SECURITIES MARKETS 1&2

TOPIC 4: MARKET EFFICIENCY

 TOPIC 4: THEMES

• The Efficient Markets Hypothesis (EMH)

• The Random Walk Hypothesis (RWH) and Market Predictability
• Event Studies
• Market Anomalies
• Behavioral Finance; the Rational vs. Behavioral Debate
• Speculation: Buying on Margin, Short Selling; Arbitrage
• Case 1: Twin Coins and the Perfect Arbitrage
• Case 2: The Porsche and Volkswagen Short Squeeze
• Case 3: The GameStop Short Squeeze
• Case 4: Mispricing in Tech Stock Carve-outs

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 TOPIC 4: QUESTIONS

• Explain the following definitions of market efficiency

 The price is right
 There is no free lunch
 Prices are unpredictable
• Do prices follow a random walk?
• According to EMH, what should you expect about the price of IBM next year?
• What are the main anomalies? What is their rational explanation? What is their
behavioral explanation?
• Do investors behave rationally, or is the market dominated by "animal spirits"?
• What does behavioral finance study? Are there behavioral effects at the
aggregate market level?
• How is short selling done? What is a short squeeze?
• What is an arbitrage? What are the risks?
• Why are there violations of the law-of-one-price? How long can they persist,
and why?

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1. EMH: DEFINITION AND CONSEQUENCES
 EFFICIENT MARKETS HYPOTHESIS (EMH)

Journalistic “definitions” of market efficiency

 Market price is right
 Prices are unpredictable
 There is no free lunch
 Prices contain all the (publicly) available information

Rigorous definition: Efficient Market Hypothesis (EMH)

 Market price satisfies the present value formula!
• Eugene Fama (1965, 1970), Nobel prize in 2013

• Price = future projected cash flows discounted at the “correct”

discount rate r
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 EMH: DEFINITION
1. Prices always reflect the fundamental value of the asset

 Need to project future cash flows

 Formula only true for r = constant over time
• If r = rt is not constant, much more complicated formula (Robert
Shiller got another Nobel prize related to it, also in 2013)

2. Discount rate r is correct for the riskiness of cash flows

 Need a model of expected returns, such as CAPM

3. Investors use all available information in forming their expectations

 Past prices + other public information (accounting ratios, etc.)

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 EMH: CONSEQUENCES

How do we interpret: “market price is right”?

 The price always satisfies the PV formula

Consequence 1: Price of an asset depends only on asset’s fundamentals:

 Cash flows
 Discount rates
… and nothing else

This property sets apart economics from finance

 In economics: what is the correct price of a diamond?
• Based on supply and demand
 In finance: supply and demand matter only if they affect the fundamentals

Consequence 2: Price of an asset changes when the asset’s fundamentals change:

 Either expected cash flows change, or
 Discount rates change

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 EMH: CONSEQUENCES

Consequence 3: Prices react to new information quickly and to the right extent
 Example: after good news, a company’s price should
• Jump immediately after the news becomes public
• Stay flat at the new level on average
• To compute averages, do an event study

Consequence 4: Market under-reaction (drift up) or over-reaction  Market inefficiency !

• E.g., Could try to profit from drift up: buy right after news and sell after several days!
• But you need to measure the risk of this strategy!

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 EMH: CONSEQUENCES

Consequence 5: Over time, price of an asset evolves according to the formula:

 Pt is the price today, Pt+1 is the price next period (including dividends)
 r is the expected return
 et+1 is unpredictable (from today’s information), and mean zero

Short run: r = 0
 Approximately true: over one day, S&P 500 has r = 0.03%
 We obtain Pt+1 = Pt + et+1 , which implies that Pt+1 – Pt = et+1
 EMH  Changes in prices are unpredictable  Prices follow a random walk

Long run: r = ?
 It depends on the model we are using: CAPM, Fama-French 3, …
 Note that r > 0 generates a drift in prices
 Drifts do not mean inefficiency in the long run ! (complicated…)
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 EMH: CONSEQUENCES

Consequence 6: Any strategy S using public information should have alpha = 0

 Should not make positive alpha / abnormal returns / abnormal profits using S

Suppose you have a trading strategy S that only uses publicly available information
 Regular drift = expected return (rS ), which should reflect the correct risk model
 Abnormal drift = alpha (𝛼𝛼 S ), which should equal zero if the market is efficient

Intuition:
 One should not get a positive alpha form using just public information
 𝛼𝛼 S = 0 is the rigorous interpretation of “No free lunch”
 The only way to get higher returns is to take on more risk

In the short run:

 Strategy’s expected return rS is approximately zero
 EMH: you should not make any (expected) profits using S
 No need to worry about the correct risk model
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2. EMH: VERSIONS
 EMH: VERSIONS

In the present value formula, the expected cash flows and the expected returns
are computed by investors conditionally on their information set

Depending on the investors’ information set, there are three types of market
efficiency
1. Weak-form efficiency
• Prices reflect all information contained in past trading
2. Semistrong-form efficiency
• Prices reflect all publicly available information
3. Strong-form efficiency
• Prices reflect all relevant information, including private (inside)
information

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EMH: VERSIONS

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 EMH: WEAK FORM

Current prices fully reflect all information in past prices

 Technical analysis using past price patterns should not produce profits

Does technical analysis make sense?

 “Trend is your friend”; Charts and patterns (e.g., Resistance and Support, Head and
Shoulders); Candlestick charts, Dow theory, Elliot waves
 Hindenburg omen
• The daily number of new 52-week highs and 52-week lows in a stock market
index are greater than a threshold amount (typically 2.2%)
• The 52-week highs cannot be more than two times the 52-week lows
• The stock market index is still in an uptrend. A 10-week moving average, or the
50-day rate of change indicator, is used to indicate this
• The McClellan Oscillator (MCO), a measure of the shift in market sentiment, is
negative
 McClellan Oscillator =
(19-day EMA of Advances − Declines) − (39-day EMA of Advances −
Declines)
» 19-day EMA = (Current Day Advances − Declines)*0.10 + Prior Day EMA
» 39-day EMA = (Current Day Advances − Declines)*0.05 + Prior Day EMA
» EMA = Exponential Moving Average
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RESISTANCE AND SUPPORT

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RESISTANCE AND SUPPORT

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HEAD AND SHOULDERS

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 EMH: SEMISTRONG FORM

Current prices fully reflect all past prices and all available public information
 Fundamental analysis should not produce profits, e.g., forming portfolios on
accounting ratios, balance sheet, or income statement information should not
generate abnormal profits
 When someone refers to market efficiency without specifying the form, it is usually
the semistrong form

Difficult to distinguish private information from public

 Made easier in the U.S. after 2000: Regulation FD (“Fair Disclosure”)
• Disclosure of non-public information by a company to one person must be made
available to all
 Public information that is difficult to obtain or interpret could be considered as
private information
 The semistrong form usually involves strategies that use easily available public
information

Many investors consider themselves “fundamentalists”

 E.g., Warren Buffett, Jim Cramer
 Can professional money managers consistently beat the market using only public
information?
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JIM CRAMER – PUBLIC OR PRIVATE INFORMATION?

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PUBLIC OR PRIVATE INFORMATION?

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 EMH: STRONG FORM

Current prices fully reflect all information, public and private

 Insider Trading should not produce profits
• E.g., knowing a merger is going to take place before it is announced publicly

Many cases of insider trading

 Galleon Group’s Raj Rajaratnam got a 11-year insider trading sentence
 SAC (Steve Cohen)
 Martha Stewart got a tip from her broker, Peter Bacanovic, and sold about $230,000
in ImClone shares one day before the FDA announcement (went to jail)
 Ivan Boesky paid employees of Drexel Burnham Lambert to get information about
nearly all major M&A deals in the 1980s, including Getty Oil, Nabisco, Gulf Oil,
Chevron, Texaco
 Albert Wiggin, head of Chase National Bank, shorted his own company after the 1929
crash, made over $4 million

Insider trading of course produces very large profits

 Strong form EMH cannot be true

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 INSIDER TRADING PROFITS

Ahern (JFE 2017) – “Information networks: Evidence from illegal insider trading
tips”
 This paper exploits a novel hand-collected data set to provide a
comprehensive analysis of the social relationships that underlie illegal
insider trading networks. I find that inside information flows through
strong social ties based on family, friends, and geographic proximity. On
average, inside tips originate from corporate executives and reach buy-
side investors after three links in the network. Inside traders earn
prodigious returns of 35% over 21 days, with more central traders
earning greater returns, as information conveyed through social
networks improves price efficiency. More broadly, this paper provides
some of the only direct evidence of person-to-person communication
among investors.

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3. RANDOM WALK HYPOTHESIS
 RANDOM WALK HYPOTHESIS
“It is rational that prices are crazy”
Market prices appear to fluctuate wildly. Does this mean that markets are
irrational and inefficient?
 No! It turns out that it is rational that prices evolve randomly

Say you look at a stock XYZ which trades today at $100

 If everybody expects that XYZ’s price will go up for sure by $1 tomorrow,
what do you expect will happen today?
 ABC should go up by $1 today
• Same is true if the market expects XYZ to go up by $1 on average

Implications:
 The best estimate of the price tomorrow is the price today
 The change in price between today is tomorrow is completely
unpredictable

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 RANDOM WALK HYPOTHESIS

Denote the change between the price today and the price tomorrow by et+1
 We have the formula
Pt+1 = Pt + et+1

 et+1 must be uncorrelated with past values of et

 Pt follows a random walk

 Samuelson (1965) “Proof that properly anticipated prices fluctuate
randomly”

In other words, it is rational that markets are crazy! (“crazy” here means
“unpredictable”)

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 RANDOM WALK HYPOTHESIS

It is often thought that EMH implies RWH, but this is not true in general!
However, prices follow a process similar to a random walk with drift. Let’s prove this
mathematically. First, note that

is unpredictable at t and has mean = 0. From the definition of net return,

By taking expectation at t, we also have

By the definition of et+1, we have Pt+1 + Dt+1 = Et (Pt+1 + Dt+1) + et+1, therefore

where et+1 is completely unpredictable (and mean = 0)

 If the discount rate r is constant, and there is no dividend (Dt+1 = 0), prices follow

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 RANDOM WALK HYPOTHESIS

Over the short run

 r can be considered constant and approximately zero
 Don’t need a model for r (such as CAPM or FF3)
 EMH implies RWH: price changes are unpredictable
Pt+1 = Pt + et+1

Over the long run

 Prices need to increase on average, to compensate investors for risk
Pt+1 = Pt (1 + r) + et+1
 Need a model for r : CAPM, FF3, etc.
• Additionally, r might change over time, e.g., with the business cycle
• Also, r can be predicted by P/E ratios (which do change)
 EMH does NOT imply RWH: there might be some predictability even if EMH
is true

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 RANDOMNESS

How many of the following prices are random?

Randomness is not easy to understand

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4. EVENT STUDIES
 STOCK SPLITS

• Fama, Fisher, Jensen, Roll, 1969 studied the impact of a stock split on the
price of the stock

A stock split usually happens because the price of stock is high and
companies want to make the stocks more affordable
In the past, stock splits were often accompanied by an increase in
dividend
So the announcement of a stock split was very good news
FFJR show that prices actually jump the day of the announcement or
in anticipation of this announcement
The day of the actual split there is no clear direction of the change in
prices

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STOCK SPLITS

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 CHALLENGER

• Maloney and Mulherin, 2003, study stock returns and trading volume
surrounding the crash of Space Shuttle Challenger on January 28, 1986

The commission investigating the explosion only presented its

conclusions on June 6, 1986 (more than 5 month after the disaster,
and after extensive analysis)
Four NASA contractors had been involved in the Space Shuttle
Program: Lockheed, Martin Marietta, Morton Thiokol and Rockwell
International
The commission found that the explosion was caused by the O-rings
on the right solid fuel booster rocket
The solid fuel booster rocket was built and operated by Morton
Thiokol

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CHALLENGER

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 CHALLENGER

• The stock market reacted within minutes of the explosion

• The decline in the market capitalization of Morton Thiokol (approx. $200

mil) matched the settlements, damages and lost future cash flows incurred
by MT
Channel? No evidence of insider trading from MT or NASA

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 TARGETS OF MERGERS

Keown and Pinkerton (1981): prices of targets after merger announcements

 Flat prices after announcement indicate market efficiency for mergers

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 POST EARNINGS ANNOUNCEMENT DRIFT (PEAD)

Ball and Brown (1968): company prices after earnings announcements

 Drift indicates a significant market inefficiency

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 POST EARNINGS ANNOUNCEMENT DRIFT (PEAD)

PEAD had decreased over time (1990s vs. 1980s)

 Even if markets are not perfectly efficient, usually more efficient over time

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 NAME CHANGES

In some cases, it is hard to

believe prices are efficient…

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 NAME CONFUSION

• Rashes, 2001 – “Massively Confused Investors Making Conspicuously Ignorant

Choices (MCI-MCIC)"
• MCI Communications
 large communication company
 trades under ticker MCIC
 eventually acquired by Worldcom for $20 billion
• Massmutual Corporate Investors
 closed-end mutual fund
 trades under ticker MCI
 $200 million net assets
• There has been a lot of comovement (correlation) between their returns, despite the
fact that they do not have anything in common!
• Arbitrage probably difficult as MCI has wide bid-ask spreads, price impact is high, it is
costly to establish large arbitrage positions

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NAME CONFUSION

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5. MARKET ANOMALIES
 MARKET ANOMALIES

Anomalies are investment strategies which seem to earn high returns without
being very risky
 They are normally based on some firm characteristics
 There are also calendar anomalies

When we analyze an anomaly, we must consider

 Risk: have we used the correct asset pricing model?
 Data mining: have we verified the anomaly out of sample? (e.g. in other
periods, in other countries)
 Market frictions: have we taken into account transaction costs, short-sale
constraints, liquidity, taxes?

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 SMALL-FIRM EFFECT (SIZE EFFECT)

First documented by Banz (1981) and Reinganum (1981)

Small stocks have outperformed large stocks by about 5.7% per year over
1927–2020
 Market beta explains only 3.9%  With CAPM, there is a 1.8% alpha
 The effect seems to have disappeared since it was discovered, although
it has recovered recently
 Most of the effect only appears in January
 The “January effect”

Explanations
 Rational story (Fama & French): Small stocks are riskier
• With FF3, alpha is no longer positive
 Behavioral story: Small stocks are “neglected,” so their prices fall, or
equivalently their expected returns rise

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 VALUE EFFECT
First documented by Basu (1977, 1983)
Value stocks have outperformed growth stocks by about 4.9% per year over 1927–2021
 Value stocks have high Book-to-Market ratios
 Growth stocks have low Book-to-Market ratios (behavioralists call them glamour
stocks)
 Market beta explains only 3.7%  With CAPM, there is a 1.2% alpha

Data mining concerns: initially study done with U.S. data after 1962
 Fama & French documented the value effect also for the 1926–1962 period, and for
12 other countries

Explanations
 Rational story (Fama & French): Value stocks are riskier, maybe due to a “distress
factor”
• With FF3, alpha is no longer positive
 Behavioral story: Growth stocks are “glamorous” so their prices are high, or
equivalently their expected returns are low

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 MOMENTUM EFFECT

First documented by Jegadeesh & Titman (1993)

Recent “winners” (portfolios formed on the last 12 months of past returns, and held
over the next 12 months) outperform recent “losers” by about 14.2% a year over
1927–2021
 It works for a horizon of 3–12 months
 Market beta goes in the opposite direction and predicts -4.5%  With
CAPM, there is a 18.7% alpha! With FF3, there is a 20.7% alpha
 The effect became stronger after the original paper was published
 However, momentum lost more than 70% in 2009! (March to May)

Explanations
 Rational story (Carhart): High momentum stocks are riskier → introduce a 4-th
risk factor (UMD)
• With FF4, alpha is still 3.82%
 Behavioral story: Investors underreact to information
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 REVERSAL EFFECT

First documented by De Bondt & Thaler (1985)

Past “losers” (portfolios formed on the last 3 years of past returns, and held over
the next 3 years) outperform the market by 7% per year, while past “winners”
underperform the market by about 2% a year over 1926-1982
 Notice the asymmetry between past losers and winners

Explanations
 Rational story: Fama & French (1996) show that their 3-factor model
completely accounts for reversals!
 Behavioral story: Investors overreact (especially to negative news), so
stocks bounce back after 3-5 years

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REVERSAL EFFECT

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 JANUARY EFFECT

There is evidence of neglect from institutional investors and its connection with the
January effect

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 TURN-OF-THE-MONTH EFFECT

Abnormal returns earned by buying on day 27 and holding until day 7

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 DAY-OF-THE-WEEK EFFECT

Also called the weekend effect, or Monday effect

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 HOLIDAY EFFECT

Returns are larger in the days preceding market closures for holidays (buying
before trading halts or euphoria?)

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TIME-OF-THE-DAY EFFECT

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 MARKET ANOMALIES: OTHER EXAMPLES

Accrual anomaly (Sloan, 1996)

 Study period: 1962-1991
 Portfolio: long stocks with low accruals (lowest decile) and short stocks
with high accruals (highest decile)
 Market beta is zero
 Return of 10.4% per year

Asset growth anomaly (Cooper, Gulen, and Schill, 2008)

 Study period: 1968-2003
 Asset growth: year-on-year percentage change in total assets
 Portfolio: long stocks with low asset growth and short stocks high asset
growth
 Return of 13% per year; 8% after accounting for FF3 factors
 It is now a factor in the FF5 (FF3 + Investment + Profitability)
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 MARKET ANOMALIES: OTHER EXAMPLES

Many other anomalies / risk factors (over 400)

 FF5 (2015) = FF3 + Investment + Profitability
 q-factor model (Hou, Xue and Zhang 2014)
 BAB = Betting-Against-Beta (Frazzini and Pedersen 2014)
 QMJ = Quality Minus Junk (Asness, Frazzini and Pedersen 2013)
 Liquidity (Pastor and Stambaugh 2003, Sadka factors)
 Consumption factors (“cay”, Lettau and Ludvigson 2001)

Some anomalies have disappeared

 E.g., the Post Earnings Announcement Drift (PEAD) is reportedly not working
anymore except in microcaps

Debate: characteristics versus betas

 Daniel and Titman (1997)
 Davis, Fama and French (2000)

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6. BUBBLES, CRASHES, EXCESS VOLATILITY
 BUBBLES AND CRASHES
Bubbles
 Tulip-bulb craze (1636-37)
 The South Sea bubble (1720)
 Electronics (1960s), Biotech (1980s)
 Internet and NASDAQ bubble (late 1990s)
 Volkswagen spike on October 28, 2008
 GameStop in early 2021

Crashes
 Wall Street Crash of 1929
• Began on “Black Tuesday” on October 24, 1929
• 24% drop in prices in the first two days
• 90% peak-to-trough decline in DJIA
• Return to peak (September 3, 1929) only on November 23, 1954
 “Black Monday”
• 20% drop in prices on October 19, 1987
 Flash Crash of May 6, 2010
• 9% drop in DJIA, almost full recovery in minutes
• Many “flash crashes” recently (even in bonds, commodities)

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 BUBBLES AND CRASHES

Can the PV formula explain bubbles and crashes?

 PV formula becomes the Gordon growth formula if dividends grow at constant rate g

 Rewrite this formula by involving the P/E ratio (the “Multiple”) 

 P is very sensitive in the growth rate g  Changes in market opinion about g could
explain large swings in prices
 Can we be sure the market overreacted in a particular case? (Bubble/Crash?)
 Robert Shiller (Nobel Prize in 2013): The market overreacts on average
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 EXCESS VOLATILITY

Shiller (1981): Market volatility is too high to be explained by fundamentals

 Let’s go back to the definition of Market Efficiency
Pt = Et (Fundamentals)
where the fundamentals are discounted cash flows
 The PV equation implies that prices are less volatile than fundamentals
 In reality, prices are much more volatile than cash flows

How can we explain this apparent contradiction? Two options:

1. Rewrite the PV formula by introducing additional noise:
Pt = Et (Fundamentals) + “Animal Spirits”
“Animal spirits” can add to volatility without making prices more
predictable
2. Discount rates are also volatile, so they add to price volatility: indeed,
they are predicted by the D/P ratio, which is time-varying

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 EXCESS VOLATILITY AND RETURN PREDICTABILITY

What is the PV formula when the discount rate r is not constant?

This follows from Campbell-Shiller log-linearization of return formula

The PV formula implies

 Current D/P ratio predicts future returns, and/or future dividend growth
Turns out D/P (or P/D) predicts future returns, but not dividend growth

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RETURN PREDICTABILITY

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RETURN PREDICTABILITY

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 PREDICTABILITY OF RETURNS

• “Returns are predictable" is the same as saying “expected return varies over time"

where is a predictor of returns

• If returns are not predictable, it means that b=0 and it follows (after taking
expectations):

so the expected return is constant

• If returns are predictable, then b≠0 and it follows:

so the expected return varies in time

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7. BEHAVIORAL FINANCE
 RATIONAL BEHAVIOR: RISK AVERSION

Recall the gamble where you will either gain 40,000 if a coin lands heads, or lose 20,000 if it
lands tails

Compare the gamble with getting 10,000 for sure

Risk Aversion:
 Most people would prefer the sure 10,000: they are risk averse
 If the sure thing reward was only 5,000, you might choose the lottery instead
 Risk premium = difference between expected value and sure reward

 Risk aversion is considered rational behavior

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 BEHAVIORAL FINANCE – LEARNING

Behavioral finance studies deviations from rational behavior

Reality is noisy + We are not well equipped to learn about randomness

Example of noisy knowledge (60% – 40%):

Strategy A
60% of time choose 1
40% of time choose 2

Strategy B
100% of time choose 1

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 BEHAVIORAL FINANCE – LEARNING

Strategy B is the rational decision

 Even though truth is 60% – 40%, the correct decision is to choose door
1 for 100% of the time
• Strategy B gets you cheese 60% of the time
• Strategy A gets you cheese 52% of the time

Investors should focus on process not outcome

 Outcome is random: 40% of the time you will get door 2
 Process is deterministic: choose Strategy B (door 1) 100% of the time

Noisy reality does not necessarily imply that we must make noisy decisions

But some (many?) investors do appear to make noisy decisions

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“MADNESS OF CROWDS”

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 LOSS AVERSION

Kahneman & Tversky (1979) point out different investor mistakes/biases

25% $1,000,000
100%
A $240,000 OR B
75% $0

25% $0
100%
C – $750,000 OR D
75% – $1,000,000

25% $240,000 25% $250,000

A+D OR B+C
75% – $760,000 75% – $750,000

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 LOSS AVERSION

This is an example of loss aversion

 Psychologically, losses are twice as powerful as gains
 Risk management is necessary to avoid suboptimal behavior due to loss
aversion

Loss aversion is related to the disposition effect: investors tend to

 Sell assets that have gone up, but
 Hold on to assets that have gone down
• Realizing the loss is painful

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 RATIONAL VS. BEHAVIORAL DEBATE

The rational versus behavioral debate:

 The rationalist: If an anomaly persists even after investors know about it
(e.g. the value, or the momentum effect), then it must be due to some
kind of risk
 The behavioralist’s response: No, it is due to some systematic investor
bias (e.g. glamour, or underreaction)
 The rationalist: But if there was a systematic investor bias, a rational
arbitrageur would profit from it
 The behavioralist’s response: No, there are limits to arbitrage, e.g., short-
sale constraints, predatory trading, etc
 Conclusion:
• Rational view: anomalies are due to risks we might not understand
• Behavioral view: anomalies are due to a steady supply of “biased”
people, and smart arbitrageurs cannot do anything about it: there are
limits to arbitrage

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 RATIONAL VS. BEHAVIORAL DEBATE

Can a market be fully efficient?

 Suppose the market is 100% efficient
 Nobody would make any superior profits given their risk
 Who will spend resources on security analysis?
 This is the Grossman-Stiglitz paradox. Illustration:
• Two economists walk down the street and spot a $20 bill. One starts
to pick it up, but the other one says “Don’t bother: if the bill were real,
someone would have picked it up already”

Solution: some traders lose on average. Who are they?

• Noise traders
• Impatient (or liquidity) traders
• Those who derive other benefits, e.g., hedgers
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8. BUYING ON MARGIN, SHORT SELLING
 BUYING ON MARGIN

Example: IBM’s stock price is $100 but you believe IBM is going up to $110

Case 1. Buy 2 shares of IBM for 2 x $100 = $200

 If IBM goes to $110, profit = 2 x ($110 – $100) = $20
 If IBM goes to $90, profit = 2 x ($90 – $100) = – $20

Case 2. Borrow 50% of purchase price  borrow $100 to buy one more IBM
share  buy 3 shares of IBM
 If IBM goes to $110, profit = 3 x ($110 – $100) = $30
 If IBM goes to $90, profit = 3 x ($90 – $100) = – $30

Case 2 is called buying on margin

 In this case, both profits and losses are amplified by 50%
 Risk increases by 50% !
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 BUYING ON MARGIN

Buy 2 shares IBM

Buy 2 shares IBM and 1 on margin
Stock Cash Stock Cash
2 -200 3 -300

This is an example of leverage

 Borrow money to amplify profits (and losses!)
 In this case, the leverage is 1.5 to 1
 Risk increases by 50%…

In practice, one can use futures or options

• Leverage can be 10 to 1, or even higher !

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 SHORT SELLING

Example: IBM’s stock price is $100 but you believe IBM is going down to $90

Case 1. If you own the stock, sell it

Case 2. If you don’t own the stock, you can short-sell (or short it)
 Borrow 1 share IBM from lender L (e.g., pension fund)
 Sell immediately for $100
• In practice, you must keep the $100 in a margin account (+ some
initial extra cash)
 Wait until IBM stock price goes to $90
 Buy back 1 share at $90 and return to L

What is your profit?

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 SHORT SELLING

If IBM goes to $90, profit = $100 – $90 = $10

What if IBM doesn’t go to $90?

 If IBM goes to $110, profit = $100 – $110 = – $10
 If IBM goes to $0, profit = $100 – $0 = $100
 If IBM goes to $200, profit = $100 – $200 = – $100
Note that in principle losses could be unlimited
 This is why you need the margin account

Short-selling appears complicated, but it is the opposite of buying

Buy 1 share IBM Short 1 share IBM

Stock Cash Stock Cash
1 -100 -1 100

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 (STATISTICAL) ARBITRAGE

Example: You believe that Ford will perform much better than GM. Both have beta
= 1, but Ford has alpha = 5% and GM has alpha = 0. How can you exploit this
knowledge without taking market risk?
 Ford, GM, and the Market index are all priced at 100

Solution: Do an arbitrage:
 Buy Ford (go long Ford)
 Short-sell GM (go short GM)

Scenario 1: Market ↑ to 110

 You expect: GM ↑ to 110; Ford ↑ to 115; Arbitrage ↑ 115 – 110 = 5
Scenario 2: Market ↓ to 90
 You expect: GM ↓ to 90; Ford ↓ to 95; Arbitrage ↑ 95 – 90 = 5

 You make profits in up markets or in down markets  You avoid market risk
 Arbitrage is statistical, because Ford and GM do not have identical cash
flows (you expect to be right on average)
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9. LAW-OF-ONE-PRICE AND ARBITRAGE
 LAW-OF-ONE-PRICE
Law-of-One Price: Same cash flows  Same price!
 Violations of this law are exploited by investors called “hedge funds” (e.g., LTCM)
 Example: on-the-run bonds vs. off-the run bonds (the “bond-old bond spread”)

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 LAW-OF-ONE-PRICE
Another violation of the law-of-one-price: “Siamese twins”
 Royal Dutch shares (traded in Amsterdam)
 Shell shares (traded in London)
 Both have ADRs trading in the US, but Royal Dutch was in S&P 500 until July 10, 2002

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CASE: The Twin Coin Arbitrage
 CASE: The Twin Coin Arbitrage

In June 2019, two founders of the cryptocurrency GreenCoin decided to launch

two more cryptos: RedCoin and BlueCoin, a.k.a. “twin coins” or “twins”
 On June 30th, 2022, RedCoin and BlueCoin will be exchangeable for one
GreenCoin (which is a stablecoin pegged to the dollar)

On June 15th, 2019, the twins’ prices diverged:

 RedCoin went up to $1.10
 BlueCoin went down to $0.90

Bill has $190 K (hard earned…) savings  Starting capital

He decided to take advantage of this mispricing:

 Arbitrage

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 TWIN ARBITRAGE
Arbitrage set up on June 15th, 2019
 Buy BlueCoin (cheap asset) and short RedCoin (expensive asset)

What happens now (on June 15th)?

 Bill shorts 100,000 RedCoin, and gets $110 K
 For $90 K he buys 100,000 BlueCoin
 Bill gets right now $20 K !

What happens in 3 years (on June 30th, 2022)?

 Bill sells 100,000 BlueCoin at the GreenCoin price on that day, say $1.15
 Bill uses the $115 K to buy 100,000 RedCoin, and return them to lender L
 Bill closes the arbitrage at no cost !

 Bill gets money now and can go to Bahamas for 3 years…

Bill could scale everything up by 10 or 100  profits multiplied by 10 or 100 !

Too good to be true? Are there any risks or limits in executing this strategy?

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 MARGIN ACCOUNT

Bill needs a margin account for the short position

 Keep the proceeds ($110 K) in the margin account
 Also, an initial margin requirement of 50% = $55 K

Shorted Short Sale Initial Margin Total Margin

Price/Unit
Quantity Value Requirement Requirement

100 K $1.10 $110 K $55 K $165 K

If RedCoin increases further  maintenance margin requirement of 30% of the

(increased) short sale value
 We usually ignore lending fees ( = haircut in interest on margin account)

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 MARGIN ACCOUNT

If RedCoin price increases further, you might get margin calls:

Maintenance
Shorted Short Sale Total Margin
Price/Unit Margin Margin Call
Quantity Value Requirement
Requirement

100 K $1.20 $120 K $36 K $156 K $0

100 K $1.30 $130 K $39 K $169 K $4 K

100 K $1.40 $140 K $42 K $182 K $17 K

100 K $1.80 $180 K $54 K $234 K $69 K

On June 20th, 2019, RedCoin jumped to $1.80

 Bill got a margin call for $69 K = $180 K ⨯ (100% + 30%) – $165 K
 Bill’s capital, $45 K = $190 K – $90 K (long position) – $55 K (initial margin), is
not enough to cover the margin call
 Parents helped with $30 K but that’s it

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 ARBITRAGE GAP

Bill is wondering: How long can the market stay irrational??

 Markets can remain irrational for longer than you can remain solvent!
(John Maynard Keynes)

Let’s think more carefully about the arbitrage:

 There is a gap between the RedCoin and the BlueCoin that has no
fundamental justification. The initial gap is $0.20
 Gap should be $0 in 3 years
 Gap goes to $0 now  Bill closes position now
• Stays with profit of $0.20 per each twin pair
 Gap widens  worse for Bill (who loses capital)

What else can go wrong?

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 SCENARIOS

1. Suppose Bill wants to liquidate his position

 Buy RedCoin and sell BlueCoin
 Gap becomes wider, worsening Bill’s position
 Moreover, BlueCoin is usually illiquid (hence its low price – people don’t
want it)  makes the gap even worse!

2. What if other people hold positions similar to Bill’s?

 They could unwind positions before Bill  makes gap worse !
 Knowing others may leave, Bill might want to leave first
• Self-fulfilling prophecy…
• Race to the bottom…
• Economists: “multiple equilibria”…

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 SCENARIOS

3. What if a (ruthless) trader, e.g., Sam, finds out about Bill’s position?
 Sam could take the opposite position to Bill’s
• Buy RedCoin and sell BlueCoin
• Gap becomes wider  Bill will eventually be forced to liquidate
 Bill buys RedCoin (at high price) and sells BlueCoin (at low price)
 Sam sells RedCoin (at high price) and buys BlueCoin (at low price)
 Bill has been caught in a short squeeze
 Sam engages in predatory trading

4. What if Bill was running a hedge fund and investors found out about losses?
 Normally, hedge fund investors have a lock-up period (usually 3 years)
 After the lock-up period, investors could pull money out
 Fund’s equity is tied in BlueCoin, which is illiquid
 Bill would be forced to liquidate at the wrong time…
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CASE: Porsche and Volkswagen Short Squeeze
CASE: Porsche and Volkswagen Short Squeeze

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 CASE: Porsche and Volkswagen Short Squeeze

• By Oct. 2008, Porsche

had secretly acquired
control of 75% of
Volkswagen’s shares

• Hedge funds went short

VW earlier, but were
caught in a squeeze

• For a brief time, on Oct.

29, 2008, VW became
the world’s most
valuable company

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CASE: The Gamestop Short Squeeze
CASE: The GameStop Short Squeeze

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 CASE: The GameStop Short Squeeze

In Jan. 2021, GameStop (GME), a U.S. video game retailer, went up by 1700%
 “Bubble”: on Jan. 28, the (pre-market) price ↑ above $500
 “Crash”: in early February GME price ↓ to “only” $50
 Price jump was helped by Reddit users (r/wallstreetbets), but also by hedge funds
and Elon Musk
 Robinhood platform (commission-free trades) tried to stop GME trading
 On Jan. 28, GME was the highest-value company in the Russell 2000
 Short interest went up to 140%, with Melvin Capital a leading short seller
• Melvin Capital had been short GME since 2014: it thought the business model
was outdated and that a $3 price was too high
 As a result of shorting, GME price ↓ to $0.99 on July 17, 2020, but ↑ to $3
in October 2020
• Melvin Capital shorted GME again in October  In Jan. 2021, it lost $7 bn from
(about 53% of its total value)  It closed the GME position and accepted a $2.75
bn bailout by hedge funds Citadel + Point 72 Asset Mgmt.
 GME price as of Oct. 12, 2022 (adjusted after a 4-to-1 split) > $100
 Is the “bubble” continuing?

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CASE: Mispricing in Tech Stock Carve-outs
 CASE: Mispricing in Tech Stock Carve-outs

Lamont and Thaler (2003), “Can the Market Add and Subtract? Mispricing in
Tech Stock Carve-outs”
 1998-2000 sample of equity carve-outs
 Holders of 1 share of company A are expected to receive b shares of
company B, yet
PA < b x PB
• Example: A = 3Com, B = Palm
 This is a violation of the law-of-one-price!
 Why cannot arbitrage eliminate this mispricing?
 Answer: shorting costs are extremely high, eliminating exploitable
arbitrage opportunities

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PALM

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SAMPLE OF CARVE-OUTS

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STUB VALUES: TABLE

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STUB VALUES: 3COM/PALM

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STUB VALUES: CREATIVE COMPUTERS/UBID

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SHORT INTEREST: TABLE

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 STUB VS. SYNTHETIC STUB

Difficult to short Palm: report of 35% (annual) lending fee in July 2000
Could use a synthetic short: put-call parity  Shorting is the same as buying a put,
writing a call, and borrowing strike K (or – S = P – C – B)

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 TOPIC 4: QUESTIONS

• Explain the following definitions of market efficiency

 The price is right
 There is no free lunch
 Prices are unpredictable
• Do prices follow a random walk?
• According to EMH, what should you expect about the price of IBM next year?
• What are the main anomalies? What is their rational explanation? What is their
behavioral explanation?
• Do investors behave rationally, or is the market dominated by "animal spirits"?
• What does behavioral finance study? Are there behavioral effects at the
aggregate market level?
• How is short selling done? What is a short squeeze?
• What is an arbitrage? What are the risks?
• Why are there violations of the law-of-one-price? How long can they persist,
and why?

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