Efficient Markets and Behavioral Finance Principles of Corporate Finance Tenth Edition Chapter 13 Efficient Markets and Behavioral Finance Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. 1 1 1 1 1 2
Topics Covered We Always Come Back to NPV What is an Efficient Market? Random Walk Efficient Market Theory The Evidence Against Market Efficiency Behavioral Finance Six Lessons of Market Efficiency 2 2 2 2 3 2
Return to NPV NPV employs discount rates These discount rates are risk adjusted The risk adjustment is a byproduct of market established prices Adjustable discount rates change asset values
Return to NPV Example The government is lending you $100,000 for 10 years at 3% and only requiring interest payments prior to maturity. Since 3% is obviously below market, what is the value of the below market rate loan?
Return to NPV Example The government is lending you $100,000 for 10 years at 3% and only requiring interest payments prior to maturity. Since 3% is obviously below market, what is the value of the below market rate loan? Assume the market return on equivalent risk projects is 10%.
Random Walk Theory The movement of stock prices from day to day DO NOT reflect any pattern. Statistically speaking, the movement of stock prices is random (skewed positive over the long term).
Random Walk Theory Coin Toss Game $106.09 $103.00 $100.43 $100.00 Heads $106.09 Heads $103.00 $100.43 Tails $100.00 Heads $100.43 $97.50 Tails $95.06 Tails
5 yrs of the Coin Toss Game? Random Walk Theory S&P 500 Five Year Trend? or 5 yrs of the Coin Toss Game?
Random Walk Theory
Random Walk Theory
Random Walk Theory
Random Walk Theory
Efficient Market Theory Microsoft Stock Price $40 30 20 Actual price as soon as upswing is recognized Upswing Cycles disappear once identified Last Month This Month Next Month
Efficient Market Theory Weak Form Efficiency Market prices reflect all historical information Semi-Strong Form Efficiency Market prices reflect all publicly available information Strong Form Efficiency Market prices reflect all information, both public and private
Efficient Market Theory Fundamental Analysts Research the value of stocks using NPV and other measurements of cash flow
Efficient Market Theory Adjusted stock return = return on stock – return on market index
Efficient Market Theory Announcement Date
Efficient Market Theory Average Annual Return on Mutual Funds and the Market Index
Efficient Market Theory The average return 1972–2001 on stocks of firms over the six months following an announcement of quarterly earnings. The 10% of stocks with the best earnings news (portfolio 10) outperformed those with the worst news (portfolio1) by about 1% per month.
Log Deviations From Royal Dutch Shell / Shell T&T Parity Price Anomalies Log Deviations From Royal Dutch Shell / Shell T&T Parity 1980 - 2004 Deviation, %
Efficient Market Theory 2009 Recession
Efficient Market Theory 2000 Dot.Com Boom
Efficient Market Theory 1987 Stock Market Crash
Behavioral Finance Factors related efficiency and psychology Attitudes towards risk Beliefs about probabilities Limits to arbitrage Incentive problems and the subprime crisis
Lessons of Market Efficiency Markets have no memory Trust market prices Read the entrails There are no financial illusions The do it yourself alternative Seen one stock, seen them all
Example: How stock splits affect value -29 30 Source: Fama, Fisher, Jensen & Roll
Web Resources Click to access web sites Internet connection required www.thecorporatelibrary.com www.towers.com www.businessweek.com www.forbes.com