Lecture 4 - Financial Crises: Research Methods Flashcards
What is the relationship between Efficient Market Hypothesis (EFH) and Neoclassical Finance?
The Efficient Market Hypothesis (EFH) is one of the pillars of Neoclassical Finance
How does EFH act as a pillar of Neoclassical Finance?
- EFH is the idea that competition among well-informed rational traders implies that stock returns follow random patterns
- This goes back to 1890 when the French Mathematician Bachelier published his PhD thesis, The Theory of Speculation
- Bachelier demonstrated that the random patterns follow the Normal Distribution
What were the French Mathematician Mandelbrot’s opinion of EFH?
Mandelbrot, the creator of ‘fractal theory’, criticized the EFH by observing that stock return variations are not smooth but exhibit wild and irregular fluctuations
How did Robert Shiller criticize the EFH?
Robert Shiller criticized the EFH by arguing that stock returns exhibit ‘excess volatility’ that goes against the prediction that they should be normally distributed
What did Mandelbrot and Shiller’s ideas provide the basis for development for?
- Mandelbrot’s ideas provided the basis for the development of Complex Systems Theory
- Shiller’s work encouraged the development of Behavioural Finance
What are the main building blocks of the Neoclassical Approach?
The main building blocks of the Neoclassical Approach are the postulates of:
1- The rationality of agents
2- Competitive markets
3- Market clearing (equilibrium)
What have researchers in behavioural finance mainly challenged?
Researchers in behavioural finance have mainly challenged the rationality assumption that imposes restrictions on the types of decisions that agents make and on how they make these decisions
What does the rationality assumption in behavioural finance entail?
- Rational agents choose portfolios to maximise their expected utility
- They have full information about the distributions of asset returns and about the correlations between them
Suppose that there are 2 states of the world. With probability p wealth is equal to W1 and with probability 1-p wealth is equal to W2. Give the equation for calculating the expected utility
E[U(W)] = pU(W1) + (1-p)U(W2)
When all the assumptions of neoclassical finance are satisfied, what do equilibrium prices reflect?
When all the assumptions of neoclassical finance are satisfied, equilibrium prices reflect all available information and therefore the best predictors of future prices are current prices (EFH)
How do researchers in behavioural finance suggest that we can better explain the behaviour of market participants?
- Stock market returns are unpredictable and are normally distributed
- Therefore the neoclassical model fails to account for the sharp rise of prices during bubble periods and their eventual collapse
- Researchers in behavioural finance have argued that we can better
explain the behaviour of market participants by relaxing the rationality assumption
Where does researcher’s criticism of the rationality assumption of the Neoclassical Approach come from?
- The research field into the Neoclassical approach has been pioneered by the psychologists Kahneman and Tversky who proposed that the complexity of the economic environment implies that market participants do not have the information nor the computational capacity to make rational decisions
- Instead when they have to make decisions under uncertainty they follow simple ‘heuristics’ (rule of thumb)
What are the three components of ‘heuristics’?
1- Representativeness: When people are asked to judge the probability that an object or event A belongs to class B,
probabilities are evaluated by the degree to which A is
representative of B (by the degree to which A resembles B)
2- Availability: When people are asked to assess the probability of an event, they do so by the ease with which instances or occurrences can be brought to mind
3- Anchoring and Adjustment: In numerical prediction, when a
relevant value (an anchor) is available, people make estimates by starting from an initial value (the anchor) that is adjusted to yield the final answer. The adjustments are typically insufficient
What is Neoclassical finance?
- Neoclassical finance is a natural extension of the general equilibrium model obtained by the introduction of uncertainty
- The model imposes restrictions not only on the behaviour of agents (rationality) but also on market outcomes
What does the notion of equilibrium imply?
The notion of equilibrium implies that all markets clear instantaneously (all trades are executed at market clearing prices)
What is the main objective of the neoclassical finance model?
The main objective of the model is to explain how quantities and prices of goods produced and exchanged in a decentralized economy
are determined
What is meant by decentralization?
Decentralization captures the idea that in market economies there is
no central authority intervening in the allocation of goods and the
setting of their prices
In a decentralized economy, what ensures that market clearing will be attained?
Adam Smith explained that the ‘invisible hand’ of the market would ensure that resources would be allocated in such a way that the market would be cleared
What are the three main arguments that decentralization is consistent with market clearing?
1- Agents have complete information about the economy and also the computational capacity to calculate equilibrium outcomes
2- Equilibrium is achieved through a tatonnement process where trades are executed in auction markets and only when the auctioneer has called prices that equal supply and demand
3- Market clearing is a limiting case of a decentralized price setting process that is a very good approximation of what happens in competitive markets with a large number of agents
What are the three respective counterarguments for arguing that decentralization is consistent with market clearing?
1- The economy is too complex and such computations are not feasible
2- Such markets exist but are very limited
3- If agents have limited market power and on average are well informed then price fluctuations should be random. The model fails to account for the sharp rise in prices during bubbles and their eventual burst
Explain what is meant by Complex Systems and give some examples of them
- Complex Systems is a new interdisciplinary field of science that studies how the elements of a system give rise to the collective
behaviour of the system - Examples of complex systems are social
systems formed out of people, the brain formed out of neurons, molecules formed out of atoms, the weather formed out of air flows
What does the complexity approach of complex systems examine?
The complexity approach examines how interacting elements produce aggregate patterns that in turn can affect these elements
What type of approach do complex systems follow?
Complex systems follow a bottom-up approach to complexity deducing the aggregate behaviour (macro) of a system in
terms of a large number of elements (micro) interacting by simple
rules
What is Agent-Based Modelling (ABM)?
- In ABM models individual behaviour follows simple behavioural rules with agents interacting only locally
- Aggregate behaviour emerges as statistical regularities which cannot be deduced directly from the simple rules imposed on individual behaviour
- Aggregate behaviour
feeds back to the individual level and through adaptation to the new
environment individual rules evolve (learning)
