ࡱ> ~}!` Hbjbj\\ -L>>F"(FFF8FFTv$TGTGjGjGjGEHEHEHOOOO?P  c @v$xhozdv9IEHEHIIdvjGjGvGOGOGOIjGjGOGOIOGOGOGOjGHG P\FKGO{ODv0vGO{N{GO{GO4EHZH@GOH4IEHEHEHdvdvNXEHEHEHvIIIIdtd't' Efficient Markets Note: Bring up websites before class: vanguard.com: growth and value index funds; sites comparing performance of index funds to managed funds. I. Introduction Market efficiency => asset prices fully reflect all available information Economic market efficiency => asset prices reflect information to the point where the marginal benefits of acting on information do not exceed the marginal costs of collecting and acting on the information. II. Reasons for Efficiency A. Competition between traders 1. Overview 1) The same amount of wealth exists before and after a transaction between traders 2) If price < value (given full information), wealth transferred to buyer (from seller) 3) If price > value (given full information), wealth transferred to seller (from buyer) 2. Results 1) Both buyer and seller have incentive to be fully informed. 2) Trade will only occur if price = value Note: wealth may be lost by traders due to transaction costs. B. Elimination of arbitrage opportunities Keys: 1) Mispriced assets create opportunity for arbitrage 2) Exploitation of arbitrage opportunities eliminates arbitrage opportunities. => Earn only fair return for efforts, risk, etc. Results: 1) Arbitrage will force price differences for same asset in different markets to be t-costs to engage in arbitrage. 2) Arbitrage will force price differences between homogeneous assets t-costs of arbitrage. => financial assets differ only by risk => very homogeneous. III. Tests of Efficiency Notes: 1) Stronger form false. => Primary question: Is economic efficiency a good approximation? 2) Main difficulty in testing for efficiency: Joint hypothesis problem => must jointly test efficiency and equilibrium model (like CAPM) => if anomalous price behavior, unclear if inefficiency or misspecified model. 3) Incentive problem A. Tests of return predictability Q: => can future returns be predicted? Related question: Are stock prices too volatile? (overreact?) Results: 1. Daily/weekly stock returns not predictable 2. Long horizon (1-10 year) stock returns appear to be predictable Prediction variables: past returns, dividend yields, P/E ratios, default spreads, term spreads, level of short term interest rates, Value Line forecasts (my study w/ Reichenstein => JPM, FSR, and FAJ. Q: What does this imply? 1) rational variation through time of the market risk premium 2) irrational deviations of price from value (speculative bubbles) 3) spurious results that don't mean anything 3. Markets are too volatile to be explained solely by volatility of dividends. => possible explanations: 1) markets overreact 2) volatility also stems from changes in required return => supported by other evidence 4. Seasonality anomalies: a. returns on Mondays lower than rest of week b. returns higher the day before a holiday than other days c. returns higher on the last day of the month than on other days d. most of the return on securities occur at the beginning and end of the day e. returns are higher in January than in other months => most of the return comes between last trading day in December and 1st 5 days of January Notes: 1) most abnormal returns less than spread => can't profitably trade on them 2) most of January effect confined to the smallest stocks (very small value relative to market). 5. Small firm affect key => stock of small firms tend to out preform stock of large firms even after adjust for risk note: if take out returns between 75 and 83, small firm effect goes away 6. Growth stocks vs. value stocks a. Value stock - stock for which earnings are expected to grow at a slower-than-average rate in the future Note: can be identified by high book-to-market ratio (low mkt/book), low P/E, high dividend yield Ex. Time Warner, Dillards, Tyson Food b. Growth stock - stock for which earnings are expected to grow at a faster-than-average rate in the future Note: can be identified by low book-to-market ratio (high mkt/book), high P/E, low dividend yield Ex. Amazon, Lucent Technologies, Hershey, Dell c. Basic result: Value stocks produce higher returns than growth stocks (by a large margin) with less risk Between 1963 and 1990: => Firms in lowest growth decile = 21.4% annual return => Firms in highest growth decile = 8% annual return Impact: If invest $2000 per year for 35 years, then growth portfolio becomes $109,232 (in todays dollars) value portfolio becomes $1,839,369 (in todays dollars) d. Reason: => too much expected of growth stocks => growth stocks: perceived long-term growth does not pan out => receive negative surprises and stock price falls => value stocks: perceived long-term poor performance does not occur => receive positive surprises and stock price rises Note: Study by Kothari, Shanken, and Sloan => much of results driven by suvivorship bias in data => data only includes firms that survived, not all firms => returns on value firms overstated Q: How have growth and value stocks performed lately? => See Vanguard website B. Event studies Q: do prices adjust to public announcements? Note: most direct test of efficiency Results: => on average, stock prices adjust quickly to information about investments, dividends, capital structure changes, corporate control transactions (LBOs, mergers, spin offs, etc.) => prices adjust only slowly to earnings announcements. C. Tests for private information Q: => do specific investors have information not reflected in prices? Results: 1. Corporate insiders have private information that not fully reflected in prices => earn abnormal returns Note: outsiders cannot profit from public information about insider trading 2. Unclear whether professional investment managers have private information not reflected in prices. Note: Professional investment managers include mutual fund managers, pension fund managers, analysts, writers of newsletters, etc. a. "Best" tests suggest that professional investment managers do not have private information Notes: 1) Results depend on which equilibrium model use 2) Joint hypothesis problem makes conclusions difficult b. Anecdotal evidence: => see fortune article & overheads c. Changes in Value Line's rankings and private information of analysts surveyed in "Heard of the Street" in WSJ have permanent (small) impact on stock prices => contain private information D. Conclusions: Overall => with the exception of inside information and possibly growth vs. value stocks, markets fairly efficient Unless have inside information, should act as if markets are efficient Note: If have inside information, should not trade on it since illegal and unethical. IV. Implications of Market Efficiency A. Implications for Investors 1. Over the long run, can't use information to earn excess return Notes: 1) excess return => return > required return given risk. => all security transactions are zero NPV. 2) anyone can get lucky for a while. => Coin example (bring up yahoo.finance site after flip coins) 3) Reason => information already reflected in prices. 4) Technical and fundamental analysis useless 2. Investment produces higher return than speculation for any risk level. Notes: 1) Investment => buy and hold (trade only for cash & tax reasons) 2) Speculation => attempting to trade mispriced stocks. 3) Reason => Earn no excess returns since securities are fairly priced, but pay higher transaction costs if speculate. 3. Stock prices deviate randomly from expected drift. Notes: 1) Reason => rational response to new (unexpected) info. 2) New info. has equal chance of being better or worse than expected. 4. Even if markets are efficient, investors have preferred strategies. => depends on tax bracket and risk preferences. => dart board is not a good way to pick investments. 5. Historical and public information is useful => reveals risk of asset B. Corporate Finance 1. Management should not manipulate accounting numbers since market won't be fooled. Note: not talking about fraud 2. Mgt should issue new securities when need funds rather than trying to issue when the market is high. Reason => mgt can't time the market any better than investors. V. 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