Portfolio Management - Chapter 9

8/3/2019 Portfolio Management - Chapter 9

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Chapter 9

The Capital Markets and Market Efficiency

Prof. Rushen Chahal 1

Prof. Rushen Chahal



The notion that science, left to itself, is bound toevolve more and more of the truth about the

world is another illusion, for science can never exist outside a society, and that society, whether

deliberately or unconsciously, directs its course.

- Northrop Frye




Outline

Introduction

Role of the capital markets

Efficient market hypothesis Anomalies




Introduction

Capital market theory springs from the notion

that:

±

People like return

± People do not like risk

± Dispersion around expected return is a reasonable

measure of risk




Role of the Capital Markets

Definition

Economic function

Continuous pricing function Fair price function




Definition

Capital markets trade securities with lives of more than one year

Examples of capital markets

± New York Stock Exchange (NYSE)

± American Stock Exchange (AMEX)

± Chicago Board of Trade ± Chicago Board Options Exchange (CBOE)




Economic Function

The economic function of capital markets

facilitates the transfer of money from savers

to borrowers

± E.g., mortgages, Treasury bonds, corporate stocks

and bonds




Continuous Pricing Function

The continuous pricing function of capital

markets means prices are available moment

by moment

± Continuous prices are an advantage to investors

± Investors are less confident in their ability to get a

quick quotation for securities that do not tradeoften




Fair Price Function

The fair price function of capital marketsmeans that an investor can trust the financialsystem

± The function removes the fear of buying or selling at an unreasonable price

± The more participants and the more formal themarketplace, the greater the likelihood that thebuyer is getting a fair price




Efficient Market Hypothesis

Definition

Types of efficiency

Weak form

Semi-strong form

Strong form

Semi-efficient market hypothesis

Security prices and random walks




Definition

The efficient market hypothesis (EMH) is the

theory supporting the notion that market

prices are in fact fair

± The EMH is perhaps the most important paradigm

in finance




Types of Efficiency

O perational efficiency measures how well

things function in terms of speed of execution

and accuracy

± It is a function of the number of order that are lost

or filled incorrectly

± It is a function of the elapsed time between thereceipt of an order and its execution




Types of Efficiency (contd)

I nformational efficiency is a measure of howquickly and accurately the market reacts tonew information

± It relates directly to the EMH

± The market is informationally very efficient

Security prices adjust rapidly and accurately to newinformation

The market is still not completely efficient




Weak Form

Definition

Charting

Runs test




Definition

The weak form of the EMH states that it is

impossible to predict future stock prices by

analyzing prices from the past

± The current price is a fair one that considers any

information contained in the past price data

± Charting techniques or of no use in predicting stock prices




Definition (contd)

Example

Which stock is a better buy?


Stock A

Stock B

Current Stock Price



Definition (contd)

Example (contd)

Solution: According to the weak form of the EMH, neither stock

is a better buy, since the current price already reflects all past

information.




Charting

People who study charts are technical

analysts or chartists

± Chartists look for patterns in a sequence of stock

prices

± Many chartists have a behavioral element




Runs Test

A runs test is a nonparametric statisticaltechnique to test the likelihood that a series of price movements occurred by chance

± A run is an uninterrupted sequence of the sameobservation

± A runs test calculates the number of ways an observed number of runs could occur given the

relative number of different observations and theprobability of this number




Conducting A Runs Test


1 2

1 2

1 2 1 2 1 2

2

1 2 1 2

1 2

where number of runs2

1

2 (2 )

( 1)

, number of observations in each category

standard normal variable

R x Z

R

n n x

n n

n n n n n n

n n n n

n n

Z

W

W

!

!

!

!

!

!



Semi-Strong Form

The semi-strong form of the EMH states that

security prices fully reflect all publicly

available information

± E.g., past stock prices, economic reports,

brokerage firm recommendations, investment

advisory letters, etc.




Semi-Strong Form (contd)

Academic research supports the semi-strong form of the EMH by investigating variouscorporate announcements, such as:

± Stock splits

± Cash dividends

± Stock dividends

This means investor are seldom going to beatthe market by analyzing public news




Strong Form

The strong form of the EMH states that

security prices fully reflect all public and

private information

This means even corporate insiders cannot

make abnormal profits by using inside

information

± I nside information is information not available to

the general public




Semi-Efficient

Market Hypothesis The semi-efficient market hypothesis (SEMH)

states that the market prices some stocks

more efficiently than others

± Less well-known companies are less efficiently

priced

± The market may be tiered

± A security pecking order may exist




Security Prices and

R

andomW

alks The unexpected portion of news follows a

random walk

± News arrives randomly and security prices adjust

to the arrival of the news

We cannot forecast specifics of the news very

accurately




Anomalies

Definition

Low PE effect

Low-priced stocks

Small firm effect

Neglected firm effect

Market overreaction

January effect




Anomalies (contd)

Day-of-the-week effect

Turn-of-the calendar effect

Persistence of technical analysis

Chaos theory




Definition

A financial anomaly refers to unexplained

results that deviate from those expected

under finance theory

± Especially those related to the efficient market

hypothesis




Low PE Effect

Stocks with low PE ratios provide higher

returns than stocks with higher PEs

Supported by several academic studies

Conflicts directly with the CAPM, since studyreturns were risk-adjusted (Basu)




Low-Priced Stocks

Stocks with a low stock price earn higher

returns than stocks with a high stock price

There is an optimum trading range

Every stock with a high stock price shouldsplit




Small Firm Effect

Investing in firms with low marketcapitalization will provide superior risk-adjusted returns

Supported by academic studies

Implies that portfolio managers should givesmall firms particular attention




Neglected Firm Effect

Security analysts do not pay as much attention

to firms that are unlikely portfolio candidates

Implies that neglected firms may offer

superior risk-adjusted returns




Market Overreaction

The tendency for the market to overreact toextreme news

± Investors may be able to predict systematic price

reversals

Results because people often rely too heavily

on recent data at the expense of the moreextensive set of prior data




January Effect

Stock returns are inexplicably high in January

Small firms do better than large firms early in the year

Especially pronounced for the first five trading

days in January




January Effect (contd)

Possible explanations:

± Tax-loss trading late in December (Branch)

± The risk of small stocks is higher early in the year

(Rogalski and Tinic)




Types of Firms in January


January

return

January return minus

average monthly return

in rest of year

January return

after adjusting for

systematic risk

S&P 500

Companies

Highly Researched 2.48% 1.63% -1.44%

Moderately

Researched

4.95% 4.19% 1.69%

Neglected 7.62% 6.87% 5.03%

Non-S&P 500

Companies

Neglected 11.32% 10.72% 7.71%



Day-of-the-Week Effect

Mondays are historically bad days for the

stock market

Wednesday and Fridays are consistently good

Tuesdays and Thursdays are a mixed bag




Day-of-the-Week

Effect (contd)

Should not occur in an efficient market

± Once a profitable trading opportunity is identified,

it should disappear

The day-of-the-week effect continues to

persist




Turn-of-the-Calendar Effect

The bulk of returns comes from the last

trading day of the month and the first few

days of the following month

For the rest of the month, the ups and downs

approximately cancel out




Persistence of

Technical Analysis Technical analysis refers to any technique in

which past security prices or other publiclyavailable information are employed to predict

future prices Studies show the markets are efficient in the

weak form

L

iterature based on technical techniquescontinues to appear but should be useless




Chaos Theory

Chaos theory refers to instances in which

apparently random behavior is systematic or

even deterministic

Econophysics refers to the application of

physics principles in the analysis of stock

market behavior

± E.g., an investment strategy based on studies of

turbulence in wind tunnels


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Portfolio Management - Chapter 9

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