Market efficiency Behaviour Flashcards
(41 cards)
Stock prices: what happens?
random walk
–> stock market predictability
A random walk: definition
a random process in a discrete period t=1,2i.e., a sequence of random states
𝑋𝑡 that are connected to each other
xt = Xt-1 + rt
random increment r1,r2…
independent and identically distributed (iid)
Cov (rt+ 1, rt) = 0
Price changes are…
random
If past price changes could predict future price changes, one could easily…
make a profit. But there is no free lunch.
–> You can’t get something for nothing.
Randomness is not a sign of irrationality, it is consistent with?
with rational market participants
new information is released, market participants process this information and prices adjust accordingly:
adjustment process is very fast as only the fastest traders will make a profit from the new information
Share prices in an efficient market:
- Prices in financial markets immediately and correctly reflect all publicly available information –> everything that can be
derived from it - Unpredictability: As price changes reflect the random flow of new information, price changes must also occur randomly.
- Random Walk: Prices change erratically as new and value relevant information arrives
3 forms of market efficiency
- weak-form efficiency
- semi-strong-form efficiency
- strong-form efficiency
weak-form efficiency
A market is weak-form efficient if it is not possible to achieve systematically superior investment performance (on average,
across segments, and periods of market occurrences) on the basis of the analysis of historical prices and returns
–> they are well-known and incorporated in today’s prices
semi-strong- form efficiency
A market is semi-strong-form efficient if it is not possible to achieve systematically superior investment performance (on
average, across segments, and periods of market occurrences) on the basis of all publicly available information
strong-form efficiency
A market is strong-form efficient if it is not possible to achieve systematically superior investment performance (on average,
across segments, and periods of market occurrences) on the basis of any information, public or private.
–> Hence, even insider information cannot be exploited!
How does market efficiency work?
- mpirically test whether market efficiency holds, researchers have analyzed how fast security prices respond to different types
of information, such as earnings, dividend, or takeover announcements - For takeovers this test of market efficiency has practical implications as well
- It is legally forbidden to disclose this tender price before the offer is made available to the public (insider trading)
–> the bank and the regulator will monitor the movement of the stock price before the takeover announcement date. Any drift
towards the offer price before the announcement is public could indicate information leakage and insider trading.
transforms various “events” from calendar time to event time
each announcement takes place on day t = 0
–> To isolate the effect of an event on the stock return, we have to look at abnormal returns rather than raw returns
market model: calculation
ARi = r^observed - rf - Bi (rm - rf)
academics refer to “market efficiency”: 2 thing in mind
- There is no free lunch: There are no arbitrage opportunities, i.e., riskless profits without any investment are not possible
- Prices are equal to value: The market price of a security is equal to its fundamental value (e.g., the discounted stream of future dividends).
= definitions are not identical! For instance, the price of a stock might not be equal to its fundamental value, but arbitrageurs cannot act on this price difference (due to transaction costs, short-sale constraints,…)
To challenge market efficiency
- If you find two assets with identical cash flows which do not sell for the same price, one market efficiency assumption is violated
- 2 example of challenges to market efficiency which academics have documented :
–> Siamese twin companies (Royal Dutch Shell)
–> Equity carve outs (3COM/ Palm)
Equity carve outs: definition
capital market transactions in which a
company decides to sell off part of its business in the form of an IPO
Momentum
A simple strategy that buys past “winner” stocks and sells short past “loser” stocks.
To assess the real performance of the strategy
The index must be exactly replicated and include all stocks that were ever included.
Ex-ante rules need to be applied to stocks that disappear (because of takeover, delisting, bankruptcy) or drop out of the SMI
Behavioral finance : what do they explain ?
why prices can depart from fundamental values.
Behavioral finance : underlying assumption
People are not always rational
Behavioral finance usually relies on…
insights from psychology and attempts to explain empirically observed patterns which are inconsistent with rational investors and efficient markets
people are risk-averse when?
it comes to choices involving gains
