Week 9 Efficient Market Hypothesis Flashcards
1
Q
What is an efficient market?
A
- The notion that stock reflect all available information - prices at any time are based on a ‘correct’ valuation of all available information.
- In an efficient market, stocks react quickly and efficiently to new information.
2
Q
Why do we care about market efficiency?
A
- Why is an efficient market desirable? Because prices are fair.
- -> when firms issue securities they will get fair price
- -> Investors will pay fair prices
- -> the market will allocate resources smoothly (inefficient allocation of resources can seriously hurt the economy)
- IF PRICES ARE FAIR/CORRECT, THE ONLY WAY AN INVESTOR GETS HIGHER RETURNS ON AVERAGE IS BY TAKING ON MORE RISK
3
Q
Weak Form Efficient
A
- the market incorporates all useful information in past pricing data when it sets prices today
- -> prices
- -> trading volume
- -> short interest
- implies trend analysis is fruitless. WFE holds that if such data every conveyed reliable signals about future performance, all investors would’ve already exploited the signals. CANNOT USE PAST PRICE DATA TO GENERATE HIGHER EXPECTED RETURNS
4
Q
Semi-strong efficient
A
- the market correctly uses all relevant public information available at time t to set prices at time t
- -> past prices
- -> fundamental data on the firm’s product line
- -> earnings forecast
- -> accounting info
- -> balance sheet composition
- CANNOT USE ANY PUBLICLY AVAILABLE INFORMATION TO GENERATE HIGHER EXPECTED RETURNS
5
Q
Strong Form Efficient
A
- market correctly uses all relevant public and private information available at time t to set prices at time t
- EVEN POEPLE WITH INSIDER INFO CAN’T GENERATE HIGHER EXPECTED RETURNS UNRELATED TO RISK
6
Q
Testing Market Efficiency
A
- we could test market efficiency if we observed correct prices, but we only observe the prices the market sets
- would could test wether the market is efficient if we knew how the market determined expected returns
7
Q
Joint Hypothesis Problem
A
- we don’t know how the market determines expected returns
- we need a model of market equilibrium to tell us how expected returns are determined by the market
- any test is simultaneously a test of efficiency and of correctness of the model of market equilibrium
- most evidence for and against market efficiency suffers from joint hypothesis problem
- -> one hypothesis is CAPM, another hypothesis is market efficiency. In examples it is impossible to tell which hypothesis fails: the CAPM or the market efficiency.
- Abnormal returns in excess of the CAPM represent a way of adding return without raking on more risk, or they represent a return for risk that we don’t’ understand
8
Q
Evidence Against Market Efficiency
A
- Small stocks have higher returns on average than larger stocks, even after adjusting for their beta with the market
- “value” stocks, i.e. stocks with a high book to stock price ratio have higher returns than “growth” stocks
- times of high P/E ratios or high price-dividend ratios for the overall stock market tend to be followed by periods of low returns
9
Q
Tests of Market Efficiency
A
- a common way is by using event studies –> event studies look at the pattern of prices/returns around a public event (i.e. cuts to dividends, announcement buy-backs, positive/negative earnings surprises)
- pattern:
- -> a sudden drop or rise in the stock price on announcement
- -> comparatively little movement in prices in the days following the announcement
- -> occasionally there is a drift in the “right” direction prior to announcement
- evidence suggest that markets are semi-strong
10
Q
What is behavioural finance?
A
The study of how security prices are affected by systematic errors made by investors –> based on cognitive psychology
–> the systematic errors are caused by cognitive behavioural biases
11
Q
Cognitive Biases
A
- people tend to not process information correctly
- people over react to exciting/dramatic information
- people under react to boring information
- people over react to private information
- people under react to public info
12
Q
The Small Firm Effect
A
Abnormal Risk-adjusted returns
- small stocks may have outperformed large stocks by ~10% per year
- Small stocks may be riskier; but even when adjusted for risk, still consistent premium
- we would not expect such minimal effort to yield such strong returns
13
Q
January Effect
A
- much of the small firm effect occurs in January
- generally stocks do better in January, particularly early in the month, than the rest of the year. Investors tend to sell-off low performing stocks at the end of each year. They tend to buy those stocks back a few weeks or even days later
14
Q
Day of the Week Effect
A
- returns on Mondays have been consistently lower than returns on other days
15
Q
Turn of the month effect
A
stock prices usually increase during the last 4 days and first 3 days of each month
