Financial Market History (1900-2016)
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Questions and Answers

What defines a bubble in stock market terms?

  • An increase in stock prices over a period of five years.
  • A drop of at least 50% in the following year. (correct)
  • A rapid increase that is not followed by a crash.
  • A decrease of less than 50% in the following year.

In which year did the first great stock market bubble in France burst?

  • 1740
  • 1720 (correct)
  • 1710
  • 1730

What constitutes a 'boom' in stock market analysis?

  • A mild fluctuation in stock prices without significant impact.
  • A steady increase in stock prices over ten years.
  • A large, rapid increase in stock prices. (correct)
  • A small increase in market value lasting more than a year.

According to the data presented, what percentage of markets experienced returns over 100%?

<p>2% (D)</p> Signup and view all the answers

What is a clear indicator of a bubble regarding price dynamics?

<p>A high price-to-earnings ratio. (C)</p> Signup and view all the answers

What is the conditional frequency of a market doubling in the subsequent year after a 100% return?

<p>8.33% (D)</p> Signup and view all the answers

How many market-years were included in the data set constructed by Dimson, Marsh, and Staunton?

<p>3387 (B)</p> Signup and view all the answers

What is a characteristic outcome associated with volatile markets?

<p>Higher probability of significant losses. (A)</p> Signup and view all the answers

What was the Sharpe ratio range for the carry trade when considering the entire period up to 2012?

<p>0.2 – 0.4 (B)</p> Signup and view all the answers

During which periods did the carry trade yield high risk-adjusted returns?

<p>1985-2012 and 1920-1927 (B)</p> Signup and view all the answers

What factor accounted for only one-third of the returns during the interwar period for carry and momentum strategies?

<p>Transaction costs (D)</p> Signup and view all the answers

How did the performance of momentum strategies in the 1920s compare to subsequent periods?

<p>Stronger than in any modern period (C)</p> Signup and view all the answers

What is one major reason cited for the inconsistent performance of carry and momentum strategies?

<p>Exchange rate regime changes (A)</p> Signup and view all the answers

What were the large losses incurred by both the carry and momentum strategies associated with?

<p>Risk compensation (D)</p> Signup and view all the answers

What was the primary focus of Doskov and Swinkels' research?

<p>Long-run profitability of carry trade (A)</p> Signup and view all the answers

What challenge is often faced in predicting financial returns on durable assets like real estate?

<p>Lack of empirical data (B)</p> Signup and view all the answers

What trend occurred in the US financial sector between 1970 and 2007?

<p>It more than doubled in size. (D)</p> Signup and view all the answers

What financial innovation allowed US consumers to transform their housing assets?

<p>Securitization (D)</p> Signup and view all the answers

Which group of borrowers faced significant risks due to variable interest rate loans?

<p>Subprime borrowers (C)</p> Signup and view all the answers

What misleading belief did many individuals hold regarding the stability of the US financial system?

<p>It was uniquely capable of withstanding large capital inflows. (A)</p> Signup and view all the answers

What was one consequence of the run-up in housing prices exceeding 100% in five years?

<p>It indicated overvaluation and potential risks. (D)</p> Signup and view all the answers

Which of the following was NOT identified as a strength of the US financial system?

<p>Dependence on domestic savings (B)</p> Signup and view all the answers

What was a significant contributing factor to the challenges faced by subprime borrowers?

<p>Rising interest rates and a slowing economy (C)</p> Signup and view all the answers

What effect did the attempts to maintain economic growth have in early 2008?

<p>They exacerbated financial instabilities. (D)</p> Signup and view all the answers

What is the primary indicator used to measure a country's vulnerability as a foreign borrower?

<p>Sovereign ratings reported by Institutional Investor (D)</p> Signup and view all the answers

At what external debt to GNP level do risks of a credit event begin to increase significantly for emerging markets?

<p>Above 30-35% (B)</p> Signup and view all the answers

Which percentage of observations in countries with a sound credit history is below 30% external debt to GNP?

<p>47% (B)</p> Signup and view all the answers

How is the proxy for default risk constructed using the Institutional Investor ratings?

<p>By subtracting IIR from 100 (D)</p> Signup and view all the answers

What was a significant change in the nature of external debt in emerging markets before a crisis?

<p>External debt was primarily public (C)</p> Signup and view all the answers

For countries with a tarnished credit history, what external debt to GNP level captures the majority of observations?

<p>Above 40% (A)</p> Signup and view all the answers

What historical period saw significant instability in exchange rates that had not been seen again for nearly a century?

<p>The Napoleonic Wars (C)</p> Signup and view all the answers

Which factor does NOT contribute to measuring debt intolerance?

<p>Inflation rates (D)</p> Signup and view all the answers

What is a primary consequence of countries experiencing sustained high inflation?

<p>Shift towards dollarization (A)</p> Signup and view all the answers

What do Institutional Investor ratings range from, in terms of default likelihood?

<p>0 to 100 (A)</p> Signup and view all the answers

What does the term 'liability dollarization' refer to?

<p>Indexation of financial assets to foreign currency (B)</p> Signup and view all the answers

Why is dedollarization considered particularly challenging?

<p>Persistent dollarization despite disinflation (A)</p> Signup and view all the answers

What does hysteresis refer to in the context of a country's dollarization?

<p>The tendency to remain dollarized long after inflation is controlled (C)</p> Signup and view all the answers

What has been a notable outcome after periods of elevated inflation regarding dollarization levels?

<p>Levels of dollarization often remain the same or increase (A)</p> Signup and view all the answers

What is the main aim of disinflation policy after high inflation?

<p>Regaining control of monetary policy (B)</p> Signup and view all the answers

Which exchange rate crises occurred in the late 20th century?

<p>Russian Crisis and Mexican Crisis (D)</p> Signup and view all the answers

What is the primary intuition that time-series analysis borrows from cross-sectional analysis?

<p>Assets that underperform in bad times should earn higher returns. (C)</p> Signup and view all the answers

Which external factors contribute to a decline in required equity market returns?

<p>Decreased macro volatility and lower trading costs. (B)</p> Signup and view all the answers

What type of indicators are considered the most reliable for predicting market conditions over longer horizons?

<p>Value and yield indicators. (B)</p> Signup and view all the answers

Which of the following is true regarding momentum and value signals?

<p>Value and momentum signals are usually negatively correlated. (C)</p> Signup and view all the answers

What is a significant problem associated with the use of in-sample data for forecasting?

<p>It assumes investors can predict future outcomes based only on past performance. (D)</p> Signup and view all the answers

What is a common feature of the predictors over short horizons?

<p>Momentum and macro indicators are generally more helpful. (C)</p> Signup and view all the answers

What does the Inverse Shiller P/E ratio primarily forecast?

<p>Expected real returns. (D)</p> Signup and view all the answers

Which statement accurately describes the usefulness of tactical indicators for near-term market timing?

<p>No tactical indicators are particularly reliable for near-term market timing. (C)</p> Signup and view all the answers

Flashcards

Market Boom

A period of large, rapid price increases in a market, often followed by a significant decline.

Market Crash

A significant and rapid drop in prices, often after a period of rapid increases.

Market Bubble

A market condition characterized by a boom followed by a crash.

Market Doubling

A year in which a market experiences a price increase of at least 100%.

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Market Halving

A year in which a market experiences a price decline of at least 50%.

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Market Reversal

The tendency for markets that experience a doubling to also experience a halving in the following year.

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Price-to-Earnings Ratio (P/E Ratio)

The ratio of a company's share price to its earnings per share

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Bubble Deflation

The period of time it takes for a market bubble to deflate after a boom.

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Carry Trade

A trading strategy that involves borrowing in a currency with a low interest rate and investing in a currency with a high interest rate.

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Momentum Strategy

A trading strategy that benefits from the continuation of past price trends.

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Interwar Period

The period between 1920 and 1939, characterized by fluctuating exchange rates and economic instability.

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Sharpe Ratio

A measure of an investment's risk-adjusted returns.

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Tail Risk

The potential for large, abrupt losses in an investment.

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Arbitrage

A trading strategy aimed at taking advantage of differences in currency values between different markets.

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Managed Float Period

The era of managed floating exchange rates, where governments intervene to regulate exchange rates.

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Durable Assets

Assets that hold their value over time, such as real estate, gold, and art.

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Dollarization

Shift in an economy towards using a foreign currency for transactions, accounting, and storing value.

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Dollarization Hysteresis

The tendency for a country that has become dollarized to stay that way even after the reasons for dollarization are gone (like high inflation).

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High Inflation and Dollarization

A situation where a country's currency loses value rapidly, leading to a loss of trust in the currency and people opting for a foreign currency instead.

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De-dollarization

When governments try to control inflation by reducing the use of foreign currency and promoting their own currency again.

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Liability Dollarization

Indexation of bank accounts, bonds, or financial assets to a foreign currency, often the US dollar.

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Dollarization as a Long-Term Cost

Dollarization is a long-term consequence of high inflation that can be difficult to reverse, even after inflation is controlled.

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Dollarization and Loss of Monetary Control

Dollarization can make it harder for governments to control their money supply and implement monetary policy effectively.

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Exchange Rate Instability and Dollarization

Evidence from historical periods like the Napoleonic Wars and modern exchange rate crises suggests that currency instability can significantly increase.

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Debt Intolerance Threshold

The likelihood of a country experiencing extreme debt problems increases significantly when its external debt to GNP ratio rises above 30-35%.

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Risk Premium in Bad Times

Assets that perform poorly during market downturns should provide higher returns to compensate investors for taking on that risk.

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External Debt to GNP Ratio

This ratio measures the amount of a nation's external debt relative to its gross national product (GNP). It reflects the proportion of a country's total output dedicated to servicing its external borrowings.

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Secular Explanations for Equity Returns

Factors that can influence required equity market returns over a longer period, including lower volatility, cheaper trading costs, and easier access to global equity portfolios.

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Momentum Indicators

Market indicators that rely on recent price trends or momentum to predict future market behavior. Often negatively correlated with value indicators.

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Sovereign Ratings

A country's vulnerability to debt default can be assessed using sovereign ratings assigned by agencies like Institutional Investor.

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Institutional Investor Ratings (IIR)

Sovereign ratings are compiled by experts (economists and sovereign risk analysts) at leading institutions who assess the likelihood of a country defaulting on its debt obligations.

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Value or Yield Indicators

Indicators that measure the relative value of assets based on factors like price-to-earnings ratios, dividend yield. Useful for predicting market returns over longer periods.

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Proxy for Default Risk

A proxy for default risk can be calculated by subtracting the IIR score from 100. This proxy measures the likelihood of a country defaulting on its debt obligations.

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Market Timing Indicators

Tactical indicators that are less reliable in predicting near-term market behavior. Despite showing promise over longer horizons, their practical use is limited.

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In-Sample Data Bias

Using historical data to test a strategy or model by assuming that investors had access to the same data in the past. This approach can lead to misleading results.

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Debt Intolerance

The concept of 'debt intolerance' describes a situation where a country faces increasingly higher risks of defaulting on its external debt as its debt levels rise.

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Out-of-Sample Testing

Adjusting a model's performance based on historical data by using a rolling average to simulate a more realistic 'out-of-sample' testing scenario.

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Total External Debt

A country's susceptibility to debt default is also determined by the total external debt (public and private), scaled by its GNP and exports.

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Out-of-Sample Performance

A measure of how well a strategy or model performs when tested on new data that wasn't used for training.

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External Debt in Emerging Markets

Historically, many emerging markets have had significant government debt in the form of external borrowing. Even private external debt often became public during crises.

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Securitization

The practice of pooling together individual mortgages and selling them as securities, allowing for easier trading and greater access to capital.

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Subprime Borrowers

Borrowers with lower credit scores and higher risk of defaulting on loans.

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Teaser Rates

Loans with variable interest rates that start off low but can increase significantly over time.

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This Time is Different Syndrome

A belief that current economic conditions are different from the past, leading to excessive risk-taking.

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Leverage

The act of borrowing money to purchase assets, often using the asset itself as collateral.

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Mortgage-to-GDP Ratio

The total value of mortgages in a country compared to the overall size of its economy.

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Exceptionalism

The concept that a country's unique economic and political factors make it immune to financial risks.

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Global Financial Integration

The process of integrating national financial markets with global markets, leading to increased cross-border capital flows.

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Study Notes

Financial Market History (1900-2016)

  • Cumulative real total returns include reinvested income, measured in local currency, adjusted for inflation. Reinvestment uses dividends, interests, or other income to buy more shares.
  • Equities performed best long-term, followed by government bonds, and then Treasury bills. Resource-rich or New World countries had the best equity markets.
  • In the US, an initial $1 investment in equities grew to $1271, $10 in bonds to $100, and $2.70 in bills to $27 over 116 years. The US was not the top performer globally for equities.
  • UK equities saw an initial £1 investment grow to £445, £7 in bonds to £70, and £3.30 in bills to £33.
  • Real annualized equity returns averaged 3-6% for most countries.
  • Risky equities performed better than bonds or bills, but investors did not benefit from volatility.

Time-Variation of Expected Returns

  • There's a shift from assuming constant expected returns to time-varying returns.
  • Bond investors use current market yields to estimate long-term returns, adjusting for roll-downs and default risk.
  • Equity investors often use long-run realized returns to estimate future returns, assuming constant expected returns over time.
  • Historical average returns are a good estimate for long periods, mitigating sampling variation.
  • Models are refined to include time-varying cash and bond yields, plus a constant equity premium. Historical data (1900-2015) show a 5% compound annual real return for global equities, 3.2% over global bonds and 4.2% over Treasury bills.
  • The assumption of constant real returns forecasts a 5% future return.

Challenges of Timing the Market

  • Practical market timing rules often have poor track records.
  • Short-term predictability is limited, holding onto underperforming assets is difficult.
  • No market-timing strategy universally outperforms buy-and-hold over time.
  • Diversification, rather than tactical timing, often leads to better returns.

Time-Varying Returns and Market-Timing Opportunities

  • Market-timing success is more art than science. Exploit historical data, theories, and market yields/valuations.
  • Rational explanations of time-varying expected returns include time-varying volatility, risk aversion, rare-disaster risk. These are often cyclical, but there can be secular explanations like lower macro volatility or lower trading costs
  • Irrational explanations for time-varying expected returns include changing sentiment and cycles of greed/fear and social interactions.

Valuation-Based Indicators

  • Value and price momentum tend to be negatively correlated.
  • Signals agree, like cheap markets with recent (positive) improvement, indicating a stronger signal.
  • Longer-horizon value and yield indicators tend to offer better predictive ability than short-horizon momentum or macro indicators.

Currency Speculation Strategies (Carry, and Momentum)

  • Carry: Borrowing low-interest rate currencies and investing in high-interest rate ones.
  • Momentum: Borrowing from currencies with lower recent returns and investing in high-return currencies.
  • Both are profitable strategies, some time, but performance is time-varying.

Historical Data Challenges and Biases

  • Easy data bias: Scholars often overlook troubled periods and use readily available data sources. Secondary data is less clear in terms of methodology, which leads to bias
  • Selection bias: Favoring large companies in statistics
  • Survivorship bias: Only considering surviving companies ignores failures.
  • Weighting bias: Indices may not represent the investable universe equally.
  • Non-synchronous trading effects can introduce bias in analyses because different securities don't always trade at the same time

Domestic and External Default

  • Serial defaults often occur with external or domestic public debt: these defaults can range from wholesale repudiation to strategic partial defaults via rescheduling.
  • Debt intolerance is a syndrome that stems from weak institutions and political systems, leading struggling countries to engage in risky external borrowings.
  • High debt-to-GNP ratios (often above 100%) increase the risk of default.
  • A typical default involves a vicious cycle of market distrust, rising interest rates, and political resistance to repayment.

Other Information

  • Inflation crises : typically chronic high-inflation episodes exceeding 15% annual for many years
  • Banking crises : Systemic crises feature widespread bank runs, mergers/closures or government intervention. In milder crises, institutions show financial distress
  • External Debt crisis : The failure of governments to meet debt obligations.
  • Domestic debt crisis : Includes freezing bank deposits, forcing conversions to local currency and other forcible actions to deal with debts

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Description

Explore the historical performance of financial markets from 1900 to 2016. This quiz covers the long-term returns of equities, bonds, and Treasury bills, highlighting the differences in growth across various countries. Test your knowledge about investment returns and market performance over the last century.

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