Behavioral Finance Law of One Price Jan 26, 2012 Behavioral Finance Economics 437

Behavioral Finance Law of One Price Jan 26, 2012 These Should Have Been Read By Now (in their entirety) Malkiel (online) Shiller (online) Shleifer (book, Ch 1)

Behavioral Finance Law of One Price Jan 26, 2012 Begin Reading Black & Shliefer Black on Toolkit Shliefer on Toolkit

Behavioral Finance Law of One Price Jan 26, 2012 The Efficient Market Hypothesis (EMH) Price captures all relevant information Modern version based upon “No Arbitrage” assumption – Stock prices (adjusted) satisfy “Martingale” property Fama Definitions: Strong Hypothesis Semi-strong Hypothesis Weak Hypothesis

Behavioral Finance Law of One Price Jan 26, 2012 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

Behavioral Finance Law of One Price Jan 26, 2012 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)

Behavioral Finance Law of One Price Jan 26, 2012 Fungibility (convertibility from one form to another) Example: a call option and a put option Suppose you own a January 40 Call and are “Short” a January 40 Put On expiration you will own 100 shares of the stock If P > 40, you will exercise and buy stock If P < 40, put owner will exercise and you will be compelled to buy stock Thus, this option position is “fungible” by the expiration date of the two options

Behavioral Finance Law of One Price Jan 26, 2012 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

Behavioral Finance Law of One Price Jan 26, 2012 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)

Behavioral Finance Law of One Price Jan 26, 2012 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

Behavioral Finance Law of One Price Jan 26, 2012 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)

Behavioral Finance Law of One Price Jan 26, 2012 The End