Solution to Sample Midterm Exam #1

FINA 4310 - Spring 2012

Trading Strategies and Financial Models
c 2012 Alexander Barinov
1 Multiple Choice Questions (10 questions, 3 points
each)
1. Assuming that the momentum eect is mispricing, you would expect that
a Recent losers will have positive returns around earnings announcements, and
even more so if they were highly volatile before they started losing value
b Recent losers will have negative returns around earnings announce-
ments, and even more so if they were highly volatile before they
started losing
c Recent losers will have positive returns around earnings announcements, but
less so if they were highly volatile before they started losing value
d Recent losers will have negative returns around earnings announcements, but
less so if they were highly volatile before they started losing value
Losers continue to lose because they are still overpriced even given the initial
loss. The overpricing is stronger for the stocks with high limits to arbitrage
and will be corrected at earnings announcements.
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2. If the value eect is explained by risk, then the value minus growth portfolio should
a Have positive market beta
b React positively to a sudden increase in dividend yield
c Have high expected return in the periods of high GDP growth
d Have negative CAPM alphas in the periods of increasing market
volatility
If value eect is an anomaly, it means that the market beta cannot explain
why the returns to value rms and growth rms are dierent. Hence, the
market beta of the value minus growth portfolio can be anything, it does not
matter. If the value minus growth portfolio gains in response to a sudden
increase in dividend yield (usually a signal of bad times), it is a hedge against
recessions, and it is even more puzzling why it has a positive CAPM alpha. If
the expected return (and, hence, the risk) of the value minus growth portfolio
is high when GDP growth is high (good times) and low otherwise, it is a hedge
again. But negative CAPM alphas when market volatility increases (usually
during market downturns) clearly point towards the value minus growth port-
folio being risky, which may explain its positive average CAPM alpha.
3. MOM is the portfolio that buys recent winners and shorts recent losers. If the
regression of MOM on the excess return to the market yields MOM = 0.77 0.12
(MKT RF), what do you conclude?
a One can earn 77 bp per month if one buys the winners and shorts the losers
b One can earn 77 bp per month if one buys the winners, shorts the
losers, and buys the market for $12 for each $100 one turns around
in MOM
c One can earn 77 bp per month if one buys the winners, shorts the losers,
and shorts the market for $12 for each $100 one turns around in MOM
d One can earn 77 bp per month if one shorts the winners, buys the losers,
and buys the market for $12 for each $100 one turns around in MOM
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You need to buy to cancel out the negative beta. You will not get 77 bp if
you do not, you will get 77 bp less 0.12 times the market risk premium. (d)
has the momentum strategy backwards.
4. The 3-0-3 momentum strategy suggests buying winners and shorting losers based on
their return in the previous 3 months and holding to the positions for 3 months after
opening. Assuming that all positions are closed at the end of the 3 months holding
period, what is the highest level of one-way trading cost at which the strategy will
still be protable, if its average abnormal annual return is just a bit over 15%?
a 0.9375% =
15%
4 4
b 1.875%
c 3.75%
d 7.5%
When you open and close the positions in the momentum strategy, you
have to pay the one-way trading costs 4 times: when you buy winners, when
you sell them back, when you short losers, when you buy them back. Also, if
the holding period is 3 months, you have to do it 4 times a year. If the one-
way trading costs are above 0.9375%, trading costs per year, > 0.9375% 4 4,
beat the return to the strategy, 15%, and the strategy is not protable on the
after-cost basis.
5. Mispricing or apparent mispricing should be stronger for
a Volatile rms, large rms, rms with low Roll measure
b Firms with high Amihud measure, rms with high bid-ask spread,
rms with high short interest
c Low volatility rms, rms with low Amihud measure, rms with high prob-
ability to be on special
d Small rms, rms with high residual institutional ownership, illiquid rms
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We are looking for the rms with high limits to arbitrage (mispricing) or
high trading costs (apparent mispricing). In (a), both large rms and rms
with low Roll measure (high bid-ask spread) do not t this description. In (c),
low volatility rms have low limits to arbitrage and rms with low Amihud
measure (low price impact) have low trading costs. In (d), rms with high IO
have low limits to arbitrage.
6. If the new issues puzzle is risk, then, controlling for the market return, the correlation
between the realized returns to new issues and the returns to the futures on the
Treasuries should be
a Negative
b Positive
c Positive in expansions and negative in recessions
d Impossible to tell
New issues have negative CAPM alphas, thus, a risk-based explanation
should show that they have low risk, e.g., that they lose less value in reces-
sions than what the CAPM predicts. Treasuries usually gain during recessions
(Treasury bill rate goes down in recessions, and Treasury prices go up), and so
do futures on them. Hence, controlling for the market return, the correlation
between the realized returns to new issues and the returns to the futures on
Treasuries should be positive.
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7. Assuming that the value eect is caused by risk, you would expect the realized
returns to the HML factor to be
a Positively correlated with future labor income and positively cor-
related with future Treasuries yield
b Negatively correlated with future labor income and positively correlated with
future Treasuries yield
c Positively correlated with future labor income and negatively correlated with
future Treasuries yield
d Negatively correlated with future labor income and negatively correlated with
future Treasuries yield
Risk is losing money just before things turn south - i.e., labor income drops
and Treasury yields (and expected ination) decrease.
8. You are creating a multifactor model with the momentum factor. The momentum
factor is the portfolio long in winner rms and short in loser rms. You can interpret
this model as the ICAPM
a Only if momentum is mispricing
b Only if momentum is risk
c The ICAPM does not allow the use of the momentum factor
d You can use the momentum factor in the ICAPM irrespective of whether
you think momentum is risk or mispricing
ICAPM is a risk-based model, in contrast to APT, which just assumes
that the factors are there, and other multifactor models, which may ask
the question if the LHS variable is simply related to existing anomalies. All
ICAPM factors have to be risk.
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9. If the new issues puzzle is mispricing, then it should be stronger for the rms with
a Low institutional ownership and high short ratio
b Low institutional ownership and low short ratio
c High institutional ownership and high short ratio
d High institutional ownership and low short ratio
New issues have negative alphas, and you have to short them to make prot
and to arbitrage away the anomaly. In the subsample of rms that are costly
to short no one is able to short new issues (or no one nds it protable) and the
new issues puzzle persists. In the subsample of rms that are easy to short,
everyone shorts new issues, they stop being overpriced, and the new issues
puzzle disappears.
Short sale costs are high if either the demand to short is high or the supply
of shares to short is low. Demand is proxied for by short ratio, and supply is
proxied for by institutional ownership. Shares that are hard to short normally
have high short ratio and/or low institutional ownership, and the new issues
puzzle should be stronger for these rms.
10. If the idiosyncratic volatility discount is mispricing, then
a Firms with low idiosyncratic volatility should be more mispriced if they also
have high probability to be on special
b Firms with low idiosyncratic volatility should be more mispriced if they also
have low probability to be on special
c Firms with high idiosyncratic volatility should be more mispriced if they also
have low probability to be on special
d Firms with high idiosyncratic volatility should be more mispriced
if they also have high probability to be on special
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The idiosyncratic volatility discount refers to the positive alpha of the port-
folio that buys low volatility rms and shorts high volatility rms. Firms with
high volatility have negative alphas and need to be shorted. If investors can-
not short them due to high shorting fees, their negative alphas will persist and
they will remain overpriced. The high volatility rms that have low shorting
fees will be actively shorted and will stop being overpriced.
Probability to be on special is the probability of having the shorting fee so
high that it exceeds the risk-free rate. Hence, high probability to be on special
means high shorting fees, and the high volatility rms with high probability
to be on special will be more overpriced.
2 Short Questions (5 questions, 10 points each)
1. High turnover of the stock (trading volume divided by market capitalization) is
usually interpreted as either high uncertainty about the stock value or high liquidity
of the stock. Explain how, under the hypothesis that the post earnings announcement
drift is mispricing, each interpretation of turnover would impact your prediction
about the cross-sectional relation between turnover and the strength of the post
earnings announcement drift.
If PEAD is mispricing, then it should be stronger if limits to arbitrage are
higher. High uncertainty is a limit to arbitrage - it can be dangerous to
hold the stocks you do not understand, even if you are after a regularity
in returns that requires no analysis of separate companies. If turnover is
uncertainty, then PEAD should be stronger for high turnover stocks.
High liquidity means low limits to arbitrage (the stock is easy to buy
and sell). If turnover is liquidity, then PEAD should be weaker for
high turnover rms. Overall, the prediction on the relation between the
PEAD strength and turnover is ambiguous. Empirically, it is positive, so
turnover as uncertainty wins. For your use, you can separate turnover into
average and unexpected - average is liquidity, unexpected is uncertainty.
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2. Investment-to-capital ratio is known to be higher during expansions (rms invest a
lot if demand is high). What is the expected sign of the correlation between expected
market return and the lagged value of the aggregate investment-to-capital ratio to
be? Explain.
High investment-to-capital ratio means expansion, when risks are low and
expected returns are also low. Therefore, high investment-to-capital ra-
tion should predict low expected market returns. That is, the correlation
has to be negative.
3. You are trying to explain the new issues puzzle using conditional CAPM. What will
be your hypothesis about the relation between the CAPM beta of IPOs and lagged
values of GDP growth and unemployment rate? Explain.
IPOs have negative CAPM alphas. Therefore, they have to be less risky
than what the CAPM thinks. In the conditional CAPM, the only form
of low risk is the decrease in the CAPM beta during recessions. GDP
growth is low during recessions, hence it has to be positively correlated
with the CAPM beta of IPOs to explain the new issues puzzle. The
unemployment rate is high in recessions, hence it has to be negatively
correlated with the CAPM beta of IPOs.
4. You have noticed that the zero-investment portfolio buying rms that do not invest a
lot and shorting rms that do invest a lot has positive and signicant CAPM alpha.
The next regression you ran was the two-factor model with the market factor and
the HML factor, and in this model the investment-based arbitrage portfolio turned
out to have an insignicantly negative alpha. What do you conclude if you believe
that the value eect is risk? How does the conclusion change if you believe that the
value eect is mispricing?
If the value eect is risk, than HML (which is essentially the value minus
growth portfolio) is a risk factor. The fact that adding it to the market
model eliminates the alpha of the investment strategy means in this case
that the CAPM alpha of the investment strategy is not abnormal return,
but rather a fair compensation for the value risk.
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If you believe that the value eect is mispricing, you would conclude
from the insignicant alpha of the two-factor model that the investment
anomaly is just another reincarnation of the value eect.
5. The Roll measure of Delta Airlines (DAL) is 1.2%, the Amihud measure of Delta
Airlines is 0.009%. What is the dollar cost of buying $50M worth of Delta shares in
one day? Assume that the true price is at the midpoint and the price impact starts
at the ask.
You lose half of the bid-ask spread when you buy every share of DAL. The
Roll measure measures the bid-ask spread. Hence, you lose 0.6% $50M =
$300K on the bid-ask spread.
Then the price impact happens. On the rst lot, you lose nothing. By
the time you trade the last lot, the price has gone up by 0.009% 50 =
0.45% (0.009% is the Amihud measure). On average, you lose half of this
number, or, in dollars, 0.225% $50M = $112.5K.
The total loss of the one-way trade is $300K+$112.5K=$412.5K.
3 Long Question (4 parts, 5 points each)
This question refers to the ICAPM, estimated for Vanguard International Value (VTRIX)
fund using the data from January 1999 to December 2009. The numbers in brackets are
standard errors.
Ret
t
RF
t
= 0.35
(0.24)
+ 0.88
(0.05)
(MKT
t
RF
t
) + 1.21
(6.55)
TB
t
5.86
(2.88)
DIV
t
Looking at the coecient on the change in the dividend yield, does the fund look riskier
than what its market beta implies? Explain.
Dividend yield is high in recessions, so an increase in dividend yield is bad
news. The negative slope on DIV suggests that, controlling for the market
risk, the fund responds to the bad news by posting negative return, which
means that the fund is riskier than what its market beta implies. (Note also
that the coecient is statistically signicant).
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If dividend yield increases by 1% and the expected ination decreases by 3%, by how
much will the fund beat/trail the CAPM?
If dividend yield increases by 1%, the fund will post -5.86% loss on top of
the loss coming from the market decline that normally accompanies increases
in dividend yield. If expected ination decreases by 3%, the Treasury bill rate
also decreases by 3%. The fund will respond by posting 1.21 3% = 3.63% loss
on top of the loss coming from the market decline that normally accompanies
decreases in the Treasury bill rate. Hence, if dividend yield increases by 1%
and the expected ination decreases by 3%, the fund will underperform the
CAPM by 5.86%+3.63%=9.49%. (Note: 5.86 and 1.21 in the solution are
slopes from the regression above).
Your colleague suggests that the Vanguard fund is a good investment, because the
ICAPM above estimates that its alpha is positive. Give two objections.
One obvious objection is that the alpha is not signicant (0.35/0.24=1.462).
The second more subtle objection is that the dividend yield on the market
portfolio is not a return to a tradable asset, hence, the alpha does not have to
equal zero and can be anything even if the fund yields no abnormal return.
Another colleague suggests that you throw in the change in GDP as the fourth factor.
What sign of the slope on GDP growth would suggest that the fund is even riskier than
what you would think looking at the regression above?
Low values of GDP growth mean recessions. Risk means losing money in
recessions, i.e., having low return when GDP growth is low. Hence, if the fund
is even riskier than what you would conclude from the regression above, the
slope on GDP growth should be positive.
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