Financial Market Dynamics and Investment Principles

Agency Theory and Corporate Governance

Agency Theory: Managers' interests often diverge from those of the owners. For example, managers may over-consume perks (such as private jets) or avoid risky but profitable projects. Firms use "carrots and sticks" to realign incentives, primarily through:

1. Stock-based compensation
2. The threat of removal by the board of directors

Risk, Return, and Asset Roles

Risk and Return: Investors compete for assets offering a high return relative to their risk. Buying these assets raises their price and lowers the expected return. In equilibrium, return is commensurate with risk; a high expected return survives only when accompanied by risk (e.g., stocks vs. T-bills). The converse is not necessarily true: the trade-off constrains high-return assets, but not every risky bet (e.g., a casino is a high-risk, low-return environment).

Financial Assets: These serve four primary roles:

• Information Role: High prices make it easier to raise capital, leading to more investment.
• Consumption Smoothing: Managing wealth over the life cycle.
• Risk Allocation: Shifting risk to those most willing to bear it.
• Separation of Ownership and Management: This provides scale and stability, tying back to making real assets productive.

Investment Strategies and Market Efficiency

Active vs. Passive (A/P): Active investors attempt to beat the market by picking mispriced securities or timing the market, while passive investors hold the market portfolio. Competition makes bargains rare, and active trading is often self-defeating due to transaction costs. Because competition makes prices roughly fair, there is little to gain from analysis, making a passive investor’s market return hard to beat. However, it is noted that not everyone can be a passive investor.

Fixed Income and Federal Policy

Repo and Haircuts: Repurchase agreements allow one to lend cash without bearing the borrower’s default risk (e.g., JP Morgan vs. Apple using Treasuries). A sale plus a repurchase constitutes a collateralized loan, where the interest is the price difference. A haircut means the collateral value exceeds the cash lent, providing a cushion against a fall in collateral value. In the event of default, the lender keeps the collateral.

IORB and ON RRP: Interest on Reserve Balances (IORB) serves as a risk-free alternative for banks. The ability to borrow below IORB and deposit for arbitrage creates a floor for banks. Since non-banks do not have reserve accounts, the Overnight Reverse Repo (ON RRP) facility—where the Fed borrows from non-banks—acts as a floor for them. Generally, IORB is greater than ON RRP.

Municipal Bonds (Munis): Interest on these bonds is exempt from federal tax. Investors should compare after-tax returns to find the cutoff tax bracket. High-bracket investors should hold munis, while low-bracket and tax-exempt investors should avoid them.

The FOMC Announcement Effect

Pre-FOMC Drift: Research found gains of over 49 bps in the 24 hours before FOMC announcements, accounting for approximately 80% of equity gains between 1994 and 2011. Other days saw gains near zero. This drift was predictable from a public calendar and occurred before the news was released. The strategy involved buying the day before and selling at 2:00 PM. However, after accounting for trading costs, this effect largely vanished after 2015.

Index Weighting and Equity Issuance

Weighting Methods:

• Price-weighted: One share of each stock.
• Value-weighted: Proportional to market value.
• Equal-weighted: Equal dollar amounts in each stock.

Price and value weighting are "buy-and-hold" strategies. Equal weighting requires constant rebalancing. Index funds tracking buy-and-hold indices can be managed without frequent trading, whereas equal weighting requires continual trades that incur costs, especially in small, illiquid stocks.

IPOs and Underwriting

Partial Adjustment: A preliminary prospectus states a filing price range, but the final offer price is set just before trading. Strong demand raises the price only partially (the 20.7 / 10.0 / 0.6 ordering). A common strategy is to buy deals priced above the initial range.

IPO Performance: Jay Ritter’s research (comparing first-day close to three-year performance against matched firms) shows long-run underperformance. IPOs are often overvalued at the offer relative to peers; high first-day returns often pair with low long-run returns. A common trade is to underweight recent IPOs.

Underwriting: Underwriters buy shares and then resell them. The spread is the offer price minus what the firm receives. Underwriters bear the price risk because the firm’s proceeds are fixed. Unsold shares are dumped at a loss, which incentivizes a conservative offer price.

Market Microstructure and Trading

Futures Leadership: Futures are simple, cheap, shortable, and leveraged. Information often trades in futures first due to sticky (path-dependent) liquidity. Leverage is easier to obtain in futures than in ETFs. The SEC/CFTC split is a political outcome rather than a purely technological one.

US vs. EU Markets: The US utilizes all-to-all order books, whereas the EU relies more on dealer/client structures. SEC reforms (like Reg NMS) and centralized clearing are hidden enablers of the US system. Clearing and credit act as gatekeepers in Treasuries and FX. In Europe, the dealers’ "liquidity pact" and venue competition allowed High-Frequency Trading (HFT) to enter. "Last look" remains a controversial feature.

Make/Take Model: A "Make" order cannot execute upon arrival and rests in the order book in a time-priority queue. A "Take" order is priced to execute immediately against a resting order. Makers earn the spread but are exposed to adverse selection; price moves can make quotes stale. This creates a race to cancel versus a race to execute, where latency determines the winner.

Market Symmetry: Exchanges fear empty screens and use rebates, symmetric vs. asymmetric speed bumps, "last look," and purge ports to manage liquidity. There is ongoing controversy over who profits and the revenue exchanges generate from speed.

The 2010 Flash Crash: An execution algorithm acted as the trigger. Discrepancies between the consolidated tape and private feeds, failed integrity checks, and empty order books led to market orders executing at absurd prices. These actions were individually prudent but collectively disastrous.

Macroeconomic Indicators and Models

The 10-2 Spread: A negative spread (where the 10-year yield is below the 2-year) indicates the market expects future short rates to be below today's. Under the Taylor Rule (with fixed inflation), lower rates correlate with weaker growth (a lower output gap). Thus, the market forecasts a weak economy, making this a leading recession signal.

The Three-Step Model: The economy and stocks generally move together. Leverage (debt financing) makes this relationship more than one-for-one; a 2:1 multiplier is typically stipulated rather than estimated. Other links—such as yield being read as an expected rate (r*), specific coefficients, and the inflation gap—are also assumptions. Consequently, this is a model output rather than a raw forecast.

Monetary Policy: The Taylor Rule maps inflation and output gaps into the policy rate. Positive coefficients mean the rate summarizes the state of the economy. Bond yields provide the market’s expected future short rates. An inverted rule turns each expected rate into an output-gap forecast. Because firms are debt-financed, the chain links policy to stocks. The term spread is not strictly required as a leading indicator in this framework.

Yield Identity (y10 - y2): To be exact, one must solve the identity for the forward rate. The spread is a difference in yields; they share the same sign but have different magnitudes. The spread understates the forward rate's distance from the 2-year yield (due to maturity scaling) and ignores the effects of compounding.