Dynamic Markets

Joshua D. Coval; Erik   Stafford

Course Overview Note | March 2008

Dynamic Markets

Abstract

The Dynamic Markets course at Harvard Business School is organized around the hands-on application of financial decision making in a wide variety of capital market settings. The course relies heavily on in-class simulations of a range of market settings where students compete with their classmates for profits. The main pedagogical approach used in the course is what we call deriving by doing. The essential aspects of this pedagogy are dynamic decision settings, a strong reliance on competitive markets, and derivation of core concepts through active student decision-making. The upTick financial simulation software, developed at the Harvard Business School, is used to realistically recreate classic decision-settings in a competitive classroom setting. We convey the timing and uncertainty inherent in real-world finance problems by presenting the "case facts" sequentially (i.e., as they become available to the real-world decision maker), thereby allowing students to modify or reverse decisions as new information become available, and to respond strategically to the decisions of their competitors. Additionally, we clear student decisions in realistic capital markets, such that equilibrium outcomes are determined by competitive student interaction. Even though students participate in markets corresponding to a particular setting, the prices determined in the simulations are set by the participants and can depart from the historical prices within bounds set by the instructor.

Keywords: Value Creation; Decision Making; Capital Markets; Competitive Strategy; Profit; Software; Information; Strategy; Price; Outcome or Result; Curriculum and Courses; Theory;

Format: Print

19 pages

Citation:

Coval, Joshua D., and Erik Stafford. "Dynamic Markets." Harvard Business School Course Overview Note 208-143, March 2008.

We decompose bank activities into passive and active components and evaluate the performance of the active components of the bank business model by controlling for passive maturity transformation strategies that can be executed in the capital market. Over the period 1960–2016, we find that (1) unlevered bank assets underperform passive portfolios of maturity-matched U.S. Treasury bonds; (2) the cost of bank deposits exceeds the cost of bank debt; (3) bank equities have CAPM betas near one, while passive maturity transformation strategies have CAPM betas near zero; and (4) portfolios of bank equities consistently underperform portfolios designed to passively mimic their economic exposures. The very strong investment performance of passive maturity transformation strategies over this period may mask the underperformance of the specialized bank activities.

While we commend the initiative of Snyder and Welch (2017), we lay out in this short reply why we remain highly confident in our results and our interpretation thereof. We welcome authors to continue to explore the data for themselves and look forward to the new questions they can tackle with it.

Private equity funds tend to select relatively small firms with low EBITDA multiples. Publicly traded equities with these characteristics have high risk-adjusted returns after controlling for common factors typically associated with value stocks. Hold-to-maturity accounting of portfolio net asset value eliminates the majority of measured risk. A passive portfolio of small, low EBITDA multiple stocks with modest amounts of leverage and hold-to-maturity accounting of net asset value produces an unconditional return distribution that is highly consistent with that of the pre-fee aggregate private equity index. The passive replicating strategy represents an economically large improvement in risk- and liquidity-adjusted returns over direct allocations to private equity funds, which charge average fees of 6% per year.

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