BEHAVIORAL ECONOMICS

Law of One Price

The Efficient Market Hypothesis (EMH)

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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 Famas Definition

Weak
Hypothesis

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Past prices and returns are

irrelevant

Semi-Strong
Hypothesis

All publicly known

information is irrelevant

Strong
Hypothesis

Public and private

information is irrelevant

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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?

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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

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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
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The Mysterious Case of Royal Dutch and Shell (stocks)

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

Royal Dutch should trade at 1.5 times Shell

but it doesnt.
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Example: Safe asset versus unsafe asset

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 anything7

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Example: Safe asset versus unsafe asset

(contd)

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

(contd)

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

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