L8 - Efficient Market Hypothesis Flashcards
What does a market being efficient mean?
A market is efficient if asset prices reflect information fully and immediately
Why is this important?
- For investors: identify mispricing, avoid risky firms
- –For issuing firms: accounting reporting methods, security issuance timing
- –Can affect social welfare
•Trading profits motivate investors to acquire and analyze information and ensure market efficiency
What are the general roles of Buy and Sell-side analysts?
- Sell-side analysts
- –Follow a couple of firms and produce research reports to clients
- –Paid by their employer (brokerage, etc.) –> want to encourage trading as they earn a commission when you trade
- •Buy-side analyst
- –Employed by mutual or pension funds
- –Provide research to their employers only
- –Employed by mutual or pension funds
What are the two types of Stock analysis?
Technical analysis
- –Use historical prices and volume information to predict future prices
- –Mainly for market timing purpose
•Fundamental Analysis
- –Use economic and accounting information to predict stock prices (firm’s financial statements, historic performance, future plans, economy/industry environment, ……)
- –Mainly for stock selection purpose
What are the three forms of market efficiency?
- Weak-form market efficiency
- –Current prices reflect all historical information.
- •Semi-strong-form market efficiency
- –Current prices reflect all public information.
- •Strong-form market efficiency:
- –Current prices fully reflect all information. (public + private information)
•It’s not about the speed. It’s about what kind of information is reflected in current prices.
What is the implication of Weak-form efficiency?
- You cannot earn an abnormal return (the “a” in asset pricing models) by studying history.
- •If a market is weak-form efficient, technical analysis (i.e., trading rules based on historical prices/returns) does not generate an abnormal return
- •A market can remain weak-form efficient if there is strong competition among investors.
Prices should follow a random walk ( there is no relationship between yesterday’s price change (or return) and today’s price change (or return)
- supported by a test on the pair of returns of Microsoft stock on two successive days between March 1990 and July 2001
What is some counter-evidence against weak-form Market Efficiency?
Returns over the short horizon:
- –Short-run momentum (Jegadeesh and Titman, 1993):
- Positive (negative) returns tend to follow positive (negative) returns
•Returns over the long horizon:
- –Substantial negative correlations of returns over one period relative to a subsequent period
- –Long-run mean reversion (DeBondt and Thaler, 1985): Positive (negative) returns tend to be followed by negative (positive) returns
What are the implications of Semi-Strong market efficiency?
- All the public information is impounded into prices immediately once it is released.
- –Public information includes financial reports, earnings announcements, management changes, etc.
- therefore it doesn’t pay to buy when there is positive news about a stock as the competition among investors with drive the price to its fair value
- –If it holds, neither technical analysis nor fundamental analysis can yield abnormal return.
- –Public information includes financial reports, earnings announcements, management changes, etc.
How do you perform empirical Tests for Semi-Strong Form Market Efficiency?
•Perform event studies around important announcements to see whether the news is reflected immediately
–We use mergers & acquisitions (M&As) –> this is good for a target firm as there is a demand for their shares as the acquiring firm wants to buy enough shares to agree to the merger
–t = 0 represents the announcement day
–Calculate the cumulative abnormal returns (CARs) of target firms from t = -30 to t = 5
–CART=∑Tt=-30(ARt), where ARt is the abnormal return on day t
–If the market is efficient, ARt should be zero for t < 0 and t > 0 but significantly positive at t = 0.
–It follows that the CART should be zero for T < 0, jump up for T = 0, and then remain flat for T > 0.
•Empirical evidence is mixed. –>
- (on the one hand, we sometimes see a jump in the share price on the announcement day)
- On the other hand Post-Earnings, announcement drift shows that the larger the earning surprise the bigger the initial jump and the more the share price rises over time after then announcement. Whereas if there is no earnings surprise nothing happens to the stock price
- (against the semi-strong form)
What is Strong-Form Market Efficiency?
- All information (public and private) is impounded into prices.
- If the market is strong-form efficient,
−all assets 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
What are the empirical tests for strong form efficiency?
- Assess the profitability of insider trading
- There is anecdotal evidence that insider trading leads to positive abnormal returns.
- However, a large-sample empirical test remains difficult because insider trading is prohibited by the SEC.
- Some researchers use mutual fund performance to test market efficiency. However, results are mixed (potentially because not all fund managers have insider information).
Why do investment superstars still exist when the market is efficient?
•Why do investment superstars still exist when the market is efficient?
–They have superior skills.
–Luck. The probability of beating the market for n consecutive years is (0.5)n. With 10,000 managers in the market, this number equals 312 for n=5 and 10 for n=10.
- •Bill Miller from the Legg Mason Capital Management Value Trust
- –His fund’s after-fee return beat the S&P 500 index for 15 consecutive years from 1991 to 2005.
- –Miller said, “As for the so-called streak, that’s an accident of the calendar. If the year ended on different months it wouldn’t be there and at some point, the mathematics will hit us. We’ve been lucky. Well, maybe it’s not 100% luck—maybe 95% luck.”
What are the difficulties of testing Market Efficiency?
•The magnitude
- –Abnormal return must be large enough to be statistically significant.
- –However, even a 0.01% abnormal return is still a huge amount of money if your position is large.
•The selection bias:
- –Profitable trading strategies are kept secret so the researcher is not aware of them.
•It remains difficult for researchers to cleanly separate luck from skill.
What is Passive Management?
–Usually just try to replicate a certain index. No attempt to outsmart the market
–Examples: index funds and exchange-traded funds (ETFs)
–Charge low fees
- Index mutual funds and ETFs are becoming more and more popular over active management
What is Active Management?
–Apply complicated trading strategies and trade more actively
–The marginal return from active trading may be so small that only large investors find them worthy
–Charge higher fees
What are some possible sources of Market efficiency?
- •Transactions costs (fees, taxes, costs of borrowing, regulatory constraints) eliminate abnormal returns from arbitrage.
- •Investors may behave irrationally
- –Being irrational (not following your utility function) is not the same as being un-informed (just imitate other peoples behaviour), although they generate similar behaviour. This is why testing behavioral theories are difficult.
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•Behavioral finance incorporates psychology to explain the behavior of individual and institutional investors.
- –Because of human nature, people make particular types of mistakes.
- –Richard Thaler was awarded the 2017 Nobel Prize
