IntroductionIntroduction

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PlanPlan

MotivationMotivation Specifics of financial dataSpecifics of financial data

– Time and cross dimensionsTime and cross dimensions– Market microstructure effectsMarket microstructure effects

Modeling financial dataModeling financial data– Rational vs. behavioral modelsRational vs. behavioral models– Different types of empirical testsDifferent types of empirical tests– Methodological issuesMethodological issues

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How to explain asset How to explain asset prices?prices?

0

20

40

60

80

100

10/29/99 10/13/00 9/28/01 9/13/02 8/29/03 8/13/04

GAZPROM

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From prices to returnsFrom prices to returns

ReturnsReturns– Simple: RSimple: Rtt = (P = (Ptt-P-Pt-1t-1)/P)/Pt-1t-1

Easy to compute portfolio returnEasy to compute portfolio return

– Log: RLog: Rtt = ln(P = ln(Ptt/P/Pt-1t-1)) Easy to aggregate over timeEasy to aggregate over time Doesn't violate limited liabilityDoesn't violate limited liability

– Arythmetic vs geometric averageArythmetic vs geometric average

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How to explain asset How to explain asset returns?returns?

-0.2

-0.1

0.0

0.1

0.2

0.3

10/29/99 10/13/00 9/28/01 9/13/02 8/29/03 8/13/04

RET

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Stylized factsStylized facts

Non-normalityNon-normality– Thick tailsThick tails– AsymmetryAsymmetry

Autocorrelation of returnsAutocorrelation of returns– Ultra-short horizon -, short +, long –Ultra-short horizon -, short +, long –

Cross-correlation of returnsCross-correlation of returns

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Gazprom in 1999-2005Gazprom in 1999-2005

0

20

40

60

80

-0.2 -0.1 0.0 0.1 0.2

Series: RETSample 11/05/1999 3/18/2005Observations 281

Mean 0.010763Median 0.003101Maximum 0.231134Minimum -0.192979Std. Dev. 0.062011Skewness 0.416175Kurtosis 4.729441

Jarque-Bera 43.13081Probability 0.000000

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Stylized facts (2)Stylized facts (2)

VolatilityVolatility– Clustering in timeClustering in time– Inverse relation with prices Inverse relation with prices – Smaller when the market are closedSmaller when the market are closed– Higher in times of forecastable releases of Higher in times of forecastable releases of

infoinfo– Inverse relation with auto-correlationInverse relation with auto-correlation– Common factors for different assetsCommon factors for different assets– Too high relative to fundamentalsToo high relative to fundamentals

Often explosive growth or crashesOften explosive growth or crashes

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Stylized facts (3)Stylized facts (3)

Cross-sectional “anomalies”Cross-sectional “anomalies”– Price-related company Price-related company

characteristicscharacteristics– Calendar effectsCalendar effects

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Market microstructure Market microstructure effectseffects How to measure returns?How to measure returns?

– Average vs. close pricesAverage vs. close prices Low liquidityLow liquidity Impact of the bid-ask spreadImpact of the bid-ask spread

– Can you make profit out of asset Can you make profit out of asset mispricing taking into account mispricing taking into account transaction costs?transaction costs?

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Rational vs. behavioral Rational vs. behavioral modelsmodels Traditional analysis: explain asset Traditional analysis: explain asset

prices by rational modelsprices by rational models Only if they fail, resort to Only if they fail, resort to

irrational investor behaviorirrational investor behavior– Behavioral finance modelsBehavioral finance models

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The efficient market The efficient market hypothesishypothesis Informational efficiency: asset Informational efficiency: asset

prices accommodate all relevant prices accommodate all relevant informationinformation– History of prices / all public History of prices / all public

variables / all private informationvariables / all private information Why is it importantWhy is it important??

– For corporate financeFor corporate finance– For (financial) investmentsFor (financial) investments

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Is this market Is this market efficient?efficient?

0

20

40

60

80

100

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GAZPROM

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Efficient marketsEfficient markets

Price movements must be random!Price movements must be random!– Otherwise one can forecast future price Otherwise one can forecast future price

and make arbitrage profitand make arbitrage profit– Prices should immediately respond to new Prices should immediately respond to new

informationinformation Sufficient conditions:Sufficient conditions:

– No transaction costsNo transaction costs– No information costsNo information costs– Homogeneous expectationsHomogeneous expectations

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Basic model for prices: Basic model for prices: random walk with random walk with trendtrendAsset price

Time

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What does it imply for What does it imply for the business?the business? No place for active investment policyNo place for active investment policy

– There are no under- or overpriced There are no under- or overpriced assets, no opportunities for arbitrageassets, no opportunities for arbitrage

– Most portfolio managers should be Most portfolio managers should be fired!fired!

– Still, role for diversification, choice of Still, role for diversification, choice of risk, and tax optimizationrisk, and tax optimization

No place for active corporate policyNo place for active corporate policy– It does not matter which capital It does not matter which capital

structure to choosestructure to choose

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How realistic is it?How realistic is it?

The paradox of Grossman-Stiglitz (1980):The paradox of Grossman-Stiglitz (1980):– No one will make research on the market, if No one will make research on the market, if

all info is already reflected in the pricesall info is already reflected in the prices– There must be some inefficiency in the There must be some inefficiency in the

equilibrium to provide incentives for equilibrium to provide incentives for information acquisitioninformation acquisition

Operational efficiency:Operational efficiency:– One cannot make profit on the basis of One cannot make profit on the basis of

information, accounting for info acquisition information, accounting for info acquisition and trading costsand trading costs

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What if the EMH is What if the EMH is rejected?rejected? The The joint hypothesis problemjoint hypothesis problem: :

we simultaneously test market we simultaneously test market efficiency and the modelefficiency and the model– Either the investors behave Either the investors behave

irrationally,irrationally,– or the model is wrongor the model is wrong

Ex-ante expected profit within Ex-ante expected profit within information and transaction costsinformation and transaction costs

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What if the EMH is What if the EMH is rejected?rejected? (2)(2) Empirical illusionsEmpirical illusions

– Data miningData mining– Survivor biasSurvivor bias– Selection biasSelection bias– Short-shot bias (rare events): it Short-shot bias (rare events): it

could be luckcould be luck– Trading costs, esp. invisible market Trading costs, esp. invisible market

impact costsimpact costs

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What if the EMH is What if the EMH is rejected?rejected? (3)(3) Why not try more complicated Why not try more complicated

rational models?rational models?– Multiple periodsMultiple periods– Imperfect markets: liquidity, short-Imperfect markets: liquidity, short-

sale constraintssale constraints– Uncertainty over other investors’ Uncertainty over other investors’

demand curvesdemand curves

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Different forms of Different forms of rationalityrationality Maximal: all investors are rationalMaximal: all investors are rational Intermediate: asset prices are set as Intermediate: asset prices are set as

if all investors are rationalif all investors are rational Minimal: there are no abnormal Minimal: there are no abnormal

profit opportunities, thoughprofit opportunities, though– Sometimes a small group of irrational Sometimes a small group of irrational

investors are able to determine asset investors are able to determine asset pricesprices E.g., acquiring firms tend to overpayE.g., acquiring firms tend to overpay

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Examples of Examples of irrationalityirrationality Reference points and loss aversionReference points and loss aversion

– Endowment effectEndowment effect / Status quo bias/ Status quo bias OverconfidenceOverconfidence

– Biased self-attribution / Disposition effectBiased self-attribution / Disposition effect– Illusion of controlIllusion of control

Statistical errorsStatistical errors– Gambler’s fallacy / Misjudging very rare Gambler’s fallacy / Misjudging very rare

eventsevents– Extrapolation bias / OverreactionExtrapolation bias / Overreaction

Miscellaneous errors in reasoningMiscellaneous errors in reasoning– Sunk costs / Cognitive dissonanceSunk costs / Cognitive dissonance

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Information Information aggregationaggregation Example: locating the missing US Example: locating the missing US

submarine in 1968submarine in 1968– 5 months of extensive search efforts 5 months of extensive search efforts

in the 20-mile circle brought no in the 20-mile circle brought no effecteffect

– The experts were asked for The experts were asked for opinions, the average response gave opinions, the average response gave the location, where the sub was the location, where the sub was ultimately found!ultimately found!

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Information Information aggregationaggregation (2)(2) Security marketsSecurity markets

– From the ‘invisible hand’ principle of Adam From the ‘invisible hand’ principle of Adam Smith…Smith…

– to Friedrich Hayek: the price system utilizes to Friedrich Hayek: the price system utilizes bits of knowledge not given to anyone in totalbits of knowledge not given to anyone in total

– An investor must consider the vast amount of An investor must consider the vast amount of info already impounded in prices before info already impounded in prices before making a bet based on his own infomaking a bet based on his own info

Recent improvement in market efficiencyRecent improvement in market efficiency– Advances in technology and organized marketsAdvances in technology and organized markets– Derivatives designed to trace different risksDerivatives designed to trace different risks

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Basis for Basis for minimal minimal rationalityrationality Profitable trading strategies are self-Profitable trading strategies are self-

destructibledestructible Irrational investors self-destruct (become Irrational investors self-destruct (become

poor)poor)– Excess trading volume, under-diversification, Excess trading volume, under-diversification,

disposition effectdisposition effect– Even if all investors are irrational, in Even if all investors are irrational, in

aggregate the market can be rationalaggregate the market can be rational Overconfidence causes many investors to Overconfidence causes many investors to

spend much money on research spend much money on research – Overly efficient markets?Overly efficient markets?

E.g., there are much more active mutual funds than E.g., there are much more active mutual funds than passive onespassive ones

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How to test market How to test market efficiency?efficiency? The The joint hypothesis problemjoint hypothesis problem: :

– We need the model for the expected We need the model for the expected prices (or returns)prices (or returns)

The rejection of the null implies The rejection of the null implies thatthat– Either investors behave irrationally,Either investors behave irrationally,– or the model is wrongor the model is wrong

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Different types of testsDifferent types of tests

Statistical significance: e.g., the market Statistical significance: e.g., the market model model RRtt==αα++ββRRM,M,tt++γγXXt-1t-1++εεtt– HH00: : γγ = 0 = 0

Economic significance :Economic significance :– HH00: (risk-adjusted) : (risk-adjusted) profit from the investment profit from the investment

strategy strategy = 0= 0– It is important to account for transaction costsIt is important to account for transaction costs– Should use only variables available to investors Should use only variables available to investors

Fundamental efficiency:Fundamental efficiency:– HH00: price = fundamental value: price = fundamental value– Otherwise the bubble partly explains the asset’s Otherwise the bubble partly explains the asset’s

priceprice

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Empirical evidenceEmpirical evidence

Up to the end of 1970s: belief in the Up to the end of 1970s: belief in the efficient markets and CAPMefficient markets and CAPM– Past prices and other public variables Past prices and other public variables

do not predict future pricesdo not predict future prices– Profits from technical analysis are Profits from technical analysis are

close to 0close to 0– The market quickly reacts to new infoThe market quickly reacts to new info– Portfolio managers cannot beat the Portfolio managers cannot beat the

marketmarket

Event study analysisEvent study analysis

How quickly does the market How quickly does the market react to new information?react to new information?

0 +t-t

Announcement Date

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Reaction to the Reaction to the unexpected eventunexpected event

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Performance Performance evaluationevaluation ExperimentExperiment: : compare returns of compare returns of

two portfoliostwo portfolios– 1: chosen by experts1: chosen by experts– 2: chosen by the monkey throwing 2: chosen by the monkey throwing

dartsdarts– No significant difference!No significant difference!

FormallyFormally:: e.g., based on CAPM e.g., based on CAPM

RRtt - - RRF,tF,t = = αα + + ββ(R(RM,M,tt-R-RF,tF,t) + ) + εεtt

– The Jensen’s alpha was close to The Jensen’s alpha was close to 00

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Empirical evidenceEmpirical evidence (2)(2)

After 1970s: inefficient markets?After 1970s: inefficient markets?– Price anomalies in 1980s and 1990s, Price anomalies in 1980s and 1990s,

unexplained by the CAPMunexplained by the CAPM Calendar effects: e.g., Monday (negative), Calendar effects: e.g., Monday (negative),

January (positive)January (positive) Book/market, value/growth and size Book/market, value/growth and size

effectseffects Short-run momentum and long-run price Short-run momentum and long-run price

reversal effectsreversal effects

– Mutual funds performance persistenceMutual funds performance persistence

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Possible Possible explanationsexplanations Heterogeneity of investorsHeterogeneity of investors

– Tax considerationsTax considerations Each investor chooses assets to Each investor chooses assets to

minimize his own efficient tax rate (role minimize his own efficient tax rate (role of dividends)of dividends)

Investors fix losses on losing stocks at Investors fix losses on losing stocks at the end of the year (January anomaly)the end of the year (January anomaly)

– Liquidity considerations (sharp Liquidity considerations (sharp market movements)market movements)

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Possible explanations Possible explanations (2)(2) Transaction costsTransaction costs

– Short-sales restrictions (cannot Short-sales restrictions (cannot profit from overprices assets, e.g., profit from overprices assets, e.g., losing mutual funds)losing mutual funds)

– Bid-ask spread (reduces Bid-ask spread (reduces substantially profits, esp. from small substantially profits, esp. from small stocks – size and January anomalies)stocks – size and January anomalies)

– Market impact (invisible costs)Market impact (invisible costs)

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Possible explanations Possible explanations (3)(3) Statistical illusionsStatistical illusions

– Data mining (5 out of 100 irrelevant Data mining (5 out of 100 irrelevant variables will be significant at the variables will be significant at the 5% level)5% level)

– Selection bias (e.g., survivor bias)Selection bias (e.g., survivor bias) Should not exclude stocks of small Should not exclude stocks of small

companies (funds) that disappearedcompanies (funds) that disappeared

– Short-shot bias (rare events): it Short-shot bias (rare events): it could be luckcould be luck

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Possible explanations Possible explanations (4)(4) Mechanical relationshipsMechanical relationships

– Financial leverage effects (lower Financial leverage effects (lower stock prices increase beta and imply stock prices increase beta and imply higher return)higher return)

– All variables based on current All variables based on current prices (e.g., size and BE/MEprices (e.g., size and BE/ME ) are ) are automatically related to future automatically related to future returns returns PPtt is negatively related to R is negatively related to Rtt=P=Pt+1t+1/P/Ptt

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Possible explanations Possible explanations (5)(5) More complicated rational More complicated rational

modelsmodels– Time-varying betas and risk Time-varying betas and risk

premiumspremiums– Multiple factorsMultiple factors– Imperfect markets: liquidity, short-Imperfect markets: liquidity, short-

sale constraints, etc.sale constraints, etc.

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Topics covered in this Topics covered in this coursecourse Time series analysis of asset returnsTime series analysis of asset returns

– Predictability at different horizonsPredictability at different horizons– Event study analysisEvent study analysis

Speed of stock price adjustment in response Speed of stock price adjustment in response to news announcementsto news announcements

Cross-sectional analysis of asset Cross-sectional analysis of asset returnsreturns– CAPM and market efficiencyCAPM and market efficiency– Return anomalies and multi-factor asset Return anomalies and multi-factor asset

pricing modelspricing models

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Topics covered in this Topics covered in this coursecourse (2)(2) Performance evaluation of mutual Performance evaluation of mutual

fundsfunds– Performance persistence, Performance persistence,

survivorship bias, dynamic strategies, survivorship bias, dynamic strategies, gaming behavior, etc.gaming behavior, etc.

Investor behaviorInvestor behavior– Overconfidence, herding, home bias, Overconfidence, herding, home bias,

impact of demographic impact of demographic characteristics, etc.characteristics, etc.

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Topics outside of this Topics outside of this coursecourse Fixed income / derivativesFixed income / derivatives Corporate financeCorporate finance Trading and market Trading and market

microstructuremicrostructure– Ultra high-frequency analysisUltra high-frequency analysis

International financeInternational finance Financial intermediariesFinancial intermediaries