FINA 3010: FINANCIAL MARKETS

Wenxi JIANG
(Fall 2015)

Lecture Note 8:
Departure from EMH

© Wenxi Jiang

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Outline

1. The “arbitrage critique”

2. Limits to arbitrage
- Risks in arbitrage
- Costs in arbitrage
- Riding the bubble

3. Real world cases

- Twin shares
- Equity carve-outs

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Overview
Course content
Part I: Financial Assets and Instruments
- Debt
- Stock
- Insurance, futures, and options
Part II: Investor in Financial Markets
- Individual investors
- Institutional investors
Part III: Prices of Financial Assets
- Efficient market hypothesis (EMH)
- Departure from EMH
- Aggregate asset market return
- The cross-section of asset return
- Bubble and crash

EMH is based on the traditional framework

- Rational investors
- No friction => no arbitrage

However, EMH appears to be inconsistent with the data in real

financial markets
- Which assumption goes wrong?

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The arbitrage critique

• Intuitively, people may think that excessive investor

optimism/pessimism can cause financial assets to become
over/under-valued
• This idea was not taken seriously by academic economists until the
1990s
- The reason: the “arbitrage critique”
- Says that irrational investor cannot have substantial or long-lived
impact on asset prices

• If irrational investors cause an asset to become mispriced, this

immediately creates an attractive opportunity for rational investors
- These rational investors trade aggressively against the
mispricing, causing it to quickly disappear

• Process of correcting a mispricing is sometimes called “arbitrage”

- And the people who do it, “arbitrageurs”

• The arbitrage critique had a powerful effect on academic discourse

and also on finance education
- It prevented serious academic discussion of irrational investors’’
impact for decades

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• However, in the 1990s, some researchers re-examined the arbitrage
critique and realized that it had serious flaws

Limits to arbitrage

• The arbitrage critique posits that rational investors can easily

correct a mispricing
• In reality, however, arbitrageurs face risks and costs when they try to
correct a mispricing
- These risk and cost limit their ability to correct the mispricing
- And allow irrational investors to affect prices for long periods
- There are “limits to arbitrage”
• This counter-argument to “arbitrage critique” has proven persuasive
to both academics and practitioners

Risks in arbitrage

1. Fundamental risk

the risk that there will be adverse news about the fundamental value of
the mispriced asset
• this risk can be hedged by taking an offsetting position in a
“substitute” security
- but this is only partially effective

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2. Noise trader risk

The risk that the mispriced asset will become even more mispriced in
the short term, forcing the arbitrageur to close out the trade at a loss

• the risk arises because most arbitrageur manage other people’s

money
- and because they use leverage
• poor short-term performance can lead clients to withdraw their
money
- forcing the arbitrageur to sell at a loss
• The use of leverage compounds the problem
- Poor short-term performance can lead lenders to call their loans
- Forcing arbitrageurs to sell at a loss

Knowing this in advance, the arbitrageurs will not trade too

aggressively against the mispricing

3. Horizon risk
The risk that the mispricing takes so long to correct that a trade that
exploits it earns less that the risk-free rate

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4. Model risk
The risk that the perceived mispricing is not actually a mispricing

Costs in arbitrage

1. Trading costs:
- transaction costs and commissions
- shorting fees
- bid-ask spreads
- price impact

2. Costs of discovering, evaluating, and exploiting a mispricing

• An important observation is limited attention

- Arbitrageurs have limited attention and processing power to
track the fundamental value of all assets at any point of time
- Arbitrage critique says that when mispricing appears,
arbitrageurs can quickly find and correct it
- But finding the arbitrage opportunities is often costly and takes
time

• Evidence to limited attention: post-earnings announcement drift

(PEAD)

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 - Stocks with a good earnings surprise tend to have higher returns
in the subsequent 60 days after the announcement
- Also, the size of PEAD is larger for earnings announcements that
take place on … Fridays

Source: Bernard and Thomas (1989)

“Riding the bubble”

In some cases, rational investors prefer to trade in the same direction
as the irrational investors, rather than against them

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 - E.g., if the irrational investors are naively extrapolating past
returns into the future

• This makes it all the less likely that the mispricing will quickly
correct
• Evidence: during the internet bubble, hedge funds were overweight
technology stocks (Brunnermeier and
Hedge Funds and the NagelBubble
Technology 2004) 2023

Proportion invested in Nasdaq high P/S stocks Nasdaq Peak

0.35

0.30

0.25

0.20

0.15

0.10

0.05

0.00
Mar-98 Jun-98 Sep-98 Dec-98 Mar-99 Jun-99 Sep-99 Dec-99 Mar-00 Jun-00 Sep-00 Dec-00

Hedge Fund Portfolio Market Portfolio

Figure 2. Weight of Nasdaq technology stocks (high P/S) in aggregate hedge fund port-
folio versus weight in market portfolio. At the end of each quarter, we compute the weight,
in terms of market value, of high P/S quintile Nasdaq stocks in the overall stock portfolio of hedge
funds, given their reported holdings on form 13F. For comparison, we also report the value-weight
of high P/S stocks in the market portfolio (all stocks on CRSP).

is at least somewhat consistent with the remark of Soros Fund Managements’

then-chief investment officer Stanley Druckenmiller that they were “calling the
bursting of the internet bubble” in spring 1999.6 As it turned out, this call was
too early. The bubble did not burst yet. Then, within just one quarter, hedge
funds increased the weight of technology stocks from 16% to 29% in September
Real-world cases
1999. The market portfolio weights only changed from 14% to 17%. Interest-
ingly, this increase occurred just before the final price run-up of technology
stocks. From the end of September 1999 to February 2000, the high P/S seg-
We now look at some well-known mispricings and try to understand
ment of the Nasdaq gained almost 100% (see Figure 1). Relative to market
portfolio weights, September 1999 marks the peak of technology exposure of
the limits tohedge
arbitrage
funds. Thethat allowgradually
gap narrows them to persist
over the subsequent quarters. At the
end of 2000, the hedge fund portfolio weight is very close to the market portfolio
weight.
Could this tilt toward technology stocks in hedge fund portfolios simply be
the result of preferential share allocations in initial public offerings (IPO)? Re-
cently, there have been allegations that hedge funds and other institutional in-
vestors received favorable allocations of shares in “hot” IPOs, that is, stocks that
would rise substantially on their first day of trading—in exchange for provid-
ing kickbacks to investment banks in the form of inf lated trading commissions

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“After having made money in the internet pre-January 1999, on the long side, we were too early
in calling the bursting of the internet bubble.” (Pacelle (1999)). 9
 Case I: twin shares – Royal Dutch and Shell

• Twin shares: distinct shares that are claims to the same cash-flow
stream
• Royal Dutch and Shell
- Used to be independent companies
- In 1907, merged their interests while remaining separate entities
- Royal Dutch: claim to 60% of the combined firm’s cash flow
- Shell: claim to 40% of the combined firm’s cash flow
• In a rational economy with no frictions, we should see
𝑣𝑎𝑙𝑢𝑒(𝑅𝑜𝑦𝑎𝑙 𝐷𝑢𝑡𝑐ℎ)
= 1.5
𝑣𝑎𝑙𝑢𝑒(𝑆ℎ𝑒𝑙𝑙)
• But this has been far from true, historically

Fig. 1. Log deviations from Royal Dutch/Shell parity. Note: This "gure shows on a percentage basis
the deviations from theoretical parity of Royal Dutch and Shell shares and ADRs traded on the
NYSE. Data are from the Center for Research in Security Pricing (CRSP).

• how did this mispricing manage to survive for so long?

• how did this mispricing manage to survive for so long?
- What are the limits to arbitrage?
– what are the limits to arbitrage?
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Case II: equity carve-outs

• An equity carve-out is an IPO of shares in a subsidiary company

• Researchers found 70 cases between 1985 and 2000 where, after a
carve-out, the parent company traded for less than its subsidiary
- Mitchell, Pulvino, Stafford (2002)
• Those events are widely viewed as mispricings
• To exploit them, an arbitrageur would short the subsidiary and buy
the parent
- What are the limits of arbitrage in this case?

Fundamental risk:
• The risk of adverse fundamental news
• Out of the 70 events, 18 terminated unsuccessfully

Noise trader risk:

• The risk of being forced to liquidate the trade at a loss if the
mispricing worsens in the short run
- Forced liquidation may be due to margin calls
• E.g., Creative computers (parent) and Ubid (subsidiary)

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• e.g. Creative Computers (parent) and Ubid (sub-
sidiary)

Figure 1. Paths of stock prices for Creative Computers and Ubid.

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Horizon risk:
• Sometimes, the mispricing takes so long to correct that traders
would have been better off investing at the risk-free rate

Implementation cost:
• Shorting costs
• Costs of understanding the mispricing are much higher

Summary
The past 25 years have been seen a major shift in thinking
• Now, most academic economists (and finance practitioners) believe
that there are “limits to arbitrage”
• In other words, most academics and practitioners now believe that
irrational investors can have an impact on prices

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Suggested readings

Sections 2, Barberis, Nicholas, and Richard Thaler. "A survey of behavioral finance." Handbook of the
Economics of Finance 1 (2003): 1053-1128.

Reference

Bernard, Victor L., and Jacob K. Thomas. "Post-earnings-announcement drift: delayed price
response or risk premium?." Journal of Accounting research (1989): 1-36.

Brunnermeier, Markus, and Stefan Nagel. "Hedge funds and the technology bubble." The Journal of
Finance 59.5 (2004): 2013-2040.

Mitchell, Mark, Todd Pulvino, and Erik Stafford. "Limited arbitrage in equity markets." Journal of
Finance 57.2 (2002).

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