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Topics Covered
We Always Come Back to NPV What is an Efficient Market? !andom Walk Efficient Market Theory The Evidence A"ainst Market Efficiency Behavioral #inance $essons of Market Efficiency %mplications Essentials

!et&rn to NPV
NPV employs disco&nt rates These disco&nt rates are risk ad'&sted The risk ad'&stment is a (yprod&ct of market esta(lished prices Ad'&sta(le disco&nt rates chan"e asset val&es

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!et&rn to NPV
Example The "overnment is lendin" yo& )*++,+++ for *+ years at -. and only re/&irin" interest payments prior to mat&rity0 1ince -. is o(vio&sly (elow market, what is the val&e of the (elow market rate loan?

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NPV = amo&nt (orrowed 2 PV of interest pmts 2 PV of loan repayment

!et&rn to NPV
Example The "overnment is lendin" yo& )*++,+++ for *+ years at -. and only re/&irin" interest payments prior to mat&rity0 1ince -. is o(vio&sly (elow market, what is the val&e of the (elow market rate loan?

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Ass&me the market ret&rn on e/&ivalent risk pro'ects is *+.0

*+ -,+++ *++,+++ NPV = *++,+++ t *+ : * 0 *+ 9 : * 0 *+ 9 t =* = *++,+++ 78,566 = )4-,+*3

EM;
Efficiency <how s&ccessf&l is the market in esta(lishin" share prices that reflects the =worth> of the shares?@0is new info incorporated in a rapid and &n(iased manner the speed and /&ality of price ad'&stment to new information EM; is a s&(set of the !ational EApectation ;ypothesis :!E;9 <in a competitive world, economic a"ents will eAploit all availa(le information to take advanta"e of any perceived profita(le opport&nities?@that will eliminate opport&nities for a(normal "ains

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EM;
Be"rees of efficiencyC Perfect, Near Efficiency and %nefficiency Near efficiency one that capt&res a partic&lar info set in its share prices in s&ch a way as to prevent all (&t the most skillf&l investors from earnin" eAcess ret&rns from the same information@0 :Weak, 1emi21tron" and 1tron" form9 #actors contri(&tin" to market inefficiencyC 2 The information "ap Biased !eportin" Personal EAperience2 =(eatin" the market>

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!andom Walk Theory

The movement of stock prices from day to day BD NDT reflect any pattern0 1tatistically speakin", the movement of stock prices is random (skewed positive over the
long term).

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#actors that contri(&te towards <"eneratin" prices that f&lly reflect the worth of assets (ein" traded?C

EM;
;omo"eneity all shares are viewed in terms of risks and eApected ret&rns, which provides some de"ree of compara(ility within the price str&ct&re of the sec&rities market that distin"&ishes it si"nificantly from most other markets0 This red&ces the compass of informational demand and esta(lishes the foc&s on risk and eApected ret&rns0 $ocation %ndependence val&es of shares of the same company traded in different eAchan"es is independent of location :&nlike tan"i(le assets like an apartment or a chair90 This red&ces the ran"e of investors? potential information needs0

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EM;
%nformation s&pport The o&tstandin" feat&res of any sec&rities market is <how or"aniEed and ela(orate is the information machinery which services it?0 %t concerns not only the /&ality and the amo&nt of information s&pply (&t e/&ally important is the rapidity with which the information is disseminated amon" the market participants0 This provides motivation for rapid and widespread information dissemination0

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EM;
%nterpretations a(o&t nat&re of market efficiency@00
=1&rely, the market is always ri"ht>@0 =EM; ass&mes that all investors (ehave rationally>@ =1tock market (&((les imply inefficiency>@

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EM;
%nterpretations on evidence for market efficiencyC
=Efficiency applies only to certain shares>@ =1tatistical evidence is ins&fficient>@0 =Prices are determined (y s&pply and demand>@ =Whilst there may (e little scope in the lon" term for achievin" a(ove avera"e profits, there will always (e occasional short term opport&nities>@

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!andom Walk Theory

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Efficient Market Theory

Microsoft Stock Price
)4+
Act&al price as soon as &pswin" is reco"niEed

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-+

3+ Cycles disappear once identified

$ast Month

This Month

NeAt Month

Efficient Market Theory

Weak #orm Efficiency
Market prices reflect all historical information

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1emi21tron" #orm Efficiency

Market prices reflect all p&(licly availa(le information

1tron" #orm Efficiency

Market prices reflect all information, (oth p&(lic and private

Efficient Market Theory

Fundamental Analysts
!esearch the val&e of stocks &sin" NPV and other meas&rements of cash flow Meas&res the impact of the chan"es in the market, ind&stry and the firm on the firm?s share price

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Efficient Market Theory

Technical Analysts
#orecast stock prices (ased on the watchin" the fl&ct&ations in historical prices :th&s =wiggle watchers>9

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Efficient Market Theory

Anno&ncement Bate

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Behavioral #inance
Ar(itra"e limitations2 limits for rational investors to eAploit market inefficiencies@ the risk that prices will diver"e even f&rther (efore they conver"e $TCM eAample Why mi"ht prices depart from f&ndamental val&es? *0 Attit&des towards risk 30 Beliefs a(o&t pro(a(ilities

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$essons of Market Efficiency

Markets have no memory :weak form efficient9 Tr&st market prices :yo& cannot consistently earn s&perior ret&rns &nless yo& have inside information9 !ead the entrails :the detailed info re/&ired to assess the f&t&re prospects9 There are no financial ill&sions :investors read reported fi"&res at face val&eF000the case of #%#D and $%#D in times of increasin" inflation@9 The do it yourself alternative

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$essons of EM;
1een one stock, seen them all : BGT %nvestors (&y stock for its prospects of fair ret&rns for its risk0 The BB for stocks are &s&ally hi"hly E$A1T%CF0 %f prospects "ood everyone scram(les for the share and if prospects are not "ood, everyone avoids the share0 Block trades will affect prices &nless can convince other investors that yo& have no private information9

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Example: How stock splits affect value

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!ou"ce: Fama# Fishe"# $ensen % &oll

Market Efficiency
%mplications of a fairly efficient marketC
Earn normal ret&rns on consistent (asis No spec&lative profits %nvestment 1trate"y Passive No val&e for #&ndamental and Technical strate"ies for analysts *0 What is the difference (etween <efficiency? and
<rationality?? 30 What is meant (y <paradoA of market efficiency?? -0 %s there s&ch thin" as <a(sol&te efficiency?? Why?

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Essentials for market efficiency

*0 Characteristics of the sec&rity and the iss&er 30 Characteristics of the market in the sec&rity trades -0 The efficiency of technolo"y availa(le to analysts to "ather and process information and to trade $ar"er firms are perceived to (e more efficient than smaller firms, (eca&seC
They en'oy (etter economies of scale in prod&ction and processin" of information and as well as tradin" They en'oy lower costs of tradin", commissions and (id2ask spread They possess efficient technolo"ies to identify deviations of prices and val&e and have the means to correct these deviations /&ickly as they have efficient technolo"ies to process info and tradin"0

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Case and !eadin"s

'ase: Bill Miller and Val&e Tr&st :!efer to Pa"es 3-2-6 of the Book, Case 1t&dies in #inanceC Mana"in" for Corporate Val&e Creation, (y !o(ert #0 Br&ner, Henneth M0 Eades and Michael I0 1chill, 8th Edition, McJraw2;ill %nternational Edition, 3+*+90 A"ticlesC *0 M0 !&(instein, !ational MarketsC Kes or No?, The Affirmative Case?The #inancial Anaysts Io&rnal 7L :MayMI&ne 3++*9, ppC *72350 30 B0J0 Malkiel, Efficient Market ;ypothesis and its critics, Io&rnal of Economic Perspectives *L, Winter 3++-, ppC 752630

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