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Maturity Preference Theory

admin — Thu, 08 Dec 2011 10:28:28 +0000

Another traditional theory of the term structure asserts that lenders prefer to lend short-term to avoid tying up funds for long periods of time. In other words, they have a preference for shorter maturities. At the same time, borrowers prefer to borrow long-term to lock in secure financing for long periods of time.
According to the maturity preference theory, then, borrowers have to pay a higher rate to borrow long term rather than short term to essentially bribe lenders into loaning funds for longer maturities. The extra interest is called a maturity premium.
The Fisher hypothesis, maturity preference theory, and expectations theory can coexist without problem. For example, suppose the shape of a yield curve is basically determined by expected future interest rates according to expectations theory. But where do expected future interest rates come from? According to the Fisher hypothesis, expectations regarding future interest rates are based
on expected future rates of inflation. Thus expectations theory and the Fisher hypothesis mesh quite nicely.
Furthermore, a basic yield curve determined by inflationary expectations could also accommodate maturity preference theory. All we need to do is add a maturity premium to longer term interest rates. In this view, long-term, default-free interest rates have three components, a real rate, an anticipated future inflation rate, and a maturity premium.

Traditional Theories of the Term Structure

admin — Thu, 08 Dec 2011 10:27:36 +0000

Yield curves have been studied by financial economists for well over a century. During this period a number of different theories have been proposed to explain why yield curves may be upward sloping at one point in time and then downward sloping or flat at another point in time. We discuss three of the most popular traditional theories of the term structure in this series of posts. We then present a modern perspective on the term structure in the following series of articles.

Why Would a Market be Efficient?

admin — Thu, 24 Nov 2011 10:25:05 +0000

The driving force toward market efficiency is simply competition and the profit motive. Investors constantly try to identify superior performing investments. Using the most advanced information processing tools available, investors and security analysts constantly appraise stock values, buying those that look even slightly undervalued and selling those that look even slightly overvalued. This constant appraisal and buying and selling activity, and the research that backs it all up, act to ensure that prices never differ much from their efficient market price.
To give you an idea of how strong the incentive is to identify superior investments, consider a large mutual fund such as the Fidelity Magellan Fund. This is the largest equity fund in the United States, with over $70 billion under management (as of mid-1999). Suppose Fidelity was able through its research to improve the performance of this fund by 20 basis points (recall that a basis point is 1 percent of 1 percent, i.e., .0001) for one year only. How much would this one-time 20-basis point improvement be worth?
The answer is .002 × $70 billion, or $140 million. Thus Fidelity would be willing to spend up to $140 million to boost the performance of this one fund by as little as 1/5 of 1 percent for a single year only. As this example shows, even relatively small performance enhancements are worth tremendous amounts of money, and thereby create the incentive to unearth relevant information and use it.
Because of this incentive, the fundamental characteristic of an efficient market is that prices are correct in the sense that they fully reflect relevant information. If and when new information comes to light, prices may change, and they may change by a lot. It just depends on the new information. However, in an efficient market, right here, right now, price is a consensus opinion of value, where that consensus is based on the information and intellect of hundreds of thousands, or even millions, of investors around the world.

Strong-form efficient market

admin — Wed, 16 Nov 2011 10:21:41 +0000

In a strong-form efficient market no information of any kind, public or private, is useful in beating the market. Notice that if a market is strong-form efficient, it is necessarily weak- and semistrong-form efficient as well. Ignoring the issue of legality, it is clear that nonpublic inside information of many types would enable you to earn essentially unlimited returns, so this case is not particularly interesting. Instead the debate focuses on the first two forms.

Semistrong-form efficient market

admin — Mon, 14 Nov 2011 10:20:46 +0000

In a semistrong-form efficient market, publicly available information of any and all kinds is of no use in beating the market.
The implications of semistrong-form efficiency are, at a minimum, semistaggering. What it literally means is that nothing in the library, for example, is of any value in earning a positive excess return. How about a firm’s financial statements? Useless. Information in the financial press? Worthless. A book? Sad to say, if the market is semistrong-form efficient, there is nothing in a book that will be of any use in beating the market. You can probably imagine that this form of market efficiency is hotly disputed.

Weak-form efficient market

admin — Sat, 12 Nov 2011 10:20:04 +0000

A weak-form efficient market is one in which the information reflected in past prices and volume figures is of no value in beating the market. You probably realize immediately what is controversial about this. If past prices and volume are of no use, then technical analysis is of no use whatsoever. You might as well read tea leaves as stock price charts if the market is weak-form efficient.

Forms of Market Efficiency

admin — Thu, 10 Nov 2011 10:19:17 +0000

Now that we have a little more precise notion of what it means to beat the market, we can be a little more precise about market efficiency. A market is efficient with respect to some particular information if that information is not useful in earning a positive excess return. Notice the emphasis we place on “with respect to some particular information.”
For example, it seems unlikely that knowledge of Shaquille O’Neal’s free-throw shooting percentage would be of any use in beating the market. If so, we would say that the market is efficient with respect to the information in O’Neal’s free throw percentage. On the other hand, if you have prior knowledge concerning impending takeover offers, you could most definitely use that information to earn a positive excess return. Thus, the market is not efficient with regard to this information. We hasten to add that such information is probably “insider” information and insider trading is illegal (in the United States, at least). Using it might well earn you a jail cell and a stiff financial penalty.
Thus, the question of whether or not a market is efficient is meaningful only relative to some type of information. Put differently, if you are asked whether a particular market is efficient, you should always reply, “With respect to what information?” Three general types of information are particularly interesting in this context, and it is traditional to define three forms of market efficiency: (1) weak, (2) semistrong, and (3) strong.

What Does “Beat the Market” Mean?

admin — Tue, 08 Nov 2011 10:19:09 +0000

Good question. There is a risk-return trade-off. On average at least, we expect riskier investments to have larger returns than less risky investments. So, the fact that an investment appears to have a high or low return doesn’t tell us much. We need to know if the return was high or low relative to the risk involved. Instead, to determine if an investment is superior, we need to compare excess returns. The excess return on an investment is the difference between what that investment earned and what other investments with the same risk earned. A positive excess return means that an investment has outperformed other investments of the same risk. Thus consistently earning a positive excess return is what we mean by “beating the market.”

Payday loans

admin — Sun, 10 Apr 2011 11:28:51 +0000

Did you ever have an unexpected financial problem? People usually live from paycheck to paycheck, having little or no savings in their bank accounts. When an emergency strikes, like a broken car that needs immediate fixing or some health problems of your beloved ones that need expensive medical attention, you may find out that the money you have saved up to date may not be sufficient to pay the bill. Most people will visit their local banks to apply for a loan but what id they have a poor credit rating? No financial institution will grant them a loan. They can turn to their closest family or friends for help or they can apply for a so-called payday loan. Payday loans are short-terms loans granted by many financial institutions that forego a lot of expensive procedures such as credit verification to provide the borrower with an immediate financial relief for a fee.
Click to go to Payday Loan Facts.

Internal measures

admin — Sat, 04 Sep 2010 10:50:34 +0000

We have already examined the cost-of-capital and the use of hurdle rates as target minimum returns. In most companies all businesses, irrespective of different levels of risk, are given the same hurdle rate. Some advantages are that it is simple to determine and communicate. A highly successful American company had an enterprise- wide hurdle rate of 12% that remained unchanged for many years. The rationale for the 12% number was that it was equivalent to 1% each month. This made it extremely easy to communicate across the company.
A more sophisticated approach is to draw on CAPM and estimate the beta for each business using external sources. This can be done by identifying listed companies that operate largely in the same areas and taking a measure of their betas as determined from return correlations with the stock market. This approach is generally used more for valuation purposes when a company is considering selling a particular business than as a means to set hurdle rates. At a psychological level targets must stretch managers but have a realistic chance of being achieved if they are to be useful as a motivational lever.