Lecture 3 Flashcards
Financial intermediaries appear to be highly rewarded, despite… (2 concepts)?
The fierce competition between them and the uncertainty about whether they add value through their acitvitiy (concept of market efficiency).
Why can markets NOT be fully efficient?
1) If no-one has an incentive to collect information in an efficient market, how does the market become efficient? 2) If asset markets are efficient, then why do active managers earn positive fees?
3) It is thus logically impossible that both market for asset managment and asset markets are fully efficient.
What is the clearest evidence against market efficiency? Give an example.
Failure of the Law of One Price. Example: Royal Dutch/Shell Siamese twin stock spread on Amsterdam and London exchange.
List 5 evidences against the Law of One Price. Each in different asset class.
1) Stocks: Siamese twin stock spreads.
2) Asset management: Closed-end fund at discount/premium.
3) Bonds: off-the-run versus on-the-run bond spreads.
4) FX: Covered interest-rate parity violations.
5) Credit: CDS-bond spread.
Why can markets NOT be fully inefficient (completely divorced from fundamentals)?
If they were, making money would be very easy. But, professional managers hardly beat the market on average!
Markets are efficiently inefficient. For that to hold they must be:
Inefficient enough that active investors are compensated for their costs.
Efficient enough to discourage additional active investing (not easy enough to make money).
Give a more formal definition of efficiently inefficient markets.
Prices reflect the market information but only partially.
So that some managers have the incetive to expand resources to obtain information.
But only some managers achieve good information (it is costly and difficult).
So that investors have the incentive to expend resources to find informed managers.
What are the 3 big players of any financial market?
Investors, asset managers, and securities.
Define the role of investors and asset managers.
Investors: instiutional invesotrs examine asset managers assessing their investment process, trading infrastructure, risk management… Individual investors also search for asset managers.
Asset managers: play a central role in making financial markets efficient, as their size allows them to spend significant resources on acquiring and processing information.
Give a reason for each: why are securities, asset managers, and investor markets efficiently inefficient?
Securities: exploiting active strategies requires information collection, trading costs, and incurs liqudity risk.
Asset managers: good managers exist, but picking them is difficult (requires resrouces, manager selection team, due dilligence).
Investors: more sophisticated investors can perform better. They can educate themselves and spend resources picking good managers.
What are the investment applications for the efficient, inefficient and efficiently inefficient markets?
Efficient: passive investing.
Inefficient: active investing.
Efficiently inefficient: active investing by those with comparative advantage.
What are the empirical implications of efficiently inefficient markets (in relation to active funds)?
A sizeable minority of managers pick stocks well enough to more than cover their costs. The fact that top active funds outperform small unsophisticated investors is consistent with the model because it goes with the asusmption that investors face large search costs. Relatively, however, these search costs are low compared to the capital invested by big players. Small investors are better off by uninformed investing.
Is the degree of market inefficiency static? Explain.
No. The randomness of markets makes the degree of inefficiency not static. It keeps fluctuating from an efficient to inefficient level.
What are the 2 profit sources in an efficiently inefficient market?
Information and liquidity.
What are the 3 profit sources for compensation for liqudity risk?
1) Market liquidity risk. 2) Funding liquidity risk. 3) Providing liquidity to demand pressure.
