Syllabus and Reading list
University of Chicago Booth School of Business
35150 Advanced Investments -- John H. Cochrane Winter 2013
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Do the required readings before class. The problems for each week will use some facts from that week's reading, and we will discuss readings in class.
All papers will be here on this website. Lecture notes and problem sets are on the main class webpage. .
There is an “Optional / Additional reading suggestions” following the required readings. Many of these are full-text versions of papers that I will mention in lecture. I’ll typically just show one table or picture. You’re not responsible for the paper. You are responsible for understanding the lecture discussions, table and/or picture. Other “not required” readings are further readings in some main topic areas, for your interest if you want to go deeper.
Important copyright notice: PDF files are distributed for class use only. You may not redistribute them, post them on the web, etc.
Note: you do not need to buy the whole book Asset Pricing. The assigned readings are all here. However, I won’t object if you do!
Outline and course policies and lots of other information Read before the first class
Before first class. Background
- Notes This includes an investments review. Skim to make sure you know this stuff and where to find it when you need it later. This week, pay special attention to Chapters 2 (probability and statistics review, regressions, and especially time series) and 5 (everything you need to know about matrices).
Week 1. Returns are predictable over time; predictability and volatility; present value models.
- Asset Pricing Ch. 20, p. 389-404. “Time series predictability.”
- Cochrane, John, 2011, Discount rates Journal of Finance 66, 1047-1108 (August 2011). This week, read p. 1047-1058. This is a review paper, basically summing up a lot of this course. We'll read it all over the course of the quarter; feel free to read it at once to keep the themes in view, or to read the selections as they come.
Week 2. The cross section of stock returns; from CAPM to value, size, momentum and anomalies
- Fama Eugene F. and Kenneth R. French 1996, "Multifactor Explanations of Asset Pricing Anomalies", Journal of Finance 51, 55-84. Skip section V, 68-75.
- Asset Pricing Ch 20 p. 422-453. Read 422-423, 435-453 now. We’ll come back to 424-435 later. My summary and interpretation of Fama and French
- Cochrane, John, 2011, Discount rates p. 1058-1064.
Week 3. Additional variables in the time-series and cross-section (and finishing up week 1/2)
- Fama, Eugene F., and Kenneth R. French 2006, “Dissecting Anomalies” Journal of Finance 63 (4) 1653-1678. An investigation of new anomalies that have cropped up since value. And a strong suspicion that many anomalies are only present in dusty corners of the market.
- Cochrane, John, 2011, Discount rates p. 1091-1095; 1097-1103
Week 4-5A. Asset pricing theory
- Utility, discount factors, expected returns. Asset Pricing Ch 1 through 1.4 3-25. Ch. 2, 35-45.
- Cochrane, John, 2011, Discount rates p. 1064-1072.
Week 5B. Asset Pricing Empirical Methods
- Asset Pricing Ch.12, 229-239; 243-250. Your goal here is to understand how to do time-series, cross-section and Fama-MacBeth procedures, why they do what they do, and where to look up formulas. You do not have to memorize formulas!
Week 6. Mutual funds
- Carhart, Mark M., 1997, “On Persistence in Mutual Fund Performance,” Journal of Finance 52, 57-82.
- Fama, Eugene F. and Kenneth R. French, 2010, "Luck versus Skill in the Cross-Section of Mutual
Fund Returns" Journal of Finance 65, 1915-1947. A brilliant new calculation based on the distribution of alphas.
- Cochrane, John, 2009, Note explaining Fama and French
- Berk, Jonathan, 2005" Five Myths of Active Portfolio Management," Journal of Portfolio Management, Vol. 31, pp. 27-31. This is only 6 pages, and summarizes Berk and Green in the optional reading below. If active management is so bad, why does it survive?
Week 7A. Hedge funds
- Mitchell, Mark and Todd Pulvino, 2001, “The characteristics of risk and return in risk arbitrage” Journal of Finance 56, 2135-2176 Link through library Really about merger arbitrage, but a nice detailed example with many lessons, in particular how equity trading can result in option-like performance.
- Asness, Cifford, Robert Krail and John Liew, 2001, Do hedge funds hedge? Journal of Portfolio Management, 28 (Fall) 6-19. The main paper. Big points are the size of betas and how hard they are to measure.
- From alpha to smart beta. Economist. One page. Fun
Week 7B. Liquidity, short sales constraints, downward-sloping "demand" curves.
- Lamont Owen, and Richard Thaler 2003, “Can the Market Add and Subtract?: Mispricing in Tech-StockCarve-Outs” Journal of Political Economy 111: 227-268 Link through JPE online edition
- Cochrane, John H., “Stock as Money: Convenience Yield and the Tech-Stock Bubble” Manuscript. (Published in William C. Hunter, George G. Kaufman and Michael Pomerleano, Eds., Asset Price Bubbles Cambridge: MIT Press 2003. Alas, no pdf available.)
Week 8A. Price pressure and trading.
Price pressure, and example.
- Brandt Michael and Kenneth A. Kavajecz, 2004, “Price Discovery in the U.S. Treasury Market: The impact of Orderflow and Liquidity on the Yield Curve” Journal of Finance 59, (Dec) 2623-2654. Focus on Table IV through Table VII and surrounding discussion. Stop reading at section III p. 2644.
Two papers on high frequency trading.
- Joel Hasbrouck and Gideon Saar, 2011, Low-Latency Trading. Finally, an academic paper on what millisecond trading is all about. Read p.1-17 and 33-37. The rest (really the meat of the paper) is a set of regressions designed to see if low-latency trading helps or hurts the markets. That's a bigger question than we have time for, I'm only assigning this as a description of the markets.
- Kirilenko, Andrei, Albert S. Kyle, Mehrdad Samadi, Tagkan Tuzun, 2011, "The Flash Crash: The Imact of High Frequency Trading on an Electronic Market" Manuscript. What the heck happened? You can skim the regressions. Digest the pictures. Don't miss the "discussion" on p. 35-38 (Section X).
Week 8B. Financial crisis
The most important lessons from the financial crisis are a) the possibility of runs in modern financial contracts b) small arbitrage opportunities than can open up when the usual active traders are out of the market.
- Duffie, Darrell, 2009, “The Failure Mechanics of Dealer Banks” Journal of Economic Perspectives 24, 51–72. This is fantastic, both to understand nuts and bolts, why there were runs, and how these markets work. This has since become a book, see optional readings.
- Gorton, Gary, 2010, E-coli, Repo Madness, and the Financial Crisis Business Economics 45(3) 164-173. link to journal
Cochrane, John, 2011, "Discount rates" p. 1069-1079. Some of the arbitrages, some of the theories, and a view that maybe the macro drives the frictions and maybe not the other way around.
Week 9 Term structure.
- Asset Pricing Ch 19.1 349-354. 19.1 is background and review reading. You need to remember yields, forward rates, expectations hypothesis, and duration. The Notes also have a quick review of this material. (If you know dz and dt, I encourage you to read 19.5. It will make Veronesi’s course look like child’s play. However, the class discussion will be limited to discrete time models in order to avoid continuous time mathematics.)
- Asset Pricing 20 p. p. 422-453. Read 20.1 426-435, “Bonds” and “Foreign Exchange”
- Cochrane, John H. and Monika Piazzesi, “Bond Risk Premia American Economic Review March 2005. Ignore section V “Tests.” (web only) Appendix to “Bond Risk Premia,” only read A.2-A.5, B.3
Week 10. Portfolio theory and practice.
- Cochrane, John H. 1999, “Portfolio Advice for a Multifactor World” Economic Perspectives Federal Reserve Bank of Chicago 23 (3) 59-78.
- Cochrane, John, 2011, Discount rates Journal of Finance 66, 1047-1108 (August 2011). p. 1079-end
- Cochrane, John H., 2012, A Mean-Variance Benchmark for Intertemporal Portfolio Theory, forthcoming, Journal of Finance. p 1-11 only (Up to "Literature." You don't have to read the equations. The first page summarizes them)
OPTIONAL/ADDITIONAL READING SUGGESTIONS
These are the original sources for many of the additional results I bring to class. These are also some classic additional readings you should look at if you get intersted in these topics.
Antti Ilmanen's book Expected Returns is an excellent summary of lots of things we do here, and also goes much further in some areas.
Week 1. Stock returns are predictable over time.
Additional reading/review papers FYI
- Cochrane, John H., Financial Markets and the Real Economy p. 244-251. This covers some of the same material. It’s a more recent, more condensed but updated summary.
- Cochrane, John H., 2008, “The dog that did not bark: A defense of return predictability’’Review of Financial Studies 21 (4) 1533-1575. My last word on the statistical controversies.
- Sean D. Campbell, Morris A. Davis, Joshua Gallin, Robert F. Martin, (2009) "What moves housing markets: A variance decomposition of the rent–price ratio" Journal of Urban Economics 66, 90–102. I didn't know about this when I wrote "Discount Rates" but they do the price volatility regression for houses much better than I did.
Week 2. The cross section of stock returns; from CAPM to value, size, momentum and anomalies
Main extra papers I plan to talk about in class
- Cliff Asness, Lasse Pedersen, and Tobias Moskowitz, 2012, Value and Momentum Everywhere, Moskowitz website , forthcoming Journal of Finance. Value and momentum exsit across asset classes and are negatively correlated. Is there one big value+momentum factor? (Data for value and momentum portfolios)
- Kent Daniel, Ravi Jagannathan and Soohun Kim Tail Risk and Momentum Strategy Returns NBER Working paper 18169. Shows how momentum has infrequent huge losses. Data
- Tobias J. Moskowitz, Yao Hua Ooi, Lasse Heje Pedersen, 2012, Time series momentum, Journal of financial economics Volume 104, Issue 2, May 2012, Pages 228–250 html at sciencedirect; DOI link. This paper very nicely ties together the "time series" approach of running forecasting regressions with the "cross section" approach of making portfolios. They are the same thing! But time and portfolio dummies matter.
- Avramov, Doron, Tarun Chordia, Gergana Jostova and Alexander Philipov, 2007, “Momentum and Credit Rating” Manuscript. Momentum is primarily a phenomenon of low credit firms. Another “latest word on momentum” paper, showing how people are interacting momentum with other variables to better forecast returns
- Lee, C. M. C. and B. Swaminathan (2000). "Price Momentum and Trading Volume." Journal of Finance 55(5): 2017-2069. Stop reading at section E p.2038 I’ll summarize the main point, which you have to dig out of the tables: a twin sort on volume and momentum gives a bigger spread in average returns, but is pretty well explained by hml betas (we don’t need a new factor). I put it here because cross-sorts involving past volume are a big part of many hedge fund models.
- Narasimhan Jegadeesh and Sheridan Titman 2011, Momentum, Annual Review of Financial Economics Vol. 3: 493-509 ( DOI: 10.1146/annurev-financial-102710-144850. A good, recent readable review of momentum. However, they forget that momentum is a factor not just a feature of indvidual returns.
Additional or review papers on size, value, momentum
- Davis, James, Eugene F. Fama, and Kenneth R. French 2000, “Characteristics, Covariances, and Average Returns: 1929 to 1997” Journal of Finance 55 389-406. Our problem set suggests that the characteristics (size, b/m) are more powerful predictors of returns than the betas. There’s nothing wrong with that; betas are not perfectly measured. Still, is it true? Here’s FF’s view of the issue.
- Fama, Eugene F. and Kenneth R. French 2011 Size, Value and Momentum in International Stock Returns, Journal of Financial Economics 105 (2012) 457–472. Always read the latest Fama French paper on anything.
- Cochrane, John H., Financial Markets and the Real Economy p. 251-257. This is mostly a summary of the Fama French paper.
Week 3. Additional Variables
The whole betting against beta thing is the latest AQR strategy, worth looking at a bit
- Frazzini, Andrea, and Lasse H. Pedersen 2011 Betting against beta Section II starting p. 20 only. The latest alpha from AQR. Forget the theory, understand the tables. We have looked for profit as expected return without beta. But beta without expected return is also profit!
- Andrea Frazzini and Lasse Heje Pedersen (2011) Embedded Leverage Extends the arugment in BaB. People like me objected, if people want leverage, let them buy options. The claim here, options also have too low expected returns. "Strong evidence from index options, equity options, and leveraged ETFs."
Some high-frequency time-series forcasters::
- Tim Bollerslev, James Marrone, Lai Xu and Hao Zhou, 2011, "Stock Return Predictability and Variance RiskPremia: Statistical Inference and International Evidence" Skip right to table 4 and 5. They claim that the difference between realized and implied volatility can forecast stock returns, at short horizons. This is an example of the higher-frequency forecast variables that many hedge funds are using.
- Stefan Nagel, 2011, Evaporating Liquidity ( Local link) This one documents short-term reversal strategies, how they are "liquidity provision" strategies and highly correlated with volatility forecasts. Again, you can skip the theory and read the tables.
Week 4-5 Asset pricing theory and empirical methods
I used to do a half-lecture on equity premium, then other more interesting things intruded. Still, the question “will stocks outperform bonds in your lifetime?” “What is the market premium and why” are enduring, and you should think about them at some point.
- Equity premium and macroeconomic risks. Asset Pricing Ch. 21.1. 455-474
- Cochrane, John H., Financial Markets and the Real Economy p. 257-26, p. 314.
I don't want to leave you with the feeling that the consumption model is hopeless. Here is my best effort, and a good recent paper which also illustrates a nice cross sectional regression
- Campbell, John Y. and John H. Cochrane, 199, By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior Journal of Political Economy, 107, 205-251
- Jagannathan, Ravi, and Yong Wang, 2007, Lazy Investors, Discretionary Consumption, and the Cross-Section of Stock Returns
The Journal of Finance, 62 (4) 1623-1661, also at JSTOR The consumption CAPM works quite well from December to December.
Papers I plan to mention in class:
- Berk, Jonathan and Jules H. van Binsbergen, 2012, "Measuring Managerial Skill in the Mutual Fund Industry" Manuscript. A retort to Fama and French. They measure skill by gross alpha times assets under management. 1 bp alpha on $1 billion is a lot. The use tradeable benchmarks, and also use only benchmarks available at the time in vanguard funds. Voila' lots of skill.
- Davis, James, L., 2001, “Mutual Fund Performance and Manager Style” Financial Analysts Journal. 57, 19-27 Link through library This is a cool little paper, and I will present the main table in class. Sort funds based on their HML betas, in the same way that Carhart sorted based on past return. It turns out that growth funds actually seem to beat the terrible returns of the growth portfolio. Perhaps the story of "we can find alpha in growth stocks" has some merit.
- Judith Chevalier; Glenn Ellison , “Are Some Mutual Fund Managers Better than Others? Cross-Sectional Patterns in Behavior and Performance,” The Journal of Finance, Vol. 54, No. 3. (Jun., 1999), pp. 875-899. Link through JSTOR Performance ought to be about managers. Do managers with MBAs do better? No, alas
- Judith Chevalier; Glenn Ellison , “Risk Taking by Mutual Funds as a Response to Incentives,” The Journal of Political Economy, Vol. 105, No. 6. (Dec., 1997), pp. 1167-1200. Link through JSTOR This has the great graph I show in class, showing how good returns lead to more money. The "flow-performace" puzzle is central to a charge of irrational investors, and the central observation that Berk and Green want to refute.
- Frazzini, Andrea, Lauren Cohen and Christopher Malloy, 2008 “The Small World of Investing: Board Connections and Mutual Fund Return” Journal of Political Economy 16. Mutual fund managers who went to HBS put a lot of money in companies headed by HBS classmates -- and do surprisingly well in those investments. Alas, you didn't go there. You'll have to learn some finance instead of just networking to get inside information.
Just for fun
- Andrea Frazzini, David Kabiller and Lasse Heje Pedersen (2012) Buffett‛s Alpha, "Berkshires‛ leverage is about 1.6-to-1 on average. Berkshires' returns can thus largely be explained by the use of leverage combined with exposures to Betting-Against-Beta and quality minus junk factors"
- Insider Monkey: Warren Buffett's style drift and Warren Buffett's alpha;
More great mutual fund papers
- French, Kenneth R., "Presidential Address: The Cost of Active Investing," Journal of Finance 63 (4) 1537-1573 (2008). The average investor has to hold the market, so alpha is a zero-sum game. We need to think about the contrast between this and Berk's view.
- Kruger, Samuel A., 2007, “Persistence in Mutual Fund Performance: Analysis of Holdings Returns”, manuscript, University of Chicago. This was a student paper for Fama’s research class. Kruger replicates Carhart, extending data as we do, and using the returns on reported fund holdings rather than fund returns. This allows him to see if transactions costs and expenses really do account for Carhart’s bad alphas. They do. So the puzzle of the negative alphas is solved
- Chen, Hsiu-Lang, Narasimhan Jegadeesh, and Russ Wermers, 2000, “The Value of Active Mutual Fund Management: An Examination of the Stockholdings and Trades of Fund Managers” The Journal of Financial and Quantitative Analysis, Vol. 35, No. 3. (Sep., 2000), pp. 343-368. One of the cool things going on in mutual fund research is that we now have holdings data, so we can see what they do. This nice paper looks at what funds hold and what they trade. It checks how stocks do after fund managers buy them. Funds buy stocks after they went up; this gives them some momentum success.
- Marcin Kacperczyk, Clemens Sialm, Lu Zheng, 2005, “Unobserved Actions of Mutual Funds”, NBER Working Paper 11766 Another paper exploiting the holdings data. We see holdings once per quarter. How do actual returns differ from holding the disclosed portfolio without further trading? Does the trading add anything?
- Cremers, Martijn and Antti Pettajisto, 2010, How Active is you Fund Manager? A new measure that predicts performance Review of Financial Studies, 2009, 22(9):3329-3365. Another paper using holdings data. Funds are "Active" whose holdings deviate a lot from benchmarks. They find "active" funds outperform! But then there's a fight with Carhart about benchmarks.
- Carhart, Mark M., Ron Kaniel, David K. Musto and Adam V. Reed, 2002 “Leaning for the Tape: Evidence of Gaming Behavior in Equity Mutual Funds” Journal of Finance LVII (2) 661-691.Funds seem to push up some stock prices at the end of the year in order to make their NAVs look good and get the flows documented by Chevalier & Ellison. Interestingly, being in the top rank is more important than beating the S&P or other goals.
- Jonathan B. Berk and Richard C. Green, 2004 “Mutual fund flows and performance in rational markets” Journal of Political Economy 112, 1269-1295. This is the long version of "Five Myths." It's a very nice economic model of the puzzling fact that funds with good past returns get more money. No, you don’t need irrational investors to generate the facts.
- Berk, Jonathan and Richard Stanton, “Managerial Ability, Compensation, and the closed-end fund discount” Journal of Finance 62, 529-556. Extends the argument to closed end funds.
- David Blitz, Joop Huij 2012 Another Look at the Performance of Actively Managed Equity Mutual Funds Passive funds can't attain the same performance as Fama French factors, so take the overall level of alphas with a grain of salt.
- Lauren Cohen, Christopher Malloy and Andrea Frazzini (2010) Sell Side School Ties, Journal of Finance 65, 1409-1437. Analysts outperform by up to 6.60% per year on their stock recommendations when they have an educational link to the company.
"board connections" above but for analysts.
Papers I will draw on in class:
- Cochrane, John, 2011, Hedge Funds. This is a powerpoint presentation I put together to summarize the lessons of this class. There are a lot of important issues that I will skip, especially the incentives implied by option contracts and the issues that arise when you put hedge funds in a portfolio.
- Agarwal, Vikas and Narayan Naik, 2004, “Risk and Portfolio Decisions Involving Hedge Funds” Review of Financial Studies. 17: 63 - 98. Skim the introduction and skip section 5. Just focus on Table 4 and 5 of performance evaluation. They do a good job of constructing an option-writing factor.
- Malkiel, Burton , and Atanu Saha, 2005, “Hedge Funds: Risk and Return,” Financial Analysts Journal 61 (6) 80-89. Documents selection bias.
- Lo, Andrew W., 2001, “Risk Management for Hedge Funds: Introduction and Overview” Financial Analysts Journal. This is a nice overview of fat tails, survivor bias, etc. and what it means for hedge fund evaluation.
- "The Madoff Case: Quantitative Beats Qualitative!" How you could easily have uncovered Madoff with a simple regression! The graph of Madoff returns vs. S&P 500 really says it all.
More great hedge fund papers
- Stulz, Rene, 2007, “Hedge Funds: Past, Present and Future,” Journal of Economic Perspectives 21(2) 175-194. This is a good overview. Lite reading.
- William N. Goetzmann, Sharon Oster, 2012, Competition Among University Endowments, NBER working paper 18173. University endowments care not so much about absolute money, but about having more than their competitors. They document this, and endowments betting the farm on hedge funds to catch up. It's an interesting insight to the question, who invests in hedge funds and why?
- Asness, Clifford, 2004, “An Alternative Future Part II: An Exploration of the Role of Hedge Funds.” Journal of Portfolio Management, Fall 2004, v. 31, iss. 1, pp. 8-23. Beautiful exposition of where funds are, where they’re going, and why they’re likely to stick around. Disagrees a lot with Stulz.
- Cassar, Gavin and Joseph Gerakos, 2009, “Hedge funds: pricing controls and the smoothing of self-reported returns,” (You can skip “robustness tests” p. 27-31.) Is autocorrelation in fund returns a sign of illiquidity or report management? They split up hedge funds by how much discretion managers have over return reporting, to see if more discretion means more autocorrelation. It's not as strong as you might think, suggesting illiquidity rather than results management.
- Lo, Andrew W. 2009, Hedge funds: an analytic perspective. A whole book of Andy’s wisdom on Hedge funds.
- Naik, Narayan Y., 2006, “Why is Santa so Kind to Hedge Funds?’’ Manuscript, London Business School . “Leaning for the tape” in hedge funds. With illiquid and hard to value assets, NAVs rise suspiciously at Christmas.
- French, Craig, Damian Ko and Vivek Jindal 2006, "The Topography of Hedge Fund Returns" Manuscript. When you're tired, look at this one. It's just lots of pretty pictures summarizing hedge fund returns.
- What's it all about, alpha? Mar 22nd 2007 The Economist This piece captures some of my schizophrenic feelings about hedge fund performance evaluation.
- Hasanhodzic, Jasmina and Andrew W. Lo, 2007, “Can Hedge-Fund Returns be Replicated?: The Linear Case” Journal of Investment Management 5(2) 5-45. This paper goes on and on, but there are some interesting points in Table 5 and 7 and associated figures. They look at individual funds, not indices. There is a lot of variety in HF betas across funds. The most interesting numbers are the autocorrelations. Hedge funds returns are very autocorrelated!
- Hasanhodzic, Jasmina, and Andrew W. Lo, 2006, “Attack of the clones”, Institutional Investor’s Alpha June 2006. Popular version of the previous paper. Description of new "exotic beta" products.
- Schmid, Markus and Samuel Manser, 2008, "The performance persistence of equity long/short hedge funds" Manuscript. Like Carhart did for mutual funds, applied to hedge funds.
- Jakub Jurek, and Erik Stafford, 2012, The Cost of Capital for Alternative Investments, forthcoming Journal of Finance. A more sophisticated replication of the overall hedge fund portfolio to a short-put passive strategy. Table III last column shows put writing accounts for all the alpha
Will Gotezmann and Yale teaches a whole class on hedge funds. Here is his reading list and outline
Liquidity, short sales constraints, downward sloping demand curves
- Cochrane, John, 2004, Liquidity, Trading and Asset Prices, NBER Reporter. This is a summary of what I know about liquidity and trading.
Short sales constraints:
- Here we go again..From Wall Street Journal: Shorting Facebook Is a Pricey Proposition, For Now (WSJ) May 23, 2012, 1:41 PM; Shorting Facebook Quickly Goes From
Pricey to Cheap May 23, 2012 3:06 PM (WSJ); Short Sellers Find Friends in Banks May 24, 2012, 8:39 p.m. (WSJ)
- D'Avolio, Gene, 2002, The Market For Borrowing Stock, Journal of Financial Economics 66(2-3) 271-306. A very clear explanation of the short market, and fairly comprehensive tests for overpricing.
- Lamont, Owen, (2012) “Go Down Fighting: Short Sellers vs. Firms” Review of Asset Pricing Studies 2 (1):1-30. link to journal Manuscript, Yale University. Real fun. An alpha prize, but you can’t trade on it. This is, I think, the biggest documented inefficiency in Finance.
- Rich Karlgaarda, January 3 2012 Wall Street Journal, A short seller takes on a vitamin vendor. ( link to WSJ ) A new data point for Lamont. Short seller exposes pyramid scheme.
- Lamont, Owen, and Jeremy C Stein, "Aggregate Short Interest and Market Valuations" American Economic Review, May 2004. This shows a puzzle: short interest is not very high at peaks. Their view: shorts get wiped out on the way up. My view: few people who want to short the index do so by shorting individual stocks. Still, a good fact to know. In Oct 2008, it seems that longs got wiped out on the way down!
- Lamont, Owen, Short Sale Constraints and Overpricing Manuscript Yale University. An easy-to-read summary
- Boehmer, Ekkehart, Charles M. Jones and Xiaoyan Zhang, 2008, "Which Shorts are Informed?" Journal of Finance 63 (2) 491-527. The latest on short sales, and which category of investor’s short decisions are followed by poor returns. Interesting in that poor returns should follow a short constraint, i.e. unrequited desire to short. Poor returns should not follow a lot of shorting; the shorting should lower the price right away.
- Cohen, Lauren, Karl Diether and Christopher Malloy, 2006, “Supply and Demand Shifts in the Shorting Market” Forthcoming Journal of Finance. Link through Cohen’s website This is a really nice analysis based on the short lending program of a big quasi-passive investment firm.
- Battalio, Robert and Paul Schultz, 2009, “Regulatory Uncertainty and Market Liquidity: The 2008 Short Sale Ban’s Impact on Equity Option Markets,” Manuscript, University of Notre Dame. In the financial crisis, our fearless leaders had the brilliant idea of banning short-sales of bank stocks. This paper examines how it all worked out.
- Ekkehart Boehmer, Charles Jones, Xiaoyan Zhang 2010 Shackling Short Sellers: The 2008 Shorting Ban Columbia University Research Paper Series No. 34-09. Another nice analysis of the short-sale ban in 2008. Did it prop up prices? Even if you can't short, you can sell, why didn't everyone sell? Getting rid of the shorts dramatically reduces market liquidity. Not in the paper, the short ban also threw a monkey wrench in many trading strategies, with dire consequences for many financial firms and hedge funds. Regulators quickly exempted dealers from the short ban, allowing the dealers to clean up. Merry Christmas.
- Steven N. Kaplan, Tobias J. Moskowitz, and Berk A. Sensoy, 2010, "The Effects of Stock Lending on Security Prices: An Experiment" Forthcoming, Journal of Finance. They convinced a large manager to randomly offer for short some stocks with high demand. No effects on prices.
Arbitrages -- the same thing selling for two different prices.
- Mei, Jianping, José Scheinkman and Wei Xiong, 2009, Speculative Trading and Stock Prices: Evidence from Chinese A-B Share Premia Annals of Economics and Finance 10, 225-255.
This nice paper shows many of the points in “Stocks as money” hold in Chinese A-B shares.
- Kalok Chan, Albert J. Menkveld, Zhishu Yang, " Information Asymmetry and Asset Prices: Evidence from the China Foreign Share Discount" Journal of Finance 63(1) 159-196. Another paper on this cool phenomenon.
- Maymin, Phillip, "Self-imposed limits to arbitrageJournal of Applied Finance 2011, vol. 21, no. 2, pp.88-105. HSBC had two classes of shares, whih sold for up to 10% different prices. On the same exchange.
Price pressure, downward sloping demand, etc.
- Mitchell, Mark, Todd Pulvino and Erik Stafford, 2004, “Price Pressure Around Mergers” Journal of Finance, 59, 31-63. Stafford’s website Arbitrageurs move prices around merger announcements.
- Shleifer, Andrei, 1986, “Do Demand Curves for Stocks Slope Down?” The Journal of Finance, 41, 579-590. Inclusion in the S&P500 raises your price a bit. Famous as one of the first "demand curve for stocks slopes down" papers. Cool, but the glass still is 99% full.
- Nicholas Barberis Andrei Shleifer and Jeffrey Wurgler, 2005 “Comovement” Journal of Financial Economics 75, 283-317 This follows up on Shleifer’s original, showing stocks start to move together more when they get included.
- Mitchell, Mark , Lasse Heje Pedersen, and Todd Pulvino. 2007. "Slow-Moving Capital." American Economic Review, 97(2): 215–220. DOI:10.1257/aer.97.2.215 Hedge funds that specialize in convertible arb get wiped out. Spreads widen. It takes a while for the multi-strategy funds to move in. (Not required: Slides) This is about the period before the crash, but the mechanism is the same.
Fixed income price pressure, arbitrage, liquidity etc. (I may refer back to these during the fixed income lecture)
- Robin Greenwood and Dimitri Vayanos, 2010, "Price Pressure in the Government Bond Market" American Economic Review: Papers & Proceedings 100 , 585–590.
AEA link. Two nice experiments: The UK told pension funds to buy long term bonds, and the US changed its maturity structure. Both seem to have affected bond prices.
- Arvind Krishnamurthy and Annette Vissing-Jorgensen, 2012, The Aggregate Demand for Treasury Debt, Jstor link Journal of Political Economy, Vol. 120, No. 2 (April 2012), pp. 233-267. See Figure 1. The paper suggests that something very like money demand occurs for long-term Treasury debt.
- Grace Xing Hu, Jun Pan, and Jiang Wang 2012, "Noise as Information for Illiquidity," Manuscript. times when dealers have less cash show larger "arbitrage" spreads in the yield curve, and forecast higher returns from arbitrage strategies.
- Matthias Fleckensteinm Francis A. Longstaff,
Hanno Lustig (2010) "Why Does the Treasury Issue Tips? The TIPS-Treasury Bond Puzzle" UCLA link A large fixed income "arbitrage." There is a huge arbitrage available by shorting Treasuries (once again), buying TIPS (less liquid) and buying inflation swaps. "Supply" variables are important in this spread, and many similar "arbitrage spreads" open up at the same time. Authors suspect mispricing of Tips, I suspect mispricing of inflation swaps, but it's a cool puzzle in any case.
- Francis A. Longstaff 2004, "The Flight to Liquidity Premium in U.S. Treasury Bond Prices" Journal of Business 77, 511-526, 2004, Contrasts treasury bonds with identical Refcorp bonds to isolate the liquidity premium.
- Beber, Alessandro, Michael W. Brandt, and Kenneth A. Kavajecz, 2008, “Flight-to-Quality or Flight-to-Liquidity? Evidence from the Euro-Area Bond Market,” Review of Financial Studies. As in Longstaff, a nice decomposition of quality vs. liquidity in bond markets.
- Duarte, Jefferson, Francis Longstaff and Fan Yu, 2006 Risk and Return in Fixed Income Arbitrage: Nickels in Front of a Steamroller? Review of Financial Studies 20,769-811 This paper has a great description of the fixed-income "arbitrage" strategies. It finds alpha, and especially in "difficult" to execute strategies that require modeling. Curiously, it finds postively skewed returns, not option-writing. Why demoted to optional readings? It stops in 2006. I suspect that all of these strategies fell apart monstrously in the crisis. Just read them and you can tell -- the first strategy relies on libor-repo rates being different; Another relies on buying MBS and hedging interest rate risk. So this is a great paper to read to understand the strategies, but I wouldn't bet a nickel on the results!
- Brad M. Barber Yi-Tsung Lee Yu-Jane Liu Terrance Odean, 2008, Just How Much Do Individual Investors Lose by Trading? The Review of Financial Studies 22, 609-632. Individuals lose, on aggressive trades. Institutions take their money.
- Matthew Baron Jonathan Brogaard Andrei Kirilenko, 2012 The Trading Profits of High Frequency Traders manuscript. Table 3 is the best, documenting who takes money from who. "Liquidity-taking" active funds seem to be the winners. Slides
- Kaniel, Ron, Giedon Saar and Sheridan Titman, 2008, "Individual Investor Trading and Stock Returns," Journal of Finance 63, 273-310. When institutions sell, individuals buy.
- Green, Richard C., Dan Li, and Norman Schurhoff, 2010, "Price Discovery in Illiquid Markts: Do Financial Asset Prices Rise Faster than they Fall?" Journal of Finance LXV 1669 ff . This is a realy cool paper about the municipal bond market. It doesn't work anything like the Treasury market in Brandt et al. Dealers buy from big customers and sell to small types, so they pass along price increases quickly, but only pass along price decreases slowly. This gives some concrete sense about what dealers do and how they make money.
- Randall Dodd, Opaque Trades IMF Finance and Development 2010. An overview of modern trading
- Economist, What Caused the Flash Crash? (local link) Economist magazine, Oct 1 201
Art in high frequency markets
- Sawtooth trading WSJ;
- Weird stuff in high frequency markets and More weird behavior in high frequency markets from my grumpy economist blog. WTF?
- Nanex has devoted itself to making picutres of high frequency markets run amok.
- Strange Days June 8'th, 2011 - NatGas Algo (nanex.net)
- Knightmare on Wall Street
- Here is their Main nanex research page with hundreds of pictures.
There is a huge amount being written on the financial crisis of course. These struck me as particularly good:
- Gorton, Gary B., and Andrew Metrick, Getting up to Speed on the Financial Crisis: A One-Weekend-Reader’s Guide
Journal of Economic Literature, 50(1): 128-50. A good overview of literature.
- Gorton, Gary B., and Andrew Metrick, 2009, “Securitized Banking and the Run on Repo” Forthcoming, Journal of Financial Econcomics. Only read to p. 18. A deeper analysis of how repos are "money" and a run on repo is like a "systemic" bank run.
- Gorton, Gary B., and Andrew Metrick, 2009, “Haircuts”, Federal Reserve Bank of St. Louis Review Nov/Dec 2010, 507-520. More detail on the rise in repo haircuts in teh financial crisis.
- Swagel, Phillip, 2009, “The finanical crisis: An inside view” Forthcoming Brookings Papers on Economic Activity. This is a nice view of the political and legal constraints as well as the government’s perspective. Not really asset pricing, so not on the main list, but if you want to understand why the government did apparently crazy things, go here.
- Brunermeier, Markus, 2009, “Deciphering the Liquidity and Credit Crunch 2007-2009” Journal of Economic Perspectives 23 77-100. (Optional longer version with more graphs) The chronology is good. I'm dubious about the "mechanisms" p. 91-99, but they are common stories.
- Gorton, Gary B, 2010, Questions and Answers about the Financial Crisis Manuscript, Prepared for the U.S. Financial Crisis Inquiry Commission
- Bernanke, Ben S., 2010, Statement
Financial Crisis Inquiry Commission, web version From the guy at the top. Once I read it closely it had a lot less insight than I remembered.
- Wallison, Peter, Dissent from the Majority Report of the Financial Crisis Inquiry Commission Jan 14 2011. If you want a "root cause" it's government housing policy. I focus on the "run" as propagating mechanism, but this is really damning on the "root cause" issue.
Arbitrages in the crisis: (Also see previous week)
- Baba, Naohiko and Frank Packer, 2009, “Interpreting deviations from covered interest parity during the financial market turmoil of 2007-2008” BIS Working paper 267 ssrn
- CDS negative basis blog post
- Fontana, Alessandro, 2010 The persistent negative CDS-bond basis during the 2007/08 Financial crisis Alessandro Fontana Department of Economics, University Ca' Foscari, Venice
- Nicolae Garleanu and Lasse Heje Pedersen, 2010 “Margin-Based Asset Pricing and Deviations from the Law of One Price”, working paper, New York University, forthcoming Review of Financial Studies. Skip the theory, but nice pictures at the end of arbitrage between corporate bonds and treasury bonds
- Sqam Lake Working Group, 2010, Prime Brokers and Derivatives Delers. This is the short squam version; since we read Duffie in class it repeats the main points.
- Duffie, Darrell, 2010 "How big banks fail, and what to do about it" The book version of "Failure mechanics"
- Corzine Firm's Final Struggles Wall Street Journal Nov. 5 2011. What, you thought it couldn't happen again? This is a good case study to compare to Duffie's paper. ( Hilarious Daly Show clip on MF Global)
- Lehman's Demise and Repo 105 Knowledge@wharton report. How Lehman dressed its windows -- and MF global did the same thing later.
- Cochrane, John H, Lessons from the financial crisis Jan 2010 Regulation 32(4), 34-37. In my view, solving TBTF expectations is the crucial policy challenge, and “regulation” with a broader TBTF guarantee isn’t going to do it.
- Duffie, Darrell, 2009, “How Should we regulate derivatives markets?” Pew Financial reform project Briefing Paper 5 Pew link
- Duffie, Darrell, 2009, “Policy Issues Facing the Market for Credit Derivatives” in The Road Ahead for the Fed, edited by John D. Ciorciari and John B. Taylor, Hoover Institution Press, 2009. This is a short, very clear overview of the CDS issue. No, exchanges are not the magic bullet.
- Squam Lake Working Group, “Credit Default Swaps, Clearinghouses and Exchanges” 2009
Structured products, repos, runs
- Gorton, Gary, 2008, "The Subprime Panic " Manuscript, Yale University, forthcoming European Financial Management. This has a good summary of how subprime mortgages and complex structures actually worked. I don't totally buy the "obscure assets" and information story, that the ABX index forced marks to market, but it's well worth reading. Gorton’s website
- Coval, Joshua, Jakub Jurek and Erik Stafford, "The economics of structured finance,” Journal of Economic Perspectives, 23:1, 3-26. A nice piece showing how tranches of securitized debt end up creating index options – same probability of default, more systemic and hence higher priced risk.
- Krishnamurthy, Arvind, 2009, “How Debt Markets Have Malfunctioned in the Crisis” Manuscript, Kellogg Graduate School of Management. Winter 2010 Journal of Economic Perspectives. Link to Krishnamurthy’s webpage. A simple overview of repo and other debt markets, and some little arbitrages. I don’t buy the “spirals” but the description is good.
- Covitz, Daniel M., Nellie Liang and Gustavo Suarez, 2009, “The Evolution of a Financial Crisis: Panic in the Asset-Backed Commercial Paper Market” Manuscript, Federal Reserve Board. SSRN Empirical work in the asset-backed commercial paper market showing how ABCB is prone to “runs” like old-fashioned bank accounts.
- Cochrane, John H., The Monster Returns Will the silly idea of buying up “toxic assets” not go away?
- Cochrane, John H. and Luigi Zingales Lehman and the Financial Crisis September 15 2009 We don’t buy the “all would have been fine if they bailed out Lehman” line.
- Did “Efficient Markets Cause the Crash,” and does the crash prove behavioral was right all along? Fama and French refute this silliness on their blog, and Ray Ball wrote a beautiful essay, and I have a few choice words in a longer response to Krugman's New York Times Magazine Article on the crash.
- Cochrane, John H. Asset pricing after the crash March 20 2009 This is a piece based on a panel discussion titled “Rethinking asset pricing” at the Spring 2009 NBER Asset Pricing meeting. It includes sceptical views on just how important credit constraints and liquidity really are. Liquidity is the frosting on the cake of finance. There is a lot of frosting these days, but still some cake.
- Berkshire Hathaway Letter This is beautifully written and I agree with almost all of it, and illustrates Buffet’s thinking in the depth of the crisis. Buffet’s views on writing insurance are a real high point. Part of my “put option” writing sermon was that writing put options is a good business, if you are transparent about the risks. Buffet is. However, he makes a great point that municipalities are much more likely to default if they know an insurer will lose money rather than if their own taxpayers and voters will lose money, so that historical default probabilities are a poor guide. The only place he gets it a little bit wrong is in the last diatribe against the Black-Scholes formula at the end. He forgot about “state prices.” A parachute, delivered to row 3b in the event that the back of the plane blew up, is worth a lot more than the $1000 it costs to order a parachute online. Similarly, the value of any promise to pay something in the state of the world that the S&P is lower 99 years from now than today (essentially, the economy is back to the stone age) is worth a lot more than probability x dollar suggests.
Anything written by Doug Diamond, Raghu Rajan, Anil Kashyap, Luigi Zingales Darrell Duffie and Gary Gorton is worth reading. Even when I disagree with them, I learn a lot.
Term structure/Exchange rates
The Fama-French approach comes to bond markets and foreign exchange.
- Lustig, Hanno, Nikolai L. Roussanov, and Adrien Verdelhan, 2011, "Common Risk Factors in Currency Markets," Review of Financial Studies 24: 3731-3777 doi:10.1093/rfs/hhr068. Read only through p. 3750.
- Nozawa, Yoshio, 2012 Corporate Bond Premia. The Fama-French approach (sort into portfolios HML factor) applied to corporate bonds.
- Craig Burnside, Martin Eichenbaum, and Sergio Rebelo "Understanding the Profitability of Currency-Trading Strategies" NBER Reporter 2012 Number 3. A short, readable summary of their work. They emphasize currency momentum as well as carry trade, see also Moskowitz and Asness "value and momentum everywhere," and address fat tails.
- Palhares, Diogo, 2012, Cash-Flow Maturity and Risk Premia in CDS Markets Manuscript, University of Chicago. What is the term (maturity) premium in CDS? The Fama French approach
Expectations hypothesis and its failures
- Jurek, Jakub, 2009, "Crash-Nuetral Currency Carry Trades," Manuscript Princeton Univeristy. Tables I, II, Fig. 1 and Fig 8. are the important parts. They should be pretty self-explanatory. Understanding the "pooled" and "XS" last two rows of Table I is the only subtlety. The idea here is that it seemed you could enhance carry trades by buying put options and still make money. The crash really creamed the carry trade since foreig interest rates were higher than dollar rates, but the flight to quality made the dollar go up.
- Burnside, Craig, Martin Eichenbaum, and Sergio Rebelo, 2008, “ Do Peso Problems Explain the Returns to the Carry Trade? Manuscript, Northwestern University.
- Burnside, Eichenbaum and Rebelo have a string of papers ("Microstructure approach," Emerging Markets," "Returns to currency specualtion") that say bid/ask spreads explain the carry trade. I don't agree, see Cochrane, Comments on “The Returns to Currency Speculation” if you’re curious.. Still, I salute people taking transactions costs seriously.
- Comments on ‘Macroeconomic Implications of Changes in the Term Premium’ My thoughts on the “Conundrum” and some deeper analysis of term structure than we’ll have time for in class.
Term structure models
- Cochrane, John H. and Monika Piazzesi 2008, Decomposing the Yield Curve, Manuscript. Extends our understanding of risk premia to multiple horizons and an "affine" model.
- Pancost, N. Aaron (2012) "Zero-CouponYields and the Cross-Section of Bond Prices" Great paper. Fits a term structure model to the underlying data, not pre-processed zero curves. Shows a lot of what was going on Dec 2008. Source of pretty graphs shown in lecture
Week 10. Portfolio theory.
- Review Notes Ch. 4 on maximization
Strongly recommended. Just inspiring words, no equations
- Cochrane, John H. 2012, A Mean-Variance Benchmark for Intertemporal Portfolio Theory This is how I think we’ll all do portfolio theory in the far future. Inspiring, I hope. Read the introduction with inspiring essay. Stop when you get to equations.
- Cochrane, John H., 2012, The size of finance. This is another essay, written in response to "finance is too big" articles. I think through a lot of issues you've seen in this course, in particular how active management and portfolio formation work.
- Cochrane, John H. Is now the time to buy stocks? Manuscript version of my Nov 2008 WSJ editorial. The source of the dp vs. ex post return graph, and proof I got one call right: no, Dec 2008 was not the time to dump everything (see "liquidating harvard")
A "real" treatment of portoflio theory and a reference
- Cochrane, John H., 2007, “Portfolio theory” draft of a new chapter for Asset Pricing. All the math especially for intertemporal portfolio theory.
- Cochrane, John H., Portfolio Formation in the new Financial World October 6,8 2009 Slides for a talk I gave covering all the portfolio theory points. Short simple version
An important case
- Ang, Andrew "Liquidating Harvard," Columbia University Case. Our endowment, and Harvard's, went on a fire sale in December 2008. Why? (I had to remove the link and file since it's copyrighted.)
How to find additional academic papers. You must be connected to the Booth network or enable the proxy server mechanism on your own machine. I 1: go to the library catalog. 2. Use the “journal alphabetical” search to find the journal. 3. There will be an “electronic resource” link to the online issues. 4. Find the issue you want and download.