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A Rational Approach to an Irrational Market Practical Methods for Exploiting Market Anomalies

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In the US and UK, 60 days following an earnings announcement, stocks with the ... Follow the market maxim: Sell your losses (stop loss) and ride your winners ... – PowerPoint PPT presentation

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Title: A Rational Approach to an Irrational Market Practical Methods for Exploiting Market Anomalies


1
A Rational Approach to an Irrational
MarketPractical Methods for Exploiting Market
Anomalies
  • Practical Methods for Exploiting Financial
    Anomalies

2
Synopsis
  • There is nothing so dangerous as the pursuit of
    a rational investment policy in an irrational
    world
  • John Maynard Keynes

3
Equity Markets - Efficient Markets
  • How are stocks valued by analysts?
  • Discounted Cash Flow
  • Assumption?
  • If agents are rational and there are no
    frictions, a securitys price equals its
    discounted sum of expected future cash flows
  • but...
  • Are traders rational agents?

4
Index Inclusions/Exclusions
  • 58.31 of the 1.9 trillion assets under
    management (400 billion in equity)
  • On average when a stock is added to the SP 500
    for example, it jumps by 3.52
  • One dramatic illustration is when Yahoo! was
    added, it jumped by 24 in one single day
  • Clearly, its DCF has not altered by its addition
    to the index
  • The question is - is this anomaly exploitable?

Index Tracking Funds
Indices are not static
Mispricing? Exploitable?
1 Source IMA Fund Management Survey, 2002
2 Source Handbook of Economics of Finance, 2003
5
Evidence of Inefficient Pricing
  • Event 3Com sells 5 of Palm Inc in an IPO and
    announces that remainder will be sold in Nov 00
    with each 3Com S/H given 1.5 shares of Palm

Day 1
Mar 00
Nov 00
3Com 81 Palm 95
  • Arbitrage Short Palm, Buy 3Com
  • - but inability to short
  • Take on Market Risk Buy 3Com

Receive 1.5 shares of Palm for 100 Profit 100
- 81 19 Sell 3Com at 80 1 loss Total
Profit 18
  • Lesson Look for mispricing in spin-offs
    especially when the spinoff is of a class of
    security in high demand

6
Other Evidence of Inefficient Pricing
  • Stocks independently incorporated, separate legal
    entities, listed on more than one exchange but
    control the same assets
  • Relative market values anything but constant!
    (eg. Royal Dutch in SP 500, Shell is not)
  • Between 1985-2000, 26 documented cases of
    subsidiaries worth more than their parents (in
    terms of market cap)
  • 26 terminated without convergence
  • often trade at discount to Net Asset Value (NAV)
  • why do investors buy them in the first place?

Twin Shares
Parent Company Puzzle
Closed End Funds
7
Earnings Announcement Drift
  • A wheel with 100 numbers is spun and the person
    asked whether the number of African countries in
    the UN is greater or smaller than that number and
    then to guess how many there are
  • Estimates biased by spin 25 and 45 were the mean
    guesses of those who got 10 and 65 on the wheel
    respectively
  • In the US and UK, 60 days following an earnings
    announcement, stocks with the biggest positive
    earnings surprises tend to outperform the market
    by 2
  • Stock Markets under-react to fundamental
    information

Anchoring
Market Under-reaction
  • Lesson Buy stocks with positive earnings
    surprises

8
Availability Bias
  • People assess the probability of an event by the
    ease with which occurrences can be recalled
  • As a result, there is a persistent over-emphasis
    on stocks that have received significant press
    coverage
  • Stocks with very high levels of press coverage
    have been shown to underperform the market in the
    subsequent 2 years

Availability Bias
Market Over-reaction
9
Short Term Mean Reversion
  • Securities that have experienced extreme price
    movements display significant negative serial
    correlation prices are mean reverting
  • It has been shown that stocks that suffer a 10
    one day decline, on average return 3.95 over the
    next 5 days
  • Only for large stocks
  • In line with availability bias

Mean Reversion
Market Over-reaction
  • Lesson Buy stocks that have experienced a very
    large one day decline - though assess the reasons
    first Is it over reaction - or is it another
    ENRON?

10
The Disposition Effect
  • Game 1
  • Which do you prefer?
  • (A) a sure gain of 2500
  • (B) a 25 chance of a 10,000 gain and a 75
    chance of winning nothing
  • Game 2
  • Which do you prefer?
  • (A) a sure loss of 7500
  • (B) a 75 chance of 10k loss 25 chance of
    losing nothing at all

11
The Disposition Effect
12
The Disposition Effect
  • Fact People dislike losses and are willing to
    gamble with them
  • Game 1
  • Which do you prefer?
  • (A) a sure gain of 2500
  • (B) a 25 chance of a 10,000 gain and a 75
    chance of winning nothing
  • Game 2
  • Which do you prefer?
  • (A) a sure loss of 7500
  • (B) a 75 chance of 10k loss 25 chance of
    losing nothing at all
  • Translated into private investor behaviour?
  • Analysis of discount broker accounts shows 15 of
    gains realised against 10 of losses
  • Unsold losers then return 5 in next year while
    sold winners return a further 11.6
  • Follow the market maxim Sell your losses (stop
    loss) and ride your winners

13
Calendar Effects
Turn of Month Most return in DJIA occurs over 4
days
Turn of year January Effect (1/3 of annual
returns)
Equity Calendar Effects1
Turn of Week Index rises on Fridays, falls on
Mondays
Intraday Effects Falls Mon in first 45mins but
rises on other days
1 as identified in the early 90s and most have
since disappeared
14
Why do calendar effects arise?
  • Pension and mutual funds receive payments at
    given dates
  • Individual investors ratio of buy orders to sell
    orders (according to Merrill Lynch) are high in
    early Jan and low in late Dec
  • Window dressing by fund managers (dump
    embarrassing holdings)
  • Risk adjusted trading depending on firms
    financial year
  • well known fact that suicides are most common on
    Mondays

Flow of Funds?
Investor Behavior?
Plain psychology?
15
The Fixed Income Markets
  • What is a bond?
  • A bond is a simple loan
  • The buyer lends a given amount of money to the
    borrower for a predefined period of time
  • In return, the lender is paid interest for the
    duration of the loan, usually in semi-annual
    instalments
  • When the loan expires, the borrower repays the
    money to the holder of the bond.
  • Who issues bonds?
  • Governments issue bonds to raise funds to cover
    expenses which general taxation income does not
    meet.
  • Corporations To fund large-scale investments,
    acquisitions, leveraged buy-outs, or to provide
    working capital to finance aggressive growth

16
Credit Ratings
Junk Bonds
17
Credit Ratings
  • Arbitrary cutoff- yet lots of investment managers
    are precluded by their mandates from holding
    high-yield bonds
  • When a bond is downgraded, it must be dumped by
    the managers resulting in higher yields for these
    bonds than implied by their probability of
    default
  • All airline bonds had been assigned junk status
    after the events of 11-9-01, as passengers
    evaporated and cash flows were decimated

Junk Bonds
Eg. Airline Industry
18
Other Fixed Income Market Mispricing
  • A bond allowing the issuer to repurchase it for a
    specified price on certain dates prior to the
    bond's maturity.
  • Clearly, holder is short a call option. The price
    should therefore be worth less than the
    non-callable version. This is not always the case
  • T-bonds with no remaining intermediate coupon
    payments and identical maturity dates to T-bills
    should have the same price (as they have an
    identical cash flow)
  • Studies have shown that T-bonds sell at a premium
    on average of 10
  • Referred to as a liquidity premium
  • Popularized by Salomon Bond traders of the 80s
    and by LTCM
  • On the run treasuries are cheaper due to higher
    liquidity but as they become off-the-run
    treasuries, the spreads with other off-the-runs
    narrow
  • No longer a profitable trade due to transaction
    costs

Callable Bonds
T-bills vs T-bonds?
On/Off Run Treasuries
19
Foreign Exchange
  • Buying currencies with high interest rate
    differential consistently yields positive returns
  • Inconsistent with Interest Rate Parity!
  • Intraday, FX rates mean revert while daily, they
    trend
  • Traders place stops at particular numbers -
    resulting in cascade effects

Forward Rate Bias
Momentum
Trader Behaviour
20
A Word of Warning . . .
  • The market can stay irrational longer than you
    can stay solvent
  • John Maynard Keynes
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