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Chapter 8 and 9

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

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Chapter 8 and 9

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  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. 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 Surrounding the Event -t 0 +t Announcement Date

  16. 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)

  17. 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

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

  19. 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

  20. 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

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

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

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

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

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

  26. Behavioral Biases Framing Mental accounting Regret avoidance Prospect theory

  27. Limits to Arbitrage Fundamental risk Implementation costs Model risk

  28. 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

  29. Exercise42 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

  30. Chapter 10 Bond prices and yields

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

  32. 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

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

  34. 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

  35. 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

  36. 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

  37. 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%

  38. 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

  39. Prices and Yield Price Yield

  40. 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%

  41. 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%

  42. 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

  43. 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

  44. 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%

  45. 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

  46. Figure 10.6 Premium and Discount Bonds over Time

  47. Default Risk and Ratings Rating companies Moody’s Investor Service Standard & Poor’s Fitch Rating Categories Investment grade Speculative grade (BBB or BaB below)

  48. Figure 10.8 Definitions of Each Bond Rating Class

  49. Factors Used by Rating Companies Coverage ratios Leverage ratios Liquidity ratios Profitability ratios Cash flow to debt

  50. Term Structure of Interest Rates Relationship between yields to maturity and maturity Yield curve - a graph of the yields on bonds relative to the number of years to maturity Usually Treasury Bonds Have to be similar risk or other factors would be influencing yields

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