efficient

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An Alternative View of
Risk and Return The
Arbitrage Pricing Theory
Arbitrage Pricing Theory

An asset’s return is related to common risk
factors
2
Example: Fama French Model

Returns are a function of three risk factors
 Size

factor
Return on the averages small firm minus the average large firm
 Value

factor
Return on the average value firm minus the average growth
firm
 Market

Factor
Same as CAPM
R  βSML(SML)  βHML (HML)  βM (MKT )
3
Multi-Factor Betas

Since we are allowing for multiple risk factors, how
will b change?
4
Example

What is a stock’s expected return if its betas
are:
 SML:
0.5
 HML: 3.0
 Mkt: 2.0
 SML is 8%, HML is 5%, the market risk premium
is 4%, and the risk free rate is 3%
5
Why We Care

Another investment rule
6
Corporate Financing
Decisions and Efficient
Capital Markets
News and Returns

All news, and announcements contain anticipated
and unexpected components

The market prices assets based on the
anticipated component of the news
 This

is where expected return comes from
The surprise is what creates un-expected return
8
Breaking Returns Down

A security’s actual return is comprised of:
1.
2.

The expected return
The un-expected return
Therefore, a stock’s return is:
R  R U
where
R is the expected part of the return
U is the unexpected part of the return
9
Where does U come from?

Systematic Surprises:

Unique Surprises:
10
Breaking Returns Down (2)
We defined returns as: R  R  U
 We can break U down further: R  R  m  
 m is the return earned because of unexpected
movements in systematic risk
  is the return from unique surprises

11
Example

Lets use the Fama French factors:


SML, HML, and Mkt
Our model is:
R  R  βSML FSML  βHML FHML  βMkt FMkt  ε
12
Surprises

Expected SML to be 3%, but it was 8%; surprise is?

Expected HML to be 4%, but it was 1%; surprise is?

Expected Mkt to be 10%, but it was stable; surprise is?

Finally, the firm attracted a “superstar” CEO, and this
unanticipated development contributes 1% to the
return.
13
Example Betas


The stock’s betas are:
1. bSML = -2.30
2. bHML = 1.50
3. bMkt = 0.50
Remember the stock’s expected return was
8%
14
Example’s Actual Return
R  R  βSML FSML  βHML FHML  βMkt FMkt  ε
15
Underlying Assumption

The assumption we made, and that drove the
last example, is that the stock is priced in an
efficient market
16
What is an efficient market?

A market is efficient when it uses all available
information to price assets.
 Information
is quickly incorporated into prices
Efficiency is the degree to which prices reflect
available information.
 Stock prices only respond to surprises, which
arrives randomly, so prices follow a random walk


Price tomorrow = today’s price + random (+/-)
17
Price: Today and Tomorrow
Do you see a pattern
that you want to put
money on?
18
Reactions to Beating Expectations
Over Reaction
Under Reaction
Efficient Response
19
Reaction to Not Meeting Expectations
Under Reaction
Efficient Reaction
Over Reaction
20
Potential Causes of Efficient
Markets

Investor Rationality
 Everyone
is rational → Everyone makes the right
decision

Independent Deviation from Rationality
 No
one is rational → Everyone makes the wrong
decision but each makes a different wrong decision


Average out the wrongness
Arbitrage
 Only
some people are rational → Smart money takes
21
from less smart money
Types of Efficient Markets
Strong
Semi-Strong
Weak
22
Weak Form Efficiency

Prices reflect all information contained in past
prices and volumes
 No
investor is able to form a trading strategy based
on historic prices and volumes and earn an excess
return
23
Disbelievers

Chartists, or Technical Analysts
 Analyze

Chartist believe in identifiable and predictable
patterns in these characteristics
 Make

“charts” of a stock‘s Price and/or Volume
investment decisions based on these patterns
Brokerage firms tend to love chartists
24
Head and Shoulders
25
Stock Price
Why Technical Analysis Fails
Investors will eliminate any opportunities associated with
stock price patterns
If there is a profitable
pattern, everyone would do
it, and the profits would be
competed away.
Sell
Sell
Buy
Buy
Time
Semi-Strong Form Efficiency

Security prices reflect all publicly available
information.
 Encompasses

weak form efficiency
Publicly available information includes:
 Historical price
 Published
and volume information
accounting statements
 Information
found in the WSJ
27
Disbelievers

Fundamental Analysts
 Use
revenues, earnings, future growth forecasts,
return on equity, profit margins, and other data to
determine a company's underlying value and
potential for future growth (Financial Statements)

These guys make more sense than technical
analysts. Why?
28
Strong Form Efficiency

Strong form efficiency says that anything
pertinent to the stock price and known to at
least one investor is already incorporated in the
security’s price.
 Public
& Private
 Implies:

Insider trading will not earn excess return
Strong form efficiency incorporates weak and
semi-strong form efficiency.
29
Disbelievers
Pretty much everyone
 Insiders trading is generally profitable

 Martha
Stewart
 Galleon
30
What EMH Does and Does NOT Say

Investors can throw darts to select stocks.
 Kind

of: We still need to consider risk
Prices are random or uncaused.
 Prices
reflect information.
 Price CHANGES are driven by new information,
which by definition is random
31
Implications of Efficient Markets
Purchase or sale of any security can never be a
positive NPV transaction.
 Trust market prices
 Stocks with similar risk are substitutes
 Mutual fund managers cannot systematically
outperform the market

32
The Evidence

The record on the EMH is extensive,
and generally supportive of the market
being semi-strong form efficient
33
Event Studies
 Event
Studies examine returns around
information release dates
 EX:
Earnings, Dividend announcements
 A test of semi-strong form efficiency
 Look
at how quickly prices adjust to the
information
 Looking
for under-reaction, over-reaction, early
reaction, or delayed reaction around the event.
34
Event Study Results
The studies generally support the view that the
market is semi-strong form efficient.
 Studies suggest that markets may even have
some foresight into the future, i.e., news tends
to leak out in advance of public
announcements.

35
Cumulative abnormal returns
(%)
Event Studies: Dividend Omissions
Cumulative Abnormal Returns for Companies Announcing
Dividend Omissions
1
0.146 0.108
-8
-6
0.032
-4
-0.72
0
-0.244
-2 -0.483 0
-1
2
-2
-3
-3.619
-4
-5
4
6
8
Efficient market
response to “bad news”
-4.563-4.747-4.685-4.49
-4.898
-5.015
-5.183
-5.411
-6
Days relative to announcement of dividend omission
36
The Record of Mutual Funds
If the market is semi-strong form efficient,
then mutual fund managers, should not be able
to consistently beat the average market return
 When we compare the record of mutual fund
performance to a market index, we see that
mutual funds are not able to
CONSISTENTLY beat the market.

 Consistent
with the market being semi-strong form
efficient
37
Mutual Fund Performance
All funds
Smallcompany
growth
Otheraggressive
growth
-2.13%
Growth
Income
-0.39%
-2.17%
Growth and
Maximum
income
capital gains
Sector
-1.06%
-0.51%
-2.29%
-5.41%
-8.45%
Taken from Lubos Pastor and Robert F. Stambaugh, “Mutual Fund Performance and
Seemingly Unrelated Assets,” Journal of Financial Exonomics, 63 (2002).
38
Insider trading
 Strong
form market efficiency implies
that even insiders trading on private
information cannot earn excess return
 A number of studies find that insiders are
able to earn abnormal profits
 Violation
of Strong form efficiency
39
Verdict on Market Efficiency
Market is pretty efficient
 Opportunities for easy profits are rare.
 Financial managers should assume, at least as
a starting point, that security prices are fair and
that it is difficult to outguess the market.
 New information is rapidly incorporated into
the prices.

40
EMH Exercises

Indicate whether or not the EMH is contradicted,
if so which form of EMH is contradicted
 An
investor consistently earn an abnormal return over
that expected by the market by examining charts of
historical prices
 The acquisition of the latest annual report of a company
enables an investor to earn an abnormal return.
 A stock which has been fluctuating between $25 and
$27 in the last three months suddenly rises to $40 per
share right after management announces a new project
that has a promising impact on the firm's expected
future cash inflows.
 By subscribing to the Value Line Investment Survey, an
investor can earn at least 5% over that earned by the
market on comparable risk investments.
41
Why We Care

Offering several points of view on how the
market works, and the evidence for and against
 Using
this you can form your own opinion about
how the market works and invest accordingly
42
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