Question

please explain each of the following

1. The role of competition in financial markets
2. Luck vs. skill in mutual fund performance
3. How to read a graph of credit spreads between bonds with different ratings
4. Our discussion on HFT and electronic markets
5. What is the concept of convexity and why do investors like it?

Answer 1

(a).

when the competition is high, the qulaity of services will become much higher. the one who uses all these affectively they can be benefited and the others will not. when the market is filled with many suppliers, then the firm may choose higher lenth of payment to the suppliers. in the same way they can extend higher credit periods to the buyers also.

when funds are available at cheeper cost, business firms interest to borrow funds and expand the business into different areas or different segments.

(d).

HFT in many ways harmful both to incestors and market.

HFT is a broader term for various trading strategies that involve buying and selling financial products at extremely high speeds. Computers can identify market patterns and buy or sell these products in a matter of milliseconds based on algorithms
It can degrade investor's confidence in market and hence erode wealth.

It is also associated with increase in cost of capital.

(e).

Convexity helps to approximate the change in price that is not explained by duration. If you go back to the third property of a bond's price volatility you will see that when there is a large change in rates, the duration measure can be way off because of the convex nature of the yield curve.

Convexity is always positive for vanilla bonds. Furthermore, the price-yield curve flattens out at higher interest rates, so convexity is usually greater on the upside than on the downside, so the absolute change in price for a given change in yield will be slightly greater when yields decline rather than increase. Consequently, bonds with higher convexity will have greater capital gains for a given decrease in yields than the corresponding capital losses that would occur when yields increase by the same amount.

Some additional properties of convexity include the following:

• Convexity increases as yield to maturity decreases, and vice versa.
  • Convexity decreases at higher yields because the price-yield curve flattens at higher yields, so modified duration is more accurate, requiring smaller convexity adjustments. This is also the reason why convexity is more positive on the upside than on the downside.
• Among bonds with the same YTM and term length, lower coupon bonds have a higher convexity, with zero-coupon bonds having the highest convexity.
• This results because lower coupons or no coupons have the highest interest rate volatility, so modified duration requires a larger convexity adjustment to reflect the higher change in price for a given change in interest rates