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Chapter 10:Market Efficiency and
Behavioral Finance
Corporate Finance, 3eGraham, Smart, and Megginson
© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.
Efficient Financial Markets
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Informational efficiency The efficient markets hypothesis (EMH)
asserts that financial asset prices fully reflect all available information.
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Forms of Market Efficiency
Weak-form efficiency:Prices will be unpredictable and will
change only in response to new information.
This means prices follow a random walk.
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Forms of Market EfficiencySemistrong-form efficiency
Asset prices incorporate all publicly available information
The level of asset prices should correctly reflect all pertinent historical, current, and predictable future information obtainable from public sources.
Asset prices should change fully and instantaneously in response to relevant new information.
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Semistrong-Form Efficiency and Fundamental Analysis Recall the definition of efficient markets: In an efficient
market, prices rapidly incorporate all relevant information.
Semi-strong form efficiency uses “all public information” as its definition of “information.”
Prices move so fast in response to public information that trading on it profitably is nearly impossible!
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The Strong Form of Market Efficiency
Prices should reflect all information, public and private.
Usually tested by seeing if corporate insiders earn superior returns on their trades in company stock
Evidence suggests insiders can “beat the market.”
Insiders’ decision to trade at corporate level may be informative.
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Empirical Evidence on Market Efficiency
Tests for return predictabilityTests of simple trading rules Tests of the effectiveness of technical analysis Tests for return continuations or reversalsTests of the performance of newly issued
sharesHigh initial IPO returns followed by subpar longer-
term performance
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Tests for Rapid Price Adjustment
Event studyEvent time rather than calendar time
Firms that split their stock do so after an extended period when their stock earns above-market returns.
After the split stock earns returns roughly equal to those of the overall market.
Markets are efficient: investors who buy shares after split announcements do not earn above-market returns.
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Tests for Private Information
Tests of the Profitability of Insider Trading
Tests of Mutual Fund Investment Performance
Selectivity Timing
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Tests for Private Information
Tests of Pension Fund and Hedge Fund Investment Performance
Tests of the Stock-Picking Abilities of Security Analysts
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Behavioral finance: financial markets are irrationally volatile traders in financial markets are human
beings subject to all the foibles and fads of human judgment in other spheres of life.
Human errors do not simply “cancel out” in markets, but cause prices to deviate far from “fundamental value” in ways that market competition does not immediately eliminate.
The Behavioral Finance Critiqueof Market Efficiency
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The Behavioral Finance Critiqueof Market Efficiency
An information cascade occurs when a piece of “information” rapidly travels through a large group of market participants, influencing trading behavior and being accepted as correct—whether it is or not. All three of these phenomena, if they in
fact exist, are inconsistent with market efficiency.
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Behavioral Finance Argues that market participants suffer from
systematic psychological biases that result in suboptimal decisions
Investors underreact to new information that contradicts prior beliefs (e.g., dramatic
change in earnings).Investors overreact to a string of similar
information (e.g., investors expect recent trends to continue).
Investors are overly confident in their ability to identify misvalued stocks.
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-5 -4 -3 -2 -1 0 +1 +2 +3 +4 +5 Time (months)
0
Cum
ulat
ive
Abn
orm
al R
etur
n
The line that is going upward is showing the returns on a group of
stocks that have (in month 0) reported unexpectedly
high earnings. The line that is trending
down is showing the returns on a group of
stocks that have (in month 0) reported unexpectedly
low earnings.
Stock Price Momentum
Investors are underreacting to the recent good (bad) earnings news.
Subsequent news after the announcement continues to be good (bad), so investors didn’t fully realize how good (bad) the initial announcement was.
The Underreaction Phenomenon
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The Overreaction Phenomenon
The line that trends up and then reverses represents
returns on stocks that have performed very well for the last several years, and vice
versa for the other line.
-5 -4 -3 -2 -1 0 +1 +2 +3 +4 +5 Time (years)
0
Cum
ulat
ive
Abn
orm
al R
etur
n
Stock Price Momentum
The time period we are looking at here is long (several years) and investors are overreacting to a perceived long-term trend.
This is distinct from the previous slide where investors were (over a much shorter time span) underreacting to brand new information.
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Theoretical Underpinnings of Behavioral Finance
There is no fully developed model of behavioral finance, but behaviorists have explained how markets might be less than fully efficient.
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Assessing Behavioral Finance and Market Efficiency Behaviorists present persuasive evidence that
price bubbles occur, and somewhat less compelling evidence that the U.S. stock market was grossly overvalued near the turn of the century.
On balance, investors and managers are wise to take the efficient markets hypothesis seriously.
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What Does Market Efficiency Imply for Corporate Financing?
How do markets process accounting and other information releases?
How do markets respond to corporate financing announcements?
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Communication StrategyHow can managers devise a
corporate “communications” policy?Assume that your words and actions
have consequences.Assume that loose lips sink corporate
ships.Consider honesty to be the best policy.Listen to your stock price.
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