Efficient Capital Markets And Behavioral Finance

Question 1

What is the efficient market hypothesis

Answer 1

EMH is said to be concerned with how good the market is at reflecting VALUE RELEVANT information in asset prices
Market is said to be efficient if prices fully reflects the information that is available to investors
Market inefficiencies can sometimes be spotted

Question 2

What is the random walk theory

Answer 2

Stock prices move in a random unpredictable way and are therefore independent.
Efficient market hypothesis implies stock prices reflect all available information and move randomly. This is supported by the random walk theory.

Question 3

What are the theoretical foundations of the EMH theory

Answer 3

Investors assumed to be rational
Investors can be irrational but their impact is random (may act out of bias or fear) and not significant
Rational investors (arbitrageurs) correct the mistakes of irrational investors (take advantage of these mispricings and make profits)
Helps correct the market

Question 4

What is independent deviations from rationality

Answer 4

Idea that market still stays efficient despite having irrational investors.
How?
Idea that irrational investors work independently ( not connected ) so these irrational behaviours will eventually cancel out each other as they’re uncorrelated
May affect trading volume (how much trading occurs) however won’t impact prices in the long run as the impacts cancel each other out.

Question 5

What is arbitrage and how does it work

Answer 5

Practice of buying a security from one market and selling it in another market where it’s priced higher to make profits
E.g. market B= overpriced and market A = cheaper
Investors sell the overpriced security , this makes the price drop because of selling
Investors buy the cheaper security, this makes price rise due to buying
: brings prices closer together across markets and corrects any mispricing

Question 6

Describe 3 violations of the efficient market hypothesis

Answer 6

1.) January effect : violation of weak form
Where stock prices rise in January compared to other months., especially small. Means historically, stock prices rise more in January . Stocks have higher returns in January
As January effect is consistent, this implies it’s predictable which shouldn’t be the case if the market was efficient .
Violates weak form (past information reflected in stock prices) as it suggests past performances can still be used to predict stock performance which weak form says shouldn’t be possible

2.) Weekend effect ( violation of weak form )
Stock returns lower on Monday (first day of trading week) compared To other days, stock prices drop over weekend.
3.) excess volatility ( violates semi strong ) public info
Stock prices fluctuating very strongly as a result of news or events even if the company’s actual business performance hasn’t changed much
Violating because emh for semi strong suggests that stock prices should change when there’s new public information that affects the fundamental value of the company.
Excess volatility suggests that stock prices are reacting too strongly.