Market Efficiency

Time Series Anomalies: Calendar and Momentum/Overreaction

Calendar: January effect Momentum/Overreaction: investors overreact to release of unexpected public information - stock prices inflated on release of good news.

Other Anomalies

Closed-End Investment Fund Discounts: on average, they trade at discounts to their NAV Earnings Surprise: IPOs: IPO is set too low and price increases on first day of trading Most evidence supports idea that markets in developed countries are semi strong form, however evidence does not support strong form

Implications of Efficient Market Hypothesis

For Developed Markets: Markets are weak form efficient - investors cannot earn abnormal returns by trading on basis of historical prices Markets are semi strong efficient -investors cannot earn abnormal return by studying financial statements as that info is already reflected in asset price Markets are NOT strong efficient - securities laws are intended to prevent exploitation of private information

Information Cascades

Herding: clustered trading that may or may not be based on information Information Cascade: transmission of information from those participants who act first and whose decisions influence the decision of others.

Factors that affect Market Efficiency

Market Participants: more participants = more efficiency Information Availability and Financial Disclosure: the more info available, the more efficeint markets are. Limits to trading: when investors are unable to short securities, or when costs to short securities is high, market prices may deviate from intrinsic values Transaction Costs and Info Acquisition Costs: higher costs related to gaining information and acting on the information cause markets to be less efficient

Market Value vs. Intrinsic Value

Market Value = price asset can be bought or sold. The intersection of supply and demand Intrinsic Value = value that would be placed on asset by investors if they had complete understanding of assets investment characteristics. Present value of all expected future cash flows of the asset If market is highly efficient, investors usually accept market prices as accurately reflecting intrinsic values If IV> MV = undervalued asset

Other Behavioral Biases

Representativeness, gambler's falacy, mental accounting, conservatism, dispositoin effect, and narrow framing. Disposition Effect: investors tend to avoid realizing losses and seek to realize gains Narrow Framing: investors focus on issues in isolation

Cross Section Anomalies:

Size Effect: small caps out perform large caps on risk adjusted basis Value Effect: stocks with below average P/E, and above average dividend yields, have consistently outperformed growth stocks over long periods of time.

Efficient Market

a market in which asset prices reflect new information quickly and rationally. A market in which asset prices reflect all past and present information. no market is perfectly efficeint prices should be expected to react only to the elements of information releases that are not anticipated fully by investors reducing number of market participants can accentuate market imperfections and impede market efficiency Penalizing insider trading encourages market participation, which increases market efficiency

Market Anomalies

anomalies are exceptions to the notion of market efficiency excess returns are not attributed to any new or relevant information

Market Efficiency

concerns the extent to which market prices incorporate available information. If they do not fully incorporate info, then opportunities may exist to make profit from gathering and processing info.

Fundamental Analysis

examination of public information to estimate intrinsic value of asset assume markets are semi strong inefficient Fundamental analysis helps semi strong markets by disseminating value relevant information

Behavioral Finance

field of financial thought that examines investor behavior and how this behavior affects what is observed in financial markets. Market can still be considered efficient even if market participants exhibit irrational behavior, such as herding. Efficient Market Hypothesis requires only that markets are rational. Attempts to begin to explain why investors do what they do and begins to possibly explain pricing anomalies. Risk Aversion: investors are willing to assume risk if compensated with higher returns. Overconfidence: investors place too much emphasis on their ability to process and interpret information about a security. They do not process information appropriately which may lead to stocks being mispriced.

Technical Analysis

investors look at patterns of prices and trading volumes Technical Analysts believe that market is weak form inefficient Although some patterns persists, exploiting these patterns may be too costly and would not produce abnormal returns By detecting and exploiting patterns in prices, technical analysis assists markets in maintaining weak form efficiency

Weak Form

prices reflect all past market data (historical prices and volume information) Investors cannot predict future price changes by extrapolating prices or patterns of prices from past

Semi Strong Form

prices reflect all past market data as well as all publicly known and available information (financial statement data) If market is semi-strong, than it must be weak form too. Efforts to analyze public information are futile because that info is already reflected in asset price

Strong Form

security prices reflect all historical prices, all public info, and all private info. Strong form market is also semi strong and weak Even insiders would be unable to generate abnormal returns from trading on basis of private info Many studies have found that investors can generate abnormal returns by trading on basis of private info