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Efficient Capital Markets
Chhachhi/BA 519/RWJ/Ch. 13 4/21/2017 Efficient Capital Markets Do security prices reflect the effect of all information? Corporate Finance/5th ed.
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What is meant by efficiency?
Chhachhi/BA 519/RWJ/Ch. 13 4/21/2017 What is meant by efficiency? Efficient Capital Markets: security prices adjust rapidly to the arrival of new information Efficient Markets Hypothesis (EMH) Chhachhi/519/Ch. 13 Corporate Finance/5th ed.
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Market Efficiency-- Continued
Chhachhi/BA 519/RWJ/Ch. 13 4/21/2017 Market Efficiency-- Continued Why should we expect mkts. to be efficient? There are a large # of profit-maximizing participants that analyze & value securities New information comes to the mkt. randomly Prices adjust rapidly to reflect the new information Price adjustments are imperfect, yet unbiased. Chhachhi/519/Ch. 13 Corporate Finance/5th ed.
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Reaction of S.P. to New Info. in Efficient and Inefficient Markets
Chhachhi/BA 519/RWJ/Ch. 13 4/21/2017 Reaction of S.P. to New Info. in Efficient and Inefficient Markets Stock Price Overreaction to “good news” with reversion Delayed response to “good news” Efficient market response to “good news” Days before (-) and after (+) announcement Chhachhi/519/Ch. 13 Corporate Finance/5th ed.
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Reaction of S.P. to New Info. in Efficient and Inefficient Markets
Chhachhi/BA 519/RWJ/Ch. 13 4/21/2017 Reaction of S.P. to New Info. in Efficient and Inefficient Markets Stock Price Efficient market response to “bad news” Delayed response to “bad news” Overreaction to “bad news” with reversion Days before (-) and after (+) announcement Chhachhi/519/Ch. 13 Corporate Finance/5th ed.
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Three Forms of Efficient-Market Hypothesis (EMH)
Chhachhi/BA 519/RWJ/Ch. 13 4/21/2017 Three Forms of Efficient-Market Hypothesis (EMH) Weak Form Efficient Market Prices reflect information set of past prices Random Walk Semi-strong Form Efficient Market Prices reflect publicly available information Strong Form Efficient Market Prices reflect all information relevant to a stock Chhachhi/519/Ch. 13 Corporate Finance/5th ed.
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Efficient-market hypothesis (EMH)-- weak-form
Chhachhi/BA 519/RWJ/Ch. 13 4/21/2017 Efficient-market hypothesis (EMH)-- weak-form Current S.P. fully reflect all security-market information. e.g., historical prices, odd-lot trading..... rates of returns are independent over time past stock price patterns cannot be used to make extraordinary profits Technical Analysis is contrary to weak form of EMH Chhachhi/519/Ch. 13 Corporate Finance/5th ed.
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Why Technical Analysis Fails
Chhachhi/BA 519/RWJ/Ch. 13 4/21/2017 Why Technical Analysis Fails Investor behavior tends to eliminate any profit opportunity associated with stock price patterns. Stock Price Sell 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 Buy Time Chhachhi/519/Ch. 13 Corporate Finance/5th ed.
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Chhachhi/BA 519/RWJ/Ch. 13 4/21/2017 What Pattern Do You See? Random Stock Price Changes (Random Walk) Support Weak Form Efficiency Chhachhi/519/Ch. 13 Corporate Finance/5th ed.
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Efficient-market hypothesis (EMH)-- semi-strong Form
Chhachhi/BA 519/RWJ/Ch. 13 4/21/2017 Efficient-market hypothesis (EMH)-- semi-strong Form Current S.P. fully reflect all public information. e.g., earnings/dividends information, div. yield.... encompasses the weak-form EMH trading decisions made based on new info. after it is public should not derive extraordinary profits Chhachhi/519/Ch. 13 Corporate Finance/5th ed.
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Efficient-market hypothesis (EMH)-- strong Form
Chhachhi/BA 519/RWJ/Ch. 13 4/21/2017 Efficient-market hypothesis (EMH)-- strong Form Current S.P. fully reflect all private or public information. e.g., insider information encompasses semi-strong form EMH trading decisions based on any information, private or public, should not derive extraordinary profits! Chhachhi/519/Ch. 13 Corporate Finance/5th ed.
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Relationship among Three Different Information Sets
Chhachhi/BA 519/RWJ/Ch. 13 4/21/2017 Relationship among Three Different Information Sets All information relevant to a stock Information set of publicly available information Information set of past prices Chhachhi/519/Ch. 13 Corporate Finance/5th ed.
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Tests & results of alternative EMH
Chhachhi/BA 519/RWJ/Ch. 13 4/21/2017 Tests & results of alternative EMH Weak-form: filter rules Small filters yield above-average profits-- BEFORE taking account of trading commissions. SUPPORT weak-form EMH Semi-strong form most studies support the semi-strong form of EMH Chhachhi/519/Ch. 13 Corporate Finance/5th ed.
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Implications for Corporate Finance
Chhachhi/BA 519/RWJ/Ch. 13 4/21/2017 Implications for Corporate Finance Accounting choices should not affect stock prices unless, of course, it affected firm’s cash flows In efficient markets, firm’s decision to issue new stock should not affect current S.P. Reality: some temporary price-pressure Chhachhi/519/Ch. 13 Corporate Finance/5th ed.
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What the EMH Does and Does NOT Say
Chhachhi/BA 519/RWJ/Ch. 13 4/21/2017 What the EMH Does and Does NOT Say Investors can throw darts to select stocks. This is almost, but not quite, true. An investor must still decide how risky a portfolio he wants based on risk aversion and the level of expected return. Prices are random or uncaused. Prices reflect information. The price CHANGE is driven by new information, which by definition arrives randomly-- thus, the “Random Walk.” Therefore, financial managers cannot “time” stock and bond sales. Chhachhi/519/Ch. 13 Corporate Finance/5th ed.
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