FNCE30001 Investments
Market Efficiency and Behavioural Finance
A market is informationally efficient if price equals intrinsic value — 'the price is right' and 'no free lunch'. Competition among profit-seeking traders pushes prices to value fast, so returns become unpredictable: a random walk. The Efficient Market Hypothesis comes in three nested forms — weak (prices reflect all past price and volume, killing technical analysis), semi-strong (all public information, killing fundamental analysis on public data) and strong (public and private, killing even insiders) — with academic consensus sitting near semi-strong. Anomalies like size, value, momentum and PEAD challenge strict efficiency, but only count as inefficiencies if they survive a beta adjustment. Behavioural finance then asks how not-fully-rational psychology shapes prices: biases move prices only if they are correlated across investors AND limits to arbitrage stop smart traders from correcting them. The chapter closes with market microstructure — the limit order book, the bid-ask spread, order types — and the mechanics of margin trading and short-selling, including the margin-call calculation, an AHA-unit worth getting cold.
What this chapter covers
- 0110.1 The three forms of the EMH (weak, semi-strong, strong)
- 0210.2 Anomalies (size, value, momentum, PEAD) and the beta-adjustment test
- 0311.1 Behavioural biases and prospect theory
- 0411.2 Over- vs under-reaction and limits to arbitrage
- 0510.3 Microstructure: the order book, order types and the bid-ask spread
- 0610.4 Margin and short-selling mechanics
- 07Solving for the margin-call price (long vs short)
Worked example: the long margin call
- +1Identify. A long position — the danger is the price falling; set the margin percentage equal to the maintenance level and solve for P.
- +1Loan. The investor owns 60%, so borrows 40%: Loan = 0.40(36,000) = $14,400 (this stays fixed).
- +1Set up: margin% = (stock value − loan)/(stock value), so 0.35 = (800P − 14,400)/(800P).
- +1Solve: 0.35(800P) = 800P − 14,400 → 14,400 = 0.65(800P) → 800P = 22,153.8 → P = $27.69.
- +1Interpret: a fall from $45 to $27.69 (about −38%) triggers the call. The investor must then deposit cash, add stock or sell shares to restore the margin.
Key terms
- Efficient Market Hypothesis (EMH)
- A market is informationally efficient if price equals intrinsic value, so returns are unpredictable (a random walk). Three nested forms: weak (all past prices), semi-strong (all public info), strong (public and private). The EMH does not say no one ever beats the market — only that no one does so consistently after risk and fees.
- Anomaly
- A robust return pattern the CAPM cannot explain — size (small caps outperform), value (high book-to-market outperforms growth), momentum (past winners keep winning), PEAD (drift after an earnings surprise). An anomaly is evidence of inefficiency only if the abnormal return survives a beta adjustment; if 'anomaly' stocks just have higher beta, the extra return is fair compensation.
- Limits to arbitrage
- Why mispricing can persist even when smart traders spot it: fundamental risk (news may worsen), noise-trader risk (mispricing can widen before it closes), margin and borrow costs, and short-sale constraints. A bias bends a price only when many investors share it AND limits to arbitrage stop traders from cheaply trading against it.
- Prospect theory
- Kahneman and Tversky's account: value is judged versus a reference point, the value function is concave over gains and convex over losses, and it is steeper for losses than for equal gains. This loss aversion is the source of the disposition effect (selling winners too early, holding losers too long).
- Margin call
- The trigger that fires when an account's equity percentage falls to the maintenance level. For a long position the danger is the price falling; for a short, the price rising. Set margin% = maintenance and solve for the price — the long uses (nP − Loan)/nP, the short uses (Assets − nP)/nP, where the fixed term differs between them.
Market Efficiency and Behavioural Finance FAQ
Does an anomaly automatically mean the market is inefficient?
No. A return pattern is inconsistent with the CAPM only if it survives a beta adjustment. If the high-return 'anomaly' stocks simply have higher beta, the extra return is fair compensation for systematic risk, not a free lunch. Always ask: is the premium left over after controlling for systematic risk? A predictable, beta-adjusted abnormal return from public data (like post-earnings-announcement drift) is the kind of thing that genuinely challenges semi-strong efficiency.
When do behavioural biases actually move prices?
Only when two conditions both hold: the bias must point the same direction across many investors (correlated, not random noise that cancels out), AND limits to arbitrage must stop smart traders from cheaply correcting it. Examiners want you to name the bias, then check both conditions. Under-reaction to news produces momentum and drift; over-reaction to a run of news produces long-run reversal and the value effect — the same psychology that generates the anomalies.
How does a market order interact with the bid-ask spread?
The limit order book ranks resting bids (buyers) and asks (sellers). A market order executes immediately by crossing the spread — you buy at the ask and sell at the bid — and a large market order walks the book, eating successive price levels for price impact. A limit order avoids the spread (buy at or below your limit, sell at or above) but may not fill. A limit buy placed above the best ask executes immediately at the lowest available ask, not at your higher limit.
How do I find the margin-call price for a long versus a short?
Set the margin percentage equal to the maintenance level and solve for P. For a long, margin% = (nP − Loan)/(nP), the loan is fixed, and the call comes when the price falls. For a short, margin% = (Assets − nP)/(nP) where Assets = proceeds + posted margin is fixed, and the call comes when the price rises. The two traps are using the wrong numerator (which term is fixed) and getting the direction backwards. Compute any return on your equity, not the gross position.
Exam move
Split your revision into the conceptual half and the calculation half. For the EMH, memorise the three nested forms and what each kills, and rehearse the beta-adjustment test — an anomaly only breaks the CAPM if the abnormal return survives a risk adjustment. For behaviour, learn the two-condition test (correlated bias AND limits to arbitrage) and a handful of named biases (overconfidence, loss aversion, the disposition effect) plus prospect theory. These are reasoned in words, so practise tight one-paragraph answers. For microstructure and margin, make the margin-call calculation automatic: set margin% = maintenance, solve for P, and get the direction right (long calls on a fall, short calls on a rise). The recap box's six lines are a good final-night checklist.
