Efficient Market Hypothesis Flashcards
Neoclassical Finance vs Behavioural Finance
Neoclassical: Investors are rational, prices reflect fundamentals correctly. Beliefs: Baynesian Updating - new evidence is accurately incorporated into expectations
Preferences: Choices are made according to Expected Utility Theory
Behavioural Finance: Investors are irrational and make mistakes
What makes a market efficient/inefficient?
A market is efficient if it satisfies either one of the 3 conditions (gets progressively weaker):
1. All investors are rational, make no mistakes
2. Investors can make mistakes but mistakes are uncorrelated and cancel out
3. Investors make mistakes that are correlated but rational investors exploit the errors and restore efficiency
Markets are inefficient when:
1. Investors make correlated mistakes
2. Arbitrage is limited
Efficient Market Hypothesis definition and explanation
Markets are informationally efficient if security prices fully reflect relevant information about the fundamentals
3 types: 1. Weak 2. Semi Strong 3. Strong
If markets are efficient, security prices should not move in the absence of news about its fundamental value.
Prices should not react to a change in demand or supply that are not caused by the news about fundamental value.
Security prices react to incorporate news about fundamental value quickly and correctly
Evidence of EMH
- Random Walk
- Asset Portfolio Management
- Reaction to news
Random Walk
Stock prices follow a random walk, the best indicator of price tomorrow is the price today.
No systematic evidence that technical trading strategies like buying stocks when the price increases and selling stocks will the price decreases are profitable
Price of stock likely to increase after previous day increase as after a previous day decline
Evidence of weak form EMH
Active Portfolio Management
If prices contain all available information, active portfolio management cannot make money. On average, funds do not outperform the market
Reaction to news
It must be swift and accurate
Weak Form EMH definition and challenges
Investor cannot gain excess profits from using past price info
- Reversal (Representativeness)
- Momentum (Conservatism)
Reversal
De Bondt and Thaler (1985) found that portfolio of prior “losers” outperform the portfolio of prior “winners” - Long term effect
Portfolio are formed conditional on past excess profits over 36 months
Found that losing stocks earn 25% more than winning stocks
Cannot be explained by CAPM
Contradicts EMH by showing that prices do not react correctly to information. There is an overreaction
Momentum
Stocks performing well in the past outperform stocks performing badly in the past. - Short term effect
Selecting stocks based on their 6 month returns and holding them for 6 months generated a compounded excess return of 12.01% per year on average
Cannot be explained by CAPM
Contradicts the EMH by showing that prices do not react correctly to information. There is an under reaction
Empirical challenges to Semi Strong Form EMH
Investors cannot make excess profit based on public information
1. Size Effect
2. Value Effect
3. Post Earnings Announcement Drift
4. Reaction to Non-Information
Size Effect
Small firms on average have significantly higher adjusted returns than large firms
Excess returns from holding small firms long and very large firms short is 1.52% per month or 19.8% on annual
Cannot be explained by CAPM
Firm size is publicly available information which helps to predict returns in contract to Semi Strong form EMH
Value Effect
Growth firms “High book to market ratio” earn sharply lower returns than Value Firms “Low book to market ratio”
Cannot be explained by CAPM
Firm value is publicly available information, helps to predict returns in contrast to semi strong form EMH
Post Earnings Announcement Drift
Stock prices of firms tend to drift in the same direction as the earnings surprises following earnings announcements
Roughly 50% of the adjusted stock returns to earnings surprises occurs over a 90 day period after the earnings are announced
Cannot be explained by CAPM
Contradicts EMH by showing that prices do not react quickly to information. After several weeks, there is still a continued drift in prices.
Reaction to Non Information
Stocks newly included into the S&P 500 index have earned positive abnormal returns at the announcement of the inclusion
Inclusion into index is unlikely to convey any information about the firm about generates a substantial demand for the firm’s shares through index fund
Prices increase by 3% immediately after as inclusion is announced
