Lecture 8-Stock market & Efficiency Flashcards

Question

What is strong-form efficiency?

Answer 1

- 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

Answer 2

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

Answer 3

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

Answer 4

- 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

Answer 5

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

Answer 6

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%

Answer 7

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

Answer 8

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

Answer 9

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

Answer 10

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

Answer 11

No Allowing for administrative costs “Actively” managed funds do not out-perform the market

Answer 12

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

Answer 13

- 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

Answer 14

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

Answer 15

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