Behavioral Finance Shleifer on Noise Jan 22-27, 2015
Behavioral Finance
Economics 437
Behavioral Finance Shleifer on Noise Jan 22-27, 2015
Euro Debt
Behavioral Finance Shleifer on Noise Jan 22-27, 2015
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
Behavioral Finance Shleifer on Noise Jan 22-27, 2015
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
Behavioral Finance Shleifer on Noise Jan 22-27, 2015
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
Behavioral Finance Shleifer on Noise Jan 22-27, 2015
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
Behavioral Finance Shleifer on Noise Jan 22-27, 2015
Short Sale Mechanics100 shares of GOOG at 1101
Short seller Stock buyer100 shares
$ 110,100
UVA Endowment Short seller100 shares
$ 110,100
Behavioral Finance Shleifer on Noise Jan 22-27, 2015
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)
Behavioral Finance Shleifer on Noise Jan 22-27, 2015
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
Behavioral Finance Shleifer on Noise Jan 22-27, 2015
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
Behavioral Finance Shleifer on Noise Jan 22-27, 2015
Decifering Shleifer Chapter 2
The assets The players Their behavior Equilibrium Profitability of the players
Behavioral Finance Shleifer on Noise Jan 22-27, 2015
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)
Behavioral Finance Shleifer on Noise Jan 22-27, 2015
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
Behavioral Finance Shleifer on Noise Jan 22-27, 2015
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)
Behavioral Finance Shleifer on Noise Jan 22-27, 2015
Question
Can s and u trade at different prices? If yes, EMH is false
Behavioral Finance Shleifer on Noise Jan 22-27, 2015
The End