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Oleg Shibanov
New Economic School
March, 2014
Did you bring your calculator? Did you read the chapter ahead of time?
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Historically, there has been much confusion here: most people mean perfect
markets when they say ecient markets.
Perfect Market Ecient Market
but
Perfect Market
// Ecient Market
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Covered Topics
I
The problem is: what does right mean? We need to have a good model for
the right target.
Advantages of ME: you can learn from market values; and you know where
you can add value and where not.
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That the market uses all information in its setting of the current price, to give you
whatever the rate of return should be [according to model].
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Illustration
A Specific Example: PepsiCo
The market estimates PepsiCos expected value next year to be $55 per share. It
also estimates all other interesting characteristics, such as cash ows,
market-betas, covariances, liquidity, etc.
Say the CAPM is the correct pricing model. Then the nancial market looks at
PepsiCos market beta, the risk-free rate, and the expected rate of return on the
market, and sets PepsiCos expected rate of return. Say this CAPM expected rate
of return is 10%.
The price today is $55/1.1 = $50 per share.
(Q: What would you conclude to have gone wrong if you saw a price of, say,
$45.83 today?)
The General Case
The nancial markets estimate the statistical distribution of future cash ows,
including their expected cash ow values, covariances, liquidity, and anything else
possibly of interest.
Oleg Shibanovmarket
(NES)
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2014
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The nancial
determines the Ecient
appropriate
expected rate of return,
given
all
If agents are not stupid (and there are innitely many smart ones), then any
perfect market will become ecient.
However, even in an imperfect market (e.g., with transaction costs), the market
could still be ecient, setting prices at whatever level is appropriate.
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You see that the price of IBM is such that you expect it to
earn 20% over the next year. Can you conclude that the
market is inecient?
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An expected 10% in one day is contradicting ME, because it is not plausible that
any reasonable equilibrium model could tell you that you should earn 10% in one
day.
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Nope. You can always claim that the model was wrong. Some people believe ME
is close to religion, which for long periods it may be.
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Think about extent of market perfection. The closer a market is to being perfect,
the more likely it is to being ecient, too.
Of course, if the market is not perfect, there may not even be an ecient value.
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Focuses on the relation between price reecting underlying value, and closely
linked to behavioral nance:
True believer: Price is always PV of the rms cash ow.
Firm believer: Price deviates from PV, but this is not exploitable.
Mild believer: Price deviates from PV, and exploiting it is possible, giving you as
an investor a mild edge.
Non believer: Price deviates strongly from PV, so investors can easily get rich.
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Causality
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Maybe 10%/255 0.04% per day (4bp per day). More realistically, 0.02% per
day.
I
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If you can expect to outperform by an extra 2% per year, you are a star! This is
less than 1 basis points a day.
Presume you are a true superstar.
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of topic)
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For example, a bet with equal probability payos of $1 or +$100 million is not
an arbitrage, but it is a great bet.
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Nope.
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Finance Models
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People who look at patterns of historical stock prices and try to predict the
market with it.
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See before: 100 years for few-stock strategies, 30 years for large-portfolio
strategies.
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In-house for a couple of years. The bad ones close, the good ones are advertised.
Survivorship bias.
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About half every year (not exact, of course) so about 1/1000 in 10 years
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A lot more than 1/1000 (not exact, of course) due to survivorship bias.
Tests of persistence of outperformance perform similarly poorly. That is, the funds
that do the best in one periods usually do not do the best the following period.
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Not good, not bad. For sure, its historical performance and behavior is not a
secret. Even if Buett is good at making money, this is certainly already known to
investors, who have bid up the BH price to take this into acount.
(This was also explained at the end of Chapter 2.)
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The fund manager (or existing investors). There is more than enough outside
money to fund great managers. Money by itself does not bring anything great to
the table.
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You cannot add value by doing things that investors can do (or undo). [splits,
dividends, etc.]
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Nope.
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