week 11 Flashcards
Market efficiency
o An efficient market is one where the security prices reflect all available information
o In its most general sense, an efficient market is one where the market price is an unbiased estimate of the true value of the investment
Random and unbiased errors
If the market is efficient
o Market price is the best estimate of value, the process of valuation becomes one of justifying the market price
o As an investor, you do not pick undervalued / overvalued stocks
o Instead you diversify across a broad band of stocks and not trade often
If the market is inefficient
o The market price may be wrong
o Your investment philosophy depends on why you believe markets make mistakes and how they correct them
o Investors who can find these mis valued stocks and time the market correction will then be able to make higher returns than other investors
o Accomplishing the very difficult task of beating the market
Market efficiency Implications
o It is extremely unlikely that all markets are efficient to all investors all the time
o It is possible that some markets are more efficient with respect to the average investor
Housing market vs stock market
o Also possible that some markets are more efficient to some investors and not to others in time periods etc
Tax rates, transaction costs
o An efficient market as a self-correctly mechanism, where inefficiencies appear at regular intervals and are corrected by profit-maximising investors who constantly seek out ways of beating the market
Market efficiency: misunderstandings about market efficiency
o Stock prices cannot deviate from true value at any point in time?
There can be large deviations from true value but these deviations have to be random
There is an equal chance that stocks are under- or over-valued
o No investor will ‘beat’ the market in any time period?
Prior to transaction costs, approximately half of all investors should beat the market in any period
o No investor will ‘beat’ the market in the long term?
Given the number of investors in the markets, the laws of probability would suggest that a fairly large number of them are going to beat the market consistently over long periods
Because they are lucky, not skill
Eugene Fama’s classification
o Three forms
o Weak form efficiency
Current price reflects the information contained in ALL PAST PRICES
o Semi-strong form
Current price reflects the information contained not only in past prices but all public information, including financial statements and news reports
o Strong form
All information, public as well as private, no investors will be able to consistently find under-valued stocks
Market efficiency: how to get there
o Markets do not become efficient automatically
It is the actions of investors, sensing bargains and putting into effect schemes to beat the market, that altogether make markets efficient
Arbitrage
If transaction costs are high, less trades therefore less efficient
o Probability of finding inefficiencies
Decrease as the ease of trading on the asset increases
Increases as the transactions and information cost of exploiting the inefficiency increases
Increases if the investors can establish a cost advantage
Performance Benchmark
o Comparison to various indices: compare to returns you would have made by investing in an index, without adjusting for risk
SPX and SPY
o Risk and return models: adjusting for risk in the comparison
Mean variance measures
• Sharpe ratio: average return / standard deviation of returns from strategy
CAPM based measures
• Jensen’s alpha: actual return minus expected return from CAPM
• Treynor Index: (actual return – risk-free rate) / beta, beta from CAPM
Arbitrage pricing Theory and multi-factor models
• Stephen Ross arbitrage pricing theory
• Fama-french 3 factor model, 5 factor model
• Fama-French-Carhart 4-factor model
o Methodology
Portfolio study
• Firms with specific characteristics are viewed more likely to be under or over-valued
• Create portfolios of such firms at the beginning of a time period and examining returns over the time period
Event study
• An event study is designed to examine market reactions to, and excess returns around specific information events
Regressions
o Weak Form Efficiency
Concerned with whether an investor might consistently earn higher than normal returns based on knowledge of historical price sequences
One can never prove weak form efficiency because there are infinite number of ways to forecast future returns from past returns
One might argue that certain tests imply efficiency / inefficiency with regard to a specific sequence or pattern of prices
An investor armed with the knowledge of a test indicating a market inefficiency might expect to earn a higher than normal return, or face a market impediment preventing him from doing so
Weak Form Efficiency: Runs test
o Use price charts and price patterns as tools for predicting future price movements
o Look at sequences of up or down periods and test them against randomness
o E.g. expected runs is 5
o More runs than 5 suggests mean reversion or price reversal
o A smaller number than 5 suggests momentum or positive correlation between sequential price changes
o We observed 4, less than 5, slight evidence of momentum
o On day 11, because it’s a negative price + momentum, you should short sell
Weak Form Efficiency: Moving averages
o Moving average techniques consolidate shorter series of observations into longer series, and are commonly used for smoothing data variability, and are frequently used as reference point to gauge daily fluctuations
How the trend interpreted then depends upon the chartist
o Note that those who use historical data to predict the price does not believe in market efficiency
o Suppose you assume that the 3-day moving average price represents the true value of the stock.
If the market price is higher than the MA, you sell the stock
Price is lower than MA, buy the stock
Weak Form Efficiency: Serial Correlation
o Suppose you read from AFR that today is a big up day for BHP, what does this tell us about BHP tomorrow?
o Is the stock currently experiencing a momentum or reversal?
o Serial correlation measures the correlation between price changes in consecutive time periods
o Measure of how much price change in any period depends upon price change over prior time period
=0 imply that price changes in consecutive time periods are uncorrelated with each other
>0 evidence of prior momentum in markets
<0 evidence of price reversals
o Empirical evidence on serial correlation can be classified into 4 classes
Really short term (minutes and hours) price behaviour
Short term (daily and weekly)
Medium term (monthly or yearly)
Long term (2-year, 5 year)
o Each time horizon we find different results
Does todays return have correlation with yesterday’s return
Performance = returns
Also price level is automatically correlated
o There are many ways to determine the nature of the relationship between the return on a security and its prior day’s return
Examine whether there exists a linear relationship based on a simple ordinary least squares regression
.772 correlation means that its highly correlated, refers to beta1 hat, yesterdays return increase by 1% -> todays return will increase by 0.72%
If t-stat is larger than 1.96 & p-value is less than 5% then it is statistically significant
Weak Form Efficiency: Portfolio Study
o Firms with lower P/E ratio are more likely to be under-valued, which implies a higher return to buy and hold them
o Check the beta for each stock in each portfolio, calculate the returns on the market index
o Compute the raw returns on each portfolio
o Need to compare to excess returns, is the performance due to the market? Or is it due to the firm outperforming? Many different variables
High Volume Return Premium
o Stocks experiencing unusually high trading volume over a day or a week tend to outperform those experiencing unusually low trading volume over the course of the following month
o Both HVRP and HVRD are evidence against market efficiency
