This presentation is about cost-benefit analysis

This presentation is about cost-benefit analysis

1. Fi8000Fi8000
Valuation ofValuation of
Financial AssetsFinancial Assets
Spring Semester 2010Spring Semester 2010
Dr. Isabel TkatchDr. Isabel Tkatch
Assistant Professor of FinanceAssistant Professor of Finance

2. CAPM ReviewCAPM Review
Under strict assumptions, the CAPM results in Under strict assumptions, the CAPM results in a a
prescription for a fair return (price)prescription for a fair return (price)::
The fair expected return on an asset depends only The fair expected return on an asset depends only
on the on the market risk premiummarket risk premium and on the measure and on the measure
of systematic risk of systematic risk betabeta..
Stocks with high betas have higher expected Stocks with high betas have higher expected
return, stock with low betas have lower expected return, stock with low betas have lower expected
return, but there is no compensation for any risk return, but there is no compensation for any risk
factor other than the systematic market risk (beta).factor other than the systematic market risk (beta).

3. CAPM CritiqueCAPM Critique
☺Roll (1977) points out that the CAPM is not Roll (1977) points out that the CAPM is not
directly testabledirectly testable
☺
It is a one period modelIt is a one period model
☺
The market portfolio cannot be identified empiricallyThe market portfolio cannot be identified empirically
☺
To test the model, we need the market portfolio to be on To test the model, we need the market portfolio to be on
the “efficient frontier” (proxies won’t work)the “efficient frontier” (proxies won’t work)
☺Indirect tests fail to support the CAPMIndirect tests fail to support the CAPM
☺
Other risk factors are priced (firm size, book-to-market Other risk factors are priced (firm size, book-to-market
ratio), but there is no theoretical (economic) explanation ratio), but there is no theoretical (economic) explanation
for these risk factors.for these risk factors.

4. Market Efficiency - OverviewMarket Efficiency - Overview
☺Efficient market:Efficient market:
Returns are fair / normal = The market is in equilibriumReturns are fair / normal = The market is in equilibrium
☺Key Insight:Key Insight:
We can test whether returns are fair / normalWe can test whether returns are fair / normal
only within the context of (assuming)only within the context of (assuming)
a specific asset pricing modela specific asset pricing model
We can test the asset pricing modelWe can test the asset pricing model
only within the context of (assuming)only within the context of (assuming)
a market that is in equilibrium / efficienta market that is in equilibrium / efficient

5. Normal and Abnormal ReturnsNormal and Abnormal Returns
☺Normal returns: Normal returns:
Fair or equilibrium returns given by a Fair or equilibrium returns given by a
theoretical asset pricing model like the CAPMtheoretical asset pricing model like the CAPM
☺Abnormal returns:Abnormal returns:
Returns that are systematically higher (or Returns that are systematically higher (or
lower) than the normal returnslower) than the normal returns

6. Normal and Abnormal ReturnsNormal and Abnormal Returns
☺For each asset For each asset ii the CAPM predicts a fair / normal, risk- the CAPM predicts a fair / normal, risk-
adjusted rate of return:adjusted rate of return:
E(RE(R
ii) = rf + ) = rf + ββ
ii [ E(R [ E(R
mm) – rf ]) – rf ]
☺We observe asset We observe asset ii over time over time tt, and compare the , and compare the
realized returnrealized return R R
itit to the to the model (CAPM) returnmodel (CAPM) return::
αα
itit = R = R
itit – E(R – E(R
ii) = R) = R
itit – { rf + – { rf + ββ
ii [ E(R [ E(R
mtmt) – rf ] }) – rf ] }
☺If the If the realized returnrealized return of asset of asset ii is is systematically higher systematically higher
than the than the model (CAPM) returnmodel (CAPM) return, we say that the return of , we say that the return of
asset asset ii is abnormal. is abnormal.
Abnormal return: Average[ Abnormal return: Average[ αα
it it ] = [] = [αα
i1i1 + + αα
i2i2 +…+ +…+ αα
iTiT] / T >] / T > 0 0

7. The Efficient Market HypothesisThe Efficient Market Hypothesis
☺Three forms of efficiency:Three forms of efficiency:
☺
Weak form market efficiencyWeak form market efficiency
☺
Semi-Strong form market efficiencySemi-Strong form market efficiency
☺
Strong form market efficiencyStrong form market efficiency
☺Note that the EMH is a HypothesisNote that the EMH is a Hypothesis
☺
We should look for evidence that reject the hypothesisWe should look for evidence that reject the hypothesis
☺
We should look for evidence to decide which form of We should look for evidence to decide which form of
EMH is more likelyEMH is more likely

8. Weak Form EfficiencyWeak Form Efficiency
☺Definition: Definition:
A market is A market is weakweak form efficient if the current form efficient if the current
asset prices reflect all asset prices reflect all historical price historical price
informationinformation
☺Implication:Implication:
Trading strategies based on the analysis of Trading strategies based on the analysis of
historical prices should not yield abnormal historical prices should not yield abnormal
returns (on average!)returns (on average!)

9. Semi-Strong Form EfficiencySemi-Strong Form Efficiency
☺Definition: Definition:
A market is A market is semi-strongsemi-strong form efficient if the form efficient if the
current asset price reflects all current asset price reflects all publicly available publicly available
informationinformation
☺Implication:Implication:
Trading strategies based on the analysis of Trading strategies based on the analysis of
publicly available information (fundamental publicly available information (fundamental
analysis such as analyst reports) should not analysis such as analyst reports) should not
yield abnormal returns (on average!)yield abnormal returns (on average!)

10. Strong Form EfficiencyStrong Form Efficiency
☺Definition: Definition:
A market is A market is strongstrong form efficient if the current form efficient if the current
asset price reflects asset price reflects all information (including all information (including
private / insider informationprivate / insider information))
☺Implication:Implication:
There is no (legal) trading strategy that yields There is no (legal) trading strategy that yields
abnormal returns (on average!). One cannot abnormal returns (on average!). One cannot
make money even by following the trades of make money even by following the trades of
informed insiders.informed insiders.

11. NestingNesting
☺Information: Information:
Information about Information about past prices past prices
is included in the set of is included in the set of publicly availablepublicly available information, which is information, which is
included in the included in the complete set of informationcomplete set of information..
☺Market efficiency:Market efficiency:
The The strongstrong form of market efficiency implies form of market efficiency implies
the the semi-strongsemi-strong, which implies , which implies
the the weakweak form. form.
Note that the Note that the strongest form strongest form of the EMH is the of the EMH is the strongest and strongest and
the most restricting efficiency assumptionthe most restricting efficiency assumption: the complete set of : the complete set of
information is included in the prices.information is included in the prices.

12. Evidence of Weak Form EMHEvidence of Weak Form EMH
☺Consistent evidence: Consistent evidence:
Technical trading rules, based on past price Technical trading rules, based on past price
patterns, do not appear to be profitable.patterns, do not appear to be profitable.
☺Contradicting evidence:Contradicting evidence:
The “January” effect – almost every January, The “January” effect – almost every January,
stock returns (usually for small firms) are stock returns (usually for small firms) are
positive.positive.

13. Evidence ofEvidence of
Semi-Strong Form EMHSemi-Strong Form EMH
☺Consistent evidence: Consistent evidence:
New publicly available information (such as earnings New publicly available information (such as earnings
release) affects prices quickly.release) affects prices quickly.
☺Contradicting evidence:Contradicting evidence:
Small firms and firms with high ratio of book-value to Small firms and firms with high ratio of book-value to
market-value have, on average, higher returns.market-value have, on average, higher returns.
Some portfolio managers consistently outperform the Some portfolio managers consistently outperform the
market (Peter Lynch, Warren Buffet, John Templeton market (Peter Lynch, Warren Buffet, John Templeton
and John Neff are in Paul Samuelson’s hall of fame, and John Neff are in Paul Samuelson’s hall of fame,
1989).1989).

14. Evidence of Strong Form EMHEvidence of Strong Form EMH
☺Consistent evidence: Consistent evidence:
Insiders of corporations appear able to earn abnormal Insiders of corporations appear able to earn abnormal
returns from their trades. On average, price increases returns from their trades. On average, price increases
just after insiders purchase the stock and decreases just after insiders purchase the stock and decreases
just after a they sell the stock.just after a they sell the stock.
☺Contradicting evidence:Contradicting evidence:
Prices react to public information that had been private. Prices react to public information that had been private.
For example, prices react to earning announcements For example, prices react to earning announcements
even though someone must have known their content even though someone must have known their content
before the official announcement day.before the official announcement day.

15. Market Efficiency and EquilibriumMarket Efficiency and Equilibrium
☺An efficient market is a market in (CAPM) An efficient market is a market in (CAPM)
equilibriumequilibrium
☺Inefficient markets occur when asset Inefficient markets occur when asset
prices are different from their equilibrium prices are different from their equilibrium
pricesprices
☺In theory, traders who exploit market In theory, traders who exploit market
inefficiencies should move market prices inefficiencies should move market prices
back to their fair / equilibrium level.back to their fair / equilibrium level.

16. The Joint Hypothesis ProblemThe Joint Hypothesis Problem
☺A test of market efficiency can only be conducted A test of market efficiency can only be conducted
by using a theoretical asset pricing model to define by using a theoretical asset pricing model to define
normal returns (fair prices)normal returns (fair prices)
☺Finding an abnormal average return can be Finding an abnormal average return can be
interpreted in more than one way:interpreted in more than one way:
☺
Reject the Market Efficiency Hypothesis (MEH)Reject the Market Efficiency Hypothesis (MEH)
☺
Reject the theoretical asset pricing model of fair / Reject the theoretical asset pricing model of fair /
normal returnsnormal returns
☺
Reject bothReject both

17. MEH – Are Markets Efficient?MEH – Are Markets Efficient?
☺Grossman and Stigliz (1980): the logical question must Grossman and Stigliz (1980): the logical question must
always be always be to what extentto what extent markets are efficient markets are efficient
☺Empirical evidenceEmpirical evidence
☺Implications for trading strategies?Implications for trading strategies?
☺
Technical analysisTechnical analysis
☺
Fundamental analysisFundamental analysis
☺
Trading on insider informationTrading on insider information
☺Is there a portfolio manager who systematically Is there a portfolio manager who systematically
outperforms the market?outperforms the market?
☺
Is a small abnormal return detectable?Is a small abnormal return detectable?
☺
Will they tell us about their winning strategy (selection bias)?Will they tell us about their winning strategy (selection bias)?
☺
How can we distinguish between luck and talent?How can we distinguish between luck and talent?

18. Economist on Market EfficiencyEconomist on Market Efficiency
Eugene Fama, of the University of Chicago, Eugene Fama, of the University of Chicago,
defined its essence: that defined its essence: that the price of a the price of a
financial asset reflects all available financial asset reflects all available
information that is relevant to its valueinformation that is relevant to its value..
Efficiency and beyondEfficiency and beyond
The Economist, Jul 16th 2009 The Economist, Jul 16th 2009

19. Economist on Market Efficiency Cont.Economist on Market Efficiency Cont.
From that idea powerful conclusions were drawn, not least on From that idea powerful conclusions were drawn, not least on
Wall Street. Wall Street. If the EMH held, then markets would price financial If the EMH held, then markets would price financial
assets broadly correctlyassets broadly correctly. Deviations from equilibrium values . Deviations from equilibrium values
could not last for long. If the price of a share, say, was too low, could not last for long. If the price of a share, say, was too low,
well-informed investors would buy it and make a killing. If it well-informed investors would buy it and make a killing. If it
looked too dear, they could sell or short it and make money that looked too dear, they could sell or short it and make money that
way. It also followed that bubbles could not form—or, at any rate, way. It also followed that bubbles could not form—or, at any rate,
could not last: some wise investor would spot them and pop could not last: some wise investor would spot them and pop
them. them. And trying to beat the market was a fool’s errand for And trying to beat the market was a fool’s errand for
almost everyone. If the information was out there, it was already almost everyone. If the information was out there, it was already
in the price.in the price.

20. Economist on Market Efficiency Cont.Economist on Market Efficiency Cont.
Mr Scholes thinks much of the blame for the recent woe should be Mr Scholes thinks much of the blame for the recent woe should be
pinned not on economists’ theories and models but on those on Wall pinned not on economists’ theories and models but on those on Wall
Street and in the City who pushed them too far in practice.Street and in the City who pushed them too far in practice.
He has also been “criticizing for years” the “value-at-risk” (VAR) He has also been “criticizing for years” the “value-at-risk” (VAR)
models used by institutional investors to work out how much capital models used by institutional investors to work out how much capital
they need to set aside as insurance against losses on risky assets. they need to set aside as insurance against losses on risky assets.
These models mistakenly assume that the volatility of asset prices These models mistakenly assume that the volatility of asset prices
and the correlations between prices are constantand the correlations between prices are constant, says Mr Scholes. , says Mr Scholes.
When, say, two types of asset were assumed to be uncorrelated, When, say, two types of asset were assumed to be uncorrelated,
investors felt able to hold the same capital as a cushion against investors felt able to hold the same capital as a cushion against
losses on both, because they would not lose on both at the same losses on both, because they would not lose on both at the same
time. time. However, as Mr Scholes discovered at LTCM and as the entire However, as Mr Scholes discovered at LTCM and as the entire
finance industry has now learnt for itself, at times of market stress finance industry has now learnt for itself, at times of market stress
assets that normally are uncorrelated can suddenly become highly assets that normally are uncorrelated can suddenly become highly
correlated.correlated. At that point the capital buffer implied by VAR turns out to At that point the capital buffer implied by VAR turns out to
be woefully inadequate.be woefully inadequate.

21. Economist on Market Efficiency Cont.Economist on Market Efficiency Cont.
In 1980 Sanford Grossman and Joseph Stiglitz, another In 1980 Sanford Grossman and Joseph Stiglitz, another
subsequent winner of a Nobel prize, pointed out a paradox. subsequent winner of a Nobel prize, pointed out a paradox.
If prices reflect all information, then there is no gain from If prices reflect all information, then there is no gain from
going to the trouble of gathering it, so no one will. going to the trouble of gathering it, so no one will. A little A little
inefficiency is necessary to give informed investors an inefficiency is necessary to give informed investors an
incentive to drive prices towards efficiency. incentive to drive prices towards efficiency.

22. Economist on Market Efficiency Cont.Economist on Market Efficiency Cont.
However, However, a second branch of financial economics is far more a second branch of financial economics is far more
skeptical about markets’ inherent rationalityskeptical about markets’ inherent rationality. Behavioral . Behavioral
economics, which economics, which applies the insights of psychology to finance,applies the insights of psychology to finance,
has boomed in the past decade.has boomed in the past decade.
Mr Thaler Mr Thaler concedes that in some ways the events of the past concedes that in some ways the events of the past
couple of years have strengthened the EMH. couple of years have strengthened the EMH. The hypothesis has The hypothesis has
two parts, he says: the “no-free-lunch part and the price-is-right two parts, he says: the “no-free-lunch part and the price-is-right
partpart, and if anything the first part has been strengthened as we , and if anything the first part has been strengthened as we
have learned that some investment strategies are riskier than have learned that some investment strategies are riskier than
they look and they look and it really is difficult to beat the market.” The idea it really is difficult to beat the market.” The idea
that the market price is the right price, however, has been badly that the market price is the right price, however, has been badly
dented.dented.

23. Economist on Market Efficiency Cont.Economist on Market Efficiency Cont.
Financial economists also need better theories of why liquid Financial economists also need better theories of why liquid
markets suddenly become illiquid and of how to manage markets suddenly become illiquid and of how to manage
the risk of the risk of “moral hazard”—the danger that the existence of “moral hazard”—the danger that the existence of
government regulation and safety nets encourages market government regulation and safety nets encourages market
participants to take bigger risks than they might otherwise participants to take bigger risks than they might otherwise
have done. have done. The sorry consequences of The sorry consequences of letting Lehman letting Lehman
Brothers fail, which was intended to discourage moral Brothers fail, which was intended to discourage moral
hazardhazard, showed that the middle of a crisis is not the time to , showed that the middle of a crisis is not the time to
get tough. But when is?get tough. But when is?

24. Lucas on the EMH and the CrisisLucas on the EMH and the Crisis
THERE is THERE is widespread disappointment widespread disappointment with with
economists now because we economists now because we did not forecast did not forecast
or prevent the financial crisis or prevent the financial crisis of 2008. … two of 2008. … two
fields, fields, macroeconomicsmacroeconomics and and financial financial
economics economics ……
Robert Lucas, University of ChicagoRobert Lucas, University of Chicago
In defense of the dismal scienceIn defense of the dismal science
The Economist, Aug 6th 2009 The Economist, Aug 6th 2009

25. Lucas on the EMH Cont.Lucas on the EMH Cont.
One thing One thing we are not going to havewe are not going to have, now or ever, is a set of , now or ever, is a set of
models that forecasts sudden falls in the value of financial models that forecasts sudden falls in the value of financial
assetsassets, like the declines that followed the failure of Lehman , like the declines that followed the failure of Lehman
Brothers in September. This is nothing new. It has been known Brothers in September. This is nothing new. It has been known
for more than 40 years and is for more than 40 years and is one of the main implications of one of the main implications of
Eugene Fama’s “efficient-market hypothesis” (EMH), which Eugene Fama’s “efficient-market hypothesis” (EMH), which
states that the price of a financial asset reflects all relevant, states that the price of a financial asset reflects all relevant,
generally available informationgenerally available information. If an economist had a formula . If an economist had a formula
that could reliably forecast crises a week in advance, say, then that could reliably forecast crises a week in advance, say, then
that formula would become part of generally available that formula would become part of generally available
information and prices would fall a week earlier. (information and prices would fall a week earlier. (The term The term
“efficient” as used here “efficient” as used here means that individuals use means that individuals use informationinformation in in
their own private interest. their own private interest. It has nothing to do with socially It has nothing to do with socially
desirable pricingdesirable pricing; people often confuse the two.); people often confuse the two.)

26. Lucas on the EMH Cont.Lucas on the EMH Cont.
Mr Fama tested the predictions of the EMH on the behavior of Mr Fama tested the predictions of the EMH on the behavior of
actual prices. These tests could have come out either way, but actual prices. These tests could have come out either way, but
they came out very favorably. His empirical work … has been they came out very favorably. His empirical work … has been
thoroughly challenged by a flood of criticism which has served thoroughly challenged by a flood of criticism which has served
mainly to confirm the accuracy of the hypothesis. mainly to confirm the accuracy of the hypothesis. Over the years Over the years
exceptions and “anomalies” have been discovered (even tiny exceptions and “anomalies” have been discovered (even tiny
departures are interesting if you are managing enough money)departures are interesting if you are managing enough money)
but for the purposes of macroeconomic analysis and forecasting but for the purposes of macroeconomic analysis and forecasting
these departures are too small to matter. these departures are too small to matter. The main lesson we The main lesson we
should take away from the EMH for policymaking purposes is the should take away from the EMH for policymaking purposes is the
futility of trying to deal with crises and recessions by finding futility of trying to deal with crises and recessions by finding
central bankers and regulators who can identify and puncture central bankers and regulators who can identify and puncture
bubbles. If these people exist, we will not be able to afford them.bubbles. If these people exist, we will not be able to afford them.

27. Krugman: Krugman: How did economists get it so wrong How did economists get it so wrong
(NYTimes Sep 6(NYTimes Sep 6
thth
, 2009), 2009)
Few economists saw our current crisis comingFew economists saw our current crisis coming, but this , but this
predictive failure was the least of the field’s problems. More predictive failure was the least of the field’s problems. More
important was the profession’s blindness to the very possibility of important was the profession’s blindness to the very possibility of
catastrophic failures in a market economy. During the golden catastrophic failures in a market economy. During the golden
years, years, financial economists came to believe that markets were financial economists came to believe that markets were
inherently stable — indeed, that stocks and other assets were inherently stable — indeed, that stocks and other assets were
always priced just right. There was nothing in the prevailing always priced just right. There was nothing in the prevailing
models suggesting the possibility of the kind of collapse that models suggesting the possibility of the kind of collapse that
happened last year. happened last year. Meanwhile, macroeconomists were divided Meanwhile, macroeconomists were divided
in their views. in their views.

28. Krugman Cont.Krugman Cont.
By 1970 or so, however, the study of financial markets … was By 1970 or so, however, the study of financial markets … was
dominated by dominated by the “efficient-market hypothesis,” promulgated by the “efficient-market hypothesis,” promulgated by
Eugene Fama of the University of Chicago, which claims that Eugene Fama of the University of Chicago, which claims that
financial markets price assets precisely at their intrinsic worth financial markets price assets precisely at their intrinsic worth
given all publicly available information. given all publicly available information. (The price of a (The price of a
company’s stock, for example, always accurately reflects the company’s stock, for example, always accurately reflects the
company’s value given the information available on the company’s value given the information available on the
company’s earnings, its business prospects and so on.) And by company’s earnings, its business prospects and so on.) And by
the 1980s, finance economists, notably Michael Jensen of the the 1980s, finance economists, notably Michael Jensen of the
Harvard Business School, were arguing that because financial Harvard Business School, were arguing that because financial
markets always get prices right, the best thing corporate markets always get prices right, the best thing corporate
chieftains can do, not just for themselves but for the sake of the chieftains can do, not just for themselves but for the sake of the
economy, is to maximize their stock prices. economy, is to maximize their stock prices. In other words, In other words,
finance economists believed that we should put the capital finance economists believed that we should put the capital
development of the nation in the hands of what Keynes had development of the nation in the hands of what Keynes had
called a “casino.”called a “casino.”

29. Krugman Cont.Krugman Cont.
To be fair, finance theorists didn’t accept the efficient-market To be fair, finance theorists didn’t accept the efficient-market
hypothesis merely because it was elegant, convenient and hypothesis merely because it was elegant, convenient and
lucrative. They also produced a great deal of statistical evidence, lucrative. They also produced a great deal of statistical evidence,
which at first seemed strongly supportive.which at first seemed strongly supportive. But this evidence was But this evidence was
of an oddly limited form. Finance economists rarely asked the of an oddly limited form. Finance economists rarely asked the
seemingly obvious (though not easily answered) question of seemingly obvious (though not easily answered) question of
whether asset prices made sense given real-world fundamentals whether asset prices made sense given real-world fundamentals
like earnings. Instead, they asked only whether asset prices like earnings. Instead, they asked only whether asset prices
made sense given other asset prices. made sense given other asset prices. Larry Summers, now the Larry Summers, now the
top economic adviser in the Obama administration, once mocked top economic adviser in the Obama administration, once mocked
finance professors with a parable about finance professors with a parable about “ketchup economists” “ketchup economists”
who “have shown that two-quart bottles of ketchup invariably sell who “have shown that two-quart bottles of ketchup invariably sell
for exactly twice as much as one-quart bottles of ketchup,” and for exactly twice as much as one-quart bottles of ketchup,” and
conclude from this that the ketchup market is perfectly efficient.conclude from this that the ketchup market is perfectly efficient.

30. Cochrane’s Response to KrugmanCochrane’s Response to Krugman
(Sep 16th, 2009)(Sep 16th, 2009)
Krugman’s attack has two goals. Krugman’s attack has two goals. First, he thinks financial First, he thinks financial
markets are “inefficient,” fundamentally due to “irrational” markets are “inefficient,” fundamentally due to “irrational”
investors, and thus prey to excessive volatility which needs investors, and thus prey to excessive volatility which needs
government control.government control. Second, he likes the huge “fiscal stimulus” Second, he likes the huge “fiscal stimulus”
provided by multi trillion dollar deficits.
‐
provided by multi trillion dollar deficits.
‐
It’s fun to say we didn’t see the crisis coming, but It’s fun to say we didn’t see the crisis coming, but the central the central
empirical prediction of the efficient markets hypothesis is empirical prediction of the efficient markets hypothesis is
precisely that nobody can tell where markets are goingprecisely that nobody can tell where markets are going – neither – neither
benevolent government bureaucrats, nor crafty hedge fund
‐
benevolent government bureaucrats, nor crafty hedge fund
‐
managers, nor ivory tower academics.
‐
managers, nor ivory tower academics.
‐
Krugman writes as if the volatility of stock prices alone disproves Krugman writes as if the volatility of stock prices alone disproves
market efficiency, and efficient marketers just ignored it all these market efficiency, and efficient marketers just ignored it all these
years. ... years. ... There is nothing about “efficiency” that promises There is nothing about “efficiency” that promises
“stability.” “Stable” growth would in fact be a major violation of “stability.” “Stable” growth would in fact be a major violation of
efficiency.efficiency.

31. Cochrane’s Response Cont.Cochrane’s Response Cont.
In fact, In fact, the great “equity premium puzzle” is that if efficient, stock the great “equity premium puzzle” is that if efficient, stock
markets don’t seem risky markets don’t seem risky enough to deter more people from enough to deter more people from
investing! investing! Gene Fama’s PhD thesis Gene Fama’s PhD thesis was on “fat tails” in stock was on “fat tails” in stock
returns.returns.
It is true and very well documented that It is true and very well documented that asset prices move more asset prices move more
than reasonable expectations of future cashflows. than reasonable expectations of future cashflows. This might be This might be
because people are prey to bursts of irrational optimism and because people are prey to bursts of irrational optimism and
pessimism. pessimism. It might also be It might also be because people’s willingness to take because people’s willingness to take
on risk varies over time, and is lower in bad economic timeson risk varies over time, and is lower in bad economic times. As . As
Gene Fama pointed out in 1970, Gene Fama pointed out in 1970, these are observationally these are observationally
equivalent explanationsequivalent explanations. Unless you are willing to elaborate your . Unless you are willing to elaborate your
theory to the point that it can quantitatively describe theory to the point that it can quantitatively describe how much how much
and when and when risk premiums, or waves of “optimism” and “pessimism,” risk premiums, or waves of “optimism” and “pessimism,”
can vary, you know nothing. No theory is particularly good at that can vary, you know nothing. No theory is particularly good at that
right now.right now.

32. Cochrane’s Response Cont.Cochrane’s Response Cont.
Are markets irrationally exuberant or irrationally depressed? Are markets irrationally exuberant or irrationally depressed?
It’s hard to tell. This difficulty is no surprise. It’s It’s hard to tell. This difficulty is no surprise. It’s the central the central
prediction of free market economics, as crystallized by
‐
prediction of free market economics, as crystallized by
‐
Hayek, that no academic, bureaucrat or regulator will ever Hayek, that no academic, bureaucrat or regulator will ever
be able to fully explain market price movements. Nobody be able to fully explain market price movements. Nobody
knows what “fundamental” value is. knows what “fundamental” value is. If anyone could tell what If anyone could tell what
the price of tomatoes should be, let alone the price of the price of tomatoes should be, let alone the price of
Microsoft stock, communism would have worked.Microsoft stock, communism would have worked.
The case for free markets never was that markets are The case for free markets never was that markets are
perfect. The case for free markets is that government control perfect. The case for free markets is that government control
of markets, especially asset markets, has always been much of markets, especially asset markets, has always been much
worse. worse. ... Careful behavioralists know this, and do not ... Careful behavioralists know this, and do not
quickly run from “the market got it wrong” to “the government quickly run from “the market got it wrong” to “the government
can put it all right.”can put it all right.”

33. Practice ProblemsPractice Problems
BKM 7th Ed. Ch. 11: BKM 7th Ed. Ch. 11:
1-9, 14, 16-18, 25, 27-28;1-9, 14, 16-18, 25, 27-28;
BKM 8th Ed. Ch. 11:BKM 8th Ed. Ch. 11:
1-3, 6-5, 13, 19, 20, 23, CFA: 1-4.1-3, 6-5, 13, 19, 20, 23, CFA: 1-4.