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Efficient Capital Markets and Behavioural Finance (Efficiency Forms…
Efficient Capital Markets and Behavioural Finance
Efficient Market Hypothesis
Share prices fully reflect all available information
Investors can only expected a normal rate of return
Firms should expect to receive a fair value for its securities
Share prices reflect underlying value
Slow responses are due to market inefficiencies
What causes market efficiency?
Rationality - investor respond to news rationally
Indepedent Deviations - irrational responses offset each other
Arbitrage - rational professionals can correct the market by trading
Efficiency Forms
Weak
Market incorporates past prices
Semi-strong
Market incorporates past prices and publicly available information
Strong
Market incorporates past prices and all available information (public and private)
Misconceptions about Market Efficiency
Dart Throwing
EMH does not imply investors can choose securities at random
Still need to choose risk tolerance
Price Fluctuations
New information constantly available
No fluctuations suggest market inefficiencies
Shareholder Disinterest
Only a small number of active shareholders are needed for markets to be efficient
Evidence of EMH
Semi-strong
Markets generally react to new public information
Recent studies suggest that this doesn't always happen immediately
Investment funds tend not to outperform the market, net of expenses
Strong
Insider trading is profitable - does not support strong form
Weak
No significant serial correlation with past share prices
Behavioural Finance
Rationality
Investors often act irrationally (sell stocks which are doing well, hold poorly performing stocks in hopes of making back losses
Independent Deviations
Representativeness - drawing conclusions from insufficient data (leads to bubbles)
Conservatism - people are slow to adjust their beliefs
Arbitrage
Large investments required to overturn market mispricing, usually investors are unwilling to take this risk
Challenges to Market Efficiency
Limits of arbitrage
Differences in prices between the same company on two exchanges
Earnings surprises
Markets don't always react immediately to earnings surprise and often continue to react in the following months
Value vs Growth
Value stocks often outperform growth stocks - could be due to market inefficiencies or differences in risk
Crashes and Bubbles
Occur because of irrational exuberance (representativeness)
Implications for Corporate Finance
Accounting Choices
Cannot fool market with semi-strong efficiency - only through fraudulent figures
Timing
Managers are typically able to issue shares when they are overpriced - rebut stong-form
Speculation
Managers speculate whether interest rates will rise of fall and borrow accordingly