1. Principles of Finance with Excel, 2 nd edition Instructor materials Chapter 14 Efficient markets

2. “Efficient markets”  “Efficient markets” is term covering a variety of statements, all of which say that you cannot profit from publicly-available information 2

3. Four principles of Efficient Market 1. Single price for a single good 2. Price additivity 3. Information is critical 4. Transactions costs are important 3

4. Efficient markets principle 1: Single price for single good  If a same good is traded at various places, then the price should be the same  Example: IBM stock traded on New York Stock Exchange and on San Francisco Stock Exchange: Price should be the same 4

5. Transactions costs  Limits to Principle 1 (same good, same price):  If it costs to transport or to arbitrage  Example: Could a pound of sugar have a different price in Miami and Chicago?  Answer: Up to the transportation costs … 5

6. Efficient markets principle 2: Pricing additivity  Portfolio is composed of two assets, A and B. Then  Price[Portfolio]=Price[A] + Price[B] 6

7. Bond pricing: Application of price additivity  Bond A: Sells today for $100, pays off $110 in year 1.  Bond A IRR= 10%  Bond B: Sells today for $100, pays off $125 in year 2.  Bond B IRR = (125/110) 0.5 -1=11.8%  Bond C: Pays $23 in year 1 and $1023 in year 2. 7

8. Price additivity  Use prices of Bond A and Bond B to price Bond C 8

9. 9

10. Open-end mutual funds 10

11. Open-end mutual fund  Fund buys shares in companies  Investors buy shares in the fund at price reflecting the total value of shares in fund:  Mutual fund pricing reflects Value Additivity 11

12. Closed-end mutual funds: A failure of price additivity  Fund buys shares in companies  Fund shares are listed on stock market  Investors buy shares in fund  BUT: Often price additivity is violated 12

13. Closed-end fund example  Zweig Fund  Fund objective:  “The Fund seeks capital appreciation, primarily through investment in equity securities, consistent with the preservation of capital and elimination of unnecessary risk, as determined by the Fund's Investment Adviser.”  Most holdings publicly-traded stock 13

14. Zweig Fund major holdings 14

15. Zweig Fund trades at a discount 15

16. What is NAV?  NAV stands for “net asset value”  NAV = Sum of market values of fund components, divided by number of shares in fund  Zweig trades at 8.71% less than the NAV 16

17. Zweig usually trades at a discount to NAV 17

18. Why does Zweig trade at discount?  Open-end mutual fund:  If there is excess demand, fund buys more assets  If excess supply (redemptions), fund sells assets  If there is a difference between fund price and NAV, you can arbitrage  Closed-end mutual fund:  Shares of fund trade separately from investment portfolio of fund 18

19. Principle 3: Cheap information is worthless  Information is important, BUT:  The more public is the information, the less it is worth 19

20. Weak-form market efficiency  Weak-form efficiency: You cannot use past prices to predict future prices  Why: Past prices are cheaply available to all  Therefore worthless in predicting the future 20

21. Weak form efficiency: example  “Technical analysis” of stocks: Using past prices to predict future prices  Nonsense … ?? 21

22. Technical analysis  The author does some technical analysis on Microsoft stock:  “Resistance level”: stock tends not go up over this price (unless it does … )  “Floor” stock tends to stay above this price 22

23. Nonsense?  At an earlier date, author also drew a floor: In March 2009, author suggested that $27.25 was a floor for MSFT stock.  Was he right? 23

24. Semi-strong efficiency  Weak-form efficiency: Previous price information is incorporated in current price  Semi-strong efficiency: All publicly- available information is worthless.  Prices, firm financial statements, etc…  Sometimes true, sometimes not  Principle: Cheap information is worthless  But some publicly-available information may require work to understand … not cheap! 24

25. Strong-form efficiency  All information worthless  Almost certainly never true  Example: Insiders have information about their companies  Forbidden to reveal this information  It’s valuable! 25

26. Take-aways  In efficient markets  The same good has the same price across markets, up to transactions costs  Prices and values are additive: Value[A+B] = Value[A] + Value[B]  Cheap information is worthless  Transactions costs are important 26