1. Market Efficiency and Behavioral Finance
Chapter 12

2. Efficient Market Hypothesis (EMH)
Do security prices reflect information ?
Why look at market efficiency?
Implications for business and corporate finance
Implications for investment

3. Random Walk and the EMH Random Walk - stock prices are random
Actually submartingale
Expected price is positive over time
Positive trend and random about the trend

4. Random Walk with Positive Trend
Security
Prices
Time

5. Random Price Changes Why are price changes random?
Prices react to information
Flow of information is random
Therefore, price changes are random

6. EMH and Competition
Stock prices fully and accurately reflect publicly available information.
Once information becomes available, market participants analyze it.
Competition assures prices reflect information.

7. Forms of the EMH
Weak
Semi-strong
Strong

8. Types of Stock Analysis
Technical Analysis - using prices and volume information to predict future prices.
Weak form efficiency & technical analysis
Fundamental Analysis - using economic and accounting information to predict stock prices.
Semi strong form efficiency & fundamental analysis

9. Active or Passive Management
Active Management
Security analysis
Timing
Passive Management
Buy and Hold
Index Funds

10. Market Efficiency & Portfolio Management
Even if the market is efficient a role exists for portfolio management:
Appropriate risk level
Tax considerations
Other considerations

11. Empirical Tests of Market Efficiency
Event studies
Assessing performance of professional managers
Testing some trading rule

12. How Tests Are Structured
1. Examine prices and returns over time

13. Returns Over Time -t +t
Announcement Date

14. How Tests Are Structured (cont’d)
2. Returns are adjusted to determine if they are abnormal.
Market Model approach
a. Rt = at + btRmt + et
(Expected Return)
b. Excess Return = (Actual - Expected)
et = Actual - (at + btRmt)

15. How Tests Are Structured (cont’d)
2. Returns are adjusted to determine if they are abnormal.
Market Model approach
c. Cumulate the excess returns over time: -t +t

16. Issues in Examining the Results
Magnitude Issue
Selection Bias Issue
Lucky Event Issue
Possible Model Misspecification

17. What Does the Evidence Show?
Technical Analysis
Short horizon
Long horizon
Fundamental Analysis
Anomalies Exist

18. Anomalies Small Firm Effect (January Effect) Neglected Firm
Market to Book Ratios
Reversals
Post-Earnings Announcement Drift

19. Explanations of Anomalies
May be risk premiums
Behavioral Explanations
Information Processing Errors
Behavioral Biases
Limits to Arbitrage

20. Information Processing
Forecasting Errors
Overconfidence
Conservatism
Sample Neglect and Representativeness

21. Behavioral Biases
Framing
Mental Accounting
Regret Avoidance

22. Limits to Arbitrage
Fundamental Risk
Implementation Costs
Model Risk

23. Mutual Fund Performance
Some evidence of persistent positive and negative performance.
Potential measurement error for benchmark returns.
Style changes
May be risk premiums
Superstar phenomenon