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"41113_MarketEfficiency_handout

"41113_MarketEfficiency_handout - Lecture 6 Market...

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Lecture 6: Market Efficiency Limits to arbitrage Behavioral Theories Readings: BKM chapter 8
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22 Scenario: Ford’s fundamental value is $20. Overly pessimistic investors push down the price to $15. Our assumption has been that arbitrageurs step in and aggressively buy Ford stocks. This pushes the price back up to $20. Efficient Market Hypothesis
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33 Fundamental risk What if arbitrageurs buy Ford (on margin) and a piece of bad news causes Ford’s value to fall further? Noise trader risk What if mispricing worsens in the short-run? Most real-world arbitrageurs are not managing their own money, but rather mange money for other people. à If mispricing worsens in the short-run, generating negative returns, investors may decide the manager is incompetent, and withdraw their funds, forcing the arbitrageur to (prematurely) liquidate their positions. à Arbitrageur may not trade as aggressively b/c he/she is worried about being forced to liquidate their position before prices have corrected Limits to Arbitrage
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44 The effect of leverage: E.g., your weight in Ford is 3, your weight in the risk-free asset is -2 (you borrowed money), the risk-free rate is 5% You buy Ford at $15. Now assume the price of Ford falls to $12 “ r = -20%. What is the return on your portfolio? Small changes in price due to fundamental risk and/or noise trader risk can have devastating effects on your portfolio when highly levered.
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