Efficient Capital Markets April 25, 2007 (LA) or April 24, 2007 (OCC) 1

Overview of Session Efficient market theory Arbitrage and alternatives to CAPM Summary of issues in capital structure Modigliani and Miller (M-M) capital structure propositions The debate concerning M-M propositions Debt and residual claims on a firm’s assets

Efficient Markets Information efficiency vs. other definitions Forms of informational efficiency Weak (past prices) Semi-strong (past public information) Strong (inside or all information) Channels of information Evidence on each 22

Information Channels to Market 23

Tests of Market Efficiency Tests of hypotheses that market is efficient are based on whether statistical tests can reject the hypothesis of efficiency Impossible to prove that the market is efficient as you would need to know everything Most evidence suggests that we cannot reject the hypothesis of efficiency in the weak and semistrong form 24

Evidence in Support of Market Efficiency Patterns in prices support weak form hypothesis Lack of correlation in prices No other patterns Nonetheless, there are anomalies Event studies support semistrong form Define the arrival of information Behavior of excess returns Strong form does not seem supported 25

Implications of Market Efficiency Assets or equity in balance sheets with similar risks and returns should have the same value Should earn no profits from no investment and no risk in equilibrium Can earn risk-adjusted returns from investing capital Can earn returns from taking risk Can’t earning anything without one or both

Efficient Market Summary Table on page 376 Implications of inefficiency uninformed investors market disequilbrium unpredictable behavior Importance of market efficiency in finance 26

Arbitrage Arbitrage means earning risk-free profits by buying an asset in a cheap market and selling it in an market where identical assets are expensive (dear) Commodity arbitrage involves buying commodities in cheap markets and shipping them to expensive markets, e.g. wheat Pure arbitrage profits are not possible in efficient markets

Arbitrage: Strips and Bonds Can buy a Treasury bond or buy strips with same payments (e.g. May, 2005):

Effects of Arbitrage Commodity arbitrage drives commodity prices in different markets toward equality after accounting for shipping and storage costs Arbitrage in financial markets mean cash flows with identical timing and risks cost the same In our example, the strip and bond prices are driven into agreement via arbitrage Notions of arbitrage are the basis for our discussion of the importance of capital structure

Arbitrage Pricing Theory (APT) APT states that there should be no profit opportunity without risk or invested funds Most important application of APT is to option pricing Black-Scholes Option Pricing won Nobel prize in economics Very wide application and often viewed as an alternative to net present value analysis

APT and Net Present Values Present value analysis requires forecasting cash flows and choosing a risk-adjusted discount rate Arbitrage pricing requires identifying traded assets which in combination have the same pattern of cash flows as the asset under study Options can replicate many (all) patterns of cash flows

Example: Stocks and Bonds An unlevered company is all equity A levered company has debt and equity in its capital structure If two companies have identical assets but they have different financial structures, the total value of the companies (equity in the unlevered company and debt and equity in the levered company) should be the same because of arbitrage unless another factor

Class 14 -April 30 (LA) or April 26 (OCC) Read Chapters 15 and 16 Do assigned problems Look at your PVFIRM05 results and issues with assumptions or inputs for sheets 1 to 3 Begin thinking about a strategy for reviewing for final, start looking over course objectives, previous class slides, and old examinations