LA 6: Ch 4 R&B - Efficient Capital Markets

Question 1

What is the first premise of an efficient market?

Answer 1

Large # competing, profit-maximising participants who analyse and value securities, each independently of the others

Question 2

What is the second premise of an efficient market?

Answer 2

New info regarding securities comes to market in random fashion

Question 3

What is the third premise of an efficient market?

Answer 3

Profit-maximising investors cause security prices to adjust rapidly to reflect the effect of new information

Question 4

What are the results of the premises of an efficient market?

Answer 4

• Security price changes should be INDEPENDENT and RANDOM
• prices that prevail at ANY time should be an UNBIASED REFLECTION of all CURRENTLY AVAILABLE INFO
• the EXPECTED RETURNS implicit in the current price of a stock should be CONSISTENT with perceived RISK of the stock

Question 5

What are the general three Efficient Market Hypotheses?

Answer 5

• Random walk hypothesis
• Fair game model
• Efficient market hypothesis

Question 6

What is the basic gist of random walk hypothesis?

Answer 6

Changes in security prices occur randomly i.e. they follow a random walk

Question 7

What is the basic gist of fair game hypothesis?

Answer 7

Current MARKET PRICE reflects ALL AVAILABLE INFO about a security and the EXPECTED RETURN based upon this price CONSISTENT with its RISK

Question 8

What is the three sub-hypotheses of the efficient market hypothesis?

Answer 8

Weak-form EMH
Semi-strong-form EMH
Strong-form EMH

Question 9

What is the basic gist of Weak-form EMH?

Answer 9

Current prices reflect all security-market HISTORICAL INFO, incl. the historical sequence of

• prices
• rates of return
• trading volume data
• other market-generated info
  i. e. prices reflect all historical information

Question 10

What does Weak-form EMH imply?

Answer 10

Implies that PAST RATES OF RETURN and other MARKET DATA should have NO relationship with future rates of return

Question 11

What is the basic gist of semi-strong-form EMH?

Answer 11

Current prices reflect all PUBLIC info, incl.

• market
• non-market info
  i. e. all prices reflect all public information

Question 12

What does semi-strong-form EMH imply?

Answer 12

Decisions made on NEW INFO after it is public SHOULD

NOT lead to ABOVE-AVERAGE RISK-ADJUSTED PROFITS from those transactions

Question 13

What is the basic gist of strong-form EMH?

Answer 13

Stock prices FULLY reflect ALL INFO from public and private sources
i.e. prices reflect all public and private info

Question 14

What does strong-form EMH imply?

Answer 14

Implies no group of investors should be able to consistently derive above-average risk-adjusted rates of return

Question 15

What does strong-form EMH assume?

Answer 15

Assumes perfect markets in which all info is cost-free and available to everyone at the same time

Question 16

What are the results of tests of Weak-form EMH?

Answer 16

• When pre-2000 trading costs were considered all the trading profits turned to losses. (recent lower trading costs could have a diff result)
• Testing results generally support the weak-form EMH but results not unanimous

Question 17

Based on the results of return prediction studies on quarterly earnings reports, what is NOT instantaneously reflected in security prices?
(From tests of Semistrong-EMH)

Answer 17

Earnings price is not instantaneously reflected in security prices

Question 18

Based on the results of return prediction studies on TIME SERIES TESTS FOR ABNORMAL RETURNS, what has been shown to be limited? What has been shown to be successful?
(From tests of Semistrong-EMH)

Answer 18

Short-horizon returns have limited results
Long-horizion returns analysis have been quite successful based on
- div yeld (D/P)
- default spread
- term structure
Quarterly earnings reports may yield abnormal returns due to
- unanticipated earnings change

Question 19

What is the January anomaly?

From tests of Semistrong-EMH

Answer 19

Stocks with negative returns during the prior year had higher returns right after the first of the year

Question 20

When does all the market’s cumulative advance occur?

From tests of Semistrong-EMH

Answer 20

During the first half of the trading months

Question 21

What is different w.r.t. Monday/weekend returns in comparison to the rest of returns?
How does this effect affect large and small firms respectively?
(From tests of Semistrong-EMH)

Answer 21

They were significantly negative in the return prediction studies
Large firms: weekend effect - negative monday effect occured BEFORE the market opened
Small firms: most of effect occured during the day (i.e. monday trading effect)

Question 22

What is the low and high price-earnings ratios shown to be correlated with? What is this inconsistent with?
(From tests of Semistrong-EMH)

Answer 22

Low P/E stocks experienced superior risk-adjusted results relative to market
High P/E stocks had significantly inferior risk-adjusted results

This is inconsistent with semistrong EMH

Question 23

In the tests of how do stock splits and IPOs affect stock prices for semi-strong EMH what was shown?

Answer 23

Stock splits: splits result in abnormal gains before the announcement not after
IPO: underpriced by about 18% at offering (varies with time) & price is adjusted within one day

Question 24

Do corporate insiders conform to strong-form EMH?

Answer 24

Not really, many insiders had above-average returns implying they had private info that the market did not

Question 25

What did the tests of Security Analysts show? (Strong-form EMH)

Answer 25

Evidence in favour of existence of superior analysts who apparently posses private info

Question 26

Why did they study Professional money managers?

Answer 26

• group that is most likely to achieve-above average returns

- non-insider group that is most likely to obtain inside information

Question 27

What did the study of professional money managers yield in results w.r.t. strong-form EMH?

Answer 27

Some weak support for strong-from EMH