Chapter 1 1

1. Chapter 11 Market Efficiency

2. Chapter Overview • This chapter examines the concept of market efficiency, that is, in general, securities are fairly priced and one cannot expect to outperform the market, risk-adjusted consistently over time. • The implications of market efficiency for investors and studies of the efficient capital market hypothesis are presented in detail.

3. Learning Objectives After studying this chapter, • the student should thoroughly understand the concept of market efficiency and how to make rational investment decisions based upon the existence of market efficiency. • The student also should have a thorough understanding of the many tests of market efficiency, the forms of market efficiency, and observed market anomalies.

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

5. 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

6. Random Walk with Positive Trend Security Prices Time

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

8. 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.

9. Forms of the EMH • Weak • Semi-strong • Strong

10. 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

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

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

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

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

15. Returns Over Time -t 0 +t Announcement Date

16. How Tests Are Structured (cont’d) 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)

17. How Tests Are Structured (cont’d) 2. Returns are adjusted to determine if they are abnormal. Market Model approach c. Cumulate the excess returns over time: -t 0 +t

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

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

20. Anomalies • Small Firm Effect (January Effect) • Neglected Firm • Market to Book Ratios • Reversals • 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 Manager Performance • Some evidence of persistent positive and negative performance. • Potential measurement error for benchmark returns. • Style changes • May be risk premiums • Superstar phenomenon