Efficient%20Capital%20Markets

1
Efficient Capital Markets

• April 25, 2007 (LA) or
• April 24, 2007 (OCC)

2
Overview of Session

• Efficient market theory
• Arbitrage and alternatives to CAPM
• Summary of issues in capital structure
• Modigliani and Miller (M-M) capital structure
  propositions
• The debate concerning M-M propositions
• Debt and residual claims on a firms assets

3
Efficient Markets

• Information efficiency vs. other definitions
• Forms of informational efficiency
• Weak (past prices)
• Semi-strong (past public information)
• Strong (inside or all information)
• Channels of information
• Evidence on each

4
Information Channels to Market
5
Tests of Market Efficiency

• Tests of hypotheses that market is efficient are
  based on whether statistical tests can reject the
  hypothesis of efficiency
• Impossible to prove that the market is efficient
  as you would need to know everything
• Most evidence suggests that we cannot reject the
  hypothesis of efficiency in the weak and
  semistrong form

6
Evidence in Support ofMarket Efficiency

• Patterns in prices support weak form hypothesis
• Lack of correlation in prices
• No other patterns
• Nonetheless, there are anomalies
• Event studies support semistrong form
• Define the arrival of information
• Behavior of excess returns
• Strong form does not seem supported

7
Implications of Market Efficiency

• Assets or equity in balance sheets with similar
  risks and returns should have the same value
• Should earn no profits from no investment and no
  risk in equilibrium
• Can earn risk-adjusted returns from investing
  capital
• Can earn returns from taking risk
• Cant earning anything without one or both

8
Efficient Market Summary

• Table on page 376
• Implications of inefficiency
• uninformed investors
• market disequilbrium
• unpredictable behavior
• Importance of market efficiency in finance

9
Arbitrage

• Arbitrage means earning risk-free profits by
  buying an asset in a cheap market and selling it
  in an market where identical assets are expensive
  (dear)
• Commodity arbitrage involves buying commodities
  in cheap markets and shipping them to expensive
  markets, e.g. wheat
• Pure arbitrage profits are not possible in
  efficient markets

10
Arbitrage Strips and Bonds

• Can buy a Treasury bond or buy strips with same
  payments (e.g. May, 2005)

11
Effects of Arbitrage

• Commodity arbitrage drives commodity prices in
  different markets toward equality after
  accounting for shipping and storage costs
• Arbitrage in financial markets mean cash flows
  with identical timing and risks cost the same
• In our example, the strip and bond prices are
  driven into agreement via arbitrage
• Notions of arbitrage are the basis for our
  discussion of the importance of capital structure

12
Arbitrage Pricing Theory (APT)

• APT states that there should be no profit
  opportunity without risk or invested funds
• Most important application of APT is to option
  pricing
• Black-Scholes Option Pricing won Nobel prize in
  economics
• Very wide application and often viewed as an
  alternative to net present value analysis

13
APT and Net Present Values

• Present value analysis requires forecasting cash
  flows and choosing a risk-adjusted discount rate
• Arbitrage pricing requires identifying traded
  assets which in combination have the same pattern
  of cash flows as the asset under study
• Options can replicate many (all) patterns of cash
  flows

14
Example Stocks and Bonds

• An unlevered company is all equity
• A levered company has debt and equity in its
  capital structure
• If two companies have identical assets but they
  have different financial structures, the total
  value of the companies (equity in the unlevered
  company and debt and equity in the levered
  company) should be the same because of arbitrage
  unless another factor

15
Class 14 -April 30 (LA) or April 26 (OCC)

• Read Chapters 15 and 16
• Do assigned problems
• Look at your PVFIRM05 results and issues with
  assumptions or inputs for sheets 1 to 3
• Begin thinking about a strategy for reviewing for
  final, start looking over course objectives,
  previous class slides, and old examinations