Equilibrium in Financial Markets - Current Trends in Finance Flashcards
What are the current trends in Finance?
1-A more realistic view of the financial phenomena
2-Development of theoretical models closer to reality
3-Development of Behavioral Finance
Regarding the more realistic view of the financial phenomena, what says Soros and the Theory of Reflexivity?
Says that there is a crossed causality of the fundamentals on prices and of the prices on fundamental - the info we have impacts prices which impact economy. If the markets are very efficient, prices will reacho an equilibrium but since they are unstable we’ll have a cycle
Regarding the more realistic view of the financial phenomena, Shiller studied the effect of social trends on prices by analyzing the factors leading to the technology bubble in stock markets in 200. What are they?
1)structural factors that cause more price increases so the upward cycle begins again - there is a positive correlation between prices and demand -> when prices increase, more investors will enter the market making the prices increase again
2)cultural factores - when prices are very high and very difficult to be justified by theories, people don’t want to think they are wrong so they create new theories to justify the prices
3)psycological factors, like overconfidence
Regarding the more realistic view of the financial phenomena, Prechter brings out the differences between financial and economic markets. Which are them?
In an economic market, lower prices mean more utility and tend to increase demand, while higher prices tend to increase supply, while in financial markets higher prices increase the demand, and in one moment an investor can be a supplier and in the other a demander
In the theoretical models closer to reality, what was needed regarding the post autistic economics?
The use of models connected with reality
In the theoretical models closer to reality, regarding the efforts for models to be connected with the expectations of investors, we have models of heterogeneous expectations. What is a good example of one of those models?
the miller model
One of the implications of the Miller model is that the demand curve for financial assets has a negative slope , why?
Even at a very high price, a firm can sell a modest quantity of stock to investors who hold the most favorable opinions and lowering a stock price tends to increase the quantity that investors demand
What puzzles can we understand through the Miller model?
1) many investors don’t diversify their investments, maybe because they have priveleged information or because prices are too high
2) target company shareholders appear to capture all the gains in corporate takeover - more optimistic shareholders will ask for more to sell their shares.
3) the value effect - value stocks outperform growth stocks - opinions are more uniform, valued more optimisticaly
4) the high beta effect - stocks with high beta tend to underperform compared to the expected return - these stocks have a higher level of risk, which will lead to higher uncertainty valuing -> higher price which in the long run will mean lower returns
The high beta effect contradicts the traditional model, why?
Tradicional models predict a positive relationship between risk and expected return. Although, in many circumstnces, like with shortsale restrictions, we migh see a negative correlation
In the theoretical models closer to reality, regarding models with incomplete information we have the Merton Model that explains why idiosyncratic risk matters (specific risk that investors can eliminate through diversification). Why does it matter?
because of the incomplete information investors will only hold securities whose risk and return characteristics they are familiar with - investor recognition hypothesis
-Hold undiversified portfolios and demand compensation for the idiosyncratic risk - reflects on price -> positive relation between idiosyncratic risk and expected returns
How do behavioral finance models work?
in a first approach they try to understand how investors behave, how they choose what stocks to sell/buy, what moment to enter/leave the market and try to extract some general rules. Also, there is a use of other disciplines to try and understand the behaviors
What are some of the cognitive and emotional biases investors may present?
1) overconfidence
2) endowment effect - any asset they own is considered more valuable than it really is
3) loss aversion - people sometimes dislike losses so much they seek risk to avoid them
4) anchoring
5) availability bias, self-atribution bias, etc
