Market Efficiency

Question 1

Stock Market Efficiency

What does EMH state?

What was Fama’s two definitions of an efficient market?

Answer 1

Market Efficiency is a concept

“Efficient Markets Hypothesis” (EMH) states that stock prices reflect all available information.

Fama (1969): First definition of “efficient market”=“a market which adjust rapidly to new information”

Fama (1970): “A market in which prices always “fully reflect” available information is called “efficient”.”

Question 2

In December 2006, many economist expected a financial crisis in 2007. According to EMH, when the stock price will decline

a. In December 2006, when the expectation of financial crisis has released

b. In the 4th quartile of 2007, when the financial crisis occurred.

c. In both dates, with the announcement and when the event has taken place.

Answer 2

According to the Efficient Market Hypothesis (EMH), stock prices reflect all available information at any given time
. Therefore, the correct answer is:

c. In both dates, with the announcement and when the event has taken place
.

The stock price would decline both when the expectation of the financial crisis was released (December 2006) and when the financial crisis actually occurred (4th quarter of 2007).

Question 3

What are the implications of the Efficient Markets Hypothesis? – An overlook

Three forms: Weak, Semi-strong, and Strong and what it means for Investors, Companies, and Analysts.

Answer 3

Weak Form:

• Investors can’t consistently outperform the market using past price data.
• Companies can’t time their share issues/buybacks based on past prices.
• Analysts can’t use technical analysis to earn abnormal returns.

Semi-Strong Form:

• Investors can’t consistently beat the market using public information.
• Companies can’t time share issues/buybacks using past or public info.
• Analysts can’t use fundamental analysis to earn abnormal returns.

Strong Form:

• Investors can’t outperform the market using private information.
• Companies can’t time share issues/buybacks using any information.
• Analysts can’t use inside information to earn abnormal returns.

Question 4

Assumptions of market efficiency (3/2,4)

Answer 4

Random Walk Theory

• The movement of stock prices from day to day DO NOT reflect any pattern
• Statistically speaking, the movement of stock prices is random (slightly positive drift over the long term)

Rationality

• Investor are rational and hence value securities rationally
• Investors focus on the fundamental values when valuing securities
• To calculate the present values of the future cash flows of a security by using appropriate models
• even if some investors are not rational, as long as their irrationally inspired trades are random the effects of their irrational actions would cancel each other out.

Arbitrage theory

Arbitrage is the act of exploiting price differences on the same security or similar securities by simultaneously selling the overpriced security and buying the underpriced security.

1. Different investors come up with different security prices
2. An arbitrage opportunity arises
3. In a competitive market, an arbitrage opportunity will eliminates itself instantaneously
4. Security prices reflect fundamental values

Question 5

Behavioral Finance versus Traditional Finance

Behavioral Finance
Assumes: (2)

Traditional Finance
Assumes: (2)

Answer 5

Behavioral Finance
Assumes:

• Investors suffer from cognitive biases that may lead to irrational decision making.
• Investors may overreact or under-react to new information.

Traditional Finance
Assumes:

• Investors behave rationally.
• Investors process new information quickly and correctly.

Question 6

Loss aversion is

Answer 6

• Like gains
• Dislike losses

Question 6

If Investors Suffer from Cognitive Biases, Must Markets Be Inefficient?

Answer 6

Evidence suggests “No!”
If all that is required for markets to be efficient is that investors cannot consistently beat the market on a risk-adjusted basis, then the evidence supports market efficiency.

Question 7

Test of weak-form EMH

What is weak form market effciency?
What are 2 ways to test it?

Answer 7

Weak-form market efficiency, in simple terms, suggests that stock prices reflect all past trading information. There are two key parts here:

Serial correlation in security returns: This checks whether past returns can predict future returns. If there’s no correlation, it suggests the market is efficient.

Usefulness of technical analysis: This examines if analyzing past price movements and trading volume data helps predict future prices. If technical analysis doesn’t add value, the market is efficient.

Question 8

How is Efficient Markets Hypothesis tested? — Testing for Weak Form Efficiency

What would be empirical evidence for Random Walks

What is the serial correlation coefficient

Answer 8

Successive price changes are independent of one another

Price change at T and price change at T+1 are uncorrelated

Serial Correlation Coefficient (ρ):

This coefficient measures the relationship between today’s price change and tomorrow’s price change. It ranges from -1 to 1:

• ρ > 0 (Continuation): If the price increased today, it’s likely to increase tomorrow too.
• ρ = 0 (Uncorrelated): Today’s price movement gives no indication of tomorrow’s movement.
• ρ < 0 (Reversal): If the price increased today, it’s likely to drop tomorrow, and vice versa.

Question 9

Weak-Form Efficient Market Theory

Technical Analysts

What is it?
Result?

Answer 9

• Forecast stock prices based on the watching the fluctuations in historical prices & volumes
• Should have no marginal value if the market is weak form efficient!

Question 10

Semistrong Form of Market Efficiency
What does it state

2 key points about it?

Answer 10

States that stock prices reflect all publicly available information:

Prices Reflect Public Information:

• It means any public news, reports, or data about a company is already factored into its stock price.
• You can’t beat the market by trading on public news because everyone else knows it too.

Fundamental Analysis:

• Fundamental analysis involves evaluating a company’s financial statements and health to determine its value.
• In a semistrong efficient market, this kind of analysis won’t help you consistently achieve above-average returns since prices already reflect all that information.

Question 11

Semi-strong Efficient Market Theory

Fundamental Analysts

• Research the value of _________
• Company data: using _____ and other measurements of _______ _______
• _______ estimates
• Industry and economic data: economic ___________, _____________, and ____________ rates
• Should have no ___________ ________ if the market is semi-strong form efficient

Answer 11

• Research the value of stocks
• Company data: using NPV and other measurements of cash flow
• Risk estimates
• Industry and economic data: economic growth, inflation, and interest rates
• Should have no marginal value if the market is semi-strong form efficient

Question 12

How can we design the test for semi-strong form efficiency?

3 things should happen?

Event study

Concept?
Focus?
Abnormal Result Calculation

Answer 12

1. Semi-Strong Form Efficiency (SSFE): Assumes all public information is already reflected in current stock prices.
2. Market Reaction: Prices should adjust quickly and fully to new information.
3. Empirical Evidence: Researchers look at how stock markets respond to information releases.

Event Study:
Concept: First introduced by Fama et al. in 1969, event studies are foundational in empirical research on market efficiency.

Focus: Examines abnormal returns around specific events like takeovers, dividend announcements, or earnings reports.

Abnormal Return Calculation: actual returns -expected returns

Question 13

Testing for Semi-strong Form Efficiency

If prices are semi strong form efficient what should happen?

Study regarding this, who made it and what did it say?

Answer 13

If prices are semi-strong form efficient then prices reflect all public information

Patell & Wolfson (1984) found that when new information is released, the major part of the adjustment in price occurs within 10 minutes of the announcement

Question 14

Not a test

Empirical Evidence

Answer 14

Examples:

• Stock splits [Fama, Fisher, Jensen and Roll (1969)]
• Capital restructures [Masulis (1980)]
• Dividend/Earning announcements [Ball and Brown (1968), Rendleman, Jones and Latane (1982)]
• Merger announcements [Jensen and Ruback (1983)
• New Issues/Secondary Issues [Smith (1986)]

Empirical finding is that prices do react to information – consistent with semi-strong form market efficiency

Question 15

Evidence against SSFE: Market’s reaction to unexpected good/bad earnings

Answer 15

Post-earnings announcement drift: Bernard and Thomas (1989) have found that cumulative abnormal returns (CARs) continue to drift up for firms that report unexpectedly good earnings and drift down for firms that report unexpectedly bad figures for up to 60 days after the announcement.

Question 16

How is Efficient Markets Hypothesis tested?—Testing for Strong Form Efficiency

What is SFE?

4 steps

Answer 16

SFE: All relevant information (including private information) is fully incorporated into current prices

1. Market prices should react rapidly and fully to private information (however it can be difficult to access private info)
2. To see whether corporate insiders can earn abnormal returns by trading their own firms’ securities. (Insider trading)

if yes

3. To see whether corporate insiders can earn abnormal returns by trading their own firms’ securities. (Insider trading)
4. Inside info is not fully reflected in market prices

SFE might be rejected

Almost all existing studies examining insider trading show that insiders make significant profits on their transactions. For example, Lisa Meulbroek (1992) documents that the abnormal return surrounding insider trades average 3% per day.