CHAPTER 8 Mc GrawHillIrwin Efficient Markets The Behavioral
CHAPTER 8 Mc. Graw-Hill/Irwin Efficient Markets & The Behavioral Critique © 2007 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 8 -2
Random Walk and the EMH Random Walk - stock prices are random – Actually submartingale Expected price is positive over time Positive trend and random about the trend 8 -3
Random Walk with Positive Trend Security Prices Time 8 -4
Random Price Changes Why are price changes random? – Prices react to information – Flow of information is random – Therefore, price changes are random 8 -5
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 8 -6
Figure 8 -1 Cumulative Abnormal Returns Surrounding Takeover Attempts 8 -7
Figure 8 -2 Returns Following Earnings Announcements 8 -8
Forms of the EMH Weak Semi-strong Strong 8 -9
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 8 -10
Implications of Efficiency for Active or Passive Management Active Management – Security analysis – Timing Passive Management – Buy and Hold – Index Funds 8 -11
Market Efficiency and Portfolio Management Even if the market is efficient a role exists for portfolio management Appropriate risk level Tax considerations Other considerations 8 -12
Empirical Tests of Market Efficiency Event studies Assessing performance of professional managers Testing some trading rule 8 -13
How Tests Are Structured 1. Examine prices and returns over time 8 -14
Returns Surrounding the Event -t 0 +t Announcement Date 8 -15
How Tests Are Structured (cont. ) 2. Returns are adjusted to determine if they are abnormal Market Model approach a. Rt = at + bt. Rmt + et (Expected Return) b. Excess Return = (Actual - Expected) et = Actual - (at + bt. Rmt) 8 -16
How Tests Are Structured (cont. ) 2. Returns are adjusted to determine if they are abnormal Market Model approach c. Cumulate the excess returns over time: -t 0 +t 8 -17
Issues in Examining the Results Magnitude Issue Selection Bias Issue Lucky Event Issue 8 -18
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 8 -19
Tests of Semi-strong Form: Anomalies Small Firm Effect (January Effect) Neglected Firm Market to Book Ratios Post-Earnings Announcement Drift Higher Level Correlation in Security Prices 8 -20
Figure 8 -3 The Size Effect from 1926 to 2003 8 -21
Figure 8 -4 Average Rate of Return as a Function of Book to Market 8 -22
Figure 8 -5 Cumulative Abnormal Returns in Response to Earnings Announcements 8 -23
Implications of Test Results Risk Premiums or market inefficiencies Anomalies or data mining Behavioral Interpretation – Inefficiencies exist – Caused by human behavior 8 -24
The Behavioral Critique Information Processing Behavioral Biases Limits to Arbitrage 8 -25
Information Processing Forecasting errors Overconfidence Conservatism Sample size neglect and representativeness 8 -26
Behavioral Biases Framing Mental accounting Regret avoidance 8 -27
Limits to Arbitrage Fundamental risk Implementation costs Model risks 8 -28
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 Superstars 8 -29
Figure 8 -6 Estimates of Individual Mutual Fund Alphas 8 -30
Figure 8 -7 Persistence of Mutual Fund Performance 8 -31
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