Efficient Markets and Limits to Arbitrage

Question 1

Why study Market Efficiency?

Answer 1

I) Understanding Aggregate Outcomes
II) Efficient Allocation of Capital
III) Financial Stability
IV) Financial Market as an Idealized Market (Corner Case)

Question 2

State the Efficient Market Hypothesis

Answer 2

• Prices always reflect the fundamental value of any asset
• Fundamental Value = All discounted future income flows of a security
• All public information is immediately incorporated into prices

Question 3

What is the Fundamental Mechanism to ensure Efficiency

Answer 3

Arbitrage.
Arbitrage opportunities are exploited very quickly and should not persist. Upward pressure on undervalued stocks, downward pressure on overvalued stocks.
“Law of one price”

Question 4

Three arguments for efficient market hypothesis

Answer 4

I) Rational investors (high stakes)
II) Irrationality is random and canceled out (irrationality is random)
III) Irrational investors eventually are pushed out of the market (make mistakes and are taken advantage of by arbitrageurs)

Question 5

Empirical Challenges to EMH

Answer 5

I) Excess volatility
II) Overreaction hypothesis
III) Siamese twins

Question 6

Excess volatility

Answer 6

If the rational price is equal to the actual price (conditional expectation of the rational price, given all available information in period t), plus an ex-post error, then rational price of the fundamental value should have higher variance than expectations over the rational price.
Empirics show that actual price actually fluctuates more than the rational price.
-> Excess Volatility at odds with EMH

Question 7

Over-reaction hypothesis

Answer 7

EMH: “All info is rationally incorporated into prices, excess returns are unpredictable”
Prices move to much in response to new information
Eventual correction.
Winner portfolios are outperformed by looser portfolios in subsequent period.
Predictability of returns points to unexploited arbitrage opportunities.

-> At odds with EMH

Question 8

Siamese Twins

Answer 8

EMH: “Strict substitute securities should trade at the same price ratios.”
Shell and Royal Dutch. 40:60
Securities should trade at the same proportions as their respective claim to pooled cash flows.
-> Massive Swings in price ratios at odds with EMH

Question 9

Limits to arbitrage considering EMH Arguments

Answer 9

I) Investors might be irrational, even professionals or subject to biases
II) Irrationality might be non-random, systematic over-reaction
III) Irrational investors are always replaced by new irrational investors

-> Arbitrage might be limited

Question 10

Risk to Arbitrageurs

Answer 10

i) fundamental risk (different dividends than expected)
ii) noise trader risk
Noise trades might create miss pricing that outlasts the planning horizon of arbitrageurs. In an overlapping generations model, noise traders generate risk in the second period when arbitrageurs want to sell. Since bullishness is drawn randomly in each period, arbitrageurs have to incorporate that risk and might decide not to participate.
Noise traders might cause persistent and enhancing mis-pricing

Question 11

Findings of theoretical literature on limits of arbitrage (2) and studying of behavioral biases (3)

Answer 11

• Behavioral biases can have aggregate implications
• Deviations from EMH are likely and plausible
• Non-standard beliefs
• Non-standard preferences
• bounded rationality

Question 12

Practical Limits to arbitrage (Managing)

Answer 12

Fund managers have short planning horizons, increasing their reluctance to exploit all arbitrage opportunities.