What are the chicago and yale view of financial markets
- Chicago: Markets are efficient, you only get what you deserve given the risks you have taken
- Yale: There are market inefficiencies from which some investors can take advantage of and be rewarded beyond the compensation they recieve based on the risk they have taken
What does the yale view of financial markets suggest about profits
- That π − π∗ > 0
- So we have abnormal profit
What does the Chicago view of financial markets suggest about profits
- That π − π∗ = 0
- In an efficient market you can earn π∗ but not beyond that
- Profit can still be generated since π∗ can be positive, just not abnormal profit
What is the notion of an efficient market closely linked to and explain
- The notion of market prices being correct so that it is not possible to make abnormal profits using publicly available information
- In such a market profits solely reflect the right compensation expected by investors given the risks they are taking for any strategy
- If all market prices are fair value prices then we must have π - π∗ = 0
What is the efficient market hypothesis
- Financial markets reflect all available information in asset prices at any given time
- Such that π - π∗ = 0
What are the behavioural explanations behind π - π∗ > 0
- Some strategies do generate abnormal returns because investors are subject to psychological biases and either overreact or underreact to news
- Smart investors take advantage of this
What is the conecpt of Thinking Fast and Slow
- People are not accustomed to thinking hard and are often content to trust a plausible judgement that comes quickly to mind, inducing decision mistakes
What is the representativeness heuristic
- Investors confuse “plausibility” with “probability”
What is the calculation for the future value of an investment
- £FV = £P * (1+r)^n
What is the calculation for the future value of an investment that compounds m times a year
- £FV = £P * (1+r/m)^n * m
What is the calculation for the future value of an investment that compounds continuously
- £FV = £P * e^R * n
Hint: Use the formula for m times compounding
Prove the formula for continuous compounding
Check Ipad
What is the Effective Annual Rate (EAR/AER)
- The rate of interest, when compounded anually produces the same yield as the nominal rate of interest
How do you calculate the EAR/AER
- Ra = (1 + R/m)^m - 1
How do you calculate a continuously compounding AER/EAR
- R = ln(1+Ra)
How do you calculate the present value
- PV = FV / (1+ R)^n
How do you calculate the present value with compounding
- PV = FV/(1 + R/m)^mn
How do you calculate the PV of a future cashflow where all periods pay the same and prove it
- PV = (1 - 1/ (1 + R)^n) * S / R
- Check Ipad
How do you calculate the present value of an income stream
- PV = sum(S(k) / (1 + R)^k)
What is the Dividend Discount model and prove it
- Po = sum(1 to inf)[ Dt / (1+r)^t
What is the interpretation of the Dividend Discount Model
- That todays stock price equals the present discounted value of all future dividend cash flows
What is the Gordon Growth Model and prove it
- P0 = D1 / r - g
- Proof on Ipad
What is the difference between the DDM and the Gordon Growth Model
- The DDM uses the fact that we know all future dividend cash flows, where the Gordon Growth Model assumes a growth rate for dividends
What is the pitfall of the Gordon Growth Model
- When r - g is small, valuation becomes extemely sensitive
