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Behavioral Finance

Behavioral Finance. Sris Chatterjee. AGENDA. Modern Finance Theory and EMH Anomalies and Puzzles Psychological Foundations of Behavioral Finance Possible Applications Bibliography. Implications of EMH. Weak Form EMH Semi-Strong Form EMH Law of One Price Price Reflects Fundamental Value

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Behavioral Finance

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  1. Behavioral Finance Sris Chatterjee

  2. AGENDA • Modern Finance Theory and EMH • Anomalies and Puzzles • Psychological Foundations of Behavioral Finance • Possible Applications • Bibliography

  3. Implications of EMH • Weak Form EMH • Semi-Strong Form EMH • Law of One Price • Price Reflects Fundamental Value • No Free Lunch

  4. Twin Share Puzzle • Royal Dutch Shell • Unilever NV and Unilever PLC • SmithKline Beecham

  5. Royal Dutch Shell • Royal Dutch Petroleum and Shell Transport & Trading are independently incorporated in the Netherlands and England. • All cash flows, adjusting for corporate tax considerations and control rights, are split 60:40 after a 1907 alliance. The Annual Report clarifies these linkages and price disparities lead to “Switch” trades. • Royal Dutch trades primarily in the U.S. and the Netherlands, and is included in the S&P500 and virtually every Dutch Index. Shell trades predominantly in the U.K. and is in the FTSE. • Royal Dutch is sometimes 35% underpriced, and sometimes 15% overpriced !

  6. Unilever NV and Unilever PLC • Unilever N.V. and Unilever PLC are independently incorporated in the Netherlands and England. • 1930 Equalization Agreement of Cash Flows created a single group with the same board and shares as similar as possible. • Unilever N.V. trades mostly in the Netherlands and also in Switzerland and U.S. (it is in S&P500). Unilever PLC trades predominantly in the U.K. (it is in FTSE). • Unilever N.V. is sometimes 40% underpriced from parity, and sometimes 20% overpriced !

  7. SmithKline Beecham • SmithKline Beckman and Beecham Group merged in 1989. • Holders of Beecham (a U.K. company) received class A ordinary shares and holders of SmithKline Beckman (a U.S. company) received class E shares comprised of 5 shares of SmithKline Beecham class B ordinary shares and one preferred share. • Dividends are equalized, so that one class E share provides the same dividends as one class A share. • A shares trade predominantly in the U.K., and E shares and ADRs on A shares trade predominantly in the U.S. • ADRs are typically overpriced from parity, in the range of 4% to a little above 16% !

  8. Tech-Stock Carve-outs followed by Spin-offs • On March 2, 2000, 3Com completed a 5% Equity Carve-out of Palm and announced that, pending an IRS approval, it would Spin-off its remaining 95% ownership. • Spin-off terms: 3Com shareholders would receive about 1.5 Palm shares (1.525 exactly) for every 3Com share. • The day before the Palm IPO, 3Com closed at $104.13 and after the first day of trading, Palm closed at $95.06. • 3Com should have jumped to $145, but actually fell to $81.81. • This implied a stub value of ($63) for 3Com ! • Alternatively, the value of non-Palm business is negative $22 bn !!

  9. Tech-Stock Carve-outs Contd. • Owen Lamont and Richard Thaler examine 18 Equity Carve-outs where the parent clearly announced a later spin-off and identify 6 cases of unambiguously negative stubs. • Stubs start negative and gradually get close to zero. • Short Sales Restrictions

  10. Evidence on Short Sales : % Short Interest First Month Second Peak: Parent Sub Month: Sub Sub _____________________________________________________ Creative/UBID 4.2 8.5 54.7 70.9 HNC/Retek 7.5 19.8 37.4 53.4 Daisytek/PFSWeb 1.6 17.7 48.6 63.7 Metamor/Xpedior 4.9 17.2 24.6 26.8 3Com/Palm 2.6 19.4 44.9 147.6 Methode/Stratos 1.5 31.8 50.3 114.7 Average 3.7 19.1 43.4 79.5

  11. Evidence from Palm Options Palm Options on March 17, 2000 Call Put Bid Ask Bid Ask May 55 5.75 7.25 10.625 12.625 August 55 9.25 10.75 17.25 19.25 Nov 55 10 11.5 21.625 23.625 _____________________________________________________ Palm Stock Price $55.25 3Com stock price $69

  12. Index Inclusions • S&P states that adding a stock to the Index is not an information event: “Judgments as to the investment appeal of the stocks do not enter into the selection process”. • But two early studies show that when a stock is added to the Index it jumps in price by an average of 3.5%, and much of this jump is permanent. • When Yahoo was added to the Index, its share price jumped by 24% in a single day ! • While there is evidence of information and liquidity effects, the re-weighting of some 31 stocks in the TSE300 and the positive price effects point towards mis-pricing, because no new information is available on these stocks.

  13. Closed-End Fund Puzzle • A Closed-End Fund issues a fixed number of shares that trade in the market. The puzzle consists of the fact that shares in the fund deviate a lot from the per share Net Asset Value. • Closed-end Funds may start out at a premium of 10%. • Although they start at a premium, closed-end funds start to trade at an average discount of 10% within 120 days. In some cases, discount is as large as 25% ! • Discounts on closed-end funds are subject to wide fluctuations. • Standard explanations based on agency costs, liquidity or taxes do not seem to explain the puzzle. • But “Investor Sentiment” seems to be the best explanation.

  14. Psychological Insights & Foundations • Preferences • Prospect Theory • Beliefs • Overconfidence • Optimism • Representativeness • Conservatism • Belief Perseverance • Anchoring • Availability Biases

  15. Applications • The Aggregate Stock Market • Average Cross Sectional Returns • Investor Behavior • Corporate Finance

  16. Aggregate Stock Market • The Equity Premium • Excess Volatility • Related Predictability Puzzle

  17. Cross-Section of Average Returns • The Size Premium • Momentum • Long-Term Reversals • Event Studies

  18. Investor Behavior • Insufficient Diversification • Excessive Trading • Selling and Buying Decisions

  19. Corporate Finance • Security Issuance • Capital Structure • Dividends

  20. Bibliography • Andrei Shleifer, Inefficient Markets: An Introduction to Behavioral Finance, Oxford University Press, 2000. • Nicholas Barberis and Richard Thaler, “A Survey of Behavioral Finance”, September 2002, working paper. • Kenneth Froot and Emil Dabora, “How are stock prices affected by the location of trade ?”, Journal of Financial Economics 53 (1999), pages 189-216. • Owen Lamont and Richard Thaler, “Can the market add and subtract? Mispricing in tech stock carve-outs”, Journal of Political Economy, April 2003, pages 227-268.

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