Financial Management Topic 12

Three forms of market efficiency

weak form, semi-strong form, strong form efficiency

(connect) Assume all stock prices fairly reflect all of the available information on those stocks. Which one of the following terms best defines the stock market under these conditions?

Efficient capital market

(connect) Which one of the following statements related to market efficiency tends to be supported by current evidence?

Markets tend to respond quickly to new information

Financial Markets

Serve a lot of important functions, one of which is giving us information about the relation between risk and returns

How do we know this?

by looking at returns over very long periods of time for various types of investments

Average returns in small stocks

highest returns (high risk), highest fluctuations in price (high standard deviation and variance)

(connect) To convince investors to accept greater volatility, you must:

increase the risk premium

(connect) Evidence seems to support the view that studying public info to identify mispriced stocks is

ineffective

Which one of the following categories of securities had the highest average annual return for the period 1926-2016?

small- company stocks

(connect) Inside information has the least value when financial markets are:

strong-form efficient

Efficient financial markets fluctuate continuously because

the markets are continually reacting to new info

Looking back through time, we know that:

--There is a reward for bearing risk --The greater the risk, the greater the return --That is, risk and return go hand in hand

semi-strong efficiency

-Prices reflect all public (but not private) information -Investors cannot earn returns disproportionate to risk by trading on publicly available information -Empirical evidence indicates that markets are for the most part semi-strong form efficient

weak form efficiency

-Prices reflect only past market information such as past prices and past volume -Investors cannot earn returns disproportionate to risk by trading on trends and patterns in data -Technical analysis does not work!!!

What makes markets efficient?

-There are many investors out there doing research. -As new information comes to market, this information is analyzed and trades are made based on this information -Therefore, prices should reflect all available public information -If investors stop researching stocks, then the market will not be efficient

efficient capital market

-market where prices reflect all available information -stock prices are fairly priced -prices only react to "new" info and if the info is unexpected -all stock investments are "zero" NPV investments

strong form efficiency

-prices reflect all information, including public and private -Investors can not earn returns disproportionate to risk regardless of what information they possess -Reality check --> markets are NOT strong form efficient --> E.g., insiders can earn abnormal returns

Know this for exam

Computing returns: The difference between expected and realized returns Computing Variance: Computing realized and expected variance Risk and return: Higher risk implies higher returns. No risk w/o return Efficient Market Hypothesis: Efficient market hypothesis and three forms of market efficiency

Efficient markets mean?

DO NOT mean that you can't make money do mean that, on average, you will earn a return that is appropriate for the risk undertaken and there is not a bias in prices that can be exploited to earn excess returns

Average returns in short-term government bonds

lowest rate of returns risk free

(connect) Individual investors who continually monitor the financial markets seeking mispriced securities:

make the markets increasingly more efficient

(connect) You are aware that your neighbor trades stocks based on confidential information he overhears at his workplace. This information is not available to the general public. This neighbor continually brags to you about the profits he earns on these trades. Given this, you would tend to argue that the financial markets are at best _____ form efficient.

semi-stong form efficient

(connect) Which form of market efficiency would most likely offer the greatest profit potential to an outstanding professional stock analyst?

weak