Ch.10: EMH

Question 1

Define allocative efficiency?

Answer 1

Efficiency with which the capital markets allocate the scarce capital funds to the most productive uses

Question 2

How would allocative efficiency work in an ideal world?

Answer 2

Funds allocated to whoever can achieve the best marginal returns

Question 3

Define operational efficiency?

Answer 3

Cost efficiency of the FMs and FIs described ITO charges to investors (ie. minimising cost of raising capital and transaction costs)

Question 4

What is informational efficiency?

Answer 4

The extent to which market prices of securities fully incorporate information and react to changes in information so that abnormal returns cannot be be made on a consistent basis

Question 5

What are the three types of informational efficiency? What do they all follow?

Answer 5

1) Weak-form efficiency
2) Semi-strong-form efficiency
3) Strong-form efficiency

A random walk!

Question 6

Explain what weak-form efficiency is?

Answer 6

Where the current price of securities instantly and fully reflects all information of the past history of securities prices

Question 7

Explain what semi-strong-form efficiency is?

Answer 7

Current prices of securities instantly and fully reflect all publicly available information

Question 8

Explain what strong-form efficiency is?

Answer 8

Current prices of securities instantly and fully reflect all information, both publicly available information and privately held information held by company insiders (evidence the market is not this!)

Question 9

What is the efficient markets hypothesis? Explain what this means for investors if the hypothesis holds?

Answer 9

A hypothesis that states that all prices reflect all available information

This means that any info. that is available will already be incorporated into the price, tf an investor will never be able to consistently beat the market with ‘extra’ information since it doesn’t exist!

Question 10

What type of game could the EMH be compared to and why?

Answer 10

Comparable to the idea of a FAIR GAME because there is not systemic difference between actual return on the game and expected return on the game

Question 11

If the EMH holds, how would we model the expected rate of return for one period ahead on security i? Explain the aspects of this model. (3)

Answer 11

R(t+1)=R(t)+u(t+1)

where error term: E(u(t+1))=0, and u(t+1) is independent of the E(RofR) on a security and is tf not predictable on the basis of any information available at time t

Question 12

What are the implications of the EMH with:

a) WFEMH
b) SSFEMH?

Answer 12

a) Chartiists and technical analysts will not be profitable on average
b) Forecasts from investment and research analysts will not be profitable on average

Question 13

What are the implications of the EMH with SFEMH?

Answer 13

Even those with access to private information will not be able to consistently profit because ALL information is already incorporated into the share price

Question 14

Why is StrongFEMH believed to be false?

Answer 14

If those with access to private information could not beat the market, then this would mean there would be no need for Chinese Walls in firms and no need to stop insider trading

Question 15

What are Chinese Walls?

Answer 15

Barriers within institutions to prevent conflicts of interest

Question 16

Why does the EMH not mean one shouldn’t invest in the FMs?

Answer 16

Because the equity premium is roughly 7% (ie. the amount shares outperform other assets such as bonds); the EMH just states that it is not possible to consistently beat this 7% rate of return!

Question 17

What is active fund management? Explain an issue with these fund types?

Answer 17

A manager will use skills to buy and sell over/underpriced shares to try beat the market

Often can cause high transaction costs (eg. brokerage charges, cost of workers in funds etc.)

Question 18

What is passive fund management? Explain an advantage of these fund types? Give an example.

Answer 18

Strategy where a fund buys and holds shares, often to track a market index; want to select a portfolio with the desired risk characteristics!

Since portfolio is rarely changed, the fund incurs much lower transaction costs!

example: index funds!

Question 19

What does the EMH imply regarding fund management types?

Answer 19

If EMH holds there is no need for active fund management (since won’t make a difference)

Question 20

What are index funds?

Answer 20

When the fund uses a portfolio that is weighted by the firm size of the index it is tracking

Question 21

How can one test for WFEMH?

Answer 21

Statistical tests can be done to detect if RW; one common method is to use filter-rule tests

Question 22

What are filter rule tests? Draw graph showing these?

Answer 22

The idea behind a FRT is that if WFEMH holds then it should not be possible to use a FR (ie. of x%) to consistently beat the market. FRs are often recommended by investors BUT when tested using past prices of data, they often do not actually outperform the market! (see notes for diagram)

Question 23

read

Answer 23

Basically, FRs are rules that have been developed from looking at past record of prices and they tell one whether to buy/sell depending on what the prices are currently doing; if WFEMH holds, then the past record of prices would tell nothing about the future therefore making these rules obsolete!

Question 24

Explain 3 data anomalies that go against WFEMH, suggesting that stock prices do not incorporate all historical price data?

Answer 24

1) Day-of-the-week effect: share prices observed to generally fall on mondays (gloomy) and rise on fridays (happy) (note: evidence shows this effect has now disappeared!)
2) January effect: returns on stocks noted to grow lots over the course of January. If WFEMH holds, then once this has been realised by the market this effect would disappear. Since it continues to occur, implies markets are not WFEMH
3) Winner-loser problem: data shows that in the 7 months following a successful quarterly announcement firms tend to do better but in the 8-36month horizon they tend to do worse. Again, any pattern in the data should be eliminated once it is realised; since it has been realised and not eliminated, this implies that markets are not WFEMH

Question 25

January effect possible causes? (2)

Answer 25

Analysts generally attribute this rally to an increase in buying, which follows the drop in price that typically happens in December when investors, engaging in tax-loss harvesting to offset realized capital gains, prompt a sell-off.
Another possible explanation is that investors use year-end cash bonuses to purchase investments the following month.

Question 26

Explain a test for SSEMH? What does evidence generally show?

Answer 26

EVENT STUDIES: Analysis to see if different news announcements, such as earnings data or changes in div policy, affect share price in period post-announcement compared to pre-announcement
The idea is that new information should cause a sharp change in share price as it is realised, then stock should continue to trade at this level until further news

Evidence generally supports this hypothesis!

Question 27

What may happen following news releases? If investors realise this has happened, what may they do to profit? Show this with a diagram?

Answer 27

The market may over/under-react to news (see notes)
If overreact then investors should sell or short-sell
If under-react investors should buy

Question 28

What are 3 data anomalies that go against SSEMH? (semi-strong)

Answer 28

1) Size effect
2) Price-earnings effect
3) Earnings-announcement effect

Question 29

Explain how the size effect goes against SSEMH?

Answer 29

Excess returns on stocks of smallest companies are greater than those of the largest companies tf implying that not all firm info. is included in stock price., and that smaller firms are undervalued

If markets were SSEMH then investors would realise small firms are undervalued and buy up their stock until the excess returns reduced, and then the effect would disappear

Question 30

Explain how the price-earnings effect goes against SSEMH?

Answer 30

see notes (dont understand)

Question 31

Explain how the earnings-announcement effect goes against SSEMH? (2)

Answer 31

Stock prices have been observed to start moving in anticipation prior to the announcement suggesting a degree of insider information is ALSO present in stock pricing!

ALSO
Significant and predictable returns could be made in 90 days following the announcement – therefore not all news are priced into the market at the time of announcement

Question 32

What is a speculative bubble? What does a speculative bubble imply?

Answer 32

A term used to describe fast dramatic price rises of shares or something else that is likely to prove unsustainable (builds on the confidence of investors, not a true rise in the value of the underlying asset!)

It suggests that EMH is wrong because prices do not seem to be explained by available information!

Question 33

Explain the 1987 stock market crash?

Answer 33

Jan-Oct 1987: most stock indices around the world experienced a bull marketUK market was up 75% in the yearUS market up 30%Hong Kong index up 70%

19 Oct 1987 – ‘black Monday’: a dramatic collapseUS market fell by 23% that dayUK market fell 30% over 3 daysHong Kong index fell 50% over the week

Question 34

Explain 2 counter-arguments to the notion that speculative bubbles imply EMH is wrong?

Answer 34

1. Rational bubble – bubble where many speculators believe a security or asset is significantly overpriced and likely to collapse in price at some time in future BUT they continue to buy the overpriced security so long as expected rise is sufficient to compensate for risk of an eventual collapse of the price.
2. Stock market crashes - can still be consistent with market efficiency if sufficient bad news arrives to alter future expectations, enough to justify sharp lower stock prices

Question 35

Why is it difficult to test for SFEMH?

Answer 35

Because it is difficult to find a proxy for inside information!

Question 36

Explain a piece of evidence that suggests markets are not SFEMH?

Answer 36

If markets obey SF efficiency, then even those with inside info would not be able to make excess returns
BUT studies that have looked at the purchases/sales of stocks by directors and managers (who are NOT allowed to trade on the basis of price sensitive information) have found that they DO tend to make excess returns. This implies that they have inside information, and therefore because this information is being used to beat the market, it implies that the market is not SFEMH since those with the additional inside info. can beat it! (ie. prices do not contain all private firm information)

Question 37

Explain another piece of evidence that suggests markets are not SFEMH?

Answer 37

Financial analysts presumably have more access to inside information about a firm and their tips are not necessarily known to the wider public.
There is a positive correlation found between analysts forecasts of excess return and actual return from acting on the recommendations of analysts. This implies that investors who have access to this additional ‘inside’ information do better since market prices do not already contain this information, tf going against SFEMH

Question 38

What are the 4 main assumptions behind the EMH? Which of these can be weakened reasonably?

Answer 38

Perfect markets: ie:

1) zero transaction costs
2) costless information
3) rational investors
4) homogenous expectations

All of them are questionable:

1) may be small but not zero
2) costs of obtaining info are not truly zero
3) not all agents are rational - only need a proportion to be though!
4) homogenous expectations (different info from agents -> different expectations!)

Question 39

3 implications if EMH holds?

Answer 39

1) shares follow a RW
2) buy and hold strategy is optimal
3) impossible to consistently beat market without inside info