Market Efficiency & Modern Financial Management Efficiency in financial versus product markets Why financial markets tend to be more competitive & efficient Introduction to market efficiency Key feature of modern economic thought & market workings What is an efficient market? The three forms of market efficiency The three “forms” of market efficiency Weak form, semi-strong form, and strong-form efficiency What does market efficiency imply for corporate financial management? How do markets process firm-specific information releases? How should managers communicate with investors & analysts?
Financial Versus Product Markets Many examples of corporations creating value through real asset investments R&D, product innovations, marketing programs create value Few product markets approach perfect competition standard Manufactured goods face barriers to entry (branding, capital requirements, physical distribution costs) Far fewer opportunities to create value through purely financial activities Financial markets much larger, more competitive, more transparent, more homogeneous than product markets Innovations cannot be patented; easily imitated Arbitrage is easy & safe; keeps relative prices in line Much harder to create value thru purely financial activities
Economic Definitions Of EfficiencyForm Definition ExampleAllocative A financial system exhibits Stock market investors shun allocative efficiency if it security offers from firms in allocates capital to its declining industries, but welcome highest and best (most offerings from firms in more productive) use. promising industries.Operational A financial system exhibits Average daily trading volume on operational efficiency if it the New York Stock Exchange produces a given output at now over 10 times its level of 20 lowest possible input cost-- years ago--in the same Wall or, alternatively, it Street location. The NASDAQ maximizes output for any market’s trading volume has given level of inputs. increased even more.Informational In a market exhibiting When company A receives a informational efficiency, takeover bid from company B asset prices incorporate all that seems certain to succeed, relevant information fully the stock price of A increases and instantaneously. immediately to reflect the per share bid premium.
Efficient Market Hypothesis (EMH)• Do security prices reflect information ? – An efficient capital market is one in which security prices adjust rapidly to the arrival of new information and, therefore, the current prices of securities reflect all relevant information.• Why look at market efficiency? – Implications for business and corporate finance – Implications for investment
Early Study on Market Behavior – In the 1950s, researchers couldn’t find any predictable pattern in stock prices. – Immediate conclusion was that these results appeared to support the irrationality of the market.
Does randomness = irrationality?– Suppose researchers found that security prices are predictable and then developed a model to predict the prices.– Following this model, investors would reap unending profits simply by purchasing stocks that would appreciate in price and selling stocks that would decrease in price!
Ramifications of Predictability– Suppose a model predicts that XYZ stock price (currently $100) would rise dramatically in three days to $110.– Obviously, everybody will want to BUY it; no one would want to SELL it.– The prediction of under-pricing of a security would lead to an immediate price increase!
Ramifications of Predictability– As soon as there is any information predicting that stock XYZ is under-priced, investors will flock to buy the stock and immediately bid up its price to a fair level.– However, if prices are bid immediately to fair levels, given all available information, it must be that these prices increase or decrease only in response to new information.– New information (by definition) must be unpredictable, which means that stock prices should follow a “random walk.”
Grossman-Stiglitz TheoremASSUMPTIONS: Two types of investors: - Uninformed: Liquidity or noise traders - Informed: Spend serious amounts of money to dig up information no one else has
Grossman/Stiglitz Theorem• Informed: Do research until marginal benefit = marginal cost.• Uninformed: Do NO research.• Some of the informed have marginal benefits > marginal costs, some have marginal benefits < marginal costs. On average, marginal benefit = marginal
Grossman/Stiglitz TheoremExample:A manager of a $50 billion fund wants to increasereturns 1/2% above what the market averages.How much is she willing to spend to do this??Willing to spend:$50 billion x .005 = $ 0.25 billionor$250 million on research to find incorrectly pricedstocks.
Grossman/Stiglitz Theorem• So, the informed make the market efficient for the uninformed! Justification for professionals!!• If active managers fail to use information properly or have excessive transaction costs, they will do worse than a passive portfolio.• In equilibrium, investors should earn the same return investing in a passive index fund as in an actively managed fund after research & transaction costs.
Random Walk HypothesisIf stock prices follow a random walk (with orwithout a trend), then future stock pricescannot be predicted based on past stockprices.New information is a “surprise”.When new information arrives, stock priceswill adjust immediately.
Example: Positive SurprisePrice Stock Price of XYZ New Information Arrives Time
Efficient Market Hypothesis (EMH)• In 1970 Eugene Fama defined the efficient market hypothesis and divided it into 3 levels. – Weak Form Efficient – Semi-Strong Form Efficient – Strong Form Efficient• Each differs with respect to the information that is reflected in the stock prices.
Relation of 3 Forms of EMH StrongWeak Past Market All Public All Public & Info Info Private Info Semi- Strong
Three Forms Of Market EfficiencyForm Definition ExampleWeak Financial asset (stock) prices Nothing of value is to beForm incorporate all historical gained by analyzing past stock information into current prices; price changes, since this future stock prices cannot be doesn’t help you predict future predicted based on an analysis price changes. Renders of past stock prices. “technical analysis” useless.Semi- Stock prices incorporate all The relevant information in anstrong publicly available information SEC filing will be incorporatedForm (historical and current); there will into a stock price as soon as not be a delayed response to the filing is made public. information disclosures.Strong Stock prices incorporate all Stock prices will react to aForm information--private as well as dividend increase as soon as public; prices will react as soon the firm’s board of directors as new information is generated, votes--and before the board rather than as soon as it is announces its decision publicly disclosed. publicly.
EMH: Weak Form• Stock Prices reflect all past market price and volume information – It is impossible to make abnormal risk adjusted returns by using past prices or volume data to predict future stock prices.
Technical Analysts• Do not think the stock market is weak form efficient.• Believe that investors are emotionally driven and predictable. Therefore, you can exploit this predictability, as it shows up in past prices and volume.• “Quants” – use computers to find patterns.
Technical AnalystsPrice Buy Here Stock Price of XYZ Stock First Starts Rising Time
EMH: Semi-Strong FormStock Prices reflect all publicly availableinformation about a firm. It is impossible to make abnormal risk- adjusted returns by analyzing anypublic information to predict futurestock prices.
Fundamental Analysts• Do not think the stock market is semi- strong form efficient.• They use publicly available information to identify firms that are worth more (or worth less) than everyone else’s estimate of their values.
EMH: Strong FormStock Prices reflect all information (publicand private) about a firm. It is impossible to make abnormal risk- adjusted returns by analyzing publicly available information or trading based on private or “inside” information.
Trading On Inside Information• Not legal to trade on inside information• offenders prosecuted• Rules protect the small investor
Question…• What is the meaning of the Efficient Markets Hypothesis to the Investment Industry? – debate between active and passive portfolio management. – Billions of dollars are at stake!
Active or Passive Management• Active Management – Security analysis – Timing• Passive Management – Buy and Hold – Index Funds
Market Efficiency & Portfolio Management• Even if the market is efficient a role exists for portfolio management: – Appropriate risk level – Tax considerations – Other considerations
Ironic Situation• If the stock market is efficient, you may be better off buying index funds.• However, if everyone buys index funds, market would not be as efficient, because no one is willing to search for information.
Difficult to Determine If Market is EfficientIf we can find people who beat the market basedon skill, this would imply abnormal returns arepossible and the market is not efficient.Difficult to distinguish luck from skill!
Applied to Professional Investors• Record whether or not an investor beats the market each year for 10 years.• By pure chance there is a 50% probability an investor will beat the market in any given year (ignoring fees and expenses).• If there are 10,000 professional money managers, how many will have a perfect record of beating the market every year due to chance?
SOLUTIONPossible Permutations (outcomes) over 10years = 210 = 1024Probability of being correct each year for10 years = 1 / 1024 = 0.00097Expected number of “gurus” = 10,000 x 0.00097 = 9.7