Lecture 5&6 Flashcards
What drives stock price?
- Finance and market-based accounting says only information should drive the share price
- However, non-information (sentiment) can also drive prices
Why do we do fundamental analysis?
To identify misvalued securities for investment purposes. Difference between intrinsic value and current price
Efficient Market Hypothesis (EMH)
- In an EM prices reflect all available information
- Price = Fundamental value of the firm
- No profitable investment opportunities from superior analysis
- No difference in performance between knowledge investors (professionals) and picking stocks randomly
Speed of adjustment
Time it takes the market to fully incorporate the effect of new information
When is a market efficient?
- When prices of securities traded in the market act as though they fully reflect all available information
- When prices react instantaneously in an unbiased fashion to new information
Weak-form market efficiency
- Prices reflect the information contained in past stock prices
- There are no predictable patterns in (abnormal) returns
Semi-strong market efficiency
- Prices reflect all publicly available information
Strong form market efficiency
- Prices reflect all information both publicly and privately
- Insider trading is illegal
Efficient Capital Markets
Precondition for security prices to reflect all information fully is that information and trading costs always equal zero
Joint-hypothesis problem
- Market efficiency per se is not testable
- It must be tested with an “equilibrium” asset pricing model
- Anomalous evidence on market returns may reflect market inefficiency or a bad model (or both)
Test of market efficiency
- Tests of return predictability
- Event studies
- Tests for private information
Maximally rational market
All investors are rational
Rational market
Investors may not be rational, but markets are rational
Minimally rational markets
- Even if markets aren’t rational, no abnormal profit opportunities exist even for rational investors
- The vital importance of trading costs
Rubinstein’s “Prime Directive” (Rubinstein, 2001)
“Explain asset prices by rational models. Only if all attempts fail, resort to irrational investor behaviour”
Information Asymmetry
Different market participants have different information about the firm/product/service
- Leads to an inefficient market, market timing and wealth expropriation
Signalling
A mechanism to reduce the effects of adverse selection
- Something to show that your product is high quality
Adverse Selection
A market mechanism that leads to market collapse
Market for lemons
When customers don’t know the true value of products and will happily pay an average price, the higher quality, more expensive products will not be bought causing those sellers to opt out of the market. This decreases the average willingness to pay resulting in lower quality products in the market
A Signal and its Credibility
The more expensive a signal, the more credible
E.g.
- Dividend increase
- Credit ratings
- R&D expense
Stock Market Anomalies
Trading strategies that violate the EMH
- Ability to earn positive abnormal returns systematically
Anomalies based on market under/overreaction to firm news
- Short-window and long-horizon event studies
Anomalies based on observable firm characteristics
Some traditional Anomalies
- The size (small firm) effect
- The P/E anomaly
- The value (book/market) anomaly
- Price momentum (continuation of prior returns)
- Earnings momentum
- The accruals anomaly
Key issues in fundamental analysis and stock market anomalies (Richardson, 2010)
- Need for credible alternative hypothesis
- Sound treatment of risk? The standard joint hypothesis criticism
- Transaction costs issues? Trading costs and other market frictions usually ignored
- Additivity issues. How does this new anomaly differ from existing one?
A Caveat (Richardson, 2010)
When forecasting future stock returns it’s difficult to explain why stock prices in a highly competitive capital market are not efficient and why a given accounting attribute seems to be ignored by many individuals who have strong financial incentives to exploit any and all useful forecasting “information”
Testing market efficiency - Event studies
- Identify the event of interest and the timing of the event - what’s the actual event date?
- Specify a benchmark or expected return for comparative non-event (normal) stock return behaviour
- Calculate abnormal returns around event date
Benchmark Event studies models
- The (single factor) market model
- The cumulative abnormal return (CAR) Metric
- The buy-and-hold abnormal return (BHAR) metric
- Market adjusted return model
- CAPM model
Fama, 1970
Weak-form, semi-strong form and strong form market efficiency
Fama, 1965
“In an efficient market, on the average, competition (among rational, profit-maximising participants) will cause the full effects of new information on intrinsic value to be reflected instantaneously in actual prices.”
Fama, 1991
Efficient Capital Markets, The Joint-hypothesis problem, tests of market efficiency
RAST, 2013
Report 333 publicly identified “anomalies” (“return predictive signals”) 1970 – 2010
- Many correlated
