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  1. There is an enormous discrepancy between returns on stocks and fixed income securities. Between 1926 and 1990, for instance, the annual real rate of return on U.S. stocks has been about 7%, while the real return on U.S. treasury bills has been less than 1%. The choice of the initial year is interesting! The Wall Street Crash of October 1929, was the most devastating stock market crash in the history of the United States. Asset Pricing 1 Thursday, 05 June 20147:45 AM

  2. Definition A Treasury Bill also called a T-bill, is a short-term security issued by the federal government. Treasury bills have face values ranging from $10,000 to $1 million, and sell at a discount based on current interest rates. It is a short-term obligation that is not interest bearing (it is purchased at a discount); can be traded on a discount basis for 91 days. Asset Pricing 2

  3. Definition A Treasury Bond is the longest-term investment issued by the Federal Government. They have maturities between ten and thirty years and pay interest every six months until maturity. Asset Pricing 3

  4. Here’s what will happen if the U.S. defaults on its debt Nobody knows exactly when America would default on its bills if Congress fails to raise a cap on government borrowing. But the recent past gives a pretty good idea of how a default could unfold. Even the Treasury Department can’t know how much tax revenue will come in each day after Oct. 17, when it expects to hit its US$16.7 trillion debt ceiling. Nor can officials anticipate exact costs, such as how many people will apply for jobless benefits that week. Financial Post – Reuters 4 October 2013 Asset Pricing 4

  5. Things get really spooky on Halloween (31 Oct) when a US$6 billion interest payment to bond holders comes due. Financial Post – Reuters 4 October 2013 Hence the name, Halloween Bonds! The US Congress has passed a bill to reopen the federal government and approve new sovereign borrowings, ending three weeks of high drama on Capitol Hill that pushed the US to the edge of a debt default. Financial Times 17 October 2013 Asset Pricing 5

  6. Definition Stock is the capital raised by a corporation through the issue of shares entitling holders to an ownership interest (equity); “he owns a controlling share of the company's stock”. In finance, in general, you can think of equity as ownership in any asset after all debts associated with that asset are paid off. Asset Pricing 6

  7. Did you think ethics was a county north-east of London? Is ethical banking an oxymoron (a figure of speech that combines contradictory terms)? Ethics 7

  8. Islamic Banking On October 28, 2013, Osborne announced the launch of an Islamic bond plan. George Osborne, the chancellor, will on Tuesday announce plans for Britain to issue the first Islamic bond outside the Muslim world, as he seeks to turn the City of London into the “unrivalled western centre for Islamic finance”. Mr Osborne hopes that £200m bond or sukuk will act as a catalyst for the City to become a leading player in the sharia-compliant finance market, which is worth $1tn globally. To read more on Islamic Finance, four articles introducing Islamic banking and finance concepts written by Mark Andrews, Risk Reward Ltd. 5.8 8

  9. Gemach Gemach (an abbreviation for gemilut chasadim "acts of kindness") is a Jewish free-loan fund which subscribes to both the positive Torah commandment of lending money and the Torah prohibition against charging interest on a loan. Establishing gemachs, or free-loan societies, is an old Jewish custom. When Jews arrived in America from Europe, one of the first institutions to arise in each community was a Hebrew Free Loan society. Today, there are hundreds of such organisations functioning as parts of synagogues, yeshivas, and other Jewish institutions. People donate money to the society as charity, and the society in turn lends money without interest to anyone requesting a loan (Katz 2001). 5.9 9

  10. What About The U.K.? Bankers should behave at work as they do at home, says Archbishop Vincent Nichols, 18-9-2012. Business leaders including Vodafone’s chief executive Vittorio Colao and Unilever’s Paul Polman joined the Archbishop of Westminster in a drive to restore business’s battered reputation for ethical behaviour. Five years on from the start of the financial crisis, and after a series of initiatives to promote “moral capitalism”, executives are concerned that little progress has been made to restore public trust. 5.10 10

  11. What About The U.K.? Archbishop warns Wonga that Church wants to force it out of business, 25-7-2013. The Archbishop of Canterbury (Most Rev. Justin Welby) has told the payday lender Wonga that he wants to force it out of business by competing with it. He has said he plans to expand the reach of credit unions, which provide small loans to their members, as part of a long-term campaign to boost competition in the banking sector. The Church of England has plans to encourage congregation members with relevant skills to volunteer at credit unions. Small, local lenders could also be invited to use church buildings and other community locations with the help of church members. The church, which claims to have a strong ethical investment policy that explicitly bans companies involved in payday lending, invests in Accel Partners, the US venture capital firm that led Wonga’s 2009 fundraising . 5.11 11

  12. What About The U.K.? Faith, hope and hedge funds for Church of England By Miles Johnson, Hedge Fund Correspondent, Financial Times March 4, 2014 The Church of England is ramping up the exposure of its £6bn endowment to alternative investments such as hedge funds and private equity in a move that will cement its position as one of the UK’s largest single investors in these types of assets. The ethical investment policy was called into question last year when it was revealed that the endowment had an indirect holding in Wonga, the payday lender that had been publicly attacked by Justin Welby, Archbishop of Canterbury. Mr Welby had said he wanted to put Wonga “out of existence” by championing credit unions. 5.12 12

  13. What About The U.K.? The Telegraph – 28 July 2013 5.13 13

  14. What About The U.K.? BBC News - Comic Relief money invested in arms and tobacco shares 10 December 2013 Millions of pounds donated to Comic Relief have been invested in funds with shares in tobacco, alcohol and arms firms, BBC Panorama has learned. The BBC has also seen evidence which suggests Save the Children censored criticism of energy firms, to avoid upsetting corporate partners. Comic Relief said it used its funds to "deliver the greatest benefits to the most vulnerable people". Save the Children said its campaigns were unaffected by any partnerships. 5.14 14

  15. What Else? The scandal over banks’ attempted manipulation of the Libor (London Interbank Offered Rate) benchmark borrowing rate and mis-selling of interest rate swaps to small businesses. Currently under review (26-10-2012) are the following 16 banks; Bank of America, Bank of Tokyo Mitsubishi UFJ, Barclays, Citigroup, Credit Suisse, Deutsche Bank, HSBC , JPMorgan Chase, Lloyds Banking Group, Norinchukin Bank , Rabobank, Royal Bank of Canada, Royal Bank of Scotland, Société Générale, UBS and West LB. 5.15 15

  16. What Else? BBC News - Fannie Mae sues banks for $800m over Libor - 31 October 2013 US mortgage giant Fannie Mae is suing nine banks including Barclays and Royal Bank of Scotland (RBS) over losses relating to the Libor scandal. The mortgage financer is seeking more than $800m (£499m) in damages. "Fannie Mae filed this action to recover losses it suffered as a result of the defendants' manipulation of Libor," a spokesman said. 5.16 16

  17. What Else? Several banks have already admitted wrongdoing over the scandal, and have settled with regulators. Libor refers to the London interbank offered rate, which is an interest rate used by many banks, mortgage lenders, and others to set the price of borrowing on trillions of dollars of financial contracts. Several banks have indicated that they colluded to set the rate artificially low, which could have deprived lenders like Fannie Mae of higher profits. 5.17 17

  18. What Else? The nine banks being sued by Fannie Mae are Barclays, RBS, Rabobank, UBS, Bank of America, Citigroup, Credit Suisse, Deutsche Bank and JP Morgan Chase. Of those, Barclays , RBS, Rabobank and UBS have previously settled with regulators over similar allegations. Barclays was fined £290m by UK and US authorities in 2012, while RBS was fined £390m earlier this year. 5.18 18

  19. What Else? Rabobank received a fine of £662m from regulators earlier this week. A string of international banks have been implicated in the affair and several criminal charges have been brought against traders. It is also not the first time banks have been sued over Libor manipulation. In March, the other major US mortgage financer Freddie Mac sued more than a dozen banks. BBC News - Fannie Mae sues banks for $800m over Libor - 31 October 2013 5.19 19

  20. What Else? FDIC sues banks over Libor manipulation - FT - 15 March 2014 The US Federal Deposit Insurance Corporation sued more than a dozen banks from Barclays to Citigroup over losses attributed to manipulation of the London interbank offered rate. The FDIC said it was acting on behalf of 38 failed banks, which it said lost money because of the way the largest international banks are alleged to have distorted the benchmark interest rate to hide their weak financial position during the crisis or to make money on derivatives trades. It is only the latest in a series of private and government lawsuits against the panel of banks, which were supposed to submit a realistic rate at which they could borrow money. Fannie Mae and Freddie Mac, the government-controlled mortgage companies, have previously sued nearly a dozen banks and the British Bankers’ Association for allegedly causing them to suffer hundreds of millions of dollars in losses. 5.20 20

  21. What Else? Swiss and UK watchdogs step up forex investigations - FT 31/3/2014 Switzerlands competition commission has launched an investigation into eight domestic and international banks after it found indications that they co-operated to manipulate a pivotal foreign exchange rate. The fresh probe by the Wettbewerbskommission marks the first time a regulator has publicly confirmed that it has uncovered signs of possible competition law breaches. Weko is looking at whether banks including Barclays and UBS co-operated in fixing several important currencies. This widens the number of banks under investigation, with Weko saying it is probing domestic lenders Credit Suisse, Julius Baer and Zcher Kantonalbank as well as foreign banks JPMorgan, Citigroup and Royal Bank of Scotland. 5.21 21

  22. What Else? Under-fire FCA spells out its targets for the year ahead | The Guardian 31-3-2014 A review of how firms can prevent traders manipulating key benchmarks in a bid to stop a new Libor scandal and an investigation into how lenders treat borrowers who have fallen behind on repayments are among the City regulator's plans for the year ahead. The FCA takes over regulation of the consumer credit sector on Tuesday, and it also outlined plans for a review of how struggling borrowers are treated by the industry, and how loans are advertised. It has already signalled that it plans to get tough on the payday lenders that offer short-term loans at high interest rates, with new restrictions set to come into force in July, and it said it planned to visit the top five firms to check they are following the rules. Wheatley said: "Taking on the regulation of consumer credit is an enormous task which effectively doubles the number of firms we regulate. "Using our new power we want to tackle harm to consumers who are most at risk and our work will focus on protecting vulnerable consumers." 5.22 22

  23. What Else? This has been accompanied by controversies elsewhere, such as accusations that traders and speculators are rigging the oil price. In July 2012, GlaxoSmithKline was fined $3bn for abusive practices in marketing drugs in the US link. 5.23 23

  24. What Else? There is also (of course) a personal element to these events. Snorradóttir et al. (2013) considered psychological distress among surviving bank employees differently entangled in downsizing and restructuring following the financial crisis of 2008. In the banks, where all employees experienced rapid and unpredictable organizational changes, psychological distress was higher among employees most entangled in the downsizing and restructuring process. Being subjected to downsizing within their own department, salary cut, and transfer to another department, were directly related to increased psychological distress. Employees most entangled in organizational changes are the most vulnerable and should be prioritized in workplace interventions during organizational changes. 5.24 24

  25. On The Other Hand Why do rich celebrities steal groceries? Why do students risk their academic careers by cheating for just a few extra marks? Ruedy  et al. (2013) may have the answer: because it feels good. Many theories of moral behaviour assume that unethical behaviour triggers negative affect. They challenge this assumption and demonstrate that unethical behaviour can trigger positive affect, which they term a “cheater’s high.” 5.25 25

  26. On The Other Hand Across 6 studies, they found that even though individuals predict they will feel guilty and have increased levels of negative affect after engaging in unethical behaviour (Studies 1a and 1b), individuals who cheat on different problem-solving tasks consistently experience more positive affect than those who do not (Studies 2–5). They find that this heightened positive affect does not depend on self-selection (Studies 3 and 4), and it is not due to the accrual of undeserved financial rewards (Study 4). 5.26 26

  27. On The Other Hand Cheating is associated with feelings of self-satisfaction, and the boost in positive affect from cheating persists even when prospects for self-deception about unethical behaviour are reduced (Study 5). Their results have important implications for models of ethical decision making, moral behaviour, and self-regulatory theory. The Cheaters High How Being Bad Feels 5.27 27

  28. On The Other Hand Since the recent financial crisis, regulators and the general public have focused on financial speculation as one of its potential causes. In addition to the roles played by rating agencies and complicated financial engineering, speculative short sales (The sale of a security that is not owned by the seller, or that the seller has borrowed.) have been put into question. Laypeople's moral judgments about this type of financial speculation have been investigated. 5.28 28

  29. On The Other Hand Across four studies (Lotz and Fix 2013), found that laypeople's moral judgments of short selling are significantly harsher than their judgments of long positions (The buying of a security, with the expectation that the asset will rise in value.). Both successful (Study 1) and unsuccessful (Study 2) short selling receives harsher moral judgments. In addition, studies which manipulate the moral character of the shorted asset (Study 3) or the time horizon of the investment strategy (Study 4) support the conclusion that short selling is considered less moral than taking a similar long position. The results present consistent support for a judgment bias of economic laypeople in the domain of financial economics. 5.29 29

  30. On The Other Hand Interestingly Kouchaki and Smith (2013) have demonstrated that people are more moral in the morning than in the afternoon. They propose that the normal, unremarkable experiences associated with everyday living can deplete one’s capacity to resist moral temptations. In a series of four experiments, both undergraduate students and a sample of U.S. adults engaged in less unethical behaviour (e.g., less lying and cheating) on tasks performed in the morning than on the same tasks performed in the afternoon. This morning morality effect was mediated by decreases in moral awareness and self-control in the afternoon. Furthermore, the effect of time of day on unethical behaviour was found to be stronger for people with a lower propensity to morally disengage. 5.30 30

  31. Mehra and Prescott (1985) show that the combination of a high equity premium, a low risk-free rate, and smooth consumption cannot be reconciled with plausible levels of investors’ risk aversion within a standard paradigm of expected utility maximization. This has become known as the equity premium puzzle. And is clarified below. Asset Pricing 31

  32. The equity premium puzzle. Put simply if real returns to investors from the purchases of U.S. government bonds have been estimated at 1% per year, while real returns from stock (“equity") in U.S. companies have been estimated at 7% per year (Kocherlakota, 1996). General utility-based theories of asset prices have difficulty explaining (or fitting, empirically) why the first rate is so low and the second rate so high, not only in the U.S. but in other countries too. Asset Pricing 32

  33. Mehra and Prescott (1985) estimate that the coefficient of relative risk aversion (see definitions) should be higher than 30 to explain the historical equity premium, whereas previous estimates and theoretical arguments suggest that the actual figure should be close to 1. See explanation below. Asset Pricing Definitions 33

  34. Relative Risk Aversion S&P 500 34

  35. Relative Risk Aversion First Derivative The slope 35

  36. Relative Risk Aversion Second Derivative The slope of the slope 36

  37. Relative Risk Aversion The ratio d2/d 37

  38. A coefficient of relative risk aversion close to 30 corresponds to a situation like the following one: Suppose that Primus is offered a 50–50 gamble between $100,000 and $50,000 (expected value of $75,000); then his certainty equivalent (the value he would accept) should be around $51,209 (Mankiw and Zeldes, 1991). This is an extreme risk aversion. Reitz (1988) has argued that the equity premium may be a rational response to a time-varying risk of economic catastrophe, as bonds protect capital investment better than equity. This explanation is not testable. Asset Pricing 38

  39. Moreover, since the data from 1926 contain the 1929 crash, the catastrophe in question must be of greater magnitude. Also, the hypothetical catastrophe should affect equity but not bonds: thus, hyperinflation would not qualify. A different line of research has managed to explain part of the equity premium introducing unexpected utility preferences. In particular, Constantinides (1990) suggested a habit-formation model in which the utility of consumption depends on past levels of consumption as well. Asset Pricing 39

  40. People become averse to reductions in their consumption and this may be used to explain the equity risk premium. Asset Pricing 40

  41. What Does Equity Risk Premium Mean? It is the excess return that an individual stock or the overall stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of the equity market. The size of the premium will vary as the risk in a particular stock, or in the stock market as a whole, changes; high-risk investments are compensated with a higher premium. Asset Pricing Equity Risk Premium 41

  42. The reason behind this premium stems from the risk-return trade off, in which a higher rate of return is required to entice investors to take on riskier investments. The risk-free rate in the market is often quoted as the rate on longer-term government bonds, which are considered risk free because of the low chance that the government will default on its loans. On the other hand, an investment in stocks is far less guaranteed, as companies regularly suffer downturns or go out of business. Asset Pricing Equity Risk Premium 42

  43. If the return on a stock is 15% and the risk-free rate over the same period is 7%, the equity-risk premium would be 8% (15%-7%) for this stock over that period of time. Asset Pricing Equity Risk Premium 43

  44. To explain the equity risk premium Campbell and Cochrane (1999) perfect this intuition with a carefully crafted model. While this sort of model is probably on the right track, emphasising only consumption-based habit-forming neglects the weighty role of pension funds, endowments, and very wealthy individuals with long horizons. Asset Pricing 44

  45. This leaves us with two questions that are still open: Why is the equity premium so large, and why is anyone willing to hold bonds? This lecture is meant to show you how this sort of question can be approached using insights from behavioural finance. Asset Pricing 45

  46. Benartzi and Thaler (1995) puts forth a behavioural explanation of the equity premium puzzle based on a partial equilibrium model. They exploit two ideas from the psychological evidence about decision making. The first notion is loss aversion, which refers to the tendency for individuals to be more sensitive to reductions in their levels of well being than to increases. This translates into a slope of the utility function, which is greater over wealth decrements than over increments. Asset Pricing - Myopic Loss Aversion 46

  47. The second notion is mental accounting, which refers to the practice of implicitly earmarking financial outcomes as belonging to different accounts. This bears relevance on how outcomes are aggregated: because of loss aversion, aggregation rules may not be neutral. Asset Pricing - Myopic Loss Aversion 47

  48. However a word of caution from Andersen et al. (2010). “For one celebrated example, consider Benartzi and Thaler (1995), who use laboratory-generated estimates from college students to calibrate a model of the behaviour of US bond and stock investors. Such exercises are fine as ‘finger mathematics’ exemplars, but are no substitute for estimation on the comparable samples.” Asset Pricing - Myopic Loss Aversion 48

  49. Here is an example drawn from Barberis and Huang (2001). It compares the purchase of two shares as an entity, or as two separate purchases. An investor named Primus exhibits loss aversion, modelled by a utility function over wealth increments such as u(x) = x if x ≥ 0 and u(x) = 2x if x < 0. Asset Pricing - Myopic Loss Aversion 49

  50. Asset Pricing - Myopic Loss Aversion 50