Rational Expectations Theory

Question 1

Efficient Market Hypothesis (EMH)

Answer 1

• Claims the market price already incorporates all the relevant information
• The market price mechanism is such that the active trading patterns of a small number of informed analysts can lead to accurate market prices
• Uninformed investors can take a free ride, in the knowledge that the research of others is keeping the market efficient

Question 2

Efficient Market

Answer 2

Markets are efficient if the prices of assets in the market quickly and accurately reflect all the relevant information

Question 3

Weak Form EMH

Answer 3

• Market prices incorporate all of the information in the historical price data
• Technical analysis cannot be used to generate excess risk-adjusted returns
• Share Prices has the Markov Property

Question 4

Semi-Strong Form EMH

Answer 4

• Market Prices incorporate all publicly available information
• Fundamental analysis cannot be used to generate excess risk-adjusted returns

Question 5

Strong Form EMH

Answer 5

• Market Prices incorporate all information, whether it is publicly available or not
• Insider trading cannot be used to generate risk-adjusted returns

Question 6

Active vs Passive Fund Management

Answer 6

• Active Fund Managers attempt to detect exploitable mispricings, since they believe the markets are not universally efficient
• Passive Fund Managers simply aim to diversify across a whole market, perhaps because they believe they lack the skill to identify mispricings
• If Markets are inefficient, we would expect active managers to perform on average better than passive managers.
• However, performance should be considered net of various fees and transactions costs
• To demonstrate an exploitable opportunity in the market, the opportunity should be sufficiently large to remain intact even after all these costs are taken into account

Question 7

Tests of the EMH

Answer 7

…………………………..

Question 8

Over-reaction to events (Informational Efficiency Test)

Answer 8

(Price moved in the correct direction, but too far)

• Past winners tend to be future losers and the market appears to over-react to past performance
• Certain accounting ratios appear to have predictive powers, eg over-reacting to past growth
• Firms coming to the market have poor subsequent performance

Question 9

Under-reaction to events (Informational Efficiency Test)

Answer 9

(Price moved in the correct direction, but not far enough)

• Stock prices continue to respond to earnings announcements up to a year after the announcement
• Abnormal Excess Returns for both the parent and subsidiary firms following a de-merger
• Abnormal negative returns following mergers

Question 10

Shiller’s Methodology and Criticism of Shiller’s Methodology

Answer 10

(Shiller formulated the claim of excess volatility into a testable proposition. He found strong evidence that the observed level of volatility contradicted the EMH. Subsequent studies found the violation of the EMH had borderline statistical significance)

• The choice of terminal value for the stock price
• The use of a constant discount rate
• Bias in estimates of the variance due to autocorrelation
• Possible non-stationarity of the series ie the series may have stochastic trends that invalidate the measurements obtained for the variance of the stock price

Question 11

State reasons why it is hard to test whether any of the three forms hold in practice

Answer 11

• Tests need to make assumptions (which may be invalid) such as normality of returns or stationarity, and these assumptions may be invalid
• Transaction costs may prevent the exploitation of anomalies so that the EMH might hold net of transaction costs
• Testing the strong form EMH is problematic as it requires access to
  information that is not in the public domain

Question 12

Arbitrage-free market

Answer 12

Any 2 assets which give the same payoff, must have the same price