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Behavioral Finance Lecture
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Law of One Price
BEHAVIORAL ECONOMICS
The Efficient Market Hypothesis (EMH)
• Price captures all relevant information• Modern version based upon “No
Arbitrage” assumption• Fama Definitions
• Strong Hypothesis• Semi-Strong Hypothesis• Weak Hypothesis
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Eugene Fama’s Definition
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• Past prices and returns are irrelevantWeak Hypothesis
• All publicly known information is irrelevant
Semi-Strong Hypothesis
• Public and private information is irrelevantStrong Hypothesis
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Law of One Price
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• Identical things should have identical prices
• But, what if two identical things have different names?
• Example A: Baseball, hardball
• Example B: Two companies with exact same cash flow but they are different companies in name, and in every other way they are different (think of two bonds, if it makes any easier to imagine)
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Fungibility
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• Fungibility is convertibility from one form to another
• Example: a call option and a put option• Suppose you own a January 40 Call and are
“short” a January 40 Put
• On expiration you will own 100 shares of the stock
• If P > 40, you will exercise and buy stock
• If P < 40, put owner will exercise and you will be compelled to buy stock
• Thus, this option position is “fungible” by the expiration date of the two options
Royal Dutch
• Incorporated in the Netherlands
• Trades primarily in Netherlands and US
• Entitled to 60% of company economics
Shell
• Incorporated in England
• Trades predominantly in the UK
• Entitled to 40% of company economics
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The Mysterious Case of Royal Dutch and Shell (stocks)
Royal Dutch should trade at 1.5 times Shell…but it doesn’t.
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Example: Safe asset versus unsafe asset
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• Imagine an economy with two assets (financial assets)
• Safe Asset, s
• Unsafe Asset, u
• Assume a single consumption good
• Suppose that s is always convertible (back and forth between the consumption good and itself)
• That means the price of s is always 1 in terms of the consumption good
• It is called the “safe” asset – its price is always 1, regardless of anything
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Example: Safe asset versus unsafe asset (cont’d)
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• Why is u an unsafe asset?
• Because its price is not fixed because u is not convertible back and forth into the consumption good
• You buy u on the open market and sell it on the open market
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Example: Safe asset versus unsafe asset (cont’d)
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• Both s and u pay the same dividend, d• d is constant, period after period • d is paid with complete certainty, no
uncertainty at all• This implies that neither s or u have
“fundamental” risk• If someone gave you 10 units of s
and you never sold it, your outcome would be the same as if someone gave you 10 units of u
