1. The document discusses how stock prices reflect all available information in the market and how efficiently markets incorporate new information. It examines the concepts of weak, semi-strong, and strong forms of market efficiency. 2. Event studies are discussed as tests of semi-strong form efficiency that generally support the view that markets quickly and accurately respond to new public information. However, evidence suggests markets may have some foresight into future information. 3. While strong form efficiency says prices reflect all public and private information, evidence shows insider trading can be profitable, suggesting prices do not fully reflect private information.

1. MBA Managerial Finance Week 9
Tai Tran

2. In investment,
Everything is reflected in Price

3. Information
• Business results
• Next year performance plan
• Dividends
•
•
M&A
Change in personnel
Financial
•
•
Capital raising: bond issuance, stock issuance
Employee stock option plan (ESOP)
Market
• Law suits
• Industry structure
• Other changes that affect the business
Price

4. React to
Information Investors
Financial
Market
Firm
Price

5. React to
Information Investors
Financial
Market
Firm
Price

6. React to
Information Investors
Buy/sell
financial
instruments
Financial
Market
Firm
Price

7. React to
Information Investors
Buy/sell
financial
instruments
Financial
Market
Firm
Price

8. React to
How
Information Investors
Buy/sell
financial
instruments
Financial
Market
Firm
Price

9. React to
How
Information Investors
Buy/sell
financial
instruments
Financial
Market
Firm
Price
How
Supply & demand equilibrium

10. React to
How
Information Investors
Buy/sell
financial
instruments
Financial
Market
Firm
If market is efficient, Price should reflect Information
Price
How
Supply & demand equilibrium

11. React to
How
Information Investors

12. React to
How
Information Investors
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

13. React to
How
Information Investors
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 after (+)
news” with reversion announcement

14. Information
1. All historical information
2. All public information
3. All public and private information
Firm
If market is efficient, Price should reflect Information
Price

15. Information
1. All historical information: Weak form
2. All public information: Semi-strong form
3. All public and private information: Strong form
Firm
If market is efficient, Price should reflect Information
Price

16. Information
1. All historical information: Weak form
2. All public information: Semi-strong form
3. All public and private information: Strong form
Arrives
randomly
Firm
If market is efficient, Price should reflect Information
Price

17. A note on Technical Analysis
Technical
analysts
believe
there are
patterns in
asset price
movements.
Technical
analysts try
to forecast
future prices
using these
patterns.

18. Weak Form Market Efficiency
• Since stock prices only
respond to new
information, which by
definition arrives
randomly, stock prices are said
to follow a random walk. Past prices
• Technical analysis: no value. Past volume

19. Why Technical Analysis is of no value
Stock Price
Sell
Sell
Buy Follow
Profit
Everybody Compe-titio Profit is
elimina
patterns would do it n
-ted
Buy
Time
Investor behavior tends to eliminate any profit
opportunity associated with stock price patterns.

20. Semi-Strong Form Market Efficiency
• All publicly available
information
Published accounting
Statements
Annual Report
Past prices
Past volume

21. Semi-Strong Form Market Efficiency
• All information: public and
private
All other
• Strong form efficiency says information
that anything pertinent to the Published
accounting
stock and known to at least Statements
Annual
one investor is already Report
incorporated into the
security’s price. Past prices
Past volume

22. Implications
• Investors can throw • Prices are random or
darts to select stocks. uncaused.
– This is almost, but not – Prices reflect information.
quite, true. – The price CHANGE is
– An investor must still driven by new
decide how risky a information, which by
portfolio he wants based definition arrives
on risk aversion and randomly.
expected return. – Therefore, financial
managers cannot “time”
stock and bond sales.

23. Doubts?
Does the
market
Are stock quickly and Records of
prices accurately investment
random? respond to firms
new
information?

24. Doubts?
Optical illusions: Many
psychologists and
Are stock statisticians believe that
prices most people want to see
random? patterns even when faced
with pure randomness.

25. Event Studies
Event studies
are tests of Does the
semi-strong market
form quickly and
accurately
respond to
new
information?

26. Event Studies
Cumulative Abnormal Returns for Companies
Cumulative abnormal returns (%)
Announcing Dividend Omissions
1
0.146
0.108 0.032 0
-0.244
-0.483
-10 -5 -0.72 -1 0 5 10
-2
Efficient market
-3 response to “bad news”
-3.619
-4
-4.49
-4.563 -4.685
-5 -4.898 -4.747
-5.015 -5.183
-5.411
-6
Days relative to announcement of dividend omission

27. Event Studies
The studies Studies suggest
generally that markets
Does the may even have
support the view some foresight
that the market market into the
is semi-strong quickly and future, i.e., news
form efficient. accurately tends to leak out
in advance of
respond to public
new announcements.
information?

28. Doubts?
Strong form: public and private information
Use private information:
insider trading
Evidence: insider trading Records of
is profitable investment
firms
Not many do it
Strong form doesn't hold

29. React to
Information Irrational
Investors
Representativeness: drawing Buy/sell
conclusions from too little data financial
instruments • Fail to diversify
e.g. see a jump in a stock and
• Trade too much
believe that stock will rise • Holder losers
• Sell winners =>
maximize taxes
Conservativism: hold on to
positions / old beliefs

30. Small
stocks vs.
large
stocks
Seasonality
Evidences against EMH
Value
stocks vs.
growth
stock

31. 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

32. Homework
• RWJ 9e, questions 1-28, page 460