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CHAPTER 11

CHAPTER 11. The Efficient Market Hypothesis. 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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CHAPTER 11

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  1. CHAPTER 11 The Efficient Market Hypothesis

  2. Do security prices reflect information ? Why look at market efficiency? Implications for business and corporate finance Implications for investment Efficient Market Hypothesis (EMH) Bahattin Buyuksahin, JHU, Investment

  3. Figure 11.1 Cumulative Abnormal Returns Before Takeover Attempts: Target Companies Bahattin Buyuksahin, JHU, Investment

  4. Figure 11.2 Stock Price Reaction to CNBC Reports Bahattin Buyuksahin, JHU, Investment

  5. 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 Bahattin Buyuksahin, JHU, Investment

  6. Weak Semi-strong Strong Versions of the EMH Bahattin Buyuksahin, JHU, Investment

  7. 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 Bahattin Buyuksahin, JHU, Investment

  8. Active Management Security analysis Timing Passive Management Buy and Hold Index Funds Active or Passive Management Bahattin Buyuksahin, JHU, Investment

  9. Even if the market is efficient a role exists for portfolio management: Appropriate risk level Tax considerations Other considerations Market Efficiency & Portfolio Management Bahattin Buyuksahin, JHU, Investment

  10. Empirical financial research that enables an observer to assess the impact of a particular event on a firm’s stock price Abnormal return due to the event is estimated as the difference between the stock’s actual return and a proxy for the stock’s return in the absence of the event Event Studies Bahattin Buyuksahin, JHU, Investment

  11. Returns are adjusted to determine if they are abnormal Market Model approach a. rt = at + brmt + et (Expected Return) b. Excess Return = (Actual - Expected) et = rt - (a+ brMt) How Tests Are Structured Bahattin Buyuksahin, JHU, Investment

  12. Magnitude Issue Selection Bias Issue Lucky Event Issue Are Markets Efficient Bahattin Buyuksahin, JHU, Investment

  13. Weak-Form Tests Returns over the Short Horizon Momentum Returns over Long Horizons Bahattin Buyuksahin, JHU, Investment

  14. Predictors of Broad Market Returns Fama and French Aggregate returns are higher with higher dividend ratios Campbell and Shiller Earnings yield can predict market returns Keim and Stambaugh Bond spreads can predict market returns Bahattin Buyuksahin, JHU, Investment

  15. P/E Effect Small Firm Effect (January Effect) Neglected Firm Effect and Liquidity Effects Book-to-Market Ratios Post-Earnings Announcement Price Drift Semistrong Tests: Anomalies Bahattin Buyuksahin, JHU, Investment

  16. Figure 11.3 Average Annual Return for 10 Size-Based Portfolios, 1926 – 2006 Bahattin Buyuksahin, JHU, Investment

  17. Figure 11.4 Average Return as a Function of Book-To-Market Ratio, 1926–2006 Bahattin Buyuksahin, JHU, Investment

  18. Figure 11.5 Cumulative Abnormal Returns in Response to Earnings Announcements Bahattin Buyuksahin, JHU, Investment

  19. Strong-Form Tests: Inside Information Bahattin Buyuksahin, JHU, Investment The ability of insiders to trade profitability in their own stock has been documented in studies by Jaffe, Seyhun, Givoly, and Palmon SEC requires all insiders to register their trading activity

  20. Interpreting the Evidence Bahattin Buyuksahin, JHU, Investment • Risk Premiums or market inefficiencies—disagreement here • Fama and French argue that these effects can be explained as manifestations of risk stocks with higher betas • Lakonishok, Shleifer, and Vishney argue that these effects are evidence of inefficient markets

  21. Figure 11.6 Returns to Style Portfolio as a Predictor of GDP Growth Bahattin Buyuksahin, JHU, Investment

  22. Interpreting the Evidence Continued Anomalies or Data Mining The noisy market hypothesis Fundamental indexing Bahattin Buyuksahin, JHU, Investment

  23. Stock Market Analysts Do Analysts Add Value Mixed evidence Ambiguity in results Bahattin Buyuksahin, JHU, Investment

  24. Some evidence of persistent positive and negative performance Potential measurement error for benchmark returns Style changes May be risk premiums Hot hands phenomenon Mutual Fund Performance Bahattin Buyuksahin, JHU, Investment

  25. Figure 11.7 Estimates of Individual Mutual Fund Alphas, 1972 - 1991 Bahattin Buyuksahin, JHU, Investment

  26. Table 11.1 Performance of Mutual Funds Based on Three-Index Model Bahattin Buyuksahin, JHU, Investment

  27. Figure 11.8 Persistence of Mutual Fund Performance Bahattin Buyuksahin, JHU, Investment

  28. Table 11.2 Two-Way Table of Managers Classified by Risk-Adjusted Returns over Successive Intervals Bahattin Buyuksahin, JHU, Investment

  29. CHAPTER 12 Behavioral Finance and Technical Analysis

  30. Behavioral Finance Investors Do Not Always Process Information Correctly Investors Often Make Inconsistent or Systematically Suboptimal Decisions Bahattin Buyuksahin, JHU, Investment

  31. Information Processing Critique Forecasting Errors Overconfidence Conservatism Sample Size Neglect and Representativeness Bahattin Buyuksahin, JHU, Investment

  32. Behavioral Biases Framing Mental Accounting Regret Avoidance Prospect Theory Bahattin Buyuksahin, JHU, Investment

  33. Figure 12.1 Prospect Theory Bahattin Buyuksahin, JHU, Investment

  34. Limits to Arbitrage Fundamental Risk Implementation Costs Model Risk Bahattin Buyuksahin, JHU, Investment

  35. Limits to Arbitrage and the Law of One Price Siamese Twin Companies Equity Carve-outs Closed-End Funds Bahattin Buyuksahin, JHU, Investment

  36. Figure 12.2 Pricing of Royal Dutch Relative to Shell (Deviation from Parity) Bahattin Buyuksahin, JHU, Investment

  37. Evaluation of the Behavioral Critiques Bubbles and Behavioral Economics Arguments that the Evidence Does Not Support One Type of Irrationality Relatively New Field Bahattin Buyuksahin, JHU, Investment

  38. Technical Analysis and Behavioral Finance Trends and Corrections Dow Theory Moving averages Breadth Sentiment Indicators Trin Statistic Confidence Index Put/Call Ratio Bahattin Buyuksahin, JHU, Investment

  39. Figure 12.3 Dow Theory Trends Bahattin Buyuksahin, JHU, Investment

  40. Figure 12.4 Dow Jones Industrial Average in 1988 Bahattin Buyuksahin, JHU, Investment

  41. Figure 12.5 Moving Average for Microsoft Bahattin Buyuksahin, JHU, Investment

  42. Example 12.4 Moving Averages Bahattin Buyuksahin, JHU, Investment

  43. Figure 12.6 Moving Averages Bahattin Buyuksahin, JHU, Investment

  44. Figure 12.7 Market Diary Bahattin Buyuksahin, JHU, Investment

  45. Table 12.1 Breadth Bahattin Buyuksahin, JHU, Investment

  46. Figure 12.8 Actual and Simulated Levels for Stock Market Prices of 52 Weeks Bahattin Buyuksahin, JHU, Investment

  47. Figure 12.9 Actual and Simulated Changes in Stock Prices for 52 Weeks Bahattin Buyuksahin, JHU, Investment

  48. CHAPTER 13 Empirical Evidence on Security Returns

  49. Overview of Investigation Tests of the single factor CAPM or APT Model Tests of the Multifactor APT Model Results are difficult to interpret Studies on volatility of returns over time Bahattin Buyuksahin, JHU, Investment

  50. The Index Model and the Single-Factor APT Bahattin Buyuksahin, JHU, Investment Expected Return-Beta Relationship Estimating the SCL

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