Chapter 13Principles of

Corporate FinanceTenth Edition

Efficient Markets and Behavioral

Finance

Slides by

Matthew Will and Bo Sjö(2012)

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

13-2

Topics Covered

�We Always Come Back to NPV

�What is an Efficient Market?– Random Walk and the behaviour of asset prices

– Efficient Market Theory

�The Evidence Against Market Efficiency?

�Behavioral Finance

�Six Lessons of Market Efficiency

13-3

Kendall in the 50s

�A British statistician Maurice Kendall in 1953 investigated stock prices and found that they changed in unpreditable ways.

�He results were disturbing to many economists and politicians, priests, poets and the lot.

�He and others though he had proven that investors were driven by ”Animal spirits” rather than rational behaviour.

�Was he right?

13-4

Return to NPV

�People are risk averse, the have diversified portfolios of real and financial wealth

� => Risk-adjusted returns are what matters

�NPV shows the similarity between investment and financing decisions

�The discount rates (the opportunity costs) are risk adjusted

�The risk adjustment is a byproduct of market established prices

13-5

Information Efficiency

�Since all investors are wealth maximisers it follows that they will use all relevant information when they determine the prices and thereby the expected returns on assets.

�They will not ignore information that helps them to predict future prices and returns.

�Since they are risk averse, they demand compensation for risk, and determine risk-adjusted expected returns.

13-6

Information Efficiency

�As a consequence, short-term changes in asset prices are only due to unpredictable news.

�What investors already know is already in the price, why prices only changes due to unpreditable news and/or whatever effects the risk premiums.

�Hypothesis: You cannot predicts risk-adjusted return on an efficient market. You can predict changes in risk premiums but cannot use available information to make predictions of risk-adjusted returns in order to make ”excess returns” above compensation for risk.

13-7

Information Effiency

�Of course, markets cannot be efficient at all times, if you are the first to learn about relevant ”news” you can make make money until prices changes to restore market efficiency.

� ”Micro-market efficiency” tick prices etc. A bit different from what we are discussing, which is if prices adjust quickly to new relavant information.

13-8

Random Walk

�The movement of stock prices from day to day DO NOT reflect any pattern.

�Statistically speaking, the movement of stock prices is random with an expected value of zero (skewed positive over the long term).

13-9

And Yes

�Prices seem to move unpredictable over time, there is no pattern.

�But, are nor prices and returns related to the real economy?

�Yes in the long-run, calculate HPR ver 2 year intervalls and you can see how returns are related to GDP growth.

13-10

Random Walk Theory

$103.00

$100.00

$106.09

$100.43

$97.50

$100.43

$95.06

Coin Toss Game

Heads

Heads

Heads

Tails

Tails

Tails

13-11

Random Walk Theory

S&P 500 Five Year Trend?or

5 yrs of the Coin Toss Game?

13-12

The Coin Tossing

�Show that randomness create spuriuous patterns in data, which has no predictive power.

�Thus, a list of which mutual funds that made the largest returns the last 5-10 years is completly uninteresting because it is most likely the outcome of luck, not skills.

13-13

The Random Walk

�Random walk model xt = xt-1 + et

�Where et ”is white noise” et ∼ N(0, σ2), so that

�E(et) = 0

�=> ∆xt = et and E(∆xt) = 0.

�A random walk variable has a ”stochastic trend”, no constant growth, all changes are unpredictable.

�This is an hypothesis about how asset prices changes over time.

13-14

Finance Theory

�Says that asset prices are unpredictable conditional on all relevant information (It) , in particular what determines the risk premium:

�E(xt+1; It) = xt and E(∆xt+1; It) = 0

�The best prediction of future prices are today’s price given that the information set includes all relevant info = risk premium factors. All changes are also unpredictable given the relevant information It.

�This process is called a martingale process.

�The random walk hypothesis can work in the short run since It and risk factors do not change much.

13-15

Efficient Market Theory

Last Month

This Month

Next Month

$40

30

20

Microsoft Stock Price

Cycles disappear

once identified

Actual price as soon as upswing is recognized

Upswing

13-16

Efficient Market Theory

� Fama (1967) divided “relevant information” into three categories of data and efficiency:

� Weak Form Efficiency

– Market prices reflect all historical information from markets, prices, trading volumes etc.

� Semi-StrongForm Efficiency

– Market prices reflect all publicly available information, weak + info for fundamental valuation

� Strong Form Efficiency

– Market prices reflect all information, both public and private

13-17

Efficient Market Theory

�Fundamental Analysts– Research the value of stocks using NPV and other

measurements of cash flow – doesn’t pay-off

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Only risk-adjusted returns are relevant

market on return Expected riskpreiumrf ×+= β

Risk-adjusted stock return= return on stock – compensation for risk

EMH toaccording 0)I AR;(

)~ (~return expected - return actual return Abnormal

1-t =−−=

=

E

rr mβα

13-19

The Evidence�Prices move to unexpected news. Prices do not move

to known events => Random Walk behavior. �Mutual funds cannot beat the market (index) portfolio.�No evience that actively managed funds beats the

market. (A passive strategy, buy and hold the market portfolio is best)

�Prices move in reaction to news (and in the right direction).

�Buy and sell recommendations from financial news papers, analysts etc. are useless. Yeasterday’s news.

�Don’t forget the surviors bias, bad investors disapear from the market. You underestimate risk by only looking at survivors.

13-20

EMH and Information

�EMH deals with information efficiency – how people use available information on average

�People can make temporay mistakes but not systematic mistakes.

�EMH does not ask about economic efficiency. Can there be an even better use of resources than what we have, to achive more wealth (economic growth, productivity, consumer utility for consumption)?

�Common confusion in the debate.

13-21

Debate Confusion II

�There are people who thinks that politicians can solve problems better than financial markets.

�They have a problem proving their point.�We do not life in a first or even second best

world. However, the problem in financial markets is asymmetric information.

�Politicials do not have better information than the rest of us – therefore they cannot solve the problems! Always ask what can they know (what do I know) that the rest of the market doesn’t know already?

13-22

Speculation etc

�Graphs on the white board

�Understand speculation – good and bad– Speculators are basically good, necessary for an

efficient market.

– Friedman 1954

�Understand bubbles

�Understand sunspots

13-23

Speculation is Good

�Beware of ”ethics” and priest and Poets they have no idea of ethics or market or limited resources.

�Speculation can be good and bad.�Anyone who has an opinion about future prices

and trade on this opinion is a speculator. Only, purley passive investors are non-speculators.

�In general speculation is good, of course.�You can never separate bad from good

speculation .

13-24

Signs of Inefficiency

�New-Issue Puzzle, IPOs are underpriced

�Small firm in January ?

�Signs of Bubbles

�October 1987, drastic fall but no news!

�Behavioral finance finds evidence of ”fear of losses” and ”over-confidence”

�Excess volatility of socks, volatility cannot be explained by underlying volatility in expected fundamentals.

13-252009 Recession

Learn that small changes in expected growth has huge effects on value, examples:

000,7$041.072.

217)( 2009May =

−=

−=

gr

DivstocksPV

028,6$036.072.

217)( dropsgrowth =

−=

−=

gr

DivstocksPV

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Efficient Market Theory

2000 Dot.Com Boom

883,1208.092.

6.154)( 2000 March =

−=

−=

gr

DivindexPV

589,8074.092.

6.154)( 2002October =

−=

−=

gr

DivindexPV

13-27

Efficient Market Theory

1987 Stock Market Crash

119310.114.

7.16)( crash pre =

−=

−=

gr

DivindexPV

928096.114.

7.16)( crashpost =

−=

−=

gr

DivindexPV

13-28

Lessons of Market Efficiency

�Markets have no memory

�Trust market prices

�Read the entrails

�There are no financial illusions

�Markets are weakly efficient (trading rules does not give abnormal risk-adjusted returns)

13-29

EMH

�Markets are sufficient effective to be effective. Anomalities are not that significant. Relative valuation is OK. Investments are geared to the right investments.

�Always ask what is it that you think you know that the market does not already know?

13-30

Web Resources

Click to access web sites

Internet connection required

www.thecorporatelibrary.comwww.towers.comwww.businessweek.comwww.forbes.com