BF Notes Session 5 - I nefficient Ma rkets and Corporate...

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Inefficient Markets and Corporate Decisions (Ch. 5) Overview Chapter 5 describes what is perhaps the most controversial issue separating the views of traditionalists and behaviorists, the degree to which markets are efficient . The chapter explains the main issues that define the controversy, describes the views of both traditionalists and behaviorists on these issues, and discusses the implications for corporate decisions. Lying at the heart of the market efficiency debate between traditionalists and behaviorists are a series of empirical findings known as anomalies . The chapter explains the main anomalies, and the different interpretation of what these anomalies mean. Traditionalists contend that smart money will quickly take advantage of arbitrage opportunities associated with mispricing, thereby rendering inefficiencies temporary and small. Behaviorists contend that there are limits to arbitrage that allow inefficiencies to be long-lasting and large. Managers perceive inefficiencies in the market, and take decisions in response. The chapter describes three types of decisions. First, if managers perceive a conflict between maximizing NPV and impacting short-term earnings adversely, they typically refrain from maximizing NPV. Second, managers might split the stocks of their firms, even though splitting does not increase market value when prices are efficient. Third, managers might engage in timing with respect to initial public offerings (IPOs). Moreover, IPOs are characterized by three behavioral phenomena: hot issue markets ,
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initial underpricing , and long-term underperformance . In addition to behavioral phenomena, agency conflicts also play a role in respect to IPO issues. Traditional Approach to Market Efficiency Market efficiency has the following three forms: weak, semi-strong, and strong. These reflect the degree to which past prices, public information, and all information respectively are reflected in current prices. Economist Eugene Fama, who developed the efficient market framework pointed out that when prices are efficient, prices coincide with intrinsic value. When the market is efficient, investors cannot earn abnormal returns and so expected returns reflect the underlying risk. In particular, the factors in the factor models that explain expected returns measure different aspects of risk. The Market Efficiency Debate: Anomalies In the context of the market efficiency debate, anomalies are empirical pricing phenomena that appear to be inconsistent with markets being efficient. Three specific anomalies are presented. The winner-loser effect pertains to long-term reversals. Momentum pertains to short-term continuation (or drift). Post-earnings-announcement drift pertains to the market’s reaction to earnings surprises, and features both long-term reversals and short-term continuation. Limits of Arbitrage
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BF Notes Session 5 - I nefficient Ma rkets and Corporate...

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