Risk and Risk Aversion
Initial wealth: $100,000
a) Safe investment in T-bill
W = 105,000 sure profit = 5,000 (5%)
b) Speculation
1) "price is right"
W1 = $130,000
profit = 30,000
W2 = $80,000
profit = -20,000
W1 = $150,000
profit = 50,000
W2 = $80,000
profit = -20,000
p=0.6
W=$100,000
1-p=0.4
E(W) = .6*130,000+.4*80,000= 110,000
Expected profit = 10,000 (10%)
2) "I really hate to take risk."
p=0.6
W=$100,000
1-p=0.4
E (W) = .6*150,000 + .4*80,000 = 122,000
Expected profit = 22,000 (22%)
Risk premium = 22,000 - 5,000 = 17,000 (17%)
Is average investor risk averse?
Are they different in the degree of risk aversion?
Equity premium over the last 70 years is about 8-10%. (Too high? Puzzle?)
 If you feel the urge to gamble, direct your gambling desire to investment in financial
markets. The stock market is a casino with odds in your favor. (Von Neumann)
Market Efficiency or Market Anomaly (Chapter 13)
1. Definition
a. Stock prices reflect all available information.
b. Stock prices adjust to new information rapidly, accurately and rationally
2. Three Forms of Efficient Market Hypothesis and Relationship among Three Different
Information Sets
a) Weak Form Efficient Market (Random Walk): Prices reflect information set of
past prices
-
The movement of stock prices from day to day DO NOT reflect any pattern.
Statistically speaking, the movement of stock prices is random (skewed
positive over the long term).
b) Semi-strong Form Efficient Market: Prices reflect publicly available information
c) Strong Form Efficient Market: Prices reflect all information relevant to a stock
3. Reaction of Stock Price to New Information in Efficient and Inefficient Markets
13-1
13-1
Fifth
Edition
Reaction of Stock Price to New Information
in Efficient and Inefficient Markets
Stock
Price
Corporate
Finance
Overreaction and
reversion
.
.
Delayed response
Efficient-market
response to new information
Ross
Westerfield
Jaffe
–30 –20 –10
Irwin/McGraw-Hill
0
+10 +20 +30
Days before (+) and
after (-) announcement
© The McGraw-Hill Companies, Inc., 1999
4. How come market can be efficient? I don’t read newspapers or else.
Fundamental Analysts
 Research the value of stocks using NPV and other measurements of cash flow.
Technical Analysts
 Forecast stock prices based on the watching the fluctuations in historical
prices (thus “w
wiggle watchers”).
5. Test methodology
if market is NOT efficient, easy money.
- Abnormal or superior returns, more than risk-adjusted return
Joint test of market efficiency and model of expected return
Excess expected return = 0,
where excess (or abnormal) return is measured relative to expected return
- Benchmark expected return.
a. market-adjusted excess return (Ri-Rm)
b. market model residuals (Ri,t = i + i Rm,t + i,t )
c. Risk-adjusted return, where risk is measured relative to CAPM, size, MB ratio,
etc.
Test based on
a. AAR (average abnormal return) and CAR (cumulative average abnormal return)
b. BHAR (buy and hold average return)
5. Empirical evidence
1) test of random walk (serial correlation)
2) filter rule
3) Seasonality (January, week-end, holiday, etc.)
4) small-firm effect or recent large-firm effect
5) event study
6) mutual fund performance
7) value (high Book-to-market ratio, EPS ratio) beats glamour
8) momentum or contrarian strategy
9) new issue puzzle: long-term stock returns after IPO and SEO
10) stock market crash - drop by 23% on Monday, October 19, 1987
11) trading strategy based on
Based on the time period of
a. short-term (-10,+10 days)
b. medium-term (3-12 months)
c. long-term (3-5 years)
6. Implications for Corporate Financial Managers
1)
2)
Markets have no memory.
Trust market prices. – Securities are fairly priced. c.f. over-price or underprice
-
3)
I will issue new stocks because our company's stock is over-priced.
Current stock price is the best estimate of the stock's true worth
By switching from straight-line depreciation to accelerate depreciation, I can
affect both accounting earnings and stock price.
Empirical evidence of market inefficiency: LIFO/FIFO, Change in Accruals
4)
Big hands (block trade) can sway the market.