Academic Finance and the Crisis of 2008 by gabyion

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									Academic Finance and the Recent Financial Crisis:
      Are University Professors Grossly Overpaid?


                                        Andriy Shkilko
                             Wilfrid Laurier University
What I would like to talk about today

       Financial Crisis: causes, consequences

       How did we allow this to happen?

       Where do we go from here?

       Where do you fit in?
           Careers in finance



    2
Have we been here before?
S&P 500: Jan. 1950-Oct. 2009




3
Really, have we?
(courtesy G.W. Schwert)




 4
Past ~60 years of GDP growth:
Canada and the U.S.
10


 8


 6


 4


 2


 0
     1   1   1   1   1   1   1   1   1   1   1   1   1   1   1      1    1   1   1   1   1   1   1   1   1   2   2   2   2   2
-2   9   9   9   9   9   9   9   9   9   9   9   9   9   9   9      9    9   9   9   9   9   9   9   9   9   0   0   0   0   0
     5   5   5   5   5   6   6   6   6   6   7   7   7   7   7      8    8   8   8   8   9   9   9   9   9   0   0   0   0   0
     1   3   5   7   9   1   3   5   7   9   1   3   5   7   9      1    3   5   7   9   1   3   5   7   9   1   3   5   7   9
-4


-6


-8
                                                             U.S.       Canada




5
Past ~30 years unemployment:
Canada and the U.S.
14


12


10


 8


 6


 4


 2


 0
     1   1   1   1   1   1   1   1   1   1   1   1   1   1   1      1   1    1   1   1   2   2   2   2   2   2   2   2   2   2
     9   9   9   9   9   9   9   9   9   9   9   9   9   9   9      9   9    9   9   9   0   0   0   0   0   0   0   0   0   0
     8   8   8   8   8   8   8   8   8   8   9   9   9   9   9      9   9    9   9   9   0   0   0   0   0   0   0   0   0   0
     0   1   2   3   4   5   6   7   8   9   0   1   2   3   4      5   6    7   8   9   0   1   2   3   4   5   6   7   8   9

                                                             U.S.           Canada




6
From the Great Moderation
to the Great Recession
       Great Moderation
           monetary policy as a economic panacea
           interest rates were too low for too long

       Homeownership as a societal goal
           Government-backed Fannie and Freddie
           Do you know what you are getting into?

       Cheap money, cheap oil
           Building far, building lots

       Deregulation and complexity
           Repeal of Glass-Steagall
           Shifting risks, skyrocketing leverage


    7
Should we blame economists?
       Economists have been warning about the possibility of such
        crises!
           Diamond and Dybvig (1983 JPE): bank runs, liquidity, and deposit
            insurance
           Holmstrom and Tirole (1998 JPE): moral hazard, managerial
            ownership, adequate capitalization, government as liquidity provider
            of last resort

           Kiyotaki and Moore (1997 JPE): credit spirals and domino effect
           Fostel and Geanakoplos (2008 AER): leverage cycles

                     BOTTOM LINE:
                  RESTRICT LEVERAGE
                        and/or
DON’T ALLOW INTEREST RATES TO BE TOO LOW FOR TOO LONG!

       Why are they not being heard?

    8
Why are they not being heard?

       Politics




       There are no ultimate truths in economics
        and finance
           Huh?!



    9
Research in social sciences


                       Theory




            Empirics


                           Experiments




10
Tricks of theory
    A simple microstructure model of price
     changes (Sadka, 2006 JFE)




    11
The big flaws of theory

    Faulty assumptions

        Rational agents

        Efficient markets

        Unrestricted arbitrage

        Absence of feedback and adaptation



    12
People are not rational:
Frame-dependence (courtesy H. Shefrin)
    Choose one of the following:
        A: a sure gain of $2,400 or
        B: a 25% chance to gain $10,000 and a 75% chance
         to gain nothing

    Choose one of the following:
        C: a sure loss of $7,500 or
        D: a 75% chance to lose $10,000 and a 25% chance
         to lose nothing

    What if you have to make these decisions
     jointly?
        A&D or B&C?


    13
People are not rational:
Calibration and overconfidence       (courtesy H. Shefrin)

    The Dow closed at 9,181 in 1998. As a price
     index, the Dow does not include dividends.
     If the Dow were redefined to reflect
     dividends since May 1896, when
     commenced at a value of 40, what would its
     value have been at the end of 1998?

    In addition to writing down your best guess,
     also write down a low guess and a high
     guess, so that you feel 90% confident that
     the true answer will lie between your low
     guess and your high guess

    14
People are not rational:
Underreaction and conservatism                (courtesy W. Edwards)

    I have two bags:
        Bag 1 contains 700 black and 300 red poker chips
        Bag 2 contains 300 black and 700 red poker chips
    I randomly pick one bag out of the two bags.
     What are the chances that this is Bag 1?

    I start randomly taking chips out of the bag,
     putting them back after noting their color
    I draw 12 chips this way
        8 of them are black and
        4 are red
    What is the likelihood that I am handling BAG
     1?

    15
Empirical trickery

             X           X


             X           ?




                     ?




16
The serious empirical flaws
    Lack of data
    Data errors

    Multicollinearity
        price=f(bad short selling, good short selling, X)
    Causality
    Selection bias
    Survivorship bias
    Failure of out-of-sample forecasts


    17
Successes and embarrassments
    Black-Scholes option pricing framework




    Li’s copula




    18
Symbiosis of theory and empirics:
CAPM and Fama-French 3-factor model
    E ( R p )  aE Ri   1  a E Rm                  R p   a 2 i2  1  a 2  m  2a1  a  im
                                                                                           2



     E( R p )
      a
               = E( Ri ) - E( Rm )
                                                a     2
                                                           
                                              ( Rp ) 1 2 2
                                                      = a  i + 1 - a   2 + 2a(1- a) im
                                                                        2
                                                                           m
                                                                                            1 2
                                                                                                 2a  i2 - 2  2 + 2a  2 + 2  im - 4a  im 
                                                                                                                  m        m




 E( R p )                                    ( Rp )     - 2               E( R p )/a        E( ) - E( Rm ) E Rm   R f
           = E( Ri ) - E( Rm )                           = im m                                   = Ri           
   a a 0                                       a a 0    m                  ( R p )/a a 0     im -  2
                                                                                                              m       m
                                                                                                          m


       E Ri  = R f +
                                        im E   -   R   E R   R 
                                                Rm R f
                                       m 2               f   i     m     f


     Fama and French (1996, JF)
          CAPM explains 61-90% of variation in returns
          3-factor model explains 83-97% of this variation


       E Ri = R f +  i E R m  - R f   si E SMB   hi E HML 

    19
Where do we go from here?
    Behavioral finance

    Neuroscience

    Adaptive markets

    Arbitrageurs, hedge funds, seeking alpha

    Liquidity: crises and spirals


    …

20
Where do you fit in?
    Lots left to do and discover

    Adequate compensation

    Careers in finance
        academia
        practice
            investment banking, hedge funds
            corporate finance
            financial services, financial advising



    21
Thank you!

								
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