12 Flipped Lecture

Question 1

What where the key discussion points between Eugene Fama (EMH) and Richard Thaler (Behavioural finance)

Answer 1

• Many economists say that markets are efficient and incorporate all information
  o Behavioural economists disagree with this
  o As it is easy to say but hard to test, can you beat the market and are prices correct?
  o Ultimately it is a model and only an approximation and is good for most purposes
• A against argument is black Monday where without news over the weekend the markets closed 25% lower on Monday than they did the prior Friday
  o How can these both be rational in the absence of news
• Unpredictable doesn’t mean rational
• Adjustment from announcements to earnings takes a few days
  o There is also a following momentum from behavioural drift
  o Markets are not perfectly efficient question is how inefficient it is an close to efficiency
  o When you move away from CAPM you are saying each unit of variance justifies a different price
• Argument of people picking stocks for their taste
  o If you buy these undervalued stocks you could make higher returns
  o But this requires (some) people to change their minds
• Markets are the best way of distributing resources we have created
• Ignore sunk costs, assume everyone else doesn’t
  o People aren’t all rational
  o There will never be a perfect correct model
  o Physics doesn’t build good bridges, you need engineering
   This is as economic theory is to the real world

Question 2

What were the key points by Chris McKnett on Sustainable investing

Answer 2

• The largest institutional investors have the power to drive the change to sustainable investments
• The over consumption of resources is an economic issue
  o It will affect the risk and return of the future
• Therefore, are the investment rules of today going to be the rules of tomorrow when there are greater constraints on resources
  o Water, waste, pollution, land, trees
• Limiting future risk by adding ESG KPIs to financial information
• Data shows stocks with high ESG scores perform as well as the market
  o Shows environmental leadership is compatible with returns
  o Some outperform the market and as it helps the plant why not
• There are risk to action but there are also the risks of inaction

Question 3

What did Burton Malkiel say on the The Efficient Market Hypothesis and Its Critics

Answer 3

• It was generally believed that securities markets were extremely efficient in reflecting information about individual stocks and about the stock market as a whole. The accepted view was that when information arises, the news spreads very quickly and is incorporated into the prices of securities without delay. Thus, neither technical analysis, which is the study of past stock prices in an attempt to predict future prices, nor even fundamental analysis, which is the analysis of financial information such as company earnings and asset values to help investors select “undervalued” stocks, would enable an investor to achieve returns greater than those that could be obtained by holding a randomly selected portfolio of individual stocks, at least not with comparable risk
• The efficient market hypothesis is associated with the idea of a “random walk,” which is a term loosely used in the finance literature to characterize a price series where all subsequent price changes represent random departures from previous prices. The logic of the random walk idea is that if the flow of information is unimpeded and information is immediately reflected in stock prices, then tomorrow’s price change will reflect only tomorrow’s news and will be independent of the price changes today. But news is by definition unpredictable, and, thus, resulting price changes must be unpredictable and random. As a result, prices fully reflect all known information, and even uninformed investors buying a diversified portfolio at the tableau of prices given by the market will obtain a rate of return as generous as that achieved by the experts

Question 4

What did George Akerlof say on Asymmetric information

Answer 4

• In the 80s there was a growth in the amount of capital in the big investment banks
  o New forms of investments such as credit default swaps which could be hedged helped grow this number.
• When an asset deviates actual value deviates from its fundamental value it will revert to the mean
  o Then two assets are correlated but one has deviated from the mean more than the other one can be brought and the other sold short, however to make significant profits very high leverage is needed
   Very high debts for normal operations
   When they messed up then they would expose their creditors to huge default risks and made a long line of dominoes
   They worked well in normal times but when models failed to describe reality, when the EMH broke down and prices diverged from averages not reverted it broke to system
• Confidence means trust and full belief
  o Means that people are not always rational, belief.
  o A trusting person goes beyond the rational and throws away some of the rational
  o When they are trusting asset values are high as long as confidence in the valuations stays, when it fails it does not come back
• Free markets make what people desire as long as they can make a profit
  o But they do make snake oil
  o Often, they produce what they think people want as long as they make a profit
  o When overconfident markets with little regulation are overconfident they will produce anything they can sell for a profit, not things that are needed by the buyer
• Most business cycles are associated with stories
  o The stories are the underlying basis on people confidence
  o For instance the dot.com boom people built the story that they were rationally priced, a lack of skepticism where they put their money in assets that couldn’t be accurately rated
  o This created a story of low risk and people flocked in to buy the snake oil
  o When the story changed the bust followed
• Failure can be based on use of financial models but this gave an incomplete view on how the markets actually worked
• This really looks at protecting non financial experts from financial experts looking to make high profits

Question 5

What did Professor Sohnke Bartram say on How can we determine mkt efficiency

Answer 5

• Are the extra returns for investment strategies:
  o From the additional risk
  o From data mining or snooping
  o Or from the capture of market inefficiencies and arbitrage of mispricing
• For this need to find out the fair value but this is hard as models are based on assumptions that often do not hold true
• Then need to make sure they are not extra returns for risk
  o So need to discount for extra risk carried
• Finds it is possible to get risk adjusted profits
  o Means that markets are not efficient
  o Biggest in Asia-Pacific
  o Also emerging markets
   Suggesting these are the least information efficient
• Tries to make back testing consider if it is possible for a trader to have followed the strategy
• Also considers transactional costs
• There is a decay in returns over time