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Week 9: Market Efficiency (part II) (Concept of market efficiency (The…
Week 9: Market Efficiency (part II)
Concept of market efficiency
Finding: no predictable pattern in stock price
Implication: stock market follows "animal spirit" without any logical rules
Conjecture: stock prices reflect the prospects of the firm
Do security prices accurately reflected information?
Informational efficiency: price changes consistently predictable?
Allocational efficiency: prices accurately reflect cash flows?
The role of competition among investors
stock prices fully and accurately reflect publicly available information very quickly
questions arise about efficiency due to
information asymmetry
structural market problems (i.e: limits to arbitrage)
behavioral finance
Informational efficiency
price of an asset fully reflects all available information
market reaction
instantaneous: immediate price reaction
unbiased: the magnitude of the price change reflects the news
Random walk and Market efficiency
stock prices follow a random walk
a pure random walk implies
informational efficiency
flow of new information is hard to predict => price changes are random
Kendall and Fama
Different versions of market efficiency
Weak form efficiency
The relevant information is
historical
prices and other trading data such as trading volume
Semi- strong form efficiency
The relevant information is
all publicly available information
, including past prices, trading volume data
Strong form efficiency
The relevant information is
all information
, including past stock, market information, public and private
Trading by corporate insiders are often limited and must be reported
Outsiders can observe insiders reaction and follow
Implications of market efficiency
Technical Analysis (TA)
TA used
historical
stock prices and volume to predict future price changes
Fundamental Analysis (FA)
Use
economic and accounting
information to predict stock price changes
everyone can do in competitive market => hard to make a profit
Active vs Passive Portfolio Management
Active (assumes inefficient)
Timing strategies
Investment newsletters
Security analysis
Passive (consistent with semi- strong form)
buy and hold portfolios
index funds
Roles of Portfolio Management (p.31)
Resource Allocation (p.31)
Tests of market efficiency
Event studies
examine how quickly information is integrated into prices around informational event
EMH (Efficient Market Hypothesis)
implies rapid assimilation of information into prices
abnormal return: earnings below/ above forecast
How to determine abnormal return?
Market model: r(t) = a + b[r(index,t)] + e(t)
Abnormal return (AR) = Actual - Expected
Expected = a + b[r(index,t)]
r(index,t) = return on the market index during the event window
Cumulative AR = Total AR
Assessing Performance of Professional Managers
EMH suggests professionals will
not outperform
the market
Testing a trading rule (p.40) (?)
Issues in examining the results (p.41)
The selection bias issue
The lucky event issue
The magnitude issue
Joint hypothesis (p.42)
Roll (1977)
Selected empirical evidence
Weak form EMH tests
1.1: Momentum effect: positive serial correlation at stock level,
short- term horizon
1.2: Reversal effect: negative serial correlation at stock level,
long- term horizon
1.3: Negative serial correlation at stock market level
Semi- strong form EMH tests
2.1: The size effect: return predictability at
security
level, shares of small stocks outperform shares of big stocks
2.2: The value effect:
value stocks
consistently outperform
growth stocks
(p.48)
Graham and Dodd on value investing
Invest with a margin of safety (p.51): high net asset (efficient or not?)
Expect volatility and profit from it
Know what type of investors you are
2.3: Neglected vs Glamour effect
Strong form EMH tests (insiders)
Interpretation of evidence
Risk premiums or inefficiencies?
Data mining?
Limits to arbitrage
Transaction costs in general and short sale constraints
Model risk
Fundamental risk
Misconception about market efficiency (p.57)