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Fourth Edition
Market
Efficiency
Chapter 8
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? Do security prices reflect information ?
? Why look at market efficiency
- Implications for business and corporate finance
- Implications for investment
Efficient Market Hypothesis (EMH)
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? 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
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Random Walk with Positive Trend
Security
Prices
Time
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Why are price changes random?
? Prices react to information
? Flow of information is random
? Therefore, price changes are random
Random Price Changes
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? 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
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? Weak
? Semi-strong
? Strong
Forms of the EMH
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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.
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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
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? 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
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? Active Management
- Security analysis
- Timing
? Passive Management
- Buy and Hold
- Index Funds
Implications of Efficiency for Active
or Passive Management
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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.
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Anomalies
? The size effects
? The value effect
? The short-term momentum
? The long-term reversal
? The new issues puzzle
? The January effect…
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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?
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? Event studies
? Assessing performance of professional
managers
? Testing some trading rule
Empirical Tests of Market Efficiency
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1. Examine prices and returns over time
How Tests Are Structured
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Returns Over Time
0+t-t
Announcement Date
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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)
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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)
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? Magnitude Issue
? Selection Bias Issue
? Lucky Event Issue
? Possible Model Misspecification
Issues in Examining the Results
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? Small Firm Effect (January Effect)
? Neglected Firm
? Market to Book Ratios
? Reversals
? Post-Earnings Announcement Drift
? Market Crash of 1987
Anomalies
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? 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