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From Securities Regulation Daily, October 14, 2013

Economics Nobel Laureates make strange bedfellows

By Anne Sherry, J.D.

The 2013 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel has been awarded to Robert J. Shiller, Eugene F. Fama, and Lars Peter Hansen. The Yale and University of Chicago economists received the award for their very different research and conclusions on the theme of prediction and modeling of asset prices.

Research. Fama’s research beginning in the 1960s demonstrated that new information is very quickly incorporated into stock prices, making them extremely difficult to predict in the short run. Paradoxically, Shiller discovered in the early 1980s that asset prices are predictable over a longer span of several years. The University of Michigan economist Justin Wolfers tweeted surprise at the two economists sharing an award, noting, “Fama is the father of efficient market theory; Shiller is the father of [the] inefficient market.”

Hansen’s contribution to asset-pricing prediction was the development of a statistical method to test rational theories of asset pricing. His generalized method of moments (GMM) model “is now one of the most commonly used tools in econometrics, both for structural estimation and forecasting and in microeconomic as well as macroeconomic applications,” as the scientific background on the prize explains.

Market response. The popular science background notes that the laureates’ work influenced not only subsequent research but also market practice. Fama’s efficient market hypothesis led to close examination of mutual fund performance and to the growth in passively managed index funds when research revealed that active management often yields negative excess returns. Event studies provide insights into how the market reacts to corporate actions such as stock splits or takeover bids. In addition, Shiller’s work in behavioral economics, including the Case-Shiller housing price index, aids investors in assessing risk and gauging pricing trends.

SEC rulemaking and MMMF reform. Behavioral economics has informed the SEC’s approach to economic analysis for rulemaking, as exemplified in a 2012 white paper from the Division of Risk, Strategy, and Financial Innovation responding to SEC commissioners’ questions regarding money market fund redemptions and the 2010 reforms. Among other questions, the commissioners asked how future reforms could affect the demand for alternatives to money market funds and the size of the underlying short-term funding market.

The SEC’s release on money market reform, which proposes either a floating NAV or the use of liquidity fees and redemption gates to reduce run risks, cites to research in behavioral economics suggesting that investors tend to prefer possible losses to certain losses, even when the amount of possible loss is significantly higher than the certain loss. This may favor liquidity fees rather than redemption gates to reduce run risks because investors fearing that a money market fund may suffer losses may prefer to stay in the fund rather than redeem and lock in payment of the liquidity fee.

The Squam Lake Group, a group of 13 academic economists including Robert Shiller, commented that the floating NAV would not achieve the goal of materially decreasing the systemic risk posed by money market funds because the NAV would not reflect actual prices at which investors and the fund itself could transact in a crisis. The group suggested that if this alternative is adopted, money market funds should not be allowed to use amortized cost accounting for instruments maturing in 60 days or less. The group also cautioned that liquidity fees and redemption gates could actually exacerbate run incentives and harm financial stability. An appropriately sized capital buffer for prime money market funds would have a more meaningful impact on financial stability, the group concluded.

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