Summary

of the Asset Pricing Papers

Week 1 – Lecture 1.2

Notes

Portfolio theory:
- Investors should hold a combination of the risk-
free asset and the market portfolio.
o The exact combination depends on the
(increasing) utility function

Von Neuman Morgenstern Expected Utility (VNM):
- A decision-maker faced with risky outcomes of different choices will behave as if he
is maximizing the expected value of some function defined over the potential
outcomes.

Demand for the market portfolio:
- (+) increases with expected return
- (-) decreases with risk-free rate
- (-) decreases with risk
- (-) decreases with risk aversion
- (-) decreases with wealth
o Rich people will invest a lower percentage in the market portfolio, so lower
utility Is gained from extra wealth.

CAPM:
- If everyone holds the market portfolio, all assets i should have the same marginal
utility.
- Practical translation: how are the returns of individual stocks correlated with the
market index?

CML and SML:

Capital Market Line (CML):
- Depicts the level of return above the risk-free rate for each change in the level of
risk.
o Takes into account the risk-free rate
o More risk means higher return, so it must be upward sloping
o Point M: feasible region for risky assets, rational investors would invest in this
portfolio.
o Steeper the slope, the higher the return per unit of risk
o Goal: maximize the return for minimum risk.

Security Market Line (SML):
- Depicts the market beta versus the market return
o Beta = a stock’s volatility or – risk – relative to the market
o The higher the beta, the higher the return, but the higher the losses can be
o If a stock falls above the SML, it is undervalued, since it pays a return higher
than the market average given the level of risk.
o If a stock falls under the SML, it is overvalued, since it pays a lower return
than the market average given the level of risk.

Paper: Fama & MacBeth – Risk, Return, and Equilibrium: Empirical Tests (1973)

What does the paper test?
This paper tests the relationship between average return and risk for the NYSE common
stocks. Can beta be estimated over past data explain next period stock return?

Fama-MacBeth framework:
- Two-parameter model: mean and variance.
- Expected returns: forecasting next period returns using this period information

What about the methodology?
The data for this study are monthly percentage returns for all stocks traded on the NYSE.

Three testable implications (hypotheses) based on CAPM equation:

- Hypothesis 1: The relation between expected return and risk is linear 


- Hypothesis 2: Beta is a complete measure of risk of security i in portfolio m 

- Hypothesis 3: Higher risk should be associated with higher expected returns 


FM estimate the following equation:

- y1 is related to Hypothesis 3 -> should be positive
- y is related to Hypothesis 1 -> should be zero
2
 - y3 is related to Hypothesis 2 (s is any other risk measure besides beta) -> should be
zero
- y0 -> should equal the risk free rate

Empirical issues:
- Data:
o Monthly returns from all stocks traded on the NYSE are used, what about the
annually?
- What is ‘the’ market?
o Here: equally weighted average of all stocks
- What is ‘the’ risk-free rate?
o Here: 1-month T-bill

Difficulty estimating Beta:
- For out-of-sample testing (expected returns, future periods), you need to estimate
beta based on a pre-testing period
o You assume that beta stays constant for next period
o Trade-off between stability and length of the sample period. Taking monthly
averages yields a more erratic curve than annual averages, this is the tradeoff
you make.
- There is no real solution to these problems. They remain of arbitrary choice.

Solution of FM:
- Use portfolios so noise is averaged out
- Re-estimate betas after portfolio information

The Fama-MacBeth method (practically):
1. Use first 4 years of data to calculate b for each security
2. Rank all securities based on b and create 20 portfolios
3. Re-estimate b using the next 5 years of data and calculate averages per portfolio
4. For each next month, update the average portfolio b’s from step 3
5. For each year, re-estimate b’s from step 3
6. Create a measure of non-b risk (idiosyncratic volatility)
7. For each month, estimate a cross sectional regression:

The Fama-MacBeth method (generally):
- The estimated g’s are used to test the hypotheses. All the steps are repeated several
times, as much as the data permits.
- The steps are repeated several times, as much as the data permits (9 times in FM
paper).
- Use ALL available stocks that are traded on NYSE


Critical observations:
- The results vary greatly over sub-samples.
- H3, main result, only significant at the 10% level.

Results:
- On average, there seems to be a positive tradeoff between return and risk, with risk
measured from the portfolio viewpoint. In other words, the portfolio risk, or beta, is
related to the expected returns. Taking more risk yields a higher return.
- An investor should assume that the relationship between a security’s portfolio risk
(beta) and its expected return is linear.
- No measure of risk, in addition to portfolio risk (beta), systematically affects average
returns. In other words, the portfolio risk, or beta, is the complete measure of risk.
- The fair game properties of the coefficients and residuals of the risk-return
regressions are consistent with an efficient capital market- that is, a market where
prices of securities fully reflect available information.

Week 2 – Lecture 2.1
Paper: Fama & French – The Cross-Section of Stock Returns (1992)

Central questions in this paper:
- Is beta related to the expected returns?
- Are other factors than beta related to expected returns?
o At the time of writing, a number of papers had found individual factors. Fama
and French combine them to see which one persists.

In this paper, Fama & French use more data and more sophisticated tests than in the Fama
& MacBeth paper from 1979.

Data used in this paper:
- All nonfinancial firms from NYSE, AMEX and NASDAQ between (1962-1989)
o They exclude financial firms because financial firms are highly leveraged.
- Annual accounting data starting at June
o The fiscal year ends December 31st, Fama & French chose June to be sure
that every firm had the chance to publicize their data.
- Monthly market data

Company characteristics they take into account:
- BE/ME: book-to-market value
This equals the book-value of the company (accounting value) divided by the market
value (stock market). This ratio is smaller than 1 because ME includes expected
growth.
- ME: size
This is the stock market capitalization, the number of outstanding stocks times the
stock price.
- A: assets
The total assets (accounting value)
- E: earnings
The total earnings per share of this company

Two methods used in this paper:
1. Sort stocks in buckets based on company characteristics in previous period and
check return in this period. Here there is no need to assume a linear relation.
2. For each month, run a cross-sectional regression with the returns of this period as
dependent variable (Y) and company characteristics in previous period as
explanatory variable (X). This is the Fama & MacBeth method.

Two problems with estimating the beta:
1. Properly estimating the beta is hard
Solution: use portfolio betas instead of individual stock betas
2. There is a strong relation between beta and size, which makes it difficult to separate
the effects. Smaller stocks tend to be more risky.
Solution: double-sorting

Double-sorting:
- Sort stocks into size deciles
- Take 2-5 years of data prior to size sorting date to estimate beta per stock
- Within each size decile, sort stocks into beta deciles à 100 size-Beta portfolios
- Calculate the return of portfolio over next year
- Redo the above
- For each of the 100 size-Beta portfolios, estimate a portfolio beta over the full
sample period

Results:
1. Sorting on Beta and size (ME):
a. Beta: there is no clear pattern. This does not indicate that there is a relation
between beta and return.
b. Size (ME): there is a clear pattern. This entails that there is a relationship
between the size and market return.

2. Sorting on book-to-market and size(ME):
a. There seems to be a clear relation in both dimensions. This indicates that
both size and book-to-market relate to the returns.

3. Regressions
For each month, different forms of the following cross-sectional regression are
estimated:
𝑅 = 𝛼 + 𝛾 𝛽 + 𝛾 𝑙𝑛(𝑀𝐸 ) +𝛾 𝑙𝑛(𝐵𝐸/𝑀𝐸 ) +𝛾 𝑙𝑛(𝐴/𝑀𝐸 ) +𝛾 𝑙𝑛(𝐴/𝐵𝐸 )
𝑖𝑡 1 𝑖𝑡−1 2 𝑖𝑡−1 3 𝑖𝑡−1 4 𝑖𝑡−1 5 𝑖𝑡−1
+𝛾 𝐸/𝑃 + 𝜀
6 𝑖𝑡−1 𝑖𝑡
Take the average of the estimated y’s over the months.
Results:
a. (B): Beta is positive, but not significant
b. (ME): Larger companies earn lower returns (negative relation)
c. (BE/ME): Higher book-to-market value gives higher returns (positive relation)
d. (ME and BE/ME):

Conclusions:
- Beta is NOT a complete measure of risk
- Size (ME) and book-to-market value (B/M) ARE relevant

In a paper from 1993, Fama & French propose two additional factors or factor mimicking
portfolios:
1. SMB: small minus big stocks
a. Sort all stocks on their market capitalizations (ME, or size) and split them
across the median
b. Go long in the bottom half, go short in the top half
2. HML: high minus low stocks
a. Sort all stocks on their book-to-market value (BE/ME) and split them in three
parts (30/40/30)
b. Go long in the top 30% and go short in the bottom 30%

Now constitute the Three Factor Model:
- Traditional CAPM is given by:
- Adjusted to the 3-factor model:
- All three Betas should be related to the expected returns, because Beta is not a
complete measure of risk, so the exposure to risk factor is related to the E(rt).

Testing the Three Factor Model:
- If the three factors capture all common variation in stock returns, the intercept
should be zero
- Apply a time-series test
- Using 25 portfolios: two-way sorts between 5 size and 5 B/M quintiles

Intercepts:
- If we have a model that captures all expected returns, then the intercepts should be
zero.
- If the intercept is bigger than zero, then a part is not captured by the risk factors.
- The t-values are significant for the intercepts.
- The smaller stocks are closer to zero than the bigger stocks.

The Three Factor Model does a reasonable job in explaining stock returns. We can do the
following with the model:
1. Portfolio selection
2. Performance evaluation
If you have a portfolio to check if these returns are good, than you can compare
them to a risk factor. This model allows you to make this comparison.
3. Measuring abnormal returns in event studies
For instance, a long-run effect of a merger.
4. Calculation of cost of capital

Paper: Fama & French – Five Factor Model (2015)

In this paper, Fama & French propose a five factor model

The five factors proposed are:
- Market return minus risk-free rate (RMRF)
- Size (SMB)
- Book-to-market value (HML)
- Profitability (RMW)
- Investments (CMA)


Model rationalization:

- Fix everything but M and r → Lower M implies higher r → Book to market predicts
returns
- Fix everything but Y and r → Higher Y implies higher r → Earnings predict returns
- Fix everything but dB and r → Higher dB implies lower r → Investments predict lower
returns

The five factor model:

- MKTRF, SMB and HML are the same as before
- RMW
o Long-short on 30/40/30 sorts on operating profitability
o Operating profitability (OP) = (Revenues – cost of goods sold – interest
expenses – selling, general and administrative expenses)/ book equity
- CMA:
o Long-short on 30/40/30 sorts on Investments
o Investments = growth in total assets / total assets

Conclusion of results:
- Size, HML (B/M), OP and Inv are important in explaining stock returns
- We are able to reject the semi-strong form of market efficiency.

The semi-strong form of market efficiency:
Semi-strong form efficiency is a class of EMH (Efficient Market Hypothesis) that implies all
public information is calculated into a stock's current share price, meaning neither
fundamental nor technical analysis can be used to achieve superior gains. This class of EMH
suggests only information not publicly available can benefit investors seeking to
earn abnormal returns on investments. All other information is accounted for in the stock's
price and no amount of fundamental or technical analysis achieves superior returns.


Week 2 – Lecture 2.2

Paper: Jegadeesh & Titman – Returns to buying winners and selling losers (1993)

Central question:
- Are past returns related to future/expected returns?

Information on momentum:
- Very short run (weeks / 1 month): mean reversion
- Short run (3 months / year): momentum
- Long run (3-5 years): mean reversion

Choosing the periods:
- Lookback period: how many past returns to include?
- Holding period: how many periods do you keep the portfolio?

Jegadeesh & Titman look at the short run (momentum:
- Lookback period between J = 1 to 4 quarters
- Holding period between K = 1 to 4 quarters

Procedure:
1. Calculate the returns of ALL stocks over the past J quarters 

2. Rank the stocks ascending based on their past returns 

3. Create 10 deciles 

4. Buy the winner decile, sell the loser decile 

5. Calculate returns in next month 

6. Repeat steps 1 to 5 each months

Reading the results:
- The J’s are the lookback periods
- Horizontally is the holding period
- The sell is the portfolio of losers
- The buy is the portfolio of winners
- The buy-sell is winners-losers (most important one)

Why would we be more interested in the buy-sell then sell or buy portfolios?
- Both portfolios have a sort beta, which is sorted out once you go short or long
- It’s a zero cash portfolio, you don’t need capital to hold it.

Observations
- J = 12, K = 3 portfolio gives best result (1.31% per month)
- Almost all combinations of buy-sell portfolios are significant, except for (K=3, J=3)
- Loser portfolios (sell) also have positive returns
o However, they have negative excess returns
o Results are driven by winner portfolios (buy)
o Only positive momentum, not negative

The Beta indicates how much the value of the stock goes up or down relative to the market.
On average, the stock prices increase 6%. A momentum strategy means that you try to
capture (long position) the stocks that increase, and (sell) take a short position in the stocks
that perform less (lower beta). In the long run, this strategy should be fine. However, this
strategy does become problematic once prices go down.


Momentum model:

- MOMt is the factor mimicking portfolio
o Sorting is based on returns from month -12 to -2
o Long in top 30%, short in bottom 30%

Factor investing:
- Investment strategy that aims to harvest factor premia (such as size, B/M,
momentum, etc.)
- Also known as ‘smart beta’

Improving momentum results (after 2008 crash):
- Residual momentum
o Take residuals from three factor model to calculate momentum scores
- Momentum and volume
o High momentum and high volume is a bad sign (overbought)
o High momentum and low volume is a good sign (underreaction)
- Momentum and volatility
o Volatility and correlation adjustments

Overreaction:
- Psychological evidence suggests that people overreact to unexpected new events,
for instance the Brexit results
- Excessive reaction to current information

De Bondt & Thaler (1984) study mean reversion and the momentum strategy:
- Results are consistent with the overreaction hypothesis
o The loser portfolio significantly outperforms the winner portfolio (for
instance Brexit)
- Results are mainly driven by the loser portfolio
o Is this consistent with results being driven by winner portfolio in the previous
paper?
§ No, if the results were consistent, the winners would be very negative
and the loser portfolio would be flat. But we see that winners of the
past 3 years underperform the losers.
- Year one is not significant, the results are mainly driven by the second and third year

There is a pattern:
- The stocks that have gone down in the past, increase now. It has a steep increase in
January, and then continues to increase slightly. This is not a very strong result.


Bias in how investors form expectations:
- Representativeness
o People have the tendency to think that recent outcomes are representative
for the entire distribution.
In finance, an earning pattern is not the expectation that it would continue,
but the earnings surprises will lead to the pattern thinking.
This leads to mean-reversion thinking (returning to an all-time average, the
mean)
- Conservatism
o Conservatism is the tendency to revise beliefs insufficiently when presented
with new evidence.
In finance, if the next earnings outcome is positive, this will lead to a positive
price reaction. If the next earnings outcome is negative, however, there will
be no price reaction.
Conservatism leads to momentum.

The economic intuition behind what causes expected return:
1. Cynical view: Data mining
Statistical result is coincidence, there is no real effect between past returns and
expected returns.
2. Neo-classical view:
Economic risk factor is causing the expected return.
3. Behavioral view:
Investors want to buy stocks for other reason, such as mispricing.

The Neoclassical camp:
- Fama & French (support the risk statement)
Premia associated with factors represent compensation for systematic risk.
- Because the factors (characteristics) are priced, they MUST be measuring risk
(because the market is efficient). In other words, the factor loading is related to
expected returns.

The Behavioral camp:
- Daniel & Titman (support the characteristics/factors statement)
They reject risk model in favor of characteristics model.
- Investors have a preference for certain types of companies. This causes mispricing,
which is unrelated to actual risks. The characteristic (factor) itself is related to
expected returns.

Conclusions:
- The weak form of market efficiency is rejected (it claims that past price movements
and volume data do not affect stock prices)


Week 3 – Lecture 3.1

Notes

Neo-classical vs. Behavioral approach:
- Neo-classical
o Investors are rational
o Markets are efficient
o Normative approach
o ‘How should markets work?’
- Behavioral
o Investors are boundedly rational
o Markets can deviate from efficiency (limits to arbitrage)
o Positive approach
o ‘How do markets actually work, deviation from perfect setting?’

Efficient Market Hypothesis (EMH):
- Definition:
An efficient market is one in which prices are equal to their fundamental value. That
is, all relevant available information is incorporated (and nothing but all relevant
information, no sentiment).

Different forms:
- Strong à all information is included in the price
- Semi-strong à all public information is included in the price
- Weak-form à all past public information

- All deviations from this efficiency, thus in case of inefficiency, the deviations will be
undone by rational arbitrageurs.

Assumptions behind EMH (a lot):
- Rational agents (expected utility and rational expectations)
- Equal and free access to information
- Perfect competition
- Complete markets
- No taxes
- Equal interest for lending and borrowing
- No transaction costs
- Endless liquidity
- Endless short selling
- Infinite divisibility of assets


Definition of arbitrage:
General definition
- The practice of taking advantage of a price difference between two or more markets:
striking a combination of matching deals that capitalize upon the imbalance, the
profit being the difference between the market prices.
- In academics:
An arbitrage is a transaction that involves no negative cash flow at any probabilistic
or temporal state and a positive cash flow in at least one state. In simple terms, it is
the possibility of a risk-free profit after transaction costs. For instance, an arbitrage
is present when there is opportunity

Arbitrage keeps the markets efficient, and therewith is a central concept in EMH.

Paper: Shleifer & Vishny – The limits of arbitrage (1997)

Main concept of the paper:
- Textbook arbitrage is NOT riskless and NOT for free (capital is needed)
- What are the consequences of this?

Example of textbook arbitrage:
- If one stock of company A can be bought in London for 12 euro and in Amsterdam
for 10 euro, an arbitrageur would buy the stock in Amsterdam and sell the stock
(short) in London. In this way, the prices will adjust immediately and the arbitrageur
made profit immediately.

Arbitrage in:
- Theory:
Arbitrage is done by infinite number of small risk-neutral investors and prices adjust
immediately. There is no risk for the investor because the investor is only a small
part of the total portfolio.
- Reality:
Arbitrage is done by a small number of highly specialized institutional investors,
through which prices adjust slower. Now investors need to hold positions for a
longer time, which causes investors to hold market risk (you hold market risk when
you hold stocks for a longer period), so arbitrage is not completely riskless. This gives
rise to risks and costs: arbitrage becomes risk arbitrage.


Three main reasons for limits to arbitrage:
1. Implementation costs
a. Transaction costs: bid/ask spread because of liquidity
b. Capital requirements: short positions cost money, because you need to have
a margin account as collateral
c. Limited liquidity for very big positions
2. Noise trader risk
a. Prices could further diverge from each other in the short run. As a result,
arbitrageurs can make a loss on the short run (e.g. if the stock of company A
increases to 13 in London and decreases to 9 in Amsterdam, the arbitrageur
makes a short run loss).
b. A margin call (asking the investors to deposit more money into the margin
that acts as a collateral in a short position) for a short leg (part of the
investment that holds short positions) costs money.
c. Can be caused by noise traders themselves. Noise traders are irrational
investors and if this group is big enough, then they may reinforce mispricing,
which creates more losses for the arbitrageurs.
d. Short run losses can trigger investors (customers of arbitrageurs) to withdraw
funds from institutional parties (arbitrageurs). Therefore, arbitrage pressure
decreases when mispricing increases (more opportunity for arbitrage).
Performance based arbitrage (PBA): capital is pulled out by investors when
arbitrage companies perform badly.
3. Fundamental risk
a. The market can move against the position of the arbitrageur. For instance, if
BMW is underpriced and Mercedes is correctly priced, the arbitrageur takes a
long position in BMW stocks and a short position in Mercedes stocks (to
hedge the long position). Only taking the BMW long position leaves the
arbitrageur exposed to market risk. This hedge is not perfect, because BMW
and Mercedes are not 100 % correlated, due to idiosyncratic risk (firm-
specific risk/unsystematic risk). Both stocks might change but since they are
not 100% correlated, they will not change in the same proportions. Thus, this
hedge is not a perfect hedge. This implies that the markets are not complete.

Results of limits to arbitrage:
- Prices might not always reflect the fundamental value. This rejects the weak form of
market efficiency.
- EMH is tested as a test for random walk of prices
o Classic approach: there may be non-rational traders active in the market that
cause mispricing, but these will be driven out by rational arbitrageurs
o Behavioral finance answer: other underlying price factors can also be
completely random, such as sentiment, that contribute to mispricing.

Where does arbitrage take place in reality?
- Bond market: for bond the cash flow is known, so more fundamental risks in non-
equity bonds
- Foreign exchange markets: currency triangle, dollar/euro, dollar/yen, euro/yen, all
prices should be equal
Paper: De Long, Shleifer, Summers & Waldman – Noise trader risk in financial markets

Main statement of this paper:
- Noise traders can survive in the long run. This rejects the neo-classical view that
claims that noise traders get driven out of the market by rational arbitrageurs.

Structure of the model:
- Overlapping generations: 2 periods, young and old
- Young people work (labor income), old people consume
- Young people want to invest to increase consumption in the future
- Choose between two different assets:
o Safe asset s, fixed dividend r, perfectly elastic supply (riskless short term
bond)
o Unsafe asset u, fixed dividend r, fixed supply (equity)
- Two types of agents:
o Sophisticated rational agent
o Noise agent (have a bias in expectation rt) – fraction µ in the equation

Model information:
- The expected wealth (E(U)) of noise agents is higher due to the misperception of the
expected price by the noise agents (they are too optimistic).
- Noise agents have more demand for the risky asset u because they are more positive
about the future, so they would take on more risk.

Price solution that takes into account the uncertainty of the noise trader’s misperception

µr∗

- Price pressure effect (+):
0
Represents the increase in price when the fraction noise agents µ increases, or when
the expected price r goes up. In general, the price on average will be higher when
there are more noise traders in the market. The average optimism is higher, then the
equilibrium in the market will also be higher.

- Create space effect (-):

The noise traders increase the risk in the market. The misperception is a stochastic
variable, part of this volatility is translated into prices. Prices will be more volatile
when there are more noise traders. Noise traders create the volatility and thus
increase the risk. The sophisticated traders do not like risk, they are risk averse, and
will therefore buy less of the risky asset (this increase in market risk pushes away
arbitrageurs and take capital out of the market). The noise traders can create space
by removing the sophisticated traders. Therefore, this effect lowers the price (has a
negative effect on the equilibrium). Namely, the risk increases, which lowers the
demand for the risky assets, which lowers the prices.


Return difference:
- Traditionally: noise traders should lose money.
- Here: the difference in returns between noise and sophisticated traders equals the
difference in the demand for the risky asset * the return of the risky asset:

- The expectation of this difference in returns between the agents:

Effects (key of this paper):
- Price pressure effect:
If the noise traders are more optimistic, they will push up prices today and the
return will be lower over time.
- Create space effect:
The higher the volatility, the more the noise traders will drive out risk averse
investors.
- Hold more effect:
The noise traders will hold more risky assets on average, and on average the stock
market will get to a higher return.
- Friedman effect:
Focus on the bad timing of the noise traders. They always buy when prices are high
and sell when prices are low. Noise traders will all buy and sell at the same moment.
This will hurt their return difference.

Return vs Utility:
- Depending on the average misperception, noise traders can have a higher average
return than sophisticated traders.
- The utility of sophisticated traders is by definition higher than the utility of noise
traders. The demand for unsafe assets in the utility maximization creates a bias.
- Extra return does not compensate for extra risk for noise traders, so in the end the
noise traders will have a lower utility.

Imitation of beliefs:
- Choices based on return: µ à 1 (only noise traders because of higher return)
- Choices based on utility: µ à 0 (only sophisticated traders because of higher utility)


Implications for asset pricing:
- Noise traders provide a possible explanation for:
o Excess volatility
Market prices move too much compared to their fundamental value. If this
misperception is translated into prices, prices will become more volatile.
o Mean reversion
Because of the create space effect and the extra risk in the market, it takes
longer for the prices to be reversed to their means.

Conclusion:
- Noise traders can outperform sophisticated traders based on return, and do not get
driven out of the market. This depends on the:
o Hold more effect
o Create space effect
o Price pressure effect
o Friedman effect
- Markets are not as perfect as textbooks assume
o Limits to arbitrage (especially noise trader risk)

Week 3 – Lecture 3.2

Paper: Baker & Wurgler – Investor Sentiment in the Stockmarket

Main concept of the paper:
- Measuring and concretizing the theoretical notion of noise.
- On average, in the DSSW paper, the noise trader effect on asset pricing is:
o Noise traders push up the price level (lower expected return)
o Increase the price variation

Noise and investor sentiment:
- Definition (terms are interchangeable):
The overall attitude of investors toward a particular security or larger financial
market. Market sentiment is the feeling or tone of a market, or its crowd psychology.
Sentiment does not have to be related to news.

Challenges of measuring sentiment:
- Difficult to concretize theoretical construct
- Needs to be a systemic measure
- Should not represent fundamentals (at least not contemporaneously)
- Positive contemporaneous relation with returns:
If sentiment is positive today, priced will go up today.
- Negative relation with return in the next month:
If sentiment is positive today, prices are pushed up a lot today, and there will be a
mean-reversion in the future, so prices have to go down as well.





Suggested measures of sentiment:
- Exogenous
o Surveys: ask people how they feel. A drawback is that you don’t know
whether it is a sentiment or whether it is set by fundamentals
o Investor mood
- Retail investors
o These are seen as noise traders that act on sentiment. An increase in activity
of noise traders indicates that there is more sentiment.
- Market based:
o Dividend premium: if people are moving into stocks that pay dividends, the
people are risk averse.
o Option implied volatility
o IPO returns: IPO returns are usually positive, the more positive they are, the
higher the sign for positive sentiment
- Corporate decisions:
The managers know more about the company than others do, which creates
information asymmetry
o IPO volume
o Equity issues: a sign that a manager inside a company sees that the stock is
overvalued, for instance.
o Insider trading

This paper combines the following set of proxies based on the above measures to see if they
represent investor’s sentiment:
- Closed-end fund discount
- Turnover
- Number of IPO’s
- First-day IPO returns
- Dividend premium
- Equity share

Principal component model:

In the updated model they remove the turnover component because of the high-tradeoff
investors.

The results should not be correlated with the news, since the macro fundamentals are
representative for the news. Baker and Wurgler take out the residuals of the equation
(orthogonal to macro fundamentals, the residuals are not correlated with the macro
fundamentals).


Relation between sentiment and market returns:
- If sentiment is very low in the previous month, then we have positive returns (left
side of the graph)
- If sentiment in the previous month was above average, then we have negative
returns (right side of the graph). This is due to longer term mean reversion of a short
term price increase.

Baker & Wugler mainly focus on cross-sectional differences in sensitivity to sentiment:
- Why are some stocks more sensitive to sentiment than others?
o For instance, small stocks are more sensitive to sentiment than large stocks.

Valuation level (theoretically):
- Low sentiment:
The easy to value and arbitrage stocks are hurt the most (maturity companies).
Some companies are much easier to value than others and thus easier to arbitrage.
- High sentiment:
The speculative and difficult to arbitrage stocks are hurt the most (start-ups or young
companies). Growth companies, like Uber, are more difficult to arbitrage.

Two methods to measure the relation between sentiment and future market returns:
1. In-sample
a. Take all the stocks in the US market
b. Sort stocks on, e.g. volatility over the previous 12 months
c. Create 10 deciles, from low to high volatility and calculate portfolio return
d. Repeat steps a-c for each month
e. Over the full sample, estimate the sentiment adjusted CAPM model for each
decile:
Results show sentiment betas that are consistent with the theory. The save and easy
to arbitrage stocks have negative sentiment beta. Speculative stocks have a high and
positive sentiment beta.







 2. Out-of-sample
a. Take all stocks in the US market
b. Sort stocks on, e.g., volatility over the previous 12 months
c. Create 10 buckets, from low to high volatility
d. Calculate returns in the next month and split up:
i. If sentiment in previous period was >0
ii. If sentiment in previous period was <0
e. Repeat for each month
Results show that the overall black line is downward sloping. In other words, there is
no proper risk return trade-off, in that case it should be upward sloping. Note that
beta only looks at market specific volatility, not to firm specific risk.
A CAPM approach on these results:
Safe stocks have low volatility, and the unsafe stocks have a higher volatility.
Therefore, Fama would say that more risk has to be accompanied with more return.
In this case, the black line should be upward sloping (the riskier stocks are on the
right). However, this is apparently not the case.
Furthermore, high sentiment in the previous month, means that the speculative
stocks (right) went up a lot, but should go down in the next month (which it does in
the graph). Low sentiment in the previous month for speculative stocks, if they went
down in the previous month, have to be compensated in the next month. Vice versa
for the safe-stocks.

Different measures:
- Baker and Wugler show that the results are consistent for all the different measures,
where on the left you have the small company deciles, and the big company deciles
are indicated on the right.
o Size (ME)
o Age: when a company is young, there is little data available, which makes it
hard to determine its value, so it becomes more valuable for sentiment.
o Total risk
o Earnings
o Dividends
o PPE/A

When checking for other factors, it turns out that sentiment is still significant after
controlling for other factors. Therefore, sentiment is a price factor in stock returns.

Sentiment is thus a priced factor in finance, but also in the cross-section of assets. Higher
investments due to sentiment lead to more required capital and more required labor in
companies.







Paper: Bouman & Jacobsen – The Halloween Indicator, sell in May and Go Away

Main concept of this paper:
- Study calendar effects, the persistent forecastability in returns through time that
cannot be explained by economic factors.
o Intra-day effect: because of lunch
o January effect: higher in January
o Holiday effect: market is smaller, less risk absorptive effect
o Monday effect: people are more depressed on this day
- These effect form a direct violation of the weak form of market efficiency.

Anomaly:
- A deviation or departure from the normal or common order, form or rule.

Market Anomaly (or market inefficiency):
- A price and/or rate of return distortion on a financial market that seems to
contradict the efficient market hypothesis.
- Any example where risk return is not explained by risk can be seen as a market
anomaly.
- Types of market anomalies:
o Time-series anomalies (country index or volatility index)
o Cross sectional anomalies (differences in stocks and differences in sensitivity
to anomalies)

Closer look at the paper:
- There is a large difference between winter and summer returns.
- Compares emerging markets with developed countries. Data is significant for many
countries.
- The effect of Sell in May holds up for the long-run, so for countries where there is
more data available.
- Model

o S is a dummy equal to one in the winter (November-April) and switches to -1
from May-October.

Conclusions:
- There is a large difference between winter and summer returns.
- The investment strategy, you buy in fall and sell in spring works.
o This strategy has very low transaction costs
o The standard deviation is lower (than the buy and hold strategy, which is
logical because with the Halloween strategy you hold the risk free portfolio
for half of the period)
o Significant for most countries, even after adjustment for the January effect
o 60 percent of years’ winter returns are better than summer returns.
o Less risk (lower volatility) and higher returns means that there is no
compensation for risk
- The Halloween strategy is better than the Buy and Hold strategy.
Week 4 – Lecture 4.1

Notes

Remember:
- VNM expected utility theory
o Possible outcomes are given a utility value
o Possible outcomes are weighted by their probability
- Mean-variance utility (first and second moment utility)
o Conditional on wealth
o Agents are risk averse

Prospect theory:
- Utility is defined over gains and losses
- Risk aversion over gains
- Risk seeking over losses
- Loss aversion

Paper: Barberis et. al – Prospect theory and stock returns: an empirical test

Main purpose:
- In this paper, the authors derive predictions for the cross-section of stock returns of
a simple prospect theory based model and test these predictions in both US and
international data.
- Capture the effect of prospect theory on asset prices at market level.

Expected utility theory:
- Issue of probability transformation
y axis = perceived probability, low probabilities are
overvalued, low probability feels as a higher probability.
x axis = real probability

The way investors with PT preferences represent a stock in
their minds:
- The distribution of the stock’s past return
o Monthly returns over the past 5 years
o Returns in excess of market return
o Easily accessible proxy for the distribution of the
stock’s future returns

TK, the prospect theory value of a stock’s distribution:
- High TK stocks:
o Receive a high weight in PT investor portfolio, which pushes up the price and
lowers expected return
- Low TK stocks:
o Receive a lower weight in PT investor, which pushes down the prices and
increases the expected returns.
Data:
- All stocks in the US from 1926 to 2010 with at least 5 years of monthly data available
- Calculate TK for each stock and sort into deciles
- Rebalance for each month
- This creates 10 time-series of monthly TK portfolios

Methods:
- Alphas of long-short portfolios
o For 10 deciles on different performance masures
o From left to right à performance decreases
o Also EW (equal weighted) and VW (value weighted) separated, the effect
drops for VW
- Fama-MacBeth
o TK is negative and significant even after controlling for other variables.

The effects of limits to arbitrage:
- TK is stronger for small, illiquid, high volatility, low institutional holding stocks

Conclusion:
- Prospect theory offers an interesting alternative to the expected utility theory
o Utility is conditional on a reference point
o Prospect theory focuses on the difference between gains and losses
- However, prospect theory still only depends on mean (first moment) and variance
(second moment).

Paper: Harvey & Siddique – Conditional skewness in asset pricing tests

Mean variance set-up:
- Investors have preferences over mean and the variance of portfolio returns. The
systematic risk of a security is measured as the contribution to the variance of a well-
diversified portfolio. However, there is considerable evidence that the unconditional
returns distributions cannot be adequately characterized by mean and variance
alone. Therefore, we focus on the next moment – skewness.

Skewness:
- Investor should prefer portfolios that are right-skewed (kurtosis left) to portfolios
that are left skewed (kurtosis right), ceteris paribus. This is consistent with risk
aversion. Hence, assets that decrease a portfolio’s skewness (i.e., that make the
portfolio returns more left skewed) are less desirable and should command higher
expected returns. Similarly, assets that increase a portfolio’s skewness should have
lower expected returns.






This paper presents:
- An asset pricing model where skewness is priced. In this asset pricing model,
conditional skewness is incorporated to help understand the cross-sectional
variation in several sets of assets returns. Conditional skewness also captures
asymmetry in risk, especially downside risk, as opposed to unconditional skewness.
- Focus on monthly US equity returns.
- Forming portfolios of equities on criteria
o Industry
o Size
o B/M
o Coskewness (skewness related to the market portfolio skewness)
o Momentum (both monthly and longer holding periods)
o Individual equity return

Goal of analysis:
- The ability of conditional coskewnewss to explain the cross-sectional variation of
asset returns in comparison with other factors.

Findings:
- Coskewness can explain some of the apparent nonsystematic components in cross-
sectional variation in expected returns even for portfolios where previous studies
have been unsuccessful.
- Intuition: if investors know that the asset returns have conditional coskewness at
time t, expected returns should include a component attributable to conditional
coskewness. This is incorporated in the asset pricing model of the authors, by
incorporating measures of conditional coskewness.
- The authors estimate their model for several sets of equity returns, both individually
as well as jointly, using portfolios formed using different criteria.
- Incorporating coskewness is helpful in explaining the cross-sectional variation of
equity returns.
- Momentum effect is related to systematic skewness.

Motivation to use skewness:
- Cross-sectional tests of the single factor asset pricing model have shown that
systematic risk as measured by the covariance (or the beta) with the market and
other factors does not satisfactorily explain the cross-sectional variation in expected
excess returns.

Slide notes

Coskewness/systematic skewness:
- How much skewness does asset I add to a portfolio’s skewness (this is coskewness)?
o Compare to covariance: How much variance does asset I add to a portfolio’s
variance?
- Negative coskewness means that a stock adds negative skewness to a portfolio
o Such a stock should have a higher expected return

Tests:
- Calculate the coskewness of all stocks over the past 60 moths
o Rank stock on their coskewness from low to high
o Create long-short portfolios with top S+/bottom S- 30%
o Calculate returns for month 61
- If the asset pricing model is correct, no return should be left unexplained
- In the regression

- If there is still some alpha left, this means that part of the average return is not
explained by the market SMB and/or HML.
- If we observe that the alpha gets closer to zero, then the skewness term is adding to
the explanation power of the model.

F-test for three factor:
- Jointly these alphas are not equal to zero, so the test is rejected. It tests the joint
significance of all alphas.

F-test for four factors:
- At a 10% confidence interval, the H0 of zero alpha is accepted. Results show that
skewness is often explaining the result.

Skewness versus Fama-MacBeth:
1. First step: compare R-squares of both asset pricing models
a. R-squared is always higher when skewness is included
b. It also shows that it is something different than size and book/market
2. Second step:
a. Skewness switches signs
b. Skewness is important, but only for young companies (the authors don’t
know why). Potential reason could be the lack of information.

Skewness and momentum
- They have winner (1) and loser portfolios (10)
- The volatility is lower for the winner portfolio, which does not explain the
momentum effect.
- The winner portfolio has a much lower skewness than the loser portfolio. Maybe this
is driven by the skewness preferences of the investors.

Kurtosis:
- The loser portfolio has a much higher kurtosis than the winner portfolios. Maybe this
is an indication that people prefer lower kurtosis over higher kurtosis. With higher
kurtosis you lose more often but gain more when you gain, as compared to lower
kurtosis.

Mean-variance is very convenient, not enough to describe investor’s preferences (PT+skew)
Week 4 – Lecture 4.2

Notes

Fintech in asset pricing:
- Organization of markets
o From physical markets to markets on a server. There are no graphical
limitations nowadays
o Buy and sell orders are no longer performed by human beings
o You don’t have to call your broker anymore for an order
- Electronic trading
- Intermediation
o Block chain is used to register who owns which stock. This is much safer.

Market microstructure:
- The study of the process and outcomes of exchanging assets under explicit trading
rules. While much of economics abstracts from the mechanisms of trading,
microstructure literature analyzes how specific trading mechanisms affect the price
formation process (how trading affect prices).
- The mechanism that creates the price has effect on the ultimate price.

Market structure and design:
- The relationship between price determination and trading rules. How market
structure affects trading costs, and whether one structure is more efficient than
another. Market microstructure relate the behavior of market participants.

Price formation and discovery:
- The process by which the price of an asset is determined.
The speed of the formation depends on the market structure.

Transaction cost and timing cost:
- Transaction cost and timing cost and the impact of transaction cost on investment
returns and execution methods.
How much does it cost to buy or sell an asset, and how much time does it take?

Information and disclosure:
- Market information and transparency, and the impact of the information on the
behavior of the market participants.
How much do you know about the other participants in the market, and how much
does it affect the price?


Types of markets:
- Order-driven market: direct interaction between traders, no intermediaries
o Buy and sell orders are matched directly, without intermediaries
o Incoming liquidity from constant flow of orders from market participants
§ The amount of liquidity depends on the number people are trading at
that moment, if no one wants to buy then there is no liquidity.
o There are no market makers, only brokers (but do not take a position):
§ The dealers are the market makers, they do take a position
o Market order vs limit order
§ Market order: ‘I want 10 shares for the best ask price’ - you are
certain about the timing but not about the price.
§ Limit order: you want a certain amount of stocks given a price
constraint, you don’t know when the trade will be executed.

- Quote-driven market: intermediated trade
There is a market maker who clears the market on basis of bid and asks. The market
makers guarantee liquidity and are exposed to risk.
o Trades are based on prices quoted by designated liquidity suppliers (the
intermediaries: market maker, or dealer)
o Monopoly on trading and market making
§ Traders need to deal with the market maker
§ Limit orders (price constraint) are not possible
§ Market makers have obligation to quote prices
§ Market makers guarantee liquidity
§ Market makers trade on own account, take positions
o The market maker:
§ Benefits: bid-ask spread
This is the source of income of the market maker. Profits come from
the difference of sell and buy price.
§ Costs:
• Order processing
1. Physical cost of orders: computers
2. Risk exposure towards stocks inventory
3. Seller or buyer who knows more than you could result in
selling or buying for the wrong price
These three factors can contribute to the bid-ask spread
o Determinants of the bid-ask spread:
§ Volume (-)
§ Risk (+)
§ Firm size (+), (-) for smaller firms because it’s more difficult to value
them due to possible information asymmetry
§ Institutional holdings (+), also a more likely characterstics for maturity
firms
- Hybrid-combination:
In reality, all markets are hybrid markets.


Comparison of order & quote-driven markets:
- Pro order-driven markets:
o It is cheaper (there is a tighter bid-ask spread)
o It is a more transparent market
- Pro quote-driven markets:
o Liquidity is guaranteed (by market makers, intermediaries)
o It is more expensive (wider bid-ask spread)
o It is a less transparent market

Results of technological advancement:
- Fragmented markets
o No longer 1 place to buy/sell stocks
o Increased competition for order flow
§ This has an impact on prices: lower bid-ask spread
- Dark Pools:
o You can buy and sell your stocks, usually owned by big investment banks.
Some market parties may not want to show their positions, in this case
investment strategies cannot be copied.
o Have private exchanges or forums for trading securities, which are only
accessible for members.

High frequency trading (HFT):
- Technological advancement from the side of the trader:
o Algorithmic trading
§ Computer code is doing the buy and sell orders
o High frequency trading
- HFT’s:
o Firms using investor capital to trade for their own account using
algorithms/high-frequency strategies.
- Automated trading in ultra-high frequency (in milliseconds)
o Approximately 70% of current trade is HFT
- What type of strategies?
o Liquidity making strategies
§ Market making
o Liquidity taking strategies
§ Fake quotes to manipulate prices. Fool other investors by putting a lot
of orders on one side to push the best bid further down, which makes
it look like there is potential demand. They put the orders in to
manipulate the prices
§ Arbitrage
• Between trading venues
• Events
§ Ticker tape trading: investing based on data they have about volumes,
etc.
§ News based trading


Is HFT good or bad?
- What are the effects on market quality (liquidity, costs, volatility and price
discovery)?
o Academia are predominantly positive about HFT
o Main issue: uncertainty whether HFT’s take advantage of slow traders

Flash crashes:
- Extremely large price swings within one day
- No clear fundamental reason
- Possible explanations:
o Fat finger problem (an order to buy or sell is placed far greater than intended
for the wrong stock or contract for the wrong price; input errors)
o Technical issues
o Correlated HFT trading

Paper: Madhavan – Exchange- traded funds, market structure and the Flash Crash

Madhaven studies the relationship between fragmentation and the flash crash (of May 6):
- All exchange-traded equity instruments
- Calculate price decline during flash crash
- Calculate fragmentation per instrument (by use of Herfindahl index: market share
for top k exchanges)
o Higher Herfindahl index results in a higher concentration of the stock market.
A more concentrated stock market reacts less to a flash crash. So, a low
Herfindahl index means that fragmentation is high and reaction is high.
- Look at relation between max drawdown and fragmentation, controlling for stuff.

Findings:
- Fragmentation is highest during flash crash (lower Herfindahl)
- High frequency trading activity is also highest during flash crash (higher ISO)


Week 5 – Lecture 5.1

Notes

Asset pricing with frictions:
- In frictionless markets, securities with the same cash flow profiles need to have the
same price
- For no arbitrage to apply, you need to be able to trade at no cost
- If there are trading frictions, such as illiquidity in the market or a constraint on short-
selling, then it is not necessarily the case that securities with the same cash flow
have the same price
- Conclusion: frictionless market à equal prices of securities; friction à prices may
differ; no arbitrage à no trading cost

Definitions of liquidity:
1. Affecting price
The ability to convert an asset to cash or vice versa without affecting the price.
(selling an asset à getting cash, buying an asset à paying cash; if these transactions
don’t affect the price à liquidity)
2. Time
The ability to convert an asset to cash or vice versa quickly (time)
a. Time component: how fast can you convert cash?
Very large transactions may take more time, the first and second definitions
are related to each other. A big order in one go goes fast but drives down the
price (remember that the transaction may not affect the price in case of
liquidity).
3. Cost
The cost of converting an asset to cash or vice versa.

Sources of illiquidity
1. Exogenous trading cost
a. Think of a broker or exchange commissions. Fee for setting up a trading
system.
2. Private information:
a. If there is a possibility of trading against an informed trader, the bid-ask
spread will be higher and the market maker (intermediary with more
information) will require a compensation in the form of bid-ask spread
(adverse selection).
3. Search costs
a. Especially in OTC (underdeveloped) markets, finding a counterparty may
require time, which is costly because of the uncertainty on the price at which
the trade is executed.
4. Inventory risk for the market maker
a. Market makers intermediate between sellers and buyers and needs to carry
inventory. The intermediary bears a risk that fundamentals change in the
meantime. The bid-ask spread that the market maker offers compensates the
market-maker for the inventory risk due to change in fundamentals.
Measuring liquidity (is hard):
1. Cost dimension
The bid-ask spread as a fraction (percentage) of the price
2. Price impact dimension
Amihud’s ratio, focuses on the price impact. It is a measure of illiquidity, and looks at
the absolute return divided by volume. A very liquid stock has a high volume and
very small change in price, thus a very low Amihud ratio.
3. Speed dimension
The fraction of time with zero returns

Paper: Pastor & Stambaugh – Liquidity risk and expected stock returns
Neoclassical paper

Research question of this paper:
- Do investors demand extra return for bearing liquidity?
o In other words, testing whether illiquidity is priced
o Why should it be priced?
§ You want to be compensated as an investor for running liquidity risk
- Is the sensitivity of a stock to market wide liquidity priced?
o Stock market wide liquidity: average liquidity of the stocks in the market (this
is what the paper focuses on)

Positive relation between liquidity and welfare:
- Liquidity is low when investors need to sell to raise cash
o Liquidity is a risk factor
- Intuition:
o When markets are positive, liquidity is high. The opposite is true for bad
markets, because in a bad market nobody wants to buy the stocks.

Market liquidity – measuring liquidity by Pastor and Stambaugh
- Market level liquidity per month as the average stock level liquidity.
The liquidity of the market is determined by the average liquidity of the stocks.

- Return reversal following a particular volume is negatively related to liquidity – price
impact.
Buyers today push op the price of a stock until it is higher than its fundamental price,
which has a negative effect on the stock price of tomorrow because the price
reverses.

- Using daily data within each month estimate
Negative news returns, for instance, and a high volume will result in positive returns
tomorrow.

Model – measuring liquidity by Paston and Stambaugh:
- g = the estimated coefficient and measure of liquidity
- If a certain amount of volume X return caused a price impact on day 0, then it has to
be reversed on day 1.
- For each month and for each stock a g is obtained.
- If the stock is not perfectly liquid à stock return is negative à the stock’s sell
volume pushes the price up too much à which should be followed by a reversal in
the next period. Illiquidity of a stock pushes up the price but is reversed the day after
- Expect g to be negative and larger for more liquid stocks.

Findings:
- On average, liquidity of stocks follows a pattern of mean reversion.
- During crises, too many people are selling than that the market can handle, which
causes a short term disruption, but the level of liquidity reverses back to the mean in
the next periods.

Is liquidity a priced factor? - methods
1. Time-series 5 factor model Fama-MacBeth
Fama-MacBeth using liquidity beta’s
a. Compare with RMRF
2. They create decile portfolios based on liquidity forecast beta
a. 10 portfolios
b. Redo every year
3. Estimate four factor model on post-formation portfolios
a. To check if liquidity is priced, they go back to the four factor model, as
opposed to step one above.

Is liquidity a priced factor? – procedure
- For each month, estimate the time-series regression model
o It uses forecast betas rather than only taking betas

- Other papers assumed that beta would stay constant. Here: Beta it forecasts the
liquidity beta of the next period
- At the end of each day, sort stocks on their forecasted liquidity beta. This forecasts
the exposure of the stock in the next period.
- Form 10 portfolios, calculate the postformation returns, and estimate four-factor
model on post-ranking portfolios

Results on forecasting regression:
- If the company has a high company beta, it remains high
o Historical beta is important, the details are not
- More volume means a higher liquidity beta


Properties of the decile portfolios:
- Results table:
o Shows the estimated liquidity betas, and the liquidity betas increase with the
deciles, which confirms the theory
o The right portfolios include large stocks with a high liquidity beta
o The left portfolios include small stocks with a low liquidity beta
- The left portfolios are significantly negative, and the right portfolios are significantly
positive
- Market cap is also increasing: large stocks with high liquidity beta (right portfolios)
have more exposure to market wide liquidity than small stocks with low liquidity
beta.
o High market cap à high liquidity beta
o Small stocks have a lower liquidity than large stocks, but small stocks have a
lower exposure to the liquidity factor (= something different than liquidity)
- When there is a crisis situation, smaller portfolios gain a bit. Large asset managers
will al start selling their stocks, which are all focusing on big stocks. As a result,
these large stocks become more sensitive to liquidity exposure.
- MKT Beta: size of the stock is related with the market exposure (positive relation)
- MOM (momentum): the difference (10-1) is positive and significant. Apparently
there is a relation: the size of the stock is related to momentum (positive relation)

Liquidity beta and alpha:
- After controlling for size of the FF alpha, the effect is still there
- The 10-1 decile portfolio has significantly high results in all three rows
- The four-factor alpha model is showing a difference of 7.5% between low liquidity (1
portfolio) and high liquidity risk (10 portfolio)

Most important result: liquidity appears to be priced!
Because: stocks with higher liquidity beta offer a higher alpha (constant return)

If there is any alpha left, beta does not account for all the risk.

There is a large correlation between liquidity (LIQ) and momentum (MOM). They conclude
that liquidity can explain the MOM from a purely rational view. You can see this in the
results by comparing the MOM weight (20.85%) when liquidity factor (LIQ) is not included in
the model with the situation wherein MOM and LIQ are both included in the model, here
the momentum weight (MOM) is 6.47.

Therefore: the liquidity premium explains part of the momentum effect.


Paper: Brunnermeier & Pedersen – Market liquidity and funding liquidity

Market liquidity:
- How easy is an asset traded (how fast/cheap and does it have impact on the market
price)?

Funding liquidity:
- How easy can traders obtain funding to trade?
o Trading requires capital, and the main issue is margin.

Margin
- Cannot exceed a trader’s capital
- Collateral that the holder of a financial instrument has to deposit to cover some or
all of the credit risk of their counterparty

Three situations of margin:
1. Buying on collateral:
When you borrow money to buy a stock (third party is included)
2. Derivative contracts
3. Short selling:
You sell something you don’t own. When you go short the potential loss is infinite

Focus of this paper:
- Studies the interaction between funding liquidity (=margin) and market liquidity.

Underlying idea:
- There is a circular relation between market and funding liquidity
o If funding liquidity is tight:
§ Investors will be reluctant to take positions
§ There will be lower market liquidity as less people are active in the
stock market
§ The funding institutions will increase their margin requirements,
which will tighten the funding liquidity


The five main results of the paper:
1. Margins can increase illiquidity
Margins can increase illiquidity when the source of fluctuations is unclear.
Destabilizing margins force speculators to de-lever in crisis.
-
2. As long as capital is abundant, liquidity is insensitive to changes in margins. OR:
when speculators hit capital constraints, reduce positions and liquidity declines
This reinforces itself, because the only way then to get cash is to sell stocks. But if
everybody is selling stocks at the same time, market liquidity declines even further.
Loss spiral
-
3. The ratio of illiquidity to margin is the same across all assets
If the banks will change the margin requirements, this will affect all stocks. There will
be both commonality of liquidity and market liquidity correlated across all stocks.
4. Market liquidity declines as fundamental volatility increases
If the actual underlying value becomes more uncertain, then the capital providers
will become more uncertain and will increase the margins.
5. (main result) The risk that funding constraints become binding, limits provision of
market liquidity
The funding constraints become binding when investors do not have enough capital
available. The capital providers know that we might end up in a bad economic
situation, and therefore increase their margins. If constraints hit, it’s more difficult
to get money, so you start selling stocks (Loss Spiral). You have to come up with
buffers.

Main conclusions:
- Funding liquidity can affect market liquidity and vice versa

Week 5 – Lecture 5.2

Notes

Definitions:
- Short selling:
o Short selling is the practice of selling securities or other financial instruments
that are not currently owned and subsequently repurchasing them.
- Naked short selling:
o The practice of short-selling a tradable asset of any kind without first
borrowing the security or ensuring that the security can be borrowed
(There is no actual exchange of asset, only an agreement to look at the price
on a specific date)


Effect of short selling bans on the market:
- Liquidity: ambiguous
o Increase bid-ask spread due to uncertainty about fundamentals
o Reduces bid-ask spread due to less informed traders in the market, reduced
adverse selection
o You need more stocks in inventory when there are short sellers, which
increases the spreads
- Speed of price discovery: goes down
o Negative information is impounded slower
- Overpricing: ambiguous
o More positive people in the market
o Everyone is aware that there are more positive investors and the price is
compensated
o More uncertainty about underlying value of stock à more risk averse
investors à underpricing

Paper: Beber & Pagano – Short-selling bans around the world

Short-sell ban:
- It’s no longer possible to go short in financial stocks. Doing this brings about more
costs than benefit.

Measures:
- Liquidity:
o Bid-ask spread and Amihud measure
- Speed of price discovery
o Correlation of individual stock returns with past market returns
o If price recovery is very fast, then information about the market is directly
imposed and you would find no relation. If price discovery is very slow,
market information from yesterday still needs to be incorporated in prices
today.
- Overpricing
o Excess returns
- Ban dummies
o Naked ban: only naked bans are forbidden
o Covered: both naked and covered bans are forbidden
o Disclosure

Methods:
- Panel regression
o Stock fixed effects
o Time fixed effects
o Volatility control
- Event study
o 50 days before and after ban


Results:
- Naked ban: positive significant, bid ask was wider
- Covered ban: bigger effect than naked ban
o 1.98 means a 2% increase in bid ask spread

Liquidity results:
- blue line > red line
o The stocks subject to the ban were already less liquid, authorities were
targeting stocks who already had a hard time
o Black line shows stocks ban affected significant

Liquidity for size, volatility and options result:
- Small stocks are harder affected by the ban
o High volatility stocks have higher coefficient
- You expect stocks with option market to be less affected, but you can buy put
options instead of going short

Results price discovery:
- Negative news slows down the prices more than positive news decreases the price.
Short-sell bans slow down positive and negative news, but it slows down negative
news more.

Results price support US:
- Only financial stocks were banned
- Stocks with ban end up in 10 percent different price levels

Results price support rest of the world:
- No significant effect of the ban

Conclusion:
- Short selling bans
o Reduce liquidity
o Slow down price discovery
o Do not provide price support outside the US
o Stronger for small caps, high volume and stocks without options


Paper: Hong & Sraer – Speculative betas
Main ingredient:
- Disagreement
o Disagreement + short sale constraints = overpricing
§ Investors with negative expectation cannot express this is trading
§ Their opinion is not incorporated into the market price
§ Investors with positive expectations are overrepresented
§ Prices are too high

Main intuition:
- High beta stocks have a higher exposure to common component of cash flows.
Higher exposure to market factor
- Disagreement about the common factor has larger impact on high beta than on low
beta stocks
o Beta amplifies disagreement.
o High beta have higher disagreement, are more overpriced and have a lower
expected return
- More mutual funds, more people are bounded by overpricing, more overpricing
- Combined with short-sale constraints, this creates overpricing of high beta stocks as
compared to low beta stocks
o This creates a tradeoff between
§ Risk sharing motive (higher beta à higher expected returns)
§ Speculative overpricing (more disagreement à more overpricing à
lower future expected returns)

Setting of the economy:
- Two groups of investors
o Mutual funds
§ Heterogeneous beliefs
§ By law not allowed to go short
o Hedge funds
§ Homogeneous beliefs
§ No short sale constraints

Hypotheses:
- High beta stocks experience more disagreement in months with high aggregate
disagreement
Confirmed: higher beta means more disagreement. The relationship is steeper with
higher disagreement.
- There is an increasing relationship between shorting a beta

Main conclusions:
- CAPM (investors have same expectations) works when there is no disagreement
o The CAPM has an upward sloping SML
o With disagreement, the SML curve is concave
§ Low disagreement months: SML is upward sloping
§ High disagreement months: SML is concave
Week 6 – Lecture 6.1

Notes

How to determine the performance of a mutual fund?
- Benchmarking
o How does a fund perform relative to other funds in the same style?
- Outperformance relative to known risks
o Academic approach:
Smaller alpha in the four factor model means that the model is better in
explaining the factors in the model
High alpha means that the model is outperformed relative to its factor
loadings
Persistent alpha is the goal, this means that you continue to have a certain
alpha over time, not accidentally a high or low alpha
- Performance persistence
o If performance persists, it is easy to choose the fund based on previous
performance

Paper: Carhart – On persistence in mutual fund performance

Carhart studies mutual funds:
- Whether funds have exposure to the four factors
- Whether funds’ (out)performance is persistent, i.e., are certain managers better
than other?
Alpha = investment quality of fund managers

Method:
- Sorts funds on previous year performance (based on returns)
- Forms decile portfolios based on equally weighted returns
- Holds the portoflios for 1 year
- Reform portfolios, etc.
- 10 time-series of returns

Results performance and persistence:
1. Decreasing in decile
2. CAPM is useless for mutual funds, if it worked we should observe high beta in decile
1 and then decreasing until 10
3. All information is captured in the alpha
4. SMB à not much variation, slightly significant
5. HML à negative and significant
6. PR1YR (MOM) à negative significant
7. After controlling for 4 factors, alpha becomes negative for all deciles and none of
them gets a fair return for risk à no added value, underperforming alpha


Conclusion:
- Mutual funds produce positive absolute returns
- But, mutual funds produce negative risk adjusted returns
- So why do we have these funds markets if they produce negative risk returns?

Paper: Sirri & Tufano – Mutual fund flows

Fund performance:
- The investment behavior of the fund manager

Fund flows:
- The investment behavior of the mutual fund investor

Interaction:
- Fund managers want to maximize the size of the fund
o Maximize returns, maximize capital inflow
- What can fund managers do to maximize flows knowing the behaviors of their
investors?

Theoretically:
- Pick a mutual fund with the highest expected future performance (alpha, e.g.)
- Can individual investors earn excess returns by actively selecting mutual funds?
o Costly search: it is costly to search for the best mutual fund given the huge
supply
o Only access to historical information of funds

Carhart says:
- Bad performance is persistent, good performance is not.

Findings say:
- Exactly the opposite
- Managers get a higher fee if they have a larger fund, which incentivizes them to
increase risk of the fund. In case of bad luck there will not be outflow, and in case of
good luck, there will be large inflows. In other words, there is no downside risk, but a
big upside risk.
- The top performers attract a lot of money (convex relationship)

Conclusion:
- Mutual fund investor chase returns
- Unclear if they should do this
o Indirectly, though, given the lack of performance persistence investors should
not do this


Paper: Berk – Active versus passive management

Active versus passive management:
- Passive: the fund follows the benchmark as close as possible
o Tracking error as performance measure
- Active: the fund tries to outperform the benchmark as much as possible
o Alpha as performance measure

Carhart indicates:
- The average fund underperforms
- There is no persistence in outperformance

Then why is the mutual fund industry so large?
- Rational explanations
o Cost of acquiring information (hard to do it yourself)
o Risk sharing and diversification (small portfolios hard to diversify)
o Liquidity (easy to buy and sell)
o Institutional reasons (pensions are usually invested through mutual funds)
o Berk and Green argument
1. Return measures managerial skill
2. The average manager lacks skill
3. Skill implies persistence
4. Investors chase past returns
5. Managers do not have performance-based contracts
- Behavioral explanations
o Financial sophistication of retail investors?
§ Mutual funds attract retail investors, you can treat them with
marketing
§ Overly confident in their asset manager
§ Marketing machine of funds
§ Unclarity about fees

Conclusion:
- Delegated asset management:
o Large industry, but the performance is questionable
o Flows do not respond to negative performance
- Returns decrease with size. Small funds can have high returns, but once they get
high inflows and become big, they affect the market themselves so their strategy
does not work anymore.
- All firms will in the end have zero outperformance