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Chap 05

This chapter discusses market efficiency and anomalies that challenge the efficient market hypothesis. It presents evidence of long-term reversals where past losers outperform winners, momentum where recent performance continues in the short-term, and post-earnings announcement drift where surprises are followed by continued price movement. Behavioral explanations are given for these effects, including representativeness bias and over/under-reaction. The chapter also examines limits to arbitrage and whether managers' actions suggest they believe markets are inefficient.

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52 views29 pages

Chap 05

This chapter discusses market efficiency and anomalies that challenge the efficient market hypothesis. It presents evidence of long-term reversals where past losers outperform winners, momentum where recent performance continues in the short-term, and post-earnings announcement drift where surprises are followed by continued price movement. Behavioral explanations are given for these effects, including representativeness bias and over/under-reaction. The chapter also examines limits to arbitrage and whether managers' actions suggest they believe markets are inefficient.

Uploaded by

Zara Faryal
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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Chapter 5

INEFFICIENT MARKETS AND


CORPORATE DECISIONS

Behavioral Corporate Finance


by Hersh Shefrin

1
Traditional Approach to
Market Efficiency
 The risk premium for a security is the
additional expected return, over and above
the risk-free rate, that investors require in
order to compensate them for risk.
 When the additional expected return
exceeds the risk premium, investors are
said to earn a positive abnormal return.

2
Cont…

 The efficient-market hypothesis holds that


investors cannot expect to make abnormal returns
because market prices correctly reflects the
information available to the market as a whole.
 Market efficiency is subtle and involves three
different versions:
 weak-form efficiency
 semi strong-form efficiency
 strong-form efficiency.

3
Cont…

 Weak-form efficiency pertains to


information in past prices, semistrong-
form efficiency to all publicly available
information, and strong-form efficiency to
all information including the information
held by insiders.

4
Cont…

 In the traditional framework, rational


investors smart money constantly
monitor markets for abnormal profit
opportunities.
 The buying of underpriced securities and
selling of overpriced securities, is known
as (risky) arbitrge.

5
Cont…

 Arbitrage will eliminate the opportunities


as smart money bids up the prices of
underpriced securities and bids down the
prices of overpriced securities.
 Therefore, in the traditional view,
inefficiencies will be small, temporary,
and unpredictable.

6
Cont…

 This is because a firm whose market


value of equity lies below its book value
of equity is more likely to be facing
financial distress than a firm whose
market value of equity lies above its book
value of equity.

7
The Market Efficiency
Debate: Anomalies
 An issue of great debate between
finance traditionalists and behaviorists is
whether or not markets are efficient.
 Traditionalists contend that markets are
efficient in the sense that departures
from efficiency are temporary, small, and
infrequent.

8
Cont…

 Behaviorists contend that because of the


behavioral phenomena, there are
particular circumstances in which
departures from efficiency are likely to be
large and occur for long periods of time.

9
Long-Term Reversals:
Winner-Loser Effect
 Winner-Loser Effect: Extreme past losers
tend subsequently to outperform the market,
and extreme past winners tend subsequently
to underperform the market.
 Behaviorists suggest that the winner-loser
effect occurs because representativeness
leads investors to exhibit extrapolation bias in
respect to prior earnings.

10
Cont..

 In the behavioral perspective, investors


overreact to stocks that have been past
losers, causing those stocks to become
undervalued.
 By the same token, investors overreact
to past winners, causing those stocks to
become overvalued.

11
Momentum: Short-Term
Continuation
 Momentum: recent losers tend
subsequently to underperform the
market, and recent winners tend
subsequently to outperform the market.

12
Cont…

 Behaviorists view short-term momentum


as evidence against weak-form efficiency
and propose three possible explanations
for its occurrence:
 The first explanation is that analysts and investors
under react to new information.
 A second explanation is that subsequent to a news
event and the initial market reaction, overconfident
investors overreact to later events.

13
Cont…

 A third explanation for momentum is based on


investors who behave in accordance with prospect
theory. In the event of good news about a stock,
risk aversion predisposes investors to sell the stock
at a gain relative to the original purchase price,
thereby retarding the increase in price.

14
Cont…

 Underreact: The percentage change in


market price in response to an event is
too small.
 Overreact: The percentage change in
market price in response to an event is
too large.

15
Post-Earnings-
Announcement Drift
 Post-earning-announcement drift: The
stocks of firms giving rise to positive
earnings surprises experience positive
drift after the announcement, while the
stocks of firms giving rise to negative
earnings surprises experience negative
drift after the announcement.

16
Cont…

 Post-earnings-announcement drift is a
phenomenon that illustrates both short-term
continuation and long-term reversal.
 Post-earnings-announcement drift features
momentum for a year after the first earnings
surprise, but reversal after a year.
 In other words, momentum continues for up to
12 months and is then followed by reversal.

17
Cont…

 Given that earnings constitute nonprice


public information, behaviorists interpret
post-earnings-announcement drift as
evidence against semistrong-form
efficiency.

18
Limits of Arbitrage

 Limits of Arbitrage: Smart investors do


not fully exploit mispricing because of the
attendant risks that the mispricing will
become larger before it becomes smaller.
 Arbitrage is the process of exploiting
mispricing, essentially buying low and
selling high.

19
Do Managers Trust Prices?

 Managers appear to behave as if they believe


markets are inefficient.
 Managers indicate that they would reject
positive NPV projects if accepting those
projects would lower their firm’s EPS.
 Managers split their stocks, even though doing
so has no value when markets are efficient.
 Managers time IPOs to take advantage of hot
issue markets.

20
Market Efficiency, Earnings
Guidance, and NPV
 Financial managers routinely disclose
information to security analysts in a
process called guidance
 Among the most important information
that managers disclose is the managers’
own forecasts of what future earnings
per share will be for their firms.

21
Cont…

 For this reason, managers are able to


influence stock prices by choosing to
disclose information to analysts and
investors.
 Net present value (NPV), when properly
computed, measures incremental
intrinsic value.

22
Cont…

 In an efficient market, maximizing NPV is


equivalent to maximizing market value.
 When prices are inefficient, maximizing NPV
based on cash flows might not be the same
as maximizing the market value of the firm.
 As a result, market inefficiency can present
financial managers with a dilemma.

23
Stock Splits

 According to the efficient-market view, a


firm that splits its stock should not expect
to see an abnormal change in its market
value of equity.
 However, it turns out that there is
positive drift associated with stock splits.

24
Example: Tandy’s Stock
Split
 Firms that announce stock splits are
much less likely to experience a decline
in future earnings, relative to firms with
comparable characteristics.

25
To IPO Or Not To IPO

26
Three Phenomena

 IPO decisions take place against the


backdrop of three phenomena: a hot issue
market, initial underpricing, and long-term
underperformance.
 Hot issue market: Demand for new issues is
relatively high.
 Initial underpricing: The offer price is too
low, resulting in a large first-day price pop.

27
Cont…

 Long-Term underperformance: New


issues earn lower returns than stocks
with comparable characteristics against
which they have been matched.

28
The end

29

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