Bubbles and Crashes

Question 1

What was Shiller’s (1981) ‘excess volatility’ argument?

Answer 1

That stock prices were far more volatile than the EMH could justify (ie. given fluctuations in dividends, stock prices seem to be overvolatile!)
Thought that if dividends didn’t fluctuate too much then stock prices shouldn’t either!

Question 2

When are crashes justified by the EMH?

Answer 2

If there is ‘drastic’ news (often there isn’t drastic news but crashes happen tf against EMH!)

Question 3

See

Answer 3

panopto 3-9mins

Question 4

2 explanations of overvaluation?

Answer 4

1) calendar anomalies (see prev.)
2) Success of ‘momentum’ strategies: evidence shows that stocks that have done well in past 6 months do better in the next 6 months than those who have done poorly in last 6 months

Question 5

What did schliefer hypothesise? What has been observed

Answer 5

That the price of a share should not be affected by it being moved into or out of an index since FV hasn’t changed

Observed: large scale buying/selling of index funds means prices do change!

Question 6

Explain the Grossman-Stiglitz Paradox?

Answer 6

Idea: there cannot be a perfectly informationally efficient market
Why?
In such a market, prices follow a RW, so no one would have incentive to gather information to produce efficiency tf the market would not be efficient! (or maybe investors are irrational?)

Question 7

Given the evidence against the EMH, a better model might preserve its insights but be a more ‘General Theory’ - might include a behavioral element!

Answer 7

.

Question 8

Why is EMH compatible with small deviations from a RW/anomalies? (2)

Answer 8

Because of transaction costs
Also no reason why all expectations should be the same since investors may these expectations based on the info they have, which varies hugely between them!

Question 9

Explain why the marginal investor is important?

Answer 9

If a rational agent gathers info until MB=MC, since different agents have different cost functions and different levels of information may -> different expectations!

Question 10

See notes

Answer 10

Top of side 2

Question 11

How can Schleifer’s ‘indexing’ result be explained?

Answer 11

With heterogenous preferences

Question 12

Is it possible to explain all anomalies with heterogenous expectations?

Answer 12

Probably not…eg. extreme share overvaluation, momentum effects, bubbles and crashes etc.

Question 13

What are the 3 (possible) alternative states of market?

Answer 13

1) Normal functioning EMH-obeying market (fundamental state) (would explain why tests of EMH often fail to reject it!)
2) Bubble (Bull) market (share price > FV, investors buy to sell to next investor at a higher price)
3) Bear market (when bubbles burst)

Question 14

If, in a bubble market, shares are massively overpriced, why would anyone be holding them?

Answer 14

If any RATIONAL agent were holding them they’d have sold them tf implies they must be being held by irrational agents (ie. noise traders)

Question 15

What do noise traders do?

Answer 15

They don’t buy and sell based on FVs

Question 16

If, in a bubble market, given shares are massively overpriced, why would rational investors not be short-selling?

Answer 16

Is possible that the price may still rise further due to presence of irrational investors! tf share could be further overvalued tf short selling -> losses (short selling v risk, unlimited liability)

Question 17

Can it be rational to participate in a bubble?

Answer 17

YES

Question 18

How are bubbles likely explained?

Answer 18

The interaction between rational and irrational investors (is possible they may be kicked off by a true change in FVs (eg. .com)

Question 19

In a bear market, share prices are falling but the prices are still overvalued. Why might this be?

Answer 19

Non-rational agents continue to hold shares for various other reasons

Question 20

Possible candidates for noise traders?

Answer 20

Index fund managers, fund managers motivated by relative performance etc.

Question 21

What strategy is implied by the EMH?

Answer 21

Buy and Hold strategy; evidence that active investors often trade away from better performing shares

Question 22

What return is predicted by the EMH?

Answer 22

No excess (risk-adjusted) return since RW markets

Question 23

When would an index manager trade?

Answer 23

If they need to rebalance their portfolio bc. overweight in a share

Question 24

What is a common criticism of the EMH and counter argument to this?

Answer 24

It isn’t true because agents aren’t ALL rational

In reality, only need enough rational agents to create EMHs (ie. to buy and sell as over and under valuations occur)