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13_Oheads - Lecture Notes 13 Efficient Capital Markets The...

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1 Lecture Notes 13 Efficient Capital Markets The basic idea • In efficient capital markets, asset prices quickly reflect the con- sequences of all relevant publicly available information. Hence: i. announcements of relevant future events alter asset prices now ; ii. if an expected event occurs as announced prices don’t change; iii. investors cannot expect abnormal risk-adjusted returns; iv. firms should expect to receive fair market value for securities. Public , readily available information includes current and past: i. stock prices, dividends, earnings, earnings forecasts, operating expenses, revenues and investments; ii. production levels, market shares, debt levels and taxes paid; iii. patents, inventions or product announcements; iv. personnel changes; v. proposed and announced mergers or acquisitions; vi. stock trading by CEOs and major shareholders; vii. economic data on the economy and individual industries.
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2 • Investors therefore cannot make excess profits (relative to the risks they bear) using such information. Implications for financing decisions of firms • In efficient capital markets, the following cannot be positive NPV projects for a firm: i. altering the timing of issues of bonds or stocks; ii. staggering the sale of financial assets to alter their price; iii. manipulating accounts, so long as the manipulations do not Figure 1: Reaction of stock prices to new information Stock Price Days before (-) and after (+) Efficient market response to new information Overreaction and reversion Delayed response Early response 0 +10 +20 +30 -30 -20 -10 Public announcement day announcement
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3 reduce the information available to investors (the Enron , World- Com etc. cases did affect the information available to investors); iv. “re-packaging” returns into new securities (again so long as information, for example about total debt, is not hidden). • Financing strategies can create value by allowing firms to ex- ploit tax subsidies, reduce transactions costs or perhaps issue a new security at a high price to a previously-unsatisfied clientele. Efficient markets and the information set • Different information sources produce different notions of infor- Figure 2: Information sets for different market efficiency notions All relevant information All publicly Past prices available
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4 mational efficiency: i. Weak Form : Past prices cannot be used to make abnormal prof- its relative to the risks being borne. ii. Semistrong Form : Public information cannot be used to make abnormal profits relative to the risks being borne. iii. Strong Form : Prices always reflect all relevant information. Weak-form Efficiency • Prices reflect anything past prices say about likely future prices. • Predictable price movements unrelated to risk would be elimi- nated by investors buying at troughs and selling at peaks.
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