INVESTMENTS Fourth Edition Market Efficiency Chapter 8 INVESTMENTS Fourth Edition ? Do security prices reflect information ? ? Why look at market efficiency - Implications for business and corporate finance - Implications for investment Efficient Market Hypothesis (EMH) INVESTMENTS Fourth Edition ? Random Walk - stock prices are random - Actually submartingale ?Expected price is positive over time ?Positive trend and random about the trend Random Walk and the EMH INVESTMENTS Fourth Edition Random Walk with Positive Trend Security Prices Time INVESTMENTS Fourth Edition Why are price changes random? ? Prices react to information ? Flow of information is random ? Therefore, price changes are random Random Price Changes INVESTMENTS Fourth Edition ? Stock prices fully and accurately reflect publicly available information ? Once information becomes available, market participants analyze it ? Competition assures prices reflect information EMH and Competition INVESTMENTS Fourth Edition ? Weak ? Semi-strong ? Strong Forms of the EMH INVESTMENTS Fourth Edition Types of market efficiency ? The weak-form of efficiency: price accurately reflect all information that can be derived by examining market trading data such as past prices, trading volume, short interest rate, etc. ? The semistrong form of efficiency: prices accurately reflect all public available information, including past prices, fundamental dat on the firm’s product line, quality of management, balance sheet composition, patens held, earning forecasts, accounting practice, etc. ? The strong form of efficiency: prices accurately reflect all information that is known by any one, including inside information. INVESTMENTS Fourth Edition Some words about market efficiency ? An inefficiency ought to be an exploitable opportunity. If there is nothing investors can properly exploit in a systematic way, then it is very hard to say that information is not being properly incorporated into stock prices;--- Richard Roll ? Financial markets are efficient because they don’t allow investors to earn above-average returns without taking above-average risk---Burton Malkiel ? The efficient markets theory holds that the trading by investors in a free and competitive market drives security prices to the true “fundamental” values. The market can better assess what a stock or a bond is worth than any individual investor.---Andrei Shleifer INVESTMENTS Fourth Edition ? Technical Analysis - using prices and volume information to predict future prices - Weak form efficiency & technical analysis ? Fundamental Analysis - using economic and accounting information to predict stock prices - Semi strong form efficiency & fundamental analysis Types of Stock Analysis INVESTMENTS Fourth Edition ? Active Management - Security analysis - Timing ? Passive Management - Buy and Hold - Index Funds Implications of Efficiency for Active or Passive Management INVESTMENTS Fourth Edition Mutual fund performance ? Equity funds: on avrage, active managers underperform index funds when both are measured after expenses, and those that do outperform in one-period are not typically the ones who outperform in the next. ? Fixed-income funds: on average, bond funds underperform passive fixed-income indexes by an amount roughly equal to expense, and there is no evidence that past performance can predict future performance. INVESTMENTS Fourth Edition Anomalies ? The size effects ? The value effect ? The short-term momentum ? The long-term reversal ? The new issues puzzle ? The January effect… INVESTMENTS Fourth Edition The bottom line ? The efficient market hypothesis is a useful framework for modeling financial markets. ? Like any model, the efficient market hypothesis is not a perfect description of reality; some prices are almost certainly “wrong”. ? However, it would be na?ve to think that prices are always wrong or that it is easy to exploit priceing errors. ? Instead of asking whether or not the market is efficient, the more relevant questions are: ? ---how efficient is the market? ? ---how does the market react to new information arrivals? And why? ? ---what are the mechanisms that bring market prices to fundamental values? INVESTMENTS Fourth Edition ? Event studies ? Assessing performance of professional managers ? Testing some trading rule Empirical Tests of Market Efficiency INVESTMENTS Fourth Edition 1. Examine prices and returns over time How Tests Are Structured INVESTMENTS Fourth Edition Returns Over Time 0+t-t Announcement Date INVESTMENTS Fourth Edition 2. Returns are adjusted to determine if they are abnormal Market Model approach a. R t = a t + b t R mt + e t (Expected Return) b. Excess Return = (Actual - Expected) e t = Actual - (a t + b t R mt ) How Tests Are Structured (cont’d) INVESTMENTS Fourth Edition 2. Returns are adjusted to determine if they are abnormal Market Model approach c. Cumulate the excess returns over time: 0+t-t How Tests Are Structured (cont’d) INVESTMENTS Fourth Edition ? Magnitude Issue ? Selection Bias Issue ? Lucky Event Issue ? Possible Model Misspecification Issues in Examining the Results INVESTMENTS Fourth Edition ? Small Firm Effect (January Effect) ? Neglected Firm ? Market to Book Ratios ? Reversals ? Post-Earnings Announcement Drift ? Market Crash of 1987 Anomalies INVESTMENTS Fourth Edition ? Some evidence of persistent positive and negative performance ? Potential measurement error for benchmark returns - Style changes - May be risk premiums ? Superstar phenomenon Mutual Fund and Professional Manager Performance