ECON 308

the adaptive markets hypothesis

- Andrew W.Lo, main idea: financial markets are governed more by the laws of biology than by the laws of physics. 5 basic tenets of adaptive markets 1. people act in their own self-interest 2. people make mistakes 3. from those mistakes, they learn, adapt, and innovate 4. as they experiment and fail or succeed, the process of antural selection operates on individuals, institutions, and markets just as it operates on bacteria, see slugs, and chimpanzees 5. this evolutionary process is what deterines financial market dynamics - AMH applies the framework of evolutionary biology to specific fianancial ocntexts - new insights: human intelligence works very much the way internet search engines work. this idea, which comes from the neuroscience and AI literature, has surprisingly broad implications not just for finance but for life in general - expert systems nowadays process enormous data storage, humans make decisions very much the same way that modern search engines do. we rely on big data to make predictions. - instead of evolving one generation at a time, a single human can go through man generations of ideas and pick the one that seems best, based on her past experiences. BUT this is not the ideal decision-making mechanism for determining our asset-allocation - human behavior as a central liaison. we can improve by first acknowledging that iwe make decisions emotionally, not rationally - we need to create investment plans that adapt to market conditions and take into account our emotions - both personal and professional investors have the same problem of controlling emotions -AMH reconciles and integrates the EMH with behavioral finance. dual nautre of human: rational and emotional at times - build AMH portfolio tools

All of my friends say that Asch and Berns are wrong. Now I'm not sure that their work is valid. Please help and explain!

- Asch conjectured that social pressure caused participants of his experiments to pick the wrong line even when they knew that their answer was incorrect. - Bern's study found that other people's errors actually affect how someone perceives the external world - internet bubble provides a classic example of incorrect investment judgments leading people to go mad in herds - not limited to unsophisticated individual investors. mutual fund managers have a tendency to follow the same strategies and herd into the same stocks. - investors tend to put their money into the kinds of mutual funds that have recently had good performance. - individual investors must avoid being carried away by herd behavior

Is there momentum in the stock market? Discuss

- Chartists believe momentum exists in the market. But! The stock market has little memory. While the market does exhibit some momentum, it does not occur dependably and there are frequent momentum crashes. Stock prices behave very much like a random walk. It does not conform perfectly to the mathematician's ideal of the complete independence of present price movements from those in the pasts.

some critics have argued that not every participant in the stock market pays attention to economic information such as the policy that the Fed has been pursuing. Does this mean that the prices of stocks will not reflect that info?

- False. it is not necessary that everyone follows what is happening for the market to be efficient. The research indicares that if enough people in the market eliminate unexploited profit opportunities that arise, the prices will reflect the info

Summarize the implications for investors at the end of the chapter.

- If past prices contain little or no useful info for predicting future prices, there is no point in following technical trading rules. Buying and selling tend to generate taxable capital gains. By following any technical strategy, you are likely to realize short-term capital gains and pay larger taxes than you would under a buy-and-hold strategy. Simply buying and holding a diversified portfolio will enable you to save on investment expense, brokerage charges and taxes.

is it possible to earn supernormal profit based on superior info if the EMH is true?

- In real terms, the people with superior info are the ones who profit from such trades and thus eliminate the unexploited oportunities to make the market efficient

if inflation and interest rates become more volatile, what would you expect to see happen to the slope of the yield curve

- Investors are likely to demand a higher risk premium in the face of increased volatility. There is more uncertainty regarding the real return on investments and the price for which you could sell a bond before maturity. Assuming the uncertainty rises the longer the term to maturity, you should expect the yild curve to become steeper

define M2

- M1+savings accounts+ small certificates of deposits + money market accoounts

lessons learned from liquidating money earlier than the bond maturity year

- RET= yield to maturity=i if the bond is heald to maturity - if the bond is sold prior to maturitym the return depends on the interest rate at the time of scale - prices move inversely to interest rates prices of long-term bonds are more sensitive to changes in interest rates

what problem associated with asymmetric info was central to Bernard Madoff's success in cheating so many investors for so long

- The Madoff fraud is an example of a moral hazard problem that arises from the absence of perfect monitoring. Investors with Bernard Madoff did not adequately monitor his behavior to insure that he was using their funds as they expected. Perahps they assumed that earlier investors had carried out this monitoring and so they did not need to incur the cost. They may also have assumed that the overnight of the SEC was sufficient to safeguard their funds.

Briefly describe fundamental analysis and explain why it might fail to work.

- The fundamentalist' estimate the firm's future stream of earnings and dividend :four basic determinants to help estimate the proper value for any stock. the expected growth rate, expected dividend payout, the degree of risk, level of market interest rates - why it might fail - the information and analysis may be incorrect, security analyst's estimate of value may be faulty, stock price may not converge to its value estimate

do you think the term spread was an effective preditor of the recession that started in December 2007?

- The information in both the term strcuture and the risk strcuture point ot a healthy economy. The term spread ( the gap between the 10 year Treasury bond yild and the three-month Tresut bull rate) is positive and widening. This tells us that the yiled curve is upward sloping and getting more steeply upward sloping. This implies that interest rates are expected to continue to rise in the future: a sign that the economy is expected to do well - the risk spread (the gap between Treasury and corporate 10 year bonds) is narrowing. this is a sign of a healthy economy as people do not require such a high risk premium on corporate bonds

according to liquidity premium theory, if the yield on both one- and two-year bonds are the same, would you expect the one-year yield in one year's time to be higher, lower, or the same?

- according to the theory, the two-year yile dis an average of this year's and next year's one year yiled divded by 2 plus a term premium to compensate for the inflation and interest rate risk associated with the longer maturity. if the current one-and-two-year yields are the same and there is a risk premium included in the two year yield, then next year's one-year yield must be lower than this year'

structure of liquidity premium theory

- assumes that peopl are RA in the following sense. Inflation erodes the real return from bonds. The longer the horizon, the greater is the uncertainty about inflation so LT bonds are riskier. Also, there is interest rate risk: we know that LT bond prices fluctuate more than ST bond prices in response to interest rate changes. so, since their prices are less volatile, ST bonds are safer - thus, investors demand a term premium in order to hold LT bonds - this theorem explains why rates on bonds of different maturities tend to move together (same explanationsas EH: rate changes today tend to change the expectations of future ST rates) - it also explains why yield curves are usually positively sloped via the term premium

Your Credit Rating

- both companies and individuals have credit ratings - there are companies that keep track of your financial information, rate your creditworthiness - all of this info is combined into something called the credit score - Lenders use credit scores to calculate the interest rate they charge on a loan - the better your credit score, the lower the interest rate - ironically, someone who has never had a credit card and never owed anyone any money has no credit history at all and so will have a low credit score - cannot start sonner in creating a good credit record

what does yield to maturity depend on

- both on the coupon payment and any capital gain or loss arising from the difference between the selling price and the face value of the bond

monetary neutrality

- changes in the nominal quantity of money affect nominal variables such as the price level but leave real variables unaffected - evidence: money appears to be non-neutral in the short run. Money appears to be neutral in the long run

Describe the castle-in-the-air theory. Who does Malkiel say enunciated it most lucidly and what does it have to do with newspaper beauty contests?

- concentrates on psychic values. - John Maynard Keynes enunciated the theory most lucidly in 1936 - professional investors prefer to devote their energies not to estimating intrinsic values, but rather to analyze how the crowd of investors to behave in the future and how during periods of optimism they tend to build their hopes in the air. - analogous to entering a newspaper beauty-judging contest: one must select the prettiest faces out of many photographs. Personal criteria of beauty are irrelevant in determining the contest winner , best strategy:predict average opinion. Like beauty contests, investors anticipate future buyers' valuations.

equity premium puzzle

- considerigng data from 1871 through 1993, a couple of economists were interested to find that the S&P 500 stocks earned significantly more annually than short-term safe investments - why a puzzle: roughly S&P earn 4-6% more annually puzzle is difference is so large and could not find a reasonable measure of risk aversion to explain it

what are suggestions for solving the adverse selection problem

- create more information for investors: government required disclosure, private collection, production of info (CAREFAX for used cars e.g.) - provide guarantees in the form of financial contracts that can be written so a firm's owners suffer together with the people who invested in the company if the firm does poorly - make sure lenders are compensated even if borrowers default (collateral)

Describe the firm foundations theory. Who does Malkiel say is probably the most successful disciple of the theory?

- each investment instrument has a firm anchor of something called intrinsic value, which can be determined by careful analysis of present conditions and future prospects. - Warren Buffet

would efficient stock market today make you more or less likely to invest in stocks for your 401k retirement plan when you get your first job?

- efficient market suggest that all relevan info is incorporated into stock prices, and that changes in prices on particular day reflect that days' news. - in this view, prediction of stock prices into the future is equivalent to trying to forecast generqlly unknowable vents. - your devision to invest in equities for retirement likely is based on other ino, like your attitude toward risk and knowledge of the historical long-run performance of a diversified portfolio of stocks

why is a booming stock market now always a good thing for the economy

- if stock prices are rising for reasons that are not related to economic fundamentals, there may be a misallocation of resources in the economy. Companies invest in projects that may not be the most productive and do not add to economic growth. - As investors' wealth increases, they change their consumption patterns, leading to increased demand for certain goods and services that cannot be sustained when the stock market readjusts.

How does the performance of mutual funds compare with that of broad market indices?

- just as past earnings growth cannot predict future earnings, neither can past fund performance predict future results - fund management is subject to random events, no consistency in superior performance - unlikely that one can beat the broad market, more optimal to buy an index fund, a fund that simply buys and holds all the stocks in a broad stock market index - the investment performance of professionally managed portfolios as a group has been worse than that of a broad-based index.

What's Warren Buffett's advice?

- lethargy bordering on sloth remains the best investment style. The correct holding period for the stock market is forever - Don't overtrade! Investors that move from stock to stock accomplish nothing from this except incurring transactions costs and paying more taxes

four possible effect to repond :what happens to i when the money supply increased

- liquidity effect: assume people are initially porfolio equilibirum. they are holding the desired mix of money and bond. then Money supply increases and people hold more money than they want at initial i. They try to get out of money into bonds, Price of bonds increase and nominal rate of interest decrease until i drops to new i - income effect: money supply increases, GDP and wealth increase , money demand increase in the short run and i increases, money is non-neutral in short run - price level effect: money supply increases general price level increases, money demand increases and i increases - fisher effect : i increases also - so the net effect is theortically unclear, data suggests that i tends to move directly with Ms growth rate - nomial interest rates move roughy one on one with inflation, so the real interest rate stays roughly the same or exhibits no clear pattern with inflation

is it better ot be holding a long term or a short term bond if interest rates decline

- long term bonds because their prices would increase more than short term bonds, giving them a higher returen - recall the formula of present value. that is, the cahge in the interest rate has a larger effect on the price of LT bond than a ST bond because the LT bond has more future coupons which are discounted over a longer period of time

Briefly relate the Tulip Mania to the castle-in-the-air theory.

- mass psychology: everyone makes their assumptions based on their observations of others' behaviors and decisions. - In 1593, a botany professor brought to Leyden a collection of unusual plants originated in Turkey. The Dutch were fascinated. It became expensive as a nonfatal virus caused the tulip petals to develop contrasting stipes. Bulb merchants tried to predict the most popular variegated style for the coming year and buy an extra-large stockpile to anticipate a rise in price. Tulip-bulb prices rose rapidly, people viewed them as smart investments. 1630s, people barter their personal belongings to obtain bulb. It shows how profits are made by foreseeing changes in valuation ahead of the general public.

Briefly discuss how well bitcoin performs the three functions of money. According to Malkiel, how much energy is required to mine a single bitcoin token?

- medium of exchange: Bitcoin appears to some extent to meet the first requirement. It is accepted worldwide for many different types of transactions. - However, the extreme volatility in the value of the bitcoin makes it fail the second and third definitions of money. - an asset that gains and loses a substantial percentage of its initial value each day will serve neither as a useful unit of account nor as a dependable store of value. - creating a single token requires as much electricity as the typical American house consumes in two years

Explain the analogy between amateur tennis and investing in the market.

- most points are won not by adroit plays on your part but rather by mistakes on the part of your opponent. So it is in investing. - most investors beat themselves by engaging in mistaken stock-market strategies rather than accepting the passive buy-and-hold indexing approach - the stock market= a loser's game. - tennis amateurs tries to return the ball with no fancy moves and usually wins, so does the investor who simply buys and holds a diversified portfolio comprising all of the stocks that trade in the market.

How long does your investment take to double

- rule of 72: #years for an investment to double, divide annual interest rate measured as integer into 72 - power of compounding, works for anything that is growing at a constant rate - use he rule of 69.3 based on the use of logarithms for very low interest rate - but for the range of interets rate 4 to 12 percent, 72 works better

The Cost of Payday Loans

- sign "Checks Cashed" on streets of a U.S. city. these financial intermediaries lend to people who cannot borrow from mainstream financial institutions (banks) - most common type of loan these websites or stores offer: payday loan. To get one, provide very limited amount of info to identify yourself. if online, receive a deposit into bank account within a day or two and must agree to let the lender directly debit your account when the loan is due, usually within two weeks. If transaction in a store, walk out with the cash - huge fee, typically equal to 15% of the loan's principal. Lenders are required to disclose implied annaul interest rate on these loans, can exceed 2000 percent - main problem: they trap some borrowers in a vicious syscle of new fees for repeated loan renewals. - in response, federal government is moving to protect borrowers from certain lending practices - June 2017, CFPB proposed a set of rules aimed at ending payday debt traps. - new regulations would require lenders to verify a borrower's income & borrowing history, ensure that new loan can be repaid - would limit renewals in the absence of material imporvement in the borrower's financial conditions

issues involved in solving the moral hazard problem in equity fianancing

- solutions hard to come by - info on the quality of management can be useful but only if owners have the power to fine managers - attempted to align manger's interests with those of shareholders. Executives were given stock options that provided lucrative payoffs if firm's stock price increases - this approach worked until managers found ways to misrepresent their company's profitability - so far, no perfect solution to this problem

With what have most bubbles been associated with?

- some new technology or some new business opportunity

use the Fisher equation to explain in detail what a borrower is compensating a lender for when he pays her a nominal rate of interest

- the Fisher equation illustrates that the nominal interest rate can be broken down into two components where i=r+expected inflation. Taking i to be an annual interest rate, the borrower is compensating the lender for the inflation that is expected over the coming year, as this will reduce the purchasing power of a given number of dollars. The borrower is also paying the lender a real interest rate to compensate the lender for the use of her money. The lender is foregoing the use of her money for the duration of the loan and so needs to be compensated for this opportunity cost.

do you think the widespread belief in the efficient markets theory was a significant contributor to the 2007-2009 financial crisis?

- the efficient market hypothesis does not postulate that market prices of securities are always correct, but that they reflect all known info that impact their value. the criss emerged as it became evident that relevant info was incomplete or incorrect, leading to large price movements as investors reassessed the risks associated with certain securities

why is value at risk so important for banks

- the first concern of a bank's management is to stay open. this means making sure that the risk of bankrupcy remains very small. - that means focuing on the worst case, which is what value at risk does.

suppose that the yield curve is mildly upward-sloping for short-term bonds but then slopes up steeplu for longer maturities, what might this suggest the market is expecting

- the initial portion of the yield curve suggests that interest rates are expected to be pretty steady in the shorter term but to tise in the longer term. due to the connection between interest rates and expected inflation, the yield curve might suggest that the market is ecpecting inflation to rise in the longer term

Shadow Banking in China

- the residents of China save more than any other population in the world - yet recently, they have had few attractive avenues for investing - until 2015, regulation capped bank deposit rates at a level far below the growth rate of the economy: financial repression - 2008 as global economy tanked, China sought to boost domestic demand by relaxing the supply of credit. - rise of shadow banking in China constitued backdoor financial liberalization. however, Neither lenders nor borrowers had interest in controlling risk taking. - lack of clarity: who bears the risk of failure? - rapid credit growth and GDP soared, potential financial crisis. - the challenge for China's authorities: keep the benefits of shadow banking while containig the risks - large & efficient financial system requries curbing government authority, let markets determine prices and allocate resources

suppose that the income tax exemption on minucipal bonds is eliminated. what effect would this have on the interest rates paid by such bonds on by treasury bonds

- tresury bonds would become more attractive. so, municipal bond demand would drop and Treasury bond demand would increase. this would lead to an increase in the interest rates on municipal bonds and a decrese in the rates on Treasury bonds

Distinguish among the weak, semi-strong, and strong forms of efficient market theories.

- weak - technical analysis cannot helps investors - prices move from period to period very much like a random walk - semi strong - fundamental analysis is not helpful either - no public info will help the analyst select undervalues securities - string - fundamental analysis is not helpful - nothing known or even knowable about a company will benefit the fundamental analyst - not even inside info can help the investor

Why might charting work? Why might it not work? Explain why investment firms hire chartists. (See Chapter 6 here as well.)

- why might work: - argued that crowd instinct of mass psychology makes trends perpetuate themselves, - there may be unequal access to fundamental info about a company. Favorable news goes to insiders first, charting helps prevent us knowing the information last - investors often underreact initially to new info - why might fail - the chartist buys only after price trends have been established and sells only after they have been broken. Sharp reversals may offer suddenly and chartistes often misses the boat - such techniques must ultimately self-defeat. as more and more people use it, the value of any technique depreciate - hire them in the hope that their analysis may help encourage investors to do more in-and-out trading and thus generate more commissions

suppose a new website was launched providing up to date, credible info on all firms wishing to issue bonds. what would you expect to happen to the overall level of interest rates in the bond market

- you would expect interest rates overall to fall. The website would reduce the adverse selection problem by making it easier for investors to distinguish between firms of different levels of creditworthiness. Demand for bonds should rise, raising bond prices and reducing interest rates

risk premiums on corporate bonds tends to be countercyclical, how come?

-Fewer corporations go bankrupt during a business cycle boom and so there is less default risk on corporate bonds. so, the riks premium drops during a boom. on the other hand, default risk increases in a recession and so the risk premium goes up

Explain the pattern of home prices since 1890.

-from the late 1800s to the late 1900s, inflation-adjusted house prices were stable. House prices went up, but only as much as the general price level. Prices did dip during the Great Depression of the 1930s, but they ended the century at the same level at which they started. In the early 2000s, the house price index doubled. But all bubbles eventually pop. The decline was broad-based and devastatin, particularly since 2007.

define M1

= currency + coins + demand deposits + other checkable deposits + travelers checks

Silly rules of thumbs

E.g, 401k retirement plans, ppl tend to put 1/n of savings in n available investment options An experiment with three possible investment funds suggested that ppl pretty much blindly followed this rule of thumb without considering the final mix of their portfolios

Inadequate diversification

Evidence that people may invest too heavily in stocks of local companies or of their employer because familiarly breeds contentment . It may not lead to a well-diversified portfolio

Hindsight bias

In hindsight mer may have a selective memory of events that allows us to convince ourselves that we knew that a particular investment would be successful. We may also blame our failures on external events not our choices

Excessive trading

Males trades more than females and did worse After considering trading costs, the average investor did worse than it they had held the S&P 500. Index. Most active traders did the worst Traders who previously traded by phone but switched to the internet traded more and did worse

Bubbles prove that the market is irrational. Comment.

No. In each case the bubble burst, the market did correct itself. The market eventually corrects any irrationality in its own slow fashion. Anomalies can crop up, markets can get irrationally optimistic and often attract unwary investors. But eventually, true value is recognized by the market and this is the main lesson

Disposition effect

People may be reluctant to sell an asset when the current price is smaller than purchase price, even if it makes sense to do so

Availability bias

We may bu sticks that for some reason catch our attention, not as a res7or or thoughtful, thorough analysis

Representative bias

We may take some past experience to be representative of a more general truth. We may believe that a company will continue to experience great success in the future simply based in recent evidence

Above average effect

When asked to rate their driving ability or looks as many as 80-95% of us say that we are above average. We may believe that we surely can do better than the average investor