Transcript Slide 1

CHAPTER 11
The Efficient
Market
Hypothesis
Investments, 8th edition
Bodie, Kane and Marcus
Slides by Susan Hine
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Efficient Market Hypothesis (EMH)
• Do security prices reflect information?
– Yes
• Why look at market efficiency?
– Implications for business and corporate
finance
– Implications for investment
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Figure 11.2 Stock Price Reaction to
CNBC Reports
• Impact on Stock prices
from news reports
• This is one type of EMH
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Efficient Market Hypothesis (EMH)
• Why look at market efficiency?
» Models need solution concept to generate predictions
(positive tests of theory).
– Implications for business and corporate
finance
– Implications for investment
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Figure 11.1 Cumulative Abnormal
Returns Before Takeover Attempts:
Target Companies
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EMH and Competition
• Stock prices fully and accurately reflect
publicly available information
• Once information becomes available,
market participants analyze it
• Competition assures prices reflect
information
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Competition as source of EMH
• If prices reflect “all available information”,
why use resources on information
gathering?
– Bottom line: invest in information to the extend
that it increases expected return
• In any market equilibrium:
– efficient information gathering should be fruitful
(i.e. increase expected returns)
– Gains (on info) can be very high:
• .05% increase in expected return for a $10 billion fund results in $5million
enough to pay high salaries to many finance analysts
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Versions of the EMH
• Weak
– Stock prices already reflect all information that can
derived by examining market trading data
• E.g. history of past prices, trading volume, so on.
• Semi-strong
– “…” all publicly available information regarding the
prospects of firm.
• E.g. same info as before plus, how good is
management, balance sheet composition, patents
held, earning forecasts, accounting practice
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Versions of the EMH
• Strong
– Stock prices already reflect all information relevant
to firm prospects, including information only
available to insiders
• As it is clear, Weak and semi-strong have
more support, strong efficiency have less
support.
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Types of Stock Analysis
• Technical Analysis - using prices and volume
information to predict future prices
– Weak form efficiency & technical analysis
• EMH imply that technical analysis is
without merit
– Information that is both public and has little
cost should already be incorporated on stock
prices
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Self-destructing
• A procedure that “seems to work” (i.e. increase
rates of returns) will continue to work in the
future?
• The test of EMH is if prices reflect information.
Once a useful procedure that “works” is
discovered, it ought to be invalidated as more
traders starts using it.
– Price patterns are “self-destructing”
– Any “beat the market” procedure that is known, will
tend to be invalidated
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Types of Stock Analysis
• Fundamental Analysis - using economic and
accounting information to predict stock prices
i.
analysis of Industry or Sector
Industry is growing (media companies = turbulent earning prospects)
ii.
analysis of companies financials, its management
effectiveness, competitive advantage
Apple
iii.
analysis of economy of country (or global)
•
In summary: Warren Buffet’s job
– Semi strong form efficiency &
fundamental analysis
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Active or Passive Management
• Active Management
– Security analysis
– Timing
• Passive Management
– Buy and Hold
– Index Funds
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Market Efficiency & Portfolio
Management
Even if the market is efficient a role exists for
portfolio management:
• Appropriate risk level
– (Solve problem: one risky asset and one risk-free)
• Tax considerations
– (to maximize the risk-free rate)
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