ACTSC 372 Behavioural Finance

ACTSC 372 Behavioural Finance - How to explain market...

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Winter 2012 How to explain market prices
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General Observations Modeling securities returns is hard. Modeling risk is hard. But something must be done. CAPM, APT and EMH are all “best efforts” approaches.
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Asset Pricing Theories CAPM Returns (thus prices) are a function of the security’s beta (systematic risk) Portfolios are chosen to maximize return and minimize variance APT Returns (thus prices) are a function of the risk of the security, measured by its response to factors CAPM is a one factor APT model
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CAPM and APT CAPM Makes sense if people’s utility functions are exponential (they aren’t) Returns are normally distributed (they aren’t) People have homogeneous expectations and time horizons (they don’t) APT Makes sense if We know what the factors are (we don’t)
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Did we learn anything this term? CAPM The idea of a risk vs. return trade-off, and the importance of correlations in diversification is valuable. The problems are with the details of the quantification of all this. APT The recognition that specific factors affect different securities differently, and that this can be “controlled” is valuable. But what are the factors?
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A Quick Test Many advisors recommend investors sell covered calls in order to enhance their returns (the income from the call premium can increase total earnings). Assume we all believe that CAPM is the correct model to price securities and estimate returns. Comment on the advisors’ advice.
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Efficient Market Hypothesis No free lunch Prices should reflect the no-arbitrage condition. Risk free profits (above the risk free rate) should not be available. (small differences less than transaction costs are ignored) Abnormal profits (above those described by CAPM or APT) should not be available. Weak-form Semi-Strong form Strong form
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Consequences of EMH Reaction to news/arbitrage opportunities Prices should react immediately to news; thus, no abnormal profits can be realized. Rational traders will eliminate anomalies immediately. Technical analysis is useless. Fundamental analysis is useless Insider trading is useless There should be very little trading, since trading incurs transaction costs.
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Evidence of EMH Mixed evidence Mutual fund returns are below the index (usually by an amount equal to the MER) – supports EMH Prices seem to move wildly Price volatility far greater than earnings volatility, general GDP volatility, dividend volatility. Crash/bounce back events 1987 2010 “Flash Crash” Any one of the MANY bubbles.
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Other Problems with EMH How does one determine if a strategy works? Calculate the abnormal returns; if they are positive,
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ACTSC 372 Behavioural Finance - How to explain market...

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