Market Efficiency

Question 1

What are the three forms of market efficiency?

Answer 1

Distinguished by the degree of information reflected in security prices:

1. Weak market efficiency
   Prices reflect: past prices
   –> prices follow a random walk
2. Semi-strong market efficiency
   Prices reflect: past prices & public information
   –> prices will adjust immediately to public information
3. Strong-market efficiency
   Prices reflect: past prices, public & private information
   –> some more lucky or unlucky investors, but no one can consistently beat the market

Question 2

What is a random walk?

Answer 2

Prices of stocks and commodities follow a random process in a discrete period. The random increments are independent and identically distributed, meaning that the coefficient of correlation between each day’s price and the next is in average zero.

Logic: if past prices changes could predict future changes, one could easily make a profit which would violate the “no free lunch” assumption of efficient markets.

Question 3

What are the two key assumptions that academics refer to “market efficiencies” and how are they challenged?

Answer 3

1. There is no free lunch
   There are no arbitrage opportunities, i.e. no strategy can exploit market inefficiencies and generate superior returns consistently
2. Market price = Fundamental value of a security
   It is not possible to find expected returns greater (or less) than risk-adjusted opportunity cost of capital

Challenged by:
- Siamese twin companies (theoretical price parity, meaning that two assets with identical CFs should have the same price, is inconsistent)
- Small-firm effect
- Behavioural finance

Question 4

Explain: Behavioural Finance

Answer 4

Behavioural finance is the study of the influence of psychology on the behaviour of financial practtioners and the subsequent effect on markets. It tries to explain why prices can depart from fundamental values based on the key assumption that people are not always rational.

Key take-aways:
1. Attitude towards risk
Generally, people are risk-averse when it comes to choices involving gains, but risk-seeking when it comes to choices involving losses.
Additionally, the more an investor wins, the more risk he is willing to take on, violating hereby the assumption that investors are only forward-looking.

2. Beliefs about probabilities
   Generally, people are overly confident when assessing the probabilities about uncertain events or when comparing themselves to their peers.
   Anchoring is the tendency of investors to overly rely on the first information provided (stock purchase price).

Question 5

What are the consequences of mispriced company shares (overpriced & underpriced)?

Answer 5

Overpriced: help current stakeholders by selling additional stock and use the cash to invest in projects with positive NPV or otherwise purchase common stock.

Underpriced: forgo opportunities to invest in a positive NPV project rather than to allow new investors to buy into your own firm on the cheap. If needed finance investments by an issue of debt.

Underpriced