1. The Efficient Market Hypothesis
CHAPTER 11

2. Efficient Market Hypothesis (EMH)
Do security prices reflect information ?
Why look at market efficiency?
Implications for business and corporate finance
Implications for investment

3. Figure 11.1 Cumulative Abnormal Returns Before Takeover Attempts: Target Companies

4. Figure 11.2 Stock Price Reaction to CNBC Reports

5. EMH and Competition
Stock prices fully and accurately reflect publicly available information
Once information becomes available, market participants analyze it
Competition assures prices reflect information

6. The market price is more informative (accurate) than individual value estimates
V = the true fundamental value, P = the market price, vi = value estimate of trader i; vi = V + ei, where E(ei) = 0, Di = trader i’s desired position in the security; Di = a(vi – P), where a is a constant. From ∑ Di = ∑ a(vi – P) = 0 (i.e., zero net supply), we have ∑ a(vi – P) = 0 → a∑(vi – P) = 0 → ∑(vi – P) = 0 → ∑vi – ∑P = 0 → ∑vi = ∑P = N * P → P = (1/N) ∑vi P = (1/N) ∑vi = (1/N) ∑(V + ei) = V + eM, where eM = (1/N) ∑ei ≈ 0.

7. Versions of the EMH
Weak
Semi-strong
Strong

8. Types of Stock Analysis
Technical Analysis - using prices and volume information to predict future prices
Weak form efficiency & technical analysis
Fundamental Analysis - using economic and accounting information to predict stock prices
Semi strong form efficiency & fundamental analysis

9. Active or Passive Management
Active Management
Security analysis
Timing
Passive Management
Buy and Hold
Index Funds

10. Market Efficiency & Portfolio Management
Even if the market is efficient a role exists for portfolio management:
Appropriate risk level
Tax considerations
Other considerations

11. Event Studies
Empirical financial research that enables an observer to assess the impact of a particular event on a firm’s stock price
Abnormal return due to the event is estimated as the difference between the stock’s actual return and a proxy for the stock’s return in the absence of the event

12. How Tests Are Structured
Returns are adjusted to determine if they are abnormal
Market Model approach
a. rt = at + brmt + et
(Expected Return)
b. Excess Return = (Actual - Expected)
et = rt - (a + brMt)

13. Are Markets Efficient Magnitude Issue Selection Bias Issue
Lucky Event Issue

14. Weak-Form Tests Returns over the Short Horizon Momentum
Returns over Long Horizons

15. Predictors of Broad Market Returns
Fama and French
Aggregate returns are higher with higher dividend ratios
Campbell and Shiller
Earnings yield can predict market returns
Keim and Stambaugh
Bond spreads can predict market returns

16. Semistrong Tests: Anomalies
P/E Effect
Small Firm Effect (January Effect)
Neglected Firm Effect and Liquidity Effects
Book-to-Market Ratios
Post-Earnings Announcement Price Drift

17. Figure 11.3 Average Annual Return for 10 Size-Based Portfolios, 1926 – 2006

18. Figure 11.4 Average Return as a Function of Book-To-Market Ratio, 1926–2006

19. Figure 11.5 Cumulative Abnormal Returns in Response to Earnings Announcements

20. Strong-Form Tests: Inside Information
The ability of insiders to trade profitability in their own stock has been documented in studies by Jaffe, Seyhun, Givoly, and Palmon
SEC requires all insiders to register their trading activity

21. Interpreting the Evidence
Risk Premiums or market inefficiencies—disagreement here
Fama and French argue that these effects can be explained as manifestations of risk stocks with higher betas
Lakonishok, Shleifer, and Vishney argue that these effects are evidence of inefficient markets

22. Interpreting the Evidence Continued
Anomalies or Data Mining
The noisy market hypothesis
Fundamental indexing

23. Stock Market Analysts Do Analysts Add Value Mixed evidence
Ambiguity in results

24. Mutual Fund Performance
Some evidence of persistent positive and negative performance
Potential measurement error for benchmark returns
Style changes
May be risk premiums
Hot hands phenomenon

25. Figure 11.7 Estimates of Individual Mutual Fund Alphas, 1972 - 1991

26. Table 11.1 Performance of Mutual Funds Based on Three-Index Model

27. Figure 11.8 Persistence of Mutual Fund Performance

28. Table 11.2 Two-Way Table of Managers Classified by Risk-Adjusted Returns over Successive Intervals