1. ASSET PRICING Flashcards
“Two Pillars of Asset Pricing” by Fama, Eugene F. (2014).
What are the forms of market efficiency?
- Weak: prices reflect only past information (impossible to beat the market using technical analysis)
- Semi-strong: prices reflect all publicly-available information (past and present)
- Strong: prices reflect all available information (public and private)
“Two Pillars of Asset Pricing” by Fama, Eugene F. (2014).
What are the two pillars of asset pricing and what are they about?
Pillar I: Efficient Capital Markets
Using market efficiency tests, compare how asset prices should behave to the way they actually behave.
Pillar II: Asset pricing models
With two types of asset pricing models (standard asset pricing (e.g. CAPM) and empirical models) test the efficiency.
“Two Pillars of Asset Pricing” by Fama, Eugene F. (2014).
What are the three factors of The Three-Factor Model by Fama and French (1993)?
The size of firms, book-to-market values, and excess return on the market. In other words, the three factors used are SMB (small minus big), HML (high minus low), and the portfolio’s return less the risk-free rate of return.
“Two Pillars of Asset Pricing” by Fama, Eugene F. (2014).
What are the market efficiency tests about?
Comparing how asset prices should behave to the way they actually behave. Model how they should behave with an asset pricing model. If your tests reject market efficiency: Either the financial market in question is inefficient, or your asset pricing model is not good -> This issue is called the joint hypothesis problem (JHP) and to date remains an unresolved conundrum in asset pricing.
“Two Pillars of Asset Pricing” by Fama, Eugene F. (2014).
What are the market efficiency tests?
Event studies: In an efficient market, stock prices adjust promptly and accurately to new information (no further meandering or reversals). Fama finds that all stock split-related (positive) information is incorporated into prices months before the split, corroborating market efficiency. With short event windows, the JHP is rendered relatively unimportant. Over long-term horizons, it’s back in the spotlight.
Predictive regressions: Can expected inflation determine interest rates? Found out that bond and real estate prices already incorporate the best possible forecast of inflation. Expected inflation is negatively related to stock returns: a perverse finding. The JHP is back: is it a market inefficiency problem (=poor inflation forecasts), or an asset pricing model problem (=future inflation and stock returns are negatively related)? Time-varying expected stock returns: Investors’ capacity and willingness to bear the risk as well as the risk itself are not constant over time. This leads to time-varying expected returns and explains a lot of volatility in stock prices, which many behavioralists (prominently Shiller) attribute to investor irrationality.
“Wisdom of Crowds: The Value of Stock Opinions Transmitted Through Social Media” by Chen, Hailiang, Prabuddha De, Yu Hu, and Byoung-Hyoun Hwang. (2014).
What is Seeking Alpha (SA)? Why it is used in this article?
A site where investors describe their personal approach to stock picking and portfolio management. They employ the textual analysis suggesting that the frequency of negative words used in an article captures the tone of the report.
Used in this article to analyse user generated opinions about stock market.
“Wisdom of Crowds: The Value of Stock Opinions Transmitted Through Social Media” by Chen, Hailiang, Prabuddha De, Yu Hu, and Byoung-Hyoun Hwang. (2014).
What are the main findings?
The fraction of negative words in SA articles and the fraction of negative words in SA comments both negatively predict stock returns over the ensuing three months.
“Wisdom of Crowds: The Value of Stock Opinions Transmitted Through Social Media” by Chen, Hailiang, Prabuddha De, Yu Hu, and Byoung-Hyoun Hwang. (2014).
What could make social media a valuable source of investment advice?
- Articles are always reviewed by an editorial board. If editors from the social media platforms are educated and if the crowd allocates more attention to authors, that have produced good articles. This also creates an incentive to share good advice.
- Social platforms are unique. They provide the possibility of very fast feedback and allow users direct interaction.
- Users could derive significant utility from the attention and recognition they receive from posting opinions that subsequently are confirmed by the stock market.
“Wisdom of Crowds: The Value of Stock Opinions Transmitted Through Social Media” by Chen, Hailiang, Prabuddha De, Yu Hu, and Byoung-Hyoun Hwang. (2014).
What are the two channels, that point to the importance of social media outlets?
Predictability channel - Stock opinions revealed through social media contain value-relevant news.
Clout channel - Followers react to false or spurious publicity, which then moves market prices over the ensuing three months.
“Responsible investing: The ESG-efficient frontier” by Pedersen, H. Lasse, Shaun Fitzgibbons, and Lukasz Pomorski (2021).
What is this article about?
About developing an extension of CAPM for ESG and testing empirically if ESG improves or hurts performance.
“Responsible investing: The ESG-efficient frontier” by Pedersen, H. Lasse, Shaun Fitzgibbons, and Lukasz Pomorski (2021).
What does the ESG-SR frontier show?
It shows maximum Sharpe
ratio (SR) at each level of ESG.
“Responsible investing: The ESG-efficient frontier” by Pedersen, H. Lasse, Shaun Fitzgibbons, and Lukasz Pomorski (2021).
What were the three types of investors studied in this article, and what were their choices of investment?
Type of investors:
-U (ESG-unaware) are unaware of ESG scores and simply seek to
maximize return per unit of risk;
-A (ESG-aware) have the same goal, but they use assets’ ESG
scores to update their views on risk/return;
-M (ESG-motivated) are ready to sacrifice performance for high
ESG, but still want maximum Sharpe ratio at each ESG level.
Choices of these investors(Using ESG-SA frontier):
U – tangency portfolio ignoring ESG information;
A – tangency portfolio using ESG information;
M – a portfolio on ESG-efficient frontier.
“Responsible investing: The ESG-efficient frontier” by Pedersen, H. Lasse, Shaun Fitzgibbons, and Lukasz Pomorski (2021).
How are the prices determined by the ESG-adjusted CAPM model if each of the investor types prevails?
When type U investors prevail, the high-ESG stocks are undervalued (if ESG predicts high future
profits) because this type of investor ignores ESG information;
When type A investors prevail, the high-ESG stocks are bid up (if ESG predicts high future
profits);
When type M investors prevail, the high-ESG stocks are overvalued (if ESG predicts low expected returns) because this type of investor accepts lower return for higher ESG score.
*What does bidding up securities mean? Is the act of increasing the price an investor is willing to pay for a security.
“Responsible investing: The ESG-efficient frontier” by Pedersen, H. Lasse, Shaun Fitzgibbons, and Lukasz Pomorski (2021).
What is the main conclusion after the test made in this article?
Maximum SR that incorporates G proxy is about 12% higher
than the maximum SR that ignores such information → G
contains useful information.
Basically, G had an important role in this test. Investors should focus more on the Governmental side to be included in their portfolio.
“Responsible investing: The ESG-efficient frontier” by Pedersen, H. Lasse, Shaun Fitzgibbons, and Lukasz Pomorski (2021).
What are the two channels through which ESG can impact returns?
- If ESG correlates with future fundamentals (profitability), then ESG can be used to pick ”better” stocks that will have
higher return; this is a positive effect (return premium); - If ESG correlates with investor demand, then high-ESG stocks are sought by many investors, which pushes their
valuation up and expected return down; this is a negative effect (return discount).
