EMH Corporate Finance

8/17/2019 EMH Corporate Finance

1/38

Hailey College of Bankingand Finance

Instructor: Abdul Qadeer

[email protected]!"""#$%&'&$


2/38

“Investors, as a group, can do no better

than the market, because collectively

they are the market. Most investors trailthe market because they are burdenedby commissions and fund expenses.” (

)onathan Cleents* the Wall Street Journal, )une +&* +,,&

)ust Cro-ed


3/38

An ecient ca/ital arket is a arket that is

ecient in /rocessing inforation.

0e are talking about an 1inforationally ecient2arket* In other -ords* -e ean that the arketquickly and correctly ad3usts to ne- inforation.

In an inforationally ecient arket* the /rices ofsecurities observed at any tie are based on

1correct2 evaluation of all inforation available atthat tie. 4herefore* in an ecient arket* /rices

iediately and fully re5ect available inforation.

6cient Ca/ital 7arket


4/38

"In an efcient market, competition among the many

intelligent participants leads to a situation where, atany point in time, actual prices o individual securitiesalready reect the eects o inormation ased oth onevents that have already occurred and on eventswhich, as o now, the market e!pects to take place inthe uture In other words, in an efcient market at any

point in time the actual price o a security will e a

good estimate o its intrinsic value#

Faa* 6ugene* 89ando 0alks in tock 7arket ;rices*2

$inancial %nalysts Journal * +,#


5/38

Conce/t that tock /rice oveents follo-

=Bro-nian 7otion > and are thus = 9ando 0alk >

-as /resented in 1!! by "ouis #achillier in his;h? 4hesis at orbonne >: = &h'orie de laSpeculation >.

In +,!< Albert 6instien* = INTRODUCED > the

Bro-nian 7otion in as ;articles.

In +,!#* arl ;earson* argued that = STOCK PRICES

FOLLOW RANDOM WALK >


6/38

4he 6cient 7arkets Hy/othesis 67H is

ade u/ of three /rogressively stronger

fors: 0eak For

eiDstrong For

trong For

67H and Ca/ital 7arkets


7/38

4he 0eak For

4he -eak for of the 67H says that /ast /rices* volue* andother arket statistics /rovide no inforation that can beused to /redict future /rices.

If stock /rice changes are rando* then /ast /rices cannot beused to forecast future /rices.

;rice changes should be rando because it is inforation thatdrives these changes* and inforation arrives randoly.

;rices should change very quickly and to the correct level-hen ne- inforation arrives see neEt slide.

4his for of the 67H* if correct* re/udiates technical analysis. 7ost research su//orts the notion that the arkets are -eak

for ecient.


8/38

4echnical Analysis using /rices and volue inforation

to /redict future /rice changes

4A assues /rices use /redictable trend

the trend line is there because Grs invest in ;/ro3ects on average

If the markets are e$cient, %ill technical analysisbe able to consistently predict price changes&

4echnical Analysis


9/38

;rice Ad3ustent -ith e-

Inforation

At 10AM EST, the U.S. Supreme Court refused to hear an appeal

from MSFT regarding its anti-trust case. The stoc immediatel!

dropped. This e"ample, one of hundreds a#aila$le e#er! da!,

illustrates that prices ad%ust e"tremel! rapidl! to ne& information.

'ut, did the price ad%ust correctl!( )nl! time &ill tell, $ut it does

seem that o#er the ne"t hour the maret is searching for the correct

le#el.

*otes+ Each $ar represents high, lo&, and close for one-minute. Each solid gridline represents the top of an hour, and each

dotted gridline represents a half-hour.


10/38

4he eiDstrong For of 67H

and Ca/ita 7arkets

4he seiDstrong for says that /rices fully re5ect all/ublicly available inforation and eE/ectationsabout the future.

4his suggests that /rices ad3ust very ra/idly to ne-inforation* and that old inforation cannot beused to earn su/erior returns.

4he seiDstrong for* if correct* re/udiatesfundaental analysis.

7ost studies Gnd that the arkets are reasonablyecient in this sense* but the evidence is soe-hatiEed.


11/38

Fundaental Analysis using econoic and

accounting inforation to /redict stock /rice

changes 'ill fundamental analysis be able to

consistently predict price changes&

Fundaental Analysis

If the markets are only %eak form e$cient&

(undamental )nalysis *)+ predict price changes

If the markets are semistrong or strong form e$cient&

(undamental )nalysis *)++- predict price changes


12/38

(undamental analysis assumes that

stock prices should be equal to the

discounted value ; of the eE/ected future cash 5o-s the stock is eE/ected to /rovide toinvestors.

(undamental analysis is thus the 1art2 ofidentifying overD and undervalued securitiesbased on an analysis of the GrJs future/ros/ects.

Fundaental Analysis


13/38

(undamental

)nalysis(undamental analysis varies intechnique but generally focuses onforecasting the GrJs future dividendsor earnings* discounting those futurecash 5o-s by the required rate of

return usually obtained fro theCA;7* and co/aring the resultingestiated /rice -ith the current stock/rice.


14/38

If Intrinsic alue is less than arket value

If Intrinsic alue is greater than arket value

?ecisionD7is/ricing:

Kndervalued L Mvervalued


15/38

4he 67H

ra/hically In this diagra* the

circles re/resent theaount of inforation

that each for of the67H includes.

ote that the -eak forcovers the least aountof inforation* and thestrong for covers allinforation.

Also note that eachsuccessive for includesthe /revious ones.All inforation* /ublic and

/rivate

All /ublic inforation

All historical /rices andreturns

Strong Form

Semi-Strong

Weak Form


16/38

AnalystsN

;erforance

This chart from the all Street ournal, sho&s that &hen anal!sts issue

sell recommendations, those stocs freuentl! outperform those &ith

$u! or hold ratings. /f the professionals cant get it right, &ho can(


17/38

4he trong For

4he strong for says that /rices fully re5ectall inforation* -hether /ublicly available or

not. 6ven the kno-ledge of aterial* nonD/ublic

inforation cannot be used to earn su/eriorresults.

7ost studies have found that the arkets arenot ecient in this sense.


18/38

Informational /$ciency

Are /rice changes consistently /redictable 6ciency centers on the idea that stock /rices al-ays re5ect

inforation.

6cient arkets hel/ investors to feel conGdent about the

accuracy of stock /rices* and that stocks are fairly /rices.

0o security prices accurately reectinformation&


19/38

0hy are /rice changes randoO

In very co/etitive arkets /rices should react

to only 60 inforation

Flo- of 60 inforation is rando

4herefore* /rice changes are rando

Idea that stock /rices follo- a 19ando 0alk2

9ando ;rice Changes


20/38

Anoalies

?eviation fro the -hat is said as standard oreE/ected

Anoalies are uneE/lained e/irical resultsthat contradict the 67H:

4he iPe eect.

4he 1Incredible2 )anuary 6ect. ?ay of the 0eek 7onday 6ect.


21/38

4he iPe 6ect

Beginning in the early +,%!Ns a nuber ofstudies found that the stocks of sall Grs

ty/ically out/erfor on a riskDad3usted basisthe stocks of large Grs.

4his is even true aong the largeDca/italiPation stocks -ithin the R;

saller but still large stocks tend toout/erfor the really large ones.


22/38

4he 1Incredible2

)anuary 6ect tock returns a//ear to be higher in )anuary

than in other onths of the year.

4his ay be related to the siPe eect since itis ostly sall Grs that out/erfor in

)anuary.

It ay also be related to end of year taE

selling.

4h ? f h


23/38

4he ?ay of the0eek 6ect Based on daily stock /rices fro +,#" to +,%< ei

found that returns are higher on Fridays and lo-eron 7ondays than should be eE/ected.

4his is /artly due to the fact that 7onday returnsactually re5ect the entire Friday close to 7ondayclose tie /eriod -eekend /lus 7onday* ratherthan 3ust one day.

7oreover* after the stock arket crash in +,%&* this

eect disa//eared co/letely and 7onday becaethe best /erforing day of the -eek bet-een +,%,and +,,%.


24/38

uary of 4ests of

the 67H 0eak for is su//orted* so technical analysis

cannot consistently out/erfor the arket. eiDstrong for is ostly su//orted * so

fundaental analysis cannot consistentlyout/erfor the arket.

trong for is generally not su//orted. If you havesecret 1insider2 inforation* you CA use it toearn eEcess returns on a consistent basis.

Kltiately* ost believe that the arket is veryecient* though not /erfectly ecient. It isunlikely that any syste of analysis couldconsistently and signiGcantly beat the arketad3usted for costs and risk over the long run.


25/38

)ctive Management

2assive Management

)ctive or 2assiveManagement

Assues ineciency*use technical andLorfundaental analysisto /ick securitiesecurity analysis

4iing strategiesInvestent e-sletters

Buy and Hold /ortfolios

Consistent -ith

seiDstrongeciency


26/38

3elected Mini *ases


27/38

7ini Case +

#I (arkets are efcient, what should e thecorrelation coefcient etween stock returns or two

non overlapping time periods)


28/38

Sero* other-ise returnsfro the /rior /eriod

could be used to /redictreturns in the subsequent

/eriod.


29/38

7ini Case '

1A successful Gr like TintelN has consistentlygenerated large /roGts for years. Is this aviolations of the 67HO


30/38

o. 0hyO7aybe due to a higher

riskO7aybe due to constantsur/rises beyondeE/ected sur/riseearnings.


31/38

7ini Case "

1;rices of tock before stock s/lits sho- onaverage consistently /ositive abnoral returns. Is

this a violation of the 67HO


32/38

ot necessarily* 0hyO

It could indicate inforation leakage UVa violation of 67H or it could indicate thats/lits occur during /rice runu/s UV stillconsistent of 67H.


33/38

7ini Case $

1If the business cycle is /redictable* and a stockhas a /ositive beta* the stockNs returns also ust

be /redictable.2 9es/ond


34/38

o* 0hyO

Wou -onNt get abnoral returns if the econoiccycle is /redictable* the ne-s -ill already beincor/orated in the stockNs /rice.


35/38

7ini Case <

1Wou kno- that Gr XWS is very /oorly run. Mn aanageent scale of + -orst to +! best* you-ould give it a score of ". 4he arket consensusevaluation is that the anageent score is only

'. hould you buy or sell the stockO


36/38

o* 0hyO

Wou -onNt get abnoral returns if the econoiccycle is /redictable* the ne-s -ill already beincor/orated in the stockNs /rice.


37/38

Interediate Investents F"!< "&

Is the 7arket 9ationalO

4he Behavioralists vie- the arket bubble of

the ,!Ns as /roof that investors are notrational

har/e* a 9ationalist su//orter* could noteE/lain the arket crash of +,%&. He

described it as 1unusual2. His other later toldhi* 1Fifteen years of education* threeadvanced degrees and all you can say is TItNsunusualNO2

CMCYKIMO 6ven behavioralists assue the arkets are ecient-hen calculating cost of ca/ital

6ven 67H su//orters adit they need /eo/le to tryto beat the arkets to kee/ the ecient

o* buy and hold* diversify and control your costsZ


38/38

Interediate Investents F"!< "%

Anoalies in 4echnical andFundaental Investing

4echnical hortDter /ositive correlations

YongDter negative correlations

all Firs in )anuary eect

Fundaental

Investing for value v. gro-th ishny and Yalinshock

Faa and French

EMH Corporate Finance

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