Capital Market-Intro Chapter9

7/31/2019 Capital Market-Intro Chapter9

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Chapter 9

The Capital Markets andMarket Efficiency


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The notion that science, left to itself, is bound toevolve more and more of the truth about the world

is another illusion, for science can never existoutside a society, and that society, whether

deliberately or unconsciously, directs its course.

- Northrop Frye


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OutlineIntroduction

Role of the capital markets

Efficient market hypothesis

Anomalies


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IntroductionCapital market theory springs from the

notion that:

People like return

People do not like risk

Dispersion around expected return is a

reasonable measure of risk


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Role of the Capital MarketsDefinition

Economic function

Continuous pricing function

Fair price function


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DefinitionCapital markets trade securities with lives

of more than one year

Examples of capital markets

New York Stock Exchange (NYSE)

American Stock Exchange (AMEX) Chicago Board of Trade

Chicago Board Options Exchange (CBOE)


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Economic FunctionThe economic function of capital markets

facilitates the transfer of money from savers

to borrowers E.g., mortgages, Treasury bonds, corporate

stocks and bonds


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Continuous Pricing FunctionThecontinuous pricing function of capital

markets means prices are available moment

by moment Continuous prices are an advantage to investors

Investors are less confident in their ability toget a quick quotation for securities that do not

trade often


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Fair Price FunctionThefair price function of capital markets

means that an investor can trust the

financial system The function removes the fear of buying orselling at an unreasonable price

The more participants and the more formal themarketplace, the greater the likelihood that thebuyer is getting a fair price


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Efficient Market HypothesisDefinition

Types of efficiency

Weak form

Semi-strong form

Strong form

Semi-efficient market hypothesis

Security prices and random walks


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DefinitionThe efficient market hypothesis (EMH) is

the theory supporting the notion that market

prices are in fact fair The EMH is perhaps the most important

paradigm in finance


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Types of EfficiencyOperational efficiency measures how well

things function in terms of speed of

execution and accuracy It is a function of the number of order that are

lost or filled incorrectly

It is a function of the elapsed time between the

receipt of an order and its execution


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Types of Efficiency (contd)Informational efficiency is a measure of

how quickly and accurately the market

reacts to new information It relates directly to the EMH

The market is informationally very efficient

Security prices adjust rapidly and accurately to newinformation

The market is still not completely efficient


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Weak FormDefinition

Charting

Runs test


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DefinitionThe weak form of the EMH states that it is

impossible to predict future stock prices by

analyzing prices from the past The current price is a fair one that considers

any information contained in the past price data

Charting techniques or of no use in predicting

stock prices


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Definition (contd)Example

Which stock is a better buy?

Stock A

Stock B

Current Stock Price


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Definition (contd)Example (contd)

Solution: According to the weak form of the EMH,neither stock is a better buy, since the current price

already reflects all past information.


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ChartingPeople who study charts aretechnical

analysts orchartists

Chartists look for patterns in a sequence ofstock prices

Many chartists have a behavioral element


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Runs TestAruns test is a nonparametric statistical

technique to test the likelihood that a series

of price movements occurred by chance Arun is an uninterrupted sequence of the sameobservation

A runs test calculates the number of ways an

observed number of runs could occur given therelative number of different observations andthe probability of this number


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Conducting A Runs Test

1 2

1 2

1 2 1 2 1 2

21 2 1 2

1 2

where number of runs

21

2 (2 )

( 1)

, number of observations in each category

standard normal variable

R xZ

R

n nx

n n

n n n n n n

n n n n

n n

Z


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Semi-Strong FormThe semi-strong form of the EMH states

that security prices fully reflect all publicly

available information E.g., past stock prices, economic reports,

brokerage firm recommendations, investment

advisory letters, etc.


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Semi-Strong Form (contd)Academic research supports the semi-strong

form of the EMH by investigating various

corporate announcements, such as: Stock splits

Cash dividends

Stock dividends

This means investor are seldom going tobeat the market by analyzing public news


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Strong FormThe strong form of the EMH states that

security prices fully reflect all public and

private informationThis means even corporate insiders cannot

make abnormal profits by using inside

information Inside information is information not available

to the general public


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Semi-Efficient

Market HypothesisThesemi-efficient market hypothesis

(SEMH) states that the market prices some

stocks more efficiently than others Less well-known companies are less efficiently

priced

The market may be tiered

A security pecking order may exist


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Security Prices and

Random WalksThe unexpected portion of news follows a

random walk

News arrives randomly and security pricesadjust to the arrival of the news

We cannot forecast specifics of the news very

accurately


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AnomaliesDefinition

Low PE effect

Low-priced stocks

Small firm effect

Neglected firm effect

Market overreaction

January effect


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Anomalies (contd)Day-of-the-week effect

Turn-of-the calendar effect

Persistence of technical analysis

Chaos theory


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DefinitionA financialanomaly refers to unexplained

results that deviate from those expected

under finance theory Especially those related to the efficient market

hypothesis


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Low PE EffectStocks with low PE ratios provide higher

returns than stocks with higher PEs

Supported by several academic studies

Conflicts directly with the CAPM, since

study returns were risk-adjusted (Basu)


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Low-Priced StocksStocks with a low stock price earn higher

returns than stocks with a high stock price

There is anoptimum trading range

Every stock with a high stock price

should split


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Small Firm EffectInvesting in firms with low market

capitalization will provide superior risk-adjusted returns

Supported by academic studies

Implies that portfolio managers should givesmall firms particular attention


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Neglected Firm EffectSecurity analysts do not pay as much

attention to firms that are unlikely portfolio

candidates

Implies that neglected firms may offer

superior risk-adjusted returns


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Market OverreactionThe tendency for the market to overreact to

extreme news

Investors may be able to predict systematicprice reversals

Results because people often rely too

heavily on recent data at the expense of themore extensive set of prior data


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January EffectStock returns are inexplicably high in

January

Small firms do better than large firms earlyin the year

Especially pronounced for the first fivetrading days in January


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January Effect (contd)Possible explanations:

Tax-loss trading late in December (Branch)

The risk of small stocks is higher early in the

year (Rogalski and Tinic)


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Types of Firms in JanuaryJanuaryreturn

January return minus

average monthly return

in rest of year

January return

after adjusting for

systematic risk

S&P 500

CompaniesHighly Researched 2.48% 1.63% -1.44%

Moderately

Researched

4.95% 4.19% 1.69%

Neglected 7.62% 6.87% 5.03%

Non-S&P 500

Companies

Neglected 11.32% 10.72% 7.71%


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Day-of-the-Week EffectMondays are historically bad days for the

stock market

Wednesday and Fridays are consistently

good

Tuesdays and Thursdays are a mixed bag


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Day-of-the-Week

Effect (contd)Should not occur in an efficient market

Once a profitable trading opportunity is

identified, it should disappear

The day-of-the-week effect continues to

persist


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Turn-of-the-Calendar EffectThe bulk of returns comes from the last

trading day of the month and the first few

days of the following month

For the rest of the month, the ups and

downs approximately cancel out


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Persistence of

Technical AnalysisTechnical analysis refers to any technique

in which past security prices or otherpublicly available information are employedto predict future prices

Studies show the markets are efficient in theweak form

Literature based on technical techniquescontinues to appear but should be useless


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Chaos TheoryChaos theory refers to instances in which

apparently random behavior is systematic or

even deterministicEconophysics refers to the application of

physics principles in the analysis of stock

market behavior E.g., an investment strategy based on studies of

turbulence in wind tunnels

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