1. Efficient Markets and behavioral finance13
Efficient Markets and behavioral finance
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 13-1 return to net present value
NPV Employs Discount Rates
Risk adjusted
Byproduct of market-established prices
Adjustable discount rates change market prices
Provides a brief review of NPV.

3. 13-1 return to net present value
Example
Government lends $100,000 for 10 years at 3%, interest payments required only prior to maturity. Determine loan value.
Financing decisions are explained in terms of NPV of borrowing. This is an example of a subsidized loan. Subsidized loans have positive NPVs.
NPV = amount borrowed – PV of interest payments – PV of loan repayment

4. 13-1 return to net present value
Example, continued
Assume 10% market return on equivalent risk projects
In this case there is a transfer of wealth from the government to the firm through subsidized loan.

5. 13-2 What is an efficient market?
Random Walk Theory
Movement of stock prices from day to day do not reflect a pattern
Statistically, movements are random
Skewed positive over long term
Random walk theory states that the stock price movements are random. That is, there is no pattern to stock price movements. If there were a pattern, then investors would be able to earn huge profits by exploiting the pattern.

6. 13-2 What is an efficient market?
Repeated coin tossing should show no pattern, or that the outcomes are random.

7. Figure 13.1 five years: Standard and Poor’s index and coin toss game
This chart shows the movement of S&P 500 index over time. It also shows a series of cumulated random numbers. People tend to see patterns where there are no patterns.

8. Figure 13.2a Microsoft
Each dot shows a pair of returns on two successive days. This is called a scatter diagram. It shows no significant relationship between returns on successive days for Microsoft. There are a total of four slides that depict the same information for different companies. Note the lack of a pattern in each diagram.

9. Figure 13.2b deutsche bank
The same exact diagram as the previous slide, other than it represents Deutsche Bank.

10. Figure 13.2c philips electronics
The same exact diagram as the previous slide, other than it represents Philips.

11. Figure 13.2d sony
The same exact diagram as the previous slide, other than it represents Sony.

12. Figure 13.3 cycles
Microsoft stock prices over time are shown. Cycles disappear once they are identified.

13. 13-2 What is an efficient market?
Three Forms of Market Efficiency
Weak
Prices reflect all historical information
Semistrong
Prices reflect all publicly available information
Strong
Prices reflect all private and public information
These three forms of market efficiency were defined to facilitate statistical testing of the hypothesis. The implication is that trading rules, using this type of information, cannot generate above-normal profits in the long run.

14. 13-2 What is an efficient market?
Fundamental Analysts
Research stock value using NPV and other cash-flow measurements
Fundamental analysis tries to uncover information about a firm’s profitability and hence the value of its stock. Fundamental analysts are researchers who research the value of stocks using discounted cash-flow methods. Markets are efficient because investors compete to acquire relevant information and trade on the basis of it. But if prices always fully reflect that information, investors have no incentive to incur the costs of analysis. Thus, the limits to market efficiency are set by the cost of obtaining information. These days the cost of information is practically zero. A lot of free information is available on the Internet.

15. 13-2 What is an efficient market?
Adjusting for Market Movements
Adjusted stock return = return on stock – return on market index
The return on a stock can be expressed relative to its performance against the market index. This concept is depicted in this slide along with a formula.

16. Figure 13.4 stock performance versus market
The announcement of the takeover attempt seems to be fully reflected in the stock prices on the announcement day.

17. Figure 13.5 diversified equity funds versus wilshire 5000 index
Mutual funds underperform the market in approximately half the years.

18. Figure 13.6 average returns following quarterly announcements, 1972-2001
Another test of market efficiency, this chart depicts stock performance after earnings announcements.

19. Figure 13.7 deviations from royal Dutch shell/ shell T&T parity, 1980-2004
Royal Dutch Petroleum (Dutch firm) and Shell Transport & Trading (British firm) were Siamese twins that shared the profits from the same cash-flow stream. Royal Dutch got 60% and Shell T&T got 40%. So the ratio of Royal Dutch to Shell T&T market prices should be 60/40 = 1.5. The graph shows that the two shares traded away from parity for long periods.

20. 13-3 evidence against market efficiency
2009 Recession
This and the following two slides show the dramatic impact that growth can have on the value of a stock index. If we assume the dividends on the index do not change, then the drop in the market must be explained by growth. The decline in growth need not be large to cause a major drop in values.

21. 13-3 evidence against market efficiency
2000 Dot.com Boom
If the dividend growth rate is 8%, the index value is 12,883. If the dividend growth were only 7.4%, then the value of the index would fall to 8,589. Even small changes in growth perception affect the index value dramatically. This may be one way to explain the 2000 Dot.com boom and bust later.

22. 13-3 evidence against market efficiency
1987 Stock Market Crash
Similarly, the 1987 stock market crash can be explained through small changes in growth perceptions. If the dividend growth rate is 10%, the index value is 1,193. If the dividend growth were only 9.6%, then the value of the index would fall to 928.

23. 13-4 Behavioral finance Factors Relating Efficiency and Psychology
Attitudes toward risk
Beliefs about probabilities
Limits to Arbitrage
Incentive Problems and the Subprime Crisis
Behavioral finance provides some answers to the question: How could the inefficiencies survive in a world where a large number of rational and energetic investors stand ready to exploit any unusual profit opportunities?
Limits to arbitrage. In practice, arbitrage is defined as a strategy that exploits market inefficiency and generates superior returns if and when prices return to fundamental values.
Similarly, factors related to efficiency and psychology are:
-Attitudes toward risk
-Beliefs about probability

24. 13-5 Six lessons of market efficiency
Markets Have No Memory
Trust Market Prices
Read the Entrails
There are No Financial Illusions
Remember the Do-It-Yourself Alternative
Seen One Stock, Seen Them All
These are the implications of the market efficiency to the financial managers. It is very difficult to outguess the market, as the security prices are fair for the most part. The six lessons are:
Markets have no memory. Follows directly from the random walk literature.
Trust market prices. In an efficient market you can trust prices because they reflect all available information. For example, it is very difficult for portfolio managers to achieve better-than-average risk-adjusted performance by identifying over- or underpriced stocks. The Orange County investment portfolio is discussed.
Read the entrails. Because they impound all available information, security prices can tell us a lot about the future if we can interpret them properly. For example, the stock market is a good leading indicator of economic activity. The history of Viacom’s bid for Paramount is discussed; here the text discusses and uses abnormal returns.
There are no financial illusions. In an efficient market, prices change when true value changes. Investors are not concerned with cosmetics. Two examples are given: market reaction to (1) stock splits and dividends, and (2) accounting changes.
Remember the do-it-yourself alternative. In an efficient market, investors will not pay others for what they can do themselves.
Seen one stock, seen them all. “You can sell large blocks of stock at close to the market price as long as you can convince other investors that you have no private information.”

25. 13-5 Six lessons of market efficiency
Example: How Stock Splits Affect Value
-29 30
Source: Fama, Fisher, Jensen, & Roll
Markets absorb new information quickly. There is usually a rise before the split and no abnormal changes after the split. This is an important research technique for determining the cumulative abnormal returns due to announcements. It has become a widely used method for research in finance and has spread to other fields. This is a famous study by Fama, Fisher, Jensen, and Roll that has grown into an entire field of study called “event studies.” The same methodology is now being used in other fields also.