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MN50324

This lecture explores efficient markets and their impact on corporate financing decisions. It discusses the incorporation of new information into share prices, the rationality of investors, evidence of excessive volatility, and the concept of stock market bubbles. Additionally, it examines the limitations of market timing and the evidence of investors being fooled by repackaging of shares into complex securities. The lecture also covers price over-reactions, slow response times, and the foundations of market efficiency, including rationality, independent deviations from rationality, and arbitrage. It further explores weak-form, semi-strong-form, and strong-form efficiency and the implications of efficient markets. The lecture concludes by discussing empirical challenges to market efficiency and behavioral foundations such as representativeness, conservatism, overconfidence, and bounded rationality.

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MN50324

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  1. MN50324 Lecture 8: Corporate Financing Decisions and Efficient Markets.

  2. Efficient Markets • All new information rapidly incorporated into share prices. • Investors are fully rational • But: • Evidence of excessive volatility (in excess of volatility of news). • Stock Market Bubbles. • Over- and under-reaction to news.

  3. Efficient Markets. • In a perfect world (in absence of agency and information problems) a firm cannot create value by just re-packaging finance (MM irrelevance). • But evidence that investors are fooled by repackaging of shares into complex securities: • Twin shares. • January effect and Friday effect

  4. Market timing • In an efficient market: no scope for mkt timing (eg share repurchases) or insider trading. • But evidence to the contrary.

  5. Example • Firm X announces a new positive NPV project: market should immediately react. • Investors should only expect to earn the normal (CAPM) rate of return. • Investors should pay a fair price for their shares. • All of the positive NPV should go to initial shareholders.

  6. Efficient versus inefficient markets. Price Over-reaction and reversion Slow response time News

  7. Foundations of Market Efficiency • Rationality • Independent deviations from rationality. • Arbitrage. • BF: Limits to arbitrage.

  8. Types of efficiency • Weak Form efficiency: fully incorporates past information into current prices. • Prices follow a random walk. • Trading strategy: Buy a stock after it has gone up 3 days in a row. • Sell a stock after it has gone down 3 days in a row. Therefore, strategy only uses past prices. Not earnings, forecasts or fundamentals of companies.

  9. Weak form efficiency (continued) P Sell Sell Buy Buy t p Random Fluctuations (News) t

  10. Semi-strong and strong- form Efficiency • Semi-strong: prices incorporate all publically available information (eg news, published accounts, historical prices). • Strong: Prices incorporate all information (public and private) • Weak firm nested within semistrong nested within strong-form.

  11. Are markets efficient? • Weak-form? May be: Past prices easy to find and act on • Semi-strong: requires more sophisticated investors, able to understand economics and statistics, and expert in individual companies and industries. • Strong-form: But insider info/trading.

  12. Implications of efficient markets. • EMH: on average, a professional security analyst will not be able to achieve an abnormal or excess return. • Dart-throwing! • MV = FV. • Price fluctuations. • (heterogeneous investors).

  13. Evidence • Weak Form: serial correlation. • Reversal/reversion to the mean. • Semi-strong form: event studies (eg announcement of a dividend or share repurchase, or equity issue: • Abnormal return • Cumulative Abnormal Returns. Strong Form: evidence of insider trading profits.

  14. BCF. • Human Irrationality • Independent deviations from rationality. • Arbitrage (mispricing today => greater mispricing tomorrow!).

  15. BCF: empirical challenges to mkt efficiency. • Empirical challenges: Limits to arbitrage: Twin stocks. • Earnings surprises: investor overconfidence: investor conservatism • Size. • Value versus growth. • Crashes and Bubbles. • Chaos theory (Bernice Cohen).

  16. Behavioural foundations • Representativeness. • Conservatism. • Overconfidence. • Bounded rationality.

  17. BCF • Inefficient markets: rational managers exploitation of irrational investors (eg repackaging of securities: twin stocks etc: timing (eg share repurchases). • Later: we will look at managerial irrationality too!

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