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Ch04.pdf
1.
Chapter 4: Challenges
to market efficiency Powerpoint Slides to accompany Behavioral Finance: Psychology, Decision-making and Markets by Lucy F. Ackert & Richard Deaves ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part. 1
2.
Key trading rules
that have shown to be effective i. • Small cap portfolios vs. large cap portfolios? – Small cap wins out! • Portfolios formed based on P/Es: – Low P/Es do better! • Earnings announcements momentum: – Reaction to extreme announcements is slow! 2 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
3.
Key trading rules
that have shown to be effective ii. • Value vs. growth portfolios (usually value firm has a high book/market and a growth firm here is one with an absence of value): – Go for value! • Predictable serial correlation: – Medium-term momentum! • Long-term winners vs. losers: – Reversals: losers become winners! 3 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
4.
Value vs. growth
portfolios: International evidence 4 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
5.
Momentum evidence 5 ©2010 Cengage
Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
6.
Reversal evidence 6 ©2010 Cengage
Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part. Source: Figure 3 from De Bondt, W. F. M., and R. Thaler, 1985, “Does the stock market overreact?” Journal of Finance 40, 793–807. © 1985 Wiley Publishing, Inc. this material is used by permission of John Wiley & Sons, Inc.
7.
Theoretical foundations of efficient
markets Market efficiency requires that only one of the following three conditions need hold: 1. Universal rationality 2. Uncorrelated errors 3. Unlimited arbitrage 7 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
8.
Market efficiency and
arbitrage • One of main foundations of EMH is no- arbitrage condition. • If there are pricing errors (e.g., caused by irrational investors) smart-money traders arbitrage them away. • No free lunches are left on the table! 8 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
9.
Example of arbitrage
opportunity: Triangular arbitrage • February 27/06 • $Cdn/$US forex rate = 1.1426 • $US/euro forex rate = 1.1855 • What must $Cdn/euro rate be to nullify arbitrage? 1.1426 * 1.1855 = 1.3546 • While this was observed, what if this had not been true? 9 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
10.
What hampers arbitrage exploitation? 1.
Fundamental risk 2. Noise-trader risk 3. Implementation costs 10 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
11.
Fundamental risk • If
you think a stock is underpriced you can buy it, but: – You might be sideswiped by the market. – Or maybe by the industry. – Plus there is idiosyncratic risk. • Pure arbitrage seeks to eliminate all of these. • Problem: you need to find perfect substitutes. 11 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
12.
But where are
these substitutes? • Say Ford is too cheap. • You buy Ford. – But market may drop. – Or auto industry may drop. • So you buy Ford and short GM. – But Ford itself may falter without industry or market dropping (idiosyncratic risk) . • Even you totally manage fundamental risk, there is still noise-trader risk: spread may widen as investors get it even more wrong. 12 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
13.
Sentiment and noise •
Noise is opinion on value unrelated to fundamental information (i.e., based on misinformation) • Sentiment is correlated noise, and has the potential power to move markets. • This implies that price movements can be driven by misinformation rather than information. 13 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
14.
Noise-trader risk • Noise
trader risk is risk that mispricing being exploited by the arbitrageur might worsen. • It has been shown that noise-trader risk is systematic, which means that it cannot be diversified away. • Real world arbitrageurs cannot wait it out because as professional money managers they do not have long horizons – they are usually evaluated at least at once per year. 14 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
15.
Implementation costs • In
some cases, horizon is short but short-selling is: – Expensive (commissions, spreads, price impact & fees for shorting stock) – Difficult or even impossible (lack of availability regardless of fees; legal factors: many institutions cannot short) • Plus there is cost of finding these arbitrage opportunities. 15 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
16.
3Com and Palm •
March 2, 2000: 3Com carves out in an IPO 5% of its subsidiary Palm. • At same time 3Com announced that in the near future the remaining 95% of the shares would be distributed to current shareholders (roughly 1.5 of Palm/share of 3Com). • Two ways of buying Palm: – Buy Palm directly. – Buy 3Com getting Palm and rest of 3Com business. 16 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
17.
3Com and Palm
cont. • Clearly if investors are rational: P(3Com) = 1.5* P(Palm) + Residual value • What happened? – After 1st day of Palm trading: • P(Palm) = $95.06 • P(3Com) = $81.81 • Implied residual value: less than zero. • Implication: Value of residual 3Com was: negative $22 billion. 17 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
18.
3Com and Palm
cont. ii. • Everyone seemed to understand the situation: – “The nature of the mispricing was so simple that even the dimmest market participants and financial journalists were able to grasp it.” • Incredibly the mispricing persisted for months! • And other such examples can be cited! 18 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
19.
What can explain
this? • “Smart” investors were limited in their ability to short-sell Palm (as documented in Lamont and Thaler), so it wasn’t their fault. • But this cannot explain why anybody would buy Palm instead of 3Com – for this one needs irrationality. • In facts 2 things are needed for mispricing to exist: – Irrational investors – Limits to arbitrage (here due to implementation costs) • 3Com & Palm case illustrates that mispricing does not imply a free lunch! 19 ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.
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