III, ASSET PRICING, ASPECTS OF FINANCIAL SYSTEM

Question 1

Wisdom of Crowds: The Value of Stock Opinions Transmitted Through Social Media
Chen, Hailiang, Prabuddha De, Yu Hu, and Byoung-Hyoun Hwang, 2014

What is an earnings surprise?

Answer 1

The difference between the reported EPS and the average of financial analysts’ EPS forecasts issued/updated within 30 days prior to the earnings announcement.

Question 2

Wisdom of Crowds: The Value of Stock Opinions Transmitted Through Social Media
Chen, Hailiang, Prabuddha De, Yu Hu, and Byoung-Hyoun Hwang, 2014

What are the consequences of the rise of social media platforms?

Answer 2

1. Creation and consumption of user-generated content
2. Believing to fellow consumers instead of trusting experts opinion.

Question 3

Wisdom of Crowds: The Value of Stock Opinions Transmitted Through Social Media
Chen, Hailiang, Prabuddha De, Yu Hu, and Byoung-Hyoun Hwang, 2014

What is seeking alpha (SA)?

Answer 3

One of the biggest investment related social media websites in the U.S.

Question 4

Wisdom of Crowds: The Value of Stock Opinions Transmitted Through Social Media
Chen, Hailiang, Prabuddha De, Yu Hu, and Byoung-Hyoun Hwang, 2014

Bitcoin has definitely attracted a lot of attention in social media. The authors discuss the two channels through which the emergence of social media and the development of DIY financial analysis could affect investors. Please name and describe the aforementioned two channels.

Answer 4

◦ Predictability channel: SA articles and comments views contain pieces of value-relevant information, not fully factored into the price as of the article publication date. As investors subsequently learn from the SA view, prices gradually adjust -> if true: SA views indeed predict future stock market performance; social media outlets are a useful source of value-relevant advice
◦ Clout channel: “SA views reflect false or spurious information yet still cause investors to trade in the direction of the underlying articles and comments and move prices accordingly” (i.e. exploiting naïve investors)

Question 5

Wisdom of Crowds: The Value of Stock Opinions Transmitted Through Social Media
Chen, Hailiang, Prabuddha De, Yu Hu, and Byoung-Hyoun Hwang, 2014

What are the two channels the investors can voice their opinion?

Answer 5

Opinion articles and comments.

Question 6

Wisdom of Crowds: The Value of Stock Opinions Transmitted Through Social Media
Chen, Hailiang, Prabuddha De, Yu Hu, and Byoung-Hyoun Hwang, 2014

How does the fraction of negative words in SA articles & comments affect future stock returns?

Answer 6

Both negatively predict stock returns over the ensuing three months.
The predictability arising from SA comments is particularly evident when the number of comments over which the fraction of negative words is computed is relatively high.

Question 7

Wisdom of Crowds: The Value of Stock Opinions Transmitted Through Social Media
Chen, Hailiang, Prabuddha De, Yu Hu, and Byoung-Hyoun Hwang, 2014

Do SA users’ opinions have an impact on earnings surprises?

Answer 7

The fraction of negative words in SA articles and comments strongly predict subsequent scaled earnings surprises. Given that earnings are unlikely to be caused by SA users’ opinions, the earnings-surprise predictability suggests that the opinions expressed in SA articles and comments indeed provide value-relevant information (beyond that provided by financial analysts).

Question 8

Wisdom of Crowds: The Value of Stock Opinions Transmitted Through Social Media
Chen, Hailiang, Prabuddha De, Yu Hu, and Byoung-Hyoun Hwang, 2014

What are the main findings of the paper? Based on the authors’ findings, describe a return-maximizing investment strategy. What do these findings imply about market efficiency?

Answer 8

All of the findings in this study point to the usefulness and value relevance of peer-based advice in the investment domain stock returns and earning surprises. Social media outlets are unique in the sense that they enable direct and immediate interaction among users… these interactions, combined with the seeming intelligence of the “crowd,” may be one of the primary reasons social media platforms are able to produce value-relevant content that is incremental to that revealed through traditional news channels.

Question 9

Wisdom of Crowds: The Value of Stock Opinions Transmitted Through Social Media
Chen, Hailiang, Prabuddha De, Yu Hu, and Byoung-Hyoun Hwang, 2014

Explain what are two possible channels for negative comments on social media influencing stock returns?

Answer 9

◦ Predictability channel: SA articles and commentaries views contain pieces of value-relevant information, not fully factored into the price as of the article publication date. As investors subsequently learn from the SA view (through the SA platform itself/sources referring to it), prices gradually adjust -> if true: SA views indeed predict future stock market performance; social media outlets are a useful source of value-relevant advice
◦ Clout channel: “SA views reflect false or spurious information yet still cause investors to trade in the direction of the underlying articles and comments and move prices accordingly” (i.e. exploiting naïve investors)

Question 10

Wisdom of Crowds: The Value of Stock Opinions Transmitted Through Social Media
Chen, Hailiang, Prabuddha De, Yu Hu, and Byoung-Hyoun Hwang, 2014

Why is one of them less likely to be true?

Answer 10

(1) lack of return reversal; (2) SA followers’ insufficient capital to cause documented market movements.

Question 11

Wisdom of Crowds: The Value of Stock Opinions Transmitted Through Social Media
Chen, Hailiang, Prabuddha De, Yu Hu, and Byoung-Hyoun Hwang, 2014

Provide at least two mechanisms that Seeking Alpha uses to ensure that advice given on their platform is relevant?

Answer 11

SA followers can “differentiate between authors that offer historically good versus bad advice and the “popularity” of these authors’ changes accordingly.

Question 12

Wisdom of Crowds: The Value of Stock Opinions Transmitted Through Social Media
Chen, Hailiang, Prabuddha De, Yu Hu, and Byoung-Hyoun Hwang, 2014

What are the incentives of truly informed users to share their insights?

Answer 12

Attention and recognition, money, public feedback, convergence to fundamental value.

Question 13

Two Pillars of Asset Pricing
Fama, Eugene F., 2014

Some behavioral economists might call this spike a bubble. What is meant by a “bubble”? Why is Eugene F. Fama criticizing the term “bubble” in this paper and Shiller in particular? Please argue using examples from the reading.

Answer 13

No evidence of reliable predictions of negative market returns when the forecast variable is the short-term bill rate. However, policy statements seem to define a “bubble” as an irrational strong price increase that implies a predictable strong decline -> the available research says there is no evidence that price declines are ever predictable (i.e. forecasting a ‘bubble’ is a guessing game and successful ‘forecasters’ emerge from the ex post selection bias).
Moreover, it seems that large swings in stock prices are responses to large swings in real activity, with stock prices forecasting real activity -> consistent with an efficient market in which the term “bubble,” at least as commonly used, has no content.

Question 14

Two Pillars of Asset Pricing
Fama, Eugene F., 2014

The efficient markets hypothesis distinguishes three forms of market efficiency. Name the three forms of market efficiency and briefly explain what each of them implies about security prices. What is the main problem inherent in market efficiency tests?

Answer 14

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)
JHP - it is impossible to tell whether the the result reflects the market inefficiency or the misuse of CAPM.

Question 15

Two Pillars of Asset Pricing
Fama, Eugene F., 2014

What is a joint hypothesis problem?

Answer 15

Market returns may reflect market inefficiency, an inaccurate asset pricing model or both.
Relevant only in a long-term.

Question 16

Two Pillars of Asset Pricing
Fama, Eugene F., 2014

Why does Fama and Schwert (1977) test on Fisher’s hypothesis on longer-term bonds, real estate, and stock returns, does hold for all, except stocks?

Answer 16

Joint hypothesis problem is back – perhaps, expected stock returns vary in time and the assumption that holds for bonds and real estate does not hold for stocks.

Question 17

Two Pillars of Asset Pricing
Fama, Eugene F., 2014

What does accurately predict stock returns?

Answer 17

Default spread on bonds (the difference between the yields on long-term bonds of high and low credit risk) and term spread (the difference between long-term and short-term yields on high grade bonds) predict stock returns (and so does dividend yield).
Default spreads and dividend yields are related to long-term business conditions, and term spreads are strongly related to short-term business cycles. The general result is that expected returns are high when business conditions are poor and low when they are strong.

Question 18

Two Pillars of Asset Pricing
Fama, Eugene F., 2014

What are the two types of capital asset pricing models?

Answer 18

Standard asset pricing models: work forward from assumptions about investor tastes and investment opportunities (e.g., CAPM), then test the model.
Empirical models: backward procedure – take as given a pattern in average returns and propose models to capture them.

Question 19

Two Pillars of Asset Pricing
Fama, Eugene F., 2014

What is the The Three-Factor Model by Fama and French?

Answer 19

CAPM + SMB and HML factors
◦ Does well on the anomalies associated with size, sales growth, and various price ratios, but fails with other
anomalies → it’s still just a model (but it is better than CAPM and is “arguably the most successful asset pricing model in empirical tests to date”)
◦ According to Fama, the main challenge is momentum – not only to this model, but to the EMH as such
◦ Fama says additional factors do not prove inefficiency. Factors can be a result of unspecified state variables or
investor preferences (if investors simply like growth stocks, they will have lower expected returns due to higher prices)

Question 20

… and the Cross-Section of Expected Returns
Harvey, R. Campbell, Yan Liu, and Heqing Zhu, 2016

The authors of the paper argue that a new factor
discovered today should have a t-statistic that exceeds 3.0 as opposed to the conventional t-statistic
of 1.96. What are the three reasons for a tougher criterion today and why is the adjusted threshold
rising through time? What does it imply for the t-statistics required to declare significance for the
market beta discovered in late 1960s and the momentum factor discovered in late 1990s?

Question 21

Responsible investing: The ESG-efficient frontier
Pedersen, H. Lasse, Shaun Fitzgibbons, and Lukasz Pomorski, 2021

Governance aspect (G) of ESG, proxied by low
accruals, is a significant positive predictor of future abnormal stock returns. For their adjusted CAPM, they argue that, in general, any ESG factor can impact future returns both positively and negatively. Describe the 2 channels that determine the net effect.

Answer 21

If ESG correlates with future 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). This means market does not fully incorporate information on G, and G offered “guiltless saintliness” → consider G in your portfolio.

Question 22

Responsible investing: The ESG-efficient frontier
Pedersen, H. Lasse, Shaun Fitzgibbons, and Lukasz Pomorski, 2021

What is an ESG-SR efficient frontier?

Answer 22

Portfolios are combinations of the risk-free asset, the tangency portfolio, the minimum-variance portfolio, and the so-called ESG tangency portfolio. Gives maximum Sharpe ratio at each level of ESG.

Question 23

Responsible investing: The ESG-efficient frontier
Pedersen, H. Lasse, Shaun Fitzgibbons, and Lukasz Pomorski, 2021

When talking about ESG, what are the types of investors?

Answer 23

◦ Type-U (ESG-unaware) are unaware of ESG scores and simply seek to maximize return per unit of risk.
◦ Type-A (ESG-aware) have the same goal, but they use assets’ ESG scores to update their views on risk/return.
◦ Type-M (ESG-motivated) are ready to sacrifice performance for high ESG, but still want maximum Sharpe ratio at each ESG level.

Question 24

Responsible investing: The ESG-efficient frontier
Pedersen, H. Lasse, Shaun Fitzgibbons, and Lukasz Pomorski, 2021

What do the authors mean by mixed results of E, S, ESG on future profitability/returns?

Answer 24

Their theory predicts high valuations and low expected returns. They find high valuations and low or insignificant returns, in line with the theory.

Question 25

Prone to Fail: The Pre-crisis Financial System
Duffie, Darrell, 2019

In his paper the author argues that “the core of the financial system became a key channel of propagation and magnification of losses suffered in the housing market”. He emphasises the detrimental role of excessive reliance of some key dealers on short-term debt. Provide the two risks associated with this source of funding and illustrate them using either overnight or intra-day repo example.

Question 26

Prone to Fail: The Pre-crisis Financial System
Duffie, Darrell, 2019

Provide an example of any three changes in the financial regulation since the crisis.

Question 27

Prone to Fail: The Pre-crisis Financial System
Duffie, Darrell, 2019

What is one of the key remaining concerns in the regulation of the over-the-counter market? Please draw a comparison with the ‘too-big-to-fail’ banks in the
run-up to the crisis.

Question 28

Prone to Fail: The Pre-crisis Financial System
Duffie, Darrell, 2019

What was the trigger of financial crisis?

Answer 28

The financial crisis that began in 2007 was triggered by over-leveraged homeowners and a severe downturn in US housing markets.

Question 29

Prone to Fail: The Pre-crisis Financial System
Duffie, Darrell, 2019

What were the main sources of fragility prior GFC?

Answer 29

Weakly supervised and regulated balance sheets of the 5 major banks, which relied heavily short-term lending.
Run-prone designs.
Weak regulation for OTC derivatives and market securities.
Trust of financial system: the idea that markets can regulate themselves & regulation would be counter-productive.

Question 30

Prone to Fail: The Pre-crisis Financial System
Duffie, Darrell, 2019

What does “too big to fail” mean?

Answer 30

An assumption of creditors that the biggest banks were too important to be allowed by the government to fail and thus creditors would not take losses if any of the largest banks or investment banks were to approach insolvency.

Question 31

Prone to Fail: The Pre-crisis Financial System
Duffie, Darrell, 2019

What were the 5 largest banks prior the GFC? & which ones kept operating after?

Answer 31

Lehman Brothers, Bear Stearns, Merrill Lynch; only Morgan Stanley & Goldman Sachs survived the crisis.

Question 32

Prone to Fail: The Pre-crisis Financial System
Duffie, Darrell, 2019

The largest US financial intermediaries were permitted by regulators to have insufficient capital and liquidity. Why was the supervision so ineffective?

Answer 32

◦ The SEC’s original mission is to protect the customers of financial firms, which crowded out a parallel
focus on financial stability → a financial regulator with inappropriate goals
◦ Too difficult for regulators to detect the excessive build-up of risk and flight-prone short-run debt and derivatives in the core of the pre-crisis financial system, especially given the significant financial innovation and complexity
◦ Irrationally low probabilities to disaster outcomes, especially with respect to the performance of the housing market → underestimation of risk
◦ Undue reliance on market discipline
◦ Historical US emphasis on a decentralized banking system → political choice

Question 33

Prone to Fail: The Pre-crisis Financial System
Duffie, Darrell, 2019

How were the investment banks regulated before GFC? Who was responsible for the economic downturn?

Answer 33

The largest investments banks in US chose to be regulated by a SEC. In terms of solvency, SEC did a poor job supervising the banks, the existential crisis in 2008 and post-crisis drop in leverage only proves that.
Evidence show that the regulatory was aware of the risks Bear Sterns was facing, but did not take action.

Question 34

Prone to Fail: The Pre-crisis Financial System
Duffie, Darrell, 2019

How did SEC run the supervision of the financial banks prior GFC?

Answer 34

SEC was mainly concern to protect the banks’ assets of clients rather than to tell the companies how should they run the operations.
Inadequate resource allocation can be observed -> SEC did assign 4 supervisors per bank (the FED devoted 19).
Banks did choose the SEC, as their LAX supervision.

Question 35

Prone to Fail: The Pre-crisis Financial System
Duffie, Darrell, 2019

What is a repo?

Answer 35

A repurchase agreement, when on each repo, a dealer transfers securities as collateral to its creditor, and in turn receives cash. When an overnight repo matures the next morning, the dealer is responsible for returning the cash with interest, and is given back its securities collateral.

Question 36

Prone to Fail: The Pre-crisis Financial System
Duffie, Darrell, 2019

What is a tri-party repo?

Answer 36

Tri-party repos: cash investors in repos (e.g. money
market mutual funds, securities lending firms) often
held the collateral securities provided to them by
dealers in accounts at two “tri-party” agent banks, J.P.
Morgan Chase and Bank of New York Mellon (only 2 in
the pre-crisis period). Likewise, these repo investors
transferred their cash to the dealers’ deposit accounts
at the same two tri-party banks.

Question 37

Prone to Fail: The Pre-crisis Financial System
Duffie, Darrell, 2019

Question 38

Prone to Fail: The Pre-crisis Financial System
Duffie, Darrell, 2019