WEEK 10 - Efficient Market Hypothesis Flashcards
In an efficient capital market what do security prices reflect?
Security prices (E.G. Shares) rationally reflect available information
What happens in the efficient capital market when new information is released?
If new info revealed about a firm, incorporated into the share price rapidly and rationally with respect to direction of the share price movement and size of that movement
What is the Efficient Market Hypothesis? (Actual Definition)
share prices reflect all
Information and consistent alpha generation is impossible.
-stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices.
-As such investors can never beat the market.
What does Efficiency not mean?
- Prices don’t depart from true econ value
- Will not come across an investor beating the market in a single time period
- No investor following a particular investment strategy will beat the market in the long term
GRAPH OF SHARES WITH NEW INFO RELEASED
SEE IN NOTES
What is the Value of an Efficient Market?
- To encourage share buying
- To give correct signals to company managers
(Managers need to be assured that the implication of a decision is accurately signalled to shareholders and to management through the share price)
- Rate of return investors demand on securities
- Info communicated to the market - To help allocate resources
What does a random walk have to do with the efficient market hypothesis?
News is random, so price will be random
What is the Efficient Market Hypothesis? (For exam purposes)
Impossible to predict future prices of shares based on past price
BREAKOUT GRAPH
SEE IN NOTES
What are the three levels of efficiency?
- Weak Form efficiency: Share prices fully reflect all information contained in past price movements
- Semi-Strong form: Share prices fully reflect all the relevant publicly available info
- Strong form: All relevant info, including that which is privately held, is reflected in the share price
What are weak form tests?
- No mechanical trading rules based on past movements which will generate profits in excess of the average market return
- Done via a simple price chart
What are the differing patterns seen in the weak form test?
- Head and Shoulders patterns
- Filter Approach
(If above moving average should buy as can out perform the market) - Breakout strategy
What exactly is the Filter approach?
Focus on the long-term trends and to filter out short-term movements
What is return reversal?
To outperform the market based on past returns
What was De Bondt and Thaler’s approach on return reversal?
Shares that had given the worst returns over a three years period outperformed the market by an average of 19.6% in the next 36 months
What was Arnold and Baker’s (2007) approach on return reversal?
Loser shares outperformed winner shares by 14% per year
What was Jegadeesh and Titman’s strategy around the price (return) momentum?
A strategy that selects shares on their past six month returns and holds them for 6 months, realises a compounded return above the market of 12.01% per year on average
What are the possible explanations behind Titman’s strategy?
- Investors under-reacting to new information
- Investors overreacting during the test period
What are Semi-strong form tests?
- Tells us fundamental analysis don’t make sense -> All info you need is in the price
- Seasonal, Calendar or Cyclical effects: The Weekend effect, The January Effect etc.
What do the studies say about Small Firms?
Studies in the 1980’s found that smaller firms’ shares outperformed in the USA, Canada, Aus, Belgium, Finland, The Netherlands, France, Germany, Japan and Britain
- Perhaps the researchers had not adequately allowed for the extra risk of small shares (beta)
- Proportionately more expensive to trade in small companies’ shares
- ‘Institutional Neglect’
(Big banks will focus more on analysing big firms)
What’s meant by Underreaction in the market?
- Investors are slow to react to the release of info in some circumstances
- ‘Post-earnings announcement drift’
What’s meant by Value Investing?
E.g.
Low price-earning ratio shares, high dividend yield, high book-to-market ratio
What is the evidence for Semi-strong efficiency?
Significant but not so overwhelming that there’s no hope of outperformance for the able and dedicated
- Publication Bias
- Hundreds of researchers examining of data
What’s the paradox behind the Semi-strong efficiency?
In order for the market to remain efficient there has to be a large body of investors who believe it to be inefficient
What are the elements of Strong-form tests?
- Trading shares on the basis of info not in the public domain and make abnormal profits (Insider knowledge)
What does the term ‘Insider’ mean?
-Covers anyone with sensitive information, not just a company director or employee
How can we solve insider trading (even tho its illegal already)
- Raise the level of info disclosure
- Prohibit certain individuals from dealing in the company’s shares for crucial time periods
What are the implications of the EMH for investors?
1 For the vast majority of people public information cannot be used to earn abnormal returns
2 Investors need to press for a greater volume of timely information
3 The perception of a fair game market could be improved by more constraints and deterrents placed on insider dealers
What are the implications of the EMH for Companies?
1 Focus on substance, not on short-term appearance
2 The timing of security issues does not have to be fine-tuned
3 Large quantities of new shares can be sold without moving the price
4 Signals from price movements should be taken seriously
