QUESTION

INVESTMENT- Financial ANALYSIS

Question 1

Explain the dividend policy problem (or the irrelevance of dividend policy) as formulated in the Modigliani and Miller paper.

Question 4

Outline the basic assumptions and pricing equation of the residual income model suggested by Ohlson. How does he overcome the issue of estimating future residual income? Explain your answer.

SECTION C. Answer one question from this section. Each question is worth 30% of the marks for the paper.

Question 1

How do Francis and Schipper (Journal of Accounting Research, 1999) test about value relevant accounting information? How do they extend the tests to account for the change in relevance over time? Explain your answers.

Question 2

Explain the properties of timeliness and conservatism of accounting income. With reference to the main findings of Ball, Kothari & Robin ( Journal of Accounting & Economics, 2000) explain what is the effect of international institutional factors (common law vs. code law) on the properties of accounting income?

Question 10

Lakonishok, Shleifer and Vishny (Journal of Finance, 1994) try to shed more light on the issue of why value strategies have consistently outperformed the market. Explain the main features of such strategies and outline the main findings of their paper. How do they explain the persistence in performance of value stock over glamour stocks?

SECTION A:

Question 1.

Define the main terms in the Miller Modigliani equity valuation model, X0, I, and r*. Discuss briefly how you would estimate each of them from a company’s annualreport and accounts.

Question 2.

Describe briefly the Shiller test, American Economic Review 1981, for excess volatility in share prices.

Question 3.

Define the following in 2-3 sentences each; institutional investor, asset allocation, corporate governance, capital market anomaly, value investment.

Question 4.

What are the advantages and disadvantages of top down versus bottom up securities analysis?

SECTION B: Answer 1 question from this section. Each question is worth 30% of the marks for the paper.

Question 5.

a)     Describe carefully the information cascade mechanism proposed by Bikhchandani, Hirshleifer and Welch, Journal of Political Economy, 1992. (20 marks).

b) Explain to what extent this mechanism is likely to explain stock market behaviour, paying particular attention to the findings of DeBondt and Thaler, American Economic Review, 1990. (10 marks).

Question 6.

a)     What is the rationale for a contrarian investment strategy? (5 marks)

b) Describe and evaluate the Lakonishok, Schleifer and Vishny (Journal of Finance, 1994) evidence that such a strategy is successful. (25 marks)

Question 7.

a) Discuss the main findings of Barth, Cram and Nelson (Accounting Review, 2001) concerning the components of earnings and discuss its implications for investors.

b) What evidence is there to suggest that investors fully understand the nature of accruals?

SECTION C: Answer 1 question from this section. Each question is worth 30% of the marks for the paper.

Question 8.

a) How should the performance of active managers be evaluated? (20 marks)

b) To what extent does the empirical literature suggest that active management is profitable?

Question 9.

a) Comment on the roles played by theories of the term structure, interest rate risk, duration and convexity in bond trading and investment.

b) What are the main approaches to active bond portfolio management?

Question 10.

a) What are the main market wide and firm specific anomalies that economists have discovered in the operation of capital markets ? (20 marks)

b) What causes of such anomalies have been suggested? (10 marks)

SECTION BB. Answer 1 question from this section. Each question is worth 30% of

the marks for the paper.

1- (a) Discuss the competing views on whether variations in GAAP around

the world affect the operations of financial markets?

(b) Discuss the work of Ball, Kothari and Robin (Journal of Accounting

and Economics, 2000) in relation to international accounting standards.

(20 marks)

2- (a) If we are to assess the relevance of financial statements to investors we

must define what we mean by relevance. Briefly outline the four interpretations of the value relevance of financial statements put forward by Francis and Schipper (Journal of Accounting Research, 1999). (10 marks)

(b) How do Lev and Zarowin (Journal of Accounting Research, 1999) test

the association between earnings and share returns? According to their results, how has this association changed over time? (20 marks)

7 (a) How can information cascades arise? Discuss in the context of the

Bikhchandani, Hirshleifer and Welch model (Journal of Political Economy, 1992).

(b) Why might information cascades be fragile? (10 marks)

SECTION CC. Answer 1 question from this section. Each question is worth 30% of the marks for the paper.

1- (a) Specify the main features of the mean-variance approach to securities

investment.

(b) What types of institutional investors would or would not adopt a mean

variance approach and why? – what would be the alternative approaches?

2- (a) What are the costs and benefits of international investment by

institutional investors?

(b) Why do investors typically not hold the “global portfolio”, but rather

exhibit “home asset preference”?

3- (a) Give a critical outline of why institutional investors might be subject to “herding behaviour”, and of the main models of herding in the literature.

(b) What are the potential consequences for financial stability of such

behaviour? Give examples from a financial crisis of the past.

Question 4

Explain the Francis and Schipper test (Journal of Accounting Research, 1999) which examines whether earnings are more relevant for investors than cash flow.

Question 5

Explain the intuition behind an information cascade in Bikhchandani, Hirshleifer and Welch (Journal of Political Economy, 1992). Can such cascades apply to equity markets?

SECTION BBB. Answer one question from this section. Each question is worth 30% of the marks for the paper.

Question 5

What types of security markets do you know in terms of securities traded on them? Describe their characteristics? Which securities are traded on these security markets? What characteristics do these securities have?

Question 6

What types of investment companies do you know? Describe their characteristics? Explain different costs of investing in a mutual fund. Comment on the importance of these costs for a short-term vs. long-term investment.

Question 7

What measures of portfolio risk do you know? Comment on their advantages and disadvantages? How is the value at risk estimated?

SECTION CCC. Answer one question from this section. Each question is worth 30% of the marks for the paper.

Question 8

Explain briefly the intuition behind the excess volatility test of Shiller (American Economic Review, 1981).

How is it suggested in Lakonishok, Shleifer and Vishny (Journal of Finance, 1994) that such excess volatility might be exploited? Is the strategy successful?

Question 9

Compare and contrast the main features of the Miller Modigliani investment opportunities valuation model with that of Ohlson’s residual income model.

In the light of the evidence by Dechow, Hutton and Sloan (Journal of Accounting & Economics, 1999), (i) identify which model best explains market prices, and (ii) explain the intuition for the finding.

Question 10

What overall conclusions can be drawn from the studies by Breton & Taffler (Accounting & Business Research, 2001) and Barth, Cram and Nelson (Accounting Review, 2001) which seem to point in opposite directions concerning the relevance of earnings.

Question 3

Explain the dividend policy problem (or the irrelevance of dividend policy) as formulated in the Modigliani and Miller paper. Question 4

Outline the basic assumptions and pricing equation of the residual income model suggested by Ohlson. How does he overcome the issue of estimating future residual income? Explain your answer.

SECTION BBBB. Answer one question from this section. Each question is worth 30% of the marks for the paper.

Question 5

What securities are traded in the bond market? Describe them? Provide a comparison of the bond market with other markets in terms of their (1) profitability and (2) risk. What derivatives do you know? Describe them and plot their pay-off profiles.

Question 6

What information can be extracted from the historical distribution of the prices? Provide examples for different asset classes. What do the first, second, third and fourth moments of this distribution characterise?

Question 7

Comment on the possibility of sustaining high returns over several years by mutual funds. Describe the fee structure of a mutual fund. What is trading on margin? Give an example of such a transaction using a T-account.

SECTION CCCC. Answer one question from this section. Each question is worth 30% of the marks for the paper.

Question 8

How do Francis and Schipper (Journal of Accounting Research, 1999) test about value relevant accounting information? How do they extend the tests to account for the change in relevance over time? Explain your answers.

Question 9

Explain the properties of timeliness and conservatism of accounting income. With reference to the main findings of Ball, Kothari & Robin ( Journal of Accounting & Economics, 2000) explain what is the effect of international institutional factors (common law vs. code law) on the properties of accounting income? Page 4 of 4

Question 10

Lakonishok, Shleifer and Vishny (Journal of Finance, 1994) try to shed more light on the issue of why value strategies have consistently outperformed the market. Explain the main features of such strategies and outline the main findings of their paper. How do they explain the persistence in performance of value stock over glamour stocks?

SOLUTION

FINANCIAL Analysis

Section B

Question 4

a) What is the difference between the exponentially weighted moving average (EWMA) model and the GARCH(1,1) model for updating volatilities? (20 Marks)

b) Show that the GARCH (1,1) model

= w + α + β

is equivalent to the stochastic volatility model

dV = a(  – V)dt + ξVdz

where time is measured in days, V is the variance of the asset price, and

a = 1 – α – β,   =  , ξ = α

What is the stochastic volatility model when time is measured in years? (Note: The variables  is the return of the asset price in time δt. It can be assumed to be normally distributed with mean zero and standard deviation . It follows that the means of  and  are  and , respectively. (40 Marks)

c) Previous studies of low-frequency (daily or weekly) index returns and implied volatilities have produced conflicting conclusion about the informational efficiency of the S&P 100 option markets. Recently, the use of high-frequency (five minutes) returns showed that the minor incremental information in high-frequency returns was almost subsumed by implied volatilities. Briefly discuss. (40 Marks)

Question 5

a) Consider a position consisting of a £80,000 investment in asset A and a £90,000 in asset B. Assume that the daily volatilities of both assets are 2% and that the coefficient of correlation between their returns is 0.4. What is the 5-day 95% value at risk for the portfolio?  (20 Marks)

b) Value at Risk: a multivariate switching regime approach (JEF 2000). Briefly discuss on the contribution given by the paper. (40 Marks)
(40 Marks)

c) Briefly compare VaR(iance) to tracking error and discuss the issues surrounding measure of risk adjustment performance. (40 Marks)

Question 6

a) Discuss on how financial institutions can reduce potential losses in the event of a default. (20 Marks)

b) In 1974, Merton proposed a model where a company’s equity is an option on the assets of the company. Introduce the model and derive the risk-neutral probability that the company will default on the debt. (40 Marks)

c) Knowledge about the link between stock prices, stock return volatilities and CDS spreads is important not only for risk managers using credit default swaps for hedging purposes, but also to anyone trying to profit from arbitrage possibilities in the CDS market. Briefly discuss on the evidence of a link between the iTraxx credit default swap (CDS) index market and the stock market. (40 Marks)

JF91