Seminar questions Dr Andreas Krause Seminar 1 Problem You are - PDF document

MSc Applied Economics MSc Applied Economics with Banking & Financial Markets Department of Economics ES50122 – Financial Markets Seminar questions Dr Andreas Krause

Seminar 1 Problem You are employed as a trader in a bank and are looking for profitable trading strategies across a range of markets. Amongst many other aspects, you looked at the 1 minute returns generated for a range of stocks. Below is an example for one stock that is representative of most stocks you investigated: 0.00016 0.00014 0.00012 0.0001 0.00008 0.00006 0.00004 0.00002 0 -0.00002 08:00:00 08:30:00 09:00:00 09:30:00 10:00:00 10:30:00 11:00:00 11:30:00 12:00:00 12:30:00 13:00:00 13:30:00 14:00:00 14:30:00 15:00:00 15:30:00 16:00:00 16:30:00 17:00:00 The vertical axis shows the cumulative returns over an average trading day and the horizontal axis showing the trading time; the bold line represents the mean cumulative returns while the thin lines are the 5% and 95% quantiles, respectively. Can you develop a profitable trading strategy based on this result? Is your finding consistent with market efficiency? Refer to relevant academic literature in your answer. Review questions 1. If there is a widespread belief that the stock price will increase in the period after the next, why would this increase already be priced into the current stock price if the market is efficient? 2. Speculation can be good and bad for market efficiency. Explain the circumstances in which either of these apply.

Seminar 2 Problem You are the manager of an investment trust and have the role of selecting stocks for inclusion in the portfolio of your trust. Obviously, you are a keen follower of market news and how these are received by fellow investors and traders. You are inspired by a select group of fund managers that seem to persistently pick the right time to buy and sell stocks, generating large returns that puts them regularly at the upper end of performance league tables. After a discussion at an awards ceremony, where you were lucky to be placed at the same table as two of these star performers, you think that the key to their success is that they do not much follow the actual news on stocks, but have a keen ear for the opinions of other traders and investors. Based on these opinions they will then determine the optimal timing to buy and sell. As you are ambitious in generating a better performance for your fund with the aim of advancing your career, you decide to adopt their approach to buying and selling stocks. You start to focus more on market rumours and base your decisions on the opinion of other market participants, which often seem to contradict what your analysis based on market news suggests. Do you think that this approach is advisable for your stated goal? In your answer refer to economic theories covered in the lectures and academic papers you find yourself. Review questions 1. You receive information that a stock is going to perform badly in the near future. In contrast, many investors you know are very upbeat about the prospects of this stock. Is it advisable that you disregard your information? 2. Markets can fickle in that widely held opinions about the future prospect of stocks can reverse quickly and without obvious reason. How can you explain this observation?

Seminar 3 Problem Working for a private equity firm, you seek to identify undervalued companies that the firm might invest in. You approach the valuation by looking at the earnings and cash flows of the companies and making projections for their future development based on a range of information available about these companies. Using this approach, you have difficulties finding any companies that are undervalued, in the vast majority of cases the price in the stock market is significantly higher than the value you attach to it. For unlisted companies, any approaches based on your valuation are rebuffed as being much too low. A more experienced colleague tells you that your entire approach is wrong. He identifies underpriced companies by comparing the price-earnings ratios of companies and, after a few adjustments, selects those that have ratios at the lower end of the spectrum. For unlisted companies he simply applies a low price-earnings ratio to determine an offer price. Is this approach preferable to yours? Explain your answer referring to a range of relevant economic theories. Review questions 1. You determine the fundamental value of a stock using the market consensus on future dividends on a quarterly basis. Upon comparing the volatility of the fundamental value with that of the quarterly returns of the stock, you observe the former to be higher. Why? 2. Why would you consider buying a stock that you know is trading above its intrinsic value?

Seminar 4 Problem You observe the pattern of the stock market as indicated in the graph below. 120 110 100 90 80 70 60 50 01/01/2013 01/01/2014 01/01/2015 01/01/2016 The bold line represents the stock price observed in the stock market and the thin line the value of the stock you calculated using the market consensus on future expected earnings. How can you explain the pattern observed? Make additional assumptions as is appropriate to provide a rationale for your answer and, if appropriate, provide alternative answers. Review questions 1. On numerous occasions in history, we have seen that stock markets can crash without any apparent cause. How can you explain this phenomenon? 2. There are many stories about successful traders making significant profits; however, trading (in contrast to investing) is often referred to as a zero-sum game. If this is true, who is making losses and why are they not refusing to trade?

Seminar 5 Problem You are a trader at an investment bank and are given the below chart by your manager who in turn has been given it as an explanation for recent market events that have taken him by surprise. The vertical axis shows the ratio of the price change after on order has been execured and the size of this order, i. e. the price impact an order has. The horizontal axis shows the time in trading days. How do you explain the evolution of this graph? Refer to theories of trading in stock markets for your answer. Review questions 1. While most traders look at stock prices to understand market sentiments, you suggest to friends to pay more attention to trading volumes. How do you explain the significance of trading volumes? 2. In order to exploit any information you have in certain stocks, you adjust your portfolio. Why can you not simply base the level of adjustment on the relative returns of these stocks but need to consider the variances as well?