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Chapter 4: Challenges to

market efficiency
Powerpoint Slides to accompany Behavioral
Finance: Psychology, Decision-making and
Markets by Lucy F. Ackert & Richard Deaves

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

Key trading rules that have


shown to be effective i.
Small cap portfolios vs. large cap
portfolios?
Small cap wins out!

Portfolios formed based on P/Es:


Low P/Es do better!

Earnings announcements
momentum:
Reaction to extreme announcements is slow!
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2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

Key trading rules that have


shown to be effective ii.
Value vs. growth portfolios (usually
value firm has a high book/market
and a growth firm here is one with an
absence of value):
Go for value!

Predictable serial correlation:


Medium-term momentum!

Long-term winners vs. losers:


Reversals: losers become winners!
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2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

Value vs. growth portfolios:


International evidence

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

Momentum evidence

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

Reversal evidence

Source: Figure 3 from De Bondt, W. F. M., and R. Thaler, 1985, Does the stock market overreact?
Journal of
Finance 40, 793807. 1985 Wiley Publishing, Inc. this material is used by permission of John Wiley
& Sons, Inc.

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

Theoretical foundations of
efficient markets
Market efficiency requires that only
one of the following three conditions
need hold:
1.Universal rationality
2.Uncorrelated errors
3.Unlimited arbitrage

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

Market efficiency and


arbitrage
One of main foundations of EMH is
no-arbitrage condition.
If there are pricing errors (e.g.,
caused by irrational investors) smartmoney traders arbitrage them away.
No free lunches are left on the table!

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

Example of arbitrage
opportunity: Triangular
arbitrage

February 27/06
$Cdn/$US forex rate = 1.1426
$US/euro forex rate = 1.1855
What must $Cdn/euro rate be to
nullify arbitrage?
1.1426 * 1.1855 = 1.3546
While this was observed, what if this
had not been true?
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2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

What hampers arbitrage


exploitation?
1. Fundamental risk
2. Noise-trader risk
3. Implementation costs

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2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

Fundamental risk
If you think a stock is underpriced you
can buy it, but:
You might be sideswiped by the market.
Or maybe by the industry.
Plus there is idiosyncratic risk.

Pure arbitrage seeks to eliminate all of


these.
Problem: you need to find perfect
substitutes.
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2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

But where are these


substitutes?
Say Ford is too cheap.
You buy Ford.
But market may drop.
Or auto industry may drop.

So you buy Ford and short GM.


But Ford itself may falter without industry or market
dropping (idiosyncratic risk) .

Even you totally manage fundamental


risk, there is still noise-trader risk:
spread may widen as investors get it
even more wrong.
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2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

Sentiment and noise


Noise is opinion on value unrelated to
fundamental information (i.e., based
on misinformation)
Sentiment is correlated noise, and has
the potential power to move markets.
This implies that price movements can
be driven by misinformation rather
than information.
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2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

Noise-trader risk
Noise trader risk is risk that mispricing being
exploited by the arbitrageur might worsen.
It has been shown that noise-trader risk is
systematic, which means that it cannot be
diversified away.
Real world arbitrageurs cannot wait it out
because as professional money managers
they do not have long horizons they are
usually evaluated at least at once per year.

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2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

Implementation costs
In some cases, horizon is short but shortselling is:
Expensive (commissions, spreads, price impact &
fees for shorting stock)
Difficult or even impossible (lack of
availability regardless of fees; legal factors: many
institutions cannot short)

Plus there is cost of finding these arbitrage


opportunities.

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

3Com and Palm


March 2, 2000: 3Com carves out in an
IPO 5% of its subsidiary Palm.
At same time 3Com announced that
in the near future the remaining 95%
of the shares would be distributed to
current shareholders (roughly 1.5 of
Palm/share of 3Com).
Two ways of buying Palm:
Buy Palm directly.
Buy 3Com getting Palm and rest of 3Com business.
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2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

3Com and Palm cont.


Clearly if investors are rational:
P(3Com) = 1.5* P(Palm) + Residual
value
What happened?
After 1st day of Palm trading:
P(Palm) = $95.06
P(3Com) = $81.81
Implied residual value: less than zero.

Implication: Value of residual 3Com was:


negative $22 billion.
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2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

3Com and Palm cont. ii.


Everyone seemed to understand the
situation:
The nature of the mispricing was so simple that
even the dimmest market participants and financial
journalists were able to grasp it.

Incredibly the mispricing persisted


for months!
And other such examples can be
cited!
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2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

What can explain this?


Smart investors were limited in their ability to
short-sell Palm (as documented in Lamont and
Thaler), so it wasnt their fault.
But this cannot explain why anybody would buy
Palm instead of 3Com for this one needs
irrationality.
In facts 2 things are needed for mispricing to
exist:
Irrational investors
Limits to arbitrage (here due to implementation costs)

3Com & Palm case illustrates that mispricing


does not imply a free lunch!
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2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.