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Empirical Financial Economics

This seminar review by Stephen Brown from NYU Stern discusses major developments in financial economics over the past 35 years, focusing on the Efficient Markets Hypothesis (EMH) and its implications for portfolio theory, asset pricing, corporate finance, and behavioral finance. It explores the relationship between information processing in markets, various testing methodologies, and predictions of asset performance. The review highlights how EMH continues to shape empirical finance and the importance of conditioning in financial research and practical applications.

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Empirical Financial Economics

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  1. Empirical Financial Economics The Efficient Markets Hypothesis Review of Empirical Financial Economics Stephen Brown NYU Stern School of Business UNSW PhD Seminar, June 19-21 2006

  2. Major developments over last 35 years • Portfolio theory

  3. Major developments over last 35 years • Portfolio theory • Asset pricing theory

  4. Major developments over last 35 years • Portfolio theory • Asset pricing theory • Efficient Markets Hypothesis

  5. Major developments over last 35 years • Portfolio theory • Asset pricing theory • Efficient Markets Hypothesis • Corporate finance

  6. Major developments over last 35 years • Portfolio theory • Asset pricing theory • Efficient Markets Hypothesis • Corporate finance • Derivative Securities, Fixed Income Analysis

  7. Major developments over last 35 years • Portfolio theory • Asset pricing theory • Efficient Markets Hypothesis • Corporate finance • Derivative Securities, Fixed Income Analysis • Market Microstructure

  8. Major developments over last 35 years • Portfolio theory • Asset pricing theory • Efficient Markets Hypothesis • Corporate finance • Derivative Securities, Fixed Income Analysis • Market Microstructure • Behavioral Finance

  9. Efficient Markets Hypothesis which implies the testable hypothesis ... where is part of the agent’s information set In returns: where

  10. Examples • Random walk model • Assumes information set is constant • Event studies • For event dummy (event) • Time variant risk premia models • zt includesX • Important role of conditioning information

  11. Efficient Markets Hypothesis • Tests of Efficient Markets Hypothesis • What is information? • Does the market efficiently process information? • Estimation of parameters • What determines the cross section of expected returns? • Does the market efficiently price risk?

  12. Efficient Markets Hypothesis • Weak form tests of Efficient Markets Hypothesis • Example: trading rule tests • Semi-strong form tests of EMH • Example: Event studies • Strong form tests of EMH • Example: Insider trading studies (careful about conditioning!)

  13. Trading Rules: Cowles 1933 • Cowles, A., 1933 Can stock market forecasters forecast? Econometrica 1 309-325 • William Peter Hamilton’s Track Record 1902-1929 • Classify editorials as Sell, Hold or Buy • Novel bootstrap in strategy space Return on DJI

  14. Asset pricing models: GMM paradigm • Match moment conditions with sample moments • Test model by examining extent to which data matches moments • Estimate parameters

  15. Example: Time varying risk premia Time varying risk premia imply a predictable component of excess returns where the asset pricing model imposes constraint

  16. Estimating asset pricing models: GMM • Define residuals • Residuals should not be predictable using instruments zt-1 that include the predetermined variables Xt-1 • Choose parameters to minimize residual predictability

  17. Estimating asset pricing models: Maximum likelihood • Define residuals • Choose parameters to minimize • Establishes a connection to Fama and MacBeth • Resolves the “measurement error problem” • Relationship to GMM: when instruments zt include the predetermined variables Xt

  18. Fama and MacBeth procedure 30 10 15 20 25 0 5 t

  19. Fama and MacBeth procedure 30 10 15 20 25 0 5 t

  20. Fama and MacBeth procedure 30 10 15 20 25 0 5 t

  21. The Likelihood Function

  22. The market model regression

  23. The Fama MacBeth cross section regression

  24. Updating market model

  25. Full Information Maximum Likelihood

  26. Estimating asset pricing models: A simpler way • Time varying risks and time varying premia: • This collapses to a simpler model • which generalizes: • Investment management style analysis (GSC) • Performance benchmark issues • “Pure play” definitions

  27. Conclusion • Efficient Market Hypothesis is alive and well • EMH central to recent developments in empirical Finance • EMH highlights importance of appropriate conditioning • in empirical financial research • in practical applications

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