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Efficient Markets

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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
    and contradicts the EMH
    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%
                                                                 Risk premium
                                                                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
               premium
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
   premium of the market portfolio. This leads to the
   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
              they follow the largest
           • 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.
             Answer #1

 c. Predictable returns should not
  occur according to the weak-form
  efficient market hypothesis. Higher
  than average returns in the month of
  January each year contradicts the
  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
     • Buy and Hold
         • 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 –
           mimic a broad benchmark of
           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.
                 Answer #2

 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 Attribution: Assessing
     performance of professional managers
    Testing of filter / trading rules
    Event studies
           Performance Attribution

   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.)
   Testing of Filter/Trading Rules

 Very   limited support of trading rules
  • A trading rule might suggest you buy when
    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
            by your model
          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
  via the radio and TV to unsuspecting buyers
  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
           higher return to invest.
                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
           firms, investors require a higher rate of return to
           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.
               Answer #3

 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
 supports or contradicts the EMH?
              Problem #4

 Pricesof stocks before stock splits show
  on average consistently positive
  abnormal returns. Is this a violation of
  the EMH?
               Answer #4

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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