Corporate Finance Lecture 10 Shama-e Zaheer Capital Market Efficiency & Alternate Risk Theories Capital Market Efficiency

Stock prices fully reflect all available information in an efficient market. Foundations Rationality: New information is a !uste instantaneously by investors in con!unction with e"istin# information an stock prices accor in#ly a !ust. $rbitrary %n epen ent &eviations from Rationality: Not all players in the market have to be completely rational' even if some are irrational( as lon# as the irrationality is arbitrary( i.e. there is no common pattern( an in epen ent( i.e. one)s irrationality es not epen on or affect others( the eviations woul ten to cancel each other out on avera#e. $rbitra#e: $rbitra#e is riskless profit throu#h simultaneous purchase an sale at ifferent pries of i entical *or even same+ securities. Sophisticate players( hopin# to e"ploit market inefficiencies *if any+( woul sell overprice an buy un erprice stocks( which woul lea to their prices a !ustin# automatically. ,herefore( the possibility of arbitra#e makes the market efficient. Forms -eak .orm: $ capital market is weak-form efficient if it fully incorporates past ata. Mathematically( /t 0 /t-1 2 E*R+ 2 Ran om Error ,he ran om components are unrelate amon#st themselves( an is sai to follow a 3ran om walk3. Test: ,est for serial correlation or autocorrelation between the aily stock returns. %f the market is efficient( hi#her than avera#e return woul not necessarily be consistently followe by hi#her-than-avera#e returns *positive autocorrelation+ or lower-than-avera#e return *ne#ative autocorrelation+. Speculators who o not believe markets are weak form efficient( use technical analysis( the stu y of patterns( to pre ict stock prices. Semistron#: $ capital market is semistron# form efficient if it fully incorporates all public ata *past an present+. E.#. %f a firm announces a new investment opportunity( the price shoul imme iately rise followin# the announcement( an no one woul be able to buy at a lower price to take a vanta#e of the new info. Test: 4Event Stu ies3 are common tests for semistron# market efficiency. ,est for C$R *Cumulative $bnormal Return 5$R 0 Ri 6 Rm7 to see if abnormal returns persist beyon ate t for an announcement at ate t. Speculators who o not believe markets are semistron# form efficient( use fun amental analysis( the stu y of firm performance ata( to pre ict stock prices.

Stron#: $ capital market is stron# form efficient if it fully incorporates all ata( public an private. Test: ,est for abnormal returns ma e throu#h insi er tra in#. $rbitra#e /ricin# ,heory Each stock)s return epen s on pervasive macroeconomic factors an partly on 8noise)( that is uni9ue to the company. Return 0 a 2 b1*r.1+ 2 b:*r.:+ 2 b;*r.;+ 2 < 2 noise E*Risk /remium+ 0 r 6 rf 0 b1*r.1 6 rf+ 2 b:*r.: 6 rf+ 2 b;*r.; 6 rf+ 2 < %f the returns across portfolios i not hol ( arbitra#e woul be possible( until the returns reache the correct level. ,he risk premium associate with each factor is calculate from factor analysis of past macroeconomic an market ata. ,he factor sensitivities *b-s+ are calculate for each stock or portfolio usin# re#ression analysis. .ama-.rench ,hree-.actor Mo el .ama an .rench came up with a similar cate#ory mo el: r 6 rf 0 bmarket*rmarket factor+ 2 bsi=e*rsi=e factor+ 2 bbook-to-market*rbook-to-market+ $part from the market portfolio return( small firms return more than lar#e firms an hi#her book-to-market ratio firms *vale stocks+ return more than lower book-to-ratio firms *#rowth stocks+. Economic >alue $ e *E>$+ Measure of financial performance base on cost of capital. E>$ 0 E?%,*1-t+ 6 5-$CC @ *&2E+7 E>$ is earnin#s after capital costs. E>$ forces mana#ers to consi er financin# cost in evaluatin# performance. E>$ also un erstan s the importance of scale( unlike other measures( e.#. RA$.