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Transcript of the Efficient Marke
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BM410 Investments
The Efficient MarketHypothesis
orIs there really a free lunch?
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Objectives
R. Review Portfolio Theory up to today
A. Understand the efficient market
hypothesis and why securities pricesshould 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
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Review of Financial Theory
What we have discussed
A two asset portfoliowith leverage
Modern Portfolio Theory
The development of the efficient frontier
The efficient frontier with CALs
CAPM, and its movement toward Beta
APT
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E(r)
E(rp) = 15%
rf= 7%
= 22%0
P
F
P
) S = 8/22
E(rp)- rf= 8%
CAL:
(Capital
Allocation
Line)
Two Assets and the CAL
Slope: Reward to variability ratio: ratioof risk premium to std. dev.
Risk premium
This graph is the risk return combination available by choosing different valuesof y. Note we have E(r) and variance on the axis.
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r = 0
E(r)
r = 1r = -1
r = -1
r = .3
13%
8%
12% 20%St. Dev
TWO SECURITY PORTFOLIOS WITHDIFFERENT CORRELATIONS
MPT: The Impact of Correlation
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E(r)
The minimum-variance frontier of risky
assets
Efficientfrontier
Globalminimum
variance
portfolio Minimum
variancefrontier
Individual
assets
St. Dev.
The Efficient Frontier
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E(r)
CAL (Globalminimum variance)
CAL (A)CAL (P)
M
P
A
F
P P&F A&FM
A
G
P
M
s
The Efficient Frontier with CALs
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E(r)
E(rM)
rf
SML
M
= 1.0
CAPM and The Security Market Line
Notice that instead of using standarddeviation, the SML uses Beta
SML Relationships
b = [COV(ri,rm)] / sm2
Slope SML = E(rm)rf = market risk
premium
SML = rf + b[E(rm) - rf]
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CAPM: Expected Return
Beta Relationship
Expected return - beta relationship
E(rM) - rf = E(rs) - rf
1 bsIn other words, the expected rate of return of an asset
exceeds the risk-free rate by a risk premium equal
to the assets systematic risk (its beta) times the riskpremium of the market portfolio. This leads to thefamiliar:
E(rs) = rf + bs [E(rM) - rf ]
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APT and the
Security Characteristic Line
Excess Returns (i) SCL
.
.
...
.
. .
. ..
. . .. .
. ..
..
.
. .
. ..
...
. .
..
.
. . .. .
.
. ... .. .. .
Excess returns
on market index
Ri= a i+ iRm+ ei
Plot of a companys excess return as a
function of the excess return of the market
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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
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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
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Degrees of Informational Efficiency
Weak form
Stock prices reflect all information contained in the
history of past tradingno benefit from past prices
Semi-strong form Stock prices reflect all publicly available
informationno benefit from 10Ks, 10Qs, etc.
Strong form
Stock prices reflect all relevant information,
including past, public, and inside informationno
benefit from any insider information
SF SSF
Weak Form
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What is a Random Walk?
The notion that stock prices are random and
unpredictable
Since information comes randomly, then itsimpact 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 and the EMH
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SecurityPrices
Time
Random Walk with Positive Trend
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Efficient Markets Hypothesis
and Competition
Stock prices 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 reflectinformation, as securities will be bought and
sold until the point that all new information
is embedded in the price
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Are there Other Theories?
Semi-efficient market hypothesis (among
others)
A cousin of the EMH
States that some stocks are priced moreefficiently than others
This is generally used to support the notion of
tiering in the markets
Analysts can only follow so many stocks, sothey follow the largest
The smaller are less followed, and hence are
more likely to be less-efficiently priced
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Questions
Any questions of the Efficient Market
Hypothesis and why stock prices should
be unpredictable?
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Problem #1
Which of the following most appears tocontradict the proposition that the stockmarket is weak-form efficient? Explain.
A. Over 25% of mutual fundsoutperforms the markets on average.
B. Insiders earn abnormal trading profits
C. Every January, the stock market earnsabove normal returns.
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Answer #1
c. Predictable returns should not
occur according to the weak-form
efficient market hypothesis. Higherthan average returns in the month of
January each year contradicts the
weak-form EMH.
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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 andaccounting information to predict stock prices
Violates semi-strong form efficiency
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Active Management
If markets are efficient, then it depends on the
degree of efficiency
Security analysis assumes you can add even alittle bit of value
It doesnt have to be too much if you are
managing a large fund
Timing assumes you can make decisionsregarding the attractiveness of various asset
classes
Implications of EMH Efficiency
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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 cant beat them, join them
mimic a broad benchmark of
securities, i.e. the S&P 500
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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
Market Efficiency and Portfolio
Management
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Questions
Do you understand how the implications
of the EMH will affect trading
strategies?
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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 portfoliomanagement.
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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.
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How are tests made of the Efficient
Market Hypothesis?
Most common are:
Performance Attribution: Assessing
performance of professional managers
Testing of filter / trading rules
Event studies
C. Understand Empirical Tests
of Market Efficiency
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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.)
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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 45day 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
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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 resultsSee how well your actual results were predicted
by your model
Event Studies
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Event Studies(continued)
Results of Event Studies:
If the results are good, you invest money with
the testyou 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 dont know any better
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0 +t-t
Announcement Date
Returns Surrounding the Event
Event Studies(continued)
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Key Issues:
Magnitude Issue
A 1 basis point improvement for a $100K
portfolio is much less important than for a $10bnportfolio
Size matters
Selection Bias Issue
Investment schemes that dont work arepublished, and those that do are used to make
money
We only hear of those that dont work
Final Thoughts on
Market Efficiency
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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
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Market Efficiency (continued)
What Does the Evidence Show?
If it sounds too good to be true, itusually is
It must make good common businesssense
Common sense is all too uncommon
Technical Analysis May be helpful for certain events
But generally hasnot shownexcessreturns for a longer period of time
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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.
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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?
D. Understand Anomalies
to the EMH
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Anomalies(continued)
Price Earnings Effect
Portfolios 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.
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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 windowdressing 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
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Anomalies(continued)
Liquidity Effect
Less liquid stocks sometimes perform better than
more liquid stocks
Investors may require a higher return premiumto 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)
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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
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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
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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.
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Answer #3
d). A market anomaly refers to price
behavior that differs from the behavior
predicted by the efficient market
hypothesis.
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Questions
Do you understand the tests of market
efficiency and can you cite evidence that
supports or contradicts the EMH?
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Problem #4
Prices of stocks before stock splits show
on average consistently positive
abnormal returns. Is this a violation of
the EMH?
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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.
Fi l Th h
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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!!!!!!!
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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 thatmake 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?