6/10/2013 1 Behavioral Finance - PowerPoint Presentation

1. 6/10/20131Behavioral Finance Behavioral Finance

2. Efficient Markets Hypothesis6/10/2013Behavioral Finance2Security prices fully reflect available info (Fama, ‘70)-- identical securities should trade at identical prices = companies with identical cashflows and riskiness (discount factors, cost of capital) are worth the same-- it is impossible to make abnormal returns using only current information = since prices reflect all available information there’s no opportunity for anyone to price securities better then the market does-- one cannot consistently beat the market = abnormal performance is a chance event

3. Efficient Markets Hypothesis -26/10/2013Behavioral Finance3Key components of EMH-- investors are rational= investors do not make mistakes -- if not rational then trade randomly= even if investors do mistakes these are not correlated across investors, i.e. mistakes investors makes are “different” -- if not rational and trade in similar ways then mispricing is eliminated by arbitrageurs= even if mistakes made by some unsophisticated investors point in the same direction, e.g. investors may erroneously believe that security is worth more than it truly is, there is an army of sophisticated investors which will immediately spot the mispricing and correct it

4. Efficient Markets Hypothesis - 36/10/2013Behavioral Finance4[Textbook] Arbitrage:By simultaneously selling and purchasing identical securities at favorably different prices, the arbitrageur captures an immediate payoff with no up-front capital and no riskExample: -- market price of asset 1 > fundamental value -- strategy: sell short the expensive asset 1 and buy “identical”, but cheaper asset 2 (substitute security)Suppose that companies ABC and DEF are identical. Their fair value is 10$/share. However, ABC is currently trading at 12$/share.An arbitrageur would (short) sell the security ABC and buy DEF.

5. Efficient Markets Hypothesis - 46/10/2013Behavioral Finance5This strategy would lead to immediate net payoff of 2$/share. Since there will be many arbitrageurs pursuing this strategy prices of ABC and DEF will equate soon – value of short and long positions would soon be equal = no risk of losing moneyOutcome 1: arbitrageur pockets immediate gain equal to the difference in price of assets 1 and 2, no risk as 1 and 2 have identical pay-offs in the futureOutcome 2: mispricing could only be short-lived as opportunistic behavior of arbitrageurs will bring price of asset 1 back to fundamental value

6. Market Efficiency: subsets of available information6/10/2013Behavioral Finance6.Information in past stock pricesAll Public InformationAll Available Information including inside or private informationEMH: “A market is efficient if it reflects ALL available information”[1] Strong-form [2] Semi-strong form [3] Weak-form

7. 3 forms of market efficiency6/10/2013Behavioral Finance7If Weak-form of the hypothesis is valid:Technical analysis or charting becomes ineffective. You won’t be able to gain abnormal returns based on it.If Semi-strong form of the hypothesis is valid:No analysis will help you attain abnormal returns as long as the analysis is based on publicly available information.If Strong-form of the hypothesis is valid:Any effort to seek out insider information to beat the market are ineffective because the price has already reflected the insider information. Under this form of the hypothesis, the professional investor truly has a zero market value because no form of search or processing of information will consistently produce abnormal returns.

8. Early empirical evidence: semi-strong form 6/10/2013Behavioral Finance8Keown and Pinkerton (1981): target’s stock price reaction to the takeover bidBodie, Kane, and Marcus, “Investments”, 7th ed., p.359

9. Expected Utility paradigm6/10/2013Behavioral Finance9Rational utility maximizersPeople aim to maximize their well being or satisfactionSatisfaction is a function of the goods and services that the individual consumes and be measured using a utility functionMaximization occurs in the presence of budget constraintsCare about levels of goodsIndividuals derive satisfaction from how much goods and services they have at a particular point in time, not how much quantities of goods and services have changed over timeLevel of satisfaction at a certain point in time depends only on the levels/quantities of goods and services at the point in time; the path, i.e. previous quantities are irrelevantCorrectly estimate probabilities of events

10. Let’s do a simple reality check6/10/2013Behavioral Finance10How are you doing?Here’s 20$ How are you doing now?Now give it back to meHow are you doing now?

11. What’s wrong?6/10/2013Behavioral Finance11Why not so happy?Should you be not so happy?You have the right to feel this way; economics should explain why

12. Challenges to EMH: individuals - 16/10/2013Behavioral Finance12Attitude towards riskAssess gambles on changes rather then levels Kahneman and Tversky (1979)Losing-and-gaining or gaining-and-losing equal amounts generally makes you feel worse off (even though your original level of wealth did not get affected)Prefer to play safe when gaining, double up when losing

13. Challenges to EMH: individuals - 26/10/2013Behavioral Finance13Non-Bayesian formation of expectations Do not form expectations about the likelihood of events correctly.Example: see patterns where there’s none

14. Challenges to EMH: individuals - 36/10/2013Behavioral Finance14RepresentativenessLinda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations.Which is more likely?A: Linda is a bank tellerB: Linda is a bank teller and is active in the feminist movementMany people chose answer B even though it is not possible

15. Deal or no deal 6/10/2013Behavioral Finance15Yellow box is the one you set aside, blue ones are on stageThe boxes are worth 1$, 75 000$, 1 000 000$, 1 000 000$You can accept the deal and go homeor no deal and eliminate one of the blue boxes I offer you410 000 $

16. Deal or no deal 6/10/2013Behavioral Finance16Yellow box is the one you set aside, blue ones are on stageThe boxes are worth 1$, 75 000$, 1 000 000$, 1 000 000$You can accept the deal and go homeor no deal and eliminate one of the blue boxes I offer you603 000 $

17. Deal or no deal 6/10/2013Behavioral Finance17Yellow box is the one you set aside, blue ones are on stageThe boxes are worth 1$, 75 000$, 1 000 000$, 1 000 000$You can accept the deal and go homeor no deal and eliminate the remaining blue box I offer you416 000 $

18. Deal or no deal 6/10/2013Behavioral Finance18Yellow box is the one you set aside, blue ones are on stageThe boxes are worth 1$, 75 000$, 1 000 000$, 1 000 000$You are walking home with a yellow box Yes, you are correct, there’s 1 dollar inside

19. 6/10/2013Behavioral Finance19male nurse Richie Bell, “Deal or No Deal”, episode 407 (October 22nd, 2008) People believe that they got hot hands, can influence the outcome etc

20. 6/10/2013Behavioral Finance20Overweighting extreme probabilitiesKahneman and Tversky (1973)Highly unlikely events are either ignored or overweightedChallenges to EMH: individuals - 4Example: We overestimate the risk of ’spectacular’ risks Plane crashesSARSWe underestimate the risk of common risksE.g. Cancer

21. Slovic, Fischhoff, Lichtenstein (1982)6/10/2013Behavioral Finance21

22. Challenges to EMH: individuals - 56/10/2013Behavioral Finance22Example: imagine that the U.S. is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people.Program A: 200 people will be savedProgram B: 1/3 likelihood of 600 saved, 2/3 that none savedProgram A: 400 people will dieProgram B: 1/3 likelihood of nobody dying, 2/3 that 600 die72282278Sensitivity of decision making to framing of the problems Different choices as a result of a different presentation of the same problemBenartzi and Thaler (1995)

23. Do we care about the mistakes of individuals?6/10/2013Behavioral Finance23It is all extremely interesting… People are making a lot of mistakes. May be, by knowing its origin, one can avoid some…”But does it matter for big picture?Errors individuals are making may tend to cancel each other without any effect on aggregate market behaviorIf not, arbitrageurs should eliminate those deviations fastBut do they? (next classes)

24. Challenges to EMH: markets6/10/2013Behavioral Finance24Stocks are more volatile then classical theory can justifyShiller (1981) Past performance can predict futureMean-reversion (contrarian): De Bondt and Thaler (1985)Momentum Carhart (1997)And much more …

25. De Bondt and Thaler (1985)6/10/2013Behavioral Finance25

26. Traditional vs. Behavioral6/10/2013Behavioral Finance26TraditionalRational InvestorsCorrect (Bayesian) Updating of the Likelihoods of Events HappeningChoices Consistent with Expected UtilityArbitrageAlways corrects short-term mispricingBehavioralSome are Not Fully RationalInvestor SentimentsLimits to ArbitrageInvestment horizonRisk-bearing capacity

27. Challenges to Behavioral Finance6/10/2013Behavioral Finance27Collection of stories, not a unified theory(Mostly) does NOT provide magnitudes of the effect, only a directionBehavioral puzzles often can be explained within rational framework if one gives a try …

28. Pontiac Allergic to Ice Cream6/10/2013Behavioral Finance28Pontiac gets a crazy complaintFamily eats ice cream after dinner every nightFamily votes; father drives to get oneVanilla ice cream – car won’t startAny other – just fineCustomer admits that it is silly, but still …Engineer was sent to make a checkResponsible person; many days spent

29. Did the car turn behavioral?6/10/2013Behavioral Finance29First evidence: Vanilla the most popular ice cream; sold at the front for quick pick upOther types – at the back, more time to find and check outThe problem about timing! not vanillaA little bit of critical thinkingVapour lockEngine was still hot when then man got vanilla

30. Roadmap6/10/2013Behavioral Finance30Behavioral FinanceLimits to ArbitragePsychologyViolation of Exp. UtilityViolation of Bayesian Rules

31. Roadmap-26/10/2013Behavioral Finance31Limits to arbitrage:Examples of limits to arbitrageWhat prevents arbitrage from correcting the prices quicklyNoise Trader riskNote: take investor irrationality for granted and analyze the effect on pricesBehavioral BiasesProspect TheoryPsychological Biases: evidence from experimentsMarket AnomaliesNote: try to understand the causes of investor irrationalityBehavioral Trading strategiesIs there money to make?Persistence of behavioral trading strategiesFree lunch or another source of risk?

32. Topics6/10/2013Behavioral Finance32Limits to Arbitrage : securities may not be fairly pricedNegative stubs: subsidiary is worth more than subsidiary+parentRenaming of stocksClosed-end fund puzzleCase on Closed-end fund PuzzleCertainty, Probability and PossibilityHumans do not behave like they were supposed toProspect theoryBehavioral biasesAsset Pricing: Failure of CCAPM and Behavioral ResponseEquity Premium puzzleExcess Volatility PuzzleExcess Correlation puzzleExistence of Cash DividendsSelf-control, Mental Accounting and Regret Avoidance

33. Topics -26/10/2013Behavioral Finance33FramingAffecting choice through different representation of informationAttention AnomaliesDecision making when attention is a scarce resourceLimited attention and stock returnsStock Return PredictabilityAre Stock returns predictable?Overreaction and Underreaction in financial markets

34. Topics -36/10/2013Behavioral Finance34Relativity and AnchoringPeople make judgments in relative rather than absolute termsPeople use (at times arbitrary) anchors / reference points to make judgmentsGroup Process“One brain is good, two brains is better “ is not necessarily trueWhy? Ask EnronHerdingBlind leading blind: how could it happen?How come that herding could be a) rational; b) individually efficient; c) overall inefficient?…Happiness

35. Let’s talk about CAPM CAPM is market efficientRate of return (cost of capital) depends only on systematic risk and that systematic risk can be measured precisely by security’s betaWhat is missing here?All work and no play make Jack a dull boy. All work and no play make Jack a dull boy. All work and no play make Jack a dull boy. All work and no play make Jack a dull boy. All work and no play make Jack a dull boy. All work and no play make Jack a dull boy. All work and no play make Jack a dull boy. All work and no play make Jack a dull boy. All work and no play make Jack a dull boy. All work and no play make Jack a dull boy. All work and no play make Jack a dull boy. All work and no play make Jack a dull boy. All work and no play make Jack a dull boy. All work and no play make Jack a dull boy. 6/10/201335Behavioral Finance

36. 6/10/201336Behavioral Finance

37. Fine print (we tend to forget about):All investors are price takersUnlimited access to funds: can borrow and lend unlimited amounts at the risk-free ratesNo taxes and no transaction costs (that includes no short-selling constraints)Investors attempt to construct efficient porfolios (i.e. The rational utility maximizers)Investors are homogenous: Share same believes about distributions of returnsThey know the same about all assetsWhen you happen to live in the economy blessed with this set of assumptions everyone holds market portfolio (which appear also to be on the efficient frontier), passive investment strategy is optimal and prices of securities reflect fundamentals 6/10/201337Behavioral Finance

38. Limits to arbitrageWhat do we mean by this:1. Price of security does not reflect its fundamental value2. This mispricing is not corrected within short period of timeQuestion: what is the fundamental value of an asset?Suppose I give you a company to evaluate: what is likelihood that you all come to the same conclusion about the company value?Valuation is not easy, a lot of uncertainy involved (model risk)Textbook arbitrage: two identical assets are traded at different prices. Sell expensive, buy cheap – no money involved and no riskReality: There’s no two identical assetsWurgler and Zhuravskaya (2001): at best you can achieve R2 of 25% when trying to explain a return on asset with a matched security (as many of 3 of them)Real arbitrage is not riskless!6/10/201338Behavioral Finance

39. Joint Hypothesis Problem6/10/2013Behavioral Finance39In order to claim that the price of security differs from its fundamental value one needs a proper asset pricing modelFama (1970): any test of mispricing is therefore a joint test of mispricing and of an asset pricing modelIs it that security is mispriced?Or that your model is wrong?__________________________In a number of cases mispricing can be established beyond any reasonable doubt. We are going to analyze some of them

40. Can market add and subtract?Palm, the maker of PalmPilot used to be a division of 3Com4.1% of Palm equity was issued at $38 on March 1, 2000.The shares of Palm opened at $145, peaked at $165 and closed at $95.06At close, this implies a negative value of $21bn put on the remainder of 3Com’s businessThe mispricing persisted for several months6/10/201340Behavioral Finance

41. Negative stubsDefinition: negative stub: market value of the parent is less than market value of parent’s ownership stake in a publicly traded subsidiaryWhere can it come from?:Equity carve-outs (3Com/Palm)Acquisitions of stakes in publicly listed companies6/10/201341Behavioral Finance

42. Value of Palm, 3COM and stub6/10/201342Behavioral Finance

43. 3Com-Palm stub timeline6/10/201343Behavioral Finance

44. Negative stub: how was this possible?6/10/2013Behavioral Finance44Why did the mispricing occure in the first place?A lot of investors bullish on the prospects of Palm; drive price of Palm upWe need a reason why prices deviate from fun-da-mentals: mistakes of investors are correlatedWhy lack of short-selling allows for mispricing to exist/persist?How limits to short-selling affect pricesWhy real-life short selling may be difficultBut then, this creates a risk-free arbitrage opportunity!Buy cheap (3Com), short sell expensive (Palm), pocket the differenceShort selling Palm is risky and virtually impossible (why?)Small Palm floatWe need a reason why arbitrageurs cannot step in and correct mispricing immediately: Short selling overpriced stock was difficult

45. Short-selling allowedOptimistists and pessimists balance each other outCorrect price is achievedShort-selling not allowedOptimists are there, but pessimists can not make their opinion countThe price is biased upwardsoptimistspessimistsoptimists6/10/201345Behavioral Finance

46. Mechanics of Real Life Arbitrage Textbook arbitrage: buy cheap, short sell expensive, no capital involvedReal life arbitrage requires capitalExample:Let if the market value of the parent equal to the market value of its stake in the subsidiary 1 share of a parent be worth 0.7154 shares of a subsidiaryCurrently parent trades at $26.25/share, subsidiary at $48.00.Investor wishes to buy1 share of a parent and sell short 0.7154 shares of a subsidiaryValue of subsidiary less value of parent=48*0.7154-26.25*1=$8.09>0, subsidiary overpriced, negative stubThen she has to contribute at least $30.29 (50 % of both long and short position) to comply with Fed’s requirements (Regulation T), initial margin26.25*1*0.50+48.00*0.7154*0.50=$30.29In addition to posting the required amount, investors may choose to allocate additional precautionary capital6/10/201346Behavioral FinanceThis is how much money we should make when value of parent will become equal to the value of its stake in subsidiaryThis would correspond to 8.09/30.29=26.70% return

47. Mech. of Real Life Arbitrage-2: Short-rebatesIf investor A has a long position in company C and his shares are held through a brokerage acount B then it is a brokerage B who lends shares to another investor D who wishes to sell C’s shares short.A can demand shares of C to be physically delivered to it. In such a case, shares that A owns would not be possible to be shorted (unless directly negotiated with A).A broker who lends shares to investors pays them interest on the amount posted as a collateral to borrow shares, ”short-rebate”Short-rebate is typically 25 to 50 bp less then Fed funds rateHowever, short-rebate may ocasionnaly be lower than that or even NEGATIVE = borrowers pay interest on the collateral they posted6/10/201347Behavioral Finance

48. Mech. of Real Life Arbitrage-3: Margin Callsinvestor is supposed to keep a deposit which corresponds to a certain % of the value of the position : maintenance marginNYSE and NASDAQ require minimum margin of 25% of long positions and 30% of short positionswhat if security prices move such that the investor's position has less then required maintenance margin?he receives a margin calleither post additional collateral or liquidate part of the position to meet margin requirementsbad thing: you have to post additional funds when you are losing money rather than making them ...6/10/201348Behavioral Finance

49. Margin Calls : example cont’dLet’s go back to the previous example:Maintenance margin on NASDAQ is 25% of longs and 30% of shorts 26.25*1*0.25+48.00*0.7154*0.30=$16.87What do we have to worry about? we put $30.29 in initial marginLet prices of both shares doubleMaintenance margin goes up to 52.5*1*0.25+96.00*0.7154*0.30=$33.73>$30.296/10/201349Behavioral Finance

50. Margin Calls : example cont’dPost more collateralWe put additional money in the amount of 33.73-30.29=$3.43If convergence occurs next day we realize 8.09/(30.29+3.43)=23.98%<26.70% we originally expected6/10/201350Behavioral FinanceSame dollar returnOn more invested capital

51. Margin Calls : example cont’dPartially liquidate the positionLet’s do it proportionally x*(52.5*1*.25+96.00*0.7154*.3)= 3.43 x=10.17% of both long and short positions has to be liquidatedIf convergence occurs next day we realize 6/10/201351Behavioral Finance0.8983 bought @ 26.25 liquidated @ P10.6426 sold short @ 48.00 liquidated @ P2(such that the value of long position @ P1 was equal to value of short position @ P2)Dollar profit = -0.8983*26.25+0.6426*48=$7.270.1017 bought @ 26.25 liquidated @ 52.50.0728 sold short @ 48 liquidated @ 96Dollar profit =0.1017(52.5-26.25)+0.0728*(48-96)=$-0.82Total return (7.27-0.82)/30.29=21.27%<26.70% originally expected Lower dollar return on the remaining positionsLoss on part of the position terminated due to a margin call

52. Mech. of R.L. Arbitrage: Shares RecallOnce a short seller has initiated a position by borrowing stock, the borrowed stock may be recalled at any time by the lender.If the short seller is unable to find another lender, he is forced to close his position.6/10/201352Behavioral Finance

53. Some facts about short-selling constraints6/10/2013Behavioral Finance53Short Selling: (US market):– Most stocks can be borrowed– Only 16% of the stocks are impossible to short(mainly small cap stocks)– Only 7% of the loan capacity is currently utilized– 10% of stocks are never shorted– For 91% of the stocks the borrowing costs are less than 1% per annum– Only 9% have average loan fees of ~4%– Recall is rare, only 2% of the stocks on loanSource: D’Avolio, “The market for borrowing stock”In short, market for borrowing stocks usually works very well, except when you want to use, in which case it works terribly.It can be difficult or expensive to short stocks that many people belieave are overpriced and many people want to short.

54. How does the convergence happen:1. favorable movements in the prices of the parent and subsidiaryPrice of parent may increase relative to the price of subsidiary so that the value of the parent will exceed the value of its stake in the subsidiary2. distribution of shares of subsidiary to parent shareholdersThis creates a more liquid market for subsidiary sharesMore opportunities to short, hence arbitragers could correct prices6/10/201354Behavioral Finance

55. We need reasons why arbitrageurs were not taking large positions6/10/201355Behavioral FinanceFundamental riskFinancing riskHorizon riskMargin riskBuy-in riskUncertainty over the nature of anomaly, little ability to hedge

56. Fundamental RiskConvergence of arbitrage spread is by no means assured!About 30% of times the link between parent and subsidiary disappears without converge of the arbitrage spread:Acquisition/delisting of the parent/subsidiaryRemember: 1. The arbitrage trade involves holding a long position in the parent firm and a short position in the subsidiary firm. 2. The long position in the parent firm gives the arbitrageur an indirect holding of the subsidiary firm, which can be shorted out, leaving a net position in only the stub assets. 3. The key to the trade is the link between the parent and the subsidiary firm created by the parent’s substantial ownership of the subsidiary.6/10/201356Behavioral Finance

57. Converge is not clear ahead of timeDaisytek (the parent of PFSWeb) recently announced that it had received an unsolicited offer to acquire all of Daisytek’s outstanding shares. After considering a variety of factors, Daisytek’s board determined that the offer was inadequate and inconsistent with Daisytek’s previously disclosed plans to complete the spin-off. If, however, the bidder decides to begin a tender offer for the outstanding shares of Daisytek without the approval of Daisytek’s board, such an offer, or stockholder litigation in connection with such an offer, could significantly divert our attention away from our operations and disrupt or delay our proposed spin-off from Daisytek. In addition, if the bidder is successful in acquiring control of Daisytek prior to the proposed spin-off, it would control a majority of our shares and the spin-off would likely not occur.6/10/201357Behavioral Finance

58. Financing risk: horizon + margin risksThe path to convergence can be long and bumpyarbitrageurs have to deal with the possibility of interim liquidations even in the case when convergence is certain.Substantial variability in the time to termination, even for negative-stub-value investments that eventually converge:the average time between initial mispricing and a terminating event is 92 days, the minimum is 1 day the maximum is 2796 daysas a result: even if convergence is eventually achieved, the negative-stub-investment often underperforms the risk-free ratediscourages investments by arbitrageurs who are uncertain of the time to convergence and unable to close the arbitrage spread of their own6/10/201358Behavioral Finance

59. Horizon risk (illustration):increasing the length of the path reduces the arbitrageur's return: "horizon" riskillustration: if investment strategy yields 15% return over 92 days (sample median) annualized return is 47%a decrease in the number of days to 25th percentile increases the return to 238% annualizedan increase to 75th percentile would decrease annualized return to 14%6/10/201359Behavioral Finance

60. Margin riskIf the arbitrageur faces a margin call, he will be forced to post additional collateral or partially liquidateExample: Creative Computers/UbidCreative Computer (parent) ; Ubid (subsidiary). On December 4th 1998 parent carves out 20% of its online auctions subsidiary in an IPO. At the time of IPO announces intention to distribute, after a minimum of 6 month, the remaining shares of Ubid to Creative Computer's shareholdersAt the end of first trading day Ubid's total equity was 349$ mlnThe implied value of Creative Computer's 80% stake in Ubid was greater then Creative Computers' total market value by appr 80$ mln6/10/201360Behavioral Finance

61. What could have been in ideal worldSince shares at IPO companies are often not available shorting for a few days following IPO let's assume that arbitrageur's initial trade was placed on December 9th, 4 days following the IPO. By the time the value of the stub was -28$mln (mispricing has decreased)Arbitrageur trying to profit from this opportunity should have shorted 0.72 shares of Ubid for every 1 long share of Creative ComputerIn six months, if the remaining Ubid shares were distributed , the value of the stub would turn positive, anticipated return at the end of six months ~45%6/10/201361Behavioral Finance

62. How it happened in realityBy December 18, 1998, the discrepancy between Creative Computers and Ubid stock prices had increased substantially—the value of the stub assets had decreased from negative $28 million to negative $94 million. Using margin maintenance requirements specified by NYSE and NASD, the arbitrageur would have faced a margin call and would have been forced to partially liquidate his position to satisfy maintenance margin requirements. The arbitrageur would have lost 26 percent in seven trading days.6/10/201362Behavioral Finance

63. How it happened in reality-2On December 21, 1998, the value of Creative Computers’ stub assets decreased to negative $254 million. For a second trading day in a row, the arbitrageur would have faced a margin call and been forced to reduce his position even further, incurring an additional one-day loss of 84 percent. Bad luck continued when, on the following trading day, the value of Creative Computers’ stub assets fell to negative $505 million, causing a one-day loss of 91 percent. 6/10/201363Behavioral Finance

64. How it happened in reality-3On December 23, 1998, the value of Creative Computers’ stub assets reached its minimum level of negative $766 million. The arbitrageur received his fourth and final margin call and an additional one-day loss of 63 percent.After December 23, 1998, the prices of Ubid and Creative Computers become to converge.6/10/201364Behavioral Finance

65. Creative Computers/Ubid timeline6/10/201365Behavioral Finance

66. How did it come out eventually?The portion of the arbitrageur’s capital that was not liquidated returned 150 percent between the peak mispricing on December 23, 1998, and the spinoff on June 7, 1999. However, because the arbitrageur lost most of his capital prior to December 23, 1999, his overall return from the Creative Computers/Ubid investment was negative 99 percent. To avoid the costly margin calls, the arbitrageur would have had to post $4.53 of excess cash for every $1 of long position. Doing so would have generated a return of 8.7% between December 9, 1998, and June 7,1999. This is significantly lower then 45.9% return he could have obtain with the same initial investment had he not been required to liquidate to meet margin calls.Note: setting so much capital aside either requires perfect foresight or very deep pockets and nerves of steel6/10/201366Behavioral Finance

67. What if we create portfolios?A bit better, but still not so well: abnormal performance in excess of 1% monthly, but barely statistically significantdiversification may alleviate the problem of margin calls to some extent, but not solve it completelyGraph: at one point the spread on most of the negative stub spreads widened6/10/201367Behavioral Finance

68. Buy-in riskif arbitrageur is unable to maintain his short position he will be forced to terminate the trade.When shares available for shorting are most scarce, brokers cannot maintain their clients’ short positions no matter what interest rate the investor is willing to pay. This situation, which arises when owners of the stock demand that their loaned-out shares be returned, is often referred to as being “bought-in.”The possibility of being bought-in at an unattractive price provides a disincentive for arbitrageurs to take a large position and represents a substantial friction to executing the arbitrage trade.Overall: returns to a specialized arbitrageur would be roughly 50% higher if the path to termination was smooth6/10/201368Behavioral Finance

69. Buy-in risk -2 : negative short-rebateConsider the case of the most extreme negative short rebate, Stratos Lightwave. An arbitrageur wishing to exploit the relative mispricing of Methode/Stratos Lightwave would have been charged a 40% annual interest rate on short proceeds from short selling Stratos Lightwave. The arbitrageur would have invested in the deal on July 11, 2000, and would have still been invested at the end of the year. Over this period, the equity value of the position increased 21.1 percent before including the effects of the negative short rebate. However, after paying nearly six months of negative short rebate, the arbitrageur’s return is reduced to -0.6%.6/10/201369Behavioral Finance

70. Why did negative stub value persist?1. enormous uncertainty over the economic nature of the mispricing and time to learn about it. 2. Uncertainty over the distribution of returns (after all there are not so many cases when mispricing was so apparent). Remember that in about 30% of cases arbitrage opportunity terminated without convergence. Events which are causing disadvantageous termination are idiosyncratic, hence could not be hedged against.3. uncertainty over the course of actions when mispricing widens. Remember Creative Computers6/10/201370Behavioral Finance

71. PunchlineAt times some crazy things happenMispricing can persist for a long period of time due to limits to arbitrageCosts and risks for arbitragers are substantialAdditionally, a lot of uncertainty aboutThe economic nature of the phenomenon (there are not so many of these events to be prepared to act in advance)The profit opportunities it offersDistribution of returns is very non-normal and though on average there are some abnormal profits to make at times arbitrageur’s entire wealth would be wiped out before Transaction costs also have a huge bit on arbitrageur’s profitsBright side: fewer then 100 cases in 15 years. 6/10/201371Behavioral Finance

72. Short-selling constraints again ...Negative stubs: is this the only time when short-selling constraints lead to inflated prices of assets?Greenwood (2009):Examines a series of stock splits in Japan in which firms restrict the ability of their investors to sell their shares for a period of approximately 2 months. By removing potential sellers from the market, the restrictions have the effect of increasing the impact of trading on prices. The greater the desire of investors to trade, and the greater the restrictions, the larger the impact of the restrictions. Particularly severe restrictions are associated with returns of over 30% around the ex-date, most of which are reversed when investors are allowed to sell again. Firms are more likely to issue equity or redeem convertible debt during the restricted period, suggesting strong incentives for manipulation.6/10/201372Behavioral Finance

73. SS constraints: spillover to other marketsSo far: constraints on short-selling equity lead to inflated prices of equity, may persist for a long timeHow about other markets? Do constraints on short-selling equity have effect on equity derivative markets?Robert Battalio and Paul Schultz “Hastily Implementing Rules that are not Well Thought Out: The Impact of the 2008 Short Sale Ban on Equity Option Markets“In the early morning hours of September 19th, the SEC issued a ban, effective immediately, on short selling for 797 financial stocks. The ban was set to expire in 10 days, but could be extended to 30 days at the SEC’s discretion. 6/10/201373Behavioral Finance

74. SS constraints: cont’dWere options markets used to avoid the short selling restrictions?How did the ban affect trading costs and liquidity in the options market?Did biases in option prices emerge during the short sale ban?Did the short sale ban produce price gaps that would allow arbitrage profits to be earned with short selling?6/10/201374Behavioral FinanceFind no evidence of a migration of trading to the options market.Disastrously. By all measures, trading costs increased dramatically for options on banned stocks.Yes, it did. Put call parity was grossly violatedYes, when the arbitrage required selling the shares short and buying stock synthetically. In practice, these opportunities could not be exploited.

75. Companies Fighting Short SellingMany corporate managers do not like short-sellers as they believe that their actions are directed toward artificially reducing the price of the stock“Your activities are mean, shameful and loathsome. They are motivated by appalling avarice and greed, and they will not be permitted to go unanswered”.Firms can take a variety of actions to impede short-selling of their stocksCoordinate with their shareholders to withdraw shares from short-selling marketFile lawsuit against short-sellers as those spreading false information about the companyDevise technical actions which force shareholders not to lendRequire shareholders to send their stock certificated to the firm’s transfer agent in order to receive a distribution. An owner cannot send in the certificate unless he is in physical possession of it.6/10/201375Behavioral Finance

76. Companies Fighting Short selling -2Solv-Ex, a firm that claimed to have a technology for economically extracting crude oil from tar-laden sand.Short sellers claimed Solv-Ex was a fraud.Managers of Solv-Ex faxed a letter to brokers and shareholders “To help you control the value of your investment … we suggest that you request delivery of the Solv-Ex certificates as soon as possible”.Any shareholder which follow Solv-Ex suggestion would have withdrawn his shares from the stock lending market, making short-selling more difficult/expensive.Additionally, Solv-Ex hireda private investigator to find out who was spreading misinformation about the firm and subsequently filed suit against a well-know short-seller, claiming he had spread false information.6/10/201376Behavioral Finance

77. Companies Fighting Short selling -3It appears that companies fighting short selling do in fact have a reason to be worried aboutTheir shares appear to be overpriced4-factor adjusted returns are -2.40%/month!Actions, that firms undertake make short-selling more expensive, lead to distorted prices6/10/201377Behavioral Finance

78. Companies Fighting Short selling -4In 1991 SEC official testified: “many of the complaints we receive about alleged illegal short selling com from companies and corporate officers who are themselves under investigation by the Commission or others for possible violations of the securities or other laws”.During the same testimony officials from three firms testified as well.Subsequent to this testimony, the presidents of two of these three firms were prosecuted for fraud.For third firm, the SEC determined the company had made materially false and misleading statements, but that the evidence was insufficient to prosecute.What happened to Solv-Ex?Within a year Solv-Ex delisted and shortly thereafter entered bankruptcy. In 2000 the court ruled that the firm defrauded investors.6/10/201378Behavioral Finance

79. A rose is a rose is a rose is a rose ...No, common sense tells us it is not (unless it is a credible signal about one’s future looks)In fact, if you chose a “hot” name it does helpSee Cooper et al. (2003): Measuring the effect of renaming a company to “.com” during the bubble yearsRoughly a 80% announcement effectMeasuring the effect of removing “.com” after the bubble yearsRoughly 70% cumulative abnormal returnIfcalls himselfdoes it make him more attractive?6/10/201379Behavioral Finance

80. Cooper et al ”A Rose by Any Other Name”6/10/201380Behavioral Finance

81. Money on the table?What caused the mispricing?Errors by individual investors, often confused about what they buy”When AppNet Systems filed for IPO under symbol APPN, investors began buying shares of Appian Technology (inactive circuit manufacturer) even before the IPO of AppNet systems”. Appian technology earned return of 142.757% in two days after filing with over 7.3 mlns shares traded, compared to 200 the day before filing.Micro stocksVery small size and trading volumeA buy or sell order moves price up or down (price taking)No arbitrageur would mess up with a profit opportunity of 300$.6/10/201381Behavioral Finance

82. Closed-end fund puzzle6/10/2013Behavioral Finance82Mutual fund industry:Broadly speaking the industry is divided into three types of fundsMutual Funds (open-end funds)Closed End FundsHedge FundsClosed-end fund:Holds publicly traded securities(Unlike open-end fund) issues a fixed number of shares that are traded on a stock marketTo liquidate a holding in a fund investor must trade with other investors, cannot redeem shares with a fund itself.

83. Closed-end fund puzzle -2 6/10/2013Behavioral Finance83Lee, Shleifer and Thaler (1991) define the puzzle as: Closed-end funds are usually issued at about 10% premium to their NAV, more often than not start trading at a premium NAV, and then decline. On average, closed end funds trade at a discount of 10 to 20 % relative to their NAV The discount is subject to wide variation over time and across funds. Discounts disappear as the fund approaches the open end date Discount co-varies with return on small stocks

84. Closed-end fund puzzle -36/10/2013Behavioral Finance84

85. Earlier rational explanations6/10/2013Behavioral Finance85TaxesReported NAV of a closed-fund funds does not reflect the capital gains tax that must be paid by the fund if the assets in the funds are sold.The tax liability associated with assets which have appreciated in value would reduce the liquidation value of the fund’s assetsProblems:The discounts are too large to be explained by taxesThe discounts should widen when the stock market raises which is opposite to what is observed in realityAt the fund’s closure (open ending) NAV should fall down to the fund’s share prices, however it is funds prices go up to be closer to NAVs

86. Earlier rational explanations -26/10/2013Behavioral Finance86Assets IlliquidityIf closed-end funds hold substantial amounts of illiquid (and/or private) stocks the market value of these securities would be lower then that of similar liquid stocks. However, these illiquid securities may be overvalued in calculation of NAVProblems: large closed-end funds (like TRICON) hold almost exclusively very liquid stocks. The effect is likely to be less then 0.5%Additionally regulation required the funds to discount illiquid securities when calculating NAV to reflect their true market valueWhat if closed-end funds hold large blocks of securities and their discounts merely reflect the fact that such blocks could only be liquidated at a discount?But then we would expect the price of the fund to go down at the announcement of its closure (anticipation of discounted selling)Instead, the price of the fund goes up, gets closer to NAV.

87. Earlier rational explanations -36/10/2013Behavioral Finance87Agency costs (management expenses)Management fees are relatively stable: fixed % of NAV, little fluctuationsClosed-end funds’ discount exhibit wild swingsAdditionally, can not explain why closed-end funds initially sell at a premium

88. Beh.’l Explanation of closed end fund puzzle6/10/2013Behavioral Finance88We draw from the model of noise trader risk discussed beforeSuppose that the safe asser s is the portfolios of a closed end fund, and the unsafe asset u is the fund itselfSuppose that noise’ traders’ beliefs about the return on u relatively to the return on s are subject to fluctuating sentimentThe risk from holding a closed end fund (and any other security subject to the same sentiment) consists of two partsThe risk of holding fund’s portfolio itself We abstract from thatRisk that noise trader sentiment about the funds changesThe latter leads to a discount relatively to NAVRecall: more risky security is traded at a lower priceSince sentiment is stochastic (random) this leads to time-variation in a discountNote: think of price of u as expressed relative to s. In that way the price of s (relative to s) ≡ 1. Now you could fit closed-end fund puzzle into the model of investor sentiments without any adjustments.

89. Behavioral Explanation -2 6/10/2013Behavioral Finance89The noise trader approach to closed end fund puzzle explains why fund mispricing relatively to its portfolios is not eliminated by arbitrageThe hedge in which an arbitrageur buys an underpriced closed end fund, and sells short its underlying portfolio, even if feasible and costless, is not a pure arbitrage opportunity unless the arbitrageursHave an infitinte time horizonNever forced to liquidate their positions

90. Behavioral Explanation -36/10/2013Behavioral Finance90Why wouldn’t a threat of takeover push prices back to fundamentals (NAV)?Free-raiding funds’ investors would not tender their shares unless they get NAV; no gain for arbitrageurSome of closed-end fund successfully fought multiple restructuring attempts

91. Behavioral Explanation -46/10/2013Behavioral Finance91Why would funds go public at a premium?When investors are particularly overexcited, entrepreneurs can profit by putting assets into closed end funds and selling them to noise traders. In fact, most of the funds are started when discounts are relatively lowLST: ”It seems necessary to introduce some type of irrational investors to be able to explain why anyone buys the fund shares at the start when the expected return over the next few months is negative”.

92. 6/10/2013Behavioral Finance92

93. Behavioral Explanation -56/10/2013Behavioral Finance93Why is discount eliminated at the announcement of the fund closure?Noise trade risk is being eliminated (reduced) and so the discountYou know the terminal date = when the convergence between fund’s price and NAV would be achieved, i.e. when there would be no mispricingThe latter means that investing in a close end fund becomes a riskless strategy (subject to the promise of fund’s liquidation to come true)

94. Behavioral Explanation -66/10/2013Behavioral Finance94Securities/portfolios affected by the same sentiment should comoveCo-movement of discounts of closed-end fundsSince closed-end funds are held primarily by individual investors it is not surprising that the discount comoves with returns on small stocks (which are also dispropportionally held by small investors)

95. Closed-end Fund: Rational Re-thinking6/10/2013Behavioral Finance95Elton, Gruber and Busse (1998): If investor sentiment is a market wide phenomenon (systematic risk factor like size, book/market or momentum) than it should be reflected in stock returns/ values:Stocks which are more subject to investor sentiment should be priced lower (extra risk)Relate investor sentiment (proxied by the discount on the closed-end funds) to stock returns and portfolio returns and find no evidence of a relationshipPresumably investor sentiment should affect larger stocks (held primarily by large institutional investors) to a lesser degree and have more pronounced effect for smaller stocksFind no evidence of this after controlling for usual risk factorsEGB conclusion: closed-end fund discount is not related to a systematic risk

96. Steve Ross’s critique:6/10/2013Behavioral Finance96Consider a fund whose manager is paid a fraction c of the fund’s value at the end each year (say 1%)What is the value of manager’s claim if investor leaves money in fund forever, and all dividends are reinvested?PV of first years’ compensation = c x current value of fundPV of second year’s compensation = c x (1-c) x current valueThe current manager gets everything! This holds for any c>0 {any management fee}

97. Steve Ross’s critique: (cont’d)6/10/2013Behavioral Finance97In general, if the fund pays a constant fraction of assets every year, , and if the manager charges a proportional fee , then Fee based discount: Df = /( + )Plug in actual numbers and we obtain that average discount is about 7.7%; just like in realityDiscounts are positively correlated with NAV’s and negatively correlated with market returnsWhen NAV goes up less dividends are paid: dividend + (unrealized) capital gainWhen stock market goes up more dividends are paid: keeping up with a benchmark

98. Steve Ross’s critique: (cont’d)-26/10/2013Behavioral Finance98Why do we observe that returns on small stock and returns on closed end funds are correlated? This holds even for country funds (which invest in foreign securities)?As a fund manager you want to keep your clients happy:Once again: small stocks and closed end funds (domestic or country) are held primarily by individual investorsWhen returns on small stocks do well you want live a good feeling with your clients which also hold small stocks in their portfoliosIt is true both for domestic and country funds as they serve the same clientele

99. Steve Ross’s critique: (cont’d)-36/10/2013Behavioral Finance99But why do these funds start at a premium?Let’s go back to our nice picture on short-selling constraintsOnly optimistic investors buy closed end funds at the inception; pessimistic investors could not make their opinions count – no shorting ability; arbitrage is limitedoptimists

100. Jonathan Berk’s critique6/10/2013Behavioral Finance100 Fee based discount: Df = /( + ) is enough to explain the average magnitude of discounts, but there’s not enough variation in fees to explain the cross-sectional variation in discountsManagerial ability:In the absence of fees, good managers should trade at premia and bad managers should trade for a discountProblem:Investors must expect that manager is good or average at the IPOAfter the IPO investors must expect most managers to be poorLST: Logic suggests that it is impossible for both predictions to be rational

101. Jonathan Berk’s critique -26/10/2013Behavioral Finance101Competitive capital marketsInvestors always receive a fair returnBerk and Green (2002): tradeoff -- fees (-) vs ability (+)If managers add more in ability than they charge in fees the funds must trade at premiumIf managers add less in ability that they charge in fees the fund must trade at a discount

102. Jonathan Berk’s critique -36/10/2013Behavioral Finance102Inferences:Uncertainty exists on managerial abilityNeither investors nor the manager himself knows the ability of the manager, they have the same priors and update based on the same info.What happens?Bad managers are entrenched and so these funds trade at discountsGood managers leave so these funds do not trade at premia.

103. Jonathan Berk’s critique -46/10/2013Behavioral Finance103Closed end fund IPOPick a fee such that a fund trades at parInvestors understand that they are providing employment insurance for the manager, the fee is reduced to take this option into accountSo this means that for the first period, at least, investors expect managers to make more than they charge in feesPost IPOInvestors expect good managers to leave (or get a pay raise) and bad managers to become entrenched, so they rational expected the average fund to fall into discountThey still get a fair return, because in each period, the discount adjusts to ensure this

104. Jonathan Berk’s critique -56/10/2013Behavioral Finance104DiscountsSince discounts adjust to ensure that investors get a competitive return, they reflect the cross sectional variation in management ability, so they have wide cross sectional and time series variationSince discounts are the capitalized value of the expected cost of entrenchment, they shrink to zero as the open end date approachesAside: It’s not cross sectional variation in fees that drives variation in discounts --- it is variation in perceived ability.

105. Summary of rational critiques6/10/2013Behavioral Finance105The conclusion that the behavior of closed end funds is a hard proof evidence of irrationality is premature

106. Limits to arbitrage: summary6/10/2013Behavioral Finance106Markets are efficient (mostly)Prices may not reflect fundamental valuesMistakes of investors may not cancel outHowever, this is not sufficient for the prices to deviate from fundamentalsCause arbitrageurs have to be unable to do their jobThis may happen due to their limited risk-taking ability Risk of mispricing widening & performance based arbitrageLiquidity shortageShort-selling constraintsAt times profit opportunites are also too small for arbitrageurs to be botheredReal-life arbitrage is risky; taking into accounts convergence risk and transaction costs profit opportunities are usually not that great

107. Limits to arbitrage: summary -26/10/2013Behavioral Finance107“prices are right” “no free lunch”“no free lunch” “prices are right”Even though the security is mispriced returns are not necessarily predictableRisk of forced liquidation means that many arbitrageurs effectively face short horizon may not be able to wait until mispricing disappears = possibility of a lossHence, do not take large positionsThe road to the disappearance of mispricing may be very bumpy; Implies that arbitrageurs’ returns adversely affected by forced liquidations due to capital shortages, margin calls etc; model risk