Download Understanding Market Efficiency and Implications: Efficient Markets & Behavioral Finance and more Study notes Finance in PDF only on Docsity! 1 Finance and The Financial Manager Finance and the Financial Manager Chapter 12 Efficient Markets and B havioral Finance Learning objectives We always come back to NPV What is an efficient market? • Random walk • Efficient market theory Evidence against market efficiency Behavioral finance Six lessons of market efficiency NPV and the discount rate • NPV employs discount rates that adjust for risk • The risk adjustment is a by-product of established prices in financial markets • A change in risk (and hence the discount rate) changes an asset’s value Random walk theory • Stock price movements from day to day do not reflect any observable pattern. • Statistically speaking, the movement of stock prices is nearly random - with a nearly equal probability of an uptick or a downtick. – Returns measured over long horizons tend to be positively skewed (that is, with more observations in the right tail than would be expected from the normal distribution). $103.00 $100.00 $106.09 $100.43 $97.50 $100.43 $95.06 Coin Toss Game Heads Heads Heads Tails Tails Tails Random walk theory Heads ⇒ 3% Tails ⇒ -2.5% 80 120 160 200 240 280 1 Month Le ve l S&P 500 returns or an outcome of the Coin Toss Game? Random walk theory Coin toss S&P 500 Random walk theory 2 Random walk theory Efficient market theory In an efficient market… • Prices react to new information instantaneously and without bias. • Thus, prices reflects “true” or “fundamental” asset values. Last Month This Month Next Month $40 30 20 Microsoft Stock Price Cycles disappear once identified Actual price as soon as upswing is recognized 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 Efficient market theory • Fundamental Analysis – Fundamental analysts research the value of stocks using NPV and other measurements of cash flow (e.g., FI 857 Security Analysis) • Technical Analysis – Technical analysts forecast stock prices based on observed fluctuations in prices Efficient market theory -16 -11 -6 -1 4 9 14 19 24 29 34 39 Days Relative to annoncement date C um ul at iv e A bn or m al R et ur n (% ) Announcement date Efficient market theory