EMH Flashcards
(23 cards)
Describe 3 types of efficieny
-Operation efficency refers to how transaction costs within the markets can be low and market allows for quick easy trade of securites.
-Allocation effecciency refets to how capital is directed to its most efficent use, based on invester demand and accurate pricing
-Pricing efficency: applies to the EMH is where secuirty prices FULLY reflect all infortiom avaliable.
Describe the EMH
-EMH states security prices reflecrs all avaliable information in the market, making it impossible to consistenyl make abonormal returns.
-Prices adjust instantly without bias to new, unpredicatblae info.
-Price changes follow a random walk, indepedent of past movements and prices react rationall and quickly to new information.
-There exists no trading stratefy which can ‘beat the market; and make abnormal returns using known info.
-Under/overvalued stocks dont exist under this hypothesis.
-There exists market analysts. (chartist or fundemental) who seek to make abnormal returns
Describe the ‘random walk’ woth share prices in the EMH.
-Share prices dollow a random walk, meaning today’s price change cannot predict tomorrow’s—price movements are independet random and uncorrelated.
-Price changes over different periods are uncorrelated.
-Price changes follow a random walk because they already reflect all known information.
New information, which causes price changes, is unpredictable and unrelated to past data.
-Mathematically expressed as
Pt = Pt -1 + expected return + random error at t where the random error reflects new, unpredictable info
- E(random error) = 0, meaning it represents the unpredictable part of a stock’s price change—caused by new, unexpected information.
Describe chartists (market analyst)
-Chartists use historical share price patterns and trading rules (eg filter rules) to forecase stock movements without considering fundemental data.
-They beleive prices move in treds/cycles and use tools like price charts and buy/sell signals.
-Assume sluggish price responses therefore can profit
-No sufficient evidence to show chartists produce abnormal returns beyond costs.
-Edge typically eroded due to imitation of succesful patterns/methods to make abonrmal returns, making them ineffective.
Describe fundemental analysts (type of anaylust aiming to make abnormal returns)
-Fundemental analysts aim to make abnormal returns by studying a companies financlails, opetations and industryto estimate its intrisnice value and search for mispriced secutires.
-Rely on public info and specifcalise in certain industries.
-Aim to predict price changes before market adjusts.
-Evidence shows rarely outperdorm market post costs.
-Competition and imitation leads to lack of edge within the market.
Describe weak form efficiency (type of EMH effiecny ) + evidence
-Weak form eff refers to how all past TRADING information (hostorical prices/volue) is fully refelcted in share prices.
-Chartists methosd are ineffective, price patterts/trends cant be used to make abnormal returns.
-This form of effieincy supports the idea prices follow a random walk.
-Evidence shows serial tests, run tests and filter rules find no consistent patters within past share prices. Evidence supports concept prices follow a random walk.
Define abnormal returns
-Refers to return on investment whoch exceeds that which is expected.
Abnormal return = Actual return - expected (capm predictions)
- used to assess whether an investor, strategy, is outperforming the market, possibly due to skill, luck, or inefficiency.
Describe semi-strong efficency (type of effiency within EMH)
-Semi-strong eff refers to how all PUBLICALLY avaliable information (past prices/trading info, news, financial statements)is fully reflected in prices.
-Under this effiecincy Fundemental analysists cannot earn abnormal returns once info is released as prices adjust rationally and accurately to new info.
-Evidence shows studies on stock splits, earnings announcemets etc show prices/markets respond almost instantly.
-Delayed trading after new news is relased offers no edge for fundemental analysts.
Defien strong form efficiency
-Strong Form Efficiency refers to how ALL INFO public and private (insider) is refelcted within share prices.
-No invester, even those with insider info can consistently earn abnormal reutnrs.
-This effiecimy suggests perfect market transpaercny which is an unrealistic assumption.
-Evidence from insider trading prosecutios show investors with inside information can earn abnormal profits, violating this effiency.Therefore strong form is more theortical and a unrealistic assumption in real markets.
Describe the importance and implications of EMH specifically investors and companies
Investors:
-EMH shows no consistent advantage from different analysis methods, prices reflect all known data.
-Undervalued stocks dont exist within an effiecint market.
-EMH promotes fairness for investors, investors can trust share prices are fair/unbiased.
Companies:
Share prices reflect true value and market expectations, guiding better investment decisions.
Provide performance feedback to managers.
Accounting tricks by companies won’t mislead the market according to EMH.
Affects cost of capital—biased prices can lead to poor investment choices.
Describe the importance and implications of EMH specifically shareholders and fundemental/chartist analyssi.
Fundamental and Technical analysis can’t make abnormal returns in an efficient market because prices already reflect all public info.
-Both technical and fundemental analysists by seeking abnormal returns increase the speed at which prices absorb new info, promoting market efficiency.
For shareholders assuming the market is efficient EMH directly links companies market price to shareholder wealth. Eff market provides link between value and shareholder wealth.
The accuracy of wealth measurement depends on the efficiency of the market itself
Decribe how serial correlation and runs tests and filter rules can test weak form effiency and what shows
Serial correlation tests measure the relationship between. a variable and its past values (eg, todays return vs yesterdays)
-A positive normal correlation suggests trends may persist, suggesting a potential to earn abnormal returns, thus violating EMH/weak form effeicny (where correlation should be 0)
-Evidence shows only small positive correlations with most firms, consistent with weak form.
-Runs tests: is a test which focuses on the sign (+ or -) of price changes elimiating the effect of outliers.
-Runs test is a statistical test the likelihood of a series of price movements occured by chance or not.
-Few or too many ‘runs’ implies non randomness /potential ineficeincy. Most evidence doesn’t reject randomness, thus supporting weak form efficeincy.
-Filter rules is a method to test weak form by simulating trading strategies to test whether such strategies outperform the market using historical data.
-Evidence shows filter rules fail to deliver consistent abnormal returns post costs, supporting the EMH.
Describe how to test semi-form effiency using information announcments + draw graph
-Tests related to semi-strong form focus on whether it is worthwhile to aqquire and analyse publically avaliable info.
-Event studies/information announcements can be used to track how stock prices react to new information.
-Test to see if share prices adjust imideitally and fully after announcment. Evidence shows no existence of consistent abnormal returns post announemetns and most information (annuanl) is already reflected into the share price before relesae
-Graph shows how prices can over/under adjust and a effecient respone.
Describe how record of mutual funds and manipulation of earnings can test semi-sttrong form efficiency
-Mutual fund performance can be compared to the market index to determine if fund managers can consistently outform the market. In semi-strong effieicny they shouldnt be able to, as all info priced into share prices.
-Most evidence is mixed with some studies showing positive performance and some finding negative performance.
-Firms may legally alter earnings, using depreication methods for eg, however seim strong effeicnt markets should take this infot account and prices shouldnt react to accounting tricks.
-Most studies find no price change from earnings manipulation, supporting semi-strong however some extereme cases find misleadining eanrings effecting prices.
-Most evidence supports semi-strong efficiency
Describe how to test for strong form effieincy/insisder trading
-Strong form is mainly theoretical, markets are not strong form efficient.
-Strong form suggests no one not even insiders can make abnormal profits, in reality not the case. Insider trading is illegal and undeermines market fairness and shareholder trusts, abormal returns can be made at teh expense of others.
List some anomolies in share price behaviour
-share prices may exhibit ‘stronae behaviour nott predicted.accounted for my the EMH including:, deviations from expected behavioru
Small firm effect
-Book to market ratios
-value effects
-return reversal
-momentum effects
-Seasonal and cyclical effects
Explain how the small firm efect is an anomolie in share price behaviour and how
-Small firms have histroically produced higher average returns eg) us: 12.1% vs 9.7%). This contradicts the EMH as these hgih returns are abnormal and persistent. Vioalting emh.
-Cause of this anomoly may be: greater risk taking, less attention from institutional investors and more growth potential as start from a smaller base.
-However small firms make up small % of total market trading, minimal effect on macroeconomic indicators.
describe how book-market rations can show ianomolies in share price behaviour and how
-Book to market ratio is a strong predictor of returns, higher b/m ratio tend to have higher returns reflecting higher risk taken.
-This challegens the EMH as traditiaonl beta/risk measure fails to explain returns once size and b/m is considered.
-Fama and french found… and beta alone cannot fully explain returns when other factors are included.
describe how value effects show annomolies in share price behabioir
-Value stocks, those with low PE ratios, typically earn above average returns. These are stocks with high earnings, cash flows and tangible assets relative to price.
-However Fama and french found the PE effect disapreers once b/m and sizr are taken into account suggesting investors overemphasise short-term eanrings thus mispring stocks –> ineffieicny.
Describe how return reversal shows annomolies in share price behaviour
-Return reversal refers to tendemcy of poor preforming stocks and well performing stocks to expreince reversals in folllowing periods (3-5 months)
-This is exaplined by the overation hypothesis stating investers over-punish losers and over-reward winners.
-Arnold and baker/evidence found strong reversal efects (1986-1998)in the UK compared to the UK. Stocks were ranked by 5 year performance and grouped by size.
Describw how the momentum effect shows share price behaviour anomolies + evidence
-Momentum effect refers to stocks which perform well/poor in a 3-12 montj period tend to continue this performance in the short-mediium term.Key point: Momentum is short-term returns (3–12 months), while return reversal is a longer-term effect (3–5 years
-Due to undereacting (conservatism) to news thus prices gradually adjust as more info increases.
-Herd behaviour can also push prices of winning stocks away from fundemental value, to high, and vise versa.
-Evidence shos momentum effects are well documented and apparent across markets and some ecnomists including this effect within pricing models
Describe how Seasonal, calendar, or cyclical effects show share price behaviour anomolies
-Weekend effect refers to how stocks oftern gain abnormal returns on fridays and drop on mondays.
-BNB deal refers to when investors sell shares before the end of the tax year then wuickly repurchase them.
-30 day rule implemented in 1998 banned quick repurchases, investors must wait to claim tax benefits –> reducing anomoly in share price.
Strong form effiecinecy/insider trading case study RULE 10b5-1 and SVB
Rule 10b5-1 allows insiders to pre-plan trades if they’re not in possession of insider info.
-SVB CEO Greg Becker entered into a rule 10b5-1 rule i jan 2023 sold $3.6m in shares a month later just before SVB collapsed/disclosed a large loss/stockslife.
-This raised concerns because was he in possession of inside information.
-Following this the SEC updated regulation (Feb 2023) and introduced a 90 day cooling off periood, requited waiting time to prevent trades on insider information. Under new rules trade wouldve been blocked.
This case shows markets are not semi strong efficient as insiders can act on this information and earn abnormal returns, new regulation –> reducing likelhood of insider trading/more strong eff.
