# Efficient Markets by dffhrtcv3

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```									   BM410 Investments

The Efficient Market
Hypothesis
or
Is there really a free lunch?
Objectives

R. Review Portfolio Theory up to today
 A. Understand the efficient market
hypothesis and why securities prices
should be essentially unpredictable
 B. Be able to formulate investment
strategies that make sense in
informationally efficient markets.
 C. Understand the tests of market
efficiency and cite evidence that supports
Review of Financial Theory

 What   we have discussed
A two asset portfolio – with leverage
Modern Portfolio Theory
The development of the efficient frontier
The efficient frontier with CALs
CAPM, and its movement toward Beta
APT
CAL:
E(r) Two       Assets and the CAL                     (Capital
Allocation
Line)

P
E(rp) = 15%
E(rp) - rf = 8%
) S = 8/22
rf = 7%
F Slope: Reward to variability ratio: ratio
of risk premium to std. dev.

0                                      P = 22%         s
This graph is the risk return combination available by choosing different values
of y. Note we have E(r) and variance on the axis.
E(r)
MPT: The Impact of Correlation
13%
r = -1

r=0           r = .3
r = -1
8%                            r=1

TWO SECURITY PORTFOLIOS WITH
DIFFERENT CORRELATIONS

12%             20%   St. Dev
The Efficient Frontier
Efficient
frontier
E(r)
Individual
Global                             assets
minimum
variance
portfolio                     Minimum
variance
frontier
The minimum-variance frontier of risky
assets                        St. Dev.
E(r)The   Efficient Frontier with CALs
CAL (P)           CAL (A)
M
M
P
P
CAL (Global
minimum variance)
A                 A
G

F

P   P&F   M   A&F            s
CAPM and The Security Market Line
    Notice that instead of using standard
deviation, the SML uses Beta
E(r)    SML Relationships

b = [COV(ri,rm)] / sm2        SML
Slope SML = E(rm) – rf    =   market risk
E(rM)
rf                          SML = rf + b[E(rm) - rf]

ß                                  ß
M=   1.0
CAPM: Expected Return–
Beta Relationship

Expected return - beta relationship
E(rM) - rf           =           E(rs) - rf
1                              bs
In other words, the expected rate of return of an asset
exceeds the risk-free rate by a risk premium equal
to the asset’s systematic risk (its beta) times the risk
familiar:

E(rs) = rf + bs [E(rM) - rf ]
APT and the
Security Characteristic Line
Excess Returns (i)                                    SCL

. .. .
Plot of a company’s excess return as a
. .. .
function of the excess return of the market
.             . .
.       . .. .
. . .. . .
.        . . . Excess returns
. .. .. .
. .      . . ..      on market index

. . . .. . .      .. . .
.                 R = a + ßR + e
i      i     i   m    i
A. Efficient Market Hypothesis and why
Securities Prices should be Unpredictable
   What is the Efficient Market Hypothesis (EMH)?
• A hypothesis (or theory) that security prices reflect
all available information, i.e., historical, public, and
non-public
• A framework for trying to understand the
movements in stock prices
• Probably the single most important paradigm in
finance
   Why is it important?
• It helps us understand formulate a basis for various
investment strategies and also explain why prices
move the way they do
What is Market Efficiency?

   What is efficiency?
• The quality or degree of being efficient, effective
operation as measured by a comparison of
production/energy with cost/output
   Are their different types of efficiency?
• Operational efficiency
• The measure of how well things function in
terms of speed of execution and accuracy
• Informational efficiency (i.e. market efficiency)
• The measure of how quickly and accurately the
market reacts to new information
Degrees of Informational Efficiency

   Weak form
• Stock prices reflect all information contained in the
history of past trading—no benefit from past prices
   Semi-strong form
• Stock prices reflect all publicly available
SF SSF
information — no benefit from 10Ks, 10Qs, etc.
   Strong form
• Stock prices reflect all relevant information,
Weak Form
including past, public, and inside information– no
benefit from any insider information
Random Walk and the EMH

   What is a Random Walk?
• The notion that stock prices are random and
unpredictable
• Since information comes randomly, then its
impact on stock prices should be random as well
• Price changes are actually a sub martingale
• The expected price is generally positive over
time
• It has a positive trend and is random about the
trend
Random Walk with Positive Trend

Security
Prices

Time
Efficient Markets Hypothesis
and Competition
 Stockprices fully and accurately reflect
publicly available information
• Once information becomes available, market
participants analyze it
• Participants will buy and sell based on that
new information
• Competition assures prices reflect
information, as securities will be bought and
sold until the point that all new information
is embedded in the price
Are there Other Theories?

   Semi-efficient market hypothesis (among
others)
• A cousin of the EMH
• States that some stocks are priced more
efficiently than others
• This is generally used to support the notion of
tiering in the markets
• Analysts can only follow so many stocks, so
• The smaller are less followed, and hence are
more likely to be less-efficiently priced
Questions

 Any questions of the Efficient Market
Hypothesis and why stock prices should
be unpredictable?
Problem #1

 Which  of the following most appears to
contradict the proposition that the stock
market is weak-form efficient? Explain.
 A. Over 25% of mutual funds
outperforms the markets on average.
 B. Insiders earn abnormal trading profits
 C. Every January, the stock market earns
above normal returns.

 c. Predictable returns should not
occur according to the weak-form
efficient market hypothesis. Higher
than average returns in the month of
weak-form EMH.
B. Investment Strategies in
Informationally Efficient Markets
    Does your view of efficient markets have an
impact on how you manage a portfolio?
 Stock analysis assumes the markets are not weak
and semi-strong form efficient
 Technical Analysis - using prices and volume
information to predict future prices
 Violates weak-form efficiency
 Fundamental Analysis - using economic and
accounting information to predict stock prices
 Violates semi-strong form efficiency
Implications of EMH Efficiency

   Active Management
• If markets are efficient, then it depends on the
degree of efficiency
• Security analysis assumes you can add even a
little bit of value
• It doesn’t have to be too much if you are
managing a large fund
• Timing assumes you can make decisions
regarding the attractiveness of various asset
classes
Implications of EMH Efficiency

 Passive   Management
• This is useful and cheap
• Since the EMH indicates prices are at
a fair value, it makes no sense to buy,
sell, or do any type of analysis
• Index Funds
• If you can’t beat them, join them –
securities, i.e. the S&P 500
Market Efficiency and Portfolio
Management
 What if the markets are efficient? Is
there still a role for portfolio
management?
• Even if the markets are efficient, a role
exists for portfolio management
• Determining an appropriate risk level
• Understanding tax considerations
• Taking into account other individual
investment considerations for a portfolio
Questions

 Do you understand how the implications
of the EMH will affect trading
strategies?
Problem #2

 Some scholars contend that professional
managers are incapable of outperforming
the market. Others come to an opposite
conclusion. Compare and contrast the
assumption about the stock market that
support (a) passive portfolio
management and (b) active portfolio
management.

 Assumptions that support passive management
are that all available information is already
reflected in the price of stocks. The fees for
passive management are minimal.
 Assumptions that support active management
are that there are pockets of market
inefficiency. Active management is more
feasible for managers of large portfolios.
C. Understand Empirical Tests
of Market Efficiency
 Howare tests made of the Efficient
Market Hypothesis?
Most common are:
performance of professional managers
Testing of filter / trading rules
Event studies

   Results from Mutual Fund and Professional
Manager Performance
• There is some evidence of persistent positive and
negative performance
• The problem is that it takes time to determine
both
• Sometimes positive returns are from managers
investing outside their benchmark
• Potential measurement error for benchmark returns
• Style changes have occurred
• May be risk premiums involved
• There is a superstar phenomenon (Lynch, Buffett, etc.)

 Very   limited support of trading rules
the stock passes its 360 day moving
average and sell when it drops below its 45
day moving average
 Those who make money on trading rules
are generally those selling the books
• Once a trading rule is known, it is generally
exploited and then the inefficiency is lost
Event Studies

   How Tests Are Structured
1. Examine prices and returns over time
Formulate a hypothesis (and choose an
appropriate test statistic)
2. Adjust returns to determine if they are abnormal
Select a model, i.e. Rt = at + btRmt + et and
compare expected returns to actual returns
3. Compare actual results with expected results
See how well your actual results were predicted
Event Studies (continued)

Results of Event Studies:
 If the results are good, you invest money with
the test—you do not let anyone know, but
make lots of money and retire early
 If the results are bad, you publish the results
and make tenure, or try to sell books and tapes
who don’t know any better
Event Studies (continued)

-t                   0                +t

Announcement Date

Returns Surrounding the Event
Final Thoughts on
Market Efficiency
   Key Issues:
• Magnitude Issue
• A 1 basis point improvement for a \$100K
portfolio is much less important than for a \$10bn
portfolio
• Size matters
• Selection Bias Issue
• Investment schemes that don’t work are
published, and those that do are used to make
money
• We only hear of those that don’t work
Market Efficiency (continued)

• Lucky Event Issue
• It is more difficult to prove skill than luck
• It takes more time to prove skill
• Possible Model Misspecification
• Perhaps the market is efficient but the
model is incorrectly stated
• We may be using the wrong model
Market Efficiency (continued)

 What   Does the Evidence Show?
• If it sounds too good to be true, it
usually is
• It must make good common business
sense
• Common sense is all too uncommon
• Technical Analysis
• May be helpful for certain events
• But generally has not shown excess
returns for a longer period of time
Market Efficiency (continued)

• Fundamental Analysis
• Has been shown to add value
• But analysts must forecast firms earnings
better than everyone else
• Anomalies Exist
• But invest in them at your peril
• An anomaly discussed means it is known
• It is less like to do the same next time
because others will be watching for it
as well.
D. Understand Anomalies
to the EMH
• What is a market anomaly?
• A market anomaly refers to price behavior that
differs from the behavior predicted by the
efficient market hypothesis.
• An anomaly discussed means it is known
• It is less like to do the same next time
because others will be watching for it as
well.
• Are their anomalies that are known?
Anomalies (continued)

   Price Earnings Effect
• Portfolio’s of low P/E stocks have exhibited higher
average risk-adjusted returns than higher P/E
Stocks
• Investors prefer cheaper stocks even if risk
levels are the same.
   Small Firm Effect
• Smaller firms generally earn higher returns
• May be tied to fact that ownership of smaller
firms is left to smaller investors who require a
Anomalies (continued)

   January Effect
• Stocks tend to exhibit a higher return in January
than any other month (higher for smaller stocks)
• May be tied to tax-loss selling or window
dressing at year-end
   Neglected Firm Effect
• Firms not followed by analysts tend to perform
better than those followed
• Because costs are higher to analyze smaller
invest in less liquid stocks
Anomalies (continued)

   Liquidity Effect
• Less liquid stocks sometimes perform better than
more liquid stocks
• Investors may require a higher return premium
to compensate for lower liquidity
   Market to Book Ratios
• Stocks with lower price to book ratios (or higher
book to market ratios) perform better
• Investors prefer to invest in cheaper stocks (in
reference to their assets)
Anomalies (continued)

 Reversals
• Extreme stock market performance tends to
reverse itself, i.e. reversion to the mean.
• Losers rebound and winners fall
 Value Line Enigma
• Stocks rated highly by Value Line perform
better
• Investors may read Value Line
Anomalies (continued)

   Post-Earnings Announcement Drift
• The effect of earnings announcements
continue for many days after the
announcement
• May be due to trading costs, particularly
for smaller companies
Problem #3

   What is a market anomaly? A market anomaly refers
to:
• A. An exogenous shock to the market that is sharp
but not persistent.
• B. A price or volume even that is inconsistent with
historical price or volume trends.
• C. A trading or pricing structure that interferes with
efficient buying and selling of securities.
• D. Price behavior that differs from the behavior
predicted by the efficient markets hypothesis.

 d). A market anomaly refers to price
behavior that differs from the behavior
predicted by the efficient market
hypothesis.
Questions

 Do you understand the tests of market
efficiency and can you cite evidence that
Problem #4

 Pricesof stocks before stock splits show
on average consistently positive
abnormal returns. Is this a violation of
the EMH?

No this is not a violation of the EMH.
 Usually stock splits occur as a response
to good performance which drives up the
stock price and leads managers to split
the stock.
 When the managers announce a stock
split the good performance of the stock is
already accounted for in the price of the
stock.
Final Thoughts on
Securities Analysis
 Securities   Analysis is like a horse show
• But its not determining which is the best
horse
• But which horse will the judges consider
the best horse!

 You   have to decide!!!!!!!
Review of Objectives

   A. Do you understand the efficient market
hypothesis and why securities prices should be
essentially unpredictable?
   B. Can you formulate investment strategies that
make sense in informationally efficient markets?
   C. Do you understand the tests of market efficiency
and cite evidence that supports or contradicts the
EMH?
   D. Do you understand anomalies that exist to the
EMH?

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