Post on 20-Dec-2015
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Topics covered Efficient market theory
Definition Implications Foundation Types Evidence
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Efficient market theory Efficient market:
Implications of the efficient market theory:
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Reaction of Stock Price to New Information in Efficient and Inefficient Markets
Stock Price
-30 -20 -10 0 +10 +20 +30Days before (-) and
after (+) announcement
Efficient market response to “good news”
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Reaction of Stock Price to New Information in Efficient and Inefficient Markets
Stock Price
-30 -20 -10 0 +10 +20 +30
Days before (-) and after (+)
announcement
Efficient market response to “bad news”
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Foundations of market efficiency Rationality:
Independent deviations from rationality:
Arbitrage
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Weak Form Market Efficiency Security prices reflect
Pt = Since stock prices only respond to new
information, which by definition arrives randomly, stock prices are said to follow
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Semi-Strong Form of Market Efficiency Semi-strong form:
Historical price and volume information
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Strong Form of Market Efficiency Strong form:
Incorporates weak and semi-strong form efficiency.
Anything pertinent to the stock and known to at least one investor is already incorporated into the security’s price.
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The Evidence for market efficiency Are changes in stock prices random? Are
there profitable “trading rules”? Event studies: does the market quickly
and accurately respond to new information?
The record of professionally managed investment firms.
Insider trading
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Are Changes in Stock Prices Random? Random stock price changes support
Serial correlation:
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What Pattern Do You See?
0
0.2
0.4
0.6
0.8
1
1.2
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
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Are Changes in Stock Prices Random? The serial correlation coefficients for firms
have been found to be The evidence is consistent with
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Event Studies Event studies are one type of test of the semi-
strong form of market efficiency Examines prices and returns around the arrival of
new information: under reaction, overreaction, early reaction, delayed reaction around the event…
The abnormal return of a given stock on a particular day: AR= R – RM
AR= R – ( + RM)
Cumulative abnormal returns (CAR)
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Event Studies: Dividend Omissions
Cumulative Abnormal Returns for Companies Announcing Dividend Omissions
0.146 0.108
-0.72
0.032-0.244-0.483
-3.619
-5.015-5.411-5.183
-4.898-4.563-4.747-4.685-4.49
-6
-5
-4
-3
-2
-1
0
1
-8 -6 -4 -2 0 2 4 6 8
Days relative to announcement of dividend omission
Cum
ulat
ive
abno
rmal
ret
urns
(%
)
Efficient market response to “bad news”
S.H. Szewczyk, G.P. Tsetsekos, and Z. Santout “Do Dividend Omissions Signal Future Earnings or Past Earnings?” Journal of Investing (Spring 1997)
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Event studies This metholdology has been applied to a
large number of corporate events Dividend announcement Stock repurchase Merger and aquisition Earnings announcement Change in the management etc
These studies are generally supportive of
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The Record of Mutual Funds If the market is semi-strong efficient, then
mutual-fund managers should
Compare the performance of professionally managed mutual funds with the return on a market index.
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The Record of Mutual Funds
Taken from Lubos Pastor and Robert F. Stambaugh, “Mutual Fund Performance and Seemingly Unrelated Assets,” Journal of Financial Exonomics, 63 (2002).
-2.13%
-8.45%
-5.41%
-2.17% -2.29%
-1.06%-0.51%-0.39%
All funds Small-companygrowth
Other-aggressive
growth
Growth Income Growth andincome
Maximumcapital gains
Sector
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Insider trading Trades by insiders are found to be related
to large profits. The evidence is
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Behavial challenge to market efficiency Investors do not behave rationally
Patterms in deviation from rationality
Arbitrage is risky