More bubbles Flashcards
How do we make sense of negative “stub” values? When mother comp is worth negative when subtracting its subsidiary.
- Seems to violate “law of one price”, and arbitrage should take care of it but it fails, either because of irrationality (as Lamont-Thaler states) or because of convenience yield (as Cochrane states).
What does Cochrane mean by convenience yield?
You know you will lose money by buying Palm, but per day it is a very small loss, and you get short term payoffs. Because 3com and Palm is not the same thing and you want the Palm-style payoffs, very specifically. The fact that the stocks’ variance does not move in parallell is the Cochrane argument for this.
What do we expect rational hedge funds to do when we have the period of Nasdaq bubble?
We expect them to attack the bubble/mispricing.
What is the problem for hedge funds when it comes to attach/short sell the overvalued shares?
- That the loss is unlimited while the upside is limited. The shares can only shrink to 0 but they can continue to grow in the bubble to crazy numbers.
- Even if the prices does not reach the sky, it will still take time for others to realize this mispricing, so you don’t want to be the first short-seller, you want to be the last one that makes the market turn. (coordination problem).
Did the hedge funds held the same proportion as the average market in tech/IT shares?
No, hedge funds were overweight in this sector. They don’t attack the mispricing, they don’t short, they are not even underweight –> they hold more!!
What happened with in- and outflows to the hedge funds when they invested in tech vs not?
When hedge funds invested in tech –> the inflows increased, meaning that investors put more money into the funds because they believed in the tech sector.
When hedge funds started to short –> investors took their money out of the funds…
What is it that hedge funds cannot do, that Fama says they should (be rational)?
They can’t be rational and make their decisions to short even if they believe that short-selling is the right thing. Hedge funds are sophisticated and educated and even if they understand that tech sector is overvalued and mispricing is going on, they can’t short because then uneducated investors take their money out of the fund. So at the end of the day, it is the uneducated investors that influence and steer the investments of the hedge funds…
Did hedge funds anticipate price peaks?
Yes on average they do really well, because they were heavily overweight in the high P/S part of the market before the price peak and then sold a lot just before the peak and continued decreasing their holdings in the years after.
= predictable investor sentiment! = you have a sentiment of how the market is going to change and you exploit that as a hedge fund.
Can it be the case that when hedge funds sold their holdings before the peak, they affected the price to go down?
Maybe not only because the hedge funds sold their holdings because they are not big enough to affect the price alone, but they can signal to others so that not so sophisticated traders look at what hedge funds do and then they do the same. So aggregating this can affect the price to go down. –> they can make the bubble burst.
How is predictable investor sentiment related to the 3com-Palm story?
Sophisticated H-funds with predictable sentiment have reason to believe that Palm will go more up than down, why? Because they know that stocks are locked up until expiration. The H-funds know that until then, this stock can only go one way, it can’t be short-selled so the price must go up. The way we structure markets is biased towards optimists due to this constrain. So that’s why they invest too. Because they have this knowledge and sentiment of where the market is going.
What is the bubble component in the Hong-paper?
It is the option value that you include in your valuation because you think that another group of investors are more optimistic and that you will be able to sell the asset to them in the future. Since you are actually more pessimistic than you believe that the other group is, you should not value this asset so high –> but you buy it anyway and push the price up… so this is the bubble component (the extra value you add in your demand function utöver the fundamental belief).
How is Hong’s paper linked to Pastor & Veronesi?
Because both of them are talking about seeing stocks as options, where uncertainty is very high. P&V talks about the small tails in the distribution and that the sky is the limit (should value the upper tail more!) and Hong talks about the uncertainty in expectations and if you are pessimistic, there are probably some that are very optimistic, and this you should value high.
How is a bubble affected by liquidity/shares outstanding in the Hong model?
An asset with less shares (Q), will easier get a bubble because there is a larger possibility for one group to hold the entire Q –> therefore willing to pay extra for this. If the Q is large, the chance is small, the bubble component shrinks.
What can we learn from the liquidity implication, when it comes to policies in the financial market?
That liquidity and free float is extremely important for avoiding bubbles.
Hong paper: if risk bear.cap- goes up, what happens with the bubble?
It increases because investors will require less compensation for holding the asset and can take more risk, and therefore the bubble increases.
