Guiding Seminar 2 (2020) Flashcards
(128 cards)
1
Q
Hedge Funds: Past, Present, and Future. Stulz, R.M. (2007).
What is a closed-end fund?
A
A closed-end fund is created when an investment company raises money through an IPO and then trades its shares on the public market like a stock. Closed-end funds limit the amount of shares issued.
2
Q
Hedge Funds: Past, Present, and Future. Stulz, R.M. (2007).
What is an open-end fund?
A
Open-end fund does not limit the amount of shares a company issues, but rather issues as many as investors want.
(unlimited amount of shares issued, option to buy back shares). Valued at NAV (net asset value= (total asset value - liabilities)/total shares outstanding)).
3
Q
Hedge Funds: Past, Present, and Future. Stulz, R.M. (2007).
What is an ETF?
A
Exchange traded fund - A collection of securities(e.g. stocks) that tracks an underlying index, although they can invest in any number of industry sectors or use various strategies. (e.g. SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index)
4
Q
Hedge Funds: Past, Present, and Future. Stulz, R.M. (2007).
What is a hedge fund?
A
A private investment fund that markets itself almost exclusively to wealthy investors. Actively managed (complex strategies), specific requirements for potential investors. Small in size, but require BIG initial INVESTMENT.
5
Q
Hedge Funds: Past, Present, and Future. Stulz, R.M. (2007).
What is a mutual fund?
A
A type of financial vehicle made up of a pool of money collected from many investors to invest in securities. Mutual funds are operated by professional money managers. Almost anyone can invest in mutual funds. BIG in size, but small initial investment required. NO leverage/short-selling.
6
Q
Hedge Funds: Past, Present, and Future. Stulz, R.M. (2007).
Describe regulation and disclosure policies of hedge funds vs. mutual funds
A
Hedge funds- unregulated leading to aggressive and risky strategies. No disclosure needed (meaning their wishy washy strategies are protected but risk evaluation is impossible). Sometimes they disclose voluntarily to attract funds.
Mutual funds - heavily regulated (risk level, manager’s compensation, governance). Disclosure, reporting and auditing required.
7
Q
Hedge Funds: Past, Present, and Future. Stulz, R.M. (2007).
Describe funds withdrawal of hedge funds vs. mutual funds
A
Hedge funds: Lock - up (window of time when investors are not allowed to buy or sell shares of a particular investment) period is set by hedge fund (month - years) Notice about withdrawal should be given month in advance.
Mutual funds: very LIQUID, shares can be bought and sold daily.
8
Q
Hedge Funds: Past, Present, and Future. Stulz, R.M. (2007).
Describe managers compensation of hedge funds vs. mutual funds
A
Hedge funds: 1 -2% of assets under management. 15-25% above the hurdle rate (the minimum rate of return on a project or investment required by a manager or investor). Managers get compensated only when loss is recovered.
Mutual funds: depends on assets under management.
9
Q
Hedge Funds: Past, Present, and Future. Stulz, R.M. (2007).
What do hedge funds do?
A
Attempt to find trades that are almost arbitrage opportunities. They use derivatives and short-selling, which allows them to make use of arbitrage opportunities better that mutual funds.
Some have been accused of making money in wishy-washy ways: insider trading, late trading.
10
Q
Hedge Funds: Past, Present, and Future. Stulz, R.M. (2007).
Will hedge funds be affected by the changes in the market?
A
Not really - if the stock market drops, the mutual fund would lose but a hedge fund no. They become market-neutral over time. Hedge funds are expected to have average performance (while equity markets have good or bad performance).
11
Q
Hedge Funds: Past, Present, and Future. Stulz, R.M. (2007).
Describe hedge fund strategies (4).
A
- A long-short equity. Takes both - long and short positions in stocks. E.g., they identify undervalued stocks, then take long positions, and hedge with short options and futures.
- Event-driven. Takes advantage of opportunities created by significant events (spin-offs, mergers and acquisitions, bankruptcies). They try to predict the outcome.
- Macro hedge fund. Identify mispriced valuations in stock markets, interest rates, foreign exchange rates, create leveraged betas in these markets.
- Fixed income arbitrage. Find arbitrage opportunities in fixed-income markets. (e.g. where government and corporate bonds are traded)
12
Q
Hedge Funds: Past, Present, and Future. Stulz, R.M. (2007).
How have hedge funds been performing vs. the mutual funds?
A
Hedge funds perform slightly better with less risk.
Returns: 10.8% (hedge); 10.3% (mutual)
Risk: 7.8% (hedge); 14.5% (mutual)
Alphas: positive (hedge); negative/0 (mutual)
13
Q
Hedge Funds: Past, Present, and Future. Stulz, R.M. (2007).
Why is it difficult to assess individual hedge fund performance? (4)
A
- Biased Sample: only hedge funds who voluntarily send their returns can be observed (because they are not regulated).
- Need to adjust for market exposure: complex strategies with complex derivatives make it hard to measure risk-adjusted returns. (it is hard to measure what big brain do)
- Past performance of hedge fund gives selective view of risk: hedge funds may have similar payoffs to those of earthquake insurance companies (most of the time earthquakes don’t happen and a company gets profit, but when it does, they have to pay out a lot)
- Problems of valuation: OTC traded securities.
14
Q
Hedge Funds: Past, Present, and Future. Stulz, R.M. (2007).
What are the risks of hedge funds to the economy? (4)
A
- Investor protection: 10% of hedge funds stop working every year because of poor performance
- Risks to financial institutions: Create credit exposures (they borrow, transact, use derivatives). They are very levered, and a collapse of large hedge fund may create problems in the economy.
- Liquidity risks: hedge funds rely on the ability to get out of trades when things are going wrong, but if they do this when things are going wrong, it can make matters worse.
- Excess to volatility risks: hedge funds can lead prices to overreact by making trades that push prices away from fundamental values (NOT enough EVIDENCE for this)
15
Q
Hedge Funds: Past, Present, and Future. Stulz, R.M. (2007).
What is the future of hedge funds? (3)
A
As the hedge fund industry grows, concerns about their regulation also (žuļiki jāreguleito).
- this would make them similar to mutual funds
- discretion will have to decline when they get more institutional investors
- growing industry will result in everyone running after same price discrepancies (profits), which makes everyone get less.
16
Q
Hedge Funds: Past, Present, and Future. Stulz, R.M. (2007).
What is LTCM and what happened to it?
A
Hedge fund with extreme exposure and leverage, huge initial investment required to join, amazing performance in first years (40%).
They held assets worth 125B$, where only 4B$ were their own (the rest borrowed). Derivatives in the amount of 1 Trillion.
When Russia defaulted on its debt in 1998, there was a worldwide flight to safety by investors.
17
Q
Prone to Fail: The Pre-Crisis Financial System
Duffie, D. (2019)
What were the largest 5 investment banks in the US in the time of crisis?
A
Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley
18
Q
Prone to Fail: The Pre-Crisis Financial System
Duffie, D. (2019)
In broad terms, how was the government regulation of finance firms before the crisis?
A
A well-supervised financial system could have been more resilient to such event, but the impact on real economy was much larger than necessary.
The largest firms were permitted to have insufficient capital and liquidity relative to the risks they took.
Oversight of the capital adequacy of the largest investment banks by the Securities and Exchange Commission (SEC) was particularly lax. AIG was not effectively supervised as well.
19
Q
Prone to Fail: The Pre-Crisis Financial System
Duffie, D. (2019)
Who are market makers?
A
A dealer in securities or other assets who undertakes to buy or sell at specified prices at all times.
E.g. sometimes if you want to sell a security, no one is willing to buy it from you (sad), thus, a market maker will buy it, and sell it sometime later, so everyone’s happy. He gets bid-ask rate as profit.
20
Q
Prone to Fail: The Pre-Crisis Financial System
Duffie, D. (2019)
What are repos?
A
Short-term borrowing for dealers in government securities. One sells government securities to someone else, usually on an overnight basis, and buys them back the following day at a slightly higher price.
21
Q
Prone to Fail: The Pre-Crisis Financial System
Duffie, D. (2019)
What are tri-party repos?
A
Banks deal with repos, so that two parties do not have to deal with it themselves. Cash investors held their collateral securities (overnight) at tri-party banks.
22
Q
Prone to Fail: The Pre-Crisis Financial System
Duffie, D. (2019)
What is a credit crunch?
A
Decrease in lending by financial institutions. Usually an outcome of flight to safety, when the banks cannot pay back the money or issue new loans.
23
Q
Prone to Fail: The Pre-Crisis Financial System
Duffie, D. (2019)
2 things that triggered the financial crisis.
A
Over-leveraged homeowners, severe downturn in US housing markets.
24
Q
Prone to Fail: The Pre-Crisis Financial System
Duffie, D. (2019)
What are the key sources of why crisis happened? (4)(fragility)
A
- Weakly supervised balance sheets of largest banks
- The run-prone designs
- Weak regulation of the markets for securities and OTC derivatives.
- Reliance of regulators on the market discipline.
25
Prone to Fail: The Pre-Crisis Financial System
Duffie, D. (2019)
Why was supervision of the banks so bad? (5)
1. SEC put it as their mission to protect customers of financial firms rather than financial stability, they devoted very few resources for supervising (only 4 staff members for big firms). Investment firms actually knew this and chose SEC instead of FED.
2. High difficulty level of assessing risk, derivatives and flight-proneness (everyone too dumb dumb to understand what the heck was happening)
3. Everyone assigned low probabilities to disasters happening
4. Reliance on market discipline
5. Historical emphasis on decentralized banking system.
26
Prone to Fail: The Pre-Crisis Financial System
Duffie, D. (2019)
Describe credit provision in the US.
Credit provision in the US is more dependent on capital markets (where savings and investments are moved between suppliers of capital and those who are in need of capital) rather than how it's usually done.
27
Prone to Fail: The Pre-Crisis Financial System
Duffie, D. (2019)
Why were repos a problem?
Capital markets in the US rely heavily on largest dealers who used short-term financing A LOT (mainly through repos). Intra-day financing (when investment bank repos expired, they repaid cash, and were in need for financing until new repos, which was provided by tri-party agent banks) created systemic risks. (2.8$ trillion were issued).
When there was a risk of solvency, cash investors could decide to not renew daily financing (not do repos anymore), thus, the other party (the one selling collateral) needs to sell it really quickly - at fire-sale prices. Also, banks would sell the collateral, as the dealer (investment bank) is not paying back cash, and the cash investors who had bought collateral would sell it too. All this is done at fire -sale (very low) prices.
28
Prone to Fail: The Pre-Crisis Financial System
Duffie, D. (2019)
What is a SIV?
Special Investment Vehicles. They attempt to profit from the spread between short-term debt and long-term investments by issuing commercial paper of varying maturities.
Particularly prone to runs, could have caused a complete meltdown of securities financing market. It happened in 2008, only FED and US Treasury invoked emergency lending and saved economy from an even worse state.
29
Prone to Fail: The Pre-Crisis Financial System
Duffie, D. (2019)
What regulations have been implemented since the crisis? (7)
1. Elimination of intra-day credit provision by tri-party agent banks.
2. Securities inventories are smaller - reduced need for financing
3. Declining presumption of "too big to fail" has led dealer financing costs to increase, incentive to hold giant inventories is reduced.
4. Tighter regulation of money funds - Reduced dependence of dealers on flight-prone financing from money market mutual funds.
5. Bank capital requirements apply to all large dealers
6. The two investment banks that survived, took banking charters and are regulated as banks (under FED).
7. New bank liquidity coverage regulations introduced.
30
Prone to Fail: The Pre-Crisis Financial System
Duffie, D. (2019)
Why were OTC derivatives dangerous?
No regulations, very complex trading, no observable risk exposures. When derivatives runs happened, they drain liquidity and eliminate hedges needed by the dealer, increase in concern about creditworthiness of investment banks.
AIG had sudden heavy margin calls on credit-default-swap protection that it had provided to major dealers.
The dependence of these dealers on AIG’s performance on these credit default swaps was an important factor in the decision by the Fed and then the Treasury to rescue AIG.
31
Prone to Fail: The Pre-Crisis Financial System
Duffie, D. (2019)
What is a margin call?
Margin call occurs when the value of an investor's margin account (that is, one that contains securities bought with borrowed money) falls below the broker's required amount. A margin call is the broker's demand that an investor deposit additional money or securities so that the account is brought up to the minimum value, known as the maintenance margin.
A margin call is usually an indicator that one or more of the securities held in the margin account has decreased in value. When a margin call occurs, the investor must choose to either deposit more money in the account or sell some of the assets held in their account.
32
Prone to Fail: The Pre-Crisis Financial System
Duffie, D. (2019)
What regulations have been set for OTC derivatives since the crisis?
1. Increased use of CENTRAL CLEARING (clearinghouses enter a derivatives trade as the buyer to the original seller, and as the seller to the original buyer).
- -> original counterparties become insulated from each other’s default risk
- -> improves the transparency of derivatives positions
- -> enforces uniform collateral practices that are more easily supervised by regulators, all swap transactions must be reported publicly
2. New REGULATORY CAPITAL REQUIREMENTS (amount of capital a bank or other financial institution has to have as required by its financial regulator)
3. COMPRESSION TRADING —> fintech approach that helps to eliminate redundant sequences of derivative positions (way to reduce the number of outstanding contracts but keep the same economic exposure)
33
Prone to Fail: The Pre-Crisis Financial System
Duffie, D. (2019)
Why is "too big to fail" bad?
People assumed that:
1. Banks can be relied upon to provide rigorous risk control.
In reality, banks risk management were topped by going after profits.
2. Markets will always self-correct.
People relied on market discipline - excessive risk taking will be limited by cost of debt financing risk of losses at insolvency. BUT, there was no plan for resolving insolvency systemically important financial firms without triggering or deepening a crisis.
People started saying that largest firms are too big to fail, government would save them - moral hazard was created.
The incentive to borrow caused by being too big
to fail and the lack of methods for safely resolving
an insolvency of any of these firms, combined
with the forbearance of regulators, created an
increasingly toxic brew of systemic risk.
34
Prone to Fail: The Pre-Crisis Financial System
Duffie, D. (2019)
What are the unresolved problems of the financial crisis?
1. There is still no known operational planning for US government failure resolution of derivatives clearinghouses
2. Regulations have forced the majority of derivatives risk into these clearinghouses, which are the new “too big to fail” financial firms
3. A threat that fading memories of the costs of the last crisis will lower the resolve and vigilance of legislatures and financial regulators to monitor changes in practice and to take steps to control socially excessive risk-taking
35
The Economic Consequences of Legal Origins.
La Porta, Lopez, Schleifer. (2008)
Describe how civil and common law developed.
Common Law: lawyers and property owners wanted to provide strong protections for property and limit the crown's ability to interfere with markets
Civil Law: originates from Roman Law, adopted by Catholic Church. State-desired.
36
The Economic Consequences of Legal Origins.
La Porta, Lopez, Schleifer. (2008)
Describe Legal Origin Theory.
A style of social control of economic life. Traces different strategies of common and civil law and how different broad ideas were incorporated into specific legal rules. Despite colonization and conquest, fundamental strategies of these legal systems survived and influenced economic outcomes.
37
The Economic Consequences of Legal Origins.
La Porta, Lopez, Schleifer. (2008)
Describe common law and civil law.
COMMON LAW: DISPUTE RESOLVING. Seeks to support private market outcomes. English Law. Puts greater emphasis on judicial independence, uses precedents (case law).
CIVIL LAW: POLICY IMPLEMENTING. Seeks to replace outcomes with state - desired allocations. French Law. Puts emphasis on maintaining social order. Strict enforcement rather than interpretation.
38
The Economic Consequences of Legal Origins.
La Porta, Lopez, Schleifer. (2008)
What economic benefits is common law associated with?
1. Better investor protection -> better financial development -> better access to finance -> higher ownership dispersion
2. lighter government ownership and regulation -> less corruption -> better functioning labor markets -> smaller unofficial economies (unregistered firms)
3. more independent judicial systems -> more secure property rights -> better contract reinforcement
Overall: common law countries have moved sharply ahead civil law in financial development in 20th century
39
The Economic Consequences of Legal Origins.
La Porta, Lopez, Schleifer. (2008)
Why common law leads to better economic outcomes?
1. More respective of private property and contracts
2. More emphasis on private contracting rather than central regulation (dispute resolving vs. policy implementing)
3. More adaptive framework -> better quality over time
40
The Economic Consequences of Legal Origins.
La Porta, Lopez, Schleifer. (2008)
How common law and civil law deal with crisis?
Common Law: support market system. State's presence in general is less pervasive.
Civil Law: repress market system or replace it with state mandates
41
The Economic Consequences of Legal Origins.
La Porta, Lopez, Schleifer. (2008)
What is the criticism of Legal Origins theory?
It is merely a proxy for other factors influencing legal rules and outcomes (culture, history, politics).
42
The Economic Consequences of Legal Origins.
La Porta, Lopez, Schleifer. (2008)
Describe 4 propositions by legal origins theory
1. Legal rules differ across countries, differences can be measured and quantified.
2. Differences in legal rules are accounted for by legal origins significantly
3. Historical divergence explains why legal rules differ
4. Measured differences in legal rules matter for economic and social outcomes.
43
The Economic Consequences of Legal Origins.
La Porta, Lopez, Schleifer. (2008)
What is the author's view on future law?
If the world remains peaceful, globalization will drive the world towards common-law type solutions
44
The Economic Consequences of Legal Origins.
La Porta, Lopez, Schleifer. (2008)
Does Legal Origins Theory point to overall superiority of common law?
No. It points to superiority of civil law WHEN the problem of disorder is severe. When the markets can work well it is better to support them than to replace them.
45
Bitcoin. Economics, Technology, and Governance.
Bohme (2015).
What is Bitcoin?
Digital currency. There are no physical bitcoins, only balances kept on a public ledger in the cloud, that – along with all Bitcoin transactions – is verified by a massive amount of computing power. Bitcoins are not issued or backed by any banks or governments, nor are individual bitcoins valuable as a commodity.
It is built on transaction log
46
Bitcoin. Economics, Technology, and Governance.
Bohme (2015).
What is a transaction log?
A record of all changes made to the database while the actual data is contained in a separate file.
47
Bitcoin. Economics, Technology, and Governance.
Bohme (2015).
Describe Bitcoin design principles (3)
1. First adopted mechanism to provide absolute scarcity of money supply (there are only 21 million bitcoins, after they all have been mined, no further will be created)
2. No centralized authority to distribute coins or track
3. Issues new currency to private parties at a controlled pace to avoid incentive to maintain bookkeeping system
48
Bitcoin. Economics, Technology, and Governance.
Bohme (2015).
Describe block chain
Data structure that verifies all Bitcoin activity.
Transaction -> Verifying -> Stored in block -> Hash (given unique code) -> Block chain
1. every new transaction is grouped together in a block of recent transactions
2. to verify that no unauthorized transactions have been inserted, block is compared to most recently published block -> links blocks -> blockchain (new block added every ~10 minutes)
49
Bitcoin. Economics, Technology, and Governance.
Bohme (2015).
Describe Bitcoin mining
Encourages users to assist in the primary purpose of mining: to support, legitimize and monitor the Bitcoin network and its blockchain. Because these responsibilities are spread among many users all over the world, bitcoin is said to be a "decentralized" cryptocurrency.
Mining requires big money (as more people try, puzzles to solve to receive bitcoins become harder, increasing computing and electricity requirements).
50
Bitcoin. Economics, Technology, and Governance.
Bohme (2015).
What does Bitcoin not have?
No governance structure:
1. No obligation for financial institution to verify user's identity
2. No prohibition of sales (drugs, hehe)
3. Irreversible payments (you ain't getting money back for accidental purchase)
51
Bitcoin. Economics, Technology, and Governance.
Bohme (2015).
Name Bitcoin intermediaries
1. Currency exchanges
2. Digital Wallet Services
3. Mixers
4. Mining Pools
52
Bitcoin. Economics, Technology, and Governance.
Bohme (2015).
Describe Bitcoin Currency Exchanges
Convert traditional currencies into bitcoins, significant regulatory and cost requirements
53
Bitcoin. Economics, Technology, and Governance.
Bohme (2015).
Describe Bitcoin Digital Wallet Services
Applications for managing user's account in a convenient way (less space, mobility, better interface). Prone to hackers!
54
Bitcoin. Economics, Technology, and Governance.
Bohme (2015).
Describe Bitcoin Mixers
The Bitcoin transaction log shows each transaction along with public keys (basically your username) and one who knows the true identity can track ALL transactions carried out.
MIXERS let users pool sets of transactions in unpredictable transactions, preventing this tracking.
55
Bitcoin. Economics, Technology, and Governance.
Bohme (2015).
Describe Mining Pools
Combine resources from various miners so that when they win bitcoins, they share the earnings.
Oversized mining pools threaten decentralisation as an attacker who holds majority of Bitcoin's computational resources can alter system's records (e.g. inserting false transactions, rejecting actual transactions)
56
Bitcoin. Economics, Technology, and Governance.
Bohme (2015).
Describe the history of users of Bitcoin
1. Early: Illicit Activities (e.g. Silk Road, gambling activities)
2. Now: Consumer Payments (low cost compared to credit cards but no bonuses, currency exchange charges, processing time)
3. Possibly in the future: General purpose payments, enabling technology (transfers of digital property, digital signatures)
57
Bitcoin. Economics, Technology, and Governance.
Bohme (2015).
Name risks in Bitcoin
```
Market risk
Shallow market problem
Counterparty risk
Transaction risk
Operational risk
Privacy risk
Legal risk
```
58
Bitcoin. Economics, Technology, and Governance.
Bohme (2015).
What is Market Risk in Bitcoin?
The value of Bitcoins is highly volatile (fluctuations in exchange rates between bitcoin and legitimate currencies)
59
Bitcoin. Economics, Technology, and Governance.
Bohme (2015).
What is shallow market problem in Bitcoin?
person seeking to trade in large amount of bitcoins cannot do so quickly without affecting the market price
60
Bitcoin. Economics, Technology, and Governance.
Bohme (2015).
What is counterparty risk in Bitcoin?
currency exchanges may stop their operations without reimbursing their consumers, digital wallet services are prone to hackers
61
Bitcoin. Economics, Technology, and Governance.
Bohme (2015).
What is transaction risk in Bitcoin?
There is no built-in mechanism to cancel a transaction if bitcoins sent due to error or fraud
All that remains after a failed transaction is to try to convince the recipient of funds to return them voluntarily. That's because there is no intermediary guarantor, as is the case with bank cards.
Smth else addd, I no get !!!
62
Bitcoin. Economics, Technology, and Governance.
Bohme (2015).
What is operational risk in Bitcoin?
1. Threats to security of private key
2. 51 percent attack - a group of miners controlling more than 50% of the network's computing power would be able to prevent new transactions from gaining confirmations.
3. Denial of service attack - tries to prevent others from solving the puzzle, getting bitcoins by swamping the miner with messages so it becomes very slow
63
Bitcoin. Economics, Technology, and Governance.
Bohme (2015).
What is privacy risk in Bitcoin?
Transaction can be linked back to people who made them (real identities often disclosed at currency exchanges)
64
Bitcoin. Economics, Technology, and Governance.
Bohme (2015).
What is legal risk in Bitcoin?
A law abiding user can lose funds in an exchange frozen due to criminal activity
If a person is good but transacts with a bad person, then he will suffer and not get money back from this deal.
65
Bitcoin. Economics, Technology, and Governance.
Bohme (2015).
What is the regulation of Bitcoin?
1. Fighting Crime
Bitcoin Specific Crime - attacks on currency exchanges, mining pools
Money Laundering
Bitcoin facilitated crime - illegal goods
2. Consumer Protection
counterparty risk, irreversible transactions
3. Regulatory Options
Key questions: Where to impose constraints? You cannot regulate everyone and users can switch countries/systems to avoid regulation
66
Bitcoin. Economics, Technology, and Governance.
Bohme (2015).
Describe Bitcoin as social science laboratory
1. Bitcoin as a financial asset - diversification benefits, arbitrage
2. Incentive compatibility - miner reward issues
3. Privacy and Anonymity - transaction patterns
4. Monetary Policy - k -percent rule - The K-Percent Rule was a proposal by economist Milton Friedman that the central bank should increase the money supply by a constant percentage every year, which is done in Bitcoin
67
Bitcoin. Economics, Technology, and Governance.
Bohme (2015).
Describe remaining questions for Bitcoin in the society
1. Does one service serve all needs?
2. Will it replace other forms of payment completely?
3. Will other competing virtual currencies outperform Bitcoin?
68
Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
Describe Moore's Law in financial markets
From 1929 to 2009 the total market capitalisation of the US stock market has been doubling every decade
69
Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
Describe Murphy's Law
“whatever can go wrong will go wrong” (faster and with worse consequences when computers are involved)
70
Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
What is algorithmic trading?
The use of mathematical models, computers, and telecommunications networks to automate the buying and selling of financial securities
71
Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
What are (3) benefits of Algorithmic trading?
* lowering costs / scalability
* reducing human error
* increasing productivity
72
Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
What major developments in the financial industry have facilitated growth of algorithmic trading? (5)
1. Quantitative models in finance
2. The emergence and rapid increase of index funds
3. Arbitrage trading activities
4. The push for lower costs of intermediation and execution
5. The increase of high-frequency trading
73
Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
How has quantitative finance contributed to rise of algorithmic trading? (what are the breaktrough models?)
1. Portfolio Optimization Theory (Markowitz)
2. CAPM
3. Statistical and computational achievements
4. BMS
74
Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
What is two fund separation theorem?
A risk-less bond and a mutual fund—the tangency portfolio— are the only investments needed to satisfy the demands of all mean–variance portfolio optimisers. (think CML)
Once a portfolio has been established, the algorithmic trading strategy—the number of shares of each security to be bought or sold—is given by the difference between the optimal weights and the current weights.
(think CML but done by computers)
75
Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
How has concept of passive investing changed?
Now, investment is called “passive” if it does not require any discretionary human intervention— it is based on a welldefined and transparent algorithm. Today, a passive investor may be an active trader to minimise transaction costs, manage risks, participate in new investment opportunities or respond more quickly to changing objectives and market conditions.
76
Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
What is the "recipe" for an index fund?
1. define a collection of securities by some set of easily observable attributes
2. construct a portfolio of such securities weighted by their market capitalisation
3. add and subtract securities from this collection from time to time to ensure that the portfolio continues to accurately reflect the desired attributes
77
Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
Why it was usual to fix the set of securities and value-weight them (index funds)?
1. reduce the amount of trading needed to replicate the index in a cash portfolio;
2. a value-weighted portfolio need never be rebalanced since the weights automatically adjust proportionally as market valuations fluctuate
—> most investors and managers equated “passive” investing with low-cost, static, value-weighted portfolios
78
Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
What are new investment products that are now passive investing despite active nature of their trading due to automation?
1. TARGET-DATE FUNDS (class of mutual funds that rebalances asset class weights over time so that it begins heavier to stocks when you are younger and heavier to bonds as you age)
2. ETFs
3. STRATEGY INDEXES such as 130/30 (short selling 30% of stocks in portfolio)
4. CURRENCY CARRY-TRADE ( a high-yielding currency funds the trade with a low-yielding currency)
5. HEDGE - FUND REPLICATION
6. TREND - FOLLOWING FUTURES
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Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
How has arbitrage trading contributed to the rise of algorithmic trading?
Algorithmic traders try to profit from deviations in the law of one price (the most popular method). However, in practice, it is rarely the case that prices differ for seemingly identical cash flows, and risk-less profit does not exist.
However, if the statistical properties of the arbitrage portfolios can be quantified and managed, the risk/reward profiles of these strategies might be very attractive to investors with the appropriate tolerance for risk:
Examples:
Development of "statistical arbitrage strategies" in the 1980s - large portfolios of equities were constructed to maximise expected returns while minimising volatility.
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Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
Describe statistical arbitrage strategies.
Why can they profit during market downturns?
- Large portfolios of equities constructed to maximise expected returns while minimising volatility.
- The risks embedded in statistical arbitrage strategies are different from market risk. Arbitrage portfolios are long and short, and hence they can be profitable during market downturns.
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Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
What 2 important roles do arbitrage strategies play in the financial system? Describe how.
LIQUIDITY PROVISIONS: arbitrageurs increase the amount of trading activity, ensuring greater liquidity (investors can now buy or sell securities more quickly, in larger quantities, and with lower price impact).
PRICE DISCOVERY: because arbitrage trading exploits temporary mispricings, it tends to improve the informational efficiency of market prices.
• However, if arbitrageurs become too dominant in any given market, they can create systemic instabilities —> “Quant Meltdown”
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Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
Describe the quant meltdown.
In 2007 during 2 days some of the most
successful hedge funds suffered record losses. These losses were highest among quantitatively managed equity market-neutral or “statistical arbitrage” hedge funds.
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Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
Describe Market Making
An intermediary participates in buying and selling securities to smooth out temporary imbalances in supply and demand because buyers and sellers do not always arrive at the same time.
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Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
Why is algorithmic trading central to the automation of large buy and sell orders of publicly traded securities?
Executing a large order in a single transaction is typically more costly than breaking up the order into a sequence of smaller orders.
Automation of the trading process means that the rewards from market making activities accrue not necessarily to those who register with the exchanges
as their designated market makers, but to those with the best connectivity, best algorithms, and best access to customer order flow. (nu pagaidām ir liels wtf)
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Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
Describe the steps to become a market maker
1. Register as a designated MM —> satisfy certain net capital requirements
2. Provide continuous two-sided quotes during trading hours (bid-ask)
3. Demand compensation (the bid-ask spread) to protect yourself against possible losses
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Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
What is high frequency trading?
A form of automated trading that takes advantage of innovations in computing and telecommunication to consummate millions upon millions of trades per day.
High-frequency trading is estimated to account for 40 to 60
percent of all trading activity across the universe of financial markets (2012).
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Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
Do high frequency traders engage in provision of liquidity in markets?
In contrast to a number of public claims, high-frequency traders do not engage in the provision of liquidity like traditional market makers. IN FACT, THOSE THAT DO NOT provide liquidity ARE THE MOST PROFITABLE and their profits increase with the degree of “aggressive,” liquidity-taking activity.
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Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
Describe Unwind Hypthosis (with respect to the quant meltdown)
To unwind a position is to close it out.
A large equity market - neutral portfolio had to raise cash and unwind, leading to big price impacts and other similar portfolios now had to do the same to lessen losses -> the deadly loop of coordinated forced liquidations leading to the deterioration of collateral value.
Bottom line: the scaling up and down of portfolios can affect many other portfolios and investors.
Algorithmic trading greatly magnifies the impact of these consequences
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Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
What is a market-neutral strategy?
Investors seek to profit from both increasing and decreasing prices in market, while attempting to completely avoid some specific form of market risk.
90
Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
Describe the Flash Crash of 2010
In the course of 33 minutes, US financial markets experienced one of the most turbulent periods in their
history. The Dow Jones Industrial Average declined enormously and stock prices of some of the world’s largest companies traded at weird prices ( Accenture traded at a penny a share, while Apple traded at $100,000 per share)
Why did it happen?
1. Algorithm caused a rapid sale of 75000 E-mini S&P 500 stock index future contracts (worth about 4.1$ billion)
2. High frequency traders reached critical inventory levels after 10 minutes and began unwinding when liquidity was an issue
3. Cross-market arbitrage trading algorithms rapidly sped up price declines in the E-mini futures market to the markets for stock index ETFs
BOTTOM LINE: A liquidity event in the futures market triggered by an automated selling program cascaded into a systemic event for the entire US financial market system.
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Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
Describe Pricing Initial Public Offerings in the Digital Age - Facebook
Interest in Facebook shares was too high —> NASDAQ system was trying to (re)calculate the price while
new offers and cancellations kept coming in, which created an infinite loop that required human
intervention
• a 30-minute delay in Facebook’s IPO
• errors persisted for hours
• heavy losses to traders, some didn’t get any shares, others overbought (around $100m)
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Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
Describe Pricing Initial Public Offerings in the Digital Age - BATS
• BATS operated as the third-largest stock exchange in the United States and was among the most
technologically advanced firms
• BATS decided to list its IPO on its own stock exchange;
• When BATS launched its own IPO its price plunged to less than a tenth of a penny in a second and a half due to a software bug affecting stocks with ticker symbols from A to BFZZZ, creating an infinite loop that made these symbols inaccessible on the BATS system
• BATS was forced to suspend trading in its own stock, and cancelled its IPO
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Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
Describe what happened to Knight Capital Group
Knight Capital Group sent out incorrect orders into the market because of a technology issue with newly-installed software.
These orders and the unintended trades resulted in a rapid accumulation of positions “unrestricted by volume caps”—> significant price swings in 150 stocks.
The company had to liquidate its positions, resulting in a $457.6 million loss, wiped out capital, stock lost 70% of value, were forced to seek rescuers.
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Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
What is spoofing?
Intentionally manipulating prices by placing an order to buy or sell a security and then canceling it shortly thereafter, at which point the spoofer completes a trade in the opposite direction of the canceled order.
YOU ARE ORDERING TO BUY STOCK, CANCEL SHORTLY AFTER, THEN SELL STOCK (you have pushed the price up, now it is profitable to sell)
Happens over fractions of seconds
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Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
What is layering?
Placing a sequence of limit orders at successively increasing or decreasing prices to give the
appearance of a change in demand and artificially increase or decrease the price that unsuspecting
investors are willing to pay; after a trade is completed at the manipulated price, the layered limit orders
are canceled.
YOU PLACE A LOT OF LIMIT ORDER TO BUY STOCKS, ARTIFICIALLY INCREASE PRICE, SELL SHARE AT THIS HIGH PRICE, CANCEL LIMIT ORDERS.
Happens over fractions of seconds
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Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
What is the regulatory struggle of algorithmic trading?
The software and hardware that control financial markets have become so complex that no individual or group of individuals is capable of conceptualising all possible interactions that could occur among various components of the financial system.
Financial regulatory framework has become obsolete in the face of rapid technological advances that drastically reduced costs to intermediation, but have not correspondingly increased or distributed the benefits of greater immediacy
—> the tradeoff between
1) the costs to different types of intermediaries for maintaining a continuous presence in a market and
2) the benefits to different types of market participants for being able to execute trades as “immediately” as possible
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Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
What are the proposed policies in regulating Algorithmic Trading? Describe
1.DO NOTHING: would allow intermediaries to find more ways to reduce the costs of being continuously present in the market, leading to an even greater supply of immediacy and more efficient trading, but is unlikely to address investors’ concerns about fair and orderly markets
2. BAN: will lead to fairness, but also reduce liquidity, efficiency, and capital formation
3. CHANGE THE RULES OF WHO CAN BE A DESIGNATED INTERMEDIARY: may also
lead to more fair and orderly markets since such designations will prevent them from withdrawing from the market when their services are needed most. However, such redesignation would also increase the cost to intermediaries of being present in the
market due to higher capital requirements, additional compliance costs for each designated market, and greater legal costs by virtue of being a regulated entity.
4. FORCE TRADING TO OCCUR AT FIXED DISCRETE INTERVALS OF TIME: leads to reduced immediacy. Need more analysis to evaluate the effects connected with demand for immediacy
5. TOBIN TAX on all financial transactions: will reduce trading activity, liquidity and make hedging more costly and remove HFT
98
Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
What are the proposed policies in regulating Algorithmic Trading? Describe.
1.DO NOTHING: would allow intermediaries to find more ways to reduce the costs of being continuously present in the market, leading to an even greater supply of immediacy and more efficient trading, but is unlikely to address investors’ concerns about fair and
orderly markets
2. BAN: will lead to fairness, but also reduce liquidity, efficiency, and capital formation
3. CHANGE THE RULES OF WHO CAN BE A DESIGNATED INTERMEDIARY: may also
lead to more fair and orderly markets since such designations will prevent them from withdrawing from the market when their services are needed most. However, such redesignation would also increase the cost to intermediaries of being present in the
market due to higher capital requirements, additional compliance costs for each designated market, and greater legal costs by virtue
of being a regulated entity.
4. FORCE TRADING TO OCCUR AT FIXED DISCRETE INTERVALS OF TIME: leads to reduced immediacy. Need more analysis to evaluate the effects connected with demand for immediacy
5. TOBIN TAX on all financial transactions: will reduce trading activity, liquidity and make hedging more costly and remove HFT
99
Moore's Law vs. Murphy's Law: Algorithmic Trading and Its Discontents
Kirilenko, Andrew (2013)
What financial regulation design principles do authors suggest about algorithmic trading?
1. SYSTEMS: should approach financial markets as complex systems composed of multiple software applications, hardware devices and human
personnel
2. SAFEGUARDS: both human and machine safeguards are necessary to ensure the safe functioning of the system
3. TRANSPARENCY: should aim to make the design of financial products more transparent and accessible to regular automated audits
4. PLATFORM: should be designed to encourage innovation in technology and finance and should be neutral with respect to the specifics of how core
computing technologies work
100
Towards a Political Theory of the Firm.
Zingales (2017)
What is the main point Zingales is trying to get across?
Interaction of concentrated corporate power
and politics is a threat to the functioning of the free market economy and to the economic prosperity it can generate, and a threat to democracy as well.
101
Towards a Political Theory of the Firm.
Zingales (2017)
Describe the current situation of large firms
10 companies are among the largest 30 entities in the world in a list of corporate and government revenues (2015). All of them have higher annual revenues than government of Switzerland, Norway, Russia.
Large corporations have large security forces, public relations offices, more lawyers than the US Justice Department, enough money to capture majority of elected representatives.
COMPANIES ARE OFTEN MORE POWERFUL THAN GOVERNMENTS lacking only direct power to wage war and legal power to detain people.
102
Towards a Political Theory of the Firm.
Zingales (2017)
Describe theory of the firm. Is it true?
Firm is simply a nexus (collection) of contracts with no objectives separate from contracting parties.
This is NOT reality of giant global corporations. The largest modern firms have massive economic (and political) power in the hands of a few people, who are not really accountable to anyone.
103
Towards a Political Theory of the Firm.
Zingales (2017)
Describe the situation of East India Company
Formed for the exploitation of trade.
A 15-year monopoly right that lasted 233 years.
A harsh reminder of how dangerous the mixing of economic and political power can be.
As British Parliament tried to introduce competition for the East India Company, company's stockholders bought shares of a rival and forced to merge, becoming monopoly again.
When monopoly expired, they would pay bribes to extend it.
The company prohibited local traders and dealers from
“hoarding” rice —> 10 million people died of starvation when drought struck.
Company lost monopoly of trade with India, it promoted export of opium to China, started two opium wars.
104
Towards a Political Theory of the Firm.
Zingales (2017)
Describe the Gilded Age (19th century) in the context of corporations
Incorporation (the legal process used to form a corporate entity or company) became a right of citizens.
The rise in economies of scale during Second Industrial Revolution contributed to ensuring market power to firms.
In a winner-take-all economy, entrepreneurs lobby and corrupt, not only to seize a crucial first-mover advantage, but also to preserve their power over time as they fear political expropriation (the action by the state of taking property from its owner for public use or benefit).
105
Towards a Political Theory of the Firm.
Zingales (2017)
Describe The Power of Competition and Takeovers (20th century)
1. Competitive selection process eliminates a lot of managerial discretion by the pressure of the corporate control market. A publicly traded firm that is not performing good, is an arbitrage opportunity - someone can buy it, fix it, resell or operate, make money.
2. Moving attention more away from the “power” aspect towards a more technological one. Neoclassical economics argued, in a world with perfect competition and no transactions costs, firms are nothing
more than isoquant maps. However, it turns out that even in a perfectly competitive environment, corporations are powerless only if there is perfect contractibility (an agreement enforceable by law)
106
Towards a Political Theory of the Firm.
Zingales (2017)
What is the Incomplete Contract Paradigm?
Most contracts are incomplete - they will not fully specify the division of surplus in every possible way. The theory of incomplete contracts creates scope for lobbying, rent seeking, and power grabbing.
107
Towards a Political Theory of the Firm.
Zingales (2017)
What factors affect incompleteness contract, which creates room for bargaining?
1. Which party has the ownership
2. Availability of alternatives
3. Institutional environment
All these factors determine the allocation of authority or power.
108
Towards a Political Theory of the Firm.
Zingales (2017)
What is the “Medici vicious circle”?
MONEY USED TO GAIN POLITICAL POWER
->POWER USED TO MAKE MONEY -> MONEY USED TO GAIN POLITICAL POWER ->ETC.
Most firms are actively engaged in protecting their source of competitive advantage through a mixture of innovation, lobbying, or both.
—> when there is more INNOVATION -> NOthing to WORRY about
—> when LOBBYING is dominant, things get
PROBLEMATIC
109
Towards a Political Theory of the Firm.
Zingales (2017)
What has happened with US industries in the last two decades? (think: size, public listings)
In the last two decades, more than 75% of US industries experienced an increase in concentration levels
The size of the average publicly listed company in the United States tripled in market capitalisation.
110
Towards a Political Theory of the Firm.
Zingales (2017)
Name two trends to why US companies have become so large in size.
1. the reduction in the rate of birth of new firms
| 2. very much merger activity (you merge, you get big)
111
Towards a Political Theory of the Firm.
Zingales (2017)
What are (3) explanations for US firms to have become so large?
1. NETWORK EXTERNALITIES: situations in which an increase in usage leads to a direct increase in value for other users (Internet had no value initially but when a lot of people started using it, it is super nice)
2. WINNER-TAKE-ALL INDUSTRIES: the increase of information-intensive goods that have high fixed and low- marginal costs (Walmart)
3. REDUCED ANTITRUST ENFORCEMENT:
antitrust laws - a collection of federal and state government laws that regulates the conduct and organization of business corporations, generally to promote competition for the benefit of consumers.
When this is reduced, monopolies can arise more.
112
Towards a Political Theory of the Firm.
Zingales (2017)
Name and describe (3)
the power of corporations to shape the rules of
the game has become stronger for three main reasons:
1. Increased SIZE and MARKET SHARE —> lower competition; corporations are more powerful.
2. The size and complexity of REGULATION has INCREASED, which makes it easier to tilt the playing field in the firm's advantage for personal reasons of involvement.
3. END OF ANTIBUSINESS IDEOLOGY that previously prevailed among Democrats. This has reduced the costs of being perceived as too friendly to the interests of big business for both parties
113
Towards a Political Theory of the Firm.
Zingales (2017)
Describe ideal state between power of state and power of firms (goldilocks)
1. If the state is too weak to enforce property rights, then firms will either enforce them by themselves or collapse.
2. If a state is too strong, rather than enforcing property rights it will be tempted to take property from firms
3. When firms are too weak they risk being expropriated (they will need to give their property to government either directly or by paying large returns on investments)
4. When firms are too strong they may shape the definition of property rights and its enforcement in their own interest and not in the interest of the public.
114
Towards a Political Theory of the Firm.
Zingales (2017)
What is goldilocks principle?
The Goldilocks principle states that something must fall within certain margins, as opposed to reaching extremes. (no pasakas "Zeltmatīte un 3 lāči"
115
Towards a Political Theory of the Firm.
Zingales (2017)
What are the mechanisms (4) in the formation of a democratic consensus?
1. The world of the MEDIA, can be influenced by the political power (through censorship, ownership,
subsidies, and leaks) and by the economic power (through advertising, direct ownership, financing, and
access to information). SHOULD NOT BE AFFECTED BY ANY.
2. ELECTORAL PROCESS shaped both by the electoral law and by the rules for campaign financing. A mixture of limitations on private donations, matched by public financing, is an attempt to find a
balance
3. IDEOLOGY: in some countries, political legitimisation is linked to a formal election process; in other
countries, governments formed in different ways are nonetheless regarded as legitimate. Ideology is also
based on perceptions of the relative benefits of being dominated by economic interests
4. JUDICIARY POWERS: differ in their degree of independence from the political and the
economic powers and in their prevalent ideology
116
Towards a Political Theory of the Firm.
Zingales (2017)
Economic characteristics: what does company’s ability to obtain what it wants from the political system depend on (4)?
1. ability to make credible LONG-TERM PROMISES (for example, future employment opportunities for
politicians and regulators), which is highly dependent upon a company’s long-term survival probability
2. the GRIP a company has ON the market for SPECIFIC HUMAN CAPITAL (how many potential
employers of nuclear engineers are there?)
3. company's ability to wrap its self-interest in a bigger, noble IDEA (for example, Fannie Mae and the goal
that every American should be able to borrow to purchase a house)
4. the CONTROL that a company has THROUGH its IMAGE in society by way of employment, data ownership, media ownership, advertising, research funding, and other methods
A firm’s size and the level of concentration within a market affect positively all the crucial factors that determine a firm’s ability to influence the political system.
117
Towards a Political Theory of the Firm.
Zingales (2017)
What political tools may be put to use to limit corporate risks to politics? (6)
1. increases in TRANSPARENCY of corporate activities;
2. improvements in CORPORATE DEMOCRACY;
3. better rules against revolving doors and more attention to the risk of capture of scientists and economists by corporate interests (?????)
4. more AGGRESSIVE USE of the ANTITRUST authority;
5. attention to the functioning and the INDEPENDENCE of the MEDIA market.
BROADER PUBLIC AWARENESS
118
Towards a Political Theory of the Firm.
Zingales (2017)
What non-market factors Medici vicious circle depends upon? (5)
1. the main source of political power
2. the conditions of the media market
3. the independence of judiciary power
4. the campaign financing laws
5. the dominant ideology
119
The US Equity Return Premium: Past, Present and Future
What is an equity premium puzzle?
If you invested in a diversified portfolio of equities (like S&P 500) vs bonds (like the US government issued bonds), you would get a 6% higher return from equities WITHOUT BEARING MORE RISK. Since this premium has persisted for more than a century (meaning 20th century), it is called equity premium puzzle because it is not understandable why equities yield higher return if the RISK IS THE SAME.
6% is in the US, but it exists also in other countries.
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The US Equity Return Premium: Past, Present and Future
What is the potential objection to equity premium puzzle?
Short term asset liquidity effect – investors are willing to accept lower gains on returns on the bonds because they are able to convert them to cash in the case of the emergency.
-> Objection: In this case, the puzzle should be less pronounced for the long term bonds with lower liquidity; however, it is EVEN MORE PRONOUNCED: in only 2% of the cases in the 20th century would investing in bonds outperform investing in stocks.
121
The US Equity Return Premium: Past, Present and Future
What are the possible explanations of the equity premium puzzle?
1. Expected utility theory
2. Transaction costs
3. Lower tail risk
4. Learning about the return distribution
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The US Equity Return Premium: Past, Present and Future
How does expected utility theory explains the equity premium puzzle?
Risk and loss aversion - pain you feel from a loss is more pronounced than a happiness you feel from an equally sized gain. Unrealistic though as it would mean that pain of losing 1$ is the same as happiness from winning 170$; also, agents should be risk neutral on all bets that do not involve a substantial fraction of lifetime wealth. Annual stock markets returns do not covary enough with current consumption and lifetime wealth to justify the substantial risk aversion toward stock returns that would explain such large premium.
----Behavioural finance – people have difficulties to restrict their own biases, thus they act against their own interests by investing in bonds instead of stocks (myopia – focus on short term risk instead of long term gains, loss aversion, ambiguity aversion- do not know the distribution of stock returns in the future)
123
The US Equity Return Premium: Past, Present and Future
How do Transaction Costs explain the equity premium puzzle?
Due to TC, many people do not trade at all. For example, borrowing constraints for young people.
->another approach: investors are subject to uninsurable idiosyncratic income shocks that are correlated with returns on equities (income shock specific to a person, e.g. being fired in recession)
124
The US Equity Return Premium: Past, Present and Future
How does lower tail risk explains the equity premium puzzle?
In the sample (20th century), there were not much low-probablity but large magnitude economic chatastrophies (black swans) as a rational investor would expect -> there should be more of those events in the future, so the premium will decrease
-> Objection: we should have black swan events extremely often to justify such premium- it is not possible.
125
The US Equity Return Premium: Past, Present and Future
How does learning about the return distribution explain the equity premium puzzle?
People have fears due to what they experienced in e.g. great depression, so are afraid to invest in stocks
-> Objection: people learn, better financial institutions are created. It has resulted in more equity investments, thus driving prices (hence returns) higher.
126
The US Equity Return Premium: Past, Present and Future
How would you describe the future of equity premium?
The authors believe premium will persist over the next few years; however, the rate will be lower (perhaps 4% instead of 6%).
127
The US Equity Return Premium: Past, Present and Future
What are the reasons for changes in the equity premium in future?
Faded memory of great depression; appearance of more mutual funds, pension funds etc, which invest in equities.
128
The US Equity Return Premium: Past, Present and Future
What does the existence of equity premium means?
The society has untapped risk bearing capacity: can bear more volatiliy that could lead to more gains in the future.
