FFM - Week 7 (Market Efficiency)

Semi-Strong Form Hypothesis

Market prices reflect not only information implied by past price changes, but also all other publicly-available information relevant to a company's securities

On average mutual funds do not outperform the market (negative average returns). What is the implication of this on market efficiency? Why?

No abnormal returns are made beyond the market (SML). Hence the market is semi-strong form efficient (public and past price information)

If a market is efficient, is timing of equity issue important?

No, if efficient, it is implied that equity is sold for its true value, so timing decision is unimportant

If a market is Weak form efficient, will it also be Semi-Strong form efficient?

No, weak form does not mean market includes all other publicly available information

Is the January effect consistent with EMH? Why?

No. If market was efficient, the pattern would be eroded by investors noticing the pattern

A company's share price displays a cyclical pattern. Would this be consistent with the EMH?

No. Investors begin to notice the pattern, buy at low points and sell at high points. This would eliminate the cyclical pattern, leaving only random fluctuations. This implies that the market is inefficient if a cyclical pattern is seen.

Assumptions of Efficient Market Hypothesis

- All investors agree on the same fundamental value for a stock - All transactions take place at this fundamental value

How does Warren Buffer consistently outperform the market?

- Deep understanding of operating business - Management evaluation - Financial measures - Value investing

Explain why weak form efficiency implies a security's price movement in the past is unrelated to its future price movement (RWH)

- If a market is weak form efficient, cannot make abnormal returns by observing past prices - Suggesting there is not a trend between past and future prices

Possible explanations for January Effect

- Tax effects; profit taking at end of year - Smaller firms hold riskier stocks. Managers who held small stocks during year to achieve high growth may sell these stocks ahead of end of year (window-dressing). Once end of year presentations to trustees are over, fund managers once again buy up riskier stocks, thus pushing up their prices in January

3 Types of Market Efficiency

- Weak Form - Semi-Strong Form - Strong Form

Mutual Fund

A pool of assets (a portfolio) containing stock, bonds, options... (invest on the skill of the fund manager)

Efficient Markets Hypothesis

A theory stating that it is impossible to beat the market, because share prices always incorporate and reflect all information available. Hence prices are always fair, so investors cannot benefit from any information or timing advantage

If a market is Semi-Strong form efficient, will it also be Weak form efficient?

Yes

Why is weak form efficiency the 'weakest' type of efficiency?

Because historical price information is the easiest kind of information about a company's equity to acquire

Although January effect is not consistent with EMH, how may this effect still be possible in efficient markets?

Effect may simply reflect that returns have not been appropriately adjusted for risk or market imperfections such as taxes have not been taken into account

Why should firms expect to receive a fair value for the securities they sell in an efficient market?

Fair means that the price they receive from issuing securities is the present value. Thus, valuable financing opportunities that arise from fooling investors are unavailable in efficient capital markets

T/F: If the market is semi-strong efficient, financial analysis is worthwhile

False. If prices reflect all publicly available information, financial analysis based upon public information is useless

T/F: A daily price fluctuation is consistent with market inefficiency

False. Daily price changes responding to new information is not a sign of inefficiencies. Daily price changes are not the same as cyclical price movements

T/F: if a market is weak form efficient, it is possible to earn abnormal profits based upon past information

False. The market price already incorporates information about past prices. So no investor can gain an advantage by using past price information

What is the impact of a *stock split* on the number of outstanding shares and their value?

Increases number of shares Reduces value per share

In an efficient market, investors should only expect to obtain a normal rate of return. Why?

Information is reflected in prices immediately, so no investor can gain an advantage by sourcing information, so the investor cannot make abnormal returns - the price adjusts before the investor has time to trade on it

If RWH is true, then...

It is *not* possible to predict future changes in prices

Weak Form Hypothesis

Market prices reflect all information that can be inferred from past price changes

Strong Form Hypothesis

Market prices reflect all relevant information including private information available only to company's insiders

Explain why RWH is random using an equation

Price of stock today, is equal to the sum of the last observed price + expected return + random error The random component is due to new information, and is unrelated to the random component in any past period. Hence this random component is not predictable from past prices

A market is weak form inefficient when...

Prices do not incorporate information about past price changes (Can make abnormal returns by observing past prices)

A market is said to be weak form efficient when...

Prices fully incorporate information about past price changes

Equation representing Random Walk Hyptothesis

Pt = Pt-1 + Expected Return + Random Error (Next price = Previous Price + Expected Return + Random Error) Random error arises from new information released, uncorrelated to previous random components

Examples of publicly available information (included in semi-strong form prices)?

Published accounting statements, quarterly earnings report, government money supply information

Calendar anomalies are deviations from the EMH such as...

Seasonal effects e.g January Effect

Random Walk Hypothesis (RWH)

Security price changes are unpredictable, and driven by relevant new information

Stock Split Effect

Stock splits increase number of outstanding shares and decrease their value. However, before and after announcement, the market reacts and stock price rises. This is the stock split effect

Is the RWH consistent with the EMH? Why?

Yes. If RWH is true, then there is no correlation between past prices, as price changes are unpredictable, so an investor cannot earn abnormal profit from having information. Price changes are instead driven by relevant new information releases

(Small firms) in January Effect

The observation that small-firm stocks appear to exhibit abnormally high returns in the month of January

Market Efficiency

The price of an asset should reflect, instantaneously, all available information in the market

If RWH is false, then...

There is a serial correlation between successive price changes (it is possible to predict future price changes(

T/F: In a strong form efficient market, nobody ever makes consistently superior profits

True (Even those with insider knowledge cannot cain abnormal returns)

T/F: If the market is weak form efficient, technical analysis is useless

True. Abnormal returns cannot be made by (technical analysis) analysing past price information

Irrational Exuberance

Unsustainable investor enthusiasm dives asset prices up to levels that aren't supported by fundamentals

Most successful investor of 20th Century?

Warren Buffett

Stock Split

When company divides its existing shares into multiple shares

Why may a firm decide to use a stock split?

When firm realises share price is very high. It splits stock to encourage new activity of stock - a sign of growth of firm

An efficient market is one in which share prices fully reflect...

available information

Concept of Irrational Exuberance explains/analyses speculative _____________

bubbles

If share price is increasing, the firm is more likely to issue equities. If the managers have inferior timing ability, the price will...

continue to rise (unintended consequence)

According to the ______________ ____________ __________, no investor has an advantage in predicting a return on a stock price because no one has access to information not already available to everyone else

efficient markets hypothesis

If share price is increasing, the firm is more likely to issue equities. Hence if the managers have superior timing ability, the share price will...

fall (the intended consequence by the financial manager; to reduce value of stock)

The quicker the market adjusts prices in response to relevant, new information, the ______________ the market efficiency

greater

Shares are more likely to be issued after equity prices have _______________. Market efficiency implies that the share price of the firm, on average, neither rises nor falls (relative to market indicies) after issuance of equity

increased

If a market responds to 'fake news' such as a fake Tweet e.g stock price crashes, the market is believed to be _____________

inefficient

If a market is strong form efficient, an investor cannot...

make abnormal returns by looking at past prices, using public information or using private information

A trading strategy recommends buying a share after it has gone up 3 days in a row, and recommends selling a share after it has gone down 3 days in a row. This strategy is based upon...

past prices only

If a market is efficient, the only way an investor can obtain higher returns is by...

purchasing riskier investments

In addition to price responding to new information instantaneously, market efficiency also depends on how good the market is at distinguishing between ... and ...

relevant irrelevant information

Any seasonal pattern which is not explained by additional __________ is not consistent with the EMH (e.g January Effect)

risk

On average, markets tend to be ... efficient

semi-strong form

If public information cannot be used to make abnormal returns, the market is at least...

semi-strong form efficient

Warren Buffett consistently outperforms the market, implying...

the market is inefficient (deviation from EMH)

Irrational Exuberance is an example showing that...

there are deviations from the EMH

If market is efficient, then the stock price reflects true value. Hence there is no...

under/overvaluation

The market interprets a share buyback announcement as a signal that the stock is considered to be _____________ by management

undervalued

A market is efficient when price equals...

value of stock