Chapter 1: The efficient market hypothesis

Question 1

What two conditions a must security satisfy to be considered efficient

Answer 1

1. Price reflects all available information.
2. Price of a security is equal to its investment value

Question 2

What are the different forms of the efficient market hypothesis.

Rememeber to define in terms of what the markert price incorporates

Answer 2

1. Weak - info in historiccal data, technical analysis won’t produce excess risk adjusted returns
2. semi-strong - info in publicly available info, fundamental analysis won’t produce excess risk adjusted returns
3. Strong form - All info, inside information won’t produce excess risk-adjusted returns

Question 3

Does an investor make a profit in efficient or inefficient markets ?

Make sure to explain why

Answer 3

Ineffiecient
Make a profit if security is over or under priced. For example you can buy it when it is under-priced and sell it when price goes up.

Question 4

What are the limitations to semi-strong form efficiency

Answer 4

• No universal definition of what is public information
• Even if the information is publicly available, there is a cost to attaining it
• Under this form the cost of attaining information as well as using it should be zero.
• Investors are to trade until prices reflect this information

Question 5

What is the difference between active and passive investment management

Answer 5

Active investors aim to exploit mispricings in the market, as they believe that the market is inefficient
Passive investors aim to diversify their portfolios across the market.

Question 6

Give at least 4 (there are 6) reasons why there is conflicting emperical evidence when testing EMH

Answer 6

• Invalid implicit or explicit assumptions - might be testing something else.
• Historical data from one time period may only apply to that time period - nature of the market and available information may have changed.
• Parties with vested interests may only publish results that support their position
• Terminology issues (efficiency not taking costs into account)
• Not making appropriate allowances for risk - ie. cost of attaining and using information
• Joint hypothesis problem: testing EMH and pricing model

Question 7

Discuss whether emperical evidence supports weak form EMH

Answer 7

• Studies have not identified the benefit of technical analysis over random stock selection
• Econometric evidence suggests that stocks tend to exhibit short-rum momentum and medium-run mean reversion - meaning that prices already reflect historical data.

Question 8

Discuss whether emperical evidence supports strong form EMH

Answer 8

• Requires information that is not publicly available - making it difficult to test.
• Studies of director share holdings suggest that even with insider information, it is difficult to out-perform

Question 9

Discuss whether emperical evidence supports semi-strong form EMH

Answer 9

Informational efficiency
* EMH does not explicitly show effect of new info on prices
* Emperically difficult to determine when new information comes
* Studies show that markets tend to under or over react to new information

Over-reaction
* Past-performance
- can use contracyclical investment policy to make profits
* Certain accounting ratios appear to have predictive powers
* Firms coming into the market may have high intial performance and poor subsequent perfomance

Under-reaction
* Reacting to positve news a year after they have been released
* Abnormal excessive returns for both parent and subsidiary after a demerger - price goes down during the de-merger
* Abnormal negative returns after a merger - price goes up during a merger

This is where most of the research lies

Question 10

Why can’t anomalies be used to disprove efficiency

Answer 10

They are usually few shocks in the system which are not present in the long run

Question 11

Explain how risk and reward does not disprove EMH

Answer 11

Higher risk => high expected return
* It does not mean that the investor has better info, just a high risk apetite
* What would contradict efficiency would be returns that are higher given the risk taken on

Question 12

Describe Shiller’s work

Answer 12

Claim: Stocks are excessively volatile, which cannot be expalined by the presence of news alone

Method
* Consider a discounted cashflow model dating back to 1870.
* Using actual dividends and a terminal value for the stock, calculated the perfect foresight price.
* Forecast errors are the difference between the actual price and the perfect foresight price
* If market participants were rational, we would expect no systematic (consistently in one direction) forecast errors
* Broad movements in the perfect forecast price should be correlated with broad movements in the actual price since they are based on the same information.
* Shiller 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 the subsequent fluctuations in dividends.

Question 13

State some criticisms of Shiller’s work

Answer 13

• Violation of EMH only had borderline statistical significance
• Choice of terminal value
• Use of constant discount rate
• Bias in estimates of variances due to autocorrelation
• Possibility of non-stationarity for the series
• Model for dividends and distributional assupmtions