1 Part 3 Market efficiency

2 What Have We Done So Far? There are one or many investment projectsAssume we have sufficient funds to invest in a project Try to decide which project to invest Investment under certainty: (given discount rate) Figure out future cash flows Understand the time value of money Perform NPV analysis Investment under uncertainty: In addition to above steps, we need to determine the discount rate Understand what kind of risk will be rewarded Measure the systematic risk The CAPM model—the risk and return relationship

3 What Have We Done So Far? “Raise money” for the positive NPV projectsTake firms’ present portfolios of real assets and its future investment strategy as given Choose the best financing strategy: Should the firm issue stock or should it borrow? From a firm’s perspective When a company actually sells its stock or bond in the market, how can they be sure to get a fair price? From investors’ perspective How much investors are willing to pay for each financing options? Pricing stock and bond From the market perspective What mechanism market can provide to ensure an equilibrium outcome between the two parties

4 Security Prices and Market EfficiencyThe “true value” is not the ultimate future value Investors aren’t expected to tell fortunes The “true value” reflects the best assessment of the market How security prices aggregate available information? Investors rationally evaluate all available information when submitting their demand for securities When the market equates the supply and demand for securities, equilibrium prices should aggregate all available information Therefore, the value of a security reflects all information currently available to investors An efficient capital market should guarantee the speedy dissemination and reflection of information in security price Financial markets are efficient if and only if security prices rapidly reflect all relevant information about asset values, and all securities are fairly priced in light of the available information.

5 Implications of the Efficient Market HypothesisA market is efficient with respect to a set of information It is not possible to make a positive NPV decision based on that information Market prices of securities are equal to their present value Investors buying securities can expect to make a fair rate of return on a risk-adjusted basis A firm can expect to obtain a fair price when it sells securities How is the set of information available to investors related to market efficiency?

6 Three Forms of Market EfficiencyStrong-form Efficiency (Info: all information) Semi-strong-form Efficiency (Info: public Information) Weak-form Efficiency (Info: past prices) Weak-form efficiency: Market prices rapidly reflect all information contained in past prices or returns. Semi-strong-form efficiency: Market prices reflect all publicly available information Strong-form efficiency: Security prices reflect all information

7 The Weak-form EfficiencyThe information set of concern is limited to price or trading volume Price changes are unpredictable from past behavior of prices There are no persistent patterns can be used to predict future returns Price changes are random Random Walk model for security prices Security returns are independent over time Price changes have no trends or patterns

8 Why “Random Walk” Model?If the market is efficient, current stock prices should already reflect all information about the firm; only new information can cause prices to change New information is by definition unpredictable Security returns in efficient market Changes in return can only be caused by new information Returns should also be unpredictable The “random walk” model implies random changes in prices or returns

9 Simulating Random WalkA white noise process: Random walk with/without drift: 𝑌 𝑡 = 𝑌 𝑡−1 + 𝜇 𝑡 𝑅 𝑡 = 𝜇 𝑡 𝜇 𝑡 ~𝐼𝐼𝐷(0, 𝜎 2 )

10 Mechanism Ensuring Market EfficiencyThe capital market is competitive Large number of investors Variety choices for investors Competition among analysts Information is cheaply and widely available to investors Security law prohibits insider trading and market manipulation Information available to all investors Regulation FD

11 Fundamentalists vs. TechniciansFundamental analysts Those who study companies’ business and try to uncover information about their profitability Competition among fundamental analysts will tend to ensure price reflect all relevant information price changes are unpredictable Technical analysts Those who attempt to profit by looking for patterns in stock prices Competition in technical research will tend to ensure current prices reflect all information in the past sequence of prices future price changes cannot be predicted from past prices

12 Semi-strong Form EfficiencyIt usually means stock prices should respond rapidly to public release of information Examples: announcements of earnings and dividends forecasts by analysts changes in accounting practices disclosures of stock splits Price Days Event

13 Testing Semi-strong Form—Event StudyA research methodology designed to measure the impact of an event of interest on stock prices after the event date Design of the test: Examine return instead since prices are different at different events Use the abnormal return since return can change due to overall market movement ARt = Rt - Rm,t Abnormal return can also be refined using the market model or the CAPM as: ARt = Rt - ( +  Rm,t)

14 Event Study When market is efficient: In practice:Before event at time t-1  ARt-1 = 0 Event at time t  ARt After event at time t+1  ARt+1 = 0 In practice: Low power of using AR We use CAR – Cumulative Abnormal Return If semi-strong efficient  CAR should be constant after the event CAR Days Event

15 Inefficient response to new informationOverreaction to “good news” with reversion Stock Price Delayed response to “good news” Efficient market response to “good news” Days before (-) and after (+) announcement

16 Inefficient response to new informationEfficient market response to “bad news” Delayed response to “bad news” Stock Price Overreaction to “bad news” with reversion Days before (-) and after (+) announcement

17 Findings This methodology is easy to apply, and has been used to study a large number of events: Dividend changes Earnings Mergers Capital expenditures New issues of stock, or new issues of debt Changes in stock exchange listing Stock buybacks, etc.

18 Earnings announcements

19 Dividend initiations and omissions

20 Stock repurchases

21 Strong Form EfficiencyPrices reflect not just public information, but all information No investor can make superior forecasts Who might know more? portfolio managers corporate insiders The evidence: portfolio managers don’t outperform the market (after adjusting for risk) insiders do outperform the market

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23 Ranking Consistency Ten Year Rank Order of Top 20 Equity Funds Average Return % 11.1% All Funds % 11.7%

24 Evidence From Mutual Funds

25 业绩排名 2006年 2007年 2008年 2009年 2010年 10 华夏大盘精选 国富弹性市值 博时平衡配置 易方达价值成长 泰达宏利成长 9 汇添富优势精选 华安宏利 汇丰晋信2016 银华领先策略 东吴价值成长 8 鹏华中国50 华宝兴业收益增长 华夏回报 融通深证100 嘉实优质企业 7 泰达宏利行业精选 东方精选 国投瑞银融华债券 中邮核心优选 天治创新先锋 6 招商优质成长 华夏红利 兴全可转债 兴全社会责任 华夏优势增长 5 银华核心价值优选 光大保德信红利 南方宝元债券 华商盛世成长 4 富国天益价值 易方达深证100ETF 泰达宏利风险预算 华商动态阿尔法 3 上投摩根中国优势 博时主题行业 申万菱信盛利配置 新华优选成长 嘉实增长 2 上投摩根阿尔法 银河收益 银河行业优选 1 景顺长城增长 金元比联宝石动力

26 Misinterpretations of the EMHStock prices cannot be fair We do observe that stock prices go up and down In fact, as long as there is news, prices should change Portfolio managers are incompetent Not so: market efficiency exists because there is a lot of competition, and managers are doing their job Investors should just throw darts to choose stocks Not so: you should allocate your assets at the risk level you feel comfortable with

27 Some Lessons of Market EfficiencyCreative accounting doesn’t work! Corporations have some leeway in reporting earnings Does the market increase your stock price if you increase reported earnings without improving cash flow? No! Example: Kaplan and Roll (1972). Looked at firms that switch from accelerated depreciation to straight-line. Slower depreciation increases reported earnings, decreases cash flow (why?). Findings: company’s stock price was punished Timing an issuance doesn’t work Managers seem reluctant to issue equity after a stock price fall Claim to ride the market while it is high If markets have no memory, it shouldn’t matter If insiders have extra info, it could matter Findings: though managers do this, there is no evidence that they can time successfully

28 Some Lessons of Market EfficiencyThere are no free lunches You can trust market prices; if there doesn’t appear to be a reason for a difference in price, look harder Example: short-term Treasury bills yield about 6%. Two-year bonds yield 7%; 30-years yield 7.5%. Should you sell your bills and buy longer maturity bonds? Not necessarily The possibilities: Investors think that short-term rates will rise over the coming year The longer bonds are riskier, so the higher yield is a risk premium The final word The EMH may not be perfect. Occasionally, there may be abnormal profits available for the first investors with new information or a new way to predict price. But the competition is fierce, and the pack is so smart, that your first assumption should be that you are not the first one with the information

29 Behavioral Challenges-- The study of how psychology affects finance

30 Anomalies The January effect The Monday effect The holiday effectsmall firms outperform large firms by a lot in January, but all stocks seem to go up at the start of the year (violates weak-form; what trading rule would you use to profit?) The Monday effect stock prices seem to go down on Mondays The holiday effect stock prices seem to go up the day before a holiday Outperformance of some groups of stocks value stocks outperform glamour stocks by as much as 8% per year small market capitalization stocks outperform large capitalization stocks by 5% a year (Would it violate weak-form efficiency? What about semi-strong form?)

31 Anomalies (Cont’d) Return predictabilitysome positive serial correlation in stock returns at monthly intervals some negative serial correlation in stock returns at 5-yr intervals There is some drift in stock prices after earnings announcements New IPOs seem to do poorly 1-5 years after issuance The crash of 1987 no obvious new information to justify a 20% decline The closed-end fund puzzle On average, closed-end funds are selling at a 10% discount relative to their net asset value

32 Financial markets Are financial investors really rational?Behavioral errors Systematic errors Limit of arbitrage Financial markets Are financial investors really rational? Are behavioral biases systematical? Are markets frictionless?

33 Limits to arbitrage EMH posits that actual prices reflect fundamental values There is “no free lunch”: no investment strategy can earn excess risk-adjusted average returns, or average returns greater than are warranted for its risk. If misvaluations caused by psychological biases occur, “arbitrageurs” will take positions and eliminate them before they become large. A type of investor who attempts to profit from price inefficiencies in the market by making simultaneous trades that offset each other and capturing risk-free profits.

34 Limits to arbitrage Suppose that the fundamental value of a share of Ford is $20. Imagine that a group of irrational traders becomes excessively pessimistic about Ford’s future prospects and through its selling, pushes the price to $15. Defenders of the EMH argue that rational traders, sensing an attractive opportunity, will buy the security at its bargain price and at the same time, hedge their bet by shorting a “substitute” security, such as General Motors, that has similar cash flows to Ford in future states of the world. The buying pressure on Ford shares will then bring their price back to fundamental value.

35 Limits to arbitrage First, a deviation from fundamental value creates an attractive investment opportunity. Second, rational traders will immediately snap up the opportunity, thereby correcting the mispricing. Does a mispriced asset immediately creates an opportunity for riskless profits? “prices are right”  “no free lunch” “no free lunch” -/-> “prices are right” When a mispricing occurs, strategies designed to correct it can be both risky and costly, thereby allowing the mispricing to survive.

36 Limits to arbitrage Fundamental riskBad mews about a firm’s fundamentals drives price to fall further. This can be hedged by shorting a substitute (e.g., General Motors ). However, substitute securities are rarely perfect, and often highly imperfect. e.g., industry-wide news, but not firm specific news can be hedged

37 Limits to arbitrage --evidenceIndex inclusions When a stock is added to S&P 500 index, it jumps in price by an average of 3.5%, and much of this jump is permanent . A deviation from fundamental value is evidence of both mispricing and limited arbitrage: the price of the share changes even though its fundamental value does not. Stocks without close substitutes (those stocks for which the arbitrage is riskiest) experience higher price jumps upon inclusion into the S&P 500 Index. It is hard to find good substitute securities for individual stocks: For most regressions of included stock returns on the returns of the best substitute securities, the R2 is below 25%.

38 Limits to arbitrage --evidence

39 Limits to arbitrage Noise trader riskMispricing worsens in the short run e.g., pessimistic investors cause a firm’s price to be undervalued in the first place become even more pessimistic Noise trader risk matters because it can force arbitrageurs to liquidate their positions early. e.g., arbitrageurs –professional money managers– are managing other people’s money on their behalf.

40 Limits to arbitrage --evidenceTwin shares In 1907, Royal Dutch and Shell Transport, at the time completely independent companies, agreed to merge their interests on a 60:40 basis while remaining separate entities. If prices equal fundamental value, the market value of Royal Dutch equity should always be 1.5 times the market value of Shell equity. Royal Dutch is sometimes 35% underpriced relative to parity, and sometimes 15% overpriced.

41 The ratio of Royal Dutch equity value to Shell equity value relative to the efficient markets benchmark of 1.5

42 Limits to arbitrage Implementation costsTransaction costs: commissions, bid-ask spread or price impact. Shorting is essential to the arbitrage process, there are costs associated with shorting. Short-constraints: short-selling is not allowed in some countries. There is a fee charged for borrowing a stock, which ranges between 10 and 15 bp. Sometimes, arbitrageurs may not be able to find shares to borrow at any price. Many money managers – pension fund and mutual fund managers – are prohibited from short-selling. Finding mispricing is a tricky matter

43 Limits to arbitrage --evidenceInternet carve-outs In March 2000, 3Com sold 5% of its wholly owned subsidiary Palm Inc. in an IPO, retaining ownership of the remaining 95%. After the IPO, a shareholder of 3Com indirectly owned 1.5 shares of Palm. 3Com also announced its intention to spin off the remainder of Palm within 9 months, at which time they would give each 3Com shareholder 1.5 shares of Palm. At the close of trading on the first day after the IPO, Palm shares stood at $95, putting a lower bound on the value of 3Com at $142. In fact, 3Com’s price was $81, This implies a market valuation of 3Com’s substantial businesses outside of Palm of about −$60 per share! Implementation costs: Many investors who tried to borrow Palm shares to short were either told by their broker that no shares were available, or else were quoted a very high borrowing price.

44 Return Anomalies Empirical evidence: excess returns in the stock market appear exhibit short-term momentum, that is positive autocorrelation, in the short to medium run (1 to 12 months) and long-term reversal, that is negative autocorrelation, in the long run (3 to 5 years) Behavioral explanations: Over short horizons security prices underreact to news. News is incorporated only slowly into prices, leading to positive return autocorrelations Over longer horizons security prices overreact to consistent patterns of news. Securities that have had a long record of good news tend to become overpriced and have low average returns

45 Value: a portfolio that longs stocks with good value characteristics (a high ratio of book value to market value) and short stocks with poor value characteristics (a low ratio of book value to market value) Momentum: a portfolio that longs stocks that have performed well recently and short those stocks with poor momentum characteristics Combo: a portfolio that is a 50/50 combination of value and momentum

46 Behavioral ExplanationsBarberis, Shleifer and Vishny (1998) argue that much of anomalies is the result of systematic errors that investors make when they use public information to form expectations of future cash flows Two biases play roles: conservatism, the tendency to underweight new information relative to priors; and representativeness (or the law of small numbers) whereby people expect even short samples to reflect the properties of the parent population

47 Behavioral ExplanationsWhen a company announces surprisingly good earnings, conservatism means that investors react insufficiently, pushing the price up too little. Since the price is too low, subsequent returns will be higher on average, thereby generating both post-earnings announcement drift and momentum. After a series of good earnings announcements, though, representativeness causes people to overreact and push the price up too high. Since the price is now too high, subsequent returns are too low on average, thereby generating long-term reversals

48 Behavioral ExplanationsDaniel, Hirshleifer and Subrahmanyam (1998, 2001) stress biases in the interpretation of private, rather than public information. Investors are more likely to be overconfident about private information they have worked hard to generate than about public information. The overconfidence effect becomes particularly stronger due to self-attribution bias when public information eventually confirms their private information.

49 Behavioral ExplanationsThe public information alters the investor’s confidence in his original private information in an asymmetric fashion, a phenomenon known as self-attribution bias: Public news which confirms the investor’s research strongly increases the confidence he has in that research. Disconfirming public news, though, is given less attention, and the investor’s confidence in the private information remains unchanged. Initial overconfidence is on average followed by even greater overconfidence, generating momentum.

50 Behavioral ExplanationsIf the private information is positive, overconfidence means that investors will push prices up too far relative to fundamentals. Future public information will slowly pull prices back to their correct value, thus generating long-term reversals and a scaled-price effect.

51 Behavioral ExplanationsHong and Stein (1999) build a model where two groups of investors interact. “Newswatchers” make forecasts based on private information, but do not condition on past prices. “Momentum traders” condition only on the most recent price change. Investors are boundedly rational: They are only able to process a subset of available information. They are unable to extract each others’ private information from prices.

52 Behavioral ExplanationsPrivate information diffuses slowly through the population of news-watchers, generating momentum. Momentum traders are then added to the mix. Their optimal strategy is to engage in positive feedback trading: a price increase last period is a sign that good private information is diffusing through the economy. This behavior preserves momentum, but also generates price reversals: Momentum traders keep buying even after price has reached fundamental value, generating an overreaction that is only later reversed.

53 Thank You!