CORPORATE FINANCE

Efficient Markets and Behavioral

Finance
13.0. Introduction

Shark Attack
Why the WallStreetBets crowd are able to profit from predatory trading
Textbooks say it can’t happen. But there are times when front-running distressed traders pays off
“There are no loyalties on Wall Street. When you smell blood in the water, you become a shark.” The
sentiment—or lack of it—would not look out of place on r/wallstreetbets, the locus for a new breed of
stockmarket hammerheads, which has helped push up the share prices of tech darlings and
bombed-out companies to nosebleed levels, crippling professional short-sellers in the process. But
the quote comes from a boomer, not a millennial: “Confessions of a Wall Street Addict”, by Jim
Cramer, a trader-cum-tv-star. He is describing the remorseless logic of predatory trading.
…
The Economist, Finance & economics, Feb 6th 2021 edition

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13.0. Introduction

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13.0. Introduction

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Can Financing Decisions Create Value?

Three Ways to Create Value

Managers

Asymmetric Information
know more
than Pursue

Subsidies
investors. project
Potential for specific Create new

Financial Engineering
mispricing. government securities to
subsidies. take
Tax-efficient advantage
securities. of excess
market
demand.

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13-1 Return to Net Present Value

• All financial decisions involve valuation of risky assets => use of

NPV analysis

• Both for investment and financing decisions:

• Much easier to find positive NPV in investment decisions

than in financing decisions

• NPV Employs Discount Rates

• Risk adjusted

• Byproduct of market-established prices

• Adjustable discount rates change market prices

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13-1 Return to Net Present Value

•Example:
Government lends $100,000 for 10 years at
3%, interest payments required only prior to
maturity. Determine loan value.

NPV = amount borrowed − PV of interest pmts

− PV of loan repayment

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13-1 Return to Net Present Value

•Example, continued
• Assume 10% market return on equivalent
risk projects

 10 3,000  100,000
NPV = 100,000 −  t 
− 10
 t =1 (1. 10)  (1.10)
= 100,000 − 56,988
= $43,012

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13-1 Return to Net Present Value
 Differences between Investment and
Financing Decisions:
 Ways (angles) in which investment decisions are
simpler:
• Number of financing alternatives and corresponding
characteristics is more complex.
 Ways (angles) in which financing decisions are
simpler:
• Financing decisions are much easier to reverse;
• It is harder to make money through financing
decisions– financial markets are much closer to
perfection than real assets markets.
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13-2 Random Walk Theory

 The movement of stock prices from day to day

DO NOT reflect any pattern
 Statistically speaking, the movement of stock
prices is random (skewed positive over the long term)

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13-2 What is an Efficient Market?

•Random Walk Theory

• Movement of stock prices from day to day
do not reflect a pattern;

• Statistically, movements are random

• Skewed positive over long term;

• Price changes are independent of one another.

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13-2 What is an Efficient Market?

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Figure 13.1 five years: Standard and Poor’s index and
coin toss game

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Figure 13.2a Microsoft

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Figure 13.2b Deutsche Bank

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Figure 13.2c Philips Electronics

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Figure 13.2d Sony

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Figure 13.3 Cycles

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13-2 What is an Efficient Market?

•Three Forms of Market Efficiency

• Weak:
• Prices reflect all historical information
• Semistrong:
• Prices reflect all publicly available information
• Strong:
• Prices reflect all private and public information

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13-2 What is an Efficient Market?

•Fundamental Analysts:

• Research stock value using NPV and other

cash-flow measurements

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13-2 What is an Efficient Market?

•Adjusting for Market Movements

• Adjusted stock return = return on stock – return
on market index

A more refined adjustment will take into consideration

the fact that b is normally different from 1:
Expected stock return = + × return on market index

Abnormal s ! = actual stock return − expected stock return

= ̃ −( + % ̃ )

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Figure 13.4 Stock Performance versus Market

This example is
based in merger
announcements

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Figure 13.5 Diversified Equity Funds versus Wilshire
5000 index A test of the
strong form
hypothesis

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Evidence Against Market Efficiency (earnings announcement puzzle): Figure 13.6
Average Returns following Quarterly Announcements, 1972-2001 (six month
period after the announcement)

Investors seem to
underreact to
earnings
announcements

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Evidence against Market Efficiency (Earnings
Announcement Puzzle): Figure 13.7 deviations from
Royal Dutch Shell/ Shell T&T parity, 1980-2004

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13-3 Evidence Against Market Efficiency

•2009 Recession

Div $250million
PV(stocks) February 2012 = = = $12,500
r − g .060 − .040

Div $250million
PV(stocks) growth drops = = = $10,000
r − g .060 − .035

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13-3 Evidence Against Market Efficiency

•2000 Dot.com Boom

Div $154.6million
PV(index) March 2000 = = = $12,883million
r−g .092 − .08

Div $154.6million
PV(index) October 2002 = = = $8,589million
r−g .092 − .074

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13-3 Evidence Against Market Efficiency

•1987 Stock Market Crash

Div $16 .7 million

PV(index) pre -crash = = = $1193 million
r−g .114 − .10

Div $16 .7 million

PV(index) post -crash = = = $928 million
r−g .114 − .096

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13-4 Behavioral Finance
• Factors Relating Efficiency and Psychology
• Attitudes toward risk:

• Investors are particularly averse to losses of principal (basis for

Prospect Theory);
• Value to investors seems to depend from gains since moment of
investment or last appraisal;
• Investors are particularly averse to even the small probability of a loss
and need to get a high return to compensate for it.
• Beliefs about probabilities:

• Investors tend to put much weight on a set of recent events that are
considered as good predictors of the future
• Part (most) of the investors tend to be too conservative – tend to take
too long to adapt their beliefs to recent events; others are
overconfident – most new entrepreneurs think their probability of
success is clearly higher than what really is.
• Sentiment: most investors’ overall feeling about market evolution swings
frequently
• Limits to Arbitrage: limits for rational investors to take advantage of market
inefficiencies.
• Incentive Problems and the Subprime Crisis
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 13-4 Behavioral Finance
Spread between Bullish and Bearish Investors
 13-5 Five Lessons of Market Efficiency

•Markets Have No Memory

•Trust Market Prices
•Read the Entrails
•Remember the Do-It-Yourself Alternative
•Seen One Stock, Seen Them All

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Thank You