Market Theory

Question 1

What are perfect markets?

Answer 1

• Many buyers and sellers
• All information available to all buyers and sellers
• No barriers to entry or exit
• No transaction costs

Question 2

Name 2 theories of Real Markets?

Answer 2

• Random Walk Theory – no relationship between successive movement in share price
• Efficient Market Hypothesis (EMH) Fama 1965

Question 3

What is EMH?

Answer 3

• An “efficient” market has large numbers of rational profit maximisers actively competing with each other trying to predict future market values of individual securities where all important current information is freely available to all participants.
• In an “efficient” market the actual price of a security reflects information based on events past and future – actual price is a good estimate of its intrinsic value.
• Fama identified three distinct levels of efficiency: Weak, Semi-strong and Strong

Question 4

What is weak EMH?

Answer 4

Prices only reflect known historical information

Question 5

What is semi-strong form of EMH?

Answer 5

All public information is immediately reflected in prices. Share prices will move quickly to a new consensus value when companies publish earnings announcements or analysts publish buy/sell recommendations

Question 6

What is the strong form of EMH?

Answer 6

All public and private information is immediately reflected in prices. Current market price is best available predictor of a fair price

Question 7

Which EMH holds?

Answer 7

Empirical evidence suggests that

• Weak form EMH holds all of the time
• Semi-strong EMH holds most of the time
• Strong form EMH holds some of the time

Question 8

What are the implications for weak form EMH?

Answer 8

Future prices cannot be predicted from a study of historic prices. Excess abnormal returns cannot be achieved using information in past prices and volumes: thus technical or chart analysis should be unprofitable

Question 9

What are the implications for semi-strong EMH?

Answer 9

Future prices cannot be predicted by analysing freely available public information. Excess abnormal returns cannot be consistently achieved using analysis of public information such as company reports and announcements. This rather calls into question the whole investment research and analysis sector.

Question 10

What are the implications for strong form EMH?

Answer 10

Future prices cannot be predicted even by using private information. Excess abnormal returns cannot be achieved even using private information. So insider dealing could not happen.