Empirical Financial Economics

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

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

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

17. 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

18. 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

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

22. The Likelihood Function

23. The market model regression

24. The Fama MacBeth cross section regression

25. Updating market model

26. Full Information Maximum Likelihood

27. 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

28. 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