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Behavioral Finance

This review explores the Efficient Market Hypothesis (EMH) and Behavioral Finance, covering the history of EMH, noise trading, and the arguments for and against market efficiency. It also discusses the Law of One Price and the impact of behavioral biases on stock prices.

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Behavioral Finance

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  1. Behavioral Finance Economics 437

  2. Review of EMH • Four Different Articles addressing what EMH means and the history of Behavioral Finance • Shleifer (Chapter 1) • Schiller (on Collab at course website) • Malkiel (on Collab at course website) • Fama (on Collab at course website)

  3. Reading (starting Jan 25)“Noise Trading” – Limits to Arbitrage • Black on Toolkit • Shliefer on Toolkit or Chapter 2 in book • Burton & Shah, pp 1-51

  4. 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

  5. The 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

  6. 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

  7. Others: • Shiller: focuses on who volatile stock prices are relative to how stable are the things that are supposed to determine stock prices – expected future interest rates, dividends, etc. • Malkiel: argues that it is extremely difficult to “beat the market” implying that that must mean that EMH is likely to be true • Shleifer: makes the “limits to arbitrage” argument to counter the Friedman view that arbitrageurs will make markets efficient

  8. 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

  9. 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

  10. The End

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