Market Efficiency 1 Flashcards
Corporate Finance (4/6) (45 cards)
How do we measure the extent of prices accurately reflecting information?
By examining the efficient market hypothesis.
What is the efficient market hypothesis?
The idea that the price of a security accurately reflects available information.
How efficient are markets seen to be?
Neither completely efficient nor completely inefficient, somewhere in between.
How should evidence be used for market efficiency?
The evidence should be used to reach a view as to what extent markets are efficient.
What is meant by a non-instantaneous Price Reaction?
Shareholders not acting on complete information as it arises.
What is a bias Price Reaction?
A situation where shareholders over or under react to market information.
What are tests of return predictability?
Tests that determine whether future returns can be predicted based on information.
What are some examples of information used for return predictability?
Past returns, company size, dividend yield, ratio of a company’s book value to its market value.
What are event studies?
Analysis of the behaviour of share prices around the time of significant events.
What are tests for private information?
Tests that determine whether investors can trade profitably by asking decisions on the basis of information that is not publicly available.
What do tests of market efficiency examine?
Whether abnormal returns can be made from trading on information.
What are abnormal returns?
Actual returns - Expected returns.
What happens to the measure of abnormal returns if the model determining expected returns isn’t valid?
The abnormal returns will also be invalid.
If a market is found by a test to not be efficient, what could it mean?
It could mean the market is inefficient, but it could also indicate that an invalid model is being used to determine expected returns.
What is the inherent problem with being able to systematically generate positive abnormal returns from examining past returns?
If this can occur then the market is not efficient, as information contained in past return series doesn’t fully reflect current prices.
What is a common way for testing short-term patterns in returns?
Testing for correlation between returns in one period and returns in a prior period.
Are there profitable trading strategies based on short-term price patterns?
No, as the correlations recorded are generally weak.
Are there profitable trading strategies based on long-term price patterns?
Yes, as better performing shares tend to continue outperforming.
Give an example of a momentum strategy.
Purchasing shares that have performed well in the past 6 months and selling shares that have performed poorly in the last 6 months to invest for the next 6 months.
What is a 52-Week high strategy?
Buying shares at or close to their 52-week high, and selling shares that are far away from their 52-week high.
Over longer horizons how does the momentum effect continue?
It generally reverses.
What are some factors shown to predict future returns?
- Firm size
- Book Value to Market Value ratio
- Dividend Yield
- Net share issues made by the firm
- The level of accounting accruals
- The growth in assets of the firm.
What is the relationship between firm size and future returns?
Smaller firms have higher returns (%).
What are some explanations for firm size future returns?
- Default Risk higher in small firms.
- Small firms less heavily traded, return compensates for low liquidity.
