Ch. 6

Arbitrage

(market participants) arbitrageurs eliminates the unexploited profit opportunities; the return on the security is larger than what's justified

Two types of tests in Technical analysis

1. Empirical analysis described earlier to evaluate the performance of any financial analyst, technical concludes to technical analyst fare no better than other ones they don't outperform the market; successful forecasting in the past doesn't mean forecast will outperform well in the future. 2. Rules developed in the technical analysis for when to buy and sell stocks and applies to the new datas. They also discredit the fact that it doesn't outperform the overall market.

2 tests in random walk behavior

1. Examining stock market to see if there are changes related to past that can be predicted on that basis. 2. If the publicly available information other than past stock prices have been used to predict changes. More stringent because additional information (money supply growth, government spending, interest rate, corporate profits) might helped to forecast stock return

Important implications of finance

1. In efficient capital market, one investment is good as any other because the securities are correct. 2. Security's price reflects all available information about the intrinsic value of the security. 3. security prices can be used by managers of both financial and non-financial firms to assess their cost of capital (cost of financing their investments) accurately and hence that security prices can be used to help them make the correct decisions about whether a specific investment is worth making.

Case: Should Foreign Exchange Rate follow a Random Walk?

1. People buy the currency immediately and bid the current price leading to reducing the expected return. 2. The process would stop only when the predictable change in the exchange rate dropped to near 0 so that the optimal forecast return are no longer differed from the equilibrium return. 3. If people are able to predict that the currency would decrease by 1%, they will sell until the predicted exchange rate is near 0

Evidences on the Efficient Market Hypothesis

1. Performance of investment analysis and mutual funds 2. Do stock prices reflect on the publicly available information? 3. Random Walk Behavior of Stock Prices 4. Technical Analysis

Evidences Against Market Efficiency

1. Small Firm Effect 2. January Effect 3. Market Overreaction 4. Excessive Volatility 5, Mean Reversion 6. New information is not always immediately incorporated into stock prices.

Guides to Investing in Stock Market

1.How valuable are published reports by investment advisers? 2. Should you be skeptical of hot tips? 3. Do Stock Prices Always rises when there is a good news? 4. Efficient Markets Prescription for the Investor

What is the common test when performing investment analysis and mutual funds?

Common test is to buy and sell recommendations from group of advisers or mutual funds and later compare the performance of resulting selection of stocks with markets overall.

Security's Equilibrium Return

Current prices in a financial market will be set so that the optimal forecast of a security's return using all available information

Case: Foreign Exchange Rate

EMH predicts that FX rates should be unpredictable. Oddly enough, that is exactly what empirical tests show.

Case: What do stock market crashes tells us about the efficient market hypothesis?

EMH showed a large role in determining asset price to market psychology and institutional structure of marketplace. Other economist believed that market crashes and bubbles suggest that unexploited profit opportunities may exist. Lesson from the crash: factors except for market fundamentals might have an effect on asset prices.

Why the efficient Market Hypothesis Does not Imply that Financial markets are efficient?

EMH states that (1) expectations are rational, and (2) prices are always correct and reflect market fundamentals. three important implications: 1. One investment is just as good as any other (stock picking is pointless) 2. Prices reflect all information 3. Cost of capital can be determined from security prices, assisting in capital budgeting decisions

New Information is not always immediately incorporated into stock price

Evidence suggests stock prices do not instantaneously adjust to profit announcements. Stock prices continue to rise for some time after the announcement of unexpectedly high profits.

Excessive Volatility

Fluctuation in stock prices may be greater than warranted by fluctuations in the fundamental values. E.g. S&P 500 stock index couldn't be justified by the fluctuations of dividends.Other research finds that there are smaller fluctuations in stock prices when stock markets are closed.

Do Stock Prices Reflect on Publicly Available information?

If information is already publicly available, a positive announcement about a company will not, on average, raise the price of its stock because this information is already reflected in the stock price. When it's announced, there is an effect but stock but after the stock prices are split there's no effect on average causes stock price to rise.

Random Walk Behavior of Stock Prices

If stock is predicted to rise, people will buy to equilibrium level; if stock is predicted to fall, people will sell to equilibrium level (both in concert with EMH) If stock prices predicable, price change be near 0, but never happen. - Buy the rumor, sell the fact

What happens to the unexploited profit opportunities in efficient market?

In an efficient market, all unexploited profit opportunities will be eliminated. Not everyone in the financial market must be well informed about a security for its price to be drive to the point which the efficient market condition holds. The hypothesis is valid because it doesn't require anyone to be cognizant of what's happening to every security

Mini Case: Raj Rajarantam

In the mid-2000s, Mr. Rajaratnam made millions for himself and his investors by investing in firms on which he allegedly received inside information. His strategy shows that you can profit from information that the market does not have.

Efficient Markets Prescription for the Investor

Investors should not try to outguess the market by constantly buying and selling securities. The EMH indicates that no mutual fund can consistently outperform the market. Instead, an investor should purchase a no-load (commission-free) mutual fund that has low management fees. - Conclusion: investors and others fitting into the category should not try to outguess the market by buying and selling securities.

Mean Reversion

It is stocks with low returns today & high returns in future (vice versa). - Predictable positive changes in future price lead to stock prices are not random walk - Controversial

January Effect

It occurs when experiencing an abnormal price rise from December; January that is predictable and inconsistent with random walk behavior. This still occurs in small companies - Cause: tax issues People anticipate higher price on January by buying it in December.

Performance of Investment Analysis and Mutual Funds

Mutual funds not only do not outperform market on average, but when its divided into groups based on the profits in their chosen period, the mutual funds that did well in the first period did not beat the market in the second period. The "Investment Dartboard" often beats investment managers. Usually it's impossible to beat the market, but the only way to beat the market is to use inside information. In the U.S., it is illegal to trade on such information, but that is not true in all countries. Insider trading is done secretively.

DO Stock Prices Always rises when there is a good news?

NO. In an efficient market, stock prices will respond to announcements only when the information being announced is new and unexpected. if good news was expected (or as good as expected), there will be no stock price response. And, if good news was unexpected (or not as good as expected), there will be a stock price response.

Buy into a mutual funds or tracker

No mutual funds can consistently outperform market, investor should not buy ones with high management fees or that pays sales commissions to brokers but rather should purchase a no-load (commission-free) mutual fund that has low management fees.

Expected Return on Security

Optimal Forecast of the Return & Equilibrium Return

2 Arbitrage Types

Pure Arbitrage and Arbitrage with risks

Short sales in Behavioral Finance

Short selling is when people borrow stocks from brokers and sell them in the market. They hope that they will earn profit by buying the stocks again (covering the short) after it has fallen in price.

Market Overreaction

Stocks may overreact to news announcements and the pricing errors are corrected only slowly. When corporations announce a major change in earnings, say, a large decline, the stock price may overshoot. This violates EMH due to investor earn abnormally high returns by buying stock immediately conclude to selling it after weeks and its back to normal level

Small Firm Effect

The Small-Firm Effect is an anomaly. Small firms have earned abnormally high returns over long periods of time, even when the greater risk for these firms has been considered. The small-firm effect seems to have diminished in recent years but is still a challenge to the theory of efficient markets. Possible Causes: Rebalance of portfolios by investors, stocks or firms.

Behavioral finance

The concepts from other social sciences such as anthropology, sociology and commonly psychology to understand behavior of securities prices.

Overview of Evidence on the Efficient Market Hypothesis

The evidence seems to suggest that the EMH can be a reasonable starting point for evaluating behavior in financial markets, but there is a violation of the market efficiency that suggests that the efficient market hypothesis may not be the whole story and may not be generalizable to behavior in financial markets.

Theory John Bogle

Two things: we buy everything, the whole market and never sell (hold onto it)

How valuable are published reports by investment advisers?

We should look for legal information that's useful. We try to discover things earlier than anyone else by looking at evolution of friends, influences. We should find new information. No forecaster is accurate at predicting market, there will always be a group of consistent winders.

Should you be skeptical of hot tips?

Yes, The EMH indicates that you should be skeptical of hot tips. The stock market has already priced the hot tip stock so that its expected return will equal the equilibrium return. As soon as the information hits the street, the unexploited profit opportunity will be quickly eliminated.

Overconfidence and social contagion:

describing the stock market bubble

Pure arbitrage

elimination of unexploited profit opportunities have no risks

Market Fundamentals

items that have a direct impact on the future income stream of the securities

Random Walk

movement of a variable whose future changes cannot be predicted because with the today's value given, the variable is just likely as to fall as to rise.

Theory of Efficient Capital Markets = Efficient Market Hypothesis

price of the securities in financial markets will fully reflect on all available information

Positive feedback loop

prices continues to rise with speculative bubble which it finally crashes when the price gets too far out of line with fundamentals.

"buy and hold" strategy

purchase stocks and holds them for a long period of time leading to same return on average, but higher investor's net profit due to less brokerage commission paid.

Technical Analysis

study the past stock price data and find for patterns (trends and regular cycles) EMH suggests that technical analysis is a waste of time. Best way to understand the reasons of using the random walk result where the past stock price data cannot help predict changes in stock prices. Therefore, technical analysis, which relies on such data to produce its forecasts, cannot successfully predict changes in stock prices

Random Walk

the movement of a variable whose future changes cannot be predicted because with today's value given, the variable is just likely as to fall as to rise.