Challenges To Market Efficiency Flashcards
What are noise traders
Any departure from Bayesian rationality due to the use of heuristics and judgment biases that are inconsistent with classical statistics or non-standard preferences is often termed investor sentiment.
Investors who exhibit investor sentiment are often called noise traders.
What did the early evidence in the 1960/1970s concentrate on?
Stale and publicly available information should not affect current prices of securities as they are already incorporated = weak and semi-strong form of EMH.
Fama (1965) found that stock prices approximately followed a random walk.
Thereafter: event studies became very popular. Studies concentrated on ‘earnings announcements, take over news etc to see whether there was an immediate effect on security prices.
Results largely in line with weak and semi-strong form of EMH.
Since the late 79s EMH challenged
What is excess volatility
Shiller in 1981 documented excess volatility in stock prices that could not be explained by fundamental values.
The excess stock price volatility canno be explained with rational agents = empirical finding without explanation.
What did de Bondt and Thaler discover?
De Bondt and Thaler (1985) studies the performance of winners and losers over past 3 years and relate this to the subsequent return in the folling 5 years.
Result: previous winners give subsequently low/negative returns and losers give high/posititive returns.
They conclude that markets over/underreact and subsequently gradually correct prices.
Past performance is able to predict future returns –> contractiont to weak form EMH ( public information).
What are Siamese Twins?
EMH requires srictly subsitute securities to show no consistent differences.
Froot abd Dabora (1999) examine share prices of Siamese Twin companies:
(1) Companies that have merged at some point in the post but operate in geographically separate areas
(2) Pool their cash flows, but each twins retains its own stock.
Examples: Royal Dutch Petrolum and Shell, Unilever NV and Unilever PLC
Finding: traded price rarely in the proportion x:y which contradicts EMH
What did Cutler discover?
- Cutler (1991) discovered that the stock market crash of 1987 in which the Dow Jones fell by 22,6% was not accompanied by any news.
They showed that no major news accompanied the 50 largest one day stock price movements since WWII.
Evidence for this also comes from the inclusion of new stocks in the S&P500 index. INduction in index per se does not convey any news that was not available before.
What is prospect theory and what are its defining features?
Prospect theory is a positive theory concerning people’s choices under risk.
Defining features:
(1) Probability weighting = overweighing small and underweighing large
(2) Reference dependent value function = gains/losses when compared to reference points instead of absolute terms
(3) Loss aversion
(4) Diminishing sensitivity to losses and gains
Tversky & Kahneman
