Chapter 14

Description of Efficient Capital Markets EMH= Efficient Market Hypothesis

An efficient capital market is one in which stock prices fully reflect available information. The EMH has implications for investors and firms. Since information is reflected in security prices quickly, knowing information when it is released does an investor little good. Firms should expect to receive the fair value for securities that they sell. Firms cannot profit from fooling investors in an efficient market.

Event Studies on EMH

Event Studies are one type of test of the semi-strong form of market efficiency. - Recall, this form of the EMH implies that prices should reflect all publicly available information. To test this, event studies examine prices and returns over time—particularly around the arrival of new information. Test for evidence of under reaction, overreaction, early reaction, or delayed reaction around the event. Returns are adjusted to determine if they are abnormal by taking into account what the rest of the market did that day.

Creating Value through Financing: Fool Investors / Reduce Costs or Increase Subsidies / Create a New Security

Fool Investors Empirical evidence suggests that it is hard to fool investors consistently. Reduce Costs or Increase Subsidies Certain forms of financing have tax advantages or carry other subsidies. Create a New Security Sometimes a firm can find a previously-unsatisfied clientele and issue new securities at favorable prices. In the long-run, this value creation is relatively small.

Foundations of Market Efficiency

Investor Rationality- They will buy stocks that are cheap resulting in increase of price which will ensure the market is efficiently being run. Independence of events of rationality- even if some disagree with what will happen in the market others will agree and so they offset (think telephone popularity) Arbitrage- Arbitrage is the word that comes to mind here because arbitrage generates profit from the simultaneous purchase and sale of different, but substitute, securities. If the arbitrage of professionals dominates the speculation of amateurs, markets would still be efficient.

What EMH does and does not say

Investors can throw darts to select stocks. - This is almost, but not quite, true. - An investor must still decide how risky a portfolio he wants based on risk aversion and expected return. Prices are random or uncaused. - Prices reflect information. - The price CHANGE is driven by new information, which by definition arrives randomly. - Therefore, financial managers cannot "time" stock and bond sales.

Strong Form EMH Studies

One group of studies of strong form market efficiency investigates insider trading. A number of studies support the view that insider trading is abnormally profitable. Thus, strong form efficiency does not seem to be substantiated by the evidence.

Event Studies Results

Over the years, event study methodology has been applied to a large number of events including: - Dividend increases and decreases - Earnings announcements - Mergers - Capital Spending - New Issues of Stock The studies generally support the view that the market is semistrong 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. If the market is semistrong form efficient, then no matter what publicly available information mutual fund managers rely on to pick stocks, their average returns should be the same as those of the average investor in the market as a whole.

Weak Form

Security prices reflect all information found in past prices and volume. If the weak form of market efficiency holds, then technical analysis is of no value. Since stock prices only respond to new information, which by definition arrives randomly, stock prices are said to follow a random walk!! Random stock price changes support weak form efficiency.

Strong Form

Security prices reflect all information—public and private. Strong form efficiency incorporates weak and semi-strong form efficiency. Strong form efficiency says that anything pertinent to the stock and known to at least one investor is already incorporated into the security's price.

Semi-Strong Form

Security prices reflect all publicly available information. Publicly available information includes: - Historical price and volume information - Published accounting statements - Information found in annual reports

Evidence of EMH

The record on the EMH is extensive, and, in large measure, it is reassuring to advocates of the efficiency of markets. Studies fall into three broad categories: 1) Are changes in stock prices random? Are there profitable "trading rules?" 2) Event studies: does the market quickly and accurately respond to new information? 3) The record of professionally managed investment firms.

3 Different Types of Efficient Markets

Weak Form Security prices reflect all historical information Semistrong Form Security prices reflect all publicly available information Strong Form Security prices reflect all information—public and private