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CHAPTER 6 EFFICIENT CAPITAL MARKETS CONCEPTS
1. Discuss the rational for expecting an efficient efficient capital market. market. What factors would you you look for to differentiate the market efficiency for two alternative stocks? A: There are several reasons why one would expect expect capital markets to be efficient: a. The foremost foremost being that there are a large number number of independent, profit-maximizing profit-maximizing investors investors engaged in the analysis and valuation of securities. b. A second assumption assumption is that new new information comes to the market market in a random random fashion. c. The third assumption is that the the numerous numerous profit-maximizing profit-maximizing investors will adjust security security prices rapidly to reflect reflect this new information. information. Thus, price changes changes would be independent independent and random. d. Finally, because because stock prices reflect reflect all information, information, one would expect expect prevailing prevailing prices prices to reflect “true” current value. Capital markets as a whole are generally expected to be efficient, but the markets for some securities might not be as efficient as others . Recall that that markets are expected expected to be efficient because there are are a large number of investors who who receive new information information and analyze analyze its effect on security values. If there is a difference in the number of analysts following a stock and the volume of trading, one could conceive of differences in the efficiency of the markets. For example, new information regarding actively traded stocks such as IBM and Exxon is well publicized and numerous analysts evaluate the effect. Therefore, one should expect the prices for these stocks to adjust rapidly and fully reflect the new information. On On the other hand, new information regarding a stock with a small number of stockholders and low trading volume will not be as well publicized and few analysts follow such firms. Therefore, prices may not adjust as rapidly to new information and the possibility of finding a temporarily undervalued stock are also greater. Some also argue that the size of the firms is another factor to differentiate the efficiency of stocks. Specifically, it is believed that the markets for stocks of small firms are less efficient than that of large firms. 2. Define and discuss the weak-form EMH. Describe the two sets of tests used to examine examine the weak-form EMH. A: The weak-form efficient market hypothesis hypothesis contends that current stock prices reflect all available security-market information including the historical sequence of prices, price changes, and any volume information. The implication is that there should be no relationship between past price changes and future price changes. Therefore, any trading rule that uses past market data alone should be of little value. The two groups of tests of the weak-form EMH are: (1) statistical tests of independence independence and (2) tests of trading rules. Statistical tests of independence can be divided further into two groups: a. the auto autocor correl relati ation on tests tests and and b. the runs tests. The autocorrelation tests are used to test the existence of significant correlation, whether positive or negative, of price changes on a particular day with a series of consecutive previous days. The runs tests examine the sequence of positive and negative changes in a series and attempt to determine the existence of a pattern. For a random series one would expect 1/3(2n - 1) runs, where n is the the number of observations. If there there are too few runs (i.e., long sequences of positive changes or long sequences of negative changes), the series is not random, i.e., you would not expect a positive change to consistently follow a positive change and a negative change consistently after a negative change. Alternatively, if there are too many runs (+-+-+-+- etc.), again again the series is not random random since you would would not expect a negative change to consistently follow a positive change. 6-1
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In the trading rule studies, the second major set of tests, investigators attempted to examine alternative technical trading rules through simulation. The trading rule studies compared the riskreturn results derived from the simulations, including transaction costs, to results obtained from a simple buy-and-hold policy. 3. Define and discuss the semistrong-form EMH. Describe the two sets of tests used to examine the semistrong-form EMH. A: The semistrong-form efficient market hypothesis contends that security prices adjust rapidly to the release of all new public information and that stock prices reflect all public information. The semistrong-form goes beyond the weak-form because it includes all market and also all nonmarket public information such as stock splits, economic news, political news, etc. Using the organization developed by Fama, studies of the semistrong-form EMH can be divided into two groups: (1) Studies that attempt to predict futures rates of return using publicly available information (goes beyond weak-form EMH). These studies involve either time-series analysis of returns or the cross-section distribution of returns. (2) Event studies that examine abnormal rates of return surrounding specific event or item of public information. These studies determine whether it is possible to make average risk-adjusted profits by acting after the information is made public. 4. What is meant by the term abnormal rate of return? A: Abnormal rate of return is the amount by which a security’s return differs from the expected rate of return based upon the market’s rate of return and the security’s relationship with the market. 5. Describe how you would compute the abnormal rate of return for a stock for a period surrounding an economic event. Give a brief example for a stock with a beta of 1.40. A: The CAPM is grounded in the theory that investors demand higher returns for higher risks. As a result of risks specific to each individual security, the announcement of a significant economic event will tend to affect individual stock prices to a greater or lesser extent than the market as a whole. Fama, Fisher, Jensen, and Roll portrayed this unique relationship of stock returns and market return for a period prior to and subsequent to a significant economic event as follows: R it = ai + Bi R mt + e where R it = ai = Bi = R mt = e =
the rate of return on security i during period t the intercept or constant for security in the regression the regression slope coefficient for security i equal to cov im/m2 the rate of return on a market index during period t a random error that sums to zero
As an example of how one would derive abnormal risk-adjusted returns for a stock during a specific period, assume the following values for a firm: ai = .01 and B i = 1.40 If the market return (R mt) during the specified period were 8 percent, the expected return for stock i would be: E(R it)
=
.01 + 1.4(.08) =
.01 + .112 = .122
The fact that this is the expected value implies that the actual value will tend to deviate around the expected value. We will define the abnormal return (AR it) as the actual return minus the expected return. In our example, if the actual return for the stock during this period were 10 percent, the abnormal return for the stock during the period would be AR it = .10 - .122 = -.022 Thus, the stock price reacted to the economic event in a manner that was 2.2 percent less than expected where expectations were based upon what the aggregate market did and the stock’s relationship with the market. This abnormal return surrounding an economic event can be used to 6-2
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determine the effect of the event on the individual security. 9. For many of the EMH tests, it is really a test of a “ joint hypothesis ”. Discuss what meant by this concept. A: Studies on market efficiency are considered to be dual tests of the EMH and the CAPM. These tests involve a joint hypothesis because they consider not only the efficiency of the market, but also are dependent on the asset pricing model that provides the measure of risk used in the test. For example, if a test determines that it is possible to predict future differential risk-adjusted returns, the results could either have been caused by the market being inefficient or because the risk measure is bad thereby providing an incorrect risk-adjusted return. 10. Define and discuss the strong-form EMH. Why do some observers contend that the strongform hypothesis really requires a perfect market in addition to an efficient market. Be specific. A: The strong-form efficient market hypothesis asserts that stock prices fully reflect all information, whether public or private. It goes beyond the semistrong-form because it requires that no group of investors have a monopolistic access to any information. Thus, the strong-form efficient market hypothesis calls for perfect markets in which all information is available to everyone at the same time. 14. Describe the general goal of behavioral finance. A: Behavioral finance deals with individual investor psychology and how it affects individuals’ actions as investors, analysts, and portfolio managers. The goal of behavioral finance is to understand how psychological decisions affect markets and to be able to predict those effects. Behavioral finance looks to explain anomalies that can arise in markets due to psychological factors. 16. What does the EMH imply for the use of technical analysis? A: The basic premise of technical analysis is that the information dissemination process is slow-thus the adjustment of prices is not immediate but forms a pattern. This view is diametrically opposed to the concept of efficient capital markets, which contends that there is a rapid dissemination process and, therefore, prices reflect all information. Thus, there would be no value to technical analysis because technicians act after the news is made public which would negate its value in an efficient market. 17. What does the EMH imply for fundamental analysis? Discuss specifically what it does not imply. A: The proponents of fundamental analysis advocate that at one point in time there is a basic intrinsic value for the aggregate stock market, alternative industries, and individual securities and if this intrinsic value is substantially different from the prevailing market value, the investor should make the appropriate investment decision. In the context of the efficient market hypothesis, however, if the determination of the basic intrinsic value is based solely on historical data, it will be of little value in providing above average returns. Alternatively, if the fundamental analyst makes superior projections of the relevant variables influencing stock prices then, in accordance with the efficient market hypothesis, he could expect to outperform the market. The implication is that even with an excellent valuation model, if you rely solely on past data, you cannot expect to do better than a buy-and-hold policy. 21. Describe the goals of an index fund. Discuss the contention that index funds are the ultimate answer in a world with efficient capital markets. A: Index funds are security portfolios specially designed to duplicate the performance of the overall security market as represented by some selected market index series. The first group of index funds was created in the early 1970s because people started realizing that capital markets are efficient and it is extremely difficult to be a superior analyst. Thus, instead of trying to outperform the market, a large amount of money should be managed “passively” so that the investment performance simply matches that achieved by the aggregate market and costs are minimized so as not to drop returns below the market. An abundance of research has revealed that the performance of professional money managers is not superior to the market, and often has been inferior. This is precisely what one would expect in an 6-3
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efficient capital market. Thus, rather than expending a lot of effort in selecting a portfolio, the performance of which may turn out to be inferior to the market, it is contended by some that portfolios should be designed to simply match the market. If you match the market and minimize transactions costs you will beat two-thirds of the institutional portfolio managers on average. The index funds are intended to match the market and minimize costs as suggested above. Thus, they are consistent with the EMH. 24(c). Briefly explain two major roles or responsibilities of portfolio managers in an efficient market environment. A: Portfolio managers have several roles or responsibilities even in perfectly efficient markets. The most important responsibility is to: 1. Identify the risk/return objectives for the portfolio given the investor’s constraints. In an efficient market, portfolio managers are responsible for tailoring the portfolio to meet the investor’s needs rather than requirements and risk tolerance. Rational portfolio management also requires examining the investor’s constraints, such as liquidity, time horizon, laws and regulations, taxes, and such unique preferences and circumstances as age and employment. Other roles and responsibilities include: 2. Developing a well-diversified portfolio with the selected risk level. Although an efficient market prices securities fairly, each security still has firm-specific risk that portfolio managers can eliminate through diversification. Therefore, rational security selection requires selecting a welldiversified portfolio that provides the level of systematic risk that matches the investor’s risk tolerance. 3. Reducing transaction costs with a buy-and-hold strategy. Proponents of the EMH advocate a passive investment strategy that does not try to find under-or-overvalued stocks. A buy-and-hold strategy is consistent with passive management. Because the efficient market theory suggests that securities are fairly priced, frequently buying and selling securities, which generate large brokerage fees without increasing expected performance, makes little sense. One common strategy for passive management is to create an index fund that is designed to replicate the performance of a broad-based index of stocks. 4. Developing capital market expectations. As part of the asset-allocation decision, portfolio managers need to consider their expectations for the relative returns of the various capital markets to choose an appropriate asset allocation. 5. Implement the chosen investment strategy and review it regularly for any needed adjustments. Under the EMH, portfolio managers have the responsibility of implementing and updating the previously determined investment strategy of each client. PROBLEM SOLVING Given: Stock Rit Rmt Βi
B F T C E
11.5% 10.0 14 12 15.9
4.0% 8.5 9.6 15.3 12.4
0.95 1.25 1.45 0.70 -0.30
R it - R mt
R it (R t)
7.5 1.5 4.4 -3.3 3.5
(beta) 7.7 -.625 .08 1.29 19.62
Rit = return for stock i during period t Rmt = return for the aggregate market during period t β = systematic risk measure
1. Compute the abnormal rates of return for the ff. stocks during period t (ignore differential systematic risk). Abnormal Returnit = R it R mt 6-4
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AR it AR Bt AR Ft AR Tt AR Ct AR Et
= = = = = =
R it - R mt 11.5 - 4.0 = 10.0 - 8.5 = 14.0 - 9.6 = 12.0 - 15.3 = 15.9 - 12.4 =
7.5 1.5 4.4 - 3.3 3.5
2. Compute the abnormal rates of return for the five stocks assuming the given betas. Abnormal Returnit = R it (Beta R mt) AR it AR Bt AR Ft AR Tt AR Ct AR Et
= = = = = =
R it - (beta) (R mt) 11.5 - .95(4.0) = 7.7 10.0 - 1.25(8.5) = -.625 14.0 - 1.45(9.6) = .08 12.0 - .70(15.3) = 1.29 15.9 - (-.3)(12.4) = 19.62
3. Compare the abnormal returns in items 1 & 2 and discuss the reason for the difference in each case. A: The reason for the difference in each case is due to the implications of beta. Beta determines how the stock will move in relation to movements in the market. Considering stock C, a one percent change in the market return will result in a .70 percent change in stock C’s return. Therefore, comparing the abnormal return for stock C, the value becomes positive in Problem 2. Conversely, the 1.25 percent change expected by stock F, for every 1 percent change in the market, resulted in the abnormal return moving from positive to negative. Stock E should move opposite the market because of the negative beta value. Thus, stock E has a very large abnormal return. For stocks B and T, the positive abnormal returns remain positive but do change in value.
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