Chapter 13 Efficient Capital Markets

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Chapter 13Efficient Capital Markets
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Objectives

• Understand what is meant by Efficient Markets.
• Understand the differences between the three
  forms of market efficiency
• Gain a familiarity with the scientific evidence
  on market efficiency
• Methods used
• Examples of studies
• Conclusions about market efficiency
• Understand the implications of market efficiency
  for corporate decisions.

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Definition of Efficient Markets

• Security prices fully reflect available
  information
• Security prices react instantaneously to new
  information, and do so in an unbiased manner
• Suppose a firm announces a quarterly earnings of
  3.00 per share (last quarter EPS 2.50, year
  ago EPS 2.25).
• In an efficient market, what will happen to the
  stock price?

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Efficient Market Reaction to New Information
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Over and Under Reaction to New Information
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Economically Efficient Markets
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Efficient Market Implies

• Given the available information, security prices
  are fair prices
• Neither too high, nor too low
• What is the ex-ante NPV and IRR of security
  investments?
• You cannot earn above average returns
  consistently.

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Efficient Capital Markets

• Necessary conditions for an efficient market
• 1. Large number of profit maximizing
  participants valuing securities independently
• 2. New information comes to the market in a
  random fashion
• 3. Market reacts to information rapidly
• 4. Expected returns implicitly include the risk
  of a security

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Market Efficiency

• Mathematical representation of market efficiency
• Xj,t1 pj,t1 E(pj,t1 It)
• Xj,t1 Abnormal profit to be made after
  considering all information
• Market efficiency says that E(Xj,t1It) 0.
  Thus, on average no profits can be made by
  trading on a particular information set.

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Three Different Types of Market Efficiency

• Weak Form
• Security prices reflect all information found in
  past prices and volume.
• Semi-Strong Form
• Security prices reflect all publicly available
  information.
• Strong Form
• Security prices reflect all informationpublic
  and private.

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Information Sets
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Testing Market Efficiency

• Magnitude issue
• 0.5 of 1 billion 5 million
• Selection bias
• If your method works, would you disclose it?
• Luck
• Need to use large samples and long time periods
• Joint hypothesis
• Compare realized returns with those predicted by
  an asset pricing model (e.g. CAPM)

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Weak Form of Market Efficiency

• Cannot earn above average returns consistently by
  using information contained in past prices.
• Looking for patterns in past prices is a futile
  exercise.
• Pt Pt-1(1 E(R) et) where E(R) is the
  expected return and et is a random error term.
• Expected Return is a function of the securitys
  risk.
• Random error term is unpredictable.

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Testing for Weak Form of Market Efficiency

• Serial Correlation (correlation over time)
• Are successive price changes significantly
  serially correlated?
• Philip Morris (Table 13.1 of text)
• Daily serial correlation 0.075
• 0.0752 0.005625 or about 0.56
• Yesterdays price change explains 0.56 of
  todays price change

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Serial Correlation Microsoft (3/1990 7/2001)
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Technical Analysis

• An examination of past price patterns in an
  attempt to forecast future prices.
• Head and shoulders
• Triple tops
• Inverted bottom
• Moving averages
• Does trading based on these patterns result in
  superior performance?
• No!

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Why Technical Analysis Fails
Investor behavior tends to eliminate any profit
opportunity associated with stock price patterns.
Stock Price
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.
Time
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Which is the real SP 500 Index?
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Are Markets Efficient in the Weak Form?

• A large body of evidence indicates they are.
• Some anomalies
• Monday effect
• January effect
• Size effect
• Are they real anomalies, or just a
  miss-specification of the asset pricing model?
• If markets are efficient in the weak form, why
  are there so many technical analysts?

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Semi-Strong Form of Market Efficiency

• Cannot earn above average returns consistently by
  using publicly available information.
• Historical prices and trading volume
• Financial and operating information (annual
  reports)
• Managerial announcements (dividends, earnings,
  stock splits, takeovers etc.)
• Industry and economic announcements (market
  demand, interest rate changes)
• Security prices react instantaneously to new
  information, and do so in an unbiased manner.
• If you trade after new information is released,
  prices will already have adjusted.

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Event Study Methodology

• Define an event (e.g. dividend announcements).
• Collect sample of firms that experienced this
  event.
• Define day 0 as day of announcement.
• For each firm, measure abnormal return for
  several days before and after the announcement
• the event window
• For each day, average out these abnormal returns
  across all firms in sample
• average abnormal return
• Cumulate the average abnormal returns over time
• Cumulative Abnormal Returns (CARs)

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Computing CARs
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Event Studies Dividend Omissions
Efficient market response to bad news
S.H. Szewczyk, G.P. Tsetsekos, and Z. Santout Do
Dividend Omissions Signal Future Earnings or Past
Earnings? Journal of Investing (Spring 1997)
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Stock Split Announcements
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Mutual Fund Performance (1963 1998)
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Summary of Evidence

• A large body of evidence indicates that markets
  are reasonably efficient in the semi-strong form.
• Simple strategies will not enable you to earn
  above average returns consistently.
• In semi-strong form efficient markets, what is
  the role of Fundamental Analysis?

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The Behavioral Challenge to Market Efficiency

• Rationality
• People are not always rational
• Many investors fail to diversify, trade too much,
  and seem to try to maximize taxes by selling
  winners and holding losers.

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The Behavioral Challenge to Market Efficiency

• Independent Deviations from Rationality
• Psychologists argue that people deviate from
  rationality in predictable ways
• Representativeness drawing conclusions from too
  little data
• This can lead to bubbles in security prices
• Conservativism people are too slow in adjusting
  their beliefs to new information.
• Security Prices seem to respond too slowly to
  earnings surprises.

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The Behavioral Challenge to Market Efficiency

• Arbitrage
• Suppose that your superior, rational, analysis
  shows that company ABC is overpriced.
• Arbitrage would suggest that you should short the
  shares.
• After the rest of the investors come to their
  senses, you make money because you were smart
  enough to sell high and buy low.
• But what if the rest of the investment community
  doesnt come to their senses in time for you to
  cover your short position?
• This makes arbitrage risky.

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Strong Form Market Efficiency

• Security Prices reflect all informationpublic
  and private.
• Strong form efficiency incorporates weak and
  semi-strong form efficiency.
• Strong form efficiency says that anything
  pertinent to the stock and known to at least one
  investor is already incorporated into the
  securitys price.

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Evidence on Strong Form of Market Efficiency

• One group of studies of strong-form market
  efficiency investigates insider trading.
• A number of studies support the view that insider
  trading is abnormally profitable.
• Thus, strong-form efficiency does not seem to be
  substantiated by the evidence.

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What Market Efficiency does NOT say

• Security prices are random
• It is impossible to earn high returns
• It is impossible to earn high above average
  returns
• You might as well select stocks randomly

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Implications for Corporate Finance

• Firms should expect to receive the fair value for
  securities that they sell.
• A firm can sell as many shares of stocks or bonds
  as it desires without depressing prices.
• Financial managers cannot time issues of stocks
  and bonds using publicly available information.
• The price of a companys stock cannot be affected
  by a change in accounting.