week 6

Question 1

 Efficient Market

Answer 1

o Price reflects all available information
o A market that is efficient in processing information
o The price of securities observed at any time are based on correct evaluations of all information available at that time

Question 2

 Dot.com crash

Answer 2

o Value of equity in the U.S. dropped about 5trillion from peak in 1999 to 2002
o U.S. GDP is 13 trillion
o The investors overvalued the technological change / valued it too early
o Decisions made on impulse rather than calculations?
 Noise investing
 Invest because other people are investing
 Nothing particularly underpinning this
o Hard to distinguish a bubble in hindsight

Question 3

 Noise or information

Answer 3

o Noise is data or news that is not information or relevant
o Investors mistake it for information
 If it is easy to distinguish, there will be no market
 People buy and sell due to differing opinions

Question 4

 Inefficient markets

Answer 4

o Price is a function of demand and supply
o Price is a clearing point where supply of goods = demand
o Prices are efficient and provide basis for optimal resource allocation
 Incorporates more information about value than that held by any person or entity
 Prices are smarter than people
o Inefficient market -> prices are misleading indicator of value
 Cause a misallocation of resources
 Irrationally high bubble resulting in unjustifiable prices
• Too many resources going into the sector
 Demand may also be irrationally low resulting in too few resources
 Painful corrections

Question 5

 Efficient Market Hypothesis

Answer 5

o Investors are rational
o Arbitrage corrects inefficiencies
o Noise traders cancel each other out
o Price accurately reflects all publicly available information
o Limitations
 There are assets that do not have an intrinsic value but have a price
 Exotic assets e.g. paintings

Question 6

 Market efficiency: the key issue

Answer 6

o Markets are the best relative to the alternatives
o Markets and prices work, generally
o We judge the market based on its alternatives

Question 7

 Theoretical foundations for EMH

Answer 7

o Investors are rational and value securities rationally
o Even if some investors are not rational, their trades cancel each other out
o Smart investors arbitrage away the influence of irrational investors
o Irrational investors lose money and cannot survive in the long-term

Question 8

 Eugene Fama’s famous typology of market efficiency

Answer 8

o Weak form efficiency: prices reflect information implicit in past patterns of returns
 Implication: it’s not possible to earn abnormal risk adjusted returns by reviewing historic data

o Semi-strong efficiency: prices reflect publicly available information
 Implication: not possible to earn abnormal risk adjusted returns by reviewing publicly available information

o Strong-form efficiency: prices reflect public and privately available information
 Implication: not possible to earn abnormal risk-adjusted returns by reviewing any information from any source

Question 9

 Theoretical challenges to EMH

Answer 9

o Investors are not fully rational
 React to irrelevant information, fail to diversify
o Limits to arbitrage
 Deviation from fundamental value -> opportunity is corrected fast
 Cannot exploit this inefficiency

Question 10

 Risks and costs faced by the arbitrageur

Answer 10

o Fundamental risk
 Risk that bad news may emerge that causes an underpriced security to become even further underpriced
 E.g. housing prices, interest rates decreasing, more housing -> housing prices increase
o Noise-trader risk
 Risk that mispricing may worsen before it gets better as a result of uninformed investors dominating the market
o Risk is greater when arbitrageurs are investing other people’s money and the evaluation horizon is shorter than period for mispricing to correct
o Implementation costs
 Wide bid-ask spreads
 Price impact costs
 Costs of borrowing stocks to short-sell
 Cost of identifying mispriced securities: no one hangs a sign saying this stock is mispriced

Question 11

 Three clear messages

Answer 11

o Markets generally work
o Persistent pricing anomalies
o An anomaly is an outcome that isn’t explained by theory
o Difficult to profit from apparent pricing anomalies