Behavioral Finance Economics 437
Reading (starting Jan 22) “Noise Trading” – Limits to Arbitrage Black on Toolkit Shliefer on Toolkit (Chapter 2 in book) Burton & Shah, pp 1-51
Recall Efficient Market Hypothesis (according to Fama 1970) Three forms: Weak Semi-strong Strong Differ by what information is used Weak – past stock prices and returns Semi-strong – publicly known information Strong – all information including private Strong implies S-S implies Weak
Fama’s Conclusions Weak form strongly supported by data Semi-strong seems to be supported but Some evidence of return correlation Strong form contradicted by market maker study
But “traders” saw things otherwise January tells the tale Blue Monday; Happy Friday Good market precede holidays Trading Rules Technical analysis (charting stock prices) Graham and Dodd “Security Analysis” 1934 Price momentum (related to charting) Booms and busts
The Milton Friedman argument for market efficiency in the presence of “noise traders” If noise traders are truly “random,” then their effects will “cancel out.” (Kind of a law of large numbers result) Noise traders are “systematic,” then arbitrage traders will “trade against them” and take all of their money Thus prices will be efficient in either case
The Law of One Price Can the same product trade at two different prices without some tendency for the two prices to converge to one another? Law of One Price says “no” But…….. Oct 19 1987 (22% drop with no information change) Royal Dutch Shell Closed End Funds Palm Pilot Stub Meanwhile: Kahneman and Tversky DeBondt and Thaler Winner’s Curse
Fisher Black on “Noise” Noise is good Otherwise no trades Otherwise no liquidity Is the market efficient? Yes Why? – As long as it is within double the “correct” price
Shleifer, Chapter 2 (or on Collab) Four authors: Shleifer, Summers, DeLong, Waldman Issue: can there be two different prices for two assets with exactly the same “fundamentals” Can such a discrepancy persist? Can ‘noise traders’ actually do better than the ‘smart traders?’
The End