8- Evidence on market (in)efficiency Flashcards
What are the 3 requirements for market efficiency?
-Rational investors
-Investors’ errors are uncorrelated
-No arbitrage
What does it mean in market efficiency that investors are rational?
Agents trade based on fundamentals and not price extrapolations
How does financial forecasting/analysis differ to other fields such as the weather?
Financial forecasting/analyses itself influences the system it is looking at like Schrodingers cat
What is noise trading?
Trading done for reasons other than information and pricing e.g. business reasons
Describe noise trading in currency markets
Majority of FX participants are non-speculative, they are businesses and fund managers making intermediary transactions in the currency market
Describe noise trading in equity markets
Large real money players may have to rebalance their portfolios and sell equities based on idiosyncratic reasons such as composition of pensioners
Describe noise trading in commodities/rates
Corporates may trade in commodities/rates markets to hedge their idiosyncratic exposures with no fundamental directional views
What are the 2 main benefits of noise trading?
-Provides liquidity
-Provides counterparts for informed traders
Why does noise trading benefit informed traders?
If the market was solely made up of informed traders operating with the same information (and hence view) then there’d be no one to take the other side of their trade
Why can noise be correlated (sentiment)?
Social pressures to buy/sell assets, there is evidence of fear of missing out with large portfolio managers overweighting assets they do not have fundamental conviction in because of career risk
What is noise?
Opinion on value unrelated to fundamental information
How can smart-money traders exploit noise trading and sentiment?
-An arbitrage opportunity realises, with over- (under-) valuation
-Smart traders anticipate this, and buy (sell), contributing even more to the build-up of sentiment
-Prices go up (down), and this positive-feedback creates an illusion
-Uninformed traders may fall prey of this illusion and buy (sell) right now
-At some point the fundamentals should become evident to all
-Smart money exits the trade early enough to make a positive profit
-Noise traders are late and lose money when the arbitrage close
What does evidence suggest on correlations across time horizons?
-Short-term (one month): reversal
-Medium-term (several months): momentum
-Long-term (years): reversal
Describe a prominent piece of empirical evidence on reversals
De Bondt & Thaler (1985) chose 50 best and worst performing stocks, by comparing them to the market benchmark over three years- Losers outperformed
What are 2 main limitations of trading models?
-Transaction costs
-Assets can be listed on different exchanges, with different times (gap risk)
