Efficient Markets and behavioral finance 13 Efficient Markets and behavioral finance

13-1 return to net present value Example Government lends $100,000 for 10 years at 3%. 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

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.

13-1 return to net present value NPV Employs Discount Rates Difference between Investment and Financing Decisions Investment Decisions Financing Decisions Provides a brief review of NPV.

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.

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

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.

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.

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

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

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

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

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.

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.

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.

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.

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

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

DO INVESTORS RESPOND SLOWLY TO NEW INFORMATION 1. Earnings Announcement Puzzle 2. The New-Issue Puzzle

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.

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.

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.

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.

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

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.”