Chapter 1 Efficient Market Hypothesis

Question 1

Efficient Security Market

Answer 1

An efficient security market is one in which the price of every security fully reflects all available information and hence is equal to its ‘true’ investment value.
Marginal cost of obtaining additional information +trading>marginal benefits
No over or underraction ie speed of returning to equilibrium.
Correctly reflected on the market / equilibrium state.

Question 2

Fundamental Analysis

Answer 2

Involves detailed scrutiny of company accounts, to calculate fundamental values, and thus ascertain when a given investment is cheap or expensive.

Uses information concerning the issuer of the security (eg: turnover, profitability, liquidity, level of gearing) and general economic and investment conditions (eg: real interest rates and inflation) in order to determine the “true” or “fundamental” value of a security and hence whether or not it is cheap or expensive.

Question 3

Give an argument in favour of passive investment management style.

Answer 3

If markets are indeed efficient, market prices already incorporate the relevant information. The market price mechanism is such that the active trading patterns of a small number of informed analysts can lead to accurate market prices. Uninformed( or cost-conscious, since actively trading incurs potentially unnecessary costs) investors can then take a free ride, in the knowledge that the research of others is keeping the market efficient.

Question 4

Weak form EMH

Answer 4

Market prices incorporate all of the information contained in historical price data. If markets are weak form efficient, then technical analysis(analyzing charts of prices and spotting patterns) cannot be used to generate excess risk-adjusted returns.

Question 5

Semi strong form EMH

Answer 5

Marker prices incorporate all publicly available information. If markets are semi-strong form efficient, then fundamental analysis cannot be used to generate excess risk-adjusted returns because this information is already contained the price.

Question 6

Strong form EMH

Answer 6

Market prices incorporate all information, whether or not it is publicly available information. If markets are strong form efficient, then insider trading cannot be used to generate excess risk-adjusted returns.

Question 7

Insider trading

Answer 7

Trading in the basis of privileged information that is not publicly available.

Question 8

Active fund managers

Answer 8

Attempt to detect exploitable mispricings since they believe that markets are not universally efficient.

Question 9

Passive fund managers

Answer 9

Aim to diversify across the whole market, perhaps because they do not believe they have the ability to spot mispricings

Question 10

According to EMH why can active management not be justified?

Answer 10

It is impossible to exploit the mispricings of securities in order to generate higher expected returns. Even if price anomalies exist, then the costs of identifying them and then trading will outweigh the benefits arising from the additional investment returns.

Question 11

Alternative definition of efficiency

Answer 11

Prices reflect all available information up to the point which the marginal costs and benefits on that information are equal. If these marginal costs and benefits differ between investors, some investors may enjoy an advantage over their peers.

Question 12

Give the evidence for and against WFEMH

Answer 12

For
Comparison of stock chosen using technical analysis VS purely random stock selection(after allowing for costs). Both methods seemed to generate the same returns on average

Against:
Minimal credible evidence

Question 13

Give evidence for and against SFEMH

Answer 13

For
Studies of directors share dealings suggest even with insider trading its difficult to outperform.

Against
Insider trading restrictions.

Question 14

Discuss informational efficiency

Answer 14

EMH in its various forms states that asset prices reflect information. However it does not explicitly tell us how new information affects prices. Eg the speed and extent to which it does so.
It is empirically difficult to establish precisely when informations arrives. Eg many events are widely rumored prior to official announcement.

Studies show that the market over reacts to certain events and under reacts to other events

Question 15

Explain excessively volatile stock prices

Answer 15

The change in the market value of stocks(observed volatility) could not be justified by the presence of news.
Security prices are more volatile than the underlying fundamental variables that should be driving them.
Evidence of market over reaction which was not compatible with efficiency.

Question 16

Explain Shillers approach to testing excessive volatility in share prices

Answer 16

He considered a discounted cash flow model of equities going back to 1870. By using the actual dividends that were paid and some terminal value for the stock, he was able to calculate the perfect foresight price, the “correct” equity price, if market participants had been able to predict future dividends correctly.

The difference between the perfect foresight price and the actual prices arises from the forecast errors of future dividends. If market participants are rational, we would expect no systematic forecast errors. Also if markets are efficient, broad movements in the perfect foresight price should be correlated with moves in the actual price as both react to the same news.

Schiller found strong evidence that the observed level of volatility in the S&P 500 stock index contradicted the EMH as such volatility was not in line with subsequent fluctuations in the dividends.

Question 17

Name the critisms of Shillers methodology.

Answer 17

The choice of terminal value for the stock price

The use of a constant discount rate.

Bias in estimate of the variance due to autocorrelation.

Possible non stationarity of the series.

Question 18

Name the critisms of Shillers methodology.

Answer 18

The choice of terminal value for the stock price

The use of a constant discount rate.

Bias in estimate of the variance due to autocorrelation.

Possible non stationarity of the series.

Question 18

Name the critisms of Shillers methodology.

Answer 18

The choice of terminal value for the stock price

The use of a constant discount rate.

Bias in estimate of the variance due to autocorrelation.

Possible non stationarity of the series.

Question 19

Name the critisms of Shillers methodology.

Answer 19

The choice of terminal value for the stock price

The use of a constant discount rate.

Bias in estimate of the variance due to autocorrelation.

Possible non stationarity of the series.

Question 19

Name the critisms of Shillers methodology.

Answer 19

The choice of terminal value for the stock price

The use of a constant discount rate.

Bias in estimate of the variance due to autocorrelation.

Possible non stationarity of the series.

Question 20

Name the critisms of Shillers methodology.

Answer 20

The choice of terminal value for the stock price

The use of a constant discount rate.

Bias in estimate of the variance due to autocorrelation.

Possible non stationarity of the series.