Abnormal returns are a way of measuring the difference between an actual return and the

expected return. The expected return is based on a benchmark or model, such as the CAPM.
In the context of the CAPM, the expected return is based on the riskfree rate, the market risk
premium, and the beta coefficient of the asset.

The CAPM alpha, represented by the symbol 𝛼, is a measure of the abnormal returns of a
security or portfolio. It represents the excess return that an investor earns beyond what
would be expected given the asset's beta and the market risk premium. If a security has a
positive alpha, it means that it has outperformed its expected return based on the CAPM
model. Conversely, a negative alpha indicates that the asset has underperformed compared
to its expected return.

• To estimate the alpha and beta coefficients, one can use linear regression to find the
bestfitting line that represents the relationship between the asset's returns and the
market returns.
• The slope of this line represents the beta, which measures the asset's sensitivity to
market risk. The intercept of the line represents the alpha, which measures the
abnormal return of the asset.
• Therefore, by estimating the intercept and slope of the line, one can calculate the
alpha and beta coefficients of the asset.

For better representation we plot the graph with rm rf as the x axis and rk rf as the y axis
An asset's characteristic line is the line of the best fit for the scatter plot that represents
simultaneous excess returns on the asset and on the market.

• beta is the slope of the line that is generated out of running a regression to find a best
fitting line
• alpha is the intercept on the y axis that shows the realised excess return on the asset
in question
Sure, the Efficient Market Hypothesis (EMH) is a theory that states that financial markets are
informationally efficient, meaning that current prices reflect all available information. In other
words, it is impossible to consistently achieve returns that are higher than the market
average, because any new information is immediately reflected in the market price of an
asset.

To test the EMH, researchers often use the concept of abnormal returns. Abnormal returns
are returns that are greater or less than what is predicted by a given model, such as the Capital
Asset Pricing Model (CAPM). If excess returns are predictable, it suggests that the market is
not efficient, as investors could exploit this predictability to achieve returns greater than the
market average.

However, as mentioned earlier, tests of market efficiency by means of abnormal returns also
depend on the correctness of the benchmark model being used, such as the CAPM. If the
benchmark model is incorrect, then any evidence of abnormal returns may not necessarily
indicate market inefficiency.

Overall, the concept of abnormal returns and testing market efficiency is closely linked to the
Efficient Market Hypothesis and plays a crucial role in empirical research in finance.

The concept of market efficiency suggests that securities prices reflect all available
information in the market. To test this idea, researchers use the concept of abnormal returns,
which represent returns that are in excess of what can be expected based on an asset's risk
level.

To calculate abnormal returns, a benchmark model is used, such as the Capital Asset Pricing
Model (CAPM). If the actual returns exceed the returns predicted by the benchmark, then the
asset is considered to have abnormal returns, suggesting that the market is inefficient.

However, the validity of the benchmark model must also be considered. If the benchmark
model is not accurate, then it cannot accurately capture how expected returns are
determined in the real world. For example, the CAPM assumes that the only relevant risk is
market risk, but this may not always be the case. Other factors such as political instability,
technological change, and macroeconomic trends may also affect returns, but are not
accounted for in the CAPM.

Therefore, tests of market efficiency using abnormal returns are actually testing two joint
hypotheses: first, whether the market is informationally efficient, and second, whether the
benchmark model used to evaluate abnormal returns is appropriate. If either of these
hypotheses is not supported, then it calls into question the concept of market efficiency.

The jointhypotheses problem in efficiency tests arises because the test must simultaneously
evaluate two hypotheses: the market efficiency hypothesis and the benchmark model
hypothesis. The market efficiency hypothesis states that stock prices fully reflect all available
information, meaning that it is impossible to consistently earn abnormal returns through
trading strategies based on publicly available information. The benchmark model hypothesis
refers to the model that is used to calculate the expected returns for securities based on their
risk and other characteristics.

If a test of market efficiency produces evidence of abnormal returns, it is unclear whether

these abnormal returns are evidence of market inefficiency or a problem with the benchmark
model. It is possible that the abnormal returns are due to the failure of the market to fully
reflect all available information, which would suggest market inefficiency. However, it is also
possible that the abnormal returns are simply the result of using an incorrect benchmark
model to calculate expected returns.

Therefore, the interpretation of the results of an efficiency test is not straightforward. If

abnormal returns are observed, it is not clear whether they are the result of market
inefficiency or a problem with the benchmark model. A possible solution to this problem is to
use multiple benchmark models to test for consistency of results. If multiple models produce
similar results, it is more likely that the abnormal returns are evidence of market inefficiency
rather than a problem with the benchmark model.

3 forms of market efficiency

The concept of market efficiency is a key part of financial theory and is used to describe how
well market prices reflect all available information about a security or asset. It refers to the
degree to which financial markets are able to incorporate all available information into asset
prices in a timely and accurate manner.

The weak form of market efficiency suggests that all historical information is already reflected
in asset prices, meaning that technical analysis (i.e. analysis of past prices, trading volumes,
etc.) cannot be used to generate abnormal returns. In other words, any historical patterns in
asset prices are already accounted for and cannot be exploited to generate profits.

The semistrong form of market efficiency suggests that asset prices reflect not only historical
information but also all publicly available information, including fundamental data such as
earnings reports, economic indicators, and news reports. This means that fundamental
analysis (i.e. analysis of a company's financial statements, industry trends, etc.) cannot be
used to generate abnormal returns, since all such information is already reflected in the asset
prices.

Finally, the strong form of market efficiency suggests that asset prices reflect not only all
public information, but also all private information, including insider information. This implies
that insider trading cannot be used to generate abnormal returns, since all insider information
is already incorporated into the asset prices.

It is important to note that while the concept of market efficiency is widely accepted among
financial economists, there is ongoing debate about the extent to which financial markets are
truly efficient. Some argue that markets may be inefficient due to factors such as behavioral
biases, market frictions, and information asymmetry. Others argue that even if markets are
not perfectly efficient, it is extremely difficult if not impossible for investors to consistently
generate abnormal returns.
Weak Form

To further elaborate on weak form efficiency, it is important to understand that historical

information includes all past trading data, such as past stock prices and trading volumes. If
market prices are efficient in the weak form, then it should not be possible to consistently
earn abnormal returns using this historical information.

One way to test for weak form efficiency is to analyse the correlations between consecutive
stock returns, such as weekly or monthly returns. If there is no predictability in stock prices,
then last week's returns should not be able to predict this week's returns. In other words, the
correlation between rt and rt+1 should be close to zero.

Empirical tests of weak form efficiency using correlationbased methods have typically
documented correlations close to zero. This provides evidence in support of weak form
efficiency. However, it is important to note that weak form efficiency does not rule out the
possibility of predictability based on other information, such as fundamental analysis or
insider trading.

Overall, weak form efficiency is concerned with the notion that past prices and trading data
are already incorporated into current stock prices, and thus, it is difficult to earn abnormal
returns using historical information alone.

Semi Strong form

• In semistrong form efficiency, all publicly available information is already reflected in

stock prices, which means that it is not possible to consistently achieve abnormal
returns by analysing publicly available information. This includes information such as
financial reports, company news, and other information available to the public.
•
• Investors and analysts who attempt to earn excess returns by analyzing publicly
available information will find that the information is already reflected in stock prices,
and that they are unable to use this information to consistently outperform the
market.
•
• To test for semistrong form efficiency, researchers can examine how stock prices react
to the release of new information. If the stock price rapidly adjusts to the new
information and there is no discernible pattern in how the stock price reacts, then the
 market is considered to be semistrong form efficient. This is because the new
information is quickly incorporated into the stock price, leaving no opportunity for
investors to earn abnormal returns by trading on this information.
•
• Overall, the semistrong form of market efficiency is an important concept in finance,
as it implies that it is difficult to achieve excess returns by analyzing publicly available
information. This highlights the importance of other factors, such as diversification,
risk management, and the ability to generate proprietary information or use
nonpublic information to gain an edge in the market.
•
• If markets are semistrong efficient, it should not be possible to consistently earn
abnormal returns using only publicly available information. To test whether markets
are semi strong efficient, event studies are commonly used. These studies examine
how stock prices react to corporate events, such as mergers and acquisitions, dividend
announcements, and earnings reports.
•
• To evaluate the impact of an event or announcement, the effect of changes in other
factors affecting a firm's stock price, such as changes in inflation or interest rates, must
be filtered out. Therefore, event studies estimate what the stock price would have
been in the absence of the event, using models such as the CAPM or the FamaFrench
three factor model. The impact of the event is then measured by the abnormal
returns, which is the difference between the actual stock price and the estimated
benchmark price. Event studies typically consider stock price reactions over several
days, using cumulative abnormal returns.
•
• The use of cumulative abnormal returns is important because it accounts for the
possibility that the market may not immediately react fully to the news of an event.
Instead, the reaction may occur over a period of days or weeks. By considering
cumulative abnormal returns, event studies can more accurately measure the impact
of the event on the firm's stock price.
• Studies on impact of takeover announcement are examples of typical event studies
• In takeovers, acquiring firms typically (must) offer a substantial premium above
target’s current price to get the deal done
• Since takeover is on average good news for targets, their stock prices should increase
when takeover is announced, provided the announcement is indeed news
• The study by Keown and Pinkerton (1981) is an example of a typical event study that
examines the impact of a takeover announcement on stock prices. In takeovers,
acquiring firms often offer a premium above the target's current stock price to
complete the deal. If the takeover announcement is news to the market, the target's
stock price should increase after the announcement.
• The study analyzes the cumulative abnormal returns (CARs) of target firms before and
after the takeover announcement. CAR is the accumulated sum of abnormal returns
over a specific period, such as several days or weeks, and measures the overall impact
of an event on a stock's price. Abnormal returns are the difference between the actual
return of the stock and the expected return based on a benchmark model, such as the
CAPM.
 • The study found that target firms experienced positive and statistically significant
CARs in the days surrounding the announcement. The results suggest that the
takeover announcement was news to the market, and the market perceived it as a
positive event for the target firms. The study also illustrates how event studies use
benchmark models to filter out the impact of other factors, such as changes in interest
rates, and estimate abnormal returns as a measure of the event's impact on stock
prices.

Support of Semi Strong form

• Event studies test the impact of a specific event, such as a takeover announcement,
on stock prices
• Semistrong form efficiency suggests that stock prices should adjust immediately to
new public information and abnormal returns cannot be consistently earned using this
information
• Results of event studies can provide evidence for or against semistrong efficiency
• A price jump on the announcement day supports semistrong efficiency, as it reflects
large positive abnormal returns due to the news
• No clear drift in stock prices after the announcement suggests that the news was fully
reflected in the price
• However, an upward drift in stock prices about 30 days before the announcement may
suggest information leakages or anticipation of the event by market participants
• Dramatic price jump on the announcement day indicates that the takeover news was
news to many participants in the market, supporting semistrong efficiency.

Another approach to test market efficiency for semi strong forms

Sure, here's a more elaborate version of the bullets:

• Mutual funds can be a useful tool to evaluate market efficiency in the semistrong
form, as their performance reflects the ability of professional portfolio managers to
outperform the market by identifying mispriced securities based on publicly available
information.
• If markets are semistrong efficient, mutual fund managers should not be able to
generate excess returns over the long term, as all public information should already
be reflected in stock prices.
• Research has shown that the vast majority of actively managed mutual funds fail to
consistently outperform their benchmark index over the long term, which supports
the notion of semistrong efficiency.
• One possible explanation for this underperformance is the high fees charged by
mutual funds, which can erode any excess returns generated and make it difficult for
the fund to consistently beat the market.
• However, a small percentage of mutual funds have been able to generate statistically
significant alpha even after accounting for fees and expenses, leading to a debate over
whether their performance is truly due to their ability to identify mispriced securities
or simply due to luck or statistical noise.
 • Overall, the performance of mutual funds provides a useful testing ground for market
efficiency in the semistrong form, as it can help to identify potential anomalies and
inform our understanding of how information is incorporated into stock prices

• Studies have shown that the overall performance of professional portfolio managers
is consistent with market efficiency.
• Most managers do not perform better than the market after expenses are deducted.
• While some funds may outperform the market, their superior performance is usually
not persistent. Past winners may become losers in the following year.
• Only a very small number of mutual funds have been found to consistently outperform
the market.
• Skilled managers who do outperform the market tend to attract new funds, which
eventually drives down their alpha to zero due to the costs of managing those extra
funds.
• These findings are consistent with the semistrong form of market efficiency, as they
suggest that publicly available information is quickly incorporated into market prices,

• Actively managed funds generally fail to outperform the market over the long term.
• An alternative to active management is passive investing, which involves investing in
index funds that track a benchmark index.
• Passive funds charge much lower fees than actively managed funds, which can eat into
returns and make it difficult to consistently beat the market.
• However, if all investors were to invest passively, there would be no one left to collect
information and make informed investment decisions. This would make prices less
informative and potentially create opportunities for abnormal returns for those who
do collect information.
• Fierce competition is an important reason why most active funds do not deliver
abnormal returns. This is because there are a large number of managers and analysts
all trying to generate alpha, making it difficult for any one fund to consistently
outperform.
• The debate over how much or how little indexing the market can sustain is ongoing.
Some argue that excessive indexing could lead to market inefficiencies and increased
volatility, while others believe that indexing is a healthy development that leads to
lower fees and more efficient markets.

Strong form Efficiency

• Strong form efficiency is the idea that all information, both public and private, is
reflected in stock prices. If this is the case, then it should not be possible to earn
abnormal returns by trading on any information, including insider information.
• It is an extreme hypothesis that few people expect to hold true in practice, as there is
evidence that insiders can and do earn abnormal profits by trading on their privileged
information.
• The ability of insiders to trade profitably in their own company's stock has been
documented in academic research and realworld examples.
• Trading on inside information is regulated by organizations such as the Securities and
Exchange Commission (SEC) in the United States. For example, the SEC requires all
 insiders to register their trading activity and disclose it to the public in a timely
manner.
• While the regulation of insider trading can help to prevent abuses of insider
information, it is not a foolproof solution. There are still opportunities for insiders to
profit from their information, particularly if they are able to conceal their trading
activity or use other tactics to avoid detection.
• Overall, the notion of strong form efficiency is an idealized concept that may not fully
reflect the realities of financial markets, particularly when it comes to insider trading
and other forms of nonpublic information.

Puzzles and Anomalies

Beside evidence in support of market efficiency, regularities, so-called puzzles and anomalies,
have been document, that seem incompatible with efficient markets

Here are some detailed explanations of the puzzles and anomalies that challenge the efficient
market hypothesis:

1. Size Effect: One puzzle that challenges the efficient market hypothesis is the size effect,
which suggests that small-cap stocks have higher average returns than large-cap stocks, even
after adjusting for risk. This goes against the efficient market hypothesis, which would predict
that higher returns would be associated with higher risk.
2. Book-to-Market: Another anomaly is the book-to-market effect, which suggests that stocks
with high book-to-market ratios (i.e., those that are undervalued relative to their accounting
value) tend to have higher average returns than stocks with low book-to-market ratios. This
contradicts the efficient market hypothesis, which would predict that the market would
quickly adjust stock prices to reflect these differences in valuation.

3. Stock Price Momentum and Reversal: A third anomaly is the stock price momentum and
reversal effect. This refers to the tendency for stocks that have performed well in the recent
past (momentum) to continue performing well, and for stocks that have performed poorly
(reversal) to continue to perform poorly. This contradicts the efficient market hypothesis,
which would predict that stock prices should adjust quickly to reflect new information and
that past performance should not be a reliable indicator of future performance.

a more detailed explanation of medium-term stock price momentum and long-term stock
price reversal:

Medium-term stock price momentum:

- This refers to the tendency for stocks that have performed well or poorly over the past few
months (usually 3 to 12 months) to continue to perform well or poorly in the following
months.
- This phenomenon was first documented in a 1993 study by Jegadeesh and Titman.
- The idea is that investors tend to underreact to new information, causing stock prices to
adjust gradually over time rather than immediately. This can create momentum in the
direction of the initial price change.
- There are different theories about why this occurs. One is that investors may be slow to
update their beliefs about a company's future prospects, leading to a delay in the market's
response to new information. Another is that momentum could be driven by behavioral
biases such as herding or overconfidence.
- Some investors attempt to profit from this momentum effect by buying stocks that have
recently performed well and selling those that have performed poorly. However, this strategy
can be risky as momentum can also reverse suddenly and unexpectedly.

Long-term stock price reversal:

- This refers to the tendency for stocks that have performed well over a longer period of time
(usually 3 to 5 years) to underperform in the following years, and vice versa.
- This phenomenon was first documented in a 1985 study by De Bondt and Thaler.
- The idea is that market participants may overreact to news and events, causing stock prices
to overshoot their intrinsic value. This can lead to mean reversion, where stock prices
eventually return to their true value after deviating too far from it.
- Another explanation for this effect is that stocks that have done well over a long period of
time may become overvalued, making it harder for them to continue to outperform.
- Some investors attempt to profit from this reversal effect by buying stocks that have recently
performed poorly and selling those that have performed well over the long term. However,
this strategy can also be risky as the market may continue to overreact in the short term,
causing prices to fluctuate.

4. Post Earnings Announcement Drift: The post-earnings announcement drift is another

anomaly that challenges the efficient market hypothesis. This refers to the tendency for
stocks to drift upward or downward following the announcement of earnings, even after
accounting for the information revealed in the earnings report. This suggests that the market
may be slow to adjust to new information, which would be inconsistent with the efficient
market hypothesis.

- Efficient markets theory suggests that new information should be quickly and fully reflected
in stock prices, leading to no predictable patterns in price movements after news is
announced.
- However, studies have found that earnings announcements can generate predictable trends
in stock prices.
- Rendleman, Jones, and Latane (1982) conducted a study where they calculated cumulative
abnormal returns for a large sample of firms around earnings announcement days.
- The firms were sorted into 10 groups based on the magnitude of earnings surprises, which
is the difference between this year's and last year's earnings.
- The study found that firms with positive earnings surprises experienced a significant price
increase in the days leading up to the announcement, as well as a continued price increase in
the days following the announcement.
- Firms with negative earnings surprises experienced a significant price decrease in the days
leading up to the announcement, as well as a continued price decrease in the days following
the announcement.
- These findings suggest that even in a semi-strong efficient market, there may be predictable
patterns in stock prices following the announcement of new information.

5. Twin-Stock Puzzle: The twin-stock puzzle is a phenomenon where companies with very
similar fundamental characteristics (such as industry, market capitalization, and price-to-
earnings ratio) can have very different stock returns. This is puzzling because if the market is
efficient, companies with similar fundamentals should have similar stock returns.

- Royal Dutch (RD) and Shell are two separate companies that are part of a joint venture, with
RD incorporated in the Netherlands and Shell in England.
- RD primarily trades in the Netherlands and the US, while Shell primarily trades in the UK.
- In the merger agreement between the two companies in 1907, RD was entitled to 60% of
the joint company's earnings and dividends, while Shell was entitled to 40%.
- The efficient market hypothesis suggests that there should be no opportunity for arbitrage,
meaning that the prices of RD and Shell shares should reflect this 60/40 split in earnings and
dividends.
- However, in reality, the prices of RD and Shell shares do not reflect this split, and instead,
the price ratio between the two companies is typically around 1.3:1, which is different from
the expected 1.5:1 ratio based on the 60/40 split.
- Efficient markets hypothesis implies that by no-arbitrage the prices should be

– In reality, this is NOT what we see

- This inconsistency between the expected and actual prices of RD and Shell shares is referred
to as the "Siamese twin" puzzle, and it challenges the efficient market hypothesis.
UNILEVER
brief bullets to elaborate on the Unilever N.V. and Unilever PLC "twin-stock" puzzle:

- Unilever N.V. and Unilever PLC are two separate companies with equal economic interests
and share the same board of directors.
- The two companies are incorporated in different countries and trade on different stock
exchanges.
- Despite sharing the same economic interests and board of directors, the prices of their
shares differ significantly.
- The efficient markets hypothesis suggests that the prices of the two stocks should be the
same due to the equal sharing of cash flows.
- However, the reality is that the two stocks trade at different prices, presenting a puzzle for
market efficiency.

6. Dot-com Bubble: Finally, the dot-com bubble of the late 1990s and early 2000s is often
cited as an example of a market inefficiency. During this period, investors bid up the prices of
many internet-related stocks to unsustainable levels, even though many of these companies
had never turned a profit. This suggests that investors may have been irrational or overly
optimistic about the future prospects of these companies, which would be inconsistent with
the efficient market hypothesis.

- The dot-com bubble was a period of excessive speculation in internet-based companies that
occurred between 1995 and 2000.
- During this period, investors poured a lot of money into dot-com companies, leading to a
surge in their stock prices and market capitalizations.
- The surge in stock prices was driven by expectations of high future earnings and growth
potential, rather than current profits.
- Many investors believed that the internet was a game-changer, and that traditional
valuation metrics no longer applied to dot-com companies.
- As a result, many dot-com companies with little or no revenue or profits had sky-high
valuations.
- However, when it became clear that many of these companies would not be able to turn a
profit, investors began to sell their shares, leading to a sharp decline in stock prices.
- This decline was exacerbated by the fact that many investors had borrowed heavily to invest
in dot-com companies, leading to a wave of margin calls and forced selling.
- The dot-com bubble burst in 2000, and many dot-com companies went bankrupt, wiping
out investors' investments.
- The dot-com bubble is seen as a prime example of a speculative bubble, and is often cited
as evidence against the efficient market hypothesis.

Interpreting anomalies

- The anomalies or regularities observed in the market can be interpreted in different ways.
- Some of the anomalies that have been observed may be due to data mining or statistical
artifacts, and they may disappear when more data is collected or when the methodology is
refined.
- However, anomalies such as book-to-market, size, and momentum appear to be persistent
and robust, suggesting that they may be real anomalies.
- Fama and French argue that these effects can be explained by risk premiums, which means
that investors are compensated for taking on additional risk associated with these factors.
- On the other hand, some researchers argue that these effects may be evidence of inefficient
markets or behavioral biases, which means that investors may not always make rational
decisions based on all available information.

Limits to arbitrage
- Inefficiencies in markets can persist due to limits to arbitrage, which prevent rational
investors from correcting mispricing. This is because arbitrage involves buying undervalued
assets and shorting overvalued assets to make a profit, but it can be costly or difficult to do
so.
- Limits to arbitrage can arise due to implementation costs such as commissions, bid-ask
spreads, price impact, short sale costs and constraints, and the costs of discovering and
exploiting mispricing.
- Another factor that can exacerbate mispricing in the short run is noise trade risk, which
refers to the possibility that market participants may trade based on noise or irrelevant
information rather than fundamentals.
- Some investors may not be 100% rational and may have psychological or social biases that
affect their decision-making. These biases can contribute to market inefficiencies and persist
even in the presence of rational investors.

Implementation Costs: Short Sales

- Short selling refers to selling shares that an investor does not own with the expectation of
buying them back at a lower price in the future, thus profiting from the price difference.
- However, short selling can be costly due to various reasons such as commissions, bid-ask
spreads, and other trading fees.
- Additionally, there can be constraints on short selling in some markets or stocks, such as a
lack of willing lenders for the stock being sold short.
- The cost of borrowing shares to sell short can vary depending on supply and demand
factors, and it may not always be feasible to find someone willing to lend the stock.
- If the costs of short selling exceed the potential gains from exploiting a mispricing, then
rational investors may not engage in arbitrage activities to correct the mispricing.
- As a result, mispricing may persist for some time despite the presence of rational and
smart investors due to the costs and constraints associated with short selling.

How short selling works

– A borrows shares from B (usually her broker) and sells the share in the market (the term
of a stock loan is usually one day, but is typically renewed many times)
– A must post a collateral with B, with the collateral value > stock value (the difference is the
“margin requirement”)
– A pays B the dividends of the stock, and B pays A an interest on the collateral
– The interest that B pays A (called the “rebate rate”) is determined by the supply and
demand for shares to short
– In most cases, rebate rate < risk free rate (the difference is called the “haircut”)

- Short selling requires borrowing shares from another investor, which typically involves
paying a fee or interest rate to the lender.
- In addition to the borrowing cost, short sellers must put up collateral in the form of cash or
other securities to cover potential losses if the short position moves against them. This
collateral may earn a lower return than other investments, resulting in an opportunity cost.
- To account for the risk of the borrower defaulting on the loan, lenders may require a
haircut, or a percentage of the market value of the borrowed securities held in reserve as
additional collateral. This further reduces the short seller's return.
- Finally, there is a risk that the lender may recall the shares before the short seller has the
opportunity to cover her position. This is known as "buy-in risk" and can result in the short
seller being forced to close her position at a loss if she cannot find other shares to borrow.

Noise trade risk

- Noise traders are investors who trade in the market without accounting for information
- Noise trade risk arises due to unpredictable changes to demand/supply caused by noise
traders
- Noise traders can be motivated by various factors, such as a need for cash or a windfall
gain
- As a result of noise trading, stock prices can reflect not only information but also the
unpredictable actions of noise traders
• - This can create short-term fluctuations in stock prices that are not necessarily
based on fundamental factors, making it difficult for rational arbitrageurs to profit
from mispricing

Noise trading makes arbitrage (more) risky

• Return to the twin stock example of Royal Dutch/Shell
• Suppose, investor wants to do an arbitrage trade at point A (year 1980). In this case

• Arbitrage strategy
o Sell short 1.5 units of Shell buy 1 unit of Royal Dutch and wait until prices
converge
o Once prices converged, close the short position by selling Royal Dutch and
buying back 1.5 units of Shell
• Arbitrageur hopes that prices will converge and parity be restored
o Indeed, if everyone starts taking long position on Dutch and short on Shell,
then PRoyal Dutch ↑ and PShell ↓
o Hence, market forces work towards restoring parity
• Suppose, positions are closed at time t in point B, where the parity is restored.
Realized profit at time t:

• The parity is restored in point B:

• Arbitrage profit

• However, it took four years until prices converged – In the meantime, the mispricing
becomes even worse – Royal Dutch price drops further, and if position needs to be
closed earlier, trading strategy makes (big) loss – Mutual funds need profits over
short horizons because otherwise investors (may) withdraw their capital
BUBBLES AND OVERCONFIDENCE

• Small reduction in growth can lead to dramatic price reduction in a “purely rational
world” Suppose S&P 500 firms pay $154.6m in dividends in 2000 and investors learn
that dividend growth drops from 8% to 7.4% With a 9.2% discount rate on the index

• Still, evidence strongly suggests behavioural explanations for dot.com bubble (as for
other bubbles)
• For instance, firms could increase their stock price simply adding “.com” to their
names

Lessons of Market Efficiency

• There is strong evidence in favour of market efficiency: Investors rapidly incorporate

new information into prices
• There is evidence which is difficult to reconcile with efficient market hypothesis
• However, earning money by exploiting mispricing is nonetheless difficult due to
limits to arbitrage
o Irrespective of whether EMH is true or not, strategies that promise high
abnormal returns should be taken with caution
o The fact that skilled investors cannot take advantage of predictable patterns
means that these patterns are to some extent useless