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Chapter 9: Efficient Markets (Behavioural finance: the reason why prices…
Chapter 9: Efficient Markets
Market efficiency: In an efficient market - it is impossible to make abnormal (Returns above CAPM expected return) profits by trading stocks
Reason: Prices adjust instantly to any relevant information
Jansen's & Malkiel Definition of efficiency
Jansen's: A market is informationally efficient with respect to information set Q if one cannot make economic profit by trading on the information in Q (market is only efficient in the information set if the information set cannot be used to make economic profit)
Malkiel: A market is informationally efficient with respect to information set Q if it fully and correctly reflects all information affecting stock prices.
This means that the stock prices are unaffected by revealing information in Q; we cannot make profits by trading information contained in Q
Conditions/ Assumptions for market to be efficient
Any one of the conditions should lead to efficiency (Schleifer)
Rationality
All investors are rational, receive timely information and adjust stock valuations similarly, and prices adjust immediately
Independent deviations from rationality
If not everyone is rational, there will be optimists or pessimists who balance out, and stocks will be fairly priced
Dominance of rational, professional investors
If prices are wrong, big investors who are rational and trade in big sizes push prices to the 'right' level
Terms in efficiency concept
Information set
Refers to pieces of information required to forecast stock returns
A market can only be judged efficient or not with respect to a given information set; different information set leads to different kind of market efficiency
Weak Form - All historic Public information; past prices; past financial data
Weak form market efficiency: current prices fully reflect all security market information; including past prices, rates of return - hence it is not possible to make abnormal returns using technical analysis
TEST of weak form EMH
These tests found that stock prices follow a 'random walk'
(successive returns are random; tests include autocorrelation tests - showing that returns are not significantly correlated overtime)
Semi Strong Form - All public information: earnings and dividend announcements, price earnings ratio, dividend yield
Current prices reflect all relevant publicly available information, it is impossible to make abnormal profits using fundamental analysis
TEST of semi-strong form EMH
Assumes stock prices adjust quickly to the release of all new public information
These test measures how fast stock prices respond to news; to isolate announcement effect, we need to calculate the expected return using asset pricing model then compare this with actual stock return to calculate economic profits
Empirical studies found that stock prices of target companies in take over jump up on announcement day of takeover but thereafter does not exhibit any further unusual price movements, stock prices adjustments are immediate and complete when new stock price fully reflect the takeover premium: conforms SSF EMH
Strong Form: All public and private information
Current prices reflect all relevant information both public and private, it is not possible to profit from both public and privately held information, hence insider trading will not be profitable.
TEST of strong form EMH
These tests examine the recommendations of professional security analysts - studies found that they are generally unable to outperform market, top performing manager might outperform a market in one year and under perform the next and professionally managed funds generally matched the market before expenses and earn lower return after expenses.
Therefore after knowing this - many investors have chosen to buy index funds (passively managed funds) which track stock market indicies and minimise fund management fees while maximising diversification.
Risk and return definitions: Find RR for a portfolio given its risk, in order to calculate economic profit. Return has to be over and above the RR.
Trading costs: For a portfolio to make economic profit, it must account for transaction costs (brokerage fees and commissions)
Market efficiency - considerations
Efficiency and Random Returns
stock prices in competitive markets follow a random walk, tomorrows price change is uncorrelated to today's. Any opportunity for profit from information is immediately eliminated by investors taking advantage of them.
In an efficient market, only new information can move prices, random returns is consistent with the notion that stock prices and company fundamentals are related. Increased dividends could lead to higher stock prices but these prices adjust instantly, hence not possible to forecast returns.
Abnormal returns and Fair game
Fair game = describe abnormal returns in efficient markets; expected value = 0
The Joint Hypothesis Problem
To test the presence of market efficiency, we use asset pricing model such as CAPM, however, CAPM may not be reflective of what expected return should be. Hence efficiency tests are invariably testing joint hypothesis that:
market is informationally efficient
correct asset pricing model is used to calculate abnormal returns
Rejecting the null hypothesis could imply that either 1 or 2 are invalid
Behavioural finance: the reason why prices might depart from fundamental values is attributed to behavioural finance, people do not always behave rationally
Too conservative; update on their beliefs in light of new information too slowly/ little in magnitude
Overconfidence; betting against each other, only one will win but both always behave one is winning party
Beliefs about probabilities, tend to place too much weight on small number of recent events, stock markets rise for past3 years, expect future profits to be made, without considering the the limited information from 3 years experience
Investor sentiments - explains short term momentum of stocks (if rising, continues to rise)
Attitudes towards risk (2 scenario, choose the one with no losses)
Lessons of market efficiency
Read the entrails
In an efficient market, prices incorporate all available information. Hence security prices provide information about the future. eg if a company bond is selling at depressed prices = may face prospect of bankruptcy
if investors expect i/r to rise - long term i/r higher than the short term i/r
The Do It Yourself Alternative
In an efficient market, investors will not pay others what they can do better themselves
Be it borrowing / diversifying
Firm considers issuing debt, it will consider whether the company can issue debt more cheaply than the shareholders can borrow on his account, if yes, they will not issue debt; same for diversification, companies should not merge if the shareholders can diversify cheaply in investing in different companies
Trust market prices
Market prices incorporate all available information about the value of each security; not possible to achieve superior returns; therefore non financial corporations should use hedging rather than second guess the market
Seen one stock, seen them all
In an efficient market, investors can buy or sell any amount of stock without much effect on the stock price, investors buy a stock for the return it offers given its risk, therefore demand for stocks should be highly elastic; if return is too low, no one will buy it, if returns high relative to risk, everyone will buy it
if you intend to sell a large block of stocks - sell it only a slight discount to market price provided the market believes you have no private information - otherwise if market thinks you have private information that is detrimental for the stock, they will reduce their valuation - demand is still elastic but whole demand curve shifts down - means you can only sell at a much lower price - therefore efficient markets and elastic demand in stocks = buy/sell as much as you like, provided the market believes you do not have private information
Markets have no memory
Weak form EMH - one cannot forecast future price changes from the sequence of past price changes - market has no memory
Yesterday's price does not determine what should be the price of stock today - it is fundaments that determine its value; just because a stock is selling below last year's price, it does not mean it is undervalued, could be undervalues based on fundaments