Class Business Upcoming Homework Upcoming Midterm – Review Session Wed (5/18) 5 – 6 pm 270 TNRB

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 Price Time

Why are price changes random? Prices react to information Flow of information is random Therefore, price changes are random Usually look at returns (instead of price movements), so we don’t have to worry about trend Random Price Changes

Weak – all historical price and trading information incorporated into prices Semi-strong – all public information incorporated into prices Strong – all information incorporated into prices Forms of the EMH

Technical Analysis - using prices and volume information to predict future prices – Contradicts Weak form efficiency Fundamental Analysis - using economic and accounting information to predict stock prices – Contradicts Semi strong form efficiency Insider Trading – using inside information to predict stock prices – Contradicts Strong form efficiency Types of Stock Analysis relative to EMH

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

Structure of Event Study 0+t-t Announcement/Event Date 1. Examine prices or more generally returns over time

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)

Weak Form (Technical Analysis) – Short horizon returns (momentum) – Long horizon returns (negative serial correlation) – Reversals “The only thing we know for certain about technical analysis is that it's possible to make a living publishing a newsletter on the subject.” Martin S. Fridson, Investment Illusions “Technical analysts are the witch doctors of our business. By deciphering stock price movement patterns and volume changes, these Merlins believe they can forecast the future.” William Gross, Everything You've Heard About Investing is Wrong! What Does the Evidence Show?

Efficiency Evidence Semi-Strong (Fundamental Analysis) – Small Firm in January – Book-to Market – Post Earnings Announcement

Stock prices fully and accurately reflect available information is a static concept Once information becomes available, we expect market participants analyze it quickly ( ‘time’ now enters argument) Competition assures prices quickly reflect information Most interesting questions deal with how quickly prices adjust to new information or sets of information EMH and Competition