Chapter 1 - Efficient Market Hypothesis Flashcards
Efficient security market
The price of every security fully reflects all available & relevant information. The EMH states that security markets are efficient
Identify & explain the 3 different forms of EMH
1) WEAK form - market prices incorporate all of the info contained in historical price data (if markets are of this form, then TECHNICAL analysis cannot be used to generate excess risk-adjusted returns)
2) SEMI-STRONG form - market prices incorporate all publicly available info (if markets are of this form, FUNDAMENTAL analysis cannot be used to generate excess risk-adjusted returns)
3) STRONG form - market prices incorporate all info, whether or not it’s publicly available (if markets are of this form, then INSIDER TRADING cannot be used to generate excess risk-adjusted returns)
What does the level of efficiency depend on?
Whether information is freely available (which may depend on the level of disclosure required by regulation)
[Even if info is publicly available, there’s a cost involved in obtaining the info quickly & accurately]
What is the relationship between the 3 forms of EMH?
strong -> semi -> weak
Importance of market efficiency
Derives from the fact that if markets are inefficient then investors with better info may be able to generate higher investment returns. If however, they are efficient then active investment management is difficult to justify.
> > Active fund managers attempt to detect exploitable mispricings (since they believe markets are not universally efficient)
> > Passive fund managers simply diversify across a whole market (because they don’t believe they have the ability to spot mispricing)
Tests of EMH
Tests of EMH are fraught with difficulty.
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What would contradict the EMH is an investment strategy that provided returns over & above those necessary to compensate an investor for the risk they faced.
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WEAK > studies have failed to identify a difference between the returns on stocks selected using technical analysis & those from purely random stock selection (use price history to forecast)
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SEMI-STRONG > research has concentrated on the semi-strong form & in particular tests of informational efficiency & volatility tests
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STRONG > studies of directors’ dealings suggest that, even with inside info, it’s difficult to outperform (requires researcher to have info not available in the public domain)
market price mechanism
active trading patterns of a small # of informed analysts can lead to accurate market prices. Uninformed investors can take a free-ride in the knowledge that research of others is keeping the market efficient
Informational efficiency
EMH states that asset prices reflect info. However, it doesn’t explicitly tell us how the new info affects the prices. It is also empirically difficult to establish precisely when info arrives.
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Many studies show that market over-reacts to certain events & under-reacts to other events. The over/under-reaction is corrected over a long time period. If this is true then traders can take advantage of the slow correction of the market, and efficiency would not hold.
Over-reaction to events
1) Past winners tend to be future losers & market appears to over-react to PAST PERFORMANCE
2) Certain ACCOUNTING RATIOS appear to have predictive powers (an e.g of the market apparently over-reacting to past growth)
3) FIRMS COMING to the market have poor subsequent performance
Under-reaction to events
1) Stock prices continue to RESPOND TO EARNINGS announcement up to a year after their stock announcement
2) Abnormal EXCESS returns for both the parent & subsidiary firms ffg a DE-MERGER
3) Abnormal NEGATIVE returns ffg MERGERS
Volatility tests
Def: there has been claims that markets are extremely volatile (i.e the prices of securities are more volatile than the underlying fundamental variable driving them)
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Shillers’ ‘excessive volatility’ - he found strong evidence that the observed level of volatility contradicted the EMH. However, subsequent studies found that the violation of EMH only had borderline significance.
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Shiller-> DCF of equities by using actual dividends paid & some terminal value for stock
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perfect foresight price -> actual dividend price used to forecast future dividends (the difference between the pfp & actual are the forecast errors), however the rationale is that there are no systematic errors
Criticism’s of Shiler’s methodology
CANT
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- use of a CONSTANT discount rate
- bias in estimates of the variances due to AUTOCORRELATION (ACF)
-possible NON-STATIONARITY of the series
-choice of the TERMINAL value of the stock price
Schiller’s assumptions
PCD
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-PRICES reflect the expected future dividends
- real expected returns are CONSTANT over time
-DIVIDENDS: stationary process with a constant growth rate
