The Efficient Hypothesis

CHAPTER 11 EFFICIENT MARKET HYPOTHESIS (EMH)

Do prices reflect information ? Why look at market efficiency? Implications for business and corporate 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 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

- using prices and volume information to predict future prices Weak form efficiency & technical analysis  - using economic and accounting information to predict stock prices Semi strong form efficiency & fundamental analysis

BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 7 ACTIVE OR

Security analysis Timing Passive Management  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 Horizon  Returns over Horizons

BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 13 PREDICTORS OF BROAD MARKET RETURNS

Fama and French Aggregate returns are higher with higher ratios Campbell and Shiller Earnings 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 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 ANALYSTS

Do Analysts Add Value Mixed evidence Ambiguity in results

BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 23 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

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 of returns over time

BAHATTIN BUYUKSAHIN, JHU, INVESTMENT 49 THE INDEX MODEL AND THE SINGLE- FACTOR APT

Expected Return- 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 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