FNCE3302

INVESTMENTS AND
SECURITY ANALYSIS

Liping Qiu
CHAPTER 7: CAPITAL ASSET
PRICING AND ARBITRAGE
PRICING THEORY
CHAPTER 8: THE EFFICIENT
MARKET HYPOTHESIS

Mar. 25, 2020

Today’s Schedule
• Chapter 7
• Multifactor Models and CAPM
• Chapter 8
• Random Walks and Efficient Market
Hypothesis
• Implications of the Efficient Market Hypothesis
 4

After This Class, You Should Be Able To:

• Understand multifactor models.
• Understand random walk.
• Understand versions of the efficient market
hypothesis.
• Understand technical analysis and fundamental
analysis.
Today’s Schedule
• Chapter 7
• Multifactor Models and CAPM
• Chapter 8
• Random Walks and Efficient Market
Hypothesis
• Implications of the Efficient Market Hypothesis
 6

Multifactor Models and CAPM (I)

• Factors that explain security returns can be
classified as macroeconomic, fundamental, and
statistical factors.
• The general form of a multifactor model with k
factors is as follows:
E ( Ri )  rf
 i1  E (Factor 1)+i 2  E (Factor 2)+ +ik  E (Factor k)
Multifactor Models and CAPM (II)
•
 8

Multifactor Models and CAPM (III)

• Fama-French Three-Factor Model
Rit  i  iM RMt  iSMBSMBt  iHML HMLt  eit
• SMB = Small Minus Big (firm size)
• HML = High Minus Low (book-to-market ratio)
• Estimation results:
• Three aspects of successful specification
• Higher adjusted R-square
• Lower residual SD
• Smaller value of alpha
 9

Multifactor Models and CAPM (IV)

• The FF model was developed because the
researchers found that stocks of smaller firms,
and of firms with a high book-to-market ratio, had
higher stock returns than predicted by single
factor models.
• The Fama-French (FF) three factor model has
become a standard in equity analysis.
• Value stocks: high book-to-market
• Growth stocks: low book-to-market
• Value Premium
 10

Multifactor Models and CAPM (V)

• The Fama/French factors are constructed using
the 6 value-weight portfolios formed on size and
book-to-market.
• SMB (Small Minus Big)
• The average return on the three small portfolios
minus the average return on the three big portfolios.
• HML (High Minus Low)
• The average return on the two value portfolios minus
the average return on the two growth portfolios.
• rm-rf, the excess return on the market
Today’s Schedule
• Chapter 7
• Multifactor Models and CAPM
• Chapter 8
• Random Walks and Efficient Market
Hypothesis
• Implications of the Efficient Market Hypothesis
 12

Random Walks and Efficient

Market Hypothesis
• Random Walk
• Competition as Source of Efficiency
• Factors that Affect a Market’s Efficiency
• Versions of EMH
 13

Random Walks
• Random Walk
• Notion that stock price changes are random

• Efficient Market Hypothesis (EMH)

• Prices of securities fully reflect available
information
 14

Cumulative Abnormal Returns before Takeover Attempts:

Target Companies
 15

Stock Price Reaction to CNBC Reports

 16

Competition as Source of Efficiency

• Investor competition should imply stock prices
reflect available information
• Investors exploit available profit opportunities
• Competitive advantage can verge on insider
trading
 17

Factors that Affect a Market’s

Efficiency
• Number of market participants
• Availability of information
• Impediments to trading
• Transaction and information costs
 18

Versions of Efficient Market Hypothesis

• Weak-form EMH
• Stock prices already reflect all information
contained in history of trading
• Semistrong-form EMH
• Stock prices already reflect all public information

• Strong-form EMH
• Stock prices already reflect all relevant
information, including inside information
 19

Versions of Efficient Market Hypothesis

• The three forms of hypotheses are dependent and serially
higher ordered in degree of efficiency.
 20

Question 1
• Suppose you find the following phenomena. Is
each of phenomena consistent with EMH? If not,
which version of EMH is violated? Explain.
• (1)One could have made superior returns by
buying stock after an 8% rise in price and selling
after an 8% fall.
• (2) Low P/E stocks tend to have positive
abnormal returns.
Today’s Schedule
• Chapter 7
• Multifactor Models and CAPM
• Chapter 8
• Random Walks and Efficient Market
Hypothesis
• Implications of the Efficient Market
Hypothesis
 22

Implications of the Efficient Market

Hypothesis
• Technical Analysis
• Fundamental Analysis
• Active versus Passive Portfolio
Management
• Role of Portfolio Management in Efficient
Market
 23

Technical Analysis
• Research on recurrent/predictable price
patterns and on proxies for buy/sell
pressure in market
• Resistance Level
• Unlikely for stock/index to rise above

• Support Level
• Unlikely for stock/index to fall below
 24

Resistance Level and Support Level

 25

Moving Average Crossovers

 26

Fundamental Analysis
• Research on determinants of stock value,
i.e. earnings, dividend prospects, future
interest rate expectations and firm risk
• Assumes stock price equal to discounted value of
expected future cash flow
 27

Active versus Passive Portfolio

Management
• Active management assumes market
inefficiency
• Passive management consistent with semi-
strong efficiency
• Passive investment strategy
• Buying well-diversified portfolio without attempting to
find mispriced securities
• Index fund
• Mutual fund which holds shares in proportion to market
index representation
 28

Role of Portfolio Management in

Efficient Market
• Inefficient market pricing leads to inefficient
resource allocation
• Even if markets are efficient, portfolio
managers can add value:
• by establishing and implementing portfolio risk
and return objectives
• by assisting clients with portfolio diversification,
asset allocation, record keeping, and tax
management.
 29

Homework
• Read Chapters 7 and 8.
• Assignment
• Chapter 7: 1, 3, 4, 6, 9, 25
• Chapter 8: 1, 4, 6, 7, 11, 12, 13