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Chapter 8

Chapter 8 . Efficient Market Hypothesis. 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 8

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  1. Chapter 8 Efficient Market Hypothesis

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

  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

  4. Random Walk with Positive Trend Security Prices Time

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

  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

  7. Figure 8-1 Cumulative Abnormal Returns Surrounding Takeover Attempts

  8. Figure 8-2 Returns Following Earnings Announcements

  9. Forms of the EMH Weak Semi-strong Strong

  10. Are Markets Efficient? • The Magnitude Issue • - Consider an investment manager overseeing a $2 billion portfolio. • - If she can improve performance by only 1/10th of 1 percent per year, that effort will be worth .001 x $2 billion = $2 million annually. • - This manager clearly would be worth her salary! Yet can we, as observers, statistically measure her contribution? • - Probably not: a 1/10th of 1 percent contribution would be swamped by the yearly volatility of the market

  11. Are Markets Efficient? • The Selection Bias Issue • Only investors who find that an investment scheme cannot generate abnormal returns will be willing to report their findings to the whole world. • The Lucky Event Issue • - If many investors using a variety of schemes make fair bets, statistically speaking, some of those investors will be lucky and win a great majority of the bets. • - The winners, though, turn up in The Wall Street Journal as the latest stock market gurus; then they can make a fortune publishing market newsletters.

  12. 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

  13. Implications of Efficiency for Active or Passive Management Active Management Security analysis Timing Passive Management Buy and Hold Index Funds

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

  15. Empirical Tests of Market Efficiency Event studies Assessing performance of professional managers Testing some trading rule

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

  17. Returns Surrounding the Event -t 0 +t Announcement Date

  18. How Tests Are Structured (cont.) 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)

  19. How Tests Are Structured (cont.) 2. Returns are adjusted to determine if they are abnormal Market Model approach c. Cumulate the excess returns over time: -t 0 +t

  20. Issues in Examining the Results Magnitude Issue Selection Bias Issue Lucky Event Issue

  21. Exercise 243 1. The semi-strong form EMH states that ________ must be reflected in the stock price. A) all market trading data B) all publicly available information C) all information including inside information D) none of the above 2. _________ considerations make portfolio management useful even in a perfectly efficient market. A) Diversification B) Investor tax C) Investor risk profile D) all of the above 3. The term random walk is used in investments to refer to ______________. A) stock price changes that are random but predictable B) stock prices that respond slowly to both old and new information C) stock price changes that are random and unpredictable D) stock prices changes that follow the pattern of past price changes

  22. Exercise42 1. A market anomaly refers to ____. A) an exogenous shock to the market that is sharp but not persistent B) a price or volume event that is inconsistent with historical price or volume trends C) a trading or pricing structure that interferes with efficient buying and selling of securities D) price behavior that differs from the behavior predicted by the efficient market hypothesis 2. The semi-strong form of the efficient market hypothesis contradicts __________. A) technical analysis, but supports fundamental analysis as valid B) fundamental analysis, but supports technical analysis as valid C) both fundamental analysis and technical analysis D) technical analysis, but is silent on the possibility of successful fundamental analysis

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