Share Price Behaviour & Informational Efficiency PDF

Topic 5 Share price behaviour and informational efficiency Lectures 11 & 12 1 Share price behaviour: lecture aims 1. To show how to calculate investment performance—calculating investment returns over single and multi-periods 2. To consider summary measures of return and how to measure return variab...

Topic 5 Share price behaviour and informational efficiency Lectures 11 & 12 1 Share price behaviour: lecture aims 1. To show how to calculate investment performance—calculating investment returns over single and multi-periods 2. To consider summary measures of return and how to measure return variability/volatility 2 Investment performance & share returns Return on an investment = gain/loss from the investment The holding period rate of return on an investment/security over a single holding period of length t 3 Pt = price/value of the security at the end of period t Ct = any cash payment—such as a dividend or interest—from the security during t Pt-1 = price at the beginning of t , adjusted to the same basis as Pt Pt + Ct − Pt −1 Pt + Ct Rt =  −1 Pt −1 Pt −1 4 Example: Medlock Plc 1/1/18–30/6/18: Pt-1 =490, Pt =510, Dt =4.5 6-month return 510 + 4.5 − 490 Rt = = 0.05  5% 490 annualised return (1 + 0.05) 12 / 6 − 1 = 10.25% 5 SAQ Over the 9 month period up to November 2018 Progen Plc’s share price fell from 472.5p to 268p. Progen paid a dividend of 7.5p at the end of November. What return would an investor in Progen have made (a) over the 9 months, and (b) on an annualised basis? Pt + Ct − Pt −1 268 + 7.5 − 472.5 (a) R t = = = −41.7% Pt −1 472.5 (b) (1 − 0.417) (12 / 9 ) − 1 = −51.3% 6 Multi-period and average returns R1 , R2 , …, RT (0.04, –0.03, 0.01, 0.12, 0.16) Holding period return over 1 to T 1 1 R T = [(1 + R 1 )  (1 + R 2 )    (1 + R T )] − 1 R 5 = [(1.04)(0.97)(1.01)(1.12)(1.16)] − 1 = 32.37% 7 Average return—two types Arithmetic average R1 +  + R T RA = T 0.04 + (−0.03) + 0.01 + 0.12 + 0.16 = = 6% 5 Geometric average R G = [(1 + R 1 )    (1 + R T )] (1 / T ) −1 = [(1.04)(0.97)(1.01)(1.12)(1.16)]1/ 5 − 1 = 5.77% 8 Characteristics of return Two main characteristics of return – (arithmetic) average return: measures what you expect to earn each period as things even out over time – standard deviation of return or return variability or volatility: gives a measure of how far from the average you expect the return to be in any one period standard deviation = (variance)1/2 9 Calculating historical sample standard deviation 1. Find the deviation of each return from the arithmetic average, R t − R 2 ( R − R ) 2. Square these, t 3. Add to get the sum of squared deviations, (R 1 − R ) 2 + (R 2 − R ) 2 +  + (R T − R ) 2 4. Divide by T – 1 to get an unbiased estimate of the variance and take the square root to get the standard deviation T 1 2 s 2 (R ) = ( R − R )  t T − 1 t =1 s( R ) = s 2 ( R ) 10 Example: Calculating St. Deviation 1. Find the deviation of each return from the arithmetic average, R t − R 0.04 -0.03 0.01 Period 1 2 3 4 5 Sum Return 0.04 -0.03 0.01 0.12 0.16 0.3 Average SUM/5 0.06 0.12 0.04 + (−0.03) + 0.01 + 0.12 + 0.16 = 6% 0.16 5 Diff Ret-Ave 0.04-0.06 -0.03-0.06 0.01-0.06 0.12-0.06 0.16-0.06 Diff Ret-Ave -0.02 -0.09 -0.05 0.06 0.1 11 2. Square these, (R t − R ) 2 Diff RetPeriod Return Ave 1 0.04 -0.02 2 -0.03 -0.09 3 0.01 -0.05 4 0.12 0.06 5 0.16 0.1 Sum 0.3 Average SUM/5 Squared Diff (-0.02)^2 (-0.09)^2 (-0.05)^2 (0.06)^2 (0.1)^2 Squared Diff 0.0004 0.0081 0.0025 0.0036 0.01 0.06 12 3. Add to get the sum of squared deviations, Sum : ( R1 − R ) + ( R2 − R ) +  + ( RT − R ) 2 Period 1 2 3 4 5 Sum Return 0.04 -0.03 0.01 0.12 0.16 0.3 Average SUM/5 0.06 2 Diff RetAve -0.02 -0.09 -0.05 0.06 0.1 Sum 2 Squared Diff 0.0004 0.0081 0.0025 0.0036 0.01 0.0246 13 4. Divide by T – 1 to get an unbiased estimate of the variance and take the square root to get the standard deviation T 1 2 2 s 2 (R ) = ( R − R ) s( R ) = s ( R )  t T − 1 t =1 Period 1 2 3 4 5 Sum Average SUM/5 Return 0.04 -0.03 0.01 0.12 0.16 0.3 Diff RetAve -0.02 -0.09 -0.05 0.06 0.1 Sum Squared Diff 0.0004 0.0081 0.0025 0.0036 0.01 0.0246 0.06 T-1 1/T-1 5-1=4 0.25 Variance 0.25*0.0246 0.00615 St Dev SQRT of Var 0.078422 ST Dev; 7.84% 14 Summary Stock return is the most useful measure of investment performance useful measures of multi-period performance are the arithmetic and geometric average return Important summary characteristics of risky returns are (arithmetic) return and standard deviation (volatility) of return. 15 Informational Efficiency: aims of lecture 1. To consider why share prices change: share prices and informational efficiency 2. To explain how share prices behave if markets are informationally efficient 3. To explain how share prices behave if markets are informationally inefficient 16 Price behaviour and information Why do share prices change? Informational efficiency (IE) or capital market efficiency 1. Prices reflect all information available to investors 2. Prices react immediately to reflect new information 17 Implications of IE for investors – prices are the best indicators of value— prices reflect fundamentals – active traders, on average, perform no better than passive investors – uninformed investors can expect a fair return implications of inefficiency? 18 Price behaviour share price Overreaction and subsequent correction Underreaction and gradual adjustment Informationally efficient reaction 0 Date relative to announcement Price movements in response to good news announced at date 0 19 Observations on IE 1. IE  prices respond immediately to information – example 2. Only the unexpected (surprise) part of any news is information announcement = expected part + surprise part 3. Can we predict returns ( price changes)? – need to be careful about the question … 20 On average, shares promise positive returns to compensate for risk  we expect positive returns Can we predict unexpected returns (returns that are different from the level required to compensate for the risk involved)? IE  you cannot predict unexpected returns—unexpected price changes are random... 21 Why does IE  random price changes? 1. IE means prices change unexpectedly only to new information 2. New information, by definition, is independent of previous information  unexpected price changes must be unrelated to previous changes (random) Price changes v. unexpected price changes 22 Informational inefficiency Prices systematically underreact or overreact with subsequent correction We can therefore predict unexpected returns We can earn returns above the level required to compensate for risk Unexpected price changes are nonrandom  there are regularities/anomalies in (unexpected) price changes 23 Summary Informationally efficient prices impound all currently available information and react immediately to reflect new information IE  you cannot predict future unexpected returns 24