efb201 sam week 2

What is an efficient capital market? Illustrate with an example.

An efficient capital market is one in which prices adjust instantaneously and in an unbiased fashion to the receipt of new information. For example, if a company announces an unexpectedly large increase in profit, then this information should be impounded in the company's share price within a very short time and there should be no expectation of making abnormal returns by purchasing shares in the company at the new price. Likewise, if the RBA unexpectedly drops interest rates, we would expect Commonwealth Bond prices to rise.

What does the EMH imply for a portfolio manager?

If the portfolio manager has superior analysts then they should concentrate on the areas where the analysts have expertise. Without superior analysts, the portfolio manager can still perform a valuable service. The major efforts of the portfolio manager should be directed toward determining the risk preferences of his clients and offering, accordingly, a portfolio approximating the risk and return desires of the clientele. Second, the portfolio manager should attempt to achieve complete diversification - eliminate all unsystematic risk. Thus, the portfolio should be highly correlated with the market portfolio of risky assets. Finally, it is important to minimize transactions costs - minimize taxes for the client, minimize commissions by reducing trading turnover, and minimizing liquidity costs by only trading currently liquid stocks.

Can a market be weak form inefficient, but strong form efficient?

No. If a market is weak form inefficient then it doesn't reflect past price information. This implies it doesn't reflect all available information (hence it can't be strong-form efficient).

GJ posts his share tips online every morning. Jim has been following them and has consistently lost 20% PA over the last 5 years. What does this suggest about market efficiency?

Semi-strong market inefficiency. In an efficient share market it should be just as a hard to be a consistent loser as it is a winner. As a strategy, do the opposite of GJ (i.e. buy when he says sell and sell when he says buy) and this should generate a consistent abnormal return).

Discuss what is meant by the joint test issue in EMH tests.

Studies on market efficiency are considered to be dual tests of the EMH and a pricing model (e.g. the Capital Asset Pricing Model). These tests involve a joint hypothesis because they consider not only the efficiency of the market, but also are dependent on the asset pricing model that provides the measure of risk used in the test. For example, if a test determines that it is possible to predict future differential risk-adjusted returns, the results could either have been caused by the market being inefficient or because the risk measure is bad thereby providing an incorrect risk-adjusted return.

What does the EMH imply for a technical analyst?

The basic premise of technical analysis is that the information dissemination process is slow-thus the adjustment of prices is not immediate but forms a pattern. This view is diametrically opposed to the concept of efficient capital markets, which contends that there is a rapid dissemination process and, therefore, prices reflect all information. Thus, there would be no value to technical analysis because technicians act after the news is made public which would negate its value in an efficient market.

What would cause a market to be efficient?

The main argument in support of efficiency is the existence of a competitive market in which numerous investors are competing in an effort to make abnormal returns. It is suggested that, in such a market, investors will seek information and take immediate action to buy or sell securities based on any new information. As a result, information will be impounded very quickly in market prices. Market efficiency may be improved by an increase in the quantity and quality of information that is made publicly available, and a reduction in restrictions on insider trading.

What does the EMH imply for a fundamental analyst?

The proponents of fundamental analysis advocate that at one point in time there is a basic intrinsic value for the aggregate stock market, alternative industries, and individual securities and if this intrinsic value is substantially different from the prevailing market value, the investor should make the appropriate investment decision. In the context of the efficient market hypothesis, however, if the determination of the basic intrinsic value is based solely on historical data, it will be of little value in providing above average returns. Alternatively, if the fundamental analyst makes superior projections of the relevant variables influencing stock prices then, in accordance with the efficient market hypothesis, he could expect to outperform the market. The implication is that even with an excellent valuation model, if you rely solely on past data, you cannot expect to do better than a buy-and-hold policy. In short, if markets are reasonably semi strong-from efficient, then the fundamental analyst either needs to be very good or have access to information the market doesn't in order to make a consistent abnormal return.

. Define and discuss the semi strong-form form EMH. Describe two sets of tests used to examine the semi strong-form EMH.

The semi strong-form efficient market hypothesis contends that security prices adjust rapidly to the release of all new public information and that prices reflect all public information. The semi strong-form goes beyond the weak-form because it includes all market and also all nonmarket public information such as stock splits, economic news, political news, etc. Using the organization developed by Fama, studies of the semi strong-form EMH can be divided into two groups: (1) Studies that attempt to predict futures rates of return using publicly available information (goes beyond weak-form EMH). (2) Event studies that examine abnormal rates of return surrounding specific event or item of public information. These studies determine whether it is possible to make average risk-adjusted profits by acting after the information is made public.

Define and discuss the strong-form form EMH. Describe two sets of tests used to examine the strong-form EMH.

The strong-form efficient market hypothesis asserts that stock prices fully reflect all information, whether public or private. It goes beyond the semi strong-form because it requires that no group of investors have a monopolistic access to any information. The strong-form efficient market hypothesis can be tested by looking at the trades of insiders and examining the performance of professional fund managers.

Define and discuss the weak-form form EMH.

The weak-form efficient market hypothesis contends that current prices reflect all available security-market information including the historical sequence of prices, price changes, and any volume information. The implication is that there should be no relationship between past price changes and future price changes. Therefore, any trading rule that uses past market data alone should be of little value.

Interpret the following statements in terms of market efficiency (a) Shares continue to rise for two weeks after a profit increase is announced. (b) Small firms consistently earn larger returns than large firms. (c) The Australian dollar always falls after Christmas but rises after Australia Day. (d) Shares in the target companies rise before a takeover is announced.

a) Semi-strong inefficiency. (b) Possibly semi-strong inefficiency, but more likely the result that small firms are riskier than large firms. If the small firms are riskier than the large firms then the larger return is consistent with market efficiency. (c) Weak Form inefficiency. (d) Strong Form inefficiency.