Lecture 9 - Efficient Markets

Question 1

What is efficient market?

Answer 1

The price of securities will fully reflect all information that is publicly known about those securities.

• Instantaneous and unbiased

Usually requires many rational investors.

Question 2

How do market prices fully reflect all public information?

2 factors

Answer 2

1. Investors individual estimates must be on average ‘unbiased’
   
   1. On average market is correct
2. Assume decisions are independent (not correlated)

Question 3

3 consequences for risk averse investor

Answer 3

1. Investing is a fair game – can’t earn abnormal returns.
   
   1. Normal rate of return for the systematic risk.
2. Random walk à today’s change in price will not tell anything about tomorrow.
3. Naive investor à price protected (no adverse selection)

Question 4

Efficient Market Hypothesis (EMH)

Answer 4

Robert Shiller:

• Stock price fluctuated more than dividends
• Investors are pricing expected future cash flows à only future cash flows are priced

Question 5

4 implications of efficient for Financial reporting

Answer 5

1. Accounting policy will not impact security price
   
   1. No difference between disclosure and recognition.
   2. E.g. depreciation method
      
      1. Investors are only interested in future cash flows and dividends
2. Full disclosure enhances efficient
   
   1. Accurate prices (lack of adverse selection)
3. Naïve Investors are price protected
4. Accountants in competition

Competition with other sources à incentive to provide relevant, reliable, timely and cost effective information.

Question 6

Conditions necessary for an efficient market to exist

Answer 6

• All investors are utility maximisers
• Bayes rule is followed (i.e. rational expectations)
  
  • Assume errors equal 0

Question 7

3 conditions that are required for an inefficient market

Answer 7

1. Individuals are not perfectly rational
   
   • Over or under react
2. Individuals investors’ mistakes are the same
   
   • E.g. correlated bias à ensures bias is not cancled out.
3. Limited arbitrage:
   
   • Existence of some rational investors should not be sufficient to make markets efficient
   • E.g. sophisticated investors (investment banks), are unable to sway markets back to efficiency.

Question 8

Outline 3 biases relevant to processing new information.

Answer 8

1. Representativeness bias (Kahneman and Tversky, 1982)
2. Conservatism Bias (Edwards, 1968)
3. Other biases: over confidence and biased self-attribution.

Question 9

How does representativeness Heuristic impact efficiency in the market?

Answer 9

People judge similarity to familiar types.

e.g Artistic woman would be associated with a sculptress, rather than a bank teller.

Guess should be based on base rate.

Law of small numbers:

• people see patterns in small sample
• When in reality is should be a random walk

E.g. recent high growth sales à indicate a patter of success.

Question 10

How does conservatism impact efficiency in the market?

Answer 10

Investors are slow to update beliefs

• Underweight sample information
• Can result in:
  
  • E.g.
  • Short term momentum in stock returns

post earnings drift 3-12 month drift

Question 11

How does overconfidence impact efficiency?

Answer 11

• Too much faith in their ability to process information
• Investors overreact to private information, in regard to company’s prospects.

Question 12

How does self attribution impact efficiency?

Answer 12

Over or under reaction:

• Attribute success to our skills
• Failures to the external environment

Contradictory evidence is viewed as due to chance, thus discounted.

Question 13

How does limited attention/bounded rationality impact efficiency?

Answer 13

Can’t process all the information in the market.

Lead to poor decisions.

Question 14

What is the difference between classic and prospect theory?

Answer 14

Classic: investors should rank choices according to the utility from expected wealth levels.

Prospect Theory suggests that individuals make decisions on changes in wealth.

• i.e. gains or loses to some reference point.
• Becomes risk seeking to avoid losses, the ‘hurt’ of a $100 loss is more painful than a $100 gain.
  
  • Perceived payoff asymmetry.

e.g. Gambler goes into casino with $20, if below this amount, will continue to gamble to not make a loss (risk seeking).

This results in 2 consequences called the disposition effect:

1. Cash out gains too early (risk aversion)

Hold onto losses until it turns around (risk seeking)

Question 15

Why must individual investors’ errors/biases be correlated?

Why may this be rational?

Answer 15

To ensure an inefficient market, people’s errors must not cancel out, i.e. one be buy one be sell.

People share similar heuristics

Question 16

Why is limited arbitrage required for an inefficient market?

Answer 16

Limited arbitrage:

• The efficient market theory is underpinned by the assumption that some rational market participants, who have incentive to gather, process and trade on information will arbitrage away systematic mispricing, caused by investors’ information processing biases.

I.e. some sophisticated investors will operate in the market and counter any errors caused by investors.

Question 17

What could limit sophisticated investor’s arbitrage? (5 reasons)

Answer 17

1. Trading/holding costs
   
   • E.g. Brokerage, duration of arbitrage, costs of short selling
2. Information costs
   
   • E.g. information acquisition, analysis and monitoring
3. Limited capital
   
   • i.e. not enough funds
4. Arbitrageur faces ‘noise trader’
   
   • i.e. mispricing can cause stock price to become worse before it returns to the correct value.
   • Noise traders: trade for liquidity reasons
5. Close substitutes may not be available
   
   • Arbitrage requires buying and selling of identical assets (i.e. 2 assets)

Question 18

2 points of evidence for inefficient markets

Answer 18

1. CAPM (Beta) does not fully explain average realised reutnrs.
   
   1. Changes are not fully explained by systematic risk of the stock.
2. Stock markets are too volatile

Moves too much relative to fundamentals.

Question 19

2 market anomalies related to accounting information:

Answer 19

1. Post earnings drift (Ball & Brown)
2. ‘accruals anomaly’
   
   • Accruals have greater measurement error à less likely to persist.

However market still impounds this information.

Question 20

6 red flags of earnings management

Answer 20

1. Earnings quality
2. Sales quality
3. Margins quality (expense)
4. Soft Expenses
5. Abnormal depreciation
6. Auditor quality