1. Chapter 8The Efficient MarketHypothesis

2. Efficient Market Hypothesis(EMH) Do security prices reflect relevant informationfully and immediately? What kind of information? Past prices, trading volume, etc Weak form EMH Public information announced Semi-strong EMH Private information of managers Strong EMH Competition assures prices to reflect information Once information becomes available, market participants analyze it and trade on it 2 3. What are the implications of the EMH? Implications for investment Will it be possible to beat the market consistently over time? In efficient markets, technical trading rules should not worksince all of the past information is contained in current prices Empirical evidence is mixed Evidence of overreaction or underreaction to information, etc. Do stock prices follow random walk? Stronger assumption than the EMH In fact, EMH allows a submartingale process Expected price is increasing over time Positive trend and random about the trend Implications for corporate finance and business Should be difficult to find a project with positive NPVs3 4. Security Random Walk with Positive TrendPricesTime4 5. Implications for Active or PassiveManagement Active Management Security analysis Technical analysis Market timing Fundamental analysis Stock selection Passive Management Buy and Hold Index Funds Empirical evidence Investing in passively managed funds such as index fund hasoutperformed actively managed funds for the last severaldecades. What does this imply? It is difficult to beat the market consistently over time 5 6. EMH and Competition Stock prices fully and accurately reflect publiclyavailable information Once information becomes available, marketparticipants analyze it Competition assures prices reflect information 6 7. Then, do we need portfolio managers in an efficient market? Even if the market is efficient, there exists arole for portfolio managers Find an optimal portfolio on the efficient frontier Two-fund separation theorem Maintain appropriate risk level Tax considerations7 8. Types of Security Analysis Technical Analysis Use prices and volume information to predict future prices Mainly for market timing purpose Related to the weak form efficiency Fundamental Analysis Use economic and accounting information to predict stock prices Mainly for stock selection purpose Related to the semi-strong form efficiency This includes Economic Analysis Industry Analysis Security Analysis 8 9. Empirical Tests of Market Efficiency Weak form efficiency Test profitability of some trading rules to see whether past priceor volume contains useful information Semi-strong form efficiency Perform event studies around important announcements to seewhether public information is reflected immediately Strong form efficiency Assess performance of professional managers or insiders to seewhether they have superior information unknown to publicinvestors 9 10. How Tests Are Structured Examine prices and returns over time Serial correlation? Seasonality? Any predictability? Calculate abnormal returns around event windows Using the market model, estimate the following:a. Rt = at + btRmt + et Expected Return = at + btRmt Excess Return = Actual Expected return= (at + btRmt + et) (at + btRmt) = etb. Cumulate the excess returns over event windows 10 11. Abnormal returns around the Event-t0 +t Announcement Date Cumulative Abnormal Returns around the Event-t0 11 +t 12. Tests of Weak Form EMH Returns over short horizons Very short horizons (over a couple of weeks) Small magnitude of positive trends and reversals 3~12 months Some evidence of positive momentum Returns over long horizons (over 3~5 years) Pronounced negative correlation, i.e., reversals12 13. Monthly abnormal returns on momentum portfolios Possible explanations? Time-varying risk premium vs. market inefficiency? Industry effect? Under-reaction to information? (behavioral finance)13 14. Cumulative monthly returns on momentum Increase up to one-year after the portfolio formation,and then, reverse thereafter.1614 . Cumulative monthly returns (%)121086420 1 611 1621 26 3136 4146 5156 14 Event Months since portfolio formation (6- month/ 6- month momentum strategy) 15. Tests of Semi-strong Form EMH Small Firm Effect (January Effect) Book-to-Market ratios Earnings-to-price ratios Cash flow-to-price ratios Dividend-to-price ratios Post-Earnings Announcement Drift 15 16. Size effect (Small firm effect) Why does the small firm effect concentrate inJanuary?16 17. Book-to-market effect Value vs. Growth stocks Value premium? Fama-French 3-factor model MKT, SMB, HML 17 18. Post-Earnings Announcement Drift Under-reaction to earnings announcements? 18 19. Cumulative excess returns around stock split Does the stock split add value to the firm? Information leakage prior to the event 19 20. Tests of Strong Form EMH:Professional Manager Performance Some evidence of persistent positive andnegative performance of mutual funds Potential measurement problems Performance depends on investment style, e.g.,momentum, value strategies, etc. Could be compensation for risk Superstar phenomenon Only a small portion survives20 21. Implications of Test Results Risk premiums or market inefficiencies More relevant question isHow efficient is the market? True anomalies or data mining Behavioral Interpretation Inefficiencies exist Caused by human behavior21 22. Behavioral Possibilities Forecasting Errors Overconfidence Regret avoidance Loss aversion (disposition effect) 22