01. Introduction Flashcards

1
Q

What does traditional economic theory assume?

A
  • Traditional economic theory assumes that economic agents have unlimited cognitive abilities and willpower.
  • But individuals frequently and systematically make decisions in contradiction with these standard presumptions.
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2
Q

What is the EMH?

A
  • Traditional finance theory is based on the idea that financial markets are efficient = Efficient market hypothesis.
  • It stresses that at any instant in time, the price of a security equals its fundamental value = discounted value of all future income flows associated with the security.
  • All publicly available information is immedately incorporated into security prices
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3
Q

What is short selling?

A
  • Where you borrow a stock and sell it, only to buy it back in a second period to make a profit.
  • Central elements of this example:
    1) Presence of subsitute securities
    2) Shorting is possible
    3) Irrational investors = noise traders
    4) Rational Investors = arbitrageurs –> This is the vast majority of investors.
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4
Q

What are the main 3 assumptions of EMH?

A

1) Rationality: the vast majority of investors is rational
A) In response to new information, investors update beliefs according to Bayes rule
B) When faced with a risky situation, investors evaluate the risky choices according to expected utility theory and make normatively acceptable choices.

2) Irrationality = if it exists, it cancels out in the aggregate, since it is random
3) Irrational investors exit the market because they make mistakes and are taken advantage of by arbitrageurs. They lose money and exit the market.

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5
Q

What are rational investors?

A

1) In response to new information, investors update their beliefs according to Bayes Rule

P(G/identified G) = P(Identified G/G) x P(G) / P(identified G)

2) Rational preferences across all possible outcomes and states of nature:
A) Completeness: x > y, xy and y>z implies x>z
C) Independence: if X>Y, then p x X + (1-p)Z > p x Y + (1-p) x Z for all Z

3) Utility maximization: utility function assings numbers to choice options so that more preferred options get higher numbers:
When ordering is important = ordinal utility
When the actual number is important = cardinal utility

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6
Q

What is expected utility theory?

A
  • Normative theory that describes how rational people should behave when facesd with risks.
    Handles absolute levels of wealth in 2 different future states and it is not relative to your current situation
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7
Q

What is risk aversion

A

When offered 2 assets with the identical expected return, it is intuitive to choose the asset which entails lower risks. One needs to be compensated to take on more risks.

Risk averse investors prefer the utility of the expected value of a prospect E(P), the the expected utility of the prospect:
U(P): u(E(P))>U(P)

Most common measure of risk aversion is the Arrow-Pratt measure of risk aversion: r(w) = - U’‘(w)/U’(w):
Example: CARA = Constant Absolute Risk of Aversion
Level of risk aversion is independent of wealth.

Risk aversion is not necessarily a part of utility theory, but an assumption.

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8
Q

What are irrational investors?

A
  • Noise traders
    Investors that exhibit investor sentiments are called noise traders.

They pose a risk to arbitrageurs:
(1) Mispricing caused by noise traders might get worse in the future

(2) Arbitrageurs might not be able to hold on to a loss making position for the legth of the time that it takes for noise traders to lose enough to exit the market

Simple model: De Long (1990): aim of the model is to show how the optimal behavior of rational investors, market prices and returns are affected by noise trader risk.

Noise traders might outlast the rational arbitrageurs

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9
Q

What are the limits to arbitrage?

A

The impact of noise traders and noise traders risk becomes even more severe if one is managing other people’s money, as they have the ability to hire and fire –> investment horizon short.

Due to the complexity off market conditions, they will base their view of investment ability on short term performance.

Short investment horizon will make money managers reluctant to try to exploit all arbitrage opportunities.

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10
Q

What are some testable predictions associated with EMH?

A

1) Stale and publicly available information should not affect current prices of securities as they are already incorporated = weak ad semi-strong form of EMH?
2) Investors dhould not be able to earn more than the average market profits by using information not available to others. Other investors would instanteously pick it up, wiping out the possibility of abnormal profits = strong form of EHM.
3) No under/overreaction to news about the fundamental value
4) No consistent difference in prices of strict subtitutes securities
5) Securities should not react to no-news, news that is unrelated to fundamental values.

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