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CHAPTER 11CHAPTER 11The EfficientThe Efficient

MarketMarketHypothesisHypothesis

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• Do security prices reflect information ?• Why look at market efficiency?

 – Implications for business and corporate

finance – Implications for investment

Efficient Market Hypothesis (EMH

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• !tock prices fully and accurately reflect

publicly available information

• "nce information becomes available#

market participants analy$e it

• %ompetition assures prices reflect

information

EMH and %ompetition

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• Weak

• !emi&stron'

• !tron'

ersions of the EMH

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• Technical Analysis & usin' prices and volumeinformation to predict future prices

 – Weak form efficiency ) technical analysis

• Fundamental Analysis & usin' economic andaccountin' information to predict stock prices

 – !emi stron' form efficiency ) fundamental

analysis

*ypes of !tock +nalysis

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•  +ctive Mana'ement – !ecurity analysis

 – *imin'

• ,assive Mana'ement

 – -uy and Hold

 – Inde. /unds

 +ctive or ,assive Mana'ement

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Even if the market is efficient a role e.ists forportfolio mana'ement0

•  +ppropriate risk level

• *a. considerations• "ther considerations

Market Efficiency ) ,ortfolio

Mana'ement

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• Empirical financial research that enables anobserver to assess the impact of a particular

event on a firm1s stock price

•  +bnormal return due to the event is estimatedas the difference bet2een the stock1s actual

return and a pro.y for the stock1s return in the

absence of the event

Event !tudies

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• Ma'nitude Issue• !election -ias Issue

• 3ucky Event Issue

 +re Markets Efficient

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Weak&/orm *ests

• 4eturns over the !hort Hori$on – Momentum

• 4eturns over 3on' Hori$ons

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,redictors of -road Market 4eturns

• /ama and /rench – +''re'ate returns are hi'her 2ith hi'her

dividend ratios

• %ampbell and !hiller  – Earnin's yield can predict market returns

• 5eim and !tambau'h

 – -ond spreads can predict market returns

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• ,6E Effect• !mall /irm Effect (7anuary Effect

• 8e'lected /irm Effect and 3i9uidity Effects

• -ook&to&Market 4atios

• ,ost&Earnin's +nnouncement ,rice Drift

!emistron' *ests0 +nomalies

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!tron'&/orm *ests0 Inside Information

• *he ability of insiders to trade profitability intheir o2n stock has been documented in

studies by 7affe# !eyhun# :ivoly# and ,almon

• !E% re9uires all insiders to re'ister theirtradin' activity

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Interpretin' the Evidence

• 4isk ,remiums or market inefficiencies;disa'reement here

 – /ama and /rench ar'ue that these effects

can be e.plained as manifestations of riskstocks 2ith hi'her betas

 – 3akonishok# !hleifer# and ishney ar'ue

that these effects are evidence of inefficient

markets

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Interpretin' the Evidence %ontinued

•  +nomalies or Data Minin'• *he noisy market hypothesis

• /undamental inde.in'

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!tock Market +nalysts

• Do +nalysts +dd alue – Mi.ed evidence

 – +mbi'uity in results

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• !ome evidence of persistent positive andne'ative performance

• ,otential measurement error for benchmark

returns – !tyle chan'es

 – May be risk premiums

• Hot hands phenomenon

Mutual /und ,erformance

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/i'ure <<=> Estimates of Individual

Mutual /und +lphas# <>@ & <<

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/i'ure <<=A ,ersistence of Mutual /und

,erformance