Chapter 13 PrinciplesPrinciples

ofof

CorporateCorporate

FinanceFinance

Tenth Edition

Efficient Markets and Behavioral Finance

Slides by

Matthew Will

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McGraw Hill/Irwin

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Topics Covered

We Always Come Back to NPVWhat is an Efficient Market?

– Random Walk– Efficient Market Theory

The Evidence Against Market EfficiencyBehavioral FinanceSix Lessons of Market Efficiency

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Return to NPV

NPV employs discount ratesThese discount rates are risk adjustedThe risk adjustment is a byproduct of

market established pricesAdjustable discount rates change asset

values

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Return to NPV

Example

The government is lending you $100,000 for 10 years at 3% and only requiring interest payments prior to maturity. Since 3% is obviously below market, what is the value of the below market rate loan?

Assume the market return on equivalent risk projects is 10%.

012,43$

988,56000,100

)10.1(

000,100

)10.1(

000,3000,001NPV

10

10

1

tt

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Efficient Market Theory

Weak Form Efficiency– Market prices reflect all historical information

Semi-Strong Form Efficiency– Market prices reflect all publicly available

information

Strong Form Efficiency– Market prices reflect all information, both

public and private

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Efficient Market Theory

Fundamental Analysts– Research the value of stocks using NPV and other

measurements of cash flow

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Efficient Market Theory

Technical Analysts– Forecast stock prices based on the watching the

fluctuations in historical prices (thus “wiggle wiggle watcherswatchers”)

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Efficient Market Theory

-16

-11

-6

-1

4

9

14

19

24

29

34

39

Days Relative to annoncement date

Cu

mu

lati

ve

Ab

no

rma

l Re

turn

(%

)

Announcement Date

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Efficient Market Theory

Average Annual Return on Mutual Funds and the Market Index

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Efficient Market Theory

0

5

10

15

20

First Second Third Fourth Fifth

Av

era

ge

Re

turn

(%

)

IPO

Matched Stocks

IPO Non-Excess Returns

Year After Offering

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Price AnomaliesD

evia

tion,

%Log Deviations From Royal Dutch Shell / Shell T&T Parity

1973 - 2006

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Efficient Market Theory

2000 Dot.Com Boom

883,1208.092.

6.154)( 2000 March

gr

DivindexPV

589,8074.092.

6.154)( 2002October

gr

DivindexPV

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Efficient Market Theory

1987 Stock Market Crash

119310.114.

7.16)( crash pre

gr

DivindexPV

928096.114.

7.16)( crashpost

gr

DivindexPV

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Behavioral Finance

Arbitrage limitationsLTCM example

Factors related efficiency and psychology

1. Attitudes towards risk

2. Beliefs about probabilities

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Lessons of Market Efficiency

Markets have no memoryTrust market pricesRead the entrailsThere are no financial illusionsThe do it yourself alternativeSeen one stock, seen them all

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Example: How stock splits affect value

0

5

10

15

20

25

30

35

40

Month relative to split

Cumulative abnormal return %

-29 0 30

Source: Fama, Fisher, Jensen & Roll