Transcript Chpt13
Chapter 13
Efficient Capital Markets
Two Views on Capital Market Efficiency:
• “ . . . in price movements . . . the sum of every scrap of
knowledge available to Wall Street is reflected as far as the
clearest vision in Wall Street can see.”
Charles Dow, founder of Dow-Jones, Inc. and first editor of The
Wall Street Journal (1903)
• “In an efficient market, prices ‘fully reflect’ available
information.”
Professor Eugene Fama, financial economist (1976)
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Efficient Capital Markets
Capital Markets Informational Efficiency:
Asset prices fully reflect all relevant information.
Question: What is the set of “relevant information”?
Three Theories (Hypotheses)
• Markets are weak form efficient
• Markets are semistrong form efficient
• Markets are strong form efficient
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What is the set of “Relevant Information”?
3 Forms of Market Efficiency:
I Weak Form:
Relevant information includes just historical information
(e.g. historical prices, past dividends, etc...).
Implications:
– Security prices already reflect all historical info.
– We say that security prices follow a random walk (the
relationship between today’s price and yesterday’s price is
random).
– Knowing historical data cannot be used to price securities
more efficiently than the market.
– Investors can’t make abnormal profits using historical data.
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What is the set of “Relevant Information”?
II Semistrong Form:
Relevant information is all historical info + all relevant
public info (e.g. firm financial statements, dividend
announcements, inflation rates, etc..)
Implications:
– Security prices already reflect all that info.
– Knowing this info cannot be used to price securities more
efficiently than the market.
– Investors can’t make abnormal profits by using it.
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What is the set of “Relevant Information”?
IIIStrong Form:
Relevant information is all historical and public info + all
relevant private info (e.g. insider info).
Implications:
– Security prices already reflect all that info.
– Knowing this info cannot be used to price securities more
efficiently than the market.
– Investors can’t make abnormal profits by using it
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Relationship among Three Different Information Sets
All information
relevant to a stock
(inc. private info)
Information set
of publicly available
information
Information
set of
past prices
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Market Efficiency - Examples
Technical Analysts & Chartists
• Believe in weak form inefficiency:
They look for patterns in past stock prices and trading volumes,
in order to predict the (near) future and make abnormal returns
in the short-run.
• Fundamental Analysts
Believe in semistrong form inefficiency:
They make forecasts of future earnings and dividends, in order
to project future stock prices and returns.
• Insider Trading Violators
Believe in a strong form inefficiency.
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Efficient Capital Markets : Evidence & Findings
I Weak Form
Can you earn Abnormal Returns, using historical info?
Definition:
• Abnormal Returns (AR):
ARt = return in day t - normal return
Findings:
• In general the market is weak form efficient:
For daily returns - today’s excess return is not related to past
excess returns
r(ARt, ARt-1) = 0
• Evidence of Exceptions (Anomalies):
– For consecutive transactions: r(ARt, ARt-1) 0
– End of The Year effect: ARDec < 0 and ARJan > 0
– Friday The 13th effect: ARFri, 13 < 0
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II Semistrong Form
Do stock prices compound all public available info?
Events Studies Tests:
Examine Announcements of events known to have a price effect. If
the market is semistrong form efficient, prices will adjust immediately
Events & Findings:
AR 0
Dividend increase
Stock repurchase
AR 0
Floating new shares
AR 0
Takeover announcements (target firm)
AR 0
Insider holding increase
AR 0
Conclusion:
In general Markets are semi-strong form efficient
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Reaction of Stock Price to New Info in Efficient and Inefficient Markets
Stock
Price ($)
Overreaction and
correction
Delayed reaction
Efficient market reaction
–8 –6 –4 –2
0
+2 +4 +6 +7
Days relative
to announcement day
Announcement day
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III Strong Form
Can private info be used to beat the normal return?
3 types of traders have been examined:
(a) Insiders (CEO`s, Board of Directors, large shareholders)
By law: cannot use confidential undisclosed info.
Findings:
• Insiders earn positive excess returns
(b) Stock Exchange Specialists
Earn abnormal returns consistently
(c) Mutual Fund & Pension Fund Managers
Do not outperform the normal returns.
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Implications of an Efficient Capital Market for Corporate
Financial Managers
Financial managers cannot “fool” investors by changing accounting
practices
Financial managers cannot “time” security sales
There are no price pressure effects when a firm sells many
bonds/shares
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