Financial Management II : Corporate Finance 23/24

Topic 1: Definition of efficient markets

1. CAN FINANCING DECISIONS CREATE VALUE?

We always come back to the NPV, which stands for Net Present Value. An important concept lies in the
basic similarities between the criteria for making financing and investment decisions:

Both involve valuation of a risky asset.

In both cases we end up computing net present value 1

We calculate the net present value (NPV) of the loan.

𝑁𝑃𝑉 = 𝐴𝑚𝑜𝑢𝑛𝑡 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑 – 𝑃𝑉 𝑜𝑓 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 – 𝑃𝑉 𝑜𝑓 𝑙𝑜𝑎𝑛 𝑟𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡

The key point to consider is what interest rate my firm would have to pay to borrow money directly from
the capital markets rather than from the government. The answer lies in the market return on
equivalent-risk projects, denoted as r = 10%, representing the opportunity cost of capital.

Differences between financing and investment decisions:

• The number of different securities and financing strategies is well into the hundreds.
• There are ways in which financing decisions are easier than investments decisions. It’s harder to
make money by smart financing strategies: financial markets are more competitive than product
markets.
• In short: it is more difficult to find positive NPV-financing opportunities than positive NPV-
investment opportunities.  In general securities are fairly priced (NPV = 0).

2. WHAT IS AN EFFICIENT MARKET?

a. Efficient Market Hypothesis (EMH)

According to Fama (1970), an efficient market is one in which share prices accurately reflect all available
information. In an efficient market model void of frictions such as transaction costs, taxes, and
bankruptcy expenses, we operate in hypothetical markets assuming perfect conditions:

• Perfect information accessibility: All information is instantly available to all participants in the
market.

• Perfect competition: Public information, including anticipated news, is instantaneously

incorporated into stock prices, making price changes unpredictable (termed as a "random walk").

• Three levels of stock market efficiency testing:

• Weak form: Stock prices reflect all publicly available historical information, confirming
that technical analysis does not yield super-returns.

• Semi-strong form: The speed at which new information is absorbed at macro and
company-specific levels confirms that reacting immediately to news doesn't generate
super-returns.

• Strong form: Insider information's reflection in stock prices, confirming that insiders can
generate super-returns, although insider trading is strictly regulated.

b. Foundations of Efficient Markets

The efficiency of a market relies on three conditions, any of which will lead to market efficiency (Shleifer,
2000):

• Rational investors: Investors value securities based on their fundamental value.

Financial Management II : Corporate Finance 23/24

• Independence of deviations from rationality.

• Absence of arbitrage opportunities: Investment strategies that promise superior returns without
risk are non-existent.

What the EMH Says What the EMH Doesn't Say

- Prices reflect underlying value. - Markets are perfect (without taxes, transaction
costs, etc.).
- Financial managers won't profit from timing - All equities have the same expected returns. 2
equity and bond sales as they are fairly priced
by the market.
- Managers cannot inflate share prices via - Investors should randomly select shares.
creative accounting; no financial illusions exist.
- There is no upward trend in share prices.
Implications of the EMH

• Investors should anticipate a normal rate of return.

• Prices adjust before investors can trade on them.

• Firms should expect fair value for the securities they sell, reflecting the present value of expected
future cash flows.

• Financing opportunities arising from deceiving investors are unavailable in efficient capital
markets.

3. THE DIFFERENT TYPES OF MARKET EFFICIENCY

a. Three Forms of Market Efficiency

1. Weak Form Efficiency: Market prices reflect all historical information.

2. Semi-strong Form Efficiency: Market prices reflect all publicly available information.

3. Strong Form Efficiency: Market prices reflect all information, both public and private

Note that:

𝑆𝑡𝑟𝑜𝑛𝑔 𝑓𝑜𝑟𝑚 𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦 ⇒ 𝑆𝑒𝑚𝑖 𝑠𝑡𝑟𝑜𝑛𝑔 𝑓𝑜𝑟𝑚 𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦 ⇒ 𝑊𝑒𝑎𝑘 𝑓𝑜𝑟𝑚 𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦
𝑆𝑡𝑟𝑜𝑛𝑔 𝑓𝑜𝑟𝑚 𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦 ⇍ 𝑆𝑒𝑚𝑖 𝑠𝑡𝑟𝑜𝑛𝑔 𝑓𝑜𝑟𝑚 𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦 ⇍ 𝑊𝑒𝑎𝑘 𝑓𝑜𝑟𝑚 𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦

In market efficiency hierarchy, strong form implies semi-strong and weak forms; weak form doesn't
guarantee other forms. Reciprocally, weaker forms don't ensure stronger ones. It showcases
information reflection levels within markets, with stronger forms encompassing weaker ones, but not
vice versa.

A) THE WEAK FORM

The weak form of market efficiency aligns with the random walk theory, exemplified by a coin toss game
where stock prices change unpredictably. Characteristics include:

- Daily stock price movements lack discernible patterns→ Follow a Random Walk.

- Past returns are inadequate for predicting future prices.

- Stock price movements are statistically random, tending towards a positive trend over time.
Financial Management II : Corporate Finance 23/24

In competitive markets, prices follow a random walk to prevent predictable patterns. If past changes
predicted future prices, investors could exploit this for easy profits. Consequently, stock prices promptly
adjust to past information, encapsulating it within current prices.

Testing the weak form hypothesis involves assessing serial correlation coefficients of share price returns
near zero. Studies on trading rules reveal no consistent patterns in day-to-day returns worldwide,
supporting the idea of an unpredictable, random walk model.

The random walk theory, initially introduced by Louis Bachelier in 1900, gained traction when Maurice 3
Kendall furthered the concept in 1953 to describe the evolution of financial asset prices through a
mathematical model.

B) THE SEMI-STRONG FORM

In the analysis of the semi-strong form of the efficient market hypothesis, researchers employ event
studies to evaluate how quickly security prices react to various news events. These events include
earnings or dividends announcements, news related to takeovers, and macroeconomic information. The
focus is on measuring abnormal stock returns (ASR) associated with these events.

Regarding information timing:

• Information released at time t – 1 corresponds to ASRt–1.

• Information released at time t corresponds to ASRt.

• Information released at time t + 1 corresponds to ASRt + 1.

It is crucial to isolate the effect of these announcements on stock prices during the assessment, aiming
to understand the specific impact each event has on the price movements of stocks. This process aids in
determining how efficiently stock prices adjust to new information, supporting or challenging the semi-
strong form of market efficiency.

The abnormal stock return (ASR):

𝐴𝑆𝑅 = 𝐴𝑐𝑡𝑢𝑎𝑙 𝑆𝑡𝑜𝑐𝑘 𝑅𝑒𝑡𝑢𝑟𝑛 – 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑆𝑡𝑜𝑐𝑘 𝑅𝑒𝑡𝑢𝑟𝑛

= 𝐴𝑐𝑡𝑢𝑎𝑙 𝑆𝑡𝑜𝑐𝑘 𝑅𝑒𝑡𝑢𝑟𝑛 – ( +  𝑥 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑀𝑎𝑟𝑘𝑒𝑡 𝐼𝑛𝑑𝑒𝑥)

: states how much on average the stock price changed when the market index was unchanged.

: tell us how much “extra” the stock price moved for each 1% in the market index.

Cumulative abnormal return: estimation and event windows

Estimation and event windows play pivotal roles in this assessment:

• Estimation Window: Utilized to estimate α and β using stock returns during a specific period.
• Event Window: Comprises the actual stock returns during this timeframe and calculated
expected stock returns, enabling the calculation of abnormal stock returns to analyze the impact
of particular announcements on stock prices.

4. THE LESSONS OF MARKET EFFICIENCY.

The main lessons from the Efficient Market Hypothesis are straightforward:

1. Arbitrage quickly removes chances for profit, restoring market prices to fair levels.

2. Financial managers should understand there are no easy gains when starting in the Stock
Exchange.
Financial Management II : Corporate Finance 23/24

Lesson 1: Markets Have No Memory

This lesson reflects the Random Walk Theory, suggesting that stock prices move randomly without
adhering to any discernible pattern or memory of past movements.

Lesson 2: Trust Market Prices

In an efficient market, trust in prices is paramount. Market prices encapsulate all available
information about security values. Consistently achieving superior returns is challenging for most
4
investors, requiring knowledge beyond not just anyone but everyone else in the market.

Lesson 3: Read the Entrails

Market assessments of a company's securities offer vital insights into its prospects. For instance,
significantly higher bond yields than the average indicate potential company troubles.

Lesson 4: No Financial Illusions

Managers should avoid assuming investors suffer from financial illusions or misinterpretations, such
as those stemming from accounting changes.

Lesson 4: The Do-It-Yourself Alternative

Within an efficient market, investors refrain from paying for services they can perform equally well
themselves. This raises questions about the necessity for financial managers to diversify or issue
debt when investors can manage these tasks more efficiently independently.

Lesson 5: Seen One Stock, Seen Them All

Stocks are perceived as perfect substitutes within efficient markets. The ability to sell or buy large
stock blocks hinges on convincing others of a lack of private information. Demand elasticity differs
between raw materials (low) and stocks (high), influencing investor perceptions during large stock
transactions.

5. Market anomalies and Behavioral Finance

Market Anomalies: Evidence Against Market Efficiency

1. Earnings Surprises (The
Earnings Announcement Puzzle)
2. Size, Small Firm Effect
3. Siamese Twins
4. Crashes and Bubbles
EMH suggests prices adjust immediately to
announcements, yet research shows slow price adjustment
to earnings news.
Small stocks yield higher average returns than larger
equities, unexplained by the higher risk of small stocks.
A market anomaly creating arbitrage opportunities and
complicating the assessment of a company's true value.
Sudden and drastic changes in stock prices not justified by
the underlying fundamentals of the involved companies.

Market anomalies often serve as signals of potential irrationality within financial markets. These
anomalies, which suggest deviations from expected market behavior, find explanation in the realm of
Behavioral Finance. This theory, a relatively new addition to finance, is rooted in the limitations of
arbitrage and the psychological aspects influencing investor decisions (Schleifer and Summers, 1990). A
poignant reflection by J.M. Keynes encapsulates this theory's essence: "Markets can remain irrational far
longer than you or I can remain solvent."
Financial Management II : Corporate Finance 23/24

Traditional Theories of
finance only explain the
first square. When rational
investor takes rational
decisions. However,
investor cannot be 100%
rational nor behave
rational 100% times in a 5
given time point. Imagine
what could happen in a
long period.

Clues in Financial Analysis

Behavioral Finance Considers human behavior impacting investment decisions.
Investment decisions Macro data like GDP, interest rates, currency values.
Liquidity Market liquidity, average trading volumes.
Technical Analysis Charts, RSI, MACD, Moving averages, etc.
Sentiment of the Bear and Bull market sentiments.
Market
Company Results Earnings growth, profits, efficiency metrics.
Valuations Price-to-Earnings Ratio (PER), P/B, dividend returns.
Expectations of Earnings and sector reviews, changes in estimations.
Investors
Human Behavior Psychological factors like fear, euphoria, frustration.

Limits to Arbitrage Theory

Arbitrage involves benefiting from price differences of the same product in distinct markets,
providing a risk-free advantage. However, limits to arbitrage arise from the following factors:

1. Market Efficiency

2. Different Types of Risk: Fundamental risk, Trader noise risk, Implementation cost Model risk

3. Limited Effectiveness of Arbitration Evidence

Prospective Theory

The prospective theory, based on decision-making under risk, explores the contrast between loss
aversion and risk aversion (Kahneman and Tversky, 1987). It highlights decision-making in terms of
probable results relative to a benchmark, known as the framing effect. Additionally, it emphasizes
the limitation imposed by segregating investments in isolation (mental accounting), hindering
investors' capacity to minimize risk and maximize returns without a portfolio approach.

Grossman-Stiglitz EMH Paradox

This paradox questions market efficiency in the absence of security analysis. It contends that for the
market to be efficient, it requires investors who believe it isn't. It's akin to the anecdote: "Two
economists walk down the street and spot a $20 bill. One starts to pick it up, but the other one says:
'don't bother; if the bill were real, someone would have picked it up already.