Chapter 14

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  • Chapter 14

    1. 1. Chapter 14:Corporate Financing Decisions and Efficient Capital Markets
    2. 2. 14- Chapter Outline 14.1 Can Financing Decisions Create Value? 14.2 A Description of Efficient Capital Markets 14.3 The Different Types of Efficiency 14.4 The Evidence 14.5 Implications for Corporate Finance 14.6 Summary and Conclusions McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    3. 3. 14- 14.1 Can Financing Decisions Create Value? • Earlier parts of the book show how to evaluate investment projects according to NPV criterion. • The next five chapters concern financing decisions. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    4. 4. 14- What Sort of Financing Decisions? • Typical financing decisions include: – How much debt and equity to sell – When (or if) to pay dividends – When to sell debt and equity • Just as we can use NPV criteria to evaluate investment decisions, we can use NPV to evaluate financing decisions. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    5. 5. 14- How to Create Value through Financing 1) Fool Investors • Empirical evidence suggests that it is hard to fool investors consistently. • If market is efficient, the structure of the offering is immaterial. • Investors will be shrewd and see through the complexity to the underlying risk/reward characteristics McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    6. 6. 14- How to Create Value through Financing 2) Reduce Costs or Increase Subsidies • Certain forms of financing have tax advantages or carry other subsidies. • Minimizing issuance costs will improve financing options. • Fee structure in Initial Public Offerings (IPOs) has a set and variable component McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    7. 7. 14- Public Offerings McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited 3-7
    8. 8. 14- Public Offerings • Public offerings: registered with the OSC (Ontario - SEC in USA) and sale is made to the investing public McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited 3-7
    9. 9. 14- Public Offerings • Public offerings: registered with the OSC (Ontario - SEC in USA) and sale is made to the investing public – Red herring McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited 3-7
    10. 10. 14- Public Offerings • Public offerings: registered with the OSC (Ontario - SEC in USA) and sale is made to the investing public – Red herring – Prospectus McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited 3-7
    11. 11. 14- Public Offerings • Public offerings: registered with the OSC (Ontario - SEC in USA) and sale is made to the investing public – Red herring – Prospectus – Short form prospectus McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited 3-7
    12. 12. 14- Public Offerings • Public offerings: registered with the OSC (Ontario - SEC in USA) and sale is made to the investing public – Red herring – Prospectus – Short form prospectus • Initial Public Offerings (IPOs) McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited 3-7
    13. 13. 14- Public Offerings • Public offerings: registered with the OSC (Ontario - SEC in USA) and sale is made to the investing public – Red herring – Prospectus – Short form prospectus • Initial Public Offerings (IPOs) – Evidence of underpricing McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited 3-7
    14. 14. 14- Public Offerings • Public offerings: registered with the OSC (Ontario - SEC in USA) and sale is made to the investing public – Red herring – Prospectus – Short form prospectus • Initial Public Offerings (IPOs) – Evidence of underpricing – Performance McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited 3-7
    15. 15. 14- Fees: The 7% Plus Contract McGraw-Hill Ryerson 8 © 2005 McGraw–Hill Ryerson Limited
    16. 16. 14- Fees: The 7% Plus Contract Economic Benefits McGraw-Hill Ryerson 8 © 2005 McGraw–Hill Ryerson Limited
    17. 17. 14- Fees: The 7% Plus Contract Economic Benefits – No signaling to the market with consistent 7% contract McGraw-Hill Ryerson 8 © 2005 McGraw–Hill Ryerson Limited
    18. 18. 14- Fees: The 7% Plus Contract Economic Benefits – No signaling to the market with consistent 7% contract – A flat spread encourages the issuer to look for the ‘best’ IB/UW for the job. This encourages quality in the UWs. McGraw-Hill Ryerson 8 © 2005 McGraw–Hill Ryerson Limited
    19. 19. 14- Fees: The 7% Plus Contract Economic Benefits – No signaling to the market with consistent 7% contract – A flat spread encourages the issuer to look for the ‘best’ IB/UW for the job. This encourages quality in the UWs. – Reduces the negotiated elements of the issuance. McGraw-Hill Ryerson 8 © 2005 McGraw–Hill Ryerson Limited
    20. 20. 14- Fees: The 7% Plus Contract Economic Benefits – No signaling to the market with consistent 7% contract – A flat spread encourages the issuer to look for the ‘best’ IB/UW for the job. This encourages quality in the UWs. – Reduces the negotiated elements of the issuance. – Conclusion: This structure has not lead to abnormal profits for the UW(underwriter )s. McGraw-Hill Ryerson 8 © 2005 McGraw–Hill Ryerson Limited
    21. 21. 14- Switching UWs for Follow-On Issues McGraw-Hill Ryerson 9 © 2005 McGraw–Hill Ryerson Limited
    22. 22. 14- Switching UWs for Follow-On Issues Hypotheses: McGraw-Hill Ryerson 9 © 2005 McGraw–Hill Ryerson Limited
    23. 23. 14- Switching UWs for Follow-On Issues Hypotheses: 1) Too much money left on the table in IPO McGraw-Hill Ryerson 9 © 2005 McGraw–Hill Ryerson Limited
    24. 24. 14- Switching UWs for Follow-On Issues Hypotheses: 1) Too much money left on the table in IPO 2) IPO placement strategy not successful McGraw-Hill Ryerson 9 © 2005 McGraw–Hill Ryerson Limited
    25. 25. 14- Switching UWs for Follow-On Issues Hypotheses: 1) Too much money left on the table in IPO 2) IPO placement strategy not successful 3) Trading desk of the IPO UW did not maintain an active market in the IPO McGraw-Hill Ryerson 9 © 2005 McGraw–Hill Ryerson Limited
    26. 26. 14- Switching UWs for Follow-On Issues Hypotheses: 1) Too much money left on the table in IPO 2) IPO placement strategy not successful 3) Trading desk of the IPO UW did not maintain an active market in the IPO 4) The IPO UW research department did not provide research coverage in a timely manner McGraw-Hill Ryerson 9 © 2005 McGraw–Hill Ryerson Limited
    27. 27. 14- Switching UWs for Follow-On Issues Hypotheses: 1) Too much money left on the table in IPO 2) IPO placement strategy not successful 3) Trading desk of the IPO UW did not maintain an active market in the IPO 4) The IPO UW research department did not provide research coverage in a timely manner 5) Issuing company could obtain the services of an underwriter with a better reputation McGraw-Hill Ryerson 9 © 2005 McGraw–Hill Ryerson Limited
    28. 28. 14- Switching UWs for Follow-On Issues McGraw-Hill Ryerson 10 © 2005 McGraw–Hill Ryerson Limited
    29. 29. 14- Switching UWs for Follow-On Issues Conclusion: McGraw-Hill Ryerson 10 © 2005 McGraw–Hill Ryerson Limited
    30. 30. 14- Switching UWs for Follow-On Issues Conclusion: McGraw-Hill Ryerson 10 © 2005 McGraw–Hill Ryerson Limited
    31. 31. 14- Switching UWs for Follow-On Issues Conclusion: Issuers did not get too upset about leaving money on the table. McGraw-Hill Ryerson 10 © 2005 McGraw–Hill Ryerson Limited
    32. 32. 14- Switching UWs for Follow-On Issues Conclusion: Issuers did not get too upset about leaving money on the table. McGraw-Hill Ryerson 10 © 2005 McGraw–Hill Ryerson Limited
    33. 33. 14- Switching UWs for Follow-On Issues Conclusion: Issuers did not get too upset about leaving money on the table. Why? McGraw-Hill Ryerson 10 © 2005 McGraw–Hill Ryerson Limited
    34. 34. 14- Why Doesn’t Underpricing Bother Issuers? McGraw-Hill Ryerson 11 © 2005 McGraw–Hill Ryerson Limited
    35. 35. 14- Why Doesn’t Underpricing Bother Issuers? 1) Creates market buzz for the issuer McGraw-Hill Ryerson 11 © 2005 McGraw–Hill Ryerson Limited
    36. 36. 14- Why Doesn’t Underpricing Bother Issuers? 1) Creates market buzz for the issuer 2) Buzz allows managers [former sole proprietors, not shareholders] to sell shares at a profit [or at least have a higher personal net worth] McGraw-Hill Ryerson 11 © 2005 McGraw–Hill Ryerson Limited
    37. 37. 14- Why Doesn’t Underpricing Bother Issuers? 1) Creates market buzz for the issuer 2) Buzz allows managers [former sole proprietors, not shareholders] to sell shares at a profit [or at least have a higher personal net worth] 3) Once enough funds is raised to support the corporate goals, the bargaining ends. McGraw-Hill Ryerson 11 © 2005 McGraw–Hill Ryerson Limited
    38. 38. 14- Why Doesn’t Underpricing Bother Issuers? McGraw-Hill Ryerson 12 © 2005 McGraw–Hill Ryerson Limited
    39. 39. 14- Why Doesn’t Underpricing Bother Issuers? 4) Issuers have ‘mental accounts’ and view the 7% direct cost more strictly than the lost funds from underpricing [which can be >7%] McGraw-Hill Ryerson 12 © 2005 McGraw–Hill Ryerson Limited
    40. 40. 14- Why Doesn’t Underpricing Bother Issuers? 4) Issuers have ‘mental accounts’ and view the 7% direct cost more strictly than the lost funds from underpricing [which can be >7%] 5) The ‘plus’ is greater than 7%. The ‘plus’ is more vigorously negotiated than the 7% or the lost funds due to underpricing McGraw-Hill Ryerson 12 © 2005 McGraw–Hill Ryerson Limited
    41. 41. 14- How to Create Value through Financing 3) Create a New Security • Sometimes a firm can find a previously unsatisfied clientele and issue new securities at favourable prices. • In the long-run, this value creation is relatively small, however. • Ex: seg funds, equity-linked GIC McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    42. 42. 14- 14.2 A Description of Efficient Capital Markets(ECM) • An efficient capital market is one in which stock prices fully reflect available information. • The EMH has implications for investors and firms. – Since information is reflected in security prices quickly, knowing information when it is released does an investor no good. – Firms should expect to receive the fair value for securities that they sell. Firms cannot profit from fooling investors in an efficient market. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    43. 43. 14- Review of the Basics - Efficient Markets Hypothesis (EMH) • Do security prices reflect information? • Prices should equal expected discounted cash flows. • At least to within trading costs, no mispriced securities • An investor cant find any relevant information that the market hasnt already considered and used • Pt Vt , Vt is intrinsic value or true worth. The price is right. When Vt changes, price adjusts very rapidly McGraw-Hill Ryerson 15 © 2005 McGraw–Hill Ryerson Limited
    44. 44. 14- The Efficient Markets Hypothesis (EMH) • Why are markets efficient? …. Because prices are “efficient” - they reflect all available facts. Future prices differ from current prices only if buyers or sellers get new information. This by definition, is random. But why should prices be efficient? Put simply, if they are not, it means the market is ignoring price-sensitive information. But this gives whoever has that information a chance to make big profits by trading on it. As soon as he does so, the overlooked information is incorporated in the price. This will make it “efficient”. -The Economist, December 5, 1992  Stock prices fully and accurately reflect publicly available information  Once information becomes available, market participants analyze it  Competition assures prices reflect information McGraw-Hill Ryerson 16 © 2005 McGraw–Hill Ryerson Limited
    45. 45. 14- Paradox • Analysts gather information in a more or less efficient market. • You may argue that this is a waste of time. • If they stopped, then the market would likely be less efficient. • Without competition, the incentive to do this work is not there. McGraw-Hill Ryerson 17 © 2005 McGraw–Hill Ryerson Limited
    46. 46. 14- Reaction of Stock Price to New Information in Efficient and Inefficient Markets Stock Price Days before (-) and after (+) announcement McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    47. 47. 14- Reaction of Stock Price to New Information in Efficient and Inefficient Markets Stock Price Efficient market response to “good news” -30 -20 -10 0 +10 +20 +30 Days before (-) and after (+) announcement McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    48. 48. 14- Reaction of Stock Price to New Information in Efficient and Inefficient Markets Stock Price Overreaction to “good news” with reversion Efficient market response to “good news” -30 -20 -10 0 +10 +20 +30 Days before (-) and after (+) announcement McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    49. 49. 14- Reaction of Stock Price to New Information in Efficient and Inefficient Markets Stock Price Overreaction to “good news” with reversion Delayed response to “good news” Efficient market response to “good news” -30 -20 -10 0 +10 +20 +30 Days before (-) and after (+) announcement McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    50. 50. 14- Reaction of Stock Price to New Information in Efficient and Inefficient Markets Stock Price Days before (-) and after (+) announcement McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    51. 51. 14- Reaction of Stock Price to New Information in Efficient and Inefficient Markets Efficient market Stock response to “bad news” Price -30 -20 -10 0 +10 +20 +30 Days before (-) and after (+) announcement McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    52. 52. 14- Reaction of Stock Price to New Information in Efficient and Inefficient Markets Efficient market Stock response to “bad news” Price -30 -20 -10 0 +10 +20 +30 Overreaction to “bad Days before (-) and news” with reversion after (+) announcement McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    53. 53. 14- Reaction of Stock Price to New Information in Efficient and Inefficient Markets Efficient market Stock Delayed response to “bad news” Price response to “bad news” -30 -20 -10 0 +10 +20 +30 Overreaction to “bad Days before (-) and news” with reversion after (+) announcement McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    54. 54. 14- Overreaction and Reversion… • Are the norm . • The markets tend to a longer termed average and fluctuate above and below this (overreaction) when there is information imputed into the price of the stock McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    55. 55. 14- For the market to be efficient, • We assume that all investors are rational: people prefer more to less, sell/buy appropriately • The deviations from reality are independent: people are as likely to over as to underreact • Arbitrage exists. They bring prices back in line. Speculators take advantage of mispricings. [remember the difference between CAPM and APT with respect to arbitrage] McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    56. 56. 14- 14.3 The Different Types of Efficiency • Weak Form – Security prices reflect all information found in past prices and volume. • Semi-Strong Form – Security prices reflect all publicly available information. • Strong Form – Security prices reflect all information—public and private. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    57. 57. 14- Weak Form Market Efficiency • Security prices reflect all information found in past prices and volume. • If the weak form of market efficiency holds, then technical analysis is of no value. • Often weak-form efficiency is represented as Pt = Pt-1 + Expected return + random error t • Since stock prices only respond to new information, which by definition arrives randomly, stock prices are said to follow a random walk. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    58. 58. 14- Random Walk • Debate began with the discovery that stock prices seem to follow a random walk: Price changes are unpredictable Pt+1 = Pt + et+1 E(Pt+1) = Pt ; since E(et+1) = 0 • Do stock prices have a trend? [submartingale] McGraw-Hill Ryerson 24 © 2005 McGraw–Hill Ryerson Limited
    59. 59. 14- Random Walk • Why are price changes random?  Prices react to information  Flow of information is random  Therefore, price changes are random McGraw-Hill Ryerson 25 © 2005 McGraw–Hill Ryerson Limited
    60. 60. 14- Technical Analysis – Trends and Charting – Technical indicators – Technical analysis and efficient markets McGraw-Hill Ryerson 26 © 2005 McGraw–Hill Ryerson Limited
    61. 61. 14- The Appeal of Technical Analysis • Technical analysis broadly defined refers to the study of past price, volume, or other trading related data to predict future prices in an attempt to exploit recurring and predictable patterns • Technical analysis is a reflection of the idea that the stock market moves in trends which are determined by the changing attitudes of investors to a variety of economic, monetary, political and psychological forces. The art of technical analysis, for it is an art, is to identify changes in trends at an early stage and to maintain an investment posture until a reversal of that trend is indicated. • Dates back at least to late 19th / early 20th century, well before fundamental analysis McGraw-Hill Ryerson 27 © 2005 McGraw–Hill Ryerson Limited
    62. 62. 14- The Appeal of Technical Analysis • Technicians’ beliefs: – Shifts in market fundamentals can be discerned before their impact is fully reflected in prices – Market fundamentals can be perturbed by irrational factors • These presumptions are in contradiction with the weak form of the EMH • Some more recent systems are based on sophisticated computerized trading strategies McGraw-Hill Ryerson 28 © 2005 McGraw–Hill Ryerson Limited
    63. 63. 14- The Appeal of Technical Analysis • MAIN POINTS – The market discounts everything – Prices move in trends – History tends to repeat itself McGraw-Hill Ryerson 29 © 2005 McGraw–Hill Ryerson Limited
    64. 64. 14- Technical Analysis and Behavioural Biases • There is a delay in the correction of mispricing – beneficial to technicians • Overconfidence leads to higher volumes of trading • Broad misinterpretation of macroeconomic data offers openings • Contrarian strategies are based on volatility as well as volume charts McGraw-Hill Ryerson 30 © 2005 McGraw–Hill Ryerson Limited
    65. 65. 14- Dow Theory trends McGraw-Hill Ryerson 31 © 2005 McGraw–Hill Ryerson Limited
    66. 66. 14- Why Technical Analysis Fails Investor behaviour tends to eliminate any profit opportunity associated with stock price patterns. Stock Price If it were possible to make Sell big money simply by Sell finding “the pattern” in the stock price movements, Buy everyone would do it and the profits would be Buy competed away. Time McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    67. 67. 14- Empirical Evidence – Weak Form Tests • Short horizon – There is now some evidence indicating short run momentum for both good and bad performing stocks (nonzero return correlations), but it is not clear that there are profitable trading opportunities • Long horizon – Some studies have found evidence of strong negative serial correlation in returns over several years, but this could be due to changing discount rates (either because of changes in risk free rates or changes in risk premia) McGraw-Hill Ryerson 33 © 2005 McGraw–Hill Ryerson Limited
    68. 68. 14- Empirical Evidence – Weak Form Tests • Predictor of broad markets returns – It has been documented that some variables such as risk spreads on corporate bonds, dividend yields, or earning yields can help to predict overall stock market performance McGraw-Hill Ryerson 34 © 2005 McGraw–Hill Ryerson Limited
    69. 69. 14- Semi-Strong Form Market Efficiency • Security prices reflect all publicly available information. • Publicly available information includes: – Historical price and volume information – Published accounting statements. – Information found in annual reports. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    70. 70. 14- Strong Form Market Efficiency • Security prices reflect all information—public and private. • Strong form efficiency incorporates weak and semi-strong form efficiency. • Strong form efficiency says that anything pertinent to the stock and known to at least one investor is already incorporated into the security’s price. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    71. 71. 14- Relationship among Three Different Information Sets All information relevant to a stock Information set of publicly available information Information set of past prices McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    72. 72. 14- Some Common Misconceptions • Much of the criticism of the EMH has been based on a misunderstanding of what the hypothesis says and does not say. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    73. 73. 14- What the EMH Does and Does NOT Say • Investors can throw darts to select stocks. – This is almost, but not quite, true. – An investor must still decide how risky a portfolio he wants based on risk aversion and the level of expected return. • Prices are random or uncaused. – Prices reflect information. – The price CHANGE is driven by new information, which by definition arrives randomly. – Therefore, financial managers cannot “time” stock and bond sales. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    74. 74. 14- 14.4 The Evidence • The record on the EMH is extensive , and in large measure it is reassuring to advocates of the efficiency of markets. • Studies fall into three broad categories: 1. Are changes in stock prices random? Are there profitable “trading rules”? 2. Event studies: does the market quickly and accurately respond to new information? 3. The record of professionally managed investment firms. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    75. 75. 14- 1. Are Changes in Stock Prices Random? • Can we really tell? – Many psychologists and statisticians believe that most people want to see patterns even when faced with pure randomness. – People claiming to see patterns in stock price movements are probably seeing optical illusions . • A matter of degree – Even if we can spot patterns, we need to have returns that beat our transactions costs. • Random stock price changes support weak- form efficiency. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    76. 76. 14- What Pattern Do You See? Randomly Selected Numbers 1.0000 0.7500 0.5000 0.2500 0 1 3 5 7 9 11 13 15 17 19 21 23 25 McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    77. 77. 14- What Pattern Do You See? Randomly Selected Numbers 1.0000 0.7500 0.5000 0.2500 0 1 3 5 7 9 11 13 15 17 19 21 23 25 Double-click on this Excel chart to see a different random series. With different patterns, you may believe that you can predict the next value in the series—even though you know it is random. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    78. 78. 14- Event Studies: How Tests Are Structured • Event studies are one type of test of the semi-strong form of market efficiency.  This form of the EMH implies that prices should reflect all publicly available information. • To test this, event studies examine prices and returns over time—particularly around the arrival of new information. • Test for evidence of underreaction, overreaction, early reaction, delayed reaction around the event. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    79. 79. 14- How Tests Are Structured (cont.) • Returns are adjusted to determine if they are abnormal by taking into account what the rest of the market did that day. • The Abnormal Return on a given stock for a particular day can be calculated by subtracting the market’s return on the same day (RM) from the actual return (R) on the stock for that day: AR= R – Rm • The abnormal return can be calculated using the Market Model approach: AR= R – (α + βRm) McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    80. 80. 14- Event Studies: Dividend Omissions Cumulative Abnormal Returns for Companies Announcing Dividend Omissions 1.500 Cumulative abnormal returns (CARs) fall on both the day before the announcement and the day of the announcement of dividend omissions. CARs have very little movement after the announcement date. This pattern Cumulative abnormal returns (%) 0 is consistent with market efficiency. -1.500 Efficient market response to “bad news” -3.000 -4.500 -6.000 -7 -5 -4 -2 0 2 4 5 7 Days relative to announcement of dividend omission McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    81. 81. 14- Event Study Results • Over the years, event study methodology has been applied to a large number of events including: – Dividend increases and decreases – Earnings announcements – Mergers – Capital spending – New issues of stock • The studies generally support the view that the market is semistrong-form efficient. • In fact, the studies suggest that markets may even have some foresight into the future—in other words, news tends to leak out in advance of public announcements. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    82. 82. 14- Event Studies • All kinds of news events have been examined (earnings reports, dividend announcements, takeover bids, stock splits, new share issues, repurchases, issues of debt, block trades, etc.) • Typically find evidence in support of market efficiency; no post-announcement drift (sometimes pre-announcement drift suggesting leakage of information) McGraw-Hill Ryerson 47 © 2005 McGraw–Hill Ryerson Limited
    83. 83. 14- Space Shuttle Crash McGraw-Hill Ryerson 48 © 2005 McGraw–Hill Ryerson Limited
    84. 84. 14- McGraw-Hill Ryerson 49 © 2005 McGraw–Hill Ryerson Limited
    85. 85. 14- McGraw-Hill Ryerson 50 © 2005 McGraw–Hill Ryerson Limited
    86. 86. 14- McGraw-Hill Ryerson 51 © 2005 McGraw–Hill Ryerson Limited
    87. 87. 14- The Record of Mutual Funds • If the market is semistrong-form efficient, then no matter what publicly available information mutual-fund managers rely on to pick stocks, their average returns should be the same as those of the average investor in the market as a whole. avg. R mut. fund = avg. R of investor • We can test efficiency by comparing the performance of professionally managed mutual funds with the performance of a market index. compare performance of MF to performance of market index McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    88. 88. 14- The Record of Mutual Funds Annual Return Performance of Different Types of U.S. Mutual Funds Relative to a Broad-Based Market Index (1963-1998) -0.39% -0.51% -1.06% -2.13% -2.17% -2.29% -5.41% -8.45% All funds Small-company growth Other-aggressive growth Growth Income Growth and income Maximum capital gains Sector McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    89. 89. 14- Mutual Fund Performance • Carhart, 1997 – Some evidence of persistence in performance at extremes – Persistence due to expenses and transaction costs (Carhart, 1997) • Potential measurement error for benchmark returns – Style changes – May be risk premium • Superstar phenomenon McGraw-Hill Ryerson 54 © 2005 McGraw–Hill Ryerson Limited
    90. 90. 14- Semi-strong Tests: Anomalies • Statistical regularities that occur over long periods of time and are present in the stock markets of different countries - Not explicable by any financial model, but are so persistent that they cannot be a market inefficiency – Small firm effect (January effect) – Day-of-the-week effect – Neglected firm – Book-to-market ratios – Reversals – Inside information – Post-earnings announcement drift – P/E effect - portfolios of low P/E stocks have higher average returns than portfolios of high P/E stocks McGraw-Hill Ryerson 55 © 2005 McGraw–Hill Ryerson Limited
    91. 91. 14- Book-to-Market Effect higher BM ratio / higher avg. return McGraw-Hill Ryerson 56 © 2005 McGraw–Hill Ryerson Limited
    92. 92. 14- The Strong Form of the EMH • One group of studies of strong-form market efficiency investigates insider trading . • A number of studies support the view that insider trading is abnormally profitable. • Thus, strong-form efficiency does not seem to be substantiated by the evidence. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    93. 93. 14- Views Contrary to Market Efficiency • Stock Market Crash of 1987 – The NYSE dropped between 20-percent and 25-percent and the TSE dropped by more than 11-percent on a Monday following a weekend during which little surprising information was released. • Temporal Anomalies – Turn of the year, —month, —week. – For large-capitalization Canadian stocks there is no longer a day- of-the week effect. • Speculative Bubbles – Sometimes a crowd of investors can behave irrationally. • Size – Small cap stocks seem to outperform large cap stocks. • Value versus Growth – High book-value-to-stock-price stocks and/or high P/E stocks outperform growth stocks. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    94. 94. 14- 14.5 Implications for Corporate Finance • Because information is reflected in security prices quickly, investors should only expect to obtain a normal rate of return. – Awareness of information when it is released does an investor little good. The price adjusts before the investor has time to act on it. • Firms should expect to receive the fair value for securities that they sell. – Fair means that the price they receive for the securities they issue is the present value. – Thus, valuable financing opportunities that arise from fooling investors are unavailable in efficient markets. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    95. 95. 14- 14.5 Implications for Corporate Finance • The EMH has 3 implications for corporate finance: 1. The price of a company’s stock cannot be affected by a change in accounting. 2. Financial managers cannot “time” issues of stocks and bonds using publicly available information. 3. A firm can sell as many shares of stocks or bonds as it desires without depressing prices . • There is conflicting empirical evidence on all three points. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    96. 96. 14- Why Doesn’t Everybody Believe the EMH? • There are optical illusions , mirages , and apparent patterns in charts of stock market returns. • The truth is less interesting. • There is some evidence against market efficiency: – Seasonality – Small versus Large stocks – Value versus Growth stocks • The tests of market efficiency are weak. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited
    97. 97. 14- Implications of EMH for Investment Policy • Why not just pick stocks randomly? – Diversification – Tax reasons – Unique characteristics of investor – risk profile These fall under the broad definition of ‘financial planning’ McGraw-Hill Ryerson 62 © 2005 McGraw–Hill Ryerson Limited
    98. 98. 14- 14.6 Summary and Conclusions • An efficient market incorporates information in security prices. • There are three forms of the EMH: – Weak-Form EMH Security prices reflect past price data. – Semistrong-Form EMH Security prices reflect publicly available information. – Strong-Form EMH Security prices reflect all information. • There is abundant evidence for the first two forms of the EMH. McGraw-Hill Ryerson © 2005 McGraw–Hill Ryerson Limited

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