Market Efficiency

Weak-Form Market Efficiency

Current security prices fully reflect ALL CURRENTLY AVAILABLE SECURITY MARKET DATA. * past price and volume information will have no predictive power about the future direction of security prices. *investor cannot achieve positive-risk adjusted returns on average by using TECHNICAL ANALYSIS. Markets can be weak-form efficient without being semi-strong form or strong form efficient.

Implications of Anomalies

Majority of the evidence suggests that reported anomalies are not violations of market efficiency, but are due to the methodologies used in the tests of market efficiency. Underreaction and overreaction have both been found in the market, suggesting that prices are efficient on average. Anomalies are transient relations, too small to profit from, or simply reflect returns to risk that the researchers have failed to account for. *Portfolio management based on previously identified anomalies will likely be unprofitable.

Strong-Form Market Efficiency

Security prices fully reflect ALL INFORMATION FROM BOTH PUBLIC AND PRIVATE SOURCES -- past security market information, public information, and inside information. No group of investors should be able to consistently achieve positive abnormal returns. Given the prohibition on insider trading in most markets, markets are not strong-form efficient.

Abnormal Profit / Risk-Adjusted Return

calculations are often used to test market efficiency. To calculate abnormal profits, the expected return for a trading strategy is calculated given its risk, using a model of expected returns such as CAPM or a multifactor model. If, on avg., returns are greater than equilibrium expected returns, we can reject the hypothesis of efficient prices with respect to the information on which the strategy is based.

Information cascases

potential explanation for the evidence of the slow adjustment of security prices to new information the idea that uninformed traders, when faced with unclear information, watch the actions of informed traders to make their decisions. somewhat similar to herding behavior (trading occurs in clusters and is not necessarily driven by information); information cascades do not necessarily tend toward correct security pricing

Technical Analysis

seeks to earn +ive risk-adjusted returns based on historical price and trading (volume) data. Evidence shows that in general, technical analysis does not produce abnormal profits, so can't reject the hypothesis of weak-form efficiency. Technical analysis has been shown to have success in emerging markets.

Factors that affect the degree of market efficiency:

*Number of market participants - the larger the # of investors, the more efficient the market. *Availability of information - more information available, more efficient market. - depends on country, asset type, OTC/regulated exchange -reg FD (fair disclosure) requires that firms disclose the same information to the public that they disclose to stock analysts. *Impediments to trading - impediments to arbing out inefficiencies will make markets less efficient - short selling makes markets more efficient *Transaction and information costs - if costs of information, analysis, and trading are greater than the potential profit from trading misvalued securities, market prices will be less efficient.

Other behavioral biases:

*representativeness - investors assume good companies / good markets are good investments. *gambler's fallacy - recent results affect investor estimates of future probabilities *mental accounting - investors classify different investments into separate mental accounts instead of viewing them as a total portfolio *conservatism -investors react slowly to changes *disposition effect - investors are willing to realize gains but unwilling to realize losses. *narrow framing - investors view events in isolation.

Other Anomalies

Closed-End Investment Funds - shares of closed-end investment funds that sometimes deviate from NAV of the fund shares, often trade at large discounts to NAV. Transaction costs would eliminate any profits from exploiting the unexplained portion of closed-end fund discounts. Earnings announcements - positive/negative earnings surprises lead to positive/negative price reaction beyond one day. IPOs - typically underpriced, but long-term performance of IPO shares as a group is below average, suggesting that investors overreact in that they are too optimistic about a firm's prospects on the offer day. Economic Fundamentals

Semi-Strong Form Market Efficiency

Current security prices fully reflect ALL PUBLICLY AVAILABLE INFORMATION. Security prices rapidly adjust without bias to the arrival of all new public information. Security prices include all past security market information and nonmarket information available to the public. *Investor cannot achieve positive risk-adjusted returns on average by using FUNDAMENTAL ANALYSIS. If markets are semi-strong form efficient, they must also be weak-form efficient, since public information includes market information. If markets are semi-strong form efficient, investors should invest passively.

Who came up with 3 forms of market efficiency?

Eugene Fama

Market Value vs. Intrinsic Value

Market Value - asset's current price. Intrinsic Value - value that a rationale investor with full knowledge about the asset's characteristics would willingly pay. In highly efficient markets, investors can typically expect market values = intrinsic values. The more complex an asset, the more difficult it is to estimate its intrinsic value. Intrinsic value is constantly changing as new (unexpected) information becomes available.

Informationally Efficient Capital Market

Market in which the current price of a security fully, quickly, and rationally reflects all available about that security. "You can't beat the market" In a perfectly efficient market, investors should use a PASSIVE INVESTMENT STRATEGY since ACTIVE INVESTMENT will underperform due to transaction costs and management fees. Generally, markets are neither perfectly efficient nor completely inefficient. To determine the degree of market efficiency, look at the lag from the time that information is disseminated to the time prices reflect the value implications of that information. Only new information (not well-anticipated information) should move prices.

Market Anomalies in Cross-Sectional Data

Size effect - small caps outperform large stocks. Could not be confirmed in later studies, suggesting that either oppty was eliminated, or that the finding was random result. Value effect - finding that value stocks (lower P/E, M/B, higher div yields) outperformed growth stocks. Violates semi-strong form efficiency.

Market Anomalies in Time Series Data

avoid data snooping/data mining bias *Calendar anomalies - January effect, turn of the year effect. Can be explained by tax-loss selling or window dressing. Does not appear to persist over time. *Overreaction anomaly - firms with poor stock returns over the prev 3-5 years have better subsequent returns than firms that had high stock returns over the prior period. Pattern is present for some bonds and in some international markets. Violates weak-form market efficiency. *Momentum anomaly - high short-term returns are followed by continued high returns. Pattern is present in some international markets. Violates weak-form market efficiency.

Fundamental Analysis

based on public information such as earnings, dividends, and accounting ratios/estimates. Semi-strong form says that all public info is already reflected in stock prices. EVENT STUDY - method of testing semi-strong form. Examine abnormal returns before and after the release of new information that affects a firm's intrinsic value. Evidence in developed markets suggests that markets are generally semi-strong form efficient, but there is evidence of semi-strong form inefficiency in emerging markets.

Behavioral Finance

examines investor behavior, its effect on financial markets, how cognitive biases may result in anomalies, and whether investors are rational. If investor rationality is viewed as a prerequisite for market efficiency, then markets are not efficient. If market efficiency only requires that investors cannot consistently earn abnormal risk-adjusted returns, then research supports the belief that markets are efficient. Loss aversion - tendency for investors to be risk averse when faced with potential losses and less risk averse when faced with potential gains. Investors dislike losses more than they like gains of an equal amount. If there is a prevalence of investor overconfidence, securities will be mispriced.