Week 8 - Other anomalies, Asset Prices

Question 1

Open-ended funds v closed-ended funds

Answer 1

Open-ended funds create new share, cost = NAV

Closed-end funds issue fixed number of shares

Question 2

How are shares traded

Answer 2

on exchanges, buy at the prevailing price from another investor

Question 3

Closed-end Funds Puzzle

Answer 3

puzzle: fund share prices differ NAV - typical fund trades at a discount to NAV of about 10% on average

Difference between price and NAV varies substantially over time

When closed-end funds are created, share price is typically above NAV

When they are terminated, either through liquidation or open-ending, gap between price and NAV closes

Question 4

Rational explanations

Answer 4

• Expenses
• expectations about future fund manager performance
• tax liabilities

BUT: none of them can explain all aspects of the evidence - management fees explain why fund usually sell at discounts but not why they sell at a premium or why discounts vary from week to week

Question 5

Behavioural explanations

Answer 5

Investor sentiment
- individuals who are the primary owners of closed-ended funds are noise traders
- Sometimes they are too optimistic, other times they are too pessimistic
- changes in sentiment affect fund share prices and hence difference between prices and NAV

Owners of closed-end funds have two sources of risk
- fluctuations in value of assets and noise trader sentiments
- rational investors demand compensation for this

This also explains why new closed-end funds are sold at a premium
- entrepreneurs whill choose to create closed-end funds at times of investor exhuberance

Question 6

Limited Attention 1

Answer 6

Because of limited attention, investors may underreact to news

May explain PEAD

Question 7

How to test Limited attention

Answer 7

1. PEAD is stronger for firms that announce earnings at the same time as many other firms
2. PEAD stronger for firms that announce earnings on Friday
3. PEAD stronger for low volume stocks

Question 8

Underreaction to Customer links

Answer 8

firms are required to report their major customers - investors are slow to recognise that good news for a customer is good news for associated firm

Question 9

Underreaction to Demographic news

Answer 9

Investors are slow to recognise impact of demographic shifts on the future profitability of firms with age-sensitive products

Question 10

Limited Attention 2

Answer 10

Attention more important for individual investor’s buying decisions than for selling decisions

Barber and Odean (2008) - there is stronger buying interest than selling interest for attention grabbing stocks (stocks with extreme returns, high volume or news announcements)

Question 11

How do prices comove according to traditional view

Answer 11

• Common factor in future cash flows
• Changes in rf
• changes in risk aversion
• common factor in news about risk

Question 12

Example of comovement anomaly 1

Answer 12

Twin shares (eg. Royal Dutch and Shell)

• Shares should move in lock-step, but they dont
• Royal Dutch shares comove strongly with S&P

Question 13

Example of Comovement anomaly 2

Answer 13

Closed-end Funds

• CEFs comove strongly with one another even though their asset fundamentals are weakly related
• CEFs comove with small stocks even when they hold only large stocks
  -Closed-end country funds comove as strongly with the national market in the country where fund is traded as with the market where the assets are traded

Question 14

Frictional explanation for Comovement

Answer 14

• Based on investor Habitats
• Some investors choose to hold and trade only subset of all securities
• As risk aversion or sentiment changes, they buy or sell this subset - common factor in returns of securities in this subset

Question 15

Behavioural explanation for Comovement

Answer 15

Assumptions:
- Investors group stocks into categories (eg. value, growth, small-cap, large-cap, etc.)
- investors’ beliefs about future return on a category is a weighted average of its past returns

Predictions:
- excessive comovement within a category

Applications:
- Comovement of value stocks, small stocks
- Comovement of commodities

Question 16

Categorical thinking

Answer 16

Barberis, Shleifer, Wurgler predict that stocks added to the S&P500 will comove more with the index after addition than before

Question 17

Bubble definition

Answer 17

Bubble is an episode in which an asset become significantly overvalued for some period of time

• price is higher than a reasonable present value of its future cash flows
• Price is higher than it would be in an economy with fully rational investors

Question 18

Empirically-based definition of bubble

Answer 18

Episode in which the price of an asset rises sharply over some period of time and then collapses
- during the price rise, there is much talk of overvaluation in the media and among investors

Question 19

Facts about Bubbles

Answer 19

• Very high trading volumes
• Extrapolative expectations
• Sophisticated investors ‘riding the bubble’
• Good fundamental news near the start of the price rise

Question 20

New models to understand bubbles

Answer 20

-All use extrapolation to get rising prices

• Different in volume mechanisms

Question 21

Barberis et al. Model for Bubbles

Answer 21

• Extrapolators form their beliefs based on two signals - value and growth signal (opposite directions)
• relative weight an extrapolator puts on the two signals varies slightly over time
• this is called wavering
• variations stem from small fluctuations in relative attention extrapolators pay to the two signals

Question 22

Barberis et Al. Volume mechanism

Answer 22

• degree of wavering is constant over time but endogenously generates much higher volumes during the bubble

Extrapolator i’s demand:
Wi,tVt + (1-Wi,t)Gt

• 0.01 shift in Wi,t leads to a change in share demand of 0.01(|V-G|)
• during normal times, value and growth signals have small magnitudes so shift in W leads to small demand shift
• During Bubble, Value and growth signals have much higher values so shifts are much more impactful for demand

Question 23

DeFusco et al Model for bubbles

Answer 23

• more tailored to the housing market
• investors have different holding horizons - price increases endogenously attract short-term buyers more strongly than long-term buyers
• Short-term buyers amplify volume by selling more frequently, and they destabilise prices through positive feedback
• Model predicts a lead-lag relationship between volume and prices

Question 24

Liao, Peng, Zhu model for bubbles

Answer 24

• Theory based on extrapolation and the disposition effect
• Disposition effect: investors’ tendency to sell stocks trading at a gain and hold on to stocks with losses

During a bubble:
- Extrapolation induces outsiders to get in
- Disposition effect prompts insiders to get out
- leads to high volume