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Lecture 1 - Nov. 3, 2011

Lecture 1 - Nov. 3, 2011

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Published by: Vladimir Gusev on Dec 21, 2011
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11/3/20111
EmiricsofFinancialMarkets 
Patrick J. Kelly, Ph.D.
MICEX 
150020002500
      e      x       L      e      v      e        l
MICEX
 
Levels
 
© 2011 Patrick J. Kelly2
05001000
 S   e  p t   e m b   e r 
 9  7  F   e b   r  u a r   y 
 9  8  J    u l     y 
 9  8  e c  e m b   e r 
 9  8  M a  y 
 9  9  O c  t   o b   e r 
 9  9  M a r  c  h  
 0  0  A  u  g u s  t  
 0  0  J    a n u a r   y 
 0  J    u n e
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 0  A   p r  i    l   
 0  S   e  p t   e m b   e r 
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 0  3  J    u l     y 
 0  3  e c  e m b   e r 
 0  3  M a  y 
 0  4  O c  t   o b   e r 
 0  4  M a r  c  h  
 0  5  A  u  g u s  t  
 0  5  J    a n u a r   y 
 0  6  J    u n e
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 0  6  A   p r  i    l   
 0  7  S   e  p t   e m b   e r 
 0  7  F   e b   r  u a r   y 
 0  8  J    u l     y 
 0  8  e c  e m b   e r 
 0  8  M a  y 
 0  9  O c  t   o b   e r 
 0  9  M a r  c  h  
 0  A  u  g u s  t  
 0  J    a n u a r   y 
 J    u n e
       I      n        d
MICEX returns
© 2011 Patrick J. Kelly3
 WHY?
MICEX + constituents: levels
© 2011 Patrick J. Kelly5
MICEX + constituents: returns
© 2011 Patrick J. Kelly6
 
11/3/20112
 Asset Pricing Models in General
Asset pricing models relate expected stock returns tofactors. Typically, these are written as linear models(because easier than non-linear):These linear models are an approximation of marginalutility growth.This says: Discounted aggregate marginal utility growthapproximately follows some function of factors ( 
 f 
 )
© 2011 Patrick J. Kelly7
 What Are Factors?
These factors are proxiesfor marginal utility growth:Factors signal current (or forecast future) marginalutility growth.
 
 –What grows or stunts marginal utility?
States of the economy: consider when the economy goes bad, putextra value on assets/portfolios with high payoffs in these bad states
 –Such portfolios will have high prices and low returns
 –In some models factors can be those that forecast futuremarginal utility growth, but they shouldn
t predict too well
(otherwise the models will predict larger than factual interest variation)
This is why we use changes, not levels: returns, not prices
© 2011 Patrick J. Kelly8
 Asset Pricing Models:
Different ways to model marginal utility growthCapital Asset Pricing Model (CAPM)
 –One factor
IntertemporalCAPM (ICAPM)
 –CAPM + 1 factor to capture changes in investmentopportunities
Arbitrage Pricing Theory (APT)
 –Multi-factor
© 2011 Patrick J. Kelly9
CAPM
r
 w 
is the return to current wealth –NOT just themarket. Includes:
 –Labor income –Real estate –Any private property  –All public property (parks, lakes, roads, bridges)
One period model (ignores time)
© 2011 Patrick J. Kelly10
 The foundations of CAPM
Sharpe, Lintnerand Treynor(separately) groundedasset pricing in a single market factor
 –Because they created models of asset prices that built on theintuition in Markowitz’s portfolio theory, whichsimply notes that
Investors do not ( 
should not? 
 ) care about any oneasset in theirportfolio of assets, but they should only care about the risk andreward of the entireportfolio.
and demonstrates
The power of diversification across many assets
© 2011 Patrick J. Kelly11
 This class
© 2011 Patrick J. Kelly12
 
11/3/20113
Goal of Course
Briefly introduce key theories in finance
 –Mostly related to
Asset pricing Market efficiency 
And what the data tell us about the theories
© 2011 Patrick J. Kelly13
 What we will cover
Portfolio theory 
 –With liquidity and short sale constraints
Asset Pricin
 –Event studies
Return predictabilit
 –At long and short horizons
Behavioral Finance
© 2011 Patrick J. Kelly14
Syllabus
40% of class –3 projects
 –Find onepartner
E-mail me if you have problemspkelly@nes.ru
 –I expect you know Gauss and Excel
If you don’t, rethink taking this class
 
60% of grade final exam
 –In English –You will have at least one sample exam
Few surprises
Please pay attention to my.nes.ru!
© 2011 Patrick J. Kelly15
Portfolio Selection
© 2011 Patrick J. Kelly16
 What’s next?
We are going to run through about 1/4
th
to 1/3
rd
thematerial I cover in a typical MBA Investments andPortfolio Management class…
 –in about 45 min to an hour.
The point:
 –To give you some of the basic intuition before you startapplying the reasoning to the data in your assignments
© 2011 Patrick J. Kelly17
Portfolio Selection
Marokowitz(1952)
 –Prior belief: investors should solely maximize the discounted value of cash flows
Two assets with the same discounted cash flows are equally goodregardless of risk 
 –Proposes/Assumes the Mean-Variance Criterion
Investors care about both risk and return
 –Shows that through diversification investors can get amaximum return for a minimum of risk 
© 2011 Patrick J. Kelly18

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