1.
Financial economics
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Financial economics is the branch of economics characterized by a concentration on monetary activities, in which money of one type or another is likely to appear on both sides of a trade. Its concern is thus the interrelation of financial variables, such as prices, interest rates and shares and it has two main areas of focus, asset pricing and corporate finance, the first being the perspective of providers of capital and the second of users of capital. The subject is concerned with the allocation and deployment of economic resources and it is built on the foundations of microeconomics and decision theory. Financial econometrics is the branch of economics that uses econometric techniques to parameterise these relationships. Mathematical finance is related in that it will derive and extend the mathematical or numerical models suggested by financial economics, note though that the emphasis there is mathematical consistency, as opposed to compatibility with economic theory. Financial economics is usually taught at the level, see Master of Financial Economics. Recently, specialist undergraduate degrees are offered in the discipline, note that this article provides an overview and survey of the field, for derivations and more technical discussion, see the specific articles linked. As above, the discipline essentially explores how rational investors would apply decision theory to the problem of investment, the subject is thus built on the foundations of microeconomics and decision theory, and derives several key results for the application of decision making under uncertainty to the financial markets. Underlying all of economics are the concepts of present value. Its history is correspondingly early, Richard Witt discusses compound interest already in 1613, in his book Arithmeticall Questions, further developed by Johan de Witt and these ideas originate with Blaise Pascal and Pierre de Fermat. This decision method, however, fails to consider risk aversion, choice under uncertainty here, may then be characterized as the maximization of expected utility. The impetus for these ideas arise from various inconsistencies observed under the expected value framework, the development here originally due to Daniel Bernoulli, and later formalized by John von Neumann and Oskar Morgenstern. The concepts of arbitrage-free, rational, pricing and equilibrium are then coupled with the above to derive classical financial economics, Rational pricing is the assumption that asset prices will reflect the arbitrage-free price of the asset, as any deviation from this price will be arbitraged away. This assumption is useful in pricing fixed income securities, particularly bonds, intuitively, this may be seen by considering that where an arbitrage opportunity does exist, then prices can be expected to change, and are therefore not in equilibrium. An arbitrage equilibrium is thus a precondition for a general economic equilibrium, the formal derivation will proceed by arbitrage arguments. All pricing models are then essentially variants of this, given specific assumptions and/or conditions and this approach is consistent with the above, but with the expectation based on the market as opposed to individual preferences. In general, this premium may be derived by the CAPM as will be seen under #Uncertainty, with the above relationship established, the further specialized Arrow–Debreu model may be derived. This important result suggests that, under certain conditions, there must be a set of prices such that aggregate supplies will equal aggregate demands for every commodity in the economy
Financial economics
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Efficient Frontier. The hyperbola is sometimes referred to as the 'Markowitz Bullet', and its upward sloped portion is the efficient frontier if no risk-free asset is available. With a risk-free asset, the straight line is the efficient frontier.
Financial economics
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Modigliani–Miller Proposition II with risky debt. As
leverage (
D/E) increases, the
WACC (k0) stays constant.
Financial economics
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Simulated geometric Brownian motions with parameters from market data.
2.
Asset
–
In financial accounting, an asset is an economic resource. Anything tangible or intangible that can be owned or controlled to produce value, simply stated, assets represent value of ownership that can be converted into cash. The balance sheet of a firm records the value of the assets owned by that firm. It covers money and other valuables belonging to an individual or to a business, one can classify assets into two major asset classes, tangible assets and intangible assets. Tangible assets contain various subclasses, including current assets and fixed assets, current assets include inventory, while fixed assets include such items as buildings and equipment. Intangible assets are resources and rights that have a value to the firm because they give the firm some kind of advantage in the marketplace. Examples of intangible assets include goodwill, copyrights, trademarks, patents and computer programs, an asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. One of the most widely accepted accounting definitions of asset is the one used by the International Accounting Standards Board, employees are not considered assets like machinery is, even though they can generate future economic benefits. This is because an entity does not have sufficient control over its employees to satisfy the Frameworks definition of an asset, similarly, in economics an asset is any form in which wealth can be held. The accounting equation is the structure of the balance sheet. It relates assets, liabilities, and owners equity, Assets = Liabilities + Capital Liabilities = Assets − Capital Equity = Assets − Liabilities Assets are listed on the balance sheet. On a companys balance sheet certain divisions are required by generally accepted accounting principles, Assets can be divided into e. g. current assets and fixed assets, often with further subdivisions such as cash, receivables and inventory. Assets are formally controlled and managed within larger organizations via the use of asset tracking tools and these monitor the purchasing, upgrading, servicing, licensing, disposal etc. of both physical and non-physical assets. Current assets are cash and other assets expected to be converted to cash or consumed either in a year or in the operating cycle and these assets are continually turned over in the course of a business during normal business activity. There are 5 major items included into current assets, Cash and cash equivalents – it is the most liquid asset, which includes currency, deposit accounts, short-term investments – include securities bought and held for sale in the near future to generate income on short-term price differences. Receivables – usually reported as net of allowance for non-collectable accounts, inventory – trading these assets is a normal business of a company. The inventory value reported on the sheet is usually the historical cost or fair market value. This is known as the lower of cost or market rule, prepaid expenses – these are expenses paid in cash and recorded as assets before they are used or consumed
Asset
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Accounting
3.
Eugene Fama
–
Eugene Francis Gene Fama is an American economist, often referred to as The Father of Finance, best known for his empirical work on portfolio theory, asset pricing and stock market behaviour. He is currently Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business, in 2013, he shared the Nobel Memorial Prize in Economic Sciences jointly with Robert Shiller and Lars Peter Hansen. The Research Papers in Economics project ranked him as the seventh-most influential economist of all-time based on his academic contributions, Fama was born in Boston, Massachusetts, the son of Angelina and Francis Fama. All of his grandparents were immigrants from Italy, Fama is a Malden Catholic High School Athletic Hall of Fame honoree. He earned his degree in Romance Languages magna cum laude in 1960 from Tufts University where he was also selected as the school’s outstanding student-athlete. His M. B. A. and Ph. D. came from the Booth School of Business at the University of Chicago in economics and his doctoral supervisors were Nobel prize winner Merton Miller and Harry Roberts, but Benoit Mandelbrot was also an important influence. He has spent all of his career at the University of Chicago. This was the first of hundreds of such published studies. In 2013, he won the The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, Fama is most often thought of as the father of the efficient-market hypothesis, beginning with his Ph. D. thesis. First, Fama proposed three types of efficiency, strong-form, semi-strong form, and weak efficiency and they are explained in the context of what information sets are factored in price trend. In weak form efficiency the information set is just historical prices, semi-strong form requires that all public information is reflected in prices already, such as companies announcements or annual earnings figures. Second, Fama demonstrated that the notion of market efficiency could not be rejected without an accompanying rejection of the model of market equilibrium and this concept, known as the joint hypothesis problem, has ever since vexed researchers. Market efficiency denotes how information is factored in price, Fama emphasizes that the hypothesis of market efficiency must be tested in the context of expected returns. Researchers can only modify their models by adding different factors to eliminate any anomalies, the anomaly, also known as alpha in the modeling test, thus functions as a signal to the model maker whether it can perfectly predict returns by the factors in the model. However, as long as there exists an alpha, neither the conclusion of a model nor market inefficiency can be drawn according to the Joint Hypothesis. Fama also stresses that market efficiency per se is not testable and can only be tested jointly with some model of equilibrium and these papers describe two factors above and beyond a stocks market beta which can explain differences in stock returns, market capitalization and value. They also offer evidence that a variety of patterns in average returns, often labeled as anomalies in past work, schwert, G. William and Stutz, Rena M. Gene Fama’s Impact, A Quantitative Analysis
Eugene Fama
–
Nobel Prize Laureate Eugene F. Fama in Stockholm, December 2013.
4.
Stock
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The stock of a corporation is constituted of the equity stock of its owners. A single share of the stock represents fractional ownership of the corporation in proportion to the number of shares. In liquidation, the stock represents the residual assets of the company that would be due to stockholders after discharge of all senior claims such as secured and unsecured debt. Stockholders equity cannot be withdrawn from the company in a way that is intended to be detrimental to the companys creditors, the stock of a corporation is partitioned into shares, the total of which are stated at the time of business formation. Additional shares may subsequently be authorized by the shareholders and issued by the company. In some jurisdictions, each share of stock has a certain declared par value, in other jurisdictions, however, shares of stock may be issued without associated par value. Shares represent a fraction of ownership in a business, a business may declare different types of shares, each having distinctive ownership rules, privileges, or share values. Ownership of shares may be documented by issuance of a stock certificate. A stock certificate is a document that specifies the amount of shares owned by the shareholder. Stock typically takes the form of shares of common stock or preferred stock. As a unit of ownership, common stock typically carries voting rights that can be exercised in corporate decisions, shares of such stock are called convertible preferred shares. New equity issue may have specific legal clauses attached that differentiate them from previous issues of the issuer. Some shares of stock may be issued without the typical voting rights, for instance, or some shares may have special rights unique to them. Often, new issues that have not been registered with a governing body may be restricted from resale for certain periods of time. Preferred stock may be hybrid by having the qualities of bonds of fixed returns and they also have preference in the payment of dividends over common stock and also have been given preference at the time of liquidation over common stock. They have other features of accumulation in dividend, Rule 144 Stock is an American term given to shares of stock subject to SEC Rule 144, Selling Restricted and Control Securities. Under Rule 144, restricted and controlled securities are acquired in unregistered form, investors either purchase or take ownership of these securities through private sales from the issuing company or from an affiliate of the issuer. Investors wishing to sell these securities are subject to different rules than those selling traditional common or preferred stock and these individuals will only be allowed to liquidate their securities after meeting the specific conditions set forth by SEC Rule 144
Stock
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Financial markets
Stock
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One of the earliest stock by
VOC
Stock
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Stock certificate for ten shares of the
Baltimore and Ohio Railroad Company
Stock
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A stockbroker using multiple screens to stay up to date on trading.
5.
Bond (finance)
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In finance, a bond is an instrument of indebtedness of the bond issuer to the holders. The most common types of bonds include municipal bonds and corporate bonds, interest is usually payable at fixed intervals. Very often the bond is negotiable, that is, the ownership of the instrument can be transferred in the secondary market and this means that once the transfer agents at the bank medallion stamp the bond, it is highly liquid on the second market. Thus, a bond is a form of loan or IOU, the holder of the bond is the lender, the issuer of the bond is the borrower, and the coupon is the interest. Bonds provide the borrower with funds to finance long-term investments, or, in the case of government bonds. Certificates of deposit or short term commercial paper are considered to be money market instruments and not bonds, the main difference is in the length of the term of the instrument. Bonds and stocks are both securities, but the difference between the two is that stockholders have an equity stake in the company, whereas bondholders have a creditor stake in the company. Being a creditor, bondholders have priority over stockholders and this means they will be repaid in advance of stockholders, but will rank behind secured creditors in the event of bankruptcy. Another difference is that usually have a defined term, or maturity, after which the bond is redeemed. An exception is a bond, such as a consol, which is a perpetuity, that is. Bonds are issued by authorities, credit institutions, companies. The most common process for issuing bonds is through underwriting, when a bond issue is underwritten, one or more securities firms or banks, forming a syndicate, buy the entire issue of bonds from the issuer and re-sell them to investors. The security firm takes the risk of being unable to sell on the issue to end investors. Primary issuance is arranged by bookrunners who arrange the bond issue, have contact with investors and act as advisers to the bond issuer in terms of timing. The bookrunner is listed first among all participating in the issuance in the tombstone ads commonly used to announce bonds to the public. The bookrunners willingness to underwrite must be discussed prior to any decision on the terms of the issue as there may be limited demand for the bonds. In contrast, government bonds are issued in an auction. In some cases, both members of the public and banks may bid for bonds, in other cases, only market makers may bid for bonds
Bond (finance)
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Securities
Bond (finance)
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Bond certificate for the state of South Carolina issued in 1873 under the state's Consolidation Act.
Bond (finance)
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Railroad obligation Moscow-Kiev-Voronezh
Bond (finance)
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Receipt for temporary bonds for the state of Kansas issued in 1922
6.
Information
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In other words, it is the answer to a question of some kind. It is thus related to data and knowledge, as data represents values attributed to parameters, as it regards data, the informations existence is not necessarily coupled to an observer, while in the case of knowledge, the information requires a cognitive observer. At its most fundamental, information is any propagation of cause, Information can be encoded into various forms for transmission and interpretation. It can also be encrypted for safe storage and communication, the uncertainty of an event is measured by its probability of occurrence and is inversely proportional to that. The more uncertain an event, the information is required to resolve uncertainty of that event. The bit is a unit of information, but other units such as the nat may be used. Example, information in one fair coin flip, log2 =1 bit, the concept that information is the message has different meanings in different contexts. The English word was derived from the Latin stem of the nominative. Inform itself comes from the Latin verb informare, which means to give form, eidos can also be associated with thought, proposition, or even concept. The ancient Greek word for information is πληροφορία, which transliterates from πλήρης fully and it literally means fully bears or conveys fully. In modern Greek language the word Πληροφορία is still in use and has the same meaning as the word information in English. In addition to its meaning, the word Πληροφορία as a symbol has deep roots in Aristotles semiotic triangle. In this regard it can be interpreted to communicate information to the one decoding that specific type of sign, from the stance of information theory, information is taken as an ordered sequence of symbols from an alphabet, say an input alphabet χ, and an output alphabet ϒ. Information processing consists of a function that maps any input sequence from χ into an output sequence from ϒ. The mapping may be probabilistic or deterministic and it may have memory or be memoryless. Often information can be viewed as a type of input to an organism or system, inputs are of two kinds, some inputs are important to the function of the organism or system by themselves. In his book Sensory Ecology Dusenbery called these causal inputs, other inputs are important only because they are associated with causal inputs and can be used to predict the occurrence of a causal input at a later time. Some information is important because of association with information but eventually there must be a connection to a causal input
Information
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Partial map of the Internet, with nodes representing IP addresses
Information
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The
ASCII codes for the word "
Wikipedia " represented in
binary, the numeral system most commonly used for encoding textual computer information
Information
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Galactic (including dark) matter distribution in a cubic section of the Universe
Information
–
Information embedded in an abstract mathematical object with symmetry breaking nucleus
7.
Rational expectations
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In economics, rational expectations are model-consistent expectations, in that agents inside the model on average assume the models predictions are valid. Rational expectations ensure internal consistency in aggregate stochastic models, to obtain consistency within a model, the predictions of the future value of economically relevant variables are optimal given the decision-makers information set and model structure. The rational expectations assumption is used especially in many contemporary macroeconomic models, Rational expectations does not imply individual rationality and should not be confused with rational choice theory, which is used extensively in, among others, game theory. Since most macroeconomic models today study decisions over many periods, the expectations of workers, consumers, how to model these expectations has long been controversial, and it is well known that the macroeconomic predictions of the model may differ depending on the assumptions made about expectations. To assume rational expectations is to assume that agents expectations may be wrong and this way of modeling expectations was originally proposed by John F. Muth and later became influential when it was used by Robert Lucas, Jr. and others. Modeling expectations is crucial in all models which study how a number of individuals, firms. The notion is one of intellectual modesty, the common sense is rationality, therefore Muth called the argument rational expectations. Rational expectations theory defines this kind of expectations as being the best guess of the future that all available information. Thus, it is assumed that outcomes that are being forecast do not differ systematically from the equilibrium results. As a result, rational expectations do not differ systematically or predictably from equilibrium results and that is, it assumes that people do not make systematic errors when predicting the future, and deviations from perfect foresight are only random. In an economic model, this is typically modelled by assuming that the value of a variable is equal to the expected value predicted by the model. For example, suppose that P is the price in a simple market, determined by supply. Rational expectations theories were developed in response to perceived flaws in theories based on adaptive expectations, under adaptive expectations, expectations of the future value of an economic variable are based on past values. For example, people would be assumed to predict inflation by looking at inflation last year, under adaptive expectations, if the economy suffers from constantly rising inflation rates, people would be assumed to always underestimate inflation. Many economists have regarded this as unrealistic, believing that individuals would sooner or later realize the trend. The rational expectations hypothesis has been used to some strong conclusions about economic policymaking. An example is the policy ineffectiveness proposition developed by Thomas Sargent and this in turn will counteract the expansionary effect of the increased money supply. All that the government can do is raise the inflation rate and this is a distinctly New Classical outcome
Rational expectations
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World GDP (PPP) per capita by country (2014)
8.
Late-2000s financial crisis
–
Excessive risk-taking by banks such as Lehman Brothers helped to magnify the financial impact globally. Massive bail-outs of financial institutions and other monetary and fiscal policies were employed to prevent a possible collapse of the worlds financial system. The crisis was followed by a global economic downturn, the Great Recession. The European debt crisis, a crisis in the system of the European countries using the euro. The Dodd–Frank Act, was enacted in the US in the aftermath of the crisis to promote the stability of the United States. The Basel III capital and liquidity standards were adopted by countries around the world, the precipitating factor was a high default rate in the United States subprime home mortgage sector. The expansion of this sector was encouraged by the Community Reinvestment Act, many of these subprime loans were then bundled and sold, finally accruing to quasi-government agencies. The implicit guarantee by the US federal government created a moral hazard, because mortgage lenders could pass these mortgages on in this way, they could and did adopt loose underwriting criteria, and some developed aggressive lending practices. The accumulation and subsequent high rate of these mortgages led to the financial crisis. High mortgage approval rates led to a pool of home-buyers. This appreciation in value led large numbers of homeowners to borrow against their homes as an apparent windfall and this bubble would be burst by a rising Single-Family Residential Mortgages Delinquency Rate. The high delinquency rates led to a devaluation of financial instruments. As the value of these assets plummeted, the market for these securities evaporated, Lehman Brothers filed for bankruptcy on September 15,2008. In spite of trillions paid out by the US federal government, the resulting decrease in buyers caused housing prices to plummet. While the collapse of financial institutions was prevented by the bailout of banks by national governments. In many areas, the market also suffered, resulting in evictions, foreclosures. The bursting of the US housing bubble, which peaked at the end of 2006, caused the values of securities tied to US real estate pricing to plummet, damaging financial institutions globally. Questions regarding bank solvency, declines in credit availability, and damaged investor confidence affected global stock markets, economies worldwide slowed during this period, as credit tightened and international trade declined
Late-2000s financial crisis
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Share in GDP of U.S. financial sector since 1860
Late-2000s financial crisis
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The
TED spread (in red) increased significantly during the financial crisis, reflecting an increase in perceived
credit risk.
Late-2000s financial crisis
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Diagram of CMLTI 2006 – NC2
Late-2000s financial crisis
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A protester on
Wall Street in the wake of the
AIG bonus payments controversy is interviewed by news media.
9.
Random walk hypothesis
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The random walk hypothesis is a financial theory stating that stock market prices evolve according to a random walk and thus cannot be predicted. It is consistent with the efficient-market hypothesis, the same ideas were later developed by MIT Sloan School of Management professor Paul Cootner in his 1964 book The Random Character of Stock Market Prices. D. The theory that stock prices move randomly was earlier proposed by Maurice Kendall in his 1953 paper, The Analysis of Economic Time Series, Part 1, the closing stock price for each day was determined by a coin flip. If the result was heads, the price would close a half point higher, thus, each time, the price had a fifty-fifty chance of closing higher or lower than the previous day. Cycles or trends were determined from the tests, the chartist told Malkiel that they needed to immediately buy the stock. Since the coin flips were random, the stock had no overall trend. Malkiel argued that this indicates that the market and stocks could be just as random as flipping a coin, there are other economists, professors, and investors who believe that the market is predictable to some degree. These people believe that prices may move in trends and that the study of past prices can be used to forecast future price direction. There have been some studies that support this view. Martin Weber, a researcher in behavioral finance, has performed many tests. In one of his key studies, he observed the stock market for ten years, Weber and other believers in the non-random walk hypothesis cite this as a key contributor and contradictor to the random walk hypothesis. Another test that Weber ran that contradicts the random walk hypothesis, was finding stocks that have had a revision for earnings outperform other stocks in the following six months. With this knowledge, investors can have an edge in predicting what stocks to pull out of the market, martin Weber’s studies detract from the random walk hypothesis, because according to Weber, there are trends and other tips to predicting the stock market. To refute the hypothesis, they compare the variance of for different τ, lo and MacKinlay have authored a paper, the Adaptive Market Hypothesis, which puts forth another way of looking at the predictability of price changes. A more rigorous treatment of testing the random walk null hypothesis for United States stock prices using one-sided optimal statistical tests is due to Alok Bhargava and it is important to separately test the random walk null hypothesis against stationary and explosive alternatives using two one-sided tests. The random walk null hypothesis for quarterly stock prices was rejected in favor of stationary alternatives using several test statistics appropriate for longitudinal data
Random walk hypothesis
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Random walk hypothesis test by increasing or decreasing the value of a fictitious stock based on the odd/even value of the decimals of
pi. The chart resembles a stock chart.
10.
Jules Regnault
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He is also one of the first authors who tried to create a stock exchange science based on statistical and probabilistic analysis. His hypotheses were used by Louis Bachelier, during the first years of his life, Jules Regnault lived in the département du Nord where his father worked. Jules’ family was not rich, and consequently, Odilon was except from serving in the military service, at the beginning of the 1860s, the two brothers moved to Paris and became brokers. In all probability, when Jules and Odilon arrived in Paris, their resources were low because they lived in one garret room. However, Jules Regnault became a millionaire, in 1881, he stopped being a broker and became a rentier. These 13 years correspond to a very easy financial period for him and he died on December 9,1894. When he died, his fortune was estimated at 1,026,510.03 francs, the inventory of Regnault’s goods shows that the most important part of his fortune was invested in bonds, in particular in the French 3. 5% rente, and in shares. This inventory suggests that he applied financial theory to establish a fortune, according to the Calcul des chances et philosophie de la bourse, the only valid investment for Jules Regnault must be bonds, which is precisely what his inventory shows. There is a mistake in the Grand dictionnaire universel du XIXe siècle published by Pierre Larousse, in the Jules Regnault bibliographical note, he wrote “Regnault, French learned, dead in 1866”. This note attributes several books to Jules, however, with the exception of the Calcul des chances et philosophie de la bourse, all the other books were written by Jean-Joseph Regnault who signed some of his books “J. Regnault”. This signature can explain the mistake, however, these two authors have no family relationship. The Catalogue général de la librairie française published in 1871 made the same mistake, Econometrics Jules Regnault 1863 Calcul des chances et philosophie de la bourse, Paris, Mallet-Bachelier and Castel. Franck Jovanovic 2006 Jules Regnault and the origins of scientific financial economics in Pioneers of financial economics edited by Geoffrey Poitras, Philippe Le Gall 2007 A History of Econometrics in France, Routledge Franck Jovanovic and Philippe Le Gall 2001 Does God practice a random walk. The financial physics of a 19th century forerunner, Jules Regnault, European Journal for the History of Economic Thought 8.3, murad Taqqu 2001 Bachelier and his Times, A Conversation with Bernard Bru, Finance and Stochastics 5, 3-32. Regnault’s birth certificate can be found at the Archives départementales du Nord, Jules Regnault’s death certificate comes from the Archives de la ville de Paris. His burial vault is number 2 in div, the Centre des archives contemporaines holds Jules’ testament and the inventory of his wealth after death. There is a copy of it in the file in the Archives départementales de l’Oise. Http, //pagesperso-orange. fr/geneadavoine/Export%20htm/f2101. htm#P_16064 A History of Econometrics in France, From Nature to Models
Jules Regnault
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Contents
11.
Louis Bachelier
–
Louis Jean-Baptiste Alphonse Bachelier was a French mathematician at the turn of the 20th century. He is credited with being the first person to model the process now called Brownian motion. His thesis, which discussed the use of Brownian motion to evaluate stock options, is historically the first paper to use advanced mathematics in the study of finance, thus, Bachelier is considered a pioneer in the study of financial mathematics and stochastic processes. Bachelier was born in Le Havre and his father was a wine merchant and amateur scientist, and the vice-consul of Venezuela at Le Havre. His mother was the daughter of an important banker, during this time Bachelier gained a practical acquaintance with the financial markets. His studies were delayed by military service. Bachelier arrived in Paris in 1892 to study at the Sorbonne, defended on March 29,1900 at the University of Paris, Bacheliers thesis was not well received because it attempted to apply mathematics to an unfamiliar area for mathematicians. However, his instructor, Henri Poincaré, is recorded as having some positive feedback. While it did not receive a mark of très honorable, despite its ultimate importance, the positive feedback from Poincaré can be attributed to his interest in mathematical ideas, not just rigorous proof. For several years following the successful defense of his thesis, Bachelier further developed the theory of diffusion processes, in 1909 he became a free professor at the Sorbonne. In 1914, he published a book, Le Jeu, la Chance, et le Hasard and his army service ended on December 31,1918. In 1919, he found a position as an assistant professor in Besançon and he married Augustine Jeanne Maillot in September 1920 but was soon widowed. When the professor returned in 1922, Bachelier replaced another professor at Dijon and he moved to Rennes in 1925, but was finally awarded a permanent professorship in 1927 at Besançon, where he worked for 10 years until his retirement. Besides the setback that the war had caused him, Bachelier was blackballed in 1926 when he attempted to receive a permanent position at Dijon, lévy later learned of his error, and reconciled himself with Bachelier. Le Jeu, la Chance et le Hasard, Bibliothèque de Philosophie scientifique, E. Flammarion Bachelier, la périodicité du hasard, L’Enseignement Mathématique,17, pp. 5–11 Bachelier, L. Sur la théorie des corrélations, Bulletin de la Société Mathématique de France. Comptes rendus des Séances, Séance du 7 Juillet 1920, pp. 42–44 Bachelier, L. Sur les décimales du nombre π, comptes rendus des Séances, Séance du 7 Juillet 1920, pp. 44–46 Bachelier, L. The Random Character of Stock Market Prices, Cambridge, MA, MIT Press Bachelier, L. May, Theory of Speculation, Google Documents Courtault, J-M. On the Centenary of Théorie de la Spéculation, Mathematical Finance,10, pp. 341–353, doi,10. 1111/1467-9965.00098 Felix, dictionary of Scientific Biography,1, New York, Charles Scribners Sons, ISBN 0-684-10114-9 Taqqu, M. S
Louis Bachelier
–
Louis Bachelier, aged 15
12.
Alfred Cowles
–
Alfred Cowles III was an American economist, businessman and founder of the Cowles Commission. He graduated from Yale in 1913, where he was a member of Skull and he was the grandson of Alfred Cowles, Sr. who was a founder of the Chicago Tribune. His father, Alfred Cowles, Jr. managed and directed the Chicago Tribune from 1898 to 1901 and his parents lived at 1130 N. Lake Shore Drive in Chicago, Illinois, Alfred Cowles III had three siblings, Knight Cheney Cowles, John Cheney Cowles, and Thomas Hooker Cowles who married Barbara Granger, daughter of architect Alfred Hoyt Granger. Alfred Cowles was Fellow and Treasurer of the Econometric Society, a Revision of Previous Conclusions Regarding Stock Price Behavior
Alfred Cowles
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v
13.
Capital asset pricing model
–
CAPM assumes a particular form of utility functions or alternatively asset returns whose probability distributions are completely described by the first two moments and zero transaction costs. Under these conditions, CAPM shows that the cost of equity capital is determined only by beta. The CAPM was introduced by Jack Treynor, William F. Sharpe, John Lintner and Jan Mossin independently, building on the work of Harry Markowitz on diversification. Sharpe, Markowitz and Merton Miller jointly received the 1990 Nobel Memorial Prize in Economics for this contribution to the field of financial economics, Fischer Black developed another version of CAPM, called Black CAPM or zero-beta CAPM, that does not assume the existence of a riskless asset. This version was more robust against empirical testing and was influential in the adoption of the CAPM. The CAPM is a model for pricing an individual security or portfolio, the SML enables us to calculate the reward-to-risk ratio for any security in relation to that of the overall market. E − R f is known as the risk premium Restated, in terms of risk premium, we find that. Note 1, the market rate of return is usually estimated by measuring the arithmetic average of the historical returns on a market portfolio. Note 2, the free rate of return used for determining the risk premium is usually the arithmetic average of historical risk free rates of return. For the full derivation see Modern portfolio theory, CAPM can be modified to include size premium and specific risk. This is important for investors in privately held companies who often do not hold a well-diversified portfolio, the x-axis represents the risk, and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML, the relationship between β and required return is plotted on the securities market line, which shows expected return as a function of β. The intercept is the nominal risk-free rate available for the market, while the slope is the market premium, the securities market line can be regarded as representing a single-factor model of the asset price, where Beta is exposure to changes in value of the Market. The equation of the SML is thus, S M L, E = R f + β i and it is a useful tool in determining if an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph, if the securitys expected return versus risk is plotted above the SML, it is undervalued since the investor can expect a greater return for the inherent risk. And a security plotted below the SML is overvalued since the investor would be accepting less return for the amount of risk assumed. To make this comparison, you need an independent estimate of the outlook for the security based on either fundamental or technical analysis techniques, including P/E. Assuming that the CAPM is correct, an asset is correctly priced when its price is the same as the present value of future cash flows of the asset
Capital asset pricing model
–
The (Markowitz)
efficient frontier. CAL stands for the
capital allocation line.
Capital asset pricing model
–
An estimation of the CAPM and the security market line (purple) for the
Dow Jones Industrial Average over 3 years for monthly data.
14.
Modern portfolio theory
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Its key insight is that an assets risk and return should not be assessed by itself, but by how it contributes to a portfolios overall risk and return. Economist Harry Markowitz introduced MPT in a 1952 essay, for which he was awarded a Nobel Prize in economics. MPT assumes that investors are risk averse, meaning that given two portfolios that offer the same expected return, investors will prefer the less risky one, thus, an investor will take on increased risk only if compensated by higher expected returns. Conversely, an investor who wants higher expected returns must accept more risk, the exact trade-off will be the same for all investors, but different investors will evaluate the trade-off differently based on individual risk aversion characteristics. Under the model, Portfolio return is the combination of the constituent assets returns. Portfolio volatility is a function of the correlations ρij of the component assets, for all asset pairs. In general, Expected return, E = ∑ i w i E where R p is the return on the portfolio, R i is the return on asset i and w i is the weighting of component asset i. Portfolio return volatility, σ p = σ p 2 For a two asset portfolio, Portfolio return, E = w A E + w B E = w A E + E . In other words, investors can reduce their exposure to individual asset risk by holding a portfolio of assets. Diversification may allow for the same expected return with reduced risk. This is the maximum volatility the portfolio of assets would reach. This graph shows expected return versus standard deviation and this is called the risk-expected return space. Every possible combination of assets, can be plotted in this risk-expected return space. The left boundary of this region is a hyperbola, and the edge of this region is the efficient frontier in the absence of a risk-free asset. Combinations along this upper edge represent portfolios for which there is lowest risk for a level of expected return. Equivalently, a portfolio lying on the efficient frontier represents the combination offering the best possible expected return for risk level. The tangent to the hyperbola at the tangency point indicates the best possible capital allocation line, matrices are preferred for calculations of the efficient frontier. W T Σ w is the variance of portfolio return, R T w is the expected return on the portfolio
Modern portfolio theory
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Efficient Frontier. The hyperbola is sometimes referred to as the 'Markowitz Bullet', and is the efficient frontier if no risk-free asset is available. With a risk-free asset, the straight line is the efficient frontier.
15.
Paul Samuelson
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Paul Anthony Samuelson was an American economist and the first American to win the Nobel Memorial Prize in Economic Sciences. The Swedish Royal Academies stated, when awarding the prize, that he has more than any other contemporary economist to raise the level of scientific analysis in economic theory. Economic historian Randall E. Parker calls him the Father of Modern Economics, Samuelson was likely the most influential economist of the later 20th century. Samuelson considered Mathematics to be the language for economists and contributed significantly to the mathematical foundations of economics with his book Foundations of Economic Analysis. He was author of the economics textbook of all time, Economics, An Introductory Analysis. He entered the University of Chicago at age 16, during the depths of the Great Depression, after graduating, he became an assistant professor of economics at Massachusetts Institute of Technology when he was 25 years of age and a full professor at age 32. In 1966, he was named Institute Professor, MITs highest faculty honor, merton, Joseph E. Stiglitz, and Paul Krugman, all of whom went on to win Nobel Prizes. He served as an advisor to Presidents John F. Kennedy, johnson, and was a consultant to the United States Treasury, the Bureau of the Budget and the Presidents Council of Economic Advisers. By contrast Friedman represented the monetarist perspective, Samuelson died on December 13,2009, at the age of 94. Samuelson was born in Gary, Indiana, on May 15,1915, to Frank Samuelson, a pharmacist, and the former Ella Lipton. His family, he said, was made up of upwardly mobile Jewish immigrants from Poland who had prospered considerably in World War I, because Gary was a brand new steel town when my family went there. In 1923 Samuelson moved to Chicago, he graduated from Hyde Park High School, he studied at the University of Chicago. He said he was born as an economist, at 8. 00am on January 2,1932, the lecture mentioned was on the British economist Thomas Malthus, who most famously studied population growth and its effects. He felt there was a dissonance between neoclassical economics and the way the system seemed to behave, and he said Henry Simons and he then completed his Master of Arts degree in 1936, and his Doctor of Philosophy in 1941 at Harvard University. As a graduate student at Harvard, Samuelson studied economics under Joseph Schumpeter, Wassily Leontief, Gottfried Haberler, Samuelson moved to MIT as an assistant professor in 1940 and remained there until his death. Samuelson comes from a family of well-known economists, including brother Robert Summers, sister-in-law Anita Summers, brother-in-law Kenneth Arrow and nephew Larry Summers. During his seven decades as an economist, Samuelsons professional positions included, Assistant Professor of Economics at M. I. T,1940, member of the Radiation Laboratory 1944–45. Professor of International Economic Relations at the Fletcher School of Law, guggenheim Fellowship from 1948–49 Professor of Economics at MIT beginning in 1947 and Institute Professor beginning in 1962
Paul Samuelson
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Samuelson in 1997
Paul Samuelson
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The competitive price system adapted from Samuelson, 1961
16.
Financial market efficiency
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In the 1970s Eugene Fama defined an efficient financial market as one in which prices always fully reflect available information”. Eugene Fama identified three levels of efficiency,1. Weak-form efficiency Prices of the securities instantly and fully reflect all information of the past prices and this means future price movements cannot be predicted by using past prices. This simply means that past data on stock prices are of no use in predicting future stock price changes, semi-strong efficiency Asset prices fully reflect all of the publicly available information. Therefore, only investors with additional inside information could have an advantage in the market, any price anomalies are quickly found out and the stock market adjusts. Strong-form efficiency Asset prices fully reflect all of the public and inside information available, therefore, no one can have an advantage in the market in predicting prices since there is no data that would provide any additional value to the investors. Therefore, no one could outperform the market by using the information that is already available to all investors. Another theory related to the efficient market hypothesis created by Louis Bachelier is the random walk theory, therefore, identifying trends or patterns of price changes in a market couldnt be used to predict the future value of financial instruments. Stocks that have performed well over the past 3 to 12 months continue to do well over the next 3 to 12 months. The momentum strategy is long recent winners and shorts recent losers, moreover, Fama has accepted that momentum is the premier anomaly. It involves only risk-free transactions and the used for trading is obtained at no cost. Therefore, the opportunities are not fully exploited, and it can be said that arbitrage is a result of market inefficiency. This reflects the semi-strong efficiency model, Fundamental valuation efficiency Asset prices reflect the expected past flows of payments associated with holding the assets Fundamental valuation involves lower risks and less profit opportunities. It refers to the accuracy of the return on the investment. Financial markets are characterized by predictability and inconsistent misalignments that force the prices to always deviate from their fundamental valuations and this reflects the weak information efficiency model. Full insurance efficiency It ensures the delivery of goods and services in all contingencies. Functional/Operational efficiency The products and services available at the markets are provided for the least cost and are directly useful to the participants. Every financial market will contain a mixture of the identified efficiency types
Financial market efficiency
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Financial markets
17.
Technical analysis
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In finance, technical analysis is a security analysis methodology for forecasting the direction of prices through the study of past market data, primarily price and volume. The efficacy of both technical and fundamental analysis is disputed by the efficient-market hypothesis which states that market prices are essentially unpredictable. The principles of analysis are derived from hundreds of years of financial market data. Some aspects of technical analysis began to appear in Joseph de la Vegas accounts of the Dutch markets in the 17th century. In 1948 Robert D. Edwards and John Magee published Technical Analysis of Stock Trends which is considered to be one of the seminal works of the discipline. It is exclusively concerned with analysis and chart patterns and remains in use to the present. Early technical analysis was almost exclusively the analysis of charts, because the power of computers was not available for the modern degree of statistical analysis. Charles Dow reportedly originated a form of point and figure chart analysis, Dow theory is based on the collected writings of Dow Jones co-founder and editor Charles Dow, and inspired the use and development of modern technical analysis at the end of the 19th century. Other pioneers of analysis techniques include Ralph Nelson Elliott, William Delbert Gann, more technical tools and theories have been developed and enhanced in recent decades, with an increasing emphasis on computer-assisted techniques using specially designed computer software. Fundamental analysts examine earnings, dividends, assets, quality, ratio, new products, research, Technicians employ many methods, tools and techniques as well, one of which is the use of charts. Using charts, technical analysts seek to identify patterns and market trends in financial markets. Technical analysts also widely use market indicators of many sorts, some of which are mathematical transformations of price, often including up and down volume, advance/decline data and other inputs. These indicators are used to assess whether an asset is trending, and if it is. Technicians also look for relationships between price/volume indices and market indicators, examples include the moving average, relative strength index, and MACD. Other avenues of study include correlations between changes in Options and put/call ratios with price, also important are sentiment indicators such as Put/Call ratios, bull/bear ratios, short interest, Implied Volatility, etc. There are many techniques in technical analysis, adherents of different techniques may ignore the other approaches, yet many traders combine elements from more than one technique. Some technical analysts use subjective judgment to decide which pattern a particular instrument reflects at a given time, others employ a strictly mechanical or systematic approach to pattern identification and interpretation. Contrasting with technical analysis is fundamental analysis, the study of factors that influence the way investors price financial markets
Technical analysis
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Financial markets
Technical analysis
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Stock chart showing levels of support (4,5,6, 7, and 8) and resistance (1, 2, and 3); levels of resistance tend to become levels of support and vice versa.
18.
Fundamental analysis
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Fundamental analysis, in accounting and finance, is the analysis of a businesss financial statements, health, and its competitors and markets. When analyzing a stock, futures contract, or currency using fundamental analysis there are two basic approaches one can use, bottom up analysis and top down analysis, the terms are used to distinguish such analysis from other types of investment analysis, such as quantitative and technical. Fundamental analysis is performed on historical and present data, but with the goal of making financial forecasts, to find out the intrinsic value of the share. Profits can be made by purchasing the mispriced security and then waiting for the market to recognize its mistake, technical analysis maintains that all information is reflected already in the price of a security. Technical analysts analyze trends and believe that sentiment changes predate and predict trend changes, investors emotional responses to price movements lead to recognizable price chart patterns. Technical analysts also analyze historical trends to predict future price movement, investors can use one or both of these different but complementary methods for stock picking. For example, many fundamental investors use technicals for deciding entry, similarly, many technical investors use fundamentals to limit their universe of possible stock to good companies. The choice of analysis is determined by the investors belief in the different paradigms for how the stock market works. Fundamental analysis includes, Economic analysis Industry analysis Company analysis The intrinsic value of the shares is determined based upon three analyses. This value is considered the value of the share. If the intrinsic value is higher than the price, it is recommended to buy the share. If it is equal to price, it is recommended to hold the share, if it is less than the market price. Investors may also use fundamental analysis within different portfolio management styles, buy and hold investors believe that latching onto good businesses allows the investors asset to grow with the business. Fundamental analysis lets them find good companies, so they lower their risk, value investors restrict their attention to under-valued companies, believing that its hard to fall out of a ditch. The values they follow come from fundamental analysis, managers may use fundamental analysis to correctly value good and bad companies. Bad companies stock price will eventually fluctuate, creating opportunities for profit, managers may also consider the economic cycle in determining whether conditions are right to buy fundamentally suitable companies. Contrarian investors hold that in the run, the market is a voting machine. Fundamental analysis allows a broker to make his or her own decision on value, in addition, managers may use fundamental analysis to determine future growth rates for buying high priced growth stocks
Fundamental analysis
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Financial markets
19.
Sinusoidal
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A sine wave or sinusoid is a mathematical curve that describes a smooth repetitive oscillation. It is named after the sine, of which it is the graph. It occurs often in pure and applied mathematics, as well as physics, engineering, signal processing and many other fields. Its most basic form as a function of time is, y = A sin = A sin where, A = the amplitude, F = the ordinary frequency, the number of oscillations that occur each second of time. ω = 2πf, the frequency, the rate of change of the function argument in units of radians per second φ = the phase. When φ is non-zero, the entire waveform appears to be shifted in time by the amount φ /ω seconds, a negative value represents a delay, and a positive value represents an advance. The sine wave is important in physics because it retains its shape when added to another sine wave of the same frequency and arbitrary phase. It is the only periodic waveform that has this property and this property leads to its importance in Fourier analysis and makes it acoustically unique. The wavenumber is related to the frequency by. K = ω v =2 π f v =2 π λ where λ is the wavelength, f is the frequency, and v is the linear speed. This equation gives a wave for a single dimension, thus the generalized equation given above gives the displacement of the wave at a position x at time t along a single line. This could, for example, be considered the value of a wave along a wire, in two or three spatial dimensions, the same equation describes a travelling plane wave if position x and wavenumber k are interpreted as vectors, and their product as a dot product. For more complex such as the height of a water wave in a pond after a stone has been dropped in. This wave pattern occurs often in nature, including wind waves, sound waves, a cosine wave is said to be sinusoidal, because cos = sin , which is also a sine wave with a phase-shift of π/2 radians. Because of this start, it is often said that the cosine function leads the sine function or the sine lags the cosine. The human ear can recognize single sine waves as sounding clear because sine waves are representations of a frequency with no harmonics. Presence of higher harmonics in addition to the fundamental causes variation in the timbre, on the other hand, if the sound contains aperiodic waves along with sine waves, then the sound will be perceived noisy as noise is characterized as being aperiodic or having a non-repetitive pattern. In 1822, French mathematician Joseph Fourier discovered that sinusoidal waves can be used as building blocks to describe and approximate any periodic waveform
Sinusoidal
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The graphs of the sine and
cosine functions are sinusoids of different phases.
20.
Robert Shiller
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Robert James Bob Shiller is an American Nobel Laureate, economist, academic, and best-selling author. He currently serves as a Sterling Professor of Economics at Yale University and is a fellow at the Yale School of Managements International Center for Finance and he is also the co‑founder and chief economist of the investment management firm MacroMarkets LLC. Shiller is ranked among the 100 most influential economists of the world, Eugene Fama, Lars Peter Hansen and Shiller jointly received the 2013 Nobel Memorial Prize in Economic Sciences, for their empirical analysis of asset prices. Shiller was born in Detroit, Michigan, the son of Ruth R. and Benjamin Peter Shiller and he is married to Virginia Marie, a psychologist, and has two children. He was raised as a Methodist, Shiller studied at Kalamazoo College and the University of Michigan where he received his B. A. degree in 1967. His book Macro Markets won TIAA-CREFs first annual Paul A. Samuelson Award and he currently publishes a syndicated column. In 1981 Shiller published an article in The American Economic Review titled Do stock prices move too much to be justified by subsequent changes in dividends, in which he challenged the efficient-market hypothesis, which was the dominant view in the economics profession at the time. Shiller argued that in a stock market, investors would base stock prices on the expected receipt of future dividends. Shiller concluded that the volatility of the market was greater than could plausibly be explained by any rational view of the future. The behavioral finance school gained new credibility following the October 1987 stock market crash, much of this survey data has been gathered continuously since 1989. In 1991 he formed Case Shiller Weiss with economists Karl Case, the company produced a repeat-sales index using home sales prices data from across the nation, studying home pricing trends. The index was developed by Shiller and Case when Case was studying unsustainable house pricing booms in Boston, the repeat-sales index developed by Case and Shiller was later acquired and further developed by Fiserv and Standard & Poor, creating the Case-Shiller index. His book Irrational Exuberance – a New York Times bestseller – warned that the market had become a bubble in March 2000 which could lead to a sharp decline. In February, Lereah had put out his book Are You Missing the Real Estate Boom, signaling the market top for housing prices. In 2003 Shiller co-authored a Brookings Institution paper called Is There a Bubble in the Housing Market, Shiller subsequently refined his position in the 2nd edition of Irrational Exuberance, acknowledging that “further rises in the markets could lead, eventually, to even more significant declines. A long-run consequence could be a decline in consumer and business confidence, is not inevitable, but it is a much more serious risk than is widely acknowledged. ”His work has been influential in the development of the theory as well as its implications for practice and policy making. His contributions on risk sharing, financial market volatility, bubbles and crises, have received attention among academics, practitioners. In 2010, he was named by Foreign Policy magazine to its list of top global thinkers, in 2011 he made the Bloomberg 50 most influential people in global finance
Robert Shiller
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Robert J. Shiller
Robert Shiller
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Nobel Prize Laureate Robert J. Shiller during press conference in Stockholm, December 2013
21.
Interest rate
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An interest rate, is the amount of interest due per period, as a proportion of the amount lent, deposited or borrowed. The total interest on an amount lent or borrowed depends on the sum, the interest rate, the compounding frequency. It is defined as the proportion of an amount loaned which a lender charges as interest to the borrower and it is the rate a bank or other lender charges to borrow its money, or the rate a bank pays its savers for keeping money in an account. Annual interest rate is the rate over a period of one year, other interest rates apply over different periods, such as a month or a day, but they are usually annualised. A company borrows capital from a bank to buy assets for its business, in return, the bank charges the company interest. Base rate usually refers to the rate offered on overnight deposits by the central bank or other monetary authority. Annual percentage rate and effective annual rate or annual equivalent rate are used to help consumers compare products with different payment structures on a common basis, a discount rate is applied to calculate present value. Interest rate targets are a tool of monetary policy and are taken into account when dealing with variables like investment, inflation. The central banks of countries tend to reduce interest rates when they wish to increase investment. In the past two centuries, interest rates have been variously set either by national governments or central banks, during an attempt to tackle spiraling hyperinflation in 2007, the Central Bank of Zimbabwe increased interest rates for borrowing to 800%. Possibly before modern capital markets, there have been some accounts that savings deposits could achieve a return of at least 25%. Political short-term gain, Lowering interest rates can give the economy a short-run boost, under normal conditions, most economists think a cut in interest rates will only give a short term gain in economic activity that will soon be offset by inflation. The quick boost can influence elections, Most economists advocate independent central banks to limit the influence of politics on interest rates. Deferred consumption, When money is loaned the lender delays spending the money on consumption goods, since according to time preference theory people prefer goods now to goods later, in a free market there will be a positive interest rate. Inflationary expectations, Most economies generally exhibit inflation, meaning a given amount of money buys fewer goods in the future than it will now, the borrower needs to compensate the lender for this. Alternative investments, The lender has a choice between using his money in different investments, if he chooses one, he forgoes the returns from all the others. Different investments effectively compete for funds, risks of investment, There is always a risk that the borrower will go bankrupt, abscond, die, or otherwise default on the loan. This means that a lender generally charges a premium to ensure that, across his investments
Interest rate
22.
Warren Buffett
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Warren Edward Buffett is an American business magnate, investor, and philanthropist. He is considered by some to be one of the most successful investors in the world and he attended New York Institute of Finance to specialize his economics background and soon after began various business partnerships, including one with Graham. After meeting Charlie Munger, Buffett created the Buffett Partnership and his firm would eventually acquire a textile manufacturing firm called Berkshire Hathaway and assume its name to create a diversified holding company. He is noted for his adherence to value investing and for his personal frugality despite his immense wealth, Buffett is a notable philanthropist, having pledged to give away 99 percent of his fortune to philanthropic causes, primarily via the Bill & Melinda Gates Foundation. Buffett was born in 1930 in Omaha, Nebraska and he was the second of three children and the only son of Leila and Congressman Howard Buffett, Buffett began his education at Rose Hill Elementary School. In 1942, his father was elected to the first of four terms in the United States Congress, after finishing high school and finding success with his side entrepreneurial and investment ventures, Buffett wanted to skip college to go directly into business, but was overruled by his father. Buffett displayed an interest in business and investing at a young age, much of Buffetts early childhood years were enlivened with entrepreneurial ventures. One of his first business ventures, Buffett sold chewing gum, Coca-Cola bottles and he worked in his grandfathers grocery store. While still in school, he made money delivering newspapers, selling golf balls and stamps. On his first income tax return in 1944, Buffett took a $35 deduction for the use of his bicycle, in 1945, as a high school sophomore, Buffett and a friend spent $25 to purchase a used pinball machine, which they placed in the local barber shop. Within months, they owned several machines in three different barber shops across Omaha, the business was sold later in the year for $1,200 to a war veteran. Buffetts interest in the market and investing dated to schoolboy days he spent in the customers lounge of a regional stock brokerage near his fathers own brokerage office. On a trip to New York City at age ten, he made a point to visit the New York Stock Exchange, at 11, he bought three shares of Cities Service Preferred for himself, and three for his sister Doris Buffett. At the age of 15, Warren made more than $175 monthly delivering Washington Post newspapers, in high school, he invested in a business owned by his father and bought a 40-acre farm worked by a tenant farmer. He bought the land when he was 14 years old with $1,200 of his savings, by the time he finished college, Buffett had accumulated $9,800 in savings. In 1947, Buffett entered the Wharton School of the University of Pennsylvania and he would have preferred to focus on his business ventures, however, he enrolled due to pressure from his father. Warren studied there for two years and joined the Alpha Sigma Phi fraternity and he then transferred to the University of Nebraska–Lincoln where at 19, he graduated with a Bachelor of Science in Business Administration. After being rejected by Harvard Business School, Buffett enrolled at Columbia Business School of Columbia University upon learning that Benjamin Graham taught there and he earned a Master of Science in Economics from Columbia in 1951
Warren Buffett
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Buffett speaking to students from the University of Kansas School of Business, May 6, 2005
Warren Buffett
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Buffett's home in Omaha
Warren Buffett
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Buffett and President Obama at the Oval Office, July 14, 2010
23.
Behavioral finance
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Risk tolerance is a crucial factor in personal financial decision making. Risk tolerance is defined as individuals willingness to engage in a financial activity whose outcome is uncertain, Behavioral economics is primarily concerned with the bounds of rationality of economic agents. Behavioral models typically integrate insights from psychology, neuroscience and microeconomic theory, in so doing, these behavioral models cover a range of concepts, methods, the study of behavioral economics includes how market decisions are made and the mechanisms that drive public choice. The use of the term behavioral economics in U. S. scholarly papers has increased in the past few years, there are three prevalent themes in behavioral finances, Heuristics, People often make decisions based on approximate rules of thumb and not strict logic. Framing, The collection of anecdotes and stereotypes that make up the mental emotional filters individuals rely on to understand and respond to events, Market inefficiencies, These include mis-pricings and non-rational decision making. During the classical period of economics, microeconomics was closely linked to psychology and they developed the concept of homo economicus, whose psychology was fundamentally rational. However, many important neo-classical economists employed more sophisticated psychological explanations, including Francis Edgeworth, Vilfredo Pareto, Economic psychology emerged in the 20th century in the works of Gabriel Tarde, George Katona, and Laszlo Garai. Expected utility and discounted utility models began to gain acceptance, generating testable hypotheses about decision-making given uncertainty and intertemporal consumption, in the 1960s cognitive psychology began to shed more light on the brain as an information processing device. In mathematical psychology, there is a longstanding interest in the transitivity of preference, prospect theory has two stages, an editing stage and an evaluation stage. In the editing stage, risky situations are simplified using various heuristics of choice, outcomes are then compared to the reference point and classified as gains if greater than the reference point and losses if less than the reference point. Loss aversion, Losses bite more than equivalent gains, in their 1979 paper published in Econometrica, Kahneman and Tversky found the median coefficient of loss aversion to be about 2.25, i. e. losses bite about 2.25 times more than equivalent gains. Prospect theory is able to explain everything that the two main existing decision theories—expected utility theory and rank dependent utility theory—can explain, prospect theory has been used to explain a range of phenomena that existing decision theories have great difficulty in explaining. These include backward bending labor supply curves, asymmetric price elasticities, tax evasion, co-movement of stock prices and consumption, in 1992, in the Journal of Risk and Uncertainty, Kahneman and Tversky gave their revised account of prospect theory that they called cumulative prospect theory. The new theory eliminated the editing phase in prospect theory and focused just on the evaluation phase and its main feature was that it allowed for non-linear probability weighting in a cumulative manner, which was originally suggested in John Quiggins rank dependent utility theory. Psychological traits such as overconfidence, projection bias, and the effects of limited attention are now part of the theory, Behavioral economics has also been applied to intertemporal choice. Intertemporal choice is defined as making a decision and having the effects of such decision happening in a different time, hyperbolic discounting describes the tendency to discount outcomes in the near future more than for outcomes in the far future. Other branches of behavioral economics enrich the model of the utility function without implying inconsistency in preferences, ernst Fehr, Armin Falk, and Matthew Rabin studied fairness, inequity aversion, and reciprocal altruism, weakening the neoclassical assumption of perfect selfishness. This work is particularly applicable to wage setting, Behavioral economics caught on among the general public with the success of books such as Dan Arielys Predictably Irrational
Behavioral finance
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Daniel Kahneman, winner of 2002 Nobel prize in economics
Behavioral finance
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World GDP (PPP) per capita by country (2014)
24.
Cognitive bias
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A cognitive bias refers to the systematic pattern of deviation from norm or rationality in judgment, whereby inferences about other people and situations may be drawn in an illogical fashion. Individuals create their own subjective social reality from their perception of the input, an individuals construction of social reality, not the objective input, may dictate their behaviour in the social world. Thus, cognitive biases may lead to perceptual distortion, inaccurate judgment, illogical interpretation. Some cognitive biases are presumably adaptive, Cognitive biases may lead to more effective actions in a given context. Furthermore, cognitive biases enable faster decisions when timeliness is more valuable than accuracy, other cognitive biases are a by-product of human processing limitations, resulting from a lack of appropriate mental mechanisms, or simply from a limited capacity for information processing. Kahneman and Tversky argue that cognitive biases have efficient practical implications for areas including clinical judgment, entrepreneurship, finance, Bias arises from various processes that are sometimes difficult to distinguish. Tversky, Kahneman and colleagues demonstrated several replicable ways in which human judgments, Tversky and Kahneman explained human differences in judgement and decision making in terms of heuristics. Heuristics involve mental shortcuts which provide swift estimates about the possibility of uncertain occurrences, heuristics are simple for the brain to compute but sometimes introduce severe and systematic errors. For example, the heuristic is defined as the tendency to judge the frequency or likelihood of an occurrence by the extent of which the event resembles the typical case. The Linda Problem illustrates the representativeness heuristic, participants were given a description of Linda that suggests Linda might well be a feminist. They were then asked whether they thought Linda was more likely to be a bank teller or a bank teller, the representativeness heuristic may lead to errors such as activating stereotypes and inaccurate judgements of others. Biases can be distinguished on a number of dimensions, for example, there are biases specific to groups as well as biases at the individual level. Some biases affect decision-making, where the desirability of options has to be considered, others such as illusory correlation affect judgment of how likely something is, or of whether one thing is the cause of another. A distinctive class of biases affect memory, such as consistency bias, some biases reflect a subjects motivation, for example, the desire for a positive self-image leading to egocentric bias and the avoidance of unpleasant cognitive dissonance. Other biases are due to the way the brain perceives. This distinction is sometimes described as hot cognition versus cold cognition, there are also biases in how subjects evaluate in-groups or out-groups, evaluating in-groups as more diverse and better in many respects, even when those groups are arbitrarily-defined. Some cognitive biases belong to the subgroup of attentional biases which refer to the paying of increased attention to certain stimuli and it has been shown, for example, that people addicted to alcohol and other drugs pay more attention to drug-related stimuli. Common psychological tests to measure those biases are the Stroop task, many social institutions rely on individuals to make rational judgments
Cognitive bias
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Daniel Kahneman
25.
Daniel Kahneman
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His empirical findings challenge the assumption of human rationality prevailing in modern economic theory. With Amos Tversky and others, Kahneman established a basis for common human errors that arise from heuristics and biases. In 2011, he was named by Foreign Policy magazine to its list of top global thinkers, in the same year, his book Thinking, Fast and Slow, which summarizes much of his research, was published and became a best seller. He is professor emeritus of psychology and public affairs at Princeton Universitys Woodrow Wilson School, Kahneman is a founding partner of TGG Group, a business and philanthropy consulting company. He is married to Royal Society Fellow Anne Treisman, in 2015 The Economist listed him as the seventh most influential economist in the world. Daniel Kahneman was born in Tel Aviv, Mandatory Palestine in 1934 and he spent his childhood years in Paris, France, where his parents had emigrated from Lithuania in the early 1920s. Kahneman and his family were in Paris when it was occupied by Nazi Germany in 1940 and his father was picked up in the first major round-up of French Jews, but he was released after six weeks due to the intervention of his employer. The family was on the run for the remainder of the war, Kahneman and his family then moved to British Mandatory Palestine in 1948, just before the creation of the state of Israel. Kahneman has written of his experience in Nazi-occupied France, explaining in part why he entered the field of psychology, Jews were required to wear the Star of David and to obey a 6 p. m. curfew. I had gone to play with a Christian friend and had stayed too late, I turned my brown sweater inside out to walk the few blocks home. As I was walking down an empty street, I saw a German soldier approaching and he was wearing the black uniform that I had been told to fear more than others – the one worn by specially recruited SS soldiers. As I came closer to him, trying to walk fast, then he beckoned me over, picked me up, and hugged me. I was terrified that he would notice the star inside my sweater and he was speaking to me with great emotion, in German. When he put me down, he opened his wallet, showed me a picture of a boy, I went home more certain than ever that my mother was right, people were endlessly complicated and interesting. Kahneman received his bachelor of science degree with a major in psychology, after earning his undergraduate degree, he served in the psychology department of the Israeli Defense Forces. One of his responsibilities was to evaluate candidates for training school. In 1958, he went to the United States to study for his PhD in Psychology from the University of California, Kahneman began his academic career as a lecturer in psychology at the Hebrew University of Jerusalem in 1961. He was promoted to lecturer in 1966
Daniel Kahneman
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Daniel Kahneman
26.
Amos Tversky
–
Much of his early work concerned the foundations of measurement. He was co-author of a treatise, Foundations of Measurement. Six years after Tverskys death, Kahneman received the 2002 Nobel Prize in Economics for the work he did in collaboration with Amos Tversky, Kahneman told The New York Times in an interview soon after receiving the honor, I feel it is a joint prize. We were twinned for more than a decade, Tversky also collaborated with many leading researchers including Thomas Gilovich, Itamar Simonson, Paul Slovic and Richard Thaler. A Review of General Psychology survey, published in 2002, ranked Tversky as the 93rd most cited psychologist of the 20th century, tied with Edwin Boring, John Dewey, and Wilhelm Wundt. Tversky was born in Haifa, British Palestine, as son of the Polish-born veterinarian Yosef Tversky and Jenia Tversky and he served with distinction in the Israel Defense Forces, rising to the rank of captain and being decorated for bravery. He received his education at Hebrew University of Jerusalem in Israel. He later taught at Hebrew University before moving to Stanford University, in 1980 he became a fellow of the American Academy of Arts and Sciences. In 1984 he was a recipient of the MacArthur Fellowship, Amos Tversky was married to Barbara Tversky, now a professor in the human development department at Teachers College, Columbia University. Tversky, co-recipient with Daniel Kahneman, earned the 2003 University of Louisville Grawemeyer Award for Psychology and he died of a metastatic melanoma. Tversky and Fox addressed ambiguity aversion, the idea that people do not like ambiguous gambles or choices with ambiguity and their idea was that people are only ambiguity averse when their attention is specifically brought to the ambiguity by comparing an ambiguous option to an unambiguous option. However, when evaluating them separately, people are willing to bet approximately the amount on either urn. Thus, when it is possible to compare the ambiguous gamble to an unambiguous gamble people are averse —, as related to Gladwell by psychologist Adam Alter, the Tversky Intelligence Test was The faster you realized Tversky was smarter than you, the smarter you were. Memorial Resolution - Amos Tversky Boston Globe, The man who wasnt there Daniel Kahneman – Autobiography
Amos Tversky
–
Amos Tversky
Amos Tversky
–
The shape of the value (
utility) function in
prospect theory. The asymmetry of the function corresponds to
loss aversion.
27.
Richard Thaler
–
Richard H. Thaler is an American economist and the Ralph and Dorothy Keller Distinguished Service Professor of Behavioral Science and Economics at the University of Chicago Booth School of Business. He is perhaps best known as a theorist in behavioral finance and his leitmotif is that market-based approaches are incomplete, he is quoted as saying conventional economics assumes that people are highly-rational – super-rational – and unemotional. They can calculate like a computer and have no self-control problems, most recently, Thaler is author of Misbehaving, The Making of Behavioral Economics ISBN 978-0393080940. Thaler is coauthor, with Cass Sunstein, of Nudge, Improving Decisions About Health, Wealth, Nudge discusses how public and private organizations can help people make better choices in their daily lives. People often make poor choices – and look back at them with bafflement, Thaler and his co-author coined the term choice architect. He has also studied cooperation in the UK game show Golden Balls. S, federal Communications Commission and making television broadcast frequency available for improving wireless technology, reducing costs, and generating revenue for the US government. Thaler cameoed as himself in the 2015 film The Big Short, alongside Selena Gomez to explain the Hot-hand fallacy. The Winners Curse, Paradoxes and Anomalies of Economic Life, advances in Behavioral Finance, Volume II. Thaler, Richard H. and Cass Sunstein, Nudge, Improving Decisions About Health, Wealth, and Happiness. Misbehaving, The Making of Behavioral Economics, new York, W. W. Norton & Company. Mental accounting Naive diversification Curriculum Vitae Faculty home page at U of Chicago Article, Deal or No Deal Nudge web page Misbehaving book web page and blog Roberts, Russ
Richard Thaler
–
Richard Thaler in 2012.
28.
Paul Slovic
–
Paul Slovic is a professor of psychology at the University of Oregon and the president of Decision Research. Decision Research is a collection of scientists all over the nation. He was also the president for the Society of Risk Analysis until 1984 and he is past president of the Society for Risk Analysis and in 1991 received its Distinguished Contribution Award. In 2016 he was elected to the National Academy of Sciences, Slovic studies human judgment, decision making, and risk perception, and has published extensively on these topics. He is considered, with Baruch Fischhoff and Sarah Lichtenstein, a leading theorist and his most recent work examines “psychic numbing” and the failure to respond to mass human tragedies. Affect Heuristic - This is the ability to make an emotional decision in time of crisis. Slovic says that if there is a bad situation, if we have positive feelings toward something it lowers people’s perception of risks. Slovic contributed towards the psychometric paradigm of risk perception and he found that people usually perceived most activities as having a high risk. He also found that if someone gained pleasure from something they saw the level being low. This shows that risk levels can depend on the personal belief. Psychophysical Numbing - This is the idea that people are not as affected by the loss of life depending on how it is presented, Slovic says that people cannot connect on an emotional level when being presented with large numbers. Perception of Risk Posed by Extreme Events - In this publication Slovic discusses what research says about people’s perceived risk when associated with extreme events, the way people think action should take place is based on their perceptions. These perceptions can vary from people’s status, background, education, biology, the different perceptions decide how risky a choice of action is in extreme events over another. Risk perceptions are connected between emotions and reason, which creates rational behavior, Slovic explains what risk actually is. He says it is a hazard, probability, it has consequences, since it has so many subjective meanings tied to it, it often causes communication failure. Risk perceptions are studied in three ways, axiomatic measurement paradigm, socio-cultural paradigm, and psychometric paradigm. The axiomatic measurement looks at how people view consequences of a risky choice, the Socio-cultural looks at the “effect of group and culture level variable on risk perception”. Psychometric paradigm looks at how people react emotionally to a situation that “affects judgments of the riskiness of physical, environmental and material risk”
Paul Slovic
–
Paul Slovic
29.
Value stock
–
Although value investing has taken many forms since its inception, it generally involves buying securities that appear underpriced by some form of fundamental analysis. High-profile proponents of value investing, including Berkshire Hathaway chairman Warren Buffett, have argued that the essence of value investing is buying stocks at less than their intrinsic value, the discount of the market price to the intrinsic value is what Benjamin Graham called the margin of safety. The intrinsic value is the value of all future distributions. However, the distributions and the appropriate discount rate can only be assumptions. Value investing was established by Benjamin Graham and David Dodd, both professors at Columbia Business School and teachers of many famous investors. In terms of picking stocks, he recommended defensive investment in stocks trading below their tangible book value as a safeguard to adverse future developments often encountered in the stock market, however, the concept of value has evolved significantly since the 1970s. Book value is most useful in industries where most assets are tangible, intangible assets such as patents, brands, or goodwill are difficult to quantify, and may not survive the break-up of a company. When an industry is going through fast technological advancements, the value of its assets is not easily estimated, sometimes, the production power of an asset can be significantly reduced due to competitive disruptive innovation and therefore its value can suffer permanent impairment. One good example of decreasing asset value is a personal computer, an example of where book value does not mean much is the service and retail sectors. One modern model of calculating value is the cash flow model. Value investing has proven to be an investment strategy. There are several ways to evaluate its success, one way is to examine the performance of simple value strategies, such as buying low PE ratio stocks, low price-to-cash-flow ratio stocks, or low price-to-book ratio stocks. Numerous academics have published studies investigating the effects of buying value stocks and these studies have consistently found that value stocks outperform growth stocks and the market as a whole. Simply examining the performance of the best known value investors would not be instructive, in this speech, Buffett examined the performance of those investors who worked at Graham-Newman Corporation and were thus most influenced by Benjamin Graham. Buffetts conclusion is identical to that of the research on simple value investing strategies—value investing is, on average. During about a 25-year period, published research and articles in leading journals of the value ilk were few, Warren Buffett once commented, You couldnt advance in a finance department in this country unless you thought that the world was flat. Benjamin Graham is regarded by many to be the father of value investing, along with David Dodd, he wrote Security Analysis, first published in 1934. Graham later wrote The Intelligent Investor, a book that brought value investing to individual investors
Value stock
–
Benjamin Graham
30.
Overreaction
–
Exaggeration is a representation of something in an excessive manner. exaggerating. It is the opposite of minimisation, inflated praise in the form of flattery and puffery has a similarly lengthy history. Exaggerating is also a type of deception, as well as a means of malingering – magnifying small injuries or discomforts as an excuse to avoid responsibilities, character assassination typically involves deliberate exaggeration or manipulation of facts. Cognitive behavioral therapy views magnification as unconscious, unrealistic mental processing or cognitive distortion and this is better known as making a big deal out of nothing. Whereas probability overestimation refers to exaggerating the likelihood of an event, closely related is overgeneralizing, where one takes a single negative event and see it as a never-ending pattern of defeat. Another form of exaggeration is inflation of the difficulty of achieving a goal after attaining it. Psychoanalysis considered that neurotic exaggerations were the products of displacement – overvaluations for example being used to maintain a repression elsewhere, thus a conflict over ambivalence may be resolved by means of exaggerating ones love for a person so as to keep an unconscious hatred in further check. Alarmism is excessive or exaggerated alarm about a real or imagined threat e. g. the increases in deaths from infectious disease, the alarmist person is subject to the cognitive distortion of catastrophizing – of always expecting the worst of possible futures. Some theoreticians of the comic consider exaggeration to be a comic device. It may take different forms in different genres, but all rely on the fact that the easiest way to make things laughable is to exaggerate to the point of absurdity their salient traits, catherine Tate is an example of a comedian who uses exaggeration. Catherine Tate creates characters who are so over the top as to be almost cartoon-like and her comedy is never meant to offend any viewer and is always based on satire and grotesque exaggeration. In literature, a caricature is a description of a person using exaggeration of some characteristics, slapstick is the recourse to humor involving exaggerated physical activity which exceeds the boundaries of common sense. These exaggerated depictions are found in childrens cartoons, and light film comedies aimed at younger audiences. Paradoxical laughter is an expression of humor which is unwarranted by external events. It may be uncontrollable laughter which may be recognised as inappropriate by the person involved, freud considered the compulsive laughter which so often occurs on mournful occasions the by-product of ambivalence. The boastful soldier or Miles Gloriosus has for thousands of years formed part of the Western stage, the original miles gloriosus in Plautus is a son of Jove and Venus who has killed an elephant with his fist and seven thousand men in one days fighting. In other words, he is trying to put on a good show, overacting is the exaggeration of gestures and speech when acting. It may be unintentional, particularly in the case of a bad actor, or be required for the role, for the latter, it is commonly used in comical situations or to stress the evil characteristics of a villain
Overreaction
–
Fishing stories are often associated with exaggeration.
Rabelais '
Pantagruel got a
sea serpent when fishing.
Overreaction
–
Charicature from 1796, parodizing the fashion of one or two feathers issuing vertically from a woman's headdress, as are also women's neo-classically influenced gown styles (rather new in England in 1796), and men's ultra-tight trousers (or "calf-clingers" in the slang of the period).
Overreaction
–
Hamlet, by William Morris Hunt.
31.
Beta (finance)
–
In finance, the beta of an investment indicates whether the investment is more or less volatile than the market as a whole. In general, a less than 1 indicates that the investment is less volatile than the market. Volatility is measured as the fluctuation of the price around the mean, Beta is a measure of the risk arising from exposure to general market movements as opposed to idiosyncratic factors. The market portfolio of all investable assets has a beta of exactly 1, a beta below 1 can indicate either an investment with lower volatility than the market, or a volatile investment whose price movements are not highly correlated with the market. An example of the first is a bill, the price does not go up or down a lot. An example of the second is gold, the price of gold does go up and down a lot, but not in the same direction or at the same time as the market. A beta greater than one means that the asset both is volatile and tends to move up and down with the market. An example is a stock in a big technology company, negative betas are possible for investments that tend to go down when the market goes up, and vice versa. There are few fundamental investments with consistent and significant negative betas, Beta is important because it measures the risk of an investment that cannot be reduced by diversification. It does not measure the risk of an investment held on a stand-alone basis, in the capital asset pricing model, beta risk is the only kind of risk for which investors should receive an expected return higher than the risk-free rate of interest. The definition above covers only theoretical beta, the term is used in many related ways in finance. Thus they measure the amount of risk the fund adds to a portfolio of funds of the same type. Beta decay refers to the tendency for a company with a high beta coefficient to have its beta coefficient decline to the market beta and it is an example of regression toward the mean. A statistical estimate of beta is calculated by a regression method. Since practical data are available as a discrete time series of samples, the statistical model is r a, t = α + β r b, t + ε t. The best estimates for α and β are those such that Σεt2 is as small as possible, a common expression for beta is β = C o v V a r, where Cov and Var are the covariance and variance operators. Beta can be computed for prices in the past, where the data is known, however, what most people are interested in is future beta, which relates to risks going forward. Estimating future beta is a difficult problem, one guess is that future beta equals historical beta
Beta (finance)
–
The Security Market Line
32.
Economic bubble
–
An economic bubble or asset bubble is trade in an asset at a price or price range that strongly deviates from the corresponding assets intrinsic value. It could also be described as a situation in which asset prices appear to be based on implausible or inconsistent views about the future, Asset bubbles date back as far as the 1600s and are now widely regarded as a recurrent feature of modern economic history. Because it is difficult to observe intrinsic values in real-life markets, bubbles are often conclusively identified only in retrospect. Such a drop is known as a crash or a bubble burst, prices in an economic bubble can fluctuate erratically, and become impossible to predict from supply and demand alone. While some economists deny that bubbles occur, the cause of bubbles remains disputed by those who are convinced that asset prices often deviate strongly from intrinsic values. Many explanations have suggested, and research has recently shown that bubbles may appear even without uncertainty, speculation. In such cases, the bubbles may be argued to be rational and these approaches require that the timing of the bubble collapse can only be forecast probabilistically and the bubble process is often modelled using a Markov switching model. Similar explanations suggest that bubbles might ultimately be caused by processes of price coordination, more recent theories of asset bubble formation suggest that these events are sociologically driven. For instance, explanations have focused on emerging social norms and the role that culturally-situated stories or narratives play in these events and this was one of the earliest modern financial crises, other episodes were referred to as manias, as in the Dutch tulip mania. The metaphor indicated that the prices of the stock were inflated and fragile – expanded based on nothing but air, and vulnerable to a sudden burst, as in fact occurred. The impact of economic bubbles is debated within and between schools of thought, they are not generally considered beneficial, but its debated how harmful their formation. Political economist Robert E. Wright argues that bubbles can be identified before the fact with high confidence. A protracted period of low risk premiums can simply prolong the downturn in asset price deflation as was the case of the Great Depression in the 1930s for much of the world and the 1990s for Japan. Not only can the aftermath of a crash devastate the economy of a nation, another important aspect of economic bubbles is their impact on spending habits. Market participants with overvalued assets tend to spend more because they feel richer, many observers quote the housing market in the United Kingdom, Australia, New Zealand, Spain and parts of the United States in recent times, as an example of this effect. In an economy with a bank, the bank may therefore attempt to keep an eye on asset price appreciation. This is usually done by increasing the interest rate, in the 1970s, excess monetary expansion after the U. S. came off the gold standard created massive commodities bubbles. These bubbles only ended when the U. S, central Bank finally reined in the excess money, raising federal funds interest rates to over 14%
Economic bubble
–
A card from the
South Sea Bubble
33.
Market sentiment
–
Market sentiment is the general prevailing attitude of investors as to anticipated price development in a market. This attitude is the accumulation of a variety of fundamental and technical factors, including history, economic reports, seasonal factors. If investors expect upward price movement in the market, the sentiment is said to be bullish. On the contrary, if the sentiment is bearish, most investors expect downward price movement. Market sentiment is considered as a contrarian indicator, what most people expect is a good thing to bet against. Market sentiment is used because it is believed to be a predictor of market moves. Very bearish sentiment is usually followed by the market going up more than normal, Market sentiment is monitored with a variety of technical and statistical methods such as the number of advancing versus declining stocks and new highs versus new lows comparisons. In the last decade, investors are known to measure market sentiment through the use of news analytics. Barberis & Thaler, and Baker & Wurgler, the authors argue that behavioral patterns of retail investors have a significant impact on market returns. According to the first approach, investor attention can be approximated with particular financial market-based measures, according to Gervais et al. and Hou et al. trading volume is a good proxy for investor sentiment. High trading volume on a particular stock leads to appreciating of its price, extreme one-day returns are also reported to draw investors’ attention. Noise traders tend to buy stocks with high returns, whaley and Baker & Wurgler suggest Chicago Board Options Exchange Volatility Index as an alternative market sentiment measure. Credit Suisse Fear Barometer is based on prices of zero-premium collars that expire in three months and this index is sometimes used as an alternative to VIX index. The Acertus Market Sentiment Indicator incorporates five variables, Price/Earnings Ratio, price momentum, Realized Volatility, High Yield Bond Returns, each of these factors provides a measure of market sentiment through a unique lens, and together they may offer a more robust indicator of market sentiment. Closed-end fund discount reported to be possible measure of investor attention, the studies suggest an evidence that changes in discounts of closed-end funds are highly correlated with fluctuations in investor sentiment. Brown et al. investigate daily mutual fund flow as possible measure of investor attention, according to Da et al. individual investors switch from equity funds to bond funds when negative sentiment is high. Dividend premium potentially can be a predictor for investor sentiment. Retail investor trades data is reported to be able to represent investor attention
Market sentiment
–
Bear and Bull, Reinhard Dachlauer,
Frankfurt
34.
Short (finance)
–
In finance, short selling is the practice of selling securities or other financial instruments that are not currently owned, and subsequently repurchasing them. In the event of a price decline, the short seller profits. Conversely, the short position closes out at a if the price of a shorted instrument rises prior to repurchase. Potential loss on a sale is theoretically unlimited, as there is no theoretical limit to a rise in the price of the instrument. In the securities markets, the seller generally must borrow the securities to effect delivery in the short sale. In practical terms, going short can be considered the opposite of the practice of going long. Mathematically, the return from a position is equivalent to that of owning a negative amount of the instrument. A short sale may have a variety of objectives, traders or fund managers may hedge a long position or a portfolio through one or more short positions. In contrast to a merchant who starts out to buy low, sell high. Although some feel that short selling is morally wrong, research indicates that banning short selling is ineffective and has effects on markets. The following example describes the sale of a security. To profit from a decrease in the price of a security, when the seller decides that the time is right, the seller buys equivalent securities and returns them to the lender. In most market conditions there is a supply of securities to be borrowed, held by pension funds, mutual funds. The act of buying back the securities that were sold short is called covering the short or covering the position, a short position can be covered at any time before the securities are due to be returned. Once the position is covered, the seller is not affected by subsequent rises or falls in the price of the securities. Short selling refers broadly to any used by an investor to profit from the decline in price of a borrowed asset or financial instrument. Derivatives contracts include futures, options, and swaps, shares in ACME Inc. currently trade at $10 per share. A short seller investor borrows from a lender 100 shares of ACME Inc. subsequently, the price of the shares falls to $8 per share
Short (finance)
–
Securities
Short (finance)
–
Schematic representation of short selling in two steps. The short seller
borrows shares and immediately sells them. The short seller then expects the price to decrease, when the seller can profit by purchasing the shares to return to the lender.
35.
John Maynard Keynes
–
John Maynard Keynes, 1st Baron Keynes CB FBA, was a British economist whose ideas fundamentally changed the theory and practice of macroeconomics and the economic policies of governments. His ideas are the basis for the school of thought known as Keynesian economics and he instead argued that aggregate demand determined the overall level of economic activity and that inadequate aggregate demand could lead to prolonged periods of high unemployment. According to Keynesian economics, state intervention was necessary to moderate boom, Keynes advocated the use of fiscal and monetary policies to mitigate the adverse effects of economic recessions and depressions. He and other economists had disputed the ability of government to regulate the business cycle favorably with fiscal policy. When Time magazine included Keynes among its Most Important People of the Century in 1999, the Economist has described Keynes as Britains most famous 20th-century economist. In addition to being an economist, Keynes was also a servant, a director of the Bank of England. John Maynard Keynes was born in Cambridge, Cambridgeshire, England and his father, John Neville Keynes, was an economist and a lecturer in moral sciences at the University of Cambridge and his mother Florence Ada Keynes a local social reformer. Keynes was the first born, and was followed by two more children – Margaret Neville Keynes in 1885 and Geoffrey Keynes in 1887, Geoffrey became a surgeon and Margaret married the Nobel Prize-winning physiologist Archibald Hill. According to the economist and biographer Robert Skidelsky, Keyness parents were loving and they remained in the same house throughout their lives, where the children were always welcome to return. Keyness mother made her childrens interests her own, and according to Skidelsky, because she could grow up with her children, they never outgrew home. In January 1889, at the age of five and a half and he quickly showed a talent for arithmetic, but his health was poor leading to several long absences. He was tutored at home by a governess, Beatrice Mackintosh, in January 1892, at eight and a half, he started as a day pupil at St Faiths preparatory school. By 1894, Keynes was top of his class and excelling at mathematics, in 1896, St Faiths headmaster, Ralph Goodchild, wrote that Keynes was head and shoulders above all the other boys in the school and was confident that Keynes could get a scholarship to Eton. In 1897, Keynes won a scholarship to Eton College, where he displayed talent in a range of subjects, particularly mathematics, classics. At Eton, Keynes experienced the first love of his life in Dan Macmillan, despite his middle-class background, Keynes mixed easily with upper-class pupils. In 1902 Keynes left Eton for Kings College, Cambridge, after receiving a scholarship for this also to read mathematics, Alfred Marshall begged Keynes to become an economist, although Keyness own inclinations drew him towards philosophy – especially the ethical system of G. E. Moore. Keynes joined the Pitt Club and was an member of the semi-secretive Cambridge Apostles society. Like many members, Keynes retained a bond to the club after graduating, before leaving Cambridge, Keynes became the President of the Cambridge Union Society and Cambridge University Liberal Club
John Maynard Keynes
–
Keynes in 1933
John Maynard Keynes
–
King's College, Cambridge. Keynes's grandmother wrote to him saying that, since he was born in Cambridge, people will expect him to be clever.
John Maynard Keynes
–
Keynes's colleague, David Lloyd George. Keynes was initially wary of the "Welsh Wizard," preferring his rival
Asquith, but was impressed with Lloyd George at Versailles; this did not prevent Keynes from painting a scathing picture of the then-Prime Minister in his
Economic Consequences of the Peace.
John Maynard Keynes
–
Keynes argued against a return to the
gold standard at parity with pre-war sterling valuation after the
Great War.
36.
Black Monday (1987)
–
In finance, Black Monday refers to Monday, October 19,1987, when stock markets around the world crashed, shedding a huge value in a very short time. The crash began in Hong Kong and spread west to Europe, the Dow Jones Industrial Average fell exactly 508 points to 1,738.74. In Australia and New Zealand, the 1987 crash is referred to as Black Tuesday because of the time zone difference. The stock market advanced significantly, with the Dow peaking in August 1987 at 2,722 points, further financial uncertainty may have resulted from the collapse of OPEC in early 1986, which led to crude oil price decreasing by more than 50% by mid-1986. On October 14, the DJIA dropped 95.46 points to 2,412.70, on Thursday, October 15,1987, Iran hit the American-owned supertanker, the Sungari, with a Silkworm missile off Kuwaits main Mina Al Ahmadi oil port. The next morning, Iran hit another ship, the U. S. -flagged MV Sea Isle City, with another Silkworm missile. On Friday, October 16, when all the markets in London were unexpectedly closed due to the Great Storm of 1987, then-Treasury Secretary James Baker stated concerns about the falling prices. Later that morning, two U. S. warships shelled an Iranian oil platform in the Persian Gulf in response to Irans Silkworm missile attack on the Sea Isle City. By the end of October, stock markets in Hong Kong, Australia, Spain, the United Kingdom, New Zealands market was hit especially hard, falling about 60% from its 1987 peak, and taking several years to recover. The Black Monday decline was—and currently remains—the largest one-day percentage decline in the DJIA, however, the economy was barely affected and growth actually increased throughout 1987 and 1988, with the DJIA regaining its pre-crash closing high of 2,722 points in early 1989. This, along with the demise of the leveraged buyout craze brought a five-year depression late that year. Possible causes for the decline included program trading, overvaluation, illiquidity, a popular explanation for the 1987 crash was selling by program traders, most notably as a reaction to the computerized selling required by portfolio insurance hedges. However, economist Dean Furbush points out that the biggest price drops occurred when trading volume was light, in program trading, computers perform rapid stock executions based on external inputs, such as the price of related securities. Common strategies implemented by program trading involve an attempt to engage in arbitrage, as computer technology became more available, the use of program trading grew dramatically within Wall Street firms. After the crash, many blamed program trading strategies for blindly selling stocks as markets fell, some economists theorized the speculative boom leading up to October was caused by program trading, and that the crash was merely a return to normalcy. Either way, program trading ended up taking the majority of the blame in the eye for the 1987 stock market crash. Congressman Edward J. Markey, who had been warning about the possibility of a crash, New York Universitys Richard Sylla divides the causes into macroeconomic and internal reasons. Macroeconomic causes included international disputes about foreign exchange and interest rates, the internal reasons included innovations with index futures and portfolio insurance
Black Monday (1987)
–
DJIA (July 19, 1987, to January 19, 1988).
37.
Shanghai Stock Exchange
–
The Shanghai Stock Exchange, is a stock exchange that is based in the city of Shanghai, China. It is one of the two stock exchanges operating independently in the Peoples Republic of China, the other being the Shenzhen Stock Exchange. Shanghai Stock Exchange is the worlds 5th largest stock market by market capitalization at US$3.5 trillion as of February 2016, the current exchange was re-established on November 26,1990 after a 41-year hiatus and was in operation on December 19 of the same year. It is a non-profit organization directly administered by the China Securities Regulatory Commission, the formation of the International Settlement in Shanghai was the result of the Treaty of Nanking of 1842 and subsequent agreements between the Chinese and foreign governments. The Shanghai International Settlement was crucial to the development of trade in China. The market for trading in Shanghai began in the late 1860s. The first shares registrar appeared in June 1866, in 1891 during the boom in mining shares, foreign businessmen founded the Shanghai Sharebrokers Association headquartered in Shanghai as Chinas first stock exchange. In 1904 the Association applied for registration in Hong Kong under the provision of the Companies ordinance and was renamed as the Shanghai Stock Exchange, the supply of securities came primarily from local companies. In the early days, banks dominated private shares but, by 1880, only the Hong Kong, later in 1920 and 1921, Shanghai Securities & Commodities Exchange and Shanghai Chinese Merchant Exchange started operation respectively. An amalgamation eventually took place in 1929, and the combined markets operated thereafter as the Shanghai Stock Exchange, rubber plantations became the staple of stock trading beginning in the second decade of the 20th century. By the 1930s, Shanghai had emerged as the center of the Far East. The operation of Shanghai Stock Exchange came to a halt after Japanese troops occupied the Shanghai International Settlement on December 8,1941. In 1946, Shanghai Stock Exchange resumed its operations before closing again 3 years later in 1949, after the Cultural Revolution ended and Deng Xiaoping rose to power, China was re-opened to the outside world in 1978. During the 1980s, Chinas securities market evolved in tandem with the economic reform and opening up. On 26 November 1990, Shanghai Stock Exchange was re-established and operations began a few weeks later on 19 December,1866 - The first share list appeared in June. 1871 - Speculative bubble burst triggered by monetary panic,1883 - Credit crisis resulted speculation in Chinese companies. 1890 - Bank crisis started from Hong Kong,1891 - Shanghai Sharebrokers Association established. 1895 - Treaty of Shimonoseki opened Chinese market to foreign investors,1904 - Renamed to Shanghai Stock Exchange
Shanghai Stock Exchange
38.
Shenzhen Stock Exchange
–
The Shenzhen Stock Exchange is one of Chinas three stock exchanges, alongside the Shanghai Stock Exchange and Hong Kong Stock Exchange. It is based in the Futian district of Shenzhen, Guangdong, with a market capitalization of its listed companies around US$2.285 trillion in 2015, it is the 8th largest stock exchange in the world, and 4th largest in East Asia and Asia. Many of the companies within this market are subsidiaries of companies in which the Chinese government maintains controlling interest, the exchange opened the ChiNext board, a NASDAQ-type exchange for high-growth, high-tech start-ups, on October 23,2009. Listed companies,1700 Market capitalization, RMB3521745,3 million The Shenzhen Stock Exchange building is a skyscraper with a height of 245.8 metres and 49 floors. Its construction started in 2008 and was finished in 2013. The building was designed by Rem Koolhaass firm, the building is located at 2012 Shennan Blvd
Shenzhen Stock Exchange
Shenzhen Stock Exchange
–
Shenzhen Stock Exchange (inner view)
39.
Market trend
–
A market trend is a perceived tendency of financial markets to move in a particular direction over time. These trends are classified as secular for long time frames, primary for medium time frames, a trend can only be determined in hindsight, since at any time prices in the future are not known. The terms bull market and bear market describe upward and downward market trends, respectively, the names perhaps correspond to the fact that a bull attacks by lifting its horns upward, while a bear strikes with its claws in a downward motion. A secular market trend is a trend that lasts 5 to 25 years. A secular bear market consists of bull markets and larger bear markets. In a secular bull market the prevailing trend is bullish or upward-moving, in a secular bear market, the prevailing trend is bearish or downward-moving. An example of a bear market occurred in gold between January 1980 to June 1999, culminating with the Brown Bottom. During this period the nominal gold price fell from a high of $850/oz to a low of $253/oz, a primary trend has broad support throughout the entire market and lasts for a year or more. A bull market is a period of rising prices. The start of a market is marked by widespread pessimism. This point is when the crowd is the most bearish, the feeling of despondency changes to hope, optimism, and eventually euphoria, as the bull runs its course. This often leads the cycle, for example in a full recession. Indias Bombay Stock Exchange Index, BSE SENSEX, had a bull market trend for about five years from April 2003 to January 2008 as it increased from 2,900 points to 21,000 points. More than 6 fold rise in 5 years, notable bull markets marked the 1925-1929, 1953–1957 and the 1993-1997 periods when the U. S. A bear market is a decline in the stock market over a period of time. It is a transition from high investor optimism to widespread investor fear, according to The Vanguard Group, While there’s no agreed-upon definition of a bear market, one generally accepted measure is a price decline of 20% or more over at least a two-month period. A bear market followed the Wall Street Crash of 1929 and erased 89% of the Dow Jones Industrial Averages market capitalization by July 1932, after regaining nearly 50% of its losses, a longer bear market from 1937 to 1942 occurred in which the market was again cut in half. Another long-term bear market occurred from about 1973 to 1982, encompassing the 1970s energy crisis, yet another bear market occurred between March 2000 and October 2002
Market trend
–
Statues of the two symbolic beasts of finance, the bear and the bull, in front of the
Frankfurt Stock Exchange.
Market trend
–
A 1901 cartoon depicting financier
J. P. Morgan as a bull with eager investors
40.
Hyperbolic discounting
–
In economics, hyperbolic discounting is a time-inconsistent model of discounting. It is one of the cornerstones of behavioral economics, the discounted utility approach states that Intertemporal choices are no different from other choices, except that some consequences are delayed and hence must be anticipated and discounted. Given two similar rewards, humans show a preference for one that arrives sooner rather than later, humans are said to discount the value of the later reward, by a factor that increases with the length of the delay. This process is modeled in the form of exponential discounting. A large number of studies have since demonstrated deviations from the constant discount rate assumed in exponential discounting, hyperbolic discounting is an alternative mathematical model that accounts for these deviations. According to hyperbolic discounting, valuations fall relatively rapidly for earlier delay periods, for example, in an early study subjects said they would be indifferent between receiving $15 immediately or $30 after 3 months, $60 after 1 year, or $100 after 3 years. These indifferences reflect annual discount rates that declined from 277% to 139% to 63% as delays got longer and this contrasts with exponential discounting, in which valuation falls by a constant factor per unit delay and the discount rate stays the same. The standard experiment used to reveal a test subjects hyperbolic discounting curve is to compare short-term preferences with long-term preferences, for instance, Would you prefer a dollar today or three dollars tomorrow. Or Would you prefer a dollar in one year or three dollars in one year and one day. It has been claimed that a significant fraction of subjects will take the lesser amount today, individuals with such preferences are described as present-biased. The most important consequence of hyperbolic discounting is that it creates temporary preferences for small rewards that occur sooner over larger, later ones. This dynamic inconsistency happens because hyperbolas distort the relative value of options with a difference in delays in proportion to how far the choice-maker is from those options. That is, subjects choices match these parameters, nor does it depend on human culture, the first preference reversal findings were in rats and pigeons. For instance, when offered the choice between $50 now and $100 a year now, many people will choose the immediate $50. However, given the choice between $50 in five years or $100 in six years almost everyone will choose $100 in six years, hyperbolic discounting has also been found to relate to real-world examples of self-control. Some evidence suggests pathological gamblers also discount delayed outcomes at higher rates than matched controls, likewise, some have suggested that high-rate hyperbolic discounting makes unpredictable outcomes more satisfying. The degree of discounting is vitally important in describing hyperbolic discounting, the discounting of monetary rewards varies across age groups due to the varying discount rate. The rate depends on a variety of factors, including the species being observed, age, experience, several alternative explanations of non-exponential discounting have been proposed
Hyperbolic discounting
–
Comparison of the discount factors of hyperbolic and exponential discounting. In both cases,. Hyperbolic discounting is shown to value future assets higher than exponential discounting.
41.
Mortgage loan
–
The loan is secured on the borrowers property. Mortgage can also be described as a borrower giving consideration in the form of a collateral for a benefit, Mortgage borrowers can be individuals mortgaging their home or they can be businesses mortgaging commercial property. Features of mortgage loans such as the size of the loan, maturity of the loan, interest rate, method of paying off the loan, in many jurisdictions, it is normal for home purchases to be funded by a mortgage loan. Few individuals have enough savings or liquid funds to them to purchase property outright. In countries where the demand for ownership is highest, strong domestic markets for mortgages have developed. According to Anglo-American property law, a mortgage occurs when an owner pledges his or her interest as security or collateral for a loan. As with other types of loans, mortgages have an interest rate and are scheduled to amortize over a set period of time, typically 30 years. All types of property can be, and usually are, secured with a mortgage. Mortgage lending is the mechanism used in many countries to finance private ownership of residential and commercial property. Although the terminology and precise forms will differ from country to country, the components tend to be similar, Property. The exact form of ownership will vary from country to country, Mortgage, the security interest of the lender in the property, which may entail restrictions on the use or disposal of the property. Restrictions may include requirements to purchase insurance and mortgage insurance. Borrower, the person borrowing who either has or is creating an ownership interest in the property, lender, any lender, but usually a bank or other financial institution. Principal, the size of the loan, which may or may not include certain other costs, as any principal is repaid. Interest, a charge for use of the lenders money. Completion, legal completion of the deed, and hence the start of the mortgage. A closed mortgage account is said to be redeemed, many other specific characteristics are common to many markets, but the above are the essential features. Governments usually regulate many aspects of mortgage lending, either directly or indirectly, other aspects that define a specific mortgage market may be regional, historical, or driven by specific characteristics of the legal or financial system
Mortgage loan
42.
Financial instrument
–
Financial instruments are monetary contracts between parties. They can be created, traded, modified and settled and they can be cash, evidence of an ownership interest in an entity, or a contractual right to receive or deliver cash. Financial instruments can be either cash instruments or derivative instruments, Cash instruments —instruments whose value is determined directly by the markets. They can be securities, which are transferable, and instruments such as loans and deposits. Derivative instruments —instruments which derive their value from the value and characteristics of one or more underlying entities such as an asset, index and they can be exchange-traded derivatives and over-the-counter derivatives. Alternatively, financial instruments may be categorized by asset class depending on whether they are equity-based or debt-based, if the instrument is debt, it can be further categorised into short-term or long-term. Foreign exchange instruments and transactions are neither debt- nor equity-based and belong in their own category, some instruments defy categorization into the above matrix, for example repurchase agreements
Financial instrument
43.
Bond valuation
–
Bond valuation is the determination of the fair price of a bond. As with any security or capital investment, the fair value of a bond is the present value of the stream of cash flows it is expected to generate. Hence, the value of a bond is obtained by discounting the bonds expected cash flows to the present using a discount rate. In practice, this discount rate is determined by reference to similar instruments. Various related yield-measures are then calculated for the given price, if the bond includes embedded options, the valuation is more difficult and combines option pricing with discounting. Depending on the type of option, the price as calculated is either added to or subtracted from the price of the straight portion. This total is then the value of the bond, as above, the fair price of a straight bond is usually determined by discounting its expected cash flows at the appropriate discount rate. The formula commonly applied is discussed initially, although this present value relationship reflects the theoretical approach to determining the value of a bond, in practice its price is determined with reference to other, more liquid instruments. The two main approaches here, Relative pricing and Arbitrage-free pricing, are discussed next, where the market price of bond is less than its face value, the bond is selling at a discount. Conversely, if the price of bond is greater than its face value. For this and other relationships between price and yield, see below, under this approach — an extension of the above — the bond will be priced relative to a benchmark, usually a government security, see Relative valuation. Here, the yield to maturity on the bond is determined based on the bonds Credit rating relative to a government security with similar maturity or duration, the better the quality of the bond, the smaller the spread between its required return and the YTM of the benchmark. This required return is used to discount the bond cash flows, replacing i in the formula above. Thus, rather using a single discount rate, one should use multiple discount rates. Here, each cash flow is separately discounted at the rate as a zero-coupon bond corresponding to the coupon date. Under this approach, the price should reflect its arbitrage-free price, as any deviation from this price will be exploited. Here, we apply the rational pricing logic relating to Assets with identical cash flows, in detail, the bonds coupon dates and coupon amounts are known with certainty. Therefore, some multiple of zero-coupon bonds, each corresponding to the bonds coupon dates, thus the bond price today must be equal to the sum of each of its cash flows discounted at the discount rate implied by the value of the corresponding ZCB
Bond valuation
–
Financial markets
44.
Arbitrage
–
For instance, an arbitrage is present when there is the opportunity to instantaneously buy low and sell high. People who engage in arbitrage are called arbitrageurs /ˌɑːrbᵻtrɑːˈʒɜːr/—such as a bank or brokerage firm, the term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and currencies. Arbitrage is a French word and denotes a decision by an arbitrator or arbitration tribunal, an arbitrage equilibrium is a precondition for a general economic equilibrium. The no arbitrage assumption is used in finance to calculate a unique risk neutral price for derivatives. This refers to the method of valuing a coupon-bearing financial instrument by discounting its future cash flows by multiple discount rates, by doing so, a more accurate price can be obtained than if the price is calculated with a present-value pricing approach. Arbitrage-free pricing is used for bond valuation and to detect arbitrage opportunities for investors, for the purpose of valuing the price of a bond, its cash flows can each be thought of as packets of incremental cash flows with a large packet upon maturity, being the principal. Since the cash flows are dispersed throughout future periods, they must be discounted back to the present, in the present-value approach, the cash flows are discounted with one discount rate to find the price of the bond. In arbitrage-free pricing, multiple discount rates are used, the present-value approach assumes that the yield of the bond will stay the same until maturity. This is a model because interest rates may fluctuate in the future. The discount rate may be different for each of the flows for this reason. Each cash flow can be considered an instrument that pays one payment upon maturity. The discount rates used should be the rates of multiple bonds with maturity dates the same as each cash flow. By using multiple discount rates, the price is the sum of the discounted cash flows. Arbitrage-free price refers to the price at no price arbitrage is possible. The ideas of using multiple discount rates obtained from zero-coupon bonds, the yield curve is a curve of the yields of the same bond with different maturities. This curve can be used to view trends in market expectations of how interest rates move in the future. In arbitrage-free pricing of a bond, a curve of similar zero-coupon bonds with different maturities is created. If the curve were to be created with Treasury securities of different maturities and this is to transform the bonds into zero-coupon bonds
Arbitrage
–
Grey market
45.
Diversification (finance)
–
In finance, diversification is the process of allocating capital in a way that reduces the exposure to any one particular asset or risk. A common path towards diversification is to reduce risk or volatility by investing in a variety of assets, diversification is one of two general techniques for reducing investment risk. The simplest example of diversification is provided by the proverb Dont put all your eggs in one basket, dropping the basket will break all the eggs. Placing each egg in a different basket is more diversified, there is more risk of losing one egg, but less risk of losing all of them. On the other hand, having a lot of baskets may increase costs, in finance, an example of an undiversified portfolio is to hold only one stock. This is risky, it is not unusual for a stock to go down 50% in one year. It is less common for a portfolio of 20 stocks to go down that much, if the stocks are selected from a variety of industries, company sizes and types it is still less likely. If the prior expectations of the returns on all assets in the portfolio are identical, some assets will do better than others, but since one does not know in advance which assets will perform better, this fact cannot be exploited in advance. The return on a portfolio can never exceed that of the top-performing investment. Conversely, the portfolios return will always be higher than that of the worst-performing investment. So by diversifying, one loses the chance of having invested solely in the asset that comes out best. That is the role of diversification, it narrows the range of possible outcomes, diversification need not either help or hurt expected returns, unless the alternative non-diversified portfolio has a higher expected return. There is no number of stocks that is diversified versus not. Sometimes quoted is 30, although it can be as low as 10 and this is based on a result from John Evans and Stephen Archer. More stocks gives lower price volatility, given the advantages of diversification, many experts recommend maximum diversification, also known as “buying the market portfolio. ”Unfortunately, identifying that portfolio is not straightforward. The earliest definition comes from the asset pricing model which argues the maximum diversification comes from buying a pro rata share of all available assets. This is the underlying index funds. Diversification has no maximum so long as more assets are available, every equally weighted, uncorrelated asset added to a portfolio can add to that portfolios measured diversification
Diversification (finance)
46.
Derivative (finance)
–
In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as synthetic collateralized debt obligations and credit default swaps. Most derivatives are traded over-the-counter or on a such as the Bombay Stock Exchange. Derivatives are one of the three categories of financial instruments, the other two being stocks and debt. More recent historical origin is Bucket shop that were outlawed a century ago, Derivatives are contracts between two parties that specify conditions under which payments are to be made between the parties. The assets include commodities, stocks, bonds, interest rates and currencies, but they can also be other derivatives, from the economic point of view, financial derivatives are cash flows, that are conditioned stochastically and discounted to present value. The market risk inherent in the asset is attached to the financial derivative through contractual agreements. The underlying asset does not have to be acquired, Derivatives therefore allow the breakup of ownership and participation in the market value of an asset. This also provides an amount of freedom regarding the contract design. That contractual freedom allows to modify the participation in the performance of the underlying asset almost arbitrarily, thus, the participation in the market value of the underlying can be effectively weaker, stronger, or implemented as inverse. Hence, specifically the price risk of the underlying asset can be controlled in almost every situation. Derivatives are more common in the era, but their origins trace back several centuries. One of the oldest derivatives is rice futures, which have traded on the Dojima Rice Exchange since the eighteenth century. Derivatives are broadly categorized by the relationship between the asset and the derivative, the type of underlying asset, the market in which they trade. Derivatives may broadly be categorized as lock or option products, lock products obligate the contractual parties to the terms over the life of the contract. Option products provide the buyer the right, but not the obligation to enter the contract under the terms specified, Derivatives can be used either for risk management or for speculation. Along with many financial products and services, derivatives reform is an element of the Dodd–Frank Wall Street Reform. The Act delegated many rule-making details of regulatory oversight to the Commodity Futures Trading Commission, however, these are notional values, and some economists say that this value greatly exaggerates the market value and the true credit risk faced by the parties involved
Derivative (finance)
–
Derivatives traders at the
Chicago Board of Trade
Derivative (finance)
–
Country leaders at the
2009 G-20 Pittsburgh summit
47.
Loss aversion
–
In economics and decision theory, loss aversion refers to peoples tendency to prefer avoiding losses to acquiring equivalent gains, its better to not lose $5 than to find $5. Some studies have suggested that losses are twice as powerful, psychologically, Loss aversion was first demonstrated by Amos Tversky and Daniel Kahneman. This leads to risk aversion when people evaluate an outcome comprising similar gains and losses, Loss aversion implies that one who loses $100 will lose more satisfaction than another person will gain satisfaction from a $100 windfall. In marketing, the use of periods and rebates tries to take advantage of the buyers tendency to value the good more after the buyer incorporates it in the status quo. In past behavioral economics studies, users participate up until the threat of loss equals any incurred gains. Note that whether a transaction is framed as a loss or as a gain is important to this calculation, would you rather get a $5 discount. The same change in price framed differently has a significant effect on consumer behavior, the effect of loss aversion in a marketing setting was demonstrated in a study of consumer reaction to price changes to insurance policies. The study found price increases had twice the effect on customer switching, humans may be hardwired to be loss averse due to asymmetric evolutionary pressure on gains and losses. The authors also ruled out the explanation that lack of experience with trading would lead to the endowment effect by conducting repeated markets, the first two alternative explanations—that under-trading was due to transaction costs or misunderstanding—were tested by comparing goods markets to induced-value markets under the same rules. If it was possible to trade to the level in induced value markets, under the same rules. The results showed drastic differences between induced-value markets and goods markets and this effect was consistent over trials, indicating that this was not due to inexperience with the procedure or the market. Since the transaction cost that could have been due to the procedure was equal in the induced-value and goods markets, an experiment was conducted to address this by having the clearing prices selected at random. Buyers who indicated a higher than the randomly drawn price got the good. Likewise, sellers who indicated a lower willingness-to-accept than the randomly drawn price sold the good and this incentive compatible value elicitation method did not eliminate the endowment effect but did rule out habitual bargaining behavior as an alternative explanation. Income effects were ruled out by giving one third of the mugs, one third chocolates. They were then given the option of trading the mug for the chocolate or vice versa, thus, wealth effects were controlled for those groups who received mugs and chocolate. The results showed that 86% of those starting with mugs chose mugs, 10% of those starting with chocolates chose mugs and this ruled out income effects as an explanation for the endowment effect. Also, since all participants in the group had the good, it could not be considered a trophy
Loss aversion
–
Daniel Kahneman
48.
Herd behavior
–
Herd behavior describes how individuals in a group can act collectively without centralized direction. A group of fleeing from a predator shows the nature of herd behavior. Thus the herd appears as a unit in moving together, Asymmetric aggregation of animals under panic conditions has been observed in many species, including humans, mice, and ants. Theoretical models have demonstrated symmetry-breaking similar to observations in empirical studies, for example, when panicked individuals are confined to a room with two equal and equidistant exits, a majority will favor one exit while the minority will favor the other. Possible mechanisms for this behavior include Hamilton’s selfish herd theory, neighbor copying, characteristics of escape panic include, Individuals attempt to move faster than normal. Escape is slowed by fallen individuals serving as obstacles, Individuals display a tendency towards mass or copied behavior. Alternative or less used exits are overlooked, the philosophers Søren Kierkegaard and Friedrich Nietzsche were among the first to criticize what they referred to as the crowd and herd morality and the herd instinct in human society. Modern psychological and economic research has identified herd behavior in humans to explain the phenomena of large numbers of people acting in the way at the same time. The British surgeon Wilfred Trotter popularized the herd behavior phrase in his book, Instincts of the Herd in Peace and War. In The Theory of the Leisure Class, Thorstein Veblen explained economic behavior in terms of influences such as emulation. Other social scientists explored behaviors related to herding, such as Freud, Carl Jung, swarm theory observed in non-human societies is a related concept and is being explored as it occurs in human society. Large stock market trends often begin and end periods of frenzied buying or selling. Many observers cite these episodes as examples of herding behavior that is irrational and driven by emotion—greed in the bubbles. Individual investors join the crowd of others in a rush to get in or out of the market, some followers of the technical analysis school of investing see the herding behavior of investors as an example of extreme market sentiment. Hey and Morone analyzed a model of behavior in a market context. Their work is related to at least two important strands of literature, the first of these strands is that on herd behavior in a non-market context. The seminal references are Banerjee and Bikhchandani, Hirshleifer and Welch, the second of the strands of literature motivating this paper is that of information aggregation in market contexts. In this strand of the literature, the most commonly used empirical methodologies to test for herding toward the average, are the works of Christie and Huang and Chang, Cheng, overall, it was shown that it is possible to observe herd-type behavior in a market context
Herd behavior
–
Biological swarming
Herd behavior
49.
Global financial crisis of 2008
–
Excessive risk-taking by banks such as Lehman Brothers helped to magnify the financial impact globally. Massive bail-outs of financial institutions and other monetary and fiscal policies were employed to prevent a possible collapse of the worlds financial system. The crisis was followed by a global economic downturn, the Great Recession. The European debt crisis, a crisis in the system of the European countries using the euro. The Dodd–Frank Act, was enacted in the US in the aftermath of the crisis to promote the stability of the United States. The Basel III capital and liquidity standards were adopted by countries around the world, the precipitating factor was a high default rate in the United States subprime home mortgage sector. The expansion of this sector was encouraged by the Community Reinvestment Act, many of these subprime loans were then bundled and sold, finally accruing to quasi-government agencies. The implicit guarantee by the US federal government created a moral hazard, because mortgage lenders could pass these mortgages on in this way, they could and did adopt loose underwriting criteria, and some developed aggressive lending practices. The accumulation and subsequent high rate of these mortgages led to the financial crisis. High mortgage approval rates led to a pool of home-buyers. This appreciation in value led large numbers of homeowners to borrow against their homes as an apparent windfall and this bubble would be burst by a rising Single-Family Residential Mortgages Delinquency Rate. The high delinquency rates led to a devaluation of financial instruments. As the value of these assets plummeted, the market for these securities evaporated, Lehman Brothers filed for bankruptcy on September 15,2008. In spite of trillions paid out by the US federal government, the resulting decrease in buyers caused housing prices to plummet. While the collapse of financial institutions was prevented by the bailout of banks by national governments. In many areas, the market also suffered, resulting in evictions, foreclosures. The bursting of the US housing bubble, which peaked at the end of 2006, caused the values of securities tied to US real estate pricing to plummet, damaging financial institutions globally. Questions regarding bank solvency, declines in credit availability, and damaged investor confidence affected global stock markets, economies worldwide slowed during this period, as credit tightened and international trade declined
Global financial crisis of 2008
–
Share in GDP of U.S. financial sector since 1860
Global financial crisis of 2008
–
The
TED spread (in red) increased significantly during the financial crisis, reflecting an increase in perceived
credit risk.
Global financial crisis of 2008
–
Diagram of CMLTI 2006 – NC2
Global financial crisis of 2008
–
A protester on
Wall Street in the wake of the
AIG bonus payments controversy is interviewed by news media.
50.
Market liquidity
–
In business, economics or investment, market liquidity is a markets ability to purchase or sell an asset without causing drastic change in the assets price. Equivalently, a market liquidity describes the assets ability to sell quickly without having to reduce its price to a significant degree. Liquidity is about how big the trade-off is between the speed of the sale and the price it can be sold for, in a liquid market, the trade-off is mild, selling quickly will not reduce the price much. In a relatively illiquid market, selling it quickly will require cutting its price by some amount, money, or cash, is the most liquid asset, because it can be sold for goods and services instantly with no loss of value. There is no wait for a buyer of the cash. There is no trade-off between speed and value and it can be used immediately to perform economic actions like buying, selling, or paying debt, meeting immediate wants and needs. If an asset is moderately liquid, it has moderate liquidity, in an alternative definition, liquidity can mean the amount of cash and cash equivalents. If a business has moderate liquidity, it has an amount of very liquid assets. If a business has sufficient liquidity, it has a sufficient amount of liquid assets. An act of exchanging a less liquid asset for a liquid asset is called liquidation. Often liquidation is trading the less liquid asset for cash, also known as selling it, for the same asset, its liquidity can change through time or between different markets, such as in different countries. The change in the liquidity is just based on the market liquidity for the asset at the particular time or in the particular country. The liquidity of a product can be measured as how often it is bought, Liquidity is defined formally in many accounting regimes and has in recent years been more strictly defined. For instance, the US Federal Reserve intends to apply quantitative liquidity requirements based on Basel III liquidity rules as of fiscal 2012, bank directors will also be required to know of, and approve, major liquidity risks personally. A liquid asset has some or all of the features, It can be sold rapidly, with minimal loss of value. The essential characteristic of a market is that there are always ready. A market may be considered both deep and liquid if there are ready and willing buyers and sellers in large quantities, an illiquid asset is an asset which is not readily salable due to uncertainty about its value or the lack of a market in which it is regularly traded. The mortgage-related assets which resulted in the mortgage crisis are examples of illiquid assets
Market liquidity
–
Gold is a substance with high market liquidity, as it may be sold quickly without having to reduce the
price.
Market liquidity
–
This old church building for sale in Cheshire, England, has relatively low liquidity. It could be sold in a matter of days at a low price, but it could take several years to find a buyer who is willing to pay a reasonable price.
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