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MGM332H5 (1)


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University of Toronto Mississauga
Will Huggon

• Lecture 1: Market Efficiency ◦ Operational Efficiency:Amarket condition in which transaction costs are low ▪ If it's too expensive to trade securities, it will be difficult for firms to raise capital, and investment will be lower than it should be ◦ Allocation efficiency: Market condition in which there are enough securities to efficiently allocate risk ◦ Informational efficiency:Amarket condition in which important information is reflected in share prices ▪ If managers announce details of a decision that they think should increase market values ▪ Investors will analyze the information and market prices will likely increase ▪ If share prices are chaotic (share prices reflect past actions in a predictable way that is magnified many times), they will not reflect the information in the announcement, it will instead reflect past pact ions ▪ Managers have no idea whether their owners agree or disagree with their decision ▪ Share prices are like a score sheet used to evaluate management ▪ Closer the link between manager actions and the score sheet, the more informationally efficient the capital market ◦ Focus of chapter 10 is whether or not important information is reflected in share prices ▪ All material facts should be disclosed to the capital market ▪ Material facts;Anything that can be expected to affect the share price ▪ Legal requirement for a firm to divulge material facts through a press release that is filed with the securities commission ◦ Defining Market Efficiency ▪ Efficient Market:Amarket that reacts quickly and relatively accurately to new public information, which results in prices that are correct on average ▪ One in which the prices of all securities accurately reflect all relevant and available information abut the securities ▪ Implies that security prices, as determined in the capital market, are 'correct' ▪ Prices will reflect rational expectations about what will happen in the future and will therefore mirror today's beliefs about future interest rate changes, future profits, potential mergers, and so on. ▪ Integrity of the market ▪ Critical condition for market efficiency ▪ All market participants are treated fairly ▪ This is why there is so much emphasis on disclosure ▪ The revelation of all material facts so that everyone in the market is buying and selling based not he same disclosed material facts about the firm ▪ Essential part of securities law: ▪ Body of law that ensures, through capital market regulations, that all investors have equal access to, and an equal opportunity to react to, new and relevant information ▪ Insider trading laws prevent 'insiders' from acting on private information before that information is made public ▪ Black markets/ small, less regulated markets, tend to be less efficient and prices do not accurately reflect available information ▪ Info is not disclosed, disclosed late, or not to all participants ▪ Insider trading ▪ Market efficiency suggests that market prices are always correct ▪ Requires instantaneous and perfect price adjustments in response to new information ▪ Not practical in reality but- ▪ Efficient markets do react quickly and relatively quickly and accurately to new information and prices are correct on average ▪ Market efficiency is a matter of degree, inefficient markets processing information slower and less accurate than more efficient ones (therefore prices in inefficient markets are further to their true values) ▪ Assumptions of efficient markets ▪ Many rational, profit-maximizing investors who actively participate in the market by analyzing, valuing, and trading securities. The markets are assumed to be competitive, meaning no one investor can significantly affect the price of a security ▪ Information is costless and widely available to participants at the same time ▪ Information arrives randomly, therefore announcement are not related to one another ▪ Investors react quickly and fully to new information, which is reflected in the stock prices ▪ Maynard Keynes ▪ Raised the question of whether or not the actions of many specialist investors and analysts made the stock market more or less efficient ▪ He believed that heir actions destabilized markets ▪ Believed that stock market should have high transaction costs (should be operationally inefficient) ▪ To keep out small investors who didn't know what they were doing, and contributed to stock market instability ▪ Behavioural finance ▪ Argued that investors make systematic mistakes in both their processing of information and their investing activities ◦ The Efficient Market Hypothesis (EMH) ▪ Markets are efficient and therefore, prices accurately reflect all available information at any given time ▪ Weak Form EMH ▪ Security prices fully reflect all market data, which refers to all past price and volume trading information ▪ Historical trading data will already be reflected in current prices and should be of new value in predicting future prices ▪ Pt = Pt-1 + expected return + random component ▪ t = time ▪ Price today = Price last week + expected return in the last week + a random component ▪ Expected return is a function of the security's risk, based on a model like CAPM ▪ Random component is a function of new information (random component in any one period is unrelated to he random component in any past period) ▪ If stock prices follow this equation, they are said to follow a random walk ▪ Semi-Strong Form EMH ▪ All publicly known and available information, including market data, is reflect in security prices ▪ Encompasses the weak form ▪ If a market is semi-strong form efficient, it must also be weak form efficient ▪ Markets that quickly incorporate all publicly available information into its prices ▪ Futile to analyze publicly available information such as financial statements, in an attempt to identify underpriced or overpriced securities ▪ Strong Form EMH ▪ Stock prices fully reflect all information, including both public and private ▪ Encompasses both weak and semi-strong, because market and publicly available information must be reflected in prices, as well as private information known by only some participants ▪ No investors could take advantage of the possession of superior information or the superior processing of information to identify misplaced securities, because prices would already properly reflect all infuriation ▪ Weak Form Evidence ▪ If markets are weak form efficient, current market prices will reflect all historical trading data ▪ Past prices changes (and total returns) should be unrelated to future price changes ▪ Random Walk Hypothesis ▪ Prices follow a random walk, with price changes over time being independent of one another ▪ Logical if information arrives randomly, and if investors react to it immediately ▪ Testing ▪ Serial correlation tests measure the correlation between successive price changes for various lags (one day, two days, one month, etc…) ▪ Correlations between successive price changes are not related in an economically significant manner ▪ Astatistical pattern exists, but it is too weak to be exploited by investors ▪ Signs test found the same (tracking 'runs' of +, 0, or -) ▪ For the most part, price changes in the capital markets are independent of one another ▪ TechnicalAnalysis:Analysis of historical trading information to identify patterns in trading data that can be used to invest successfully ▪ Technical analysts argue that more sophisticated trading strategies should be applied ▪ There are almost an infinite amount of strategies ▪ Most evidence suggests that technical trading rules have not been able to outperform simply buy-and- hold strategy, after accounting for risks and trading costs ▪ Most evidence supports the notion that markets are weak form efficient ▪ There have been a few anomalies: Exception to a rule or theory ▪ Any evidence supporting the existence of market inefficiencies must be consistent over reasonably long periods of time to be valid ▪ Otherwise sample selection could contribute to the evidence's validity ▪ Many anomalies are found through data mining ▪ Examining data in many forms, using many approaches, until you find an interesting observation/the result you were looking for before you began the analysis ▪ Often disputed.Although they are statistically significant, it would be difficult to translate to economic gains after accounting of risk and costs ▪ Stock price 'reversals' ▪ People overreact to information, leading to stock price reversals ▪ Stocks that performed poorly over a 3-5 year period (losers), tended to outperform in the subsequent 3-5 years. ▪ The opposite was observed as well ▪ Strategies designed to exploit this pattern are commonly referred to as contrarian strategies because it is based not he notion of investing contrary to the stock's pass performances ▪ This contradicts weak form efficiency because it implies that future stock returns can be predicted by examining pass trading data ▪ Momentum: Tendancy for stocks that have experienced high returns in the previous 3-12 month period tend to outperform int he subsequent 3-12 month period ▪ Contrasts with contrarian, long-term strategy ▪ Strong evidence to support the existence of momentum ▪ There is also evidence of seasonal patterns in stock returns ▪ January Effect: Stock returns, especially those for smaller companies, are statistically higher in January, than in other months. Most of these returns occur in the first five trading days ▪ Less prevalent, suggesting that it has been 'traded' away, or mostly exploited ▪ Semi-Strong Form Evidence ▪ Most studies supper the semi-strong EMH ▪ Testing ▪ Examine the speed of adjustment of stock prices to announcements of significant new information ▪ In a semi-strong form efficient market, prices would adjust quickly and accurately to this new information so that investors could not act on it and earn abnormally high risk-adjusted returns ▪ In contrast, if the market overreacts or under reacts, or if there are time lags before the prices adjust, and investors can exploit these flaws, the market is not semi-strong form efficient ▪ Event Study: Stock returns are examined to determine the impact of a particular event on stock prices ▪ Most support the notion that the market adjusts to new public information rapidly and accurately, and that investors could not earn abnormal returns based on inefficient market reactions to significant information announcements ▪ Abnormal Returns: Returns that exceed the expected return on a stock according to a model of stock returns, such as the CAPM ▪ Results of most event studies are similar ▪ Prices begin to react to the event before the announcement is made public, and the final price adjustment occurs rapidly when the actual announcement is made ▪ Supports semi-strong efficiency because investors could not have earned abnormal returns after the information was made public. ▪ Doesn't support strong efficiency because some investors are profiting from private information about upcoming price changes by buying the securities before the information is made public ▪ Exception ▪ Earnings "surprises": Earnings announcements that either exceed or fall short of consensus earnings estimates ▪ There is a lag between the adjustment of stock prices to earning surprises - ▪ Companies with the largest positive earnings surprises displayed superior subsequent performance ▪ Companies with low or negative earnings surprises displayed poor subsequent performance ▪ Substantial price adjustments still occurred before, and not he date of the actual announcement ▪ The substantial adjustments occurring after the announcement date contradict semi- strong form effieicny ▪ Stocks that have experienced positive earnings forecast revisions have been found to produce positive abnormal returns subsequent to the revision, on average ▪ Larger the revision, greater the excess returns ▪ ALso contradicts the semi-strong form of the EMH ▪ Related to the momentum anomaly ▪ SLow reaction of markets to earnings announcements or other news contributes to the price momentum effect ▪ Prices react positively to good news (and the opposite), but the full extent of the reaction is insufficient, therefore, prices will continue to appreciate (depreciate) ▪ Examine the performance of investors to see if they are able to use publicly available information to consistently generate abnormal risk-adjustted returns over sustained periods ▪ Suggests that active strategies do not outperform a simple buy-and-hold strategy ▪ Professional fund managers, with all of their expertise, do not outperform the market on a risk-adjusted basis, on average ▪ After expenses, the average active portfolio manager is substantially worse than the performance of their passive benchmarks ▪ Shows how difficult it is to 'beat the market' ▪ Ellis believes that there are so many professional investors, all very talented, that it makes it so difficult for any one of their number to do significantly better than the others, particularly long-term ▪ Abundance of evidence supporting semi- strong form efficiency ▪ Exceptions ▪ 'Value' stocks have consistently outperformed 'growth stocks' ▪ Value stocks - Generally those that have below- average price-to-earnings (P/E) and market-to-book (M/B) ratios, and that have above-average dividend yields ▪ Growth stocks -Above average P/E, M/B, and below- average dividend yields ▪ Investors willing to pay premium because they expect them to display above-average future growth in earnings and share price ▪ Popular strategy ▪ Future growth is difficult to predict, therefore investors should concern themselves with demonstrated performance ▪ Contradicts semi- strong market efficiency ▪ All ratios used to categorize stocks in this manner are publicly available ▪ The pattern has not disappeared, in spite of its wide-spread recognition ▪ In efficient markets, when investors recognize this pattern, they should increase their demand for value stocks, driving up their prices and causing the excess returns to disappear ▪ The price of growth stocks should decline in response to the demand decrease ▪ Patterns still persist ▪ Size effect:An anomaly in which small market cap stocks tend to outperform large cap stocks, even after adjusting for risk ▪ Alarge portion of the size effect has occurred in january ▪ 'Small firm in January effect" ▪ Small cap returns were more volatile, and have substantially higher trading costs because they tend to trade less actively ▪ ValueLine ranks stocks from 1(best) to 5(worst) ▪ 1 and 2 performs better than lower-ranked stocks ▪ Strong Form Evidence ▪ Investors with access to 'private' information have consistently abnormal returns, refuting strong form effieicny ▪ Only slightly better than average ▪ Summary of Empirical Evidence ▪ Weak Form Efficiency ▪ Very well supported ▪ Reasonable to conclude that markets are weak form efficient, although a few anomalies do exist ▪ Semi Strong Form Effieicny ▪ Well supported ▪ More contradictory evidence for this version of the EMH than for the weak form ▪ Strong FOrm Efficiency ▪ Not very well supported ▪ Reasonable to conclude that markets are not strong-form efficiency in the strictest sense • Lecture 2A: Investment Banking and Securities Law ◦ Conflicts Between Issuers and Investors ▪ The Basic Problem ofAsymmetric Information ▪ Asymmetric information: Information that one party has in a deal that the other doesn't; an extreme example is someone selling a security that the investor doesn't know are worthless (completely fraudulent) ▪ Valuation of securities ▪ An initial outflow to buy the security ▪ Series of expiated future cash inflows ▪ These are discounted back to the present to estimate the present value of a security ▪ If both the investor and issuer agree on the expected stream of future cash flows, the situation is symmetric ▪ What the investor expects to receive is what the issuer expects to pay ▪ The investor's expected rate or return is equal to the issuer's cost of raising capital ▪ This is the basic approach of corporate finance ▪ If the current interest rate on long-term debt is 6%, we say that the cost of long-term debt financing to the firm is 6% ▪ If we estimate the CAPM required rate of return on equity is 12%, we say the cost of common equity financing is 12% ▪ The principal assumption is that the investor and issuer agree not he value of the expected stream of cash flow nd come up wight he same estimate ▪ The problem: Capital markets exhibit information asymmetries ▪ People frequently have different information bout the same future stream of cash flows, thus they value the securities differently ▪ Financing gap: Investors and issuers disagree about the security so much that no one will find the security. ▪ Example of market failure ▪ Good cars (properly maintained, worth $15K), and lemon cars (poor condition but doesn't look so, worth $10K) ▪ Assuming that there are equal amounts of both, the average price for the car will be $12.5K, or, considering the risk of buying a lemon, $11K ▪ At a market price of $11K, owners of good cars won't offer them for sale as they know their car is good and worth $15K. The supply of good cars will go down ▪ These owners will sell their cars privately to someone that trusts them, like a relative or friend ▪ At a market price of $11K, owners of lemon cars will put their cars up for sale, knowing that their car is only worth $10K and the market price exceeds its true value ▪ Results in an unequal supply of good cars and lemons, eventually leading to almost all lemons in the market ▪ Example of 'Gresham's Law" ▪ Bad money drives out the good ▪ Clipping: One shilling coin was worth one shilling, though some of the coins were 'clipped' (people shaved or clipped off some of the coin for their silver or gold). ▪ Applies to any situation in which there is a single market price, yet the value of the commodity traded differed ▪ Inevitably, the inferior-valued commodity is passed on ▪ Much of the richness of financial markets is derived from arrangements developed to deal with these information asymmetries ▪ For used car market, you could get a mechanic report, buy from a reputable dealer, or from someone who has no friends or relatives ▪ A fraudulent security dealer will receive the initial cash and provide the investor with the security ▪ The dealer provides some 'legal' documentation and a few certificates (paper) ▪ The dealer raises a lot of cash through initial investments, makes a few payments the investors, and then flees the country to someone that won't extradite them ▪ Bearer bonds: Unregistered bonds that are payable to whomever holds them ▪ Popular in europe, often used for tax evasion ▪ Rare in NA as most bonds are registered and maintained as computer book entries ▪ The interest payments and repayments of principal for registered bonds go tot he individual who is the registered owner ▪ Paper trail for the cash that all can see, including the CRA ▪ Arbitrage opportunity ▪ Buying something in one market and resell it for more in a mother market ▪ Implies the ability to earn a profit without assuming risk ▪ This insight drives almost all securities law ▪ If investors cannot distinguish good investments from lemons offered by fraudsters, they will not invest int he public markets ▪ If investors are not confident that they are treaded fairly in capital markets, they will invest offshore, or they will invest in real assets like houses and gold ▪ Social loss from the collapse of financial markets ▪ Explains the direct (positive) correlation between the existence of public capital markets and respect for the 'rule of law'. In countries with no confidence in the enforcement of laws against fraud, or where markets appear rigged, financial transactions are done mostly through private placements in which the borrower and lender know each other ▪ Alternative market mechanisms have evolved in financial markets so that investors can invest with some assurance that they are not buying lemons or fraudulent investments ▪ Security legislation and corporate law. Securities offered to the public are checked to ensure that they are legitimate, and known criminals are kept out of the market ▪ Due Diligence: Process of checking securities offered to the public to ensure they are legitimate ▪ If it sounds too good to be true, it probably is ▪ The easiest person to defraud is someone who has a high opinion of themselves ▪ Those of above-average intelligence and workaholics that consider themselves to be financially literate ▪ They have lots of money and are eager to get more, while they are also clover enough o think they understand whats going on and don't need advice ◦ Primer on Securities Legislation in Canada ▪ Securities Legislation - Basic Responsibilities ▪ Canada has no federal securities regulator because financial markets are a provincial responsibility ▪ Main regulators are in Ontario, BC, Quebec provincial securities commissions ▪ When securities are sold in other provinces, the issue must be cleared with their authorities as well ▪ Securities and Exchange Commission (SEC) ▪ USAgency that is, in effect, a national securities regulator ▪ Issues can be sold within a state if no out-of-state investors are involved ▪ Securities regulation is designed to protect investors in that jurisdiction ▪ This is why scam artists in Toronto sold into the US and not Canada, the Ontario Securities COmmission was not directly involved ▪ Why the majority of Internet fraud comes from Russia, where regulation is lax ▪ Asecurity according to the Ontario SecuritiesAct (OSA) includes ▪ Any document, investment or writing commonly known as a security ▪ Not exhaustive ▪ In determining whether a security exists ▪ Whether the promoter raises money and leads the investor to expect a profit ▪ Whether the investor has any control on how the money is spent ▪ Whether there is risk involved ▪ Almost any document can be construed as a security ▪ The point is the protection of the public interest, and courts have taken a broad view ▪ OSC is involved in five major areas in which securities are transferred or traded ▪ Primary market offerings ▪ Secondary market trading ▪ Activities of investment professionals ▪ Insider trading ▪ Takeover bids ▪ Broad definition of a trade ▪ Sale of a security for valuable consideration ▪ Activities of traders on an organized exchange, registered to buy and sell securities, and any 'act, advert, solicitation, conduct, or negotiation to directly or indirectly further a trade' ▪ Security offerings ▪ Promotion aspect ▪ Anyone who phones around trying to generate a sale is involved in trading ▪ Documents used to generate sales of securities are highly regulated ▪ Initial Public Offerings (IPO) ▪ Most signif
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