1. Behavioral Finance Shleifer on Noise Jan 22-27, 2015 Behavioral Finance Economics 437

2. Behavioral Finance Shleifer on Noise Jan 22-27, 2015 Euro Debt

3. Behavioral Finance Shleifer on Noise Jan 22-27, 2015 The Efficient Market Hypothesis (EMH) Price captures all relevant information Modern version based upon “No Arbitrage” assumption Why do we care? Implications Only new information effects prices Publicly known information has no value Investors should “index” Allocation efficiency

4. Behavioral Finance Shleifer on Noise Jan 22-27, 2015 Definition of EMH (Eugene Fama’s Definition) from Shleifer’s Chapter One Weak Hypothesis: past prices and returns are irrelevant Semi-Strong Hypothesis: all publicly known information is irrelevant Strong Hypothesis: public and private information is irrelevant

5. Behavioral Finance Shleifer on Noise Jan 22-27, 2015 Black on “Noise” Black strong believer in noise and noise traders in particular They lose money according to him (though they may make money for a short while) Prices are “efficient” if they are within a factor of 2 of “correct” value Actual prices should have higher volatility than values because of noise

6. Behavioral Finance Shleifer on Noise Jan 22-27, 2015 What is a short sale? Sell 100 shares of GOOG at 1101 What happens? You enter an order to sell 100 shares at 1101 The order is “executed” – meaning that you have sold 100 shares to someone else somewhere Mechanically, how do provide the 100 shares to the buyer? You borrow the 100 shares from an institutional holder (like UVA’s Endowment) You provide collateral equal to the value of the stock ($ 110,100) and perhaps a little more collateral in case the stock price goes up. You mark to market If stock goes to 1096, you send $ 500 more in cash to lender If stock goes to 1106, lender sends you $ 500 in cash Where do you get the $ 110,100? The buyer gives you $ 110,100 and you pass that through to the stock lender On some future date, you buy 100 shares at say 900, paying $ 90,000 which you receive back from the stock lender when you return the 100 shares to the lender

7. Behavioral Finance Shleifer on Noise Jan 22-27, 2015 Short Sale Mechanics 100 shares of GOOG at 1101 Short seller Stock buyer 100 shares $ 110,100 UVA Endowment Short seller 100 shares $ 110,100

8. Behavioral Finance Shleifer on Noise Jan 22-27, 2015 The Law of One Price Identical things should have identical prices But, what if two identical things have different names? Example: baseball, hardball Another example: two companies with exact same cash flow but they are different companies in name, but in every other way they are different (think of two bonds, if it makes any easier to imagine)

9. Behavioral Finance Shleifer on Noise Jan 22-27, 2015 Fungibility (convertibility from one form to another) Imagine two “different” products Product A Product B Imagine a machine that you can plug A into and out comes B and you can plus B into and out comes A This is called “fungibility” You can easily turn one thing into another and vice versa costlessly

10. Behavioral Finance Shleifer on Noise Jan 22-27, 2015 The Mysterious Case of Royal Dutch and Shell (stocks) Royal Dutch – incorporated in Netherlands Shell – incorporated in England Royal Dutch Trades primarily in Netherlands and US Entitled to 60% of company economics Shell Trades predominantly in the UK Entitled to 40% of company economics Royal Dutch should trade at 1.5 times Shell But it doesn’t

11. Behavioral Finance Shleifer on Noise Jan 22-27, 2015 Decifering Shleifer Chapter 2 The assets The players Their behavior Equilibrium Profitability of the players

12. Behavioral Finance Shleifer on Noise Jan 22-27, 2015 Imagine an economy with two assets (financial assets) A Safe Asset, s An Unsafe Asset, u Assume a single consumption good Suppose that s is always convertible (back and forth between the consumption good and itself) That means the price of s is always 1 in terms of the consumption good (that is why it is called the “safe” asset – it’s price is always 1, regardless of anything)

13. Behavioral Finance Shleifer on Noise Jan 22-27, 2015 Safe asset, s, and unsafe asset, u Why is u an unsafe asset? Because it’s price is not fixed because u is not convertible back and forth into the consumption good You buy u on the open market and sell it on the open market

14. Behavioral Finance Shleifer on Noise Jan 22-27, 2015 Now imagine Both s and u pay the same dividend, d d is constant, period after period d is paid with complete certainty, no uncertainty at all This implies that neither s or u have “fundamental” risk (If someone gave you 10 units of s and you never sold it, your outcome would be the same as if someone gave you 10 units of u)

15. Behavioral Finance Shleifer on Noise Jan 22-27, 2015 Question Can s and u trade at different prices? If yes, EMH is false

16. Behavioral Finance Shleifer on Noise Jan 22-27, 2015 The End