Download 8.1 random walks and the efficient market hypothesis

CHAPTER 8
The Efficient Market
Hypothesis
McGraw-Hill/Irwin
Copyright © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
8.1 RANDOM WALKS AND THE EFFICIEN
MARKET HYPOTHESIS
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Efficient Market Hypothesis (EMH)
Do security prices reflect information?
Any information that could be used to predict
stock performance should already be reflected in
prices.
As soon as there is any information indicating
that the stock is underpriced investors should
buy the stock and immediately bid up its price to
a fair level.
Only new information will move stock prices
which is unpredictable.
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Random Walk and the EMH
Stocks already reflect all available
information is referred to as the efficient
market hypothises (EMH)
The stock prices should follow a random
walk, that is the price changes should be
random and unpredictable.
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Random Walk and the EMH
Random Walk - stock prices are random
– Randomly evolving stock prices are the
consequence of intelligent investors
competing to discover relevant information
Expected price is positive over time
Positive trend and random about the trend
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Random Walk with Positive Trend
Security
Prices
Time
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Random Price Changes
Why are price changes random
– Prices react to information
– Flow of information is random
– Therefore, price changes are random
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EMH and Competition
Stock prices fully and accurately reflect
publicly available information.
Once information becomes available,
market participants analyze it.
Competition assures prices reflect
information.
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Figure 8.1 Cumulative Abnormal Returns
Before Takeover Attempts
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Figure 8.2 Stock Price Reaction to CNBC
Reports
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Versions of the EMH
Weak
Semi-strong
Strong
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8.2 IMPLICATIONS OF THE EMH
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Weak Form Efficiency
Weak form: Prices already reflect all
historical information such as past prices,
trading volume etc.
How to test;
– Technical Analysis - using prices and volume
information to predict future prices
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Semi-strong Form of Efficiency
Semi-strong: all publicly available information must be
reflected already in the prices, in addition to the past
prices, fundamental data on the firm’s product line,
quality of management, B/S composition, patents held
etc.
How to test;
- Fundamental Analysis:
using economic and accounting information to
predict stock prices.
- Event studies:
Determination of event date
Calculation of abnormal return (what market adjustment
is needed?)
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How Tests Are Structured
1. Examine prices and returns over time
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Returns Over Time
0
Announcement Date
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How Tests Are Structured (cont’d)
2. Returns are adjusted to determine if they
are abnormal.
Market Model approach
a. Rt = at + btRmt + et
(Expected Return)
b. Excess Return =
(Actual - Expected)
et = Actual - (at + btRmt)
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How Tests Are Structured (cont’d)
c. Cumulate the excess returns over time:
-t
0
+t
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Strong-form of Efficiency
Strong: Stock prices reflect all information
relevant to the firm, even including
information available only to company
insiders. It is quite extreme.
How to test;
– Testing of Insider trading,
– Tests of the mutual funds and big fund
(portfolio) managers. (Assessing performance
of professional managers)
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Anomalies
P/E Effect
Small firm (size) effect
Neglected Firm
Market to Book Ratios
Post-Earnings Announcement
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P/E Effect: Basu find that portfolios of the low
P/E ratio stocks have higher returns than do the
portfolios of high P/E ratio stocks.
Small firm (Size) Effect: Banz shows the
historical performance of portfolios formed by
dividing the NYSE into 10 porfolios each year
according to the size. And found that average
annual returns are higher on small-firm porfolios.
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Neglected-Firm Effect: Arbel and Strabel.
Because small firms are tend to be
neglected by large institutional traders,
information about smaller firms is less
available. This information deficiency
makes smaller firms riskier investments
that command higher returns.
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Book-to Market Ratios: Fama and French
and Reinganum showed that a powerful
predictor of returns across securities is the
ratio of B/M. Low B/M ratio porfolios have
greater returns than those of high.
Post-Earnings Announcement: There is a
large abnormal return on the earnings
announcement day.
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The Role of Portfolio Management in
an Efficient Market
Even if the market is efficient a role
exists for portfolio management:
– Appropriate risk level
– Tax considerations
– Other considerations
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– Appropriate risk level: Even if all stocks are
priced fairly each still posses firm-specific risk
that can be eliminated through diversification.
Rational security selection calls for the
selection of well-diversified portfolio providing
systematic risk level that the investors wants.
– Tax considerations:High-tax braket investors
will not want the securities which are
favorable for the low-tax braket investors.
Capital gains and periodic income (dividend
and interest) may have different tax rates.
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