Test 2 Flashcards
(24 cards)
Types of market participants
Investor vs speculator
hedger vs speculator
institutional vs retail
Dealer, investment bank, market maker
Describe EMH
- financial markets informationally efficient
- no one can earn excess risk-adjusted returns given the info available at the time the investment is made
- everyone is competing so hard that it negates any efforts to beat the market
- history doesn’t matter, it is already reflected in market price at new equilibrium
- market reactions normally distributed, due to external random events, and are proportional
Analogy for EMH
dropping pebble or stone into water
-immediately raises to new equilibrium with a proportional reaction to the pebble
2 parts of EMH that 1987 crash invalidated
- not normally distributed
- not always proportional to events of the day
How SHOULD the growth of the internet have validated EMH?
Information even easier to attain
??
Briefly describe the sand pile analogy
Complex system
The effect of the next grain relies on not only the grain but also the state of the pile, there is friction.
Each grain can cause no change, a small avalanche or a big avalanche
Cause and effect hard to identify and not proportional ie earthquakes or jenga
What characteristics set apart the sand pile from the EMH analogy?
There is friction to keep the sand pile from spreading out and finding new equilibrium like the water does, instead the pile builds up until eventual avalanche ie feedback theory
Feedback theory
- initial price increases lead to more increases or lead to the expectation of future price increases
- increased confidence in risk taking due to patterns of price increases
What assumptions of Black Scholes option pricing formula were invalidated by the 1987 crash?
lognormal distribution and markets are continuous
Briefly outline LTCM ccase and aply 3 class concepts to it
feedback theory sand pile analogy confirmation bias hindsight bias randomness looks streaky
Describe an example that Shiller uses to demostrate the exuberance of the late 90’s tech bubble
He would overhear people discusses at dinner and it was always on the tv
Minsky Financial Instability Hypothesis
Prosperous times or times of stability Leads to risk-taking and leverage Further lead to speculative euphoria Leading to financial fragility and collapse Normal part of free-market economics
Outline the issues around differentiating process vs outcome
Hindsight and confirmation bias plays a big role
The matrix
outcome/process G/G deserved sucess G/B dumb luck B/G bad break B/B poetic justice
Peter Bernstein quote
“The fundamental law of investing is the uncertainty of the future”
3 strats for seperating outcome and process
- focus on process and decisions
- constantly search for favorable odds/positive expected value
- understand the role of time
hedging int rate risk good or bad?
good process because outcome unknown
Why does randomness look streaky
20 coin flips
streaks are likely over long periods
confirmation bias
definition and 2 components
-tendency to favor info that supports the belief or hypothesis
1) sellectively gather info
2) interpret info in a biased way
Strat to deal with confirmation bias
Look for evidence against
Complex System
composed on many components which interact - sandpile
Complex Adaptive systems
like sandpile PLUS LEARNING
complex-diverse and made up of multiple interconnected elements
adaptive-have the capacity to learn and change from experience
Process vs outome
when is it important?
what should you do?
In complex or random systems
Judge the quality of decision by the info available at the time of the decision
Hedger
Speculator
Investor
Market Maker
H- taking an offsetting position to hedge an existing risk ie westjet hedging fuel costs
S- Short term price appreciation, increasing risk, attempting to profit from price change
I- Long term price appreciation, interest, dividends
MM- willing to buy sell at certain prices ie pawn shop (dealer, investment bank)
