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Chapter 9 The Capital Markets and Market Efficiency

Chapter 9 The Capital Markets and Market Efficiency

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Chapter 9 The Capital Markets and Market Efficiency

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  1. Chapter 9The Capital Markets and Market Efficiency

  2. Outline • Introduction • Role of the capital markets • Efficient market hypothesis • Anomalies

  3. Introduction • Capital market theory springs from the notion that: • People like return • People do not like risk • Dispersion around expected return is a reasonable measure of risk

  4. Role of the Capital Markets • Definition • Economic function • Continuous pricing function • Fair price function

  5. Definition • Capital markets trade securities with lives of more than one year • Examples of capital markets • New York Stock Exchange (NYSE) • American Stock Exchange (AMEX) • Chicago Board of Trade • Chicago Board Options Exchange (CBOE)

  6. Economic Function • The economic function of capital markets facilitates the transfer of money from savers to borrowers • E.g., mortgages, Treasury bonds, corporate stocks and bonds

  7. Continuous Pricing Function • The continuous pricing function of capital markets means prices are available moment by moment • Continuous prices are an advantage to investors • Investors are less confident in their ability to get a quick quotation for securities that do not trade often

  8. Fair Price Function • The fair price function of capital markets means that an investor can trust the financial system • The function removes the fear of buying or selling at an unreasonable price • The more participants and the more formal the marketplace, the greater the likelihood that the buyer is getting a fair price

  9. Efficient Market Hypothesis • Definition • Types of efficiency • Weak form • Semi-strong form • Strong form • Semi-efficient market hypothesis • Security prices and random walks

  10. Definition • The efficient market hypothesis (EMH) is the theory supporting the notion that market prices are in fact fair • The EMH is perhaps the most important paradigm in finance

  11. Types of Efficiency • Operational efficiency measures how well things function in terms of speed of execution and accuracy • It is a function of the number of order that are lost or filled incorrectly • It is a function of the elapsed time between the receipt of an order and its execution

  12. Types of Efficiency (cont’d) • Informational efficiency is a measure of how quickly and accurately the market reacts to new information • It relates directly to the EMH • The market is informationally very efficient • Security prices adjust rapidly and accurately to new information • The market is still not completely efficient

  13. Weak Form • Definition • Charting • Runs test

  14. Definition • The weak form of the EMH states that it is impossible to predict future stock prices by analyzing prices from the past • The current price is a fair one that considers any information contained in the past price data • Charting techniques or of no use in predicting stock prices

  15. Definition (cont’d) Example Which stock is a better buy? Stock A Current Stock Price Stock B

  16. Definition (cont’d) Example (cont’d) Solution: According to the weak form of the EMH, neither stock is a better buy, since the current price already reflects all past information.

  17. Charting • People who study charts are technical analysts or chartists • Chartists look for patterns in a sequence of stock prices • Many chartists have a behavioral element

  18. Runs Test • A runs test is a nonparametric statistical technique to test the likelihood that a series of price movements occurred by chance • A run is an uninterrupted sequence of the same observation • A runs test calculates the number of ways an observed number of runs could occur given the relative number of different observations and the probability of this number

  19. Conducting A Runs Test

  20. Semi-Strong Form • The semi-strong form of the EMH states that security prices fully reflect all publicly available information • E.g., past stock prices, economic reports, brokerage firm recommendations, investment advisory letters, etc.

  21. Semi-Strong Form (cont’d) • Academic research supports the semi-strong form of the EMH by investigating various corporate announcements, such as: • Stock splits • Cash dividends • Stock dividends • This means investor are seldom going to beat the market by analyzing public news

  22. Strong Form • The strong form of the EMH states that security prices fully reflect all public and private information • This means even corporate insiders cannot make abnormal profits by using inside information • Inside information is information not available to the general public

  23. Semi-Efficient Market Hypothesis • The semi-efficient market hypothesis (SEMH) states that the market prices some stocks more efficiently than others • Less well-known companies are less efficiently priced • The market may be tiered • A security pecking order may exist

  24. Security Prices and Random Walks • The unexpected portion of news follows a random walk • News arrives randomly and security prices adjust to the arrival of the news • We cannot forecast specifics of the news very accurately

  25. Anomalies • Definition • Low PE effect • Low-priced stocks • Small firm effect • Neglected firm effect • Market overreaction • January effect

  26. Anomalies (cont’d) • Day-of-the-week effect • Turn-of-the calendar effect • Persistence of technical analysis • Chaos theory

  27. Definition • A financial anomaly refers to unexplained results that deviate from those expected under finance theory • Especially those related to the efficient market hypothesis

  28. Low PE Effect • Stocks with low PE ratios provide higher returns than stocks with higher PEs • Supported by several academic studies • Conflicts directly with the CAPM, since study returns were risk-adjusted (Basu)

  29. Low-Priced Stocks • Stocks with a “low” stock price earn higher returns than stocks with a “high” stock price • There is an optimum trading range • Every stock with a “high” stock price should split

  30. Small Firm Effect • Investing in firms with low market capitalization will provide superior risk-adjusted returns • Supported by academic studies • Implies that portfolio managers should give small firms particular attention

  31. Neglected Firm Effect • Security analysts do not pay as much attention to firms that are unlikely portfolio candidates • Implies that neglected firms may offer superior risk-adjusted returns

  32. Market Overreaction • The tendency for the market to overreact to extreme news • Investors may be able to predict systematic price reversals • Results because people often rely too heavily on recent data at the expense of the more extensive set of prior data

  33. January Effect • Stock returns are inexplicably high in January • Small firms do better than large firms early in the year • Especially pronounced for the first five trading days in January

  34. January Effect (cont’d) • Possible explanations: • Tax-loss trading late in December (Branch) • The risk of small stocks is higher early in the year (Rogalski and Tinic)

  35. Types of Firms in January

  36. Day-of-the-Week Effect • Mondays are historically bad days for the stock market • Wednesday and Fridays are consistently good • Tuesdays and Thursdays are a mixed bag

  37. Day-of-the-Week Effect (cont’d) • Should not occur in an efficient market • Once a profitable trading opportunity is identified, it should disappear • The day-of-the-week effect continues to persist

  38. Turn-of-the-Calendar Effect • The bulk of returns comes from the last trading day of the month and the first few days of the following month • For the rest of the month, the ups and downs approximately cancel out