Chapter 8 investments the efficient market hypothesis

Chapter 8 The Efficient Market Hypothesis 8.1 Random Walks and Efficient Market Hypothesis 8-2 Why are price changes random? Random Price Changes In very competitive markets, prices should react to only NEW information Flow of NEW information is random Therefore, price changes are random Idea that stock prices follow a “Random Walk” 8-3 Random Walk and the EMH 8-4 • Stock prices that change in response to new (unpredictable) information must move unpredictably.  Random Walk • If stock price movements were predictable, that would be evidence of stock market inefficiency because the ability to predict prices would indicate that all available information was not already reflected in stock prices. • Efficient Market Hypothesis (EMH) : The hypothesis that prices of securities fully reflect available information about securities. Cumulative Abnormal Returns before Takeover Attempts: Target Companies In this case there appears to be information leakage before the announcement date (day 0), but markets adjust quickly. 8-5 Stock Price Reaction to CNBC Midday Reports 8-6 Forms of the EMH  Weak-form hypothesis - The relevant information is past information such as historical prices and trading volume. - If the markets are weak form efficient, use of such information provides no benefit “at the margin.” - This version of the hypothesis implies that trend analysis is fruitless. 8-7 Forms of the EMH  Semistrong-form hypothesis - The relevant information is all publicly available information such as past prices and fundamental data on firm’s prospects. - If the markets are semi-strong form efficient, then studying past price and volume data & studying earnings and growth forecasts provides no net benefit in predicting price changes at the margin. 8-8 Forms of the EMH  Strong-form hypothesis - The relevant information is all information both public and private or inside information. - If the markets are strong form efficient, use of any information (public or private) provides no benefit at the margin. - SEC Rule 10b-5 limits trading by corporate insiders (officers, directors and major shareholders). Inside trading must be reported. 8-9 Relationships between forms of the EMH • Notice that _______________________________ __________________ (but _____________) • Strong form efficiency would imply that __________________________________________. semi-strong efficiency implies weak form efficiency holds NOT vice versa both semi-strong and weak form efficiency hold 8-10 [...]... securities Consistent with semistrong efficiency 8- 20 Market Efficiency and Portfolio Management Even if the market is efficient, a role exists for portfolio man agement Identify risk & choose appropriate risk level Tax considerations Other considerations such as liquidity needs or diversify away from the client’s industry 8- 21 8. 3 Are Markets Efficient? 8- 22 Empirical Tests of Informational Efficiency... cash flows by the required rate of return (usually obtained from the CAPM), and comparing the resulting estimated price with the current stock price 8- 17 Fundamental Analysis If the estimated price is greater than the current price, an inv estor should buy the stock since it is undervalued and since it s price should increase to the "true" or "fundamental" value uncovered by the analyst If the estimated... In this case there appears to be information leakage before the announcement date (day 0), but markets adjust quickly 8- 25 Stock Price Reaction to CNBC Midday Reports 8- 26 Figure 8. 5: Cumulative Abnormal Returns in Response to Earnings Announcements Short term momentum effect that is counter to efficiency 8- 27 Mutual Fund Managers So, Are Markets Efficient?  There are enough anomalies in the empirical... predict price changes If the markets are semi-strong or strong form efficient? Fundamental Analysis CANNOT predict price changes 8- 15 the discounted value of the expected future cash flows the stock is expected to provide to investors “art” of identifying over- and undervalued securities based on an analysis of the firm's financial statements and future prospects 8- 16 forecasting the firm's future dividends... increase to the "true" or "fundamental" value uncovered by the analyst If the estimated price is less than the current price, the stock should be sold because the stock is currently overvalued by t he market In either case if the analyst is correct, the investor should rec eive an “abnormal return” 8- 18 8-19 Implications of Efficiency for Active or P assive Management Active Management Security analysis... managers Can professional managers, using their resources and tools, “beat” the market after considering risk? Testing a trading rule EMH suggests professionals will not outperform the market Testing whether a rule that uses available information can earn abnormal returns after considering the risk and cost of using the rule EMH suggests that such rules will not work 8- 24 Cumulative Abnormal Returns before... repeatedly rises to $31.25 and then declines, indicating that investors are reluctant to pay more than this price for the stock A stock price above $31.25 would then indicate a 'breakout' which would be a bullish signal 8- 14 Types of Stock Analysis & Relationship to the EMH Using economic and accounting information to predict stock price changes If the markets are only weak form efficient? Fundamental Analysis... the search for underpriced securities that clearly goes on  However, the bulk of the evidence suggests that any superior investment strategy should be taken with a lot of effort  The market is competitive enough that only differentially superior information or insight will earn money  In the end it is likely that the margin of superiority that any professional manager can add is so slight that the. . .8. 2 Implications of the EMH (for Security Analysis) 8- 11 8- 12 Basic Types of Technical Analysis Identifying common price patterns One of these patterns is real and one of these is computer simulated with random price changes Can you tell which is which? 8- 13 Basic Types of Technical Analysis Support and resistance levels Support... practice, this means that when trying to figure out if some portfolio manager is earning abnormal returns, we must co mpare their performance to a randomly chosen portfolio I.E they must outperform the random portfolio, or in practi ce, they must beat some benchmark rate of return 8- 23 Empirical Tests of Inform Efficiency Event studies Examine how quickly information is integrated into prices around an . Chapter 8 The Efficient Market Hypothesis 8. 1 Random Walks and Efficient Market Hypothesis 8- 2 Why are price changes random? Random Price Changes In very competitive markets,. information leakage before the announcement date (day 0), but markets adjust quickly. 8- 5 Stock Price Reaction to CNBC Midday Reports 8- 6 Forms of the EMH  Weak-form hypothesis - The relevant information. volume. - If the markets are weak form efficient, use of such information provides no benefit “at the margin.” - This version of the hypothesis implies that trend analysis is fruitless. 8- 7 Forms