1. Corporate Financing Decisions and Efficient Capital Markets

2. An efficient market is one in which current market prices reflect all available information. What information is available? Depends on costs/benefits of collection/evaluation/use of information. We will see that the EMH has strong implications for investors/firms/financial managers.

3. Preview – An Efficient Market Because information is reflected in prices immediately, investors should only expect to obtain an equilibrium rate of expected return (as predicted by the SML). Awareness of information when it is released does the investor no good. The price adjusts before the investor can trade on it. –Firms should expect to receive a fair value for securities they issue. –Financial managers cannot time issues of securities. –A firm can sell as many shares of stock or as many bonds as it wants without fear of depressing the price. –Stock and bond markets cannot (barring fraud) be affected by firms artificially increasing earnings (cooking the books).

4. Stock PriceOverreaction and reversion Early response Delayed response Efficient market response to new information Days before (–) and after(+) announcement Public announcement day Reaction of Stock Price to New Information in Efficient and Inefficient Markets –30 –20 –10 0 +10 +20 +30

5. “Forms” of Market Efficiency Weak Form Efficiency –A capital market is said to be weakly efficient or to satisfy weak-form efficiency if current prices fully incorporate the information in past prices (more generally trading information). –In a financial market that is weak form efficient, investors can't trade on the basis of past returns and expect abnormal profits.

6. “Forms” of Market Efficiency Semi-Strong Form Efficiency –A market is said to be semi-strong form efficient if current market prices fully incorporate all publicly available information (e.g., information in the WSJ). –Since past prices are publicly available information, if a market is semi-strong form efficient, it is necessarily weak form efficient. –In a market that is semi-strong form efficient investors cannot trade based on publicly available information and expect profits in excess of an equilibrium expected return (as specified by, for example, the SML).

7. “Forms” of Market Efficiency Strong Form Efficiency –A market is said to be strong form efficient if current market prices fully incorporate all (including inside) information. –Since publicly available information is a subset of all information, if a market is strong form efficient it is semi-strong form efficient and weak form efficient. –In a strong form efficient market no investor can make profits in excess of the equilibrium expected return trading on any information (including "inside" information). –This is obviously an extreme form of efficiency.

8. Chartists: Technical Analysis These folks analyze "charts" or graphs of movements of different aspects of the stock markets. –Share price movements –Trading Volume Ratios of volumes on up price movements to those on down price movements Chartists believe that there exist identifiable and exploitable trends or patterns in these variables. Hardly believable. But the jury is still out. Who Thinks They Can Beat The Market?

13. Why Technical Analysis Fails Stock Price Time Investor behavior tends to eliminate any profit opportunity associated with stock price patterns. If it were possible to make big money simply by finding “the pattern” in the stock price movements, everyone would do it and the profits would be competed away. Sell Buy

14. Fundamental Analysis Based upon the belief that stock market values reflect economic values. And that there is publicly available information that will allow them to form a better estimate of value than is contained in market prices. If there is information (examples?) that will allow an analyst to form a better estimate of future dividends (or cash flow) than the market's estimate, as reflected in current price, then there may be money to be made. In liquid, standard markets, it’s not too likely.

15. Insiders Trade on private information. Often on impending changes in control structure or new product innovations. Probably, it is illegal but Martha showed us what that means.

16. The Evidence Are Stock Prices Random? Serial correlation of stock returns near zero. More complete tests show that after expected return is accounted for, past returns add little or no information to help predict future returns. Technical analysts may be observing "optical illusions".

17. WHICH IS THE REAL MARKET INDEX? THIS ONE… Months Level

18. ... OR THIS ONE? Months Level

19. Event Studies Is new information concerning a firm quickly and completely incorporated into stock price? –Stock Splits –Dividend/Earnings Announcements –Mergers –Capital Expenditures Findings generally support semi-strong form efficiency.

20. Abnormal Returns for Companies Announcing Stock Splits Cumulative abnormal returns (percent) +33Total sample (940 splits, 1926 - 1965) 0 Splits followed by +33increase in dividend (672 stocks) 0 +33 Splits followed by decrease in dividend (268 stocks) 0 Months relative to split -30 0 +30 Cumulative abnormal returns rise prior to month of split. Very likely this occurs because splits take place in good times, that is, they take place following a rise in stock price. Abnormal returns are flat after month of split, a finding consistent with efficient capital markets. Redrawn from E. F. Fama, L. Fisher, M. C. Jensen and R. Roll, “The Adjustment of Stock Prices to New Information,” International Economic Review 10 (February 1969), pp. 1-31.

22. Mutual Fund Performance Mutual fund managers, who use public information and presumably have the time and talent to process the information they collect, cannot consistently beat the S&P 500 index.

23. The Record of Mutual Funds Taken from Lubos Pastor and Robert F. Stambaugh, “Evaluating and Investing in Equity Mutual Funds,” unpublished paper, Graduate School of Business, University of Chicago (March 2000).

24. Insiders Reports of insiders who trade in their own shares show these traders are able to achieve abnormal profits.

25. Contrary Views and Evidence Shiller - Are stock prices too variable? –Fads/bubbles in stock prices. –Momentum studies. Seasonalities –January Effect –Size Effect –Book-to-Market Effect –Underperformance of IPO and Seasoned Equity Issues Suggestive Occurrences –October 19, 1987 –Tulip Craze of 17th Century in Holland

26. Accounting and the EMH In a semi-strong form efficient market purely cosmetic accounting practice changes won't fool investors. Studies support this result. –Changes in depreciation methods –Accounting for inventories –Reporting mergers and acquisitions All can change earnings reports but have been shown not to affect stock prices. When information is withheld or incorrect information is provided prices can be/are affected. Implications for Corporate Finance

27. Timing the Issuance of New Financings In an efficient market managers should not be able to time issues of new securities. Year to year variation in the use of new financing appears as if it is explained by firms' attempts to time new issues. New issues seem to follow rises in stock price. –May be attempts to exploit weak or semi-strong form inefficiency. –Price rise may simply reflect a new investment opportunity. –Inside information. Price Pressure In an efficient market a firm will be able to issue as much equity as it wishes without fear of depressing price due to an "over-supply" of its claims.

28. Does Say –Prices reflect underlying value. –Financial managers cannot time stock and bond issues. –Sales of stock and bonds will not depress prices. –You cannot cook the books. Doesn't Say –Prices are uncaused. –Prices should not fluctuate. –Investors all need to know all information. –All shares of stock have the same expected returns. –Investors should throw darts to select stocks. –There is no upward trend in stock prices. What the EMH Does and Does Not Say