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PPF > Lecture 8-Stock market & Efficiency > Flashcards

Lecture 8-Stock market & Efficiency Flashcards

1
Q

Big 3 stock markets in the world are

A

New York, London, Tokyo

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2
Q

How can the the size of stock markets be measured

A
  • Number or value of trades

- Number or value of listed companies

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3
Q

The overall performance of a stock market is measured by what?

A

index of leading companies

E.g. Dax, Nasdaq, Hang Seng, Cac

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4
Q

What is the FTSE100?

A

Index of the 100 largest UK companies by market capitalisation

Launched at 1000 on 3/1/1984
Represents ~ 80% of the UK market value

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5
Q

How often is the FTSE100 updated?

A
  • Updated quarterly
  • Included if ranked 90th or better
  • Deleted if ranked 111th or worse
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6
Q

What happens to deleted companies in the FTSE100?

A

drop into next index which is the FTSE250

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7
Q

What are index calculations?

A

All indices aim to reflect market performance but can be calculated in many ways

  • Number of compaines
  • Calculation i.e arithmetic average or weighted average
  • Inclusion of companies i.e. fixed or changing
  • Starting point i.e 100, 1000
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8
Q

What is the value of efficient markets?

A

Encourages share buying
Investors will only invest if they can be sure they will get a fair price when they come to sell their shares
This increases market liquidity and reduces investor risk

-Signals management
Lets management know if they are making the right decisions to maximise the wealth of their shareholders

-Allocates resources
Pricing inefficiency could mean funds fail to flow to where they can best be utilised

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9
Q

What are the 3 types of efficiency?

A
  • Operational efficiency: e.g. cheap transaction costs
  • Allocational efficiency: resources flow to where they are required
  • Pricing efficiency: Prices instantaneous adjust to reflect relevant information
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10
Q

What are perfect capital markets?

A

Markets are frictionless
No transaction costs, no taxes
All assets are perfectly divisible

  • Perfect competition: participants are price takers
  • Informationally efficient: information is costless and received simultaneously by all
  • Individuals are rational
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11
Q

What is the efficient market hypothesis?

A

Relates to pricing efficiency

Efficient capital markets don’t have to be perfect capital markets

The EMH says that “prices instantaneously reflect all available relevant information”

Traders cannot “beat” the market

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12
Q

What is security analysis (SA)?

A

-Predicting share prices

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13
Q

What are the two types of security analysis?

A
  • Fundamental analysis

- Technical analysis

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14
Q

What is fundamental analysis?

A

-Looks at news and information

Company specific information
Earnings, dividends, debt, production techniques, personnel, etc

Economic information
Unemployment rates, government policies, etc

Financial information
Changes in interest rates or exchange rates, etc

General information
The weather forecast, sports results, etc

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15
Q

What is technical analysis?

A

-Look at patterns in past prices

Ignores all fundamental information

Establishes trading rules based solely on the pattern of past share prices (and volumes) volumes)

Technical analysts (also known as chartists) believe past performance is a good indicator of future performance

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16
Q

What is the dow theory?

A

-Dow theory argues three forces simultaneously affect stock prices

17
Q

Three forces that affect stock prices in dows theory

A

-Primary trend:the long-term movement of prices, lasting from several months to several years.

-Secondary trends or intermediate trends: caused by short-term deviations of prices from the underlying trend line
These deviations are eliminated via corrections when prices revert back to trend values.

-Tertiary or minor trends: daily fluctuations which are of little importance

18
Q

What are the three levels of efficiency?

A

Weak Form Efficient Markets

Semi-Strong Form Efficient Markets

Strong Form Efficient Markets

19
Q

What is weak form efficiency?

A

The current share price reflects all information contained in past prices only

Past share prices or patterns in prices cannot predict future share prices

Mechanical/computer trading rules will not yield abnormal profits

Technical analysts/Chartists will not yield abnormal profits

20
Q

What is the only way that chartists can make money?

A

-markets need to be weak form inefficient

21
Q

What are random walks in relation to market efficiency?

A

-Random walks imply there is no relationship between the share price movement today and the movement yesterday

22
Q

What is semi-strong form efficiency?

A

Prices reflect all PUBLICLY available information

i.e. all company announcements, earnings and dividend news, technological breakthroughs (as well as all past share prices) are already incorporated in the current price

Trading rules based on publicly available information will not yield abnormal profits

Fundamental analysts will not achieve abnormal profits

23
Q

What are examples of all publicly available information in semi-strong efficiency?

A

Information from past share prices

Company annual report and accounts

Press and TV coverage

Earnings, dividends and trading announcements

Directors share holdings and
dealings

Restructuring proposals

New debt or equity issues

24
Q

Can an investment analyst out perform the market?

A
  • Not in a semi-strong efficient market

- As all public information is incorporated into the prices

25
Q

What is strong-form efficiency?

A
  • Price reflect all relevant information i.e. any information, public or not, is incorporated in the share price
  • Even traders using “inside” information cannot make abnormal profits
26
Q

What is the overlap between different market efficiencies?

A

If a market is strong form efficient

  • It must be semi-strong form efficient as well
  • It must be weak form efficient as well

If a market is semi strong form efficient

  • We don’t know if it is strong form efficient
  • It must be weak form efficient

If a market is NOT weak form efficient

  • It cannot be strong form efficient
  • It cannot be semi-strong form efficient
27
Q

What if someone makes abnormal gains in the markets?

A
  • they are inefficient - they do not fully reflect all relevant information
  • By acting quickly you can make a profit while the market “catches up”
28
Q

Tests to see if a market is efficient

A
  • If money can be made
  • Weak-form tests: Can you make money from studying charts - the chartist

Semi-Strong form tests: Can you make money by studying public information – the investment analyst

Strong form test: Can you make money from knowing everything – the director

29
Q

Tests and results of weak form efficiency

A

Purchase a diversified portfolio of stocks
Purchase a second portfolio based on chartist trading rules

-Returns are the same
Chartists don’t make abnormal returns
This implies the market is weak form efficient

30
Q

Evidence to contradict anticipating patterns

A

DeBondt & Thaler (1985)

Buy the worst performing shares based on last 3 years trading, hold for the next 3 years 3 years
Portfolio outperformed the market by 20%

Buy the best performing shares based on the last 3 years trading, hold for the next 3 years
Portfolio underperformed the market by 5%

31
Q

Support for DeBondt & Thaler (1985)

A

Arnold & Baker (2005) looked at UK data from 1960 to 1998
They present strong evidence that buying a portfolio of shares that have recently done very badly, will significantly outperform a similar portfolio of shares that recently has done very well

32
Q

Reaction time for markets in relation to Arnold & Baker (2005)

A

The above suggests in the long term (3years) markets over-react
i.e. A long-term reversal pattern

However, similar studies where performance measured over 3 months give opposite results!
i.e. A short-term momentum pattern

33
Q

Testing semi-strong efficiency

A

Researchers can check for abnormal returns

-Researchers use an “event study” methodology to test for efficiency here.
The event can be any release of new information

Define a “window” after the event to check returns

34
Q

Evidence of semi strong form efficiency.

A

Comparing actual returns after the “event” to what you would have expected to happen

Evidence indicates:
Returns are generally the same

Investment analysts don’t make abnormal returns

This suggests the market is Semi Strong Form efficient

35
Q

Do fund managers generally make a profit?

A

No

Allowing for administrative costs “Actively” managed funds do not out-perform the market

36
Q

Semi-strong conclusions

A

A tendency for the market to “overreact”

Shares fall too far on bad news e.g. 11/09/01
Shares rise too far on good news e.g. dot coms

The best we can say is that the markets are almost semi-strong efficient, most of the time

37
Q

Where does efficiency come from?

A
  • competition between investors
  • A “Catch-22” situation

Market inefficiencies lead to abnormal gains

Which leads to more investors seeking out new information hoping to make gains

Which leads to more efficiency

Which leads to fewer gains

-In equilibrium – must be just enough inefficiency to reward effort of analysts

38
Q

Strong form and insider trading

A

We know a share price will jump if a company announces really good news

Mining company strikes oil or gold
Drugs company finds new cure

We know insiders can purchase shares before this news is released and make abnormal returns

Thus the markets are not strong form efficient

Insider dealing damages confidence in the market and is outlawed in most countries

39
Q

EMH and Irrational investors

A

Efficient markets don’t necessarily require all investors to be rational

One irrational investor will not influence the market

If irrational investor trades are random, they will cancel each other out

A sufficient number of rational investors will take advantage of irrational inspired price movements

PPF (9 decks)

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