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Fina2802: Investments and Portfolio Analysis Spring, 2010 Dragon Tang

Lecture 10 The Efficient Market Hypothesis February 11, 2010 Readings: Chapter 11 Practice Problem Sets: 2,3,4,7,9,15,16,19,20. Fina2802: Investments and Portfolio Analysis Spring, 2010 Dragon Tang. Efficient Markets and Critique. Objectives

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Fina2802: Investments and Portfolio Analysis Spring, 2010 Dragon Tang

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  1. Lecture 10 The Efficient Market Hypothesis February 11, 2010 Readings: Chapter 11 Practice Problem Sets: 2,3,4,7,9,15,16,19,20 Fina2802: Investments and Portfolio AnalysisSpring, 2010Dragon Tang Chapter 11: Market Efficiency

  2. Efficient Markets and Critique • Objectives • Define the concept of Market Efficiency and its implication for security prices. • Demonstrate why if market are efficient security price movements should be essentially unpredictable. • Cite evidence that supports and contradicts the efficient market hypothesis. • Formulate investment strategies that make sense in informationally efficient markets. Chapter 11: Market Efficiency

  3. Where Are We? Pricing: Risk vs. Return Securities Investment Trading Investment Companies Market Efficiency Trading Behavior Chapter 11: Market Efficiency

  4. If we know stock prices follows: Pt+1 = a + b Xt + et with enough historical observations, we can find a and b. Given the current market condition Xt, we can predict future return Pt+1 with high precision. What happens next? Stock Return Predictability Chapter 11: Market Efficiency

  5. Market Efficiency Definition:Markets are efficient if prices of securities fully reflect allavailable information about securities. The belief in market efficiency is called Efficient Market Hypothesis (EMH). Prices change only due to new information Stock price changes are random and unpredictable (Random Walk) Market efficiency Chapter 11: Market Efficiency

  6. Random Walk with Positive Trend Security Prices Time Chapter 11: Market Efficiency

  7. Why market efficiency? Many highly paid analysts are searching for ways to improve investment performance. Competition among these analysts make mispriced securities difficult to find. Chapter 11: Market Efficiency

  8. Cumulative Abnormal Returns Surrounding Takeover Attempts Chapter 11: Market Efficiency

  9. Returns Following Earnings Announcements Chapter 11: Market Efficiency

  10. Three Versions of EMH • Weak-form EMH: prices reflect all past info • Semistrong-form EMH: prices reflect all public (past&current) info • Strong-form EMH: prices reflect all (past&current, public&private) info Strong Semistrong Weak Form Form Form Chapter 11: Market Efficiency

  11. Implications of EMH for Investment Policy • Technical Analysis: useless • Fundamental Analysis: adds little value • Active versus Passive Portfolio • Management: passive wins EMH You can’t “Beat the Market” Chapter 11: Market Efficiency

  12. The Role of Portfolio Managementin an Efficient Market • Need for a well-diversified portfolio • Tax considerations • Individual considerations • Age considerations Chapter 11: Market Efficiency

  13. But Are Markets Efficient? Hard question! • The Magnitude Issue • The Selection Bias Issue • The Lucky Event Issue Chapter 11: Market Efficiency

  14. Short Horizon Tests of Weak-form EMH Confirming EMH: • Patterns in stock prices cannot be exploited • Runs of stock prices cannot be used to predict the next price movement • Filter rules cannot generate trading profits • Momentum: Serial correlation may exist over short periods (Jegadeesh & Titman, 1993) Chapter 11: Market Efficiency

  15. Long Horizon Tests of the Weak-form EMH • Reversal: Serial correlation may be negative over long horizons (“Overreaction”) • Excess volatility may result when market prices are compared to “fundamentals” Short-run overreaction Short-run momentum Long-run reversal Chapter 11: Market Efficiency

  16. Evidence Against EMH:Predictors of Broad Market Movements • Dividend yield • Earnings yield • Bond yield spreads Q: Are these proxies for a change in Market risk premium? Chapter 11: Market Efficiency

  17. Problems in Testing EMH • Most tests require risk adjustments • Risk adjustment require a model of risk (typically uses CAPM) • Tests of risk-adjusted returns are joint tests • of the EMH and the risk adjustment procedure • Rejecting risk-adjustment procedure leaves • no conclusions about EMH • EMH is essentially untestable. Chapter 11: Market Efficiency

  18. Tests of the Semistrong-form EMH Anomalies (evidence against EMH): • P/E Effect:low P/E, High returns • Small-firm-in-January effect: Small firm, High • return, in January • Neglected-Firm Effect: Less known firms have • higher return • Book-to-Market effect: high B/M high returns • Postearnings effect: sluggish response of price to • earnings announcements Chapter 11: Market Efficiency

  19. The Size Effect from 1926 to 2003 Chapter 11: Market Efficiency

  20. Average Rate of Return as a Function of Book to Market Chapter 11: Market Efficiency

  21. Cumulative Abnormal Returns in Response to Earnings Announcements Chapter 11: Market Efficiency

  22. Tests of the Strong-form EMH Against strong-form EMH: • Inside information • SEC regulations Chapter 11: Market Efficiency

  23. Why Anomalies? Risk premiums or inefficiencies? Anomalies or data mining? Behavioral interpretation: — Inefficiencies exist — Caused by human behavior Interpreting the Evidence Chapter 11: Market Efficiency

  24. Information Processing Behavioral Biases Limits to Arbitrage The Behavioral Critique Chapter 11: Market Efficiency

  25. Reality Check of the Semistrong-form EMH Mutual fund performance Skilled equity investment professionals do not consistently beat the market. Chapter 11: Market Efficiency

  26. Estimates of Individual Mutual Fund Alphas Chapter 11: Market Efficiency

  27. Persistence of Mutual Fund Performance Chapter 11: Market Efficiency

  28. Search for Abnormal Returns • Trading rule becomes less valuable once exploited • Markets are made more efficient as new techniques are used • If you find a rule that work, don’t tell anybody…markets might be efficient! Chapter 11: Market Efficiency

  29. Are Markets Efficient? • Search for underpriced securities continues • Several anomalies have not been adequately • explained • Markets generally are very efficient but • rewards may be available to the gifted (not • only the lucky!). Chapter 11: Market Efficiency

  30. Summary • Research shows stock prices tend to follow a random walk • Three forms of the efficient market hypothesis • Technical analysis (violation of Weak form) • Fundamental analysis (violation of Semistrong form) • Empirical studies have generally shown that technical analysis does not generate trading profits • Several anomalies exist regarding fundamental analysis • Professionally managed funds generally cannot consistently beat the market Chapter 11: Market Efficiency

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