market efficiency. news and returns all news, and announcements contain anticipated and unexpected...
TRANSCRIPT
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 moveSurprises cause unexpected returns
2
3
Breaking Returns Down
A security’s return is comprised of:1. The expected return, based on expectations2. The un-expected return, based on surprises
Therefore, a stock’s return is:
return theofpart unexpected theis
return theofpart expected theis
where
U
R
URR
Where does U come from? Systematic Surprises:
Difference between what we expect our factor to do and what actually happens
Ex: Market goes up 10% when expected 7% Unique Surprises:
Unanticipated eventsEx: CEO dies
4
5
Breaking Returns Down (2)
We defined returns as: We can break U down further: is the return earned because of unexpected
movements in systematic risk is the return from unique surprises
URR
mRR
m
6
Example Lets use the Fama French factors:
SML, HML, and Mkt Our model is:
εFβFβFβRR M ktM ktH M LH M LSM LSM L
Surprises 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, and this
unanticipated development contributes 1% to the return.
7
8
Example Betas The stock’s betas are:
1. SML = -2.30
2. HML = 1.50
3. Mkt = 0.50
The stock’s expected return is 8%
Underlying Assumption
The assumption we made, and that drove the last example, is that the stock is priced in an efficient market
10
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 (+/-)
11
15
Potential Causes of Efficient Markets
Investor RationalityEveryone 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
ArbitrageOnly some people are rational → Smart money takes
from less smart money
17
Weak Form Efficiency
Prices reflect all information contained in past prices and volumesNo investor is able to form a trading strategy based
on historic prices and volumes and earn an excess return
18
Disbelievers
Chartists, or Technical AnalystsAnalyze “charts” of a stock‘s Price and/or Volume
Chartist believe in identifiable and predictable patterns in these characteristicsMake investment decisions based on these patterns
Brokerage firms tend to love chartists
Why Technical Analysis Fails
-If there is a profitable pattern, everyone would do it
-If everyone follows the same strategy competition will eliminate any opportunity associated with the pattern
Sto
ck P
rice
Time
Sell
Sell
Buy
Buy
21
Semi-Strong Form Efficiency
Security prices reflect all publicly available information.Encompasses weak form efficiency
Publicly available information includes: Historical price and volume information
Published accounting statements
Information found in the WSJ
22
Disbelievers
Fundamental AnalystsUse 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?
23
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 & PrivateImplies: Insider trading will not earn excess return
Strong form efficiency incorporates weak and semi-strong form efficiency.
Disbelievers
Pretty much everyone Insiders trading is generally profitable
Galleon Raj Rajaratnam
Martha Stewart
24
25
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
26
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
27
The Evidence The record on the EMH is extensive,
and generally supportive of the market being semi-strong form efficient
28
Event Studies
Event Studies examine returns around information release datesEX: Earnings, Dividend announcementsA test of semi-strong form efficiency
Look at how quickly prices adjust to the informationLooking for under-reaction, over-reaction, early
reaction, or delayed reaction around the event.
29
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.
30
Event Studies: Dividend OmissionsCumulative Abnormal Returns for Companies Announcing
Dividend Omissions
0.146 0.108
-0.72
0.032-0.244-0.483
-3.619
-5.015-5.411-5.183
-4.898-4.563-4.747-4.685-4.49
-6
-5
-4
-3
-2
-1
0
1
-8 -6 -4 -2 0 2 4 6 8
Days relative to announcement of dividend omission
Cum
ulat
ive
abno
rmal
ret
urns
(%
)
Efficient market response to “bad news”
31
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
32
Mutual Fund Performance
Taken from Lubos Pastor and Robert F. Stambaugh, “Mutual Fund Performance and Seemingly Unrelated Assets,” Journal of Financial Exonomics, 63 (2002).
-2.13%
-8.45%
-5.41%
-2.17% -2.29%
-1.06%-0.51%-0.39%
All funds Small-companygrowth
Other-aggressive
growth
Growth Income Growth andincome
Maximumcapital gains
Sector
33
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 profitsViolation of Strong form efficiency
34
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.
35
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.
36
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