1. Behavioral Finance
Economics 437

2. Review of EMH

3. Immediate Reading Malkiel (online) Shiller (online)
Shleifer (book, Ch 1)
Fama (online)

4. Reading (starting Jan 26) “Noise Trading” – Limits to Arbitrage
Black on Toolkit
Shliefer on Toolkit
Burton & Shah, pp 1-51

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 1970 Article Random Walk Special Case is the “Fair Game” model
f(rj, t+1|Φt) = f(rj, t+1)
Where the density function ft is the same for all t
Special Case is the “Fair Game” model
E(pj, t+1|Φt) = [1 + E(rj, t+1|Φt)]pj,t
Sub-martingale
E(pj, t+1|Φt) ≥ pj,t or E(rj, t+1|Φt) ≥ 0

7. 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

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 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

10. 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 (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

11. The End