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Behavioral Finance exam slides 1
Terms in this set (28)
Tradtional financial economists
assume markets are always efficient - EMH and all participants are rational.
Rational market theory says:
-prices are always right(price = value)
- investors are rational (rational expectation in beliefs and expected utility).
-arbitragers correct mispricing.
argues many financial phenomena are the results of irrationality on the part of some participants and it borrows insigs from cogniitive psyhology.
-prices are sometimes wrong
-Often due to investor irrationality: people make systematic error
-there are limits to arbitrage.
EMH two approaches to investing
-fundamental analysis: good investments can be found thorough careful analysis of financial and economic data
-technical analysis: charting - good investments by examining past price/return patterns.
in 1960s economists intuition that markets were perfectly competeitive, two approaches to investings, no free lunch, securities markets seemed approximate to theoretical "perfectly compeitive markets" which led to EMH
believes there is an efficient capital market. An efficient capital market is a market that is efficeint in processing information. The prices of securities can be observed at any time and are basd on "correct" evaluations of ALL information available in that time. In an efficeint market, prices fully reflect available information.
the hypothesis that real capital markets actually are efficent by fama's definition.
-P= E[P*] for all securiites at all times
E[P*] = E[CF]/(1+E[R])^t
EMH does not say which E[R] or E[CF] use. just says that markets are rate. P is equaly to the best possibel estimate of p* that can be made using a given information set.
the fundamental value, the present value of all cash flows investors rational expect to receive.
Three sets of information might be used to form E[p*]
-all publically available information
-all public and private infomration
three notions of market efficiency
- "Weak form": all info in past prices is efficiently included
- "Semi-strong form": all public info efficiently included
- "Strong form": all info efficiently included (!)
weak form market efficiency
past prices cannot prediect abnormal future returns. Technical analysis is a waste of time
semi strong form
Public information CANNOT predict abnormal future returns. (Fundamental analysis is also waste of time.)
All information (public + private) CANNOT predict abnormal future returns. (Even insider trading CANNOT produce abnormal return.)
Theoretical underpinnings of EMH
EMH looks strong of each of these conditions hold
1. All investors are rational: value securities based on their expected discounted cash flows and accurately use all info to determine E[P*] the fundamental value.
2. Some investors are irrational but their uncorrelated misperceptions cancel out. think that P<E[P
] and an equal number of "pessimists" think P>E[P
], they can trade with each other without affecting P. The pessimists sell to the optimists
3. If arbitrage is unlimited: Big rational institutional investors who trade in large quantities
empirical foundations of EMH
- news is incorporated quickly and accurately. there is no overreaction or under reaction.
-price should not move without any news related to value.
most popular model of expected return
mean variance investors
investors are rational, and like higher mean return, dislike variance.
Rational investors will diversify, and don't acre about the performance of any one asset, only care about overall portfolio return
covariance of i with market/variance of market.
slope of CAPM
Who wins, who loses in investing
If market is efficent (prices are right), average investors can't really make a mistake (as long as they stay diversified). Higher risk will be compensated with higher (expected) return.
If prices are NOT right, unsophisticated traders(who don't understand the game) may lose money. More generally, irrational prices can arbitrarily affect allocation of wealth in the economy
if market is efficent
You lose your job.
If the financial market is indeed completely efficient, the society does not need such a big financial industry.
No need to search good investing strategies, since everything is fair. higher returns with higher risk.
have to see if given information set, once can forecast abnormal returns(risk adjusted returns).
next month the market will perform well
Next month, small stocks will outperform the large stocks.
early EMH tests
Early tests generally supported weak-form EMH
Conclusion: Even if abnormal returns could be forecast (slightly) using past prices, trading costs would probably eat up any profits
joint hypothesis problem
test for abnormal returns
AND Have to maintain a hypothesis about E[R] (e.g., that it is CAPM, or a constant) in order to test the hypothesis of interest (that there are no "abnormal returns")
FFJR Stock Splits
Testing semi strong.
testing if historical, and public information can generate abnormal returns
-Fama, fisher, jensen, roll 1969 studied 940 split events.
- Such events occur after steep price rises
- Since splits are just purely cosmetic changes to the # of shares outstanding
- They shouldn't in themselves affect value of company or returns going forward
Conclusion: On average, investors don't underreact or overreact to stock split. Evidence consistent with semi-strong EMH. FFJR found that you can't use a stock split once it becomes public infor to form a trading rule that earns abnormal returns
three steps to an event study
1. pick a model of expected returns and calculate abnormal returns for each seucirty for each day around the event. AR = Ri-E(r)it
2. take an average abnormal return across securities to get an average abnormal return in "event time"
3. construct the cumulative abnormal return from k through l
Testing semi strong EMH
mutual fund managers rely mainly on publically available information
Jensen (1968) alpha. Do returns on mutual funds just reflect their given level of risk
115 mutual funds over 1945-1964
uses CAPM to model E[R]
Runs 115 regressions to get 115 alphas
Most estimated alphas are around zero
- Before expenses, the average alpha is negative
- After expenses, even more negative
- No evidence of fund manager skill
Conclusion: Early tests supported semi strong. Even highly skilled investors using public info (Mutual Fund managers) didn't make abnormal profits. But still joint hypothesis problem
Michael jensen quote
"I believe there is no other proposition in economics which has more solid empirical evidence than the Efficient Markets Hypothesis."
early EMH Tests
Overall, early tests supported semi-strong EMH
- Most event studies found that mkt reacts correctly to news
- No systematic over or under reaction, therefore no easy trading rules
- Even highly skilled investors using public info (Mutual Fund managers) didn't make abnormal profits.
THIS SET IS OFTEN IN FOLDERS WITH...
FINA4325 Exam Slides 2
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