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Are Financial Markets Efficient ?
This course describes the intense academic controversy over economic theories of
asset (stock) prices. Such theories make assumptions about investor behaviour (their
degree of rationality, their ability to engage in arbitrage).
On the one hand, there are those who defend the “Efficient Market Hypothesis”, on
the grounds that financial markets offer very few opportunities to make riskless
profits, which leads to the fact that prices are almost always right. On the other hand,
advocates of “Behavioral Finance” contend that existing theories consistent with the
EMH have very little predictive power over asset prices, and that significant riskless
arbitrage opportunities do survive on financial markets.
This lively debate has provided the underpinnings for the vast empirical literature on
asset pricing that will be reviewed in this course.
1. Small bits of theory of asset pricing in equilibrium: the EMH
a. CAPM and tests of CAPM : not so great.
b. CCAPM and test of CCAPM : equity premium puzzle
c. APT
Cochrane, John, “Asset Pricing”, MIT Press
Fama and French, 2004, “The Capital Asset Pricing Model: Theory and Evidence”,
Journal of Economic Perspectives
Julliard and Parker, 2005, “Consumption Risk and the Cross Section of Expected
Returns”, Journal of Political Economy
2. First attack : Post announcement drift
a. EMH - Event studies : M&As, Repurchase, SEO
Roll, Richard, 1986, “The Hubris Hypothesis of Corporate Takeovers”, Journal of
b. The post announcement drift
Lakonishok and Vermaelen, 1990, “Anomalous Price Behavior Around Repurchase
Tender Offers”, Journal of Finance
Loughran and Vijh, 1997, “Do Long Term Shareholders Benefit from Corporate
Acquisitions ?”, Journal of Finance
Loughran and Ritter, 1995, “The New Issues Puzzle”, Journal of Finance
Bernard and Thomas 1990, “Post Earnings Announcement Drifts: Delayed Price
Response or Risk Premium ?”, Journal of Accounting Research
c. The Mitchell and stafford critic: back to square one.
Mitchell and Stafford, 2000, “Managerial Decision and Long Term Stock Price
Performance”, Journal of Business
3. Second attack: irrational investors
a. The Value Premium
De Bondt and Thaler, 1985, “Does the Stockmarket Overreact ?” ,Journal of Finance
De Bondt and Thaler, 1987, “Further Evidence on Investor Overreaction and
Stockmarket Seasonality” ,Journal of Finance
Lakonishok, Shleifer and Vishny, 1994, “Contrarian Investment, Extrapolation and
Risk”, Journal of Finance
b. Momentum
Jegadeesh and Titman, 1993, “The Returns From Buying Winners and Selling
Losers: Implications for Stockmarket Efficiency”, Journal of Finance
Frazzini and Cohen, 2006, “Economic Links and Predictable Returns”, Journal of
c. Risk Factors are back, but where is the theory now ?
Fama and French, 1992, “The Cross Section of Expected Stock Returns”, Journal of
Fama and French, 1996, “Multifactor Explanations of Asset Pricing Anomalies,
Journal of Finance
d. A Less nihilistic alternative: the conditionnal CAPM
Jagannathan and Wang, 1996, “The Conditionnal CAPM and the Cross Section of
Expected Returns”
4. Third attack: Noise and the weak predictive power of prices
a. R²: The CAPM, information and noise
Roll, Richard, 1988, “R²”, The Journal of Finance
b. How Much Information on Future Dividends is There in Prices ?
Shiller, 1981, “Do Stock Prices Move Too Much To Be Justified by Changes in
Dividends”, American Economic Review
Campbell and Shiller, 1988, “The Dividend Price Ratio and Expectations of Future
Dividends and Discount Factors”, Review of Financial Studies
Larrain and Yogo, 2006, “Does Firm Value Move Too Much to be Justified by
Subsequent Changes in Cash Flows?”, Review of Financial Studies
c. Noise Trading risk: Theory and Evidence
De Long, Shleifer, Summers and Vishny, 1990, “Noise Trader Risk in Financial
Markets”, Journal of Political Economy
Lee, Shleifer and Thaler, 1991, “Investor Sentiment and the Closed End Fund
Puzzle”, Journal of Finance
Scruggs, 2007, “Noise Trader Risk: Evidence From the Siamese Twins”, Journal of
Financial Markets
Barber and Odean, 2000, “Boys Will be Boys: Gender, Overconfidence and Common
Stock Investment”, Quarterly Journal of Economics
Hvidjkaer, 2006, “Small Trades and the Cross Section of Expected Returns”, mimeo
University of Maryland
Barber, Odean and Zhu, 2006, “Do Noise Traders Move Markets ?”, mimeo UC Davis
Hong and Yu, 2006, “Gone Fishin’: Seasonnality in Trading Activity and Asset
Prices”, mimeo Princeton University
5. Fourth attack: Factor versus characteristics
Daniel and Titman, 1997, “Evidence on the Characteristics of Cross Sectional
Variation of Stock Returns”, The Journal of Finance
Davis, Fama and French, 2000, “Characteristics, Covariances and Average Returns:
1929 to 1997”, Journal of Finance
Daniel, Titman and Wei, 2001, “Explaining the Cross Section of Stock Returns in
Japan: Factors or Characteristics”, Journal of Finance
6. Recent research: volatility
a. Did idiosyncratic volatility increase ?
Campbell, Lettau, Malkiel, Xu, 2001, “Have Individual Stocks Become More Volatile?
An Empirical Exploration of Idiosyncratic Risk”, Journal of Finance
Brandt, Brav and Graham, 2007, “The Idiosyncratic Volatility Puzzle: Trends or
Speculative Episodes”, mimeo Duke University
b. Is volatility
evidence of information ?
Morck, Yeung and Yu, 2000, “The Information Content of Stock Markets: Why Do
Emerging Markets Have Synchronous Stock Price Movements?”, Journal of Financial
c. Idiosyncratic risk is costly to hold ?
Pastor and Stambaugh, 2003, “Liquidity Risk and Expected Stock Returns”, Journal
of Political Economy
Ang, Chen, Xing, 2006, “Downside Risk”, Review of Economic Studies
Goyal and Santa-Clara, 2003, “Idiosyncratic Risk Matters !”, Journal of Finance
Ang, Hodrick, Xing and Zhang, 2006, “High Idiosyncratic Volatility and Low Returns:
International and Further US Evidence”, mimeo Columbia
7. Recent research: Limits to arbitrage
Thaler, 1999 ,”The end of Behavioral finance”, Financial Analyst Journal
a. Short sales constraints
Chen, Hong and Stein, 2002, “Breadth of Ownership and Stock Returns”, Journal of
Financial Economics
Lamont and Jones, 2003, “Short Sales Constraints and Stock Returns”, Journal of
Financial Economics
Lamont and Thaler, 2003, “Can The Market Add or Substract ? Mispricing in Tech
Stocks Carve Outs”, Journal of Political Economy
Lamont and Frazzini, 2006, “The Earnings Announcement Premium and Trading
Volume”, mimeo Yale
b. Demand effects from large investors
Wurgler and Zhuravskaya, 2002, « Does Arbitrage Flatten Demand Curves for
Stocks ? », Journal of Business
Coval and Stafford, “Asset Fire Sales (and Purchases) in Equity Markets”,
forthcoming Journal of Financial Economics
Frazzini, 2006, “The Disposition effect and Under-reaction to news”, Journal of
Frazzini and Lamont, 2006, “Dumb Money: Mutual Fund Flows and the Cross Section
of Returns”, Journal of Financial Economics
c. Information asymmetries
Coval and Moskowitz, 2001, “The Geography of Investment: Informed Trading and
Asset Prices”, Journal of Finance
Hong, Kubik and Stein, 2006, “The Only Game in Town: Stock Price Consequence of
Local Bias”,mimeo Princeton
Cohen, Frazzini, Mallo, 2007, “The Small World of Investing: Board Connections and
Mutual Fund Returns”, NBER WP N°13121