Investment analysis and portfolio management 8th reilly and brown chapter 06

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Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Eighth Edition by Frank K Reilly & Keith C Brown Chapter Chapter Efficient Capital Markets Questions to be answered: • What is does it mean to say that capital markets are efficient? • Why should capital markets be efficient? • As a portfolio manager, why should we care if capital markets are efficient? • What factors contribute to an efficient market? • Given the overall efficient market hypothesis, what are the three sub-hypotheses and what are the implications of each of them? • How you test the three efficient market hypothesis (EMH) and what are the results of the tests? • For each set of tests, which results support the hypothesis and which results indicate an anomaly related to the hypothesis? What Constitutes An Efficient Capital Market? • Two forms of market efficiency – Informational efficiency – the subject of this chapter – Transactional efficiency – minimize cost • Economies of scale • Economies of scope • In an efficient capital market, security prices – Reflect all available information – Adjust rapidly to the arrival of new information • Whether markets are efficient has been extensively researched and remains controversial Why Should Capital Markets Be Efficient? The premise of an efficient market: – A large number of competing profit-maximizing participants analyze and value securities, each independently of the others – New information regarding securities comes to the market in a random fashion – Profit-maximizing investors rapidly adjust (in an unbiased fashion) security prices to reflect the impact of new information Conclusion: In an efficient market, the expected returns embedded in the current price of a security should accurately reflect its risk Efficient Market Hypotheses (EMH) • Random Walk Hypothesis – first hypothesized by Louis Bachlier, a French doctoral student in mathematics, in 1900 Said that changes in security prices occur randomly & unpredictably • Eugene Fama (1970) Fair Game Model – current market price reflect all available information about a security and the expected return based upon this price is consistent with its risk • Efficient Market Hypothesis (EMH) – Fama divided EMH into three sub-hypotheses depending on the information set involved – Weak-form efficient – Semi-strong form efficient – Strong-form efficient Efficient Market Hypotheses (EMH) • Weak-Form EMH - prices reflect all information contained in the past record of prices & volumes • Semi-strong-form EMH - prices reflect all public information • Strong-form EMH - prices reflect all public and private information Random Walk Theory: Microsoft Stock Price Changes from March 1990 to May 2004 For Microsoft stock over the period March 1990 to May 2004, the correlation between a price change on day t and a price change on day t+1 was +0.025 Random Walk Theory: Weekly Returns, May 1984 – May, 2004 FTSE 100 (correlation = -.08) Return in week t + 1, (%) FTSE is an independent company owned by The Financial Times and the London Stock Exchange Their sole business is the creation and management of indices and associated data services, on an international scale Return in week t, (%) Random Walk Theory: Weekly Returns, May 1984 – May, 2004 Nikkei 500 (correlation = -.06) Return in week t + 1, (%) The Nikkei is the major index for the Tokyo Stock Exchange Return in week t, (%) Random Walk Theory: Weekly Returns, May 1984 – May, 2004 DAX 30 (correlation = -.03) Return in week t + 1, (%) The DAX 30 is an index of 30 top German stocks In German, DAX is short for DEUTSCHER AKTIENINDEX, which means “performance index” Return in week t, (%) Tests and Results of Semistrong-Form EMH • Ratio of Book Value of a firm’s Equity to Market Value of its equity – Significant positive relationship found between current values for this ratio and future stock returns – Results inconsistent with the EMH • Size and BV/MV appear to dominate other ratios such as P/E ratio or leverage • This combination only works during periods of loose monetary policy Tests and Results of Semistrong-Form EMH • Event studies – Stock split studies show that splits not result in abnormal gains after the split announcement, but before – Initial public offerings seems to be underpriced by almost 18%, but that varies over time, and the price is adjusted within one day after the offering • Suppose you had bought stock immediately following each IPO & then held that stock for five years • Over the period 1970 – 2002, your average annual return would have been 4.2% less than the return on a portfolio of similar-sized stock – Listing of a stock on an national exchange such as the NYSE may offer some short term profit opportunities for investors Tests and Results of Semistrong-Form EMH • Event studies (continued) – Stock prices quickly adjust to unexpected world events and economic news and hence not provide opportunities for abnormal profits • Patell & Wolfson found that when new information is released, the major part of the adjustment in price occurs within 10 minutes of the announcement – Announcements of accounting changes are quickly adjusted for and not seem to provide opportunities – Stock prices rapidly adjust to corporate events such as mergers and offerings – The above studies provide support for the semistrongform EMH Summary on the Semistrong-Form EMH • Evidence is mixed – Strong support from numerous event studies with the exception of exchange listing studies – Studies on predicting rates of return for a crosssection of stocks indicates markets are not semistrong efficient • Dividend yields, calendar patterns, and earnings surprises all appear to yield valuable information • Predictors such as size, the BV/MV ratio & P/E ratios appear to yield valuable information Tests and Results of Strong-Form EMH • Strong-form EMH contends that stock prices fully reflect all information, both public and private • This implies that no group of investors has access to private information that will allow them to consistently earn above-average profits Testing Groups of Investors • • • • Corporate insiders Stock exchange specialists Security analysts Professional money managers Corporate Insider Trading • Insiders include corporate officers, directors, and owners of 10% or more of any equity class of securities • Insiders must report their trades to their Provincial Securities Commission within 10 calendar days of a trade occurring • These insider trading reports are made public within minutes of filing (note that the textbook refers to weeks – in Canada, it is within minutes of filing) • Corporate insiders generally experience above-average profits Corporate Insider Trading • This implies that many insiders had private information from which they derived above-average returns on their company stock • Studies showed that public investors who traded with the insiders based on announced transactions would have enjoyed excess risk-adjusted returns (after commissions), but the markets now seems to have eliminated this inefficiency (soon after it was discovered) • Other studies indicate that you can increase returns from using insider trading information by combining it with key financial ratios and considering what group of insiders is doing the buying and selling Stock Exchange Specialists • Specialists have monopolistic access to information about unfilled limit orders • You would expect specialists to derive above-average returns from this information • The data generally supports this expectation Security Analysts • Tests have considered whether it is possible to identify a set of analysts who have the ability to select undervalued stocks • The analysis involves determining whether, after a stock selection by an analyst is made known, a significant abnormal return is available to those who follow their recommendations • There is evidence in favor of the existence of superior analysts – Warren Buffet, Peter Lynch (Fidelity Magellan Fund) Warren Buffet • Buffet Partnership Ltd (1957 – 1969) beat the Dow Jones Industrial Average every year of its existence, with a cumulative return of 2,749% versus the Dow’s cumulative return of 152.6% • Buffet acquired Berkshire Hathaway in 1965 • Since then he beat the return on the Dow in 36 out of 41 years • After-tax cumulative return of 305,134% versus 5,583% (pre-tax) for the Dow Ivan Boesky • By 1986 Ivan Boesky had become an arbitrageur who had amassed a fortune of about US$200 million by betting on corporate takeovers • He was investigated by the US SEC for making investments based on tips received from corporate insiders • These stock acquisitions were sometimes brazen, with massive purchases occurring only a few days before a corporation announced a takeover • Although insider trading of this kind was illegal, laws prohibiting it were rarely enforced until Boesky was prosecuted • Boesky cooperated with the SEC and informed on several of his insiders, including junk bond trader Michael Milken • As a result of a plea bargain, Boesky received a prison sentence of 3.5 years and was fined US$100 million • Although he was released after two years, he was barred from working in the securities business for the remainder of his life Professional Money Managers • Trained professionals, working full time at investment management • If any investor can achieve above-average returns, it should be this group – Mark Carhart analyzed 1,493 mutual funds to see if professional money managers could out-perform the market – He found that, on average, mutual funds earn a lower return than the benchmark after expenses and roughly match the benchmark return before expenses Conclusions Regarding the Strong-Form EMH • Mixed results, but much support • Tests for corporate insiders and stock exchange specialists not support the hypothesis – Both groups seem to have monopolistic access to important information and use it to derive above-average returns The Rationale and Use of Index Funds and ExchangeTraded Funds • Efficient capital markets and a lack of superior analysts imply that many portfolios should be managed passively (so their performance matches the aggregate market & minimizes the costs of research and trading) • ETFs duplicate the composition and performance of many indices ... Financial Times and the London Stock Exchange Their sole business is the creation and management of indices and associated data services, on an international scale Return in week t, (%) Random Walk... involve a joint hypothesis and are dependent both on market efficiency and the asset pricing model used Tests and Results of Semistrong-Form EMH • Price-earnings ratios and returns – Low P/E stocks... researched and remains controversial Why Should Capital Markets Be Efficient? The premise of an efficient market: – A large number of competing profit-maximizing participants analyze and value
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