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Behavioral Finance

Behavioral Finance. Economics 437. Bear Stearns (BSC). 160. 105. 80. 52. 30. 11 ½. 4 1/2. Sept 2007. Mar 1. Today. May 2007. One Tumultuous Week:. Why is Bear Stearns Trading at 11 ½ ?.

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Behavioral Finance

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  1. Behavioral Finance Economics 437

  2. Bear Stearns (BSC) 160 105 80 52 30 11 ½ 4 1/2 Sept 2007 Mar 1 Today May 2007

  3. One Tumultuous Week:

  4. Why is Bear Stearns Trading at 11 ½ ? • Language in the deal: JPM agrees to guarantee BSC positions even if the shareholders vote “no” to the deal • A Deal Mistake: Language in the deal said that JPM would guarantee BSC trades even if the shareholders voted down the deal!!! • Dimon scrambled to put a new deal in place • New Deal announced yesterday

  5. The Revised JPM acquisition of BSC • $ 10 per share (five times the earlier deal) • JPM immediately acquires 39.9 percent of BSC stock (through share issuance) • The $ 10 is paid to shareholders on record date (which may be a very, very different group from the shareholders at the time of the earlier deal) • Raises serious questions about the FRS’s role

  6. Return now to Fama-French

  7. Eugene Fama and Kenneth French: “The Cross Section of Expected Stock Returns,” 1992 • Background • CAPM predicts that “β” explains stock returns • Evidence says “no relationship” • So, what does “explain” stock returns, if not “β” • Size seems to be a predictor in previous research • Lower size implies higher returns

  8. Results of F-F Empirical Work • BE/ME and ME are main predictors of returns • Not beta • Not P/E • Interpretation • Markets could be irrational: EMH is false • EMH is true • There are other “factors” that are “proxied” by BE/ME • Beta’s impact is obscured by • Mismeasurement of beta • Obscured by other variables

  9. DeBondt – Thaler – The Over Reaction Hypothesis (Mean Reversion) • Stocks that have done well in the past will do poorly in the future….stocks that have done poorly in the past will do well in the future. • Idea: “…individuals tend to overweight recent information and underweight prior…data” • “…considerable evidence that the actual expectations of professional security analysts display the same overreaction bias…” • “…our goal is to test whether the overreaction hypothesis is predictive”

  10. What do DeBondt-Thaler do? • Form “winner” portfolios and “loser” portfolios • Five years of data determine with the “W” and the “L” portfolios • Then look at the next five years • Definition of returns: Rjt - RMt • Difference between stock’s return and market’s return • Conclusion: • “Over the past half-century, loser portfolios of 35 stocks outperform the market by, on average, 19.6 %, thirty six months after portfolio formation

  11. Interesting facts • Most of the excess returns are in January • Loser effect more pronounced: • Losers earned 19.6 % more than the market • Winners earn 5.0 % less than the market • Loser portfolio minus Winner portfolio return = 24.6 %!!!!! • Most of the return difference is during 2nd and 3rd year • Larger loses become larger winners; larger winners become larger losers

  12. Jegadeesh & Titman: Under Reaction…Earnings or Price Momentum • 3 to 12 months horizons (compared to 3 to 5 years in DeBondt-Thaler • In the trade, this is called “momentum” or “relative strength” • Zero cost portfolio results • 6 month/6 month yields 12 % per year return • 12 month/ 3 month is best 1.31% per month

  13. End

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