McGraw-Hill/Irwin
Chapter 12
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Efficient Market Hypothesis (EMH)
Do security prices reflect information ?
Why look at market efficiency?
Implications for business and corporate finance
Implications for investment
12-2

Random Walk and the EMH
Random Walk - stock prices are random
Actually submartingale
Expected price is positive over time
Positive trend and random about the trend
12-3

Random Walk with Positive Trend
Security
Prices
Time
12-4

Random Price Changes
Why are price changes random?
Prices react to information
Flow of information is random
Therefore, price changes are random
12-5

EMH and Competition
Stock prices fully and accurately reflect publicly available information.
Once information becomes available, market participants analyze it.
Competition assures prices reflect information.
12-6

Forms of the EMH
Weak
Semi-strong
Strong
12-7

Types of Stock Analysis
Technical Analysis - using prices and volume information to predict future prices.
Weak form efficiency & technical analysis
Fundamental Analysis - using economic and accounting information to predict stock prices.
Semi strong form efficiency & fundamental analysis
12-8

Active or Passive Management
Active Management
Security analysis
Timing
Passive Management
Buy and Hold
Index Funds
12-9

Market Efficiency & Portfolio Management
Even if the market is efficient a role exists for portfolio management:
Appropriate risk level
Tax considerations
Other considerations
12-10

Empirical Tests of Market Efficiency
Event studies
Assessing performance of professional managers
Testing some trading rule
12-11

How Tests Are Structured
1. Examine prices and returns over time
12-12

Returns Over Time
-t 0
Announcement Date
+t
12-13

How Tests Are Structured (cont’d)
2. Returns are adjusted to determine if they are abnormal.
Market Model approach a. R t
= a t
+ b t
R mt
+ e t
(Expected Return) b. Excess Return =
(Actual - Expected) e t
= Actual - (a t
+ b t
R mt
)
12-14

How Tests Are Structured (cont’d)
2. Returns are adjusted to determine if they are abnormal.
Market Model approach c. Cumulate the excess returns over time:
-t 0 +t
12-15

Issues in Examining the Results
Magnitude Issue
Selection Bias Issue
Lucky Event Issue
Possible Model Misspecification
12-16

What Does the Evidence Show?
Technical Analysis
Short horizon
Long horizon
Fundamental Analysis
Anomalies Exist
12-17

Anomalies
Small Firm Effect (January Effect)
Neglected Firm
Market to Book Ratios
Reversals
Post-Earnings Announcement Drift
12-18

Explanations of Anomalies
May be risk premiums
Behavioral Explanations
Information Processing Errors
Behavioral Biases
Limits to Arbitrage
12-19

Information Processing
Forecasting Errors
Overconfidence
Conservatism
Sample Neglect and
Representativeness
12-20

Behavioral Biases
Framing
Mental Accounting
Regret Avoidance
12-21

Limits to Arbitrage
Fundamental Risk
Implementation Costs
Model Risk
12-22

Mutual Fund Performance
Some evidence of persistent positive and negative performance.
Potential measurement error for benchmark returns.
Style changes
May be risk premiums
Superstar phenomenon
12-23