Guiding Seminar 1

Question 1

Wisdom of Crowds: The Value of Stock Opinions
Transmitted Through Social Media

What are the two reasons why consumers rely less on expert advice and turn to fellow customers instead?

Answer 1

i) emergence and proliferation of social media
platforms;
ii) creation and consumption of user-generated content

Question 2

Wisdom of Crowds: The Value of Stock Opinions
Transmitted Through Social Media

What were the two research questions the authors researched?

Answer 2

1) Do peer opinions actually transmit value-relevant information? (or are they just
“random chatter”, and we rather leave the task to professionals?)
2) Are some users attempting to intentionally spread false information to mislead
“fellow customers”?

Question 3

Wisdom of Crowds: The Value of Stock Opinions
Transmitted Through Social Media

What are the two channels to voice one’s opinion on seekingalpha.com?

Answer 3

1) Opinion articles (reviewed by a panel, subject to editorial changes)
2) Commentaries written in response to articles, other users sharing their views

Question 4

Wisdom of Crowds: The Value of Stock Opinions
Transmitted Through Social Media

What methodology was used by the authors?

Answer 4

Textual analysis: the frequency of negative words (as a fraction of the total
wordcount) used in an article/commentary captures its tone. The finance-specific
negative word list compiled by Loughran and McDonald (2011) has been used
NegSAi,t – average fraction of negative words across all single-ticker articles
published on SA about company i on day t
NegSA-Commenti,t – average fraction of negative words across all SA comments
posted in response to single-ticker articles about company i on day t

Question 5

Wisdom of Crowds: The Value of Stock Opinions
Transmitted Through Social Media

What were the results?

Answer 5

The faction of negative words in an article or comment has a statistically significant impact on the subsequent stock price performance. (holds even after controlling for the effect of traditional advice sources).
SA has a long term effect on the stock performance as opposed to I/B/E/S (perhaps due to a difference in popularity).

More negative words in an article about a company –> its abnormal returns are lower.
If there are many negative words in an article–> naive investors immediately short the stock and vice versa, hence, the stock’s value decreases

More negative words in an article –> subsequent scaled earnings (Net income) is lower than market expectations (by 0.23%-0.26%).

Question 6

Wisdom of Crowds: The Value of Stock Opinions
Transmitted Through Social Media

What are the two reasons for the relationship between negative words in an article and negative abnormal returns for the stock?

Answer 6

1. Predictability channel- the articles contain value-relevant information, which is not yet reflected in the price of the stock –> market participants learn the information and adjust the prices accordingly
2. Clout channel- SA views reflect false and spurious information–> SA readers are naive and trade in the direction suggested, which is unlikely due to i) no return reversal and ii) capital constraints of SA followers

Question 7

Wisdom of Crowds: The Value of Stock Opinions
Transmitted Through Social Media

What is an earnings surprise?

Answer 7

Difference between the reported quarterly Net income and the average Net income forecasts across all equity analysts following the company

Question 8

Wisdom of Crowds: The Value of Stock Opinions
Transmitted Through Social Media

What incentives informed market participants have to share their value-relevant insights?

Answer 8

• Striving to become celebrities: Users derive significant utility from the attention
and recognition they receive from others when their opinions are confirmed by
the stock market. Occasionally SA contributors are even referred to in such
prominent outlets as Forbes, WSJ-Marketwatch, and Morningstar
• Money: Each SA contributor earns $10 per 1,000 page views that his/her article
receives, and authors with good track record attract more followers
• Feedback system: other users can intervene and correct bad articles, which
further discourages attempts of misinformation
• Convergence to fundamental value: if SA users can move stock prices, authors
may want to incentivize the convergence of market prices to what they perceive
to be the fair fundamental values

Question 9

The U.S. Equity Return Premium: Past, Present, and
Future

What is an equity premium puzzle?

Answer 9

Definition: for more than a century, diversified long-horizon investments in
America’s stock market has consistently received higher returns (almost by 6%
p.a. on average) than those in bonds with no more risk

Question 10

The U.S. Equity Return Premium: Past, Present, and
Future

Why do more people invest in T-bills or bonds rather than equities if they outperform bonds?

Answer 10

1. Utility theory (marginal utility of wealth differs for gains and losses)
2. Risk aversion (rather make certain gains as opposed to uncertain ones). High risk aversion should lead to high risk free-rate- but in reality risk free rate very low –> risk-free rate puzzle
3. Loss aversion (losing money brings more pain compared to the happiness of gaining money –> prospect theory).
4. Transaction costs and investor heterogeneity (most people do not trade at all)
5. Uninsurable idiosyncratic income shocks correlated with the market (e.g. being fired during a recession)
6. Unknown true lower-tail risk.
7. Learning about the return distribution- investors and regulators misread the riskiness of equities in the early 20th century, then they adjusted their expectations–> prices rose even more and not they overstated the equity premium –> we can expect the equity premium to decrease as market participants learn about the return distribution of equities

Question 11

The U.S. Equity Return Premium: Past, Present, and
Future

What is the future of the equity premium?

Answer 11

• Many Wall Street observers agree that a substantial equity premium remains as of today and will persist in the future
• Equity premium forecasts: financial economists: 6-7% over the next 10-30 years; CFOs : 3.2%; authors’ estimates: 2.55-4.33%
• It is reasonable to believe that equity premium will likely continue, though at a lower rate than historically – perhaps at around 4% p.a. instead of 6% (institutional changes (ERISA), interest in profiting from equity premium, faded memory from the Great Depression)

Question 12

Two Pillars of Asset Pricing

What are market efficiency tests/ Joint hypothesis problem (JHP)? What are the three forms of market efficiency?

Answer 12

3 forms of market efficiency:
▪ Weak: prices incorporate only the information from past price movements (invalidates technical
analysis)
▪ Semi-strong: all publicly-available information is incorporated into prices (past and current)
▪ Strong: prices incorporate all available information (public and non-public)
Market efficiency tests: 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 no good
This issue is called the joint hypothesis problem (JHP) and to date remains an unresolved
conundrum in asset pricing

Question 13

Two Pillars of Asset Pricing

What does Fama find about market efficiency through event studies?

Answer 13

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 JPH is rendered relatively unimportant. Over long-term
horizons, it’s back in the spotlight

Question 14

Two Pillars of Asset Pricing

What does Fama find about market efficiency through predictive regressions?

Answer 14

Can expected inflation determine interest rates? –> bond and real estate prices already incorporate the best possible forecast for inflation
Expected inflation is negatively related to stock returns.

Question 15

Two Pillars of Asset Pricing

What does Fama find about market efficiency through time-varying expected stock returns?

Answer 15

Time-varying expected stock returns. Investors’ capacity and willingness to bear risk as well as the risk itself are not constant over time. This leads to time-varying expected returns and explains (according to rationalists) a lot of volatility in stock prices, which many behavioralists (prominently Shiller) attribute to investor irrationality

Question 16

Two Pillars of Asset Pricing

What does Fama find about market efficiency through bubbles?

Answer 16

Bubbles: irrational price increases that lead to predictable declines. Fama doesn’t believe in bubbles. Fama claims that:
▪ No price declines are ever predictable (50/50 guessing game)
▪ Price declines are not irrational because they are driven by slowdowns in real economic activity
Fama denounces behavioral finance for not offering a viable alternative but merely criticizing the existing models. Fama: “Which leg of a “bubble” is irrational: the up or the down?” (i.e. irrational optimism vs. irrational pessimism)
Effient market hypothesis –> cannot predict price decreases and cannot anticipate bubbles

Question 17

Two Pillars of Asset Pricing

What are the two types of asset pricing models?

Answer 17

Asset Pricing Models:
• Standard models work forward from assumptions about investor tastes and investment opportunities (CAPM and its variations)
• Empirical models work backwards – they take as given the patterns in average returns, and propose other variables that capture them (FF factor models, APT)

Question 18

Behavioral Economics: Past, Present, and Future

What is the main problem with the current theory?

Answer 18

One theory, two tasks: relying on one theory to both characterize optimal behavior and predict
actual behavior (supposedly irrelevant factors, or SIFs, determining behavior) --> one theory cannot do both

Question 19

Behavioral Economics: Past, Present, and Future

What are the characteristics of a Homo economicus (rational behavior)?

Answer 19

Idealized model of Homo economicus:
• Agents have well-defined preferences and unbiased beliefs and expectations (infinite cognitive
abilities)
• They make optimal choices based on these beliefs and preferences (infinite willpower)
• Their primary motivation is self-interest

Question 20

Behavioral Economics: Past, Present, and Future

What are explain-away-tions?

Answer 20

“Explain-away-tions”:
Models of rational behavior became standard because they were easier to solve (not meant as a
put-down: “one begins learning physics by studying objects in vacuum; atmosphere can be added
later, but its importance was never denied by physicists”)
Models of rational behavior are good in some cases, but they miserably fail in others (tic-tac-toe vs.
chess – agents are expected to act as if they understood the complicated model)

Question 21

Behavioral Economics: Past, Present, and Future

Refute the claim: We should judge theories based on not whether they describe but whether they predict
behavior – expert billiard player example

Answer 21

Refute: But what about non-experts? Moreover, even experts are unable to optimize when the
problems are difficult (e.g. chess)

Question 22

Behavioral Economics: Past, Present, and Future

Refute the claim: The errors of humans are randomly distributed with the mean of zero, cancelling out when
individual observations are aggregated; non-experts just have more noise (higher variance)

Answer 22

Refute: humans make judgements that are systematically biased, which could be predicted using a theory of human cognition; 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)
riskless payoff vs. B) risky payoff tests)

Question 23

Behavioral Economics: Past, Present, and Future

Refute the 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)

Answer 23

Refute 1: no learning in the Heads-Tails experiment due to the lack of feedback and false
reinforcement
Refute 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 (mug vs book example)

Question 24

Behavioral Economics: Past, Present, and Future

Refute the claim the “invisible handwave” – when agents interact in a market environment, any
tendencies to misbehave will be vanquished

Answer 24

Refute: 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)

Question 25

Behavioral Economics: Past, Present, and Future

What is the efficient market hypothesis? And what are the two components of EMH?

Answer 25

The activities of “smart money” arbitrageurs can assure that markets behave “as if” everyone is
smart
Two EMH components:
“No free lunch”: not possible to beat the market on a risk-adjusted basis (the active mutual fund
industry does not beat the market on average)
“Price is right”: difficult to test as the security fundamental value is not known – use the law of one
price (CUBA closed-end mutual fund trading at a huge premium relative to its net asset value)

Question 26

Behavioral Economics: Past, Present, and Future

What are the two issues of rationalist theories?

Answer 26

Policymakers shouldn’t assume that EMH holds to avoid bubbles
There isn’t much confidence that prices in other markets with no easy short selling opportunities
are good measures of value (e.g. labor power – can workers become significantly less productive by
changing industries)

Question 27

Behavioral Economics: Past, Present, and Future

What is prospect theory?

Answer 27

Prospect theory:
• Utility is derived from changes in wealth relative to some reference point rather than levels of
wealth
• The “value function” has a kink at the origin with losses weighing more heavily than gains (“loss
aversion”)
• Decision weights are a function of probabilities

Hence, people are not rational and should include bahavioral theory in the models.

Question 28

Behavioral Economics: Past, Present, and Future

What is intertemporal choice?

Answer 28

Intertemporal choice (“myopia”) – the discount rate between “now” and “later” is much higher
than between “later” and “even later” (i.e. people are impatient)

Question 29

Behavioral Economics: Past, Present, and Future

What are the alternative models to the rational models?

Answer 29

1. Intertemporal choice (“myopia”) - people are impatient
   • Two-self, or “two-system” approach, which helps to overcome the paradox of long-sighted
   planner and “myopic” doer (elements of both- rational and myopic behavior)
   • “Beta-delta” model, where delta is the standard exponential discount rate and beta measures
   short-term impatience (portable extension to existing models – standard model is a special case
   with a beta of 1)
2. Prospect theory (losses weigh more than gains)
3. “Other-regarding preferences” models: humans are not completely selfish, even to strangers (e.g.
   one-shot prisoner’s dilemma, public goods games)

Question 30

Anomalies: The Law of One Price in Financial Markets

What is the law of one price?

Answer 30

The Law of One Price: if there are no transaction costs or other constraints (e.g. short
selling), identical goods must have identical prices
Motivation: should two identical goods be traded at different prices, arbitrageurs will
immediately step in and exploit the arbitrage opportunity
An arbitrage opportunity is an option to make a riskless profit by trading in misprices
assets

Question 31

Anomalies: The Law of One Price in Financial Markets

Why doesn’t the law of price hold?

Answer 31

In financial markets, not all of these conditions hold:
▪ Not all goods have close or any substitutes (GM shares; the whole US stock
market)
▪ Financial markets often are fragmented
▪ Arbitrage opportunities are hardly ever completely riskless. Oftentimes, they are
good but risky bets
–> short selling forbidden in some countries (?)

Question 32

Anomalies: The Law of One Price in Financial Markets

What is a closed-end country fund and why does the law of one price not hold within it? (Claim and refute)

Answer 32

Closed-end country funds (i) invest significant amounts in foreign securities (e.g. $1bn);
(ii) issue shares representing ownership in the fund (e.g. 10m shares) and list them on a
stock exchange; (iii) the shares are traded like those of a regular company; (iv) the fund’s
CFs (from dividends or sale of company shares) are distributed to shareholders or
reinvested (1-2% annual management fee)
The relationship between the fund prices and net asset values (NAVs) can vary across
funds and time with both huge discounts and premia (due to manager’s fee) –> NAV and the the price of the fund should be equal

–>Argument: the two assets (the fund’s shares and the underlying basket) are not precisely
identical – the fund portfolio manager charges a fee and incurs other expenses (CF to the
basket and to the fund’s shareholders are not identical) or has a superior stock-picking
abilities
–>Refute: This could justify only moderate discounts/premia. + In practice there is little
relation between discounts/premia and fund performance
–>Argument: the premium of country funds could be due to legal barriers preventing investors from
buying foreign stock (i.e. LOP may not hold due to market fragmentation or in presence of
significant transaction costs)
–> Taiwan country fund story: shortly after its launch in the U.S., the country fund traded at a 205%
premium (the premium stayed above 100% for 10 weeks and above 50% for 30 weeks..)
–>Argument: legal barriers prevented U.S. investors from buying Taiwanese stocks directly
–>But why pay so much? (equivalent to paying $1 for $0.33 of assets)
In other cases premiums persisted even in the absence of trading barriers:
• German country fund story: after Berlin wall fell, the fund value rose more than the value of
underlying stocks – from trading at a 9% discount to a 100% premium; after the euphoria in the
U.S. wore off, the premium fell close to 0%
But U.S. investors were free to invest directly in Germany

Question 33

Anomalies: The Law of One Price in Financial Markets

What examples did the authors provide to show that the law of one price does not hold?

Answer 33

1. Closed-end country funds (market price vs NAV)
2. American Depositary Receipts (ADRs)- Infosys story- American investors pay huge premiums to ADRs to have shares in a company in India, while prices are low in domestic India’s markets.
3. Twin shares (two types of shares with fixed claims of assets and cash flows)- Royal Dutch shares got 60% of company’s profits, while Shell shares only 40% event though the same company.
4. Dual class shares (identical CFs but different voting rights)- Molex story- when voting shares were added to S&P 500, the premium rose 49%.
5. Corporate spinoffs (3com created a new division Palm–> 1 share of 3com had an embedded share of 1.5 Palm shares)

Question 34

Anomalies: The Law of One Price in Financial Markets

What is Long-Term capital management? What is a noice-trader risk?

Answer 34

Long-Term Capital Management: a venerable multi-billion hedge fund trading mainly in fixed income securities (making bets on the convergence of bond spreads). Had a range of converge-divergence exposures in equities as well.
Fell victim of the “noise trader” risk. Even though spreads between identical assets should in theory be eliminated, in practice they can stay constant or even widen for longer than any arbitrageur can sustain their position

Question 35

Anomalies: The Law of One Price in Financial Markets

What prevents arbitraguers from enforcing the law?

Answer 35

What prevents arbitrageurs from enforcing the Law:
i) Short selling constraints:
• Lendable supply of shares or products is limited (most of shares held by noninstitutional investors – Palm) + legal barriers to foreign trading (country funds)
• Transaction costs
ii) Noise trader risk: after an arbitrageur takes a position, the disparity can widen →
margin calls → forced to liquidate the position at a loss (think LTCM)

Question 36

Anomalies: The Law of One Price in Financial Markets

What is the concluson about the violations of law of one price?

Answer 36

Violations of the Law generally do not create arbitrage opportunities (sure profits with no
risk) – they create good but risky bets

Question 37

Forensic Finance

What is forensic investigation?

Answer 37

Forensic investigation: using scientific knowledge (chemical traces, DNA, prices,
quantities, market institutions, etc.) to collect and sift evidence of possible crimes

Question 38

Forensic Finance

What were the findings by forensic investigators?

Answer 38

1. NASDAQ stocks being quoted in even-eights of a dollar, wlthough one-eights were allowed–> dealers colluding to keep the bid ask spread wider
2. Late trading of mutual funds- can trade on the market’s price of the fund’s portfolio (NAV) calculated once per day (4 pm EST), orders received after 4pm should be executed at tomorrow’s NAV, however, some brokerage firms were allowed to submit their orders after 4pm–> not fair since many firms announce news after 4 pm on purpose). firms choose granting date after having observed on what date during month the stock had the lowest price) (Apple example with Steve Jobs). –> Sarbanes-Oxley Act- executives are obligated to report insider trades within 2 business days of the transaction.
3. Spinning of IPOs- IB receives an order to buy shares, but if the order is oversubscribed, the IB can allocate the shares how it wants (since usually IPO offer price is lower than the market price). IB often allocate underpriced (‘hot’) IPOs to the personal brokerage accounts. (Bernie Ebbers scandal).
4. Rewriting the history of market recommendations- I/B/E/S –> Thompson Financial claimed that it was a programming error.

Question 39

Forensic Finance

What is spring loading? Option backdating?

Answer 39

Employee stock option backdating- market price of the stock can’t be higher than the exercise price–> firms choose granting date after having observed on what date during a month the stock had the lowest price).
Spring loading- granting options immediately before the announcement of good news.
Bullet dodging- a shady employee stock option granting practice, in which the granting of the options is delayed until a piece of really bad news involving the company has been made public and the stock’s price falls. (Investopedia)
Sarbanes-Oxley Act- executives are obligated to report insider trades within 2 business days of the transaction.

Question 40

Forensic Finance

What are the reasons for option backdating?

Answer 40

• Managers are receiving an increased value directly if and when the options are exercised
• Employees should be willing to accept lower wages if offered cheap options (boosts reported
profits)
• The value of exercised options is deductible from taxable income (conserving cash through
paying less tax)

Question 41

Forensic Finance

What is meant by spinning?

Answer 41

Spinning of IPOs- IB receives an order to buy shares, but if the order is oversubscribed, the IB can allocate the shares how it wants (since usually IPO offer price is lower than the market price). IB often allocate underpriced (‘hot’) IPOs to the personal brokerage accounts. (Bernie Ebbers scandal).

Question 42

Should We Fear Derivatives?

What are derivatives? What are the types of derivatives?

Answer 42

financial instruments whose promised payoffs are derived from the value of the “underlying” (level of S&P 500, winner of the presidential elections, number of bankruptcies, amounts of rainfall, etc.)
• Plain vanilla: forwards, futures, options, and their combinations (e.g.
swaps)
• Exotic: complicated function of one or more underlyings (rainbow, binary,
cash or share, Bermudan, etc.)
The derivative must be worth the same as the replicating portfolio if financial markets are frictionless, since otherwise there’s an arbitrage
opportunity
First ever options on tulip bulbs in Holland and futures market for rice in Japan

Question 43

Should We Fear Derivatives?

Who uses derivatives and why?

Answer 43

–>Nonfinancial firms (59.8% of them do):
• Reduce their stock volatility by 5%, interest rate risk exposure by 22%, and foreign exchange risk
exposure by 11%
• Minimize accounting earnings volatility
• Reduce the present value of their tax liabilities
• Underuse derivative to increase the value of managerial stock options
• Speculate
–>Financial firms (banks and IBs):
• Trade derivatives to profit (96.6% of the portfolio)
• Manage risk (3.4% of the portfolio)
–>The use of derivatives by individuals is very limited, as they cannot hedge through derivatives the
risk associated with the value of their house or the value of their human capital

Question 44

Should We Fear Derivatives?

What are the benefits of derivatives?

Answer 44

–> Improved risk allocation (risk is taken by investors who are in the best position to
bear the risk)
–> Enhanced information efficiency of the underlying securities’ markets (e.g.
through futures, CDSs, etc.) Especially if the underlying security is illiquid
–> Cheaper than replication (much lower transaction costs, circumvent the need for
continuous trading in replicating portfolios)
–> Hedging: derivatives render previous unhedgeable risks hedgeable (think weather
derivatives). Expanding investment opportunities: with more refined handling of risk, investors’
investment universe is markedly widened

Question 45

Should We Fear Derivatives?

What are the risks of derivatives?

Answer 45

• -> Derivatives are often very difficult to value properly due to their illiquidity and
  complexity. The neat assumptions used in theory (e.g. those underpinning the BMS
  model) are often invalid in practice
• -> Liquidity. Many derivatives are at best thinly traded (non-standardized products in OTC markets). This makes certain derivative positions hard to get out of
• -> Derivatives may create complicated webs of exposures among many financial institutions (systematic risk). If a systemically-important actor (typically large in size and well-connected) faces imminent trouble, its counterparties may rush for the exit (unwind their positions) (LTCM)
• -> Firms’ reporting of derivative positions and related risks is imperfect
• -> Perverse incentives: derivatives may generate superior absolute but not riskadjusted profits. Firms may be incapable of accounting for all the associated risks. Their tools are often too blunt

Question 46

Hedge Funds: Past, Present, and Future

What is the difference between mutual and hedge funds?

Answer 46

Mutual funds- heavily regulated, large in size with small initial investment, passive or active, almost anyone can become an investor, simple investment strategies, investors allowed to withdraw funds daily, obligated to disclose a lot of information.
Hedge funds- relatively unregulated, smaller in size with larger initial investment, actively managed, issue securities privately, fund returns don’t depend on market returns, complex investment strategies, restric the abilitiy of investors to withdraw funds, lack of disclosure makes proper risk evaluation very difficult).

Question 47

Hedge Funds: Past, Present, and Future

What are the 5 hedge fund strategies?

Answer 47

1) Long-short equity (31%) and (more broadly) convergence/divergence strategies seek to exploit temporary mispricings between identical or very similar assets. e.g. two similar oil companies trading at different valuations. Buy the cheap one and short the expensive one (equal $ amounts), obtain a market-neutral strategy
2) Event-driven strategies (20%) are aimed at trading around market-moving events with a view to exploiting erroneous investor sentiment or superior information & timing
3) Macro strategies (10%) seek to identify mispricings in equity markets, interest rates, FX, commodities. Use a top-down approach to research
4) Fixed-income arbitrage (8%) strategies attempt to find arbitrage opportunities in the fixed-income markets
5) Multi-strategy funds (13%) combine two or more of the existing strategies

Question 48

Hedge Funds: Past, Present, and Future

What are funds-of-hedge-funds ?

Answer 48

Since there are no investable hedge fund indices, you can invest in a fund-of-hedge-fund- a fund that invests in many hedge funds providing diversification across multiple HFs for its investors.

Question 49

Hedge Funds: Past, Present, and Future

What are the problems with evaluating the risk-adjusted performance of hedge funds?

Answer 49

▪ Biased sample due to voluntary reporting
▪ Difficult to measure risk-adjusted returns due to complex strategies with complex derivatives
and non-linear payoffs
▪ Black swans or low-probability events of severe magnitudes may not be observed within a single
fund’s lifetime. Thus, the true risks may be underestimated
▪ Problems of valuation of OTC-traded securities. Managerial discretion in such valuation leads to
serially-correlated returns (smoothing returns)
On average, hedge funds generate positive but insignificant alphas
Moreover, performance tends to persist, according to some studies. Hence, it makes sense to invest
in top-performing hedge funds

Question 50

Hedge Funds: Past, Present, and Future

What are the risks associated with hedge funds?

Answer 50

1) Investor protection: Annually, 10% of hedge funds discontinue their operations. Some do so because
of poor performance, other because of fraud
2) Risks to financial institutions: hedge funds borrow extensively to make leverage bets and act as
counterparties in many derivatives positions (think LTCM)
3) Liquidity risk: Hegde funds often tend to pile in and out of the same trades at the same time. Liquidity
may evaporate, prices overreact → asset value plummet → vicious cycle. (i.e. if many hedge funds have established similar positions, they may be unable to get out of these positions when prices turn against
them)
4) Excess volatility risk: Evidence exists on both sides of the argument, no rock-solid conclusions (i.e. in
some cases hedge funds have been praised for having stabilized the markets)

Question 51

Hedge Funds: Past, Present, and Future

What is the future of hedge funds?

Answer 51

▪ The prospects for greater regulation of hedge funds, which will make them more similar to mutual
funds, are very real
▪ The discretion of hedge fund managers will decline as they acquire more institutional investors with
fiduciary duties of their own (less risk taking and more disclosure)
▪ Growing industry will result in more hedge funds chasing the same price discrepancies (less profitable)

Question 52

The Capital Asset Pricing Model: Theory and Evidence

What are the assumptions of CAPM?

Answer 52

• Investors are risk averse and have the same information about the market
• Investors are rational and care only about the mean and variance of their returns (seek mean-variance-efficient portfolios)
• All investors face the same choice of investable assets
• Predictions about the return distribution are the same for all investors (E[r], volatility, covariance)
• Borrowing and lending at a risk-free rate
• Perfect capital markets (unrestricted short-selling, no transaction costs, costless information, infinitely divisible assets, no taxes)

Question 53

The Capital Asset Pricing Model: Theory and Evidence

What are the three testable relationships of CAPM?

Answer 53

• Expected returns linearly related to their betas (no other variable has marginal explanatory power)
• The beta premium (the excess market return) is positive
• Assets uncorrelated with the market portfolio have expected returns equal to 𝑅𝑓

Question 54

The Capital Asset Pricing Model: Theory and Evidence

What are the results for CAPM presented by the authors?

Answer 54

CAPM underestimated returns on low-beta stocks and overestimated those on high-beta
stocks. The observed premium per unit of beta is in fact lower than predicted by the Sharpe-Lintner CAPM.
intercept (𝛼𝑖
- “Jensen’s alpha”) is greater than the average risk-free rate, the coefficient on beta is less than the average excess market return (i.e. beta does not explain all variation in security returns)
Much of the variation in expected returns is unrelated to market beta.
Use ICAPM - add other variables (e.g. E/P, Mcap, B/M) to add to the explanation of expected stock returns provided by market betas.

Question 55

The Capital Asset Pricing Model: Theory and Evidence

What are the two views on CAPM failure?

Answer 55

Behavioral view: explanatory power of other factors than beta is due to mispricing–> CAPM holds, but investors misprice securities.
Rationalist view- other factors account for risks not captured by beta. There is no mispricing in securities- just a different model is needed to fully explain how asset pricesare formed (e.g. International CAPM, APT, 3-factor model, etc).

Question 56

The Capital Asset Pricing Model: Theory and Evidence

Why can’t CAPM really be tested?

Answer 56

Market proxy problem- not theoretically clear which assets can be excluded from the market portfolio (e.g. human capital).
Unavailability of data limits the universe of assets that can be included in CAPM tests.
–> CAPM can be used for practical purposes if we find a good proxy for market portfolio.