Lecture 6 and Reading Flashcards
Efficient Market Hypothesis
Asset prices fully reflect information about the asset’s future
What are the three forms of market efficiency?
Weak: stock prices reflect all information contained in the history of past price
Semi-strong: stock prices already reflect all publicly available information
Strong: prices reflect all relevant information, including
What is the form of market’s evidence suggests?
Efficient in weak form, and most likely in semi-strong form
What happens if markets are not efficient?
- Prices may diverge from fundamentals
- Expected returns different from predicted by the model
- Abnormal returns can be earned
- Investment decisions (allocation of capital) are not efficient
Technical analysis
The search of recurrent and predictable patterns in stock prices
Resistance levels
Price levels above which it is difficult for stock prices to rise, or below which it is unlikely for them to fall, and they are believed to be levels determined by market psychology
What would happen to market efficiency if all investors attempted to follow a passive strategy?
If everyone follows a passive strategy, sooner or later prices will fail to reflect new information. At this point there are profit opportunities for active investors who uncover mispriced securities. As they buy and sell these assets, prices again will be driven to fair levels.
Cumulative abnormal return (CAR)
the sum of all abnormal returns over the time period of interest (leakage of information to some investors that gain profit)
Suppose that we see negative abnormal returns (declining CARs) after an announcement date. Is this a violation of efficient markets?
Predictably declining CARs do violate the EMH. If one can predict such a phenomenon, a profit opportunity emerges: Sell (or short sell) the affected stocks on an event date just before their prices are predicted to fall.
Serial correlation
refers to the tendency for stock returns to be related to past returns. Positive serial correlation means that positive returns tend to follow positive returns (a momentum type of property). Negative serial correlation means that positive returns tend to be followed by negative returns (a reversal or “correction” property).
Fundamental analysis
Uses earnings and dividend prospects of the firm, expectations of future interest rates, and risk evaluation of the firm to determine proper stock prices. Ultimately, it represents an attempt to determine the present value of all the payments a stockholder will receive from each share of stock.
The semistrong form of the efficient market hypothesis asserts that stock prices:
Fully reflect all publicly available information.
Assume that a company announces an unexpectedly large cash dividend to its shareholders. In an efficient market without information leakage, one might expect:
An abnormal price change at the announcement
A “random walk” occurs when
Future price changes are not correlated with past price changes.
Random walk is followed by stock prices that cannot be exploited by investors as there is no predictable pattern which can be followed.
So, market efficiency has evidenced that stock prices reflect all the information and any new information will result in change in stock prices that can be bad or good for investors.
“If all securities are fairly priced, all must offer equal expected rates of return.” Comment.
All the securities that are fairly priced do not offer equal expected rate of return because it differs due to different risk premiums. Risk is dependent upon uncertain events. Some securities are purchased to get interest and dividends. Some are purchased for growth or increase in the price of shares.
Some securities give rate of return in the form of dividends and some securities have growth prospects that can help in increasing the price. Generally companies paying dividends are considered safer and solid for buying purpose.
One should buy shares of growth stocks and can earn good profit by selling them when prices go above a level.
