L10 Efficient Market Hypothesis Flashcards
1
Q
What is meant by Efficiency?
A
- In an efficient capital market, security (for example, shares) prices rationally reflect available information
- If new information is revealed about a firm, it 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
- No trader will be presented with an opportunity for making a return on a share greater than a fair return for the riskiness associated with that share, except by chance
- The current share price level is an unbiased estimate of its true economic value based on the information revealed –> market is not always equal to true value at every point, but errors that are made are unbiased therefore deviations happen at random
2
Q
What does efficiency not mean?
A
- Prices do not depart from true economic value –> current price is based on probable estimates on information valuable, doesnt necessary mean that in a few years the company was undervalued and thus rises
- You will not come across an investor beating the market in any single time period
- No investor following a particular investment strategy will beat the market in the long-term
3
Q
How can the effect of new information be represented on a graph, in both effcicient and inefficient markets?
A
4
Q
Whats the value an efficient market?
A
- To encourage share buying - wouldnt buy shares if market was inefficient as prolonged inefficiency can lead to cases where the value of a company doesnt rise even though they are performing well
- To give correct signals to company managers
- Managers need to be assured that the implication of a decision is accurately signalled to shareholders and to management through the share price
- The rate of return investors demand on securities
- Information communicated to the market
- To help allocate resources
5
Q
What happens to share price patterns?
A
- as investors notice patterns they benefit from them initial, but as others start recognising it the gains are lessen, furthermore people start predicting the pattern earlier and earlier until everyone is investing at random times and thus the pattern disappears
6
Q
What are the three levels of efficiency?
A
- Weak-form efficiency. Share prices fully reflect all information contained in past price movements
- Semi-strong form efficiency. Share prices fully reflect all the relevant publicly available information
- Strong-form efficiency. All relevant information, including that which is privately held, is reflected in the share price
7
Q
What are the three types of efficiency?
A
- Operational efficiency –> refers to the cost, speed and reliability of transactions in securities on the exchange
- Allocational Efficiency –> Society has a sacrcity of resources and it is important that we find mechanisms which allocate those resources to where they can be most productive
- Pricing Efficiency –> investors can expect to earn mearly a risk-adjusted return from a n investment as prices move instantaneously and in an unbiased manner to any news
8
Q
What are Weak-form tests?
A
- •There will be no mechanical trading rules based on past movements which will generate profits in excess of the average market return (except by chance)
Profit of weak form efficiency:
- Based on patterns, e.g. head and shoulders, line and breakout patterns (support and resistance)
- The filter approach
- Focus on the long term trends and to filter out short-term tends
- Moving averages (Brock et al. 1992) –> e.g. if short run MA (say 50 days) starts trending above the long run MA (say 200 days) you should buy
- The Dow Theory
- Primary - long trends (over years), Intermediate trends (weeks and months, Tertiary (days or hours) - looking at reversals
- Park and Irvin (2007 - In general with technical analysis it is said you will not be able to beat the market
9
Q
What was the empirical evidence of return reversal?
A
(weak-form tests)
- De Bondt and Thaler (1985) - in the US
- Shares that had given the worst returns over a three-year period outperformed the market by an average of 19.6 percent in the next 36 months
- Those that gave the highest return over the past 36 months actually underperformed the market by 5% in the next 3 years
- Arnold and Baker (2007) - UK
- Loser shares (worst in past 5 years) outperformed winner shares by 14 percent per year
- Winners underperformed that market by -0.4%
10
Q
Jegadessh and Timan (1993)?
A
- Price (return momentum) - weak form
Jegadeesh and Titman (1993): a strategy that selects shares on their past six-month returns and holds them for six months, realises a compounded return above the market of 12.01 per cent per year on average
•Possible explanations:
–Investors underreacting to new information - takes time to reach the efficient level
–Investors overreacting during the test period - bandwagon effect which sends the price flying up
11
Q
What are Semi-strong form tests?
A
- •Is worthwhile expensively acquiring and analysing publicly available information? - arguing that Fundamental analysis doesnt make sense - as according the EMH all avaiable information is in the stock price
- •Fundamental analysts try to estimate a share’s true value based on future business returns –> trying to exploit any mispricing of assets from their true economic value
- •Majority of the early evidence (1960s and 1970s) supported the hypothesis
- •Some academic studies which appear to suggest that the market is less than perfectly efficient
- •Seasonal, calendar or cyclical
- – The weekend effect (markets tend to give higher returns on friday and lower on monday)
- , the January effect, etc. (market returns is higher in the first few days)
- However these effect disappear as soon as people predict them and start buying earlier
12
Q
How are Small firms a Semi-strong form tests?
A
- •Studies in the 1980s found that smaller firms’ shares outperformed in the USA, Canada, Australia, Belgium, Finland, the Netherlands, France, Germany, Japan and Britain
- •Perhaps the researchers had not adequately allowed for the extra risk of small shares, beta (also liquidity risk)
- •Some researchers have argued that small firms suffer more in recessions –> riskier so higher required rate of returns
- •Proportionately more expensive to trade in small companies’ shares
- Institutional neglect - analyst at be hedge funds and pension funds skip the small companies
13
Q
Dimson et al. (2002)
A
- Small-cap reversal in the US and the UK
- Before 1989, it was true that small-cap firms out performed the larger ones
- After this information was revealed, small firms actually under performed compared to large firms
14
Q
What are some cases when we could question semi-strong form efficiency?
A
•Underreaction
- Investors are slow to react to the release of information in some circumstances;
- ‘Post-earnings-announcement drift’ - extra good news announced with respect to earnings leads to higher prices and takes time to adjust, opposite also occurs for bad news
•Value investing
- For example low price-earning ratio shares, high dividend yield, high book-to-market ratio –> tend to provide abnormal returns
15
Q
What can be said about the literature on semi-strong efficiency?
A
- Despite the evidence of some work showing departures from semi-strong efficiency, for most investors most of the time the market may be regarded as efficient
- The evidence for semi-strong efficiency is significant but not so overwhelming that there is no hope of outperformance for the able and dedicated
- Publication bias - case where semi-strong efficiency doesnt hold - doesnt get published quickly - case where it doesnt hold - gets published quickly
- Hundreds of researchers examining the data
- Paradox: in order for the market to remain efficient there has to be a large body of investors who believe it to be inefficient
