chapter 8 the efficient market hypothesis. mcgraw-hill/irwin © 2004 the mcgraw-hill companies,...
TRANSCRIPT
Chapter 8
The Efficient Market Hypothesis
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Efficient Market Hypothesis (EMH)
• Do security prices reflect information ?• Why look at market efficiency
• Implications for business and corporate finance
• Implications for investment
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• Random Walk - stock prices are random• Actually submartingale
• Expected price is positive over time• Positive trend and random about the trend
Random Walk and the EMH
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Security Security PricesPrices
TimeTime
Random Walk with Positive TrendRandom Walk with Positive Trend
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• Why are price changes random?• Prices react to information• Flow of information is random• Therefore, price changes are random
Random Price Changes
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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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Forms of the EMH
• Weak• Semi-strong• Strong
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Types of Stock Analysis
• Technical Analysis - using prices and volume information to predict future prices• Weak form efficiency & technical analysis
• Fundamental Analysis - using economic and accounting information to predict stock prices• Semi strong form efficiency & fundamental analysis
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• Active Management• Security analysis• Timing
• Passive Management• Buy and Hold• Index Funds
Implications of Efficiency for Active or Passive
Management
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Even if the market is efficient a role exists for portfolio management
• Appropriate risk level• Tax considerations• Other considerations
Market Efficiency and Portfolio Management
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• Event studies• Assessing performance of professional
managers• Testing some trading rule
Empirical Tests of Market Efficiency
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1. Examine prices and returns over time
How Tests Are Structured
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00 +t+t-t-t
Announcement DateAnnouncement Date
Returns Surrounding the Event
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2. Returns are adjusted to determine if they are abnormalMarket Model approach
a. Rt = at + btRmt + et
(Expected Return)
b. Excess Return = (Actual - Expected)
et = Actual - (at + btRmt)
How Tests Are Structured (cont.)
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2. Returns are adjusted to determine if they are abnormalMarket Model approach
c. Cumulate the excess returns over time:
00 +t+t-t-t
How Tests Are Structured (cont.)
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• Magnitude Issue• Selection Bias Issue• Lucky Event Issue
Issues in Examining the Results
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Tests of Weak Form
• Returns over short horizons• Very short time horizons small magnitude
of positive trends• 3-12 month some evidence of positive
momentum
• Returns over long horizons – pronounced negative correlation
• Evidence on Reversals
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• Small Firm Effect (January Effect)• Neglected Firm• Market to Book Ratios• Post-Earnings Announcement Drift• Higher Level Correlation in Security
Prices
Tests of Semi-strong Form: Anomalies
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Implications of Test Results
• Risk Premiums or market inefficiencies• Anomalies or data mining• Behavioral Interpretation
• Inefficiencies exist• Caused by human behavior
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Behavioral Possibilities
• Forecasting Errors• Overconfidence• Regret avoidance• Framing and mental accounting errors
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Mutual Fund and Professional Manager
Performance• Some evidence of persistent positive
and negative performance• Potential measurement error for
benchmark returns• Style changes• May be risk premiums
• Superstar phenomenon