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Principles of FinanceBS 2100

Efficient Markets & Behavioural Finance

Pete HahnFaculty of Finance

Room 5012

Cass Building

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Topics Covered

Review CAPM

– We Always Come Back to NPV

– What is an Efficient Market?• Random Walk• Efficient Market Theory

– The Evidence Against Market Efficiency– Why doesn’t this stuff work????– Behavioral Finance– Six Lessons of Market Efficiency

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Return to NPV

• NPV employs discount rates• These discount rates are risk adjusted• The risk adjustment is a by-product of market

established prices• Adjustable discount rates change asset values

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Return to NPVExample

The government is lending you £100,000 for 10 years at 3% and only requiring interest payments prior to maturity. Since 3% is below the market rate, what is the value of the below market rate loan?

repayment loan of PV-

pmtsinterest of PV- borrowedamount NPV

5

Subsidised Finance…..

Assume that the government is making below market loans to

1. Students (for tuition),

2. Manufacturers (for new machines),

3. Property Developers (to build)

Why do governments do this? How can a business value such a loan?

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Return to NPV

Example

The government is lending you £100,000 for 10 years at 3% and only requiring interest payments prior to maturity. Since 3% is below the market rate, what is the value of the below market rate loan?

Assume the market return on equivalent risk projects is 10%.

012,43£

988,56000,100

)10.1(

000,100

)10.1(

000,3000,001NPV

10

10

1

tt

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Random Walk Theory

• The movement of stock prices from day to day DOES NOT reflect any pattern.

• Statistically speaking, the movement of stock prices is random (skewed positive over the long term).

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Random Walk Theory

$103.00

$100.00

$106.09

$100.43

$97.50

$100.43

$95.06

Coin Toss Game

Heads

Heads

Heads

Tails

Tails

Tails

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Random Walk Theory

S&P 500 Five Year Trend?or

5 yrs of the Coin Toss Game?

70

120

Month

Lev

el

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Random Walk Theory

S&P 500 Five Year Trend?or

5 yrs of the Coin Toss Game?

80

130

180

230

Month

Le

ve

l

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Random Walk Theory

12

Random Walk Theory

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

-5% -3% -1% 1% 3% 5%

Microsoft (correlation = -.019)

Jan 1, 1990 - May 14,2009

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Random Walk Theory

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

-5% -3% -1% 1% 3% 5%

Sony (correlation = 0.026)

Jan 1, 1990 - May 14, 2009

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Random Walk Theory

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

-5% -3% -1% 1% 3% 5%

BP (correlation = .004)

Jan 1, 1990 - May 14, 2009

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Random Walk Theory

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

-5% -3% -1% 1% 3% 5%

Philips Electronics (correlation = -0.03)

Jan.1, 1990 - May 14, 2009

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Efficient Market Theory

Last Month

This Month

Next Month

$40

30

20

Microsoft Stock Price

Cycles disappear

once identified

Actual price as soon as upswing is recognized

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Efficient Market Theory

• Weak Form Efficiency– Market prices reflect all historical information

• Semi-Strong Form Efficiency– Market prices reflect all publicly available information

• Strong Form Efficiency– Market prices reflect all information, both public and

private

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Efficient Market TheoryFundamental Analysts

– Research the value of stocks using NPV and other measurements of cash flow

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Efficient Market TheoryTechnical Analysts

– Forecast stock prices based on the watching the fluctuations in historical prices (thus “wiggle watchers”)

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Efficient Market Theory

-16

-11

-6

-1

4

9

14

19

24

29

34

39

Days Relative to annoncement date

Cu

mu

lati

ve

Ab

no

rma

l Re

turn

(%

)

Announcement Date

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Efficient Market TheoryAverage Annual Return on Mutual Funds and the Market Index

1962

1963

1964

1965

1966

1967

1968

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

-50

-40

-30

-20

-10

0

10

20

30

40

50

Funds

Market

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Efficient Market TheoryThe average return 1972–2001 on stocks of firms over the six months following an announcement of quarterly earnings. The 10% of stocks with the best earnings news (portfolio 10) outperformed those with the worst news (portfolio1) by about 1% per month.

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Efficient Market Theory

0

5

10

15

20

First Second Third Fourth Fifth

Av

era

ge

Re

turn

(%

)

IPO

Matched Stocks

IPO Non-Excess Returns

Year After Offering

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-50.0

-40.0

-30.0

-20.0

-10.0

0.0

10.0

20.0

30.0

40.0

Price AnomaliesD

evia

tion,

%Log Deviations From Royal Dutch Shell / Shell T&T Parity

1973 - 2006

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Efficient Market Theory1987 Stock Market Crash

119310.114.

7.16)( crash pre

gr

DivindexPV

928096.114.

7.16)( crashpost

gr

DivindexPV

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Random Picks vs. Professional Asset Managers

1999-2002

Who won? Or What did we learn?

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Behavioral Finance

Arbitrage limitationsLong Term Capital Markets example

Factors related efficiency and psychology

1. Attitudes towards risk

2. Beliefs about probabilities

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Lessons of Market Efficiencyor is it about discipline?

1.Markets have no memory– Don’t look back

2.Trust market prices– Still the best information

3. Are there details unknown to some?– You have to study hard

4.There are no financial illusions– When it doesn’t make sense….

5.The do it yourself alternative– Make your own market index

6.Seen one stock, seen them all– It is all about numbers (risk vs. return)

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Example: How stock splits affect value

Wow, today I have one share and tomorrow I can return it to the company in exchange for 2 shares!

A share is worth 600p today, how much will a share tomorrow be worth?

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By Matt Phillips and Randall Smith, Wall Street Journal, March 2011

“CITIGROUP INC. BECAME A $40 STOCK FOR THE FIRST TIME SINCE LATE 2007, AS ITS SHARE PRICE APPEARED TO RISE MORE THAN 850% FROM FRIDAY'S CLOSE. ONE CATCH: INVESTORS DIDN'T EARN A DIME ON MONDAY.

CITIGROUP, THE HEAVIEST-TRADED U.S. STOCK THAT ACCOUNTED FOR 6.8% OF TOTAL U.S. STOCK TRADING VOLUME LAST YEAR, DRASTICALLY SHRUNK ITS SHARE COUNT. THE MOVE INSTANTLY ERASED ITS SINGLE-DIGIT STOCK PRICE, WHICH HAS BEEN A PERSISTENT REMINDER OF THE TRAUMA THE BANK SUFFERED DURING THE FINANCIAL CRISIS.

THROUGH A REVERSE SPLIT, CITIGROUP WAS ABLE TO AX A HUGE NUMBER OF SHARES OUTSTANDING BY TURNING EVERY 10 SHARES INTO A SINGLE SHARE. INSTEAD OF TRADING FOR LESS THAN $5 A SHARE, WHERE CITIGROUP HAS LANGUISHED DESPITE IMPROVEMENTS IN PROFITS AND CAPITAL, THE NEW YORK FINANCIAL BEHEMOTH INSTANTLY BECAME A $40 STOCK. SHARES OF THE BANK FELL $1.04, OR 2.3%, TO $44.16…..”

Citigroup Instantly Becomes a $40 Stock

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Prospect Theory

Last year you bought two shares (A +B) for £100 each. Today A is trading at 80 and B is trading at 120. You need £80.

Which will you sell?

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More Behaviour….

What did Chancellor (Kahneman) say human and discounting?

What does the Hong Kong IPO experience say about efficient markets?

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Topics Covered

– We Always Come Back to NPV

– What is an Efficient Market?• Random Walk• Efficient Market Theory

– The Evidence Against Market Efficiency– Behavioral Finance– Six Lessons of Market Efficiency

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Rational?

ra·tion·al   [rash-uh-nl, rash-nl] – adjective

1. agreeable to reason; reasonable; sensible: a rational plan for economic development.

2. having or exercising reason, sound judgment, or good sense: a calm and rational negotiator.

3. being in or characterized by full possession of one's reason; sane; lucid: The patient appeared perfectly rational.

If I forsake a good investment to go on holiday, am I irrational?

Be careful.

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See you next week and good luck