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Information• Business results• Next year performance plan• Dividends•• M&A Change in personnel Financial•• Capital raising: bond issuance, stock issuance Employee stock option plan (ESOP) Market• Law suits• Industry structure• Other changes that affect the business Price
React to HowInformation Investors Stock Price Overreaction to “good news” with reversion Delayed response to “good news” Efficient market response to “good news” -30 -20 -10 0 +10 +20 +30 Days before (-) and after (+) announcement
React to HowInformation Investors Efficient market Stock Delayed response to “bad news” Price response to “bad news” -30 -20 -10 0 +10 +20 +30 Overreaction to “bad Days before (-) and after (+) news” with reversion announcement
Information 1. All historical information 2. All public information 3. All public and private information FirmIf market is efficient, Price should reflect Information Price
Information 1. All historical information: Weak form 2. All public information: Semi-strong form 3. All public and private information: Strong form FirmIf market is efficient, Price should reflect Information Price
Information 1. All historical information: Weak form 2. All public information: Semi-strong form 3. All public and private information: Strong form Arrives randomly FirmIf market is efficient, Price should reflect Information Price
A note on Technical Analysis Technical analysts believe there are patterns in asset price movements. Technical analysts try to forecast future prices using these patterns.
Weak Form Market Efficiency• Since stock prices only respond to new information, which by definition arrives randomly, stock prices are said to follow a random walk. Past prices• Technical analysis: no value. Past volume
Why Technical Analysis is of no valueStock Price Sell Sell Buy Follow Profit Everybody Compe-titio Profit is elimina patterns would do it n -ted Buy Time Investor behavior tends to eliminate any profit opportunity associated with stock price patterns.
Semi-Strong Form Market Efficiency• All publicly available information Published accounting Statements Annual Report Past prices Past volume
Semi-Strong Form Market Efficiency• All information: public and private All other• Strong form efficiency says information that anything pertinent to the Published accounting stock and known to at least Statements Annual one investor is already Report incorporated into the security’s price. Past prices Past volume
Implications• Investors can throw • Prices are random or darts to select stocks. uncaused. – This is almost, but not – Prices reflect information. quite, true. – The price CHANGE is – An investor must still driven by new decide how risky a information, which by portfolio he wants based definition arrives on risk aversion and randomly. expected return. – Therefore, financial managers cannot “time” stock and bond sales.
Doubts? Does the marketAre stock quickly and Records of prices accurately investmentrandom? respond to firms new information?
Doubts? Optical illusions: Many psychologists andAre stock statisticians believe that prices most people want to seerandom? patterns even when faced with pure randomness.
Event StudiesEvent studiesare tests of Does thesemi-strong marketform quickly and accurately respond to new information?
Event StudiesThe studies Studies suggestgenerally that markets Does the may even havesupport the view some foresightthat the market market into theis semi-strong quickly and future, i.e., newsform efficient. accurately tends to leak out in advance of respond to public new announcements. information?
Doubts?Strong form: public and private information Use private information: insider tradingEvidence: insider trading Records ofis profitable investment firms Not many do it Strong form doesnt hold
React toInformation Irrational Investors Representativeness: drawing Buy/sellconclusions from too little data financial instruments • Fail to diversify e.g. see a jump in a stock and • Trade too much believe that stock will rise • Holder losers • Sell winners => maximize taxes Conservativism: hold on to positions / old beliefs
Small stocks vs. large stocksSeasonality Evidences against EMH Value stocks vs. growth stock
Implications for Corporate Finance1. The price of a companys stock cannotbe affected by a change in accounting2. Financial managers cannot "time" issuesof stocks and bonds using publiclyavailable information3. A firm can sell as many shares of stocksor bonds as it desires without depressingprices