Market Efficiency Flashcards
What is an efficient market
a market where all relevant information currently available is fully reflected in the security prices instantaneously and in an unbiased way
What is a random walk
price changes are independent of one another/unpredictable
What are the assumptions of Market efficiency theory
- Rationality
2. Arbitrage theory
If it is not reasonable to assume investors will be rational, will market efficiency theory collapse because of the unrealistic assumption
No, because 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
What type of information is available for SFE
All relevant information
What type of information is available for SSFE
Public information (current and past)
What type of information is available for WFE
Past information
What is a feature and example of WFE
Future prices cannot be predicted based on analysis of past prices.
Current prices have already fully incorporated historical dividend records
What are the features and Example of SSFE
- Prices respond to information disclosure immediately
- If a market is efficient in ssf it must also be efficient in wf
Share prices react to a dividend increase as soon as a decision is announced
What are the features and example of SFE
- 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 ssf and wf
Share prices react to a dividend increase as soon as the decision is made rather than when the decision is announced to the public
How is WFE tested?
- See if market prices follow a Random walk; if so then WFE may be accepted
- See if technical analysis can make abnormal returns; if so WFE may be rejected
What happens in reality if a market follows WFE
- Market prices do not follow any predictable pattern and therefore follow random walk
- Any forecast based on past price patterns is useless and therefore technical analysis is useless
What is the empirical evidence to prove random walk
T and T+1 are uncorrelated.
P=0 then it is uncorrelated.
What is technical analysis
Studies of historical prices using charts and other tools with the intention of discovering particular patterns of share price movements that appear to recur
TA What do they study
Historical price Movements
FA What do they study
Companies ability to generate future cashflow
TA what tools are used
Price charts
FA what tools are used
Valuationa models such as CFDM and DDM
TA what is the aim
to discover recurring price movements, patterns or cycles
FA What is the aim
To price securities based on valuation on fundamentals
TA what do they believe
Patterns can be identified through examining past price movements and abnormal return is likely to be achieved through TA
FA what do they believe
Security prices can be determined through valuing fundamentals of companies and abnormal return is likely to be achieved through FA
How can we design a test for SSFE
the study of EVENT study and how the tock markets react to new information releases
What is Event Study and who first studied it
Fama et al. (1969)
studied the abnormal returns around an announcement
Abnormal return = Actual return- expected return
What specific evidence is there against SSFE
Bernard and Thomas (1989) found that Cumulative abnormal returns CAR continue to drift up for firms that report unexpectedly good earnings and vice versa for up to 60 days after the announcement
ie
- Sluggish response
- Investors do not move share prices sufficiently
- Market under-reaction
- Market is not efficient in SSF
What does the evidence conclude about SSFE
Overall, there is no overwhelming evidence suggesting market is SSFE. With great majority of early evidence (1960s and 1970s) supporting the hypothesis, since late 1980s there has been increasing evidence suggesting otherwise
How can we design a test for SFE
If SFE then market prices should react rapidly and fully to private information
BUT it is difficult to access private information
Test whether corporate insiders can earn abnormal returns by trading their own firms securities
If YES then reject SFE
What does the evidence say about SFE
Almost all existing studies supports that insider trading allows the insider to make significant profits
Meulbroek (1992) Documents that the abnormal returns surrounding insider trades average 3% per day
What are the implications on abnormal returns to INVESTORS for WFE SSFE and SFE
All Can’t make consistent abnormal returns
What are the implications on abnormal returns to COMPANIES for WFE SSFE and SFE
All Can’t time share issue/buy backs
SSFE creative accounting should not affect market value
What are the implications on abnormal returns to ANALYSTS for WFE SSFE and SFE
Technical analysis cannot be used consistently
Fundamental analysis cannot be used consistently
Inside information cannot be used consistent
what is creative accounting
choosing accounting methods to stabilise and increase reported earnings (LIFO vs FIFO)
inflation is high choose FIFO
What is the empirical evidence for creative accounting and what does this mean
Kaplan and Roll (1972) Accelerated vs straight line depreciations - a switch would increase accounting earning but have no effect on stock price
Hong, Kaplan and Mandelker Pool method vs purchase method - stock prices not affected by the artificially higher earnings
Conclusion - creative acc cannot fool the market and market appears to be efficient enough to see through different accounting choices
what are anomalies in emh
facts and phenomena which are inconsistent with the emh and systematic examples where the market does not appear to be efficient
What are the anomalies of EMH
Under-reaction Small firm effect Bubbles Weekend effect January effect
Despite existence of anomalies, people tend to work in finance with the assumption that markets are SSFE
