6/10/2013 1 Behavioral Finance Behavioral Finance

Transcript:6/10/2013 1 Behavioral Finance Behavioral Finance:
6/10/2013 1 Behavioral Finance Behavioral Finance Efficient Markets Hypothesis 6/10/2013 Behavioral Finance 2 Security 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 Efficient Markets Hypothesis -2 6/10/2013 Behavioral Finance 3 Key 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 Efficient Markets Hypothesis - 3 6/10/2013 Behavioral Finance 4 [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 risk Example: -- 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. Efficient Markets Hypothesis - 4 6/10/2013 Behavioral Finance 5 This 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 money Outcome 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 future Outcome 2: mispricing could only be short-lived as opportunistic behavior of arbitrageurs will bring price of asset 1 back to fundamental value Market Efficiency: subsets of available information