16-1 copyright 2009 mcgraw-hill australia pty ltd ppts t/a business finance 10e by peirson slides...

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Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by PeirsonSlides prepared by Farida Akhtar and Barry Oliver, Australian National University

Chapter 16

Capital Market Efficiency

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Learning Objectives• Understand the concept of market efficiency.

• Distinguish between different categories of market efficiency.

• Understand the methods used to test for market efficiency.

• Understand the major trends in tests of market efficiency that have uncovered evidence that is ‘anomalous’ from a market efficiency viewpoint.

• Understand the implications of the developing field of behavioural finance for the efficient market hypothesis.

• Understand the implications of market efficiency for investors and financial managers.

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Efficient Market Hypothesis (EMH)• ‘EMH’: that the price of a security (such as a share)

accurately reflects all available information.

• If the market processes new information efficiently, the reaction of market prices to new information will be instantaneous and unbiased.

• The concept of efficient markets with respect to information was introduced by Fama (1970).

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Different Price Reactions• An non-instantaneous price reaction.

• An instantaneous price reaction would, in practice, mean that after new information becomes available, it should be fully reflected in the next price established in the market.

• If the market often fails to react instantaneously, what simple rules can share traders follow to generate excess profits?

• A Biased Price Reaction

• Overreaction– A biased response of a price to information in which the

initial price movement can be expected to be reversed.

• Underreaction– A biased response of a price to information in which the

initial price movement can be expected to continue.

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Categories of Capital Market Efficiency• The EMH implies that investors cannot earn abnormal

returns by using information that is already available.

• The market may be efficient with respect to some sources of information, but not with respect to others.

• Fama (1970) provided a useful classification of market efficiency:– Weak-form efficiency — the information contained in the

past sequence of prices of a security is fully reflected in the current market price of that security.

– Semi-strong-form efficiency — all publicly available information is fully reflected in a security’s current market price.

– Strong-form efficiency — all information, whether public or private, is fully reflected in a security’s current market price.

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• The information content associated with each successive classification is cumulative.

• The implication of strong-form efficiency is that an investor cannot earn abnormal returns from having inside information. If this were true, investors would have no incentive to seek information.

• Paradox: the capital market can be efficient only if at least some investors believe it to be inefficient.

• However, if the market is less than strong-form efficient, there are incentives for investors to seek information.

Categories of Capital Market Efficiency (cont.)

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• Fama (1991) — classifies capital market efficiency by the research methodology used to evaluate efficiency.

– Tests of returns predictability — can future returns be predicted on the basis of past information?

– Event studies — analyse the behaviour of security returns around a significant event such as profit/dividend announcement or takeover bid.

– Tests for private information — test if investors can systematically profit from investments based on non-public information.

Categories of Capital Market Efficiency (cont.)

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Market Efficiency and the Joint Test Problem

• Testing for market efficiency involves testing for abnormal returns.

• We use an asset pricing model, such as the CAPM, to determine normal or expected returns.

• Deviations from this are classified as abnormal and could be due to market inefficiency.

• Joint test problem arises because of the possibility that the underlying asset pricing model may be incorrect.

• What appear to be abnormal returns due to market inefficiency may be due to a misspecification of the asset pricing model.– For example, the correct asset pricing model may be the

Fama and French (1996) three-factor model.

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Tests of Return Predictability• In an efficient market, investors should not be able to

earn abnormal returns by predicting future price movements.

• Three aspects of return predictability are:1. Relationship between past and future returns — in an

efficient market, all information in past prices should be reflected in current prices.

2. Seasonal effects in returns — returns should not be related to the time at which they are earned, this would lead to return predictability.

Examples include, time of year, month, week and even time of day.

3. Predicting returns on the basis of some other forecast variable — should not be able to earn abnormal returns by selecting stocks based on company size, book-to-market ratio, dividend yield or some other variable.

Excess returns associated with such factors can be treated as risk premiums.

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Relationship between Past and Future Returns• Short-term patterns

– Early tests focused on random walk hypothesis — too strict requirement to show market efficiency.

– A common method is to test for serial correlation.

– Serial correlation tests Measure the correlation between successive price

changes or, more frequently, the correlation between yields in one period and yields in a prior period.

Run tests.

Act as an alternative test for independence.

Examine the sign of price changes, or yields, during a specified sample period.

– In general, tests for patterns suggest that successive price changes (yields) are uncorrelated.

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Relationship between Past and Future Returns (cont.)

• Short-term patterns (cont.)– US evidence is mixed:

Lo and MacKinlay (1988) find positive serial correlation in weekly returns.

A re-examination of more recent data by Lo and MacKinlay (1999) finds the result is no longer as strong as previously found.

– Australian evidence is that returns are more predictable over shorter periods.

– Brailsford and Faff (1993) find positive serial correlation in daily returns for top 50 stocks on ASX.

– Brailsford (1995) examines returns over 5-minute intervals within a trading day — strong evidence of positive serial correlation.

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Relationship between Past and Future Returns (cont.)

• Long-term patterns– Another group of researchers have suggested that there

may be other kinds of inefficiency that will be detected only by taking a long-term view.

– Pricing errors that are eliminated so slowly that it could take years for the market to eliminate the errors.

– Fama and French (1988) find evidence of this kind of behaviour in stock returns.

– Jegadeesh and Titman (1993) find evidence of long-run serial correlation.

– Several studies have found evidence of long-run share return reversals: Lee and Swaminathan (2000) and Jegadeesh and Titman (2001) for the US, and Brailsford (1992) and Allen and Prince (1995) for Australia.

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Presence of Seasonal Effects in Returns

• Monthly share price patterns:– US — the average return in January is more than five times

larger than the average returns in the other 11 months.

– Australia — December and January together contribute more than half the yearly return.

– Possible explanation of ‘tax loss selling’: Investment strategy in which the tax rules make it

attractive for an investor to sell certain shares just before the end of the tax year.

– Turn-of-the month effect: On average, share prices increase abnormally at the start of

each month. Evidence of such effects in the US, Australia, UK, Switzerland

and West Germany.

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Presence of Seasonal Effects in Returns (cont.)

• Daily share price patterns

– US average returns — negative on Mondays and positive on Fridays.

– Recent evidence for US shows Monday provides best return and Thursday provides worst return — Rubenstein (2001).

– Australia — Thursdays positive, Tuesdays negative.

– Recent evidence that negative Tuesday return has disappeared.

– Large positive average returns on the days preceding public holidays.

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Presence of Seasonal Effects in Returns (cont.)

• Intraday share price patterns

– Evidence of systematic returns during the trading day.

– Hodgson (1992) finds positive returns in opening and closing trading intervals (10 minutes) and negative returns mid-morning and afternoon.

– Positive return on opening may be result of overreaction to news released during market’s closure.

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Predictions Based on Other Forecast Variables• Size effect or small-firm effect

– The observation that returns on the shares of small companies exceed the returns on the shares of larger companies both before and after adjusting for beta risk.

– Cause of the size effect is still unclear.

• The dividend yield effect

– Dividend yield = dividend per share/the share price.

– Beta-adjusted returns are found to be higher, the higher the dividend yield.

– That is, there appears to be a relationship between returns and dividend yields that cannot be explained by the capital asset pricing model.

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Predictions Based on Other Forecast Variables (cont.)• Price–earnings effect

– Price–earnings ratio = share price/earning per share

– The P/E effect — even after adjusting for beta, there is a relationship between share returns and P/E ratios.

– In Australia — P/E effect appears to be weaker but has been documented for larger companies.

• Book-to-market effect

– Book-to-market ratio — book value of a company's equity divided by market value of the company’s equity.

– Book-to-market effect — even after adjusting for beta risk, there is a relationship between share returns and book-to-market ratios.

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Predictions Based on Other Forecast Variables (cont.)• Book-to-market effect (cont.)

– Fama and French (1992) found that companies with low book-to-market ratios tended to earn low returns, while companies with high book-to-market ratios tended to earn high returns.

– Recent Australian evidence is mixed — Halliwell, Heaney and Sawicki (1999) finding no effect, while Faff (2001) using a later sample finds evidence of the book-to-market effect.

• Over the past decades, increasing number of researchers have begun to study reports of return predictability of managed investment funds.

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Event Studies• Efficient market hypothesis requires security prices to

adjust instantaneously to an event, such as a public announcement.

• Research testing whether there are any post-event abnormal returns.– Such a test is generally called an event study: a research

method that analyses the behaviour of a security’s price around the time of a significant event such as the public announcement of the company’s profit.

• Methodology– Basic questions to be answered for an event study:

What is the (new) information? When was it announced? Were there abnormal returns associated with its

announcement?– Each of these questions will be considered using the

announcement of annual profit as an example.

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Event Studies: Methodology (cont.)• The standard market model:

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Tests for Private Information• Strict view of EMH requires that abnormal returns be

unavailable even to investors who have private (inside) information about a company.

• However, it is effectively impossible to identify the date on which private information becomes available.

• Event study methodology cannot be applied directly to studies of private information and the EMH.

• One less direct test of strong-form efficiency involves identifying those investors who might be assumed to have access to private information, and then determining whether they earn abnormal returns!

• Evidence relating to both Australia and the US supports the conclusion that neither market is strictly (strong-form) efficient.

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Behavioural Finance and the EMH • Behavioural finance — study of human fallibility in

competitive markets. Behavioural finance suggests that arbitrage is risky when market participants are behaving irrationally.

• This irrational behaviour can arise from a belief that a share price will continue to rise (fall) and if it is not purchased (sold) immediately a profit (loss) will be forgone (ensured).

• Market sentiment plays a role in market inefficiency.

• This type of behaviour can lead to the formation of what is often referred to as asset price bubbles.

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Behavioural Finance and the EMH (cont.)

• Price bubbles — Share prices might display bubbles:

– Prices show a strong tendency to rise for a period, possibly followed by a decrease, which may be quite sudden.

– As a result, the price departs from the true, fundamental value of the asset.

• Whether price bubbles occur is a controversial issue.

• Bubbles can be rational if there is a belief of high and increasing future profits. These beliefs justify rising share prices.

• If there is a change in expectations, such as profits not materialising or growing, the share price will fall dramatically.

• Surveys of behavioural finance framework can be found in Shleifer (2000), Hirshleifer (2001) and Shiller (2002).

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Behavioural Finance and the EMH (cont.)

• Fama (1998) defends EMH against behavioural finance criticisms:– Price over-reactions and under-reactions are as common

as each other — consistent with EMH.

– Many results indicating market inefficiency are methodology-driven and, as such, are not true reflections of inefficiency.

– Substitute for EMH requires a theory of price formation that can be tested.

• Implications of evidence on EMH– Suppose that notwithstanding the evidence on anomalies,

the stock market is semi strong-form efficient.

– Then there are clear implications for investors in securities and for financial managers.

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Implications of the EMH for Investors in Securities• Charting or technical analysis

– Plotting a share’s historical price record on a chart and then using this as the basis for predictions as to the likely future short-term course of prices.

– However, the alleged benefits of this type of analysis are dubious.

– Batten and Ellis (1996) find that for Australian shares, technical trading rules did not deliver abnormal returns after transaction costs.

– Lo, Mamaysky and Wang (2000) find small positive returns in US data.

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Implications of the EMH for Investors in Securities (cont.)

• Fundamental analysis

– Based on the belief that the market either ignores some publicly available information, or systematically misinterprets that information.

– Therefore, careful analysis of available information may reveal mispriced securities and, therefore, excess returns can be made by the skilled fundamental analyst.

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Implications of the EMH for Investors in Securities (cont.)

• Random selection of securities

– While the EMH asserts that all securities are ‘correctly’ priced, given the information available, this does not imply that investors should select their investments randomly.

– A randomly-chosen portfolio is likely to have a similar risk to the market portfolio; however, this may not suit the risk preferences of the investor.

– Investors should also consider their tax position when selecting investments, which is unlikely to be suitable if investments are selected randomly.

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Implications of the EMH for Investors in Securities (cont.)• Buy-and-hold policies

– A strategy in which shares are bought and then retained in the investor’s portfolio for a long period.

– Barber and Odean (2000, 2001) find support for buy and hold — their study finds 20% of households that trade most regularly earn 8% lower return than the average for whole sample.

– An inflexible buy-and-hold policy is not optimal.

Portfolio will need to be rebalanced at times because as share prices change over time, so will the risk of the portfolio, possibly diverging from the investor’s desired risk level.

Some investors may also come upon private information about a company, which if acted upon, will yield excess returns.

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Implications of the EMH for Investors in Securities (cont.) • Beating the market

– In a market that is semi strong-form efficient, it is not sensible for the average investor to try to beat the market.

– Only if an investor has private information does beating the market become a possibility.

– Most investors should adopt a long-term view, hold a diversified portfolio, and trade infrequently.

– The popularity of passive investment (index) funds arises from the EMH and a perception that investors cannot beat the market and instead try to replicate market returns.

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Implications of the EMH for Financial Managers

• Project selection

– If investing in a project really does increase the company’s ‘true value’, the company’s share price should reflect this fact when the information becomes available to the market.

• Communicating with the stock market

– Announcements are important as they convey information, as suggested by the ASX continuous disclosure rules.

– Managers must expect that announcements will elicit a price response that represents the market’s collective view of the true situation and is not a mechanical response.

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Implications of the EMH for Financial Managers (cont.)

• Using share price as a measure of company performance:

– In an efficient market, the current share price is the best available estimate of a company’s ‘true value’.

– Past share prices should reflect past performance of the company, its profits and dividends.

– The price behaviour is likely to be related to management and its actions but may also arise out of exogenous factors.

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Implications of the EMH for Financial Managers (cont.)• Issuing new securities

– Pricing the security:

If the market is efficient and new shareholders are charged the market price, the wealth of existing shareholders is not affected.

– The timing of new issues:

If the market is efficient, shares will be priced correctly, given the current publicly available information.

Timing will only matter if a company’s financial manager has some private information suggesting that the company’s shares are mispriced.

If company equity is believed to be underpriced, it would not issue new shares at market price.

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• The financial manger and evidence on the EMH

– Until further research has clarified the issues, the implications of the EMH provide a useful guide to financial managers.

– However, whether this is correct will ultimately require a personal value judgment.

– Generally speaking, there is not much a financial manager can do to correct perceived market inefficiency with respect to the company’s share price.

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• The financial manger and evidence on the EMH (cont.)

– Providing more information to the market may help improve accuracy of pricing.

– Buy-back announcements stating motivation as being the undervaluation of companies shares.

– Directors purchasing shares in the company provide positive signals that may improve informational and pricing efficiency.

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Summary • Efficient market — security prices reflect all

available information.

• Prices should react to new information instantaneously, precluding consistent excess returns.

• Market efficiency can be classified by:

– Return predictability — are there ways of predicting future returns?

– Event studies — look for excess returns around an event and quick price adjustment.

– Tests for private information — look for excess returns to parties that may have private info.

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Summary (cont.)• Examples of evidence suggesting market

inefficiency include: – Post event drift in returns — not unbiased and

instantaneous.– Calendar-based anomalies.– Firm size effects. – Dividend yield, price earnings and book to market ratio

effects.

• Fundamental analysis and charting will not earn excess returns in an efficient market.

• This, however, does not suggest random stock selection.• Should not seek to beat market.• While anomalies to EMH exist, it is a useful way to

approach asset price formation and behaviour.

16-1 copyright 2009 mcgraw-hill australia pty ltd ppts t/a business finance 10e by peirson slides...

Documents

concept of market efficiency

tests of market efficiency

market efficiency viewpoint

securitys current market

reaction of market prices

available information

sources of information

business finance