Chapter 6 - Market Efficiency

Question 1

Arbitrage condition for market efficiency (2)

Answer 1

1. Same asset trades with different prices on 2 different exchanges
2. 2 assets with identical cash flows & risk but different prices

Question 2

What happens when arbitrage opportunities are exploited and why (3)?

Answer 2

they disappear!

1. Buy the cheaper assed D increases
2. Ceteris paribus, the price of the cheapest asset goes up
3. when the price of the cheapest asset converges to the higher price, there are no more arbitrage opportunities

Question 3

Arbitrage and Efficient Market Hypothesis

Answer 3

Arbitrage opportunities can’t survive for long in a competitive market. There are other investors who will see a profit and take advantage. The fact that there are few arbitrage opportunities shows that there are few securities whose price does not reflect all publicly available info.

Question 4

EMH

Answer 4

Investors are rational. they form their best guess of the future using all available information. if a few investors are rational, then it is enough to guarantee that market prices reflect all available information.
- rationale behind this is arbitrage -

Question 5

EMH (semi-strong form)

Answer 5

the security’s price reflects all available public information at all times.
- you can still profit from private information-

Question 6

EMH (weak form)

Answer 6

all past stock prices are reflected in today’s stock price

Question 7

EMH (strong form)

Answer 7

All information, public or private, is priced-in. Prices reflect the true fundamental value of securities.

Question 8

EMH implications (3)

Answer 8

1. as new information comes in, securities are re-evaluated
2. investors’ expectations are correct
3. Market earns a ‘fair’ return in equilibrium, based on the riskiness of the security

Question 9

EMH evidence (3)

Answer 9

1. Random walk behavior of stock prices
2. Anticipated announcements don’t affect stock price
3. You can’t beat the market - not even analysts and funds

Question 10

Random walk of stock prices

Answer 10

future changes in stock prices should be unpredictable if EMH is right, the best predictor for tomorrow’s price is today’s price.

Question 11

Anticipated announcements

Answer 11

a positive but anticipated announcement about a company will not raise the price of its stock (vice versa). This is because this information was already reflected in the stock price.

Question 12

Can’t Beat the Market

Answer 12

If EMH is right, investment analysts and mutual funds should not be able to consistently beat the market.

Question 13

Does EMH Work? (pro & con)

Answer 13

Pro: Eugene Fama (1970) - evidence for EMH is extensive, contradictory evidence is sparse
Con: Robert Shiller (2013) - “Irrational Exhuberance” & “Animal Spirits”

Question 14

Evidence against EMH (4)

Answer 14

1. January effect
2. small-firm effect
3. market overreaction and momentum
4. excessive volatility

Question 15

January Effect

Answer 15

Stock prices fall in December and rise in January. Abnormal positive return in the month of January is predictable and inconsistent with random walk behavior

Question 16

Small firms effect

Answer 16

small firms have earned abnormally high returns over long periods of time, even when the greater risk of these firms has been considered. No stock should consistently exhibit excess returns.

Question 17

Market Overreaction and Momentum

Answer 17

sometimes stock prices overreact to news announcements, sometimes prices continue to rise after a positive news.

Question 18

momentum strategies

Answer 18

sell stocks that have bad returns and buy those with high returns in the last 3-12 months

Question 19

excessive volatility

Answer 19

EMH implies that prices basically reflect all and only market fundamental (PV of future dividends). Stocks appear to have excess volatility, meaning that if these fluctuations can’t be justified by subsequent fluctuations in the dividends of the stocks, then there must be factors other than the fundamentals affecting stock prices