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1

Efficient Market Hypothesis

markets are informationally efficient, meaning:

Security prices should fully reflect all available information; and,

New information should be incorporated into security prices in an instantaneous and unbiased manner

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when assessing market efficiency, we should be concerned with both

The speed at which new information is incorporated into prices and,

 Whether new information is correctly incorporated into stock prices

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An instantaneous price reaction will mean 

Imagine a firm whose shares trade every 15 minutes. Further:

Shares in the firm last traded at 10.30am for exactly $1; and,

At 10.38am (ie after the 10.30am trade), information has been released about the firm that should see its value decrease and the share price fall by 40%. 

information is reflected in the next price established in the market after its release 

this will be at 10.45am.

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non-instantaneous price reaction 

delay between the release of information and its reflection in the share price. Here, this will be after the 10.45am trade.

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biased price reaction 

overreaction

an initial response to information and a subsequent revision to it

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biased price reaction 

underreaction 

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If markets are informationally efficient 

 information which could predict the performance of an instrument should already be impounded into its price. 

  • any new information will be instantaneously and unbiasedly impounded into prices;
  • As new information is unpredictable, changes in prices resulting from this information will also be unpredictable; and,
  • therefore, stock price changes should follow a random walk. 

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three versions of the EMH 

weak-form hypothesis

argues that prices reflect historical information

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three versions of the EMH 

semistrong-form hypothesis

prices reflect all publicly available information, past and present

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three versions of the EMH 

strong-form hypothesis

prices reflect all publicly and privately available information, past and present

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Tests of weak-form efficiency focus on

Tests of weak-form efficiency focus on whether trading based on historical price patterns yields abnormal profits.

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Tests of weak-form efficiency focus on whether trading based on historical price patterns yields abnormal profits. To do this, they study

the relationship between past and present returns over short horizons and long horizons

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Tests of weak-form efficiency focus on whether trading based on historical price patterns yields abnormal profits. To do this, they study the relationship between past and present returns over short horizons and long horizons

Short horizons

Testing provides some evidence of positive serial correlation, or performance persistence at the portfolio level eg the momentum effect

14

Tests of weak-form efficiency focus on whether trading based on historical price patterns yields abnormal profits. To do this, they study the relationship between past and present returns over short horizons and long horizons

long horizons

There is evidence of negative serial correlation consistent with periods of market overshooting followed by correction.

15

Many tests of semistrong-form efficiency consider

whether publicly available information can be used to predict abnormal risk-adjusted returns.

If the market is indeed semistrong-form efficient, this should not be possible; but

Empirical evidence suggests that a number of publicly available factors can explain returns. Examples of these factors (or anomalies) include size, book-to-market and liquidity.

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Other tests of semistrong-form efficiency employ an

event study methodology to test whether security prices adjust instantaneously to an event such as a public announcement

17

Other tests of semistrong-form efficiency employ an event study methodology to test whether security prices adjust instantaneously to an event such as a public announcement:

why?

any expected component of the announcement should already be impounded in share prices, we should only observe a reaction to the unexpected component of the announcement; and,

This reaction should be observed as an abnormal return (relative to what was otherwise expected) at the time of the announcement.

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If markets are strong-form efficient,

insiders including company directors who possess private (inside) information should not be able to make abnormal returns from trading on this information.

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If markets are strong-form efficient, insiders including company directors who possess private (inside) information should not be able to make abnormal returns from trading on this information. Importantly:

We do not expect markets to be strong-form efficient given regulations prevent / limit trades based on inside information;

Insiders must report their trades with regulators within designated timeframes for publication. At this point, information becomes public;

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strong-form efficiency

 If markets are efficient,

information contained in the reports will be instantaneously and unbiasedly incorporated into share prices, meaning investors should not be able to profit from following insider trades; and,

 Consistent with this, evidence suggests any abnormal returns earned by following insider trades are less than the transaction costs incurred in executing them.

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what do the anomalies mean in terms of market efficiency

Some argue they are evidence of market inefficiency (see, for example, Lakonishok et al, 1995);

Others argue they are simply risk premiums and indicate the need to augment the CAPM to include other sources of risk (see, for example, Fama and French, 1993); and,

 Others still argue they are the result of data mining.

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Interpreting the Evidence

The best test of market efficiency is

whether skilled investors can consistently earn abnormal trading profits. They should not be able to do this if markets are efficient; and,

We will look evidence in this regard for two groups of professional investors, namely analysts and mutual fund managers

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Mutual Funds Performance

Testing of mutual funds’ ability:

 Involve examining risk-adjusted mutual fund performance, that is, returns adjusted for exposure to systematic risk factors. Risk adjustment is typically made using Cahart’s Four-Factor Model;

 Suggests that, while some managers can outperform some of the time, most managers don’t seem to be able to consistently outperform (ie earn abnormal returns) after fees; but,

 There are some notable exceptions.

24

Analyst Performance

 

Studies of analyst performance:

  • Look at the relationship between levels of (changes in) analyst recommendations and stock price movements following release of these recommendations (changes);
  •  Suggest firms with better recommendations (positive changes in recommendations) outperform those with lesser recommendations (negative changes in recommendations);
  • Do not conclude whether these returns are the result of analysts providing new information or changes in demand and supply following releases of analyst recommendations / changes therein; and,
  •  Does not resolve whether any returns would be greater than the transaction costs incurred in earning them.

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Are Markets Efficient?

The performance of professional managers is broadly consistent with market efficiency;

Most managers do not do better than the passive strategy; but,

 There is sufficient empirical evidence of anomalies to justify the ongoing search for underpriced securities. 

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Behavioural Finance

argues that the anomalies are consistent with irrationalities observed in individuals when making complex decisions

 

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Behavioural finance argues that the anomalies  are consistent with irrationalities observed in individuals when making complex decisions. In particular:

Investors don’t always process information correctly and therefore don’t infer incorrect probability distributions about future rates of return; and,

 Even if they infer correct probability distributions, they often make inconsistent or systematically suboptimal decisions.

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Behavioural Finance

Information Processing

Important biases include:

  • Forecasting errors: People give too much weight to recent experiences;

 Overconfidence: People are unjustifiably confident in the forecasts they make;

Conservatism: Investors are slow to update their beliefs when new information becomes available; and,

 Sample size neglect and representativeness: Investors generalise patterns observed in small samples to the population in general.

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Behavioural Finance

Information Processing

Behavioural biases include:

Framing: Framed can significantly impact how investors choose between investment choices. A type of framing, where people segregate particular decisions, is known as mental accounting;

Regret avoidance: Investors are more regretful of decisions with bad outcomes when they are unconventional and, therefore, tend to avoid them; and,

 Prospect theory: Conventional finance theory argues utility depends on the level of an investors’ wealth. Under prospect theory, it depends on changes in wealth from current levels.

 

30

Limits to Arbitrage

The ability to profit from any mispricing is limited as a result of:

 Fundamental Risk: Investors worry about the risk of investing in stocks that are underpriced given the potential for the underpricing to get worse;

ImplementationCosts: Tradingisnotcostless. Indeed, transaction costs may make mispricing not worth exploiting; and,

Model Risk: Investors may be concerned that the valuation model is faulty and the stock might not really be mispriced.