0 Portfolio Management 3-228-07 Albert Lee Chun Market Efficiency Lecture 8 30 Oct 2007.

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Portfolio ManagementPortfolio Management3-228-073-228-07

Albert Lee ChunAlbert Lee Chun

Market EfficiencyMarket Efficiency

Lecture 8Lecture 8

30 Oct 2007

Albert Lee Chun Portfolio Management 2

Brownian MotionBrownian Motion


A Little Bit of HistoryA Little Bit of History

The Roman Lucretius's scientific poem The Roman Lucretius's scientific poem On the Nature On the Nature of Thingsof Things (c. 60 BC) : " (c. 60 BC) : "Observe what happens when Observe what happens when sunbeams are admitted into a building and shed light sunbeams are admitted into a building and shed light on its shadowy places. You will see a multitude of on its shadowy places. You will see a multitude of tiny particles mingling in a multitude of ways... their tiny particles mingling in a multitude of ways... their dancing is an actual indication of underlying dancing is an actual indication of underlying movements of matter that are hidden from our sight... movements of matter that are hidden from our sight... It originates with the atoms which move of It originates with the atoms which move of themselvesthemselves””

Jan Ingenhousz had described the irregular motion of Jan Ingenhousz had described the irregular motion of coal dust particles on the surface of alcohol in 1785.coal dust particles on the surface of alcohol in 1785.


A Little Bit of HistoryA Little Bit of History

Brownian motion is traditionally regarded as Brownian motion is traditionally regarded as discovered by the botanist discovered by the botanist Robert BrownRobert Brown in 1827. It in 1827. It is believed that Brown was studying pollen particles is believed that Brown was studying pollen particles floating in water under the microscope .floating in water under the microscope .

The first person to describe the mathematics behind The first person to describe the mathematics behind Brownian motion was Thorvald N. Thiele in 1880 in Brownian motion was Thorvald N. Thiele in 1880 in a paper on the method of least squares. a paper on the method of least squares.

This was followed independently by This was followed independently by Louis BachelierLouis Bachelier in 1900 in his PhD thesis "in 1900 in his PhD thesis "Théorie de la spéculation", ", in which he presented a stochastic analysis of the in which he presented a stochastic analysis of the stock and option markets.stock and option markets.


Louis BachelierLouis Bachelier

Louis Bachelier, in his Ph.D. thesis (Théorie de la spéculation) at the Sorbonne in 1900, wrote: “Past,

present, and even discounted future events are reflected in market price.”


Louis Was Way Ahead of His Time...Louis Was Way Ahead of His Time...

The tragic hero of financial economics was the The tragic hero of financial economics was the unfortunate unfortunate Louis BachelierLouis Bachelier..

In his 1900 dissertation written in Paris, In his 1900 dissertation written in Paris, Theorie de la Theorie de la SpéculationSpéculation (and in his subsequent work, esp. 1906, (and in his subsequent work, esp. 1906, 1913), he anticipated much of what was to become 1913), he anticipated much of what was to become standard fare in financial theory: random walk of standard fare in financial theory: random walk of financial market prices, Brownian motion and financial market prices, Brownian motion and martingales.martingales.

Bachelier's work on random walks predated Einstein's Bachelier's work on random walks predated Einstein's celebrated study of Brownian motion by five years. celebrated study of Brownian motion by five years.


Louis Was Way Ahead of His Time...Louis Was Way Ahead of His Time...

His innovativeness, however, was not appreciated by His innovativeness, however, was not appreciated by his professors or contemporaries. His dissertation his professors or contemporaries. His dissertation received poor marks from his teachers and, received poor marks from his teachers and, consequently blackballed, he quickly dropped into the consequently blackballed, he quickly dropped into the shadows of the academic underground.shadows of the academic underground.

After a series of minor posts, he ended up obscurely After a series of minor posts, he ended up obscurely teaching in Besançon for much of the rest of his life. teaching in Besançon for much of the rest of his life.

Virtually nothing else is known of this pioneer - his Virtually nothing else is known of this pioneer - his work being largely ignored until the 1960s.work being largely ignored until the 1960s.


The Life of LouisThe Life of Louis 11 March 1870 Louis Jean-Baptiste Alphonse Bachelier is born in Le Havre 11 January 1889 Father’s death 7 May 1889 Mother’s death 1891–1892 Military service 1892 Student at Sorbonne October 1895 Bachelor in sciences at Sorbonne July 1897 Certificate in mathematical physics 29 March 1900 Bachelier defends his thesis, Théorie de la Spéculation 1909–1914 Free lecturer at Sorbonne 1912 Publication of Calcul des Probabilités 1914 Publication of Le Jeu, la Chance et le Hasard 9 September 1914 Drafted as a private in the French army 31 December 1918 Back from the army 10 December 1919 A member of the French Mathematical Society 1919–1922 Assistant professor in Besan¸con 1922–1925 Assistant professor in Dijon 1925–1927 Associate professor in Rennes January 1926 Blackballed in Dijon 1 October 1927 Professor in Besan¸con 1937 Professor Emeritus 1 October 1937 Retirement 1941 His last publication 28 April 1946 Louis Bachelier dies in Saint-Servan-sur-Mer; and is buried in Sanvic near Le Havre 1996 The Bachelier Finance Society is founded


Efficient Market HypothesisEfficient Market Hypothesis

“Past, present, and even discounted future events are reflected in market price.” Louis Bachelier


Portfolio Management StrategiesPortfolio Management Strategies

There are 2 principal classes of portfolio management There are 2 principal classes of portfolio management strategies. strategies.

1.1. Passive Passive2. 2. Active Active

Why would an investor choose an active strategy over a Why would an investor choose an active strategy over a passive strategy, or visa versa?passive strategy, or visa versa?

The answer depends on the beliefs of the investors on The answer depends on the beliefs of the investors on whether or not the market is efficient. whether or not the market is efficient.


The 3 EMH and Their Information SetsThe 3 EMH and Their Information Sets

Informationset of

past prices

Information setof publicly available

information

All informationrelevant to a stock

Weak

Strong

Semi-Strong


Fama (1970): 3 Forms of EMHFama (1970): 3 Forms of EMH

Weak form efficiencyWeak form efficiency: The past behavior of prices : The past behavior of prices cannot help us predict future movements in prices. cannot help us predict future movements in prices. Price changes over time are statistically Price changes over time are statistically independent.independent.

Semi-strong form efficiencySemi-strong form efficiency: There is no public : There is no public information that can help us predict future information that can help us predict future movements in prices. Prices quickly reflect new movements in prices. Prices quickly reflect new value-changing information.value-changing information.

Strong form efficiencyStrong form efficiency: Even the ‘private’ : Even the ‘private’ information of experts and insiders cannot help us information of experts and insiders cannot help us predict future movements in prices. Ppredict future movements in prices. Professional rofessional managers are unable to accurately forecast the managers are unable to accurately forecast the future prices of individual stocks.future prices of individual stocks.


In other words...In other words...

Weak form efficiencyWeak form efficiency: : Past prices are useless!Past prices are useless!

Semi-strong form efficiencySemi-strong form efficiency: : Public information is useless!Public information is useless!

Strong form efficiencyStrong form efficiency: : All available information, including ‘private’ All available information, including ‘private’ informationinformation is useless! is useless!


Efficient Market HypothesisEfficient Market Hypothesis

Assumptions for Efficient Market Hypothesis:Assumptions for Efficient Market Hypothesis:

The number of participants in the market is large and The number of participants in the market is large and that they are profit maximizing. Think of large banks, that they are profit maximizing. Think of large banks, hedge funds, institutional investors... hedge funds, institutional investors...

Investors rapidly adjust the prices of securities Investors rapidly adjust the prices of securities

to reflect any new information.to reflect any new information. New information here is defined as a surprise - New information here is defined as a surprise -

something random and unpredictable.something random and unpredictable.


Implications of Weak Form Efficiency:Implications of Weak Form Efficiency: Past trading data contains no relevant information

about future prices. Best guess of the future price is the current price

plus the expected return on the stock.

Consistent with Random Walk Theory: Movements in stock prices from day to day do not reflect any pattern, they are random.

Implications of Weak Form EfficiencyImplications of Weak Form Efficiency

Number Random Return Expected1 tt PP


A Note on the Weak FormA Note on the Weak Form

Technical analysis is useless if this is true! Technical analysis is useless if this is true! Technical Technical analysisanalysis looks for patterns in past prices, as opposed looks for patterns in past prices, as opposed to to fundamental analysisfundamental analysis which looks for fundamental which looks for fundamental value.value.

Even if there are patterns in the market, the presence Even if there are patterns in the market, the presence of a few smart investors would be cause them to of a few smart investors would be cause them to profit from these patterns for a while, but once the profit from these patterns for a while, but once the market recognizes the pattern it will disappear.market recognizes the pattern it will disappear.


Empirical Evidence on EMHEmpirical Evidence on EMH

Tests on aggregate stock indices (TSX and NYSE) support weak form efficiency.

However, momentum strategies provide a counterexample to the weak form of the EMH. Momentum strategies are based on the momentum of stock returns, i.e. past performers would outperform past losers.


Implications of Semi-Strong Form EfficiencyImplications of Semi-Strong Form Efficiency

Implications of Semi-Strong Form Efficiency:Implications of Semi-Strong Form Efficiency: Analysis of financial statements such as income statements

and balance sheets will not reveal any relevant information about future prices.

Financial analysts cannot identify mis-priced stocks from financial statements.

Fund managers who try to beat the market by selecting stocks could do no better than earn an average return.



Research has found that fund managers on average do not beat the market. It is really hard to find a fund manager who beats the market consistently.

Passive index-tracking funds perform as well as managed funds.


Implications of Strong Form EfficiencyImplications of Strong Form Efficiency

Implications of Strong Form EfficiencyImplications of Strong Form Efficiency Insider information and insider trading is not

useful. There will be no gradual information leakage.



Insider trading is the trading of a corporation's stock or other securities by corporate insiders such as officers, directors, or holders of more than ten percent of the firm's shares. Illegal insider trading refers to trading a security based on nonpublic information about the security.

Research has shown that insider information is valuable and one can profit from insider trading.


Insider Trading ExampleInsider Trading Example

In 2002, a Martha Stewart was charged with insider trading regarding the sale of 3,928 shares in pharmaceutical company ImClone, days before its application for a new drug was denied. According to SEC allegations, she avoided a loss of $45,673 by selling all 3,928 shares of her ImClone stock. Stewart was a friend of ImClone cofounder Samuel Waksal. The day following her sale, the stock value fell 16%. Over the next month, the price of the shares dropped 70%.


Quick Review of Market EfficiencyQuick Review of Market Efficiency

Weak Form Efficiency: Prices reflect the information Weak Form Efficiency: Prices reflect the information set comprising set comprising past market trading data past market trading data (i.e. prices, (i.e. prices, volume, dividends, etc.)volume, dividends, etc.)

Semi-Strong Form Efficiency: Prices reflect the Semi-Strong Form Efficiency: Prices reflect the information set comprising past market trading data information set comprising past market trading data plus all other currently available plus all other currently available public information.public information.

Strong Form Efficiency: Prices reflect all Strong Form Efficiency: Prices reflect all public and public and privateprivate information. information.


Is the Market Efficient?Is the Market Efficient?

There is little reason to believe markets are strong There is little reason to believe markets are strong form efficient.form efficient.

There seems to be compelling reason to believe that There seems to be compelling reason to believe that markets are weak-form efficient.markets are weak-form efficient.

A compromise: some prices, some of the time, might A compromise: some prices, some of the time, might not reflect all publicly available information, but most not reflect all publicly available information, but most assets, most of the time, do reflect this information. assets, most of the time, do reflect this information.


Implication of EMHImplication of EMH

Competitive forces in the capital markets drive the Competitive forces in the capital markets drive the market prices of securities to their fundamental market prices of securities to their fundamental values. values.

The more competitive a market, the more efficient it The more competitive a market, the more efficient it is.is.

If the markets are efficient, the price of a security If the markets are efficient, the price of a security today is the best predictor of its fundamental value.today is the best predictor of its fundamental value.


Implication of EMHImplication of EMH

Efficiency does not imply that the observed prices Efficiency does not imply that the observed prices reflect the fundamental value of the stock at all times.reflect the fundamental value of the stock at all times.

It implies only that deviations from it's fundamental It implies only that deviations from it's fundamental value are random and unpredictable.value are random and unpredictable.

If the markets are not efficient, security prices may If the markets are not efficient, security prices may deviate from their fundamental value. This implies deviate from their fundamental value. This implies that there exist strategies for beating the market.that there exist strategies for beating the market.


Inefficient MarketsInefficient Markets

Reasons for Inefficient MarketsReasons for Inefficient Markets

1. Market Segmentation1. Market Segmentation

2. Illiquidity2. Illiquidity

3. High Costs of Transaction and Information 3. High Costs of Transaction and Information


Passive Management StrategiesPassive Management Strategies


Active vs. Passive Strategy and Efficient Active vs. Passive Strategy and Efficient MarketsMarkets

Investor AInvestor A: Believes the market is : Believes the market is efficientefficient and that it and that it is not possible to beat the market and finds it optimal is not possible to beat the market and finds it optimal to follow a to follow a passivepassive strategy by holding the market strategy by holding the market index.index.

Investor BInvestor B: Believes the market is : Believes the market is not efficientnot efficient and and that it is possible to beat the market, and thus seeks to that it is possible to beat the market, and thus seeks to follow an follow an activeactive strategy. strategy.


Active and Passive StrategiesActive and Passive Strategies

Passive equity portfolio managementPassive equity portfolio management Long-term buy-and-hold strategy Usually tracks an index over time Designed to match market performance Manager is judged on how well they track the

target index Active equity portfolio managementActive equity portfolio management

Attempts to outperform a passive benchmark portfolio on a risk-adjusted basis


Passive StrategyPassive Strategy

1. 1. Buy and HoldBuy and Hold: Form a portfolio based on certain : Form a portfolio based on certain criteria and hold for a predetermined period.criteria and hold for a predetermined period.

2. 2. Portfolio IndexationPortfolio Indexation: Replicate the performance of a : Replicate the performance of a market index. The strategy does not try to look for market index. The strategy does not try to look for undervalued or overvalued stocks, nor does it try to undervalued or overvalued stocks, nor does it try to predict movements in the market.predict movements in the market.


Motivation for IndexingMotivation for Indexing

Theoretical motivationTheoretical motivation: According to the CAPM, the : According to the CAPM, the market portfolio is the portfolio tangent to the market portfolio is the portfolio tangent to the efficient portfolio, and it is not possible obtain higher efficient portfolio, and it is not possible obtain higher returns for any level of risk using another portfolio.returns for any level of risk using another portfolio.

Costs of Active ManagementCosts of Active Management: There are costs of : There are costs of researching information, costs of analyzing researching information, costs of analyzing information, transaction costs.information, transaction costs.


Motivation for IndexingMotivation for Indexing

Empirical MotivationEmpirical Motivation: :

1. Individual investors under-perform the S&P 500. 1. Individual investors under-perform the S&P 500. Barber and Odean (1997, 1998, 2000)Barber and Odean (1997, 1998, 2000)

2. Institutional investors (who have lowers transactions 2. Institutional investors (who have lowers transactions costs and access to better information) do not costs and access to better information) do not outperform the market: outperform the market: Jensen(1968), Malkiel (1995), Jensen(1968), Malkiel (1995), Cahart (1997). This is also true when you adjust for Cahart (1997). This is also true when you adjust for the price of risk using CAPM or a multifactor model. the price of risk using CAPM or a multifactor model.


Percentage of Managers that Beat the S&P 500

Source: Aswath Damodaran (http://pages.stern.nyu.edu/~adamodar/)


Source: Aswath Damodaran (http://pages.stern.nyu.edu/~adamodar/)

Active vs. Passive Index Fund


Empirical Tests of the EMHEmpirical Tests of the EMH


Event StudiesEvent Studies

If security prices reflect all available information, then If security prices reflect all available information, then price changes must reflect new information.price changes must reflect new information.

Suppose that the single index model holdsSuppose that the single index model holds

RRtt = = a + bRa + bRmtmt + e + ett

Abnormal returnAbnormal return eett = ( = (ActualActual - - ExpectedExpected))

et = Rt - (at + btRmt)Abnormal Returns are those beyond what would be predicted

by market movements alone.


Event StudiesEvent Studies

Examine prices and returns over timeExamine prices and returns over time

0 +t-t

Announcement Date


Stock Price Reaction to CNBC ReportsStock Price Reaction to CNBC Reports

Response of 172 firms in which a controlling Response of 172 firms in which a controlling shareholder offered to buy out the minority shareholder offered to buy out the minority shareholders. shareholders.

Acquiring shareholders pay a premium over current Acquiring shareholders pay a premium over current market prices. So an announcement should cause market prices. So an announcement should cause prices to jump!prices to jump!

This is evidence of an This is evidence of an efficient marketefficient market in that prices in that prices fully reflect the new information within minutes of fully reflect the new information within minutes of the announcement.the announcement.

A positive report gets digested by the market within A positive report gets digested by the market within 5 minutes, whereas a negative report takes on average 5 minutes, whereas a negative report takes on average 12 minutes to digest.12 minutes to digest.


Stock Price Reaction to CNBC ReportsStock Price Reaction to CNBC Reports

Minute by minute report of stock prices of firms featured in CNBC’s “Morning” or “Midday Call.”


Leakage of information occurs when information regarding a Leakage of information occurs when information regarding a relevant event is released to a small group of investors relevant event is released to a small group of investors before the official public release. before the official public release.

The price might start to increase days or weeks before the The price might start to increase days or weeks before the announcement and calculating the abnormal return on the announcement and calculating the abnormal return on the announcement date may not best measure the impact of the announcement date may not best measure the impact of the new information. One should calculate cumulative returns.new information. One should calculate cumulative returns.

Cumulative abnormal returns over timeCumulative abnormal returns over time

0 +t-t

Cumulative Abnormal ReturnsCumulative Abnormal Returns

10-4410-44


Cumulative Abnormal ReturnsCumulative Abnormal Returns


Are the Markets Efficient?Are the Markets Efficient?

Magnitude IssueMagnitude Issue How efficient are the markets? Stock prices are very How efficient are the markets? Stock prices are very

close to efficient values, and only managers of very close to efficient values, and only managers of very large portfolios can profit from mis-pricings. large portfolios can profit from mis-pricings.

Selection Bias IssueSelection Bias IssueWould you publish your successful money making Would you publish your successful money making

strategy? No. Only those who fail will publish their strategy? No. Only those who fail will publish their results to the world. Pre-selection in favor of failed results to the world. Pre-selection in favor of failed strategies.strategies.


The Lucky Event IssueThe Lucky Event Issue

Every take out a coin.Every take out a coin. Flip the coin 10 times. Flip the coin 10 times. Heads you win, tails you lose!Heads you win, tails you lose! Count the number of heads.Count the number of heads.

Who is our big winner?Who is our big winner?

Now let’s repeat the exercise.Now let’s repeat the exercise.

Are successful winners able to repeat! Most likely not! Is it Are successful winners able to repeat! Most likely not! Is it skill or merely luck? It is purely luck.skill or merely luck? It is purely luck.


Weak Form TestsWeak Form Tests

• Serial CorrelationSerial Correlation Positive or negative serial correlation is evidence that stock Positive or negative serial correlation is evidence that stock

returns are related to past returns. returns are related to past returns. Evidence:Evidence: Over very short Over very short time horizons evidence of weak price trends. Not enough to time horizons evidence of weak price trends. Not enough to suggest the existence of trading opportunities.suggest the existence of trading opportunities.

• Momentum EffectMomentum Effect Good or bad performance continues over time for the best and Good or bad performance continues over time for the best and

worst recent performers. worst recent performers. Evidence:Evidence: Over 3-12 month holding Over 3-12 month holding periods, there is some evidence of positive momentumperiods, there is some evidence of positive momentum

• Returns over Long HorizonsReturns over Long Horizons (over multiyear periods) (over multiyear periods)Evidence:Evidence: pronounced negative correlation, evidence on pronounced negative correlation, evidence on

reversals. reversals. Reversal Effect:Reversal Effect: Winners become losers and losers Winners become losers and losers become winners.become winners.


Semi-Strong Form TestsSemi-Strong Form Tests

Fundamental analysis calls on a much stronger range of Fundamental analysis calls on a much stronger range of information than does technical analysisinformation than does technical analysis

Tests of fundamental analysis are more difficult to Tests of fundamental analysis are more difficult to evaluate.evaluate.

We will review a number of anomalies – evidence that We will review a number of anomalies – evidence that seems inconsistent with the efficient market seems inconsistent with the efficient market hypothesis. hypothesis.

- Small firm in January Effect- Small firm in January Effect

- Book to Market Ratios- Book to Market Ratios

- Post Earnings Price Drift- Post Earnings Price Drift


Small Firm (January) EffectSmall Firm (January) Effect


Book-to-Market EffectBook-to-Market Effect


Post-Earnings-Announcement DriftPost-Earnings-Announcement Drift


Mutual Fund AlphasMutual Fund Alphas


Mutual Fund PerformanceMutual Fund Performance

0 Portfolio Management 3-228-07 Albert Lee Chun Market Efficiency Lecture 8 30 Oct 2007.

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Transcript of 0 Portfolio Management 3-228-07 Albert Lee Chun Market Efficiency Lecture 8 30 Oct 2007.