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Unformatted text preview: 1 CORPORATE FINANCING DECISIONS AND EFFICIENT CAPITAL MARKETS Ross, Westerfield & Jaffe “ Corporate Finance” 7th ed.: Chapter 13 A Description of Efficient Capital Markets 2 An efficient capital market is one in which stock prices fully reflect available information. Suppose IBM announces it has invented a new, faster and better microprocessor. The price of a share of IBM should increase immediately to a new equilibrium level. The EMH has implications for investors and firms. Since information is reflected in security prices quickly, knowing information when it is released does an investor no good. Firms should expect to receive the fair value for securities that they sell. Firms cannot profit from fooling investors in an efficient market (markets are in equilibrium). Relationship among Three Different Information Sets 3 All information relevant to a stock Information set of publicly available information Information set of past prices What the EMH Does and Does NOT Say 4 Much of the criticism of the EMH has been based on a misunderstanding of the hypothesis says and does not say. Investors can throw darts to select stocks. This is almost, but not quite, true. An investor must still decide how risky a portfolio he wants based on risk aversion and the level of expected return. Prices are uncaused. Prices reflect information. The price CHANGE is driven by new information, which by definition arrives randomly. Therefore, financial managers cannot “time” stock and bond sales. The Evidence 5 The record on the EMH is extensive, and in large measure it is reassuring to advocates of the efficiency of markets. Studies fall into three broad categories: 1. Are changes in stock prices random? Are there profitable “trading rules”? 2. Event studies: does the market quickly and accurately respond to new information? 3. The record of professionally managed investment firms. The Weak Form 6 To test the weak efficiency, researchers have measured the profitability of trading rules used by ‘tape‐watchers’. Evidence is consistent with the weak form They have also employed statistical tests to look for patters, specifically autocorrelation between a series of returns or prices Serial autocorrelation: correlation between the current return of the security and part returns Positive correlation: Continuation Negative correlation: Reversal Near zero correlation: Random walk The Weak Form: Serial correlations 7 The Weak Form: Serial correlations 8 9 Are Changes in Stock Prices Random: Testing the weak form of efficiency Can we really tell? Many psychologists and statisticians believe that most people want to see patterns even when faced with pure randomness. People claiming to see patterns in stock price movements are probably seeing optical illusions. A matter of degree Even if we can spot patterns, we need to have returns that beat our transactions costs. Random stock price changes support weak‐form efficiency. Testing the Semi Strong Form 10 The semi strong form implies that prices reflect all publically available information. There are two basic types of tests for the semi‐
strong form: Event studies The record of the mutual funds Event Studies: How Tests Are Structured 11 Event studies measure how rapidly security prices respond to different items of news e.g. earnings or dividend announcements, news of takeover or mergers, macroeconomic information, etc. Test for evidence of under reaction, overreaction, early reaction, delayed reaction around the event. To isolate the effect of the news, calculate a measure of relative performance How Tests Are Structured (cont.) 12 Returns are adjusted to determine if they are abnormal by taking into account what the rest of the market did that day. The Abnormal Return on a given stock for a particular day can be calculated by subtracting the market’s return on the same day (RM) from the actual return (R) on the stock for that day: AR= R – RM The abnormal return can be calculated using the CAPM approach: AR= R – ( + RM), i.e. AR = actual – expected return Event Studies 13 According to the EMH, news at time t should only affect Art. Any information released before that will effect past AR’s and so will already be incorporated in past prices. Event studies therefore try to estimate if the effect of news is felt on days other than the announcement day Event Studies 14 Some studies also measure the cumulative abnormal returns (CAR’s). If bad news is fully incorporated on the day of announcement then CAR should drop on day before and on the day of announcement CAR should remain virtually the same post‐
announcement Event Studies: Dividend Omissions 15 Cumulative abnormal returns (%) Cumulative Abnormal Returns for Companies Announcing
0.146 0.108 0.032
-0.483 0 Efficient market response to “bad news” -1
-8 -6 -4 -2 0 2 4 6 8 Days relative to announcement of dividend omission
S.H. Szewczyk, G.P. Tsetsekos, and Z. Santout “Do Dividend Omissions Signal Future Earnings or Past Earnings?” Journal of Investing (Spring 1997) Event Studies 16 Event Study Results 17 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 The studies generally support the view that the market is semi strong‐from efficient. In fact, the studies suggest that markets may even have some foresight into the future—in other words, news tends to leak out in advance of public announcements. The Record of Mutual Funds 18 If the market is semi strong‐form efficient, then no matter what publicly available information mutual‐fund managers rely on to pick stocks, their average returns should be the same as those of the average investor in the market as a whole. We can test efficiency by comparing the performance of professionally managed mutual funds with the performance of a market index. The Record of Mutual Funds 19 All funds Smallcompany
growth -2.13% Growth Income
-0.39% -2.17% Growth and Maximum
capital gains Sector
-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). The Strong Form of the EMH 20 One group of studies of strong‐form market efficiency investigates insider trading. A number of studies support the view that insider trading is abnormally profitable. Thus, strong‐form efficiency does not seem to be substantiated by the evidence. For the most part, these studies suffer from lack of data. The Grossman‐Stiglitz(1980) Paradox 21 If information is freely available, it is symmetrical and shared equally Suppose instead then that information is costly to acquire Then Grossman‐Stiglitz propose the following: ‘… because information is costly, prices cannot perfectly reflect the information which is available, since if it did, those who spent resources to obtain it would receive no compensation.’ Only if prices do not fully reflect the information is there an incentive to expend resources in collecting it The implication of the Grossman–Stiglitz paradox is that strong form efficiency is a rare occurrence, likely to be observed only when all information is freely (hence symmetrically) available. Challenges to EMH: Explaining anomalies 22 Calendar effects. a. b. c.
e. The January (or ‘turn‐of‐the‐year’) effect. The shares of many small companies (those with a smaller‐than‐average market capitalization) tend to experience above average returns in January, especially in the first half of the month The September effect. It has been calculated that $1 invested in US stocks in 1890 would have grown to $410 by 1994 if the month of September had been excluded. This is about four times the increase if the $1 had been invested for the whole of each year. Week‐of‐the‐month effect. Shares tend to show above‐average returns in the first half of the month. Monday blues. Rates of return on many shares tend to be negative each Monday. Hour‐of‐the‐day effect. On Monday mornings shares tend to show below‐average returns in the first forty‐five minutes of trading than the early trading period for other days of the week. Challenges to EMH: Explaining anomalies 23 Weather and stock markets. There is evidence that asset prices are positively correlated with sunny days The small‐firm effect, or size effect. Evidence has been produced that small companies earn higher returns than predicted by models such as the CAPM. Baytas, et al.(1999) found that over 1980‐1997 in the capital markets of Japan, equity investments, as a group, earned less than bonds or convertible bonds. 18 years is a long time for this anomaly to persist. The Behavioral Challenge to Market Efficiency 24 Rationality People are not always rational: Many investors fail to diversify, trade too much, and seem to try to maximize taxes by selling winners and holding losers. Independent Deviations from Rationality Psychologists argue that people deviate from rationality in predictable ways: Representativeness: drawing conclusions from too little data This can lead to bubbles in security prices Conservativism: people are too slow in adjusting their beliefs to new information. Security Prices seem to respond too slowly to earnings surprises. The Behavioral Challenge to Market Efficiency 25 Arbitrage Suppose that your superior, rational, analysis shows that company ABC is overpriced. Arbitrage would suggest that you should short the shares. After the rest of the investors come to their senses, you make money because you were smart enough to “sell high and buy low”. But what if the rest of the investment community doesn’t come to their senses in time for you to cover your short position? This makes arbitrage risky. Empirical Challenges to Market Efficiency (anomalies) 26 Limits to Arbitrage “Markets can stay irrational longer than you can stay insolvent.” John Maynard Keynes E.g. Merger of Royal Dutch Petroleum and Shell in 1907 Earnings Surprises Stock prices adjust slowly to earnings announcements. Behavioralists claim that investors exhibit conservatism. Size Small cap stocks seem to outperform large cap stocks. Value versus Growth High book‐value‐to‐stock‐price stocks and/or high P/E stocks outperform growth stocks. Empirical Challenges to Market Efficiency (anomalies) 27 Crashes On October 19, 1987 the stock market dropped between 20 and 25 percent on a Monday following a weekend during which little surprising news was released. A drop of this magnitude for no apparent reason is inconsistent with market efficiency. Bubbles Consider the tech stock bubble of the late 1990s. Reviewing the Differences 28 1.
3. Financial Economists have sorted themselves into three camps: Market efficiency Behavioral finance Those that admit that they don’t know This is perhaps the most contentious area in the field. Implications for Corporate Finance 29 Because information is reflected in security prices quickly, investors should only expect to obtain a normal rate of return. Awareness of information when it is released does an investor little good. The price adjusts before the investor has time to act on it. Firms should expect to receive the fair value for securities that they sell. Fair means that the price they receive for the securities they issue is the present value. Thus, valuable financing opportunities that arise from fooling investors are unavailable in efficient markets. Implications for Corporate Finance 30 The EMH has four implications for corporate finance: 1. 2. Financial managers cannot “time” issues of stocks and bonds using publicly available information. 3. Managers cannot profitably speculate in foreign currencies and other instruments. 4. The price of a company’s stock cannot be affected by a change in accounting. Managers can reap many benefits by paying attention to market prices There is conflicting empirical evidence on the first three points. Informational and Allocative Efficiency 31 Markets are said to be informationally efficient if their prices accurately reflect all of the available information about fundamental value Weak form efficient Semi‐strong form efficient Strong form efficient Markets are said to be allocatively efficient if they channel resources to the right places 32 Informational and Allocative Inefficiency Assume all agents are risk neutral and rf has been neutralized to 0. there are two states of the world and they both occur with equal probability (0.5) Type 1 Project ‐100 $110 Type 2 Project $114 ‐100 $96 $88 NPV1 = ½ (110‐100) + ½ (96‐100) NPV2= ½ (114‐100) + ½ (88‐100) Bondholders will demand at least 4% from type 1 managers and 12% from type 2. = $3 = $1 33 Informational and Allocative Inefficiency E(return 1) = ½ $0 + ½ ($110 – 104) = $3 E(return 2) = ½ $0 + ½ (114–112) = $1 Suppose managers alone know the type of their project but no one else can distinguish between type 1 and type 2 projects. Bondholders know exactly half the projects in the market are type 1 and the remaining are type 2. Bondholders demand : ½ 4% + ½ 12% = 8% What is the return to the mangers in this case? E(return 1) = ½ $0 + ½ (110‐108) = $1 E(return 2) = ½ $0 + ½ (114‐108) = $3 Adverse selection : lemons problems (George Akerlof, 1970) ...
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