Market Efficiency Chapter 12

Do security prices reflect information ? Why look at market efficiency - Implications for business and corporate finance - Implications for investment Efficient Market Hypothesis (EMH)

Random Walk - stock prices are random - Actually submartingale  Expected price is positive over time  Positive trend and random about the trend Random Walk and the EMH

Random Walk with Positive Trend Security Prices Time

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

Stock prices fully and accurately reflect publicly available information Once information becomes available, market participants analyze it Competition assures prices reflect information EMH and Competition

Weak Semi-strong Strong Forms of the EMH

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 Types of Stock Analysis

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

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

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

1. Examine prices and returns over time How Tests Are Structured

Returns Over Time 0+t-t Announcement Date

2. Returns are adjusted to determine if they are abnormal Market Model approach a. R t = a t + b t R mt + e t (Expected Return) b. Excess Return = (Actual - Expected) e t = Actual - (a t + b t R mt ) How Tests Are Structured (cont’d)

2. Returns are adjusted to determine if they are abnormal Market Model approach c. Cumulate the excess returns over time: 0+t-t How Tests Are Structured (cont’d)

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

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

Small Firm Effect (January Effect) Neglected Firm Market to Book Ratios Reversals Post-Earnings Announcement Drift Market Crash of 1987 Anomalies

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