Week 9 - Efficient Market Hypothesis Flashcards
What does the Efficient Mkt Hypothesis assert?
Prices in money and capital markets are efficient.
- Current market prices reflect all available information
- It is impossible to earn excess returns by using information available to the market to guide your trading
- Information is rapidly and accurately disseminated
- It is not possible to predict price changes by using current information
What is the Fair Game Model?
εt+1 = rt+1 − E(rt+1|Ωt)
Where:
- > εt+1 = the difference between an observed return and its predicted value
- > Ωt is information at time t
- > E(rt+1|Ωt) is the rational expectation of a return at time, given information available at time t
How do we define εt+1 as a fair game?
In an efficient market we should find E(εt+1|Ωt) = 0
(Essentially returns unpredictable)
This defines εt+1 as a fair game.
How do we calculate the Martingale Property
E(pt+1|Ωt) = pt
INFO = PRICE CHANGES
-> If prices follow the property then returns are a fair game -> Expected Value = 0
-> Essentially from all info tomorrow’s price = today’s price -> Info random prices
What does the Martingale Property mean?
means that a return at one date gives no
information about the return at any other date.
Returns should not be serially correlated.
Zero serial correlation supports EMH
Why do we use Sub-Martingale?
Since returns are always increasing over time
SEE EQUATION IN NOTES
What is a Random Walk?
Results independent of what happened before -> News is random so is price
- Follows Martingale Property
Why Cycles self destructive?
Self-destruct soon as recognised by investors - Price jumps to PV of expected future price
Thus, you cannot completely predict prices since moment you notice it so has everyone else
What are the 3 levels of Efficiency?
- > Weak Form: share prices reflect all current and past information on prices and returns, or market trading data in general.
- > Semi-strong form: share prices reflect all current and past public information
- > Strong form: all current and past information, public or private.
What are the 3 implications of EMH?
- Info search pointless
- What’s the point of active investment
- Resource Allocation
What is meant by infomation search is pointless (1st implication of EMH)
-> If mkts efficient, why spend resources looking for inefficiency -.> This not rational -> But if people not rational, prices inefficient (THIS IS THE EMH PARADOX (1))
-> Fundamental Analysis also pointless -> If mkt price already embodies fundamental info, why do fundamental info again?
(THIS IS EMH PARADOX (2))
How is the EMH Paradox (1) solved by Grossman-Stiglitz?
->Efficiency is not an “all-or-nothing” matter.
->Investors spend resources until the marginal cost of gathering and processing information is just equal to the marginal
benefit.
What is meant by what’s the point of active investment (2nd implication of EMH)
- > Professional portfolio managers have no informational advantages over other investors
- > Better to invest in index fund -> Cheaper costs
If active management doesn’t help ‘beat the mkt’ why is it still used?
Professional portfolio managers may not have special information but they can design portfolios for specific purposes:
- Tax efficiency
- Particular levels of systematic risk for example by holding specific positions in treasury bills
“Beating the market” need not be the goal of portfolio
management
What is meant by Resource Allocation (3rd implication of EMH)
->If asset prices are mispriced, then incorrect signals are sent to the market, to investors and to firms.
Cash may flow into over-valued activities:
the dot.com bubble of late 1990s led to over-investment in firms in IT industries.
What are the 3 major areas of disagreement in the EMH?
A. The magnitude issue
B. The selection bias issue
C. The lucky event issue
What is the Magnitude Issue?
- > Small opps to make abnormal profit may still exist -> Just not detected by statistical analysis since too small % increase
- > Acitve management may still be worthwhile
- > Mkt is not all or nothing efficient
What is the Selection Bias
Simply put more attention on certain stocks than others
- > Tests of the EMH on published investment tips show that these strategies are worthless.
- > Truly profitable strategies or “tips” would not be publicised.
- > Published techniques may not work but effective private techniques may exist.
What is the Lucky Event Issue?
Simply Survivorship bias
Abnormal performance -> May just be due to luck
Evidence of inefficiency needs to be persistent abnormal profit -> i.e we only know about the successful funds, what about the unsuccessful ones that have left the mkt?
What can we observe about returns over the short horizon with empirical evidence on EMH: Weak Form Tests?
- Returns over the Short Horizon
- Momentum: Good or bad recent performance continues over short to intermediate time horizons (esp. portfolios)
Returns over Long Horizons
Episodes of overshooting followed by correction
Use of serial correlation
What can we observe about returns over the long horizon with empirical evidence on EMH: Weak Form Tests?
- > Episodes of overshooting followed by correction
- >Use of serial correlation
What do tests of short term predictability examine?
Like Correlation Tests
->Examine whether return in
the prior period (usually a day or days) can predict today’s return.
Correlation test see in notes
What differing models predict Broad Market Returns?
Fama and French:
Aggregate returns are higher with higher dividend ratios
Campbell and Shiller:
Earnings yield can predict market returns
Keim and Stambaugh:
Bond spreads can predict market returns
What is some empiricial evidence on EMH via Semi-Strong Tests?
P/E Effect (adjustment for risk?) -> Doesn’t really violate EMH -> Lower P/E ratio -> Higher return -> Could just be Risk Premium
Small Firm Effect (January Effect) -> Small cap firms outperform Large Cap firms could just be January Effect
Neglected Firm Effect, Liquidity Effects
Book-to-Market Ratios (Fama-French) -> Could just be not accounting for other sources of risk
Post-Earnings Announcement Price Drift
What are Event Studies?
- > the effect of an announcement on share price
- > Aim to determine what information is reflected in price and, if its impact is unclear, to determine whether the announcement is good or bad news.
What is the Methodology of Event Studies?
- Collect a sample of firms that had a surprise announcement
(the event). - Determine the precise day of the announcement and designate this day as zero.
- Define the period to be studied.
- For each of the firms in the sample, compute the return on each of the days being studied.
- Compute the “abnormal” return for each of the days being studied for each firm in the sample.
- Compute for each day in the event period the average abnormal return for all the firms in the sample
What does the Empirical evidence of EMH using Strong-Form Tests show?
The ability of insiders to trade profitability in their own stock has been documented in studies by Jaffe, Seyhun, Givoly, and
Palmon
SEC requires all insiders to register their trading activity
What are the biggest anomalies in testing the EMH?
price-earnings, small-firm,
market-to-book, momentum, and long-term reversal.
What does Fama and French argue these effects can be explained by?
these effects can be explained by
risk premiums
What does Lakonishok,Shleifer and Vishney argue these effects can be explained by?
these effects are
evidence of inefficient markets
