Report about “Inefficient markets

and the new finance” article

Prepared by MBA- Finance ladies group:

 Azza Nour Eldin

 Hend Hossam Eldin
 Mariam Tayia
 Marry Louis Shoukry
 Rasha Elhagrassy
 Reham Refaat
 Yasmin Abd Elazim
[Title]

Report about “Inefficient markets

and the new finance”

 What is the type of valuation models used in the article?

 Do you think that the results of the article are consistent with the fair
valuation or the market valuation or the valuation theory of finance?

The investigated article is “Inefficient markets and the new finance” was extracted from
The Mechanisms of Market Inefficiency: An Introduction to the New Finance, 28 J. Corp.
L. 633 (2003), written by Lynn A. Stout , Professor of Law, UCLA School of Law; Principal
Investigator, UCLA-Sloan Foundation Research Program on Business Organizations. The
article was published within the series of law & economics research paper by the school of
law at university of California, Los Angeles.

The article discuss there major topics:

(1) Work on asset pricing when investors have heterogeneous expectations
(2) Scholarship on how and why arbitrage may move public information into prices more
slowly and incompletely than earlier writings suggested
(3) The exploding literature in “behavioral finance.”

The valuation models that the article studies are :

i. the Capital Assets Pricing Model (CAPM)
ii. the Heterogeneous Expectations Asset Pricing Model (“HEAPM”)

The article examines the limitation of Efficient market theory regarding those two
models, as well as the consistency of those two valuation models with the implications of the
efficient market theory regarding actual status of market inefficiency and investors
disagreement.

To begin with, the author states that the efficient market theory means A market
commonly is described as efficient when prices fully reflect available information, the word
“fully reflects” in that definition includes two things :
First : informationally efficient which is how quickly prices respond to new information.
Yet informational efficiency, alone, does not imply that market prices respond to new
information correctly or even that prices respond at all.
Second: fundamental value efficiency, Markets are efficient in the fundamental value sense
if prices respond to new information not only quickly but accurately, so that price reflects
the best possible estimate
Those two principles of market efficiency requires a theory of how market participants use
information to estimate values and set prices. The most widely-employed of these theories is
the Capital Asset Pricing Model (CAPM) but the main deficit of this model is the reliance
on an unrealistic assumption that investors share homogenous expectations regarding
securities’ future risks and returns and by turn the market must mirror this “best”
estimate because only one estimate exists—the estimate of the homogenous investor. In
other words, they assumed all investors agree. Yet people do not agree on the intrinsic
worth of particular securities. The literature of New Finance focus on asset prices in a
world where investors disagree, when we acknowledge disagreement while still assuming
perfect markets, price-moving arbitrage of the sort assumed by many commentators
becomes impossible. Indeed, market equilibrium becomes impossible, and these threaten the
existence of the efficient market and makes that theory appears like the Utopia that doesn’t
exist on earth. To deal with three realistic assumptions:
 investor disagreement
 limits on short selling
 risk aversion

The introduction of heterogeneous expectations asset pricing model “HEAPM” must come
with the existence of those market imperfections.
The HEAPM predicts that even at a very high price, a firm can sell a few shares
of stock to a few very optimistic investors. If the firm wants to sell more shares, however, it
must lower the price. Lowering price increases demand both because less optimistic
individuals who do not already own the stock become interested and buy.
These findings demonstrate that in many respects the HEAPM does a better job
than the CAPM of predicting how actual markets behave. They also highlight a basic
lesson of the New Finance: when investors disagree, market prices can change for a variety
of reasons unrelated to any change in underlying value.

"HEAPM" is based on the following assumptions :

 Investor disagreement
 Limits on short selling
 Risk aversion
 Downward sloping demand curve
 Market prices can change for a variety of reasons unrelated to the change in
value
 Greater uncertainty about the stock return could raise the prices regardless
of value & this could be used to explain several market anomalies ( Bubble ,
why many investors don't fully diversify , price shifting effects of share issues
& shares repurchases & large premium paid for take overs )

INEFFICIENT MARKETS AND THE LIMITS OF ARBITRAGE

The article also addresses the issue of the limitations of arbitrage in inefficient markets.
Fundamental value efficiency is not the only possible understanding of efficiency. Many
theorists who speak of “efficient markets” seem to be relying on the alternate idea of
informational efficiency—that prices respond so quickly to new information it is impossible
for traders to make profits on the basis of the information.

Are markets even informationally efficient? Can arbitrageurs in fact quickly move prices?
In the years immediately following the development of the ECMH it was subjected to
extensive empirical testing as researchers analyzed how quickly prices responded to public
announcements of stock splits, corporate mergers.

Several recent papers explore the limits to arbitrage that explain such a delayed market
response:
 First, arbitrage is not costless. Information is expensive to acquire, process, and
verify, and trading also involves costs.
 Second, arbitrageurs control only finite amounts of money, and can usually only
afford to hold a small percentage of a firm’s stock.
 Third, arbitrageurs are also likely risk-averse.
 Fourth and perhaps most important, arbitrageurs can only profit from superior
information if the rest of the market eventually comes to agree with their value
assessments.

Finally the article addressed a rival challenge to traditional ECMH namely behavioral
finance. Behavioral finance theorists rely on the psychological literature, and especially on
studies of human behavior in experimental games, to identify forms of cognitive bias that
cause people to make mistakes. They then examine whether these biases can explain or
predict market anomalies that cannot be explained or predicted by traditional finance.

Conclusion:
1- CAPM assumes market efficiency which implies both informational and
fundamental efficiency and is consistent with the ECMH , but it is not realistic and
fails to absorb the heterogeneous expectations of the investors in the market which
makes market equilibrium practically impossible under conditions of investors
disagreement about risk and return.
2- HEAPM is more realistic – a variant of the CAPM- that overcomes the theoretical
fragility of flat demand and does a better job than the CAPM in predicting how
actual markets behave. HEAPM can help actual markets phenomena like market
bubbles.
3- Real world actual markets are imperfect and inefficient, CAPM is not enough to
achieve equilibrium prices under heterogeneous investors expectations , because it is
based on the ECMH that is why investors need HEAM which violates the efficient
market assumptions.

If efficient market theory is failing, what can replace it? Skepticism about the validity of
the ECMH should not lead to skepticism about our ability to understand and predict
market behavior.
To sum up, this article suggests that:

1- Issuing more shares decreases price while share repurchases raise price
2- Short sales restrictions raise price while developments that make shorting easier
decrease price
3- Increased uncertainty raises price
4- Prices under-react to information presented to the public in a form that is difficult
to access or understand
5- Limited opportunities for profitable arbitrage exist that can be exploited by a
minority of traders
6- Prices under-react to information surprises but overreact to perceived trends
7- Equities offer excess returns relative to risk-free investments even after adjusting
for non-diversifiable risk; and, last but not least
8- Market price need not bear any close relationship to the best estimate, in light of the
available information, of a security’s expected risk and return.