Distinguish between Traditional and Behavioral Finance

10 points

Traditional 1) Rational Expectation 2) Risk-aversion 3) Asset Integration Behavioral: 1) Biased Expectation 2) Loss-aversion 3) Asset Segregation

**** EXTRA CREDIT POINTS??? **** my notes on Traditional vs Behavioral in Reading #13 a. Critique the classic objection to behavioral finance that rational agents will quickly undo any dislocations caused by irrational traders In a traditional market framework, agents are rational and there are no frictions, a stock price will equal its “fundamental value” (the discounted sum of its future cash flows). Investors can process all information and apply a similar discount rate. This is the Efficient Market Hypothesis (EMH). In an efficient market, there is no free lunch. Behavioral Finance argues that deviations DO occur due to traders that are irrational. EMH and Friedman argue that: (1) as soon as there is a deviation from fundamental value (“mispricing”) and attractive investment opportunity is created. (2) Rational traders will immediately snap up the opportunity, correcting the mispricing. Behavioral Finance does not take issue with the second step. It has issues with the first step. Even when an asset it mispriced, strategies designed to take advantage of it can be costly and risky, rendering them unattractive. An arbitrage investment is supposedly an investment strategy that offers riskless investment at no cost. Behavioral Finance argues that this is NOT true. These strategies can often be very risky. (Irrational Traders = “Noise Traders” and Rational Traders = “Arbitrageurs”) b. Explain how the statement “there is no free lunch” can be valid in both efficient and inefficient markets, and discuss its relationship to the statement “prices are right” “Prices are right” = “No free lunch” BUT “No Free Lunch” <> “Prices are Right” In an efficient market, the prices are always right and thus there is no free lunch. There is no chance to gain any riskless profit since all prices are at equilibrium. In an inefficient market, the price may not be right but there is still may be no free lunch since the strategies to take advantage of the mispricing price to be too costly or risky for the return gained. c. Evaluate the implementation costs and risks, including fundamental risks and noise trader risk, associated with trades designed to profit from asset mispricing. Fundamental Risk: Trader buys the asset and a piece of bad news make the stock drop further, leading to losses. This can be mitigated by selling short a similar security BUT substitute securities are rarely perfect making it impossible to remove all fundamental risk. (Shorting GM to protect against any losses holding Ford long protects from the car industry as a whole but not against Ford specific news). Noise Trader Risk: the risk that the mispricing being exploited by the arbitrageur worsens in the short run. Pessimistic investors (irrational investors) drive the price down even further. Nose Trader Risk matters since drops in price may force some arbitrageurs to liquidate their positions early at potentially steep losses. If arbitrageurs are risk adverse and have a sort time horizon (cannot wait for things to turn around) – this could be an issue. The possibility of forced liquidation means that many arbitrageurs effectively have short time horizon (get in and get out). AGENCY FEATURE – if a person is a portfolio manger for a fund, he will be less likely to engage in strategies to take advantage of any mispricing since the steep losses could affect his performance (rendering him looking incompetent) and cause people to withdraw form the fund. CREDITORS: Short Term losses could cause creditors to call their loans (margin calls) Implementation Costs: • transaction costs such as commissions, bid-ask spreads • Short sale constraints (fee charged to borrow stocks) – sometimes arbitrageurs cannot find a stock to borrow at any price. Legal constraints. Money managers cannot short sell) • Cost of finding and learning about mispricing • Cost of resources to needed to exploit it Some arbitrageurs will trade WITH (same direction) as noise traders – thereby increasing the mispricing. Example: Positive Feedback traders will latch on to the stock (the earlier price rise signals to them that something good is happening). This will drive the price up further – arbitrageurs will exit at a profit. Evidence: It’s hard to prove that arbitrage is limited – there are only a few examples that are beyond a reasonable doubt. What is a good benchmark to determine if mispricing exists?