Global Financial Management Campbell R Harvey Fuqua School of Business Duke University charveymaildukeedu httpwwwdukeeducharvey Overview Market Efficiency Theory of efficient markets ID: 656788
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Slide1
Market Efficiency and
Performance Evaluation
Global Financial Management
Campbell R. Harvey
Fuqua School of Business
Duke University
charvey@mail.duke.edu
http://www.duke.edu/~charveySlide2
Overview
Market Efficiency
Theory of efficient markets
Types of market efficiency
Evidence
Implications
Measuring Mutual Fund Performance
Performance measuresSlide3
The Net Present Value Rule
Investment
Projects
Primary
Market
Secondary
Market
NPV of
project
NPV of
financing
NPV of share
purchase
PV cash
inflows
Money
raised
Value of
shares
Initial
Investment
Value of
liability
Price of
shares
=
=
=
-
-
-
Competitive
Advantage
Competition
in Capital Markets
NPV of projects can be positive
NPV of transactions is zero
Prices are "fair"Slide4
Three Forms of Market Efficiency
Prices reflect all
information from
past prices
Prices reflect all
publicly available
information
Prices reflect all
relevant available
information
Technical Analysis
is valueless
Fundamental
Analysis isunprofitable
Insider Tradingis unprofitableWeak FormSemi-strong FormStrong FormSlide5
Weak Form Efficiency: Tests
A market is weak form efficient if current prices
reflect all information contained in past prices
and price movements.
Implications
Past prices cannot predict price movements in the future.
Trading rules based on technical analysis cannot yield superior returns.
Tests
Tests of correlation of prices.
Tests of trading rules.Slide6
Head and Shoulders Pattern
Stock
Price
TimeSlide7
Bollinger Bands
12/31
02/19
04/09
05/29
07/18
09/06
70
75
80
85
90
95
100
105
110
Price ($)
IBM Bollinger BandsSlide8
Studies on the Correlation of Markets
Elton/Gruber, 15.2, p. 409Slide9
Weak Form: Summary
Evidence in favor
Implications:
Technical rules are useless.
If the price of a stock has just gone up or down, then it does not follow that it will go up or down in the future.
Reason:
If technical rules worked, everyone would use them. As a result
they would not work anymore.
This does
not
imply:Prices are “uncaused”.Markets do not behave according to rules.Investors are incompetent.Slide10
Semi-Strong Form Efficiency
A market is semi-strong form efficient if all
publicly available information is reflected in market prices.
Implications:
Market reacts to information about companies
’
fundamentals
Macroeconomic news.
News on earnings.
Price adjustments are fast and appropriate: no systematic under/overshooting after announcement.
Tests:
Event studies of price reactions to news announcements.Tests of asset pricing modelsJoint hypothesis problemSlide11
Semi-Strong Form Evidence
Event Studies
Earnings announcements.
Dividend announcements.
Leading indicators.
Stock splits.
Accounting changes.
Mergers and acquisitions.
Corporate reconstructions.
Block sales.
Rights issues.
Share tips.Slide12
Macroeconomic Announcements
Time Content of Annoucement
9.15 am Industrial Production
Capacity Utilization
10.00 am Business Inventories
Construction Spending
Factory Inventories NAPM Survey
New Single-Family Home Sales
Personal Income
2.00 pm Federal Budget
no fixed time: Instalment Credit
Time Content of Annoucement8.30 am Consumer Price Index Durable Goods Orders Employment Gross National Product Housing Starts Merchandise Trade Deficit Leading Indicators Producer Price Index Retail SalesSlide13
Reaction to Macroeconomic Announcements
Question
How quickly do markets absorb information? Is the reaction appropriate?
Method
Investigate reaction of futures markets on Treasury bonds, dollar and deutche marks traded on CBOT and CME.
Results
Almost all the price adjustment takes place in the first minute after the announcement (eg for
CPI between 8.30 and 8.31.
Later adjustments cannot be predicted from earlier reactions
No systematic over or underreaction;
No profitable trading on news.Slide14
Semi-Strong Form Conclusions
Evidence
Unbiased evaluation by investors.
Pre-announcement information leakage.
Rapid adjustment to new information.
Implications
Fundamental analysis is valueless
Unless it is original, or it incorporates private information.
Check if price has already moved
If not, must be able to act fast!Slide15
Strong Form Efficiency
A market is strong form efficient if all relevant information
(public or private) is reflected in market prices.
Implications:
Analysts
’
knowledge doesn
’
t help.
No profits from insider trading.
Tests:
Profitability of trading on inside information.Performance of fund managers.Slide16
Strong Form Evidence
Fund managers
’
peformance:
Mutual funds
Pension funds
Specialists and insiders
Market makers
Corporate officers
Analysts
’
skillsAdvisory servicesInternal researchTransactions analysisAnalyze mutual fund performanceImplications for semi-strong form efficiencySlide17
Mutual Fund Styles
Aggressive Growth
Growth
Growth-Income
Income-Growth
Balanced
IncomeSlide18
Style and Beta RiskSlide19
Style and VolatilitySlide20
Style and Average ReturnsSlide21
Jensen
’
s Alpha
From the CAPM:
Any expectation can be written as a realized value plus a shock:
Check intercept of the regression model:
If fund managers have no additional information we should have:Slide22
Measuring Mutual Fund Performance
Return
of Fund
Beta
1.0Slide23
Historical Performance of Mutual FundsSlide24
Distribution of AlphasSlide25
Distribution of t-StatisticsSlide26
Portfolio Manager Ability
Stock Picking
Stock-picking ability:
Can the manager identify which stocks
will outperform the market or the industry?Slide27
Portfolio Manager Ability
Market-Timing
Market-timing ability:
Can the manager identify turning points between bull and bear markets?Slide28
Perfect Market-Timing AbilitySlide29
Sharpe Ratios
Idea: use the Capital Market Line
If markets are efficient
and
CAPM holds, return/risk ratio should be the same for all assets
The
Sharpe Ratio
is the ratio of excess returns to volatility:
Compare the Sharpe Ratio for a particular fund to that of the market (or appropriate benchmark):Slide30
Ex-Post Sharpe RatiosSlide31
The Treynor Measure
Idea: use the security market line:
If markets are efficient
and
CAPM holds, all assets should lie on SML
The
Treynor Measure
is the ratio of excess returns to systematic risk:
Compare the Yreynor Measure for a particular fund to that of the market (or appropriate benchmark):Slide32
b
i
E[r
i
]
SML
r
f
ABC
XYZ
M
Ex post Treynor index
higher than the market
Ex post Treynor index
lower than the market
The Treynor MeasureSlide33
Graham-Harvey Measures
Create a portfolio of S&P500 futures contracts and a money market account that matches the volatility of the particular mutual fund.
Lever the mutual fund volatility to match the S&P500 futures volatility by borrowing or lending.
In each case, compare the returns of the two portfolios. Slide34
Graham-Harvey MeasureSlide35
Mutual Fund Performance:
New Evidence
Issue
Investigate forecasting ability of individual managers:
“
hot
”
hands and
“
icy
”
hands in stock picking.TestDoes the past performance of a fund predict its future performance: correlation between returns.Results Underperformance is more persistent than outperformance of the market.Past return data help to predict the future relative performance of the fund.Even funds with “hot hands” do only marginally better than the market.Conclusion Invest in index funds, not in actively managed funds.Source: Hendricks et. al. (1993)Slide36
Performance PersistenceSlide37
Investment Newsletter Performance
Graham and Harvey (1995) study the performance of recommendations of 200 investment newsletters.
Given the evidence on market efficiency, what should we expect?
Even if the newsletter writers have inside information - should we expect to make money by following their recommendations? Slide38
Performance of All NewslettersSlide39
Performance of Long-Lived NewslettersSlide40
Ability to Time Bull Markets
0%
10%
20%
30%
40%
50%
60%
70%
-30%
-20%
-10%
0%
10%20%
Percent of letters which increased weights in each month
Performance of Newsletter Strategies
Graham and Harvey (1995)
Fitted Regression
Line
Monthly S&P500
ReturnSlide41
Ability to Time Bear MarketsSlide42
Implications of Market Efficiency
There Are No Money Machines
Hence:
Don
’
t pay a premium for acquisitions unless you can add value.
Don
’
t use the capital structure to speculate on market movements:
international borrowing to speculate on currencies.
Debt structure, swaps, and timing to speculate on interest rates.
Don’t manipulate accounts to boost earnings.Slide43
Implications of Market Efficiency
Trust Market Prices
Hence:
Treat market prices as values; assume price changes reflect information or the value of management actions.
Use the market
’
s free forecasts
’
to value projects using market currency and interest rate forecasts.