Lecture 5: Enhanced Flashcards
What is market speculation?
Market speculation refers to the act of buying and selling financial instruments with the primary objective of making profits from short-term price fluctuations, rather than the intrinsic value of the asset.
What are economic bubbles?
Economic bubbles occur when the prices of assets rise significantly above their intrinsic value due to excessive demand, often driven by speculative behavior, followed by a sudden collapse in prices.
What is investor behavior?
Investor behavior refers to the psychological and behavioral factors influencing how individuals and institutions make investment decisions, including tendencies like herding behavior, overconfidence, and loss aversion.
What are the key phases of an economic bubble?
The key phases are displacement, boom, euphoria, profit-taking, and panic.
What was the Tulip Mania and when did it occur?
Tulip Mania was a speculative bubble in the Netherlands during the early 17th century (1637) where tulip bulbs achieved prices higher than town homes in Amsterdam.
What characterized the Tulip Mania bubble and its collapse?
Prices of tulip bulbs rose to extraordinary levels due to speculation, but the bubble burst in February 1637, leading to a sharp decline in prices and financial turmoil among speculators.
How did futures contracts play a role in the Tulip Mania?
Many contracts for tulip bulbs were made for future settlement, but the lack of legal enforcement meant they were often settled for a fraction of their promised purchase price after the bubble burst.
How did the issue of scarcity relate to Tulip Mania?
Tulip bulbs, unlike land, are self-replicating and potentially unlimited, leading to limited long-run scarcity and emphasizing the speculative nature of the bubble.
What significant lesson does the Tulip Mania demonstrate about markets?
Tulip Mania demonstrated that the price of a good need not be connected to its functional utility and that greed and fear can drive markets.
What is herding behavior in investor psychology?
Herding behavior is the tendency to follow the crowd or mimic the actions of a larger group, often leading to market bubbles and crashes.
How does overconfidence affect investors?
Overconfidence leads investors to overestimate their knowledge or skills, resulting in excessive risk-taking.
What is loss aversion in investor behavior?
Loss aversion is the tendency to prefer avoiding losses over acquiring equivalent gains, causing investors to hold onto losing investments too long or sell winning investments too quickly.
What is the anchoring effect in investment decisions?
The anchoring effect is relying too heavily on the first piece of information encountered when making decisions, which can lead to suboptimal investment choices.
What is confirmation bias in investing?
Confirmation bias is seeking out information that confirms one’s preexisting beliefs while ignoring contradictory evidence, leading to skewed investment decisions.
How do emotions affect investment decisions?
Emotions such as fear, greed, and panic can drive irrational investment decisions, leading to market volatility.
What happened on Black Thursday during the 1929 stock market crash?
On Black Thursday (October 24, 1929), the stock market experienced an initial crash with the Dow Jones Industrial Average dropping 11% at the opening bell, leading to panic selling.
What occurred on Black Monday and Black Tuesday during the 1929 stock market crash?
On Black Monday (October 28, 1929), the stock market fell by another 13%, and on Black Tuesday (October 29, 1929), the market plummeted by 12%, marking the most significant drop and leading to widespread financial ruin.
How did speculation contribute to the 1929 stock market crash?
Excessive speculation and margin buying created a bubble in stock prices. Investors heavily borrowed money to invest, expecting prices to continue rising.
What economic imbalances contributed to the 1929 stock market crash?
Overproduction in industries, agricultural decline, uneven wealth distribution, and a lack of financial regulation contributed to the underlying economic weaknesses that led to the crash.
How did margin buying and broker loans exacerbate the 1929 stock market crash?
Investors bought stocks on margin, only paying a partial down-payment.
Brokers extended credit, and when stock prices fell, investors faced margin calls, causing further selling and price drops.
What was the immediate consequence of the 1929 stock market crash?
The crash triggered the Great Depression, a decade-long economic downturn characterized by massive unemployment, bank failures, and a significant decline in industrial production.
How did the 1929 stock market crash affect banks?
Many banks failed due to bad loans and panic withdrawals, leading to a loss of savings for many Americans and further exacerbating the economic crisis.
What were the key recovery efforts following the 1929 stock market crash?
President Franklin D. Roosevelt’s New Deal included programs and reforms aimed at reviving the economy, providing relief to the unemployed, and preventing future economic disasters.
What regulatory reforms were implemented after the 1929 stock market crash?
Reforms included the establishment of the Securities and Exchange Commission (SEC) to regulate the stock market, the Glass-Steagall Act separating commercial and investment banking, and the creation of the Federal Deposit Insurance Corporation (FDIC) to insure bank deposits.
How did margin calls impact investors during the 1929 stock market crash?
As stock prices fell, investors faced margin calls where brokers demanded additional capital. Failure to meet these calls led brokers to sell stocks, causing further price declines and more margin calls.
What lessons were learned regarding investor debt loads from the 1929 stock market crash?
The crash highlighted the dangers of high investor debt loads, leading to increased regulation to prevent excessive borrowing and speculative investment, although deregulation in later years has led to recurring bubbles and crashes.
What is a speculative bubble?
A speculative bubble occurs when the prices of assets rise significantly above their intrinsic value due to excessive demand and speculation, followed by a sudden collapse in prices.
What is margin buying?
Margin buying is the practice of purchasing stocks with borrowed money, only paying a partial down-payment and financing the rest with a loan from a broker.
What is a margin call?
A margin call is a demand by a broker for an investor to deposit additional money or securities to cover potential losses when the value of their investment falls below a certain level.
What is a broker loan?
A broker loan is credit extended by brokers to their clients to help finance the purchase of securities, often used in margin buying.
What is the Great Depression?
The Great Depression was a decade-long global economic downturn starting in 1929, characterized by widespread unemployment, bank failures, and a significant decline in industrial production.
What is the Securities and Exchange Commission (SEC)?
The SEC is a U.S. government agency established in 1934 to regulate the securities markets and protect investors by enforcing laws against market manipulation and fraud.
What is the Glass-Steagall Act?
The Glass-Steagall Act was a law passed in 1933 that separated commercial banking from investment banking to reduce the risk of financial speculation and protect consumers.
What is the Federal Deposit Insurance Corporation (FDIC)?
The FDIC is a U.S. government agency created in 1933 to insure bank deposits, restore trust in the American banking system, and prevent bank runs.
What is investor debt load?
Investor debt load refers to the amount of borrowed money used by investors to purchase assets, which can amplify gains but also increase the risk of significant losses during market downturns.
What is the Dow Jones Industrial Average (DJIA)?
The Dow Jones Industrial Average (DJIA) is a stock market index that measures the performance of 30 large, publicly-owned companies listed on stock exchanges in the United States. It is one of the oldest and most widely recognized indices.
What is Black Monday in the context of the 1987 stock market crash?
Black Monday refers to October 19, 1987, when the stock market crashed and the Dow Jones Industrial Average (DJIA) dropped by 508 points, a loss of 22.6% in a single day.
What was the performance of the Dow Jones Industrial Average leading up to the 1987 crash?
The DJIA rose from 776 in August 1982 to a peak of 2722 in August 1987, an increase of over 250% in just 5 years, before crashing on Black Monday.
What role did program trading play in the 1987 stock market crash?
Program trading, involving computer algorithms executing large stock trades automatically based on market conditions, contributed to the crash by exacerbating the selling pressure.
How did automated trading and loss limit orders impact the 1987 crash?
Automated trading and loss limit orders meant that as margin calls became imminent, computers would automatically liquidate stock to stem losses, leading to a downward cascade of sell orders.
What was the state of margin trading and debt levels before the 1987 crash?
Similar to the 1929 crash, margin trading was common and debt levels were high, contributing to the severity of the crash when the market declined.
What is a downward cascade in the context of the 1987 stock market crash?
A downward cascade occurred when each sell order led to many more sell orders, pushing the market down rapidly and exceeding the human ability to assimilate and assess the situation.
What are electronic circuit breakers and why were they implemented after the 1987 crash?
Electronic circuit breakers are mechanisms to halt trading temporarily during extreme volatility.
They were implemented to give human traders time to assess the situation and potentially disable automated trading systems during periods of market stress.
How did exuberance and unjustified optimism contribute to the 1987 stock market crash?
A period of exuberance and unjustified optimism led to a rapid rise in stock prices, which created conditions for a severe market correction when sentiment changed.
What similarities did the 1987 crash have with the 1929 crash?
Both crashes involved periods of rapid market gains followed by sudden declines, high levels of margin trading, and significant selling pressure exacerbated by automated trading mechanisms.
How did computerized trading affect the 1987 stock market crash?
Computerized trading greatly increased the speed and magnitude of the decline, as automated systems executed large sell orders without human intervention, leading to a rapid market downturn.
What was the dot-com bubble?
The dot-com bubble was a period of excessive speculation in the late 1990s and early 2000s centered around Internet-based companies, leading to a rapid rise and subsequent crash in tech stock prices.
How did the NASDAQ Composite index perform during the dot-com bubble?
The NASDAQ Composite index, heavily weighted with tech stocks, rose dramatically during the dot-com bubble, reaching a peak on March 10, 2000.
What role did speculative interest play in the dot-com bubble?
Speculative interest led to significant investment in any company that was a dot-com, driving up stock prices based on the potential of Internet-based business models rather than actual earnings.
How did the promise of moving from brick and mortar to online commerce impact the dot-com bubble?
The promise of abandoning costly brick and mortar stores for easy-to-use, low-cost web pages seemed to promise a new era of hyper-profitable commerce, attracting significant investment and inflating stock prices.
What challenges did dot-com companies face with web and logistics during the bubble?
Many dot-com companies were not ready for the rush to online commerce. Services were fractured, delivery was expensive, and many companies could not meet investor expectations despite high stock valuations.
What were some notable corporate casualties of the dot-com bubble?
Notable corporate casualties included Webvan, a warehouse and distribution service, and Petfood.com, a company focused on selling dog food online, both of which went bankrupt due to unprofitable business models.
What was the long-term impact on investors who bought into the NASDAQ at its peak?
Investors who bought into the NASDAQ at its peak on March 10, 2000, had to wait until May 1, 2015, more than 15 years, just to break even.
What is speculative mania, and how did it contribute to the dot-com bubble?
Speculative mania refers to irrational exuberance where investors drive asset prices to unsustainable levels.
It contributed to the dot-com bubble as investors believed the Internet would revolutionize business, leading to overvaluation of tech stocks.
Why were many dot-com business models unsustainable?
Many dot-com business models were unsustainable because they prioritized growth and market share over profitability, often lacking viable plans to generate consistent revenue.
What was the economic impact of the dot-com bubble crash?
The crash led to significant losses for investors, with trillions of dollars in market value wiped out and a broader economic slowdown, though not as severe as the Great Depression.
Which companies survived the dot-com crash and became successful?
Companies like Amazon, eBay, and Google survived the dot-com crash and became highly successful, shaping the future of the Internet economy.
What regulatory changes followed the dot-com bubble crash?
Increased scrutiny and regulation of financial markets, including changes in accounting standards and corporate governance practices, followed the dot-com bubble crash.
What lesson did the dot-com bubble teach about investing?
The dot-com bubble underscored the importance of evaluating a company’s fundamentals, such as profitability and sustainable business models, rather than just market hype.
What is NASDAQ?
NASDAQ (National Association of Securities Dealers Automated Quotations) is a global electronic marketplace for buying and selling securities, as well as the benchmark index for U.S. technology stocks.
How did the NASDAQ Composite index perform during the dot-com bubble?
The NASDAQ Composite index, heavily weighted with tech stocks, rose dramatically during the dot-com bubble, reaching a peak on March 10, 2000.
What are Mortgage-Backed Securities (MBS)?
MBS are financial instruments created by pooling mortgages (assets) into a portfolio. Cash flows from mortgage payments are then re-prioritized into different tranches (divisions) of the MBS, spreading the risk.
What are Asset Backed Securities (ABS)?
ABS are financial securities backed by a pool of assets such as loans, leases, credit card debt, or receivables. MBS are a specific type of ABS backed by mortgage loans.
What are tranches in the context of MBS?
Tranches are divisions within an MBS that categorize the pooled mortgages into different levels of risk and return, allowing for the marketing of the MBS to a wide range of investors.
What is an Adjustable Rate Mortgage (ARM)?
An ARM is a mortgage with an interest rate that changes periodically based on a benchmark rate. ARMs offered low initial interest rates that later increased, contributing to cash-flow stress in the MBS.
What is an adverse incentive in the context of MBS?
Adverse incentive refers to the lack of motivation for investment banks to ensure the quality of the underlying mortgages in MBS, as they sold the tranches quickly, minimizing their exposure to the risk.
How did rating agencies contribute to the MBS crisis?
Rating agencies, which ranked the quality of MBS investments, provided inflated ratings due to competitive pressures and profit incentives, misleading investors about the true risk.
How did government policies contribute to the MBS crisis?
Governments enjoyed large tax flows from the construction and real estate industries and were reluctant to address potential bubbles to avoid impacting revenue, indirectly supporting risky lending practices.
