Market Efficiency Flashcards
Strong Form Effiency
All Relevant Information (private’s and public)
Prices react to new information as soon as it is generated, rather than when it is publicly disclosed. If a market is efficient in strong form it must be efficient in semi strong form and weak form
Semi-strong form efficiency
Public information (current and past)
Prices respond to information disclosure immediately. if a market is efficient in semi strong form it must be efficient in weak form
Weak form efficiency
Past information
Future prices cannot be predicted based on analysis of Past prices
Example of what happens with dividend information in weak form
Current prices have already fully incorporated all historical dividend records
Example of what happens with dividend information in semi strong form
Share prices react to a dividend increase as soon as the decision is announced
Example of what happens with dividend information in strong form
Share prices react to a dividend increase as soon as the decision is made, rather than when the decision is announced to the public
TESTING FOR WFE
if market prices do not follow any predictable patterns
It must follow a random walk
Therefore forecast based on past price patterns are useless
TESTING FOR WFE
if prices follow a random walk
Technical analysis is useless
Technical Analysis?
Past information
Fundamental analysis?
Public information
Private information?
Insider trading
TESTING FOR WFE
See if technical analysis can make abnormal returns
If YES then WFE can be rejected
How does a spread out scatter graph empirically price random walk theory
Correlation between change at T and price change at T+1 is weak
Therefore share price movements follow a random walk, thus further implying that stock markets are efficient in the weak form
TECHNICAL ANALYSIS
forecast stock prices based on watching the fluctuations in historical prices and volume should have no marginal value if the market is
WFE
If there are patterns in the market a few smart investors would profit from these patterns in the short run but once the market recognises the pattern it will disappear
EMPIRICAL EVIDENCE IN WF EMH
tests to support this?
- Tests on aggregate stick indices (ftse 100) support WFE
2. Recent evidence suggests returns from portfolios of small stocks might have some autocorrelations (small firm effect)
EMPIRICAL EVIDENCE IN WF EMH
counter example to weak form of EMH
momentum strategies
Past performers would outperform past losers
Is the expected return for stocks equal to zero in an efficient market?
no. abnormal returns will be 0 as cannot beat the market
the weak form of efficient market theory implies that technical analysis is valuable
no
the small-firm effect is cited as evidence against market efficiency
yes
what happens when fundamental analysts research the value of stocks in ssfe?
this should have no marginal value
who first spoke about event study
fama et al 1969
event study is the corner stone of much research in stock market efficiency
what is event study
abnormal returns (actual return - expected return) around an announcement
how long should the event window be?
long enough to capture the significant effect of an event and at the same time effectively control for the compounding effects.
in the case of confounding events a short event window is preferred
many empirical studies arbitrarily defined their long event windows without further explanation
how do we calculate abnormal return for event study
estimate normal returns
You gather 60 monthly returns for Tesco Corporation and estimate its beta as 1.35 and its alpha as +0.7% per month. Next month both the market and Grecian Urns’s stock price fall by 5%. What is Grecian Urns’s abnormal return?
r^i - (a^i + B^i + r^m)
-0.05(0.007+1.35*(-.05)) = 0.0105 = 1.05%
how do you test the hypothesis for abnormal return?
AR = 0 H^0 = the event has no impact on the firms value
how to compute abnnormal return
AR^it = R^it - E(R^it) AR = abnormal return for the firm i on day t R = abnormal return for i on day t E(R) = expected return
How do you test for ssfe event study?
- Get sample of firms that have experienced type of announcement
- for each firm compute the abnormal returns
- for any date around the announcement, compute the cumulative abnormal return over time (CAR)
- test whether these cumulative abnormal returns are statistically different from zero
how do you compute cumulative abnormal returns (CAR)
CAR^t = E^t (AR^it)
conn 2005 examines
the announcement and post-acquisition share returns of uk acquirers of acquisitions; domestic, cross-border, public and private targets.
CONN 2005
what happens to domestic public acquisitions
negative announcement and post announcement returns
CONN 2005
what happens to public cross border acquisitions
zero announcement and post announcement returns
CONN 2005
What happens to domestic and cross-border private acquisitions
positive announcement returns and zero post-acquisition returns
CONN 2005
the main differences between private and public acquisitions
- Glamour acquirers underperform in the public acquisitions but not in private acquisitions
- Acquirers using noncash methods of payments underperform in domestic public acquisitions but not in domestic private acquisitions
CONN 2005
what happens to cross-border acquisitions in comparison to domestic acquisitions
cross-border result acquisitions result in lower announcement and long run returns than domestic acquisitions
CONN 2005
When do cross-border acquisitions do well
- High-tech firms
2. Firms with lo national cultural differences
What did pattell and wolfson 1984 find
when new information is released, a major part of the adjustment in price occurs within 10 minutes of the announcement
what are empirical evidence examples of
- Stock splits
- Capital restructures
- Dividend/earnings announcements
- Merger announcements
- Fama, Fisher, jenson and roll 1969
- Masulis 1980
- Ball and brown 1968
- jenson and ruback 1983
implications of financial statements in ssfe
- analysis of financial statements such as IS and BS will not reveal any information about future prices
- Financial analysts cannot identify mis-priced stocks from fs
what evidence is there against ssfe
Bernard and Thomas 1989 found that CAR continue to drift up for firms that report unexpectedly good earnings and vice versa for up to 60 days after the announcement
What did Bernard and Thomas (1989) find
found that CAR continue to drift up for firms that report unexpectedly good earnings and vice versa for up to 60 days after the announcement
There is a sluggish response to the announcement as investors don’t move share prices sufficiently to incorporate the news on the day of the announcement (under-reaction) therefore market is not efficient in ssfe
What is the event study process
- Event definition
- Firm selection criteria
- Estimating normal expected returns
- Calculating the excess abnormal returns
- Estimation procedure
- Testing procedures
- interpretations and conclusions
What tests are there for SFE
- Insider trading is profitable which suggests markets are NOT sfe
- Performance of mutual funds DOES NOT generate abnormal returns which is consistent with sfe
an example of insider trading
martha stewart in 2002 was charged with insider trading regarding the sale of all her shares in ImClone days before its application for a new drug was denied
what does muelbrouk 1992 talk about
Directors trading
directors are allowed to BUY/SELL shares in own company but must disclose as they in theory should know whether a company is over/under valued
What evidence from portfolio managers in the research of mutual funds found that they don’t generate abnormal returns which is consistent with sfe
Jenson 1968
Ippolito 1989
Blake, lehman and timmerman 1999
Why is it hard to test SFE
Market prices should react rapidly and fully to private information and it is difficult to access private information
what are examples of anomalies of the EMH
- Under-reaction
- Bubbles - share prices deviate markedly from fundamental values
- Small-firm effect - small firms outperform large firms
- Weekend effect
- January effect
what are the core thoughts of market efficiency theory
- What is an efficient market - share prices reflect information immediately, fully and in an unbiased way
- How do security prices move in an efficient market? - random walk (recurring patterns don’t happen
- What is the relationship between security prices and fundamental values - share prices reflect fundamental values
MEAN REVERSION
what did fama and french 1988 find
long run returns are predictable
1. Negative correlation = mean reversion
MEAN REVERSION
who found evidence of mean reversion in PE ratios
1. when PE ratio hits bounds there is an adjustment in prices
Campbell and shiller 1998 2005
MEAN REVERSION
what did poterba and summer 1988 find
- negative serial correlation in the LR
2. Positive correlation in the SR
SMALL FIRM/PE
what did Basu 1977 1983 find
PE ratios are predictors of subsequent performance
1. in particular high PE firms (growth stocks) have lower returns than low PE firms (value stocks)
SMALL FIRM/PE
Which two people found that the PE effect was related to firm size, that small firms tend to outperform large firms even after an allowance is made for the likelier riskier characteristics of small firms
Banz 1981
Reinganum 1981
SMALL FIRM/PE
what did Lakonishok et al 1994 find
value stocks significantly outperform growth stocks over the next 5 years by 11% per year in year 5
What are behavioural finance assumptions
- Investors suffer from cognitive biases that may lead to irrational decision-making
- Investors may over-react or under-react to new information
what are traditional finance assumptions
- Investors behave rationally
2. Investors process new information quickly and correctly
if investors suffer from cognitive biases, must markets be inefficient. what does theory say
YES
If investors must be rational for efficient markets to exist, then all the foibles of human investors suggest that markets cannot be efficient
if investors suffer from cognitive biases, must markets be inefficient. what does evidence say
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
REPROACHES to ME
What did grossman 1976 and grossman and stiglitz 1980 argue
that perfectly informationally efficient markets are an impossibility, for if markets are perfectly efficient, the return to gathering information is nil, in which case there would be little reason to trade and markets would eventually collapse
who agrees with grossman 1976 and grossman and stiglitz 1980
Campbell, Lo and Mackinlay 1999
They are in favour of the notion of relative efficiency - the efficiency that one market is measured against another
What did Lo and mackinlay 1999 say
emh is not a well defined and empirically refutable hypothesis. To make it operational one must specify additional structure e.g. investors preferences, information structure, business conditions.
then a test of EMH becomes a test of several auxiliary hypotheses as well, and a rejection of such a joint hypothesis tells us little about which aspect of the joint hypothesis is inconsistent with the data
What is the bad model problem
says that emh per se is not testable. It must be testes jointly with some other model of equilibrium. When we then find anomalies its hard to determine whether theres an inefficient market or a bad model
