MGMP 543, Finance
Session 21 & 22 – Behavioral Finance
Professor Kunal Sachdeva
Motivation
,Efficient Market Hypothesis (EMH) [REVIEW]
Prices reflect all available information
• Information is reflected in prices immediately
• Investors should only expect to obtain a normal rate of return.
• Awareness of information when it is released does an investor no good.
• The price adjusts before the investor have time to trade on it.
• Firms should expect to receive fair value for securities that they sell
• Fair means that the price they receive from issuing securities is the present value.
• Thus, valuable financing opportunities that arise from fooling investors are unavailable.
• The price is right!
3
Necessary Conditions [REVIEW]
What Causes Market Efficiency?
• Rationality
• When new information is released in the marketplace, all investors will adjust their
estimates of stock prices in a rational way.
• Independent Deviations from Rationality
• Market efficiency does not require rational individuals—only countervailing irrationalities.
• Arbitrage
• If the arbitrageurs dominates the speculation of others, financial markets would still be
efficient.
4
,Efficient vs. Inefficient Response [REVIEW]
5
Always Relating Back to PV
+
,(
!"#$% = ' (
1+r
()*
• An implication of the EMH is that a security’s price is always equal to the PV of
its future cash-flows. If the price is set in this way, the security’s expected return
will be r. If markets are efficient…
1. A security’s price is always equal to the discounted value of expected future cash flows.
2. Security price changes only (and immediately) in response to either new information
about its future cash flows, or investors’ discount rate.
>> Does this always hold? Can we find violations?
6
, Example of a Violation of the EMH
Example of a Violation of the EMH
>> How can we square this (and many other examples)
against the efficient mark hypothesis?
Session 21 & 22 – Behavioral Finance
Professor Kunal Sachdeva
Motivation
,Efficient Market Hypothesis (EMH) [REVIEW]
Prices reflect all available information
• Information is reflected in prices immediately
• Investors should only expect to obtain a normal rate of return.
• Awareness of information when it is released does an investor no good.
• The price adjusts before the investor have time to trade on it.
• Firms should expect to receive fair value for securities that they sell
• Fair means that the price they receive from issuing securities is the present value.
• Thus, valuable financing opportunities that arise from fooling investors are unavailable.
• The price is right!
3
Necessary Conditions [REVIEW]
What Causes Market Efficiency?
• Rationality
• When new information is released in the marketplace, all investors will adjust their
estimates of stock prices in a rational way.
• Independent Deviations from Rationality
• Market efficiency does not require rational individuals—only countervailing irrationalities.
• Arbitrage
• If the arbitrageurs dominates the speculation of others, financial markets would still be
efficient.
4
,Efficient vs. Inefficient Response [REVIEW]
5
Always Relating Back to PV
+
,(
!"#$% = ' (
1+r
()*
• An implication of the EMH is that a security’s price is always equal to the PV of
its future cash-flows. If the price is set in this way, the security’s expected return
will be r. If markets are efficient…
1. A security’s price is always equal to the discounted value of expected future cash flows.
2. Security price changes only (and immediately) in response to either new information
about its future cash flows, or investors’ discount rate.
>> Does this always hold? Can we find violations?
6
, Example of a Violation of the EMH
Example of a Violation of the EMH
>> How can we square this (and many other examples)
against the efficient mark hypothesis?
