3.1 Market Efficiency

Question 1

How do we price risky CFs?

Answer 1

• CFs with “same risk” discounted at the same rate
• “Riskier” CFs are discounted at higher rates

Question 2

What did Kendall (1953) find about stock and commoditiy prices?

Answer 2

Stock prices and commodity prices (contrary to his expectation of “price cycles”) moved randomly.

Question 3

What do we call “random walk”?

Answer 3

Brownian motion. Kendall called it the “demon of chance”

Question 4

Samuelson (1965) on speculation and expectation

Answer 4

“If one could be sure that price will rise, it would already have risen” … ”speculation is doing its best because it leaves everyone with white noise”

Question 5

What does EMH state?

Answer 5

A financial market is efficient when the market prices reflect all available information about securities’ values.

Question 6

What are the three forms of EMH? Describe each.

Answer 6

• Weak form - includes all past prices
• Semi-strong from - includes all past prices and public information
• Strong form - includes all information including private information.

Question 7

What does it mean if prices reflect all information?

Equation?

Answer 7

All financial transactions at current prices are zero NPV activities,

Question 8

Implications of the weak form EMH?

Answer 8

• Future market prices cannot be predicted from the past
  
  • Prices follow random walks
  • Average returns merely compensate for time value of money and risks borne
• Technical (chart-based) trading, e.g. using trend- or other pattern-based strategies, is not consistently profitable

Question 9

Imagine a pharmaceutical company produced a cure for dementia.

What outcomes might we expect? Diagram.

Answer 9

• Overshoot and return to fair value
• Immediately rise to fair value
• Gradually rise to fair value

Question 10

Implications of the semi-strong form EMH?

Diagram.

Answer 10

• Share prices react swiftly to news such as earnings reports and mergers.
• All publicly available information about the firm is reflected in market prices.

Question 11

Why is evidence for strong form EMH weak?

Answer 11

In most developed markets, laws against insider trading - although recent development.

However, reaction to quarterly earnings announcements suggests that private information has not fully been discounted.

Question 12

Key summary points of EMH (5)

Answer 12

• Markets have no memory. Stock prices follow a random walk
• Trust market prices
  
  • Buying and selling assets are zero NPV activities
  • Market prices give the best estimate of value for projects
  • Firms receive “fair” value for securities they issue
• Use prices to find information
  
  • If market price reflects all available information, we can extract information about the future from prices
• There are no financial illusions
  
  • Prices only change when true value changes.
  • Market price reflects value only from an asset’s payout, investors are not concerned with cosmetics (stock splits, dividends, accounting changes).
• It is not easy to trick the market

Question 13

Caveats of EMH (3)

Answer 13

• In reality, markets may not be perfectly efficient.
• Limits to arbitrage
  
  • Transaction costs impede price convergence from arbitrage to a certain extent
• Long literature on anomalies
  
  • Earnings announcement, size, book-to-market, momentum, and other puzzles