1.  The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 12-1 Market Efficiency Chapter 12

2.  The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 12-2 Do security prices reflect information ? Why look at market efficiency - Implications for business and corporate finance - Implications for investment Efficient Market Hypothesis (EMH)

3.  The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 12-3 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

4.  The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 12-4 Random Walk with Positive Trend Security Prices Time

5.  The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 12-5 Why are price changes random? Prices react to information Flow of information is random Therefore, price changes are random Random Price Changes

6.  The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 12-6 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

7.  The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 12-7 Weak Semi-strong Strong Forms of the EMH

8.  The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 12-8 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

9.  The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 12-9 Active Management - Security analysis - Timing Passive Management - Buy and Hold - Index Funds Implications of Efficiency for Active or Passive Management

10.  The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 12-10 Even if the market is efficient a role exists for portfolio management Appropriate risk level Tax considerations Other considerations Market Efficiency and Portfolio Management

11.  The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 12-11 Event studies Assessing performance of professional managers Testing some trading rule Empirical Tests of Market Efficiency

12.  The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 12-12 1. Examine prices and returns over time How Tests Are Structured

13.  The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 12-13 Returns Over Time 0+t-t Announcement Date

14.  The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 12-14 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)

15.  The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 12-15 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)

16.  The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 12-16 Magnitude Issue Selection Bias Issue Lucky Event Issue Possible Model Misspecification Issues in Examining the Results

17.  The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 12-17 Technical Analysis - Short horizon - Long horizon Fundamental Analysis Anomalies Exist What Does the Evidence Show?

18.  The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 12-18 Small Firm Effect (January Effect) Neglected Firm Market to Book Ratios Reversals Post-Earnings Announcement Drift Market Crash of 1987 Anomalies

19.  The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 12-19 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