Lecture Two (1 - 50)

Question 1

what did Keynes think about economic models?

Answer 1

argued that the assumptions they had were not backed by sound reasoning and said “it’s better to be roughly right than precisely wrong”

Question 2

what happens when the efficient market hypothesis fails? (in the context of schumpeter’s flow)

Answer 2

when investors don’t trust the entrepreneurs or feel they’re not getting fair value for the price they’re paying then the circular flow doesn’t work

… this makes stock market inefficiency socially costly

Question 3

has technical analysis ever been proven

Answer 3

yes, but with weak evidence (50.5% of the time it was successful)

Question 4

what happened in circa 1975 that greatly affected how academics and practitioners view the financial markets and EMH?

Answer 4

Fama published work on the EMH and Burton Malkiel published Random Walk down Wall St. which made people start taking the EMH more seriously

Question 5

what are the 2 main propositions with the pricing of securities through the EMH according to Fama

Answer 5

1. securities are priced based on past information
2. only new information can change a security’s price

Question 6

have statistical test on whether or not hedge funds beat the market ever been right? … and what’s the caveat

Answer 6

no, hedge funds and all other “fundamentally selected” portfolios have not proven to beat randomly selected portfolios over time.

… the caveat is that these stats tests are too noisy to prove that mkts are efficient

Question 7

weak form
semi strong form
strong form
… EMH

Answer 7

weak: past and present stock returns do NOT predict future returns
semi strong: stock returns can’t be predicted with public info
strong: future stock returns cannot be predicted

Question 8

what is the lucas critique in finance (how does it apply to the mkts)?

Answer 8

lucas critique: models in social sciences don’t work when ppl know about the models, so ppl should bake that into their models (rational expectations)

• when applying this to finance, models designed to capitalize on people’s mistakes in the mkt eventually won’t work b/c they’ll learn about the model being used (alpha gets evaporated)

Question 9

does the lucas critique in finance imply EMH

Answer 9

Yes

Because it argues that eventually all alpha from quantitative models and trading strategies will be eroded to the point where there is no extra return to be captured

Question 10

law of large numbers

Answer 10

the mean of every independent estimate is always more accurate than the closest estimate

Question 11

using Shiller’s empirical evidence of stock market efficiency, are securities actually priced based on the PV of future dividends?

Answer 11

No because the variance in S&P returns is too high to be explained by the variance in future dividends
- this means that there are other factors at play, like psychology

Question 12

what is the idea of bounded rationality

Answer 12

rational people base their actions on approx. solutions / heuritistics if the cost of getting an exact solution is GREATER than the cost of occasional mistakes from using heuristics

Question 13

what are transcomputational problems

Answer 13

problems that can be solved but takes too much time and resources for it to be worth solving

Question 14

how does bounded rationality relate to the cost of information for arbitrageurs

Answer 14

the incremental value of information diminishes as you go up the curve and becomes ‘too costly’ for arbitrageurs to pursue

… this means that semi strong EMH doesn’t apply since not ALL public information is reflected in stock prices

Question 15

at what point to arbitrageurs stop pursuing addtl. information for trading decisions?

Answer 15

beyond MC(I) = MR(I)

(i.e. marginal cost of more information can’t be lower than the marginal revenue generated from it)

Question 16

what is the zen equilibrium?

Answer 16

if the mkt is too efficient, arb traders can’t earn enough to cover information cost and noise traders affect prices more (less efficient mkt)

if the mkt is too inefficient, then arb traders are more active and noise traders affect prices less (more efficient mkt)

… then the mkt comes to rest at an efficient level of inefficiency where MC(I) = MR(I)

Question 17

what happened with the collapse of LTCM and what did it imply about arbitrage

Answer 17

LTCM saw a mispricing between US dollar denominated Russian bonds and ruble denominated Russian bonds, so they sold US den. bonds short and bought ruble den. bonds

… the Russian Gov. defaulted on its ruble den. bonds but not its US den. bonds which went against their trade

… when they were required to sell out of their position they didn’t have enough $ to pay back investors and Merton + Scholes had a slurry of lawsuits

Question 18

what is the evidence that arbitrage is incomplete

Answer 18

people attach different values to different goods (i.e. stocks)

if the mkt were totally efficient, then a one cent rise/fall in a stock would cause infinite sell/buy demand (keeping the price of the security in check)

but this doesn’t hold because people have different values assigned to different stocks

Question 19

describe the differences between the US and CA stock mkt indexes weighting methods

Answer 19

in the US companies are weighted just by mkt cap

in CA, companies are weighted based on mkt cap but the P x Shares is based on public float (not all outstanding shares)

public float is the amount of shares not held by control blocks (i.e. shareholders holding 20% or more of shares)

Question 20

what was Fischer Black’s view on the efficient market hypothesis

Answer 20

“theory is accepted not because it is confirmed by empirical tests but because researchers persuade one another that the theory is correct & relevant”

… “markets look a lot less efficient from the banks of the Hudson than the banks of the Charles”

Question 21

three types of noise traders

Answer 21

abritrageurs (detect mispricing)
noise traders (idiot traders)
savers (contribute capital)

Question 22

what is a CEF?

Answer 22

closed end fund

whose only assets are shares in other firms

Question 23

T or F: in an efficient market, the price of a CEF should equal the price of its NAV/sh

Answer 23

True!

However, CEF managers actually pay themselves salaries which means that CEF dividends are less than those of the individual stocks

• this implies that P(CEF) < NAV(CEF)

Question 24

in reality, prices are never aligned with the true NAV/Sh of CEFs, where are they typically priced in bull and bear markets?

Answer 24

bull mkts: P(CEF) > NAV(CEF)

bear mkts: P(CEF) < NAV(CEF)

… this is because noise traders buy into CEFs and rational investors buy individual securities, and noise traders tend to have market mania mentalities

Question 25

pigou effect

Answer 25

people who become poorer become more cautious, which deters new business formation, risk taking, etc.

Question 26

what are animal spirits

+ what are some indicators of animal spirits

Answer 26

irrational optimism or pessimism drives stock market returns and economic growth. (not fundamental economic measures)

non-economic measures like music downloads and length of women’s skirts are indicators of animal spirits

Question 27

what is the Keynesian beauty contest?

Answer 27

basing decisions off of what other people think that other people think the best decisions are

Question 28

what’s an information cascade

Answer 28

where people follow the 1st mover that they believe is informed so everyone does the same thing

… this actually works, unless the 1st mover is wrong

(Lemming animals are an example)

Question 29

what worsens cognitive load?

Answer 29

age, poverty, IQ

Question 30

what was Descartes Error and what was his original arguemtn

Answer 30

he argued that people are governed by dualism (emotion and rational decision making)
… so if their amygdalas were removed than they would only make rational decisions

… however, when people had no amygdala they couldn’t make any decisions

THUS, all decisions are based on emotion

Question 31

describe the elephant / lawyer theory for rational decision making (relate it to ________ _______)

Answer 31

the theory says that people will make a decision based off of emotion (heuristic / thinking fast), then the lawyer justifies it (thinking slow), but we’re never actually making decisions entirely based on rationality … which relates to Decartes’ Error

Question 32

describe Minsky’s P/E measure of investor sentiment

Answer 32

formula that backs out the discount rate investors were using in the perpetuity growth formula

if the formula spits out a very high or very low number, then investors were overly optimistic or pessimistic

Question 33

describe Shiller’s CAPE

Answer 33

shiller’s cyclically adjusted PE ratio is a more refined version of Minsky’s formula that has a mean of 18

if the formula output is overly higher or lower than 18, then the mkt is overly optimistic/pessimistic

… in Shiller’s CAPE, he adjusts S&P returns by assuming all dividends are reinvested

Question 34

describe how Shiller’s CAPE can be used to predict mtk returns

Answer 34

Buy stocks when Shiller CAPE is low you get a high return over the next 20 years

Buy stocks when Shiller CAPE is high you get a very low return over the next 20 years

Question 35

is the “R” squared value declining or increasing when comparing CAPM to the US mkt?

Answer 35

it’s declining compared to 100 years ago

Question 36

how does the R squared value differ in other economies

Answer 36

developing countries have a higher rsquared value compared to developed countries, and CAPM can explain a significantly larger % of the market’s returns

… this is tied to the lower volatility of market returns compared to

Question 37

what is the 4th form of the EMH (according to James Tobin)

Answer 37

the functional efficiency of the economy (i.e. efficiency of Schumpeter’s FLow)

if it’s efficient, then the market directs savings into NPV > 0 projects

Question 38

how to assess functional effiency of the economy (Tobin’s 4th form EMH)

Answer 38

measure it through the correlation coefficient (p) of capital spending & value added to the economy

• will be = 1 if functionally efficient
• will be = 0 if not functionally efficient

Question 39

T or F: Stocks move less harmoniously in countries with more functionally efficient financial systems, stronger Schumpeter’s circular flows, & more prosperity

Answer 39

true that

Question 40

what’s the 5th reason that rsquared values are lower in developING countries compared to developED countries

Answer 40

slower pace of innovation

… more big winners and losers, which pushes individual firm values higher and lower than the broader market

… BUT in a economy without this innovation there’s less individual variation more co-movement

Question 41

T or F: stocks in industries (in the US) with more technology and innovation have larger co-movement with the economy?

Answer 41

False!

stocks in industries with higher innovation move less with the market and have greater individual variation

Question 42

what is the Keynesian explanation of homophobia and racism

Answer 42

people are terrified of being socially excluded, so they protect themselves by:

• demonstrate absolute affirmation and acceptance of social norms
• aggressively and loudly show to others that I agree with social norms

Question 43

does Keynesian Beauty contest apply to anything else outside of finance?

Answer 43

yes, it applies to abstract art, arts and humanities research, and postmodernism …. and even science, medicine, and finance

Question 44

what is cargo cult science?

Answer 44

using scientific terms without justifying what the words mean or if they make sense to apply to a topic

throwing around jargon to impress the uninformed reader

Question 45

what are socially useful speculative bubbles?

Answer 45

gold, fiat money and stock market bubbles

• fiat money is useful because it makes transactions more easy
• stock market manias are useful because they can boost investment in new innovative technologies

Question 46

why are speculative bubbles useful in the context of the Kindleberger Cycle?

Answer 46

speculative bubbles and market manias are useful because they can encourage investment in new tech which may not have otherwise received attention or capital

rational investors would otherwise underinvest in innovation, because they’re not always considering the higher social NPVs that are generated by the positive externalities