Lecture 8: Corporate Financing Decisions and Efficient Markets.

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Presentation transcript:

Lecture 8: Corporate Financing Decisions and Efficient Markets. MN50324 Lecture 8: Corporate Financing Decisions and Efficient Markets.

Efficient Markets All new information rapidly incorporated into share prices. Investors are fully rational But: Evidence of excessive volatility (in excess of volatility of news). Stock Market Bubbles. Over- and under-reaction to news.

Efficient Markets. In a perfect world (in absence of agency and information problems) a firm cannot create value by just re-packaging finance (MM irrelevance). But evidence that investors are fooled by repackaging of shares into complex securities: Twin shares. January effect and Friday effect

Market timing In an efficient market: no scope for mkt timing (eg share repurchases) or insider trading. But evidence to the contrary.

Example Firm X announces a new positive NPV project: market should immediately react. Investors should only expect to earn the normal (CAPM) rate of return. Investors should pay a fair price for their shares. All of the positive NPV should go to initial shareholders.

Efficient versus inefficient markets. Price Over-reaction and reversion Slow response time News

Foundations of Market Efficiency Rationality Independent deviations from rationality. Arbitrage. BF: Limits to arbitrage.

Types of efficiency Weak Form efficiency: fully incorporates past information into current prices. Prices follow a random walk. Trading strategy: Buy a stock after it has gone up 3 days in a row. Sell a stock after it has gone down 3 days in a row. Therefore, strategy only uses past prices. Not earnings, forecasts or fundamentals of companies.

Weak form efficiency (continued) P Sell Sell Buy Buy t p Random Fluctuations (News) t

Semi-strong and strong- form Efficiency Semi-strong: prices incorporate all publically available information (eg news, published accounts, historical prices). Strong: Prices incorporate all information (public and private) Weak firm nested within semistrong nested within strong-form.

Are markets efficient? Weak-form? May be: Past prices easy to find and act on Semi-strong: requires more sophisticated investors, able to understand economics and statistics, and expert in individual companies and industries. Strong-form: But insider info/trading.

Implications of efficient markets. EMH: on average, a professional security analyst will not be able to achieve an abnormal or excess return. Dart-throwing! MV = FV. Price fluctuations. (heterogeneous investors).

Evidence Weak Form: serial correlation. Reversal/reversion to the mean. Semi-strong form: event studies (eg announcement of a dividend or share repurchase, or equity issue: Abnormal return Cumulative Abnormal Returns. Strong Form: evidence of insider trading profits.

BCF. Human Irrationality Independent deviations from rationality. Arbitrage (mispricing today => greater mispricing tomorrow!).

BCF: empirical challenges to mkt efficiency. Empirical challenges: Limits to arbitrage: Twin stocks. Earnings surprises: investor overconfidence: investor conservatism Size. Value versus growth. Crashes and Bubbles. Chaos theory (Bernice Cohen).

Behavioural foundations Representativeness. Conservatism. Overconfidence. Bounded rationality.

BCF Inefficient markets: rational managers exploitation of irrational investors (eg repackaging of securities: twin stocks etc: timing (eg share repurchases). Later: we will look at managerial irrationality too!