FINC2011 Lec 11 Efficient Markets and Behavioural Finance Flashcards
What keeps security prices efficient?
Analysts uncover info, clients trade on the basis of this info, first clients make to trade make a profit, trading process causes security prices to reflect the info uncovered by the analysts.
Thus, it is the activities of analysts and thier clients that cause prices to be effficient.
What are the 3 forms of market efficieny?
- Weak-form efficiency: prices reflect all info contained in the record of past prices.
- Semi-strong-form efficiency: prices fully reflect all publicly available info. (Earnings announcements, news rumors).
- Strong-form efficiency: all available info is fully reflected in current prices.
What is an example of how WEAK-FORM efficiency would occur?
Traders might have access to new info, and begin to reveal that info by the effect on prices.
Perceiving a trend, other market participants transact in an attempt to profit from the new info.
This speeds up the impounding of the info revealed by the initial price movement, subsequent movements after the initial info has been impounded will be random.
E.g. If I try to buy, others will buy, and therefore next period cannot reflect the same pattern. (anti-technical analysis).
What are the implications of a SEMI-STRONG-FORM efficient market?
Semi-strong-form must also be weak-form efficient, bc historic prices are publicly available info.
Semi-strong-form market reacts immediately to the release of any new info.
What are the implications of a STRONG-FORM efficient market?
Strong-form must also be semi-strong-form (and therefore weak-form efficient) bc publicly available info and historical prices forms part of “all available info”.
Pisces should also reflect private info (e.g. insider info (illegal)). Insider info could, in theory, be reflected in prices if insiders trade on info and are able to move prices, thus revealing the info.
How to test whether market is WEAK-FORM efficient?
Prices movements should be random and should not exhibit trends:
- Do prices follow a “RANDOM WALK”?
- Are TRADING RULES profitable?
Weak-form efficiency “RANDOM WALK” test:
Prices follow a random walk if current price is unrelated to previous price (i.e. the value linking the two (e) should be a random number (i.e. not same, or constantly +ve)
P_t = P_(t-1) + e
Weak-form efficiency TRADING RULES / FILTER RULES with PAIRED STOCK test:
Should not be possible to make systematic profits from trading rules which are triggered by price trends.
Filter represents a set percentage by which a stock must rise / fall in order to trigger a buy / sell. (e.g. buy if stock rises 10% from its previous lowest price). Assumes future price movements can be inferred from past prices.
Buy / sells triggered on first stock, also done on paired stock. If there is as much profit on paired stock than original stock, then any profit must be through sheer luck, rather than a successful strategy.
How to test whether market is SEMI-STRONG-FORM efficient?
“EVENT STUDY” test: Do prices react rapidly to info from earnings announcements or large trades?
Since stock price movements may also be caused by broad market movements, it is necessary to isolate abnormal (excess) returns (on top of the market).
AR = R - E(R)
E(R) is calculated using CAPM! Not ave of returns.
E(R) = Rf + B(Rm -Rf)
Day before - large AR - insider trading
Day - large AR - rapid market reaction
Day after - slight negative AR - overreaction correction
Day after that - basically no AR - info already reflected in share price.
How do we infer strong-form efficiecny / inefficiency?
From the fact that insider trading is illegal in Australia, there have been a nubmer of convictions, and those convicted have profited.
What are some behavioural finance theories?
- Prospect theory: attitudes towards risk, weighting of gains and losses.
- Beliefs about probabilities: conservative or overconfidence
- Limits to arbitrage: short squeeze
- Unconscious herding behavior.
