1. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 12-1 Market Efficiency Chapter 11

2. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 12-2 Chapter Overview This chapter examines the concept of market efficiency, that is, in general, securities are fairly priced and one cannot expect to outperform the market, risk- adjusted consistently over time. The implications of market efficiency for investors and studies of the efficient capital market hypothesis are presented in detail.

3. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 12-3 Learning Objectives After studying this chapter, the student should thoroughly understand the concept of market efficiency and how to make rational investment decisions based upon the existence of market efficiency. The student also should have a thorough understanding of the many tests of market efficiency, the forms of market efficiency, and observed market anomalies.

4. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 12-4 Do security prices reflect information ? Why look at market efficiency?  Implications for business and corporate finance  Implications for investment Efficient Market Hypothesis (EMH)

5. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 12-5 Random Walk - stock prices are random  Actually submartingale  Expected price is positive over time  Positive trend and random about the trend Random Walk and the EMH

6. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 12-6 Random Walk with Positive Trend Security Prices Time

7. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 12-7 Why are price changes random? Prices react to information Flow of information is random Therefore, price changes are random Random Price Changes

8. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 12-8 Stock prices fully and accurately reflect publicly available information. Once information becomes available, market participants analyze it. Competition assures prices reflect information. EMH and Competition

9. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 12-9 Weak Semi-strong Strong Forms of the EMH

10. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 12-10 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 Types of Stock Analysis

11. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 12-11 Active Management  Security analysis  Timing Passive Management  Buy and Hold  Index Funds Implications of Efficiency for Active or Passive Management

12. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 12-12 Even if the market is efficient a role exists for portfolio management: Appropriate risk level Tax considerations Other considerations Market Efficiency and Portfolio Management

13. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 12-13 Event studies Assessing performance of professional managers Testing some trading rule Empirical Tests of Market Efficiency

14. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 12-14 1. Examine prices and returns over time How Tests Are Structured

15. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 12-15 Returns Over Time 0+t-t Announcement Date

16. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 12-16 2. Returns are adjusted to determine if they are abnormal. Market Model approach a. R t = a t + b t R mt + e t (Expected Return) b. Excess Return = (Actual - Expected) e t = Actual - (a t + b t R mt ) How Tests Are Structured (cont’d)

17. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 12-17 2. Returns are adjusted to determine if they are abnormal. Market Model approach c. Cumulate the excess returns over time: 0+t-t How Tests Are Structured (cont’d)

18. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 12-18 Magnitude Issue Selection Bias Issue Lucky Event Issue Possible Model Misspecification Issues in Examining the Results

19. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 12-19 Technical Analysis  Short horizon  Long horizon Fundamental Analysis Anomalies Exist What Does the Evidence Show?

20. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 12-20 Small Firm Effect (January Effect) Neglected Firm Market to Book Ratios Reversals Post-Earnings Announcement Drift Anomalies

21. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 12-21 Explanations of Anomalies May be risk premiums Behavioral Explanations  Forecasting errors  Overconfidence  Regret avoidance  Framing and mental accounting

22. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 12-22 Some evidence of persistent positive and negative performance. Potential measurement error for benchmark returns.  Style changes  May be risk premiums Superstar phenomenon Mutual Fund and Professional Manager Performance