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CHAPTER 8

CHAPTER 8. Efficient Markets & The Behavioral Critique. 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

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  1. CHAPTER 8 Efficient Markets & The Behavioral Critique

  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. Figure 8-5 Cumulative Abnormal Returns in Response to Earnings Announcements

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

  25. The Behavioral Critique • Information Processing • Behavioral Biases • Limits to Arbitrage

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

  27. Behavioral Biases • Framing • Mental accounting • Regret avoidance

  28. Limits to Arbitrage • Fundamental risk • Implementation costs • Model risks

  29. 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 • Superstars

  30. Figure 8-6 Estimates of Individual Mutual Fund Alphas

  31. Figure 8-7 Persistence of Mutual Fund Performance

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