Lecture09 Limits to Arbitrage

Lecture09 Limits to Arbitrage - Limits to Arbitrage Tyler R...

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Unformatted text preview: Limits to Arbitrage Tyler R. Henry 1 FINA 4310 Outline Contents 1 Behavioral Finance 1 1.1 Limits to Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 1.2 Investor Psychology . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 1 Behavioral Finance Acknowledgement Much of the material for this lecture is adapted from: "A Survey of Behavioral Finance", by Nicholas Barberis and Richard Thaler, September 2002. • Available for free download at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=327880 Investor Rationality Question : Are all investors making rational investment decisions, and if not, does this matter for asset prices? The Response from Classical Asset Pricing: • CAPM: Yes. – Investors are rational mean-variance optimizers, and do mean-variance calculations when making portfolio decisions. • APT: Does not matter. – Rational arbitrageurs with no capital constraints will correct any deviations from fair value (almost) immediately. Pricing Anomalies Are they... 1. Chance sampling outcomes ("data mining")? 2. Inefficiencies that are caused by market frictions? 3. Mispricings caused by persistent irrational behavior? 1 What is Rational? • Traditional theories of asset pricing assume rational agents: – Investors update their beliefs correctly according to the laws of probability (Bayes’ Law) when receiving new information. – Investor preferences are consistent with the notion of maximizing expected utility. • Behavioral explanations of asset pricing assume that not all investors are rational, and relax one or both of the above claims: – Investors fail to update their beliefs correctly (with the wrong probabili- ties), and/or – Investors make decisions that are not self-optimizing. Behavioral Finance Behavioral Finance • A field of finance that considers the effect of psychological biases and deviations from rational, self-optimizing behavior on asset prices. In other words... • Markets are driven by the people that trade in them, and these people may have biases and may make suboptimal decisions. • Ultimately, the important question is: Can these deviations from optimal behavior, on aggregate, affect prices? Behavioral Finance is rooted in two principles: 1. Limits to arbitrage 2. Investor psychology 1.1 Limits to Arbitrage Limits to Arbitrage vs. EMH • Efficient Market Hypothesis (EMH) – Prices reflect fundamental value. – Any deviation from fundamental value is corrected by arbitrageurs. – Irrational effect on prices is thus very short-lived. • Limits to Arbitrage – Market frictions make arbitrage both risky and costly. 2 – Irrational traders ("Noise traders") can have a substantial and long-lived impact on prices....
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This note was uploaded on 06/06/2011 for the course FINA 4310 taught by Professor Staff during the Spring '08 term at UGA.

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Lecture09 Limits to Arbitrage - Limits to Arbitrage Tyler R...

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