Behavioral finance midterm

Malkiel's definition of EMH:

"markets do not allow investors to earn above average returns without accepting above average risks."

Why EMH could be undermined/false

- Stock prices seem to be too volatile to be consistent w EMH - Stock prices seem to have "predictability" patterns in historical data -There are unexplained behavioral data items—"anomalies"—Richard thaler Shliefer Limits to arbitrage arguments Predicability in stock prices

ETFs(Exchange Traded Funds)

Created much like closed end funds: securities pooled together to create a fund. Then shares in the pool sold to the public. But ("creation units") Shares can be created, Shares can be destroyed. Permits arbitrage to solve the closed end puzzle

(loss aversion) example

Deciding to cover one's shorts is psychologically difficult

Shiller mentions Eugene Fama's critique of Behavioral Finance in his article. What is Fama'scritique, according to Shiller and how does Shiller respond to Fama's critique?

- The first was that anomalies that were discovered tended to appear to be as often under reaction by investors as overreaction. -The second was that the anomalies tended to disappear, either as time passed or asmethodology of the studies improved. -Shiller responds to Fama's critique by stating that the first criticism reflects an incorrect view of the psychological underpinnings of behavioral finance. Since there is no fundamental physiological principle that people tend to always over react or always under react, it is nosurprise that research on financial anomalies does not reveal such a principle either. Shiller says Fama's second critique is also weak. It is the nature of scholarly research, at the frontier, in all disciplines, that initial claims of important discoveries are often knocked down by later research. The most basic anomaly of excess volatility seems hardly to have been knocked down and is in fact graphically reinforced by the experience of the past few years in stock markets of the world. Moreover, the mere fact that anomalies sometimes disappear or switch signs with time is no evidence that the markets are fully rational.

Malkiel--random walk idea:

- price changes are independent of past events - so if the flow is unimpeded and information is immediately reflected in stock prices then tomorrow's price change will reflect only tomorrow's news -news is unpredictable and random, price fully reflects all known info

"arbitrage trader"

-Arbitrageurs are traders who trade on fundamental information, they see the correct distribution of prices. -Arbitrage traders "correctly" perceive the true distribution of pt+1.

macroeconmics and noise

-Business cycles cause by many small things that are difficult to measure and essentially impossible to control. -Noise and uncertainty effects economic markets because it is difficult to shift physical and human capital between sectors -Difficult to predict values for things like inflation or money stock because noise makes them dependent on expectations, and expectations don't follow rational rules.

Friedman argued that noise traders would lose their money to the smart (arbitrage) traders. Exactly how does Shleifer counter Friedman's argument? Explain in simple language why Shleifer's results differ from Friedman's views (not just that he results are different, but why they are different.)

-Friedman argued that noise traders would lose their money to smart arbitrage traders because arbitrage traders would trade against the noise traders on actual information and therefore drive the noise traders out of the market. -Shleifer's results differ from Friedman's views because in his model there is one type of noise trader so the collective systematic risk of noise can be greater than arbitragers' willingness or ability to counteract the price effects due to limits such as risk aversion and not having sufficient money to counteract. Thus, when noise traders are systematically optimistic, they hold more of the risky asset and can earn higher returns than arbitrageurs.

econometrics and noise

-Noise makes it very difficult to observe the true value of econometric variables because most, if not all, of them are tainted by noise. -Noise makes it hard to determine causal relationships between variables.

Finance and noise

-Noise traders are the basis for financial markets. Without them, a trader with special information knows that everyone else has that information, and thus there is no reason to trade. -With noise traders, it pays to trade on special information and to seek out information to trade on. -Noise traders create liquid markets, which allow us to observe prices. -Information traders will offset the effect that noise traders have on an asset price over time. -Noise creates the opportunity to trade profitably, but also makes it difficult to do so.

Anchoring

-Presence of a figure in chooser's mind that influences their choice "the number of stars in the sky is 10,000"; e.g. Did Gandhi live to 142 years old? Vs. How long did Gandhi live to?

What are the assets in Shleifer and how are they different; how are they similar? What is the point of the way that Shleifer has defined his assets?

-Schleifer's model has two assets, a safe asset and an unsafe asset. Both assets pay a constant dividend, r. -The safe asset has perfectly elastic supply and a price of 1. The risky asset (constant supply) price is determined by the market. -The point of defining assets in this way is to show that though they are nearly identical and pay the same dividends, noise can significantly affect the price of the risky asset in comparison to the safe one, even though there was no change in information.

Shiller is a critic of EMH. What is Shiller's main argument against the validity of the EMH?

-Shiller's main argument against the validity of EMH is that excess volatility can not be described by an efficient market. The only way to describe a market price that is much more volatile than that securities' market value would be by admitting markets are inefficient. -The excess volatility argument by Shiller challenges the EMH because the volatility of stock prices is much greater than the volatility of the value (which is relatively stable) so that E + P t * ≠ P t

What does Shleifer mean by a "noise trader"? How is a noise trader defined in Shleifer? Why is Shleifer's definition important and how important is Shleifer's definition of a noise trader to his ultimate conclusion in his paper?

-Shleifer defines a noise trader as a momentum trader who follows the charts and trades on information that has no connection to the fundamental value of a price. They are irrational traders and have .a biased view of the mean P t and thus can cause prices to greatly diverge from their fundamental value. His definition is important because he shows that two identical assets can have two very completely different prices due to the presence of noise traders. Also, because noise traders have a biased view, they can drive prices so far up or down that arbitrageurs limit their trades with them in response to the noise trader risk they create, that they may be so extreme and keep driving prices up. Arbitrageurs must wait to liquidate until price is so far away that it's almost impossible for noise traders to keep going. Thus, in bull markets and when optimism is high or noise traders had more of the risky asset, they can make profits and more than arbitrageurs. Thus, this definition correlates with Shiller conclusions that two identical assets can sell for different prices and noise traders can make profits over arbitrageurs and have effects in the market that can't be ignored. Comment on mine: "Noise traders all the same" ******Thus, when noise traders are bullish (systematically optimistic) they invest therefore the effects of noise cannot be eliminated.

Friedman versus Shleifer (Friedman argues that noise traders will cancel each other out and that arbitrage traders will, in any event, take all of their money). How does Shleifer's noise trader model deal with each of theses Friedman views?

-Shleifer's model differs in that noise traders act collectively and systematically and thus are much more powerful than those noise traders in Friedman's model who work randomly. In Friedman's model, some might be optimistic and some might be pessimistic so they cancel each other out or are not able to deviate the price far enough from value to depress arbitrageurs from trading and stealing their money. -In Shleifer's model they can act optimistically and create risk, depressing arbitrageurs from trading and consequently allowing them to benefit on their portfolio or risky assets.

"Expected Utility",

U = -e^ (-(2λ)w)

What is the excess volatility argument advanced by Shiller?

-The excess volatility argument by Shiller challenges the EMH because the volatility of stock prices is much greater than the volatility of the value (which is relatively stable) so that E + P t * ≠ P t Concern was whether stocks show excess volatility relative to what would be predicted by the efficient markets model If most of the volatility in the market was unexplained, it would call into question the underpinnings of the entire efficient markets theory Excess volatility is more troubling for efficient markets theory than other anomalies (ie. January effect) o Imply that changes in price occur for no fundamental reason at all, that they occur because of things like "sunspots" or "animal spirits" of just mass psychology

How does Shleifer deal with the passage of time in his model? How many people are living at one moment in Shleifer's article and how old are these people?

-agents, arbitrageurs and noise traders live in two periods. -T is period 1 of their life and T-1 is period 2 of their life. -The generations overlap. There are the "young" who buy their portfolio (safe and unsafe assets) in period 1 and the old who consume (sell their portfolio) in period 2 and die. -noise traders is µ, measure of arbitrage traders is 1 - µ

What is a short sale? What is required to do a short sale?

A short sale is an investment betting against the success of a stock. For a short sale, you need a lender. You sell a stock you don't own and borrow it from a lender. Pay the lender collateral and a fee. If the price of the stock rises, you must give more money to the lender and if it drops, you demand some back. When done with the trade, you buy stock in the market and return it to the lender profiting off the difference.

Malkiel paper conclusion

-stock markets are far more efficient and far less predictable than some recent academic papers. Whatever anomalous behavior of stock prices may exist, it does not create a portfolio trading opportunity that enables investors to earn extraordinary risk adjusted returns.' -Markets can be efficient even when they sometimes make errors. -Markets can be efficient even if many market participants are quite irrational. -Markets can be efficient even if stock prices exhibit greater volatility than can apparently be explained by fundamentals such as earnings and dividends.

calendar effects

-the market does very well in January, predictor of how the rest of the year will go -real or statistical illusion? Unsolved issue in financial economics. Not enough data - Mondays are BLUE= . Bad days in the stock market - Stocks lose money on Mondays - Would expect Monday to capture the weekend as well but instead goes down doesn't make sense according to the efficient market

main point of contention between freidman and shliefer over safe and unsafe assets

-they're identical because they both pay the same dividends -Friedman says the prices cannot be different because the assets are exactly the same -Shleifer must fix the price of one of the assets -Focus attention on the price of the unsafe asset -MOST IMPORTANT ASSUMPTION: the safe asset is freely - convertible at no cost into the consumption good - Fixes the price of the safe asset= 1 but price of unsafe asset determined by market and noise traders could produce uncertainty - Friedman's argument doesn't really hold because it seems like there is always something going on that can't be rationally explained by information changes

closed end fund

.mutual fund which holds other publicly traded securities and has a limited number of shares

The theoretical foundations of the EMH

1. Investors are assumed to be rational and hence to value securities rationally Value each security for its fundamental value: the net present value for its future cash flows, discounted using their risk characteristics → the impossibility of earning superior risk-adjusted returns 2. Some investors are not rational; trading strategies for irrational investors are uncorrelated, their trades are random and therefore cancel each other out without affecting prices prices are still close to fundamental values 3. Investors are irrational in similar ways; they are met in the market by rational arbitrageurs who eliminate their influence on prices - arbitrage Irrational investors do manage to transact at prices that are different from fundamental values, they only hurt themselves and bring about the own demise Conclusion: Both investor rationality and market forces bring about the efficiency of financial markets

The empirical foundations of the EMH

1. When news about the value of a security hits the market, its price should react and incorporate this news both quickly and correctly For weak form efficiency, the relevant stale information is past prices and returns impossible to earn excess profits o Stock prices indeed approximately follow random walks For semi-strong form efficiency, investors cannot earn superior risk-adjusted returns using any publicly available information = weak form efficiency o Event studies - the jump in share prices on the announcement is not followed by a continued trend up or a reversal down For strong form efficiency, earning abnormal risk-adjusted profits from inside information is impossible because the insiders' information quickly leaks out and is incorporated into prices 2. Prices should not react to changes in demand or supply of a security that are not accompanied by news about its fundamental value (non-reaction to non-information) Substitution hypothesis: When a seller unloads a block of shares on the market, other investors would gladly increase their holdings of the stock a bit in exchange for only a trivial price concession, and perhaps reduce their holds of close substitutes to keep the risk of their portfolio constant.

Status Quo Bias

A preference for the current state that biases a person from both buying and selling the same item at the same price; It's hard to make concessions/agreements when one party is bound to gain lesser utility - due to risk aversion [p.304-5]. So, we prefer status quo.

Define short selling and explain how a short sale takes place and what happens when someone decides to no longer be short.

A short sale is an investment betting against the success of a stock. For a short sale, you need a lender. You sell a stock you don't own and borrow it from a lender. Pay the lender collateral and a fee. If the price of the stock rises, you must give more money to the lender and if it drops, you demand some back. When done with the trade, you buy stock in the market and return it to the lender profiting off the difference. When someone no longer decides to be short, a short squeeze occurs which means that the owners of the stock stop lending it out and those who need it lose money and must buy in the market place.

One of the most compelling arguments for the BF noise trader point of view we can never seem to get away from it

All kinds of people talking in noise trader language -If they are just cannon fodder for the smart guys like Friedman says, then why are there so many of them and why do they continue to exist? -Contradicts Friedman's idea that they all get weeded out -The noise trader's survival is casual evidence that they win in the market -There must be times when the foolish strategy is winning -Must conclude that the noise traders can make an impact

Excessive optimism-(Kahneman)

Allows people to take risks o Irrationality could actually provide benefits o Fewer greater ideas would be pursued in a capitalist economy

Efficient markets hypothesis (EMH):

An efficient financial market as one in which security prices always fully reflect the available information The market truly knows best An average investor cannot hope to consistently beat the market The vast resources that such investors dedicate to analyzing, picking, and trading securities are wasted the current market price reflects all the known information No such thing as a cheap or expensive stock Get what you pay for Stock price that you see is what it's worth Smart people will take money away from the stupid people and the price will go back to what it should be Money managers are based on the fact that the market isn't efficient o Often times the smartest portfolio manager doesn't beat the monkey throwing darts o Money managers are fans of behavioral finance Prices reflect all the known information o Info price (function of info)

Open End Funds are the Typical

An investors sends cash to the mutual fund to buy a unit interest in the fund The fund takes the investor's cash and buys securities in exactly the same proportions as exist in the current fund When an investor sells his unit interest, the fund liquidates shares in the funds to redeem the investor's interest No problem with open end fund.

Why is u an unsafe asset?

Because it's price is not fixed because u is not convertible back and forth into the consumption good You buy u on the open market and sell it on the open market

Behavioral finance:

Behavioral finance is an attack on the idea that the asset market is efficient Behavioral finance has answers for huge fluctuations in stocks with no information change The study of human fallibility 1. The limited arbitrage (why market is inefficient) 2. Investor sentiment (how investors form their inefficiency) Systematic and significant deviations from efficiency are expected to persist for long periods of time The key forces by which markets are supposed to attain efficiency, such as arbitrage, are likely to be much weaker and more limited than the efficient market theorists have BF believes that stock prices are partially predictable on the basis of past stock price patterns as well as certain "fundamental" valuation metrics o Malkiel disagrees defends the EMH and random walk

Black sees "noise traders" as useful to financial markets. Why?

Black looks at noise traders in contrast to information traders. If noise traders did not exist then the price would not move as information traders would not want to trade with each other because they wouldn't know whose information was correct. Noise traders bring the price away from the fundamental value and allow information traders to make a risk-adjusted profit.

What is Black's conclusion as to whether financial markets are efficient or not?

Black thinks that markets are efficient 90% of the time. An efficient market is one in which price is within a factor of two (the price is more than half the value and less than twice the value). Black believes that noise causes markets to be inefficient, but that does not necessarily allow us to take advantage of the inefficiencies. He thinks that the information traders will not take large enough positions to eliminate the noise. The information traders will be able to make money off of the noise traders. Information gives an edge but does not guarantee profits. In regards to limits to arbitrage, he believes that taking a larger position means taking on more risk so there is a limit to how large a position a trader will take. He does believe that the farther the price of a stock gets from its value, the more aggressive the information traders become (more will come in and take even larger positions).

There are two assets and one consumption good in Shleifer's model. How are the assets different, or are they different? What role does making the safe asset convertible into the consumption good play in SHleifer's model?

Both the safe asset, s, and the unsafe asset, u, have constant dividends, d. The safe asset is in perfectly elastic supply and can be converted into the consumption good with a price of 1. The unsafe asset is in fixed supply and its price is affected or determined by the market. Because s can be converted into the consumption good, it is unaffected by the noise traders that can change the price of u. This is important because it shows how identical assets can have two different prices due to noise.

Value Investing

Buying something that is "out of favor" with the vast majority of investors

What does Shleifer mean by "fully reflect" available information. If there is a major news announcement and if the stock price reacts gradually over a few days to incorporate new information, is that kind of stock price reaction consistent or inconsistent with EMH and why or why not?

By fully reflect, he means that information is immediately incorporated into the security price, before an investor has any time to advantageously buy or sell. If the stock price took a few days to incorporate the information, this would be inconsistent with EMH because, according to the semi-strong form of EMH (by Fama), publicly known information is immediately reflected in stock price.

when Price per share is not what you would predict by looking

Clear that the EMH says this is not possible - cannot be systematically different BF say sure - people can be way too optimistic and bend the price per share way up Shareholders can decide to close the fund, sell the stock Net asset value and price per share converge

fastest growing type of mutual fund

ETF exchange traded funds trade on exchanges (ie. NY stock exchange, London stock exchange) buying vanguard pacific index, basically buying japan, chinese, and korean stock exchanges if you want china and Korea but not Japan, use ETF

How do bubbles end?

Even once people realize prices are crazy, it might go on o When one bubble is collapsing, other bubbles can pick up steam Don't know enough about bubbles to make conjectures about them o Mostly historical data - limiting o Experimental economics - can create bubbles in experiments

Kahneman

Excessive optimism isn't necessarily a bad thing Kahneman Allows people to take risks Irrationality could provide benefits Fewer great ideas would be pursued without it

If two prices that are the same trade at different prices, what is the economic impact?

Feedback models attempt to explain -If a price is wrong motivates feedback models -Prices are a signal for the economy affect supply/demand= Signal scarcity -If prices aren't right, resources might not be allocated effectively

When and how does malkiel agree with the behavioralists and why does that not bother him?

He agrees with the behavioralists in saying that the market pricing is not always perfect and that psychological factors do influence prices. However, he says that 'while the stock market in the short run may be a voting mechanism, in the long run it's a weighing mechanism'. True value always wins in the end. Ex: the internet bubble - he says it was an exception, not a rule. - many predictable patterns are not robust but dependable in different sample periods. - if patterns do exist, they self-destruct. Ex: January effect.

Framing

Framing: Different ways of presenting the same info evokes different emotions, e.g. "90% fat-free" sounds better than "10% fat" [p.88]. How question is framed (wording) influences our preferences Burton experiment: 600 infected with disease. Choose... A: Save 200 people for sure B: 1/3 chance 600 will survive, 2/3 chance 600 will die Result: Most people will choose A - the certain good outcome - over the risky bad outcome But what about... A: Kill 400 people for sure B: 1/3 chance 600 will survive, 2/3 chance 600 will die Result: Most people will choose B - the risky good outcome - over the sure bad outcome

Given an explanation of the EMH that you would give to your grandmother.

Fran's Answer: I would tell my grandmother that it is impossible to beat the market because prices are constantly changing as they reflect all news and information to that exactly specific point in time. No one has an advantage and can beat out the market due to the unpredictability of news and information. Thus, the market is efficient and always wins.

What Does Shleifer Accomplish?

Given two assets that are "fundamentally" identical, he shows a logic where the market fails to price them identically Assumes "systematic" noise trader activity Shows conditions that lead to noise traders actually profiting from their noise trading Shows why arbitrageurs could have trouble (even when there is no fundamental risk)

what is Malkiel's point? Why does he think it's efficient?Why does Shleifer think it's not?

His definition of the EMH is that you cannot make higher than average returns unless you take higher than average risk so even with anomalies affecting stock price so its impossible for investor to make high risk adjusted profit. . So his defense is that anomalies and patterns willalways be found and exploited so you cant beat the market. He also cites that about 3/4 of money managers ant beat the market.While there's anomolous information, there's no opportunity to consistently outperform the market; prices changes are unpredictable so you can't depend on trends. random walk,

The Law of One Price

Identical things should have identical prices

What is Malkiel's defense of the EMH.

Malkiels main line of defense of EMH is that even if anomalies affecting the stock price exist, it is still impossible for an investor to make high risk-adjusted profits. When he wrote the article in the previous decade, ¾ of money manager did not beat the market.

Feedback (in the sense of Hirschleifer's article):

In Hirschleifer's article, he argues that as a result of feedback in which noise traders drive up the price and subsequently other noise traders buy into it and further drive up the price, those irrational but early investors are able to profit, while late irrational traders get smashed. Additionally, Hirschleifer argues that when people see the price of a stock going up, they perceive it to be a profitable company and increase their knowledge and skills to work for the firm, which increases productivity of the firm. Example is Netscape.

Theoretical challenges to the EMH

It is difficult to sustain that people in general are fully rational; investors hardly pursue the passive strategies expected of uninformed market participants by the efficient markets theory People deviate from the standard decision making model in three fundamental areas: 1. Attitudes toward risk - individuals do not assess risky gambles following the precepts of von Neumann-Morgenstern rationality 2. non-Bayesian expectation formation - individuals systematically violate Bayes rule and other maxims of probability theory in their predictions of uncertain outcomes 3. Sensitivity of decision making to the framing* of problems - individuals make different choices depending on how a given problem is presented to them Investor sentiment: Beliefs based on heuristics rather than Bayesian rationality o Investor sentiment reflects the common judgment errors made by a substantial number of investors, rather than uncorrelated random mistakes o The efficient markets theory states that irrational trades cancel each other out. However, the psychological evidence shows precisely that people do not deviate from rationality randomly, but rather most deviate in the same way (Kahneman and Tversky) Unsophisticated (noise traders): Investors whose conduct is not rational according to the normative model *Argument: Real-world arbitrage is risky and therefore limited

Is the fundamental risk the same or different between the safe and unsafe asset in the Shleifer model? Why?

The fundamental risk is exactly the same. Both assets pay the same dividends at the same time intervals.

Saliency

Low probability event is assumed to have probability of zero. But once the unlikely event occurs, then its probability is assumed to be greater than it actually is. Examples: Buying flood insurance after a flood, buying flight insurance only at the airport, avoid real estate after a housing bubble (2008 crisis), Cyprus deposits.

Malkiel view of EMH

Malkiel defines the EMH by stating that i. Markets don't allow investors to earn above average returns without accepting above average risks i• argues that the evidence for the EMH is that money managers just don't beat the market. No matter where you look, hedge funds, trust funds, etc. people don't beat the market. Obviously, there are some who beat the market. Malk is saying that all money managers in the long run don't beat the market. In the short run, any manager can beat the market. • Malk says that 80% (Random number burton chose) of money managers don't beat the market. If 80% of money managers don't beat the market, then the odds are 80% that you are not going to find those money managers that beat the market view is that the evidence shows that money managers cannot beat simple indexes like the S&P500 over time If the market were not efficient, then people would be beating the market, but we don't see that. Malkiel says this means the market is efficient. To Malkiel, that means the market is efficient

Malkiel seems to have one overwhelming argument in favor of the EMH...what is that argument? Isn't it possible that EMH could be fale and yet Malkiel's argument is true?

Malkiel's overwhelming argument in favor of EMH is that investors cannot earn extraordinary risk adjusted returns. In short, money managers cannot beat the market. It is possible that the general accepted definition for EMH is true while Malkiel's argument is true.

Is Black's view of what constitutes an "efficient market price" the same as that give by Shleifer?

No. An efficient market price for Black is within a factor of 2 of the value (1/2 or 2 times) as he thinks price is largely affected by noise. A price that fully reflects available information under Shleifer's EMH is ideally usually more rigidly aligned with the correct value.

Shleifer defines two kinds of people in hi model: noise traders and arbitrage traders. How are these two types of people defined? How many people are in Shleifer's model?

Noise traders are irrational investors who make decisions on market tides, hunches and often bandwaggoning. Noise trader act as a collective unit and if they have enough risky assets in their portfolios they can make a profit off of their own optimism through noise-drive risk. Arbitrageurs are the informational traders who look at dividends and future cash flows to bring the stock price back toward its fundamental value. There are an infinite number of people. Mu noise traders and 1- mu arbitrageurs.

When Do Noise Traders Profit More Than Arbitrageurs?

Noise traders can earn more than arbitrageurs when ρ* is positive. (Meaning when noise traders are systematically too optimistic) Why? Because they relatively more of the risky asset than the arbitrageurs But, if ρ* is too large, noise traders will not earn more than arbitrageurs The more risk averse everyone is (higher λ in the utility function, the wider the range of values of ρ for which noise traders do better than arbitrageurs

Do noise traders make money in Shleifer's model? Under what circumstances are noise traders more likely to make money and under what circumstances are they unlikely to make money?

Noise traders can make money in this model if they are collectively optimistic with risky, unsafe, noise-prone assets in their portfolio and the amount of risk they have created is too high for arbitrageurs to want to invest (risk averse). Noise traders wouldn't make money if they are collectively pessimistic with safe, not prone to noise assets and the risk is not too high for arbitrageurs to bring price back to value.

Hirshleifer's article deals with "feedback". What exactly is feedback in Hirshleifer's article?

Noise traders raise a price which earns a profit, creating interest by other noise traders, increasing demand for the stock. This raises the profit again. Here, early irrational investors make a profit and late irrational investors lose money. In his feedback system people invest and work in firm because rise in price increases output and makes firms more profitable.

Closed end funds

Once set up, there are never any shares created or reduced There will always be the same number of shares Does not have to buy an index Unsafe asset = closed end fund that owns the underlying stock - shares of the mutual fund Do not trade at net asset value Share price is determined by the market value

Endowment Effect

People often demand much more to give up an object than they would be willing to pay to acquire it; people place a higher value on objects they own relative to objects they do not. What you start with matters!

EMH

Price captures all relevant information Modern version based upon "No Arbitrage" assumption

Problem arises with closed end fund

Price of a share can diverge from the stock values in the fund Begin at a premium and, over time, trade at a discount Discount only goes away when fund is terminated

Shillers view of EMH

Prices should be based upon fundamental Future cash flows (or dividends) and future interest rates Prices are way too volatile as compared to the modest changes over time in expectations of future cash flows and interest rates Thus, the market is not efficient - prices are too volatile to be consistent with efficiency

Problems for EMH

Problem for EMH if technical trading is wrong, why does it continue? Why does it work? The very existence of such a large body of technical trading goes against the EMH o Central argument of behavioral finance states that real world arb is risky and thus limited Imperfect substitutes

Malkiel defends the EMH (efficient market hypothesis) from its critics in his 2000 article, while Shiller heralds the triumph (in his opinion) of the behavioral finance advocates in his 2000 article. When Malkiel and Shiller talk about EMH, are they talking about the same thing? How do each of them define the EMH and are those definitions essentially the same thing or are they different? Can one be true while the other is false?

Shiller defines the efficient market hypothesis as one in which EMH, P t =E t P t *. By this he means that the current price is equal to the expected optimal price of a stock and price and that the only change in E t P t * results as a change in information. Malkiel, a supporter of the efficient market hypothesis, has a revised definition in which prices, which reflect news at that specific point in time, follow a random walk and therefore are unpredictable and one cannot beat the market. So, they are different because Malkiel takes into account the volatility of stock prices and its random walk effect and doesn't try to say the market is perfect, but efficient. He states that the anomalies that Shiller uses against EMH are the exception, not the rule, caused by irrational investors in the market. So, Shiller's definition can be false while Malkiel's is true because Malkiel is not using the old definition that Shiller refers to in his article, and takes randomness into account.

Feedback Models (as used by Shiller):

Shiller describes feedback as when noise traders drive up the price of stocks based on irrationality, other noise traders see the prices going up and further drive the price up. This notion of feedback explains bubbles and that will eventually pop.

Empirical challenges to the EMH

Shiller's Stock market volatility: Stock market prices are far more volatile than EMH defined for the price change (opened the whole new way of research) o De Bondt and Thaler's finding (in terms of weak form efficiency) - stock prices overreact; the extreme losers have become too cheap and bounce back, whereas the extreme winners have become too expensive and earn lower subsequent returns Long-term phenomenon 'reverses' themselves o (In terms of semi-strong form efficiency) Individual stock prices over the period of six to twelve months tend to predict future movements in the same direction; returns are predictable! Short-term phenomenon 'continues' Using example on pg18, company's size and the coming of the month of January is information known to the market (public information) Market-to- book ratio o Value investing: Investing in low market-to- book companies based on the ratio of the market value of a company's equity to the accounting book value of its assets Investors invest to the companies with lower ratio of market-to- book ratio because of De Bondt and Thaler's finding on market overreaction Challenges EMH because this stale information helps predict returns but this strategy is not due to higher risk; however, interpretation of the ratio is controversial Stock prices do not react to non-information? o The crash of 1987

How does Shleifer describe the life span of the people in his model? Who are the investors? Who are the consumers?

Shleifer believes that both agents, arbitrageurs and noise traders live in two periods. T is period 1 of their life and T-1 is period 2 of their life. The generations overlap. There are the "young" who buy their portfolio (safe and unsafe assets) in period 1 and the old who consume (sell their portfolio) in period 2 and die.

Shliefer- limits to arbitrage

Shows the limits to arbitrage -Noise traders can make money if there are enough of them even if they are wrong -noise traders are able to push the price to even more unreasonable levels -Arbs will sometimes even hop on the idiot wagon because they think they can make money from it -Can be influenced by the noise traders

Why have closed ends funds in the first place?

Something has recently done well (ie. gold has gone up a lot in the last year) someone will create a closed end stock for gold People will bid the price up and pay a premium to own shares in this fund The bubble bursts shares start trading at a discount Never come into existence under normal circumstances More short term you were excited about the old market

Friedman

TEAM EMH o If prices aren't right then smart people with money will enter the market and sell things that are too high, buy things that are too low, and force prices back to efficient level o Two identical products with different prices cannot exist , something will bring them into communion o Shell and Royal Dutch; contradicts this belief o Proven wrong is you can't arbitrage away the difference between the safe & unsafe asset I o irrational traders are cannon fodder for rational ones

Malkiel

TEAM EMH o Money managers still can't beat the market----Huge point for validity of EMH o Efficiency--markets that do not allow investors to earn above average returns without accepting above average risks o disagrees that stock prices are partially predictable on the basis of past stock price patters as well as certain fundamental valuation metrics o In the short run the market is not perfectly efficient o Any truly repetitive and exploitable pattern that can be discovered in the stock market and can be arbitraged away will self-destruct-- January Effect

1. Representativeness

Tendency for most people to read too much into stereotypes and over-adjusting base rates. E.g. Guessing a person's major. Is the introverted, uncreative, nerdy Tom, likely to be engineering or humanities major? Knowing his personality increases the odds that he is engineering, but still, humanities is better guess.

example that hurt EMH and Malkiel's defense

The incident of 1987 -Market began at 2200 rallied to 2700 collapsed 22% in one day went back to 2200 -Embarrassing episode for Team EMH: Huge change in stock market with essentially no change in information Malkiel's defense: -A number of factors could rationally have changed investor's views -Minor external events cumulated o BF doesn't struggle to explain this crash :t's behavioral - people operate in herds

Loss Aversion / Prospect Theory

The most important theory. The only practical outcome of biases. "$1.00 of loss is more paintful than $1.00 of gain." Loss aversion means modern finance and EMH does not work well, because utility function becomes path-dependent. But its very true.

According to Shleifer, even if not all investors are rational (meaning that there are potentially many irrational traders and noise traders present in the market place), it is still possible for EMH to be true. Give two reason why EMH can sill be valid in the presence of noise traders and irrational market participants.

The practice of arbitrage or simultaneous purchasing and selling of the same asset in different markets at advantageous prices, can bring the price back to the securities value. Also, irrational investors are random and their trades will cancel each other out.

What difference is there between the safe and unsafe assets in the Shleifer model?

The safe asset is convertible to the consumption good. There is also an unlimited supply of safe assets.

Definition of an arbitrage (or rational trader) in the Shleifer Model.

The simultaneous purchase and sale of the same or essentially similar, security in two different markets for advantageously different prices.

EMH hypothesis

There are many definitions for EMH. All implies non-predictability. 1. Definition for the rest of your life: Fama's semi-strong hypothesis. "All publicly known information is irrelevant, incorporated in stock price" 2. Definition for your grandma: "Price captures all relevant information"

Closed End Funds

They begin by purchasing securities Then they do an IPO to the public selling shares in the fund After that, the fund shares are fixed in number and the shares trade in the open market Problem: the price of share can diverge the stock values in the fund, begin at premium and over time trade at a discount.

Open end funds

Trade at NAV (net asset value) Grow and contract depending on investors coming in Put in cash have a unit interest in the fund No room for arbitrage

What is a "growth" stock? What is a "value" stock?

Value stock- future earnings of value stocks are better than predictions- high book to market growth stock-stock everyone else loves

8. Sunk Cost Bias / Regret

We tend to not change our minds once we have invested ourselves in it. E.g. Bought a movie ticket for $20, even though movie turns out bad, we stay all the way; or, once you missed the investing opportunity, you wait and hope prices fall to same levels again.

Fama's Trichotomy of EMH

Weak EMH - previous stock prices don't convey the information o Past stock prices have no value o Trends don't matter Semi-strong EMH - no publicly known information has value o Where the REAL BATTLEGROUND is o Most evidence from both sides Strong EMH - no information, public or private, is of any value o Stock price reflects all known and unknown information o Insider information is of no value

Fama definition of EMH

Weak Hypothesis: past prices and returns are irrelevant Semi-Strong Hypothesis: all publicly known information is irrelevant Strong Hypothesis: public and private information is irrelevant

INERTIA THEORY

Whatever is going on will continue going on

A Martingale Process

defined as a process with the following property: E[X(t)] = X(s) for all t, s where s > t

Does Black think markets are efficient? Black refers to "information" traders. Does he think, as Friedman does, that they will make money while noise traders lose money? Where does Black stand on the "limits to arbitrage" argument?

Yes, Black thinks markets are efficient if the price is within a factor of two of the value (1/2 or twice the fundamental value), which he says is the case 90% of the time. Black acknowledges that information traders need noise traders to make profit, but disagrees with Freidman because noise traders could drive up demand and also make a profit. Black thinks there are limits to arbitrage because you can't tell the true value of a stock because of noise (can't know how far away the price is from the true value).

"fungibility"

You can easily turn one thing into another and vice versa costlessly That means the price of s is always 1 in terms of the consumption good (that is why it is called the "safe" asset

Fundamental analysis

analysis of financial information such as company earnings and asset values to help investors select stocks

creation unit

borrowing stocks people can buy stocks they send in money, person who started the fund goes into the open market and borrows the exact same stocks he borrowed and then returns the borrowed stocks can create it out of anything - stocks, bonds, etc. not an open ended fund once it exists, the price can go higher or lower if lower, you can make a new creation unit natural way to arbitrage

ETf vs closed end funds

closed end funds just don't work because they would trade at a discount and you don't know when they were going to converge Even open ended funds have a tax problem Late enterers are at a disadvantage because of tax reasons ETF is a better option that a closed end fund ETF - get diversification

What is Malkeil's main line of defense?

even if anomolies affecting stock prices exist, it is still impossible for an investor to make high risk adjusted profits. When he wrote the article, in the previous decade, 3/4 of money managers did not beat the market -Malkiel believes that the theory of efficient markets is concerned with whether prices at any point in time fully reflect available information. He believes that the EMH is associated with the idea of a random walk (price changes are independent of past events). News is unpredictable and resulting price changes can be unpredictable. Thus, prices fully reflect all known information and even uninformed investors can be as successful as informed investors.

Bernoulli Paradox

game that has infinite value but no one will pay except for a small amount of value

Conclusion of Shleifer model:

he is able to show that if you have systematic noise traders than two things that we would normally consider identical can trade at two different prices Limit to how much the arb can force the price back to where it should go

Ponzi schemes

involves a superficially plausible but unverifiable story about how money is made for investors and the fraudulent creation of high returns for initial investors by giving them the money invested by the subsequent investors Real stock market speculative bubbles resemble ponzi schemes

BF

o BF believes that stock prices are partially predictable on the basis of past stock price patters as well as certain fundamental valuation metric o finance from a broader social science perspective including psychology and sociology

"Feedback" in the sense of the Hirshelifer model. What does the feedback feed back into?

misperceptions of irrational investors affect these underlying cash flows because of feedback from stock prices to cash flows. Feedback, which plays a central role in our model, can arise in practice for a variety of reasons. For example, a higher stock price can help firms attract customers and employees, can reduce the firm's cost of capital, and may provide a cheap currency for making acquisitions.4 Higher stock prices also can encourage increased investment in comple- mentary technologies. In our basic model, feedback arises because the stakeholders of the firm (such as suppliers, customers, and employees) choose to make greater firm- specific investments (e.g., the workers exert more effort) when the firm's prospects are better. It is rational for them to do so because the firm provides better opportunities to its stakeholders when it is doing well. We also consider an extended model in which feedback arises because stock prices affect the amount of capital raised in a security issue

Martingale process

o A martingale is a process whose value at any future date is not predictable with certainty. Given the information today, the best estimate of a future stock prices is todays price o On average, you will neither make nor lose money o Appropriate model for EMH bc on any date, past info offers no real clue to predicting future prices value is exactly equal to current value) Xt = E(Xt + s)

Blacks definition of efficient

o A price is efficient if it's no more than twice or less than half the correct price o All markets are efficient almost all of the time (90%)---Markets are not perfectly efficient. o Burton disagrees

Fama found fault in BF for two reasons

o Anomalies that were discovered tended to appear to be as often underreaction by investors as overreaction. ------not really correct because Represents an incorrect view of the psych underpinnings of BF o Anomalies tended to disappear, either as time passed or as methodology of the studies improved -----Also a weak critique - excess volatility hardly seems to have been knocked down, in fact it's been reinforced in the past few years

arbitrage

o Arb: the simultaneous purchase and sale of the same, or essentially similar, security in 2 diff markets @ advantageously different prices. o Brings security prices in line with fundamental value • In long run, market efficiency prevails because of competitive selection and arb

Why BF over EMH

o BF has answers for huge fluctuations in stocks with no information change oEvidence from BF helps us to understand that the recent worldwide stock market boom and then crash after 2000 had its origins in human foibles and arbitrary feedback relations and must have generated a real and substantial misallocation of resources

Main Black points

o Black thinks that markets are efficient 90% of the time. o Black believes that noise causes markets to be inefficient, but that does not necessarily allow us to take advantage of the inefficiencies o In regards to limits to arbitrage, he believes that taking a larger position means taking on more risk so there is a limit to how large a position a trader will take. He does believe that the farther the price of a stock gets from its value, the more aggressive the information traders become (more will come in and take even larger positions). o Noise trading is good for the market o Noise or uncertainty has its effects in the economic markets because there are costs in shifting physical and human resources within and between sectors

Fungibility

o Convertibility from one form to another; similar assets can be converted, arbitrage is possible, so prices should be same. o In the real world, when two things are fungible, you rarely have price discriminations

Shiller

o Excess volatility argument : Prices are too volatile for the market to be efficient o Prices should be based upon fundamentals: future cash flows (or dividends) and interest rates o Very troubling for EMH

Friedman on noise traders?

o Freidman said all noise traders do is provide cannon fodder for smarter people -- lose their money to arbitragers o argument for market efficiency in the presence of "noise traders" o If noise traders are truly "random," then their effects will "cancel out." (Kind of a law of large numbers result) o Noise traders are wiped out

In chapter 2, Shleifer tackles the problem of whether on not he can give a legitimate argument for why prices can diverge for identical products

o Friedman says that two identical products with different prices cannot exist - something will bring them into communion o Shleifer aims to show a logical explanation that two identical products can have different prices and this discrepancy can persist o Challenging the law of one price

Two pieces of information that determine stock prices

o Future dividends o Future interests rates

Feedback model problem with feedback theory:

o If price is wrong motivates feedback models: Central idea is that a price higher than efficient price might have "real" effects. o Resources may be allocated ineffectively o Feedback models: when speculative prices increase leading some investors to success, this attracts public attention, enthusiasm among investors, and heightens expectations for further price increases. This increases investor demand and prices increase again, thus creating a speculative bubble; this is not sustainable and the bubble eventually bursts and prices fall o When speculative prices go up, it attracts public attention and heightens expectations for future price increases o Tulip bubble in Holland in the 1630's o Feedback may be an essential source of inexplicable "randomness" o Human judgments of probability of future events show systematic biases -Representativeness heuristic - predict by seeking the closest match to past patterns o problem with feedback theory: implies that speculative price changes are serially correlated through time/ inconsistent with random walk

Shleifer Model

o Issue is between Shleifer and the BF on one hand and Friedman and Fama on the other oFriedman : if prices aren't right, then the smart people with money will enter the market and sell things that are too high, buy that are too low, and force prices back to the efficient level BUT There are limits to arbitrage o Friedman's idea of the smart guys balancing out the dumb guys has its limits -Startling that the noise traders can make more money than the arbitrageurs in the Shleifer model -If the noise traders are optimistic and there are enough of them (m is significantly large), then they can move this price in such a way that they can make money and can also make money in the future IMPORTANT: in the SR, noise traders can win the game You can have a bubble of mispricing that can go on for quite a long period of time o During that time the arbitrageurs lose money and they will leave the market o Possible for the arbitrageurs to blow up Provided a valid argument as to why the arbitrageurs can't force the noise traders out RISK o The arbitrageurs might be wrong

Shleifer chapter 2 players

o Noise Traders: People who form erroneous beliefs about future distribution of risky asset's price - Assumes he has the same normal distribution but is either too optimistic or too pessimistic - Mean expectation is either higher or lower o Arbitrageurs: People who take advantage of NT's misperceptions -Knows the right price (1-1 ratio) o Only difference: expectations o Shleifer is out to show that excessive optimism can cause the price to diverge for a long period of time o By assuming all noise traders are the same, must assume the market events are systematic o More noise traders there are in the market, less likely to get to the true price of 1 o Going after Friedman's argument that the arbitrageurs take all the money away from the noise traders For Noise trader risk to exist, Noise Traders must... 1. Be systematic 2. Survive (unlike what Friedman says) 3. Be concentrated

According to Shliefer, how can price arbitrarily diverge from 1

o Noise traders are overly optimistic (otherwise they lose money and get forced out of the market) o There are a lot of them

Shleifer EMH definition

o the current market price reflects all the known information o Prices reflect all known information

Overlapping generations structure

oAll agents live in two periods -Born in period 1 and buy a portfolio - Live and die in period two and consume o The later part of the first generation of agents lives overlap with the beginning part of the second generations' lives o Young part of life: gather assets, don't consume oOlder part: consuming assets Model clearly delineates young and old in the asset market

Black and noise trading

o Noise trading - trading on noise as if it were information/ Noise trader is an agent who acts on misinformation and is therefore incorrect in his assessment of a security's value o More NT more liquid the markets are o Noise is what makes financial markets possible but also makes our observations imperfect o Little trading of individual assets with out it o Cutting back on NT also cuts back on info trading and prices will not move as much o says Price of a stock includes both info and noise o As the amount of noise trading increases, it will become more profitable for people to trade on information • Fischer black is a strong believer in noise and noise trading in particular. Fischer thinks that having noise trading is great. He thinks the market is efficient • He's not denying that there is a lot of movement in stock prices, but he finds that is okay • Noise traders- they might make money for a little while, but eventually they lose it- these guys might be right in the short run, but they will g et cleaned out by the smart guys in the long run • Black says that: prices are 'efficient' if they are within a factor of 2 of "correct" value would be tough to violate this definition of efficiency • Burtons reading of black- black desperately wants to defend the Efficient market process. His view is the market is broadly efficient, it just creates opportunities for smart people to take advantage of. • Noise makes trading in financial markets possible, and thus allows us to observe prices for financial assets • Noise causes markets to be somewhat inefficient, but often prevents us from taking advantage of inefficiencies

Malkiel's defenses to "anomalies" and predictable patterns

o Patterns are self-destructing o The more potentially profitable a discoverable pattern is, the less likely it is to survive

Econometrics of black's study

o People assume causality o Econometric studies involving economic variables are hard to interpret for two reasons o Easiest economic variable to observe is money stock o Black thinks it does not have an important role in the workings of the economy o Still, correlated with every measure of economic activity because it is related to the volume of trade

Mysterious Case of Royal Dutch & Shell

o Same company but one in Netherlands and one in England o RD Entitled to 60 % of company economics o Shell Entitled to 40 % o RD should trade at 1.5 times Shell but it DOESN'T o Most notorious example of two identical things selling at different prices No difference sin rights between 2 shares of RD and 3 of Shell However, they don't trade in this ration the market values them differently Goes against Friedman's argument o Cannot arbitrage these stocks because there is no fungibility

Does Malkiel believe markets are completely efficient?

o Some market participants are less than rational and the collective judgment of investors will sometimes make mistakes -----Can lead to ST pricing irregularities and predictable patterns o Admits that the market is not perfectly efficient in SR but in LR is o Whatever patterns or irrationalities in the pricing of individual stocks have been discovered are unlikely to persist and will not provide investors with a method to obtain extraordinary returns

Econometric studies involving economic variables are hard to interpret for two reasons

o The coefficients of regression tell us little about casual relations even when the variables are observable o The variables are subject to lots of measurement error and the errors are probably related to the true values of the variables

What doesn't cause noise?

o The kind of uncertainty caused by unanticipated shifts in the general price level or in the level of government spending is not noise o if business cycles are caused by unanticipated shifts in the entire pattern of tastes and technologies across sectors = noise unanticipated shifts in tastes and technology within and across sectors called information in financial markets o HOWEVER called noise in economic markets

Defenses for EMH

o Unless irrational behavior is systematic, it is won't have an effect on the market (cancel out) o Money managers still can't beat the market --Never know when a manager has good skill or not(malkiel) • Empirical foundations: 1. When news about value of security hits the market, its price should react and incorporate news both quickly and correctly 2. Since a securities price must be equal to its value, prices shouldn't react to changes in demand or supply of a security that aren't accompanied by news about its fundamental value.

Fischer black beliefs

o Well aware that market prices weren't always correct o Noise traders are actually helpful because they provide liquidity to financial markets o Believes that prices are generally efficient - o A price is efficient if it's no more than twice or half the correct price (ie. price is 2 range from 1 - 4) Burton doesn't agree In his soul he was always a commodities trader Roughly speaking, the market is not distorting prices too much People who believe in the EMH are troubled by large stock fluctuations with seemingly no reasoning behind the shift

EMT on arbitrage

o When irrational optimists buy a stock, smart money sells o When irrational pessimists sell a stock, smart money buys o Eliminates the effect of irrational traders on market price o Shiller is doubtful that smart money has the power to drive market prices to fundamental values

Bandwagon effect

o individuals see a stock price rising and are drawn into the market Underreaction to new information

Random walk

o knowledge of the past doesn't help oSubsequent price changes represent random departures from previous prices

Biased self-attribution

o pattern of human behavior whereby individuals attribute events that confirm the validity of their actions to their own high ability and attribute events hat disconfirm their actions to bad luck or sabotage

Survivorship bias

o poorly performing funds tend to be merged into other funds in the mutual fund's family complex, thus burying many under-performers Affects data

Efficient markets theory

o price of a stock equals the mathematical expectation, conditional on all information available at the time, of the present value P* of actually subsequent dividends accruing to that share o Stock prices are the expected PV of future dividends discounted using marginal rates of substitution of consumption o Price = optimal forecast of P* o P(t) = E(t)P*(t) E(t) = mathematical expectation conditional on public information available at time t o P*(t) = P(t) + U(t) U(t) is the forecast error Consumption discount model does not work well because it does not justify the volatility of stock prices

technical traders will

price of a stock will end to move back toward its value over time o fast technical traders will perceive and speed up o slow technical traders will be unsure and not take larger positions o the farther it moves the faster it will tend to move back Technical "indicators" Ie. rising volume in the market, growing bearishness or bullishness (are people more optimistic now that they were last week?) Past information Weak and semi-strong EMH would say that's irrelevant

The EMH is static or dynamic?

static -Serious limitations Economic theory is designed to come up with some logical explanation for why we see the things we see

If there were no "noise traders,"

then there would be no variance in the price of the risky asset.....but, there are noise traders, hence the risky asset is a risky asset

State the martingale definition of EMH

• E[Xt + s] = Xt. A martingale is a process whose value at any future date is not predictable with certainty. Given the information today, the best estimate of a future stock prices is todays price.