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EFB201 Financial Markets Learning Guide

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Workload Expectations The unit has a two-­‐hour lecture with a one-­‐hour workshop/tutorial each week. QUT Guidelines are that “Eight to 10 hours per unit per week should be spent outside the classroom reading and working on assignments and tutorial tasks.” This unit covers a large amount of material commensurate with the workload expectations described above. The lectures are an integral part of the course materials and will contain spoken or written material that is additional to that in the textbook and set readings. Conversely, not all the set textbook or other readings will be covered in the lectures. In addition, you will be expected to do your own research in respect of particular topics, and this also forms part of the unit materials. All unit material is assessable; in other words, it is not possible to identify unit material that will not be assessed and can be ignored. The weekly workshop/tutorial is not a source of sample exam questions and solutions. The unit has three assessment items, in Weeks 5, 10 and in the central exam period at the end of semester. If you work to expectations throughout the unit you should not need to do much additional work to prepare for the assessment items. Lecture Each lecture will comprise two parts. The first hour will be spent covering the standard story, the accepted theories or the standard textbook descriptions on each weekly topic. This is the foundation of the course and material will be taken from the textbook and other references set out in this learning guide. It will be taught with the aid of overheads but it is expected that you will have prepared by reading the set materials prior to the lecture and it will be presented on this basis. The second hour will be spent on a critical analysis of the weekly topic, beyond or contrary to the standard theory or story. You should expect to develop your own thoughts about this material. This second hour will not typically be taught with overheads but in a free-­‐form and unstructured style. I may use video, articles and other web-­‐based materials. These will be introduced each week and are not in the learning guide, but anything I introduce will be posted on the Blackboard site after the lecture. For this critical analysis the materials I introduce will not be definitive; that is, you should seek other, additional materials in the library and on the web that help you to understand and develop your own critical analysis. It is expected that you will take notes during the lecture and combine them with the other unit materials and your own research to create your own set of comprehensive reference materials. The lectures will be recorded so you can go back to them if required.

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1. Introduction

Tutorial/Workshop The weekly tutorial/workshop will have two objects. First, to help you with any problems of questions you may have with the previous week’s material. You should prepare and bring any questions you have to the workshop/tutorial and be prepared to ask and discuss them. Second, to both reinforce and help you develop the skills to critically analyse the unit material from that week. You will undertake activities both individually and in groups, and will be provided with immediate feedback. You will be given the activities in the tutorial/workshop, so no specific preparation is required other than attendance at the preceding lecture and an understanding of the material covered in the previous weeks.

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2. Critical Analysis

Two core Assurance of Learning Goals of the QUT Business School require skills in Critical Analysis. Have knowledge and skills pertinent to a particular discipline (KS) 1.1 Integrate and apply disciplinary theory and skills to practical situations Be critical thinkers and effective problem solvers (CTA) 2.1 Identify, research and critically analyse information relevant to a business problem or issue, be able to synthesise that information in order to evaluate potential solutions, make recommendations or otherwise effectively address the problem or issue Critical analysis is central to EFB201. This section provides you with a framework for developing those skills as I want you to apply them in this unit. The Questions of Economics & Finance To undertake critical analysis in this unit you need to understand that there are two basic types of question that we attempt to answer in economics & finance, and that questions/topics in this unit that require critical thinking will relate to one or both of these. The first, described as Positive, is the question of WHY the world, or a particular part of the world, is the way it is. This includes the question of WHY a particular event occurred or occurred in the way it did. As economics & finance are social sciences, these questions typically address why people or their institutions are as they are or behave the way they have or do or will. The second, described as Normative, is that question of WHAT should be done, usually given a particular state of the world. It implicitly assumes that an individual or an institution can, through their choices and actions, influence the future state of the world, and so prescribes what action they should take. Economics & finance typically try to answer their questions by proposing theories or models, which try to explain some observable aspects of the world (EFFECT, or Dependent aspects) in terms of some other observable aspects (CAUSE, or Independent aspects). These theories and models do not necessarily have to be numerical, but they often are, in which case both the dependent and independent aspects are described by giving numerical values to defined variables, and the variables are related in a mathematical formula or function. The classic example from finance is a Pricing Model, that tries to explain the observed price of an asset as a function of other numerical parameters. For example:

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In finance these pricing models are, often, also applied normatively to tell an individual what price they should pay or receive for an asset, and even how much value they will be adding or losing should they trade at a different price. An example of an economic theory that is non-­‐numerical is the theory of Moral Hazard, which positively explains that a person will not avoid a risk if he or she is insured against it. It is obvious that the theory can also be applied normatively to suggest actions for a whole range of individuals in a whole range of circumstances. For example, it has been cited as a key principle in the design of banking regulation. Types of Positive Theories and Models When a positive theory or model tries to explain the state of the world, it may be trying to explain the future state, and not just the past or present state. If it tries to explain the future, then the theory or model is predicting; when it tries to explain the past or present it is post-­‐dicting. But in a sense the distinction is not that great; the real distinction comes in testing the theory or model to see if it does actually explain. When a theory or model is used to postdict, we can presumably see the extent to which it is correct immediately (although in practice it is often not so simple). When it is used to predict, then we obviously have to wait to see what happens before we can draw any conclusions as to its explanatory success. The positive theories and models are not limited to the state of the world at a particular time; they can also try to explain changes in the state of the world. The Efficient Markets Hypothesis in finance, for example, predicts/postdicts that a change in the market price of an asset over time is only due to previously unknown new information becoming available. There are different reasons a particular positive theory or model might be proposed, but we can put them into three general categories that I would describe as follows. 1. Mechanism: A mechanism or process is observed by which a cause gives rise to an effect. This is described by a THEORY. 2. Statistical (Econometric): A numerical relationship between independent variables and dependent variables is observed. This is described by a MODEL. 3. Logical: A theory is logically implied from the observed or assumed nature of particular elements of the world including, for people, their incentives and constraints. Or the theory is logically implied by, or is an extension of, another theory or model. While I have outlined three general categories, they are absolutely not exclusive. An explanation might represent a combination of two or even all three. In fact, its basis in more than one category strengthens an explanation. For example, a very strong

P = CF / 1 + d, where P is the dependent variable, Price, and CF and d are independent variables, Cash Flow and Discount Rate.

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explanation would be one that has an observed process, is also confirmed statistically and is also logically consistent with other theories and assumptions.1 Types of Normative Theories and Models As can be observed, the same theories and models are often used in both positive and normative applications (although there are normative theories and models, such as moral or ethical prescriptions, that have no positive counterpart). The transition from a positive to normative application of a theory or model does, however, introduce an additional dimension by which we might classify them. 1. Arbitrage: The theory or model tries to show some inefficiency in the state of the world that can be exploited by an individual for risk-­‐less gain. 2. Optimization: The theory or model tries to identify the action that is the optimal in terms of trading off one outcome or state against another. For example, in finance the standard theories are founded on an optimal trade off between risk and return. 3. Outcome: The theory or model tries to identify actions that will lead to the achievement of particular outcomes or states of the world. General Requirements for Answering a Question Before considering how to specifically answer a question in this unit, it is well worth first setting out some general principles of answering such a question. 1. PRACTICE. You will only learn the skills of critical analysis by doing it – over and over. If you don’t want to practice then don’t be surprised if you can’t do it. The tutorial/workshops have been designed to give you this practice but you need to be prepared to do more on your own. 2. DON’T EVER START WRITING YOUR ANSWER STRAIGHT AWAY. There is no way you can give a good answer, or even an acceptable answer, to a question without planning first. In this unit you will be given plenty of time for planning and then writing your response to a question in an assessment or practice setting. There will never be a test of how quickly you can write. 3. CONCISENESS IS CRITICAL. Planning is very important not only for you to organize the content of your answer, but also to help you plan the layout and style of your answer. In particular you must learn and practice writing concisely, so that you make your points clearly and quickly. A good answer is one the reader needs to read only once. If you pad out your answer with information or opinion that is irrelevant to the answer then in an assessment you will lose marks, and a reader will not find you convincing, even if that irrelevant information or opinion is true or reasonable, because it will be obvious that you do either do not know understand the question, 1 It is worth noting here some confusion in language, especially relating to the word empirical. Empirical

essentially means observation, and empirical evidence can be both observation of a mechanism and observation of real statistics. Note also there is common confusion between theories and models, and the terms are often, incorrectly, used interchangeably.

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4. YOU MUST AVOID LOGICAL FALLACIES IN YOUR ARGUMENTS. Go to Wikipedia and read this. Learn it. http://en.wikipedia.org/wiki/Fallacy Avoidance of these fallacies is absolutely critical to answering any question properly, and not just in this unit.

5. YOU ARE NOT AN ADVOCATE. Critical analysis is not the same as making a case, like a lawyer makes the best case for his or her client. Critical analysis is not a formal debate with each party taking one side. To ignore or wilfully misrepresent “the other side” of an argument is not critical analysis. Be particularly careful about ideological or political arguments that pretend to be critical analysis. 6. QUESTION EVERYTHING. Critical analysis is just that – critical. One of the fallacies in point 4 above is the “Argument from Authority”; in effect, it is true because I say so, and I am important. You should not make such arguments yourself, and nor should you accept such arguments from others, no matter what their credentials. But you should also be very critical of data and arguments presented in support of a position, no matter who presents or makes it (and that includes me). There are a lot of advocates posing as impartial analysts, and a lot of apparently credible people who simply don’t know what they are talking or writing about. 7. YOU MUST ATTEMPT TO ANSWER THE QUESTION. The whole purpose of learning about economics and finance is so that you can answer or address real world questions or issues. Otherwise you are wasting your time. University study is not simply memorizing things. So in answering a question do not simply write down everything you know in the hope that some of it might be relevant. Even if you are lucky enough to mention the relevant information you will be marked down in an assessment unless you explicitly relate it to the question that is asked. You must know the unit material While this is a general hint it is important enough that it gets a section of its own. University study is not only about memorizing things, but you do need to know a lot of things and have them at your recall. You cannot properly plan or answer a question if you don’t have the information in your mind. Having knowledge is a necessary but not sufficient condition to answering a question successfully. Knowing States of the world When we talk about states of the world we are usually referring to events that are significant in some way. They might represent a major change from the status quo – the previous state – or they might represent something that was unanticipated or unexpected – something that was a surprise. To understand of a state of the world you have to understand why and to what extent it was a change from the previous state, or why it was unanticipated and unexpected. For example, something may be a surprise because an individual or individuals acted in a way that was inconsistent with the way they were meant to act, or had even EFB201 Learning Guide 7

do not know how to approach it, or do not know how to answer it clearly or concisely.

undertaken to act. In order to understand this event you need to understand not only how these individuals were meant to act, but also to understand their incentives and their relationships with other individuals. Or an event may be a surprise because the event was inconsistent with some generally held expectation or understanding about the world. You need to understand why and in which context this generally held expectation arose. What you must avoid is having only a trivial understanding of an event, or an overly simplified understanding that changes or leaves out important things. As we shall discuss shortly, people have a tendency to fit simple explanations to events after the fact (this is called the Narrative Fallacy). Many journalists, for example, now seem incapable of describing a situation or event without mixing up the description with some trite or trivial explanation for it. This means that when you try to research and understand an event, you need to disentangle the casual and uninformed narrative from the facts. Knowing Theories and models You cannot understand a theory or model simply as a one-­‐line statement or conclusion, and yet that is often how they are presented. You need to dig down into it, and understand at least the following: 1. What EXACTY does the theory or model predict or explain? You may find that it is different, and in particular that is far more limited or general, than what is commonly perceived. 2. What kind of theory or model is it? Positive or normative? 3. What is the basis of the theory or model? If it is positive, is it mechanical, statistical or logical? If normative, is it arbitrage, optimization or outcome? 4. What EXACTLY does it assume about the world? Note that it is often difficult to disentangle assumptions from prediction. 5. What is the empirical evidence in support of the theory or model? 6. What are the existing criticisms of the theory or model? Answering a positive question Recall that economics & finance has positive theories and models that try to explain the state of the world or changes in its state. Questions that require critical analysis in a positive sense can take a number of different forms, but they might generally be classified into three different types as follows. You might be asked to: 1. Critically analyse a particular theory or model as explanation of a particular state of the world. (e.g. “The massive increase in US money supply since 2008 will not cause high inflation because of the existence of a Liquidity Trap.” Discuss.)

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2. Critically analyse a particular theory or model as a general explanation of the world. (e.g. Compare and contrast the Capital Asset Pricing Model and the Fama-­‐French Three Factor Model.) 3. Critically analyse a particular state of the world. (e.g. Identify and analyse the major causes of the global financial crisis.) In all three cases you will need, ultimately, to come to a conclusion as to the truth or otherwise the theory or model as an explanation.

The questions above really only differ in their specificity and the amount of information you are given to begin with. The first is quite specific as you are told exactly which theory to analyse and in the context of which particular state of the world. In the second you are given the theory or model but you must identify and decide which particular states of the world – if any – to which it can or could be applied. In the third you are given a particular state of the world and you must identify and decide which theories or models to apply to it. Clearly the second and third types of questions are a greater test of your knowledge, but also allow greater scope to develop your own approach to the question. There are two general ways of analysing a theory or model as an explanation of the world. The first we might call Empirical, the second we might call Logical. Empirical Analysis If a statement (including a theory or model) is a description or prediction of the world, then you can ask if is it possible to observe any actual states of the world where that description or prediction is incorrect or inconsistent with it. But the search for contradictions is not limited to direct contradictions. You should also: • Identify further predictions that are logical implications of the statement, and ask if there are states of the world in which these predictions are incorrect. • Identify any assumptions of the statement and ask if there are states if the world in which these assumptions are incorrect. You must, however, be very careful drawing hard conclusions based on an apparent contradiction. While it is claimed that it only takes one counter-­‐example to invalidate a statement, the reality is far more subtle. • Is the counter-­‐example really inconsistent with the statement? • Can the statement be amended or extended to be consistent with the counter-­‐ example, and still be valid?

• Is the statement still a useful approximation even if there are counter-­‐examples? In other words, does it still give us useful insight, or does the statement depend sensitively on its assumptions or consistency with the world being true? EFB201 Learning Guide 9

Incomplete Information The greatest challenge for empirical analysis is that we are always dealing with incomplete information. We can never observe the entire state of the world. A statement that appears to be inconsistent with a particular state of the world might become consistent if some other information about the world was known. But conversely, it is impossible to prove a statement is true by listing all the known states of the world and showing it is consistent with them. There can always be a counter-­‐ example that we have not and could not observe. So what can we say? The more states of the world that are consistent with a statement, without a counter-­‐ example, being found, the more confident we might be in the truth of the statement PROVIDED that the counter-­‐examples cover a range of times and locations. The world might change over time or from place to place. You might recognize this approach from statistics/econometrics, where we specify our confidence in the validity of numerical models based on the size and the nature of the samples of data with which they are tested. But the general approach is not limited to numerical models, we can approach statements of theory or descriptions of the state of the world in the same way. Ceteris Paribus Because we cannot know everything about the world, many (if not most) theories in economics & finance are ceteris paribus. This means “all else being equal”, or “all other things held the same”. Essentially the theory talks about one piece of the world, or one process or part of a process. An explanation or relationship is proposed on the assumption that all other things or processes or parts of processes are held constant or unchanged. The reason is that the world is too complex and with too many pieces or processes to grasp in its entirety, so we try to isolate relationships of explanations between parts of them. But of course everything else never is held the same, and so when we look at things empirically we have to accept that the relationship or process described by a theory can never be isolated from the rest of the messy or “noisy” world. That is one reason it may be legitimate to accept a theory or model even if there appear to be counter-­‐examples, and why it is accepted that data can never perfectly confirm a theory even if that theory is legitimate, and in statistics/econometrics we identify confidence bands and measurements of error. This does not mean, however, that all theories are equally true even if they don’t conform with the world. The theory or model could just be plain wrong. And there is another important problem to be aware of, which goes to the whole idea of ceteris paribus theories and models. We are ultimately interested in the world, and it may be that the world cannot be understood or explained as the sum of its parts even if we have good theories or models of each of those parts in isolation. The behaviour of the world, a complex system, might be emergent. The other danger of ceteris paribus explanations is that while there may be a positive relationship between two things, everything else held equal, the strength of that EFB201 Learning Guide 10

relationship matters. How much does a change in one thing lead to a change in another? It may only be a trivial change, even if the relationship is strong. But focussing on ceteris paribus explanations can lead us to drastically overweight this relationship and ignore the possibility of other unknown relationships that may offset it, and may be significantly stronger. Generalization I mentioned previously that the world can change, and that a relationship or explanation that holds in one part of the world or at one time may not necessarily hold in another. As we know the world is both complex and changeable, this makes it extremely dangerous to generalize an explanation from a specific time or place to another or to the world as a whole. Econometrics recognizes that this can only be done where the world (more specifically, the underlying process) is what is called stationary. You need to be very cautious of simply assuming (or implicitly assuming) that the world is stationary. To put it another way, you cannot simply assume that what happened yesterday – or more specifically, the process that generated what happened yesterday -­‐ will be the same process that generates what happens tomorrow. Logical Analysis A good explanation has a logical basis. A logical argument, or a chain of logical arguments linking initial assumptions or observations to final conclusions or prediction, is identified or reasonably assumed. Logical analysis is analysis of these arguments, both individually and together. There are a number of questions you can ask. 1. Is the logic internally consistent? Does the theory or model require or assume two things that are inconsistent with each other. 2. Are there gaps or leaps in the chain of logic. If the theory or model requires that one thing necessarily follows or implies or requires another thing, does it actually do so? 3. Does it rely on any of the fallacies referred to in D.4 above? Absence of logic A purely arbitrary statement is one that has no logical basis – it has no theory behind it. The statement that the moon is made of cheese, for example, is arbitrary. It might be nice to say that we don’t have to deal with such arbitrary statements in economics and finance but we do, albeit that they are often a bit more subtle that saying the moon is made of cheese. I previously warned about the many political or ideological, or even totally ignorant, statements about economics and finance that can be found.

Data Mining You also need to be aware that the existence of huge amounts of numerical data allows for what is called data mining. Modern computing power allows data to be “mined” to find statistically significant relationships between variables, that can be expressed as a model, but that is without any underlying logical theory.

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What often happens is that data mining suggests a relationship and then a theory is sought to explain it, but not always. Statistical arbitrage is a trading strategy – and often very successful – that relies on data mining relationships without underlying theory, and the fact that there is no underlying theory we can identify does not mean that there is no actual causal relationship. Because of our incomplete information we may just not be able to see it directly but we can infer from the statistics that it exists. But the other possibility is that the apparent relationship is simply random, and the more data we mine then the more likely it becomes that such spurious relationships will be found. In fact, if we mine enough data then we are also certain to find relationships that are spurious. Narrative Fallacy You also need to be aware that theories are often proposed after the fact, and we must be extremely cautious of these. A classic example is that of the nightly news where the financial journalist says that “The market went up/down today because investors …” But in fact this is something that we all do naturally, and it has been called the narrative fallacy. Something happens, and we feel the need to make up a simple story to explain it. While this differs from a genuine investigation – consider an air crash or murder enquiry – the two are not discrete so much as opposite ends of a spectrum. You need to be extremely aware that while a particular story might be consistent with the known facts, this does not make it true. There may be a whole range of stories consistent with a given set of facts or observations. There is a huge difference between a theory that makes a prediction, which is subsequently confirmed by empirical evidence, and an ex-­‐ post narrative. Answering a normative question Recall that a normative theory or model tries to show what an individual or institution should do. Questions that require critical analysis in a normative sense can take many different forms, but they might again be generally classified into the three different types as follows. You might be asked to: 1. Critically analyse what a particular normative theory or model would tell an individual or institution to do in a particular state of the world. (e.g. How would Keynesians and Austrians differ in their prescriptions for reducing unemployment in the US?) 2. Critically analyse whether a particular theory or model is valid in a normative sense; that is, whether it should be used to tell individuals or institutions what to do. (e.g. “The insight of the Black-­‐Scholes Model is that option pricing is or should be risk neutral.” Discuss in the context of real financial markets.). 3. Critically analyse a given state of the world to identify which normative theories or models would be, or purport to be, applicable to achieve some particular target or objective. (e.g. How can the over-­‐exploitation of fish stocks in the High Seas be avoided?)

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Again you can see that the later questions are more general, and with less specific guidance, than the first. Normative theories and models are fundamentally the same as positive theories and models When considering a normative question you need to recognize that they are explaining, as with the positive questions, states of the world . A normative theory or model is a prediction – do this and it will have that consequence. So everything I have said about analysing positive questions (above) applies equally to analysing normative questions, but with some important additional factors to consider. The positive basis of normative theories or models Where a theory or model is applied both positively and normatively, and in particular where a positive theory is then adopted and applied normatively, you need to ask a fundamental question. Is the use of the theory or model normatively consistent with the assumptions and logic of the positive theory or model?

The clearest example of the potential problem is this one. The normative use of a theory or model assumes that the individual has freedom to choose the particular actions he or she takes, and that these actions are the causes of effects identified by the theory or model. But is freedom of choice consistent with the logic or assumptions of the positive theory or model? Another good example of the potential problem relates to arbitrage normative theories or models, that purport to show some inefficiency in the world that can be exploited. If this normative model actually comes from a positive model, does the positive model assume or allow or predict the world to be inefficient? Feedback When dealing with a physical system, you can often rely on a certain cause having a certain effect, even if you have to assume ceteris paribus. This is the nature of physical sciences. But when dealing with social systems, the system that you are normatively attempting to influence comprises not inanimate physical objects or substances, but other people. If you assume that you have the ability to choose, to exercise free will, (which is what normative theories and models assume), then you must assume that those other people do as well. Worse, if your choices affect other people (as normative theories and models do assume) then those other people will not only respond to your choices with their own choices, but that they can anticipate your choices in making their choices. This feedback – a blurring of cause and effect, with choices being made simultaneously with respect of each other -­‐ fundamentally changes the nature of social science from that of physical science. You need to ask how the normative theory addresses and deals with feedback. You may find that it does not at all, in which case you need to consider how its prescriptions would change in the presence of feedback. Is it still a good theory, or does it fundamentally change its predictions? EFB201 Learning Guide 13

Many effects We know intuitively that a single cause often has a range of effects. You need to ask whether a normative theory or model contemplates a whole range of effects or is limited to a small set or even a single one. If the theory or model is so limited, then you need to ask what are or what may be the “unintended consequences” of the action it prescribes? This is important because an action may have two or more effects, where we want one to occur but don’t want the other. This also means that you need to ask which effect or potential effect we are interested in. It is not sufficient to say that a normative model tells us what to do. You need to understand why it tells us what to do, in terms of what objective it assumes we are trying to achieve. You also need to assess or consider whether this is the proper objective, in addition to analysing whether the theory or model correctly predicts that outcome.

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3. Introduction to Financial Markets

Part 1 – Standard Story Viney Chapter 1

You must be intimately familiar with the different financial instruments, markets and institutions, as described in Chapter 1 of the textbook. It is important you invest the time early in the unit, in fact in the first week, to know this material. It will be assumed knowledge after week 1. In this first lecture we will also consider, more generally, the nature, purpose and use of a market in finance. You should be prepared to take notes on this in the lecture and then afterwards develop your own ideas on the subject. The standard theory is that financial markets contribute to the welfare of society by facilitating the efficient allocation of capital to the most productive uses. They do so by bringing together, in a competitive environment, those who currently have opportunities to invest, but lack the capital to do so, and those who have excess capital to invest, but lack the opportunities. The market ensures that capital goes to those who will use it most efficiently in terms of generating the greatest benefit or maximizing the welfare of society.

Part 2 – Critical Analysis For this first week only I will provide in this learning guide an overview of, and the material for, critical analysis of the standard story. Keynes, Chapter 12 The General Theory of Employment, Interest and Money (1936) http://www.marxists.org/reference/subject/economics/keynes/general-­‐ theory/ch12.htm

This extremely famous work is a counter to the standard view of financial markets. It says that they do not merely provide for efficient allocation of capital to long-­‐term investment. They also facilitate speculation, and speculation can lead to the inefficient allocation of a society’s capital, its resources and a failure to maximize its welfare.

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4. Financial Markets & Finance Theory Part 1 – Standard Theory

DCF Pricing Models The standard theories of finance culminate in what are called Pricing Models. These are formulas or algorithms that calculate the "true" value for a financial instrument or any other type of asset. For convenience I will hereafter refer only to “assets”, which you should interpret as including financial instruments. The basic form of the pricing model is as follows. Asset Value or Price = E(CF1) / (1+r1) + E(CF2) / (1+r2) + … + E(CFn) / (1+rn) Where

E(CFt) = expected asset cashflow at time t rt = Rft + Risk Premium Rft is the risk free rate of return the period ending at time t Risk Premium is a quantity determined by asset’s contribution to the uncertainty of the asset owner’s cashflow (which is called the asset’s risk). There are different pricing models for different types of financial instrument – equity and debt – but all are built on this same foundation, which is called a Discounted Cashflow Model or DCF. Discounting the asset’s expected future cashflows gives a Present Value, which is the true value of the asset. For an introduction to DCF see Viney 5.1.1 and revise Viney 1.2. Where the cashflow of the asset is certain, then the asset is described as Risk-­‐Free, and the Risk Premium is equal to zero. The value or price of the risk free asset is determined only by its certain cashflow and the risk-­‐free rate of return, Rft. The risk-­‐free rate is different for different values of t. See Viney 2.1 (introduction only, not 2.1.1). Efficient Markets Hypothesis Financial markets have a central place in the theories and models of finance. The most important is described by the Efficient Markets Hypothesis (EMH). This hypothesis is different from the standard story in Section 3 (above) that markets allocate capital efficiently to maximize society’s welfare. Your textbook describes the standard form, or at least the modern form, of the EMH as having three elements (see Viney 8.5.1, 8.5.2). The weak form, also known as the Random Walk Hypothesis, says that future changes in the price at which an asset (including a financial instrument) is traded in a market are random. The semi-­strong form says that the price at which an asset is traded in a market at any time reflects all information that is publicly available at that time. The strong

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form says the price at which an asset is traded in a market at any time reflects all information available at that time, whether private or public. The various forms of the EMH imply the standard DCF Pricing Models, for the information that they refer to is information on the values of the parameters, or inputs, of those models; in particular the expected cashflows of the assets and their risk. And so when the semi-­‐strong and strong forms of the EMH refer to the asset price “fully reflecting” information, they imply that the market price of the asset is its true price according to the DCF Pricing Model where everything that is known or knowable about the asset’s cashflow and risk is reflected in the inputs for CF and Risk Premium. The logical basis of the EMH is that no-­‐one would rationally pay more for an asset than its true value, but nor would anyone sell it for less than its true value. Competition between buyers and sellers in the market ensures that this holds true. With competition, anyone thinking of selling an asset for less than its true value will find other buyers willing to pay more for it, up to its true value. And anyone willing to pay more for an asset than its true value will find other sellers willing to sell for less, down to its true value. The consequence is that even if a buyer or seller that does not know the asset’s true price they will still buy or sell the asset at its true price, provided only that he or she pays the lowest price anyone is willing to sell for or sells for the highest price any buyer is willing to accept. The market price is the true price. This also means that if we observe the market price of an asset changes, it can only have changed because of a change in the values of the inputs into the DCF Model; namely the expected cashflows or risk of the asset. But these changes can only be a surprise to those with public information; if they were known previously then they would already have been reflected in the asset’s price. So the semi-­‐strong and strong forms of the EMH both imply the weak form, the random walk, at least for anyone without private information. For them, prices must change randomly because they change only as previously unknown, and therefore random, new information becomes known. The true value of an asset is, in effect, an equilibrium to which the price of the asset will immediately converge. Other implications of the EMH for Financial Markets The EMH has important implications for those who wish to buy or sell assets in financial markets. It says that previous changes in prices can have no impact on future changes in prices. Anyone who tries to predict – and profit from – future changes in prices by looking at past changes in prices (called Technical Analysis, see Viney 8.4) will do no better than randomly guessing. And the same will apply to anyone who tries to profit from identifying overpriced or underpriced assets in the market (called Fundamental Analysis, see Viney 8.2, 8.3). Another important implication of the EMH is Rational Expectations. The distribution of an asset’s future cashflows, from which are observed its expected cashflow and risk, must be objective and observable by all rational participants in the market, for the true price must be objective and observable by them all. It they were not, then competition EFB201 Learning Guide 17

between those market participants would not drive the asset’s price to any equilibrium at the objective true value. The owner of an asset can anticipate cashflow from owning that asset, which we can call its Income, but it can also anticipate an alternative cashflow, the proceeds from selling the asset at its then Market Price. The asset’s future income and its future market price are both future cashflows that should determine the asset’s value under the standard DCF pricing models. But they are alternatives; the owner of an asset can either receive its income or its market price by selling it, and thus giving up the right to its income. Actually, there are a whole series of alternative cashflows from an asset, each one representing a combination of the market price at a particular future time and the asset’s income up to that time. The EMH implies that each of these alternative cashflows, when input into the DCF pricing model, all give the same present value for the asset. In other words, the value of an asset today is independent of if and when the owner might intend to sell it. It follows that there are rational expectations of all future market prices of an asset as well as all its future income. The EMH requires also that financial markets are Liquid. For any buyer of an asset there is always more than one seller willing to sell for the true price, and for any seller of an asset there is always more than one buyer willing to pay the true price. Liquidity provides the competition that drives the price of an asset to its true value.

The EMH also implies the Law of One Price. Two assets (or fractions thereof) that have the same expected cashflow and risk will have the same true value and must therefore have the same price. This law prevents Arbitrage, and No-­‐Arbitrage is another implication of the EMH. It is not possible to buy and sell the same asset, or two assets that have the same expected cashflow and risk, for different prices at the same time. If it were possible, then it would be possible to make Arbitrage Profits – pure windfall profits without any investment or risk. The Law of One Price gives rise to the second major form of pricing model under the standard theories of finance; the Arbitrage Pricing Models, which give us the true value of assets whose cashflows are derived directly from the cashflows of other assets, namely Derivatives. The combination of Liquidity and the Law of One Price gives us another implication of the EMH, which is that of Market Completeness. This means that for any combination of expected return and risk that you choose, market participants will be willing to sell you or buy from you an asset with that profile, and at its true price. This allows for the possibility of Perfect Hedging, which means that if you are exposed to a particular risk you can always eliminate it at a cost that exactly offsets the expected cashflow associated with it. A final, but very important implication of the EMH is Market Discipline. Assets with higher risk have lower true values and thus prices in the market. Under rational expectations those risks, and thus the true values, are identified by potential buyers of the asset. Any entity that creates assets with high risk will be penalized, and thus “disciplined” by only being able to sell them at a low price for them commensurate with that risk.

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5. Government Debt Markets Part 1 – Standard Story The standard story of government debt markets focuses on their role as a major channel of prudent government fiscal and monetary policy, and as the risk-­‐free benchmark for the market pricing of all other risky financial instruments in their home currency.

The observed price of risk-­‐free government debt implies the value for Rf, that is the basic input into the DCF pricing model for all other assets. Changes to the price of government debt translate directly into changes in the true value of all assets. Viney Chapter 10 Introduction, 10.1 and 10.2

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6. Corporate Debt Markets

Part 1 – Standard Story Viney 2.2, 6.5, 6.8 The major features of the corporate debt markets are the requirement for credit ratings to certify the risk of the financial instruments and, in the case of capital market instruments, liquidity so that investors will willingly fund long-­‐term investments. These requirements reflect that corporate debt markets are dis-­‐intermediated markets, in which end investors with surplus funds deal directly with corporations that wish to raise funds (called Issuers). Credit Ratings http://en.wikipedia.org/wiki/Bond_credit_rating

Investment banks and other financial institutions play an important role in the provision of liquidity in the corporate debt markets (see Section 8, below). The corporate bond markets are distinguished from the intermediated markets, where corporations raise funds directly from an intermediary such as a commercial bank. In those markets the commercial bank raises funds from, and certifies the risk of the assets and provides liquidity to, end investors. While the disintermediated and intermediated debt markets may be alternatives for corporates wishing to raise funds, they are often complementary and corporates may utilize them both simultaneously to diversify their funding sources. Issuers in the corporate debt markets are not just pure corporations. A significant part of the market comprises CP or bonds issued by special purpose corporations in a process known as securitization. Securitization is a form of intermediation, and it blurs the distinction between disintermediated and intermediated markets. http://www.imf.org/external/pubs/ft/fandd/2008/09/pdf/basics.pdf

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7. Commercial Banks Part 1 – Standard Story Commercial banks are financial intermediaries. They sit between those with surplus funds to invest and those who require funds. By pooling together multiple sources of funds from depositors and the public debt markets, and on-­‐lending those funds to borrowers in large loan portfolios, they fulfil the important functions of asset, liquidity and maturity transformation. This also means that they interact through financial markets on three fronts;

Assets – the long-­‐term illiquid loans that banks make. Funding – the short-­‐term, liquid deposit and other debt funding that banks borrow in order to on-­‐lend. Capital – the bank’s equity that provides a margin of safety to its funders. Banks are also highly regulated by governments to ensure that they can safely fulfil their important functions as channels of credit and monetary policy, and in particular money creation. Viney 1.5.3 The Benefits of Financial Intermediation Viney 3.1, 3.2, 3.3, 3.5, 3.6

Excel spreadsheet on Blackboard, "Model Bank", to be covered in class.

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8. Broker Dealers and Shadow Banks

Part 1 – Standard Story Viney 3.7 There are a range of financial intermediaries that are not regulated commercial banks, the major consequence of which is that they are not able to take deposits from the public and normally are not able to access direct funding from the central bank.

The classic example is an investment bank; more generally called a broker-­‐dealer in the US. The do not hold financial assets for the long-­‐term, but instead originate and trade them. They focus on underwriting, broking, trading and “innovative” service business and raise the funds they need in the wholesale and capital markets. The Repo Market is a critical financial market for the shadow banking system.

http://www.icmagroup.org/Regulatory-­‐Policy-­‐and-­‐Market-­‐Practice/short-­‐term-­‐ markets/Repo-­‐Markets/Repos-­‐and-­‐the-­‐repo-­‐market/ Other unregulated institutions that perform the same asset transformation role as commercial banks include money market funds and bank off-­‐balance sheet entities such as SIVs. http://en.wikipedia.org/wiki/Money_market_fund http://en.wikipedia.org/wiki/Structured_investment_vehicle

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9. Public Equity Markets Part 1 – Standard Story Public stock markets (exchanges) provide for the issue of shares in the primary market, allowing corporations to raise new equity funds, and the subsequent trading of those shares between investors in the secondary market. Modern electronic trading and settlement practices, and the full disclosure of information required by exchange rules, remove frictions and inefficiencies and allow the public stock markets to optimally translate information about firms into the market prices that reflect the true value of a firm’s equity. The price (or at least a change in the price) of its shares in the public stock market thus provides a clear measure of the performance of a corporation’s managers. An increase in the share price can be attributable to the manager adding value to the corporation and thus its shareholder owner’s, and so the public stock market has an important role in corporate governance. Viney Chapter 6.1, 6.2, 7 Introduction, 7.1, 7.1.1, 7.1.2, 7.1.5, 7.1.6, 7.1.7, 7.3, 7.4.1 Modern stock markets also provide greater liquidity – and thus more true pricing of shares -­‐ by encouraging high-­‐frequency electronic traders to buy and sell shares in fractions of a second, ensuring that every order is immediately matched with a buyer or seller immediately in a highly competitive environment. http://www.investopedia.com/terms/h/high-­‐frequency-­‐trading.asp#axzz20sauS1CL Part 2 – Critical Analysis …

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10. Alternative Equity Markets

Part 1 – Standard Story By number, relatively few corporations actually list on a public stock market, which is dominated by the very largest. Yet there are other, informal markets for equity in companies not listed on stock exchanges. The most well-­‐known are for Private Equity and Venture Capital, where the investors are usually dedicated funds raised and managed for the purpose. This is the private equity industry’s description of itself. http://www.pegcc.org/education/ This glowing description of venture capital is also from an industry lobby group. http://www.nvca.org/index.php?option=com_content&view=article&id=141&Itemid=5 89 More recently a form of equity market has developed which blurs the distinction between public stock markets and private equity markets. These are known as Dark Pools, and allow investors in listed companies to buy and sell those shares anonymously. http://www.economist.com/blogs/schumpeter/2011/08/exchange-­‐share-­‐trading

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11. Derivatives Markets Part 1 – Standard Story The future cashflows of governments, corporations and individuals may be exposed to changes in the market prices of commodities, financial instruments and other risk factors. Derivatives are financial instruments that allow them to create an equal and opposite exposure to the same risk factor, offsetting their “natural” exposure. This is called “hedging”, with the result that the entity has no residual exposure to the risk factor. The risk has been eliminated. Derivatives are very important instruments for risk management, and can help reduce risk and volatility in the economy. Viney Chapter 7.1.3, 11.3, 11.4, 11.5, 11.6 Derivatives come in two general forms, which are defined by the markets in which they are created and traded. Exchange-­‐traded derivatives come in standard forms and are highly regulated. Margin requirements enable counter-­‐party risk to be eliminated, and they are highly liquid. Over-­‐the-­‐counter derivatives are unregulated private contracts that are in non-­‐standard form. They can allow an entity to perfectly hedge a complex natural exposure and so avoid basis risk, where the natural exposure and a standard form of derivative may not perfectly offset each other.

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12. Foreign Exchange Markets

Part 1 – Standard Story Viney Chapter 9 Introduction, 9.1 -­‐ 9.4, 9.8 Markets for foreign exchange (FX), in which one currency is bought and sold for another, are the closest approximation to the perfect markets of economic theory and so should be the most efficient of all financial markets. Open 24 hours a day, they have large numbers of homogenous market participants with extremely low transaction costs, and investors today have immediate electronic access to all prices and relevant information. The massive volume traded in FX markets, many trillions of dollars (equivalent) each day, facilitate the flow of goods, services and capital throughout the global economy.

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