slide chương 4 tài chính hành vi lucy f ackert richard deaves

May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part.... May not be scanned, copied or duplicated, or posted to a publicly available w

Chapter 4: Challenges to market

efficiency

Powerpoint Slides to accompany Behavioral

Finance: Psychology, Decision-making and Markets

by Lucy F Ackert & Richard Deaves

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!

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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!

Value vs growth portfolios:

International evidence

4

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posted to a publicly available website, in whole or in part

Momentum evidence

Reversal evidence

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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.

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

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!

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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?

What hampers arbitrage

exploitation?

1 Fundamental risk

2 Noise-trader risk

3 Implementation costs

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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.

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.

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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.

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.

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Implementation costs

• In some cases, horizon is short but short-selling is:

stock )

of fees; legal factors: many institutions cannot short)

• Plus there is cost of finding these arbitrage

opportunities.

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.

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3Com and Palm cont.

• Clearly if investors are rational:

P(3Com) = 1.5* P(Palm) + Residual value

• What happened?

– After 1 st 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.

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!

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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!