1. Asset pricing Flashcards
“Wisdom of Crowds: The Value of Stock Opinions Transmitted Through Social Media”
What is the era of DIY financial analysis and what are the reasons behind it?
The era of DIY financial analysis:
§ reduced reliance on expert advice
§ increased reliance on peer reviews (25% of investors)
Reasons behind such trends:
§ emergence of social media platforms
§ creation and consumption of user-generated content
“Wisdom of Crowds: The Value of Stock Opinions Transmitted Through Social Media”
What are the motivators for contributors to write articles for the SA?
Users derive significant utility from the attention and recognition received from the articles (Forbes, Morningstar, etc.)
SA contributors earn money for page visits (article views and read- to-ends), while publishing depends on SA editorial board
Informed investors have an incentive to contribute to SA to convince others to follow their approach
“The U.S. Equity Return Premium: Past, Present, and Future”
Authors propose several possible explanations for the equity premium puzzle. State and shortly elaborate on three of the proposed explanations. (6p)
1) Ambiguity aversion: investors require a premium for not knowing the true probability distribution of the stock market
2) Risk aversion
Extremely high degree of risk aversion needed to support the existing equity premium (coefficient of 50
outside the reasonable range from 1 to 3)
Agents should be nearly risk-neutral on all bets that do not involve a substantial fraction of lifetime wealth, because only substantial variations in lifetime wealth, and thus in current consumption, could justify such risk aversion
3) Loss aversion: greater sensitivity to losses than to gains
Chance of relative gain = 10 ∗ Chance of relative loss
Average amount of gain = 17 ∗ Average amount of loss
The average dollar lost relative to the risk-free return would have to be 170 times more painful than the average dollar gained is pleasurable.
4) Lower-tail risk
Fewer low-probability but large-magnitude economic catastrophes in the returns history.
Large and unknown true lower-tail risk (the magnitude of the “black swan” should be strong enough, affect equities without affecting bills and bonds)
5) Myopia: improper discounting and much attention to high short-term risks
6) Transaction costs (larger for equities)
“The U.S. Equity Return Premium: Past, Present, and Future”
What is equity premium puzzle?
And what is the risk of investing in equity rather than bonds?
Def: for more than a century, the diversified long-horizon investments in America’s stock market have consistently received higher average returns than those in bonds with no more risk (by 6% p.a. on average)
Evidence: Since WWII U.S. equity returns have averaged 6.9% per year, while those of real government bills and bonds averaged only 1.4% and 1.1% respectively (also documented in other economies)
SHORT RUN RISK:
in 35% of past century’s years bonds have outperformed stocks, in 1931 bonds have outperformed equities by 60%
“The U.S. Equity Return Premium: Past, Present, and Future”
What are the provisions of equity premium in the future?
Why and how CFO’s predictions differ from financial economists’ predictions?
Equity premium forecasts: financial economists – 6-7% over the next 10-30 years, CFOs –3.2%, authors’ calculations based on valuation models – 2.55-4.33%.
CFO’s predictions are biased. They are interested in lower r(e) to be able to finance more projects.
r(e) reinvest more
No plausible explanation as to why the future is likely to be any different from the past
It is reasonable to believe that EP will continue at a lower level, e.g. 4% (institutional changes, interest in profiting from EP, faded memory of the Great Depression, etc.)
“The Capital Asset Pricing Model: Theory and Evidence”
Authors discuss the relationship between beta and expected return that has prevailed in the US stock market over the past few decades.
(i) How the empirical relationship compares with that predicted by the Sharpe- Lintner version of the CAPM?
(ii) How the CAPM can be modified to take into account of the pattern in the data and what are economic explanations for this pattern? (4p)
i) The version of the CAPM developed by Sharpe and Lintner has never been of empirical success. The evidence shows that the relation of beta and average return is too flat (the intercept is greater than the average risk-free rate; the coeff on beta is less than the average excess market return). Fama and French also prove with the test that in real life the relation between beta and average return is much flatter than CAPM predicts. The returns on low beta portfolios are too high, and the returns on high beta portfolios are too low.
ii) Merton’s Intertemporal Asset Pricing Model (ICAPM) is an extension of CAPM. In this model, investors are
concerned not only with their end-of-period payoff but also with the opportunities they will have to consume or invest the payoff. It requires additional betas for stated variables (labor income, prices of consumption goods, etc). As a result, optimal portfolios are “multifactor efficient” (=> have the largest possible exp returns, given their return variances and the covariances with relevant state variables).
“Two Pillars of Asset Pricing”
- What is the Joint Hypothesis Problem?
- Why does it make it hard to convincingly prove that the Efficient Market Hypothesis is wrong?
- Which anomaly in the markets, in particular, remains an issue for the Efficient Market Hypothesis? (3p)
- JHP arises with market efficiency tests when comparing how prices should react to the way they actually behave. If the test fails, we don’t know whether the problem is in an inefficient market or a bad model of market equilibrium.
- EMH - asset prices reflect all available information. The difficulty is making the hypothesis testable. We can’t test whether the market does what it is supposed to do unless we specify what it is supposed to do.
- Irrational bubbles.EMH would argue that bubbles don’t really exist. In essence, then, the market price is an accurate reflection of value, and a bubble is simply a notable change in the fundamental expectations about an asset’s returns (not predictable by EMH, can be predictable by other economists).
“Two Pillars of Asset Pricing”
Explain the price-to-price feedback theory. What is Eugene Fama’s attitude towards irrational bubbles? (5p)
BUBBLES: Commonly defined as irrational strong price increase that implies a predictable corrective strong decline, but is that so?
§ Some evidence shows that large swings in stock prices (“bubble candidates”) are responses to large swings in real activity, with stock prices forecasting real activity – argument in favor of the EMH.
§ Some say bubbles are market corrections of too high prices.
But which leg of a “bubble” is irrational: the up or the down? (irrational optimism vs irrational pessimism)
What are CAPM assumptions?
- Investors are rational and risk-averse.
- Investors can borrow and lend at risk free rate unlimited amount.
- Assets are infinitely divisible.
- Investors are never satiated.
- Investors are price takers, they cannot influence prices.
- Trade without transaction or taxation costs.
- Assume all information is available at the same time to all investors.
- All investors have homogeneous expectations and expectations concerning equity market.
What is arbitrage pricing theory?
And what are the three factors from Three Factor Model?
If there is no arbitrage in the economy, then we can also price assets relative to one another based on their comovement with these factors.
1) Market factor risk premium
2) Size factor risk premium
Smaller stocks -> higher return.
Large companies are stable thus less volatile and less risky.
3) Book-to-market-factor risk premium.
Higher book-to-market (interpreted as more risky) -> higher return.
“Behavioral Economics: Past, Present, and Future”
Why the current economic models are criticised and do they remain valid in the future?
What is the conclusion about behavioral economics?
Models of rational behavior became standard because they were easier to solve (“one begins learning physics by studying objects in vacuum; atmosphere can be added later, but its importance was never denied by physicists”).
Economists said that the existence of air does not matter all too much, or they denied the existence of air (these are called - explainawaytions). Economists started studying Econs not Humans.
While rational models are quite good in some cases, they miserably fail in others (tic-tac-toe vs. chess – agents are expected to act as if they understood the complicated model).
The behavioral theory should be evidence-based and serve to enhance the existing economic theories. Thus in the future “behavioural” will disappear and will be the new “economics” with behavioural models included as a base.
“Behavioral Economics: Past, Present, and Future”
Refute this claim:
The errors of humans are randomly distributed with the mean of zero, washing out on
aggregate; non-experts just have more noise
humans make judgments that are systematically biased, which could be predicted using a theory of human cognition. E.g. by utilizing clever framing, a majority of subjects can be induced to select a dominated pair of options (prospect theory: decision making under uncertainty – A) sure payoff vs. B) chance payoff tests)
“Behavioral Economics: Past, Present, and Future”
Refute this claim:
agents should have higher stakes and pay more attention or they can choose a few times and learn from previous mistakes (big vs. small decisions – not both)
1) no learning in the Heads-Tails experiment due to the lack of feedback and false reinforcement
2) “preference reversal” – of those who preferred the p-bet, a majority reported a higher selling price for the $-bet, implying that they valued it more; raising stakes raises the frequency of reversals (other than that, not much evidence on stakes)
“Behavioral Economics: Past, Present, and Future”
Refute this claim:
the “invisible handwave” – when agents interact in a market environment, any tendencies to misbehave will be vanquished
How is the market going to help? For businesses it is easier and more profitable to cater to biases than to eradicate them ($70 unlimited monthly fee vs. 10 visits for $100, house mortgages and the recent financial crisis, retirement savings)
“Behavioral Economics: Past, Present, and Future”
What are the behavioural beliefs that distract and harm finance and economics?
§ Expectations seem to rely too much on extrapolation of recent trends (HHHHH -> next must be T, but noo.. its 50/50 that it can be H or T)
§ Agents have no self-awareness of their lack of predictive skills (CFO forecasting experiment)
