Chapter 13 - Efficient Capital Markets and Behavioral Challenges

EFM - Does not say

- Prices are uncaused - Investors are foolish and too stupid to be in the market - All shares of stock have the same expected returns - Investors should throw darts to select stocks - There is no upward trend in stock prices

EFM - Does say

- Prices reflect underlying value - Financial managers cannot time stock and bond sales - Managers cannot profitably speculate in foreign currencies - Managers cannot boost stock prices through creative accounting

Actively managed funds use ________ to beat the market

- price and volume patterns - publicly available information - certain analytical skills

Efficient Market Hypothesis (EMH)

1. Because information is reflected in prices immediately, investors should only expect to obtain a normal rate of return 2. Firms should expect to receive fair value for securities that they sell. Fair means that the price they receive for the securities they issue is the present value

Markets are more likely to be weak form efficient than semi-strong form efficient because

1. Easy profits would lead everyone to trade on historical information 2. Historical stock price information is easy to get

Challenging Market Efficiency Hypothesis

1. Limits to Arbitrage 2. Earnings Surprises: the difference between current quarterly earnings and quarterly earnings four quarters ago, divided by the SD. Desire extreme positive surprises 3. Size: returns on stocks with small market capitalizations were greater then the returns on stocks with large market capitalizations 4. Value versus Growth: stocks with high book-value to stock-price ratios (value stocks) outperform growth stocks 5. Crashes and bubbles

Three conditions that lead to efficiency

1. Rationality 2. Independent deviations from rationality 3. Arbitrage

Cumulative abnormal returns (CARs)

ARs (Date) Time -1 -- 1% Time 0 -- -3% Time 1 -- 6% CARs Time -1 -- 1% Time 0 -- -2% (1% + -3%) Time 1 -- 4% (1% + -3% + 6%)

Semistrong Efficiency

All public information

Arbitrage

Arbitrage generates profit from the simultaneous purchase and sale of different, but substitute, securities Irrational amateurs vs. rational professionals Professional investors, knowing that securities are mispriced, could buy the underpriced ones while selling correctly priced (or even overpriced) substitutes.

Abnormal Return (AR) on a given stock

Calculated by subtracting the market's return on the same day (Rm) as measured by a broad-based index such as the S&P composite index - from the actual return (R) on the stock for that day AR = R - Rm R: actual return on the stock Rm: market's return on the same day

Weak Form Efficiency

Fully incorporates information in past stock prices. It's weak because past information is very easy to acquire.

Representativeness

Gambler who believes a run of black will continue is in error since, in reality, the probability of a black spin is still only about 50%. Gamblers behaving in this way exhibit the psychological trait of representativeness. They draw conclusions from insufficient data. The gambler believes the small sample he observed is more representative of the population that it really is.

Efficient Capital Markets

One in which stock prices fully reflect available information

Serial Correlation

Only involves one security. Correlation between the current return on a security and the return on the same security over a later period. Positive coefficient - tendency toward a continuation (higher than average return today is likely to be followed by higher-than-average returns in the future. Same as lower today as lower in the future Negative coefficient - reversal, higher to lower, or lower to higher. Significantly positive or negative serial correlation coefficients are indications of market inefficiencies

Conservatism

People are too slow in adjusting their beliefs to new information. Wanting to be a dentist all your life like everyone in your family but there comes a drug that prevents tooth decay that may deplete the necessity of dentist. How fast do you adjust? Does your emotional ties to the industry make you too conservative?

Arbitrage results in stock prices that are

Priced correctly

Strong Efficiency

Prices reflect all information, public and private

What types of information affect the rates at which stock prices adjust to new information?

Publicly available, past, and all information

People deviate from rationality in accordance with a number of basic principles like:

Representativeness Conservatism

EMH - Stock's Abnormal Return at Time t (ARt) should reflect what kind of information?

Should only reflect information at the same time, t. Any information released before then should have no effect on abnormal returns in this period, because all of its influence should have been felt before.

Beating the market with _______ would illustrate a violation of semi-strong form efficiency.

analyzing financial statements

If you can beat the market by _________ then you are violating weak form efficiency.

analyzing historical price patterns

According to EMH, timing of a new equity issue is ______ important

not

Difference in returns on small and large stocks and be explained by a difference in

risk

Event studies

statistical studies that examine whether the arrows are as shown or whether the release of information influences returns on other days

Although fund my underperformance, can still good be a good thing because:

they permit the investor to buy a portfolio that has a large number of stocks in it (well-diversified portfolio)

On average, all funds _________ the market by _____% per year

underperforms, 2%