CH 5: revised EM; ch 18

Three classic views of market efficiency

1. weak form efficiency- current stock prices fully reflect all the information contained in historic stock market data 2. semi-strong form efficiency- current stock prices fully reflect all publicly available information (public info includes historic stock market data) 3. Strong form efficiency: current stock prices fully reflect all information, publicly available information and private information o All 3 Only differ based on data set § Binary: meaning you are or you are not § Either reflects all or it does not o Might be semi-strong not relative to Russel 1000 o Might be semi-strong relative to S&P o Big cap- no doubt o Small cap- no

Event study on Back test

- estimation period is where we estimate the "normal return" -Pre ann period is to insulate the estimation of normal from any anticipation -announcement period is where we expect to see a market response to the announcement -post ann period is where we expect returns to return to normal o Want to see things going flat after announcement o 30 year period exist so Estimated return doesn't get effected by o Does not bias estimate of normal: pre ann period on inefficient graphs o Expect normal return before the ann. And then above expected and then go back to normal return o 3 ways to estimate normal: § Use mean adjusted return · Take 250 days and calculate average return security has for those 250 days · Requires 250 · Requires estimation period § Marked adjusted return · Assumption - security moves equivalent to maker assuming security has beta of 1 · Requires no estimation period § Market model · Allowing beta the security movement with the market to vary · Requires a estimation period o Announcement period - cumulate daily excess returns § 3 day announcement § Cumulate data through list of equations § Observed return - expected return on I on day T § Cumulative abnormal return § S&P 500= ARnt

Surprise earnings; standard unexpected earnings

SUE: actual earnings- forecasted earnings/ SD of the forecast -§ Studies that address quarterly reports are considered part of the time series analyst. These studies examine whether it is possible to predict future individual stock returns based on publicly available information on changes in quarterly earnings that differed from expectations § The results generally indicated that there were abnormal stock returns during the 13 or 26 weeks following the announcement of a large unanticipated earnings change- earnings surprise § These results indicate that an earnings surprise is not instantaneously reflected in security prices. o If they trade based on SUE: § Trade based on earning surprised § A has lots of dispersion in their SD of forecast § B has pretty close variables to error § Decile portfolios - each portfolio consist of 2000 announcements so highest at top (positive announcements) and lowest at bottom (negative announcements) and middle is no significant information -use SUE for back test

Runs Test

a runs test looks at the sign of successive price changes of security I over time if there are significant runs, the market is not weak form efficient non parametric § Given a series of price changes, each price change is either designated a plus (+) if it is an increase in price or a minus (-) if it is a decrease in price. The result is a set of pluses and minus: +++-+--++--++. § A run occurs when 2 consecutive changes are the same; two or more consecutive positive or negative price changes constitute one run. When the price changes in a different direction (negative price change is followed by a positive price change), the run ends, and a new run may begin. § To test for independence, you would compare the number of runs for a given series to the number in a table of expected values for the number of runs that should occur in a random series. § Independence of stock prices changes over time. · The actual number of runs for stock price series consistently fell into the range expected for a random series, which would confirm the independence of stock price changes over time § Although short- horizon stock returns (monthly, weekly, and daily) have generally supported the weak form, studies examined price changes for individual transactions on the NYSE found significant serial correlations. · Serial correlation meant that momentum could be used to generate excess risk adjusted returns, but it was concluded that the substantial transaction costs wiped out the profits.

Test of serial or auto correlation

effectively you measure the correlation of the returns of secuirty I on day t, to the returns of security I on day t+1 (this is different that measuring the correlation of the returns of security I on day t, to the returns of secuirty j on day t) pit,it+1, not pit,jt If the correlation is significantly different than 0, the market is not weak form efficient § Measure signific of positive or negative correlation in returns over time. § The results of studies that examined the serial correlations among stock returns for relatively short time horizons including 1 day, 4 days, 9 days, and 16 days typically indicated insignificant correlation in stock returns over time. § Portfolios of stocks of difference market size have found that auto correlation is stronger for portfolios of small market size stocks. § Although initial results tend to support the hypothesis, some subsequent studies cast doubt on the hypothesis for portfolios of small firms, although these results could be offset by the higher transaction costs of small-cap stocks . o Serial and auto correlation = same things comparing I and J

3 ways to estimate a normal return

mean adjusted and market adjusted used the estimated period and market model does not need estimated period

Efficient Market Responses

o A - announcing period o Pi= prices o When announcement comes out and price responds before giving normal return and security price goes along · In efficient market it should go flat after announcement · Post announcement drift: violation of strong form : line shoots up after announcement · Market is efficient to earnings announcements, stock announcements,

Semi strong

o Asserts that security prices adjust rapidly to the release of all public information; that is, current security prices fully reflect all public information o Encompasses weak form hypothesis because all the market info considered by the weak form hypothesis, such as stock prices, rates of return, and trading volume, is public. o Public info also includes all nonmarket information such as earnings and dividend announcements, price to earnings ratios, dividend yield ratios, price book value ratios, stock splits, news about the economy, and political news. o Implies that investors who base their decisions on any important new information after it is public should not derive above-average risk adjusted profits from their transactions, considering the cost of trading. -do not depend on normal distribution

Weak form

o Assumes that current stock prices fully reflect all security market information, including the historical sequence of prices, rates of return, trading volume data, and other market generated information, such as odd lot transactions and transactions by market-makers. o Because it assumes that current market prices already reflect all past returns and any other security market information, this hypothesis implies that pas rates of return and other historical market data should have no relationship with future rates of return ( rates of return should be independent). § Gain little from using any trading rule which indicates that you should buy or sell a security based on past rates of return or any other past security market data. o Movement in prices is unrelated, independent= week form o If movement in prices are related, Dependent- market is not weak from efficient o Serial I movements against itself- serial movements o Serial correlation : I against J. in weak form § Assuming normal distribution § When we test it we expect if the correlation is 0 then price movements are independent § If correlation is positive or negative, then price movements are dependent and rejects weak from efficient § Correlation is not significantly different than 0

Strong-form EMH

o Contends that stock prices fully reflect all information from public and private sources. o Assumes that no group of investors has monopolists access to information relevant to the formation of prices, which implies that no group of investors should be able to consistently derive above average risk adjusted rates of return. o Encompasses both weak and semi strong forms o Extends the assumption of EM to assume perfect markets, in which all information is cost-free and available to everyone at the same time - do not depend on normal distribution

Risk adjusted HPR table

o List of the abnormal returns, 2.075% abnormal return over 3 days, return above the market, anything without and astirx is 0. o Important because law of large number o Not significance mathematically o Buying securities based on negative announcements = - # § In a EM: Found a bump during announcement period that is above normal that is of the sign of the information (positive info= positive bump) § Attainable set- S&P § 250 day market model return § Portfolio manager does not § Every test that is Semi-strong Is a joint hypothesis test market that the market is semi-strong and the test that the model that u used to estimate normal is correct · regardless of calendar time is we can assign a time 0 to event time o around announcement period is 2-3 days o each observation moves with them · 2.075 abnormal return for the highest SUE portfolio, that is the return that happens over those 3 days. Would earn 8% return over the market if you followed this way · Significant statistically but not economically= negative · Buying in bad news = negative on lowest SUE - bottom feeders · 60 days following announcement you could earn return of 1.8% · A broker would look at this by buying high SUE and selling low SUE o Joint hypothesis test because it assumes that only the market is strong form efficient and model you use if correctly specified o Running it against existing portfolio - back test · Market mode incorrectly specified: that's what this table tells us, did not correctly adjust for the risk · Released from corp, released security analysts where they make some discovery about info, research article that says you can make money = public info · In efficient market it should be priced away · If it doesn't have asrtic then number is 0 · Post announcement drift: violation of strong form : line shoots up after announcement · Conclusion of table: Appears that from 1979 that the marker model was incorrectly specified relative to measuring S&P 500 but periods following 1982 market was correctly specified

· Semi strong form Test

o You need to adjust the security's rates of return for the rates of return of the overall market during the period considered. The point is that a 5% return in a stock during the period surrounding an announcement is meaningless until you know what the aggregate stock market did during the same period and how this stock normal acts under such condition's § If market experiences a 10% return during the ann period, the 5 % return for this stock may be lower than expected. - abnormal returns and expected rate of returns market is not strong form

Inefficient Market Responses

o announcement predicted and then announcement comes out and price changes § Anticipation § Doesn't interfere and security reflects all the info from public announcement

Tests of weak-form EMH

tests of random movement. if the movement in stock prices from trade-to-trade or day-to-day is random or independent the market is said to be weak form efficient. If the price movements are dependent on each other from trade to trade or day to day the market is not weak form efficient 1. test of serial or auto correlation 2. runs test 3. filter rule o Two tests: involving statistical tests of independence between rates of return and comparing risk-return results for trading rules to make investment decisions based on past market info relative to the results from a simple buy and hold policy, which assumes that you buy stock at the beginning of a test period and hold it to the end.

Filter rule

this is a trading rule based upon price changes. The rule basically says that you buy if the security rises by more than X% and sell if the security falls by more than X%. The X is the filter, a 2% filter, a 5% filter, etc. you examine your profits from the filter rule If you can make a profit from the filter rule, the market is not weak form efficient § If we apply filter rile and we have No profit- weak form § Filter rules worked and said the market was not weak form efficient - 1970/s § We are weak form efficient o An investor trades a stock when the price change exceeds a filter value set for it. o An investor using a 5% filter would identify a positive breakout if the stock were to rise 5% from some base, suggesting that the stock price would continue to rise. A technician would acquire the stock to take advantage of the expected increase. o 5% decline from some peak price would = (-) breakout and technician would expect a further price decline and would sell any holdings of the stock and possible even sell the stock short o Results from studies indicated that Small filters would yield above average profits before taking account of trading commissions. § However small filters generate numerous trades and therefore substantial trading costs. o Trading using larger filters did not yield returns above those of. Simple buy and hold policy o Evidence from simulations of specific trading rules indicates that most trading rules tested have not been able to beat a buy and hold policy. Therefore, early test results generally support the weak form EM but the results are clearly not unanimous, especially if one considers the current substantially lower commissions.

Semi strong set of studies

§ . Studies to predict future rates of return using available public information beyond pure market information considered in the weak form tests. These studies can involve either time series analysis of returns or the cross section distribution of returns for individual stocks § Advocates of the EM contend that it would not be possible to predict future returns using past returns or to predict the distribution of future returns using public info § 2. Event studies that examine how fast stock prices adjust to specific significant economic events. These studies test whether is possible to invest in a security after the public announcement of a signific event ( earnings, stock splits, major economic events) and whatever they can experience signific abnormal returns. Advocates of EM would expect security prices to adjust rapidly, such that it would not be possible for investors to experience superior risk adjusted returns by investing after the public announcement and paying normal transaction costs. · - would have job as security analysts, you create the info would also have job of : o Construct a diversified portfolio o Specify level of risk minimize transaction cost and taxes o Maintain risk level of portfolio

o Expected rate of return:

§ ARit= Rit-E(Rit) · E(Rit)= expected return for stock i during period i based on the market rate of return and the stock's normal relationship with the market (its beta)

o Statistical tests of independence

§ EM contends that security returns over time should be independent of one another because new info comes to the market in a random, independent fashion, and security prices adjust rapidly to this new info. Two statistical tests verify this independence: Auto correlation tests and runs test -autocorrelation and runs test

3 major pitfalls can negate the results of a trading rule study:

§ Investigator should use only publicly available data when implementing the trading rule § When computing the returns from a trading rule, you should include all transaction costs involved in implementing the trading strategy because trading rules generally involve many more transactions that a simple buy and hold policy § You must adjust the results for risk because a trading rule might simply select a portfolio of high risk securities that should experience higher returns. -filter rule

Efficient and inefficient market responses

§ Post announcement drift, after announcement and security price and return goes flat suggesting price has fully reflected all § and inefficient continues to drift in direction of announce suggesting that security did not fully reflect the security price when it was made o Concentrate on specific announcement - this becomes systematic portion o Earnings- only systematic component

Event Studies

§ Research that examines the reaction of a securities price to a specific company, world event, or news announcement · Examines abnormal rates of return for a period immediately after an announcement of a signific economic event, such as a stock split or a proposed merger to determine whether an investor can derive above average risk adjusted rates of return by investing after the release of public info § Attempt to predict cross sectional returns by examining public ingo regarding individual stocks that will allow investors to predict the cross sectional distribution of future risk adjusted rates of return § Testing whether it is possible to use variables such as the price earnings ratio, market value size, the price/book value ratio, the price earnings/growth rate ratio, or the dividend yield to predict which stocks will experience above average or below average risk adjusted rates of return in the future § Emphasis on the analysis of abnormal rates of return that deviate from long term expectations,

Abnormal returns

§ The amount by which a security's actual return differs from its expected rate of return, which is based on the markets rate of return and the security's relationship with the market. § ARit= Rit-Rmt

o results of event studies:

§ intent of event studies is to examine abnormal rates of return surrounding significant economic information. Those who advocate the EM would expect returns to adjust quickly to announcements of new info such that investors cannot experience positive abnormal rates of return by acting after the announcement of an event

Sub hypothesis

· EM based on the random walk hypothesis which contended that changes in stock prices occurred randomly. o FAMA attempted to formalize the theory and organize the growing empirical evidence. Fama presented the EM in terms of a fair game model, contending that current market prices reflected all available info about a security and therefore, the expected return based upon this price is consistent with its risk. o Each sub hypothesis test is based on different information sets and implications of each of them

Global View of market Efficiency

· Efficient capital market- one in which security prices adjust rapidly to the arrival of new info, which implies that the current prices of securities reflect all information about the security. 1. we will have a larger number of profit maximizing investors analyzing securities independently of each other 2. new information will arrive in a random fashion 3. security prices reflect new info rapidly -· the buy and sell decisions of all those profit maximizing investors cause security prices to adjust rapidly to reflect the effect of new info. o Although the price adjustment may be imperfect, it is unbiased., which means that sometimes the maker will over adjust and other time it was under adjust, but you cannot predict which will occur. o Security prices adjust rapidly because the many profit maximizing investors are competing against one another to profit from the new info. o The combined effect of; § Info coming in a random, independent, unpredictable fashion and § Numerous competing investors adjusting stock prices rapidly to reflect this new info means that prices should be independent and random. o This implies that EM require some minimum amount of trading and that more trading by numerous competing investors should cause a faster price adjustment, making the market more efficient. 4, therefore, price changes will be independent and random -o because security prices adjust to all new info, these security prices should reflect all info that is publicly available at any point in time, including the risk involved in owning the security. Therefore, the expected returns implicit in the current price of the security should reflect its risk, so investors buy at these informationally efficient prices should receive a rate of return that is consistent with the security's risk. o Information arriving at a certain time- would not be global efficient o Is information uncensored and arriving throughout the day, random. o If a court sophisticated enough to compare a car or items then you will have unfortunate event investing with them, probs don't want to do that o Loss decade: low growth, high inflation

Small and large caps

· Large Cap- most efficient, more correct risk specification · Small cap- misspecification appears, meaning abnormal returns appear o Cannot correctly measure the risk o Adjust info more slowly · Low P/E stock and Low book ratio stocks- will get you abnormal returns on small cap stock · Once they made public announcement those abnormal returns should have gone away but they didn't

Public announcements

· Once they made public announcement those abnormal returns should have gone away but they didn't

Recurring abnormal return/event

· is considered an anomaly

Trading Rules

· second group of tests of weak form EM o Developed in response to the assertion that some of the prior statistical tests of independence were too rigid to identify the intricate price patterns examined by technical analysts. § Technical analysts do not expect a set number of positive or negative price changes as a signal of a move to a new equilibrium. They look for consistency in the price trends over time that might include both positive and negative changes. o Trading rule studies compared the risk- return derived from trading rule simulations, including transaction costs, to the results from a simple buy and hold policy.

Anamoly based strategies

· small cap, SUE depending on capitalization