Lecture note 6- Market efficiency.pdf

Lecture note 6- Market efficiency.pdf - Behavioral...

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Behavioral Economics and Finance Efficient Markets and Noise Trading February 14, 2018 Behavioral Economics and Finance 1 / 32
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This Week Efficient Markets and Arbitrage; Noise Traders and Limits to Arbitrage. Behavioral Economics and Finance 2 / 32
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Prior to the Efficient Market Hypothesis Until the 1960’s there were two basic approaches to investing: Fundamental analysis; Good investments can be found through careful analysis of financial statements and economic data. Graham and Dodd’s Security Analysis (1934). Technical analysis Good investments can be found through careful analysis of past price/return patterns. Until the 1960s, academia had little to add. Behavioral Economics and Finance 3 / 32
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Competitive Markets In the 1960’s economists continued do develop theories of competitive markets. Agents compete with one another down to zero economic profits. In a perfectly competitive market, can there ever be a free lunch? Do securities markets appear competitive? Behavioral Economics and Finance 4 / 32
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Efficient Capital Markets Eugene Fama (1976): “An efficient capital market is a market that is efficient in processing information. The prices of securities observed at any time are based on ‘correct’ evaluations of all information available at that time. In an efficient market, prices ‘fully reflect’ available information." The Efficient Market Hypothesis (EMH): Real capital markets are efficient by Fama’s definition. Behavioral Economics and Finance 5 / 32
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Efficient Capital Markets Alternatively: P = E [ P * ] , where P is the price of a financial asset and P * is its fundamental value and so all securities n with time- t cash flows CF nt and discount rates R nt : P = E [ P * ] = X t = 1 E CF nt 1 + R nt (1) The EMH does not necessarily state the correct cash flows and discount rates to use. The EMH does state that the cash flows and discount rates implicit in market prices are “correct”. Behavioral Economics and Finance 6 / 32
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Expectations and Information As everywhere else, expectations E [] are taken with respect to some information set. What are the different kinds of information sets used to form expectations about fundamental value? Typically think of three (each leading to a distinct notion of efficiency): Past prices/returns (weak form); Publicly -available information (semi-strong form); Public and private information (strong form). Behavioral Economics and Finance 7 / 32
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Price Implications of Different Notions of Efficiency Suppose an earnings announcement for a publicly-traded company.
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