Transcript TITLE HERE - Texas Tech University

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 move
 Surprises
cause unexpected returns
2
Breaking Returns Down

A security’s return is comprised of:
1.
2.

The expected return, based on expectations
The un-expected return, based on surprises
Therefore, a stock’s return is:
R  R U
where
R is the expected part of the return
U is the unexpected part of the return
3
Breaking Returns Down (2)
We defined returns as: R  R  U
 We can break U down further: R  R  m  
 m is the return earned because of unexpected
movements in the economy
  is the return from firm specific surprises

4
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
5
Underlying Assumption

The assumption underlying our discussion, is
that the stock is priced in an efficient market
6
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 (+/-)
7
Price: Today and Tomorrow
Do you see a pattern
that you want to put
money on?
8
Reactions to Beating Expectations
Over Reaction
Under Reaction
Efficient Response
9
Reaction to Not Meeting Expectations
Under Reaction
Efficient Reaction
Over Reaction
10
Potential Causes of Efficient
Markets

Investor Rationality
 Everyone
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
11
from less smart money
Types of Efficient Markets
Strong
Semi-Strong
Weak
12
Weak Form Efficiency

Prices reflect all information contained in past
prices and volumes
 No
investor is able to form a trading strategy based
on historic prices and volumes and earn an excess
return
13
Disbelievers

Chartists, or Technical Analysts
 Analyze

Chartist believe in identifiable and predictable
patterns in these characteristics
 Make

“charts” of a stock‘s Price and/or Volume
investment decisions based on these patterns
Brokerage firms tend to love chartists
14
Head and Shoulders
15
Stock Price
Why Technical Analysis Fails
-If there is a profitable
pattern, everyone would do
it
Sell
Sell
Buy
Buy
Time
-If everyone follows the
same strategy competition
will eliminate any
opportunity associated with
the pattern
Semi-Strong Form Efficiency

Security prices reflect all publicly available
information.
 Encompasses

weak form efficiency
Publicly available information includes:
 Historical price
 Published
and volume information
accounting statements
 Information
found in the WSJ
17
Disbelievers

Fundamental Analysts
 Use
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?
18
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
& Private
 Implies:

Insider trading will not earn excess return
Strong form efficiency incorporates weak and
semi-strong form efficiency.
19
Disbelievers
Pretty much everyone
 Insiders trading is generally profitable

 Galleon

Raj Rajaratnam
 Martha
Stewart
20
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
21
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

22
The Evidence

The record on the EMH is extensive,
and generally supportive of the market
being semi-strong form efficient
23
Event Studies
 Event
Studies examine returns around
information release dates
 EX:
Earnings, Dividend announcements
 A test of semi-strong form efficiency
 Look
at how quickly prices adjust to the
information
 Looking
for under-reaction, over-reaction, early
reaction, or delayed reaction around the event.
24
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.

25
Cumulative abnormal returns
(%)
Event Studies: Dividend Omissions
Cumulative Abnormal Returns for Companies Announcing
Dividend Omissions
1
0.146 0.108
-8
-6
0.032
-4
-0.72
0
-0.244
-2 -0.483 0
-1
2
-2
-3
-3.619
-4
-5
4
6
8
Efficient market
response to “bad news”
-4.563-4.747-4.685-4.49
-4.898
-5.015
-5.183
-5.411
-6
Days relative to announcement of dividend omission
26
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
27
Mutual Fund Performance
All funds
Smallcompany
growth
Otheraggressive
growth
-2.13%
Growth
Income
-0.39%
-2.17%
Growth and
Maximum
income
capital gains
Sector
-1.06%
-0.51%
-2.29%
-5.41%
-8.45%
Taken from Lubos Pastor and Robert F. Stambaugh, “Mutual Fund Performance and
Seemingly Unrelated Assets,” Journal of Financial Exonomics, 63 (2002).
28
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 profits
 Violation
of Strong form efficiency
29
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.

30
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.
31
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
32
Why We Care

Offering several points of view on how the
market works, and the evidence for and against
 Using
this you can form your own opinion about
how the market works and invest accordingly
33
Risk and Return
Primer
Expectations
Expected value (μ) is weighted sum of possible
outcomes
 E(X) = μ = p1X1 + p2X2 + …. psXs

 E(X) – Expected value of X
 Xi – Outcome of X in state i
 pi – Probability of state i
 s – Number of possible states
 Probabilities have to sum to 1

p1 + p2 + …..+ ps = 1
35
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
36
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
37
What is risk?
Uncertainty
38
Measuring Risk
 There
is no universally agreed-upon
measure
 However,
variance and standard deviation are both
widely accepted measures of total risk
39
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 outcomes

 More
uncertainty
40
Different Variances
41
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 samples
 BUT each give very different answers with small
samples

Ex. s=3
σ2 = p1 * (X1 – μ)2 + p2 * (X2 – μ)2 + p3 * (X3 – μ)2
42
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%

43
Calculations
Expected Return =
Variance =
Standard Deviation =
44
Calculations
Expected Return = p1X1 + p2X2 + p3X3
= 0.2*0.20+0.3*0.05+0.5*(-0.09) = 0.01
Variance =
Standard Deviation =
45
Calculations
Expected Return = 0.01
Variance = 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 =
46
Calculations
Expected Return = 0.01
Variance = 0.0127 =127 (%)2
Standard Deviation = √ σ2
√0.0127 = 0.113 = 11.3%
47
Historical Data

In practice we do not know all of the possible
states of the world, so we use historical data to
form expectations
 Idea:
Look at what has happened in the past and
we can calculate the mean and variance

What is each states probability of occurring?
48
Risk Example 2



1996
1997
1998
1999
2000
20%
15%
-5%
5%
10%
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%
49
Risk
A risky asset is one in which the rate of return
is uncertain.
 Risk is measured by ________________

50
Risk
A risky asset is one in which the rate of return
in uncertain.
 Risk is measured by standard deviation.
 higher σ → more uncertainty

51
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

52
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 Ford
 A guaranteed 10% dominates a possible 10%
53
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 rate
Compensation for bearing risk

54
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
55
The Risk-Return Tradeoff
18%
Small-Company Stocks
Annual Return Average
16%
14%
Large-Company Stocks
12%
10%
8%
6%
T-Bonds
4%
T-Bills
2%
0%
5%
10%
15%
20%
25%
30%
35%
Annual Return Standard Deviation
56
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?

57
Why we care?
This is the very basics of investing
 General knowledge that “finance” people
possess

58