KECD 2265 - FINANCIAL ECONOMICS

Traditional finance is fundamentally based on the premise that investors and managers are rational and that asset prices are “efficient”. However, this paradigm is insufficient to describe many features of actual financial markets. This course is a Ph.D. level exploration of research papers that help us understand how institutional and behavioral frictions affect financial markets and therefore financial decision-making. We first set the stage by defining the efficient market hypothesis, reviewing basic asset pricing models and reviewing early evidence on market efficiency. We then consider alternatives to models of rational pricing. We first consider the role of non-standard preferences (e.g., prospect theory). We then consider the role of distortions in expectations, which we categorize in a simple, but hopefully useful, way: (a) under-reaction to news and (b) over-reaction to news. We use these categories and frameworks to discuss well-known portfolio-based anomalies in financial markets. The second-part of the course discusses limits of arbitrage: in a market with perfect arbitrage activity, alternative preferences and beliefs are irrelevant as they are wiped out by arbitrageurs. We first discuss evidence for the existence of imperfect arbitrage in financial markets: demand curves for single securities are not flat; sometimes, the law of one price fails to apply. We then discuss why arbitrage is imperfect: (i) trading frictions (such as marging constraints and costly short-selling) (ii) risk (both fundamental and noise trading risk). The combination of non-standard preferences/beliefs and limits of arbitrage provides a powerful framework to analyze financial markets. We end the course by applying this framework in the context of investors' disagreement and its impact on asset prices. In particular, the final lecture will provide an extensive review of the literature on speculative bubbles. The course will consist essentially of (hopefully interactive) lectures. We will meet on Thursdays, from 10:15am to 12:15pm.

Stéphane GUIBAUD

Séminaire

English

Outline 1. Lecture 1: Efficient Market Hypothesis, early tests and some puzzles i. Efficient Market Hypothesis: definitions and the joint hypothesis problem ii. Benchmark models: CAPM, CCAPM iii. Early evidence and early dentson market efficiency Required readings: • Fama, Eugene (1970). Efficient Capital Markets: A Review of Theory and Empirical Work. Journal of Finance, 25:383-417. • Malkiel, Burton (2003). The Efficient Market Hypothesis and Its Critics. Journal of Economic Perspectives, 17:59-82 • Shiller, Robert (1981). Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?. The American Economic Review Vol. 71, No. 3 2. Lecture 2: Alternative preferences – prospect theory i. Quick introduction to Prospect Theory ii. Myopic loss aversion and the equity premium puzzle iii. Retail investors and the disposition effect Required readings: • Kahneman Daniel and Amos Tversky (1979). Prospect Theory: An Analysis of Deci sion under Risk. Econometrica, 47: 263-292. • Mehra, Rajnish and Edward C. Prescott (1985). The equity premium: A puzzle. Journal of Monetary Economics, Volume 15, Issue 2, Pages 145-161. • Shlomo Benartzi, and Richard H. Thaler (1995). Myopic Loss-Aversion and the Equity Premium Puzzle. Quarterly Journal of Economics, 110: 73-92. • Odean, Terrance (1998). Are Investors Reluctant to Realize Their Losses? Journal of Finance, 53: 1775-1798. 3. Lecture 3: Under-reaction and market anomalies i. Sticky expectations and evidence on under-reaction ii. Under-reaction and classical market anomalies iii. Neglected news Required readings: • Bouchaud, Jean-Phillipe, Stefano Ciliberti, Augustin Landier, Guillaume Simon and David Thesmar (2015). The Excess Returns of 'Quality' Stocks: A Behavioral Anomaly. Working Paper. • DellaVigna, Stefano and Joshua Pollet (2007). Investor Inattention and Friday Earnings Announcements. Journal of Finance. 64: 709-749. • Fedyk, Anastassia (2018). Front Page News: The Effect of News Positioning on Finan cial Markets. Working Paper 4. Lecture 4: Over-reaction and market anomalies i. Diagnostic expectations and evidence on over-reaction ii. Over-reaction and classical market anomalies iii. Interpretation and robustness Required readings: • Bordalo, Pedro, Nicola Gennaioli, Rafael LaPorta, and Andrei Shleifer. 2019. “Diag nostic Expectations and Stock Returns.” Journal of Finance 74 (6): 2839-2874. • McLean David and Jeffrey Pontiff (2016). Does Academic Research Destroy Stock Return Predictability? Journal of Finance 71 (1): 5-32 5. Lecture 5: Downward sloping demand curves in financial markets i. Demand shocks and asset prices: index reconstitution ii. Failure of the law of the one price in financial markets: stub arbitrage, closed-end fund puzzle Required readings: • Chang, Yen-cheng, Harrison Hong and Inessa Liskovich. Regression Discontinuity and The Price Effects of Stock Market Indexing. Review of Financial Studies. • Lamont, Owen A., and Richard Thaler (2003). Can the Market Add and Subtract? Mispricing in Tech Stock Carve-Outs. Journal of Political Economy, 111: 227-268. • Mitchell, Mark, Todd Pulvino, and Erik Stafford (2002). Limited Arbitrage in Equity Markets. Journal of Finance, 57: 551-584. 6. Lecture 6: Risky arbitrage i. Trading frictions: margin constraints and shorting costs ii. Risky arbitrage: idiosyncratic risk iii. Noise trading risk iv. Arbitrageurs' capital structure Required readings: • Wurgler, Jeffrey, and Zhuravskaya, Ekaterina (2002). Does Arbitrage Flatten Demand Curves For Stocks? Journal of Business, 75: 583-608. • De Long, Bradford, Andrei Shleifer, Lawrence H. Summers and Robert J. Waldmann (1990). Noise Trader Risk in Financial Markets. The Journal of Political Economy, 98: 703-738 7. Lecture 7: Asset pricing and disagreement i. Disagreement and short-sales constraints: Overpricing ii. The low volatility anomaly Required readings: • Diether, Karl, Christopher Malloy and Anna Scherbina (2002). Journal of Finance, 57: 2113-2141. • Frazzini, Andrea and Lasse Pedersen (2014). Betting against Beta. Journal of Financial Economics, 111: 1-25. • Hong, Harrison and David Sraer (2016). Speculative Betas. Journal of Finance 8. Lecture 8: Speculative bubbles i. Speculation and disagreement ii. Synchronization risk Required readings: • Ofek Eli and Matthew Richardson (2003). DotCom Mania: The Rise and Fall of Internet Stock Prices. Journal of Finance, 58: 1113-1137. • Hong, Harrison, Jose Scheinkman and Wei Xiong (2006). Asset Float and Speculative ´ Bubbles. Journal of Finance • Abreu, Dilip and Markus K. Brunnermeier (2003). Bubbles and Crashes. Econometrica, 71: 173–204. Complete References : • Abreu and Brunnermeier 2002. Synchronization risk and delayed arbitrage. Journal of Fi nancial Economics • Abreu and Brunnermeier 2003. Bubbles and crashes. Econometrica • Adrian, Etula and Muir 2014. Financial intermediaries and the cross-section of asset returns. Journal of Finance • Allen and Gale 2000. Bubbles and crises. Economic Journal • Ang, Hodrick, Xing and Zhang 2006. The Cross-Section of Volatility and Expected Returns. Journal of Finance • Asness, Moskowitz and Pedersen 2013. Value and momentum everywhere. Journal of Fi nance • Baker, Brendan and Wurgler 2011. Benchmarks as limits to arbitrage: Understanding the low volatility anomaly. Financial Analysts Journal • Barber and Odean 2001. Buys will be boys: Gender, overconfidence, and common stock investment. Quarterly Journal of Economics • Barberis, Huang and Santos 2001. Prospect Theory and Asset Prices. Quarterly Journal of Economics • Barberis, Huang and Thaler 2006. Individual Preferences, Monetary Gambles, and Stock Market Participation: A Case for Narrow Framing. American Economic Review • Barberis, Mukherjee and Wang 2014. Propsect Theory and Stock Returns: An Empirical Test. • Benartzi and Thaler 1995. Myopic Loss Aversion and the Equity Premium Puzzle. Quarterly Journal of Economics • Bernard 1992. Stock Price Reactions to Earnings Announcements. In: Thaler, R. (Ed.), Advances in Behavioral Finance. New York: Russell • Black, Jensen and Scholes 1972. The capital asset pricing model: some empirical tests. Studies in the Theory of Capital Markets • Blanchard and Watson 1982. Bubbles, rational expectations, and financial markets. Crisis in the Economic and Financial Structure • Bouchaud, Stefano, Landier, Simon and Thesmar 2015. The Excess Returns of “Quality” Stocks: A Behavioral Anomaly. Working paper • Brunnermeier and Nagel 2004. Hedge funds and the technology bubble. Journal of Finance • Brunnermeier, Nagel and Pedersen 2008. Carry trades and currency crashes. NBER Macroe conomics Annual • Campbell and Shiller 1988. The dividend-price ratio and expectations of future dividends and discount factors. Review of Financial Studies • Campbell and Vuolteenaho 2004. Bad Beta, Good Beta. American Economic Review • Chen and Zhao 2009. What drives Stock Price Movement? Review of Financial Studies • Chen, Hong and Stein 2002. Breadth of Ownership and Stock Returns.Journal of Financial Economics. • Cheng, Hong and Liskovich 2015. Regression discontinuity and the price effects of stock market indexing. Review of Financial Studies • Chevalier and Ellison 1997. Risk taking by mutual funds as a response to incentives. Journal of Political Economy • Chevalier and Ellison 1999. Career concerns of mutual fund managers. Quarterly Journal of Economics • Cochrane 2011. Asset pricing, chapter 1, 2, 9. Princeton University Press. • Cochrane 2011. Presidential address: discount rates. Journal of Finance • Cohen and Frazzini (2008). Economic Links and Predictable Returns. Journal of Finance • Cohen, Polk and Vuolteenaho 2005. Money Illusion in the Stock Market: The Modigliani Cohn Hypothesis. Quarterly Journal of Economics • Coval and Stafford 2007. Asset fire sales (and purchases) in equity markets. Journal of Financial Economics • D'avolio 2002. The market for borrowing stock. Journal of Financial Economics. • Dasgupta, Prat and Verardo 2011. Institutional trade persistence and long-term Equity re turns. Journal of Finance • De Long, Shleifer, Summers and Waldmann 1990. Noise trader risk in financial markets. Journal of Political Economy • DeBondt and Thaler 1985. Does the stock market overreact? Journal of Finance • DellaVigna and Pollet 2007. Demographics and Industry Returns. American Economics Review • DellaVigna and Pollet 2009. Investors Inattention and Fridays' earnings Announcements. Journal of Finance • Diether, Malloy and Scherbina 2002. Differences of Opinion and the Cross-Section of Stock Returns. Journal of Finance. • Fahlenbrach and Stulz 2011. Bank CEO incentives and the credit crisis. Journal of Financial Economics • Fama 1970. Efficient Capital Markets: A Review of Theory and Empirical Work. Journal of Finance • Fama and French 1992. The cross-section of expected stock returns. Journal of Finance • Fama and French 1993. Common risk factors in the returns on stock and bonds. Journal of Financial Economics • Fleckenstein, Longstaff and Lustig 2013. The TIPS–Treasury bond puzzle. Journal of Fi nance • Foucault, Sraer and Thesmar 2011. Individual investors and volatility. Journal of Finance • Frazzini and Pedersen 2013. Betting against Beta. Journal of Financial Economics • Froot and Dabora 1999. How are Stock Prices affected by the Location of Trade. Journal of Financial Economics • Greenwood and Shleifer 2014. Expectations of returns and expected returns. Review of Financial Studies • Guerrieri and Kondor 2013. Fund managers, career concerns, and asset price volatility. American Economic Review • Harvey, Liu and Zhu 2015. ... and the Cross-Section of Stock Returns. Working Paper • Hombert and Thesmar 2014. Overcoming limits of arbitrage: theory and evidence. Journal of Financial Economics • Hong and Sraer (2014). Speculative Betas. Working Paper. • Hong, Scheinkman and Xiong 2006. Asset Float and speculative bubbles. Journal of Finance • Huberman and Regev 2001. Contagious Speculation and a Cure for Cancer: A non-event that Made Stock Prices Soar. Journal of Finance • Hwang (2011). Country-specific sentiment and security prices. Journal of Financial Eco nomics • Jegadeesh and Titman 1993. Returns to buying winners and selling losers: implications for stock market efficiency. Journal of Financial Economics • Jensen and Meckling 1976. Theory of the firm: managerial behaviour, agency cost and ownership structure. Journal of Financial Economics • Keim 1983. Size-related Anomalies and Stock Return Seasonality. Journal of Financial Economics • Lakonishok and Shmidt 1988. Are seasonal anomalies real? A ninety-year perspective. Review of Financial Studies • Lamont and Thaler 2003. Can the Market Add and Subtract? Mispricing in Tech Stock Carve-Outs. Journal of Political Economy • Lee, Shleifer and Thaler 1991. Investor Sentiment and the Closed-End. Journal of Finance • Lucca and Moench (Forthcoming). The Pre-FOMC Announcement Drift. Journal of Finance • DeLong, Shleifer, Summers and Waldman 1990. Positive Feedback Investment Strategies and Destabilizing Rational Speculation. Journal of Finance • Malmendier and Nagel 2011. Depression babies: Do macroeconomic experiences affect risk taking. Quarterly Journal of Economics • McLean and Pontiff (Forthcoming). Does Academic Publication Destroy Stock Return Pre dictability? Journal of Finance • Mehra and Prescott 1985. The equity premium: a puzzle. Journal of Monetary Economics • Mei, Scheinkman and Xiong 2003. Speculative Trading and Stock Prices: Evidence from Chinese A-B Share Premia. Annals of Economics and Finance • Miller 1977. Risk, uncertainty, and divergence of opinion. Journal of Finance • Mitchell and Pulvino 2001. Characteristics of risk and return in risk arbitrage. Journal of Finance 7 • Mitchell, Mark, Todd Pulvino, and Erik Stafford (2002). Limited Arbitrage in Equity Mar kets. Journal of Finance • Mitchell, Stafford and Pulvino 2002. Limited Arbitrage in Equity Markets. Journal of Fi nance • Ofek and Richardson 2003. DotCom Mania: The Rise and Fall of Internet Stock Prices. Journal of Finance • Saunders 1993. Stock Prices and Wall Street Weather. Journal of Finance • Scharfstein and Stein 1990. Herd behavior and investment. American Economic Review • Scheinkman and Xiong 2003. Overconfidence and speculative bubbles. Journal of Political Economy • Scruggs 2007. Noise trader risk: Evidence from the Siamese twins,Journal of Financial Markets • Shiller 1981. Do stock prices move too much to be justified by subsequent changes in divi dends? American Economic Review • Shleifer and Vishny 1997. The limits of arbitrage. Journal of Finance • Sias 2004. Institutional herding. Review of Financial Studies • Stein 2005. Why are most funds open-end? Competition and the limit of arbitrage. Quarterly Journal of Economics • Wurgler and Zhuravskaya 2002. Does arbitrage flatten demand curves for stocks? Journal of Business • Yu 2011. Disagreement and Portfolio Return Predictability. Journal of Financial Economics. • Yu and Xiong 2011. The Chinese Warrants Bubble. American Economic Review

Autumn 2024-2025