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
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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
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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
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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)
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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
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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
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STOCK MARKET INDICATORSSTOCK MARKET INDICATORS` Composite report of market behavior on a given day` Facilitate measurement of share price performance
` 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
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STOCK MARKET INDICATORSSTOCK MARKET INDICATORS` Composite report of market behavior on a given day` Facilitate measurement of share price 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
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BUT WHAT INFLUENCES STOCK PRICES??BUT...WHAT INFLUENCES STOCK PRICES??
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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
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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
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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
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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?
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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
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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)
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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!
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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
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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
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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
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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
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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
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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
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MARKET ANOMALIES & BEHAVIOURAL FINANCEMARKET ANOMALIES & BEHAVIOURAL FINANCE` Anomalies: Exceptions that appear to be contrary to
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
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MARKET ANOMALIES & BEHAVIOURAL FINANCEMARKET ANOMALIES & BEHAVIOURAL FINANCE` Anomalies: Exceptions that appear to be contrary to
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.
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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
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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!
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CONCLUSIONS IICONCLUSIONS II
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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
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FOOD FOR THOUGHTFOOD FOR THOUGHT...
Are markets rational and/or efficient??Can large corporations affect the market? Any examples?
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Can large corporations affect the market? Any examples?