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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)

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

  4. Figure 11.2 Stock Price Reaction to CNBC Reports

  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

  6. The market price is more informative (accurate) than individual value estimates V = the true fundamental value, P = the market price, vi = value estimate of trader i; vi = V + ei, where E(ei) = 0, Di = trader i’s desired position in the security; Di = a(vi – P), where a is a constant. From ∑ Di = ∑ a(vi – P) = 0 (i.e., zero net supply), we have ∑ a(vi – P) = 0 → a∑(vi – P) = 0 → ∑(vi – P) = 0 → ∑vi – ∑P = 0 → ∑vi = ∑P = N * P → P = (1/N) ∑vi P = (1/N) ∑vi = (1/N) ∑(V + ei) = V + eM, where eM = (1/N) ∑ei ≈ 0.

  7. Weak Semi-strong Strong Versions of the EMH

  8. 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

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

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

  11. 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

  12. 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

  13. Magnitude Issue Selection Bias Issue Lucky Event Issue Are Markets Efficient

  14. Weak-Form Tests Returns over the Short Horizon Momentum Returns over Long Horizons

  15. 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

  16. 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

  17. Figure 11.3 Average Annual Return for 10 Size-Based Portfolios, 1926 – 2006

  18. Figure 11.4 Average Return as a Function of Book-To-Market Ratio, 1926–2006

  19. Figure 11.5 Cumulative Abnormal Returns in Response to Earnings Announcements

  20. Strong-Form Tests: Inside Information 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

  21. Interpreting the Evidence • 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

  22. Interpreting the Evidence Continued Anomalies or Data Mining The noisy market hypothesis Fundamental indexing

  23. Stock Market Analysts Do Analysts Add Value Mixed evidence Ambiguity in results

  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

  25. Figure 11.7 Estimates of Individual Mutual Fund Alphas, 1972 - 1991

  26. Table 11.1 Performance of Mutual Funds Based on Three-Index Model

  27. Figure 11.8 Persistence of Mutual Fund Performance

  28. Table 11.2 Two-Way Table of Managers Classified by Risk-Adjusted Returns over Successive Intervals

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