Limits to arbitrage & Behavioural Flashcards
For behavioral biases to affect market prices and thus market efficiency, we need 2 conditions:
- Behavioral biases do not cancel out across investors
- Arbitrage is NOT successful in correcting mispricing
Shortly after the of this period (September 1991), the % deviation from theoretical price parity exceeds -10%, which indicates that ABB AB is overpriced relative to ABB AG. The appropriate arbitrage position is a long position in ABB AG and a short position in ABB AB. This position needs to be maintained until prices have at least converged somewhat. As can be seen from the graph, that can take some time (some two years in this case) and in the meantime the mispricing worsens to over 20%, which may be hard to justify to your investors as you need to temporarily report a loss. This type of noise trader risk (or horizon risk) can be a powerful limit to arbitrage.
Prospect Theory (Kahneman & Tversky, 1979); three key novel aspects
1.In Prospect Theory, people care about gains and losses relative to a reference point instead of about total wealth
2. Losses hurt more than gains help (loss aversion)
3. People are risk averse in the gains domain (“concave utility function”) and risk seeking in the loss domain (“convex utility function”).
Stock price patterns derived from investor behavior may violate the EMH if the relation is
- Predictable
- Persistent
- Exploitable
- Not based on a rational (systematic risk-based) explanation
Zoom call vs zoom video
Which behavioral finance principle (or behavioral bias) is most consistent with this finding? We know that behavioral biases should not matter for stock pricing if rational arbitrageurs can exploit the mispricing.
Give two examples of limits to arbitrage that can prevent such mispricing from being corrected. Briefly explain your answers. (4 points)
Confusion (or limited attention): Retail investors thought they were trading Zoom Video, which was able to ‘benefit’ from Covid-19 as people needed an online meeting tool. Stocks with similar tickers can have short-term and sometimes even long-term co-movements. This example is similar to the example explained in class with tickers MCI and MCIC. Limit to arbitrage:
* Short-sell restrictions mean that investors cannot show their negative sentiment for a stock, meaning that if a stock is overpriced due to behavioral biases, they cannot control for this misalignment by selling short.
* Implementation costs: o Transaction costs: transaction costs could be higher than the profit of exploiting the mispricing, rational investors would not trade.
o Capital/margin requirement: cost of borrowing stocks is high
o Cannot borrow at risk free rate
* Fundamental risk: markets can stay irrational longer than investors can remain liquid or lack of perfect substitutes.
What are anomolies?
In asset pricing, anomalies were seen as empirical patterns (in time-series or cross-section) of security returns inconsistent with standard theories such as CAPM (the “old paradigm”)
Difficult to “rationalize,” or if implausible assumptions are necessary to explain it within the paradigm”
What is the Campbell-Shiller decomposition
Realized return = E[R] + CF news + DR news + “noise”
The disposition effect implies that investors are more likely to sell a stock that has gone up in value than one that has gone down in value. As discussed in workshop 4, investors tend to stay in losing trades longer than in profitable trades. We can see this in the graph due to a steeper slope in the loss’s quadrant (loss aversion). Technical analysis can be used to set a threshold (profit taking or stop loss), based on repetitive patterns or (Fibonacci) levels, to minimize losses.
What are the six limits to arbitrage
- Transaction costs
- Cannot borrow at risk-free rate
- Short-sale constraints, short-sales costs
- Capital/margin requirements (i.e., limited capital)
- Lack of perfect substitutes (a.k.a. “fundamental risk”)
- Betas change over time
What is a times series anomaly?
We hold a balanced portfolio for a certain period for which we predict higher returns, we do not assume that some securities earn higher returns than others.
What is the Information Processing error?
whatdoes it lead to?
Errors in information processing can lead investors to misestimate the true probabilities
of possible events or associated rates of return. Several such biases have been uncovered.
There are 5 important ones
Name the 5 information processing errors
-** Limited Attention, Underreaction, and Overreaction** Individuals have limited
time and attention and as a result may rely on rules of thumb or intuitive decisionmaking
procedures known as heuristics.
**- Overconfidence, **People tend to overestimate the precision of their beliefs or forecasts,
and they tend to overestimate their abilities.
- Conservatism A conservatism bias means that investors are too slow (too conservative)
in updating their beliefs in response to new evidence. This means that they might initially
underreact to news about a firm so that prices will fully reflect new information only
gradually. Such a bias would give rise to momentum in stock market returns.
Confirmation Bias Confirmation bias is the tendency to interpret new information in a way that confirms or supports one’s prior beliefs. “horen wat je wilt horen”
Extrapolation and Pattern RecognitionPeople are adept at discerning patterns,
sometimes even perceiving patterns that may be illusory. They also are overly prone to
believe, even when employing only limited evidence, that these patterns are likely to characterize an entire population, especially if the small sample exhibits other (even possibly irrelevant) similarities with a broad population. This sort of error is called representativeness bias, and it holds that people commonly act as if a small sample is just as informative about a population as a large one.
Mental accounting
Mental accounting is a specific form of framing in which peoplesegregate certain decisions. For example, an investor may take a lot of risk with one investment account but establish a very conservative position with another account that is dedicated to her child’s education.
Dispossition effect
Holding on to losing investents (until you sell, its just a paper loss)
there is considerable evidence that investors are more prone to sell stocks with gains
than those with losses, precisely contrary to a tax-minimization strategy.12 This reluctance
to realize losses is called the disposition effect.
What are behavioural biases
Even if information processing were perfect, many studies conclude that individuals would
tend to make less-than-fully-rational decisions using that information. These behavioral
biases largely affect how investors frame questions of risk versus return and, therefore,
make risk–return trade-offs.
Examples: framing, mental accounting (disposition effect), regret avoidance, Affect and Feelings, prospect theory
What is prospect theory?
Panel A, illustrates the conventional description of a risk-averse investor. Higher wealth provides higher satisfaction, or “utility,” but at a diminishing rate (the curve flattens as the individual becomes wealthier).
Panel B, shows a competing description of preferences characterized by “loss aversion.”
1. Thus, losses hurt more that wins give satisfaction (gains of 1000 increases utility less than loss of 1000 reduces) = loss aversion
2. Utility depends not on the level of wealth, as in Panel A, but on changes in wealth from current levels. = relative to a point
3. Moreover, to the left of zero (zero denotes no change from current wealth), the curve is convex rather than concave. The convex curvature to the left of the origin in Panel B will induce investors to be risk seeking rather than risk averse when it comes to losses
