Week 7 - Market efficiency

Question 1

Efficient market

Answer 1

A market in which asset prices reflect all past and present information

Question 2

Joint hypothesis problem

Answer 2

All tests of efficiency are a test of a joint hypothesis containing 2 parts:
1. The market under analysis is informationally efficient
2. The correct asset pricing model is used to generate abnormal returns.

*If we reject the null hypothesis it can be because either (or both) of the parts of the hypothesis are invalid. This creates UNCERTAINTY when interpreting any efficiency test results.

Question 3

How does information get reflected in prices?

Answer 3

1. Investors will have prior expectations.
2. In an efficient market, prices are expected to react only to elements of information that have not been fully anticipated by investors - it is the “surprise” (or “unexpected”) news that affects prices.
3. Investors update their expectations which are incorporated into market prices through trades.

Question 4

Any 1 of 3 conditions that could lead to efficiency (foundations of efficiency)

Answer 4

1. Rationality
   - Assume all investors are rational, receive info in a timely fashion & process quickly. Thus, all investors adjust stock valuations in same way when news arrive & prices adjust instantly. (Obviously not all in reality.)
2. Independent deviations from rationality
   - Equal influence of irrationality on markets should cancel out
3. Dominance of rational, professional investors
   - should push prices to correct level

Question 5

Efficient market hypothesis (EMH)

Answer 5

Stock prices accurately reflect all available information.
Hence, there is no return predictability in the market.

Question 6

3 forms of market efficiency

*In efficient markets, price changes are random! → EMs follow RANDOM WALKS. So can’t predict how prices will change.

Answer 6

1. Weak form
   - investors can’t predict abnormal returns using PAST STOCK PRICES, TRADING VOLUME & other TRADING DATA
2. Semi-strong form
   - investors can’t predict abnormal returns given PUBLICLY AVAILABLE INFORMATION (eg. mgmt quality, balance sheet composition, acct. performance, corporate news etc.) + past trading data
3. Strong form
   - investors can’t predict abnormal returns using past, publicly and PRIVATELY AVAILABLE information

• The weak and semi-strong forms of market efficiency hold to some extent. The strong form of market efficiency is unlikely to hold.
  *If markets violate weak form, violates all forms! If weak, doesn’t mean it’s strong.

Question 7

4 puzzles & anomalies that challenge the EMH

Answer 7

1. Stock price momentum & reversal
   - Stocks that have delivered superior returns over the last few weeks or months tend to deliver superior returns in the future. While poorly performing stocks tend to continue to disappoint.
   > CAPM would require the beta of winners to be higher than that of the losers
   Momentum: go long on winners, short losers in the portfolio for eg. 6 months. Will see profits go up then decrease over a longer term
   Reversal: Long on losers, short winners and hold over the long term. For this to work over long term, losers have to become winners and vice versa.
2. Post earnings announcement drifts
   - Returns increase at first but drift after some time.
   - Contradicts SEMI-STRONG form of market efficiency
3. Twin-stock puzzles
   - potentially can have mispricing and make arbitrage but according to EMH, this shouldn’t be the case as the RATIO should be fixed, eg. Royal Dutch & Shell
4. Asset price bubbles
   - fundamental values are far diff. from what they’re traded in the market

Question 8

2 limits to arbitrage + the main assumption of EMH

Answer 8

Assumed that the market is frictionless & no transaction costs, that can long/short unlimited amounts of bonds (ie. arbitrageurs have unlimited capital & unlimited risk capacity)

2 limitations
1. IMPLEMENTATION COSTS & time element (and cost) of finding mispricing
- Can’t always buy bonds we want from broker; need to post collateral with broker, so Can’t make arbitrage profit if you have constraints to long/short
- If there is slight mispricing (eg. 50p) and the transaction cost is 70p, you can’t make an arbitrage profit and mispricing will continue

2. NOISE TRADER RISK
   eg. you’re selling stocks just because you need $$, or you’re buying just because you have a lot of $$
   - in short run noise traders might push prices in the wrong direction