Unit 6: Efficient Market Hypothesis and its Critiques

Predictable cycles in stock price movements:

Tend to self-destruct as soon as investors recognize them

Six lessons of market efficiency

1: Markets have no memory 2: Trust market prices 3: Read the entrails 4: There are no financial illusions 5: The do-it yourself alternatiev 6: Seen one stock, seen them all

Name six lessons of market efficiency

1: Markets have no memory 2: Trust market prices 3: Read the entrails 4: There are not financial illusions 5: the do-it yourself alternative 6: Seen one stock, seen them all

List the three forms of market efficiency and explain the bases for them.

1: Weak-Form efficiency 2: Semi-strong efficiency 3: Strong-form efficiency These distinctions are based on the level of information reflected in the security prices. Weak-form efficiency deals with historical prices. Semi-strong form deals with publicly available information that also includes historical information. Lastly, strong form includes all information that can be acquired by painstaking analysis of the company and the economy.

Strong-form market efficiency states that the market incorporates all information into stock prices. Strong-form efficiency implies that:

An insider or corporate officer cannot outperform the market by trading on the inside information.

Briefly discuss some of the important findings of behavioral finance studies.

Behavioral finance studies have focused on two important areas: (1) Attitudes toward risk, and (2) beliefs about probabilities. Behavioral finance focuses on results that can lead to security mispricing. This can be caused by investors' attitudes towards risk and the way investors assess probabilities. Prospect theory contributed to the understanding of how investors behave in the face of capital gains and losses. Most investors are either too conservative or overconfident. In other words, investors are not 100% rational 100% of the time. Behavioral finance provided some new interpretations of some long-standing puzzles and anomalies.

Generally, a firm is able to find positive NPV opportunities among its

Capital Investment Decisions

Weak-form efficiency implies that past stock returns:

Do not matter

The semistrong form of the efficient markets hypothesis has been tested by measuring how rapidly security prices react to various news items like:

Earnings announcements, dividend announcements, news of takeovers, macroeconomic information

T or F: A majority of research supports the theory that past stock movements can predict future asset prices.

FALSE

Briefly explain why, in a competitive securities market, successive price changes are random.

In a competitive market, prices reflect all available information. The only reason prices change is due to new information arrival. By definition new information arrives randomly. Therefore, security prices change randomly. If security prices did not change randomly, intelligent traders could profitably trade upon the recognition of such a patter. Competition among traders would then act to change prices, in reaction to such trades, thus helping erase the originally discovered patter.

Which of the following observations would provide evidence against the strong form of efficient market theory?

Managers who trade in their own firm's stocks make superior returns.

Financing decisions differ from investment decisions for what reason?

Markets for financial assets are more active than for real assets.

In order to test the semi-strong form of the efficient-market hypothesis, researchers have mostly relied on the

Measurement of how rapidly security prices adjust to different news items

Investors are particularly averse to the possibility of even a very small loss and need a high return to compensate for it. Such a concept is related to which theory?

Prospect theory

What are puzzles and anomalies?

Puzzles and anomalies are abnormal behavior of stocks that apparently contradicts the efficient market hypothesis. There are quite a few of them. For example, stocks of small firms have provided abnormally high returns compared to stocks of large firms.

State the semi-strong form of market effiency and its implications.

Security prices reflect all publicly available information. If markets are efficient in this sense, then prices will adjust immediately to public announcements.

State the strong form of market efficiency.

Security prices reflect all the information that is available to the investors.

State the weak form of market efficiency and its implications.

Security prices reflect the information contained in the record of past prices. This implies that prices will follow a random walk. It is impossible to make consistently superior profits by studying past returns.

One important implication of the efficient markets hypothesis is that most investors:

Should avoid active trading.

What is a statement of semi-strong form efficiency?

Stock prices will adjust immediately to public information.

The conviction of Raj Rajratnam for insider trading supplies evidence against which form of the efficient markets hypothesis?

Strong-form efficiency

T or F: If a stock's returns follow a random walk pattern, then one should expect to calculate a statistically insignificant autocorrelation coefficient, calculated between each successive day's stock returns.

TRUE

T or F: If capital markets are completely efficient, then the purchase or sale of any security at the prevailing price is never a positive - NPV transaction.

TRUE

T or F: In a completely competitive market, security prices follow a random walk.

TRUE

T or F: In an efficient market, investors will not pay others what they can do equally well themselves.

TRUE

T or F: The collections of evidence against market efficiency are referred to as "puzzles" or anomalies.

TRUE

T or F: When a firm announces a dividend change, or publishes its latest earnings, the major part of any price adjustment usually takes place within a few minutes of the announcement.

TRUE

The three forms of market efficiency are:

Weak form, semi-strong form, and strong form.

Stock price cycles or patterns tend to self-destruct as soon as investors recognize them through:

trading by investors.