Capital Markets and Information

CAPITAL MARKETS ANDINFORMATION

LECTURE 8

LEARNING OBJECTIVESLEARNING OBJECTIVES` Understand the way stock market and its participants

operate` Discuss various factors that affect share prices` Analyse the concept of efficient markets and its

significance to investors ` Reactions to arrival of information

` Understand the efficient market hypothesis and its various forms

` Discuss the anomalies (deviations from EMH) in modern ( )stock markets

WBS, 2013-14Panagiotis Dontis Charitos2

IN TODAYS LECTUREIN TODAY S LECTURE...` Topics` Role and uses of financial markets` Stock prices and information` Efficient markets` Efficient market hypothesis

F f ffi i` Forms of efficiency` Implications of EMH` Anomalies and behavioural finance` Anomalies and behavioural finance

` Conclusions


ROLE OF FINANCIAL MARKETSROLE OF FINANCIAL MARKETS` Help firms and governments raise capital by selling claims

against themselves` Share issues` Bond issues

` Provide a place where investors can act on their beliefs` Help allocate cash to where it is most productive` Help lower the cost of exchangep g


ROLE OF FINANCIAL MARKETSROLE OF FINANCIAL MARKETS` Primary markets` New securities are issued in a primary market` Initial public offerings (IPOs)` Issue facilitated by investment banker` Intermediaries between issuer and investor

` Secondary markets` Secondary markets` Markets where investors trade previously issued securities` Stock Exchanges` Stock Exchanges London Stock Exchange (LSE) New York Stock Exchange (NYSE)


STOCK EXCHANGESSTOCK EXCHANGES` Secondary, auction markets in equity shares` Provide the platform for securities trading` Listing requirements for traded firms` Specialists assigned to each traded equity to make a market

in that stockS k h li d h l` Some stock exchanges are listed themselves


STOCK MARKET INDICATORSSTOCK MARKET INDICATORS` Composite report of market behavior on a given day` Facilitate measurement of share price performance

` Dow Jones Industrial Average` Composed of 30 blue-chip stocksp p` Price-weighted index: Essentially adds the prices of 30 stocks,

divides by 30` Adjusted for stock splits, stock dividends

` Oldest, most well-known measure` Used since 1st October, 1928



` FTSE 100` The Financial Times Index

C d f 100 bl hi k` Composed of 100 blue-chip stocks` Value-weighted index` Weights based on market capitalization` Weights based on market capitalization` Adjusted for stock splits, stock dividends

` Expressed as index number relative to a base index value of d1000 (3rd January, 1984)

` Most widely used measure of UK share performance



` The list goes on` FTSE 250` FTSE ALL SHARE` FTSE ALL SHARE` S&P 500` DAX (30 blue-chip stocks)` DAX (30 blue-chip stocks)` CAC 40` IBEX 35` NIKKEI` ASX 200


BUT WHAT INFLUENCES STOCK PRICES??BUT...WHAT INFLUENCES STOCK PRICES??


EFFICIENT MARKETS: INFORMATIONEFFICIENT MARKETS: INFORMATION` Past information` Company related factors` Profits, dividends, cash flows, P/E ratios, profitability, efficiency,

growth, quality of management ,etc.` Economy related factors

GDP i h l fi ` GDP, interest rates, exchange rates, unemployment figures, status of economy, oil prices etc.

` Current information` Current information` Events

` I f ti th t b bl i f d` Information that can be reasonably inferred` Investor expectations


EFFICIENT MARKETS: QUESTIONSEFFICIENT MARKETS: QUESTIONS` How well do markets respond to new information?

` Should it be possible to decide between a profitable and p punprofitable investment given current information?

` Efficient Markets` The prices of all securities quickly and fully reflect all available ` The prices of all securities quickly and fully reflect all available

information


EFFICIENT MARKETS: ASSUMPTIONSEFFICIENT MARKETS: ASSUMPTIONS` Investors value stocks based on expectations for future

cash flows and risk involved` Information is a central issue

` Efficient Markets` The prices of all securities quickly and fully reflect all available

information and offer an expected return consistent with level of risk


EFFICIENT MARKETS: CONDITIONSEFFICIENT MARKETS: CONDITIONS` Large number of rational, profit-maximizing investors` Actively participate in the market` Individuals cannot affect security prices

` Information is costless and widely available to all participants simultaneously` Is information indeed free?

` Information is generated randomly, no leaksg y` Investors react quickly and fully to new information` What about the marginal benefits of acting on information g g

vs. the marginal costs?


EFFICIENT MARKETS: CONSEQUENCESEFFICIENT MARKETS: CONSEQUENCES` Quick price adjustment in response to the arrival of

random information makes the reward for analysis low` Prices reflect all available information` Price changes are independent of one another and move

in a random fashion` New information is independent of past


EFFICIENT MARKETS: EMHEFFICIENT MARKETS: EMH` Efficient market hypothesis (EMH)` To what extent do securities markets quickly and fully reflect

different available information?

` Three levels/forms of market efficiency (Fama, 1970)` Weak form` Market level data

` Semistrong form` P blic inf rmati n` Public information

` Strong form` All information (including private information)` All information (including private information)


EMH: WEAK FORMEMH: WEAK FORM` Prices reflect all past price and volume data

` Technical analysis, which relies on the past history of y p yprices, is of little or no value in assessing future changes in price

` Market adjusts or incorporates this information quickly j p q yand fully

` Aggressive investors believe in weak form!


EMH: SEMISTRONG FORMEMH: SEMISTRONG FORM` Prices reflect all publicly available information

` Investors cannot act on new public information after its pannouncement and expect to earn above-average, risk-adjusted returns

` Encompasses weak form as a subsetp


EMH: STRONG FORMEMH: STRONG FORM` Prices reflect all information, public and private

` No group of investors should be able to earn abnormal g prates of return by using publicly and privately available information

` Encompasses weak and semistrong forms as subsetsp g


EMH: IMPLICATIONSEMH: IMPLICATIONS` Technical analysis` In contrast with weak form EMH` Conflicting underlying assumptions:

M k d l d fl d d h i d l dj Market data already reflected vs. trends that persist gradual adjustment

` If EMH holds, technical analysis has no value` Empirical evidence cannot categorically refute technical analysis` Empirical evidence cannot categorically refute technical analysis` Nevertheless, it is extremely difficult to assess all techniques of

technical analysis


EMH: IMPLICATIONSEMH: IMPLICATIONS` Fundamental analysis` Again in contrast with EMH if semistrong form holds` No form of analysis based on publicly available information is useful` Intrinsic values already reflected in stock prices

` Only superior fundamental analysis can work` Only investors with better estimates can earn above average results` Only investors with better estimates can earn above average results` Others that make same interpretations will experience average

results


EMH: THE PARADOXEMH: THE PARADOX` Technical and fundamental analysts believe that they can

beat the market...` The paradox is that this belief facilitates market efficiency` Intuition` Investors search for mispriced securities` Upon discovery they act immediately` Information is conveyed into the market` Through buying and selling process

` If enough of this activity occurs, all information is reflected in k istock prices


MARKET ANOMALIES & BEHAVIOURAL FINANCEMARKET ANOMALIES & BEHAVIOURAL FINANCE` Anomalies: Exceptions that appear to be contrary to

market efficiency` Earnings announcements affect stock prices` Adjustment occurs before announcement but significant amount after` Contrary to efficient market because the lag should not exist

` Low P/E ratio stocks tend to outperform high P/E ratio stocks` Low P/E ratio stocks tend to outperform high P/E ratio stocks` Low P/E stocks generally have higher risk-adjusted returns` But P/E ratio is public information` But P/E ratio is public information

` Should portfolio be based on P/E ratios?` Could result in an undiversified portfolio



market efficiency` Size effect` Tendency for small firms to have higher risk-adjusted returns than

large firms

` January effect` January effect` Tendency for small firm stock returns to be higher in January ` Of 30.5% size premium, half of the effect occurs in Januaryp J y



market efficiency` The Value Line ranking system` The largest investment advisory service in U.S.` Roughly 1700 stocks are ranked (1 to 5 scale, best to worst)` Relative performance of five rankings has been very strong` Relative performance of five rankings has been very strong Category 1 outperforms category 2 and so on...

` Other anomalies are presentp` Holiday effect, turn of month, day of week etc.


MARKET ANOMALIES & BEHAVIOURAL FINANCEMARKET ANOMALIES & BEHAVIOURAL FINANCE` Behavioural finance` Rationality as a principle of behavior` Are there systematic deviations from the norms of rationality?` How do human beings make decisions?` Distortion throughout the process of decision-making I ki di ti i i th i t In making predictions, perceiving the environment

` In essence, behavioral finance is the marriage of psychology and financefinance


CONCLUSIONS ICONCLUSIONS I` Role and use of financial markets` Information flow in markets` Factors affecting stock prices

` Market efficiency and EMH` Forms - assumptionsp` Implications

` Behavioural finance and anomalies` Anomalies do exist!


CONCLUSIONS IICONCLUSIONS II


READING LISTREADING LIST` Core reading` Perks and Leiwy` Chapter 5

` Further reading` Jones*` Chapter 12

*Jones C.P. Investments: Principles and Concepts 11th ed. John Wiley & Sons


FOOD FOR THOUGHTFOOD FOR THOUGHT...

Are markets rational and/or efficient??Can large corporations affect the market? Any examples?


Can large corporations affect the market? Any examples?

Documents

Capital Markets and Information