Lecture 7 Flashcards
Efficient market hypothesis states
Any information that could be used to predict the stock performance should already be reflected in the stock price
Increases/ decreases in stock prices due to
New information (unpredictable)
Random walk
Stock price changes should be random and unpredictable
If stock prices are predictable
Stock markets are inefficient
Weak form EMH
Stock prices reflect all past information that can be derived by examining market trading data
Trend analysis in weak form EMH
Pointless > any relevant information regarding the future performance will already be reflected
Semi-strong EMH
All publicly available information regarding the prospects of a firm must be reflected in the stock price
Strong form EMH
Stock prices reflect all information relevant to the firm, even if only available to insiders
Technical analysis =
Search for recurrent and predictable patterns in stock prices
Fundamental analysis =
Uses earnings and dividend prospects, expectations of future interest rates and risk evaluation to determine proper stock prices
If the present discounted value of payments stockholder received exceeds stock price
Purchase stock
EMH predicts that the majority of fundamental analysis is
Doomed to fail > if analysts use the same publicly available info, little different between their analysis
Investor’s trick =
To find firms that are better than other’s estimate/ not as bad as the stock price suggests
Mututal funds benefit from
Economies of scale
Active management according to EMH
Largely wasted effort
EMH advocates
The passive investment strategy > because stock prices are at fair levels, makes no sense to buy and sell frequently and incur large brokerage fees
Index funds
Designed to replicate the performance of a broad based index of stocks
Firm specific risk can be eliminated through
Diversification
Tax considerations (3)
- Tax brackets of investors impacts their preference
- Capital gains are taxed less heavily than dividends
- Investment opportunities can be sensitive to tax benefits eg real estate
Role of portfolio manager in efficient market =
To tailor portfolio to investors’ needs instead of beating the market
Deviations from efficiency may
Offer profit opportunity for better informed traders
Disadvantage of deviations from efficiency
Can result in large costs > inefficient resource allocation
If inefficient capital markets (2)
- Investment opportunities may be foregone
- Overpriced securities may be able to obtain capital too cheaply
Event studies =
Assess the impact of an event on the firm’s stock price using empirical financial research
Can measure the impact of an event by
Estimating the abnormal return of a stock at the moment the information about the event becomes known to the market
Leakage information
Occurs when information regarding an event is released to a small group of investors before public release
Leakage information skews
Abnormal returns on announcement date > therefore cumulative abnormal return better indicator
Are markets efficient? > The magnitude issue
Against large fluctuations in the market, small increases in the performance can be hard to detect
Are markets efficient? > The selection bias issue
Investors are unlikely to share successful techniques with others
Are markets efficient? > the lucky event issue
Only tend to hear about the large wins, not the corresponding losses
Weak-form tests (5)
- Returns over the short horizon
- Returns over the long horizon
- Fama & French
- Campbell & Shiller
- Kiem & Stambaugh
Fama & French
Aggregate returns are higher with higher dividend ratios
Campbell & Shiller
Earnings yield can predict market returns
Kiem & Stamburgh
Bond spreads can predict market returns
Semi-strong tests (5)
- PE effect
- Small firm effect
- Neglected firm effect
- Book-to-market ratios
- Post-earnings announcement price drift
Strong form tests (2)
- Insider trading studies by Jaffe
- SEC requires all insiders to register trading activity
