Irrational Behavior

This paper demonstrates an alternative of EMH theory that focuses on the roles of investor sentiment and limited arbitrage in determining the asset prices.

First, this paper explains the limited arbitrage in the real world. Arbitragers are supposed to assure the relative prices of securities must be in line for there is no riskless arbitrage opportunity. But in reality, there are no substitute portfolios for arbitragers to use to make the market equivalent. Arbitragers also face two types of risk. One is fundamental risk. For example, a arbitrager with a short position and the situation is better than expected, then they will face a loss. Another risk is unpredictability of future resale price. Following the same example, When arbitragers want to liquidate his position, there is a risk that the stock is even ore overpriced. In addition, the arbitragers might not know the exact fundamental value of securities so they are not able to detect the deviations from fundamental values.

Second, the investors are not fully rational and their demand for risk assets is affected by their beliefs and sentiments. Many trading strategies are based on pseudo-signals, noise and popular trends. And all these strategies are not justified by fundamental news.

Then, this paper discusses the implications of unpredictability of investor sentiment. Here the author focuses on the pricing of closed-end fund. Closed fund presents an interesting puzzle because their fundamental value is higher than their price. When investors are bullish about the closed end fund, the discount narrows, and when investors are bearish about the closed end fund, the discount widens. Why arbitrage dose not eliminate the discount is because arbitragers need to liquidate his position in finite time and the risk from unpredictability of investor sentiment at the time he liquidates prevent him from aggressive betting that would eliminate discounts.

Another implication this paper talk about is positive...