Understanding the Economics Nobel Prize 2013

Lasse Heje Pedersen

Economics Nobel 2013

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2013 was awarded jointly to

Eugene Fama Lars Peter Hansen Robert Shiller

“for their empirical analysis of asset prices”

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The Nobel Events

October: the phone calls

December: Swedish king awards the medal

Gala dinner

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Market Efficiency Fight

4

Efficient! Inefficient!

I’m just testing..

NB: The “quotes” in this presentation are made up to illustrate the debate, they are not literal quotes

market efficient if prices �always `fully reflect’ available � �

information

See also Asness and Liew, “The Great Divide over Market Efficiency”http://www.institutionalinvestor.com/Article/3315202/Asset-Management-Equities/The-Great-Divide-over-Market-Efficiency.html

Market Efficiency: Random Walk?

Prices: , where k is a constant required return Returns: i.e., random walk with drift k

Test: Stock split evidence looks like random walk– Event study methodology developed by Fama, Fisher, Jensen, and Roll (1969)

– But “post earnings announcement drift” and drift in other events

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Prices Vary Too Much for Random Walk and Mean-Revert

Shiller: Excess volatility of market prices– Prices appear to bounce around more than earnings– Price-earnings ratio varies significantly (average = 16.5)

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Prices Vary Too Much for Random Walk and Mean-Revert

Dividend yield varies and high D/P appears to predict high future returns– Regressing yields

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If Not Random Walk, then What?

The expected return varies over time– Prices , where is a pricing kernel, e.g. – Returns or

Why does the expected return (i.e., the risk premium) vary?

The Believer The “Atheist” The Agnostic

the risk premium is naturally high in

recessions, plus its measured with error

No, it’s because people make

mistakes and suffer behavioral biases

My GMM method can test this stuff. I reject standard consumption-based asset

pricing models, but …

low high low is messed up

Joint Hypothesis Problem

Joint hypothesis problem: – Any rejection of a model of the risk premium and market efficiency means– One of them is wrong, but not necessarily both

Rejection of the joint hypothesis means:

The Believer The “Atheist” The Agnostic

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the model of the risk premium is wrong and the market is efficient market efficiency is

wrong

I can reject any model - but is it wrong in

important or unimportant ways?

Bubbles

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I called the internet bubble

Dude - you called it way

early

December 3, 1996

Relative to “post bubble”: Mkt went up 19% but underperformed Rf=30%

Bubbles

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I called the housing bubble

Dude - you called it early

again

Early 2003

Relative to “post bubble”: Prices went down ~7%, but must consider9 years housing services and Rf = 17%

Bubbles

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Dude – you trade on it every day

with DFA

You cannot trade on this “bubble”

nonsense

Conclusion: Financial Economics Has Had Huge Real-World Impact

Market efficiency– Very useful idea with broad implications – cf. Darwin’s survival of the fittest – Focus on diversification and low fees– E.g., index funds

Behavioral finance– Focus on how people actually make decision– You can nudge people to make better decisions– E.g. by having a good default: save for retirement

Empirical tests– Decisions and knowledge should be based on rigorously tested facts– Important to understand data mining biases

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