BKM Chapter 11 Flashcards
Efficient market hypothesis (EMH)
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stock prices reflect all available information at a given point in time
Cause of stock price changes under EMH
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release of new information
Main consequence of EMH
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stock prices should follow a random walk (e.g. random & unpredictable)
Support for EMH
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competition b/w investment firms (to identify & exploit mispricing) leads to investors immediately bidding up or forcing down prices
> > suggests stock prices reflect nearly all available information
Difference between an efficient market and an efficient portfolio
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efficient market = information rapidly reflected in stock prices
efficient portfolio = highest expected return for a given level of risk
Forms of the EMH (3)
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- weak-form
- semistrong-form
- strong-form
Difference between forms of the EMH
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meaning of “all available information”
Weak-form EMH
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stock prices reflect all information that can be derived from historical data
Implication of the weak-form EMH
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trend analysis is not worthwhile
Types of data considered in weak-form EMH (3)
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- past stock prices
- trade volume
- short interest
Semistrong-form EMH
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stock prices reflect all publicly available information related to a firm’s prospects
*implies weak-form EMH
Types of data considered in semistrong-form EMH (6)
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- product lines
- quality of management
- balance sheet composition
- patents held
- earnings forecasts
- accounting practices
Strong-form EMH
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stock prices reflect all information relevant to a firm, including information only available to company insiders
*implies semistrong- and weak-form EMH
Common aspect of all forms of EMH
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prices should reflect available information
Technical analysis
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search for recurrent and predictable patterns in stock prices
*only works if stock prices are slow to respond to market forces of supply and demand
Technical analysis & efficient markets
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if markets are truly efficient, technical analysis will not work (b/c stock prices already reflect all available information)
Resistance levels in technical analysis
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values at which it is difficult for stock prices to rise above/fall below (driven by market psychology)
Self-destructing nature of price patterns
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once a useful price pattern is discovered, it is soon invalidated once it is exploited by many traders
Fundamental analysis
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using a firm’s earnings and dividend prospects + expectations of future interest rates to determine stock prices
Buy decisions in fundamental analysis
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if PV(future payments) > current stock price, then buy
Fundamental analysis & efficient markets
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under EMH, fundamental analysis will not work since it relies on publicly available information and it is unlikely for evaluations to be significantly different b/w competing firms
Critical element of success for firms in fundamental analysis
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superior firm analysis relative to other firms (e.g. more accurate projections)
Are small investors better off using active or passive portfolio management?
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passive strategy
Advantage of using index funds in a passive strategy
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minimizes trading costs/management fees
Reasons portfolio management is still necessary in an efficient market (3)
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- portfolio must be well-diversified to eliminate firm-specific risk (select stocks that provide strong diversification)
- optimal securities depend on the tax bracket of the investor (preferences for low-yield, tax-exempt bonds to minimize taxes)
- must consider the risk profile of the individual investor (e.g. age or other sources of income)
Event study
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method to measure the impact of an event/release of new information on stock prices
Steps in an event study (2)
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- find a benchmark return to represent what the stock price would have been in the absence of the event
- calculate the abnormal return due to the event
Possible benchmark returns for an event study (3)
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- broad market index (e.g. S&P 500)
- narrow broad index down to firms of similar size, beta, etc.
- use an asset pricing model to estimate an expected ROR (e.g. CAPM)
Estimating alpha and beta with event studies
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should be estimated using data sufficiently separated in time from the event so they are not impacted by event-period abnormal performance
Impact of information leakage on an event study
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flawed event stud because it does not recognize the change in prices ahead of the event caused by leakage
Cumulative abnormal return (CAR)
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sum of all abnormal returns over the period where the market is responding to new information
(captures the impact of the event + information leakage)
Common uses for event studies (2)
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used:
1. by the SEC to assess violation of insider trading or other securities laws
- in fraud cases to assess damages
Issues that make it challenging to determine if markets are truly efficient (3)
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- magnitude issue
- selection bias issue
- lucky event issue
Magnitude issue in determining if markets are efficient
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small increases in performance are difficult to detect against market fluctuations
Selection bias issue in determining if markets are efficient
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more likely to observe failed techniques because investors who can consistently beat the market would not publicize their techniques
Lucky event issue in determining if markets are efficient
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luck of an individual investor winning more or less frequently than would be implied by the average results
Tests of weak-form EMH & conclusions (2)
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- patterns in stock returns - short-term momentum (representing market over-reaction) followed by long-term reversals (representing correction of past errors)
- predictors of broad market returns - more likely predictors such as dividend yield are proxies for changes in market risk premium
(alternative interpretation to #1 could be that market risk premiums are changing over time)
Serial correlation of stock returns
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measures correlation of consecutive return periods
positive serial correlation: positive returns tend to follow positive returns
Market anomalies
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easily accessible statistics that seem to predict abnormal risk-adjusted returns
Tests of semistrong-form EMH
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studies of efficient market anomalies
Disadvantages of evaluating risk-adjusted returns
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actually evaluating 2 things:
- the EMH
- the risk adjustment procedure used
Market anomalies associated with semistrong-form EMH (5)
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- small-firm effect
- neglected firm effect
- liquidity effect
- book-to-market ratios
- post-earnings-announcement price drift
Small firm effect market anomaly
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smaller firms (= low market capitalization) produce higher returns than larger firms even after risk adjustment
Neglected firm effect market anomaly & explanation
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smaller firms ignored by investment firms have higher returns
> > explanation: lack of information can be seen as a form of risk premium
Liquidity effect market anomaly & explanation
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small/neglected firms tend to have less liquid stocks
> > explanation: lack of liquidity can be a form of risk premium
Book-to-market effect market anomaly & potential explanations (2)
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firms with high book-to-market ratios have higher returns
> > explanations:
1. high book-to-market firms are relatively under-priced
- book-to-market is a proxy for a risk factor impacting market returns
Post-earnings-announcement price drift market anomaly
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abnormal returns continue to rise/fall gradually after the announcement (which should not happen in an efficient market)
Strong-form tests of EMH (3)
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- whether outsiders can profit following insiders’ trades
- market anomalies & data mining
- market bubbles
Different interpretations for market anomalies (2)
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- effects are related to risk premiums rather than market inefficiencies (e.g. proxies for risk factors)
- market inefficiencies: investment analysts extrapolate past performance leading to over/under pricing and prices eventually self-correct
Argument that market anomalies are related to data mining
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false patterns appear to show predictive power that isn’t really there
Possible explanations for stock price increases following changes in market analyst recommendations (2)
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- analysts have unique insights and are revealing new information when upgrading a stock
- demand increases because of the upgrade (stock price change is driven by demand not new information)
Better indicator of skill in managing funds compared to alphas & rationale
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increase in amount of funds under management - skilled mutual fund managers attract new funds and the cost of managing those funds drives alphas to 0
