1. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 1 Chapter 9 The Efficient Market Hypothesis

2. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 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. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 3 Random Walk - stock prices are random –Actually submartingale Expected price is positive over time Positive trend and random about the trend Random Walk and the EMH

4. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 4 SecurityPrices Time Random Walk with Positive Trend

5. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 5 Why are price changes random? –Prices react to information –Flow of information is random –Therefore, price changes are random Random Price Changes

6. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 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. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 7 Forms of the EMH Weak Semi-strong Strong

8. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 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. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 9 Active Management –Security analysis –Timing Passive Management –Buy and Hold –Index Funds Implications of Efficiency for Active or Passive Management

10. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 10 Even if the market is efficient a role exists for portfolio management Appropriate risk level Tax considerations Other considerations Market Efficiency and Portfolio Management

11. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 11 Event studies Assessing performance of professional managers Testing some trading rule Empirical Tests of Market Efficiency

12. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 12 1. Examine prices and returns over time How Tests Are Structured

13. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 13 0+t-t Announcement Date Returns Surrounding the Event

14. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 14 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 ) How Tests Are Structured (cont.)

15. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 15 2. Returns are adjusted to determine if they are abnormal Market Model approach c. Cumulate the excess returns over time: 0+t-t How Tests Are Structured (cont.)

16. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 16 Magnitude Issue Selection Bias Issue Lucky Event Issue Possible Model Misspecification Issues in Examining the Results

17. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 17 Technical Analysis Fundamental Analysis Anomalies Exist What Does the Evidence Show?

18. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 18 Small Firm Effect (January Effect) Neglected Firm Market to Book Ratios Reversals Value Line Enigma Post-Earnings Announcement Drift Higher Level Correlation in Security Prices Anomalies

19. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 19 Mutual Fund and Professional Manager Performance Some evidence of persistent positive and negative performance Potential measurement error for benchmark returns –Style changes –May be risk premiums Superstar phenomenon