• Dual listed stocks and closed-end fund securities: Dual listed stocks are shares in twin companies that are listed on two different markets (3), with identical dividend payments. Nevertheless, the prices of the two stocks may differ over a long period.

Similarly, the value of closed-end fund securities (made up only of listed stocks) can be listed over a long period at a discount or a premium to net asset value. Standard discounts applied to conglomerates (4) do not explain the size of the discount on certain funds, and even less so the premiums on others! It is interesting to note that these premiums or discounts compared to the intrinsic value can last over the long term, which explains why arbitrage (something simple to implement) becomes complex for any investor that does not have a very long-term investment period. 

 Calendar effect: Certain studies highlight the fact that returns on financial securities may depend on the day of the week or the month in the year. Stocks seem to perform less well on Mondays than on other days, and returns in January are higher than in other months (this phenomenon is especially true for smaller firms). For each of these observations, reasons that are backed by investor rationality are put forward (5). Nevertheless, it does appear that the anomalies are not clear enough for profitable arbitrage to be carried out, given the amount of transaction costs.

 Weather anomaly: It has been noted that returns on shares are higher when the weather is fine than when it rains (6). But here again, although the statistics of these observations are significant, they are not a sufficient basis for arbitrage.

Accordingly, there would appear to be a body of evidence that implies that the theory of efficient markets is invalid. Eugène Fama, the high priest of efficient markets, defends the theory doggedly. For him, the observation of anomalies can largely be explained by the methodology used. Fama especially challenges observations of systematic over- or under-reactions of markets noted by other economists.  Nevertheless, some economists have arrived at the conclusion that markets are (even partially) inefficient.

If we do arrive at the conclusion that the theory of efficient markets is invalid, it then becomes necessary (i) to understand what it was in the initial modelling that did not correspond to reality (ii) and to attempt to develop a new modelling of investor behaviour that is closer to reality.

2/ Investor behaviour

And what if the initial assumption underlying modern theory was a false assumption: are investors really rational (ie, do they act in a consistent manner in order to maximise returns)? Behavioural finance uses an innovative method for testing this assumption. Experiments have been carried out in order to determine the real behaviour of investors faced with a choice.

The results of certain psychological experiments (even though not directly linked to economic choices) can be applied to finance.  For example, tests seem to prove that individuals answer questions put to them by making mental associations or taking short cuts (7): a number between 0 and 100 is chosen at random in front of a sample of people who are then asked to guess whether the number of African countries is higher or lower than the number drawn, and then to guess how many countries there actually are in Africa. It is interesting to note that the average number of countries given by people in the different samples to the last question, depends on the initial number drawn. This example demonstrates the fact that investor decisions can be influenced (independently of fundamental choices to be made)…

A typology of experiments that is also used to appreciate the attitude of investors to financial products, involves giving a sample of individuals a choice between several lotteries (the gains on which are associated with probabilities), with or without a financial risk. Here we see a direct link with psychology. The field of behavioural finance has in fact been developed by financiers and psychologists in tandem. The results of these studies undermine some of the basic assumptions of investor rationality.  The following behaviours can be cited: 

• Investors do not make the same choices for gains and for losses. They prefer taking risks when there is a strong probability of loss (a probability of 50% of losing 100 rather than the certainty of losing 50), but they prefer to plumb for a lower gain when the probability is high (certainty of gaining 50 rather than having one chance in two of gaining 100).

• If the probability gap is narrow, individuals will choose the lottery offering the highest possibility of gain, but if there is a wide probability gap, they will take a close look at the expected gain. This generates a number of paradoxes. It is possible to prefer A to B and B to C, but to prefer C to A.  For a financier, this means preferring BNP Paribas to Fortis, Fortis to Mediobanca but Mediobanca to BNP Paribas! This observation is the sort of thing that can drive an asset manager crazy!

3/ Impact on the market

The irrationality of some investors does not really present a problem if the anomalies can be quickly corrected by arbitrage and if there is a rapid return to efficiency. Additionally, the presence of irrational investors among market players does not necessarily mean that markets are inefficient, especially if the trades made by these investors set each other off, or if rational investors can use arbitrage to bring about a return to balanced prices.

Nevertheless, some of the anomalies we’ve looked at (dual listing, closed-ended funds) last over the long term, which is proof that the inefficiency of markets cannot systematically be corrected by arbitrage. Some even seem to prove that the market systematically over- (or under-) reacts to some information. The super-performance of a share (or a portfolio) tends to follow on an under-performance, and vice-versa.

4/ Implications

It's very easy to criticise, but a lot harder to come up with something better. What is important is that we don’t throw out the baby with the bathwater, by exploding the theory of markets in equilibrium, with all the consequences that that would entail (no more CAPM, impossible to value financial products). What we need are suggestions for a new framework for finance. Existing models put forward by economists are, in our view, of limited use in their current state (especially for corporate finance). They focus on the first line of reasoning: model the behaviour of investors in order to determine whether they get anything useful out of it and to identify how they understand financial products. This is just the first step in the reconstruction of a model, which goes as far as the valuation of shares. So, we’re not quite there yet. But Rome wasn’t built in a day and we’ll keep a close eye on developments in the field of behavioural finance, waiting with some impatience for the direct applications thereof to corporate finance. 

In some ways, behavioural finance is battering on open doors.  Investors are human beings, not computers, and are thus sensitive and irrational, and that’s the way it should be. Can we model irrationality without making it dissappear? And if behavioural finance manages to do that, won’t it be a sort of Pyrrhic victory?

But while we wait, we’d like to draw a quick parallel with physics.  The theory of gravity remains valid, even though it has been proved to be defective at both the macro and micro level, by the theory of relativity and quantum theory. So we’ll just soldier on for another few years with the theory of markets in equilibrium as our guide, at the risk of appearing old-fashioned, but our rational opinion is that this is a risk worth taking!

Real estate debt in the USA currently stands at around $10,000bn, which is three-quarters of GDP. This debt is divided into several categories, depending on the solvency of the borrower (we talk about prime and subprime, and also near prime or Alt-A borrowers) and whether the interest rate is fixed or floating.

Very few prime households, which account for close to 40% of US households have defaulted on their mortgage repayments. Most subprime households, however, which account for around 15% of US households have defaulted on more than one occasion. The rest (45%) is a sort of morass of near prime or Alt-A borrowers, which covers borrowers with no proof of a stable income or with an average credit record.

The volume of subprime loans granted in the USA is around $1,300bn, or 13% of all mortgages. They are mainly granted at a floating rate (65% compared with 35% at a fixed rate), while only 20% of prime loans are issued at a floating rate.

The increase in the number of subprime loans issued has enabled a large number of US households to buy their own homes. Over the last 10 years, the rate of homeownership has risen from 65% to 69%, and more than half of this gain is due to subprime buyers.

Lenders generally earn around 2% more on subprime loans than on standard mortgages, which explains why around two-thirds of these loans were acquired directly or indirectly via RMBS (Residential Mortgage Backed Securities) by investors seeking higher returns, some of whom had obviously forgotten the golden rule in finance – a higher return equals a higher risk.

Many subprime mortgages were granted over the last two to three years at initially low, fixed interest rates, which rise contractually after two to three years. A growing number of US subprime households now find in 2007, and this will continue into 2008, that their monthly mortgage repayments have increased dramatically (by 30% and more):

So, it is hardly surprising that the percentage of subprime mortgages on which borrowers are unable to meet their mortgage repayments – and whose homes are being repossessed by mortgage lenders is rising exponentially – 4% in 2006, 6% in 2007 and an estimated 10% in 2008.