1. Efficient Capital Markets Two Views on Capital Market Efficiency: “... in price movements... the sum of every scrap of knowledge available to Wall Street is reflected as far as the clearest vision in Wall Street can see.” Charles Dow, founder of Dow-Jones, Inc. and first editor of The Wall Street Journal (1903) “In an efficient market, prices ‘fully reflect’ available information.” Professor Eugene Fama, financial economist (1976) Chapter 13 Jacoby, Stangeland and Wajeeh, 2000 1

2. Capital Markets Informational Efficiency: Asset prices fully reflect all relevant information. Question: What is the set of “relevant information”? Three Theories (Hypotheses) Markets are weak form efficient Markets are semistrong form efficient Markets are strong form efficient Efficient Capital Markets Jacoby, Stangeland and Wajeeh, 2000 2

3. What is the set of “Relevant Information”? 3 Forms of Market Efficiency: IWeak Form: Relevant information includes just historical information (e.g. historical prices, past dividends, etc...). Implications: –Security prices already reflect all historical info. –We say that security prices follow a random walk (the relationship between today’s price and yesterday’s price is random). –Knowing historical data cannot be used to price securities more efficiently than the market. –Investors can’t make abnormal profits using historical data. Jacoby, Stangeland and Wajeeh, 2000 3

4. IISemistrong Form: Relevant information is all historical info + all relevant public info (e.g. firm financial statements, dividend announcements, inflation rates, etc..) Implications: –Security prices already reflect all that info. –Knowing this info cannot be used to price securities more efficiently than the market. –Investors can’t make abnormal profits by using it. What is the set of “Relevant Information”? Jacoby, Stangeland and Wajeeh, 2000 4

5. IIIStrong Form: Relevant information is all historical and public info + all relevant private info (e.g. insider info). Implications: –Security prices already reflect all that info. –Knowing this info cannot be used to price securities more efficiently than the market. –Investors can’t make abnormal profits by using it What is the set of “Relevant Information”? Jacoby, Stangeland and Wajeeh, 2000 5

6. Relationship among Three Different Information Sets Information set of past prices Information set of publicly available information All information relevant to a stock (inc. private info) Jacoby, Stangeland and Wajeeh, 2000 6

7. Technical Analysts & Chartists Believe in weak form inefficiency: They look for patterns in past stock prices and trading volumes, in order to predict the (near) future and make abnormal returns in the short-run. Fundamental Analysts Believe in semistrong form inefficiency: They make forecasts of future earnings and dividends, in order to project future stock prices and returns. Insider Trading Violators Believe in a strong form inefficiency. Market Efficiency - Examples Jacoby, Stangeland and Wajeeh, 2000 7

8. I Weak Form Can you earn Abnormal Returns, using historical info? Definition: Abnormal Returns (AR): AR t = return in day t - normal return Findings: In general the market is weak form efficient: For daily returns - today’s excess return is not related to past excess returns  (AR t, AR t-1 ) = 0 Evidence of Exceptions (Anomalies): –For consecutive transactions:  (AR t, AR t-1 )  0 –End of The Year effect: AR Dec 0 –Friday The 13th effect: AR Fri, 13 < 0 Efficient Capital Markets : Evidence & Findings Jacoby, Stangeland and Wajeeh, 2000 8

9. II Semistrong Form Do stock prices compound all public available info? Events Studies Tests: Examine Announcements of events known to have a price effect. If the market is semistrong form efficient, prices will adjust immediately Events & Findings: Dividend increase Stock repurchase Floating new shares Takeover announcements (target firm) Insider holding increase Conclusion: In general Markets are semi-strong form efficient 9

10. Reaction of Stock Price to New Info in Efficient and Inefficient Markets Stock Price ($) Days relative to announcement day –8–6 –4–20+2 +4+6 +7 Overreaction and correction Delayed reaction Efficient market reaction Announcement day Jacoby, Stangeland and Wajeeh, 2000 10

11. III Strong Form Can private info be used to beat the normal return? 3 types of traders have been examined: (a) Insiders (CEO`s, Board of Directors, large shareholders) By law: cannot use confidential undisclosed info. Findings: Insiders earn positive excess returns (b) Stock Exchange Specialists Earn abnormal returns consistently (c) Mutual Fund & Pension Fund Managers Do not outperform the normal returns. Jacoby, Stangeland and Wajeeh, 2000 11

12. Implications of an Efficient Capital Market for Corporate Financial Managers uFinancial managers cannot “fool” investors by changing accounting practices uFinancial managers cannot “time” security sales uThere are no price pressure effects when a firm sells many bonds/shares Jacoby, Stangeland and Wajeeh, 2000 12