BKM 11

(BKM 10th Edition, Concept Check 11.3) What would happen to market efficiency if all investors attempted to follow a passive strategy?

At some point, prices will no longer reflect new information, allowing for profit opportunities if active investors re-entered the market. They would then drive those prices back to fair levels.

Suppose that markets are perfectly efficient. Explain why it would still be beneficial for an investor to actively manage a portfolio.

Even in perfectly efficient markets, there is a role for portfolio management. Younger investors will likely want to have stronger roles in riskier assets. Investors in higher tax brackets may consider more tax-exempt options. Investors employed in a particular industry will likely benefit by not holding as many shares in that industry.

Describe the difference between technical and fundamental analysis. Discuss which form(s) of the EMH would allow for one but not the other to be effective.

Fundamental analysis is a basic principle of portfolio management. It involves using future prospects of a company to try to predict which assets would best be included in a portfolio. The weak form of the EMH does not necessarily dictate that fundamental analysis is without merit, since the weak form does not include information about future prospects. Technical analysis is the attempt to predict future movements based on past trends (similar to regression analysis). No form of the EMH would grant any merit to technical analysis.

The efficient market hypothesis implies that abnormal returns should be zero. Market efficiency is ensured by the existence of arbitrageurs who can force prices back into equilibrium. If arbitrageurs are able to earn profits by doing so, does this present an inconsistency with market efficiency?

No - the EMH does not imply that arbitrageurs cannot make profits - it focuses on net economic profits, not raw profits. The profits of arbitrageurs are diminished by transaction costs and the cost of gathering information. Also, there is a distinction between net profits and expected profits. The EMH expects net expected profits to be zero. Otherwise, more individuals would enter the arbitrage business until the opportunity no longer exists, so it is the force of competition that drives down profit.

An investor is reviewing historical prices for Apple stock in comparison with the S&P 500. Based on the information, the investor believes he has identified a potential for profit by investing in Apple stock. Identify what approach he is likely using to make that decision, and a potential reason that the technique may not yield as much profit as suggested by the data above.

Since he is comparing returns of a stock to some general index, he is using the relative strength technique. If we look at the growth in price, we can see that Apple has been growing much faster than the index over the time period shown (annualized). A potential pitfall with this technique is that while Apple stock has been exhibiting excessive growth relative to the index, it may stop growing (or stop growing as quickly) when it approaches market resistance levels. The investor would need to have an idea of what he believes to be those levels. Alternately, basing the decision on 8 months of data may not be a good idea if historically the stock has been volatile. Alternately, if many investors identify the same trends and all want to purchase stocks, the stock price will shoot up suddenly, making it difficult to profit. Alternately, while Apple may be exhibiting momentum for the time period, periods of momentum have historically been followed by corrections where price returns to a lower level.

Investopedia defines the "Cramer Bounce" as "the sudden overnight rise of a stock's price after it has been recommended by Jim Cramer on his CNBC show, Mad Money."10 Some studies have shown that the prices of smaller stocks can see overnight increases of 5% following an announcement on his show. The abnormal increase lasts for only about 12 days, after which the stock price returns to its original price. Explain how short sellers can use the Cramer Bounce effect to keep the market efficient.

Since the price run up happens immediately, a savvy short seller can short sell a stock in the opening minutes of the next day. This is a bet that eventually prices will fall. In a couple of weeks when prices revert back to normal, the short sellers will profit.

Discuss three market anomalies that appear to be related, and explain what could be driving the anomalies, and why it may be difficult to exploit them.

Small firms tend to be the most neglected firms, and also tend to be those with high book-to-market values. These firms tend to outperform their counterparts. This could be seen as market inefficiency, or it could be seen as a risk premium demanded for holding investments in these types of firms. Even given that they outperform, it may still be difficult to exploit a potential mispricing because these types of firms tend to be associated with higher transaction costs. (This idea has been postulated as being related to the SMB factor loading in the Fama-French Model.)

The EMH implies that abnormal returns should be zero. However, in order for markets to be efficient, arbitrageurs must have the ability to force prices into equilibrium. If an arbitrageur can earn profits by doing this, does this violate the EMH?

The EMH does not in and of itself imply that arbitrageurs cannot be profitable. However, one should consider net profits, which include the time and transaction costs included with engaging in such activities, as well as the force of competition. If arbitrage were a consistently profitable activity, more and more arbitrageurs would enter the market, and the opportunities for profit would decline

A specific firm has consistently generated large profits over the past decade. Your friend tells you that this is a violation of the EMH. How would you respond?

The fact that this firm has earned high profits for years is not indicative of a violation. Investors who purchase stock in this firm may not earn high returns on their investments, if they purchase stock after the firm was already successful.

Assuming a perfectly efficient market, support or contradict the statement that no investor will ever beat the market.

This is false; in any given time period roughly half of investors should beat the market. On average though, the expected excess return is 0.

The random walk theory says that stock prices cannot be determined by their past prices. Explain whether noticeable patterns in stock prices (bull markets and bear markets) contradict the random walk theory.

Your answer to this question depends on your view of the efficiency of markets. If markets are not fully efficient, then there is some pattern in stock prices. If they were not, then only new information would cause prices to change, so the random walk theory would be sensible. One could certainly argue that markets are not perfectly efficient, due to certain phenomena like momentum. Ignoring transaction costs, a savvy investor could profit based off analysis of past prices.

2. The image below (from ResearchGate) shows an event study for copper futures with 2 months to maturity. The top, middle, and lower curves represent positive, neutral, and negative events, respectively. a. Describe whether the graph indicates the presence of information leakage. b. Describe whether the graph indicates an efficient market.

a. The graph does indicate that there may have been information leakage; in the cases of both positive and negative news events, prices started to increase (or drop) well prior to the day of the actual announcement, after which the prices leveled off. b. If investors can earn abnormal risk-adjusted profits then the EMH is violated (and the market is not efficient). Since the stock price changes appear to occur when only insiders should be aware of the upcoming news event, then the strong-form is violated. If we assume that information was leaked, then the semistrong-form was also violated.

Explain how market efficiency would differ between: a. Emerging markets versus well-established markets b. Large stocks versus small stocks

a. There is less information publicly available on emerging markets, so there would be more room for inefficiency in an emerging market than there would be in a well-established market. b. Small stocks would tend to be less analyzed, and therefore would tend to have prices that are less efficient than their larger counterparts.

Indicate which form(s) of the EMH the following would necessarily violate: a. You observe that high-level managers earn superior returns on their own company's stock. b. You are able to earn excess returns by observing patterns about a company's earnings prospects.

a. This violates the strong-form (inside information used here) b. This violates the semistrong and strong forms of efficiency. The semistrong violation is evidenced by the use of future prospects; if the semistrong-form is violated, the strong-form is also automatically violated since it includes that information.

Which of the following situations would indicate a violation of the semistrong-form of the EMH? a. Using some model that regresses upon past stock prices, a brokerage firm can consistently earn 2% abnormal profits, net of transaction costs. b. Investors in 2016 on average earned positive profit on their investments. c. An arbitrageur in the mid-80s was seen to be blessed with the ability to determine and invest in potential takeover targets, and benefit from the uptick in prices. It was later discovered that he paid investment bank M&A managers for pre-takeover information.

a. Violation - in the semistrong-form, we shouldn't be able to use past information to predict future prices b. Not a violation - the market on average produces positive returns. We care only about abnormal returns. c. Not a violation of the semistrong-form (though it would violate the strong-form version)

Indicate which is the highest level of the forms of efficient market hypothesis the following scenarios would allow for: a. A study tested 5,000 technical rules and found them to be unsuccessful at generating excess returns. b. Active fund managers historically do not outperform the market more than what would be randomly expected. c. You see that Amazon's stock is at a 30-day low, but do not believe it indicates in which direction it will move in the future. d. Only the company's CEO knows about a new equity offering, and this is reflected in the stock price. e. Stocks that perform well in one week perform poorly in the week thereafter.

a. Weak (technical rules rely only on past price information) b. Semi-strong (fund managers rely on past and current information) c. Weak (the past 30 days reflects past price information) d. Strong (relies on inside information) e. None (the EMH is violated - investors can use past information to exploit mispricings.)

(BKM 10th edition, 11.21) Investors expect the market rate of return in the coming year to be 12%. The T-bill rate is 4%. Changing Fortunes Industries' stock has a beta of 0.5. The market value of its outstanding equity is $100 million. a. What is your best guess currently as to the expected rate of return on Changing Fortunes' stock? You believe that the stock is fairly priced. b. If the market return in the coming year actually turns out to be 10%, what is your best guess as to the rate of return that will be earned on Changing Fortunes' stock? c. Suppose now that Changing Fortunes wins a major lawsuit during the year. The settlement is $5 million. Changing Fortunes' stock return during the year turns out to be 10%. What is your best guess as to the settlement the market previously expected Changing Fortunes to receive from the lawsuit? (Continue to assume that the market return in the year turned out to be 10%.) The magnitude of the settlement is the only unexpected firm-specific event during the year.

a. Would expect: 𝐸(𝑟𝐶𝐹) = 4% + 0.5(12% −4%) = 𝟖% b. Would expect: 𝐸(𝑟𝐶𝐹) = 4% + 0.5(10% −4%) = 𝟕% c. Since the actual return of 10% was 3% greater than the expected return, and the only surprise was the settlement, the surprise factor has value of 3% of 100 million, or $3 million. The expected return was therefore $2 million.

Discuss briefly how to empirically test for market efficiency, making sure to differentiate between the forms of the EMH.

• Weak-Form: Look for a momentum effect (stock prices continue to rise or fall over time) or reversal effects (stocks prices go back to "normal" after a period of sharp increases or decreases). Either of these observations would indicate that stock prices can be predicted using only historical pricing information. • Semistrong-Form: We look for market anomalies (P/E effect, small-firm effect, neglected-firm effect, book-to-market effects, post-earnings-announcement price drift). If any of these anomalies are observed, one could predict stock prices using historical and current information. • Strong-Form: We look for insiders outperforming the market. This would indicate that stock prices can be predicted, given information known only to insiders.