1. 1 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency Fina2802: Investments and Portfolio Analysis Spring, 2010 Dragon Tang Lecture 10 The Efficient Market Hypothesis February 11, 2010 Readings: Chapter 11 Practice Problem Sets: 2,3,4,7,9,15,16,19,20

2. 2 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency Efficient Markets and Critique Objectives 1.Define the concept of Market Efficiency and its implication for security prices. 2.Demonstrate why if market are efficient security price movements should be essentially unpredictable. 3.Cite evidence that supports and contradicts the efficient market hypothesis. 4.Formulate investment strategies that make sense in informationally efficient markets.

3. 3 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency Where Are We? Investment Securities Investment Companies Pricing: Risk vs. Return Trading Market Efficiency Trading Behavior

4. 4 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency Stock Return Predictability If we know stock prices follows: P t+1 = a + b X t + e t with enough historical observations, we can find a and b. Given the current market condition X t, we can predict future return P t+1 with high precision. What happens next?

5. 5 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency Market Efficiency Definition: Markets are efficient if prices of securities fully reflect all available information about securities. The belief in market efficiency is called Efficient Market Hypothesis (EMH). Market efficiency Prices change only due to new information Stock price changes are random and unpredictable (Random Walk)

6. 6 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency SecurityPrices Time Random Walk with Positive Trend

7. 7 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency Why market efficiency? Many highly paid analysts are searching for ways to improve investment performance. Competition among these analysts make mispriced securities difficult to find.

8. 8 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency Cumulative Abnormal Returns Surrounding Takeover Attempts

9. 9 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency Returns Following Earnings Announcements

10. 10 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency Three Versions of EMH Weak-form EMH: prices reflect all past info Semistrong-form EMH: prices reflect all public (past&current) info Strong-form EMH: prices reflect all (past&current, public&private) info Weak Form Semistrong Form Strong Form

11. 11 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency Implications of EMH for Investment Policy Technical Analysis: useless Fundamental Analysis: adds little value Active versus Passive Portfolio Management: passive wins EMHYou can’t “Beat the Market”

12. 12 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency The Role of Portfolio Management in an Efficient Market Need for a well-diversified portfolio Tax considerations Individual considerations Age considerations

13. 13 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency But Are Markets Efficient? Hard question! The Magnitude Issue The Selection Bias Issue The Lucky Event Issue

14. 14 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency Short Horizon Tests of Weak-form EMH Confirming EMH: Patterns in stock prices cannot be exploited Runs of stock prices cannot be used to predict the next price movement Filter rules cannot generate trading profits Momentum: Serial correlation may exist over short periods (Jegadeesh & Titman, 1993)

15. 15 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency Long Horizon Tests of the Weak-form EMH Reversal: Serial correlation may be negative over long horizons (“Overreaction”) Excess volatility may result when market prices are compared to “fundamentals” Short-run overreaction Short-run momentum Long-run reversal

16. 16 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency Evidence Against EMH: Predictors of Broad Market Movements Dividend yield Earnings yield Bond yield spreads Q: Are these proxies for a change in Market risk premium?

17. 17 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency Problems in Testing EMH Most tests require risk adjustments Risk adjustment require a model of risk (typically uses CAPM) Tests of risk-adjusted returns are joint tests of the EMH and the risk adjustment procedure Rejecting risk-adjustment procedure leaves no conclusions about EMH EMH is essentially untestable.

18. 18 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency Tests of the Semistrong-form EMH Anomalies (evidence against EMH): P/E Effect : low P/E, High returns Small-firm-in-January effect: Small firm, High return, in January Neglected-Firm Effect : Less known firms have higher return Book-to-Market effect : high B/M high returns Postearnings effect: sluggish response of price to earnings announcements

19. 19 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency The Size Effect from 1926 to 2003

20. 20 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency Average Rate of Return as a Function of Book to Market

21. 21 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency Cumulative Abnormal Returns in Response to Earnings Announcements

22. 22 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency Tests of the Strong-form EMH Against strong-form EMH: Inside information SEC regulations

23. 23 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency Interpreting the Evidence Why Anomalies? Risk premiums or inefficiencies? Anomalies or data mining? Behavioral interpretation: —Inefficiencies exist — Caused by human behavior

24. 24 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency Information Processing Behavioral Biases Limits to Arbitrage The Behavioral Critique

25. 25 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency Reality Check of the Semistrong-form EMH Mutual fund performance Skilled equity investment professionals do not consistently beat the market.

26. 26 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency Estimates of Individual Mutual Fund Alphas

27. 27 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency Persistence of Mutual Fund Performance

28. 28 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency Search for Abnormal Returns Trading rule becomes less valuable once exploited Markets are made more efficient as new techniques are used If you find a rule that work, don’t tell anybody…markets might be efficient!

29. 29 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency Are Markets Efficient? Search for underpriced securities continues Several anomalies have not been adequately explained Markets generally are very efficient but rewards may be available to the gifted (not only the lucky!).

30. 30 Fin 2802, Spring 10 - Tang Chapter 11: Market Efficiency Summary Research shows stock prices tend to follow a random walk Three forms of the efficient market hypothesis Technical analysis (violation of Weak form) Fundamental analysis (violation of Semistrong form) Empirical studies have generally shown that technical analysis does not generate trading profits Several anomalies exist regarding fundamental analysis Professionally managed funds generally cannot consistently beat the market