Market Efficiency

News and Returns All news, and announcements contain anticipated

and unexpected components The market prices assets based on what is

expected to happen (Anticipated news)Changes in expectations will cause the price to

move Unexpected news is a surprise and will cause

prices to moveSurprises cause unexpected returns

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Breaking Returns Down

A security’s return is comprised of:1. The expected return, based on expectations2. The un-expected return, based on surprises

Therefore, a stock’s return is:

return theofpart unexpected theis return theofpart expected theis

where

UR

URR

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Breaking Returns Down (2)

We defined returns as: We can break U down further: is the return earned because of unexpected

movements in the economy is the return from firm specific surprises

URR

mRR

m

Example Assume that SML, HML and Mkt represent the

economy Expected SML to be 3%, but it was 8%; surprise is?

0.08 – 0.03 = 5% Expected HML to be 4%, but it was 1%; surprise is?

0.01 – 0.04 = -3% Expected Mkt to be 10%, but it was stable; surprise is?

0.00 - 0.10 = -10% Finally, the firm attracted a “superstar” CEO, this is?

U

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Underlying Assumption

The assumption underlying our discussion, is that the stock is priced in an efficient market

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What is an efficient market? A market is efficient when it uses all available

information to price assets.Information is quickly incorporated into prices

Efficiency is the degree to which prices reflect available information.

Stock prices only respond to surprises, which arrives randomly, so prices follow a random walk

Price tomorrow = today’s price + random (+/-)

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Price: Today and Tomorrow

Do you see a pattern that you want to put money on?

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Reactions to Beating Expectations

Efficient Response

Over Reaction

Under Reaction

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Reaction to Not Meeting Expectations

Over Reaction

Efficient ReactionUnder Reaction

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Potential Causes of Efficient Markets

Investor RationalityEveryone is rational → Everyone makes the right

decision Independent Deviation from Rationality

No one is rational → Everyone makes the wrong decision but each makes a different wrong decision

Average out the wrongness Arbitrage

Only some people are rational → Smart money takes from less smart money

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Types of Efficient Markets

Weak

Semi-Strong

Strong

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Weak Form Efficiency

Prices reflect all information contained in past prices and volumesNo investor is able to form a trading strategy based

on historic prices and volumes and earn an excess return

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Disbelievers

Chartists, or Technical AnalystsAnalyze “charts” of a stock‘s Price and/or Volume

Chartist believe in identifiable and predictable patterns in these characteristicsMake investment decisions based on these patterns

Brokerage firms tend to love chartists

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Head and Shoulders

Why Technical Analysis Fails

-If there is a profitable pattern, everyone would do it

-If everyone follows the same strategy competition will eliminate any opportunity associated with the pattern

Stoc

k Pr

ice

Time

SellSell

Buy

Buy

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Semi-Strong Form Efficiency

Security prices reflect all publicly available information.Encompasses weak form efficiency

Publicly available information includes: Historical price and volume information Published accounting statements Information found in the WSJ

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Disbelievers

Fundamental AnalystsUse revenues, earnings, future growth forecasts,

return on equity, profit margins, and other data to determine a company's underlying value and potential for future growth (Financial Statements)

These guys make more sense than technical analysts. Why?

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Strong Form Efficiency Strong form efficiency says that anything

pertinent to the stock price and known to at least one investor is already incorporated in the security’s price.Public & PrivateImplies: Insider trading will not earn excess return

Strong form efficiency incorporates weak and semi-strong form efficiency.

Disbelievers

Pretty much everyone Insiders trading is generally profitable

Galleon Raj Rajaratnam

Martha Stewart

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What EMH Does and Does NOT Say Investors can throw darts to select stocks.

Kind of: We still need to consider risk Prices are random or uncaused.

Prices reflect information. Price CHANGES are driven by new information,

which by definition is random

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Implications of Efficient Markets Purchase or sale of any security can never be a

positive NPV transaction. Trust market prices Stocks with similar risk are substitutes Mutual fund managers cannot systematically

outperform the market

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The Evidence The record on the EMH is extensive,

and generally supportive of the market being semi-strong form efficient

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Event Studies

Event Studies examine returns around information release datesEX: Earnings, Dividend announcementsA test of semi-strong form efficiency

Look at how quickly prices adjust to the informationLooking for under-reaction, over-reaction, early

reaction, or delayed reaction around the event.

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Event Study Results The studies generally support the view that the

market is semi-strong form efficient. Studies suggest that markets may even have

some foresight into the future, i.e., news tends to leak out in advance of public announcements.

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Event Studies: Dividend OmissionsCumulative Abnormal Returns for Companies Announcing

Dividend Omissions

0.146 0.108

-0.72

0.032-0.244-0.483

-3.619

-5.015-5.411-5.183

-4.898-4.563-4.747-4.685-4.49

-6

-5

-4

-3

-2

-1

0

1

-8 -6 -4 -2 0 2 4 6 8

Days relative to announcement of dividend omission

Cum

ulat

ive

abno

rmal

retu

rns

(%)

Efficient market response to “bad news”

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The Record of Mutual Funds If the market is semi-strong form efficient,

then mutual fund managers, should not be able to consistently beat the average market return

When we compare the record of mutual fund performance to a market index, we see that mutual funds are not able to CONSISTENTLY beat the market.Consistent with the market being semi-strong form

efficient

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Mutual Fund Performance

Taken from Lubos Pastor and Robert F. Stambaugh, “Mutual Fund Performance and Seemingly Unrelated Assets,” Journal of Financial Exonomics, 63 (2002).

-2.13%

-8.45%

-5.41%

-2.17% -2.29%

-1.06%-0.51%-0.39%

All funds Small-companygrowth

Other-aggressive

growth

Growth Income Growth andincome

Maximumcapital gains

Sector

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Insider trading Strong form market efficiency implies

that even insiders trading on private information cannot earn excess return

A number of studies find that insiders are able to earn abnormal profitsViolation of Strong form efficiency

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Verdict on Market Efficiency

Market is pretty efficient Opportunities for easy profits are rare. Financial managers should assume, at least as

a starting point, that security prices are fair and that it is difficult to outguess the market.

New information is rapidly incorporated into the prices.

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EMH Exercises Indicate whether or not the EMH is contradicted,

if so which form of EMH is contradicted An investor consistently earn an abnormal return over

that expected by the market by examining charts of historical prices

The acquisition of the latest annual report of a company enables an investor to earn an abnormal return.

A stock which has been fluctuating between $25 and $27 in the last three months suddenly rises to $40 per share right after management announces a new project that has a promising impact on the firm's expected future cash inflows.

By subscribing to the Value Line Investment Survey, an investor can earn at least 5% over that earned by the market on comparable risk investments.

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EMH Exercises An investor consistently earn an abnormal return over that expected by

the market by examining charts of historical prices Yes, Weak

The acquisition of the latest annual report of a company enables an investor to earn an abnormal return. Yes, Semi-Strong

A stock which has been fluctuating between $25 and $27 in the last three months suddenly rises to $40 per share right after management announces a new project that has a promising impact on the firm's expected future cash inflows. No

By subscribing to the Value Line Investment Survey, an investor can earn at least 5% over that earned by the market on comparable risk investments. Yes, Semi-Strong

Why We Care

Offering several points of view on how the market works, and the evidence for and againstUsing this you can form your own opinion about

how the market works and invest accordingly

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Risk and ReturnPrimer

Expectations Expected value (μ) is weighted sum of possible

outcomes E(X) = μ = p1X1 + p2X2 + …. psXs

E(X) – Expected value of XXi – Outcome of X in state ipi – Probability of state is – Number of possible statesProbabilities have to sum to 1

p1 + p2 + …..+ ps = 1

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Horse Race

There are three horse racing in the Finance Derby. Your horse is “Love of NPV”. If your horse has a 30% chance of coming in first, and a 40% chance of coming in second. How much do you expect your horse to win? 1st pays $1,500 2nd pays $750 3rd pays $250

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Horse Race

There are three horse racing in the Finance Derby. Your horse is “Love of NPV”. If your horse has a 30% chance of coming in first, and a 40% chance of coming in second. How much do you expect your horse to win? 1st pays $1,500, 2nd pays $750, 3rd pays $250

Chance of coming in 3rd: 1-0.3-0.4 = 0.3 0.3*1,500 + 0.4*750 + 0.3*250 = $825

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What is risk?

Uncertainty

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Measuring Risk There is no universally agreed-upon

measureHowever, variance and standard deviation are both

widely accepted measures of total risk

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Statistics Review: Variance Variance (σ2) measures the dispersion of

possible outcomes around μ Standard deviation (σ) is the square root of

variance Higher variance (std dev), implies a higher

dispersion of possible outcomesMore uncertainty

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Different Variances

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Variance Calculation Variance = σ2 = Σpi * (Xi – μ)2: Use this one

Alternative formulas you may have seen σ2 = Σ(Xi – μ)2 / N σ2 = Σ(Xi – μ)2 / (N-1)

All give similar answers with large samplesBUT each give very different answers with small

samples

Ex. s=3σ2 = p1 * (X1 – μ)2 + p2 * (X2 – μ)2 + p3 * (X3 – μ)2

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Risk Example

Economy is “Good” with 20% probability DJIA will return 20%

Economy is “Fair” with 30% probability DJIA will return 5%

Economy is “Bad” with 50% probability DJIA will return -9%

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Calculations

Expected Return =

Variance =

Standard Deviation =

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Calculations

Expected Return = p1X1 + p2X2 + p3X3 = 0.2*0.20+0.3*0.05+0.5*(-0.09) = 0.01

Variance =

Standard Deviation =

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Calculations

Expected Return = 0.01Variance = p1(X1- μX)2+p2(X2-μX)2+p3(X3-μX)2

=0.2*(0.20-0.01)2 + 0.3*(0.05-0.01)2 + 0.5*(-0.09-0.01)2

= 0.0127 =127 (%)2

Standard Deviation =

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Calculations

Expected Return = 0.01

Variance = 0.0127 =127 (%)2

Standard Deviation = √ σ2 √0.0127 = 0.113 = 11.3%

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Historical Data

In practice we do not know all of the possible states of the world, so we use historical data to form expectationsIdea: Look at what has happened in the past and

we can calculate the mean and variance What is each states probability of occurring?

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Risk Example 2

Sample Mean = 0.2*0.20+0.2*0.15+0.2*(-0.05)+0.2*0.05+0.2*0.10 = 0.09 = 9%

Sample Variance = = 0.2*(0.20-0.09)2 + 0.2*(0.15-0.09)2 + 0.2*(-0.05-0.09)2 + 0.2*(0.05-0.09)2 + 0.2*(0.10-0.09)2 = 74%2

Standard Deviation = √0.0074 = 0.086 = 8.6%

1996 1997 1998 1999 2000

20% 15% -5% 5% 10%

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Risk

A risky asset is one in which the rate of return is uncertain.

Risk is measured by ________________

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Risk

A risky asset is one in which the rate of return in uncertain.

Risk is measured by standard deviation. higher σ → more uncertainty

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General Securities

T-bills are a very safe investment No default risk, short maturity Risk free asset

Stocks are much riskier Bond’s riskiness is between T-bills and Stocks

Why Do We Demand a Higher Return Investors seem to dislike risk (ex. insurance)

Risk Averse If the expected return on T-Bills (risk-free), is

10%, and the expected return for Ford is 10%, which would you buy?The 10% offered by T-Bills is guaranteed while

this is not the case for FordA guaranteed 10% dominates a possible 10%

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Return Breakdown

A risky asset’s return has two components:Risk free rate + Risk premium

Risk free rate: The return one can earn from investing in T-Bills

Risk Premium: The return over and above the risk free rateCompensation for bearing risk

Average Risk Premiums (1926-2005)

Small company stocks : 17.4% – 3.8% = 13.6%

Large company stocks : 12.3% – 3.8% = 8.5%

Long-term corporate bonds : 6.2% – 3.8% = 2.4%

The more risk the larger the risk premium

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The Risk-Return Tradeoff

2%

4%

6%

8%

10%

12%

14%

16%

18%

0% 5% 10% 15% 20% 25% 30% 35%

Annual Return Standard Deviation

Ann

ual R

etur

n A

vera

ge

T-BondsT-Bills

Large-Company Stocks

Small-Company Stocks

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Quick Quiz

Which of the investments discussed has had the highest average return and risk premium?

Which of the investments discussed has had the highest standard deviation?

Why is the normal distribution informative? What is the difference between arithmetic and

geometric averages?

Why we care?

This is the very basics of investing General knowledge that “finance” people

possess

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