Financial Economics - Chapter 6 - Are Financial Markets Efficient?

How is a bubble created?

-A bubble is when the prices of assets rise well above their fundamental values -Caused by overconfidence and social contagion -When stock prices go up, investors attribute profits to their intelligence and talk up the stock market -This word-of-mouth enthusiasm causes even more investors to think stock prices will rise, which will produce a speculative bubble

What is excessive volatility?

-Fluctuations in stock prices may be much greater than is warranted by fluctuations in their fundamental value

What is the small firm effect?

-Small firms have earned abnormally high returns over long periods of time

What is the January effect?

-Stock prices experience an abnormal price rise from December to January -May be due to sell of to reduce tax liability before year end

What is market overreaction?

-Stock prices may overreact to news announcements and that pricing errors are corrected only slowly

Do stock prices always rise when there is good news?

-Stock prices will respond to announcements only when the information being announced is new and unexpected

What is mean reversion?

-Stock with low returns today tend to have high returns in the future, and vice versa

What is the efficient market hypothesis?

-Views expectations as equal to optimal forecasts using all available information -A security's price fully reflects all available information in an efficient market

What are evidence in favor of market efficiency?

1. Performance of investment analysts and mutual funds 2. Stock prices reflect all publicly available information 3. Random-walk behavior of stock prices (future changes in stock prices are unpredictable) 4. Technical analysis

What are evidence against market efficiency?

1. Small firm effect 2. January effect 3. Market Overreaction 4. Excessive Volatility 5. Mean reversion 6. New info not always immediately incorporated into stock prices

How did economists test the random walk hypothesis?

1. Used past prices and trends to see if stock prices in the past could be used to predict future prices 2. Used data to see if publicly available info other than stock prices could be used to predict changes (government spending, growth in money supply, interest rates) Both results proved that stock prices are not predictable and follow a random walk