5. Market Efficiency, Noise Traders and Limited Arbitrage

Question 1

What does Efficient Market Hypothesis mean

Answer 1

• Where security prices at any time “Fully Reflect” all
  available information.
• Fama 1970

Question 2

What role does information play in EMH?

Answer 2

• It’s important for investors to value each asset.

Question 3

How are stock price changes accounted for in EMH?

Answer 3

• Investors receive new information are are revising expectation.

Question 4

What is rational expectation in EMH?

Answer 4

• Investors do not make systematic errors.

Question 5

What are the arguments for EMH?

Answer 5

• Forecasting with no systematic errors.
• Noise trades are cancelled out.
• Rational arbitrage can eliminate irrational traders.

Question 6

What are the three forms of EMH?

Answer 6

• Weak form
• Semi-Strong form
• Strong form

Question 7

What is strong form EMH?

Answer 7

• Market prices reflect all information relevant to the security.

Question 8

Assumptions/Characteristics of Strong Form EMH

Answer 8

• 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

Question 9

How is EMH strong form a close equivalent to allocative efficiency?

Answer 9

• 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.

Question 10

Price/Market Mechanism |(Signalling)

Answer 10

• 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.

Question 11

Price/Market Mechanism (Incentive)

Answer 11

• 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.

Question 12

Price/Market Mechanism (Rationing)

Answer 12

• 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.

Question 13

What are the challenges on Strong Form EMH?

Answer 13

• 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.

Question 14

What is Semi-Strong form EMH?

Answer 14

• 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.

Question 15

What is weak form EMH?

Answer 15

• Market prices reflect all the past trading information relevant to the security.

Question 16

Assumptions/Characteristics of Weak form EMH

Answer 16

• 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.

Question 17

What are the implications for investing in EMH?

Answer 17

• Hot tips: information set
• Excessive trading: commissions costs.
• Mutual fund: management fees, sales commissions.

Question 18

How can behavioural finance/economics argue against rational expectation?

Answer 18

• Applying psychology to decisions: investors are irrational and show behavioural biases.
• Limits to arbitrage: preventing rational arbitrage.

Question 19

Arbitrage

Answer 19

• 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.

Question 20

What does behavioural finance/economics show against EMH? (EVAL)

Answer 20

• Shows that the market is not efficient.
• Investors make systematic errors.
• Market prices can be systematically and persistently deviating from fundamental values.

Question 21

How may arbitrageurs be limited from eliminating from behavioural biases of irrational crowd?

Answer 21

• 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.

Question 22

How can flashcard 21 lead to persistent mispricing?

Answer 22

• 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.

Question 23

What examples of biases/behaviours from psychology can explain this?

Answer 23

• 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.

Question 24

How expectations are formed is important because expectations influence?

Answer 24

• Demand for Assets.
• Bond Prices
• Risk structure of interest rates.
• Term structure of interest rates.

Question 25

What does the term “random walk” describe?

Answer 25

• Stocks prices are for all practical purposes unpredictable.

Question 26

What does Strong - EMH suggest?

Answer 26

• 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.

Question 27

What is Loss Aversion?

Answer 27

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.

Question 28

The EMH is that in an efficient market….

Answer 28

• Unexploited profit opportunities will be quickly eliminated.

Question 29

Implications of the Strong view of Market Efficiency in an efficient market

Answer 29

• 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.