Ch. 7- stock price behavior and market efficiency

(new information)Efficient market reaction:

The price instantaneously adjusts to, and fully reflects, new information. There is no tendency for subsequent increases or decreases to occur.

(new information)Overreaction and correction:

The price over-adjusts to the new information; it overshoots the appropriate new price but eventually falls to the new price.

(new information)Delayed reaction

The price partially adjusts to the new information, but days elapse before the price completely reflects new information.

Efficient market hypothesis (EMH):

Theory asserting that, as a practical matter, the major financial markets reflect all relevant information at a given time.

to clarify the three forms of market efficiency

To be clear, if the information allows an investor to earn excess returns on an investment, the market is not efficient with respect to that information. Therefore, if an investor uses past price information to earn an excess return, then the market is not weak-form efficient. If an investor uses a firm's financial statements to earn an excess return, the market is not semistrong-form efficient. Finally, if an investor uses inside information to earn an excess return, the market is not strong-form efficient.

"Beat the Market"

To judge if an investment "beat the market," we need to know if the return was high or low relative to the risk involved. We need to determine if the investment has earned a positive excess return in order to say it "beat the market."

A random walk

is related to the weak-form version of the efficient market hypothesis because past knowledge of the stock price is not useful in predicting future stock prices.

Rational Investors

If every investor always made perfectly rational investment decisions, earning an excess return would be difficult. If everyone is fully rational, equivalent risk assets would all have the same expected returns. Put differently, no bargains would be there to be had, because relative prices would all be correct.

market efficient example

). Suppose Fidelity was able, through its research, to improve the performance of this fund by 20 basis points for one year only. How much would this one-time 20-basis point improvement be worth? The answer is 0.0020 times $45 billion, or $90 million. Thus, Fidelity would be willing to spend up to $90 million to boost the performance of this one fund by as little as one-fifth of 1 percent for a single year only. This example shows that even relatively small performance enhancements are worth tremendous amounts of money and thereby create the incentive to unearth relevant information and use it.

Strong-form efficient market:

A market in which information of any kind, public or private, is of no use in beating the market. everything

Weak-form efficient market

A market in which past prices and volume figures are of no use in beating the market.Technical analysis

Semistrong-form efficient market:

A market in which publicly available information is of no use in beating the market. fundamental and behavorial

Excess return:

A return in excess of that earned by other investments having the same risk.

Prices can adjust to news announcements in three ways:

Efficient market reaction, Delayed reaction, Overreaction and correction

How does new information get into stock prices

In its semi-strong form, the EMH is the simple statement that stock prices fully reflect publicly available information. Stock prices change when traders buy and sell shares based on their view of the future prospects for the stock. The future prospects for the stock are influenced by unexpected news announcements.

Three economic forces can lead to market efficiency

Rational Investors, Independent deviations from rationality, Arbitrage. any one of them can result in market efficiency

Market efficiency:

Relation between stock prices and information available to investors indicating whether it is possible to "beat the market;" if a market is efficient, it is not possible except by luck.

If markets are efficient:

Security selection is less important; investors may as well hold index funds to minimize their costs. There is little need for professional money managers. Investors should not try to time the market. (In fact, successful market timing is very difficult to achieve, even ignoring market efficiency.)

random walk example

To qualify as a true random walk, Intel stock price changes would have to be independent and identically distributed. Still, the graph of daily price changes for Intel stock is essentially what a random walk looks like. It is certainly hard to see any pattern in these daily price changes.

"A market is efficient with respect to some particular information if that information is not useful in earning a positive excess return." So, a market can only be determined to be efficient with respect to specific information. The three forms include

Weak-form efficiency, with respect to information reflected in past price and volume figures. Semistrong-form efficiency, with respect to any publicly available information. Strong-form efficiency, with respect to any information, both public and private.

Implications of market efficiency with respect to the forms of market efficiency, as follows

Weak-form efficiency: If weak-form efficiency holds, then technical analysis is of no use, and the efforts of technical analysts are of no benefit to investors. Semistrong-form efficiency: If semistrong-form efficiency holds, then fundamental analysis using publicly available information is of no benefit, and most of the financial analysts and mutual fund managers are not providing any value. Strong-form efficiency: If strong-form efficiency holds, then inside information is of no value, suggesting that there should be no restrictions on insider trading.

Arbitrage

buying relatively inexpensive stocks and selling relatively expensive stocks. suppose collective irrationality does not balance out. suppose there are some well-capitalized, intelligent, and rational investors if rational traders dominate irrational traders, the market will still be efficient.

Market efficiency cont.

driving force toward market efficiency is simply competition and the profit motive. even a relatively small peformance enhancement can be worth a tremendous amount of money. This profit potential creates incentives to unearth relevant information and use it.

Random walks and stock prices

many people would say stock market prices are predictable. actually it is very difficult to predict stock market prices. stock market prices change through time as if they are random. when there is no discernible pattern to the path that a stock price follows, then the stock's price behavior is largely constant with the notion of a random walk.

A. Does Old Information Help Predict Future Stock Prices?

researchers have sued sophisticated techniques to test whether past stock movements help predict future stock price movements Not enough predictability to earn an excess return. Result: buy-and-hold strategies involving broad market indexes are extremely difficult to putperform

Independent deviations from rationality

suppose that many investors are irrational the net effect might be that these investors cancel each other out. so, irrationality is just noise that diversified away. what is important here is that irrational investors have different beliefs