Competing Theories of Financial Anomalies. Alon Brav & J. B. Heaton. Outline. Background and definitions Objectives Main body: Models Explaining financial anomalies Learning and arbitrage Conclusion. Financial Anomalies:
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Alon Brav & J. B. Heaton
patterns of price behavior inconsistent with the predictions of traditional efficient markets, rational expectations asset pricing theory, such as overreaction, underreaction, calendar effect, puzzle of close-end mutual fund and etc.
Rational structural uncertainty
Evolution of the competing theories
Rational expectations world
Rational expectations Rationality all structural knowledge
a phenomenon where subjects expect key population parameters to be “represented” in any recent sequence of general data. Thereby, recent evidence is overweighted while base rates (prior beliefs and/or other data) and older evidence are ignored.
a documented deviation from Bayesian judgment where base rates receive excessive weight and new data are underweighted.
Representativeness heuristic Conservatism
1.1 The assets and the representative investors:
--a one-period risky asset
-- ’s payoff at the end of period t
Representative investor: risk neutral and values at its expected payoff,
called the valuation-relevant parameter
Key structural feature of the economy—stability of :
Unstable, if it varies through time, with the location of change point
where is the mean of the most recent n/2 payoffs,
Beh denotes “behavioral”
RH denotes the “representativeness heuristic”
Risk-neutral Bayesian investor’s estimator
which is equivalent to
where , which implies
subscript C denotes “conservatism”
NOT/Biased Bayesian methods
Fully Bayesian methods
Key structural features (stability of and if not stable, the location of change point)
DON’T knowCrucial differences between the irrational investors and the rational investors
Using Bayesian change-point analysis (Smith, 1975),
where is a posterior distribution for or , conditioned on the change having occurred at a given change point, r.
2.1 Overreaction and underreaction
The predictability of good(bad) future returns from bad(good) past performance
The predictability of good(bad) future returns from good(bad) past performance
2.2 Overreaction and underreaction in the behavioral and rational models
Reasons for difficulty in distinguishing the theories arise from:
explored and highlighted the explanatory approaches of behavioral and rational theories and the need to more carefully distinguish them
connections between the competing theories
normative differences that exist in the competing theories(more details next)