Chapter 13: Efficient Markets and Behavioral Finance

How to test strong-form EMH?

1. Performance of mutual funds. 2. Insider trades => trades by corporate employees who buy/sell securities of their own company. - Insiders' buys are associated with positive abnormal returns. - Top managers are contrarian traders. - Insiders purchased (sold) shares before good (bad) earnings forecasts.

1. Weak-form EMH: 2. Semi-strong form EMH: 3. Strong form EMH:

1. Security prices reflect all historical market information. (e.g., historical prices, trading volume, etc.) 2. Security prices reflect all public information. (e.g. earnings announcements, economic/political news, etc.) 3. Security prices reflect all public and private information => no groups of market participants have an informational advantage.

Random Walk Theory: The movement of stock prices from day to day does not reflect a pattern. Statistically, movements are random. How are we able to test weak-form efficiency?

1. Trading rules: Compare the risk-return results from trading rules to the results from a simple buy-and-hold policy. (e.g. comparison of risk-adjusted returns from various filters vs. Buy-and-hold policy). 2. Statistical tests of independence - test whether security returns over time are independent of one another: - Serial correlation (SC) - measures the correlation between current returns and lagged/past returns in a time series of returns (e.g. SC in 1 day, 5 days, or 10 days returns) - Runs test - checks for trends in positive or negative returns (e.g. +++--+----++--+)

What is an efficient market?

A market in which prices reflect all known value relevant information; therefore, nothing will be overvalued or undervalued.

Behavioral finance Explain how incentive and agency problems might contribute to mispricing of securities or to bubbles. Give examples.

Anytime there is a separation of ownership and control, it is possible that the resulting agency costs will lead to market distortions. Many people hire others (explicitly or implicitly) to manage their money, and these managers may not have the same incentives to push for the best price. Over large markets, we might expect many of these distortions to have less impact, but some imperfections may remain. As described in the text, one example of this is the mortgage securitization market. Because banks were paid a fee for packaging the securities and did not retain the risks of ownership, they may not have pushed for adequate underwriting. This may have led to easy credit terms and a housing market bubble.

Bubbles Some extreme bubbles are obvious with hindsight, after they burst. But how would you define a bubble? There are many examples of good news and rising stock prices, followed by bad news and falling stock prices. Can you set out rules and procedures to distinguish bubbles from the normal ups and downs of stock prices?

It is difficult to define ex-ante rules for identifying bubbles where prices differ from some measure of intrinsic value. Research in this area focuses on excessive liquidity, inflationary pressures, a rigorous analysis of "underlying fundamentals," and other factors that may cause prices to exceed intrinsic value (whatever that means). But since we expect prices to move in a random walk—and since this random walk might sometimes move rapidly upwards—the process of identifying bubbles is vexing.

Market efficiency evidence Which of the following observations appear to indicate market inefficiency? Explain whether the observation appears to contradict the weak, semistrong, or strong form of the efficient-market hypothesis. a. Tax-exempt municipal bonds offer lower pretax returns than taxable government bonds. b. Managers make superior returns on purchases of their company's stock. c. There is a positive relationship between the return on the market in one quarter and the change in aggregate profits in the next quarter. d. There is some evidence that stocks that have appreciated unusually in the recent past continue to do so in the future. e. The stock of an acquired firm tends to appreciate in the period before the merger announcement. f. Stocks of companies with unexpectedly high earnings appear to offer high returns for several months after the earnings announcement. g. Very risky stocks on average give higher returns than safe stocks.

One of the ways to think about market inefficiency is that it implies there is easy money to be made. The following appear to suggest market inefficiency: (b) Strong form. The strong form says that prices reflect all information available about a company; even what is known by management. (d) Weak form. The weak form dictates that it is impossible to make consistently superior profits by studying past returns. (f) Semistrong form. In the semistrong form, stock prices will adjust immediately to new information, such as earnings announcements.

Behavioral finance Many commentators have blamed the subprime crisis on "irrational exuberance." What is your view? Explain briefly.

Opinion question; answers will vary. Some of the blame may indeed rest with borrowers who held overly optimistic views of housing market appreciation and of their ability to repay mortgages. Similarly, purchasers of mortgage-backed securities may have unwisely believed that these instruments offered an adequate return. Alternative explanations include inaccurate ratings, agency cost problems (where loan originators lacked incentives to underwrite the loans effectively), the purchase activity and implicit government backing of Fannie Mae and Freddie Mac, and other information asymmetry problems.

Market efficiency "If the efficient-market hypothesis is true, the pension fund manager might as well select a portfolio with a pin." Explain why this is not so.

The efficient market hypothesis does not imply that portfolio selection should be done with a pin. The manager still has three important jobs to do. First, she must make sure that the portfolio is well diversified. It should be noted that a large number of stocks is not enough to ensure diversification. Second, she must make sure that the risk of the diversified portfolio is appropriate for the manager's clients. Third, she might want to tailor the portfolio to take advantage of special tax laws for pension funds. These laws may make it possible to increase the expected return of the portfolio without increasing risk.

Market efficiency implications What does the efficient-market hypothesis have to say about these two statements? a. "I notice that short-term interest rates are about 1% below long-term rates. We should borrow short-term." b. "I notice that interest rates in Japan are lower than rates in the United States. We would do better to borrow Japanese yen rather than U.S. dollars."

The efficient-market hypothesis says that there is no easy way to make money. Thus, when such an opportunity seems to present itself, we should be very skeptical. For example: - In the case of short- versus long-term rates, and borrowing short term versus long term, there are different risks involved. For example, suppose that we need the money long term, but we borrow short term. When the short-term note is due, we must somehow refinance. However, this may not be possible or may be possible only at a very high interest rate. - In the case of Japanese versus United States interest rates, there is the risk that the Japanese yen-U.S. dollar exchange rate will change during the period of time for which we have borrowed.

Market efficiency implications Two financial managers, Alpha and Beta, are contemplating a chart showing the actual performance of the Standard and Poor's Composite Index over a five-year period. Each manager's company needs to issue new shares of common stock sometime in the next year. Alpha: My company's going to issue right away. The stock market cycle has obviously topped out, and the next move is almost surely down. Better to issue now and get a decent price for the shares. Beta: You're too nervous; we're waiting. It's true that the market's been going nowhere for the past year or so, but the figure clearly shows a basic upward trend. The market's on the way up to a new plateau. What would you say to Alpha and Beta?

They are both under the illusion that markets are predictable, and they are wasting their time trying to guess the market's direction. Remember the first lesson of market efficiency: Markets have no memory. The decision as to when to issue stock should be made without reference to "market cycles."

Market efficiency evidence Fama and French show that average stock returns on firms with small market capitalizations have been significantly higher than average returns for "large-cap" firms. What are the possible explanations for this result? Does the result disprove market efficiency? Explain briefly.

This does present some evidence against the efficient capital market hypothesis. One key to market efficiency is the high level of competition among participants in the market. For small stocks, the level of competition is relatively low because major market participants (e.g., mutual funds and pension funds) are biased toward holding the securities of larger, well-known companies. Thus, it is plausible that the market for small stocks is fundamentally different from the market for larger stocks and, hence, that the small-firm effect is simply a reflection of market inefficiency. But there are at least two alternative possibilities. First, this difference might just be coincidental. In statistical inference, we never prove an affirmative fact. The best we can do is to accept or reject a specified hypothesis with a given degree of confidence. Thus, no matter what the outcome of a statistical test, there is always a possibility, however slight, that the small-firm effect is simply the result of statistical chance. Second, firms with small market capitalization may contain some type of additional risk that is not measured in the studies. Given the information available and the number of participants, it is hard to believe that any securities market in the United States is not very efficient. Thus, the most likely explanation for the small-firm effect is that the model used to estimate expected returns is incorrect and that there is some as-yet-unidentified risk factor.

Market efficiency Supply the missing words: "There are three forms of the efficient-market hypothesis. Tests of randomness in stock returns provide evidence for the _____ form of the hypothesis. Tests of stock price reaction to well-publicized news provide evidence for the _____ form, and tests of the performance of professionally managed funds provide evidence for the _____ form. Market efficiency results from competition between investors. Many investors search for new information about the company's business that would help them to value the stock more accurately. Such research helps to ensure that prices reflect all available information; in other words, it helps to keep the market efficient in the _____ form. Other investors study past stock prices for recurrent patterns that would allow them to make superior profits. Such research helps to ensure that prices reflect all the information contained in past stock prices; in other words, it helps to keep the market efficient in the _____ form."

Weak, semistrong, strong, strong, weak

Market efficiency How would you respond to the following comments? a. "Efficient market, my eye! I know lots of investors who do crazy things." b. "Efficient market? Balderdash! I know at least a dozen people who have made a bundle in the stock market." c. "The trouble with the efficient-market theory is that it ignores investors' psychology." d. "Despite all the limitations, the best guide to a company's value is its written-down book value. It is much more stable than market value, which depends on temporary fashions."

a. An individual can do crazy things, but still not affect the efficiency of markets. The price of the asset in an efficient market is a consensus price as well as a marginal price. A nutty person can give assets away for free or offer to pay twice the market value. However, when the person's supply of assets or money runs out, the price will adjust back to its prior level (assuming there is no new, relevant information released by his action). If you are lucky enough to know such a person, you will receive a positive gain at the nutty investor's expense. You had better not count on this happening very often, though. Fortunately, an efficient market protects crazy investors in cases less extreme than the above. Even if they trade in the market in an "irrational" manner, they can be assured of getting a fair price since the price reflects all information. b. Yes, and how many people have dropped a bundle? Or, more to the point, how many people have made a bundle only to lose it later? People can be lucky and some people can be very lucky; efficient markets do not preclude this possibility. c. Investor psychology is a slippery concept, more often than not used to explain price movements that the individual invoking it cannot personally explain. Even if it exists, is there any way to make money from it? If investor psychology drives up the price one day, will it do so the next day also? Or will the price drop to a "true" level? Almost no one can tell you beforehand what "investor psychology" will do. Theories based on it have no content. d. What good is a stable value when you can't buy or sell at that value because new conditions or information have developed which make the stable price obsolete? It is the market price, the price at which you can buy or sell today, which determines value.

Market efficiency Respond to the following comments: a. "The random-walk theory, with its implication that investing in stocks is like playing roulette, is a powerful indictment of our capital markets." b. "If everyone believes you can make money by charting stock prices, then price changes won't be random." c. "The random-walk theory implies that events are random, but many events are not random. If it rains today, there's a fair bet that it will rain again tomorrow."

a. There is risk in almost everything you do in daily life. You could lose your job or your spouse, or suffer damage to your house from a storm. That doesn't necessarily mean you should quit your job, get a divorce, or sell your house. If we accept that our world is risky, then we must accept that asset values fluctuate as new information emerges. Moreover, if capital markets are functioning properly, then stock price changes will follow a random walk. The random walk of values is the result of rational investors coping with an uncertain world. b. To make the example clearer, assume that everyone believes in the same chart. What happens when the chart shows a downward movement? Are investors going to be willing to hold the stock when it has an expected loss? Of course not. They start selling, and the price will decline until the stock is expected to give a positive return. The trend will "self-destruct." c. Random-walk theory as applied to efficient markets means that fluctuations from the expected outcome are random. Suppose there is an 80% chance of rain tomorrow (because it rained today). Then the local umbrella store's stock price will respond today to the prospect of high sales tomorrow. The store's sales will not follow a random walk, but its stock price will because each day the stock price reflects all that investors know about future weather and future sales.

Market efficiency implications Here again are the five lessons of market efficiency. For each lesson give an example showing the lesson's relevance to financial managers. a. Markets have no memory. b. Trust market prices. c. Read the entrails. d. The do-it-yourself alternative. e. Seen one stock, seen them all.

a. An investor should not buy or sell shares based on apparent trends or cycles in returns. b. A CFO should not speculate on changes in interest rates or foreign exchange rates. There is no reason to think that the CFO has superior information. c. A financial manager evaluating the creditworthiness of a large customer could check the customer's stock price and the yield on its debt. A falling stock price or a high yield could indicate trouble ahead. d. The company should not seek diversification just to reduce risk. Investors can diversify on their own. e. Stock issues do not depress prices if investors believe the issuer has no private information.

Market efficiency True or false? a. Financing decisions are less easily reversed than investment decisions. b. Tests have shown that there is almost perfect negative correlation between successive price changes. c. The semistrong form of the efficient-market hypothesis states that prices reflect all publicly available information. d. In efficient markets, the expected return on each stock is the same.

a. False. Financing decisions do not have the same degree of finality as investment decisions and are therefore more easily reversed. b. False. Tests have shown that there is essentially no correlation between stock price changes. c. True d. False. An individual stock's return is dependent on the stock's market risk as measured by beta.

Market efficiency implications True or false? a. If markets are efficient, shareholders should expect to receive only the risk-free interest rate on their investment. b. If markets are efficient, investment in the stock market is a mug's game. c. If markets are efficient, investors should just invest in firms with good management and an above-average track record. d. In an efficient market, investors should expect stocks to sell at a fair price.

a. False. If markets are efficient, an investor should only earn a return commensurate with the risk of the underlying investment, given some risk model (e.g. CAPM or Fama-French Three Factor Model). Therefore, diversified shareholders should earn zero NPV returns in the stockmarket. b. False. Investment in the stock market is still a useful activity within an efficient markets framework. Managers of pension funds, for example, provide service by ensuring proper diversification, adjusting risk exposure, and optimizing tax adjusted returns. After all, a zero NPV investment is still an investment that should be undertaken. c. False. A firm with above average management and track record should come at a higher price, therefore reducing returns to the investor back to the risk adjusted required return (i.e. NPV will still equal zero). d. True.

Market efficiency True or false? The efficient-market hypothesis assumes that: a. There are no taxes. b. There is perfect foresight. c. Successive price changes are independent. d. Investors are irrational. e. There are no transaction costs. f. Forecasts are unbiased.

a. False. The efficient market hypothesis recognizes that investors read financial statements and understand the impact of taxes. b. False. The principles of arbitrage dictate that there is no such thing as perfect foresight. c. True. d. False. Many investors are affected by their attitudes toward risk and their beliefs about probabilities as found in behavioral finance studies, but arbitrage eliminates any profit opportunities. e. False. Transaction costs are often quite high. For example, some trading costs are very high and some trades are difficult to execute. f. True

Market efficiency evidence Give two or three examples of research results or events that raise doubts about market efficiency. Briefly explain why.

a. There is evidence that two securities with identical cash flows (e.g., Royal Dutch Shell and Shell Transport & Trading) sold at different prices. b. Small-cap stocks appear to have provided above-average returns for their level of risk in some historical time periods. c. Evidence seems to indicate that some IPOs provide relatively low returns after their first few days of trading.

Behavioral finance True or false? a. Most managers tend to be overconfident. b. Psychologists have found that, once people have suffered a loss, they are more relaxed about the possibility of incurring further losses. c. Psychologists have observed that people tend to put too much weight on recent events when forecasting. d. Behavioral biases open up the opportunity for easy arbitrage profits.

a. True. Overconfidence is a systematic bias. b. False. Once investors have incurred a loss, they are often even more concerned about future losses. c. True. d. False. There are limits on the ability of the rational investors to exploit market inefficiencies. These limits include things such as trading costs and the availability of shares to borrow.

Market efficiency Which (if any) of these statements are true? Stock prices appear to behave as though successive values... (a) Are random numbers. (b) Follow regular cycles. (c) Differ by a random number.

c; Price changes are independent of one another and follow a "random walk". Efficient markets dictate that stock price changes must be random and unpredictable.