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Chapter 8

Chapter 8. The 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. Chapter8 The 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. Forms of the EMH • Weak • Semi-strong • Strong

  8. 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

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

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

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

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

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

  14. 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)

  15. 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

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

  17. Tests of Weak Form • Returns over short horizons • Very short time horizons small magnitude of positive trends • 3-12 month some evidence of positive momentum • Returns over long horizons – pronounced negative correlation • Evidence on Reversals

  18. Tests of Semi-strong Form: Anomalies • Small Firm Effect (January Effect) • Neglected Firm • Market to Book Ratios • Post-Earnings Announcement Drift • Higher Level Correlation in Security Prices

  19. Implications of Test Results • Risk Premiums or market inefficiencies • Anomalies or data mining • Behavioral Interpretation • Inefficiencies exist • Caused by human behavior

  20. Behavioral Possibilities • Forecasting Errors • Overconfidence • Regret avoidance • Framing and mental accounting errors

  21. Mutual Fund and Professional Manager 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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