Market Efficiency
Market Efficiency
Market Efficiency
CORPORATE FINANCE
Laurence Booth W. Sean Cleary Chapter 10 Market Efficiency
Lecture Agenda
Learning Objectives Important Terms The Importance of Market Efficiency Market Efficiency Defined The Efficient Market Hypothesis Empirical Evidence Regarding Market Efficiency Implications of EMH Summary and Conclusions
Concept Review Questions
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Learning Objectives
1. 2. 3. 4. What is meant by market efficiency How to differentiate among different levels of efficiency How to use the concepts in this chapter to judge the appropriateness of corporate decisions How the concepts in this chapter are used in regulating market activity
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Understanding how securities are valued is important because these valuation principles provide guidelines to managers how they should manage businesses on behalf of the shareholders. It is the legal requirement and managerial responsibility for managers to act in the owners best interest. The discount rate that represents shareholders required rate of return is established as a result of benchmark rates in the capital markets such as the Risk-Free Rate (RF) and the market risk premium. A question remainsDO MARKET PRICES REFLECT THE ACTIONS OF MANAGERS?
If they do, then managers must learn what actions they should take in order to fulfill their legal and managerial responsibilities to shareholders.
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Operational Efficiency
Transactions costs are low, thereby enhancing trading of securities
Allocational Efficiency
There are enough securities to efficiently allocate risk
Informational Efficiency
Market prices fairly and quickly reflect all available information.
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Informational Efficiency is the focus of this chapter. The closer the link between actions of managers and the value of the firm, the more informationally efficient the capital market.
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Fair and equal treatment of all market participants through disclosure requirements that ensure all participants have simultaneous access to the same information about publicly-traded firms.
The use of cease-trading orders when new information is being released to the market is an example of how regulators ensure that information is widely disseminated to all market participants before trading is allowed to occur. In this way, all market participants are trading on the basis of the same and complete information ensuring that some participants do not have an informational advantage over others.
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Asymmetric Information
Asymmetric information is when one party to a transaction has access to more a complete and accurate set of facts than the other party.
When this condition exists, it is possible for the party with better information to use that at their own personal gain, and at the expense of the other.
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Asymmetric Information
An Example The Used Car! An example of Asymmetric information from everyday life might be the situation between a buyer and seller of a used car in a private transaction.
The seller has intimate knowledge of recent car history including past owners, collisions, repairs, and problems. The buyer (presuming no expertise as a mechanic) has only their limited skills of observation and investigation to inform their purchase decision.
In the foregoing example, it is possible, in the absence of rules and regulations, for the seller to take advantage of the buyer because of information asymmetry. This means, the buyer is likely to pay more for the car than they should! The seller reaps the rewards of superior information.
In some provinces, before such a transaction can occur, a sellers information package must be obtained from the Ministry of Transportation. This package will include an estimate of wholesale and retail price of the used car, and a list of past owners. This is an example of government regulation to try to reduce the information advantage sellers have over buyers.
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Ultimately, the capital market would not be able to channel sufficient surplus funds to underwrite economic activity such as plant expansions, research and development, etc. In the end, companies would lack capital, and increasingly become inefficient and ineffective in their markets. Jobs would be lost and the standard of living of all would decline.
CHAPTER 10 Market Efficiency
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An Efficient Market
Is a market that reacts quickly and relatively accurately to new public information, which results in prices that are correct, on average.
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Market Efficiency
Requisite Conditions
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The Efficient Market Hypothesis is The theory that markets are efficient and therefore, in its strictest sense, implies that prices accurately reflect all available information at any given time.
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The theory that security prices reflect all market data, referring to all past price and volume trading information.
Implication:
If Weak Form efficient, historical trading data will already be reflected (discounted) in current prices and should be of no value in predicting future price changes.
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The theory that all publicly known and available information is reflected in security prices. Assumes the weak-form set of information as well as all public information pertinent to the security such as:
Earnings Dividends Corporate investments, Management changes
Implication:
If semi-strong efficient, it is futile to analyze public information such as earnings projections and financial statements in an attempt to identify underpriced or overpriced securities.
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The theory that stock prices fully reflect all information, which includes both public and private information.
Implications:
Stock prices are fairly priced. It is not possible to use public information to identify over-priced or under-priced stocks It is not possible to use insider information to identify over-priced or under-priced stocks
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All tests of the EMH try to demonstrate that using a particular source of information allows an investor to consistently earn abnormal returns. Abnormal returns are percentage returns that are greater than a nave buy-and-hold strategy where the investor passively buying a market index portfolio such as the S&P/TSX 60 composite index.
In other words, can an active investment strategy, using a particular trading rule or source of information, generate greater risk-adjusted returns than a passive, nave, yet achievable, investment strategy?
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If markets are weak form efficient historical trading data will already be reflected in current prices and should be of no value in predicting future price changes.
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The Random Walk Hypothesis states prices follow a random walk with price changes over time being independent of one another.
This hypothesis is logical if information arrives randomly, as it should, and if investors react quickly to it.
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25 20 15 10 5 0
20.7 6
14.75
5.9 9
6.10
Top 30
Bottom 30
Top-Bottom
TSX
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A market that quickly incorporates newly released information (to the public) is semi-strong efficient.
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Event studies examine stock returns to determine the impact of a particular event on stock prices, in particular, what happens to the stock price, before, during and following the event.
Events include:
Company-specific announcements such as stock splits, takeover announcements, dividend changes, accounting changes. Economy-wide changes such as unexpected interest rate changes
Figure 10 2 (on the following slide) illustrates the price adjustment process for:
(A) an efficient market (B) - overreaction in an efficient market (C) - slow reaction in an efficient market
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B A
$23
$20
t
Announcement Date
Time
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Most event studies have shown that stock prices change before the announcement as demonstrated in Figure 10 3 on the following slide. These results demonstrate that an investor cannot move quickly enough at the time an event occurs (announcement is made) to profit from the change, so this speaks to market efficiency in the semi-strong form,
On the other hand This evidence does not provide support for the strong form of the EMH because some investors are profiting from private information about impending price changes.
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B A
$23
$20
t
Announcement Date
Time
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Semi-strong Anomalies
Earnings Surprises
Several studies have confirmed a lag exists when earnings either exceed or fall short of consensus earnings estimates.
Largest positive earnings surprises displayed superior subsequent performance Low or negative earnings surprises displayed poor subsequent performance
The substantial adjustments after the announcement date contradicts the semi-strong form of the EMH
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Tests to determine whether investors can use publiclyavailable information to obtain abnormal returns have shown that value investment styles have consistently outperformed growth styles. Value stocks are those that have:
below-average price-to-earnings (P/E) and market-to-book (M/B) ratios, and above-average dividend yields
Growth stocks are those that investors are prepared to pay a premium price for because expected future growth in earnings and share price and have:
above-average P/E and M/B ratios, and below-average dividend yields
(Figure 10 4 on the following slide depicts the relative performance of the two investment styles from 1982 to 2006)
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Semi-strong Anomalies
Small Firm Effect
Figure 10 5 (found on the following slide) depicts the returns on Canadian small cap stocks versus the broad market. Over this period small caps outperformed the broader index providing an annual return of 16.25% versus 11.91%.
Smaller cap stock returns are much more volatile (24.8% versus 15.12%), and Transactions costs are greater for small cap stocks
Therefore, attempting to capitalize on the small firm effect is not a free lunch
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Semi-strong Anomalies
Value Line Investment Survey Effect
Value Line Investment Survey is a widely followed stock publication that ranks a large universe of stocks from 1 (best) to 5 (worst)
Substantial evidence suggests that stocks ranked 1 or 2 experience superior performance over the following 12 monthsand those in lower-ranked categories perform poorly.
These findings contradict the semi-strong EMH However, again, transactions costs make it difficult to profit from this anomaly.
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Most studies support the Semi-strong Form of the EMH A number of anomalies (or exceptions) have been identified including:
The Value investment style has consistently outperformed the growth style The size effect that shows that small market cap stock tend to outperform large cap stocks on a riskadjusted return basis The Value Line Investment Survey effect
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The strong form asserts that prices reflect all public and private information. If a market is strong-form efficient, then insiders could not profit from inside information not known by the public. Tests of this hypothesis include determining whether any group of investors has information that allows them to earn abnormal profits consistently.
Several studies found consistent abnormal profits Others found only slightly better than average returns.
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On balance, evidence does not support the strong form of the EMH.
It should be noted that insider trading laws do restrict the ability of insiders to act and therefore, profit from their inside information, so this is one reason why evidence may be muted regarding the degree of advantage insiders enjoy under current law.
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1. Weak form efficiency is very well supported, and it is reasonable to conclude that markets are weak form efficient, although a few anomalies do exist. 2. Semi-strong form efficiency is well supported; however, more contradictory evidence exists for this version of the EMH than for the weak form. 3. Strong form efficiency is not very well supported by the evidence, and it is reasonable to conclude that markets are not strong form efficient in the strictest sense.
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Markets may not be perfectly efficient, but they are relatively efficient.
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1. Technical analysis is not likely to be rewarded. 2. Fundamental analysis is also unlikely to be successful at generating abnormal profits after transactions costs, research costs and taxes. 3. Active trading strategies are unlikely to outperform passive buy-and-hold strategiesfavouring index mutual funds or exchange-traded funds (ETFs) 4. Investors should focus on the basics of good investing by defining investment goals in terms of expected return and acceptable risk levels.
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1. Timing of security issues or share repurchases in unimportant because prices are correct on average. 2. Management should monitor the price of the firms securities to see whether price changes reflect new information or short-run momentum and/or overreaction.
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Copyright
Copyright 2007 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein.
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