Few Loose End Questions

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chaddy

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Can anyone please help me answer these questions
(1) “Demonstrate the use of Cobb-Douglas in obtaining dividend discount estimate of intrinsic value of an equity market”
I understand C-D, but what is the connection between the model, or the growth in real GDP, versus the inputs in discount models?
(2) Is it true that you simply honor the smaller of ability or willingness to take risk, unless the investor is rich and has too low willingness?
(3) Explain the importance of Spread Duration
(4) Compare duration and interest rate sensitivity approaches to hedging MBS
MBS have negative convexity at lower yields… what difference are they looking for here?
(5) What is the core-satellite approach to portfolio construction?
(6) “Discuss the use of preferred stock in venture capital investment” ?
(7) Compare the basis-risk of commodity futures with that of financial futures
 
This is from memory, so fellow AF’ers pls correct me if wrong:
1.) Often a top-down approach is used to determine individual firm prospects. GDP growth is an input in alot of regression models that determine earnings growth based on the level of the economy, which would plug into DDM. Higher GDP will lead to higher earnings, particularly in consumer cyclicals, and therefore higher value via DDM.
2.) I am unclear, I usually go with this rule unless they are rich and too low as you said (counseling to show them they can take on more risk) but moreso if they are poor and willingness too high (counseling to let them know they are stupid)
3.) for corporate bonds, there is a treasury yield component, and a spread component. Theoretically, treasury yield curve can stay the same, but spread to treasury can increase due to idosyncratic firm risks, or perhaps industry risks. This measures the sensitivity of the bond price to these moves, holding the treasury curve constant.
4.) All this means is that duration approaches such as simply matching duration with a short treasury is inadequate due to the negative convexity found in the mortgage security. That is, if rates decline, the short treasury loses more than the MBS will gain due to the call at the MBS stopping it from rising above par (or whatever the call price is, typically around par). MBS are yield curve sensitive not just duration sensitive, because of the constant stream of principal and interest payments, therefore duration is insufficient.
5.) Core is either passive index, enchanced index, or both combined. Satellite adds active return by throwing in active managers.
6.) Preferred stock comes in rounds to fund VC firms, subsequent issues have increasing priority of payments under a typical structure, e.g. round 2 preferred is senior in the payment waterfall to round 2 preferred [verify]
7.) Basis risk in commodity futures can come from different delivery locations (just look at WTI vs Brent crude oil), delivery timing, hedging a commodity with another that does not have perfect correlation (such as hedging oil with heating oil or something) and I think interest rate movements.
Financial futures comes from interest rate movements, and I think the passage of time. Pretty sure i may have left a few out on this one, so someone should verify.
 
Awesome answers, I really appreciate it. I wish analyst forum had a way to give people points for being helpful.
Could you, or someone else, elaborate on the core-satellite approach with respect to adding a completeness fund to control risk exposures, and its advantages/disadvantages? I know what a completeness fund is for an investor with low-basis holdings, but this must be something different.
 
My only guess would be that if the investor decided he wanted to back off of active risk exposures and match the index more, he would add appropriate securities to bring the overall portfolio composition close, in terms of either holdings or risk exposures, to that of the passive benchmark he wishes to replicate.
Advantages would probably be that it reduces risk exposures effectively, not sure what else…. disadvantage is that substantial liquidity is needed to buy the positions to make the completion portfolio, significant time is required, and in the absence of liquidity you would have to leverage your portfolio.
 
1. Cant we use the growth rate in cobb douglas and apply it to the DDM? Is that the link?
 
I know what a completeness fund is for an investor with low-basis holdings, but this must be something different.
thats called a completion portfolio
 
Ah yes, those are different, thanks for making me realize it.
Why would we use the C-D growth rate in the gordon model? It’s neither the required return nor the growth rate of earnings– just correlated to the latter.
 
CD estimates the GDP growth you expect, lets call it g
g = TFP + Capital(z) + Labor(1-z)
now if GDP growth is correlated to growth in equity market returns (assume they grow at same rate) you can use g from above step to value an index.
Index Value = D1/(k-g)
 
That completeness fund and protfolio are not too differenct.
The advantage woith completeness funds is that they try to attain the allocation of a benchmark index which leads to diversification.
Their disadvantage is that completeness funds elimitae misfit risk which leadss to reduction in alpha
 
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