Topics Covered

We Always Come Back to NPV What is an Efficient Market?

andom Walk Efficient Market Theory

The Evidence A!ainst Market Efficiency Behavioral "inance #essons of Market Efficiency $mplications Essentials

et%rn to NPV
NPV employs disco%nt rates These disco%nt rates are risk ad&%sted The risk ad&%stment is a 'yprod%ct of market

esta'lished prices Ad&%sta'le disco%nt rates chan!e asset val%es

et%rn to NPV
Example The !overnment is lendin! yo% ()**+*** for )* years at ,- and only re.%irin! interest payments prior to mat%rity/ 0ince ,- is o'vio%sly 'elow market+ what is the val%e of the 'elow market rate loan?

NPV = amount borrowed - PV of interest pmts - PV of loan repayment

et%rn to NPV
Example The !overnment is lendin! yo% ()**+*** for )* years at ,and only re.%irin! interest payments prior to mat%rity/ 0ince ,- is o'vio%sly 'elow market+ what is the val%e of the 'elow market rate loan?

Ass%me the market ret%rn on e.%ivalent risk pro&ects is )*-/ 10

3,000 100,000 NPV = 100,000 t 10 $ 1 # 10 " $ 1 # 10 " t =1 = 100,000 !,988 = $43,012

EM1
Efficiency 2 3how s%ccessf%l is the market in

esta'lishin! share prices that reflects the 4worth5 of the shares67/is new info incorporated in a rapid and %n'iased manner 2 the speed and .%ality of price ad&%stment to new information EM1 is a s%'set of the ational E8pectation 1ypothesis 9 E1: 2 3in a competitive world+ economic a!ents will e8ploit all availa'le information to take advanta!e of any perceived profita'le opport%nities67that will eliminate opport%nities for a'normal !ains

EM1
;e!rees of efficiency< Perfect+ Near Efficiency and $nefficiency Near efficiency 2 one that capt%res a partic%lar info

set in its share prices in s%ch a way as to prevent all '%t the most skillf%l investors from earnin! e8cess ret%rns from the same information7/ 9Weak+ 0emi=0tron! and 0tron! form: "actors contri'%tin! to market inefficiency< = The information !ap Biased eportin! Personal E8perience= 4'eatin! the market5

andom Walk Theory

The movement of stock prices from day to

day ;> N>T reflect any pattern/ 0tatistically speakin!+ the movement of stock prices is random (skewed positive over the long
term). "actors that contri'%te towards 3!eneratin!

prices that f%lly reflect the worth of assets 'ein! traded6<

EM1
1omo!eneity 2 all shares are viewed in terms

of risks and e8pected ret%rns+ which provides some de!ree of compara'ility within the price str%ct%re of the sec%rities market that distin!%ishes it si!nificantly from most other markets/ This red%ces the compass of informational demand and esta'lishes the foc%s on risk and e8pected ret%rns/ #ocation $ndependence 2 val%es of shares of the same company traded in different e8chan!es is independent of location 9%nlike tan!i'le assets like an apartment or a chair:/ This red%ces the ran!e of investors6 potential information needs/

EM1
$nformation s%pport 2 The o%tstandin!

feat%res of any sec%rities market is 3how or!ani?ed and ela'orate is the information machinery which services it6/ $t concerns not only the .%ality and the amo%nt of information s%pply '%t e.%ally important is the rapidity with which the information is disseminated amon! the market participants/ This provides motivation for rapid and widespread information dissemination/

EM1
$nterpretations a'o%t nat%re of market

efficiency7//

40%rely+ the market is always ri!ht57/ 4EM1 ass%mes that all investors 'ehave rationally57 40tock market '%''les imply inefficiency57

EM1
$nterpretations on evidence for market

efficiency<

4Efficiency applies only to certain shares57 40tatistical evidence is ins%fficient57/ 4Prices are determined 'y s%pply and demand57 4Whilst there may 'e little scope in the lon! term for achievin! a'ove avera!e profits+ there will always 'e occasional short term opport%nities57

andom Walk Theory

Efficient Market Theory

Microsoft Stock Price
$40
,+tual pri+e as soon as upswin- is re+o-ni.ed

30

20 *y+les disappear on+e identified

%ast &ont'

('is &ont'

Ne)t &ont'

Efficient Market Theory

Weak "orm Efficiency Market prices reflect all historical information 0emi=0tron! "orm Efficiency

Market prices reflect all p%'licly availa'le information

0tron! "orm Efficiency Market prices reflect all information+ 'oth p%'lic and private

Efficient Market Theory

Fundamental Analysts
/ 0esear+' t'e 1alue of sto+2s usin- NPV and ot'er measurements of +as' flow / &easures t'e impa+t of t'e +'an-es in t'e mar2et, industry and t'e firm on t'e firm3s s'are pri+e

Efficient Market Theory

Technical Analysts
/ 4ore+ast sto+2 pri+es based on t'e wat+'in- t'e flu+tuations in 'istori+al pri+es $t'us 5wiggle watchers6"

Efficient Market Theory

,nnoun+ement 7ate

Behavioral "inance
Ar'itra!e limitations= limits for rational investors to e8ploit market inefficiencies7the risk that prices will diver!e even f%rther 'efore they conver!e #TCM e8ample Why mi!ht prices depart from f%ndamental val%es? )/ Attit%des towards risk @/ Beliefs a'o%t pro'a'ilities

#essons of Market Efficiency

Markets have no memory 9weak form

efficient: Tr%st market prices 9yo% cannot consistently earn s%perior ret%rns %nless yo% have inside information: ead the entrails 9the detailed info re.%ired to assess the f%t%re prospects: There are no financial ill%sions 9investors read reported fi!%res at face val%eA///the case of "$"> and #$"> in times of increasin! inflation7: The do it yourself alternative

#essons of EM1
0een one stock+ seen them all

9 BBT $nvestors '%y stock for its prospects of fair ret%rns for its risk/ The ;; for stocks are %s%ally hi!hly E#A0T$CA/ $f prospects are !ood everyone scram'les for the share and if prospects are not !ood+ everyone avoids the share/ Block trades will affect prices %nless can convince other investors that yo% have no private information:

What $" the markets are $NE""$C$ENT?

$mplications for "inancial mana!ers< )/ Market inefficiencies mi!ht offer economic rents/

"irms sho%ld not invest %nless it can identify a competitive advanta!e and so%rce of economic rents/ @/ $f financial mana!ers to have an advanta!e of 3inside information6 that yo%r share is 3over priced / Wo%ld this &%stify iss%in! new shares 9cheaply: and invest in pro&ects that offers lower rate of ret%rn than yo% can earn somewhere else in the market 9this will res%lts in ne!ative NPVA:/ What if the share is 3%nder priced6?///iss%e de't to financeA

What $" the markets are $NE""$C$ENT?

,/ What if the company shares are ca%!ht in a

3'%''le6? The financial mana!er will face personal and ethical challen!es/ 0ho%ld they 3talk=down6 the hi!h flyin! price 9'on%ses and stock options are %s%ally tied to share pricesA:+ or sho%ld they cover 'ad news and 3man%fact%re6 !ood news 9remem'er EN >N?:? >nce the '%''le '%rsts7/it will 'e time for law s%its+ &ail terms for mana!ers and poor time for shareholders7//C !ood time for re!%latorsA

Example: How stock splits affect value

-29

30

Source: Fama, Fisher, Jensen & Roll

Market Efficiency
$mplications of a fairly efficient market< Earn normal ret%rns on consistent 'asis No spec%lative profits $nvestment 0trate!y 2 Passive No val%e for "%ndamental and Technical strate!ies for analysts )/ What is the difference 'etween 3efficiency6 and 3rationality6?

@/ What is meant 'y 3parado8 of market efficiency6? ,/ $s there s%ch thin! as 3a'sol%te efficiency6? Why?

Essentials for market efficiency

)/ Characteristics of the sec%rity and the iss%er @/ Characteristics of the market in the sec%rity

trades ,/ The efficiency of technolo!y availa'le to analysts to !ather and process information and to trade #ar!er firms are perceived to 'e more efficient than smaller firms+ 'eca%se<

They en&oy 'etter economies of scale in prod%ction and processin! of information and as well as tradin! They en&oy lower costs of tradin!+ commissions and 'id=ask spread They possess efficient technolo!ies to identify deviations of prices and val%e and have the means to correct these deviations .%ickly as they have efficient technolo!ies to

Anomalies
Evidence that is contrary to EM1 E8amples< )/ 0mall firms persistently o%tperform lar!e

firms @/ "irms with small PDE o%tperform firms with lar!e PDE6s ,/ ;elay in reaction to news7/earnin!s anno%ncement7new iss%es E/ 0iamese Twins7/ oyal ;%tch Petrole%m and 0hell Transport C Tradin! company share prices B%''les+ ;ot/Com "iasco7/

Behavioral "inance
$n real world case+ markets are often

inefficient and there are a lot of investors lookin! for a'normal !ains7how co%ld inefficiencies s%rvive in this sit%ation? Beca%se+ limits to which investors are a'le to e8ploit inefficient opport%nities 9limits to ar'itra!e:7prices can !et o%t of line and stay that way for a lon! time if risks for ar'itra!e strate!y o%twei!hs the e8pected ret%rns

Behavioral "inance C EM1

$f ar'itra!e is N>T EN>BF1 to correct mispricin!+

then what determines the nat%re and direction of pricin!?////$nvestor6s psycholo!y7that they are not )**- rational all the time as indicated 'y their attit%de towards risk7prospect theory/ Beliefs a'o%t pro'a'ilities7investors tend to place too m%ch wei!h on recent events7too slow to %pdate their 'eliefs in li!ht of new evidence7/and overconfidence of %nderestimatin! the chances of %nlikely eventsA The val%e of 'ehavioral finance depends on whether it can predict mispricin! 'efore it is act%ally o'served7/

Case and eadin!s

Case: Bill Miller and Val%e Tr%st 9 efer to Pa!es @,=,G of the

Book+ Case 0t%dies in "inance< Mana!in! for Corporate Val%e Creation+ 'y o'ert "/ Br%ner+ Henneth M/ Eades and Michael I/ 0chill+ Jth Edition+ McFraw=1ill $nternational Edition+ @*)*:/ Articles< )/ M/ %'instein+ ational Markets< Kes or No?+ The Affirmative Case?The "inancial Anaysts Io%rnal LM 9MayDI%ne @**):+ pp< )L=@N/ @/ B/F/ Malkiel+ Efficient Market 1ypothesis and its critics+ Io%rnal of Economic Perspectives )M+ Winter @**,+ pp< LN=G@/