By Charles M. C. Lee Peking University Stanford University

3. Seminar Outline Informational role of markets The social value of markets in society Limits of a na�ve view of market efficiency An alternative framework Integrating behavioral finance and fundamental analysis Applications to accounting research

4. The Role of Markets What is the social value of markets?

5. The role of markets in society

6. The role of markets in society

7. The role of markets in society

8. The Efficient Market Hypothesis

11. The Central Paradox

14. Cornell Cayuga MBA Fund

16. II. An Integrative Framework

17. Shiller (1984): A Noise Trader Alternative

18. Shiller (1984):

19. Implications of the Model

20. How might we measure sentiment? A. Focus on fundamental value Estimate the present value of future cash flows for a firm (V), and compare it to price. The difference is a measure of investor sentiment. B. Focus on noise trader demand Look for sentiment indicators that help to predict the direction of noise trader demand (Yt )

21. What gives rise to sentiment? Sentiment involves systematic deviations of price from intrinsic value The mistakes must be correlated across noise traders More like mass psychology than animal spirits What gives rise to a common sentiment? (what affects Yt ?) sub-optimal use of actual signals misreaction to value-relevant information (earnings surprises, quality-of-earnings indicators) Black: �pseudo-signals� signals that contain no real information, yet are persuasive

22. Example: Conolog Corp (CNLG), Thurs 2/17/2005

23. The news event�

24. Commentary�

25. Understanding the information

26. Equilibrium is reached by the end of the third day�

27. An Example: KKD (7/7/01)

28. On the other hand�

29. So what is next for KKD?

30. KKD: Revisited (next 12 months)

31. KKD: Revisited (a longer view)

32. Prices in equity markets are much noisier than many people expect Black (1986): "All estimates of value are noisy, so we can never know how far away price is from value. However, we might define an efficient market as one in which price is within a factor of 2 of value, i.e., the price is more than half of value and less than twice value� By this definition, I think almost all markets are efficient almost all the time. "Almost all" means at least 90%."

33. Evidence from Closed-end Funds: A closed-end fund is a publicly traded stock whose only asset consists of a portfolio of other publicly traded securities. The closed-end fund puzzle is the empirical phenomenon that the stock price (SP) of these funds is rarely equal to the net asset value (NAV) of these securities. Typically, these funds trade at a discount to their NAV (DISC = (SP-NAV)/NAV*100). Occasionally, they also trade at a premium. For U. S. funds DISC routinely fluctuate between an upper bound of around +5 to 10%, and a lower bound of �30% to 40%. (LST (1991)) What accounts for the upper and lower bounds on DISC? If arbitrage bounds can be this wide when valuation is transparent, how wide would they be for other stocks?

34. Relevance to Accounting Research

35. But I don�t like behavioral assumptions� This is a useful framework in which to think about mispricing in equilibrium, even if you do not wish to make behavioral assumptions Two out of the three key elements do not require behavioral assumptions However, if you wish to understand forces that drive price away from �value� (the time-series behavior of Yt), you need a theory of mistakes