Part 8. Market Efficiency

Question 1

Informationally efficient capital market

Answer 1

The one in which current price of security fully, quickly, and rationally reflects all available information about that security.

A statistical concept.

e.g. given all available info, current security prices are unbiased estimates of their values, so expected return on any security is just equilibrium return necessary to compensate investors for the risk (uncertainty) regarding future cash flows.

Question 2

Passive investment strategy

Answer 2

• in a perfectly inefficient market, passive investments are used (buying broad market index of stocks and holding it) as active investment strategies underperform due to transaction costs, and management fees.
• the extent to which market prices are inefficient, active investment strategies can generate positive risk-adjusted returns.

Question 3

Measuring market efficiency

Answer 3

• to determine the time taken for trading activity to cause info to be reflected in security prices (i.e. lag from time info is disseminated to time prices reflect value implications of that info).
• with significant lag, trader can use info to potentially generate positive risk-adjusted returns.
• prices should only move if positive expectations are exceeded.

Question 4

Market value

Answer 4

• The current price of an asset.
• Reflect intrinsic values if markets are highly efficient, but if not managers buy assets for which they think intrinsic values are greater than MV, and sell for IV less than MV.

Question 5

Intrinsic/fundamental value

Answer 5

• The value that rational investor with full knowledge about assets characteristics would willingly pay.
  e. g. bond investor would fully know and understand bonds coupon, maturity, default risk, liquidity and other characteristics, to est. intrinsic value.
• cannot be known with certainty, estimated by investors who have differing estimates of assets IV, with more complex assets increasing its difficulty.
• IV constantly changes to new info becoming available.

Question 6

Factors affecting degree of market efficiency

Answer 6

1. Number of market participants
   - the larger the number of investors, the more efficient the market.
2. Availability of information

• the more info available to investors, the more efficient the market.
• some assets such as bonds, currencies, swaps, forwards, mortgages, and money market securities that trade OTC markets have less available info.
• access to info should not favour one party over another, so US SEC require firms disclose same info to public as they do to stock analysts

3. Impediments to trading

• arbitrage refers to buying asset in one market and simultaneously selling it at higher price in another market, until prices in two markets are equal.
• impediments to arbitrage such as high TC, lack of info will limit activity, and allow price inefficiencies.
• short selling improves market efficiency, as its sale pressure prevents overvaluation, but restrictions (ability to borrow stock cheaply) reduces market efficiency.

4. Transaction and information costs

• extent costs of info analysis, trading are greater than potential profit from trading mis valued securities, market prices will be inefficient.
• markets are efficient if after deducting costs, there is no risk-adjusted returns to be made from trading based on public info.

Question 7

3 forms of market efficiency:

Answer 7

1. Weak form market efficiency
2. Semi strong form market efficiency
3. Strong form market efficiency

Question 8

Weak form market efficiency

Answer 8

• states current security prices fully reflect all currently available security market data.
• past price and volume information have no predictive power about future direction of security prices as price changes will be independent from one period to next.
• investor cannot achieve positive risk-adjusted returns on average by using technical analysis.

Question 9

Semi strong form market efficiency

Answer 9

• the security prices rapidly adjust without bias to arrival of all new public information, so security prices fully reflect all public available info.
• security prices include all past security market info and nonmarket info available to public.
• implication investor cannot achieve positive risk-adjusted returns on average using fundamental analysis.

Question 10

Strong form market efficiency

Answer 10

• the security prices fully reflect all info from both public and private sources.
• this includes all types of info: past security market info, public, and private (inside) info.
• no group of investors have monopolistic access to info relevant to formation of prices, and none should be able to consistently achieve positive abnormal returns.

Question 11

Abnormal profit (risk adjusted returns)

Answer 11

• often used to test market efficiency.
• the ER for trading strategy is calculated given its risk, using model of ER such as CAPM or multifactor model.
• if returns on average are greater than equilibrium ER, we can reject hypothesis of efficient prices wrt information on which strategy is based.
• results of test of various forms of ME have implications about value of tech analysis, fundamental analysis, and portfolio management in general.

Question 12

Technical analysis

Answer 12

• Seeks to earn positive risk-adjusted returns by using historical price and volume (trading) data.
• Test of WME examined whether tech analysis produces abnormal profits, proving it des not, so cannot reject hypothesis that markets are WFE.
• this has shown to have success in emerging markets, with success of any tech analysis strategy evaluated considering costs of info, analysis and trading.

Question 13

Fundamental analysis

Answer 13

• Based on public info such as earnings, dividends, and various accounting ratios and estimates.
• semi-strong for of ME suggests all public info is already reflected in stock prices, so investors should not be able to earn abnormal profits by trading on this info.
• method for testing SSF is event study.
• event study = examine abnormal returns before and after release of new info that affects firms IV such as earnings announcements or dividend changes.
• H0 = investors should not be able to earn positive abnormal returns on average by trading based on firm events as price will rapidly reflect news about about firms prospects.
• evidence shows developed markets are generally semi strong form efficient, with evidence of some in emerging markets, questioning usefulness of fundamental analysis.

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Question 14

Passive portfolio management

Answer 14

• if markets are semi-strong form efficient, investors should invest passively (invest in index portfolio that replicates returns on market index).
• most mutual fund managers cannot outperform passive index strategy over time.
• if markets are efficient, managers add value by est. and implementing portfolio risk and return objectives, assisting clients with portfolio diversification, asset allocation and tax management.

Question 15

Market anomaly

Answer 15

Something that deviates from common rule, such as tests for EMH, something that will lead us to reject the hypothesis of market efficiency.

• historical data can find patterns in security returns that violate market efficiency, but unlikely to recur in future.
• data mining investigates data until statistically significant relation is found.
• to avoid data mining bias, analyst should first ask if there is economic basis for relationships they find between certain variable and stock returns, the test relationships discovered with large sample of data to determine if persistent and present in various subperiods.

Question 16

Anomalies in time series data

Answer 16

1. Calendar anomalies
   - Jan/turn of the year effect = finding that during first 5 days of Jan, stock returns for small firms are significantly higher than the rest of the year, where efficient markets traders exploit profit opportunity to eliminate it.

reasons for:

• tax-loss selling = investors sell losing positions in Dec to realise losses for tax purposes, then repurchase stocks in Jan to push price up.
• window dressing = as portfolio managers sell risky stocks in Dec to remove from year end statements, and repurchase in Jan.

other calendar anomalies: do not appear to persist

• turn of the month effect - stock returns higher in days surrounding month end.
• day of the week effect - average Monday returns are negative.
• weekend effect - positive Friday returns followed by negative Monday
• holiday effect - pre-holiday returns are higher

2. Overreaction and momentum anomalies

overreaction effect - finding firms with poor stock returns over previous 3 or 5 years have better returns than firms with high stock returns over prior period, due to investor overreaction to good and bad news.

momentum effects - high ST returns are followed by continued high returns, present in international markets too.

Both effects - violate WME as provide evidence of profitable strategy based only on market data, and some argue nature of statistical tests reflects rational investor behaviour.

Question 17

Anomalies in cross-sectional data

Answer 17

1. Size effect

• refers to initial findings that small-cap stocks outperform large-cap stocks.
• evidence not confirm effect so either investors traded on, eliminated anomaly or initial finding was a random result.

2. Value effect

• finding value stocks (lower P/E, lower M/B, higher dividend yields) outperform growth stocks (higher P/E, higher M/B, lower dividend yield).
• violates SSME as info necessary to classify stocks value or growth is public
• some believe value effect to greater risk of value stocks not captured in risk adjustment procedure.

Question 18

Other anomalies

Answer 18

1. Close-end investment funds

• the shares of these funds trade at prices that sometimes deviate from the net asset value of fund shares often trading at large discounts.
• anomaly as by arbitrage value of pool of assets should be same as market price of close end shares, but transaction costs eliminate this.

2. Earnings announcements

• earning surprise is a portion of announced earnings that was not expected by the market, with positive earnings precede periods of positive risk-adjusted post-announcement stock returns and vice versa.
• investors can exploit this anomaly by buying positive and selling negative.

3. IPOs

• typically under priced with offer price below market price once trading begins, with LT performance of IPO shares as a group below average.
• indicates investors overreact, too optimistic about firms prospects on offer day.

4. Economic fundamentals

• stock returns related to fundamentals such as dividend yields, stock volatility, and interest rates.
• this is only expected in efficient markets, so relation between returns and yields are not consistent over all time periods.

Question 19

Implications for investors

Answer 19

• reported anomalies are not violation of ME, but due to methodology used in test of ME.
• under and over reaction found in markets mean prices are efficient on average.
• evidence of anomalies is that they are transient relations, too small to profit from or reflect returns to risk researchers have failed to account for.
• portfolio management based on previous identified anomalies are unprofitable.
• IM based solely on anomalies have no sound economic basis.

Question 20

Behavioural finance

Answer 20

This examines actual decision-making process of investors, concluding investors are not rational utility max. decision makers with complete info that traditional finance assumes, exhibiting decisions bias and not evaluating risk like traditional models assume they do.

Question 21

Observed investor bias/behaviour considered evidence of irrational behaviour include:

Answer 21

1. Loss aversion
   - the tendency of investors to be more risk averse when face with potential losses than gains, so dislike loss more than gain of equal amount.
2. Investor overconfidence
   - tendency to overestimate their abilities in analysing security info and identify differences between securities market prices and IV.
3. Herding
   - tendency of investors to act in concert on same side of market, acting not on private analysis, but mimic investment actions of other investors.

Question 22

Information cascade

Answer 22

The result of investors mimicking the decisions of others, with uninformed watching/following actions of informed traders.

Those who act first are more knowledgeable investors, those who follow be part of process of incorporating new info into securities prices moving market price to IV, improving info efficiency.

• behaviour finance explains how securities market price deviate from rational, based on est. of IV.
• if rationality is viewed as prerequisite for ME, then markets are not efficient.
• if ME only requires investors cannot consistently earn abnormal risk-adjusted returns, research supports belief markets are efficient.