Week 7- The Efficient Market Hypothesis

Question 1

What is operational efficiency?

Answer 1

Where transaction costs in the market should be as low as possible and any trading can be quickly achieved.

Question 2

What is allocational efficiency?

Answer 2

Where the capital market, through the medium of pricing efficiency, allocates funds to their most productive use

Question 3

What is pricing efficiency?

Answer 3

Where the prices of capital market securities, such as shares and bonds, fully and fairly reflect all information concerning past events and all events that the market expects to occur in the future.

Question 4

The term “efficient market hypothesis” applies to which form of efficiency only?

Answer 4

Pricing Efficiency

Question 5

What does the concept of efficient capital markets mean?

Answer 5

Security prices fully reflect all available information

Question 6

If security prices fully reflect all available information, what is true about new information, what are these price changes called?

Answer 6

New information by definition is unpredictable and unforeseen, so price changes are a random walk, that is stock price
changes are independent of each other.

Question 7

In an efficient market, why can’t trading rules be made to “beat the market”?

Answer 7

As the undervaluing or overvaluing of shares does not exist.

Question 8

In an efficient market, how do prices react to new information?

Answer 8

Rationally and speedily

Question 9

What are abnormal returns?

Answer 9

Returns in excess of those that could be made over the same period from securities of similar risk

Question 10

Can today’s price t, be used to predict tomorrow’s t+1 change in share price?

Answer 10

No

Question 11

When do prices follow a random walk process? Explain the equatoin.

Answer 11

• 𝑃𝑡 = 𝑃𝑡−1 +expected return + random error𝑡
  where,𝑃𝑡−1 is the last observed price,
• Expected return is a function of a security’s risk and would be based on the models of risk and return, e.g. CAPM,
• Random component is due to new information about the company, and it is unrelated to the random component in any
  past period.

Question 12

What is the error term of the random error?

Answer 12

0

Question 13

List 5 keys points about technical analysis.

Answer 13

• Key to success is a sluggish response of stock prices to fundamental supply-and-demand factors.
• Fundamental info about the firm is not utilised by Chartists.
• Chart of historical price data is all that is required to forecast P.
• Believed security prices move in cycles.
• Very difficult to predict new trends using this approach.

Question 14

Give an example of a filter rule

Answer 14

• If shares price rises by 5% from its low point then buy since its price is on an upward trend.
• If share price falls by 5% from its peak then sell since on a downward trend.

Question 15

Is there much evidence to suggest technical analysis works after transaction costs? What is another issue with it?

Answer 15

• No evidence exists to suggest that such a strategy works after transaction costs are taken into consideration.
• Even if chartists have a rule that works its highly likely that other traders will find out!

Question 16

Give 4 key points about fundamental analysis.

Answer 16

• Study all company affairs and fundamentals (e.g. profit etc..) in order to determine the true value of the firm.
• Specialise in specific sectors and individual companies – so they gain more knowledge than anyone else.
• Rely upon public sources for their information.
• Objective is to predict price change before it occurs using available info.

Question 17

Is there data to support fundamental analysis?

Answer 17

• The evidence suggests that fundamentalists do not consistently exceed normal returns by a margin that covers transaction costs.
• League tables of fund management performance do not consistently report the same winners.

Question 18

What happens if one fundamental analysis team is very successful?

Answer 18

They will be copied by other teams

Question 19

What is the weak form efficiency of the EMH? What is the application of this and what evidence can be done to test this?

Answer 19

• Weak form efficiency: Current share prices reflect all past information, such as past share price movements.
• Implication: Making abnormal returns using trading rules based on studying past share prices is not possible.
• Empirical evidence: Random walk hypothesis, serial correlation tests, run tests and filter tests.

Question 20

What is the semi-strong form efficiency of the EMH? What is the application of this and what evidence can be done to test this?

Answer 20

• Semi-strong efficiency: Current share prices reflect past information and all publicly available information. (Info includes dividends announcements, new investments)
• Implication: no advantage in analysing publicly available information after it has been released, because the market has
  already absorbed it into the price.
• Empirical evidence: Stock splits, anticipation of annual reports and mergers.

Question 21

Can fundamental anlysts make an abnormal return in the case of semi-strong efficiency?

Answer 21

No, as they use publicly available information

Question 22

What is the strong form efficiency of the EMH? What is the application of this and what evidence can be done to test this?

Answer 22

• Current share prices reflect all information both publicly and privately (inside) held.
• Implication: It is not possible to make any abnormal returns, not even investors who act on ‘insider information’.
• Empirical evidence: Why is insider dealing illegal? Investors do make abnormal returns by insider dealing, as shown by occasional prosecutions for this offence in several countries.

Question 23

How can serial correlation be used to test the weak form efficiency?

Answer 23

• If stock prices follow a random walk then ≠ abnormal returns by considering past behaviour.
• A positive coefficient of serial correlation for a particular share indicates that a higher-than-average return today is likely to be followed by higher-than-average returns in the future.

Question 24

What is a runs test, and how can be be used to test weak form efficiency?

Answer 24

• A runs test is a statistical technique to test the likelihood that a series of price movements occurred by chance.
• If price changes are positively related then one would expect a + to be followed by another +, and conversely a - by a -. That is, we wouldn’t expect a sign change.
• If the prices are random then no pattern should be observed between the price change + and – values.

Question 25

What relationship do correlation tests (serial correlation/runs tests) generally find?

Answer 25

A small positive relationship between price changes.

Question 26

What are filter rules, when would they be used, and what does the evidence state?

Answer 26

Filter rules can be used to look for more complex patterns than those found in a similar linear relationship
- Filter rules formulate a trading rule for an appropriate pattern of returns and then use the data to see what would have happened if one had actually traded using such a rule.
- e.g.: Purchase the stock if it rises by X% from the previous low and hold it until it declines by Y% from the subsequent high – then sell at this point.
- The empirical evidence doesn’t suggest that filter rules are profitable.

Question 27

What do tests of semi-strong form efficiency focus on? What are the implications if it is true?

Answer 27

• Tests focus on whether it is worthwhile to expensively acquire and analyse publicly available information.
• If semi-strong efficiency is true, then this undermines the work of fundamental analysts – i.e. it isn’t possible to predict price
  changes to generate an abnormal return even when incorporating public info.

Question 28

How can tests on semi-strong form efficiency be carried out? What are the results?

Answer 28

• Event studies and the record of mutual funds are possible tests for the semi-strong form efficiency.
• Most evidence in 1960/70’s supported the semi-strong form hypothesis particularly once transactions costs are taken into account.

Question 29

How can it be tested to see if abnormal gains can be made by trading immediately post-release of new info (eg dividends or profit announcements)? What did early studies find?

Answer 29

• Through Event Studies, which are statistical studies that examine if new (company specific) information is incorporated into the stock price in one single price jump upon public release by tracking the returns around
  the arrival of new information with a comparison group of firms of similar industry and risk.
• They found no evidence of abnormal returns & most info included in annual reports was already incorporated into the share price before any announcements made.

Question 30

What kind of efficiency do most studies still support?

Answer 30

The semi-strong form of efficiency

Question 31

How can the performance of mutual funds be used to test semi-strong form efficiency?

Answer 31

• If the market is semi-strong form efficient, then no matter what publicly available information mutual fund managers rely on to
  pick stocks, their average returns should be the same as those of the average investor in the market as a whole.
• We can test efficiency by comparing the performance of professionally managed mutual funds with the performance of
  a market index.
• In general, research has shown that mutual funds do not consistently outperform the market, which is consistent with semi-strong form

Question 32

Why can mutual funds be useful?

Answer 32

• Important in the construction of a well-diversified portfolio.
• Provide a variety of services: tax consideration; risk profile of the investor; employment and age of the investor.

Question 33

What did Kaplan and Roll (1972) find?

Answer 33

Kaplan and Roll (1972) found share prices did not change as a result of changes in depreciation policy – investors were aware
of the accounting practices.

Question 34

How can firms manipulate their earnings? What is the potential effects of this on share prices, and how we we expect a semi-strong form efficient market to respond to this?

Answer 34

• Firms can manipulate their earnings by legally changing accounting practice.
• For instance, the depreciation rate applied to assets can be changed – this would increase reported profits.
• Semi strong markets should not be fooled by this practice.
• Collapse in the share price of ENRON indicates misleading and illegal accounting practices can affect share price.

Question 35

What are the 3 ways of testing semi-strong efficiency?

Answer 35

• Information announcements
• The record of mutual funds
• Manipulation of earnings

Question 36

How strong is the evidence for semi-strong efficiency?

Answer 36

The evidence for semi-strong efficiency is significant but not so overwhelming that there is no hope of outperformance for the
able and dedicated

Question 37

Why are markets not strong firm efficient?

Answer 37

Because despite insider trading being illgeal, it is generally accepted that it is possible to trade shares on the basis of information not in the public domain and make abnormal returns.

Question 38

Why is insider trading an issue?

Answer 38

Credibility and viability of the stock market is threatened when investors do not believe that they are paying a fair price for stock.

Question 39

Which plan permits directors, officers, and other insiders to trade a pre-determined number of shares at a predetermined time without risk of insider trading liability. As long as they are not in possession of material non-public information.

Answer 39

A Rule 10b5-1 plan, but they cannot do this if they have non public information.

Question 40

How has the rule 10b5-1 been updated?

Answer 40

Now there is a 90-day “cooling off” period between the filing date and the first sale.

Question 41

Are the returns from smaller firms in the long run greater than the average return for all companies? Why and what is this known as?

Answer 41

Yes, to compensate for the greater risk associated with them. This is known as “the small firm effect”

Question 42

What does a financial anomaly refer to? Have these been found in research into market efficiency?

Answer 42

A financial anomaly refers to unexplained results that deviate from those expected under finance theory. Research into market efficiency has produced evidence of anomalies in share price behaviour.

Question 43

Give 3 potential reasons for the small firm effects:

Answer 43

• To compensate for the greater risk associated with them.
• Small firms tend to be neglected by large institutional traders, hence limited information available.
• The growth prospects of smaller companies are better because they start from a lower base

Question 44

What did Fama and French (1992) find?

Answer 44

Fama and French (1992) show that a powerful predictor of returns across securities is the ratio of the book value of the firm’s equity
to the market value of equity. The authors also found that, after controlling for the size and book-to-market effects, beta seemed to
have no power to explain average security returns.

Question 45

Why does the small market effect have little macroeconomic significance?

Answer 45

However, small companies account for only a small proportion of the equity trading on major stock exchanges, so have little
macroeconomic significance

Question 46

Describe the value effect.

Answer 46

• Above-average returns can apparently be gained by investing in value stocks, which are shares with high earnings, cash flows or
  tangible assets relative to current share price, i.e. by investing in shares with low price/earnings ratios.
• Fama and French (1989) argue that once size and market to book are accounted for, the price/earnings effect disappears.

Question 47

Explain under/overeaction

Answer 47

• Investors are slow to react to the release of new information. In EMH should have speedily adjustment to abnormal returns.
• When there is +ve news returns continue to ↑ and conversely when there is –ve news returns continue to ↓ for up to 60 days
  after new info is made publicly available.

Question 48

Give 5 examples of types of anomalies in share behaviour

Answer 48

• The small firm effect
• Book to market ratios
• Value effects
• Under/overreactions
• Seasonal, calendar or cyclical effects

Question 49

Describe the momentum effect in short and medium horizons

Answer 49

The tendency of poorly performing stocks and well-performing stocks in one period to continue that abnormal performance in following periods is the momentum effect.

Question 50

Describe the reversal effect in situations with long horizons

Answer 50

Reversal effect is the tendency of poorly performing stocks and well-performing stocks in one period to experience reversals in
following periods.

Question 51

Give 3 examples of seasonal, calender or cyclical effects

Answer 51

• The ‘weekend effect’: systematic abnormal returns on Fridays relative to falls on Mondays.
• The bed and breakfast deal (April in the UK and January in the USA): This is a selling strategy designed to crystallise capital losses for tax purposes as the start of April is the end of the UK tax year.
• People investing in stock markets in January after receiving their yearly bonuses, leading to abnormal return in January

Question 52

What is the importance and implications of the EMH for investors?

Answer 52

• Paying for investment research will not produce above average returns.
• Studying published accounts and investment tips will not produce above-average returns.
• There are no bargains (underpriced shares) to be found on the stock market.
• Fairness – Investors should be encouraged by the fact that the buying/selling price of shares is fair.

Question 53

What is the importance and implications of the EMH for companies?

Answer 53

An efficient market gives the correct signals to managers.
- The share price of a company fairly reflects its value and market expectations about its future performance and returns.
- Value – When making investment decisions managers need to know that this is fully reflected in the share price.
- Performance – Share prices provide feedback to managers upon how well the firm is performing.
- Cosmetic manipulation of accounting information will not mislead the market.
- Finance, the ability of the company to raise finance is affected

Question 54

If the EMH holds and the ability of a firms ability to raise finance is affected, why is this?

Answer 54

• Companies would use inefficient internal investment criteria.
• Over 2 periods the expected rate of return, r, is expressed as:
  r = (DIV+P1+P0)/PO
• If current prices P0 are biased ↑ the RoR (r) is too low
• Conversely, if P0 is biased ↓ the RoR (r) is too high.
• This will obviously impact upon investment decision making

Question 55

What is the importance and implications of the EMH for fundamental and technical analysts?

Answer 55

• It is not possible to make abnormal gains if capital markets are efficient, since all publicly available information will already be reflected in share prices.
• Note that both technical analysis and fundamental analysis, by seeking abnormal returns, increase the speed with which
  share prices absorb new information and reach equilibrium, thereby preventing abnormal returns from being achieved.

Question 56

What is the importance and implications of the EMH for shareholders?

Answer 56

• The firm’s objective is to maximise shareholder wealth. EM provides the vital link between the overall value of a company
  and the market price of its shares, which in turn is taken as a measure of shareholder wealth.
• Whether the market price of a company’s shares represents an accurate and appropriate measure of a shareholder’s
  wealth depends heavily on the efficiency of the markets in which the shares are traded.