WEEK 10 - Efficient Market Hypothesis

Question 1

In an efficient capital market what do security prices reflect?

Answer 1

Security prices (E.G. Shares) rationally reflect available information

Question 2

What happens in the efficient capital market when new information is released?

Answer 2

If new info revealed about a firm, incorporated into the share price rapidly and rationally with respect to direction of the share price movement and size of that movement

Question 3

What is the Efficient Market Hypothesis? (Actual Definition)

Answer 3

share prices reflect all
Information and consistent alpha generation is impossible.
-stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices.
-As such investors can never beat the market.

Question 4

What does Efficiency not mean?

Answer 4

• Prices don’t depart from true econ value
• Will not come across an investor beating the market in a single time period
• No investor following a particular investment strategy will beat the market in the long term

Question 5

GRAPH OF SHARES WITH NEW INFO RELEASED

Answer 5

SEE IN NOTES

Question 6

What is the Value of an Efficient Market?

Answer 6

1. To encourage share buying
2. To give correct signals to company managers
   (Managers need to be assured that the implication of a decision is accurately signalled to shareholders and to management through the share price)
   - Rate of return investors demand on securities
   - Info communicated to the market
3. To help allocate resources

Question 7

What does a random walk have to do with the efficient market hypothesis?

Answer 7

News is random, so price will be random

Question 8

What is the Efficient Market Hypothesis? (For exam purposes)

Answer 8

Impossible to predict future prices of shares based on past price

Question 9

BREAKOUT GRAPH

Answer 9

SEE IN NOTES

Question 10

What are the three levels of efficiency?

Answer 10

1. Weak Form efficiency: Share prices fully reflect all information contained in past price movements
2. Semi-Strong form: Share prices fully reflect all the relevant publicly available info
3. Strong form: All relevant info, including that which is privately held, is reflected in the share price

Question 11

What are weak form tests?

Answer 11

• No mechanical trading rules based on past movements which will generate profits in excess of the average market return
• Done via a simple price chart

Question 12

What are the differing patterns seen in the weak form test?

Answer 12

• Head and Shoulders patterns
• Filter Approach
  (If above moving average should buy as can out perform the market)
• Breakout strategy

Question 13

What exactly is the Filter approach?

Answer 13

Focus on the long-term trends and to filter out short-term movements

Question 14

What is return reversal?

Answer 14

To outperform the market based on past returns

Question 15

What was De Bondt and Thaler’s approach on return reversal?

Answer 15

Shares that had given the worst returns over a three years period outperformed the market by an average of 19.6% in the next 36 months

Question 16

What was Arnold and Baker’s (2007) approach on return reversal?

Answer 16

Loser shares outperformed winner shares by 14% per year

Question 17

What was Jegadeesh and Titman’s strategy around the price (return) momentum?

Answer 17

A strategy that selects shares on their past six month returns and holds them for 6 months, realises a compounded return above the market of 12.01% per year on average

Question 18

What are the possible explanations behind Titman’s strategy?

Answer 18

• Investors under-reacting to new information

- Investors overreacting during the test period

Question 19

What are Semi-strong form tests?

Answer 19

• Tells us fundamental analysis don’t make sense -> All info you need is in the price
• Seasonal, Calendar or Cyclical effects: The Weekend effect, The January Effect etc.

Question 20

What do the studies say about Small Firms?

Answer 20

Studies in the 1980’s found that smaller firms’ shares outperformed in the USA, Canada, Aus, Belgium, Finland, The Netherlands, France, Germany, Japan and Britain

• Perhaps the researchers had not adequately allowed for the extra risk of small shares (beta)
• Proportionately more expensive to trade in small companies’ shares
• ‘Institutional Neglect’
  (Big banks will focus more on analysing big firms)

Question 21

What’s meant by Underreaction in the market?

Answer 21

• Investors are slow to react to the release of info in some circumstances
• ‘Post-earnings announcement drift’

Question 22

What’s meant by Value Investing?

Answer 22

E.g.

Low price-earning ratio shares, high dividend yield, high book-to-market ratio

Question 23

What is the evidence for Semi-strong efficiency?

Answer 23

Significant but not so overwhelming that there’s no hope of outperformance for the able and dedicated

• Publication Bias
• Hundreds of researchers examining of data

Question 24

What’s the paradox behind the Semi-strong efficiency?

Answer 24

In order for the market to remain efficient there has to be a large body of investors who believe it to be inefficient

Question 25

What are the elements of Strong-form tests?

Answer 25

• Trading shares on the basis of info not in the public domain and make abnormal profits (Insider knowledge)

Question 26

What does the term ‘Insider’ mean?

Answer 26

-Covers anyone with sensitive information, not just a company director or employee

Question 27

How can we solve insider trading (even tho its illegal already)

Answer 27

• Raise the level of info disclosure

- Prohibit certain individuals from dealing in the company’s shares for crucial time periods

Question 28

What are the implications of the EMH for investors?

Answer 28

1 For the vast majority of people public information cannot be used to earn abnormal returns
2 Investors need to press for a greater volume of timely information
3 The perception of a fair game market could be improved by more constraints and deterrents placed on insider dealers

Question 29

What are the implications of the EMH for Companies?

Answer 29

1 Focus on substance, not on short-term appearance
2 The timing of security issues does not have to be fine-tuned
3 Large quantities of new shares can be sold without moving the price
4 Signals from price movements should be taken seriously