efficient market hypothesis Flashcards
what is efficient market hypothesis?
The Efficient Market Hypothesis (EMH) suggests that financial markets are “informationally efficient.”
In other words, financial markets rapidly and efficiently incorporate all publicly available information into the prices of securities, making it difficult or impossible for investors to consistently achieve above-average returns through trading based on that information.
why does The EMH imply that it is impossible to consistently achieve returns that are higher than those of the overall market ?
because all relevant information about securities is already reflected in the current prices. This means that attempting to time the market or pick individual stocks based on research or analysis is unlikely to be successful in the long run.
what are the three forms of the EMH?
weak, semi-strong, and strong
what does the weak EMH suggest?
The weak form suggests that past prices and trading volumes cannot be used to predict future prices
what does the semi-strong EMH suggest?
The semi-strong form suggests that all publicly available information, including financial statements, news, and economic data, is already reflected in security prices
what does the strong EMH suggest?
The strong form suggests that even private information is already reflected in security prices, making insider trading impossible
Market may be close to efficiency, but not perfectly efficient. Why is this?
Trend:
– The market takes time to absorb information.
Reversal:
– The market did over-react to information, there will be an adjustment.
Even if market is perfectly efficient in Semi-strong form, price can still move, why is this?
when there is a NEWS.
- Surprise
- Confirmation
- Resolution of Uncertainty
what would happen if markets were inefficient
resources would be systematically misallocated.
– Firm with overvalued securities can raise capital too cheaply.
– Firm with undervalued securities may have to pass up profitable opportunities because cost of capital is too high.
what is meant by price discovery
Price Discovery is the most important function of the financial market:
– Quickly and correctly reflect the change in value of company to asset price.
– New information and events are incorporated into asset price through investors’ trades.
what is meant by abnormal return
The abnormal return of firm’s stock price due to an event is the difference between the stock’s actual return and its hypothetical return in the absence of the event.
what is:
Post EarningsAnnouncementPriceDrift? (long answer)
Post-Earnings Announcement Price Drift (PEAD) is a phenomenon where stock prices of companies continue to move in the same direction as the earnings surprise, even after the initial announcement.
For example, if a company announces earnings that are significantly better than what was expected by the market, the stock price may jump on the day of the announcement. However, the stock price may continue to drift upwards in the following weeks or months, even in the absence of any significant news or events. This phenomenon is known as PEAD.
what is:
Post EarningsAnnouncementPriceDrift (short answer)
An anomaly related to price reaction after an event day.
– Cumulative abnormal returns exhibit momentum.
– The market adjusts to firm’s earnings information only gradually.
what are some Anomalies:
(Well-known evidence against EMH) 8 points.
- Short-run momentum
– Long-run reversal
– P/E Effect
– Small Firm Effect
– Neglected Firm Effect
– Liquidity Effects
– Book-to-Market Ratios
– Post-Earnings Announcement Price Drift
what is the Challenge of testing EMH? (The joint test problem)
Difficulty of interpreting the tests:
Tests of risk adjusted returns are joint tests of the EMH and the risk adjustment procedure (the model).
If it appears that a portfolio strategy can generate superior returns (alpha), we must choose between rejecting the EMH and rejecting the risk adjustment technique (or both).
