Guiding Seminar 1 Flashcards
How do we know that the excess return is received without bearing more risk? (The U.S. Equity Return Premium: Past, Present, and Future)
Only in 2% of the cases in the 20th century, bonds have given more return than equities. Thus we cannot justify the fact that one gets 6% p.a. on average more in equities than in bonds.
What is the risk-bearing capacity of society? (The U.S. Equity Return Premium: Past, Present, and Future)
There are different agents (people in society) that have different investing preferences, for example, young people who can live off their salary are not that dependent on their portfolio return and thus can tolerate changes in the market. Most people actually don’t invest as they face different roadblocks that prevent them from doing that. (Transaction fees, lack of cost-effective investment vehicles, etc.)
Why the lower tail risk maybe not the most practical explanation of the equity premium puzzle? (The U.S. Equity Return Premium: Past, Present, and Future)
There were fewer economic disasters than we expected, so we are afraid that we are yet to see the remaining unobserved catastrophes and thus don’t want to invest in equities that would be hit when the disaster occurs. The catastrophe must affect only affect stock prices and must be small but severe.
How would equity premium fall from learning about the distribution if prices rise as the result of investors correcting their misperceptions
about riskiness? (The U.S. Equity Return Premium: Past, Present, and Future)
When people started to learn that equities are not as risky as initially believed, more agents started to buy stocks, which resulted in higher prices. Thus, investors who bought equities prior to the wave of learning would see their realized return higher as the result of prices at which they cash out being higher due to learning. More people learn -> less premium.
What do we mean by “many of the historically discovered factors would be deemed “significant” by chance”? (… and the Cross-Section of Expected Returns)
Type I error —> false-positive —> declaring that a factor is significant when in fact it’s not. If there are 1000 separate factor tests conducted, the expected ‘false positive’ factors rise to 50. Thus, a bottom line is that the more factors are tested over approximately the same data set, and the p-value is left unadjusted, the higher is the number of factors deemed “significant” by chance. Only 5 factors survived the tests: Momentum, Volatility, M/B ratio, Market beta, Durable consumption goods.
Why is the adjustment time-varying? (… and the Cross-Section of Expected Returns)
Adjustments account for the number of tests conducted prior to the respective test the significance level of which we want to adjust. Thus, if one wants to adjust the t-statistics required for the MKT factor (~1975) and the HML (~1995), the resulting hurdles will differ as there were more factor tests conducted before 1995 than before 1975. For a simple example, think Bonferroni where adjusted p-value will decrease as M increases.
What role do investment banks perform in an IPO? (Forensic Finance)
IPO - when a private company goes public via issuing stock on a particular stock exchange; investment banks are usually involved in an IPO as underwriters who approach investors to sell the shares of the company. The price must be just right, not too high, not too low.
What are “soft dollars” and what do they do? (Forensic Finance)
Because of the ability to collect additional commission payments, known as “soft dollars,” from institutional investors that are competing for allocations of the underpriced shares, bookrunners make greater profits on an initial public offering if the company being sold allows greater underpricing. An underpriced IPO leaves money on the table. More money left on the table is beneficial to the book runner because rent-seeking investors are willing to pay additional soft dollars on other trades as a way of currying favor for these. allocations.
Major issues of IPO spinnings. (Forensic Finance)
By taking advantage of agency problems and bribing executives, one can affect the actions of the executives.
The more severe underpricing of these IPOs results in the issuing firms raising less money and reducing the returns of their pre-issue shareholders. Thus, when executives cooperated in spinning, not only were their corporate decisions more biased but also the company raised less money than it otherwise could.
What are market efficiency tests/ Joint hypothesis problem (JHP)? What are the three forms of market efficiency? (Two pillars of asset pricing)
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
What does Fama find about market efficiency through event studies? (Two Pillars of Asset Pricing)
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.
What are the characteristics of a Homo economicus (rational behavior)? (Behavioral Economics: Past, Present, and Future)
• 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.
What is the main problem with the current theory? (Behavioral Economics: Past, Present, and Future)
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.
