1. Chapter 13 Principles PrinciplesofCorporateFinance Tenth Edition Efficient Markets and Behavioral Finance Slides by Matthew Will Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin

2. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 14- 2 McGraw Hill/Irwin 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

3. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 14- 3 McGraw Hill/Irwin 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. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 14- 4 McGraw Hill/Irwin 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 %.

5. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 14- 5 McGraw Hill/Irwin 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

6. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 14- 6 McGraw Hill/Irwin Efficient Market Theory  Fundamental Analysts –Research the value of stocks using NPV and other measurements of cash flow

7. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 14- 7 McGraw Hill/Irwin Efficient Market Theory  Technical Analysts wiggle watchers –Forecast stock prices based on the watching the fluctuations in historical prices (thus “wiggle watchers”)

8. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 14- 8 McGraw Hill/Irwin Efficient Market Theory Announcement Date

9. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 14- 9 McGraw Hill/Irwin Efficient Market Theory Average Annual Return on Mutual Funds and the Market Index

10. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 14- 10 McGraw Hill/Irwin Efficient Market Theory IPO Non-Excess Returns Year After Offering

11. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 14- 11 McGraw Hill/Irwin Price Anomalies Deviation, % Log Deviations From Royal Dutch Shell / Shell T&T Parity 1973 - 2006

12. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 14- 12 McGraw Hill/Irwin Efficient Market Theory 2000 Dot.Com Boom

13. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 14- 13 McGraw Hill/Irwin Efficient Market Theory 1987 Stock Market Crash

14. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 14- 14 McGraw Hill/Irwin Behavioral Finance  Arbitrage limitations  LTCM example  Factors related efficiency and psychology 1.Attitudes towards risk 2.Beliefs about probabilities

15. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 14- 15 McGraw Hill/Irwin 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

16. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 14- 16 McGraw Hill/Irwin Example: How stock splits affect value -290 30 Source: Fama, Fisher, Jensen & Roll