most well-known example of a CDO would be mortgage-backed securities (MBS), a type of asset-backed security (ABS) secured by a collection of mortgages. MBS that consisted of subprime loans played a central role in the housing financial crisis and revealed one weakness of the securitization process: the lack of transparency in the assets pooled. Many felt the combination of collateral concealed the lack of quality to make the MBS appear less risky. In addition, securitization allowed for mortgage originators to originate new, low-quality mortgages and then quickly offload them through an MBS offering. What is an asset-backed security (ABS), and how do they differ from MBS? Asset-backed securities (ABS) function similarly to mortgage-backed securities (MBS). Although mortgages are technically classified as an "asset," the differences lie in how ABS is typically used to refer to financing (e.g., credit card loans, car loans or leases, student debt). In comparison, the ABS market is smaller than the MBS market since the borrowings related to ABS are typically smaller than mortgages, especially in the US. What are collateralized loan obligations (CLO)? Collateralized loan obligations (CLOs) are securities backed by a pool of low-rated corporate loans. CLOs are structured using low-credit rated corporate loans that are bundled together. The CLOs will have many tranches to appeal to different investors from a risk perspective, CLOs would be an example of a CDO but are unique in that usually just business loans are involved, and each distinct class of owners will receive differing yields based on the tranche and risk they're undertaking. What is a forward contract? Forward contracts are formal agreements between two parties in which one party agrees to purchase an underlying asset from the other party at a later date. The future date of purchase and the price at which the purchase will be made will both be stated in the original agreement. What are futures contracts? Futures are derivative instruments that serve as a contractual obligations for two parties to exchange an underlying asset at a predetermined price at a later date. This exchange is completed regardless of the change in the asset's price (whether up or down). The buyer must either buy the underlying asset, or the seller must sell the underlying asset at the pre-specified set price. Historically, futures were most common with commodities such as bushels of corn. Physical commodities would be physically settled, meaning the commodity (e.g., corn, barrels of oil, lumber) would actually be delivered in person. But in today's market, equity and interest rate futures have significantly higher trading volumes in comparison, which don't involve any physical delivery since they are monetary exchanges. (i.e., cash-settled based on the value difference). What is the difference between forwards and future contracts? The two derivatives, forward and future contracts, are similar in that both involve agreements between two parties to buy or sell an underlying asset at a predetermined price by a specified date. The difference is that a forward contract is a private agreement that settles at the end of the agreement term and is traded over- the-counter. A futures contract has more standardised terms (i.e. less customisation) and is traded on exchanges, in which the changes in prices can be readily seen daily until the end of the contract term. How does the spot exchange rate and forward exchange rate differ? Spot Exchange Rate: The spot exchange rate is the exchange ratio of one currency into another currency on a particular day. The key characteristics of spot exchange rates are that they're reported on a real-time basis and determined by the supply/demand of that currency relative to the same supply/demand dynamics of the other currency (i.e., set by the market).  Forward Exchange Rates: In forward exchange rates, two parties will exchange currency at a specific date in the future. These deals are executed to hedge against foreign exchange risk, to which many multinational companies are exposed. Forward exchange rates can be quoted for limited durations (e.g., 30 days, 60 days, 90 days, 180 days). Distinction: The key distinction is that the rate is negotiated and agreed upon by the two parties for forward exchange rates (rather than letting the market determine the rate).  What is the difference between a warrant and a stock option? Warrants: A warrant gives the holder the right, but not the obligations, to purchase common shares of stock directly from the issuing company at a fixed price for a predetermined period. The key distinction is that the warrant is issued directly by a company to an investor. Therefore, if the warrant is exercised, the shares required to fulfil the agreement are issued, so warrants have more of a dilutive impact when exercised because the company will actually issue new stock.  Stock Options: A stock option gives the holder the right, but not the obligation, to purchase or sell shares at a pre-specified price for a defined period. Options are commonly traded amongst investors. THe exercising of a stock option has less of a dilutive impact because no new shares are issued since options are derivatives based on an underlying asset (i.e., the pre-existing common shares of the company).  What is implied volatility? The implied volatility ("IV") is the market's expectations of the movement in a specific security or indexes' price. Implied volatility has a significant role in the pricing of option contracts, as higher IV results in higher premiums (and vice versa). During periods of bearish sentiment, implied volatility typically increases, whereas when the market is bullish, the implied volatility decreases. If the implied volatility were to rise, how would option prices be affected? The implied volatility has a significant impact on the options market. The higher the volatility of the underlying asset (e.g., share price, commodity price), the higher is the price for both call and put options. The reason being higher implied volatility means there's a greater price movement being expected by market participants, thus increased upside and downside potential. As a general proxy, higher implied volatility (IV) indicates uncertainty in the markets that can cause swings in either direction, but it's interpreted as a bearish signal because many equity investors exit the market when there's greater uncertainty. What will happen if North Korea invades Soutk Korea? Sample response: “If North Korea invades South Korea, stocks and stock futures will fall, most notably in the direct market (say the KOSPI) and across the world. Assets would pour into safe-haven assets, US Treasuries, Gold, and currencies such as the Swiss Franc. Time Value: The time value of an option is the amount that an investor will pay in excess of the intrinsic value. As the expiration date nears, the time decay of the option will cause the option premium to decline.  Implied Volatility: The pace of the decline will depend on the implied volatility of the stock and any potential catalysts on the horizon (e.g., investor presentation, earning report release).  If an option has more time until expiration and greater implied volatility, would you expect the premium to be greater or smaller? The option premium would be greater since there's more time for the price of the underlying asset to increase, and more volatility means a greater likelihood of price movements in either direction. Explain the role that time decay has in the value of an option. Time decay, which is denoted by the option Greek theta, is the measurement of the rate of decline in the value of an option from the passage of time as the expiration date nears. As the expiration date comes closer, the effect of time decay on the option's value accelerates as there's less time for the underlying asset to change in value. However, the rate of this value erosion will be slower, and the option will retain more of its value if it's currently in-the-money (ITM). What would you expect the theta of a long-term option to be? A long-term contract will have a theta close to zero because it doesn't lose value each passing day, and the expiration date is far away. Theta would be significantly higher for short-term options nearing expiration, especially if it's out-of-the-money. Short term options will lose value each day, as they have more premium to lose relative to a long-term option. What is the relationship between delta and gamma? Delta: A measure of the expected change in an option's price resulting from a $1.00 change in the price of the underlying asset (security or index) - used by many traders to determine the likelihood of an option being in-the-money on the expiration date. Gamma: A measure of the rate of change in the delta of an option per $1.00 change in the price of the underlying asset - gamma is a proxy for the stability of delta.  What is the difference between American options and European options? The major distinction is that American-style options can be exercised before the expiration date, whereas European-style options can only be exercised on the date of expiration. For this reason, the ability to exercise an option contract before expiration makes American options more valuable than European options, all else being equal. However, whether an early exercise would have been the most profitable choice would depend on the time premium remaining on the option and the potential for events in the future that can affect its value (which cannot be predicted). What are eurobonds? A eurobond is a type of bond that's denominated in a currency different from the currency of the country in which the bond is being issued and sold. When spelled with a non-capitalised "e," the term "euro" refers to external rather than Europe. What is the bid-ask spread? The bid-ask spread is the difference between the hgihest price that a buyer will pay for a particular asset and the lowest price that a seller will sell it. The more illiquid an asset is, the greater the bid-ask spread will be. What is a black swan event? A black swan event is an unexpected, very improbable event statistically rarely occurs, but when it does - it brings havoc and severe consequences. These events cannot be predicted and often cause catastrophic damage to the global financial markets and economy.