BUSFIN 4224 FinalP

Bubble

A fundamentally unsound commercial undertaking accompanied by a high degree of speculation Prices go up because speculators keep buying in the belief that prices will keep going up Price driven purely by speculation - detached from underlying fundamentals of companies

Efficient Capital Market

A market that is efficient in processing information The prices of securities observed at any time are based on 'correct' evaluations of all information available at that time In an efficient market prices fully reflect available information

Heuristic

A mental shortcut or "rule of thumb" to simplify decision making

Strong-form market efficiency

ALL information is efficiently included (including private)

Momentum

Abnormal returns on individual stocks are positively autocorrelated at 3 to 12 month horizon No pattern between momentum and size or beta Violation of weak-form EMH

IPO Underperformance

After the initial jump, average IPO has low idiosyncratic returns over the 3-5 years following the issue

Weak-form market efficiency

All information in past prices is efficiently included

Semi-strong form market efficiency

All public information is efficiently included

SEO Underperformance

Almost exact same magnitude as IPO underperformance Investors do recognize potential for market timing

Calendar effects

Average returns differ within the calendar Returns are unusually high/low in certain months, certain days of the month, certain weekdays, etc. Show up as regular periodic blips Simple and blatant example of violating EMH (some of the earliest discovered)

Hot Hand Fallacy

Belief that a person who has experienced success has a greater chance of further success in additional attempts

Optimism

Beliefs tend to be biased in the optimistic direction Most severe among the young Prone to an illusion of control (exaggerated sense of how much they control fate, underestimate the role of chance)

Acquisition by stock when...

Bidder is relatively overvalued Earn negative long-run returns

Short side (arbitrage)

Borrow asset you don't own, sell it, eventually "cover" by repurchasing asset and returning it to lender Betting on low returns (i.e., believe P>P*) Lose from CFs and P appreciation

High sentiment associated with

Bubble

Technical analysis ("charting")

Can find good investments by examining past price/return patterns

Other trading costs arbitrageurs must pay

Commissions Bid-ask spread Price impact Collateral for short positions Overhead (employing traders) Taxes *don't even consider trade until mispricing is big enough to cover fixed cost*

Low sentiment associated with

Crash

CAPM Formula

E(R) = Rf + beta(MRP)

3 Considerations for Real-world Arbitrage

Expected abnormal return Risk Trading horizon

B/M Effect

Firms with high book equity value to market equity value have higher returns (not attributable to beta or size)

What limits arbitrage in practice?

Fundamental risk Noise-trader risk Transaction/implementation costs Delegated arbitrage and short horizons

Investor Sentiment

General investor mood

Fundamental analysis

Good investments can be found through careful analysis of financial and economic data

Joint hypothesis problem

Have to maintain a hypothesis about E(R) (e.g., that it is CAPM, or a constant) in order to test the hypothesis of interest (that there are no "abnormal returns") Critique always lurking in the background

Why do investors behave irrationally?

Human beings have limited attention, cognition, and time Financial world is challenging decision environment filled with countless pieces of information, calculations, decisions, etc.

No return reward for _____ risk

Idiosyncratic

Post-earnings announcement drift

In few months after the earnings announcement, stocks earn abnormal returns

SEOs

In seasoned equity offering at P>P*, ongoing shareholders gain by selling overvalued shares

Disposition Effect

Individuals sell winners and hold losers

IPOs

Insiders have high incentives to sell out when P>P* Public equity may be available at lower risk-adjusted cost than other types of financing

Noise trader risk

Irrational trading - trading for reasons unrelated to valid information MIspricing may actually get worse before it's corrected A real risk if arbitrageur has a short horizon (arbs may have to bail out when mispricing is greatest

Market timing

Issue securities (increase supply) when P>P* (overpriced) Repurchase (reduce supply) when P<P* (underpriced)

Catering is more likely when...

It doesn't interfere with long-run investment policy Managers can profit from short-run overvaluation Managers have short horizons

"Other" January Effect

January predicts return over the rest of the year

Arbitrageur in Behavioral Finance

Knows P* (sophisticated, recognizes mispricing) May not be able to find a truly riskless trade to enforce P=P* May pursue mere good bets (abnormal returns on average) as well as true textbook arbitrages (abnormal returns guaranteed)

Lead-lag effect

Large stocks "lead" small stocks over a horizon of a few weeks There's a positive cross-autocorrelation between abnormal returns on large stocks this week and small stocks next week

Exploit mispricing for benefit of _____ shareholders

Long-term

Value Investing

Look for stocks with market price low relative to some measure of fundamental value

Size effect

Low market cap firms have higher returns (not attributable to higher beta) Closely related to January effect (outside January, no size effect - outside small stocks, no January effect)

Catering

Managerial actions to boost current share price by appealing to investor sentiment

Dividends

Managers initiate/continue dividends when investors prefer (put higher valuations on ) dividend payers Managers omit dividends when investors prefer nonpayers Nonpayers initiate dividends when existing payers are trading at a premium

Tobin's Q

Market value of installed capital/replacement cost (sometimes approximated with market-to-book assets ratio) Shows positive vs negative NPV projects

_____ arbitrage when there's _____ fundamental risk

More; less

Stocks with the greatest fundamental risk should be the _____ mispriced

Most

Long-run reversal

Negative autocorrelation in abnormal returns at horizons of 3-8 years Potential violation of weak-form EMH

Two ingredients for mispricing to occur

Noise trading Limits to arbitrage

Prices more likely to reflect _____ than _____

Optimism; pessimism

Three sets of information used to form P*

Past prices/returns All publicly available information All public AND private information

Anchoring and Conservative Adjustment

People make estimates by starting from an initial value (anchor) that is adjusted to yield the final answer - the anchor may be suggested by the formulation of the problem, or may be irrelevant Different starting points yield different estimates, which are biased toward the initial values

Overconfidence

People set their subjective confidence intervals too tightly - they are surprised too often

Market capitalization =

Price * shares oustanding

Availability Heuristic

Probability is estimated by the ease with which similar instances or associations can be brought to mind Biases occur when availability and true frequency diverge Easily retrievable instances overestimated Ex. homicides, airline accidents, shark attacks, etc.

Long side (arbitrage)

Purchase of underpriced asset Betting on high returns (i.e., believe P<P*) Gain from cash flows (dividends) and price appreciation

Efficient Market Hypothesis (EMH)

Real capital markets *actually are* efficient by Fama's definition

Traditional Finance: high beta = high returns

Reality: low beta stocks earn higher returns than high beta stocks

Traditional Finance: no reward for idiosyncratic risk

Reality: stocks with higher idiosyncratic risk have lower returns

Traditional Finance: investors only care about means and variances

Reality: stocks with higher skew have lower returns

Why categorize?

Reduces complexity - can respond to items in terms of their category, rather than as individual items Facilitates interference - don't have to be taught about novel objects if we can effectively categorize them, can use existing knowledge of items in category to infer attributes

Categorization

Result of limited attention, cognition Group similar (but not identical) assets together, evaluate/update as a category

Abnormal returns

Returns that, on average, beat the appropriate E(R) benchmark

September Effect

September is (by far) the worst month of the year for stocks In the US, it is the only month to have a negative average return (effect also exists internationally)

Do past returns predict future returns?

Shouldn't be able to if the market is weak-form efficient (no identifiable patterns over time, not short term anyways, but doesn't hold true for 6 months-year)

Arbitrage

Simultaneous purchase and sale of same, or essentially similar, security in two different markets for advantageously different prices

Textbook arbitrage

Simultaneous purchase and sale of same, or essentially similar, security in two different markets for advantageously different prices (a trading strategy that generates *completely riskless* profit)

January Effect

Small stocks (stocks with relatively low market capitalization) have high returns in January, on average Tax-loss selling? Emphasizes drop in demand around end of December/abatement of selling pressure in Jan Portfolio rebalancing? Emphasizes jump in demand in Jan (investing year-end bonuses, etc.)

Stocks most sensitive to sentiment

Small stocks, young stocks, high volatility stocks, non-dividend-paying stocks, distressed stocks, and unprofitable stocks

Noise trading (for mispricing)

Some "noise traders" (often investors with irrational beliefs) must buy/sell to push prices away from fundamentals

Early evidence found

Stock market is not strong-form efficient, but it is weak and semi-strong

Turn-of-the-month effect

Stocks do best around the turn of the month (possibly when people get paid?)

Weekend Effect

Stocks do well on Friday, badly on Monday (good mood vs. bad mood)

Holiday Effect

Stocks do well right before holidays

Beta measures _____ risk

Systematic

Acquisition by cash when...

Target is absolutely undervalued (likely hostile deal) Earn positive long-run returns

P

The actual stock price

Gambler's Fallacy

The belief that the odds of a chance event increase if the event hasn't occurred recently

P*

The correct stock price (fundamental value)

Local Representativeness

The essential characteristics of the process will be represented, not only globally in the entire sequence (50% B, 50% G in the population), but locally in each of its parts Results from reliance on "law of small numbers" (small samples perceived to represent population to same extent as large samples) Exaggerate how likely it is that a small sample resembles the parent population from which it is drawn

Representativeness Heuristic

The probability that event X belongs to set Y is judged on the basis of how similar X is to the stereotype of Y Biases occur when prior probabilities (base rates) are ignored

Limits to arbitrage (for mispricing)

There must be impediments preventing arbitrageurs from restoring prices to fundamental value (i.e. from undoing the actions of noise traders) Without this, arbitrageurs would sell overpriced assets and buy underpriced assets until prices reflected fundamental value

P seems to _____ in short term, _____ in long term

Underreact; overreact

Average Investor

Unsophisticated Doesn't know P* (incorrect estimates of fundamental value) Irrational beliefs (heuristics and biases) Limited attention (categorization)

Bayes Rule

Use laws of probability to revise expected future cash flows in response to all relevant information Probability of A conditional on B Mathematically expresses how rational individuals should update beliefs in response to news - has to do with updating your beliefs

How shorting works

When A wants to short a stock, A borrows it from B and sells the stock to C Since B is effectively using collateral to borrow, B must pay interest to A When loan is closed, B repays cash to A, including interest, and A returns the shares to B The interest rate B pays to A (rebate rate) is negotiated, and depends on how difficult it is to short that stock

Repurchasees

When P<P* rational managers can benefit ongoing shareholders by reducing supply Over 3-5 years following repurchase, firms do outperform (returns are abnormally high)

Why behavioral finance matters

Who wins, who loses in investing Economic planning Corporate governance Allocation of risk across investors Allocation of capital across firms