Reading summaries

Question 1

Wisdom of crowds

Answer 1

RQ1 - Do peer opinions actually impart value-relevant news? Or do they merely constitute “random chatter”?
RQ2 - Are some users attempting to intentionally spread false “information” and mislead fellow market participants?

2 reasons behind findings:
1) SA views indeed predict future stock market performance
2) Exploiting naïve investors
Negative words in SA articles and comments strongly predict subsequent scaled earnings surprises, thus the 2nd reasoning is false.

Incentives of truly informed users:

1) Attention and recognition
2) Monetary compensation
3) Public feedback
4) Convergence to real value

Question 2

The cross section of expected returns

Answer 2

Many of the historically discovered factors would be deemed “significant” by chance.
Nevertheless, a t-statistic of 2.0 is no longer appropriate —even for factors that are derived from theory.

Question 3

Two pillars of asset pricing

Answer 3

Joint Hypothesis problem
1st pillar - tests of market efficiency:
1) Event studies
2) Predictive regressions
3) Dependency on time
Bubbles – ambiguous as no reliable evidence that expected stock returns are sometimes negative.
2nd pillar – Asset pricing models (CAPM, 3 factor model)

Question 4

Behavioral economics

Answer 4

Problem - one theory to accomplish two tasks -> to characterize optimal behavior and to predict actual behavior.
Contrary to the predictions of traditional theory, SIFs matter; in fact, in some situations the single most important determinant of behavior is a SIF.
Agents are expected to act as if they understood the complicated model.
EMH components:
1) No free lunch – mispricing;
2) Price is right – lack of predictability does not imply correct pricing (e.g. CUBA)
Defenses and refutes:
1) One should judge theories based on not whether they describe but whether they predict behavior – but what about non-experts?
2) Errors of humans are randomly distributed with the mean of zero - humans make judgements that are systematically biased.
3) Raising the stakes – the more expensive, the less practice we get.
4) Invisible handwave – humans are not master economists, markets will exacerbate behavioural biases by catering to those preferences.
All economics should be behavioral.

Question 5

30-year perspective on property derivatives

Answer 5

Advantages:
1) Futures provide info on future prices.
2) Can hedge property risk.
3) Get exposure to Real Estate without owning it.
4) Reverse mortgages (elderly).
Why created:
1) Slow growth of prices.
2) Existence of covered mortgages.
3) Shift from balloon payments to adjustable-rate mortgages, shifting risk of inflation to buyers.
4) Land prices increased for residential land.
Obstacles:
1) Index construction mismatch
2) Low liquidity (nobody wants to short housing market)
3) Difficult to price.
4) Increased regulation now.

Question 6

Anomalies - law of one price

Answer 6

LOP violation conditions:
1) Some agents falsely believe that there are real differences between two identical goods
2) Arbitrageurs are facing obstacles preventing them from profiting from the mispricing
Violations:
Closed end country funds.
ADRs – offer great diversification opportunity.
Twin shares – index inclusion hypothesis.
Dual class shares – SnP firm rights example.
Corporate spinoffs
What prevents the arbitrageurs from enforcing the LOP:
Short selling constraints
Noise trader risk

Question 7

Hedge funds

Answer 7

Types of funds:
1)	Closed end funds
2)	Open end funds
3)	ETFs
4)	Hedge funds
Hedge fund strategies:
1)	Long and short equities
2)	Event driven
3)	Macro hedge fund
4)	Fixed income arbitragers
Difficulties of assessing performance:
	1) Biased sample
	2) Varying exposure to markets.
	3) Past performance rarely predicts future behavior
	4) Problems of valuation
Key concerns:
1)	Investor protection
2)	Risks to financial institutions - credit exposures for financial institutions lending, transacting, etc.
3)	Liquidity risks 
Growing industry - more activist hedge funds, dependence on reputation and the range of products offered

Question 8

Bitcoin

Answer 8

Irreversible transactions, a prescribed path of money creation overtime, and a public transaction history.
1)	Transactions and the blockchain
2)	Built-in incentives
3)	No governance structure – decentralization
Intermediaries (centralization):
1)	Exchanges
2)	Wallets
3)	Mixers
4)	Mining pools
Risks of Bitcoin:
1)	Market risk – volatility
2)	Liquidity
3)	Dependency on intermediaries
Regulation:
1)	Fighting crime
2)	Consumer protection
3)	Regulatory options – where to impose?

Question 9

Prone to fail

Answer 9

Sources of fragility:

1) Regulators failed
2) Financing meltdown risks
3) Opaque swap markets – complex webs of derivatives
4) Too-big-to-fail mentality

Question 10

Moores law vs murphys law

Answer 10

Developments pushing the growing popularity of AT:
1)	Quantitative finance
2)	Index funds
3)	Arbitrage trading
4)	Automated execution and market making
5)	High-frequency trading
Examples of problems:
1)	Quant meltdown
2)	Flash crash
3)	System bugs
Financial regulation 2.0:
1)	Systems -> engineered
2)	Safeguards -> heavy
3)	Transparency -> rich
4)	Platform -> neutral

Question 11

Towards a political theory of the firm

Answer 11

Giant global corporations.
Increased concentration - in the last 2 decades, size of the average publicly listed company in the United States tripled.
Due to 2 trends:
1) Less new firms
2) High merger activity
Possible explanations
1) Network externalities
2) Winner-takes-all industries
3) Reduced anti-trust enforcement
1) The size and market share of companies has increased
2) The size and complexity of regulation has increased
3) Democrats now also lobby corporations
Need a goldilocks balance – firms and state need to be strong and weak enough.

Question 12

PBOC

Answer 12

What affects the size of PBOC premium:
1) Size of the block traded
2) Presence of another shareholder
3) Sellers bargaining power
4) Industry
5) Tangibility of assets
How PBOC affects financial development:
1) Fewer companies are public – equity markets are thus underdeveloped.
2) Afraid of giving out shares -> less widely held companies.
3) Governments will sell companies privately.
What curbs PBOC:
1) Legal institutions
2) Public opinion pressure
3) Government as monitor through tax enforcement
4) Product market competition
PBOC premiums highest in ex-Comme countries

Question 13

Behind the scenes: corporate governance preferences of institutional investors

Answer 13

Investors can:
Voice their concerns.
Threaten exit.
Institutional investors are active overall.
What determines the effectiveness of Voice:
1) Stock liquidity – more No.
2) Investment horizon – Long term -> more activism
3) Size of the stake – no evidence found but should be positive.
Voice and exit threats are complements.
Free rider problem and inadequate legal rules – discourage activism.
Main drivers of activism:
1) Excessive managerial compensation
2) Disagreement with large mergers and acquisitions
3) Contributions to politicians
Proxy advisors provide institutional investors with research, data, and recommendations on management and shareholder proxy proposals.
Can give too standardized advice.
Difficult to evaluate.
Low-cost analysis as they are also profit seeking.

Question 14

Active ownership

Answer 14

Socially responsible investing that seeks to deliver social as well as financial benefits.
Effects of CSR:
1) Based on LR strategy – firm value UP.
2) Channel to express personal values (of stakeholders) – firm value UP.
3) Can reveal agency problems – firm value DOWN.
Channels of ESG value enhancement:
1) Consumers
2) Employees
3) Morals
4) Progressiveness
You can either raise awareness or request for change!
Determinants of successful ESG engagement:
1) Large and mature firms
2) Institutional ownership
3) Underperforming firms
4) Consumer industries
ESG activism increases stakeholder value when engagements are successful and does not destroy value if fails.

Question 15

The agency problems of institutional investors

Answer 15

By aggregating the assets of investors, institutional investors hold substantial.
Stewardship activities - engagement with public companies to promote corporate governance practices (voting, monitoring, engaging with the management).
3 types of institutional investors:
1) Index funds
2) Active funds
3) Hedge funds
Investment managers of index funds bear full costs of stewardship but capture only a fraction of benefits.
Index funds engaging in stewardship do not improve relative performance to attract more assets. Free-rider problem!
Their investors are in fact incentivized to switch to their competitors that free ride on others’ expenses, as they offer the same return without higher fees to finance it.
Active funds also capture very small benefits from stewardship.
Potential sources of agency problems:
1) Most capture only a fraction of the benefits.
2) Investing in stewardship can reduce relative performance of the fund.
3) Institutional investors don’t want to ruin relationship with managers.
For hedge funds it is easier due to more risky positions, larger commission (incentive), larger stake in smaller number of firms (capture more benefit from stewardship).

Question 16

Extreme governance

Answer 16

Determinants of dual class status:
1) PBOC
2) Personal name
3) Media companies
4) Activity of the founder
Key findings:
1) Firm value positively associated with insiders’ CF rights.
2) Firm value negatively associated with insiders voting rights.
3) Firm value negatively associated with difference between CF rights and voting rights.
Despite the evidence that dual-class system can reduce the value of the firm, a majority owner of a private company can still rationally choose to sacrifice some of firm value to maintain PBOC.

Question 17

Bonding hypothesis on takeover defenses

Answer 17

Bonding hypothesis - the company will not act opportunistically and appropriate them, encouraging partners to make relation-specific investments.
Takeover defenses are used more often when you:
1) Have a large customer.
2) Dependent supplier.
3) Strategic alliance
Acts as an IPO anti-takeover defense.
IPO announcement benefits the customer as well but bring more risk.
More defenses associated with larger positive returns of main customer (Spillover effect)

Question 18

On the foundations of CSR

Answer 18

CSR in Civil law countries is mandated by law.
Political institutions lag behind the legal origins as a predictor for the level of CSR.
Cultural values and religion don’t seem to affect CSR.
The “marginal” effect theory: civil law firms outperform because they are more responsive to the shocks changing the demand for CSR actions.
Two channels of responsiveness:
1) Consumer channel – changes in consumer demands.
2) Legal channel – firms in more stakeholder-orientated legal environments are more responsive.

Question 19

Do investors value sustainability?

Answer 19

Investors mostly look at globe ratings.
Also, they focus on extreme outcomes.
Reasons why:
1) Institutional constraints (but pattern is visible in regular investors as well).
2) Rational performance expectations – expect these stocks to do better (the paper finds no evidence of them doing better though).
3) Irrational expectations - irrationally expect these stocks to do better

Question 20

Is there a zero lower bound?

Answer 20

• Above the ZLB, all banks pass on most of the policy interest rate cut.
• Around the ZLB, little pass through, even after a year only 20% of the original cut is reflected
• Below the ZLB, pass through increases but only for financially sound banks.
Amount of the pass-through depends on the health of banks.
Banks do not experience large deposit outflows when they implement negative rates.
Firms exposed to NIR experience higher fixed asset growth and decrease in liquidity.
The positive effects of the NIRP on the economy are stronger if banks are healthy.

Question 21

Risks and returns of cryptocurrencies

Answer 21

Exposure to asset pricing factors is small apart from Alphas.
Alphas are large and statistically significant.
No evidence of exposure to currencies.
No evidence of exposure to metal commodities (Ethereum to gold).
No evidence of exposure to macroeconomic factors (Ethereum to consumption growth).
Crypto specific factors (significant):
1) Time-series momentum
2) Positive media attention
3) Negative media attention
“Cryptocurrency represents an asset class that can be assessed using simple finance tools.
At the same time, cryptocurrencies comprise an asset class which is radically different from traditional asset classes.”

Question 22

ETFs 101 for economists

Answer 22

Investor does not interact with the market directly.
ETF manager is in a legal contract with Authorized Participants (large financial institutions) who interact with the market.
ETF intricacies:
1) Reduced transaction costs.
2) Trades occur at a market determined price.
3) Transparent investment strategy.
4) Shorting, lending, margin trading available.
Types of ETFs:
1) Equity ETFs - (Market cap based, Sector based, Smart beta based)
2) Fixed income ETFs (Convenient, higher transparency, greater liquidity)
3) Commodity ETFs (often used as a hedge or for diversification)
Concerns:
1) Closures of ETFs
2) Short selling of ETFs
3) Securities lending by ETFs
4) Liquidity mismatch – if APs step down in a crisis (default), there is no party to provide liquidity.

Question 23

Is the US public corporation in trouble?

Answer 23

Low numbers of newly listed firms and high numbers of delists.
Main reasons for delist:
1) No longer meets the requirements.
2) Has been acquired.
3) Voluntary.
Observations:
1) Tobin’s Q – peaked at Dot com bubble.
2) Herfindahl index – concentration of firms – concentration of profits.
3) The regulatory burden of being public increased.
4) Increase in intangible assets -> less informative balance sheet.
5) Share repurchases increased considerably.
Larger firms have a higher ratio of cash flow to assets → firms have been performing poorly on average, except for the largest firms.
Average public firm has more cash than debt!!! - Bank loans have become less important.
Agency problem of Free CFs – low payouts - Fall of inventory holdings but hold more cash.
Implications:
1) Firms don’t want to disclose their projects.
2) Institutional ownership more widespread.
3) More financing from Private equity and Venture capitals.
4) Economies of scope hypothesis - small firms have become less able to grow on their own.
5) Increased concentration.
6) Difficult to grow without patents.
7) Renting and outsourcing – makes it easier to put a product out (less funds required).

Question 24

Fintech and Banking

Answer 24

Fintech - technologically enabled financial innovation.
Investments in Fintech are higher:
1) financially developed countries.
2) with less competitive banking systems.
3) higher lending and lower deposit interest rates.
Services:
1) Credit, deposits and capital raising (P2P lending, shadow banks).
2) Payments.
3) Investment management services.
4) Insurance.
Problems with P2P platforms (no bank):
1) Insufficient screening (no skin in the game)
2) Origination fees (causes overlending)
P2P advantage over banks – Operating costs
Bank advantage over P2P – trust to make good loans
The role of cryptocurrencies and fiat money:
CB digital currency and monetary policy.
Blockchain enables agents to collaborate without having to go through a neutral central authority.

Question 25

Covid-19 and corporate finance

Answer 25

Banks in a much more stable position than during GFC.
Fed’s corporate bond purchases helped raise money cheaply.
Substantial increases both for bonds rated A or higher as well as for bonds rated BBB or lower.
Financial markets functioned smoothly.
Impact of the pandemic – zombie firms (supported from relief subsidies).
Environmental and social stocks suffered smaller drops – also volatility was lower.
Customer loyalty kept profits high.

Question 26

Feverish stock price reaction to pandemic

Answer 26

In the fever period – concerns about corporate debt arose.
In Fever, the value of cash increased strongly.
Cash was particularly valuable for firms expected to have the biggest problems accessing external capital.
Perceived high corporate debt problematic for higher book-to market firms.
Higher returns for those who did not mention Covid-19.
The Fed announced massive credit support measures:
- the cross-sectional stock price reactions that had taken place in the Fever period temporarily reversed.
- temporarily mitigated the symptoms of the crisis.

Question 27

Capital structure

Answer 27

External financing mostly consists of debt.
Net stock issues are frequently negative.
Smaller, riskier and more rapidly growing firms rely heavily on stock issuance.
Industry debt ratios are low or negative when profitability and business risk are high.
Trade-off theory - firm will borrow to where the marginal value of tax shields on the additional debt is just offset by the increase in default costs.
Costs of financial distress:
1) Direct - the costs of bankruptcy or reorganization.
2) Indirect – agency costs when in distress.
Pecking order theory – firms prefer internal financing and debt to equity issue, due to information asymmetry between managers and investors.
Dividends are sticky.
Firms’ debt ratios reflect the cumulative need for external financing.
Free CF theory – empire building with retained earnings (a theory about the consequences of high debt ratios).
- Solution -> increase leverage
Debt and equity holder conflicts:
1) Investment in riskier assets/risk-shifting/overinvestment.
2) Borrow more/cash out.
3) Debt overhand/underinvestment.
4) Play for time.
- Solution – debt covenants.

Question 28

Corporate payout policy

Answer 28

Lifecycle theory – at first low payout due to positive NPV, then higher payout at maturity.
What stimulates payout:
1)	Pressure from investors.
2)	Incentive to build a reputation.
What lowers payouts:
1)	Agency problems.
2)	Servicing different tax clienteles.
Changes in dividends tell us about what has already happened.
If dividends increase, less likely to experience a decline in earnings.
Biases in investors:
1)	Consume only out of dividends.
2)	Regret aversion – afraid to sell off.
3)	Mental accounting – irrational valuation.
Clientele effect – firms will tailor to certain clientele tax preferences. (doubtful)
Reasons for high dividends:
1)	Lower agency costs.
2)	Low growth companies.
3)	Signaling theory.
4)	Bird in hand theory.
5)	Clientele effect.
6)	Trading costs – for investors to replicate dividends.
Reasons for low dividends:
1)	Costs of financial distress.
2)	Growth prospects.
3)	Minimize personal taxes.
4)	Clientele effect.
Advantages of stock repurchases:
1)	Financial flexibility.
2)	Correct stock market valuation (correct undervalued stock).
3)	Remove low valuation stockholders (anti takeover).
4)	Allocation of voting rights.
5)	Increase reported EPS.
6)	Save transaction costs.
7)	Provides liquidity to investors.

Question 29

Equity valuation using multiples

Answer 29

Simple valuation technique.
Forward earnings – best.
Intrinsic value < Forward earnings.
Performance improves when multiples are computed using harmonic mean.