„Two Pillars of Asset Pricing“ Fama, Eugene F. Flashcards
What is the main idea?
Father of EMH on efficient capital markets and asset pricing model.
“the central question is whether asset prices reflect all available information — what I labeled the efficient markets hypothesis”
What is the main question?
Do asset prices reflect all available information → are markets efficient? (Efficient market hypothesis)
A small recap on forms of market efficiency:
◦ Weak: prices reflect only past information (impossible to beat the market using technical analysis)
◦ Semi-strong: prices reflect all publicly-available information (past and present)
◦ Strong: prices reflect all available information (public and private) ← this is what Fama writes about
What is the main problem with the main question?
Joint hypothesis: If then asset pricing model doesn’t fit data, don’t know if it is a bad model or an inefficient market
Do stock prices adjust accurately to new info?
On average, all relevant info about the stock split is incorporated in stock prices in the months leading up to the split, with no reaction after - exactly the prediction of market efficiency.
Short period: Exp. returns relatively unimportant because the reaction is typically much larger than short-horizon expected returns (Joint hypothesis not a problem)
Long period: Not true over longer periods (several years) - expected returns are larger than the price effect of a studied event; thus, JHP becomes relevant again
When are expected returns high?
The general result is that expected returns are high when business conditions are poor and low when they are strong.
Why do expected returns likely vary over time?
Expected return likely varies in time for stocks because both - the underlying risk and willingness to bear the risk – for investors are likely to be dynamic.
What do efficient market supporters and behaviorists thinks about predictability of returns?
Efficient market supporters: Variation (predictability) in returns is rational, it’s the result of variation in risk or willingness to bear risk
Behaviorists: Much of the variation/predictability is due to irrational swings of prices away from fundamental values
What is a bubble?
Bubble – irrational price movement (rapid increase and a rapid crash).
Existence of bubbles doesn’t have sufficient evidence, because of
o The absence of evidence that price declines are ever predictable
o The evidence that the common “bubble” examples seem to be associated with rather impressive market forecasts of real activity, not irrational price movements (Common bubble examples forecasted economic activity, so since there is correlation, bubbles are not random)
What was the problem with CAPM and how did Fama and French deal with it?
CAPM’s major prediction that β is the only factor necessary to explain cross-section of expected returns simply does not hold.
Fama and French made a three-factor-model, which explains returns by size, book-to-market ratio and the market returns (empirical model)
o Explains some of the CAPM anomalies, but has its own
What is overreaction hypothesis?
Market prices overreact to the recent good times of growth stocks and the bad times of value stocks.
