1. Efficient Markets and Behavioral Finance
Principles of
Corporate Finance
Tenth Edition
Chapter 13
Efficient Markets and Behavioral Finance
Slides by
Matthew Will
McGraw-Hill/Irwin
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. 1 1 1 1 1 2

2. 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 2 2 2 2 3 2

3. 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

4. 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?

5. 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%.

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

7. Random Walk Theory Coin Toss Game $106.09 $103.00 $100.43 $100.00
Heads
$106.09
Heads
$103.00
$100.43
Tails
$100.00
Heads
$100.43
$97.50
Tails
$95.06
Tails

8. 5 yrs of the Coin Toss Game?
Random Walk Theory
S&P 500 Five Year Trend? or
5 yrs of the Coin Toss Game?

9. Random Walk Theory

10. Random Walk Theory

11. Random Walk Theory

12. Random Walk Theory

13. Efficient Market Theory
Microsoft Stock Price
$40 30 20
Actual price as soon as upswing is recognized
Upswing
Cycles disappear once identified
Last Month
This Month
Next Month

14. 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

15. Efficient Market Theory
Fundamental Analysts
Research the value of stocks using NPV and other measurements of cash flow

16. Efficient Market Theory
Adjusted stock return = return on stock – return on market index

17. Efficient Market Theory
Announcement Date

18. Efficient Market Theory
Average Annual Return on Mutual Funds and the Market Index

19. Efficient Market Theory
The average return 1972–2001 on stocks of firms over the six months following an announcement of quarterly earnings. The 10% of stocks with the best earnings news (portfolio 10) outperformed those with the worst news (portfolio1) by about 1% per month.

20. Log Deviations From Royal Dutch Shell / Shell T&T Parity
Price Anomalies
Log Deviations From Royal Dutch Shell / Shell T&T Parity
Deviation, %

21. Efficient Market Theory
2009 Recession

22. Efficient Market Theory
2000 Dot.Com Boom

23. Efficient Market Theory
1987 Stock Market Crash

24. Behavioral Finance Factors related efficiency and psychology
Attitudes towards risk
Beliefs about probabilities
Limits to arbitrage
Incentive problems and the subprime crisis

25. 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

26. Example: How stock splits affect value
-29 30
Source: Fama, Fisher, Jensen & Roll

27. Web Resources Click to access web sites Internet connection required