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International Finance And Capital Markets > Market Efficiency > Flashcards

Market Efficiency Flashcards

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1
Q

What is an efficient market

A

a market where all relevant information currently available is fully reflected in the security prices instantaneously and in an unbiased way

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2
Q

What is a random walk

A

price changes are independent of one another/unpredictable

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3
Q

What are the assumptions of Market efficiency theory

A
  1. Rationality

2. Arbitrage theory

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4
Q

If it is not reasonable to assume investors will be rational, will market efficiency theory collapse because of the unrealistic assumption

A

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

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5
Q

What type of information is available for SFE

A

All relevant information

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6
Q

What type of information is available for SSFE

A

Public information (current and past)

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7
Q

What type of information is available for WFE

A

Past information

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8
Q

What is a feature and example of WFE

A

Future prices cannot be predicted based on analysis of past prices.

Current prices have already fully incorporated historical dividend records

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9
Q

What are the features and Example of SSFE

A
  1. Prices respond to information disclosure immediately
  2. 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

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10
Q

What are the features and example of SFE

A
  1. Prices react to new information as soon as it is generated rather than when it is publicly disclosed
  2. 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

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11
Q

How is WFE tested?

A
  1. See if market prices follow a Random walk; if so then WFE may be accepted
  2. See if technical analysis can make abnormal returns; if so WFE may be rejected
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12
Q

What happens in reality if a market follows WFE

A
  1. Market prices do not follow any predictable pattern and therefore follow random walk
  2. Any forecast based on past price patterns is useless and therefore technical analysis is useless
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13
Q

What is the empirical evidence to prove random walk

A

T and T+1 are uncorrelated.

P=0 then it is uncorrelated.

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14
Q

What is technical analysis

A

Studies of historical prices using charts and other tools with the intention of discovering particular patterns of share price movements that appear to recur

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15
Q

TA What do they study

A

Historical price Movements

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16
Q

FA What do they study

A

Companies ability to generate future cashflow

17
Q

TA what tools are used

A

Price charts

18
Q

FA what tools are used

A

Valuationa models such as CFDM and DDM

19
Q

TA what is the aim

A

to discover recurring price movements, patterns or cycles

20
Q

FA What is the aim

A

To price securities based on valuation on fundamentals

21
Q

TA what do they believe

A

Patterns can be identified through examining past price movements and abnormal return is likely to be achieved through TA

22
Q

FA what do they believe

A

Security prices can be determined through valuing fundamentals of companies and abnormal return is likely to be achieved through FA

23
Q

How can we design a test for SSFE

A

the study of EVENT study and how the tock markets react to new information releases

24
Q

What is Event Study and who first studied it

A

Fama et al. (1969)

studied the abnormal returns around an announcement

Abnormal return = Actual return- expected return

25
Q

What specific evidence is there against SSFE

A

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

  1. Sluggish response
  2. Investors do not move share prices sufficiently
  3. Market under-reaction
  4. Market is not efficient in SSF
26
Q

What does the evidence conclude about SSFE

A

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

27
Q

How can we design a test for SFE

A

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

28
Q

What does the evidence say about SFE

A

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

29
Q

What are the implications on abnormal returns to INVESTORS for WFE SSFE and SFE

A

All Can’t make consistent abnormal returns

30
Q

What are the implications on abnormal returns to COMPANIES for WFE SSFE and SFE

A

All Can’t time share issue/buy backs

SSFE creative accounting should not affect market value

31
Q

What are the implications on abnormal returns to ANALYSTS for WFE SSFE and SFE

A

Technical analysis cannot be used consistently

Fundamental analysis cannot be used consistently

Inside information cannot be used consistent

32
Q

what is creative accounting

A

choosing accounting methods to stabilise and increase reported earnings (LIFO vs FIFO)

inflation is high choose FIFO

33
Q

What is the empirical evidence for creative accounting and what does this mean

A

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

34
Q

what are anomalies in emh

A

facts and phenomena which are inconsistent with the emh and systematic examples where the market does not appear to be efficient

35
Q

What are the anomalies of EMH

A 
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

International Finance And Capital Markets (4 decks)

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