Efficient Market Theory (LECTURE 5) Flashcards
What is an EFFICIENT MARKET?
Where there is no systematic under-valuation or over-valuation of securities.
Not possible to come up with a clever trading strategy to beat the market. (no abnormal profits)
If someone earns abnormal profits, it would be a pure chance and nothing else.
The current price of a common share reflects all known information, both past and present, about the corporation, including information about a company’s earnings, financial strength, management strengths and weaknesses, and future plans as announced through press releases and the management discussion and analysis in its financial statements.
Why do we need efficient markets?
- To encourage buying of assets/shares.
- increase investors’ confidence
- pay fair price
- To give correct signal to company’s managers.
- Shareholders’ wealth maximisation requires efficient markets
- To help allocate resources.
- Resource allocation to where it is needed most
- Managers need to know the discount rate
EFFICIENT MARKET HYPOTHESIS
In an efficient capital market, security (e.g. shares) prices rationally reflect available information.
Ne information revealed about a firm:
-Will be incorporated into the share price rapidly and rationally, with respect to the direction of the share price movement and the size of that movement.
The current share price level is an unbiased estimate of its true economic value based on the information revealed.
What does market efficiency not mean?
- Prices are not always equal to the true value.
- Errors are random
- Errors are unbiased
- You will never come across someone beating the market at some point.
- You will never come across someone using a particular strategy and beating the market for very long.
What happens in the market in the real world?
- Many buyers and sellers of securities.
- New information revealed.
- Quick reaction from investors.
- Exploit any profitable opportunity.
- And the opportunity disappears quickly.
What would happen if markets weren’t efficient?
If markets were not informationally efficient:
- Investors may not be able to trust that market prices are up to date and investors should then conduct their own research (or hire a researcher) to validate the price.
What are the three forms of efficiency?
- WEAK FORM: current share prices reflect all information contained in past price movements.
- SEMI-STRONG FORM: current market prices reflect all publicly available information.
- STRONG FORM: current prices reflect all relevant information whether held publicly or privately.
WEAK FORM EFFICIENCY
Weak form EMH is the theory that security prices reflect all market data, referring to all past price and volume trading information.
IMPLICATIONS:
If weak form efficient, historical trading data will already be reflected (discounted) in current prices and should be of no value in predicting future price changes.
No abnormal profits for anyone: a profit in excess of that expected for the asset’s level of risk on a consistent basis.
Why does technical analysis fail?
Investor behaviour tends to eliminate any profit opportunity associated with stock price patterns.
What are the tests of weak form efficiency?
The evidence:
RANDOM WALK HYPOTHESIS:
- Prices follow a random walk.
- Prices change over time being independent of one another.
- Toss a coin
- could be head or tail
- similarly share prices cannot be predicted.
TECHNICAL ANALYSIS:
- Analysis of historical trading information to attempt to identify patterns.
- Findings: no performance noted compared to a simple buy - and - hold strategy.
Why is it difficult to exploit anomalies in weak form efficiency?
- Averages that are observed in the past.
- Do not occur all the time.
- Take into account trading costs (profits will disappear).
SEMI-STRONG FORM EFFICIENCY
In a market that is SSFE, asset prices reflect all publicly known info.
*includes info about earnings, dividends, corporate investments, management changes, etc.
IMPLICATION:
If SSE, it is futile to analyse public info such as earnings projections and financial statements in an attempt to identify under-priced or over-priced securities.
What is the evidence on semi-strong form?
What are we testing?
- Does market react to bad news?
- How much?
- Should quickly and accurately incorporate the effect
- If not such as if the market overreacts or under-reacts, or if time lags exist in stock price adjustments.
Most studies test using event study methodology.
Anomalies in semi strong form.
-Many studies support the SSF of EMH.
A number of anomalies (or exceptions) have been identified including:
- The “value” investment style has consistently outperformed the “growth” style.
- The “size effect” that shows that small market cap stock tend to outperform large cap stocks on a risk-adjusted return basis.
- The momentum effect.
- Sin stock effect.
STRONG FORM EFFICIENCY
Strong form EMH is the theory that stock prices fully reflect all information, which includes both public and private information.
IMPLICATIONS:
- Stock prices are fairly priced.
- It is not possible to use public information to identify over-priced or under-priced stocks.
- It is not possible to use insider information to identify over-priced or under-priced stocks.
