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1. Chapter 4: Challenges to market
efficiency
Powerpoint Slides to accompany Behavioral
Finance: Psychology, Decision-making and Markets
by Lucy F. Ackert & Richard Deaves
©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.
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2. Key trading rules that have shown to
be effective i.
• Small cap portfolios vs. large cap portfolios?
– Small cap wins out!
• Portfolios formed based on P/Es:
– Low P/Es do better!
• Earnings announcements momentum:
– Reaction to extreme announcements is slow!
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©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

3. Key trading rules that have shown to
be effective ii.
• Value vs. growth portfolios (usually value firm
has a high book/market and a growth firm
here is one with an absence of value):
– Go for value!
• Predictable serial correlation:
– Medium-term momentum!
• Long-term winners vs. losers:
– Reversals: losers become winners!
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©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

4. Value vs. growth portfolios:
International evidence
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©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

5. Momentum evidence
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©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

6. Reversal evidence
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©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.
Source: Figure 3 from De Bondt, W. F. M., and R. Thaler, 1985, “Does the stock market overreact?” Journal of
Finance 40, 793–807. © 1985 Wiley Publishing, Inc. this material is used by permission of John Wiley & Sons,
Inc.

7. Theoretical foundations of
efficient markets
Market efficiency requires that only one of the
following three conditions need hold:
1. Universal rationality
2. Uncorrelated errors
3. Unlimited arbitrage
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©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

8. Market efficiency and arbitrage
• One of main foundations of EMH is no-
arbitrage condition.
• If there are pricing errors (e.g., caused by
irrational investors) smart-money traders
arbitrage them away.
• No free lunches are left on the table!
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©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

9. Example of arbitrage opportunity:
Triangular arbitrage
• February 27/06
• $Cdn/$US forex rate = 1.1426
• $US/euro forex rate = 1.1855
• What must $Cdn/euro rate be to nullify
arbitrage?
1.1426 * 1.1855 = 1.3546
• While this was observed, what if this had not
been true?
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©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

10. What hampers arbitrage
exploitation?
1. Fundamental risk
2. Noise-trader risk
3. Implementation costs
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©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

11. Fundamental risk
• If you think a stock is underpriced you can buy
it, but:
– You might be sideswiped by the market.
– Or maybe by the industry.
– Plus there is idiosyncratic risk.
• Pure arbitrage seeks to eliminate all of these.
• Problem: you need to find perfect substitutes.
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©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

12. But where are these substitutes?
• Say Ford is too cheap.
• You buy Ford.
– But market may drop.
– Or auto industry may drop.
• So you buy Ford and short GM.
– But Ford itself may falter without industry or market dropping
(idiosyncratic risk) .
• Even you totally manage fundamental risk,
there is still noise-trader risk: spread may
widen as investors get it even more wrong.
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©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

13. Sentiment and noise
• Noise is opinion on value unrelated to
fundamental information (i.e., based on
misinformation)
• Sentiment is correlated noise, and has the
potential power to move markets.
• This implies that price movements can be
driven by misinformation rather than
information.
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©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

14. Noise-trader risk
• Noise trader risk is risk that mispricing being
exploited by the arbitrageur might worsen.
• It has been shown that noise-trader risk is
systematic, which means that it cannot be diversified
away.
• Real world arbitrageurs cannot wait it out because as
professional money managers they do not have long
horizons – they are usually evaluated at least at once
per year.
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©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.

15. Implementation costs
• In some cases, horizon is short but short-selling is:
– Expensive (commissions, spreads, price impact & fees for shorting
stock)
– Difficult or even impossible (lack of availability regardless
of fees; legal factors: many institutions cannot short)
• Plus there is cost of finding these arbitrage
opportunities.
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posted to a publicly available website, in whole or in part.

16. 3Com and Palm
• March 2, 2000: 3Com carves out in an IPO 5%
of its subsidiary Palm.
• At same time 3Com announced that in the
near future the remaining 95% of the shares
would be distributed to current shareholders
(roughly 1.5 of Palm/share of 3Com).
• Two ways of buying Palm:
– Buy Palm directly.
– Buy 3Com getting Palm and rest of 3Com business.
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posted to a publicly available website, in whole or in part.

17. 3Com and Palm cont.
• Clearly if investors are rational:
P(3Com) = 1.5* P(Palm) + Residual value
• What happened?
– After 1st day of Palm trading:
• P(Palm) = $95.06
• P(3Com) = $81.81
• Implied residual value: less than zero.
• Implication: Value of residual 3Com was:
negative $22 billion.
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posted to a publicly available website, in whole or in part.

18. 3Com and Palm cont. ii.
• Everyone seemed to understand the situation:
– “The nature of the mispricing was so simple that even the
dimmest market participants and financial journalists were able
to grasp it.”
• Incredibly the mispricing persisted for
months!
• And other such examples can be cited!
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posted to a publicly available website, in whole or in part.

19. What can explain this?
• “Smart” investors were limited in their ability to
short-sell Palm (as documented in Lamont and
Thaler), so it wasn’t their fault.
• But this cannot explain why anybody would buy Palm
instead of 3Com – for this one needs irrationality.
• In facts 2 things are needed for mispricing to exist:
– Irrational investors
– Limits to arbitrage (here due to implementation costs)
• 3Com & Palm case illustrates that mispricing does
not imply a free lunch!
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©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part.