CHAPTER 11 The Efficient Market Hypothesis Investments 8

CHAPTER 11 The Efficient Market Hypothesis Investments, 8 th edition Bodie, Kane and Marcus Slides by Susan Hine Mc. Graw-Hill/Irwin Copyright © 2009 by The Mc. Graw-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 11 -2

Figure 11. 1 Cumulative Abnormal Returns Before Takeover Attempts: Target Companies 11 -3

Figure 11. 2 Stock Price Reaction to CNBC Reports 11 -4

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 11 -5

Versions of the EMH • Weak • Semi-strong • Strong 11 -6

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 11 -7

Active or Passive Management • Active Management – Security analysis – Timing • Passive Management – Buy and Hold – Index Funds 11 -8

Market Efficiency & Portfolio Management Even if the market is efficient a role exists for portfolio management: • Appropriate risk level • Tax considerations • Other considerations 11 -9

Event Studies • Empirical financial research that enables an observer to assess the impact of a particular event on a firm’s stock price • Abnormal return due to the event is estimated as the difference between the stock’s actual return and a proxy for the stock’s return in the absence of the event 11 -10

How Tests Are Structured • Returns are adjusted to determine if they are abnormal Market Model approach a. rt = at + brmt + et (Expected Return) b. Excess Return = (Actual - Expected) et = rt - (a + br. Mt) 11 -11

Are Markets Efficient • Magnitude Issue • Selection Bias Issue • Lucky Event Issue 11 -12

Weak-Form Tests • Returns over the Short Horizon – Momentum • Returns over Long Horizons 11 -13

Predictors of Broad Market Returns • Fama and French – Aggregate returns are higher with higher dividend ratios • Campbell and Shiller – Earnings yield can predict market returns • Keim and Stambaugh – Bond spreads can predict market returns 11 -14

Semistrong Tests: Anomalies • • • P/E Effect Small Firm Effect (January Effect) Neglected Firm Effect and Liquidity Effects Book-to-Market Ratios Post-Earnings Announcement Price Drift 11 -15

Figure 11. 3 Average Annual Return for 10 Size-Based Portfolios, 1926 – 2006 11 -16

Figure 11. 4 Average Return as a Function of Book-To-Market Ratio, 1926– 2006 11 -17

Figure 11. 5 Cumulative Abnormal Returns in Response to Earnings Announcements 11 -18

Strong-Form Tests: Inside Information • The ability of insiders to trade profitability in their own stock has been documented in studies by Jaffe, Seyhun, Givoly, and Palmon • SEC requires all insiders to register their trading activity 11 -19

Interpreting the Evidence • Risk Premiums or market inefficiencies— disagreement here – Fama and French argue that these effects can be explained as manifestations of risk stocks with higher betas – Lakonishok, Shleifer, and Vishney argue that these effects are evidence of inefficient markets 11 -20

Figure 11. 6 Returns to Style Portfolio as a Predictor of GDP Growth 11 -21

Interpreting the Evidence Continued • Anomalies or Data Mining • The noisy market hypothesis • Fundamental indexing 11 -22

Stock Market Analysts • Do Analysts Add Value – Mixed evidence – Ambiguity in results 11 -23

Mutual Fund Performance • Some evidence of persistent positive and negative performance • Potential measurement error for benchmark returns – Style changes – May be risk premiums • Hot hands phenomenon 11 -24

Figure 11. 7 Estimates of Individual Mutual Fund Alphas, 1972 - 1991 11 -25

Table 11. 1 Performance of Mutual Funds Based on Three-Index Model 11 -26

Figure 11. 8 Persistence of Mutual Fund Performance 11 -27

Table 11. 2 Two-Way Table of Managers Classified by Risk-Adjusted Returns over Successive Intervals 11 -28