Outstanding questions

I - Random walk == efficient market?
II- treasury yield curve relationship to mortgage yield curve
III- concrete example of incompleteness arising from transactions costs.

Let's start with 2005.II.5 tomorrow?

Market Efficiency and the Expectations Hypothesis

Is the expectations hypothesis a consequence of the efficient markets hypothesis? Is so explain why. If not explain how the two concepts are related.

B&S and CAPM Redux

I created a new post about this because the previous one is already in the "older posts" section. To refresh your memory, this is about 2005, II.4.

Here are my 2 cents, let me know if it makes sense:

Answer to first question: you can use CAPM to estimate expected excess returns of options under certain assumptions: HARA class of utility functions.

Answer to second question:

(Preliminary note: CAPM is about expected excess returns and and is mute about price levels. B&S is about arbitrage free price levels and is mute about expected excess returns.)

Role of Beta in CAPM: quantifies the amount of the priced factor in an asset, to measure its expected excess return. The price of risk is given by the expected market premium.

In that sense, sigma in B&S is analogous to the expected market premium and not to beta. The delta of an option is analogous to beta. Making sigma = 0, the option is worth its intrinsic value (something analogous to the risk free rate).

Investment-cash flow sensitivity

We spent quite a lot of time in 239D discussing investment-cash flow sensitivity. It is not clear to me why this is an interesting/important topic. What is the significance of Inv-CF sensitivity? Is it simply a proxy for financial constraints (i.e. firms that are constrained have investment that is more sensitive)?

Over(under) stated estimates/t-stats

This is related to problem II.13 from 2005 day 2. Do we have a good list of cases where estimates are over or understated, or where the t-stats are? perhaps we can discuss this next time.

When is the next meeting/what is the group meeting schedule now?

thanks,

Javed

Complete Markets with BM

I was looking at PS3 Problem 2 in 239B yesterday (Black Scholes with Stochastic Interest Rates) and I noticed that the set up of the problem has two risky assets (a stock and a zero coupon bond) and two independent brownian motions. However, a unique EMM does not exist and the markets are not complete.

It seems counterintuitive to have a non complete market with two risky assets and two indep BMs. In what situations with these conditions can markets be incomplete?

Two Fund Risky Separation

I am trying to solve Jacob's Prelim 2002 Problem (IIB). It is a two fund risky separation question with distributional assumptions (jointly normal asset returns). I can't make the portfolio weights independent of each investor's initial wealth. Maybe I am missing a key conceptual step. Need help here!