1. McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. The Efficient Market Hypothesis CHAPTER 8

2. 8-2 8.1 RANDOM WALKS AND THE EFFICIENT MARKET HYPOTHESIS

3. 8-3 Efficient Market Hypothesis (EMH) Do security prices reflect information? Any information that could be used to predict stock performance should already be reflected in prices. As soon as there is any information indicating that the stock is underpriced investors should buy the stock and immediately bid up its price to a fair level. Only new information will move stock prices which is unpredictable.

4. 8-4 Random Walk and the EMH Stocks already reflect all available information is referred to as the efficient market hypothises (EMH) The stock prices should follow a random walk, that is the price changes should be random and unpredictable.

5. 8-5 Random Walk - stock prices are random –Randomly evolving stock prices are the consequence of intelligent investors competing to discover relevant information Expected price is positive over time Positive trend and random about the trend Random Walk and the EMH

6. 8-6 SecurityPrices Time Random Walk with Positive Trend

7. 8-7 Why are price changes random –Prices react to information –Flow of information is random –Therefore, price changes are random Random Price Changes

8. 8-8 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.

9. 8-9 Figure 8.1 Cumulative Abnormal Returns Before Takeover Attempts

10. 8-10 Figure 8.2 Stock Price Reaction to CNBC Reports

11. 8-11 Versions of the EMH WeakSemi-strongStrong

12. 8-12 8.2 IMPLICATIONS OF THE EMH

13. 8-13 Weak Form Efficiency Weak form: Prices already reflect all historical information such as past prices, trading volume etc. How to test; –Technical Analysis - using prices and volume information to predict future prices

14. 8-14 Semi-strong Form of Efficiency Semi-strong: all publicly available information must be reflected already in the prices, in addition to the past prices, fundamental data on the firm’s product line, quality of management, B/S composition, patents held etc. How to test; - Fundamental Analysis: using economic and accounting information to predict stock prices. using economic and accounting information to predict stock prices. - Event studies: Determination of event date Calculation of abnormal return (what market adjustment is needed?)

15. 8-15 How Tests Are Structured 1. Examine prices and returns over time

16. 8-16 Returns Over Time 0 Announcement Date

17. 8-17 How Tests Are Structured (cont’d) 2. Returns are adjusted to determine if they are abnormal. Market Model approach a. R t = a t + b t R mt + e t (Expected Return) b. Excess Return = (Actual - Expected) e t = Actual - (a t + b t R mt )

18. 8-18 How Tests Are Structured (cont’d) c. Cumulate the excess returns over time: 0+t-t

19. 8-19 Strong-form of Efficiency Strong: Stock prices reflect all information relevant to the firm, even including information available only to company insiders. It is quite extreme. How to test; –Testing of Insider trading, –Tests of the mutual funds and big fund (portfolio) managers. (Assessing performance of professional managers)

20. 8-20 Anomalies P/E Effect Small firm (size) effect Neglected Firm Market to Book Ratios Post-Earnings Announcement

21. 8-21 P/E Effect: Basu find that portfolios of the low P/E ratio stocks have higher returns than do the portfolios of high P/E ratio stocks. Small firm (Size) Effect: Banz shows the historical performance of portfolios formed by dividing the NYSE into 10 porfolios each year according to the size. And found that average annual returns are higher on small-firm porfolios.

22. 8-22 Neglected-Firm Effect: Arbel and Strabel. Because small firms are tend to be neglected by large institutional traders, information about smaller firms is less available. This information deficiency makes smaller firms riskier investments that command higher returns.

23. 8-23 Book-to Market Ratios: Fama and French and Reinganum showed that a powerful predictor of returns across securities is the ratio of B/M. Low B/M ratio porfolios have greater returns than those of high. Post-Earnings Announcement: There is a large abnormal return on the earnings announcement day.

24. 8-24 Even if the market is efficient a role exists for portfolio management: –Appropriate risk level –Tax considerations –Other considerations The Role of Portfolio Management in an Efficient Market

25. 8-25 –Appropriate risk level: Even if all stocks are priced fairly each still posses firm-specific risk that can be eliminated through diversification. Rational security selection calls for the selection of well-diversified portfolio providing systematic risk level that the investors wants. –Tax considerations:High-tax braket investors will not want the securities which are favorable for the low-tax braket investors. Capital gains and periodic income (dividend and interest) may have different tax rates.