Efficient Markets and Behavioral Finance

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Presentation transcript:

Efficient Markets and Behavioral Finance Chapter 13 Principles of Corporate Finance Tenth Edition Efficient Markets and Behavioral Finance Slides by Matthew Will McGraw Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved

Topics Covered We Always Come Back to NPV What is an Efficient Market? Random Walk Efficient Market Theory The Evidence Against Market Efficiency Behavioral Finance Six Lessons of Market Efficiency

Return to NPV NPV employs discount rates These discount rates are risk adjusted The risk adjustment is a byproduct of market established prices Adjustable discount rates change asset values

Return to NPV Example The government is lending you $100,000 for 10 years at 3% and only requiring interest payments prior to maturity. Since 3% is obviously below market, what is the value of the below market rate loan? Assume the market return on equivalent risk projects is 10%.

Efficient Market Theory Weak Form Efficiency Market prices reflect all historical information Semi-Strong Form Efficiency Market prices reflect all publicly available information Strong Form Efficiency Market prices reflect all information, both public and private

Efficient Market Theory Fundamental Analysts Research the value of stocks using NPV and other measurements of cash flow

Efficient Market Theory Technical Analysts Forecast stock prices based on the watching the fluctuations in historical prices (thus “wiggle watchers”)

Efficient Market Theory Announcement Date

Efficient Market Theory Average Annual Return on Mutual Funds and the Market Index

Efficient Market Theory IPO Non-Excess Returns Year After Offering

Log Deviations From Royal Dutch Shell / Shell T&T Parity Price Anomalies Log Deviations From Royal Dutch Shell / Shell T&T Parity 1973 - 2006 Deviation, %

Efficient Market Theory 2000 Dot.Com Boom

Efficient Market Theory 1987 Stock Market Crash

Behavioral Finance Arbitrage limitations LTCM example Factors related efficiency and psychology Attitudes towards risk Beliefs about probabilities

Lessons of Market Efficiency Markets have no memory Trust market prices Read the entrails There are no financial illusions The do it yourself alternative Seen one stock, seen them all

Example: How stock splits affect value -29 30 Source: Fama, Fisher, Jensen & Roll