Market Efficiency Flashcards
What is an efficient capital Market
A capital market in which prices reflect all available information regarding asset prices
What are the 3 forms of efficient market hypothesis
Weak: stock prices already reflect all historic trading data such as (prices, trading volume and short interest)
Semi-strong: all publicly available information regarding a company is incorporated in the price already
Strong: all relevant information both public and private is reflected in the price
The first figure suggests that the average professional money manager is not able to beat the market, as
four-factor alphas (Carhart model) are very close to zero on average. In fact, alphas are negative on
average at almost -1% per annum. As discussed during the lecture, this is most likely driven by fees. The second figure suggests that the outperformance of the minority of funds with positive alpha is not
persistent. After 1 year, the top performing funds are hardly outperforming other funds, while after 4
years they are very close to average.
These results are consistent with the Efficient Market Hypothesis, though they do not necessarily rule out
managerial skill (e.g., Berk-Green model with equilibrium view” on mutual funds).
Suppose Alphabet Inc. has a steady market beta of 1.1. The expected market return is 6% and the riskfree rate is 2%. Suppose that Alphabet had a return last year of 7%. Assuming that markets are efficient (and estimates of beta, market returns, and risk-free rate are accurate) what does this imply? What is the “joint hypothesis problem” in tests of the Efficient Markets Hypothesis? Briefly explain your
answers.
The abnormal return of Alphabet last year was 7% - (2% + 1.1 (4%)) = +0.6%. Under efficient markets, positive abnormal returns can only arise because of unexpected returns, which suggests that – on average – there was firm-specific good news (cash flow news and/or discount rate news) for Alphabet last year.
The joint hypothesis problem in tests of the Efficient Markets Hypothesis refers to the fact that almost all tests of market efficiency require an assumption about the correct asset pricing model.
Since we do not know what the correct asset pricing model is, we can only test the EMH jointly with an assumption about the correct asset pricing model. Because the question does not explicitly state that the CAPM is true, another possible implication of the example in this question is thus that the CAPM is not the correct asset pricing model.
Name the 3 anomalies?
The result can be due to (i) statistical fluke, (ii) risk or (iii) mispricing:
Suppose you find that prices of stocks before large dividend increases show on average consistently positive abnormal returns. Is this a violation of the Efficient Market Hypothesis? Briefly explain your answer.
Market efficiency implies investors cannot earn excess risk-adjusted profits. If the stock price run-up occurs when only insiders know of the coming dividend increase, then it is a violation of strong-form efficiency. If the public also knows of the increase, then this violates semistrong-form efficiency.
If a professionally managed portfolio consistently outperforms the CAPM, which conclusion can be drawn? Briefly explain your answer.
Either the market is not efficient or the CAPM is not the correct asset pricing model. This is the “joint hypothesis” problem in asset pricing tests.
Based on a ton of research on past stock market data, you discover a promising new investment strategy: the Investments exam anomaly. Specifically, you buy the FTSE 100 index on the Friday before the RSM Investments exam (mid-December) and sell it after a month. In the rest of the year, you invest your money in a risk-free asset. With this strategy, in the past you would have made an average annualized return of 12% with relatively low standard deviation. After controlling for the CAPM market factor, you find a positive and significant alpha for the returns of your strategy.
Assume that the Fama and French (1993) three-factor model is the true asset pricing model. (i) Is this a time-series anomaly or a cross-sectional anomaly? (ii) Can you conclude if this market is efficient or not? If yes: is this market efficient? If no: why not? Briefly explain your answers.
This is a time-series anomaly. We hold a balanced portfolio for a certain period for which we predict higher returns, we do not assume that some securities earn higher returns than others.
We do not have sufficient information to conclude whether this market is efficient or not, because of the joint hypothesis problem (mentioning this term is not a requirement – explaining the idea is). Either the market is inefficient, or the CAPM is not the accurate asset pricing model, or both. Given that we assume that the Fama and French three-factor model is the true asset pricing model, we know that the CAPM is not the accurate model. And we do not know the three-factor alpha. Therefore, we cannot conclude if the market is efficient or not based on these results. Note: even if the three-factor alpha was significantly positive in the past, we cannot be sure that this is not a chance result for this particular trading strategy, or a systematic deviation from market efficiency.
You want to test the weak form of the Efficient Market Hypothesis (EMH) and estimate the following regression: Ri,t = 0.13 – 0.09 Ri,t-1, where Ri,t is return of stock i at time t, and 0.13 is the estimated intercept. What is the weak form of the EMH? Assume that the coefficient on Ri,t-1 (that is, –0.09) is statistically significant, what can you conclude from this regression about the weak form of the EMH? What common pattern in stock returns is indicated by the coefficient on Ri,t-1? Briefly explain your answers.
The weak form of the EMH says that you cannot predict changes in stock prices (returns) using past price movements and trading volume. If the coefficient on Ri,t-1 is significant, the stock return of this stock i is predictable based on its stock return in the previous period. Consequently, there is an indication that this stock’s return patterns contradict the weak form of the EMH. In particular, this regression shows evidence of the common pattern of (time-series) mean reversion (or reversal) in stock returns. [Note that if this result only obtains for a single stock, it could be a chance result, but if it obtains for many stocks (as has been shown in the literature for short horizons), this is a clear indication of a violation of the weak form of the EMH.]
What is the random walk hypothesis
The “random walk” in security prices refers to the hypothesis that stock market prices evolve according to a random walk and thus cannot be predicted. It suggests that the future price movement of a stock is independent of its past movement, implying that price changes are random and do not follow any pattern. This theory is grounded in the efficient market hypothesis, which asserts that stock prices fully reflect all available information and that any new information affecting a company’s value is quickly and accurately incorporated into the stock price.
In essence, the random walk hypothesis argues that the best predictor of tomorrow’s price is today’s price, without any discernible trend or pattern over time. This means that attempts to forecast future price movements or identify undervalued stocks are, on average, doomed to fail, and that strategies such as technical analysis or market timing are ineffective. It implies that the market is efficient, and the only way to achieve higher returns is by purchasing riskier investments.
What does the EMH say about
Fundamental analysis, quant strategies and technical analysis?
EMH says: none of these work!
The efficient market hypothesis implies that technical analysis should be fruitless. The past history of prices and trading volume is publicly available at minimal cost. Therefore, any information that was ever available from analyzing past trading has already been reflected in stock prices. As investors compete to exploit their common knowledge of a stock’s price history, they necessarily drive stock prices to levels where expected rates of return are exactly
commensurate with risk. At those levels one cannot expect abnormal returns.
Empirical tests of market efficiency, what are the two ways?
Two main types of tests:
Type 1: Can we identify patterns in security returns that are inconsistent with the random walk hypothesis and/or rational asset pricing theories such as CAPM?
* Time-series tests
* Can we predict prices/returns?
* Cross-sectional tests
* Do certain securities earn higher returns than others for reasons unrelated to systemic risk?
Type 2: Is it possible to beat the market?
* Do professional investors (mutual fund managers, stock analysts)
“generate alpha”?
What are anomolies?
In asset pricing, anomalies were seen as empirical patterns (in time-series or cross-section) of security returns inconsistent with standard theories such as CAPM (the “old paradigm”)
What is the joint hypothesis problem?
- Almost all tests of the EMH require a model for what return you
would expect on a security (you need the true asset pricing model) - That is, researchers can only test the EMH in combination with an
assumption about the correct asset pricing model!
