5. Market Efficiency, Noise Traders and Limited Arbitrage Flashcards
What does Efficient Market Hypothesis mean
- Where security prices at any time “Fully Reflect” all
available information. - Fama 1970
What role does information play in EMH?
- It’s important for investors to value each asset.
How are stock price changes accounted for in EMH?
- Investors receive new information are are revising expectation.
What is rational expectation in EMH?
- Investors do not make systematic errors.
What are the arguments for EMH?
- Forecasting with no systematic errors.
- Noise trades are cancelled out.
- Rational arbitrage can eliminate irrational traders.
What are the three forms of EMH?
- Weak form
- Semi-Strong form
- Strong form
What is strong form EMH?
- Market prices reflect all information relevant to the security.
Assumptions/Characteristics of Strong Form EMH
- All investors have held the best information currently available on anything that may impact the firm’s performance and the investors’ decisions.
- Including both public and private information: insider trading isn’t relevant.
- Asymmetric information is fully mitigated by the market mechanism and prices are always correct.
- A close equivalent to allocative efficiency
How is EMH strong form a close equivalent to allocative efficiency?
- Prices guide resource allocation.
- Firms with over/under priced equity and bonds pay less/more for capital than is socially optimal and hence over/under borrow.
- Informational inefficiency leads to distortion of capital allocation.
Price/Market Mechanism |(Signalling)
- Price perform this; they adjust to demonstrate where resources are required.
- Prices rise and fall to reflect scarcities and surpluses.
- If prices are rising because of high demand from consumers, this signals suppliers to expand production to meet higher demand.
Price/Market Mechanism (Incentive)
- Through choices consumers send information to producers about their changing nature of needs and wants.
- Decision making is decentralised, no single body is responsible for deciding what to produce and in what quantities.
Price/Market Mechanism (Rationing)
- Prices ration scarce resources when demand outstrips supply.
- When there is a shortage, price is bid up - leading those with willingness and ability to pay to buy.
What are the challenges on Strong Form EMH?
- Grossman and Stiglitz 1980
- No profit in arbitraging (costly gathering info and research) in strongly efficient markets.
- Should be some inefficiency (profit opportunities) remaining to compensate market participants for such activities.
What is Semi-Strong form EMH?
- Market prices reflect all publicly available information relevant to the security.
- No “free lunch” for information acquisition.
- Market prices react quickly and rationally to all “new” public information: fundamentals in the past do not alter the price.
- Asymmetric information is not fully mitigated: prices are not necessarily at welfare maximising level.
What is weak form EMH?
- Market prices reflect all the past trading information relevant to the security.
Assumptions/Characteristics of Weak form EMH
- Investors quickly learn all the patterns in price movements in the past, thus eliminating these patterns.
- Prices form a random walk.
- Investors cannot use historic market trading data to ‘beat’ the market.
- Prices are not at a social welfare maximising level.
What are the implications for investing in EMH?
- Hot tips: information set
- Excessive trading: commissions costs.
- Mutual fund: management fees, sales commissions.
How can behavioural finance/economics argue against rational expectation?
- Applying psychology to decisions: investors are irrational and show behavioural biases.
- Limits to arbitrage: preventing rational arbitrage.
Arbitrage
- The simultaneous purchase and sale of the same of similar asset in different markets in order to profit from tiny differences in the asset’s listed price.
- Exploits short-lived variations in the price of identical or similar financial instruments in different markets or in different forms.
What does behavioural finance/economics show against EMH? (EVAL)
- Shows that the market is not efficient.
- Investors make systematic errors.
- Market prices can be systematically and persistently deviating from fundamental values.
How may arbitrageurs be limited from eliminating from behavioural biases of irrational crowd?
- Fundamental risk: no perfect substitutes assets to hedge for arbitrage.
- Noise trader risk: can be large and persistent enough to force rational traders to quit.
- Implementation costs: trade commissions, shot-sale constraints, cost of identifying mispricing.
How can flashcard 21 lead to persistent mispricing?
- Some even public information may not be fully priced-in.
- Arbitrageurs don’t always choose to act.
- Noise/irrational traders can survive in the long run.
What examples of biases/behaviours from psychology can explain this?
- Overconfidence and self-deception: under-diversification, winner’s curse over private signals, more aggressive following success. Self-attribution short run continuation of stock returns and long-run reversal.
- Representativeness and Conservatism: heuristic learning, over/under reaction, momentum and reversals.
- Sentiments and feelings: seasonal mood.
- Prospect theory, ambiguity aversion and hyperbolic discounting.
How expectations are formed is important because expectations influence?
- Demand for Assets.
- Bond Prices
- Risk structure of interest rates.
- Term structure of interest rates.
What does the term “random walk” describe?
- Stocks prices are for all practical purposes unpredictable.
What does Strong - EMH suggest?
- Investors should not try to outguess the market by constantly buying and selling securities.
- Investors do better on average if they adopt a “buy and hold” strategy.
- Buying into a mutual fund is a sensible strategy for a small investor.
What is Loss Aversion?
The unhappiness of a person feels when they suffer a monetary loss and it excess the happiness the same person experiences from receiving a monetary gain of the same amount.
The EMH is that in an efficient market….
- Unexploited profit opportunities will be quickly eliminated.
Implications of the Strong view of Market Efficiency in an efficient market
- One investment is as good as any other because the securities’ prices are correct.
- Security prices can be used by managers if both financial and non financial firms to assess their cost of capital (cost of financing their investments) accurately.
- A security’s price reflects all available information about he intrinsic value of the security.
