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Week 1 - summary with definitions and graphs

Financial Markets (Yale University)

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Financial markets - Week 1

VaR and Stress Tests

A portfolio is a collection of financial investments like stocks, bonds, commodities, cash,

and cash equivalents, including closed-end funds and exchange traded funds (ETFs).
People generally believe that stocks, bonds, and cash comprise the core of a portfolio.
Though this is often the case, it does not need to be the rule. A portfolio may contain a wide
range of assets including real estate, art, and private investments (diversification is a key
concept in portfolio management). A person's tolerance for risk, investment objectives, and
time horizon are all critical factors when assembling and adjusting an investment portfolio.

Closed-end funds : A closed-end fund is a portfolio of pooled assets that raises a fixed
amount of capital through an initial public offering (IPO, refers to the process of offering
shares of a private corporation to the public in a new stock issuance) and then lists shares
for trade on a stock exchange.

VaR : value at risk (appeared after the stock market crash in 1987), a measure to quantify
risk of an investment or portfolio, quoted in units of dollars for a given probability and time
horizon. Example: 1% one year VaR of $10 million means 1% chance that a portfolio will
lose $10 million in a year.

VAR : variance.
The variance of a portfolio is defined as a measure of its variability

Currency depreciation, in the context of the U.S. dollar, refers to the decline in value of the
dollar relative to another currency. (opposite: currency appreciation)

Stress test : originally, term referred to a medical procedure to check for cardiovascular
fitness then moved to finance. It's not a basic statistical concept but a measure, a method of
assessing risks to firms or portfolios. It’s usually ordered by the government to see how the
firm will stand up to a financial crisis.
The Dodd-Frank Act in the United States of 2010 requires the Federal Reserve to do annual
stress tests for non-bank financial institutions it supervises (response to the financial crisis of
2007 to 2008).
The European banking authority which was created in 2011, after the financial crisis, has
also instituted regular stress tests for European banks.
There is a growing amount of skepticism if they can really measure what will happen in the
next crisis.

S&P 500

The S&P 500, or simply the S&P, is a stock market index that measures the stock
performance of 500 large companies listed on stock exchanges in the United States. It is
one of the most commonly followed equity indices.

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*2007 to 2009 drop caused by the crisis.

*unstableness of the stock market
*huge growth shows dependance across the 500 stocks

Mortgage : debt instrument, secured by the collateral of specified real estate property, that
the borrower is obliged to pay back with a predetermined set of payments - a legal
agreement by which a bank, building society, etc. lends money at interest in exchange for
taking title of the debtor's property, with the condition that the conveyance of title becomes
void upon the payment of the debt.

*drop in the beginning of the pandemic

The stock market refers to the collection of markets and exchanges where regular activities
of buying, selling, and issuance of shares of publicly-held companies take place. Such
financial activities are conducted through institutionalized formal exchanges or
over-the-counter (OTC) marketplaces which operate under a defined set of regulations.
There can be multiple stock trading venues in a country or a region which allow transactions
in stocks and other forms of securities.

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Over-the-counter (OTC) refers to the process of how securities are traded via a
broker-dealer network as opposed to on a centralized exchange. Over-the-counter trading
can involve equities, debt instruments, and derivatives, which are financial contracts that
derive their value from an underlying asset such as a commodity.

Steve Jobs was fired from his own company (Apple Corporation). When the value dropped
after, they hired him again and the company did very well and still is even after his death.

Beta is a measure of a stock's volatility in relation to the overall market. By definition, the
market, such as the S&P 500 Index, has a beta of 1.0, and individual stocks are ranked
according to how much they deviate from the market.
A stock that swings more than the market over time has a beta above 1.0. If a stock moves
less than the market, the stock's beta is less than 1.0. High-beta stocks are supposed to be
riskier but provide higher return potential; low-beta stocks pose less risk but also lower
returns.
Beta is probably a better indicator of short-term rather than long-term risk.

Market risk Idiosyncratic risk

Market risk is the possibility of an investor
experiencing losses due to factors that
affect the overall performance of the
financial markets in which he or she is
involved. Market risk, also called
"systematic risk," cannot be eliminated
through diversification, though it can be
hedged against in other ways. Sources of
market risk include recessions, political
turmoil, changes in interest rates, natural
disasters and terrorist attacks. Systematic,
or market risk tends to influence the entire
market at the same time.
Idiosyncratic risk is a type of investment risk
that is endemic to an individual asset (like a
particular company's stock), or a group of
assets (like a particular sector's stocks), or
in some cases, a very specific asset class
(like collateralized mortgage obligations).
Idiosyncratic risk is also referred to as a
specific risk or unsystematic risk. Therefore,
the opposite of idiosyncratic risk is a
systematic risk, which is the overall risk that
affects all assets, such as fluctuations in the
stock market, interest rates, or the entire
financial system.

y= am+b. The slope m is how much y changes for a 1 unit increase in x.

In finance:
- y is the return on the company’s stock
- x is the return on the market
- slope m as beta tells how much a particular stock co-moves with the market and thus
as a measure of the stock systematic risk
- constant b as alfa

Distribution and Outliers

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Normal distribution:

Cauchy distribution: (fat tail distribution)

The central limit theorem :

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The central limit theorem in statistics states that, given a sufficiently large sample size, the
sampling distribution of the mean for a variable will approximate a normal distribution
regardless of that variable’s distribution in the population.
- Averages of a large number of independent identically distributed stocks (whose
variance is finite) are approximately normally distributed.
- Can fail if the underlying shocks fat tailed.
- Can fail if the underlying shocks lose their independence.

A stock market crash is a rapid and often unanticipated drop in stock prices. A stock
market crash can be a side effect of a major catastrophic event, economic crisis, or the
collapse of a long-term speculative bubble. Reactionary public panic about a stock market
crash can also be a major contributor to it, inducing panic selling that depresses prices even
further. Famous stock market crashes include those during the 1929 Great Depression,
Black Monday of 1987, the 2001 dotcom bubble burst, the 2008 financial crisis, and during
the 2020 COVID-19 pandemic.

Covariance

Covariance measures the directional relationship between the returns on two assets. A
positive covariance means that asset returns move together while a negative covariance
means they move inversely. Covariance is calculated by analyzing at-return surprises
(standard deviations from the expected return) or by multiplying the correlation between the
two variables by the standard deviation of each variable.

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● Covariance is a statistical tool that is used to determine the relationship between the
movement of two asset prices.
● When two stocks tend to move together, they are seen as having a positive covariance;
when they move inversely, the covariance is negative.
● Covariance is a significant tool in modern portfolio theory used to ascertain what
securities to put in a portfolio.
● Risk and volatility can be reduced in a portfolio by pairing assets that have a negative
covariance.

Covariance evaluates how the mean values of two variables move together. If stock A's
return moves higher whenever stock B's return moves higher and the same relationship is
found when each stock's return decreases, then these stocks are said to have positive
covariance. In finance, covariances are calculated to help diversify security holdings.
When an analyst has a set of data, a pair of x and y values, covariance can be calculated
using five variables from that data. They are:
➔ xi = a given x value in the data set
➔ xm = the mean, or average, of the x values
➔ yi = the y value in the data set that corresponds with xi
➔ ym = the mean, or average, of the y values
➔ n = the number of data points

Given this information, the formula for covariance is:

Cov(x,y) = SUM [(xi - xm) * (yi - ym)] / (n - 1)

NB: While the covariance does measure the directional relationship between two assets, it
does not show the strength of the relationship between the two assets; the coefficient of
correlation is a more appropriate indicator of this strength.

The correlation coefficient is a statistical measure of the strength of the relationship

between the relative movements of two variables. The values range between -1.0 and 1.0. A
calculated number greater than 1.0 or less than -1.0 means that there was an error in the
correlation measurement. A correlation of -1.0 shows a perfect negative correlation, while a
correlation of 1.0 shows a perfect positive correlation. A correlation of 0.0 shows no linear
relationship between the movement of the two variables.
Correlation statistics can be used in finance and investing. For example, a correlation
coefficient could be calculated to determine the level of correlation between the price of
crude oil and the stock price of an oil-producing company, such as Exxon Mobil Corporation.
Since oil companies earn greater profits as oil prices rise, the correlation between the two
variables is highly positive.

Risk is determined by covariance.

The market demands higher returns from higher beta
stock, that means high covariance with the market stock.
And they're willing to take low returns if the beta is low,
because that means it's less contributing to risk in the
portfolio.

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Insurance fundamentals

In insurance, the term "risk pooling" refers to the spreading of financial risks evenly among
a large number of contributors to the program. Insurance is the transference of risks from
individuals or corporations who cannot bear a possible unplanned financial catastrophe to
the capital markets, which can bear them easily – at least in theory. The capital markets,
meanwhile, are generally happy to take on risk from individuals and corporations – in
exchange for a premium they believe is sufficient to cover the risk.

If n policies, each has independent probability p of a claim, then the number of claims follows
the binomial distribution. The standard deviation of the fraction of policies that result in a
claim is 𝑝(1 − 𝑝)/𝑛
Law of large numbers : as n gets large, standard deviation approaches zero.

The law of large numbers, in probability and statistics, states that as a sample size grows,
its mean gets closer to the average of the whole population. In the 16th century,
mathematician Gerolama Cardano recognized the Law of Large Numbers but never proved
it. In 1713, Swiss mathematician Jakob Bernoulli proved this theorem in his book, Ars
Conjectandi. It was later refined by other noted mathematicians, such as Pafnuty
Chebyshev, founder of the St. Petersburg mathematical school.
In a financial context, the law of large numbers indicates that a large entity which is growing
rapidly cannot maintain that growth pace forever. The biggest of the blue chips, with market
values in the hundreds of billions, are frequently cited as examples of this phenomenon.

The Law of Large Numbers is important because it guarantees stable long-term results for
the averages of some random events.

Moral hazard is the risk that a party has not entered into a contract in good faith or has
provided misleading information about its assets, liabilities, or credit capacity. In addition,
moral hazard also may mean a party has an incentive to take unusual risks in a desperate
attempt to earn a profit before the contract settles. Moral hazards can be present at any time
two parties come into agreement with one another. Each party in a contract may have the
opportunity to gain from acting contrary to the principles laid out by the agreement.
Any time a party in an agreement does not have to suffer the potential consequences of a
risk, the likelihood of a moral hazard increases.

Fundamental insurance principles and issues:

- Risk pooling is the source of all value in insurance
- Moral hazard dealt with partially by deduction and coinsurance
- Selection bias dealt with by group policies, by testing and referrals, and by mandatory
government insurance

Moral hazard occurs when people knowing they are insured take more risks. So for example,
if your house is insured against fire you may say, "I don't care, I'll be careless with fire
because it's insured." So then the risk goes up. Or even worse, if the insurance company
insures your house for more than you think you can sell it, you would say, "I'll just burn it

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down and pretend it was an accident. And then I'll get more money than I would have for
selling the house."

Sample selection bias is a type of bias caused by choosing non-random data for statistical
analysis. The bias exists due to a flaw in the sample selection process, where a subset of
the data is systematically excluded due to a particular attribute. The exclusion of the subset
can influence the statistical significance of the test, and it can bias the estimates of
parameters of the statistical model.

We are transforming from financial capitalism into philanthropy capitalism - Robert Shiller

Insurance milestones

Radical finance innovation - example 1: insurance :

- Burial societies Ancient Rome, true insurance policies appeared in Italy in 14th century
- Rapid development of actuarial theory staring in 1600s with notion of probability
- Morris Robinson Mutual life of NY 1840: highly paid salesman (agency theory)
- Henry Hyde Equitable life assurance society 1880s: large cash value (psychological
framing)
- Viviana Zelizer: challenging God, tempting fate (psychological framing)
- Inventions copied around the world
- Life insurance is a relic, of a day when people die young

Insurance is a local phenomenon

The Dodd Frank act of 2010 created a federal insurance office that monitors insurance
companies, looking for systemic risks. There are no national insurance companies, they all
have state charters.

State insurance guarantee funds:

● Most US states have guarantee funds protecting insurance against failure of the
insurance company
● The first state to set up such a fund was New York, in 1941
● Protects individuals, not businesses or group insurance

Connecticut Life and health insurance guaranty association

- Founded in 1972 by Connecticut legislature
- Maximum death benefit $500,000 and maximum cash value insurance $500,000.
Connecticut's (along with NY and NJ) is generous (benefits not taxable)
- Even so, not big enough. If you were buying life insurance for your family, $1 million
minimum
- You can’t increase coverage by buying multiple policies (as you can with FDIC)
- CT disallows mentioning the guaranty in insurance company advertising (opposite FDIC)

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In september 2008, CIRC (China Insurance Regulatory Commission) set up a nonprofit

state-owned corporation with a registered capital of 100 million yuan to manage its insurance
protection fund, amounting to at least 7 billion yuan (about $1 billion).

China insurance protection fund:

- Policyholders’ losses that are no more than 50,000 yuan ($7,500) will be fully covered
by the fund
- For losses in excess of that number, the fund covers 90% of the extra for individual
policyholders and 80% for corporate policyholders

AIG (American International Group, Inc.) is an American multinational finance and insurance
corporation with operations in more than 80 countries and jurisdictions. As of January 1,
2019, AIG companies employed 49,600 people.

US government regulation of insurance:

- McCarran Ferguson Act 1945 delegated insurance regulation to the states. 50
different state regulators (this is chaos, because companies like to operate nationally)
- National Association of Insurance Commissioners (NAIC) *not government creates
standardized suggested laws
- Gramm-Leach-Bliley Financial Modernization Act of 1999 allowed banks to affiliate
with insurance companies

Health insurance

Proposed in 1694 by Hugh the Elder Chamberlen.

First US health insurance: Franklin Health Assurance Company of Massachusetts, 1850.

The Health Maintenance Organization Act of 1973:

- Required employers with 25 or more employees to offer federally certified HMO options
- Designed to overcome moral hazard problem, doctors earning fees for procedures make
more money if people are sick
- HMO doctors are salaried, each patient has a “primary” who serves as gatekeeper
- Yale Health Plan is an HMO, Yale employees can also choose Blue Cross

The US Emergency Medical Treatment and Active Labor Act ( EMTALA) 1986 is an
“unfunded mandate” that requires hospitals and ambulance services to provide care to
anyone needing emergency treatment.

US patient protection and affordable care Act 2010 (Obamacare):

- Penalty for individuals not buying insurance
- Penalties for companies not buying insurance for their employees
- New insurance exchanges. A health insurance exchange is a set of state-regulated
and standardized health care plans, from which individuals may purchase health
insurance that is eligible for Federal subsidies
- Insurance companies may not disallow for preexisting conditions, or drop people who
get sick

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Disasters

Haiti earthquake came in 2010, before the earthquake there was the movement that tried to
get Caribbean countries to buy insurance.

Casualty insurance in Haiti: (before the earthquake)

- Since 2007, Haiti has participated in the Carribean Catastrophe Risk Insurance Facility,
funded by donors and member countries.
- But that covered only $8 million of losses
- Coverage from private insurers similarly small (premiums about 0.3% of GDP)
- Losses from the Haitian earthquake reached into many billions

Hurricane Katrina 20 foot high storm surge, august 19, 2005

Assessment of insurance performance in US after Katrina:
- The total insured property loss of Katrina, $34.4 billion
- 70% of claims were settled by january 2006, $7.5 billion paid out by insurers (Insurance
Information Institute)
- Roughly 200,000 homes severely damaged, so payment was about $40,000 per home
- Insurance companies argued homes were damaged by flood, not wind
- Many homeowners did not have flood insurance (60% of homeowners in Orleans parish)
- Insurance premiums in Louisiana had already gone up by 70% between 1997 and 2005,
causing many people to cancel their insurance

Before 9/11/2001, insurers generally did not exclude terrorism risk, which they then saw as
inconsequential (insignificant). After 2001, insurers wanted these exclusions
US Terrorism Risk Insurance Act of 2002 (TRIA) required insurers to offer terrorism
insurance for three years. The government agreed to pay 90% of insurance industry losses
above a deductible of $100 billion. In december 2005, TRIA renewed for 2 more years, and
in 2007 for 7 more years. In 2015, the act was renewed again to 2020 (that act keeps
expiring and keeps being renewed again).

If you couldn't pay your bills in 1800, they had special prisons for you called debtor's prisons.

Eggs in one basket

An alternative to insurance: portfolio management. Diversification of ownership

Portfolio management is the art and science of selecting and overseeing a group of
investments that meet the long-term financial objectives and risk tolerance of a client, a
company, or an institution.
Portfolio management requires the ability to weigh strengths and weaknesses, opportunities
and threats across the full spectrum of investments. The choices involve trade-offs, from
debt versus equity to domestic versus international and growth versus safety.

“There is an old saying that it is unadvisable to have all your eggs in one basket” in
Alexander Crump’s book on investment in 1874.

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A later insight : if people are all like me, all calculating with the same data, all wanting to hold
portfolio on the frontier, then they all want to hold the same portfolio (and cash) so that has
to be the market portfolio

Portfolio diversification:
- All that should matter to an investor is the performance of the entire portfolio
- Mean and variance of portfolio matter
- Law of large numbers means that spreading over many independent assets reduces
risk, has no effect on expected return

Salon - Risk

Hedge funds are investment companies that are not approved for the general retail market.
So they're not allowed to advertise. They're not well-known, because they're not allowed to
promote themselves, except through private conversations, and to invest in them you have
to be an accredited investor, not a general investor. So they are allowed to do sophisticated
and dangerous things. The idea is a hedge fund is regulated for people who have
professional advisors or family offices. You know what a family office is? If you are really rich
you don't just hire an advisor. You get a team of advisers who work on your family
investments. That's what hedge funds are really for.
They were doing very well in the past but not lately.

Definition : the use of hedge funds in financial portfolios has grown dramatically since the
start of the 21st century. A hedge fund is just a fancy name for an investment partnership
that has freer rein to invest aggressively and in a wider variety of financial products than
most mutual funds. It's the marriage of a professional fund manager, who is often known as
the general partner, and the investors, sometimes known as the limited partners. Together,
they pool their money into the fund. This article outlines the basics of this alternative
investment vehicle.

Home prices last fell during the great depression, so people didn’t expect it to happen in
2008 during the crisis.

Robert Shiller : Obama was proposing government insurance. I don't see why it has to be
exclusively government. There could be private insurers or private markets that would help
protect people against loss of income. But I think it's actually very important now, more so
than in the past, because of the rapid increase in information technology on robotics, and the
rapid globalization. So things can happen really fast that make one's investment in human
capital obsolete. And absolutely, there should be risk management devices for that. And the
important thing, as I've argued in my books, is if you help people manage risks, they will take
more risks. That's what we want. We want people, in their decisions about their education, to
do some risk-taking.

Capital Asset Pricing Model (CAPM)

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- CAPM asserts that all investors hold their optimal portfolio

- Consequence of the mutual fund theorem: all investors hold the same portfolio of risky
assets, the tangency portfolio
- Therefore the CAPM says that the tangency portfolio equals the market portfolio

The Capital Asset Pricing Model (CAPM) describes the relationship between systematic
risk and expected return for assets, particularly stocks. CAPM is widely used throughout
finance for pricing risky securities and generating expected returns for assets given the risk
of those assets and cost of capital.

𝐸𝑅𝑖 = 𝑅𝑓 + β𝑖 (𝐸𝑅𝑚 − 𝑅𝑓)

Where 𝐸𝑅𝑖: expected return of investment
𝑅𝑓: risk-free rate
β𝑖: covariance of stock with market
The market has a beta of 1 usually. If the market is up 10% and the stock 20% or market
down 5% and stock 10%, the beta will be 2. If the market is down 10% and stock down 5%,
beta 0,5
𝐸𝑅𝑚: expected stock market return
(𝐸𝑅𝑚 − 𝑅𝑓): market risk premium

Investment companies as providers of diversification:

● Investments trusts (before 1940s)
● Mutual funds (especially index funds)
● Closed end investment companies
● Unit investment trusts
All these institutions can enable small investors to overcome transaction cost and lumpiness
problems in achieving diversified portfolios.

So before the 1940s, we had what were called investment trusts. Later they became a
different form called the mutual fund.

Doubts about diversification : complete diversification would imply holding much in fixed
incomes, real estate, etc. but hasn't the stock market outperformed these?

Equity premium puzzle

- US geometric average real stock market return 1802-2012 : 6.6% (Siegel Stocks for
the long run 5th edition 2014 figure 1.1)
- US geometric average real short-term governments retur 1802-2012 : 2.7%
- Equity premium = 6.6% - 2.7% = 3.9%
- Puzzle : why has the equity premium been so high?
The United States is the most successful capitalist country in the world.
International evidence : Median real stock market appreciation rate for 39 countries 1926-96:
0.8% per year. For the US: 4.3% per year (Philippe Jorion and William Goetzmann, Journal
of finance 54:953-80,1999).
⇾ so US equity (stock) premium may reflect a selection bias.

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The “equity premium puzzle” defines the “equity premium” as equity returns minus bond
returns and is supposed to reflect the relative risk of stocks compared to “risk-free”
government bonds.

Additional note : in 1929, that sector that grew the most and crashed was the utilities sector.

Chalk Talk: Beta

If the return of the market goes up, the S&P 500 goes up 10%, then you should have 15%
for Apple, which gives you the beta of 1.5 on average. >> Right, but it won't be exactly. It
doesn't fall exactly in line. But they differ from the line, and that's called idiosyncratic risk. It's
not related to the market, it's Apple risk. So the market could do great in one year. And Steve
Jobs could get sick in that year. It's just something. So Apple didn't do well. That's
idiosyncratic. The theory of the capitalized pricing model is that investors care more about
beta than they do about idiosyncratic risk. because all these companies' idiosyncratic risks
will average out and wont matter. What matters is the systematic risk. The risk that
correlates with the market. Those things do not average out no matter how many stocks you
put in your portfolio.

Gold might in many cases be a negative beta stock because when the stock market crashes
people panic and they get upset, and they want to hold something very safe. At least gold is
always safe in one sense, it stays gold. No matter what happens. It’s also something that
you can run with. If you think that you're going to be a refugee, you’d want something you
can stash in your purse and just get out of here. Gold has that aspect. So it's some
psychological effect, that at least in some time periods, it looks like a negative beta asset.

Short sales

A short sale is a transaction in which the seller does not actually own the stock that is being
sold but borrows it from the broker-dealer through which they are placing the sell order. The
seller then has the obligation to buy back the stock at some point in the future. Short sales
are margin transactions, and their equity reserve requirements are more stringent than for
purchases.
The main advantage of a short sale is that it allows traders to profit from a drop in price.
Short sellers aim to sell shares while the price is high, and then buy them later after the price
has dropped. Short sales are typically executed by investors who think the price of the stock
being sold will decrease in the short term (such as a few months).
- Brokers can enable you to hold a negative quantity of a tradable asset: they borrow the
security and sell it, escrow the proceeds, you receive the proceeds, owe the security
- Short sales in the US were briefly abolished in September 2008 for a list of 799 stocks
https://www.sec.gov/news/press/2008/2008-211.htm

Capital asset pricing model assumes that, yeah, you can buy positive or negative amounts.
Let's find the optimal portfolio. But then it turns out, however, that if you really take the idea
that everyone would do the same thing, no stock could ever have an optimal holding of a
negative number because there would be a negative holding for everybody. And everyone

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would want to short it, and that can't add up. So we're going to allow short sales in our math,
but we'll assume that they won't happen, not on average.
Here's why short sales won't happen. In our model, the optimal portfolio decision of all
investors in equilibrium will be symmetric or identical. Given that, we can conclude that no
single investor will ever short a stock in equilibrium because then everybody in our model
would be shorting that stock.

Calculating the optimal portfolio

Let's illustrate the idea of how levering up to the hilt can give you any expected
portfolio return you want. Let's say you start with $1 and there are only two investable assets
in the world. Let's look at a risky asset which offers an expected return of 20% and a return
standard deviation of 5%. And the other asset is the risk free asset which guarantees a
return of 10% with no risk. If you want 100% expected return on your $1 portfolio. First,
borrow, AKA "short", $8 from the risk free market, and now you have $9 to play with. Invest
all $9 in the risky asset. This provides you with an expected return next period of 20%. So
your portfolio now has $10.80 on average. Pay back what you owe which is 8*1.1 or $8.80,
you're left with $2 in your portfolio and you have thus doubled your initial investment on
average. Remember though, you took on an 8 to 1 leverage ratio to get here. Using the
formula the standard deviation of your portfolio return was 9*5%, or 45%. If the risky asset
realized any return less than -2.2% which is half of one standard deviation away from the
mean, you would have to file for bankruptcy.

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When the covariance is negative, both assets tend to move in opposite directions. Hence a
negative covariance decreases the variance of your portfolio.

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