the efficient marke

8/13/2019 the Efficient Marke

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BM410 Investments

The Efficient MarketHypothesis

orIs there really a free lunch?


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Objectives

R. Review Portfolio Theory up to today

A. Understand the efficient market

hypothesis and why securities pricesshould be essentially unpredictable

B. Be able to formulate investment

strategies that make sense in

informationally efficient markets.

C. Understand the tests of market

efficiency and cite evidence that supports

and contradicts the EMH


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Review of Financial Theory

What we have discussed

A two asset portfoliowith leverage

Modern Portfolio Theory

The development of the efficient frontier

The efficient frontier with CALs

CAPM, and its movement toward Beta

APT


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E(r)

E(rp) = 15%

rf= 7%

= 22%0

P

F

P

) S = 8/22

E(rp)- rf= 8%

CAL:

(Capital

Allocation

Line)

Two Assets and the CAL

Slope: Reward to variability ratio: ratioof risk premium to std. dev.

Risk premium

This graph is the risk return combination available by choosing different valuesof y. Note we have E(r) and variance on the axis.


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r = 0

E(r)

r = 1r = -1

r = -1

r = .3

13%

8%

12% 20%St. Dev

TWO SECURITY PORTFOLIOS WITHDIFFERENT CORRELATIONS

MPT: The Impact of Correlation


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E(r)

The minimum-variance frontier of risky

assets

Efficientfrontier

Globalminimum

variance

portfolio Minimum

variancefrontier

Individual

assets

St. Dev.

The Efficient Frontier


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E(r)

CAL (Globalminimum variance)

CAL (A)CAL (P)

M

P

A

F

P P&F A&FM

A

G

P

M

s

The Efficient Frontier with CALs


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E(r)

E(rM)

rf

SML

M

= 1.0

CAPM and The Security Market Line

Notice that instead of using standarddeviation, the SML uses Beta

SML Relationships

b = [COV(ri,rm)] / sm2

Slope SML = E(rm)rf = market risk

premium

SML = rf + b[E(rm) - rf]


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CAPM: Expected Return

Beta Relationship

Expected return - beta relationship

E(rM) - rf = E(rs) - rf

1 bsIn other words, the expected rate of return of an asset

exceeds the risk-free rate by a risk premium equal

to the assets systematic risk (its beta) times the riskpremium of the market portfolio. This leads to thefamiliar:

E(rs) = rf + bs [E(rM) - rf ]


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APT and the

Security Characteristic Line

Excess Returns (i) SCL

.

.

...

.

. .

. ..

. . .. .

. ..

..

.

. .

. ..

...

. .

..

.

. . .. .

.

. ... .. .. .

Excess returns

on market index

Ri= a i+ iRm+ ei

Plot of a companys excess return as a

function of the excess return of the market


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A. Efficient Market Hypothesis and why

Securities Prices should be Unpredictable

What is the Efficient Market Hypothesis (EMH)?

A hypothesis (or theory) that security prices reflect

all available information, i.e., historical, public, and

non-public

A framework for trying to understand the

movements in stock prices

Probably the single most important paradigm in

finance

Why is it important?

It helps us understand formulate a basis for various

investment strategies and also explain why prices

move the way they do


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What is Market Efficiency?

What is efficiency?

The quality or degree of being efficient, effective

operation as measured by a comparison of

production/energy with cost/output Are their different types of efficiency?

Operational efficiency

The measure of how well things function in

terms of speed of execution and accuracy

Informational efficiency (i.e. market efficiency)

The measure of how quickly and accurately the

market reacts to new information


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Degrees of Informational Efficiency

Weak form

Stock prices reflect all information contained in the

history of past tradingno benefit from past prices

Semi-strong form Stock prices reflect all publicly available

informationno benefit from 10Ks, 10Qs, etc.

Strong form

Stock prices reflect all relevant information,

including past, public, and inside informationno

benefit from any insider information

SF SSF

Weak Form


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What is a Random Walk?

The notion that stock prices are random and

unpredictable

Since information comes randomly, then itsimpact on stock prices should be random as well

Price changes are actually a sub martingale

The expected price is generally positive over

time It has a positive trend and is random about the

trend

Random Walk and the EMH


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SecurityPrices

Time

Random Walk with Positive Trend


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Efficient Markets Hypothesis

and Competition

Stock prices fully and accurately reflect

publicly available information

Once information becomes available, market

participants analyze it

Participants will buy and sell based on that

new information

Competition assures prices reflectinformation, as securities will be bought and

sold until the point that all new information

is embedded in the price


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Are there Other Theories?

Semi-efficient market hypothesis (among

others)

A cousin of the EMH

States that some stocks are priced moreefficiently than others

This is generally used to support the notion of

tiering in the markets

Analysts can only follow so many stocks, sothey follow the largest

The smaller are less followed, and hence are

more likely to be less-efficiently priced


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Questions

Any questions of the Efficient Market

Hypothesis and why stock prices should

be unpredictable?


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Problem #1

Which of the following most appears tocontradict the proposition that the stockmarket is weak-form efficient? Explain.

A. Over 25% of mutual fundsoutperforms the markets on average.

B. Insiders earn abnormal trading profits

C. Every January, the stock market earnsabove normal returns.


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Answer #1

c. Predictable returns should not

occur according to the weak-form

efficient market hypothesis. Higherthan average returns in the month of

January each year contradicts the

weak-form EMH.


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B. Investment Strategies in

Informationally Efficient Markets

Does your view of efficient markets have an

impact on how you manage a portfolio?

Stock analysis assumes the markets are not weak

and semi-strong form efficient Technical Analysis- using prices and volume

information to predict future prices

Violates weak-form efficiency

Fundamental Analysis- using economic andaccounting information to predict stock prices

Violates semi-strong form efficiency


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Active Management

If markets are efficient, then it depends on the

degree of efficiency

Security analysis assumes you can add even alittle bit of value

It doesnt have to be too much if you are

managing a large fund

Timing assumes you can make decisionsregarding the attractiveness of various asset

classes

Implications of EMH Efficiency


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Implications of EMH Efficiency

Passive Management

This is useful and cheap

Buy and Hold

Since the EMH indicates prices are at

a fair value, it makes no sense to buy,

sell, or do any type of analysis

Index Funds If you cant beat them, join them

mimic a broad benchmark of

securities, i.e. the S&P 500


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What if the markets are efficient? Is

there still a role for portfolio

management?

Even if the markets are efficient, a role

exists for portfolio management

Determining an appropriate risk level

Understanding tax considerations

Taking into account other individual

investment considerations for a portfolio

Market Efficiency and Portfolio

Management


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Questions

Do you understand how the implications

of the EMH will affect trading

strategies?


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Problem #2

Some scholars contend that professional

managers are incapable of outperforming

the market. Others come to an opposite

conclusion. Compare and contrast the

assumption about the stock market that

support (a) passive portfolio

management and (b) active portfoliomanagement.


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Answer #2

Assumptions that support passive management

are that all available information is already

reflected in the price of stocks. The fees for

passive management are minimal. Assumptions that support active management

are that there are pockets of market

inefficiency. Active management is more

feasible for managers of large portfolios.


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How are tests made of the Efficient

Market Hypothesis?

Most common are:

Performance Attribution: Assessing

performance of professional managers

Testing of filter / trading rules

Event studies

C. Understand Empirical Tests

of Market Efficiency


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Performance Attribution

Results from Mutual Fund and Professional

Manager Performance

There is some evidence of persistent positive and

negative performance The problem is that it takes time to determine

both

Sometimes positive returns are from managers

investing outside their benchmark Potential measurement error for benchmark returns

Style changes have occurred

May be risk premiums involved

There is a superstar phenomenon(Lynch, Buffett, etc.)


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Testing of Filter/Trading Rules

Very limited support of trading rules

A trading rule might suggest you buy when

the stock passes its 360 day moving

average and sell when it drops below its 45day moving average

Those who make money on trading rules

are generally those selling the books Once a trading rule is known, it is generally

exploited and then the inefficiency is lost


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How Tests Are Structured

1. Examine prices and returns over time

Formulate a hypothesis (and choose an

appropriate test statistic)2. Adjust returns to determine if they are abnormal

Select a model, i.e. Rt= at+ btRmt+ et and

compare expected returns to actual returns

3. Compare actual results with expected resultsSee how well your actual results were predicted

by your model

Event Studies


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Event Studies(continued)

Results of Event Studies:

If the results are good, you invest money with

the testyou do not let anyone know, but

make lots of money and retire early If the results are bad, you publish the results

and make tenure, or try to sell books and tapes

via the radio and TV to unsuspecting buyers

who dont know any better


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0 +t-t

Announcement Date

Returns Surrounding the Event

Event Studies(continued)


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Key Issues:

Magnitude Issue

A 1 basis point improvement for a $100K

portfolio is much less important than for a $10bnportfolio

Size matters

Selection Bias Issue

Investment schemes that dont work arepublished, and those that do are used to make

money

We only hear of those that dont work

Final Thoughts on

Market Efficiency


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Market Efficiency (continued)

Lucky Event Issue

It is more difficult to prove skill than luck

It takes more time to prove skill

Possible Model Misspecification

Perhaps the market is efficient but the

model is incorrectly stated

We may be using the wrong model


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What Does the Evidence Show?

If it sounds too good to be true, itusually is

It must make good common businesssense

Common sense is all too uncommon

Technical Analysis May be helpful for certain events

But generally hasnot shownexcessreturns for a longer period of time


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Fundamental Analysis

Has been shown to add value

But analysts must forecast firms earnings

better than everyone else

Anomalies Exist

But invest in them at your peril

An anomaly discussed means it is known It is less like to do the same next time

because others will be watching for it

as well.


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What is a market anomaly?

A market anomaly refers to price behavior that

differs from the behavior predicted by the

efficient market hypothesis. An anomaly discussed means it is known

It is less like to do the same next time

because others will be watching for it as

well. Are their anomalies that are known?

D. Understand Anomalies

to the EMH


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Anomalies(continued)

Price Earnings Effect

Portfolios of low P/E stocks have exhibited higher

average risk-adjusted returns than higher P/E

Stocks

Investors prefer cheaper stocks even if risk

levels are the same.

Small Firm Effect

Smaller firms generally earn higher returns May be tied to fact that ownership of smaller

firms is left to smaller investors who require a

higher return to invest.


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January Effect

Stocks tend to exhibit a higher return in January

than any other month (higher for smaller stocks)

May be tied to tax-loss selling or windowdressing at year-end

Neglected Firm Effect

Firms not followed by analysts tend to perform

better than those followed Because costs are higher to analyze smaller

firms, investors require a higher rate of return to

invest in less liquid stocks


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Liquidity Effect

Less liquid stocks sometimes perform better than

more liquid stocks

Investors may require a higher return premiumto compensate for lower liquidity

Market to Book Ratios

Stocks with lower price to book ratios (or higher

book to market ratios) perform better Investors prefer to invest in cheaper stocks (in

reference to their assets)


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Reversals

Extreme stock market performance tends to

reverse itself, i.e. reversion to the mean.

Losers rebound and winners fall

Value Line Enigma

Stocks rated highly by Value Line perform

better Investors may read Value Line


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Post-Earnings Announcement Drift

The effect of earnings announcements

continue for many days after the

announcement May be due to trading costs, particularly

for smaller companies


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Problem #3

What is a market anomaly? A market anomaly refers

to:

A. An exogenous shock to the market that is sharp

but not persistent.

B. A price or volume even that is inconsistent with

historical price or volume trends.

C. A trading or pricing structure that interferes with

efficient buying and selling of securities.

D. Price behavior that differs from the behavior

predicted by the efficient markets hypothesis.


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Answer #3

d). A market anomaly refers to price

behavior that differs from the behavior

predicted by the efficient market

hypothesis.


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Questions

Do you understand the tests of market

efficiency and can you cite evidence that

supports or contradicts the EMH?


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Problem #4

Prices of stocks before stock splits show

on average consistently positive

abnormal returns. Is this a violation of

the EMH?


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Answer #4

No this is not a violation of the EMH.

Usually stock splits occur as a response

to good performance which drives up the

stock price and leads managers to split

the stock.

When the managers announce a stock

split the good performance of the stock is

already accounted for in the price of the

stock.

Fi l Th h


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Final Thoughts on

Securities Analysis

Securities Analysis is like a horse show

But its not determining which is the best

horse

But which horse will the judges consider

the best horse!

You have to decide!!!!!!!


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Review of Objectives

A. Do you understand the efficient market

hypothesis and why securities prices should be

essentially unpredictable?

B. Can you formulate investment strategies thatmake sense in informationally efficient markets?

C. Do you understand the tests of market efficiency

and cite evidence that supports or contradicts the

EMH? D. Do you understand anomalies that exist to the

EMH?

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