The Royal Swedish Academy of Sciences awarded this year’s Nobel Prize in Economics to three economists in recognition of their work on asset prices and the behavior of markets. The three economists, Eugene Fama, Lars Peter Hansen, and Robert Shiller, have independently undertaken research that attempts to explain how markets operate and to provide analysis of asset price movements. Notable aspects of their work include the efficient market hypothesis, statistical techniques applicable to macro-financial modeling, and the identification of asset price bubbles and irrational exuberance. Eugene Fama is best known for his work on the efficient market hypothesis and his belief that all information is efficiently reflected in asset prices by rational investors. His work led to the development of the concept of index-linked investment strategies with the objective of replicating the market performance of a specific index. Lars Peter Hansen made significant contributions to econometric methodology with work in the area of modeling relationships between asset prices and various explanatory economic variables. Robert Shiller undertook empirical analysis of asset prices and developed metrics to assess the extent of overvaluation in asset prices. While their theoretical work is widely acclaimed in the academic community, some aspects of their work have been somewhat controversial in the light of contrary evidence from the actual experience of asset management strategies. Indeed, Fama and Shiller differ in their views as to the efficiency of markets.
Eugene Fama is the Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business. His research work on The Behavior of Stock Market Prices concluded that stock price movements are unpredictable and follow a random walk. Fama’s research on Efficient 2013Capital Markets: a Review of Theory and Empirical Work introduced the concept of three different types of market efficiency, namely, strong form, semi-strong form and weak form of efficiency. Market efficiency denotes how information is factored into price. The semi-strong form of market efficiency implies that all public information, such as a company’s earnings and future earnings guidance, is already reflected in market pricing. Fama reasoned that when a model of expected returns generates results that differ from actual returns, there is uncertainty as to whether the market is inefficient or the model is imperfect. In collaboration with Kenneth French, Fama also developed a three-factor asset pricing model that expands upon the classic Capital Asset Pricing Model (CAPM), by including market capitalization and value as two factors in addition to the CAPM’s standard beta measure.
Lars Peter Hansen is the David Rockefeller Distinguished Service Professor of Economics at the University of Chicago. His work in developing the econometric modeling method Generalized Method of Moments has wide application in macroeconomics, finance, labor economics and other fields. His methodology is particularly useful in modeling situations where it would be difficult to fully specify a model of a complex economic environment where maximum likelihood estimation is impractical. His other significant contributions include research on the nature of the long-run risk-return tradeoff as well as the term structure of pricing risk shocks in dynamic macroeconomic models utilizing dynamic valuation decomposition. Hansen is also known for his work in collaboration with Thomas Sargent on Knightian Uncertainty, studying the difference between the concepts of risk and uncertainty. The behavioral aspects of relating to uncertainty under conditions of complexity represent a relatively new frontier for financial and economic research. Larsen is currently engaged in research into the measurement of Systemic Risk, a topic of increasing importance in the aftermath of the 2008 global financial crisis.
Robert Shiller is Sterling Professor of Economics at Yale University and is a Fellow at the Yale School of Management’s International Center for Finance. His major research work includes Rational Expectations and the Structure of Interest Rates. He has challenged the efficient market hypothesis and has written extensively on behavioral finance, particularly with reference to stock market prices and the real estate markets. Shiller postulated that if the stock market were rational, investors would determine stock prices based on factual evidence such as the expected receipt of future dividends, appropriately discounted to a rational present value. Based on detailed studies of the actual behavior of stock prices over a long historical period, he developed measures of the extent of expectations of future dividends and discount rates that would be consistent with the wide degree of variation in stock market valuations over the period. His conclusion was that the extent of stock market price volatility was greater than might reasonably be explained by a rational assessment of future outcomes. His use of the term Irrational Exuberance has become part of the accepted terminology of behavioral finance to describe the occurrence of asset price bubbles. He is currently on record with expressions of concern about today’s stock market valuation level.