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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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Presentation Transcript
chapter 12

Chapter 12

MarketEfficiency

12-1

efficient market hypothesis emh
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

random walk and the emh
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

random price changes
Random Price Changes

Why are price changes random?

  • Prices react to information
  • Flow of information is random
  • Therefore, price changes are random

12-5

emh and competition
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

forms of the emh
Forms of the EMH
  • Weak
  • Semi-strong
  • Strong

12-7

types of stock analysis
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

implications of efficiency for active or passive management
Implications of Efficiency for Active or Passive Management
  • Active Management
    • Security analysis
    • Timing
  • Passive Management
    • Buy and Hold
    • Index Funds

12-9

market efficiency and portfolio management
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

empirical tests of market efficiency
Empirical Tests of Market Efficiency
  • Event studies
  • Assessing performance of professional managers
  • Testing some trading rule

12-11

how tests are structured
How Tests Are Structured

1. Examine prices and returns over time

12-12

returns over time

-t

0

+t

Announcement Date

Returns Over Time

12-13

how tests are structured cont d
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

how tests are structured cont d1
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

issues in examining the results
Issues in Examining the Results
  • Magnitude Issue
  • Selection Bias Issue
  • Lucky Event Issue
  • Possible Model Misspecification

12-16

what does the evidence show
What Does the Evidence Show?
  • Technical Analysis
    • Short horizon
    • Long horizon
  • Fundamental Analysis
  • Anomalies Exist

12-17

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

12-18

mutual fund and professional manager performance
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