Behavioral Finance Shleifer on Noise Jan 22-27, 2015 Behavioral Finance Economics 437.

Behavioral Finance Shleifer on Noise Jan 22-27, 2015

Behavioral Finance

Economics 437


Euro Debt


The Efficient Market Hypothesis(EMH) Price captures all relevant

information Modern version based upon

“No Arbitrage” assumption Why do we care? Implications

Only new information effects prices

Publicly known information has no value

Investors should “index” Allocation efficiency


Definition of EMH (Eugene Fama’s Definition) from Shleifer’s Chapter One

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


Black on “Noise”

Black strong believer in noise and noise traders in particular

They lose money according to him (though they may make money for a short while)

Prices are “efficient” if they are within a factor of 2 of “correct” value

Actual prices should have higher volatility than values because of noise


What is a short sale? Sell 100 shares of GOOG at 1101 What happens?

You enter an order to sell 100 shares at 1101 The order is “executed” – meaning that you have sold 100 shares to someone else

somewhere Mechanically, how do provide the 100 shares to the buyer?

You borrow the 100 shares from an institutional holder (like UVA’s Endowment) You provide collateral equal to the value of the stock ($ 110,100) and perhaps a little

more collateral in case the stock price goes up. You mark to market

If stock goes to 1096, you send $ 500 more in cash to lender If stock goes to 1106, lender sends you $ 500 in cash

Where do you get the $ 110,100? The buyer gives you $ 110,100 and you pass that through to the stock lender

On some future date, you buy 100 shares at say 900, paying $ 90,000 which you receive back from the stock lender when you return the 100 shares to the lender


Short Sale Mechanics100 shares of GOOG at 1101

Short seller Stock buyer100 shares

$ 110,100

UVA Endowment Short seller100 shares

$ 110,100


The Law of One Price

Identical things should have identical prices But, what if two identical things have different

names? Example: baseball, hardball Another example: two companies with exact

same cash flow but they are different companies in name, but in every other way they are different (think of two bonds, if it makes any easier to imagine)


Fungibility (convertibility from one form to another) Imagine two “different” products

Product A Product B

Imagine a machine that you can plug A into and out comes B and you can plus B into and out comes A

This is called “fungibility” You can easily turn one thing into another and

vice versa costlessly


The Mysterious Case of Royal Dutch and Shell (stocks) Royal Dutch – incorporated in Netherlands Shell – incorporated in England

Royal Dutch Trades primarily in Netherlands and US Entitled to 60% of company economics

Shell Trades predominantly in the UK Entitled to 40% of company economics

Royal Dutch should trade at 1.5 times Shell But it doesn’t


Decifering Shleifer Chapter 2

The assets The players Their behavior Equilibrium Profitability of the players


Imagine an economy with two assets (financial assets)

A Safe Asset, s An Unsafe Asset, u

Assume a single consumption good

Suppose that s is always convertible (back and forth between the consumption good and itself)

That means the price of s is always 1 in terms of the consumption good (that is why it is called the “safe” asset – it’s price is always 1, regardless of anything)


Safe asset, s, and unsafe asset, u

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


Now imagine

Both s and u pay the same dividend, d d is constant, period after period d is paid with complete certainty, no

uncertainty at all This implies that neither s or u have

“fundamental” risk (If someone gave you 10 units of s and you

never sold it, your outcome would be the same as if someone gave you 10 units of u)


Question

Can s and u trade at different prices? If yes, EMH is false


The End

Behavioral Finance Shleifer on Noise Jan 22-27, 2015 Behavioral Finance Economics 437.

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Transcript of Behavioral Finance Shleifer on Noise Jan 22-27, 2015 Behavioral Finance Economics 437.