1. Efficient Markets and Behavioral Finance
Chapter 13
Principles of
Corporate
Finance
Tenth Edition
Efficient Markets and Behavioral Finance
Slides by
Matthew Will
McGraw Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved

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

3. 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

4. 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%.

5. 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

6. Efficient Market Theory
Fundamental Analysts
Research the value of stocks using NPV and other measurements of cash flow

7. Efficient Market Theory
Technical Analysts
Forecast stock prices based on the watching the fluctuations in historical prices (thus “wiggle watchers”)

8. Efficient Market Theory
Announcement Date

9. Efficient Market Theory
Average Annual Return on Mutual Funds and the Market Index

10. Efficient Market Theory
IPO Non-Excess Returns
Year After Offering

11. Log Deviations From Royal Dutch Shell / Shell T&T Parity
Price Anomalies
Log Deviations From Royal Dutch Shell / Shell T&T Parity
Deviation, %

12. Efficient Market Theory
2000 Dot.Com Boom

13. Efficient Market Theory
1987 Stock Market Crash

14. Behavioral Finance Arbitrage limitations LTCM example
Factors related efficiency and psychology
Attitudes towards risk
Beliefs about probabilities

15. 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

16. Example: How stock splits affect value
-29 30
Source: Fama, Fisher, Jensen & Roll