Chapter 13 Principles PrinciplesofCorporateFinance Tenth Edition Efficient Markets and Behavioral Finance Slides by Matthew Will Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin 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
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin 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
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin 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 %.
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin 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
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Efficient Market Theory Fundamental Analysts –Research the value of stocks using NPV and other measurements of cash flow
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Efficient Market Theory Technical Analysts wiggle watchers –Forecast stock prices based on the watching the fluctuations in historical prices (thus “wiggle watchers”)
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Efficient Market Theory Announcement Date
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Efficient Market Theory Average Annual Return on Mutual Funds and the Market Index
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Efficient Market Theory IPO Non-Excess Returns Year After Offering
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Price Anomalies Deviation, % Log Deviations From Royal Dutch Shell / Shell T&T Parity
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Efficient Market Theory 2000 Dot.Com Boom
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Efficient Market Theory 1987 Stock Market Crash
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Behavioral Finance Arbitrage limitations LTCM example Factors related efficiency and psychology 1.Attitudes towards risk 2.Beliefs about probabilities
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin 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
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Example: How stock splits affect value Source: Fama, Fisher, Jensen & Roll