Financial Economics Lectures Flashcards
Market Efficiency Concepts: Allocatively Efficiency?
Allocate scarce resources to most productive use.
Market Efficiency Concepts: Operationally Efficiency?
Transaction costs are determined competitively. Therefore no frictions.
Market Efficiency Concepts: Informationally Efficient?
Current prices fully reflect all available information.
What do perfectly efficient markets satisfy?
Allocative, operationally and informational efficiency.
What efficiencies do we assume Security Markets to have?
Allocative and Operational Efficiency.
Efficient Market Hypothesis?
Market prices instantaneously and fully reflect all relevant available information. So, if efficient, market price (Pt) = fundamental price (Pf,t). If prices are unpredictable then market price won’t equal fair price, but given the transaction cost, this isn’t possible to exploit.
Fundamental price?
The fair price (PV).
Unpredictable?
Unforeseen change within a company which investors did not know of when investing.
When do we have a ‘fair game model’ and what is this model used for in our course?
If there is no systematic difference between the actual and expected return before the game is played. EMH can be explained using a fair game model.
In the fair game model, a security market is said to be efficient when the error value is what?
The error has to be a non-systematic error. Expected and actual return on the security before the game is played.
When is the error consistent?
If, on average the error = 0. So there is no difference between actual and expected.
Fair game model: When is the error independent?
If it is uncorrelated with the expected return. So there is no relationship between the error and expected return.. If there was a relationship, we would not be using all of the information.
Fair game model: When is an error term efficient?
If it is contemporaneously and serially uncorrelated.
Fair game model: Contemporaneously and serially uncorrelated?
covariance of errors = 0.
Stochastic?
Having a random probability distribution or pattern that may be analysed statistically but may not be predicted precisely.
If EMH holds, what is the result on the securities market?
The securities market will be in a continuously stochastic equilibrium and either:
a) market price = fundamental price at all times
b) Fair prices are only affected by unpredictable information which cannot be exploited to make a predicted profit.
Weak-Form Information Set?
Contains past prices
Semi-Strong-Form Information Set?
Contains all publicly available information
Strong-Form Information Set?
Contains all known information (public+private)
Random Walk?
The return on a security tomorrow is equal to the return on a security today plus an amount that depends on the new information generated between today and tomorrow, which is unpredictable given today’s information set. A Random walk model assumes Weak form EMH.
Weak-Form EMH?
Current security prices instantaneously and fully reflect all information contained in the past security prices.
Semi-Strong-Form EMH?
Current security prices instantaneously and fully reflect all publicly available information (price changes are unpredictable). e.g. balance sheets and profit/loss accounts.
Strong-Form EMH?
Current security prices instantaneously and fully reflect all known information. Trading with inside information is not profitable.
How information is reflected in security prices - Strong-Form?
Requires that the market is Fully Aggregating Information: security prices reflect information as though is held by all investors
How information is reflected in security prices - Semi-Strong-Form?
Requires that the market is Averaging Information (not all investors are the same): response of security prices to new information depends on the balance of
‘informed’ and ‘uninformed’ investors. This assumption is more realistic.
Informed investors?
Invest in costly superior information to make excess returns and affect security prices.
Uninformed investors?
AKA Noise Traders - infer information by observing security prices’ fluctuations in response to trades by ‘Informed’ investors.
Net vs Gross?
Net is the total amount minus all the costs. Gross is the total.
Information-Efficient Equilibrium?
Requires a balance between informed and uninformed investors in order to make net return = 0 and both have the same gross return.
Weak-Form EMH evidence?
Alexander (1961). k% filter trading rule should generate excess returns as prices up overtime. Buy when the security price is up (down) k% above (below) its previous low (high). If there are systematic patterns over time in security prices. them a filter rule should earn excess returns over a bit and hold strategy.. The k will depend on the success of the strategy, if to low, to many transactions will be made, and the transaction costs will eat into returns. If to high, many opportunities will be missed.
Conclusion: Whatever the size of k, no filter rule can systematically generate excess returns (after transaction costs) over a bu-and-hold strategy. It provided strong evidence that markets are weak for efficient: security prices incorporate any information embodies in past prices far too rapidly for there to be a profitable trading rule based on the movement of past prices.
Serial Correlation?
What is ‘Serial Correlation’
Serial correlation is the relationship between a given variable and itself over various time intervals. Serial correlations are often found in repeating patterns, when the level of a variable effects its future level.
Also referred to as ‘autocorrelation’ or ‘lagged correlation’.
Contemporaneous Correlation?
Correlation between the realizations of two time series variables in the same time period.
Semi-Strong-Form EMH Evidence and findings i) (Ball and Brown)?
Ball and Brown (1968) examine whether information contained in company reports/ announcements affect security prices. 90% of price adjustments occur on average 12 months before public announcements made, with 10% being made in the in the subsequent 6 months. It would be to late for an investor to wait until the announcement is reported in the financial press the following day.
No trading rule based on exploiting public earnings announcements
generates excess returns over buy-and-hold strategy if semi-strong form EMH is true.
Semi-Strong-Form EMH Evidence and findings ii) (Kraus and Stoll)?
Kraus and Stoll (1972) examine whether information involved in ‘block trades’ can be exploited. If an individual with insider information sold a large number of shares, others may follow expecting an announcement of bad news, resulting in the lowering of the share price, but markets may overreact. As such, an investor could make excess returns, adjusting for risk and TCs, though buying after a block trade and then selling once the slightly higher equilibrium price is reached.
On average, prices fell by 1.1% as a result of the sale and then rose by
0.7% just fifteen minutes after the sale.
No excess returns are available more than a few minutes after news of the block sale becomes publicly available. The evidence shows that markets tend to be semi-strong-form efficient as no excess returns are to be made just a few minutes after the block trade.
Semi-Strong-Form EMH Evidence and findings iii) and iv)?
Announced changes in the BoE’s base rate do not generate excess returns. Most changes in price occur due to anticipation of a rate change. No evidence that securities consistently lead or lag the business cycle.
Therefore this is evidence that the markets are not only weak form efficient but also semi-strong for efficient.
Strong-Form EMH (legal information) Evidence i)? 1968
Jenson shows that unit trusts only just generate excess returns when adjusted for risk and costs over a buy and hold strategy with the use of legal informed information. We conclude that on average, unit trusts make the same return, adjusted for risk and costs, as a buy-and hold strategy
Strong-Form EMH evidence contributors and the year of contribution?
Meiselman (1962)
Modigliani & Sutch (1966)
Malkiel (1966)
Jensen (1968)
Strong-Form EMH evidence from bond market? (1962)
1962 - Meiselman shows that revisions to one-year implied forward rates (1rf2) were highly correlated with forecasting errors in models used to predict future interest rates. Remember formula used. Further evidence of strong form emh. Check sheets.
Strong-Form EMH evidence from bond market? 1966
1966 - Modigliani and Sutch confirmed the Expectations Hypothesis.
Also 1966 - Malkiel found that changes in relative supplies of bonds at different maturities had no effect on interest rate differentials at these maturities. This indicated that bonds at different maturities were perfect substitutes for each other, so that the supply of a bond of a particular maturity could be increased without changing its relative price vis-a-vis other bonds.
Evidence against Weak-Form EMHi)?
1992 - Brock shows that Double Moving Average Rule generated excess returns over 1897-1986 of on average 17% per annum.
He also showed that the Channel Rule (trading range breakout rule) generated excess returns.
How did Brock Double Moving Average Rule work? (when to buy or sell security)
Using a short (10-day) and a long (60 day) moving average MA of security prices. Short MA > Long MA (purchase). Short MA < Long MA (purchase security).
How would you operate the Channel Rule?
Buy when closing price is greater than the highest price over the last 100 days, as long as the previous days closing price was below the highest price. This rule generated excess returns of 18% on average.
What do unit funds (mutual funds) do?
Heavily invest in company research to generate information (private).
Evidence against Semi-strong form EMH (3)? (Excess returns can be made)
- Calendar effects (excess returns can be made after announcements such as Black Friday and Christmas announcement in January)
- Effects related to a firms’ characteristics; size, market-to-book ratio, earnings-price ratio (trading on the basis of these characteristics can generate excess returns)
- Volatility tests.
Perfect foresight price of as share?
Discounted value of all future dividends of a share (assuming all dividends are known).
What does covariance show and how does it differ from correlation?
The direction of a relationship. Correlation deals with the strength of a relationship. It is the expected product of the deviations of two return from their means/
The perfect foresight price (P0*)of a share?
When all future dividends are down with certainty.
Cov(X,X)?
Var(X) = 𝛔^2(X).
Covariance formula (𝝆)?
[(Cov(Ri,Rj)] / [SD(Ri)SD(Rj)]
R values are in percentages.
In a fair game, what are the three properties of the error term?
- Consistency: On average the prediction error is 0.
- Independence: uncorrelated from expected return,
- Efficient: contemporaneously and serially uncorrelated.
What do the two volatility bounds Shiller found state?
With regards to the share price relationship with all future dividends being known; Shiller showed that if semi-strong EMH holds, then the volatility of the perfect foresight share price should exceed the volatility of the actual share price.
With the dividend alternative form of the variance bounds, he showed that if the semi-strong form EMH holds, the volatility of dividends (divided by the square root of twice the firms cost of capital, which chiller assumed to be constant_ should exceed the volatility of share price changes.
Who showed the upper volatility (variance) bound and what was the final formula?
Where did the original evidence of this come from? What was the outcome of this with regards to the real world data?
Shiller:
𝛔(Po) Greater than or equal to 𝛔(Po).
Where Po is the fundamental price.
From the equity markets.
He showed that both variance bounds were violated, with both bounds being exceeded by a factor of 6, showing excess volatility. He concluded that this was inconsistent with market efficiency and even suggested that it was inconsistent with the rational behaviour of investors.
What does 𝛍 equal in the alternative upper variance bound and what is the relationship with Po if EMH holds?
𝛍 = P1 + d + Po(1+r).
The error in predicting P1 at t=0(due to the errors in predicting P1, e1 and e0).
If EMH holds, 𝛍 will be uncorrelated with Po.
Further Evidence against semi strong form in equity markets, not Shiller, iv)?
DeBont and Thaler (1985) showed that security markets overreact; shares whose price falls for 3 years would show excess returns of 6.1% per year for the subsequent 3 years.
Evidence against the Semi-Strong Form EMH from the Bond market (Shiller)?
Shiller (1979) found that long-term interest rates were excessively volatile in comparison to short-term interest rates. He showed that 𝛔(rh) is less than or equal to 𝛔(r) / ((2r)^1/2. Recite rest of this from sheet. rh is the holding period and r is the short term interest rate. There was excess volatility while, although less than with shares, being only 1.14x.
What does the evidence indicate about securities markets from the 1960s?
The market is both weak-form and semi-strong-form dependent. Not possible to generate excess returns in for risk and transaction costs with information on lagged security prices are currently available public information.
They appear to be strong form efficient on the basis of using privately generated information, but inefficient when it came to illegally obtained insider information
Lecture 2 Start
What assumptions do we hold when testing whether Capital markets benefit society?
- All outcomes from Investment (I) are known with certainty
- No transaction costs/taxes
- Two periods economy, t = {0; 1}
Production possibility schedule (PPS) and what is its implications?
A schedule of productive investment opportunities that each agent has, arranged from the highest rate of return to the lowest. Each individual has a productive opportunities schedule. There will be demising returns on investment, as the more an individual invests, the less the rate of return on the marginal investment.
Marginal Rate of Transformation (MRT)?
The slope of the Production Possibility Schedule (The rate at which £1 of consumption today forgone is transformed by the productive investment into consumption tomorrow.
When does an individual ‘I’ maximise U)Co,C1)?
When MRT = MRSi. The individual will invest in productive opportunities that have rates of rerun higher than his or her subjective rate of time preference.
What do Capital Markets facilitate?
The inter temporal exchange of consumption bundles between borrowers and lenders at a market-determined rate of interest, r. Without them, two individuals with the same investment opportunities and same endowment may choose completely different levels of consumption due to their preferences.
Capital Market Line?
Represents the borrowing and lending opportunities, with initial endowment (y0,y1), agents can reach any point along CML by borrowing or lending at r.
