The Efficient Market Hypothesis
CHAPTER 11 EFFICIENT MARKET HYPOTHESIS (EMH)
Do security prices reflect information ? Why look at market efficiency? Implications for business and corporate finance Implications for investment
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 2 FIGURE 11.1 CUMULATIVE ABNORMAL RETURNS BEFORE TAKEOVER ATTEMPTS: TARGET COMPANIES
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 3 FIGURE 11.2 STOCK PRICE REACTION TO CNBC REPORTS
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 4 EMH AND COMPETITION
Stock prices fully and accurately reflect publicly available information Once information becomes available, market participants analyze it Competition assures prices reflect information
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 5 VERSIONS OF THE EMH
Weak Semi-strong Strong
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 6 TYPES OF STOCK ANALYSIS
Technical Analysis - using prices and volume information to predict future prices Weak form efficiency & technical analysis Fundamental Analysis - using economic and accounting information to predict stock prices Semi strong form efficiency & fundamental analysis
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 7 ACTIVE OR PASSIVE MANAGEMENT
Active Management Security analysis Timing Passive Management Buy and Hold Index Funds
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 8 MARKET EFFICIENCY & PORTFOLIO MANAGEMENT
Even if the market is efficient a role exists for portfolio management: Appropriate risk level Tax considerations Other considerations
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 9 EVENT STUDIES
Empirical financial research that enables an observer to assess the impact of a particular event on a firm’s stock price Abnormal return due to the event is estimated as the difference between the stock’s actual return and a proxy for the stock’s return in the absence of the event
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 10 HOW TESTS ARE STRUCTURED Returns are adjusted to determine if they are abnormal Market Model approach
a. rt = at + brmt + et
(Expected Return) b. Excess Return = (Actual - Expected)
et = rt - (a + brMt)
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 11 ARE MARKETS EFFICIENT
Magnitude Issue Selection Bias Issue Lucky Event Issue
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 12 WEAK-FORM TESTS
Returns over the Short Horizon Momentum Returns over Long Horizons
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 13 PREDICTORS OF BROAD MARKET RETURNS
Fama and French Aggregate returns are higher with higher dividend ratios Campbell and Shiller Earnings yield can predict market returns Keim and Stambaugh Bond spreads can predict market returns
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 14 SEMISTRONG TESTS: ANOMALIES
P/E Effect Small Firm Effect (January Effect) Neglected Firm Effect and Liquidity Effects Book-to-Market Ratios Post-Earnings Announcement Price Drift
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 15 FIGURE 11.3 AVERAGE ANNUAL RETURN FOR 10 SIZE-BASED PORTFOLIOS, 1926 – 2006
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 16 FIGURE 11.4 AVERAGE RETURN AS A FUNCTION OF BOOK-TO-MARKET RATIO, 1926–2006
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 17 FIGURE 11.5 CUMULATIVE ABNORMAL RETURNS IN RESPONSE TO EARNINGS ANNOUNCEMENTS
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 18 STRONG-FORM TESTS: INSIDE INFORMATION The ability of insiders to trade profitability in their own stock has been documented in studies by Jaffe, Seyhun, Givoly, and Palmon SEC requires all insiders to register their trading activity
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 19 INTERPRETING THE EVIDENCE
Risk Premiums or market inefficiencies— disagreement here Fama and French argue that these effects can be explained as manifestations of risk stocks with higher betas Lakonishok, Shleifer, and Vishney argue that these effects are evidence of inefficient markets
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 20 FIGURE 11.6 RETURNS TO STYLE PORTFOLIO AS A PREDICTOR OF GDP GROWTH
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 21 INTERPRETING THE EVIDENCE CONTINUED
Anomalies or Data Mining The noisy market hypothesis Fundamental indexing
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 22 STOCK MARKET ANALYSTS
Do Analysts Add Value Mixed evidence Ambiguity in results
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 23 MUTUAL FUND PERFORMANCE
Some evidence of persistent positive and negative performance Potential measurement error for benchmark returns Style changes May be risk premiums Hot hands phenomenon
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 24 FIGURE 11.7 ESTIMATES OF INDIVIDUAL MUTUAL FUND ALPHAS, 1972 - 1991
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 25 TABLE 11.1 PERFORMANCE OF MUTUAL FUNDS BASED ON THREE-INDEX MODEL
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 26 FIGURE 11.8 PERSISTENCE OF MUTUAL FUND PERFORMANCE
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 27 TABLE 11.2 TWO-WAY TABLE OF MANAGERS CLASSIFIED BY RISK-ADJUSTED RETURNS OVER SUCCESSIVE INTERVALS
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 28 Behavioral Finance and Technical Analysis
CHAPTER 12 BEHAVIORAL FINANCE
Investors Do Not Always Process Information Correctly Investors Often Make Inconsistent or Systematically Suboptimal Decisions
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 30 INFORMATION PROCESSING CRITIQUE
Forecasting Errors Overconfidence Conservatism Sample Size Neglect and Representativeness
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 31 BEHAVIORAL BIASES
Framing Mental Accounting Regret Avoidance Prospect Theory
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 32 FIGURE 12.1 PROSPECT THEORY
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 33 LIMITS TO ARBITRAGE
Fundamental Risk Implementation Costs Model Risk
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 34 LIMITS TO ARBITRAGE AND THE LAW OF ONE PRICE
Siamese Twin Companies Equity Carve-outs Closed-End Funds
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 35 FIGURE 12.2 PRICING OF ROYAL DUTCH RELATIVE TO SHELL (DEVIATION FROM PARITY)
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 36 EVALUATION OF THE BEHAVIORAL CRITIQUES Bubbles and Behavioral Economics Arguments that the Evidence Does Not Support One Type of Irrationality Relatively New Field
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 37 TECHNICAL ANALYSIS AND BEHAVIORAL FINANCE Trends and Corrections Dow Theory Moving averages Breadth Sentiment Indicators Trin Statistic Confidence Index Put/Call Ratio
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 38 FIGURE 12.3 DOW THEORY TRENDS
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 39 FIGURE 12.4 DOW JONES INDUSTRIAL AVERAGE IN 1988
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 40 FIGURE 12.5 MOVING AVERAGE FOR MICROSOFT
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 41 EXAMPLE 12.4 MOVING AVERAGES
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 42 FIGURE 12.6 MOVING AVERAGES
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 43 FIGURE 12.7 MARKET DIARY
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 44 TABLE 12.1 BREADTH
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 45 FIGURE 12.8 ACTUAL AND SIMULATED LEVELS FOR STOCK MARKET PRICES OF 52 WEEKS
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 46 FIGURE 12.9 ACTUAL AND SIMULATED CHANGES IN STOCK PRICES FOR 52 WEEKS
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 47 Empirical Evidence on Security Returns
CHAPTER 13 OVERVIEW OF INVESTIGATION
Tests of the single factor CAPM or APT Model Tests of the Multifactor APT Model Results are difficult to interpret Studies on volatility of returns over time
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 49 THE INDEX MODEL AND THE SINGLE- FACTOR APT
Expected Return-Beta Relationship
E()( ri r f i E r M r f Estimating the SCL
rit r ft i b i() r Mt r ft e it
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 50 TESTS OF THE CAPM
Tests of the expected return beta relationship: First Pass Regression Estimate beta, average risk premiums and unsystematic risk Second Pass: Using estimates from the first pass to determine if model is supported by the data Most tests do not generally support the single factor model
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 51 SINGLE FACTOR TEST RESULTS
Return % Predicted
Actual
Beta
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 52 ROLL’S CRITICISM The only testable hypothesis is on the efficiency of the market portfolio In any sample of observations of individual returns Infinite number of ex post mean-variance efficient portfolios using the sample-period returns and covariances CAPM is not testable unless we know the exact composition of the true market portfolio and use it in the tests Benchmark error
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 53 MEASUREMENT ERROR IN BETA
Statistical property If beta is measured with error in the first stage, second stage results will be biased in the direction the tests have supported Test results could result from measurement error
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 54 TABLE 13.1 SUMMARY OF FAMA AND MACBETH (1973) STUDY (ALL RATES IN BASIS POINTS PER MONTH)
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 55 JAGANATHAN AND WANG STUDY
Included factors for cyclical behavior of betas and human capital When these factors were included the results showed returns were a function of beta Size is not an important factor when cyclical behavior and human capital are included
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 56 TABLE 13.2 EVALUATION OF VARIOUS CAPM SPECIFICATIONS
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 57 TABLE 13.3 PORTFOLIO SHARES RELATIVE TO TOTAL ASSETS BY AGE AND NET WORTH
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 58 TABLE 13.4 DETERMINANTS OF STOCKHOLDINGS
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 59 TESTS OF THE MULTIFACTOR MODEL
Chen, Roll and Ross 1986 Study Factors Growth rate in industrial production Changes in expected inflation Unexpected inflation Unexpected Changes in risk premiums on bonds Unexpected changes in term premium on bonds
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 60 STUDY STRUCTURE & RESULTS
Method: Two -stage regression with portfolios constructed by size based on market value of equity Fidings Significant factors: industrial production, risk premium on bonds and unanticipated inflation Market index returns were not statistically significant in the multifactor model
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 61 TABLE 13.5 ECONOMIC VARIABLES AND PRICING (PERCENT PER MONTH X 10), MULTIVARIATE APPROACH
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 62 FAMA-FRENCH THREE FACTOR MODEL
Size and book-to-market ratios explain returns on securities Smaller firms experience higher returns High book to market firms experience higher returns Returns are explained by size, book to market and by beta
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 63 TABLE 13.6 THREE FACTOR REGRESSIONS FOR PORTFOLIOS FORMED FROM SORTS ON SIZE AND BOOK-TO-MARKET RATIOS (B/M)
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 64 INTERPRETATION OF THREE-FACTOR MODEL Size is a proxy for risk that is not captured in CAPM Beta Premiums are due to investor irrationality or behavioral biases
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 65 RISK-BASED INTERPRETATIONS
Liew and Vassalou Petkova and Zhang
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 66 FIGURE 13.1 DIFFERENCE IN RETURN TO FACTOR PORTFOLIOS IN YEAR PRIOR TO ABOVE-AVERAGE VERSUS BELOW- AVERAGE GDP GROWTH
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 67 FIGURE 13.2 HML BETA IN DIFFERENT ECONOMIC STATES
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 68 BEHAVIORAL EXPLANATIONS
Market participants are overly optimistic Analysts extrapolate recent performance too far into the future Prices on these glamour stocks are overly optimistic Lower book-to-market on these glamour firms leads to underperformance compared to value stocks Chan, Karceski and Lakonishok LaPort, Lakonishok, Shleifer and Vishny
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 69 FIGURE 13.3 THE BOOK-TO-MARKET RATIO REFLECTS PAST GROWTH, BUT NOT FUTURE GROWTH PROSPECTS
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 70 FIGURE 13.4 VALUE MINUS GLAMOUR RETURNS SURROUNDING EARNINGS ANNOUNCEMENTS, 1971-1992
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 71 LIQUIDITY AND ASSET PRICING
Acharya and Pedersen Premiums observed in the three-factor model may be illiquidity premiums Liquidity may explain the size premium but not the book-to-market premium
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 72 TABLE 13.7 PROPERTIES OF LIQUIDITY PORTFOLIOS
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 73 TABLE 13.8 ESTIMATES OF THE CAPM WITH AND WITHOUT LIQUIDITY FACTORS
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 74 TIME-VARYING VOLATILITY
Stock prices change primarily in reaction to information New information arrival is time varying Volatility is therefore not constant through time
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 75 STOCK VOLATILITY STUDIES AND TECHNIQUES Volatility is not constant through time Improved modeling techniques should improve results of tests of the risk-return relationship ARCH and GARCH models incorporate time varying volatility
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 76 FIGURE 13.5 ESTIMATES OF THE MONTHLY STOCK RETURN VARIANCE 1835 - 1987
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 77 FIGURE 13.6 IMPLIED VERSUS ESTIMATED VOLATILITY
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 78 EQUITY PREMIUM PUZZLE
Rewards for bearing risk appear to be excessive Possible Causes CAPM doesn’t consider the impact of consumption Predicting returns from realized returns Survivorship bias also creates the appearance of abnormal returns in market efficiency studies
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 79 TABLE 13.9 ANNUAL CONSUMPTION GROWTH, 1954-2003 (%)
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 80 TABLE 13.10 ANNUAL EXCESS RETURNS AND CONSUMPTION BETAS
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 81 FIGURE 13.7 CROSS-SECTION OF STOCK RETURNS: FAMA-FRENCH 25 PORTFOLIOS, 1954-2003
BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 82