MSCI-4131 - Investment Analysis

Topic 4: Efficient Capital Markets

Dr. Khalil Wahla

(
[email protected]
k
)

Khwaja Fareed University of

Engineering and Information
Technology
Department of Management
Dr. Khalil Wahla
Sciences
Investment Analysis 1 / 38
Topic 3: learning outcomes

After going through the lecture slides and readings of this

topic, students should be able to answer the following
questions:

 What does it mean to say that capital markets are efficient

Why should markets be efficient
 What factors contribute to market efficiency What are the
three forms of market efficiency
 What is behavioral finance and how does it relate to efficient
market hypothesis
 What are some of the main findings of behavioral finance
and what are the implications of these findings for efficient
market hypothesis

Dr. Khalil Wahla Investment Analysis 2 / 38

What is an efficient market?

 ... one in which security prices adjust rapidly to the arrival of

new information
 and, hence, current prices reflect all available information.
 We are considering this topic for two reasons:
 We discussed how capital markets function, but we need to
consider the efficiency of these markets in terms of how
prices react to now information?
 Overall evidence on capital market is best described as
mixed.
 Set of assumptions that imply efficient market:

 A large number of profit-maximizing participants analyze

and value securities
 New information regarding securities comes to the market
in a random fashion
 The buy and sell decisions of all profit-maximizing
investors who adjust prices rapidly reflect the effect of
Dr. Khalil Wahla Investment Analysis 3 / 38
Market value versus intrinsic value

 Market value is the price at which an asset can currently be bought

or sold in the market.
 Intrinsic value (fundamental value/price) is the price that would be
placed on the asset if investors had a complete understanding of
the asset’s investment characteristics.
 If investors believe that markets are highly efficient, they will
usually accept the market price as accurate reflection of the
intrinsic value.
 However, if investors believe that markets are relatively inefficient,
they may try to develop an independent estimate of the intrinsic
value.
 Differences between market prices and intrinsic values represent
foundation for profitable active investments. Active investors seek
to own assets that are selling below perceived intrinsic value, and
to sell or short-sell assets trading above their perceived intrinsic
value in the market.

Dr. Khalil Wahla Investment Analysis 4 / 38

Alternative efficient market hypotheses (EMH)

 Fama (1970) divided the EMH and the empirical tests into three
sub-hypotheses depending on the information set involved:
 Weak-form EMH
 Prices fully reflect all security market information, such
as historical prices, rates of return, trading volume
data, etc.
 You should gain little from using any trading rules.
 Semi strong-form EMH
 Prices adjust rapidly to the release of all public
information.
 It encompasses weak-form hypothesis.
 Investors who base their decisions on information after
it is public should not derive above-average risk-
adjusted profits.
 Strong-form EMH
 Prices reflect all information from public and private
sources.
 It encompasses both weak & semi strong forms of
Dr. Khalil Wahla Investment Analysis 5 / 38
Weak-form hypothesis: tests & results

 Evidence on EMH is mixed.

 Some studies indicate that capital markets are efficient.
 Others report anomalies related to these hypotheses.
 Two groups of test:
 Statistical tests of independence
 Autocorrelation test: measures the significance of
positive and negative correlation in returns over
time.
 Tests of trading rules
 They compare risk-return results derived from
trading simulations to the results from a simple
buy-and-hold policy.
 Operational problems:
 Trading rules require subjective interpretation of data to
simulate mechanically.
 Extensive number of trading rules.

Dr. Khalil Wahla Investment Analysis 6 / 38

Semistrong form hypothesis: tests & results

 Studies that test semistrong-form EMH can be divided into:

 Return prediction studies: predict future rates of
return using available public information beyond pure
market information such as prices and trading volume
considered in the weak-form tests.
 Either time-series analysis or cross-section
distribution.
 Event studies: examine how fast stock prices adjust
to specific significant economic events.
 For any of these tests, you need to adjust security’s rate
of return for those of the overall market during the period
considered. In other words, AR
you need to derive abnormal
i t = Ri t − Rmt

return.

where:
ARi t = abnormal rate of return on security i during period
Dr.tKhalil Wahla Investment Analysis 7 / 38
Semistrong form hypothesis: tests & results -
Cont’d
 Results of return prediction studies
 The time-series analysis assumes that in an efficient market the
best estimate of future rates of return will be the long-run
historical rates of return.
 Risk premium proxies
 Quarterly earnings reports
 January anomaly
 Predicting cross-sectional returns
 Studies in this category attempt to determine if you can use public
information to predict which stocks will enjoy above-average or
below-average risk-adjusted returns.
 Price-earnings ratios
 Size effect
 Neglected firms and trading activity
 Book value - market value ratio
 Results of event studies
 Stock split studies
 IPOs
 Unexpected world events and economic news

Dr. Khalil Wahla Investment Analysis 8 / 38

Strong form hypothesis: tests & results

 Corporate insiders
 Mixed support, as several studies suggest that insiders make
abnormal returns, while subsequent studies indicate it is not the
case.
 Stock exchange specialists
 Specialists have monopolistic access to information about unfilled
limit orders.
 specialists are doing more trading as dealers and return on their
capital was in excess of 20%.
 Security analysts
 A set of analysts may have the ability to select undervalued
stocks.
 Value line enigma
 Analysts’ recommendations
 Professional money managers
 Most studies have examined mutual funds, lately also pension
plans and endowment funds.
 Results for a large sample of endowments confirm inability to
outperform the market. In contrast, largest endowments in terms
of size experiences superior risk-adjusted performance.
Dr. Khalil Wahla Investment Analysis 9 / 38
Explaining biases

 Prospect theory (Scott et al., 1999)

 Investors hold onto ”losers” too long and sell
”winners” too soon.
 Overconfidence (Solt and Statman, 1989; Shefrin and
Statman, 1996)
 Analysts overestimate growth rates for growth
firms and overemphasize good news while
ignoring negative news for these firms.
 Self-attribution (Gervais and Odean, 2001)
 Investors ascribe success to their own talents and
blame any failure on ”bad luck”.
 Noise traders (Brown, 1999)
 When there is shift in sentiment, these traders
move together which increases prices and
volatility during trading hours.
Dr. Khalil Wahla Investment Analysis 10 /
Implications of EMH

 Implications of efficient markets are important to

investment managers and analysts as they affect the
value of securities and the way in which they are
managed.
 Several implications can be drawn from the evidence
on efficient markets:
 Securities markets are weak-form efficient, and
therefore, investors cannot earn abnormal returns by
trading on the basis of past trends in prices.
 Securities markets are semi-strong efficient, and
therefore, analysts who collect information must
consider whether that information has already been
reflected in the price.
 Securities
Dr. Khalil Wahla markets Investment
are not Analysisstrong-form efficient
11 /
EMH & portfolio management

 If securities markets are weak-form and semi-strong

form efficient , the implication is that active trading
is not likely to generate abnormal returns.
 Portfolio managers cannot beat the market on
consistent basis; therefore, passive portfolio
management should outperform active portfolio
management.
 The role of portfolio manager is not necessarily to beat
the market, but rather to establish and manage a
portfolio consistent with the portfolio’s
objectives and constraints.
 Even if markets are efficient, portfolio managers must
diversify their portfolios and make sound decisions
when itWahla
Dr. Khalil comes to asset allocation
Investment Analysis and risk preferences
12 /
Summary

 Market efficiency is affected by the number of market participants

and depth of analyst coverage, information availability, and limits
to trading.
 There are three forms of efficient markets, each based on what is
considered to be the information used in determining asset prices.
In the weak form, asset prices fully reflect all market data, which
refers to all past price and trading volume information. In the
semi-strong form, asset prices reflect all publicly known and
available information. In the strong form, asset prices fully reflect
all information, which includes both public and private
information.
 Intrinsic value is true value of an asset, whereas market value is
the price at which asset can be bought or sold in the market.
When markets are efficient, the two should be the same,
otherwise, the two can diverge significantly.
 Most empirical evidence supports the idea that securities markets
are semi-strong- form efficient; however, empirical evidence does
not support the strong form of the efficient market hypothesis.
Dr. Khalil Wahla Investment Analysis 13 /
 Any
questions?

Dr. Milica Matovi FINM014 Investment 14 /