Findings

Playing the Market

Kevin Lewis

December 02, 2009

Alexander Hamilton, Central Banker: Crisis Management During the U.S. Financial Panic of 1792

Richard Sylla, Robert Wright & David Cowen
Business History Review, Spring 2009, Pages 61-86

Abstract:
Most scholars know little about the Panic of 1792, America's first financial market crash, during which securities prices dropped nearly 25 percent in two weeks. Treasury Secretary Alexander Hamilton adroitly intervened to stem the crisis, minimizing its effect on the nascent nation's fragile economic and political systems. U.S. policymakers soon forgot the crisis management techniques Hamilton invented but failed to codify. Many of them were later rediscovered, and became theoretical and practical standards of modern central bank crisis management. Hamilton, for example, formulated and implemented Bagehot's rules for central bank crisis management eight decades before Walter Bagehot wrote about them in Lombard Street.

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New Evidence on the First Financial Bubble

Rik Frehen, William Goetzmann & Geert Rouwenhorst
NBER Working Paper, September 2009

Abstract:
The first global financial bubble in stock prices occurred 1720 in Paris, London and the Netherlands. Explanations for these linked bubbles primarily focus on the irrationality of investor speculation and the corresponding stock price behavior of two large firms: the South Sea Company in Great Britain and the Mississippi Company in France. In this paper we examine a broad cross-section of security price data to evaluate the causes of the bubbles. Using newly collected stock prices for British and Dutch firms in 1720, we find evidence against indiscriminate irrational exuberance and evidence in favor of speculation about two factors: the Atlantic trade and the incorporation of insurance companies. The fundamentals of both sectors may have led to high expectations of future growth. Our findings are consistent with the hypothesis that financial bubbles require a plausible story to justify investor optimism.

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Nature or Nurture: What Determines Investor Behavior?

Amir Barnea, Henrik Cronqvist & Stephan Siegel
University of Washington Working Paper, September 2009

Abstract:
We examine the foundations of investor behavior. Using data on identical and non-identical twins, matched with their complete portfolios, we decompose the cross-sectional heterogeneity in key measures of investment behavior into genetic and environmental influences. We find that up to 45 percent of the variation in stock market participation, asset allocation, and portfolio risk choices is explained by a genetic component. Genetic variation is a very important explanation for variation in investment behavior compared to the influence of education, net worth, entrepreneurial activity, and other factors studied in existing work. Furthermore, the family environment is found to have an effect on young individuals' portfolios, but in contrast to the genetic effect, it disappears with age as an individual acquires own experiences. Frequent contact between individuals leads to a common effect on investment behavior beyond the genetic factor. Finally, we find that twins who were reared apart still have similar portfolios.

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Cross-Country Causes and Consequences of the 2008 Crisis: Early Warning

Andrew Rose & Mark Spiegel
Federal Reserve Bank Working Paper, July 2009

Abstract:
This paper models the causes of the 2008 financial crisis together with its manifestations, using a Multiple Indicator Multiple Cause (MIMIC) model. Our analysis is conducted on a cross-section of 107 countries; we focus on national causes and consequences of the crisis, ignoring cross-country contagion effects. Our model of the incidence of the crisis combines 2008 changes in real GDP, the stock market, country credit ratings, and the exchange rate. We explore the linkages between these manifestations of the crisis and a number of its possible causes from 2006 and earlier. We include over sixty potential causes of the crisis, covering such categories as: financial system policies and conditions; asset price appreciation in real estate and equity markets; international imbalances and foreign reserve adequacy; macroeconomic policies; and institutional and geographic features. Despite the fact that we use a wide number of possible causes in a flexible statistical framework, we are unable to link most of the commonly-cited causes of the crisis to its incidence across countries. This negative finding in the cross-section makes us skeptical of the accuracy of early warning systems of potential crises, which must also predict their timing.

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Paulson's Gift

Pietro Veronesi & Luigi Zingales
NBER Working Paper, October 2009

Abstract:
We calculate the costs and benefits of the largest ever U.S. Government intervention in the financial sector announced the 2008 Columbus-day weekend. We estimate that this intervention increased the value of banks' financial claims by $131 billion at a taxpayers' cost of $25-$47 billions with a net benefit between $84bn and $107bn. By looking at the limited cross section we infer that this net benefit arises from a reduction in the probability of bankruptcy, which we estimate would destroy 22% of the enterprise value. The big winners of the plan were the three former investment banks and Citigroup, while the loser was JP Morgan.

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Rogue Finance: The Life and Fire Insurance Company and the Panic of 1826

Eric Hilt
Business History Review, Spring 2009

Abstract:
In July of 1826, a financial panic on Wall Street caused several companies to fail abruptly and precipitated runs on two of New York City's fifteen banks. Life and Fire Insurance became the largest of the bankruptcies. In violation of New York's banking statutes, the firm had engaged in lending on a massive scale during the speculative boom that prevailed in 1824-25. Innovative lending techniques had been developed outside the traditional banking sector - in this case, in the insurance industry. These lending practices, based on an instrument known as a post note, were initially sound, but were later extended to riskier borrowers and ultimately proved ruinous. In the credit crisis that began in late 1825, the value of the Life and Fire's assets fell dramatically, and in a desperate effort to raise cash, the directors resorted to fraud.

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Rule Britannia! British Stock Market Returns, 1825-1870

Graeme Acheson, Charles Hickson, John Turner & Qing Ye
Journal of Economic History, December 2009, Pages 1107-1137

Abstract:
This article presents a new series of monthly equity returns for the British stock market for the period 1825-1870. In addition to calculating capital appreciation and dividend yields, the article also estimates the effect of survivorship bias on returns. Three notable findings emerge from this study. First, stock market returns in the 1825-1870 period are broadly similar for Britain and the United States, although the British market is less risky. Second, real returns in the 1825-1870 period are higher than in subsequent epochs of British history. Third, unlike the modern era, dividends are the most important component of returns.

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Market-Based Corrective Actions

Philip Bond, Itay Goldstein & Edward Simpson Prescott
Review of Financial Studies, forthcoming

Abstract:
Many economic agents take corrective actions based on information inferred from market prices of firms' securities. Examples include directors and activists intervening in the management of firms and bank supervisors taking actions to improve the health of financial institutions. We provide an equilibrium analysis of such situations in light of a key problem: if agents use market prices when deciding on corrective actions, prices adjust to reflect this use and potentially become less revealing. We show that market information and agents' information are complementary, and discuss measures that can increase agents' ability to learn from market prices.

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The Long and Short of It: Why Are Stocks with Shorter Runs Preferred?

Priya Raghubir & Sanjiv Das
Journal of Consumer Research, forthcoming

Abstract:
This article examines how consumers process graphical financial information to estimate risk. We propose that consumers sample the local maxima and minima of a graph to infer the variation around a trend line, which is used to estimate risk. The local maxima and minima are more extreme the higher the run length of the stocks (the consecutive number of upward or downward movements of a price series with identical mean, variance, skewness, and kurtosis). Three experiments show that this leads to stocks with higher run lengths being perceived as riskier: the run-length effect. Importantly, the run-length effect is greater for investors who are more educated, are employed full time, trade more frequently, have had longer experience trading, and trade a wider range of financial instruments. Implications for the communication of financial products, public policy, and consumer welfare are discussed, as are theoretical implications for the processing of visual and financial information and behavioral finance.

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Sentiment and stock price: The case of aviation disasters

Guy Kaplanski & Haim Levy
Journal of Financial Economics, forthcoming

Abstract:
Behavioral economic studies reveal that negative sentiment driven by bad mood and anxiety affects investment decisions and may hence affect asset pricing. In this study we examine the effect of aviation disasters on stock prices. We find evidence of a significant negative event effect with an average market loss of more than $60 billion per aviation disaster, whereas the estimated actual loss is no more than $1 billion. In two days a price reversal occurs. We find the effect to be greater in small and riskier stocks and in firms belonging to less stable industries. This event effect is also accompanied by an increase in the perceived risk: implied volatility increases after aviation disasters without an increase in actual volatility.

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Stock market response to changes in movies' opening dates

Liran Einav & Abraham Ravid
Journal of Cultural Economics, November 2009, Pages 311-319

Abstract:
How does the market react to news regarding large uncertain projects? We analyze stock market reactions to information about changes in opening dates of movies, and present two main findings. First, we find systematic negative stock price responses to the scheduling changes we consider, suggesting that any changes are interpreted as bad news by the market. Second, we find that the market reaction is greater for movies with higher production costs, but is unrelated to subsequent box office revenues. This may point to a limited ability of the market to predict the box office performance of a movie, and to increased sensitivity of the market to cost effects, which are easier to forecast.

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Islamic Alternatives to Purely Capitalist Modes of Finance: A Study of Malaysian Banks from 1999 to 2006

Tamer ElGindi, Mona Said & John William Salevurakis
Review of Radical Political Economics, December 2009, Pages 516-538

Abstract:
Like Western financial markets, Islamic modes of finance offer services characterized by profit-and-loss sharing while also providing certain debt-based instruments. Unlike traditional capitalist modes of finance, however, Islamic finance places a unique emphasis upon the former, thus prompting many comparisons between the performance of Islamic banks and conventional ones. Given the mixed results of these studies, our paper analyzes eight banks in Malaysia offering both conventional and Islamic banking operations. Our comparison is conducted via discussions of profitability, liquidity, and asset quality. It is illustrated via this micro-level analysis that Islamic modes of finance may generally equal or surpass the quantitative measures of performance describing traditional capitalist finance systems and simultaneously encourage higher levels of social equity and economic stability in the era of financialization.

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Why Markets Make Mistakes

Henry Birdseye Weil
MIT Working Paper, August 2009

Abstract:
Many models of markets are based on assumptions of rationality, transparency, efficiency, and homogeneity in various combinations. They assume, at least implicitly, that decision makers understand the structure of the market and how it produces the dynamics which can be observed or might potentially occur. Are these models acceptable simplifications, or can they be seriously misleading? The research described in this article explains why markets routinely and repeatedly make 'mistakes' that are inconsistent with the simplifying assumptions. System Dynamics models are used to show how misestimating demand growth, allowing financial discipline to lapse, unrealistic business planning, and misperception of technology trajectories can produce disastrously wrong business decisions. The undesirable outcomes could include vicious cycles of investment and profitability, market bubbles, accelerated commoditization, excessive investment in dead-end technologies, giving up on a product that becomes a huge success, waiting too long to reinvent legacy companies, and changes in market leadership. The article illuminates the effects of bounded rationality, imperfect information, and fragmentation of decision making. Decision makers rely on simple mental models which have serious limitations. They become increasingly deficient as problems grow more complex, as the environment changes more rapidly, and as the number of decision makers increases. The amplification and tipping dynamics typical of highly coupled systems, for example, bandwagon, network, and lemming effects, are not anticipated. Examples are drawn from airlines, telecommunications, IT, aerospace, energy, and media. The key conclusions in this article are about the critical roles of behavioral factors in the evolution of markets.

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Financial Regulatory Reform: The Politics of Denial

Richard Posner
The Economists' Voice, November 2009

"Our reform-minded officials need a better understanding of the causes of the 2008 financial collapse, and for that they need to look inward. It is a bad sign that Bernanke and the others refuse to acknowledge their own contribution to the collapse. It is another bad sign that proposals for ambitious regulatory reform have been made, and are being pressed, before the financial crisis has run its course and before there has been an impartial, in-depth study of the causes of the crisis...Congress has appointed a Financial Crisis Inquiry Commission to conduct an 18-month study of those causes, and reform proposals should be tabled until the study is completed and evaluated - that or a better study. For I have no great hopes for the FCIC. It is bipartisan rather than nonpartisan, none of its members is a professional economist, and its executive director is a prosecutor. It is likely to embrace the populist theory of the crisis without adequate reflection. Fortunately there is no great urgency about restructuring the financial regulatory system. Everyone in the system, public and private, is hyperalert to signs of new bubbles and excessive risk-taking. Everyone on the private side is concerned to avoid the kind of risk-triggered failure that invites a government takeover and a congressional inquisition, and everyone on the public side is concerned with steering the economic recovery between the Scylla of economic stagnation (even deflation) and the Charybdis of runaway inflation. Let us see how the recovery proceeds. There will be time enough to address issues of financial regulatory reform when a restored economy enables such issues to be addressed candidly, not defensively; professionally, not angrily; patiently, not hastily - and by a fresh team, unembarrassed and unconstrained by past errors."

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Crash of '87 - Was it expected? Aggregate market fears and long range dependence

Ramazan Gençay & Nikola Gradojevic
Journal of Empirical Finance, forthcoming

Abstract:
We develop a dynamic framework to identify aggregate market fears ahead of a major market crash through the skewness premium of European options. Our methodology is based on measuring the distribution of a skewness premium through a q-Gaussian density and a maximum entropy principle. Our findings indicate that the October 19th, 1987 crash was predictable from the study of the skewness premium of deepest out-of-the-money options about two months prior to the crash.

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Power Laws in Economics and Finance

Xavier Gabaix
Annual Review of Economics, 2009, Pages 255-294

Abstract:
A power law (PL) is the form taken by a large number of surprising empirical regularities in economics and finance. This review surveys well-documented empirical PLs regarding income and wealth, the size of cities and firms, stock market returns, trading volume, international trade, and executive pay. It reviews detail-independent theoretical motivations that make sharp predictions concerning the existence and coefficients of PLs, without requiring delicate tuning of model parameters. These theoretical mechanisms include random growth, optimization, and the economics of superstars, coupled with extreme value theory. Some empirical regularities currently lack an appropriate explanation. This article highlights these open areas for future research.

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Learning by Trading

Amit Seru, Tyler Shumway & Noah Stoffman
Review of Financial Studies, forthcoming

Abstract:
Using a large sample of individual investor records over a nine-year period, we analyze survival rates, the disposition effect, and trading performance at the individual level to determine whether and how investors learn from their trading experience. We find evidence of two types of learning: some investors become better at trading with experience, while others stop trading after realizing that their ability is poor. A substantial part of overall learning by trading is explained by the second type. By ignoring investor attrition, the existing literature significantly overestimates how quickly investors become better at trading.

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Testing the evolving efficiency of Arab stock markets

Walid Abdmoulah
International Review of Financial Analysis, forthcoming

Abstract:
Our goal is to examine whether Arab stock markets are becoming more efficient during the last decade thanks to organizational improvements and agents' learning. To achieve this goal a Test of Evolving weak-form Efficiency using GARCH-M (1,1) approach along with state-space time-varying parameters is implemented for 11 Arab stock markets for periods ending in March 2009, rather than studying their efficiency/inefficiency at a given point of time as commonly done. All markets show high sensitivity to the past shocks and are found to be weak-form inefficient. Moreover, the efficiency does not clearly improve towards the first quarter of 2009 and negatively reacts to contemporaneous crises, except temporary sub-periods of efficiency improvement for the largest markets. This contrasts with mature markets and reveals the ineffectiveness of the reforms so far undertaken and calls to intensify efforts to expand and deepen these markets besides improving their liquidity and transparency and counteracting the shortcomings of the large individual trading by enhancing investment culture and spreading institutional trading.

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Momentum in Residential Real Estate

Eli Beracha & Hilla Skiba
Journal of Real Estate Finance and Economics, forthcoming

Abstract:
This paper examines whether there is return momentum in residential real estate in the U.S. Case and Shiller (American economic review 79(1):128-137, 1989) document evidence of positive return correlation in four U.S. cities. Similar to Jegadeesh and Titman's (Journal of finance 56:699-720, 1993) stock market momentum paper, we construct long-short zero cost investment portfolios from more than 380 metropolitan areas based on their lagged returns. Our results show that momentum of returns in the U.S. residential housing is statistically significant and economically meaningful during our 1983 to 2008 sample period. On average, zero cost investment portfolios that buy past winning housing markets and short sell past losing markets earn up to 8.92% annually. Our results are robust to different sub-periods and more pronounced in the Northeast and West regions. While zero cost portfolios of residential real estate indices is not a tradable strategy, the implications of our results can be useful for builders, potential home owners, mortgage originators and traders of real estate options.

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A feeling for finance: Motivations for trading on the stock exchange

Margery Mayall
Emotion, Space and Society, forthcoming

Abstract:
Emotions have long been associated with financial markets. For traders trying to make money by profiting from market fluctuations, the uncertainties and risks of involvement loom large, and the outcomes of participation are instantly measurable. Much research has therefore focused on the role that emotions - such as fear, greed, trust, confidence and hope - play in motivating traders to try and anticipate what the market is doing. But there is a different kind of emotional experience that is equally important in motivating financial trading and which research has hitherto neglected. The development of communications technology has generated new kinds of objects (represented in visual formats displayed on computer screens) with which people interact, forming emotionally-laden relationships comparable, in some ways, to more traditional social relationships. This paper focuses on individual online share traders who use a style known as Technical Analysis. It examines how they become emotionally engaged in and attached to their trading practices, in ways that motivate them, independently of any concern with financial outcomes. The paper then provides a broader conceptualisation of the roles of reason and emotion in financial markets.

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The Geography of Hedge Funds

Melvyn Teo
Review of Financial Studies, September 2009, Pages 3531-3561

Abstract:
This article analyzes the relationship between the risk-adjusted performance of hedge funds and their proximity to investments using data on Asia-focused hedge funds. I find, relative to an augmented Fung and Hsieh (2004) factor model, that hedge funds with a physical presence (head or research office) in their investment region outperform other hedge funds by 3.72% per year. The local information advantage is pervasive across all major geographical regions, but is strongest for emerging market funds and funds holding illiquid securities. These results are robust to adjustments for fund fees, serial correlation, backfill bias, and incubation bias. I show also that distant funds, especially those based in the United States and the United Kingdom, are able to raise more capital, charge higher fees, and set longer redemption periods, despite their underperformance relative to nearby funds. It appears that distant funds trade investment performance for better access to capital.


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