S1 - market efficiency Flashcards
what is the efficient market hypothesis
states that stock prices reflect all available information
A market which adjusts rapidly to new information
A Market which always fully reflects available information
Slow reaction, persistent inefficiency, anticipatory price movements, overreaction followed by adjustment, efficient market
Not possible to beat the stock market unless we have private information (illegal) because prices already reflect all public information
Technical and fundamental analysis is pointless
what is weak form efficiency
investors can’t make consistent abnormal returns through trades based on past prices
Companies can’t time share issues or buy backs through looking at patterns of past prices
Technical analysis cannot be used to earn consistent abnormal returns
Strong empirical evidence - accurate
what is the test for weak form
Test - serial correlation in security returns + usefulness of technical analysis
Test random walk and if successive price changes are correlated. If not correlated then it likely follows random walk and is efficient in weak form
technical analysts forecast prices based on watching the fluctuations in historical prices but this should have no marginal value - fundamental could work
what is semi strong form efficiency
investors can’t make consistent abnormal returns through trades based on public information
Companies can’t time share issues or buy backs based on past prices or public information
Fundamental analysts cannot be used to earn consistent abnormal returns
Fundamental analysts research the value of stocks using company data, risk estimates and industry data but should have no marginal value
Prices reflect all public information
what is the test for semi strong
Test: all public information is fully incorporated into current prices, market prices should react rapidly and fully to new information. See how they actually respond with an event study of an abnormal return around an announcement
Sluggish response - investors do not move share prices sufficiently on day of announcement - under reaction - not efficient in semi strong form
what is strong form efficiency
investors can’t make consistent abnormal returns through trades based on private information
Companies can’t time share issues or buy backs based on past prices, public information or private information
Inside information cannot be used to earn consistent abnormal returns
Not much empirical evidence - wrong
what is the test for strong form
Test:
All relevant information is fully incorporated into current prices
Market prices should react rapidly and fully to private information
May be difficult to access private information. Insiders could earn abnormal returns by trading their own firms securities and inside info can be used to make abnormal returns so isn’t fully reflected in market prices and SFE may be rejected
Insider trading
investors may take risks for higher reward. Can’t consistently beat the markets as everyone has available information
what is an efficient market and its assumptions
Efficient market
all relevant information currently available is fully reflected in the security prices instantaneously and in an unbiased way
Assumptions:
Random walk theory
Arbitrage
Rationality
what is the random walk theory
Random walk theory - Maurice Kendall
movement of stock prices from day to day do not reflect any pattern - random
Price changes are independent of one another (like a coin toss)
Impossible to predict the next day —> price tomorrow = price today + unpredictable change Pt + et+1
what is the test for the random walk theory
Test:
p>0 is continuation and a price increase today is likely to be followed by further price increase tomorrow
p=0 is uncorrelated and todays price change gives no indication of tomorrow’s price movement
P<0 is reversal and price increase today is likely to be followed by a price drop tomorrow
what is rationality
investors are rational and value securities rationally
Focus on fundamental values
Calculate present values of the future cash flows of a security by using appropriate models
Not reasonable because not all investors are rational but a long as their irrationality is random, it cancels out
Behavioural explanations
what is behavioural finance v traditional
behavioural assumes that investors suffer from cognitive biases that may lead to irrational decision making - may overreact or under react to new information
Traditional assumes that investors behave rationally and process new information quickly and correctly
Investors can be over confident when they receive new information and misprice securities - can still be efficient as they cannot consistently beat the market
what is the arbitrage theory
foundation of market efficiency theory
Act of exploiting price differences on the same security or similar securities by simultaneously selling the overpriced security and buying the underpriced security
In a competitive market, arbitrage opportunities will eliminate themselves instantaneously
Security prices reflect fundamental values
what are the anomalies of efficient market hypothesis
under reaction
Bubbles - share prices deviate markedly from fundamental values
Small firm effect - small firms shares outperformed larger
Weekend effect - abnormal returns tend to appear on Fridays
January effect - shared give excess returns in the first few days of January
Despite this, people tend to work with the assumption that markets are semi strong
