Chapter 8 and 9

1. Chapter 8 and 9 Efficient Market Hypothesis and Behavioral Finance

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. Figure 8-1 Cumulative Abnormal Returns Surrounding Takeover Attempts

8. Figure 8-2 Returns Following Earnings Announcements

9. Forms of the EMH Weak Semi-strong Strong

10. Are Markets Efficient? • The Magnitude Issue • - Consider an investment manager overseeing a $2 billion portfolio. • - If she can improve performance by only 1/10th of 1 percent per year, that effort will be worth .001 x $2 billion = $2 million annually. • - This manager clearly would be worth her salary! Yet can we, as observers, statistically measure her contribution? • - Probably not: a 1/10th of 1 percent contribution would be swamped by the yearly volatility of the market

11. Are Markets Efficient? • The Selection Bias Issue • Only investors who find that an investment scheme cannot generate abnormal returns will be willing to report their findings to the whole world. • The Lucky Event Issue • - If many investors using a variety of schemes make fair bets, statistically speaking, some of those investors will be lucky and win a great majority of the bets. • - The winners, though, turn up in The Wall Street Journal as the latest stock market gurus; then they can make a fortune publishing market newsletters.

12. 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

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

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

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

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

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

18. 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)

19. 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

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

21. 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

22. 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

23. Figure 8-3 The Size Effect from 1926 to 2003

24. The Small Firm Effect • Banz found that both total and risk-adjusted rates of return tend to fall with increases in the relative size of the firm, as measured by the market value of the firm's outstanding equity. • Later studies (Keim, Reinganum, and Blume and Stambaugh) showed that the small-firm effect occurs virtually entirely in January, in fact, in the first two weeks of January. The size effect is in fact a "small-firm-in-January" effect. • Some researchers believe that the January effect is tied to tax-loss selling at the end of the year. (Many people sell stocks that have declined in price during the previous months to realize their capital losses before the tax year ends, and do not put the proceeds from these sales back into the stock market until after the turn of the year)

25. Figure 8-4 Average Rate of Return as a Function of Book to Market

26. Market-to-Book Ratios • Fama and French and Reinganum show that a very powerful predictor of returns across securities is the ratio of the book value of the firm's equity to the market value of equity. • The decile with the highest book-to-market ratio had an average monthly return of 1.65% while the lowest-ratio decile averaged only 0.72 percent per month.

27. Reversals • DeBondt and Thaler, Jegadeesh, and Lehman all find strong tendencies for poorly performing stocks in one time period to experience sizable reversals over the subsequent period (losers rebound and winners fade back) • This phenomenon, dubbed the reversal effect, is suggestive of overreaction of stock prices to relevant news. • These tendencies seem pronounced enough to be exploited profitably and so present a strong challenge to market efficiency.

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

29. The Behavioral Critique Information Processing Investors do not process information correctly Behavioral Biases Investors often make inconsistent or systematically suboptimal decisions Limits to Arbitrage

30. Information Processing Forecasting errors Overconfidence Conservatism Sample size neglect and representativeness

31. Behavioral Biases Framing Mental accounting Regret avoidance Prospect theory

32. Limits to Arbitrage Fundamental risk Implementation costs Model risk

33. Exercise 243 1. The semi-strong form EMH states that ________ must be reflected in the stock price. A) all market trading data B) all publicly available information C) all information including inside information D) none of the above 2. _________ considerations make portfolio management useful even in a perfectly efficient market. A) Diversification B) Investor tax C) Investor risk profile D) all of the above 3. The term random walk is used in investments to refer to ______________. A) stock price changes that are random but predictable B) stock prices that respond slowly to both old and new information C) stock price changes that are random and unpredictable D) stock prices changes that follow the pattern of past price changes

34. Exercise43 1. A market anomaly refers to ____. A) an exogenous shock to the market that is sharp but not persistent B) a price or volume event that is inconsistent with historical price or volume trends C) a trading or pricing structure that interferes with efficient buying and selling of securities D) price behavior that differs from the behavior predicted by the efficient market hypothesis 2. The semi-strong form of the efficient market hypothesis contradicts __________. A) technical analysis, but supports fundamental analysis as valid B) fundamental analysis, but supports technical analysis as valid C) both fundamental analysis and technical analysis D) technical analysis, but is silent on the possibility of successful fundamental analysis

35. Chapter 10 Bond prices and yields

36. Bond Characteristics Face or par value Coupon rate Coupon payment Maturity Yield to maturity

37. Accrued interest and quoted bond prices Accrued Interest = (Annual coupon payment/2)x(days since last coupon payment/days separate coupon payment) Invoice price = quoted price + accrued interest

38. Provisions of Bonds Secured or unsecured Call provision Convertible provision Put provision (putable bonds) Floating rate bonds Sinking funds

39. Exercise 2 A bond pays a semi-annual coupon and the last coupon was paid 61 days ago. If the annual coupon payment is $75, what is the accrued interest? A. $13.21B. $12.57C. $15.44D. $16.32

40. Bond Pricing T  ParValue C P T t = + B + T + ( 1 r ) T ( 1 r ) = t 1 Bond price = PV of Annuity + PV of lump sum CF PB = Price of the bond Ct = interest or coupon payments T = number of periods to maturity r = semi-annual discount rate or the semi-annual yield to maturity

41. Example: Price of 8%,semiannual coupon payment, 10-yr. with yield at 6% 20 1 1 Σ P = x + x 40 1000 t 20 B ( 1 . 03 ) ( 1 . 03 ) = t 1 P = 1 , 148 . 77 B Coupon = 4%*1,000 = 40 (Semiannual) Discount Rate = 3% (Semiannual Maturity = 10 years or 20 periods Par Value = 1,000

42. Exercise in class • A coupon bond which pays interest semi-annually, has a par value of $1,000, matures in 5 years, and has a yield to maturity of 8%. If the coupon rate is 10%, the intrinsic value of the bond today will be __________. A) $855.55 B) $1,000 C) $1,081 D) $1,100 2. A coupon bond which pays interest of $40 annually, has a par value of $1,000, matures in 5 years, and is selling today at a $159.71 discount from par value. The actual yield to maturity on this bond is __________. A) 5% B) 6% C) 7% D) 8%

43. Bond Prices and Yields Prices and Yields (required rates of return) have an inverse relationship When yields get very high the value of the bond will be very low When yields approach zero, the value of the bond approaches the sum of the cash flows

44. Prices and Yield Price Yield

45. Alternative Measures of Yield Current Yield Annual coupon payment/current bond price Yield to Call Call price replaces par Call date replaces maturity Example: Suppose the 8% coupon (semiannual payment), 30-year maturity bond sells for $1,150 and is callable in 10 years at a call price of $1,100. What is the yield to maturity and yield to call? Given: PMT: 40; N: 60; FV:1000; PV: -1150  YTM = 6.82% Given: PMT: 40, N: 20; FV:1100; PV: -1150  YTC = 6.64%

46. Alternative Measures of Yield Holding Period Yield Considers actual reinvestment of coupons Considers any change in price if the bond is held less than its maturity You purchased a 5-year annual interest coupon bond one year ago. Its coupon interest rate was 6% and its par value was $1,000. At the time you purchased the bond, the yield to maturity was 4%. If you sold the bond after receiving the first interest payment and the bond's yield to maturity had changed to 3%, your annual total rate of return on holding the bond for that year would have been __________. A) 5.00% B) 5.51% C) 7.61% D) 8.95%

47. Convertible Bonds A bond with an option allowing the bondholder to exchange the bond for a specified number of shares of common stock in the firm. Conversion ratio: # of shares can be exchanged for each bond Market conversion value: current value of shares for which bond maybe exchanged Conversion premium: the difference of conversion value and its bond price

48. Example 2 A convertible bond has a par value of $1,000 but its current market price is $833. The current price of the issuing company's stock is $22 and the conversion ratio is 40 shares. The bond's market conversion value is __________. a. $1,000 B $880 c. $833 d. $800

49. Exercise in class • A coupon bond which pays interest of $50 annually, has a par value of $1,000, matures in 5 years, and is selling today at an $84.52 discount from par value. The current yield on this bond is __________. A) 5% B) 5.46% C) 5.94% D) 6.00% 2. A callable bond pays annual interest of $60, has a par value of $1,000, matures in 20 years but is callable in 10 years at a price of $1,100, and has a value today of $1055.84. The yield to call on this bond is __________. A) 6.00% B) 6.58% C) 7.20% D) 8.00%

50. Premium and Discount Bonds Premium Bond Coupon rate exceeds yield to maturity Bond price will decline to par over its maturity Discount Bond Yield to maturity exceeds coupon rate Bond price will increase to par over its maturity