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CHAPTER 11

CHAPTER 11. The Efficient Market Hypothesis. Do security prices reflect information? Yes Why look at market efficiency? Implications for business and corporate finance Implications for investment. Efficient Market Hypothesis (EMH). Figure 11.2 Stock Price Reaction to CNBC Reports.

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CHAPTER 11

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  1. CHAPTER 11 The Efficient Market Hypothesis

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

  3. Figure 11.2 Stock Price Reaction to CNBC Reports • Impact on Stock prices • from news reports • This is one type of EMH

  4. Why look at market efficiency? Models need solution concept to generate predictions (positive tests of theory). Implications for business and corporate finance Implications for investment Efficient Market Hypothesis (EMH)

  5. Figure 11.1 Cumulative Abnormal Returns Before Takeover Attempts: Target Companies

  6. 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

  7. If prices reflect “all available information”, why use resources on information gathering? Bottom line: invest in information to the extend that it increases expected return In any market equilibrium: efficient information gathering should be fruitful (i.e. increase expected returns) Gains (on info) can be very high: .05% increase in expected return for a $10 billion fund results in $5million enough to pay high salaries to many finance analysts Competition as source of EMH

  8. Weak Stock prices already reflect all information that can derived by examining market trading data E.g. history of past prices, trading volume, so on. Semi-strong “…” all publicly available information regarding the prospects of firm. E.g. same info as before plus, how good is management, balance sheet composition, patents held, earning forecasts, accounting practice Versions of the EMH

  9. Strong Stock prices already reflect all information relevant to firm prospects, including information only available to insiders As it is clear, Weak and semi-strong have more support, strong efficiency have less support. Versions of the EMH

  10. Technical Analysis - using prices and volume information to predict future prices Weak form efficiency & technical analysis EMH imply that technical analysis is without merit Information that is both public and has little cost should already be incorporated on stock prices Types of Stock Analysis

  11. A procedure that “seems to work” (i.e. increase rates of returns) will continue to work in the future? The test of EMH is if prices reflect information. Once a useful procedure that “works” is discovered, it ought to be invalidated as more traders starts using it. Price patterns are “self-destructing” Any “beat the market” procedure that is known, will tend to be invalidated Self-destructing

  12. Fundamental Analysis - using economic and accounting information to predict stock prices analysis of Industry or Sector Industry is growing (media companies = turbulent earning prospects) analysis of companies financials, its management effectiveness, competitive advantage Apple analysis of economy of country (or global) In summary: Warren Buffet’s job Semi strong form efficiency & fundamental analysis Types of Stock Analysis

  13. Active Management Security analysis Timing Passive Management Buy and Hold Index Funds Active or Passive Management

  14. Even if the market is efficient a role exists for portfolio management: Appropriate risk level (Solve problem: one risky asset and one risk-free) Tax considerations (to maximize the risk-free rate) Market Efficiency & Portfolio Management

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