Market Efficiency and Arbitrage TIP If you do not understand something, ask me! Sorry, no free lunch!

2 Random Walk Theory zThe movement of stock prices from day to day DO NOT reflect any pattern. zStatistically speaking, the movement of stock prices is random (skewed positive over the long term).

3 Random Walk Theory

4 Efficient Capital Markets zStock prices are in equilibrium or are “fairly” priced zIf this is true, then you should not be able to earn “abnormal” or “excess” returns, in expectation. Investors cannot “beat the market” except through good luck or better information. zEfficient markets DO NOT imply that investors cannot earn a positive return in the stock market. zThey do mean that, on average, you will earn a return that is appropriate for the risk undertaken and there is not a bias in prices that can be exploited to earn excess returns.

5 3 Levels of Market Efficiency zWeak Form Efficiency yMarket prices reflect all historical price information zSemi-Strong Form Efficiency yMarket prices reflect all publicly available information zStrong Form Efficiency yMarket prices reflect all information, both public and private

6 Efficient Market Theory Last Month This Month Next Month $ Microsoft Stock Price Cycles disappear once identified

7 Market return at announcement of takeover (or positive earnings news) Announcement Date

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9 Weak-form efficiency zCan’t profit by looking at past price trends. A recent decline is no reason to think stocks will go up (or down) in the future. There is no predictable price pattern based on price path. zEvidence supports weak-form EMH, but “technical analysis” is still used by some people.

10 Weak-form efficiency z Technical Analysts wiggle watchers yForecast stock prices based on the watching the fluctuations in historical prices (thus “ wiggle watchers ”) yThese guys do not believe in the weak form of market efficiency.

11 Semi-strong form efficiency zAll publicly available information is reflected in stock prices, so it doesn’t pay to over-analyze annual reports looking for undervalued stocks. zLargely true, but superior analysts can still profit by finding and using new information.

12 Semi-strong form efficiency z Fundamental Analysts yResearch the value of stocks by delving into detailed accounting and operating numbers. yThese guys do not believe in semi-strong form of market efficiency.

13 But how is their performance? Average Annual Return on 1493 Mutual Funds and the Market Index

14 (will not test) Hedge return across small and big stocks.

15 (Will not test) Hedge return across high B/M and low B/M stocks.

16 ( Will not test) Hedge return across low accrual stocks and high accrual stocks.

17 (Will not test) One-year-ahead hedge returns based on capital investment levels. ©Donglin Li 2004 z Go long the lowest investment stocks. z Go short the highest investment stocks. z 12 month size adjusted buy and hold hedge returns after May each year. z Positive in 36 out of 39 years, average 12.6% z Pattern is consistent with market mispricing band against semi-strong efficiency.

18 Strong-form efficiency zAll information, even inside information, is embedded in stock prices. That is, one cannot profit even on private information. zNot true--insiders can gain by trading on the basis of insider information, but that’s illegal.

19 Is the stock market efficient? zEmpirical studies have been conducted to test the three forms of efficiency. Most of which suggest the stock market was: yHighly efficient in the weak form. yReasonably efficient in the semistrong form. yNot efficient in the strong form. Insiders could and did make abnormal (and sometimes illegal) profits. zBehavioral finance – incorporates elements of cognitive psychology to better understand how individuals and markets respond to different situations.

20 What Makes Markets Efficient? zThere are many investors out there doing research yAs new information comes to market, this information is analyzed and trades are made based on this information yTherefore, prices should reflect all available public information, and almost instantly. zIf investors stop researching stocks, then the market will not be efficient.

21 Lessons of Market Efficiency  Markets have no memory (you cannot tell whether stock is overvalued based on historical pattern.)  Trust market prices (example)  Read the entrails (Price reflects valuable information.)  There are no financial illusions (FIFO to LIFO, earnings & price)  Seen one stock, seen them all (The market is deep. You can buy or sell in large quantities.) zWhen the market is not efficient, you can make money by arbitraging.

22 Arbitrage zAn arbitrage opportunity arises when an investor can construct a zero investment portfolio that will yield a sure profit. zTo construct a zero investment portfolio, one has to be able to sell (go short on) some securities and use the proceeds to purchase (go long on) other assets. zBorrowing may be viewed as a short position in a risk free assets. zArbitrage always means buying undervalued and selling the overvalued.

23 Arbitrage Example 1  Suppose gold is trading at $250 per ounce in New York and £ per ounce in London. z Current exchange rate is $1.425/ £. z You can immediately buy (go long) gold at $250 in New York and sell (go short) it at £ in London. z Then you can change £ into *1.425=$300 and make profit of a sure $50. z Arbitrage activities will drive gold price to be equal across two market, at a price in between.

24 Arbitrage on several assets zIf you can use one or more assets to replicate or exceeds the payoff from asset A, then the price of your replicating portfolio must be no lower than the price of A.

25 Arbitrage Example 2 zBond A pays coupon rate of 6% and matures in 10 years. Price=$1000 zBond B pays coupon rate of 12% and matures in 10 years. Price=$1100 zBond C pays coupon rate of 9% and matures in 10 years. Price=$1060 zBuy (go long) 1 share of Bond A and 1 share of bond B, go short 2 shares of bond C. zMake a profit of $20 immediately. zIn the next 10 years, use the cash inflows from Bond A and Bond B to pay off your obligation under Bond C.

26 Arbitrage zIn every market that reveals arbitrage opportunities, there will be arbitrageurs operating. Arbitrage opportunities appear and disappear extremely quickly. (Example.) zTransaction cost (commission fee, bid-ask spread) may prevent people from taking arbitrage opportunities.