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# CLASS NOTES WEEK IX

MARKET EFFICIENCY Reading Assignment: BMA 13

Alex Kane

1

IPCOR421 Finance

**How we think of time-series processes
**

• The value of any RV (random variable) in a time series, here price of a security, P(t), can be represented by:

•

•

P(t+1) = E(P) + e(t+1), where E(P) is the expectation at time t for the price at time t+1, and e(t+1) is a (zero-mean) surprise This useful decomposition is just a tautology -- it is true by definition of expectation, E(P), and tells us nothing about the process of prices In analyzing time series we ask: What do we know about E(P) and e(t+1)?

2 IPCOR421 Finance

Alex Kane

**Two alternative time series
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• Consider two alternative time series of daily prices

2. P(t+1) = P* + e(t+1), where E(P)=P* is a known value that doesn’t change from day to day 3. P(t+1) = P(t) + e(t+1). Here, E(P)=P(t) is changing daily. The expectation for the next-day price is today’s price (this is called a random walk)

Alex Kane 3 IPCOR421 Finance

**The two specifications tell vastly different stories
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• With the first specification, no matter what the price today, we expect it to revert to P* tomorrow • This means that if P(t)>>P*, we can say P(t) is abnormally high. Similarly if P(t)<<P*, it is abnormally low • With the second specification, E[P(t+1)]=P(t), Declaring today’s price is “abnormal” would be insincere, since we expect it to stay where it is

Alex Kane 4 IPCOR421 Finance

More on P(t+1)=P*+e(t+1)

• We call such a series “stationary” because its location stays the same over time. • We say the price is “mean reverting” because it goes back to the mean. Here we expect it to revert to the mean immediately (in one day) • The series: E[P(t+1)] = P* + 0.5[P*–P(t)], is also mean reverting (stationary). Each day, yesterday’s surprise is expected to be cut in half. No matter how small the number in place of 0.5 is, sooner or later the price will revert to P*. Hence, still stationary

Alex Kane 5 IPCOR421 Finance

More on P(t+1)=P(t)+e(t+1)

• This series is non-stationary (not mean reverting), as the location changes each day permanently -- there is no indication the price will revert to any “normal” level • By permanently we mean that at time t, E[P(t+h)]=P(t), no matter how far in the future (h) we look • No matter how high or low the level P(t) has drifted to, we expect it to stay at that level • Clearly, the notion of “high” or “low” prices is meaningless. If we were serious about such adjectives, we would expect the price to get back to what we think is “normal”

Alex Kane 6 IPCOR421 Finance

**Which rule would we like prices to follow?
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• A stationary price is more pleasing. However slow the mean reversion may be, it makes sense to us that, sooner or later, prices will revert to what we consider “reasonable” • For example, if NASDAQ index drifts to very high levels (5000), its P/E ratio will become “irrational” and we would feel the index “must” come down soon to where P/E is “reasonable” • The fly in the ointment is that any degree of mean reversion implies predictability

Alex Kane 7 IPCOR421 Finance

**Why predictability trumps stationarity
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• Suppose prices are “pleasing” in that they are mean reverting to some extent, and P(t)= NASDAQ is “high” • Investors know that, sooner or later, NASDAQ will drift back to P* • How can we expect any rational investor to hold on to a NASDAQ portfolio? Surely investors will sell it the moment they consider the index to be too high • In such environment, rational investors won’t let the price drift away from “normal,” say a reasonable P/E, even for an instant. Therefore: P(t) = P* always. We must conclude that P* changes daily, and E[P(t+1)]=P(t) always. Conclusion: investor rationality => nonstationarity

Alex Kane 8 IPCOR421 Finance

**Suppose investors are rational
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• We know already that prices will be non-stationary, that is, no mean reversion. Hence, changes from P(t) will be unpredictable • What else? – Investors will bid on a stock no more than what they believe is the intrinsic value – To arrive at the intrinsic value, investors will use all available information • Conclusion – market price, P(t), will reflect all available information – Any price change must be a surprise, driven by NEW

information

Alex Kane 9 IPCOR421 Finance

**Market (informational) efficiency
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• We define an efficient market as one where prices reflect all available information • In this market, prices are always equal to intrinsic values (derived from all available information)

P(t) = PV(future CFs, discounted at appropriate rate)

• Prices must be non-stationary • The expected rate of return on any asset is the appropriate discount rate for future cash flows • No abnormal profits can be expected, that is, NPV=0, since expected returns equal the appropriate rate

Alex Kane 10 IPCOR421 Finance

**Do we care about market efficiency?
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• Most people see market efficiency as an issue of distributive justice

– No investor can expect a greater profit than any other investor; everyone expects to earn the “appropriate” rate of return (that is, equal rate when adjusted for risk)

**• The major reason efficient markets are valuable
**

– Since capital will flow into industries with high expected returns relative to risk, and out of industries with low risk-adjusted expected returns, then, – when prices reflect all available information, the capital flows will make for the optimal allocation of capital to new investments

Alex Kane 11 IPCOR421 Finance

**Stock price and capital allocation
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• In general, as equity prices in an industry rise, more investment will take place and vice versa • Hence, when stocks are overpriced, investment in these companies will be too high, so that marginal investments will have negative NPV. When stocks are underpriced, too little investment takes place, positive NPV will be lost • In sum, inefficient capital markets lead to inefficient allocation of capital to new investments (see example last slides)

Alex Kane 12 IPCOR421 Finance

**Can markets be perfectly efficient?
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• Unfortunately, they cannot. This can be proved mathematically • The reason is that in perfectly efficient markets there is no incentive for anyone to conduct security analysis, since investors are better off choosing a passive investment rather than pay for an active one • When none conducts security analysis, nothing holds down prices to intrinsic values • The question is therefore: How near to efficiency are capital asset prices?

Alex Kane 13 IPCOR421 Finance

**How markets come closer to efficiency
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• The first target of research into profit opportunities would be “cheap” ways of discovery • Example: regress, P(t+1) = a + b*P(t) +e(t+1). Significant deviations from a=0, b=1, imply opportunities for abnormal profits • Next would come more expensive research • Example: conduct macro analysis to predict overall market movements, resulting in profits from market timing • Once such methods become widely known and used, prices will move to eliminate these profit opportunities and come closer to informational efficiency

Alex Kane 14 IPCOR421 Finance

**When does this process stop
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• As analysts exhaust low cost, available to all methods of analysis, what remains are research methods that require talent (intellectual property) and significant resources • This aspect suggests there will be outfits (employed talent and resources) with abnormally high returns • Such outfits will proceed as long as uncovered profit opportunities exceed marginal cost • Remaining inefficiencies will be hard to uncover as, by design, only few know how to uncover them

Alex Kane 15 IPCOR421 Finance

Levels of efficiency

• The idea that improved efficiency eliminates “cheap” profit opportunities first, leads to segment the EMH (efficient market hypothesis) to three levels of information that can lead to abnormal profits – The weak form: information about past prices only (technical analysis) – The semi-strong form: any publicly available info (fundamental analysis) – The strong form: inside information (illegal in most markets). However, when issuing new shares, this issue becomes legitimately relevant since management has inside info • We expect markets to, at least, pass weak form EHM tests

Alex Kane 16 IPCOR421 Finance

**Difference in efficiency across markets
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• As markets grow and become more transparent (e.g., better accounting), it becomes easier and more profitable to conduct sophisticated analysis • Hence, such markets will automatically be closer to efficiency than others • Example: emerging markets used to be all the rage. However, as they grew, partly because of large capital flows resulting from discovered inefficiencies, and as transparency improved, they lost much of their luster • Still, large differences in efficiency across markets remain

Alex Kane

17

IPCOR421 Finance

Discovering inefficiencies

• Making profits from discovered inefficient prices requires taking extra risk • By construction, you must reduce diversification in order to tilt your portfolio to use mispriced securities • Therefore, you can evaluate an active strategy only if you assume some model of asset pricing that predicts risk-return relationship • An extra difficulty is created: any test of efficiency is a joint test: (1) is there inefficiency (2) is the model used to test the hypothesis valid and reliable • It’s possible that we will reject efficiency because our model isn’t valid

Alex Kane 18 IPCOR421 Finance

**Abnormal returns and CAR
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• Joint normality of asset rates of return leads to a linear relationship (see Week 9 slides) ri – rf = alpha + beta*(rM–rf) + e, where rM is the benchmark Pf and rf the risk-free rate • When the CAPM/APT are valid, alpha = 0 • Accordingly, if we take the difference, date-bydate: ri(t)–rf(t)–beta*[(rM(t)–rf(t)], we should get e(t). The CAR (cumulate abnormal returns) over successive dates: t=1,…,T: Σe(t), should approach zero (and so should their average = Σe(t)/T)

Alex Kane 19 IPCOR421 Finance

**CAR and market efficiency
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• The average CAR of returns on an asset over a sample period makes for the estimate of alpha • A significant non zero alpha (average CAR) contradicts the joint hypothesis of CAPM/APT and market efficiency (EMH) • The test is more powerful the smaller the variance of e(t) • Therefore, tests with portfolios that diversify most of e(t) and reduce its variance, rather than individual assets with high Var(e), are preferred

Alex Kane 20 IPCOR421 Finance

Recorded anomalies

• A number of anomalies were recorded over the years. The major ones are:

– Size: smaller stocks have positive average CAR – BE/ME: larger ratios (value) stocks have positive CAR (negative for low-ratio stocks = growth or glamour stocks) – IPOs (initial public offerings) – Turn of the year returns (returns in early January) – Momentum strategies (use the inadequate speed of adjustment of stock prices to new information)

Alex Kane 21 IPCOR421 Finance

**Inadequacy of beta as measure of risk
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• Size and BE/ME help explain rates of return • This is believed to result from inadequate measurement of risk by beta (the market factor) alone • This is believed to be an issue of CAPM/APT misspecification, rather than market inefficiency • The CAPM/APT specification can be improved by

– Add factors (size and BE/ME Pfs) – Improve measurement of betas (econometrics) by allowing the coefficients to vary over time – Separate betas for cash flows and capital gains

Alex Kane 22 IPCOR421 Finance

IPOs

• For a long time, it was taken for a fact that investment in IPOs leads to abnormal returns. Hence, IPO returns were considered a significant anomaly • Part of this anomaly, early gains, is explained by market structure -- practices of investment banking. Recent auction-based IPOs seem to eliminate this phenomenon • Long term losses on IPOs appear to be explained away by the BE/ME phenomenon of the return deficiency of growth stocks (Newly issued stocks are mostly growth firms) • In general, it appears that anomalies tend to disappear over time, providing some evidence that “cheap” profit opportunities cannot last

Alex Kane 23 IPCOR421 Finance

**The January effect: A weak-form anomaly!
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• Records show most of the market annual risk premiums were achieved in early January • This was more so for small stocks. Hence, a Pf long small and short large stocks would have earned abnormal returns • Rationale: Investors sell stocks for tax reasons prior to Jan. 1, depressing prices. These stocks rise to normal levels in early Jan. (The tax selling is indeed a good idea! Sell matched losers with winners to wipe out capital gain tax liabilities and obtain the allowed loss offset) • Still, it appears this phenomenon is fading -- but small number of years (data) makes such inference difficult

Alex Kane 24 IPCOR421 Finance

Momentum strategies

• The general idea is that investors do not adjust portfolio demand promptly on the heels of new information -- sometime they over-react, other times they are too slow to react • The most prominent example is earning announcements: investors have consistently under-reacted to surprise announcements and were slow to revise forecasts of earnings • Portfolios that take advantage of these anomalies have consistently outperformed the market

Alex Kane 25 IPCOR421 Finance

Behavioral finance

• For years, behaviorists (pioneers were the late Tversky, and Nobel laureates Kahanman and Allais) showed that people confront risky prospects with irrational behavior (prospect theory) • Discovery of momentum anomalies led behaviorists to declare they emanate from such behavior • Counter arguments invoke the role of arbitrageurs (APT) in eliminating such easy profit opportunities • The jury is still out, but the popularity of these ideas is evident by the curriculum of CFA programs that now prominently include behavioral finance

Alex Kane 26 IPCOR421 Finance

**The true story of “irrational exuberance”
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• Date NASD 12/5/96 Irrational exuberance speech 1300 12/6/96 A day later 1288 12/13/96 A week later 1285 12/5/97 A year later (r=25.7%) 1634 12/6/99 Three years later (irr=39.8%) 3546 3/10/00 Highest NAD ever (irr=51.9%) 5049 10/9/02 Lowest NASD since (irr= –2.5%) 1114 6/1/07 Last Friday (3pm) (irr = 6.4%) 2613 • Soros: “The best gains come at the tail end of a boom” • From the speech to today, IRR still better than T-bills. Predictions with no date are of little value

Alex Kane 27 IPCOR421 Finance

Event Studies

• Suppose we can date (t) the arrival of a significant packet of new information, one that we know should affect security prices • We can calculate CAR from well before the event date (t–h), through t and well after (t+h) • The chart of an efficient market will show about zero CAR up to t, a one time jump to a new level at t, and zero changes thereafter • CAR changes prior to t suggest anticipation/leak • Slow response of CAR at t and after suggests underreaction • A large change of CAR at t and shortly after, followed by a later retreat shows over-reaction

Alex Kane 28 IPCOR421 Finance

**Results of three event studies (good news)
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CAR efficient t–h t t+h Time

**slow reaction Time leak Time overreaction
**

Alex Kane 29 IPCOR421 Finance

**Measuring intrinsic values
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• The CAPM/APT suggests ways to estimate expected return • The model doesn’t tell the dollar value of an enterprise; it only provides one piece of the puzzle • To get intrinsic value we must use a discounted dividend (or free CF) model • In addition to the required rate we need to estimate growth rates of current dividends/cash flows • Intrinsic values are very sensitive to g, allowing for difference of intrinsic values across investors and rapid price changes of stock, the source of high volatility in rates of return and difficulty in assessing efficiency

Alex Kane 30 IPCOR421 Finance

**Summary of the lessons from EMH
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1. Prices have no memory, only P(t) tells about the future (history adds nothing) 2. Prices indicate intrinsic values 3. (from 2), price changes reveal required rates and suggest value of announced policies 4. Prices are unaffected by “veils,” e.g., accounting methods 5. Assets will be priced to reflect information about value creation only -- not opportunities investors can obtain by trading in financial markets 6. Financial assets (and portfolios) are perfect substitutes, providing the same risk-return tradeoffs (mean/beta)

Alex Kane 31 IPCOR421 Finance

**A challenging example of capital allocation
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• A corporation has 2 million shares outstanding, selling at $5/share. Hence, current market value of the firm is $10 million • The corporation surprisingly identifies a project that will pay $12 million next year (only) for an investment of $8 million now • Management believes the project risk requires 20%, that is, NPV=$2 mil. Hence, they believe share value is (10+2)/2=$6 • Management has no cash on hand, cannot borrow any more, and must finance the project by floating new shares • Upon announcement of the project idea and required financing (before flotation), the share price goes up to $x/share • Will the corporation invest in the new project?

Alex Kane 32 IPCOR421 Finance

Answer to question

• With a price of $x/share, the corporation has to sell 8/x million shares • Current shareholders will then own a fraction: 2/(2+8/x) = x/(x+4) of the corporate shares • According to mgt’s assessment, the total value of the company (when shares sold) will be 10+12/1.2=$20 mil • Equity of current SH will have value of $20x/(x+4) mil • Since current value is $10 mil, they will invest only if 20x/(x+4)>10, that is, x>$4. ($4 is the break-even price) • At $4 they must sell 2 mil shares. At higher prices, they will have to sell less shares and retain more value

Alex Kane 33 IPCOR421 Finance

**What’s in it for new investors?
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• A higher share price means lower expected return • At $4/share, 2 million shares must be sold (N=4 mil) and each share buys value of 4 = [10+12/(1+r)]/(2+2), implying: r=100% • At $6 (the value management believes is right), 8/6 mil shares sold: 6=[10+12/(1+r)]/(8/6+2), r=20% • Conclusion, the higher the expected return investors assign to new projects, the higher they will bid for share prices. When they bid higher prices, corporations will invest more (at less than $4 this corp will invest zero)

Alex Kane 34 IPCOR421 Finance