Chapter 9 Market Efficiency

Chapter Summary Objective: To discuss the efficient market hypothesis and to examine the empirical evidence supporting or not the notion of market efficiency. The Efficient Market Hypothesis Empirical Tests of Market Efficiency

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 price change unpredictably Actually stock prices follow a submartingale Expected price is positive over time Positive trend and random around the trend

Random Walk with Positive Trend Security Prices Time

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

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

Forms of the EMH Weak –all past market trading information Semi-strong –all publicly available information regarding the prospects of a firm Strong – all information relevant to the firm

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

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

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

Summary Reminder Objective: To discuss the efficient market hypothesis and to examine the empirical evidence supporting or not the notion of market efficiency. The Efficient Market Hypothesis Empirical Tests of Market Efficiency

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

How Tests Are Structured 1. Examine prices and returns over time +t -t Announcement Date

How Tests Are Structured (cont’d) 2. Returns are adjusted to determine if they are abnormal Market Model approach a. Rt = a + bRmt + et (Expected Return) b. Excess Return = (Actual - Expected) et = Actual - (at + btRmt)

How Tests Are Structured (cont’d) Market Model approach c. Cumulate the excess returns over time: +t -t

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

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

Anomalies Small Firm Effect (January Effect) Neglected Firm Book to Market Ratios Reversals Note: above anomalies may actually be risk-premiums

Anomalies (cont.) Weekend effect Inside information Post-Earnings Announcement Drift

Explanations of Anomalies May be risk premiums Behavioral explanations Forecasting errors Overconfidence Regret avoidance Framing and mental accounting

Mutual Fund and Professional Managers’ Performance Some evidence of persistent positive and negative performance Potential measurement error for benchmark returns Style changes May be risk premiums Superstar phenomenon