FAQs re test/exam With regard to Topic 1, the following sections of Bodie et al. will not be examined: 7 th edition: Chapter 7 Appendix A and B (pp ) Sections 8.4 (pp ); Sections (pp ) 6 th edition: Chapter 6 Appendix A Section 8.5 Sections 9.2, 9.3

Tests of return predictability 4.Long-term returns … market timing Among the variables that seem to explain (subsequent) long-term fluctuations in returns are: Price-earnings ratio for the market as a whole Index relative to its long term average Long-minus-short interest rates (“term premium”) Risky corporate minus government bond yield (“corporate bond risk premium”) These may be correlated with risk aversion And with fewer observations, statistical tests are weaker for long-term efficiency – harder to detect data-mining

Tests of return predictability 4.Long-term returns … market timing “Irrational exuberance” (Alan Greenspan, Dec 5, 1996) Shiller points out that large long-term fluctuations in real stock price averages are consistent with a recurrent social phenomenon in history “when markets have been bid up to unusually high and unsustainable levels under the influence of market psychology” -- often correlated across countries -- precipitated by highly visible “new era” technologies -- fuelled by media and market talk -- very high trading volumes

Tests of return predictability “Irrational exuberance” continued Earnings not adequate explanation to be true driver (except with extrapolation of short-term trends – Gordon growth model); Interest rate movements also not big enough

Growth and value Computing “fair value” if we have info on future dividends and appropriate (risk-adjusted discount rate = required rate of return=CC) Gordon growth model – dividend growth forever!

Shiller: Irrational Exuberance

Event studies Identify events which represent “surprises” to the market Day zero is the surprise date (could be seconds or minutes in the day if data is available) Group positive and negative events separately See how quickly returns respond – mostly very quickly See if there were anticipations – have often been found: but was it insider trading?

Excess returns around merger announcement date (Keown and Pinkerton JOF 1981)

Strong-form efficiency Excess volatility (Shiller) –Equity prices represent expected future dividends –Changes in equity prices mean change in expected dividends –But dividends are too smooth to explain equity price volatility

Shiller 1981

Even professionals cannot beat the market Average mutual fund underperforms the market Relatively little persistence in mutual fund performance They don’t even seem to exploit the additional factors

Strong-form efficiency Do analysts add value? –Academic consensus: on average no: maybe some good ones do. –Mutual fund performance (gross and net of fees) –Survivor bias –Index funds