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1PD Hahn 1
Principles of FinanceBS 2100
Efficient Markets & Behavioural Finance
Pete HahnFaculty of Finance
Room 5012
Cass Building
2PD Hahn 2
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
13
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
14
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
15
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
21
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
22
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?
31
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
35
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.
36PD Hahn 36
See you next week and good luck