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Chapter 9

Chapter 9. Market Efficiency. Chapter Summary. Objective: To discuss the efficient market hypothesis and to examine the empirical evidence supporting or not the notion of market efficiency. The Efficient Market Hypothesis Empirical Tests of Market Efficiency.

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Chapter 9

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  1. Chapter 9 Market Efficiency

  2. Chapter Summary • Objective: To discuss the efficient market hypothesis and to examine the empirical evidence supporting or not the notion of market efficiency. • The Efficient Market Hypothesis • Empirical Tests of Market Efficiency

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

  4. Random Walk and the EMH • Random Walk - stock price change unpredictably • Actually stock prices follow a submartingale • Expected price is positive over time • Positive trend and random around the trend

  5. Security Prices Time Random Walk with Positive Trend

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

  7. 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

  8. Forms of the EMH • Weak –all past market trading information • Semi-strong –all publicly available information regarding the prospects of a firm • Strong – all information relevant to the firm

  9. 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

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

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

  12. Summary Reminder • Objective: To discuss the efficient market hypothesis and to examine the empirical evidence supporting or not the notion of market efficiency. • The Efficient Market Hypothesis • Empirical Tests of Market Efficiency

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

  14. -t 0 +t Announcement Date How Tests Are Structured 1. Examine prices and returns over time

  15. How Tests Are Structured (cont’d) 2. Returns are adjusted to determine if they are abnormal Market Model approach a. Rt = a + bRmt + et (Expected Return) b. Excess Return = (Actual - Expected) et = Actual - (at + btRmt)

  16. -t 0 +t How Tests Are Structured (cont’d) Market Model approach c. Cumulate the excess returns over time:

  17. Issues in Examining the Results • Magnitude Issue • Selection Bias Issue • Lucky Event Issue • Possible Model Misspecification

  18. What Does the Evidence Show? • Technical Analysis • Short horizon • Long horizon • Fundamental Analysis • Anomalies Exist

  19. Anomalies • Small Firm Effect (January Effect) • Neglected Firm • Book to Market Ratios • Reversals • Note: above anomalies may actually be risk-premiums

  20. Anomalies (cont.) • Weekend effect • Inside information • Post-Earnings Announcement Drift

  21. Explanations of Anomalies • May be risk premiums • Behavioral explanations • Forecasting errors • Overconfidence • Regret avoidance • Framing and mental accounting

  22. Mutual Fund and Professional Managers’ Performance • Some evidence of persistent positive and negative performance • Potential measurement error for benchmark returns • Style changes • May be risk premiums • Superstar phenomenon

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