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comm 308: introduction to corporate finance > chapter 10: market efficiency > Flashcards

chapter 10: market efficiency Flashcards

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1
Q

An efficient market

A

one in which the prices of all securities accurately reflect all relevant and available information about the securities

market that reacts quickly and relatively accurately to new public information, which results in prices that are correct on average

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2
Q

what is the importance of disclosure?

A

keeping integrity in the market

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3
Q

disclosure

A

the revelation of all material facts so that everyone in the market is buying and selling based on the same disclosed material facts about the firm

info is available to everyone

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4
Q

securities law

A

the body of law that ensures, through capital market regulations, that all investors have equal access to, and an equal opportunity to react to, new and relevant information

the body of law that governs the buying and selling of securities

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5
Q

Assumptions Underlying Market Efficiency

A
  1. There are a large number of rational, profit-maximizing investors who actively participate in the market by analyzing, valuing, and trading securities

–> The markets are assumed to be competitive, which means that no one investor can significantly affect the price of a security

  1. Information is costless and widely available to market participants at the same time
  2. Information arrives randomly; therefore, announcements are not related to one another
  3. Investors react quickly and fully to the new information, which is reflected in stock prices
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6
Q

sell-side analysts

A

they work for the investment banks that underwrite and sell securities to the public

securities analysts whose job is to monitor companies and regularly report on their value through earnings forecasts and buy/sell/hold recommendations

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7
Q

buy-side analysts

A

securities analysts whose job is to evaluate the research and recommendations produced by the sell-side analysts

they work for institutions in the capital market that invest in securities

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8
Q

the three components to market efficiency

A

operational efficiency

allocational efficiency

informational efficiency

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9
Q

operational efficiency

A

that transaction costs are low

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10
Q

allocational efficiency

A

there are enough securities to efficiently allocate risk

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11
Q

informational efficiency

A

important information is reflected in share prices

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12
Q

what do we mean when we say that there has to be a connection between the decisions made by managers and the level of share prices?

A

share prices are like a score sheet used to evaluate management

The closer the link between the actions of managers and this score sheet, the more informationally efficient the capital market

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13
Q

material facts

A

all should be disclosed to the capital market

Material facts are anything that can be expected to affect the share price

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14
Q

The efficient market hypothesis (EMH)

A

states that markets are efficient

prices accurately reflect all available information at any point in time

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15
Q

how do we break down the efficient market hypothesis (EMH)

A

The weak form EMH

The semi-strong form EMH

The strong form EMH

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16
Q

The weak form EMH

A

states that security prices fully all past price and volume trading information

historical trading data will already be reflected in current prices and should be of no value in predicting future price changes

looking at graphs of previous stock prices is of no value

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17
Q

The semi-strong form EMH

A

states that all publicly known and available information is reflected in security prices

–> includes information about earnings, dividends, corporate investments, management changes, and so on

–> It would also include market data, which are publicly available

—-> Therefore, this version of the EMH encompasses the weak form

it is futile to analyze publicly available information, such as financial statements, in an attempt to identify underpriced or overpriced securities

buying “undervalued” stocks based on P/E ratios or dividend yields is of no value

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18
Q

The strong form EMH

A

asserts that stock prices fully reflect all information

–> includes both public and private information

no investor can take advantage even of “inside” information that has not yet been released to the stock market

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19
Q

the random walk hypothesis

A

past price changes (and total returns) should be unrelated to future price changes

–> we assume we are in the weak form EMH

states that prices follow a random walk, with price changes over time occurring independently of one another

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20
Q

methods of testing weak form efficiency

A

Statistical Tests

Technical Analysis

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21
Q

Technical Analysis

A

the analysis of historical trading information in order to identify patterns in trading data that can be used to invest successfully

22
Q

what do technical analysts argue about statistical tests

A

they are inconclusive because they are not applied to more sophisticated trading strategies

23
Q

data mining

A

the process of examining data in various manners and forms, and using various empirical approaches, until you find an interesting observation and/or the result you were looking for before you began the analysis

used a lot to uncover profitable anomalies

24
Q

momentum

A

the tendency for stocks that have experienced high returns in the previous 3- to 12-month period to outperform in the subsequent 3- to 12-month period

25
Q

Violations of Weak Form Efficiency

A

anomalies in the weak form of efficiency

stock momentum in the weak form of efficiency

seasonal patterns

26
Q

Semi-Strong Form Evidence

A

Stock Price Adjustments

investor Returns

27
Q

in a semi strong form efficient market, how would prices adjust after new information becomes available

A

prices would adjust quickly and accurately to this new information so that investors could not act on it and earn abnormally high risk-adjusted returns

28
Q

an event study

A

stock returns are examined to determine the impact of a particular event on stock prices

support the notion that the market adjusts to new public information rapidly and accurately,

–> that investors could not earn abnormal returns based on inefficient market reactions to significant information announcements

29
Q

abnormal returns

A

returns that exceed the expected return on a stock according to a model of stock returns, such as the CAPM

30
Q

what does it mean if, in a semi strong efficient market, the stock price went up (or down) before the news came out?

A

there was was some insider trading because investors supposedly can’t earn abnormal returns

31
Q

Perhaps the strongest evidence of semi-strong market efficiency

A

the fact that professional fund managers, with all of their training, expertise, technological capability, and access to data, do not outperform the market on a risk-adjusted basis, on average

–> most studies indicate the performance of the average active portfolio manager, after expenses, is substantially worse than the performance of their passive benchmarks

32
Q

Violations of Semi-Strong Form Efficiency

A

some investment styles have been able to produce abnormal returns

“value” stocks have consistently outperformed “growth” stocks

value stocks appear to be less risky than growth stocks

–> This anomaly involving value stocks contradicts semi-strong market efficiency, because all the ratios used to categorize stocks in this manner are publicly available

the size effect anomaly

33
Q

Value stocks

A

those that have below-average price-to-earnings (P/E) and market-to-book (M/B) ratios and above-average dividend yields

34
Q

“growth” stocks

A

have above-average P/E and M/B ratios, but below-average dividend yields

35
Q

according to data, which are less risky, value or growth stocks?

A

value stocks

36
Q

the size effect anomaly

A

small cap stocks tend to outperform large cap stocks, even after adjusting for risk

37
Q

what is the main proof that strong form of market efficiency is inexistent

A

insider trading

–> studies have found they have consistently earned abnormal returns on their stock transactions, which refutes strong form efficiency

38
Q

what are the three main conclusions points we can identify after studying the weak, semi strong, and strong market efficiencies?

A
  1. Weak form efficiency is very well supported, and it is reasonable to conclude that markets are weak form efficient, although a few anomalies do exist
  2. Semi-strong form efficiency is well supported

–> more contradictory evidence exists for this version of the EMH than for the weak form

  1. Strong form efficiency is not very well supported by the evidence, and it is reasonable to conclude that markets are not strong form efficient in the strictest sense
39
Q

behavioural finance

A

a developing field of finance

a field of financial thought that suggests that investor behaviour is not always rational but is influenced by psychological biases that cause investors to make systematic errors in judgement

examines human psychology in an attempt to explain how and why investor behaviour can deviate significantly from the predictions associated with the traditional view of finance, which may lead to persistent market inefficiencies

40
Q

what does the traditional view of finance suggest about investors

A
  1. they consider all available information

2 they act rationally and do not make systematic errors, either in processing information or in implementing investment decisions

  1. they adhere to the basic tenets of modern portfolio theory (MPT), which implies they are risk averse, they diversify, and they consider risk in the context of a well-diversified portfolio.
41
Q

Irrational Forces Motivating Investors

A

Market Volatility and Loss Aversion

Investor Overconfidence and Anchoring

42
Q

what does it often mean when the market is extremely volatile?

A

market prices may not reflect underlying fundamentals

43
Q

loss aversion

A

investors’ unwillingness to place “fair bets”

the tendency to place a heavier emphasis on losses than on comparable gains

implies that investors may engage in suboptimal investing decisions to avoid losses, which they dislike more than they like comparable gains

not the same thing as risk aversion

44
Q

risk aversion

A

investors dislike risk but are willing to assume risk if they are adequately compensated in the form of higher expected returns

45
Q

how can loss aversion impact investors (examples from the book)

A

investors may invest too conservatively, especially if they have experienced losses recently

–> could cause them to hold investments that are inappropriate for their investing objectives

–> their portfolios may not be adequately diversified

can also lead investors to hold on to “losers” too long (so they can avoid recognizing the loss) and sell “winners” too early (so they will realize the gains and avoid potentially losing these gains)

46
Q

effects of overconfidence

A

investors tend to focus on information that they consider important and downplay other pertinent information

investors tend to attribute their investing successes to their ability rather than to market factors

–> they tend to attribute investing failure to factors beyond their control

can lead investors to hold overly risky securities that might produce huge payoffs, which they take credit for, or huge losses, which they can blame on external factors they can’t control

might also lead them to hold poorly diversified portfolios, either because they hold too many risky securities or because they don’t hold a sufficient number of securities

47
Q

Anchoring

A

the tendency to become emotionally tied to some initial price or perception

48
Q

effects of anchoring

A

investors are often reluctant to sell investments below their original purchase price, or below some historically higher price

may cause investors to not invest, because they could have done so at a lower price in the past

causes investors to adapt too slowly to new information as it is released

tends to go hand in hand with mental accounting

49
Q

mental accounting

A

refers to the process of accounting for individual investments separately

can cause investors to be poorly diversified, among other things

50
Q

Bubbles

A

significant and generally unwarranted increases in asset prices that lead to unsustainably high price levels

51
Q

Implications of Market Efficiency

A
  1. Technical analysis, is not likely to be rewarded by substantial abnormal returns, because markets appear to be weak form efficient
  2. Fundamental analysis is also likely to be unsuccessful at generating abnormal profits, although some opportunities appear to be available

–> to benefit from such data, the analysis must be of superior and consistent quality

–> Average, or below-average, analysis will likely be unfruitful

  1. “active” trading strategies are unlikely to outperform “passive” portfolio management strategies on a consistent basis

–> involve buy-and-hold tactics and the purchase of such products as index mutual funds or exchange-traded funds (ETFs) that replicate the performance of a market index

  1. Whether investors decide to pursue a passive or active strategy, it is critical that they focus on the basics of good investing by defining their objectives in terms of expected return and acceptable risk levels, and by maintaining an adequately diversified portfolio
52
Q

Two of the most important implications for corporate officers

A
  1. The timing of security issues or repurchases is unimportant in an efficient market because prices will be correct, on average

–> prices will not become inflated, so there is no optimal time to sell new securities, and securities will not be undervalued, so there is no optimal time to repurchase outstanding securities

  1. If short-run momentum and overreaction continue, we would expect the opposite: that firms should sell equity after a price run-up and repurchase shares after a price decline

–> management should monitor the price of the company’s securities and determine whether price changes reflect new information or short-run momentum and/or overreaction

comm 308: introduction to corporate finance (13 decks)

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