Are markets efficient? Let the two Nobel Economics Laureates debate!

Two Nobel laureates in economics from University of Chicago, Eugene Fama (2013) and Richard Thaler (2017) debate the efficient market hypothesis. This debate is required viewing for anyone with even a remote interest in finance!  (spoiler alert – virtually all derivatives pricing models covered in Finance 4366 assume that the underlying asset follows a random walk, which corresponds to the so-called “weak form” of Fama’s efficient market hypothesis)…

Eugene F. Fama and Richard H. Thaler discuss whether markets are prone to bubbles.
review.chicagobooth.edu

Extra Credit opportunity: Cyber Day Panel Discussion

Here is a very worthwhile extra credit opportunity for Finance 4366. You may earn extra credit by attending and reporting on the Cyber Day Panel Discussion described below.  In order to receive extra credit for this presentation, you must submit (via email sent to options@garven.com) a 1-2 page executive summary of what you learn from this panel discussion. The executive summary is due by no later than 5 p.m. on Monday, October 9th.  This extra credit will replace your lowest quiz grade in Finance 4366 (assuming the extra credit grade is higher).

Important empirical evidence on hedge fund performance…

An ongoing debate in finance is whether “active” investment strategies can outperform “passive” strategies. The empirical evidence in favor of passive strategies which appears in studies published by peer-reviewed scientific journals is overwhelming. For example, in studies of mutual fund performance, passive strategies almost always blow away active strategies. Similarly, the empirical evidence on frequency of trading by “retail” customers is that on average, portfolio performance is inversely related to trading frequency; i.e., the more people trade, the worse they do. Even hedge funds chronically underperform passive investment strategies. For example, the authors of a 2011 Journal of Financial Economics (JFE) article entitled “Higher risk, lower returns: What hedge fund investors really earn” find that hedge fund returns are on the magnitude of 3% to 7% lower than corresponding buy-and-hold fund returns, reliably lower than the return on the Standard & Poor’s (S&P) 500 index, and only marginally higher than the riskless rate of interest.

Notwithstanding the growing popularity of critiques of the efficient market hypothesis (e.g., see “The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street” by Justin Fox), the growing body of scientific evidence which corroborates efficient market theory is very impressive indeed!

Paul Samuelson’s Secret (on the origin of hedge funds)…

In a 2011 article, economics columnist David Warsh provides a fascinating narrative (see “Paul Samuelson’s Secret” for the PDF version) concerning the late MIT economist and Nobel Laureate Paul Samuelson’s involvement in one of the earliest and most influential hedge funds ever, Commodities Corp. Along the way, Mr. Warsh also manages to provide a rich conceptual framework and intellectual history for understanding how important developments in finance theory which were largely pioneered by the likes of Professors Samuelson and Fama (e.g., the notion that financial markets are informationally efficient which in turn implies that stock prices follow a random walk) have influenced the evolution over time of financial markets and institutions. Mr. Warsh also liberally references Sebastian Mallaby’s book entitled “More Money Than God: Hedge Funds and the Making of a New Elite”, which he refers to as a “…very interesting book about the origins and recent history of the hedge fund industry”.

Mexico Earthquakes Test Plan for Investors to Absorb Government Disaster Costs

More on the role of catastrophe (cat) bonds and related derivatives in helping public as well as private entities in insuring natural disasters. See also http://derivatives.garven.com/2017/08/26/catastrophe-bonds-fall-as-hurricane-harvey-bears-down-on-texas/ and http://blog.garven.com/2005/08/03/cat-bonds/ for more on cat bonds.

Investors recently bought a catastrophe bond designed to minimize the financial hit to the Mexican government from earthquakes. They could now be on the hook for as much as \$150 million after two major quakes struck the country in quick succession.

Ed Thorp, the Man Who Beat the Dealer and the Market (extra credit opportunity)

Here is an extra credit opportunity for Finance 4366. You may earn extra credit by listening to and reporting on the 1 hour, 40 minute podcast hosted by Barry Ritholtz’s Masters of Business podcast (link provided below) entitled “Ed Thorp, the Man Who Beat the Dealer and the Market”.  In order to receive extra credit for this assignment, you must submit (via email sent to options@garven.com) a 1-2 page executive summary of what you learned from this podcast; it is due by no later than 5 p.m. on Monday, September 18.  This extra credit assignment will replace your lowest quiz grade in Finance 4366 (assuming the extra credit grade is higher).
Bloomberg View columnist Barry Ritholtz interviews Ed Thorp, one of the most storied people in finance. A math professor at MIT and UC Ivine, Thorp figured out how to beat Las Vegas at blackjack and baccarat, created statistical arbitrage, and ran a hedge fund that not only beat the market by a wide margin, but never had a losing quarter. He is the author of several books, including “Beat the Dealer” and “Beat the Market”; his latest book is “A Man for All Markets.” Thorp tells Ritholtz that the secret to beating the market is having an edge that’s specific, definable and mathematical. If you don’t, you should be in index funds instead. This interview aired on Bloomberg Radio.

On the role of replicating portfolios in the pricing of financial derivatives

Replicating portfolios play a central role in terms of pricing financial derivatives. Here is a preview of what comes next in Finance 4366:

1. Buying forward is equivalent to buying the underlying on margin, and selling forward is equivalent to shorting the underlying and lending money. Like options, forwards and futures are priced by pricing the replicating portfolio and invoking the “no-arbitrage” condition. If the forward/futures price it too low, then one can earn positive returns with zero risk and zero net investment by buying forward, shorting the underlying and lending money. Similarly, if the forward futures price is too high, one can earn positive returns with zero risk and zero net investment by selling forward and buying the underlying with borrowed money. This is commonly referred to as “riskless arbitrage”; it’s riskless because you’re perfectly hedged, and it’s arbitrage because you are buying low and selling high.
2. The replicating portfolio for a call option is a margined investment in the underlying. For example, in my teaching note entitled “A Simple Model of a Financial Market”, I provide a numerical example where the interest rate is zero, there are two states of the world, a bond which pays off \$1 in both states is worth \$1 today, and a stock that pays off \$2 in one state and \$.50 in the other state is also worth one dollar. In that example, the replicating portfolio for a European call option with an exercise price of \$1 consists of 2/3 of 1 share of stock (costing \$0.66) and a margin balance consisting of a short position in 1/3 of a bond (which is worth -\$0.33). Thus, the value of the call option is \$0.66 – \$0.33 = \$0.33.
3. Since the replicating portfolio for a call option is a margined investment in the underlying, it should come as no surprise that the replicating portfolio for a put option consists of a short position in the underlying combined with lending. Thus, in order to price the put, you need to determine and price the components of the replicating portfolio; we will begin class tomorrow by determining the the relative weightings (delta and beta) for the put’s replicating portfolio.
4. If you know the value of a call, the underlying, and the present value of the exercise price, then you can use the put-call parity equation to figure out the price for the put option; i.e., ${C_0} + PV(K) = {P_0} + {S_0} \Rightarrow {P_0} = {C_0} + PV(K) - {S_0}.$ Since we know the price of the call (\$0.33), the present value of the exercise price (\$1), and the stock price (\$1), then it follows from the put-call parity equation that the value of the put is also 33 cents. More generally, if you know the values of three of the four securities that are included in the put-call parity equation, then you can infer the “no-arbitrage” value of the fourth security.

Kids Explain Futures Trading

For next Tuesday’s introduction to forward and futures contracts, other than the assigned readings, it’s hard to beat the following video tutorial on this topic:

How government policy exacerbates hurricanes like Harvey

Here’s the (very timely) cover story of the latest issue of The Economist. Quoting from the article, “Underpricing (of flood insurance) encourages the building of new houses and discourages existing owners from renovating or moving out. According to the Federal Emergency Management Agency, houses that repeatedly flood account for 1% of NFIP’s properties but 25-30% of its claims. Five states, Texas among them, have more than 10,000 such households and, nationwide, their number has been going up by around 5,000 each year. Insurance is meant to provide a signal about risk; in this case, it stifles it.”

As if global warming were not enough of a threat, poor planning and unwise subsidies make floods worse.