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î Do security prices reflect relevant information
fully and immediately?
± What kind of information?
‡ Past prices, trading volume, etc î Weak form EMH
‡ Public information announced î Semi-strong EMH
‡ Private information of managers î Strong EMH
± Competition assures prices to reflect information
‡ Once information becomes available, market
participants analyze it and trade on it

’
Ô

 



   

î Ñmplications for investment
± Will it be possible to beat the market consistently over time?
‡ Ñn efficient markets, technical trading rules should not work
since all of the past information is contained in current prices
± Empirical evidence is mixed
‡ Evidence of overreaction or underreaction to information, etc.
î Do stock prices follow random walk?
± Stronger assumption than the EMH
± Ñn fact, EMH allows a submartingale process
‡ Expected price is increasing over time
‡ Positive trend and random about the trend
î Ñmplications for corporate finance and business
± Should be difficult to find a project with positive NPVs
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î ·ctive Management
± Security analysis
‡ Technical analysis î Market timing
‡ Fundamental analysis î Stock selection
î Passive Management
± Buy and Hold
± Ñndex Funds
î Empirical evidence
± Ñnvesting in passively managed funds such as index fund has
outperformed actively managed funds for the last several decades.
± What does this imply?
‡ Ñt is difficult to beat the market consistently over time

 
 

c



î Stock prices fully and accurately reflect publicly

available information
î Once information becomes available, market
participants analyze it
î Competition assures prices reflect information

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î Even if the market is efficient, there exists a
role for portfolio managers
± Find an optimal portfolio on the efficient frontier
‡ Two-fund separation theorem
± Maintain appropriate risk level
± Tax considerations

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± Use prices and volume information to predict future prices

± Mainly for market timing purpose
± Related to the weak form efficiency
î Î   


± Use economic and accounting information to predict stock prices

± Mainly for stock selection purpose
± Related to the semi-strong form efficiency
± This includes
‡ Economic ·nalysis
‡ Ñndustry ·nalysis
‡ Security ·nalysis

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î Weak form efficiency
± Test profitability of some trading rules to see whether past price
or volume contains useful information
î Semi-strong form efficiency
± Perform event studies around important announcements to see
whether public information is reflected immediately
î Strong form efficiency
± ·ssess performance of professional managers or insiders to see
whether they have superior information unknown to public
investors

§

ô  
î Examine prices and returns over time
± Serial correlation?
± Seasonality?
± ·ny predictability?
î Calculate abnormal returns around event windows
± Using the market model, estimate the following:
a. Rt = at + btRmt + et
î Expected Return = at + btRmt
î Excess Return = ·ctual ± Expected return
= (at + btRmt + et) ± (at + btRmt) = et
b. Cumulate the excess returns over event windows
Õ
 




















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î Returns over short horizons

± Very short horizons (over a couple of weeks)
‡ Small magnitude of positive trends and reversals
± 3~12 months
‡ Some evidence of positive momentum
î Returns over long horizons (over 3~5 years)
± Pronounced negative correlation, i.e., reversals

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 ~


 






  
î Possible explanations?
± Time-varying risk premium vs. market inefficiency?
± Ñndustry effect?
± Under-reaction to information? (behavioral finance)

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î Ñncrease up to one-year after the portfolio formation,

and then, reverse thereafter.




    
 
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î Small Firm Effect (January Effect)

î Book-to-Market ratios
î Earnings-to-price ratios
î Cash flow-to-price ratios
î Dividend-to-price ratios
î Post-Earnings ·nnouncement Drift

Õ 
 ^^


î Why does the small firm effect concentrate in
January?

Õ]
 å  
 
î Value vs. Growth stocks ± Value premium?
î Fama-French 3-factor model ± MKT, SMB, HML

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î Under-reaction to earnings announcements?

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î Does the stock split add value to the firm?
± Ñnformation leakage prior to the event

Õ§
 ô   

 



 

î Some evidence of persistent positive and
negative performance of mutual funds
î Potential measurement problems
± Performance depends on investment style, e.g.,
momentum, value strategies, etc.
± Could be compensation for risk
î Superstar phenomenon
± Only a small portion survives

’
 Ñ


  ô  

î Risk premiums or market inefficiencies

± More relevant question is
³How efficient is the market?´
î True anomalies or data mining
î Behavioral Ñnterpretation
± Ñnefficiencies exist
± Caused by human behavior

’Õ
 å







î Forecasting Errors
î Overconfidence
î Regret avoidance
î Loss aversion (disposition effect)

’’