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Chapter 9 The Capital Markets and Market Efficiency

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New York Stock Exchange (NYSE) American Stock Exchange (AMEX) Chicago Board of Trade ... Chartists look for patterns in a sequence of stock prices ... – PowerPoint PPT presentation

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Title: Chapter 9 The Capital Markets and Market Efficiency


1
Chapter 9The Capital Markets and Market
Efficiency
2
Outline
  • Introduction
  • Role of the capital markets
  • Efficient market hypothesis
  • Anomalies

3
Introduction
  • Capital market theory springs from the notion
    that
  • People like return
  • People do not like risk
  • Dispersion around expected return is a reasonable
    measure of risk

4
Role of the Capital Markets
  • Definition
  • Economic function
  • Continuous pricing function
  • Fair price function

5
Definition
  • Capital markets trade securities with lives of
    more than one year
  • Examples of capital markets
  • New York Stock Exchange (NYSE)
  • American Stock Exchange (AMEX)
  • Chicago Board of Trade
  • Chicago Board Options Exchange (CBOE)

6
Economic Function
  • The economic function of capital markets
    facilitates the transfer of money from savers to
    borrowers
  • E.g., mortgages, Treasury bonds, corporate stocks
    and bonds

7
Continuous Pricing Function
  • The continuous pricing function of capital
    markets means prices are available moment by
    moment
  • Continuous prices are an advantage to investors
  • Investors are less confident in their ability to
    get a quick quotation for securities that do not
    trade often

8
Fair Price Function
  • The fair price function of capital markets means
    that an investor can trust the financial system
  • The function removes the fear of buying or
    selling at an unreasonable price
  • The more participants and the more formal the
    marketplace, the greater the likelihood that the
    buyer is getting a fair price

9
Efficient Market Hypothesis
  • Definition
  • Types of efficiency
  • Weak form
  • Semi-strong form
  • Strong form
  • Semi-efficient market hypothesis
  • Security prices and random walks

10
Definition
  • The efficient market hypothesis (EMH) is the
    theory supporting the notion that market prices
    are in fact fair
  • The EMH is perhaps the most important paradigm in
    finance

11
Types of Efficiency
  • Operational efficiency measures how well things
    function in terms of speed of execution and
    accuracy
  • It is a function of the number of order that are
    lost or filled incorrectly
  • It is a function of the elapsed time between the
    receipt of an order and its execution

12
Types of Efficiency (contd)
  • Informational efficiency is a measure of how
    quickly and accurately the market reacts to new
    information
  • It relates directly to the EMH
  • The market is informationally very efficient
  • Security prices adjust rapidly and accurately to
    new information
  • The market is still not completely efficient

13
Weak Form
  • Definition
  • Charting
  • Runs test

14
Definition
  • The weak form of the EMH states that it is
    impossible to predict future stock prices by
    analyzing prices from the past
  • The current price is a fair one that considers
    any information contained in the past price data
  • Charting techniques or of no use in predicting
    stock prices

15
Definition (contd)
  • Example
  • Which stock is a better buy?

Stock A
Current Stock Price
Stock B
16
Definition (contd)
  • Example (contd)
  • Solution According to the weak form of the EMH,
    neither stock is a better buy, since the current
    price already reflects all past information.

17
Charting
  • People who study charts are technical analysts or
    chartists
  • Chartists look for patterns in a sequence of
    stock prices
  • Many chartists have a behavioral element

18
Runs Test
  • A runs test is a nonparametric statistical
    technique to test the likelihood that a series of
    price movements occurred by chance
  • A run is an uninterrupted sequence of the same
    observation
  • A runs test calculates the number of ways an
    observed number of runs could occur given the
    relative number of different observations and the
    probability of this number

19
Conducting A Runs Test
20
Semi-Strong Form
  • The semi-strong form of the EMH states that
    security prices fully reflect all publicly
    available information
  • E.g., past stock prices, economic reports,
    brokerage firm recommendations, investment
    advisory letters, etc.

21
Semi-Strong Form (contd)
  • Academic research supports the semi-strong form
    of the EMH by investigating various corporate
    announcements, such as
  • Stock splits
  • Cash dividends
  • Stock dividends
  • This means investor are seldom going to beat the
    market by analyzing public news

22
Strong Form
  • The strong form of the EMH states that security
    prices fully reflect all public and private
    information
  • This means even corporate insiders cannot make
    abnormal profits by using inside information
  • Inside information is information not available
    to the general public

23
Semi-Efficient Market Hypothesis
  • The semi-efficient market hypothesis (SEMH)
    states that the market prices some stocks more
    efficiently than others
  • Less well-known companies are less efficiently
    priced
  • The market may be tiered
  • A security pecking order may exist

24
Security Prices and Random Walks
  • The unexpected portion of news follows a random
    walk
  • News arrives randomly and security prices adjust
    to the arrival of the news
  • We cannot forecast specifics of the news very
    accurately

25
Anomalies
  • Definition
  • Low PE effect
  • Low-priced stocks
  • Small firm effect
  • Neglected firm effect
  • Market overreaction
  • January effect

26
Anomalies (contd)
  • Day-of-the-week effect
  • Turn-of-the calendar effect
  • Persistence of technical analysis
  • Chaos theory

27
Definition
  • A financial anomaly refers to unexplained results
    that deviate from those expected under finance
    theory
  • Especially those related to the efficient market
    hypothesis

28
Low PE Effect
  • Stocks with low PE ratios provide higher returns
    than stocks with higher PEs
  • Supported by several academic studies
  • Conflicts directly with the CAPM, since study
    returns were risk-adjusted (Basu)

29
Low-Priced Stocks
  • Stocks with a low stock price earn higher
    returns than stocks with a high stock price
  • There is an optimum trading range
  • Every stock with a high stock price should split

30
Small Firm Effect
  • Investing in firms with low market capitalization
    will provide superior risk-adjusted returns
  • Supported by academic studies
  • Implies that portfolio managers should give small
    firms particular attention

31
Neglected Firm Effect
  • Security analysts do not pay as much attention to
    firms that are unlikely portfolio candidates
  • Implies that neglected firms may offer superior
    risk-adjusted returns

32
Market Overreaction
  • The tendency for the market to overreact to
    extreme news
  • Investors may be able to predict systematic price
    reversals
  • Results because people often rely too heavily on
    recent data at the expense of the more extensive
    set of prior data

33
January Effect
  • Stock returns are inexplicably high in January
  • Small firms do better than large firms early in
    the year
  • Especially pronounced for the first five trading
    days in January

34
January Effect (contd)
  • Possible explanations
  • Tax-loss trading late in December (Branch)
  • The risk of small stocks is higher early in the
    year (Rogalski and Tinic)

35
Types of Firms in January
36
Day-of-the-Week Effect
  • Mondays are historically bad days for the stock
    market
  • Wednesday and Fridays are consistently good
  • Tuesdays and Thursdays are a mixed bag

37
Day-of-the-Week Effect (contd)
  • Should not occur in an efficient market
  • Once a profitable trading opportunity is
    identified, it should disappear
  • The day-of-the-week effect continues to persist

38
Turn-of-the-Calendar Effect
  • The bulk of returns comes from the last trading
    day of the month and the first few days of the
    following month
  • For the rest of the month, the ups and downs
    approximately cancel out
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