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Administrative Studies
ADMS 3530
Lois King

EMBA 807 Corporate Finance Dr. Rodney Boehme CHAPTER 13 CORPORATE-FINANCING DECISIONS AND EFFICIENT CAPITAL MARKETS Assigned problems are 5, 8, 10, 11, 12, 14, 16, and 22. I. Introduction to Market Efficiency A Description of Efficient Capital Markets Prices in informationally efficient capital or financial markets should reflect allavailable information. An important consequence of market efficiency is that investments in publicly traded financial securities, such as stocks and bonds, are zero NPV investments (as opposed to the assumed positive NPVs of most real or productive assets). Investors should expect to earn a fair or normal return that is consistent with the risk (defined by CAPM or APT) of the security. Companies should expect to receive a fair price when they issue securities. Current prices should represent a fair and unbiased forecast or estimate of the true, intrinsic, or fundamental value of the firm, i.e., the Present Value of all future expected cash flows. If this were not the case, we would find many instances where security prices were systematically biased, i.e., either consistently underpriced or overpriced. Some reasons why market efficiency is a critical issue and concept: 1. It affects the price that the firm will receive for any new stocks and bonds that it may issue. Also, if a firm can sell new stock that is overvalued, it is perhaps likely to do such. 2. It affects the cost of capital or required rate of return on securities. The cost of capital affects the capital budgeting or new capital expenditure decisions. 3. If you want to link management compensation to stock price or shareholder value, then it is especially important that the stock price be representative of the true value of the firm, i.e., stockholders want a stock price that is fair and unbiased. 4. An asset’s price should be driven by unbiased estimates of future cash flows and the true systematic risk associated with the cash flows. If this were not the case, investors would be able to earn returns that are inconsistent with the true level of risk of an asset. Portfolio managers are very interested in any mispricing in the stock market. A mispriced stock would be thought of as cash lying in the street waiting for someone to pick it up. Normal versus Abnormal Returns If financial markets are not efficient, then strategies would exist that can systematicallyearn above normal or below normal returns, referred to as abnormal returns. However, in order to actually calculate any abnormal return for any given asset, we first need some Asset Pricing Model such as the Arbitrage Pricing Theory or Capital Asset Pricing Model that gives us an estimate or idea of what the normal or expected return to that asset should have been. Abnormal Return = ActualReturn observed – Expected Return Page 1 EMBA 807 Corporate Finance Dr. Rodney Boehme The expected or normal return of the asset is based on: (1) the stock’s level of risk and (2) what actually happened with the relevant systematic or macroeconomic source(s) of risk. For example, in a CAPM world, if the overall market goes down, the stock under investigation would likely also have gone down in price. Reaction of Stock Price to New Information In an efficient market, prices respond instantaneously to new and material information and fully reflect that information. Delayed responses (under-reaction) and overreaction to new information would suggest that markets are inefficient. Next, we look at three information sets and the corresponding level or form of market efficiency. II. Information and Forms of Efficient Market Hypothesis (EMH) Three information sets are used to describe the EMH. Note that set 1 is a subset of 2 and that both 1 and 2 are subsets of 3. Each set corresponds to one form of the EMH as discussed below. 1. Historic stock prices and other market related information (e.g., trading volume, etc.) 2. Publicly available information (this also includes all historical market information) 3. All information relevant to a stock (both public and private information) Three forms of Efficient Market Hypothesis or EMH 1. Weak form efficiency: asset prices already reflect all historical market related trading information such as past prices, returns, trading volume, or trends in volume or prices. Most tests show that this information cannot be used to generate or earn abnormal returns after adjusting for risk. This makes sense because this information is available at almost zero cost. If the market is weak-form efficient, thentechnical analysis or chart reading should not produce abnormal returns. Stock prices should closely follow a random walk. Individuals have an unfortunate tendency to look for patterns or trends, even in random series. Take a good look at the four graphs on page 10 of these notes. Two of the graphs are actual performance of the U.S. market for a 10-year period, and the other two are computer generated from a random walk model (an upward trend of 10% per year with 20% annual standard deviation). See if you can tell which graphs are real! 2. Semi-strong form efficiency: asset prices already reflect all information that is publicly available, i.e., earnings, dividends, analyst forecasts, expectations of the future, etc. Most tests show that material public announcements are accompanied by an immediate change in price. In a semi-strong efficient market, the market's reaction to new and material information should be both instantaneous and unbiased, i.e., without any systematic pattern of over or underreaction. In addition, the market should only react to the extent that new information differs from what had been expected. Semi-strong efficiency also means that 1 The problem is that perhaps people have an incomplete concept of what randomness should look like. A random walk in stock prices is essentially an overall upward trend with a noise term that produces a variation around the overall upward trend. Page 2 EMBA 807 Corporate Finance Dr. Rodney Boehme most financial analysis work or fundamental analysis, based on using public information, should not work. Opportunities may occasionally exist that produce above normal or excess returns. However, after the information or strategies become known to the public, they should no longer produce excess returns; e.g., the January effect in small stocks has vanished. Also, a talented investment analyst might still be able to beat the market, provided that he/she is able to consistently interpret information better than the competition can. 3. Strong form efficiency: asset prices already reflect all private and public information. We know that inside information is very valuable to anyone that chooses to (illegally in most cases) act upon this information, so the market is certainly not strong formefficient. Implications of The Semi-Strong Form Market Efficiency: • Stock prices are expected to increase over time, but future returns are expected to be consistent with the systematic risk. • Investments in financial assets are expected to be ZERO Net Present Value. This means that you should expect to earn an average future return that is determined by the systematic risk of the investments. • What if no one performed security analysis? Then the first person that becomes an analyst will find countless mispriced assets and trading rules that earn excess or abnormal returns. Such profitable opportunities would certainly lead to many more individuals entering the analyst field. Competition will quickly begin to eliminate most of the mispriced assets. • Due to intense competition, it will become difficult to earn abnormal returns. The marginal benefit of analysis will just equal the marginal cost of analysis for the average analyst or investor. • It thus follows that individuals should be exceedingly suspicious of anyone that advertises some investment technique that earns abnormal returns. 2f the method really works, then any rational person would keep the technique undisclosed! This holds for the weak-form market efficiency as well, as many attempt to sell methods for technicalanalysis. III. The Evidence for Market Efficiency: • Aremarkets strong form efficient? Certainly not. • Aremarkets weak-form efficient? Evidence strongly suggests yes. Random successes look appealing, but most tests are not supportive of trading strategies that use market related data. 2 After all, how many industrial corporations prefer to give away their patents, knowledge, or other proprietary information that generates NPV? Given that industrial firms don’t give away these items of knowledge, it follows that successful trading methods or strategies won’t be disclosed either. Page 3 EMBA 807 Corporate Finance Dr. Rodney Boehme • Aremarkets perfectly semistrong efficient? No. The recent bubble in internet/technology stocks is a somewhat obvious example of prices not reflecting their fundamental value. • Aremarkets largely semistrong efficient? Yes, based on most of the evidence, especially for event studies and mutual fund performance. However, there are many reported anomalies in stock prices. Do these anomalies represent actual mispricings that an astute portfolio manager can convert into abnormal returns (ARs)? No, for the most part. Perhaps they once worked, before they became public knowledge. Also, what might produce apparent or measured abnormal returns on paper might be difficult to actually implement using actual money. Tests of the EMH fall under three major categories: 1. Tests for random walk in stock prices 2. Event Studies 3. Performance of professional investors All these tests compare observed stock returns against returns predicted by the EMH, controlling for systematic risk. We first need to understand what any stock's normal returns should look like, based upon its level of risk. Therefore, tests of the EMH are joint tests market efficiency and the asset pricing model (e.g. the CAPM or APT) used to estimate systematic risk. Tests of the Weak Form EMH (do prices follow a Random Walk?) Tests for serial correlationare often used to test the weak form EMH. Positive serial correlation: above (below) normal returns are followed by subsequent above (below) normal returns, otherwise referred to as momentum . Negative serial correlation: above (below) normal returns are followed by subsequent below (above) normal returns, otherwise referred to as reversals in returns. Both positive serial correlation and negative serial correlation would imply violations of the weak form EMH if they are found to exist and also if they are economically significant after accounting for transactions costs. The majority of empirical evidence isconsistent with the weak formEMH. Tests of Semi-strong Form Efficiency Event studies look at stock price reaction to new information released to the public. Delayed responses or overreaction to new public information implies a violation of the semi-strong form EMH. There is a little mixed empiricalevidence fromevent studies, but efficiency is generally supported. In addition, the problem of jointly testing the underlying asset pricing model and market efficiency is still unresolved, i.e., first you need to know what the normal returns should 3 Research that reports market inefficiencies tend to get reported, while those that support market efficiency are not as exciting. If you perform 20 studies of events that have no actual abnormal returns, onaverage one of them will by pure chance report spurious abnormal returns that are statistically significant at the 5% level. That study would be exciting, while the other 19 are not interesting. Page 4 EMBA 807 Corporate Finance Dr. Rodney Boehme look like before any inference can be made concerning market efficiency. Also, always remember that the true asset pricing model is not known. Mutual fund performance studies compare the return on actively managed mutual funds to returns on a passivebroad-based index mutual fund, e.g., a mutual fund that onlyattempts to match the S&P 500 or Willshire 5000 indices. Since trading on insider information is illegal, most active fund managers have to rely on public information to formulate their investment strategies. The majorityof mutual fund studies find that most active mutual fund managers do not outperform passive index funds, supporting the semi-strong form EMH. The Value Line Investment Surveypublishes information about stocks that have broad investor interest. Value Line ranks stocks on a scale from 1 to 5. The stocks ranked 1 and 5 are expected to have the best and worst future performance, respectively. Research has shown that,on paper, the 1 ranked stocks have indeed outperformed the 5 ranked stocks. However, the two mutual funds that Value Line manages have actually underperformed the market, even though they use the Value Line ranking system in formulating their investment decisions. Apparently, what looks great on paper cannot always be implemented to generate above normal returns. Some Contrary Views of the EMH Size: Studies have shown that small firms (measured by market capitalization) earn higher returns than large firms after adjusting for systematic risk (Beta CAPM risk in these studies). One controversy on this finding is whether a correct or properly specified asset pricing model was used to adjust for systematic risk. Returns cannot be said to be above or below normal when you don't have a good idea of what the "normal" returns should look like. In any case, small firms do not constitute much value in the overall market. Of all the publicly traded firms in the U.S., the largest 10% of firms make up around 85% of the total value of the U.S. stock market. The smallest 10% of firms make up only about 0.3% of the overall market value. Even the smallest 30% of firms only make up about 2.5% of the overall market value. Temporal Anomalies : Researchers discover several stylish facts (patterns) in stock returns, implying that stock prices do not follow a random walk. However, these findings are not strong evidence against the EMH because these patterns cannot be exploited to earn abnormal profits after accounting for transaction costs. Furthermore, one of these patterns (negative average return on Mondays) has disappeared recently. Value versus Glamour: This is the latest battleground for the EMH. Several studies show that public information (the ratio of book value of equity to market value of equity or BV/MV) can be used to select stocks that produce abnormal returns. If the finding is not driven by risk, then a challenge to the EMH exists. The verdict on this topic is stil
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