Slide8 - Chapter
8

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Unformatted text preview: Chapter
8

 The
Efficient
Market
Hypothesis
 8.1
Random
Walks
and
The
Efficient
 Market
Hypothesis
 Efficient
Market
Hypothesis
(EMH)
 •  The
hypothesis
that
prices
of
securiAes
fully
 reflect
available
informaAon
about
securiAes.
 •  EMH suggest stock prices should not be predictable. 
 CumulaAve
abnormal
returns
before
and
aEer
 the
announcement
of
a
takeover
aFempt
 Stock
price
reacAon
to
on‐air
reports
 during
the
“Midday
Call”
on
CNBC
 EMH
and
CompeAAon
 •  CompeAAon
among
investors
implies
that
stock
 prices
fully
and
accurately
reflect
publicly
available
 informaAon
very
quickly.

 •  Else
there
are
unexploited
profit
opportuniAes.
 •  Once
informaAon
becomes
available,
market
 parAcipants
quickly
analyze
it
&
trade
on
it
&
 frequent,
low
cost
trading
assures
prices
reflect
 informaAon.
 QuesAons
arise
about
efficiency
due
to:
 •  Unequal
access
to
informaAon
 •  Structural
market
problems
 •  Psychology
of
investors
(Behavioralism)
 Random
Price
Changes
 •  In
very
compeAAve
markets
prices
should
 react
to
only
NEW
informaAon
 •  Flow
of
NEW
informaAon
is
random
 •  Therefore,
price
changes
are
random
 Idea
that
stock
prices
follow
a
“Random
Walk”
 Random
Walk
and
the
EMH
 •  Random
Walk:
stock
price
changes
are
 random
and
unpredictable.
 •  Stock
prices
actually
follow
a
Random
Walk
 with
a
posiAve
trend.
 –  Investors expect stocks to have a positive risk premium
 Random
Walk
with
PosiAve
Trend
 Security

 Prices
 Time
 Forms
of
the
EMH
 •  Prices
reflect
all
relevant
informaAon
 •  Varying
InformaAon
Set:
Weak,
semi‐strong,
 strong
form
of
EMH
 •  Weak
form
EMH
 –  The
relevant
informaAon
is
historical
prices
and
other
 trading
data
such
as
trading
volume.
 •  Semi‐strong
form
EMH
 –  The
relevant
informaAon
is
all
publicly
available
 informaAon
regarding
the
firm’s
prospects,
including
 financial
data,
informaAon
about
the
industry,
firm
 management,
etc
 Forms
of
the
EMH
 •  Strong
form
EMH
 –  The
relevant
informaAon
is
“all
informaAon”,

both
 public
and
private
or
“inside”
informaAon.
 –  SEC
Rule
10b‐5
limits
trading
by
corporate
 insiders,
(officers,
directors
and
major
 shareholders).

Inside
trading
must
be
reported.
 RelaAonships
between
forms
of
the
 EMH
 • 

Semi‐strong
efficiency
implies
weak‐form
efficiency
holds,
 



but
not
vice
versa.
 • 

Strong‐form
efficiency
implies
that
both
semi‐strong
and

 


weak
form
efficiency
hold.
 Exercise
1
 •  Suppose
you
observed
that
high‐level
managers
 make
superior
returns
on
investments
in
their
 company’s
stock.
Would
this
be
a
violaAon
of
 weak‐form
market

efficiency?
Would
this
be
a
 violaAon
of
strong‐form
market
efficiency?
 •  If
the
weak
form
of
the
EMH
is
valid,
must
the
 strong
form
also
hold?
Conversely,
does
strong‐ form
efficiency
imply
weak‐form
efficiency?
 8.2 
ImplicaAons
of
the
EMH
(for
 Security
Analysis)

 Types
of
Stock
Analysis
&
RelaAonship
 to
the
EMH
 •  Technical
Analysis
(TA):

assumes
prices
follow
 recurrent
and
predictable
paFerns.
 •  TA
uses
prices
and
volume
informaAon
to
 predict
future
price
changes.
 •  If
the
markets
are
weak
form
efficient
or
semi‐ strong
form
efficient
or
strong
form
efficient,
 will
technical
analysis
be
able
to
consistently
 predict
price
changes?
 NO
 Basic
Types
of
Technical
Analysis
 Support
and
resistance
levels
 •  Support
level:

 –  A
price
level
below
which
it
is
supposedly
unlikely
for
 a
stock
or
stock
index
to
fall.

 •  Resistance
level:

 –  A
price
level
above
which
it
is
supposedly
unlikely
for
 a
stock
or
stock
index
to
rise.

 A
resistance
level
may
arise
at
say
$31.25
if
a
stock
repeatedly
 rises
to
$31.25
and
then
declines,
indicaAng
that
investors
are
 reluctant
to
pay
more
than
this
price
for
the
stock.


 A
stock
price
above
$31.25
would
then
indicate
a
'breakout'
 which
would
be
a
bullish
signal.
 •  Fundamental
Analysis
(FA):
 Types
of
Stock
Analysis
&
RelaAonship
 to
the
EMH
 –  using
economic
and
accounAng
informaAon
to

 predict
stock
price
changes,
including
earnings
and
 dividend
prospects,
expectaAons
for
future
interest
 rates,
and
risk
of
the
firm.
 –  If
the
markets
are
weak
form
efficient
or
semi‐strong
 form
efficient
or
strong
form
efficient,
will
 fundamental
analysis
be
able
to
consistently
predict
 price
changes?
 Under
weak‐form:
Fundamental
Analysis
CAN
predict
price
changes
 Under
semi‐strong
or
strong
form
efficient:

 Fundamental
Analysis
CANNOT
predict
price
changes
 Fundamental
Analysis
 •  Fundamental
analysis
assumes
that
stock
 prices
should
be
equal
to

 



the
discounted
value
of
the
expected
future
 cash
flows
the
stock
is
expected
to
provide
to
 investors.
 •  Fundamental
analysis
is
thus
the

 “art”
of
idenAfying
over‐
and
undervalued
 securiAes
based
on
an
analysis
of
the
firm's
 financial
statements
and
future
prospects.


 Fundamental
Analysis
 •  Fundamental
analysis
varies
in
technique
but
 generally
focuses
on

 –  forecasAng
the
firm's
future
dividends
or
earnings,

 –  discounAng
those
future
cash
flows
by
the
required
 rate
of
return
(usually
obtained
from
the
CAPM),

 –  and
comparing
the
resulAng
esAmated
price
with
the
 current
stock
price.


 Fundamental
Analysis
 •  If
the
esAmated
price
is
greater
than
the
current
price
 an
investor
should
buy
the
stock
since
it
is
undervalued
 and
since
its
price
should
increase
to
the
"true"
or
 "fundamental"
value
uncovered
by
the
analyst.


 •  If
the
esAmated
price
is
less
than
the
current
price
the
 stock
should
be
sold
because
the
stock
is
currently
 overvalued
by
the
market.


 •  In
either
case
if
the
analyst
is
correct
the
investor
 should
receive
a
posiAve
abnormal
return.
 Fundamental
Analysis
 •  Forecasts
already
exist
and
for
FA
to
add
value,
 your
forecast
must
be
beFer
than
the
 consensus
forecast.


 •  Not
enough
to
find
a
good
company,
you
must
 find
a
company
that
is
beFer
than
others
 believe,
i.e.,
mispriced.
 ImplicaAons
of
Efficiency
for
AcAve
or
 Passive
Management
 •  AcAve
management:
 –  Security
analysis
 –  Timing
strategies
 –  Investment
NewsleFers
 Assumes
inefficiency,
use
 technical
and/or
 fundamental
analysis
to
 pick
securiAes
 •  Passive
management:
 –  Buy
and
Hold
poriolios
 –  Index
Funds
 Consistent
with
semi‐ strong
efficiency
 Market
Efficiency
and
Poriolio
 Management
 Even
if
the
market
is
efficient
a
role
exists
for
 poriolio
management
 –  IdenAfy
risk
&
choose
appropriate
risk
level
 –  Tax
consideraAons
 –  Other
consideraAons
such
as
liquidity
needs
or
 diversify
away
from
the
client’s
industry.
 ...
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This note was uploaded on 05/12/2011 for the course FIN 300 taught by Professor Wang during the Spring '11 term at UChicago.

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