Economics 134a

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Economics 134a

• Lecture notes

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Exam 2 grade distribution
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Review

• Capital market efficiency prices reflect
  present values BASED ON SOME INFORMATION.
• Implication if markets are efficient with
  respect to some information
• And if you have only that information, you cannot
  trade profitably
• If market is inefficient with respect to
  information that you have, then you can trade
  profitably

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Technical, Fundamental Analysis

• Technical analysis trading based on price
  patterns
• Fundamental analysis trading based on
  researching the company
• Attempts to identify fundamental value
• Presumption price fluctuates around fundamental
  value you can trade profitably based on the
  discrepancy

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A typology of market efficiency

• Weak-form market is efficient with respect to
  past prices
• Implication technical analysis doesnt work
• Fundamental analysis may or may not work
• Semi-strong form market is efficient with
  respect to all public information
• Implication neither technical nor fundamental
  analysis can work
• Contrast price fluctuates around fundamental
  value vs. price equals fundamental value
• Strong-form market is efficient with respect to
  all information including private information
• Not likely!

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Note the direction of implication

• Strong-form implies semi-strong form,
• Semi-strong form implies weak-form
• But not vice-versa

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Ch. 13 -- Conditions for Market Efficiency

• Universal rationality
• Random departures from rationality
• Arbitrage

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Evaluation rationality

• Universal rationality appears pretty implausible
• If the market is nearly efficient, its rational
  to be uninformed
• You can free ride on others information

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Evaluation random departures from rationality

• Not so good either fads crowd behavior

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Evaluation arbitrage

• The argument is that professional investors would
  exploit irrationality
• questionable mutual funds bet fads as much as
  individuals
• Arbitrageurs have limited resources may be too
  risky to try to exploit.
• Especially if the mispricing could last forever.

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Examples

• Royal Dutch Shell
• Palm-3Com

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Random Walk Model

• Assertion if markets are weak-form efficient,
  stock prices follow a random walk
• where e t1 is a sequence of INDEPENDENT random
  variables
• This sequence implies expected rate of return is
  constant (neglecting dividends, risk aversion)

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Random Walk Model

• is what you would expect in an efficient market
• It doesnt conflict with NPV if prices are
  discounted cash flows, changes in prices occur as
  a result of new information.
• New information is unforecastable
• However, if markets are inefficient, prices
  systematically overreact or underreact to
  information this conflict with random walk.

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Random Walk Model

• Conflicts with technical analysis
• Not so clear with fundamental analysis, because
  fundamental analysis bases forecasts on variables
  other than past prices.

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Evidence

• autocorrelation tests
• runs of gains and losses are about what youd
  expect with a random walk
• Correlation of price changes are about zero
• trading rules -- they are not profitable
  supports weak-form efficiency
• Tests of technical analysis predictors

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Mutual funds

• Do not outperform the market, even without
  considering management charges
• supports semi-strong-form efficiency
• Managers who do outperform for a while dont
  continue to do so.

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Event studies

• consider pattern of returns surrounding
  information event -- that is clearly publicly
  known
• Should affect stock prices on the date of release
• Or maybe before (if insiders trade based on their
  information)
• In an efficient market, there should be no
  systematic effect after the release date

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Example

• Suppose the event is announcement of an earnings
  increase

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• Event studies mostly support semi-strong form
  efficiency
• Exception prices often drop after IPOs
• Suggests that managers know when their firm is
  overvalued issue new securities then.

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Pricing Anomalies

• The evidence against CAPM (beta isnt correlated
  with expected returns) can be interpreted as
  evidence against market efficiency
• Value versus growth
• Bubble episodes
• Crash of 1987

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Opinions about Market Efficiency

• In 1970s, opinions were polarized academics
  supported, practitioners didnt
• Now both groups are more mixed
• Growth of index funds
• practitioners compute betas, try to construct
  efficient portfolios

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Behavioral Finance

• more comfortable with irrationality
• Robert Shiller, Irrational Exuberance
• Andrei Shleifer, Inefficient Markets
• Be careful with these guys!
• Its not very clear exactly what they mean by
  irrationality

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Accounting Issues

• Market efficiency implies investors are good at
  allowing for accounting differences
• Change of accounting (LIFO-FIFO, for example)
  doesnt affect stock prices
• However Enron