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Chapter 12

Chapter 12. Market Efficiency. Efficient Market Hypothesis (EMH). Do security prices reflect information ? Why look at market efficiency Implications for business and corporate finance Implications for investment. Random Walk and the EMH. Random Walk - stock prices are random

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Chapter 12

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  1. Chapter 12 MarketEfficiency 12-1

  2. Efficient Market Hypothesis (EMH) • Do security prices reflect information ? • Why look at market efficiency • Implications for business and corporate finance • Implications for investment 12-2

  3. Random Walk and the EMH • Random Walk - stock prices are random • Actually submartingale • Expected price is positive over time • Positive trend and random about the trend 12-3

  4. Security Prices Time Random Walk with Positive Trend 12-4

  5. Random Price Changes Why are price changes random? • Prices react to information • Flow of information is random • Therefore, price changes are random 12-5

  6. EMH and Competition • Stock prices fully and accurately reflect publicly available information • Once information becomes available, market participants analyze it • Competition assures prices reflect information 12-6

  7. Forms of the EMH • Weak • Semi-strong • Strong 12-7

  8. Types of Stock Analysis • 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 12-8

  9. Implications of Efficiency for Active or Passive Management • Active Management • Security analysis • Timing • Passive Management • Buy and Hold • Index Funds 12-9

  10. Market Efficiency and Portfolio Management Even if the market is efficient a role exists for portfolio management • Appropriate risk level • Tax considerations • Other considerations 12-10

  11. Empirical Tests of Market Efficiency • Event studies • Assessing performance of professional managers • Testing some trading rule 12-11

  12. How Tests Are Structured 1. Examine prices and returns over time 12-12

  13. -t 0 +t Announcement Date Returns Over Time 12-13

  14. How Tests Are Structured (cont’d) 2. Returns are adjusted to determine if they are abnormal Market Model approach a. Rt = at + btRmt + et (Expected Return) b. Excess Return = (Actual - Expected) et = Actual - (at + btRmt) 12-14

  15. How Tests Are Structured (cont’d) 2. Returns are adjusted to determine if they are abnormal Market Model approach c. Cumulate the excess returns over time: -t 0 +t 12-15

  16. Issues in Examining the Results • Magnitude Issue • Selection Bias Issue • Lucky Event Issue • Possible Model Misspecification 12-16

  17. What Does the Evidence Show? • Technical Analysis • Short horizon • Long horizon • Fundamental Analysis • Anomalies Exist 12-17

  18. Anomalies • Small Firm Effect (January Effect) • Neglected Firm • Market to Book Ratios • Reversals • Post-Earnings Announcement Drift • Market Crash of 1987 12-18

  19. Mutual Fund and Professional Manager Performance • Some evidence of persistent positive and negative performance • Potential measurement error for benchmark returns • Style changes • May be risk premiums • Superstar phenomenon 12-19

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