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CH14 Market Efficiency


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Unformatted text preview: CORPORATE FINANCING DECISIONS AND MARKET EFFICIENCY (Chapter 14 of the Textbook) 1 Topics: Topics: 14.1 Differences between investment and financing decisions 14.2 What is market efficiency? 14.3 Types of market efficiency 14.4 Empirical evidence 14.5 Implications and lessons of market efficiency 2 Background Background Till now you learned how to spend money ­ the capital budgeting decision ­ the left­hand side of the balance sheet Now you will learn how to raise money i.e. financing the capital expenditures ­ the right­ hand side of the balance sheet Hold the firm’s capital budgeting decision constant and determine what is the best financing strategy 3 14.1 Differences between Investment and 14.1 Differences between Investment and Financing Decisions Typical financing decisions include: How much debt and equity to sell When (or if) to pay dividends When to sell debt and equity Financing decisions easier to reverse Capital investment decisions - positive NPV projects, Capital firm does not assume it is facing a perfectly competitive market competitive Where does value come from? Where Financing Schemes. If securities issued by firm are Financing fairly priced then the financing activities have NPV = 0 4 BIG QUESTION BIG QUESTION Are securities fairly priced? 5 An Example An Example You have a project, which yields perpetuity of $1 every year. The discount rate for the project is 10%. The required initial capital outlay is $5. You have only $3 needed for the investment. You form a company to finance the project. You decide to sell 40% of the ownership of the company to your friend for $2. Questions: NPV of the project: Value of the equity (if 100% owned) Is the equity sold to your friend fairly priced? Is financing NPV enhancing? 6 14.2 Efficient Capital Markets 14.2 Efficient Capital Markets An efficient capital market is one in which stock prices fully reflect available information Efficiency here is informational efficiency A market in which information is widely and cheaply available to investors and all relevant information is already reflected in security prices ­ Prices are “right” at any time Any new information disseminates quickly and is instantly reflected in share prices 7 Example: Reaction of Stock Price to New Information in Efficient and Inefficient Markets Efficient Stock Price Overreaction to “good news” with reversion Delayed response to “good news” Efficient market response to “good news” -30 -20 -10 0 +10 +20 +30 Days before (-) and after (+) 8 announcement Implications of the Efficient Implications of the Efficient Market Hypothesis (EMH) Investors Investors may hope for superior returns but all Investors hope they can rationally expect in an efficient market is rationally expect that they shall obtain a return that is just sufficient to compensate them for the time value of money and for the risks they bear and Firms expect fair value for securities they sell 9 In the words of press: In the words of press: …. Because prices are “efficient” ­ they reflect all available facts. Future prices differ from current prices only if buyers or sellers get new information. This by definition, is random. But why should prices be efficient? Put simply, if they are not, it means the market is ignoring price­ sensitive information. But this gives whoever has that information a chance to make big profits by trading on it. As soon as he does so, the overlooked information is incorporated in the price. This will make it “efficient”. ­The Economist, December 5, 19920 1 14.3 Different Types of Efficiency 14.3 Different Types of Efficiency Weak form of market efficiency Stock prices fully reflect all information contained in past Stock prices and volume prices Stock price movements are independent of what happened Stock in the past Semi-strong form of market efficiency Stock prices fully reflect all publicly available information Publicly available information includes historic prices and Publicly published accounting statements published Strong form of market efficiency Strong Stock prices fully reflect all information, public or private 11 Technical analysis & Weak Form Technical analysis & Weak Form Efficiency Current price incorporates all useful information contained in past stock prices, stock returns and trading volume Technical analysts argue that when intrinsic values change, (a) prices slowly adjust to the new fair price, and (b) adjustment patterns repeat themselves 12 Technical analysis & Weak Form Technical Efficiency Efficiency • Proper charting of prices (and perhaps related series like volume) will detect when a shift has occurred Stock Price Sell Sell • If a market is weak form efficient it is impossible to make consistently superior returns by technical analysis. Why? •No arbitrage principle/law of one price Buy Buy Time 13 Debate on market efficiency began with the discovery that stock prices seem to follow a random walk (Maurice Kendall, 1953) What does random walk mean? If stock prices follow eqn. (14.1) they are said to follow a random walk Pt = Pt­1 + expected return + et (random error) E(Pt) = Pt­1 + expected return Weak Form Efficiency & Weak Form Efficiency & Random walk 14 Semi­strong Form Efficiency & Semi­strong Form Efficiency & Fundamental analysis Prices incorporate all publicly available information contained in accounting statements and in past stock prices, stock returns and trading volume Fundamental analysts study firm/industry fundamentals and try to judge whether a stock is under­ or over­valued If a market is semi­strong form efficient It is impossible to make consistently superior returns by fundamental analysis Markets and stock prices react exceptionally fast to the release of information i.e. profit opportunities disappear fairly quickly before they become publicly known. 15 Strong Form Efficiency Strong Form Efficiency Prices incorporate all information, public or private Anything pertinent to the stock and known to at least one investor is already incorporated into the security’s price. If a market is strong form efficient it is impossible to make consistently superior returns from insider information 16 Relationship among Three Different Relationship among Three Different Information Sets All information relevant to a stock Information set of publicly available information Information set of past prices Strong-form efficiency ⇒ Semi-strong form efficiency ⇒ Weak-form efficiency 17 Some misconceptions about Some misconceptions about EMH Investors can throw darts to select stocks. Prices are random or uncaused. Prices reflect information. The price CHANGE is driven by new information, which by definition arrives randomly. 18 14.4 Empirical Evidence on Market 14.4 Empirical Evidence on Market Efficiency: Tests on Weak form efficiency Serial correlation of stock returns ­ no predictable cycles in stock prices ­ low correlation coefficients 19 Data Data 20 Data Data 32 21 2. Tests on Semi­strong form 2. Tests on Semi­strong form efficiency a. Event Studies Test Event studies—prices and returns around the arrival of new information. Day ­2 ­1 0 1 2 AR 0 ­3.5 ­1.5 ­0.75 ­0.25 22 CART0 How do we measure abnormal returns? Two approaches: (1) Subtracting the market’s return on the same day (RM) from the actual return (R) on the stock for that day: AR = R – Rm (2) Market Model approach: AR = R – (a + β Rm) Which approach do you think is better? Cumulative abnormal return (CAR): CAR = ∑ ARt T 0 t =0 T 23 An example: Event Studies: An example: Event Studies: Dividend Omissions Cumulative abnormal returns (%) Cumulative Abnormal Returns for Companies Announcing Dividend Omissions 1 0.146 0.108 -8 -6 -4 -0.72 0.032 0 -0.244 -2 -0.483 0 -1 -2 -3 -3.619 -4 -5 -4.49 -4.563 -4.747-4.685 -4.898 -5.015 -5.183 -5.411 Efficient market 2 4 response to “bad 6 news” 8 -6 S.H. Szewczyk, G.P. Tsetsekos, and Z. Santout “Do Dividend Omissions Signal Future Earnings or Past Earnings?” Journal of Investing (Spring 1997) 24 Days relative to announcement of dividend omission Event studies evidence Event studies evidence Over the years, event study methodology has been applied to a large number of events including: Dividend increases and decreases Earnings announcements Mergers Capital spending New issues of stock Most event studies do not conclude that there are profit opportunities. Any exceptions? Some continuing positive return after good earnings announcements. IPOs tend to under­perform over moderate lengths of time. Most violations of SS­EMH from events are more subtle and temporary. 25 Tests on SS­EMH: Tests on SS­EMH: b. Mutual Fund Performance Expert money managers (mutual funds) do not outperform the market consistently 26 Data Data Annual Return Performance of Different Types of U.S. Mutual Funds Relative to a Broad-Based Market Index (1963-1998) All funds Smallcompany growth Otheraggressive growth Growth Income -0.39% Growth and Maximum income capital gains -0.51% -2.29% Sector -1.06% -2.13% -2.17% -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). 27 3. Tests on Strong form efficiency 3. Tests on Strong form efficiency Strong form efficiency does not hold ­ insider trading profitable 28 Efficiency Failure: Stock Market Efficiency Failure: Stock Market Crash of 1987 The NYSE dropped 22.6% on Oct. 19, 1987, and the TSE dropped by more than 11­percent on a Monday following a weekend during which little surprising information was released. “The Black Monday” 29 In 1999, when 3Com divested Palm Computing, they retained a 95% stake. On Palm’s IPO day, the price per share went from $38 (offer price) to $95.06. Palm’s market cap was $54.3 billion 3Com’s market cap was $28 billion Another Efficiency Failure: Another Efficiency Failure: 3Com and Palm 30 Why? Why? You would like to buy 3Com and sell Palm. For an IPO, it is difficult to short­sell. 31 EMH Anomalies (1) EMH Anomalies (1) Pricing anomalies (statistical regularities that occur over long periods of time and are present in the stock markets of different countries ­ they cannot be explained by existing financial models) Small vs. large stocks Value vs. growth (Fig. 14.7) January effect / weekend effect Turn of the year, —month, —week. For large­capitalization Canadian stocks there is no longer a day­of­the week effect. 32 EMH Anomalies (2) EMH Anomalies (2) Some beliefs: Momentum and contrarian investors Price reversal ­ the most extreme losers (winners) over the past few years (3 to 5 year period) tend to have strong (low) returns relative to the market during the following years (DeBondt and Thaler) Momentum –Over 3 to 12 months returns tend to carry a momentum (Jegadeesh and Titman) 33 Investors are behavioral. E.g., speculative bubbles. (1987 market crash, 1999­2001 internet bubble) Recent trends: Behavioral Recent trends: Behavioral finance 34 14.5 Implications of EMH for 14.5 Implications of EMH for Corporate Finance If markets are efficient prices mean something. (How about price change?) Accounting and efficient markets Timing of issuance of securities 35 Lessons of Market Efficiency Lessons of Market Efficiency Trust market prices ­ Prices impound all information about the value of each security ­ No free lunches on Bay Street Markets have no memory ­ sequence of past price changes contain no information about future changes All investors need not have access to all information Investors are not fooled 36 On May 15, 1997, the government of Kuwait offered to sell 170 million BP shares, worth about $2 billion. Goldman Sachs was contacted after the stock market closed in London and given one hour to decide whether to bid on the stock. They decided to offer $11.59 per share, and Kuwait accepted. Then Goldman Sachs started looking for buyers. They lined up 500 institutional and individual investors worldwide and resold all the shares at $11.70. The resale was complete before the London Stock Exchange opened the next morning. Goldman Sachs made $15 million overnight. What does this deal say about market efficiency? 37 Example Example See the following WSJ article appearing on the Oct. 18, 2004 issue: Readings: EMH or NOT? The Readings: EMH or NOT? The debate goes on… Stock Characters: As Two Economists Debate Markets, The Tide Shifts; Belief in Efficient Valuation Yields Ground to Role Of Irrational Investors; Mr. Thaler Takes On Mr. Fama 38 Review Questions # Review Questions # Why are markets efficient? 14.3 ­ 8, 13, 18, 19, 21, 23 39 Assignment Questions # Assignment Questions # Assignment Questions # 14.13, 14.16, 14.22, 14.24 40 ...
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