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Efficient Capital Markets
In an efficient capital market, security prices adjust rapidly to the arrival of new information, therefore the current prices of securities reflect all information about the security
Whether markets are efficient has been extensively researched and remains controversial
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Why Should Capital Markets Be Efficient?
The premises of an efficient market• A large number of profit-maximizing
participants analyze and value securities• New information regarding securities
comes to the market in a random fashion• Profit-maximizing investors adjust security
prices rapidly to reflect the effect of new information
Conclusion: the current price of a security should reflect its risk
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Alternative Efficient Market Hypotheses
Weak-form efficient market hypothesis Semistrong-form EMH Strong-form EMH
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Weak-Form EMH
Current prices reflect all security-market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information
This implies that past rates of return and other market data should have no relationship with future rates of return
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Semistrong-Form EMH
Current security prices reflect all public information, including market and non-market information
This implies that decisions made on new information after it is public should not lead to above-average risk-adjusted profits from those transactions
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Strong-Form EMH
Stock prices fully reflect all information from public and private sources
This implies that no group of investors should be able to consistently derive above-average risk-adjusted rates of return
This assumes perfect markets in which all information is cost-free and available to everyone at the same time
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Tests and Results of Weak-Form EMH
Statistical tests of independence between rates of return• Autocorrelation tests have mixed results• Runs tests indicate randomness in prices
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Tests and Results of Weak-Form EMH
Comparison of trading rules to a buy-and-hold policy is difficult because trading rules can be complex and there are too many to test them all• Filter rules yield above-average profits with
small filters, but only before taking into account transactions costs
• Trading rule results have been mixed, and most have not been able to beat a buy-and-hold policy
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Tests and Results of Weak-Form EMH
Testing constraints• Use only publicly available data• Include all transactions costs• Adjust the results for risk
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Tests and Results of Weak-Form EMH
Results generally support the weak-form EMH, but results are not unanimous
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Tests and Results ofSemistrong-Form EMH
Studies to predict future rates of return using public information beyond market information• Time series analysis• Cross-section distribution
Event studies examine how fast stock prices adjust to significant economic events
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Tests and Results of Semistrong-Form EMH
Test results should adjusted a security’s rate of return for the rates of return of the overall market during the period considered
Arit = Rit - Rmt where:
Arit = abnormal rate of return on security i during period t
Rit = rate of return on security i during period t
Rmt =rate of return on a market index during period t
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Tests and Results ofSemistrong-Form EMH
Arit = Rit - E(Rit)
where: E(Rit) = the expected rate of return for stock I during
period t based on the market rate of return and the stock’s normal relationship with the market (its beta)
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Tests and Results of Semistrong-Form EMH
Time series tests for abnormal rates of return• short-horizon returns have limited results• long-horizon returns analysis has been
successful based on– dividend yield (D/P)
– default spread
– term structure spread
• Quarterly earnings reports may yield abnormal returns due to
– unanticipated earnings change
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Tests and Results of Semistrong-Form EMH
Tests of standardized unexpected earnings (SUE) normalize the difference in actual and expected earnings by the standard error of estimate from the regression used to derive the expected earnings figure SUE =
Reported EPSt - Predicted EPSt
Standard Error of Estimate for the Estimating Regression Equation
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Tests and Results of Semistrong-Form EMH
Large SUEs result in abnormal stock price changes, with over 50% after the announcement
Unexpected earnings can explain up to 80% of stock drift over a time period
These are evidence against the EMH Additional tests include calendar studies
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Tests and Results of Semistrong-Form EMH
The January AnomalyStocks with negative returns during the prior
year had higher returns right after the first of the year - studies indicate an excess return on AMEX but not on NYSE
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Tests and Results of Semistrong-Form EMH
Other calendar effects• All the market’s cumulative advance occurs
during the first half of trading months• Monday/weekend returns were significantly
negative
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Tests and Results of Semistrong-Form EMH
Predicting cross-sectional returnsAll securities should have equal risk-adjusted
returns Studies examine alternative measures of
size or quality as a tool to rank stocks in terms of risk-adjusted returns• These tests include a joint hypothesis and
are dependent both on market efficiency and the asset pricing model used
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Tests and Results of Semistrong-Form EMH
Price-earnings ratios and returns• Examine historical P/E ratios and returns• Stocks are divided into five P/E classes• Low P/E stocks had higher returns and had
lower risk• Publicly available P/E ratios could be used
for abnormal returns• This is inconsistent with semistrong
efficiency
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•Tests and Results of Semistrong-Form EMH
The size effect (total market value)• All stocks on NYSE and AMEX were ranked by
market value and divided into ten equally weighted portfolios
• The risk-adjusted returns for extended periods indicate that the small firms consistently experienced significantly larger risk-adjusted returns than large firms
• Could this have caused the P/E results previously studied?
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•Tests and Results of Semistrong-Form EMH
The P/E studies and size studies are dual tests of the EMH and the CAPM
Abnormal returns could occur because either • markets are inefficient or • market model is not properly specified and
provides incorrect estimates of risk and expected returns
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Tests and Results of Semistrong-Form EMH
Adjustments for riskiness of small firms did not explain the large differences in rate of return
The impact of transactions costs of investing in small firms depends on frequency of trading• Daily trading reverses small firm gains
The small-firm effect is not stable from year to year
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Tests and Results of Semistrong-Form EMH
Neglected Firms• Firms divided by number of analysts following
a stock• Neglected firm effect caused by lack of
information, crosses size classes• Contradictory results from another study
Trading volumeStudied relationship between returns, market
value, and trading activity
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Tests and Results of Semistrong-Form EMH
Firm size has emerged as a major predictor of future returns
This is an anomaly in the efficient markets literature
Attempts to explain the size anomaly in terms of superior risk measurements, transactions costs, analysts attention, trading activity, and differential information have not succeeded
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Tests and Results of Semistrong-Form EMH
Book value-market value ratio• As a predictor of stock returns• Significant positive relationship between the
current values for this ratio and future stock returns are evidence against EMH
Size and BV/MV dominate other ratios such as E/P ratio or leverage
This combination only works during expansive monetary policy
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Tests and Results of Semistrong-Form EMH
Event studies• Stock split studies show that splits do not result
in abnormal gains after the split announcement, but before
• Initial public offerings seems to be underpriced by about 15%, but that varies over time, and the price is adjusted within one day after the offering
• Being listed on an exchange may offer some short term profit opportunities
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Tests and Results of Semistrong-Form EMH
Event studies (continued)• Unexpected world events and economic
news are quickly adjusted to and do not provide opportunities
• Announcements of accounting changes are quickly adjusted for and do not seem to provide opportunities
• Corporate events such as mergers and offerings are adjusted to within a few days
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Summary on the Semistrong-Form EMH
Evidence is mixed Strong support from numerous event
studies with the exception of exchange listing studies
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Summary on the Semistrong-Form EMH
Studies on predicting rates of return for a cross-section of stocks indicates markets are not semistrong efficient
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Summary on the Semistrong-Form EMH
Studies on predicting rates of return for a cross-section of stocks indicates markets are not semistrong efficientDividend yields
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Summary on the Semistrong-Form EMH
Studies on predicting rates of return for a cross-section of stocks indicates markets are not semistrong efficientDividend yields, risk premiums
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Summary on the Semistrong-Form EMH
Studies on predicting rates of return for a cross-section of stocks indicates markets are not semistrong efficientDividend yields, risk premiums, calendar
patterns
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Summary on the Semistrong-Form EMH
Studies on predicting rates of return for a cross-section of stocks indicates markets are not semistrong efficientDividend yields, risk premiums, calendar
patterns, and earnings surprises
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Summary on the Semistrong-Form EMH
Studies on predicting rates of return for a cross-section of stocks indicates markets are not semistrong efficientDividend yields, risk premiums, calendar
patterns, and earnings surprises This also included cross-sectional
predictors such as size, the BV/MV ratio (when there is expansive monetary policy), E/P ratios, and neglected firms.
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Tests and Results of Strong-Form EMH
Strong-form EMH contends that stock prices fully reflect all information, both public and private
This implies that no group of investors has access to private information that will allow them to consistently earn above-average profits
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Testing Groups of Investors
Corporate insiders Stock exchange specialists Security analysts Professional money managers
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Corporate Insider Trading
Insiders include major corporate officers, directors, and owners of 10% or more of any equity class of securities
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Corporate Insider Trading
Insiders include major corporate officers, directors, and owners of 10% or more of any equity class of securities
Insiders must report to the SEC each month on their transactions as insiders
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Corporate Insider Trading
Insiders include major corporate officers, directors, and owners of 10% or more of any equity class of securities
Insiders must report to the SEC each month on their transactions as insiders
These insider trades are made public about six weeks later and allow for study
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Corporate Insider Trading
Corporate insiders generally experience above-average profits especially on purchase transaction
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Corporate Insider Trading
Corporate insiders generally experience above-average profits especially on purchase transaction
This implies that many insiders had private information from which they derived above-average returns on their company stock
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Corporate Insider Trading
Studies showed that public investors who traded with the insiders based on announced transactions would have enjoyed excess risk-adjusted returns, but the markets now seem to have eliminated this inefficiency (soon after it was discovered)
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Corporate Insider Trading
Other studies indicate that you can increase returns from using insider trading information by combining it with key financial ratios and considering what group of insiders is doing the buying and selling
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Stock Exchange Specialists
Specialists have monopolistic access to information about unfilled limit orders
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Stock Exchange Specialists
Specialists have monopolistic access to information about unfilled limit orders
You would expect specialists to derive above-average returns from this
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Stock Exchange Specialists
Specialists have monopolistic access to information about unfilled limit orders
You would expect specialists to derive above-average returns from this
The data generally supports this
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Security Analysts
Tests have considered whether it is possible to identify a set of analysts who have the ability to select undervalued stocks
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Security Analysts
Tests have considered whether it is possible to identify a set of analysts who have the ability to select undervalued stocks
This looks at whether, after a stock selection by an analyst is made known, a significant abnormal return is available to those who follow their recommendation
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The Value Line enigma
Value Line (VL) publishes financial information on about 1,700 stocks
The report includes a timing rank from 1 down to 5
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The Value Line enigma
Value Line (VL) publishes financial information on about 1,700 stocks
The report includes a timing rank from 1 down to 5
Firms ranked 1 substantially outperform the market
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The Value Line Enigma
Value Line (VL) publishes financial information on about 1,700 stocks
The report includes a timing rank from 1 down to 5
Firms ranked 1 substantially outperform the market
Firms ranked 5 substantially underperform the market
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The Value Line Enigma
Changes in rankings are quickly price adjusted into the market
Some content that the Value Line effect is merely the unexpected earnings anomaly due to changes in rankings from unexpected earnings
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Security Analysts
There is evidence in favor of existence of superior analysts who apparently posses private information
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Efficient Markets and Technical Analysis
Technical analysts develop systems to detect movement to a new equilibrium (breakout) and trade based on that
Contradicts EMH rapid price adjustments
If the capital market is weak-form efficient, a trading system that depends on past trading data can have no value
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Efficiency in European Equity Markets
Hawawini study indicates behavior of European stock prices is similar to U.S. common stocks
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Future topicsChapter 9
Analysis of Financial Statements Financial Ratios Evaluating Performance
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