Please enable JavaScript.
Coggle requires JavaScript to display documents.
Market Efficiency and Challenges (Challenges to Market Efficiency…
Market Efficiency and Challenges
No predictable pattern in stock price changes. Prices are as likely to go up as to go down
A forecast about favourable future performance leads to favourable current performance
The Efficient Market Hypothesis says stock prices already reflect all available information
Markets rush to trade on new information
This new info is unpredictable, stock price change in response to new info also move unpredictably
Stock price changes follow a random walk: Pt = Pt-1 + Expected return + Random error
Fully digest positive news faster than negative news (5 vs 12 mins)
Versions of EMH
Weak form EMH. Stock prices reflect all info in history. Random walk due to new info
Semistrong form EMH. Stock prices reflect all public info
Strong form EMH. Stock prices reflect relevant info, including insider info
Implications of the EMH
Technical Analysis
Active Management
Fundamental Analysis
Passive Management
Joint Hypothesis problem:
Markets are efficient, a fair return on a security is from a particular model. Rejection means markets are not efficient. method for calculating fair returns is faulty
Challenges to Market Efficiency
Momentum effect: tendency of poorly or well performing stocks to continue abnormal performance in following periods
Reversal effect: tendency of poorly or well performing stocks to experience reversals in following periods
Small firm effect: stocks of small cap firms can earn abnormal returns than large cap firms
Book to market effect: value vs growth portfolios
P/E effect: low P/E firms had higher returns but lower betas
Post earnings announcement drift: sluggish response of stock price to firms earnings announcement. Earnings surprise is the difference between the reported quarterly or annual earnings and analysis expectations
Transaction costs and analysis costs
Four factor model: The 3 Fama French factor: return on market index, returns to portfolios based on size and book to market ratio. plus a momentum factor
Arbitrage: an arbitrage opportunity arises when an investor can earn riskless profits without making a net investment
Actions of arbitragers are limited
Fundamental risk: may be sideswiped by the market or industry
Noise trader risk: opinion on value unrelated to fundamental info. Implies price movements can be driven by misinformation rather than information. Mispricing being exploited by an arbitrager might worsen.
implementation costs: short selling is expensive, and difficult
Law of one price: effectively identical assets should have identical prices. Siamese Twin Companies.
In efficient market, under reaction as frequent as over reaction.
