Financial economics

Equilibrium in
Capital Markets

Chapters 11 & 12
 Learning outcomes

1 Understand the concept of market efficiency.

2 Be able to make rational investment decisions based
upon efficient markets.
3 Have a thorough understanding of the many tests of
market efficiency.
4 Be able to describe the forms of market efficiency, and
observed market anomalies.
5 Be able to identify and describe the key errors made by
individuals in processing information.
6 Explain the premise of behavioural finance.

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 Learning outcomes (cont)

7 Discuss the criticism against behavioural finance.

8 Discuss the linkages between behavioural finance and
the phenomenon of socially responsible investing.
9 Indicate how behavioural finance can influence the
construction of a portfolio.
10 Be able to explain the biases uncovered by
psychologists.
11 Demonstrate the ability to use the different types of
technical indicators that are used in the market.

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 Chapter Eleven Overview

 What is market efficiency?

 Are securities fairly priced?
 Is it possible that investors outperform market?
 Implications of market efficiency for investors
 Studies of efficient capital hypothesis

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 Random Walks and the
Efficient Market Hypothesis
 Maurice Kendall (1953) found no predictable pattern in
stock price changes
 Likelihood of price going up = likelihood of price going
down on any particular day
 How do we explain random stock price changes?
 EMH Share prices reflect all available information
 A forecast about favourable future performance leads to
favourable current performance, as market participants
rush to trade on new information
 Result Prices change until expected returns
exactly match risk
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 Random Walks and the EMH (cont)
 New information unpredictable
 If predicted, then prediction part of today’s information
 Share prices change in response to new (unpredictable)
information – prices also move unpredictably
 Share price changes follow random walk

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 EMH and Competition
 Information: Most precious commodity on Wall Street

 Strong competition prices reflect information

 Information-gathering motivated by desire for higher

investment returns

 Marginal return on research activity may be so small that

only managers of largest portfolios will find them worth
pursuing

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 Versions of the EMH
 Weak
 Historical data included in share prices
 Technical analysis useless
 Semi-strong
 Publicly available info included in share price
 Fundamental analysis useless
 Strong Semi-
Weak
Strong strong
 All info reflected in share form form
form
set set
 prices as well as info set

 available to insiders
 All versions assert that prices should reflect available
information
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 Implications of the EMH
 Technical analysis
 Use prices and volume information to predict future
prices look for patterns
 Key Success depends on sluggish response of
share prices to fundamental supply-and-demand
factors
 Share prices reflect historical info in weak form
efficiency

 Relative strength
 Compare share performance over period to
performance of market/other share

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 Implications of the EMH
 Resistance and support levels
 Price levels above or below which is unlikely to
break through

Resistance level

Support level

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 Implications of the EMH
 Fundamental Analysis – using economic and accounting
information to predict stock prices
 Try to find firms that are better than everyone else’s
estimate
 Try to find poorly run firms that are not as bad as the
market thinks
 Share prices reflect fundamental analysis info and
past data in semi-strong form efficiency market

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 Implications of the EMH
 Active versus passive portfolio management
 Active Management
 An expensive strategy
 Suitable only for very large portfolios
 Passive Management
 No attempt to outsmart the market
 Accept EMH
 Index Funds and ETFs
 Very low costs

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 Implications of the EMH (cont)

 Role of portfolio management in an efficiency market

 Regardless of form of market efficiency, portfolio
management important
 Diversification
 Eliminate firm-specific risk (diversifiable risk,
unsystematic risk)
 Tax considerations
 Investors in higher tax brackets may favour
capital gains over steady income from dividends
and coupons
 Appropriate risk level
 Risk profile of investor (risk-taker vs risk-averse,
age) 13
 Implications of the EMH (cont)

 Resource allocation
 If markets inefficient and securities mispriced,
resources systematically misallocated
 Firm with overvalued securities can raise capital too
cheaply
 Firm with undervalued securities may have to pass up
profitable opportunities because cost of capital is too
high
 Efficient market ≠ perfect foresight market

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 Event studies
 Empirical financial research enables us to assess impact
of a particular event on a firm’s share price

 Abnormal return due to event = difference between

share’s actual return and proxy for share’s return in
absence of event

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 Event
 Structure of tests
 Returns adjusted to determine if they are abnormal
 Market Model approach

 Expected return = Average rate of return of stock in

period with zero market return + (beta x Market
return) + security’s return resulting from firm-
specific events

rt = a + brMt + et

 Abnormal Return = Actual return – Expected return

et = rt – (a + brMt) 16
 Event studies
 Example:
 Suppose that the analyst has estimated that a =
0.07% and b = 0.9
 What is expected return if you predict the market to
go up by 1%?
rt = a + brmt + et
rt = 0.07+ (0.9 x 1)
= 0.97
 If share price actually rises by 3%, calculate the
additional return caused by the firm-specific news on
that day et = rt – (a + brMt)
et = 3 – (0.07 +
0.9 x 1)
= 2.03%
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 Event studies
 Assume the following: Company with market value of
$100 million falls by 4% on day news of an accounting
scandal surfaces. Rest of market, however, generally
does well that day. Market indexes up sharply and on
basis of usual relationship between stock and market, a
2% gain on stock expected.

 Conclusion: Impact of scandal was a 6% drop in value,

difference between 2% gain expected and 4% drop
actually observed. Infer that damages sustained from
scandal were $6 million, because value of firm after
adjusting for general market movements, fell by 6% of
$100 million when investors become aware of news and
reassessed value of stock. 18
 Are markets efficient?
 Three factors influencing market efficiency
 Magnitude issue
 Only managers of large portfolios can earn enough
trading profits to make the exploitation of minor
mispricing worth the effort
 Manages R5b portfolio, improve performance by
0.1% pa earnings of R5m annually
 Selection bias issue
 Only unsuccessful investment schemes made
public
 Good schemes remain private
 Lucky event issue
 Superior performance pure luck
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 Weak-form tests
 Returns over the short horizon
 Momentum effect Good or bad recent
performance continues over short to intermediate time
horizons in aggregate market and across particular
securities
 Returns over Long Horizons
 Negative L-T serial correlation in performance of
aggregate market “fads” hypothesis stating that
stock market might overreact to relevant news
 Episodes of overshooting followed by correction
 Reversal effect winners and losers swop places

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Predictors of broad market returns
 Fama and French
 Aggregate returns higher with higher dividend ratios
 Campbell and Shiller
 Earnings yield predict market returns
 Keim and Stambaugh
 Bond yield spreads for high- and low-grade bonds
predict broad market returns
 Fama and French Yield spread for low-grade
bonds greater predictive power than high-grade bond
yield spread

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 Semistrong tests: Anomalies
 Anomaly Patterns of returns contradicting EMH
 P/E Effect
 Low P/E portfolios provide higher returns than high P/E
portfolios
 Small Firm Effect
 Investments in shares of small firms appear to have
earned abnormal returns
 Neglected-Firm Effect and Liquidity Effects
 Investments in shares of less well-known firms have
generated abnormal returns
 Book-to-Market effect
 Tendency of shares of firms with high ratios of book-to-
market value to generate abnormal returns
 Post-Earnings Announcement Price Drift
 Earn abnormal returns by waiting for earnings news
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 Strong-form tests: Inside
Information
 Jaffe, Seyhun, Givoly, and Palmon Ability of
insiders to trade profitably in their own shares
documented

 SEC requires all insiders to register their trading activity

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 Interpreting anomalies
 Most puzzling anomalies
 Price-earnings
 Small-firm effect
 Market-to-book effect
 Momentum and long-term reversal effect
 Fama and French
 Effects explained by risk premiums
 Lakonishok, Shleifer, and Vishney
 Effects evidence of inefficient markets

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 Interpreting evidence
 Anomalies or data mining?
 Some anomalies disappeared
 Book-to-market, size and momentum may be real
anomalies
 Anomalies over time
 Attempts to exploiting anomalies move prices to
eliminate abnormal profits
 Chordia, Subramanyam and Tong
 Some anomalies disappeared over time
 Weakening of alphas greatest in most liquid
securities where trading activity is least costly

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 Interpreting evidence
 Bubbles and market efficiency
 Prices appear to differ from intrinsic values
 Rapid run up followed by crash
 Bubbles difficult to predict and exploit

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 Stock market analysts
 Some analysts may add value, but:
 Difficult to separate effects of new information from
changes in investor demand
 Findings may lead to investing strategies that are too
expensive to exploit

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 Mutual fund performance
 Conventional performance benchmark today four-factor
model, which employs:
 Three Fama-French factors (return on market index,
and returns to portfolios based on size and book-to-
market ratio)
 Plus momentum factor (a portfolio constructed based
on prior-year stock return)

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 Mutual fund performance (cont)
 Consistency in mutual fund performance
 Fama and French use 4-factor model
 Alphas positive before fees, negative after
 Cahart
 Minor persistence in relative performance across
managers
 Persistence due to expenses and transactions costs
 Bollen and Busse
 Support for performance persistence over short time
horizons
 Berk and Green
 Skilled managers attract new funds until costs of
managing those extra funds drive alphas down to
zero
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 Are markets efficient?
 Performance of professional managers broadly
consistent with market efficiency
 Most managers do not do better than passive strategy
 Exceptions to the rule
 Peter Lynch
 Warren Buffett

Study unit 6, Chapter 12 to follow … 30

 Chapter Twelve Overview
 Conventional vs behavioural finance
 Information processing and behavioral irrationalities
 Limits to arbitrage and bubbles in behavioural
economics
 Technical analysis and strategies

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 Behavioural Finance

Conventional Finance Behavioral Finance

 Prices correct and  What if investors don’t
equal to intrinsic value behave rationally?
 Resources allocated
efficiently
 Consistent with EMH

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 The Behavioural Critique

 Two categories of irrationalities

 Investors do not always process information correctly
 Result: Incorrect probability distributions of future
returns
 Even when given a probability distribution of returns,
investors may make inconsistent or suboptimal
decisions
 Result: They have behavioural biases

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 Errors in information processing:
Misestimating true probabilities
1 Forecasting Errors Too much weight is placed on
recent experiences

2 Overconfidence Investors overestimate their

abilities and the precision of their forecasts

3 Conservatism Investors are slow to update

their beliefs and under react to new information

4 Sample Size Neglect and Representativeness

Investors too quick to infer a pattern or trend from a
small sample

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 Behavioural Biases: Examples

1 Framing
 How risk is described, “risky losses” vs “risky gains”, can
affect investor decisions
2 Mental Accounting
 Investors may segregate accounts or monies and take
risks with their gains that they would not take with their
principal
3 Regret Avoidance
 Investors blame themselves more when an
unconventional or risky bet turns out badly
4 Prospect Theory
 Conventional view – Utility depends on level of wealth
 Behavioural view – Utility depends on changes in
current wealth
 Limits to Arbitrage
 Behavioural biases would not matter if rational
arbitrageurs could fully exploit mistakes of behavioural
investors
 Fundamental Risk
 “Markets can remain irrational longer than you can
remain solvent”
 Intrinsic value and market value may take too long to
converge

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 Limits to Arbitrage
 Implementation Costs
 Transactions costs and restrictions on short selling
can limit arbitrage activity
 Model Risk
 What if you have a bad model and market value is
actually correct?

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 Limits to Arbitrage and the
Law of One Price
 Siamese Twin Companies
 Royal Dutch should sell for 1.5 times Shell
 Have deviated from parity ratio for extended periods
 Example of fundamental risk
 Equity Carve-outs
 3Com and Palm
 Arbitrage limited by availability of shares for shorting
 Closed-End Funds
 May sell at premium or discount to NAV
 Can also be explained by rational return expectations
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Bubbles and Behavioral Economics
 Bubbles easier to spot after they end
 Dot-com bubble
 Housing bubble

 Rational explanation for stock market bubble using

dividend discount model:

D1
PV0 
kg

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Bubbles and Behavioral Economics
 Example: Near peak of dot-com boom in 2000,
dividends paid by firms included in S&P 500 totaled
$154.6 million. If discount rate for index was 9.2% and
expected dividend growth was 8%, value of these
shares according to constant growth discount model
would be

Value = D / (k – g)
= $154.6 / (0.092 – 0.08)
= $12 883 million

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Bubbles and Behavioral Economics
 Value close to actual total value of firms. But estimate is
highly sensitive to input values and even a small
reassessment of prospects would result in big revision of
price. Assume expected dividend growth rate fell to 7.4%
(decline of 0.6% from 8%). Value of index

Value = D / (k – g)
= $154.6 / (0.092 – 0.074)
= $8 589 million

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 Technical Analysis and
Behavioural Finance
 Technical analysis attempts to exploit recurring and
predictable patterns in share prices
 Prices adjust gradually to a new equilibrium
 Market values and intrinsic values converge slowly
 Disposition effect – tendency of investors to hold on to
losing investments
 Demand for shares depends on price history
 Can lead to momentum in share prices

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 Technical Analysis: Trends and
Corrections
 Momentum and moving averages
 Moving average is average level of prices over a
given interval of time, where interval is updated as
time passes
 Bullish signal – market price breaks through
moving average line from below, it is time to buy
 Bearish signal – when prices fall below moving
average, it is time to sell
 Visit https://za.investing.com/equities/ to view
charts of share prices

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 Technical Analysis: Relative
Strength
 Relative strength
 Measures extent to which a security has out- or
underperformed either market as a whole or its
particular industry
Relative strength = Security price .

Industry price index

Month Stock A (4 shares) Stock B (2 shares) Relative strength
1 $100 $100 1.00
2 96 96 1.00
3 88 90 0.98
4 88 80 1.10
5 80 78 1.03
6 76 76 1.00 44
 Technical Analysis: Relative
strength
 Breadth
 Often measured as spread between number of
shares that advance and decline in price
 Visit
https://www.wsj.com/market-data/stocks/marketsdiary
– look at NYSE at the number of advances and
number of declines (latest close)

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 Technical Analysis: Sentiment
Indicators
 Trin Statistic – ratios above 1.0 bearish

Volume declining
Number declining
Trin =
Volume advancing
Number advancing

 Visit https://www.wsj.com/market-data/stocks/
marketsdiary – look at NYSE at the number of
advances, number of declines, volume of advances and
volume of declines

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 Technical Analysis: Sentiment
Indicators
 Confidence Index
 Ratio of average yield on 10 top-rated corporate
bonds divided by average yield on 10 intermediate-
grade corporate bonds
 Higher values bullish

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 Technical Analysis: Sentiment
Indicators
 Put/Call Ratio
 Calls right to buy

 A way to bet on rising prices

 Puts right to sell

 A way to bet on falling prices

 Rising ratio may signal investor pessimism and a

coming market decline
 Contrarian investors see a rising ratio as a buying
opportunity
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 Technical Analysis:
A Warning
 Possible to perceive patterns that really don’t exist
 Figure 12.6A based on real data
 Graph in panel B generated using “returns” created by
random-number generator

 Figure 12.7 shows obvious randomness in weekly price

changes behind two panels in Figure 12.6

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