EC4024 2011 Slides25012011 - Stephen Kinsellastephenkinsella.net/.../uploads/2011/01/EC4024_2011_Lecture1.pdf · Mar 9 Lecture 7: Dealing with ... 1 Do reading before class ... foreign

Financial EconomicsLecture Notes

Stephen Kinsella

Department of Economics,Kemmy Business School,University of [email protected]

www.stephenkinsella.net

January 25, 2011

Stephen Kinsella (UL) EC4024 January 25, 2011 1 / 149

Welcome to EC4024. Here’s what I want you to learn fromthis module:

How to read the financial pages

What a stock, bond, or any risky asset is, and how to value it

The economists’ approach to decision making under uncertainty

The canonical models of finance: CAPM, APT, and Black-Scholes

Elementary probability theory and data analysis

Some frontier topics in financial economics, but also inmacroeconomics

Important episodes in financial history.


Admin Stuff

Contact: [email protected], twitter.com/stephenkinsella,061-233611 (leave a message), office hours Wednesdays 9-11, drop inthen.

TA: Juan M. Covarrubias, Email: [email protected] Office hoursMon 1000–1200.

Please note tutorials aren’t reruns of the lecture. You are there todiscuss and interpret material, ask and answer questions, and enjoytalking about the subject. They begin in week 3.


Module OutlineJan 26 Lecture 1: Data, terminology, theory, and ‘the market’Feb 2 Lecture 2: Vincent O’Sullivan, Macroeconomics, Finance, andRegulationFeb 9 Lecture 3: Probability and stochastic processesFeb 16 Lecture 4: Zombie theories of financeFeb 23 Lecture 5: Fat tailed finance or: what happens when things govery wrongMar 2 Lecture 6: Finance without Probability Theory, Project 1 DueMar 9 Lecture 7: Dealing with uncertainty: Info-gap approaches tofinance, Project 1 feedback dueMar 16 Lecture 8: EMU and Ireland: Macro-Finance perspectivesMar 23 Lecture 9: Banking and crises: Minsky strikes back.Mar 30 Lecture 10: Bond markets & bond pricing,Apr 6 Lecture 11: Theories of the exchange rate. Project 2 due.Apr 13 Lecture 12: Discounting, behavioural finance & Neurofinance,Project 2 feedback due.Apr 20 Easter BreakApr 27 Lecture 13: Presentations.

Assessment

10 Page data project, due March 2. This is peer reviewed. Moredetails on the site. 40%

5 page ‘market report’. This is peer reviewed. More details on thesite. Due April 6th. 40%

Group presentation on Ireland’s economic crisis, 20%, Apr 27th


Peer Review

You write a project. You submit 2 copies of that project using thesubmission template.

We give each copy to a different classmate. They mark it, accordingto the guidelines we give them. They will be fair, and will suggest agrade that we will approve.

You will be doing the same for some of them. All of this isanonymous.

You’ll get 30% of your grade for writing your project, and 10% forcommenting on other students’ submissions. You submit thecomments 7 days after you get the paper to read and review.

Organisation is very important here. So: no late entries. Any lateentry loses 99% of their mark. No late submission of anything, forany reason.

Students found plagiarising/communicating regarding theirsubmissions will be pummeled with bags of unripened Kumquats.


What I expect you to know already

Marginal Analysis, basic supply and demand stuff, macro bits,elasticities.

Lagrange multiplier analysis

Description of Households & Firms

Elementary theory of the Business Cycle

Check out stephenkinsella.net/teaching and Economics for Business fornotes if you’re rusty on any of these concepts.


Readings

It is what you read when you don’t have to that determines whatyou will be when you can’t help it. Oscar Wilde

Course Page on http://stephenkinsella.net/classes

Regular Blog Posts, links to media, notes like these, as well as in classworksheets.

Readings up on the blog, downloadable today.

No textbook for this module, but some ‘key’ books to read if youwant a good mark.

Readings for each lecture will be posted on the blog, they are almost allelectronic this year.


Policies

1 Do reading before class

2 Do exercises in notes/slides to check your understanding. Ask mequestions in class if something makes no sense.

3 Show up to lectures, check site daily.

4 Email me (and the TA) whenever, but:

5 Don’t send me text messages as emails. Or I shall smite thee, from aheight. Refer to the email policy on my site for guidance.


Part I

Lecture 1: Data, terminology, theory, and the‘market’


Today

Introduction to the module

Learning materials and assessment

Some new bits and pieces this year

Terminology

Critique of standard theory

Better representation of ‘the market’


Today’s Problem

The markets are already pricing in the near certainty of aquarter-point rise from the Bank of England by May with anotherincrease expected before October. But perhaps not wanting tobe left out, the zealous guardians of Europe’s monetary system,who measure inflation rates across the 17-country bloc to thesecond decimal point, have recently raised their rhetoric to suchan extent that investors are openly speculating that in spite ofthe continent’s tight fiscal policy European rates are now likelyto rise before the end of summer. As they say in the land ofmacro investing, the cycle isn’t over until the Europeans liftrates. Just don’t bet on money staying tight for long.

—Hugh Hendry, Eclectica Asset Management, Financial Times, January19 2011.


Keywords for this module

Keywords

Growth Debt Balance Sheets Deflation Interest Rates Markets BondsStocks EU Arbitrage Imperfect Markets Information Uncertainty HistoryCollapse Cycles


Concepts, Data & TerminologySee handout.

Stocks

Bonds

Assets

Forwards & Futures

Options

Time Value

Risk and return


Terminology

Underlying Assets

Underlying assets can be stocks, bonds, currency, commodities, and otherfinancial assets, or combinations of these. The traditional stock and bondmarkets raise necessary capital for corporations and governments, and theforeign exchange market facilitates international trade and investment.

StocksStocks represent the claim of the owners of a firm. Stocks are issued bycorporations and can be traded in the stock market. Common stockusually entitles the shareholder to vote in the election of directors andother matters.


BondsBonds are issued by anyone who borrows money - firms, governments, etc.They are fixed-income instruments because they promise to pay fixed sumsof cash in the future. Bondholders have an IOU (I owe you) from theissuer, but no corporate ownership privileges, as stockholders do.

Derivative AssetsDerivatives are financial instruments that take their value from the pricesof one or more other assets such as stocks, bonds, foreign currencies, orcommodities. Derivatives serve as tools for managing risks associated withthese underlying assets. The most common types of derivatives are optionsand futures.


Terminology

Forwards and FuturesA forward is a financial contract in which two parties agree to buy and sella certain amount of the underlying commodity or financial asset at aprespecified price at a specified time in the future. The specified time iscalled the time-to-maturity of the forward contract and the price specifiedin the contract is called the forward price.

Options

An option is a financial contract, which provides the holder with the rightto buy or sell a certain amount of the underlying asset at a prespecifiedprice at or before a specified time in the future.


Example

Say you decide to buy a new car. Dealer tells you that if you place theorder today and place a deposit, then you can take delivery of the car in 3months time. If in 3 months time the price of the model has decreased orincreased, it doesn’t matter. When the agreement between you and thedealer is reached, you have entered into a forward contract: you have theright and also the obligation to buy the car in 3 months. Instead, supposethe car you selected is on offer at 30,000 euros but you must buy it today.You don’t have that amount of cash today and it will take a week toorganize a loan. You could offer the dealer a deposit, for example 200euros, if he will just keep the car for a week and hold the price. During theweek, you might discover a second dealer offering an identical model for alower price, then you don’t take up your option with the first dealer. Atthe end of the week the 200 euros is the dealer’s whether you buy the car,or not. In this case, you have entered an option contract, a call optionhere. It means that you have the right to buy the car in a week, but notthe obligation. The expiration time is one week from now, the strike priceis 30,000 euros.


Time Value

Time ValueTime value of money refers to the fact that money in hand today is worthmore than the expectation of the same amount to be received in thefuture. Money has a time value because of the opportunity to earn interestor the cost of paying interest on borrowed capital. Where is time value inour example?

Compounding - the process of going from today’s value, or present value(PV ), to future value (FV ). Future value is the amount of money aninvestment will grow to at some date in the future by earning interest atsome compound rate. Ifi is the interest rate and n is the number of years,the future value of a present value is given by:

FV =PV

(1 + i)t(1)


Risk and Return

One aside: There is a fundamental assumption that with a higher amountof risk must come a higher rate of return on any asset–it would beirrational to hold a riskier asset than you desire for less return than doingsomething else with your cash. This view, assumes you know a lot aboutother assets, and it is something we’ll return to in much more detail lateron.


Critique of standard theory

So far in your study of economics, you’ve seen that much of humanbehaviour is modeled according to two principles: either

1 optimisation: people try to choose the best patterns of consumptionthey can afford (Friedman’s life cycle consumption notion)

2 Equilibrium: prices adjust until the amount that people demand ofsomething is equal to that supplied (Marshallian microeconomicsupply and demand, Walrasian general equilibrium, Nash/Cournotgame theory)


Common sense or not?

Both these principles seem like common sense. Why wouldn’t people tryto do the best they can for themselves? It turns out however that to makethese postulates work, you need to assume crazy things that are notreflected in empirical data we see every day.

Economics is not physics.In physics, a complicated problem can be reduced to a simple problembecause of invariances.The laws of physics don’t change if the time scale we measure themon changes.Why? Local invariances (translational/rotational/relativity/constantvelocity) allow repeatable experiments, reproducible by anyone. Thisallows discovery of laws, much stronger than just models of behaviour.Progress is possible in true science because of these invariances.In contrast there is very little new in economics.Humanly invented laws can always be violated.Only law that can’t, afaik, is Balance sheet restriction(s). This maybe a socio economic invariance. Certainly Godley and Lavoie (2006)claims this.Stephen Kinsella (UL) EC4024 January 25, 2011 22 / 149

The best we can hope for

A truly successful economic theory would capture and reproduce theessentials of historical data for specific markets over particular timehorizons.

There is no guarantee the future will be the same. None.

Example: Insurance companies

Use probability distributions based on historical events.

Financial economics provides us with millions of data points at smalltime scales (second by second). Best place to start.


A maths refresher

[We’ll go through this in class]


Demand analysis

In 2 dimensions, with U(x) = ln(x) and p = 1/x , the slope p of thebuyers’s demand curve decreases towards zero as the quantity gets largerand larger. This is the law of demand. Put another way, if the price of xgoes up, the demand for x at each price, D(p), will drop. There’s a similarstory with supply curves.The asking price will increase as the quantity supplied increases, asincreasing price induces suppliers to increase production of x .Market clearing is assumed: everyone who wants to trade finds someone tomatch with. The market clearing price is the equilibrium price, where totaldemand equals total supply. Dissatisfaction, or excess demand, cannotexist.


Supply and Demand

100 1 2 3 4 5 6 7 8 9

12

0

1

2

3

4

5

6

7

8

9

10

11

Price of Items at a point in time

Qua

ntity

Dem

ande

d at

eac

h pr

ice,

Qua

ntity

Sup

plie

d at

eac

h pr

ice

Supply at each Price, S(p)

Demand at each Price, D(p)

Figure: Idealised supply and demand.Stephen Kinsella (UL) EC4024 January 25, 2011 26 / 149

Excess Demand and Market equilibrium

The story goes that agents exchange information. Just how muchinformation may stagger you. Supply and demand schedules for infinitefutures by presented and read by every agent within a transaction, andeach agent must know exactly what quantity of x they want, for the restof their lives.Excess demand vanishes when xD = D(p), or:

xD − xs = D(p)− S(p) = 0. (2)

The equilibrium price, when it exists, solves this set of nonlinear equations.Excess demand becomes

�(p) = D(p)− S(p) (3)


Excess demand and market equilibrium

The market efficiency can be measured as

e(p) = min(S

D,D

S). (4)

The market is efficient when e(p) = 1.For a general equilibrium to exist, and be stable, it must be that:

dp

dt= �(p) (5)

In order for this to hold, agents must have perfect foresight over theinfinite future.


Equilibrium trading with perfect information

Equivalent todp

dt= D(p, t)− S(p, t) = �(p, t) (6)

You’ll get equilibrium when �(p, t) = 0. To get dynamics on D and S, weonly need to specify x = D(p), and x = S(p).


Traditional Supply and Demand

Figure: Textbook supply and demand.

Quick mathematical digression

Definition (Function)

A function is a relation between a given set of elements (the domain), overa specified range. The function associates each element in the domainwith exactly one element in the range.

A function takes an input, X , and pumps out an output, f (X ). Example:y = x3.

Question for Review

How does this relate to Demand/Supply?


Story

Mrs Ryan wants to buy a dress in BTs on O’Connell St. There are 2 in theshop then and there her size. What does the supply curve for BTs looklike, in reality, and what does Mrs Ryan’s demand curve look like?


Supply


Real Demand and Supply Correspondence: A step function

Figure: See Osborne, 1977, Chapters 1and 2 for more details.


Real world demand and supply

Figure: caption

Supply and Demand, Redone

One More Thing to RememberArbitrage

Definition (Arbitrage)

An arbitrage is a set of transactions such that

1 It requires non positive initial investment;

2 Yields non-negative payoffs Bouchard et al. (2002);


Types of Markets

exchanges: physical location for trading, trading by members who owna seat on the exchange. Stock traded on exchange are listed stocks

OTC trading electronically all over world, eg. NASDAQ.

direct trading


Types of Orders

Shorting

Margin trades

Institutional trades


Order Types

Investor orders brokers to do stuff with their holdings.

1 Market orders: buy/sell orders at lowest/highest prices. Noguarantees.

2 Limit orders. Buy/sell at fixed price. EG “buy at $50 or less”, “sell at$52 or more”.

3 Market specialist records orders in limit order book

4 investor sets reservation price, BUT no guarantee that limit order willbe executed


Order types

Stop order

1 order lies dormant

2 turns into market order when certain price (“the stop”) is reached:“buy if price rises to $60”, “sell if price falls to $58”

3 Stop loss orders.

4 investor does not have to watch market, but in a volatile market stopcould be triggered prematurely-losing you money.

5 stop limit order turns into limit order when stop is reached “buy ifprice rises to $60, but only is executed at $65 or less”


Short Selling

1 sale of borrowed stock

2 profit from belief that stock price is too high will fall soon how?

3 borrow stock through broker

4 sell stock

5 buy and return later

Fundamentally short sellers believe

price will fall and SOON

but price not currently falling

face unlimited losses if price rises


Margin buying

1 buyer borrows part of purchase price of stock, using stock as collateral

2 borrow at call money rate

3 Fed sets initial margin requirement

4 minimum cash payment 50% or so.

5 if stock price falls, collateral worth less

6 if collateral worth only 125% of loan (maintenance margin)

7 margin call: owner must put up more cash or sell stock margin callscan worsen stock crash

8 Example. 1000 shares, $20 per share $20,000 cost $10,000 cash,borrow $10,000

9 leverage gains/losses on $20,000 capital–but tied up only $10,000capital

10 if prices falls to $12,value of stock $12,000 below 125% of $10,000loan–get a margin call


Limit Order Markets

Definition (Limit Order)

A limit order is an instruction to trade a specific quantity of an asset at aspecified price, or a better price. The order is an ex-ante pre-commitment(t, j , x , p) made on a date t to trade up to a given amount x of an asset jat a pre-specified limit price p. The order is in force until filled or cancelled,so unfilled orders accumulate in an limit order book. Kyle (1989).


Order Books

Definition (Limit Order Book)

The limit order book is characterised by a discrete set of prices at whichtraders may submit orders.


Example

Example (Limit Orders in motion.)

A limit order to buy 100 shares can be filled at $47.50 or below. A limitorder to sell at $50.25 can be filled at $50.25 and above. The existence ofthe limit order is independent of having anyone to actually trade to fulfilthe order. As time passes, one might not be able to fill the order. Thereseveral advantages to limit order markets. The first is the ability to obtaina better price. The second is the discrete nature of each trade: a limitorder to buy simply means you specify how much of something you want,and and how much you are willing to pay for it, and vice versa for thesupplier. Both demand and supply are discrete functions of price. Anycombination of these orders in a specific time and place gives rise to alimit order only interrupted market where the orders are matched up forexecution ((Osborne, 1977, Chapter 2) is the classic exposition of LOOM).


More Examples

Price D(p) Priority LO(Buy) LO(Sell) Priority S(p)> 46 0 - - 1 - 5p = 46 0 - 0 1 5 5p = 45 1 1 1 1 4 4p = 44 2 2 1 1* 3 3p = 43 3 3 1 1 2 2p = 42 4 4 1 1 1 1p = 41 5 5 1 - - 0< 41 5 - 0 - - 0

Table 1: Limit Order example. LO(Buy) is a limit order to buy, similarly for LO(Sell). Source: Osborne,(1977), pg. 42.

Price D(p) Priority LO(Buy) LO(Sell) Priority S(p)> 46 0 - - 1 - 5p = 46 0 - 0 1 5 5p = 45 1 1 1 1 4 4p = 44 4 2,3,4 3=1,1,1 1* 3 3p = 43 5 5 1 1 2 2p = 42 6 6 1 1 1 1p = 41 7 7 1 - - 0< 41 7 7 0 - - 0


How do you explain to they guy at LOS 44(1*) that his trade wasn’t executed?

5 Exercises

5.1 Exercise 1

Solve this limit order market with differing order sizes. Solve for the match point price. What does this tellyou about buying in bulk?

Do you see the difference between assuming a line when in reality it is a line of closely spaced dots?

5.2 Exercise 2

(From Osborne [1965, pg. 91].)Take the data of table 4.1 and double every order. Now add at P = 1000 first 1, then 2, then 3, then 4,

etc. The idea is that p = 1000 represents a positive infinity for limit orders. Use the following rule to makeout strike prices: take the mean of the possible highest and lowest match point price, to find the executed(strike) prices, and the transaction sizes. How many really big price jumps at p = 1000 before you settledown to p = 1000 with an order size of 10?

References

M.F.M. Osborne. Dynamics of stock trading. Econometrica, 33(1):88–113, 1965.

M.F.M. Osborne. The Stock Market and Finance from a Physicist’s Viewpoint. Crossgagr Press, 1977.

7


More Examples

Price D(p) Priority LO(Buy) LO(Sell) Priority S(p)> 46 0 - - 1 - 5p = 46 0 - 0 1 5 5p = 45 1 1 1 1 4 4p = 44 2 2 1 1* 3 3p = 43 3 3 1 1 2 2p = 42 4 4 1 1 1 1p = 41 5 5 1 - - 0< 41 5 - 0 - - 0


Price D(p) Priority LO(Buy) LO(Sell) Priority S(p)> 46 0 - - 1 - 5p = 46 0 - 0 1 5 5p = 45 1 1 1 1 4 4p = 44 4 2,3,4 3=1,1,1 1* 3 3p = 43 5 5 1 1 2 2p = 42 6 6 1 1 1 1p = 41 7 7 1 - - 0< 41 7 7 0 - - 0


How do you explain to they guy at LOS 44(1*) that his trade wasn’t executed?

5 Exercises

5.1 Exercise 1

Solve this limit order market with differing order sizes. Solve for the match point price. What does this tellyou about buying in bulk?

Do you see the difference between assuming a line when in reality it is a line of closely spaced dots?

5.2 Exercise 2

(From Osborne [1965, pg. 91].)Take the data of table 4.1 and double every order. Now add at P = 1000 first 1, then 2, then 3, then 4,

etc. The idea is that p = 1000 represents a positive infinity for limit orders. Use the following rule to makeout strike prices: take the mean of the possible highest and lowest match point price, to find the executed(strike) prices, and the transaction sizes. How many really big price jumps at p = 1000 before you settledown to p = 1000 with an order size of 10?

References

M.F.M. Osborne. Dynamics of stock trading. Econometrica, 33(1):88–113, 1965.

M.F.M. Osborne. The Stock Market and Finance from a Physicist’s Viewpoint. Crossgagr Press, 1977.

7


Econophysics, Summary[See: http://tinyurl.com/ec40241]

1 Eugene Wigner: Invariance Laws, non-violable laws of nature, egGravity/Inertia. Base entire (empirical) theories on these invariants.

2 Basic idea: a mathematical law cannot be discovered from empiricaldata unless something is repeated systematically.

3 Karl Popper: you’re not doing science unless you can falsify:Falsifiable models have no free parameters to tweak that would makea wrong model fit adequate data.

4 Basis for modern econ. theory:1 The optimization principle. People try to choose the best patterns of

consumption they can afford, and/or2 The equilibrium principle: prices adjust until the amount that people

demand of something is equal to the amount that is supplied.5 Falsifiable finance models: empirically based.6 Falsifiable classes of market dynamics models deduced directly from

empirical data. Apply to Money, income, wealth, and the stockmarket, etc.


Macroeconomics

Question: What happens when we sum loads of step functions of the formx = D(p) for loads of individuals? It turns out, the only known downwardsloping macroscopic demand curve is for cornflake sales in the UK. If weaggregate demand schedules, so we get a macro demand curve? No(Sonnenschein, 1973a, b). What if the economy is not in equilibrium?This is where Keynes begins. Keynes argues capitalism is not a stable orself regulating system at all, but tends towards stable and unstable inphases. There is no evidence for stability in unregulated markets.

dp

dt= �1(p, L) �= 0 (7)

withdL

dt= �2(p, L) �= 0 (8)

Where p is the price vector of commodities and financial market interestrates, and L is the amount of Labour employed. This leaves us with thetantalising question of what to do as economists when so little of what weknow is truly relevant.


Summary of Lecture 1

Data is everywhere in finance.

Theory is very poor at explaining it.

That doesn’t mean we shouldn’t teach it to you–it just means youshould take this knowledge with a barrel of salt.

Next Time:

Guest Lecture: Vincent O’Sullivan (UL, NUIG, LSE) onMacroeconomics, finance, and regulation.


Documents

EC4024 2011 Slides25012011 - Stephen Kinsellastephenkinsella.net/.../uploads/2011/01/EC4024_2011_Lecture1.pdf · Mar 9 Lecture 7: Dealing with ... 1 Do reading before class ... foreign