Question

1.Explain the concept of rationality in respect to financial markets.

2.Explain how, according to Shleifer (2000), supporters of EMH reconcile irrationality with efficient markets in the case of:

i)Uncorrelated trading strategies

ii)Correlated trading strategies

3.According to neoclassical theories, prices are always set according to asset risk (The CAPM). What are the behavioural implications of this assertion?

Answer 1

1. Rationality is the quality of being rational. It implies the conformity of ones beliefs with ones reasons to believe and of ones actions with ones reasons for action. ystematic risk as it relates torecession that impact the entire market. Market risk is the risk that the value of an investment will decrease due to change market factors.Its a systematic risk.Examples,credit risk, liquidity risk, and operational risk.

2. Efficient Market Hypothesis impliesasset prices incorporates all known public information and adjust instatly to any new public information.Asset prices incorporates and adjust instantly to all information, whether public or private. The only way an invester can exploit one at a meaningful level is tio trade an enormous sum and with high leverage.Very few investor can trade in high enough volume even if they could identify an arbitrage opportunity.

i)Uncorrelated assets are assets classes that do not necessarily move together, nor do they necessarly move in opposite directions.Hence they are uncorrelated. Gold and U.S stocks are examples. Gold prices are just a likely to rise or diminishes in weak or strong strong markets.Same thing for bond prices versus stocks.Some times go intogether and some times they go in opposite

ii)Correlated stratefy inwhich the investor gets exposure to the average correlation of an intex.The key to this is being able to predict when future realised correlation among the stock of particular index will be greater or less than the inplied correlation derived from derivativeson the index and its single stocks . The lower the correletion among the individual securities,lower the overall volatility of the entire portfolio.

3. Neoclassical prices are set according to asset risks, here markets are not always efficient as indicated by the presence of market anomalies. Noise trader risk is a possible case of market anomalies. The model used to quantify noise trader risk may be restrictive. Neo-classist ignores the role played by noise traders, a significant amount of empirical evidence is available to show what noise traders are active market participants and that their participation gives rise to market anomalies.Behavioural finance allows for market inefficiency on the grounds that market participants are subject to human errors that arise from biases.