CFA Level 1 Reading 46 - Market Efficiency

Factors that affect Market's Efficiency: Limits to trading

restrictions on short selling limit arbitrage trading, which impedes market efficiency

Time Series : Calendar anomalies

significant differences in returns on different days, months, or years -the most commonly known calendar anomaly is the January effect, in which stocks tend to outperform in the month of January -- part of which amy be explainable by individual investors or fund managers selling off during the previous december

LOS- what are market anomalies

-market anomalies occur when a change in the price of an asset or security cannot directly be linked to current relevant information known in the market, or the release of new information -anomalies may be a result of data mining -as such, market anomalies are only valid if they are consistent over long periods of time and not the result of data mining, or examining data with the intent of developing a hypothesis

Time Series: Overreaction and Momentum Anomalies

-overreaction: stock prices become inflated (depressed) for those companies releasing good (bad) news -Momentum: securities that have xperienced high returns in the short term tend to continue to generate high returns i nsubsquent periods

Other Anomalies

1) closed-end fund discounts: closed-end funds sometimes sell at a discount to their net asset value, or the price that the fund's holding could theioretically be sold for if fully liquidated 2) earnings surprise: stock prices have a tendency to underreact to new information, allowing for a momentum strategy to be potentially profitable 3) intital public offerings (IPOs) : investors able to purchase a sotck at its initial offering price earn excess returns 4) Prio information: some researchers have found that equity returns relate to prior information like interest rates, inflation reates stock volatitlity and dividend yields

Cross-sectional Anomalies

1) size effect: small companies tend to outperform larger companies 2) value effect: value stocks, which generally are stocks with below-average price-to-earnings and market-to-book ratios, and aboe average dividend yields, have consistently outperformed growth stocks over long periods of time

intrinsic value

An estimate of a stock's "true" value based on accurate risk and return data. The intrinsic value can be estimated but not measured precisely.

Information cascades

Uninformed traders watch the actions of informed traders and follow when they are given a lot of unclear information; Consistent with investor rationality and improved market efficiency if they stem from uninformed traders; Said to be fragile if it does not lead towards the correct pricing of an asset

Factors that affect Market's Efficiency: Market Participant

a large number of investors follow the major financial markets closely on a daily basis, and if mispricing exist in these markets investors will act so that these mispricing disappear quickly

Efficient capital market

a market in which security prices reflect available information

Behavioral Fiance

assumes that: - investors suffer from cognitive errors and emotional biases that may lead to irrational decision making -runs contrary to traditional finance which assumes that : investors behave rationally -investors process new information quickly and correctly

Market Efficiency

describes the extent to which available information is quickly reflected in the market price

Herding Bias

market participants tend to trade along with other investors, while potentially ignoring their own private inforamtion or analysis this bias may also serve as a possbile explanation for the under-reaction and overreaction market anomalies

overconfidence bias

the bias in which people's subjective confidence in their decision making is greater than their objective accuracy

Factors that affect Market's Efficiency: Information Availability and Financail Disclosure

the more information market participants have, the more accuerate the market's estimates of intrinsic value thus creating greater market efficiency

Loss Aversion Bias

we irrationally prefer avoiding loss about twice as much as acquiring gains