corporate finance

1. 14- 1
EMH
 Efficiency – ‘how successful is the market in
establishing share prices that reflects the “worth”
of the shares’….is new info incorporated in a
rapid and unbiased manner – the speed and quality
of price adjustment to new information
 EMH is a subset of the Rational Expectation
Hypothesis (REH) – ‘in a competitive world,
economic agents will exploit all available
information to take advantage of any perceived
profitable opportunities’…that will eliminate
opportunities for abnormal gains

2. 14- 2
EMH
 EMH assumes that at all times, a security value
fully reflects the true rational value of the
security….or it is fairly priced.
 For this to happen, the market price must reflect
all available value-relevant information.
 Rational investors will use all relevant info to
determine the expected cash flows, the riskiness of
the cash flows and appropriate discount rate to
apply to the security’s expected cash flows.

3. 14- 3
EMH
 Degrees of efficiency:
 Perfect, Near Efficiency and Inefficiency
 Near efficiency – one that captures a particular info set in
its share prices in such a way as to prevent all but the most
skillful investors from earning excess returns from the
same information….
 (Weak, Semi-Strong and Strong form)
 Factors contributing to market inefficiency:
– The information gap
– Biased Reporting
– Personal Experience- “beating the market”

4. 14- 4
Random Walk Theory
The movement of stock prices from day to
day DO NOT reflect any pattern.
Statistically speaking, the movement of
stock prices is random (skewed positive over the
long term).
Factors that contribute towards ‘generating
prices that fully reflect the worth of assets
being traded’:

5. 14- 5
Random Walk Theory

6. 14- 6
EMH
 Homogeneity – all shares are viewed in terms of
risks and expected returns, which provides some
degree of comparability within the price structure
of the securities market that distinguishes it
significantly from most other markets. This
reduces the compass of informational demand and
establishes the focus on risk and expected returns.
 Location Independence – values of shares of the
same company traded in different exchanges is
independent of location (unlike tangible assets like
an apartment or a chair). This reduces the range of
investors’ potential information needs.

7. 14- 7
EMH
 Information support – The outstanding features of
any securities market is ‘how organized and
elaborate is the information machinery which
services it’. It concerns not only the quality and
the amount of information supply but equally
important is the rapidity with which the
information is disseminated among the market
participants. This provides motivation for rapid
and widespread information dissemination.

8. 14- 8
EMH
Interpretations about nature of market
efficiency…..
– “Surely, the market is always right”….
– “EMH assumes that all investors behave
rationally”…
– “Stock market bubbles imply inefficiency”…

9. 14- 9
EMH
Interpretations on evidence for market
efficiency:
– “Efficiency applies only to certain shares”…
– “Statistical evidence is insufficient”….
– “Prices are determined by supply and
demand”…
– “Whilst there may be little scope in the long
term for achieving above average profits, there
will always be occasional short term
opportunities”…

10. 14- 10
Efficient Market Theory
Last
Month
This
Month
Next
Month
$40
30
20
Microsoft
Stock Price
Cycles
disappear
once
identified
Actual price as soon as upswing is
recognized

11. 14- 11
Efficient Market Theory
Weak Form Efficiency
– Market prices reflect all historical information
Semi-Strong Form Efficiency
– Market prices reflect all publicly available
information
Strong Form Efficiency
– Market prices reflect all information, both
public and private

12. 14- 12
Efficient Market Theory
Fundamental Analysts
– Research the value of stocks using NPV and other
measurements of cash flow
– Measures the impact of the changes in the market,
industry and the firm on the firm’s share price

13. 14- 13
Efficient Market Theory
Technical Analysts
– Forecast stock prices based on the watching the
fluctuations in historical prices (thus “wiggle
watchers”)

14. 14- 14
Efficient Market Theory
-16
-11
-6
-1
4
9
14
19
24
29
34
39
Days Relative to annoncement date
Cumulative
Abnormal
Return
(%)
Announcement Date

15. 14- 15
Behavioral Finance
Arbitrage limitations- limits for rational
investors to exploit market
inefficiencies…the risk that prices will
diverge even further before they converge
LTCM example
Why might prices depart from fundamental
values?
1. Attitudes towards risk
2. Beliefs about probabilities

16. 14- 16
Lessons of Market Efficiency
Markets have no memory (weak form efficient)
Trust market prices (you cannot consistently earn
superior returns unless you have inside
information)
Read the entrails (the detailed info required to
assess the future prospects)
There are no financial illusions (investors read
reported figures at face value!...the case of FIFO
and LIFO in times of increasing inflation…)
The do it yourself alternative

17. 14- 17
Lessons of EMH
Seen one stock, seen them all
( BUT Investors buy stock for its prospects of
fair returns for its risk. The DD for stocks are
usually highly ELASTIC!. If prospects good
everyone scrambles for the share and if
prospects are not good, everyone avoids the
share. Block trades will affect prices unless
can convince other investors that you have no
private information)

18. 14- 18
Example: How stock splits affect value
0
5
10
15
20
25
30
35
40
Month relative to split
Cumulative
abnormal
return %
-29 0 30
Source: Fama, Fisher, Jensen & Roll

19. 14- 19
Market Efficiency
Implications of a fairly efficient market:
– Earn normal returns on consistent basis
– No speculative profits
– Investment Strategy – Passive
– No value for Fundamental and Technical
strategies for analysts
1. What is the difference between ‘efficiency’ and
‘rationality’?
2. What is meant by ‘paradox of market efficiency’?
3. Is there such thing as ‘absolute efficiency’? Why?

20. 14- 20
Essentials for market efficiency
 1. Characteristics of the security and the issuer
 2. Characteristics of the market in the security trades
 3. The efficiency of technology available to analysts to
gather and process information and to trade
 Larger firms are perceived to be more efficient than
smaller firms, because:
– They enjoy better economies of scale in production and processing
of information and as well as trading
– They enjoy lower costs of trading, commissions and bid-ask spread
– They possess efficient technologies to identify deviations of prices
and value and have the means to correct these deviations quickly
as they have efficient technologies to process info and trading.

21. 14- 21
Anomalies
This is evidence AGAINST EMT
Small Firm Effect
January Effect
Weekend Effect
If a firm is earning a positive Alpha, is this
an anomaly?

22. 14- 22
Case and Readings
 Case:
 Bill Miller and Value Trust (Refer to Pages 23-38 of the
Book, Case Studies in Finance: Managing for Corporate
Value Creation, by Robert F. Bruner, Kenneth M. Eades
and Michael J. Schill, 6th Edition, McGraw-Hill
International Edition, 2010).
 Articles:
 1. M. Rubinstein, Rational Markets: Yes or No?, The
Affirmative Case?The Financial Anaysts Journal 57
(May/June 2001), pp: 15-29.
 2. B.G. Malkiel, Efficient Market Hypothesis and its
critics, Journal of Economic Perspectives 17, Winter 2003,
pp: 59-82.