PowerPoint PresentationKey Concepts and SkillsChapter Outline13.1 A Description of Efficient Capital MarketsFoundations of Market EfficiencyStock Price ReactionsSlide 713.2 The Different Types of EfficiencyWeak Form Market EfficiencyWhy Technical Analysis FailsSemistrong Form Market EfficiencyStrong Form Market EfficiencyInformation SetsWhat the EMH Does and Does NOT SaySlide 1513.4 The EvidenceAre Changes in Stock Prices Random?What Pattern Do You See?Event StudiesSlide 20Event Studies: Dividend OmissionsEvent Study ResultsThe Record of Mutual FundsSlide 24The Strong Form of the EMH13.5 The Behavioral ChallengeThe Behavioral ChallengeSlide 2813.6 Empirical ChallengesEmpirical Challenges13.6 Reviewing the Differences13.8 Implications for Corporate FinanceImplications for Corporate FinanceWhy Doesn’t Everybody Believe?Quick Quiz13-1EFFICIENT CAPITAL MARKETS AND BEHAVIORAL CHALLENGESChapter 13Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.13-2KEY CONCEPTS AND SKILLS•Articulate the importance of capital market efficiency•Define the forms of efficiency•Know the empirical tests of market efficiency•Describe the implications of efficiency for corporate finance managers13-3CHAPTER OUTLINE13.1 A Description of Efficient Capital Markets13.2 The Different Types of Efficiency13.3 The Evidence13.4 The Behavioral Challenge to Market Efficiency13.5 Empirical Challenges to Market Efficiency13.6 Reviewing the Differences13.7 Implications for Corporate Finance13-413.1 A DESCRIPTION OF EFFICIENT CAPITAL MARKETS•An efficient capital market is one in which stock prices fully reflect available information.•The EMH has implications for investors and firms.•Since information is reflected in security prices quickly, knowing information when it is released does an investor little good.•Firms should expect to receive the fair value for securities that they sell. Firms cannot profit from fooling investors in an efficient market.13-5FOUNDATIONS OF MARKET EFFICIENCY•Investor Rationality•Independence of events•Arbitrage13-6STOCK PRICE REACTIONSStock Price-30 -20 -10 0 +10 +20 +30Days before (-) and after (+) announcementEfficient market response to “good news”Overreaction to “good news” with reversionDelayed response to “good news”13-7STOCK PRICE REACTIONSStock Price-30 -20 -10 0 +10 +20 +30Days before (-) and after (+) announcementEfficient market response to “bad news”Overreaction to “bad news” with reversionDelayed response to “bad news”13-813.2 THE DIFFERENT TYPES OF EFFICIENCY•Weak Form•Security prices reflect all historical information. •Semistrong Form•Security prices reflect all publicly available information.•Strong Form•Security prices reflect all information—public and private.13-9WEAK FORM MARKET EFFICIENCY•Security prices reflect all information found in past prices and volume.•If the weak form of market efficiency holds, then technical analysis is of no value.•Since stock prices only respond to new information, which by definition arrives randomly, stock prices are said to follow a random walk.13-1013-10WHY TECHNICAL ANALYSIS FAILSStock PriceTimeInvestor behavior tends to eliminate any profit opportunity associated with stock price patterns.If it were possible to make big money simply by finding “the pattern” in the stock price movements, everyone would do it, and the profits would be competed away.SellSellBuyBuy13-11SEMISTRONG FORM MARKET EFFICIENCY•Security prices reflect all publicly available information.•Publicly available information includes:•Historical price and volume information•Published accounting statements •Information found in annual reports13-12STRONG FORM MARKET EFFICIENCY•Security prices reflect all information—public and private.•Strong form efficiency incorporates weak and semistrong form efficiency.•Strong form efficiency says that anything pertinent to the stock and known to at least one investor is already incorporated into the security’s price.13-13INFORMATION SETSAll informationrelevant to a stockInformation setof publicly availableinformationInformationset ofpast prices13-14WHAT THE EMH DOES AND DOES NOT SAY•Investors can throw darts to select stocks.•This is almost, but not quite, true.•On average an investor will not be able to achieve an abnormal or excess return•An investor must still decide how risky a portfolio he wants based on risk aversion and expected return.•Prices are random or uncaused.•Prices reflect information. •The price CHANGE is driven by new information, which by definition arrives randomly. •Therefore, financial managers cannot “time” stock and bond sales.13-15WHAT THE EMH DOES AND DOES NOT SAY•Stockholder Disinterest•Many are skeptical that the market is efficient because only a fraction of shares trade each day•But, as long as traders who believe there is a reason to incur the cost of a trade participate in the market it remains efficient•Further, stock price reflects available information (i.e., is efficient) as long as a number of interested traders use the available information13-1613.4 THE EVIDENCE•The record on the EMH is extensive, and, in large measure, it is reassuring to advocates of the efficiency of markets.•Studies fall into three broad categories:1. Are changes in stock prices random? Are there profitable “trading rules?”2. Event studies: Does the market quickly and accurately respond to new information?3. The record of professionally managed investment firms.13-17ARE CHANGES IN STOCK PRICES RANDOM?•Small serial correlation coefficients support weak form efficiency and randomness•Can we really tell?•Many psychologists and statisticians believe that most people do not understand what randomness looks like•People claiming to see patterns in stock price movements are probably seeing optical illusions.•A matter of degree•Even if we can spot patterns, we need to have returns that beat our transactions costs.•Random stock price changes support weak form efficiency13-1813-18WHAT PATTERN DO YOU SEE?13-19EVENT STUDIES-Event Studies are one type of test of the semistrong form of market efficiency.•Recall, this form of the EMH implies that prices should reflect all publicly available information. -To test this, event studies examine prices and returns over