FMI Spring 2021 Lecture 2 Handout

Diversification Beta Arbitrage Asymmetric Information
Financial Markets and Institutions: Lecture 2
Anurag Singh
Instituto Tecnológico Autónomo de México (ITAM)
Spring 2021
Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 0 / 30

The Course Outline
Introduction and Motivation
Types of Financial Institutions
Risk: Types of Risk and Measuring the Risk
Managing Risk

The Course Outline
Introduction and Motivation
Introduction to Financial Intermediation: Basic Concepts
Financial Intermediation & Financial Institutions: An Overview
Types of Financial Institutions
Risk: Types of Risk and Measuring the Risk
Managing Risk

Topic to be Covered Today

Introduction to Financial Intermediation: Basic Concepts
Risk Preferences
Risk Diversification
Beta of A Stock
Riskless Arbitrage
Asymmetric Information
Adverse Selection
Agency and Moral Hazard

Risk Diversification: ‘N’ Asset Example (Contd.)
We assumed that we can find ‘N’ assets with returns that are pairwise
uncorrelated
With pairwise
PN 0 correlation, the variance of the portfolio can be written
2
as: σP2 = i=1 yi2 σi2 ≤ σmax /N
Thus, with sufficiently many assets with (pairwise) uncorrelated
returns, portfolio risk decreases (eventually to 0 in limit)
In reality, there are systemic shocks and it is hard for investors to
drive down risk to 0
Systemic shocks lead to positive covariance between asset returns
which makes it necessary to accommodate for non-zero covariance in
the equation above
Let us now look at ‘N’ assets with non-zero pairwise correlation
A proportion ‘yi ’ of portfolio invested in asset ‘i’
Average return and standard deviation of asset ‘i’: ‘ri ’ & ‘σi ’
Covariance between returns of asset ‘i’ & asset ‘j’: Cov (i, j) = σi σj ρij ,
where ‘ρij ’ represents correlation between returns of asset ‘i’ & asset ‘j’

Average rate of return on portfolio:

N
X
rp = yi ri
i=1
Average variance on portfolio:

N
X N X
X
σp2 = Var (rp ) = yi2 σi2 + 2 yi yj Cov (ri , rj )
i=1 i=1 j>i


Assuming equal investment in all assets (yi = 1/N)
N N
1 X 2 2 XX
σp2 = 2 σi + 2 Cov (ri , rj )
N N
i=1 i=1 j>i
PN PN P
2
1 i=1 σi N −1 i=1 j>i Cov (ri , rj )
σp2 = + N(N−1)
N N N
2
1 N −1
σp2 = Avg (Var ) + Avg (Cov )
N N
Thus, for a diversified portfolio, average covariance among stocks

might be dominant component of portfolio variance
Common variation in returns (‘systematic’ risk) become important
Stock-specific risk (‘idiosyncratic’ risk) gets diversified away
Let us assume that we are looking at stocks in the software industry

In general, the asset returns of software stocks have a standard
deviation of 20%
The average correlation between these software industry stocks is 0.6
(highly correlated being the same industry)
If you invest only in software, what is the variance in your portfolio as
a function of ‘N’ (number of software firms you invest in)?t
What is the answer if N = 10 - Today’s Quiz
What is the answer if N → ∞ - Today’s Quiz
What is the answer if the average correlation is changed to 0 or to 1?


Risk Diversification: Other Related Concepts

In the two asset example, we drew the set of possible risk-return
strategies that showed:
Feasible portfolios
Minimum-variance boundary and minimum-variance portfolio
Efficient frontier and inefficient frontier
Tangency portfolio
All efficient portfolios are combinations of the riskless asset and a
unique portfolio of stocks, called the tangengy portfolio.
Optimal portfolio maximizes the slope of the line
The tangency portfolio has the best risk-return trade-off of any
portfolio. It maxizes the slope or Sharpe ratio of any portfolio. Sharpe
ratio is given as:
E (rp ) − rf
σp
All the the above concepts can be explained using the Capital
Market Line from 2 asset example!
Beta of a Stock
Beta of a stock (Apple) measures the fluctuations in the price of that
stock (Apple) to changes in the overall stock index (S&P 500)
Beta of Apple measures how responsive Apple is with respect to
changes in overall stock market or how volatile changes in return for
Apple are with respect to changes return for overall stock market
Thus, a beta of 1.2 for Apple means that
Apple is 20% more volatile than the market
If the market is expected to go up by 10% today (average rate of
return on the overall market is 10%), this means that Apple is expected
to go up by 1.2 × 10 = 12% (rate of return on the Apple stock is 12%)
This is an average relationship - sometimes Apple stock goes up more
than 12%, sometimes by less than 12%.
A positive beta means that the stock prices move in the same direction
as the overall market
A negative beta means that the stock prices move in the opposite
direction as the overall market. Gold is a negative beta stock. Works
as insurance against ‘systemic risks’ ?
Beta of a Stock
How responsive is a stock to overall market movements or how much

does a stock go up or down when the overall market goes up or down?
ri = α + β · rm +
This is equation of a line, similar to y = mx + c, which is known as a

Regression equation in technical terms. Beta as is clear, is the slope
of the line or the Regression slope.
= firm-specific return (‘diversifiable’ or ‘idiosyncratic’ risk)
β = sensitivity to market returns (‘systemic’ or ‘non-diversifiable’ risk)
A stock’s systemic risk is measured by beta

Beta of a Stock
Use daily stock prices of Apple and S&P 500 from Yahoo Finance
(last five years)
Calculate daily rate of returns from the stock prices
Get a line that fits the data the best, slope of the line is beta
Or look at wolfram alpha

Beta of a Stock

A motivation for !Riskless Arbitrage: In News
The New York Times: Full Article

Must Watch Video: YouTube



Riskless Arbitrage
Arbitrage is the simultaneous purchase and sale of identical goods or

securities that are trading at disparate prices
This opportunity is transitory because the exploitation of such
opportunities eliminates the initial price disparities
Arbitrage term is often loosely applied to situations in which objects of
trade are similar, but not identical, and where the risk is small but not
totally absent
Riskless arbitrage is profit without risk and without investment
In an equilibrium of a financial market, it should not be possible to
implement a riskless arbitrage strategy

Riskless Arbitrage: An Illustration
State-Contingent Payoffs and Prices of Securities

Security Payoff in State Current Price
Good Bad
R1 $120 $0 $10
R2 $0 $120 $10
B $60 $60 $12
Suppose:
2 possible states of the economy next period: Good and Bad
2 risky securities, R1 and R2 , and a riskless bond, B
Does a riskless arbitrage opportunity exist?

Riskless Arbitrage: An Illustration (Contd.)

Does a riskless arbitrage opportunity exist?
R1 and R2 can be combined to get a payoff equivalent to that from B
Buy one unit each of R1 and R2 for a total of $20
This ensures a payoff of $120 tomorrow regardless of the state
This is equivalent to 2 units of B
Sell two units of B at $24 earning a riskless profit of $4
Since you can sell these two units of B before you even buy R1 and R2 ,
your profit requires no investment on your part and no risk
If you sell more and more units of B, the price of B will go down
If you buy more and more units of R1 and R2 , the price of R1 and R2
will go up
Prices of the securities to converge, thereby eliminating the
opportunity for riskless arbitrage
Asymmetric Information
Transactions between economic agents often involve parties with

different information or asymmetric information e.g housing market
The better-informed economic agents have a natural incentive to
exploit their informational advantage
Uninformed agents should anticipate their informational handicap and
behave accordingly
Inclination of the informed to strategically manipulate and the
anticipation of such manipulation by the uninformed results in
distortions away from the “first best” and causes two problems:
Adverse selection
Moral hazard

Adverse Selection
The Economist: Full Article

Adverse Selection
Adverse selection occurs when one party in a negotiation has

relevant information the other party lacks.
This asymmetry of information often leads to making bad decisions,

such as doing more business with less-profitable or riskier market
segments
Example: Health insurance and Smoking
A smoker might manage to obtain insurance coverage as a nonsmoker
Smoking is a key identified risk factor for health insurance, so a smoker
must pay higher premiums for the same coverage as a nonsmoker
By concealing his choice to smoke, an applicant is leading the
insurance company to make decisions on premium costs that are
adverse to the insurance company’s management of financial risk

Adverse Selection
“The Market for ’Lemons’: Quality Uncertainty and the Market Mechanism”
George Akerlof illustrated the concept in used cars market

Owner of the car knows more about its quality than potential buyers
Assume two possible quality levels that the used car: q1 > q2 (lemon)
q1 is worth $10 while q2 is worth $2
Buyers believe that probability of car being either quality if 0.5
Nobody wants to pay more or receive less than the worth. What will be
the outcome?
Risk neutral buyers will compute the expected value of a (randomly
chosen) car: 0.5 ∗ $10 + 0.5 ∗ $2 = $6
q1 quality will leave the market
Buyer will know that this will happen
Buyer will now offer $2 and only lemons will be sold

Adverse Selection
The Economist - A New Study on Second Hand Car Market: Full Article

Adverse Selection and Signaling

Can we solve the ‘market of lemons’ problem?

Yes! By signaling. e.g. guanrantees, insurance, brand-names
Let cars of different qualities have different probabilities of engine
failure, and these differences are reflected in their values
Let the failure probability be 0.1 for q1 and 0.95 for q2
Can warranty play a role in this market?
Yes!. If the high quality announces a warranty for engine failure and
the market believes that this warranty can come only from high quality
and the low quality has no incentive to mimic
Let us say q1 announces to pay $10 in case of engine failure
Value of q1 to the buyer: $10 + 0.1 ∗ $10 = $11
If q2 tries to mimic, he gets: $11 − .95 ∗ $10 = $1.5
Thus, q1 will be sold for $11 with warranty while q2 will be sold for $2
without warranty

Adverse Selection

Moral Hazard
It has been observed that the key distinction between man and machine is moral hazard
Like adverse selection, moral hazard occurs when there is asymmetric

information between two parties, but where a change in the behavior
of one party is exposed after a deal is struck
Adverse selection occurs when there’s a lack of symmetric information

prior to a deal between a buyer and a seller
Moral hazard is the risk that a party has not entered into a contract
in good faith or has provided misleading information about its assets,
liabilities, or credit capacity

Moral Hazard
It has been observed that the key distinction between man and machine is moral hazard

Examples of Moral Hazard
If an employee has a company car for which he does not have to pay
for repairs or maintenance, the employee might be less likely to be
careful and more likely to take risks with the vehicle
If you have a car that you know is worth $500 and your collision
insurance will pay you $1,000 if the car is completely destroyed!
One reason why we observe deductibles in insurance contracts
In the investment banking sector, it may become known that

government regulatory bodies will bail out failing banks
Bank employees may take on excessive amounts of risk to score
lucrative bonuses
They know that if their risky bets do not pan out, the bank will be
saved anyhow

Financial Crisis of 2008 and Moral Hazard
On the lender side

Mortgage brokers working for originating lenders may have been
encouraged through the use of incentives to originate as many loans as
possible (regardless of the financial means of the borrower)
Since the loans were intended to be sold to investors, shifting the risk
away from the lending institution, the lender experienced financial gains
from the increased risk while the burden of the risk fell on the investors
On the borrower side

When borrowers struggled to make their mortgage payments they had
two options: meet the financial obligation or walk away from loans
The homes were worth less than the amount owed on the mortgages
Homeowners may have seen this as an incentive to walk away, as their
financial burden would be lessened by abandoning a property

Moral Hazard
For moral hazard to arise, the following must occur:

The agent’s actions (that affect the final outcome) must not be
costlessly observed by the principal
There must be some noise (exogenous uncertainty) that masks the
agent’s action in the final outcome
Ways to tackle moral hazard

Deductibles and other coinsurance provisions in insurance contracts
Bondholders address moral hazard by limiting the firm’s debt by
requiring collateral, and by including in the debt contract covenants
that restrict the borrower’s actions
Moral hazard is not the same as fraud
Most interesting cases of moral hazard do not involve illegal behavior

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Diversification Beta Arbitrage Asymmetric Information

Financial Markets and Institutions: Lecture 2

Instituto Tecnológico Autónomo de México (ITAM)

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 0 / 30

The Course Outline

Introduction and Motivation

Types of Financial Institutions

Risk: Types of Risk and Measuring the Risk

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 1 / 30

The Course Outline

Introduction and Motivation

Introduction to Financial Intermediation: Basic Concepts

Financial Intermediation & Financial Institutions: An Overview

Types of Financial Institutions

Risk: Types of Risk and Measuring the Risk

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 1 / 30

Topic to be Covered Today

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 2 / 30

Risk Diversification: ‘N’ Asset Example (Contd.)

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 3 / 30

Risk Diversification: ‘N’ Asset Example (Contd.)

Average rate of return on portfolio:

Average variance on portfolio:

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 4 / 30

Risk Diversification: ‘N’ Asset Example (Contd.)

Thus, for a diversified portfolio, average covariance among stocks

Risk Diversification: ‘N’ Asset Example (Contd.)

Let us assume that we are looking at stocks in the software industry

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 6 / 30

Risk Diversification: ‘N’ Asset Example (Contd.)

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 7 / 30

Risk Diversification: Other Related Concepts

How responsive is a stock to overall market movements or how much

This is equation of a line, similar to y = mx + c, which is known as a

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 10 / 30

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 11 / 30

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 12 / 30

A motivation for !Riskless Arbitrage: In News

The New York Times: Full Article

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 13 / 30

A motivation for !Riskless Arbitrage: In News

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 14 / 30

A motivation for !Riskless Arbitrage: In News

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 15 / 30

Arbitrage is the simultaneous purchase and sale of identical goods or

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 16 / 30

Riskless Arbitrage: An Illustration

State-Contingent Payoffs and Prices of Securities

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 17 / 30

Riskless Arbitrage: An Illustration (Contd.)

Transactions between economic agents often involve parties with

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 19 / 30

The Economist: Full Article

Adverse selection occurs when one party in a negotiation has

This asymmetry of information often leads to making bad decisions,

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 21 / 30

George Akerlof illustrated the concept in used cars market

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 22 / 30

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 23 / 30

Adverse Selection and Signaling

Can we solve the ‘market of lemons’ problem?

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 24 / 30

The Economist: Full Article