Chapter 10 EFFICIENT CAPITAL MARKETS. Chapter 10 Questions What do we mean when we say that capital markets are efficient?What do we mean when we say

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  • Slide 1
  • Chapter 10 EFFICIENT CAPITAL MARKETS
  • Slide 2
  • Chapter 10 Questions What do we mean when we say that capital markets are efficient?What do we mean when we say that capital markets are efficient? Why should capital markets be efficient?Why should capital markets be efficient? What factors contribute to an efficient market?What factors contribute to an efficient market? Given the overall efficient market hypothesis (EMH), what are the three subhypotheses and what are the implications of each?Given the overall efficient market hypothesis (EMH), what are the three subhypotheses and what are the implications of each?
  • Slide 3
  • Chapter 10 Questions How do we test the three efficient market subhypotheses, and what are the results of the tests?How do we test the three efficient market subhypotheses, and what are the results of the tests? For each set of tests, which of the results support the EMH and which indicate an anomaly related to the hypothesis?For each set of tests, which of the results support the EMH and which indicate an anomaly related to the hypothesis? What is behavioral finance, and how does it relate to the EMH?What is behavioral finance, and how does it relate to the EMH?
  • Slide 4
  • Chapter 10 Questions What are some of the major findings of behavioral finance, and what are the implications for the EMH?What are some of the major findings of behavioral finance, and what are the implications for the EMH? What are the implications of the efficient market test results forWhat are the implications of the efficient market test results for Technical analysis? Fundamental analysis? Portfolio managers with superior analysts? Portfolio managers with inferior analysts?
  • Slide 5
  • Efficient Capital Markets In an efficient capital market, security prices adjust rapidly to the arrival of new information, therefore the current prices reflect all information about the securityIn an efficient capital market, security prices adjust rapidly to the arrival of new information, therefore the current prices reflect all information about the security Whether markets are efficient has been extensively researched and remains controversialWhether markets are efficient has been extensively researched and remains controversial
  • Slide 6
  • Why does it matter? If prices do fully reflect all current information, it would not be worth an investors time to use information to find undervalued securities.If prices do fully reflect all current information, it would not be worth an investors time to use information to find undervalued securities. If prices do NOT fully reflect information, FIND AND USE THAT INFORMATION, and perhaps you will be able to make a killing in the market.If prices do NOT fully reflect information, FIND AND USE THAT INFORMATION, and perhaps you will be able to make a killing in the market.
  • Slide 7
  • Investing and Market Efficiency Would stock selection amount to throwing darts at a wall in an efficient market?Would stock selection amount to throwing darts at a wall in an efficient market? Hardly! Risk still matters. We would still want to research the risk-return properties of securities.Hardly! Risk still matters. We would still want to research the risk-return properties of securities.
  • Slide 8
  • Why Should Capital Markets Be Efficient? What would be the ingredients of an informationally efficient market?What would be the ingredients of an informationally efficient market? A large number of profit-maximizing participants analyze and value securities New information regarding securities comes to the market in a random fashion Profit-maximizing investors adjust security prices rapidly to reflect the effect of new information Price adjustments are unbiased correct on average.Price adjustments are unbiased correct on average. Under these conditions, a securitys price would be appropriate for its level of risk.Under these conditions, a securitys price would be appropriate for its level of risk.
  • Slide 9
  • Alternative Efficient Market Hypotheses The various forms of the efficient market hypothesis differ in terms of the information that security prices should reflect. Weak-form EMHWeak-form EMH Semistrong-form EMHSemistrong-form EMH Strong-form EMHStrong-form EMH
  • Slide 10
  • Weak-Form EMH Current prices fully reflect all security- market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated informationCurrent prices fully reflect all security- market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information This implies that past rates of return and other market data should have no relationship with future rates of returnThis implies that past rates of return and other market data should have no relationship with future rates of return
  • Slide 11
  • Implications of the Weak- From EMH Examining recent trends in price and other market data in order to predict future price changes would be a waste of time if the market is weak-form efficient.Examining recent trends in price and other market data in order to predict future price changes would be a waste of time if the market is weak-form efficient. A lot of people do price charting and other forms of technical analysis.A lot of people do price charting and other forms of technical analysis.
  • Slide 12
  • Semistrong-Form EMH Current security prices reflect all public information, including market and non- market informationCurrent security prices reflect all public information, including market and non- market information This implies that decisions made on new information after it is public should not lead to above-average risk-adjusted profits from those transactionsThis implies that decisions made on new information after it is public should not lead to above-average risk-adjusted profits from those transactions
  • Slide 13
  • Implications of the Semistrong-Form EMH If the market is efficient in this sense, information in The Wall Street Journal, other periodicals, and even company annual reports is already fully reflected in prices, and therefore not useful for predicting future price changes.If the market is efficient in this sense, information in The Wall Street Journal, other periodicals, and even company annual reports is already fully reflected in prices, and therefore not useful for predicting future price changes.
  • Slide 14
  • Strong-Form EMH Stock prices fully reflect all information from public and private sourcesStock prices fully reflect all information from public and private sources This would require perfect markets in which all information is cost-free and available to everyone at the same time (which is clearly not the case)This would require perfect markets in which all information is cost-free and available to everyone at the same time (which is clearly not the case) Implication: Not even insiders would be able to beat the market on a consistent basisImplication: Not even insiders would be able to beat the market on a consistent basis
  • Slide 15
  • Tests and Results: Weak-Form EMH Two Approaches Tests of statistical memory in security prices and returnsTests of statistical memory in security prices and returns Tests of trading rulesTests of trading rules
  • Slide 16
  • Tests and Results: Weak-Form EMH Statistical tests of independence between rates of returnStatistical tests of independence between rates of return Autocorrelation tests Mostly support the weak-form EMH and indicate that price changes are randomMostly support the weak-form EMH and indicate that price changes are random Some studies using more securities and more complicated tests cast some doubtSome studies using more securities and more complicated tests cast some doubt Runs tests Indicate randomness in pricesIndicate randomness in prices
  • Slide 17
  • Tests and Results: Weak-Form EMH Comparison of trading rules to a buy- and-hold policyComparison of trading rules to a buy- and-hold policy Some filter rules seem yield above- average profits with small filters, but only before taking into account the substantial transactions costs involved Trading rule results have been mixed, and most have not been able to beat a buy- and-hold policy
  • Slide 18
  • Tests and Results: Weak-Form EMH Problems with tests Cannot be definitive since trading rules can be complex and there are too many to test them allCannot be definitive since trading rules can be complex and there are too many to test them all Testing constraintsTesting constraints Use only publicly available data Should include all transactions costs Should adjust the results for risk (an apparently successful strategy may just be a very risky strategy)
  • Slide 19
  • Conclusions: Weak-Form EMH Results generally support the weak- form EMH, but results are not unanimousResults generally support the weak- form EMH, but results are not unanimous Some strategies too subjective to test Not all trading rules are disclosed If you had a trading strategy that worked, would you reveal it?!If you had a trading strategy that worked, would you reveal it?!
  • Slide 20
  • Reality Check! If someone writes a book on how to beat the market, you can bet that book sales are more lucrative than the trading strategy!If someone writes a book on how to beat the market, you can bet that book sales are more lucrative than the trading strategy! Even if it once worked, if its widely known, it wont work any more!Even if it once worked, if its widely known, it wont work any more! Dont quit your day job to trade on-line using a published strategy!Dont quit your day job to trade on-line using a published strategy!
  • Slide 21
  • Tests and Results: Semistrong- Form EMH Three different groups of tests: Time series analysis using public informationTime series analysis using public information Event studies examine how fast stock prices adjust to significant economic eventsEvent studies examine how fast stock prices adjust to significant economic events Cross-sectional analysis of returns based on public informationCross-sectional analysis of returns based on public information Tests involve the estimation of abnormal returns, where expected abnormal returns are zero in an efficient market.
  • Slide 22
  • Tests and Results: Semistrong-Form EMH Tests often involve market-adjusted returns, created by subtracting the market return from the securitys return, thereby defining a securitys abnormal return:Tests often involve market-adjusted returns, created by subtracting the market return from the securitys return, thereby defining a securitys abnormal return: AR it = R it - R mt where: AR it = abnormal return on security i during period t R it = return on security i during period t R mt = return on a market index during period t
  • Slide 23
  • Tests and Results of Semistrong-Form EMH Another definition of abnormal return is a risk-adjusted return or market model which adjusts for the securitys own required rate of return, given its systematic risk (as measured by beta):Another definition of abnormal return is a risk-adjusted return or market model which adjusts for the securitys own required rate of return, given its systematic risk (as measured by beta): AR it = R it - E(R it ) where: E(R it ) = the expected rate of return for stock i during period t based on the market rate of return and the stocks normal relationship with the market (its beta)
  • Slide 24
  • Tests and Results: Semistrong- Form EMH Time series tests for predictability of returns and profit opportunities Short-horizon returns have shown very limited predictabilityShort-horizon returns have shown very limited predictability Long-horizon returns analysis shown some predictability of returns based on:Long-horizon returns analysis shown some predictability of returns based on: Dividend yield (D/P) Default spread Term structure spread
  • Slide 25
  • Tests and Results: Semistrong- Form EMH Time series tests for predictability of returns and profit opportunities Quarterly earnings reports informationQuarterly earnings reports information Unanticipated earnings changes or earnings surprises are not immediately reflected in security prices The January Anomaly (A calendar effect)The January Anomaly (A calendar effect) Large returns in January present opportunities to purchase in December, and sell in January and earn abnormal returns.
  • Slide 26
  • Tests and Results: Semistrong- Form EMH Time series tests for predictability of returns and profit opportunities Other calendar effectsOther calendar effects Monthly effect Day-of-the-week effects Monday returns were significantly negativeMonday returns were significantly negative
  • Slide 27
  • Tests and Results: Semistrong- Form EMH Predicting cross-sectional returns In an efficient market, all securities should have equal risk-adjusted returnsIn an efficient market, all securities should have equal risk-adjusted returns Studies examine alternative measures of size or quality as a tool to rank stocks in terms of risk-adjusted returnsStudies examine alternative measures of size or quality as a tool to rank stocks in terms of risk-adjusted returns These tests include a joint hypothesis of both market efficiency and the asset pricing model used to generate abnormal returns
  • Slide 28
  • Tests and Results: Semistrong- Form EMH Predicting cross-sectional returns Price-earnings ratiosPrice-earnings ratios Examine historical P/E ratios and returns Low P/E stocks had higher risk-adjusted returns than high P/E stocks Publicly available P/E ratios could be used for abnormal returns Price-earnings/Growth ratiosPrice-earnings/Growth ratios Mixed results
  • Slide 29
  • Tests and Results: Semistrong- Form EMH Predicting cross-sectional returns The size effectThe size effect The risk-adjusted returns for extended periods indicate that the small firms consistently experienced significantly larger risk-adjusted returns than large firms Abnormal returns could occur because either markets are inefficient or the market model is not properly specified and provides incorrect estimates of risk and expected returns (joint test)
  • Slide 30
  • Tests and Results: Semistrong- Form EMH Predicting cross-sectional returns The size effectThe size effect Adjustments for riskiness of small firms did not explain the large differences in rate of return The impact of transactions costs of investing in small firms is substantial (takes away the differential with a short-term tradin...

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